Insurance Ch22

Chapter 3
Insurance
Companies
and Pension
Funds
Chapter Preview
We look at two nonbank institutions: insurance
companies and pension funds. We view them in
a similar light as other financial intermediaries
because they take funds from one sector and
invest them in another. Topics include:
Insurance Companies
Fundamentals of Insurance
Growth and Organization of Insurance Companies
Types of Insurance
Copyright 2006 Pearson Addison-Wesley. All rights reserved.
22-2
Chapter Preview
Pensions
Types of Pensions
Regulation of Pension Plans
The Future of Pension Funds
22-3
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-aversethey would rather
pay a certainty equivalent (the premium)
than accept a gamble
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Insurance Companies:
Major Employer
Figure 22.1 Number of Persons Employed in the U.S. Insurance Industry, 19602002
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Although there are many types of
insurance and insurance companies,
there are seven basic principles all
insurance companies are subject to:
1. There must be a relationship between the
insured and the beneficiary. Further, the
beneficiary must be someone who would
suffer if it werent for the insurance.
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2. The insured must provide full and accurate
information to the insurance company.
3. The insured is not to profit as a result of
insurance coverage.
4. If a third party compensates the insured for the
loss, the insurance companys obligation is
reduced by the amount of the compensation.
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5. The insurance company must have a large
number of insured so that the risk can be spread
out among many different policies.
6. The loss must be quantifiable. For example, an
oil company could not buy a policy on an
unexplored oil field.
7. The insurance company must be able to
compute the probability of the losss occurring.
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Adverse Selection and Moral Hazard

in Insurance
As we have seen in previous chapters,
asymmetric information plays a large role
in the design of insurance products. As
with other industries, the presence of
adverse selection and moral hazard
impacts the industry, but is fairly well
understood the insurance companies.
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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.
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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.
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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.
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Another problem is that most people dont

purchase enough insurance. Insurance
companies use a strong sales force to
combat this.
Independent agents may sell the insurance products

of a number of different insurance companies.
Exclusive agents only sell the products of

one company.
An underwriter reviews each policy prior to its

acceptance to determine if the risk is acceptable.
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Growth and Organization

of Insurance Companies
The number of insurance companies grew
steadily until 1988, and since then the
number has fallen steadily.
This can be seen in the next slide.
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Figure 22.2 Number of Life Insurance Companies in the U.S., 1950-2002

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The previous slide also shows that insurance
companies may be organized in two
difference ways:
A stock company is owned by shareholders and has a
profit motive
A mutual insurance company is owned by the
policyholders and attempts to provide the lowest
cost insurance
At the end of 2002, only 83 of 1159 insurance

companies were mutual insurance companies.
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Types of Insurance
Insurance is classified by which type of
undesirable event is covered:
Life Insurance
Health Insurance
Property and Casualty Insurance
22-17
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 1020 years.
Whole Life: similar to term life, but allows the
policyholder to borrow against the policies cash
value. When the term of policy expires, the
insured can get the cash value of the policy.
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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.
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Expected Life of Persons

at Various Ages
22-20
Sample Annual Premiums
22-21
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 companys assets,
as well as assets invested in mortgages.
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Life Insurance:
Figure 21.3 Distribution of Life Insurance Company Assets (beginning of 2003)
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Life Insurance:
Figure 20.4 Percentage of Life Insurance Company Assets Invested in Mortgages

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Life Insurance:
Life insurance companies have two
primary liabilities:
Life insurance payouts
Pension fund payouts
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Health Insurance
Health insurance policies are highly
vulnerable to the adverse selection problem.
Those with known or expected health
problems are more likely to seek coverage.
This is why most health insurance is offered
through group policies. Individual policies
must be priced assuming adverse selection.
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Health Insurance
Health insurance is a hot topic in the
political environment, focusing on
increased costs and availability
of coverage.
Insurance programs are attempting to shift
costs to the employers.
Health Maintenance Organizations are
another attempt to keep costs down.
22-27

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
22-28

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.
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Insurance Regulation
The McCarran-Ferguson Act of 1945
explicitly exempts insurance companies
from any type of federal regulation.
Most insurance regulations is at the
state level
Regulation is typically designed to protect
policyholders from losses, or expand
insurance coverage in the state.
22-30
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
22-31
Pensions
Definition: A pension plan is an asset pool that
accumulates over an individuals 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.
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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
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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
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Types of Pensions
Defined-Contribution Pension Plan: a plan where
a set amount is invested for retirement, but the
benefit payout is uncertain.
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)
22-35
Private Pension Plan Assets
Figure 22.5 Distribution of Private Pension Plan Assets (end of 2003)
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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.
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Social Security Assets
Figure 22.6 Social Security Fund Assets, 19572003

22-38
Social Security Assets
Figure 22.7 Projected Social Security Trust Fund Assets

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A major U.S. Supreme Court decision in
1949 established that pension benefits
were a legitimate part of collective
bargaining. The number of plans
increased from this as unions negotiated
for
such plans.
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Employee Retirement Income Security Act
of 1974
Established guidelines for funding
Allowed plan credit to transfer with employees
Established vesting requirements to gain
plan benefits
Increased disclosure requirements
Assigned regulatory oversight to the
Department of Labor
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ERISA also established the Pension
Benefit Guarantee Corporation to insure
pension benefits if an underfunded pension
plan is unable to meet its obligations.
Accounting makes it difficult to assess funding
status of a plan
May be in trouble as plans appear
underfunded
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Pension reform Act of 1978 authorized
individual retirement accounts.
Enjoy a preferential tax treatment
Keogh plans are similar plans for selfemployed individuals
SIMPLE IRAs are simplified retirement plans
for small businesses.
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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.
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Insurance Ch22

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Chapter 3

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Adverse Selection and Moral Hazard

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Adverse Selection in Insurance

Adverse Selection in Insurance

Moral Hazard in Insurance

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Another problem is that most people dont

Independent agents may sell the insurance products

Exclusive agents only sell the products of

An underwriter reviews each policy prior to its

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Growth and Organization

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Growth and Organization

Figure 22.2 Number of Life Insurance Companies in the U.S., 1950-2002

Growth and Organization

At the end of 2002, only 83 of 1159 insurance

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Expected Life of Persons

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Sample Annual Premiums

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The next figures shows the distribution of

Figure 21.3 Distribution of Life Insurance Company Assets (beginning of 2003)

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Figure 20.4 Percentage of Life Insurance Company Assets Invested in Mortgages

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Property and Casualty Insurance

Property and Casualty Insurance

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The Practicing Manager:

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Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Private Pension Plan Assets

Figure 22.5 Distribution of Private Pension Plan Assets (end of 2003)

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Social Security Assets

Figure 22.6 Social Security Fund Assets, 19572003

Social Security Assets

Figure 22.7 Projected Social Security Trust Fund Assets

Regulation of Pension Plans

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Regulation of Pension Plans

Regulation of Pension Plans

Regulation of Pension Plans

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The Future of Pension Funds

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