1. Financial Markets and Institutions 6th Edition
PowerPoint Slides for:
Financial Markets and Institutions 6th Edition
By Jeff Madura
Prepared by
David R. Durst
The University of Akron

2. Insurance
Operations 26

3. Chapter Objectives
Present the two major areas of insurance: 1) life and health and 2) property and casualty
Describe the different types of insurance policies and their sources of funds
Describe the main uses of insurance company funds
Explain the exposure of insurance companies to various forms of risk
Describe the regulatory environment of insurance companies

4. Insurance Companies Provide contractual risk management for:
Risks of insurable asset losses (auto insurance)
Risks of liability claims (product liability)
Risk of large medical costs (health insurance)
Risk of disability (disability insurance)
Risk of premature death (life insurance)
Risk of longevity (annuities)

5. Insurance Companies, cont.
Major capital market intermediary
Major investor in corporate (life) and state and municipal bonds (property/casualty)
Major long-term commercial mortgage lender (life)
Mutual or stock form of ownership
Premium and investment revenue
Losses and loss adjustment expenses

6. Insurance Concepts Pure vs. financial risk
Insure fortuitous, independent risk occurrence
Premium covers losses, administrative expenses and profits
Insured contracts for known loss (premium) in return for protection
Moral hazard and adverse selection

7. Background Life insurance companies
Provide risk management contracts for individuals and businesses
Risk areas include premature death, health maintenance costs, and disability
Life insurance provides cash benefits to the beneficiary of a policy on the policyholder’s death
Life insurance premiums reflect
Probability of making payment to the beneficiary
Size and timing of the payment
Have portfolios of policies and use mortality figures and actuarial tables to forecast claims

8. Types of Life Insurance Policies
Cash Value Insurance
Term Insurance
Group
Universal Life
Group
Variable Life
Term
Whole Life

9. Types of Life Insurance Policies
Whole life insurance includes both a death benefit (term insurance) and a savings component that
Builds a tax sheltered cash value amount for the future for the owner of the policy
Generates periodic cash flow payments over the life of the policy for the insurance company to reinvest
Pays fixed death benefit at death

10. Types of Life Insurance Policies
Term life insurance characteristics
Temporary, providing death benefits only over a specified term
Premiums paid represent insurance only with no saving component
Considerably lower cost for the insured than whole life—able to buy more insurance protection for any amount of premium
Term is for those who would rather invest their savings in other contracts or securities

11. Types of Life Insurance Policies
Variable life insurance
Whole life with variable cash value amounts
Cash values invested in equities and will vary with the investment performance
Flexible premium option since 1984
Universal life insurance
Combines the features of term and whole life
Variable premiums over time—buys terms and invests difference in a variety of investments
Builds a varying cash value based on contributions and investment performance

12. Types of Life Insurance Policies
Group plans
Employees of a corporation offered life insurance or life insurance purchased on life of employee
Cash value or term insurance
Low cost (term) because of its high volume
Can cover group members and dependents

13. Health Care Insurance Health maintenance organizations or HMOs
Intermediaries between purchasers and providers of health care
Annual fee or premium
Covers all medical expenses
Medical staff is designated by the HMO
Losses in recent years for HMOs

14. Sources of Life Insurance Company Funds
Cash value reserves—accumulated cash values owed insureds (liability)
Pension reserves—accumulated “insured” pension commitments (liability)
Annuity reserves—accumulated annuity commitments (liability)
Unearned premium income—premiums received; not yet earned (liability)
Loss reserves--losses incurred, not yet paid
Capital funds

15. Uses of Life Insurance Company Funds
Major investor in corporate bonds
Government securities
Common stock
Commercial mortgage
Real Estate
Policy loans to insured

16. Uses of Funds—Policy Loans
Policy loans are loans to policyholders
Whole life policies
Borrow up to the cash value of the policy
Guaranteed interest rate is stated in the policy
Usually used by borrowers during periods of rising rates to lock in the lower rate associated with their policy

17. Insurance Company Capital
Build capital by issuing new stock (stock companies) or retaining earnings
Used to finance investments in fixed assets
Cushion against operating losses
Capital requirements vary depending on asset risk
Credibility with customers is also enhanced by adequate capital
Mutual companies owned by policyholders—includes earnings retained over time

