Chapter 21

Financial Institutions
10871412
Dr. Muath Asmar
AN-NAJAH
NATIONAL UNIVERSITY
Faculty of Economics and
Social Sciences
Department of Finance

Financial Markets and Institutions
Ninth Edition, Global Edition
Chapter 21
Insurance Companies and
Pension Funds
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Chapter Preview
• We look at two non-bank institutions: insurance companies
and pension funds. Topics include:
– Insurance Companies
– Fundamentals of Insurance
– Growth and Organization of Insurance Companies
– Types of Insurance
– Pensions
– Types of Pensions
– Regulation of Pension Plans
– The Future of Pension Funds

Insurance Companies
• Insurance companies assume the risk of their clients in
return for a fee, called the premium.
• Most people purchase insurance because they are risk-
averse - they would rather pay a certainty equivalent (the
premium) than accept a gamble

Figure 21.1 Number of Persons Employed in the U.S.
Insurance Industry, 1960–2015
Source: https://www.acli.com/.

Fundamentals of Insurance (1 of 3)
Although there are many types of insurance and insurance
companies, there are seven basic principles all insurance
companies are subject to:
1. There must be a relationship between the insured and the
beneficiary. Further, the beneficiary must be someone
who would suffer if it weren’t for the insurance.

2. The insured must provide full and accurate information to
the insurance company.
3. The insured is not to profit as a result of insurance
coverage.
4. If a third party compensates the insured for the loss, the
insurance company’s obligation is reduced by the amount
of the compensation.

5. The insurance company must have a large number of
insured so that the risk can be spread out among many
different policies.
6. The loss must be quantifiable. For example, an oil
company could not buy a policy on an unexplored oil field.
7. The insurance company must be able to compute the
probability of the loss’s occurring.

Adverse Selection and Moral Hazard in
Insurance
• Asymmetric information plays a large role in the design of
insurance products.
• The presence of adverse selection and moral hazard
impacts the industry, but is fairly well understood the
insurance companies.

Adverse Selection in Insurance (1 of 2)
The adverse selection problem raises the issue of which
policies an insurance company should accept:
• Those most likely to suffer loss are most likely to apply for
insurance.
• In the extreme, insurance companies should turn anyone
who applies for an insurance policy.

Adverse Selection in Insurance (2 of 2)
However, insurance companies have found reasonable
solutions to deal with this problem:
• Health insurance policies require a physical exam.
• Preexisting conditions may be excluded from the policy.

Moral Hazard in Insurance
Moral hazard occurs in the insurance industry when the
insured fails to take proper precautions (or takes on more
risk) to avoid losses because losses are covered by the
insurance policy.
• Insurance companies use deductibles to help control this
problem.

Selling Insurance
• Another problem is that most people don’t purchase
enough insurance. Insurance companies use a strong
sales force to combat this.
– Independent agents may sell the insurance products
of a number of different insurance companies.
– Exclusive agents only sell the products of one
company.
– An underwriter reviews each policy prior to its
acceptance to determine if the risk is acceptable.

Mini Case: Insurance Agent: The
Customer’s Ally
• One agent working for Prudential Insurance was
responsible for selling a large number of fire insurance
policies and was always careful to document clearly when
a fire hydrant was on the property by including it in a
photograph.
• One photo, however, showed a plastic fire hydrant lying in
the trunk of his car – one he put on property as needed to
give a low quote!

Growth and Organization of Insurance
Companies (1 of 2)
• The number of insurance companies grew steadily until
1988, and since then the number has fallen steadily.
• This can be seen in the next slide.

Figure 21.2 Number of Life Insurance Companies in the
United States, 1950–2014
Source: https://www.acli.com, Life Insurance Fact Book.

Growth and Organization of Insurance
Companies (2 of 2)
• Insurance companies may be organized in two difference
ways:
– A stock company is owned by shareholders and has a
profit motive
– A mutual insurance company is owned by the
policyholders and attempts to provide the lowest cost
insurance

Types of Insurance
Insurance is classified by which type of undesirable event is
covered:
• Life Insurance
• Health Insurance
• Property and Casualty Insurance

Life Insurance (1 of 2)
• Life insurance policies come in many forms. Some of the
typical policies include:
• Term Life: the insured is covered while the policy is in
effect, usually 10–20 years.
• Whole Life: similar to term life, but allows the policyholder
to borrow against the policies cash value. When the term
of policy expires, the insured can get the cash value of the
policy.

Life Insurance (2 of 2)
Life insurance policies come in many forms. Some of the
typical policies include:
• Universal Life: includes both a term life portion and a
savings portion.
• Annuities: pays a benefit to the insured until death, to
cover retirement years.

