FIN 3080 chapter 15
investment yield formula
% ROI or profit loss on investment divided by premiums
You want to buy a term life insurance product that pays $80,000 if you die within one year. Assume that the probability of death over the next year is q% and that the insurance company's goal is to break even. That is, the insurance company needs to charge a premium equal to the expected payout. You receive a quote of $85.20 from the insurance company. What is the insurance company's estimate of q%?
1.07%
cash for life insurance companies %
1.9
liability insurance %
12.6
homeowners multiple peril %
15
other assets for life insurance companies %
3.2
automobile liability and physical damage %
38.2
commercial multiple peril %
4.5
net policy reserves % for life insurance liabilities
45.1
bonds for life insurance companies %
45.6
other liabilities % for life insurance liabilities
46
other investments for life insurance companies %
49.3
fire insurance and allied lines %
5
capital and surplus % for life insurance liabilities
5.9
what does the combined ratio after dividends tell you
for every $1 dollar in premiums, you paid x amount in losses, LAE, expenses, dividends
endowment features
guaranteed payment, expiration, savings, time policy to expire at an event like retirement
features of whole
guaranteed payment, no expiration, no savings, can borrow against cash value
variable features
guaranteed payment, no expiration, savings, invest in stocks/bonds/ mutual funds
universal features
guaranteed payment, no expiration, savings, premiums and payouts can vary
what is most difficult for severity vs freqency
high severity and low frequencey
severity vs frequency
high severity/low severity vs high frequency/low frequency
according to national vista stat report, the likelihood that 20-year old person dies within next year is .13%. life insurance company anticipates likelihood that 20 year old policy holder dies is
higher than .13% due to adverse selection
what is credit line
if have big debt like house and want to pay off if die. term life sold in conjunction with some debt contract. their cost per unit of coverage is usually much higher than other methods of covering these liabilities in event of unexpected death.
exclusions are what
if you die while commit felony, insurance company wont pay
unexpected increases in expenses are result
increases in commission cost to brokers, general expenses, taxes, and other expenses related to acquisitions
loss rates
influenced by whether product lines are property or liability, whether they are low severity high frequency lines or high severity low frequency lines and whether they are long tail or short tail. affected by product inflation and social inflation
how to deal with moral hazard
insured must bear some financial responsibility (like a deductible and exclusion)
is group life or john Hancock individual vitality cheaper
john Hancock because they do full medical exam to make sure healthy and group life is no questions asked
loss risk
key feature of loss risk is actuarial predictability of losses relative to premiums earned. this predictability depends on a number of characteristics of features on perils insured.
what is casualty only
liability insruance
policy reserves
liability term for insurers that reflects their expected payment commitments on existing policy contracts
contrast balance sheet of depository institutions with those of life insurance firms
life insurance companies have long term liabilities because of life insurance products they sell. as result, asset side of BS predominantly includes long-term government and corporate bonds, corporate equities, and declining amount of mortgage products. asset side of depository institution's balance sheet is comprised primarily of short and medium term loans to corporations and individuals and some liquid investment securities. a major similarity between depository institutions and insurance firms is high degree of financial leverage incurred by both groups of firms. both groups solicit funds and use them to finance an asset portfolio predominately consisting of debt securities. a major difference between them is their composition of liabilities, which is fixed for depository institutions but stochasatic for insurance firms. while face value of bank deposits is fixed, insurance company's net policy reserves depend on expected future required payouts which can be highly uncertain. other difference is that insurance companies are allowed to invest in equity instruments, which currently are prohibited for depository institutions
how can life insurance and annuity products be used to create a steady stream of cash disbursements and payments so as to avoid either payment or receipt of single lump sum cash amount
life insurance policy (whole life or universal life) requires regular premium payments which then entitle the beneficiary to a single lump sum. Upon receipt of such a lump sum, a single annuity could be obtained which would generate regular cash payments until the value of the insurance policy is depleted.
examples of bonds for life insurance companies
long term investments
combined ratio after dividends formula
loss ratio + loss adjustment expense ratio + expense ratio + dividend ratio
what is easier to predict for severity vs frequency
low severity and high frequency
loss ratio
measure of pure losses incurred to premiums earned (dollars paid in claims)
long tail example
medical mal practice, asbestos. many years before a claim is filed
Which statement best describes the balance sheets of commercial banks?
their primary assets are loans and investment securities
annuitites
think of annuity as reverse of a life insurance policy. the party purchases right to receive periodic payments depending on market conditions. contract may be initiated by investing a lump sum or by making periodic payments before annuity payments begin.
