1. Chapter Fifteen
Insurance Companies

2. Insurance Companies (ICs)
The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, in exchange for premiums paid
insurance underwriters assess and price risk
insurance brokers sell insurance contracts
Insurance is broadly classified into two groups
life insurance policies provide protection against untimely death or illness, and/or transfer wealth through time to retirement
property-casualty insurance protects against personal injury and liability associated with specific events
Insurance companies also sell a variety of investment products similar to other FIs 2

3. Life Insurance Companies
Approximately 2,000 life insurance companies exist in the U.S. in the mid-2000s
compares to 2,300 in 1988
the industry has seen consolidation to take advantage of scale and scope economies
Aggregate industry assets were $4.94 trillion at the beginning of 2010
compares to $1.1 trillion in 1988 3

4. Life Insurance Companies
Life 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
This allows the transfer of income related uncertainties from the individual to the group
Other activities of life insurance companies:
sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time
manage pension plans (e.g., tax-deferred savings plans)
provide accident and health insurance 4

5. Life Insurance Companies
Insurance companies accept or underwrite risk that a pre-specified event will occur in return for insurance premiums
underwriting decisions determine which risks are accepted and which are not
underwriting decisions determine how much to charge (in the form of premiums) for accepted risk
The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage 5

6. Life Insurance Companies
Moral hazard occurs when, after an insurer and a customer enter into an insurance contract, the insured engages in risky behavior because the risk is covered
Actuaries reduce the risks of underwriting insurance
With life insurance, actuaries analyze mortality, produce life tables, and apply time-value-of-money tools to price life insurance annuities and endowment policies
With health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc. 6

7. Life Insurance Companies
Ordinary life insurance is marketed to individuals—policyholders make periodic premium payments in exchange for coverage
Term life
beneficiary receives payout at time of death
if insured lives beyond the term of the contract, no benefits are paid
Whole life
policy protects over entire lifetime
beneficiary receives face value of contract upon death 7

8. Life Insurance Companies
Endowment life
beneficiary receives payment at time of death
if insured lives beyond the term of the contract, insured receives face value of the contract
Variable life
premiums are invested in market securities
value of policy depends on the value of the securities
Universal life
allows the insured to change both the premiums and the maturity of the contract
Variable universal life
a universal policy where the premiums are invested in variable rate earning assets
Because of the costs and fees on insurance policies with a savings feature many investors are better off buying term insurance and investing for retirement on their own in some other tax advantaged vehicle as long as they are disciplined enough to save on their own for retirement. 8

9. Life Insurance Companies
Group life insurance covers a large number of persons under a single policy
contributory—both the employer and the employee cover a share of the premiums
noncontributory—the costs are borne entirely by the employer
Credit life insurance protects lenders against borrower death 9

10. Life Insurance Companies
Other life insurance activities
Annuities are investment vehicles that liquidate a fund (pay investors) over a long period of time
Annuity sales were $303 billion in 2009
Private pension funds compete with other financial service companies.
In 2010 insurers administered more than $2.3 trillion of pension fund assets
Guaranteed investment contracts (GICs) are instrumental in many of these plans 10

11. Life Insurance Companies
Other life insurance activities
Accident and health insurance accounted for more than $171 billion of premiums written in 2009
Life insurers write over 50% of all health premiums 11

12. Life Insurance Lines 12

13. Annuities Example
You have a policy with a cash value of $250,000 which you wish to annuitize. You are currently 62 years old and your spouse is 58. Interest rates are 5% per year, and you are considering receiving monthly payments under three 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.
With option 3 you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years.
How much will you receive per month with each option (ignoring administrative costs and fees)? 13

14. 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.
With option 3 you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years. 14

15. Life Insurance Company Balance Sheet
Policy loans are loans made by an insurance company to its policyholders using the policy as collateral
Note: long term nature of assets matches liabilities 15

16. Life Insurance Company Balance Sheet
Policy reserves reflect expected payment commitments on existing policy contracts
Funds in separate account business are monies for which the insurer maintains separate accounting (annuities and certain insurance policies) 16

17. Insurers and the Financial Crisis of 2008-2009
The life insurance industry performed well during the mid-2000s while the stock markets and the economy were performing well
As the crisis began, insurers experienced losses on mortgage-backed securities, commercial loans, particularly commercial real estate, and on corporate bonds
The result was very large profit declines in 2008 (over 50% declines from 2007) and continuing poor conditions in 2009 on more losses on investments
With dropping equity markets, insurers also collected lower fees on their variable annuity products which are largely equity based. This means that insurers with large amounts of separate account activity had more extensive losses than other insurers. The very low interest rate environment meant that insurers could not lower crediting rates on new policies. This encouraged existing policyholders to surrender their policies if they were already at the minimum crediting rate. There were also large losses on common and preferred stock holdings in their own investments.
Industry conditions improved in 2010 and should be better in 2011 unless the economy slips back into another recession. The worst of the profit problems seems to be over but giving the expected lackluster growth of the economy the profit outlook is not strong. 17

