Functions and Organization of Insurers Chapter 23

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Table 23-2: Combined Ratios for Selected Insurance Lines, 1994-2002

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

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

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

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

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?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Functions and Organization of Insurers Chapter 23