Chapter Fifteen

Insurance Companies

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Insurance Companies (ICs)

The
Theprimary
primaryfunction
functionof
ofinsurance
insurancecompanies
companiesisisto
to
compensate
compensatepolicyholders
policyholdersififaaprespecified
prespecifiedevent
eventoccurs,
occurs,
in
inexchange
exchangefor
forpremiums
premiumspaid
paid

insurance
insuranceunderwriters
underwritersassess
assessand
andprice
pricerisk
risk
insurance
insurancebrokers
brokerssell
sellinsurance
insurancecontracts
contractsfor
forcoverage
coverageor
orfor
foraa
policy
policy

Insurance
Insuranceisisbroadly
broadlyclassified
classifiedinto
intotwo
twogroups
groups

life
lifeinsurance
insuranceprovides
providesprotection
protectionagainst
againstuntimely
untimelydeath,
death,illness,
illness,
and
retirement
and retirement
property-casualty
property-casualtyinsurance
insuranceprotects
protectsagainst
againstpersonal
personalinjury
injuryand
and
liability
liability

Insurance
Insurancecompanies
companiesalso
alsosell
sellaavariety
varietyof
ofinvestment
investment
products
productssimilar
similarto
toother
otherFIs
FIs
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Life Insurance Companies

Approximately
Approximately1,300
1,300life
lifeinsurance
insurancecompanies
companiesexist
existin
inthe
the
U.S.
U.S.in
inthe
themid-2000s
mid-2000s

compares
comparestoto2,300
2,300inin1988
1988
the
theindustry
industryhas
hasseen
seenconsolidation
consolidationtototake
takeadvantage
advantageof
ofscale
scaleand
and
scope
scopeeconomies
economies

Aggregate
Aggregateindustry
industryassets
assetswere
were$4.8
$4.8trillion
trillionatatthe
the
beginning
beginningof
of2007
2007
compares
comparestoto$1.1
$1.1trillion
trillioninin1988
1988

Life
Lifeinsurance
insurancecompanies
companiescan
canbe
beeither
eitherstock
stockor
ormutually
mutually
owned
owned(where
(wherethe
thepolicyholders
policyholdersare
arethe
theowners)
owners)
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Life Insurance Companies

Life
Lifeinsurers
insurerspool
poolthe
therisks
risksof
ofindividuals
individualsto
todiversify
diversify
away
awaysome
someof
ofthe
thecustomer-specific
customer-specificrisk
risk

thus,
thus,they
theyare
areable
abletotooffer
offerinsurance
insuranceservices
servicesatataacost
costlower
lowerthan
than
any
anyindividual
individualcould
couldachieve
achievesaving
savingfunds
fundson
ontheir
theirown
own
allows
allowsthe
thetransfer
transferof
ofincome
incomerelated
relateduncertainties
uncertaintiesfrom
fromthe
the
individual
individualtotothe
thegroup
group

Other
Otheractivities
activitiesof
oflife
lifeinsurance
insurancecompanies
companies

sell
sellannuities,
annuities,which
whichare
aresavings
savingscontracts
contractsthat
thatinvolve
involvethe
the
liquidation
liquidationof
ofthose
thosefunds
fundssaved
savedover
overaaperiod
periodof
oftime
time
manage
managepension
pensionplans
plans(e.g.,
(e.g.,tax-deferred
tax-deferredsavings
savingsplans)
plans)
provide
provideaccident
accidentand
andhealth
healthinsurance
insurance

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Life Insurance Companies

Insurance
Insurance companies
companies accept
accept or
or underwrite
underwrite risk
risk
that
that aa prespecified
prespecified event
event will
will occur
occur in
in return
return for
for
insurance
insurance premiums
premiums

underwriting
underwritingdecisions
decisionsdetermine
determinewhich
whichrisks
risksare
are
accepted
acceptedand
andwhich
whichare
arenot
not
underwriting
underwritingdecisions
decisionsdetermine
determinehow
howmuch
muchto
tocharge
charge
(in
(inthe
theform
formof
ofpremiums)
premiums)for
foraccepted
acceptedrisk
risk

The
The adverse
adverse selection
selection problem
problem isis the
the problem
problem
that
that customers
customers who
who apply
apply for
for insurance
insurance policies
policies
are
are more
more likely
likely to
to be
bethose
thosein
in need
need of
ofcoverage
coverage
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Life Insurance Companies

