Insurance

• This lecture discusses basics of insurance, agency problems in insurance, Solvency II, pensions, and the Finnish pension system.

Basics of Insurance

• Insurance companies are risk-neutral, while insurance buyers are risk-averse.
• Insurance firms act as risk bearers.
• They underwrite risks for a premium.
• Insurance firms have two main cash sources: initial underwriting income from premiums and from investment income from holding premiums.
• Underwriting, i.e deciding which risks to take and how much to charge, is crucial.
• There must be a relationship between the insured and beneficiary, such that the beneficiary would suffer a loss if insurance hadn't been taken out.
• Insurance should not be used for gambling.
• The insured must supply full and accurate information to the insurer.
• The insured cannot profit from insurance coverage.
• If a third party compensates the insured for a loss, the insurer’s obligation is reduced by that amount.
• Insurers need a large pool of insured parties to spread risk through many policies.
• Losses must be quantifiable, as exemplified by the impracticality of insuring an unexplored oil field.
• Insurers must compute the probability of loss occurrence when writing policies.

Warren Buffett's View on Insurers

• Premiums are received upfront, and claims are paid later ("collect-now, pay-later").
• The large sums held are called "float."
• Insurers invest this float.
• Underwriting profit adds to investment income from the float if premiums exceed total expenses and eventual losses.

Agency Problems in Insurance

• The underlying issue is information asymmetry: insurers lack full knowledge of applicants and insured actions.
• Adverse selection means those most likely to need insurance are more inclined to apply.
• Moral hazard means coverage may alter risk-taking behavior.
• Agents earning commissions may prioritize sales over assessing policy risk.

Addressing Adverse Selection

• Screening involves collecting applicant data before policy issuance to mitigate adverse selection, using questions/medical evaluations.
• Risk-based premiums correlate premiums to policyholder risk, ensuring insurer profitability.
• Charging premiums which reflect average risk will entice riskier individuals to purchase insurance.

Mitigating Moral Hazard

• Restrictive provisions discourage actions leading to claims like suicide exclusions in life insurance and door-locking requirements for burglary coverage.
• Investigations before claim payouts detect fraud.
• Threatening policy cancellation in cases where actions increase claim likelihood which is exemplified by auto insurance cancellations due to excessive speeding tickets.
• Deductibles define a fixed amount the insured must cover on a claim, reducing moral hazard.
• Lowered premiums are due to reduced claim risk, creating a disincentive for inflated claims.
• Coinsurance is similar to deductibles but involves sharing a loss percentage; medical insurance covering 80% of bills acts as an example.

Non-Life(Property and Casualty) Insurance

• Property and casualty insurance covers losses from fire, theft, storm, explosion, or neglect.
• Casualty (or liability) insurance protects against liabilities for harm to others from product failure or accidents.
• Car insurance encompasses property coverage (damage to your car) and casualty coverage (if you cause an accident).

Solvency II Regulation

• Solvency II was introduced in 2016 (Solvency I in the 1970s).
• The aim is to harmonize insurance regulations across the EU, enhance policyholder protection, and improve sector resilience and reduce the probability of insurers failing.
• It is part of the Capital Markets Union Action Plan.
• This regulation establishes a modern set of capital requirements, valuation techniques, governance, and reporting standards.
• Solvency II is a risk-based capital regime; similar in concept to banking's Basel III.
• Insurers can utilize internally developed or regulatorily standardised models to assess capital needs.
• Insurers have a 16-year transition to fully implement these valuation requirements.
• Its major shift is away from life insurers which provide guaranteed long-term investments.
• Such investments demand significant capital under Solvency II.

Unit-Linked Insurance

• It combines insurance with an investment vehicle.
• A policyholder's unit-linked plan is composed of mutual fund units.
• Policyholders can select a personalized investment mix matching their investment needs and risk appetite.
• The ability to gift such policies to family members with low tax burden is available in certain countries.
• The client retains command over wealth distribution upon death.

Insurance Saving

• It is a type of long-term savings and investment: insurance saving does not mean insuring assets; instead, it is an investment made instead through insurance companies.
• There are benefits to insurance saving not available with traditional investment funds or bank accounts.
• A unit-linked insurance policy is savings plan that allows you, within that savings plan, to invest in a variety of investment objects and to reallocate investments without the gains from those changes being taxed.

Pensions

• “Pension insurance contracts specify pension plans contributions to an insurance undertaking in exchange for which the pension plan benefits will be paid when the members reach a specified retirement age or on earlier exit of members from the plan.” - OECD definition.

Types of Pension Plans

• Defined-Benefit (DB) Plans: Pays a constant accrual rate for each year of service and is calculated based on lifetime average earnings.
  • Benefit is based on lifetime average revalued earnings.
• Place the burden on the employer to properly fund expected payouts.
• Fully funded: sufficient funds are available to meet payouts.
• Overfunded: funds exceed the expected payout.
• Underfunded: funds are not expected to meet the required benefit payouts.
• Defined-Contribution (DC) Pension Plans: Contributions flow into an individual account with the converted accumulation of contributions and investment returns converted into a pension-income stream at retirement. -The benefit payout is uncertain.
• Private Pension Plans: any pension plan set up by employers, groups, or individuals.
• Public Pension Plan is set up by a government body for the general public, for example, Social Security

401(k) schemes

• A retirement savings plan sponsored by an employer.
• Workers save and invest a portion of their paycheck before taxes.
• Taxes are not paid until money is withdrawn from the account.
• Employers may make matching contributions or add profit-sharing.
• These plans began in the 1980s as a supplement to pensions, named after a code in the US tax code.
• Individuals control how their money is invested in the plan and are offered mutual funds.
• Target-date funds are a popular option.
• As of year-end 2023, 401(k) plans held $7.4 trillion and were the largest portion of DC plan assets sponsored by employers (Investment Company Institute).

The Finnish Pension System

• When you work, you earn Pension; this is called Earnings-related pension insurance.
• This guarantees income when you are old, develop a disability, or the wage earner in your family dies.
• Individuals may get a national and a guarantee pension paid by the Social Insurance Institution of Finland (Kela).
• These earnings are earnings-related.
• Earnings-related pensions are statutory and set up by law.
• The statutory pension security consists of defined-benefit earnings related pension income along with, resident-based national pension and guarantee pension that ensure minimum security.
• The statutory earnings-related system is mainly financed through a “pay-as-you-go” system; partial funding finances approximately 25% of the system by utilizing both earnings-related pension expenditure and previously collected funds.