1. Lecture 20
Insurance Companies

2. Chapter Preview
We look at two nonbank institutions: insurance companies and pension funds. We view them in a similar light as other financial intermediaries because they take funds from one sector and invest them in another. Topics include:
Insurance Companies
Fundamentals of Insurance
Growth and Organization of Insurance Companies
Types of Insurance

3. Chapter Preview Pensions Types of Pensions Regulation of Pension Plans
The Future of Pension Funds

4. Insurance Companies
Insurance companies assume the risk of their clients in return for a fee, called the premium.
Most people purchase insurance because they are risk-averse—they would rather pay a certainty equivalent (the premium) than accept a gamble

5. Fundamentals of Insurance
Although there are many types of insurance and insurance companies, there are seven basic principles all insurance companies are subject to:
There must be a relationship between the insured and the beneficiary. Further, the beneficiary must be someone who would suffer if it weren’t for the insurance.

6. Fundamentals of Insurance
The insured must provide full and accurate information to the insurance company.
The insured is not to profit as a result of insurance coverage.
If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of the compensation.

7. Fundamentals of Insurance
The insurance company must have a large number of insured so that the risk can be spread out among many different policies.
The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field.
The insurance company must be able to compute the probability of the loss’s occurring.

8. Adverse Selection and Moral Hazard in Insurance
Asymmetric information plays a large role in the design of insurance products. As with other industries, the presence of adverse selection and moral hazard impacts the industry. Any example of adverse selection in insurance?

9. Adverse Selection in Insurance
The adverse selection problem raises the issue of which policies an insurance company should accept:
Those most likely to suffer loss are most likely to apply for insurance.
In the extreme, insurance companies should turn anyone who applies for an insurance policy.

10. Adverse Selection in Insurance
However, insurance companies have found reasonable solutions to deal with this problem:
Health insurance policies require a physical exam.
Preexisting conditions may be excluded from the policy.

11. Moral Hazard in Insurance
Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy.
Insurance companies use deductibles to help control this problem.

12. Types of Insurance
Insurance is classified by which type of undesirable event is covered:
Life Insurance
Health Insurance
Property and Casualty Insurance

13. Life Insurance
Many insurance companies provide policies that offer retirement benefits as we;; as life insurance
In such a policy, the premium combines cost of life insurance with a saving program
The cost of of life insurance depends on age of the insured, average life expectancy, health and life style (smoking, adventurous), and insurance company operating costs

14. Life Insurance
In its simplest form, life insurance and provides income for heirs of the deceased
Life insurance policies come in many forms. Some of the typical policies include:
Term Life: the insured is covered while the policy is in effect, usually 10–20 years.
This form of policy contains no saving element
Once the policy period expires, there are no residual benefits
As the insured ages, the probability of death increases, so the cost of the policy rises

15. Types of Life Insurance
Whole Life: similar to term life, but require the insured to pay more in the beginning than the required premium
The overpayment accumulates as a cash value
The policy allows the policyholder to borrow against the cash value.
When the term of policy expires, the insured can get the cash value of the policy.

16. Types of Life Insurance
Universal life:
Universal life policy allows for cash value to accumulate at a much higher rate than in whole life
One important advantage that universal life policies have over many alternative investment plans is that the interest earned on the savings portion of the account is tax-exempt until withdrawn

17. Life Insurance
Annuities: pays a benefit to the insured until death, to cover retirement years.
These policies are more susceptible to the adverse selection problem (HOW?)

18. Expected Life of Persons at Various Ages

19. Sample Annual Premiums

20. Life Insurance: Company Assets and Liabilities
Life insurance companies derive funds from two sources:
They receive premiums that must be used to payout future claims when the insured dies
They receive premiums paid into pension funds managed by the life insurance company
The next figures shows the distribution of the typical life insurance company’s assets, as well as assets invested in mortgages.

21. Life Insurance: Company Assets and Liabilities

22. Life Insurance: Company Assets and Liabilities

23. Life Insurance: Company Assets and Liabilities
Life insurance companies have two primary liabilities:
Life insurance payouts
Pension fund payouts

24. Health Insurance
Health insurance policies are highly vulnerable to the adverse selection problem. Those with known or expected health problems are more likely to seek coverage.
This is why most health insurance is offered through group policies. Individual policies must be priced assuming adverse selection.

25. Health Insurance Health Insurance
Health insurance is a hot topic in the political environment, focusing on increased costs and availability of coverage.
Insurance programs are attempting to shift costs to the employers.
Health Maintenance Organizations are another attempt to keep costs down.

26. Property and Casualty Insurance
Property Insurance: protects businesses and owners from the risk associated with ownership.
Named-peril policies: insures against any losses only from perils specifically named in the policy
Open-peril policies: insures against any losses except from perils specifically named in the policy
Casualty Insurance
Reinsurance

27. Property and Casualty Insurance
Casualty Insurance: also known as liability insurance, it protects against financial losses because of a claim of negligence.
Reinsurance: allocates a portion of the risk to another company in exchange for a portion of the premium.

28. The Practicing Manager: Insurance Management
Screening
Risk-Based Premium
Restrictive Provisions
Prevention of Fraud
Cancellations of Insurance
Deductibles
Coinsurance
Limits on the Amount of Insurance