CHAPTER 6

INSURANCE COMPANY
OPERATIONS

“People who work for insurance companies do a lot more than

sell insurance.”
Insurance Information Institute

L$–!$%$& O#($)*%+$,

After studying this chapter, you should be able to

◆ Explain the ratemaking function of insurers.

◆ Explain the steps in the underwriting process.

◆ Describe the sales and marketing activities of insurers.

◆ Describe the steps in the process of settling a claim.

◆ Explain the reasons for reinsurance and the various types of reinsurance treaties.

◆ Explain the importance of insurance company investments and identify the various types of
investments of insurers.

103
 M ichael, age 26, is a political science major at a large university in Illinois.
The placement director has an annual job fair where recruiters from different
business firms interview students for possible employment. Michael signed up for
an interview with a property insurer to learn about job opportunities. The recruiter
explained that job openings exist in several areas, and that the company hires new
employees with a wide variety of educational backgrounds. Michael is surprised
to learn of the wide range of jobs in the property and casualty insurance industry.
Jobs!are available in ratemaking, underwriting, sales, claims, finance, information
technology, accounting, legal, and other areas as well.
To make insurance available to the public, insurers must perform a wide variety of
specialized functions or operations. In this chapter, we discuss the major functional
operations of insurers, including ratemaking, underwriting, production, claim
settlement, reinsurance, and investments. The financial operations of insurers are
discussed in Chapter 7.

INSURANCE COMPANY buy gas for your car, the rate per gallon multiplied by
OPERATIONS the number of gallons purchased equals the amount
paid. Likewise, in property and casualty insurance,
The most important insurance company operations the rate times the number of exposure units deter-
consist of the following: mines the premium paid. We discuss this concept and
■ Ratemaking ratemaking in greater detail in Chapter 7.
■ Underwriting Insurance pricing differs considerably from the
■ Production pricing of other products. When other products are
■ Claim settlement sold, the company generally knows in advance the
■ Reinsurance costs of producing those products, so that prices can
■ Investments be established to cover all costs and yield a profit.
However, the insurance company does not know in
Insurers also engage in other operations, such as advance what its actual costs are going to be. The
accounting, legal services, loss control, and informa- total premiums charged for a given line of insurance
tion systems. may be inadequate for paying all claims and expenses
The sections that follow discuss each of these during the policy period. It is only after the period
functional areas in some detail. of protection has expired that an insurer can deter-
mine its actual losses and expenses. Of course, the
insurer hopes that the premium it charges plus invest-
RATING AND RATEMAKING ment income will be sufficient to pay all claims and
Ratemaking refers to the pricing of insurance and expenses and yield a profit.
the calculation of insurance premiums. The premium The person who determines rates and premi-
paid by the insured is the result of multiplying a rate ums is known as an actuary. An actuary is a highly
determined by actuaries by the number of expo- skilled mathematician who is involved in all phases
sure units, and then adjusting by various rating of insurance company operations, including plan-
plans (a! process called rating). A rate is the price ning, pricing, and research. In life insurance, the
per unit of insurance. An exposure unit is the unit actuary studies important statistical data on births,
of measurement used in insurance pricing, which deaths, marriages, disease, employment, retire-
varies by line of insurance. For example, when you ment, and accidents. Based on this information, the
104
 UNDERWRITING -./

actuary determines the premiums for life and health business with a low profit margin or a smaller volume
insurance policies and annuities. The objectives are with a larger margin of profit. Classes of business
to calculate premiums that will make the business that are acceptable, borderline, or prohibited must be
profitable, enable the company to compete effec- clearly stated. The amounts of insurance that can be
tively with other insurers, and allow the company to written on acceptable and borderline business must
pay claims and expenses as they occur. A life insur- also be determined.
ance actuary must also determine the legal reserves a The insurer’s underwriting policy is determined
company needs for future obligations.1 by top-level management in charge of underwriting.
Professional certification as a life insurance actuary The underwriting policy is stated in detail in an
is attained by passing a series of examinations admin- underwriting guide that specifies the lines of insurance
istered by the Society of Actuaries, which qualifies the to be written; territories to be developed; forms and
actuary as a Fellow of the Society of Actuaries. rating plans to be used; acceptable, borderline, and
In property and casualty insurance, actuaries also prohibited business; amounts of insurance to be
determine the rates for different lines of insurance. written; business that requires approval by a senior
Rates are based on the company’s past loss experi- underwriter; and other underwriting details.
ence and industry statistics. Statistics on hurricanes,
tornadoes, fires, crime rates, traffic accidents, and
Basic Underwriting Principles
the cost of living are also carefully analyzed. Many
companies use their own loss data in establishing the Underwriting is based on a number of principles.
rates. Other companies obtain loss data from advi- Three important principles are as follows:
sory organizations, such as the Insurance Services
■ Attain an underwriting profit.
Office (ISO). These organizations calculate historical
■ Select prospective insureds according to the
or prospective loss costs that individual companies
company’s underwriting standards.
can use in calculating their own rates.
■ Provide equity among the policyholders.
Actuaries in property and casualty insurance also
determine the adequacy of loss reserves,2 allocate The primary objective of underwriting is to
expenses, and compile statistics for company man- attain an underwriting profit. The objective is to pro-
agement and for state regulatory officials. duce a profitable book of business. The underwriter
To become a certified actuary in property and constantly strives to select certain types of applicants
casualty insurance, an actuarial science student must and to reject others so as to obtain a profitable port-
pass a series of examinations administered by the folio of business.
Casualty Actuarial Society. Successful completion The second principle is to select prospective
of the examinations enables the actuary to become a insureds according to the company’s underwriting
Fellow of the Casualty Actuarial Society. standards. This means that the underwriters should
select only those insureds whose actual loss experience
is not likely to exceed the loss experience assumed in
the rating structure. For example, a property insurer
UNDERWRITING may wish to insure only high-grade factories, and
Underwriting refers to the process of selecting, expects that its actual loss experience will be well
classifying, and pricing applicants for insurance. The below average. Underwriting standards are estab-
underwriter is the person who decides to accept or lished with respect to eligible factories, and a rate
reject an application. is established based on a relatively low loss ratio.3
Assume that the expected loss ratio is established at
70 percent, the ratio of losses plus loss adjustment
Statement of Underwriting Policy
expenses to earned premiums, and the rate is set
Underwriting starts with a clear statement of accordingly. The underwriters ideally should insure
underwriting policy. An insurer must establish an only those factories that can meet stringent under-
underwriting policy that is consistent with company writing requirements, so that the actual loss ratio for
objectives. The objective may be a large volume of the group will not exceed 70 percent.
-.0 C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

The purpose of the underwriting standards is important that the agent follow company policy
is to reduce adverse selection against the insurer. when soliciting applicants for insurance.
There is an old saying in underwriting, “select or be In life insurance, the agent must also solicit
selected against.” Adverse selection is the tendency applicants in accordance with the company’s under-
of people with a higher-than-average chance of loss writing policy. The agent may be told not to solicit
to seek insurance at standard (average) rates, which applicants who are active drug addicts or alcoholics,
if not controlled by underwriting, will result in or who work in hazardous occupations.
higher-than-expected loss levels.
A final underwriting principle is equity among
Sources of Underwriting Information
the policyholders . This means that equitable
rates should be charged, and that each group of The underwriter requires certain information in
policyholders should pay its own way in terms deciding whether to accept or reject an applicant for
of!losses and expenses. Stated differently, one group insurance. Important sources of information include
of policyholders should not unduly subsidize another the following:
group. For example, a group of 20-year-old persons
and a group of 80-year-old persons should not pay ■ Application. The type of information required
the same premium rate for individual life insurance. depends on the type of insurance requested. In
If!identical rates were charged to both groups, younger property insurance, the application provides
persons would be subsidizing older persons, which information on the physical features of the
would be inequitable. Once the younger persons building, including type of construction, occu-
became aware that they were being overcharged, pancy of the building, quality of fire protection,
they would seek other insurers whose classification exposures from surrounding buildings, whether
systems are more equitable. The first insurer would the building has a sprinkler system, and other
then end up with a disproportionate number of loss control features.
older persons, and the underwriting results would In life insurance, the application indicates the
be unprofitable. Thus, because of competition, there age; gender; weight; occupation; personal and family
must be rate equity among the policyholders. health history; any hazardous hobbies, such as sky-
diving; and the amount of insurance requested.
Steps in Underwriting ■ Agent’s report. Many insurers require the agent
After the insurer’s underwriting policy is established, or broker to give an evaluation of the prospec-
it must be communicated to the sales force. Initial tive insured. In property insurance, the agent or
underwriting starts with the agent in the field. broker may submit an application that does not
completely meet the underwriting standards of
Agent as First Underwriter This step is often called the company. In such cases, the agent’s evalua-
field underwriting. The agent is told what types of tion of the applicant is especially important.
applicants are acceptable, borderline, or prohibited. In life insurance, the agent may be asked how
For example, in auto insurance, an agent may be long he or she has known the applicant, the applicant’s
told not to solicit applicants who have been con- annual income and net worth, whether the applicant
victed for drunk driving, who are single drivers plans to surrender or exchange an existing life insur-
under age 21, or who are young drivers who own ance policy for the new policy, and whether the
high-powered sports cars. In property insurance, application is the result of the agent’s solicitation.
certain exposures, such as bowling alleys and res-
taurants, may have to be submitted to a company ■ Inspection report. In property insurance, the
underwriter for approval. company may require an inspection report
In property and casualty insurance, the agent by some outside agency, especially if the
often has authority to bind the company immediately, underwriter suspects moral hazard. An outside
subject to subsequent disapproval of the application firm investigates the applicant for insurance and
and cancellation by a company underwriter. Thus, it makes a detailed report to the company.
 UNDERWRITING -.1

In life insurance, the report may provide illustrate this second type of decision. Before a crime
information on the applicant’s financial condition, insurance policy is issued, the applicant may be
marital status, outstanding debts or delinquent required to place iron bars on windows or install an
bills,! felony convictions, any drinking or drug approved burglar alarm system; the applicant may
problems, whether the applicant has ever declared be refused a homeowners policy and offered a more
bankruptcy and additional information as well. limited dwelling policy; a large deductible may be
inserted in a property insurance policy; or a higher
■ Physical inspection. In property insurance and
rate for life insurance may be charged if the applicant
casualty insurance, the underwriter may require
is substandard in health. If the applicant agrees to the
a physical inspection before the application is
modifications or restrictions, the policy is then!issued.
approved. For example, in workers compensation
The third decision is to reject the application.
insurance, the inspection may reveal unsafe work-
However, excessive and unjustified rejection of appli-
ing conditions, such as dangerous machinery;
cations reduces the insurer’s revenues and alienates
violation of safety rules, such as not wearing
the agents who solicited the business. If an application
goggles when a grinding machine is used; and an
is rejected, the rejection should be based on a clear
excessively dusty or toxic plant.
failure to meet the insurer’s underwriting standards.
■ Physical examination. In life insurance, a physical
Many insurers now use computerized underwrit-
exam may be required to determine if the appli-
ing for certain personal lines of insurance that can be
cant is overweight; has high blood pressure; or
standardized, such as auto and homeowners insurance.
has any abnormalities in the heart, respiratory
As a result, underwriting decisions can be expedited.
system, urinary system, or other parts of the
body. An attending physician’s report may also
be required, which is a report from a physician Other Underwriting Considerations
who has treated the applicant in the past.
Other factors are considered in underwriting. They
As part of the physical exam, a life insurer may include the following:
request a report from MIB Group, Inc. (Medical
■ Rate adequacy and underwriting. Property and
Information Bureau report). Companies that belong
casualty insurers are more willing to underwrite
to this trade association report any health impair-
new business for a specific line if rates are
ments, which are recorded and made available to
considered adequate. However, if rates are
member companies. For example, if an applicant
inadequate, prudent underwriting requires a
has high blood pressure, this information would be
more conservative approach to the acceptance of
recorded in the MIB files. The files, however, do not
new business. If moral hazard is excessive, the
reveal the underwriting decision made by the submit-
business generally cannot be insured at any rate.
ting company.
In addition, in commercial property and casualty
Making an Underwriting Decision After the insurance, the underwriters have a considerable
underwriter evaluates the information, an impact on the price of the product. A great deal
underwriting decision must be made. There are three of negotiation over price takes place between line
basic underwriting decisions with respect to an initial underwriters and agents concerning the proper
application for insurance: pricing of a commercial risk.
Finally, the critical relationship between
■ Accept the application
adequate rates and underwriting profits or losses
■ Accept the application subject to certain restric-
results in periodic underwriting cycles in certain
tions or modifications
lines of insurance, such as commercial general
■ Reject the application
liability and commercial multiperil insurance. If
First, the underwriter can accept the application rates are adequate, underwriting profits are higher,
and recommend that the policy be issued. A second and underwriting is more liberal. Conversely, when
option is to accept the application subject to certain rates are inadequate, underwriting losses occur, and
restrictions or modifications. Several examples underwriting becomes more restrictive.
-.2 C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

