Insurance Companies

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					Insurance and Life & Health
   Insurance Companies




        Business 4039
Agenda


1. Size, Structure and Composition

2. Balance Sheet and Recent Trends

3. Regulatory System

4. Property and Casualty Firms
       Insurance Companies
• Deposit-taking FIs are distinguished by a
  unique liability – deposits.
  – Deposits, the debts of deposit-taking
    institutions, are crucial to society because
    society considers them to be money.
• Insurance companies are distinguished by
  a unique set of liabilities – actuarial
  liabilities
      Actuarial Liabilities


• The expected net present value of
  contingent obligations to make payment to
  insurance policy beneficiaries upon the
  occurrence of a loss.
• The obligations are defined in insurance
  contracts – undertakings to indemnify
  beneficiaries.
       Indemnify
• To put the beneficiary back to the same financial
  condition as prior to the occurrence of the loss.

  NOTE: because of this, insurance is a lousy
   investment. The best you can hope for is to be put
   back to your original condition…but since you pay a
   premium, you have reduced your assets in order to
   buy this coverage. In addition, there is usually a
   deductible involved…this helps to avoid the moral
   hazard problem in insurance … (the incentive to
   purposefully suffer the loss in order to capitalize on
   the presence of insurance.)
      What do Insurance Companies Do?


• Insurance companies address the
  problems of risk faced by customers by
  providing:
  – Risk off-laying
  – Risk absorption
  – Risk transformation
                          Services.
      Pure Risk

• In insurance parlance, “pure risk” involves
  only the chance of loss, and not of gain.
• Examples of pure risk are:
  – Death
  – Disability
  – Accidental dismemberment
  – Damage due to hail
       Speculative Risk

• Where a chance of gain exists, insurers have
  called the risk “speculative risk.”
• Speculative risk is what financial theorists call
  “risk” pure and simple, and corresponds with the
  measures of market risk.
• When you invest in a negotiable financial asset,
  such as a stock or bond, you assume market (or
  price) risk.
• Although you may not be „speculating‟ according
  to insurers…this is still speculative risk because
  there is a chance to sell the asset for more than
  what you paid for it.
      Speculative Risk

• Generally, insurers will not insure
  speculative risks.
• Investors, however, can mitigate and even
  immunize themselves from this risk using
  derivative instruments and other
  techniques (like duration matching
  strategies)
      Insured Risks

• The major risks that insurance companies
  have traditionally insured involve:
  – Personal injury, illness and death
  – Loss and destruction of property, and
  – Legal liability
Size, Structure and Composition
         of the Industry




             4039
      The Life Insurance Industry

• The life insurance industry in Canada is
  about one-quarter the size of the banking
  industry when measured in terms of
  assets or income, and slightly under half
  the size in terms of equity and employees.
      The Insurance Industry


• The industry has seen massive
  consolidation in recent years. At the end
  of 1998, just 129 life and health insurance
  companies were operating, compared with
  170 at the end of 1980.
           Life Insurance Products

• Traditionally, life companies have provided two main services:
    – Protection
    – Wealth management

• Life insurance allows individuals to protect themselves and their
  beneficiaries against losses in income through premature death.
• Life annuities protect individuals against insufficient income due to
  unexpectedly extended life.
• By pooling risks, life insurance companies not only transfer income-
  related uncertainties from the insured individual to the group, but
  also reduce these risks.
• Other important products include:
    – Disability insurance
    – Critical illness insurance
       Wealth Management Products


• Life insurance companies manage pension
  plans and sell life annuity contracts, registered
  retirement income funds (RRIFs) and registered
  retirement savings plans (RRSPs)
• Life insurance companies sell a type of pooled
  investment known as segregated funds.
      RRIF


• A registered retirement income fund is a
  retirement tax shelter, allowed by the
  government, from which the retiree must
  withdraw specific amounts each year.
       RRSP

• A registered retirement savings plan is a
  tax shelter allowed by the government to
  encourage individuals to save (up to
  certain limits) for retirement.
• Initial contributions to and interest on the
  RRSP are tax deductible.
       Segregated funds

• A wealth management product.
• Are a type of pooled investment available
  through life insurance companies.
• As a life insurance company product, they
  enjoy some unusual features for example
  they are „creditor-proof‟ just like pensions.
• Like mutual funds, there are many types –
  fixed-income, growth, etc.
         Types of Life Insurance

•    Two basic classes or lines of life
     insurance distinguished by the manner in
     which they are sold to purchasers:
    1. Individual life insurance
    2. Group life insurance
       Individual Life Insurance
• Is sold one policy at a time, person to person,
  through company and independent agents.
• Traditionally, personal sales have been
  expensive but result in tailor-made financial
  services for each individual buyer;
• To reduce the cost of individual life insurance
  delivery, insurance companies have
  implemented “affinity insurance” sold through
  organizations such as alumni associations,
  professional associations or unions where
  members share common characteristics.
        Group Life Insurance
• Covers many people under a single policy.
• These policies are usually issued to corporate or
  government employers.
• Their premiums may be fully paid by the
  employer or shared by the employer and
  employee.
• The plans are subject to mass sales and
  administration.
• Average commissions and screening costs per
  individual are correspondingly lower for group
  life policies than for individual life policies. Some
  of these savings are passed on to customer
  through lower premiums.
         Insurance in Canada

• The total face value of life insurance policies in force in
  Canada is about $2 trillion, about twice our GDP.
• Relative to GDP, Canada‟s ownership of life insurance is
  second only to Japan‟s.
• Individual life insurance used to account for almost all
  policies in force. Then in the 1950s and 1960s, group
  life grew rapidly to 59 percent of policies in 1979.
• Over the past 20 years, however, as employee benefits
  have come under pressure and companies and
  governments have down-sized, group insurance has
  stabilized at about half the dollar amount of insurance in
  force.
      Terms and Definitions
Insurance Underwriter:
    The insurance company or group that assumes the
     obligations under the insurance contract by
     insuring a particular risk.
Insurance Agent:
    A sales representative for an insurance company.
Insurance Broker:
    An independent person or company who acts on
     behalf of the insured to place an insurance
     contract with an underwriter (and may represent
     the interests of the insured or beneficiary to the
     underwriter in the event of a claim.)
       Terms and Definitions
Legal for Life:
     A regulated quality standard that an investment
      asset must achieve before it can be booked by a
      life insurance company (ie. bonds must be BBB or
      above).
Policy Loan
     A loan made by an insurance company to a
      policyholder using his or her policy as collateral.
How to Price Life Insurance




           4039
       Pricing Insurance


• Insurance is priced according to the
  severity (dollar value of the loss to be
  isured) and frequency (how likely the
  insured event is to occur.
          Figure 3:                  Classification of Pure Risk

                               Increasing Probability of Loss
Increasing Magnitude of Loss
            Figure 3:                  Classification of Pure Risk

                                 Increasing Probability of Loss
  Increasing Magnitude of Loss




                                                Losses to property (flood, fire,
                                                theft) – Losses to human capital
                                                – high magnitude but low
                                                probability.




Probability and Magnitude of loss help to select an appropriate risk
                      management strategy.
         Counterintuitive
• An increasing probability of loss does not
  necessarily mean that you require insurance against
  the risk.
• When the probability of loss is very high, buying
  insurance is of no value, since it would simply be a
  prepayment plan.
• Can you give me examples of this?
    •   Lava flow damage next to a volcano
    •   Earthquake damage on structures built on the San Andres fault
    •   Water damage on homes built outside Winnipeg‟s flood way.
        What about High Probability But Low
        Magnitude?



