Insurance Companies

1. Insurance Companies Chapter 18 © 2003 South-Western/Thomson Learning

2. Learning Objectives • What life insurance, health insurance, and property and casualty companies do • How adverse selection and moral hazard create risks for insurance companies and how these are managed • Various types of life insurance policies available • Recent trends for these financial intermediaries and how they are regulated

3. Life is Uncertain Two fundamental assumptions underlie how financial theorists think about financial risk and its management: • Most people are risk averse • Reluctant to fully bear the financial or physical loss of an event • Future is uncertain

4. Insurance Companies Contractual-type financial intermediaries that offer the public protection against the financial costs associated with the loss of life, health, or property in exchange for premiums.

5. Life Insurance Companies Insurance coverage creates two additional forms of risk: • Adverse selection • Occurs when least desirable individuals are those most likely to pursue and be selected for a transaction • Moral Hazard • Risk that policyholder will behave in more risky manner than he or she would have in absence of insurance coverage

6. Life Insurance Companies Four primary types of insurance professionals: • Actuaries • Trained in mathematical aspects of insurance • Responsible for calculating policy premiums • Agents • Exclusive agents sell only products of one particular company • Independent agents sell policies issued by wide number of companies • Underwriters • Review, approve or reject policy applications written by insurance agents • Claims adjusters • Assist policyholders with filing claims by verifying losses and determining insurance company’s liability

7. Life Insurance Companies • Beneficiary • Receives insurance payment or annuity stream after a policyholder dies

8. Types of Coverage – Term Life Insurance • Straight term insurance • Provides death benefit to insured policyholder’s beneficiary if insured dies within specified period of time, or “term” • Premiums based on mortality tables which estimate number of people of given age who are expected to die during a year • Renewable term insurance • Allows policyholder to continue policy for an additional term after original policy expires • Group life insurance • Provided by many businesses, labor unions and professional organizations to employees or members

9. Types of Coverage – Term Life Insurance • Insurance companies have developed whole, universal, and variable life policies that accumulate cash values • Some term insurance policies are convertible into these other kinds of insurance • Policyholder has right to change his or her term life insurance policies into a whole, universal, or variable life product

10. Types of Coverage – Permanent Life Insurance • Whole life insurance (straight life policy or continuous premium policy) • Charges a fixed premium • Pays a fixed death benefit • Differ from term insurance • Not limited to a particular term • Premiums are substantially higher • Two main tax advantages of accumulating cash reserve in this way • Cash reserves accumulated within insurance policy grow tax deferred • Death benefits usually pass to beneficiaries free of taxation

11. Types of Coverage – Permanent Life Insurance • Universal Life Insurance • Provides pure insurance product • Separate account that grows at fluctuating rate of interest similar to that received on a money market account or short-term CD • Variable Life Insurance • Provides pure insurance product • Separate account that may be used by policyholder to purchase mutual funds from a list of insurance company approved funds

12. Exhibit 18–2 A Comparison of Term, Whole, Universal, and Variable Life Insurance Products

13. Types of Coverage – Annuities • Annuitant is owner of annuity Annuities: provide a periodic income at regular intervals for a specified amount of time

14. Types of Coverage – Disability Insurance Disability Insurance: covers a portion of an insured worker’s previous income if worker becomes unable to work due to illness or injury

15. Types of Coverage – Long-Term Care Insurance Long-Term Care Insurance: compensates insured policyholders needing assistance with the daily tasks of bathing, eating, dressing, and moving about.

16. Health Insurance Companies Offer protection, in exchange for premiums, against the financial costs associated with events such as doctor visits, hospital stays, and prescription drugs • Health Maintenance Organizations (HMOs) • Specialized health care insurers • Provide almost complete medical care in exchange for fixed per person premiums

17. Property and Casualty Companies Provide protection against the effects of unexpected occurrences on property • Property Insurance • Contingent claims, in exchange for premiums, that protect insured policyholders from financial costs of property loss, damage, or destruction

18. Property and Casualty Companies • Casualty (Liability) Insurance • Exchanged for premiums • Protects insured policyholders from financial responsibilities to those harmed by an accident, product failure, or professional malpractice • No-Fault Insurance • Pays an accident victim regardless of who caused an accident or damage

19. Managing Adverse Selection and Moral Hazard in Insurance Industry All insurance companies must actively manage their clients to prevent adverse selection and moral hazard problems

20. Exhibit 18–4 Top 10 Ways to Manage Adverse Selection, Moral Hazard, and Other Risks in the Insurance Industry

21. Managing Adverse Selection and Moral Hazard in Insurance Industry • Effective screening • Insurance underwriters screen out those applicants who would be poor risks • Risk-based premiums • Charges that increase with perceived risk of policyholder • Deductibles • Fixed amount that insured policyholder is required to pay before insurance coverage becomes effective • Coinsurance • Percentage share or fixed amount of a claim that must be paid by policyholder

22. Managing Adverse Selection and Moral Hazard in Insurance Industry • Threaten or cancel coverage • Restrictive provisions • Fraud prevention • Limit amount of insurance • Reinsurance • Practice by smaller insurance companies of sharing risk of a large policy with other insurance companies • Effective credit, interest rate, liquidity and exchange rate risk management

23. Regulation • Government agencies created to provide outside supervision of the industry • Insurance companies regulated almost exclusively by state-level insurance commissioners • Each state establishes own set of safety and soundness regulations • McCarren-Ferguson Act (1945) • Exempts life insurance companies from federal regulation • Defers its oversight to state insurance commissioners in each state