CHAPTER
25
Insurance
Operations
Insurance
•Historical and Religious
Connotations
•Ways to deal with risk
•Avoid or reduce risk
•Assume risk
•Transfer risk
Where do deaths occur?
20% in a land-based vehicle
17% in the home
14% to pedestrians on streets or sidewalks
16% when travelling by air, rail, or water
33% in a hospital
But only 0.001% in a church
Moral: safest place to be is in church
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Insurance
Ways to Transfer Risk:
-- loss of income due to death (life insurance)
-- loss of income due to illness or injury (disability insurance)
-- loss of money in bank (deposit insurance)
-- loss from not paying off debts (credit insurance)
-- loss from malpractice or negligence (liability insurance)
-- loss from medical costs (medical insurance)
-- loss of income from no job (unemployment insurance)
Etc.
Law of Large Numbers
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Insurance
Problems of assessing risk-based
premiums
1. Adverse Selection


People who get insurance are more likely to suffer losses
and file claims than people who don’t get insurance
E.g. renter insurance is not a big deal for Beth because she
locks her door but Bob doesn’t lock his door so he feels
the need to get insurance
2. Moral hazard

People take more risks once they’re insured
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Life Insurance

Life insurance pays out
policy amount in cash to the
beneficiary (tax free!) upon
\ accidental or natural death

Provides for loss of income

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Keep you poor while you are alive so you can die rich
Life insurance premiums reflect


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Probability of making payment to the beneficiary (age and health)
Size and timing of the payment (policy amount)
Use mortality figures and actuarial tables to forecast claims
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Types of Life Insurance Policies
Cash Value Insurance
Term Insurance
Group
Universal Life
Group Term
Variable Life
Individual
Term
Whole Life
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Premiums Under Various Policies
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Types of Life Insurance Policies

Whole life insurance includes both a death
benefit (term insurance) and a savings
component that

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Builds a tax sheltered cash value for the future for
the owner of the policy (forced savings plan)
Generates periodic cash flow over the life of the
policy for the insurance company to reinvest
Pays fixed death benefit at death
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Types of Life Insurance Policies

Term life insurance characteristics
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Temporary, providing death benefits only over a
specified term
Premiums paid represent insurance only with no
saving component
Considerably lower cost for the insured than
whole life—able to buy more insurance protection
per dollar of premium
Term is for those who would rather invest their
savings elsewhere (why pay ins. co. to invest?)
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Types of Life Insurance Policies

Variable life insurance

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Whole life with variable cash value amounts
Cash values invested in equities and will vary with
the investment performance
Flexible premium option since 1984
Universal life insurance

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Combines the features of term and whole life
Variable premiums over time—buys terms and
invests difference in a variety of investments
Builds a varying cash value based on contributions
and investment performance
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Types of Life Insurance Policies

Group plans

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Employees of a corporation offered life insurance
or life insurance purchased on life of employee
Cash value or term insurance
Low cost (term) because of its high volume
Can cover group members and dependents
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Uses of Life Insurance Company Funds
ASSETS
Corporate bonds
32%
(Largest investor in bonds because maturities can be matched; limited
mostly to quality bonds, subject to interest-rate risk)
Gov’t bonds
Mortgages & Real Est.
Stocks
Policy Loans
Cash and Other
8%
18%
28%
2%
12%
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Sources of Life Ins. Company Funds

Liabilities (claims, annuities)

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PV of actuarially-determined claims (determined
by age, health, life expectancy, policy amount)
Surplus

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Stock owned (95% of companies)
Risk-based capital requirementsOr mutually
owned (5% of companies but 46% of volume)

See list of mutuals
https://en.wikipedia.org/wiki/Mutual_insurance
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Operations of Life Insurance Company

INCOME

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Premiums earned
Investment Income (large source of income; Buffet calls this “float”
income – earned from investing the excess of premiums collected over
claims paid)
EXPENSES

PV of Claims

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In early 1980s, paid 75% of premiums out in claims; but now, only 60%. They
say returns/inflation in 1980s allowed them to do this.
Operating Costs (commissions, admin., mktg, tax)
NET INCOME
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Operations of Life Insurance Company
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Uses of Funds—Policy Loans

Policy loans are loans to policyholders

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Whole life policies
Borrow up to the cash value of the policy
Guaranteed interest rate is stated in the policy
Usually used by borrowers during periods of
rising rates to lock in the lower rate associated
with their policy
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Regulation

Pricing is market-based with no federal guarantee

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Ins. Co.s are highly regulated by state ins. agencies
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Ratings by AM Best, Standard & Poors, Duff and Phelps,
Moody’s, and Wiess Research.
Reinsurance (Lloyds of London is a big re-insurer; known
to insure all kinds of risks, such as body parts).
Make sure insurance companies provide adequate service
Agent licensure
States approve/review rates
The National Association of Insurance
Commissioners (NAIC)


