1. Copyright© 2003 John Wiley and Sons, Inc. Power Point Slides for: Financial Institutions, Markets, and Money, 8 th Edition Authors: Kidwell, Blackwell, Peterson and Whidbee Prepared by: David R. Durst, The University of Akron

2. CHAPTER 18 INSURANCE COMPANIES AND PENSION FUNDS

3. Copyright© 2003 John Wiley and Sons, Inc. The Insurance Service -- Indemnify another against risk of economic loss. Requires pooling of a large number of similar, but independent risks -- law of large numbers. Insurance is the last step after other pure risk control and reduction techniques of risk management. Pure risk, the chance of loss, differs from speculative or investment risk which is related to the variability of returns where one can have a gain or a loss. Insurance reduces society's cost of bearing risk.

4. Copyright© 2003 John Wiley and Sons, Inc. The Insurance Mechanism An insurer assumes objective risk which is the deviation of actual losses from expected losses. It is part of the operating risk of an insurance company.

5. Copyright© 2003 John Wiley and Sons, Inc. Insurable Risks homogeneous or similar. fortuitous, random or occurring by chance. circumstances of loss can be identifiable. a probability of loss can be estimated. the losses occur independent of each other-- not all at once, such as a flood, wiping out the insurer. premiums must be economically feasible for the insured.

6. Copyright© 2003 John Wiley and Sons, Inc. Objective risk control methods include: use of loss prevention techniques such as "safety" programs. accept "average" risks as customers. require deductibles or shared losses with the insured.

7. Copyright© 2003 John Wiley and Sons, Inc. Insurance premiums represent the sum of: expected losses, plus operating costs, plus target profit, less premium investment income

8. Copyright© 2003 John Wiley and Sons, Inc. Interest rate risk affects insurance companies. Insurance contracts are long-term contracts: interest rates vary providing incentives for cancellations and revision of intentions. high interest rates encourage "cash flow underwriting" and policy loans.

9. Copyright© 2003 John Wiley and Sons, Inc. Life/Health Insurance Companies Dominated in numbers by stock companies; in asset size, by mutuals (32%). Oldest financial intermediary in U.S. (1759) Slow growth in 1990’s after pension and mutual funds

10. Copyright© 2003 John Wiley and Sons, Inc. Term Insurance General Payment for death only Lower premium Large amount of protection per premium dollar

11. Copyright© 2003 John Wiley and Sons, Inc. Term Insurance (concluded) Term policy variables Straight -- coverage for specific time period with premiums increasing with age. Renewable -- option to continue after expiration date, independent of health changes. Decreasing -- pay level premiums over a period of years while level of coverage declines. Convertible -- policyholder may convert to a whole life policy for an added premium fee.

12. Copyright© 2003 John Wiley and Sons, Inc. Whole Life Insurance: General Characteristics Level premiums for constant level of protection. Premium includes cost of insurance (decreasing term) and savings contribution. Cash values (savings accumulated by insured) increase with time. Death benefit includes decreasing term amount and "return" of savings.

13. Copyright© 2003 John Wiley and Sons, Inc. Whole Life Insurance: General Characteristics (concluded) Provides "living" benefits in form of accumulated savings. Combines life insurance and savings (at a relatively low but contractual rate). Interest or dividends on cash values accumulate free of income taxes- important tax shelter.

14. Copyright© 2003 John Wiley and Sons, Inc. Endowment life policy Pays face value of policy at death or at maturity of policy contains term and endowment concepts. More savings oriented than term or whole life--a reverse annuity.

15. Copyright© 2003 John Wiley and Sons, Inc. Universal life The most popular interest-sensitive permanent policies. Flexible premium policy with varying death benefit and premium amounts. Pays market rate on savings.

16. Copyright© 2003 John Wiley and Sons, Inc. Variable Life Popular in the 1990’s with rapid growth in equity values. Fixed-premium Insured direct investment of cash values Guaranteed death benefit No guaranteed cash value

17. Copyright© 2003 John Wiley and Sons, Inc. Annuities Superannuation- risk of living beyond one’s means A life annuity, for a given payment, pays a life long stream of payments. The period of time and survivorship terms vary. The longer the "certainty," the less the payments.

18. Copyright© 2003 John Wiley and Sons, Inc. Health Insurance Covers medical, disability, and dental expenses. Insurance companies write about sixty percent of health insurance premiums.

