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Module 5 Study Guide and

Deliverables
Lecture Nonbank Financial Institutions

Topics:
Readings: Madura: Ch. 22, 23, 24, and 25
Discussions: 5: Large Insurance Companies
Initial post due by Wednesday, April 17

at 11:59 PM ET
Reply posts due by Sunday, April 21 at
11:59 PM ET
Activities: Case Study #2 The U.S. Banking Panic

of 1933 and Federal Deposit Insurance
due by Sunday, April 21 at 11:59 PM ET
Week 5 Introduction
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Non-Bank Financial Institutions

In this lecture, we'll focus on a rather wide range of non-bank financial institutions, starting with investment banks,
insurance companies and pension funds and then into a grouping of investment companies, most prominently
mutual funds.
Investment Banking
Investment banks serve some of the same clientele as commercial banks, but the services they offer are rather
different. The fact that some commercial banks also provide some of these services should not be misleading.
They may be a commercial bank but are, in those circumstances, wearing an investment banking hat. We'll focus
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on the hat in this session. What services define investment banking? Perhaps most prominently, it is the
underwriting of stocks and bonds that is at the core of the institution. That means that investment banking involves
the management of the issuance of debt and equity securities to investors. Related to the underwriting function are
brokerage services—the primary and secondary trading of stock/bonds for external clients, stock lending, and the
like. Associated with both of these functions is the provision of investment advice both to those issuing securities
and those buying and selling them. In addition, I Banks frequently lend their own funds, especially in connection
with merger and acquisition transactions, and they undertake proprietary trading and investment with their own
capital.
Until 1999, investment banks in the U.S. could not conduct commercial banking activities, and vice versa; in most
of the world, financial institutions are allowed to do both investment and commercial banking. They are called
universal bank s.
One of the main functions of investment banking firms (I Banks) is raising capital for corporations. I Banks
originate, structure, and place securities in the capital markets. They serve as an intermediary rather than a lender
or investor; their role is an agent. As an intermediary, their compensation is typically in the form of fees. There
certainly are instances in which the I Bank plays a direct role instead of that as an intermediary, but that is the
exception rather than the rule. In underwriting, the origination of new equity securities, the I Bank will often make
recommendations regarding the appropriate amount of stock to issue. Too much may overwhelm market demand,
while too little might reduce the attractiveness of the issuer to the market. I Banks evaluate the corporation's
financial condition to determine the appropriate stock price and assist the company in filing required registration
documents with the SEC.
Equity Underwriting
The registration statement is intended to ensure that accurate information is disclosed by the issuing corporation.
Included in the registration information is the prospectus, disclosing relevant financial data on the firm and provision
applicable to the security. The I Bank and the issuing firm may organize and engage in a road show to meet with
institutional investors to drum up interest in a forthcoming security issue.
The I Bank may form an underwriting syndicate and ask other I Banks to underwrite a portion of the stock. This is
typical for issues of any significant size. The bank may, in playing the role as an agent, enter into a best-efforts
agreement, where the I Bank does not guarantee a price to the issuing corporation. The bank may, however, set up
the transaction as a bought deal, whereby the I Bank buys the entire issue and then attempts to re-sell it to other
investors.
The pricing of securities during an Initial Public Offering (IPO) is particularly challenging given the lack of clear
market guidelines. I Banks want to set the price high so that the issuing corporation receives higher proceeds, but
they do not want to set the price too high in order to successfully place the entire issue and to satisfy its
purchasing clients as well. Historically, IPOs have tended to be underpriced as evidenced by the rapid escalation of
the price of the newly issued stock.
The sales process for a stock underwriting is more complex than it first appears. The I Bank must ensure that all
potential investors receive the basic documents regarding the issuer and that no extraneous claims are made. The
prospectus is distributed to all potential purchasers of the stock, and the issue is advertised to the public. Some I
Banks have brokerage subsidiaries that can sell stock on a retail level, while others deal only with institutional
investors or separate brokerage firms.
The issuing corporation incurs two types of flotation costs in connection with a stock offering – fees paid to the
underwriters and related issue costs, including printing, legal, registration, and accounting expenses. Together
these can absorb perhaps 2 to 5% of the proceeds of the issue.
The I Bank acts as an adviser during the origination stage and may provide advice after the stock is issued.
The private placement of stocks differs somewhat from a wider public offering. I Banks may be able to place an
entire offering with a small set of institutional investors. Rule 144A allows firms to engage in private placement
without the registration statement and, depending on the size of the issue, an underwriting syndicate may not be
necessary. All this reduces the cost to the issuing firm.
Debt Underwriting
The process followed in the origination of debt securities is rather similar. The I Bank may suggest a maximum
amount of bonds to be issued based on existing debt levels. The coupon rate, maturity, and other provisions are
decided, generally in consultation with potential institutional investors and by evaluating market prices of existing
bonds. Issuers of bonds must register with the SEC, and a registration statement must be filed. As well, the I Bank
may act as an intermediary with rating agencies to obtain their rating before the issue is sold.
Some issuers may solicit competitive bids on the price of bonds from various I Banks, running something of a
beauty contest. The objective is to obtain the lowest interest rate possible and to succeed in placing the entire
planned bond issue. Underwriting spreads on newly issued bonds are normally lower than on newly issued stock,
and to facilitate the successful placement, the I Bank may organize an underwriting syndicate to participate in
placing the bonds.
I Banks also provide a wide range of services to assist a company and may be retained in an advisory capacity.
They may assess the market value of the firm to assist with mergers or acquisitions. I Banks receive fees from
divestitures of divisions or may provide bridge loans if additional financing is needed or until longer-term financing
can be issued. It may also provide advice on defense takeover tactics and finance takeovers. It can arrange
financing, which involves raising funds and purchasing any common stock outstanding that is held by the public. It
may be asked to purchase a portion of the firm's assets to provide financial support. However, taking such a direct
role in the financing process (as opposed to an intermediary role), exposes the I Bank to a higher degree of risk.
Arbitrage
Arbitrage activity involves the purchasing of undervalued shares and the resale of those shares for a higher profit.
Arbitrage firms search for undervalued firms, and I Banks raise funds for these firms. They may also engage in
asset stripping which involves acquiring the firm and selling off its individual divisions, since the sum of the parts is
greater than the whole. I Banks generate fee income from advising arbitrage firms and receive a commission on the
bonds issued to support the arbitrage activity. Some arbitrage firms take positions in hostile takeover targets to
benefit from the expected takeover by another group. Some attempts at arbitrage fail because target firms are
successful at defending against a takeover. In working with arbitrage firms, an I Bank may stand accused of acting
in a partisan manner and must be careful to guard against reputational risk.
Sometimes arbitrage firms have accumulated shares of targets with the expectation that targets will buy back the
shares at a premium. Greenmail – derived from "blackmail" — is an effort by an owner of a significant block of
stock to obtain concessions or favorable treatment from management by buying back the block of stock at an
above-market price; some I Banks helped to finance greenmail.
Arbitrage activity has been criticized because it often results in excessive financial leverage and risk for
corporations and the restructuring of divisions after acquisitions result in layoffs.
I Banks provide advice on corporate restructuring. They can assess potential synergies that might result from the
combination of two businesses. I Banks may suggest a carve-out in which the firm sells a unit of the firm to new
shareholders through an IPO by the unit. The unit may also be spun off, where new shares of the unit are created
and distributed to existing shareholders. Apart from advisory fees, all these potential activities could generate
additional income possibilities for the I Bank. They also provide advice on mergers and acquisitions and can be
critical in the valuation of the business in providing an independent, expert view on the true value. I Banks have also
loaned out their own funds to companies involved in mergers and acquisitions, generally on a short-term basis, or
even provided equity financing.
Brokerage
Most I Banks also have brokerage units involved in the primary and secondary market buying and selling
securities. There is currently a wide range of business models for securities brokerage. Full-service brok erage
firms provide information and advice as well as executing transactions; discount brok erage firms only execute
transactions upon requests and do not provide personalized advice although they do conduct some degree of
research on a web site. Many investors have been attracted to such discount brokers since the required minimum
opening balance is typically very low, between $1,000 and $3,000.
The following table summarizes the sources of income for I Banks and the types of income this generates.
Sources of Investment Banking Revenue
Services
Underwriting Fees from underwriting stock or bond offerings
Fees for advice to firms about identifying potential targets, valuing

