CHAPTER 21

Insurance
Companies and
Pension Funds

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All rights reserved.
 Insurance Companies
 Insurance companies assume the risk of
their clients in return for a fee, called
the premium.
 Most people purchase insurance because
they are risk-averse—they would rather pay
a certainty equivalent (the premium) than
accept a gamble

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 Insurance Companies:
Major Employer

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 Fundamentals of Insurance

Although there are many types of insurance

and insurance companies, there are seven
basic principles all insurance companies are
subject to:
1.There must be a relationship between the
insured and the beneficiary. Further, the
beneficiary must be someone who would
suffer if it weren’t for the insurance.

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 Fundamentals of Insurance

2. The insured must provide full and accurate

information to the insurance company.
3. The insured is not to profit as a result of
insurance coverage.
4. If a third party compensates the insured for
the loss, the insurance company’s
obligation is reduced by the amount of the
compensation.
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 Fundamentals of Insurance
5. The insurance company must have a large
number of insured so that the risk can be
spread out among many different policies.
6. The loss must be quantifiable. For example,
an oil company could not buy a policy on an
unexplored oil field.
7. The insurance company must be able to
compute the probability of the loss’s
occurring.
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 Adverse Selection and Moral
Hazard in Insurance

As we have seen in previous chapters,

asymmetric information plays a large role in
the design of insurance products. As with
other industries, the presence of adverse
selection and moral hazard impacts the
industry, but is fairly well understood the
insurance companies.

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 Adverse Selection in Insurance

The adverse selection problem raises the

issue of which policies an insurance company
should accept:
Those most likely to suffer loss are most
likely to apply for insurance.
In the extreme, insurance companies should
turn anyone who applies for an insurance
policy.
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 Adverse Selection in Insurance

However, insurance companies have

found reasonable solutions to deal with
this problem:
Health insurance policies require a
physical exam.
Preexisting conditions may be excluded
from the policy.

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 Moral Hazard in Insurance

Moral hazard occurs in the insurance industry

when the insured fails to take proper
precautions (or takes on more risk) to avoid
losses because losses are covered by the
insurance policy.
Insurance companies use deductibles to
help control this problem.

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 Selling Insurance
 Another problem is that most people don’t
purchase enough insurance. Insurance
companies use a strong sales force to
combat this.
─ Independent agents may sell the insurance products
of a number of different insurance companies.
─ Exclusive agents only sell the products of
one company.
─ An underwriter reviews each policy prior to its
acceptance to determine if the risk is acceptable.

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 Growth and Organization
of Insurance Companies
 The number of insurance companies grew
steadily until 1988, and since then the number
has fallen steadily.
 This can be seen in the next slide.

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 Growth and Organization
of Insurance Companies

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 Growth and Organization
of Insurance Companies
 The previous slide also shows that insurance
companies may be organized in two
difference ways:
─ A stock company is owned by shareholders and has a
profit motive
─ A mutual insurance company is owned by the
policyholders and attempts to provide the lowest
cost insurance

 At the end of 2005, only 135 of 1119 insurance

companies were mutual insurance companies.

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 Types of Insurance

Insurance is classified by which type of

undesirable event is covered:
Life Insurance
Health Insurance
Property and Casualty Insurance

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 Life Insurance
 Life insurance policies come in many forms.
Some of the typical policies include:
 Term Life: the insured is covered while the policy
is in effect, usually 10–20 years.
 Whole Life: similar to term life, but allows the
policyholder to borrow against the policies cash
value. When the term of policy expires, the
insured can get the cash value of the policy.

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 Life Insurance

Life insurance policies come in many forms.

Some of the typical policies include:
Universal Life: includes both a term life
portion and a savings portion.
Annuities: pays a benefit to the insured until
death, to cover retirement years.

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 Expected Life of Persons
at Various Ages

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 Sample Annual Premiums

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 Life Insurance:
Company Assets and Liabilities
 Life insurance companies derive funds from
two sources:
─ They receive premiums that must be used to
payout future claims when the insured dies
─ They receive premiums paid into pension funds
managed by the life insurance company
 The next figures shows the distribution of the
typical life insurance company’s assets, as
well as assets invested in mortgages.
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 Life Insurance:
Company Assets and Liabilities

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 Life Insurance:
Company Assets and Liabilities

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 Life Insurance:
Company Assets and Liabilities
 Life insurance companies have two
primary liabilities:
─ Life insurance payouts
─ Pension fund payouts

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 Health Insurance
 Health insurance policies are highly
vulnerable to the adverse selection
problem. Those with known or expected
health problems are more likely to seek
coverage.
 This is why most health insurance is offered
through group policies. Individual policies
must be priced assuming adverse selection.

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 Health Insurance

Health insurance is a hot topic in the political

environment, focusing on increased costs
and availability of coverage.
Insurance programs are attempting to shift
costs to the employers.
Health Maintenance Organizations are
another attempt to keep costs down.