■ Reinsurance and underwriting. Availability of Professionalism in Selling

reinsurance may result in more liberal underwrit-
The marketing of insurance has been character-
ing. However, if reinsurance cannot be obtained
ized by a distinct trend toward professionalism
on favorable terms, underwriting may be more
in recent years. This means that the modern agent
restrictive. Reinsurance is discussed in greater
should be a competent professional who has a high
detail later in the chapter.
degree of technical knowledge in a particular area
■ Renewal underwriting. In life insurance, poli-
of insurance and who also places the needs of his
cies are not cancellable. In property and casualty
or her clients first. The professional agent identifies
insurance, most policies can be canceled or not
potential insureds, analyzes their insurance needs,
renewed. If the loss experience is unfavorable,
and recommends a product to meet their needs. After
the insurer may either cancel or not renew the
the sale, the agent has the responsibility of providing
policy. Most states have placed restrictions on
follow-up service to clients to keep their insurance
the insurer’s right to cancel.
programs up to date. Finally, a professional agent
abides by a code of ethics.
Several organizations have developed profes-
PRODUCTION sional designation programs for agents and other
The term production refers to the sales and marketing personnel in the insurance industry. In life and health
activities of insurers. Agents who sell insurance are insurance, The American College has established
frequently referred to as producers. This word is used the Chartered Life Underwriter (CLU) program. An
because an insurance company can be legally chartered, individual must pass certain professional examina-
personnel can be hired, and policy forms printed, but tions to receive the CLU designation.
no business is produced until a policy is sold. The key to The American College also awards the
the insurer’s financial success is an effective sales force. Chartered Financial Consultant (ChFC) desig-
nation for professionals who are working in the
financial services industry. To earn the ChFC
Agency Department designation, students must also pass professional
examinations.
Life insurers have an agency or sales department. This
A similar professional program exists in property
department is responsible for recruiting and training
and casualty insurance. The American Institute
new agents and for the supervision of general agents,
for CPCU has established the Chartered Property
branch office managers, and local agents.
Casualty Underwriter (CPCU) program. The CPCU
Property and casualty insurers have marketing
program also requires an individual to pass profes-
departments. To assist agents in the field, special
sional examinations.
agents may also be appointed. A special agent is a
Other professionals are also important in the
highly specialized technician who provides local
insurance industry. Many financial planners are also
agents in the field with technical help and assistance
licensed as insurance agents. The Certified Financial
with their marketing problems. For example, a
Planner (CFP) designation is granted by the Certified
special agent may explain a new policy form or a
Financial Planner Board of Standards, Inc. Many
special rating plan to agents in the field.
agents in property and liability insurance have been
In addition to development of an effective sales
awarded the Certified Insurance Counselor (CIC)
force, an insurance company engages in a wide variety
designation sponsored by the National Alliance for
of marketing activities. These activities include
Insurance Education & Research.
development of a marketing philosophy and the
company’s perception of its role in the marketplace;
identification of short-run and long-run produc-
tion goals; marketing research; development of new
CLAIMS SETTLEMENT
products to meet the changing needs of consumers Every insurance company has a claims division or
and business firms; development of new marketing department for adjusting claims. This section of the
strategies; and advertising of the insurer’s products. chapter examines the basic objectives in adjusting
 CLAIMS SETTLEMENT -.3

claims, the different types of claim adjustors, and the Types of Claims Adjustors
various steps in the claim-settlement process.
The person who adjusts a claim is known as a claims
adjustor. The major types of adjustors include the
Basic Objectives in Claims Settlement following:
From the insurer’s viewpoint, there are several basic ■ Agent
objectives in settling claims.4 ■ Company adjustor
■ Verification of a covered loss ■ Independent adjustor
■ Fair and prompt payment of claims ■ Public adjustor
■ Personal assistance to the insured
An insurance agent often has authority to set-
The first objective in settling claims is to verify tle small first-party claims up to some maximum
that a covered loss has occurred. This step involves limit. A first-party claim is a claim submitted by the
determining whether a specific person or property insured to the insurer, such as a small theft loss by
is covered under the policy, and the extent of the the insured. The insured submits the claim directly to
coverage. This objective is discussed in greater detail the agent, who has the authority to pay up to some
later in the chapter.. specified amount. This approach to claims settlement
The second objective is the fair and prompt has several advantages: it is speedy, it reduces adjust-
payment of claims. If a valid claim is denied, the ment expenses, and it preserves the policyholder’s
fundamental social and contractual purpose of goodwill.
protecting the insured is defeated. Also, the insurer’s A company adjustor can settle a claim. The
reputation may be harmed, and the sales of new policies adjustor is usually a salaried employee who repre-
may be adversely affected. Fair payment means that sents only one company. After notice of the loss is
the insurer should avoid excessive claim settlements received, the company adjustor will investigate the
and should resist the payment of fraudulent claims, claim, determine the amount of loss, and arrange
because they will ultimately result in higher premiums. for!payment.
The states have passed laws that prohibit unfair An independent adjustor can also be used
claims practices. These laws are patterned after the to adjust claims. An independent adjustor is an
National Association of Insurance Commissioners’ organization or individual that adjusts claims
Model Act. Some unfair claim practices prohibited for a fee. Claims personnel are highly trained
by these laws include the following:5 individuals who adjust claims on a full-time
basis.!Property and casualty insurers often use inde-
■ Refusing to pay claims without conducting a
pendent adjustors when a catastrophic loss occurs
reasonable investigation.
in a given geographical area, such as a hurricane,
■ Not attempting in good faith to provide prompt,
and a large number of claims are submitted at the
fair, and equitable settlements of claims in which
same time.
liability has become reasonably clear.
In addition, independent adjustors include indi-
■ Compelling insureds or beneficiaries to
viduals who reside in certain geographical areas
institute lawsuits to recover amounts due
where the volume of claims is too low to justify the
under its policies by offering substantially less
expense of a branch office with full-time adjustors.
than the amounts ultimately recovered in suits
A public adjustor can be involved in settling
brought by them.
a claim. A public adjustor represents the insured
A third objective is to provide personal assistance rather than the insurance company and is paid a
to the insured after a covered loss occurs. Aside from fee based on the amount of the claim settlement.
any contractual obligations, the insurer should also A public adjustor may be employed by the insured
provide personal assistance after a loss occurs. For if a complex loss situation occurs and technical
example, the claims adjustor could assist the agent assistance is needed, and also in those cases where
in helping a family find temporary housing after a the insured and insurer cannot resolve a dispute
fire occurs. over a claim.
--. C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

Steps in Settlement of a Claim the loss. For example, under the homeowners policy,
the insured may be required to file a proof of loss
There are several important steps in settling a claim:
that indicates the time and cause of the loss, interest
■ Notice of loss must be given. of the insured and others in the damaged property,
■ The claim is investigated. other insurance that may cover the loss, and any
■ A proof of loss may be required. change in title or occupancy of the property during
■ A decision is made concerning payment. the term of the policy.

Notice of Loss The first step is to notify the insurer Decision Concerning Payment After the claim is
of a loss. A provision concerning notice of loss is investigated, the adjustor must make a decision con-
usually stated in the policy. A typical provision cerning payment. There are three possible decisions.
requires the insured to give notice immediately or The claim can be paid. In most cases, the claim is paid
as soon as possible after the loss has occurred. For promptly according to the terms of the policy. The
example, the homeowners policy requires the insured claim can be denied. The adjustor may believe that
to give immediate notice; a medical expense policy the policy does not cover the loss or that the claim is
may require the insured to give notice within 30 days fraudulent. Finally, the claim may be valid, but there
after the occurrence of a loss, or as soon afterward as may be a dispute between the insured and insurer
is reasonably possible; and the personal auto policy over the amount to be paid. In the case of a dispute,
requires that the insurer must be notified promptly a policy provision may specify how the dispute is to
of how, when, and where the accident or loss hap- be resolved. For example, if a dispute concerning the
pened. The notice must also include the names and value of lost or damaged property arises under the
addresses of any injured persons and of witnesses. homeowners policy, both the insured and insurer
select a competent appraiser. The two appraisers
Investigation of the Claim After notice is received, select an umpire. If the appraisers cannot agree on
the next step is to investigate the claim. An adjustor an umpire, a court will appoint one. An agreement
must determine that a covered loss has occurred and by any two of the three is then binding on all parties.
must also determine the amount of the loss. A!series When there is disagreement over the claim settle-
of questions must be answered before the claim is ment, consumers may file a complaint with the state
approved. The most important questions include the insurance department. The National Association
following:6 of Insurance Commissioners (NAIC) now has a
Web!site that permits consumers to check the com-
■ Did the loss occur while the policy was in force?
plaint record of individual insurers (see Insight 6.1).
■ Does the policy cover the peril that caused
the!loss?
■ Does the policy cover the property destroyed or
damaged in the loss? REINSURANCE
■ Is the claimant entitled to recover? Reinsurance is another important insurance
■ Did the loss occur at an insured location? operation. This section discusses the meaning of
■ Is the type of loss covered? reinsurance, the reasons for reinsurance, and the
■ Is the claim fraudulent? different types of reinsurance contracts.
The last question dealing with fraudulent claims
is especially important. Insurance fraud is wide-
Definitions
spread, especially in auto and health insurance.
Dishonest people frequently submit claims for bodily Reinsurance is an arrangement by which the primary
injuries that have never occurred. insurer that initially writes the insurance transfers to
another insurer (called the reinsurer) part or all of the
Filing a Proof of Loss An adjustor may require a potential losses associated with such insurance. The
proof of loss before the claim is paid. A proof of loss primary insurer that initially writes the insurance is
is a sworn statement by the insured that substantiates called the ceding company. The insurer that accepts
 REINSURANCE ---

INSIGHT 0.-
Be a Savvy Consumer—Check the Insurer’s Claims Record Before You Buy
Consumers often experience considerable frustration in complaint was filed, and final decisions regarding the
their efforts to obtain accurate and timely information on complaints.
complaints against specific insurers. Some state insurance • Complaint ratio report. This source is valuable because
departments provide detailed information on complaints and it compares a specific insurer with all insurers nation-
rank the insurers operating in the state based on a complaint ally using a single index number. This source compares
index. However, not all states provide easily accessible com- the ratio of the insurer’s market share of complaints to
plaint data to the public. the insurer’s market share of premiums for a specific
The National Association of Insurance Commissioners policy type. For example, in 2011, the national median
(NAIC) has a Web site that provides a wealth of information complaint ratio for private passenger auto insurance was
to consumers with respect to complaints against specific 1.00. The above insurer received a score of 0.35, which
insurers. Go to the NAIC Consumer Information Source (CIS) was below the national median.
at https://eapps.naic.org/cis/. Type in the company name, state, • Closed complaint trend report. This source shows whether
and business type. After locating the company, click on Closed complaints against the insurer are increasing or decreas-
Complaints. Note that this Web site and address may change ing. The information presented shows the total number
if the NAIC makes changes to its current site. of complaints in the database for consecutive years with
The information provided is based on closed consumer the percentage change in complaint counts between
complaint reports. Four types of complaint data are available: years. For example, the total number of complaints from
all persons for the above insurer increased from 1114 in
• Complaint counts by state. This source shows the total 2010 to 1172 in 2011, or a 5 percent increase.
number of complaints in each state for a specific insurer.
For example, one national auto insurer that advertises Information on complaints is especially valuable if you
extensively on television received 1172 complaints for pri- are shopping around for auto, homeowners, or health
vate passenger auto insurance from all persons in 2011. insurance and want to avoid insurers that have bad repu-
• Complaint counts by code. This source shows the total tations for paying claims or for providing other services
number of complaints by type of coverage, reason the to policyholders.

