Insurance Operations

MO D U L E 8 . 1

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 Chapter Objectives

Explain Describe Describe Describe Explain Identify

Explain how insurance Describe how insurance Describe the main Describe the main Explain the exposure of Identify the factors that
premiums are companies are operations of life operations of other insurance companies to affect the value of
determined. regulated. insurance companies. types of insurance various forms of risk. insurance companies.
companies.

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 The premium charged by an insurance company for each
insurance policy is based on the probability under which
the company will have to provide a payment to the insured
(or the insured’s beneficiary) and the potential size of the
payment.

Setting
Insurance The premium charged is determined by the present value
of a payment that they will have to make for a specific
Premiums (1 of insurance policy.
2)

The premium will also contain a markup to cover overhead

expenses and to provide a profit beyond expenses.

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 Adverse Selection

• The adverse selection problem means

that people who have insurance are
Setting more likely to suffer losses (and
therefore to file claims) than people
Insurance who do not have insurance.
Premiums (2 of
2) Moral Hazard

• There is a moral hazard problem which

means that some people take more
risks once they are insured.

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 • The insurance industry is highly regulated by state
agencies.
• Each state attempts to make sure that insurance
companies are providing adequate services, and
the state also approves the rates insurers may
Regulation of charge.
Insurance • The National Association of Insurance
Companies (1 Commissioners (N A I C) facilitates cooperation
among the various state agencies whenever an
of 2) insurance issue is a national concern.
• The Insurance Regulatory Information System (I R I
S) has been developed by a committee of state
insurance agencies to assist in each state’s
regulatory duties.

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 • Assessment System
• The regulatory system is designed to detect any
problems in time to search for a remedy before the
company deteriorates further.
Regulation of • The more commonly used financial ratios assess a
Insurance variety of relevant characteristics, including the
following:
Companies (2 • The ability of the company to absorb either losses
of 2) or a decline in the market value of its investments.
• Return on investment.
• Relative size of operating expenses.
• Liquidity of the asset portfolio.

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 Regulation of Capital
• Insurance companies are required to report a risk-
based capital ratio to insurance regulators.
• The ratio was created by the N A I C and is intended to
force those insurance companies with a higher
Regulation of exposure to insurance claims, potential losses on
assets, and interest rate risk to hold a higher level of
Insurance capital.
Companies Regulation of Failed Insurance Companies
• The insurance commissioner proposes a plan within
the court system on how the assets should be
distributed
• If the company is to be liquidated, property insurance
policies are canceled and state guaranty funds.

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 Regulation of Financial Services Offered
• In 19 99, Congress passed the Financial Services
Modernization Act, which allowed insurance
companies to merge with commercial banks and
securities firms.

Background (1 Federal Insurance Office

of 2) • In July 2010, the Financial Reform Act was
implemented.
• One provision called for creation of the Federal
Insurance Office to be housed within the Treasury
Department.
• This office is responsible for monitoring the
insurance industry and providing recommendations
to Congress about insurance regulations.

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 • International Insurance Regulations
Background (2 • Companies must comply with foreign
of 2) regulations regarding services offered in
the respective countries.

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 Ownership
• There are about 700 life insurance companies
Life Insurance classified as having stock with about 100 with
mutual ownership.
Operations (1 of • A stock-owned company is owned by its
10) shareholders
• A mutual life insurance company is owned by its
policyholders.

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 Types of Life Insurance
• Whole Life Insurance
• Protects insured until death.
• Provides a form of savings to the policyholder. It
Life Insurance builds a cash value that the policyholder is entitled
Operations (2 of to even if the policy is canceled.
10) • Term Insurance
• Providing insurance over a specified term; no cash
value
• Significantly less expensive than whole life
insurance

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 Types of Life Insurance (continued)
• Variable Life Insurance
• The benefits awarded by the life insurance company to
a beneficiary vary with the assets backing the policy.
• Universal Life Insurance
Life Insurance • Combines the features of term and whole life
Operations (3 of insurance.
• Specifies a period of time over which the policy will
10) exist but also builds a cash value for the policyholder
over time.
• The first portion of the premium payment is used to pay
the death benefit identified in the policy and to cover
any administrative expenses. The second is used for
investments and reflects savings for the policyholder.

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 Sources of Funds
• Life insurance companies obtain much of their
funds from premiums. (Exhibit 25.1)
Life Insurance • The largest single source of funds is the provision
Operations (4 of of annuity plans, which offer a predetermined
10) amount of retirement income to individuals.
• Capital
• Insurance companies build capital by retaining
earnings or issuing new stock.

