T3-FMP-2-Ch2-InsCos-v3 - Study Notes

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P1.T3. Financial Markets & Products
Chapter 2. Insurance Companies and Pension Plans
Bionic Turtle FRM Study Notes

DESCRIBE THE KEY FEATURES OF THE VARIOUS CATEGORIES OF INSURANCE COMPANIES AND
IDENTIFY THE RISKS FACING INSURANCE COMPANIES. ............................................................ 3
DESCRIBE THE USE OF MORTALITY TABLE AND CALCULATE PREMIUM PAYMENT FOR A POLICY
HOLDER............................................................................................................................ 11
DISTINGUISH BETWEEN MORTALITY RISK AND LONGEVITY RISK AND DESCRIBE HOW TO HEDGE
THESE RISKS. ................................................................................................................... 15
DESCRIBE A DEFINED BENEFIT PLAN AND A DEFINED CONTRIBUTION PLAN FOR A PENSION FUND
AND EXPLAIN THE DIFFERENCES BETWEEN THEM. ................................................................ 16
CALCULATE AND INTERPRET LOSS RATIO, EXPENSE RATIO, COMBINED RATIO, AND OPERATING
RATIO FOR A PROPERTY CASUALTY INSURANCE COMPANY. .................................................. 17
DESCRIBE MORAL HAZARD AND ADVERSE SELECTION RISKS FACING INSURANCE COMPANIES,
PROVIDE EXAMPLES OF EACH, AND DESCRIBE HOW TO OVERCOME THE PROBLEMS. .............. 19
EVALUATE THE CAPITAL REQUIREMENTS FOR LIFE INSURANCE AND PROPERTY-CASUALTY
INSURANCE COMPANIES. ................................................................................................... 20
COMPARE THE GUARANTY SYSTEM AND THE REGULATORY REQUIREMENTS FOR INSURANCE
COMPANIES WITH THOSE FOR BANKS. ................................................................................. 22
2

 Describe the key features of the various categories of insurance companies and
identify the risks facing insurance companies.
 Describe the use of mortality table and calculate premium payment for a policy
holder.
 Distinguish between mortality risk and longevity risk and describe how to hedge
these risks.
 Describe a defined benefit plan and a defined contribution plan for a pension fund
and explain the differences between them.
 Calculate and interpret loss ratio, expense ratio, combined ratio, and operating
ratio for a property casualty insurance company.
 Describe moral hazard and adverse selection risks facing insurance companies,
provide examples of each, and describe how to overcome the problems.
 Evaluate the capital requirements for life insurance and property-casualty
insurance companies.
 Compare the guaranty system and the regulatory requirements for insurance
companies with those for banks.
Describe the key features of the various categories of insurance

companies and identify the risks facing insurance companies.
Insurance companies can be classified into four broad categories. They are life insurance,
property-casualty insurance (non-life), health insurance, and pension plans. Regardless of
the type of insurance offered, all insurance companies operate in a common way: they
accept payments (premiums) from policyholders with the promise of receiving contingent
payout(s) when the contractual terms are triggered.
Property-Casualty Health Pension

Life Insurance Insurance (Non-life) Insurance Plans
Term Life Insurance Property (accidents,
fire, theft, water)
Whole Life Insurance Casualty (legal
liability)
Variable life insurance
Universal life insurance
Variable-Universal life
insurance
Endowment life insurance
Group life insurance
Annuity contracts
3
Life insurance companies

Life insurance companies offer products that pay off when the life
of a policyholder ends. Typically, life insurance contracts are long
term. Life insurance contracts may take the following forms:
 Term life insurance, also known as temporary life
insurance: a term life insurance contract only pays off
when the policyholder dies during the period covered by the
contract. Term life insurance policies usually have a constant or declining face value
over time. When a premium is not constant over the years of the contract, the policy
is referred to as an annual renewable term policy. In an annual renewable term
policy, the policyholder renews the policy at the rate that reflects the age of the
policymaker regardless of the policymaker’s health. Typical 2020 term rates are
shown in the following table.
4
 Whole life insurance: a whole life insurance contract

