Nonbank finance

1. Nonbank finance Group 8 Ashley Lowe Rolla Mooney Shane John Sean Walsh

2. What is Insurance? • Life Insurance • Presbyterian Ministers Fund, PA, 1759 – Present • 1000 life insurance companies

3. Cont… • Stock companies are owned by stockholders, which are 90% of life insurance companies • Pacific Life Insurance • Mutual companies are technically owned by policy holders, some of the largest insurance companies are organized as mutuals • Penn Mutual Life • Federal governments do not regulate insurance companies, but the state regulation is directed at sales practices • The provision of adequate liquid assets to losses and restriction on the amount of risky assets such as common stock that companies can hold. The state authority is typically a state insurance commissioner. www.pacificlife.com/ www.pennmutual.com/

4. Two forms of Life insurance policies • Permanent- universal and variable policies • Constant premium throughout life • Policy holder can borrow against the cash value of the permanent life of policy or claim it by cancelling the policy • Temporary- premiums rise overtime at the probability of death rises. • No cash value( no savings aspect)

5. Weak investment returns on permanent life insurance in the 1970’s led to slow growth of demand for life insurance products. • The results was a shrinkage in life insurance relative to other financial intermediaries. • Insurance companies started selling annuities, which are arrangements whereby the customer pays an annual premium in exchange for a future stream of annual payments beginning at 65 and ending at death. • This increased market share of life insurances and held steady since 1980.

6. Property and causality • 2700 in U.S • Two largest are State Farm and Allstate • Stock and Mutual companies, regulated by the state in which it operates • Affected by two basic facts • Largest share of assets are held in tax exempt municipal bonds because they are subject to federal income tax. • Property loss is uncertain than death rate in population, these insurers are less able to predict how much they will have to pay policy holders. • Natural disasters • LA earthquake in 1994 • Sept 11,2001 destruction of WTC • Hurricane Katrina, which devastated New Orleans • Hurricane Ike, which devastated Galveston in 2008 • These natural disasters exposed property and causality insurance to billions of dollars in loses. Therefore they hold more liquid assets.

7. Cont… • Property and Casuality insurance include • Fire • Theft • Negligence • Malpractice • Earthquakes • Automobile accidents • In order to reduce risk companies might come together to write a policy and share risk. • Another way they might reduce risk is to obtain reinsurance, which allocates a portion of risk to another company in exchange for a portion of the premium and is particularly important for small companies.

8. The competitive threat from the banking industry • Until recently, banks have been restricted in their ability to sell life insurance products. • The OOC ( office of Comptroller of the currency), encouraged banks to enter the insurance field because getting into insurance would help diversify banks business, thereby improving their economic health and making bank failures less likely. • Gramm-Leach-Bliley act of 1999, banking institutions further engaged in the insurance business, blurring the distinction between insurance companies and banks.

9. Credit insurance • Credit default swap (CDS) • The seller is required to make a payment to the holder of the CDS if there is a credit event for that instrument • Ex. Bankruptcy, downgrading of the firms credit rating • Issuing a CDS is thus tantamount to providing insurance on debt instrument because it makes payment to the holder of CDS when there is a negative credit event. • AIG Blowup

10. Cont… • Monoline Insurance • Specialize in credit insurance alone • The only insurance company that are allowed to provide insurance that guarantees the timely repayment of bond principal and interest when a debt issuer defaults • Ambac financial group and MBIA, have become more important in the municipal bond market, where they issue a large percentage of these securities. www.ambac.com www.mbia.com

11. The Subprime Financial Crisis • This Financial Crisis is primarily based around the growth of purchases in Real Estate shortly after the tech bubble in the Late 1990’s and the events of September 11th, 2001. • After these events The economy was struggling and to stimulate it, the Federal Reserve cut interest rates to historically low levels. • The message of spending was patriotic and was necessary to stimulate the economy was relayed through out the country and in 2003 the Fed-Reserves interest rates hit 1% which was record breaking. The rates of 30-year fixed rate mortgages were the lowest they had been in 40 years and real estate seemed like the cheapest source of equity available.

