Ch15: Insurance Companies PDF

Ch15: Insurance Companies Financial Markets and Institutions (8th Ed) Saunders, Cornett and Erhemjamts Insurance companies provide insurance policy contracts that ensures payment to the insured under certain conditions in exchange for periodic fee Insurance provider can act in one...

Ch15: Insurance Companies Financial Markets and Institutions (8th Ed) Saunders, Cornett and Erhemjamts Insurance companies provide insurance policy contracts that ensures payment to the insured under certain conditions in exchange for periodic fee Insurance provider can act in one of two roles: Insurance underwriter assess risk of an applicant for coverage Insurance brokers sell insurance contracts 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 (e.g., mutual funds and annuities) Premiums charged by insurance company for insurance policy are based on the probability of providing payment to insured - Present value of expected payment  Insurance companies invest premiums and fees until funds are needed to pay insurance claims 740 life insurance companies existed in the U.S. in 2021 In 1988, there were more than 2,300 life insurers Industry has experienced major mergers in recent years to take advantage of economies of scale and scope and other synergies Aggregate industry assets were $8.7 trillion in 2021 In 1988, aggregate assets of life insurers were $1.12 trillion Ten largest life insurers represented 43.7% of the industry’s assets in 2021 Life insurers pool the risks of individuals to diversify away some of the customer-specific risk Life insurers transfer income-related uncertainties, such as those due to retirement, from the individual to the group  Other activities of life insurance companies: Sell annuity contracts, which are savings contracts that involve the liquidation of those funds saved over a period of time Manage pension plans (tax-deferred savings plans) Provide accident and health insurance Stock-owned insurers are owned by their shareholders (Ex: Met Life, AIG and Prudential) Mutual life insurance companies are owned by their policy holders (Ex: Northwestern Mutual and New York Life) Over 80% of life insurance companies are classified as having stock ownership Stock-owned insurers can raise money by issuing stock Insurance companies accept or underwrite risk that a pre-specified event will occur in return for insurance premiums  Major part of underwriting process is determining which risks should be accepted and which should be rejected For accepted risks, underwriters must determine how much to charge (in the form of premiums) E.g., a smoker would likely be charged a higher premium than a non-smoker Adverse selection problem exists because customers who apply for insurance policies are more likely to be those most in need of coverage E.g., someone with chronic health problems is more likely to purchase a life insurance policy than someone in perfect health Actuaries have traditionally worked in life insurance to reduce the risks of underwriting and selling life insurance With traditional life insurance, actuaries analyze mortality, produce life tables, and apply time value of money concepts to produce life insurance, annuities, and endowment policies With health insurance, actuaries analyze rates of disability, morbidity, mortality, fertility, and other contingencies  Ordinary life policies are marketed on an individual basis, policyholders make periodic premium payments in exchange for coverage Term life is the closest to pure life insurance Has no savings element attached and beneficiary receives payout at the time of the individual’s death during the coverage period Whole life protects the individual over an entire lifetime rather than for a specified coverage period Accumulates cash value that can be borrowed against throughout life Endowment life combines a pure (term) insurance element with a savings element If insured person dies during endowment period beneficiaries receive face value and if insured person survives endowment expiration policyholder gets face value Variable life invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments Beneficiary receives investment returns upon death Universal life provides policy holder flexibility on premium amounts and contract maturity  Variable universal life provides investment component of policy 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 the employer and employee to cover a share of the insurance cost Noncontributory means the cost of the employee’s insurance is paid entirely by the employer 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 Other activities of life insurers include the sale of annuities, private pension plans, and accident and health insurance Annuities represent different methods of liquidating a fund over a long period of time Assets Life insurers concentrate their asset investments at the longer end of the maturity spectrum (e.g., corporate bonds, equities, and government securities)  In 2021, 6.0% of assets were invested in government securities, 65.7% in corporate bonds and stocks, and 8.0% in mortgages Liabilities Net policy reserves made up $6.4 trillion, or 73.7% of total liabilities and capital, in 2021 Policy reserves represent the expected payment on existing contracts To meet unexpected future losses, life