1. Insurance and Pension Fund Operations
Chapter 25
Insurance and Pension Fund Operations
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. Chapter Outline Background Life insurance operations
Property and casualty insurance operations
Health care insurance operations
Business insurance
Regulation of insurance companies
Exposure to risk
Valuation of an insurance company
Performance evaluation

3. Chapter Outline (cont’d)
Interaction with other financial institutions
Participation in financial markets
Multinational insurance companies
Background on pension funds
Pension regulations
Pension fund management
Performance of pension funds
Pension fund participation in financial markets

4. Background Insurance companies:
Provide various form of insurance and investment services to individuals
Charge a fee (premium) for the services
Provide a payment to the insured (or a named beneficiary) under conditions specified by the insurance policy contract
Help individuals or firms to reduce the potential financial damage due to specified conditions
Common types of insurance are life insurance, property and casualty insurance, health insurance, and business insurance

5. Background (cont’d)
Individuals who are more exposed to specific conditions that cause financial damage will purchase insurance against those conditions
Adverse selection problem
Insurance can cause the insured to take more risks because they are protected
Moral hazard problem
Underwriters are employed by insurance companies to calculate the risk of specific insurance policies
Decide what types of policies to offer based on the potential level of claims and the premiums that they could charge

6. Background (cont’d) Determinants of insurance premiums
The premium is based on:
The probability of the condition under which the company will need to provide payment
The potential size of the payment in present value terms
The degree of competition in the industry for that type of insurance
Overhead expenses and insurance company profit
Whether the policy is for an individual or a group

7. Background (cont’d) Investments by insurance companies
Insurance companies invest premiums and fees until the funds are needed to pay claims
Investment decisions balance the goals of return, liquidity, and risk
Those insurance companies whose claims are less predictable need to maintain more liquidity

8. Life Insurance Operations
Life insurance companies:
Are a dominant force in the industry
Generate more than $100 billion in premiums each year
Compensate the beneficiary of a policy upon the policyholder’s death
Charge a premium that reflects the probability of making a payment as well as the size and timing of the payment
Have historically forecasted with reasonable accuracy the benefits they will have to provide
Use actuarial tables and mortality figures to forecast the percentage of policies that will require compensation

9. Life Insurance Operations (cont’d)
Group plans:
Are offered to employees of a corporation
Can be distributed at a low cost because of high volume
Make up about 40 percent of total life coverage

10. Life Insurance Operations (cont’d)
Types of life insurance
Whole life insurance:
Protects policyholders until death or as long as premiums are paid
Builds a cash value that the policyholder is entitled to even if the policy is canceled
Generates periodic premiums for the life insurance company that can be invested
Typically provides a fixed amount of benefits
Term insurance:
Is temporary, providing insurance only over a specified term
Does not build a cash value
Is significantly less expensive than whole life insurance
Includes decreasing term insurance, where benefits decrease over time

11. Life Insurance Operations (cont’d)
Types of life insurance (cont’d)
Variable life insurance:
Provides benefits that vary with the assets backing the policy
Includes flexible-premium variable life insurance, providing flexibility on the size and timing of payments
Universal life insurance:
Combines the features of term and whole life insurance
Specifies a period of time over which the policy will exist but also builds a cash value
Allows flexibility on the size and timing of the premiums

12. Life Insurance Operations (cont’d)
Sources of funds
The most important source is annuity plans
Offer a predetermined amount of retirement income to individuals
The second largest source of funds is premiums
The third largest source of funds is investment income

13. Life Insurance Operations (cont’d)
Uses of funds
Life insurance companies are major institutional investors
Government securities
Life insurance companies invest in U.S. Treasury securities, state and local government bonds, and foreign bonds
Corporate securities
Corporate bonds are the most popular asset of life insurance companies
Some focus on high-grade bonds, others invest a portion in junk bonds
Life insurance companies expect to maintain some bonds until maturity
Corporate stock is another use of funds, but significantly less than bonds

