Nondepository Financial
Institutions
Chapter 10
Life Insurance Companies
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Oldest type of intermediary in the U.S.
1759 in Philadelphia (now called Presbyterian
Ministers’ Fund)
Invest funds obtained through the sale of policies.
Primary investments: Long term taxable, not highly
marketable securities: corporate bonds and
commercial mortgages.
Income paid to policy holders is tax exempt - return
on the policy holders investment
Insure against dying too soon and living too long.
Life Insurance Companies
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Regulation of life insurance companies
includes:
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Sales practices
Premium rates
Allowable investments
Usually overseen by a state insurance
commissioner, who might also be the
state banking commissioner
Types of Life Insurance Policies
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Whole Life Insurance
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Constant premium that is paid through
entire life of policy
Build up cash reserves or savings which
can be withdrawn as borrowing or outright
by canceling the policy
Savings component pays a money market
rate of interest that changes with market
conditions
Types of Life Insurance Policies
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Term Life Insurance
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Pure insurance with no cash reserve or savings element
Premiums are relatively low at first but increase with the age
of the insured individual
Universal (variable) Life
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Variation on whole life policy
“Unbundle” the term insurance and tax-deferred savings
component
Owner can elect how to allocate the savings component
among a menu of investment options, thereby potentially
earning above money market rates
Life Insurance Companies
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Based on actuarial tables, life insurance
companies have ability to predict cash flow
Typically insurance companies use excess
funds to buy long-term corporate bonds and
commercial mortgages
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Higher yields
Unlikely of having to sell prior to maturity
However, lately they have branched out into
riskier ventures such as common stock and
real estate
Life Insurance Basics
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Public makes payments in exchange for
protection
Companies lend out the funds collected.
Companies use the interest and dividend
income received to pay benefits to
policyholders
Insurance companies have a reasonably
predictable stream of payments to policy
holders distributed over time.
Dealing with AsymmetricInformation Problems in Insurance
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Limiting adverse selection
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Restricting the availability and quantity of
insurance.
Limiting moral hazard in insurance
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Deductible: A fixed amount of an insured loss that
a policyholder must pay before the insurer is
obliged to make payments.
Coinsurance: A policy feature that requires a
policyholder to pay a fixed percentage of a loss
above a deductible.
Pension Funds
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Program established by an employer to
provide retirement benefits to employees.
History
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established at the end of the 19th century by
railroads.
1875 - American Express Company who was
closely associated with railroading.
Many failed during the depression - led to
increased regulation.
Pension Funds
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Individuals need pension plans to
supplement Social Security benefits
Most pension fund assets are in
employer-sponsored plans
Defined Benefit Plan
Defined Contribution Plan
Defined Benefit Plan
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Retirement benefits are defined by the plan
Employer contributions are adjusted to meet the
benefits and insure the plan is fully funded—enough
funds to meet future obligations
Vesting
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Employee Retirement Income Security Act (ERISA)
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Retirement benefits remain with the employee if they leave
the firm and is based on length of employment
Establishes minimum reporting, disclosure, vesting, funding
and investment standards to safeguard employee pension
rights
Pension Benefit Guaranty Corporation—
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Guarantees some benefits in defined benefit plans if company
is unable to meet its accrued pension liabilities
Defined Contribution Plan
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Contributions are defined by the plan
Contribution may be made by employees or
employers or a combination of the two
Employee contributions are tax deferred—taxes
payable when funds are withdrawn
Benefits depend on the performance of the assets in
the plan
Avoids the problems of vesting and funding
Individual employee has the ability to choose the
assets in which to invest
Most common are 403(b) and 401(k)
Pension Funds
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Defined contribution plans are the type
favored by most employers, although some
employers offer both plans
In addition to employer-sponsored plans,
some individuals are given tax incentives to
set up their own pension plans
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Keogh Plans—self-employed individuals
Individual Retirement Accounts (IRAs)—
working people who are not covered by companysponsored pension plans
Pension Fund Basics
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Tax-exempt institutions set up to
provide participants with retirement
income that will supplement other
sources of income.
The number of people likely to retire
each year is quite predictable.
As a result they invest about 80% of
their funds in corporate equities.
Property and Casualty Insurance
Companies
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Insure against casualties such as
automobile accidents, fire, theft,
personal negligence, malpractice, etc.
Losses can be unexpected and highly
variable.
Invest in tax-free municipal bonds and
short-term securities.
Property and Casualty
Insurance Companies (Cont.)
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State insurance commissions set ranges
for rates, enforce operating standards,
and exercise overall supervision over
company policies
Little federal involvement in regulating
these companies
Most Costly Natural Disasters
Since 1992
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Hurricane Andrew caused $30 billion in damages in 1992
Midwest floods caused $20 billion in damages in 1993
The Northridge earthquake in California caused $42 billion in
damages in 1994;
Severe weather and floods in Texas, Oklahoma, Louisiana, and
Mississippi caused $5.5 billion in damages in 1995
Hurricane Marilyn caused $2.1 billion in damages in 1995
Hurricane Mitch caused an estimated $2.1 billion in damages in
Central America and the United states in 1998
The southern plains drought caused $4 billion in damages in 1996
Hurricane Fran caused $5 billion in damages in 1996
The winter blizzard of 1996 caused $500 million in damages
Red River floods in North Dakota and Minnesota caused $4 billion in
damages in 1997
Preliminary figures from 1998's Hurricane Georges show it killed 350
people and total insured losses could end up reaching $2 billion
Cost to insurers
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ACE and XL Capital:
$1bn-1.1bn
AIG: $500m
Allianz: $930m
AXA: $300-400m
Berkshire Hathaway:
$2.2bn
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www.berkshirehathaw
ay.com
CNA Financial:
$200m-350m
•Chubb: $500-600m
•Employers' Re: $600m
•GE: $600m
•Hannover Re: $365m
•Munich Re: $1.95bn
•Partner Re: $350-400m
•Royal & Sun Alliance: $220m
•Scor: $150m-200m
•Swiss Re: $1.25bn
•Zurich Financial: $400m
Mutual Funds
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Money Market Mutual funds have been
prominent on the American financial scene
since the 1970s
However, stock market mutual funds (Mutual
Funds) have been in existence since the
1950s.
A mutual fund pools the funds of many
people and managers invest the money in a
diversified portfolio of securities to achieve
some stated objective
Open-end Mutual Fund
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Sell redeemable shares in the fund to the general
public
Shares represent a proportionate ownership in a
portfolio held by the fund
Shareholder can go directly to fund and buy
additional shares or redeem shares at their net asset
value (NAV)
No-load Funds--Sold directly to public at the current
NAV
Load Funds—Sold through brokers and buyer pays a
sales commission
Open-End Mutual Funds
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Net Asset Value (NAV)
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Fund calculates the total market value of
its portfolio and divides this figure by the
number of outstanding shares.
Redeem outstanding shares or issue new
ones at the NAV.
Number of shares is not fixed but increases
as more money is invested.
Commonly known as Mutual Funds.
Closed-End Investment Company
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Issues a fixed number of shares.
Invests the proceeds in a portfolio of
assets.
No load but brokerage fee.
Shares are transferable.
Price of the share is determined by
supply and demand.
Mutual Funds
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Mutual funds are regulated by the Securities
and Exchange Commission (SEC)
Primary objective of regulation is the
enforcement of reporting and disclosure
requirements to protect the investor
Many investors are attracted to families of
mutual funds
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Number of mutual funds operated under one
management umbrella
Investors can easily transfer money among funds
within the family
Net Asset Value Example
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A fund has 10 million shares and is
worth $100 million.
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Investors invest $20 million more.
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NAV = $10.00
At $10/share → 2 million shares → $120
million in assets with 12 million shares.
You can buy fractional shares.
Low-load Funds
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Load is ≤ 3% and goes to the fund.
Front end load
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Charged when shares are purchased.
Back end load
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Charged when shares are sold.
Full Load Funds
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Sold by salespeople who earn a
commission.
Load is split between the salesperson
and the fund.
Max load allowed by the SEC is 9.589%
12b-1 Plans
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Charge for advertising and selling
expenses, including sales commissions
to brokers.
All shareholders in the fund bear the
burden, not just new investors.
Funds that use 12b-1 plans call
themselves “no-load”.
Mutual Fund Information
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Mutual Fund Education Alliance
Morningstar.com
Valueline.com
Vanguard.com
Wall Street Journal
Bloomberg.com
Finance Companies
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Consumer Finance Companies
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Commercial finance Companies
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Make consumer loans
Specialty Finance Companies—specialize in
credit card financing
Make commercial loans usually on a secured
(collateralized) basis
Loans not as risky as consumer loans
Since lending is short-term, these companies
borrow substantial amounts in commercial
paper market
Finance Companies
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Historically finance companies have played an
important role in financing growing
undercapitalized companies
Commercial finance companies originated the
concept of leveraged buyout (LBOs) which
relies heavily on debt to pay for acquisition of
a company
Captive Finance Companies—Finance
purchase of commercial and retail oriented
businesses such as General Motors products
(GMAC)
Securities Brokers and Dealers
and Investment Banks
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These financial institutions play a crucial role
in the distribution and trading of huge
amounts of securities
Investment Banks
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Sell and distribute new stocks and bonds directly from issuing
corporations to original purchasers
League Tables rank investment banks by the volume of
securities they underwrite
Underwriting is typically conducted through a syndicate
which includes many investment banks and brokerage firms
Investment banks derive a substantial amount of income from
offering advice to firms involved in mergers and acquisitions
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What price one firm should pay for another
How the transaction should be structured
Provide strategic advice in hostile takeovers—when one firm
seeks to acquire another against the other’s wishes
Brokers and Dealers
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Involved in the secondary market,
trading “used” or already outstanding
securities
Brokers match buyers and sellers and
earn a commission
Dealers commit their own capital in the
buying and selling of securities and
hope to make profit on the transaction
Brokers and Dealers
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Many of the nationwide stock exchange firms
act as investment bankers, dealers, and
brokers
A number of large stock exchange firms have
branched out to provide new types of
financial services previously out of their
operating charter
Commercial banks, investment banks, and
broker dealers have now combined under
single holding company umbrellas
Venture Capital Funds, Mezzanine
Debt Funds, and Hedge Funds
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Venture capital funds, mezzanine debt funds,
and hedge funds are usually not available to
public investors and not registered with SEC
Funding comes from wealthy individuals or
other financial institutions, possibly sponsored
by brokerage firms and banks
Both venture capital funds and mezzanine
debt funds provide an important source of
funding to small and midsize companies
Financing by both venture and mezzanine
funds is non-traded and held until maturity
Venture Capital Funds
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Invest funds in start-up companies
Traditional bank financing for these firms in
the early stage of growth would be very
limited
The Venture Capital Fund receives a
substantial equity stake in the firm
Although many start-up companies will fail,
significant profit on those that are successful
Receives profits when it takes the successful
company public in an initial public offering
(IPO).
Mezzanine Debt Funds
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Provide debt funds to small and midsize
companies
Issue convertible debt and subordinated
debt
Sometimes simply invest in a combination of
high-yielding debt and equity issued by the
same company
Used to provide long-term funds, sometimes
part of a management-buyout financing
package
Hedge Funds
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Hedge funds:
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Limited partnerships that, like mutual funds,
manage portfolios of assets on behalf of
savers, but with very limited governmental
oversight as compared with mutual funds.
Long Term Capital
Management
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Founded by John Meriwether in 1993
LTCM had more credibility than the
average broker/dealer on Wall St.
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Two Nobel laureates: Robert Merton and
Myron Scholes
Former Vice Chair of the Board of
Governors of the Federal Reserve: David
Mullins
Biggest losers
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LTCM partners $1.1 billion
UBS $690 million
Dresdner Bank $100 million
Sumitomo Bank $100 million
Bank of Italy $100 million
Credit Suisse $55 million
Banks Versus Nondepository
Institutions
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Many nondepository institutions offer services
that compete directly with banks
Traditionally many of the different markets
were segmented, however, today they often
compete for the same business
The Gramm-Leach-Bliley Act of 1999
allowed the creation of financial holding
companies (FHCs) that can own
commercial banks, investment banks, and
insurance underwriters
Banks Versus Nondepository
Institutions (Cont.)
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The creation of FHCs brings the United
States much closer to the universal
banking regulatory model adopted by
the European Union