1. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-1 Chapter 10 Insurance Company Financial Management Issues

2. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-2 Overview of the Operations of Insurance Companies Gross written premiums provided by policy- holders are used to cover commissions and administrative expenses. Reserves are put aside as commitments by the insurer for the insured policyholder and invested in securities of maturity equivalent to contracts. A portion of the premiums received in a given year may be used to cover claims incurred within that year.

3. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-3 INSURANCE COMPANIES Life Insurance CompaniesP/L Insurance Companies TYPICAL COMMON SIZE INCOME STATEMENT FOR % Total Revenues Revenues: % Revs. Revenues: % Revs Premium Payments 64% Net Investment Earnings 36% Expenses:% Exps. Benefits Payments 59% Additions to Policy Reserves 24% Operating Expenses 12% Taxes 3% Dividends to Stockholders 2% Additions to Surplus 2% Earned Premiums 87% Net investment Earnings 13% Expenses: % Exps. Loss Expenses 74% Operating Expenses 25% Policyholders Dividends 1% Source: American Council of Life Insurance Fact Book and Insurance Information Institute Property/Casualty Insurance Facts

4. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-4 Details on Life Insurance Revenues Premium income sources Life insurance premiums (28% in 1997) Health insurance premiums (23% in 1997) Annuity considerations (49% in 1997) Premiums paid by individuals (50% in 1997) Group insurance premiums (49% in 1997) Rate of return on assets fell from 9.1% in 1987 to 7.17% in 1997.

5. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-5 Life Insurers Assets Property/Liability Insurers Assets

6. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-6 Types of Assets Held and Trends P/C insurers hold short-term and intermediate-term bonds due to the unexpected maturities of their insurance contracts. Life insurers hold long-term contracts and therefore hold long-term, higher yielding bonds. Life insurers hold few municipals since their investments are not taxed.

7. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-7 Life insurers increased their holdings of stocks in the 1990’s: as states relaxed regulations; and to take advantage of the bull stock market. Life insurers’ percentage of mortgage and real estate holdings fell from 24% of assets in 1986 to 10% in 1997 as a result of large losses from real estate loans in the 1990’s.

8. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-8 Life Insurers Obligations and Net Worth Property/Liability Insurers Obligations and Net Worth Surplus and Common Stock Reserves Surplus and Common Stock Dividends/Other Obligations

9. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-9 Life Insurer Obligations and Surplus Funds Policy Reserves Dividend Reserves Policy Dividend Accumulations Dividend Obligations Payable Asset Valuation Reserves Interest Maintenance Reserves

10. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-10 Statutory Accounting Insurers are subjected to regulatory accounting principles and GAAP. Statutory accounting affects P/L insurers more than life insurers. Under statutory accounting P/L insurers: are required to report unrealized gains or losses on stock holdings on the balance sheet; and may only include admitted assets in “other assets.”

11. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-11 Common Financial Ratios For Life and P/L Insurers Return on Equity Return on Assets Net Underwriting Margin Net Profit Margin Asset Utilization Equity Multiplier Average Yield on Investments to Earning Assets

12. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-12 Net Underwriting Margins (NUM) NUM = Premium Income - Policy Expenses Total Assets Policy expenses for life insurers include benefits payments, additions to policy reserves, and operating expenses. Policy expenses for P/L insurers include loss expenses and operating expenses.

13. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-13 Additional Ratios for Life Insurers Benefits Payments to Assets Additions to Policy Reserves to Assets Operating Expenses to Assets

14. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-14 Regulatory Ratios for Life Insurers Additions to Surplus Net Income/Total Revenues Commissions/Premium Payments Real Estate Investments/Total Assets Changes in Premium Payments Changes in Asset Mix Changes in Product Mix

15. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-15 Financial Ratios for P/L Companies Loss Ratio = Loss Expense Total Premiums Earned If the loss ratio is > 1 (> 100%), losses were greater than premiums earned. Loss ratios have risen on average for the industry over time from 60% in 1951 to 80% in 1996.

16. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-16 Expense Ratio = Operating Expenses Total Premiums Written P/L insurers have become more efficient in controlling commissions and other costs. The expense ratio declined from 32% in 1951 to 26.2% in 1996.

17. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-17 Combined Ratio = Loss Ratio + Expense Ratio and Overall Profitability = 100% - ( Combined Ratio + Investment Yield) If the combined ratio is > 1 (>100%), a P/L insurer has an underwriting loss with expenses greater than premium income. In the last two decades the ratio has been over 100%. Since P/L companies have had underwriting losses, their profitability has depended on generating revenues from their investment portfolios

18. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-18 Underwriting Cycle for P/L Insurers: Soft Market Premiums are lowered and insurance coverage is amply available. Premiums received are invested in financial assets. In a rising rate environment, the desire to increase premium income to increase investment income may lead to price wars. Price wars may result in underwriting losses.

19. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-19 Underwriting Cycle: Hard Market To recuperate underwriting losses, insurers increase premiums. Insurers encounter customer resistance to higher rates which postpones the insurers’ financial recovery. If interest rates have fallen, investment income may not make up for continued losses.

20. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-20 Social and Economic Factors Affecting P/L Insurers Increased litigation and increased awards to plaintiffs have resulted in greater risk. P/L insurers use reinsurance to deal with increased risk. Major features of liability policies have been changed in response to severe losses in the mid 1980’s. These changes have made liability insurance unaffordable for some.

21. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-21 Consumer advocates passed legislation putting limits on the premiums P/L insurers could charge (example: California’s Proposition 103). Some P/L insurers pulled out of the affected states. Insurers embarked on a campaign of tort law reforms. Insurers publicized the skill and sensitivity with which many perform their services in times of trouble. Insurers developed new coverage and purchasing techniques.

22. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-22 Social and Economic Factors Affecting Life Insurers Have faced adverse public opinion as a result of the public’s dissatisfaction with HMO’s; and AIDS testing requirement before insuring an individual, leaving many without coverage. Experienced increased cost as a result of the AIDS epidemic. To increase capital, many insurers have converted to mutual holding companies or stock-owned companies.

23. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-23 Increased intraindustry and interindustry mergers. Expanding lines of business include: mutual funds; banking through the use of the one savings and loan holding company loophole; and banking through bancassurance and assurbanking ventures.

24. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-24 Insurer Distribution Systems Direct writer system - an agent represents a single insurer. Independent agent - an agent represents multiple insurers. Increased use of the internet.

25. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-25 An Overview of Insurance Operations Product Design and Development Production and Distribution Product Management Rate-making Underwriting Claims Adjustment and Settlements

26. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-26 Services Administration Finance and Investments

27. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-27 Regulatory Oversight Insurers are subject to capital requirements. Capital backing is required for four (4) risk categories: Investment or asset risk; Credit risk, such as reinsurance; Off-balance sheet risk, such as separate accounts; and Underwriting risk, such as the loss ratio and reserve adequacy.

28. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-28 Regulators use early warning systems to monitor for solvency risk. IRIS is most widely used and looks at 11 financial ratios. FAST is used to monitor major insurers. –Fast has separate screening models for P/L, life, and health insurers. –Fast uses an expanded list of financial ratios. –FAST scores are used to prioritize how much regulatory scrutiny a major insurer needs.

29. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-29 Whole Life Policy Policyholders pay fixed annual premiums over their lives in exchange for a policy with a known death benefit. Policyholders pay premiums that are larger than what is actuarially needed in early years. Policyholders build cash value from the earnings from the excess premiums that can be cashed in, in lieu of maintaining full death protection, or against which low rate loans can be made.

30. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-30 Variable Life Policy Excess premiums that add to cash value earn variable rather than fixed rates. The rates are based on the insurer’s yield on the assets of the policyholder’s choice. A minimum death benefit is specified in the policy, although there is no maximum.

31. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-31 Term Life Policy Premiums are based only on what is actuarially needed to protect the policyholder’s beneficiaries given the covered person’s age and medical history. Premiums rise with age.

32. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-32 Universal Life Combines the death protection features of term insurance with the opportunity to earn market rates of return on excess premiums. Allows the policyholder to take advantage of the tax-free investment accumulations. The face amount of the guaranteed death protection can be changed at the policyholder’s option. Cash value has a minimum guaranteed return.

33. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-33 Asset Management Considerations for Life Insurers Default and interest-rate risk analysis for bond portfolios Liquidity needs as a result of new policies Understanding interest rate theories and hedging techniques Understanding real estate markets and finance

34. Copyright © 2000 by Harcourt, Inc. All rights reserved. 10-34 Asset Management Considerations for P/L Insurers Stress the importance of estimating cash outflows resulting from policy claims. If estimates are carefully made, asset portfolios can be selected with cash inflows to match the anticipated series of outflows. Increased used of immunization and hedging techniques.