Insurance Companies
Insurance Companies: Differences in services provided by:
- Life Insurance Companies
- Property and Casualty Insurance
Life Insurance Companies:
- Size, Structure and Composition of the Industry:
In 1988: 2,300 life insurance companies with aggregate assets of $1.12 trillion
In early 2000s: 1,500 companies / $3.4 trillion
4 largest wrote 19% of new premium business
Increasing involvement of commercial banks in insurance policy sales
- Large scale mergers
Life Insurance: Issues
- Demutualization
- Adverse selection
Insured have higher risk than general population
Alleviated by grouping of policyholders into risk pools
Life Insurance Products:
Ordinary life
Term life, Whole life, Endowment life.
Variable life, Universal life, Variable universal life.
Group life
Industrial life
Credit life
Other Life Insurer Activities
Annuities
Reverse of life insurance activities.
Private pension funds
Compete with other financial service companies.
Accident and health insurance
Morbidity insurance
Effects of growth in HMO enrollment
Depository Institutions
Depository Institutions:
- Commercial Banks
Largest depository institutions are commercial banks.
Differences in operating characteristics and profitability across size classes.
Notable differences in ROE and ROA as well as the spread
- Thrifts
S&Ls
Savings Banks
Credit Unions
- Mix of very large banks with very small banks
Functions & Structural Differences:
Functions of depository institutions
Regulatory sources of differences across types of depository institutions.
Structural changes generally resulted from changes in regulatory policy.
Example: changes permitting interstate branching
Reigle-Neal Act
Commercial Banks:
Primary assets:
Real Estate Loans: $2,272.3 billion
C&I loans: $870.6 billion
Loans to individuals: $770.5 billion
Investment security portfolio: $1,789.3 billion Of which, Treasury bonds: $1,005.8 billion
Inference: Importance of Credit Risk
Primary liabilities:
Deposits: $5,028.9 billion
Borrowings: $1,643.3 billion
Other liabilities: $238.2 billion
Inference: Highly leveraged
Balance Sheet and Trends
Business loans have declined in importance
Offsetting increase in securities and mortgages
Increased importance of funding via commercial paper market
Securitization of mortgage loans
Some Terminology:
-Transaction accounts
-Negotiable Order of Withdrawal (NOW) accounts
-Money Market Mutual Fund
-Negotiable CDs: Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market.
Off-balance Sheet Activities
Heightened importance of off-balance sheet items
Large increase in derivatives positions is a major issue
Standby letters of credit
Loan commitments
When-issued securities
Loans sold
Other Fee-generating Activities
- Trust services
Correspondent banking
Check clearing
Foreign exchange trading
Hedging
Participation in large loan and security issuances
Payment usually in terms of noninterest bearing deposits
Savings Banks
Mutual organizations
Primarily East Coast
Not exposed to the oil-based shocks of 1980s
Real estate price exposure
Demutualization
May be regulated at both state and federal level
- Commercial Banks
Largest depository institutions are commercial banks.
Differences in operating characteristics and profitability across size classes.
Notable differences in ROE and ROA as well as the spread
- Thrifts
S&Ls
Savings Banks
Credit Unions
- Mix of very large banks with very small banks
Functions & Structural Differences:
Functions of depository institutions
Regulatory sources of differences across types of depository institutions.
Structural changes generally resulted from changes in regulatory policy.
Example: changes permitting interstate branching
Reigle-Neal Act
Commercial Banks:
Primary assets:
Real Estate Loans: $2,272.3 billion
C&I loans: $870.6 billion
Loans to individuals: $770.5 billion
Investment security portfolio: $1,789.3 billion Of which, Treasury bonds: $1,005.8 billion
Inference: Importance of Credit Risk
Primary liabilities:
Deposits: $5,028.9 billion
Borrowings: $1,643.3 billion
Other liabilities: $238.2 billion
Inference: Highly leveraged
Balance Sheet and Trends
Business loans have declined in importance
Offsetting increase in securities and mortgages
Increased importance of funding via commercial paper market
Securitization of mortgage loans
Some Terminology:
-Transaction accounts
-Negotiable Order of Withdrawal (NOW) accounts
-Money Market Mutual Fund
-Negotiable CDs: Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market.