provides the policyholder protection for the life of the
policyholder – meaning the contract pays off upon the
death of the insured. The insurance company uses
the portion of the premium not required to meet
expected payouts in the early years of the policy and
invests it with the intent to cover the expected
payouts in later years. One of the main advantages of
whole life insurance is its tax benefits, where the present value of the tax paid may
be less than it would be if the investor had chosen to invest funds directly rather than
through the insurance company. As an example, consider the following figure1 below.
Suppose a man purchases a $1 million whole life insurance policy at age 40 that
costs $20,000 per year. The probability of a male dying from age 40 to 41 is 0.00209.
When one multiplies this 0.00209 by $1 million, a “fair premium” would be $2,090.
The man actually paid $20,000, meaning the contract had a $17,910 premium that
the insurance company invests. The contract eventually becomes an expected
positive for the policyholder when the expected value is greater than the amount
paid. In this example, this occurs when the man reaches 70 with a probability of
death of 0.02353. The man pays $20,000, while the expected payment is $23,530.
 Variable Life Insurance: a variation of whole life insurance is variable life insurance.
The distinction between variable life insurance and whole life insurance is that the
surplus premiums shown in the figure above are invested in a fund chosen by the
policyholder. The policyholder could opt to invest the surplus premiums in equity,
bond, or money market funds, among others. Usually, the policy will detail a
minimum guaranteed payout on death with the potential for a larger payout if the
investments outperform. Variable life insurance policies allow for shifting among
investment funds.
1
Hull, John C. (2018), Risk Management and Financial Institutions, John Wiley & Sons, Inc.,
Hoboken New Jersey
5
 Universal Life: another variation on whole life insurance is when the premium trends
down over time to a specified minimum without a lapse in coverage. The insurance
company invests the surplus premiums in safe fixed-income investments such as
mortgages, money market instruments, and bonds. After guaranteeing a minimum
return of say 3%, the policymaker is given the option on what to do with the policy
upon the policyholder’s death. The policyholder can opt for a fixed benefit upon death
or the policyholder can choose a fixed benefit for their beneficiaries plus an amount
above the fixed benefit if the investment return is greater than a contractual
minimum. Obviously, because the second option has a richer benefit structure, the
second option has higher premiums compared to the first.
 Variable-Universal Life Insurance: a variable-universal life insurance policy
combines features of variable life insurance and universal life insurance contracts.
The policyholder decides on final death benefits, as well as the investment of surplus
premiums. Each policy can differ slightly, with the only constant being that the
insurance company guarantees a minimum death benefit. The investment of surplus
premiums and the structure of premium payments are decided upon by the
policyholder.
 Endowment Life Insurance: an endowment life insurance policy is different from the
other types of policies mentioned up to this point in that the policy has a defined
period and pays off either at the end of the period or when the policyholder dies. The
amount that is paid out is negotiated in advance and is independent regardless of
whether the end period is met or the policyholder dies. Sometimes policies include a
provision for payout if the policyholder develops a critical illness. Some types of
endowment life insurance policies include:
o With-profits endowment policy, where the insurance company announces
periodic bonuses depending upon the performance of the investments. The
bonuses are reinvested and are paid out at the end of the life of the policy.
o Unit-linked endowment is completely dependent upon the performance of the
fund over the period leading up to the maturity of the endowment life
insurance policy.
o Pure endowment policy only pays out if the policymaker survives to the end of
the policy.
 Group Life Insurance: a group life insurance policy covers groups of people under a
single policy. A policy is often purchased by a company for its employees. There are
two main types of group life insurance policies:
o Contributory, where the employer and the employee contribute to the
premium payments; or
o Noncontributory, where the employer covers the entire cost of the policy.
Insurance companies and employers generally find economies of scale in group life
insurance contracts. Additionally, group life insurance contracts generally do not
require medical tests when purchasing life insurance policies, in contrast to individual
policies.
6
Annuity contract
Annuity contracts are typically the opposite of life insurance contracts. Instead of making
monthly payments in exchange for a lump sum payment at the end of the specified period
(or upon death), an annuity contract offers payments in exchange for an upfront lump-sum
payment. Typically, an annuity provides the policyholder with an income stream beginning
from a future date for the rest of the policyholder’s life. In some instances, the annuity starts
immediately right after the lump-sum payment by the policyholder. More typically, though,
the lump-sum payment is made by the policyholder years in advance of expected payments.
This deferred annuity structure allows the insurance company to invest the funds and build
up larger balances in anticipation of payments.
Annuity contracts are often used for their tax advantages because taxes are typically
deferred until the annuity income is received. Annuity values often grow over time, and this
growth in value is referred to as the accumulation value. Generally, annuity funds can be
withdrawn early, but the surrender value is typically lower than the accumulation value
because the insurer has administrative costs to cover. Also, increasingly popular are
penalty-free withdrawals where the policyholder can withdraw a certain portion of their
accumulation value without penalty. Usually, if a policyholder dies before annuity payments
begin, the full accumulation value can be withdrawn penalty-free.
In recent years, annuity contracts that track certain well-known stock indices, such as the
S&P 500, have become popular. Very popular annuity contracts have provisions that offer
minimum and maximum returns, such as 2% and 8%. The insurance company guarantees
that the return on the annuity will be at least 2% even if the market returns -25%. Of course,
the upside is also limited. If the market gains 30% in a year, the maximum return the
policyholder will earn is 8%. These types of annuities are attractive to investors wanting
some exposure to the higher return the market can provide but do not want the risk of losing
money.
Property-casualty insurance companies
Property-casualty insurance companies can be subdivided
based on their concentration of activities in either property
insurance or casualty insurance.
 Property insurance provides protection against loss

of or damage to property from accidents, fire, theft,
water damage, and other adverse events on a property.
 Casualty insurance provides protection to individuals
and companies against legal liability due to actions of
the insured, such as a child breaking a bone while
playing on an insured party’s property.
Property-casualty insurance contracts usually last for a year and are typically renewed every
year. The premiums collected by property-casualty insurance companies may increase or
decrease each year depending upon the expected payouts, profit margins, and competition,
among other factors.
7
Risks associated with property and casualty insurance contracts can be divided into two
main risk groups.
 Easy to predict payouts. Payouts that have a history

