Topic 6: NonBank Financial Institutions I: Insurance Companies

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Topic 6 Non-Bank Financial Institutions I
Insurance Companies

• Definition of Insurance Companies.
• Origin of Insurance Operations.
• Types of Insurance Operations.
• Sources and Uses Funds
• Assessment and Regulation of Operations
• Risk Exposure
• Valuation of Insurance Companies

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Definition of Insurance Companies

• Deal with underwriting of risks undertake
  policies that are used to hedge against risks
• Insurance is act of equitable transferring of
  the risk of a potential loss, from one entity to
  another, in exchange for a reasonable fee,
  premium. The premium is based on predetermined
  rate and nature of risk involved. An insurer
  often makes underwriting profit.
• Insurance is a contract between the insured and
  the insurer. It specifies compensation and the
  indemnified (indemnity) items.
• Insurance policies are usually based on certain
  principles
• - Uncertainty of time and occurrence
• - Predictability of level of loss
• - Loss must be significant de minimis.
• - The loss must not be catastrophic insurer
  must not be insolvent.

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Origin of Insurance

• Originated from caravan traders practice in
  ancient Babylonia. Led to the Code of Hammurabi
  in 2100 BC.
• Life insurance originated from ancient Rome
  burial clubs were formed to meet funeral expenses
  of member and help survivors. Later led to the
  formation of Medieval guilds.
• Earliest known insurance contract started in
  1347, in Genoa, by European maritime nations.
• Modern insurance business started from the 17th
  century in England. It began in 1688 at Lloyds
  Coffee House in London, by merchants, and
  ship-owners.
• The first set of stock companies to get into the
  business of insurance were chartered in England
  in 1720. The first Insurance company was
  established in 1735.

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Types of Insurance

• Life Insurance
• Annuity investment for retirement, provides a
  stream of annual income at old age.
• Endowment regular contribution, policy holder
  receives specific sum at a pre-specified date or
  at death.
• Whole life policy that cover entire life
  duration till death, as long as premiums are
  paid. It is a form of savings to policyholder and
  can be cancelled.
• Term Insurance temporary, provides insurance
  cover only over a specific period, does not serve
  as savings, less expensive than whole life. It
  may be a decreasing (benefit) form.
• Variable life insurance policy benefits vary
  with the assets backing the policy.
• Universal life insurance combines the features
  of both whole life and term policies. It has
  timing and builds up cash for holder, cash builds
  depends on frequency of premium payment.
• Group plans undertaken by employers on behalf
  of employees.
• Health care insurance for coverage against
  illness.

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Types of Insurance (contd.)

• Non-Life Insurance Property and casualty
  Insurance
• Freight insurance indemnity against goods and
  services transportation, such as marine, air,
  road.
• Fire insurance
• Accident insurance
• Burglar or theft insurance
• Reinsurance A system whereby insurance
  companies also obtain insurance from other
  insurance companies.

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Sources and Uses of Funds

• Sources of funds
• Capital issuing of stocks, retained earnings.
• Premiums
• Annuity based on retirement income plan.
• Investment
• Uses of funds
• Government securities treasury bonds, municipal
  bonds, etc.
• Corporate securities
• Mortgages
• Real estate purchase of real estate for
  commercial leasing.
• Policy loans

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Assessment and Regulation of Insurance Companies

• Assessment of Insurance Companies based on
• Loss absorptive capacity ability to absorb loss
  or decline in value of market investment.
• Return on investment
• Relative size of operating expenses
• Liquidity of assets.
• Regulation of capital
• Risk-based capital ratio - that is, their
  capital base must be commensurate with their
  risks.

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Risk Exposure

• Major types of risk faced by insurance companies
  include Interest rate risk, credit risk, market
  risk, and liquidity risk
• Interest rate risk
• - most of insurance companies investment is
  usually tied in long-term fixed interest rate
  securities.
• - interest rate risk can be reduced by a
  reduction in average maturity of securities,
  investing in long-term asset with floating rates,
  and the use of futures contracts and interest
  rate swaps.
• Credit risk
• - portfolio assets of insurance companies such
  corporate bonds, mortgages, state and local
  government securities, and real estate are
  characterised by high risk
• - insurance companies hedge against credit risk
  by investing in only securities with high credit
  rating, as well as engaging in portfolio
  diversification
• Market risk
• - market risk relates to weak economy, financial
  market crisis etc., which affect prices of stock
• Liquidity risk
• - a high frequency of claim at a particular time
  period may lead to liquidity risk
• - life insurance companies can hedge against
  liquidity risk by diversifying the age
  distribution of their customer base.

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Valuation of Insurance Companies

• Insurance companies are usually valued to monitor
  their performance over time period.
• Value of insurance companies is the same as that
  of commercial banks, that is

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Performance Evaluation

• Some of the performance indicators of insurance
  companies are
• Liquidity ratio - Invested asset
• Loss reserves and unearned premium reserves
• Return on Net worth - Net profit
• Policyholders surplus
• Where net profit consists underwriting profits,
  investment income, and realised capital gains.
• Net underwriting margin - Premium income
  Policy expenses
• Total assets