Chapter 25 Insurance and Pension Fund Operations Outline Background Determinants of Insurance Premiums Investments by Insurance Companies Regulation of Insurance Companies Life Insurance Operations Ownership Types of Life Insurance Sources of Funds Uses of Funds Asset Management of Life Insurance Companies Interaction with Other Financial Institutions Participation in Financial Markets Other Types of Insurance Operations Property and Casualty Insurance Health Insurance Business Insurance Bond Insurance Mortgage Insurance Exposure to Risk Interest Rate Risk Credit Risk Market Risk Liquidity Risk Exposure to Risk During the Credit Crisis Valuation of an Insurance Company Factors That Affect Cash Flows Factors That Affect Rate of Return by Investors Indicators of Value and Performance Background on Pension Funds Public Versus Private Pension Funds Defined-Benefit Versus Defined-Contribution Plans Pension Regulations Pension Fund Management Management of Insured versus Trust Portfolios Management of Portfolio Risk Corporate Control by Pension Funds Performance of Pension Funds Pension Fund’s Stock Portfolio Performance Pension Fund’s Bond Portfolio Performance Performance Evaluation Performance of Pension Portfolio Managers Key Concepts 1. Describe the role of insurance companies. 2. Explain how insurance companies are exposed to risk. 3. Describe how insurance companies participate in financial markets. 4. Describe the purpose of pension funds and how they participate in financial markets. POINT/COUNTER-POINT: Should Pension Fund Managers be More Involved with Corporate Governance? POINT: No. Pension fund managers should focus more on assessing stock valuations and determining which stocks are undervalued or overvalued. If pension funds own stocks of firms that perform poorly, the pension fund managers can penalize those firms by dumping those stocks and investing their money in other stocks. If pension funds focus too much on corporate governance, they will lose sight of their goal of serving the pension recipients. COUNTER-POINT: Yes. To the extent that pension funds can use governance to improve the performance of the firms in which they invest, they can improve the fund performance. In this way, they also improve the returns to the pension recipients. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: There is a possible compromise. Pension funds can use most of their time to focus on making good investments. However, they have opportunities to vote on particular matters as shareholders and they can vote in a manner that will discipline corporate managers to maximize the stock price. They may also work with other institutional investors to prompt corporate managers or boards about possible changes that could improve corporate performance and therefore the firm’s stock price (which would be beneficial to the pension fund participants). Questions 1. Life Insurance. How is whole life insurance a form of savings to policyholders? ANSWER: Whole life insurance is permanent as it protects the policyholder until death or as long as premiums are promptly paid. It is a form of savings as it builds a cash value the policyholder is entitled to even if the policy is canceled. 2. Whole Life versus Term Insurance. How do whole life and term insurance differ from the perspective of insurance companies? From the perspective of the policyholders? ANSWER: Term insurance provides insurance only over a specified term; it is not permanent like whole life insurance. Term insurance does not build a cash value, so it is not a savings mechanism. Also, term insurance is less expensive than whole life insurance. 3. Universal Life Insurance. Identify the characteristics of universal life insurance. ANSWER: Universal life insurance specifies a time period over which the policy exists. It builds a cash value that interest is earned on until the policyholder uses those funds. Universal life insurance allows flexibility on the size and timing of premiums. 4. Group Plan. Explain group plan life insurance. ANSWER: Group life insurance can be provided to a group of employees by an insurance company. It can be distributed at a low cost because of the high volume. It sometimes covers dependents of the group members as well. Some unions and professional associations participate in group plans. 5. Assets of Life Insurance Companies. What are the main assets of life insurance companies? Identify the main categories. What is the main use of funds by life insurance companies? ANSWER: Life insurance companies invest in government securities, corporate securities, mortgages, real estate, and policy loans. The main investment by life insurance companies is corporate bonds. 6. Financing the Real Estate Market. How do insurance companies finance the real estate market? ANSWER: Life insurance companies hold all types of mortgages as assets. Mortgages are originated by other financial institutions and then are sold to insurance companies in the secondary market. Yet, they are serviced by the originating institutions. 7. Policy Loans. What is a policy loan? When is it popular? Why? ANSWER: A policy loan occurs as insurance companies lend funds to whole life policyholders based upon their cash value of the policy. They are popular during times of rising interest rates as they have a guaranteed rate of interest, so are less expensive sources of funds during these times. 8. Government Rescue of AIG Why did the government rescue AIG? ANSWER: AIG had sold credit default swaps that were intended to cover against default for about $440 billion in debt securities, many of which represented subprime mortgages. In 2008, AIG experienced severe financial problems because many of these debt securities defaulted. If AIG failed, many of the counterparties whose securities were covered against default might have failed. Thus, the Fed's rescue of AIG was intended to prevent systemic risk in the financial system. 