Insurance: Theory and PracticeLecture 1. Introduction to Insurance

Xiang Fang

The University of Hong Kong

January 20, 2020

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About Me

I Name: Xiang Fang, Assistant Professor of Finance

I Office: KKL 818

I Email: xiangf@hku.hk

I Office hours: By appointment

I Education: Ph.D (2019, UPenn), MA (2013, Tsinghua), BA(2011, Fudan)

I Research: international finance, asset pricing, macro finance,especially the FX market and global financial institutions

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Outline

1. Motivation

2. Basics of insurance

3. The economics and finance of insurance

4. Course overview

5. History and development of insurance

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1. Motivation

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Insurance and Daily Life

I Key words about insurance that come to your mind

I Do you, your family or friends have any experience related toinsurance?

I Do you know what insurance you and your family havebought?

I Do you know how these insurance products work?

I Do you know how you and your family make decisions oninsurance products?

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Insurance Examples

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Insurance Examples

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What Information is Needed?

I For the travel insurance?I Age

I For the auto insurance?I Information of the car: model, age, milesI Information of the driver: experience, previous accident record

I Why is this information needed?

I Are they reliable?

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Can We Create an Insurance Product on Our Own?

I My friend is facing the doctoral preliminary exam in gradschool and he is worried about whether he could pass

I Deal: If he passes, he treats me 3 meals in a Michelin 3-starrestaurant in New York; if not, I treat him one meal in thesame restaurantI Fair deal? What does the ratio 3:1 imply?I Will he choose to fail the exam for the 1 3-star Michelin meal?I What happened then?

I He passed the examI After several years, I have never been to any Michelin 3-star

restaurant in New York, stillI We are still good friends

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Why Don’t We? Why Do We Need Professtional Insurers?

I To determine the ratio (3:1)

I Incentive: how to make sure he does not fail deliberately?

I Implementation

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Insurance Industry and Career ChoiceI Insurance industry is prosperous, especially in Hong Kong

I As of 2019 September: 162 authorized Insurers, more than100,000 insurance agents

I 2018 Gross insurance premium 514.5 billion HKD, while GDPin 2018 is 2850 billion HKD

I Salary...

I What kind of preparation do you need for making careerchoice?I What do employees in the industry do?

I Sales, underwriting, claimsI Asset management, reinsurance, ...

I Why do they need to know insurance?I Is insurance an industry worth entering? Does it fit your

interest?

I Having said that, this is not a course about career choice, it isan introductory course in financial economics. But hopefully,there can be some practical value for everyone in this class.

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2. Basics of Insurance

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Insurance

I Protect individuals and corporations from adverse eventsI Individuals and corporations pay upfront (premium) and get

paid if certain specified events occur

I Key idea: risk pooling

I One way of risk management

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Terminology

I Insurance policy: the insurance contract

I Endorsement: a written document attached to a policy tomodify the coverage of the policy

I Insurer: insurance company

I Reinsurer: insurance company from which an insurancecompany buys insurance

I Insured: the insured person or company

I Policyholders: the individual or business that pays for andowns the policy

I Beneficiary: the recipient of insurance benefit

I Insurance premium: the cost of insurance policy, paidperiodically or in a lump sum (single)

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Categories

I Life insurance and annuitiesI Life insurance: Protect against death, illness, and retirement

I Property-casualty insuranceI Property insurance: Protect against the loss of real and

personal propertyI Casualty insurance: Protect against legal liability exposures

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Life Insurance: Traditional

I Term life insuranceI Insure against death during the coverage period (from 1 year

to 40 years or more)

I Whole life insuranceI Coverage period: the whole lifeI Saving element: the beneficiary gets paid for sure if the

policyholder continues to pay the premium

I Endowment life: a combinationI Insure against death during the coverage periodI If living up to the coverage period, get paid the face value of

the contract

I All three: premium fixed, promised payment fixed

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Life Insurance: New

I Variable lifeI Fixed premiumI Promised payment changes with market returnsI Policyholders choose investments to reflect their preferences

(stocks, bonds, money market funds, etc)

I Universal lifeI The premium and maturity can be changed

I Variable universal life: combination

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Annuities

I The reverse of life insuranceI Life insurance: different ways of building up fundsI Annuities: liquidating funds

I Policyholder pays when young (single or over multipleperiods), gets payment (regularly) when old

I Annuity payment varies with the return of investmentportfolios

I Why annuities?I Longevity risk: The risk that people outlive their money

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Property-Casualty Insurance

I Property insurance: Protect against the loss of real andpersonal property (auto, home, etc)

I Casualty insurance (liability insurance): Protect again legalliabilities exposures

I Blurred boundary between property and casualty insurance

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Public Insurance and Social Security

Private vs. Public. Why matter?

