Insurance Companies Are Businesses
You Need To Understand Them
Insurance companies are businesses, and those that are privately owned operate to make a profit. For most, they are in business to make money. When insurers lose money, things usually get pretty crazy for companies and their insureds (policyholders).
Insurance companies do serve a social good by providing financial stability that society would not otherwise have, but they are still for-profit businesses. Each customer is evaluated by an underwriter to determine if that customer will be a money winner or a money loser.
An underwriter is an employee of the insurer who makes decisions to accept, reject, or accept with risk modifications each applicant for insurance. More complex commercial risks are hand underwritten while many standard risks are may have automated decisions providing input for efficiency.
Insurance is based on a pooling concept. Basically, a large number of homogeneous exposure units (policyholders with like risk characteristics) put money in a pot so when one of the members in the pool suffers a covered financial loss money comes out of the pot to pay the claim.
Insurance is not gambling.
There is a common perception in the public that insurance is gambling. This notion is totally false. The underwriting function of insurance companies and the pooling concept remove gambling characteristics totally.
Actuaries, who are high level statisticians, determine as best they can the probabilities of a given group of insureds incurring covered financial losses. A key factor in this process is the loss history of the homogeneous group.
Rates determined by the actuaries are applied per $100 or per $1000 of coverage, for example, and the policy premium is calculated. So, if the rate is $0.10 per $1,000 of coverage the policyholder will pay 0.10 x 1,000 = $100 for the policy period.
Policy periods are normally semi-annual (6 months), annual, or can be as much as two to three years. Insurers generally do not like to issue policies for more than annual terms because if the policyholder has many covered losses it may be more difficult to terminate the policy mid-term (prior to the expiration date).
Once again, keep in mind that insurance is a business. State regulators normally keep close tabs on insurance companies that cancel policyholders for insufficient reasons, such as multiple covered losses. State insurance directors often take appropriate actions in such cases.
For insurance rates to be fair and adequate to,
provide money for insurance companies to pay operating expenses,
and make a profit,
the law of large numbers must apply. There must be a sufficiently large number of covered policyholders with accurate loss histories to set appropriate rates.
To be covered most all policies require that the financial loss be accidental and sudden. A pre-planned financial loss submitted to the company for payment would be insurance fraud.
Claims can be paid on an occurrence basis or a claims-made basis.
Occurrence basis loss payments are paid based on the fact that the loss occurred during the policy period regardless to when it was submitted to the insurer for payment. There is a requirement in every policy that the insured is must notify the company "as soon as practicable."
As soon as the policyholder knows or discovers that a covered loss occurred he/she is required to notify the insurer. To do otherwise voids the policy contract.
Claims made policies can take any number of forms, but generally will pay covered financial losses if they are presented for payment during the policy period, regardless to when they occurred. Professional liability is commonly written this way.
Indemnification is the loss payment concept. This means that the insurance company will "make the insured whole" again after a covered financial loss. This is to prevent policyholders from submitting fraudulent claims to make a profit.
Hazards + Coverage = Exposures
This is the basic underwriting formula.
A hazard is a condition which increases the likelihood of loss. For example, gasoline soaked rags lying around in a building is a fire hazard; an icy walk way is a slip and fall hazard.
Coverage is what is included, not excluded in the policy which is a legal contract. Most all insurance policies legalities have been set in stone through common law adjudication in the courts. That is why the language of policies rarely changes.
An exposure to an underwriter is a warning signal of potential loss. The underwriter must decide if the risk of loss is large or severe enough to reject the risk; if not, can a greater rate be applied to charge adequate premium for the assumed risk.
Another option is to modify the contract to remove the unwanted exposures. That means exclude coverage clauses to remove the exposure.
Deductibles are put in policies to remove frequent nuisance claims that can drag an insurer under financially. A deductible is the amount of the loss that the policyholder pays before the insurer pays.
Increasing deductibles can reduce policy premiums (your cost); basically because you pay more and the company pays less on submitted, covered claims.
When you buy insurance never, ever buy based on price. Insurers do go bankrupt. Many household names have done so over the past 20 to 30 years.
Many commercial insurers have experienced severe financial trouble because in business insurance there is not as much loss history as personal lines (auto, homeowners, and life). Underwriter judgment plays a bigger role in underwriting commercial risk decisions.
The buyer's order of priority is
#1 - Financial stability of the insurer,
#2 - Their reputation and claims paying ability, and
#3 - The types of risks they insure (volatile versus innocuous)
#4 - And, the price.
Financial stability is number one. A.M. Best rating service in the past has rated insurers for financial stability. A rating of "A+" is best, and "D" is worst. You can go to ambest.com online and research their website for ratings. Hard copies can possibly be accessed in a public library with a good business section.
