J. K. Dietrich - FBE 524 - Fall, 2005 Non-Bank Financial Institutions Week 3 – September 14, 2005.

J. K. Dietrich - FBE 524 - Fall, 2005

Non-Bank Financial Institutions

Week 3 – September 14, 2005


Non-Bank Financial Institutions Insurance-type

– Life and property and casualty– Pension funds

Asset management firms and funds Securities firms Others

– Finance companies– Mortgage bankers– Government-sponsored agencies


Insurance Liabilities

Promise to pay depending on contingency– Life - Pay upon death, or retirement– Property and casualty - Pay on occurrence of

accident or loss due to theft or hazard (fire, weather, earthquake, flood)

Differences between life and accident– Life probabilities known with accuracy– Casualty has two risks: incidence and severity


Insurance Services

Life and annuity contract– Probabilities usually not influenced by insured– Cash flows from coverage are predictable– Cancellations, lapses, policy loans

Casualty contract– Period short– Policy-holders influence the incidence and

severity of claims


Life Insurance Contracts

AgeAgeRetirement RetirementDeath Death

Whole Life Contract Limited Pay Life

Pre

miu

ms,

Ben

efit

s

Pre

miu

ms,

Ben

efit

s


Life Insurance Contracts (cont’d)

AgeAgeRetirement RetirementDeath Death

Endowment Policy Life and Annuity

Pre

miu

ms,

Ben

efit

s

Pre

miu

ms,

Ben

efit

s


Insurance Distribution

Life insurance– Ordinary– Group– Industrial– Credit

Independent agents Economics of insurance marketing

– Compensation of agents and brokers– Political power in the insurance industry


Insurance Company Income Revenue: Premium income

– Earned premiums

Investment income

Expenses: Policy Benefits and Losses– Direct payments to claimants

– Loss expenses (evaluation, processing)

Marketing expenses

Non-interest expense– Labor and related expenses– Communication, fees


Insurance Market


Life Insurance Assets


Role of Insurance Equity

Equity in insurance is sometimes referred to as surplus since it represents premium collections above claims payments

Income is approximately:– Premiums + investment income – claims– Income/loss adds to/subtracts from equity

Equity or surplus absorbs large surges in claims as in catastrophes (e.g. Katrina)


Insurance Balance Sheets

Balance sheet: liabilities are insurance reserves, unearned premiums, and surplus (plus equity capital)

Assets are investments in corporate and municipal bonds, real estate, equities,

Balance sheet management consists of matching asset risks to liability risks– Many liabilities have long tails or durations


Property-Casualty Insurance


Contrast Life/Casualty Insurance

Probabilities of claims in life insurance are well known (vital statistics yield accurate actuarial estimates)

Moral hazard limited in life insurance Dollar claims in casualty insurance are

affected by incidence and severity of damages and may have more are affected by incidence and severity of damages and may have more systematic risk


Pension Funds

Private versus state and local government Defined benefit versus defined contribution Self-directed pension plans Pensions, taxes, and responsibilities

– Corporate tax treatment– Personal tax treatment– Corporate responsibilities under ERISA


Pension Fund Assets


Asset Management

Economics of the industry– Performance measurement– Principal-agent problems

A “temporary” disequilibrium– Historical perspective

Services provided by asset managers Issues in asset management


Asset Management Firms

Revenue: Management Fees– Based on assets under management

Expenses: Research Costs– Analysts (labor expense)

– Data and computer expenses

Marketing expenses

Non-interest expense– Overhead labor and related expenses– Communication, fees


Securities Firms

Brokers– Find buyers for sellers– Organize markets

Dealers– Provide liquidity to market– Hold inventories and take price risk

Securities originators– Design and place financial instruments for primary

market issuers


Brokers and Investment Banking

Full-line firms offer retail and institutional trading, securities origination and financial advisory services, and market-making services

Clearing brokers (e.g. Bear Stearns) present securities for settlement

Wire houses transmit orders to other firms for execution


Investment Banking

Bulge bracket firms (e.g. Morgan Stanley) are largest investment banking firms

Regional firms (e.g. Wedbush Morgan) operate in local markets

Boutique firms specialize in certain types of transactions (e.g high tech or health care)

Terms are not mutually exclusive


Securities Firm Income Revenue:

Commissions Fees - Advisory, investment banking, asset

management

Gains (and losses) and interest Expenses:

Labor costs Communications and space Clearing fees Borrowing costs


Finance Companies Three basic types

– Captive finance companies (owned by manufacturer, e.g. GMAC)

– Commercial finance companies and financial firm affiliates (owned by banks or other financial firms, e.g. Foothill Group)

– Consumer or personal finance companies (specialized in high-risk finance, like Household Finance)

Funding sources - Bank credit, commercial paper, affiliate company financing


Finance Company Investments


Asset-Pools Origination

– Government-sponsored agencies (GSEs)» Federal National Mortgage Association (FNMA or Fannie

May)

» Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)

» Student Loan Marketing Corporation (SLMC or Sallie May)

– Private originators

Servicing– Servicing fees and costs

– Transactions in servicing portfolios


Other Financial Firms

Mortgage banks Information and advisory firms Clearing firms and depositories Exchanges and communication networks Clear differences between types are eroding, but

traditionally were due to– Regulation, taxation, and charters– Specialization and expertise– Historical evolution


Next week: Sept. 21, 2005 Read Chapters 4 and 17 of Money and

Capital Markets Read selections from trade press selected by

students and download handouts before class

Form a group of three or four students for the group project and provide a tentative choice for the group project from the list provided or as discussed with me

Bring a Wall Street Journal to class every Wednesday

J. K. Dietrich - FBE 524 - Fall, 2005 Non-Bank Financial Institutions Week 3 – September 14, 2005.

Documents

insurance services u

dietrich fbe

life insurance u dollar

life insurance assets

insurance industry slide

insurance market slide

insurance reserves

funds u securities firms