Moral
Moralhazard
hazardoccurs
occurswhen,
when,after
afteran
aninsurer
insurerand
andaa
customer
customerenter
enterinto
intoan
aninsurance
insurancecontract,
contract,the
theinsured
insured
takes
takesan
anaction
actionnot
nottaken
takeninto
intoaccount
accountin
inthe
thecontract
contractthat
that
changes
changesthe
thevalue
valueof
ofthe
theinsurance
insurance
Actuaries
Actuariesreduce
reducethe
therisks
risksof
ofunderwriting
underwritinginsurance
insurance
with
withlife
lifeinsurance,
insurance,actuaries
actuariesanalyze
analyzemortality,
mortality,produce
producelife
life
tables,
tables,and
andapply
applythe
thetime-value-of-money
time-value-of-moneytotoproduce
producelife
life
insurance
insuranceannuities
annuitiesand
andendowment
endowmentpolicies
policies
with
withhealth
healthinsurance,
insurance,actuaries
actuariesanalyze
analyzethe
therates
ratesof
ofdisability,
disability,
morbidity,
morbidity,mortality,
mortality,fertility,
fertility,etc.
etc.

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Life Insurance Companies

Ordinary
Ordinarylife
life insurance
insurance isis marketed
marketed to
to
individualspolicyholders
individualspolicyholders make
make periodic
periodic
premium
premiumpayments
payments in
in exchange
exchange for
for coverage
coverage
term
termlife
life

beneficiary
beneficiaryreceives
receivespayout
payoutatattime
timeof
ofdeath
death
ififinsured
insuredlives
livesbeyond
beyondthe
theterm
termof
ofthe
thecontract
contractno
nobenefits
benefitsare
are
paid
paid

whole
wholelife
life

policy
policyprotects
protectsover
overentire
entirelifetime
lifetime
beneficiary
beneficiaryreceives
receivesface
facevalue
valueof
ofcontract
contractupon
upondeath
death

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Life Insurance Companies

endowment
endowmentlife
life

beneficiary
beneficiaryreceives
receivespayment
paymentatattime
timeof
ofdeath
death
ififinsured
insuredlives
livesbeyond
beyondthe
theterm
termof
ofthe
thecontract,
contract,insured
insured
receives
receivesface
facevalue
valueof
ofthe
thecontract
contract

variable
variablelife
life

premiums
premiumsare
areinvested
investedininmarket
marketsecurities
securities
value
valueof
ofpolicy
policydepends
dependson
onthe
thevalue
valueof
ofthe
thesecurities
securities

universal
universallife
life

allows
allowsthe
theinsured
insuredtotochange
changeboth
boththe
thepremiums
premiumsand
andthe
the
maturity
of
the
contract
maturity of the contract

variable
variableuniversal
universallife
life

combines
combinesfeatures
featuresof
ofvariable
variableand
anduniversal
universallife
lifeinsurance
insurance

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Life Insurance Companies

Group
Group life
life insurance
insurance covers
covers aa large
largenumber
number of
of
persons
persons under
under aa single
single policy
policy
contributoryboth
contributoryboththe
theemployer
employerand
andthe
theemployee
employee
cover
coveraashare
shareof
ofthe
thepremiums
premiums
noncontributorythe
noncontributorythecosts
costsare
areborne
borneentirely
entirelyby
bythe
the
employer
employer

Credit
Credit life
life insurance
insurance protects
protects lenders
lenders against
against
borrower
borrower death
death

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Life Insurance Companies

Other
Other life
life insurance
insurance activities
activities
annuities
annuitiesare
areinvestment
investmentvehicles
vehiclesthat
thatliquidate
liquidateaafund
fund
over
overaalong
longperiod
periodof
oftime
time
private
privatepension
pensionfunds
fundscompete
competewith
withother
otherfinancial
financial
service
servicecompanies
companies
accident
accidentand
andhealth
healthinsurance
insuranceaccounted
accountedfor
formore
more
than
than$142
$142billion
billionof
ofpremiums
premiumswritten
writtenin
in2007
2007

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Life Insurance Company

Balance Sheets (2007)
Corporate
Corporatebonds
bondsand
andstocks
stocksrepresent
represent73.4%
73.4%of
oftotal
total
assets
assets
matches
matchesthe
thelong-term
long-termnature
natureof
oftheir
theirliabilities
liabilities

Government
Governmentsecurities
securitiesrepresent
represent10.4%
10.4%of
oftotal
totalassets
assets
Policy
Policyloans
loansrepresent
represent7.5%
7.5%of
oftotal
totalassets
assets
policy
policyloans
loansare
areloans
loansmade
madeby
byan
aninsurance
insurancecompany
companytotoits
its
policyholders
policyholdersusing
usingthe
thepolicy
policyas
ascollateral
collateral