18. Life Insurance Regulation
McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICs
state insurance commissions charter and examine ICs
the National Association of Insurance Commissioners (NAIC) has developed a coordinated examination system
States promote insurance guarantee funds
funds are run by the insurance companies themselves
contributions are paid only when an IC fails (except in NY)
The Financial Services Modernization Act (FSMA) of 1999 allowed CBs, IBs, and ICs to exist as subsidiaries under one Financial Holding Company (FHC) 18

19. Life Insurance Regulation
During the financial crisis Congress considered adding a federal regulator of the insurance industry, but left regulation to the states
Dodd-Frank bill created the Federal Insurance Office (FIO) that reports to Congress and the President on the insurance industry
The FIO is supposed to identify systemic risks arising from insurers, monitor international insurance events, eliminate state regulatory gaps and encourage the offering of insurance products to underserved segments 19

20. Property-Casualty (P&C) Insurance Companies
Currently about 2,600 companies sell property-casualty (P&C) insurance
top 10 firms have a 49% market share
top 200 firms have a 94% market share
Property insurance involves coverage related to the loss of real and personal property
Casualty insurance offers protection against legal liability exposure 20

21. Property-Casualty (P&C) Insurance21

22. Property-Casualty (P&C) Insurance
Fire insurance and allied lines
4.3% of premiums written in 2006 vs. 16.6% in 1960
Homeowners multiple peril (MP)
12.5% of premiums written in 2006 vs. 5.2% in 1960
Common multiple peril
4.3% of premiums written in 2006 vs. 0.4% in 1960
Auto liability and physical damage (PD)
39.3% of premiums written in 2006 vs. 43.0% in 1960
Liability insurance (other than auto)
14.7% of premiums written in 2006 vs. 6.6% in 1960 22

23. Balance Sheets of Property-Casualty (P&C) Insurance Companies
Reinsurance: Insurance companies can attempt to share risks by buying insurance from other insurance companies 23

24. Balance Sheets of Property-Casualty (P&C) Insurance Companies
Policyholder surplus is equity 24

25. Balance Sheets of Property-Casualty (P&C) Insurance Companies
Loss reserves and loss adjustment expenses
loss reserves are set aside to meet losses from underwriting
loss adjustment expenses represent the administrative and adjusting costs associated with settling claims
Unearned premiums
includes premiums that have been paid before insurance coverage has been provided 25

26. Property-Casualty (P&C) Insurance
Underwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income
Underwriting risk may result from:
unexpected increases in loss rates
unexpected increases in expenses
unexpected decreases in investment yields 26

27. Property-Casualty (P&C) Insurance
Loss risk is a function of actuarial predictability
property vs. liability
severity vs. frequency
long-tail vs. short tail
product inflation vs. social inflation
Loss risk is a measure of pure losses incurred to premiums earned
premiums earned are premiums received and earned on insurance contracts because time has passed with no claim filed
Expense risk occurs from two major sources:
loss adjustment expenses (LAE)
commissions and other expenses 27

28. Property-Casualty (P&C) Insurance
The combined ratio is a measure of overall profitability
equals the loss ratio plus LAE to premiums written plus commissions and other expenses to premiums written
Investment yield is measured as net interest income divided by premiums earned
The operating ratio is also a measure of overall profitability
equals the combined ratio minus the investment yield 28

29. P&C Insurance Profitability
*First six months of 2010, Source Text, from AM Best,
Loss Ratio: Losses and adjustment expenses to premiums earned
Expense Ratio: Expenses incurred to premiums written
Dividends: Dividends to policyholders to premiums earned
Combined Ratio = Loss Ratio + Expense Ratio
Combined Ratio after Dividends = Combined Ratio plus dividends 29

30. Property-Casualty (P&C) Insurance
Many catastrophes of historically high severity have occurred recently
9/11/2001 terrorist attacks
2004 Florida hurricanes, 2005 hurricane Katrina, 2008 hurricane Ike
An underwriting cycle is a pattern that the profits in the P&C industry tend to follow
The federal government has consistently increased their role of providing compensation and reconstruction assistance following natural disasters 30

31. Property-Casualty (P&C) Insurance Regulation
P&C insurers are chartered at the state level
P&C insurers are regulated by state commissioners
State guarantee funds provide (some) protection to policyholders
The NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS) 31

32. Global Issues
About 55% of total global life insurance premiums written are generated by four countries: the U.S., Japan, the United Kingdom, and France
The world’s largest life insurer by revenue in 2010 was Japan Post Holdings with revenue of $202.2 billion
The largest P&C insurer was the German firm Allianz with $126.0 billion of revenue 32