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Nondepository Financial Institutions

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Title: Nondepository Financial Institutions


1
Nondepository Financial Institutions
  • Chapter 10

2
Life Insurance Companies
  • Oldest type of intermediary in the U.S.
  • 1759 in Philadelphia (now called Presbyterian
    Ministers Fund)
  • Invest funds obtained through the sale of
    policies.
  • Primary investments Long term taxable, not
    highly marketable securities corporate bonds and
    commercial mortgages.
  • Income paid to policy holders is tax exempt -
    return on the policy holders investment
  • Insure against dying too soon and living too
    long.

3
Life Insurance Companies
  • Regulation of life insurance companies includes
  • Sales practices
  • Premium rates
  • Allowable investments
  • Usually overseen by a state insurance
    commissioner, who might also be the state banking
    commissioner

4
Types of Life Insurance Policies
  • Whole Life Insurance
  • Constant premium that is paid through entire life
    of policy
  • Build up cash reserves or savings which can be
    withdrawn as borrowing or outright by canceling
    the policy
  • Savings component pays a money market rate of
    interest that changes with market conditions

5
Types of Life Insurance Policies
  • Term Life Insurance
  • Pure insurance with no cash reserve or savings
    element
  • Premiums are relatively low at first but increase
    with the age of the insured individual
  • Universal (variable) Life
  • Variation on whole life policy
  • Unbundle the term insurance and tax-deferred
    savings component
  • Owner can elect how to allocate the savings
    component among a menu of investment options,
    thereby potentially earning above money market
    rates

6
Life Insurance Companies
  • Based on actuarial tables, life insurance
    companies have ability to predict cash flow
  • Typically insurance companies use excess funds to
    buy long-term corporate bonds and commercial
    mortgages
  • Higher yields
  • Unlikely of having to sell prior to maturity
  • However, lately they have branched out into
    riskier ventures such as common stock and real
    estate

7
Life Insurance Basics
  • Public makes payments in exchange for protection
  • Companies lend out the funds collected.
  • Companies use the interest and dividend income
    received to pay benefits to policyholders
  • Insurance companies have a reasonably predictable
    stream of payments to policy holders distributed
    over time.

8
Dealing with Asymmetric-Information Problems in
Insurance
  • Limiting adverse selection
  • Restricting the availability and quantity of
    insurance.
  • Limiting moral hazard in insurance
  • Deductible A fixed amount of an insured loss
    that a policyholder must pay before the insurer
    is obliged to make payments.
  • Coinsurance A policy feature that requires a
    policyholder to pay a fixed percentage of a loss
    above a deductible.

9
Pension Funds
  • Program established by an employer to provide
    retirement benefits to employees.
  • History
  • established at the end of the 19th century by
    railroads.
  • 1875 - American Express Company who was closely
    associated with railroading.
  • Many failed during the depression - led to
    increased regulation.

10
Pension Funds
  • Individuals need pension plans to supplement
    Social Security benefits
  • Most pension fund assets are in
    employer-sponsored plans
  • Defined Benefit Plan
  • Defined Contribution Plan

11
Defined Benefit Plan
  • Retirement benefits are defined by the plan
  • Employer contributions are adjusted to meet the
    benefits and insure the plan is fully
    fundedenough funds to meet future obligations
  • Vesting
  • Retirement benefits remain with the employee if
    they leave the firm and is based on length of
    employment
  • Employee Retirement Income Security Act (ERISA)
  • Establishes minimum reporting, disclosure,
    vesting, funding and investment standards to
    safeguard employee pension rights
  • Pension Benefit Guaranty Corporation
  • Guarantees some benefits in defined benefit plans
    if company is unable to meet its accrued pension
    liabilities

12
Defined Contribution Plan
  • Contributions are defined by the plan
  • Contribution may be made by employees or
    employers or a combination of the two
  • Employee contributions are tax deferredtaxes
    payable when funds are withdrawn
  • Benefits depend on the performance of the assets
    in the plan
  • Avoids the problems of vesting and funding
  • Individual employee has the ability to choose the
    assets in which to invest
  • Most common are 403(b) and 401(k)

13
Pension Funds
  • Defined contribution plans are the type favored
    by most employers, although some employers offer
    both plans
  • In addition to employer-sponsored plans, some
    individuals are given tax incentives to set up
    their own pension plans
  • Keogh Plansself-employed individuals
  • Individual Retirement Accounts (IRAs)working
    people who are not covered by company-sponsored
    pension plans

14
Pension Fund Basics
  • Tax-exempt institutions set up to provide
    participants with retirement income that will
    supplement other sources of income.
  • The number of people likely to retire each year
    is quite predictable.
  • As a result they invest about 80 of their funds
    in corporate equities.

