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Collection of tutorials and a guide for using TGJU & Financial Markets
Copays and deductibles are features of health insurance plans. A copay is a fixed amount paid by a patient for receiving a particular health care service, with the remaining balance covered by his insurance company. A deductible is a fixed amount a patient must pay during a given time period, usually a year, before his health insurance benefits cover the costs.
For example, suppose a patient has a health insurance plan with a $30 copay to visit a primary care physician, a $50 copay to see a specialist and a $10 copay for generic drugs. The patient pays these fixed amounts for those services regardless of what the services actually cost. His insurance company pays the balance; the amount paid by the insurance company is known as the covered amount. Therefore, if a visit to the patient’s endocrinologist costs $250, the patient pays $50 and the insurance company pays $200.
Now suppose the same patient has a $2,000 annual deductible before his benefits cover the costs. In January, he sprains his ankle playing basketball, and treatment costs $300. He pays the full cost because he has yet to meet his deductible. In April, he has back problems, which cost $500 to treat. Again, he pays the full cost. In August, he breaks his arm playing touch football, and the bill for his hospital visit comes to $3,500. On this bill, the patient pays $1,200; this is what is left of his deductible. Because the deductible is met at this point, the insurance company pays the remaining $2,300.
Term life insurance is the most basic of insurance policies. It is nothing more than an insurance policy that provides protection for accidental death and possibly debilitating injuries for a specified period of time. If you or your beneficiaries do not make any claims during the term the policy, it will typically expire worthless. Generally, term life insurance is cheaper to buy during the earlier years of life, when the risk of death is relatively low. Prices rise in accordance with increasing risks and advancing age.
Universal life insurance falls under a broader category of policies sometimes referred to as cash-value or permanent insurance. These types of insurance policies combine death benefits with a savings component or cash value that is reinvested and tax deferred. The savings portion is accumulated throughout the life of the policy and can often be cashed in at some future point. Because these policies are permanent, any early termination of the contract by the policyholder would result in penalties. During the earlier stages of your life, a large portion of the premium paid to this policy is routed to the savings component. During the later stages of life, when the cost of insurance is higher, less of the premium is devoted to the cash portion and more to the purchase of insurance.
For example, if a 20-year-old purchases term insurance, his or her premium might be $20 per month. With a universal policy, the same 20-year-old might pay $100 a month, with $20 going toward death insurance and the remaining $80 going toward savings. When the person reaches age 45, term insurance might cost $50 per month, while universal life would still cost $100 a month, although a lower portion would go into savings.
According to most unbiased experts, term life is more appropriate for the average individual looking to insure himself or herself against unforeseen events. However, this does not mean term life is better for everyone. For example, individuals looking for the tax advantages associated with cash-value plans are not concerned with the prohibitive costs related to those plans, and individuals who start families later in life and need insurance to protect their loved ones may also decide cash-value insurance is more suitable than term life. (To learn more, see: Buying Life Insurance: Term Versus Permanent.)
The expense ratio in the insurance industry is a measure of profitability calculated by dividing the expenses associated with acquiring, underwriting and servicing premiums by the net premiums earned by the insurance company. The expenses can include advertising, employee wages and commissions for the sales force. The expense ratio signifies an insurance company’s efficiency before factoring in claims on its policies and investment gains or losses. The expense ratio is combined with the loss ratio to give an insurance company’s combined ratio.
There are two ways to calculate expense ratios. Insurance companies typically use statutory accounting as opposed to generally accepted accounting principles (GAAP) accounting to calculate their expense ratios, as statutory accounting yields more conservative ratios. Although the expenses are the same in both ratios, statutory accounting uses the net premiums written during the period in the denominator to get the expense ratio.
GAAP accounting uses the net premiums earned during the period. Net premiums written are the new business brought in by the company, while net premiums earned may include both new business and recurring business from existing policies.
The expense ratio can be used to compare companies and analyze a company’s performance over time. An expense ratio under 100% signifies the insurance company is either earning or writing more premiums than it is paying out in expenses to generate and/or support these premiums. Although its expense ratio can be stellar, the overall profitability of an insurance company is affected by its loss ratio, investment income, and other gains and losses. Thus, the expense ratio is not a measure of ending profitability. Instead, it is a precursor to finding an insurance company’s overall profitability. (For related reading, see: What is the usual profit margin for a company in the insurance sector?)