of occurrence and a wealth of historical data can give
rise to models that can fairly accurately predict
potential payouts. Easy to predict payouts include, for
instance, payouts for car accidents and property
damage. For instance, suppose an insurance
company insures 1 million car owners, that 15% of
drivers make a claim each year, and that the average
claim payout is $5,000. In this company’s scenario, the expected dollar volume of
claims is:
1,000,000 ∙ 0.15 ∙ $5,000 = $750,000,000.
This $750 million will vary somewhat from year-to-year, but because the claim events
are independent of each other, the payout amounts will typically be around what the
models predict.
 Difficult to predict payouts. Contract payouts that
are more difficult to predict are single events that
may trigger many individual claims, such as a
hurricane, flood, or earthquake. These are referred
to as high consequence, low probability events, or
catastrophic risks. Catastrophic claims typically are
not independent of each other – either an
earthquake happens, or it does not (all-or-nothing
risks). Because of these potentially large claims, a property-casualty insurance
company must typically keep more equity capital as a percent of total assets
compared to a life insurance company. For instance, suppose the same insurance
company as above insures 1 million homes against hurricane damage. Suppose the
chance of an earthquake hitting the area covered by all 1 million homes is 0.5% each
year (once every 200 years) and that the average damage to the homes that the
insurance company would be liable for is $220,000 per home. In this case, the
insurance company has an expected payout each year of $1.1 billion.
1,000,000 ∙ 0.005 ∙ $220,000 = $1,100,000,000.
The large numbers and potentially damaging effects a catastrophic event can have
on an insurance company is the reason that insurance companies often employ
professional modeling experts to ensure the company is covered in the event of a
catastrophic event.
Health insurance companies
According to the World Health Organization2, $7.3 trillion
was spent globally on health insurance. Obviously, health
insurance is another important function of the insurance
market. Paying and control of health care can generally be
divided into two systems: (1) one in which the government
covers all or most of the costs and controls the system to a
large degree and (2) one in which private insurance markets allocate care and costs.
2
World Health Organization (2015), available at:
https://apps.who.int/iris/bitstream/handle/10665/259632/WHO-HIS-HGF-HFWorkingPaper-17.10-
eng.pdf
8
Government-controlled health insurance. In some countries, the government provides for

and controls the health insurance markets to a large degree. For instance, in Canada,
virtually all health care activities are paid for by a publicly funded, government-controlled
system. The government in Canada goes even further and generally prohibits doctors from
offering most services privately. In the United Kingdom, health care is also funded by the
government, but individuals can purchase private health insurance should they want access
to a parallel-running private system. Individuals purchase private health insurance in the
United Kingdom when they want shorter wait times for such things a routine elective surgery.
Private health insurance markets. In the U.S., most of the cost of health care is covered
through employer and employee premiums in the insurance market. Most individuals receive
health insurance through their employers. In 2010, President Obama signed the Patient
Protection and Affordable Care Act (commonly known as “Obamacare”) which expanded
Medicaid coverage (health insurance coverage for low-income and needy
individuals/families), prevented insurers from discriminating against individuals that had pre-
existing conditions, and imposed penalties and taxes on individuals and businesses for
either not having health insurance or for some other reason (in 2017, the individual mandate
to have health insurance has since been muted by the elimination of the tax for not having
health insurance). In a privately-run healthcare system, policymakers make regular premium
payments and payouts occur when services are provided. Health insurance premiums
resemble life insurance premiums because changes to the company’s assessment of the
risk of a payout do not lead to an increase in premiums. For instance, when the health of the
policyholder deteriorates, the health insurance premiums do not change. Health insurance
can also resemble property-casualty insurance because the premiums of a health insurance
company may increase when the overall costs of providing health care increase.
Pension plans
Companies often offer their employees pension plans. Pension plans are payments to
former employees once retirement commences. Pension plans are like annuity contracts,
where employers and employees make tax-deductible contributions for use later in life. The
design of each pension plan can be slightly different. There are two major types of pension
plans – defined contribution plans and defined benefit plans.
Defined contribution plans are the less risky of the two types of plans because the
employer is only guaranteeing payments to an account owned by an employee, such as a
401(k). Employees may also contribute to their accounts and often have control over the
allocation of assets.
Defined benefit plans. In contrast to defined contribution plans, defined benefit plans pool
contributions to a plan. The sponsor of the plan takes the risk of guaranteeing payments. For
instance, a common defined benefit plan offers employees future payments equal to the
average of the final three years of salary multiplied by the number of years of service and
2%. For a person having 30 years of service at the company and $75,000 in salary, the
payment would be $45,000.
=. ∙ ∙$ , =$ ,
9
Defined contribution plans Defined benefit plans

(1) Funds are typically contributed by the (1) Funds are typically contributed by
employer and the employee the employer and the employee
(2) Contributions are not pooled, but rather (2) Contributions are pooled
owned by the individual in, for example, a
401(k) plan
(3) Employees choose the allocation of (3) There is a common formula for
assets calculating the pension payments after
employment separation
(4) The risk of having enough money for (4) Riskier than contribution plans
retirement lies with the employee. The because the company is guaranteeing
employee contributes to an account, and pension payments in a certain way.
that is the end of their risk.
(5) Each year, actuaries assess the
pension plan’s obligations and assets
and arrive at a funded ratio.
(6) Important assumptions in planning
for costs associated with defined
benefit plans are the discount rate and
the assumed rate of return.
(7) At the end of the day, shareholders
bear the risk of defined plans.
Risks facing insurance companies

Given the range of activities insurance companies are involved in, it likely comes as no
surprise that insurance companies face a host of risks.
Reserves may fall short. A common concern among all insurance firms is that the reserves
held by insurance companies may fall short of needed payouts.
The investments to cover projected costs. Another risk insurance companies face is their
investment choices. Insurance companies often invest in corporate bonds. When defaults on
corporate bonds increase, it can cause an inordinate amount of drop-in profitability of the
insurance company.
Liquidity risks. Insurance companies also face the possibility that their investments may not
have a readily liquid market when the funds are needed. For instance, insurance companies
may place a higher percentage of their funds in illiquid bonds because illiquid bonds have
higher yields but typically cannot be readily converted into cash.
Credit risk. Since insurance companies enter transactions with banks and reinsurance
companies, they are also exposed to credit risk.
Operational and business risk. As with most any other industry, insurance companies are
also exposed to operational risks and business risks, such as an employee making an
investment mistake or a competitor entering the market and stealing market share.
Misprice their risk. Insurance companies operate on risk models. If their economists and
statisticians misestimate their expected costs due to, for example, an unexpected natural
disaster, the result could be bankruptcy.
10
Describe the use of mortality table and calculate premium payment