• Do you need insurance for risks like this?
    • The cost of insurance will be very very high because
      these numerous small claims will place a very high and
      costly administrative burden on any insurer willing to
      insure the risk…therefore, the cost of insurance is likely
      to exceed the cost the risk-bearer would encounter if
      they simply paid for their own repairs when they
      occurred.
• Can you give some examples?
    • Hail insurance in Fort Frances (Fort Frances is known
      by insurers as a place that experiences very frequent
      hail storms)
            Figure 3:                  Classification of Pure
            Risk
                                 Increasing Probability of Loss
  Increasing Magnitude of Loss




                                              Earthquake insurance in an
                                              earthquake zone.




Probability and Magnitude of loss help to select an appropriate risk
                      management strategy.
            Figure 3:                  Classification of Pure
            Risk
                                 Increasing Probability of Loss
  Increasing Magnitude of Loss




                                              Insurance for dents in
                                              automobile paint for a person
                                              who drives long distances on a
                                              regular basis over heavily
                                              traveled gravel roads.




Probability and Magnitude of loss help to select an appropriate risk
                      management strategy.
         Important Concepts 2
                Insurance as an Hedge
•   Why is insurance a lousy investment?
    •   Because the pure payoff is simply to indemnify you for a loss…the
        indemnification is simply equal to the loss.
    •   The pure premium (price) the insurance company sets (in a perfectly
        efficient and competitive market place) is designed to exactly balance
        cash inflows and outflows.
    •   Of course the insurance company must in addition to the pure premium,
        charge fees, commissions and keep a margin for profits/losses.


     From a consumers point of view you are always expected to make less
            from an insurance contract than what you pay in premiums.
       Life Insurance

• Obviously, death is a pure risk.
• For some individuals this may be a
  catastrophic risk that must be managed.
     • Why just some individuals?
• Insurance is usually the best way to
  manage that risk.
• What factors affect the magnitude of the
  risk?
      Figure 4:   How Much are you Worth?


Increasing   Human capital is your     Age has a major
Value        biggest asset and must    impact on your
             be protected.             need for life and
                                       disability
                                       insurance. The
                                       younger you are,
                                       the greater the
                                       amount of
                                       insurance
                                       required.

                                      Increasing Age
                What is Life Insurance?
• Life insurance, technically, is a contract between the insurer
  and the insured.


• “life insurance is a means of financing the risk of
  the premature and untimely death of a family
  member”.

• It is a „pooled‟ bet…you and a large number of like individuals
  are pooling your money (insurance premiums)…you know
  that this pure risk will hit the group in a predicable fashion, but
  it is impossible a priori (before the fact) to determine which of
  the individuals will die in any given year.
         Do you need life insurance?

• Basically if you have financial dependents, you need life
  insurance.

• Regardless of whether or not you have financial
  dependents, learning how to determine the amount of life
  insurance coverage needed is a valuable tool.
         Life Insurance
• Life insurance claim payments are generally free of income
  tax. (Although interest generated by investing such funds
  would be taxable.)
• To determine the amount of life insurance required,
  reasonable estimates of a family‟s immediate and long-term
  financial needs are required.
• This TOTAL NEEDS PLANNNING focuses on three cash and
  income needs:
  – last expenses
  – mortgage, education and emergency fund
  – dependents income
                           K. Hartviksen
          Last Expenses
• Upon death, an income earner‟s last expenses
  become the surviving family‟s first expenses. They
  include:
  –   final medical bills (doctor, hospital and nursing fees)
  –   funeral and burial costs
  –   current bills for household and personal expenses
  –   bank or other outstanding loans
  –   unpaid property taxes
  –   probate costs, legal and executor fees
  –   unpaid income tax including capital gains taxes generated
      by deemed dispositions.

                            K. Hartviksen
          Mortgage, Education and Emergency Fund

•   A key component in any life insurance plan is to provide
    surviving family members with a permanent residence. A
    mortgage fund cancels a mortgage balance and with it, all
    future interest payments.
•   As the economy continues to shift in favour of knowledge
    workers, a good education is becoming increasingly
    important. At the same time, tuition fees are rising as
    government face funding restraints. Consequently, it is more
    important than ever for income earners with dependent
    children to plan for their education.
•   Adequate funding is also needed to provide dependent
    survivors with something to draw on in case of emergency,
    serious illness, or accidents. Typically three months‟ total
    family income should be available in case of emergency.
                            K. Hartviksen
          Dependents‟ Income

•   Adequate funds are necessary to provide dependents with
    an income.
•   This may include funding until children are able to pay their
    own way.
•   This dependency usually ends when the youngest child
    reaches age 18. For children who are bound for university,
    this period extends until they graduate.
•   In addition, the surviving spouse may also require income.
•   Life insurance can provide monthly income to the surviving
    spouse, or if both parents have died, the guardian.



                             K. Hartviksen
        Capital Needs Analysis
• Determining how much life insurance is necessary is
  a two step process:
  – first, an asset inventory is prepared
  – second, estate obligations at death are determined based
    on cash needs, and income needs (discounted by a
    conservative real return rate).
  – The shortfall between available assets and estate
    obligations represents the amount of insurance required.
• Since the beneficiary of the life insurance proceeds
  will likely pay tax on the annual investment income,
  the appropriate discount rate should be the after-tax
  rate.
                          K. Hartviksen
   Mortality Tables




Construction and Interpretation
      Pricing of Life Insurance


• The pricing of insurance products follows a
  common procedure based on amount of
  the likely claim and the probability of
  occurrence.
Mortality Experience – Law of Large
Numbers
                             These tables report the
                             actual number of deaths
                             each year for a given
                             cohort of 100,000
                             people.


                             The law of large
                             numbers says that as
                             the group of insured
                             approaches 100,000, the
                             experience of the
                             sample will approach the
                             experience of the entire
                             cohort.


                             This law gives larger
                             insurance companies a
                             serious advantage over
                             smaller ones, because
                             they can more
                             accurately predict the
                             actual deaths of their
                             insured and therefore
                             more accurately price
                             their policies.
          Law of Large Numbers
• Jacob Bernoulli (1654 – 1705 …a contemporary of Isaac
  Newton and was a child when Pascal and Fermat lived)
  was the first person to consider linkages between
  probability and the quality of information.
     •   He tried to uncover probabilities from sample date in his book Ars
         Conjectandi (The Art of Conjecture)
• Jacob Bernoulli‟s theorum for calculating probabilities a
  posteriori (ex post) is known as the Law of Large
  numbers.
• All the law tells us is that the average of a large number
  of throws will be more likely than the average of a small
  number of throws to differ from the true average by less
  than some stated amount.
        Law of Large Numbers
• The Law of Large Numbers is not the same thing
  as the Law of Averages.
  – Mathematics tells us that the probability of heads
    coming up on any individual coin toss is 50% - but the
    outcome of each toss is independent of all the other.
    (It is neither influenced by previous tosses nor does it
    influence future tosses).
  – Consequently, the Law of Large Numbers cannot
    promise that the probability of heads will rise above
    50% on any single toss if the first hundred, or million,
    tosses happen to come up only 40% heads.
  – There is nothing in the Law of Large Numbers that
    promises to bail you out when you are caught in a
    losing streak.
Mortality Tables – how to read


