INSURANCE COMPANIES - Financial Institutions and Markets by Fabozzi

CHAPTER 7

INSURANCE COMPANIES

TYPE OF INSURANCE COMPANIES

Insurance companies sell insurance policies for a premium. They have two sources of income: underwriting income, and investment income.

Life Insurance

The life insurance company pays the beneficiary of the life insurance policy in the event of the death of the insured.

Health Insurance

The health insurance company pays the insured all or a portion of the medical treatment of the insured. Until the last decade, the major type of health insurance available was indemnity insurance. Due to the lack of constraints and incentives for cost savings, the medical service insured by indemnity insurance became very expensive. In response, various forms of managed health care have been developed. In general, these forms of managed health care put constraints on the choice of the provider by the insured and on the types of service provided by the provider.

Property and Casualty Insurance

Property and casualty (P&C) insurance companies insure the risk of damage to various types of property.

Liability Insurance

The risk insured against is litigation, or the risk of lawsuits against the insured due to actions by the insured or others. This is typically a third-party claim.

Disability Insurance

Disability insurance insures against the inability of employed persons to earn an income. Typically, “own occ” disability insurance is written for professionals in white-collar occupations, and “any  occ” for blue-collar workers. There are two types of policies regarding the sustainability of the policy. First, guaranteed renewable is a term where the issuer has to sustain the policy for a specified period of time, but can change the premium rates for the entire class. The other type is noncancellable and guaranteed renewable whereby the issuer has no right to make any changes in any policy during the specified period.

Long-Term Care Insurance

Long-term care insurance provides coverage for custodial care for the aged who are no longer able to care for themselves.

Structured Settlements

Structured settlements are fixed, guaranteed periodic payments over a long period of time, typically resulting from a settlement on a disability policy or other type of policy.

Investment Oriented Products

A guaranteed investment contract or guaranteed income contract (or simply GIC), is a pure investment product.  In a GIC, a life insurance company agrees, for a single premium, to pay the principal amount and a predetermined annual crediting rate over the life of the investment, all of which is paid at the maturity date. A life insurance company agrees in return for a premium to pay the principal amount and a predetermined annual crediting rate over the life of the investment. Effectively, a GIC is a zero coupon bond issued by a life insurance company and as such exposes the investor to the same credit risk. Some GICs require a single premium payment (bullet), others provide windows wherein deposits are accepted over time at the same interest rate.  GICs are popular contracts for pension funds, since interest rate risk assumed by insurance company.  But investors still have to worry about the credit risk of the insurance company.

Annuity

An annuity is often described as a mutual fund in an insurance wrapper. The income and realized gains are not taxable if not withdrawn from the annuity product. Thus, the “inside buildup” of returns receives a favorable tax treatment. Annuities can be either fixed, or variable. For a single payment or premium the insurance company will provide fixed payments for the life of the policyholder.  It can also provide a “lump sum” payment to the retiree after a number of years of accumulating and investing premium payments.

Monoline Insurance Companies

Monoline insurers guarantee the timely repayment of the bond principal and interest when a bond insurer defaults on these payments. The insured securities have traditionally been municipal bonds, but they now include structured finance bonds, CDOs, CLOs, and asset-backed bonds. Monoline insurers have been rated AAA and must have this high rating to be effective since they transfer their rating to the bond issue being insured.

INSURANCE COMPANIES VERSUS TYPES OF PRODUCTS  

Traditionally, life and health products were coupled by an insurance company because of some of the similarities of the products. Property and casualty products were also provided by P&C companies. Companies that provide both types of insurances (life, health, property, casualty) are called multiline insurance companies. Investment products tend to be sold by life insurance companies.

Recently, health insurance companies have separated from life insurance. This change has been due to mainly federal regulation of the health industry. Life insurance companies have focused on investment products. Also, disability insurance is now sold primarily by pure disability companies.

FUNDAMENTALS OF INSURANCE INDUSTRY

A fundamental aspect of the insurance industry results from the relationship between the revenues and costs. A company collects its premium income initially and invests these receipts in its portfolio. The payments on the insurance policy occur later and, depending on the type of insurance, in a perhaps very unpredictable manner. The payments are contingent on potential future events.

