FIN 336 Final
Chapter 7:
Balance sheet: a summary of what a company owns (assets) and what it owes (liabilities), and the difference between total assets and total liabilities (owner’s equities)
Total assets = total liabilities + owners equity
Financial Statements of Property and Casualty Insurers
The primary assets for an insurance company are financial assets
Insurers liabilities include required reserves; an insurer must establish reserves to assure that premiums collected in advance will be available to pay future losses
A loss reserve is an estimated amount for losses that have already occurred but that have not bee paid as of the valuation date:
Claims reported and adjusted, but not yet paid
Claims reported and filed, but not yet adjusted
Claims incurred but it yet reported to the company
Unearned Premium reserve: is a liability item that represents the unearned portion of gross premiums on all outstanding policies at the time of valuation
1 yr contract: $1200
Jan 31st: unearned premium reserve: $1100
Jan 30th: Unearned PR: $600
Dec 31st: unearned PR $0
Financial Statements of Property and Casualty Insurers
Policyholder’s surplus: is the difference between an insurance company’s assets and liabilities
The stronger a company’s surplus position, the greater is the security for its policyholders
Income and expense statement: summarizes revenues and expenses paid over a specified period of time
The two principal sources of revenue are premiums and investment income
Earned Premiums: are those premiums for which the service for which the premiums were paid (insurance protection) has been rendered
Expenses include the cost of adjusting claims, paying the insured losses that occurred, commissions to agents, premium taxes, and general insurance expenses
Measuring Performance of property and Casualty Insurers:
Loss ratio: the ratio of incurred losses and loss adjustment expenses to premiums earned
Expense ration: is equal to the company’s underwriting expenses divided by written premiums
Investment income ratio: compares net investment income to earned premiums
Overall operating ratio: is equal to the combined ratio minus the investment income ratio
This ratio measure the company’s total performance (underwriting and investments)
Financial Statements of Life Insurers:
Balance sheet
The assets of a life insurer have a longer duration, on average, than those of property and casualty insurers
Because many life insurance policies have a savings element, life insurers keep an interest-bearing asset call “contract loans” or “policy loans”
A life insurance company may have separate accounts for assets backing interest-sensitive products, such as variable annuities
Policy reserves: are a liability item on the balance sheet that must be offset by assets equal to that amount
Policyholder’s surplus is less volatile in the life insurance industry than in the property and casualty insurance industry
Benefit payments, including death benefits paid to beneficiaries and annuity benefits paid to annuitants, are the life insurer’s major expense
Measuring the Performance of Life Insurers
A number of measures can be used to gauge the performance of life insurers
Pre-tax or after-tax net income vs. total assets
Rate of return on policy owner’s surplus
Ratemaking in Property and Casualty Insurance
State Laws Require:
Rates should be adequate for paying all losses and expenses
Rates should not be excessive, such that policyholders are paying more than the actual value of their protection
Rates must not be unfairly discriminatory; exposures that are similar with respect to losses and expenses should not be charge significantly different rates
Business Rate Making Objectives include:
Rates should be easy to understand
Rates should be stable over short periods of time
Rates should be responsive to changing loss exposures and changing economic conditions
The rating system should encourage loss contrallée activities
Rate: the price per unit of insurance
Exposure unit: the unit of measurement used in insurance pricing
Pure premium: is the portion of the rate needed to pay losses ad loss adjustment expenses
Loading: the 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 the insured consists of the gross rate multiplied by the number of exposure units
There are three basic rate making methods in property and casualty insurance
Judgment rating: means that each exposure is individually evaluated, and the rate is determined largely by the judgement of underwriter
Class rating: means that exposures with similar characteristics are placed in the same underwriting class, and each is charged the same rate
Merit Rating: is a rating plan by which class rates are adjusted upward or downward based on individuals loss experience
Schedule rating: each exposure is individually rates
A basis rate is determined for each exposure, which is then modified by debits or credits depending on the physical characteristics of the exposure
Commonly used in commercial property insurance
Experience rating: the class rate is adjusted upward or downward based on past loss experience
The insurer’s past loss experience is used to determine the premium for the next policy period
Retrospective rating: the insured’s loss experience during the current policy period determines the actual premium paid for that period
Minimum and maximum premium
Ratemaking in Life Insurance
Life insurance actuaries use a mortality table or individual company experience to determine the probability of death at each attained age
The annual expected value of death claims equals the probability of death times the amount the insurer must pay if death occurs
Chapter 8: Government Regulation of Insurance
Reasons for Insurance Regulation
Maintain insurer solvency
Premiums paid in advance
Exposure to financial insecurity
Social and economic costs
Compensate for inadequate consumer knowledge
Insurance contracts complicated legal documents
Consumers are generally unable to compare different contacts
Insurance agents can potentially be unethical
Ensure reasonable rates
Not too high to charge excessive prices
Not too low to threaten solvency
Make insurance available
Available to all who need it
Insurers can be unwilling to write for all applicants
Government can step in when the private sector is unwilling to provide insurance
Historical Development of Insurance Regulation
Insurers were initially subject to few regulatory controls
Paul v. Virginia (1868) affirmed the right of the states to regulate insurance
The court ruled that insurance was not interstate commerce
In U.S. v. South-Eastern Underwriters Association (1944) the court ruled that insurance was interstate commerce when conducted across state lines and was subject to federal regulation
The McCarran-Ferguson Act (1945) states that continued regulation and taxation of the insurance industry by the states are in the public interest
Federal antitrust laws apply to insurance only to the extent that the insurance industry is not regulated by state law
The Financial Modernization Act (1999) changed federal law that earlier prevented banks, insurers, and investment firms from competing outside their core area
What Areas are regulated? - Formation and Licensing of Insurers
All states have requirement for the formation and licensing of insurers
After formation, insurers must be licensed to do business
Licensing includes minimum capital and surplus requirements
A domestic insurer is domiciled in the state
A foreign insurer is an out-of-state insurer that is chartered by another state, but licensed to operate in the state
An alien insurer is an insurer that is chartered by a foreign country, but is licensed to operate in the state
Debate on Sales of Insurance Across state lines
Insurance is regulated at the state level in accordance with the McCarran-Ferguson Act.
