Chapter 18: ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Define insurance. What are the requirements for privately insurable risks?
Solution: Insurance is a contract, which transfers specific pure risks of loss to a third party, insurance company. Risks that are insurable are those that are fortuitous, accidental, occurring randomly, and could cause monetary loss to many people, but not at one time (not catastrophic). Further an insurable risk loss should be determinable and measurable along with the risk of loss. Lastly the premiums to cover losses must be affordable so there is widespread purchase.
2. What is meant by the term objective risk and why is it so important to insurers?
Solution: Objective risk is the relative variation of actual losses experienced from losses that are expected. Objective risk is important to insurers because the companies use expected losses as a starting point for calculating premiums. If objective risk is small, premiums will cover losses; when objective risk is large, premiums may not be sufficient to cover losses and underwriting loss is experienced. Too many years of underwriting loss can lead to insurer insolvency.
3. What are the various types of insurance organizations?
Solution: Stock, mutual, fraternal, reciprocal, and Lloyd’s association are the insurance company forms.
4. What are the sources of regulation for the insurance industry and what areas are regulated?
Solution: State government agencies regulate insurance in the U.S. The National Association of Insurance Commissioners coordinates state-regulatory activity. The purpose of insurance regulation is to assure the financial strength of insurers in order to protect insurance consumers against insolvencies, to protect consumers in the drafting of insurance contracts, to assure reasonable insurance rates, and to assure availability of coverage to all who need it.
DO YOU UNDERSTAND?
1. How do term life insurance and whole life insurance differ with respect to the duration of coverage and savings accumulation?
Solution: Term life premiums cover losses, expenses and expected returns to capital, whereas whole life premiums include the "cost" of term (noted above) plus an savings program designed to provide a "cash value" living benefit to the insured/owner in case the "insurance" event does not occur. Whole life policies and companies who promote them are likely to grow quickly and to great size, while "term" specialists remain relatively small.
2. Why was universal life insurance popular in the 1980s, but not in the 1990s? What made variable life insurance popular in the 1990s?
Solution: Universal life insurance was flexible "whole life" policies, combining term insurance and a separate savings/investment account. Customers could vary the term premium/level of coverage and channel monthly premiums into savings, at some given rate of return. As a combined policy customers never knew the "cost" of their insurance, nor the rate of return on their savings. As the returns on equity investment increased in the 1990's variable life insurance became popular. Instead of a stated minimum return on the "savings" portion, the return on the stock portfolio/mutual funds was variable.
3. Why are life insurance and life annuities often described as opposites?
Solution: Life insurance provides economic protection in case of premature death; annuities protect against living too long, beyond one's means (risk of superannuation).
Both risk impact individuals at different stages of their life.
4. What are the largest asset categories on a life insurance company balance sheet?
Solution: From the third quarter, 2001 Flow of Funds Accounts (outstanding), the largest asset categories(in descending order) of life insurance companies are: corporate and foreign bonds, corporate equities, U.S. Government securities(mostly agency), mortgages, and policy loans. Life insurance companies are the largest investor in corporate and foreign bonds.
DO YOU UNDERSTAND?
1. Property insurance is available for both direct and indirect losses. Differentiate between these two types of losses.
Solution: Direct losses include fire or windstorm, perils that impact the property of the insureds "directly." Indirect losses are losses contingent upon other losses, such as loss of business revenues in case of fire or windstorm. The business can purchase business interruption insurance for the indirect losses.
2. Why is the liability loss exposure more difficult to gauge than the property loss exposure?
Solution: Liability loss exposure, such as product liability or liability to injuries to a child, may cover a long period of time in an area with little precedent and be awarded by a jury so the expected loss exposure is "open-ended" compared to fire insurance or other property insurance.
3. What are major benefits of purchasing coverage through a multiple line policy as opposed to purchasing the same coverage separately?
Solution: A multiple line policy covers several risks, and if written under one policy, cost less to produce, and can save insureds considerable over using many separate policies. Multiple line policies often provide coordinated coverage for risks not covered by separate policies, have a common expiration date, and only one payment!
4. What are the major classes of asset holdings on a property and liability insurance company balance sheet? How do the asset holdings of property and liability insurance companies differ from the holdings of life and health insurance companies?
Solution: Property and liability companies do not have a "savings" or "accumulation" portion of their premiums like life insurance companies, so PC insurers are usually smaller. They have a higher federal tax exposure than lifers so they are likely to buy up most of the preferred stock on the market and invest in municipal and state bonds. Needing liquidity to a greater extent than a lifer, PC companies usually hold more marketable issues (large issues). PC insurance covers replacement value, so investing in equities as a hedge against inflation is likely. From Exhibit 18.4, bonds, split evenly between corporate and municipal and state, followed by corporate equities and U.S. Government securities are the largest asset categories.
DO YOU UNDERSTAND?
1. How are Social Security old-age benefits funded? Are these benefits based on social adequacy or individual equity?
Solution: Social Security payments to Grandma this month come from FICA premiums paid last month, with some surpluses now being accumulated in the fund for baby boomer's needs. SS is not a funded plan, but a "pay-as-you-go" plan, a pension form that ERISA forced businesses to leave. SS benefits are slanted toward "certain categories of people based on "need," or social adequacy not on means or contributions (individual equity), the case in most private pension plans.
2. What are the tax advantages of qualified private pension plans?
Solution: Participants defer the federal and state income tax on all contributions, earnings and capital gains accumulate tax-deferred, providing the compounding of pre-tax funds. Withdrawals are taxed, is assumed, when the participant retires and is in a lower tax bracket.
Participants are able to invest deferred taxes for a long period of time, a significant benefit compared to investing after-tax funds.
3. Explain the difference between contributory and noncontributory pension plans. Differentiate between defined benefit and defined contribution pension plans.
Solution: The concept of "contributory" or not is associated with whether an employee may provide their own funds along with those of the employer. A fully contributory plan will receive only employee funds.
4. ERISA and subsequent Acts regulate several features of qualified private pensions. What is meant by portability, vesting, and fiduciary standards?
Solution: ERISAprescribestherequirementsforportabilityandvestingofemployer-provided pensions. Portability assures that when an employee leaves an employer before retirement, the employee may defer tax payment on a lump-sum distribution of the pension fund by depositing the fund into a tax-qualified retirement account. Vesting provisions assure that after the employee has been participating in the pension plan for a certain number of years, the balance in the fund belongs to the employee, even if the employee leaves the employment of the employer providing the plan. Fiduciary standards are associated with placing pension funds with responsible professionals (fiduciaries), usually outside the company or labor union to reduce the chance of self-dealing and theft.