Insurance Companies

Insurance Industry

1 Life Insurance- provides protection in the event of untimely death, illnesses, and retirement.

2 Property and Casualty Insurance- protection against personal injury and liability due to accidents, theft, fire and other catastrophes.

Life Insurance Companies

• Recent trend- like banks, consolidation has been intense. The industry has consolidated mainly to take advantage of economies of scale and scope but demutualization, the maturity of the industry and competition have also contributed.

• Purpose -by pooling risks of individual customers, life insurance companies can diversify away some of the customer specific risk at a cost (premium) lower than any individual could achieve saving funds on their own.

Life Insurance Companies

• Adverse selection- a problem that naturally faces life insurance and P&C insurers. Customers who apply for insurance policies are more likely to be those most in need of insurance.

• When calculating the probability of a payout, insurance companies may not be able to use statistics representing the overall population. Consequently, insurance companies establish different pools of the population based on health and related characteristics (such as income).

Four Basic Lines of Life Insurance 1 Ordinary Life ( 60%) - marketed on an individual basis with

policy holders making premium payments. Usually sold in $1,000 units.

2 Group Life (<40%) - Covers a large number of insured persons under a single policy. Can be either 1) contributory - employer covers a share or 2) non contributory - employer does not contribute.

3 Industrial Life (<1%) - involves weekly payments collected directly by representatives of the companies.

4 Credit Life (<2%) - protects lenders against a borrower’s death prior to repayment of a debt contract. Face amount usually reflects the P&I of the loan.

Ordinary Life - 5 Basic Contractual Types 1 Term Life - the closest to pure life insurance, it has no

savings element attached. An individual’s beneficiary receives a payout at the time of the individuals death during the coverage period. sold in $1,000 units.

2 Whole Life - protects the individual over an entire life-time rather than for a specified period. In return for periodic or level premiums, the individual’s beneficiaries receive the face value on death (vs.. term where death must occur in the coverage period). contributory - employer does not contribute.

Ordinary Life - 5 Basic Contractual Types 3 Endowment Life - combines a pure (term) insurance element

with a savings element. It guarantees a payout to the beneficiaries of the policy if death occurs during some endowment period (e.g. prior to reaching retirement age). An insured person who lives to the endowment date receives the face amount.

4 Variable Life - invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments (usually selected by policy holders). Variable life provides an alternative way to build savings as the value of the policy increases (or decreases) with the asset returns of the mutual fund(s) in which premiums are invested.

Ordinary Life - 5 Basic Contractual Types 5 Universal Life and Variable Universal Life - a universal

life policy allows the insured to change both the premium amounts and the maturity life of the contract (unlike traditional policies that maintain premiums at a given level over a fixed contract period). For some contracts, insurers invest premiums in money, equity, or bond mutual funds (as in variable) - so the savings or investment component of the contract reflects market returns (variable universal life).

Other Life Insurance Activities • Annuities- represent the reverse of life insurance policies,

that is they represent different methods of liquidating a fund over a long period of time. In contrast, life insurance insurance involves different contractual methods to build up a fund.– Annuities can be sold to an individual or group on a fixed or

variable basis (returns are linked to some underlying investment portfolio)

– Any interest earned on annuities is tax deferred. In contrast to an IRA, the tax deferred status of annual annuity contributions are not capped and are not affected by the policyholder’s income tax bracket.

Other Life Insurance Activities • Private Pension Funds- Insurance companies offer many

alternative pension plans to private employers. Some of their innovative plans are based on GICS (guaranteed investment contracts) where the rate of return is guranteed over a period of time and the annuity rates on beneficiaries contracts may also be.

• Accident and Health Insurance- protection against morbidity or ill health risk. The major line is group insurance to corporate employees. Other coverages include credit health plans, whereby individuals have their debt repayments insured against unexpected health contingecies.

Life Insurance Industry Balance Sheet12/31/98

Source: Best’s Aggregates and Averages

Assets % of TotalBonds $1,311,861 46.5%Preferred stock 16,211 0.6%Common stock 69,353 2.5%Mortgage loans 211,113 7.5%Real Estate 27,679 1.0%Policy loans 102,161 3.6%Cash and short-term investments 61,119 2.2%Other invested assets 33,856 1.0%Life and annuity premium due 11,880 0.4%Accident and health premium due 5,516 0.2%Accrued investment income 24,928 0.9%Separate account assets 922,242 32.7%Other assets 26,061 0.9%Total assets $2,823,980 100.0%

Life Insurance Industry Balance Sheet12/31/98

Source: Best’s Aggregates and Averages

Liabilities and Capital/Surplus % of TotalNet Policy Reserves $1,309,176 46.4%Policy claims 30,008 1.1%Policy dividen accumulations 20,587 0.7%Dividend reserve 15,997 0.6%Premium and deposit funds 205,502 7.3%Interest maintainance reserve 14,462 0.5%Commissions, taxes, expenses 20,267 0.7%Securities valuation reserve 37,727 1.3%Other liabilities 86,720 3.1%Separate account business 919,295 32.5%Total capital and surplus 164,239 5.8%Capital 4,088 0.1%Treasury stock (341) 0.0%Paid-in and contributed surplus 67980 2.40%Surplus notes 14527 0.50%Unassigned surplus 61897 2.20%Other Surplus 1768 0.10%Other reserves 14320 0.50%Total liabilities and capital/surplus $2,823,980 100.0%

• Net Policy Reserves- a liability for insurers that refelcts their expected payement commitments on existing policy contracts. The reserves are based on actuarial assumptions regarding expected future liability or commitment to pay out on present contracts - including death benefits, maturing endowment policies, as well as cash surrender value of policies (the cash value of a policy received from the insurer if a policyholder surrenders the policy priot to maturity.

