CHAPTER 18 INSURANCE COMPANIES AND PENSION FUNDS.
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Transcript of CHAPTER 18 INSURANCE COMPANIES AND PENSION FUNDS.
CHAPTER 18
INSURANCE COMPANIES AND PENSION FUNDS
Copyright© 2006 John Wiley & Sons, Inc. 2
The Insurance Service -
Indemnify another against risk of economic loss.Requires pooling of a large number of similar, but independent risks - law of large numbers.Insurance is the last step after other pure risk control and reduction techniques of risk management.Pure risk, the chance of loss, differs from speculative or investment risk which is related to the variability of returns where one can have a gain or a loss.Insurance reduces society's cost of bearing risk.
Copyright© 2006 John Wiley & Sons, Inc. 3
The Insurance Mechanism
An insurer assumes objective risk which is the deviation of actual losses from expected losses. It is part of the operating risk of an insurance company.
Copyright© 2006 John Wiley & Sons, Inc. 4
Insurable Risks
homogeneous or similar.fortuitous, random or occurring by chance.circumstances of loss can be identifiable.a probability of loss can be estimated.the losses occur independent of each other-not all at once, such as a flood, wiping out the insurer.premiums must be economically feasible for the insured.
Copyright© 2006 John Wiley & Sons, Inc. 5
Objective risk control methods include:
use of loss prevention techniques such as "safety" programs.
accept "average" risks as customers.
require deductibles or shared losses with the insured.
Copyright© 2006 John Wiley & Sons, Inc. 6
Insurance premiums represent the sum of:
expected losses, plus
operating costs, plus
target profit, less
premium investment income
with adjustment as necessary for competitive conditions
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Interest rate risk affects insurance companies.
Insurance contracts are long-term contracts: interest rates vary providing incentives for cancellations and revision of intentions.
Because of long-term nature of liabilities, portfolios are heavily invested in bonds
Copyright© 2006 John Wiley & Sons, Inc. 8
Term Life Insurance: Basic Model
Payment for death only
Coverage for specified term
Lower premium
Large amount of protection per premium dollar
No “investment” features
Copyright© 2006 John Wiley & Sons, Inc. 9
Term Life Insurance: Variations
Straight - coverage for specific time period with premiums increasing with age.
Renewable - option to continue after expiration date, independent of health changes.
Decreasing - pay level premiums over a period of years while level of coverage declines.
Convertible - policyholder may convert to a whole life policy for an added premium fee.
Copyright© 2006 John Wiley & Sons, Inc. 10
Whole Life
Level premiums for constant level of protection.
Premium includes cost of insurance (decreasing term) and savings contribution.
Cash values (savings accumulated by insured) increase with time.
Death benefit includes decreasing term amount and "return" of savings.
Copyright© 2006 John Wiley & Sons, Inc. 11
Whole Life, cont.
Provides "living" benefits in form of accumulated savings.
Combines life insurance and savings (at a relatively low but contractual rate).
Interest or dividends on cash values accumulate free of income taxes-important tax shelter.
Copyright© 2006 John Wiley & Sons, Inc. 12
Universal life
The most popular interest-sensitive permanent policies.
Flexible premium policy with varying death benefit and premium amounts.
Pays market rate on savings.
Copyright© 2006 John Wiley & Sons, Inc. 13
Variable Life
Popular recently with rapid growth in equity values.
Fixed-premium
Insured direct investment of cash values
Guaranteed death benefit
No guaranteed cash value
Copyright© 2006 John Wiley & Sons, Inc. 14
Annuities
Superannuation- risk of living beyond one’s means
A life annuity, for a given payment, pays a life long stream of payments.
The period of time and survivorship terms vary.
The longer the "certainty," the less the payments.
Copyright© 2006 John Wiley & Sons, Inc. 15
Health Insurance
Covers medical, disability, and dental expenses.
Insurance companies write about sixty percent of health insurance premiums.
Copyright© 2006 John Wiley & Sons, Inc. 16
Balance Sheet of Life Insurers
Liabilities and net worthLife insurance reserves - funds owed for life insurance policies, including cash values and losses owed, not yet paid.
Pension fund reserves - accumulated commitments to pay future pensions.
Surplus and net worth
Copyright© 2006 John Wiley & Sons, Inc. 17
Balance Sheet of Life Insurers, cont.
Assets - long-term matching liabilitiesCorporate bonds-largest financial investment
Corporate equities-Variable life
Mortgages
U.S. government securities
Policy loans
Copyright© 2006 John Wiley & Sons, Inc. 18
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Property/Casualty Insurers
Property insurance - protection from financial loss of property from perils such as fire and theft.
Casualty insurance - liability, worker's compensation, auto, aircraft, marine
Copyright© 2006 John Wiley & Sons, Inc. 20
Life vs. P/C operations
P/C policies shorter term than life
P/C loss payments less predictable
P/C balance sheet must be more liquid
P/C loss payments increase with inflation
Both life and P/L firms generate revenue from premiums and investment income
Copyright© 2006 John Wiley & Sons, Inc. 21
Balance Sheet of P/C Insurers
Assets - selected for income, inflation hedge, liquidity, and tax sheltering
State and municipal bonds (tax free) and corporate bonds
Corporate stock (inflation hedge and income)
Government securities (liquidity and income)
Trade credit ($ owed by customers and agents)
Copyright© 2006 John Wiley & Sons, Inc. 22
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Balance Sheet of P/C Insurers, cont.
Liabilities and net worthPolicy reserves include:
• unearned premium reserve.
• losses incurred, not paid.
Surplus and net worth
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Types of P/C Policies
Property - insurance against losses associated with physical damage.
“Named perils” : Coverage limited to specific losses listed in policy.
“All-risk coverage” or “open perils”: Any loss covered unless specifically excluded.
Liability - insurance against financial responsibility for harm to another’s person or property.
Copyright© 2006 John Wiley & Sons, Inc. 26
Types of P/C Policies, cont.
Marine insurance - covers losses related to transportation.
Ocean marine - ocean transportation
Inland marine - inland transportation and some special personal property such as furs and jewelry
Multi-peril or multi-line-combines property and liability insurance.
Copyright© 2006 John Wiley & Sons, Inc. 27
Types of Pension Plans
Private Pension PlansInsured – managed by life insurer
Noninsured• Trustee managed by a third party
• Non-trustee - managed by firm or labor union
Government-sponsored Pension PlansSocial Security
Federal, state, and local government plans
Copyright© 2006 John Wiley & Sons, Inc. 28
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Pension Plan Vocabulary
Fully funded: contributing funds sufficient to cover future obligations versus paying benefits from current revenue
Contributory: employee and employer contribute
Fully contributory: only employee contributes
Noncontributory: only employer contributes
Defined benefit: Benefits set by formula based on years of service and average salary; responsibility is fully on employer to provide promised benefits
Copyright© 2006 John Wiley & Sons, Inc. 30
Pension Vocabulary, cont.
Defined contribution: employee and employer each make contributions of some set percentage of salary; employee chooses how funds are invested; ultimate benefits depend on employee’s investing; 401k most popular example today
Vesting: employee assured of retirement benefits after a set period of time.
Portability: ability to transfer vested benefits to another plan
Copyright© 2006 John Wiley & Sons, Inc. 31
Pension Management Factors
Little need for liquidity
“Qualified” Plans not taxed
The higher the earning rate, the lower the contribution to support a given benefit
Pension funds face risk/return trade-off decisions for their beneficiaries
Regulation focuses on fiduciary duty, full funding, and prudent investing