17 Mutual Funds, Pension Funds, Insurance Companies, Finance Companies, and Other Financial Institutions C h a p t e r Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
Learning Objectives • To explore the many roles played by mutual funds, pension funds, insurance companies, finance companies, mortgage banks, and security dealers. • To discover the different services they offer. • To examine their principal sources and uses of funds. • To understand the key problems they face today.
Mutual Funds (Investment Companies) • Mutual funds, or investment companies, direct the savings of individual investors into bonds, stocks, and money market securities. • A small saver who buys mutual fund shares gains opportunities for capital gains and indirect access to higher yielding securities that can be purchased only in large blocks, and yet still enjoys price stability, low risk, and high liquidity.
Mutual Funds (Investment Companies) • Investment companies first developed in the U.K., and then made their appearance in the U.S. in 1924 as a vehicle for buying and monitoring subsidiary corporations. • Since then, the traditionally stock-investing industry has seen many innovations – bond funds, money market funds, index funds, global funds, vulture funds, small/mid/large-cap investment companies, and hedge funds.
TAX Mutual Funds (Investment Companies) • Investment companies have a favorable tax situation – they pay no federal taxes on income generated by their security holdings, provided their earnings flow through to their customers.
Mutual Funds (Investment Companies) • Open-end investment companies, or mutual funds, buy back (redeem) their shares any time the investor wishes, and sell shares in any quantity demanded. • The price of each open-end company share is equal to the net asset value of the fund – that is, the difference between the values of its assets and liabilities divided by the volume of shares issued.
Mutual Funds (Investment Companies) • Closed-end investment companies sell only a specific number of ownership shares, which usually trade on an exchange. • They offer “double discounts” – discounted prices on the stocks they hold and discounted share prices to buy into the fund itself.
17 - 8 Mutual Funds (Investment Companies) Source: Board of Governors of the Federal Reserve System
Mutual Funds (Investment Companies) • Investment companies adopt many goals. • Growth funds invest mainly in common stocks offering strong growth potential to achieve long-term capital appreciation. • Income funds typically purchase stocks and bonds paying high dividends and interest to gain current income. • Balanced funds acquire bonds, preferred stock, and common stock that offer both capital gains (growth) and current income.
Mutual Funds (Investment Companies) • It is not clear if mutual funds hold a significant advantage over other investors in seeking the highest returns available in the financial marketplace. • With the possible exception of index funds, these companies may roll over their portfolios too rapidly, running up the cost of managing the fund and reducing earnings.
Pension Funds • Pension funds protect individuals and families against loss of income in their retirement years by allowing workers to set aside and invest a portion of their current income.
Pension Funds • Defined benefit plans promise a specific monthly or annual payment to workers when they retire based upon the size of their salary during their working years and their length of employment. • Such programs have the advantage of guaranteed income, but an employee who leaves early or is dismissed before retirement may get little or nothing.
Pension Funds • Defined contribution plans specify how much must be contributed each year in the name of each worker, but the amount to be received when retirement is reached will vary depending upon the amount saved and the returns earned on accumulated savings. • The funds saved belong to the employee, and are portable.
Assets of Pension Funds $ Billions Data Source: Board of Governors of the Federal Reserve System Pension Funds
Pension Funds • Pension funds are long-term investors with limited need for liquidity. • Their incoming cash receipts are known with considerable accuracy, and their cash outflows are not difficult to forecast. • However, the pension fund industry is closely regulated in all its activities.
17 - 16 Pension Funds Source: Board of Governors of the Federal Reserve System
17 - 17 Pension Funds Source: Board of Governors of the Federal Reserve System
Pension Funds • There appear to be serious problems ahead for both the growth and stability of pension plans. • The rising proportion of pension beneficiaries to working contributors, related to the aging of the population. • The increasing cost of maintaining pension programs, especially defined benefit plans. • The rising cost of government regulation with respect to reporting requirements and employee rights.
Life Insurance Companies • Life insurance companies offer their customers a hedge against the risk of earnings losses that often follow death, disability, or retirement. • Policyholders receive risk protection in return for their payment of policy premiums. • Additional funds to cover claims and expenses are provided by the earnings from the investments made by the insurance companies.
Life Insurance Companies • The principal kinds of policies sold by life insurance companies include ordinary or whole life, term life, endowment, group life, industrial life, universal life, variable life, adjustable life, and credit life insurance. • Many policies combine financial protection against death, disability, and retirement with savings plans to help the policyholder prepare for some important future financial need.
Data Source: American Council of Life Insurers Life Insurance Companies in the U.S.
Life Insurance Companies • The insurance business is founded upon the law of large numbers – a risk that is not predictable for one person can be forecast accurately for a sufficiently large group. • So, life insurers invest the bulk of their funds in long-term securities, and frequently follow a “buy and hold” strategy. They generally pursue income certainty and safety of principal in their investments.
17 - 23 Life Insurance Companies Source: Board of Governors of the Federal Reserve System
Life Insurance Companies • The majority of the close to 1,700 U.S. life insurance companies are stockholder-owned corporations. The rest are mutuals that issue ownership shares to their policyholders. • The population reached a high of almost 2,350 in 1988 and has been falling ever since. • Most notably, the largest life insurers today are converging with other financial institutions to form huge multi-product businesses.