part or all of the insurance from the ceding com- Reinsurance also enables an insurer to retire
pany is called the reinsurer. The amount of insurance from a territory or class of business and to obtain
retained by the ceding company for its own account underwriting advice from the reinsurer.
is called the retention limit or net retention. The
amount of insurance ceded to the reinsurer is known Increase Underwriting Capacity Reinsurance can
as the cession. Finally, the reinsurer in turn may rein- be used to increase the insurance company’s under-
sure part or all of the risk with another insurer. This writing capacity to write new business. The company
is known as a retrocession. In this case, the second may be asked to assume liability for losses in excess
reinsurer is called a retrocessionaire. of its retention limit. Without reinsurance, the agent
would have to place large amounts of insurance with
several companies or not accept the risk. This is awk-
Reasons for Reinsurance ward and may create ill will on behalf of the policy-
Reinsurance is used for several reasons. The most holder. Reinsurance permits the primary company to
important reasons include the following: issue a single policy in excess of its retention limit for
the full amount of insurance.
■ Increase underwriting capacity
■ Stabilize profits Stabilize Profits Reinsurance is used to stabilize
■ Reduce the unearned premium reserve profits. An insurer may wish to avoid large fluctua-
■ Provide protection against a catastrophic loss tions in annual financial results. Loss experience can
--4 C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

fluctuate widely because of social and economic con- the remainder is unearned. On December 31, the
ditions, natural disasters, and chance. Reinsurance entire premium is fully earned. However, assume
can be used to stabilize the effects of poor loss experi- that first-year acquisition expenses are 30 percent of
ence. For example, reinsurance may be used to cover the gross premium, or $360. This amount will come
a large exposure. If a large, unexpected loss occurs, out of the insurer’s surplus up front. Thus, the more
the reinsurer would pay that portion of the loss in business it writes, the greater is the short-term drain
excess of some specified limit. Another arrange- on its surplus. A rapidly growing insurer’s ability to
ment would be to have the reinsurer reimburse the write new business could eventually be impaired.
ceding insurer for losses that exceed a specified loss Acquisition expenses must be paid up front, but off-
ratio during a given year. For example, an insurer setting income is realized with the passage of time.
may wish to stabilize its loss ratio at 70 percent. The Reinsurance reduces the level of the unearned
reinsurer then agrees to reimburse the ceding insurer premium reserve required by law and temporarily
for part or all the losses in excess of 70 percent up to increases the insurer’s surplus position. As a result,
some maximum limit. the ratio of policyholders’ surplus to net written
premiums is improved, which permits the insurer to
Reduce the Unearned Premium Reserve continue to grow.
Reinsurance can be used to reduce the unearned
premium reserve. For some insurers, especially Provide Protection Against a Catastrophic Loss
newer and smaller companies, the ability to write Reinsurance also provides financial protection
large amounts of new insurance may be restricted against a catastrophic loss. Insurers often experience
by the unearned premium reserve requirement. The catastrophic losses because of hurricanes and other
unearned premium reserve is a liability item on the natural disasters, industrial explosions, commercial
insurer’s balance sheet that represents the unearned airline disasters, and similar events. Reinsurance
portion of gross premiums on all outstanding poli- can provide considerable protection to the ceding
cies at the time of valuation. In!effect, the unearned company that experiences a catastrophic loss. The
premium reserve reflects the!fact that premiums are reinsurer pays part or all of the losses that exceed
paid in advance, but the period of protection has not the ceding company’s retention up to some specified
yet expired. As time goes!on, part of the premium is maximum limit.
considered earned, while the remainder is unearned. The tragic terrorist attacks on September 11,
It is only after the period of protection has expired 2001, show clearly the importance of reinsurance.
that the premium is fully earned. Losses from the destruction of the World Trade
As noted earlier, an insurer’s ability to grow Center and other buildings by terrorists totaled
may be restricted by the unearned premium reserve about $31.6 billion ($39.5 billion in 2008 dollars)
requirement. This is because the entire gross premium when the attacks occurred.8 Reinsurers paid a large
must be placed in the unearned premium reserve part of the total losses. Congress provided additional
when the policy is first written. The insurer also backup by enacting the Terrorism Risk Insurance Act
incurs relatively heavy first-year acquisition expenses (TRIA) of 2002, which provides federal reinsurance
in the form of commissions, state premium taxes, to property and casualty insurers if future terrorist
underwriting expenses, expenses in issuing the policy, losses exceed certain levels. TRIA was extended for
and other expenses. In determining the size of the an additional seven years in December 2007 and
unearned premium reserve, there is no allowance for is scheduled to expire at the end of 2014. The leg-
these first-year acquisition expenses, and the insurer islation is now called the Terrorism Risk Insurance
must pay them out of its surplus. Policyholders’ sur- Program Reauthorization Act (TRIPRA) of 2007.
plus is the difference between assets and liabilities.7 Hurricane Katrina in 2005 is another example
For example, a one-year property insurance policy of the importance of reinsurance. Insured property
with an annual premium of $1200 may be written on losses totaled $41.1 billion ($41.5 billion in 2010
January 1. The entire $1200 must be placed in the dollars).9 Reinsurers paid a large part of the loss,
unearned premium reserve. At the end of each month, which significantly reduced the losses retained by
one-twelfth of the premium, or $100, is earned and primary insurers.
 REINSURANCE --5

Other Reasons for Reinsurance An insurer can also can also be a problem of delay because the policy will
use reinsurance to retire from the business or from a not be issued until reinsurance is obtained. Finally,
given line of insurance or territory. Reinsurance per- during periods of poor loss experience, reinsurance
mits the insurer’s liabilities for existing insurance to markets tend to tighten, and facultative reinsurance
be transferred to another carrier; thus, policyholders’ may be more costly and more difficult to obtain.
coverage remains undisturbed.
Finally, reinsurance allows an insurer to obtain Treaty Reinsurance Treaty reinsurance means the
the underwriting advice and assistance of the rein- primary insurer has agreed to cede insurance to
surer. An insurer may wish to write a new line of the reinsurer, and the reinsurer has agreed to accept
insurance, but it may have little experience with the business. All business that falls within the scope
respect to underwriting the line. The reinsurer can of the agreement is automatically reinsured according
often provide valuable assistance with respect to to the terms of the treaty.
rating, retention limits, policy coverages, and other Treaty reinsurance has several advantages to the
underwriting details. primary insurer. It is automatic, and no uncertainty
or delay is involved. It is also economical, because
it is not necessary to shop around and negotiate
Types of Reinsurance
reinsurance terms before the policy is written.
There are two principal types of reinsurance: Treaty reinsurance could be unprofitable to the
(1) facultative reinsurance and (2) treaty reinsurance. reinsurer. The reinsurer generally has no knowledge
about the individual applicant and must rely on
Facultative Reinsurance Facultative reinsurance is the! underwriting judgment of the primary insurer.
an optional, case-by-case method that is used when The primary insurer may write bad business and then
the ceding company receives an application for reinsure it. Also, the premium received by the reinsurer
insurance that exceeds its retention limit. Reinsurance may be inadequate. Thus, if the primary insurer has
is not automatic. The primary insurer negotiates a poor selection of risks or charges inadequate rates,
a separate contract with a reinsurer for each loss the reinsurer could incur a loss. However, if the pri-
exposure for which reinsurance is desired. However, mary insurer consistently cedes unprofitable business
the primary insurer is under no obligation to cede to its reinsurers, the ceding insurer will find it diffi-
insurance, and the reinsurer is under no obligation cult to operate because reinsurers will not want to do
to accept the insurance. But if a willing reinsurer is business with it.
found, the primary insurer and reinsurer can then
enter into a valid contract. Methods for Sharing Losses
Facultative reinsurance is often used when the
primary insurer has an application for a large amount There are two basic methods for sharing losses:
of insurance. Before the application is approved, the (1)!pro rata and (2) excess-of-loss. Under the pro rata
primary insurer determines whether reinsurance method, the ceding company and reinsurer agree to
is available. If reinsurance is available and other share losses and premiums based on some propor-
underwriting standards are met, the policy can then tion. Under the excess-of-loss method, the reinsurer
be written. pays only when covered losses exceed a certain level.
Facultative reinsurance has the advantage of flex- The following reinsurance methods for the shar-
ibility because it can be tailored to fit any type of case, ing of losses are examples of both methods:
it can increase the capacity of the primary insurer to ■ Quota-share treaty
write large amounts of insurance, and it can help sta- ■ Surplus-share treaty
bilize the financial operations of the primary insurer ■ Excess-of-loss reinsurance
by shifting part of a large loss to the reinsurer. ■ Reinsurance pool
Facultative reinsurance, however, has several
disadvantages. There is some uncertainty because the Quota-Share Treaty Under a quota-share treaty,
primary insurer does not know in advance whether a the ceding company and reinsurer agree to share
reinsurer will accept any part of the insurance. There premiums and losses based on some proportion.
--6 C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

The ceding company’s retention is stated as a remaining $3000 (three-fifths). This arrangement can
percentage rather than as a dollar amount. For exam- be summarized as follows:
ple, assume that Apex Fire Insurance and Geneva Re
enter into a quota-share arrangement by which losses
and premiums are shared 50 percent and 50! per- Apex Fire $200,000 (1 line)
cent. Thus, if a $100,000 loss occurs, Apex Fire pays Geneva Re 800,000 (4 lines)
$100,000 to the insured but is reimbursed by Geneva Total underwriting $1,000,000
Re for $50,000.
Premiums are also shared based on the same capacity
agreed-on percentage. However, the reinsurer pays $500,000 policy issued
a ceding commission to the primary insurer to help Apex Fire $200,000 (2/5)
compensate for the expenses incurred in writing the
Geneva Re $300,000 (3/5)
business. Thus, in the previous example, Geneva
Re would receive 50 percent of the premium less a $5000 loss occurs
ceding commission that is paid to Apex Fire. Apex Fire $2000 (2/5)
The major advantage of quota-share reinsurance
Geneva Re $3000 (3/5)
is that the primary insurer’s unearned premium
reserve is reduced. For smaller insurers and
other! insurers that wish to reduce the drain on Under a surplus-share treaty, premiums are
surplus, a quota-share treaty can be especially also shared based on the fraction of total insurance
effective. The principal disadvantage is that a large retained by each party. However, the reinsurer pays
share of potentially profitable business is ceded to a ceding commission to the primary insurer to help
the reinsurer. compensate for the acquisition expenses.
The principal advantage of a surplus-share treaty
Surplus-Share Treaty Under a surplus-share treaty, is that the primary insurer’s underwriting capacity on
the reinsurer agrees to accept insurance in excess any single exposure is increased. The major disadvan-
of the ceding insurer’s retention limit, up to some tage is the increase in administrative expenses. The
maximum amount. The retention limit is referred surplus-share treaty is more complex and requires
to as a line and is stated as a dollar amount. If greater record keeping.
the amount of insurance on a given policy exceeds
the! retention limit, the excess insurance is ceded Excess-of-Loss Reinsurance Excess-of-loss
to the reinsurer up to some maximum limit. The reinsurance is designed largely for protection against a
primary insurer and reinsurer then share premiums catastrophic loss. The reinsurer pays part or all of the
and losses based on the fraction of total insurance loss that exceeds the ceding company’s retention limit
retained by each party. Each party pays its respective up to some maximum level. Excess-of-loss reinsurance
share of any loss regardless of its size. can be written to cover (1) a single exposure, (2)!a
For example, assume that Apex Fire Insurance single occurrence, such as a catastrophic loss from a
has a retention limit of $200,000 (called a line) for tornado, or (3) excess losses when the primary insur-
a single policy, and that four lines, or $800,000, er’s cumulative losses exceed a certain amount during
are ceded to Geneva Re. Apex Fire now has a some stated time period, such as a year. For example,
total underwriting capacity of $1 million on any assume that Apex Fire Insurance wants protection for
single exposure. Assume that a $500,000 property all windstorm losses in excess of $1! million. Assume
insurance policy is issued. Apex Fire takes the first that Apex Fire enters into an excess-of-loss arrange-
$200,000 of insurance, or two-fifths, and Geneva ment with Franklin Re to cover single occurrences
Re! takes the remaining $300,000, or three-fifths. during a specified time period. Franklin Re agrees to
These fractions then determine the amount of loss pay all losses exceeding $1!million but only to a maxi-
paid by each party. If a $5000 loss occurs, Apex Fire mum of $10! million. If a $5! million hurricane loss
pays $2000 (two-fifths), and Geneva Re pays the occurs, Franklin Re would pay $4!million.
 ALTERNATIVES TO TRADITIONAL REINSURANCE --/

