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1. Insurance Companies
• Insurance companies are in the business
of assuming risk on behalf of their
Chapter Five customers in exchange for a fee, called a
premium.
• Insurance companies make a profit by
Nonbank Finance charging premiums that are sufficient to
pay the expected claims to the company
plus a profit.
• Why do people pay for insurance?
Fundamentals of Insurance Fundamentals …
1) There must be a relationship between the 4) If a third party compensates the insured for
insured and the beneficiary. In addition, the loss, the insurance company’s obligation
the beneficiary must be someone who is reduced by the amount of the
may suffer potential harm. compensation.
2) The insured must provide full and accurate 5) The insurance company must have a large
information to the insurance company. number of insureds.
6) The loss must be quantifiable.
3) The insured is not to profit as a result of
insurance coverage. 7) The insurance company must be able to
compute the probability of the loss occurring.
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Adverse Selection and Moral Hazard in
Insurance
Cont’d…
• Adverse selection occurs when the individuals • Moral hazard occurs when the insured fails to
most likely to benefit from a transaction are take proper precautions to avoid losses
the ones who most actively seek out the because losses are covered by insurance.
transaction and are thus most likely to be • One way that insurance companies combat
selected. moral hazard is by requiring a deductible.
• The implication of adverse selection is that • A deductible is the amount of any loss that
loss probability statistics gathered for the must be paid by the insured before the
entire population may not accurately reflect insurance company will pay anything.
the loss potential for the persons who actually
want to buy policies.
Selling Insurance Types of Insurance
• Another problem common to insurance 1. Life insurance
companies is that people often fail to seek as • Provides income for the heirs of the deceased.
much insurance as they actually need. • The cost of life insurance depends on such
• Insurance does not sell itself like banking factors as the age of the insured, average life
services. expectancies, and the health and lifestyle of the
insured.
• Instead, insurance companies must hire large • The purpose of life insurance is to relieve some
sales forces to sell their products. of the concern associated with either premature
• Independent agents may sell insurance for a death or living too long.
number of different companies. • The basic products of life insurance companies
are life insurance proper, disability insurance,
• Exclusive agents sell the insurance products annuities, and health insurance.
for only one insurance company.
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Types of Insurance… Types of Insurance…
• Life insurance pays off if you die, protecting those Categories of Life Insurance
who depend on your continued earnings. 1. Term Life:
• Disability insurance replaces part of your income • The simplest form of life insurance, which pays
should you become unable to continue working out if the insured dies while the policy is in force.
due to illness or an accident. • This form of policy contains no savings element.
• An annuity is an insurance product that will help • Once the policy period expires, there are no
if you live longer than you expect. residual benefits.
• Insurances works under the law of large numbers • As the insured ages, the probability of death
• The law of large numbers says that when many increases, so the cost of the policy rises.
people are insured, the probability distribution of • Decreasing term policies have a constant
the losses will assume a normal probability premium, but the amount of the insurance
distribution, a distribution that allows accurate coverage declines each year.
predictions.
Types of Insurance… Types of Insurance…
Categories of Life Insurance… 4. Annuities
2. Whole Life
• Can be viewed as insuring against life.
• Pays a death benefit if the policyholder dies.
• Require the insured to pay a level premium
• Once purchased, it makes payments as
for the duration of the policy. long as the beneficiary lives.
3. Universal Life • They are particularly susceptible to the
• Combine the benefits of the term policy with adverse selection problem.
those of the whole life policy.
• The major benefit is that the cash value
accumulates at a much higher rate.
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Types of Insurance… Types of Insurance…
2. Health Insurance 3. Property and causality insurance
• Individual health insurance coverage is very • The earliest form of insurance.
vulnerable to adverse selection problems. • Protects against losses from fire, theft, storm,
explosion, and even neglect.
• This causes individual health insurance to be • Property insurance protects businesses and
very expensive. owners from the impact of risk associated with
• Most policies are offered through company- owning property.
sponsored programs in which the company • Casualty insurance (or liability insurance)
pays all or part of the employee’s policy protects against liability for harm the insured may
cause to others as a result of product failure or
premium.
accidents.
Types of Insurance… Types of Insurance…
• Property and casualty insurance is different • Named-peril policies insure against loss only
from life insurance. from perils that are specifically named in the
policy.
– First, policies tend to be short-term, usually for • Open-peril policies insure against all perils except
one year or less. those specifically excluded by the policy.
– Second, whereas life insurance is limited to • Other Types
insuring against one event, property and • Reinsurance allocates a portion of the risk to
casualty companies insure against many another company in exchange for a portion of the
different events. premium.
– Finally, the amount of the potential loss is • Credit Default Swaps: is insurance against default
much more difficult to predict than for life on a financial instrument, usually some kind of
insurance. securitized bond.
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2. Pension Funds Pension Funds…
• A pension plan is an asset pool that accumulates 2. Defined-Contribution Pension Plans
over an individual’s working years and is paid out • Specify only what will be contributed to the
during the nonworking years. fund.
1. Defined-Benefit Pension Plans
• The retirement benefits are entirely
• The plan sponsor promises the employees a dependent on the earnings of the fund.
specific benefit when they retire.
• Puts the burden on the employer to provide
adequate funds to ensure that the agreed
payments can be made.
3. Mutual Funds Mutual Funds…
• Mutual funds pool the resources of many • Benefits of Mutual Funds:
small investors by selling them shares in the – Liquidity intermediation
fund and using the proceeds to buy securities. – Denomination intermediation
• Through the asset transformation process of – Diversification
issuing shares in small denominations and
buying large blocks of securities, mutual funds – Cost advantages
can take advantage of volume discounts on – Managerial expertise
brokerage commissions and can purchase
diversified portfolios of securities.
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Mutual Funds… Mutual Funds…
Mutual Fund Structure • The problem with closed-end funds is that
• Mutual funds offered by companies are called once shares have been sold, the fund cannot
‘complexes.’ take in any more investment dollars.
1. Closed-End Mutual Fund • The advantage to managers is that investors
• In it, a fixed number of nonredeemable shares cannot make withdrawals.
are sold at an initial offering and are then • The only way investors have of getting money
traded in the over-the-counter market like
common stock. out of their investment in the fund is to sell
shares.
• The market price of these shares fluctuates
with the value of the assets held by the funds.
Mutual Funds… Mutual Funds…
2. Open-end Fund Investment Objective Classes:
• Investors can contribute to an open-end fund • Equity Funds: all invest in stock
at any time. • Bond Funds
• The fund simply increases the number of – Strategic income bonds
shares outstanding. – Corporate bond
• Another feature of open-end funds is that the – Government bonds
fund agrees to buy back shares from investors Bonds are not as risky as stocks.
at any time. It is relatively easy to buy and sell bonds through
the secondary market.
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Mutual Funds…
• Hybrid Funds: combine stocks and bonds into
one fund.
• Money Market Funds: are open-end
investment funds that invest only in money End of Chapter
market securities.
Thank You
