26.Key Concepts

 LO 26.a

Three categories of insurance companies include life insurance, nonlife (P&C) insurance, and health insurance. Life insurance companies usually provide long-term coverage and will make a specified payment to the policyholder's beneficiaries upon the death of the policyholder during the policy term. Risks facing insurance companies include insufficient funds to satisfy policyholders'

claims, poor return (market risk) on investments, credit risk, and operational risk.

LO 26.b

Mortality tables can be used to compute life insurance premiums. Mortality tables include information related to the probability of an individual dying within the next year, the probability of an individual surviving to a specific age, and the remaining life expectancy of an individual of a specific age.

LO 26.c

Mortality risk refers to the risk of policyholders dying earlier than expected. For the insurance company, the risk of losses increases due to the earlier-than-expected life insurance payouts. Longevity risk refers to the risk of policyholders living longer than expected. For the insurance company, the risk of losses increases due to the longer-than-expected annuity payout period. There is a natural hedge (or offset) for insurance companies that deal with both life insurance products and annuity products because longevity risk is bad for the annuity business but good for the life insurance business, and mortality risk is bad for the life insurance business but good for the annuity business.

LO 26.d

Defined benefit plans explicitly state the amount of the pension that the employee will receive upon retirement. It is usually calculated as a fixed percentage times the number of years of employment times the annual salary for a specific period. There is significant risk borne by the employer because it is obligated to fund the benefit to the employee.

Defined contribution plans involve both employer and employee contributions being invested in one or more investment options selected by the employee. There is virtually no risk borne by the employer because it is obligated simply to make a set contribution and no more. The risk of underperformance of the plan's investments is borne solely by the employee. 

LO 26.e

Term (temporary) life insurance provides a specified amount of insurance coverage for a fixed period. Endowment life insurance is a subset of term insurance that has a payout at the stated contract maturity.

Whole (permanent) life insurance provides a specified amount of insurance coverage for the life of the policyholder.

LO 26.f

P&C insurance companies compute the following ratios:

loss ratio + expense ratio = combined ratio combined ratio + dividends = combined ratio after dividends

combined ratio after dividends - investment income = operating ratio

LO 26.g

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. Methods to mitigate moral hazard include deductibles, coinsurance, and policy limits.

Adverse selection describes the situation where an insurer is unable to differentiate

between a good risk and a bad risk. Methods to mitigate adverse selection include

greater initial due diligence and ongoing due diligence.

LO 26.h

Under Solvency II, there is an MCR and a SCR:

If capital < SCR, capital must increase above the SCR.

If capital < MCR, business operations may become significantly restricted.

MCR is usually 25% to 45% of SCR. For a P&C insurance company, there is substantially more equity capital required

than for a life insurance company because of the highly unpredictable nature of

claims for P&C insurance contracts.

LO 26.1

For insurance companies in the United States, every insurer must be a member of the guaranty association in the state(s) in which it operates. If an insurance company becomes insolvent in a state, then each of the other insurance companies must contribute an amount to the state guaranty fund based on the amount of premium income it earns in that state.

The guaranty system for banks in the United States is a permanent fund to protect

depositors that consists of amounts remitted by banks to the FDIC. No such permanent fund exists for insurance companies.