CHAPTER 21

Insurance
Companies and
Pension Funds

Copyright 2012 Pearson Prentice Hall.

All rights reserved.

Insurance Companies
Insurance companies assume the risk of
their clients in return for a fee, called
the premium.
Most people purchase insurance because
they are risk-aversethey would rather pay
a certainty equivalent (the premium) than
accept a gamble

2012 Pearson Prentice Hall. All rights reserved.

21-2

Insurance Companies:
Major Employer

2012 Pearson Prentice Hall. All rights reserved.

21-3

Fundamentals of Insurance
Although there are many types of insurance
and insurance companies, there are seven
basic principles all insurance companies are
subject to:
1.There must be a relationship between the
insured and the beneficiary. Further, the
beneficiary must be someone who would
suffer if it werent for the insurance.
2012 Pearson Prentice Hall. All rights reserved.

21-4

Fundamentals of Insurance
2. The insured must provide full and accurate
information to the insurance company.
3. The insured is not to profit as a result of
insurance coverage.
4. If a third party compensates the insured for
the loss, the insurance companys obligation
is reduced by the amount of the
compensation.
2012 Pearson Prentice Hall. All rights reserved.

21-5

Fundamentals of Insurance
5. The insurance company must have a large
number of insured so that the risk can be
spread out among many different policies.
6. The loss must be quantifiable. For example,
an oil company could not buy a policy on an
unexplored oil field.
7. The insurance company must be able to
compute the probability of the losss
occurring.
2012 Pearson Prentice Hall. All rights reserved.

21-6

Adverse Selection and Moral

Hazard in Insurance
As we have seen in previous chapters,
asymmetric information plays a large role in
the design of insurance products. As with
other industries, the presence of adverse
selection and moral hazard impacts the
industry, but is fairly well understood the
insurance companies.

2012 Pearson Prentice Hall. All rights reserved.

21-7

Adverse Selection in Insurance

The adverse selection problem raises the
issue of which policies an insurance company
should accept:
Those most likely to suffer loss are most
likely to apply for insurance.
In the extreme, insurance companies should
turn anyone who applies for an insurance
policy.
2012 Pearson Prentice Hall. All rights reserved.

21-8

Adverse Selection in Insurance

However, insurance companies have
found reasonable solutions to deal with
this problem:
Health insurance policies require a
physical exam.
Preexisting conditions may be excluded
from the policy.
2012 Pearson Prentice Hall. All rights reserved.

21-9

Moral Hazard in Insurance

Moral hazard occurs in the insurance
industry when the insured fails to take proper
precautions (or takes on more risk) to avoid
losses because losses are covered by the
insurance policy.
Insurance companies use deductibles to
help control this problem.

2012 Pearson Prentice Hall. All rights reserved.

21-10

Selling Insurance
Another problem is that most people dont
purchase enough insurance. Insurance
companies use a strong sales force to
combat this.
Independent agents may sell the insurance products
of a number of different insurance companies.
Exclusive agents only sell the products of
one company.
An underwriter reviews each policy prior to its
acceptance to determine if the risk is acceptable.
2012 Pearson Prentice Hall. All rights reserved.

21-11

Growth and Organization

of Insurance Companies
The number of insurance companies grew
steadily until 1988, and since then the number
has fallen steadily.
This can be seen in the next slide.

2012 Pearson Prentice Hall. All rights reserved.

21-12

Growth and Organization

of Insurance Companies

2012 Pearson Prentice Hall. All rights reserved.

21-13

Growth and Organization

of Insurance Companies
The previous slide also shows that insurance
companies may be organized in two
difference ways:
A stock company is owned by shareholders and has
a profit motive
A mutual insurance company is owned by the
policyholders and attempts to provide the lowest
cost insurance

At the end of 2005, only 135 of 1119 insurance

companies were mutual insurance companies.
2012 Pearson Prentice Hall. All rights reserved.

21-14

Types of Insurance
Insurance is classified by which type of
undesirable event is covered:
Life Insurance
Health Insurance
Property and Casualty Insurance

2012 Pearson Prentice Hall. All rights reserved.

21-15

Life Insurance
Life insurance policies come in many forms.
Some of the typical policies include:
Term Life: the insured is covered while the policy
is in effect, usually 1020 years.
Whole Life: similar to term life, but allows the
policyholder to borrow against the policies cash
value. When the term of policy expires, the
insured can get the cash value of the policy.