The reserve ratio of an insurer is another outstanding measurement of a company's financial strength. The reserve ratio is the ratio of the premium dollars to dollar reserves. For each dollar taken in as gross income from policyholder premium payments at least one dollar should be reserved (saved).
The reserve is the money insurance companies put away for backup financial stability. Money for a "rainy day." Generally a minimum acceptable ratio is a one dollar premium income to one dollar reserve. A ratio of one premium dollar to two to three dollars of reserve savings is better.
Insurance companies, for the most part, are regulated on the state level. State regulators watch the reserve ratio closely. Also, if the reserve ratio gets unacceptably low A.M. Best Company will lower the company's financial strength rating.
Insurance companies often perform a juggling act trying to offset underwriting losses with investment profits, and vice versa. This is often the primary reason for insurer failure, that is, when they "drop the ball." Losses and investment returns are not always predictable.
Insurance companies generally invest in
real estate. This is pretty much their investment portfolio.
With regard to commercial insurance there is generally no safety net whereby other insurance companies will step in and pay the claims of bankrupt insurers. This is one big reason why the U.S. federal government stepped in to bail out insurer AIG in 2009. An AIG collapse would have ruined the commercial world internationally.
If your commercial insurer goes bankrupt your business will have to
pay defense costs normally paid by insurers,
adjust and manage claims,
and pay actual damages.
The types of risks insured are important because businesses relative to commercial insurance that may produce huge and frequent losses make insurers vulnerable to excessive claim activity. Thus, the company's financial strength may be hurt.
Also, you want to know if the insurer has expertise in the area of your insurance concerns. This point is extremely important.
Catastrophe exposures such as flood and earthquake are excluded in most policies. State and/or federal pools normally cover these types of exposures. War is never covered.
The combined ratio is used to measure underwriting performance and profitability. The ratio is as follows.
Loss Ratio + Expense Ratio = + or - 100%
Combined Ratio less than 100% is an underwriting loss.
Combined Ratio over 100% is an underwriting profit.
The Loss Ratio formula is,
Incurred Losses + Loss Adjustment Expenses all divided by Net Earned Premium.
The Expense Ratio is,
Underwriting Expenses divided by Net Premium Written.
Net premium is gross premium minus such expenses as agent or broker commissions, etc.
Underwriters will be liberal or conservative in making decisions on risks based on underwriting performance and other factors as determined by top management.
There are generally two types of insurance companies,
Standard lines insurers, and
Excess and surplus lines (E&S).
Standard lines are the run of the mill risks. E&S are unusual risks such as large limit of coverage policies for Fortune 500 companies, exotic property exposures, etc.
Reinsurance is when one insurance company insures another. There are two general types,
Treaty is automatic where the percentages of risk in each policy issued are assumed by each participating company on a pre-determined basis. Premiums and losses are shared accordingly. Virtually every insurance policy written has a treaty arrangement whereby 10 to 20 insurers may actually be insuring you. This information however is generally not publicly available.
Facultative is on a risk by risk basis, as determined by underwriting judgment. Percentages of risk assumed and rate charges are negotiated by the underwriters in each participating company. Each underwriter can accept the terms and participate or reject them altogether.
The overall objective in buying insurance from the stand point of the buyer is to spend a small, affordable cost to remove a large, unpredictable financial loss.
Agents normally represent one insurance company. Independent brokers will represent one or multiple companies to the public for the sale of policies.
Agents, since they usually represent one company, often know their company and their policies very thoroughly. They are normally very well managed.
Independent brokers are on their own. They have no loyalty to any one company. They get their biggest commission income from selling new policies to first time buyers. They typically get small renewal commissions, often smaller than captive agents.
Since independent brokers make the bulk of their money on selling new policies they have an incentive to move one insured buyer from company to company on each policy renewal, if they can. The selling point is they found a better price.
Buying based on price will get you in deep trouble if the respective insurer goes bankrupt, especially in commercial lines insurance where the losses are big. Buy based on the financial strength of the insurer, and their coverage offerings as your dominant buying motive.
Property and liability are the two main, broad categories of lines of coverage. Property insurance is a two-party contract between the insured and the company. Liability is a three-party contract between the insured, the company, and the claimant.
Property policies pay for damage to property. Liability policies pay for civil suits brought by an injured claimant against the policyholder. Slip and fall accidents are a common example.
This is a broad overview of the operations of insurance companies. It's a huge subject that is so important to the economic stability of the world.
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A.M. Best Company has a website for easy access to some of its financial data resources.
Please click here to go to their website.