Principles of Risk Management and Insurance Chapters 5-9 Notes PDF

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Summary

Chapter 5: Types of Insurers and Marketing Systems
Chapters 6-7: Insurance Company Operations
Chapters 8-9 Regulation and Legal Principles

15 Pages of notes from lectures from the textbook, Principles of Risk Management and Insurance...

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Chapter 5: Types of Insurers and Marketing Systems ●

Types of Private Insurers: Stock Insurers, Mutual Insurers, Reciprocal exchanges, Lloyd's Associations. Blue Cross and Blue Shield plans, Health Maintenance Organizations (HMOs)

Types of Insurers: Stock Insurer: a corporation owned by stockholders ● Objective: earn profit for stockholders by increasing the value of stock and paying dividends ○ Stockholders elect board of directors; Bear all losses ○ Insurer cannot issue an assessable policy ○ Dominant in the property and liability industry Mutual Insurer: a corporation owned by the policyowners ● Policyowners elect a board of directors, who have effective management ○ Policyholders may receive dividends or rate reductions ○ Dominant in the field of life  insurance ● 3 Forms of Mutual Insurers: 1. Advance premium mutual: Owned by the policyowners… there are no stockholders, and the insurer does not issue assessable policies 2. Assessment mutual: Has the right to assess policyowners an additional amount if the insurer’s financial operations are unfavorable 3. Fraternal insurer: A mutual insurer that provides life and health insurance to members of a social or religious organization

Private Insurers: ● Reciprocal Exchange: an unincorporated organization in which insurance is exchanged among the members (called subscribers)

○ Insurance is exchanged among the members; each member of the reciprocal insures the other members ○ Managed by an attorney-in-fact ○ Most reciprocals are relatively  small and specialize in a limited number of lines of insurance ● Types of Private Insurers ○ Lloyd’s of London: NOT an insurer, but a society of members who underwrite insurance in syndicates (a group of individuals or organizations combined to promote some common interest)

■ Membership includes corporations, individual members (called Names), and limited partnerships ■ New individual members have limited legal liability ■ Corporations with limited legal liability and limited liability partnerships can also join Lloyd’s of London ■ Members must  meet financial requirements ■ Lloyd’s is licensed only in a small number of jurisdictions in the U.S. ● Lloyd’s writes unusual coverage such as Silent film comedian Ben Turpin's eyes against uncrossing, Tina Turner's legs, Celine Dion's vocal cords, etc. ○ Blue Cross and Blue Shield Plans: generally organized as nonprofit, community oriented plans ■ Blue Cross plans provide coverage for hospital services / coverage for physicians’ and surgeons’ fees ■ Most plans have merged into one entity ■ Many sponsor HMOs and PPOs ■ Some plans have converted to a for-profit status to raise capital and become more competitive ○ A Health Maintenance Organization (HMO): provides comprehensive health care services to its members ■ Broad health care services are provided for a fixed prepaid fee ■ Cost control is emphasized ■ Choice of health care providers may be restricted ■ Less costly forms of treatment are often provided

Insurance Policies are sold by Agents and Brokers ●

Agent: someone who legally represents the insurer ○ ○

Insurer is legally responsible for all acts of an agent Example: Life Insurance Agent

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Independent Agent: Represents unrelated insurers; owns renewal rights to business; compensated by commission Exclusive Agent: Represents only one insurer (or group); does not own renewal rights; compensated by commission, but lower than independent agents Broker: someone who legally represents the insured ○ attempts to place coverage with an insurer ○ paid a commission from the insurer ○ may provide services such as risk management advice (in particular: advice on loss control)

Property and Liability Insurance Marketing Systems ●

Independent Agency System – local agent represents several insurers.

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Exclusive Agency System – the agent represents only one company, does not “own expirations”, gets lower commissions, and, in exchange, receives strong support from the company.

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Direct Writer – salesperson is an employee, company absorbs all selling expenses, and employees are compensated on a salary/bonus basis.

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Direct Response System – insurers sell to selected market segments using the Internet, television, or other mass media.

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Multiple Distribution System - using more than one system to sell insurance.