• Separate Account- legal requirement that separate account business (I.e. annuity programs) be held separately from the insurance company’s other assets, because the funds can be invested w/o regard to the usual restrictions.

• Premium and Deposit Funds - represent GICs used to fund insurance company pension plan businesses.

Life Insurance - Balance Sheet

• McCarren - Ferguson Act of 1945- the most important regulatory legislation affecting insurance companies, it confirms the primacy of state over federal regulation of insurance companies.

• State Insurance Commissions - supervise and examine insurance companies using a coordinated examination system developed by the National Association of Insurance Commissioners (NAIC).

• Insurance Guarantee Funds - promoted by the states. Akin to deposit insurance. While regulators sponsor the programs, they are run and administered by the private insurance companies themselves. Contributions are made by surviving firms after a failure. Designed to protect small policyholders.

Insurance Industry - Regulation

• Consolidation- like banks and life insurers, the U.S. P&C industry has become increasingly concentrated. The top 10 firms have over 40% of the market (measured by premiums written) and the top 250 firms have over 95%.

• Property Insurance- involves the coverage of losses relating to real and personal property.

• Casualty Insurance- protects against legal liability exposures.

• Distinctions between P&C lines are becoming increasingly blurred. This is due to the tendency of P&C insurers to offer multiple activity line coverage combining features of property and liability insurance into a single policy packages.

Property and Casualty Insurance

Source: Best’s Aggregates and Averages and Best’s Review

1960

Auto Liabilities

26%

Auto Physical Damage

13%

Accident and Health

9%

Other Lines8%

Other Liabilities

6% Home MP5%

Commercial MP0%

Allied5%

Workers' Comp

9%

Fire11%

Other Lines8%

P&C Industry Net Premiums Written

$15B

Source: Best’s Aggregates and Averages and Best’s Review

1998

Auto Liabilities

26%

Auto Physical Damage

16%

Accident and Health

3%

Other Lines13%

Other Liabilities

5%

Home MP9%

Commercial MP6%

Allied1%

Workers' Comp

7%

Fire1%

Other Lines13%

P&C Industry Net Premiums Written

$281.5B

Important P&C Lines• Fire Insurance & Allied Lines - protect against the perils

of fire, lightning, and removal of property damaged in a fire.

• Homeowner’s Multiple Peril (MP) - protects against multiple perils of damage to a dwelling and personal property as well as liability coverage against the financial consequences of legal liability resulting from injury to others.

• Commercial Multiple Peril - protects commercial firms against perils similar to homeowners multiple peril insurance.

Important P&C Lines• Automobile Liability & Physical Damage (PD)

-insurance provides protection against 1) losses resulting from legal liability due to ownership or use of the vehicle (auto liability) and 2) theft or damage to vehicles (auto physical damage).

• Liability Insurance (other than auto) - provides protection to either individuals or commercial firms against non-auto related legal liability (malpractice, product liability, etc.)

P&C Insurance Balance Sheet12/31/98 (In Millions)

Source: Best’s Aggregates and Averages

Assets % of TotalUnaffiliated Investments $744,670 81.9%Bonds 518,928 57.1%Preferred Stocks 11,500 1.3%Common Stocks 146,567 16.1%Mortgage Loans 1,787 0.2%Real Estate Investment 1,004 0.1%Cash and Short-term Investments 45,871 5.0%Other Invested Assets 19,013 2.1%Investments in Affiliates 44,243 4.9%Real Estate, Office 7,868 0.9%Premium Balance 61,270 6.8%Reinsurance Funds 4,836 0.5%Reinsurance Recoverable 12,038 1.3%Federal Income Taxes Recoverable 2,010 0.2%Guarantee Funds Receivable 164 0.0%Electronic Data Processing Equipment 2,576 0.3%Accrued Interest 8,654 1.0%Recievables from Affiliates 8,934 1.0%Association Accounts 2,138 0.2%Receivable uninsured accident and health plans 67 0.0%Future Investment Income on Loss Reserves 215 0.0%Other Assets 9,084 1.0%Total Assets $908,767 100.0%

P&C Insurance Balance Sheet12/31/98 (In Millions)

Source: Best’s Aggregates and Averages

Liabilities and Capital/Surplus % of TotalLosses $301,265 33.1%Loss Adjustment Expense 63,930 7.0%Reinsurance payable on paid losses 3,643 0.4%Commissions, taxes, expenses 14,396 1.6%Federal income taxes 2,613 0.3%Borrowed money 1,676 0.2%Interest on borrowed money 57 0.0%Unearned premiums 116,668 12.8%Dividends to stockholders 338 0.0%Dividends to policyholders 1,925 0.3%Reinsurnace funds 10,116 1.1%Loss Portfolio transfer (assumed) 2,373 0.3%Loss Portfolio transfer (ceded) (3,074) -0.3%Amounts retained to others 5,604 0.6%Remittances not allocated 1,660 0.20%Foreign exchange rate adjustments 721 0.10%Drafts outstanding 4,791 0.50%Payable to affiliates 8,006 0.90%Payable for securities 2,352 0.30%Amounts held for uninsured A&H plans 10 0.0%Capital Notes 1 0.0%Discount on loss reserve -281 0.0%Other liabilities 24,670 2.7%Conditional reserves 11,980 1.3%Policyholders' surplus 333,327 36.6%Capital paid-up 8,472 0.9%Guarantee funds 257 0.0%Surplus notes 5,349 0.6%Assigned funds 145,609 16.0%Unassigned funds 173,640 19.1%Total Liabilities and capital/surplus $908,767 100.0%

• Loss Adjustment Expenses- related to expected administrative and adjusting (settling) of claims.

• Unearned Premiums - a set aside reserve that contains the portion of a premium that has been paid at the start of the coverage period and therefore before insurance coverage has been provided.

P&C Insurance - Balance Sheet

• Underwriting risk - results when the premiums generated on a given insurance line are insufficient to cover 1) the claims (losses) incurred insuring the risk and 2) the administrative expenses of providing that insurance coverage (legal expenses, commissions, taxes, etc) after taking into account 3) the investment income generated between the time when the premiums are received to the time losses are covered.

• Resulting risks1 Loss risk2 Expense risk3 Investment yield/return risk

P&C Insurance - Underwriting Risk

• The key feature of claims loss risk is the actuarial predictability of losses relative to premiums earned. Predictability depends on:– Property vs. Liability - generally, max losses are more predictable

for property than for liability.

– Severity (size) vs. Frequency (probability) - in general, loss rates are more predictable on low severity, high frequency lines than for high severity, low frequency lines (i.e. fire and auto vs. earthquake, hurricane, etc.).

– Long tail vs. Short tail - long tail losses arise in policies for which the insured event occurs during a coverage period but a claim is not filed or made until many years later (i.e. malpractice, asbestos).

P&C Insurance - Loss Risk

• The key feature of claims loss risk is the actuarial predictability of losses relative to premiums earned. Predictability depends on:– Product inflation vs. Social inflation - line specific

risk or systematic inflation (i.e. homes, autos, etc.). Liability lines may be subject to social inflation as reflected by juries willingness to award punitive and other damages at rates far above underlying inflation.

P&C Insurance - Loss Risk (cont.)

• Loss Ratio- measures the actual losses incurred on a specific policy line. Measures the ratio of loss incurred to premiums earned. A ratio <100 indicates that premiums earned were sufficient to cover losses.– Loss Ratio = Losses/Premiums Earned

P&C Insurance - Loss Risk

• Expense Risk - 2 major sources of expense risk to P&C insurers: 1) Loss Adjustment Expenses (LAE) and 2) Commissions and other expenses

• LAE - relates to the costs surrounding the settlement process. It may be included in the loss ratio because it is an expense incurred in settling claims. – Expense Ratio = Expenses/Premiums Earned– =LAE/Premiums + Commissions &

Other/Premiums.

P&C Insurance - Expense Risk

• Combined Ratio- measures the overall underwriting profitability of a line.– Combined Ratio = Loss Ratio+ Expense Ratio

+ (Dividends/Premiums)– The Combined Ratio may be calculated before

or after dividends.– A ratio >100 means the insurer must rely on

investment income in order to show a profit.

P&C Insurance - Combined Ratio

• Investment Yield/Return Risk - premiums are invested in assets between the time they are received and the time payments are made to meet claims. The behavior of interest rates and default rates on P&C investments is crucial to the insurers overall profitability.

• Operating Ratio - a measure of the overall profitability of a line.– Operating Ratio = Combined Ratio - Investment Yield– Operating Ratio = Loss Ratio + Expense Ratio +

Dividend Ratio - Investment Yield.

P&C Insurance - Operating Ratio

• With the importance of stable returns to achieve profitability and with the need for a predictable stream of cash flows, bonds (Treasury and Corporate) dominate P&C balance sheets.

• Because of the possibility of large operating losses (due to poor investment yields or catastrophic losses), P&C insurers carry a significant amount of surplus reserves (policyholder surplus) to reduce the risk of insolvency.

P&C Insurance - Operating Risk

• Limit Risk Concentration - an insurance company will put limits on the number of homes per square mile it can insure in a particular area.

• Contiguous exposure - an insurance company will give great thought to providing coverage when it knows it has other policyholders located nearby.

• Reinsurance - if all else fails, reinsurance can cap losses at a desired level.

P&C Insurance - Managing Underwriting Risk