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Insurance Companies and Pension Funds
We will learn about two nonbank institutions: insurance companies and pension funds. Most people hold one or more
types of insurance policies (health, life, homeowners, automobile, disability, and so on), and the annual revenues of
insurance companies exceed $600 billion. Currently, over 2 million Americans are employed in the insurance industry.
One major competitor to insurance has been the private, company-sponsored pension plan. Better-educated and longer-
lived workers are putting more money into pension funds than ever before. Over 65 million individuals are now invested
in a private pension fund.
Insurance companies and pension funds are considered financial intermediaries for several reasons. First, they receive
investment funds from their customers. For example, when a person buys a whole life insurance policy, the person
receives a life insurance benefit and accumulates a cash balance. Many people use insurance companies as their primary
investment avenue. Similarly, private pension funds also take in investment dollars from their customers. Second, both of
these institutions place their money in a variety of money-earning investments. Insurance companies and pension funds
make large commercial mortgage loans, invest in stocks, and buy bonds. Thus, these institutions are financial
intermediaries in that they take in funds from one sector and invest in another.
Insurance Companies
Insurance companies are in the business of assuming risk on behalf of their customers in exchange for a fee, called a
premium. Insurance companies make a profit by charging premiums that are sufficient to pay the expected claims to the
company plus a profit. People pay for insurance when they know that over the lifetime of their policy, they will probably
pay more in premiums than the expected amount of any loss they will suffer because most people are risk averse. They
would rather pay a certainty equivalent (the insurance premium) than accept the gamble that they will lose their house or
car. Thus, it is because people are risk-averse that they prefer to buy insurance and know with certainty what their wealth
will be than to incur the risk and run the chance that their wealth may fall. Without insurance companies, people would
have to set aside their own reserves in very liquid assets in case of emergency. They would be constantly worry that their
reserves would be inadequate to pay for catastrophic events such as the loss of their house to fire, theft, or the death of the
family’s breadwinner. Insurance gives peace of mind that an event can have only limited financial impact on our lives.
Although there are many types of insurance and insurance companies, all insurance is subject to several basic principles:
1. There must be a relationship between the insured (the party covered) and the beneficiary (the party who receives
the payment should a loss occur). The beneficiary must be someone who may suffer potential harm if something
happen to the insured. The insurance companies do not want people to buy policies as a way of gambling.
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 company’s obligation is reduced by the amount
of the compensation.
5. The insurance company must have a large number of insureds 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 loss occurring.
Adverse Selection and Moral Hazard
Adverse selection occurs when the individuals most likely to benefit from a transaction are the ones who most actively
seek out the transaction and are thus more likely to be selected. The party more likely to suffer a loss is the party likely to
seek insurance. The implication of adverse selection is that loss probability statistics gathered for the entire population
may not accurately reflect the loss potential for the persons who actually want to buy policies. Most insurance companies
require physical exams and may examine previous medical records before issuing a health or life insurance policy. If a
previous illness is found, the company may issue the policy but exclude this preexisting condition. Insurance firms often
offer better rates to insure groups of people, such as everyone working at a particular business, because the adverse
selection problem is then avoided.
Moral hazard takes place when the insured fails to take proper precautions to avoid losses because losses are covered by
insurance. E.g. not locking your car doors because you know the stolen car will be reimbursed. One way that insurance
companies combat moral hazard is by requiring a deductible. A deductible is the amount of any loss that must be paid by
the insured before the insurance company will pay anything. E.g. if the stolen car is worth $8,000 and the deductible is
$500, the car owner has to pay the first $500 and the insurance will pay the other $7,500. The insurance contract may
have other terms to reduce moral hazard, e.g. a business insured against fire may be required to install and maintain
sprinkler systems on its premises to reduce the loss should a fire occur.
People often fail to seek as much insurance as they actually need. Humans tend to ignore their mortality. Hence,
insurance companies must hire large sales forces to sell their products. Marketing expense account for 20% of the total
cost of a policy. The sales force can convince people to buy coverage that they never would have gotten on their own, yet
may need. Insurance is unique in that agents sell a product that commits the company to a risk.
Independent agents may sell insurance for a number of different companies. They do not have any particular loyalty to
any single firm and simply try to find the best product for their customer. Exclusive agents sell the insurance products for
only one insurance company. Most agents (independent or exclusive) are compensated by being paid a commission.
Agents are usually not concerned with the level of risk of any one policy. To keep control of the risk that agents are
incurring on behalf of the company, insurance companies employ underwriters (people who review and sign off on each
policy an agent writes and who have the authority to turn down a policy if they deem the risk is unacceptable). If
underwriters have questions about the quality customers, they may order an independent inspector to review the property
or person to be insured. A final decision to accept the policy may depend on the inspector’s report.
Growth and Organization of Insurance Companies
Insurance companies can be organized as either stock or mutual firms. A stock company is owned by stockholders and
has the objective of making a profit. Mutual insurance companies are owned by the policyholders. The objective of
mutual insurance firms is to provide insurance at the lowest possible cost to the insured. Policyholders are paid dividends
that reflect the surplus of premiums over costs. Mutual insurance dividends are not taxed like dividends received from