Reinsurance Pool Reinsurance can also be Securitization of Risk

provided by a reinsurance pool. A reinsurance pool
There is an increasing use of the securitization of risk to
is an organization of insurers that underwrites
obtain funds to pay for a catastrophe loss. Securitization
insurance on a joint basis. Reinsurance pools have
of risk means that an insurable risk is transferred to
been formed because a single insurer alone may not
the capital markets through the creation of a financial
have the financial capacity to write large amounts
instrument, such as a catastrophe bond, futures contract,
of insurance, but the insurers as a group can com-
options contract, or other financial instrument. These
bine their financial resources to obtain the neces-
instruments are also called risk-linked securities that
sary capacity. For example, the combined hull and
transfer insurance-related risks to the capital markets.
liability loss exposures on a large commercial jet
Insurers were among the first financial institutions to
can exceed $500 million if the jet should crash. Such
experiment with the securitization of risk.
high limits are usually beyond the financial capabil-
ity of a single insurer. However, a reinsurance pool
for aviation insurance can provide the necessary
Catastrophe Bonds
capacity. Reinsurance pools also exist for nuclear
energy exposures, oil refineries, marine insurance, Catastrophe bonds are an excellent example of the
insurance in foreign countries, and numerous other securitization of risk. Catastrophe bonds are corporate
types of exposures. bonds that permit the issuer of the bond to skip or reduce
The method for sharing losses and premiums scheduled interest payments if a catastrophic loss occurs.
varies depending on the type of reinsurance pool. The bonds are complex financial instruments issued
Pools work in two ways.10 First, each pool member by insurers and reinsurers and are designed to provide
agrees to pay a certain percentage of every loss. For funds for catastrophic natural disaster losses. The bonds
example, if one insurer has a policyholder that incurs pay relatively high interest rates and help institutional
a $500,000 loss, and there are 50 members in the investors to diversify their portfolios because natural
pool, each insurer would pay 2 percent, or $10,000 disasters occur randomly and are not correlated with the
of the loss, depending on the agreement. stock market or other economic factors.
Another arrangement is similar to the excess- Catastrophe bonds are made available to institu-
of-loss arrangement. Each pool member pays for tional investors in the capital markets through an entity
its share of losses below a certain amount. Losses called a special purpose reinsurance vehicle (SPRV),
exceeding that amount are then shared by all which is specifically established for that purpose. The
members in the pool. insurer purchases reinsurance from the SPRV and pays
reinsurance premiums to the SPRV. The SPRV issues
the catastrophe bonds, holds the premiums collected
ALTERNATIVES TO TRADITIONAL from insurers and the proceeds from the bond sales
in a trust, and invests the funds in U.S. Treasuries or
REINSURANCE
other high-quality assets. The bonds pay relatively high
Many insurers and reinsurers are now using the interest rates. However, if a catastrophic loss occurs,
capital markets as an alternative to traditional rein- the investors could forfeit the interest and even the
surance. The financial capacity of the property and principal, depending on how the bonds are structured.
casualty industry to pay catastrophic losses from Catastrophe bonds are typically purchased
hurricanes, earthquakes, and other natural disas- by institutional investors seeking higher-yielding,
ters is limited. Rather than rely solely on the limited fixed-income securities. The bonds generally are not
financial capacity of the insurance industry to pay available for direct purchase by individual retail inves-
catastrophic claims, some insurers and reinsurers are tors. Insurers to date have transferred only a small
using the capital markets to gain access to the capital portion of their catastrophe loss exposures to the capi-
of institutional investors. Having access to the capital tal markets. However, catastrophe bonds are growing
markets substantially increases the funds available to in importance and are now considered by many to be
pay catastrophe losses. a standard supplement to traditional reinsurance.
--0 C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

INVESTMENTS are in bonds, mortgages, and real estate; only a small

percentage of the assets is invested in stocks. In con-
The investment function is extremely important trast, state laws generally have fewer restrictions on
in the overall operations of insurance companies. the investment of assets in the separate account. As
Because premiums are paid in advance, they can be such, 80 percent of the assets in the separate account
invested until needed to pay claims and expenses. were invested in stocks in 2010 (see Exhibit 6.2).
Life insurance investments have an important
economic and social impact on the nation for several
Life Insurance Investments
reasons. First, life insurance contracts are long-term,
Assets held by life insurers have increased substan- and the liabilities of life insurers extend over long
tially over time. In 2010, U.S. life insurers held periods of time, such as 50 or 60 years. Thus, safety
$5.3! trillion in assets (see Exhibit 6.1). The funds of principal is a primary consideration. Consequently,
available for investment are derived primarily from as stated earlier, the majority of investments in the
premium income, investment earnings, and maturing general account are in bonds.
investments that must be reinvested. Second, investment income is extremely impor-
A life insurer divides its assets into two accounts. tant in reducing the cost of insurance to policyholders
The assets in the general account support the because the premiums can be invested and earn inter-
contractual obligations for guaranteed fixed dollar est. The interest earned on investments is reflected
benefits, such as life insurance death benefits. The in the payment of dividends to policyholders, which
assets in the separate account support the liabilities for reduces the cost of life insurance.
investment-risk products, such as variable annuities, Finally, life insurance premiums also are an
variable life insurance, and private pension benefits. important source of capital funds to the economy.
State laws place restrictions on the types of assets These funds are invested in shopping centers, housing
in the general account. Because of the long-term developments, office buildings, hospitals, new plants,
nature of life insurance products, most investments and other economic and social ventures.

E78%#%* 6.1
Growth of Life Insurers’ Assets

$Billions

6,000 5,311
4,823
4,648
5,000
4,253

4,000 3,380
3,182
2,827
3,000 2,324
1,942
1,665
2,000 1,408

1,000

0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

S#$%&e: American Council of Life Insurers, Life Insurers Fact Book 2011, Figure 2.1
 OTHER INSURANCE COMPANY FUNCTIONS --1

E78%#%* 6.2
Asset Distribution of Life Insurers, 2010

GENERAL ACCOUNT SEPARATE ACCOUNT

Stocks Stocks
2% 80%
Miscellaneous assets Bonds
12% 13%

Policy loans Miscellaneous assets

4% 6%

Mortgages and real estate Mortgages and real estate

10% 1%

Bonds
72%

S#$%&e: American Council of Life Insurers, Life Insurers Fact Book 2011, Figure 2.2.

Property and Casualty Insurance Investments insurance contracts generally are short-term in nature.
The policy period in most contracts is one year or less,
In 2010, property and casualty insurance company
and property claims are usually settled quickly. Also,
investments totaled $1.32 trillion.11 Most assets are
in contrast to life insurance claims, which are generally
invested in securities that can be quickly sold to pay
fixed in amount, property insurance claim payments
claims if a major catastrophe occurs—primarily in
can vary widely depending on catastrophic losses,
high-quality bonds, stocks, and cash rather than real
inflation, medical costs, construction costs, auto repair
estate (see Exhibit 6.3).
costs, economic conditions, and changing value judg-
Two important points must be stressed when
ments by society. For these reasons, the investment
the investments of property and casualty insurers are
objective of liquidity is extremely important.
analyzed. First, in contrast to life insurance, property
Second, investment income is extremely important
in offsetting unfavorable property and casualty under-
E78%#%* 6.3 writing experience. The investment of capital and sur-
Investments, Property/Casualty Insurers, 2010 plus funds, along with the funds set aside for loss reserves
and the unearned premium reserve, generate investment
INVESTMENTS BY TYPE1 earnings that usually permit an insurer to continue its
Real estate 0.74% insurance operations despite an underwriting deficit.
Preferred stock 1.34%
Other 9.17%
Cash and short-term investments OTHER INSURANCE COMPANY
6.51%
Bonds
FUNCTIONS
66.40% Insurers also perform other functions. They include
information systems, accounting, legal, and loss-
Common stock
15.85%
control services.

Information Systems
S#$%&e: National Association of Insurance Commissioners (NAIC) Annual
Statement Database, via Highline Data, LLC. Copyrighted Information. No Information systems are extremely important in
portion of this work may be copied or reproduced without the express written
permission of Highline Data, LLC. Excerpted from Insurance Information
the daily operations of insurers. These systems
Institute, The Insurance Fact Book 2012, p. 45. depend heavily on computers and new technology.
--2 C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

Computers have revolutionized the insurance indus- planning. Attorneys also draft the legal language
try by speeding up the processing and storage of and policy provisions in insurance policies and
information and by eliminating many routine tasks. review all new policies before they are marketed to
Computers are widely used in accounting, policy the public. Other activities include providing legal
processing, premium notices, information retrieval, assistance to actuarial personnel who testify at rate
telecommunications, simulation studies, market hearings; reviewing advertising and other published
analysis, training and education, sales, and policy- materials; providing general legal advice concern-
holder services. Information can quickly be obtained ing taxation, marketing, investments, and insurance
on premium volume, claims, loss ratios, investments, laws; and lobbying for legislation favorable to the
and underwriting results. insurance industry.
Attorneys must also keep abreast of the frequent
changes in state and federal laws that affect the
Accounting
company and its policyholders. These include laws
The accounting department is responsible for the affecting consumers, cost disclosure, affirmative
financial accounting operations of an insurer. action programs, truth in advertising, and similar
Accountants prepare financial statements, develop legislation. Finally, attorneys must keep up with cur-
budgets, analyze the company’s financial operations, rent court cases and legal precedents.
and keep track of the millions of dollars that flow
into and out of a typical company each year. Periodic
Loss-Control Services
reports are prepared dealing with premium income,
operating expenses, claims, investment income, and Loss control is an important part of risk man-
dividends to policyholders. Accountants prepare stat- agement, and a typical property and casualty
utory annual statements that must be filed with state insurer provides numerous loss-control services.
insurance departments. If the company is publicly These services include advice on alarm systems,
traded, accountants must also prepare accounting automatic sprinkler systems, fire prevention, occu-
statements based on Generally Accepted Accounting pational safety and health, prevention of boiler
Principles (GAAP) for investors. explosions, and other loss-prevention activities.
In! addition, loss-control specialists can provide
valuable advice on the construction of a new
Legal Function
building or plant to make it safer and more resis-
Another important function of insurance companies tive to damage, which can result in a substantial
is the legal function. In life insurance, attorneys are rate reduction. Loss-control specialists can also
widely used in advanced underwriting and estate assist underwriters.

C–,$ A99:%)–*%;$
Reinsurance can be used by an insurer to solve several b. Company B is a rapidly growing new company and
problems. Assume you are an insurance consultant who desires a plan of reinsurance that will reduce the
is asked to give recommendations concerning the type drain on its surplus because of the expense of writ-
of reinsurance plan or arrangement to use. For each of ing a large volume of new business.
the following situations, indicate the type of reinsurance c. Company C has received an application to write
plan or arrangement that the ceding insurer should use, a $50 million life insurance policy on the life of
and explain the reasons for your answer. the chief executive officer of a major corporation.
a. Company A is an established insurer and is primarily Before the policy is issued, the underwriter wants to
interested in having protection against a cata- make certain that adequate reinsurance is available.
strophic loss arising out of a single occurrence. d. Company D would like to increase its underwriting
capacity to underwrite new business.
 REVIEW QUESTIONS --3

SUMMARY exposure that the primary company wants to reinsure.

Reinsurance is not automatic. The primary company
■ Ratemaking refers to the pricing of insurance. Insurance is under no obligation to cede insurance, and the rein-
rates are determined by actuaries. surer is under no obligation to accept. In contrast, under
■ Underwriting refers to the process of selecting, classi- treaty reinsurance, if the business falls within the scope
fying, and pricing applicants for insurance. There are of the agreement, the primary company must cede insur-
several important underwriting principles: ance to the reinsurer, and the reinsurer must accept the
Attain an underwriting profit. ceded coverage.
Select prospective insureds according to the ■ Reinsurance arrangements for the sharing of losses
company’s underwriting standards. include the following:
Provide equity among the policyholders. Quota-share treaty
■ In determining whether to accept or reject an appli- Surplus-share treaty
cant for insurance, underwriters have several sources of Excess-of-loss treaty
information. Important sources include the application, Reinsurance pool
agent’s report, inspection report, physical inspection,
■ Other important insurance company operations include
and a physical examination in life insurance.
investments, information systems, legal services, and
■ Production refers to the sales and marketing activi- loss-control services.
ties of! insurers. Agents who sell insurance are called
producers.
KEY CONCEPTS AND TERMS
■ From the insurer’s viewpoint, there are several basic
Actuary (104) Insurance agent (109)
objectives in settling claims:
Catastrophe bonds (115) Loss control (118)
Verification of a covered loss
Ceding commission (114) Medical Information
Fair and prompt payment of claims Ceding company (110) Bureau report (107)
Personal assistance to the insured Certified Financial Planner Producers (108)
■ The person who adjusts a claim is known as a claims (CFP) (108) Production (108)
adjustor. The major types of adjustors are as follows: Certified Insurance Public adjustor (109)
Counselor (CIC) (108) Quota-share treaty (113)
Agent
Cession (111) Ratemaking (104)
Company adjustor
Chartered Financial Reinsurance (110)
Independent adjustor Consultant (ChFC) (108) Reinsurance pool (115)
Public adjustor Chartered Life Underwriter Reinsurer (111)
■ Several steps are involved in settling a claim: (CLU) (108) Retention limit
Chartered Property Casualty (net retention) (111)
Notice of loss must be given to the company.
Underwriter (CPCU) (108) Retrocession (111)
The claim is investigated by the company.
Claims adjustor (109) Retrocessionaire (111)
A proof of loss may be required. Company adjustor (109) Securitization of risk (115)
A decision is made concerning payment. Excess-of-loss Surplus-share treaty (114)
■ Reinsurance is used for several reasons: reinsurance (114) Treaty reinsurance (113)
Facultative reinsurance (113) Underwriting (105)
To increase the company’s underwriting capacity
Independent adjustor (109) Unearned premium
To stabilize profits
Information systems (117) reserve (112)
To reduce the unearned premium reserve
To provide protection against a catastrophic loss
■ Facultative reinsurance is an optional case-by-case
REVIEW QUESTIONS
method by which the primary company negotiates 1. How does ratemaking, or the pricing of insurance,
a separate agreement with the reinsurer for each loss differ from the pricing of other products?
-4. C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

