Ch 7 ACSC - Financial Operations of Insurers

Balance sheet - PnC

a summary of what a company owns (assets) what it owes (liabilities) and the difference between assets and total liabilities (owner’s equity)

balance sheet equation (pnc)

Total Assets = Total Liabilities + Owner’s equity

assets of a PnC insurance company

financial assets — investing premium dollars and retained earnings

• source of income

• primary investing holdings: bonds (others: stock, real estate)

2 liabilities of a PnC insurance company

1. loss reserves — the estimated cost of settling claims for losses that have already accrued but have not been paid yet such as claims reported but not yet paid, claims reported but not yet adjusted, and claims not yet reported. Injury and liability claims may take a long time to settle

2. unearned premium reserve — a liability item that represents the unearned portion of gross premiums on all outstanding policies at the time of valuation. It is to assure policyholders that future losses will be paid (it is REQUIRED) 

policyholder's surplus

the difference between an insurance company’s assets and liabilities (“balancing item on balance sheet”)

income and expense statement

summarizes revenue received and expenses paid during a specialized period of time

revenues

cash inflows that the company can claim as income

sources: premiums and investment income…premium is wholly earned when period of time has passed. investment income is interest income, dividend income

expenses 

cash outflows from the business such as cost of adjusting claims, paying for insured losses that occurred, underwriting expenses (commissions, taxes)

loss ratio

the ratio of incurred losses and loss adjustment expenses to premiums earned

(incurred losses + loss adjustment expenses) / premiums earned

expense ratio

equal to the company’s underwriting expenses divided by written premiums

combined ratio

the sum of the loss ratio and expense ratio

• one of the most common measure of underwriting profitability

investment income ratio

compares net investment income to earned premiums

(NII) / (EP)

overall operating ratio

combined ratio - investment income ratio

3 major differences between assets of PnC and life insurance companies

1. Average duration of investments — pnc contracts are short term whereas life contracts are long (40-50 years). Life invests more heavily in bonds, mortgages, real estate than pnc

2. savings element in cash-value life insurance — cash value is the savings element over time in permanent life insurance policies (the policy holder borrows loans which has interest)

3. life-separate account assets — life insurance companies may have separate accounts for assets backing interest-sensitive products (ex: variable annuities, variable life insurance, universal-variable life insurance)

liabilities for life insurers

major liability: policy reserves — premiums paid earlier are high and later are low. Then excess premiums from earlier years and held for future payments so they created the policy reserve (a future obligation)

• reserve for amounts held on deposit — liability that represents funds owed to policyholders/beneficiaries 

• asset valuation reserve (AUR) — statuary account designed to absorb asset value fluctuations not caused by changing interest rates (to smooth company’s reported surplus over time)

income and expense statement for a life insurance company

similar to pnc, major source of revenues: premiums and income from investments, major expense: claims payments (exL death benefits, annuity benefits, health benefits)

life insurer’s net gain from operations (net income)

= total revenues - total expenses = dividends federal income taxes

objectives in rate making (pnc)

regulatory objectives — protect the public

• adequate (high enough to pay all losses and expenses so claims can be paid), not excessive (not be so high that policyholders are paying more than actual value of their protection), not unfairly discrimination (similar exposures should be charged at similar rates)

Business objectives

• when designing rating systems:

1. simplicity (easy to understand, premiums quoted with minimum time/expenses)
   

2. responsiveness ( responding to changing loss exposures/economic conditions)

3. stability (maintain customer satisfaction with stable rates)

4. encouragement of loss control (loss prevention behaviors)

rate

price per unit of insurance

exposure unit

unit of measurement used in insurance pricing — varies by line of insurance

pure premium 

portion of rate needed to pay losses and loss-adjustment expenses

loading

amount that must be added to the pure premium for other expenses, profit, and a margin for contingencies

gross rate

consists of the pure premium and a loading element

gross premium

• paid by insured

• consists of gross rate x number of exposure units

3 basic rate-making methods (pnc)

1. Judgement rating

• each exposure is individually evaluated

• rate is determined by judgement of underwriter (used when loss exposure too diverse)

• ex: marines

• used when not enough data/data not homogenous

2. class rating

• exposures with similar characteristics are places in the same underwriting class

• each is charged the same rate which reflect the average loss for a class

• simple to apply, quick premium quotes

• ex) homeowners, private auto, worker’s comp

3. merit rating

• rating plan by which class rates are adjusted based on individual loss experience/risk characteristics

2 class rating methods

1. pure premium method:

pure premium = (incurred losses + loss-adjustment expenses) / (# of exposure units)

gross rate = pure premiums / (1- expense ratio)

2. loss ratio method

rate change = (actual loss ratio - expected loss ratio) / expected loss ratio

3 types of merit rating

1. schedule rating — each exposure is individually rated and basis is modified (qualitative features are used to adjust class premium)

2. experience rating — class rate adjusted based on past loss experience (historical losses)

premium change = (actual loss ratio - expected loss ratio) / (expected loss ratio) x credibility factor

3. retrospective rating — insured’s loss experience during current period determines actual premium paid for that period (re-rate the policy after expiration using actual loss in the policy period, then bill the for more or refund them).

rate making in life insurance

• mortality table

• individual company experience — used to find probability of death and expected value of loss payment