Lecture 11

• Insurance firms focus on possible profits regardless of risk, while insurance buyers avoid risk and prioritize keeping their capital above making capital gains.
• Insurance firms take on risk for a risk premium.

Sources of Cash Flow

• Underwriting income from premiums is the first source of cash flow

• Determining acceptable risks and costs is crucial.

• Investment income from holding premiums over time is the second

• Insurance firms get premiums first and pay claims later, so they collect now and pay later.

• Float refers to insurance firms' large sums of money from premiums that eventually go to others

Insurance Conditions

• There must be a relationship between the insurer and beneficiary, giving the insured insurable interest where they would suffer without insurance.
• Providing financial protection against actual losses is the purpose, not gambling.
• The insured must give the insurance firm all needed accurate information.
• Insureds cant profit from coverage
• The insurance liability falls by how much a third party covers the insured's loss.
• Insurers need a large insured base to spread risk across various policies.
• Any loss has to be quantifiable.
• Insurers must be able to calculate the likelihood of a loss.

Agency Problems

• Insurance firms cant know everything about applicants and cant perfectly monitor insureds' actions

Adverse Selection

• Those more likely to need coverage tend to apply for insurance more
• Insurance firms screen to gather data before writing a policy and lower adverse selection
• Risk-based premiums: ensure profitability by charging premiums based on the risk of policyholders.
  • If only the average premium were used, it would lead to adverse selection, so only high-risk people take out insurance.

Moral Hazard

• Moral hazard: coverage can change peoples behavior toward risk

• Insurance firms use

  • Restrictive provisions: discourages actions that incur claims:
    • Life insurance firms may not pay out in a case of suicide.
  • Prevention of fraud: investigation before paying claims.
  • Cancellation: threaten to cancel if risky behavior occurs.
    • Canceling insurance because of too many speeding tickets.
  • Deductibles: the insured pays a fixed expense when a claim is paid
  • Coinsurance: a certain percentage is covered.

• Agents paid on commission are less sensitive to policy risk since losses dont affect them

• The amount of premiums has been slowly increasing.

Non-Life Insurance

• Property insurance: covers losses from fire, theft, storm, explosion, or neglect.

• Casualty insurance: insures against liability for harm that insurance may cause others because of bad product manufacturing or accidents

• They are often paired together

  • Car insurance includes property insurance (damage to your car) and casualty insurance (liability if you cause an accident)

• Aktia sold off its non-life insurance business to focus on asset management; it still offers life insurance and had a positive 2023.

• Life insurance is there to protect against dying too soon or living too long that retirement ran out and to fix related worries

Solvency II

• Purpose: aligns rules across Europe for policyholder protection:
  • Goal: boost insurance resilience and lower the probability of firms failing.
  • Part of the EU's Capital Markets Union.
• Set new standards for capital needs, valuation, and reporting
  • Instituted a risk-based capital regime using IRB or standardized models to compute capital needs.
  • There was 16 year window to fully execute Solvency II valuations
• The biggest effect on life insurance: less offering of long-term investment guarantees and increased capital needs they bring.
  • Changes: EU cutting capital needs and promises for a mechanism similar to banks if needed Aktia's solvency capital requirements, consistent with Solvency II.

Unit-Linked Insurance

• Unit-linked insurance is a vehicles for long-range investing and savings.
  • It helps in investing and moving assets around so gains are never taxed.
• Combination of insurance security and a way to invest
• Policyholders hold a number of mutual fund units.
  • Each person can personalize their investment plans based on what they want/can accept when it comes to risk
  • Lets clients decide where their assets go when they die.

Pension Insurance Contract

• Pension insurance: pension plan (employer, government, etc.) makes payments to an insurance firm to secure future payments to plan members when they retire or exit the plan.
• Countries with larger assets relative to GDP have more solvent pension system, and low reliance on public pensions.
  • Nations with lower assets rely more on state pensions, which may lead to risky future security.

Defined-Benefit Plans (DB)

• Defined-benefit plans (DB) pay constant accrual (increasing with time) rate for each year of savings, based on lifetime average revalued earnings.
• Retirement payout: determined by employer with fixed arrangement and determined by employer with pay based salary/years of service.
• The accountability rests on employers to fund expected payouts
  • Fully funded: sufficient assets to meet payouts.
  • Overfunded: has funds above what payouts require -Underfunded: lacks funds to meet payments

Defined Contribution Plans (DC)

• Defined contribution pension plan (DC): contributions flow into an individual account, the accumulation and investment returns are converted into a steady income

• Employees or employers add to an individual account, where payout depends on investment performance, thus uncertain

  • Private: run by hires, teams or solo members
  • Public: governed by state entity
  • Within the EU, pensions vary widely

• 401k: U.S. savings plan where employees put in a part of their pay, often with employer matching; money grows without tax until its being withdrawn.

  • Employees decide how to use funds, often spread through an array of them
  • target-date funds: the most common of these, which shift over age and risk, from aggressive in the short-term to secure at the target year.

Finnish Pension System

• Earnings-related pension insurance: money aside to pay when disabled, sick or elder
  • If the plan is small, money may come from Kela.
  • Statutory system by national laws
• Earnings-relation pensions are the largest portion of total
• Most common range from 1000-2000 per month.
• Men get an average higher rate than with women, 3000+.
  • Highlighting income gaps between sexes

Finnish Pension System Setup

1. Defined benefit earnings-related pension
   • Built up by works

• Pay-as-you-go

2. Residence-based national pension
3. Guarantee pension
   • Minimum security assured

• Pension funds mostly use listed firms
• Finnish insurance firms, such as Ilmarinen and Varma, are shareholders of Finnish companies.
• The fiscal permanence among them
• Finland has significant pension debt of 350% of GDP.
• The earnings system covers more than twice than public
• Discount rates sway the obligations.
• Pressure arises as populations age
  • Long-term issues happen as fewer support old ages.