19. Copyright© 2003 John Wiley and Sons, Inc. Balance Sheet of Life Insurance Companies Liabilities and net worth Life insurance reserves -- funds owed for life insurance policies, including cash values and losses owed, not yet paid. Pension fund reserves -- accumulated commitments to pay future pensions. Surplus and net worth

20. Copyright© 2003 John Wiley and Sons, Inc. Balance Sheet of Life Insurance Companies (concluded) Assets -- long-term matching liabilities Corporate bonds-largest financial investment Corporate equities-Variable life Mortgages U.S. government securities Policy loans

21. Copyright© 2003 John Wiley and Sons, Inc. Property/Liability Insurance Companies Property insurance -- protection from financial loss of property from perils such as fire and theft. Casualty insurance -- liability, worker's compensation, auto, aircraft, marine

22. Copyright© 2003 John Wiley and Sons, Inc. Life vs. P/L operations and practices P/L policies shorter term than life P/L loss payments more erratic P/L loss payments increase with inflation P/L premiums net of losses and expenses is taxed Both life and P/L firms generate revenue from premiums and investment income.

23. Copyright© 2003 John Wiley and Sons, Inc. Balance Sheet of P/L Insurance Companies Assets -- selected for income, inflation hedge, liquidity, and tax sheltering State and municipal bonds (tax free) and corporate bonds Corporate stock (inflation hedge and income) Government securities (liquidity and income) Trade credit ($ owed by customers and agents)

24. Copyright© 2003 John Wiley and Sons, Inc. Balance Sheet of P/L Insurance Companies (concluded) Liabilities and net worth Policy reserves include: unearned premium reserve. losses incurred, not paid. Surplus and net worth

25. Copyright© 2003 John Wiley and Sons, Inc. Types of Property/Casualty/ Liability Policies Property -- insurance against losses associated with physical damage. Liability -- insurance against loss arising from the damage to the property or personal injury to others.

26. Copyright© 2003 John Wiley and Sons, Inc. Types of Property/Casualty/ Liability Policies (continued) Surety and fidelity bonds Bond -- agreement by one party (surety) to be accountable to a third person (the obligee) for the debt or default of another party (principal). Surety bond -- provides financial protection against failure to perform an agreement such as construction. Fidelity bond -- provides financial protection from the infidelity or dishonesty of employees, such as embezzlement.

27. Copyright© 2003 John Wiley and Sons, Inc. Types of Property/Casualty/ Liability Policies (continued) Marine insurance -- covers financial losses related to transportation. Ocean marine -- ocean transportation Inland marine -- inland transportation and some personal property such as furs and jewelry Homeowner's insurance -- Multi-peril or multi- line policy covering most risks of home ownership and renting. Includes property and liability insurance.

28. Copyright© 2003 John Wiley and Sons, Inc. Types of Property/Casualty/ Liability Policies (concluded) Family personal auto insurance -- A multi-peril policy covering most of the risks of owning and driving an auto liability. physical damage (collision). medical. uninsured motorist.

29. Copyright© 2003 John Wiley and Sons, Inc. Types of Pension Plans Private Pension Plans Insured -- assured by contracting with life insurance firms Noninsured Trustee managed by a third party Non-trusteed -- managed by firm or labor union Government-sponsored Pension Plans Federal Social Security (FICA) State and municipality

30. Copyright© 2003 John Wiley and Sons, Inc. Pension Plan Terms Fully funded -- contributing a pool of funds sufficient to cover future obligations versus paying retirement benefits from sales or tax revenues. Contributory -- employee contribution deducted from pay. Noncontributory -- employer makes all funding payments. Defined benefit plan -- contributions are made to meet "defined" retirement benefits for pensioners.

31. Copyright© 2003 John Wiley and Sons, Inc. Pension Plan Terms (concluded) Defined contribution plan -- benefits are variable, but contributions are defined in plan. 401k’s--most popular today. Vesting -- employee assured of retirement benefits after a set period of time. Portability -- ability to transfer vested benefits on to other pension fund as a single plan.

32. Copyright© 2003 John Wiley and Sons, Inc. Pension Fund Portfolio Management Factors Little need for liquidity Pension fund income exempt from federal income taxes The higher the earnings rate, the lower the contribution for a defined benefit plan Pension funds face risk/return trade-off decisions for their beneficiaries.