Financial Markets and Institutions (2-downloads)

Age of Insured

Cost ($)

40

134

41

147

42

153

45

192

50

286

55

461

60

810

---

Chapter 21 Insurance Companies and Pension Funds

521

Universal Life

In the late 1970s, whole life policies fell into disfavor because the rates

of return earned on the policy premiums were well below rates available on other

investments. For example, say that an investor bought a term policy instead of a whole

life policy and invested the difference in the premiums. If she did this each year for

the term of the whole life policy, she would be able to pay for term insurance and

still have a much greater amount in her investment account than if she had initially

purchased the whole life policy. Investment advisers and insurance agents began steer-

ing customers away from whole life policies. The sales pitch became “buy term and

invest the difference.” Because the agents were also selling other investments, they

did not suffer from this change in insurance plans. To combat the flow of funds out

of their companies, insurance firms introduced the universal life policy.

Universal life policies combine the benefits of the term policy with those of the

whole life policy. The major benefit of the universal life policy is that the cash value

accumulates at a much higher rate.

The universal life policy is structured to have two parts, one for the term life

insurance and one for savings. One important advantage that universal life policies

have over many alternative investment plans is that the interest earned on the sav-

ings portion of the account is tax-exempt until withdrawn. To keep this favorable

tax treatment, the cash value of the policy cannot exceed the death benefit.

Universal life policies were introduced in the early 1980s when interest rates were

at record high levels. They immediately became very popular and by 1984 accounted

for 32% of the volume of life insurance sold. Later, as interest rates fell, their popu-

larity ebbed.

Annuities

If we think of term life insurance as insuring against death, the annuity

can be viewed as insuring against life. As we noted earlier, one risk people have is

outliving their retirement funds. If they live longer than they projected when they ini-

tially retired, they could spend all of their money and end up in poverty. One way

to avoid this outcome is by purchasing annuities. Once an annuity has been purchased

for a fixed amount, it makes payments as long as the beneficiary lives.

Annuities are particularly susceptible to the adverse selection problem. When

people retire, they know more about their life expectancy than the insurance com-

pany knows. People who are in good health, have a family history of longevity, and

have attended to their health all of their lives are more likely to live longer and

hence to want to buy an annuity more than people in poor or average health. To avoid

this problem, insurance companies tend to price individual annuities expensively.

Most annuities are sold to members of large groups where all employees covered

by a particular pension plan automatically receive their benefit distribution by pur-

chasing an annuity from the insurance company. Because the annuity is automatic,

the adverse selection problem is eliminated.

Assets and Liabilities of Life Insurance Companies

Life insurance companies

derive funds from two sources. First, they receive premiums that represent future

obligations that must be met when the insured dies. Second, they receive premi-

ums paid into pension funds managed by the life insurance company. These funds are

long-term in nature.

Since life insurance liabilities are predictable and long-term, life insurance com-

panies can invest in long-term assets. Figure 21.3 shows the distribution of assets

of the average life insurance company at the beginning of 2009. Most of the assets

are in long-term investments such as bonds.

Insurance companies have also invested heavily in mortgages and real estate over

the years. In 2009, about 8% of life insurance assets were invested either in mortgage

---

522

Part 6 The Financial Institutions Industry

loans or directly in real estate. This percentage is down substantially from historic

levels. Figure 21.4 displays the percentage of assets invested in mortgages from 

1920 to 2009. The decline in mortgage investment, which represents a shift to lower-

risk assets, has been offset by increased investment in corporate bonds and gov-

ernment securities.

The shift to less risky securities may be the result of losses suffered by some

insurance companies in the late 1980s. As insurance companies competed against

mutual funds and money market funds for retirement dollars, they found that they

needed higher-return investments. This led some insurance companies to invest in

real estate and junk bonds. Deteriorating real estate values brought on by over-

building during the 1980s caused some firms to suffer large losses. The combina-

tion of large real estate losses and junk bond investment contributed to the failure

of several large firms in 1991, including Executive Life, with assets of $15 billion, and

Mutual Benefit Life, with assets of $14 billion.

Health Insurance

Individual health insurance coverage is very vulnerable to adverse selection prob-

lems. People who know that they are likely to become ill are the most likely to seek

health insurance coverage. This causes individual health insurance to be very expen-

sive. Most policies are offered through company-sponsored programs in which the

company pays all or part of the employee’s policy premium.

