7.2 Insurance Companies and Pension Funds

What do Insurance companies do?

Assume the risk of their clients in return for a fee (premium)

What is a premium?

a fee paid to insurance companies in return for covering risk

Certainty equivalent

What are most ppl who get insurance like?

Risk averse

• rather pay a certainty equivalent than accept a gamble

What are the 7 basical principles all insurance companies are subject to?

1. There must be a relationship btw insured + beneficiary. beneficiary must be someone who would suffer if it weren’t for the insurance

2. Insured must provide full and accurate info to insurance company

3. Insured is not to profit as a result of insurance coverage

4. If a 3rd party compensate the insure for the loss, the insurance company’s obligation is reduced by the amount of compensation

5. Insurance company must have a large number of insured so that the risk can be spread out among many different policies

6. loss must be quantifiable

7. insurance company must be able to compute the probability of the loss’s occuring

What problems are caused by adverse selection in insurance?

Adverse selection → raises the issue of which policies should be accepted

• most likely to suffer loss are most likely to apply for insurance

• extreme - insurance companies should turn anyone who applies for an insurance company

How do insurance companies deal with problems from adverse selection?

• health insurance companies require physical exam

• Preexisting conditions may be excluded from the policy

How does Moral hazard in insurance?

Moral hazard occurs in the insurance industry when the insured fails to take proper precautions to avoid losses because losses are covered by the insurance policy

• insurance companies use deductibles to help control this problem

What are the different ways to sell insurance?

• independent agents - may sell the insurance products of a number of different insurance companies

• Exclusive agents - only sell the products of one company

• Underwrite - reviews each policu prior to its acceptance to determine if the risk is acceptable

How are insurance companies organised?

• Stock insurance company - owned by shareholders and has a profit motive

• Mutual insurance company - owned by policyholders and attempt to provide the lowest cost insurance

what does the no. of lie insurance companies in the US show?

What are the different types of insurance?

• life insurance

• health insurance

• property and casualty insurance

What are some of the typical policies included in life insurance?

• Term life: insured is covered while the policy is in effect (usually 10-20 years)

• Whole life: similar to term life, but allows policyholder to borrow ag/ the policies cash value. when the term of policy expires, the insured can get the cash value of the policy

• Universal Life: inc term life portionand savings portion

• Annuities: pays a benefit to the insured until death to cover retirement

How do life insurance companies derive funds:

1. receive premiums that must be used to payout future claims when the insured dies

2. receive premiums paid into pensuon funds managed by the life insurance company

What are the 2 primary liabilities of life insurance?

• life insurance payouts

• pension fund payouts

What does the distribution of life insurance company asstes look like?

What does the percentage of life insurance company assets invest in mortgages

How is health insurance priced?

Health insurance is most vulnerable to adverse selection problem - those w/ health problems are more likely to seek coverage

• individual policies must be prices assuming adverse selection

• Most health insurance is offered through group policies

How do they try to reduce health insurance costs

An attempt to shift costs to employers

Health maintenance organisations

• as it is a hot topic of political enviornment

What is property insurance?

Protects businesses owners from the risk associated with ownership.

• either named-peril policies or open-peril policies

What are namediperil policies?

insures against any losses only from perils specifically named in the policy

What are open-peril policies?

insures against any losses except from perils specifically named in the policy

What is casualty insurance? What else is it known as?

also known as liability insurance

protects ag/ financial losses bc/ of a claim of negligence

What is reinsurance?

allocates a portion of the risk to another company in exchange for a portion of the premium

What did the terrorism risk insurance act of 2002 say?

based on 9-11 attacks in NYC - new lesigliation passed

limiting the amount insurance firms would be required to pay out in the event of future attacks

• gov will pay 90% of losses up to $100 billion

• limits exposure for insurance companies

What are monoline insurance companies?

specialize in credit insurance and are the only insurance companies that are allowed to provide insyrance that guarantees the timely repayment of bond principal and interest when a debt issuer defaults.

• All other insurance companies are prohibited from doing this

• Help lower required interest by providing a credit enhancement. The crisis affected them as well.

What happened with monoline insurers during the subprime crisis?

• monoline insurers did insure debt backed by subprime mortgages

• Defaults on these mortgages resulted in credit downgrades for the insurers

• Weakened value of their insurance guarantees which spilled over into their municipal securities insurance

• Investors reduced the value of their insurance 0> municipalities started seeing higher interest costs. This, in turn, resulted in lower spending on roads, schools, etc.

What is a pension plan

An asset pool that accumulates over an individual’s working years and is paid out during the nonworking years

• developed as Americans began relying less on children for care during their later years

• became popular as life expectancy increased

What are the types of pensions?

• defined-benefit pension plan

• defined-contribution pension plan

• private pension plan

• public pension plan

What is a defined-benefit pension plan?

A plan where the sponsor promises the employee a specific benefit when they retire

What are the types of defined-benefit pension plan?

• fully funded: sufficient funds are available to meet payouts

• overfunded: funds exceed the expected payout

• underfunded: funds are not expected to meet the required benefit payout

What is defined-contribution pension plan?

a plan where a set amount is invested for retirement, but the benefit payout is uncertain

What is a private pension plan?

any pension plan set up by employers, groups or individuals

What is a public pension plan?

Any pension plan set up by a gov body for the general public (social security)

What is social security?

• pay as you go system, where current funding is used to pay current benefits

• projected number of workers is falling while projected number of retirees is increasing, which will cause the problems in years to come if not

• Its difficult to measure the health of the social security system. Many factors are hard to predict such as birth rates and the rate of immigration. Although it may not fail, itd be wise for you plan other sources for your retirement cash flows

What are the future of pension funds?

We can expect their growth and popularity as the average population continues to grow

variety of pension fund offerings may increase as well

pension funds may gain significant control of corporations as their stock holdings increase