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Property and Casualty Insurance

There are on the order of 3,000 property and casualty insurance companies in the United States, the two largest of which are State Farm and Allstate. Property and casualty companies are organized as both stock and mutual companies and are regulated by the states in which they operate.

Although property and casualty insurance companies had a slight increase in their share of total financial intermediary assets from 1970 to 1990 (see Table 1), in recent years they have not fared well, and insurance premiums have skyrocketed. With the

TABLE 1 Relative Shares of Total Financial Intermediary Assets, 1970-2005 (percent)

Insurance Companies

Life insurance

15.3

11.5

12.5

12.0

12.9

Property and casualty

3.8

4.5

4.9

3.3

3.7

Pension Funds

Private

8.4

12.5

14.9

16.6

13.5

Public (state and local government)

4.6

4.9

6.7

8.8

8.0

Finance Companies

4.9

5.1

5.6

4.4

3.9

Mutual Funds

Stock and bond

3.6

1.7

5.9

17.0

17.7

Money market

0.0

1.9

4.6

6.9

5.9

Depository Institutions (Banks)

Commercial banks

38.5

36.7

30.4

24.7

27.1

S&Ls and mutual savings banks

19.4

19.6

12.5

4.7

5.2

Credit unions

1.4

L0

0.0

L0

0.0

Total

100.0

1°0.°

1°0.°

1°0.0

100.0

Source: Federal Reserve Flow of Funds Accounts.

high interest rates in the 1970s and 1980s, insurance companies had high investment income that enabled them to keep insurance rates low. Since then, however, investment income has fallen with the decline in interest rates, while the growth in lawsuits involving property and casualty insurance and the explosion in amounts awarded in such cases have produced substantial losses for companies.

To return to profitability, insurance companies have raised their rates dramatically—sometimes doubling or even tripling premiums—and have refused to provide coverage for some people. They have also campaigned actively for limits on insurance payouts, particularly for medical malpractice. In the search for profits, insurance companies are also branching out into uncharted territory by insuring the payment of interest on municipal and corporate bonds and on mortgage-backed securities. One worry is that the insurance companies may be taking on excessive risk in an attempt to boost their profits. One result of the concern about the health of the property and casualty insurance industry is that insurance regulators have proposed new rules that would impose risk-based capital requirements on these companies based on the riskiness of their assets and operations. Recent scandals have also come to the insurance industry (see the Conflicts of Interest box, "Insurance Behemoth Charged with Conflicts of Interest Violations"), which could result in increased insurance regulation.

The investment policies of these companies are affected by two basic facts. First, because they are subject to federal income taxes, the largest share of their assets is held in tax-exempt municipal bonds. Second, because property losses are more uncertain than the death rate in a population, these insurers are less able to predict how much they will have to pay policyholders than life insurance companies are. Natural and unnatural disasters such as the Los Angeles earthquake in 1994; Hurricane Katrina,

Conflicts of Interest. Insurance Behemoth Charged with Conflicts of Interest Violations

In October 2004, New York Attorney General Eliot Spitzer charged Marsh & McLennan Cos. (MMC), a $12 billion financial services company, with fraud related to its insurance brokerage business. This legal attack is likely to have far-reaching effects on an industry that has so far remained removed from the scandals that have plagued other financial services firms.

Companies hire insurance brokers to help them control risk in a cost-effective manner. An insurance broker is expected to use its expertise and influence to search for the best possible prices from the insurance industry. The broker receives a fee for providing this service.

In the complaint filed against MMC, Spitzer charged that the insurance firm engaged in bid rigging and accepted payoffs from insurance companies in exchange for directing business their way. In practicing bid rigging, MMC required some insurance companies to submit abnormally high bids. This allowed another favored insurer to receive the business at a price fixed by MMC. The insurance companies were told by MMC that if they did not follow MMC's directions they would lose future business.

MMC also required insurers to pay contingent commissions—payments to MMC for steering clients to them. These pay-to-play revenues amounted to $800 million per year to MMC, or about half of the firm's 2003 net income. An e-mail Spitzer obtained from a senior MMC executive reads, "We need to place our business in 2004 with those that . . . pay us the most." MMC, along with other major insurance brokerage firms Aon and Willis Group Holdings, has halted all contingent commissions.

In the aftermath of these conflicts of interest scandals, MMC agreed to pay an $850 million fine, and Chairman and CEO Jeffery Greenberg and four other top executives left the firm. A number of other insurance firms and insurance brokerage companies have come under further scrutiny, including the huge insurance company American International Group (AIG), whose CEO, Maurice R. "Hank" Greenburg, is the father of Jeffrey Greenberg. The board of directors of AIG had to admit that the company had engaged in faulty accounting. The board then announced a reduction in the firm's net worth by nearly $3 billion and forced Greenberg, who had run the company for nearly 40 years, to resign in March 2005.

In the past, the insurance industry has been largely self-regulated. It is likely that the abuses uncovered by Spitzer and their clear costs to consumers will result in additional regulation and oversight.

which devastated New Orleans in 2005; and the September 11, 2001, destruction of the World Trade Center exposed the property and casualty insurance companies to billions of dollars of losses. Therefore, property and casualty insurance companies hold more liquid assets than life insurance companies; municipal bonds and U.S. government securities amount to over half their assets, and most of the remainder is held in corporate bonds and corporate stock.

Property and casualty insurance companies will insure against losses from almost any type of event, including fire, theft, negligence, malpractice, earthquakes, and automobile accidents. If a possible loss being insured is too large for any one firm, several firms may join together to write a policy and thus share the risk. Insurance companies may also reduce their risk exposure by obtaining reinsurance. Reinsurance allocates a portion of the risk to another company in exchange for a portion of the premium and is particularly important for small insurance companies. You can think of reinsurance as insurance for the insurance company. The most famous risk-sharing operation is Lloyd's of London, an association in which different insurance companies can underwrite a fraction of an insurance policy. Lloyd's of London has claimed that it will insure against any contingency—for a price.

The Competitive Threat from the Banking Industry

Until recently, banks have been restricted in their ability to sell life insurance products. This has been changing rapidly, however. More than two-thirds of the states allow banks to sell life insurance in one form or another. In recent years, the bank regulatory authorities, particularly the Office of the Comptroller of the Currency (OCC), have also encouraged banks to enter the insurance field because getting into insurance would help diversify banks' business, thereby improving their economic health and making bank failures less likely. For example, in 1990, the OCC ruled that selling annuities was a form of investment that was incidental to the banking business and so was a permissible banking activity. As a result, the banks' share of the annuities market has surpassed 20%. Currently, more than 60% of banks sell insurance products, and the number is expected to grow in the future.

Insurance companies and their agents reacted to this competitive threat with both lawsuits and lobbying actions to block banks from entering the insurance business. Their efforts were set back by several Supreme Court rulings that favored the banks. Particularly important was a ruling in favor of Barnett Bank in March 1996, which held that state laws to prevent banks from selling insurance can be superseded by federal rulings from banking regulators that allow banks to sell insurance. The decision gave banks a green light to further their insurance activities, and with the passage of the Gramm-Leach-Bliley Act of 1999, banking institutions will further engage in the insurance business, thus blurring the distinction between insurance companies and banks.

 
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