what is long tail vs short tail
time to file claim
premium structure for various types of insurance typically is based on average population proportionately representing all categories of risk. The existence of proportionately larger share of high-risk customers may cause premium revenue received by insurance provider to underestimate revenue needed
to cover insured liabilities and provide reasonable profit for insurance company
moral hazard
when, after an insurer and customer enter into an insurance contract, insured customer takes an action that is not taken into account in the contract yet, which changes the value of the insurance
information asymmetry and insurance problem
you know more about yourself than insurance company does
deductible is what
you pay the first $500 on claim/loss
what is property only
fire insurance and allied lines
ratios over time takeaways
-CRAD= usually greater than 100. must be profitable on investments -Loss Ratio=volatility is coming from here. loss ratio drives volatility in combined ratio
liability example
-GM ignition switches. 23 people died. maximum loss on this liability claim? suit, loss of life, jury what is difficult to predict? loss of life
low severity, low frequency
-damage to electronics and appliances. usually self insured
low severity and high frequency
-hailstorm -minor car accident *less than $2000*
what is combination of P and C
-homeowners multiple peril -commercial multiple peril -automobile liability and physical damage
high severity and low frequency
-hurricane -tornado -extreme weather events
property example
-maximum loss on building fire. you have to know value of building
high severity and high frequency
-not a lot of great examples. war torn countries. *not eligible for insurance*
examples of property casualty
-state farm -nationwide -zurich -AIG -all state
you want to buy a term life insurance product that pays $400000 if you die within one year. probability of death over next year is "p" and insurance companies goal is to break even. company needs to charge premium equal to expected payout. calculate probability of death over next year if insurance company charges annual premium of $600?
.15=Q
balance sheet assets of life insurance companies
1) bonds 2) other investments 3) cash 4) other
products of property casualty insurance
1) fire insurance and allied lines 2) homeowners multiple peril 3) commercial multiple peril 4) automobile liability and physical damage 5) liability insurance (other than auto)
what do insurance company managers think about
1) loss risk 2) expense risk 3) investment yield
liabilities and capital surplus for life insurance companies
1) net policy reserves 2) other liabilities 3) capital and surplus
products of life insurance companies
1) ordinary life 2) group life 3) annuities 4) other
characteristics that affect predictability
1) property vs liability 2) long tail vs short tail 3) severity vs frequency
ordinary life types
1) term 2) whole 3) endowment 4) variable 5) universal
what are three sources of underwriting risk in P&C industry
1) unexpected increases in loss rates 2) unexpected increases in expenses 3) unexpected decreases in investment yields
operating ratio formula
CRAD - investment yield
how does regulation of insurance companies compare with that of depository institutions
Insurance companies are more exclusively subject to state regulations compared to depository institutions. Although there are national insurance organizations such as the National Association of Insurance Commissioners, the companies themselves are regulated by the state agencies. Depository institutions are typically subject to both national and state oversight. While both banks and insurance companies receive regulatory scrutiny as to the quality of their assets and liabilities, bank regulations also dictate minimum reserve and capital requirements. Banks have more geographic restrictions. In 2009, the U.S. Congress considered establishing an optional federal insurance charter. The move behind such a charter picked up steam following the failure of the existing state by state regulatory system to act in preventing the problems at insurance giant AIG from becoming a systemic risk to the national economy. Those in favor of an optional federal insurance charter noted that under the current state by state system, insurers face obstacles such as inconsistent regulations, barriers to innovation, conflicting agent licensing, and education requirements. The Wall Street Reform and Consumer Protection Act of 2010 established the Federal Insurance Office (FIO), an entity that reports to Congress and the President on the insurance industry. While the industry continues to be regulated by the states, the FIO has the authority to monitor the insurance industry, identify regulatory gaps or systemic risk, deal with international insurance matters and monitor the extent to which underserved communities have access to affordable insurance products. The Wall Street Reform and Consumer Protection Act also called for the establishment of the Financial Stability Oversight Council (FSOC), which is charged with designating any financial institution (including insurance companies) that presents a systemic risk to the economy and subjecting them to greater regulation. In 2013, AIG, MetLife, and Prudential Financial were designated at systemically important nonbank financial institutions.
if Q is whole population and Q' is your pool of policy holders, which will be higher
Q prime
how do life insurance companies earn profits
Insurance companies earn profits by taking in more premium income than they pay out in policy payments. Firms can increase their spread between premium income and policy payouts in two ways. The first way is to decrease future required payouts for any given level of premium payments. This can be accomplished by reducing the risk of the insured pool (provided the policyholders do not demand premium rebates that fully reflect lower expected future payouts). The second way is to increase the profitability of interest income on net policy reserves. Since insurance liabilities typically are long term, the insurance company has long periods of time to invest premium payments in interest earning asset portfolios. The higher is the yield on the insurance company's investments, the greater is the difference between the premium income stream and the policy payouts (except in the case of variable life insurance) and the greater is the insurance company's profitability.
Which of the following describes the investment strategy of the insurance company industry?
