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Trieschmann, Hoyt & Sommer Functions and Organization of Insurers Chapter 23 ©2005, Thomson/South-Western
Trieschmann, Hoyt & Sommer
Functions and Organization of Insurers
Chapter 23
©2005, Thomson/South-Western
22
Chapter Objectives
• Explain why “production” in insurance is called “selling” elsewhere
• Explain the meaning of underwriting • Show how insurance premiums are calculated and
adjusted • Understand the concept of credibility as it relates to rate
making • Differentiate between experience and retrospective
rating • Know what fair claims settlement laws are • Understand the advantages and limitations of
reinsurance
33
Functions of Insurers
• The functions performed by any insurer necessarily depend on – The type of business it writes, the degree to which it has shifted
certain duties to others, the financial resources available, the size of the insurer, the type of organization used, etc.
• These functions, which are normally the responsibility of definite departments or divisions within the firm, are – Production– Underwriting– Rate making– Managing claims and losses– Investing and financing– Accounting and other recordkeeping– Providing miscellaneous other services
• Such as legal advice, marketing research, engineering, and personnel management
44
Production (Sales)
• One of the most vital needs of an insurance firm – Is securing a sufficient number of applicants for
insurance to enable the company to operate
• Often called production in the context of the insurance industry – Corresponds to the sales or marketing function in an
industrial firm
• This is a proper term for insurance because the act of selling is production in its true sense – Insurance is an intangible item and does not exist
until a policy is sold
55
Underwriting
• Includes all the activities necessary to select risks offered to the insurer in such a manner that general company objectives are filled
• In life insurance, underwriting is performed by home or regional office personnel – Who scrutinize applications for coverage and make
decisions as to whether they will be accepted – And by agents, who produce the applications initially
in the field
66
Underwriting
• In the property-liability insurance area agents can make binding decisions in the field – But these decisions may be subject to
postunderwriting at a higher level because the contracts are cancelable on due notice to the insured
• In life insurance, agents seldom have authority to make binding underwriting decisions
• In all fields of insurance, agency personnel usually do considerable screening of risks before submitting them to home office underwriters
77
The Objective of Underwriting
• To see that the applicant accepted will not have a loss experience that is very different from that assumed when the rates were formulated
• Certain standards of selection relating to physical and moral hazards are set up when rates are calculated
• The underwriter must see that the standards are observed when a risk is accepted
88
Services that Aid the Underwriter
• In life insurance, the underwriter is assisted by – Medical reports from the physician who examined the
applicant – Information from the agent – An independent report on the applicant prepared by
an outside agency created for that purpose – Advice from the company’s own medical adviser
• In property-liability insurance as well as life insurance the underwriter has the service of – Reinsurance facilities – Credit departments
• Underwriters have increasingly been making use of the applicant’s credit history as an additional rating factor
99
Policy Writing
• In property-liability insurance, the agent frequently issues the policy to the customer, filling out forms provided by the company – Or the form may be printed in the agent’s office on a printer
controlled by the issuer’s computer • A check to determine accuracy of the rates charged,
whether a prohibited risk has been taken, and other matters is done by the examining section of the home office
• In life insurance, the policy usually is written in a special department – Whose main task is to issue written contracts in accordance with
instructions from the underwriting department and to keep a register of them for future reference
1010
Conflict Between Production and Underwriting • An apparent conflict of interest arises between the
underwriting department and an agent – Because the underwriting department may have turned
down business that previously has been sold by an agent
• Neither the agent nor the underwriter will profit long by writing underwriting that is – Too strict
• Will choke off acceptable business and may create unnecessary expenses in canceling business already bound by the agent
– Too loose • Invites substantial losses such that the company may be forced
to withdraw entirely from a given line
1111
Underwriting Associations
• Many independent associations have been formed by insurers to assist in underwriting
• Often called pools or syndicates • Normally specialize in certain areas such as
– Nuclear energy, foreign coverages, aviation risks, marine risks, windstorms
• Through such cooperation, the risk is spread among a large number of insurers
• Specialized personnel can be hired economically to supervise loss control procedures and handle other underwriting decisions
1212
Rate Making
• Extremely technical in most lines of insurance • Involves the selection of classes of exposure units on
which to collect statistics regarding the probability and severity of loss
• In life insurance, this task is relatively uncomplicated – Because the major task is to estimate mortality rates according
to age and other factors such as sex, smoking, drinking habits, and occupation