14. Life Insurance Operations (cont’d)
Uses of funds (cont’d)
Mortgages
Life insurance companies hold all types of mortgages:
One to four family, multifamily, commercial, and farm related
Mortgages are typically originated by another institution and then sold to life insurance companies in the secondary market
Commercial mortgages make up more than 90 percent of total mortgages held by life insurance companies
Real estate
Life insurance companies sometimes purchase real estate and lease it out for commercial purposes
Real estate generates higher returns but also exposes life insurance companies to higher risk

15. Life Insurance Operations (cont’d)
Uses of funds (cont’d)
Policy loans
Life insurance companies lend funds to whole life policyholders
Can borrow up to their policy’s cash value at a guaranteed rate of interest
Capital
Insurance companies retain earnings or issue new stock
Capital is used to finance investment in fixed assets and as a cushion against operating losses
Insurance companies are required to maintain adequate capital

16. Property and Casualty Insurance Operations
PC insurance protects against fire, theft, liability, and other events that result in damage
Property insurance protects businesses and individuals from the impact of financial risks associated with the ownership of property
e.g., buildings, cars
Casualty insurance protects policyholders from potential liabilities for harm to others as a result of product failure or accidents

17. Health Care Insurance Operations (cont’d)
Managed health care plans
Health maintenance organizations (HMOs)
Require individuals to choose a primary care physician who functions as a gatekeeper for that individual’s health care
Patients must first see their PCP to obtain referrals
Preferred provider organizations (PPOs)
Usually allow insured individuals to see any physician without a referral
Insurance premiums are higher than HMO insurance premiums

18. Health Care Insurance Operations (cont’d)
Health care insurance in the future
Health care expenses have risen dramatically in recent years
Some insurance companies that provide health care insurance have incurred major losses
Insurance companies increased their premiums
The status of health care insurance and reimbursement is subject to changes caused by possible health care reform

19. Business Insurance
Insurance companies provide a wide variety of business insurance policies
Property insurance:
Protects a firm against the risk associated with ownership of property
Provides insurance against property damage by fire or theft
Liability insurance:
Can protect a firm against potential liability for harm to others as a result of product failure
Is important because of increasing lawsuits
Can protect a business against potential liability from its employees

20. Business Insurance (cont’d)
Key employee insurance provides a financial payout under conditions that specified employees of a business become disabled or die
Business interruption insurance covers against losses due to a temporary closing of the business
Credit line insurance covers debt payments owed to a creditor if a borrower dies
Fidelity bond insurance covers against losses due to dishonesty by employees

21. Business Insurance (cont’d)
Marine insurance covers against losses due to damage during transport
Malpractice insurance covers business professionals from losses due to lawsuits by dissatisfied customers
Surety bond insurance covers losses due to a contract not being fulfilled
Umbrella liability insurance provides additional coverage beyond that provided by the other existing insurance policies

22. Regulation of Insurance Companies (cont’d)
Assessment system
The regulatory system is designed to detect any problems in time to search for a remedy
Commonly used financial ratios are intended to assess:
The 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 asset portfolio
Financial characteristics are monitored to ensure companies do not become overly exposed to credit risk, interest rate risk, and liquidity risk

23. Exposure to Risk Interest rate risk
Companies carry a lot of fixed-rate long-term securities and are very sensitive to interest rate fluctuations
When interest rates rise, insurance companies are unable to capitalize on higher rates
Life insurance companies:
Have been reducing their average maturity on securities
Have been investing in long-term assets that offer floating rates
Have increasingly been utilizing futures contracts and interest rate swaps to manage their exposure

24. Exposure to Risk (cont’d)
Credit risk
Corporate bonds, mortgages, state and local government securities, and real estate holdings are subject to credit risk
Some insurance companies only invest in assets with a high credit rating and diversify among securities
Market risk
Some insurance companies became insolvent in the early 1990s as a result of losses on real estate investments
The value of stock portfolios managed by insurance companies declined in 2001–2002

