Non-Bank Financial Institutions

1
Non-Bank Financial Institutions

• Week 3 September 14, 2005

2
Non-Bank Financial Institutions

• Insurance-type
• Life and property and casualty
• Pension funds
• Asset management firms and funds
• Securities firms
• Others
• Finance companies
• Mortgage bankers
• Government-sponsored agencies

3
Insurance Liabilities

• Promise to pay depending on contingency
• Life - Pay upon death, or retirement
• Property and casualty - Pay on occurrence of
  accident or loss due to theft or hazard (fire,
  weather, earthquake, flood)
• Differences between life and accident
• Life probabilities known with accuracy
• Casualty has two risks incidence and severity

4
Insurance Services

• Life and annuity contract
• Probabilities usually not influenced by insured
• Cash flows from coverage are predictable
• Cancellations, lapses, policy loans
• Casualty contract
• Period short
• Policy-holders influence the incidence and
  severity of claims

5
Life Insurance Contracts
Whole Life Contract
Limited Pay Life
Premiums, Benefits
Premiums, Benefits
Retirement
Retirement
Death
Death
Age
Age
6
Life Insurance Contracts (contd)
Endowment Policy
Life and Annuity
Premiums, Benefits
Premiums, Benefits
Retirement
Retirement
Death
Death
Age
Age
7
Insurance Distribution

• Life insurance
• Ordinary
• Group
• Industrial
• Credit
• Independent agents
• Economics of insurance marketing
• Compensation of agents and brokers
• Political power in the insurance industry

8
Insurance Company Income

• Revenue Premium income
• Earned premiumsInvestment income
• Expenses Policy Benefits and Losses
• Direct payments to claimants
• Loss expenses (evaluation, processing)Marketing
  expenses Non-interest expense
• Labor and related expenses
• Communication, fees

9
Insurance Market
10
Life Insurance Assets
11
Role of Insurance Equity

• Equity in insurance is sometimes referred to as
  surplus since it represents premium collections
  above claims payments
• Income is approximately
• Premiums investment income claims
• Income/loss adds to/subtracts from equity
• Equity or surplus absorbs large surges in claims
  as in catastrophes (e.g. Katrina)

12
Insurance Balance Sheets

• Balance sheet liabilities are insurance
  reserves, unearned premiums, and surplus (plus
  equity capital)
• Assets are investments in corporate and municipal
  bonds, real estate, equities,
• Balance sheet management consists of matching
  asset risks to liability risks
• Many liabilities have long tails or durations

13
Property-Casualty Insurance
14
Contrast Life/Casualty Insurance

• Probabilities of claims in life insurance are
  well known (vital statistics yield accurate
  actuarial estimates)
• Moral hazard limited in life insurance
• Dollar claims in casualty insurance are affected
  by incidence and severity of damages and may have
  more are affected by incidence and severity of
  damages and may have more systematic risk

15
Pension Funds

• Private versus state and local government
• Defined benefit versus defined contribution
• Self-directed pension plans
• Pensions, taxes, and responsibilities
• Corporate tax treatment
• Personal tax treatment
• Corporate responsibilities under ERISA

16
Pension Fund Assets
17
Asset Management

• Economics of the industry
• Performance measurement
• Principal-agent problems
• A temporary disequilibrium
• Historical perspective
• Services provided by asset managers
• Issues in asset management

18
Asset Management Firms

• Revenue Management Fees
• Based on assets under management
• Expenses Research Costs
• Analysts (labor expense)
• Data and computer expensesMarketing expenses
  Non-interest expense
• Overhead labor and related expenses
• Communication, fees

19
Securities Firms

• Brokers
• Find buyers for sellers
• Organize markets
• Dealers
• Provide liquidity to market
• Hold inventories and take price risk
• Securities originators
• Design and place financial instruments for
  primary market issuers

20
Brokers and Investment Banking

• Full-line firms offer retail and institutional
  trading, securities origination and financial
  advisory services, and market-making services
• Clearing brokers (e.g. Bear Stearns) present
  securities for settlement
• Wire houses transmit orders to other firms for
  execution

21
Investment Banking

• Bulge bracket firms (e.g. Morgan Stanley) are
  largest investment banking firms
• Regional firms (e.g. Wedbush Morgan) operate in
  local markets
• Boutique firms specialize in certain types of
  transactions (e.g high tech or health care)
• Terms are not mutually exclusive

22
Securities Firm Income

• Revenue Commissions Fees -
  Advisory, investment banking, asset
  management Gains (and losses) and
  interest
• Expenses Labor costs Communications and
  space Clearing fees Borrowing costs

23
Finance Companies

• Three basic types
• Captive finance companies (owned by manufacturer,
  e.g. GMAC)
• Commercial finance companies and financial firm
  affiliates (owned by banks or other financial
  firms, e.g. Foothill Group)
• Consumer or personal finance companies
  (specialized in high-risk finance, like Household
  Finance)
• Funding sources - Bank credit, commercial paper,
  affiliate company financing

24
Finance Company Investments
25
Asset-Pools

• Origination
• Government-sponsored agencies (GSEs)
• Federal National Mortgage Association (FNMA or
  Fannie May)
• Federal Home Loan Mortgage Corporation (FHLMC or
  Freddie Mac)
• Student Loan Marketing Corporation (SLMC or
  Sallie May)
• Private originators
• Servicing
• Servicing fees and costs
• Transactions in servicing portfolios

26
Other Financial Firms

• Mortgage banks
• Information and advisory firms
• Clearing firms and depositories
• Exchanges and communication networks
• Clear differences between types are eroding, but
  traditionally were due to
• Regulation, taxation, and charters
• Specialization and expertise
• Historical evolution

27
Next week Sept. 21, 2005

• Read Chapters 4 and 17 of Money and Capital
  Markets
• Read selections from trade press selected by
  students and download handouts before class
• Form a group of three or four students for the
  group project and provide a tentative choice for
  the group project from the list provided or as
  discussed with me
• Bring a Wall Street Journal to class every
  Wednesday