An insurance policy is a binding contract for which the policyholder pays premium in exchange for the insurance company’s promise to pay specified amounts contingent on future events.  The accepted policy is an asset for the owner and a liability for the insurance company.

Life insurance and property and casualty insurance companies are financial intermediaries that, for a price, will make a payment if a certain event occurs.  They function as risk bearers. The principal event that the life insurance company insures against is death:  a life insurance company agrees to make either a lump sum payment to the beneficiary of the policy or make a series of payments.  However, life insurance protection is not the only financial product sold by these companies.  A major portion of the business of life insurance companies is now in the area of providing retirement benefits. The key distinction between life insurance and property and casualty insurance (P&C) companies is the difficulty of projecting whether a policyholder will be paid off and how much the payment will be.

REGULATIONS OF INSURANCE INDUSTRY

Regulation is primarily at the state level as a result of 1945 federal statute (McCarran-Ferguson Act). Model laws and regulations are developed by National Association of Insurance Commissioners (NAIC). Insurance companies are also rated by the rating agencies.

To assure financial stability, insurance companies must maintain reserves or surplus, which are the excess of assets over liabilities. State statutory surplus requirements are called statutory surplus, which is distinguished from generally accepted accounting principles (GAAP) surplus.

STRUCTURE OF INSURANCE COMPANIES

Insurance companies are really a composite of three companies. First there is the “home office” or actual insurance company. Second, there is the investment component, which invests the premium collected in the investment portfolio. This is the investment company. The third is the distribution component of the sales force. There are different typed of distribution forces. Finally there are also brokers who sell insurance products of many companies.

Insurance companies are attracted by commercial bank customer contacts. As a result, commercial bank distribution of insurance company products has grown. This relationship is called bankassurance.

FORMS OF INSURANCE COMPANIES

There are two forms of insurance companies: stock and mutual. A stock insurance company is similar in structure to any corporation or public company. Shares (of ownership) are owned by independent shareholders and are traded publicly. The shareholders care only about the performance of their shares that is the stock appreciation and the dividends. The insurance policies are simply the products or business of the company. In contrast, mutual insurance companies have no stock and no external owners. Their policyholders are also their owners. The owners, that is the policyholders, care primarily or even solely about the performance on their insurance policies, notably the company’s ability to pay on the policy. Since theses payments may occur considerably into the future, the policyholders view may be long term.

Finally a new form of insurance company, which is a hybrid between a pure mutual and a pure stock company has been approved by some states and implemented by some insurance companies in these states since their introduction in 1996. This form is called a mutual holding company (MHC).

INDIVIDUAL VERSUS GROUP INSURANCE

Insurance products can be sold on individual and group bases. Also, in the P&C business, insurers can sell personal lines and commercial lines of insurance products.

TYPES OF LIFE INSURANCE

There are two fundamentally different types of life insurance: term (life) insurance and cash value life insurance.

Term Insurance

Term policies pay off only on death.  Three are no investment benefits and so the premiums are substantially lower than those on whole life policies.  Most group policies are term policies.  “Term” implies that coverage is available only during the premium-paying term of the contract.

Cash Value or Permanent Life Insurance  

There is a broad classification of life insurance, which is cash value, or permanent or investment type life insurance. A common type of cash value life insurance is whole life insurance. This cash value can be withdrawn and can also be borrowed against by the owner of the policy. If the owner wishes to let the policy lapse, he or she can withdraw the cash value. A major advantage of this type of policy is that the inside buildup is not subject to tax, i.e., is taxed as either income or capital gains. Neither is the beneficiary subject to income tax.

Guaranteed cash value life insurance: This insurance provides a cash value based on a minimum dividend paid on the policy. Additionally, the policy can be either participating or nonparticipating. For a nonparticipating policy, the minimum dividend and the minimum cash value on the policy are the guaranteed amounts. For the participating policy, the dividend paid on the policy is based on the realized actuarial experience of the company and its investment portfolio.