for a policy holder.
How do insurers know how much to charge individuals and companies for their policies? The
answer is mortality tables. Mortality tables are used to value life insurance contracts. The
table below contains an example mortality table of mortality rates for the U.S. as estimated
by the Social Security Administration for 2013 (https://www.ssa.gov/oact/). The interpretation
of the table is as follows for a person aged 6 (the first blue row):
 The first column shows the Exact age assumed for the calculations in the other
columns. We will refer to the first row that is highlighted in blue: Exact age = 6.
 The second column gives the single-year probability of a male aged 6 dying within
the next year. The probability is 0.000146 or 0.0146% (or a 1 in 6,849 chance).
 The third column is the probability of this male surviving to age 6. In this case, the
probability is 0.992193 or 99.219%.
 The fourth column shows the remaining life expectancy. For the 6-year old, the
remaining life is 70.88 years. On average, this male lived to age 76.88 (ie., the
current age of 6 plus 70.88 years). The same figure is given for a female in the far
right columns. A 6-year old female, on average, can expect to live another 75.57
years (far right column) to the ripe age of 81.57 years (6 years plus 75.57 years). The
probability of a 6-year old female dying within one year is 0.000109 (0.0109%) and
the probability of that female surviving to age 6 is 0.993615 (99.361%).
If you follow the remaining blue highlighted rows, you will see that the probability of death in
the following year decreases with age up to 10 years of life and then begins to increase.
As a second example, the table3 also shows the probability of death for older individuals.
Consider, the two highlighted green rows for individuals aged 90, 91, 100, and 110.
 For a 90-year old man, the probability of death is 16.7291%, while for a 100-year
old man the death probability is 35.35% and for a 110-year old man, it is 57.59%.
 For women, the probabilities of death for women aged 90, 100, and 110 in the next
year are 13.22%, 30.47%, and 54.56%, respectively.
The figures show that women generally live longer than men. Also, as one can (hopefully)
easily see, some numbers in the table can be deduced from others. The third column shows
that the (cumulative) probability of a man surviving up to age 90 is 0.177348 or 17.73%. The
probability of a man surviving up to age 91 is 14.77%. The unconditional probability of a
man dying between his 90th and 91st birthday is the difference between the two. In this case,
the unconditional probability is 0.177348 − 0.147679 = 0.029669 = 2.97%.
What about the probability that a 90-year old man will die during his 90th year? The
conditional one-year death probability is simply the one-year unconditional death probability
(0.029669) divided by the cumulative survival probability (0.177348), as shown below.
0.029669
= 0.167291
0.177348
A related calculation is the cumulative probability of a man surviving to aged 91 given that he
survived to age 90. The answer to this is 14.77% (0.177348 x (1-0.167291) = 0.147679.
3 Adapted from the U.S. Social Security Administration’s Office of the Chief Actuary, available at
https://www.ssa.gov/oact/.
11
Periodic Life Table (2013)4
4
Inspired by Table 3.1 Hull, John C. (2018), Risk Management and Financial Institutions, John Wiley
& Sons, Inc., Hoboken New Jersey, but spreadsheet hand constructed by David Harper using source
data at https://www.ssa.gov/OACT/STATS/table4c6_2013.html
12
Calculating the premium payment and expected payout for a policyholder

For example5: Suppose the yield curve (interest rates) is flat (all maturities) at 4.0% per year
with semiannual compounding. Suppose also that premiums are paid once a year at the
beginning of the year. In this scenario, what is an insurance company's break-even premium
for $100,000 of term life insurance for a man of average health aged 90?
The calculation is known as the expected payout. It is given by the probability of death
multiplied by the insurance coverage. Using the previous mortality table, the probability of
the man dying from the time the policy is purchased until the man turns 91 is 16.7291%. One
then takes the total potential payout if this situation occurs and multiplies this by the
probability of death to arrive at the expected payout of $16,729.
0.167291 × $100,000 = $16, 729
What about the present value of the expected payout? If we assume the payout occurs at
the middle point of the year, the present value of the payout is $16,404, as shown below.
=( )∙( )
=$ , ∙( ) .
=$ ,
.
The two-year calculation. What if the term insurance lasts longer than one year? If we
suppose the term insurance lasts two years, the expected payout in the first year is still
$16,729. The probability that the policyholder dies during the second year is (1 −
0.167291) × 0.184520 = 0.153651. The expected payout in the second year is then $15,365
and is calculated as 0.153651 × $100,000 = 15,365. If we assume the payout occurs in the
middle of the second year, the present value of the payout is $14,487, as calculated below.
$15,365 ∙ 0.942866 = $14,487
To calculate the total present value of payouts, one sums the two years. In this two-year
case, the present value of the expected payouts is $30,891 ($16,404 + $14,487 = $30,891).
Premium payments
Up to this point, the calculations have been on the nominal and present value of expected
payouts should death occur. What about premium payment? The insurance company has to
cover the expected payouts. In the example above, it is known that the first premium has no
risk. The second payment depends upon whether the individual lives to age 91. This
probability is the change that the person does not die during the first year. In this example,
the probability is 83.27% ((1 − 0.167291) = 0.832709).
If the premium is dollars per year, the present value of the premium payments is given by:
1
+ 0.832709 ∙ ∙ = 1.800682
(1 + 0.04)
With the above equation, the calculation of the break-even annual premium is found simply
by equating the present value of the expected premium payments to the present value of the
expected payout. In this case, the equation (below) and associated answer is $17,155.
$30,891
1.800682 ∙ = $30,891 ⇒ = = $17,155
1.800682
5
Hull, John C. (2018), Risk Management and Financial Institutions, John Wiley & Sons, Inc.,
Hoboken New Jersey. Chapter 3 and Example 3.1.
13
The Mortality Table employs conditional and cumulative probabilities (such that
unconditional probabilities can be inferred)
In response to a question about how to interpret the mortality table, David gave the following
response6:
“Hi @Flashback We recently discussed this here @ https://www.bionicturtle.com/forum/...ts-and-

