Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
And
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 18
INSURANCE
COMPANIES AND
PENSION FUNDS
The Insurance Service Indemnify another against risk of economic loss.
Requires pooling of a large number of similar, but
independent risks - law of large numbers.
Insurance is the last step after other pure risk
control and reduction techniques of risk
management.
Pure risk, the chance of loss, differs from
speculative or investment risk which is related to
the variability of returns where one can have a
gain or a loss.
Insurance reduces society's cost of bearing risk.
Copyright© 2006 John Wiley & Sons, Inc.
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The Insurance Mechanism
An insurer assumes objective risk which is
the deviation of actual losses from expected
losses. It is part of the operating risk of an
insurance company.
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Insurable Risks
homogeneous or similar.
fortuitous, random or occurring by chance.
circumstances of loss can be identifiable.
a probability of loss can be estimated.
the losses occur independent of each other-not all
at once, such as a flood, wiping out the insurer.
premiums must be economically feasible for the
insured.
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Objective risk control methods include:
use of loss prevention techniques such as
"safety" programs.
accept "average" risks as customers.
require deductibles or shared losses with the
insured.
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Insurance premiums represent the sum of:
expected losses, plus
operating costs, plus
target profit, less
premium investment income
with adjustment as necessary for
competitive conditions
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Interest rate risk affects insurance companies.
Insurance contracts are long-term contracts:
interest rates vary providing incentives for
cancellations and revision of intentions.
Because of long-term nature of liabilities,
portfolios are heavily invested in bonds
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Life/Health Insurance Companies
Dominated in numbers by stock companies;
in asset size, by mutuals (32%).
Oldest financial intermediary in U.S. (1759)
Slow growth in 1990’s after pension and
mutual funds
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Term Insurance: Basic Model
Payment for death only
Coverage for specified term
Lower premium
Large amount of protection per premium
dollar
No “investment” features
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Term Insurance: Variations
Straight - coverage for specific time period with
premiums increasing with age.
Renewable - option to continue after expiration
date, independent of health changes.
Decreasing - pay level premiums over a period of
years while level of coverage declines.
Convertible - policyholder may convert to a whole
life policy for an added premium fee.
Copyright© 2006 John Wiley & Sons, Inc.
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Whole Life
Level premiums for constant level of protection.
Premium includes cost of insurance (decreasing
term) and savings contribution.
Cash values (savings accumulated by insured)
increase with time.
Death benefit includes decreasing term amount
and "return" of savings.
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Whole Life, cont.
Provides "living" benefits in form of
accumulated savings.
Combines life insurance and savings (at a
relatively low but contractual rate).
Interest or dividends on cash values
accumulate free of income taxes-important
tax shelter.
Copyright© 2006 John Wiley & Sons, Inc.
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Universal life
The most popular interest-sensitive
permanent policies.
Flexible premium policy with varying death
benefit and premium amounts.
Pays market rate on savings.
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Variable Life
Popular in the 1990’s with rapid growth in
equity values.
Fixed-premium
Insured direct investment of cash values
Guaranteed death benefit
No guaranteed cash value
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Annuities
Superannuation- risk of living beyond one’s
means
A life annuity, for a given payment, pays a
life long stream of payments.
The period of time and survivorship terms
vary.
The longer the "certainty," the less the
payments.
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Health Insurance
Covers medical, disability, and dental
expenses.
Insurance companies write about sixty
percent of health insurance premiums.
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Balance Sheet of Life Insurers
Liabilities and net worth
Life insurance reserves - funds owed for life
insurance policies, including cash values and
losses owed, not yet paid.
Pension fund reserves - accumulated
commitments to pay future pensions.
Surplus and net worth
Copyright© 2006 John Wiley & Sons, Inc.
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Balance Sheet of Life Insurers, cont.
Assets - long-term matching liabilities
Corporate bonds-largest financial investment
Corporate equities-Variable life
Mortgages
U.S. government securities
Policy loans
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Property/Casualty Insurers
Property insurance - protection from
financial loss of property from perils such
as fire and theft.
Casualty insurance - liability, worker's
compensation, auto, aircraft, marine
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Life vs. P/C operations
P/C policies shorter term than life
P/C loss payments less predictable
P/C balance sheet must be more liquid
P/C loss payments increase with inflation
Both life and P/L firms generate revenue from
premiums and investment income
Copyright© 2006 John Wiley & Sons, Inc.
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Balance Sheet of P/C Insurers
Assets - selected for income, inflation hedge,
liquidity, and tax sheltering
State and municipal bonds (tax free) and corporate
bonds
Corporate stock (inflation hedge and income)
Government securities (liquidity and income)
Trade credit ($ owed by customers and agents)
Copyright© 2006 John Wiley & Sons, Inc.
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Balance Sheet of P/C Insurers, cont.
Liabilities and net worth
Policy reserves include:
• unearned premium reserve.
• losses incurred, not paid.
Surplus and net worth
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Types of P/C Policies
Property - insurance against losses
associated with physical damage.
“Named perils” : Coverage limited to
specific losses listed in policy.
“All-risk coverage” or “open perils”: Any
loss covered unless specifically excluded.
Liability - insurance against financial
responsibility for harm to another’s person
or property.
Copyright© 2006 John Wiley & Sons, Inc.
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Types of P/C Policies, cont.
Marine insurance - covers losses related to
transportation.
Ocean marine - ocean transportation
Inland marine - inland transportation and some
special personal property such as furs and
jewelry
Multi-peril or multi-line-combines property
and liability insurance.
Copyright© 2006 John Wiley & Sons, Inc.
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Types of Pension Plans
Private Pension Plans
Insured – managed by life insurer
Noninsured
• Trustee managed by a third party
• Non-trustee - managed by firm or labor union
Government-sponsored Pension Plans
Social Security
Federal, state, and local government plans
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Pension Plan Vocabulary
Fully funded: contributing funds sufficient to cover
future obligations versus paying benefits from current
revenue
Contributory: employee and employer contribute
Fully contributory: only employee contributes
Noncontributory: only employer contributes
Defined benefit: Benefits set by formula based on
years of service and average salary; responsibility is
fully on employer to provide promised benefits
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Pension Vocabulary, cont.
Defined contribution: employee and employer
each make contributions of some set percentage
of salary; employee chooses how funds are
invested; ultimate benefits depend on
employee’s investing; 401k most popular
example today
Vesting: employee assured of retirement
benefits after a set period of time.
Portability: ability to transfer vested benefits to
another plan
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Pension Management Factors
Little need for liquidity
“Qualified” Plans not taxed
The higher the earning rate, the lower the
contribution to support a given benefit
Pension funds face risk/return trade-off decisions
for their beneficiaries
Regulation focuses on fiduciary duty, full
funding, and prudent investing
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