Insurance Companies - Financial Institutions PDF

COURSE “FINANCIAL INSTITUTIONS” Insurance Companies Elisa Bocchialini Learning Objectives To study the business of Insurance Companies IC as a Financial Intermediary and Institutional Investor To study the main types and characteristics of insurance products “In...

COURSE “FINANCIAL INSTITUTIONS” Insurance Companies Elisa Bocchialini Learning Objectives To study the business of Insurance Companies IC as a Financial Intermediary and Institutional Investor To study the main types and characteristics of insurance products “Insurance” as a financial instrument Preview We look at one non-bank institutions: insurance companies Topics include: 1. INSURANCE COMPANIES Preview: the “pure risk management” Insurance Companies ICs as… financial intermediaries ICs as… institutional investors Characteristics of Ics Why are Ics different? Preview We look at one non-bank institutions: insurance companies Topics include: 2. INSURANCE INSTRUMENTS Adverse Selection and Moral Hazard in Insurance Types of Insurance Life insurance Non – Life insurance Life Insurance Companies Non-Life Insurance Companies Balance Sheets Underwriting Risk Regulation Fundamentals of Insurance Insurance «Instruments» Type of insurance contracts Type of Insurance Insurance is broadly classified into two groups. Life insurance policies provide protection against untimely death, illness, and retirement Property-casualty insurance protects against personal injury and liability due to accidents, theft, fire, and other catastrophes Insurance companies also sell a variety of investment products, similar to other financial service firms Types of Insurance The insurance contract Non-Life Function of Insurance Compensation Pay the premium IC Insured Function of Life Compensation Insurance / Function of Savings and Investment IF The insurer’s and/or performance WHEN is typically characterized and/or by uncertainty. HOW MUCH and/or Type of insurance: The insurance contract Art. 1882 of the Civil Code - Notion Insurance is the contract by which the insurer, against payment of a premium, promises to compensate the insured, within the agreed limits, for the damage caused to it by a claim, or to pay a capital sum or an annuity on the occurrence of an event relating to human life. Parties to the contract Pay the premium Insurance C. Insured INSURER Insurance NB: co-insurance Company (several insurers) NB: Reinsurance Parties to the contract Pay the premium Insurance C. Insured Policyholder chi contrae la polizza Insured Insured assicurato Beneficiary beneficiario È la persona (o entità) che riceverà l’indennizzo o il pagamento se si verifica l’evento assicurato. Example A GIANNI is a businessman from Bergamo (Italy). He is married to GIOVANNA and has a son, GIOVANNI. Policyholder? gianni GIANNI consults his insurance advisor at the Insured? gianni bank and decides to take out Beneficiary? giovanni a whole-life policy, paying a regular premium. The policy guarantees that a lump sum will be paid to his son GIOVANNI upon his death. Example B ENRICO is a lawyer from Milan. He is unmarried and has dedicated his entire life to his profession. In recent years, he has developed a strong bond with FILIPPO, the son of his sister ENRICA, and now considers him as family in every sense. Policyholder? enrico Seeking to provide for FILIPPO in the future, Insured? enrica ENRICO visits his insurance advisor at the bank and decides to take out a whole-life Beneficiary? filippo policy, committing to pay the premium. The policy is designed to guarantee a lump-sum payout to FILIPPO upon the insured’s death. However, the contract includes age eligibility limits that ENRICO no longer meets. The twist? The policy is taken out on the life of his sister, ENRICA, who is still within the acceptable age range. Everything stays within the family — and the purpose is achieved! Adverse Selection and Moral Hazard in Insurance Asymmetric information plays a large role in the design of insurance products Information asymmetry results from the fact that the “insured” has more information than the IC The presence of adverse selection and moral hazard impacts the industry, but is fairly well understood by the insurance companies! VIDEO https://www.youtube.com/watch?v=pUkRo9COd38 Adverse Selection in Insurance The adverse selection problem raises the issue of which policies an insurance company should accept: Those most likely to suffer loss are most likely to apply for insurance In the extreme, insurance companies should turn