2. a. Define the meaning of underwriting. c. What is the maximum amount of insurance that
b. Briefly explain the basic principles of underwriting. Delta can write on a single building under the rein-
c. Identify the major sources of information available surance agreement? Explain your answer.
to underwriters. 2. Liability Insurance Company writes a substantial
3. Briefly describe the sales and marketing activities amount of commercial liability insurance. A large con-
of!insurers. struction company requests $100 million of liability
4. Explain the basic objectives in the settlement of claims. insurance to cover its business operations. Liability
Insurance has a reinsurance contract with Bermuda Re
5. Describe the steps involved in the settlement of that enables the coverage to be written immediately.
a!claim. Under the terms of the contract, Liability Insurance
6. Briefly describe the following types of claims adjustors: pays 25 percent of the losses and retains 25 percent of
a. Agent the premium. Bermuda Re pays 75 percent of the losses
b. Company adjustor and receives 75 percent of the premium, less a ceding
c. Independent adjustor commission that is paid to Liability Insurance. Based
d. Public adjustor on the preceding, answer the following questions:
7. a. What is the meaning of reinsurance? a. What type of reinsurance contract best describes the
b. Briefly explain the reasons for reinsurance. reinsurance arrangement that Liability Insurance
c. Explain the meaning of “securitization of risk.” has with Bermuda Re?
b. If a $50 million covered loss occurs, how much will
8. Distinguish between facultative reinsurance and treaty Bermuda Re have to pay? Explain your answer.
reinsurance. c. Why does Bermuda Re pay a ceding commission to
9. Briefly explain the following types of reinsurance Liability Insurance?
methods for sharing losses: 3. Property Insurance Company is a new property
a. Quota-share treaty insurer. The company is growing rapidly because of
b. Surplus-share treaty a new homeowners policy that combines traditional
c. Excess-of-loss reinsurance homeowner coverages with insurance that pays off
d. Reinsurance pool the mortgage if the insured dies or becomes totally
10. Briefly describe the following insurance company disabled. Premiums written have increased substan-
operations: tially; new agents have been hired; and the company
a. Information systems is considering expanding into additional states.
b. Accounting However, its growth has been hampered by statu-
c. Legal services tory accounting rules that require an insurer to write
d. Loss control off immediately its first-year acquisition expenses
but do not allow full recognition of premium
income until the policy period has expired. In this
APPLICATION QUESTIONS case, explain how reinsurance will enable Property
1. Delta Insurance is a property insurer that entered into Insurance to continue to grow in an orderly fashion.
a surplus-share reinsurance treaty with Eversafe Re. 4. Felix is a property claims adjustor for a large prop-
Delta has a retention limit of $200,000 on any sin- erty insurer. Janet is a policyholder who recently
gle building, and up to nine lines of insurance may be notified the company that the roof of her home
ceded to Eversafe Re. A building valued at $1,600,000 incurred substantial damage because of a recent
is insured with Delta. Shortly after the policy was hail storm. Janet owns her home and is insured
issued, a severe windstorm caused a $800,000 loss to under a standard homeowners policy with no spe-
the building. cial endorsements. What questions should Felix
a. How much of the loss will Delta pay? ask before the claim is approved for payment by
b. How much of the loss will Eversafe Re pay? his company?
 SELECTED REFERENCES -4-

INTERNET RESOURCES ■ LIMRA is the principal source of industry sales and

marketing statistics in life insurance. Its site provides
■ The American Council of Life Insurers (ACLI) repre- news and information about LIMRA and the financial
sents the life insurance industry on issues dealing with services field, conducts research, and publishes a wide
legislation and regulation. ACLI also publishes statistics range of publications. Visit the site at
on the life insurance industry in an annual fact book.
Visit the site at limra.com

acli.com
■ The National Association of Insurance Commissioners
(NAIC) provides considerable information on com-
■ The American College is an accredited, nonprofit plaints against specific insurers. Go to NAIC Consumer
educational institution that provides graduate and Information Source, type in the company name, state,
undergraduate education, primarily on a distance and business type. After locating the company, click on
learning basis, to people in the financial services industry. Closed Complaints. Visit the site at
The organization awards the professional Chartered Life
https://eapps.naic.org/cis/
Underwriter (CLU) designation, the Chartered Financial
Consultant (ChFC) designation, and other professional ■ The National Association of Mutual Insurance
designations. Visit the site at Companies is a trade association that represents mutual
insurance companies in property and casualty insur-
theamericancollege.edu
ance. Visit the site at
■ The American Insurance Association (AIA) is an impor-
namic.org
tant trade association that represents property and
casualty insurers. The site lists available publications, ■ Towers Watson is one of the world’s largest actuarial
position papers on important issues in property and cas- and management consulting firms. Towers Watson
ualty insurance, press releases, insurance-related links, provides a substantial amount of information on the
and names of state insurance commissioners. Visit the insurance industry and advises other organizations on
site at risk financing and self-insurance. Visit the site at

aiadc.org towerswatson.com

■ The Institutes (also known as the American Institute for

CPCU) is an independent, nonprofit organization that
SELECTED REFERENCES
offers educational programs and professional certification
to people in all segments of the property and casualty Black, Kenneth, Jr., and Harold D. Skipper, Jr. Life
insurance business. The organization awards the profes- Insurance, 13th ed. Upper Saddle River, NJ: Prentice-
sional CPCU designation and other designations. Visit Hall, 2000, chs. 25–26.
the site at Bouriaux, Sylvie and Richard MacMinn. “Securitization
of Catastrophe Risk: New Developments in
aicpcu.org
Insurance-Linked Securities and Derivatives.” The
■ The Insurance Information Institute (III) is an excellent Journal of Insurance Issues, Vol. 32, No. 1 (Spring
site for obtaining information on the property and 2009), pp.!1–34.
liability insurance industry. It provides timely consumer “Catastrophes: Insurance Issues,” Issues Updates,
information on auto, homeowners, and business Insurance Information Institute, April 2012. This
insurance, and other types of property and liability source is periodically updated.
insurance. Visit the site at Cummins, J. David. “Reinsurance for Natural and Man-
iii.org Made Catastrophes in the United States: Current
State of the Market and Regulatory Reforms.” Risk
■ The Life Office Management Association (LOMA) Management & Insurance Review, Vol. 10, No. 2
provides extensive information dealing with the man- (Fall 2007), pp. 179–220.
agement and operations of life insurers and financial Graves, Edward E., ed. McGill’s Life Insurance, 8th ed.
services companies. Visit the site at Bryn Mawr, PA: The American College 2011, chs.
loma.org 17–18, 22–23.
-44 C H A P T E R ! / I N S U R A N C E C O M P A N Y O P E R AT I O N S

The Financial Services Fact Book 2012, New York: if incurred losses and loss adjustment expenses are $70
Insurance Information Institute. and earned premiums are $100, the loss ratio is 0.70, or
The Insurance Fact Book 2012, New York: Insurance 70 percent.
Information Institute. 4. For additional information on claims settlement, see
Life Insurers Fact Book 2011, Washington, DC: American Bernard L. Webb, et al., Insurance Operations and
Council of Life Insurers, 2011. Regulation, 1st ed. (American Institute for Chartered
Myhr, Ann E. and James J. Markham. Insurance Property Casualty Underwriters/Insurance Institute of
Operations, Regulation, and Statutory Accounting, America, 2002), chs. 13–15.
2nd ed., Malvern, PA: American Institute for 5. Webb, et al., pp. 13.48–13.49.
Chartered Property Casualty Underwriters/Insurance 6. Robert I. Mehr, Emerson Cammack, and Terry Rose,
Institute of America, 2004. Principles of Insurance, 8th ed. (Homewood, IL:
Orsina, Miriam A. and Gene Stone. Insurance Company Richard D. Irwin, 1985), pp. 616–617.
Operations, 3rd ed., Atlanta, GA: LOMA Education 7. Technically, for a stock insurer, policyholders’
and Training, 2012. surplus is the sum of capital stock (value of the con-
“Reinsurance,” Issues Updates. Insurance Information tributions of original stockholders), plus surplus (the
Institute, April 2012. This source is periodically updated. amount paid in by the organizers in excess of the
Webb, Bernard L., et al. Insurance Operations and par value of the stock), plus any retained earnings.
Regulation, 1st ed., Malvern, PA: American Institute In the case of a mutual insurer, there is no capital
for Chartered Property Casualty Underwriters/ account. Policyholders’ surplus is the excess of assets
Insurance Institute of America, 2002. over liabilities.
8. Insurance Information Institute, “Terrorism Risk and
Insurance,” Issues Updates, August 2011. This source
NOTES is periodically updated.
9. Insurance Information Institute, The Insurance Fact
1. A legal reserve is a liability item on a company’s bal- Book 2012, p. 133.
ance sheet that measures the insurer’s obligations to 10. Sharing the Risk, 3rd ed. (New York: Insurance
its policyholders. State laws require a company to Information Institute, 1989), pp. 119–120.
maintain policy reserves at a level sufficient to pay all 11. The Insurance Fact Book 2012, (New York: Insurance
policy obligations as they fall due. Information Institute), p. 44.
2. In property and casualty insurance, a loss reserve is an
estimated liability item that represents an amount for
claims reported but not yet paid, claims in the process
of settlement, and claims that have already occurred Students may take a self-administered test on
but have not been reported. this chapter at
3. A loss ratio is the ratio of incurred losses and loss www.pearsonhighered.com/rejda
adjustment expenses to earned premiums. For example,
CHAPTER 7

FINANCIAL OPERATIONS
OF INSURERS

“To manage an insurance enterprise successfully, you must

understand the volatility inherent in each portfolio of risks
and investments. Further, you must understand the impact
that unexpected volatility has on the balance sheet, income
statement, and cash flows.”
Mike Keyes,
Chairman of the Board and former CEO,
Oregon Mutual Insurance Company

L$–!$%$& O#($)*%+$,

After studying this chapter, you should be able to

◆ Understand the three major sections of the balance sheet for a property and casualty
insurance company: assets, liabilities, and policyholders’ surplus.

◆ Identify the sources of revenues and types of expenses incurred by a property and casualty
insurance company.

◆ Explain how profitability is measured in the property and casualty insurance industry.

◆ Understand the balance sheet and income and expense statement of a life insurance
company, and explain how profitability is measured in the life insurance industry.

◆ Explain the objectives of rate making in the property and casualty insurance industry and discuss
the basic rate-making methods, including judgment rating, class rating, and merit rating.
123
 “S o how did XYZ Insurance Company get into trouble?” board member
Lexi Armstrong asked.
“They wrote too much property insurance in a tight geographic area and they
did not purchase reinsurance. Those wind and hail storms last summer really did
a!number on their policyholders and on their financial statements,” responded
ABC!Insurance Company president, Brian Fallon.
This exchange occurred at the quarterly board meeting of ABC Insurance Company.
President Fallon asked the board of directors to consider acquiring XYZ Insurance
Company. A major rating service just lowered XYZ Insurance Company's rating
because of large losses from storms the previous summer. XYZ Insurance Company
limited its underwriting to homeowners insurance and small business coverage in one
state. ABC Insurance Company writes most of its coverage in areas where earthquake
risk is important. Where XYZ writes coverage there is little earthquake risk.
“Take a good look at XYZ's financial statements,” Fallon said to the board. They have
high-quality assets in their investment portfolio. Our surplus can easily absorb their!losses
from last summer. Once we acquire the company, our agents will be able to cross-sell
to existing XYZ policyholders, offering auto insurance, umbrella policies, and other
coverages XYZ does not market. We'll be able to write more business while reducing our
earthquake exposure. This acquisition is a no-brainer!”
This chapter discusses the financial operations of insurers. Specific topics discussed
are insurance company balance sheets, income statements, profitability measures, and
rate-making methods.

