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MGT604 - Management of Financial Institutions - Lecture Handout 35

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Role of Insurance Companies

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium. Insurer, in economics, is the company that sells the insurance. Insurance rate is a factor used to determine the amount, called the premium, to be charged for a certain amount of insurance coverage. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.

Principles of insurance

Commercially insurable risks typically share seven common characteristics.

  1. A large number of homogeneous exposure units. The vast majority of insurance policies are provided for individual members of very large classes. Automobile insurance, for example, covered about 175 million automobiles in the United States in 2004.[2] The existence of a large number of homogeneous exposure units allows insurers to benefit from the so-called “law of large numbers,” which in effect states that as the number of exposure units increases, the actual results are increasingly likely to become close to expected results. There are exceptions to this criterion. Lloyd's of London is famous for insuring the life or health of actors, actresses and sports figures. Satellite Launch insurance covers events that are infrequent. Large commercial property policies may insure exceptional properties for which there are no ‘homogeneous’ exposure units. Despite failing on this criterion, many exposures like these are generally considered to be insurable.
  2. Definite Loss. The event that gives rise to the loss that is subject to insurance should, at least in principle, take place at a known time, in a known place, and from a known cause. The classic example is death of an insured on a life insurance policy. Fire, automobile accidents, and worker injuries may all easily meet this criterion. Other types of losses may only be definite in theory. Occupational disease, for instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is identifiable. Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with sufficient information, could objectively verify all three elements.
  3. Accidental Loss. The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance. The loss should be ‘pure,’ in the sense that it results from an event for which there is only the opportunity for cost. Events that contain speculative elements, such as ordinary business risks, are generally not considered insurable.

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MGT604 - Management of Financial Institutions - Lecture Handout 23

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Mutual Funds

Criticism of managed mutual funds

Historically, only a small percentage of actively managed mutual funds, over long periods of time, have returned as much, or more than comparable index mutual funds. This, of course, is a criticism of one type of mutual fund over another.

  • Another criticism concerns sales commissions on load funds, an upfront or deferred fee as high as 8.5 percent of the amount invested in a fund (although the average upfront load is no more than 5% normally). *(Mutual Funds have to qualify to charge the maximum allowed by law, which is 8.5% and most of them DO NOT qualify for
    this.)
  • In addition, no-load funds typically charge a 12b-1 fee in order to pay for shelf space on the exchange the investor uses for purchase of the fund, but they do not pay a load directly to a mutual fund broker, who sells it.
  • Critics point out those high sales commissions can sometimes represent a conflict of interest, as high commissions benefit the sales people but hurt the investors. Although in reality, "A shares", which appear to have the highest up front load, (around 5%) are the "cheapest" for the investor, if the investor is planning on 1) keeping the fund for more than 5 years, 2) investing more than 100,000 in one fund family, which likely will qualify them for "break points”, which is a form of discount, or 3) staying with that "fund family" for more than 5 years, but switching
    "funds" within the same fund company. In this case, the up front load is best for the client, and at times "outperforms" the "no load" or "B or C shares".
  • High commissions can sometimes cause sales people to recommend funds that maximize their income. This can be easily solved, buy working with a "registered investment advisor" instead of a "broker", where the investment advisor can charge strictly for advise, and not charge a "load, or commission" for their work, at all.

This is a discussion of criticism, and solutions regarding one mutual fund over another.12b- 1 fees, which are found on most "no load funds”, can motivate the fund company to focus on advertising to attract more and more new investors, as new investors would also cause the fund assets to increase, thus increasing the amount of money that the mutual fund
managers make.

Read more: MGT604 - Management of Financial Institutions - Lecture Handout 23