Variable life insurance: Contrary to the guaranteed or fixed cash value policies based on the general account portfolio of the insurance company, variable life insurance policies allow the policy owner to, within limits, allocate their premium payments to and among separate investment accounts maintained by the insurance company.  Variable life insurance, which typically has common stock investment options, has grown quickly with the stock market rally of the 1990’s.

Flexible premium policies—universal life insurance:  The key element of universal life is the flexibility of the premium. The policy cash value is set up as the cash value fund to which the investment income is credited and from which the cost of term insurance for the insured is debited. This separation of the cash value from the pure insurance is called the unbundling of the traditional life insurance policy.

Variable universal life insurance: Variable universal life insurance combines the features of variable life and universal life policies, i.e., the choice of separate account investment products and flexible premiums.

Survivorship (Second to Die) Insurance

An added dimension of the whole life policies is that two people are jointly insured and the policy pays the death benefit not when the first person dies, but when the second person dies. This is called survivorship insurance or second-to-die insurance.  

GENERAL ACCOUNT AND SEPARATE ACCOUNT PRODUCTS

The general account of an insurance company refers to the investment portfolio of the overall company. Insurance companies must support the guaranteed performance of their general account products to the extent of their solvency. These are called general account products.

Other types of insurance products receive no guarantee from the insurance company’s general account, and their performance is not based on the performance of the insurer’s general account but solely on the performance of an account separate from the general account of the insurer. These products are called separate account products.

PARTICIPATING POLICIES

The performance of some general account products is not affected by the performance of the general account portfolio. The policy performance may not participate in the investment performance of the insurer’s general account investment portfolio. Such a policy is nonparticipating policy. Other general insurance products participate in the performance of the company’s general account performance. Such a policy is called a participating policy. Both stock and mutual insurance companies write both general and separate account products, but most participating general account products are written in mutual companies.

INSURANCE COMPANIES INVESTMENT STRATEGIES

In general the characteristics of insurance company investment portfolio should reflect their liabilities - the insurance products they underwrite. There are many differences among the various types of insurance policies.  Among them are:

§  The expected time at which the average payment will be made by the insurance company (Technically, the “duration” of the payments)

§  The statistical or actuarial accuracy of estimates

§  Other factors

The key distinction between life insurance, property and casualty insurance companies lies in the difficulty of projecting whether or not a policyholder will be paid off and how much the payment will be. There are also differences in investment strategy between public (or stock) and mutual insurance companies of the same type. The major difference is that stock companies tend to have less common stock than mutual companies. 

Most insurance company assets consist of debt, both public and private.  In fact, life insurers as a group are the largest holders of bonds.  Since life insurers are effectively taxed at very low rates, there are no advantages to holding municipals.  The reason for bond holdings are (1) to match maturities, since liabilities are often long-term and at a fixed rate, and (2) regulations require that bonds be booked at cost, while stocks must be written at market value.

CHANGES IN THE INSURANCE INDUSTRY

There have been three major types of changes in the insurance industry in the last two decades: (1) deregulation of the financial system; (2) internationalization of the insurance industry; (3) demutulization.

Deregulation of the Financial System

In 1933, Congress passed the Glass-Steagall Act, which separated commercial banking, investment banking, and insurance. This act resulted in the breakup of the House of Morgan into separate investment banking and commercial banking entities. . On November 12, 1999 the Gramm-Leach-Bliley Act (GLB), called the Financial Modernization Act of 1999, was signed into law. This act removed the 50 year old “anti-affiliation restrictions” among commercial banks, investments banks and insurance companies.  The passage of this act has eliminated the barriers between insurance companies, commercial banks, and investment banks and various combinations of these types of companies will continue to evolve. Since then, however, Citigroup sold its insurance business (Travelers) to MetLife, and no other major combinations between banking and insurance have taken place.

 

Internationalization of the Insurance Industry

Globalization has occurred in many industries, including insurance industry. With respect to the U.S. globalization operates in two directions. First, U.S. insurance companies have both acquired and entered into agreements with international insurance companies and begun operations in other countries. Second, international insurance companies, mainly European, have become even more active in acquiring U.S. insurance and investment companies. The reasons are: (1) more rapid growth of the US financial business, (2) attractive demographics and income potential of the US market, and (3) less regulations.

