Insurance

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26

• Insurance
• Operations

2
Chapter Objectives

• Present the two major areas of insurance 1) life
  and health and 2) property and casualty
• Describe the different types of insurance
  policies and their sources of funds
• Describe the main uses of insurance company funds
• Explain the exposure of insurance companies to
  various forms of risk
• Describe the regulatory environment of insurance
  companies

3
Insurance Companies

• Provide contractual risk management for
• Risks of insurable asset losses (auto insurance)
• Risks of liability claims (product liability)
• Risk of large medical costs (health insurance)
• Risk of disability (disability insurance)
• Risk of premature death (life insurance)
• Risk of longevity (annuities)

4
Insurance Companies, cont.

• Major capital market intermediary
• Major investor in corporate (life) and state and
  municipal bonds (property/casualty)
• Major long-term commercial mortgage lender (life)
• Mutual or stock form of ownership
• Premium and investment revenue
• Losses and loss adjustment expenses

5
Insurance Concepts

• Pure vs. financial risk
• Insure fortuitous, independent risk occurrence
• Premium covers losses, administrative expenses
  and profits
• Insured contracts for known loss (premium) in
  return for protection
• Moral hazard and adverse selection

6
Background

• Life insurance companies
• Provide risk management contracts for individuals
  and businesses
• Risk areas include premature death, health
  maintenance costs, and disability
• Life insurance provides cash benefits to the
  beneficiary of a policy on the policyholders
  death
• Life insurance premiums reflect
• Probability of making payment to the beneficiary
• Size and timing of the payment
• Have portfolios of policies and use mortality
  figures and actuarial tables to forecast claims

7
Types of Life Insurance Policies
Group
Group
Universal Life
Variable Life
Term
Whole Life
8
Types of Life Insurance Policies

• Whole life insurance includes both a death
  benefit (term insurance) and a savings component
  that
• Builds a tax sheltered cash value amount for the
  future for the owner of the policy
• Generates periodic cash flow payments over the
  life of the policy for the insurance company to
  reinvest
• Pays fixed death benefit at death

9
Types of Life Insurance Policies

• Term life insurance characteristics
• Temporary, providing death benefits only over a
  specified term
• Premiums paid represent insurance only with no
  saving component
• Considerably lower cost for the insured than
  whole lifeable to buy more insurance protection
  for any amount of premium
• Term is for those who would rather invest their
  savings in other contracts or securities

10
Types of Life Insurance Policies

• Variable life insurance
• Whole life with variable cash value amounts
• Cash values invested in equities and will vary
  with the investment performance
• Flexible premium option since 1984
• Universal life insurance
• Combines the features of term and whole life
• Variable premiums over timebuys terms and
  invests difference in a variety of investments
• Builds a varying cash value based on
  contributions and investment performance

11
Types of Life Insurance Policies

• Group plans
• Employees of a corporation offered life insurance
  or life insurance purchased on life of employee
• Cash value or term insurance
• Low cost (term) because of its high volume
• Can cover group members and dependents

12
Health Care Insurance

• Health maintenance organizations or HMOs
• Intermediaries between purchasers and providers
  of health care
• Annual fee or premium
• Covers all medical expenses
• Medical staff is designated by the HMO
• Losses in recent years for HMOs

13
Sources of Life Insurance Company Funds

• Cash value reservesaccumulated cash values owed
  insureds (liability)
• Pension reservesaccumulated insured pension
  commitments (liability)
• Annuity reservesaccumulated annuity commitments
  (liability)
• Unearned premium incomepremiums received not
  yet earned (liability)
• Loss reserves--losses incurred, not yet paid
• Capital funds

14
Uses of Life Insurance Company Funds

• Major investor in corporate bonds
• Government securities
• Common stock
• Commercial mortgage
• Real Estate
• Policy loans to insured

15
Uses of FundsPolicy Loans

• Policy loans are loans to policyholders
• Whole life policies
• Borrow up to the cash value of the policy
• Guaranteed interest rate is stated in the policy
• Usually used by borrowers during periods of
  rising rates to lock in the lower rate associated
  with their policy

16
Insurance Company Capital

• Capital
• Build capital by issuing new stock (stock
  companies) or retaining earnings
• Used to finance investments in fixed assets
• Cushion against operating losses
• Capital requirements vary depending on asset risk
• Credibility with customers is also enhanced by
  adequate capital
• Mutual companies owned by policyholdersincludes
  earnings retained over time

