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INSURANCE COMPANIES
_______________________
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Marijana Ćurak- University of Split, Faculty of Economics
Academic year: 2014/2015
10/22/2014
International Week – New Frontiers in Finance and Accounting 2014
University of Economics in Katowice
Course: Financial Institutions
These lecture slides are based on the
book:
Mishkin F. S., Eakins, S. G. (2012), Financial
Markets + Institutions, Addison Wesley
10/22/2014
Marijana Ćurak- University of Split, Faculty of Economics
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AGENDA
Introduction
Basic insurance principles
Adverse selection and moral hazard problems in insurance
Types of insurance organizations
Types of insurance (life and non-life insurance)
Insurance management
Review points
Marijana Ćurak- University of Split, Faculty of Economics
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10/22/2014
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INTRODUCTION (1)
Insurance companies are in the business of
assuming risk on behalf of their customers in
exchange for a fee, called premium
Insurance companies make a profit by charging
premiums that are sufficient to pay the expected
claims to the company plus a profit
10/22/2014
Marijana Ćurak- University of Split, Faculty of Economics
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INTRODUCTION (2)
Why do people pay insurance when they know
that over the lifetime of their policy, they will
probably pay more in premiums than the
expected amount of any loss they will suffer?
Most people are risk-averse – they would rather
pay a certainty equivalent (the insurance
premiums) than accept the gamble that they will
lose their house or their car
10/22/2014
Marijana Ćurak- University of Split, Faculty of Economics
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PEOPLES’ LIFE WITHOUT OF INSURANCE
Everyone would have to set aside reserves
These reserves could not be invested long-term but
would have to be kept in an extremely liquid form
People would be constantly worried that their reserves
would be inadequate to pay for catastrophic events
Insurance allows us the peace of mind that a single
event can have only a limited financial impact on our
lives
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Marijana Ćurak- University of Split, Faculty of Economics
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BASIC INSURANCE PRINCIPLES (1)
There must be a relationship between insured
(the party covered by insurance) and the
beneficiary (the party who receives the payment
in case a loss occurs)
The beneficiary must be someone who may
suffer potential harm
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Marijana Ćurak- University of Split, Faculty of Economics
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BASIC INSURANCE PRINCIPLES (2)
The insured must provide full and accurate
information to the insurance company
The insured is not to profit as a result of
insurance coverage
If a third party compensates the insured for the
loss, the insurance company’s obligation is
reduced by the amount of the compensation
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Marijana Ćurak- University of Split, Faculty of Economics
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BASIC INSURANCE PRINCIPLES (3)
The insurance company must have a large
number of insureds so that the risk can be
spread out among many different policies
The loss must be quantifiable
The insurance company must be able to
compute the probability of the loss occurring
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Marijana Ćurak- University of Split, Faculty of Economics
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BASIC INSURANCE PRINCIPLES (4)
The purpose of these principles is to maintain the
integrity of the insurance process
Without them, people may be tempted to use insurance
companies to gamble or speculate on future events
The principles provide a way to spread the risk among
many policies and to establish a price for each policy
that will provide an expectation of a profitable return
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Marijana Ćurak- University of Split, Faculty of Economics
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ADVERSE SELECTION AND MORAL HAZARD
IN INSURANCE (1)
Despite following these guidelines, insurance
companies suffer greatly from the problems of
asymmetric information
Adverse selection in insurance occurs when the
individuals most likely to benefit from a
insurance are the ones who most actively seek
out the insurance and are thus most likely to be
selected
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Marijana Ćurak- University of Split, Faculty of Economics
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ADVERSE SELECTION AND MORAL HAZARD
IN INSURANCE (2)
The implication of adverse selection is that loss
probability statistics gathered for the entire
population may not accurately reflect the loss
potential for the persons who actually want to buy
policies
The adverse selection problem raises the issue of
which policies an insurance company should accept
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Marijana Ćurak- University of Split, Faculty of Economics
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ADVERSE SELECTION AND MORAL HAZARD
IN INSURANCE (3)
For health and life insurance – insurance
companies require physical exams and may
examine previous medical records before issuing
policy
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Marijana Ćurak- University of Split, Faculty of Economics
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ADVERSE SELECTION AND MORAL HAZARD
IN INSURANCE (4)
Moral hazard occurs when the insured fails to take
proper precautions to avoid losses because losses are
covered by insurance
It occurs when the existence of insurance encourages
the insured party to take risks that increase the
likelihood of an insurance payoff
One way that insurance companies combat moral hazard
is by requiring a deductible
10/22/2014
Marijana Ćurak- University of Split, Faculty of Economics
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ADVERSE SELECTION AND MORAL HAZARD
IN INSURANCE (5)
The deductible is the amount of any loss that must
be paid by the insured before the insurance
company will pay anything
Contract terms aimed at reducing risk (prevention
activities)
Moral hazard activities could be taken by the
parsons and companies providing services related to
insurance
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SELLING INSURANCE (1)