25. Exposure to Risk (cont’d)
Liquidity risk
A high frequency of claims at a single point in time could negatively affect a company’s performance
Companies can diversify the age distribution of their customer base to reduce the exposure to this risk
If the customer base is concentrated in the older age group, life insurance companies should increase their proportion of liquid assets
Liquidity is also reduced when interest rates are high and policyholders accelerate their voluntary terminations

26. Valuation of an Insurance Company
The value of an insurance company is the present value of its future cash flows
The value should change in response to changes in expected cash flows and in the required rate of return:

27. Valuation of an Insurance Company (cont’d)
Factors that affect cash flows
The change in expected cash flows can be modeled as:
Change in payouts
Payouts are stable for life insurance companies but can be volatile for PC companies
Change in economic conditions
Economic growth increases income for firms and individuals
Debt securities are less likely to default during periods of economic growth

28. Valuation of an Insurance Company (cont’d)
Factors that affect cash flows (cont’d)
Change in the risk-free interest rate
The valuation of an insurance company is inversely related to interest rate movements
Change in industry conditions
Industry conditions include regulatory constraints, technology, and competition
Competition within the insurance industry has become more intense because of reduced barriers

29. Valuation of an Insurance Company (cont’d)
Factors that affect cash flows (cont’d)
Change in management abilities
Managers make decisions that will capitalize on external forces the company cannot control
Skillful managers determine the likelihood of events that will necessitate payouts, compute the present value of cash outflows, and analyze the creditworthiness of firms issuing the bonds insurance companies purchase

30. Valuation of an Insurance Company (cont’d)
Factors that affect the required rate of return by investors:
The risk-free rate is positively related to inflation, economic growth, and the budget deficit level, but inversely related to money supply growth
The risk premium is inversely related to economic growth and the company’s management skills
Regulatory constraints may discourage firms from taking excessive risk
Loosening of regulatory barriers to entry may increase the risk of insurance companies

31. Background on Pension Funds
Pension plans provide a savings plan for employees that can be used for retirement
Public pension funds can be either state, local, or federal
e.g., Social Security
Many public pension plans are funded on a pay-as-you-go basis

32. Background on Pension Funds (cont’d)
Private pension plans
With a defined-benefit plan, contributions are dictated by the benefits that will eventually be provided
A defined-contribution plan provides benefits that are determined by the accumulated contributions and the fund’s investment performance

33. Pension Fund Management
Private pension portfolios are dominated by common stock
Public pension portfolios are evenly invested in corporate bonds, stocks, and other credit instruments
Investment decisions with a matched funding strategy are made with the objective of generating cash flows that match planned outflow payments
Projective funding offers managers more flexibility in constructing a pension portfolio that can benefit from expected market and interest rate movements

34. Pension Fund Management (cont’d)
The corporation owning the pension specifies guidelines:
Percentage that should be used for stocks or bonds
Desired minimum rate of return
Maximum amount to be invested in real estate
Minimum acceptable quality rating for bonds
Maximum amount to be invested in any one industry
Average maturity of bonds
Maximum amount to be invested in options
Minimum size of companies in which to invest

35. Performance of Pension Funds
Determinants of a pension fund’s stock portfolio performance
Change in market conditions
Stock portfolio’s performance is usually closely related to market conditions
Change in management abilities
Stock portfolio performance can vary among pension funds in a particular time period because of differences in management abilities

36. Performance of Pension Funds (cont’d)
Determinants of a pension fund’s bond portfolio performance
Change in the risk-free rate
Bond prices are inversely related to changes in the risk-free interest rate
Change in the risk premium
Bond prices are inversely related to changes in the risk premiums required by investors who purchase bonds
Change in management abilities
Bond portfolio performance can vary among pension funds in a particular time period because of differences in management abilities

37. Performance of Pension Funds (cont’d)
Performance of pension portfolio managers
The objective is to make investments that will earn a large enough return to adequately meet future payment obligations
Some research has found that managed pension portfolios perform no better than market indexes
Pension funds may consider investing in indexed mutual funds