FIN319 Suffolk University Money and Capital Market Questions please answer all the questions and you may use the lectures attached. (for question 1 and 4 please include the formula and solving process) let me know if you have any question. thanks.
1. Suppose that a person wants to purchase an annuity today that would pay $15,000 after taxes per year until the end of that person’s life. The insurance policy expects the person to live for 25 more years and can invest the amount received for the annuity at a guaranteed interest rate of 5%. What is the fair price (the amount needed to establish the annuity).Check page 485 in the book. Men if you use a make sure you show your work, even if you use a calculator.
2. Define the following types of insurance policies:
a. Term Life
b. Whole Life
c. Endowment Life
d. Variable Life
e. Universal Lie
3. What’s the difference between an open end mutual fund and a closed end mutual fund?
4. The total value of an equity mutual fund is $354,786,500. The expenses are $29,986. There are 34,879 shares outstanding. What is the fund’s Net Asset Value (NAV)? Chapter Fifteen
Insurance
Companies
Insurance Companies (ICs)
⚫
The primary function of insurance companies is to
compensate policyholders if a prespecified event occurs, in
exchange for premiums paid
⚫
⚫
⚫
Insurance is broadly classified into two groups
⚫
⚫
⚫
Insurance underwriters assesses and prices risks
Insurance brokers sells insurance contracts
Life insurance policies provide protection against untimely
death or illness, and/or transfer wealth through time to retirement
Property-casualty insurance protects against property
damage, personal injury and liability associated with specific
events
Insurance companies also sell a variety of investment
products, similar to other FIs
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Life Insurance Companies
Continued
⚫
Life insurers pool the risks of individuals to diversify away
some of the customer-specific risk
⚫
⚫
⚫
Thus, they are able to offer insurance services at a cost lower
than any individual could achieve on his/her own
This allows the transfer of income related uncertainties from the
individual to the group
Other activities of life insurance companies:
⚫
⚫
⚫
Sell annuities, which are savings contracts that involve the
liquidation of those funds saved over a period of time
Manage pension plans (e.g., tax-deferred savings plans)
Provide accident and health insurance
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Life Insurance Companies
Concluded
⚫
Insurance companies accept or underwrite risk that a prespecified event will occur in return for insurance premiums
⚫ Underwriting decisions determine which risks are
accepted and which are not
⚫ Underwriting decisions determine how much to charge (in
the form of premiums) for accepted risks
⚫
The adverse selection problem is the problem that
customers who apply for insurance policies are more likely to
be those in need of coverage
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The Role of Actuaries
⚫
Actuaries reduce the risks of underwriting and selling
insurance
⚫
⚫
With traditional life insurance, actuaries analyze mortality,
produce life tables, and apply time-value-of-money tools to price
life insurance, annuities, and endowment policies
With health insurance, actuaries analyze the rates of disability,
morbidity, mortality, fertility, etc.
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The Four Types of Life Insurance
⚫
#1 – Ordinary life insurance is marketed to
individuals—policyholders make periodic premium
payments in exchange for coverage
⚫
⚫
⚫
⚫
⚫
Term life is the closest to pure life insurance; has no
savings element attached
Whole life protects the individual over an entire lifetime
rather than for a specified coverage period
Endowment life combines a pure (term) insurance
element with a savings element
Variable life invests fixed premium payments in mutual
funds of stocks, bonds, and money market instruments
Universal life and variable universal life
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The Four Types of Life Insurance
Continued
⚫
#2 – Group life insurance covers a large number of persons
under a single policy
⚫ Contributory—both the employer and the employee cover
a share of the premiums
⚫ Noncontributory—the costs are borne entirely by the
employer
⚫
#3 – Credit life insurance protects lenders against borrower
death prior to the repayment of a debt contract, such as a
mortgage or car loan
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The Four Types of Life Insurance
Concluded
⚫
#4 – Other activities include the sale of annuities,
private pension plans, and accident and health
insurance
⚫
Annuities represent the reverse of life insurance principals
⚫
⚫
⚫
⚫
Popular among individuals as a mechanism used to save for
retirement
Annuity sales in 2015 topped $236.7 billion
In 2016, life insurance companies were managing over $3.6
trillion in pension fund assets, equal to 41% of all private
pension plans
More than $171 billion in premiums were written annually by
life and health companies in accident-health in 2015
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Annuities Example
⚫
You have a policy with a cash value of $250,000 which you
wish to annuitize. You are currently 62 years old and your
spouse is 58. Interest rates are 5% per year, and you are
considering receiving monthly payments under three options.
⚫
⚫
⚫
⚫
In option 1, you will receive 10 years of monthly payments.
With option 2, you will receive a monthly payment until you die,
which is expected to be in 14 years.
With option 3, you will receive a monthly payment until both you
and your spouse die. Your spouse is expected to outlive you by
8 years.