Insurance companies hire large sales
forces to sell their products
The expense of marketing may account
for up to 20% of the total cost of a policy
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Marijana Ćurak- University of Split, Faculty of Economics
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SELLING INSURANCE (2)
Insurance distribution channels:
Agents (independent and exclusive)
Brokers
Direct sale
The intermediaries are compensated by
being paid a commission
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Marijana Ćurak- University of Split, Faculty of Economics
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SELLING INSURANCE (3)
Importance of underwriters – people who
review and sign off on each policy an
agent writes and who have the authority
to turn down a policy if they deem the risk
unacceptable
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Marijana Ćurak- University of Split, Faculty of Economics
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TYPES OF INSURANCE ORGANIZATIONS (1)
Stock company
Owned by stockholders and has the objective
of making a profit
Mutual insurance company
Owned by the policyholders
The objective is to provide insurance at the
lowest possible cost to the insured
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Marijana Ćurak- University of Split, Faculty of Economics
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TYPES OF INSURANCE ORGANIZATIONS (2)
Policyholder are paid dividends that reflect the
surplus of premiums over costs
Because the policyholders share in reducing
the cost of insurance, there may be some
reduction in the moral hazard that most
insurance companies face
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Marijana Ćurak- University of Split, Faculty of Economics
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TYPES OF INSURANCE
Life insurance
Non-life insurance (property-casualty)
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LIFE INSURANCE (1)
In its simplest form, life insurance provides income for
the children of the deceased
The cost of life insurance depends on such factors as the
age of the insured, average life expectancies, the health
and lifestyle of the insured and insurance company’s
operating costs
Long-term contracts
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Marijana Ćurak- University of Split, Faculty of Economics
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LIFE INSURANCE (2)
Besides financial protection of dying too young,
life insurance provides protection of living too
long
Life insurance company can predict with a high
degree of accuracy when death benefits must be
paid by using actuarial tables that predict life
expectancies
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Marijana Ćurak- University of Split, Faculty of Economics
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LIFE INSURANCE (3)
Law of large numbers says that when many people are
insured, the probability distribution of the losses will
assume a normal probability distribution, a distribution
that allows accurate predictions
Because insurance companies insure so many people,
the law of large numbers tends to make the company's
predictions quite accurate and allows companies to price
the policies so that they can earn a profit
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Marijana Ćurak- University of Split, Faculty of Economics
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TYPES OF LIFE INSURANCE
Term life
Whole life
Universal life
Annuities
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TERM LIFE
It pays out if the insured dies while the
policy is in force
This form of policy contains no saving
element
Once the policy period expires, there are
no residual benefits
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Marijana Ćurak- University of Split, Faculty of Economics
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WHOLE LIFE
Policy pays a death benefit when the policyholder dies
It usually requires the insured to pay a level premium for
the duration of the policy
In the beginning, the insured pays more than if a term
policy has been purchased
This overpayment accumulates as a cash value that can
be borrowed by the insured at reasonable rates
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Marijana Ćurak- University of Split, Faculty of Economics
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UNIVERSAL LIFE
The policies that combine the benefits of
the term policy with those of the whole
life policy
The policy is structured to have two parts,
one for the term life insurance and one for
saving
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Marijana Ćurak- University of Split, Faculty of Economics
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ANNUITY
Insurance product that helps people if
they live longer that they expect
For an initial a fixed sum or stream of
payments, the insurance company agrees
to pay beneficiary a fixed amount for as
long as he/she lives
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Marijana Ćurak- University of Split, Faculty of Economics
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ASSETS OF LIFE INSURANCE COMPANIES
Since life insurance liabilities are
predictable and long-term, life insurance
companies can invest in long-term assets
(bonds, mortgages and real estate)
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Marijana Ćurak- University of Split, Faculty of Economics
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NON-LIFE INSURANCE (1)
Property insurance protects property (houses,
cars, boats, and so on) against losses due to
accidents, fire, disasters
Liability insurance protects against liability for
harm the insured may cause to others as a
result of product failure or accidents
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Marijana Ćurak- University of Split, Faculty of Economics
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NON-LIFE INSURANCE (2)
The premiums are based simply on the
probability of the loss
The amount of the potential loss is much
more difficult to predict than for life
insurance
Short-term contracts
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Marijana Ćurak- University of Split, Faculty of Economics
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NON-LIFE INSURANCE (3)
Property insurance can be provided in
either:
Named-peril policies
Insure against loss only from perils that are
specifically named in the policy
Open-peril policies
Insure against all perils except those specifically
excluded by the policy
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Marijana Ćurak- University of Split, Faculty of Economics