• In other fields, such as liability and workers’ compensation – Elaborate classifications are necessary
• Rate making is usually supervised by specialists known as actuaries
1313
Rate Making
• Once the appropriate classes have been set up – The problem becomes one of developing reliable loss
data for each class over a sufficiently long period of time
• The next step is converting that data into a useful form for the purpose of developing a final premium – Requires incorporating estimates of the cost of doing
business into the premium structure on an equitable basis
1414
Makeup of the Premium
• The insurance rate is the amount charged per unit of exposure
• The premium is the product of the insurance rate and the number of exposure units – Thus, in term life insurance, if the annual rate
is $1.50 per $1,000 of face amount of insurance
• The premium for a $1 million policy is $1,500
1515
Makeup of the Premium
• The premium is designed to cover two major costs – The expected loss, or the pure premium
• Determined by dividing the total expected loss by the number of exposures
– The cost of doing business, or the loading • Such items as agents’ commissions, general company expenses,
premiums, taxes and fees, and allowance for profit
– The sum of the pure premium and loading is termed the gross premium
• The loading is usually expressed as a percentage of the expected gross premium
– The pure premium is the estimate of loss cost • The ratio of the loss cost to the gross premium is called the loss
ratio
1616
Makeup of the Premium
• Two factors must be estimated and are subject to errors in forecasting – Frequency of occurrence – Severity of loss
• Insureds do not know in advance exactly how often a loss will occur or what its size will be – The expected cost of a loss is a function of both
frequency and severity of loss
• Insurers handle forecasting errors and ratemaking by calculating estimates of both objective and subjective risk
1717
Investment Earnings• The basic rate-making method used in property-liability
insurance – Does not make a direct allowance for investment income to be earned
on policyholders’ funds held by the insurer until they must be paid out as losses
• In life insurance, an allowance is made for a minimum assumed rate of return on policyholders’ funds
• From the 1950s through the early 1980s, a steady rise occurred in interest rates in the United States – Even the decline at the end of the 1980s still left long-term interest
rates at near record levels – Given this increase in interest rates, policyholders and regulators
demanded that some recognition be given to the investment income factor in ratemaking
• Especially in those lines of insurance that have a long payout period – Insurers rarely make an underwriting profit in these lines because they rely on
investment income for part of their profit » Underwriting + investment revenue - expenses = profit
1818
Investment Earnings
• Table 23-2 shows that insurers almost always have a combined ratio > 100 for the selected liability lines
• They’re relying on investment income to retain their profitability
• In 2002 for the entire industry, underwriting losses were $31.9 billion – Investment income was $40.1 billion
• Thus, operating income before taxes was $7.7 billion
1919
Table 23-2: Combined Ratios for Selected Insurance Lines, 1994-2002
2020
Rate-Making Guidelines
• All states establish certain criteria that insurers are expected to observe in calculating rates, including – The rate should be adequate to meet loss burdens,
yet not be excessive – The rate should allocate cost burden among insureds
on a fair basis – The rate should encourage loss control among
insureds, if possible • While these criteria seem simple enough, applying them
raises many difficult problems
2121
Adequacy of the Rate
• If a rate is to be adequate, but not excessive, how wide a margin should these limits impose?
• From one standpoint, an underwriter may reason that to have an adequate premium – It is necessary to collect an amount sufficient for all
possible contingencies – Whereas another underwriter may have a much
different view of the size of these possible contingencies
• This problem arises because the insurance rate must be set before all the costs are known
2222
Adequacy of the Rate
• In insurance a definite estimate must often be made in advance – With no possibility of later negotiation if the estimation of
loss is incorrect – Frequently, these estimates are inaccurate because
they are derived from past experience • The insurance contract may involve a substantial future period
during which conditions change dramatically
• The problem of preventing rates from becoming excessive has been the subject of much legislation – Yet unrestricted competition often leads to rates that are
too low for the long-term solvency of insurance companies
2323
Fair Allocation of Cost Burden
• Just how far should the underwriter go in developing a rate that completely reflects the true quality of the individual hazard? – Theoretically, for life insurance purposes an attempt
should be made to set individual premiums on the basis of
• Marital status, drug or alcohol consumption, smoking record, and longevity of parents
– In practice, none of these factors affects the premium individually
• Because age, sex, and smoking habits are almost the sole determinants
2424
Fair Allocation of Cost Burden
• Another class of problems arising out of the criterion of fairness deals with the determination of the exposure unit to which the rate is applied – Consider workers’ compensation insurance
• If one employer has an exposure of 200 workers (making an average of $9 per hour), while the second has 300 workers (making an average of $6 per hour)
– Should each employer pay the same premium?