Off-balance Sheet Activities
Heightened importance of off-balance sheet items
Large increase in derivatives positions is a major issue
Standby letters of credit
Loan commitments
When-issued securities
Loans sold
Other Fee-generating Activities
- Trust services
Correspondent banking
Check clearing
Foreign exchange trading
Hedging
Participation in large loan and security issuances
Payment usually in terms of noninterest bearing deposits
Savings Banks
Mutual organizations
Primarily East Coast
Not exposed to the oil-based shocks of 1980s
Real estate price exposure
Demutualization
May be regulated at both state and federal level
An Economic Analysis of Financial Structure
Eight Basic Facts
1 Stocks are not the most important sources of external financing for businesses
2 Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
3 Indirect finance is many times more important than direct finance
4 Financial intermediaries are the most important source of external funds
5 The financial system is among the most heavily regulated sectors of the economy
6 Only large, well-established corporations have easy access to securities markets to finance their activities
7 Collateral is a prevalent feature of debt contracts
8 Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers
Transaction Costs
Financial intermediaries have evolved to reduce transaction costs
- Economies of scale
- Expertise
Asymmetric Information
Adverse selection occurs before the transaction
Moral hazard arises after the transaction
Agency theory analyses how asymmetric information problems affect economic behavior
Adverse Selection: The Lemons Problem
If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality
Sellers of good quality items will not want to sell at the price for average quality
The buyer will decide not to buy at all because all that is left in the market is poor quality items
This problem explains fact 2 and partially explains fact 1
Adverse Selection: Solutions
Private production and sale of information
Free-rider problem
Government regulation to increase information
Fact 5
Financial intermediation
Facts 3, 4, & 6
Collateral and net worth
Fact 7
Conflicts of Interest
Type of moral hazard problem caused by economies of scope
Arise when an institution has multiple objectives and, as a result, has conflicts between those objectives
A reduction in the quality of information in financial markets increases asymmetric information problems
Financial markets do not channel funds into productive investment opportunities
The economy is not as efficient as it could be
Why Do Conflicts of Interest Arise?
Underwriting and Research in Investment Banking
Information produced by researching companies is used to underwrite the securities. The bank is attempting to simultaneously serve two client groups whose information needs differ.
Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business
Auditing and Consulting in Accounting Firms
Auditors may be willing to skew their judgments and opinions to win consulting business
Auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts
Auditors may provide an overly favorable audit to solicit or retain audit business
Financial Crises and Aggregate Economic Activity
Crises can be caused by:
- Increases in interest rates
- Increases in uncertainty
- Asset market effects on balance sheets
- Problems in the banking sector
- Government fiscal imbalances
The Risk and Term Structure of Interest Rates
Risk Structure of Interest Rates
Default risk—occurs when the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
U.S. T-bonds are considered default free
Risk premium—the spread between the interest rates on bonds with default risk and the interest rates on T-bonds
Liquidity—the ease with which an asset can be converted into cash
Income tax considerations
Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield curve—a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
Upward-sloping long-term rates are above short-term rates
Flat short- and long-term rates are the same
Inverted long-term rates are below short-term rates
Facts Theory of the Term Structure of Interest Rates Must Explain
Interest rates on bonds of different maturities move together over time
When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward
Three Theories to Explain the Three Facts
- Expectations Theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity
Bonds like these are said to be perfect substitutes
Expectations Theory—Example
Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year bond to be 8% next year.
Then the expected return for buying two one-year bonds averages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be 7% for you to be willing to purchase it.
- Segmented Markets Theory
Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond
Investors have preferences for bonds of one maturity over another
If investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)
- Liquidity Premium & Preferred Habitat Theories
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond
Bonds of different maturities are substitutes but not perfect substitutes
Default risk—occurs when the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
U.S. T-bonds are considered default free
Risk premium—the spread between the interest rates on bonds with default risk and the interest rates on T-bonds
Liquidity—the ease with which an asset can be converted into cash
Income tax considerations
Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield curve—a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
Upward-sloping long-term rates are above short-term rates
Flat short- and long-term rates are the same
Inverted long-term rates are below short-term rates
Facts Theory of the Term Structure of Interest Rates Must Explain
Interest rates on bonds of different maturities move together over time
When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward
Three Theories to Explain the Three Facts
- Expectations Theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity
Bonds like these are said to be perfect substitutes
Expectations Theory—Example
Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year bond to be 8% next year.
Then the expected return for buying two one-year bonds averages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be 7% for you to be willing to purchase it.
- Segmented Markets Theory
Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond
Investors have preferences for bonds of one maturity over another
If investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)
- Liquidity Premium & Preferred Habitat Theories
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond
Bonds of different maturities are substitutes but not perfect substitutes
The Behavior of Interest Rates
Determining the Quantity Demanded of an Asset
Wealth—the total resources owned by the individual, including all assets
Expected Return—the return expected over the next period on one asset relative to alternative assets
Risk—the degree of uncertainty associated with the return on one asset relative to alternative assets
Liquidity—the ease and speed with which an asset can be turned into cash relative to alternative assets
Theory of Asset Demand
Holding all other factors constant:
The quantity demanded of an asset is positively related to wealth
The quantity demanded of an asset is positively related to its expected return relative to alternative assets
The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
The quantity demanded of an asset is positively related to its liquidity relative to alternative assets
Supply and Demand for Bonds
At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher—an inverse relationship
At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower—a positive relationship
Wealth—the total resources owned by the individual, including all assets
Expected Return—the return expected over the next period on one asset relative to alternative assets
Risk—the degree of uncertainty associated with the return on one asset relative to alternative assets
Liquidity—the ease and speed with which an asset can be turned into cash relative to alternative assets
Theory of Asset Demand
Holding all other factors constant:
The quantity demanded of an asset is positively related to wealth
The quantity demanded of an asset is positively related to its expected return relative to alternative assets
The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
The quantity demanded of an asset is positively related to its liquidity relative to alternative assets
Supply and Demand for Bonds
At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher—an inverse relationship
At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower—a positive relationship
Understanding Interest Rates
Present Value:A dollar paid to you one year from now is less valuable than a dollar paid to you today
Four Types of Credit Market Instruments
- Simple Loan
- Fixed Payment Loan
- Coupon Bond
- Discount Bond
Yield to Maturity:The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today
Rate of Return and Interest Rates
The return equals the yield to maturity only if the holding period equals the time to maturity
A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period
The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change
Real and Nominal Interest Rates
Nominal interest rate makes no allowance for inflation
Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing
Ex ante real interest rate is adjusted for expected changes in the price level
Ex post real interest rate is adjusted for actual changes in the price level
Four Types of Credit Market Instruments
- Simple Loan
- Fixed Payment Loan
- Coupon Bond
- Discount Bond
Yield to Maturity:The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today
Rate of Return and Interest Rates
The return equals the yield to maturity only if the holding period equals the time to maturity
A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period
The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change
Real and Nominal Interest Rates
Nominal interest rate makes no allowance for inflation
Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing
Ex ante real interest rate is adjusted for expected changes in the price level
Ex post real interest rate is adjusted for actual changes in the price level
What Is Money?
Meaning of Money
Money (money supply)—anything that is generally accepted in payment for goods or services or in the repayment of debts; a stock concept
Wealth—the total collection of pieces of property that serve to store value
Income—flow of earnings per unit of time
Functions of Money
Medium of Exchange—promotes economic efficiency by minimizing the time spent in exchanging goods and services
Must be easily standardized
Must be widely accepted
Must be divisible
Must be easy to carry
Must not deteriorate quickly
Unit of Account—used to measure value in the economy
Store of Value—used to save purchasing power; most liquid of all assets but loses value during inflation
Evolution of the Payments System
Commodity Money
Fiat Money
Checks
Electronic Payment
E-Money
Money (money supply)—anything that is generally accepted in payment for goods or services or in the repayment of debts; a stock concept
Wealth—the total collection of pieces of property that serve to store value
Income—flow of earnings per unit of time
Functions of Money
Medium of Exchange—promotes economic efficiency by minimizing the time spent in exchanging goods and services
Must be easily standardized
Must be widely accepted
Must be divisible
Must be easy to carry
Must not deteriorate quickly
Unit of Account—used to measure value in the economy
Store of Value—used to save purchasing power; most liquid of all assets but loses value during inflation
Evolution of the Payments System
Commodity Money
Fiat Money
Checks
Electronic Payment
E-Money
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