Institutions Ch 15 (Done)

policyholders

Primary function of insurance companies is to compensate ____________ if a prespecified event occurs, in exchange for premiums paid to the insurer by the policyholder

Insurance provider can act in one of two roles:

• Insurance underwriter assess risk of an applicant for coverage

• Insurance brokers sell insurance contracts

Insurance underwriter

______________________assess risk of an applicant for coverage

Insurance brokers

___________________sell insurance contracts

Insurance is broadly classified into two groups

• Life insurance policies provide protection against untimely death, illness, and retirement

• Property-casualty insurance protects against personal injury and liability due to accidents, theft, fire, and other catastrophes

Life insurance

_________________ policies provide protection against untimely death, illness, and retirement

Property-casualty insurance

_________________________ protects against personal injury and liability due to accidents, theft, fire, and other catastrophes

financial service firms

Insurance companies also sell a variety of investment products, similar to other __________________

Life insurers pool the risks of individuals to diversify away some of the customer-specific risk

• Because of this, they can offer insurance services at a cost (premium) lower than any individual could achieve on his or her own

• Life insurers transfer income-related uncertainties, such as those due to retirement, from the individual to the group

Other activities of life insurance companies:

• Sell annuity contracts, which are savings contracts that involve the liquidation of those funds saved over a period of time

• Manage pension plans (tax-deferred savings plans)

• Provide accident and health insurance

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

• Major part of underwriting process is determining which risks should be accepted and which should be rejected

• For accepted risks, underwriters must determine how much to charge (in the form of premiums) 

  • E.g., a smoker would likely be charged a higher premium than a non-smoker and an increased probability of a major pandemic might cause insurers to increase life and health insurance premiums to all insured groups

Adverse selection problem exists because customers who apply for insurance policies are more likely to be those most in need of coverage

• E.g., someone with chronic health problems is more likely to purchase a life insurance policy than someone in perfect health

Actuaries have traditionally worked in life insurance to reduce the risks of underwriting and selling life insurance

• With traditional life insurance, actuaries analyze mortality, produce life tables, and apply time value of money concepts to produce life insurance, annuities, and endowment policies

• With health insurance, actuaries analyze rates of disability, morbidity, mortality, fertility, and other contingencies

Four basis classes (or lines) of life insurance are distinguished by the way they are sold or marketed to purchasers:

1. Ordinary life

2. Group life

3. Credit life

4. Other activities

Life Insurance Four basic classes statistics

Of the $21.2 trillion life insurance policies in force in the U.S. at year-end 2021, ordinary life accounts for 64.2%, group life for 35.4%, and credit life for less than 1%

Ordinary life

___________ policies are marketed on an individual basis, usually in units of $1,000; policyholders make periodic premium payments in exchange for coverage

Term life

___________ is the closest to pure life insurance; has no savings element attached and beneficiary receives payout at the time of the individual’s death during the coverage period

Whole life

___________ protects the individual over an entire lifetime rather than for a specified coverage period

Endowment life

____________________ combines a pure (term) insurance element with a savings element

Variable life

________________ invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments

• Universal life and variable universal life

Group life insurance covers a large number of insured persons under a single policy

• Usually issued to corporate employers, these policies may be contributory or noncontributory

  • Contributory requires both the employer and employee cover a share of the employee’s cost of insurance

  • Noncontributory means the cost of the employee’s insurance is paid entirely by the employer; employee does not contribute to the cost of the insurance

Credit life insurance protects lenders against a borrower’s death prior to the repayment of a debt contract, such as a mortgage or car loan

• Usually, face amount of policy reflects outstanding principal and interest on the loan

Other activities of life insurers include the sale of annuities, private pension plans, and accident and health insurance

• Annuities represent the reverse of life insurance principals

  • Life insurance involves building up a fund and eventually paying out a lump sum, while annuities involve different methods of liquidating a fund over a long period of time 

  • Popular mechanism for retirement savings because, unlike IRAs, annual annuity contributions are not capped and are not affected by the policyholder’s income level

  • Annuity sales in 2021 topped $315.9b, compared to $26.1b in 1996

• Insurance companies offer many alternative pension plans to private employers

• More than $192 billion in accident and health premiums were written by life and health companies in 2021

Assets

• Life insurers concentrate their asset investments at the longer end of the maturity spectrum (e.g., corporate bonds, equities, and government securities)

  • In 2021, 6.0% of assets were invested in government securities, 65.7% in corporate bonds and stocks, and 8.0% in mortgages