In Chapter 2, the two sides of the private insur- Balance Sheet

ance industry, property and casualty insurance
A balance sheet is a summary of what a company
and life and health insurance, were discussed. The
owns (assets), what it owes (liabilities), and the
discussion of the financial operations of insurers
difference between total assets and total liabilities
is organized in the same way. First, we consider
(owners’ equity). A balance sheet shows these values
the financial statements for property and casualty
on a specific date. This financial statement is called
insurance companies and for life insurance compa-
a balance sheet because the two sides of the financial
nies. Then, we discuss rate making in property and
statement must be equal:
casualty insurance and in life insurance.
Total assets ! Total liabilities " Owners’ equity

PROPERTY AND Exhibit 7.1 shows the balance sheet for the ABC
Insurance Company at the end of 2012. Note how
CASUALTY INSURERS
the company’s total assets equal the company’s total
To understand the financial operations of an liabilities plus owners’ equity (policyholders’ surplus).
insurance company, it is necessary to examine the
insurer’s financial statements. Two important Assets The primary assets for an insurance
financial statements are the balance sheet and the company are financial assets. An insurance company
income and expense statement.1 invests premium dollars and retained earnings in
124
 PROPERTY AND CASUALTY INSURERS -4/

E78%#%* 1.-
ABC Insurance Company

ABC Insurance Company

Balance Sheet
December 31, 2$12
Assets: Liabilities:
Bonds ()*+,+++,+++ Loss Reserves (-)+,+++,+++
Common Stock ,+,+++,+++ Unearned Premiums -+-,+++,+++
Real Estate )+,+++,+++ Loss Adjustment Expenses -0,+++,+++
Cash & Short-term Investments -),+++,+++ Commissions Payable /,+++,+++
Mortgage-backed Securities .+,+++,+++ Other Liabilities --,+++,+++
Total Invested Assets (./),+++,+++ Total Liabilities )**,+++,+++

Premiums Receivable )/,!++,+++ Surplus and Capital

Data Processing Equipment 0++,+++ Paid-in Surplus -!,+++,+++
Other Assets -,,+++,+++ Unassigned Surplus -!/,+++,+++

Total Admitted Assets (00+,+++,+++ Total Liabilities and Surplus (00+,+++,+++

financial assets. These investments also provide an damage liability claims may take a long time to
important source of income for an insurer. As with settle, especially if litigation is involved. In con-
most insurance companies, ABC’s primary investment trast, property insurance claims, such as auto
holding is bonds. Other investments are in common and collision and other physical damage claims and
preferred stock, real estate, mortgage-backed securities, homeowners dwelling and personal property
marketable securities, and cash/cash equivalents. The insurance claims, are settled more quickly; hence
company’s assets total $440 million. loss reserves are relatively small for property
insurance. ABC’s loss reserves are $120!million.
Liabilities While the assets of an insurance company
are relatively straightforward, the liabilities are more Loss reserves in property and casualty insurance
complex. An insurer is required by law to maintain can be classified as case reserves, reserves based on
certain reserves on its balance sheet. Because the loss ratio method, and reserves for incurred-
premiums are paid in advance, but the period of but-not-reported claims.
protection extends into the future, an insurer must Case reserves are loss reserves that are established
establish reserves to assure that premiums collected for each individual claim when it is reported. Major
in advance will be available to pay future losses. methods of determining case reserves include the
A!property and casualty insurer is required to main- following: the judgment method, the average value
tain two principal types of financial reserves: method, and the tabular method.2

1. Loss Reserves. The loss reserve is a large ■ Under the judgment method, a claim reserve
liability item on a property and casualty insur- is established for each individual claim. The
ance company’s balance sheet. A loss reserve is amount of the loss reserve can be based on the
the estimated cost of settling claims for losses judgment of someone in the claims department
that have already occurred but that have not or estimated using a computer program. Many
been paid as of the valuation date. More spe- insurers use computer programs that apply
cifically, the loss reserve is an estimated amount guidelines to calculate the size of the loss reserve.
for (1) claims reported and adjusted but not The details of an individual claim are entered,
yet paid, (2) claims reported and filed, but not and a computer algorithm estimates the size of
yet adjusted, and (3) claims for losses incurred the required loss reserve.
but not yet reported to the company. The loss ■ When the average value method is used, an
reserve is especially important to a casualty average value is assigned to each claim. This
insurer because bodily injury and property method is used when the number of claims is
-40 C H A P T E R 1 / F I N A N C I A L O P E R AT I O N S O F I N S U R E R S

large, and the average claim amount is relatively The fundamental purpose of the unearned
small. Loss reserves for auto physical damage premium reserve is to pay for losses that occur during
claims are often based on this method. the policy period. Premiums are paid in advance, but
■ Under the tabular value method, loss reserves the period of protection extends into the future. To
are determined for claims for which the amounts assure policyholders that future losses will be paid,
paid depend on life expectancy, duration of the unearned premium reserve is required.
disability, and similar factors. This method The unearned premium reserve is also needed so
is often used to establish loss reserves involv- that premium refunds can be paid to policyholders in
ing permanent disability, partial permanent the event of coverage cancellation. If the!insurer can-
disability, survivor benefits, and similar claims. cels the policy, a full pro rata premium refund based
The loss reserve is called a tabular reserve on the unexpired portion of the policy term must be
because the duration of the benefit period paid to the policyholder. Thus, the unearned pre-
is based on data derived from mortality and mium reserve must be adequate so premium refunds
morbidity tables. can be made in the event of cancellation.
Finally, if the business is reinsured, the unearned
The case reserves just discussed establish loss
premium reserve serves as the basis for determining
reserves for individual claims. In contrast, the loss
the amount that must be paid to the reinsurer for
ratio method (loss reserves) establishes aggregate
carrying the reinsured policies until the end of their
loss reserves for a specific coverage line. Under
terms. In practice, however, the amount paid to the
the loss ratio method, a formula based on the
reinsurer may be considerably less than the unearned
expected loss ratio is used to estimate the loss
premium reserve, as the reinsurer does not incur
reserve . The expected loss ratio is multiplied by
heavy first-year acquisition expenses in acquiring the
premiums earned during a specified time period.
reinsured policies.
Loss and loss-adjustment expenses paid to date
Several methods can be used to calculate the
are then subtracted from the ultimate loss figure to
unearned premium reserve. Only one method is
determine the current loss reserve. The loss ratio
described here. Under the annual pro rata method,
method is required for certain lines of insurance,
it is assumed that the policies are written uniformly
such as workers compensation, where the expected
throughout the year. For purposes of determin-
loss ratio ranges from 65 percent to 75 percent of
ing the unearned premium reserve, it is assumed
earned premiums.
that all policies are written on July 1, which is the
Some losses occur near the end of the accounting
average issue date. Therefore, on December 31, the
period but are not reported until the next period. The
unearned premium reserve for all one-year policies
incurred-but-not-reported (IBNR) reserve is a reserve
is one-half of the premiums attributable to these
that must be established for claims that have already
policies. For two-year policies, the unearned pre-
occurred but have not yet been reported to the
mium reserve is three-fourths of the premium
insurer. For example, some accidents may occur on
income, and for three-year policies, it is five-sixths
the final day of the accounting period. A loss reserve
of the premium income.
is needed for these losses that will not be reported
Several other liabilities merit mention. There
until the next accounting period.
are! costs associated with settling and paying
2. Unearned Premium Reserve. The unearned reserved!claims. ABC Insurance Company estimates
premium reserve is a liability item that represents that the loss-adjustment expenses to settle the
the unearned portion of gross premiums on reserved claims are $14 million. Other impor-
all outstanding policies at the time of valuation. tant liability items include commissions owed to
An insurer is required by law to place the entire agents! selling ABC products and taxes owed to
gross premium in the unearned premium reserve the!government.
when the policy is first written, and to place
renewal premiums in the same reserve. ABC Policyholders’ Surplus Policyholders’ surplus is the
Insurance Company’s unearned premium reserve difference between an insurance company’s assets
is $101 million. and liabilities. It is not calculated directly—it is the
 PROPERTY AND CASUALTY INSURERS -41

“balancing” item on the balance sheet. If the insurer Income and Expense Statement
were to pay all of its liabilities using its assets, the
The income and expense statement summarizes
amount remaining would be policyholders’ surplus.
revenues received and expenses paid during a
ABC Insurance Company’s paid-in capital and
specified period of time. Exhibit 7.2 shows the
surplus total $185 million. This value is 42 percent of
income and expense statement for ABC Insurance
the company’s total assets.
Company for 2012.
Surplus can be thought of as a cushion that
can be drawn upon if liabilities are higher than Revenues Revenues are cash inflows that the com-
expected. Recall that loss reserves are an esti- pany can claim as income. The two principal sources
mate of future losses, but that actual losses of revenues for an insurance company are premiums
could easily exceed the estimate. Obviously, the and investment income. As noted in the discussion
stronger an insurance company’s surplus posi- of the unearned premium reserve, premiums are not
tion, the greater is the security for its policy- considered wholly earned until the period of time
holders. Surplus represents the paid-in capital of for which the premiums were paid has passed. The
investors plus retained income from insurance premiums written that appear on the income and
operations and investments over time. The level expense statement reflect the premiums for coverage
of surplus is also an important determinant that was placed on the books during the year. Earned
of the amount of new business that an insurance premiums represent the portion of the premiums
company can write.3 for which insurance protection has been provided.

E78%#%* 1.4
ABC Insurance Company

ABC Insurance Company

Income and Expense Statement
January 1, 2$12–December 31, 2$12
Revenues:
Premiums Written* ()+!,+++,+++
Premiums Earned ()+*,+++,+++

Investment Income:
Interest -0,+++,+++
Dividends ),0++,+++
Rental Income !++,+++
Gain on Sale of Securities -,+++,+++
Total Investment Income -,,+++,+++
Total Revenues ()).,+++,+++
Expenses:
Net Losses Incurred -..,!++,+++
Loss Adjustment Expenses -0,+++,+++
Total Losses and Loss Adj. Expenses -01,!++,+++

Commissions -,,+++,+++
Premium Taxes *,+*+,+++
General Insurance Expenses 0-,*/+,+++
Total Underwriting Expenses !0,!0+,+++
Total Expenses )-),)0+,+++

Net Income Before Taxes -+,1!+,+++

Federal Income Tax .,)!+,+++
Net Income 1,*++,+++
*Premiums written reflect coverage put in force during the accounting period.
-42 C H A P T E R 1 / F I N A N C I A L O P E R AT I O N S O F I N S U R E R S

Insurance premiums are paid in advance for a speci- Incurred

losses + Loss adjustment
expenses
fied period of protection. With the passage of time, Loss ratio = Premiums
earned
an insurer “earns” the premium and can claim it as
income under insurance accounting rules. 147,600,000
The second major source of income is investment =
205,000,000
income. Given the size of ABC’s bond portfolio, it is
not surprising that interest income is the major source = .720
of investment income. The company also received
dividend income on stocks owned and rental income The loss ratio for individual coverage lines can
on real estate the company owned. The company be determined, as well as the overall loss ratio for
also sold some securities for more than the original the company. The loss ratio is often in the 65 percent
purchase price and realized a capital gain. The to 75 percent range, but an insurer does not know
company’s total revenues for 2012 were $223 million. at the beginning of the coverage period what the
ultimate loss ratio will be.
Expenses Partially offsetting the company’s revenues A second important performance measure is
were the company’s expenses, which are cash the expense ratio. The expense ratio is equal to the
outflows from the business. The major expenses for company’s underwriting expenses divided by written
ABC Insurance Company were the cost of adjusting premiums. The expense ratio for ABC Insurance
claims and paying the insured losses that occurred. Company is:
The company paid $133.6 million in losses and
Underwriting expenses
$14 million in loss-adjustment expenses during 2012, Expense ratio =
for a total of $147.6 million. Premiums written
Underwriting expenses are the other major 64,640,000
category of expenses. These expenses consist of =
206,000,000
commissions that ABC paid agents for selling the
= .314
company’s products, premium taxes, and general
expenses. These items total $64.64 million in 2012.
As with the loss ratio, the expense ratio can be
ABC Insurance Company’s total expenses in 2012
determined for individual coverage lines and in the
were $212.24 million.
aggregate. Underwriting expenses include acquisition
The company’s taxable income (total revenues
costs (commissions), general expenses, and underwriting
minus total expenses) was $10.76 million. The
costs. Some coverages, such as personal lines, are less
company paid $3.26 million in federal income taxes.
costly to underwrite. Underwriting costs for large com-
The company’s net income after taxes was $7.5 million.
mercial accounts may be much higher. Obviously,
This money can be returned to stockholders through
a low expense ratio is preferred by insurers. Expense
dividends or be used to increase the investment
ratios are usually in the 25 percent to 40 percent range.
portfolio. If added to the investment portfolio, the
For an overall measure of underwriting
company’s total assets will increase relative to its total
performance, the combined ratio can be calculated.
liabilities, and policyholders’ surplus will increase.
The combined ratio is the sum of the loss ratio
and expense ratio.5 The combined ratio for ABC
Measuring Profit or Loss Insurance Company is 1.034:
One way of measuring the performance of an insur-
Combined ratio = Loss ratio + Expense ratio
ance company is to consider how the company did
in its core business, underwriting risks.4 A simple Combined ratio = .720 + .314 = 1.034
measure that can be used is the insurance company’s
loss ratio. The loss ratio is the ratio of incurred losses The combined ratio is one of the most common
and loss adjustment expenses to premiums earned. measures of underwriting profitability. If the
The formula and the loss ratio for ABC Insurance combined ratio exceeds 1 (or 100 percent), it indicates
Company are: an underwriting loss. If the combined ratio is less
 PROPERTY AND CASUALTY INSURERS -43

than 1 (or 100 percent), it indicates an underwriting At first glance, it may seem incorrect to subtract
profit. In the case of ABC Insurance Company, for the investment income ratio from the combined ratio.
every $100 in premiums the company collected, the However, recall that a combined ratio in excess of
company paid out $103.40 in claims and expenses. 100! percent indicates an underwriting loss and that
At this point, it is important to recall the asset investment income can reduce or totally offset an
holdings of insurance companies. The investments underwriting loss. ABC Insurance Company’s combined
an insurer makes in bonds, stocks, real estate, and ratio was 103.4. The company’s investment income ratio
other investments generate investment income. A was 8.8 percent, producing an overall operating ratio of
property and casualty insurance company can lose 94.6. An overall operating ratio of less than 100 indicates
money on its underwriting operations, but still report that the company, overall, was profitable. If the overall
positive net income if the investment income offsets operating ratio exceeds 100, it means that investment
the underwriting loss. The investment income ratio income was not enough to offset the underwriting loss.
compares net investment income to earned premiums.
The formula and the ratio for the ABC Insurance
Recent Underwriting Results
Company are provided below:
As noted in Chapter 4, the combined ratio in the U.S.
Investment = Net investment income property and casualty insurance industry has been less
income ratio Earned preminus than 100 percent in only three years between 1980 and
18,000,000 2011. The combined ratios of 92.4 and 95.6 in 2006
= and 2007, respectively, created record underwriting
205,000,000
profits. The combined ratio, however, climbed back
= .088 above 100 in 2008, reaching 105.2 and was 108.2
in 2011. The 2011 combined ratio was the highest
To determine the company’s total performance measure since 2001. The underwriting loss was attrib-
(underwriting and investments), the overall operating utable to insured losses and increased loss adjustment
ratio can be calculated. The overall operating ratio expenses. Although net investment income increased
is equal to the combined ratio minus the investment from 2010 to 2011, policyholders’ surplus declined.6
income ratio. This ratio and the result for ABC are The property and casualty insurance industry
presented below: has not been highly profitable over time. The indus-
try has lagged profitability benchmarks for various
Overall Combined Investment industry groups in most years. The two best years in
operating ratio = ratio - income ratio
the past decade for overall profitability were 2006
= 1.034 - .088 and 2007 when the property and casualty industry
= .946 or 94.6% provided competitive returns.7 Insight 7.1 discusses

