Insurance Companies
Three categories of insurance companies include life insurance, nonlife [property and casualty (P&C)] insurance, and health insurance. Life insurance companies usually provide long-term coverage and will make a specified payment to the policyholder’s beneficiaries upon the death of the policyholder during the policy term. Term (temporary) life insurance provides a specified amount of insurance coverage for a fixed period of time. Whole (permanent) life insurance provides a specified amount of insurance coverage for the life of the policyholder.
Risks facing insurance companies include:
- insufficient funds to satisfy policyholders’ claims,
- poor return on investments,
- liquidity risk of investments,
- credit risk, and
- operational risk.
Mortality Tables
Mortality tables can be used to compute life insurance premiums. Mortality tables include information related to the probability of an individual dying within the next year, the probability of an individual surviving to a specific age, and the remaining life expectancy of an individual of a specific age.
P&C Insurance Ratios
P&C insurance companies compute the following ratios:
- loss ratio + expense ratio = combined ratio
- combined ratio + dividends = combined ratio after dividends
- combined ratio after dividends − investment income = operating ratio
Moral Hazard and Adverse Selection
Moral hazard describes the risk to the insurance company that having insurance will lead the policyholder to act more recklessly than if the policyholder did not have insurance. Methods to mitigate moral hazard include deductibles, coinsurance, and policy limits.
Adverse selection describes the situation where an insurer is unable to differentiate between a good risk and a bad risk. Methods to mitigate adverse selection include greater initial due diligence and ongoing due diligence.
Mortality Risk vs. Longevity Risk
Mortality risk refers to the risk of policyholders dying earlier than expected. For the insurance company, the risk of losses increases due to the earlier-than-expected life insurance payouts.
Longevity risk refers to the risk of policyholders living longer than expected. For the insurance company, the risk of losses increases due to the longer-than-expected annuity payout period.
There is a natural hedge (or offset) for insurance companies that deal with both life insurance products and annuity products because longevity risk is bad for the annuity business but good
for the life insurance business, and mortality risk is bad for the life insurance business but good for the annuity business. Other forms of hedging include reinsurance contracts with other insurance companies and longevity derivatives.
Capital Requirements for Insurance Companies
Under an asset-liability management approach, the life insurance company attempts to equate asset duration with liability duration. There is risk associated with both sides of the balance sheet. Equity capital represents contributed capital plus retained earnings and serves as a protection barrier if payouts are larger than loss reserves.
For P&C insurance companies, assets typically comprise of highly liquid bonds with shorter maturities than those used by life insurance companies. On the liability side, there are unearned premiums (non-existent with life insurance companies) that represent prepaid insurance contracts whereby amounts are received but the coverage applies to future time periods. Finally, there is substantially more equity capital than for a life insurance company because of the highly unpredictable nature of claims for P&C insurance contracts.
Guaranty System for Insurance Companies
For insurance companies in the United States, every insurer must be a member of the guaranty association in the state(s) in which it operates. If an insurance company becomes insolvent in a state, then each of the other insurance companies must contribute an amount to the state guaranty fund based on the amount of premium income it earns in that state.
The guaranty system for banks in the United States is a permanent fund to protect depositors that consists of amounts remitted by banks to the Federal Deposit Insurance Corporation (FDIC). No such permanent fund exists for insurance companies.
Pension Plans
Defined benefit plans explicitly state the amount of the pension that the employee will receive upon retirement. It is usually calculated as a fixed percentage times the number of years of employment times the annual salary for a specific period of time. There is significant risk borne by the employer because it is obligated to fund the benefit to the employee.
Defined contribution plans involve both employer and employee contributions being invested in one or more investment options selected by the employee. There is virtually no risk borne by the employer because it is obligated simply to make a set contribution and no more. The risk of underperformance of the plan’s investments is borne solely by the employee.
