Insurance Companies Lecture Notes PDF

Insurance companies 1 Lecture overview Basics of insurance Agency problems in insurance Solvency II Pensions The Finnish pension system 2  Q’s Questions at the e...

Insurance companies 1 Lecture overview Basics of insurance Agency problems in insurance Solvency II Pensions The Finnish pension system 2  Q’s Questions at the end of the lecture What are the two insurance companies’ main sources of cash flow? How do insurance companies manage agency problems? What is Solvency II? What is unit-linked insurance? What is a “pay as you go” pension system? 3 Basics of insurance Insurance company is risk-neutral, while buyers of insurance are risk-averse Insurance companies are risk bearers – They accept (underwrite) risks in return for a premium Insurance companies have two main sources of cash – Initial underwriting income from insurance premiums – Investment income from holding the premiums over time The underwriting process, i.e. deciding which risks to take and how much to charge is crucial 4 Warren Buffett’s Annual Shareholder letter 2010 “Insurers receive premiums upfront and pay claims later... This collect- now, pay-later model leaves us holding large sums - money we call "float" - that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit... If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money - and, better yet, get paid for holding it.“ 5 Basics of insurance 1. There must be a relationship between insured and beneficiary and beneficiary must be someone who would suffer if he had not taken out insurance – Insurance should not be used for gambling 2. The insured must provide full and accurate information to the insurance company 3. The insured is not to profit as a result of insurance coverage From Mishkin & Eakins, Chapter 21 6 Basics of insurance 4. If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of the compensation 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 7. The insurance company must be able to compute the probability of the loss occurring From Mishkin & Eakins, Chapter 21 7 Agency problems in insurance Basis: Insurance company cannot…. know about all the characteristics of the applicants observe all the actions which are taken by the insured Adverse selection = Customers who apply for insurance policies are more likely to be those in need of coverage Moral hazard = Having coverage may change risk taking behavior Agents who sell insurance for a commission are less concerned with the risk of the policy because they are not affected if a loss occurs 8 Adverse selection Like banks, insurance companies have developed practices to manage agency problems Screening – Collect information before policy is written to reduce adverse selection (personal questions, medical evaluation) Risk-based premium – Charge premium according to policyholder’s risk to ensure profitability of insurance company in face of adverse selection – Reason: at a premium that reflects average risk, only the riskier than average applicants would take out the insurance 9 Moral hazard Restrictive provisions – Tool to reduce moral hazard: discourage policyholders from taking actions that make insurance claims more likely – E.g. life insurance does not pay in case of suicide or property insurance will not pay for loss by burglary if door was not locked Prevention of fraud – Conduct investigations before payout of claims to prevent fraud (moral hazard problem that insured makes invalid claim) Cancellation of insurance – Threaten to cancel insurance in case insured person’s actions increase likelihood of claim, e.g. auto insurance will be cancelled if insured gets too many speeding tickets 10 Moral hazard Deductibles – Tool to reduce moral hazard: Fixed amount that insured has to cover when claim is paid out – Leads to lower premiums because loss participation reduces insured’s incentives to increase risk of a claim Coinsurance – Like deductible but certain percentage of loss is shared, e.g. medical insurance covers 80% of medical bills 11 Breakdown of gross premiums written by Finnish insurers 2014–2023 From Slide set #2 12 Non-life (Property and casualty) insurance “Property and casualty insurance protects against losses from fire, theft, storm, explosion or even neglect. Casualty insurance (or liability insurance) protects against liability to harm insured may cause to others as a result of product failure or accidents. For example, part of your car insurance is property insurance (which pays if your car is damaged) and part if casualty insurance (which pays if you cause the accident).” From Mishkin & Eakins, Chapter 21 13 Finnish insurance in 2023: Gross premiums written, loss ratio and claims paid 14 Non-life insurers’ market shares in 2023 Gross direct premiums written in Finland total €4,6 billion OP Financial Group 32,8 % LocalTapiola Group 26,7 % If P&C 21,0 % Fennia 10,2 % Turva 2,6 % Pohjantähti 2,4 % Alandia Group 1,6 % POP Insurance 1,0 % Nordea Insurance 0,6 % Others 1,0 % Aktia’s 2018 Annual report 16 Life insurance “Life is assumed to unfold in a predictable sequence: You work for a number of years while saving for retirement; then you retire, live off the fruits of your earlier labor, and die at a ripe old age. The problem is that you could die too young and not have time to provide for your loved ones, or you could live too long and run out of retirement assets. Either option is very unappealing to most people. The purpose of life insurance is to relieve some of the concern associated with either eventuality.” From Mishkin & Eakins, Chapter 21 17 Aktia’s Life insurance * Annual Report 2023 18 * Will be discussed on slide # 24 Solvency II Solvency II was implemented for insurers on 1 January 2016. Solvency I had been introduced in the 1970s. The new regime is intended to harmonize the regulations across the EU. The main purpose of Solvency II is to enhance the level of policyholder protection across Europe. The new regime should also improve the resilience of the insurance sector to shocks and so reduce the probability of insurers failing. Part of the Capital Markets Union Action Plan 19 Solvency II Solvency II sets out to establish its new set of capital requirements, valuation techniques, and governance and reporting standards to replace the existing and outdated Solvency I requirements. Solvency II is a risk-based capital regime, similar in concept to Basel III for banking industry. As with the banks, insurers can use either internally developed models or standardised models produced by regulators to work out their capital requirements. The insurers have a transition period of 16 years in which to fully implement the Solvency II valuation requirements. 