Tài chính doanh nghiệp - Chapter 25: Insurance and pension fund operations

Chapter 25Insurance and Pension Fund OperationsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineBackgroundLife insurance operationsProperty and casualty insurance operationsHealth care insurance operationsBusiness insuranceRegulation of insurance companiesExposure to riskValuation of an insurance companyPerformance evaluation2Chapter Outline (cont’d)Interaction with other financial institutionsParticipation in financial marketsMultinational insurance companiesBackground on pension fundsPension regulationsPension fund managementPerformance of pension fundsPension fund participation in financial marketsParticipation in financial markets3BackgroundInsurance companies:Provide various form of insurance and investment services to individualsCharge a fee (premium) for the servicesProvide a payment to the insured (or a named beneficiary) under conditions specified by the insurance policy contractHelp individuals or firms to reduce the potential financial damage due to specified conditionsCommon types of insurance are life insurance, property and casualty insurance, health insurance, and business insurance4Background (cont’d)Individuals who are more exposed to specific conditions that cause financial damage will purchase insurance against those conditionsAdverse selection problemInsurance can cause the insured to take more risks because they are protectedMoral hazard problemUnderwriters are employed by insurance companies to calculate the risk of specific insurance policiesDecide what types of policies to offer based on the potential level of claims and the premiums that they could charge5Background (cont’d)Determinants of insurance premiumsThe premium is based on:The probability of the condition under which the company will need to provide paymentThe potential size of the payment in present value termsThe degree of competition in the industry for that type of insuranceOverhead expenses and insurance company profitWhether the policy is for an individual or a group6Background (cont’d)Investments by insurance companiesInsurance companies invest premiums and fees until the funds are needed to pay claimsInvestment decisions balance the goals of return, liquidity, and riskThose insurance companies whose claims are less predictable need to maintain more liquidity7Life Insurance OperationsLife insurance companies:Are a dominant force in the industryGenerate more than $100 billion in premiums each yearCompensate the beneficiary of a policy upon the policyholder’s deathCharge a premium that reflects the probability of making a payment as well as the size and timing of the paymentHave historically forecasted with reasonable accuracy the benefits they will have to provideUse actuarial tables and mortality figures to forecast the percentage of policies that will require compensation8Life Insurance Operations (cont’d)Group plans:Are offered to employees of a corporationCan be distributed at a low cost because of high volumeMake up about 40 percent of total life coverage9Life Insurance Operations (cont’d)There are about 2,000 life insurance companiesCompanies are classified as either stock or mutual ownershipA stock-owned company is owned by shareholdersA mutual company is owned by the policyholdersAbout 95 percent of companies are stock-ownedMutual companies are large and account for more than 46 percent of total assets of all life insurance companies10Life Insurance Operations (cont’d)Types of life insuranceWhole life insurance:Protects policyholders until death or as long as premiums are paidBuilds a cash value that the policyholder is entitled to even if the policy is canceledGenerates periodic premiums for the life insurance company that can be investedTypically provides a fixed amount of benefitsTerm insurance:Is temporary, providing insurance only over a specified termDoes not build a cash valueIs significantly less expensive than whole life insuranceIncludes decreasing term insurance, where benefits decrease over time11Life Insurance Operations (cont’d)Types of life insurance (cont’d)Variable life insurance:Provides benefits that vary with the assets backing the policyIncludes flexible-premium variable life insurance, providing flexibility on the size and timing of paymentsUniversal life insurance:Combines the features of term and whole life insuranceSpecifies a period of time over which the policy will exist but also builds a cash valueAllows flexibility on the size and timing of the premiums12Life Insurance Operations (cont’d)Sources of fundsThe most important source is annuity plansOffer a predetermined amount of retirement income to individualsThe second largest source of funds is premiumsThe third largest source of funds is investment income13Life Insurance Operations (cont’d)Uses of fundsLife insurance companies are major institutional investorsGovernment securitiesLife insurance companies invest in U.S. Treasury securities, state and local government bonds, and foreign bondsCorporate securitiesCorporate bonds are the most popular asset of life insurance companiesSome focus on high-grade bonds, others invest a portion in junk bondsLife insurance companies expect to maintain some bonds until maturityCorporate stock is another use of funds, but significantly less than bonds14Life Insurance Operations (cont’d)Uses of funds (cont’d)MortgagesLife insurance companies hold all types of mortgages:One to four