anyone who applies for an insurance policy However, insurance companies have found reasonable solutions to deal with this problem: Health insurance policies require a physical exam. Preexisting conditions may be excluded from the policy. Se una persona ha già una malattia, può essere esclusa dalla copertura per quella specifica condizione Moral Hazard in Insurance Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy. For example: Insurance companies use “deductibles” or “co-insurance/excess” to help control this problem Deductible (franchigia) È l'importo che l’assicurato paga di tasca propria prima che intervenga l’assicurazione. Esempio: se la franchigia è €500 e il danno è €1.000 l’assicurazione paga solo €500. Co-insurance / Excess (scoperto) L’assicurato paga una percentuale del danno. Esempio: se lo scoperto è del 20% e il danno è €1.000 il cliente paga €200, l’assicurazione €800. Questi meccanismi "responsabilizzano" l'assicurato, perché una parte del costo rimane a suo carico. Types of Insurance Insurance is classified by which type of undesirable event is covered: Life Insurance, Health Insurance, Property and Casualty Insurance, ecc. Insurance is broadly classified into 2 groups Life insurance policies provide protection against premature death, illness, and retirement Property-casualty insurance protects against personal injury and liability due to accidents, theft, fire, and other catastrophes Insurance Contracts Life Non-Life Insurance Insurance pooling dei rischi: Marco, 35 anni, padre di due figli, stipula una polizza vita da €200.000. Paga un premio annuo di €500. Se Marco muore prima della scadenza del contratto, la compagnia paga €200.000 al beneficiario (la moglie). Tuttavia, Marco è solo uno dei migliaia di assicurati: molti non muoiono durante la validità della polizza, quindi i premi raccolti da tutti servono a pagare i pochi eventi effettivamente accaduti. 1 Life Insurance Companies Life insurers pool the risks of individuals to diversify away some of the customer-specific risk. The Role of Actuaries Actuaries have traditionally Because of this, they can offer insurance services worked in life insurance to reduce the risks of underwriting and at a cost (premium) lower than any individual selling life insurance. could achieve on his or her own. With traditional life insurance, actuaries analyze Life insurers transfer income-related uncertainties, mortality, produce life tables, and apply time value of such as those due to retirement, from the money concepts to produce life insurance, annuities, and individual to the group. endowment policies. With health insurance, actuaries analyze rates of disability, morbidity, mortality, fertility, and other contingencies. Other activities of life insurance companies: Laura, 60 anni, versa €100.000 in una rendita vitalizia. In cambio, riceverà €600 al mese per tutta la vita. Se vive 25 anni riceverà in totale €180.000 Sell annuity contracts, which are savings contracts that involve the Se vive solo 5 anni riceverà €36.000 liquidation of those funds saved over a period of time. Giuseppe inizia a versare €3.000 all’anno in un piano pensione Manage pension plans (tax-deferred savings plans). assicurativo a 35 anni. I fondi crescono senza essere tassati subito (tax-deferred). Al momento della pensione (es. 67 anni), può ricevere: una rendita mensile, oppure un capitale (es. €150.000). Provide accident and health insurance. Anna stipula una polizza sanitaria che copre: Ricoveri ospedalieri fino a €100.000/anno e Interventi chirurgici e analisi © McGraw Hill Gli attuari hanno calcolato che: Il rischio per una donna della sua età è 0,7% annuo di necessitare un intervento. Il premio annuo richiesto è €850, per coprire rischio + costi amministrativi + margine.  Life Insurance 4 basis classes (or lines) of life insurance are distinguished by the way they are sold or marketed to purchasers: 1. Ordinary life Assicurazioni vita vendute individualmente, cioè una polizza per ogni persona. Il cliente paga premi periodici (mensili, trimestrali, annuali) Assicurazioni vita vendute a gruppi di persone sotto un’unica polizza collettiva. 