Questions
1. Life Insurance. How is whole life insurance a form of savings to policyholders?
ANSWER: Whole life insurance is permanent as it protects the policyholder until death or as long as
2. Whole Life versus Term Insurance. How do whole life and term insurance differ from the
perspective of insurance companies? From the perspective of the policyholders?
ANSWER: Term insurance provides insurance only over a specified term; it is not permanent like
3. Universal Life Insurance. Identify the characteristics of universal life insurance.
ANSWER: Universal life insurance specifies a time period over which the policy exists. It builds a
4. Group Plan. Explain group plan life insurance.
ANSWER: Group life insurance can be provided to a group of employees by an insurance company.
5. Assets of Life Insurance Companies. What are the main assets of life insurance companies? Identify
the main categories. What is the main use of funds by life insurance companies?
6. Financing the Real Estate Market. How do insurance companies finance the real estate market?
ANSWER: Life insurance companies hold all types of mortgages as assets. Mortgages are originated
7. Policy Loans. What is a policy loan? When is it popular? Why?
ANSWER: A policy loan occurs as insurance companies lend funds to whole life policyholders based
8. Government Rescue of AIG Why did the government rescue AIG?
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Chapter 25: Insurance and Pension Fund Operations 2
ANSWER: AIG had sold credit default swaps that were intended to cover against default for about
$440 billion in debt securities, many of which represented subprime mortgages. In 2008, AIG
9. Managing Credit Risk and Liquidity Risk. How do insurance companies manage credit risk and
liquidity risk?
ANSWER: To deal with default risk, life insurance companies typically invest in securities with high
10. Liquidity Risk. Discuss the liquidity risk experienced by life insurance companies and by property
and casualty (PC) insurance companies.
ANSWER: Life insurance companies have somewhat predictable payouts over time. However, a high
11. PC Insurance. What purpose do property and casualty (PC) insurance companies serve? Explain
how the characteristics of PC insurance and life insurance differ.
ANSWER: Property and casualty insurance companies protect against fire, theft, liability, and other
events that result in economic or noneconomic damage.
PC insurance differs from life insurance in the following ways:
12. Cash Flow Underwriting. Explain the concept of cash flow underwriting.
13. Impact of Inflation on Assets. Explain how a life insurance company’s asset portfolio may be
affected by inflation.
ANSWER: When higher inflation causes higher interest rates, the market value of existing bonds
14. Reinsurance. What is reinsurance?
15. NAIC. What is the NAIC and what is its purpose?
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Chapter 25: Insurance and Pension Fund Operations 3
ANSWER: The NAIC is the National Association of Insurance Commissioners. It facilitates
16. PBGC. What is the main purpose of the Pension Benefit Guarantee Corporation (PBGC)?
17. Defined-Benefit versus Defined-Contribution Plan. Describe a defined-benefit pension plan.
Describe a defined-contribution plan, and explain why it differs from a defined-benefit plan.
ANSWER: A defined-benefit plan requires contributions that are dictated by the benefits that will
The benefits provided by the defined-contribution plan are determined by the accumulated
contributions and the return on the fund’s investment performance. This plan allows a firm to know
18. Guidelines for a Trust. What type of general guidelines may be specified for a trust that is managing
a pension fund?
ANSWER: Guidelines may include the percentage of the portfolio allocated to stocks or bonds, a
19. Management of Pension Portfolios. Explain the general difference in the composition of pension
portfolios managed by trusts versus those managed by insurance companies. Explain why this
difference occurs.
ANSWER: Pension portfolios managed by trusts offer potentially higher returns than insured plans
20. Private versus Public Pension Funds. Explain the general difference between the portfolio
composition of private pension funds and public pension funds.
21. Exposure to Interest Rate Risk. How can pension funds reduce their exposure to interest rate risk?
ANSWER: Pension funds could reduce the average maturity of bonds held to reduce interest rate risk.
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Chapter 25: Insurance and Pension Fund Operations 4
22. Pension Agency Problems. The objective of the pension fund manager for McCanna, Inc. is not the
same as the objective of McCanna’s employees participating in the pension plan. Why?
23. ERISA. Explain how ERISA affects employees who change employers.
24. Adverse Selection and Moral Hazard Problems in Insurance. Explain the adverse selection
problem and the moral hazard problem in insurance. Gorton Insurance Co. wants to properly price the
insurance for car accidents. If Gorton wants to avoid the adverse selection and moral hazard
problems, do you think it should assess the behavior of insured people, uninsured people, or both
groups? Explain.