Demutualization

Since the mid-1990s, several insurance companies have changed from mutual to stock companies. Many industry observers believe that the recent demutualized insurance companies will either acquire other financial companies or will be acquired by other financial companies.

EVOLUTION OF INSURANCE INVESTMENT AND RETIREMENT PRODUCTS

Even prior to the Financial Modernization Act of 1999, there was an increasing overlap of insurance, investment and pension products and the distribution of those products. The passage of this Act has accelerated this convergence.

Three decades ago there were three distinct types of products for individuals: insurance, savings/investment, and retirement. Retirement products include individual retirement accounts. During the last two decades, many products have been developed that fit into two or even three of these categories. Products that are hybrid of retirement and investment products are 401k and Roth 401k.

401(k) Plans and Roth 401(k) Plans

401(k) plans are plans provided by an employer whereby an employee may elect to contribute pretax dollars to a qualified tax-deferred retirement plan.

IRAs and Roth IRAs

While a 401(k) is an employer-sponsored retirement program, the most common types of IRAs are personal tax-deferred retirement plans. Individually sponsored IRAs include traditional IRA, Roth IRA, and rollover IRA. Employer-sponsored IRA included Simplified Employee Pension (SEP) plans, and Savings Incentives Matching Plan for Employees (SIMPLE).

ANSWERS TO QUESTIONS FOR CHAPTER 6

(Questions are in bold print followed by answers.)

1.

1. What are the major sources of revenue for an insurance company?
2. How are its profits determined?

a.       An insurance company's revenue is generated from two sources: (1) premium income for policies written during the year; (2) investment income resulting from the investment of both the reserves established to pay off future claims and the P&C's surplus (asset less liabilities).

b.      Profit is determined by subtracting from the revenue for the year (as defined above in question 1a) each of the following items: (1) claim expenses: funds that must be added to reserves for new claims for policies written during the year; (2) claim adjustment expenses: funds that must be added to reserves because of underestimates of actuarially projected claims from previous years; (3) taxes; (4) administrative and marketing expenses associated with issuing policies.  If annual premiums exceed the sum of (1), (2) and (4), the difference is said to be the underwriting profit.  An underwriting loss results otherwise.

2. Name the major types of insurance and investment oriented products sold by insurance companies.

The major types of insurance products sold are: Life insurance, Health insurance, Property and casualty insurance, Liability insurance, Disability insurance, long-term care insurance, GIC and annuities.

3.

1. What is a GIC?
2. Does a GIC carry a “guarantee” like a government obligation?

a.       A guaranteed investment contract (GIC) guarantees a fixed interest income compounded over the life of the contract.  It is like a zero-coupon bond issued by an insurance company, usually to pension funds. A GIC shifts the interest rate risk from a pension fund to the issuer.

b.      The guarantee is given only by  the insurance company.  There is no government bailout in case of insolvency of the issuer.

4. What are some key differences between a mutual fund and an annuity?

In a mutual fund, all income is taxable, and no guarantees are given in its performance.  An annuity is an investment product often called a “mutual fund is in an insurance wrapper”. The wrapper is the guarantee by the insurance company. The company will pay the annuity holder.

5. Why should a purchaser of life insurance be concerned about the credit rating of his or her insurance company?

The credit rating of an insurance company is extremely important to the purchaser of the LIC product. The credit risk of insurance company has been prominent by the default of several major issues of GIC e.g. mutual Benefits and Executive Life in 1991.

6.

1. Does the SEC regulate all insurance companies?
2. If not, who regulates them?

a.       No. The insurance industry is regulated by individual states and only the SEC regulates those insurance companies whose stock is publicly traded.

b.      State laws and NAIC, a voluntary association of state insurance commissioners.

7. Does the insurance industry have a self-regulatory group and, if so, what is its role?

Model laws and regulations are developed by the National Association of Insurance Commissioners (NAIC), a voluntary association of the state insurance commissioners, for application on insurance companies in all states. An adoption of a model law or regulation by the NAIC is not, however, binding on any state. States typically use these as a model when writing their own laws and regulations.

