McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Fifteen Insurance 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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: $ 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.1 Life Insurance Basic Classes Four basic classes 1.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 Insurance 3.Credit Life 4.Others Life Insurer Activities Four basic classes 1.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 Insurance 3.Credit Life 4.Others Life Insurer Activities

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Distribution of Premiums Written on Various Life Insurance Lines

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Protects lender against a borrower’s death Credit Life

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Life Insurance Industry Balance Sheet

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.3 Regulation McCarran-Ferguson Act of 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 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Selected U.S. Catastrophes ($Mns)

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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%

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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)

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. P&C Company Profitability (p.457) (1) Loss ratio (Losses incurred/Premiums) = 79.8% (2) Expense ratio (Expenses/Premiums) = 27.9% (3) Dividend ratio (Dividends/Premiums) = 2% (4) Combined ratio after dividends = (1) + (2) + (3) = =109.7%  Premiums are too low to cover losses, expenses and dividends Operating ratio = Combined ratio after dividends – Investment yield Investment yield = 12% Operating ratio = 109.7% - 12% = 97.7% Overall profitability = 100% - Operating ratio = 100% % = 2.3% (1) Loss ratio (Losses incurred/Premiums) = 79.8% (2) Expense ratio (Expenses/Premiums) = 27.9% (3) Dividend ratio (Dividends/Premiums) = 2% (4) Combined ratio after dividends = (1) + (2) + (3) = =109.7%  Premiums are too low to cover losses, expenses and dividends Operating ratio = Combined ratio after dividends – Investment yield Investment yield = 12% Operating ratio = 109.7% - 12% = 97.7% Overall profitability = 100% - Operating ratio = 100% % = 2.3%

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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