17
Chapter
Mutual Funds, Pension Funds, Insurance
Companies, Finance Companies, and
Other Financial Institutions
Money and Capital Markets
Financial Institutions and Instruments in a Global Marketplace
Eighth Edition
Peter S. Rose
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu
17 - 2
 Learning Objectives 
 To explore the many roles played by mutual
funds, pension funds, insurance companies,
finance companies, mortgage banks, and
security dealers.
 To discover the different services they offer.
 To examine their principal sources and uses of
funds.
 To understand the key problems they face
today.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
17 - 3
Mutual Funds (Investment Companies)
 Mutual funds, or investment companies, direct
the savings of individual investors into bonds,
stocks, and money market securities.
 A small saver who buys mutual fund shares
gains opportunities for capital gains and
indirect access to higher yielding securities
that can be purchased only in large blocks, and
yet still enjoys price stability, low risk, and
high liquidity.
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Mutual Funds (Investment Companies)
 Investment companies first developed in the
U.K., and then made their appearance in the
U.S. in 1924 as a vehicle for buying and
monitoring subsidiary corporations.
 Since then, the traditionally stock-investing
industry has seen many innovations – bond
funds, money market funds, index funds,
global funds, vulture funds, small/mid/largecap investment companies, and hedge funds.
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Mutual Funds (Investment Companies)
 Investment companies have a favorable tax
situation – they pay no federal taxes on income
generated by their security holdings, provided
their earnings flow through to their customers.
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Mutual Funds (Investment Companies)
 Open-end investment companies, or mutual
funds, buy back (redeem) their shares any time
the investor wishes, and sell shares in any
quantity demanded.
 The price of each open-end company share is
equal to the net asset value of the fund – that
is, the difference between the values of its
assets and liabilities divided by the volume of
shares issued.
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Mutual Funds (Investment Companies)
 Closed-end investment companies sell only a
specific number of ownership shares, which
usually trade on an exchange.
 They offer “double discounts” – discounted
prices on the stocks they hold and discounted
share prices to buy into the fund itself.
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Mutual Funds (Investment Companies)
Source: Board of Governors of the Federal Reserve System
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Mutual Funds (Investment Companies)
 Investment companies adopt many goals.
Growth funds invest mainly in common stocks
offering strong growth potential to achieve longterm capital appreciation.
 Income funds typically purchase stocks and bonds
paying high dividends and interest to gain current
income.
 Balanced funds acquire bonds, preferred stock, and
common stock that offer both capital gains
(growth) and current income.

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Mutual Funds (Investment Companies)
 It is not clear if mutual funds hold a significant
advantage over other investors in seeking the
highest returns available in the financial
marketplace.
 With the possible exception of index funds,
these companies may roll over their portfolios
too rapidly, running up the cost of managing
the fund and reducing earnings.
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Pension Funds
 Pension funds protect individuals and families
against loss of income in their retirement years
by allowing workers to set aside and invest a
portion of their current income.
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Pension Funds
 Defined benefit plans promise a specific
monthly or annual payment to workers when
they retire based upon the size of their salary
during their working years and their length of
employment.
 Such programs have the advantage of
guaranteed income, but an employee who
leaves early or is dismissed before retirement
may get little or nothing.
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Pension Funds
 Defined contribution plans specify how much
must be contributed each year in the name of
each worker, but the amount to be received
when retirement is reached will vary
depending upon the amount saved and the
returns earned on accumulated savings.
 The funds saved belong to the employee, and
are portable.
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Pension Funds
$ Billions
Assets of Pension Funds
8,000
Private Pension Funds
7,000
Government Retirement Funds
6,000
Total Financial Assets
5,000
4,000
3,000
2,000
1,000
0
1961
1966
1971
1976
1981
1986
1991
1996
2001
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
17 - 15
Pension Funds
 Pension funds are long-term investors with
limited need for liquidity.
 Their incoming cash receipts are known with
considerable accuracy, and their cash outflows
are not difficult to forecast.
 However, the pension fund industry is closely
regulated in all its activities.
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Pension Funds
Source: Board of Governors of the Federal Reserve System
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Pension Funds
Source: Board of Governors of the Federal Reserve System
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Pension Funds
 There appear to be serious problems ahead for
both the growth and stability of pension plans.
The rising proportion of pension beneficiaries to
working contributors, related to the aging of the
population.
 The increasing cost of maintaining pension
programs, especially defined benefit plans.
 The rising cost of government regulation with
respect to reporting requirements and employee
rights.

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17 - 19
Life Insurance Companies
 Life insurance companies offer their customers
a hedge against the risk of earnings losses that
often follow death, disability, or retirement.
 Policyholders receive risk protection in return
for their payment of policy premiums.
 Additional funds to cover claims and expenses
are provided by the earnings from the
investments made by the insurance companies.
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Life Insurance Companies
 The principal kinds of policies sold by life
insurance companies include ordinary or
whole life, term life, endowment, group life,
industrial life, universal life, variable life,
adjustable life, and credit life insurance.
 Many policies combine financial protection
against death, disability, and retirement with
savings plans to help the policyholder prepare
for some important future financial need.
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Life Insurance Companies in the U.S.
Data
McGraw
Source:
HillAmerican
/ Irwin Council of Life Insurers
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
17 - 22
Life Insurance Companies
 The insurance business is founded upon the
law of large numbers – a risk that is not
predictable for one person can be forecast
accurately for a sufficiently large group.
 So, life insurers invest the bulk of their funds
in long-term securities, and frequently follow a
“buy and hold” strategy. They generally pursue
income certainty and safety of principal in
their investments.
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Life Insurance Companies
Source: Board of Governors of the Federal Reserve System
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Life Insurance Companies
 The majority of the close to 1,700 U.S. life
insurance companies are stockholder-owned
corporations. The rest are mutuals that issue
ownership shares to their policyholders.
 The population reached a high of almost 2,350
in 1988 and has been falling ever since.
 Most notably, the largest life insurers today are
converging with other financial institutions to
form huge multi-product businesses.
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Life Insurance Companies
 Life insurers are under increasing pressure to
develop new services.
 Among the most important recent innovative
services are universal and adjustable life
insurance, variable premium and variable life
insurance, mutual funds, tax shelters, venture
capital loans, guaranteed investment contracts,
corporate cash management systems, and
deferred annuities.
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17 - 26
Property-Casualty (P/C) Insurance Companies
 Property-casualty (P/C) insurers (insurance
supermarkets) offer protection against events
like fire, theft, bad weather, and negligence
that result in injury to persons or property.
 Traditional P/C insurance covers automobile,
fire, marine, personal liability, and property.
 Many P/C insurers have also branched into
health and medical insurance, clashing head-on
with life insurers.
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Property-Casualty (P/C) Insurance Companies
 There are nearly 3,000 P/C companies in the
U.S., of which about three quarters are
stockholder-owned, while the rest are mutuals.
 P/C insurance is a riskier business than life
insurance – P/C claims are less predictable and
inflation has a potent impact.
 Moreover, the P/C risk patterns appear to be
changing. For example, there has been a rapid
rise in product liability claims.
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Property-Casualty (P/C) Insurance
Companies
Source: Board of Governors of the Federal Reserve System
17 - 29
Property-Casualty (P/C) Insurance Companies
 Like life insurance firms, P/C insurers plan to
break even on their insurance product lines and
earn most of their net return from their
investments.
 However, achieving the break-even point is
difficult. In fact, P/C insurers have experienced
billions of dollars in underwriting losses in
recent years.
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Property-Casualty (P/C) Insurance Companies
 The earnings and sales revenue of the P/C
insurance industry reflect the ups and downs of
the business cycle.
 Moreover, inflation pushes up the cost of
claims, while intense competition holds
premium rates down.
 To improve their future situation, P/C insurers
must become more innovative in developing
new services.
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Finance Companies
 Finance companies grant credit to businesses
and consumers for a wide variety of purposes,
including the purchase of business equipment,
automobiles, vacations, and home appliances.
 As such, they are sometimes called department
stores of consumer and business credit.
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Finance Companies
 Consumer finance companies make personal
cash loans to individuals, such as home equity
loans and loans to support the purchase of
passenger cars and home appliances.
 Sales finance companies make indirect loans to
consumers by purchasing installment paper
from dealers selling consumer durables.
 Commercial finance companies focus mainly
on extending credit to business firms.
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Finance Companies
 Finance companies are heavy users of debt in
financing their operations.
 The lack of an extensive network of branch
offices has put many finance companies at a
disadvantage.
 The number of finance companies is on the
decline, although their average size has grown
considerably.
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17 - 34
Other Financial Institutions
 Security dealers “take a position of risk” in
securities. They trade in securities with the
expectation of earning a profitable spread.
 Investment bankers assist businesses and
governments in issuing debt and stock.
 Venture capital firms provide long-term capital
financing for new businesses and rapidly
emerging companies.
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Other Financial Institutions
 Mortgage banks work with other businesses on
real estate development projects and sell the
resulting loan instruments to other investors.
 Real estate investment trusts (REITs) fund
commercial and residential real estate projects.
 Leasing companies purchase business
equipment and other assets and then lease
them in return for rental fees.
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Trends Affecting All Financial Institutions Today
 There are several major trends affecting
virtually all financial institutions today:
increasing cost pressures
 consolidation
 service diversification and homogenization
 convergence
 technological revolution
 global competition
 regulatory cooperation and harmonization
 deregulation

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Money and Capital Markets in Cyberspace
 Mutual funds are discussed at
http://www.ici.org/, http://www.sec.gov/, and
http://investing.wsj.com/mutualfunds.html.
 More information on pension funds can be
found at http://www.pionline.com/ and
http://www.pensionsurveys.com/.
 Websites for the insurance industry include
http://www.acli.com/, http://www.iii.org/, and
http://www.namic.org/.
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Money and Capital Markets in Cyberspace
 Visit some finance companies and investment
banks like http://www.citifinancial.com/,
http://www.citgroup.com/, http://www.lehman.com/,
http://www.morganstanley.com/, and
http://www.gs.com/.
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17 - 39
Chapter Review
 Mutual Funds (Investment Companies)
The Background of Investment Companies
 Tax Status of the Industry
 Open-End and Closed-End Investment Companies
 Goals and Earnings of Investment Companies

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Chapter Review
 Pension Funds
Growth of Pension Funds
 Investment Strategies of Pension Funds
 Pension Fund Assets
 Factors Affecting the Future Growth of Pension
Funds

McGraw Hill / Irwin
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17 - 41
Chapter Review
 Life Insurance Companies
The Insurance Principle
 Investments of Life Insurance Companies
 Sources of Life Insurance Company Funds
 Structure and Growth of the Life Insurance
Industry
 New Services

McGraw Hill / Irwin
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17 - 42
Chapter Review
 Property-Casualty (P/C) Insurance Companies
Makeup of the P/C Insurance Industry
 Changing Risk Patterns in Property/Liability
Coverage
 Investments by P/C Companies
 Sources of Income
 Business Cycles, Inflation, and Competition

McGraw Hill / Irwin
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17 - 43
Chapter Review
 Finance Companies
Different Finance Companies for Different
Purposes
 Growth of Finance Companies
 Methods of Industry Financing
 Recent Changes in the Character of the Industry

 Other Financial Institutions
 Trends Affecting All Financial Institutions
Today
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.