Chapter 15 - Insurance Companies

SOLUTIONS MANUAL
Chapter Fifteen
Answers to Chapter 15
Questions:
1. The primary function of a life insurance company is to protect policyholders from adverse
events. Banks accept deposits from people and companies looking for a fairly safe, liquid place
to put their money and make loans to people and companies ho need more money.
!. The adverse selection pro"lem occurs "ecause customers ho are most in need of insurance
are most likely to acquire insurance. #oever, the premium structure for various types of
insurance typically is "ased on an average population proportionately representing all categories
of risk. Thus, the e$istence of a proportionately larger share of high-risk customers may cause
the premium revenue received "y the insurance provider to underestimate the revenue needed to
cover the insured lia"ilities and to provide a reasona"le profit for the insurance company.
%. & ma'or similarity "eteen depository institutions and insurance firms is the high degree of
financial leverage incurred "y "oth groups of firms. Both groups solicit funds (from
policyholders or depositors) and use them to finance an asset portfolio predominately consisting
of de"t securities. & ma'or difference "eteen them is their composition of the lia"ilities, hich
is fi$ed for depository institutions "ut stochastic for insurance firms. *hile the face value of
"ank deposits is fi$ed, the insurance company+s net policy reserves depend on e$pected future
required payouts hich can "e highly uncertain. The other difference is that insurance companies
are alloed to invest in equity instruments, hich currently are prohi"ited for depository
institutions.
,. *e can see in Ta"le 15-! that since the 1-!.s and %.s, life insurance companies have
increased their holdings of "onds and stocks and decreased their holdings of mortgage loans and
policy loans. /overnment securities comprise the ne$t largest component and have recently
increased "ack to their earlier levels after reaching very lo levels in the 0.s and 1.s.
5. The four "asic lines of life insurance products are2 (1) ordinary life3 (!) group life3 (%)
industrial life3 and (,) credit life. 4rdinary life is sold on an individual "asis and represents the
largest segment of the life insurance market. The insurance policy can "e structured as pure life
insurance (term life) or may contain a savings component (hole life or universal life). /roup
policies are similar to ordinary life insurance policies e$cept that they are centrally administered,
providing cost economies in evaluating, screening, selling, and servicing the policies. Industrial
life has largely "een replaced "y group life since cost economies have made group life more
afforda"le. Industrial life as historically marketed to individuals ho ould make small, very
frequent payments and ould require personal collection services. Credit life typically is term
life sold in con'unction ith some de"t contract.
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Chapter 15 - Insurance Companies
0. & typical life insurance contract requires a periodic payment "y 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. &n annuity represents a reverse contract here the party invests money to liquidate a
fund, that is, to receive periodic payments depending on the market conditions. It may "e
initiated "y investing a lump sum or making periodic payments "efore the annuity payments are
"egun.
1. & life insurance policy (hole life or universal life) requires regular premium payments hich
then entitle the "eneficiary to a single lump sum. 5pon receipt of such a lump sum, a single
annuity could "e o"tained hich ould generate regular cash payments until the value of the
insurance policy is depleted.
6. The pension fund constitutes a lia"ility for the insurance company since it ould no "e
o"ligated to pay the pensioners of the fund according to some agreed upon contract. It ould "e
shon on the right hand side of the "alance sheet in the form of reserves or a guaranteed
investment contract (/IC). The money paid into the fund "y the company and7or its employees
ould "e invested "y the insurance company, thus affecting the amount and composition of the
assets.
-. Insurance companies are more e$clusively su"'ect to state regulations compared to depository
institutions. &lthough there are national insurance organi8ations such as the 9ational &ssociation
of Insurance Commissioners, the companies themselves are regulated "y the state agencies.
:epository institutions are typically su"'ect to "oth national and state oversight. *hile "oth
"anks and insurance companies receive regulatory scrutiny as to the quality of their assets and
lia"ilities, "ank regulations also dictate minimum reserve and capital requirements. Banks have
more geographic restrictions.
In !..-, the 5.;. Congress considered esta"lishing an optional federal insurance charter.
The move "ehind such a charter picked up steam folloing the failure of the e$isting state "y
state regulatory system to act in preventing the pro"lems at insurance giant &I/ from "ecoming
a systemic risk to the national economy. Those in favor of an optional federal insurance charter
noted that under the current state "y state system, insurers face o"stacles such as inconsistent
regulations, "arriers to innovation, conflicting agent licensing, and education
requirements. *hile the #ouse version of the !.1. <inancial ;ervices =egulatory 4verhaul Bill
(approved in :ecem"er !..-) contained no provision for federal regulation of insurance
companies, <inancial ;ervices Chairman Barney <rank stated that this ould still "e a possi"ility
as the "ill moved through the regulatory process toards final passage.
