Functions of Insurers
Chapter 12: Functions of Insurers
Authors: Hoyt and Sommer; Dr. Christine Berry
Introduction
Overview of the roles and responsibilities of insurance companies as outlined in this chapter.
Functions of Insurers: Outline
Production/Distribution:
Marketing and selling policies.
Underwriting:
Selecting and classifying insurance risks.
Claims Management:
Determining amounts to pay in claims and managing risk.
Rate Making:
Determining a price to charge for the insurance product.
Investing:
Selecting investment mediums for insurance company assets.
Accounting:
Reporting financial data to regulators and others.
Reinsurance:
Diversifying insurance risk through reinsurers.
Other Services:
IT, data analytics, and human resources.
Production/Distribution
Corresponds to the sales or marketing function in an industrial firm.
Referred to as “production” because insurance is intangible; a product doesn’t exist until it is sold.
Covered in the Organizational Forms chapter.
Direct vs Indirect Marketing.
Other production-related functions include:
Finding insurers with the right “appetite.”
Conducting marketing research.
Advertising.
Risk management services.
Underwriting
Definition: All activities necessary to select risks offered to the insurer in such a manner that general company objectives are fulfilled.
Primary Objective:
To ensure that the applicant accepted will not have a loss experience that is very different from assumptions made when rates were determined.
To achieve this, underwriting must block adverse selection.
Adverse Selection: The tendency for individuals with higher risk to buy more insurance.
Underwriting: Life Insurance
Underwriting in life insurance is performed by home or regional office personnel, rarely by agents.
Company underwriters use:
Medical reports from the physician who examined the applicant.
Information from the agent prepared by an outside agency.
Advice from the company’s own medical advisor.
Underwriting: Property and Liability Insurance
In property-liability insurance, agents can sometimes make binding decisions in the field, known as field underwriting or “AGENT”.
When agents have “binding authority” or “the pen,” insurers must guard against agent bias.
Underwriting Careers
As underwriters progress, they do less “day-to-day” underwriting.
They make decisions on the most complex risks.
Often involved in insuring new risks.
Many ULM graduates work as underwriters in the surplus lines.
No two risks are the same, thus, no two days are the same.
Claims Management: Responsibilities
Responsibilities include:
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.
Claims Management: Life vs. Property
Technology significantly impacts property adjusting with tools like drones and satellites.
More extensive in property-liability insurance than in life insurance due to:
Higher frequency of losses.
Predominance of partial losses.
Uncertainty of the amount of loss in individual cases.
Claims Management: Types of Adjusters
Company Adjusters (Staff Adjusters): Salaried staff employees of the insurer.
Independent Adjusters: Engage where an insurer lacks sufficient volume to employ a staff adjuster.
Public Adjusters: Specialize in adjusting and represent policyholders in dealings with insurers.
Risk Management and Loss Control:
In large insurance and brokerage organizations, risk managers are very involved in this process (e.g., WC Claims and safety requirements).
May involve lawyers and investigators.
Rate Making
Process:
Collecting statistics on past frequency and severity of loss.
Applying these statistics to selected exposure units.
Works closely with underwriting to assign rates to selected classes.
Extremely technical in most lines of insurance, especially property and liability.
Based substantially on historical loss data and numerous rating factors such as:
Mortality rates according to age, sex, smoking/drinking habits, and occupation.
Less complicated in life insurance.
Rate Making: Who and What
Actuaries: Highly trained mathematicians/statisticians who use loss histories and other data to determine appropriate rates for insurance.
Insurance Premium: Designed to cover two major costs: the expected loss and the cost of doing business, known as the pure premium and the loading.
Rate Making: Elements
Rate per unit of coverage:
Gross Premium: Includes both the pure premium and the loading.
The amount of the premium expected to go towards covering the loss. - Pure Premium (PP):
The percentage of the gross premium expected to pay for expenses and underwriting costs.
Includes underwriting costs, commissions, taxes, and overhead.