17
Regulation

• Insurance companies are highly regulated by state
  insurance agencies
• The National Association of Insurance
  Commissioners (NAIC)
• Provides coordination among states in regulatory
  matters
• Adopted uniform regulatory reporting standards
• State Regulators
• Make sure insurance companies provide adequate
  service
• States approve/review rates
• Agent licensure
• Forms are approved to avoid misleading wording

18
Regulation

• Insurance Regulatory Information System
• Compiles financial information and lists of
  insurers
• Calculates 11 ratios to assess and monitor
  financial health
• Assessment system
• 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 the asset portfolio

19
Regulation

• Regulation of capital
• In 1994 companies were required to report
  risk-based capital ratios to insurance regulators
• Goals of requirements are to
• Discourage insurance companies from excessive
  exposure
• Back higher risks with higher capital
• Reduce failures in the industry

20
Risks of Life Insurance Companies
Pure Risk of Life Insurance Policies Pension Commi
tments and Annuities Contracts
Financial Risk includes Interest Rate Risk Credit
Risk Market Risk Liquidity Risk
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Exposure to Financial Risks

• Interest rate risk
• Fixed rate assets in company portfolios have
  market values sensitive to interest rate changes
• Firm measures and manages risks
• Credit risk
• Mortgages, corporate bonds and real estate
  holdings can involve default
• Investment-grade securities
• Diversify portfolio among debt issuers

22
Exposure to Financial Risks

• Market risk
• Exists because events like significant market
  value decreases reduce capital
• Economic downturn affects real estate investments

23
Exposure to Financial Risks

• Liquidity risk occurs because a high frequency of
  claims may require the life company to liquidate
  assets
• Life insurance companies have high cash flow from
  premiums to offset normal cash needs
• In case of large disaster (9/11) may be forced to
  sell assets to generate cash even if market value
  is low
• Companies try to balance the age distribution of
  their customer base
• As interest rates rise, voluntary terminations of
  policies occur

24
Asset Management

• Performance is significantly affected by the
  performance of the assets
• Companies get premiums for several years before
  paying out benefits
• Companies try to manage the risk of losses with
  offsetting investment gains or diversity of
  assets they hold
• Diversify into other businesses to offer a wide
  variety of financial products

25
Property and Casualty Insurance

• Property insurance (fire insurance)
• Casualty insurance (liability)
• Performance and financial bonding

26
PC Versus Life Insurance Companies

• PC have shorter contracts
• PC have more varied risk areas
• Life companies larger due to long-term savings
  and pension contracts
• PC has wider distribution of Occurrences
• PCs need liquid, marketable assets
• PCs earnings more volatile

27
Property Casualty Investment Needs

• Tax sheltering--major municipal/state bond
  investor
• Liquid, marketable assets
• Marketable corporate and government bonds
• Listed common stock
• Inflation hedge--common stock
• Reinsurance contracts--manage pure risks

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Valuation of an Insurance Company

• Value of an insurance company depends on its
  expected cash flows and required rate of return

?V f ?E(CF), ?k

Where
?V Change in value of the insurance company
?E(CF) Change in expected cash flows
?k Change in required rate or return
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Valuation of an Insurance Company

• Factors that affect cash flows

?E(CF) f (?ECON, ?Rf , ?INDUS, ?MANAB)


?
Where
E(CF) Expected cash flow
ECON Economic growth
Rf Risk free interest rate
INDUS Prevailing industry conditions for
the company
MANAB Management ability of company
30
Valuation of an Insurance Company

• Investors required rate of return

?k f(?Rf , ?RP)


Where
Rf Risk free interest rate
RP Risk premium
31
Performance Evaluation

• Common indicators of company performance are
  available
• Statistical analysis of performance
• Ratio analysis
• Trends over time
• Compare to industry average

32
Performance Evaluation

• The higher the liquidity ratio, the more liquid
  the company

Invested Assets
Liquidity Ratio

Loss Reserves and Unearned Premium Reserves
33
Performance Evaluation

• Return on net worth or policyholders surplus is
  a profitability measure

Net Profits
Return on Equity

Policyholders Surplus
34
Performance Evaluation

• Underwriting gains and losses or underwriting
  profitability measured by the net underwriting
  margin
• Profits include investment income, underwriting
  profits and realized capital gains
• Ratios can be calculated to focus on various
  sources of profits

Net Underwriting
Premium Income - Policy Expenses

Total Assets
Margin
35
Other Issues

• Insurance companies interact in a variety of ways
  with other financial institutions
• Insurance companies participate in a full range
  of financial markets
• Multinational insurance companies
• Insurance companies operate in many countries
• Some countries lack developed markets for
  insurance
• Multinational investments