Insurance Operations

CHAPTER

2626 InsuranceOperations

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Present the two major areas of insurance: 1) life and health and 2) property and casualty

Describe the different types of insurance policies and their sources of funds

Describe the main uses of insurance company funds

Explain the exposure of insurance companies to various forms of risk

Describe the regulatory environment of insurance companies

Insurance CompaniesInsurance Companies

Provide contractual risk management for: Risks of insurable asset losses (auto insurance) Risks of liability claims (product liability) Risk of large medical costs (health insurance) Risk of disability (disability insurance) Risk of premature death (life insurance) Risk of longevity (annuities)

Insurance Companies, cont.Insurance Companies, cont.

Major capital market intermediary Major investor in corporate (life) and state and

municipal bonds (property/casualty) Major long-term commercial mortgage lender

(life) Mutual or stock form of ownership Premium and investment revenue Losses and loss adjustment expenses

Insurance ConceptsInsurance Concepts

Pure vs. financial risk Insure fortuitous, independent risk occurrence Premium covers losses, administrative

expenses and profits Insured contracts for known loss (premium) in

return for protection Moral hazard and adverse selection

BackgroundBackground

Life insurance companies Provide risk management contracts for individuals

and businesses Risk areas include premature death, health maintenance

costs, and disability Life insurance provides cash benefits to the beneficiary of a

policy on the policyholder’s death Life insurance premiums reflect

Probability of making payment to the beneficiary Size and timing of the payment

Have portfolios of policies and use mortality figures and actuarial tables to forecast claims

Cash Value Insurance

Group

Types of Life Insurance PoliciesTypes of Life Insurance Policies

Whole Life

Variable Life

Universal Life

Term Insurance

Term

Group


Whole life insurance includes both a death benefit (term insurance) and a savings component that Builds a tax sheltered cash value amount for the

future for the owner of the policy Generates periodic cash flow payments over the

life of the policy for the insurance company to reinvest

Pays fixed death benefit at death


Term life insurance characteristics Temporary, providing death benefits only over a

specified term Premiums paid represent insurance only with no

saving component Considerably lower cost for the insured than

whole life—able to buy more insurance protection for any amount of premium

Term is for those who would rather invest their savings in other contracts or securities


Variable life insurance Whole life with variable cash value amounts Cash values invested in equities and will vary with

the investment performance Flexible premium option since 1984

Universal life insurance Combines the features of term and whole life Variable premiums over time—buys terms and

invests difference in a variety of investments Builds a varying cash value based on contributions

and investment performance


Group plans Employees of a corporation offered life insurance

or life insurance purchased on life of employee Cash value or term insurance Low cost (term) because of its high volume Can cover group members and dependents

Health Care InsuranceHealth Care Insurance

Health maintenance organizations or HMOs Intermediaries between purchasers and providers

of health care Annual fee or premium

Covers all medical expenses Medical staff is designated by the HMO

Losses in recent years for HMOs

Sources of Life Insurance Company Sources of Life Insurance Company FundsFunds Cash value reserves—accumulated cash

values owed insureds (liability) Pension reserves—accumulated “insured”

pension commitments (liability) Annuity reserves—accumulated annuity

commitments (liability) Unearned premium income—premiums

received; not yet earned (liability) Loss reserves--losses incurred, not yet paid Capital funds

Uses of Life Insurance Company FundsUses of Life Insurance Company Funds

Major investor in corporate bonds Government securities Common stock Commercial mortgage Real Estate Policy loans to insured

Uses of Funds—Policy LoansUses of Funds—Policy Loans

Policy loans are loans to policyholders Whole life policies Borrow up to the cash value of the policy Guaranteed interest rate is stated in the policy Usually used by borrowers during periods of

rising rates to lock in the lower rate associated with their policy

Insurance Company CapitalInsurance Company Capital

Capital Build capital by issuing new stock (stock

companies) or retaining earnings Used to finance investments in fixed assets Cushion against operating losses Capital requirements vary depending on asset risk Credibility with customers is also enhanced by

adequate capital Mutual companies owned by policyholders—

includes earnings retained over time

RegulationRegulation

Insurance companies are highly regulated by state insurance agencies

The National Association of Insurance Commissioners (NAIC) Provides coordination among states in regulatory matters Adopted uniform regulatory reporting standards