2012 Pearson Prentice Hall. All rights reserved.

21-16

Life Insurance
Life insurance policies come in many forms.
Some of the typical policies include:
Universal Life: includes both a term life
portion and a savings portion.
Annuities: pays a benefit to the insured until
death, to cover retirement years.

2012 Pearson Prentice Hall. All rights reserved.

21-17

Expected Life of Persons

at Various Ages

2012 Pearson Prentice Hall. All rights reserved.

21-18

Sample Annual Premiums

2012 Pearson Prentice Hall. All rights reserved.

21-19

Life Insurance:
Company Assets and Liabilities
Life insurance companies derive funds from
two sources:
They receive premiums that must be used to
payout future claims when the insured dies
They receive premiums paid into pension funds
managed by the life insurance company

The next figures shows the distribution of the

typical life insurance companys assets, as
well as assets invested in mortgages.
2012 Pearson Prentice Hall. All rights reserved.

21-20

Life Insurance:
Company Assets and Liabilities

2012 Pearson Prentice Hall. All rights reserved.

21-21

Life Insurance:
Company Assets and Liabilities

2012 Pearson Prentice Hall. All rights reserved.

21-22

Life Insurance:
Company Assets and Liabilities
Life insurance companies have two
primary liabilities:
Life insurance payouts
Pension fund payouts

2012 Pearson Prentice Hall. All rights reserved.

21-23

Health Insurance
Health insurance policies are highly
vulnerable to the adverse selection problem.
Those with known or expected health
problems are more likely to seek coverage.
This is why most health insurance is offered
through group policies. Individual policies
must be priced assuming adverse selection.

2012 Pearson Prentice Hall. All rights reserved.

21-24

Health Insurance
Health insurance is a hot topic in the political
environment, focusing on increased costs
and availability of coverage.
Insurance programs are attempting to shift
costs to the employers.
Health Maintenance Organizations are
another attempt to keep costs down.
2012 Pearson Prentice Hall. All rights reserved.

21-25

Property and Casualty

Insurance
Property Insurance: protects businesses and
owners from the risk associated with ownership.
Named-peril policies: insures against any losses only
from perils specifically named in the policy
Open-peril policies: insures against any losses except
from perils specifically named in the policy

Casualty Insurance
Reinsurance

2012 Pearson Prentice Hall. All rights reserved.

21-26

Property and Casualty

Insurance
Casualty Insurance: also known as liability
insurance, it protects against financial
losses because of a claim of negligence.
Reinsurance: allocates a portion of the risk
to another company in exchange for a
portion of the premium.

2012 Pearson Prentice Hall. All rights reserved.

21-27

Property and Casualty

Insurance
Terrorism Risk Insurance Act of 2002:
based on the 9-11 attacks in NYC, new
legislation was passed in 2002 limiting the
amount insurance firms would be required
to pay out in the event of future attacks
Government will pay 90% of losses, up to
$100 billion.

2012 Pearson Prentice Hall. All rights reserved.

21-28

Insurance Regulation
The McCarran-Ferguson Act of 1945
explicitly exempts insurance companies from
any type of federal regulation.
Most insurance regulations is at the
state level
Regulation is typically designed to protect
policyholders from losses, or expand
insurance coverage in the state.
2012 Pearson Prentice Hall. All rights reserved.

21-29

Conflict of Interest Violations

In 2004, NY Attorney General E. Spitzer
charged Marsh and McLennan with
insurance fraud.
Indictment cited bid-rigging and bribery.
Some of the pay-for-play fees amounted to
$800 million per year.
Many top execs left the firm in the wake of
the incident.
2012 Pearson Prentice Hall. All rights reserved.

21-30

The Practicing Manager:

Insurance Management
Screening
Risk-Based Premium
Restrictive Provisions
Prevention of Fraud
Cancellations of Insurance
Deductibles
Coinsurance
Limits on the Amount of Insurance
2012 Pearson Prentice Hall. All rights reserved.