How much will you receive per month with each option
(ignoring administrative costs and fees)?
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Annuities Example Continued
⚫
In option 1, you will receive 10 years of monthly payments.
Payment =
⚫
With option 2, you will receive a monthly payment until you die,
which is expected to be in 14 years.
Payment =
⚫
250,000
= $2,651.64
1 − 1 1.004167 120
0.004167
250,000
= $2,072.18
1 − 1 1.004167168
0.004167
With option 3, you will receive a monthly payment until both you
and your spouse die. Your spouse is expected to outlive you by 8
years.
Payment =
250,000
= $1,563.20
1 − 1 1.004167 264
0.004167
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Balance Sheets and Recent
Trends
⚫
Assets
⚫
Life insurers concentrate their asset investments at the longer
end of the maturity spectrum
⚫
⚫
⚫
E.g., corporate bonds, equities, and government securities
In 2016, 10.8% of assets were invested in government securities, 67.6%
in corporate bonds and stocks, and 6.8% in mortgages
Liabilities
⚫
⚫
Net policy reserves made up $2.9 trillion, or 44.1% of total
liabilities and equity
To meet unexpected future losses, life insurers hold a capital
and surplus reserve fund with which to meet such losses
⚫
Reserves for life insurers in 2016 totaled $280.8 billion, or 5.9% of total
liabilities and capital
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Balance Sheets and Recent
Trends Continued
⚫
Insurers earn profits by taking in more premium income
than they pay out in policy payments
⚫
⚫
Firms can increase their spread between premium income and
policy payouts in two ways:
#1 – Decrease future required payouts for any given level of
premium payments
⚫
⚫
⚫
Accomplished by reducing the risk of the insured pool
#2 – Increase the profitability of interest income on net policy
reserves
Treasury Department extended bailout funds to a
number of struggling life insurers in late 2008/early 2009
⚫
E.g., AIG, Hartford Financial Services Group, Prudential
Financial, Lincoln Financial, and Allstate
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Regulation
⚫
McCarren-Ferguson Act of 1945 confirmed primacy of
states over federal regulation of ICs
⚫
⚫
⚫
States promote insurance guarantee funds
⚫
⚫
⚫
State insurance commissions charter and examine ICs
The National Association of Insurance Commissioners
(NAIC) has developed a coordinated examination system
Funds are run by the insurance companies themselves
Contributions are paid only when an IC fails (except in NY)
The Financial Services Modernization Act (FSMA) of 1999
allowed CBs, IBs, and ICs to exist as subsidiaries under one
Financial Holding Company (FHC)
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Regulation Continued
⚫
⚫
During the financial crisis, Congress considered adding a
federal regulator of the insurance industry, but left regulation
to the states
Wall Street Reform and Consumer Protection Act of 2010
created the Federal Insurance Office (FIO) that reports to
Congress and the President on the insurance industry
⚫
⚫
The FIO is supposed to identify systemic risks arising from
insurers, monitor international insurance events, eliminate state
regulatory gaps and encourage the offering of insurance
products to underserved segments
The Financial Stability Oversight Council (FSOC) is charged with
identifying any financial institution (including insurance
companies) that presents a systemic risk to the economy and
subjecting such institutions to greater regulation
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P&C Lines
⚫
Fire insurance and allied lines
⚫
⚫
Homeowners multiple peril (MP) insurance
⚫
⚫
Protects commercial firms against perils similar to homeowners
Automobile liability and physical damage (PD) insurance
⚫
⚫
Protects against multiple perils of damage to a personal dwelling and
personal property, as well as liability coverage against the financial
consequences of legal liability resulting from the injury to others
Commercial multiple peril (MP) insurance
⚫
⚫
Protects against the perils of fire, lightning, and removal of property
damaged in a fire
Provides protection against losses resulting from legal liability
due to the ownership/use of the vehicle and theft or damage to
vehicles
Liability insurance (other than auto)
Balance Sheets of P&C Companies
⚫
Assets
⚫
⚫
⚫
P&C companies invest the majority of their assets in long-term
securities, but hold a lower proportion in common stock than do
life insurance companies
Bonds, preferred stock, and common stock made up 71.7% of
total assets in 2016
Liabilities
⚫
Loss reserves and loss adjustment expenses are a major
component (34.4% of total liabilities and capital)
⚫
⚫
Loss reserves are funds set aside to meet expected losses from
underwriting the P&C lines
Loss adjustment expenses are the expected administrative and related
costs of settling claims
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Underwriting Risk
⚫
Underwriting risk is the risk that premiums are insufficient to
cover losses and administrative expenses after taking into
account investment income
⚫
Underwriting risk may result from:
⚫ Unexpected increases in loss rates
⚫ Unexpected increases in expenses
⚫ Unexpected decreases in investment yields
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Loss Risk and Expense Risk
⚫
Loss risk is a function of actuarial predictability
⚫
⚫
⚫
⚫
⚫