The McCarran–Ferguson Act essentially sets up fifty separate state monopoly or oligopoly markets, each with its own set of state licensed health insurance providers
Citizens of Ohio who want to buy health insurance must buy it from an Ohio licensed provider, like Blue Cross Blue Shield of Ohio
Proponents: Citizens buying health insurance pay more for it and get lower quality services than they would if there was interstate competition among health insurers
Opponents:
health care is inherently local, setting up provider networks is a costly and significant barrier to entry in new markets.
race to the bottom among states trying to attract business.
adverse selection, home state insurance premium to rise.
What areas are Regulated? - Solvency regulation
Insurers are subject to financial regulations designed to maintain solvency
Assets must be sufficient to offset liabilities
Admitted assets are assets that an insurer can show on its statutory balance sheet in determining its financial condition
Life and health insurance must meet certain risk-based capital standards
Risk-based capital (RBC) standard means that insurers must have a certain amount of capital, depending on the riskiness of their investments and insurance operations (the amount your should have says the Professor)
Asset risk
Underwriting risk
Interest rate risk
Business risk
A comparison of the company’s total adjusted capital to the amount of required risk based capital determines whether the company or regulatory action is required
The purpose of investment regulations is to prevent insurers from making unsound investments that could threaten the company’s solvency and harm the policy owner’s
Laws generally place a limit on the proportion of assets in a specific asset category, such as real estate
Many states limit the amount of surplus a participating life insurer can accumulate, rather than pay as dividends
Each Insurer must file an annual report with the state insurance department in the states where it does business
The state insurance department assumes control of insurance companies that they determine to be financially impaired
All states have guaranty funds that provide for the payment of unpaid claims of insolvent property and casualty insurers
What Areas are Regulated? - Rate regulation
Rate regulation takes a variety of forms across states
Forms of rate regulation for property and casualty insurance include:
Prior approval law
Modified prior approval law
File-and-use law
Use-and-file law
Flex-rating law
State-made rates
No filing required
State Versus Federal Regulation
Should the McCarran-Ferguson Act be repealed?
Arguments for federal regulation include:
Uniformity of laws and standards
Greater efficiency
More effective in the identification and treatment of systemic risk
Systemic risk is the risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system
Advantages of state regulation include:
Quicker response to local insurance problems
Poor quality of federal regulation, e.g., in the banking industry
Reasonable uniformity of laws can be achieved by the model laws of the NAIC
Greater opportunity for innovation
Unknown consequences of federal regulation
Current Problems and Issues in Insurance regulation
Insolvency of insurers continues to be an important regulatory concern
Reasons for insolvencies include:
Inadequate rates
Inadequate reserves for claims
Rapid growth and inadequate surplus
Problems with affiliates
Overstatement of assets
Alleged fraud
Failure of reinsurers to pay claims
Mismanagement
Catastrophic losses
The principal methods of ensuring insolvency are:
•Minimum capital and surplus requirements
•Risk-based capital standards
•Review of annual financial statements
•Field examinations
•Early warning system (IRIS ratios)
•FAST system analysis
Insurers use an applicant’s credit rating for underwriting in auto and homeowners insurance
•Proponents argue:
•There is a high correlation between an applicant’s credit record and future claims experience
•Insurance scores benefit consumers
•Underwriting and rating can be more objective and consistent
•Most consumers have good credit scores and pay lower premium
•Critics argue:
•The use of credit data in underwriting or rating discriminates against minorities and other groups
•Credit reports often contain errors that can harm insurance applicants
•Credit-based insurance scores may penalize consumers unfairly during business recessions
Chapter 9:
Principle of indemnity
The insurer agrees to pay no more than the actual amount of the loss
Purpose:
To prevent the insured from profiting from a loss
To reduce moral hazard
In property insurance, indemnification is based on the actual cash value of the property at the time of loss
There are three main
When must insurable interest exist?
