Trieschmann, Hoyt & Sommer

Risk Management and the Insurance Industry

Chapter 22

©2005, Thomson/South-Western

22

Chapter Objectives • Indicate the size of the insurance industry• Describe how the insurance business is divided between the

private and public sectors• Explain why personal insurance has a larger premium volume

than property insurance• Identify and explain the differences between stock companies,

mutual companies, Lloyd’s associations, and reciprocal insurers• Indicate which types of insurance have the largest volume• Explain how insurance guaranty funds operate• Describe how insurance is distributed from insurers to

consumers and list the differences between types of agents and brokers in insurance

• Described the global nature of risk management and the insurance industry

33

The Field of Insurance

• Insurance coverages can be divided into various opposing categories – Personal (life and health) vs property (buildings, homes,

autos)– Government (flood insurance) vs private (product

liability)– Involuntary (Social Security) vs voluntary (fire insurance)

• The categories are not mutually exclusive and they overlap

• Figure 22-1 depicts the major classifications of insurance and what they have in common with each other

44

Figure 22-1: Major Classifications of Insurance

55

Personal Coverages

• Those related directly to the individual • The risk they cover is the possibility that

some peril may interrupt the individual’s income, such as – Death, accidents and sickness,

unemployment, and old age – Insurance is written on each

• Private insurers are active in providing insurance for death, accidents and sickness, and old age

• Governmental units are active in all categories

66

Property Coverages

• Directed against perils that may destroy property • Property insurance is distinguished from

personal insurance – Personal insurance covers perils that may prevent

one from earning money with which to acquire property in the future

– Whereas property insurance covers property that is already acquired

• Property insurance as used here includes fire, marine, liability, casualty, and surety insurance

• Sometimes referred to as general insurance, property/liability insurance, or property and casualty insurance

77

Private and Public Insurance

• Private insurance consists of all types of coverage written by privately organized groups – Consists of associations of individuals,

stockholders, policyholders, or some combination of these

• Public insurance includes all types of coverage written by government bodies or operated by private agencies under government supervision

88

Voluntary and Involuntary Coverages • Most private insurance comes under the

rubric of voluntary coverage • A major part of government insurance is

involuntary coverage – It is required by law that insurance be

purchased by certain groups and under certain conditions

• Examples of required insurance include automobile liability insurance and workers’ compensation insurance

99

Voluntary and Involuntary coverages• Table 22-1 shows the importance of

private passenger auto insurance

• Table 22 -2 shows that PPA made up 33.1 percent of total premiums in 1980 although there has been a relative decline since 2000 – Due to the dramatic increases in commercial

lines insurance premiums during the hard insurance market

1010

Table 22 -1: Net Premium Written by Line of Property Liability Insurance–2002

1111

Table 22 -2: Private Passenger Auto as a Percentage of Total P-L Premium

1212

Stock Companies

• A corporation organized as a profit-making venture in the field of insurance

• For companies organized in the United States – A minimum amount of capital and surplus is prescribed by state

law to serve as a fund for the payment of losses and for the protection of policyholders’ funds paid in advance as premiums

• Organized with authority to conduct certain types of insurance business

• Some pay dividends to policyholders on certain types of insurance

• Never issue what is called an assessible policy – The insured can not assess an additional premium if the

company’s loss experience is excessive • The stockholders are expected to bear any losses

– And they also reap any profits from the enterprise

1313

Mutual Companies

• Organized under the insurance code of each state as a nonprofit corporation owned by the policyholders

• Has no stockholders • No profits are made

– Because any excess income is returned to the policyholder-owners as dividends

• Or is used to reduce premiums, or retained to finance future growth

• The company is managed by a board of directors elected by policyholders

• Many types of mutual organizations exist and operate under different laws and with different types of businesses

1414

Class Mutuals

• Operate in only a particular class of insurance – Such as farm and property, lumber mills, factories, or

hardware risks • Farm mutuals

– Specialize in farm property insurance – Insure a large portion of farm property in some states,

primarily because of the specialized nature of the risks • Factory mutuals

– Specialize in insuring factories – Place emphasis on loss control – Generally do not solicit small risks due to the relatively high

cost of inspection, engineering services, surveys, and consultations that are provided by the organization in an attempt to prevent losses before they occur

1515

General Writing Mutuals

• One that accepts many types of insureds• Require an advanced premium calculated on roughly the

same basis as that of a stock insurer• Operate in several states or even internationally• May or may not pay a refund of the portion of the

premium of the dividend if experience warrants it• Many mutuals insist on relatively high underwriting

standards – Taking only the best risks so that a dividend will more likely be

paid • Some mutuals are both participating and deviating

– They plan to cut the initial rate somewhat below stock company levels and to pay dividend if warranted