Life Insurance Companies • Life insurers are under increasing pressure to develop new services. • Among the most important recent innovative services are universal and adjustable life insurance, variable premium and variable life insurance, mutual funds, tax shelters, venture capital loans, guaranteed investment contracts, corporate cash management systems, and deferred annuities.
Property-Casualty (P/C) Insurance Companies • Property-casualty (P/C) insurers (insurance supermarkets) offer protection against events like fire, theft, bad weather, and negligence that result in injury to persons or property. • Traditional P/C insurance covers automobile, fire, marine, personal liability, and property. • Many P/C insurers have also branched into health and medical insurance, clashing head-on with life insurers.
Property-Casualty (P/C) Insurance Companies • There are nearly 3,000 P/C companies in the U.S., of which about three quarters are stockholder-owned, while the rest are mutuals. • P/C insurance is a riskier business than life insurance – P/C claims are less predictable and inflation has a potent impact. • Moreover, the P/C risk patterns appear to be changing. For example, there has been a rapid rise in product liability claims.
17 - 28 Property-Casualty (P/C) Insurance Companies Source: Board of Governors of the Federal Reserve System
Property-Casualty (P/C) Insurance Companies • Like life insurance firms, P/C insurers plan to break even on their insurance product lines and earn most of their net return from their investments. • However, achieving the break-even point is difficult. In fact, P/C insurers have experienced billions of dollars in underwriting losses in recent years.
Property-Casualty (P/C) Insurance Companies • The earnings and sales revenue of the P/C insurance industry reflect the ups and downs of the business cycle. • Moreover, inflation pushes up the cost of claims, while intense competition holds premium rates down. • To improve their future situation, P/C insurers must become more innovative in developing new services.
Finance Companies • Finance companies grant credit to businesses and consumers for a wide variety of purposes, including the purchase of business equipment, automobiles, vacations, and home appliances. • As such, they are sometimes called department stores of consumer and business credit.
Finance Companies • Consumer finance companies make personal cash loans to individuals, such as home equity loans and loans to support the purchase of passenger cars and home appliances. • Sales finance companies make indirect loans to consumers by purchasing installment paper from dealers selling consumer durables. • Commercial finance companies focus mainly on extending credit to business firms.
Finance Companies • Finance companies are heavy users of debt in financing their operations. • The lack of an extensive network of branch offices has put many finance companies at a disadvantage. • The number of finance companies is on the decline, although their average size has grown considerably.
Other Financial Institutions • Security dealers “take a position of risk” in securities. They trade in securities with the expectation of earning a profitable spread. • Investment bankers assist businesses and governments in issuing debt and stock. • Venture capital firms provide long-term capital financing for new businesses and rapidly emerging companies.
Other Financial Institutions • Mortgage banks work with other businesses on real estate development projects and sell the resulting loan instruments to other investors. • Real estate investment trusts (REITs) fund commercial and residential real estate projects. • Leasing companies purchase business equipment and other assets and then lease them in return for rental fees.
Trends Affecting All Financial Institutions Today • There are several major trends affecting virtually all financial institutions today: • increasing cost pressures • consolidation • service diversification and homogenization • convergence • technological revolution • global competition • regulatory cooperation and harmonization • deregulation
Money and Capital Markets in Cyberspace • Mutual funds are discussed at http://www.ici.org/, http://www.sec.gov/, and http://investing.wsj.com/mutualfunds.html. • More information on pension funds can be found at http://www.pionline.com/ and http://www.pensionsurveys.com/. • Websites for the insurance industry include http://www.acli.com/, http://www.iii.org/, and http://www.namic.org/.
Money and Capital Markets in Cyberspace • Visit some finance companies and investment banks like http://www.citifinancial.com/, http://www.citgroup.com/, http://www.lehman.com/, http://www.morganstanley.com/, and http://www.gs.com/.
Chapter Review • Mutual Funds (Investment Companies) • The Background of Investment Companies • Tax Status of the Industry • Open-End and Closed-End Investment Companies • Goals and Earnings of Investment Companies
Chapter Review • Pension Funds • Growth of Pension Funds • Investment Strategies of Pension Funds • Pension Fund Assets • Factors Affecting the Future Growth of Pension Funds
Chapter Review • Life Insurance Companies • The Insurance Principle • Investments of Life Insurance Companies • Sources of Life Insurance Company Funds • Structure and Growth of the Life Insurance Industry • New Services
Chapter Review • Property-Casualty (P/C) Insurance Companies • Makeup of the P/C Insurance Industry • Changing Risk Patterns in Property/Liability Coverage • Investments by P/C Companies • Sources of Income • Business Cycles, Inflation, and Competition
Chapter Review • Finance Companies • Different Finance Companies for Different Purposes • Growth of Finance Companies • Methods of Industry Financing • Recent Changes in the Character of the Industry • Other Financial Institutions • Trends Affecting All Financial Institutions Today