9. Managing Credit Risk and Liquidity Risk. How do insurance companies manage credit risk and liquidity risk? ANSWER: To deal with default risk, life insurance companies typically invest in securities with high ratings and then diversify among security issuers. To reduce liquidity risk, they diversify the age distribution of customers. 10. Liquidity Risk. Discuss the liquidity risk experienced by life insurance companies and by property and casualty (PC) insurance companies. ANSWER: Life insurance companies have somewhat predictable payouts over time. However, a high frequency of claims can cause the insurance companies to be illiquid. To boost liquidity, the companies could maintain some liquid assets. PC insurance companies have claims that are less predictable, and need to maintain sufficient liquid assets to cover any payouts. 11. PC Insurance. What purpose do property and casualty (PC) insurance companies serve? Explain how the characteristics of PC insurance and life insurance differ. ANSWER: Property and casualty insurance companies protect against fire, theft, liability, and other events that result in economic or noneconomic damage. PC insurance differs from life insurance in the following ways: 1. Policies often last one year or less, as opposed to long-term or permanent life insurance. 2. PC insurance encompasses a wide variety of activities, whereas life insurance is more focused. 3. Future compensation amounts paid on PC insurance is more difficult to forecast. 12. Cash Flow Underwriting. Explain the concept of cash flow underwriting. ANSWER: Cash flow underwriting is a method of adapting prices to interest rates. As interest rates rise, PC companies tend to lower their premiums to acquire more premium dollars to invest. 13. Impact of Inflation on Assets. Explain how a life insurance company’s asset portfolio may be affected by inflation. ANSWER: When higher inflation causes higher interest rates, the market value of existing bonds decreases. However, the market values of real estate holdings tend to increase. If the life insurance company diversifies its asset portfolio, its asset portfolio will be less sensitive to inflation. 14. Reinsurance. What is reinsurance? ANSWER: Reinsurance permits companies to write large policies by allocating a portion of the risk to other insurance companies, but they then must share the return. 15. NAIC. What is the NAIC and what is its purpose? ANSWER: The NAIC is the National Association of Insurance Commissioners. It facilitates cooperation among the various state agencies when an insurance issue is of national concern. It is involved in common reporting issues to maintain uniformity and participates in legislative discussions. 16. PBGC. What is the main purpose of the Pension Benefit Guarantee Corporation (PBGC)? ANSWER: The PBGC provides insurance on pension plans. If a pension plan is terminated, the PBGC takes control as the fund manager. 17. Defined-Benefit versus Defined-Contribution Plan. Describe a defined-benefit pension plan. Describe a defined-contribution plan, and explain why it differs from a defined-benefit plan. ANSWER: A defined-benefit plan requires contributions that are dictated by the benefits that will eventually be provided. The retirement benefits are known during the time at which the employee is still working. The benefits provided by the defined-contribution plan are determined by the accumulated contributions and the return on the fund’s investment performance. This plan allows a firm to know with certainty the amount of funds to contribute. The retirement benefits are not known with certainty because they are dependent on the performance of the investments that were made with the funds that were contributed. 18. Guidelines for a Trust. What type of general guidelines may be specified for a trust that is managing a pension fund? ANSWER: Guidelines may include the percentage of the portfolio allocated to stocks or bonds, a desired minimum portfolio rate of return, a maximum amount to be invested in real estate, minimum acceptable quality ratings for bonds, the average maturity of bonds, and the maximum amount to be invested in options. 19. Management of Pension Portfolios. Explain the general difference in the composition of pension portfolios managed by trusts versus those managed by insurance companies. Explain why this difference occurs. ANSWER: Pension portfolios managed by trusts offer potentially higher returns than insured plans and have a higher degree of risk. This difference occurs because assets managed by insurance companies (insured plans) are owned by the insurance companies and are designed to create annuities. Assets managed by trusts are still owned by the company providing the pension plan. 20. Private versus Public Pension Funds. Explain the general difference between the portfolio composition of private pension funds and public pension funds. ANSWER: State and local government pension funds tend to concentrate more on credit market instruments and less on corporate stock. 21. Exposure to Interest Rate Risk. How can pension funds reduce their exposure to interest rate risk? ANSWER: Pension funds could reduce the average maturity of bonds held to reduce interest rate risk. They could also take positions in financial futures or options on futures as was described in earlier chapters. 22. Pension Agency Problems. The objective of the pension fund manager for McCanna, Inc. is not the same as the objective of McCanna’s employees participating in the pension plan. Why? ANSWER: Managers may be evaluated by short-term performance, while employees are most concerned with the long-term performance of the pension portfolio. 23. ERISA. Explain how ERISA affects employees who change employers. ANSWER: Employees that changed employers could transfer any vested amount into the pension plan of their new employers. 