Chapter 21 Insurance Companies and Pension Funds

1. Chapter 21 Insurance Companies and Pension Funds

2. Chapter Preview • We look at two non-bank institutions: insurance companies and pension funds. Topics include: • Insurance Companies • Fundamentals of Insurance • Growth and Organization of Insurance Companies • Types of Insurance • Pensions • Types of Pensions • Regulation of Pension Plans • The Future of Pension Funds

3. Insurance Companies • Insurance companies assume the risk of their clients in return for a fee, called the premium. • Most people purchase insurance because they are risk-averse - they would rather pay a certainty equivalent (the premium) than accept a gamble

4. Financial assets across countries

5. Insurance Companies: Major Employer Figure 21.1 Number of Persons Employed in the U.S. Insurance Industry, 1960–2011

7. Fundamentals of Insurance Although there are many types of insurance and insurance companies, there are seven basic principles all insurance companies are subject to: • There must be a relationship between the insured and the beneficiary. Further, the beneficiary must be someone who would suffer if it weren’t for the insurance.

8. Fundamentals of Insurance • The insured must provide full and accurate information to the insurance company. • The insured is not to profit as a result of insurance coverage. • If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of the compensation.

9. Fundamentals of Insurance • The insurance company must have a large number of insured so that the risk can be spread out among many different policies. • The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field. • The insurance company must be able to compute the probability of the loss’s occurring.

10. Adverse Selection and Moral Hazard in Insurance • Asymmetric information plays a large role in the design of insurance products. • The presence of adverse selection and moral hazard impacts the industry, but is fairly well understood the insurance companies.

11. Adverse Selection in Insurance The adverse selection problem raises the issue of which policies an insurance company should accept: • Those most likely to suffer loss are most likely to apply for insurance. • In the extreme, insurance companies should turn anyone who applies for an insurance policy.

12. Adverse Selection in Insurance However, insurance companies have found reasonable solutions to deal with this problem: • Health insurance policies require a physical exam. • Preexisting conditions may be excluded from the policy.

13. Moral Hazard in Insurance Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy. • Insurance companies use deductibles to help control this problem.

14. Types of Insurance Insurance is classified by which type of undesirable event is covered: • Life Insurance and Disability • Property and Casualty Insurance

15. Life Insurance • Life insurance policies come in many forms. Some of the typical policies include: • Term Life: the insured is covered while the policy is in effect, usually 10 - 20 years lump sum. • Whole Life: similar to term life, when the term of policy expires, the insured can get the cash value of the policy. • Survival Insurance: it pays a lump sum or an annuity if, at some date, the insured is still alive.

16. Life insurance:Italy Branch I: on the lifespan of human life: term-life /whole-life/ survival /mix Branch II: wedding and birth Ramo III: unit linked e index linked (I and II) Branch IV: Health insurance: disease and against the risk of non-self-sufficiency Branch V: Capitalisation policy/segregated accounts management Branch VI: Investment Contract/Fund management for collective contracts

17. Life Insurance Life insurance policies come in many forms. Some of the typical policies include: • Universal Life: includes both a term life portion and a savings portion. • Annuities: pays a benefit to the insured until death, to cover retirement years.

18. Expected Life of Persons at Various Ages Table 21.1 Life Expectancy at Various Ages in the United States, 2012

19. Sample Annual Premiums Table 21.2 Typical Annual Premiums on a $100,000 Term Policy for a 40-Year-Old Male Nonsmoker

20. Life Insurance: Company Assets and Liabilities • Life insurance companies derive funds from two sources: • They receive premiums that must be used to payout future claims when the insured dies • They receive premiums paid into pension funds managed by the life insurance company • The next figures shows the distribution of the typical life insurance company’s assets.

22. Life Insurance: Company Assets and Liabilities • Life insurance companies have two primary liabilities: • Life insurance payouts • Pension fund payouts • Technical reserves are set aside to cover these liabilities Actuarial calculations

23. Property and Casualty Insurance • Property Insurance: protects businesses and owners from the risk associated with ownership. • Named-peril policies: insures against any losses only from perils specifically named in the policy • Open-peril policies: insures against any losses except from perils specifically named in the policy • Casualty Insurance • Reinsurance

24. Property and Casualty Insurance • Casualty Insurance: also known as liability insurance, it protects against financial losses because of a claim of negligence. • Reinsurance: allocates a portion of the risk to another company in exchange for a portion of the premium.