Provides coordination among states in regulatory matters
Adopted uniform regulatory reporting standards
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Regulation

Insurance Regulatory Information System

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Compiles financial information and lists of
insurers
Calculates 11 ratios to assess and monitor
financial health
Assessment system

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Ability of the company to absorb either losses or a
decline in the market value of its investments
Return on investment
Relative size of operating expenses
Liquidity of the the asset portfolio
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Regulation: Dodd-Frank Act of 2010



If it weren’t for AIG, maybe the insurance industry
wouldn’t have been part of this regulation.
Now, a Federal Insurance Office is being created
which will gather info from insurance companies
each year, monitor for systemic risk, and likely
recommend a slew of regulations down the road.
NOTE: will not issue new regs itself but recommend
regs to states.
Health and crop insurance are excluded from DoddFrank
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S&P Insurance Ratings
AAA
An insurer rated 'AAA' has EXTREMELY STRONG financial
security characteristics. 'AAA' is the highest Insurer Financial
Strength Rating assigned by Standard & Poor's.
AA
An insurer rated 'AA' has VERY STRONG financial security
characteristics, differing only slightly from those rated higher.
A
An insurer rated 'A' has STRONG financial security
characteristics, but is somewhat more likely to be affected by
adverse business conditions than are insurers with higher
ratings.
BBB
An insurer rated 'BBB' has GOOD financial security
characteristics, but is more likely to be affected by adverse
business conditions than are higher rated insurers.
An insurer rated 'BB' or lower is regarded as having vulnerable
characteristics that may outweigh its strengths. 'BB' indicates
the least degree of vulnerability within the range; 'CC' the
highest
http://www.insure.com/articles/interactiv
etools/sandp/newtool1.jsp
BB
An insurer rated 'BB' has MARGINAL financial security
characteristics. Positive attributes exist, but adverse business
conditions could lead to insufficient ability to meet financial
commitments.
B
An insurer rated 'B' has WEAK financial security characteristics.
Adverse business conditions will likely impair its ability to meet
financial commitments.
CCC
An insurer rated 'CCC' has VERY WEAK financial security
characteristics, and is dependent on favorable business conditions
to meet financial commitments.
CC
An insurer rated 'CC' has EXTREMELY WEAK financial security
characteristics and is likely not to meet some of its financial
commitments.
R
An insurer rated 'R' is under REGULATORY SUPERVISION owing
to its financial condition. During the pendency of the regulatory
supervision, the regulators may have the power to favor one class
of obligations over others or pay some obligations and not others.
The rating does not apply to insurers subject only to nonfinancial
actions such as market conduct violations.
NR
An insurer rated 'NR' is NOT RATED, which implies no opinion
about the insurer's financial security.
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Exposure to Financial Risks

Interest rate risk

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Fixed rate assets (bonds) have market values
sensitive to interest rate changes
More IRR in life ins. co. than P&C
Credit risk (default risk)
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Mortgages, corporate bonds and real estate
holdings can involve default risk
Usually only hold investment-grade securities
Diversify portfolio among debt issuers
If major disaster, surplus must absorb losses
(Florida, Hurricane Hugo, etc.)
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Property and Casualty Insurance
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Property insurance (fire insurance)
Casualty insurance (liability)
Both timing and amounts of claims are
unknown!
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PC Versus Life Insurance Companies
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PC have shorter contracts
PC have more varied risk areas (default and
liquidity risk, but not interest-rate risk)
Life companies are larger due to long-term
savings and annuity pension contracts
PC has wider distribution of occurrences


PC’s need liquid, marketable assets
PC’s earnings more volatile
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Property Casualty Example (GEICO)

E.g. GEICO (Government Employees insurance Company)
13 million auto policies covering 22 million vehicles
Wholly-owned subsidiary of Berkshire Hathaway
Rated AA+ by S&P, Aa1 by Moody’s, and A++ by AM Best.

https://www.geico.com/about/corporate/at-a-glance/
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Property & Casualty Ins. Use of Funds
ASSETS
Corporate Bonds
Muni bonds
Treas./Agency Bonds
Common Stock
Cash
Other
25%
23%
15%
18%
2%
17%
(PCs face heavy tax)
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Property Casualty Investment Needs

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Tax sheltering--major municipal/state bond
investor
Liquid, marketable assets
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Marketable corporate and government bonds
Listed common stock
Inflation hedge--common stock
Reinsurance contracts
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P&C Balance Sheet (e.g. Allstate)
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P&C Balance Sheet (e.g. Allstate)
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Operations of P&C Insurance Company
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INCOME
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
EXPENSES
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Premiums earned
Investment Income (large source of income; Buffet calls this “float”
income – earned from investing the excess of premiums collected over
claims paid)
PV of Claims
Operating Costs (commissions, admin., mktg, tax)
NET INCOME
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“Float” in an Insurance Company
EXCERPT FROM WARREN BUFFET’S ANNUAL LETTER:

“Insurance float is booming. In the insurance business, you collect money up front and pay
out claims later. The money held in the meantime is called “float,” and it can be invested for
your benefit.

Berkshire’s float is now $66 billion — more than double from a decade ago. If this float were
a company, it’d be the 40th largest in the S&P 500.

Berkshire’s insurance managers have done such a phenomenal job pricing policies that
insurance claims and expenses have been covered by premiums alone, without tapping into
investment income, for eight consecutive years — almost unheard of in the industry. That
makes its float like a $66 billion interest-free loan. Better than that, actually. Shareholders
“benefit just as we would if some party deposited $66 billion with us, paid us a fee for
holding its money and then let us invest its funds for our own benefit.”
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Property Casualty (e.g. Allstate float)
Float at Allstate =
$10 billion ($29B
+$2B - $19B $2B)
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Health Care Insurance

Health maintenance organizations or HMOs


Intermediaries between purchasers and providers
of health care
Annual fee or premium
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Covers all medical expenses
Medical staff is designated by the HMO
Losses in recent years for HMOs
Preferred Provider Organizations (PPOs)

Can see any physician without a wide group
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Insurance Scandals

In 2004, Eliot Spitzer brought a civil suit
against Marsh & McClennan for:



Bid-rigging, kickbacks, price-fixing
Contingent commissions
M&M agreed to give $850 million back to its
customers. Cut 5500 jobs, blaming costs of
settlement. Agreed to adopt new reforms
including a limit on commissions.
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Insurance and Derivatives
In risk management, there’s not much difference
between using traditional insurance and derivatives to
manage risk.
E.g. Disney & business interruption insurance
E.g. Farmer buying crop insurance
E.g. Stock investor buying investment insurance
E.g. Investors buying credit insurance on bonds
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Other insurance operations
Bond Insurance
Bond insurance protects the investors that purchase bonds in the
event that the bond issuers default on their bonds.
Mortgage Insurance
Mortgage insurance protects the lender that provides mortgage
loans in the event of homeowner default.

Credit Default Swaps as a form of mortgage bond insurance


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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Credit Default Swaps (ticking time bombs)
CDS provide insurance on bonds (but they didn’t want to call it “insurance “
otherwise it would be regulated)
• If bonds lose value, the CDS would make good on the loss
• CDS were considered a good thing . . . Until speculation began
• Speculators would bet on bonds going bad (like Bob buying insurance on Jehu’s car;
since Jehu is a risky driver, Bob collects if Jehu crashes.)
• Described by Buffet as “financial weapons of mass destruction.”
World-wide GDP in
• Multiple CDS were contracted on the same bonds
2007 was $54 trillion
Global est. value of CDS
in 2007 was $58 trillion!!!
CDS were ticking time
bombs in almost every
major investment
portfolio
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AIG rolled the dice by
providing credit insurance
on $700B of Lehman Bros.
When the bonds went
bad, AIG could not make
good.
As a tell-tale symbol, the DJIA
replaced AIG with Kraft
(Altria) – a financial stock
substituted with a
food/tobacco stock!
An AIG executive said as late as August
2007 that “It is hard for us, without being
flippant, to even see a scenario within any
kind of realm of reason that would see us
losing one dollar in any of those [CDS]
transactions.” Copyright© 2002 Thomson Publishing. All rights reserved.
Credit Default Swaps (ticking time bombs)
Exposure to Risk during the Credit Crisis
 Government Rescue of AIG




American International Group (AIG) is the largest insurance
company in the world, with annual revenue of more than $100
billion and operations in more than 130 countries.
In 2008, AIG experienced severe financial problems because many
debt securities defaulted which were backed by AIG’s CDSs.
Since the failure of AIG could have a devastating effect on the
insurance industry and the rest of the financial sector, the Federal
Reserve bailed out AIG in September 2008 with support from the
U.S. Treasury.
The bailout allowed AIG to borrow up to $85 billion from the
Federal Reserve over a two-year period, and the government
received an equity stake of about 80 percent of AIG.
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Copyright© 2002 Thomson Publishing. All rights reserved.
Copyright© 2002 Thomson Publishing. All rights reserved.
Copyright© 2002 Thomson Publishing. All rights reserved.