Insurance Companies Chapter 3 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

3-2 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

3-3 Insurance Companies  Differences in services provided by: Life Insurance Companies Property and Casualty Insurance

3-4 Life Insurance Companies  Size, Structure and Composition of the Industry: In 1988: 2,300 life insurance companies with aggregate assets of $1.12 trillion Mid 2000s: 1,300 companies In early 2006: $4.5 trillion in assets  3 largest wrote 20% of new premium business in 2005 Increasing involvement of commercial banks in insurance policy sales  2005: Nationwide sold $33.1 million via banks. 45% increase over 2004

3-5 Life Insurance Companies  Significant consolidation in life insurance industry although not to the same extent witnessed in banking  Competition from within industry and from other FIs  Conversion to stockholder controlled companies

3-6 Mutual versus Stock Insurance Companies

3-7 Biggest Life Insurers

3-8 Life Insurance: Issues  Demutualization  Adverse selection Insured have higher risk than general population Alleviated by grouping of policyholders into risk pools

3-9 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

3-10 Distribution of Premiums

3-11 Other Life Insurer Activities Annuities  Reverse of life insurance activities.  Topped $272 billion in 2005  Ethics: Conseco, 2004 Private pension funds  Compete with other financial service companies.  Mid 2000s, managing $2.3 trillion (45% of all private pension plans) Accident and health insurance  Morbidity insurance  Effects of growth in HMO enrollment

3-12 Balance Sheet Long-term assets  Need to generate competitive returns on savings components of life insurance policies  Bonds, equities, government securities  Policy loans Long-term liabilities  Net policy reserves to meet policyholders’ claims  Separate account business 32.9% of total liabilities and capital in 2006.

3-13 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

3-14 Recent Regulatory Issues  2004: Proposals to create council of federal and state officials to oversee insurance  Complaints of costly and cumbersome state regulation  Possibility of a dual (State and Federal) system similar to bank regulatory system.  Resistance from states, consumer groups, Congress

3-15 Web Resources  For more detailed information on insurance regulation, visit:

3-16 Property and Casualty Insurance  Size and Structure Currently about 2,700 companies. Highly concentrated. Top 10 firms have 48% of market in terms of premiums written.  Top 100 frims: over 87%  M&A increasing concentration

3-17 P&C Products  Fire insurance and allied lines  Homeowners multiple peril insurance  Commercial multiple peril insurance  Automobile liability and physical damage insurance  Liability insurance (other than automobile)

3-18 Property-Casualty  2005: Changing composition of net premiums written since 1960: decline in fire insurance and allied lines: 3.7% in 2005 vs. 16.6% in 1960 Homeowners MP: 12.2% vs. 5.2% in 1960 Commercial MP: 6.8% vs. 0.4% in 1960 Auto L&PD: 42.8% vs. 43% in 1960 Other liability: 23.7% in 2005 vs. 6.6% in 1960

3-19 P&C Balance Sheet  Similar to life insurance cos. (Smaller asset base) Requirement for liquid assets  Major liabilities: loss reserves, loss adjustment expense and unearned premiums.

3-20 Loss Risk  Underwriting risk may result from 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.

3-21 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.

3-22 Insurance Risks Post 9/11  Crisis generated by terrorist attacks forced creation of federal terrorism insurance program in 2002  Federal government provides backstop coverage under Terrorism Risk Insurance Act of 2002 (TRIA) Caps losses for insurance companies Key provisions extended in 2004

3-23 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. Efforts to contain long-tail risks within subsidiaries. Example: Halliburton

3-24 Insurance Costs: Social Inflation  Product inflation versus social inflation Unexpected inflation may be systematic or line- specific. Social inflation: unexpected changes in awards by juries.  Reinsurance Approximately 75 percent of reinsurance by US firms is written by non-US firms such as Munich Re. Catastrophe bonds

3-25 Underwriting Ratios 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.

3-26 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.

3-27 Recent Trends  PC industry was not very profitable during  Succession of catastrophes Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane Andrew , Hurricanes Charley, Frances, Ivan, Jeanne in rapid succession generated claims comparable to Andrew.  Trough of underwriting cycle. September 11, 2001 terrorist attacks created an insurance crisis (and heightened demand).  Potential for crowding out via government actions

3-28 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.  Criticism regarding Katrina related claims

3-29 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)

3-30 World’s Largest Life Insurers Revenues ($millions)Country ING Group 138,235Netherlands AXA Group 129,839France Assicurazioni Generali 101,404Italy Aviva 92,579UK Prudential 74,745UK Nippon Life 61,158Japan

3-31 World’s Largest P & C Insurers Revenues ($millions)Country Allianz 121,406Germany American Int’l Group 108,905US Berkshire Hathaway 81,663US Zurich Financial Svc. 67,186 Switzerland Munich Re Group 60,256 Germany State Farm Insurance 59,224US

3-32 Pertinent Websites A.M. Best: Federal Reserve: Insurance Information Institute: Insurance Services Offices: National Association of Insurance Commissioners: State of NY Insurance Guarantee Fund: