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Chapter 25

Insurance and Pension Fund Operations

Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline

Background Life insurance operations Property and casualty insurance operations Health care insurance operations Business insurance Regulation of insurance companies Exposure to risk Valuation of an insurance company Performance evaluation

Chapter Outline (contd)

Interaction with other financial institutions Participation in financial markets Multinational insurance companies Background on pension funds Pension regulations Pension fund management Performance of pension funds Pension fund participation in financial markets Participation in financial markets


Insurance companies:

Provide various form of insurance and investment services to individuals Charge a fee (premium) for the services Provide a payment to the insured (or a named beneficiary) under conditions specified by the insurance policy contract 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

Background (contd)

Individuals who are more exposed to specific conditions that cause financial damage will purchase insurance against those conditions

Adverse selection problem

Insurance can cause the insured to take more risks because they are protected

Moral hazard problem

Underwriters are employed by insurance companies to calculate the risk of specific insurance policies

Decide what types of policies to offer based on the potential level of claims and the premiums that they could charge

Background (contd)

Determinants of insurance premiums


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

Background (contd)

Investments by insurance companies


companies invest premiums and fees until the funds are needed to pay claims Investment decisions balance the goals of return, liquidity, and risk

Those insurance companies whose claims are less predictable need to maintain more liquidity

Life Insurance Operations

Life insurance companies:

Are a dominant force in the industry

Generate more than $100 billion in premiums each year

Compensate the beneficiary of a policy upon the policyholders death Charge a premium that reflects the probability of making a payment as well as the size and timing of the payment Have historically forecasted with reasonable accuracy the benefits they will have to provide Use actuarial tables and mortality figures to forecast the percentage of policies that will require compensation

Life Insurance Operations (contd)

Group plans:

offered to employees of a corporation Can be distributed at a low cost because of high volume Make up about 40 percent of total life coverage

Life Insurance Operations (contd)

There are about 2,000 life insurance companies Companies are classified as either stock or mutual ownership

stock-owned company is owned by shareholders A mutual company is owned by the policyholders About 95 percent of companies are stock-owned Mutual companies are large and account for more than 46 percent of total assets of all life insurance companies

Life Insurance Operations (contd)

Types of life insurance

Whole life insurance:

Protects policyholders until death or as long as premiums are paid Builds a cash value that the policyholder is entitled to even if the policy is canceled Generates periodic premiums for the life insurance company that can be invested Typically provides a fixed amount of benefits Is temporary, providing insurance only over a specified term Does not build a cash value Is significantly less expensive than whole life insurance Includes decreasing term insurance, where benefits decrease over time

Term insurance:


Life Insurance Operations (contd)

Types of life insurance (contd)


life insurance:

Provides benefits that vary with the assets backing the policy Includes flexible-premium variable life insurance, providing flexibility on the size and timing of payments


life insurance:

Combines the features of term and whole life insurance Specifies a period of time over which the policy will exist but also builds a cash value Allows flexibility on the size and timing of the premiums

Life Insurance Operations (contd)

Sources of funds

most important source is annuity plans

Offer a predetermined amount of retirement income to individuals


second largest source of funds is premiums The third largest source of funds is investment income


Life Insurance Operations (contd)

Uses of funds

Life insurance companies are major institutional investors Government securities

Life insurance companies invest in U.S. Treasury securities, state and local government bonds, and foreign bonds Corporate bonds are the most popular asset of life insurance companies

Corporate securities

Some focus on high-grade bonds, others invest a portion in junk bonds Life insurance companies expect to maintain some bonds until maturity

Corporate stock is another use of funds, but significantly less than bonds

Life Insurance Operations (contd)

Uses of funds (contd)


Life insurance companies hold all types of mortgages:

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 percent of total mortgages held by life insurance companies

Real estate

Life insurance companies 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

Life Insurance Operations (contd)

Uses of funds (contd)

Policy loans Life insurance companies lend funds to whole life policyholders

Can borrow up to their policys cash value at a guaranteed rate of interest

Capital Insurance companies retain earnings or issue new stock Capital is used to finance investment in fixed assets and as a cushion against operating losses Insurance companies are required to maintain adequate capital

Life Insurance Operations (contd)

Asset management of life insurance companies

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


Property and Casualty Insurance Operations

PC insurance protects against fire, theft, liability, and other events that result in damage

insurance protects businesses and individuals from the impact of financial risks associated with the ownership of property

e.g., buildings, cars


insurance protects policyholders from potential liabilities for harm to others as a result of product failure or accidents


Property and Casualty Insurance Operations (contd)

There are about 3,800 individual PC companies

The largest are State Farm, Allstate, Farmers Insurance, and Nationwide Insurance

No single company controls more than 10 percent of the market The PC insurance business is only about one-fourth the life insurance business in aggregate The PC insurance business generates about the same amount of insurance premiums as the life insurance business Many companies are offering both life and PC insurance

Property and Casualty Insurance Operations (contd)

PC insurance characteristics:

are for one year or less Encompasses a wide variety of activities from auto insurance to business liability insurance Forecasting the amount of future compensation is more difficult for PC insurance than for life insurance


Property and Casualty Insurance Operations (contd)

Cash flow underwriting

As interest rates decline, the price of insurance rises to offset decreased investment income Cash flow underwriting can backfire for companies that focus on what they can earn in the short run and ignore what they will pay out later Municipal bonds dominate, followed by Treasury bonds and common stock PC companies have a much higher concentration on government bonds than life insurance companies

Uses of funds

Property and Casualty Insurance Operations (contd)

Property and casualty reinsurance:

Effectively allocates a portion of insurance companies return and risk to other insurance companies Is similar to a commercial banks acting as a lending agent by allowing other banks to participate in the loan Allows a company to write larger policies because a portion of the risk involves will be assumed by other companies

Fewer companies are offering reinsurance because of generous court awards and the difficulty in assessing the amount of potential claims


Health Care Insurance Operations

Insurance companies:

Offer coverage for hospital stays, physician visits, and surgeries Serve as intermediaries between health care providers and the recipients of health care An indemnity plan reimburses insured individuals for health care offered by health care providers A managed health care plan allows insured individuals to obtain health care services from specified health care providers who participate in the plan

Types of health care plans

Premiums are generally lower and payment is typically made directly to the provider Individual must choose providers who participate in the plan

Health Care Insurance Operations (contd)

Managed health care plans


maintenance organizations (HMOs)

Require individuals to choose a primary care physician who functions as a gatekeeper for that individuals health care Patients must first see their PCP to obtain referrals


provider organizations (PPOs)

Usually allow insured individuals to see any physician without a referral Insurance premiums are higher than HMO insurance premiums

Health Care Insurance Operations (contd)

Health care insurance in the future


care expenses have risen dramatically in recent years

Some insurance companies that provide health care insurance have incurred major losses Insurance companies increased their premiums


status of health care insurance and reimbursement is subject to changes caused by possible health care reform


Business Insurance

Insurance companies provide a wide variety of business insurance policies Property insurance:

Protects a firm against the risk associated with ownership of property Provides insurance against property damage by fire or theft Can protect a firm against potential liability for harm to others as a result of product failure Is important because of increasing lawsuits Can protect a business against potential liability from its employees

Liability insurance:

Business Insurance (contd)

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


Business Insurance (contd)

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


Regulation of Insurance Companies

The insurance industry is regulated by state agencies (commissioners)

Ensure that companies are providing adequate services and approve rates Insurance agents must be licensed Evaluate the asset portfolios to ensure that investments are reasonably safe

The National Association of Insurance Commissioners (NAIC):

Facilitates cooperation among the various state agencies Attempts to maintain a degree of uniformity in common reporting issues Conducts research on insurance issues and participates in legislative discussions

Regulation of Insurance Companies (contd)

The Insurance Regulatory Information System (IRIS):


been developed by a committee of state insurance agencies Assists in each states regulatory duties Compiles financial statements, lists of insurers, and other relevant information Assess the companies respective financial statements by calculating 11 ratios that are then evaluated by NAIC regulators

Regulation of Insurance Companies (contd)

Assessment system

The regulatory system is designed to detect any problems in time to search for a remedy Commonly used financial ratios are intended to assess:

The ability of the company to absorb either losses or a decline in the market value of its investments Return on investment Relative size of operating expenses Liquidity of the asset portfolio

Financial characteristics are monitored to ensure companies do not become overly exposed to credit risk, interest rate risk, and liquidity risk

Regulation of Insurance Companies (contd)

Regulation of capital

1994, insurance companies have been required to report a risk-based capital ratio to insurance regulators

Created by the NAIC Intended to force those companies with a higher exposure to claims, losses, and interest rate risk to hold a higher degree of capital Discourages companies from excessive exposure to risk Forces companies that take high risks to back their business with a large amount of capital

Exposure to Risk

Interest rate risk


carry a lot 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 Have been investing in long-term assets that offer floating rates Have increasingly been utilizing futures contracts and interest rate swaps to manage their exposure

Exposure to Risk (contd)

Credit risk

Corporate bonds, mortgages, state and local government securities, and real estate holdings are subject to credit risk Some insurance companies only invest in assets with a high credit rating and diversify among securities Some insurance companies became insolvent in the early 1990s as a result of losses on real estate investments The value of stock portfolios managed by insurance companies declined in 20012002

Market risk


Exposure to Risk (contd)

Liquidity risk

high frequency of claims at a single point in time could negatively affect a companys performance Companies 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

Valuation of an Insurance Company

The value of an insurance company is the present value of its future cash flows

value should change in response to changes in expected cash flows and in the required rate of return: V f E(CF ), k -


Valuation of an Insurance Company (contd)

Factors that affect cash flows

The change in expected cash flows can be modeled as:

E(CF ) f ( PAYOUT , ECON , Rf , INDUS, MANAB ) ?

Change in payouts

Payouts are stable for life insurance companies but can be volatile for PC companies Economic growth increases income for firms and individuals Debt securities are less likely to default during periods of economic growth

Change in economic conditions

Valuation of an Insurance Company (contd)

Factors that affect cash flows (contd)


in the risk-free interest rate

The valuation of an insurance company is inversely related to interest rate movements


in industry conditions

Industry conditions include regulatory constraints, technology, and competition Competition within the insurance industry has become more intense because of reduced barriers


Valuation of an Insurance Company (contd)

Factors that affect cash flows (contd)


in management abilities

Managers make decisions that will capitalize on external forces the company cannot control Skillful managers determine the likelihood of events that will necessitate payouts, compute the present value of cash outflows, and analyze the creditworthiness of firms issuing the bonds insurance companies purchase


Valuation of an Insurance Company (contd)

Factors that affect the required rate of return by investors:

k f ( Rf , RP )

The risk-free rate is positively related to inflation, economic growth, and the budget deficit level, but inversely related to money supply growth The risk premium is inversely related to economic growth and the companys management skills Regulatory constraints may discourage firms from taking excessive risk Loosening of regulatory barriers to entry may increase the risk of insurance companies

Performance Evaluation

A time-series assessment of the dollar amount of insurance premiums indicates growth A time-series analysis of investment income can be used to assess the performance of portfolio managers Liquidity can be measured as:
Liquidity ratio Invested assets Loss reserves and unearned premium reserves


Performance Evaluation (contd)

The profitability of an insurance company can be measured by:

Return on net worth Net profit Policyhold ers' surplus


profit includes underwriting profits, investment income, and realized capital gains Underwriting gains or losses are measured by:
Premium income - Policy expenses Net underwriting margin Total assets

Interaction with Other Financial Institutions

Type of Financial Institution
Commercial banks and SIs

Interaction with Insurance Company

Compete with banks and SIs to finance LBOs Compete with banks and SIs by offering CDs Compete with banks by offering an account on which checks can be written Merge with banks to offer various banking services Face increased competition for insurance-related services from banks and Sis Commonly purchase loans that were originated by banks Are sometimes acquired by finance companies and maintained as subsidiaries Compete directly with securities firms by offering mutual funds

Finance companies Securities firms


Interaction with Other Financial Institutions (contd)

Type of Financial Institution
Brokerage firms

Interaction with Insurance Company

Compete directly with brokerage firms by offering securities-related services Compete directly with brokerage firms that offer insurance-related services Compete directly with investment companies to finance LBOs Commonly purchase stocks and bonds issued by corporations that were underwritten by investment banking firms Issue stock that is underwritten by investment banking firms

Investment banking firms

Pension funds

Offer to manage pension plans for corporations


Participation in Financial Markets

Type of Financial Market
Money markets Bond markets

Participation by Finance Companies

Maintain a portion of their funds in money market securities, such as Treasury bills and commercial paper, to maintain liquidity Life insurance company assets and PC insurance company assets are allocated to corporate bond portfolios Frequently purchase bonds that are directly placed and are less likely to liquidate these bonds before maturity Purchase Treasury bonds for their safety and liquidity Purchase foreign bonds, primarily issued by Canadian firms Have allocated some of their assets to a mortgage portfolio, mostly conventional mortgages Have allocated a portion of their assets to a stock portfolio, often including foreign stocks

Mortgage markets Stock markets


Participation in Financial Markets (contd)

Type of Financial Market
Futures markets

Participation by Insurance Companies

Sell futures contracts on bonds or a bond market index to hedge their bond and mortgage portfolios against interest rate risk Take positions in stock market index futures to hedge their stock portfolios against market risk Purchase call options on particular stocks they plan to purchase in the future Purchase put options or write call options on stocks they own that may experience a temporary decline in price Commonly engage in interest rate swaps to hedge the exposure of their bond and mortgage portfolios to interest rate risk

Options markets

Swap markets


Background on Pension Funds

Pension plans provide a savings plan for employees that can be used for retirement Public pension funds can be either state, local, or federal

Social Security Many public pension plans are funded on a pay-asyou-go basis


Background on Pension Funds (contd)

Private pension plans


a defined-benefit plan, contributions are dictated by the benefits that will eventually be provided A defined-contribution plan provides benefits that are determined by the accumulated contributions and the funds investment performance


Background on Pension Funds (contd)

Underfunded pensions

obligations are uncertain because they depend on salary levels, retirement ages, and life expectancies In the early 1990s, many defined-benefit plans used optimistic projections of the rate of return on their investments

When projected rates of return were overestimated, the pension funds became underfunded Some pension funds have made high risk investments in real estate, junk bonds, and international securities

Pension Regulations

Regulation varies with the type of 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)

100 percent vesting after five years, or Graded vesting, with 20 percent vesting in the third year, 40 percent in the fourth, 60 percent in the fifth, 80 percent in the sixth, and 100 percent in the seventh Requires pension funds to concentrate their investment in highgrade securities Allows employees changing employers to transfer any vested amount into the pension plan of their new employer or to invest it in an IRA


Pension Regulations (contd)

The Pension Benefit Guaranty Corporation:


established by ERISA to provide insurance on pension plans Guarantees that participants of defined-benefit pension plans will receive their benefits upon retirement If financed by annual premiums, income from assets acquired from terminated pension plans, and income generated by investments Monitors pension plans periodically to determine whether they can provide benefits

Pension Fund Management

Private pension portfolios are dominated by common stock Public pension portfolios are evenly invested in corporate bonds, stocks, and other credit instruments 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

Pension Fund Management (contd)

Management of insured versus trust portfolios


plans are managed by life insurance companies Some pension plans are managed by trust departments of financial institutions, such as commercial banks


Pension Fund Management (contd)

The corporation owning the pension specifies guidelines:


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

Pension Fund Management (contd)

Management of portfolio risk

Very concerned about interest rate risk

May periodically hedge by selling bond futures

Portfolio managers may periodically sell futures contracts on stock indexes to hedge against market downturns 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

Corporate control by pension funds

Performance of Pension Funds

Determinants of a pension funds stock portfolio performance



in market conditions

Stock portfolios performance is usually closely related to market conditions


in management abilities

Stock portfolio performance can vary among pension funds in a particular time period because of differences in management abilities


Performance of Pension Funds (contd)

Determinants of a pension funds bond portfolio performance

PERF f ( Rf , RP, MANAB )

Change in the risk-free rate

Bond prices are inversely related to changes in the risk-free interest rate
Bond prices are inversely related to changes in the risk premiums required by investors who purchase bonds Bond portfolio performance can vary among pension funds in a particular time period because of differences in management abilities

Change in the risk premium

Change in management abilities

Performance of Pension Funds (contd)

Performance evaluation

If the manager can adjust the relative proportion of stocks versus bonds, portfolio performance should be compared to a representative benchmark Any difference between the performance of the pension portfolio and the benchmark portfolio would results from

The managers shift in the relative proportion of bonds versus stocks The composition of bonds and stocks within the respective portfolios

In many cases, the performance of stocks and bonds in a pension fund are evaluated separately

Performance of Pension Funds (contd)

Performance of pension portfolio managers


objective is to make investments that will earn a large enough return to adequately meet future payment obligations Some research has found that managed pension portfolios perform no better than market indexes

Pension funds may consider investing in indexed mutual funds


Pension Fund Participation in Financial Markets

Type of Financial Institution
Commercial banks Insurance companies Mutual funds Brokerage firms and investment banking firms

Interaction with Pension Fund

Commercial banks sometimes manage pension funds Funds purchase commercial loans that are sold by commercial banks Insurance companies create annuities for pension funds Funds invest in various mutual funds Brokerage firms execute securities transactions for pension funds Brokerage firms offer investment advice to pension portfolio managers Investment banks act as advisers on LBOs in which pension funds participate Investment banks underwrite newly issued stocks and bonds that are purchased by pension funds


Participation in Financial Markets

Type of Financial Market
Money markets Bond markets Mortgage markets Stock markets Futures markets Options markets Swap markets

Participation by Pension Fund

Maintain a small proportion of liquid money market securities that can be liquidated At least 25 percent of a pension fund portfolio is typically allocated to bonds Pension portfolios frequently contain some mortgages At least 30 percent of a pension fund portfolio is typically allocated to stocks Some pension funds use futures contracts on debt securities and on bond indexes to hedge the exposure of their bond holdings to interest rate risk Some pension funds use stock options to hedge against movements of particular stocks Pension funds commonly engage in interest rate swaps to hedge the exposure of their bond and mortgage portfolios to interest rate risk