01 fm&i chap 12 thrift and insurance

Chapter 12:

Thrift and Insurance

Operations

Credit Unions

⚫Credit unions (CUs) are nonprofit

depository institutions composed of

members with a common bond, such as

an affiliation with a particular labor union, church, university, or residential area

⚫Serve as an intermediary for members

⚫Offer interest on share deposits to

members who invest funds and channel those funds to members who need loans

Credit Unions

⚫Because CUs do not issue stock, they are technically owned by the depositors (or

members)

⚫The deposits are called shares, and

interest paid on the deposits is called a

dividend

⚫If CUs accumulate earnings, they can use the earnings either to offer higher rates on deposits or to reduce rates on loans

Advantages of Credit Unions

⚫CUs are nonprofit and therefore their

income are not taxed

⚫Offer higher deposit rates, lower fees on checking accounts, lower required

minimum balances

⚫Have relatively low noninterest expenses because their office and furniture are often donated or provided at a very low cost

through the affiliation of their members

Disadvantages of Credit Unions

⚫May not have the incentive to manage

operations efficiently

⚫May also not have the funds to invest

heavily in new technology

⚫Difficult to diversify beyond their affiliation and among various products

⚫CUs increasingly have been merging CUs are also trying to diversify their products

by offering other services to their

members

Credit Union Sources of Funds

⚫Credit unions obtain most of their funds from share deposits by members

⚫Credit unions also offer share certificates, which provide higher rates than share

deposits but require a minimum amount (such as $500) and a specified maturity

⚫Most CUs also offer checkable accounts called share drafts

Credit Union Sources of Funds

⚫Borrowed funds: From other CUs or from the Central Liquidity Facility (CLF) The CLF acts as a lender for CUs to

accommodate seasonal funding and

specialized needs or to boost the liquidity

of troubled CUs

⚫Capital: Their primary source of capital is retained earnings

Credit Union Uses of Funds

⚫Credit unions use the majority of their funds for loans to members to finance automobiles, home improvements, and other personal expenses They are

typically secured and carry maturities of five years or less

⚫CUs purchase government and agency securities to maintain adequate liquidity

Exposure of Credit Unions to Risk

⚫Liquidity risk: If a CU experiences an

unanticipated wave of withdrawals without an offsetting amount of new deposits, it could

become illiquid => sell securities, borrow from other CUs or CLF

⚫Credit risk from their loans (often secured)

⚫Interest risk: Movements in interest revenues and interest expenses of CUs are highly

correlated The spread between interest

revenues and interest expenses remains

somewhat stable over time

Credit Unions in Vietnam

⚫People Credit Funds (PCFs): Established using credit unions’ model

⚫Not true credit unions, more like small

commercial banks

⚫Circular 04/2015/TT-NHNN tries to

changes PCFs to true CUs but still long ways to go

Insurance Companies

⚫Provide contractual risk management for:

 Risks of insurable asset losses (auto

insurance)

 Risks of liability claims (product liability)

 Risk of large medical costs (health insurance)

 Risk of disability (disability insurance)

 Risk of premature death (life insurance)

 Risk of longevity (annuities)

Insurance Companies, cont.

⚫Major capital market intermediary

Major investor in corporate (life) and state and municipal bonds (property/casualty)

Major long-term commercial mortgage lender (life)

⚫Mutual or stock form of ownership

⚫Premium and investment revenue

⚫Losses and loss adjustment expenses

Insurance Concepts

⚫Pure vs financial risk

⚫Insure fortuitous (random), independent risk occurrence

⚫Premium covers losses, administrative expenses and profits

⚫Insured contracts for known loss

(premium) in return for protection

⚫Moral hazard and adverse selection

⚫ Life insurance companies

⚫ Provide risk management contracts for individuals and businesses

 Risk areas include premature death, health

maintenance costs, and disability

 Life insurance provides cash benefits to the beneficiary

of a policy on the policyholder’s death

 Life insurance premiums reflect

⚫ Probability of making payment to the beneficiary

⚫ Size and timing of the payment

 Have portfolios of policies and use mortality figures and actuarial tables to forecast claims

Cash Value Insurance

Group

Types of Life Insurance Policies

Whole Life

Variable Life Universal Life

Term Insurance

Term Group

Types of Life Insurance Policies

⚫Whole life insurance includes both a death benefit (term insurance) and a savings

component that

Builds a tax sheltered cash value amount for

the future for the owner of the policy

Generates periodic cash flow payments over

the life of the policy for the insurance company

to reinvest

Pays fixed death benefit at death

Types of Life Insurance Policies

⚫Term life insurance characteristics

Temporary, providing death benefits only over a specified term

Premiums paid represent insurance only with

no saving component

Considerably lower cost for the insured than

whole life—able to buy more insurance

protection for any amount of premium

Term is for those who would rather invest their savings in other contracts or securities

Types of Life Insurance Policies

⚫Variable life insurance

Whole life with variable cash value amounts

Cash values invested in equities and will vary with the investment performance

⚫Universal life insurance

Combines the features of term and whole life with competitive rate of return

Variable premiums over time—buys terms and invests difference in a variety of investments

