Unit 5 Insurance Companies

Life insurance companies

annuities 49 % of premiums written life insurance 26 % of premiums written accident and health insurance 25 % of premiums written

-policy holders *make periodic payments* in return for insurance coverage Ordinary life is marketed on an individual basis (78% of life insurance products) Group life is issued to groups of employees (22% of life insurance products) -advantage for insurance companies over ordinary insurance is cost economies, achieved through mass administration of plans, lower costs of evaluating individuals, and reduced selling costs *Term Life insurance is the most basic*, lowest cost policy type. Beneficiary receives payment upon death of insured, or the coverage expires and no payment is made. There are no savings/investing elements. There is a wide variety of policy types, including those that allow coverage for an entire lifetime (whole life) or allow investments in securities (variable or universal life).

25 % of premiums written -protects against disease or ill-health risk -mostly offered through group insurance plans

49 % of premiums written -providing a guaranteed stream of income for life. -think of an annuity as a reverse of a life insurance policy. life insurance builds up a lump sum by making premium payments over time. annuities involve *paying a lump sum up front and then receiving small payments* over time -can be paired with life insurance to form a steady stream of cash payments and disbursements -lots of different types of annuity contracts -can be sold as group or individual plans

Assets Mostly investments and bonds Bonds 43.8% Cash 1.60% Other Investments 52.8% Includes stock, real estate, mortgage loans, etc. Other Assets 2.20% -Concentrated on long term investments (bonds, mortgages, etc.) -Insurance company managers face interest rate risk from bonds, credit risk from other investments

Net Policy Reserves 44.1% Other Liabilities 50.0% Total Capital and Surplus 5.90% policy reserves: a liability term for insurers that reflects their expected payment commitments on existing policy contracts

Dr. Greene buys a term life insurance product that pays $50,000 if he dies within one year. How much should the insurance company charge? Assume that the probability of death over the next year is "q" and that the insurance company's goal is to break even. That is, the insurance company needs to charge a premium, $Y, equal to the expected payout. Calculate the premium payment if the insurance company believes that q = 0.2%. $Y= Q*(payout if insured dies) $Y = .002(50,000) =100 premium 35.40= x(50,000) x= .000708=>.07%

In an insurance context, information asymmetry means that you know more about you than the insurance company does Pervasive problem in finance • Car insurance, homeowners insurance, borrowing from a bank • Other areas of life (i.e., interviewing for a job)

• The Life Insurance Example is purely math. • But in finance, we need to consider the human element. • This is what makes finance interesting. • Regarding Insurance, a key thing to try to understand is how "risky" someone is.

Adverse selection Moral hazard

*adverse selection problem*: the problem that customers who apply for insurance policies are more likely to be those most in need of coverage. Intuition: insurance product attracts people who are secretly risky Result: Likelihood of accident is greater among insurance company's policyholders than in the population as a whole. How to deal with this problem? -establish different pools of the population based on health and related characteristics -Smoking/tobacco use is typically one of the key determinants of the cost of life insurance "Have you used a tobacco product in the last 12 months?" Includes chewing tobacco, cigars -Indicating "Yes" for Tobacco use increased MetLife quote by 77%

moral hazard: when, after an insurer and a customer enter into an insurance contract, the insured customer takes an action that is not taken into account in the contract, yet which changes the value of the insurance. *behaving out of character because you know you are insured* Intuition: after buying insurance, your behavior changes Examples: -after buying an automobile policy, you allow the car to be damaged -after buying fire insurance, you smoke in bed -when wearing a seat belt, you drive recklessly -*in banking, implicit government guarantee of a bailout leads to excessive risk taking.* Result: Likelihood of accident is increase among insurance company's policyholders than if those same people did not have insurance. Note: to analyze adverse selection, we look among different groups of people, to analyze moral hazard, we look among the same people before & after insurance

1. No questions asked coverage $400/year 2. Full medical exam coverage $200/year Which one was cheaper? Why? Due to adverse selection, less healthy individuals will pool in the "no questions asked" policy because they dont want to take a full medical exam, while more healthy will take the full medical exam

Property and Casuaulty insurance protects against personal injury and liabilities due to accidents, theft, fire, etc *Property* insurance offers protection related to the loss of real and personal property *Casualty* (another name for liability) insuance offers protection against legal liability exposure Examples: state farm, nationwide, allstate

Products 1. Automobile Liability and Physical Damage 39.1% 2. Homeowners Multiple Peril 15.1% 3.Liability Insurance (other than auto) 13.5% 4.Commercial Multiple Peril 4.3%

Invested assets 84.9% of industry assets -> This is 52.7% bonds, 18.2% stocks Other assets 15.1%

Loss Reserves and loss adjustment expenses (LAE) 34.4% of industry assets Other Liabilities 27.7% Policyholders' surplus 37.9% Loss reserves: funds set aside to meet expected losses (e.g., payments made to settle the claims on the insurance policies) LAE: loss adjustment expenses: administrative costs of adjusting/settling these claims

• Collect premiums, invest them until claims are paid out • Portfolio consists of a large amount of bonds • Regulated at the state level (no national charters) • State guarantee funds provide protection to policyholders

• P&C industry is much *smaller than life insurance industry* (about 1/3 the size) • P&C claims are more *unpredictable* • P&C insurance companies tend to have more capital, larger reserves, more liquid assets, and more short-term assets than life insurance companies • P&C products face rate regulation (ceilings on premiums and premium increases), which sometimes leads to insurers leaving markets with restrictive regulations.

1. Loss risk (affects loss reserves) 2. expense risk (affects LAE) 3. investment yield/return risk

Loss Risk: the key feature of claims loss risk is the actuarial *predictability* of losses relative to premiums earned. This predictability depends on a number of characteristics of features of the perils insured. This predictability depends on a number of characteristics of features of the perils insured, such as: 1. *Property versus liability * -Property losses tend to be more predictable than liability losses -The upper limit loss on a building explosion is fairly easy to calculate -What is the upper limit loss on a liability claim (GM ignition switch, BP oil spill) 2. *long tail versus short tail* tail tells you how long a person has to make a claim -Long tail: medical malpractice, asbestos cases, -Short tail: auto claims (easier to predict losses) 3. *severity versus frequency* frequency: the probability that a loss will occur severity: the size of a loss high severity - low frequency losses are more difficult to predict (natural disasters) than low severity - high frequency losses (fender benders)

Two main expenses *LAE Examples (loss adjusted expenses)* -Following a hurricane, insurance adjusters camp out in damaged areas and visit homes *Expense examples* -Commissions paid to agents -Operating expenses to run the business Expense Risk Loss Ratio: Measure of pure losses incurred to premiums earned Loss Adjustment Expense (LAE) Ratio: Costs surrounding the loss settlement process to premiums written Expense Ratio: Expenses related to commissions and other operating expenses to premiums written Dividend Ratio: Dividends paid to premiums written *Combined Ratio after Dividends = loss ratio + LAE ratio + Expense ratio + Dividend ratio* Important ratio for understanding insurance company profitability (both life and P&C insurance)

Auto insurance company charges $2,000 per year per policy. Suppose the firm sells 10,000 policies. Calculate total premiums written. Total losses are $12,000,000 and LAE is $1,500,000. Other expenses are $4,000,000 while dividends paid are $2,000,000. Calculate the combined ratio after dividends. Total $ for premiums premiums $2000 per policy x 10000 policies = 20,000,000 12m + 1.5m + 4m + 2m= 19.5m/20 = 97.5% for every $1 on premiums, the firm spends $0.975 on losses, LAE, expenses, dividends Suppose that losses jump to $13,000,000. Recalculate the combined ratio after dividends. The typical insurance company has a combined ratio after dividends over 100 How do insurance companies achieve profitability? • Balance sheet is invested assets • Returns on invested assets can make insurance companies profitable.

typical insurance company has a combined ratio after dividends over 100 insurance companies achieve profitability by: Balance sheet is invested assets returns on invested assets can make insurance companies profitable

*Overall profitability ratio* Operating Ratio = combined ratio after dividends - Investment Yield Insurance companies can make money by earning investment income Returning to the previous example, suppose that the firm earned 6% on its investments. Operating Ratio = 97.5% - 6% = 91.5% Operating Ratio = 102.5% - 6% = 96.5% Implication: insurers can write policies for a loss (to gain business) when investments are promising Ratios over time Combined ratios after dividends tend to be over 98.0 and are often over 100.0 Implication is that insurance companies need to earn income from investment activities.

often have multiple types of FIs grouped into one firm. Identify the type of FI for each of the following business group descriptions of USAA: USAA, a diversified financial services group of companies, is among the leading providers of financial planning, insurance, investments and banking products to members of the U.S. military, veterans who have honorably served and their families.

Type of FI: Insurance company (P and C)

Type of FI: Insurance Company (Life)

Type of FI: Investment Company

Type of FI: Securities firm and Investment Bank

Type of FI: Commercial Bank