25. RCA and other insurance

27. The Practicing Manager: Insurance Management • Screening • Risk-Based Premium • Restrictive Provisions • Prevention of Fraud • Cancellations of Insurance • Deductibles • Coinsurance • Limits on the Amount of Insurance

28. The risk of property and casualty insurance • Loss ratio (losses/premiums). Over 100 means premium charged are not sufficient to cover losses Expense ratio: efficiency coefficient. ratio between management costs (commisions to agents, other costs)/ premiums received) • Combined ratio: is the sum of loss ratio and expense ratio and dividend paid.If combined ratio lower than 100 premiums are large enough to cover losses and business expenses Management coefficient: Combined ratio minus investment performance yield. If lower than 100 the company is overall profitable.

29. Example • Insurer ALFA Loss ratio: 79,8% Expense ratio: 27,9% Dividendpaid 2% of premiums • Combined ratio 79,8+27,9+2=109,7% • Losses are biggerthanpremiums by 9,7%. Withoutreturn from financialactivity the insurerwould be lossmaking Butreturn on portfolio investedequals 12% • Management coefficient: 109,7%-12%=97,7% • So profitability ratio= 100%-97.7%=2,3%

30. The regulation of insurance companiesin Italy • The control body is the Ivass The powers conferred on Ivass are : Control over the management of insurance companies (technical, financial, asset and accounting management) Enactment of rules of conduct Ensuring compliance with the rules of fairness and transparency Sanctioning powers

31. The solvency margin • The solvency margin is represented by the net equity of the company net of intangible assets and includes: The share capital; The legal, statutory and optional provisions, not covering specific commitments or the correction of assets; The profits of the previous year's exercise and financial years, net of dividends payable; The losses of the exercise and of the past exercises

32. Credit Default Swaps • A CDS is insurance against default on a financial instrument, usually some kind of securitized bond. • Market essentially non-existent before 1995. By 2008, there were about $62 trillion of CDS outstanding! • The CDS market allowed speculators to bet on the health of a company, a usual no-no in insurance.

33. Credit Default Swaps: The AIG Blowup • AIG’s Financial Products division insured over $400 billion of CDS securities, of which $57 billion were debt securities backed by subprime mortgages. • Creditors quickly realized the losses may bankrupt AIG – AIG could not raise any capital • The Fed organized a bailout, but took a big stake in AIG as payment. Insurance companies nationwide will now fall under federal scrutiny.

34. Monoline Insurance • Monoline insurance companies specialize in credit insurance and are the only insurance companies that are allowed to provide insurance that guarantees the timely repayment of bond principal and interest when a debt issuer defaults. All other insurance companies are prohibited from doing this. • Help lower required interest by providing a credit enhancement. The crisis affected them as well.

35. The Subprime Crisis and the Monoline Insurers • Monoline insurers did insure debt backed by subprime mortgages. • Defaults on these mortgages resulted in credit downgrades for the insurers. • This weakened the value of their insurance guarantees, which spilled over into their municipal securities insurance. • Investors reduced the value of the insurance—municipalities started seeing higher interest costs. This, in turn, resulted in lower spending on roads, schools, etc.

36. Pensions • Definition: A pension plan is an asset pool that accumulates over an individual’s working years and is paid out during the nonworking years. • Developed as Americans began relying less on children for care during their later years. • Also became popular as life expectancy increased.

37. Types of Pensions • Defined-Benefit Pension Plans: a plan where the sponsor promises the employee a specific benefit when they retire. • For example, Annual Retirement Payment = 2%  average of final 3 years’ income  years of service • Amount not certain (depends on salary)

38. Types of Pensions • Defined-Benefit 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

39. Types of Pensions • Defined-Contribution Pension Plan: a plan where a set amount is invested for retirement, but the benefit payout is uncertain. Depends on results. • Note 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)

40. Private Pension Plan Assets Figure 21.5 Distribution of Private Pension Plan Assets (end of 2012)

41. Social Security • Pay as you go system, where current funding is used (partially) to pay current benefits. • Projected number of workers is falling while projected number of retirees is increasing, which will cause problems in years to come if not corrected. • The regulation on social security in Italy has been recently modified to go towards a fully funded one

42. Social Security Assets Figure 21.6 Social Security Fund Assets, 1957–2013

43. Social Security Assets Figure 21.7 Projected Social Security Trust Fund Assets

44. Social Security • It’s difficult to measure the health of the social security system. Many factors are hard to predict, such as birth rates and the rate of immigration. Although it may not fail, it’d be wise for you plan other sources for your retirement cash flows.

45. Other pension plans Italy • The D. LGs. 252/2005 defines the following instruments as "supplementary pension forms": Negotiated or closed funds Open funds Individual pension plans (PIP) insurance related Pre-existing funds

46. The Future of Pension Funds • We can expect their growth and popularity as the average population continues to grow. • Variety of pension fund offerings may increase as well. • Pension funds may gain significant control of corporations as their stock holdings increase.