Chapter 25
Insurance Operations
Outline
Setting Insurance Premiums
Adverse Selection Problem
Moral Hazard Problem
Regulation of Insurance Companies
Assessment System
Regulation of Capital
Life Insurance Operations
Ownership
Types of Life Insurance
Other Types of Insurance Operations
Property and Casualty Insurance
Exposure to Risk
Interest Rate Risk
Valuation of an Insurance Company
Factors That Affect Cash Flows
Chapter 25: Insurance Operations ❖ 2
Key Concepts
2. Explain how insurance companies are exposed to risk.
4. Describe the purpose of pension funds and how they participate in financial markets.
POINT/COUNTER-POINT:
Should Insurance Companies Make Risky Investments?
POINT: No. Insurance companies can best serve their policyholders by maintaining adequate reserves in
case claims are filed. If they make risky investments, they could experience liquidity problems, and may
not be able to serve their policyholders.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: Portfolio managers naturally prefer to take risks in order to strive for higher returns on their
Questions
1. Life Insurance. How is whole life insurance serve as 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
Chapter 25: Insurance Operations ❖ 3
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.
group members as well. Some unions and professional associations participate in group plans.
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?
ANSWER: Life insurance companies invest in government securities, corporate securities,
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 U.S. government rescue AIG during the credit crisis in
2008?
ANSWER: AIG had sold credit default swaps that were intended to cover against default for about
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.
Chapter 25: Insurance Operations ❖ 4
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.
12. Cash Flow Underwriting. Explain the concept of cash flow underwriting.
ANSWER: Cash flow underwriting is a method of adapting prices to interest rates. As interest rates
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?
ANSWER: Reinsurance permits companies to write large policies by allocating a portion of the risk
15. NAIC. What is the NAIC and what is its purpose?
ANSWER: The NAIC is the National Association of Insurance Commissioners. It facilitates
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.
ANSWER: When insurance companies assess the probability of a condition that will result in a
Chapter 25: Insurance Operations ❖ 5
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
If portfolio managers are compensated based on the return on investment, they may be tempted to make
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
c. “If a life insurance company wants a portfolio manager to generate sufficient cash to meet
Chapter 25: Insurance Operations ❖ 6
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 these actions 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 an effort to achieve higher
rate of return before it needs to liquidate this investment?
The stock returns are very uncertain. It is not wise to shift into stock when you know that you will
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. Very few defaults have occurred 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 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’s management? Explain.
Secura’s shareholders would benefit if the stock it purchased performs well. Its policyholders