24. Adverse Selection and Moral Hazard Problems in Insurance. Explain the adverse selection problem and the moral hazard problem in insurance. Gorton Insurance Co. wants to properly price the insurance for car accidents. If Gorton wants to avoid the adverse selection and moral hazard problems, do you think it should assess the behavior of insured people, uninsured people, or both groups? Explain. ANSWER: When insurance companies assess the probability of a condition that will result in a payment to the insured, they rely on statistics about the general population. However, an individual person has private information (about himself) that is not available to the insurance company. The individuals who have private information that makes them more likely to need insurance will buy it, while the individuals who have private information that makes them less likely to need insurance will not buy it. This is referred to as an adverse selection problem, which in general means that bad customers are selected. In the insurance industry, the moral hazard problem represents insured policyholders taking more risks because they are insured. If the insurance company did not consider this when setting insurance premiums, it may have set the premium too low. Thus, Gorton Insurance Co. should assess the sample of insured policyholders rather than the entire sample because this subsample more properly reflects the behavior of the people that it would insure. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Insurance company stocks may benefit from the recent decline in interest rates.” Insurance companies typically hold a large amount of bonds, which should increase in value if interest rates decline. Therefore, the values of insurance company stocks may rise. b. “Insurance company portfolio managers may serve as shareholder activists to implicitly control a corporation’s action.” If an insurance company holds a large amount of a specific firm’s stock, it may have some influence on the corporation’s management, because the management does not want the portfolio managers to dump the corporation’s stock in the secondary market. c. “If a life insurance company wants a portfolio manager to generate sufficient cash to meet expected payments to beneficiaries, it cannot expect the portfolio manager to achieve relatively high returns for the portfolio.” If a portfolio manager must generate sufficient cash to meet expected payments to beneficiaries, the portfolio may be composed mostly of bonds that promise fixed payments. The portfolio may not be focused on growth stocks, because there is more uncertainty about the payments that these stocks could generate over time. Therefore, the manager has less flexibility, and must give up some potential return in order to satisfy the main goal of the portfolio. Managing in Financial Markets As a consultant to an insurance company, you have been asked to assess the asset composition of the company. a. The insurance company has recently sold a large amount of bonds and invested the proceeds in real estate. Its logic was that this would reduce the exposure of the assets to interest rate risk. Do you agree? Explain. Some real estate can be highly sensitive to interest rate movements, since the demand for real estate could decline during periods of rising rates (when it is costly to borrow funds to finance real estate purchases). Therefore, the change in the asset composition may not necessarily reduce interest rate risk. b. This insurance company currently has a small amount of stock. The company expects that it will need to liquidate some of its assets soon to make payments to beneficiaries. Should it shift its bond holdings (with short terms remaining until maturity) into stock in order to strive for a higher rate of return before it needs to liquidate this investment? The stock returns are very uncertain. It is not wise to shift into stock when you know that you will have to liquidate the investment in the near future. c. The insurance company maintains a higher proportion of junk bonds than most other insurance companies. In recent years, junk bonds have performed very well during a period of strong economic growth, as the yields paid by junk bonds have been well-above high-quality corporate bonds. There have been very few defaults over this period. Consequently, the insurance company has proposed that it invest more heavily in junk bonds, as it believes that the concerns about junk bonds are unjustified. Do you agree? Explain. The junk bonds have probably performed very well because of the strong economic growth that occurred, which allowed most firms that issued junk bonds to meet their payments. However, if economic conditions worsen, junk bonds may default at a much higher rate. Therefore, this insurance company should not increase its holdings of junk bonds unless it understands the risk involved. Flow of Funds Exercise How Insurance Companies Facilitate the Flow of Funds Carson Company is considering a private placement of equity with Secura Insurance Company. a. Explain the interaction between Carson Company and Secura. How will Secura serve Carson’s needs, and how will Carson serve Secura’s needs? Secura receives funds from its customers, who pay insurance premiums in exchange for insurance. It can invest funds in Carson in an effort to earn a high return of the funds until the funds are needed to cover insurance claims. Carson benefits because it has the use of the funds to support its business expansion. b. Why does Carson interact with Secura Insurance Company instead of trying to obtain the funds directly from individuals who pay premiums to Secura? Individuals who purchase insurance premiums are not necessarily interested in investing in equity. They want insurance. The funds received by Secura are invested until they are needed. The capital market allows the financial institution to earn a return on the insurance premiums until insurance claims must be paid. c. Who will benefit if the stock purchased by Secura performs