Liabilities

• Net policy reserves made up $6.4 trillion, or 73.7% of total liabilities and capital, in 2021

• To meet unexpected future losses, life insurers hold a capital and surplus reserve fund with which to meet such losses

  • Capital and surplus reserves for life insurers in 2021 totaled $497.1 billion, or 5.7% of their total liabilities and capital

• Insurers earn profits by taking in more premium and interest income than they pay out in policy payments

• Firms can increase their spread between premium income and policy payouts in two ways:

1. Decrease future required payouts for any given level of premium payments

   • Accomplished by reducing the risk of the insured pool

2. Increase the profitability of interest income on net policy reserves

Industry was very profitable in the early and mid-2000s

2008-2009 financial crisis took a toll on this industry

• Treasury Department extended bailout funds to several struggling life insurers (e.g., AIG, Allstate, Lincoln National, etc.) in late 2008/early 2009

Late 2009 saw improvements in the industry, and premiums continued to recover in 2010 through 2021

Recent Trends

• Net income increased to $28.0 billion in 2010, and $48.7 billion in 2018, it dropped to $39.6 billion in 2020

• Life insurers paid out a record $90.4 billion in death benefit payments in 2020, a 15.4% increase from the payments in 2019

  • Greatest year-to-year increase since 1917-1918 influenza pandemic

• In 2021, net income recovered to $54.1 billion

McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of insurance companies

• State insurance commissions charter, supervise and examine ICs using a coordinated examination system develop by the National Association of Insurance Commissioners (NAIC) 

  • Regulations cover areas such as insurance premiums, insurer licensing, sales practices, commission charges, and the types of assets in which insurers may invest

States promote life insurance guarantee funds

• Run and administered by the private insurers themselves

• Contributions are paid only when an IC fails (except in NY)

• Size of required contributions that surviving insurers make to protect policyholders in failed ICs differs widely from state to state

• Delay usually occurs before small policyholders receive payments from the guarantee fund

In 2009, Congress considered establishing an optional federal insurance charter

Wall Street Reform and Consumer Protection Act of 2010 created the Federal Insurance Office (FIO), called for the establishment of the Financial Stability Oversight Council (FSOC), and resulted in the Fed becoming a major supervisor of insurance firms

• FIO has authority to monitor insurance industry, identify regulatory gaps or systemic risk, deal with international insurance matters, and monitor the extent to which underserved communities have access to affordable insurance products 

• FSOC is charged with identifying any financial institution (including insurance companies) that presents a systemic risk to the economy and subjecting such institutions to greater regulation

Currently, close to 2,600 companies sell property-casualty (P&C) insurance, and approximately half of those firms write P&C business in all or most of the U.S.

• Top 10 firms have a 51.4% market share

• Top 200 firms make up 96.2% market share

• In 2018, State Farm was the top firm, writing 9.7% of all P&C insurance premiums

Distinctions between the two broad areas of property and liability insurance are becoming increasingly blurred

• Property insurance involves insurance coverages related to the loss of real and personal property

• Casualty (or, liability) insurance offers protection against legal liability exposures

Fire insurance and allied lines

• ____________________________ protects against the perils of fire, lightning, and removal of property damaged in a fire

  • 5.4% of net premiums earned in 2021

Homeowners multiple peril (MP) insurance

• _________________________________ protects against multiple perils of damage to a personal dwelling and personal property, as well as liability coverage against the financial consequences of legal liability resulting from injury to others

  • 14.4% of net premiums earned in 2021

Commercial multiple peril (MP) insurance

• ________________________________ protects commercial firms against perils similar to homeowners MP insurance

  • 6.1% of net premiums earned in 2021

  • Automobile liability and physical damage (PD) insurance provides protection against losses resulting from legal liability due to the ownership/use of the vehicle and theft or damage to vehicles

  • 36.1% of net premiums earned in 2021

Liability insurance (other than auto)

• 11.2% of net premiums earned in 2021

Balance Sheets of P&C Companies (Assets)

• P&C insurers invest most of their assets in long-term securities, although the proportion held in common stock is lower than that of life insurance companies

• Bonds, preferred stock, and common stock represented 72.4% of total assets in 2019

Balance Sheets of P&C Companies (Liabilities)

• Loss reserves and loss adjustment expenses are a major component (31.3% of total liabilities and capital)

  • Loss reserves are funds set aside to meet expected losses from underwriting the P&C lines