The final version of the overhaul "ill, the *all ;treet =eform and Consumer >rotection
&ct of !.1. esta"lished the <ederal Insurance 4ffice (<I4), an entity that reports to Congress
and the >resident on the insurance industry. *hile the industry continues to "e regulated "y the
states, the <I4 has the authority to monitor the insurance industry, identify regulatory gaps or
systemic risk, deal ith international insurance matters and monitor the e$tent to hich
underserved communities have access to afforda"le insurance products.
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Chapter 15 - Insurance Companies
1.. ;tate guarantee funds are different from deposit insurance in several ays. <irst, the
insurance guarantee funds are administered "y the life insurance companies as opposed to a
separate company like the <:IC for deposit institutions. ;econd, insurance companies do not pay
premiums into the guarantee fund until after the failure of an insurance company. The <:IC
requires annual premium payments from all depository institutions. Third, hile the <:IC
requires premium payments to "e "ased on the amount of deposits and the risk of the assets of
the depository institutions, the contri"utions "y insurance companies typically are "ased on the
relative amount of premium income received "y the surviving insurance companies. <inally,
"ecause contri"utions to the insurance guarantee funds are requested only after the failure of a
company, the transmission of the "enefits to the policyholders occurs only after a reasona"le
delay. In contrast, the <:IC normally pays depositors ithin a fe days after the failure of a
depository institution.
11. Insurance firms earn profits "y taking in more premium income than they pay out in policy
payments. <irms can increase their spread "eteen premium income and policy payout in to
ays. 4ne ay is to decrease future required payouts for any given level of premium payments.
This can "e accomplished "y reducing the risk of the insured pool (provided the policyholders do
not demand premium re"ates that fully reflect loer e$pected future payouts). The other ay is
to increase the profita"ility of interest income on net policy reserves. ;ince insurance lia"ilities
typically are long term, the insurance company has long periods of time to invest premium
payments in interest earning asset portfolios. The higher the yield on the insurance company+s
investments, the greater the policy payout (in the case of varia"le life insurance) and the greater
the insurance company+s profita"ility. ;ince 'unk "onds offer high yields, they offer insurance
companies an opportunity to increase the return on their asset portfolio. #oever, 'unk "onds are
much more risky and as result of the recent failures of some life insurance firms, the 9&IC?s
proposed las limiting insurance company holdings of 'unk "onds in their asset portfolios.
1!. The to ma'or lines of property-casualty insurance are property insurance (insurance
compensating the insured, fully or partially, for personal or commercial property damage as a
result of accidents and other events) and lia"ility insurance (insurance compensating a third
party, fully or partially, "ecause its personal or commercial property as damaged as a result of
the accidental actions of the insured).
In many cases, property and lia"ility insurances are sold together, such as personal or
commercial multiple peril and auto insurance. <ire and allied lines usually are sold as property
insurance only. @ia"ility insurance is sold separately for coverages such as malpractice or
product lia"ility ha8ards. In addition, reinsurance provides a means for primary insurers to pool
their risk "y transferring some of the risk and premium to a reinsurer.
1%. ;ince 1-0. the "iggest decreases have "een in the fire, accident and health, and allied
categories, hile the multiple peril policies have shon the "iggest increases. The changes are
related in that much change in the num"er of policies that have decreased can "e attri"uted to the
su"suming of these policies into the multiple peril policies.
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Chapter 15 - Insurance Companies
1,. The three sources of underriting risk in the >C industry are2 (a) une$pected increases in
loss rates, (") une$pected increases in e$penses, and (c) une$pected decreases in investment
yields. @oss rates are influenced "y hether the product lines are property or lia"ility (ith the
latter "eing less predicta"le), hether they are lo-severity high- frequency lines or high-
severity lo-frequency lines (ith the latter "eing more difficult to estimate), and hether they
are long-tail or short-tail lines (ith the former "eing more difficult to estimate). @oss rates also
are affected "y product inflation and social inflation. 5ne$pected increases in e$penses are a
result of increases in commission costs to "rokers, general e$penses, ta$es and other e$penses
related to acquisitions. <inally, investment yields depend on the stock and "ond markets as ell
as on the asset allocations of the portfolios.
15. /enerally, the effect is an adverse one, particularly if the policy is ritten in terms of the
replacement cost of the asset and the premiums paid are not ad'usted for inflation. Aoreover, the
investment value of the assets of insurers, particularly "onds and other fi$ed rate securities, are
likely to "e fall in value from une$pected inflation.
10. Insurance companies have a more difficult time predicting the severity of losses for high-
severity lo-frequency lines of "usiness, such as earthquakes and hurricanes. In addition, these
catastrophic events cause severe damage, meaning the individual risks in the insured pool are not
independent. &s a result, premiums for high-severity lo-frequency lines ill "e charged higher
premiums than lo-severity high-frequency lines.
;imilarly, long-tail lines of "usinesses are harder to predict than short-tail lines "ecause
claims can "e made years after the premiums have "een made. Thus, premiums in this category
of "usiness ill "e higher. Aodern day e$amples of such lines include coverage for product
lia"ilities, such as e$posure to as"estos or chemicals like agentorange.
