chapter 25 insurance operations. copyright© 2002 thomson publishing. all rights reserved....

CHAPTER

25 Insurance

Operations

Copyright© 2002 Thomson Publishing. All rights reserved.

•Historical and Religious Connotations

•Ways to deal with risk• Avoid or reduce risk

• Assume risk

• Transfer risk

Insurance

Where do deaths occur?20% in a land-based vehicle17% in the home14% to pedestrians on streets or sidewalks16% when travelling by air, rail, or water33% in a hospitalBut only 0.001% in a church

Moral: safest place to be is in church


Insurance

Ways to Transfer Risk:-- loss of income due to death (life insurance)

-- loss of income due to illness or injury (disability insurance)

-- loss of money in bank (deposit insurance)

-- loss from not paying off debts (credit insurance)

-- loss from malpractice or negligence (liability insurance)

-- loss from medical costs (medical insurance)

-- loss of income from no job (unemployment insurance)

Etc.

Law of Large Numbers


Insurance

Problems of assessing risk-based premiums

1. Adverse Selection People who get insurance are more likely to suffer losses

and file claims than people who don’t get insurance E.g. renter insurance is not a big deal for Beth because she

locks her door but Bob doesn’t lock his door so he feels the need to get insurance

2. Moral hazard People take more risks once they’re insured


Life insurance pays out policy amount in cash to thebeneficiary (tax free!) upon\ accidental or natural death Provides for loss of income

Keep you poor while you are alive so you can die rich Life insurance premiums reflect

Probability of making payment to the beneficiary (age and health)

Size and timing of the payment (policy amount) Use mortality figures and actuarial tables to forecast claims

Life Insurance


Cash Value Insurance

Group

Types of Life Insurance Policies

Whole Life

Variable Life

Universal Life

Term Insurance

IndividualTerm

Group Term


Premiums Under Various Policies



Whole life insurance includes both a death benefit (term insurance) and a savings component that Builds a tax sheltered cash value for the future for

the owner of the policy (forced savings plan) Generates periodic cash flow over the life of the

policy for the insurance company to reinvest Pays fixed death benefit at death



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 life—able to buy more insurance protection per dollar of premium

Term is for those who would rather invest their savings elsewhere (why pay ins. co. to invest?)



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 time—buys terms and

invests difference in a variety of investments Builds a varying cash value based on contributions

and investment performance



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


Uses of Life Insurance Company Funds

ASSETS

Corporate bonds 32%(Largest investor in bonds because maturities can be matched; limited mostly to quality bonds, subject to interest-rate risk)

Gov’t bonds 8%

Mortgages & Real Est. 18%

Stocks 28%

Policy Loans 2%

Cash and Other 12%


Sources of Life Ins. Company Funds

Liabilities (claims, annuities) PV of actuarially-determined claims (determined

by age, health, life expectancy, policy amount) Surplus

Stock owned (95% of companies) Or mutually owned (5% of companies but 46% of

volume) Risk-based capital requirements Used to finance fixed assets


Operations of Life Insurance Company

INCOME Premiums earned Investment Income (large source of income; Buffet calls this “float”

income – earned from investing the excess of premiums collected over claims paid)

EXPENSES PV of Claims

In early 1980s, paid 75% of premiums out in claims; but now, only 60%. They say returns/inflation in 1980s allowed them to do this.

Operating Costs (commissions, admin., mktg, tax) NET INCOME


Operations of Life Insurance Company


Uses of Funds—Policy 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


Regulation

Pricing is market-based with no federal guarantee Ratings by AM Best, Standard & Poors, Duff and Phelps,

Moody’s, and Wiess Research. Reinsurance (Lloyds of London is a big re-insurer; known

to insure all kinds of risks, such as body parts). Ins. Co.s are highly regulated by state ins. agencies

Make sure insurance companies provide adequate service Agent licensure States approve/review rates

The National Association of Insurance Commissioners (NAIC) Provides coordination among states in regulatory matters Adopted uniform regulatory reporting standards


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


Regulation: Dodd-Frank Act of 2010

If it weren’t for AIG, maybe the insurance industry wouldn’t have been part of this regulation.

Now, a Federal Insurance Office is being created which will gather info from insurance companies each year and will probably recommend a slew of regulations down the road

Health and crop insurance are excluded


S&P Insurance Ratings

AAAAn insurer rated 'AAA' has EXTREMELY STRONG financial security characteristics. 'AAA' is the highest Insurer Financial Strength Rating assigned by Standard & Poor's. AAAn insurer rated 'AA' has VERY STRONG financial security characteristics, differing only slightly from those rated higher. AAn insurer rated 'A' has STRONG financial security characteristics, but is somewhat more likely to be affected by adverse business conditions than are insurers with higher ratings. BBBAn insurer rated 'BBB' has GOOD financial security characteristics, but is more likely to be affected by adverse business conditions than are higher rated insurers. An insurer rated 'BB' or lower is regarded as having vulnerable characteristics that may outweigh its strengths. 'BB' indicates the least degree of vulnerability within the range; 'CC' the highest

