CHAPTER 18 INSURANCE COMPANIES AND PENSION FUNDS

CHAPTER 18

INSURANCE COMPANIES AND PENSION FUNDS

Copyright© 2006 John Wiley & Sons, Inc. 2

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.


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.


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.


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.


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


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


Term Life Insurance: Basic Model

Payment for death only

Coverage for specified term

Lower premium

Large amount of protection per premium dollar

No “investment” features


Term Life 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.


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.


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.


Universal life

The most popular interest-sensitive permanent policies.

Flexible premium policy with varying death benefit and premium amounts.

Pays market rate on savings.


Variable Life

Popular recently with rapid growth in equity values.

Fixed-premium

Insured direct investment of cash values

Guaranteed death benefit

No guaranteed cash value


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.


Health Insurance

Covers medical, disability, and dental expenses.

Insurance companies write about sixty percent of health insurance premiums.


Balance Sheet of Life Insurers

Liabilities and net worthLife 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


Balance Sheet of Life Insurers, cont.

Assets - long-term matching liabilitiesCorporate bonds-largest financial investment

Corporate equities-Variable life

Mortgages

U.S. government securities

Policy loans



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


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


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)



Balance Sheet of P/C Insurers, cont.

Liabilities and net worthPolicy reserves include:

• unearned premium reserve.

• losses incurred, not paid.

Surplus and net worth



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.


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.


Types of Pension Plans

Private Pension PlansInsured – managed by life insurer

Noninsured• Trustee managed by a third party

• Non-trustee - managed by firm or labor union

Government-sponsored Pension PlansSocial Security

Federal, state, and local government plans



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


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


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

Documents

CHAPTER 18 INSURANCE COMPANIES AND PENSION FUNDS