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 Property and Casualty
Insurance
 Property Insurance: protects businesses and
owners from the risk associated with ownership.
─ Named-peril policies: insures against any losses only
from perils specifically named in the policy
─ Open-peril policies: insures against any losses except
from perils specifically named in the policy

 Casualty Insurance
 Reinsurance

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 Property and Casualty
Insurance
 Casualty Insurance: also known as liability
insurance, it protects against financial
losses because of a claim of negligence.
 Reinsurance: allocates a portion of the risk
to another company in exchange for a
portion of the premium.

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 Property and Casualty
Insurance
 Terrorism Risk Insurance Act of 2002:
based on the 9-11 attacks in NYC, new
legislation was passed in 2002 limiting the
amount insurance firms would be required
to pay out in the event of future attacks
 Government will pay 90% of losses, up to
$100 billion.

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 Insurance Regulation
 The McCarran-Ferguson Act of 1945
explicitly exempts insurance companies from
any type of federal regulation.
 Most insurance regulations is at the
state level
 Regulation is typically designed to protect
policyholders from losses, or expand
insurance coverage in the state.
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 Conflict of Interest Violations
 In 2004, NY Attorney General E. Spitzer
charged Marsh and McLennan with
insurance fraud.
 Indictment cited bid-rigging and bribery.
Some of the pay-for-play fees amounted to
$800 million per year.
 Many top execs left the firm in the wake of
the incident.
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 The Practicing Manager:
Insurance Management
 Screening
 Risk-Based Premium
 Restrictive Provisions
 Prevention of Fraud
 Cancellations of Insurance
 Deductibles
 Coinsurance
 Limits on the Amount of Insurance

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 Credit Default Swaps
 A CDS is insurance against default on a financial
instrument, usually some kind of securitized bond.
 Market essentially non-existent before 1995. By
2008, there were about $62 trillion of CDS
outstanding!
 The CDS market allowed speculators to bet on
the health of a company, a usual no-no in
insurance.

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 Credit Default Swaps:
The AIG Blowup
 AIG’s Financial Products division insured over
$400 billion of CDS securities, of which $57 billion
were debt securities backed by subprime
mortgages.
 Creditors quickly realized the losses may
bankrupt AIG – AIG could not raise any capital
 The Fed organized a bailout, but took a big stake
in AIG as payment. Insurance companies
nationwide will now fall under federal scrutiny.

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 Monoline Insurance
 Monoline insurance companies specialize in
credit insurance and are the only insurance
companies that are allowed to provide insurance
that guarantees the timely repayment of bond
principal and interest when a debt issuer defaults.
All other insurance companies are prohibited from
doing this.
 Help lower required interest by providing a credit
enhancement. The crisis affected them as well.

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 The Subprime Crisis and the
Monoline Insurers
 Monoline insurers did insure debt backed by subprime
mortgages.
 Defaults on these mortgages resulted in credit
downgrades for the insurers.
 This weakened the value of their insurance guarantees,
which spilled over into their municipal securities insurance.
 Investors reduced the value of the insurance—
municipalities started seeing higher interest costs. This, in
turn, resulted in lower spending on roads, schools, etc.

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 Pensions
 Definition: A pension plan is an asset pool that
accumulates over an individual’s working years
and is paid out during the nonworking years.
 Developed as Americans began relying less on
children for care during their later years.
 Also became popular as life expectancy
increased.

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 Types of Pensions
 Defined-Benefit Pension Plans: a plan where
the sponsor promises the employee a
specific benefit when they retire.
 For example,
Annual Retirement Payment 2%  average
of final 3 years’ income  years of service

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 Types of Pensions
 Defined-Benefit Pension Plans place a burden on
the employer to properly fund the expected
retirement benefit payouts.
─ Fully funded: sufficient funds are available to meet
payouts
─ Overfunded: funds exceed the
expected payout
─ Underfunded: funds are not expected to meet the
required benefit payouts

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 Types of Pensions
 Defined-Contribution Pension Plan: a plan where
a set amount is invested for retirement, but the
benefit payout is uncertain.
 Private Pension Plans: any pension plan set up
by employers, groups, or individuals
 Public Pension Plan: any pension plan set up by a
government body for the general public (e.g.,
Social Security)

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 Private Pension Plan Assets

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 Social Security
 Pay as you go system, where current
funding is used (partially) to pay
current benefits.
 Projected number of workers is falling while
projected number of retirees is increasing,
which will cause problems in years to come
if not corrected.

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 Social Security Assets

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 Social Security Assets

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 Social Security
 It’s difficult to measure the health of the
social security system. Many factors are
hard to predict, such as birth rates and the
rate of immigration. Although it may not fail,
it’d be wise for you plan other sources for
your retirement cash flows.

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 Participants and Beneficiaries
Receiving PBGC Payments

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 The Future of Pension Funds
 We can expect their growth and popularity
as the average population continues
to grow.
 Variety of pension fund offerings may
increase as well.
 Pension funds may gain significant
control of corporations as their stock
holdings increase.
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