Probe!s:
1. a. The annual cash flos are given "y B2
C1,...,...D BEF1-(17(1G.1.)
!.
)H7.1.I DJ B D C1,...,...7(6.51%50%1!) D C111,,5-.0!
;olving for B, annual cash flos B D C111,,5-.0!.
or using a financial calculator, 9 D !., I D 1., <K D 1,...,..., then compute >AT D
C111,,5-.0!
". In this case, the first annuity is to "e received five years from today. The initial sum today
ill have to "e compounded "y five periods to estimate the annuities2
C1,...,...(1G..1.)
5
D BEF1-(17(1G.1.)
!.
)H7.1.I
;olving for B, annual cash flos, B D C16-,10-.-.
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Chapter 15 - Insurance Companies
or using a financial calculator, 9 D !., I D 1., >K D 1,...,...(1G..1.)
5
, then compute >AT D
C111,,5-.0!
c. The required payment is the present value of C!..,... per year for !. years at 1. percent.
!..,...EF1-(17(1G.1.)
!.
)H7.1.I D C1,1.!,11!.1,
or using a financial calculator, 9 D !., I D 1., >AT D !..,..., then compute >K D
C1,1.!,11!.1,
!. The value of C1.,... deposited annually in a fund ill amount to the folloing in ten years2
<K D 1.,...EF(1G..6)
1.
-1H7..6I D C1,,,605.0!
or using a financial calculator, 9 D 1., I D 6, >AT D 1.,..., then compute <K D C1,,,605.0!
The annuities per year over the ne$t tenty years at 6L ill "e2
C1,,,605.0! D BEF1-(17(1G..6)
!.
)H7..6I
;olving for B, annual cash flos, B D C1,,15,.66
or using a financial calculator, 9 D !., I D 6, >K D 1,,,605.0!, then compute >AT D
C1,,,605.0!
%. a. <K D C1.,...EF(1G..6)
1.
-1H7..6I(1 G ..6) D C1.,... (1,.,6050!,1)(1 G ..0) D
C150,,5,.61
or using a financial calculator, 9 D 1., I D 6, >AT D 1.,..., BM/ mode, then compute <K D
C150,,5,.61
". In this case, the first annuity is to "e received ten years from today. The amount of
retirement funds at the end of year ten (the anser to part (a) of C150,,5,.61) ill "e paid out
over tenty years ith the first payment to "e
C150,,5,.61 D BEF1-(17(1G..6)
!.
)H7..6I(1..6) DJ X D C1,,15,,66
or using a financial calculator, 9 D !., I D 6, >K D C150,,5,.61, BM/ mode, then compute >AT
D C1,,15,,66
c. :eposit Kalue at :istri"ution &nnual
>eriod 1. Nears >eriod >ayment
1 percent C1,1,6%5.-- 1 percent C1%,.,1.15
- percent C1,,651.1!
- percent C105,0.!.-% 1 percent C1,,0.-.11
- percent C10,0,%.%!
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Chapter 15 - Insurance Companies
,. a. !.,...EF1-(17(1G..0)
15
)H7..0I D C1-,,!,,.-6
or using a financial calculator, 9 D 15, I D 0, >AT D !.,..., then compute >K D C1-,,!,,.-6
". !.,...EF1-(17(1G..0)
!.
)H7..0I D C!!-,%-6.,!
or using a financial calculator, 9 D !., I D 0, >AT D !.,..., then compute >K D C!!-,%-6.,!
c. <or 15 years, the lump sum is C1-,,!,,.-6 $ (1..0) D C!.5,6--.06. <or !. years, the lump
sum is C!!-,%-6.,! $ (1..0) D C!,%,10!.%%.
5. a. 9o, "ecause the com"ined ratio is 1%L G 1!.5L G 16L D 1.%.5L.
". Nes, "ecause the com"ined ratio ad'usted for investment yield is 1.%.5L - 6L D -5.5L.
0. Com"ined ratio D 11.5L G 1!.-L G 10..L D 1.0.,.L.
In order to "e profita"le, the yields on investments have to "e greater than 0.,.L.
1. >ure loss D C%.0 million - C1.-0 million D C1.0, million
M$penses D ...00 $ C%,0..,... D C!%1,0..
:ividends D ...1! $ C%,0..,... D C,%,!..
Investment returns D C11.,...
9et profits D 1,0,.,... - !%1,0.. - ,%,!.. G 11.,... D C1,5!-,!..
6. @oss ratio D C,,%,%,15.7C0,!5.,... D 0-.5L
M$pense ratio D C1,5-%,15.7C0,!5.,... D !5.5L
:ividend ratio D C150,!5.7C0,!5.,... D !.5L
Com"ined ratio D 0-.5L G !5.5L G !.5L D -1.5L
Investment ratio D C!16,15.7C0,!5.,... D %.5L
4perating ratio D -1.5L - %.5L D -,..L
4verall profita"ility D 1....L - -,..L D 0..L
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