Nondepository Financial Institutions

1. Nondepository Financial Institutions Chapter 10

2. Life Insurance Companies • Oldest type of intermediary in the U.S. • 1759 in Philadelphia (now called Presbyterian Ministers’ Fund) • Invest funds obtained through the sale of policies. • Primary investments: Long term taxable, not highly marketable securities: corporate bonds and commercial mortgages. • Income paid to policy holders is tax exempt - return on the policy holders investment • Insure against dying too soon and living too long.

3. Life Insurance Companies • Regulation of life insurance companies includes: • Sales practices • Premium rates • Allowable investments • Usually overseen by a state insurance commissioner, who might also be the state banking commissioner

4. Types of Life Insurance Policies • Whole Life Insurance • Constant premium that is paid through entire life of policy • Build up cash reserves or savings which can be withdrawn as borrowing or outright by canceling the policy • Savings component pays a money market rate of interest that changes with market conditions

5. Types of Life Insurance Policies • Term Life Insurance • Pure insurance with no cash reserve or savings element • Premiums are relatively low at first but increase with the age of the insured individual • Universal (variable) Life • Variation on whole life policy • “Unbundle” the term insurance and tax-deferred savings component • Owner can elect how to allocate the savings component among a menu of investment options, thereby potentially earning above money market rates

6. Life Insurance Companies • Based on actuarial tables, life insurance companies have ability to predict cash flow • Typically insurance companies use excess funds to buy long-term corporate bonds and commercial mortgages • Higher yields • Unlikely of having to sell prior to maturity • However, lately they have branched out into riskier ventures such as common stock and real estate

7. Life Insurance Basics • Public makes payments in exchange for protection • Companies lend out the funds collected. • Companies use the interest and dividend income received to pay benefits to policyholders • Insurance companies have a reasonably predictable stream of payments to policy holders distributed over time.

8. Dealing with Asymmetric-Information Problems in Insurance • Limiting adverse selection • Restricting the availability and quantity of insurance. • Limiting moral hazard in insurance • Deductible: A fixed amount of an insured loss that a policyholder must pay before the insurer is obliged to make payments. • Coinsurance: A policy feature that requires a policyholder to pay a fixed percentage of a loss above a deductible.

9. Pension Funds • Program established by an employer to provide retirement benefits to employees. • History • established at the end of the 19th century by railroads. • 1875 - American Express Company who was closely associated with railroading. • Many failed during the depression - led to increased regulation.

10. Pension Funds • Individuals need pension plans to supplement Social Security benefits • Most pension fund assets are in employer-sponsored plans • Defined Benefit Plan • Defined Contribution Plan

11. Defined Benefit Plan • Retirement benefits are defined by the plan • Employer contributions are adjusted to meet the benefits and insure the plan is fully funded—enough funds to meet future obligations • Vesting • Retirement benefits remain with the employee if they leave the firm and is based on length of employment • Employee Retirement Income Security Act (ERISA) • Establishes minimum reporting, disclosure, vesting, funding and investment standards to safeguard employee pension rights • Pension Benefit Guaranty Corporation— • Guarantees some benefits in defined benefit plans if company is unable to meet its accrued pension liabilities

12. Defined Contribution Plan • Contributions are defined by the plan • Contribution may be made by employees or employers or a combination of the two • Employee contributions are tax deferred—taxes payable when funds are withdrawn • Benefits depend on the performance of the assets in the plan • Avoids the problems of vesting and funding • Individual employee has the ability to choose the assets in which to invest • Most common are 403(b) and 401(k)

13. Pension Funds • Defined contribution plans are the type favored by most employers, although some employers offer both plans • In addition to employer-sponsored plans, some individuals are given tax incentives to set up their own pension plans • Keogh Plans—self-employed individuals • Individual Retirement Accounts (IRAs)—working people who are not covered by company-sponsored pension plans

14. Pension Fund Basics • Tax-exempt institutions set up to provide participants with retirement income that will supplement other sources of income. • The number of people likely to retire each year is quite predictable. • As a result they invest about 80% of their funds in corporate equities.

15. Property and Casualty Insurance Companies • Insure against casualties such as automobile accidents, fire, theft, personal negligence, malpractice, etc. • Losses can be unexpected and highly variable. • Invest in tax-free municipal bonds and short-term securities.

16. Property and Casualty Insurance Companies (Cont.) • State insurance commissions set ranges for rates, enforce operating standards, and exercise overall supervision over company policies • Little federal involvement in regulating these companies

17. Most Costly Natural Disasters Since 1992 • Hurricane Andrew caused $30 billion in damages in 1992 • Midwest floods caused $20 billion in damages in 1993 • The Northridge earthquake in California caused $42 billion in damages in 1994; • Severe weather and floods in Texas, Oklahoma, Louisiana, and Mississippi caused $5.5 billion in damages in 1995 • Hurricane Marilyn caused $2.1 billion in damages in 1995 • Hurricane Mitch caused an estimated $2.1 billion in damages in Central America and the United states in 1998 • The southern plains drought caused $4 billion in damages in 1996 • Hurricane Fran caused $5 billion in damages in 1996 • The winter blizzard of 1996 caused $500 million in damages • Red River floods in North Dakota and Minnesota caused $4 billion in damages in 1997 • Preliminary figures from 1998's Hurricane Georges show it killed 350 people and total insured losses could end up reaching $2 billion

18. Cost to insurers • Chubb: $500-600m • Employers' Re: $600m • GE: $600m • Hannover Re: $365m • Munich Re: $1.95bn • Partner Re: $350-400m • Royal & Sun Alliance: $220m • Scor: $150m-200m • Swiss Re: $1.25bn • Zurich Financial: $400m • ACE and XL Capital: $1bn-1.1bn • AIG: $500m • Allianz: $930m • AXA: $300-400m • Berkshire Hathaway: $2.2bn • www.berkshirehathaway.com • CNA Financial: $200m-350m

19. Mutual Funds • Money Market Mutual funds have been prominent on the American financial scene since the 1970s • However, stock market mutual funds (Mutual Funds) have been in existence since the 1950s. • A mutual fund pools the funds of many people and managers invest the money in a diversified portfolio of securities to achieve some stated objective

20. Open-end Mutual Fund • Sell redeemable shares in the fund to the general public • Shares represent a proportionate ownership in a portfolio held by the fund • Shareholder can go directly to fund and buy additional shares or redeem shares at their net asset value (NAV) • No-load Funds--Sold directly to public at the current NAV • Load Funds—Sold through brokers and buyer pays a sales commission

21. Open-End Mutual Funds • Net Asset Value (NAV) • Fund calculates the total market value of its portfolio and divides this figure by the number of outstanding shares. • Redeem outstanding shares or issue new ones at the NAV. • Number of shares is not fixed but increases as more money is invested. • Commonly known as Mutual Funds.

22. Closed-End Investment Company • Issues a fixed number of shares. • Invests the proceeds in a portfolio of assets. • No load but brokerage fee. • Shares are transferable. • Price of the share is determined by supply and demand.

23. Mutual Funds • Mutual funds are regulated by the Securities and Exchange Commission (SEC) • Primary objective of regulation is the enforcement of reporting and disclosure requirements to protect the investor • Many investors are attracted to families of mutual funds • Number of mutual funds operated under one management umbrella • Investors can easily transfer money among funds within the family

24. Net Asset Value Example • A fund has 10 million shares and is worth $100 million. • NAV = $10.00 • Investors invest $20 million more. • At $10/share → 2 million shares → $120 million in assets with 12 million shares. • You can buy fractional shares.

25. Low-load Funds • Load is ≤ 3% and goes to the fund. • Front end load • Charged when shares are purchased. • Back end load • Charged when shares are sold.

26. Full Load Funds • Sold by salespeople who earn a commission. • Load is split between the salesperson and the fund. • Max load allowed by the SEC is 9.589%

27. 12b-1 Plans • Charge for advertising and selling expenses, including sales commissions to brokers. • All shareholders in the fund bear the burden, not just new investors. • Funds that use 12b-1 plans call themselves “no-load”.

28. Mutual Fund Information • Mutual Fund Education Alliance • Morningstar.com • Valueline.com • Vanguard.com • Wall Street Journal • Bloomberg.com

29. Finance Companies • Consumer Finance Companies • Make consumer loans • Specialty Finance Companies—specialize in credit card financing • Commercial finance Companies • Make commercial loans usually on a secured (collateralized) basis • Loans not as risky as consumer loans • Since lending is short-term, these companies borrow substantial amounts in commercial paper market

30. Finance Companies • Historically finance companies have played an important role in financing growing undercapitalized companies • Commercial finance companies originated the concept of leveraged buyout (LBOs) which relies heavily on debt to pay for acquisition of a company • Captive Finance Companies—Finance purchase of commercial and retail oriented businesses such as General Motors products (GMAC)

31. Securities Brokers and Dealers and Investment Banks • These financial institutions play a crucial role in the distribution and trading of huge amounts of securities

32. Investment Banks • Sell and distribute new stocks and bonds directly from issuing corporations to original purchasers • League Tables rank investment banks by the volume of securities they underwrite • Underwriting is typically conducted through a syndicate which includes many investment banks and brokerage firms • Investment banks derive a substantial amount of income from offering advice to firms involved in mergers and acquisitions • What price one firm should pay for another • How the transaction should be structured • Provide strategic advice in hostile takeovers—when one firm seeks to acquire another against the other’s wishes

33. Brokers and Dealers • Involved in the secondary market, trading “used” or already outstanding securities • Brokers match buyers and sellers and earn a commission • Dealers commit their own capital in the buying and selling of securities and hope to make profit on the transaction

34. Brokers and Dealers • Many of the nationwide stock exchange firms act as investment bankers, dealers, and brokers • A number of large stock exchange firms have branched out to provide new types of financial services previously out of their operating charter • Commercial banks, investment banks, and broker dealers have now combined under single holding company umbrellas

35. Venture Capital Funds, Mezzanine Debt Funds, and Hedge Funds • Venture capital funds, mezzanine debt funds, and hedge funds are usually not available to public investors and not registered with SEC • Funding comes from wealthy individuals or other financial institutions, possibly sponsored by brokerage firms and banks • Both venture capital funds and mezzanine debt funds provide an important source of funding to small and midsize companies • Financing by both venture and mezzanine funds is non-traded and held until maturity

36. Venture Capital Funds • Invest funds in start-up companies • Traditional bank financing for these firms in the early stage of growth would be very limited • The Venture Capital Fund receives a substantial equity stake in the firm • Although many start-up companies will fail, significant profit on those that are successful • Receives profits when it takes the successful company public in an initial public offering (IPO).

37. Mezzanine Debt Funds • Provide debt funds to small and midsize companies • Issue convertible debt and subordinated debt • Sometimes simply invest in a combination of high-yielding debt and equity issued by the same company • Used to provide long-term funds, sometimes part of a management-buyout financing package

38. Hedge Funds • Hedge funds: • Limited partnerships that, like mutual funds, manage portfolios of assets on behalf of savers, but with very limited governmental oversight as compared with mutual funds.

39. Long Term Capital Management • Founded by John Meriwether in 1993 • LTCM had more credibility than the average broker/dealer on Wall St. • Two Nobel laureates: Robert Merton and Myron Scholes • Former Vice Chair of the Board of Governors of the Federal Reserve: David Mullins

40. LTCM partners $1.1 billion UBS $690 million Dresdner Bank $100 million Sumitomo Bank $100 million Bank of Italy $100 million Credit Suisse $55 million Biggest losers

41. Banks Versus Nondepository Institutions • Many nondepository institutions offer services that compete directly with banks • Traditionally many of the different markets were segmented, however, today they often compete for the same business • The Gramm-Leach-Bliley Act of 1999 allowed the creation of financial holding companies (FHCs) that can own commercial banks, investment banks, and insurance underwriters

42. Banks Versus Nondepository Institutions (Cont.) • The creation of FHCs brings the United States much closer to the universal banking regulatory model adopted by the European Union