Chapter 25

Insurance and Pension Fund

Operations

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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

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Chapter Outline (cont’d)
 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

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Background
 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

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Background (cont’d)
 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

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Background (cont’d)
 Determinants of insurance premiums
 The 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

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Background (cont’d)
 Investments by insurance companies
 Insurance 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

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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 policyholder’s
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

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Life Insurance Operations (cont’d)

 Group plans:
 Are 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

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Life Insurance Operations (cont’d)
 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
 Term insurance:
 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

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Life Insurance Operations (cont’d)

 Types of life insurance (cont’d)

 Variable 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
 Universal 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

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Life Insurance Operations (cont’d)

 Sources of funds
 The most important source is annuity plans
 Offer a predetermined amount of retirement income to
individuals
 The second largest source of funds is premiums
 The third largest source of funds is investment
income

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Life Insurance Operations (cont’d)
 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 securities
 Corporate bonds are the most popular asset of life insurance
companies
 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

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Life Insurance Operations (cont’d)
 Uses of funds (cont’d)
 Mortgages
 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

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Life Insurance Operations (cont’d)
 Uses of funds (cont’d)
 Policy loans
 Life insurance companies lend funds to whole life
policyholders
 Can borrow up to their policy’s 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

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Property and Casualty Insurance
Operations
 PC insurance protects against fire, theft, liability,
and other events that result in damage
 Property insurance protects businesses and
individuals from the impact of financial risks
associated with the ownership of property
 e.g., buildings, cars
 Casualty insurance protects policyholders from
potential liabilities for harm to others as a result of
product failure or accidents

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Health Care Insurance Operations
(cont’d)
 Managed health care plans
 Health maintenance organizations (HMOs)
 Require individuals to choose a primary care physician who
functions as a gatekeeper for that individual’s health care
 Patients must first see their PCP to obtain referrals
 Preferred provider organizations (PPOs)
 Usually allow insured individuals to see any physician
without a referral
 Insurance premiums are higher than HMO insurance
premiums

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Health Care Insurance Operations
(cont’d)
 Health care insurance in the future
 Health 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
 The status of health care insurance and
reimbursement is subject to changes caused by
possible health care reform

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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
 Liability insurance:
 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

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Business Insurance (cont’d)
 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

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Business Insurance (cont’d)
 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

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Regulation of Insurance
Companies (cont’d)
 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

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Exposure to Risk
 Interest rate risk
 Companies 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

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Exposure to Risk (cont’d)
 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
 Market risk
 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 2001–2002

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Exposure to Risk (cont’d)
 Liquidity risk
 A high frequency of claims at a single point in time
could negatively affect a company’s 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

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Valuation of an Insurance Company
 The value of an insurance company is the
present value of its future cash flows
 The value should change in response to changes in
expected cash flows and in the required rate of
return:
V  f  E (CF ), k 
 -

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Valuation of an Insurance Company
(cont’d)
 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
 Change in economic conditions
 Economic growth increases income for firms and individuals
 Debt securities are less likely to default during periods of economic
growth
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Valuation of an Insurance Company
(cont’d)
 Factors that affect cash flows (cont’d)
 Change in the risk-free interest rate
 The valuation of an insurance company is inversely related
to interest rate movements
 Change in industry conditions
 Industry conditions include regulatory constraints,
technology, and competition
 Competition within the insurance industry has become more
intense because of reduced barriers

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Valuation of an Insurance Company
(cont’d)
 Factors that affect cash flows (cont’d)
 Change 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

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Valuation of an Insurance Company
(cont’d)
 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 company’s management skills
 Regulatory constraints may discourage firms from taking
excessive risk
 Loosening of regulatory barriers to entry may increase the risk
of insurance companies
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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
 e.g.,Social Security
 Many public pension plans are funded on a pay-as-
you-go basis

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Background on Pension Funds
(cont’d)
 Private pension plans
 With 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 fund’s investment performance

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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

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Pension Fund Management
(cont’d)
 The corporation owning the pension specifies
guidelines:
 Percentage 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

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Performance of Pension Funds
 Determinants of a pension fund’s stock portfolio
performance
PERF  f ( MKT , MANAB )
 Change in market conditions
 Stock portfolio’s performance is usually closely related to
market conditions
 Change in management abilities
 Stock portfolio performance can vary among pension funds
in a particular time period because of differences in
management abilities

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Performance of Pension Funds
(cont’d)
 Determinants of a pension fund’s 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
 Change in the risk premium
 Bond prices are inversely related to changes in the risk premiums
required by investors who purchase bonds
 Change in management abilities
 Bond portfolio performance can vary among pension funds in a
particular time period because of differences in management
abilities
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Performance of Pension Funds
(cont’d)
 Performance of pension portfolio managers
 The 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

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