Table 21.1 Life Expectancy at Various Ages in the United
States, 2013 (1 of 2)
Age Male Female
1 75.78 80.49
5 71.87 76.56
15 61.96 66.64
25 52.47 56.85
35 43.17 47.19
45 33.98 37.73
55 25.41 28.74
65 17.75 20.32

Table 21.1 Life Expectancy at Various Ages in the United
States, 2013 (2 of 2)
Age Male Female
75 11.03 12.83
85 5.84 6.92
95 2.82 3.34
100 2.12 2.45
105 1.6 1.78
110 1.18 1.26
115 0.84 0.85

Table 21.2 Typical Annual Premiums on a $100,000 Term
Policy for a 40-Year-Old Male Nonsmoker
Age of Insured (years) Cost ($)
40 134
41 147
42 153
45 192
50 286
55 461
60 810

Life Insurance: Company Assets and
Liabilities (1 of 2)
• Life insurance companies derive funds from two sources:
– They receive premiums that must be used to payout
future claims when the insured dies
– They receive premiums paid into pension funds
managed by the life insurance company
• The next figures shows the distribution of the typical life
insurance company’s assets, as well as assets invested in
mortgages.

Figure 21.3 Distribution of Life Insurance Company Assets
(2015)
Source: Life Insurance Company Fact Book, 2015, Table 2.1 (American Council of Life Insurers),
https://www.acli.com/Tools/Industry%20Facts/Life%20Insurers%20Fact%20Book/Pages/RP12.

Figure 21.4 Percentage of Life Insurance Company Assets
Invested in Mortgages, 1920–2015
Source: Federal Reserve Flow of Funds Accounts, Table L117, http://www.federalreserve.gov/releases/z1/Current/z1.pdf.

Life Insurance: Company Assets and
Liabilities (2 of 2)
• Life insurance companies have two primary liabilities:
– Life insurance payouts
– Pension fund payouts

Health Insurance (1 of 2)
• Health insurance policies are vulnerable to the adverse
selection problem - those with health problems are more
likely to seek coverage.
• Individual policies must be priced assuming adverse
selection.
• Most health insurance is offered through group policies.

Health Insurance (2 of 2)
Health insurance is a hot topic in the political environment,
focusing on increased costs and availability of coverage.
• Insurance programs are attempting to shift costs to the
employers.
• Health Maintenance Organizations are another attempt to
keep costs down.

Patient Protection and Affordable Care Act
• Signed into law on March 23, 2010
• Access:
– Subsidies
– Limits on coverage denial
– Children stay on their parents’ plans until age 26
• Rules:
– Option to purchase through state-based exchanges
– Fines for not having insurance start in 2014

Property and Casualty Insurance (1 of 3)
• Property Insurance: protects businesses and owners from
the risk associated with ownership.
– Named-peril policies: insures against any losses only
from perils specifically named in the policy
– Open-peril policies: insures against any losses except
from perils specifically named in the policy
• Casualty Insurance
• Reinsurance

• Casualty Insurance: also known as liability insurance, it
protects against financial losses because of a claim of
negligence.
• Reinsurance: allocates a portion of the risk to another
company in exchange for a portion of the premium.

• Terrorism Risk Insurance Act of 2002: based on the 9-11
attacks in NYC, new legislation was passed in 2002
limiting the amount insurance firms would be required to
pay out in the event of future attacks
• Government will pay 90% of losses, up to $100 billion.

Insurance Regulation
• The McCarran-Ferguson Act of 1945 explicitly exempts
insurance companies from any type of federal regulation.
• Most insurance regulations is at the state level
• Regulation is typically designed to protect policyholders
from losses, or expand insurance coverage in the state.

The Practicing Manager: Insurance
Management
• Screening
• Risk-Based Premium
• Restrictive Provisions
• Prevention of Fraud
• Cancellations of Insurance
• Deductibles
• Coinsurance
• Limits on the Amount of Insurance

Credit Default Swaps
• A CDS is insurance against default on a financial
instrument, usually some kind of securitized bond.
• Market essentially non-existent before 1995. By 2008,
there were about $62 trillion of CDS outstanding!
• The CDS market allowed speculators to bet on the health
of a company, a usual no-no in insurance.

Credit Default Swaps: The AIG Blowup
• AIG’s Financial Products division insured over $400 billion
of CDS securities, of which $57 billion were debt securities
backed by subprime mortgages.
• Creditors quickly realized the losses may bankrupt AIG –
AIG could not raise any capital
• The Fed organized a bailout, but took a big stake in AIG as
payment. Insurance companies nationwide will now fall
under federal scrutiny.

Monoline Insurance
• Monoline insurance companies specialize in credit
insurance and are the only insurance companies that are
allowed to provide insurance that guarantees the timely
repayment of bond principal and interest when a debt
issuer defaults. All other insurance companies are
prohibited from doing this.
• Help lower required interest by providing a credit
enhancement. The crisis affected them as well.