15
Property and Casualty Insurance Companies
  • Insure against casualties such as automobile
    accidents, fire, theft, personal negligence,
    malpractice, etc.
  • Losses can be unexpected and highly variable.
  • Invest in tax-free municipal bonds and short-term
    securities.

16
Property and Casualty Insurance Companies (Cont.)
  • State insurance commissions set ranges for rates,
    enforce operating standards, and exercise overall
    supervision over company policies
  • Little federal involvement in regulating these
    companies

17
Most Costly Natural Disasters Since 1992
  • Hurricane Andrew caused 30 billion in damages in
    1992
  • Midwest floods caused 20 billion in damages in
    1993
  • The Northridge earthquake in California caused
    42 billion in damages in 1994
  • Severe weather and floods in Texas, Oklahoma,
    Louisiana, and Mississippi caused 5.5 billion in
    damages in 1995
  • Hurricane Marilyn caused 2.1 billion in damages
    in 1995
  • Hurricane Mitch caused an estimated 2.1 billion
    in damages in Central America and the United
    states in 1998
  • The southern plains drought caused 4 billion in
    damages in 1996
  • Hurricane Fran caused 5 billion in damages in
    1996
  • The winter blizzard of 1996 caused 500 million
    in damages
  • Red River floods in North Dakota and Minnesota
    caused 4 billion in damages in 1997
  • Preliminary figures from 1998's Hurricane Georges
    show it killed 350 people and total insured
    losses could end up reaching 2 billion

18
Cost to insurers
  • Chubb 500-600m
  • Employers' Re 600m
  • GE 600m
  • Hannover Re 365m
  • Munich Re 1.95bn
  • Partner Re 350-400m
  • Royal Sun Alliance 220m
  • Scor 150m-200m
  • Swiss Re 1.25bn
  • Zurich Financial 400m
  • ACE and XL Capital 1bn-1.1bn
  • AIG 500m
  • Allianz 930m
  • AXA 300-400m
  • Berkshire Hathaway 2.2bn
  • www.berkshirehathaway.com
  • CNA Financial 200m-350m

19
Mutual Funds
  • Money Market Mutual funds have been prominent on
    the American financial scene since the 1970s
  • However, stock market mutual funds (Mutual Funds)
    have been in existence since the 1950s.
  • A mutual fund pools the funds of many people and
    managers invest the money in a diversified
    portfolio of securities to achieve some stated
    objective

20
Open-end Mutual Fund
  • Sell redeemable shares in the fund to the general
    public
  • Shares represent a proportionate ownership in a
    portfolio held by the fund
  • Shareholder can go directly to fund and buy
    additional shares or redeem shares at their net
    asset value (NAV)
  • No-load Funds--Sold directly to public at the
    current NAV
  • Load FundsSold through brokers and buyer pays a
    sales commission

21
Open-End Mutual Funds
  • Net Asset Value (NAV)
  • Fund calculates the total market value of its
    portfolio and divides this figure by the number
    of outstanding shares.
  • Redeem outstanding shares or issue new ones at
    the NAV.
  • Number of shares is not fixed but increases as
    more money is invested.
  • Commonly known as Mutual Funds.

22
Closed-End Investment Company
  • Issues a fixed number of shares.
  • Invests the proceeds in a portfolio of assets.
  • No load but brokerage fee.
  • Shares are transferable.
  • Price of the share is determined by supply and
    demand.

23
Mutual Funds
  • Mutual funds are regulated by the Securities and
    Exchange Commission (SEC)
  • Primary objective of regulation is the
    enforcement of reporting and disclosure
    requirements to protect the investor
  • Many investors are attracted to families of
    mutual funds
  • Number of mutual funds operated under one
    management umbrella
  • Investors can easily transfer money among funds
    within the family

24
Net Asset Value Example
  • A fund has 10 million shares and is worth 100
    million.
  • NAV 10.00
  • Investors invest 20 million more.
  • At 10/share ? 2 million shares ? 120 million in
    assets with 12 million shares.
  • You can buy fractional shares.

25
Low-load Funds
  • Load is 3 and goes to the fund.
  • Front end load
  • Charged when shares are purchased.
  • Back end load
  • Charged when shares are sold.

26
Full Load Funds
  • Sold by salespeople who earn a commission.
  • Load is split between the salesperson and the
    fund.
  • Max load allowed by the SEC is 9.589

27
12b-1 Plans
  • Charge for advertising and selling expenses,
    including sales commissions to brokers.
  • All shareholders in the fund bear the burden, not
    just new investors.
  • Funds that use 12b-1 plans call themselves
    no-load.