mortality-tables-hull.10259/post-70531 in reference to Hull's (RM & FI Chapter 3) Mortality Tables,
see below.
 The default probability analog is: The Joint (aka, Unconditional) Prob [Default during Year T
and Survives thru end of Year T-1] = Cumulative Prob[Survive thru end of Year T-1] *
Conditional Prob [Default during Year T | Survive thru end of Year T-1] = Cumulative
Prob[Default, end of Year T] - Cumulative Prob[Default, end of Year T];
 In Hull's Mortality Table (below), the "Death w/n one year" is a Conditional Death Probability
while the "Survival" column is a Cumulative Survival Probability. Consequently, the
Conditional prob of death during the first year after the 80th birthday, Conditional Pr(death
over the next year | Survival up to 80th birthday) = Unconditional (aka, joint) Prob (death
during 80th year) / Cumulative Pr(survival up to 80th birthday) = (0.5062880 -
0.4762130)/(0.5062880) = 0.059403.
For me, the key relationship is the simple Conditional Pr(A | B) = Joint Pr(A, B) / Cumulative Pr(B);
which is the same as more familiar Conditional Pr(A | B) = Joint Pr(A, B) / Unconditional Pr(B)
because the Cumulative Pr(survive up to end of year T-1) is also an Unconditional probability. So the
potentially confusing part is ...
 The cumulative probability of survival up to (eg) the end of the 80th year is an unconditional
probability because it is from the perspective of time zero (age zero),
 But the Joint Prob (survive to 80th birthday and die during 80th year) is also an unconditional
probability because it is also from the perspective of time zero (age zero).”
6
See https://www.bionicturtle.com/forum/threads/general-question.21096/post-70875
14
Distinguish between mortality risk and longevity risk and describe

how to hedge these risks.
Mortality risk
Mortality risk is the chance that events will happen to make
individuals die sooner than what the insurance models predict.
Triggers for mortality risk include, for instance, wards, pandemics
(such as the coronavirus), epidemics (such as AIDS), massive
earthquakes, large-scale floods, and other adverse events.
 It likely goes without saying that mortality events adversely
impact not only human life but the life insurance industry. On
the flip side, mortality events could increase the profitability of
annuities because the present value of expected payments
drops.
Of importance, actuaries consider the age group demographics of
the particular policies when considering the impact of large-scale,
adverse mortality events.
Longevity risk
Longevity risk is the chance that people will live longer than
expected. Reasons for this might be a healthier lifestyle, modern
medicine, and other life choices.
 For life insurance, an increase in longevity increases the
profitability of the contracts (assuming, for the moment, no
competition for the term insurance business) because
potential payouts are either delayed or never happen at all.
 For annuity contracts, an increase in longevity may lower the profitability of the
contracts because the payouts may last for longer than what the insurance company
expected.
Insurance companies are, of course, aware that life expectancy is increasing across most of
the world. This longevity increase gets built into insurance rates.
Hedging mortality and longevity risk
Reinsurance. Insurance companies consider the effects of longevity and mortality risks
when they offer policies. When the net exposure is larger than what an insurance company
is comfortable with, the insurance company may turn to reinsurance. When an insurance
company purchases reinsurance, it is hedging a risk against adverse events. The risk is
transferred to the reinsurance company.
Derivative contracts. Another hedging option is for insurance companies to enter longevity
derivative contracts (often referred to as longevity bonds or survivor bond). These derivative
contracts provide payoffs favorable to the insurance company should the risk associated
with longevity exposure materialize. Longevity bonds are fairly straight-forward. A population
group is defined and the coupon on the bond at any given time is defined as being
proportional to the number of individuals in the population that are still alive. Financial
speculators sell these types of bonds to the insurance companies assuming that the upside
risks of payment from the insurance company is worth the potential risk should people live
longer than expected. Another reason speculators may take on the risk associated with
longevity bonds is that the bond payments are largely uncorrelated with the performance of
the stock market – thus, they diversify away some risk.
15
Describe a defined benefit plan and a defined contribution plan for

a pension fund and explain the differences between them.
Pension plans are a way for an employee and an
employer to ensure some form of income post-
employment. Generally, pension plans are paid for partly
by an employee and partly by an employer. The split
between the two depends on the company, employee,
and plan choice. Contributors to a pension plan typically
make regular contributions while the employee is
working. There are two main types of pension plans,
described below.
Defined benefit plan