Insurance companies base their business models around assuming and diversifying risk. The essential insurance model involves pooling risk from individual payers and redistributing it across a larger portfolio. Most insurance companies generate revenue in two ways: Charging premiums in exchange for insurance coverage, then reinvesting those premiums into other interest-generating assets. Like all private businesses, insurance companies try to market effectively and minimize administrative costs.
Revenue model specifics vary among health insurance companies, property insurance companies and financial guarantors. The first task of any insurer, however, is to price risk and charge a premium for assuming it.
Suppose the insurance company is offering a policy with a $100,000 conditional payout. It needs to assess how likely a prospective buyer is to trigger the conditional payment and extend that risk based on the length of the policy. (For related reading, see: How an Insurance Company Determines Your Premiums.)
This is where insurance underwriting is critical. Without good underwriting, the insurance company would charge some customers too much and others too little for assuming risk. This could price out the least risky customers, eventually causing rates to increase even further. If a company prices its risk effectively, it should bring in more revenue in premiums than it spends on conditional payouts.
In a sense, an insurer’s real product is insurance claims. When a customer files a claim, the company must process it, check it for accuracy and submit payment. This adjusting process is necessary to filter out fraudulent claims and minimize risk of loss to the company.
Suppose the insurance company receives $1 million in premiums for its policies. It could hold onto the money in cash or place it into a savings account, but that is not very efficient: At the very least, those savings are going to be exposed to inflation risk. Instead, the company can find safe, short-term assets to invest its funds. This generates additional interest revenue for the company while it waits for possible payouts. Common instruments of this type include Treasury bonds, high-grade corporate bonds and interest-bearing cash equivalents.
Some companies engage in reinsurance to reduce risk. Reinsurance is basically insurance that insurance companies buy to protect themselves from excess losses due to high exposure. Reinsurance is an integral component of insurance companies’ efforts to keep themselves solvent and to avoid default due to payouts, and regulators mandate it for companies of a certain size and type.
For example, an insurance company may write too much hurricane insurance, based on models that show low chances of a hurricane inflicting a geographic area. If the inconceivable did happen with a hurricane hitting that region, considerable losses for the insurance company could ensue. Without reinsurance taking some of the risk off the table, insurance companies could go out of business whenever a natural disaster hit.
Regulators mandate that an insurance company must only issue a policy with a cap of 10% of its value, unless it is reinsured. Thus, reinsurance allows insurance companies to be more aggressive in winning market share, as they can transfer risks. Additionally, reinsurance smooths out the natural fluctuations of insurance companies, which can see significant deviations in profits and losses.
For many insurance companies, it is like arbitrage. They charge a …
The term “pro rata” is used to describe a proportionate distribution. In the insurance industry, “pro rata” means that claims are only paid out in proportion to the insurance interest in the asset; this is also known as the first condition of average. Pro rata is also used in bankruptcy claims, where an insolvent debtor’s assets are divided proportionately among creditors based on the size of claims.
The pro rata condition of average can also be thought of this way: The insurer is only liable for the proportion of the loss that the amount of insurance under the policy bears to the actual cash value of the asset; the insured assumes all liability beyond that point.
Suppose that a homeowner takes out $200,000 worth of fire insurance on his home. The home is actually valued at $300,000. A fire subsequently breaks out in the home, causing $60,000 worth of damage.
If the fire insurance policy uses the pro rata condition of average, the insurance company is only liable in proportion to the level of insurance relative to the value of the property. Since the insurance only covers two-thirds the value of the property ($200,000 / $300,000), the insured can only recover two-thirds the cost of damage – $40,000, in this case ($40,000 / $60,000).
Most insurance literature identifies only two separate conditions of average. The first is pro rata, as described above. The second is known as a special condition of average, whereby under-insurance is not penalized unless the sum represents less than 75% of the at-risk value. Most policies with pro rata conditionality are buttressed with a special condition.