Advising
targets, identifying potential acquirers, protecting against takeover
Restructuring Fees for facilitating mergers, divestitures, carve-outs, spin-offs
Brokerage services
Management fees Fees for managing securities portfolios
Fees for executing trades securities requested by individual or firms

Trading commissions
in the secondary market
Margin interest Interest charged to investors who buy securities on margin
Investing its own funds
Investing Profits from investing in securities
The proportion of income derived from each source varies among securities firms in any particular year. For
example, when IPOs are hot, income from equity underwriting fees will be high; when junk bond issuance is high,
so will that source of income. Some securities firms emphasize investment banking and therefore generate a high
proportion of income from underwriting and advising fees, such as Goldman Sachs. Others emphasize brokerage
and generate a higher proportion of income from trading commissions, such as Charles Schwab. Most securities
firms attempt to diversify their services so that they can capitalize on economies of scope.
Regulation of Securities Firms

Securities firms are subject to a variety of regulations. The SEC, which is the primary regulator, attempts to ensure
that investors have access to financial information. The SEC has the power to ensure that publicly-traded
companies provide sufficient financial information to existing or prospective investors. The SEC tends to establish
general guidelines that can affect trading on security exchanges. Stock exchanges and the NASDAQ are expected
to prevent unfair or illegal practices, ensure orderly trading, and address customer complaints and engage in a
significant degree of self regulation, which has, at times, been questioned as to its effectiveness.
Stock exchanges are responsible for the day-to-day regulation of exchange trading through their own regulatory
divisions. The NASDAQ market is regulated by the National Association of Securities Dealers, NASD. Surveillance
departments monitor trading patterns and behavior by specialists or market makers and floor traders. Enforcement
divisions investigate possible violations and can enforce disciplinary actions.
The Federal Reserve determines margin requirements. The Securities Investor Protection Corporation (SIPC) offers
insurance on cash and securities deposited at brokerage firms and can liquidate failing brokerage firms. All brokers
registered with the SEC are assessed premiums by the SIPC. The insurance limit is $500,000, including $100,000
against claims on cash. The SIPC has a $500 million revolving line of credit and can borrow up to $1 billion from the
SEC.
The Glass-Steagall Act (1933)

The Glass-Steagall Act separated commercial banking from investment banking in the U.S. Deposit taking firms
(commercial banks) could not engage in the perceived "risky" activity of I Banking. Firms were forced to decide
whether to be commercial or I Banks. The intent was to discourage speculation in financial markets and prevent
conflict of interest and self-dealing to restore confidence in the safety and soundness of the financial system. There
have been some calls for return to Glass-Steagall in wake of the financial crisis.
Financial Services Modernization Act (1999)

The Financial Services Modernization Act allowed banking, securities activities, and insurance to be consolidated
in a financial holding company (repeal of Glass-Steagall). The Act resulted in the creation of more financial
conglomerates that included securities firms. A primary benefit to securities firms is cross-listing. The bundling of
financial services can generate more business for each type of financial institution that is part of the conglomerate.
Regulation FD
Regulation FD (for Fair Disclosure) was promulgated in October 2000 by the SEC. It requires that firms disclose
any significant information simultaneously to all market participants, and it was partially intended to prevent a firm
from leaking information to analysts. The Regulation prevented analysts working for securities firms to have a
competitive information advantage and benefited analysts who relied on their own analysis.
Rules Regarding Analyst Compensation and Ratings

When firms need underwriting or advisory services, they are more likely to hire a securities firm whose analyst
would rate the stock highly. The compensation of some analysts in the 2001–2002 period was sometimes aligned
with the new business they brought in. Consequently, analysts were tempted to inflate the ratings of stocks, and
investors were misled. In 2002, the SEC implemented new rules:
If a securities firm underwrites an IPO, it cannot use its analysts to promote the stock for the first 40 days
after the IPO
Analyst compensation cannot be directly aligned with the amount of business that the analyst brings into
the securities firm
Analysts cannot be supervised by the investment banking department within the securities firm
An analyst rating must divulge any recent investment banking business provided by the securities firm that
assigned the rating
Rules Preventing Abuse in the IPO Market

In the 2001–2003 period, various abuses occurred:
Some securities firms that served as underwriters allocated shares to corporate executives who were
considering an IPO for their firm (spinning)
Some securities firms that served as underwriters encouraged institutional investors to place bids for
the shares on the first day that are above the offer price in order to be allowed to participate in the
next IPO
The SEC investigated cases of abuse and imposed fines. The SEC enacted rules to prevent such
abuses from occurring in the future.
Repeal of the Trade-Through Rule

Specialists were sometimes able to jump ahead of other orders (called penny-jumping). This prevented other
investors from having their orders executed. In 2004, the SEC ruled that investors could circumvent the trade-
through rule to avoid penny-jumping by specialists.
Mutual Fund Disclosure

In 2003, some funds were allowing their large clients to buy or sell shares after the 4 p.m. closing at the 4 p.m.
prices (late trading at stale prices). This was a clear violation of 1968 SEC laws. The SEC imposed heavy fines on
those mutual funds and is working on laws requiring more disclosure of the fees that mutual funds charge and
better governance.
Basel II and Basel III
Major securities firms will be subject to capital adequacy and disclosure rules similar to Basel II.
Dodd-Frank Act (2010)

The Dodd-Frank Act has effectively shifted the liability onto Bondholders and equity owners in case there is a
default by investment banks, to avoid penalizing taxpayers in case there is a financial markets meltdown. Coupled
with Basel III conventions, this has forced Investment Banks to reduce risky behavior and allocate capital to
businesses which they believe are the best avenues for profit and stability.
Morgan Stanley has increased focus on its wealth management business while cutting down on Investment
Banking and Trading. Wells Fargo has focused on its mortgage business. Barclays and JP Morgan have sold off
their commodities trading business while Goldman, which has not changed much and is still focused on
Investment Banking and Trading has moved employees to lower-cost locations like Salt Lake City to reduce costs
and avoid laying off employees and slimming down businesses.
Banks exiting the Investment Banking and Client Services businesses are unlikely to return as the Dodd-Frank Act
coupled with other regulations has increased barriers-to-entry.
Markets in Financial Instruments Directive (2007) (MiFID)

Revising and expanding on its predecessor, the MiFID creates a uniform environment for investment services
across the EU. It covers all firms involved in investment services and all tradable financial products. Firms
registered and regulated in one country can operate in all countries. It also added disclosure and transparency for
all traded instruments and assures best execution of trades and visibility across all markets. The actual impact of
MiFID is somewhat unclear given implementation just prior to financial crisis.
Investment Banking Risks

I Banks are subject to the same types of risks as commercial banks. But the degree and nature of these risks are
somewhat different, especially when the I Bank is acting in a pure intermediary role instead of directly participating
in the particular financial transaction. When I Banks are engaged in trading or investing for their own accounts,
however, they are faced with the same types of risk as other portfolio managers and must take the same kind of
actions to mitigate or hedge those risks.
Market Risk
When stock prices are rising, there is a greater volume of stock offerings and secondary market transactions.
Securities firms benefit from a bullish stock market. Some take equity positions in the stocks they underwrite or
take a partial equity interest in target firms. Acquisitions tend to be more common in bullish markets. Equally, they
suffer in down markets.
Interest-Rate Risk
The market values of bonds held as investment by securities firms increase as interest rates decline. Lower
interest rates can encourage investors to withdraw deposits from banks and invest in the stock market.
Credit Risk
Securities firms offer bridge loans and other types of credit to corporations. They have to develop the same types of
internal credit evaluations and monitoring systems as commercial banks. Similarly, their customers may default on
their purchase or payment commitments. Since they tend to deal with larger entities, there may be a perception
that their customers never default. This, unfortunately, is a misconception, and I Banks must be just as diligent
with respect to credit risk as their compatriots. Default risk increases during periods when economic conditions
deteriorate.
Exchange-Rate Risk
Many securities firms have operations in foreign countries. Earnings remitted by foreign subsidiaries are reduced
when the foreign currencies weaken against the parent firm's home currency. Also, market values of foreign
investments decline as the currencies weaken against the parent firm's home currency.
Competition between Securities Firms and Commercial Banks

The distinction between commercial and investment banks is becoming very fuzzy, apart from the depository
function of commercial banks. Commercial banks may be able to offer discount brokerage services at lower fees
than full-service firms, since they do not need to maintain the same comprehensive infrastructure and overhead.
Commercial banks compete with discount brokers, but they must either establish a brokerage subsidiary or
acquire a brokerage firm to do so. On the other hand, in providing loans to the businesses that they deal with, I
Banks pose a direct competitive challenge to commercial banks.
Global Expansion of Investment Banks

In 1986, the Big Bang allowed for deregulation in the U.K. Many securities firms have increased their presence in
foreign countries, and commercial banks from the U.S. have established investment banking subsidiaries overseas.
There are both advantages and disadvantages to "going global." Doing so allows firms to place securities in various
countries and permits firms to benefit from international M&As. As well, institutional investors investing in foreign
securities prefer firms that can easily handle such transactions. Today, major firms such as Goldman Sachs or
Morgan Stanley obtain a significant portion of their revenues from international operations.
Growth in international joint ventures has been one of the primary ways in which I Banks have expanded into other
jurisdictions. It has allowed foreign market penetration with a limited stake and gives the banks access to the local
knowledge and customer base of the foreign firm. Expansion into very tight-knit or closed markets such as Japan
or China has been aided by such joint ventures.
Insurance
Essentially, insurance indemnifies the customer against risk of economic loss in return for an annual premium
payment. Premium rates are set on the basis of the likelihood/probability of incurring a loss and the size of that
loss. For a single customer, the probability is largely irrelevant – "my house will burn down or it won't" – but
probabilities make sense over a large pool of similar risks. Insurance is intended to reduce society's cost of bearing
risk.
Insurance is possible where there are a large number of similar potential risks; but those risks are (reasonably)
independent, and the probability of the risk can be predicted (at least over an extended period). Absent these two
factors and it becomes more of a speculation than a calculated risk.
Insurance companies provide various forms of insurance and investment services to individuals and charge a fee
(premium) for the services. They provide a payment to the insured (or a named beneficiary) under conditions
specified by the insurance policy contract and, in so doing, help individuals or firms to reduce the potential financial
damage due to specified conditions.
Common types of insurance are life insurance, property and casualty insurance, health insurance, and business
insurance. Individuals who are more exposed to specific conditions that cause financial damage will purchase
insurance against those conditions. This, however, creates what's termed an "adverse selection" problem where
only the customers most likely to need insurance (those most likely to file a claim) purchase it. Insurance can
cause the insured to take more risks because they are protected. This is termed a "moral hazard" problem.
Underwriters are employed by insurance companies to calculate the risk of specific insurance policies. They must
decide what types of policies to offer based on the potential level of claims and the premiums that they could
charge.
Insurance premium is based on:
The probability of the condition under which the company will need to provide payment
The potential size of the payment in present value terms
The degree of competition in the industry for that type of insurance
Overhead expenses and insurance company profit
Whether the policy is for an individual or a group
Insurance companies invest premiums and fees until the funds are needed to pay claims. Those investment
decisions balance the goals of return, liquidity, and risk. Insurance companies whose claims are less predictable
need to maintain more liquidity.
Life insurance companies are the dominant force in the industry and generate more than $100 billion in premiums
each year. Life insurance compensates the beneficiary of a policy upon the policyholder's death. The premium
charged reflects the probability of making a payment as well as the size and timing of the payment. Through the
use of actuarial tables and mortality figures, it is possible to forecast reasonably well the percentage of policies
that will require compensation.
There are about 2,000 life insurance companies. Companies are classified as either stock or mutual ownership
where a stock-owned company is owned by shareholders, and a mutual company is owned by the policyholders.
About 95% of companies are stock-owned. Mutual companies are large and account for more than 46% of total
assets of all life insurance companies.
Life Insurance Assets

Life insurance companies are major institutional investors. Given the long term and predictable nature of their
obligations, life insurers can invest on a medium- to longer-term basis without major liquidity concerns.
Government securities
Corporate securities are the most popular asset of life insurance companies. Some focus on high-grade
bonds, others invest a portion in junk bonds. Generally, life insurance companies expect to maintain some
bonds until maturity.
Corporate stock is another use of funds, but significantly less than bonds.
Mortgages represent a major asset class. All types of mortgages are held—One to four family, multifamily,
commercial, and farm related. Mortgages are typically originated by another institution and then sold to life
insurance companies in the secondary market. Commercial mortgages make up more than 90% of total
mortgages held by life insurance companies.
Real estate, in addition to mortgages, is held by life insurers. They sometimes purchase real estate and
lease it out for commercial purposes. Real estate generates higher returns but also exposes life insurance
companies to higher risk.
Policy loans are loans to insured parties, particularly whole life policyholders who can borrow up to their
policy's cash value at a guaranteed rate of interest.
Types of Life Insurance

Group plans are offered to employees of a corporation. They can be distributed at a low cost because of high
volume and make up about 40% of total life coverage.
Whole life insurance protects policyholders until death or as long as premiums are paid and typically provides a
fixed amount of benefits. It builds cash value that the policyholder is entitled to even if the policy is canceled.
Whole life generates periodic premiums for the life insurance company that can be invested.
Term insurance is temporary, providing insurance only over a specified term. It does not build cash value and
consequently is significantly less expensive than whole life insurance. Decreasing term insurance are policies
where benefits decrease over time.
Variable life insurance provides benefits that vary with the assets backing the policy. The category includes
flexible-premium variable life insurance, providing flexibility on the size and timing of payments.
Universal life insurance combines the features of term and whole life insurance. It specifies a period of time over
which the policy will exist but also builds cash value and allows flexibility on the size and timing of the premiums.
Insurance agents prefer to sell "combined' products rather than "plain vanilla' ones like term insurance since the
profit margins tend to be much higher. Customers find it more difficult to evaluate the miscellaneous bells and
whistles for value.
From a revenue standpoint, the most important source of revenues for life insurance companies are annuity plans
that offer a predetermined amount of retirement income to individuals. The second largest source of funds is
premiums followed by investment income.
Capital
Insurance companies are required to maintain adequate capital. Given the predictable nature of their business, this
capital level is generally modest in size. Capital is used to finance investment in fixed assets and as a cushion
against operating losses. Apart from retaining earnings over time, they may issue new stock to expand their capital
base.
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Balancing Risk and Reward

Life insurance companies' performance can be significantly affected by asset portfolio management. Companies
attempt to balance their portfolios so that any adverse movements in the market value of some assets will be offset
by favorable movements in others. Many companies are diversifying into other businesses by offering a wide variety
of financial products. Overall, life insurance companies want to earn a reasonable return while maintaining their risk
at a tolerable level.
Rate Setting and Return for Life Insurers

The issues around life insurance rate setting and return can be illustrated graphically quite well.
The company estimates that the average expected date of death (payout date of the insurance policy) for
this policyholder will be T1, at which time they will have to payout the policy amount.
Policy premiums, P1, are set so that premiums plus expected investment returns (at rate R1) will accrue by
time T1 to meet the payout (and have covered management costs and returned "normal" profit).
However, if the client dies "too early" at time T0, the insurance company will only have accrued A0 funds,
and thus incurs an economic loss of A1-A0. If the company had anticipated this, it could by some
combination of higher premiums and/or higher rates of return, accrued enough to meet the claim at T0.
Alternatively, if the payout date occurs after the expected date, T2, the company will have accrued much
more money, A2, and thus will realize an economic profit.
On the other hand, if the premium and/or investment income is lower, it might be sufficient to meet the A0
payout by time T2, but it will be insufficient and result in a net economic loss if the payment must be made
at T1.
Property and Casualty Sources and Uses of Funds

PC insurers' sources of funds are similar to those of life insurance companies but with much greater reliance on
premiums that can be adjusted more frequently. A lower proportion of revenues comes from investments, as those
investments tend to be more short term in nature. Nevertheless, as interest rates decline, the price of insurance
rises to offset decreased investment income.
Municipal bonds dominate the portfolio of PC companies followed by Treasury bonds and common stock. PC
companies have a much higher concentration on government bonds than life insurance companies given the shorter
nature of their obligations and, hence, the need to have a more predictable investment cash flow.
Life insurance has only two key variables – the date of payout and the rate of return which the insurance company
can realize on its portfolio. However, the distribution of payout dates is based on mortality tables, thereby reducing
the company's risk. With property and casualty and most other forms of insurance, the distribution of payout timing
is much less certain (e.g., a fire could occur tomorrow, next year or may never occur at all) and while the maximum
amount of the payout is specified in the contract, the actual payout could potentially be much lower (e.g., there
could be no hurricanes at all which come on shore, a few or many in any given year; severity could also vary
tremendously). Diversification (geographic and line-of-business) is one means to attempt to reduce the claim
uncertainty.
Profitability of PC insurance can vary substantially from one year to the next. With uncertainty as to the amount
and timing of payouts, much more reliance must be made on premium income, with less emphasis on investment
income, focusing on what likely claims will be within a relatively short period of time, such as one year. Added
uncertainty also gives rise to the demand for re-insurance, to spread the risk more widely, as well as to various
exotic forms of financing whose return might rise (or cost decrease) in the event of heavy claims activity.
Modeling the results for PC companies is much more complicated than for life companies. From year to year the
variability of claim payments is very large, and this can result in much higher returns (if there are low claims
payments) or much lower returns (if there are high claims payments).
Reinsurance
A reinsurer is an insurance company that provides insurance to other insurance companies. Effectively, it allocates
a portion of primary insurance companies' return and risk to the reinsurer. In some ways, it is similar to a
commercial bank's acting as a lending agent by allowing other banks to participate in the loan. It allows a company
to write larger policies because a portion of the risk involved will be assumed by other companies. In recent years,
fewer companies are offering reinsurance because of generous court awards and the difficulty in assessing the
amount of potential claims.
Health Care Insurance

Health insurers offer coverage for hospital stays, physician visits, and surgeries. They serve as intermediaries
between health care providers and the recipients of health care. There are two primary types of health care plans –
an indemnity plan reimburses insured individuals for health care offered by health care providers while a managed
health care plan allows insured individuals to obtain health care services from specified health care providers who
participate in the plan. Premiums are generally lower for a managed plan, and payment is typically made directly to
the provider. The patient must choose providers who participate in the plan.
Managed health care plans feature two different ways in which services are provided. Health maintenance
organizations (HMOs) require individuals to choose a primary care physician (PCP) who functions as a gatekeeper
for that individual's health care. Patients must first see their PCP to obtain referrals. The other is preferred provider
organizations (PPOs) that usually allow insured individuals to see any physician without a referral. Insurance
premiums are higher than HMO insurance premiums.
Health care expenses have risen dramatically in recent years. Some insurance companies that provide health care
insurance have incurred major losses, and the insurance companies increased their premiums. The status of
health care insurance and reimbursement is subject to changes caused by possible health care reform and, in
particular, it remains to be seen how the major reform measures enacted in 2010 will affect the industry.
Business Insurance
Insurance companies provide a wide variety of business insurance policies. This can include property insurance
which protects a firm against the risk associated with ownership of property and provides insurance against
property damage by fire or theft and liability insurance which can protect a firm against potential liability for harm to
others as a result of product failure. This is important because of the increasing frequency of lawsuits, but liability
insurance can also protect a business against potential liability from its employees. Both these areas are
extensions of PC insurance. There are some types of coverage that are unique to businesses.
Key employee insurance provides a financial payout under conditions that specified employees of a business
become disabled or die. Business interruption insurance covers against losses due to a temporary closing of the
business. Credit line insurance covers debt payments owed to a creditor if a borrower dies. Fidelity bond insurance
covers against losses due to dishonesty by employees. Marine insurance covers against losses due to damage
during transport. Malpractice insurance covers business professionals from losses due to lawsuits by dissatisfied
customers. Surety bond insurance covers losses due to a contract not being fulfilled. Umbrella liability insurance
provides additional coverage beyond that provided by the other existing insurance policies.
Insurance Regulation
The insurance industry is regulated by state agencies (commissioners). These bodies ensure that companies are
providing adequate services, and they approve rates. Insurance agents must be licensed. The regulators also
evaluate the asset portfolios to ensure that investments are reasonably safe. There have been questions of quality
and quantity of supervision, given that most state insurance commissions are relatively small; in addition, the
"revolving door" regulation where staff members move between the commission and working for insurance
companies regulated by the commission can create potential conflict.
The National Association of Insurance Commissioners (NAIC) facilitates cooperation among the various state
agencies. It attempts to maintain a degree of uniformity in common reporting issues and conducts research on
insurance issues and participates in legislative discussions.
The Insurance Regulatory Information System (IRIS) has been developed by a committee of state insurance
agencies and assists in each state's regulatory duties. It compiles financial statements, lists of insurers, and other
relevant information and assesses the companies' respective financial statements by calculating 11 ratios that are
then evaluated by NAIC regulators.
The Dodd-Frank Act (2010) will create national insurance regulation for the first time.
The regulatory system is designed to detect any problems in time to search for a remedy. In assessing insurance
companies, several key financial ratios are commonly used. These focus on the ability of the company to absorb
either losses or a decline in the market value of its investments, its return on investment, the relative size of
operating expenses and the liquidity of the asset portfolio. Financial characteristics are monitored to ensure that
companies do not become overly exposed to credit risk, interest-rate risk, and liquidity risk.
Regulation of Capital
Since 1994, insurance companies have been required to report a risk-based capital ratio to insurance regulators
according to a system created by the NAIC. It is intended to force those companies with a higher exposure to
claims, losses, and interest-rate risk to hold a higher degree of capital; this discourages companies from excessive
exposure to risk by forcing companies that take high risks to back their business with a large amount of capital.
Insurance Company Risks

As with other financial institutions, the generic categories of risk are similar, but the exact nature of those risks
varies for insurance companies.
Interest-Rate Risk
Insurance companies hold a large volume of fixed-rate long-term securities and are very sensitive to interest rate
fluctuations. When interest rates rise, insurance companies are unable to capitalize on higher rates. Life insurance
companies have been reducing their average maturity on securities and have been investing in long-term assets
that offer floating rates. Insurers overall have increasingly been utilizing futures contracts and interest-rate swaps to
manage their exposure.
Credit Risk
Corporate bonds, mortgages, state and local government securities, and real estate holdings are all subject to
credit risk. Some insurance companies only invest in assets with a high credit rating and diversify among
securities.
Market Risk
Some insurance companies became insolvent in the early 1990s as a result of losses on real estate investments.
As well, the value of stock portfolios managed by insurance companies declined in 2001-2002 and again in 2007-
2009. Similarly, in the financial crisis, the value of bond and real estate portfolios declined significantly. Many
insurers have attempted to reduce market risk by expanding their investment in so-called "alternative assets," such
as commodities, currencies, and other assets where the correlation of risk is perceived to be lower.
Liquidity Risk
A high frequency of claims at a single point in time could negatively affect a company's performance. Life insurers
can diversify the age distribution of their customer base to reduce the exposure to this risk. If the customer base is
concentrated in the older age group, life insurance companies should increase their proportion of liquid assets.
Liquidity is also reduced when interest rates are high and policyholders accelerate their voluntary terminations.
Liquidity can be measured as:
Liquidity ratio = Invested assets/[Loss reserves + premium reserves]
The profitability of an insurance company can be measured by:
Return on net worth = Net profit/Policyholders' surplus
Net profit includes underwriting profits, investment income, and realized capital gains
Underwriting gains or losses are measured by:
Net underwriting margin = [Premium income – Policy Expenses]/Total Assets
where policy expenses include payouts on policy claims
Pension Funds
Pension plans provide a savings plan for employees that can be used for retirement. Public pension funds can be
state, local, or federal, such as Social Security. Many public pension plans are funded on a pay-as-you-go basis,
that is, the funds being "saved" by active workers are used to pay the pensions of retired persons. This can create
significant problems if the proportion of active employees to retirees decreases.
Private pension plans, sponsored by private organizations, take two general forms. With a defined-benefit plan,
contributions are dictated by the benefits that will eventually be provided and generally the benefits are fixed. A
defined-contribution plan provides benefits that are determined by the accumulated contributions and the fund's
investment performance. 401K is a defined contribution plan. No set level of benefits is promised.
Underfunded pensions have created great concern in recent years. In the early 1990s, many defined-benefit plans
used optimistic projections of the rate of return on their investments. This reduced the level of contributions that the
sponsors had to make. When projected rates of return were overestimated, the pension funds became
underfunded. To compensate, some pension funds have made high-risk investments in real estate, junk bonds, and
international securities which often exacerbated the problem. In many cases, the sponsors have been required to
make large, catch-up payments to bring the funding base for their programs in line with their obligations.
Most providers are switching to a defined contribution plan since it removes all investment risks (market risk,
interest-rate risk, default risk) from the provider. Often, the beneficiary makes the investment decisions, usually
from a list of predetermined options. This leaves the beneficiary with "only himself to blame" if the returns are not
up to their expectations.
Pension Regulation
Regulation varies with the type of pension plan. All plans must comply with the IRS tax rules that apply to pension
fund income. Defined-contribution plans are subject to the Employee Retirement Income Security Act (ERISA).
This provides for 100% vesting after five years or graded vesting over a period of years. It requires pension funds to
concentrate their investment in high-grade securities and allows employees changing employers to transfer any
vested amount into the pension plan of their new employer or to invest it in an IRA.
The Pension Benefit Guaranty Corporation was established by ERISA to provide insurance on pension plans. It
guarantees that participants of defined-benefit pension plans will receive their benefits upon retirement, and it is
financed by annual premiums, income from assets acquired from terminated pension plans, and income generated
by investments. The Corporation monitors pension plans periodically to determine whether they can provide
benefits.
Pension Fund Assets

Private pension portfolios are dominated by common stock since the rate of return has historically been higher than
that of fixed-income investments. Public pension portfolios are evenly invested in corporate bonds, stocks, and
other credit instruments, a somewhat more conservative mix.
Managers use a variety of strategies to maintain a balance between their assets and liabilities. Investment
decisions with a matched funding strategy are made with the objective of generating cash flows that match planned
outflow payments. Projective funding offers managers more flexibility in constructing a pension portfolio that can
benefit from expected market and interest-rate movements.
The overall policy for investments is set by the plan's trustees who are often appointed by the corporation
sponsoring (owning) the pension plan. Guidelines are established for:
Percentage of assets that should be used for stocks or bonds

Desired minimum rate of return
Maximum amount to be invested in real estate
Minimum acceptable quality rating for bonds
Maximum amount to be invested in any one industry
Average maturity of bonds
Maximum amount to be invested in options
Minimum size of companies in which to invest
Market and interest rate risk are the primary risks facing pension fund managers.
Corporate Control by Pension Funds

Pension funds in aggregate hold a substantial portion of the common stock outstanding in the U.S. Corporate
managers consider the requests of pension funds because of the large stake the pension funds have in the
corporations. This gives the pension funds considerable influence over the companies, particularly in cases where
hostile shareholders are urging different policies on the companies.
Performance Evaluation of Pensions Plans

Pension plans usually do not attempt to maximize income but rather their objective is to make investments that
will earn a large enough return to adequately meet future payment obligations. Generally, the performance of
pension fund managers is made relative to a benchmark set on the basis of the pension fund's objectives and the
general makeup of its investment portfolio. Any difference between the performance of the pension portfolio and the
benchmark portfolio results from the manager's shift in the relative proportion of bonds versus stocks or the
composition of bonds and stocks within the respective portfolios. In many cases, the performance of stocks and
bonds in a pension fund is evaluated separately. Some research has found that managed pension portfolios perform
no better than market indexes.
Investment Companies
Investment companies were first started in Belgium in 1822; U.S. investment companies started at about the same
time. Early companies were closed-end companies, meaning that the funds were tied up in that company until it
was liquidated or the managers chose to pay a dividend. The first mutual fund companies were established in 1924.
Popular in the 1920s, the sector declined in the Great Depression. Regulations enhanced confidence, and growth
was very rapid in 1945 to 1965 when the stock market performed well. Inflation, high interest rates, and poor
market performance hurt growth in the 1970s.
New types of funds were introduced after the 1970s. These included municipal bond funds providing tax-free
income; government bond funds providing maximum safety; money market funds featuring safety and liquidity; and
index funds offering low management fees and performance which tracked an index such as the S&P 500.
Exchange-Traded Funds (ETFs) are the newest major innovation and are similar to index funds but actively traded
on stock exchanges.
Mutual Funds
Mutual funds serve as a financial intermediary by pooling investments by individual investors and using the funds to
accommodate financing needs by governments and corporations in the primary market. They provide an important
service for individuals who wish to invest funds and diversify, and they offer liquidity in their willingness to
repurchase an investor's shares upon request (open-end funds). The companies (and each mutual fund is basically
a company) offer various services, such as transfers between funds within a fund "family" and check-writing
privileges. A mutual fund hires portfolio managers to invest in a portfolio of securities that satisfies the desires of
investors. The portfolio composition is adjusted in response to changing economic conditions (actively managed
funds). Within the U.S. today, there are about 8000 mutual funds.
Each mutual fund has a board of directors whose responsibilities include selecting and monitoring the fund's
management. The board of directors establishes its procedures and ensures that the fund is properly serving its
shareholders. Under new SEC rules, a majority of board members must be outsiders.
Types of Funds
There is a wide variety of funds, not just in the number and investment objectives, but in the ways in which they are
organized. Among the most visible are:
Open-end funds that are open to investment from investors at any time and allow investors to purchase or
redeem shares at any time. Consequently, they have a constantly changing number of shares. They
maintain some cash in case redemptions exceed investments. Investment objectives vary tremendously
across open-end funds from the most conservative to the most aggressive.
Closed-end funds do not repurchase shares they sell. Instead, they require investors to sell the shares on a
stock exchange. Thus, they have a constant number of outstanding shares. The aggregate size of closed-
end funds is small, representing only about 1/40th of the asset size of open-end funds. They focus primarily
on bonds and other debt securities that are less liquid than some other instruments.
Exchange-traded funds (ETF) are relatively new with the first ones being established in the 1990s. However,
they've grown quickly. ETFs are designed to mimic particular stock indexes and are traded on a stock
exchange. They differ from open-end funds in that their shares are traded on an exchange, and their share
price changes throughout the day. They typically track an index, but the first actively managed funds have
now been established. One of the attractions of ETFs is that shares can be bought on margin or sold short.
Hedge funds sell shares to wealthy individuals and financial institutions and use the proceeds to invest in
securities. They differ from open-end funds because:
They require a much larger initial investment
They may not always accept additional investments or accommodate redemption by having
significant "lock up" periods
They are unregulated and provide very limited information to prospective investors
They invest in a wide variety of investments to achieve high returns
They feature very high management fees relative to other funds, justified by the substantial, much-
better-than-market returns which they strive to achieve
Comparison to Depository Institutions
Mutual funds repackage the proceeds from individuals to make various types of investments, and they do so in the
same way that banks package together deposits in order to make loans. However for banks, the "counterparty" to
the depositor is the bank. It is the bank that must fund a withdrawal, regardless of how well or how poorly the loans
which it made fare. Investing in mutual funds represents partial ownership, and investors share the gains or losses
generated by the fund. The fund manager has a fiduciary responsibility to manage the fund in a professional
manner but is under no obligation regarding fund performance.
Influence of Mutual Funds

Large mutual funds can exert control over the management of firms because they are often a firm's largest
shareholders. For example, Fidelity is the largest shareholder of more than 700 firms. Portfolio managers of many
funds serve on the board of directors of various firms. Many firms discuss any major policy changes with analysts
and portfolio managers of funds to convince them that the change will have a favorable effect.
Regulation and Taxation

Mutual funds are regulated by both the SEC and state regulators. Funds must register with the SEC and provide a
prospectus but are also regulated by state laws.
Mutual Funds by Assets 2014
Source: Investment Company Institute
Source: Investment Company Institute
The SEC is the primary regulator of mutual funds. Regulation focuses on fair treatment of investors and disclosure
including fees, sales practices, prohibition of insider trading (e.g., "front-running"). Several federal laws directly
affect mutual funds including the Securities Act of 1933, the SEC Act of 1934, the Investment Company Act of
1940 and the National Securities Markets Improvement Act of 1996.
Mutual funds are not taxed on income and capital gains if a fund distributes 90% or more of its taxable income to
shareholders. Dividends and capital gains are passed through to the investors on an annual basis and are taxed as
if they've been paid even if the investors have not sold their shares.
Mutual Fund Prospectuses

The prospectus is one of the primary documents for a mutual fund. It identifies the minimum amount of investment
required, the investment objective(s), the return on the fund over the past year, the past three years, and the past
five years, the exposure of the fund to various types of risk, services offered by the fund and the fees incurred by
the fund that are passed onto investors.
Net Asset Value (NAV)

The net asset value (NAV) of a mutual fund indicates the value per share. It is calculated each day by determining
the market value of all securities comprising the fund, adding interest or dividends, and subtracting expenses, then
dividing by the number of shares outstanding. The calculation is rather straightforward.
Philly Mutual Fund has 50 million shares issued to its investors. It used the proceeds to buy stock in 100 different
firms. These shares have a market value of $100 million. In addition, Philly incurred $7,000 in expenses today and
collected interest and dividends totaling $5,000. What is the net asset value per share?
Net Asset Value = Market Value of Fund/Number of Shares Outstanding

= ($100,000,000 + $5000 - $7000) 50,000,000
= $99,998,000/50,000,000
= $2.00 per share
Mutual Fund Returns and Expenses

Mutual funds generate returns to shareholders in three ways:
1. They pass on earned income as dividend payments

2. They distribute capital gains resulting from the sale of securities within the fund
3. Their share price appreciation reflects the increase in the value of the underlying assets before capital gains
are realized
Expenses Incurred by Shareholders

Mutual funds pass their expenses on to their shareholders. Expenses can be compared among mutual funds by
comparing the expense ratio that equals the annual expenses per share divided by the NAV.
Expenses include general management, analytics, portfolio management, marketing, overhead. The higher the
expense ratio, the lower the return for a given level of performance. Mutual funds with lower expense ratios tend to
outperform others with similar objectives.
Expenses include the compensation to the portfolio managers and other employees, record-keeping and clerical
fees, marketing fees and 12b-1 fees which cover advertising expenses or compensate brokerage firms that advised
their clients to invest in that fund. Rather remarkably, the mutual fund industry is one of the few where customers
are explicitly charged for the marketing expense that provides absolutely no net benefits to them.
12b-1 fees were allowed in 1980 as distribution fees and have sometimes been used by funds to pay a commission
to a broker whose clients invested in the fund. They may be charged instead of or in addition to loads (see load
funds, below). However, they are subject to much controversy because many funds do not specify how they use
the money received.
Load funds have an explicit sales charge. They are promoted by brokerage firms who earn a sales charge between
3% and 8.5% for selling the fund. Investors pay the sales charge through the difference between the bid and ask
prices of the load fund. Front-end load funds are paid when a fund is purchased while back -end load funds are paid
when the fund is sold/redeemed. No-load funds are promoted strictly by the mutual fund company that sponsors
them, like Fidelity or Vanguard. No-load funds are often preferred by investors who feel capable of making their own
investment decisions and dislike the added expense item. Recently, some small no-load funds have become load
funds because they could not attract sufficient investors, so they needed a wider group of stock brokers marketing
the funds for them.
Investing Style
Funds are often grouped together on the basis of their general objectives – growth of principal, preservation of value,
generation of current income – and the types of companies in which they invest – large, mid-sized or small. The
funds are then often identified within a "style box" as shown in the illustration below.
Among the more common styles are:
Growth Funds which include stocks of companies that have shown or are expected to show rapid earnings
and revenue growth. Growth stocks are riskier investments than most other stocks and usually make little
or no dividend payments to shareholders. The primary objective is capital appreciation.
Value Funds which include stocks that are considered to be undervalued based upon such ratios as price-
to-book or price-to-earnings (P/E). These stocks generally have lower price-to-book and price-earnings
ratios, higher dividend yields and lower forecasted growth rates than growth stocks.
Growth and Income Funds/Blend which are designed to pursue long-term growth as well as regular dividend
income.
International and Global Funds invest in foreign securities. Returns on international funds are affected by the
foreign companies' stock prices and the movements of the currencies that denominate the stocks. Global
funds include some U.S. stocks while international funds typically focus on only companies outside the
U.S.
Specialty Funds focus on a group of companies sharing a particular characteristic such as energy or
banking.
Index Funds are designed to match the performance of an existing stock index. Fees and asset
turnover tend to be very low compared with actively managed funds. For example, the Vanguard 500
tracks the S&P 500 index.
Multi-fund Funds/Fund of Funds invest in a portfolio of different mutual funds to achieve more diversification.
Often, the management fees for fund of funds are higher because there are two sets of management fees
included.
Income Funds are composed of bonds that offer periodic coupon payments and vary in exposure to risk.
Corporate bonds are subject to credit risk; Treasury bonds are not. Bonds backed by government agencies
are less risky than corporate bonds but have a lower return. Income funds may also focus on equities of
companies paying relatively high and stable dividends.
Tax-free Funds contain municipal bonds that allow investors in high tax-brackets to avoid taxes while
maintaining a low degree of credit risk.
High-yield (Junk ) Bond Funds consist of at least two-thirds of bonds rated below Baa by Moody's or BBB by
S&P.
Bond funds are commonly segmented according to the maturities of the bonds they contain; intermediate-
term bonds invest in bonds with five to ten years remaining to maturity and long-term bond funds contain
bonds with 15 to 30 years until maturity. As we've discussed previously, long-term bonds generally pay a
higher rate of interest but also have more interest-rate risk.
Asset Allocation Funds contain a variety of investments such as stocks, bonds, and money market
securities. Portfolio managers adjust the compositions of these funds in response to expectations.
The number of stock and bond funds is substantially larger today than it was during the 1980s. Growth funds,
income funds, international and global funds, and long-term municipal bond funds are the most popular types of
bonds; growth and income funds are the most popular when measured according to total assets. Common stocks
are clearly the dominant asset maintained by mutual funds.
Increasingly, large funds are being "closed" to new investors, most often when the asset base becomes too large
to allow the fund to be managed flexibly. Small- and mid-cap funds, specialty sector and country-specific funds
have been the most frequently closed. Though experience is limited, closed funds have not generally outperformed
open funds. More recently, decreases in market values have caused some "closed to new investors" funds to be
reopened.
Performance of stock mutual funds depends on:
Change in market conditions. A mutual fund's performance is closely related to market conditions. The
mutual fund's beta can be used to measure the sensitivity of the fund's exposure to market conditions.
Change in sector conditions. The performance of a fund focused on a specific sector is influenced by market
conditions in that sector. In the late 1990s, many funds focused on technology stocks which did extremely
well for a period and subsequently, extremely badly.
Change in management abilities. Mutual funds in the same sector can have different performance levels
because of differences in management abilities. Actively-managed funds depend on a "stock picker's"
expertise and luck. Index funds are much less susceptible to the manager's abilities. An efficient fund has
low expenses and high returns.
Repeated studies have shown that only a minority of actively-managed funds outperforms the benchmark indices
with any regularity, and consistent outperformance by an actively-managed fund is rare. This is another argument
for preferring index funds with their low management fees.
Performance of bond mutual funds depends on:
Change in the risk-free rate. Bond prices are inversely related to changes in the risk-free interest rate. Bond
funds focused on longer maturities are more exposed to interest rate changes.
Change in the risk premium. Bond prices decline in response to an increase in the risk premium. Poor
economic conditions tend to increase the risk premium.
Change in management abilities. The performance of specific bond classifications varies due to differences
in managers' abilities. Given the lower level of liquidity in the bond market, an active manager may be able,
through better research, to outperform a benchmark.
The performance of any given mutual fund may be primarily driven by a single economic factor. For example,
growth funds are highly dependent on the stock market's performance. Diversification across different styles and
particular funds within a style reduces susceptibility to any particular type of risk. However, within a particular
"style" or size classification, the performance of funds has a much higher correlation. Hence, investing in several
"large cap growth funds" is likely to yield only a modest diversification benefit.
The performance should be compared to a market index, and risk should be considered. Most studies find that
mutual funds do not outperform the market, especially when accounting for the type of securities that the fund
invests in. Even when returns are adjusted for risk, mutual funds fail to outperform the market. One exception is
emerging markets which may reflect those markets' lower efficiency.
Research on bond mutual fund performance also indicates that, in general, bond funds underperform bond indexes.
Bond mutual funds with higher expense ratios generate lower returns, on average. However, past performance does
not generally serve as a useful indicator for future performance in this sector.
Both results suggest that index funds are, in general, better selections than actively managed funds.
Scandals in Mutual Funds

As mentioned previously, in 2003, some funds were allowing their large clients to buy or sell the fund's shares after
the 4 p.m. closing but at the 4 p.m. prices. Late trading involves engaging in a trade on "stale" prices. This practice
clearly violated 1968 SEC laws. The SEC investigated mutual funds once this problem was publicized and heavily
fined some mutual funds. It was clearly attempting to restore investor confidence in mutual funds by prosecuting
mutual fund managers.
Governance of Mutual Funds

The roles and responsibilities of the investment company owners are different from the shareholders on the fund.
Some managers employed by mutual funds invest in the investment company rather than in the mutual funds it
manages, or they may be employees of a totally separate investment advisory firm. Consequently, there is an
incentive to charge high fees.
Each fund has a board of directors that is supposed to represent shareholders. The SEC requires that a majority of
the board of directors be independent.
Money Market Funds

Money mark et funds are portfolios of money market instruments constructed and managed by investment
companies. They allow investors to participate for a very small initial investment, often as little as $1,000, and
usually allow check-writing privileges. Their objective is to maintain the share value at $1. Viewed as the ultimate in
safe investments, one major firm's failure to maintain this value, to "break the buck," caused severe disruption in
the market at the beginning of the financial crisis.
Asset Composition of Money Market Funds
Investors place their money in money market funds for safety, not high return. Consequently, the safety and
liquidity of their investments is paramount. Nevertheless, competition among money market funds is keen, and
they attempt to find ways to generate even a few basis points of additional return.
As shown in the table below, the largest asset categories for MMFs include T-bills and other Treasury securities,
agency payer and repos. Other assets include commercial paper. Some funds encountered significant problems
when they invested in asset-backed commercial paper which lost significant value and auction-rate preferred
securities which, although with a long maturity, were viewed as suitable for MMF due to their frequent repricing and
assumed superior liquidity. When several auctions "failed" and liquidity for the auction-rate preferred disappeared,
the funds were forced to recognize a loss on these investments. Some money market funds only focus on
municipal securities thus providing a tax-free return to their investors. In the same way, the maturity structure of
fund assets is relatively short.
Management of Money Market Funds

The MMF portfolio manager maintains an asset portfolio that satisfies the underlying objective of the fund. If
economic conditions change, managers may change the asset composition to add slightly more risk to the
portfolio; they may do so by adding more commercial paper or by extending the maturity. However, compared with
other portfolio managers, MMFs have less flexibility to change their portfolio composition because of their stated
objectives.
Regulation and Taxation of Money Market Funds
The Securities Act of 1933 requires sponsoring companies to provide full information on any MMFs they offer and a
prospectus that describes the fund's investment policies and objectives. The Investment Company Act of 1940
contains numerous restrictions that prevent a conflict of interest by the fund's managers. As with other funds, if a
fund distributes at least 90 percent of its income, the fund itself is exempt from federal taxation.
Closed-End Mutual Funds

Closed-end funds have a fixed number of shares outstanding. Companies do not exchange/redeem shares.
Shareholders must buy/sell shares from/to other investors. Consequently, share price may vary significantly from
the NAV of the shares. Closed-end fund shares typically trade at a modest discount to the NAV, but this difference
varies substantially over time.
Closed-end funds tend to focus on asset classes that are less liquid than open-ended mutual funds; this could
include bonds, emerging markets or smaller-cap companies.
Exchange-Traded Funds (ETF)

