CHAPTER

25
Insurance &
Pension Fund
Operations
Chapter Objectives

 Describe the different types of insurance

policies and their sources of funds
 Describe the main uses of insurance company
funds
 Explain the exposure of insurance companies
to various forms of risk
Insurance Concepts

 Insure unexpected, independent risk

occurrence
 Premium covers losses, administrative
expenses and profits
 Insured contracts for known loss (premium) in
return for protection
 Moral hazard and adverse selection
Background

 Life insurance companies

 Provide risk management contracts for individuals
and businesses
• Risk areas include premature death, health maintenance
costs, and disability
• Life insurance provides cash benefits to the beneficiary of
a policy on the policyholder’s death
• Life insurance premiums reflect
 Probability of making payment to the beneficiary
Types of Life Insurance Policies

1. Whole life insurance includes both a death

benefit (term insurance) and a savings
component that
 Builds a tax sheltered cash value amount for the
future for the owner of the policy
 Generates periodic cash flow payments over the
life of the policy for the insurance company to
reinvest
 Pays fixed death benefit at death
Types of Life Insurance Policies

2. Term life insurance characteristics

 Temporary, providing death benefits only over a
specified term
 Premiums paid represent insurance only with no
saving component
 Considerably lower cost for the insured than
whole life—able to buy more insurance protection
for any amount of premium
 Term is for those who would rather invest their
savings in other contracts or securities
Types of Life Insurance Policies

3. Variable life insurance

 Whole life with variable cash value amounts
 Cash values invested in equities and will vary with
the investment performance
4. Universal life insurance
 Combines the features of term and whole life
 Variable premiums over time—buys terms and
invests difference in a variety of investments
 Builds a varying cash value based on contributions
and investment performance
Types of Life Insurance Policies

5. Group plans
 Employees of a corporation are offered life
insurance
 Cash value or term insurance
 Low cost (term) because of its high volume
 Can cover group members and dependents
Sources of Life Insurance Company
Funds
Insurance Company Capital

 Capital
 Build capital by issuing new stock (stock
companies) or retaining earnings
 Used to finance investments in fixed assets
 Cushion against operating losses
 Capital requirements vary depending on asset risk
 Credibility with customers is also enhanced by
adequate capital
Uses of Life Insurance Company Funds

 Major investor in corporate bonds

 Government securities
 Common stock
 Commercial mortgage
 Real Estate
 Policy loans to insured
Uses of Funds - Policy Loans

 Policy loans are loans to policyholders

 Whole life policies
 Borrow up to the cash value of the policy or a
specified portion
 Guaranteed interest rate is stated in the policy
 Usually used by borrowers during periods of
rising rates to lock in the lower rate associated
with their policy
Risks of Life Insurance Companies

Financial Risk
Pure Risk of Life
includes
Insurance Policies:
Interest Rate Risk
Pension
Credit Risk
Commitments and
Market Risk
Annuities Contracts
Liquidity Risk
Exposure to Financial Risks

 Interest rate risk

 Fixed rate assets in company portfolios have
market values sensitive to interest rate changes
 Firm measures and manages risks
 Credit risk
 Mortgages, corporate bonds and real estate
holdings can involve default
 Investment-grade securities
 Diversify portfolio among debt issuers
Exposure to Financial Risks

 Market risk
 Exists because events like significant market
value decreases reduce capital
 Economic downturn affects real estate
investments
Exposure to Financial Risks

 Liquidity risk occurs because a high frequency

of claims may require the life company to
liquidate assets
 Life insurance companies have high cash flow
from premiums to offset normal cash needs
 In case of large disaster (9/11) may be forced to
sell assets to generate cash even if market value is
low
 Companies try to balance the age distribution of
their customer base
 As interest rates rise, voluntary terminations of
policies occur
Property and Casualty Insurance (PC)
Versus Life Insurance Companies
 PC have shorter contracts
 PC have more varied risk areas
 Life companies larger due to long-term
savings and pension contracts
 PC has wider distribution of Occurrences
• PC’s need liquid, marketable assets
• PC’s earnings more volatile
Performance Evaluation

 Common indicators of company performance

are available
 Ratio analysis
 Trends
over time
 Compare to industry average
Performance Evaluation
 Return on net worth or policyholders’ surplus is a profitability measure
 Net profit consists of underwriting profits, investment income, and realized
capital gains.