In the United States, and most developed nations, regulators impose required statutory capital reserve ratios on insurance companies to conduct business. There may be large differences in the nature and definition of acceptable reserves; however, this can make it tricky for companies, and their shareholders, that operate in multiple jurisdictions.
Most reserve requirements are established at the state level. Standard levels include 8 to 12% of the insurers’ total revenues. These requirements are never really fixed since they depend on the type of risks a company has presently assumed.
The Center for Insurance Policy and Research, or CIPR, collects and examines different insurance rules across the globe. According to CIPR reports, the United States is somewhat unique because capital requirements are not seen as the primary means of risk analysis in the industry.
The CIPR identifies three stages in the U.S. regulatory system for insurance companies. The first stage involves restriction of activities or a requirement for prior approval for specific company action. The first stage is largely state-implemented and can vary across the country. The second stage involves public financial oversight, where state and federal regulators examine insurance statements for potential insolvency.
Only the last stage in the U.S. risk prevention process involves reserve ratios. These are described as backstops or risk-based capital, or RBC rules. An insurance company must always hold capital in amounts that exceed the minimum regulatory levels or else it may be forced to stay business operations until in compliance.
Each state has its own insurance regulatory body. These regulatory commissioners sometimes work in tandem to promote uniformity among the various national insurance companies. The National Association of Insurance Commissioners, or NAIC, created its own RBC formula to establish a hypothetical minimum capital level.
The NAIC uses the RBC calculator to decide if and when to take specific actions against companies that have assumed too much risk. There are no hard-and-fast rules about what reserve ratios or reserve compositions constitute actionable thresholds, however.
The automotive sector includes several types of companies besides auto manufacturers. Some of these companies focus on the component parts that go into cars and trucks. Other companies are responsible for vehicle sales, rentals or repairs.
Three kinds of companies manufacture parts used in automotive manufacturing. Although auto makers produce some of their own parts, they also buy auto parts from original equipment manufacturers (OEMs). These OEMs put together items such as seats and door handles. Companies in the rubber fabrication business, on the other hand, specialize in items such as tires, belts, hoses, wiper blades and seals. About 75% of the world’s natural rubber production goes into making tires.
Companies in the third area, replacement parts, produce and distribute aftermarket replacement components such as parking lights, brakes, clutches, air filters and oil filters. The manufactured parts are distributed through parts wholesalers, parts stores such as Pep Boys and AutoZone, online auto parts warehouses, car dealerships and auto repair shops. Many smaller auto repair shops also run gas stations on their premises to service the fuel needs of auto customers.
OEMs, replacement parts makers and auto manufacturers, in turn, obtain materials from manufacturers of stainless steel, glass, and increasingly, lighter-weight aluminum and plastic. According to the American Chemical Council, plastic comprises about 50% of the construction of a new car. Items made out of plastic include door handles, dashboards, seat belts, air conditioner vents and some engine parts.
The advent of electric cars has given rise to new types of car components. These include electric motors, lithium batteries, chargers and controllers, a type of mechanism that serves as a floodgate between the motor and the batteries. The electric car components are used by auto manufacturers as well as by a smattering of consumer enthusiasts who are converting their existing vehicles to run on electricity. Electric car components are distributed through specialists such as EV West.
New and used vehicles are sold at retail through car dealerships. Dealerships also help consumers obtain auto loans ]through financial institutions. Dealers typically accept trade-ins of preowned vehicles toward the purchase of new cars. Like auto repair shops, dealerships also diagnose and fix mechanical problems, perform emissions inspections, do body work and conduct routine maintenance services. When vehicles have been damaged in accidents, mechanical repairs and body work are often covered by auto insurance firms.
Rental car agencies buy fleets of vehicles from auto manufacturers at discount and then rent or lease the cars and trucks to consumers and businesses. Sometimes, they make arrangements to return the vehicles to manufacturers after a specified time period, although this practice has become less frequent in light of the more-careful market planning that has accompanied auto industry recovery since the financial crisis.
Traditionally, the vehicles bought back by auto manufacturers are then resold through used car dealerships. Alternatively, they are recycled through wholesale car auctions. When a vehicle reaches the end of its life cycle, its components are sometimes resold by used parts suppliers.
