chapter 21 insurance companies and pension funds

Chapter 21

Insurance Companies and Pension Funds

Copyright ©2015 Pearson Education, Inc. All rights reserved. 21-2

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• We look at two non-bank institutions: insurance companies and pension funds. Topics include:─ Insurance Companies─ Fundamentals of Insurance─ Growth and Organization of Insurance Companies─ Types of Insurance─ Pensions─ Types of Pensions─ Regulation of Pension Plans─ The Future of Pension Funds


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-averse - they would rather pay a certainty equivalent (the premium) than accept a gamble


Insurance Companies: Major Employer

Figure 21.1 Number of Persons Employed in the U.S. Insurance Industry, 1960–2011


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 weren’t for the 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 company’s obligation is reduced by the amount of the compensation.



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 loss’s occurring.


Adverse Selection and Moral Hazard in Insurance

• Asymmetric information plays a large role in the design of insurance products.

• The presence of adverse selection and moral hazard impacts the industry, but is fairly well understood the insurance companies.


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.


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.


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.


Selling Insurance

• Another problem is that most people don’t 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.


Mini Case: Insurance Agent: The Customer’s Ally

• One agent working for Prudential Insurance was responsible for selling a large number of fire insurance policies and was always careful to document clearly when a fire hydrant was on the property by including it in a photograph.

• One photo, however, showed a plastic fire hydrant lying in the trunk of his car – one he put on property as needed to give a low quote!


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.



Figure 21.2 Number of Life Insurance Companies in the United States, 1950–2011



• 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 2011, only 122 of 804 insurance companies were mutual insurance companies.


Types of Insurance

Insurance is classified by which type of undesirable event is covered:

•Life Insurance

•Health Insurance

•Property and Casualty Insurance


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 10 - 20 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.


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.


Expected Life of Persons at Various Ages

Table 21.1 Life Expectancy at Various Ages in the United States, 2012


Sample Annual Premiums

Table 21.2 Typical Annual Premiums on a $100,000 Term Policy for a 40-Year-Old Male Nonsmoker


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 company’s assets, as well as assets invested in mortgages.



Figure 21.3 Distribution of Life Insurance Company Assets (2011)



Figure 21.4 Percentage of Life Insurance Company Assets Invested in Mortgages, 1920–2012



• Life insurance companies have two primary liabilities:─ Life insurance payouts─ Pension fund payouts


Health Insurance

• Health insurance policies are vulnerable to the adverse selection problem - those with health problems are more likely to seek coverage.

• Individual policies must be priced assuming adverse selection.

• Most health insurance is offered through group policies.


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.


Patient Protection and Affordable Care Act

• Signed into law on March 23, 2010• Access:

– Subsidies – Limits on coverage denial– Children stay on their parents’ plans until age 26

• Rules:– Option to purchase through state-based

exchanges– Fines for not having insurance start in 2014


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



• 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.



• 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.


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.


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


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.


Credit Default Swaps: The AIG Blowup

• AIG’s 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.


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.


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.


Pensions

• Definition: A pension plan is an asset pool that accumulates over an individual’s 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.


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


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


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)


Mini Case: Power of the Pensions

• Managers of pensions have gained the ability to exercise substantial control over corporate management.

• For example, pension funds recently defeated management-sponsored antitakeover proxy proposals at Honeywell.

• The stated mission of the Council of Institutional Investors is to “encourage trustees to take an active role in assuring that corporate actions are not taken at the expense of shareholders.”


Private Pension Plan Assets

Figure 21.5 Distribution of Private Pension Plan Assets (end of 2012)


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.


Social Security Assets

Figure 21.6 Social Security Fund Assets, 1957–2013


Social Security Assets

Figure 21.7 Projected Social Security Trust Fund Assets


Social Security

• It’s 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, it’d be wise for you plan other sources for your retirement cash flows.


Regulation of Pension Plans

A major U.S. Supreme Court decision in 1949 established that pension benefits were a legitimate part of collective bargaining. The number of plans increased from this as unions negotiated for such plans.



• Employee Retirement Income Security Act of 1974─ Established guidelines for funding─ Allowed plan credit to transfer with employees─ Established vesting requirements to gain

plan benefits─ Increased disclosure requirements─ Assigned regulatory oversight to the Department

of Labor



• ERISA also established the Pension Benefit Guarantee Corporation to insure pension benefits if an underfunded pension plan is unable to meet its obligations.─ Accounting makes it difficult to assess funding

status of a plan─May be in trouble as plans appear underfunded



• The next slide shows the annual payments made since 1980 to failed plan participants. In 2005, the PBGC said that the plan has never been under more stress…


Participants and Beneficiaries Receiving PBGC Payments

Figure 21.8 Total PBGC Benefit Payments



• Pension Protection Act of 2006 was passed to address the growing problem of failed pension plans. The act provides for stronger funding rules, greater transparency, and a strong pension insurance system.



• Pension Reform Act of 1978 authorized individual retirement accounts.─ Enjoy a preferential tax treatment─ Keogh plans are similar plans for

self-employed individuals─ SIMPLE IRAs are simplified retirement

plans for small businesses.


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.


Chapter Summary

• Insurance Companies: the nature of the industry, including rationale and people employed in the industry, was presented.

• Fundamentals of Insurance: the seven fundamental ideas behind all insurance were listed and reviewed.


Chapter Summary (cont.)

• Growth and Organization of Insurance Companies: the changes in growth patterns over the last several decades was reviewed, including both assets and number of companies.

• Types of Insurance: the variety of insurance policies available covering life, health, etc., were presented.



• Pensions: the general idea and growth in pension funds was presented.

• Types of Pensions: the various forms, from defined-benefit to defined-contribution, were reviewed and compared.



• Regulation of Pension Plans: ERISA and other laws that govern pension funds was discussed.

• The Future of Pension Funds: we should expect their popularity, size, and power to continue to grow as the population ages.

chapter 21 insurance companies and pension funds

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