Whether you face flood or fire, theft or sickness and for any such mishap the first thing we discuss is do we have insurance. Let's see how the insurance and pension world works!
Insurance
Insurance is an agreement between an insurer and a policyholder, where the insurer receives protection from any loss events in exchange for the payment of the periodic premiums.
There are in general three categories of insurance - life insurance, non life (property and casualty) insurance and health insurance.
Life Insurance
Interesting Note: As we cannot put a price or tag on human life, the word "insurance" is replaced with assurance. -- Professor James Forjan
- Life insurance companies provide a long term coverage and make a specified payment when a policyholder's life is at risk, which implies the death of a policyholder, this includes natural death (i.e. certain) or accidental death (i.e. uncertain).
- Types of life insurance policies:
- Term life insurance:
- A term life insurance, is a contract to pay the beneficiary a predetermined amount of benefit, also called the sum assured, in case the policyholder dies with the term of contract.
- Here pays only if the policyholder dies during a certain fixed period.
- The mortality tables are used to calculate breakeven premium.
- For example, when you take out a mortgage loan, it's often a good idea to also take out term life insurance. This can provide a safety net in case any unexpected events occur and you are unable to pay back the loan. Term life insurance typically provides coverage for a specific period of time, so it's important to choose a policy that aligns with the term of your mortgage. That way, you can have peace of mind knowing that your loved ones will be taken care of if anything were to happen to you.
- Term life insurance policies usually have a constant or declining face value over time.
- When a premium is not constant over the years of the contract, the policy is referred to as an annual renewable term policy.
- In an annual renewable term policy, the policyholder renews the policy at the rate that reflects the age of the policymaker regardless of the policymaker’s health.
- Whole life insurance:
- Provides protection for the life of the policyholder, so it provides a payoff on the death of the insured, regardless of when it happens.
- Premiums are in general paid throughout the life of the policyholder.
- Variable life insurance:
- A variable life insurance policy is a type of whole life policy insurance with an investment component.
- The surplus premium are invested in a fund chosen by the policyholder e.g. bonds, equities or money market fund.
- The total benefit received on the death of the policyholder will be sum assured plus a variable amount generated from the investment account.
- Universal life insurance:
- A universal life insurance policy is a type of whole life policy insurance.
- Normally if the policyholder stops making premium payments, the policy no longer provides coverage and the policy is then referred to as lapsing. Here it provides lot more flexibility in the term of the premium payable.
- The policyholder can reduce the premium down to a special minimum without lapse in coverage.
- While reducing the premium reduces the benefits it does but not as said result in the policy lapsing.
- Variable universal life insurance:
- A variable universal life insurance policy is a type of whole life policy insurance with an investment component.
- The policyholder can choose between number of alternatives for the investment of surplus premiums.
- Endowment life insurance:
- Last for a specified period and pays a lump sum when the policyholder dies or at the end of the period, whichever comes first.
- There are many variants of endowment life insurance, such as payouts are made when policyholder suffers from critical illness.
- In a unit linked endowment policy, the policyholder chooses a fund, and the payout depends on the performance of that fund.
- In a profits endowment policy, where the insurance company announces periodic bonuses depending upon the performance of the investments. The bonuses are reinvested and are paid out at the end of the life of the policy.
- Group life insurance:
- Covers several people under a single policy and is often purchased by the company for its employees.
- The policy could be contributory, in which case the premium is shared between the employer and employee.
- Other wise, non contributory in which employee has to pay the full premium amount.
- Risk is involved for group insurance as it does not require medical exams, resulting in good and bad risks being taken.
- Annuity contract:
- An annuity contract requires the policyholder to pay lump sum, in returns the policy holder receives a regular series of payments at specified points in future.
- The insurance company funds the annuity by investing the lump sum in an investment of their choice, including securing bonds and mutual funds.
- An annuity helps the policyholder to defer the tax payable until they receive each scheduled annuity payment and may policy holders have relatively low marginal tax rates when the annuity is received.
- Some annuities begin immediately while others start on agreed upon numbers of years later such is also called as deferred annuities. This deferred annuity structure allows the insurance company to invest the funds and build up larger balances in anticipation of payments.
- The amount to which the policyholder's funds grow in an annuity contract is referred to as the accumulation value.
