Chapter 16

1. Chapter 16 Mutual Funds, Insurance Companies, Investment Banks, and Other Financial Firms

2. To explore the many roles played by mutual funds, insurance companies, investment banks, finance companies, mortgage banks, and security dealers. To discover the different services they offer. To examine their principal sources and uses of funds. To understand the many problems they face today.  Learning Objectives 

3. We now turn to a highly diverse group of financial institutions that attract savings mainly from individuals and families and, for the most part, make long-term loans in the capital market. Introduction

4. Mutual funds, or investment companies, direct the savings of individual investors into bonds, stocks, and money market securities. A small saver who buys mutual fund shares gains opportunities for capital gains and indirect access to higher yielding securities that can be purchased only in large blocks, and yet still enjoys price stability, low risk, and high liquidity. Mutual Funds (Investment Companies)

5. Investment companies first developed in the U.K., and then made their appearance in the U.S. in 1924 as a vehicle for buying and monitoring subsidiary corporations. Since then, the traditionally stock-investing industry has seen many innovations – bond funds, money market funds, index funds, exchange-traded funds, global funds, vulture funds, small/mid/large-cap investment companies, and hedge funds. Mutual Funds (Investment Companies)

6. Investment companies have a favorable tax situation – they pay no federal taxes on income generated by their security holdings, provided their earnings flow through to their customers. TAX Mutual Funds (Investment Companies)

7. Open-end investment companies, or mutual funds, buy back (redeem) their shares any time the investor wishes, and sell shares in any quantity demanded. The price of each open-end company share is equal to the net asset value of the fund – that is, the difference between the values of its assets and liabilities divided by the volume of shares issued. Mutual Funds (Investment Companies)

8. Closed-end investment companies sell only a specific number of ownership shares, which usually trade on an exchange. They offer “double discounts” – discounted prices on the stocks they hold and discounted share prices to buy into the fund itself. Mutual Funds (Investment Companies)

9. Mutual Funds (Investment Companies) Financial Assets Held by Mutual Funds (Open-End Investment Companies)

10. Investment companies adopt many goals. Growth funds invest mainly in common stocks offering strong growth potential to achieve long-term capital appreciation. Income funds typically purchase stocks and bonds paying high dividends and interest to gain current income. Balanced funds acquire bonds, preferred stock, and common stock that offer both capital gains (growth) and current income. Mutual Funds (Investment Companies)

11. It is not clear if mutual funds hold a significant advantage over other investors in seeking the highest returns available in the financial marketplace. With the possible exception of index funds, these companies may roll over their portfolios too rapidly, running up the cost of managing the fund and reducing earnings. Mutual Funds (Investment Companies)

12. As the twenty-first century began, there was mounting evidence that the managers of several prominent funds had engaged in highly questionable and often illegal practices, such as late trading and market timing. As a result, there were widespread calls for new legislation and for tighter regulation of the behavior of the mutual fund industry. Mutual Funds (Investment Companies)

13. Pension funds protect individuals and families against loss of income in their retirement years by allowing workers to set aside and invest a portion of their current income. Pension Funds

14. Defined benefit plans promise a specific monthly or annual payment to workers when they retire based upon the size of their salary during their working years and their length of employment. Such programs have the advantage of guaranteed income, but an employee who leaves early or is dismissed before retirement may get little or nothing. Pension Funds

15. Defined contribution plans specify how much must be contributed each year in the name of each worker, but the amount to be received when retirement is reached will vary depending upon the amount saved and the returns earned on accumulated savings. The funds saved belong to the employee, and are portable. Pension Funds

16. Pension Funds

17. Recently, a highly controversial form of pension plan, a so-called cash balance plan, has appeared. With such a plan, employers typically make a hypothetical contribution to an employee’s retirement account equal to a percentage of the employee’s annual salary and credit the employee’s account with an annual interest credit based upon a reference interest rate. Pension Funds

18. Pension funds are long-term investors with limited need for liquidity. Their incoming cash receipts are known with considerable accuracy, and their cash outflows are not difficult to forecast. However, the pension fund industry is closely regulated in many of its activities. Pension Funds

19. Pension Funds Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts. *Figures are for the end of the first quarter of 2004.

20. Pension Funds Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts. *Figures are for the end of the first quarter of 2004. **Less than 0.05 percent.

21. There appear to be serious problems ahead for both the growth and stability of pension plans. The rising proportion of pension beneficiaries to working contributors, related to the aging of the population. The increasing cost of maintaining pension programs, especially defined benefit plans. The rising cost of government regulation with respect to reporting requirements and employee rights. Pension Funds

22. Worse still, the pension insurance agency created by the U.S. Congress in 1974 – the Pension Benefit Guaranty Corporation (known as PBGC or, more popularly, as “Penny Benny”) – has recently reported sharply rising budget deficits. Pension Funds

23. Life insurance companies offer their customers a hedge against the risk of earnings losses that often follow death, disability, or retirement. Policyholders receive risk protection in return for their payment of policy premiums. Additional funds to cover claims and expenses are provided by the earnings from the investments made by the insurance companies. Life Insurance Companies

24. Today, life insurers have branched out to include not only traditional life insurance policies in their service menus, but also health insurance and annuity plans. Many policies combine financial protection against death, disability, illness, and retirement with savings plans to help the policyholder prepare for some important future financial need. Life Insurance Companies

25. The Principal Kinds of Insurance Policies and Annuity Plans Sold by Many Life Insurance Companies Source: American Council of Life Insurance

26. The Principal Kinds of Insurance Policies and Annuity Plans Sold by Many Life Insurance Companies Source: American Council of Life Insurance

