Chapter 3

Insurance Companies

McGraw-Hill/Irwin

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Overview

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In this segment ... Insurance Companies:

Two major groups:

Life Property & Casualty

Size, structure and composition Balance sheets and recent trends Regulation of insurance companies Global competition and trends

Insurance Companies

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Differences in services provided by:

Life Insurance Companies Property and Casualty Insurance

Life Insurance Companies

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Significant consolidation in life insurance industry although not to the same extent witnessed in banking Competition from within industry and from other FIs Conversion to stockholder controlled companies

Mutual versus Stock Insurance Companies

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Biggest Life Insurers

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Insurance Company
1. Metropolitan Life 2. American International Group 3. Prudential of America 4. Hartford Life 5. Teachers Insurance & Annuity 6. Aegon USA Inc. 7. ING Group 8. New York Life 9. Axa Financial Group 10. Northwestern Mutual

Ownership Form
Stock Stock Stock Stock Stock Mutual Stock Mutual Stock Mutual

Assets (billions)
$407.8 341.1 331.1 204.5 177.9 172.5 169.9 166.2 133.2 133.1

Life Insurance: Issues Demutualization Adverse selection

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Insured have higher risk than general population Alleviated by grouping of policyholders into risk pools

Life Insurance Companies

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Life Insurance Products:

Ordinary life

Term life, Whole life, Endowment life. Variable life, Universal life, Variable universal life.

Group life Industrial life Credit life

Distribution of Premiums

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Group Life, 5.5

Ordinary Annuities, 30.7

Accident & health, 22.2

Ordinary Life, 20.5 Group Annuities, 20.8 Other*, 0.3

Other Life Insurer Activities

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Annuities

Reverse of life insurance activities. Topped $272 billion in 2005 Ethics: Conseco, 2004 Compete with other financial service companies. Mid 2000s, managing $2.3 trillion (45% of all private pension plans)

Private pension funds

Accident and health insurance

Morbidity insurance Effects of growth in HMO enrollment

Balance Sheet

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Long-term assets

Need to generate competitive returns on savings components of life insurance policies Bonds, equities, government securities Policy loans

Long-term liabilities

Net policy reserves to meet policyholders claims Separate account business 32.9% of total liabilities and capital in 2006.

Regulation of Life Insurance Companies

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McCarran-Ferguson Act of 1945

Confirms primacy of state over federal regulation.

Financial Services Modernization Act, 1999

Recent Regulatory Issues

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2004: Proposals to create council of federal and state officials to oversee insurance Complaints of costly and cumbersome state regulation Possibility of a dual (State and Federal) system similar to bank regulatory system. Resistance from states, consumer groups, Congress

Web Resources

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For more detailed information on insurance regulation, visit: www.naic.org www.ins.state.ny.us

Property and Casualty Insurance

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Size and Structure

Currently about 2,700 companies. Highly concentrated. Top 10 firms have 48% of market in terms of premiums written.

Top 100 frims: over 87% M&A increasing concentration

P&C Products

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Fire insurance and allied lines Homeowners multiple peril insurance Commercial multiple peril insurance Automobile liability and physical damage insurance Liability insurance (other than automobile)

Property-Casualty

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2005: Changing composition of net premiums written since 1960:

decline in fire insurance and allied lines: 3.7% in 2005 vs. 16.6% in 1960 Homeowners MP: 12.2% vs. 5.2% in 1960 Commercial MP: 6.8% vs. 0.4% in 1960 Auto L&PD: 42.8% vs. 43% in 1960 Other liability: 23.7% in 2005 vs. 6.6% in 1960

P&C Balance Sheet

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Similar to life insurance cos. (Smaller asset base)

Requirement for liquid assets

Major liabilities: loss reserves, loss adjustment expense and unearned premiums.

Loss Risk

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Underwriting risk may result from

Unexpected increases in loss rates Unexpected increases in expenses Unexpected decreases in investment yields or returns. Losses from liability insurance less predictable. Example: claims due to asbestos damage to workers health.

Property versus liability:

Loss Rates

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Severity versus frequency:

Loss rates more predictable on low-severity, high-frequency lines (such as fire, auto, homeowners peril) than on high-severity, lowfrequency lines (such as earthquake, hurricane, financial guaranty). Claims in high-severity, low-frequency lines may not be independent. Higher uncertainty forces PC firms to invest in more short-term assets and hold larger capital and reserves than life insurance firms.

Insurance Risks Post 9/11

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Crisis generated by terrorist attacks forced creation of federal terrorism insurance program in 2002 Federal government provides backstop coverage under Terrorism Risk Insurance Act of 2002 (TRIA)

Caps losses for insurance companies Key provisions extended in 2004

Long Tail Versus Short Tail

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Long-tail risk exposure:

Arises where peril occurs during coverage period but claim is made many years later. Examples: Asbestos cases and Dalkon shield case. Efforts to contain long-tail risks within subsidiaries. Example: Halliburton

Insurance Costs: Social Inflation

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Product inflation versus social inflation

Unexpected inflation may be systematic or linespecific. Social inflation: unexpected changes in awards by juries. Approximately 75 percent of reinsurance by US firms is written by non-US firms such as Munich Re. Catastrophe bonds

Reinsurance

Underwriting Ratios

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Loss ratios have generally increased. Expense ratios have generally decreased. Trend toward selling directly through their own brokers rather than independent brokers.

Combined ratio:

Includes both loss and expense experience. If greater than 100 then premiums are insufficient to cover losses and expenses.

Investment Yield / Return Risk Operating ratio = Combined ratio after dividends minus investment yield. Importance of investment income:

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Causes PC managers to place importance on measuring and managing credit risk and interest rate risk.

Recent Trends

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PC industry was not very profitable during 1987 2006. Succession of catastrophes

Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane Andrew 1991 2004, Hurricanes Charley, Frances, Ivan, Jeanne in rapid succession generated claims comparable to Andrew. September 11, 2001 terrorist attacks created an insurance crisis (and heightened demand).

Trough of underwriting cycle.

Potential for crowding out via government actions

Regulation PC insurers chartered and regulated by state commissions. State guaranty funds National Association of Insurance Commissioners (NAIC) provides various services to state regulatory commissions.

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Includes Insurance Regulatory Information System (IRIS).

Some lines face rate regulation. Criticism regarding Katrina related claims

Global Issues Insurance industry becoming more global Regulatory and tax effects in Cayman Islands and Bahamas Introduction and acceleration of insurance market reforms

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cross-country mergers (insurance companies as well as universal banks)

Worlds Largest Life Insurers

Revenues ($millions) ING Group 138,235 AXA Group 129,839 Assicurazioni Generali 101,404 Aviva 92,579 Prudential 74,745 Nippon Life 61,158

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Country Netherlands France Italy UK UK Japan

Worlds Largest P & C Insurers Revenues ($millions)

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Country

Allianz 121,406 Germany American Intl Group 108,905 US Berkshire Hathaway 81,663 US Zurich Financial Svc. 67,186 Switzerland Munich Re Group 60,256 Germany State Farm Insurance 59,224 US

Pertinent Websites

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A.M. Best: www.ambest.com Federal Reserve: www.federalreserve.gov Insurance Information Institute: www.iii.org Insurance Services Offices: www.iso.com National Association of Insurance Commissioners: www.naic.org State of NY Insurance Guarantee Fund: www.ins.state.ny.us