FINA 481:
Management of Financial Institutions
Radomir Todorov
1. Introduction
3B. Insurance Companies
Insurance – brief history
▪ First recorded insurance policy:
▪ China, 3000 BC
▪ Earliest known insurance contract
▪ Genoa, Italy, 1347
▪ First actual insurance policy
▪ Pisa, Italy, 1384
▪ First insurance law:
▪ Dubrovnik, Croatia, 1686
▪ Ordo super assecuratoribus (“Maritime
Insurance Law”) 2
Insurance Companies
▪ Differences in services provided by:
▪ Life insurance companies
▪ Property and casualty insurance
companies
▪ Allows for investors to pool risks to protect
against income-related uncertainties.
Question: Can we define insurance policies as
a financial liability / asset to insurers? 4
Size, Structure, and
Composition: The U.S. case
▪ Size, structure, and composition of the
insurance industry:
▪ In 1988, more than 2,300 life insurance
companies with aggregate assets of $1.1
trillion
▪ In 2020, approximately 750 life insurance
companies with aggregate assets of $8.1
trillion
▪ 10 largest life insurers wrote 40.6% of
new business in 2020 5
Mutual vs. Stock Insurance
Companies
As of 2017, 84 percent of all U.S. life insurance companies are stock
companies.
Question: What would be the key benefit from
converting to a stockholder-controlled company? 7
Insurance Issues
▪ Adverse selection problem
▪ Insured have higher risk than general
population
▪ E.g., customer has never had life
insurance, but decides to buy some
when receiving new heath information.
▪ Alleviated by grouping of policyholders
into similar risk pools
Question: What would be other examples of adverse
selection problem faced by financial institutions other
than insurance companies? 9
Types of Life Insurance
▪ Life insurance products - underwriting:
▪ Ordinary life
Term life, whole life, endowment life are
traditional forms of ordinary life insurance
Variable life, as well as universal life (and
variable universal life), are newer forms of
products
▪ Group life
▪ Industrial life
▪ Credit life 10
Distribution of Premiums, 2020
11
Other Life Insurer Activities
▪ Annuities
▪ Tax deferred returns
▪ Topped $370 billion in 2020 vs. $26 bln in
1996
▪ Private pension plans
▪ Insurers compete with other financial
service companies
▪ Accident and health insurance
▪ Protects against morbidity (i.e., ill health)
risk
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▪ Over 210 billion in premiums in 2020
Fair Value – Annuity Example
Suppose that a person wants to purchase an
annuity today that would pay $15,000 per year until
the end of that person’s life. The insurance
company expects the person to live for 25 more
years and can invest the amount received for the
annuity at a guaranteed interest rate of 5 percent.
Estimate the fair value of the annuity policy.
13
Question:
Compare a Life insurance product with
an annuity plan product.
What is the key difference between both
products?
▪ Annuities
▪ Reverse of life insurance activities
▪ Contractual method of building up a
fund (life insurance) versus liquidating a
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fund (annuity).
Balance Sheet: The U.S. case
▪ Assets
▪ Need to generate competitive returns on
savings components of life insurance policies
▪ Focus investment on long-term assets
▪ Bonds + equities (65%), government securities (~8%),
mortgages (~7%)
▪ Policy loans and other loans (~20 %)
▪ Liabilities
▪ Policy reserves to meet policyholders’ claims
▪ Separate account business represented 38.2% of
total liabilities and capital in 2017
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Discussion:
How can insurance companies
earn profits?
▪ Premium income vs payment payouts
▪ How to increase the spread between
premium income and payment payouts?