12. The Subprime Financial Crisis • With the lowering of these interest rates, came a real estate bull market. • With such low interest rates Banks were willing to offer loans to people with abnormally low credit scores of lower than 620 (or Subprime credit scores) • They would offer these Loans or in this case Mortgages with a higher interest rate than the one given by the Fed, because these borrowers had lower credit scores implying they would be less likely to pay back the loan, and eventually in more creative types of loans. • Such as: • Interest Only Mortgages-requiring the borrower to only have to pay the interest initially • Adjustable Rate Mortgages- where your monthly payment rises or falls with the interest rates • Low Initial Fixed Rate Mortgages-have very low initial rates but eventually convert to Adjustable Rate Mortgages

13. The Subprime Financial Crisis- Initial • Things initially worked out well with the interest rates staying low and the economy continuing to grow. The real estate market continued to expand causing the value of most peoples homes to rise dramatically. • The idea for these borrowers at first worked out perfectly, paying mortgages at reasonably low rates that they would of never gotten in years past, and with the increased value of their home they would be able to refinance at more favorable rates using the equity of their home with its increase in value when the rates adjusted to less favorable ones. • And the Financial Institutions were happy because they were making a larger profit because of the increase in available money with the lowering of interest rates, made it possible for them to give out these Subprime Loans for which was bringing in additional revenue.

14. The Subprime Financial Crisis- Eventual • Eventually interest rates climbed back up, and when these Subprime Loans adjusted to higher payments, They were unable to keep up with the payments and defaulted on their mortgages. Foreclosure rates doubled year-over-year during late 2006 and 2007. • This left lenders with property worth less than the loan value because at this point with the increase in interest rates came a decreasing in the value of real estate. Defaults increased and the value of real estate became lower and lower until eventually many lenders went bankrupt. • Investors and Hedge Funds also suffered because some lenders sold mortgages into the secondary market in the forms of collateralized debt obligations (CDOs)and mortgage-backed securities (MBSs).

15. The Subprime Financial Crisis- ABS • This eventually led to spillovers through the selling of asset-backed security (ABS), which usually used a bunch of assets that had predictable similar cash flows and bundle them into a package. This created and ABS in which had the underlying real estate acting as collateral. • Also The big credit rating agencies such as Moody’s and Standard & Poor’s would rate these securities with extremely high ratings like “AAA” or “A+” because in the past they had been extremely reliable but were about to take a turn for the worst as can be seen with The Subprime Financial Crisis. • This was looked at as an advantage for investor’s to diversify their portfolio of fixed-income assets.

16. The Subprime Financial Crisis and Monoline Insurers • Eventually the Subprime Financial Crisis crossed over into bonds • Monoline Insurers provide a service as a third party for issuers of a bond to pay a premium to insure that the interest and capital repayments will be provided in a case where the issuer is unable to do so. • Prior to 2007 there had never been a default by a Monoline Insurer but the Subprime Financial Crisis caught up to them eventually too. They started defaulting on payments of bonds because of the overwhelming defaulting by the issuers and the premium for monoline insurance raised astronomically to almost 9 fold.

17. Pension Funds A financial institution that controls assets and disburses income to people after they have retired. Pension funds, which invest in a variety of securities, control such enormous sums that their investment decisions can have significant impact on individual security prices.

18. What is Pension? Series of periodic money payments made to a person who retires from employment because of age, disability, or the completion of an agreed span of service. The payments generally continue for the rest of the recipient's natural life, and they are sometimes extended to a widow or other survivor. Military pensions have existed for many centuries; private pension plans originated in Europe in the 19th century.

19. Pension History • Public pensions made to veterans of the Revolutionary War and, more extensively, the Civil War. • Expanded and get started during the progressive Era 19century and began to be offered by the government. • Federal civilian pensions were offered under the Civil Service Retirement System 1920. • Federal Employees Retirement System (FERS), in 1987. • The defined benefit plan had been the most popular and common type of retirement plan in the U.S. through the 1980s. • defined contribution plans have become the more common type of retirement plan in the United States and many other western countries.

20. Asset transformation • The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth. • Financial intermediaries are firms that borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities.

21. Pension Growth • Both Public and private pensions plans have grown in importance with their share to total financial intermediary assets rising • from 13% in 1970 to • 19.5% at the end 2008

22. Rapid growth in pension Funds 1-FederalTax Policy. Employer contributions to employee pension is tax deductable. 2- Tax policy enabling self employed individuals to open up their own tax- sheltered pension plans. 3-Keogh Plans. Similar to a single-participant 401(k), the maximum contribution to a Keogh plan is the lesser of 25% of employee compensation, or $49,000 (for 2009, adjusted higher in some years). 4-Individual retirement plan. IRA funds, or Individual Retirement Accounts, offer tax deductible contributions.

23. Two Types retirement plans • Defined contribution plans • Defined benefit plan

24. Types of retirement plans • Defined contribution plans: a defined contribution plan is an employer-sponsored plan with an individual account for each participant. • Defined contribution plans have become more widespread over recent years and are now the dominant form of plan in the private sector.

25. Defined benefit plan: is a type of pension plan in which an employer promises a specified monthly benefit . The statutory definition of defined benefit encompasses all pension plans that are not defined contribution and therefore do not have individual accounts.

26. Defined benefit plan Plan is Fully funded: If the contributions into the plan and their earnings over the years are sufficient to pay out the defined benefits when they come due. Underfunded :If the contributions and earnings are not sufficient (give example)

27. Example for underfunded • If you contribute $100 a month to your pension plan and interest 10% , and agreed after 10 years you can collect in the defined benefit plan $1500 . If the contribution and earning worth $1500 after ten years or less the plan is fully funded, but if it isn't as what you agreed on like $1400 this an example of underfunded plan.

28. Vesting a chrematistic of pension plans • The length of time that a person must be enrolled in the pension plan , before being entitled to receive benefits.

29. Pension Plans Two Types Private Pension Plans Public Pension Plans government employees who have secure benefits and private workers who increasingly are on their own.

30. Underfunded Pension Liability • Underfunded defined benefit pension plans have always carried a certain amount of risk. With the current uncertainty and downturn in the markets, low interest rates and the impact of new pension rules, pension plan sponsors with underfunded pension plans, and those who seek to acquire companies with defined benefit plans or lend to such companies, have a heightened exposure to risk.

31. Private Pension Plans • Administered by a Bank, Insurance Co, or pension fund manager. • Employer- sponsored pension plan. • Pension plans potential problems. • (ERISA) Employee Retirement Income Security Act.1974 reporting of information, set rules for vesting and the degree of underfunding, placed restrictions on investment practices, and assigned the responsibility of regulatory oversight to the dep. Of labor. • (PBGC) Pension benefit Guarantee Corporation, $54K/year. Similar to FDIC

32. Public Pension Plans • Social security Old-Age, Survivors, and Disability Insurance (OASDI) program. covers all employed in the private sector.(1935) Est. • Social security benefits include retirement income, Medicare payments, and aid to disabled.

33. When It's Time to Retire When you ultimately retire, you will be faced with making a choice on how to access your pension fund. You will generally be offered the following options: • Receive a lump-sum distribution. • Receive a "single-life" annuity or monthly payment for a fixed number of years. • Take an annuity or monthly payment for the rest of your life. • Take a "joint and survivor" annuity or monthly payment for the rest of your life with an option that guarantees your spouse a survivor benefit.

34. Should Social security be privatized?

35. What is social security? • Social Security is a federal social insurance program. Its official name is the "Old-Age, Survivors, and Disability Insurance" or OASDI. • It is the largest government plan in the world and the biggest expense for the federal budget. • Arguments for reform were provoked by the challenges this program faces such as the funding for this program which faces problems caused in part by the baby boom. (There is a low birth rate compared to that era which means there would be more retirees than tax paying workers. )

36. Social security and the challenges it faces • According to the Social Security Administration, the costs of this program cannot be sustained by the current way of running. The administration predicts that by 2016, the costs of handing out benefits will be more than what it receives through tax-payers. By 2037, the program will not function and not be able to pay out benefits in time. • A growing population of aging workers as well as an increased life expectancy is what is leading and adding to the costs of benefits leading to this problem.

37. Is privatization a solution? • A proposed solution to fixing Social Security is by privatizing the system. • This system would allow workers to make their own decisions and control their retirement money through personal investments. • Workers would then be able to invest their money in the stock market.

38. The Pros of Privatization • Using the current system to hand out benefits means further loss of money which will lead to fall of the system. • Privatization would mean no benefit cuts and no tax hikes with Social Security. • Investments will earn retirees more money than the current system. Private investments in 2008 earned an 8% percent rate of return as opposed to a return of 2% from Social Security. • Private investment gives a worker a right to their benefits which is protected by a contract. The current system does not offer that right. • In the past, budget surpluses in government have been used not for Social Security but for other programs. A private system would mean that money would not be diverted for use in other programs.

39. The Cons of privatization • Privatization may reduce the amount of benefits workers may receive. • Changing into a private system would be too expensive. There is the cost of setting up new personal accounts while still giving benefits to those currently receiving. The transition would cost an additional 1-2 trillion dollars than the system is already spending. It would outweigh the money trying to be saved through privatization. • Privatization is basically putting people’s retirement money into the stock market which can be risky. People can lose their entire retirement fund through bad decisions. • Workers, because they would be putting their money into the stock market, could become victims of stock brokers as well.

40. Conclusion • Privatization is not a good idea for a solution to fixing the problems Social Security has. • It is just too risky for someone to have to make decisions regarding their entire retirement fund and putting that money into the stock market. They could lose all their money. • The creation of private accounts would be funded by Social Security which means additional spending and additional financial problems. • Hiring people to create and manage personal accounts would also cost more money. • The move to privatize will just cost more money for the government, leading to more problems. • At the same time, it also puts the retirement funds of people at the mercy of the stock market and stock brokers. • Privatizing does not put money into the government but instead into the hands of financial corporations.