Government influence on non-salary employee benefits, also called “fringe benefits,” comes, in large part, through the tax code. The Internal Revenue Service (IRS) issues publications on the tax treatment of certain non-salary employee benefits, many of which are deductible to the employer. Certain benefits, such as unemployment insurance, are required by law.
Historically, many fringe benefits were the unintentional result of government regulation. For example, regulations during World War II made it illegal for many companies to increase the wages of their workers. This meant companies had to find alternative means of attracting and retaining skilled labor. They accomplished this by offering types of non-salary compensation that had previously not existed or that had been very uncommon.
Mandatory benefits, which are required by law, include Medicaid, Medicare, Social Security retirement and disability, Supplemental Security Income (SSI), workers’ compensation and unemployment insurance. Some economists contend that the regulations requiring these benefits do not actually help workers, since employers likely just lower their employees’ salaries to pay for them.
The most regulated types of optional fringe benefits are health insurance and retirement savings plans. Employers and plan providers are required to give a minimum level of information and protection for their employees for any such plan. These plans are also subject to IRS regulations and qualifications, or they may have optional regulations tied to tax-preferred or tax-exempt incentives.
Not all kinds of companies are regulated equally. Large corporations are often differentiated from small businesses or sole proprietorships in the types of requirements imposed for any tax benefits. The regulatory environment around fringe benefits changes frequently. A notable change came in 2010 from the Affordable Care Act (ACA), which created a host of new regulations on health insurance for providers, employers and individuals.
The irrevocable life insurance trust (ILIT) is a trust that cannot be rescinded, amended or modified in any way after its creation. Once the grantor contributes property or life insurance death benefits to the trust, he or she cannot change the terms of the trust or reclaim any property left to the trust.
There are three good reasons to utilize an ILIT. The first is for estate tax considerations, the second is for concern of leaving a large sum of money unsupervised to a minor or an irresponsible adult, and lastly, for asset protection concerns.
If an ILIT is properly structured, the death benefits paid to the trust will be free from inclusion in the gross estate of the insured. This is different from when life insurance death benefits are paid to an individual, as the proceeds are included in the taxable estate of the decedent.
If the insured has beneficiaries who are minors or adults who have had issues in the past, such as alcohol or drug abuse, or problems handling their finances, it might be a good idea to set up an ILIT with the trust as beneficiary. This appoints a trustee to act as a supervisor for the trust and distribute the assets per the terms of the trust documents per the grantor’s wishes.
The ILIT will also provide a level of asset protection for the beneficiaries should they currently be involved in litigation or see the potential for a future lawsuit against them. ILITs are not considered to be owned by the beneficiaries, which in turn makes them extremely difficult for courts to attach as assets of the beneficiary, thus making them next to impossible for creditors to access.
(For related reading, see: 7 Reasons to Own Life Insurance in an Irrevocable Trust.)
An eligible individual who is 55 years or older at the end of his tax year can make additional catch-up contributions to his Health Savings Account (HSA). The U.S. Internal Revenue Service (IRS) states that an individual can qualify for an HSA if he is covered by a high deductible health plan, he has no other health coverage except what is permitted by the IRS, he does not participate in Medicare and he is not claimed as a dependent on someone else’s tax return.
An HSA is a tax-exempt account that a qualified individual can set up with a trustee to make payments for certain medical expenses. A bank, insurance company or any other IRS-approved trustee can help establish an HSA. Employers’ benefits departments typically know which trustees are available for HSAs in their areas.
HSAs enjoy tax-privileged statuses, as contributions made by an employer are excluded from an HSA owner’s gross income. Also, an HSA owner can claim a tax deduction for contributions made by anyone, other than his employer. HSA contributions never expire, and interest and any other investment income are exempt from federal taxation. Distributions from an HSA can be also tax-free, provided that the owner spends the funds on qualified medical expenses. Finally, an HSA can be ported when an HSA owner changes employers or retires.
In 2015, the IRS established an annual contribution limit of $3,350 for an individual with an HSA. The catch-up contribution for HSA owners of 55 years or above is $1,000. The annual contribution limit is typically adjusted by the IRS for changes in the cost of living in the United States.