21-31

Credit Default Swaps

A CDS is insurance against default on a financial
instrument, usually some kind of securitized bond.
Market essentially non-existent before 1995. By
2008, there were about $62 trillion of CDS
outstanding!
The CDS market allowed speculators to bet on
the health of a company, a usual no-no in
insurance.

2012 Pearson Prentice Hall. All rights reserved.

21-32

Credit Default Swaps:

The AIG Blowup
AIGs Financial Products division insured over
$400 billion of CDS securities, of which $57 billion
were debt securities backed by subprime
mortgages.
Creditors quickly realized the losses may
bankrupt AIG AIG could not raise any capital
The Fed organized a bailout, but took a big stake
in AIG as payment. Insurance companies
nationwide will now fall under federal scrutiny.
2012 Pearson Prentice Hall. All rights reserved.

21-33

Monoline Insurance
Monoline insurance companies specialize in
credit insurance and are the only insurance
companies that are allowed to provide insurance
that guarantees the timely repayment of bond
principal and interest when a debt issuer defaults.
All other insurance companies are prohibited from
doing this.
Help lower required interest by providing a credit
enhancement. The crisis affected them as well.
2012 Pearson Prentice Hall. All rights reserved.

21-34

The Subprime Crisis and the

Monoline Insurers
Monoline insurers did insure debt backed by subprime
mortgages.
Defaults on these mortgages resulted in credit
downgrades for the insurers.
This weakened the value of their insurance guarantees,
which spilled over into their municipal securities insurance.
Investors reduced the value of the insurance
municipalities started seeing higher interest costs. This, in
turn, resulted in lower spending on roads, schools, etc.

2012 Pearson Prentice Hall. All rights reserved.

21-35

Pensions
Definition: A pension plan is an asset pool that
accumulates over an individuals working years
and is paid out during the nonworking years.
Developed as Americans began relying less on
children for care during their later years.
Also became popular as life expectancy
increased.

2012 Pearson Prentice Hall. All rights reserved.

21-36

Types of Pensions
Defined-Benefit Pension Plans: a plan where
the sponsor promises the employee a
specific benefit when they retire.
For example,
Annual Retirement Payment 2% average
of final 3 years income years of service

2012 Pearson Prentice Hall. All rights reserved.

21-37

Types of Pensions
Defined-Benefit Pension Plans place a burden on
the employer to properly fund the expected
retirement benefit payouts.
Fully funded: sufficient funds are available to meet
payouts
Overfunded: funds exceed the
expected payout
Underfunded: funds are not expected to meet the
required benefit payouts

2012 Pearson Prentice Hall. All rights reserved.

21-38

Types of Pensions
Defined-Contribution Pension Plan: a plan where
a set amount is invested for retirement, but the
benefit payout is uncertain.
Private Pension Plans: any pension plan set up
by employers, groups, or individuals
Public Pension Plan: any pension plan set up by a
government body for the general public (e.g.,
Social Security)

2012 Pearson Prentice Hall. All rights reserved.

21-39

Private Pension Plan Assets

2012 Pearson Prentice Hall. All rights reserved.

21-40

Social Security
Pay as you go system, where current
funding is used (partially) to pay
current benefits.
Projected number of workers is falling while
projected number of retirees is increasing,
which will cause problems in years to come
if not corrected.

2012 Pearson Prentice Hall. All rights reserved.

21-41

Social Security Assets

2012 Pearson Prentice Hall. All rights reserved.

21-42

Social Security Assets

2012 Pearson Prentice Hall. All rights reserved.

21-43

Social Security
Its difficult to measure the health of the
social security system. Many factors are
hard to predict, such as birth rates and the
rate of immigration. Although it may not fail,
itd be wise for you plan other sources for
your retirement cash flows.

2012 Pearson Prentice Hall. All rights reserved.

21-44

Participants and Beneficiaries

Receiving PBGC Payments

2012 Pearson Prentice Hall. All rights reserved.

21-45

The Future of Pension Funds

We can expect their growth and popularity
as the average population continues
to grow.
Variety of pension fund offerings may
increase as well.
Pension funds may gain significant
control of corporations as their stock
holdings increase.
2012 Pearson Prentice Hall. All rights reserved.

21-46