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Chapter 25
Insurance and Pension Fund
Operations
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline

Background

Life insurance operations

Property and casualty insurance operations

Health care insurance operations

Business insurance

Regulation of insurance companies

Exposure to risk

Valuation of an insurance company

Performance evaluation
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Chapter Outline (cont’d)

Interaction with other financial institutions

damage due to specified conditions

Common types of insurance are life insurance, property
and casualty insurance, health insurance, and business
insurance
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Background (cont’d)

Individuals who are more exposed to specific conditions
that cause financial damage will purchase insurance
against those conditions

Adverse selection problem

Insurance can cause the insured to take more risks
because they are protected

Moral hazard problem

Underwriters are employed by insurance companies to
calculate the risk of specific insurance policies

Decide what types of policies to offer based on the potential
level of claims and the premiums that they could charge
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Background (cont’d)

Determinants of insurance premiums

The premium is based on:

Are a dominant force in the industry

Generate more than $100 billion in premiums each year

Compensate the beneficiary of a policy upon the policyholder’s
death

Charge a premium that reflects the probability of making a
payment as well as the size and timing of the payment

Have historically forecasted with reasonable accuracy the
benefits they will have to provide

Use actuarial tables and mortality figures to forecast the
percentage of policies that will require compensation
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Life Insurance Operations (cont’d)

Group plans:

Are offered to employees of a corporation

Can be distributed at a low cost because of high
volume

Make up about 40 percent of total life coverage
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Life Insurance Operations (cont’d)

There are about 2,000 life insurance companies

Term insurance:

Is temporary, providing insurance only over a specified term

Does not build a cash value

Is significantly less expensive than whole life insurance

Includes decreasing term insurance, where benefits decrease over
time
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Life Insurance Operations (cont’d)

Types of life insurance (cont’d)

Variable life insurance:

Provides benefits that vary with the assets backing the
policy

Includes flexible-premium variable life insurance, providing
flexibility on the size and timing of payments

Universal life insurance:

Combines the features of term and whole life insurance

Specifies a period of time over which the policy will exist but
also builds a cash value



Some focus on high-grade bonds, others invest a portion in junk bonds

Life insurance companies expect to maintain some bonds until
maturity

Corporate stock is another use of funds, but significantly less than
bonds
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Life Insurance Operations (cont’d)

Uses of funds (cont’d)

Mortgages

Life insurance companies hold all types of mortgages:

One to four family, multifamily, commercial, and farm related

Mortgages are typically originated by another institution and then
sold to life insurance companies in the secondary market

Commercial mortgages make up more than 90 percent of total
mortgages held by life insurance companies

Real estate

Life insurance companies sometimes purchase real estate and
lease it out for commercial purposes


affected by asset portfolio management

Companies attempt to balance their portfolios so that any
adverse movements in the market value of some assets will be
offset by favorable movements in others

Many companies are diversifying into other businesses by
offering a wide variety of financial products

Overall, life insurance companies want to earn a reasonable
return while maintaining their risk at a tolerable level
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Property and Casualty Insurance
Operations

PC insurance protects against fire, theft, liability,
and other events that result in damage

Property insurance protects businesses and
individuals from the impact of financial risks
associated with the ownership of property

e.g., buildings, cars

Casualty insurance protects policyholders from
potential liabilities for harm to others as a result of
product failure or accidents
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Property and Casualty Insurance
Operations (cont’d)

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Property and Casualty Insurance
Operations (cont’d)

Cash flow underwriting

As interest rates decline, the price of insurance rises to offset
decreased investment income

Cash flow underwriting can backfire for companies that focus on
what they can earn in the short run and ignore what they will
pay out later

Uses of funds

Municipal bonds dominate, followed by Treasury bonds and
common stock

PC companies have a much higher concentration on
government bonds than life insurance companies
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Property and Casualty Insurance
Operations (cont’d)

Property and casualty reinsurance:

Effectively allocates a portion of insurance companies’ return
and risk to other insurance companies

Is similar to a commercial bank’s acting as a lending agent by

Individual must choose providers who participate in the plan
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Health Care Insurance Operations
(cont’d)

Managed health care plans

Health maintenance organizations (HMOs)

Require individuals to choose a primary care physician who
functions as a gatekeeper for that individual’s health care

Patients must first see their PCP to obtain referrals

Preferred provider organizations (PPOs)

Usually allow insured individuals to see any physician
without a referral

Insurance premiums are higher than HMO insurance
premiums
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Health Care Insurance Operations
(cont’d)

Health care insurance in the future

Health care expenses have risen dramatically in
recent years
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