18. Regulation
Insurance companies are highly regulated by state insurance agencies
The National Association of Insurance Commissioners (NAIC)
Provides coordination among states in regulatory matters
Adopted uniform regulatory reporting standards
State Regulators
Make sure insurance companies provide adequate service
States approve/review rates
Agent licensure
Forms are approved to avoid misleading wording

19. Regulation Insurance Regulatory Information System Assessment system
Compiles financial information and lists of insurers
Calculates 11 ratios to assess and monitor financial health
Assessment system
Ability of the company to absorb either losses or a decline in the market value of its investments
Return on investment
Relative size of operating expenses
Liquidity of the the asset portfolio

20. Regulation Regulation of capital
In 1994 companies were required to report risk-based capital ratios to insurance regulators
Goals of requirements are to
Discourage insurance companies from excessive exposure
Back higher risks with higher capital
Reduce failures in the industry

21. Risks of Life Insurance Companies
Pure Risk of Life
Insurance Policies
Pension
Commitments and
Annuities Contracts
Financial Risk
includes
Interest Rate Risk
Credit Risk
Market Risk
Liquidity Risk

22. Exposure to Financial Risks
Interest rate risk
Fixed rate assets in company portfolios have market values sensitive to interest rate changes
Firm measures and manages risks
Credit risk
Mortgages, corporate bonds and real estate holdings can involve default
Investment-grade securities
Diversify portfolio among debt issuers

23. Exposure to Financial Risks
Market risk
Exists because events like significant market value decreases reduce capital
Economic downturn affects real estate investments

24. Exposure to Financial Risks
Liquidity risk occurs because a high frequency of claims may require the life company to liquidate assets
Life insurance companies have high cash flow from premiums to offset normal cash needs
In case of large disaster (9/11) may be forced to sell assets to generate cash even if market value is low
Companies try to balance the age distribution of their customer base
As interest rates rise, voluntary terminations of policies occur

25. Asset Management
Performance is significantly affected by the performance of the assets
Companies get premiums for several years before paying out benefits
Companies try to manage the risk of losses with offsetting investment gains or diversity of assets they hold
Diversify into other businesses to offer a wide variety of financial products

26. Property and Casualty Insurance
Property insurance (fire insurance)
Casualty insurance (liability)
Performance and financial bonding

27. PC Versus Life Insurance Companies
PC have shorter contracts
PC have more varied risk areas
Life companies larger due to long-term savings and pension contracts
PC has wider distribution of Occurrences
PC’s need liquid, marketable assets
PC’s earnings more volatile

28. Property Casualty Investment Needs
Tax sheltering--major municipal/state bond investor
Liquid, marketable assets
Marketable corporate and government bonds
Listed common stock
Inflation hedge--common stock
Reinsurance contracts--manage pure risks

29. Valuation of an Insurance Company
Value of an insurance company depends on its expected cash flows and required rate of return
V = f [E(CF), k] +
Where:
V = Change in value of the insurance company
E(CF) = Change in expected cash flows
k = Change in required rate or return

30. Valuation of an Insurance Company
Factors that affect cash flows
E(CF)= f (ECON, Rf , INDUS, MANAB) + ? +
Where:
E(CF) = Expected cash flow
ECON = Economic growth
Rf = Risk free interest rate
INDUS = Prevailing industry conditions for the company
MANAB = Management ability of company

31. Valuation of an Insurance Company
Investors required rate of return
k = f(Rf , RP) + +
Where:
Rf = Risk free interest rate
RP = Risk premium

32. Performance Evaluation
Common indicators of company performance are available
Statistical analysis of performance
Ratio analysis
Trends over time
Compare to industry average

33. Performance Evaluation
The higher the liquidity ratio, the more liquid the company
Invested Assets
Liquidity
Ratio =
Loss Reserves and
Unearned Premium Reserves

34. Performance Evaluation
Return on net worth or policyholders’ surplus is a profitability measure
Net Profits
Return on Equity =
Policyholders’ Surplus

35. Performance Evaluation
Underwriting gains and losses or underwriting profitability measured by the net underwriting margin
Profits include investment income, underwriting profits and realized capital gains
Ratios can be calculated to focus on various sources of profits
Net Underwriting
Premium Income - Policy Expenses =
Margin
Total Assets

36. Other Issues
Insurance companies interact in a variety of ways with other financial institutions
Insurance companies participate in a full range of financial markets
Multinational insurance companies
Insurance companies operate in many countries
Some countries lack developed markets for insurance
Multinational investments