CHAPTER 18
ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
1. Define insurance. What are the requirements for privately insurable risks?
Solution: Insurance is a contract which transfers pure risk to a third party. Insurable risks are fortuitous and random, but losses associated with them determinable and measurable. Insurable risks are manageably distributed across time, not likely at one time (not catastrophic). Premiums must be high enough to cover losses but affordable enough so to attract widespread purchase and build a risk pool.
2. What is meant by the term objective risk and why is it so important to insurers?
Solution: Objective risk is deviation of actual from expected. Expected losses are a starting point for calculating premiums. If objective risk is small, premiums will cover losses; but if objective risk is large, premiums may not cover losses and “underwriting loss” may occur. Repeated underwriting losses can lead to insurer insolvency.
3. What are the various types of insurance organizations?
Solution: Stock, mutual, fraternal, reciprocal, and “Lloyd’s associations”.
4. What are the sources of regulation for the insurance industry and what areas are regulated?
Solution: The states regulate insurance in the U.S. The National Association of Insurance Commissioners coordinates state-regulatory activity. The purpose of insurance regulation is to assure financial strength of insurers in order to protect insurance consumers against insolvencies, to protect consumers in the drafting of insurance contracts, to assure reasonable rates, and to assure widespread availability of coverage.
5. How does securitization of risk increase insurance industry capacity?
Solution: Rather than simply relying on insurers and reinsurers to bear risk, securitization opens the door for other capital market participants to share risk. Securitization is especially important in addressing potentially catastrophic losses (earthquakes, hurricanes, etc.).
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? What made variable life insurance popular in the 1990s?
Solution: Universal life insurance was a flexible species of "whole life", which includes two separate financial services: life insurance and savings. Ambiguity about the cost of the insurance component and the return on the savings component convinced most people to “buy term and invest the difference”. Variable life, in which returns on the savings feature are tied to the company’s investment performance, became popular when the equity markets were providing double-digit returns in the late 1990s.
3. Why are life insurance and life annuities often described as opposites?
Solution: Life insurance provides economic protection for early death; annuities provide protection against late death—living beyond one’s assets.
4. What are the largest asset categories on a life insurance company balance sheet?
Solution: Corporate and foreign bonds, corporate equities, U.S. Government securities, mortgages, and policy loans.
1. Property insurance is available for both direct and indirect losses. Differentiate between these two types of losses.
Solution: Direct losses include fire, theft or other perils that impact the property of the insureds "directly." Indirect losses are losses contingent upon other losses, such as business interruption after a fire.
2. Why is the liability loss exposure more difficult to gauge than the property loss exposure?
Solution: The ultimate determination of liability exposure may be contingent, as to both timing and amount, on factors more behavioral and less predictable than either the actual value of the loss or the actual merits of the case. Such factors may include bias, corruption, or incompetence in the legal system, the inclination or disinclination of a defendant to settle, or the personal reactions of jurors. Property losses, by contrast, are determinable and measurable as of their occurrence.
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 at once, costs less to produce, and simplifies recordkeeping. Multiple line policies take advantage of the tendency of consumers who are low-risk to be low-risk in every respect.
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: P/L companies do not have a "savings" or "accumulation" portion of their premiums, so they are usually smaller than LICs. They have higher federal tax exposure than LICs so they are likely to invest heavily in preferred stock and municipal bonds. Needing more liquidity than LICs, P/L companies usually hold more marketable issues (large issues). P/L insurance covers replacement value, so investing in equities as a hedge against inflation is likely. Bonds, equities and government securities are the largest asset categories.
1. How are Social Security old-age benefits funded? Are these benefits based on social adequacy or individual equity?
Solution: Social Security is funded “pay as you go”. The federal government collects the payroll tax, pays the benefits, and spends the excess on other parts of its budget. Benefits are based on social adequacy, not individual equity. The minimum benefit over-rewards low contributors and the maximum benefit under-rewards top contributors. Participation is mandatory and participants have no property rights in their contributions. The premise is social insurance—a large population of elderly poor would be a social problem affecting all of us, irrespective of who should have done what or who deserves what.
2. What are the tax advantages of qualified private pension plans?
Solution: Participants defer income tax on all contributions, and returns compound tax-deferred. Withdrawals are taxed in retirement, when most beneficiaries are in a lower tax bracket.
3. Explain the difference between contributory and noncontributory pension plans. Differentiate between defined benefit and defined contribution pension plans.
Solution: “Noncontributory plans” are funded with employer contributions only. “Contributory plans” receive both employer and employee contributions. “Fully contributory plans” are funded with employee contributions only. “Defined benefit plans” are a traditional industrial-era arrangement under which an employer promises benefits set by some formula based on years of service and average pay. The employer is fully responsible for delivering the promised benefits. “Defined contribution plans” are the modern arrangement. Contributions defined as some percentage of salary are paid in by the employee and/or employer. The employee decides how the contributions are invested.
4. ERISA and subsequent Acts regulate several features of qualified private pensions. What is meant by portability, vesting, and fiduciary standards?
Solution: ERISA prescribes the requirements for portability and vesting of employer-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.