                    The only data required
                    to build a mortality table
                    for a given group or
                    cohort of individuals is
                    the actual number of
                    surviving individuals at
                    the start of each year
                    over the lives of a large
                    group. The larger the
                    group, the more likely
                    the law of large
                    numbers will apply.
Mortality Tables – by gender


                         Male babies
                          are not as
                          robust as
                           female




                          Males die in
                             greater
                            numbers
                         statistically in
                         every year of
                        life for the first
                        82 years of life.
Mortality Tables – how to read
                          Canadian
                            females
                             have a
                             0.58%
                          chance of
                         dying in the
                         first year of
                               life




                            Canadian
                            females if
                            they have
                           survived to
                             age one,
                              have a
                          probability of
                           surviving to
                             age 2 of
                             99.95%
Mortality Tables – how to read
                          Canadian
                            females
                             have a
                             0.58%
                          chance of
                         dying in the
                         first year of
                               life




                            Canadian
                            females if
                            they have
                           survived to
                             age one,
                              have a
                          probability of
                           surviving to
                             age 2 of
                             99.95%
Calculating the Pure Premium




     Pricing Term Life Insurance
         What is the Pure Premium?

• The Pure Premium is the price an insurer would charge a
  term policyholder if the present value of the revenues
  received by the insurance company is exactly equal to the
  expected present value of the benefits paid to the
  beneficiaries.

• The insurer is assumed not to earn a profit under the pure
  premium approach.
        Likelihood of the Insured Dying
• The Pure Premium depends on the likelihood of
  the insured dying during the insurance coverage
  period.

• Historical death rates for defined groups of
  people have been observed and reported in
  mortality tables.

• Standard Canadian mortality tables follow a
  hypothetical group or cohort of 100,000 persons
  from birth to death and report the actual number
  of deaths each year for that year.
             Calculating the Pure Premium
• The Pure Premium depends on the probability of death and
  the size of the policy face value (payoff).


Suppose a male aged 35 wants to buy $200,000 of term insurance for a year.
The mortality rate of this specific group of people – 35 year old males is .15%.


The life insurance company expects to pay to the beneficiaries on average of
 $200,000 × .0015 = $300


Thus, the insured must pay $300. This premium, paid by every other person in
his category, is just enough when pooled over a large number of policies, to pay
the death benefits that the insurance company expects to have to pay during the
year.
             Calculating the Pure
             Premium …
Suppose a male aged 35 wants to buy $200,000 of term insurance for a year.
The mortality rate of this specific group of people – 35 year old males is .15%.


The life insurance company expects to pay to the beneficiaries on average of
 $200,000 × .0015 = $300
Thus, the insured must pay $300. This premium, paid by every other person in
his category, is just enough when pooled over a large number of policies, to pay
the death benefits that the insurance company expects to have to pay during the
year.


Premiums are paid at the beginning of the year, but benefits are paid throughout
the year. The insurance payout must therefore be discounted for this period.
Assuming a 5% discount rate, the pure premium that must be charged is
equal to $300 ÷ 1.05 = $285.71
             Calculating the Pure
             Premium …

Premiums are paid at the beginning of the year, but benefits are paid throughout
the year. The insurance payout must therefore be discounted for this period.
Assuming a 5% discount rate, the pure premium that must be charged is
equal to $300 ÷ 1.05 = $285.71


If servicing costs are $35, then the final premium is equal to ($285.71 +
$35.00) or $320.71
      Calculating the Pure Premium
      … summary


• The premium on a term insurance policy
  will increase with the insured‟s age
  because the probability of death increases
  with age.
• Larger insurance companies enjoy
  economies of scale advantage that allows
  their sample of clients to more closely
  match the experience of the mortality
  tables because of the Law of Large
  Numbers.
Life Expectancy and Median
            Age




   Mortality Experience and Gender
              Differences
      Average Life Expectancy
• A commonly-quoted statistic in the popular
  press is “average life expectancy”
• Often the press actually reports the
  median age of death, starting from the
  date of birth.
• The median age is the age at which
  50,000 of the original 100,000 cohort have
  died.
  – This occurs in the 84th year for women and
    78th year for men.
Mortality Tables – Life
Expectancy and Median Age

                         Median Age
                          for Males




                        Median age for
                          females.
    Use of Conditional
      Probabilities




Pricing Term Life Insurance Policies
          Using Conditional Probabilities
          to Solve a More Common
          Problem in Insurance
• At some age, a person will decide to buy insurance,
  therefore you must measure the conditional
  probability of a person dying during the term of a
  Term Insurance policy given the fact they have
  already reached that given age.


                            Example:



 What is the probability of a 35 year old woman surviving to age 45?
              Conditional Probability
•   We rarely buy life insurance for a
    child at birth, however, and the more
    useful information is the conditional
    probability that a person will live to a
    certain age, given that she is
    already „y‟ years old.

What is the probability of a 35-year
  old woman surviving to age 45?

•   At age 35 there are 98,344 women
    surviving out of the original 100,000.
    At age 45 there are 97,356. The
    probability of survival, given that the
    woman has already reached 35, is
    97,356/98,344 = 98.99%.
               Conditional Probability Applied to An
               Insurance Premium for More Than
               One Year – THE CHALLENGE OF
               ATTRITION

    How would the insurance company calculate the level premium for a
                             $200,000 policy?

•     Each year a number of the cohort die and the insurance company pays the full
      face value of life insurance policies to the beneficiaries.
•     The rest of the insured get no cash payment.
•     The next year, only those still surviving could be eligible for a payout in the
      event of their death. The probability of receiving such a payment in the second
      year is slightly less, because there is a possibility that you died during the
      previous year.
•     Thus, we can calculate the probability of the death of an individual for each year
      for a specified number of future years, conditional each year on having survived
      to that year.
            Conditional Probability Applied to An
            Insurance Premium for More Than
            One Year …
   How would the insurance company calculate the level premium for a
   $200,000 policy for a 35-year-old single mother in favour of her son? At
    age 40, she will no longer need it, because he will receive a trust fund.
   She wants to pay a level premium. The appropriate interest rate is 7%.
      What is the pure level premium (no costs, no saving component)?

We need the conditional probability to calculate the present value of the
  expected future payouts. (This formula takes into account that the premium
  paid is made at the beginning of the period).
          Conditional Probability
          Example (NSP)
$200,000 Term policy for a 35 year old
 woman expiring at age 40 (no costs, no
          saving component).
           Conditional Probability
           Example (NSP)…
$200,000 Term policy for a 35 year
  old woman expiring at age 40 (no
    costs, no saving component).
           Conditional Probability
           Example (NSP) …
$200,000 Term policy for a 35 year
  old woman expiring at age 40 (no
    costs, no saving component).
                 Conditional Probability
                 Example (NSP) …
 $200,000 Term policy for a 35 year
   old woman expiring at age 40 (no
     costs, no saving component).




     99.93% of the
       beginning
 population of policy
 holders will survive
      to face this
 probability of death
in the second year of
   the five year life
       contract..
             Conditional Probability Applied to An
             Insurance Premium for More Than
             One Year (NAP)…
   How would the insurance company calculate the level premium for a
   $200,000 policy for a 35-year-old single mother in favour of her son? At
    age 40, she will no longer need it, because he will receive a trust fund.
   She wants to pay a level premium. The appropriate interest rate is 7%.
      What is the pure level premium (no costs, no saving component)?