I Private: Let the market workI Public: pension, health, etc

I Why provided by government?I Fundamental human rightsI Historical reasonsI Human irrationality

I Additional issues: financing, operational model, thecomposition of private and public insurance

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Insurance and Risk Management

I Insurance is one way of managing riskI Other ways

I Internal risk reductionI Loss controlI Loss financing (including insurance)

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Reinsurance

I Insurance companies’ risk managementI Why purchase reinsurance?

I Limit losses, stabilize cash flows, etc

I Example: losses within certain limits, say, 5 million to 10million, will be paid by the reinsurer to the primary insurancecompany for which a premium is paid

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3. The Economics and Finance of Insurance

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Why Finance?

I Insurance contract is a financial contractI About time and uncertaintyI Financial arrangements: risk poolingI Principles of finance applies, for example, valuation of financial

assetI Insurance is tightly connected to other areas of finance

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Insurance and the 2008 Financial Crisis

I Terminology: Subprime mortgage, mortgage backed securities(MBS)

I Subprime market failed in the summer of 2008, the relatedMBS falled sharply in values with the rise of default

I Many default insurance (credit default swaps) were written onthese securities (AIG being the major writer)

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Insurance and the 2008 Financial Crisis (Cont’ed)

I MBS falled in value, default rose

I AIG needed to pay for the credit loss, which exceeded itscapacity

I If AIG failed to pay for the credit loss, holders of MBS(banks) suffered a loss

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Open Questions to Think About

I Did banks expect the AIG to fail to pay for the credit loss,when such event happens? Why do they still buy theinsurance contract?I Too big to fail

I Did AIG expect that when such adverse events happen, it willget into trouble?I Too big to fail; credit rating

I Did the regulators notice this take some steps?I Microprudential vs. Macroprudential

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Can Insurance Increase Systemic Risk?

I Analogy: seatbelt increases the death from traffic accident

I Insurance makes each individual institutions safer (given otherfactors), thus they take more risk

I When all institutions take more risk, systematic risk increases

I Insurance companies are in trouble when the systematicadverse event happens

I The institutions are not guaranteed, in fact

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Why Economics?

I A key issue in insurance: asymmetric informationI Adverse selectionI Moral hazardI Economics: help design the contracts in the presence of these

“undesirable” features

I An important part of insurance is provided by the governmentI The government cares about the social welfare, behaves

differently from a commercial insurance companyI Fund raising, coverage, etc, market is not enough

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More Than Economics and Finance

I Philosophy: many of the insurance products are about thefundamental human rights, such as healthI Health insurance is an important and heatedly debated topic

(tradeoff between equity and efficiency)

I Politics: social insurance plan is an important part of politicalcampaign

I Math and statistics: acturial science

I ...

I These are not in this course

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Principle 1: Risk

I What is risk? Is risk equal to danger? Something bad?

I Do people love or hate risk? How to tell?

I What if people have to face some risk? Risk premium

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Principle 2: Risk Pooling

I The law of large numbers and the role of correlation

I Risk pooling

I The insurability of risk: insurable vs. uninsurable

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Principle 3: Valuation

I Valuation of a financial contract: NPV rule

Price = Expected discounted future cash flows

I Cash flowI Discount rate

I Discount rate reflects the risk property of the asset:compensation for risk

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Principle 4: Risk Premium

I How is the risk premium determined?

I The CAPM

I Many alternatives...

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Principle 5: Adverse Selection

I With heterogeneous buyers of health insurance (differ in theirhealth level), insurers need to set a price for the contractI Price = weighted average?I Healthy people opt outI Need to raise the price, and more healthy people to opt out

I What to do?I Screening: show the body check report, but there are many

“types” that are hard to checkI Insurance companies: Establish different pools of population

based on health and related characteristics (such as income)

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Principle 6: Moral Hazard

I A man is worried about getting high cholesterol, because itmeans huge medical expensesI He eats broccoli with plain chicken breast and gains no fun

from eating at all

I One day he buys a health insurance contract that covers 90%of his medical expenses

I If you were him, what will you do?I If I were him, perhaps I would eat a lot of foie gras

I Insurers lose because the offered price is really low based onhis previous health record

I What to do?I Regular update on your health status (not very implementable

in this case)

I Adverse selection vs Moral hazard: Type vs. Action

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4. Course Overview

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Overview

I Three partsI The principles of insuranceI Insurance productsI Insurance business

I Dual objectiveI Give a general introduction on insurance, especially its

economics and finance contentI General idea of risk management, insurance as an example

I More general financeI Apply to individual, corporate, government risk management

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The Principles of Insurance

I Risk, risk aversion, and risk premium

I Risk pooling, insurability of risk

I Asymmetric information

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Insurance Products

I Life insurance and annuities

I Social security

I Property-Casualty insurance

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Insurance Business

I The function and operations of insurance companies

I Tax, regulations, and legal issues

I Optional: new developments of the insurance industry

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Logistics

I Lectures

I Tutorials (10%)

I Assignments: one assignment (15%), one group project(15%), final exam (60%)

I Assignment: distributed in mid February, due after the readingweek, individual work (discussion encouraged)

I Group project: assigned after the collection of assignment,group formationI Presentation in the last weekI A report on the group project

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Materials

I Lecture slides

I The textbook (related chapters in the syllabus and may beupdated)

I Take-home practice exercises: released after every class

I If any additional material, will post online

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Class Rule

I Attendance strongly recommended

I No distracting activities allowed (eating smelly food, snoring,etc)

I Interaction strongly encouragedI I hope the class is fun, but it cannot be fun without your

participationI I have very limited number of jokes, and I am a bad joke-teller

I Interaction gets you good friendsI Interaction is the best (or at least good) way to learn

I Any question welcome

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5. The History and Development of Insurance

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Family, Community as Informal Insurance

Despite the lack of formal insurance in ancient times, informalinsurance is prevalentI (Big) family

I MarriageI Children

I Clan, lineage, etc

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The Great Fire of London, 1666

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Modern Insurance

I 1667: Physician Nicholas Barcon set up the first insurancecompany, the Fire OfficeI Differentiated premium for houses made of wood and stoneI The Father of modern insuranceI 1710: The Sun Fire Office established, still the oldest

insurance company in the world

I 1706: Amicable Society for a Perpetual Assurance OfficeI The first company that offers life insruance

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Introduction of Old-age Insurance (Cutler and Johnson,2001)

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Introduction of Old-age Insurance (Cont’ed)

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Introduction of Health Insurance

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Global Insurance Industry: 2018I Total premiums: 5193 billions USD, 6% of global GDP

I Life insurance accounts for 54%, non-life insurance accountsfor 46%

I Market share (in percent)

Region 1980 2018US 42 28

P.R.China 0 11Japan 16 8.5

UK 7.4 6.5France 5.5 5.0

Germany 8.6 4.7South Korea 0.4 1.9

Italy 0.3 3.4Canada 1.8 3.3Taiwan 2.7 2.5

Source: Swiss Re, Sigma, No. 3/2019

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Assets of Insurance Companies in the US

1960 1970 1980 1990 2000 2010 20200

2000

4000

6000

8000

10000

12000

14000

16000

Insurance CompaniesBanks

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Life Insurance and Property-Casualty Insurance Companies

1960 1970 1980 1990 2000 2010 20200

1000

2000

3000

4000

5000

6000

7000

8000

9000

Life InsuranceProperty-Casualty Insurance

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Asset Allocation

Unit: Billions of USD

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Balance Sheet of Life Insurance Companies in the US

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Balance Sheet of Non-Life Insurance Companies in the US

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Insurance Companies in Hong Kong (Life): 2018

Table: Top Insurance Companies (Life) in Hong Kong in Premiums

Company Annual SingleAIA International 84636 18814

Prudential (HK) Life 82931 3577HSBC Life 41386 3166

Manulife (International) 28514 13101China Life 37440 100

AXA China (Bermuda) 20590 1397BOC Life 19544 1160

Hang Seng Insurance 13892 2749FWD Life 9698 4879

Sun Life Hong Kong 6430 2689

Source: https://www.ia.org.hk/en/infocenter/statistics/files/Table-L13 2018.pdf

For data on nonlife insurance, seehttps://www.ia.org.hk/en/infocenter/statistics/files/T G20 2018.pdf

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Regulation

I Licensing of insurers

I Solvency monitoring

I Rates

I Residual markets

I Policy form content

I Contract interpretation and enforcement

I Insurance sales practice and information disclosure

I Compulsory purchase of coverage (such as auto insurance)

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Conclusion

I Motivate studying the course

I Very brief overview of the insurance types, and its economicsand finance principles

I History and development of insurance business

No take-home exercise for this week. We will talk about moredetails in the remaining classes in the semester

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Happy Lunar New Year!