▪ Reduce risk of the insured pool
▪ Increase return on investment
16
Property-Casualty (P&C)
Insurance
▪ Fire insurance
▪ Fire: 1.9% vs. 16.6% in 1960
▪ Homeowners multiple-peril insurance
▪ Homeowners MP: 14.8% vs. 5.2% in 1960
▪ Commercial multiple-peril insurance
▪ Commercial MP: 6.1% vs. 0.4% in 1960
▪ Automobile liability and physical damage insurance
▪ 45% vs. 43% in 1960
▪ Liability insurance (other than automobile)
▪ 10.2% vs. 6.6% in 1960
17
Canada: Property-Casualty
(P&C) Insurance Facts 2021
18
P&C Balance Sheet
▪ Like life insurance companies, PC insurers
invest most assets in long-term securities
▪ Maturity matching (next class topic)
▪ Greater levels of liquidity risk
▪ Major liabilities:
▪ Loss reserves (~32%)
▪ Loss adjustment expenses
▪ Unearned premiums (~13%)
Question: What would be the main benefit of investing
in long-term securities for P&C insurers? 20
Loss Risk
▪ Underwriting risk may result from:
▪ Unexpected increases in loss rates
▪ Unexpected increases in expenses
▪ Unexpected decreases in investment
yields or returns
▪ Property lines versus liability lines
▪ Losses from liability insurance less
predictable
▪ Example: Claims due to asbestos damage
to workers’ health
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Loss Risk (cont.)
▪ Severity of loss versus frequency of loss
▪ Loss rates more predictable on low-severity, high-
frequency lines (such as fire, auto, and
homeowners) than on high-severity, low-frequency
lines (such as earthquake, hurricane, and financial
guaranty)
▪ Higher uncertainty may force P&C insurers to invest
in more short-term assets and hold larger capital
and reserves than life insurers
22
Canada: Stats over time
23
Source: IBC
Canada: 2023 Stats
24
Source: IBC
Long Tail Versus Short Tail
▪ Long-tail loss
▪ Arises where loss occurs during
coverage period, but claim is not
made until many years later
▪ Example: Asbestos cases in 2002 –
Halliburton payout ($ 4 bln; 300,000
claims)
▪ Efforts to contain long-tail risks within
subsidiaries
25
Insurance Costs: Social Inflation
▪ Product inflation versus social inflation
▪ Unexpected inflation may be systematic or
line-specific
▪ Social inflation: Unexpected changes in
awards by juries
▪ Reinsurance
▪ Approximately 75 percent of reinsurance by
US firms is written by non-US firms, such as
Munich Re and Swiss Re
Question: Which type of P&C policy would be most likely
to be affected by product inflation? 27
Underwriting Profitability
▪ Loss ratios (losses / collected premiums)
have generally increased
▪ Expense ratios (expenses / collected
premiums) have generally decreased
▪ Attributed to change in distribution methods
▪ Insurers have begun selling directly to
consumers through their own brokers rather
than independent brokers
▪ Combined ratio
▪ Includes both loss and expense experience
▪ If greater than 100, premiums are insufficient to
cover losses and expenses
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Investment Yield / Return Risk
▪ Operating ratio = combined ratio after
dividends minus investment yield
▪ Importance of investment income
▪ Causes PC managers to place
importance on measuring and
managing credit and interest rate risk
29
Example
▪ Suppose an insurance company’s projected loss ratio is
79.8 percent, its expense ratio is 27.9 percent, and it
pays 2 percent of its premiums earned to policyholders
as dividends. The company’s investment portfolio
yielded additionally 12 percent.
▪ Combined ratio after dividend:
Loss ratio + Expense Ratio + Dividend ratio =
79.8+27.9+2=109.7 %
▪ Operating ratio:
Combined ratio after dividends – Investment yield=
109.7 – 12.0 = 97.7 %
▪ Overall profitability:
100 – Operating ratio = 100 – 97.7 = 2.3 % 30
Who regulates insurance
companies?
• Provincial regulators include:
• Financial Services Regulatory Authority (FSRA) in Ontario
• Autorité des marchés financiers (AMF) in Quebec
• Alberta Superintendent of Insurance
• BC Financial Services Authority (BCFSA) in British Columbia 31
Global Issues
▪ Insurance industry becoming
increasingly global
▪ Worldwide, 2011 was a bad year for
both life and PC insurers
▪ Japan’s earthquake and tsunami
▪ Earthquakes in New Zealand
▪ Floods in Thailand
▪ Severe tornadoes in US
▪ Insured worldwide losses were $144b
in 2017, the highest ever recorded 32
Discussion questions:
▪ How do you think advancements in
technology, such as artificial intelligence and
big data, are shaping the insurance industry?
▪ How might the COVID-19 pandemic or global
financial crises impact the insurance industry
in the long term?
▪ Do you think there should be more or less
regulation in this field?
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