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					    CHAPTER 18

INSURANCE COMPANIES AND
      PENSION FUNDS
           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.

                               Finance 308                         2
    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.




                    Finance 308                  3
             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.
                      Finance 308                   4
 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      Finance 308                  5
    Insurance premiums represent
             the sum of:
•   expected losses, plus
•   operating costs, plus
•   target profit, less
•   premium investment income




                   Finance 308     6
      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
                         Finance 308             7
   Organizational Forms in the
       Insurance Industry
• Stock Companies
• Mutual Companies
  – Demutualization
• Reciprocals
• Lloyd’s Associations
• Supervised by National Association of
  Insurance Commissioners (NAIC).
                      Finance 308         8
           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.
                          Finance 308              9
            Term Insurance

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




                    Finance 308              10
     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.


                          Finance 308                         11
  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 includes308
                     Finance
                             "return" of savings.      12
 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.
                    Finance 308             13
             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.


                   Finance 308                14
             Variable Life
• Popular in the 1990’s 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
                    Finance 308                15
                  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
                       Finance 308                16
           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.




                    Finance 308                 17
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


                      Finance 308                    18
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
                       Finance 308                   19
   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



                    Finance 308                 20
          Property Insurance
• Purchased to protect against direct or
  indirect loss to property they own
• Named-perils coverage
• All-risks coverage
  – ―Open perils‖ coverage




                    Finance 308            21
   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.



                     Finance 308                22
   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.

                          Finance 308                       23
   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.

                         Finance 308                   24
   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.

                       Finance 308             25
    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.
                   Finance 308             26
 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)

                     Finance 308                27
 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


                       Finance 308    28
        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 308
                          Finance                            29
             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.
                          Finance 308                    30
  Pension Plan Terms (concluded)

• Defined contribution plan -- benefits are variable,
  but contributions are defined in plan. 401k’s--
  most popular today.
• Cash Balance Plan—type 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.                  Finance 308                  31
        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.
                       Finance 308                     32
                    Conclusion
• Pure Risk
• Life Insurance
   –   Term
   –   Whole life
   –   Universal
   –   Variable
   –   Annuity
• Property and Liability
  Insurance
• Pension Plans
   – Defined Benefit
   – Defined Contribution
   – Cash Balance           Finance 308   33

				
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