1616

Fraternal Carriers

• Designed as a nonprofit corporation, society, or voluntary association, without capital stock, organized and carried on solely for the benefit of its members and their beneficiaries

• Have a lodge system with a ritualistic form of operation and a representative form of government that provides for the payment of benefits in accordance with definite provisions in the law

• As charitable, benevolent associations, they usually are exempt from taxation

• Some of the largest mutual insurers have converted to stock firms including – Metropolitan, Prudential, and John Hancock

1717

Reciprocals

• Sometimes called an interinsurance exchange • Like a mutual in that both are formed for the purpose of

making the insurance contract available to policyholders at cost

• Basic differences exist between the legal control and capital requirements of reciprocals and mutuals – In a reciprocal, the owner-policyholders appoint an individual or

a corporation known as an attorney-in-fact to operate that company, as opposed to the board of directors

– A mutual is incorporated with a stated amount of capital and surplus

• Whereas a reciprocal is unincorporated with no capital as such

• Operate mainly in the field of automobile insurance

1818

Lloyd’s Associations

• An organization of individuals joined together to underwrite risks on a cooperative basis

• Each member assumes risks personally and does not bind the organization for these obligations

• Each investor is individually liable for losses on the risks assumed to the fullest extent of personal assets – Unless the liability is intentionally limited

• Similar to reciprocals in that each underwriter is an insurer – However, a reciprocal is composed of individuals who are both

insurers and insureds at the same time• Whereas a Lloyd’s association is a proprietary organization

operated for profit

1919

London Lloyd’s

• Lloyd’s started in 1688 in London as an informal group of merchants taking marine risks

• Their operations are now worldwide – Operate extensively in the United States largely in the

surplus line market • Consist of risks that domestic insurers have rejected for one

reason or another

• In 2004 nearly 66 underwriting syndicates existed – Groups of names that combine their resources and

employee manager• Who determines which risks to insure

2020

Relative Importance of Private Insurers • Thousands of insurance companies

operate in the United States • However, most of that business is done by

relatively few insurers • The leading states for property-liability

insurers are Vermont, Texas, New York, and Pennsylvania – For life insurers the leading states are

Arizona, Texas, and New York

2121

Relative Importance of Private Insurers• Stock companies tend to dominate as underwriters of

various lines of property-liability insurance • Mutuals enjoy their greatest markets in the fields of

personal automobile and workers’ compensation insurance • Lloyd’s and reciprocals account for only a small share of the

total property-liability insurance market • In the field of life and health insurance, there are more than

twelve times the number of stock companies than mutuals • In property-liability insurance, mutual companies have

grown more rapidly than stock insurers – Mutuals have tended to specialize in types of insurance for which

the markets have been growing most rapidly – Mutuals have used cost-cutting methods that generally have made

the product available at lower rates

2222

Insolvency of Insurers

• Insurance institutions are not backed by a federal agency in the same way bank deposits are protected

• The danger of loss from insolvent property-liability insurers has been recognized by the establishment in all states of guaranty funds – These funds must reimburse the policyholders for any

losses caused by bankrupt insurers • Subject to stated deductibles and maximum loss limits that

vary from state to state • The funds are supported by assessments against other

insurers operating in the same state

2323

Insolvency of Insurers

• Various reasons exist for property-liability insolvencies including – Inadequate pricing

• Usually discovered when loss reserves are insufficient to pay claims

– Rapid growth – Fraud – Overstatement of the value of certain assets

2424

Employment in Insurance

• The insurance industry employed approximately 2,222,000 persons in 2002

• Most of the jobs are salaried positions

• Fewer than 1/3 are in marketing or distribution – This contradicts the frequently-held opinion

that most jobs in insurance are in sales

2525

Ownership of Insurance

• Data from the Insurance Information Institute reveals that the property-liability insurance industry has been able to reach most U.S. citizens who own homes or autos

• Roughly 95 percent of homeowners indicated that they had purchased property or liability insurance on their homes and possessions

• Some type of life insurance is owned by approximately 75 percent of Americans

2626

Direct Distribution in Life Insurance

• Life insurance is distributed in two main ways – Salaried group insurance representatives – Individual insurance agents who usually work on

commission

• Life insurance is also sold by direct contact with the consumers in advertising, mail order, or the internet – The insurer maintains a one-on-one relationship with

the insured• Independent intermediaries usually are not involved

2727

Group Insurance

• Life insurers offer many of their products on a group basis – Under contracts covering groups of persons

rather than individuals

• Customers from group coverage are generally business firms

• Persons employed to sell and service businesses usually receive a salary and bonus

2828

Individual Agents

• Policies sold to individuals are usually handled by persons known as agents, underwriters, or financial planners

• The agent or underwriter contacts the ultimate consumer and reports directly to the insurer or intermediary who in turn reports to the insurer

