chapter 3
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Insurance Companies and Pension PlansChapter 3 Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Types of Life Insurance (pages 40-43)Term lifeWhole lifeVariable lifeUniversal lifeEndowment lifeGroup lifeRisk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Cost of Whole Life Insurance Compared with Annual Premium (Figure 3.1) Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Investment of SurplusSome contracts allow the policyholder to choose how the surplus is investedThere are tax deferral advantages compared with a regular investment because no tax is paid until there is a payout on the policy
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Annuity Contracts (pages 43-44)Typically a lump sum payment is used to buy a life-time annuityAnnuity can be fixed or variableAnnuity can start immediately or be deferredAccumulated value can depend in a complicated way on the performance of stock indicesThere may be penalty-free withdrawals
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Extract from US Mortality Tables (2004): MaleRisk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
AgeProb. death within one yearProb. SurvivalLife expectancy (yrs)300.0013520.9714646.58310.0013670.9701545.64320.0014040.9688244.70330.0014670.9674643.76
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Extract from US Mortality Tables (2004): FemaleRisk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
AgeProb. death within one yearProb. SurvivalLife expectancy (yrs)300.0006210.9844251.05310.0006590.9838150.08320.0007050.9831649.11330.0007610.9824748.14
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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How Tables Are Used In Pricing Life InsuranceConsider a female aged 30Probability of death during first year is 0.000621Probability of death during second year is (1-0.000621) 0.000659 Probability of death during third year is(1-0.000621) (1-0.000659) 0.000705etcMinimum premium is such that present value of inflows equals present value of outflows.
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Longevity Derivatives (page 48)Used by life insurance companies and pension fundsA population is defined and coupon on a bond depends on the number of members of the population still aliveRisk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Property-Casualty InsuranceProperty insurance is concerned with loss or damage to property from fire, theft, etcCasualty insurance is concerned legal liability exposuresWhat are the biggest risks facing property-casualty insurers? Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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CAT Bonds (page 49-50)CAT bonds are an alternative to traditional reinsuranceThis is a bond issued by a subsidiary of an insurance company that pays a higher-than-normal interest rate.If claims of a certain type are above a certain level, the interest and possibly the principal on the bond are used to meet claims
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Example of Ratios for Property-Casualty Insurance (Table 3.2)Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Loss Ratio 75%Expense ratio30%Combined ratio105%Dividends1%Combined ratio after dividends106%Investment income(9%)Operating ratio97%
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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When Do Premiums Change?In life insurance premiums typically stay the same throughout the life of the contractIn property-casualty insurance premiums are changed from year to year as risks are reassessedIn heath insurance premiums can rise because of the overall cost of health care but not because the health risks of the policyholder increaseRisk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Moral Hazard and Adverse Selection (pages 52-53)Moral hazard is the risk that the existence of the insurance policy causes the policyholder to take more risksAdverse selection is the tendency for an insurance company to attract bad risks when it cannot perfectly distinguish between good and bad risks Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Typical Summary Balance Sheet: Life Insurance (Investments are mostly long-term corporate bonds)Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
AssetsLiabs and Net worthInvestments90Policy Reserves80Other assets10Sub Long Term Debt10Equity Capital10Total100100
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Typical Summary Balance Sheet: Property-Casualty Insurance (Investments are mostly liquid shorter maturity bonds)Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
AssetsLiabs and Net worthInvestments90Policy Reserves45Other assets10Unearned premiums15Sub Long Term Debt10Equity Capital30Total100100
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Regulation of Insurance Companies
US: Mostly at the state levelEurope: Mostly at the EU level
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Pension PlansDefined benefit planContributions are pooled Benefits are determined by a formula dependent on the final salary of the employee and the number of years of service Defined contribution planContributions for each employee are kept separate and invested on behalf of the employeeWhen the employee retires the accumulated value of the contributions is usually converted to an annuity
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Defined Benefit PlansActuaries estimate liabilities and calculate a surplus or deficit for the plan.The discount rate used is the AA borrowing rateDeficits must be funded by the company within a prescribed periodA perfect storm: Declining equity prices coupled with declining interest ratesRisk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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Are Defined Benefit Plans Viable?Employer plus employee contributions are typically 15% of salary or lessActuarial estimates show that about 25% of salary is necessary to fund most plansFunds typically invest 60% in equities and are relying on good investment returns from equity investments to meet obligationsShould members of DB plans bear some of the risk associated with equity returns?Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009*
Risk Management and Financial Institutions 2e, Chapter 3, Copyright John C. Hull 2009
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