- Depending on the terms of the contract, the accumulation value may be withdrawn prematurely but likely with penalties. Also, increasingly popular are penalty-free withdrawals where the policyholder can withdraw a certain portion of their accumulation value without penalty.
- Usually, if a policyholder dies before annuity payments begin, the full accumulation value can be withdrawn penalty-free.
Property and Casualty Insurance
Property and Casualty insurance companies usually provide annual and renewable coverage against loss events. The premiums may vary either increase or decrease based on any changes in the expected payouts.
Can be subdivided based on their concentration of activities in either property insurance and casualty insurance.
- Property Insurance: Provide protection against loss of or damage to property from accidents, fire, theft, water damage, etc.
- Casualty Insurance: Covers third party liability (such as injuries sustained on policyholder's premises or accident using the policyholder's use of vehicle) and provides protection individuals and companies against legal liability exposures.
Contracts usually last for a year, but they may be renewed every year. Premiums collected may change, either increase or decrease each year depending upon the expected payouts, profit margins, and competition, among other factors.
The contracts whose payouts are difficult to predict are those where a specific event is liable to trigger claims by many policyholders around the same time.
Most likely here the risks can be controlled by estimating the expected payouts on claims with a high degree of confidence. This is possible when many policies are written in thousands of independent events, such as in automobile insurance. When insurers may face catastrophe risks due to natural disasters, which can lead to many large claims in certain part, while in others they may benefit if there are no natural disasters. Catastrophe risks are all-or-nothing, and can be managed by using geographical, seismographic, and meteorological information to determine the probability and severity of catastrophic events.
In general, for property-casualty insurance companies, property damage claims from natural disasters and liability insurance claims are subject to fluctuating payouts and are very challenging to predict.
The property-casualty insurance company must keep more equity capital as a percent of total assets, than a life company insurance.
Property and casualty insurance company compute the following ratios:
- Loss Ratio:
- For a given year is the percentage of payouts versus premiums generated.
- The high loss ratio indicates poor financial health, could be either insurer may not be collecting enough premium to pay claims, expenses and still make a sizeable profit.
- Expense Ratio:
- For a given year is the percentage of expenses versus premiums generated.
- It shows how efficient the insurer is in terms of cash management before factoring in claims and investment gains or losses.
- The largest expenses are usually loss adjustments (e.g. claims investigation and assessing payout amounts) and selling (e.g. broker commissions).
- Combined Ratio:
- For a given year is equal to the sum of the loss ratio and the expense ratio.
- For example, for a category of policies in a particular year, if the loss ratio is 75% and the expense ratio is 30%, then the combined ratio is 105%.
- Combined Ratio after dividends:
- For a given year is equal to the combined ratio plus the payouts of dividends to policyholders as a percentage of premiums only if applicable.
- From the above example, suppose a small dividend to the tune of 1% of premiums is paid to the policyholders, we get a combined ratio after dividends of 106%.
- Operating Ratio:
- For a given year is the combined ratio (after dividends) less investment income as a percentage of premiums.
- Also could say as is the ratio obtained when investment income earned from premiums is reduced from the losses as represented by the combined ratio.
- Continuing with the example, our combined ratio after dividends was 106%, which means the insurance company makes a loss of 6% before tax on the policies being considered. If the investment income is 9% of premiums received. Then, the operating ratio would be 106 − 9 = 97%.
Risks associated with property and casualty insurance contracts can be divided into two main risk groups.
- Easy to predict payouts: Payouts with ample historical data allow for accurate predictions, e.g. car accidents and property damage.
- Difficult to predict payouts: Catastrophic risks involve single events such as hurricanes, floods, or earthquakes that may result in many individual claims. These events are known as high consequence, low probability events. Catastrophic claims are not independent of each other, and they are usually all-or-nothing risks. Because of the potentially large claims associated with these risks, property-casualty insurance companies are required to keep more equity capital as a percentage of total assets compared to life insurance companies. Here e.g. earthquakes, floods and hurricanes.
Health Insurance
- Health insurance companies provide coverage to policyholders for medical services that are not covered under a publicly funded health care system.
- Healthcare payment and control systems can be broadly classified into two categories:
- Government-run systems, where the government bears most or all of the costs and controls the system to a significant extent.
- Private insurance markets, where costs are allocated and care is provided by private insurance companies.
