Fundamentals of Financial Markets Lecture 11 PDF

**Fundamentals of Financial Markets** **12.02.2025 -- Lecture 11** Insurance companies are risk-neutral (focusing on potential gains, regardless of risk), while the buyers of insurance are risk-averse (concerned with capital preservation over capital-gains). - Insurance companies bear risk for...

**Fundamentals of Financial Markets** **12.02.2025 -- Lecture 11** Insurance companies are risk-neutral (focusing on potential gains, regardless of risk), while the buyers of insurance are risk-averse (concerned with capital preservation over capital-gains). - Insurance companies bear risk for a risk premium. Two main sources of cash flows: 1. Initial underwriting income from insurance premiums. - Deciding which risks to take and how much to charge is key. 2. Investment income from holding premiums over time. Insurance companies receive premiums upfront and pay claims later -\> collect now, pay later model. Float: large sums of money insurance companies have from insurance premiums, that eventually goes to others. Insurance conditions: 1. There must be a relationship between the insurer and beneficiary, so that the insured would have insurable interest -\> suffer without it. - Provide financial protection against actual losses, not as a gamble. 2. Insured must provide full and accurate information to insurance company. 3. The insured is not to profit because of insurance coverage. 4. If a third party compensates the insured for loss, the insurance companies' obligation is reduced by the amount of the compensation. 5. Insurance companies must have many insured to diversify risk across different policies. 6. The loss must be quantifiable. 7. Insurance company must be able to compute the probability of the loss occurring. [Agency problems in insurance:] - Insurance companies cannot know all the characteristics of the applicants and observe all the actions taken by insured. 1. Adverse selection - Customers who apply for insurance policies are more likely to be those in need to coverage. - Insurance companies use: - Screening: collecting information before policy is written to reduce adverse selection. - Risk-based premium: charge premium according to policyholders' risk to ensure profitability. - If only average was used, adversely selection -\> only high-risk take-out insurance. 2. Moral hazard - Having coverage may change risk taking behaviour. - Insurance companies use: - Restrictive provisions: discourage risky actions that make insurance claims more likely. - *Life insurance doesn't pay in case of suicide.* - Prevention of fraud: conduct investigations before payout of claims. - Cancellation: threaten to cancel if taking on risky behaviour. - *Cancel insurance if too many speeding tickets.* - Deductibles: fixed amount covered when claim is paid out. - Coinsurance: certain percentage covered. 3. Agents selling insurance for a commission are less likely to be concerned over risk of policy, as loss does not affect them. A graph of a number of years AI-generated content may be incorrect. - The amount of insurance premiums has been growing but slowly. Non-life insurance: Property insurance: insurance against losses from fire, theft, storm, explosion or neglect. Casualty insurance: insurance against liability to harm insured may cause to others because of product failures or accidents. - These are often used together under the same insurance. - *Car insurance has property insurance (how your car is damaged), and casualty insurance (which pays if you cause the accident).* Case Aktia: divested from non-life insurance to focus on asset management. Aktia still offer life insurance, with a positive year in 2023. Life insurance: insurance against potential to die young and not be able to provide for your close ones or living too long so retirement funds run out. - Purpose to relieve these concerns. [Solvency II:] - Regulation to harmonize insurance regulations across Europe, with the purpose of enhancing policyholder protection to improve resilience of insurance sector to shocks, reducing the probability of insurers failing. - A component of the Capital Markets Union. - Established new set of capital requirements, valuations techniques, reporting standards. - Risk-based capital regime: IRB models or standardized models to work out capital requirements. - Transition period of 16 years to fully implements Solvency II valuation requirements. - The biggest effect on life insurance sector: shift from offering long-term investment guarantees, which carry heavy capital requirements. - Then changes by the EU reducing capital requirements and promise to create resolution mechanism, similar to that for banks. Case: Aktia - Solvency capital requirements according to Solvency II. Unit-linked insurance: a form of long-term savings and investment; allowing investment in a variety of investment objectives and reallocating your investments without the gains from those changes being taxed. - A combination of insurance and an investment vehicle. - Policyholders hold certain number of mutual fund units. - Each policyholder has an option to select personalized investment mix based on their investment needs and risk appetite. - The life insurance element gives client control on who receives wealth when they die. Pension insurance contract: an agreement where pension plan (the retirement savings scheme set up by employer, government, etc) makes regular contributions to an insurance company, in return the insurance company guarantees to pay benefits to plan's members when reach a specified retirement age or earlier exit of members from plan.  - Countries with high pension assets relative to GDP have relatively stronger funded pension systems, reducing reliance on public pensions. - Lower ones have greater reliance on state pensions or informal savings, which can be riskier for future retirement security. Defined-benefit pensions (DB): pay constant accrual (increasing with time) rate for each year of savings, based on lifetime average revalued earnings. - Employer guarantees a fixed, pre-determined payout to employees based on salary and years of service. - Pension plans place burden on employer to properly funs the expected retirement benefit payouts. - Fully funded: sufficient funds to meet payouts. - Overfunded: funds exceed the expected payouts. - Underfunded: funds not expected to meet required benefit payouts. Defined contribution pension plan (DC): contributions flow into an individual account, the accumulation and investment returns are converted into a pension-income stream at retirement. - Employees or employers contributed to individual account, and final pension amount depends on investment performance -\> the benefit payout is uncertain. - Private: pension plan set up by employer, groups, or individuals. - Public: plan set up by government for public. - Within the EU there is large variation in the approach to pensions. 401k: US based employer-sponsored retirement savings plan, where employees contribute a portion of their salary, often with employer matching, and investments growing tax-deferred until withdrawal. - Allows employee to control how money is invested -\> often spread of mutual funds. - *Most common is target-dare funds: adjusted over time, with more risk when younger and growing more conservative until target-date*. [Finnish Pension System] Earnings-related pension insurance: the money set aside to make sure you have enough when old, disabled, or wage earner in family dies. - If your earning-related is pension is small, you may get insurance from Kela. - Statutory -- set by law. A graph of pension savings AI-generated content may be incorrect. - As it is statutory, the largest portion of total pensions are earnings-related pensions.  - The most common pension range is from 1000-2000 euros. - Men receive on average higher pensions than women, 3000+. - Highlighing income disparities between genders. [Finnish pension system set-up:] 1. Defined benefit earnings-related pension. - Accumulates from work. - Pay-as-you-go system. 2. Reisdence-based national pension. 3. Guarantee pension - Ensuring minimum security. A white and orange chart with black text AI-generated content may be incorrect. - Pension funds invest most their money into listed companies. - *By looking at the shareholders of Finnish companies, often insurance companies like Ilmarinen and Varma are there.* [Financial sustainability of Finnish Pension funds:] - Finland has massive pension liabilities, around 350% of the GDP. - Earnings-related pension system is more than double for private sector than public. - Discount rates influence the pension funds liabilities. - With an aging population, there is financial pressure on pension systems. - Long-term sustainability issues, as fewer workers will contribute to pensions.