Insurance Companies

January 12th, 2015

Class 3

The Insurance Industry

Life Insurance Companies: Protect against
untimely death; offer annuities; manage pension
plans; provide health and accident plans.
Property and Casualty (a.k.a. Liability) Insurance
Companies:
- Property insurance involves the loss of real
property from luggage to the aircraft on which it
flies.
- Casualty insurance provides protection from
liability to others such as wrongful death, injury
awards, faulty products

Life Insurance
Consolidating industry due to benefits of
economies of scale.
Stock vs Mutual Companies
Change in means of selling policies
commercial banks vs. independent
insurance sales offices.

Financial Intermediation
Life insurers pool risks of individuals so as to minimize
the financial impact of an accident involving death or
injury.
Therefore, they stand between (1) large groups of
people who pay the insurers relatively small sums and
(2) small groups of people (the unfortunate ones) and
pay out (give back) large sums of money.
Given that there is usually a timing difference between
when premiums (life insurance payments) are received
and when claims (life insurance payments to those
insured) are received, the insurers invest money. In that
sense, they are just like commercial banks in that the
hold peoples money and invest it for them.

Types of Products
Although people often break down life insurance into several
groups, there are only really two important ones:
Term life: pure life insurance where you pay so much a month and
should you die earlier than expected bingo you win and the life
insurance company loses.
Whole life: combination of pure life insurance and a tax
advantaged savings product. (The book seems somewhat confused
between Whole and Endowment Life so lets just use my definition
here).
Annuities: in addition to the main categories, life insurers are
offering annuities which are in effect the inverse of a mortgage. You
pay a large amount upfront to receive fixed payments over an
extended period of time e.g. pay $250K at retirement to receive
$1000K a month for 25 years.
RisK: Effectively there are two risks you need to consider about
when you purchase life insurance which are dying too soon
(mortality) or living too long (longevity)!

Examples
Term life: you pay $25 a month every month for $200,000 in life
insurance. You die, your beneficiary gets the $200,000. When/if you
stop making your payment; you get nothing back. So insurance is
only valid as long as you make payments.
Whole life: at age 30 you commit to pay $200 a month until you turn
65 and get $200,000 in life insurance protection. There is a savings
component so principal builds over time (cash value of life
insurance policy). If you reach 65, you get $200,000 in savings and
you stop paying premiums. If you stop before 65, you will get
whatever the cash value of the policy is less the upfront
commission to the salesperson.
Under some state regulations, it may be that for Whole life
insurance, companies are required to pay a death benefit even
after someone has stopped contributing, but that payment is
reduced to some type of average amount based on amount paid
and time passed).

Example (continued)
The sales commission on $200,000 can be say $6,000 which
means that you get very little principal and interest in the early years
credited to the Cash Value of your account. Therefore, breakeven
(where total Premiums Paid = Cash value) may occur after 7 to 10
years depending on the investment climate and terms of your
contract.
Why invest in a Whole Life policy: Tax advantaged return Uncle
Sam gives you a freebie! Helps address both mortality and
longevity risks.
Recent scandal occurred where insurance agents were pushing
people to cash in their Whole life policies to get a lot more life
insurance for their money (note the difference in premiums in our
two examples).
Regulators responded harshly fining the guilty companies heavily.

Other aspects of Life Insurance

Health and Accident; Disability require similar
ACTUARIAL analysis of the different pools.
Actuaries are rocket scientists who love statistics and
produce black boxes.
Insurers are always trying to predict the future behavior
of their insurance pools and wanting to avoid adverse
selection.
Adverse selection means that those who are most in
need of insurance will be the ones seeking it. Hence if
they are insurable they need to pay according to their
higher risk. Or if deemed uninsurable excluded. Adverse
selection would of course also include the fraudsters!

Other Aspects (continued)

Group vs individual is only a distinction in how life insurance is sold.
In terms of adverse selection there is always a transfer of the risk of
he/she who abuses or is simply in greater need of insurance to the
rest of the group. With Group policies, an employer may decide that
it is offering its employees certain insurance policies and may be
more tolerant of this risk transfer e.g. it may give the employees the
benefit of health insurance at a subsidized cost charging the healthy
and the less healthy the same. Usually, they will screen for
smoking, drugs, and alcohol abuse.
Life insurers tend to have longer term liabilities and hence tend to
invest in longer term assets compared to banks. Investments
include government bonds; corporate bonds and equity; bundled
mortgage securities.
Note the Separate Account on the balance sheet of the Life Insurers
this is where the Life Insurer is acting more like an Agent and is
holding the assets in trust for the policy holder. These include the
variable return policies where an investor chooses to be in e.g. a
stock mutual fund and is promised only the return the fund
generates as opposed to some guaranteed return (e.g. GIC or
Guaranteed Investment Contract)

Regulation
Life Insurers are regulated by the State as
opposed to the Federal Government.
Therefore, rules vary from state to state.
Investment Guarantee Funds also vary from
state to state in terms of what happens should
an insurer fail, size of fund, and maximum pay
out to policy holder.
Federal Government is looking to create a
national body to regulate insurers.

Property and Casualty Industry

Again a consolidating industry with the top 10
underwriting about half the policies and the top 100
underwriting about 87% of the business.
The top two firms underwrote 18.2% of all policies in
2005 compared to 14.5% in 1985.
Growth in Casualty (liability) insurance has far outpaced
Property insurance due to our society becoming more
litigious.
As people live longer and are required more and more to
plan their own retirement, annuities are becoming more
important to life insurance companies.
Economies of scale are probably a bigger factor in this
industry due to the high potential pay outs involved.

Gamblers ruin
If you join a card game with little money, you may lose
on your first or second hand. Even if you are a more
skilful card player than the others around the table,
random chance can cause you to lose early in which
case you are out of the game and will never have the
chance to earn back what you lost.
Insurers face such risks hence they need to be well
capitalized relative to the risks they insure. If the risk is
too big then they need to sell off part of that risk
They sell that risk to a Reinsurance Company. You can
think of an insurance company buying an insurance
policy for certain risks that exceed the risk they feel is
prudent for them to take.

Probabilities
Frequency of loss vs. Severity of Loss and their
predictability
Low loss high frequency events are far more predictable
than high loss low frequency events.
Think of a sample; the larger the sample the more likely
the distribution is going to follow the normal curve.
Hence high frequency and low cost events will follow
such predictable distributions.
An example of high frequency low cost would be
automobile collision and damage insurance. An example
of high cost low frequency would be earthquake
insurance.

Expected outcomes
Insurers look at expected outcomes.
If there is a 10% chance of a high school kid crashing his
car and causing on average $1,000 in damage, the
expected outcome would be $100 per this type of
insured. Hence the insurance company would have to
charge at least $100 just to breakeven.
If the pool is large then the likelihood of all accidents
average close to $1,000 will be high. Of course if the
pool is small then the average or expected outcome may
not prove to be close to the actual outcome since a
serious accident would skew the result.

Joint Probabilities
If two events are independent of each other then the
probability of both occurring at the same time is simply
the probability of event a occurring times the probability
of event b occurring.
Insurers of course need to assess what are independent
events and where one event could coincide with another.
E.g. Insuring houses in a drought prone area where wild
fires could burn many houses down would be an
example where the probability of one house burning
down is not independent. Hence you could not multiply
together the probability of each house burning down to
get the risk of both burning down.

Self-Insurance
Many people buy warranties and other insurance policies without
thinking about the joint nature of the risks. For example if you
always buy warranties on any electrical and electronic appliance,
you need to add up all the costs of these warranties and compare
that to what your expected losses could be.
For example you buy 10 warranties on 10 items with an average
cost of $200 per item. Your warranty cost is 15% for 3 years. (1)
You need to ask yourself if the risks are independent or not. (2) You
then need to ask yourself if (15% x 10 x $200 = $300) is worth, the
risk of 1.5 of the appliances going bad. (3) You also should factor in
the declining costs of electronic appliances and increasing
obsolescence risks.
Conclusion, you may find that by foregoing the policies and setting
aside a pool of money to replace the appliances when they go bad
is a more economical approach.
This is called self insurance.

Over Insurance
Sometimes you pay for insurances that are already
covered by another policy or where cost to the consumer
is regulated by the government.
Car rental insurance your own policy typically applies
to the car you are driving so you typically dont need
(READ THE FINE PRINT!).
States may limit the damage a rental car company can
charge you. For example, Illinois used to limit the
amount to $500. Usually, your credit card offers an
insurance policy that would cover that amount. Rental
car companies are of course happy to charge you sums
like $10.00 per day when you actually may not need.
Again READ THE FINE PRINT!.

Annuities
In essence, an annuity is a fixed payment to be received
a some point in the future. In order to receive that
payment you need to pay something up front. It could be
a lump sum or it could be e.g. a monthly fixed payment
for 10 years. In both cases, the money given to the
insurance company earns interest; this interest continues
to be earned. The easiest conceptual way of thinking of
the annuity is as the reverse of a mortgage. You pay
$300,000 in return for $2,500 a month for the next 20
years. This money is earning about 8% per annum.
With a mortgage, a bank gives you the $300,000 and
then asks you to make $2,500 a month. In both cases,
the monthly payment includes interest and principal.

Annuities (continued)
In terms of your calculator, you would enter $300,000 as
the PV, $2,500 as the payment, and 240 for n (12
months x 20 years), you would hit i to get the interest
amount which come out as interest per month, which
you would then multiply by 12 to come up with annual
rate.
If you didnt know what monthly payment you would get
but you know the interest and how much you want to
invest and for how long then it would be simply $300,000
for PV*, 8%/12 for interest, and 240 for n. You would
hen hit pmt to come up with the monthly amount.
* This PV would be the present value equivalent of a
much larger sum that you would expect to receive in the
future.