INSIGHT 1.-
How Profitable Is the Property and Casualty Insurance Industry?
The property and casualty insurance industry lags most other Even with the problems the banking sector experienced dur-
industries in profitability. In only three years between 2001 ing the financial crisis, )++/ was the only year between 2001
and 2010 did the property and casualty insurance industry and 2010 where property and casualty insurers outperformed
record higher rates of return than the life insurance industry commercial banks on a GAAP basis. The property and casualty
using GAAP accounting principles. While several industries insurance industry posted statutory underwriting losses in 2010
consistently posted double-digit rates of return between and 2011, with the combined ratio greater than -++ percent.
2001 and 2010, the property and casualty insurance industry
S#$%&e: The Insurance Fact Book 2012, New York: Insurance Information
posted double-digit gains just in )++*-)++1 using statutory Institute, p. 39. and Best’s Aggregates and Averages—Property/Casualty, 2012,
accounting and in 2006 and 2007 using GAAP accounting. p. 368, A.M. Best Company.
-5. C H A P T E R 1 / F I N A N C I A L O P E R AT I O N S O F I N S U R E R S

the profitability of property and casualty insurance be thought of as an interest-earning account receivable
relative to some peer groups over time. from the policyholder.
The third major difference in assets between a
property and casualty insurer and a life insurance
LIFE INSURANCE COMPANIES company is that a life insurance company may have
separate account assets. To protect policyholders, state
Balance Sheet
laws place limitations on a life insurance company’s
The balance sheet for a life insurance company general investments. Separate account investments
is similar to the balance sheet of a property and are not subject to these restrictions. Life insurers use
casualty insurance company. The discussion that separate accounts for assets backing interest-sensitive
follows focuses on the major differences. products, such as variable annuities, variable life
insurance, and universal-variable life insurance.
Assets Like the property and casualty insurance
companies discussed earlier, the assets of a life Liabilities Policy reserves are the major liability item
insurance company are primarily financial assets. of life insurers. Under the level-premium method of
However, there are three major differences between funding cash-value life insurance, premiums paid dur-
the assets of a property and casualty insurance ing early years are higher than necessary to pay death
company and the assets of a life insurance company. claims, while those paid in later years are insufficient
The first major difference is the average duration to pay death claims. The excess premiums collected in
of the investments. The matching principle states early years of the contract must be accounted for and
that an organization should match the maturities held for future payment as a death claim to the ben-
of its sources and uses of funds. Most property and eficiary. The excess premiums paid during the early
casualty insurance contracts are relatively short- years result in the creation of a policy reserve. Policy
term, often for one year or six months. Permanent reserves are a liability item on the balance sheet that
life insurance contracts, however, may be in force must be offset by assets equal to that amount. Policy
for 40 or 50 years, or even longer. As the match- reserves are considered a liability item because they
ing principle suggests, life insurance company represent an obligation of the insurer to pay future
investments, on average, should be of longer policy benefits. The policy reserves held by an insurer
duration than property and casualty insurance plus future premiums and future interest earnings will
company investments. Note that life insurance enable the insurer to pay all future policy benefits if
companies invest more heavily in bonds, mort- the company’s experience conforms to the actuarial
gages, and real estate than do property and casualty assumptions used in calculating the reserve. Policy
insurance companies. Property and casualty reserves are often called legal reserves because state
insurance companies place greater emphasis on insurance laws specify the minimum basis for calcu-
liquidity, holding larger relative positions in cash lating them. Reserves in life insurance are discussed
and marketable securities. in greater detail in the Appendix to Chapter 13.
The second major difference is created by the Two other life insurance company reserves
savings element in cash-value life insurance. Permanent merit discussion—the reserve for amounts held on
life insurance policies develop a savings element over deposit and the asset valuation reserve (AVR).8 The
time called the cash value, which may be borrowed reserve for amounts held on deposit is a liability
by the policyholder. When life insurance premiums that represents funds owed to policyholders and to
are calculated, it is assumed that the life insurer will beneficiaries. Given the nature of the life insurance
have the funds available to earn investment income. If business, it is common for life insurers to hold
a policyholder borrows the cash value, the life insurer funds on deposit for later payment to policyholders
must forgo the investment income that could have and beneficiaries. For example, a beneficiary
been earned on this money. Life insurance companies may select a fixed-period or fixed-amount settle-
charge interest on life insurance policy loans, and this ment option under a life insurance policy, or a
interest-bearing asset is called “contract loans” or policyholder may select the accumulate-at-interest
“policy loans” on a life insurer’s balance sheet. It can dividend option.
 RATE MAKING IN PROPERTY AND CASUALTY INSURANCE -5-

As noted earlier, statutory accounting rules A life insurer’s net gain from operations before
emphasize the solvency of insurers. As such, dividends and taxes is the insurer’s total revenues less
the surplus position of a life insurer is crucial. The the insurer’s total expenses. A life insurer’s net gain
surplus, however, is determined in large part by from operations (also called net income) equals total
the value of the assets the insurer holds. Given that revenues less total expenses, policyholder dividends,
the assets are largely financial assets, their values and federal income taxes.
are subject to considerable fluctuation. The asset
valuation reserve is a statutory account designed
Measuring Financial Performance
to absorb asset value fluctuations not caused by
changing interest rates. The net effect of this reserve is A number of measures can be used to gauge the
to smooth the company’s reported surplus over time. financial performance of the life insurance industry.
For example, pre-tax or after-tax net income could
Policyholders’ Surplus As with property and casu- be compared to total assets. An alternative measure
alty insurance companies, policyholders’ surplus is is the rate of return on policyholders’ surplus, similar
the difference between a life insurer’s total assets and to a return on equity (ROE) ratio. Using this meas-
total liabilities. Given the long-term nature of the life ure, the life insurance industry has provided higher
insurance industry, conservative long-term invest- rates of return in seven of 10 years over the past dec-
ments, and the lower risk of catastrophic losses in ade with less volatility, as compared to the property
the life insurance industry, policyholders’ surplus is and casualty insurance industry.9
less volatile in the life insurance industry than in the
property and casualty insurance industry.
RATE MAKING IN PROPERTY
Income and Expense Statement AND!CASUALTY INSURANCE
The income and expense statement for a life insurance Given the competitive nature of the insurance indus-
company is similar to the statement reviewed earlier try, premiums charged by insurance companies are
for a property and casualty insurance company. The important. Before examining specific rate-making
major sources of revenues are premiums received for methods in property and casualty insurance, the
the various products sold (e.g., ordinary life insur- objectives of rate making are discussed.
ance, group life insurance, annuities, and health
insurance) and income from investments. As with
Objectives in Rate Making
property and casualty insurers, investment income
can take the form of periodic cash flows (interest, Rate making, or insurance pricing, has several basic
dividends, and rental payments) and realized capital objectives. Because insurance rates, primarily prop-
gains or losses. erty and casualty insurance rates, are regulated by
Like a property and casualty insurance com- the states, certain statutory and regulatory require-
pany, claims payments are a major expense for a ments must be met. Also, due to the overall goal
life insurance company. Payments consist of death of profitability, certain business objectives must be
benefits paid to beneficiaries, annuity benefits paid stressed. Thus, rate-making goals can be classified
to annuitants, matured endowments paid to policy- into two categories: regulatory objectives and busi-
holders, and benefits paid under health insurance ness objectives.
policies (medical benefits and disability income
payments). Those policyholders who choose to Regulatory Objectives The goal of insurance regula-
terminate their cash-value life insurance cover- tion is to protect the public. States enact rating laws
age are paid surrender benefits, another expense that require insurance rates to meet certain standards.
for life insurers. Increased reserves, general insur- In general, rates charged by insurers must be adequate,
ance expenses, agents’ commissions and licenses, not excessive, and not unfairly discriminatory.
premium taxes, and fees round out the list of The first regulatory requirement is that rates
important expenses. must be adequate. This means the rates charged by
-54 C H A P T E R 1 / F I N A N C I A L O P E R AT I O N S O F I N S U R E R S

insurers should be high enough to pay all losses and insurance purchasers should understand how their
expenses. If rates are inadequate, an insurer may premiums are determined so that they can take active
become insolvent and unable to pay claims. As a steps to reduce their insurance costs.
result, policyholders, beneficiaries, and third-party Rates should be stable over short periods of time
claimants may be harmed. However, rate adequacy so that consumer satisfaction can be maintained.
is complicated by the fact that an insurer does not If rates change rapidly, insurance consumers may
know its actual costs when a policy is sold. The pre- become irritated and dissatisfied. They may then
mium is paid up front, but it may not be sufficient to look to government to control the rates or to enact a
pay all claims and expenses during the policy period. government insurance program.
It is only after the period of protection has expired Rates should also be responsive over time to
that an insurer can determine its actual costs. changing loss exposures and changing economic
The second regulatory requirement is that conditions. To meet the objective of rate adequacy,
rates! must not be excessive. This means that the the rates should increase when loss exposures
rates should not be so high that policyholders increase. For example, as a city grows, auto insurance
are paying more than the actual value of their rates should increase to reflect greater traffic and
protection. Exorbitant insurance prices are not in increased frequency of auto accidents. Likewise, rates
the public interest. should reflect changing economic conditions. Thus, if
The third regulatory objective is that the rates inflation causes liability awards to increase, liability
must not be unfairly discriminatory. This means that insurance rates should rise to reflect this trend.
exposures that are similar with respect to losses and Finally, the rating system should encourage loss-
expenses should not be charged significantly different control activities. Loss-control efforts are designed to
rates.10 For example, consider two men, both age 30, reduce the frequency and severity of losses. This point
who live in the same neighborhood. Each owns a is important because loss control tends to keep insur-
late-model sedan and has a clean driving record. If ance affordable. Profits are also stabilized. As you will
they purchase the same insurance coverage from the see later, certain rating systems provide a strong finan-
same insurer, they should not be charged different cial incentive for the insured to engage in loss control.
rates. However, if the loss exposures are substan-
tially different, it is fair to charge different rates.
Basic Rate-Making Definitions
Consider two other auto insurance buyers. The first
is 45, he has a clean driving record, and he drives a You should be familiar with some basic terms that
four-year-old sedan. The second is 20, and he drives are widely used in rate making. A rate is the price
a new sports car. He has been arrested for speeding per unit of insurance. An exposure unit is the unit
twice and for causing an accident by running a stop of measurement used in insurance pricing. The expo-
sign. It is fair, in this case, to charge the second man sure unit varies by line of insurance. For example, in
a higher rate for his coverage because of the higher fire insurance, the exposure unit is $100 of coverage;
probability of loss. in product liability, it is $1000 of sales; and in auto
collision insurance, it is one car-year, which is one
Business Objectives Insurers are also guided by car insured for a year.
business objectives in designing a rating system. The The pure premium refers to that portion of
rating system should meet all of these objectives: sim- the rate needed to pay losses and loss-adjustment
plicity, responsiveness, stability, and encouragement expenses. The loading refers to the amount that must
of loss control.11 be added to the pure premium for other expenses,
The rating system should be easy to understand profit, and a margin for contingencies. The gross rate
so that producers can quote premiums with a consists of the pure premium and a loading element.
minimum amount of time and expense. This is Finally, the gross premium paid by the insured
especially important in the personal lines market, consists of the gross rate multiplied by the number of
where relatively small premiums do not justify a exposure units. Thus, if the gross rate is 10 cents per
large amount of time and expense in the preparation $100 of property insurance, the gross premium for a
of premium quotations. In addition, commercial $500,000 building would be $500.
 RATE MAKING IN PROPERTY AND CASUALTY INSURANCE -55