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 Exhibit 25.1
Distribution
of U.S. Life
Insurance
Company
Income

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 Uses of Funds (Exhibit 25.2)
• Government Securities
• Life insurance companies invest in U.S. Treasury
Life Insurance securities, state and local government bonds, and
foreign bonds.
Operations (5 of • Stocks
10) • Since the early 19 90s stock investments have
increased substantially, and now account for about
the same percentage of the companies’ asset
portfolios as corporate bonds.

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 Uses of Funds (continued)
• Corporate Debt Securities
Life Insurance • Corporate bonds are the most popular asset of
Operations (6 of life insurance companies.
10) • Companies usually hold a mix of medium- and
long-term bonds for cash management and
liquidity needs.

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 Uses of Funds (continued)

• Mortgages
• Life insurance companies hold mortgages,
including family, multifamily, commercial, and
farm-related.
Life Insurance • Real Estate
• Insurance companies sometimes purchase real
Operations (7 of estate and lease it for commercial purposes.
10) • Ownership of real estate offers the
opportunity to generate high returns but also
exposes them to greater risk.
• Policy Loans
• Life insurance companies lend a small portion
of their funds to whole life policyholders.

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 Exhibit 25.2
Assets of
U.S. Life
Insurance
Companies

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 Uses of Funds
(continued)
Life Insurance • Summary of Uses of Funds
Operations (8 of (Exhibit 25.3)
10)
• Insurance companies
channel funds received
from premiums to purchase
stocks and bonds.
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 Exhibit 25.3
How Insurance
Companies
Finance
Economic
Growth

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 Asset Management of Life
Insurance Companies
• To cope with the existing forms of risk,
life insurance companies attempt to
Life Insurance balance their portfolios so that any
Operations (9 of adverse movements in the market value
10) of some assets will be offset by favorable
movements in others.
• Many insurance companies are
diversifying into other businesses by
offering a wide variety of financial
products.

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 Interaction with Other Financial Institutions
• Life insurance companies interact with financial
institutions in several ways. (Exhibit 25.4)
Life Insurance • Participation in Financial Markets (Exhibit 25.5)
Operations (10 • Insurance companies are common participants in
the stock, bond, and mortgage markets because
of 10) their asset portfolios are concentrated in these
securities.
• They use the money markets to purchase short-
term securities for liquidity purposes.

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 TYPE OF FINANCIAL INTERACTION WITH LIFE INSURANCE COMPANIES
INSTITUTION

Commercial banks and • Compete with insurance companies to finance leveraged

savings institutions (SI buyouts.
s) • Merge with insurance companies to offer various insurance-

Exhibit 25.4 related services.

• Compete with insurance companies to provide insurance-
related services.
Interaction • Provide loans to insurance companies.

between Finance companies • Are sometimes acquired by insurance companies to finance

insureds’ policy premiums.

Insurance Securities firms • Compete directly with insurance companies in offering mutual
funds.

Companies and • Compete with insurance companies to finance leveraged

buyouts.
• Underwrite new issues of stocks and bonds that are purchased
Other Financial by insurance companies.

Institutions Brokerage firms • Compete directly with insurance companies in offering

securities-related services.
• Compete directly with insurance companies in offering
insurance-related services.
• Serve as brokers for insurance companies that buy stocks or
bonds in the secondary market.

Pension funds • Are sometimes managed by insurance companies.

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 FINANCIAL HOW LIFE INSURANCE COMPANIES
MARKET PARTICIPATE IN THIS MARKET
Money markets • Maintain a portion of their funds in money market
securities, such as Treasury bills and commercial paper, to
ensure adequate liquidity.
Exhibit 25.5 Bond markets • Purchase bonds for their portfolios.

Participation of Mortgage markets • Purchase mortgages and mortgage-backed securities for

their portfolios.
Insurance Stock markets • Purchase stocks for their portfolios.

Companies in Futures markets • May sell futures contracts on bonds or a bond market index
to hedge their bond and mortgage portfolios against

Financial interest rate risk.

• May take positions in stock market index futures to hedge
their stock portfolios against market risk.
Markets Options markets • Purchase call options on particular stocks that they plan to
purchase in the near future.
• Purchase put options or write call options on stocks they
own that may experience a temporary decline in price.

Swap markets • Engage in interest rate swaps to hedge the exposure of

their bond and mortgage portfolios to interest rate risk.

