Chapter 22
Insurance Companies and Pension Funds
◼ Multiple Choice Questions
1. The earliest form of insurance was _________ insurance.
(a) life
(b) health
(c) automobile
(d) property and casualty
2. The certainty equivalent for risk-averse people who buy insurance is the
(a) maximum loss they may sustain.
(b) expected loss they may sustain.
(c) insurance premium they pay.
(d) profit the insurance company earns.
3. The problem of _________ occurs when those most likely to get large insurance payoffs are the
ones who want to purchase insurance the most.
(a) asymmetric information
(b) moral hazard
(c) adverse selection
(d) fraudulent behavior
4. When those most likely to produce the outcome insured against are the ones who purchase
insurance, insurance companies are said to face the problem of
(a) fraudulent claims.
(b) moral hazard.
(c) adverse selection.
(d) pecuniary purchases.
Chapter 22 Insurance Companies and Pension Funds 279
5. To prevent adverse selection, health and life insurance companies may do all the following except
(a) charge higher premiums to people with certain pre-existing health conditions.
(b) require potential policyholders to submit medical records.
(c) refuse to sell policies to people with certain pre-existing health conditions.
(d) charge the same premiums to all policyholders.
6. In the case of an insurance policy, _________ occurs when the existence of insurance encourages
the insured party to take risks that increase the likelihood of an insurance payoff.
(a) moral hazard
(b) opportunism
(c) adverse selection
(d) shirking
7. Some automobile owners will drive faster knowing that they are covered by health and automobile
insurance. This behavior creates the problem of
(a) fraudulent claims.
(b) moral hazard.
(c) adverse selection.
(d) pecuniary purchases.
8. In the case of an insurance policy, _________ occurs when the existence of insurance encourages
the insured party to take risks that increase the likelihood of an insurance payoff; _________ occurs
when those most likely to get large insurance payoffs are the ones who want to purchase insurance
the most.
(a) moral hazard; insurance market discrimination
(b) moral hazard; insurance segregation
(c) moral hazard; adverse selection
(d) adverse selection; moral hazard
9. To prevent the moral hazard problem, health and life insurance companies may write policies
(a) for which premiums increase dramatically once the policyholder is discovered to have
contracted an illness.
(b) containing provisions which either reduce or eliminate benefits to persons who contract pre-
specified illnesses.
(c) limiting the amount the companies will pay in the event that claims are submitted by
policyholders.
(d) with all of the above provisions.
(e) with only (a) and (b) of the above provisions.
280 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
10. To prevent the moral hazard problem, health and life insurance companies may write policies
(a) that increase benefits dramatically once the policyholder is discovered to have contracted an
illness so that the patient can recover sooner.
(b) containing provisions which either reduce or eliminate benefits to persons who contract pre-
specified illnesses.
(c) boosting the amount the companies will pay health providers in the event that claims are
submitted by policyholders.
(d) with only (a) and (b) of the above provisions.
11. Insurance management tools that give policyholders incentives to avoid accidents insured against
include
(a) deductibles.
(b) risk-based premiums.
(c) coinsurance.
(d) all of the above.
12. Which is not a management practice for reducing the problems of adverse selection and moral
hazard in insurance?
(a) deductibles
(b) restrictive provisions
(c) coinsurance
(d) reinsurance
13. Insurance companies employ underwriters
(a) as an alternative to higher deductibles.
(b) to control the risky behavior of their policy holders.
(c) to control the risk incurred on their behalf by agents.
(d) to encourage the loyalty of exclusive agents.
(e) to maintain the independence of independent agents.
14. _________ companies get a tax advantage; most new insurance companies organize as _________
companies.
(a) Mutual insurance; mutual insurance
(b) Mutual insurance; stock
(c) Stock; stock
(d) Stock; mutual insurance
Chapter 22 Insurance Companies and Pension Funds 281
15. (I) A majority of life insurance companies are organized as mutual companies. (II) State
governments have the major responsibility for regulating insurance companies.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
16. Which of the following do not help people during their retirement?
(a) Term life insurance
(b) Annuity
(c) Whole life insurance
(d) Universal life insurance
17. A term life insurance policy provides
(a) insurance benefits only.
(b) savings benefits only.
(c) both insurance and savings benefits.
(d) none of the above.
18. Which of the following types of life insurance provides no savings element?
(a) Term
(b) Whole
(c) Universal
(d) None of the above has a savings element
19. Which of the following is true of life insurance companies?
(a) They hold long-term assets that are not particularly liquid.
(b) They hold short-term liquid assets.
(c) Payouts to policyholders are relatively predictable.
(d) Both (a) and (c) of the above.
20. Of the following financial intermediaries, which holds the least liquid assets?
(a) Property and casualty insurance companies
(b) Life insurance companies
(c) Money market mutual funds
(d) Commercial banks
282 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
21. Relative to life insurance companies, property and casualty insurance companies hold
(a) more liquid assets.
(b) more long-term government bonds.
(c) more commercial mortgages.
(d) fewer municipal bonds.
22. The largest share of life insurance companies’ assets are
(a) corporate stock.
(b) corporate bonds.
(c) government securities.
(d) cash reserves.
23. The federal regulatory agency responsible for regulating the activities of life insurance companies is
(a) the Federal Deposit Insurance Corporation.
(b) the Federal Reserve.
(c) the Federal Life Insurance Board.
(d) none of the above; there is no such federal regulatory agency.
24. Which of the following is not a feature of the Terrorism Risk Insurance Act of 2002?
(a) Losses that exceed $100 billion are not covered.
(b) The law does not apply to acts of international terrorism when losses are less than $5 million.
(c) Government pays 50 percent of losses in excess of $100 billion.
(d) Government pays 90 percent of the losses.
25. Insurance companies’ attempts to minimize adverse selection and moral hazard explain which of the
following insurance practices?
(a) Risk-assessment screening
(b) Risk-based premiums
(c) Restrictive provisions
(d) All of the above
(e) Only (a) and (b) of the above
26. Insurance companies’ attempts to minimize adverse selection and moral hazard explain which of the
following insurance practices?
(a) Requiring collateral for policies
(b) Risk-based premiums
(c) Compensating balances
(d) All of the above
(e) Only (a) and (b) of the above
Chapter 22 Insurance Companies and Pension Funds 283
27. Insurance companies’ attempts to minimize adverse selection and moral hazard explain which of the
following insurance practices?
(a) Gender-neutral premiums
(b) Flat-rate premiums
(c) Restrictive provisions
(d) All of the above
(e) Only (a) and (b) of the above
28. Insurance companies’ attempts to minimize adverse selection and moral hazard explain which of the
following insurance practices?
(a) Collection of information and screening of potential policyholders
(b) Risk-based premiums
(c) Cancellation of insurance
(d) All of the above
29. Insurance companies’ attempts to minimize adverse selection and moral hazard explain which of the
following insurance practices?
(a) Collection of information and screening of potential policyholders
(b) Risk-based premiums
(c) Deductibles and coinsurance
(d) All of the above
(e) Only (a) and (b) of the above
30. If automobile insurance companies were prevented from charging risk-based premiums, but could
selectively screen potential policyholders, the likely effect would be to
(a) increase the number of young men obtaining insurance coverage relative to young women.
(b) decrease the number of young women obtaining insurance coverage relative to young men.
(c) decrease the number of young men obtaining insurance coverage relative to young women.
(d) both (a) and (b) of the above.
31. The fact that insurance companies charge young males higher automobile insurance premiums than
young females is an example of
(a) risk-based premiums.
(b) an attempt to minimize adverse selection.
(c) coinsurance.
(d) all of the above.
(e) only (a) and (b) of the above.
284 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
32. Insurance management tools that give policyholders incentives to avoid accidents insured against
include
(a) deductibles.
(b) risk-based premiums.
(c) coinsurance.
(d) all of the above.
33. Clauses in life insurance policies that eliminate death benefits if the insured person commits suicide
are an example of a
(a) restrictive provision.
(b) restrictive covenant.
(c) anti-fraud exclusion.
(d) risk-based deductible.
34. The fastest growing financial intermediary is
(a) commercial banks.
(b) pension plans.
(c) life insurance companies.
(d) mutual funds.
35. Which of the following has not contributed to the growth of pension plans?
(a) Privatization of Social Security
(b) Urbanization
(c) Retirement at earlier ages
(d) Increases in life expectancy
36. A company’s pension plan promises employees a specific amount of income when they retire.
However, the plan does not have the assets to meet these future obligations to employees. This plan
represents a defined-_________ plan that is _________.
(a) benefits; underfunded
(b) benefits; overfunded
(c) contribution; underfunded
(d) contribution; overfunded
37. Social Security is a
(a) fully funded pension plan.
(b) federally insured private pension plan.
(c) government sponsored private pension plan.
(d) “pay–as-you-go” system.
Chapter 22 Insurance Companies and Pension Funds 285
38. The Social Security system is an example of a public pension plan that is
(a) underfunded.
(b) fully funded.
(c) overfunded.
(d) none of the above.
39. Which of the following statements regarding the funding of social security is false?
(a) In 2004, workers contributed 6.2% of their wages up to a maximum of $87,900.
(b) Employers contribute an amount equal to the workers’ contributions.
(c) Interest, dividend, rent, and royalty income is also taxed to provide supplemental funds for
Social Security.
(d) Contributions exceeding the amounts paid to current Social Security recipients are invested in
Treasury bonds to build up a Social Security trust fund.
40. Which of the following is not a proposal for insuring that sufficient funds will be available to
provide Social Security benefits to future retirees?
(a) Raise the maximum income cap on which workers and employers are taxed.
(b) Provide more generous annual cost of living increases.
(c) Raise the minimum age for receiving benefits.
(d) Reduce the amount of future benefits.
41. Which proposal for insuring that sufficient funds will be available to provide Social Security
benefits to future retirees does the AARP find least objectionable?
(a) Raise the maximum income cap on which workers and employers are taxed.
(b) Provide more generous annual cost of living increases.
(c) Privatize Social Security.
(d) Lower immigration restrictions to increase the number of workers paying into the Social
Security system.
42. Privatization of Social Security
(a) would transform the program from an unfunded pay-as-you-go system to a fully funded
pension plan.
(b) would mean that workers’ current contributions to Social Security would no longer be available
to pay benefits to current retirees.
(c) receives less public support when the stock market declines.
(d) all of the above.
(e) none of the above.
286 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
43. Fraudulent practices and other abuses of private pension funds led Congress to enact the
(a) Federal Deposit Insurance Corporation Act.
(b) Employee Retirement Income Security Act.
(c) Federal Reserve Act.
(d) Social Security Act.
44. Keogh plans and IRAs are
(a) individual pension plans.
(b) government pension plans.
(c) corporate pension plans.
(d) public pension plans.
45. Private pension plan assets are invested mainly in
(a) government securities.
(b) corporate bonds.
(c) stock.
(d) certificates of deposit.
46. Which of the following pensions does not promise employees a specific retirement benefit?
(a) defined-benefit plan
(b) defined-contribution plan
(c) overfunded plan.
(d) underfunded plan.
Chapter 22 Insurance Companies and Pension Funds 287
◼ True/False
1. Adverse selection occurs when those most likely to get insurance payoffs are the ones who want to
purchase the insurance the most.
2. The fact that insurance companies charge young males higher automobile insurance premiums than
young females is an example of coinsurance.
3. When a life-long chain smoker attempts to purchase a life insurance policy, the insurance company
faces the problem of adverse selection.
4. The higher the insurance coverage, the more the policyholder can gain from risky activities that
make an insurance payoff less likely.
5. Vesting refers to the length of time that a person must be enrolled in a pension plan before being
entitled to receive benefits.
6. A defined-contribution plan promises employees a specific amount of retirement income.
7. The Pension Benefit Guarantee Corporation performs a role similar to that of the Office of Thrift
Supervision.
8. Social Security is a “pay–as-you-go” system.
9. The Social Security system is an example of a pension plan that is fully funded.
10. Demographic trends and changes in retirement patterns suggest that Social Security funding
problems will ease over the next few decades.
11. A whole life insurance policy pays a death benefit if the policyholder dies.
12. Most private pension plans are insured by the Penny Benny, which pays benefits when a plan’s
sponsor goes bankrupt.
288 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
◼ Essay
1. Would you prefer the manager of the pension plan in which you are enrolled to be paid a flat fee,
independent of the performance of the plan, or be paid based on the fund’s performance, even if that
might mean paying him or her a higher salary? Explain.
2. Who has the strongest incentive to monitor the performance of individual pension plans such as
Keoghs and IRAs? Explain.
3. Why do life insurance companies and pension plans invest heavily in long-term assets?
4. Why must insurance companies screen applicants so carefully?
5. Distinguish between different types of life insurance.
6. What are the major differences between life insurance and property and casualty insurance?
7. Why will Social Security funding problems rise in the coming decades? Identify and evaluate the
proposals that have been suggested to ease or reverse these problems.