Chapter Fifteen
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Transcript of Chapter Fifteen
McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter FifteenInsurance Companies
McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
1. Major Characteristics
2. Life Insurance
i. Basic Classes
ii. Balance Sheet
iii. Regulation
3. Property & Casualty Insurance
i. Major Types
ii. Balance Sheet and Risk
iii. Regulation
1. Major Characteristics
2. Life Insurance
i. Basic Classes
ii. Balance Sheet
iii. Regulation
3. Property & Casualty Insurance
i. Major Types
ii. Balance Sheet and Risk
iii. Regulation
McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
1. Insurance Industry
• Primary function is to compensate individuals and corporations (policyholders) if a prespecified adverse event occurs
• Two major groups:– Life: untimely death, illness, and retirement – Property Casualty: personal injury and liability due
to accidents, theft, fire, and other catastrophes
• Primary function is to compensate individuals and corporations (policyholders) if a prespecified adverse event occurs
• Two major groups:– Life: untimely death, illness, and retirement – Property Casualty: personal injury and liability due
to accidents, theft, fire, and other catastrophes
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Insurance Companies
Life
1,500 companies
Assets: $3.88 trillion (’04)
Trend: Mergers (Metropolitan Life Insurance & Prudential Insurance Co. of America - largest life insurers)
Role: Transfer income-related uncertainties from the individual to a group
Problem: Adverse selection
Property and Casualty
3,200 companies sell P&C insurance
Assets: $ 1.176 trillion (1/3 of Life Assets) (’04)
Trend: Concentration (10 firms – 45% of market share; major firms: State Farm & Allstate)
Role: Insure against the loss of property and legal liability exposure
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2.1 Life Insurance Basic Classes
Four basic classes1. Ordinary life - marketed on an individual basis in
units of $1,000 with policyholders making periodic payments (term, whole, endowment, variable, universal, variable universal)
2. Group Life Insurance3. Credit Life4. Others Life Insurer Activities
Four basic classes1. Ordinary life - marketed on an individual basis in
units of $1,000 with policyholders making periodic payments (term, whole, endowment, variable, universal, variable universal)
2. Group Life Insurance3. Credit Life4. Others Life Insurer Activities
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Distribution of Premiums Written on Various Life Insurance Lines
22.6
19.7
32.3
20.2
5 0.2
Accident & Health
Ordinary Life
Individual Annuities
Group Annuities
Group Life
Other
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Ordinary Life
a) Term Life - closes to pure life insurance, no savings attached, individual’s beneficiary receives payout at death of policyholder, term of coverage can vary from 1 year to 40 years or more.
b) Whole Life - protects individual over an entire lifetime in return for periodic premiums, beneficiaries receive face value of the contract.
c) Endowment Life - combines both term elements with a savings element, guarantees payout to the beneficiaries if death occurs during some endowment period or to the insured person who lives to the endowment date.
d) Variable life - invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments with policyholder determining risk level
e) Universal life and Variable universal life - allows the policyholder to change both the premium amounts and the maturity of the contract
a) Term Life - closes to pure life insurance, no savings attached, individual’s beneficiary receives payout at death of policyholder, term of coverage can vary from 1 year to 40 years or more.
b) Whole Life - protects individual over an entire lifetime in return for periodic premiums, beneficiaries receive face value of the contract.
c) Endowment Life - combines both term elements with a savings element, guarantees payout to the beneficiaries if death occurs during some endowment period or to the insured person who lives to the endowment date.
d) Variable life - invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments with policyholder determining risk level
e) Universal life and Variable universal life - allows the policyholder to change both the premium amounts and the maturity of the contract
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Group Life Insurance
• Covers a large number of insured persons under a single policy
• Issued to corporate employers (contributory or noncontributory)
• Involves economies of scale
• Covers a large number of insured persons under a single policy
• Issued to corporate employers (contributory or noncontributory)
• Involves economies of scale
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• Protects lender against a borrower’s death• Protects lender against a borrower’s death
Credit Life
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Other Life Insurer Activities– Annuities
• reverse of life insurance principles, involve different methods of liquidating a fund over a long period of time, a popular mechanism for retirement savings
– Private Pension Fund
• an alternative pension plan offered by insurance companies to private employers, innovative pension plans based on guaranteed investment contracts
– Accident and Health Insurance
• protects against morbidity or ill health risk
• major activity line is group insurance
• Life insurance companies write more than 50% of all policies but HMOs (nonregulated providers) have cut into their business
• face loss exposures similar to those of property-casualty insurers
– Annuities
• reverse of life insurance principles, involve different methods of liquidating a fund over a long period of time, a popular mechanism for retirement savings
– Private Pension Fund
• an alternative pension plan offered by insurance companies to private employers, innovative pension plans based on guaranteed investment contracts
– Accident and Health Insurance
• protects against morbidity or ill health risk
• major activity line is group insurance
• Life insurance companies write more than 50% of all policies but HMOs (nonregulated providers) have cut into their business
• face loss exposures similar to those of property-casualty insurers
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2.2 Life Insurance Industry Balance Sheet
• Assets– corporate bonds, equities, and government securities– policy loans - loans made by an insurance company to its
policyholders using their policies as collateral
• Liabilities– policy reserves - reflects their expected payment
commitments on existing policy contracts– surrender value of a policy - the cash value of a policy if a
policyholder surrenders the policy prior to maturity– separate account - annuity program sponsored by life
insurance companies, payoff on policy linked to assets in which policy premiums are invested
• Assets– corporate bonds, equities, and government securities– policy loans - loans made by an insurance company to its
