Insurance and Pension Fund Operations

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


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