Loss risk is a measure of pure losses incurred to premiums
earned
⚫
⚫
Property vs. liability
Severity vs. frequency
Long tail vs. short tail
Product inflation vs. social inflation
Premiums earned are premiums received and earned on
insurance contracts because time has passed with no claim filed
Expense risk occurs from two major sources:
⚫
⚫
Loss adjustment expenses (LAE)
Commissions and other expenses
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Property-Casualty (P&C) Key
Ratios
⚫
The combined ratio is a measure of overall profitability
⚫
Equals the loss ratio plus the ratios of loss-adjusted
expenses to premium earned as well as commission and
other acquisition costs to premiums written plus any
dividends paid to policyholders as a proportion of
premiums earned
⚫
Investment yield is measured as net interest income
divided by premiums earned
⚫
The operating ratio is also a measure of overall
profitability
⚫
Equals the combined ratio minus the investment yield
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
P&C Recent Trends
⚫
Many catastrophes of historically high severity have
occurred recently
⚫
⚫
⚫
See Figure 15-3 for a list of U.S. catastrophes between
1949 and 2016
An underwriting cycle is a pattern that the profits in the
P&C industry tend to follow
The federal government has consistently increased their
role of providing compensation and reconstruction
assistance following natural disasters
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Property-Casualty (P&C)
Insurance Regulation
⚫
⚫
⚫
⚫
⚫
P&C insurers are chartered at the state level
P&C insurers are regulated by state commissioners
State guarantee funds provide (some) protection to
policyholders, similar to the manner described for life
insurance companies
The NAIC provides services to state regulatory commissions
such as the Insurance Regulatory Information System
(IRIS)
Given the social welfare importance of some lines (e.g.,
workers’ compensation and auto insurance), state
commissioners often set ceilings on the premiums and
premium increases in these lines
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Chapter Sixteen
Securities Firms
and Investment
Banks
Securities Firms and Investment
Banks (IBs)
⚫
Investment banks (IBs) help corporations and
governments raise capital through debt and equity
security issues in the primary market
⚫
⚫
⚫
Underwriting is assisting in issuing new securities
IBs also advise on mergers and acquisitions (M&As) and
corporate restructuring
Securities firms assist in the trading of securities
in secondary markets
⚫
Broker-dealers assist in the trading of existing securities
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Size, Structure and Composition
of Industry
⚫
The size of the industry is usually measured by the equity
capital of firms rather than total asset size
⚫
⚫
The number of firms in the industry changed due to
economies of scale and scope, losses with the economy,
scandals at some firms, and regulations that allowed both
inter- and intra-industry mergers
⚫
⚫
⚫
⚫
⚫
Equity capital in the industry in 2015 was $235 billion
5,248 firms in 1980
9,515 firms in 1987
6,016 firms in 2006
4,115 firms in 2016
As with commercial banks, consolidation has largely
occurred through mergers and acquisitions
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Subgroups of National FullService Firms
⚫
#1 – Commercial bank or financial services holding
companies
⚫
⚫
⚫
⚫
#2 – National full-service firms specializing in
corporate finance or primary market activities
⚫
⚫
Largest of the full-service investment banks
Extensive domestic and international operations
Offer advice, underwriting, brokerage, trading, and asset
management services
Highly active in trading securities, or secondary market activities
#3 – Large investment banks maintain more limited
branch networks concentrated in major cities
⚫
Operate with predominantly institutional client bases
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Investment Banking
⚫
Investment banking
⚫
⚫
⚫
⚫
⚫
⚫
First time debt and equity issues occur through initial
public offerings (IPOs)
New issues from a firm whose debt or equity is already
traded are called seasoned security offerings
A private placement is a securities issue that is placed
with one or a few large institutional investors
Public offerings are offered to the public at large
IBs act only as an agent in best efforts underwriting
IBs act as principals in firm commitments
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Venture Capital
⚫
Venture capital (VC) is a professionally managed
pool of money used to finance new (i.e., start-up)
and often high-risk firms
⚫
⚫
⚫
VC usually purchases an equity stake in the start-up
VC firms are not generally passive investors, but instead
provide valuable expertise to the firm’s managers
Institutional venture capital firms find and fund the most
promising new firms
⚫ Venture capital limited partnerships
⚫ Financial venture capital firms
⚫ Corporate venture capital firms
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Venture Capital vs. Private Equity
⚫
Private equity investments
⚫
Private equity (PE) differs from VC in funds sources and in
types of investments
⚫
⚫
PE firms raise funds by selling securities rather
than commingling private funds
PE firms often acquire established existing firms
rather than purchase start-ups
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