2. Group life Spesso offerte da datori di lavoro ai propri dipendenti. Costi più bassi grazie alla dimensione del gruppo. Es. Un'azienda fornisce copertura vita a tutti i dipendenti inclusa nel contratto di lavoro 3. Credit lifeAssicurazioni che coprono un debito in caso di morte dell’assicurato Es. Quando accendi un mutuo, la banca ti propone una copertura vita: se muori prima di pagare tutto, il mutuo si estingue 4. Other activities © McGraw Hill  The Four Types of Life Insurance 1 1. Ordinary life policies are marketed on an individual basis, usually in units of $1,000; policyholders make periodic premium payments in exchange for coverage. Term life is the closest to pure life insurance; has no savings element a termine / per un periodo attached and beneficiary receives payout at the time of the individual’s (es. 10. 20 anni) death during the coverage period Whole life protects the individual over an entire lifetime rather than for a specified coverage period Endowment life combines a pure (term) insurance element with a savings element Elisa, 30 anni, acquista una polizza endowment di 30 anni da €200.000 per ricevere il capitale all’età di 60 anni (per la pensione). Se muore prima dei 60 anni il beneficiario riceve i €200.000. Variable life invests fixed premium Se sopravvive, payments lei stessa riceve l’importo in mutual funds of stocks, alla scadenza. Il premio fisso viene investito in fondi comuni (azioni, bonds, and money market instruments obbligazioni, liquidità). Il valore finale dipende dai rendimenti di mercato Universal life and variable universal life Francesco ha entrate variabili. Acquista una universal life dove può modificare l’importo dei premi: in anni più ricchi versa di più, in anni difficili versa meno. Parte dei premi viene investita, con rendimento minimo garantito. Può anche aumentare o diminuire la copertura assicurativa nel tempo © McGraw Hill  Example 15–1 Differences in Various Types of Ordinary Life Insurance Contracts An individual wants to purchase ordinary life insurance, but she is unsure of the differences between the various types of contracts. She contacts a local insurance agent to compare and contrast them. He summarizes them as follows: Term Life: Contract expires, no savings (policyholder gets nothing if he or she is alive when the contract expires), beneficiary receives face value on death during contract period. Whole Life: No expiration, beneficiary receives face value on death, policyholder can borrow against cash value of contract. Endowment Life: Contract expires, policyholder gets face value of contract on expiration if still alive, beneficiary receives face value on death during contract period. Variable Life: No expiration, premiums invested in mutual funds, beneficiary receives variable amount on death (a function of the return on the underlying investments). Universal Life: No expiration, premiums can vary, premiums invested in mutual funds, beneficiary receives variable amount on death (a function of premiums invested and the return on the underlying investments). © McGraw Hill  The Four Types of Life Insurance 2 2. Group life insurance covers a large number of insured persons under a single policy Usually issued to corporate employers, these policies may be contributory or noncontributory. Contributory requires both the employer and employee cover a share of the employee’s cost of insurance. il dipendente paga una parte del premio Noncontributory means the cost of the employee’s insurance is paid entirely by the employer; employee does not contribute to the cost of the insurance. il datore di lavoro paga tutto. 3. Credit life insurance protects lenders against a borrower’s death prior to the repayment of a debt contract, such as a mortgage or car loan valore nominale capitale in sospeso Usually, face amount of policy reflects outstanding principal and interest on the loan. © McGraw Hill  The Four Types of Life Insurance 3 rendite vitalizie 4. Other activities of life insurers include the sale of annuities, private pension plans, and accident and health insurance. trasformano capitale in reddito a vita Annuities represent the reverse of life insurance principals. Life insurance involves building up a fund and eventually paying out a lump sum, while annuities involve different methods of liquidating a fund over a long period of time. Popular mechanism for retirement savings because annual annuity contributions are not capped and are not affected by the policyholder’s non sono limitati income level. © McGraw Hill  La health insurance è un contratto assicurativo che copre, in parte o in tutto, le spese mediche di una persona in caso di: Health Insurance malattia, infortunio, ricovero ospedaliero, intervento chirurgico, cure specialistiche I costi sanitari possono essere molto elevati, soprattutto in Paesi dove la sanità non è pubblica o è solo parzialmente coperta (come negli USA). Health insurance policies are vulnerable to the