Financial Institutions Chapter 6
Explain how annuity activities represent the reverse of life insurance activities.
A typical life insurance contract requires a periodic payment by one party for a promised payment of either a lump sum or an annuity if a particular event occurs, such as death or an accident. An annuity represents a reverse contract where the party purchases the right to receive periodic payments depending on the market conditions. The contract may be initiated by investing a lump sum or by making periodic payments before the annuity payments begin.
What is the investment yield on premiums earned? Why has this ratio become so important to property-casualty insurers?
In cases where the combined ratio is greater than 100, the insurer must rely on investment income from premiums to achieve profitability. Since the 1980s, the combined ratio consistently has been greater than 100. That is, the loss ratio and the expense ratio have exceeded the amount of premiums received on the insurance lines. Thus, the yield on invested premiums has become critical to the overall profitability of the property-casualty insurance industry.
How do unexpected increases in inflation affect property-casualty insurers?
Inflation generally has an adverse effect on the cost of providing benefits that have been purchased by the insured, particularly if the policy is written in terms of the replacement cost of the asset and the premiums are not adjusted for inflation. In addition, the investment value of bonds and other fixed-rate assets of insurers from which claims proceeds are derived may decrease in value from unexpected inflation.
How do life insurance companies earn a profit?
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.
Contrast the balance sheet of a life insurance company (Table 6-3) with the balance sheet of a commercial bank (Table 2-6) and that of a savings institution (Table 2-10). Explain the balance sheet differences in terms of the differences in the primary functions of the three organizations.
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 commercial bank'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). The principal asset category for a savings institution is long-term mortgages. In effect, all three companies use large degrees of financial leverage to fund assets that primarily consist of debt securities. While the face value of deposits is fixed for banks and savings institutions, the composition of liabilities for insurance companies is stochastic. The primary liability category for a life insurance company is policy reserves that reflect the expected payment commitments on existing policy contracts. Insurance companies also sell short- and medium-term debt instruments called GICs that are used to fund their pension plan business. The liabilities of savings institutions are primarily short-term deposit accounts, while banks utilize short-term deposits and short-term borrowed funds, depending on the size of the bank.
A property-casualty insurer brings in $6.25 million in premiums on its homeowners multiple line of insurance. The line's losses amount to $4,343,750, expenses are $1,593,750, and dividends are $156,250. The insurer earns $218,750 in the investment of its premiums. Calculate the line's loss ratio, expense ratio, dividend ratio, combined ratio, investment ratio, operating ratio, and overall profitability.
Loss ratio = $4,343,750/$6,250,000 = 69.5% Expense ratio = $1,593,750/$6,250,000 = 25.5% Dividend ratio = $156,250/$6,250,000 = 2.5% Combined ratio = 69.5% + 25.5% + 2.5% = 97.5% Investment ratio = $218,750/$6,250,000 = 3.5% Operating ratio = 97.5% - 3.5% = 94.0% Overall profitability = 100.0% - 94.0% = 6.0%
An insurance company collected $3.6 million in premiums and disbursed $1.96 million in losses. Loss adjustment expenses amounted to 6.6 percent and dividends paid to policyholders totaled 1.2 percent. The total income generated from the company's investments was $170,000 after all expenses were paid. What is the net profitability in dollars?
Pure loss = $3.6 million - $1.96 million = $1,640,000 Expenses = 0.066 x $3,600,000 = $237,600 Dividends = 0.012 x $3,600,000 = $43,200 Investment returns = $170,000 Net profits = $1,640,000 - $237,600 - $43,200 + $170,000 = $1,529,200
What is the adverse selection problem? How does adverse selection affect the profitable management of an 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 company.
Contrast the balance sheet of a property-casualty insurance company (Table 6-5) with the balance sheet of a commercial bank (Table 2-6). Explain the balance sheet differences in terms of the differences in the primary functions of the two organizations.
The balance sheet of a PC company is similar to that of a life insurance company. Long-term financial assets such as bonds, common equities, and preferred stock comprise the majority of the assets, while loss reserves, loss adjustment expenses, and unearned premiums dominate the liabilities. In contrast, short- and medium-term financial assets dominate the asset side of the balance sheets of most banks and borrowed funds in the form of deposits are the primary liability for commercial banks. Whereas banks provide time and size intermediation for depositors, PC insurance companies use premium payments to provide assurance against certain types of risk for customers. For a bank the deposits represent borrowed funds, while the premiums to an insurance company represent the actual price for the risk coverage.
What is the combined ratio for a property insurer that has a loss ratio of 73 percent, a loss adjustment expense of 12.5 percent, and a ratio of commissions and other acquisition expenses of 18 percent?b. What is the combined ratio adjusted for investment yield if the company earns an investment yield of 8 percent?
The combined ratio is 73% + 12.5% + 18% = 103.5%. b. What is the combined ratio adjusted for investment yield if the company earns an investment yield of 8 percent? The combined ratio adjusted for investment yield is 103.5% - 8% = 95.5%.
