Insurance Operations

1. Insurance Operations 25

2. Insurance • Historical and Religious Connotations • Ways to deal with risk • Avoid or reduce risk • Assume risk • Transfer risk Where do deaths occur? 20% in a land-based vehicle17% in the home 14% to pedestrians on streets or sidewalks 16% when travelling by air, rail, or water 33% in a hospital But only 0.001% in a church Moral: safest place to be is in church

3. Insurance Ways to Transfer Risk: -- loss of income due to death (life insurance) -- loss of income due to illness or injury (disability insurance) -- loss of money in bank (deposit insurance) -- loss from not paying off debts (credit insurance) -- loss from malpractice or negligence (liability insurance) -- loss from medical costs (medical insurance) -- loss of income from no job (unemployment insurance) Etc. Law of Large Numbers

4. Insurance Problems of assessing risk-basedpremiums 1. Adverse Selection • People who get insurance are more likely to suffer losses and file claims than people who don’t get insurance • E.g. renter insurance is not a big deal for Beth because she locks her door but Bob doesn’t lock his door so he feels the need to get insurance • So if police reports show 3% of apartments experience a theft, claims will likely be higher than anticipated • Moral hazard • People take more risks once they’re insured

5. Life Insurance • Life insurance pays out policy amount in cash to the beneficiary(tax free!) upon accidental or natural death • Provides for loss of income • Keep you poor while you are alive so you can die rich • Life insurance premiums reflect • Probability of making payment to the beneficiary (age and health) • Size and timing of the payment (policy amount) • Use mortality figures and actuarial tables to forecast claims

6. Cash Value Insurance Term Insurance Types of Life Insurance Policies Group Universal Life Group Term Variable Life IndividualTerm Whole Life

7. Premiums Under Various Policies

8. Types of Life Insurance Policies • Whole life insurance includes both a death benefit (term insurance) and a savings component that • Builds a tax sheltered cash value amount for the future for the owner of the policy (forced savings plan) • Generates periodic cash flow payments over the life of the policy for the insurance company to reinvest • Pays fixed death benefit at death

9. Types of Life Insurance Policies • Term life insurance characteristics • Temporary, providing death benefits only over a specified term • Premiums paid represent insurance only with no saving component • Considerably lower cost for the insured than whole life—able to buy more insurance protection per dollar of premium • Term is for those who would rather invest their savings elsewhere (why pay ins. co. to invest?)

10. Types of Life Insurance Policies • Variable life insurance • Whole life with variable cash value amounts • Cash values invested in equities and will vary with the investment performance • Flexible premium option since 1984 • Universal life insurance • Combines the features of term and whole life • Variable premiums over time—buys terms and invests difference in a variety of investments • Builds a varying cash value based on contributions and investment performance

11. Types of Life Insurance Policies • Group plans • Employees of a corporation offered life insurance or life insurance purchased on life of employee • Cash value or term insurance • Low cost (term) because of its high volume • Can cover group members and dependents

12. Uses of Life Insurance Company Funds ASSETS 2012 Corporate bonds 32% (Largest investor in bonds because maturities can be matched; limited mostly to quality bonds, subject to interest-rate risk) Gov’t bonds 7% Mortgages & Real Est. 21% Stocks 30% Policy Loans 2% Cash and Other 8%

13. Sources of Life Insurance Company Funds • Liabilities (claims, annuities) • PV of actuarially-determined claims (determined by age, health, life expectancy, policy amount) • Surplus • Stock owned (95% of companies) • Or mutually owned (5% of companies but 46% of volume) • Risk-based capital requirements • Used to finance fixed assets

14. Operations of Life Insurance Company • INCOME • Premiums earned (prorated) • Investment Income (large source of income; Buffet calls this “float” income – earned from investing the excess of premiums collected over claims paid) • EXPENSES • PV of Claims • In early 1980s, paid 75% of premiums out in claims; but now, only 60%. They say returns/inflation in 1980s allowed them to do this. • Operating Costs (commissions, admin., mktg, tax) • NET INCOME

15. Uses of Funds—Policy Loans • Policy loans are loans to policyholders • Whole life policies • Borrow up to the cash value of the policy • Guaranteed interest rate is stated in the policy • Usually used by borrowers during periods of rising rates to lock in the lower rate associated with their policy

16. Regulation • Pricing is market-based with no federal guarantee • Ratings by AM Best, Standard & Poors, Duff and Phelps, Moody’s, and Wiess Research. • Reinsurance (Lloyds of London) • Insurance companies are highly regulated by state insurance agencies • Make sure insurance companies provide adequate service • Agent licensure • States approve/review rates • The National Association of Insurance Commissioners (NAIC) • Provides coordination among states in regulatory matters • Adopted uniform regulatory reporting standards