- For individuals, policyholders pay ongoing premiums and may increase due to general increases in health care cost and age of the policyholder similar to life insurance.
- For organizations, health insurance premiums resemble life insurance premiums when changes to the company's assessment of the risk of a payout do not lead to an increase in premiums.
- In some cases, insurance coverage may be denied to individuals which may be for certain period on new policy with preexisting medical conditions. Though it could cover if the preexisting medical conditions are unknown.
Mortality Table
- Mortality tables show the rate of death within a specific population.
- Mortality tables utilize various factors to predict the likelihood of an individual’s death in the current year.
- Mortality tables are used heavily by insurance companies to value life insurance contracts and project future insured events.
- Please find below the sample mortality table, this would differ year to year and based on the particular region or other much more finer variables.
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Credits: https://qsstudy.com/wp-content/uploads/2018/12/Mortality-Table.jpg
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- Calculate the present value of the expected payout. If we assume the payout occurs at the middle point of the year, the present value of the payout is $5269.54
- Formula: PV= (1+r)nFV
- $5,373.9 * (1 / ((1 + 0.04)^0.5)) = $5269.54
- Here,
- 5,373.9 is the expected value
- 0.04 is the given in the problem statement as 4% per annum
- 0.5 is the number of periods, as this semiannual its considered as half of one year.
- So far we have seen if the term insurance of one year, but if the term insurance lasts longer than one year, what will be the expected payout considering the present value of the two years. Let's perform two-year calculation.
- If we suppose the term insurance lasts two years, the expected payout in the first year is still $5,373.9.
- Formula for expected payoff in 2nd year:
- (1st year survival probability) * P(death in the second year) * Insurance coverage
- Here the 1st year survival probability can be calculated by 1 minus P(death in the first year)
- The probability that the policyholder dies during the second year is (1 − 0.053739)× 0.065873 = 0.06233.
- The expected payout in the second year is then $6,233 and is calculated as 0.06233 × $100,000 = $6,233.
- If we assume the payout occurs in the middle of the second year, the present value of the payout is $14,487, as calculated below.
- $6,233 * 1/((1+0.04)^1.5) = $5,876.883 # 0.5 * 3 terms = 1.5
- $6,233 * 0.942866= $5,876.88 #Simplified version
- To calculate the total present value of payouts, one sums the two years. In this two-year case, the present value of the expected payouts is $11,146.42
- Formula: PV of 1year + PV of 2year
- $5269.54 + $5,876.88 = $11,146.42
- Premium payments, up to this point, the calculations have been on the nominal and present value of expected payouts should death occur. What about premium payment? The insurance company has to cover the expected payouts. In the example above, it is known that the first premium has no risk. The second payment depends upon whether the individual lives to age 81.
- This probability is the change that the person does not die during the first year. In this example, the probability is 83.27%.
- Formula: Probability of Survival in the 1st. year = 1 - P(Death 1st year)
- 1 − 0.053739 = 0.946261
- If the premium is dollars per year, the present value of the premium payments is given by: X + 0.946261 * 1/((1 + 0.04)^1) = 0.90986X
- With the above equation, the calculation of the break-even annual premium is found simply by equating the present value of the expected premium payments to the present value of the expected payout. In this case, the equation (below) and associated answer is $17,155.
- 0.90986 * X = $11,146.42
- X = $11,146.42/ 0.90986
- X = $12,250.69
Risk Management
Major Risk Facing Insurance Companies
- Insufficient funds to satisfy policyholders's claims: The reserves held by the insurance companies to meet the payouts as required by the claims of policyholders may fall short of their estimation. This is the biggest risk faced by the insurance companies. This could be due to sudden surge of payouts in a short time (e.g. mortality risk and catastrophe risk) or payouts that continue for longer than expected (e.g. longevity risk).
- Poor return on investments: They mostly invest in corporate bonds and when defaults on corporate bonds increases, it takes a toll on the profitability of the insurance company. Diversification of investments by industry sector and geography can help mitigate such loses.
- Liquidity risk: They face liquidity risk associated with their investments. For example illiquid bonds give higher yields but they cannot be readily converted into cash to meet high claims when they are not anticipated beforehand.
- Credit risk: Since insurance companies enter into transactions with banks and reinsurance companies, they are exposed to credit risk, if the counterparty default its obligations.