Mortgages
Mortgages(mortgage
(mortgagebacked
backedsecurities)
securities)represent
represent6.4%
6.4%
of
oftotal
totalassets
assets

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Life Insurance Company

Balance Sheets (2007)
Policy
Policyreserves
reservesrepresent
represent43.9%
43.9%of
oftotal
totalliabilities
liabilitiesand
and
capital
capital
policy
policyreserves
reservesreflect
reflectexpected
expectedpayment
paymentcommitments
commitmentson
on
existing
existingpolicy
policycontracts
contracts

Separate
Separateaccount
accountbusiness
businessrepresents
represents35.8%
35.8%of
oftotal
total
liabilities
liabilitiesand
andcapital
capital
Deposit
Deposittype
typecontracts
contracts(includes
(includesGICs)
GICs)represents
represents7.0%
7.0%
of
oftotal
totalliabilities
liabilitiesand
andcapital
capital
Capital
Capitaland
andsurplus
surplusreserves
reservesrepresent
represent5.4%
5.4%of
oftotal
total
liabilities
liabilitiesand
andcapital
capital
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Life Insurance Regulation

McCarren-Ferguson
McCarren-FergusonAct
Actof
of1945
1945confirmed
confirmed primacy
primacyof
of
states
statesover
overfederal
federalregulation
regulationof
ofICs
ICs

state
stateinsurance
insurancecommissions
commissionscharter
charterand
andexamine
examineICs
ICs
the
theNational
NationalAssociation
Associationof
ofInsurance
InsuranceCommissioners
Commissioners(NAIC)
(NAIC)
has
hasdeveloped
developedaacoordinated
coordinatedexamination
examinationsystem
system

States
Statespromote
promoteinsurance
insuranceguarantee
guaranteefunds
funds

funds
fundsare
arerun
runby
bythe
theinsurance
insurancecompanies
companiesthemselves
themselves
contributions
contributionsare
arepaid
paidonly
onlywhen
whenan
anIC
ICfails
fails(except
(exceptininNY)
NY)

The
TheFinancial
FinancialServices
ServicesModernization
ModernizationAct
Act(FSMA)
(FSMA)of
of
1999
1999allowed
allowedCBs,
CBs,IBs,
IBs,and
andICs
ICsto
toexist
existas
assubsidiaries
subsidiaries
under
underone
oneFinancial
FinancialHolding
HoldingCompany
Company(FHC)
(FHC)
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Property-Casualty (P&C)
Insurance Companies
Currently
Currently 2,700
2,700 companies
companies sell
sell property-casualty
property-casualty
(P&C)
(P&C) insurance
insurance
top
top10
10firms
firmshave
haveaa48%
48%market
marketshare
share
top
top200
200firms
firmshave
haveaa94%
94%market
marketshare
share

Property
Property insurance
insurance involves
involves coverage
coverage related
related to
to
the
the loss
loss of
ofreal
real and
and personal
personal property
property
Casualty
Casualty insurance
insurance offers
offers protection
protection against
against
legal
legal liability
liability exposure
exposure
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Property-Casualty (P&C) Insurance

Fire
Fireinsurance
insuranceand
andallied
alliedlines
lines

4.3%
4.3%of
ofpremiums
premiumswritten
writteninin2006
2006vs.
vs.16.6%
16.6%inin1960
1960

Homeowners
Homeownersmultiple
multipleperil
peril(MP)
(MP)

12.5%
12.5%of
ofpremiums
premiumswritten
writteninin2006
2006vs.
vs.5.2%
5.2%inin1960
1960

Common
Commonmultiple
multipleperil
peril

4.3%
4.3%of
ofpremiums
premiumswritten
writteninin2006
2006vs.
vs.0.4%
0.4%inin1960
1960

Auto
Autoliability
liabilityand
andphysical
physicaldamage
damage(PD)
(PD)

39.3%
39.3%of
ofpremiums
premiumswritten
writteninin2006
2006vs.
vs.43.0%
43.0%inin1960
1960

Liability
Liabilityinsurance
insurance(other
(otherthan
thanauto)
auto)

14.7%
14.7%of
ofpremiums
premiumswritten
writteninin2006
2006vs.
vs.6.6%
6.6%inin1960
1960

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Balance Sheets of Property-Casualty