Builds a varying cash value based on

contributions and investment performance

Types of Life Insurance Policies

⚫Group plans

Employees of a corporation offered life

insurance or purchased life insurance on life of employee

Cash value or term insurance

Low cost (term) because of its high volume

Can cover group members and dependents

Sources of Life Insurance Company Funds

⚫Cash value reserves—accumulated cash

values owed insureds (liability)

⚫Pension reserves—accumulated “insured” pension commitments (liability)

⚫Annuity reserves—accumulated annuity

commitments (liability)

⚫Unearned premium income—premiums

received; not yet earned (liability)

⚫Loss reserves losses incurred, not yet paid

⚫Capital funds

Uses of Life Insurance Company Funds

⚫Major investor in corporate bonds

Uses of Funds—Policy Loans

⚫Policy loans are loans to policyholders

Whole life policies

Borrow up to the cash value of the policy

Guaranteed interest rate is stated in the policy

Usually used by borrowers during periods of rising rates to lock in the lower rate associated with their policy

Insurance Company Capital

⚫Capital

Build capital by issuing new stock (stock

companies) or retaining earnings

Used to finance investments in fixed assets

Cushion against operating losses

Capital requirements vary depending on asset risk

Credibility with customers is also enhanced by adequate capital

Mutual companies owned by policyholders— includes earnings retained over time

Asset Management

⚫Performance is significantly affected by

the performance of the assets

Companies get premiums for several years

before paying out benefits

Companies try to manage the risk of losses with offsetting investment gains or diversity of assets they hold

Diversify into other businesses to offer a wide variety of financial products

Premium Calculation

⚫Ex: A life insurance company has 100,000 40-year old policyholders who have policy value of $1 million

⚫The actuarial table show that the fatality rate (death rate) for 40-year-old people is

4 per 1000 per year

⚫The average number of deaths per year:

100,000 x 4/1000 = 400

400,000,000/1.08 = 370,400,000

Property and Casualty Insurance

⚫Property and casualty (PC) insurance

protects against fire, theft, liability, and

other events that result in economic or

PC Versus Life Insurance Companies

⚫PC have shorter contracts

⚫PC have more varied risk areas

⚫Life companies larger due to long-term

savings and pension contracts

⚫PC has wider distribution of Occurrences

PC’s need liquid, marketable assets

PC’s earnings more volatile

PC Company Costs and Profits

⚫Expenses

 Loss Adjustment expenses: The cost of

investigating and adjusting losses

 Brokerage and other expenses

 Loss expenses: Total losses paid out in claims

 Dividend - The return of part of the policy's premium for a policy issued on a participating basis by either

a mutual or stock insurer A portion of the surplus

paid to the stockholders of a corporation

⚫Revenues

 Premiums

 Investment incomes

PC Company Costs and Profits

➢Combined Ratio After Policyholder

Dividends = Loss ratio + Loss adjustment and other expenses ratio + Dividend ratio

➢Operating ratio = Combined Ratio After Policyholder Dividends – Investment rate

of return

➢Profit = 1 – Operating ratio

(All the ratios are calculated on the basis of total premium)

PC Company Costs and Returns

⚫Loss ratio is the ratio of total losses paid out

in claims divided by the total earned

premiums

⚫Combined Ratio After Policyholder

Dividends - The sum of the loss, expense

and policyholder dividend ratios not reflecting investment income or income taxes This

ratio measures the company's overall

underwriting profitability, and a combined

ratio of less than 100 indicates an

underwriting profit

PC Company Costs and Returns

⚫Operating Ratio (IRIS) - Combined ratio

less the net investment income ratio (net investment income to net premiums

earned) The operating ratio measures a company's overall operational profitability from underwriting and investment

activities This ratio doesn't reflect other operating income/expenses, capital gains

or income taxes An operating ratio of

more than 100 indicates a company is

unable to generate profits from its

underwriting and investment activities

Property Casualty Investment Needs

⚫Tax sheltering major municipal/state bond investor

⚫Liquid, marketable assets

Marketable corporate and government bonds

Listed common stock

⚫Inflation hedge common stock

⚫Reinsurance contracts manage pure risks

Other Insurance Operations

⚫Health care insurance

⚫Business insurance

⚫Bond insurance

⚫Mortgage insurance

Exposure to Financial Risks

⚫Interest rate risk

Fixed rate assets in company portfolios have market values sensitive to interest rate changes

Firm measures and manages risks

⚫Credit risk

Mortgages, corporate bonds and real estate

holdings can involve default

Investment-grade securities

Diversify portfolio among debt issuers

Exposure to Financial Risks

Exposure to Financial Risks

⚫Liquidity risk occurs because a high

frequency of claims may require the

company to liquidate assets

Life insurance companies have high cash flow from premiums to offset normal cash needs

In case of large disaster (9/11) may be forced to sell assets to generate cash even if market