1. ©2009, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Fifteen Insurance Companies

2. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-2 McGraw-Hill/Irwin Insurance Companies (ICs) The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, in exchange for premiums paid –insurance underwriters assess and price risk –insurance brokers sell insurance contracts for coverage or for a policy Insurance is broadly classified into two groups –life insurance provides protection against untimely death, illness, and retirement –property-casualty insurance protects against personal injury and liability Insurance companies also sell a variety of investment products similar to other FIs The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, in exchange for premiums paid –insurance underwriters assess and price risk –insurance brokers sell insurance contracts for coverage or for a policy Insurance is broadly classified into two groups –life insurance provides protection against untimely death, illness, and retirement –property-casualty insurance protects against personal injury and liability Insurance companies also sell a variety of investment products similar to other FIs

3. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-3 McGraw-Hill/Irwin Life Insurance Companies Approximately 1,300 life insurance companies exist in the U.S. in the mid-2000s –compares to 2,300 in 1988 –the industry has seen consolidation to take advantage of scale and scope economies Aggregate industry assets were $4.8 trillion at the beginning of 2007 –compares to $1.1 trillion in 1988 Life insurance companies can be either stock or mutually owned (where the policyholders are the owners) Approximately 1,300 life insurance companies exist in the U.S. in the mid-2000s –compares to 2,300 in 1988 –the industry has seen consolidation to take advantage of scale and scope economies Aggregate industry assets were $4.8 trillion at the beginning of 2007 –compares to $1.1 trillion in 1988 Life insurance companies can be either stock or mutually owned (where the policyholders are the owners)

4. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-4 McGraw-Hill/Irwin Life Insurance Companies Life insurers pool the risks of individuals to diversify away some of the customer-specific risk –thus, they are able to offer insurance services at a cost lower than any individual could achieve saving funds on their own –allows the transfer of income related uncertainties from the individual to the group Other activities of life insurance companies –sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time –manage pension plans (e.g., tax-deferred savings plans) –provide accident and health insurance Life insurers pool the risks of individuals to diversify away some of the customer-specific risk –thus, they are able to offer insurance services at a cost lower than any individual could achieve saving funds on their own –allows the transfer of income related uncertainties from the individual to the group Other activities of life insurance companies –sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time –manage pension plans (e.g., tax-deferred savings plans) –provide accident and health insurance

5. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-5 McGraw-Hill/Irwin Life Insurance Companies Insurance companies accept or underwrite risk that a prespecified event will occur in return for insurance premiums –underwriting decisions determine which risks are accepted and which are not –underwriting decisions determine how much to charge (in the form of premiums) for accepted risk The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage Insurance companies accept or underwrite risk that a prespecified event will occur in return for insurance premiums –underwriting decisions determine which risks are accepted and which are not –underwriting decisions determine how much to charge (in the form of premiums) for accepted risk The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage

6. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-6 McGraw-Hill/Irwin Life Insurance Companies Moral hazard occurs when, after an insurer and a customer enter into an insurance contract, the insured takes an action not taken into account in the contract that changes the value of the insurance Actuaries reduce the risks of underwriting insurance –with life insurance, actuaries analyze mortality, produce life tables, and apply the time-value-of-money to produce life insurance annuities and endowment policies –with health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc. Moral hazard occurs when, after an insurer and a customer enter into an insurance contract, the insured takes an action not taken into account in the contract that changes the value of the insurance Actuaries reduce the risks of underwriting insurance –with life insurance, actuaries analyze mortality, produce life tables, and apply the time-value-of-money to produce life insurance annuities and endowment policies –with health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc.

7. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-7 McGraw-Hill/Irwin Life Insurance Companies Ordinary life insurance is marketed to individuals—policyholders make periodic premium payments in exchange for coverage –term life beneficiary receives payout at time of death if insured lives beyond the term of the contract no benefits are paid –whole life policy protects over entire lifetime beneficiary receives face value of contract upon death Ordinary life insurance is marketed to individuals—policyholders make periodic premium payments in exchange for coverage –term life beneficiary receives payout at time of death if insured lives beyond the term of the contract no benefits are paid –whole life policy protects over entire lifetime beneficiary receives face value of contract upon death

8. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-8 McGraw-Hill/Irwin Life Insurance Companies –endowment life beneficiary receives payment at time of death if insured lives beyond the term of the contract, insured receives face value of the contract –variable life premiums are invested in market securities value of policy depends on the value of the securities –universal life allows the insured to change both the premiums and the maturity of the contract –variable universal life combines features of variable and universal life insurance –endowment life beneficiary receives payment at time of death if insured lives beyond the term of the contract, insured receives face value of the contract –variable life premiums are invested in market securities value of policy depends on the value of the securities –universal life allows the insured to change both the premiums and the maturity of the contract –variable universal life combines features of variable and universal life insurance

9. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-9 McGraw-Hill/Irwin Life Insurance Companies Group life insurance covers a large number of persons under a single policy –contributory—both the employer and the employee cover a share of the premiums –noncontributory—the costs are borne entirely by the employer Credit life insurance protects lenders against borrower death Group life insurance covers a large number of persons under a single policy –contributory—both the employer and the employee cover a share of the premiums –noncontributory—the costs are borne entirely by the employer Credit life insurance protects lenders against borrower death

10. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-10 McGraw-Hill/Irwin Life Insurance Companies Other life insurance activities –annuities are investment vehicles that liquidate a fund over a long period of time –private pension funds compete with other financial service companies –accident and health insurance accounted for more than $142 billion of premiums written in 2007 Other life insurance activities –annuities are investment vehicles that liquidate a fund over a long period of time –private pension funds compete with other financial service companies –accident and health insurance accounted for more than $142 billion of premiums written in 2007

11. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-11 McGraw-Hill/Irwin Life Insurance Company Balance Sheets (2007) Corporate bonds and stocks represent 73.4% of total assets –matches the long-term nature of their liabilities Government securities represent 10.4% of total assets Policy loans represent 7.5% of total assets –policy loans are loans made by an insurance company to its policyholders using the policy as collateral Mortgages (mortgage backed securities) represent 6.4% of total assets Corporate bonds and stocks represent 73.4% of total assets –matches the long-term nature of their liabilities Government securities represent 10.4% of total assets Policy loans represent 7.5% of total assets –policy loans are loans made by an insurance company to its policyholders using the policy as collateral Mortgages (mortgage backed securities) represent 6.4% of total assets

12. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-12 McGraw-Hill/Irwin Life Insurance Company Balance Sheets (2007) Policy reserves represent 43.9% of total liabilities and capital –policy reserves reflect expected payment commitments on existing policy contracts Separate account business represents 35.8% of total liabilities and capital Deposit type contracts (includes GICs) represents 7.0% of total liabilities and capital Capital and surplus reserves represent 5.4% of total liabilities and capital Policy reserves represent 43.9% of total liabilities and capital –policy reserves reflect expected payment commitments on existing policy contracts Separate account business represents 35.8% of total liabilities and capital Deposit type contracts (includes GICs) represents 7.0% of total liabilities and capital Capital and surplus reserves represent 5.4% of total liabilities and capital

13. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-13 McGraw-Hill/Irwin Life Insurance Regulation McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICs –state insurance commissions charter and examine ICs –the National Association of Insurance Commissioners (NAIC) has developed a coordinated examination system States promote insurance guarantee funds –funds are run by the insurance companies themselves –contributions are paid only when an IC fails (except in NY) The Financial Services Modernization Act (FSMA) of 1999 allowed CBs, IBs, and ICs to exist as subsidiaries under one Financial Holding Company (FHC) McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICs –state insurance commissions charter and examine ICs –the National Association of Insurance Commissioners (NAIC) has developed a coordinated examination system States promote insurance guarantee funds –funds are run by the insurance companies themselves –contributions are paid only when an IC fails (except in NY) The Financial Services Modernization Act (FSMA) of 1999 allowed CBs, IBs, and ICs to exist as subsidiaries under one Financial Holding Company (FHC)

14. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-14 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Companies Currently 2,700 companies sell property-casualty (P&C) insurance –top 10 firms have a 48% market share –top 200 firms have a 94% market share Property insurance involves coverage related to the loss of real and personal property Casualty insurance offers protection against legal liability exposure Currently 2,700 companies sell property-casualty (P&C) insurance –top 10 firms have a 48% market share –top 200 firms have a 94% market share Property insurance involves coverage related to the loss of real and personal property Casualty insurance offers protection against legal liability exposure

15. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-15 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Fire insurance and allied lines –4.3% of premiums written in 2006 vs. 16.6% in 1960 Homeowners multiple peril (MP) –12.5% of premiums written in 2006 vs. 5.2% in 1960 Common multiple peril –4.3% of premiums written in 2006 vs. 0.4% in 1960 Auto liability and physical damage (PD) –39.3% of premiums written in 2006 vs. 43.0% in 1960 Liability insurance (other than auto) –14.7% of premiums written in 2006 vs. 6.6% in 1960 Fire insurance and allied lines –4.3% of premiums written in 2006 vs. 16.6% in 1960 Homeowners multiple peril (MP) –12.5% of premiums written in 2006 vs. 5.2% in 1960 Common multiple peril –4.3% of premiums written in 2006 vs. 0.4% in 1960 Auto liability and physical damage (PD) –39.3% of premiums written in 2006 vs. 43.0% in 1960 Liability insurance (other than auto) –14.7% of premiums written in 2006 vs. 6.6% in 1960

16. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-16 McGraw-Hill/Irwin Balance Sheets of Property-Casualty (P&C) Insurance Companies (2007) Bonds and stocks represent 69.6% of total assets Losses and loss adjustment expenses represent 37.1% of total liabilities and capital –loss reserves are set aside to meet losses from underwriting –loss adjustment expenses represent the administrative and adjusting costs associated with settling claims Unearned premiums represent 13.7% of total liabilities and capital –includes premiums that have been paid before insurance coverage has been provided Bonds and stocks represent 69.6% of total assets Losses and loss adjustment expenses represent 37.1% of total liabilities and capital –loss reserves are set aside to meet losses from underwriting –loss adjustment expenses represent the administrative and adjusting costs associated with settling claims Unearned premiums represent 13.7% of total liabilities and capital –includes premiums that have been paid before insurance coverage has been provided

17. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-17 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Underwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income Underwriting risk may result from –unexpected increases in loss rates –unexpected increases in expenses –unexpected decreases in investment yields Underwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income Underwriting risk may result from –unexpected increases in loss rates –unexpected increases in expenses –unexpected decreases in investment yields

18. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-18 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Loss risk is a function of actuarial predictability –property vs. liability –severity vs. frequency –long-tail vs. short tail –product inflation vs. social inflation Loss risk is a measure of pure losses incurred to premiums earned –premiums earned are premiums received and earned on insurance contracts because time has passed with no claim filed Expense risk occurs from two major sources –loss adjustment expenses (LAE) –commissions and other expenses Loss risk is a function of actuarial predictability –property vs. liability –severity vs. frequency –long-tail vs. short tail –product inflation vs. social inflation Loss risk is a measure of pure losses incurred to premiums earned –premiums earned are premiums received and earned on insurance contracts because time has passed with no claim filed Expense risk occurs from two major sources –loss adjustment expenses (LAE) –commissions and other expenses

19. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-19 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance The combined ratio is a measure of overall profitability –equals the loss ratio plus LAE to premiums written plus commissions and other expenses to premiums written Investment yield is measured as net interest income divided by premiums earned The operating ratio is also a measure of overall profitability –equals the combined ratio minus the investment yield The combined ratio is a measure of overall profitability –equals the loss ratio plus LAE to premiums written plus commissions and other expenses to premiums written Investment yield is measured as net interest income divided by premiums earned The operating ratio is also a measure of overall profitability –equals the combined ratio minus the investment yield

20. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-20 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Much of the 1987 to 2007 period was characterized by catastrophes of historically high severity –9/11/2001 terrorist attacks –2004 Florida hurricanes –2005 hurricane Katrina An underwriting cycle is a pattern that the profits in the P&C industry tend to follow The federal government has increasingly increased their role of providing compensation and reconstruction assistance following natural disasters Much of the 1987 to 2007 period was characterized by catastrophes of historically high severity –9/11/2001 terrorist attacks –2004 Florida hurricanes –2005 hurricane Katrina An underwriting cycle is a pattern that the profits in the P&C industry tend to follow The federal government has increasingly increased their role of providing compensation and reconstruction assistance following natural disasters

21. ©2009, The McGraw-Hill Companies, All Rights Reserved 15-21 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Regulation P&C insurers are chartered at the state level P&C insurers are regulated by state commissioners State guarantee funds provide (some) protection to policyholders The NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS) P&C insurers are chartered at the state level P&C insurers are regulated by state commissioners State guarantee funds provide (some) protection to policyholders The NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS)