1.1.1.1.1Chapter Fifteen
Insurance Companies
1.1.1.2 I. Chapter Outline
1. Two Categories of Insurance Companies: Chapter Overview
2. Life Insurance Companies
a. Size, Structure, and Composition of the Industry
b. Balance Sheets and Recent Trends
c. Regulation
3. Property-Casualty Insurance Companies
a. Size, Structure, and Composition of the Industry
b. Balance Sheet and Recent Trends
c. Regulation
4. Global Issues
II. Learning Goals
1. Describe the two types of insurance companies.
2. Review the four basic lines of business performed by life insurance companies.
3. Identify the major assets and liabilities of life insurance companies.
4. Classify the major regulations governing life insurance companies.
5. Analyze the major lines of business performed by property-casualty insurance companies.
6. Identify the major assets and liabilities on property-casualty insurance company balance
sheets.
7. Recognize the main regulators of property-casualty insurance companies.
8. Describe the major trends occurring in the global insurance market.
1.1.1.3 III. Chapter in Perspective
This section continues coverage of non-depository institutions with insurance firms. For each
type of insurer, the industry and an overview of the major products offered are first examined.
The balance sheet and recent trends in profitability are then covered. The chapter does not
contain much detail about the products offered; rather the focus is on providing an overview of
each industry.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Policy loans Unearned premium
Policy reserves Frequency of loss
Policy cash and surrender value Severity of loss
Separate account Long-tail loss
McCarran-Ferguson Act of 1945 Loss ratio
Gross premium Pure premium
Insurance guaranty fund Combined ratio
Net premiums written Operating ratio
1.1.1.5
1.1.1.6 Guaranteed Investment Contracts Annuities
1.1.1.7
1.1.1.8 Reinsurance Whole life
1.1.1.9
1.1.1.10 Endowment life Universal & Variable life
1.1.1.11
1.1.1.12 Term life Actuaries
1.1.1.13
1.1.1.14 V. Teaching Notes
1. Two Categories of Insurance Companies: Chapter Overview
Property and casualty insurers are risk intermediaries; life insurers are both risk and time
intermediaries. Both allow households and other entities to limit some of the risks they face.
Life insurers also provide methods to transfer wealth through time and to future generations.
These days some insurers provide both type services and some diversified FIs own both types of
insurers.
2. Life Insurance Companies
a. Size, Structure, and Composition of the Industry
From the late 1980s to the late 2000s, the number of life insurers dropped from 2300 in 1988 to
about 1000, a decline of about 57%. Total assets over roughly the same period grew from $1.12
trillion in 1988 to $5.73 trillion at the start of 2013, a 412% increase. Economies of scale and
scope and regulatory changes similar to those in the banking industry have encouraged growth
and mergers of life insurers. 1 The four largest in 2012 in terms of assets, MetLife, Prudential,
AIG, and Hartford wrote about 24.7% of the total premium income of $704 billion.
The core business of life insurers is to remove income uncertainty due to death or retirement
from individuals. Insurers must decide which risks are worth accepting (or underwriting) and
which should be rejected. Some insurers act as agents (or insurance sellers) while other act as
underwriters and sellers. Because of cross selling allowed by regulators, many insurance
products such as annuities, are sold by other types of FIs such as banks. AIG was at the heart of
the financial crisis because the company sold extensive amounts of credit default swaps (CDSs).
CDS sellers must pay in the event of default of the underlying credit. Problems in mortgages led
to payouts and collateral requirements far beyond AIG’s ability to pay and forced the firm into a
bailout.
1 Traditionally insurers were mutually owned by policyholders. Most have now converted to stock ownership to
facilitate capital raising and growth and to gain the ability to offer stock options to top employees.
Underwriting risks must be priced. If the insurer sets the price too high, it will not be
competitive, too low and premiums will be insufficient to cover losses. Actuaries use Mortality
tables and other information to price insurance contracts. Mortality tables have been developed
to statistically estimate the percentage of a given population with certain demographics (age, sex,
smoker/nonsmoker, health history) that will die in a given year. By offering insurance to large
numbers of individuals, insurers are able to set reasonable insurance rates and make a profit
commensurate with the risk the underwriter bears. Adverse selection is a problem with life
insurance policies, as is moral hazard with property and casualty policies. Adverse selection
arises when individuals who are more likely to need life insurance quickly (e.g., an individual
with a terminal disease) seek out higher levels of coverage. Moral hazard occurs when an
individual who is insured against a risk is more likely to engage in risky activities because of the
insurance.
Types of Lines % of total premiums (Total premiums $704 billion, 2012)
Ordinary life (see below) 18.8%
Individual Annuities 27.3%
Group Annuities 23.3%
Accident & Health 25.5%
Group Life 4.9%
Other 0.2%
Source Text, from Insurance Information Website, www.iii.org
Ordinary life policies are marketed on an individual basis, typically in units of $1,000.
Ordinary life policies constitute constituted 78.8% of life insurance policies in 2012.
These include the following types:
Term life. Term life is pure insurance that pays a stated death benefit if the policyholder
dies within the given term. Annual renewable term is common. Premiums increase as
the policyholder ages. Variants include decreasing coverage amount with level premiums
or fixed premiums for periods longer than one year. There is no savings feature with term
life. Term policies become prohibitively expensive as the insured ages and most term life
ends without the policy holder collecting anything.
The remaining policies accrue a cash value over time. The insured overpays for the
insurance in the early years of the policy and the excess payment is invested by the
insurer. The earnings accrue tax free.
Whole life policies protect an individual for a lifetime. The insurer will pay a death
benefit to the policy holder’s beneficiaries (as long as the insured pays the premiums.)
Variant: Whole life paid up by a certain age.
Endowment life policies pay a death benefit if the insured dies before retirement
(usually), if the insured is alive at retirement, he or she receives the face value of the
policy.
Variable life policies invest fixed premiums into variable rate securities (mutual funds).
The insured’s death benefit is a function of the premiums paid and the rate of return
earned on the investments. The insured usually chooses the investment vehicle in which
the cash value is invested.
Universal life policies allow the policy holder to change both the premium amount and
the contract maturity over the life of the policy.
Universal and variable universal life policies are more flexible in that they allow policy
holders to change, or even skip premiums and change the maturity of the policy. If the
cash value on a universal policy is invested in variable rate earning assets the policy is a
variable universal life policy. These latter policies were created due to the decline of
traditional whole life and endowment policies in the 1960s and 1970s as individual
investors found cheaper ways to invest for retirement.
Teaching Tip: Because of the costs and fees on insurance policies with a savings feature many
investors are better off buying term insurance and investing for retirement on their own in some
other tax advantaged vehicle as long as they are disciplined enough to save on their own for
retirement.
Teaching Tip: More conservative individuals will probably prefer whole life or endowment life
policies to variable or universal life. Some of the universal and universal variable polices are
quite complex and it is difficult to predict payouts on these accounts. If an individual wants one
of these policies they should purchase them while they are young as they become prohibitively
expensive as the applicant ages.
Group life insurance (20.5% of policies) is typically available through an employer.
Group life is usually term insurance and will likely be the lowest cost form of insurance
available to individuals as in many cases employers will contribute to some of the
insurance cost (contributory plan). Cost economies and reduced adverse selection also
generate lower costs in group plans.
Industrial life
A form of low benefit insurance with weekly premiums, it is little used now. It was
traditionally used to provide burial insurance. {Industrial life became unpopular with the
Civil Rights Movement as some African-Americans sued insurers and won, claiming that
high cost, low coverage industrial life plans were sold to blacks, but cheaper, better
coverage policies were sold to whites.}
Credit life (< 1% of policies) policies pay off an outstanding loan if a borrower dies
during the term of the loan. It is typically more expensive than other plans.
Annuities
Annuities are either immediate or deferred payment contracts where life insurers make
regular payments to an annuitant. The annuity’s features vary; the payments may be
fixed or tied to the performance of an investment. The term may be for a set number of
years, or it may continue for as long as the annuitant lives. Variants include continuing
payments until the death of the longest living spouse or even continuing payments for a
certain number of years to beneficiaries. Actuarial tables are used to estimate the likely
number of payments in these cases, and the payments are then set accordingly.
Policyholder payments into an annuity are not tax deductible, but they are allowed to
accrue tax free until withdrawals begin. The amount that may be contributed to the tax
deferred annuity (TDA) is not limited as to the amount per year as is the case with an
IRA, and there is no income test involved for eligibility of use. Because of the favorable
tax features and strong equity markets, annuity sales grew from $26.1 billion in 1996 to
more than $356 billion in 2012. In 2012 about 33% of annuities sold were fixed annuities
and 67% were variable.
Example:
You have a policy with a cash value of $250,000 which you wish to annuitize. You are
currently 62 years old and your spouse is 58. Interest rates are 5% per year, and you are
considering receiving monthly payments under three options. In Option 1 you will receive
10 years of monthly payments. With Option 2 you will receive a monthly payment until you
die. With Option 3 you will receive a monthly payment until both you and your spouse die.
How much will you receive with each option (ignoring administrative costs and fees)?
Option 1
Payment = $250,000 / PVIFA (120, 5/12%) = $2,651.64
Option 2
Actuarial tables indicate that based on your health history, lifestyle, age and occupation you
are likely to live 14 more years. Thus your monthly payment with Option 2 is Payment =
$250,000 / PVIFA (168, 5/12%) = $2,072.18
Option 3
Actuarial tables indicate that based on you and your spouse’s health history, lifestyle, age and
occupation your spouse is likely to live longer than you by an additional 8 years. Thus your
monthly payment with Option 3 based on 22 years of payments is
Payment = $250,000 / PVIFA (264, 5/12%) = $1,563.20
Private pension funds
Life insurers administer many pension plans. These are called ‘insured’ pension funds.
In 2013 insurers administered more than $2.9 trillion of pension fund assets. This
amounts to about 43% of total private pension fund assets. Guaranteed investment
contracts (GICs) are instrumental in many of these plans. The GIC ‘guarantees’ that the
pension fund reserves will grow at a fixed rate for a set time period, typically three to five
years, and that the plan benefits will grow at the same rate.
Accident and health insurance
Over $179 billion in accident and health premiums were written in 2012, most for group
policies. Life insurers write over 50% of all health premiums. Growing HMO
enrollments have reduced the amount of health premium income generated by insurance
firms in recent years however.
b. Balance Sheets and Recent Trends
Life insurers have long term claims (liabilities) so they invest in primarily long term assets.
Major assets include (2013): Change from 2010
Government securities 11.6% Down
Corporate bonds 38.2% Down
Corporate equities231.8% Up
Mortgages 6.0% Down
Policy loans32.6% Down
Miscellaneous 9.8% Down
Major liabilities and equity include: Change from 2010
Net policy reserves 45.1% Down
Separate account business 35.8% Up
Deposit type contracts (GICs) 4.9% Down
Equity capital 5.9% Down
Policy reserves are the estimated current worth of expected future payouts. Net policy reserves
are monitored. Actuaries estimate the required level of policy reserves to meet expected payouts.
Required levels are based on the present value of expected future payouts (which include death
benefits, endowment policies and cash surrender value of policies).
Insurers can have unplanned liquidity needs due to unexpectedly high losses, greater than
anticipated surrenders of policies, and/or lower than anticipated investment returns. Insurers pay
the insured the surrender value of the policy (if any) if the policy is terminated. The surrender
value may be substantially less than the cash value, particularly in the early years after contract
origination.
Funds in separate account business (35.8%) are monies for which the insurer maintains
separate accounting. These funds are for annuities and life insurance policies that allow policy
holders to choose their own investments and earn variable rates of return.
Fairly low levels of capital (5.9%) indicate that the LI business is not overly risky. As will be
shown in the next major section, P&C insurers must carry much higher capital levels to offset
their risks.
Teaching Tip: You may wish to encourage your more mathematically inclined students to
consider a career as an actuary. Actuaries are well paid professionals who can eventually work
on their own. The downside of the actuarial business is the ten years of exams that apprentice
actuaries must pass. Nevertheless, actuarial jobs have been rated high in satisfaction and pay
(see the Student Exercises).
2 Investment in corporate equities peaked in the bull markets of the 1990s. Declining equity
values have hurt profitability materially in the 2000s.
3Most cash value policies allow the insured to borrow against the cash value.
Insurers and the financial crisis of 2007-2008 & more recent performance
The life insurance industry performed well while the stock markets and the economy performed
well during the mid 2000s. As the crisis began insurers experienced losses on mortgage-backed
securities, commercial loans, particularly commercial real estate, and on corporate bonds. With
dropping equity markets, insurers also collected lower fees on their variable annuity products
which are largely equity based. This means that insurers with large amounts of separate account
activity had more extensive losses than other insurers. The very low interest rate environment
meant that insurers could not lower crediting rates on new policies. This encouraged existing
policyholders to surrender their policies if they were already at the minimum crediting rate.
There were also large losses on common and preferred stock holdings in their own investments.
The result was very large profit declines in 2008 (over 50% declines from 2007) and continuing
poor conditions in 2009 on more losses on investments. AIG received government assistance
worth $127 billion. The breakdown consisted of $45 billion from TARP, $77 billion to buy
collateralized debt and mortgage backed securities and a $44 billion bridge loan. Hartford
Financial Services Group, Prudential Financial, Lincoln National and Allstate all received TARP
funds.
Industry conditions improved in 2010 through 2012. In 2012 premium income stopped falling,
net income reaching $40.9 billion, up from $28 billion in 2010. Low interest rates have
compressed spreads and hurt sales of interest bearing products such as annuities however. In
2013, the Financial Stability Oversight Council (FSOC) designated AIG, Metlife and Prudential
as systemically important non-banks. This is likely to lead to higher capital requirements and
lower profitability rates as well as additional regulations on some of their non-traditional
business lines such as credit default swaps.
c. Regulation
The McCarran-Ferguson Act of 1945 left regulation of life insurers up to individual states.
Chartering is entirely at the state level and different states may allow different activities. The
National Association of Insurance Companies (NAIC) has created a national examination system
used by state regulators to examine insurers. There was a bill before Congress as early as 2004
to introduce federal oversight of both life and P&C insurers. During the financial crisis Congress
considered adding a federal regulator of the insurance industry, but left regulation to the states.
However the Dodd-Frank bill did create the Federal Insurance Office (FIO) that reports to
Congress and the President on the insurance industry. Regulators are supposed to identify
systemic risks arising from insurers, monitor international insurance events, eliminate state
regulatory gaps and encourage offering insurance to underserved segments.
The industry wants to allow markets to set insurance prices. Currently, states regulate the
premiums and probably do not update rates as frequently as changing conditions warrant. The
industry also wants a dual regulatory system at the state and federal level so that they can choose
their regulator.
In 2004 Conseco was accused of providing special investment privileges to large investors that
were denied to small investors. Conseco allegedly allowed certain important clients to shift
funds between variable annuities while limiting similar attempts to move funds by smaller
investors.
State guaranty funds may exist to prevent policyholder losses in the event that an insurer fails.
They do not have federal backing, and virtually all states do not maintain a fund reserve. The
amounts surviving insurers may be required to pay in a given year to cover policyholders of a
defunct insurer vary from state to state. In some cases the guaranty funds will not receive
enough money to immediately cover the loss, and long delays in payments are common. It is
thus important that investors consider the creditworthiness of an insurer before placing funds
with that company. A.M. Best is the leading source of insurance ratings and is an excellent
resource for information about the insurance industry.