Most life insurance companies also offer health insurance. Health insurance

premiums account for about 24% of total premium income. Life insurance companies

compete with Blue Cross and Blue Shield organizations, nonprofit firms that are spon-

sored by hospitals. Blue Cross usually covers hospital care, and Blue Shield, doc-

tors’ services. One national agency coordinates and monitors the 73 Blue Cross/Blue

Shield organizations.

The government is also involved in health insurance through Medicare and

Medicaid. Medicare provides medical coverage for the elderly, and Medicaid provides

coverage for people on welfare or who have very limited assets.

Health insurance was a major political issue in the 1992 presidential election and

continues to be the subject of regulation and debate.

One reason for the extensive debate over medical insurance has been the spi-

raling costs of health care. For most of the past decade, the cost of health care has

Loans and Mortgages

10.9%

Miscellaneous

8.7%

Bonds

56.0%

Stocks

24.4%

F I G U R E   2 1 . 3

Distribution of Life Insurance Company Assets (2008)

Source: Life Insurance Company Fact Book, 2009, Table 2.1 (American Council of Life Insurers).

---

Chapter 21 Insurance Companies and Pension Funds

523

risen much faster than the cost of living and real wages. One factor contributing to

this increase is the more sophisticated and expensive treatments constantly being

offered. For example, studies have shown that cholesterol-reducing drugs can reduce

the likelihood of cardiovascular trouble across a broad portion of the population.

These drugs cost about $3 per day and did not even exist 20 years ago. Insurance

companies have dealt with these rising costs in a number of ways. For example, today

the risk of most company-sponsored plans is borne by the company, with the insur-

ance company administering the plan and covering catastrophic expenses. This

increases the sponsoring company’s incentive to maintain a healthy workforce and to

encourage responsible use of medical facilities by its employees. For example, many

large firms have found it cost-effective to employ physician assistants on site to

reduce medical fees and absenteeism.

Another way that insurance companies are attempting to deal with increased med-

ical costs is by controlling them. This is done by negotiating contracts with physician

groups to provide services at reduced cost and through managed care, where approval

is required before services can be rendered. Health maintenance organizations

(HMOs) shift the risk from the insurance company to the provider. The insurance com-

pany pays the HMO a fixed payment per person covered in exchange for medical ser-

vices. One problem many people find with the HMO form of health care is that the

provider has an incentive to limit medical services. Regulation was required, for exam-

ple, to ensure mothers stay at least 48 hours in the hospital following a delivery.

Following a lengthy and contentious national debate, the Patient Protection

and Affordable Care Act was signed into law on March 23, 2010. This bill is expected

Percent

1920 1930 1940 1950 1960 1970 1980 1990 1993 1995 1997 1999 2001 2003 2005 2007 2009

45

40

35

30

25

20

15

10

5

0

F I G U R E   2 1 . 4

Percentage of Life Insurance Company Assets Invested in Mortgages,

1920–2009

Source: Federal Reserve Flow of Funds Accounts, Table L117; 

http://www.federalreserve.gov/releases/z1/Current/z1.pdf

.

---

524

Part 6 The Financial Institutions Industry

to expand health coverage to include an additional 32 million Americans who are cur-

rently uninsured. Some of the more controversial provisions of this bill include:

• Options to purchase insurance through state-based exchanges

•  Subsidies for low-income people to help acquire insurance

•  Limits on insurance companies denying coverage due to preexisting conditions

•  Requirement that insurance companies allow children to stay on their par-

ents plans until age 26

•  Requirement that by 2014 everyone must purchase insurance or face a fine

Property and Casualty Insurance

Property and casualty insurance was the earliest form of insurance. It began in the

Middle Ages when merchants sent ships off to foreign ports to trade. A merchant,

though willing to accept the risk that the trading might not turn a profit, was often

unwilling to accept the risk that the ship might sink or be captured by pirates. To

reduce such risks, merchants began to band together and insure each other’s ships

against loss. The process became more sophisticated as time went on, and insur-

ance policies were written that were then traded in the major commercial centers

of the time.

In 1666, the Great Fire of London did much to advance the case for fire insur-

ance. The first fire insurance company was founded in London in 1680. In the United

States, the first fire insurance company was formed by a group led by Benjamin

Franklin in 1752. By the beginning of the nineteenth century, the assets of prop-

erty and casualty insurance firms exceeded even those of commercial banks, mak-

ing these firms the most important financial intermediary. The invention of the

automobile did a great deal to spur the growth of property and casualty insurance

companies during the twentieth century.

Property and Casualty Insurance Today

Property and casualty insurance pro-

tects against losses from fire, theft, storm, explosion, and even neglect. Property