The final step is to use the same interest rate and term of the policy to convert
   the net single premium (NSP) into an annuity of net annual premium (NAP)
           Conditional Probability
           Example (NAP) …
$200,000 Term policy for a 35 year
  old woman expiring at age 40 (no
    costs, no saving component).




                                                     Again, it is necessary to adjust
                                                     the Net Annual Premium for the
                                                     fact that there will be fewer
                                                     paying insured over the term of
                                                     the policy because of attrition.

                                     The solution assumes an
                                     annuity due.
Example of
     a
Spreadsheet
  Solution
Other Life Insurance Topics




         K. Hartviksen
        Life Insurance and Estate Planning


• Life insurance may also be a valuable tool
  in estate planning as it can:
 – build an instant estate
 – create liquidity for an estate to fund taxes arising from
   death (capital gains on deemed dispositions) and
   administration costs (probate and legal fees) thereby
   avoiding liquidating assets to meet payment obligations.
 – Facilitate transfer of an interest in a private business.




                          K. Hartviksen
         Life Insurance & Businesses

• In a partnership or private corporation, management or even
  the business‟ future can be disrupted by a partner or
  shareholder death.
• This disruption can be exacerbated when the deceased heirs
  inherit part ownership of the business.
• In such cases, it makes sense for partners and shareholders
  to take out insurance policies on each other. At the same
  time they enter into buy-sell agreements with each other.
  Upon death, insurance proceeds are used by those remaining
  to purchase the deceased interest in the business from the
  estate.

                          K. Hartviksen
Types of Life Insurance




         Term
       Permanent
          Term Insurance

• Is like a wager. The insured pays the insurance company a
  premium. If the insured dies before the policy expires, the
  insurance company pays the beneficiary. If the insured is still
  alive when the policy ends, coverage ceases and the
  insurance company pays nothing.
• Term insurance policies are generally issued for one, five, ten,
  15 or 20 years. Often they terminate at age 65.
• The biggest single advantage of term insurance is it‟s price.




                            K. Hartviksen
          Term Insurance...
•   Most term insurance policies include the right to convert to
    permanent insurance or to renew without having to prove
    insurability. Although the premium after conversion is always
    higher, it may be well justified if the life insured has suffered
    a medical impairment or taken up hazardous work.
    Insurance companies normally refuse to offer coverage when
    these conditions exist.
•   To avoid automatic expiry of term insurance, renewable term
    insurance provides an option to extend coverage for a similar
    period. The premium for the second term will be higher
    because of the age of the insured.
•   Yearly renewable term insurance can be renewed annually
    for a specified number of year, usually to a maximum age of
    60 or 65.
                              K. Hartviksen
         Permanent Insurance
•   Permanent insurance provides coverage for the whole of life
    with a level premium payment.
•   During the early years, premiums are more than enough to
    cover the risk so the difference is invested to form policy
    reserves. These reserves subsidize what would otherwise
    be an inadequate premium in later years. This concept
    forms the basis for premium calculations for all permanent
    insurance contracts.
•   If a policy owner terminate a permanent insurance contract,
    the company is released from future obligations and returns
    an equitable share of the accumulated policy reserve. This
    is known as the policy‟s cash surrender value (CSV).
•   The CSV is guaranteed and stated in the policy usually for
    years three to 20 and for ages 60 and 65.
                            K. Hartviksen
         Cash Surrender Value (CSV)


• Whole life policy reserves increase each year and at
  advanced ages (say 95 to 100) they generally equal the sum
  insured.
• Under some circumstances, the CSV is also creditor-
  protected when an insured files for personal bankruptcy.
  Generally the policy must have been in force for more than
  five years preceding the bankruptcy and the beneficiary must
  be a member of the insured‟s immediate family. In this case,
  the CSV is deemed to be held in trust for the benficiary.


                           K. Hartviksen
        Term vs. Permanent
• The main benefits of permanent insurance over
  temporary insurance are:
  – coverage is available until death whereas most term
    policies expire at age 65
  – premium payments don‟t change whereas term policy
    premiums increase with each renewal
  – in time the premium payments build up a creditor-protected
    cash surrender value and make a variety of ancillary
    benefit possible such as:
  – automatic premium loan - if the insured forgets or cannot
    pay the premium within the specified days grace period,
    APL charges unpaid premiums as a loan against the CSV
    so coverage can continue.
                          K. Hartviksen
        Term vs. Permanent ...

– in time the premium payments build up a creditor-protected cash
  surrender value and make a variety of ancillary benefit possible such as:
– Extended term insurance - when a whole life policy holder dies, only the
  insured amount is paid, not the policy reserve. However, ETI allows the
  insured to increase coverage by using the reserve to purchase
  additional term insurance. The amount and policy term purchased is
  directly proportional to the policy reserve size.
– Paid-up Insurance: if a policy owner is unwilling or unable to pay
  premiums, rather than cancelling the policy, coverage can be reduced to
  an amount equal to whatever the CSV can purchase as a single
  premium based on the insured age. Paid-up insurance also contains
  cash values which accumulate and are payable if the policy is
  surrendered before death.



                              K. Hartviksen
    Term vs. Permanent ...

– in time the premium payments build up a
  creditor-protected cash surrender value and
  make a variety of ancillary benefit possible
  such as:
– Loan Values - Banks or the insurance
  company itself are willing generally to lend
  the policy owner up to 90% of the CSV.



                   K. Hartviksen
         Permanent Insurance ...
• May be issued as either participating or non-
  participating.
  – Participating means the policy owner is entitled to a portion
    of the company‟s surplus earnings.
  – Surplus earnings arise from primarily three sources:
    • actual operating expenses are lower than anticipated.
    • Claims experience is lower than anticipated.
    • Investment income is higher than required to maintain
        policy reserves.
  – The surplus is distributed to policyowners as dividends.



                            K. Hartviksen
        Permanent Insurance ...
• The surplus distributed to policyowners is called
  dividends. Generally policy owners have up to six
  ways of receiving dividends:
  – cash - paid annually to policyowners
  – accumulation - left with the insurance company to
    accumulate interest
  – premium reduction - applied towards the next yearly
    premium
  – paid-up additions - increased whole life insurance
  – term additions - applied towards one-year term insurance
  – investment fund - applied to purchase the company‟s
    segregated fund (similar to an equity mutual fund)

                          K. Hartviksen
Permanent Insurance Riders
• For additional premiums, policy riders can be added
  such as:
  – Accidental Death Benefits: sometimes called double
    indemnity, pays two times policy face value if death is
    caused by accident.
  – Total Disability Waiver of Premium: premium payments
    are waived if the insured becomes totally disabled by
    sickness or accident prior to a predetermined age (usually
    60) and remains so disabled for three to six consecutive
    months.
  – Total Disability Monthly Income (TDMI): in addition to
    waiving premiums, some policies also pay disabled policy
    owners a monthly income, generally equal to $10 per
    month for each $1,000 K. Hartviksen
                            insured.
         New Money Policies
•   Also known as interest-rate sensitive policies
    –    premium rates are based on assumptions (estimates) of future
         claims, operating expenses and investment earnings.
    –    Since premiums and benefits for traditional whole life policies are
         guaranteed throughout the contract term, investment earnings
         estimates are conservative.
    –    In the late 1970s and early 1980s, interest rates rose to
         unprecedented levels. For competitive reasons, insurers began
         offering policies based on their new (higher return)
         investments…hence, the origin of the term new money.
    –    New money or adjustable policies usually guarantee premiums
         and death benefits for a specified time (eg. Five years) and re-
         adjust premiums and/or death benefits at the end of the period.
         Premiums may be increased or decreased depending on the
         insurance company‟s investment income.