In a defined benefit plan, regular contributions are required up to a certain age and then
lifetime pensions are provided. In a defined benefit plan, the pension received by the
employee after retirement is defined by a plan. That is, the amount of the pension is
typically calculated by a defined formula. The formula for the pension amount depends on
the company, but typical plans take the number of years of employment and the employee's
average salary for their final three years of employment. For instance, the pension of a
retired employee per year might equal to 2% (known as the multiplier) of the average of the
employee's final three years of salary multiplied by the number of years of employment. If
the employee worked say 35 years and the average of his three years of working was
$100,000, then the pension for this employee would be $70,000.
=. ∙ ∙$ , =$ ,
Spouses. Depending upon the structure of the pension plan, the employee's spouse may
also continue to receive a pension if the employee dies earlier than the spouse. The pension
check may be the same or less than what the pensioner received.
Death. Pension plans may also have death payments. For instance, some plans may
stipulate that when an employee dies while still employed, a lump sum may be paid to
dependents and a monthly income may be payable to a spouse or dependent children.
Adjusting for inflation. In a process known as indexation, the defined benefit plans may
also be adjusted for inflation (virtually every plan has the benefit adjusted for inflation). For
instance, a defined benefit plan may require an indexation equal to 75% of the increase in
the consumer price index.
Defined contribution plan
In a defined contribution plan, the contributions to the plan are defined, and the employer
and employee contributions are invested on behalf of the employee. When employees retire,
the final value of the contributions invested can be converted to a lifetime annuity or received
as a lump sum.
Taxes. Contributions to both defined benefit and defined contribution plans are tax-
deferred, meaning no taxes are payable on money contributed to the plan by the employee
and contributions made by the company are deductible. Taxes are subsequently due when
pension income is received. Depending upon the situation of the employee, this tax deferral
may result in a much lower overall tax burden over their lifetime.
16
Differences between a defined benefit and a defined contribution plan

 Benefits defined vs. contributions defined. The key difference between the two
types of pensions is in the name. In a defined benefit plan, the final benefits received
by the employee are defined. In a defined contribution plan, the monthly contributions
made by the employees and employers to the pension plan are defined.
 Pooled assets vs. individual assets. In a defined benefit plan, the contributions to
the pension fund are all pooled and payments to retirees are made from the pool. For
instance, the largest pension plan in the U.S., Social Security, is a defined benefit
plan. Employers and employees contribute to the pool of funds and distributions from
the account are made according to statute. In contrast, a defined contribution plan
places contributions into individual accounts owned by the individual employees. The
most common example of a defined contribution plan in the U.S. is a 401(k) plan.
 Risk. Perhaps the most important distinction between the two plans is risk. In a
defined benefit world, the employer takes on the risk of ensuring promised benefit
payments are made. In contrast, in a defined contribution world, the risk of having
enough money in retirement largely falls on the shoulders of the employee.
Calculate and interpret loss ratio, expense ratio, combined ratio,

and operating ratio for a property casualty insurance company.
Four ratios are addressed here: the loss ratio, the expense ratio,
the combined ratio, and the operating ratio. What’s the
difference between the four?
Loss ratio
The loss ratio is the ratio of payouts to premium revenue. It is
calculated on an annual basis. In the U.S., loss ratios are
generally in the 60% to 80% range and depend on the business
cycle, insurance companies’ models, and other factors. For instance, suppose an insurance
company earned $250 million in premium revenue and paid out $220 million in claims. This
insurance company’s loss ratio would be 88%. With the 12% not paid out for claims, the
insurance company would need to cover selling expenses, administrative expenses such as
overhead for determining the validity of a claim (commonly referred to as loss adjustment
expenses), and potentially profit for shareholders.
$
= = = .
$
Expense ratio
The expense ratio for an insurance company is the ratio of expenses to premiums earned in
a year. Typically, expense ratios in the U.S. are in the 25% to 30% range. For instance, if an
insurance company’s premium revenue was $250 million and it had $25 million in expenses,
then the company’s expense ratio would be 10%. Overall, there appears to be a general
trend to lower the expense ratio over time.
$
= = = .
$
17
Usually, the two major sources of expenses are:

 Loss adjustment expenses, which are expenses related to assessing the validity of a
claim and deciding how much the policyholder should be paid in the event of a claim.
 Selling expenses, which include the commissions paid to brokers and other
marketing expenses related to the acquisition of a new business.
Combined ratio
The combined ratio is the loss ratio plus the expense ratio. For instance, if we sum the
previous two examples, the combined ratio would be 88% + 10% = 98%.
= + = %+ %= %
Combined ratio after dividends
Often, insurance companies will make dividend payments to policyholders. The combined
ratio after dividends adds the dividend payment from the combined ratio. For instance, if the
dividend payment was 1%, then the combined ratio after dividends would be 99%.
= +
= . + .
Operating ratio
In most cases, premiums paid by policyholders to insurance companies are made at the
beginning of the year or at the beginning of a six-month period. Payouts on claims are made
continuously throughout the year, or after the end of the year. The timing of payments and
expenses leaves room for the insurance company to earn investment income from the
interest on the premiums. This investment income is subtracted from the combined ratio
after dividends to arrive at the operating ratio of an insurance company. Building on the
previous example, the operating ratio would be the 0.99 combined ratio plus investment
income. If investment income is 2%, then the operating ratio becomes 0.97 or 97%.
= +
= . − . = .
Example
The following table presents the four ratios discussed in this section.
1 Premium rev enue $250,000,000