Chapters 6-7: Insurance Company Operations Important Insurer Operations: -

Ratemaking Production Investments

- Underwriting - Claims - Reinsurance

Ratemaking: the pricing of insurance and the calculation of insurance premiums – rate: price per unit of insurance – exposure unit: the unit of measurement used in insurance pricing ★ Premium = rate *   exposure units ● Total premiums charged must be adequate for paying all claims and expenses during the policy period ● Rates and premiums are determined by an actuary, using the company’s past loss experience and industry statistics ● Actuaries also  determine the adequacy of loss reserves, allocate expenses, and compile statistics for company management and state regulatory officials.

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Class Rating (Manual rating): Exposures with similar characteristics are grouped and charged the same premium ○ Merit Rating: Class rates are adjusted up or down based on individual loss experience ○ Judgment Rating: Each exposure is individually evaluated and the rate is determined by the underwriter’s judgment Underwriting: the  process of selecting, classifying, and pricing applicants for insurance • Basic Principles: – Selection of insureds according to company’s standards – Proper balance within each rate class – Equity among policyholders • Sources of Information: Application, Agent’s report, Inspection, etc. • Other Underwriting Considerations: – Rate adequacy – Reinsurance availability • Underwriting Decision – Accept application – Accept application with modifications – Reject application Claims / Loss Adjustment • Objective of Claims Settlement: – Verify loss is covered by the policy – Pay claims fairly and promptly – Assist the insured after a loss • Claims Adjusters - Agents, company adjuster, independent adjuster, public adjuster

Claims • Settlement Steps: – Notice of loss (from insured) – Investigation of claim (by insurer) – File proof of loss (optional by insurer) – Decision is made

Measuring Profitability ●

Loss ratio: the ratio of incurred losses and loss adjustment expenses to premiums:

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It can be determined for individual insurance lines as well as in the aggregate for the whole company. The loss ratio is often 65-75%.

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Measuring Underwriting Performance ● ● ●

Combined ratio: The sum of loss ratio and expense ratio: ○ Combined ratio = loss ratio + expense ratio If the combined ratio exceeds 1 (or 100%).. it indicates an underwriting loss. A Property and Casualty can have a cr >1, but investment income may offset underwriting loss: ○ Overall operating ratio = Combined Ratio - Investment Income Ratio

Investments ➢ Because premiums are paid in advance, they can be invested until needed to pay claims ➢ Investment income: extremely important in reducing the cost of insurance to policyowners ➢ Life insurance contracts: long-term; thus, safety is a primary goal → Compound interest growth ➢ Property insurance contracts: short-term in nature, and claim payments can vary widely (depending on catastrophic losses, inflation, ..) → Combined Ratio Loss Ratio + Expense Ratio 1 = zero underwriting profit => Combined Ratio <  1

Reinsurance: an arrangement by which the primary insurer (that initially writes the insurance) transfers to another insurer (the reinsurer) part or all of the potential losses associated with such insurance. ● Ceding company: The primary insurer ●

Reinsurer: The insurer that accepts the insurance from the ceding company

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Retention limit: the amount of insurance retained by the ceding company

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Cession: The amount of insurance ceded to the reinsurer Risk Sharing in the Insurance Industry

Why Reinsurance? – Increase underwriting capacity – Stabilize profits – Provide protection against a catastrophic loss – Retire from business or from a line of insurance or territory – Obtain underwriting advice on a line for which the insurer has little experience

2 Types of Reinsurance Agreements 1. Facultative Reinsurance: An optional, case-bycase reinsurance agreement between the parties ➢ Often used when the primary insurer has an application for a large amount of insurance that exceeds its retention limit 2. Treaty (or obligatory) Reinsurance: The primary insurer is bound by obligation to cede insurance to the reinsurer, and the reinsurer is bound to accept the business ➢ all business that falls within the scope of the agreement is automatically reinsured according to the terms of the treaty

The 2 basic methods for Sharing Losses 1. Pro rata method… the ceding company and reinsurer agree to share losses and premiums based on some proportion – Also referred to as proportional reinsurance 2. Excess method… the reinsurer pays only when covered losses exceed a certain level – Also referred to as non-proportional reinsurance

Forms of Reinsurance

More Methods for Sharing Losses

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Quota-share treaty… the ceding insurer and the reinsurer agree to share premiums and losses based on some proportion ○ Example: Assume that Apex Fire Insurance and Swiss Re enter into a quota-share arrangement by which losses and premiums are shared 50-50. ■ If a $100,000 loss occurs, Apex Fire pays $100,000 to the insured but is reimbursed by Swiss Re for $50,000.