State Regulators Make sure insurance companies provide adequate service States approve/review rates Agent licensure Forms are approved to avoid misleading wording


Insurance Regulatory Information System Compiles financial information and lists of

insurers Calculates 11 ratios to assess and monitor

financial health Assessment system

Ability of the company to absorb either losses or a decline in the market value of its investments

Return on investment Relative size of operating expenses Liquidity of the the asset portfolio


Regulation of capital In 1994 companies were required to report risk-

based capital ratios to insurance regulators Goals of requirements are to

Discourage insurance companies from excessive exposure

Back higher risks with higher capital Reduce failures in the industry

Risks of Life Insurance CompaniesRisks of Life Insurance Companies

Pure Risk of LifeInsurance Policies

PensionCommitments and

Annuities Contracts

Financial Riskincludes

Interest Rate RiskCredit RiskMarket Risk

Liquidity Risk

Exposure to Financial RisksExposure to Financial Risks

Interest rate risk Fixed rate assets in company portfolios have

market values sensitive to interest rate changes Firm measures and manages risks

Credit risk Mortgages, corporate bonds and real estate

holdings can involve default Investment-grade securities Diversify portfolio among debt issuers


Market risk Exists because events like significant market value

decreases reduce capital Economic downturn affects real estate investments


Liquidity risk occurs because a high frequency of claims may require the life company to liquidate assets Life insurance companies have high cash flow

from premiums to offset normal cash needs In case of large disaster (9/11) may be forced to

sell assets to generate cash even if market value is low

Companies try to balance the age distribution of their customer base

As interest rates rise, voluntary terminations of policies occur

Asset ManagementAsset Management

Performance is significantly affected by the performance of the assets Companies get premiums for several years before

paying out benefits Companies try to manage the risk of losses with

offsetting investment gains or diversity of assets they hold

Diversify into other businesses to offer a wide variety of financial products

Property and Casualty InsuranceProperty and Casualty Insurance

Property insurance (fire insurance) Casualty insurance (liability) Performance and financial bonding

PC Versus Life Insurance CompaniesPC Versus Life Insurance Companies

PC have shorter contracts PC have more varied risk areas Life companies larger due to long-term

savings and pension contracts PC has wider distribution of Occurrences

PC’s need liquid, marketable assets PC’s earnings more volatile

Property Casualty Investment NeedsProperty Casualty Investment Needs

Tax sheltering--major municipal/state bond investor

Liquid, marketable assets Marketable corporate and government bonds Listed common stock

Inflation hedge--common stock Reinsurance contracts--manage pure risks

Valuation of an Insurance CompanyValuation of an Insurance Company

Value of an insurance company depends on its expected cash flows and required rate of return

V = f [E(CF), k]

V = Change in value of the insurance company

k = Change in required rate or return

Where:

E(CF) = Change in expected cash flows

+


Factors that affect cash flows

E(CF) = Expected cash flow

Rf = Risk free interest rate INDUS = Prevailing industry conditions for the company

Where:

E(CF)= f (ECON, Rf , INDUS, MANAB)

ECON = Economic growth

MANAB = Management ability of company

+ +?


Investors required rate of return k = f(Rf , RP)

++

Rf = Risk free interest rate

Where:

RP = Risk premium

Performance EvaluationPerformance Evaluation

Common indicators of company performance are available Statistical analysis of performance Ratio analysis

Trends over time Compare to industry average


The higher the liquidity ratio, the more liquid the company

Liquidity

Ratio

=Invested Assets

Loss Reserves and

Unearned Premium Reserves


Return on net worth or policyholders’ surplus is a profitability measure

Return on Equity =Net Profits

Policyholders’ Surplus


Underwriting gains and losses or underwriting profitability measured by the net underwriting margin Profits include investment income, underwriting profits and realized capital gains Ratios can be calculated to focus on various sources of profits

Net Underwriting=

Premium Income - Policy Expenses

Total AssetsMargin

Other IssuesOther Issues

Insurance companies interact in a variety of ways with other financial institutions

Insurance companies participate in a full range of financial markets

Multinational insurance companies Insurance companies operate in many countries Some countries lack developed markets for

insurance Multinational investments

Documents

Insurance Operations