Chapter 15 Summary - book \"Financial Markets and Institutions\" PDF

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Chapter 15: Insurance CompaniesTwo Categories of Insurance Companies: Chapter Overview  Insurance companies are financial institutions that protect individuals and corporations (policyholders) from adverse events.  The insuarnace provider can either act as a insurance underwirin or inasuance broke...

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Chapter 15: Insurance Companies Two Categories of Insurance Companies: Chapter Overview  Insurance companies are financial institutions that protect individuals and corporations (policyholders) from adverse events.  The insuarnace provider can either act as a insurance underwirin or inasuance broker  Underwiritn sells insuance contracts  Broker acts more as a middle man between underwriting and the applicant  Life insurance: prvodies protection in the event of untimels death, ilnes and reirement  Property-casual insurance: protects against personal injury and liability due to accidents, theft, fire and other catastrophes Life Insurance Companies  Size, Structure, Industry o Major mergers o Allows individuals to protect themselves and their beneficiaries against the risk of loss of income in the event of death or retirement o By pooling the risks of customers, life insurance companies can diversify away some of the customer specific risk and offer insurance series at a cost lower than any individual could achieve savings funds on his or her own o Adverse selection problem: the problem that customers who apply for insurance polices are more likely to be those in need of coverage  Ex: health problems  Deal with this by establishing different pools of the population based on health and related characteristics (gender, income) o Moral Hazard: when, after an insurer and a customer enter into an insurance contract, the insured customer takes an action that is not taken into account in the contract, yet which changes the value of the insurance.  Ex: after buying car insurance, you dive more recklessly without auto insurance the likelihood of an accident is 2% per year  With insurance rate should be higher than 2%  Mange this problem with deductibles make the insured bear financial responsibility  Life Insurance lines of business o Ordinary Life:  Term: contract expires, no savings (policy holder gets nothing if he or she is alive when the contract expires), beneficiary receives face value on death during contract period  Whole Life: no expiration, beneficiary receives face value on death, policyholder can borrow cash value of contract  Endowment Life: contract expires, policyholder gets face value of contract on expiration if still alive, beneficiary receives face value on death during contract period

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Variable Life: no expiration, premium invested in mutual funds, beneficiary receives variable amount on death (a function of the return on the underlying investments) Universal Life: no expiration, premiums can vary, premiums invested in mutual funds, beneficiary receives variable amount on death (a function of premiums invested and the return on the underlying investments) Expiration

Savings

Other

Term

Guaranteed at least some type of payment? No

Yes

No

Payment is made only if death occurs.

Whole

Yes

No

No

Can borrow against cash value Can withdraw cash (but this reduces payout)

Endowment

Yes

Yes

No

Variable

Yes

No

Yes

Universal

Yes

No

Yes

Invests in mutual funds, bonds, stocks, etc. Premiums and payouts can vary. Can be combined with Variable Life Insurance products

o Group Life Insurance: covers a large number of insured persons under a single policy. Usually to corporate employers, these polices may be either contributory (where both the employer and employee cover a share of the employee’s cost of the insurance, rather the cost is paid entirely by the employer  ex: Clemson life insurance o Credit Life: protects lenders against a borrower’s death prior to the repayment of a debt contract such as mortgage or car loan  Usually the face amount of the insurance policy reflects the outstanding principal and interest on the loan  Rarely used o Other Life Insurance Activities: sale od annuities, private pension plans and accident and health insurance  Balance Sheets and Recent Trends o Assets:  Concentrate their asset invesmtns at the longer end of the maturity spectrum (ex: corporate bonds, equities and home mortgages)  Bonds 45.6%  Other Investments 49.3%  Cash 1.9%  Other Assets 3.2% o Liabilties:  Net Policy Reserves 45.1%  Other Liabilities 46%

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Total Capital and Surplus 5.9%

Life Insurance Example You want to buy a term life insurance product that pays $100,000 if you die within one year. How much should the insurance company charge you? Assume that the probability of death over the next year is “q” and that the insurance company’s goal is to break even. That is, the insurance company needs to charge a premium, $X, equal to the expected payout. Calculate the premium payment if the insurance company estimates that q = 0.2%

Calculate the probability of death over the next year if the insurance company charges the following premiums: $X = $70.80 $X = $1,293.00

