Tài chính doanh nghiệp - Chapter 18: Insurance companies and pension funds

Power Point Slides for: Financial Institutions, Markets, and Money, 9th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson UniversityAndLanny R. Martindale, Texas A&M University 1Copyright© 2006 John Wiley & Sons, Inc.CHAPTER 18INSURANCE COMPANIES AND PENSION FUNDS2Copyright© 2005 John Wiley & Sons, IncThe Insurance Service -Indemnify another against risk of economic loss.Requires pooling of a large number of similar, but independent risks - law of large numbers.Insurance is the last step after other pure risk control and reduction techniques of risk management.Pure risk, the chance of loss, differs from speculative or investment risk which is related to the variability of returns where one can have a gain or a loss.Insurance reduces society's cost of bearing risk.3Copyright© 2006 John Wiley & Sons, Inc.The Insurance MechanismAn insurer assumes objective risk which is the deviation of actual losses from expected losses. It is part of the operating risk of an insurance company.4Copyright© 2006 John Wiley & Sons, Inc.Insurable Riskshomogeneous or similar.fortuitous, random or occurring by chance.circumstances of loss can be identifiable.a probability of loss can be estimated.the losses occur independent of each other-not all at once, such as a flood, wiping out the insurer.premiums must be economically feasible for the insured.5Copyright© 2006 John Wiley & Sons, Inc.Objective risk control methods include:use of loss prevention techniques such as "safety" programs.accept "average" risks as customers.require deductibles or shared losses with the insured.6Copyright© 2006 John Wiley & Sons, Inc.Insurance premiums represent the sum of:expected losses, plusoperating costs, plustarget profit, lesspremium investment incomewith adjustment as necessary for competitive conditions7Copyright© 2006 John Wiley & Sons, Inc.Interest rate risk affects insurance companies.Insurance contracts are long-term contracts: interest rates vary providing incentives for cancellations and revision of intentions.Because of long-term nature of liabilities, portfolios are heavily invested in bonds8Copyright© 2006 John Wiley & Sons, Inc.Life/Health Insurance CompaniesDominated in numbers by stock companies; in asset size, by mutuals (32%).Oldest financial intermediary in U.S. (1759)Slow growth in 1990’s after pension and mutual funds9Copyright© 2006 John Wiley & Sons, Inc.Term Insurance: Basic ModelPayment for death onlyCoverage for specified termLower premiumLarge amount of protection per premium dollarNo “investment” features10Copyright© 2006 John Wiley & Sons, Inc.Term Insurance: VariationsStraight - coverage for specific time period with premiums increasing with age.Renewable - option to continue after expiration date, independent of health changes.Decreasing - pay level premiums over a period of years while level of coverage declines.Convertible - policyholder may convert to a whole life policy for an added premium fee.11Copyright© 2006 John Wiley & Sons, Inc.Whole LifeLevel premiums for constant level of protection.Premium includes cost of insurance (decreasing term) and savings contribution.Cash values (savings accumulated by insured) increase with time.Death benefit includes decreasing term amount and "return" of savings.12Copyright© 2006 John Wiley & Sons, Inc.Whole Life, cont.Provides "living" benefits in form of accumulated savings.Combines life insurance and savings (at a relatively low but contractual rate).Interest or dividends on cash values accumulate free of income taxes-important tax shelter.13Copyright© 2006 John Wiley & Sons, Inc.Universal lifeThe most popular interest-sensitive permanent policies.Flexible premium policy with varying death benefit and premium amounts.Pays market rate on savings.14Copyright© 2006 John Wiley & Sons, Inc.Variable Life Popular in the 1990’s with rapid growth in equity values.Fixed-premiumInsured direct investment of cash valuesGuaranteed death benefitNo guaranteed cash value15Copyright© 2006 John Wiley & Sons, Inc.AnnuitiesSuperannuation- risk of living beyond one’s meansA life annuity, for a given payment, pays a life