2525
Rate-Making Methods
• The calculation of an insurance rate is in no sense absolute or completely scientific in nature
• The scientific method in insurance makes its greatest contribution in narrowing the area within which executive judgment must operate
2626
Manual or Class (Pure) Method
• Sets rates that apply uniformly to each exposure unit falling within some predetermined class or group
• These groups usually are set up so that loss data may be collected and organized in some logical fashion – Everyone falling within a given class is charged the same rate
• The major areas of insurance that emphasize use of this method are– Life, workers’ compensation, liability, automobile, health,
homeowners’, and surety • With life insurance, the central classifications are by age, sex, and
smoking habits • With automobile insurance the loss data are broken down
territorially by type of automobile, age of driver, gender of driver, and major use of automobile
2727
Loss Ratio Method
• It may be impractical to employ the manual rating method in developing a rate – Because of too many classifications and subclassifications
• So many categories may be involved that losses on only a small number of exposures occur in a given time – This small number of losses may be deemed insufficient
exposure on which to base decisions from a statistical point of view
• The new rate is developed by comparing the actual loss ratio of the combined group with the expected loss ratio
2828
Individual, or Merit Rating, Method
• Recognizes the individual features of a specific risk and gives a rate that reflects the particular hazard
• Some groups of insureds, and some individual insureds, have loss records that are sufficiently credible to warrant reductions or increases in their rates from that of the class to which they belong – One generally used device is to set up special rating
classes for which discounts from the manual rates are made
• Either beforehand in the form of a direct deviation or as a dividend payable at the end of the period
2929
Individual, or Merit Rating, Method
• In the field of life insurance, mutual insurers pay dividends that differ in amount according to the type of policy – Life insurers also grant rate deviations for special
classes of insured groups, known as preferred risks • And charge extra premiums on other groups, called non-
standard risks
• Automobile insurers use this method by distinguishing among applicants on the basis of their type of automobile and traffic violation records
3030
Individual, or Merit Rating, Method
• Schedule rating is another widely used plan – The best example is in the field of commercial
fire insurance • Each individual building is considered separately
and a rate is established for it • The physical features of the structure are analyzed
and rate credits are given for good features in the form of a listing, or schedule
– The insured is rewarded in advance for features it is hoped will yield a lower loss cost for all similar structures as a group
3131
Individual, or Merit Rating, Method
• An individual risk may receive special consideration through experience rating – Permeated in cases where the hazards affecting the
insured’s operation are sufficiently within the insured’s control
• So that it is reasonable to expect a reduction of losses through special efforts
• If such special efforts are made, the insured is permitted lower insurance rates for the coming period
– Requires that the insured prove the ability to keep loss ratios down before being qualified for loss reduction
3232
Individual, or Merit Rating, Method
• Retrospective rating – Permits an adjustment in rates for the period
just ended – The premium is determined by the actual
record of losses suffered by the insured during the policy year
– The final premium is determined after all the facts have been determined
3333
Combination Method
• In many lines of insurance, a combination of manual and merit rating is used in different degrees
• The rate maker may develop an annual rate and then proceed to set up a system whereby individual members of a group may qualify for reductions from the manual rate – If certain requirements are met
• They may be subjected to increased rates under certain other conditions
3434
Credibility
• Refers to the degree to which the rate maker can rely on the accuracy of loss experience observed in any given area
• For example, assume that the rate maker is faced with the task of revising a rate for a certain type of policy issued by the company in a given geographical area – The loss ratio on these policies indicates that losses have
been considerably higher than anticipated • Should future rates be based on the experience of these losses
– Or is there a considerable likelihood that the previous year produced higher-than-average losses only by chance?