Property-Casualty Insurance Companies  Major lines of P&C Insurance o Covers related to the loss of real and personal property o Fire insurance and allied lines: protect against the perils of fire, lightening and removes of property damage in a fire (5% of premiums in 2012) o Homeowners Multiple Peril: protects against multiple perils of damage to a personal dwelling and personal property as well as liability coverage against the financial consequences of legal liability resulting from injury to others (15%)  Fire, wind, theft, someone gets injured on your property o Commercial Multiple Peril: protects commercial firms against perils similar to homeowners multiple peril insurance (4.5%)  Food poisoning at your restaurant o Automobile Liability and Physical Damage: provides protection against losses resulting from legal liability due to the ownership of use of the vehicle (38.2%)  Losses resulting from the legal liability due to the ownership or use of the vehicle  Theft or damage to vehicles o Liability Insurance (other than auto): protection to either individual or commercial firms against no automobile-related legal liability (12.6%)  Balance Sheets and Recent Trends o Similar to life insurance companies, P&C insurance invest the majority of their assets in long-term securities, although the proportion held in common stock is lower than that of the life insurance companies o The maturity of their assets tends to be shorter than that for life insurance companies o 84% of assets are investments, 38% of liabilities are loss reserves and LAE  What do insurance company managers think about? o Loss Risk: the key feature of claims loss risk is the actuarial predictability of losses relative to premiums earned. This predictability depends on a number of characteristics of features of the perils insured  Property vs. Liability:  More predictable for property lines than for liability lines  Ex: monetary value of the loss or damange to an auto is realtively easy to calculate, but the upper limit on the losses to which an insurer might be exposed in a product laiblity line  Ex: asbestos damange to workers healgy might be diddicult to estimate the damange to their health  Severity vs. Frequency: loss rates are more predicatble on low severity, high frequency lines than on high severity, low frequency lines  Ex: losses on fire, auto and homeowners peril lines tend to be ex[ected to occu with high frequency and to be indepedntly

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distributed across any pool of insured customers. Only a limited numer of customers are affected Long tail vs. Short Tail:  Long tail: a loss for which a claim is made some time after a policy was written. Arises in polcies for which theinsured vent ha[[ens during coverage period, but a claim is not filed or made util amy years later o Ex: Medical mal practice file a claim years later  Short tail is more predictable o Ex: property coverage homeowners or auto 30 days to file a claim

 Expense Risk o Measuring loss risk  Loss ratio measures the avtal losses on a specific policy line. It measures the ratio of losses incurred to premiums earned  A loss ratio less than 100 means that premiums earned were sufficient to cover losses incurred on that line  Premiums earned: premiums received and earned on insurance contracts because time has passed with no claim filed  Loss Adjustment Expense (LAE): Costs surrounding the loss settlement process to premiums written o Combined Ratio: Loss Ratio + LAE Ratio + Expense Ratio  A measure of the overall underwriting profitability of a line; equals the loss ratio plus the ratios of loss-adjusted expenses to premiums earned as well as commission and other acquisition costs to premiums written plus any dividends paid to policyholders as a proportion of premiums earned Combined Ratio: Loss Ratio + LAE Ratio + Expense Ratio

Auto insurance company charges $2,000 per year per policy. Suppose the firm sells 10,000 policies. Calculate total premiums written. Total losses are $12,000,000 and LAE is $1,500,000. Other expenses are $6,000,000. Calculate the combined ratio (do this in dollars and percent).

Combined Ratio After Dividends = Combined Ratio + Dividends Ratio

Investment Yield / Return Risk Operating Ratio = Combined Ratio – Investment Yield Example: An auto insurance company provides the following financial information. Calculate the Operating Ratio. Premiums written: $80M Losses: $60M Loss Adjustment Expenses: $12M Operating Expenses: $16M Dividends Paid: $2M Investment Profit/Loss: $2M Operating Ratio: ????%

Regulation  McCarran-Ferguson Act of 1945: regulation confirming the primacy of state over federal regulation of insurance companies  Regulated by the STATE!!!!!  Insurance guarantee fund: a fund of required contributors from within-state insurance companies to compensate insurance policy holders in the event of failure  P&C insurers are chartered at the state level and regulated by state commissions  In addition, state guarantee funds provide protection to policyholders, in a manner similar to that described earlier for life insurance companies if a P&C insurance company was to fail...