8. What is the statutory surplus and why is it an important measure for an insurance company?

For an insurance company, surplus is simply total assets minus liabilities, or net worth. Due to state regulations the size of the surplus dictates the amount of common stock that an insurance company can hold and ultimately the amount of business it can write.

9. What is bank assurance?

 “Banc assurance” means combining the activities of banking and insurance companies. Several factors could explain the growing interest in banc assurance in certain regions: (1) deregulation and increased competition are forcing banking and insurance firms to seek new markets and products, (2) a growth in savings, and (3) an increased demand for insurance with investment features. 

10.

1. What is meant by “demutualization”?
2. What are the perceived advantages of demutualization?

a.       Demutualization refers to changing structure of insurance companies from being mutual companies stocks to ownership companies. This recent trend of demutualization in 1990’s is changing the landscape of insurance industry.

b.      The advantages of demutualization is more competition, transparency and pressure for better performance for the shareholders.

11. Comment on the following quotation from Frank J. Jones, “An Overview of Institutional Fixed Income Strategies,” in Volume 1 of Professional Perspectives on Fixed Income Portfolio Management (Hoboken, NJ: John Wiley & Sons, 2000):

An important impediment to the use of the total rate of return objective by stock life insurance companies is the role of equity analysts on Wall Street. . . . These equity analysts emphasize the stability of earnings and thereby prefer stable income to capital gains. Therefore, they consider only income and not capital gains, either realized or unrealized, in operating income—an important measure in their overall rating. While this practice of not considering capital gains may be appropriate for bonds, it certainly is inappropriate for common stock and provides a significant disincentive to life insurance companies for owning common stock in their portfolios. . . . this equity analyst practice does a disservice to policyholders of stock life insurance companies since their insurance companies end up having inferior asset allocations.

The statement by Jones has elements of subjective judgment and has several dimensions. It begs the merit of stocks vs. mutual structure of ownership and the respective rates of returns for the shareholders. It may be true that equity analysts emphasize the stability of earnings at the cost of capital gains. But those capital gains are reflected in the current price of the stock. It is up to the shareholders to realize those gains. Thus, the total rate of return objective by stock life insurance companies is not a real impediment.

12. What are term insurance, whole life insurance, variable life insurance, universal life insurance, and survivorship insurance?

Term insurance is pure life. If the insured person dies while the policy is intact, the beneficiary receives the death benefit.

      Whole life insurance pays off a stated amount upon the death of the insured and accumulates a cash value that can be redeemed by the policyholder.

Universal life pays a dividend that is tied to market interest rates.  Essentially, the cash value of a universal life policy builds and is used to buy term insurance.

Variable life insurance provides a death benefit that depends on the market value of the investment at the time of the insured’s death.  The premiums are typically invested in common stock; hence such policies are referred to as equity-linked policies.  While the death benefits are variable, there is a guaranteed minimum death benefit that the insurer agrees to pay regardless of the market value of the portfolio.

      Universal Life Insurance: the main element of the universal life insurance is the flexibility of premium for the policyholder. It separates term insurance from cash value element of the policy.

13. Why are all participating policies written in an insurance company’s general account?

All participating policies by the insurance company are written in the general account. The general account of an insurance company refers to the investment portfolio of the overall company. Such products “Written by the company itself” are said to have a “general account guarantee” i.e. they are a liability of the insurance company. The rating agencies provide a credit rating based on products written by or guaranteed by the general account.

14. Whose liabilities are harder to predict, life insurers or property and casualty insurers? Explain why.

Property and casualty insurers P&Cs. Life insurance actuaries can predict death rates among various age groups based upon historical data.  With P&Cs, the timing and amount of payoffs are almost random by nature.  Past experience provides little predictive assistance.  Homeowner claims are just as likely to arise in the first year of a policy or ten years later.  Even then, the dollar amount of damage claims can be small or for the entire value of the policy.

15. How does the Financial Modernization Act of 1999 affect the insurance industry?

The Financial Modernization Act of 1999 will affect significantly the insurance industry in several ways. Even before this act, there was an increase overlap of insurance, investment, pension products and the distribution of products. The passage of this act has accelerated this convergence. This act has eliminated the barriers between insurance companies, commercial banks, and investment banks and various combinations will continue to evolve.