Insurance and Pension Fund Operations: How They Invest and Manage Risk
Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2
Chapter 25 is the longest chapter in Part 7 and covers two major categories of financial institutions: insurance companies and pension funds. Both are massive investors that channel money from individuals into financial markets. Insurance companies alone hold trillions in assets. Pension funds are some of the largest institutional investors in the world.
Insurance Basics
Insurance companies provide financial protection against specified conditions in exchange for a premium. The premium reflects the probability of having to make a payment and the potential size of that payment, plus a markup for overhead and profit.
Two classic problems plague the insurance business.
Adverse selection means the people most likely to need insurance are the most likely to buy it. Madura uses a simple college example. Beth always locks her dorm room and skips the theft insurance. Randy never locks his door and buys it immediately. The insurance company sets premiums based on campus-wide theft statistics, but Randy and his fellow careless students are overrepresented among policyholders. The actual claims will exceed what the statistics predicted.
Moral hazard means people take more risks once they are insured. Mina normally locks her door but stops bothering once she has insurance. The act of being insured changes her behavior and makes her a higher risk than the company anticipated.
These two problems mean insurance companies need to assess the probability of loss for the people who actually buy insurance, not the general population.
Life Insurance
Life insurance companies generate more than $100 billion in premiums annually. They compensate beneficiaries upon the policyholder’s death. Using actuarial tables and mortality data, they can forecast with reasonable accuracy how many policies will require payouts in a given period.
There are several types:
Whole life insurance covers the policyholder until death and builds a cash value. It is essentially insurance plus a savings account. Premiums are higher because you are paying for both.
Term insurance is temporary coverage for a specified period. No cash value. Much cheaper than whole life. Decreasing term insurance reduces the benefit over time, which makes sense for families whose mortgage balance is shrinking.
Variable life insurance ties the benefit amount to the performance of the assets backing the policy.
Universal life insurance combines features of term and whole life. It builds cash value and allows flexibility in premium amounts and timing.
Where Insurance Companies Get Their Money
Life insurance company income comes from three main sources. Insurance premiums (life plus health) make up about 31 percent. Annuity plans represent the largest single source at 35 percent. Investment income is 28 percent. The remaining 6 percent is other income.
Annuity plans have become increasingly popular. These offer a predetermined amount of retirement income to individuals. They have grown to generate proportionately more income than traditional premiums.
How Insurance Companies Invest
Insurance companies are massive institutional investors. Their asset allocation looks like this:
- Corporate debt securities: 32 percent (the largest category)
- Stocks: 28 percent
- Mortgages and mortgage-backed securities: 17 percent
- Cash and other assets: 12 percent
- Government securities: 8 percent
- Policy loans: 2 percent
- Real estate: 1 percent
Corporate bonds are the most popular investment. They offer higher yields than government securities but carry credit risk. Some companies focus on investment-grade bonds while others invest in junk bonds. Insurance companies also invest in collateralized loan obligations (CLOs), which are packages of commercial bank loans sold as securities in different risk classes.
Policy loans are an interesting feature of whole life insurance. Policyholders can borrow against their policy’s cash value at a guaranteed interest rate. When market rates spike, policyholders borrow more from their insurance company because the guaranteed rate is cheaper than alternatives.
Property and Casualty Insurance
There are about 3,800 PC insurance companies. The biggest names are State Farm, Allstate, Farmers, and Nationwide. No single company controls more than 10 percent of the market.
PC insurance is very different from life insurance. Policies are typically short-term (one year or less). Forecasting claims is much harder because they depend on inflation, hurricanes, terrorism trends, and court decisions. PC companies need more liquid portfolios because of this uncertainty.
Cash flow underwriting is a cyclical phenomenon unique to PC insurance. When interest rates rise, companies lower premiums to attract more policy dollars to invest at higher rates. When rates fall, premiums go up. This can backfire badly for companies that underestimate future claims.
PC companies also use reinsurance, where they spread risk by letting other insurance companies participate in large policies. Reinsurance has become more expensive and less available due to unpredictable claims.
Health Insurance
Insurance companies offer managed care plans (HMOs and PPOs) and indemnity plans. HMOs require a primary care physician as a gatekeeper before seeing specialists. PPOs allow direct access to specialists but charge higher premiums. The Affordable Care Act of 2010 expanded insurance requirements and added conditions for health care providers billing insurance companies.
Bond and Mortgage Insurance
Bond insurance protects investors if bond issuers default. Many municipal bonds carry insurance, which lets municipalities borrow at lower rates. During the credit crisis, some bond insurers faced credit rating downgrades, which rattled the municipal bond market.
