INSURANCE COMPANIES AND PENSION FUNDS

1
CHAPTER 18

• INSURANCE COMPANIES AND PENSION FUNDS

2
The Insurance Service --

• Indemnify another against risk of economic loss.
• Requires pooling of a large number of similar,
  but independent risks -- law of large numbers.
• Insurance is the last step after other pure risk
  control and reduction techniques of risk
  management.
• Pure risk, the chance of loss, differs from
  speculative or investment risk which is related
  to the variability of returns where one can have
  a gain or a loss.
• Insurance reduces society's cost of bearing risk.

3
The Insurance Mechanism

• An insurer assumes objective risk which is the
  deviation of actual losses from expected losses.
  It is part of the operating risk of an insurance
  company.

4
Insurable Risks

• homogeneous or similar.
• fortuitous, random or occurring by chance.
• circumstances of loss can be identifiable.
• a probability of loss can be estimated.
• the losses occur independent of each other--not
  all at once, such as a flood, wiping out the
  insurer.
• premiums must be economically feasible for the
  insured
• considers Adverse Selection.

5
Objective risk control methods include

• Use the Law of Large Numbers
• As the number of insured risks increases, the
  deviation between actual and insured risks
  decline
• Underwriting
• Selection and classification of insurable risks
• Accept "average" risks as customers.
• Use of loss prevention techniques such a "safety"
  programs and sprinkler systems.
• Require deductibles and/or shared losses with the
  insured.
• Use reinsurance

6
Insurance premiums represent the sum of

• expected losses, plus
• operating costs, plus
• target profit, less
• premium investment income

7
Interest rate risk affects insurance companies.

• Insurance contracts are long-term contracts
  interest rates vary providing incentives for
  cancellations and revision of intentions.
• Underwriting Cycle
• A cyclical pattern
• High interest rates encourage "cash flow
  underwriting" and policy loans

8
Organizational Forms in the Insurance Industry

• Stock Companies
• Mutual Companies
• Demutualization
• Reciprocals
• Lloyds Associations
• Supervised by National Association of Insurance
  Commissioners (NAIC).

9
Life/Health Insurance Companies

• Oldest financial intermediary in U.S. (1759)
• Life/Health insurers sell a wide variety of
  financial services products including
• Life insurance
• Annuities
• Health insurance
• Long-term care insurance
• IRAs and mutual funds
• Protect against the economic risk of premature
  death, poor health and superannuation.

10
Term Insurance

• General
• Payment for death only
• Lower premium
• Large amount of protection per premium dollar

11
Term Insurance (concluded)

• Term policy variables
• Straight -- coverage for specific time period
  with premiums increasing with age.
• Renewable -- option to continue after expiration
  date, independent of health changes.
• Decreasing -- pay level premiums over a period of
  years while level of coverage declines.
• Convertible -- policyholder may convert to a
  whole life policy for an added premium fee.

12
Whole Life Insurance General Characteristics

• Level premiums for constant level of protection.
• Premium includes cost of insurance and savings
  contribution.
• Policy holders overpay the cost of mortality in
  the early years, and underpay in the later
  years.
• Cash values (savings accumulated by insured)
  increase with time.
• Death benefit includes "return" of savings.

13
Whole Life Insurance General Characteristics
(concluded)

• Provides "living" benefits in form of accumulated
  savings.
• Combines life insurance and savings (at a
  relatively low but contractual rate).
• The cash value serves as a savings account for
  the policyholder
• Protects against premature death during the
  income-earning years and against the risk of
  superannuation after retirement.

14
Universal life

• The most popular interest-sensitive permanent
  policies.
• Flexible premium, nonparticipating policy with
  varying death benefit and premium amounts.
• Pays market rate on savings.

15
Variable Life

• Popular in the 1990s with rapid growth in equity
  values.
• Fixed-premium
• Insured direct investment of cash values
• Guaranteed minimum death benefit
• No guaranteed cash value
• Offers a number of mutual fund alternatives for
  the cash value

16
Annuities

• Superannuation- risk of living too long after
  retirement
• A life annuity, for a given payment, pays a life
  long stream of payments.
• The period of time and survivorship terms vary.
• The longer the "certainty," the less the
  payments.
• 168.4 billion in 2002

17
Health Insurance

• Covers medical, disability, long-term care, and
  dental expenses.
• Health insurance can be purchased individually or
  made available through a group insurance plan.