                                K. Hartviksen
      New Money Policies ...
• In contrast with whole life policies that
  have level premiums, new money policies
  have premiums that vary inversely with
  interest rates:
• when interest rates are high, premiums
  decline
  – when interest rates fall, premiums increase.
• The only feature not guaranteed is policy
  dividends in a participating policy.
                     K. Hartviksen
          Universal Life

• Is the most popular and flexible interest-sensitive policy.
• It consists of two parts: term life insurance and an investment
  account.
• With each premium, a portion is used to cover administrative
  expenses and the mortality factor (ie. To purchase term
  insurance). The balance is credited to an investment account.
• The investment account is the source of the policy‟s flexibility.




                             K. Hartviksen
         Universal Life ...
• A unique universal life feature is it contains a tax
  sheltering component.
  – Life insurance proceeds payable upon death are tax
    exempt
  – within limits investment income in a universal policy is tax
    sheltered.
  – Policy owners decide what to do with each of the policy‟s
    two parts. If the investment account is interest bearing, a
    portion of the interest income is not subject to income tax.
  – Typically the interest investment is either similar to a
    savings account or is tied to a benchmark such as 95% of
    the TSE 300 Index appreciation.

                            K. Hartviksen
          Variable Life
•   Variable life policies are the insurance industry‟s equivalent
    of mutual funds, but with one exception: at death or maturity
    they guarantee at least a 75% return of the amount paid in.
    This proviso exempts then from being subject to provincial
    securities acts.
•   Variable contracts come with or without life insurance. They
    can be purchased with regular, single or intermittent
    premiums and generally have the same contract provisions
    as regular life insurance policies.
•   As with many mutual funds, sales charges can be front-end
    or back-end loaded and a fee is charged for managing the
    fund. An insurer‟s investment fund supporting variable
    contracts is segregated from all other funds.

                             K. Hartviksen
          Variable Life ...

• Every variable contract contains two main elements:
  – an insurance element as either life insurance or an annuity, and
  – a reserve which varies in value depending on segregated fund
    performance (the equity element).
• As with mutual funds, any interest, dividends or capital gains
  realized by the segregated fund are taxed in the policyowner‟s
  hands as the insurance company issues T-5 receipts.




                                K. Hartviksen
       Endowment Life Policy
• This form of insurance pays the face
  amount to the beneficiaries if the insured
  dies, however, unlike other insurance
  policies, it will also pay the face amount to
  the insured – the amount paid is called the
  endowment – if the insured lives to a
  certain age.
• The premium of an endowment policy is
  set in such a way that the savings
  component will be invested to reach the
  endowment value at a specified date.
       Buy Term and Compare the
       Difference
• The question of whether term or non-term life
  policies are better depends on whether you
  would be better off buying a term policy and
  investing the difference of the whole life
  premium and the term premium.
• This method assumes the mortality tables do not
  change during the time period of comparison.
• You can compare term and non-term life policies
  with the same face value using the approach
  found on the following slide:
Buy Term
and Invest
    the
Difference
   – an
approach
     to
 evaluate
    the
 decision
The Insurance Contract
         The Insurance Contract
•   The Application:
    –    determining and pricing risk under a life insurance policy begins
         with an application.
    –    The application, policy and any document attached to the policy
         collectively form the insurance contract.
    –    It is imperative the insured provide accurate and complete
         personal information…failure to do so may invalidate a policy.
    –    If a fact has been omitted or innocently misrepresented on the
         application, the insurance company should be informed
         immediately so any necessary adjustments can be made.
    –    By law, a life insurance policy, is incontestible after two years.
         After that time, a company cannot deny a claim except in the case
         of fraud or if the life insured‟s age was misstated. An example of
         fraud is a smoker who declares himself a non-smoker in order to
         get a reduced premium.

                               K. Hartviksen
          The Insurance Contract ...
• Recission Right is the lawful right of the insurance buyer to
  have 10 days to examine a policy and if not satisfied, return it
  and receive full premium refund. The buyer is not required to
  give any reason for doing so.
• The law also requires at least a 30 day grace period be
  provided for each premium payment other than the initial
  payment. Except for group insurance, any person to whom
  the policy is assigned or a beneficiary or a person acting on
  behalf of one of them or the insured may pay the premium.




                             K. Hartviksen
      Insurance Contract Reinstatement

• The law provides the right to apply for
  reinstatement (or revival) within two years
  of a policy lapsing.
• Such reinstatement is subject to a
  payment of overdue premiums, any unpaid
  loans plus interest and production of
  satisfactory insurability evidence.



                   K. Hartviksen
         Beneficiaries
• An insurance applicant designates a beneficiary
  which can be changed at any time unless
  designated irrevocable, in which case the
  beneficiary must consent to any change.
• The policyowner can also designate his or her
  estate as beneficiary.
• Beneficiaries may therefore be:
  – irrevocable
  – revocable
  – insured or estate of the insured


                           K. Hartviksen
         Beneficiaries...
• If the insured designates the beneficiary as irrevocable, the
  insurance money is not subject to control of the insured or the
  insured‟s creditors as it does not form part of the estate for
  probate purposes.
• The law also provides creditor protection where the
  beneficiary is not irrevocable but is a spouse, child,
  grandparent or parent. This special protection includes
  adopted children in most provinces but does not include ex-
  spouses unless he or she was named an irrevocable
  beneficiary.




                            K. Hartviksen
          Revocable Beneficiaries

• If the policy names a revocable beneficiary and is not one of
  the special class indicated prior, the policy has no creditor
  protection while it is in force. (ie. Creditors can attack the
  policy cash surrender value). However, when insurance
  money becomes payable, it becomes the beneficiary‟s asset
  and thus is not subject to the insured‟s creditors.




                            K. Hartviksen
          Settlement Options
• Typically, when an insured dies, beneficiaries have
  four settlement options:
  – lump sum payment (all proceeds received tax free)
  – interest option (the proceeds remain in trust and the insurance company
    pays cash interest on a monthly or periodic basis)
  – installment option (the company pays out proceeds together with
    interest over a pre-selected period of years.)
  – life annuity option (this provides an income that cannot be outlived)
• settlement options may be pre-selected by the
  insured or elected by the beneficiary when life of the
  insured ends.


                                K. Hartviksen
         Term to 100
• Temporary insurance that lasts to age 100 sounds like an
  oxymoron; term to 100 insurance is often categorized as
  permanent insurance.
• These policies provide the type of permanence normally
  associated with whole life policies. However, they typically do
  not pay dividends or include cash surrender values and thus
  are not subject to income taxation.
• Although these policies are more expensive than term policies
  for shorter periods, premiums are lower than traditional whole
  life products.