http://www.insure.com/articles/interactivetools/sandp/newtool1.jsp

BBAn insurer rated 'BB' has MARGINAL financial security characteristics. Positive attributes exist, but adverse business conditions could lead to insufficient ability to meet financial commitments. BAn insurer rated 'B' has WEAK financial security characteristics. Adverse business conditions will likely impair its ability to meet financial commitments. CCCAn insurer rated 'CCC' has VERY WEAK financial security characteristics, and is dependent on favorable business conditions to meet financial commitments. CCAn insurer rated 'CC' has EXTREMELY WEAK financial security characteristics and is likely not to meet some of its financial commitments. RAn insurer rated 'R' is under REGULATORY SUPERVISION owing to its financial condition. During the pendency of the regulatory supervision, the regulators may have the power to favor one class of obligations over others or pay some obligations and not others. The rating does not apply to insurers subject only to nonfinancial actions such as market conduct violations. NRAn insurer rated 'NR' is NOT RATED, which implies no opinion about the insurer's financial security.




Exposure to Financial Risks

Interest rate risk Fixed rate assets (bonds) have market values

sensitive to interest rate changes More IRR in life ins. co. than P&C

Credit risk (default risk) Mortgages, corporate bonds and real estate

holdings can involve default risk Usually only hold investment-grade securities Diversify portfolio among debt issuers If major disaster, surplus must absorb losses

(Florida, Hurricane Hugo, etc.)


Property and Casualty Insurance

Property insurance (fire insurance) Casualty insurance (liability) Both timing and amounts of claims are

unknown!


Property & Casualty Ins. Use of Funds

ASSETS

Corporate Bonds 25%

Muni bonds 23% (PCs face heavy tax)

Treas./Agency Bonds 15%

Common Stock 18%

Cash 2%

Other 17%


PC Versus Life Insurance Companies

PC have shorter contracts PC have more varied risk areas (default and

liquidity risk, but not interest-rate risk) Life companies are larger due to long-term

savings and annuity pension contracts PC has wider distribution of occurrences

PC’s need liquid, marketable assets PC’s earnings more volatile


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


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 Preferred Provider Organizations (PPOs)

Can see any physician without a wide group


Insurance Scandals

In 2004, Eliot Spitzer brought a civil suit against Marsh & McClennan for: Bid-rigging, kickbacks, price-fixing Contingent commissions

M&M agreed to give $850 million back to its customers. Cut 5500 jobs, blaming costs of settlement. Agreed to adopt new reforms including a limit on commissions.


Insurance and Derivatives

In risk management, there’s not much difference between using traditional insurance and derivatives to manage risk.

E.g. Disney & business interruption insuranceE.g. Farmer buying crop insuranceE.g. Stock investor buying investment insuranceE.g. Investors buying credit insurance on bonds


Other insurance operations

Bond Insurance

Bond insurance protects the investors that purchase bonds in the event that the bond issuers default on their bonds.

Mortgage InsuranceMortgage insurance protects the lender that provides mortgage loans in the event of homeowner default.

Credit Default Swaps as a form of mortgage bond insurance Privately negotiated contracts that protect investors against the risk of default on

particular debt securities. Insurance companies commonly serve as the counterparty and have to make

payments only if there is a default on the securities covered by the swap.


World-wide GDP in 2007 was $54 trillion

Global est. value of CDS in 2007 was $58 trillion!!!

CDS were ticking time bombs in almost every major investment portfolio

CDS provide insurance on bonds (but they didn’t want to call it “insurance “ otherwise it would be regulated)• If bonds lose value, the CDS would make good on the loss• CDS were considered a good thing . . . Until speculation began• Speculators would bet on bonds going bad (like Bob buying insurance on Jehu’s

car; since Jehu is a risky driver, Bob collects if Jehu crashes.)• Described by Buffet as “financial weapons of mass destruction.”• Multiple CDS were contracted on the same bonds

Credit Default Swaps (ticking time bombs)


AIG rolled the dice by providing credit insurance on $700B of Lehman Bros. When the bonds went bad, AIG could not make good.

As a tell-tale symbol, the DJIA replaced AIG with Kraft (Altria) – a financial stock substituted with a food/tobacco stock!

An AIG executive said as late as August 2007 that “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [CDS] transactions.”


Exposure to Risk during the Credit Crisis Government Rescue of AIG

American International Group (AIG) is the largest insurance company in the world, with annual revenue of more than $100 billion and operations in more than 130 countries.

In 2008, AIG experienced severe financial problems because many debt securities defaulted which were backed by AIG’s CDSs.

Since the failure of AIG could have a devastating effect on the insurance industry and the rest of the financial sector, the Federal Reserve bailed out AIG in September 2008 with support from the U.S. Treasury.

The bailout allowed AIG to borrow up to $85 billion from the Federal Reserve over a two-year period, and the government received an equity stake of about 80 percent of AIG.

Credit Default Swaps (ticking time bombs)

chapter 25 insurance operations. copyright© 2002 thomson publishing. all rights reserved....

Documents

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