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Surplus-share treaty… the reinsurer agrees to accept insurance in excess of the ceding insurer’s retention limit, up to some maximum amount ○ Example: Assume that Apex Fire Insurance has a retention limit of $200,000 (called a line) for a single policy, and that four lines, or $800,000, are ceded to Swiss Re. Assume that a $500,000 property insurance policy is issued. Apex Fire takes the first $200,000 of insurance, or two-fifths, and Swiss Re takes the remaining $300,000, or three-fifths. ■ If a $5000 loss occurs:

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Example: the collective of an insurer consists of 3 policies with the following sums of insurance: • contract A: 10 Mio. • contract B: 60 Mio. • contract C: 100 Mio. A surplus share treaty is concluded: • retention limit: 20 Mio. • 3 lines Who pays for a loss of 1$? • contract A: Primary insurer: 1,00 $/ Reinsurer 0,00 $ • contract B: Primary insurer: 0,33 $/ Reinsurer 0,67 $ • contract C: Primary insurer: 0,40 $/ Reinsurer 0,60 $

● Excess-of-loss treaty: Designed for protection against a catastrophic loss ○

A treaty can be written to cover a single exposure, a single occurrence, or excess losses ■ Example: Apex Fire Insurance wants protection for all windstorm losses in excess of $1 million. Assume Apex enters into an excess-of-loss arrangement with Franklin Re to cover single occurrences during a specified time period.

Franklin Re agrees to pay all losses exceeding $1 million but only to a maximum of $10 million. ● If a $5 million hurricane loss occurs, Franklin Re would pay $4 million.

Comparison of Reinsurance Forms

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In both cases, reinsurance covers the area 40 to 80 However… The effect on the density is very different XL reinsurance: concentration of probability mass on limit

Reinsurance pool: An organization of insurers that underwrites insurance on a joint basis. Reinsurance pools work in 2 ways: 1. Each pool member agrees to pay a certain percentage of every loss. 2. Each pool member pays for his or her share of losses below a certain amount; losses exceeding that amount are then shared by all members in the pool.

Alternatives to Traditional Reinsurance ●

Insurers are making increasing use of capital markets to assist in financing risk

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Securitization of risk: An insurable risk is transferred to the capital markets through the creation of a financial instrument, such as a catastrophe bond ○

Catastrophe bonds (Cat Bonds): corporate bonds that permit the issuer of the bond to skip or reduce the interest payments if a catastrophic loss occurs ■ Cat bonds are growing in importance and are now considered by many to be a standard supplement to traditional reinsurance.

Cat Bonds: Trigger Types ●

Damage-based Trigger: Similar to traditional reinsurance… the bond is triggered when a given sum of losses is observed → high correlation with incurred losses

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Industry-Index Trigger: Bond is triggered in the case that the sum of losses of the insurance industry as a whole is higher than a predetermined value

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Parametric Trigger: e.g. strength of earthquake on the Richter-Scale triggers the Cat Bond → no correlation with incurred losses

Cat Bonds vs. Traditional Reinsurance Advantages

Disadvantages

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No moral hazard issues Cat Bonds are independent of reinsurance markets ● Fast regulation (parametric trigger)

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High transaction costs Basis Risk (ex: difference between incurred losses and indemnity payments from the bond) Not very flexible

SUMMARY of Ch. 6-7: Important functions of insurers are: ➢ ➢ ➢ ➢ ➢

Ratemaking Underwriting Claims Investments Advanced Methods of Risk Assessment

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Insurers use the reinsurance market to improve their risk exposures ○ There are proportional and non-proportional reinsurance methods to do so

Chapters 8-9 Regulation and Legal Principles Why Insurance Regulation? ●

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To protect the policyholders ○ Necessary for: ■ Insufficient consumer knowledge ■ Premiums are paid in advance → policyholder as creditor ■ Default of an insurance contract can expose an insured to existential threats → maintain insurer solvency To make insurance available and ensure reasonable rates

How Can Insureds be Protected through Regulation? ● The insured’s position as a creditor can be strengthened through keeping insurers solvent • via RBC (risk-based-capital) requirements or • via rate regulation that prevents prices from being “too low” – state guaranty systems ●