family, multifamily, commercial, and farm relatedMortgages are typically originated by another institution and then sold to life insurance companies in the secondary marketCommercial mortgages make up more than 90 percent of total mortgages held by life insurance companiesReal estateLife insurance companies sometimes purchase real estate and lease it out for commercial purposesReal estate generates higher returns but also exposes life insurance companies to higher risk15Life Insurance Operations (cont’d)Uses of funds (cont’d)Policy loansLife insurance companies lend funds to whole life policyholdersCan borrow up to their policy’s cash value at a guaranteed rate of interestCapitalInsurance companies retain earnings or issue new stockCapital is used to finance investment in fixed assets and as a cushion against operating lossesInsurance companies are required to maintain adequate capital16Life Insurance Operations (cont’d)Asset management of life insurance companiesLife insurance companies’ performance can be significantly affected by asset portfolio managementCompanies attempt to balance their portfolios so that any adverse movements in the market value of some assets will be offset by favorable movements in othersMany companies are diversifying into other businesses by offering a wide variety of financial productsOverall, life insurance companies want to earn a reasonable return while maintaining their risk at a tolerable level17Property and Casualty Insurance OperationsPC insurance protects against fire, theft, liability, and other events that result in damageProperty insurance protects businesses and individuals from the impact of financial risks associated with the ownership of propertye.g., buildings, carsCasualty insurance protects policyholders from potential liabilities for harm to others as a result of product failure or accidents18Property and Casualty Insurance Operations (cont’d)There are about 3,800 individual PC companiesThe largest are State Farm, Allstate, Farmers Insurance, and Nationwide InsuranceNo single company controls more than 10 percent of the marketThe PC insurance business is only about one-fourth the life insurance business in aggregateThe PC insurance business generates about the same amount of insurance premiums as the life insurance businessMany companies are offering both life and PC insurance19Property and Casualty Insurance Operations (cont’d)PC insurance characteristics:Policies are for one year or lessEncompasses a wide variety of activities from auto insurance to business liability insuranceForecasting the amount of future compensation is more difficult for PC insurance than for life insurance20Property and Casualty Insurance Operations (cont’d)Cash flow underwritingAs interest rates decline, the price of insurance rises to offset decreased investment incomeCash flow underwriting can backfire for companies that focus on what they can earn in the short run and ignore what they will pay out laterUses of fundsMunicipal bonds dominate, followed by Treasury bonds and common stockPC companies have a much higher concentration on government bonds than life insurance companies21Property and Casualty Insurance Operations (cont’d)Property and casualty reinsurance:Effectively allocates a portion of insurance companies’ return and risk to other insurance companiesIs similar to a commercial bank’s acting as a lending agent by allowing other banks to participate in the loanAllows a company to write larger policies because a portion of the risk involves will be assumed by other companiesFewer companies are offering reinsurance because of generous court awards and the difficulty in assessing the amount of potential claims22Health Care Insurance OperationsInsurance companies:Offer coverage for hospital stays, physician visits, and surgeriesServe as intermediaries between health care providers and the recipients of health careTypes of health care plansAn indemnity plan reimburses insured individuals for health care offered by health care providersA managed health care plan allows insured individuals to obtain health care services from specified health care providers who participate in the planPremiums are generally lower and payment is typically made directly to the providerIndividual must choose providers who participate in the plan23Health Care Insurance Operations (cont’d)Managed health care plansHealth maintenance organizations (HMOs)Require individuals to choose a primary care physician who functions as a gatekeeper for that individual’s health carePatients must first see their PCP to obtain referralsPreferred provider organizations (PPOs)Usually allow insured individuals to see any physician without a referralInsurance premiums are higher than HMO insurance premiums24Health Care Insurance Operations (cont’d)Health care insurance in the futureHealth care expenses have risen dramatically in recent yearsSome insurance companies that provide health care insurance have incurred major lossesInsurance companies increased their premiumsThe status of health care insurance and reimbursement is subject to changes caused by possible health care reform25Business InsuranceInsurance companies provide a wide variety of business insurance policiesProperty insurance:Protects a firm against the risk associated with ownership of propertyProvides insurance against property damage by fire or theftLiability insurance:Can protect a firm against potential liability for harm to others as a result of product failureIs important because of increasing lawsuitsCan protect a business against potential liability from its employees26Business Insurance (cont’d)Key employee insurance provides a financial payout under conditions that specified employees of a business become disabled or dieBusiness interruption insurance covers against losses due to a temporary closing of the businessCredit line insurance covers debt payments owed to a creditor if a borrower diesFidelity bond insurance covers against losses due to dishonesty by employees27Business Insurance (cont’d)Marine insurance covers against losses due to damage during transportMalpractice insurance covers business professionals from losses due to lawsuits by dissatisfied customersSurety bond insurance covers losses due to a contract not being fulfilledUmbrella liability insurance provides additional coverage beyond that provided by the other existing insurance policies28Regulation of Insurance CompaniesThe insurance industry is regulated by state agencies (commissioners)Ensure that companies are providing adequate services and approve ratesInsurance agents must be licensedEvaluate the asset portfolios to ensure that investments are reasonably safeThe National Association of Insurance Commissioners (NAIC):Facilitates cooperation among the various state agenciesAttempts to maintain a degree of uniformity in common reporting issuesConducts research on insurance issues and participates in legislative discussions29Regulation of Insurance Companies (cont’d)The Insurance Regulatory Information System (IRIS):Has been developed by a committee of state insurance agenciesAssists in each state’s regulatory dutiesCompiles financial statements, lists of insurers, and other relevant informationAssess the companies’ respective financial statements by calculating 11 ratios that are then evaluated by NAIC regulators30Regulation of Insurance Companies (cont’d)Assessment systemThe regulatory system is designed to detect any problems in time to search for a remedyCommonly used financial ratios are intended to assess:The ability of the company to absorb either losses or a decline in the market value of its investmentsReturn on investmentRelative size of operating expensesLiquidity of the asset portfolioFinancial characteristics are monitored to ensure companies do not become overly exposed to credit risk, interest rate risk, and liquidity risk31Regulation of Insurance Companies (cont’d)Regulation of capitalSince 1994, insurance companies have been required to report a risk-based capital ratio to insurance regulatorsCreated by the NAICIntended to force those companies with a higher exposure to claims, losses, and interest rate risk to hold a higher degree of capitalDiscourages companies from excessive exposure to riskForces companies that take high risks to back their business with a large amount of capital32Exposure to RiskInterest rate riskCompanies carry a lot of fixed-rate long-term securities and are very sensitive to interest rate fluctuationsWhen interest rates rise, insurance companies are unable to capitalize on higher ratesLife insurance companies:Have been reducing their average maturity on securitiesHave been investing in long-term assets that offer floating ratesHave increasingly been utilizing futures contracts and interest rate swaps to manage their exposure33Exposure to Risk (cont’d)Credit riskCorporate bonds, mortgages, state and local government securities, and real estate holdings are subject to credit riskSome insurance companies only invest in assets with a high credit rating and diversify among securitiesMarket riskSome insurance companies became insolvent in the early 1990s as a result of losses on real estate investmentsThe value of stock portfolios managed by insurance companies declined in 2001–200234Exposure to Risk (cont’d)Liquidity riskA high frequency of claims at a single point in time could negatively affect a company’s performanceCompanies can diversify the age distribution of their customer base to reduce the exposure to this riskIf the customer base is concentrated in the older age group, life insurance companies should increase their proportion of liquid assetsLiquidity is also reduced when interest rates are high and policyholders accelerate their voluntary terminations35Valuation of an Insurance CompanyThe value of an insurance company is the present value of its future cash flowsThe value should change in response to changes in expected cash flows and in the required rate of return:36Valuation of an Insurance Company (cont’d)Factors that affect cash flowsThe change in expected cash flows can be modeled as:Change in payoutsPayouts are stable for life insurance companies but can be volatile for PC companiesChange in economic conditionsEconomic growth increases income for firms and individualsDebt securities are less likely to default during periods of economic growth37Valuation of an Insurance Company (cont’d)Factors that affect cash flows (cont’d)Change in the risk-free interest rateThe valuation of an insurance company is inversely related to interest rate movementsChange in industry conditionsIndustry conditions include regulatory constraints, technology, and competitionCompetition within the insurance industry has become more intense because of reduced barriers38Valuation of an Insurance Company (cont’d)Factors that affect cash flows (cont’d)Change in management abilitiesManagers make decisions that will capitalize on external