- Operational and business risks: Similar to banks, insurance companies faces losses due to failure of systems and procedures or external events outside the company's control (e.g. computer failure or human error).
- Misprice their risk: Insurance companies operate on risk models. If their economists and statisticians misestimate their expected costs due to, for example, an unexpected natural disaster, the result could be bankruptcy.
Moral Hazard
- Moral hazard describes the risk to the insurance company that having insurance will lead the policyholder to act more recklessly than if the policyholder did not have insurance.
- This difference in behaviour increases the risks and rises the expected payouts of the insurance company.
- Methods to mitigate against moral hazard includes the below:
- Deductibles: The policyholder is responsible for bearing the first part of any loss. For example policyholder is responsible for a fixed amount of the loss.
- Co-insurance provision: The insurance company pays a predetermined percentage (less than 100%) of losses in excess of the deductible. For example insurance company will only pay a fixed percentage of losses
- Policy limit: An upper limit to the payout is set by the insurance company. For example fixed maximum payouts.
- By aligning the interest of the policyholders more closely with those of the insurance company, moral hazard can be handled better, using the above methods.
Adverse Selection
- Adverse selection describes the situation where an insurer is unable to differentiate between a good risk and a bad risk as a result it offers the same price to everyone, thereby attracting more of the bad risks (e.g. careless drivers, sick individuals).
- Just like moral hazard, adverse selection increases the chances of claims overwhelming the insurer, something that can lead to insolvency.
- To reduce the impact of the problems created due to adverse selection, an insurance company tries to do greater due diligence such as physical examination, researching driving records and so on, about the policyholder before committing itself. Also performs ongoing due diligence for example updating driving reports and adjusting premiums to reflect changing risks.
Mortality Risk
- Mortality risk refers to the risk of policyholders dying earlier than expected could be due to illness or disease.
- Mortality risk is higher usually during wars, epidemics, natural disasters which will cause many individuals to die sooner than expected.
- From the perspective of the insurance company, the risk of losses increases due to the earlier-than-expected life insurance payout. Usually mortality risk is higher term insurance policies.
- In contrast, increased mortality risk increases the profitability of annuity contracts because the policyholders end up receiving fewer scheduled payments.
- In calculating the impact of mortality risk, it is important to consider the age groups within the population that are most affected by an event.
Longevity Risk
- Longevity Risk refers to the risk of the policyholders living longer than expected could be due to healthy lifestyle.
- From the perspective of the insurance company, the risk of losses increases due to the longer-than-expected annuity payout period. Usually longevity risk is higher term annuity policies.
- In contrast, increased longevity will improve the profitability of life insurance contracts, because the insured will end up paying more and more premiums.
- To handle loss caused due to longevity, longevity derivative or longevity bonds can be acquired.
Hedging mortality and longevity risk
- First let's understand what does hedging means, hedging is a financial strategy used to reduce or offset the risk of potential losses in investments. It involves taking actions or making investments that counterbalance the potential negative impact of adverse price movements in the market.
- In an insurance company, the risks associated with long-term payments and potential death benefits for annuity contracts are often balanced out by the risks present in their regular life insurance policies.
- However, when the overall financial exposure of the insurance company is significant, they may choose to mitigate these risks by obtaining reinsurance.
- Reinsurance is a method used by insurance companies to transfer some risk to another insurer in exchange for a premium, which helps them to mitigate potential losses.
- Derivative contracts, here the insurance companies may enter into longevity derivative contracts that provide favourable payoffs when they are concerned about their exposure to longevity risk on annuity contracts.
- A typical derivative here is the longevity bond:
- A population is defined
- A coupon payable as a particular date is a function of the number of people still alive at that point
- For example on longevity derivative contracts, let's say a pension fund purchases a longevity derivative contract for a group of retirees, and the benchmark is set at an average lifespan of 85 years. If the actual average lifespan of the retirees covered by the contract exceeds 85 years, the financial institution (counterparty) pays the pension fund an agreed-upon amount. This payout helps the pension fund offset the increased costs associated with longer life expectancies.
Fund Management
Capital Requirements for Insurance Companies
- In U.S. capital requirements are determined by state regulators using risk-based capital standards determined by the National Association of Insurance Commissioners (NAIC). The NAIC is an organization consisting of the chief insurance regulatory officials from all 50 states.
