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Chapter FifteenInsurance Companies

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Chapter Outline

1. Major Characteristics

2. Life Insurance

i. Basic Classes

ii. Balance Sheet

iii. Regulation

3. Property & Casualty Insurance

i. Major Types

ii. Balance Sheet and Risk

iii. Regulation

1. Major Characteristics

2. Life Insurance

i. Basic Classes

ii. Balance Sheet

iii. Regulation

3. Property & Casualty Insurance

i. Major Types

ii. Balance Sheet and Risk

iii. Regulation

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1. Insurance Industry

• Primary function is to compensate individuals and corporations (policyholders) if a prespecified adverse event occurs

• Two major groups:– Life: untimely death, illness, and retirement – Property Casualty: personal injury and liability due

to accidents, theft, fire, and other catastrophes

• Primary function is to compensate individuals and corporations (policyholders) if a prespecified adverse event occurs

• Two major groups:– Life: untimely death, illness, and retirement – Property Casualty: personal injury and liability due

to accidents, theft, fire, and other catastrophes

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Insurance Companies

Life

1,500 companies

Assets: $3.88 trillion (’04)

Trend: Mergers (Metropolitan Life Insurance & Prudential Insurance Co. of America - largest life insurers)

Role: Transfer income-related uncertainties from the individual to a group

Problem: Adverse selection

Property and Casualty

3,200 companies sell P&C insurance

Assets: $ 1.176 trillion (1/3 of Life Assets) (’04)

Trend: Concentration (10 firms – 45% of market share; major firms: State Farm & Allstate)

Role: Insure against the loss of property and legal liability exposure

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2.1 Life Insurance Basic Classes

Four basic classes1. Ordinary life - marketed on an individual basis in

units of $1,000 with policyholders making periodic payments (term, whole, endowment, variable, universal, variable universal)

2. Group Life Insurance3. Credit Life4. Others Life Insurer Activities

Four basic classes1. Ordinary life - marketed on an individual basis in

units of $1,000 with policyholders making periodic payments (term, whole, endowment, variable, universal, variable universal)

2. Group Life Insurance3. Credit Life4. Others Life Insurer Activities

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Distribution of Premiums Written on Various Life Insurance Lines

22.6

19.7

32.3

20.2

5 0.2

Accident & Health

Ordinary Life

Individual Annuities

Group Annuities

Group Life

Other

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Ordinary Life

a) Term Life - closes to pure life insurance, no savings attached, individual’s beneficiary receives payout at death of policyholder, term of coverage can vary from 1 year to 40 years or more.

b) Whole Life - protects individual over an entire lifetime in return for periodic premiums, beneficiaries receive face value of the contract.

c) Endowment Life - combines both term elements with a savings element, guarantees payout to the beneficiaries if death occurs during some endowment period or to the insured person who lives to the endowment date.

d) Variable life - invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments with policyholder determining risk level

e) Universal life and Variable universal life - allows the policyholder to change both the premium amounts and the maturity of the contract

a) Term Life - closes to pure life insurance, no savings attached, individual’s beneficiary receives payout at death of policyholder, term of coverage can vary from 1 year to 40 years or more.

b) Whole Life - protects individual over an entire lifetime in return for periodic premiums, beneficiaries receive face value of the contract.

c) Endowment Life - combines both term elements with a savings element, guarantees payout to the beneficiaries if death occurs during some endowment period or to the insured person who lives to the endowment date.

d) Variable life - invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments with policyholder determining risk level

e) Universal life and Variable universal life - allows the policyholder to change both the premium amounts and the maturity of the contract

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Group Life Insurance

• Covers a large number of insured persons under a single policy

• Issued to corporate employers (contributory or noncontributory)

• Involves economies of scale

• Covers a large number of insured persons under a single policy

• Issued to corporate employers (contributory or noncontributory)

• Involves economies of scale

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• Protects lender against a borrower’s death• Protects lender against a borrower’s death

Credit Life

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Other Life Insurer Activities– Annuities

• reverse of life insurance principles, involve different methods of liquidating a fund over a long period of time, a popular mechanism for retirement savings

– Private Pension Fund

• an alternative pension plan offered by insurance companies to private employers, innovative pension plans based on guaranteed investment contracts

– Accident and Health Insurance

• protects against morbidity or ill health risk

• major activity line is group insurance

• Life insurance companies write more than 50% of all policies but HMOs (nonregulated providers) have cut into their business

• face loss exposures similar to those of property-casualty insurers

– Annuities

• reverse of life insurance principles, involve different methods of liquidating a fund over a long period of time, a popular mechanism for retirement savings

– Private Pension Fund

• an alternative pension plan offered by insurance companies to private employers, innovative pension plans based on guaranteed investment contracts

– Accident and Health Insurance

• protects against morbidity or ill health risk

• major activity line is group insurance

• Life insurance companies write more than 50% of all policies but HMOs (nonregulated providers) have cut into their business

• face loss exposures similar to those of property-casualty insurers

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2.2 Life Insurance Industry Balance Sheet

• Assets– corporate bonds, equities, and government securities– policy loans - loans made by an insurance company to its

policyholders using their policies as collateral

• Liabilities– policy reserves - reflects their expected payment

commitments on existing policy contracts– surrender value of a policy - the cash value of a policy if a

policyholder surrenders the policy prior to maturity– separate account - annuity program sponsored by life

insurance companies, payoff on policy linked to assets in which policy premiums are invested

• Assets– corporate bonds, equities, and government securities– policy loans - loans made by an insurance company to its

policyholders using their policies as collateral

• Liabilities– policy reserves - reflects their expected payment

commitments on existing policy contracts– surrender value of a policy - the cash value of a policy if a

policyholder surrenders the policy prior to maturity– separate account - annuity program sponsored by life

insurance companies, payoff on policy linked to assets in which policy premiums are invested

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Life Insurance Industry Balance Sheet

Assets Liabilities & Capital/SurplusBonds 50.10% Net policy reserves 48.20%Preferred stock 0.8 Policy claims 0.9Common stock 1.7 Deposit-type contracts 7.5Mortgage loans 6.7 Interest maintenance reserve 0.4Real estate 0.5 Commissions, taxes, expenses 0.7Contract loans 2.7 Securities valuation reserve 0.8Cash and short-term investments 2 Other liabilities 5.2Other invested assets 1.5 Separate account business 30.5Premium due 0.5 Total capital and surplus 5.8Accrued investment income 0.8Separate account assets 30.6Other assets 2.1Total assets 100% Total liabilities and capital/surplus 100%

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2.3 Regulation

• McCarran-Ferguson Act of 1945 - confirms the primacy of state over federal regulation of insurance companies

• State insurance commissioners charter and examine insurance companies (role of NAIC), promote life insurance guarantee funds (l.i. firms do not have an access to a federal guarantee fund and there is no permanent insurance fund)

• Insurance guarantee fund - a fund of required contributions from within-state insurance

• McCarran-Ferguson Act of 1945 - confirms the primacy of state over federal regulation of insurance companies

• State insurance commissioners charter and examine insurance companies (role of NAIC), promote life insurance guarantee funds (l.i. firms do not have an access to a federal guarantee fund and there is no permanent insurance fund)

• Insurance guarantee fund - a fund of required contributions from within-state insurance

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3.1 Property-Casualty Insurance Companies

• Net premiums written - the entire amount of premiums on insurance contracts written

• Important P&C lines include the following– Fire Insurance and Allied Lines

• protects against fire, lightening, and removal of damaged property

– Homeowners Multiple Peril insurance• protects against damage to personal dwelling, contents, liability

– Commercial Multiple Peril Insurance• protects commercial firms similar to homeowners

– Automobile Liability and Physical Damage insurance

– Liability Insurance (other than auto)• provides protection to individuals or firms against legal liability

• Net premiums written - the entire amount of premiums on insurance contracts written

• Important P&C lines include the following– Fire Insurance and Allied Lines

• protects against fire, lightening, and removal of damaged property

– Homeowners Multiple Peril insurance• protects against damage to personal dwelling, contents, liability

– Commercial Multiple Peril Insurance• protects commercial firms similar to homeowners

– Automobile Liability and Physical Damage insurance

– Liability Insurance (other than auto)• provides protection to individuals or firms against legal liability

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Selected U.S. Catastrophes ($Mns)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

TerroristAttack 9/11

Hurricanes 2004

MidwestTornadoes

2003

CaliforniaEarthquake

1989

L.A. Riots

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3.2 Balance Sheet

Major assets• Long term assets - bonds, preferred stock, and common

stock and other investment assets – 82.4%

Major Liabilities• Loss and loss adjustment expense – 37.9%• Unearned premiums – 15.0%

Capital/Surplus – 30.1%

Major assets• Long term assets - bonds, preferred stock, and common

stock and other investment assets – 82.4%

Major Liabilities• Loss and loss adjustment expense – 37.9%• Unearned premiums – 15.0%

Capital/Surplus – 30.1%

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Balance Sheet and Underwriting Risk

• Unearned premium - reserves set aside that contain the portion of a premium that has been paid before insurance coverage has been provided

• Loss Risk – property versus liability– severity versus frequency– long tail versus short tail– product inflation versus social inflation

• Loss Ratio - measures the actual losses incurred on a specific policy line, measures the ratio of losses incurred to premiums earned (continued)

• Unearned premium - reserves set aside that contain the portion of a premium that has been paid before insurance coverage has been provided

• Loss Risk – property versus liability– severity versus frequency– long tail versus short tail– product inflation versus social inflation

• Loss Ratio - measures the actual losses incurred on a specific policy line, measures the ratio of losses incurred to premiums earned (continued)

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• Expense Risk– loss adjustment expenses (LAE)

– commissions and other expenses

– combined ratio - equal to the loss ratio plus the ratios of LAE to premiums written and commissions and other expenses to premiums written

• Investment Yield/Return Risk– operating ratio - measure of the overall profitability of the

insurer, equals the combined ratio minus the investment yield

– behavior of interest rates and default rates on P&C insurers’ investments is crucial to the P&C insurers’ overall profitability

• Expense Risk– loss adjustment expenses (LAE)

– commissions and other expenses

– combined ratio - equal to the loss ratio plus the ratios of LAE to premiums written and commissions and other expenses to premiums written

• Investment Yield/Return Risk– operating ratio - measure of the overall profitability of the

insurer, equals the combined ratio minus the investment yield

– behavior of interest rates and default rates on P&C insurers’ investments is crucial to the P&C insurers’ overall profitability

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3.3 Regulation

• Chartered at the state level and regulated by state commissions

• The National Association of Insurance Commissioners (NAIC) provides various services to the state, such as:– standardized examination system– the Insurance Regulatory Information System (IRIS) to

identify insurers with loss, combined, and other ratios operating outside normal ranges

• Rate regulation– state commissions set ceilings on the premiums for auto and

workers’ compensation insurance

• Chartered at the state level and regulated by state commissions

• The National Association of Insurance Commissioners (NAIC) provides various services to the state, such as:– standardized examination system– the Insurance Regulatory Information System (IRIS) to

identify insurers with loss, combined, and other ratios operating outside normal ranges

• Rate regulation– state commissions set ceilings on the premiums for auto and

workers’ compensation insurance