forces the company cannot controlSkillful managers determine the likelihood of events that will necessitate payouts, compute the present value of cash outflows, and analyze the creditworthiness of firms issuing the bonds insurance companies purchase39Valuation of an Insurance Company (cont’d)Factors that affect the required rate of return by investors:The risk-free rate is positively related to inflation, economic growth, and the budget deficit level, but inversely related to money supply growthThe risk premium is inversely related to economic growth and the company’s management skillsRegulatory constraints may discourage firms from taking excessive riskLoosening of regulatory barriers to entry may increase the risk of insurance companies40Performance EvaluationA time-series assessment of the dollar amount of insurance premiums indicates growthA time-series analysis of investment income can be used to assess the performance of portfolio managersLiquidity can be measured as:41Performance Evaluation (cont’d)The profitability of an insurance company can be measured by:Net profit includes underwriting profits, investment income, and realized capital gainsUnderwriting gains or losses are measured by:42Interaction with Other Financial InstitutionsType of Financial InstitutionInteraction with Insurance CompanyCommercial banks and SIsCompete with banks and SIs to finance LBOsCompete with banks and SIs by offering CDsCompete with banks by offering an account on which checks can be writtenMerge with banks to offer various banking servicesFace increased competition for insurance-related services from banks and SisCommonly purchase loans that were originated by banksFinance companiesAre sometimes acquired by finance companies and maintained as subsidiariesSecurities firmsCompete directly with securities firms by offering mutual funds43Interaction with Other Financial Institutions (cont’d)Type of Financial InstitutionInteraction with Insurance CompanyBrokerage firmsCompete directly with brokerage firms by offering securities-related servicesCompete directly with brokerage firms that offer insurance-related servicesInvestment banking firmsCompete directly with investment companies to finance LBOsCommonly purchase stocks and bonds issued by corporations that were underwritten by investment banking firmsIssue stock that is underwritten by investment banking firmsPension fundsOffer to manage pension plans for corporations44Participation in Financial MarketsType of Financial MarketParticipation by Finance CompaniesMoney marketsMaintain a portion of their funds in money market securities, such as Treasury bills and commercial paper, to maintain liquidityBond marketsLife insurance company assets and PC insurance company assets are allocated to corporate bond portfoliosFrequently purchase bonds that are directly placed and are less likely to liquidate these bonds before maturityPurchase Treasury bonds for their safety and liquidityPurchase foreign bonds, primarily issued by Canadian firmsMortgage marketsHave allocated some of their assets to a mortgage portfolio, mostly conventional mortgagesStock marketsHave allocated a portion of their assets to a stock portfolio, often including foreign stocks45Participation in Financial Markets (cont’d)Type of Financial MarketParticipation by Insurance CompaniesFutures marketsSell futures contracts on bonds or a bond market index to hedge their bond and mortgage portfolios against interest rate riskTake positions in stock market index futures to hedge their stock portfolios against market riskOptions marketsPurchase call options on particular stocks they plan to purchase in the futurePurchase put options or write call options on stocks they own that may experience a temporary decline in priceSwap marketsCommonly engage in interest rate swaps to hedge the exposure of their bond and mortgage portfolios to interest rate risk46Background on Pension FundsPension plans provide a savings plan for employees that can be used for retirementPublic pension funds can be either state, local, or federale.g., Social SecurityMany public pension plans are funded on a pay-as-you-go basis47Background on Pension Funds (cont’d)Private pension plansWith a defined-benefit plan, contributions are dictated by the benefits that will eventually be providedA defined-contribution plan provides benefits that are determined by the accumulated contributions and the fund’s investment performance48Background on Pension Funds (cont’d)Underfunded pensionsDefined-contribution obligations are uncertain because they depend on salary levels, retirement ages, and life expectanciesIn the early 1990s, many defined-benefit plans used optimistic projections of the rate of return on their investmentsWhen projected rates of return were overestimated, the pension funds became underfundedSome pension funds have made high risk investments in real estate, junk bonds, and international securities49Pension RegulationsRegulation varies with the type of planAll plans must comply with the IRS tax rules that apply to pension fund incomeDefined-contribution plans are subject to the Employee Retirement Income Security Act (ERISA)100 percent vesting after five years, orGraded vesting, with 20 percent vesting in the third year, 40 percent in the fourth, 60 percent in the fifth, 80 percent in the sixth, and 100 percent in the seventhRequires pension funds to concentrate their investment in high-grade securitiesAllows employees changing