Chapter 25
Insurance Operations
Outline
Determinants of Insurance Premiums
Adverse Selection Problem
Moral Hazard Problem
Regulation of Insurance Companies
Assessment System
Regulation of Capital
Regulation of Failed Insurance Companies
Regulation of Financial Services Offered
Federal Insurance Office
International Insurance Regulations
Life Insurance Operations
Ownership
Types of Life Insurance
Sources of Funds
Uses of Funds
Asset Management of Life Insurance Companies
Interaction with Other Financial Institutions
Other Types of Insurance Operations
Property and Casualty Insurance
Health Insurance
Business Insurance
Bond Insurance
Mortgage Insurance
Exposure to Risk
Interest Rate Risk
Credit Risk
Market Risk
Liquidity Risk
Exposure to Risk During the Credit Crisis
Government Rescue of AIG
Valuation of an Insurance Company
Factors That Affect Cash Flows
Factors That Affect Rate of Return by Investors
Indicators of Value and Performance
Chapter 25: Insurance Operations ❖ 2
Key Concepts
1. Describe the role of insurance companies.
2. Explain how insurance companies are exposed to risk.
3. Describe how insurance companies participate in financial markets.
4. Describe the purpose of pension funds and how they participate in financial markets.
POINT/COUNTER-POINT:
Should Insurance Companies Make Risky Investments?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Life Insurance. How is whole life insurance a form of savings to policyholders?
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?
3. Universal Life Insurance. Identify the characteristics of universal life insurance.
4. Group Plan. Explain group plan life insurance.
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?
7. Policy Loans. What is a policy loan? When is it popular? Why?
8. Government Rescue of AIG Why did the government rescue AIG?
9. Managing Credit Risk and Liquidity Risk. How do insurance companies manage credit risk and
liquidity risk?
10. Liquidity Risk. Discuss the liquidity risk experienced by life insurance companies and by property
and casualty (PC) insurance companies.
Chapter 25: Insurance Operations ❖ 4
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ANSWER: Life insurance companies have somewhat predictable payouts over time. However, a high
frequency of claims can cause the insurance companies to be illiquid. To boost liquidity, the
companies could maintain some liquid assets. PC insurance companies have claims that are less
predictable, and need to maintain sufficient liquid assets to cover any payouts.
11. PC Insurance. What purpose do property and casualty (PC) insurance companies serve? Explain
how the characteristics of PC insurance and life insurance differ.
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.
14. Reinsurance. What is reinsurance?
15. NAIC. What is the NAIC and what is its purpose?
16. 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.
Chapter 25: Insurance Operations ❖ 5
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
not buy it. This is referred to as an adverse selection problem, which in general means that bad
customers are selected.
In the insurance industry, the moral hazard problem represents insured policyholders taking more
risks because they are insured. If the insurance company did not consider this when setting insurance
premiums, it may have set the premium too low.
Thus, Gorton Insurance Co. should assess the sample of insured policyholders rather than the entire
sample because this subsample more properly reflects the behavior of the people that it would insure.
CRITICAL THINKING QUESTION
Investment Policy Incentives of Insurance Companies Consider a life insurance company that
needs to ensure that it can make a steady stream of payments over time to beneficiaries of its
policyholders. Assume that the compensation for the insurance company’s portfolio managers is
tied to the return earned on the investments each year. Write a short essay that explains how the
compensation plan might lead to investment strategies that do not serve the needs of the
policyholders.
ANSWER
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.”
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.”
Chapter 25: Insurance Operations ❖ 6
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
If a portfolio manager must generate sufficient cash to meet expected payments to beneficiaries,
the portfolio may be composed mostly of bonds that promise fixed payments. The portfolio may
not be focused on growth stocks, because there is more uncertainty about the payments that these
stocks could generate over time. Therefore, the manager has less flexibility, and must give up
some potential return in order to satisfy the main goal of the portfolio.
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.
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.
Flow of Funds Exercise
How Insurance Companies Facilitate the Flow of Funds
Carson Company is considering a private placement of equity with Secura Insurance Company.
Chapter 25: Insurance Operations ❖ 7
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