adverse selection problem - those with health problems are more likely to seek coverage. Individual policies must be priced assuming adverse selection. Most health insurance is offered through group policies. (in USA) Health insurance is a hot topic in the political environment, focusing on increased costs and availability of coverage. Insurance programs are attempting to shift costs to the employers. Health Maintenance Organizations are another attempt to keep costs down. (in ITA) The health insurance market is not yet very developed, because public coverage is still relevant  EXAMPLE Life Insurance Company Insurance Company Financial Statements (Simplified) Balance Sheet (as of 31/12/2024) ASSETS LIABILITIES AND EQUITY A. Investments A. Shareholders’ Equity - Real estate: €50,000,000 - Share capital: €20,000,000 - Equity investments: €30,000,000 - Reserves: €10,000,000 - Bonds and fixed income securities: €120,000,000 - Net profit for the year: €5,000,000 - Shares and mutual funds (UCITS): €25,000,000 Total Equity: €35,000,000 - Policy loans: €5,000,000 B. Technical insurance reserves Total Investments: €230,000,000 - Mathematical reserves (life): €180,000,000 B. Investments for unit/index-linked policies - Claims reserves: €10,000,000 - Unit-linked policies: €70,000,000 - Other technical reserves: €5,000,000 - Index-linked policies: €40,000,000 Total technical reserves: €195,000,000 Total linked investments: €110,000,000 C. Unit/index-linked liabilities: €110,000,000 C. Technical assets D. Other liabilities - Premiums receivable: €4,000,000 - Various payables: €10,000,000 - Reserves held by reinsurers: €3,000,000 - Accruals and deferred income: €5,000,000 D. Other assets Total Other Liabilities: €15,000,000 - Other receivables: €2,000,000 TOTAL LIABILITIES & EQUITY: €355,000,000 - Cash and cash equivalents: €6,000,000 Total Other Assets: €8,000,000 TOTAL ASSETS: €355,000,000  EXAMPLE Life Insurance Company Insurance Company Financial Statements (Simplified) Income Statement (2024) REVENUES - Gross written premiums: €60,000,000 - Investment income: €8,000,000 - Other income: €1,000,000 Total Revenues: €69,000,000 EXPENSES - Claims paid: €40,000,000 - Change in technical reserves: €10,000,000 - Operating expenses: €9,000,000 - Other expenses: €3,000,000 Total Expenses: €62,000,000 Profit before tax: €7,000,000 Income taxes: €2,000,000 Net profit: €5,000,000 Property and Casualty 2 Insurance Property Insurance: protects businesses and owners from proprietà the risk associated with ownership. (incendio, furto, eventi atmosferici (grandine, tempeste), esplosioni) Named-peril policies: insures against any losses only from perils specifically named in the policy copre solo gli eventi espressamente elencati nel contratto. Open-peril policies: insures against any losses except from perils specifically named in the policy copre tutti i rischi tranne quelli esclusi nel contratto Casualty Insurance: also known as liability insurance, it protects against financial losses because of a claim of negligence. danni causati ad altri Reinsurance: allocates a portion of the risk to another company in exchange for a portion of the premium.  Main P&C Lines Fire insurance and allied lines protects against the perils of fire, lightning, and removal of property damaged in a fire. Una fabbrica subisce un incendio che danneggia macchinari e struttura. L’assicurazione rimborsa la riparazione e la rimozione dei beni distrutti Homeowners multiple peril (MP) insurance protects against multiple perils of damage to a personal dwelling and personal property, as well as liability coverage against the financial consequences of legal liability resulting from injury to others. IlL’assicurazione tetto della tua casa viene danneggiato da una tempesta e un visitatore scivola sul pavimento bagnato. copre sia la riparazione del tetto, sia le spese mediche del visitatore È simile alla Homeow Commercial multiple peril (MP) insurance protects commercial firms against ners MP, ma perils similar to homeowners MP insurance. Un ristorante è danneggiato da un allagamento e un cliente si fa male cadendo. per le La polizza copre i danni alla struttura e l’indennizzo al cliente aziende Automobile liability and physical damage (PD) insurance provides protection against losses resulting from legal liability due to the ownership/use of the vehicle and theft or damage to vehicles. Tu causi un incidente: l’assicurazione paga i danni alla macchina dell’altro (liability) e, se coperta, ripara anche la tua auto (PD) Liability insurance (other than auto) Tutte le altre forme di responsabilità civile Un medico è accusato di errore: la polizza RC professionale copre i danni. Il tuo cane morde un passante: RC del capofamiglia copre le spese mediche © McGraw Hill  EXAMPLE Non-life Insurance Company Insurance Company Financial Statements (Simplified) Balance Sheet (as of 31/12/2024) ASSETS LIABILITIES AND EQUITY A. Investments A. Shareholders’ Equity - Real estate: €20,000,000 - Share capital: €15,000,000 - Equity investments: €15,000,000 - Reserves: €8,000,000 - Bonds and fixed income securities: - Net profit for the year: €2,000,000 €80,000,000 Total Equity: €25,000,000 - Mutual funds (UCITS): €10,000,000 B. Technical insurance reserves Total Investments: €125,000,000 - Unearned premium reserves: €25,000,000 B. Technical assets - Outstanding claims reserves: €65,000,000 - Premiums receivable: €8,000,000 - Other technical reserves: €5,000,000 - Recoverables from reinsurers: €12,000,000 Total technical reserves: €95,000,000 C. Other assets C. Other liabilities - Other receivables: €4,000,000 - Payables to reinsurers: €10,000,000 - Cash and cash equivalents: €6,000,000 - Taxes payable: €3,000,000 Total Other Assets: €10,000,000 - Accruals and deferred income: €2,000,000 Total Other Liabilities: €15,000,000 TOTAL ASSETS: €155,000,000 TOTAL LIABILITIES & EQUITY: €155,000,000  EXAMPLE Non-life Insurance Company Insurance Company Financial Statements (Simplified) Income Statement (2024) REVENUES - Gross written premiums: €90,000,000 - Investment income: €6,000,000 - Other income: €1,000,000 Total Revenues: €97,000,000 EXPENSES - Claims incurred: €55,000,000 - Change in technical reserves: €7,000,000 - Acquisition and administrative expenses: €25,000,000 - Other expenses: €5,000,000 Total Expenses: €92,000,000 Profit before tax: €5,000,000 Income taxes: €3,000,000 Net profit: €2,000,000 Underwriting Risk Underwriting risk results when premiums generated on a given insurance line are insufficient to cover claims (losses) and administrative expenses, after considering investment income generated Underwriting risk may result from the following: I sinistri sono più numerosi o più costosi del previsto. Unexpected increases in loss rates (or loss risk) Esempio: un picco di incidenti stradali inaspettato Unexpected increases in expenses (or expense risk) Aumento non previsto dei costi gestionali (stipendi, costi legali, Unexpected decreases in investment yields or returns antifrode, ecc.) (investment yield/return risk) Rendimento degli investimenti inferiore alle attese  Loss Risk Key feature of claims loss risk is the actuarial premi guadagnati predictability of losses relative to premiums earned, which are premiums received and earned on insurance contracts because time has passed without a claim being filed. In general, the following is true: Maximum levels of losses are more predictable for property Property lines sono più prevedibili di liability lines lines than for liability lines. Property (es. incendio, furto, danni a immobili): danni misurabili, frequenti, simili tra loro più facili da stimare Loss rates are more predictable onresponsabilità Liability (es. low-severity, high- civile): canni variabili, essere molto costosi meno prevedibili legali, imprevedibili, possono frequency lines than on high-severity, low-frequency lines. Se i sinistri sono frequenti, ma di piccola entità La compagnia può stimarli bene (es. piccoli incidenti auto, furti domestici) Se sono rari, ma molto gravi Difficile stimarli (es. cause legali milionarie, disastri naturali) Reinsurance, essentially insurance for insurance companies, is an alternative to managing risk on a P&C insurer’s balance sheet. © McGraw Hill  Loss Ratio and Expense Ratio Il loss ratio calcola quanto i sinistri effettivamente pagati (losses incurred) pesano rispetto ai premi maturati (premiums earned) Loss ratio measures actual losses incurred on a specific policy line; calculated as ratio of losses incurred to premiums earned. Loss ratio of less than 100 percent means that premiums earned were sufficient to cover losses incurred on that line. < 100% la compagnia ha incassato premi sufficienti a coprire i sinistri > 100% i sinistri superano i premi rischio di perdita tecnica Expense ratio is calculated as expenses incurred (before income taxes) divided by premiums written. Misura l’incidenza delle spese operative (escluse le tasse) rispetto ai premi raccolti. Two major sources of expense risk to P&C insurers are: 1. Loss adjustment expenses (LAE), which relate to the costs