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 Property and Casualty Insurance
• Protects against fire, theft, liability, and other
events that result in economic or noneconomic
damage.
• Life and P C insurance have very different
Other Types of characteristics.
Insurance • P C policies often last one year or less, as
Operations (1 of opposed to the long-term or even permanent life
insurance policies.
6) • P C insurance encompasses a wide variety of
activities, ranging from auto insurance to
business liability insurance.
• Forecasting the amount of future compensation
to be paid is more difficult for P C insurance than
for life insurance.

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 Property and Casualty Insurance (continued)

• Cash Flow Underwriting

• The P C insurance industry is cyclical.

Other Types of • As interest rates rise, companies tend to lower their rates
so as to write more policies and acquire more premium
Insurance dollars.
• As interest rates decline, the price of insurance rises to
Operations (2 of offset decreased investment income.
• Uses of Funds
6) • Relative to life insurance companies, P C hold more
government (municipal, Treasury, agency) securities.
• Property and Casualty Reinsurance
• Allocates a portion of their return and risk to other
insurance companies.

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 Health Care Insurance
• Insurance companies provide various types of
health care insurance, including coverage for
hospital stays, visits to physicians, and surgical
procedures.
Other Types of • Types of Health Care Plans
Insurance • Managed health care plan may choose only
Operations (3 of specified health care providers (hospitals and
physicians) who participate in the plan.
6)
• Indemnity plan can usually choose any provider of
health care services.
• The premiums for managed health care plans are
generally lower, and payment is typically made
directly to the provider.

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 Health Care Insurance (continued)
• Managed health care plans can be classified as
health maintenance organizations (H M Os) or
preferred provider organizations (P P Os).
Other Types of • Health maintenance organizations usually require
Insurance individuals to choose a primary care physician (P C
P).
Operations (4 of • Before patients insured under an H M O can see a
6) specialist, they must first see a P C P to obtain a
referral for the specialist.
• Preferred provider organizations usually allow
insured individuals to see any physician without a
referral.

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 Business Insurance
• Some forms of business insurance overlap with
property and casualty insurance.
Other Types of • Liability insurance can protect a firm against
Insurance potential liability for harm to others as a result of
Operations (5 of product failure or a wide range of other
conditions.
6)
• Key employee insurance provides a financial
payout if specified employees of a business
become disabled or die.

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 Bond Insurance
Bond insurance protects the investors that purchase
bonds in the event that the bond issuers default on their
bonds.
Other Types of Mortgage Insurance
Insurance • Mortgage insurance protects the lender that provides
mortgage loans in the event of homeowner default.
Operations (6 of • Credit Default Swaps as a Form of Mortgage Insurance
6) • Privately negotiated contracts that protect investors
against the risk of default on particular debt securities.
• Insurance companies commonly serve as the
counterparty and have to make payments only if there
is a default on the securities covered by the swap.

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 Interest Rate Risk

• Because insurance companies carry a large amount

of fixed-rate, long-term securities, the market value
of their asset portfolios can be very sensitive to
interest rate fluctuations.
Exposure of
Credit Risk
Insurance
Companies to • The corporate bonds, mortgages, and state and local
government securities in insurance companies’ asset
Risk (1 of 3) portfolios are subject to credit risk.

Market Risk

• Since insurance companies invest in stock, they are

exposed to possible losses on their stock portfolios
during weak stock market conditions.

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 Liquidity Risk
A high frequency of claims at a single point in time
could force a company to liquidate assets at a time
Exposure of when the market value is low, thereby depressing its
Insurance performance.
Companies to Exposure to Risk during the Credit Crisis
Risk (2 of 3) Many insurance companies that had invested
some of their funds in mortgage-backed
securities or in junk bonds experienced losses on
their investments.

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 Exposure to Risk during the Credit Crisis (continued)
• Government Rescue of A I G
• American International Group (A I G) is the largest
insurance company in the world, with annual
revenue of more than $100 billion and operations in
more than 130 countries.
Exposure of • In 2008, A I G experienced severe financial
Insurance problems because many debt securities defaulted.
Companies to • Since the failure of A I G could have a devastating
effect on the insurance industry and the rest of the
Risk (3 of 3) financial sector, the Federal Reserve bailed out A I G
in September 2008 with support from the U.S.
Treasury.
• The bailout allowed A I G to borrow up to $85
billion from the Federal Reserve over a 2-year
period, and the government received an equity
stake of about 80% of A I G.

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 Factors That Affect Cash Flows
• Change in Payouts
• The payouts on insurance claims are somewhat stable
for most life insurance companies with a diversified set
of customers.
Valuation of an • The payouts on property and casualty claims can be
Insurance volatile for P C companies.
• Change in Economic Conditions
Company (1 of • Economic growth can enhance an insurance company’s
5) cash flows because it increases the level of income of
firms and households and can increase the demand for
the company’s services.
• Change in the Risk-Free Interest Rate
• Some of an insurance company’s assets (such as bonds)
are adversely affected by rising interest rates.