The Subprime Crisis and the Monoline
Insurers
• Monoline insurers did insure debt backed by subprime
mortgages.
• Defaults on these mortgages resulted in credit downgrades
for the insurers.
• This weakened the value of their insurance guarantees,
which spilled over into their municipal securities insurance.
• Investors reduced the value of the insurance—
municipalities started seeing higher interest costs. This, in
turn, resulted in lower spending on roads, schools, etc.

Pensions
• Definition: A pension plan is an asset pool that
accumulates over an individual’s working years and is paid
out during the nonworking years.
• Developed as Americans began relying less on children for
care during their later years.
• Also became popular as life expectancy increased.

Types of Pensions (1 of 3)
• Defined-Benefit Pension Plans: a plan where the sponsor
promises the employee a specific benefit when they retire.
• For example, Annual Retirement Payment = 2%  average
of final 3 years’ income  years of service

• Defined-Benefit Pension Plans place a burden on the
employer to properly fund the expected retirement benefit
payouts.
– Fully funded: sufficient funds are available to meet
payouts
– Overfunded: funds exceed the expected payout
– Underfunded: funds are not expected to meet the
required benefit payouts

• Defined-Contribution Pension Plan: a plan where a set
amount is invested for retirement, but the benefit payout is
uncertain.
• Private Pension Plans: any pension plan set up by
employers, groups, or individuals
• Public Pension Plan: any pension plan set up by a
government body for the general public (e.g., Social
Security)

Mini Case: Power of the Pensions
• Managers of pensions have gained the ability to exercise
substantial control over corporate management.
• For example, pension funds recently defeated
management-sponsored antitakeover proxy proposals at
Honeywell.
• The stated mission of the Council of Institutional Investors
is to “encourage trustees to take an active role in assuring
that corporate actions are not taken at the expense of
shareholders.”

Figure 21.5 Distribution of Private Pension Plan Assets (end
of 2015)
Source: http://www.federalreserve.gov/releases/z1/current/z1.pdf, Table L116.

Social Security (1 of 2)
• Pay as you go system, where current funding is used
(partially) to pay current benefits.
• Projected number of workers is falling while projected
number of retirees is increasing, which will cause problems
in years to come if not corrected.

Figure 21.6 Social Security Fund Assets, 1957–2016
Source: http://www.ssa.gov/OACT/STATS/table4a3.html.

Figure 21.7 Projected Social Security Trust Fund Assets
Source: http://www.ssab.gov/Details-Page/ArticleID/207/Social-Security-Why-Action-
Should-be-Taken-Soon-December-2010.

Social Security (2 of 2)
• 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.

Regulation of Pension Plans (1 of 6)
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.

• Employee Retirement Income Security Act of 1974
– Established guidelines for funding
– Allowed plan credit to transfer with employees
– Established vesting requirements to gain plan benefits
– Increased disclosure requirements
– Assigned regulatory oversight to the Department of
Labor

• ERISA also established the Pension Benefit Guarantee
Corporation to insure pension benefits if an underfunded
pension plan is unable to meet its obligations.
– Accounting makes it difficult to assess funding status of
a plan
– May be in trouble as plans appear underfunded

• The next slide shows the annual payments made since
1980 to failed plan participants. In 2005, the PBGC said
that the plan has never been under more stress…

Figure 21.8 Total PBGC Benefit Payments
Source: http://www.pbgc.gov/documents/2015-annual-report.pdf#page=7.

• 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.

• Pension Reform Act of 1978 authorized individual
retirement accounts.
– Enjoy a preferential tax treatment
– Keogh plans are similar plans for self-employed
individuals
– SIMPLE IRAs are simplified retirement plans for small
businesses.

The Future of Pension Funds
• We can expect their growth and popularity as the average
population continues to grow.
• Variety of pension fund offerings may increase as well.
• Pension funds may gain significant control of corporations
as their stock holdings increase.

Chapter Summary (1 of 4)
• Insurance Companies: the nature of the industry, including
rationale and people employed in the industry, was
presented.
• Fundamentals of Insurance: the seven fundamental ideas
behind all insurance were listed and reviewed.

• Growth and Organization of Insurance Companies: the
changes in growth patterns over the last several decades
was reviewed, including both assets and number of
companies.
• Types of Insurance: the variety of insurance policies
available covering life, health, etc., were presented.

• Pensions: the general idea and growth in pension funds
was presented.
• Types of Pensions: the various forms, from defined-benefit
to defined-contribution, were reviewed and compared.

• Regulation of Pension Plans: ERISA and other laws that
govern pension funds was discussed.
• The Future of Pension Funds: we should expect their
popularity, size, and power to continue to grow as the
population ages.

Chapter 21

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