surrounding the loss settlement process. Costi per gestire i sinistri (perizie, consulenze, avvocati, indagini, personale del customer service) 2. Commissions and other expenses. Costi di vendita delle polizze: provvigioni agli agenti, marketing, spese amministrative © McGraw Hill  Property-Casualty (P&C) Key Ratios È l’indicatore chiave per valutare se la sola attività assicurativa tecnica (senza considerare gli investimenti finanziari) è profittevole Combined ratio is a measure of overall profitability of a line. Calculated as the loss ratio plus the ratios of loss-adjusted expenses to premium earned as well as commission and other acquisition costs to premiums written plus any dividends paid to policyholders as a proportion of premiums earned. If the combined ratio is less than 100 percent, premiums alone are sufficient to cover both losses and expenses related to the line. Investment yield is calculated as net investment income divided by premiums earned. Misura il rendimento generato dagli investimenti finanziari della compagnia, rispetto ai premi maturati Operating ratio is also a measure of overall profitability; calculated as the combined ratio minus the investment yield. È un indicatore ancora più completo, perché tiene conto sia della redditività tecnica che dei rendimenti finanziari. © McGraw Hill Regulation The legal framework for the insurance sector is primarily based on EU legislation. The tools used by the European Union have different features according to whether they are binding or non-binding and to how they are applied in Member States: Regulations, Directives, Decisions, Recommendations and Opinions (pursuant to article 288 of the Treaty on the Functioning of the European Union). Regulations are of general scope, they are binding in all their elements and directly applicable in the Member States, without the need for transposition into national law; therefore they represent the tool for achieving full harmonization, reducing national discretion and avoiding that regulatory discrepancies between Member States may result in an unlevel playing field between economic operators. ilcompagnie regolamento Solvency II che definisce i requisiti patrimoniali minimi per le assicurative in tutta l’UE. Directives are addressed to Member States and bind them as to the results to be achieved, but leave to the national authorities the choice of form and methods to be used in their implementation. una direttiva può imporre una certa tutela per i consumatori assicurativi, ma ogni Stato può decidere come attuarla (legge, regolamento, codice) Regulation The regulatory and implementing technical standards (RTS and ITS), drafted by EIOPA and adopted by the European Commission with Regulation, are also of growing relevance in the insurance framework. They are aimed to harmonize more complex and specific aspects of the market regulatory system so as to make it more comprehensive, homogeneous and unified. The Guidelines issued by EIOPA, as third-level measures, are aimed to support convergence in the application of the provisions contained in the Directives. Insurance in Italy Fundamentals of Insurance (1 of 2) Although there are many types of insurance and insurance companies, there are seven basic principles all insurance companies are subject to: 1. There must be a relationship between the insured and the beneficiary. Further, the beneficiary must be someone who would suffer if it weren’t for the insurance. 2. The insured must provide full and accurate information to the insurance company. nascondere una malattia cronica può invalidare una polizza sanitaria 3. The insured is not to profit as a result of insurance coverage. 4. If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of the compensation. Se l’assicurato riceve già un risarcimento da un terzo (es. il responsabile di un incidente), la compagnia riduce o annulla il proprio indennizzo. Evita che l’assicurato sia risarcito due volte per lo stesso danno. Fundamentals of Insurance (2 of 2) 5. The insurance company must have a large number of insured so that the risk can be spread out among many different policies. 6. The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field. non puoi assicurare una scoperta futura in un giacimento petrolifero inesplorato. 7. The insurance company must be able to compute the probability of the loss’s occurring. Per offrire copertura, la compagnia deve stimare in modo attendibile la probabilità che l’evento si verifichi. Serve a prezzare il rischio e stabilire il premio corretto. Assignment