Mortgage insurance protects lenders when homeowners default. Some insurance companies provided this through credit default swaps, which required payments only when defaults occurred. In good times, this was free money. During the credit crisis, it was devastating. Unlike traditional insurance where adverse events happen randomly to individual policyholders, mortgage defaults can happen to thousands of borrowers simultaneously during an economic downturn.
The AIG Bailout
American International Group (AIG) had sold credit default swaps covering about $440 billion in debt securities, many backed by subprime mortgages. When those securities defaulted in 2008, AIG was on the hook for massive payouts.
If AIG failed, every financial institution that had purchased credit default swaps from AIG to protect their mortgage-backed securities would have been exposed. The Federal Reserve bailed out AIG with an $85 billion credit facility, and the government took an approximately 80 percent equity stake. AIG was required to sell off business units to increase liquidity.
The rescue came one day after the Fed let Lehman Brothers fail. The key difference was that AIG had financially sound subsidiaries whose assets could serve as collateral. Lehman Brothers did not.
Insurance Company Risk
Insurance companies face four types of risk:
Interest rate risk because they hold large amounts of long-term fixed-rate bonds. Credit risk on corporate bonds and mortgages. Market risk from stock holdings. Liquidity risk if claims spike at the same time.
During the credit crisis, insurance companies got hit from multiple directions. Losses on mortgage-backed securities, junk bonds, and stock portfolios. Claims from private mortgage insurance and credit default swaps. It was a perfect storm.
Pension Funds
Pension funds provide retirement savings for employees. Money flows in from employee contributions, employer contributions, dividends and interest on investments, and capital gains. In aggregate, most contributions come from the employer.
Public pension funds include Social Security and government employee plans. Many operate on a pay-as-you-go basis, where current contributors fund current retirees. This creates obvious sustainability concerns.
Private pension plans are created by corporations and other private organizations. Some pension funds are so large they are major players in securities markets.
Defined-Benefit vs. Defined-Contribution
This is the most important distinction in pension fund design.
Defined-benefit plans promise a specific payment to retirees based on salary, years of service, and retirement age. The employer bears the risk. If investments perform poorly, the employer has to make up the difference.
Many defined-benefit plans used overly optimistic return projections, which made existing investments appear adequate. This let corporations reduce contributions and boost earnings. When actual returns fell short, plans became underfunded.
California’s pension fund is a textbook example. In 1999, the state set generous benefits and assumed investment returns that would cover future obligations. Returns came in at about 75 percent of projections. The result was a roughly $2 billion per year deficiency from 2000 to 2012. Education spending was cut to make up the difference. Students paid for unrealistic pension promises made years earlier.
Defined-contribution plans (like 401(k) plans) specify how much goes in, not how much comes out. The employee bears the investment risk. Employers may match a portion of contributions. Employees typically choose how to invest among options like stocks, bonds, real estate, and money market securities.
Defined-contribution plans have been replacing defined-benefit plans for years. They give employers cost certainty and employees more flexibility, but they shift retirement risk entirely to the individual.
Pension Fund Management
Portfolio management strategies fall into two approaches. Matched funding invests to generate cash flows that match planned payouts. It is safe but inflexible. Projective funding gives managers more freedom to capitalize on expected market movements. Many funds use a combination.
The Pension Benefit Guaranty Corporation (PBGC) insures defined-benefit plans, covering about 44 million Americans. If a plan cannot pay promised benefits, the PBGC makes up the difference. It is funded by premiums from insured plans, not taxpayer money. But during economic downturns, many plans become underfunded simultaneously, straining the PBGC.
ERISA (1974) requires pension funds to invest prudently and gives employees vesting rights after specified periods of service. It also allows employees to transfer vested amounts when changing employers.
My Take
The insurance chapter reveals a pattern that repeats throughout this book. Financial institutions that take on risk they do not fully understand get punished when conditions turn. AIG is the most dramatic example. Selling $440 billion in credit default swaps and assuming defaults would not happen across the board is a failure of both risk assessment and basic common sense.
The pension fund section is quietly terrifying. Defined-benefit plans across the country are underfunded because of optimistic return assumptions. The gap between promised benefits and available funds is a slow-moving crisis that does not make headlines until it becomes an emergency. California’s story shows how unrealistic pension promises create real damage to public services.
The shift from defined-benefit to defined-contribution plans is a transfer of risk from institutions to individuals. It makes sense for employers, but it means the next generation of retirees will have wildly different outcomes depending on their investment choices and the timing of their retirement relative to market cycles.
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