employers to transfer any vested amount into the pension plan of their new employer or to invest it in an IRA50Pension Regulations (cont’d)The Pension Benefit Guaranty Corporation:We established by ERISA to provide insurance on pension plansGuarantees that participants of defined-benefit pension plans will receive their benefits upon retirementIf financed by annual premiums, income from assets acquired from terminated pension plans, and income generated by investmentsMonitors pension plans periodically to determine whether they can provide benefits51Pension Fund ManagementPrivate pension portfolios are dominated by common stockPublic pension portfolios are evenly invested in corporate bonds, stocks, and other credit instrumentsInvestment decisions with a matched funding strategy are made with the objective of generating cash flows that match planned outflow paymentsProjective funding offers managers more flexibility in constructing a pension portfolio that can benefit from expected market and interest rate movements52Pension Fund Management (cont’d)Management of insured versus trust portfoliosInsured plans are managed by life insurance companiesSome pension plans are managed by trust departments of financial institutions, such as commercial banks53Pension Fund Management (cont’d)The corporation owning the pension specifies guidelines:Percentage that should be used for stocks or bondsDesired minimum rate of returnMaximum amount to be invested in real estateMinimum acceptable quality rating for bondsMaximum amount to be invested in any one industryAverage maturity of bondsMaximum amount to be invested in optionsMinimum size of companies in which to invest54Pension Fund Management (cont’d)Management of portfolio riskVery concerned about interest rate riskMay periodically hedge by selling bond futuresPortfolio managers may periodically sell futures contracts on stock indexes to hedge against market downturnsCorporate control by pension fundsPension funds in aggregate hold a substantial portion of the common stock outstanding in the U.S.Corporate managers consider the requests of pension funds because of the large stake the pension funds have in the corporations55Performance of Pension FundsDeterminants of a pension fund’s stock portfolio performanceChange in market conditionsStock portfolio’s performance is usually closely related to market conditionsChange in management abilitiesStock portfolio performance can vary among pension funds in a particular time period because of differences in management abilities56Performance of Pension Funds (cont’d)Determinants of a pension fund’s bond portfolio performanceChange in the risk-free rateBond prices are inversely related to changes in the risk-free interest rateChange in the risk premiumBond prices are inversely related to changes in the risk premiums required by investors who purchase bondsChange in management abilitiesBond portfolio performance can vary among pension funds in a particular time period because of differences in management abilities57Performance of Pension Funds (cont’d)Performance evaluationIf the manager can adjust the relative proportion of stocks versus bonds, portfolio performance should be compared to a representative benchmarkAny difference between the performance of the pension portfolio and the benchmark portfolio would results fromThe manager’s shift in the relative proportion of bonds versus stocksThe composition of bonds and stocks within the respective portfoliosIn many cases, the performance of stocks and bonds in a pension fund are evaluated separately58Performance of Pension Funds (cont’d)Performance of pension portfolio managersThe objective is to make investments that will earn a large enough return to adequately meet future payment obligationsSome research has found that managed pension portfolios perform no better than market indexesPension funds may consider investing in indexed mutual funds59Pension Fund Participation in Financial MarketsType of Financial InstitutionInteraction with Pension FundCommercial banksCommercial banks sometimes manage pension fundsFunds purchase commercial loans that are sold by commercial banksInsurance companiesInsurance companies create annuities for pension fundsMutual fundsFunds invest in various mutual fundsBrokerage firms and investment banking firmsBrokerage firms execute securities transactions for pension fundsBrokerage firms offer investment advice to pension portfolio managersInvestment banks act as advisers on LBOs in which pension funds participateInvestment banks underwrite newly issued stocks and bonds that are purchased by pension funds60Participation in Financial MarketsType of Financial MarketParticipation by Pension FundMoney marketsMaintain a small proportion of liquid money market securities that can be liquidatedBond marketsAt least 25 percent of a pension fund portfolio is typically allocated to bondsMortgage marketsPension portfolios frequently contain some mortgagesStock marketsAt least 30 percent of a pension fund portfolio is typically allocated to stocksFutures marketsSome pension funds use futures contracts on debt securities and on bond indexes to hedge the exposure of their bond holdings to interest rate riskOptions marketsSome pension funds use stock options to hedge against movements of particular stocksSwap marketsPension funds commonly engage in interest rate swaps to hedge the exposure of their bond and mortgage portfolios to interest rate risk61