• It is not fair for one group to subsidize another group if each group is large enough to develop a loss experience that is reasonably credible
3535
The Credibility Formula
• PP = PPi(Z) + PPp(1 – Z)– PP = pure premium to to be developed for a given
insured i – PPi = pure premium based on the insured’s past loss
experience – PPp = pure premium based on the past experience of
the largest population to which the insured belongs – Z = the weight (credibility factor) to be applied to the
insured’s past experience • Ranges from 0 to 1
3636
The Credibility Formula
• Pure premium is developed by collecting all loss data falling into each class to be rated – Dividing by the number of exposure units, and arriving at a
number representing expected losses • As Z Increases, more weight will be applied to the
insured’s past experience – If Z=1, the pure premium to be charged is based entirely
on the insured individual’s past experience • This would be the case if the insured has a very large number of
homogeneous exposure units at risk and is large enough to be self-rated
– As Z increases, the term 1 - Z decreases • And with it the weight given to the loss experience of the
population – This approach is common in workers’ compensation insurance
experience rating
3737
The Credibility Formula
• For convenience, the values given to Z are expressed as percentages
• The rate maker generally develops a scale of credibility for different lines of insurance
3838
Rate-Making Associations
• Also called rating bureaus • The largest is Insurance Services Organization
(ISO)• Most states specifically authorize such groups • This type of cooperation is essential
– Many companies do not have a sufficiently large volume of business in certain lines to enable them to develop rates that are statistically sound
• When the experience of many companies is pooled, a large enough body of data is available to permit a higher degree of credibility
3939
Rate-Making Associations
• Policy provisions must be quite uniform – Otherwise, the cooperating insurers will not
experience uniform loss ratios
• Rate making bodies have worked toward uniform policy provisions and standard policies
• ISO develops statistical data for use by its member companies in the calculation of rates in various lines of property and liability research
4040
Rate-Making Associations
• ISO performs the following functions – Conducts actuarial research– Reports loss costs– Offers advice to others on rating problems– Develops standard policies– Files forms to state insurance departments– Offers management advice to its member companies
• Other rating organizations are the National Council on Compensation Insurance and the Surety Association of America
4141
Rate-Making Associations
• ISO changed its rating philosophy in the 1980s and early 1990s – Because of concerns of regulators and
consumers over the degree of price competition in insurance markets
• Rather than filing rates for insurers, they now provides loss costs
• Insurers have to add their loading for expense
4242
Managing Claims and Losses
• Claims management – Settling losses under insurance contracts and
adjusting any differences that arise between the company and the policyholder
– Often accomplished in the field through adjusters who are employed to negotiate certain types of settlements on the spot
• These adjusters may have considerable legal training
4343
Managing Claims and Losses
• The claims department of an insurer has the responsibility of – Ascertaining the validity of written proofs of loss – Investigating the scene of the loss – Estimating the amount of the loss – Interpreting and applying the terms of the policy in
loss situations – Approving payment of the claim
• These functions are more extensive in property-liability insurance than in life insurance because of
– The higher frequency of losses, the predominance of partial losses, the uncertainty of the amount of loss in individual cases
4444
Managing Claims and Losses
• In many cases the adjuster is a salaried staff employee of the insurer
• An independent adjuster may be used in territories where an insured does not have a sufficient volume of business to employ a staff adjuster
• Public adjusters who specialize in adjusting functions are also available to represent policyholders in dealings with insurers – They are the legal agents of the policyholder and
usually work on a contingency fee
4545
Managing Claims and Losses
• Careful management of claim settlements is of paramount importance to the success of a insurer – Reluctant claims settlement brings with it public ill will
which may take years to overcome – A bad impression in a negotiation with the claims
department may result in • Loss of business, court action, regulatory censure, or
suspension of the right to carry on business in the jurisdiction involved
– An overly liberal claims settlement policy may ultimately result in higher rate levels and loss of business to competitors charging lower premiums
4646
Managing Claims and Losses• Many states have passed fair claim settlement laws that are patterned
after the Unfair Claims Settlement Practices Act • Among the practices deemed “unfair” are
– Misrepresenting pertinent facts or insurance policy provisions relating to coverages at issue
– Failing to investigate claims promptly or to acknowledge communications on claims
– Not attempting to confirm or deny coverage on claims within a reasonable time
– Not attempting to settle claims in good faith when liability has become reasonably clear
– Attempting to settle a claim for less than that to which a reasonable person would have believed he or she was entitled by reference to advertising material accompanying an application
– Delaying payment of claims by requiring an insured to submit a preliminary claim report
• And then later requiring submission of formal proof-of-loss forms – Failing to provide a reasonable explanation for denial of claims – Failing to maintain complaint-handling procedures
4747
Investing and Financing
• When an insurance policy is written, the premium is generally paid in advance for periods varying from six months to a year
• This advance payment of premiums gives the insurer funds that must be invested in some manner – Every insurance company has these funds
• As well as funds representing paid-in capital, accumulated surplus, and various types of loss reserves
• Selecting and supervising the appropriate investment for these assets is the function of an investment department
4848
Investing and Financing
