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Chapter Fifteen

Chapter Fifteen. Insurance Companies. Chapter Outline. Major Characteristics Life Insurance Basic Classes Balance Sheet Regulation Property & Casualty Insurance Major Types Balance Sheet and Risk Regulation. 1. Insurance Industry.

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Chapter Fifteen

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  1. Chapter Fifteen Insurance Companies

  2. Chapter Outline • Major Characteristics • Life Insurance • Basic Classes • Balance Sheet • Regulation • Property & Casualty Insurance • Major Types • Balance Sheet and Risk • Regulation

  3. 1. Insurance Industry • Primary function is to compensate individuals and corporations (policyholders) if a prespecified adverse event occurs • Two major groups: • Life: untimely death, illness, and retirement • Property Casualty: personal injury and liability due to accidents, theft, fire, and other catastrophes

  4. Insurance Companies Life 1,500 companies Assets: $3.88 trillion (’04) Trend: Mergers (Metropolitan Life Insurance & Prudential Insurance Co. of America - largest life insurers) Role: Transfer income-related uncertainties from the individual to a group Problem: Adverse selection Property and Casualty 3,200 companies sell P&C insurance Assets: $ 1.176 trillion (1/3 of Life Assets) (’04) Trend: Concentration (10 firms – 45% of market share; major firms: State Farm & Allstate) Role: Insure against the loss of property and legal liability exposure

  5. 2.1 Life Insurance Basic Classes Four basic classes • Ordinary life - marketed on an individual basis in units of $1,000 with policyholders making periodic payments (term, whole, endowment, variable, universal, variable universal) • Group Life Insurance • Credit Life • Others Life Insurer Activities

  6. Distribution of Premiums Written on Various Life Insurance Lines

  7. Ordinary Life • Term Life - closes to pure life insurance, no savings attached, individual’s beneficiary receives payout at death of policyholder, term of coverage can vary from 1 year to 40 years or more. • Whole Life - protects individual over an entire lifetime in return for periodic premiums, beneficiaries receive face value of the contract. • Endowment Life - combines both term elements with a savings element, guarantees payout to the beneficiaries if death occurs during some endowment period or to the insured person who lives to the endowment date. • Variable life - invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments with policyholder determining risk level • Universal life and Variable universal life - allows the policyholder to change both the premium amounts and the maturity of the contract

  8. Group Life Insurance • Covers a large number of insured persons under a single policy • Issued to corporate employers (contributory or noncontributory) • Involves economies of scale

  9. Credit Life • Protects lender against a borrower’s death

  10. Other Life Insurer Activities • Annuities • reverse of life insurance principles, involve different methods of liquidating a fund over a long period of time, a popular mechanism for retirement savings • Private Pension Fund • an alternative pension plan offered by insurance companies to private employers, innovative pension plans based on guaranteed investment contracts • Accident and Health Insurance • protects against morbidity or ill health risk • major activity line is group insurance • Life insurance companies write more than 50% of all policies but HMOs (nonregulated providers) have cut into their business • face loss exposures similar to those of property-casualty insurers

  11. 2.2 Life Insurance Industry Balance Sheet • Assets • corporate bonds, equities, and government securities • policy loans - loans made by an insurance company to its policyholders using their policies as collateral • Liabilities • policy reserves - reflects their expected payment commitments on existing policy contracts • surrender value of a policy - the cash value of a policy if a policyholder surrenders the policy prior to maturity • separate account - annuity program sponsored by life insurance companies, payoff on policy linked to assets in which policy premiums are invested

  12. Life Insurance Industry Balance Sheet

  13. 2.3 Regulation • McCarran-Ferguson Act of 1945 - confirms the primacy of state over federal regulation of insurance companies • State insurance commissioners charter and examine insurance companies (role of NAIC), promote life insurance guarantee funds (l.i. firms do not have an access to a federal guarantee fund and there is no permanent insurance fund) • Insurance guarantee fund - a fund of required contributions from within-state insurance

  14. 3.1 Property-Casualty Insurance Companies • Net premiums written - the entire amount of premiums on insurance contracts written • Important P&C lines include the following • Fire Insurance and Allied Lines • protects against fire, lightening, and removal of damaged property • Homeowners Multiple Peril insurance • protects against damage to personal dwelling, contents, liability • Commercial Multiple Peril Insurance • protects commercial firms similar to homeowners • Automobile Liability and Physical Damage insurance • Liability Insurance (other than auto) • provides protection to individuals or firms against legal liability

  15. Selected U.S. Catastrophes ($Mns)

  16. 3.2 Balance Sheet Major assets • Long term assets - bonds, preferred stock, and common stock and other investment assets – 82.4% Major Liabilities • Loss and loss adjustment expense – 37.9% • Unearned premiums – 15.0% Capital/Surplus – 30.1%

  17. Balance Sheet and Underwriting Risk • Unearned premium - reserves set aside that contain the portion of a premium that has been paid before insurance coverage has been provided • Loss Risk • property versus liability • severity versus frequency • long tail versus short tail • product inflation versus social inflation • Loss Ratio - measures the actual losses incurred on a specific policy line, measures the ratio of losses incurred to premiums earned(continued)

  18. Expense Risk • loss adjustment expenses (LAE) • commissions and other expenses • combined ratio - equal to the loss ratio plus the ratios of LAE to premiums written and commissions and other expenses to premiums written • Investment Yield/Return Risk • operating ratio - measure of the overall profitability of the insurer, equals the combined ratio minus the investment yield • behavior of interest rates and default rates on P&C insurers’ investments is crucial to the P&C insurers’ overall profitability

  19. 3.3 Regulation • Chartered at the state level and regulated by state commissions • The National Association of Insurance Commissioners (NAIC) provides various services to the state, such as: • standardized examination system • the Insurance Regulatory Information System (IRIS) to identify insurers with loss, combined, and other ratios operating outside normal ranges • Rate regulation • state commissions set ceilings on the premiums for auto and workers’ compensation insurance

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