17. Regulation • Insurance Regulatory Information System • Compiles financial information and lists of insurers • Calculates 11 ratios to assess and monitor financial health • Assessment system • Ability of the company to absorb either losses or a decline in the market value of its investments • Return on investment • Relative size of operating expenses • Liquidity of the the asset portfolio

18. Regulation: Dodd-Frank Act of 2010 • If it weren’t for AIG, maybe the insurance industry wouldn’t have been part of this regulation. • Now, a Federal Insurance Office is being created which will gather info from insurance companies each year and will probably recommend a slew of regulations down the road • Health and crop insurance are excluded

19. S&P Insurance Ratings

20. Exposure to Financial Risks • Interest rate risk • Fixed rate assets (bonds) have market values sensitive to interest rate changes • More IRR in life ins. co. than P&C • Credit risk (default risk) • Mortgages, corporate bonds and real estate holdings can involve default risk • Usually only hold investment-grade securities • Diversify portfolio among debt issuers • If major disaster, surplus must absorb losses (Florida, Hurricane Hugo, etc.)

21. Property and Casualty Insurance • Property insurance (fire insurance) • Casualty insurance (liability) • Both timing and amounts of claims are unknown!

22. Property & Casualty Ins. Use of Funds ASSETS 2012 Muni bonds 26% (PCs face heavier tax) Corporate Bonds 21% Treas./Agency Bonds 15% Common Stock 16% Other 22%

23. PC Versus Life Insurance Companies • PC have shorter contracts • PC have more varied risk areas (default and liquidity risk, but not interest-rate risk) • Life companies are larger due to long-term savings and annuity pension contracts • PC has wider distribution of occurrences • PC’s need liquid, marketable assets • PC’s earnings more volatile

24. Property Casualty Investment Needs • Tax sheltering--major municipal/state bond investor • Liquid, marketable assets • Marketable corporate and government bonds • Listed common stock • Inflation hedge--common stock • Reinsurance contracts

25. Health Care Insurance • Health maintenance organizations or HMOs • Intermediaries between purchasers and providers of health care • Annual fee or premium • Covers all medical expenses • Medical staff is designated by the HMO • Losses in recent years for HMOs • Preferred Provider Organizations (PPOs) • Can see any physician without a wide group

26. Insurance Scandals • In 2004, Eliot Spitzer brought a civil suit against Marsh & McClennan, among others, for: • Bid-rigging, kickbacks, price-fixing • Contingent commissions • M&M agreed to give $850 million back to its customers. Cut 5500 jobs, blaming costs of settlement. Agreed to adopt new reforms including a limit on commissions.

27. Other insurance operations Bond Insurance Bond insurance protects the investors that purchase bonds in the event that the bond issuers default on their bonds. Mortgage Insurance Mortgage insurance protects the lender that provides mortgage loans in the event of homeowner default. • Credit Default Swaps as a Form of Mortgage Insurance • Privately negotiated contracts that protect investors against the risk of default on particular debt securities. • Insurance companies commonly serve as the counterparty and have to make payments only if there is a default on the securities covered by the swap.

28. Insurance and Derivatives In risk management, there’s not much difference between using traditional insurance and derivatives to manage risk.E.g. Disney & business interruption insurance E.g. Farmer buying crop insurance E.g. Stock investor buying investment insurance E.g. Investors buying credit insurance on bonds

29. Credit Default Swaps (ticking time bombs) • CDS provide insurance on bonds (but they didn’t want to call it “insurance “ otherwise it would be regulated) • If bonds lose value, the CDS would make good on the loss • CDS were considered a good thing . . . Until speculation began • Speculators would bet on bonds going bad (like Bob buying insurance on Jehu’s car; since Jehu is a risky driver, Bob collects if Jehu crashes.) • Described by Buffet as “financial weapons of mass destruction.” • Multiple CDS were contracted on the same bonds • World-wide GDP in 2007 was $54 trillion • Global est. value of CDS in 2007 was $58 trillion!!! • CDS were ticking time bombs in almost every major investment portfolio

30. As a tell-tale symbol, the DJIA replaced AIG with Kraft (Altria) – a financial stock substituted with a food/tobacco stock! AIG rolled the dice by providing credit insurance on $700B of Lehman Bros. When the bonds went bad, AIG could not make good. An AIG executive said as late as August 2007 that “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [CDS] transactions.”

31. Credit Default Swaps (ticking time bombs) Exposure to Risk during the Credit Crisis • Government Rescue of AIG • American International Group (AIG) is the largest insurance company in the world, with annual revenue of more than $100 billion and operations in more than 130 countries. • In 2008, AIG experienced severe financial problems because many debt securities defaulted which were backed by AIG’s CDSs. • Since the failure of AIG could have a devastating effect on the insurance industry and the rest of the financial sector, the Federal Reserve bailed out AIG in September 2008 with support from the U.S. Treasury. • The bailout allowed AIG to borrow up to $85 billion from the Federal Reserve over a two-year period, and the government received an equity stake of about 80 percent of AIG.