  • Loss adjustment expenses are the expected administrative and related costs of adjusting (settling) claims

• Unearned premiums are 13.0% of total liabilities and capital

Underwriting risk results when premiums generated on a given insurance line are insufficient to cover claims (losses) and administrative expenses, after considering investment income generated 

Underwriting risk may result from the following:

• Unexpected increases in loss rates (or loss risk)

• Unexpected increases in expenses (or expense risk)

• Unexpected decreases in investment yields or returns (investment yield/return risk)

Key feature of claims loss risk is the actuarial predictability of losses relative to premiums earned, which are premiums received and earned on insurance contracts because time has passed without a claim being filed

• In general, the following is true:

  • Maximum levels of losses are more predictable for property lines than for liability lines

  • Loss rates are more predictable on low-severity, high-frequency lines than on high-severity, low-frequency lines

  • Long-tail risk exposure makes estimation of expected losses difficult

  • Loss rates on all P&C property policies are adversely affected by unexpected increases in inflation, while liability lines may be subject to social inflation, as reflected by juries’ willingness to award punitive and other damages at rates far above the underlying rate of inflation

• Reinsurance, essentially insurance for insurance companies, is an alternative to managing risk on a P&C insurer’s balance sheet

Loss ratio measures actual losses incurred on a specific policy line; calculated as ratio of losses incurred to premiums earned

• Loss ratio of less than 100 percent means that premiums earned were sufficient to cover losses incurred on that line

• Loss ratio, net of loss adjustment expenses (LAE), in 2021 was 62.2%, down from 63.6% in 2012

Expense ratio is calculated as expenses incurred (before federal income taxes) divided by premiums written

Two major sources of expense risk to P&C insurers are:

1. Loss adjustment expenses (LAE), which relate to the costs surrounding the loss settlement process

2. Commissions and other expenses

Combined ratio is a measure of overall profitability of a line

• Calculated as the loss ratio plus the ratios of loss-adjusted expenses to premium earned as well as commission and other acquisition costs to premiums written plus any dividends paid to policyholders as a proportion of premiums earned

  • If the combined ratio is less than 100 percent, premiums alone are sufficient to cover both losses and expenses related to the line

• In 2018, the combined ratio was 99.3%

Investment yield is calculated as net investment income divided by premiums earned

• In 2018, the investment yield was 11.4%

Operating ratio is also a measure of overall profitability; calculated as the combined ratio minus the investment yield

• In 2018, the operating ratio was 88.5%

Underwriting cycle is a pattern that the profits in the P&C industry tend to follow

• Much of 1985-2021 period was not profitable for the P&C industry

  • Combined ratio after dividends was 116.2 in 1985, 115.7 in 1992

  • Major reason for poor performance was a succession of catastrophes

  • Estimates of 2001 terrorist attacks on the World Trade Center and the Pentagon were as high as $19 billion for insurers

  • Losses rose significantly in 2008 through 2012 due to jump in catastrophe losses and losses associated with financial crisis

  • Profitability surged to its highest level in the post-crisis era in 2013-2016, but insured losses due to natural disasters in 2017 were more than triple the amount for 2016

  • The combined ratio after dividends worsened in 2020 and 2021 due to the Covid-19 pandemic, but sustained premium growth, prior-year reserve releases, and lower loss costs in auto market offset the losses

P&C insurers are chartered at the state level and regulated by state commissions

State guarantee funds provide (some) protection to policyholders, similar to the manner described for life insurance companies, should a P&C insurer fail

Additional burden faced by P&C insurers in some activity lines – especially auto insurance and workers’ compensation insurance – is rate regulation

• Given the social welfare importance of these lines, state commissioners often set ceilings on the premiums and premium increases in these lines

P&C industry has come under attack in recent years for the way it handled claims from homeowners associated with Hurricane Katrina

Insurance sector is becoming increasingly global

• While the U.S., Japan, and western Europe dominate the global market, all regions are engaged in the insurance business and many insurers are engaged internationally

2017 was the costliest year for the worldwide insurance industry

• Natural disasters cost insurers a record $138 billion in losses, though losses in North America accounted for 83% of the total

• Key driver of  losses in 2017 were the hurricanes Harvey, Irma, and Maria, which struck the USA and Caribbean in the space of a few weeks

2021 had overall economic losses from natural disasters of $259 billion, which is up 20% from the previous year’s total and also higher than the previous 10-year average of $229 million

Global Issues