Insufficient consumer knowledge can be improved through – product regulation (more transparency) – shopper’s guides

Methods for Regulating Insurers: ● Legislation – State laws -- formation of insurance companies; licensing of agents and brokers; financial regulation; rates; sales and claims practices; taxation; rehabilitation or liquidation of insurers; protection of consumer rights – Federal laws -- mail-order sales; advertising; sale of variable annuities; private pension plans ● Courts – Constitutionality of state insurance laws – Interpretation of policy clauses and provisions – Legality of administrative actions by state departments ● State Insurance Departments

● What Areas are Regulated? • Formation and licensing of insurers • Financial regulation – (ex: admitted assets; reserves; risk-based capital; investments; dividend policy; reports and examinations; liquidation of insurers) • Rate regulation – Types  of property and liability rate regulation: prior-approval laws; file-and-use laws; open-competition laws; flex-rating laws • Policy forms (→ product regulation) • Sales practices and consumer information – licensing of agents and brokers; rebating; unfair trade practices; complaint division; shoppers’ guides

Risk Based Capital ●

To reduce the risk of insolvency, insurers must meet certain RBC standards (that is, they m  ust have a certain amount of capital) depending on ○ the riskiness of their investments (bonds vs. shares) ○ the riskiness of their insurance operations (reinsurance y/n) ★ The NAIC demands a comparison of the insurer’s capital with the amount of RBC requirements. ●

Company Actions if Capital < RBC

Risk Based Capital ●

Example: Evaluation of market risk using a Worst Case Scenario (and taking into account correlations) • Here there are 2 asset classes only: shares and real estate • Assumption: the correlation between shares and real estate is 0.75 • Worst Case Scenario: fall of share prices up to 40% and fall of real estate prices up to 20% • the market value of shares is 100 → RBC( Shares) = 40 • the market value of real estate is 40 à RBC( Real Est) = 8

Solvency II in Europe

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In pillar I, the Solvency Capital Requirement needs to be calculated by - a standard formula… or - a supervisor-approved internal model

Fundamental Legal Principles  (Reflected in insurance contracts) 1. Principle of Indemnity  2. Principle of Insurable  interest 3. Principle of Subrogation  4. Principle of Utmost  good faith 1. Principle of Indemnity:  The insurer does  not pay more than the actual amount of loss ● The insured should not profit from a loss ● Purpose: to reduce moral hazard/fraud ●

Basic method for determining insurance payments: ○ Actual Cash Value (of the property): • Replacement cost less depreciation • Fair market value • Broad Evidence Rule → the determination of ACV should include all relevant factors an expert would use to determine the value of the property

★ Exceptions to this principle: – A valued policy pays the face amount of insurance if a total loss occurs (artwork) – Valued policy laws (in some states → payment of policy face value in case of total loss to real property caused by a peril specified in the law) – Replacement cost insurance (no deduction for depreciation in determining the amount paid for a loss) – Life insurance: valued policy that pays a stated sum to the beneficiary upon the insured‘s death

2. Principle of Insurable Interest:The insured must be in a position to lose financially if a covered loss occurs Purposes: – to prevent gambling – to reduce moral hazard – to measure the amount of loss in property insurance. Examples: – Property & liability: insurable interest can result from ownership, potential legal liability, secured loans (Insurable Interest must exist at the time of loss) – Life insurance: insurable interest can result from close family ties (must exist at the time of loss)

3. Principle of Subrogation: The insurer is entitled to recover from a negligent third party any loss payments made to the insured Purpose? – To hold the n  egligent person responsible – To avoid collecting twice (from insurer a nd the negligent person who caused the loss) – To hold down rates (subrogation recoveries reduce loss payments) ● Insurer can only recover the amount paid to the insured according to the contract. ●

Why is subrogation important? ○ ○ ○ ○

Insurer can collect its losses (excess to insured) The insured cannot stop insurer from subrogating Subrogation does not apply to life insurance The insurer cannot subrogate against its own insureds

4. Principle of Utmost Good Faith: A  higher degree of honesty is imposed on both parties to an insurance contract than is imposed on parties to other contracts • Supported by three legal doctrines: 1. Representations 2. Concealment 3. Warranty ● Representations: Statements made by the applicant for insurance ○ A contract is voi...