EOC solutions Chapter 15

EOC solutions Chapter 15 - Answers to Chapter 15 Questions...

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Answers to Chapter 15 Questions: 1. The primary function of a life insurance company is to protect policyholders from adverse events. Insurance companies accept premium payments in exchange for compensation in the event that certain specified, but undesirable, events occur. The primary function of depository institutions is to provide financial intermediation for individual and corporate savers. By accepting deposits and making loans, depository institutions allow savers with predominantly small, short-term financial assets to benefit from investments in larger, longer-term assets. These long-term assets typically yield a higher rate of return than short-term assets. 2. The adverse selection problem occurs because customers who are most in need of insurance are most likely to acquire insurance. However, the premium structure for various types of insurance typically is based on an average population proportionately representing all categories of risk. Thus, the existence of a proportionately larger share of high-risk customers may cause the premium revenue received by the insurance provider to underestimate the revenue needed to cover the insured liabilities and to provide a reasonable profit for the insurance company. 3. Life insurance companies have long-term liabilities because of the life insurance products that they sell. As a result, the asset side of the balance sheet predominantly includes long-term government and corporate bonds, corporate equities, and a declining amount of mortgage products. The asset side of a depository institution’s balance sheet is comprised primarily of short- and medium-term loans to corporations and individuals and some liquid investment securities (e.g., Treasury securities). A major similarity between depository institutions and insurance firms is the high degree of financial leverage incurred by both groups of firms. Both groups solicit funds (from policyholders or depositors) and use them to finance an asset portfolio predominately consisting of debt securities. A major difference between them is their composition of the liabilities, which is fixed for depository institutions but stochastic for insurance firms. While the face value of bank deposits is fixed, the insurance company's net policy reserves depend on expected future required payouts which can be highly uncertain. The other difference is that insurance companies are allowed to invest in equity instruments, which currently are prohibited for depository institutions. 4. We can see in Table 15-2 that since the 1920s and 30s, life insurance companies have increased their holdings of bonds and stocks and decreased their holdings of mortgage loans and policy loans. Government securities comprise the next largest component and have recently increased back to their earlier levels after reaching very low levels in the 60s and 70s. The need for a more certain stream of cash flows to pay off policies is a major reason for the investment in bonds. The bull market of the 1990s is a major reason for the large percentage of assets invested in
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