• The authority of the underwriter or agent is limited

2929

Individual Agents

• A general agent in life insurance is an individual employed to hire, train, and supervise agents at lower levels – Sometimes collects premiums and remits them to the

insurer’s home office – Not an independent intermediary in the sense that a

typical wholesaler is• General agent does not exercise final control over the

issuance terms of the contract – The company normally is not bound by the general agent in

putting a contract in force • The general agent exercises no control over the amount of

premium, has no investment in inventory, does not own any business written, and has no legal right to exercise any control over policyholders once he or she leaves the employment of the company

3030

Reasons for Direct Distribution in Life Insurance • The system of direct distribution has

grown up in life insurance because of several basic factors – The insurer’s need to maintain close control

over the policy product – The insurer’s need to exercise control over

sales promotion and competition – The infrequent purchase of life insurance – The agent’s ability to make a better living

through specialization

3131

The Changing Environment in the Life Insurance Company • From the 1950s to 1987 individual life insurance new

premiums maintained respectable growth greater than, or equal to, the rate of inflation – Real growth in new premiums was occurring

• Beginning in 1987 that pattern ceased – In 1988 new premiums actually declined

• Changes in U.S. demographics have contributed to the shifting of business volume away from individual life insurance – As the overall population aged, people became more interested

in financial products that were accumulation centered • Rather than protection and accumulation • These changes have meant that life insurers increasingly find

themselves competing with banks and mutual fund companies for consumers’ investment dollars

3232

Direct Writing in Property-Liability Insurance• In some lines, independent intermediaries

have been eliminated – Contract is marketed directly from the insurer

to the insured through either exclusive agents or employees who work on salary and commission

• They solicit prospects, take care of paperwork, and serve as the insurer’s direct contact with the insured

3333

Direct Writing in Property-Liability Insurance• An exclusive agent of a direct writer represents

only one insurer– Does not own business written and generally does not

handle loss claims or collect premiums – Receives a commission but it is a lower percentage

than the commissions allowed independent agents – The main tasks of the exclusive agent are to

• Sell new business • Keep in contact with customers • Served as a communications link between the insurer and

the insured

3434

Direct Writing in Property-Liability Insurance• Direct writers have their greatest volume in the

field of automobile insurance • They have been able to sell insurance at lower

cost to the final consumer• Innovations have occurred in automobile

insurance including– Continuous policies, lower agents’ commissions,

direct billing from the insurer to the customer and specialized adjusting offices to handle claims

3535

Indirect Distribution (American Agency System)• The insurance is not sold directly by the insured

to the policyholder but rather is sold through a system of intermediaries – Comparable to the wholesaler-retailer system in

tangible goods marketing • The independent agent is an autonomous, local

intermediary in the property insurance business – As the “retailer,” the independent agent deals with the

final consumer of insurance – The independent agent usually represents 10 to 30 or

more separate insurers and has authority to bind these insurers on most of the contracts written

3636

Brokers vs Agents

• Brokers operate in a manner similar to local agents– Legally brokers represent the consumer, not the

insurer

• If the customer asks a broker to obtain insurance, the broker must contact with the insurer before coverage is binding

• Agents may bind coverage immediately – Because they are the legal representatives of the

insurer– Many brokers also hold agency contracts

3737

Is the American Agency System Doomed? • Those insurers and their agents committed to the

traditional long channel of distribution have become concerned over the future of their business – Since direct writers have been growing in market share until

recently

• Table 22-3 shows that while direct writers have taken a significant portion of the personal lines market – Insurers using independent agents have maintained their

dominance in commercial insurance lines

• Although the volume of business undertaken by local independent agents is usually relatively small this is not the case for national brokers – Table 22-4 shows the name and size of the five largest brokers

3838

Table 22-3: Market Share (%) by Distribution System

3939

Table 22-4: Five Largest Brokers in the World, 2002

4040

Outlook for the Agency System and Direct Writing • Direct writing has grown fastest in lines for which there is

a mass market for a standardized product that requires little continuous service – These conditions do not exist in all areas of insurance,

particularly in the commercial market • Thus, it is extremely doubtful that direct writers will capture that

market

• It seems unlikely that the independent agency system will be replaced by direct writing unless the property insurance business becomes much more concentrated than it is now

• While direct writers continue to gain market share in the property-liability field, the life insurance industry is going in the opposite direction

4141

Direct Response

• Some insurance is sold without agents or other intermediaries through the direct response technique – Customers are found through advertising on television,

radio, newspapers, magazines, direct mail, etc. – This is the area where the internet appears to have the

greatest potential – No sales agents are employed – The policies tend to be fairly standardized and more

specialized and less costly • Examples include accident insurance, hospital indemnity, term

life, automobile, homeowners, and short-term disability income contracts

4242

Mass Merchandising

• A method of distributing property-liability insurance directly to consumers through employer payroll deduction

