Insurance Companies

8-1McGraw-Hill/IrwinChapter FifteenInsurance Companies15-2McGraw-Hill/IrwinInsurance Companies (ICs)The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, in exchange for premiums paidinsurance underwriters assess and price riskinsurance brokers sell insurance contracts for coverage or for a policyInsurance is broadly classified into two groupslife insurance provides protection against untimely death, illness, and retirementproperty-casualty insurance protects against personal injury and liabilityInsurance companies also sell a variety of investment products similar to other FIs15-3McGraw-Hill/IrwinLife Insurance CompaniesApproximately 1,300 life insurance companies exist in the U.S. in the mid-2000scompares to 2,300 in 1988the industry has seen consolidation to take advantage of scale and scope economiesAggregate industry assets were $4.8 trillion at the beginning of 2007compares to $1.1 trillion in 1988Life insurance companies can be either stock or mutually owned (where the policyholders are the owners)15-4McGraw-Hill/IrwinLife Insurance CompaniesLife insurers pool the risks of individuals to diversify away some of the customer-specific riskthus, they are able to offer insurance services at a cost lower than any individual could achieve saving funds on their ownallows the transfer of income related uncertainties from the individual to the groupOther activities of life insurance companiessell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of timemanage pension plans (e.g., tax-deferred savings plans)provide accident and health insurance15-5McGraw-Hill/IrwinLife Insurance CompaniesInsurance companies accept or underwrite risk that a prespecified event will occur in return for insurance premiumsunderwriting decisions determine which risks are accepted and which are notunderwriting decisions determine how much to charge (in the form of premiums) for accepted riskThe adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage15-6McGraw-Hill/IrwinLife Insurance CompaniesMoral 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 insuranceActuaries reduce the risks of underwriting insurancewith life insurance, actuaries analyze mortality, produce life tables, and apply the time-value-of-money to produce life insurance annuities and endowment policieswith health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc.15-7McGraw-Hill/IrwinLife Insurance CompaniesOrdinary life insurance is marketed to individuals—policyholders make periodic premium payments in exchange for coverageterm lifebeneficiary receives payout at time of deathif insured lives beyond the term of the contract no benefits are paidwhole lifepolicy protects over entire lifetimebeneficiary receives face value of contract upon death15-8McGraw-Hill/IrwinLife Insurance Companiesendowment lifebeneficiary receives payment at time of deathif insured lives beyond the term of the contract, insured receives face value of the contractvariable lifepremiums are invested in market securitiesvalue of policy depends on the value of the securitiesuniversal lifeallows the insured to change both the premiums and the maturity of the contractvariable universal life combines features of variable and universal life insurance15-9McGraw-Hill/IrwinLife Insurance CompaniesGroup life insurance covers a large number of persons under a single policycontributory—both the employer and the employee cover a share of the premiumsnoncontributory—the costs are borne entirely by the employerCredit life insurance protects lenders against borrower death15-10McGraw-Hill/IrwinLife Insurance CompaniesOther life insurance activitiesannuities are investment vehicles that liquidate a fund over a long period of timeprivate pension funds compete with other financial service companiesaccident and health insurance accounted for more than $142 billion of premiums written in 200715-11McGraw-Hill/IrwinLife Insurance Company Balance Sheets (2007)Corporate bonds and stocks represent 73.4% of total assetsmatches the long-term nature of their liabilitiesGovernment securities represent 10.4% of total assetsPolicy loans represent 7.5% of total assetspolicy loans are loans made by an insurance company to its policyholders using the policy as collateralMortgages (mortgage backed securities) represent 6.4% of total assets15-12McGraw-Hill/IrwinLife Insurance Company Balance Sheets (2007)Policy reserves represent 43.9% of total liabilities and capitalpolicy reserves reflect expected payment commitments on existing policy contractsSeparate account business represents 35.8% of total liabilities and capitalDeposit type contracts (includes GICs) represents 7.0% of total liabilities and capitalCapital and surplus reserves represent 5.4% of total liabilities and capital15-13McGraw-Hill/IrwinLife Insurance RegulationMcCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICsstate insurance commissions charter and examine ICsthe National Association of Insurance Commissioners (NAIC) has developed a coordinated examination systemStates promote insurance guarantee fundsfunds are run by the insurance companies themselvescontributions 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)15-14McGraw-Hill/IrwinProperty-Casualty (P&C) Insurance CompaniesCurrently 2,700 companies sell property-casualty (P&C) insurancetop 10 firms have a 48% market sharetop 200 firms have a 94% market shareProperty insurance involves coverage related to the loss of real and personal propertyCasualty insurance offers protection against legal liability exposure15-15McGraw-Hill/IrwinProperty-Casualty (P&C) InsuranceFire insurance and allied lines4.3% of premiums written in 2006 vs. 16.6% in 1960Homeowners multiple peril (MP)12.5% of premiums written in 2006 vs. 5.2% in 1960Common multiple peril4.3% of premiums written in 2006 vs. 0.4% in 1960Auto liability and physical damage (PD)39.3% of premiums written in 2006 vs. 43.0% in 1960Liability insurance (other than auto)14.7% of premiums written in 2006 vs. 6.6% in 196015-16McGraw-Hill/IrwinBalance Sheets of Property-Casualty (P&C) Insurance Companies (2007)Bonds and stocks represent 69.6% of total assetsLosses and loss adjustment expenses represent 37.1% of total liabilities and capitalloss reserves are set aside to meet losses from underwritingloss adjustment expenses represent the administrative and adjusting costs associated with settling claimsUnearned premiums represent 13.7% of total liabilities and capitalincludes premiums that have been paid before insurance coverage has been provided15-17McGraw-Hill/IrwinProperty-Casualty (P&C) InsuranceUnderwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment incomeUnderwriting risk may result fromunexpected increases in loss ratesunexpected increases in expensesunexpected decreases in investment yields15-18McGraw-Hill/IrwinProperty-Casualty (P&C) InsuranceLoss risk is a function of actuarial predictabilityproperty vs. liabilityseverity vs. frequencylong-tail vs. short tailproduct inflation vs. social inflationLoss risk is a measure of pure losses incurred to premiums earnedpremiums earned are premiums received and earned on insurance contracts because time has passed with no claim filedExpense risk occurs from two major sourcesloss adjustment expenses (LAE)commissions and other expenses15-19McGraw-Hill/IrwinProperty-Casualty (P&C) InsuranceThe combined ratio is a measure of overall profitabilityequals the loss ratio plus LAE to premiums written plus commissions and other expenses to premiums writtenInvestment yield is measured as net interest income divided by premiums earnedThe operating ratio is also a measure of overall profitabilityequals the combined ratio minus the investment yield15-20McGraw-Hill/IrwinProperty-Casualty (P&C) InsuranceMuch of the 1987 to 2007 period was characterized by catastrophes of historically high severity9/11/2001 terrorist attacks2004 Florida hurricanes2005 hurricane KatrinaAn underwriting cycle is a pattern that the profits in the P&C industry tend to followThe federal government has increasingly increased their role of providing compensation and reconstruction assistance following natural disasters15-21McGraw-Hill/IrwinProperty-Casualty (P&C) Insurance RegulationP&C insurers are chartered at the state levelP&C insurers are regulated by state commissionersState guarantee funds provide (some) protection to policyholdersThe NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS)