Transcript Document

26
Insurance
Operations
© 2003 South-Western/Thomson Learning
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Chapter Objectives
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Present the two major areas of insurance: 1)
life and health and 2) property and casualty
Describe the different types of insurance
policies and their sources of funds
Describe the main uses of insurance company
funds
Explain the exposure of insurance companies
to various forms of risk
Describe the regulatory environment of
insurance companies
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Insurance Companies
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Provide contractual risk management for:
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Risks of insurable asset losses (auto insurance)
Risks of liability claims (product liability)
Risk of large medical costs (health insurance)
Risk of disability (disability insurance)
Risk of premature death (life insurance)
Risk of longevity (annuities)
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Insurance Companies, cont.
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Major capital market intermediary
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Major investor in corporate (life) and state and
municipal bonds (property/casualty)
Major long-term commercial mortgage lender
(life)
Mutual or stock form of ownership
Premium and investment revenue
Losses and loss adjustment expenses
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Insurance Concepts
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Pure vs. financial risk
Insure fortuitous, independent risk occurrence
Premium covers losses, administrative
expenses and profits
Insured contracts for known loss (premium) in
return for protection
Moral hazard and adverse selection
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Background
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Life insurance companies
Provide risk management contracts for individuals
and businesses
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Risk areas include premature death, health maintenance
costs, and disability
Life insurance provides cash benefits to the beneficiary of
a policy on the policyholder’s death
Life insurance premiums reflect
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Probability of making payment to the beneficiary
Size and timing of the payment
Have portfolios of policies and 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
Variable Life
Term
Whole Life
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Types of Life Insurance Policies
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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 amount for the
future for the owner of the policy
Generates periodic cash flow payments 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
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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 for any amount of premium
Term is for those who would rather invest their
savings in other contracts or securities
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Types of Life Insurance Policies
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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
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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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Health Care Insurance
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Health maintenance organizations or HMOs
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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
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Sources of Life Insurance
Company Funds
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Cash value reserves—accumulated cash
values owed insureds (liability)
Pension reserves—accumulated “insured”
pension commitments (liability)
Annuity reserves—accumulated annuity
commitments (liability)
Unearned premium income—premiums
received; not yet earned (liability)
Loss reserves--losses incurred, not yet paid
Capital funds
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Uses of Life Insurance Company
Funds
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Major investor in corporate bonds
Government securities
Common stock
Commercial mortgage
Real Estate
Policy loans to insured
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Uses of Funds—Policy Loans
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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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Insurance Company Capital
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Capital
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Build capital by issuing new stock (stock
companies) or retaining earnings
Used to finance investments in fixed assets
Cushion against operating losses
Capital requirements vary depending on asset risk
Credibility with customers is also enhanced by
adequate capital
Mutual companies owned by policyholders—
includes earnings retained over time
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Regulation
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Insurance companies are highly regulated by state
insurance agencies
The National Association of Insurance
Commissioners (NAIC)
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Provides coordination among states in regulatory matters
Adopted uniform regulatory reporting standards
State Regulators
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Make sure insurance companies provide adequate service
States approve/review rates
Agent licensure
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Forms are approved to avoid misleading wording
Regulation
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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
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Regulation of capital
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In 1994 companies were required to report riskbased capital ratios to insurance regulators
Goals of requirements are to
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Discourage insurance companies from excessive
exposure
Back higher risks with higher capital
Reduce failures in the industry
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Risks of Life Insurance Companies
Pure Risk of Life
Insurance Policies
Pension
Commitments and
Annuities Contracts
Financial Risk
includes
Interest Rate Risk
Credit Risk
Market Risk
Liquidity Risk
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Exposure to Financial Risks
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Interest rate risk
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Fixed rate assets in company portfolios have
market values sensitive to interest rate changes
Firm measures and manages risks
Credit risk
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Mortgages, corporate bonds and real estate
holdings can involve default
Investment-grade securities
Diversify portfolio among debt issuers
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Exposure to Financial Risks
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Market risk
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Exists because events like significant market
value decreases reduce capital
Economic downturn affects real estate
investments
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Exposure to Financial Risks
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Liquidity risk occurs because a high
frequency of claims may require the life
company to liquidate assets
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Life insurance companies have high cash flow
from premiums to offset normal cash needs
In case of large disaster (9/11) may be forced to
sell assets to generate cash even if market value is
low
Companies try to balance the age distribution of
their customer base
As interest rates rise, voluntary terminations of
policies occur
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Asset Management
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Performance is significantly affected by the
performance of the assets
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Companies get premiums for several years before
paying out benefits
Companies try to manage the risk of losses with
offsetting investment gains or diversity of assets
they hold
Diversify into other businesses to offer a wide
variety of financial products
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Property and Casualty Insurance
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Property insurance (fire insurance)
Casualty insurance (liability)
Performance and financial bonding
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PC Versus Life Insurance
Companies
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PC have shorter contracts
PC have more varied risk areas
Life companies larger due to long-term
savings and pension contracts
PC has wider distribution of Occurrences
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PC’s need liquid, marketable assets
PC’s earnings more volatile
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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--manage pure risks
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Valuation of an Insurance Company
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Value of an insurance company depends on its
expected cash flows and required rate of
V
= f [E(CF), k]
return
+
Where:
V = Change in value of the insurance company
E(CF) = Change in expected cash flows
k = Change in required rate or return
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Valuation of an Insurance Company
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Factors that affect cash flows
E(CF)= f (ECON, Rf , INDUS, MANAB)
+
?
+
Where:
E(CF) = Expected cash flow
ECON = Economic growth
Rf = Risk free interest rate
INDUS = Prevailing industry conditions for the company
MANAB = Management ability of company
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Valuation of an Insurance Company
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Investors required rate of return
k = f(Rf , RP)
+
+
Where:
Rf = Risk free interest rate
RP = Risk premium
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Performance Evaluation
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Common indicators of company performance
are available
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Statistical analysis of performance
Ratio analysis
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Trends over time
Compare to industry average
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Performance Evaluation
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The higher the liquidity ratio, the more liquid the
company
Invested Assets
Liquidity
Ratio
=
Loss Reserves and
Unearned Premium Reserves
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Performance Evaluation
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Return on net worth or policyholders’ surplus
is a profitability measure
Net Profits
Return on Equity =
Policyholders’ Surplus
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Performance Evaluation
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Underwriting gains and losses or underwriting
profitability measured by the net underwriting
margin
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Profits include investment income, underwriting profits
and realized capital gains
Ratios can be calculated to focus on various sources of
profits
Net Underwriting
Margin
Premium Income - Policy Expenses
=
Total Assets
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Other Issues
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Insurance companies interact in a variety of
ways with other financial institutions
Insurance companies participate in a full
range of financial markets
Multinational insurance companies
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Insurance companies operate in many countries
Some countries lack developed markets for
insurance
Multinational investments
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