ETFs were first introduced in the early 1990s. They bear a close resemblance to index funds but feature some
unique elements which have made them very attractive to investors. ETFs are securities that track an index, a
commodity or a basket of assets like an index fund, but an ETF trades like a stock on an exchange, thus
experiencing price changes throughout the day as it is bought and sold. They have been sponsored by many of the
same companies that sponsor mutual funds. Barclay's iShares, State Street's streetTracks, Merrill Lynch Holdrs,
PowerShares, Vanguard and Fidelity are among the largest sponsors. ETFs have been the fastest-growing
segment of mutual fund industry. While the original funds tracked established indexes such as S&P 500 (SPDRS),
ETFs have been increasingly used for specialty sectors – industry, geography, commodities, etc. At the end of
2009, there were approximately 800 ETFs with total assets of $800 bil. in market capitalization.
Because it trades on an exchange like an individual stock, an ETF's price can vary continuously. It is not simply
set on a daily basis like a mutual fund. The intra-day prices may vary slightly from the underlying index. They can
be purchased on margin or sold short. A commission is paid on the purchase and sale to the executing broker, but
management fees tend to be modest, again akin to index funds. New ETFs are being launched which feature active
management rather than index tracking.
The similarities to index mutual funds are that (to date) they track indexes and feature passive management.
Management fees are generally low. The differences are perhaps more important:
Prices of the ETF vary during the trading day versus a set price during the day for mutual funds
Prices of the ETF are set by demand/supply versus the net asset value of the mutual funds
Brokerage fee for purchasing/selling an ETF is similar to the load on mutual fund
ETFs can be bought on margin or shorted
No capital gains or losses on ETF until investor sells position versus the annual distribution of gains/losses
on mutual funds
Hedge Funds
While hedge funds have been around for many years, they have attracted attention only in the last decade or so.
Hedge funds encompass a wide range of private investment funds that pursue a myriad of strategies, often using
high leverage and the use of derivatives to obtain returns significantly above the market. This also entails a high
degree of risk, and the returns from hedge funds can be quite volatile. Hedge funds sell shares to wealthy
individuals and financial institutions and use the proceeds to invest in securities. They have historically been
unregulated but are not allowed to advertise.
Hedge funds are usually organized as limited partnerships. Many "lock in" investors' funds for an extended period
of time but may allow investors to withdraw their investments with advance notice of 30 days or more.
Hedge Fund Fees
Management fees for hedge funds are extremely high compared to those of mutual funds. They usually range from
1 to 2% of the total asset base per year with additional incentive fees of often 20% on the return of the fund. Such
fees are justified by the companies as reflecting the very high rates of return that the funds have generated in the
past.
Regulation
Hedge funds are not regulated but will be required to register with the SEC under the Dodd-Frank Act.
Hedge Fund Investment Strategies
Hedge funds pursue a variety of strategies. Among the most frequently-pursued strategies are:
Global macro strategies tied to economic trends and developments including currency speculation
Acquisitions tied to potential mergers and acquisitions
Arbitrage including indexes, fixed income, closed-end funds and convertibles. These are based on
sometimes very small differences between market prices for different but related instruments
Short/long strategies using both shorting and taking of long positions often using a high degree of leverage
Market-neutral strategies designed to produce a reasonable rate of return regardless of market trends
Because they are private companies with negligible regulation, data on the size and performance of hedge funds is
difficult to get. What is available is provided by a few organizations such as Hedge Fund Research Inc (HFRI).
Real Estate Investment Trusts (REIT)

REITs are closed-end mutual funds that invest in real estate or mortgages. They allow small investors to participate
in the real estate sector with a low minimum investment. A REIT generates income by passing through rents on
real estate or interest payments on mortgages. Shares in REITs are typically bought and sold on a stock
exchange.
There are several basic classifications for REITs based on the type of assets they hold—an equity REIT, a
mortgage REIT, or a hybrid, depending on whether the REIT holds equity in the properties or mortgages on those
properties.
REITs are regulated under the federal Real Estate Investment Act of 1960 and state regulation. They are exempt
from federal income tax, if they pass on at least 90% of their net income to shareholders and if at least 75% of
income arises from real estate; in this respect, REITs are similar to mutual funds.
Investment in REITs have been cyclical, increasing rapidly in good real estate markets and then flattening or falling
during down markets.
Venture Capital
Venture capital firms (VCs) are private equity financing, generally providing financing to companies in the early
stages of development. Managerial and financing advice is provided to the companies in which they invest. Their
intent is usually to provide financing for a relatively short period of time to act as a bridge between the founders'
start-up money and an initial public offering (IPO).
VCs often classify their investments by the company's "stage" of development. These terms are flexible:
Seed financing is at the "idea" stage

Start-up financing is capital used in product development
First-stage financing is capital to initiate manufacturing and sales
Second-stage financing is for initial expansion
Third-stage financing allows for major expansion
Mezzanine financing prepares the company to go public
VCs generally demand substantial control over management decisions, including seats on the board of directors,
even if they do not control a majority of the stock. VCs think of rates of returns in terms of multiples of the amount
invested. For example, if a VC expects to receive ten times the amount invested over six years, this would be a
47% annual rate of return. A less risky third-stage investment might return five times the amount invested over five
years (38% per year). These rates of return are justified (by the VCs) on the basis of the risks that they incur and
the understanding that some investments provide no return at all (and lose the initial investment as well).

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2019/4/17 Module 5 Compiled

Module 5 - Compiled Content

Module 5 Study Guide and

Lecture Nonbank Financial Institutions

Readings: Madura: Ch. 22, 23, 24, and 25

Discussions: 5: Large Insurance Companies

Initial post due by Wednesday, April 17

Activities: Case Study #2 The U.S. Banking Panic

msm_ad712_13_su2_bchambers_w05 is displayed here

Non-Bank Financial Institutions

Sources of Investment Banking Revenue

Underwriting Fees from underwriting stock or bond offerings

Fees for advice to firms about identifying potential targets, valuing

Restructuring Fees for facilitating mergers, divestitures, carve-outs, spin-offs

Management fees Fees for managing securities portfolios

Fees for executing trades securities requested by individual or firms

Margin interest Interest charged to investors who buy securities on margin

Investing its own funds

Investing Profits from investing in securities

Regulation of Securities Firms

The Glass-Steagall Act (1933)

Financial Services Modernization Act (1999)

Rules Regarding Analyst Compensation and Ratings

Rules Preventing Abuse in the IPO Market

Repeal of the Trade-Through Rule

Mutual Fund Disclosure

Basel II and Basel III

Dodd-Frank Act (2010)

Markets in Financial Instruments Directive (2007) (MiFID)

Investment Banking Risks

Competition between Securities Firms and Commercial Banks

Global Expansion of Investment Banks

Insurance premium is based on:

Life Insurance Assets

Types of Life Insurance

Balancing Risk and Reward

Rate Setting and Return for Life Insurers

more money, A2, and thus will realize an economic profit.

Property and Casualty Sources and Uses of Funds

Health Care Insurance

Insurance Company Risks

Liquidity can be measured as:

Liquidity ratio = Invested assets/[Loss reserves + premium reserves]

The profitability of an insurance company can be measured by:

Return on net worth = Net profit/Policyholders' surplus

Underwriting gains or losses are measured by:

Net underwriting margin = [Premium income – Policy Expenses]/Total Assets

where policy expenses include payouts on policy claims

Pension Fund Assets

Percentage of assets that should be used for stocks or bonds

Corporate Control by Pension Funds

Performance Evaluation of Pensions Plans

Comparison to Depository Institutions

Influence of Mutual Funds

Regulation and Taxation

Mutual Funds by Assets 2014

Source: Investment Company Institute

Source: Investment Company Institute

Mutual Fund Prospectuses

Net Asset Value (NAV)

Net Asset Value = Market Value of Fund/Number of Shares Outstanding

Mutual Fund Returns and Expenses

1. They pass on earned income as dividend payments