Insurance Companies January 20th, 2010 Class 6 The Insurance Industry Life Insurance Companies: Protect against untimely death; offer annuities; manage pension plans; provide health and accident plans. Property and Casualty (a.k.a. Liability) Insurance Companies: - Property insurance involves the loss of real property from luggage to the aircraft on which it flies. - Casualty insurance provides protection from liability to others such as wrongful death, injury awards, faulty products… Life Insurance Consolidating industry due to benefits of economies of scale. Stock vs Mutual Companies Change in means of selling policies – commercial banks vs. independent insurance sales offices. Financial Intermediation Life insurers pool risks of individuals so as to minimize the financial impact of an accident involving death or injury. Therefore, they stand between (1) large groups of people who pay the insurers relatively small sums and (2) small groups of people (the unfortunate ones) and pay out (give back) large sums of money. Given that there is usually a timing difference between when premiums (life insurance payments) are received and when claims (life insurance payments to those insured) are received, the insurers invest money. In that sense, they are just like commercial banks in that the hold peoples money and invest it for them. Types of Products Although the book breaks down “life” insurance into several groups, there are only really two important ones: Term life: “pure life” insurance where you pay so much a month and should you die earlier than expected “bingo you win” and the life insurance company “loses”. Whole life: combination of “pure life” insurance and a tax advantaged savings product. (The book seems somewhat confused between Whole and Endowment Life – so let’s just use my definition here). Examples Term life: you pay $25 a month every month for $200,000 in life insurance. You die, your beneficiary gets the $200,000. When/if you stop making your payment; you get nothing back. So insurance is only valid as long as you make payments. Whole life: at age 30 you commit to pay $200 a month until you turn 65 and get $200,000 in life insurance protection. There is a savings component so principal builds over time (“cash value” of life insurance policy). If you reach 65, you get $200,000 in savings and you stop paying premiums. If you stop before 65, you will get whatever the “cash value” of the policy is less the upfront commission to the salesperson. Book Confusion – it may be that under “Whole life”, companies are required to pay a death benefit even after someone has stopped contributing, but that payment is reduced to some type of average amount based on amount paid and time passed). Example (continued) The sales commission on $200,000 can be say $6,000 which means that you get very little principal and interest in the early years credited to the Cash Value of your account. Therefore, breakeven (where total Premiums Paid = Cash value) may occur after 7 to 10 years depending on the investment climate and terms of your contract. Why invest in a Whole Life policy: Tax advantaged return – Uncle Sam gives you a freebie! Recent scandal occurred where insurance agents were pushing people to cash in their Whole life policies to get “a lot more life insurance for their money (note the difference in premiums in our two examples”). Regulators responded harshly fining the guilty companies heavily. Other aspects of Life Insurance Health and Accident; Disability require similar ACTUARIAL analysis of the different pools. Actuaries are “rocket scientists” who love statistics and produce “black boxes”. Insurers are always trying to predict the future “behavior” of their insurance pools and wanting to avoid “adverse selection”. Adverse selection means that those who are most in need of insurance will be the ones seeking it. Hence if they are insurable they need to pay according to their higher risk. Or if deemed uninsurable excluded. Adverse selection would of course also include the fraudsters! Other Aspects (continued) Group vs individual is only a distinction in how life insurance is sold. In terms of adverse selection there is always a transfer of the risk of he/she who abuses or is simply in greater need of insurance to the rest of the group. With Group policies, an employer may decide that it is offering its employees certain insurance policies and may be more tolerant of this risk transfer e.g. it may give the employees the benefit of health insurance at a subsidized cost charging the healthy and the less healthy the same. Usually, they will screen for smoking, drugs, and alcohol abuse. Life insurers tend to have longer term liabilities and hence tend to invest in longer term assets compared to banks. Investments include government bonds; corporate bonds and equity; bundled mortgage securities. Note the Separate Account on the balance sheet of the Life Insurers – this is where the Life Insurer is acting more like an Agent and is holding the assets in trust for the policy holder. These include the variable return policies where an investor chooses to be in e.g. a stock mutual fund and is promised only the return the fund generates as opposed to some guaranteed return (e.g. GIC or Guaranteed Investment Contract) Regulation Life Insurers are regulated by the State as opposed to the Federal Government. Therefore, rules vary from state to state. Investment Guarantee Funds also vary from state to state in terms of what happens should an insurer fail, size of fund, and maximum pay out to policy holder. Federal Government is looking to create a national body to regulate insurers. Property and Casualty Industry Again a consolidating industry with the top 