                            K. Hartviksen
          Taxes and Insurance
•   In the absence of taxes, term insurance is the clear choice
    for consumers seeking life insurance for the purpose of
    protection (as a hedge)
•   Permanent life insurance can be useful in the presence of
    taxes:
    1.   Used to pay taxes upon death of the insurance – when the deemed
         disposition at fair market value rules come into effect. (ie. in the case of
         vacation properties, valuable antiques for a small family business)
    2.   Savings sitting in whole life, universal life policies grow behind a tax shield.
         When the insured dies, the beneficiary receives the proceeds of the policy
         tax-free.
    3.   In addition, you can borrow the using the cash surrender value (CSV) of the
         policy, and any money you borrow does not create a tax liability.
          Helpful Links
• http://www.desjardinsfinancialsecurity.com/vna/content/introduction/i
  ntroSectD.asp#Calculators

• http://www.iafp.ca/publicsite/aboutiafp/IAFP_Practice_Standards_O
  ct_2003.pdf
• Assuris
       Regulatory System
• The two organizations most important for life
  insurance company regulation are OSFI and
  Canadian Life and Health Insurance
  Compensation Corporation (Assuris).
• OSFI performs the same oversight functions for
  insurance underwriters as it does for deposit
  taking FIs.
• Assuris provides liability insurance to
  policyholders: if the issuing company goes
  bankrupt, policyholders can look to Assuris to
  satisfy at least some of their claims.
• Insurance agents and brokers are registered
  provincially.
       Legal Framework
• The Insurance Companies Act
• Since 1992, the Insurance Companies Act‟s
  structure has been conformed with the Bank
  Act‟s, in recognition of the convergence of and
  competition between banks and insurance
  companies.
• Restrictions of investments by insurance
  companies in assets that were „legal for life‟
  (using legal lists) have been largely removed in
  favour of a prudent portfolio approach.
• An insurance company has wide lattitude to
  invest assets, provided that the resulting
  portfolio passes the prudent person test.
       Prudent Person Test


• A regulatory test that the portfolio selected
  by the asset manager must meet the
  standard that a prudent person investing
  his own funds would meet.
        Assuris
        (formerly known as CompCorp)

• A federally incorporated private company funded by the
  insurance industry provides each policyholder with a
  guarantee of RRIFs, RRSPs and life insurance cash
  values up to $60,000 and life insurance claims up to
  $200,000.
• Unlike CDIC, Assuris was not set up to take a regulatory
  role in overseeing individual companies.
• As a private corporation, it has no automatic ability to
  borrow from the government if it cannot cover the costs
  of its liability insurance from its current resources.
• In the century prior to CompCorp‟s establishment, no life
  insurance company in Canada had failed, a record made
  possible by industry cooperation in aiding and merging
  weak companies.
       Assuris …
• The recession of the early 1990s,
  however, left bankrupt two small life
  insurance companies:
  – Sovereign Life, and
  – Les Cooperants (in 1992)
• One large life insurance company,
  Confederation Life, failed in 1994.
Property and Casualty Insurers




         Business 4039
      Size, Structure and
      Composition of the Industry
• Less concentrated than the life and health
  industry.
      Major P&C Lines


• Property insurance
• Automobile insurance
• Liability insurance
  Problem Solutions




Chapter 3 – Insurance Companies
      Question 3 - 1
What is the primary function of an insurance
company? How does this function compare with the
primary function of a deposit-taking institution?
– The primary function of an insurance company is to provide
  protection from adverse events. The insurance companies
  accept premium payments in exchange for compensation in the
  event that certain specified, but undesirable, events occur.
– The primary function of deposit-taking institutions is to provide
  financial intermediation for individual and corporate savers. By
  accepting deposits and making loans, deposit-taking institutions
  allow savers with predominantly small, short-term financial
  assets to benefit from investments in larger, longer-term assets.
  These long-term assets typically yield a higher rate of return than
  short-term assets.
      Question 3 - 2
What is the adverse selection problem? How does
adverse selection affect the profitable management
of an insurance company?

– The adverse selection problem occurs because customers who
  are most in need of insurance are most likely to acquire
  insurance.
– However, the premium structure for various types of insurance
  typically is based on an average population proportionately
  representing all categories of risk. Thus the existence of a
  proportionately larger share of high-risk customers may cause
  the premium revenue received by the insurance provider to
  underestimate the necessary revenue to cover the insured
  liabilities and to provide a reasonable profit for the insurance
  company.
        Question 3 - 3
What are the similarities and differences among the four basic lines of
life insurance products?

 – The four basic lines of life insurance products are
     • (1) individual life;
     • (2) group life;
     • (3) industrial life; and
     • (4) credit life.
 – Individual life is sold to individuals who make periodic premium payments.
   The insurance policy can be structured as pure life insurance (term life) or
   may contain a savings component (whole life or universal life).
 – Group policies are similar to individual life insurance policies except that
   they are centrally administered, providing cost economies in evaluating,
   screening, selling, and servicing the policies.
 – Industrial life has largely been replaced by group life since cost economies
   have made group life more affordable. Industrial life was historically
   marketed to individuals who would make small, very frequent payments
   and would require personal collection services.
 – Credit life typically is term life sold in conjunction with a debt contract
   such as a mortgage or car loan.
     Question 3 - 4
Explain how annuity activities represent the
reverse of life insurance activities.

– A typical life insurance contract requires a
  periodic payment by one party for a promised
  payment of either a lump sum or an annuity if a
  particular event occurs, such as death or an
  accident.
– An annuity represents a reverse contract where
  the party purchases the right to receive periodic
  payments depending on the market conditions.
  The contract may be initiated by investing a lump
  sum or by making periodic payments before the
  annuity payments begin.
     Question 3 - 5
Explain how life insurance and annuity
products can be used to create a steady
stream of cash disbursements and payments
to avoid either paying or receiving a single-
lump sum cash amount.

– A life insurance policy requires regular premium
  payments that entitle the beneficiary to the receipt of
  a single lump sum payment. Upon receipt of such a
  lump sum, a single annuity could be obtained which
  would generate regular cash payments until the value
  of the insurance policy is depleted.
          Question 3 - 6
a.   Calculate the annual cash flows of a $1 million, 20-
     year fixed-payment annuity earning a guaranteed
     10 percent per annum if payments are to begin at
     the end of the current year.

     The annual cash flows are given by X:




     where PVA is obtained from the present value annuity tables with
     1 = 10 percent and n = 20 years. The value for X is $117,459.62.
           Question 3 – 6 …
b.   Calculate the annual cash flows of a $1 million, 20-year fixed-
     payment annuity earning a guaranteed 10 percent per annum if
     payments are to begin at the end of year five.

     In this case, the first annuity is to be received five years from today. The initial
     sum today will have to be compounded by four periods to estimate the
     annuities:




        X = $72.64171,9
         Question 3 – 6 …
c.   What is the amount of the annuity purchase required
     if you wish to receive a fixed payment of $200,000 for
     20 years? Assume that the annuity will earn 10
     percent per annum.

     The required payment is the present value of $200,000
     per year for 20 years at 10 percent.
         Question 3 – 7
     You deposit $10,000 annually into a life insurance
     fund for the next 10 years, after which time you plan
     to retire.

a.   If the deposits are made at the beginning of the year and
     earn an interest rate of 8 percent, what will be the amount
     of retirement funds at the end of year 10?
          Question 3 – 7 …
b.   Instead of a lump sum, you wish to receive annuities for the next
     20 years (years 11 through 30). What is the constant annual
     payment you expect to receive at the beginning of each year if
     you assume an interest rate of 8 percent during the distribution
     period?


     In this case, the first annuity is to be received ten years from today.
     The amount of retirement funds at the end of year ten (the answer to
     part (a) of $156,454.87) will be paid out over twenty years with the
     first payment to be received immediately.