• Premiums are usually cheaper because of various economies in mass merchandising

• Employers do not normally contribute to the premium on behalf of employees

• They have not become extremely popular – Independent agents have generally opposed the adoption of

such plans • Because many agents depend on individually issued personal-lines

business for their livelihood – The element of adverse selection exists

• Which has often produced poor underwriting experiences

4343

Globalization of Risk Management and the Insurance Industry • A globalization of business has occurred due to

– Advances in technology and improvement in transportation

– Reduced trade barriers in many countries • Firms and organizations that do business

internationally face differences in their loss exposure and in the risk-handling methods they use

• Globalization and differences in future growth potential have led many insurers to reevaluate the focus of their business and to consider expansion overseas

4444

Global Risk Management

• Almost all organizations have some employees who travel overseas

• These activities can give rise to unique exposures that are not faced if the firm operates exclusively within its own home country – Exporting goods and services overseas– Manufacturing or importing products from overseas– Hiring part-time or permanent employees overseas

4545

Global Risk Exposure

• Some kinds of risk exposure faced by international firms are the same as those faced by firms that do business only in their home country – For example, fire, natural disasters, or damage to goods in

transit

• Many of these exposures can be altered in both frequency and severity by differences in various parts of the world – Most of the deaths from natural disasters are in developing

countries • While most of the property damage resulting from natural disasters

occurs in industrial nations

– Fire loss potential is much greater in countries with poor infrastructure and lower-quality building standards

4646

Global Risk Exposure

• Global firms also face unique kinds of loss exposure that arise as a result of conducting business in multiple countries, including – Terrorism, kidnapping, political instability, uncertain legal

environment, currency risk, import/export restrictions, technology and communications, financial markets’ weaknesses, and substandard infrastructure

• The inability to assess risk accurately due to an absence of information in some underdeveloped countries can be one of the biggest challenges that a risk manager of a global firm faces – Additionally, the lack of a well-developed insurance industry can

lead to an absence of high quality risk management services such as

• Claims handling, loss assessment, loss control

4747

Global Risk Exposure• The rate of insurance in business and the use of insurance by

individuals can differ dramatically around the globe • Tax treatment of insurance differs from country to country • Local laws in some countries require the purchase of certain

types of insurance – And it either requires that insurance be purchased from a locally admitted

insurer or disallows tax-favored treatment if the insurance is purchased from a nonadmitted insurer

• The attitude toward risk management can also differ• Customary limits of coverage can vary significantly • Some religious beliefs discourage arrangements involving the

payment of interest and often limit the purchase of insurance • Significant reliance upon government social insurance programs

reduces the demand for private life and health insurance and annuity products in a number of countries

4848

Global Insurance Programs

• A global firm can rely primarily on nonadmitted insurance on a worldwide basis – Buy insurance in their home country and arrange for

coverage wherever they do business • Easy to administer and leaves the decision-making in the home

country • Disadvantages include

– It may be illegal in some countries

– Favored tax treatment of insurance premiums and loss payments may be lost

– The insured does not have a local insurer to provide claims and other services overseas

4949

Global Insurance Programs

• A global firm can leave the insurance program design and the purchase of insurance to the firm’s management in each of the countries in which it does business – Has the advantage of meeting any local laws regarding

admitted insurance and compulsory coverage requirements

• Can preserve favorable tax treatment for premium and loss payments

– Has the disadvantage in that the approach tends to lead to a very inefficient program structure if the firm does business in a number of countries

• Also, coverage limits and terms often differ significantly across countries and can lead to to important gaps in protection

5050

Global Insurance Programs

• A global firm can use a global controlled master program – A global insurer works through its own subsidiaries or

partner insurers in each of the countries in which the insured corporation does business to provide unified coverage

– Will involve locally admitted subsidiaries or partners which assures that the program meets the laws and requirements related to compulsory and admitted insurance

• These subsidiaries or partners provide local expertise in managing claims and assessing risk

5151

Globalization of the Insurance Business • Table 22-5 provides market share data for the six largest

insurance markets in the world • Perhaps the biggest driver of the increasing international

focus of the insurance business is – The globalization of the firms that buy insurance and purchase

risk management services from insurers

• Multinational firms are becoming increasingly sophisticated regarding risk management practices – They demand the ability to combine and integrate their risk

management programs on a global basis – They increasingly demand high quality risk management

services wherever they do business • Such as claims management and loss control

5252

Table 22-5: Percentage Share of World Insurance Market, 2002

5353

Globalization of the Insurance Business• An additional important factor in the

expansion of U.S. and European insurers overseas– The recognition that insurance markets in

industrial countries do not offer the same opportunities for growth in the next ten years

– The emerging economies in eastern Europe and the Pacific Rim offer double-digit growth potential in insurance demand