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... the different types of insurance policies and their sources ... Risks of insurable asset losses (auto insurance) Risks of liability claims (product liability) ... – PowerPoint PPT presentation

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Title: Insurance

  • Insurance
  • Operations

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

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)

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

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

  • 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
  • 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

Types of Life Insurance Policies
Universal Life
Variable Life
Whole Life
Types of Life Insurance Policies
  • Whole life insurance includes both a death
    benefit (term insurance) and a savings component
  • 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
  • Pays fixed death benefit at death

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

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

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

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

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

Uses of Life Insurance Company Funds
  • Major investor in corporate bonds
  • Government securities
  • Common stock
  • Commercial mortgage
  • Real Estate
  • Policy loans to insured

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

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

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

  • Insurance Regulatory Information System
  • Compiles financial information and lists of
  • 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

  • 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
  • Back higher risks with higher capital
  • Reduce failures in the industry

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
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

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

Exposure to Financial Risks
  • Liquidity risk occurs because a high frequency of
    claims may require the life company to liquidate
  • 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

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

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

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

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

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

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

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

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
Valuation of an Insurance Company
  • Investors required rate of return

?k f(?Rf , ?RP)

Rf Risk free interest rate
RP Risk premium
Performance Evaluation
  • Common indicators of company performance are
  • Statistical analysis of performance
  • Ratio analysis
  • Trends over time
  • Compare to industry average

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

Invested Assets
Liquidity Ratio

Loss Reserves and Unearned Premium Reserves
Performance Evaluation
  • Return on net worth or policyholders surplus is
    a profitability measure

Net Profits
Return on Equity

Policyholders Surplus
Performance Evaluation
  • Underwriting gains and losses or underwriting
    profitability measured by the net underwriting
  • 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
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
  • Multinational investments