18
Balance Sheet of Life Insurance Companies

• Liabilities and net worth
• Life insurance reserves -- funds owed for life
  insurance policies, including cash values and
  losses owed, not yet paid.
• Pension fund reserves -- accumulated commitments
  to pay future pensions.
• Surplus and net worth

19
Balance Sheet of Life Insurance Companies
(concluded)

• Assets -- long-term matching liabilities
• Corporate bonds-largest financial investment
• Corporate equities-Variable life
• Mortgages
• Policy loans
• Cash short-term investments
• 3.369 trillion in 2002

20
Property/Liability Insurance Companies

• Property insurance -- protection from financial
  loss of property from perils such as fire and
  theft.
• Casualty insurance -- liability, worker's
  compensation, auto, aircraft, marine

21
Property Insurance

• Purchased to protect against direct or indirect
  loss to property they own
• Named-perils coverage
• All-risks coverage
• Open perils coverage

22
Types of Property/Casualty/ Liability Policies

• Property -- insurance against losses associated
  with physical damage.
• Liability -- insurance against loss arising from
  the damage to the property or personal injury to
  others.

23
Types of Property/Casualty/ Liability Policies
(continued)

• Surety and fidelity bonds
• Bond -- agreement by one party (surety) to be
  accountable to a third person (the obligee) for
  the debt or default of another party (principal).
• Surety bond -- provides financial protection
  against failure to perform an agreement such as
  construction.
• Fidelity bond -- provides financial protection
  from the infidelity or dishonesty of employees,
  such as embezzlement.

24
Types of Property/Casualty/ Liability Policies
(continued)

• Marine insurance -- covers financial losses
  related to transportation.
• Ocean marine -- ocean transportation
• Inland marine -- inland transportation and some
  personal property such as furs and jewelry
• Homeowner's insurance -- Multi-peril or
  multi-line policy covering most risks of home
  ownership and renting. Includes property and
  liability insurance.

25
Types of Property/Casualty/ Liability Policies
(concluded)

• Family personal auto insurance -- A multi-peril
  policy covering most of the risks of owning and
  driving an auto
• liability.
• physical damage (collision).
• medical.
• uninsured motorist.

26
Life vs. P/L operations and practices

• P/L policies shorter term than life
• P/L loss payments more erratic
• P/L loss payments increase with inflation
• P/L premiums net of losses and expenses is taxed
• Both life and P/L firms generate revenue from
  premiums and investment income.

27
Balance Sheet of P/L Insurance Companies

• Assets -- selected for income, inflation hedge,
  liquidity, and tax sheltering
• State and municipal bonds (tax free) and
  corporate bonds
• Corporate stock (inflation hedge and income)
• Government securities (liquidity and income)
• Trade credit ( owed by customers and agents)

28
Balance Sheet of P/L Insurance Companies
(concluded)

• Liabilities and net worth
• Policy reserves include
• unearned premium reserve.
• losses incurred, not paid.
• Surplus and net worth
• Total of 1,042.9 billion in 2002

29
Types of Pension Plans

• Private Pension Plans
• Insured -- assured by contracting with life
  insurance firms
• Noninsured
• Trustee managed by a third party
• Non-trusteed -- managed by firm or labor union
• Government-sponsored Pension Plans
• Federal Social Security
• Old Age, Survivors, and Disability Insurance
• Social insurance Security Net
• Federal employees
• State and municipality

30
Pension Plan Terms

• Fully funded -- contributing a pool of funds
  sufficient to cover future obligations versus
  paying retirement benefits from sales or tax
  revenues.
• Contributory -- employee contribution deducted
  from pay.
• Noncontributory -- employer makes all funding
  payments.
• Defined benefit plan -- contributions are made to
  meet "defined" retirement benefits for pensioners.

31
Pension Plan Terms (concluded)

• Defined contribution plan -- benefits are
  variable, but contributions are defined in plan.
  401ks--most popular today.
• Cash Balance Plantype of defined contribution
  plan oriented to younger workers
• Vesting -- employee assured of retirement
  benefits after a set period of time.
• Portability -- ability to transfer vested
  benefits on to other pension fund as a single
  plan
• Pension Benefit Guaranty Corporation and ERISA.

32
Pension Fund Portfolio Management Factors

• Little need for liquidity
• Pension fund income exempt from federal income
  taxes
• The higher the earnings rate, the lower the
  contribution for a defined benefit plan
• Pension funds face risk/return trade-off
  decisions for their beneficiaries
• Over 7 trillion in 2002.

33
Conclusion

• Pure Risk
• Life Insurance
• Term
• Whole life
• Universal
• Variable
• Annuity
• Property and Liability Insurance
• Pension Plans
• Defined Benefit
• Defined Contribution
• Cash Balance