Insurance and Pension Fund Operations
Insurance Companies
n Provide contractual risk management for:
l Risks of insurable asset losses (auto insurance)
l Risks of liability claims (product liability)
l Risk of large medical costs (health insurance)
l Risk of disability (disability insurance)
l Risk of premature death (life insurance)
Insurance Companies
n Major capital market intermediary
l Major investor in corporate (life) and state and municipal bonds (property/casualty)
l Major long-term commercial mortgage lender (life)
n Mutual or stock form of ownership
Insurance Concepts
n Premium and investment revenue
n Losses and administrative expenses
n Premium covers losses, administrative expenses and profits
n Adverse selection and moral hazard
n Investments are more liquid for companies facing less predictable claims
Insurance Company Capital
n Capital
l Build capital by issuing new stock (stock companies) or retaining earnings
l Used to finance investments in fixed assets
l Cushion against operating losses
l Capital requirements vary depending on asset risk
l Credibility with customers is also enhanced by adequate capital
Background
n Life insurance companies
l Life insurance provides cash benefits to the beneficiary of a policy on the policyholder’s death
l Life insurance premiums reflect
u Probability of making payment to the beneficiary
u Size and timing of the payment
l Have portfolios of policies and use mortality figures and actuarial tables to forecast claims
Types of Life Insurance Policies
n Whole life insurance includes both a death benefit and a savings component that
l Builds a tax sheltered cash value amount for the future for the policy
l Generates periodic cash flow payments over the life of the policy for the insurance company to reinvest
l Pays fixed death benefit at death
Types of Life Insurance Policies
n Term life insurance characteristics
l Temporary, providing death benefits only over a specified term
l Premiums paid represent insurance only with no saving component
l Considerably lower premium for the insured than whole life
Types of Life Insurance Policies
n Variable life insurance
l Whole life with variable cash value amounts
l Cash values invested in equities and will vary with the investment performance
l Often has a flexible premium option
n Universal life insurance
l Like term insurance—temporary policy
l Variable premiums over time
l Builds a varying cash value based on contributions and investment performance
Types of Life Insurance Policies
n Group plans
l Employees of a corporation offered life insurance or life insurance purchased on life of employee
l Similar to term insurance
l Low cost (term) because of its high volume
l Can cover dependents
Policy Loans
n Policy loans are loans to policyholders
l Whole life policies
l Borrow up to the cash value of the policy
l Guaranteed interest rate is stated in the policy
l Usually used by borrowers during periods of rising rates to lock in the lower rate associated with their policy
Asset Management
n Performance is significantly affected by the performance of the assets
l Companies get premiums for several years before paying out benefits
l Performance determined by return and risk
u Companies try to manage the risk of losses with offsetting investment gains or diversity of assets they hold
Risks of Life Insurance Companies
Exposure to Financial Risks
n Interest rate risk
l Fixed rate assets in company portfolios have market values sensitive to interest rate changes
n Credit risk
l Mortgages, corporate bonds and real estate holdings can involve default
n Market risk
l Exists because events like significant market value decreases reduce capital
l Economic downturn affects real estate investments
Exposure to Financial Risks
n Liquidity risk occurs because a high frequency of claims may require the life company to liquidate assets
l Normally, premiums sufficiently cover claims
l In case of large disaster (e.g. 9/11) may be forced to sell assets to generate cash even if market value is low
l Companies try to balance the age distribution of their customer base
u More liquidity is required if customers are relatively older
Property and Casualty (PC) Insurance
n Property insurance
l Loss from fire or theft
n Casualty insurance (liability)
l Product failure or accidents
n PC insurance premiums reflect
l Probability of making payment to the beneficiary
l Size and timing of the payment
Property and Casualty Reinsurance
n Reinsurance contracts to manage pure risks by inviting other insurance companies to participate
l Similar to syndications of commercial banks
Health Care Insurance
n Managed health care vs. indemnity plan
l Premium is higher for an indemnity plan
n Health maintenance organizations or HMOs
l Intermediaries between purchasers and providers of health care
n Preferred provider organizations or PPOs
l Allows policyholders to see any physician without a referral
l Higher than HMO premiums
Performance Evaluation of Insurance Companies
n Common indicators of company performance are available
l Statistical analysis of performance
u Performance of insurance vs. performance of investments
l Ratio analysis
u Trends over time
u Compare to industry average