Property insurance: at the time of the loss
Most property insurance are contracts of indemnity
Mark sells his home to Susan, and a fire occurs before the insurance on the home is canceled
Nothing is covered
Mark doesn’t own the home and Susan doesn’t have insurance in her name
Life insurance: only at inception of the policy
Not a contract of indemnity
Beneficiary has only a legal claim to receive the policy proceeds
Michelle takes out a policy on her husband’s life and later gets a divorce
Principle of Utmost Good Faith
A higher degree of honesty is imposed on both parties (insurer and insured_ to an insurance contract than is imposed on parties to other contracts
Representations
Are statements made by the applicant for insurance
a contract is voidable if the representations is material, false, and relied on by insurer
Concealment
Intentional failure of the applicant for insurance to reveal a material fact of the insurer
Case: Joseph DeBilles — Joseph DeLuca
Warranty
A statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects
EX: Liquor store—burglar alarm system, bank—guard, firm—sprinkler
These reduce frequency of losses
Based on common law, in its strictest form, warranty is a harsh legal doctrine. Any breach of the warranty, even if minor or not material, allowed the insurer to deny payment of a claim.
Chapter 10: Analysis of Insurance Contracts
Basic Parts of an Insurance Contract:
Declarations
Tells who, what, when, and where
Lists amounts of coverage, premiums, deductibles
Usually is the first page of contract
Definitions
For example, the insured is referred to as “you” and “your”
Insurer is referred to as “we”, “our”, or “us”
Insuring agreement
Summarizes the major promises of the insurer
“Named Perils” policy
If not named, not covered
Ex: if you get a policy for wind damage
“Open Perils” policy
All perils covered unless excluded
Better for policy holders because less likely hood of gap in your policy
Different burdens of proof for these two types
Exclusions
Insurance contracts contain three major types of exclusions
Excluded perils, e.g., flood, suicide in a life policy (2 years)
Excluded losses, e.g., losses from operation of a business in the homeowners policy
Excluded property, e.g., cars, planes, pets are not covered as personal property in the homeowners
Reasons for exclusions:
Some perils are not commercially insurable
E.g., catastrophic losses due to war
Extraordinary hazards are present
E.g. premium for liability insurance under the personal auto policy-using the automobile for a taxi
Coverage is provided by other contracts
E.g. use of auto excluded on homeowners policy
To avoid duplication of coverage and to limit coverage to the policy best designed to provide it
Moral Hazard problems
Morale Hazard problems
E.g., individuals are force to bear losses that result from their own carelessness
Morale hazard is carelessness or indifference to a loss, which increases the frequency or severity of loss
Coverage not needed by typical insureds
E.g., homeowners policy does not cover aircraft
Unfair to the vast majority of insureds who do not own planes because premiums would be substantially higher
Basic Parts of an Insurance Contract Continued:
Conditions
Are provisions in the policy that qualify or place limitations on the insurer’s promise to perform
Notifying the insurer if a loss occurs
Protecting property from further damage after a loss occurs
Cooperating with the insurer in the event of a liability suit
Miscellaneous provisions
Property/casualty insurance
Assignment of policy
Cancellations
“Other-insurance” provisions
Life/Health Insurance
Grace period
Reinstatement of Lapsed policy
Endorsement and Riders
A provision that adds to, deletes from or movie
Deductibles
Out of pocket payment
A specified amount is subtracted from the total loss payment
Raising deductibles (increasing retention amount) can lower premiums significantly — up to 25% by going from $250 to $1000
Purpose of deductibles
Eliminate small claims that are expensive to handle and process
Overhead costs to investigate property claims are relatively constant
Reduce moral and morale hazard
Insured still has an incentive to avoid a loss
Provide flexibility and choice to insured
Insured can lower premium by choosing a higher deductible
Types of Deductibles
Straight Deductible
Must be satisfied for each and every loss
Aggregate deductible
Insurance company only pays after a certain amount of total losses is reached during a specific time period the pays all covered losses
Coinsurance
EX: Let's say the following amounts apply to your plan and you need a lot of treatment for a serious condition. Allowable costs are $12,000.
Deductible: $3,000
Coinsurance: 20% (you pay)
You’d pay all of the first $3,000 (your deductible)
You pay 20% of the remaining $9,000, or $1,800 (your Coinsurance)
Your total put of pocket cost would be $4,800 — your $3,000 deductible plus your $1,800 Coinsurance
Requires the insured to insure the property to stated percentage of its insurable value
If not, insured must share in the loss
Payment will never exceed the limit of coverage
Payment will never exceed the amount of the loss
Coinsurance Formula:
Amount of Insurance Purchased * Loss - Deductible Amount of Insurance “required”
Purpose of Coinsurance
Creates equity in rating
Most losses are not total losses
If everyone insured only for partial losses, rates would have to be higher
Policyowner’s who is underinsured is penalized through application of the Coinsurance formula
Coinsurance in Health Insurance
Percentage participation clause
Used in conjunction with deductible
Caps are also common
Combination of deductible, Coinsurance, and cap results in “out of pocket limit”