• Investment returns are a vital factor to the success of any insurer – For life insurance, solvency of the insured depends on
earning a minimum guaranteed return on assets
• Government regulation is involved in determining how insurance monies are invested – The investment manager must be familiar with the
laws of the various states in which the company operates
4949
Investing and Financing
• Property insurers may invest in common and preferred stocks
• Life insurers have few of their assets in stocks– Primarily because the nature of the life
insurance obligation dictates that guaranteed amounts must be repaid to policyholders
• Thus, bonds and mortgages usually are selected as the major investment mediums
5050
Investing and Financing
• Table 23-3 shows that life insurers in the United States together were responsible for assets of almost $3.4 trillion in 2002– Most of it in the form of fixed obligations such as
bonds and mortgages – They also have substantial investments in real estate
and policy loans • Table 23-4 shows the premium revenue of
property-liability and life and health insurers – While life insurers have over three times the assets of
property-liability insurers • Their premium revenue is only 35 percent greater
5151
Table 23-3: Distribution of Life Insurer Assets
5252
Table 23-4: Life and Property-Liability Insurance Premiums
5353
Investing and Financing
• Within the life side, annuities have become the largest single source of premiums – Represent 53% of premium income
• On the property-liability side, private passenger auto and homeowners’ lines account for 47.6% of premiums
• Life insurers manage two sets of portfolios – General accounts which represent assets supporting
fixed dollar obligations of insurers – Separate accounts which are assets supporting the
obligations of insurers such as pension funds and annuities
5454
Financing
• Refers to the planning and controlling of all activities that are related to supplying funds to the firm
• Insurance companies seldom have to raise outside funds – Because most of the normal financing requirements
are met by reinvested profits • However problems such as determining dividend
policies, meeting state solvency requirements, and handling the occasional negotiations for long- and short-term capital sources fall within the province of the Chief Financial Officer
5555
Accounting
• Has essentially the same purposes accounting for the operating results of any firm – To record, classify, and interpret financial data in such
a way as to guide management in its policy making
• However, given the highly regulated and complex financial nature of the insurance business – A special set of accounting rules called Statutory
Accounting Principles are applied to the financial reporting of insurers
5656
Legal Advice
• The function of the legal adviser is to assist others in the company in their tasks
• Underwriters receive aid in the preparation of policy contracts and endorsements
• In the administration of claims, primarily disputed claims, legal aid is important
• If court action is required, the legal staff must represent the company or oversee such representation by outside legal counsel
5757
Marketing Research
• Marketing research is not usually performed within the firm, except in the case of very large companies
• Typically involves selected types of research – Such as testing and developing effective
advertising that can be a vital factor in the long-run success of any insurer
5858
Engineering Services
• Are used as valuable aids to rate making and underwriting
• For example, the engineer provides information that will help answer the question – “How long will fireproof glass resist breaking
when subjected to the heat of burning building?”
5959
Human Resource Management
• Normally includes– Selecting and discharging employees – Keeping employment records– Supervising training and educational programs– Administering recreational and fringe benefit programs
• Insurance has experienced a somewhat more rapid turnover of employees than other industries – Human resource management has increased in scope
and importance due to the need for giving increased attention to this problem and discovering its causes
6060
Reinsurance • A method created to divide the task of handling risk among several
insurers • Often accomplished through cooperative arrangements, called
treaties – Specify the ways in which risks will be shared by members of the group
• Also accomplished by using the services of specific companies and agents organized for that purpose
• Table 23-5 shows the five largest reinsurers with respect to premiums written
• May be defined as the shifting by a primary insurer (ceding company) of a part of the risk it assumes to another company (reinsurer)– That portion of the risk kept by the ceding company is called the line, or
retention – That portion shifted to the reinsurer is called the cession
• The process by which a reinsurer passes on risks to another reinsurer is known as retrocession
6161
Table 23-5: Five Largest Reinsurers, 2002
6262
Uses and Advantages of Reinsurance • Enlarges the ceding insurer’s financial
capacity to accept risk
• Stabilizes profits and evens out loss ratios
• Reduces the ceding insurer’s unearned premium reserve requirement
• Offers a way for the an insurer to retire from underwriting a given segment of its insurance business
6363
Facultative Reinsurance
• Informal facultative reinsurance– Specific reinsurance on an optional basis – A primary insurer shops around for reinsurance
• Attempting to negotiate specific coverage on a particular contract – Does not affect the insured in any way – Usually satisfactory when reinsurance is of an unusual nature or
when it is negotiated only occasionally• Formal facultative contract
– An agreement whereby the reinsurer is bound to take certain types of risks involved if offered by the ceding company
• But the decision of whether to reinsure remains with the ceding company
– Used when the ceding company is bound on certain types of risks by its agents before it has an opportunity to examine the applications
6464
Automatic Treaty
• Reinsurance may be provided whereby the ceding company is required to cede some certain amounts of business and the reinsurer is required to accept them
• Two basic types of treaties have been recognized – Pro-rata treaties
• Premiums and losses are shared in some proportion
– Excess-of-loss treaties • Losses are paid by the reinsurer in excess of some
predetermined deductible or retention • No directly proportional relationship exists between their
original premium and the amount of loss assumed by the reinsurer