20  ”With 6,716 pages, Solvency II is thicker than the bible and more complex than tax law.” Talanx Solvency II The biggest impact is expected in the life insurance sector; a shift away from insurers offering long-term investment guarantees, which carry heavy capital requirements under Solvency II. “To its fans, it is a beautiful example of harmonisation, a way of protecting customers and investors that also helps to create equitable European conditions. To its opponents, it is an overly complex piece of regulation that will push up prices for consumers and impose an enormous extra administrative burden on companies.” Financial Times, March 16, 2016 21 And then: 22 Aktia’s Q3/2024 report 23 Unit-linked insurance A unit-linked insurance plan is essentially a combination of insurance and an investment vehicle. Like mutual funds, each policyholder's unit-linked insurance plan holds a certain number of mutual fund units. Each policyholder has the option to select a personalized investment mix based on his/her investment needs and risk appetite Depending on the investor’s country of tax residence, such policies can often be gifted to family members with a low tax burden. The life insurance element, meanwhile, gives the client control over who receives their wealth when they die. 24 What is insurance saving and what is unit-linked insurance? Insurance saving is a form of long-term savings and investment. Despite the name, insurance saving does not mean insuring your assets; instead, it is an investment made through an insurance company. There are many benefits to insurance saving that are not available with traditional bank accounts and investment funds. A unit-linked insurance policy is an insurance saving agreement that allows you, within that agreement, to invest in a variety of investment objects and to reallocate your investments without the gains from those changes being taxed. www.nordea.fi 25 26 Pensions Definition: “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 Total assets in retirement savings plans, in 2010 and 2020 28 OECD “Pension markets in focus 2021” DB? DC? 401(k)? 29 Types of Pensions Defined-Benefit (DB) pays a constant accrual rate for each year of service. It is based on lifetime average revalued earnings. Pension Plans place a burden on the employer to properly fund the expected retirement benefit 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 Types of Pensions Defined-Contribution (DC) Pension Plan: Contributions flow into an individual account. The accumulation of contributions and investment returns is 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: any pension plan set up by a government body for the general public (e.g., Social Security) Large variations exist in the approach to pensions in EU member states In a points system (PS), contributions paid throughout a person's career are converted into points and accumulated in an account. The pension benefit then depends on the value of a point at the time of retirement. European Parliament (2023). Understanding EU action 32 on pensions. 401 (k) scheme A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. 401(k) plans, named for the section of the US tax code that governs them, arose during the 1980s as a supplement to pensions. 33 401 (k) scheme With a 401(k), you control how your money is invested. Most plans offer a spread of mutual funds. The most popular option is target-date funds. With $7.4 trillion in assets at year-end 2023, 401(k) plans held the largest share of employer-sponsored DC plan assets (Investment Company Institute). 34 The Finnish pension system When you work, you earn pension. Earnings-related pension insurance is money that is set aside to make sure you have an income when: you are old, you develop a disability, or the wage earner in your family dies. If your earnings-related pension is small, or if you have not had income from work, you may get a national and a guarantee pension paid by the Social Insurance Institution of Finland (Kela). Earnings-related pensions are statutory, which means they have been set up in law. Finnish Centre for Pensions 35 Earnings-related pension, national pension, guarantee pension and net pension 36 Understanding Finnish pensions. SKS kirjat, 2023. Distribution of total pension in Finland in 2023 37 The Finnish pension system The statutory pension security in Finland consists of defined benefit earnings-related pension that accrues from work, as well as residence-based national pension and guarantee pension that ensure minimum security. Statutory earnings-related pension in Finland is mainly financed through the pay-as-you-go system. Some pensions are financed according to the principle of partial funding (approximately 25%), by utilizing both earnings-related pension expenditure and previously collected funds. 38 Finnish Centre for Pensions 39 Breakdown of the largest Finnish pension institutions From Lectures II TELA (The Finnish Pension Alliance) Money flows of earnings-related pensions in 2023 41 Please note: Statistics Finland 42 Mazimillian Bierbaum & Sheenam Singhal (2024). The future of pensions and retail investment in the EU. -> On the “Reading list” 43