How is the combined ratio defined? What does it measure?
The combined ratio is equal to the loss ratio plus the expense ratio. The ratio may be stated before or after dividends paid to policyholders. The ratio basically measures the underwiting profitability of an insurance line. If the combined ratio is less than 100, the premiums on the insurance have been sufficient to cover both losses and expenses on line.
What does the expense ratio measure? Identify and explain the two major sources of expense risk to a property-casualty insurer. Why has the long-term trend in this ratio been decreasing?
The expense ratio measures the expenses incurred relative to premiums written. Expense risk is comprised primarily of loss adjustment expenses, which relate to the cost surrounding the loss settlement process, and commission costs paid to insurance brokers and sales agents in an effort to attract business. Large insurance companies have found expense efficiencies in using their own brokers rather than using independent brokers to sell insurance.
What does the loss ratio measure? What has been the long-term trend of the loss ratio? Why?
The loss ratio measures the actual losses incurred on a line of insurance relative to the premiums earned on the line. A ratio greater than 100 implies that the premiums earned did not cover the losses on the product line. The loss ratio has increased from the 60 percent range in the early 1950s to the 70 and 80 percent range in the 1990s into the 2010s. Increases in social inflation and the long-tail risk exposure phenomenon have caused some insurance companies to invest in shorter-term assets that have lower yields and thus generate lower premium earnings. In addition, increased coverage in areas with higher uncertainty of losses has occurred within the industry.
What is the primary function of an insurance company? How does this function compare with the primary function of a depository institution?
The primary function of an insurance company is to provide protection from adverse events. Insurance companies accept premium payments in exchange for compensation in the event that certain specified, but undesirable, events occur. The primary function of depository institutions is to provide financial intermediation for individual and corporate savers. By accepting deposits and making loans, depository institutions allow savers with predominantly small, short-term financial assets to benefit from investments in larger, longer-term assets. These long-term assets typically yield a higher rate of return than short-term assets.
What are the three sources of underwriting risk in the property-casualty insurance industry?
The three sources of underwriting risk in the PC industry are (a) unexpected increases in loss rates, (b) unexpected increases in expenses, and (c) unexpected decreases in investment yields. Loss rates are influenced by whether the product lines are property or liability (with the latter being less predictable), whether they are low-severity high-frequency lines or high-severity low-frequency lines (with the latter being more difficult to estimate), and whether they are long-tail or short-tail lines (with the former being more difficult to estimate). Loss rates also are affected by product and social inflation. Unexpected increases in expenses are a result of increases in commission costs to brokers, general expenses, taxes, and other expenses related to acquisitions. Finally, investment yields depend on the stock and bond markets as well as on the asset allocations of the portfolios.
What are the two major activity lines of property-casualty insurance firms?
The two major lines of property-casualty insurance are: a) Property insurance: Insurance compensating the insured, fully or partially, for personal or commercial property damage as a result of accidents and other events; and b) Liability insurance: Insurance compensating a third party, fully or partially, because its personal or commercial property was damaged as a result of the accidental actions of the insured. In many cases, property and liability insurance is sold together, such as personal or commercial multiple peril and auto insurance. Fire and allied lines usually are sold as property insurance only. Liability insurance is sold separately for coverage such as malpractice or product liability hazards. In addition, reinsurance provides a means for primary insurers to pool their risk by transferring some of the risk and premium to a reinsurer.
Insurance companies will charge a higher premium for which of the insurance lines listed below? Why? a. Low-severity, high-frequency lines versus high-severity, low-frequency lines. b. Long-tail versus short-tail lines.
a. Low-severity, high-frequency lines versus high-severity, low-frequency lines. Insurance companies have a more difficult time predicting the severity of losses for high- severity, low-frequency lines of business, such as earthquakes and hurricanes. In addition, these catastrophic events cause severe damage, meaning the individual risks in the insured pool are not independent. As a result, premiums for high-severity, low-frequency lines will be higher than premiums for low-severity, high-frequency lines. b. Long-tail versus short-tail lines. Losses in long-tail lines of business are harder to predict than in short-tail lines, because claims can be made years after the premiums have been made. Thus, premiums in this category of business will be higher. Modern day examples of such lines include coverage for product liabilities, such as exposure to asbestos.
Identify the four characteristics or features of the perils insured against by property-casualty insurance. Rank the features in terms of actuarial predictability and total loss potential.
• Property versus liability: Maximum levels of losses are more predictable for property lines than for liability lines. • Severity versus frequency: Loss rates are more predictable on low-severity, high-frequency lines than they are on high-severity, low-frequency lines. • Time of exposure: The extent of expected losses is more difficult for long-tail risk exposure phenomenon than for short-tail exposures. • Inflation: The inflation risk of property lines is likely to reflect the underlying inflation of the economy, while the inflation risk of liability lines may be subject to the changing values or social risk of the society.