Insurance companies tend to focus on lower risk, safer investments such as bonds
contract balance sheets of depository institutions with those of life insurance firms
Life insurance companies have long-term liabilities because of the life insurance products that they sell. As a result, the asset side of the balance sheet predominantly includes long-term government and corporate bonds, corporate equities, and a declining amount of mortgage products. The asset side of a depository institution's balance sheet is comprised primarily of short- and medium-term loans to corporations and individuals and some liquid investment securities (e.g., Treasury securities). A major similarity between depository institutions and insurance firms is the high degree of financial leverage incurred by both groups of firms. Both groups solicit funds (from policyholders or depositors) and use them to finance an asset portfolio predominately consisting of debt securities. A major difference between them is their composition of the liabilities, which is fixed for depository institutions but stochastic for insurance firms. While the face value of bank deposits is fixed, the insurance company's net policy reserves depend on expected future required payouts which can be highly uncertain. The other difference is that insurance companies are allowed to invest in equity instruments, which currently are prohibited for depository institutions
how doe adverse selection affect profitable management of insurance company?
The adverse selection problem occurs because customers who are most in need of insurance are most likely to acquire insurance. However, the premium structure for various types of insurance typically is based on an average population proportionately representing all categories of risk. Thus, the existence of a proportionately larger share of high-risk customers may cause the premium revenue received by the insurance provider to underestimate the revenue needed to cover the insured liabilities and to provide a reasonable profit for the insurance
what are similarities and differences among four basic lines of life insurance products
The four basic lines of life insurance products are: (1) ordinary life, (2) group life, (3) credit life, and (4) other activities. Ordinary life is sold on an individual basis and represents the largest segment (80%) of the life insurance market. The insurance policy can be structured as pure life insurance (term life) or may contain a savings component (whole life or universal life). Group policies (19%) are similar to ordinary life insurance policies except that they are centrally administered, providing cost economies in evaluating, screening, selling, and servicing the policies. Credit life (<1%) typically is term life sold in conjunction with some debt contract. Their cost per unit of coverage is usually much higher than other methods of covering these liabilities in the event of unexpected death. Thus, they are a rarely used type of life insurance. Other major activities of life insurance companies are the sale of annuities, private pension plans, and accident and health insurance.
if an insurance company decides to offer a corporate customer a private pension fund, how would this change the balance sheet of insurance company?
The primary change in the balance sheet of a life insurance company would be an increase in the liability accounts that reflect these pension plans. Guaranteed investment contracts (GICs) and separate account categories likely would increase, depending on the type of pension plans provided to the customers. The premiums and contributions would be invested in the normal asset categories of the insurance company, except in cases where the pension fund requires aggressive investment strategies. In this case, the funds may be invested in specific equity mutual funds.
assets and liabilities of property-casualty insurance company balance sheets
assets: bonds and investments liabilities: loss reserves
short tail example
auto accidents
key thing in moral hazard
behavior changes
regulation
both life and PC insurance is regulated at state level. Federal charters have been proposed but not approved
what do insurance company managers think about can be applied to
both life and property casualty
loss adjustment expense ratio
costs surrounding loss settlement process to premiums written
group life insurance
covers a large number of insured persons under a single policy, usually issued to corporations or other employers (Clemson University employees). they are centrally administered, providing cost economies in evaluating, screening, selling, and servicing policies.
other
credit life, private pension funds, accident and health insurance
dividend ratio
dividends paid to premiums written
what exactly is loss ratio
dollars paid in claims
what is LAE ratio
dollars paid to adjust claims-> employees
how to deal with adverse selection
establish different pools of population based on health and related characteristics example: they ask you if you smoke or not. if you do, premium goes up 77%
expense ratio
expenses related to commissions and other operating expenses to premiums written
after seatbelt law passed, people drove more recklessly and
more pedestrian injuries.
features of term
no guaranteed payment, expiration, no savings, lowest cost
people that are low risk may
not buy insurance, which leaves insurance companies with people who will file claims/high risk
property casualty insurance protects against
personal injury and liability due to accidents, theft, fire, etc...
adverse selection problem
problem that customers who apply for insurance policies are more likely to be those most in need of coverage
if <100% it is
profitable
property casualty insurance companies has two parts
property: car, house, building casualty: liability like if you injure someone
insurance companies are financial institutions that
protect individuals and corporations (policyholders) from adverse events
life insurance companies provide
protection in the event of untimely death, illness, and retirement
ordinary life is sold on individual basis and
represents largest segment (80%) of life insurance market. insurance policy can be structured as pure life insurance (term life) or may contain savings component (whole life or universal life)
investment yields depend on
stock and bond markets as well as on asset allocations of portfolios
examples of other investments for life insurance
stock, real estate, mortgage loans
examples of life insurance companies
table 15-1 put in here