FIN 366 Week 4 Insurance Companies and Investment Banks Example

Two Other Kinds of Intermediary: A Regional Property Insurer's Combined Ratio and Float, and an Investment Bank Taking a Mid-Sized Manufacturer Public

[Student Name]

University of Phoenix

FIN/366: Financial Institutions

Week 4 Assignment

[Instructor Name]

[Date]

The insurer, the manufacturer and all figures are composites written for a model paper; concepts and research findings come from the sources listed.

Commercial banks are not the only financial intermediaries. Insurance companies pool the risks of many policyholders and invest their premiums, and investment banks help companies raise money in securities markets and advise on major transactions. An insurer is paid to take risk off its customers' hands; an investment bank is paid to carry a company's securities into the market without taking on that risk for long. This paper examines one of each.

The Insurer's Business

A composite regional insurer writes homeowners, auto and small business policies in four states, collecting about $900 million in premiums a year. It pools thousands of independent risks, so that while any single house fire is unpredictable, total losses are fairly predictable. It earns money two ways: underwriting profit, if premiums exceed claims and expenses, and investment income on the premiums it holds before claims are paid (Mishkin, 2022).

The Combined Ratio

Last year the insurer earned premiums of $880 million. Losses and loss adjustment expenses were $620 million, a loss ratio of 70.5%. Underwriting expenses, including agent commissions and administration, were $260 million, an expense ratio of 29.5%. The combined ratio is 100%: the insurer paid out everything it earned in premiums.

That does not mean it made nothing. The insurer holds about $1.4 billion of investments, mostly bonds, funded largely by float, premiums collected before claims are paid, and by reserves for claims not yet settled. At a yield of about 4%, investment income was about $56 million. Net income, after taxes, was about $44 million.

Reserves and Reinsurance

The insurer's biggest liability is its loss reserves, estimates of claims already incurred but not yet paid, including those not yet reported. If reserves are too low, future earnings will suffer as claims come in. Actuaries estimate reserves from historical patterns, and regulators review them.

A single hurricane or hailstorm could produce losses far beyond normal, so the insurer buys reinsurance, insurance for insurers. Its catastrophe reinsurance covers 90% of losses from a single event between $80 million and $400 million. The protection costs about $40 million a year, part of its expense ratio, but it keeps a severe storm from wiping out its capital.

Insurance Regulation

Insurers are regulated mainly by states, which license them, approve rates in many lines, examine their finances and set risk-based capital requirements. Guaranty funds pay policyholders if an insurer fails. The regulatory focus is solvency: ensuring the insurer can pay claims years in the future.

The Investment Bank and the Offering

A composite family-owned manufacturer of industrial pumps and valves, with revenue of $780 million, decided to go public to raise money for acquisitions and give the family liquidity. It chose a lead underwriter, a large investment bank, and two co-managers. In a firm commitment underwriting, the banks agree to buy the shares from the company and resell them, taking the risk that they cannot sell them at the planned price, in exchange for a spread of about 6% of the proceeds.

The bank's first months were due diligence: reviewing the company's operations, contracts and financial statements and helping draft the registration statement filed with the Securities and Exchange Commission. After the statement was filed and reviewed, management and the bankers held a roadshow, presenting to institutional investors. During bookbuilding, investors indicated how many shares they would buy at what prices. Demand was strong, so the price was set at $24, the top of the range, and 15 million shares were sold, raising $360 million before fees.

The First Day and Underpricing

On the first day of trading, the stock closed at $28.80, up 20%. That jump means the company and selling family received less than investors were willing to pay: about $72 million was left on the table. Ritter and Welch (2002) reviewed research on initial public offerings and found that underpricing is persistent and substantial on average, explained partly by information differences between investors and issuers and partly by underwriters' interests in pleasing investors who will buy future offerings. The pump maker's family accepted the underpricing as a cost of a successful debut but negotiated a lower spread for any later offering.

Other Investment Banking Work

Underwriting is only one line of an investment bank's business. The same bank advises companies on mergers and acquisitions, earning fees for valuation and negotiation; trades securities for clients and, within limits since 2008, for itself; and manages assets for institutions and wealthy individuals. For the pump maker, the bank that led its offering will likely pitch advisory services for the acquisitions the company plans, which is one reason banks compete for offerings even at modest spreads.

Insurers as Investors

Because insurers hold large bond portfolios, they are major buyers of corporate bonds and private placements. The regional insurer matches the maturity of its bonds to the expected timing of claims, short for auto claims that settle quickly and longer for liability claims that take years, the same asset and liability matching that banks practice.

After the Offering

The underwriters provided price support through an overallotment option and published research after the quiet period. The company now faces public reporting, internal control requirements and shareholder scrutiny.

Comparing the Intermediaries

Commercial banks take deposits and hold loans on their balance sheets, facing liquidity and credit risk, including the run risk that Diamond and Dybvig (1983) modeled. Insurers take on policyholders' risks and invest premiums, facing underwriting and catastrophe risk. Investment banks help others issue securities and hold them only briefly, facing market risk during underwriting and reputational risk. Each is regulated for different dangers: banks for runs, insurers for solvency and investment banks for fair dealing and disclosure.

Conclusion

The regional insurer earned its profit from investing float even with a combined ratio of 100%, protected by reserves and reinsurance. The investment bank carried the pump maker to market through due diligence, a roadshow and bookbuilding, and the first-day jump showed the underpricing that research documents. Both intermediaries move money and risk in ways that differ sharply from a commercial bank.

References

Diamond, D. W., & Dybvig, P. H. (1983). Bank runs, deposit insurance, and liquidity. Journal of Political Economy, 91(3), 401-419. https://doi.org/10.1086/261155

Mishkin, F. S. (2022). The economics of money, banking, and financial markets (13th ed.). Pearson.

Ritter, J. R., & Welch, I. (2002). A review of IPO activity, pricing, and allocations. The Journal of Finance, 57(4), 1795-1828. https://doi.org/10.1111/1540-6261.00478