We look at two nonbank institutions: insurance companies and pension funds. We view them in a similar light as other financial intermediaries because they take funds from one sector and invest them in another. Topics include:
The insurance company must have a large number of insured so that the risk can be spread out among many different policies.
The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field.
The insurance company must be able to compute the probability of the loss’s occurring.
Adverse Selection and Moral Hazard in Insurance
As we have seen in previous chapters, asymmetric information plays a large role in the design of insurance products. As with other industries, the presence of adverse selection and moral hazard impacts the industry, but is fairly well understood the insurance companies.
It’s 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, it’d be wise for you plan other sources for your retirement cash flows.
A major U.S. Supreme Court decision in 1949 established that pension benefits were a legitimate part of collective bargaining. The number of plans increased from this as unions negotiated for such plans.
Pension Protection Act of 2006 was passed to address the growing problem of failed pension plans. The act provides for stronger funding rules, greater transparency, and a strong pension insurance system.