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REINSURANCE
Reinsurance allocates a portion of the risk
to another company in exchange for a
portion of the premium
It reduces risk exposure for the insurers
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Marijana Ćurak- University of Split, Faculty of Economics
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INSURANCE MANAGEMENT
Both adverse selection and moral hazard can
result in large losses to insurance companies
because they lead to higher payouts on
insurance claims
Minimizing adverse selection and moral hazard
to reduce these payouts is therefore and
extremely important goal for insurance
companies
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Marijana Ćurak- University of Split, Faculty of Economics
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SCREENING
To reduce adverse selection, insurance
companies try to screen out poor
insurance risks from good ones
Effective information collection procedures
are therefore an important principle of
insurance management
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Marijana Ćurak- University of Split, Faculty of Economics
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RISK-BASED PREMIUM
Charging insurance premiums on the basis
of how much risk a policyholder poses for
the insurance company is important
principles in order to reduce adverse
selection
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Marijana Ćurak- University of Split, Faculty of Economics
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RESTRICTIVE PROVISIONS
They are insurance management tool for
reducing moral hazard
Such provisions discourage policyholders
from engaging in risky activities that make
an insurance claim more likely
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Marijana Ćurak- University of Split, Faculty of Economics
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PREVENTION OF FRAUDS
Insurance companies also face moral
hazard because an insured person has an
incentive to lie to the company and seek a
claim even if the claim is not valid
Management tool – conducting
investigations to prevent fraud
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Marijana Ćurak- University of Split, Faculty of Economics
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CANCELLATION OF INSURANCE
Management tool – be prepared to cancel
policies
Insurance companies can discourage
moral hazard by threatening to cancel a
policy when the insured person engages in
activities that make a claim more likely
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Marijana Ćurak- University of Split, Faculty of Economics
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DEDUCTIBLES
The fixed amount by which the insured’s
loss is reduced when a claim is paid off
They are additional management tool that
helps insurance companies reduce moral
hazard
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Marijana Ćurak- University of Split, Faculty of Economics
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LIMITS ON THE AMOUNT OF INSURANCE
There should be limits on the amount of
insurance provided, even though a customer is
willing to pay for more coverage
The higher the insurance coverage, the more
the insured person can gain from risky activities
that make an insurance payoff more likely and
hence the greater the moral hazard
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Marijana Ćurak- University of Split, Faculty of Economics
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LIFE INSURANCE DESITY (in US$)
Region/Country
Premiums per capita
World advanced markets
2,073.8
Emerging markets
66.9
Western Europe
1,738.2
CEE
64.5
Switzerland (Ranking 1 by total density)
4,211
Poland (Ranking 42 by total density)
217
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Marijana Ćurak- University of Split, Faculty of Economics
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Source: Swiss Re, sigma, No. 3, 2014
NON-LIFE INSURANCE DESITY (in US$)
Region/Country
Premiums per capita
World advanced markets
1547
Emerging markets
62.3
Western Europe
1,142.7
CEE
170.2
Swits(Ranking 1 by total density)
4,211
Poland (Ranking 42 by total density)
217
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Marijana Ćurak- University of Split, Faculty of Economics
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Source: Swiss Re, sigma, No. 3, 2014
LIFE INSURANCE PENETRATION (% OF GDP)
Region/Country
Premiums/GDP
World advanced markets
4.73
Emerging markets
4.41
Western Europe
4.75
CEE
0.54
Taiwan (Ranking 1 by total penetration)
14.5
Poland (Ranking 42 by total penetration)
1.6
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Marijana Ćurak- University of Split, Faculty of Economics
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Source: Swiss Re, sigma, No. 3, 2014
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NON-LIFE INSURANCE PENETRATION (% OF GDP)
Region/Country
Premiums/GDP
World advanced markets
3.53
Emerging markets
1.31
Western Europe
3.12
CEE
1.41
Taiwan (Ranking 1 by total penetration)
3.1
Poland (Ranking 42 by total penetration)
1.8
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Marijana Ćurak- University of Split, Faculty of Economics
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Source: Swiss Re, sigma, No. 3, 2014
GROWTH RATE OF LIFE INUSRANCE
PREMIUMS
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Source: Swiss Re, sigma, No. 3, 2014, p. 8
GROWTH RATE OF NON-LIFE INUSRANCE
PREMIUMS
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Source: Swiss Re, sigma, No. 3, 2014, p. 11
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TOP INSURANCE COMPANIES
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Source:
http://www.relbanks.com/top-insurance-companies/world
(Accssed: October 18, 2014)
REVIEW POINTS (1)
Insurance companies underwrite risks and
invest premiums
Life and non-life insurance
Insurance companies face the problems of
adverse selection and moral hazard
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Marijana Ćurak- University of Split, Faculty of Economics
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REVIEW POINTS (2)
Insurance companies reduce the problems
of asymmetric information using various
management tools
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REFERENCES
Mishkin F. S., Eakins, S. G. (2012), Financial
Markets + Institutions, Addison Wesley
Marijana Ćurak- University of Split, Faculty of Economics
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10/22/2014
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