policyholders using their policies as collateral
• Liabilities– policy reserves - reflects their expected payment
commitments on existing policy contracts– surrender value of a policy - the cash value of a policy if a
policyholder surrenders the policy prior to maturity– separate account - annuity program sponsored by life
insurance companies, payoff on policy linked to assets in which policy premiums are invested
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Life Insurance Industry Balance Sheet
Assets Liabilities & Capital/SurplusBonds 50.10% Net policy reserves 48.20%Preferred stock 0.8 Policy claims 0.9Common stock 1.7 Deposit-type contracts 7.5Mortgage loans 6.7 Interest maintenance reserve 0.4Real estate 0.5 Commissions, taxes, expenses 0.7Contract loans 2.7 Securities valuation reserve 0.8Cash and short-term investments 2 Other liabilities 5.2Other invested assets 1.5 Separate account business 30.5Premium due 0.5 Total capital and surplus 5.8Accrued investment income 0.8Separate account assets 30.6Other assets 2.1Total assets 100% Total liabilities and capital/surplus 100%
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2.3 Regulation
• McCarran-Ferguson Act of 1945 - confirms the primacy of state over federal regulation of insurance companies
• State insurance commissioners charter and examine insurance companies (role of NAIC), promote life insurance guarantee funds (l.i. firms do not have an access to a federal guarantee fund and there is no permanent insurance fund)
• Insurance guarantee fund - a fund of required contributions from within-state insurance
• McCarran-Ferguson Act of 1945 - confirms the primacy of state over federal regulation of insurance companies
• State insurance commissioners charter and examine insurance companies (role of NAIC), promote life insurance guarantee funds (l.i. firms do not have an access to a federal guarantee fund and there is no permanent insurance fund)
• Insurance guarantee fund - a fund of required contributions from within-state insurance
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3.1 Property-Casualty Insurance Companies
• Net premiums written - the entire amount of premiums on insurance contracts written
• Important P&C lines include the following– Fire Insurance and Allied Lines
• protects against fire, lightening, and removal of damaged property
– Homeowners Multiple Peril insurance• protects against damage to personal dwelling, contents, liability
– Commercial Multiple Peril Insurance• protects commercial firms similar to homeowners
– Automobile Liability and Physical Damage insurance
– Liability Insurance (other than auto)• provides protection to individuals or firms against legal liability
• Net premiums written - the entire amount of premiums on insurance contracts written
• Important P&C lines include the following– Fire Insurance and Allied Lines
• protects against fire, lightening, and removal of damaged property
– Homeowners Multiple Peril insurance• protects against damage to personal dwelling, contents, liability
– Commercial Multiple Peril Insurance• protects commercial firms similar to homeowners
– Automobile Liability and Physical Damage insurance
– Liability Insurance (other than auto)• provides protection to individuals or firms against legal liability
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Selected U.S. Catastrophes ($Mns)
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
TerroristAttack 9/11
Hurricanes 2004
MidwestTornadoes
2003
CaliforniaEarthquake
1989
L.A. Riots
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3.2 Balance Sheet
Major assets• Long term assets - bonds, preferred stock, and common
stock and other investment assets – 82.4%
Major Liabilities• Loss and loss adjustment expense – 37.9%• Unearned premiums – 15.0%
Capital/Surplus – 30.1%
Major assets• Long term assets - bonds, preferred stock, and common
stock and other investment assets – 82.4%
Major Liabilities• Loss and loss adjustment expense – 37.9%• Unearned premiums – 15.0%
Capital/Surplus – 30.1%
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Balance Sheet and Underwriting Risk
• Unearned premium - reserves set aside that contain the portion of a premium that has been paid before insurance coverage has been provided
• Loss Risk – property versus liability– severity versus frequency– long tail versus short tail– product inflation versus social inflation
• Loss Ratio - measures the actual losses incurred on a specific policy line, measures the ratio of losses incurred to premiums earned (continued)
• Unearned premium - reserves set aside that contain the portion of a premium that has been paid before insurance coverage has been provided
• Loss Risk – property versus liability– severity versus frequency– long tail versus short tail– product inflation versus social inflation
• Loss Ratio - measures the actual losses incurred on a specific policy line, measures the ratio of losses incurred to premiums earned (continued)
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• Expense Risk– loss adjustment expenses (LAE)
– commissions and other expenses
– combined ratio - equal to the loss ratio plus the ratios of LAE to premiums written and commissions and other expenses to premiums written
• Investment Yield/Return Risk– operating ratio - measure of the overall profitability of the
insurer, equals the combined ratio minus the investment yield
– behavior of interest rates and default rates on P&C insurers’ investments is crucial to the P&C insurers’ overall profitability
• Expense Risk– loss adjustment expenses (LAE)
– commissions and other expenses
– combined ratio - equal to the loss ratio plus the ratios of LAE to premiums written and commissions and other expenses to premiums written
• Investment Yield/Return Risk– operating ratio - measure of the overall profitability of the
insurer, equals the combined ratio minus the investment yield
– behavior of interest rates and default rates on P&C insurers’ investments is crucial to the P&C insurers’ overall profitability
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3.3 Regulation
• Chartered at the state level and regulated by state commissions
• The National Association of Insurance Commissioners (NAIC) provides various services to the state, such as:– standardized examination system– the Insurance Regulatory Information System (IRIS) to
identify insurers with loss, combined, and other ratios operating outside normal ranges
• Rate regulation– state commissions set ceilings on the premiums for auto and
workers’ compensation insurance
• Chartered at the state level and regulated by state commissions
• The National Association of Insurance Commissioners (NAIC) provides various services to the state, such as:– standardized examination system– the Insurance Regulatory Information System (IRIS) to
identify insurers with loss, combined, and other ratios operating outside normal ranges
• Rate regulation– state commissions set ceilings on the premiums for auto and
workers’ compensation insurance