Loading (LP): The additional percentage added to cover operational costs.
Rate Making: Gross Premium Equation
Rate Making: Gross Premium Equation (Continued)
Rate Making: Gross Premium Calculation Example
Example:
Pure Premium (PP) = $1.50.
Expense Loading Percentage (LP) = 33%.
Calculation:
$2.24 is the amount they need to charge to break even (if loss and expense assumptions are correct).
Rate Making: Insurance Company’s Rules and State Laws
Rates must be:
Adequate: Must be sufficient to pay claims, preventing company insolvency.
Not Excessive: Usually not an issue due to competition.
Not Unfairly Discriminatory: Must reasonably reflect the riskiness of the exposure; some factors cannot legally be included (e.g., race, religion, ethnicity).
Rate Making: Methods of Rating
Manual or Class Rating (Pure Method): Sets rates uniformly for each exposure unit within predetermined classes.
Loss Ratio Method:
Measures “performance” of insured risks (typically around 70%).
If actual loss ratio is higher than expected, rates need to be increased.
Individual or Merit Rating Method: Reflects individual risk features and hazards, also known as “judgment rating.”
Combination Method: Uses a mix of manual and merit rating across various lines of insurance.
Investing
Insurance premiums are typically paid in advance for periods of 6 months to a year.
Advance payment leads to the necessity to invest funds wisely to remain competitive.
Investment income plays a vital role in insurers' success.
In life insurance: Solvency relies on earning a minimum guaranteed return on assets.
In property and liability insurance: Investment income has historically made insurers profitable, offsetting underwriting losses.
Accounting
Given the highly regulated and complex financial nature of insurance, a special set of accounting rules apply.
Statutory Accounting Principles (SAP): Form the basis of financial filings insurers must submit to state regulators.
The aim is similar to standard accounting: to record, classify, and interpret financial data to guide management in policy-making.
Reinsurance: Terms
Primary Insurer (aka “Cedent”):
The company that originally writes the business and buys reinsurance to transfer some of the risk.
Reinsurer: The company assuming the risk from a primary insurer.
Verb: To Cede: To purchase a reinsurance contract, thereby transferring some risk.
Noun: A Cession: The act of acquiring a reinsurance contract; involves transferring risk to a reinsurer.
Reinsurance: Types
Facultative: Reinsuring ONE underlying policy.
Treaty: Reinsuring an entire book of business.
Reinsurance: Facultative vs. Treaty
Facultative: E.g., reinsuring the Mercedes Benz Superdome’s property.
Treaty: E.g., reinsuring all long-haul trucking liability in LA, TX, and AR.
Another example: All homeowners' property policies written in South Louisiana.
Reinsurance: Pro Rata: Percentage Sharing of Risk
Example with 40% Pro Rata Sharing of Premiums and Losses:
Reinsurer: 40%; Insurer: 60%.
Reinsurance: Pro Rata Examples
Cedent: $75,000.00; Claim: $125,000 Loss.
Loss borne by Cedent: $75,000.00.
Loss borne by Reinsurer: $50,000.00.
Cedent: $24,000.00; Claim: $40,000 Loss.
Loss borne by Reinsurer: $16,000.00.
Cedent: $54,000.00; Claim: $90,000 Loss.
Loss borne by Reinsurer: $36,000.00.
Reinsurance: Excess of Loss
Scenarios depicted for various loss amounts:
$125,000 Loss.
$40,000 Loss.
$90,000 Loss.
Visual aids can illustrate how a $50,000 Excess of Loss Treaty responds in terms of cedent retention and reinforcer roles.
Reinsurer Functions
Increasing Individual Risk Capacity: Allows insurers to write larger risks.
Making Books Look Better: Can help mitigate appearances of loss for growing companies.
Stabilizing Losses (Loss Ratio): Caps retained losses and can be utilized for catastrophic loss caps.
Retiring an Insured Book: Insurers can reinsure most of their risks.