long stream of payments.The period of time and survivorship terms vary.The longer the "certainty," the less the payments.16Copyright© 2006 John Wiley & Sons, Inc.Health InsuranceCovers medical, disability, and dental expenses.Insurance companies write about sixty percent of health insurance premiums.17Copyright© 2006 John Wiley & Sons, Inc.Balance Sheet of Life InsurersLiabilities and net worthLife insurance reserves - funds owed for life insurance policies, including cash values and losses owed, not yet paid.Pension fund reserves - accumulated commitments to pay future pensions.Surplus and net worth18Copyright© 2006 John Wiley & Sons, Inc.Balance Sheet of Life Insurers, cont.Assets - long-term matching liabilitiesCorporate bonds-largest financial investmentCorporate equities-Variable lifeMortgagesU.S. government securitiesPolicy loans19Copyright© 2006 John Wiley & Sons, Inc.Property/Casualty InsurersProperty insurance - protection from financial loss of property from perils such as fire and theft.Casualty insurance - liability, worker's compensation, auto, aircraft, marine20Copyright© 2006 John Wiley & Sons, Inc.Life vs. P/C operationsP/C policies shorter term than lifeP/C loss payments less predictableP/C balance sheet must be more liquidP/C loss payments increase with inflationBoth life and P/L firms generate revenue from premiums and investment income21Copyright© 2006 John Wiley & Sons, Inc.Balance Sheet of P/C InsurersAssets - selected for income, inflation hedge, liquidity, and tax shelteringState and municipal bonds (tax free) and corporate bondsCorporate stock (inflation hedge and income)Government securities (liquidity and income)Trade credit ($ owed by customers and agents)22Copyright© 2006 John Wiley & Sons, Inc.Balance Sheet of P/C Insurers, cont.Liabilities and net worthPolicy reserves include:unearned premium reserve.losses incurred, not paid.Surplus and net worth23Copyright© 2006 John Wiley & Sons, Inc.Types of P/C PoliciesProperty - insurance against losses associated with physical damage.“Named perils” : Coverage limited to specific losses listed in policy.“All-risk coverage” or “open perils”: Any loss covered unless specifically excluded.Liability - insurance against financial responsibility for harm to another’s person or property.24Copyright© 2006 John Wiley & Sons, Inc.Types of P/C Policies, cont.Marine insurance - covers losses related to transportation.Ocean marine - ocean transportationInland marine - inland transportation and some special personal property such as furs and jewelryMulti-peril or multi-line-combines property and liability insurance.25Copyright© 2006 John Wiley & Sons, Inc.Types of Pension PlansPrivate Pension PlansInsured – managed by life insurerNoninsuredTrustee managed by a third partyNon-trustee - managed by firm or labor unionGovernment-sponsored Pension PlansSocial SecurityFederal, state, and local government plans26Copyright© 2006 John Wiley & Sons, Inc.Pension Plan VocabularyFully funded: contributing funds sufficient to cover future obligations versus paying benefits from current revenueContributory: employee and employer contributeFully contributory: only employee contributesNoncontributory: only employer contributesDefined benefit: Benefits set by formula based on years of service and average salary; responsibility is fully on employer to provide promised benefits27Copyright© 2006 John Wiley & Sons, Inc.Pension Vocabulary, cont.Defined contribution: employee and employer each make contributions of some set percentage of salary; employee chooses how funds are invested; ultimate benefits depend on employee’s investing; 401k most popular example todayVesting: employee assured of retirement benefits after a set period of time.Portability: ability to transfer vested benefits to another plan 28Copyright© 2006 John Wiley & Sons, Inc.Pension Management FactorsLittle need for liquidity“Qualified” Plans not taxedThe higher the earning rate, the lower the contribution to support a given benefitPension funds face risk/return trade-off decisions for their beneficiariesRegulation focuses on fiduciary duty, full funding, and prudent investing29Copyright© 2006 John Wiley & Sons, Inc.