28
Mutual Fund Information
  • Mutual Fund Education Alliance
  • Morningstar.com
  • Valueline.com
  • Vanguard.com
  • Wall Street Journal
  • Bloomberg.com

29
Finance Companies
  • Consumer Finance Companies
  • Make consumer loans
  • Specialty Finance Companiesspecialize in credit
    card financing
  • Commercial finance Companies
  • Make commercial loans usually on a secured
    (collateralized) basis
  • Loans not as risky as consumer loans
  • Since lending is short-term, these companies
    borrow substantial amounts in commercial paper
    market

30
Finance Companies
  • Historically finance companies have played an
    important role in financing growing
    undercapitalized companies
  • Commercial finance companies originated the
    concept of leveraged buyout (LBOs) which relies
    heavily on debt to pay for acquisition of a
    company
  • Captive Finance CompaniesFinance purchase of
    commercial and retail oriented businesses such as
    General Motors products (GMAC)

31
Securities Brokers and Dealers and Investment
Banks
  • These financial institutions play a crucial role
    in the distribution and trading of huge amounts
    of securities

32
Investment Banks
  • Sell and distribute new stocks and bonds directly
    from issuing corporations to original purchasers
  • League Tables rank investment banks by the volume
    of securities they underwrite
  • Underwriting is typically conducted through a
    syndicate which includes many investment banks
    and brokerage firms
  • Investment banks derive a substantial amount of
    income from offering advice to firms involved in
    mergers and acquisitions
  • What price one firm should pay for another
  • How the transaction should be structured
  • Provide strategic advice in hostile
    takeoverswhen one firm seeks to acquire another
    against the others wishes

33
Brokers and Dealers
  • Involved in the secondary market, trading used
    or already outstanding securities
  • Brokers match buyers and sellers and earn a
    commission
  • Dealers commit their own capital in the buying
    and selling of securities and hope to make profit
    on the transaction

34
Brokers and Dealers
  • Many of the nationwide stock exchange firms act
    as investment bankers, dealers, and brokers
  • A number of large stock exchange firms have
    branched out to provide new types of financial
    services previously out of their operating
    charter
  • Commercial banks, investment banks, and broker
    dealers have now combined under single holding
    company umbrellas

35
Venture Capital Funds, Mezzanine Debt Funds, and
Hedge Funds
  • Venture capital funds, mezzanine debt funds, and
    hedge funds are usually not available to public
    investors and not registered with SEC
  • Funding comes from wealthy individuals or other
    financial institutions, possibly sponsored by
    brokerage firms and banks
  • Both venture capital funds and mezzanine debt
    funds provide an important source of funding to
    small and midsize companies
  • Financing by both venture and mezzanine funds is
    non-traded and held until maturity

36
Venture Capital Funds
  • Invest funds in start-up companies
  • Traditional bank financing for these firms in the
    early stage of growth would be very limited
  • The Venture Capital Fund receives a substantial
    equity stake in the firm
  • Although many start-up companies will fail,
    significant profit on those that are successful
  • Receives profits when it takes the successful
    company public in an initial public offering
    (IPO).

37
Mezzanine Debt Funds
  • Provide debt funds to small and midsize companies
  • Issue convertible debt and subordinated debt
  • Sometimes simply invest in a combination of
    high-yielding debt and equity issued by the same
    company
  • Used to provide long-term funds, sometimes part
    of a management-buyout financing package

38
Hedge Funds
  • Hedge funds
  • Limited partnerships that, like mutual funds,
    manage portfolios of assets on behalf of savers,
    but with very limited governmental oversight as
    compared with mutual funds.

39
Long Term Capital Management
  • Founded by John Meriwether in 1993
  • LTCM had more credibility than the average
    broker/dealer on Wall St.
  • Two Nobel laureates Robert Merton and Myron
    Scholes
  • Former Vice Chair of the Board of Governors of
    the Federal Reserve David Mullins

40
Biggest losers
  • LTCM partners 1.1 billion
  • UBS 690 million
  • Dresdner Bank 100 million
  • Sumitomo Bank 100 million
  • Bank of Italy 100 million
  • Credit Suisse 55 million

41
Banks Versus Nondepository Institutions
  • Many nondepository institutions offer services
    that compete directly with banks
  • Traditionally many of the different markets were
    segmented, however, today they often compete for
    the same business
  • The Gramm-Leach-Bliley Act of 1999 allowed the
    creation of financial holding companies (FHCs)
    that can own commercial banks, investment banks,
    and insurance underwriters

42
Banks Versus Nondepository Institutions (Cont.)
  • The creation of FHCs brings the United States
    much closer to the universal banking regulatory
    model adopted by the European Union
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