The Financial Services Industry: Insurance Companies Chapter 3 The Financial Services Industry: Insurance Companies

Overview In this segment ... Insurance Companies: Two major groups: Life, Property & Casualty Size, structure and composition Balance sheets and recent trends Regulation of insurance companies Global competition and trends

Insurance Companies Differences in services provided by: Life Insurance Companies Property and Casualty Insurance

Life Insurance Companies Size, Structure and Composition of the Industry: In 1988: 2,300 life insurance companies with aggregate assets of $1.12 trillion In early 2000s: 1,100 companies / $3.1 trillion 5 largest wrote 21% of new premium business Large scale mergers

Biggest Life Insurers

Life Insurance: Issues Demutualization Adverse selection Insured have higher risk than general population Alleviated by grouping of policyholders into risk pools

Life Insurance Companies Life Insurance Products: Ordinary life Term life, Whole life, Endowment life. Variable life, Universal life, Variable universal life. Group life Industrial life Credit life

Other Life Insurer Activities Annuities Reverse of life insurance activities. Private pension funds Compete with other financial service companies. Accident and health insurance Morbidity insurance Effects of growth in HMO enrollment

Balance Sheet Long-term liabilities Long-term assets Net policy reserves to meet policyholders’ claims Long-term assets Need to generate competitive returns on savings components of life insurance policies Bonds, equities, government securities Policy loans

Regulation of Life Insurance Companies McCarran-Ferguson Act of 1945 Confirms primacy of state over federal regulation. State insurance commissions Coordinated examination system developed by the National Association of Insurance Commissioners (NAIC). States promote life insurance guaranty funds Not permanent funds (like FDIC) Required contributions from surviving within-state firms. Financial Services Modernization Act, 1999

Web Resources For more detailed information on insurance regulation, visit: www.naic.org www.ins.state.ny.us Web Surf

Property and Casualty Insurance Size and Structure Currently about 2,500 companies. Highly concentrated. Top 10 firms have 51% of market in terms of premiums written. Top 250: 96% Balance sheet Similar to life insurance cos. (Smaller asset base) Major liabilities: loss reserves, loss adjustment expense and unearned premiums.

Property-Casualty Changing composition of net premiums written decline in fire insurance and allied lines since 1960 Homeowners MP: 10.9% vs. 5.2% in 1960 Commercial MP: 7.1% vs. 0.4% in 1960 Auto L&PD: 44.9% vs. 43% in 1960 Other liability: 19.8% in 2000 vs. 6.6% in 1960

Loss Risk Underwriting risk may result from Property versus liability: Unexpected increases in loss rates Unexpected increases in expenses Unexpected decreases in investment yields or returns. Property versus liability: Losses from liability insurance less predictable. Example: claims due to asbestos damage to workers’ health.

Loss Rates Severity versus frequency: Loss rates more predictable on low-severity, high-frequency lines (such as fire, auto, homeowners peril) than on high-severity, low-frequency lines (such as earthquake, hurricane, financial guaranty). Claims in high-severity, low-frequency lines may not be independent. Higher uncertainty forces PC firms to invest in more short-term assets and hold larger capital and reserves than life insurance firms.

Long Tail Versus Short Tail Long-tail risk exposure: Arises where peril occurs during coverage period but claim is made many years later. Examples: Asbestos cases and Dalkon shield case. Product inflation versus social inflation Unexpected inflation may be systematic or line-specific. Social inflation: unexpected changes in awards by juries.

Trends Combined ratio: Loss ratios have generally increased. Expense ratios have generally decreased. Trend toward selling directly through their own brokers rather than independent brokers. Combined ratio: Includes both loss and expense experience. If greater than 100 then premiums are insufficient to cover losses and expenses.

Investment Yield / Return Risk Operating ratio = Combined ratio after dividends minus investment yield. Importance of investment income: Causes PC managers to place importance on measuring and managing credit risk and interest rate risk.

Recent Trends PC industry was not very profitable during 1987 - 2000. Reasons: Succession of catastrophes (Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane Andrew 1991) -- trough of underwriting cycle. More recently, September 11, 2001 terrorist attacks created an insurance crisis (and heightened demand).

Regulation PC insurers chartered and regulated by state commissions. State guaranty funds National Association of Insurance Commissioners (NAIC) provides various services to state regulatory commissions. Includes Insurance Regulatory Information System (IRIS). Some lines face rate regulation.

Global Issues Insurance industry becoming more global Regulatory and tax effects in Cayman Islands and Bahamas Introduction and acceleration of insurance market reforms cross-country mergers (insurance companies as well as universal banks)

Pertinent Websites A.M. Best: www.ambest.com Federal Reserve: www.federalreserve.gov Insurance Information Institute: www.iii.org Insurance Services Offices: www.iso.com National Association of Insurance Commissioners: www.naic.org State of NY Insurance Guarantee Fund: www.ins.state.ny.us Web Surf