I.  Background

• insurance companies are risk bearers; in other words, they bear risk that individuals are willing to pay to avoid--risk of death, disability, property loss, litagation, investment fluctuation, etc.
• insurance companies receive premiums inexchange for underwriting risks
• invest premiums to meet future liabilities and make profit
• insurance company liabilities are contingent liabilities--they depend on the occurences of certain events in future
• time and amount of liabilities are uncertain (depending on type of insurance)
• an insurance company's profit/loss =  premiums + investment income - claims - overhead

• Life Insurance
• insurance against risk of death
• term life insurance
• pure life insurance
• if death within policy period, then death benefit paid; if not, then policy is worthless
• cash value life insurance
• whole life insurance
• life insurance and policy builds cash value
• premiums cover both cost of insurance and investment capital over life of policy
• universal life insurance
• life insurance and policy builds cash value
• buildup of cash value may be used to finance future premiums
• variable life insurance
• policy holders chooses how to investment premiums
• cash value and death benefit depend on investment returns
• timing and size of claims for a group of policies is predictable
• life insurance companies also offer investment products like GICs and annuities
• Health Insurance
• pays all/some of costs of medical treatment
• indeminity or fee-for-service plans (rare)
• managed care
• HMOs, PPOs
• restrict provider choice and reimbursements
• for-profit, nonprofit, government providers
• typically a separate industry
• Property and Casualty Insurance
• insurance against damages to property (house, auto)
• time and size of claims highly unpredictable
• typically a separate industry
• Liability Insurance
• insures against risk of litigation (attornies fees, settlements, jury awards)
• time and size of claims also unpredicatable
• Disability Insurance
• insures against loss of ability to work in current or any occupation (short-term or long-term)
• more predictable, like life insurance
• Long-term Care Insurance
• pays all/some of costs for long-term nursing home care or in-home care for aged/disabled
• fairly new industry
• Structured Settlements
• fixed payments over time due to disability or damages from a lawsuit
• managed by life insurance companies
• Guaranteed Investment Contracts (GICs)
• firm pays single premium ($10 million)
• insurer guarantees annual rate of return (10%) for certain period (5 years)
• 1 to 20 years is typical
• at end of period, premium and interest is paid out ($10 million x (1.1)^5 = $16.1 million)
• large premium means these are purchased by institutional investors, esp. pension funds
• insurer is bearing investment risk
• GIC is only as good as insurer's credit ratings, defaults can and do occur
• Annuities
• insurance company investsments premiums in stock/bond portfolio earning a return for investors
• premiums over time or in lump-sum
• annuity payments fixed or variable, often life-contingent
• income and capital gains are not taxable until withdrawn by investor
• some guarantee of return and principle
• compared to mutual fund
• preferential tax treatment
• higher expenses (due to guarantee)

• timing and amount of claims are uncertain, but predictability varies depending on type of insurance
• affects choice of assets
• life insurance -- more long-term assets, fewer cash assets
• P&C insurance -- fewer long-term assets, more cash assets
• time lapse between payments of premiums and payment of claims
• importance of invesmtent portfolio

• regulation at the state level with state insurance commissions
• states set similar standards through National Assoc. of Insurance Commissions (NAIC)
• there is NO federally-sponsored insurance to back the insurance industry, thus the individual credit ratings of insurers are important
• publicly held insurance companies also subject to SEC regulation
• states regulate
• the type of assets permitted
• required surplus (statutory surplus)
• assets-liabilities
• assures ability meet obligations
• taxation
• life insurance companies/products get favorable tax treatment
• tax deferral on investment gains and income for annuities and cash value life insurance
• death benefits not taxable
• deregulation
• repeal of Glass Steagall 1999
• affliations between investment co., insurance co. and commerical banks now allowed
• Citigroup (Salomon Smith Barney, Citicorp, Traveler's)

• 3 functions of insurance company
• manufacture and guarantee policy
• design and price the policy
• promises payment
• invest premiums
• sell the policies
• agents sell policies of one company
• brokers sell policies for many companies
• commercial banks also distribute policies
• functions are increasingly outsourced to difference companies
• moving away from agents
• outsourcing investment portfolio management
• buying reinsurance to distribute underwriting risk
• forms of ownership
• stock insurance company
• owned by shareholders
• potential conflict between policy holders and shareholders
• easier access to capital
• mutual insurance company, owned by policy holders
• no conflicts, and longer-term investment horizon
• limited access to capital
• protection from acquistion
• trend toward demutualization
• raise funds to merge with other financial institutions
• offer stock compensation to attract talent