chapter 26 insurance operations. chapter objectives n present the two major areas of insurance: 1)...
TRANSCRIPT
CHAPTER
2626Insurance
Operations
© 2003 South-Western/Thomson Learning
Chapter ObjectivesChapter 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
Insurance CompaniesInsurance 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.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 ConceptsInsurance 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
BackgroundBackground
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 policyholder’s 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
Cash Value Insurance
Group
Types of Life Insurance PoliciesTypes of Life Insurance Policies
Whole Life
Variable Life
Universal Life
Term Insurance
Term
Group
Types of Life Insurance PoliciesTypes 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
Types of Life Insurance PoliciesTypes 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 life—able 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 PoliciesTypes 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 time—buys terms and
invests difference in a variety of investments Builds a varying cash value based on contributions
and investment performance
Types of Life Insurance PoliciesTypes 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 InsuranceHealth 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 Sources of Life Insurance Company FundsFunds
Cash value reserves—accumulated cash values owed insureds (liability)
Pension reserves—accumulated “insured” pension commitments (liability)
Annuity reserves—accumulated annuity commitments (liability)
Unearned premium income—premiums received; not yet earned (liability)
Loss reserves--losses incurred, not yet paid Capital funds
Uses of Life Insurance Company FundsUses of Life Insurance Company Funds
Major investor in corporate bonds Government securities Common stock Commercial mortgage Real Estate Policy loans to insured
Uses of Funds—Policy LoansUses 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
Insurance Company CapitalInsurance 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 policyholders—
includes earnings retained over time
RegulationRegulation
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
RegulationRegulation
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
RegulationRegulation
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
Risks of Life Insurance CompaniesRisks of Life Insurance Companies
Pure Risk of LifeInsurance Policies
PensionCommitments and
Annuities Contracts
Financial Riskincludes
Interest Rate RiskCredit RiskMarket Risk
Liquidity Risk
Exposure to Financial RisksExposure 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 RisksExposure to Financial Risks
Market risk Exists because events like significant market value
decreases reduce capital Economic downturn affects real estate investments
Exposure to Financial RisksExposure 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
Asset ManagementAsset 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 InsuranceProperty and Casualty Insurance
Property insurance (fire insurance) Casualty insurance (liability) Performance and financial bonding
PC Versus Life Insurance CompaniesPC 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
PC’s need liquid, marketable assets PC’s earnings more volatile
Property Casualty Investment NeedsProperty 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
Valuation of an Insurance CompanyValuation 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
k = Change in required rate or return
Where:
E(CF) = Change in expected cash flows
+
Valuation of an Insurance CompanyValuation of an Insurance Company
Factors that affect cash flows
E(CF) = Expected cash flow
Rf = Risk free interest rate
INDUS = Prevailing industry conditions for the company
Where:
E(CF)= f (ECON, Rf , INDUS, MANAB)
ECON = Economic growth
MANAB = Management ability of company
+ +?
Valuation of an Insurance CompanyValuation of an Insurance Company
Investors required rate of return
k = f(Rf , RP)++
Rf = Risk free interest rate
Where:
RP = Risk premium
Performance EvaluationPerformance Evaluation
Common indicators of company performance are available Statistical analysis of performance Ratio analysis
Trends over time Compare to industry average
Performance EvaluationPerformance Evaluation
The higher the liquidity ratio, the more liquid the company
Liquidity
Ratio
=Invested Assets
Loss Reserves and
Unearned Premium Reserves
Performance EvaluationPerformance Evaluation
Return on net worth or policyholders’ surplus is a profitability measure
Return on Equity =Net Profits
Policyholders’ Surplus
Performance EvaluationPerformance 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 AssetsMargin
Other IssuesOther 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