ANSWER: When insurance companies assess the probability of a condition that will result in a
payment to the insured, they rely on statistics about the general population. However, an individual
In the insurance industry, the moral hazard problem represents insured policyholders taking more
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “Insurance company stocks may benefit from the recent decline in interest rates.”
b. “Insurance company portfolio managers may serve as shareholder activists to implicitly control a
corporation’s action.”
If an insurance company holds a large amount of a specific firm’s stock, it may have some
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Chapter 25: Insurance and Pension Fund Operations 5
c. “If a life insurance company wants a portfolio manager to generate sufficient cash to meet
expected payments to beneficiaries, it cannot expect the portfolio manager to achieve relatively
high returns for the portfolio.”
If a portfolio manager must generate sufficient cash to meet expected payments to beneficiaries,
Managing in Financial Markets
As a consultant to an insurance company, you have been asked to assess the asset composition of the
company.
a. The insurance company has recently sold a large amount of bonds and invested the proceeds in
real estate. Its logic was that this would reduce the exposure of the assets to interest rate risk. Do
you agree? Explain.
Some real estate can be highly sensitive to interest rate movements, since the demand for real
b. This insurance company currently has a small amount of stock. The company expects that it will
need to liquidate some of its assets soon to make payments to beneficiaries. Should it shift its
bond holdings (with short terms remaining until maturity) into stock in order to strive for a higher
rate of return before it needs to liquidate this investment?
c. The insurance company maintains a higher proportion of junk bonds than most other insurance
companies. In recent years, junk bonds have performed very well during a period of strong
economic growth, as the yields paid by junk bonds have been well-above high-quality corporate
bonds. There have been very few defaults over this period. Consequently, the insurance company
has proposed that it invest more heavily in junk bonds, as it believes that the concerns about junk
bonds are unjustified. Do you agree? Explain.
The junk bonds have probably performed very well because of the strong economic growth that
Flow of Funds Exercise
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Chapter 25: Insurance and Pension Fund Operations 6
How Insurance Companies Facilitate the Flow of Funds
Carson Company is considering a private placement of equity with Secura Insurance Company.
a. Explain the interaction between Carson Company and Secura. How will Secura serve Carson’s
needs, and how will Carson serve Secura’s needs?
Secura receives funds from its customers, who pay insurance premiums in exchange for
b. Why does Carson interact with Secura Insurance Company instead of trying to obtain the funds
directly from individuals who pay premiums to Secura?
Individuals who purchase insurance premiums are not necessarily interested in investing in
c. Who will benefit if the stock purchased by Secura performs well—Secura’s shareholders or
Secura’s policyholders who purchased term life insurance and property insurance? Is it
worthwhile for Secura to closely monitor Carson Company’s management? Explain.
Secura’s shareholders would benefit if the stock it purchased performs well. Its policyholders who
purchased term and property insurance receive insurance in return for their premiums, and do
Solutions to Integrative Problem for Part VII
Assessing the Influence of Economic Conditions Across a Financial Conglomerate’s Units
1. The objective of this case is to force students to compare asset portfolios across units of the
financial conglomerate, and consider how each asset portfolio is exposed to default risk and
interest rate risk. An overall comparison can only be made once these types of exposure are
evaluated.
Default Risk
In comparing the effects of the recession, assess the composition of each unit’s asset portfolio.
Regarding default risk, most units will be adversely affected, but some are more exposed than
others. For example, finance company assets may be subject to a higher default rate than the other
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Chapter 25: Insurance and Pension Fund Operations 7
Mutual funds concentrating on safe securities would be somewhat insulated from default risk
while mutual funds concentrating on junk bonds or other risky securities would be adversely
Interest Rate Risk
Regarding interest rate risk, the institutions that are more exposed to interest rate movements may
benefit from the likely interest rate movements. As the recession begins, there will likely be a
decline in the demand for funds, causing a decline in interest rates. Institutions that have debt
Effect on Brokerage Firms and Investment Banking Firms
A brokerage firm’s performance is mostly affected by its volume of brokerage transactions rather
than its composition of assets, since its main function is that of an intermediary rather than an
Summary
Overall, insurance companies and mutual funds holding a large proportion of highly rated
Savings institutions with fixed-rate mortgages and most finance companies benefit from exposure
to interest rate risk, but are adversely affected by default risk. Savings institutions with a high
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Chapter 25: Insurance and Pension Fund Operations 8
2. It is expensive and inefficient for each unit to have its own economists to provide forecasts. In
addition, economists among units conduct redundant analyses and then may even create
contradictory forecasts. Thus, one unit may be altering its asset portfolio in anticipation of higher
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.