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 Factors That Affect Cash Flows
• Change in Industry Conditions
• Insurance companies are subject to industry
conditions, including regulatory constraints,
Valuation of an technology, and competition within the industry.
Insurance • Change in Management Abilities
Company (2 of • An insurance company has control over the
composition of its managers and its organizational
5) structure.
• Its managers can attempt to make internal
decisions that will capitalize on the external forces
(economic growth, interest rates, regulatory
constraints) that the company cannot control.

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 Factors that Affect the Required Rate of Return by
Investors (Exhibit 25.6)
• The risk-free interest rate is expected to be
Valuation of an positively related to inflation, economic growth,
Insurance and the budget deficit level but inversely related
to money supply growth (assuming it does not
Company (3 of cause inflation)
5) • The risk premium on an insurance company is
inversely related to economic growth and can be
affected by industry conditions (such as
regulations) and management abilities.

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 Exhibit 25.6 A
Framework for Valuing
an Insurance Company
• A stronger economy leads to more services being provided
by insurance companies and better cash flows. It may also
enhance stock valuations, thereby increasing the valuations
of stocks held by the insurance company.

• A lower risk-free rate results in more favorable valuations of

the bonds held by the insurance company.

• The valuation of an insurance company is also influenced

by industry conditions and the firm’s management (not
shown in the diagram). These factors affect the risk
premium (and therefore the return required by investors)
and the expected cash flows to be generated by the
insurance company. In particular, property and casualty
companies are exposed to court rulings that can result in
them paying large damages awards, and health insurance
companies are exposed to regulations regarding
reimbursement for healthcare services.

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 Valuation of an Insurance Company (4 of 5)
Indicators of Value and Performance
• Indicator of Liquidity
• An insurance company’s liquidity can be measured using the
following ratio:

Invested assets
Liquidity ratio 
Loss reserves and unearned premium reserves

• The higher the ratio, the more liquid the company.

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 Valuation of an Insurance Company (5 of 5)

Indicators of Value and Performance (continued)

• Indicators of Profitability
• The profitability of insurance companies is often assessed using the
return on net worth (or policyholders’ surplus):
Net profit
Return on net worth 
Policyholder's surplus
• Net profit consists of underwriting profits, investment income, and
realized capital gains.
• Underwriting gains or losses are measured by the net underwriting
margin: Premium-Policy Expenses
Net underwriting margin 
Total Assets

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 Insurance company premiums are influenced by the likelihood of
a claim and the potential size of the claim. They also account for
the potential adverse selection problem and the moral hazard
problem.

State agencies attempt to make sure that insurance companies

SUMMARY are providing adequate services, and also approve the rates that
insurers may charge. Insurance company agents must be licensed,
(1 of 3) and the specific wording of insurance policies must be approved
by the state to ensure that the policies are not misleading.

State regulators also evaluate the asset portfolios of insurance

companies to ensure that investments are reasonably safe and
that adequate reserves are maintained to protect policyholders
that may incur a loss.

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 Life insurance companies compensate the beneficiary of a
policy upon the policyholder’s death. They obtain most of
their funds from annuity plans and from premiums; stocks and
corporate debt securities are their primary assets.

SUMMARY Other types of insurance operations include property and

casualty insurance, health care insurance, business insurance,
(2 of 3) bond insurance, and mortgage insurance.

Insurance companies are exposed to interest rate risk because

they tend to maintain large bond portfolios whose values
decline when interest rates rise. They are also exposed to
credit risk and market risk as a result of their investments in
corporate debt securities, mortgages, stocks, and real estate.

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 • The value of an insurance company is based on
its expected cash flows and the rate of return
required by investors.
• The payouts of claims (cash outflows) are
SUMMARY (3 somewhat predictable for life insurance firms, so
of 3) they tend to have stable cash flows.
• In contrast, the payouts of claims for property
and casualty insurance and other types of
insurance services are subject to much
uncertainty.

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Institutions. 13th ed: Cengage Learning.
• Mishkin, F. S. (2022). The Economics of money,
banking, and financial markets. 13th Edition.
Pearson Higher Education
• Brandl, M. (2021). Money, banking, financial
markets & institutions. 2nd Edition. Cengage
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• Saunders, A., Cornett, M., Erthemjamts, O.
(2021). Financial markets and Institution. 8th
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banking and financial markets. 6th Edition.
McGraw Hill Education.

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