1. Chapter 19 Insurance Companies and Pension Funds

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-2 Chapter Preview We look at two nonbank institutions: insurance companies and pension funds. We view them in a similar light as other financial intermediaries because they take funds from one sector and invest them in another. Topics include: – Insurance Companies – Fundamentals of Insurance – Growth and Organization of Insurance Companies – Types of Insurance

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-3 Chapter Preview – Pensions – Types of Pensions – Regulation of Pension Plans – The Future of Pension Funds

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-4 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

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-5 Insurance Companies: Major Employer Figure 22.1 Number of Persons Employed in the U.S. Insurance Industry, 1960–2002

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-6 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.

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-7 Fundamentals of 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.

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-8 Fundamentals of Insurance 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.

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-9 Adverse Selection and Moral Hazard in Insurance As we have seen in previous chapters, asymmetric information plays a large role in the design of insurance products. As with other industries, the presence of adverse selection and moral hazard impacts the industry, but is fairly well understood the insurance companies.

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-10 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.

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-11 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.

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-12 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.

13. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-13 Fundamentals of 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.

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-14 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.

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-15 Figure 22.2 Number of Life Insurance Companies in the U.S., 1950-2002 Growth and Organization of Insurance Companies

16. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-16 Growth and Organization of Insurance Companies The previous slide also shows that 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 2002, only 83 of 1159 insurance companies were mutual insurance companies.

17. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-17 Types of Insurance Insurance is classified by which type of undesirable event is covered: Life Insurance Health Insurance Property and Casualty Insurance

18. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-18 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.

19. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-19 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.

20. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-20 Expected Life of Persons at Various Ages

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-21 Sample Annual Premiums

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-22 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.

23. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-23 Figure 21.3 Distribution of Life Insurance Company Assets (beginning of 2003) Life Insurance: Company Assets and Liabilities

24. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-24 Figure 20.4 Percentage of Life Insurance Company Assets Invested in Mortgages Life Insurance: Company Assets and Liabilities

25. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-25 Life Insurance: Company Assets and Liabilities Life insurance companies have two primary liabilities: – Life insurance payouts – Pension fund payouts

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-26 Health Insurance Health insurance policies are highly vulnerable to the adverse selection problem. Those with known or expected health problems are more likely to seek coverage. This is why most health insurance is offered through group policies. Individual policies must be priced assuming adverse selection.

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-27 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.

28. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-28 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

29. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-29 Property and Casualty Insurance 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.

30. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-30 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.

31. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-31 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

32. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-32 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.

33. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-33 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

34. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-34 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

35. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-35 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)

36. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-36 Figure 22.5 Distribution of Private Pension Plan Assets (end of 2003) Private Pension Plan Assets

37. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-37 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.

38. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-38 Social Security Assets Figure 22.6 Social Security Fund Assets, 1957–2003

39. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-39 Figure 22.7 Projected Social Security Trust Fund Assets Social Security Assets

40. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-40 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.

41. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-41 Regulation of Pension 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

42. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-42 Regulation of Pension Plans 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

43. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-43 Regulation of Pension Plans 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.

44. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-44 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.

45. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-45 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.

46. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-46 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.

47. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-47 Chapter Summary (cont.) 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.

48. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 22-48 Chapter Summary (cont.) 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.