Net Profits
Return on Equity =
Policyholders’ Surplus
Performance Evaluation
 Underwriting gains and losses or underwriting profitability measured by the net underwriting
margin
 The difference between premiums collected on insurance policies and business expenses plus
claims paid out is the underwriting income.

Net Underwriting Underwriting Income

=
Margin Total Assets
Other Issues

 Insurance companies interact in a variety of

ways with other financial institutions
 Insurance companies participate in a full range
of financial markets
 Multinational insurance companies
 Insurance companies operate in many countries
 Some countries lack developed markets for
insurance
 Multinational investments
Pension Fund
Operations
Chapter Objectives

 Describe the different types of private

pension funds and the terminology of
pension funds
 Describe the pension management styles
 Explain how pension funds can become
underfunded and overfunded
Pension Fund Terminology Summary

Public vs. Trusteed vs.

Private Insured

Under Defined
Funded vs. Benefit vs.
Over Contribution
Background on Pension Funds

 Public pension funds

 Social security
 State and local governments
 Many public pensions are funded on a pay-as-
you-go system
 Private pension plans are created by private
agencies
Types of Private Pension Plans
 Defined-benefit plan
 Annual contributions are determined by the benefits
“defined” in the plan paid at retirement
 Future pension obligations of a defined-benefit plan
are uncertain because obligations are fixed payments
to retirees and payments depend on salary level,
retirement ages and life expectancies
 Employer bears the investment risk
Types of Private Pension Plans

Under-funded Pension Plan

 When the pension assets are not enough to cover the

current and future obligation
 High risk investments might be used to generate higher
returns with varied results
Types of Private Pension Plans

Over-funded Pension Plan

When investment returns for defined-benefit plans perform better than
expected, there are funds in excess of the amount needed to meet obligations
 If value of pension assets exceeds current and future benefits owed,
employer may
 Reduce future contributions
 Distribute surplus to shareholders
A portion of the surplus can be credited to the income statement of a
corporation
Types of Private Pension Plans

 Defined-contribution plan
 Provides benefits determined by the accumulated
contributions and the fund’s investment
performance
 Firm knows with certainty the amount of the
contribution
 Provides uncertain benefits to participants
Pension Fund Management

 Management of “insured” portfolios

 Some plans are managed by life insurance
companies
 Insured plans purchase annuity policies so the life
insurance company can provide benefits to the
employees upon retirement
 Retirement benefits are “assured” by credit
strength of life insurance company
 No federal insurance coverage
Pension Fund Management

 Management of trusteed portfolios

 Managed by the trust department of a financial
institution
 Corporations specify guidelines
 Returns
 Risks

 Some companies have allocation systems to

minimize risks
Pension Fund Management

 Differences between trusteed and insured

portfolios
 Trusts offer higher returns with higher risk via
investment in stocks
 Mortgages are more important in insurance
company portfolios
 Both invest in bonds
Pension Fund Management

 Management of private versus public pensions

 Private pension portfolios dominated by common
stock
 Public pension portfolios more evenly invested in
stock, bonds and other credit instruments
Pension Fund Management

 Pension
funds use their large ownership stakes
in companies to influence corporate policies
and management
 Examples of government pension funds that are
actively involved in issues of corporate control
 California Pension Employees Retirement System or
CalPERS
 New York State Government Retirement Fund
 TIAA
Pension Fund Management

 Management of interest rate risk is important

if portfolios hold long-term, fixed-rate bonds
 Funds willing to accept market returns can
purchase index portfolios for bonds and stocks
 Futures are used to hedge market downturns
 Approaches to risk vary