- In the European Union, insurance companies are regulated centrally implying similar regulatory framework across all member countries, this framework known as Solvency I.
- No global capital requirements exist for insurance company and Solvency I did not consider investment risks, however Solvency II (upgraded) is the set of rules and regulations implemented in 2016.
- Under Solvency II, there is requirements
- Solvency Capital Requirement - SCR, if the capital < SCR, warning is issued as the company must increase above the SCR.
- Minimum Capital Requirement - MCR, if the capital < MCR, business operations may become significantly restricted.
- MCR is usually 25% to 45% of SCR.
- SCR and MCR, telling how much the capital is required, are calculated based on the sum of charges for:
- investment risk (assets)
- credit risk (due to investments)
- market risk (due to investments)
- underwriting risk (liability)
- operation risk
- Property-casualty insurance company requires more capital, due to the potential catastrophic nature and amount of claims are higher.
- Life insurance risks are lesser to certain extent due to predictable longevity and mortality risks.
Guaranty System for Insurance Companies
- Guaranty system protect policyholders from an insurance company’s inability to pay claims due to insolvency.
- Guaranty system exists for both insurance companies and banks, in U.S.
- Insurance companies are regulated at state level, whereas banks are regulated at the federal level.
- Regulation of insurance companies at the state level faces some shortcomings as mentioned below.
- Regulations tend to vary across different states.
- Some insurance companies trade derivatives in the same way as banks, but are not subject to the same regulations as banks which can lead to some serious issues.
- Insurance companies are required to be members of the guaranty association in every state where they operate. If an insurance company becomes insolvent in a state, every insurance company operating in the state contributes an amount to the state guaranty fund depending on the premium income it collects. The guaranty fund’s purpose is to compensate policyholders of the insolvent company. However, there may be limits on the amount of claims and some delays in the settlement process.
- The Dodd–Frank Act of 2010 in the US resulted in the formation of Federal Insurance Office (FIO) which monitors the insurance industry and identifies gaps in regulation.
Pension
- Many companies provide insurance to employees in form of guaranteed income for their rest of the lives once they have retired.
- Both the company and its employees make regular monthly contributions to the plan and the funds in the plan are invested to provide income for retires.
Defined benefit plan
- In a defined benefit plan, the benefits to be received by the employee are defined, here employee benefit known and employer contribution unknown.
- Explicitly state the amount of the pension that the employee will receive upon retirement.
- The pension to be received by the employee after retirement is defined by a plan. The pension is calculated by a formula which is based on the number of years of employment and the employee's salary.
- There is significant risk borne by the employer because it is obligated to fund the benefit to the employee at retirement, therefore when the present value of the pension obligation exceeds the market value of the pension, the employer has to cover the deficiency.
- The computation of the pension liability is highly sensitive to the discount rate used and generally must be equal to yield on AA rated bonds.
- Additionally some defined plans may include indexation of pension amounts to account for inflation. Also continued pension payments to the surviving spouse upon the death of a retired employee, where the payout may be same or less than what pensioner received.
- A defined contribution plan is based on one employee’s individual account.
- The responsibility of the defined benefit plans lies with the employer
Defined contribution plan
- In a defined contribution plan, the monthly contributions to be made by the employees and employers to the pension plan are defined, here employer benefit known and employee contribution unknown.
- Both the employee and employer contributions are invested in one or more investments selected by the employee.
- When employees retire, the final value of the contributions invested can be converted to a lifetime annuity or received as a lump sum.
- Here the employer simply obligated to make set of contribution and risk is solely borne by the employee.
- In a defined benefit plan is based on a pooled account for all employees, as all the contributions go into and all the payments come out of the one account.
- The responsibility of the performance of a defined contribution plan is left in the hands of the employee.
Conclusion
We have covered the risks involved as the organization and individual when dealing with insurance and pension plans.
Though we wish we should never use the insurance, but it is always good be prepared for the worst case. And today investing in pension plan will reap benifits in future.
Credits and References
- https://www.youtube.com/watch?v=HyWrJRT1rWk
- https://www.youtube.com/watch?v=00_DQF3KHxg
- GARP, Schweser and Bionic Turtle Notes
- https://www.investopedia.com/
- http://chat.openai.com/ #shout out to the examples helped in learning the concepts
