Chapter 21

Insurance Companies and Pension Funds

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Chapter Preview

• The chapter is about two non-bank FI types: insurance companies and pension funds.

• The topics include:─ Insurance Companies─ Fundamentals of Insurance─ Types of Insurance─ Types of Pensions─ The Future of Pension Funds

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Insurance Companies• The primary function of insurance companies is to

compensate policyholders if a prespecified event occurs, in exchange for premiums paid

• Insurers pool the risks of individuals to diversify away some of the customer-specific risk– Thus, they are able to offer insurance services at a cost

lower than any individual could achieve on his/her own

• Insurance underwriters assess and price risk for each policy prior to its acceptance to determine if the risk is acceptable– Decide whether or not to issue insurance to an individual– If issued, decide how much to charge – the insurance premium

• Insurance brokers sell insurance contracts– Independent agents do not represent any particular insurance

agency but sell products from a large number of companies.– Exclusive agents sell the products of one company exclusively.

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Types of Insurance

Insurance is classified by which type of undesirable event is covered:• Life Insurance • Health Insurance

– Individual policies must be priced assuming adverse selection. Most health insurance is offered through group policies. Life insurers write over 50% of all health premiums

• Property and Casualty Insurance– Property insurance involves coverage related to the loss

of real and personal property– Casualty insurance offers protection against legal liability

for causing harm to others (doctors, construction, …)– Car, rental insurance combine the two types

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Types of Life Insurance

Term LifeCash Value(Permanent

Life)

Whole Life Universal Life

Single Premium

LifeVariable Life

Variable Universal

Life

Level Term Decreasing Term

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Types of Life Insurance• Term Life: Contract for 10-30 years, expires, no savings

(policyholder gets nothing if he/she is alive when the contract expires). Problems with qualifying for older or sick people.– Level term pays the same amount upon death at any time; Decreasing

term pays a smaller amount upon death as the time progresses.

• Cash Value: No expiration; part of the premiums pays for insurance and part is invested; the policyholder can use the cash value of the policy as a collateral to borrow.– Whole Life: the insurance company invests cash in fixed income securities;

constant premium (but insurance/savings amounts proportion changes).• Single premium life: simplest; one payment at the beginning• Variable Life: policyholder selects among mutual funds in which

premiums are invested; beneficiary receives variable amount on death (a function of the return on the underlying investments) but with a minimum guaranteed amount.

– Universal Life: policyholder can shift parts of the premium between insurance (affecting the death amount) and savings; premiums can vary; beneficiary receives variable amount on death (a function of premiums invested and the return on the underlying investments)

• Variable Universal Life: same as universal life and policyholder selects among mutual funds in which premiums are invested.

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Life Insurance Company Balance Sheet : Liabilities

• Policy reserves reflect expected payment commitments on existing policy contracts; Funds in separate account businessare monies for which the insurer maintains separate accounting (e.g., annuities); GIC (Guaranteed Investment Contracts in US; contrast to Guaranteed Investment Certificates issued by banks in Canada, which are equivalent to CDs in the US)

Liabilities are predictable, long-term

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Life Insurance Company Balance Sheet: Assets

• Policy loans are loans made by an insurance company to its policyholders using the policy as collateral

• Note: For life insurance firms, the long term nature of assets matches that of liabilities. In contrast, property and casualty insurers have shorter term liabilities as well as more liquid assets.

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Annuities

• Annuities are offered by insurance companies. They are insurance against running out of money due to long life – they pay until a beneficiary dies.

• Example. Suppose that a person wants to purchase an annuity today that would pay $15,000 after taxes per year until the end of that person’s life. The insurance company expects the person to live for 25 more years and can invest the amount received for the annuity at a guaranteed interest rate of 5 percent.

• What is the fair price for the annuity policy today ?

• Solution.• Using the annuity formula,

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑣𝑣𝐹𝐹𝑣𝑣𝑣𝑣𝑣𝑣 =$15000 1 − 1

1 + 0.05 25

0.05= $15000 ∗ 14.0939 = $211,409

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Annuities, Monthly Payments

• In option 1, you will receive 10 years of monthly payments.

• With option 2, you will receive a monthly payment until you die, which is expected to be in 14 years.

$2,651.64

0.0041671.00416711250,000Payment 120 =

−=

$2,072.18

0.0041671.00416711250,000Payment 168 =

−=

Example. You have a policy with a cash value of $250,000 which you wish to annuitize. You are currently 62 years old. Interest rates are 5% per year, and you are considering receiving monthly payments under two options. In option 1, you will receive 10 years of monthly payments. With option 2, you will receive a monthly payment until you die, which is expected to be in 14 years (based on actuarial tables). How much will you receive per month with each option (ignoring administrative costs and fees)?

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Credit Default Swaps (CDS)

• A CDS is an insurance contract against default on a financial instrument, usually a corporate bond.– Initial idea: a bondholder buys a CDS - insurance against

default on the bond’s P&I payments. The bondholder pays the spread (insurance premium) to the issuing insurance company. If a default event happens, the bondholder delivers the bonds to the insurance firm and receives 100% of the bond value.