27. The insurance business is founded upon the law of large numbers – a risk that is not predictable for one person can be forecast with reasonable accuracy for a sufficiently large group. So, life insurers invest the bulk of their funds in long-term securities, and frequently follow a “buy and hold” strategy. They generally pursue income certainty and safety of principal in their investments. Life Insurance Companies

28. Life Insurance Companies 16 - 28

29. The primary income source for life insurers comes from premium receipts from sales of various kinds of insurance policies. Annual net income from investments in bonds, stocks, and other assets averages only about a third of premium receipts. On balance, the industry hopes to roughly break even from its insurance underwriting operations while earning its profits from its investment income. Life Insurance Companies

30. The majority of the approximately 1,600 U.S. life insurance companies are stockholder-owned corporations. The rest are mutuals that issue ownership shares to their policyholders. The population reached a high of almost 2,350 in 1988 and has been falling ever since. Most notably, the largest life insurers today are converging with other financial institutions to form huge multi-product businesses. Life Insurance Companies

31. Life insurers are under increasing pressure to develop new services. Among the most important recent innovative services are universal and adjustable life insurance, variable premium and variable life insurance, mutual funds, tax shelters, venture capital loans, guaranteed investment contracts, corporate cash management systems, and deferred annuities. Life Insurance Companies

32. Property-casualty (P/C) insurers (insurance supermarkets) offer protection against events like fire, theft, bad weather, and negligence that result in injury to persons or property. Traditional P/C insurance covers automobile, fire, marine, personal liability, and property. Many P/C insurers have also branched into health and medical insurance, clashing head-on with life insurers. Property-Casualty (P/C) Insurance Companies

33. There are about 3,000 P/C companies in the U.S., of which about three quarters are stockholder-owned, while the rest are mutuals. P/C insurance is a riskier business than life insurance – P/C claims are less predictable and inflation has a potent impact. Moreover, the P/C risk patterns appear to be changing. For example, there has been a rapid rise in product liability claims. Property-Casualty (P/C) Insurance Companies

34. Property-Casualty (P/C) Insurance Companies

35. Like life insurance firms, P/C insurers plan to roughly break even on their insurance product lines and earn most of their net return from their investments. However, achieving the break-even point is difficult. In fact, P/C insurers have experienced billions of dollars in underwriting losses in recent years. Property-Casualty (P/C) Insurance Companies

36. The earnings and sales revenue of the P/C insurance industry reflect the ups and downs of the business cycle. Moreover, inflation pushes up the cost of claims, while intense competition holds premium rates down. To improve their future situation, P/C insurers must become more innovative in developing new services. Property-Casualty (P/C) Insurance Companies

37. Finance companies grant credit to businesses and consumers for a wide variety of purposes, including the purchase of business equipment, automobiles, vacations, and home appliances. As such, they are sometimes called department stores of consumer and business credit. Finance Companies

38. Consumer finance companies make personal cash loans to individuals, such as home equity loans and loans to support the purchase of passenger cars and home appliances. Sales finance companies make indirect loans to consumers by purchasing installment paper from dealers selling consumer durables. Commercial finance companies focus mainly on extending credit to business firms. Finance Companies

39. Finance Companies

40. Finance companies are heavy users of debt in financing their operations. The lack of an extensive network of branch offices has put many finance companies at a disadvantage. The number of finance companies is on the decline, although their average size has grown considerably. Finance Companies

41. Investment banks raise funds for and provide financial advice to corporations and government agencies around the world. In particular, they underwrite new offerings of financial instruments, purchasing them from the original issuer and placing them in the hands of buyers, hopefully at a higher price than the price paid to the issuer. Investment Banks

42. Investment banks offer a long menu of diverse services so that their revenue flows are not dependent on security underwriting alone. For example, they may give advice on corporate mergers and acquisitions, trade actively in commodities and foreign currencies as well as debt and equity instruments, manage assets, or set up hedge funds. Investment Banks

43. In the wake of the repeal of the Glass-Steagall Act of 1933, many investment banks have been absorbed in recent years by commercial banking companies. The amalgamation of commercial and investment banking opens up a wider menu of services that bankers can sell to their major corporate customers. Investment Banks

44. Security brokers bring buyers and sellers together and facilitate the exchange of assets. Security dealers “take a position of risk” in securities. They trade in securities with the expectation of earning a profitable spread. Venture capital firms provide long-term capital financing for new businesses and rapidly emerging companies. Other Financial Institutions

45. Mortgage banks work with other businesses on real estate development projects and sell the resulting loan instruments to other investors. Real estate investment trusts (REITs) fund commercial and residential real estate projects. Leasing companies purchase business equipment and other assets and then lease them in return for rental fees. Other Financial Institutions

46. There are several major trends affecting virtually all financial institutions today: increasing cost pressures consolidation service diversification and homogenization convergence technological revolution global competition regulatory cooperation and harmonization deregulation Trends Affecting All Financial Institutions Today

47. A.M. Best Company at www.bestweek.com American Council of Life Insurers at www.acli.com Insurance Information Institute at www.iii.org Investment Company Institute at www.ici.org Lloyds of London at www.lloyds.com Morningstar at www.morningstar.com Markets on the Net

48. Mortgage Bankers Association of America at www.mbaa.org National Association of Real Estate Investment Trusts at www.nareit.com National Venture Capital Association at www.nvca.org Pension Benefit Guaranty Corporation at www.pbgc.gov Markets on the Net

49. Pension and Investments Newsletter at www.pionline.com Securities and Exchange Commission at www.sec.gov Markets on the Net

50. Introduction Mutual Funds (Investment Companies) The Background of Investment Companies Tax and Regulatory Status of the Industry Open-End and Closed-End Investment Companies Goals and Earnings of Investment Companies Scandal Envelopes the Mutual Fund Industry Chapter Review