2 Claims $220,000,000
3 Loss ratio (row 2 / row 1 ) 88%
4 Ex penses $25,000,000
5 Ex pense ratio (row 4 / row 1 ) 1 0%
6 Combined ratio (row 3 + row 5) 98%
7 Div idends 1%
8 Combined ratio after div idends (row 6 + row 7 ) 99%
9 Inv estment income 2%
10 Operating ratio (row 8 - row 9) 97 %
18
Describe moral hazard and adverse selection risks facing

insurance companies, provide examples of each, and describe how
to overcome the problems.
Insurance companies face a multitude of risks. Two of the most
prominent risks are moral hazard risk and adverse selection risk.
Moral Hazard
Moral hazard is the risk that the availability of insurance
would cause policyholders to behave differently than they would without the
insurance. This difference in behavior increases the risks and the expected payouts
of the insurance company.
Examples of moral hazard include:

 A car owner buys insurance to protect against the car being stolen. As a result of the
insurance, the owner becomes less likely to lock the car.
 An individual purchases health insurance. As a result of the insurance policy, the
policyholder goes to the doctor more often, thus incurring more costs.
 An individual buys home insurance. As a result, the individual is less likely to install
alarm systems.
 As a result of a government-sponsored deposit insurance plan, a bank takes more
risks because it knows that it is less likely to lose depositors because of this strategy.
Insurance companies attempt to align their interests with those of the policyholders.
A better alignment can be achieved by using:
 Deductibles: The policyholder is responsible for bearing the first part of any loss.
 Co-insurance provision: The insurance company pays a predetermined percentage
(less than 100%) of losses in excess of the deductible.
 Policy limit: An insurance company places an upper limit to the payout.
In these three scenarios, the risk of moral hazard is somewhat minimized by requiring the
insured to have “skin-in-the-game,” meaning that any losses also impact the insured as well
as the insurance company.
Adverse Selection
Adverse selection refers to a situation when high-risk individuals are more likely to
purchase insurance than the general population. Insurance companies generally cannot
distinguish between good and bad risks. As a result, the insurance company offers the same
price to everyone, and thereby attracts bad risks at a higher rate. Adverse selection is simply
a problem of self-selection bias. Examples for adverse selection include:
 If an insurance company is not able to distinguish good drivers from bad drivers and
offers the same auto insurance premium to both, it is likely to attract drivers that are
more likely to get into accidents.
 If an insurance company is unable to distinguish healthy from unhealthy people, the

insurance company may offer the same life insurance premiums to both individuals.
In the process, the insurance company may attract a higher share of individuals that
are unhealthy.
19
To reduce the risk associated with adverse selection, an insurance company often attempts
to gather as much information about the policyholder before offering an insurance contract.
 For example, before offering life insurance, the insurance company may require the
potential policyholder to undergo a physical examination by an approved physician.
 As a second example, an insurance company will gather as much information as
possible about a potential policyholder’s driving record and behavior before offering
auto insurance to the driver.
It should be noted that although insurance companies generally attempt to address moral
hazard and adverse selection, it is impossible to completely overcome these risks without
perfect information.
Evaluate the capital requirements for life insurance and property-

casualty insurance companies.
Life insurance and property-casualty insurance companies take risks. If the downside of
taking risks materializes, the insurance company needs to be prepared. Part of planning for
potentially poor economic and business conditions is having enough capital to withstand the
“bad times”. Thus, the push from regulators for capital requirements.
Life insurance capital requirements
The table below depicts an abbreviated example balance sheet summary for a life insurance
company. In contrast to a bank, a life insurance company has exposure on both sides of the
balance sheet – the liability side and the asset side.
On the asset side of the balance sheet, a life insurance company’s investments are often
invested in corporate bonds, which may have higher default rates than say Treasury bonds.
As with banks, a life insurer attempts to match the maturity of its assets with the maturity of
its liabilities. By attempting to align maturities, the insurance company takes on credit risk
because of the higher default rate on corporate bonds.
The policy reserves of a life insurance company are often relatively conservative estimates
of the present value of payouts on the written policies. In the example of the table below, the
policy reserves are 80% of the assets.
If policyholders die earlier than expected (money gets paid out sooner) or the annuity
contract holders live longer than expected (more payments over a longer life), then actual
payouts would likely be higher than estimated. In cases when payouts are greater than
expected, 10% equity capital (in the table, this amount to $55 million) provides the safety
net.
Abbreviated Balance Sheet for Life Insurance Company7
7
Adapted from John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New
Jersey: John Wiley & Sons, 2018).
20
Property-casualty insurance capital requirements

The following table is an example balance sheet for a property-casualty insurance company.
The property-casualty business is more uncertain than the life insurance business, and as
such, generally requires higher equity capital. This is shown in the property-casualty table
below where the equity capital is $165 million compared to the $55 million for the life insurer
in the life insurance table above. The uncertainty stems from potential claims for large
disasters, such as hurricanes, floods, or earthquakes. The higher equity capital safety net
comes from somewhere. In the case of the table below, the higher equity capital equates to
lower policy reserves. As shown, the policy reserves of the property-casualty insurance
company are $248 million compared to $440 million for the life insurance company in the life
insurance table on the previous page.
Abbreviated Balance Sheet for Property-casualty Company8
Other differences. The different policy reserves and equity capital of life insurers compared
to property-casualty insurers are not the only differences. A property-casualty insurance
company has no unearned premiums whereas the life insurer has premiums yet to be
received. Also, although not shown in the table, property-casualty insurance companies
typically invest their assets in liquid bonds with shorter maturities compared to the bonds of
life insurance companies. This practice stems from attempts to match payouts with bond
maturities.
8
Adapted from John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New
Jersey: John Wiley & Sons, 2018).
21
Compare the guaranty system and the regulatory requirements for

