Chapter 15

Property-Casualty (P&C) Insurance Regulation

-P&C insurers are chartered at the state level -P&C insurers are regulated by state commissioners -State guarantee funds provide (some) protection to policyholders -The NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS)

Property-Casualty (P&C) Insurance

lUnderwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income -Underwriting risk may result from: -unexpected increases in loss rates -unexpected increases in expenses -unexpected decreases in investment yields

Property-Casualty (P&C) Insurance 4

-An underwriting cycle is a pattern that the profits in the P&C industry tend to follow -The federal government has consistently increased their role of providing compensation and reconstruction assistance following natural disasters

life insurance companies

-Approximately 1,000 life insurance companies exist in the U.S. in the 2010s -compares to 2,300 in 1988 -the industry has seen consolidation to take advantage of scale and scope economies -Aggregate industry assets were $5.73 trillion at the beginning of 2013 -compares to $1.1 trillion in 1988

Property-Casualty (P&C) Insurance Companies

-Currently about 2,700 companies sell property-casualty (P&C) insurance -top 10 firms have a 53% market share -top 200 firms have a 94% market share -Property insurance involves coverage related to the loss of real and personal property -Casualty insurance offers protection against legal liability exposure

Life Insurance Regulation 2

-During the financial crisis Congress considered adding a federal regulator of the insurance industry, but left regulation to the states -Dodd-Frank bill created the Federal Insurance Office (FIO) that reports to Congress and the President on the insurance industry -The FIO is supposed to identify systemic risks arising from insurers, monitor international insurance events, eliminate state regulatory gaps and encourage the offering of insurance products to underserved segments -In 2013, the Financial Stability Oversight Council (FSOC) designated AIG, Metlife and Prudential as systemically important non-banks

Life Insurance Companies 2

-Insurance companies accept or underwrite risk that a pre-specified event will occur in return for insurance premiums -underwriting decisions determine which risks are accepted and which are not -underwriting decisions determine how much to charge (in the form of premiums) for accepted risk -The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage

life insurance companies

-Life insurers pool the risks of individuals to diversify away some of the customer-specific risk -Thus, they are able to offer insurance services at a cost lower than any individual could achieve on his/her own -This allows the transfer of income related uncertainties from the individual to the group -Other activities of life insurance companies: -sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time -manage pension plans (e.g., tax-deferred savings plans) -provide accident and health insurance

Balance Sheets of Property-Casualty (P&C) Insurance Companies

-Loss reserves and loss adjustment expenses -loss reserves are set aside to meet losses from underwriting -loss adjustment expenses represent the administrative and adjusting costs associated with settling claims -Unearned premiums -includes premiums that have been paid before insurance coverage has been provided

Property-Casualty (P&C) Insurance 2

-Loss risk is a function of actuarial predictability -property vs. liability -severity vs. frequency -long-tail vs. short tail -product inflation vs. social inflation -Loss risk is a measure of pure losses incurred to premiums earned -premiums earned are premiums received and earned on insurance contracts because time has passed with no claim filed -Expense risk occurs from two major sources: -loss adjustment expenses (LAE) -commissions and other expenses

Life Insurance Regulation

-McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICs -state insurance commissions charter and examine ICs -the National Association of Insurance Commissioners (NAIC) has developed a coordinated examination system -States promote insurance guarantee funds -funds are run by the insurance companies themselves -contributions are paid only when an IC fails (except in NY) -The Financial Services Modernization Act (FSMA) of 1999 allowed CBs, IBs, and ICs to exist as subsidiaries under one Financial Holding Company (FHC)

Life Insurance Companies 3

-Moral hazard occurs when, after an insurer and a customer enter into an insurance contract, the insured engages in risky behavior because the risk is covered -Actuaries reduce the risks of underwriting insurance -With life insurance, actuaries analyze mortality, produce life tables, and apply time-value-of-money tools to price life insurance annuities and endowment policies -With health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc.

Life Insurance Companies 4

-Ordinary life insurance is marketed to individuals—policyholders make periodic premium payments in exchange for coverage -Term life -beneficiary receives payout at time of death -if insured lives beyond the term of the contract, no benefits are paid -Whole life -policy protects over entire lifetime -beneficiary receives face value of contract upon death -Whole life can be cost effective if purchased when young. Eventually the cash value earnings can eliminate any out of pocket payments by the insured.

Life Insurance Companies

-Other life insurance activities -Annuities are investment vehicles that liquidate a fund (pay investors) over a long period of time -Annuity sales were $356 billion in 2012 -Private pension funds compete with other financial service companies. -In 2013 insurers administered more than $2.9 trillion of pension fund assets -Guaranteed investment contracts (GICs) are instrumental in many of these plans -Other life insurance activities -Accident and health insurance accounted for about 25% of premiums written in 2012 -Life insurers write over 50% of all health premiums

Property-Casualty (P&C) Insurance 3

-The combined ratio is a measure of overall profitability -equals the loss ratio plus LAE to premiums written plus commissions and other expenses to premiums written -Investment yield is measured as net interest income divided by premiums earned -The operating ratio is also a measure of overall profitability -equals the combined ratio minus the investment yield

Insurers and the Financial Crisis of 2008-09

-The life insurance industry performed well during the mid-2000s while the stock markets and the economy were performing well -As the crisis began, insurers experienced losses on mortgage-backed securities, commercial loans, particularly commercial real estate, and on corporate bonds -The result was very large profit declines in 2008 (over 50% declines from 2007) and continuing poor conditions in 2009 on more losses on investments -Industry conditions improved in 2010 through 2012. In 2012 premium income stopped falling, net income rose to $40.9 billion, up from $28 billion in 2010.

Insurance Companies

-The primary function of insurance companies is to compensate policy holders if a prespecified event occurs, in exchange for premiums paid -insurance underwriters assess and price risk -insurance brokers sell insurance contracts -insurance brokers sell insurance contracts -insurance is broadly classified into two groups -life insurance policies provide protection against untimely death or illness, and/or transfer wealth through time to retirement -property-casualty insurance protects against property damage, personal injury and liability associated with specific events -Insurance companies also sell a variety of investment products similar to other FIs

Variable universal life

-a universal policy where the premiums are invested in variable rate earning assets

Universal Life

-allows the insured to change both the premiums and the maturity of the contract

Endowment Life

-beneficiary receives payment at time of death -if insured lives beyond the term of the contract, insured receives face value of the contract

Group life insurance

-covers a large number of persons under a single policy -contributory—both the employer and the employee cover a share of the premiums -noncontributory—the costs are borne entirely by the employer

Variable Life

-premiums are invested in market securities -value of policy depends on the value of the securities

Credit Life Insurance

-protects lenders against borrower death -Credit life is expensive so it is not used much

What is the adverse selection problem?

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.

Difference between primary function of insurance company with that of a depository institution?

The primary function of a life insurance company is to protect policyholders 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.

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