10 underwriting about half the policies and the top 100 underwriting about 87% of the business. The top two firms underwrote 18.2% of all policies in 2005 compared to 14.5% in 1985. Growth in Casualty (liability) insurance has far outpaced Property insurance due to our society becoming more litigious. Economies of scale are probably a bigger factor in this industry due to the high potential pay outs involved. Gambler’s ruin If you join a card game with little money, you may lose on your first or second hand. Even if you are a more skilful card player than the others around the table, random chance can cause you to lose early in which case you are out of the game and will never have the chance to earn back what you lost. Insurers face such risks hence they need to be well capitalized relative to the risks they insure. If the risk is too big then they need to sell off part of that risk They sell that risk to a Reinsurance Company. You can think of an insurance company buying an insurance policy for certain risks that exceed the risk they feel is prudent for them to take. Probabilities Frequency of loss vs. Severity of Loss and their predictability Low loss high frequency events are far more predictable than high loss low frequency events. Think of a sample; the larger the sample the more likely the distribution is going to follow “the normal curve”. Hence high frequency and low cost events will follow such predictable distributions. An example of high frequency low cost would be automobile collision and damage insurance. An example of high cost low frequency would be earthquake insurance. Expected outcomes Insurers look at expected outcomes. If there is a 10% chance of a high school kid crashing his car and causing on average $1,000 in damage, the expected outcome would be $100 per this type of insured. Hence the insurance company would have to charge at least $100 just to breakeven. If the pool is large then the likelihood of all accidents average close to $1,000 will be high. Of course if the pool is small then the average or expected outcome may not prove to be close to the actual outcome since a serious accident would skew the result. Joint Probabilities If two events are independent of each other then the probability of both occurring at the same time is simply the probability of event “a” occurring times the probability of event “b” occurring. Insurers of course need to assess what are independent events and where one event could coincide with another. E.g. Insuring houses in a drought prone area where wild fires could burn many houses down would be an example where the probability of one house burning down is not independent. Hence you could not multiply together the probability of each house burning down to get the risk of both burning down. Self-Insurance Many people buy warranties and other insurance policies without thinking about the joint nature of the risks. For example if you always buy warranties on any electrical and electronic appliance, you need to add up all the costs of these warranties and compare that to what your expected losses could be. For example you buy 10 warranties on 10 items with an average cost of $200 per item. Your warranty cost is 15% for 3 years. (1) You need to ask yourself if the risks are independent or not. (2) You then need to ask yourself if (15% x 10 x $200 = $300) is worth, the risk of 1.5 of the appliances going bad. (3) You also should factor in the declining costs of electronic appliances and increasing obsolescence risks. Conclusion, you may find that by foregoing the policies and setting aside a pool of money to replace the appliances when they go bad is a more economical approach. This is called self insurance. Over Insurance Sometimes you pay for insurances that are already covered by another policy or where cost to the consumer is regulated by the government. Car rental insurance – your own policy typically applies to the car you are driving so you typically don’t need (READ THE FINE PRINT!). States may limit the damage a rental car company can charge you. For example, Illinois used to limit the amount to $500. Usually, your credit card offers an insurance policy that would cover that amount. Rental car companies are of course happy to charge you sums like $10.00 per day when you actually may not need. Again READ THE FINE PRINT!. Annuities In essence, an annuity is a fixed payment to be received a some point in the future. In order to receive that payment you need to pay something up front. It could be a lump sum or it could be e.g. a monthly fixed payment for 10 years. In both cases, the money given to the insurance company earns interest; this interest continues to be earned. The easiest conceptual way of thinking of the annuity is as the reverse of a mortgage. You pay $300,000 in return for $2,500 a month for the next 20 years. This money is earning about 8% per annum. With a mortgage, a bank gives you the $300,000 and then asks you to make $2,500 a month. In both cases, the monthly payment includes interest and principal. Annuities (continued) In terms of your calculator, you would enter $300,000 as the PV, $2,500 as the payment, and 240 for n (12 months x 20 years), you would hit “i” to get the interest amount which come out as interest per month, which you would then multiply by 12 to come up with annual rate. If you didn’t know what monthly payment you would get but you know the interest and how much you want to invest and for how long then it would be simply $300,000 for PV*, 8%/12 for interest, and 240 for n. You would hen hit “pmt” to come up with the monthly amount. * This “PV” would be the present value equivalent of a much larger sum that you would expect to receive in the future.