insurance companies with those for banks.
Guaranty system
In the United States, policyholders are protected against insurance company
insolvency (i.e. unable to make payouts on claims) by insurance guaranty
associations. What is an insurance guaranty association? An insurance
guaranty association is a group of insurance companies that pay into a fund to cover
potential insolvencies of members. To operate an insurance company in the U.S., an
insurer must be a member of a guaranty association in the state where the insurance
company is conducting business. The amount an insurance company contributes to the
insolvency fund depends on the state, type of business, and the premiums the company
collects from business in the state. The fund pays out to policyholders of the insolvent
insurance company.
There may also be a cap on the amount the insurance company must contribute to the state
guaranty fund in a year. Because of this cap, and the general nature of the system,
policyholders may have to wait several years before the guaranty fund is in a position to
make a full payout on claims against it. In the case of life insurance, where policies last for
years, the policyholders of insolvent companies are usually taken over by other insurance
companies. During the takeover process, the acquiring life insurance company may make
some changes to the terms of the policy so that the policyholder may be less generous than
the acquired life insurer.
Guaranty system is different than banks
The guaranty system for insurance companies in the United States is different than the
system for banks. Banks pay into a permanent fund created from premiums paid by banks to
the Federal Deposit Insurance Corporation to protect depositors. In contrast, insurance
companies pay into no permanent fund. Insurance companies make contributions after
an insolvency has occurred as opposed to banks' pre-funded failures. There are, of
course, exceptions to this general observation. For instance, property-casualty companies in
New York pay into a permanent fund.
Regulatory requirements
In the U.S., insurance companies are regulated at the state level rather than at the
federal level. This was confirmed by the McCarran-Ferguson Act of 1945. This differs
from banking, where banks are regulated at many levels, including the federal level.
The state-level regulators are involved with issues such as the solvency of insurance
companies, their ability to satisfy policyholders' claims, and their business conduct (such as
contract terms, the setting of premiums, advertising, and the licensing of insurance agents
and brokers).
Insurance companies file detailed annual financial statements with regulators at the state
level. Regulators often conduct unannounced on-site reviews to ensure the insurance
company is complying with state law. Capital requirements are determined by state
regulators using risk-based capital standards determined by the National Association of
Insurance Commissioners (NAIC). The NAIC is an organization consisting of the chief
insurance regulatory officials from all 50 states.
22
Given the dispersed nature of insurance regulation, some observers have mentioned
potential shortcomings of the current system, such as the issues addressed below.
 Regulations tend to vary across different states, which may be a good or bad thing
depending upon one’s perspective. Larger insurance companies may prefer to
operate with one regulator as opposed to having multiple regulatory authorities.
Some large insurance companies think a national regulatory body would be more
efficient. Other researchers on this issue disagree.
 The regulations for insurance companies are different than for banks. For instance,
some insurance companies trade derivatives in the same way as banks but are not
subject to the same regulations as banks. This was a major political issue in 2008
when the world’s largest insurer – American International Group (AIG) – was bailed
out by the American taxpayer when they confirmed that without a bailout, they would
file for bankruptcy.
The U.S. federal government has responded to the concern that a state-level regulatory
framework is insufficient. In 2010, Congress passed the Dodd–Frank Act, which resulted in
the formation of the Federal Insurance Office (FIO). The FIO monitors the insurance industry
and identifies potential gaps in regulation. The push for federal control from some was
confirmed with a 2013 report to Congress by the FIO. The report argued that to improve
regulation of the insurance industry, Congress consider one of two options: (1) move to a
system where regulations are determined federally and administered at the state level or (2)
move to a system where regulations are set federally and administered federally. Neither of
these suggestions have been implemented.
In contrast to the U.S., the European Union regulates insurance companies centrally. The
framework is known as Solvency I. Solvency I requires that an insurance company hold
capital equal to 4% of the policy provisions, which implies that life insurance companies have
a 95% chance of surviving. One criticism of Solvency I was that it did not consider
investment risks. To answer this potential weakness, the European Union developed
Solvency II. Solvency II assigns capital for a wider set of risks. It was implemented in 2016.
23

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P1.T3. Financial Markets & Products

Chapter 2. Insurance Companies and Pension Plans

Bionic Turtle FRM Study Notes

Chapter 2. Insurance Companies and Pension Plans

Chapter 2. Insurance Companies and Pension Plans

Describe the key features of the various categories of insurance

Property-Casualty Health Pension

Life insurance companies

 Whole life insurance: a whole life insurance contract

 Property insurance provides protection against loss

 Easy to predict payouts. Payouts that have a history

Government-controlled health insurance. In some countries, the government provides for

Defined contribution plans Defined benefit plans

Risks facing insurance companies

Describe the use of mortality table and calculate premium payment

Periodic Life Table (2013)4

Calculating the premium payment and expected payout for a policyholder

0.167291 × $100,000 = $16, 729

$15,365 ∙ 0.942866 = $14,487

“Hi @Flashback We recently discussed this here @ https://www.bionicturtle.com/forum/...ts-and-

Distinguish between mortality risk and longevity risk and describe

Describe a defined benefit plan and a defined contribution plan for

Defined benefit plan

Differences between a defined benefit and a defined contribution plan

Calculate and interpret loss ratio, expense ratio, combined ratio,

Usually, the two major sources of expenses are:

1 Premium rev enue $250,000,000

Describe moral hazard and adverse selection risks facing

Examples of moral hazard include:

 If an insurance company is unable to distinguish healthy from unhealthy people, the

Evaluate the capital requirements for life insurance and property-

Abbreviated Balance Sheet for Life Insurance Company7

Property-casualty insurance capital requirements

Abbreviated Balance Sheet for Property-casualty Company8

Compare the guaranty system and the regulatory requirements for

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