(P&C) Insurance Companies (2007)

Bonds
Bondsand
andstocks
stocksrepresent
represent69.6%
69.6%of
oftotal
totalassets
assets
Losses
Lossesand
andloss
lossadjustment
adjustmentexpenses
expensesrepresent
represent37.1%
37.1%of
of
total
totalliabilities
liabilitiesand
andcapital
capital

loss
lossreserves
reservesare
areset
setaside
asidetotomeet
meetlosses
lossesfrom
fromunderwriting
underwriting
loss
lossadjustment
adjustmentexpenses
expensesrepresent
representthe
theadministrative
administrativeand
and
adjusting
adjustingcosts
costsassociated
associatedwith
withsettling
settlingclaims
claims

Unearned
Unearnedpremiums
premiumsrepresent
represent13.7%
13.7%of
oftotal
totalliabilities
liabilities
and
andcapital
capital

includes
includespremiums
premiumsthat
thathave
havebeen
beenpaid
paidbefore
beforeinsurance
insurancecoverage
coverage
has
hasbeen
beenprovided
provided

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Property-Casualty (P&C) Insurance

Underwriting
Underwriting risk
risk isis the
the risk
risk that
that premiums
premiums are
are
insufficient
insufficient to
to cover
cover losses
losses and
and administrative
administrative
expenses
expenses after
after taking
taking into
into account
account investment
investment
income
income
Underwriting
Underwriting risk
risk may
may result
result from
from
unexpected
unexpectedincreases
increasesin
inloss
lossrates
rates
unexpected
unexpectedincreases
increasesin
inexpenses
expenses
unexpected
unexpecteddecreases
decreasesin
ininvestment
investmentyields
yields

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Property-Casualty (P&C) Insurance

Loss
Lossrisk
riskisisaafunction
functionof
ofactuarial
actuarialpredictability
predictability

property
propertyvs.
vs.liability
liability
severity
severityvs.
vs.frequency
frequency
long-tail
long-tailvs.
vs.short
shorttail
tail
product
productinflation
inflationvs.
vs.social
socialinflation
inflation

Loss
Lossrisk
riskisisaameasure
measureof
ofpure
purelosses
lossesincurred
incurredto
topremiums
premiums
earned
earned
premiums
premiumsearned
earnedare
arepremiums
premiumsreceived
receivedand
andearned
earnedon
on
insurance
contracts
because
time
has
passed
with
no
claim
insurance contracts because time has passed with no claimfiled
filed

Expense
Expenserisk
riskoccurs
occursfrom
fromtwo
twomajor
majorsources
sources

loss
lossadjustment
adjustmentexpenses
expenses(LAE)
(LAE)
commissions
commissionsand
andother
otherexpenses
expenses

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Property-Casualty (P&C) Insurance

The
The combined
combined ratio
ratio isis aa measure
measure of
of overall
overall
profitability
profitability

equals
equalsthe
theloss
lossratio
ratioplus
plusLAE
LAEto
topremiums
premiumswritten
written
plus
pluscommissions
commissionsand
andother
otherexpenses
expensesto
topremiums
premiums
written
written

Investment
Investment yield
yield isis measured
measured as
as net
net interest
interest
income
income divided
divided by
by premiums
premiums earned
earned
The
The operating
operating ratio
ratio isis also
also aa measure
measure of
of overall
overall
profitability
profitability

equals
equalsthe
thecombined
combinedratio
ratiominus
minusthe
theinvestment
investmentyield
yield

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Property-Casualty (P&C) Insurance

Much
Muchof
ofthe
the1987
1987to
to2007
2007period
periodwas
wascharacterized
characterizedby
by
catastrophes
catastrophesof
ofhistorically
historicallyhigh
highseverity
severity

9/11/2001
9/11/2001terrorist
terroristattacks
attacks
2004
2004Florida
Floridahurricanes
hurricanes
2005
2005hurricane
hurricaneKatrina
Katrina

An
Anunderwriting
underwritingcycle
cycleisisaapattern
patternthat
thatthe
theprofits
profitsin
inthe
the
P&C
P&Cindustry
industrytend
tendto
tofollow
follow
The
Thefederal
federalgovernment
governmenthas
hasincreasingly
increasinglyincreased
increasedtheir
their
role
roleof
ofproviding
providingcompensation
compensationand
andreconstruction
reconstruction
assistance
assistancefollowing
followingnatural
naturaldisasters
disasters
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Property-Casualty (P&C)
Insurance Regulation

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

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