well—Secura’s shareholders or Secura’s policyholders who purchased term life insurance and property insurance? Is it worthwhile for Secura to closely monitor Carson Company’s management? Explain. Secura’s shareholders would benefit if the stock it purchased performs well. Its policyholders who purchased term and property insurance receive insurance in return for their premiums, and do not benefit directly from the investments made by the insurance company. It is worthwhile for Secura to monitor Carson Company’s management because it owns a large block of shares, and it can benefit directly from ensuring that Carson’s management makes decisions that have a favorable effect on Carson’s stock price. Solutions to Integrative Problem for Part VII Assessing the Influence of Economic Conditions Across a Financial Conglomerate’s Units 1. The objective of this case is to force students to compare asset portfolios across units of the financial conglomerate, and consider how each asset portfolio is exposed to default risk and interest rate risk. An overall comparison can only be made once these types of exposure are evaluated. Default Risk In comparing the effects of the recession, assess the composition of each unit’s asset portfolio. Regarding default risk, most units will be adversely affected, but some are more exposed than others. For example, finance company assets may be subject to a higher default rate than the other institutions. The default rate on mortgages (and on corporate bonds to a lesser degree) will dictate the performance of savings institutions, while the default rate on bonds (and mortgages to a lesser degree) will dictate the performance of insurance companies. It is difficult to precisely determine the impact without knowing more about the asset portfolio. An insurance company holding top-rated corporate bonds would likely experience a lower default rate than an insurance company holding junk bonds. Mutual funds concentrating on safe securities would be somewhat insulated from default risk while mutual funds concentrating on junk bonds or other risky securities would be adversely affected. Yet, the shareholders of the mutual fund would bear most of the adverse effects, but the mutual fund’s performance from the conglomerate’s perspective is related to its growth, which will subside due to poor returns on its portfolio. Interest Rate Risk Regarding interest rate risk, the institutions that are more exposed to interest rate movements may benefit from the likely interest rate movements. As the recession begins, there will likely be a decline in the demand for funds, causing a decline in interest rates. Institutions that have debt securities with fixed interest rates can benefit from the decline in market interest rates, since the market value of those debt securities will rise. Therefore, the interest rate movements can favorably affect savings institutions that provide fixed-rate mortgages, finance companies that provide consumer loans, and insurance companies that maintain a bond portfolio. The bonds would likely benefit more than mortgages or consumer loans because their time to maturity is much longer (recall that the prepayment option may reduce the potential favorable effect on long-term mortgages). Another factor that influences the relative impact is the proportion of the institution’s assets that are held in the form of fixed-rate debt securities. The higher the proportion, the more pronounced is the effect. In addition, savings institutions that concentrate on variable-rate mortgages would not benefit from the expected movement in interest rates. Mutual funds concentrating on securities such as long-term bonds and mortgages could benefit from the decline in interest rates, while money market mutual funds would not benefit. Effect on Brokerage Firms and Investment Banking Firms A brokerage firm’s performance is mostly affected by its volume of brokerage transactions rather than its composition of assets, since its main function is that of an intermediary rather than an investor. If stock trading volume declines, so will the income of the brokerage firms. Investment banking firms will be adversely affected by the reduction in investment banking services needed. However, once the merger and stock repurchase activity increases, investment banking firms will generate more business in facilitating these transactions. Summary Overall, insurance companies and mutual funds holding a large proportion of highly rated long-term bonds may perform better than most other financial institutions during the recession. They would benefit from their exposure to interest rate risk without being heavily exposed to default risk. Savings institutions with fixed-rate mortgages and most finance companies benefit from exposure to interest rate risk, but are adversely affected by default risk. Savings institutions with a high concentration of floating-rate mortgages do not benefit from lower interest rates because of low exposure to interest rate risk. This overall assessment is somewhat subjective. As with most cases, the goal of this case is not to focus on a precise answer, but to force students to use reasonable logic in developing an answer. 2. It is expensive and inefficient for each unit to have its own economists to provide forecasts. In addition, economists among units conduct redundant analyses and then may even create contradictory forecasts. Thus, one unit may be altering its asset portfolio in anticipation of higher interest rates while another alters its asset portfolio in anticipation of lower interest rates. The possible solution is anticipation of lower interest rates. The possible solution is for the holding company to employ the economists, and the forecasts denied by them are to be used by all units, who make their decisions based on those forecasts. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
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