     X = $14,754,88
           Question 3 – 7 …
c.   Repeat parts (a) and (b) above assuming earning rates of 7
     percent and 9 percent during the deposit period, and earning
     rates of 7 percent and 9 percent during the distribution period.
     During which period does the change in the earning rate have
     the greatest impact?

     Deposit            Value at               Distribution         Annual
     Period             10 Years               Period               Payment
     7 percent          $147,835.99            7 percent            $13,041.75
                                               9 percent            $14,857.72

     9 percent          $165,602.93            7 percent            $14,609.11
                                               9 percent            $16,643.32

     If you earn only 7 percent during the deposit period, earning 9 percent during the
     distribution period will barely allow you to better the distribution of the 8 percent/8
     percent pattern in parts (a) and (b). But if you earn 9 percent during the deposit period,
     the distribution amount at 7 percent will almost match the 8 percent/8 percent pattern.
         Question 3 – 8
a.   Suppose a 65-year-old person wants to purchase an annuity
     from an insurance company that would pay $20,000 per year
     until the end of that person’s life. The insurance company
     expects this person to live for 15 more years and would be
     willing to pay 6 percent on the annuity. How much should the
     insurance company ask this person to pay for the annuity?
         Question 3 – 8 …
b.   A second 65-year-old person wants the same $20,000 annuity,
     but this person is much healthier and is expected to live for 20
     years. If the same 6 percent interest rate applies, how much
     should this healthier person be charged for the annuity?
          Question 3 – 8 …
c.   In each case, what is the difference in the purchase
     price of the annuity if the distribution payments are
     made at the beginning of the year?


     For 15 years, the lump sum is $205,899.68.
     For 20 years, the lump sum is $243,162.33.
       Question 3 – 9
Contrast the balance sheet of a life insurance
company with the balance sheet of a bank. Explain
the balance sheet differences in terms of the
differences in the primary functions of the two
organizations.

Life insurance companies have long-term liabilities because of the
life insurance products that they sell. As a result, the asset side of
the balance sheet predominantly includes long-term government and
corporate bonds, corporate equities, and a declining amount of
mortgage products. The asset side of a bank‟s balance sheet is
comprised primarily of short- and medium-term loans to corporations
and individuals and securities.
       Question 3 – 9 …

In effect, both types of companies use large degrees of financial
leverage to fund assets that primarily consist of debt securities.
While the face value of deposits is fixed for banks, the composition of
liabilities for insurance companies is stochastic. The primary liability
category for a life insurance company are actuarial liabilities that
reflect the expected payment commitments on existing policy
contracts. Insurance companies also sell short- and medium-term
debt instruments called GICs that are used to fund their pension plan
business. The liabilities of banks are short-term deposits and short-
term borrowed funds.
       Question 3 – 10
 Using the data in Table 3-2, how has the
 composition of assets of Canadian life
 insurance companies changed over time?

– Table 3-2 indicates that life insurance companies have
  increased their holdings of bonds and debentures and
  decreased their holdings of mortgages and policy loans
  since 1996. Real estate has also declined over the
  period. Short-term investments and preferred shares
  have increased marginally.
          Question 3 – 11
 How do life insurance companies earn a profit?
– Insurance firms earn profits by taking in more premium income than they pay
  out in policy payments.
– Firms can increase their spread between premium income and policy
  payouts in two ways.
    • The first way is to decrease future required payouts for any given level of
      premium payments. This can be accomplished by reducing the risk of the insured
      pool (provided the policyholders do not demand premium rebates that fully reflect
      lower expected future payouts).
    • The second way is to increase the profitability of interest income on net policy
      reserves. Since insurance liabilities typically are long term, the insurance
      company has long periods of time to invest premium payments in interest earning
      asset portfolios. The higher is the yield on the insurance company's investments,
      the greater is the difference between the premium income stream and the policy
      payouts (except in the case of variable life insurance) and the greater is the
      insurance company's profitability.
            Question 3 – 12
    How would the balance sheet of a life
    insurance company change if it offered to run
    a private pension fund for another company?

•   The primary change in the balance sheet of a life insurance company would
    be an increase in the liability accounts that reflect these pension plans.
•   Guaranteed investment contracts (GICs) and separate account categories
    likely would increase, depending on the type of pension plans provided to the
    customers. The premiums and contributions would be invested in the normal
    asset categories of the insurance company, except in cases where the
    pension fund requires aggressive investment strategies. In this case, the
    funds may be invested in specific equity mutual funds.
        Question 3 – 13
 How does the regulation of insurance
 companies differ from the regulation of
 deposit-taking institutions?

– Canadian health and life insurers are regulated by OSFI at the
  federal level under the Insurance Companies Act.
– OSFI provides prudential regulations aimed at keeping domestic and
  foreign life insurers from posing a risk to the Canadian financial
  system.
– OSFI‟s guidelines thus focus on minimum capital requirements, risk
  management, liquidity management, etc. similar to the guidelines
  provided for Canadian banks.
        Question 3 – 14
 How do guarantee funds for life insurance companies
 compare with deposit insurance for banks?

– Insurance guarantee funds provide protection for policy holders
  similar to deposit insurance, but the insurance guarantee fund
  (Assuris, for Canadian life and health insurance companies) is
  administered by the life insurance companies as opposed to a
  separate company like the Canada Deposit Insurance Corporation, a
  Crown corporation, for deposit-taking institutions.
             Question 3 – 15
     What are the two major activity lines of property and
     casualty insurance firms?
    – The two major lines of property-casualty insurance are:
       a) Property insurance: Insurance compensating the insured, fully
          or partially, for personal or commercial property damage as a
          result of accidents and other events; and
       b) Liability insurance: Insurance compensating a third party, fully
          or partially, because its personal or commercial property was
          damaged as a result of the accidental actions of the insured.
•    In many cases, property and liability insurance is sold together, such as
     personal or commercial multiple peril and auto insurance. Fire and allied lines
     usually are sold as property insurance only. Liability insurance is sold
     separately for coverage such as malpractice or product liability hazards. In
     addition, reinsurance provides a means for primary insurers to pool their risk
     by transferring some of the risk and premium to a reinsurer.
       Question 3 – 16
 How have the product lines of property and casualty
 insurance companies changed over time?

– Product lines based on net premiums typically are
  included in the property and casualty insurance arena.
– The largest decreases have been in the fire and allied
  categories, while the multiple peril (or umbrella) and
  liability policies have shown the largest increases. The
  changes are related in that much of the decreased
  coverage has been subsumed into the multiple peril
  policies.
             Question 3 – 17
    Contrast the balance sheet of a property and casualty insurance
    company with the balance sheet of a bank. Explain the balance
    sheet differences in terms of the differences in the primary
    functions of the two organizations.

•   The balance sheet of a P&C company is similar to that of a life insurance company.
    Long-term financial assets such as bonds, common equities and preferred stock
    comprise the majority of the assets, while unearned premiums and unpaid claims and
    adjustment expenses dominate the liabilities.
•   In contrast, short-and medium-term financial assets dominate the asset side of the
    balance sheets of most banks, and borrowed funds in the form of deposits are the
    primary liability for banks.
•    Whereas banks provide time and size intermediation for depositors, P&C insurance
    companies use premium payments to provide assurance against certain types of risk
    for customers. For a bank the deposits represent borrowed funds, while the premiums
    to an insurance company represent the actual price for the risk coverage.
           Question 3 – 18
    What are the three sources of underwriting risk in the property
    and casualty insurance industry?

