Tài chính doanh nghiệp - Lecture 4: Insurance the archetypal risk management institution

Lecture 4: InsuranceThe Archetypal Risk Management InstitutionFundamental Insurance Principles and IssuesRisk Pooling is the source of all value in insuranceMoral Hazard dealt with partially by deductions and co-insuranceSelection bias dealt with by group policies, by testing and referrals, and by mandatory government insuranceRisk PoolingIf n policies, each has independent probability p of a claim, then the number of claims follows the binomial distribution. The standard deviation of the fraction of policies that result in a claim is Law of large numbers: as n gets large, standard deviation approaches zero.Aristotle on Probability“To succeed in many things, or many times, is difficult; for instance, to repeat the same throw ten thousand times with the dice would be impossible, whereas to make it once or twice is comparatively easy.” (De Caelo)Earliest Known Description of Insurance IdeaAnonymous letter to Count Oldenberg, 1609, proposes that people pay 1% of value of home into a fund, to be used to replace house after fire. Writer says he(she) “had no doubt that it would be fully proved, if a calculation were made of the number of houses consumed by fire, within a certain space, in the course of thirty years, that the loss would not amount, by a good deal, to the sum that would be collected in that time.Insurance as an InventionContract design, specifying risks, excluding risks subject to moral hazard or selection bias.Definition of loss and sufficient proof of lossMathematical model of risk poolingCollection of statistics on risks, and evaluation of the quality of such statistics.Corporate or mutual form for the companyGovernment verification of insurance company’s ability to payGovernment regulation of insuranceInvention of InsuranceIn ancient Rome, burial societies and bottomry. (Burial insurance still a factor in less developed countries.)Actuarial science developed in late 1600sModern fire insurance began in London, insurance gradually spread around the world.Commercial InsuranceProperty & Casualty Insurance, In US premiums paid 1997 $276 billion, $2760 per householdPrivate Health Insurance: premiums paid 1996 $137 billion, $1370 per householdLife insurance: In US, premiums paid 1997 $112 billion, or $1120 per household, 373 million policies, with value of $13.2 trillion in US in 1997, $132,000 per household. 1620 US life insurance companies.Property & Casualty Insurance Premiums, US 1997Automobile $132 billionHomeowners $27 billionOther liability $25 billionWorker’s Compensation $24 billionCommercial multiple peril $19 billionOther categories Origins of Insurance DemandSlow growth from 1660s of insurance industryRegulationMortgage institutionsPublic EducationMarketing of InsuranceMutual Life Insurance of New York in 1840s: Morris Robinson trains highly-paid life insurance salesmenEquitable Life Insurance Association in late 1800s: Henry B. Hyde invents tontine life insurance policy, sweeps the nationWhole life is successor to tontineTypes of Life Insurance ITerm insurance: level term and annual renewable term (premium increases)Whole life: guaranteed cash value builds according to schedule (nonparticipating) or with investment upside (participating). Government subsidy: income on cash value is not taxedVariable life: no guaranteed cash value, policy holder shifts investments among accountsTypes of Life Insurance IIUniversal Life: like whole life but also gives policyholder flexibility over premiums, unbundles cash value and insurance. Can increase or decrease premiums as needs changeVariable universal lifeSurvivorship (second to die) insuranceWhy the multiple forms? Marketing issuesUS Government Regulation of InsuranceMcCarran Ferguson Act 1945 delegated insurance regulation to the states. Fifty different state regulators.National Association of Insurance Commissioners (NAIC) creates standardized suggested laws.In 1993 the NAIC adopted risk-based capital requirements.Gramm-Leach-Bliley Financial Modernization Act of 1999 allowed banks to affiliate with insurance companiesCapital RequirementsInsurance companies risk being unable to pay if there are too many claims.Why don’t insurance companies define their contracts so that they cannot fail to pay?Human factors engineering of financial contracts.Surplus and ReservesStatutory Surplus: Amount beyond reserves that an insurance company has investedReserves: An accounting entry, amount they are thought to need to pay the claims.Failures of Insurance IndustryWhole life used to be stressed over term life insurance. (universal life alternative)Benefits not indexed to inflationLife annuities not indexed to inflationHuman factors behind these failures