– For example, a spread of 255.5 bp, or 2.555%, means that, to insure $100M of debt, you have to pay $2.555M per year.

– Market essentially non-existent before 1995. By 2008, there were about $62 trillion of CDS outstanding! Compare: the world GDP is $50 trillion. The CDS market allowed speculators to bet on the health of a company, conceptually similar to betting on the health/life of an individual unrelated to you.

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Pension Funds

• Pension funds (PFs) offer savings plans through which participants accumulate tax deferred savings during their working years before withdrawing them in their retirement years– earnings on funds invested are exempt from

current taxation (i.e., during working years)– tax payments are not made until funds are

withdrawn by the participant (i.e., during retirement)

• PFs were first established in the U.S. in 1759 to benefit the widows and children of church ministers

• The first corporate PF was established by American Express Co. in 1875

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Pension Funds• Government-funded or sponsored PFs

– Canada Pension Plan (CPP), BC Public Service Pension Plan, U.S. Social Security, California Public Employees' Retirement System (CalPERS)

• Private PFs are funds administered by private corporations (e.g., insurance companies or mutual funds)– Group RRSPs (Registered Retirement Savings Plan), 401(k)– Employer, e.g., SFU, contributes and hires the fund administrator

firm; employees can choose the allocation of assets from options offered by the managing firm

• Individual pension plans– Individual RRSPs, IRA (individual retirement account)– You are in complete control over your investments– 2016 Contribution limit is $25,370 in Canada and $5,500 in US

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Defined Benefit plans vs. Defined Contribution

• A pension plan governs the operation of a pension fund• Pension funds are broadly classified into two

categories: defined benefit plans and defined contribution plans

• A defined benefit PF is a fund in which the employer agrees to provide the employee with a specific cash benefit upon retirement– a flat benefit formula PF pays a flat amount for every

year of employment– a career average formula PF pays benefits based on the

employee’s average salary over the entire period of employment

– a final pay formula PF pays benefits based on a percentage of the average salary during a specified number of years at the end of the employee’s career times the number of years of service

• For example, Annual Retirement Payment = 2% × average of final 3 years’ income × years of service

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Pension Funds: Defined Contribution

• A defined contribution PF is a fund in which the employer agrees to make a specified contribution to the pension fund during the employee’s working years– For example, SFU used to contribute an amount equal to

10% of an employee’s salary to a private RRSP plan managed by SunLife Insurance.

– In general, about 25% of pension funds are administered by insurance firms, 25% by mutual funds, and 50% by banks.

– The payout at retirement is uncertain – depends on how the funds were invested.

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Funding Status of Defined-Benefit Pension Plans

• Defined-Benefit Pension Plans place a burden on the employer to properly fund the expected retirement benefit payouts.

• Defined-Benefit Pension Plans can be─ 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

Graph: Projected US Social Security Trust Fund Assets

The Quebec Pension Planis in a similar state

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Underfunding of Single Employer Defined Benefit Plans

• Pension Benefit Guarantee Corporation (PBGC) insures participants of defined benefit pension plans in the US.

• Employers paid premiums per employee ($49 / employee now)• By 2000 the PBGC operated at a record surplus of $9.7 billion, but large

pension fund bankruptcies in the early 2000s resulted in the agency posting a $23.3 billion deficit in 2005.

• Many firms convert their defined-benefits plans to defined contribution plans.

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“After-tax” Pension Plans• RRSP and traditional IRA contributions are tax-

deductible, while withdrawals are taxable.• The tax-free savings account (TFSA) and Roth

IRAs are the opposite to RRSP and traditional IRA: contributions are made with after-tax income, while withdrawals are tax-free.

• Roth IRAs were introduced in 1998, TFSA in 2009.– Contribution limits are $5,500 per year in both countries in

2016.– In the US, high-income individuals (>$132K as of 2016)

cannot contribute.

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Example. RRSP vs TFSA21.7. Investors have two options: with an RRSP account, funds added are not taxed initially but are taxed when withdrawn. With a TFSA, the funds are taxed initially, but not when withdrawn. If an investor wants to contribute $15,000 before-tax to an RRSP, what will be the difference after 30 years between the two options. Assume that the investor is in the 25% tax bracket and will remain in it in 30 years, and that both options will earn 6% /year.

Solution• With the RRSP, the after-tax final value is the future value of PV

= 15,000 invested now.𝐹𝐹𝐹𝐹 = $15000 ∗ 1 + 0.06 30 = $86,152

• After tax, it is $86,152 × (1 - 0.25) = $64,614.

• With the TFSA, the after-tax final value is the future value of PV= $15,000*(1-0.25)=$11,250 invested now.

𝐹𝐹𝐹𝐹 = $11250 ∗ 1 + 0.06 30 = $64,614• The investor is indifferent between a TFSA and RRSP.