–     The three sources of underwriting risk in the P&C industry are:
          (a) unexpected increases in loss rates,
          (b) unexpected increases in expenses, and
          (c) unexpected decreases in investment yields.
–     Loss rates are influenced by whether the product lines are property or
      liability (with the latter being less predictable), whether they are low-
      severity high-frequency lines or high-severity low-frequency lines (with the
      latter being more difficult to estimate), and whether they are long-tail or
      short-tail lines (with the former being more difficult to estimate).
–     Loss rates also are affected by product and social inflation. Unexpected
      increases in expenses are a result of increases in commission costs to
      brokers, general expenses, taxes and other expenses related to
      acquisitions.
–     Finally, investment yields depend on the stock and bond markets as well
      as on the asset allocations of the portfolios.
          Question 3 – 19

    How do unexpected increases in inflation affect
    property and casualty insurers?

–    Inflation generally has an adverse effect on the cost of providing
     the benefits that have been purchased by the insured, particularly if
     the policy is written in terms of the replacement cost of the asset
     and the premiums are not adjusted for inflation.
–    In addition, the investment value of the bonds and other fixed-rate
     assets of insurers from which claims proceeds are derived may
     decrease in value from unexpected inflation.
           Question 3 – 20
    Identify the four characteristics or features of the perils
    insured against by property and casualty insurance. Rank
    the features in terms of actuarial predictability and total
    loss potential.

–     Property versus liability: Maximum levels of losses are more
      predictable for property lines than for liability lines.
–     Severity versus frequency: Loss rates are more predictable on
      low-severity, high-frequency lines than they are on high-severity,
      low-frequency lines.
–     Time of exposure: The extent of expected losses is more difficult
      for long-tail risk exposure phenomena than for short-tail exposures.
–     Inflation: The inflation risk of property lines is likely to reflect the
      underlying inflation of the economy, while the inflation risk of
      liability lines may be subject to the changing values or social risk of
      the society.
                Question 3 – 21

         Insurance companies will charge a higher premium
         for which of the insurance lines listed below? Why?

a.       Low-severity, high-frequency lines versus high-severity,
         low-frequency lines.

     –     Insurance companies have a more difficult time predicting the
           severity of losses for high- severity low-frequency lines of business,
           such as earthquakes and hurricanes. In addition, these
           catastrophic events cause severe damage, meaning the individual
           risks in the insured pool are not independent. As a result, premiums
           for high-severity low-frequency lines will be charged higher
           premiums than low-severity high-frequency lines.
               Question 3 – 21

         Insurance companies will charge a higher premium
         for which of the insurance lines listed below? Why?

b.       Long-tail versus short-tail lines.

     –     Similarly, losses in long-tail lines of business are harder to
           predict than in short-tail lines, because claims can be made
           years after the premiums have been made. Thus, premiums in
           this category of business will be higher. Modern day examples
           of such lines include coverage for product liabilities, such as
           exposure to asbestos or chemicals like dioxins.
          Question 3 – 22
    What does the loss ratio measure? What has been the
    long-term trend of the loss ratio? Why?

–    The loss ratio measures the actual losses incurred on a line of
     insurance relative to the premium earned on the line.
–    A ratio greater than 100 implies that the premiums earned did not
     cover the losses on the product line.
–    As shown in Table 3-6, the earned loss ratio has increased from
     the 77.1 percent in 1993 to 80.0 percent in 2001, declining to 69.6
     percent in 2003.
–    Increases in social inflation and the long-tail risk exposure
     phenomenon have caused some insurance companies to invest in
     shorter-term assets that have lower yields and thus generate lower
     premium earnings. In addition, increased coverage in areas with
     higher uncertainty of losses has occurred within the industry.
       Question 3 – 23
    What does the expense ratio measure? Identify
    and explain the two major sources of expense risk
    to a property and casualty insurer. Why has the
    long-term trend in this ratio been decreasing?

–    The expense ratio measures the expenses incurred relative to
     the premiums written.
–    Expense risk is comprised primarily of loss adjustment
     expenses, which relate to the cost surrounding the loss
     settlement process, and commission costs paid to insurance
     brokers and sales agents in an effort to attract business.
–    Large insurance companies have found expense efficiencies in
     using their own brokers rather than using independent brokers
     to sell insurance.
       Question 3 – 24
    How is the combined ratio defined? What does it
    measure?

–    The combined ratio is equal to the loss ratio plus the expense
     ratio.
–    The ratio basically measures the underwiting profitability of an
     insurance line.
–    If the combined ratio is less than 100, the premiums on the
     insurance have been sufficient to cover both losses and
     expenses on line.
     Question 3 – 25
 What is the investment yield on premiums earned?
 Why has this ratio become so important to
 property and casualty insurers?

– In cases where the combined ratio is greater than
  100, the insurer must rely on investment income
  from premiums to achieve profitability.
– Since 1993, with the exception of 2003, the
  combined ratio consistently has been greater than
  100. That is, the loss ratio and the expense ratio
  have exceeded the amount of premiums received on
  the insurance lines.
– Thus, the yield on invested premiums has become
  critical in the overall profitability of the property &
  casualty insurance industry.
         Question 3 – 26
    Use the data in Table 3-6. Since 1993, what has been the
    necessary investment yield for the industry to enable the
    operating ratio to be less than 100 in each year? How is this
    requirement related to the interest rate risk and credit risk
    faced by the property and casualty insurer?

–     With the exception of 2003 when the ratio was below 100, the
      minimum investment yield required to achieve a combined ratio of 100
      or less ranged from a low of -1.6 percent in 1997 to a high of 11.0
      percent in 2001.
–     The average required investment yield over this period (for the years
      reported) was 5.9 percent.
–     In effect, P & C insurers required an average annual investment yield
      of 5.9 percent during a time when interest rates were seldom this high
      and operating losses were significant. Year-by-year values are given
      below based on data given in Table 3-6.
Question 3 – 26 …
        Question 3 – 27
An insurance company’s projected loss ratio is 77.5
percent, and its loss adjustment expense ratio is
12.9 percent. The company estimates that
commission payments will be 16 percent. What
must be the minimum yield on investments to
achieve a positive operating ratio?


The combined ratio = 77.5% + 12.9% + 16.0% = 106.40%.

In order to be profitable, the yield on investments has to be greater
than 6.40%.
          Question 3 – 28
a.   What is the combined ratio for a property insurer who has a
     simple loss ratio of 73 percent, a loss adjustment expense of
     12.5 percent, and a ratio of commissions and other
     acquisition expenses of 18 percent?


     The combined ratio is 73% + 12.5% + 18% = 103.5%.


b.   What is the combined ratio adjusted for investment yield if
     the company earns an investment yield of 8 percent?


     The combined ratio adjusted for investment yield is 95.5%.
     Question 3 – 29
An insurance company collected $3.6 million in
premiums and disbursed $1.96 million in losses.
Loss adjustment expenses amounted to 6.6
percent. The total income generated from the
company’s investments was $170,000 after all
expenses were paid. What is the net profitability in
dollars?


Pure loss = $3.6 million - $1.96 million = $1.64 million

Expenses = 0.066 x $3,600,000 = $237,600
Investment returns = $170,000
Net profits = $1,572,400

				
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