insurers hold a capital and surplus reserve fund with which to meet such losses Insurers earn profits by taking in more premium and interest income than they pay out in policy payments Firms can increase their spread between premium income and policy payouts in two ways: Decrease future required payouts for any given level of premium payments Accomplished by reducing the risk of the insured pool Increase the profitability of investment income on net policy reserves 2008-2009 financial crisis took a toll on this industry  Treasury Department extended bailout funds to several struggling life insurers (e.g., AIG, Allstate, Lincoln National, etc.) in late 2008/early 2009 Net income was $48.7 billion in 2018, it dropped to $39.6 billion in 2020 Life insurers paid out a record $90.4 billion in death benefit payments in 2020, a 15.4% increase from the payments in 2019 Greatest year-to-year increase since 1917-1918 influenza pandemic In 2021, net income recovered to $54.1 billion State regulations cover areas such as insurance premiums, insurer licensing, sales practices, commission charges, and the types of assets in which insurers may invest National Association of Insurance Commissioners (NAIC) facilitates cooperation among the various state agencies whenever an insurance issue is a national concern States promote life insurance guarantee funds  Contributions from insurance companies are used to compensate policyholders if insurance company fails Wall Street Reform and Consumer Protection Act of 2010 created the Federal Insurance Office (FIO) and resulted in the Fed becoming a major supervisor of insurance firms FIO has authority to: Monitor insurance industry Identify regulatory gaps or systemic risk Deal with international insurance matters Monitor the extent to which underserved communities have access to affordable insurance products Currently, close to 2,600 companies sell property-casualty (P&C) insurance in the U.S. Top 10 firms have a 51.4% market share In 2018, State Farm was the top firm, writing 9.7% of all P&C insurance premiums Distinctions between the two broad areas of property and liability insurance are becoming increasingly blurred  Property insurance involves insurance coverages related to the loss of real and personal property Casualty (or, liability) insurance offers protection against legal liability exposures Fire insurance and allied lines protects against the perils of fire, lightning, and removal of property damaged in a fire 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 Commercial multiple peril (MP) insurance protects commercial firms against perils similar to homeowners MP insurance 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 Liability insurance (other than auto) protects individuals or businesses from legal liability (e.g., product liability hazards) Assets P&C insurers invest most of their assets in long- term securities, although the proportion held in common stock is lower than that of life insurance companies  Bonds, preferred stock, and common stock represented 72.4% of total assets in 2019 Liabilities Loss reserves and loss adjustment expenses are a major component (31.3% of total liabilities and capital) Loss reserves are funds set aside to meet expected losses from underwriting the P&C lines Loss adjustment expenses are the expected administrative and related costs of adjusting (settling) claims 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: Loss risk - unexpected increases in loss rates Expense risk - unexpected increases in operating expenses Investment yield/return risk - unexpected decreases in investment yields or returns  Key feature of claims loss risk is the actuarial 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: Loss rates are more predictable on low-severity, high- frequency lines than on high-severity, low-frequency lines Long-tail risk exposure makes estimation of expected losses difficult Reinsurance, essentially insurance for insurance companies, is an alternative to managing risk on a P&C insurer’s balance sheet 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 Expense ratio is calculated as expenses incurred (before federal income taxes) divided by premiums written Two major sources of expense risk to P&C insurers are:  Loss adjustment expenses (LAE), which relate to the costs surrounding the loss settlement process Commissions and other expenses 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 In 2018, the combined ratio was 99.3% Investment yield is calculated as net investment income divided by premiums earned In 2018, the investment yield was 11.4% Operating ratio is also a measure of overall profitability; calculated as the combined ratio minus the investment yield In 2018, the operating ratio was 88.5% Insurance sector is becoming increasingly global  While the U.S., Japan, and western Europe dominate the global market, all regions are engaged in the insurance business and many insurers are engaged internationally 2017 was the costliest year for the worldwide insurance industry Natural disasters cost insurers a record $138 billion in losses, though losses in North America accounted for 83% of the total Key driver of losses in 2017 were the hurricanes Harvey, Irma, and Maria, which struck the USA and Caribbean in the space of a few weeks