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Insurance Companies Chapter 18 © 2003 South-Western/Thomson Learning Learning Objectives What life insurance, health insurance, and property and casualty companies do How adverse selection and moral hazard create risks for insurance companies and how these are managed

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insurance companies

Insurance Companies

Chapter 18

© 2003 South-Western/Thomson Learning

learning objectives
Learning Objectives
  • What life insurance, health insurance, and property and casualty companies do
  • How adverse selection and moral hazard create risks for insurance companies and how these are managed
  • Various types of life insurance policies available
  • Recent trends for these financial intermediaries and how they are regulated
life is uncertain
Life is Uncertain

Two fundamental assumptions underlie how financial theorists think about financial risk and its management:

  • Most people are risk averse
    • Reluctant to fully bear the financial or physical loss of an event
  • Future is uncertain
insurance companies4
Insurance Companies

Contractual-type financial intermediaries that offer the public protection against the financial costs associated with the loss of life, health, or property in exchange for premiums.

life insurance companies
Life Insurance Companies

Insurance coverage creates two additional forms of risk:

  • Adverse selection
    • Occurs when least desirable individuals are those most likely to pursue and be selected for a transaction
  • Moral Hazard
    • Risk that policyholder will behave in more risky manner than he or she would have in absence of insurance coverage
life insurance companies6
Life Insurance Companies

Four primary types of insurance professionals:

  • Actuaries
    • Trained in mathematical aspects of insurance
    • Responsible for calculating policy premiums
  • Agents
    • Exclusive agents sell only products of one particular company
    • Independent agents sell policies issued by wide number of companies
  • Underwriters
    • Review, approve or reject policy applications written by insurance agents
  • Claims adjusters
    • Assist policyholders with filing claims by verifying losses and determining insurance company’s liability
life insurance companies7
Life Insurance Companies
  • Beneficiary
    • Receives insurance payment or annuity stream after a policyholder dies
types of coverage term life insurance
Types of Coverage – Term Life Insurance
  • Straight term insurance
      • Provides death benefit to insured policyholder’s beneficiary if insured dies within specified period of time, or “term”
      • Premiums based on mortality tables which estimate number of people of given age who are expected to die during a year
  • Renewable term insurance
      • Allows policyholder to continue policy for an additional term after original policy expires
  • Group life insurance
      • Provided by many businesses, labor unions and professional organizations to employees or members
types of coverage term life insurance9
Types of Coverage – Term Life Insurance
  • Insurance companies have developed whole, universal, and variable life policies that accumulate cash values
  • Some term insurance policies are convertible into these other kinds of insurance
  • Policyholder has right to change his or her term life insurance policies into a whole, universal, or variable life product
types of coverage permanent life insurance
Types of Coverage – Permanent Life Insurance
  • Whole life insurance (straight life policy or continuous premium policy)
    • Charges a fixed premium
    • Pays a fixed death benefit
    • Differ from term insurance
      • Not limited to a particular term
      • Premiums are substantially higher
    • Two main tax advantages of accumulating cash reserve in this way
      • Cash reserves accumulated within insurance policy grow tax deferred
      • Death benefits usually pass to beneficiaries free of taxation
types of coverage permanent life insurance11
Types of Coverage – Permanent Life Insurance
  • Universal Life Insurance
    • Provides pure insurance product
    • Separate account that grows at fluctuating rate of interest similar to that received on a money market account or short-term CD
  • Variable Life Insurance
    • Provides pure insurance product
    • Separate account that may be used by policyholder to purchase mutual funds from a list of insurance company approved funds
slide12

Exhibit 18–2

A Comparison of Term, Whole, Universal, and Variable Life Insurance Products

types of coverage annuities
Types of Coverage – Annuities
  • Annuitant is owner of annuity

Annuities: provide a periodic income at regular intervals for a specified amount of time

types of coverage disability insurance
Types of Coverage – Disability Insurance

Disability Insurance: covers a portion of an insured worker’s previous income if worker becomes unable to work due to illness or injury

types of coverage long term care insurance
Types of Coverage – Long-Term Care Insurance

Long-Term Care Insurance: compensates insured policyholders needing assistance with the daily tasks of bathing, eating, dressing, and moving about.

health insurance companies
Health Insurance Companies

Offer protection, in exchange for premiums, against the financial costs associated with events such as doctor visits, hospital stays, and prescription drugs

  • Health Maintenance Organizations (HMOs)
    • Specialized health care insurers
    • Provide almost complete medical care in exchange for fixed per person premiums
property and casualty companies
Property and Casualty Companies

Provide protection against the effects of unexpected occurrences on property

  • Property Insurance
    • Contingent claims, in exchange for premiums, that protect insured policyholders from financial costs of property loss, damage, or destruction
property and casualty companies18
Property and Casualty Companies
  • Casualty (Liability) Insurance
    • Exchanged for premiums
    • Protects insured policyholders from financial responsibilities to those harmed by an accident, product failure, or professional malpractice
  • No-Fault Insurance
    • Pays an accident victim regardless of who caused an accident or damage
managing adverse selection and moral hazard in insurance industry
Managing Adverse Selection and Moral Hazard in Insurance Industry

All insurance companies must actively manage their clients to prevent adverse selection and moral hazard problems

slide20

Exhibit 18–4

Top 10 Ways to Manage Adverse Selection, Moral Hazard, and Other Risks in the Insurance Industry

managing adverse selection and moral hazard in insurance industry21
Managing Adverse Selection and Moral Hazard in Insurance Industry
  • Effective screening
    • Insurance underwriters screen out those applicants who would be poor risks
  • Risk-based premiums
    • Charges that increase with perceived risk of policyholder
  • Deductibles
    • Fixed amount that insured policyholder is required to pay before insurance coverage becomes effective
  • Coinsurance
    • Percentage share or fixed amount of a claim that must be paid by policyholder
managing adverse selection and moral hazard in insurance industry22
Managing Adverse Selection and Moral Hazard in Insurance Industry
  • Threaten or cancel coverage
  • Restrictive provisions
  • Fraud prevention
  • Limit amount of insurance
  • Reinsurance
    • Practice by smaller insurance companies of sharing risk of a large policy with other insurance companies
  • Effective credit, interest rate, liquidity and exchange rate risk management
regulation
Regulation
  • Government agencies created to provide outside supervision of the industry
  • Insurance companies regulated almost exclusively by state-level insurance commissioners
  • Each state establishes own set of safety and soundness regulations
  • McCarren-Ferguson Act (1945)
    • Exempts life insurance companies from federal regulation
    • Defers its oversight to state insurance commissioners in each state