Rate-Making Methods quickly obtained. As such, it is ideal for the personal

lines market.
There are three basic rate-making methods in prop-
Class rating is also called manual rating. Class
erty and casualty insurance: judgment, class, and
rating is widely used in homeowners insurance,
merit rating. Merit rating, in turn, can be broken
private passenger auto insurance, workers compensa-
down into schedule rating, experience rating, and
tion, and life and health insurance.
retrospective rating. Thus, the basic rating methods
There are two basic methods for determining
can be conveniently classified as follows:12
class rates: the pure premium method and the
Judgment rating loss ratio method.
Class rating
1. Pure Premium Method. As stated earlier, the pure
Merit rating
premium is that portion of the gross rate needed
Schedule rating
to pay losses and loss-adjustment expenses. The
Experience rating
pure premium can be determined by dividing
Retrospective rating
the dollar amount of incurred losses and loss-
adjustment expenses by the number of exposure
Judgment Rating Judgment rating means that units. Incurred losses include all losses paid dur-
each exposure is individually evaluated, and the ing the accounting period, plus amounts held as
rate is determined largely by the judgment of the reserves for the future payment of losses that have
underwriter . This method is used when the loss already occurred during the same period. Thus,
exposures are so diverse that a class rate cannot be incurred losses include all losses that occur dur-
calculated, or when credible loss statistics are not ing the accounting period whether or not they
available. have been paid by the end of the period. Loss-
Judgment rating is widely used in ocean marine adjustment expenses are the expenses incurred by
insurance and in some lines of inland marine insur- the company in adjusting losses during the same
ance. Because ocean-going vessels, ports, cargoes, accounting period.
and waters traveled are diverse, some ocean marine
To illustrate how a pure premium can be
rates are determined largely by the judgment of the
derived, assume that in auto collision insur-
underwriter.
ance, 500,000! autos in a given underwriting
class generate incurred losses and loss-adjustment
Class Rating The second type of property and cas- expenses of $33! million over a one-year period.
ualty rating is class rating. Most rates used today The pure premium is $66. This can be illustrated
are class rates. Class rating means that exposures by the following:
with similar characteristics are placed in the same
underwriting class, and each is charged the same
Incurred losses and loss
rate . The rate charged reflects the average loss adjustment expenses
experience for the class as a whole. Class rating Pure premium =
Number of
is based on the assumption that future losses to exposure units
insureds will be determined largely by the same set
of factors. For example, major classification fac- $33,000,000
=
tors in homeowners insurance include construction 500,000
material, age of the home, and protective devices = $66
(e.g., smoke detectors and fire extinguishers).
Accordingly, newly constructed masonry homes The final step is to add a loading for expenses,
with protective devices are not placed in the same underwriting profit, and a margin for contingencies.
underwriting class with older wood-frame homes The expense loading is usually expressed as a per-
that may not have protective devices. centage of the gross rate and is called the expense
The major advantage of class rating is that it is ratio. The final gross rate can be determined by
simple to apply. Also, premium quotations can be dividing the pure premium by one minus the expense
-56 C H A P T E R 1 / F I N A N C I A L O P E R AT I O N S O F I N S U R E R S

ratio. For example, if expenses are 40 percent of the modified by debits or credits for undesirable or
gross rate, the final gross rate is $110. This can be desirable physical features. Schedule rating is based
illustrated by the following:13 on the assumption that certain physical charac-
teristics of the insured’s operations will influence
Pure premium the insured’s loss experience. Thus, the physical
Gross rate =
1 - Expense ratio characteristics of the exposure to be insured are
$ 66 extremely important in schedule rating.
= = $ 110
1 - .40 Schedule rating is used in commercial prop-
2. Loss Ratio Method. Under the loss ratio erty insurance for large, complex structures, such
method, the actual loss ratio is compared with as an industrial plant. Each building is individu-
the expected loss ratio, and the rate is adjusted ally rated based on several factors, including
accordingly. The actual loss ratio is the ratio construction, occupancy, protection, exposure,
of incurred losses and loss-adjustment expenses and maintenance.
to earned premiums.14 The expected loss ratio
■ Construction refers to the physical characteristics
is the percentage of the premium that can be
of the building. A building may be constructed
expected to be used to pay losses. For exam-
with wood frame, brick, fire-resistive, or fire-
ple, assume that a line of insurance has incurred
proof materials. A frame building is charged a
losses and loss-adjustment expenses of $800,000
higher rate than a brick building or fire-resistive
and earned premiums of $1 million. The actual
building. Also, tall buildings and buildings with
loss ratio is 0.80 or 80 percent. If the expected
large open areas may receive debits because of
loss ratio is 0.70 or 70 percent, the rate must be
the greater difficulty of extinguishing or contain-
increased 14.3 percent. This can be illustrated by
ing a fire.
the following:
■ Occupancy refers to the use of the building.
A- E The probability of a fire is greatly influenced
Rate change = by the use of the structure. For example, open
E
flames and sparks from torches and welding
where A ! Actual loss ratio equipment can quickly cause a fire. Also, if
E ! Expected loss ratio highly combustible materials or chemicals
0.80 - 0.70 are stored in the building, a fire will be more
= difficult to!contain.
0.70
■ Protection refers to the quality of the city’s water
! 0.143, or 14.3% supply and fire department. It also includes
protective devices installed in the insured
Merit Rating The third principal type of rating in
building. Rate credits are given for a fire alarm
property-casualty insurance is merit rating. Merit
system, security guard, fire doors, automatic
rating is a rating plan by which class rates (manual
sprinkler system, fire extinguishers, and similar
rates) are adjusted upward or downward based on
protective!devices.
individual loss experience. Merit rating is based on
■ Exposure refers to the possibility that the insured
the assumption that the loss experience of a par-
building will be damaged or destroyed by a peril,
ticular insured will differ substantially from the loss
such as fire that starts at an adjacent building
experience of other insureds. Thus, class rates are
and spreads to the insured building. The greater
modified upward or downward depending on indi-
the exposure from surrounding buildings, the
vidual loss experience. There are three types of merit
greater are the charges applied.
rating plans: schedule rating, experience rating, and
■ Maintenance refers to the housekeeping and over-
retrospective rating.
all upkeep of the building. Debits are applied for
1. Schedule Rating. Under a schedule rating plan, poor housekeeping and maintenance. Thus, deb-
each exposure is individually rated. A basis rate its may be given for oily rags near a heat source
is determined for each exposure, which is then or debris strewn on the grounds of the plant.
 RATE MAKING IN LIFE INSURANCE -5/

2. Experience Rating. Under experience rating, the current policy period determines the actual
the class or manual rate is adjusted upward premium paid for that period. Under this rating
or downward based on past loss experience. plan, a provisional premium is paid at the start
The!most distinctive characteristic of experience of the policy period. At the end of the period,
rating is that the insured’s past loss experience a final premium is calculated based on actual
is used to determine the premium for the next losses that occur during the policy period. There
policy period. The loss experience over the last is a minimum and a maximum premium that
three years is typically used to determine the must be paid. In practice, the actual premium
premium for the next policy year. If the insured’s paid generally will fall somewhere between the
loss experience is better than the average for minimum and maximum premium, depending on
the class as a whole, the class rate is reduced. the insured’s loss experience during the current
If the loss experience is worse than the class policy period.
average, the rate is increased. In determining
Retrospective rating is widely used by large firms
the magnitude of the rate change, the actual loss
in workers compensation insurance, general liability
experience is modified by a credibility factor
insurance, auto liability and physical damage insur-
based on the volume of experience.15
ance, and burglary and glass insurance.
For example, assume that a retail firm has a
general liability insurance policy that is experi-
ence rated. Annual premiums are $30,000, and RATE MAKING IN LIFE
the! expected loss ratio is 30 percent. If the actual INSURANCE
loss ratio over the years is 20 percent, and the
credibility factor (C) is .29, the firm will receive a The discussion of rate making thus far has been
premium reduction of 9.7 percent. This reduction is limited to property and casualty insurance. Rate
illustrated below: making is also important for life insurance compa-
nies, especially given the long-term nature of many
A - E life insurance contracts.
Premium change = * C
E Life insurance actuaries use a mortality table
.20 - .30 or individual company experience to determine
= * .29 the probability of death at each attained age. The
.30
probability of death is multiplied by the amount
= -9.7% the life insurer will have to pay if death occurs to
determine the expected value of the death claims
Thus, the premium for the next policy period is
for each policy year. These annual expected values
$27,090. Obviously, experience rating provides a
are then discounted back to the beginning of the
financial incentive to reduce losses, because premi-
policy period to determine the net single premium
ums can be reduced by favorable loss experience.
(NSP). The NSP is the present value of the future
Experience rating is generally limited to larger
death benefit. Since most insureds pay life insur-
firms that generate a sufficiently high volume
ance premiums in installments, the NSP must be
of premiums and more credible loss experience.
converted into a series of periodic level premi-
Smaller firms are normally ineligible for experi-
ums to determine the net level premium. This is
ence rating. The rating system is frequently used in
done through a mathematical adjustment that is
general liability insurance, workers compensation,
discussed in the Appendix to Chapter 13 . After
commercial auto liability insurance, and group
the net level premium is calculated, a loading for
health insurance.
expenses is added to determine the gross premium.
3. Retrospective Rating. Under a retrospective The Appendix to Chapter 13 discusses each of these
rating plan, the insured’s loss experience during steps in greater detail.
-50 C H A P T E R 1 / F I N A N C I A L O P E R AT I O N S O F I N S U R E R S

C–,$ A99:%)–*%;$
Carolyn is senior vice president of finance and chief actu- 3. Rock Solid’s net underwriting result last year was a
ary for Rock Solid Insurance Company (RSIC). Lonnie $540,000 loss. Explain how it is possible that Rock
is double-majoring in finance and mathematics at State Solid was required to pay income taxes.
University. Lonnie applied for an internship with Rock 4. Rock Solid provides collision coverage for one
Solid, and he is working for the company during the year on 50,000 autos located in a specific territory
summer before the start of his senior year of college. within the state. During the one-year period, the
Curious to learn what Lonnie knew about insurance company expects to pay $10 million in incurred
company financial statements and ratemaking, Carolyn losses and loss-adjustment expenses for these
prepared a quiz for Lonnie to take on his first day on the 50,000 autos. Based on this information, what is
job. See if you can help Lonnie answer these questions. the pure premium?
1. At year-end last year, Rock Solid had total liabili- 5. The pure premium per unit of personal
ties of $640 million and total assets of $900 million. liability insurance for one group of prospective
What was the company’s policyholders’ surplus? purchasers is $300. If Rock Solid wants to allow
2. Explain how it is possible for Rock Solid to have for a 40! percent expense ratio for this line of
$500 million in written premiums last year and coverage, what gross rate per unit of coverage
$505 million in earned premiums last year. should be!charged?

SUMMARY expenses are loss payments, loss-adjustment expenses,

and other expenses including commissions, premium
■ A balance sheet summarizes what a company owns
taxes, and general insurance company expenses.
(assets), what it owes (liabilities), and the difference
between these two values (owners’ equity). ■ To determine an insurer’s net income, total expenses are
subtracted from total revenues. Policyholder dividends,
■ For an insurance company, the major assets are finan-
if any, are deducted to determine taxable income, and
cial assets, which are investments in bonds, stocks, real
federal income taxes are levied on taxable income.
estate, mortgage-backed securities, and marketable
securities, as well as cash. ■ The loss ratio is the ratio of a property and casualty
■ An insurer’s liabilities are called reserves. The loss insurer’s incurred losses and loss-adjustment expenses to
reserve is the estimated cost of settling claims. Loss earned premiums. The expense ratio is the ratio of the
reserves in property and casualty insurance can be clas- insurer’s underwriting expenses to written premiums.
sified as case reserves, reserves established using the ■ The combined ratio is the sum of the loss ratio and
loss ratio method, and reserves for incurred-but-not- the expense ratio. A combined ratio greater than 1
reported (IBNR) claims. (or 100 percent) indicates an underwriting loss, and a
■ Another important reserve for property and casualty combined ratio less than 1 (or 100 percent) indicates an
insurers is the unearned premium reserve. This reserve underwriting profit.
equals the unearned portion of gross premiums for out- ■ An insurance company can lose money on its
standing policies at the time of valuation. underwriting operations and still be profitable if the
■ The difference between an insurer’s total assets and total investment income offsets the underwriting loss.
liabilities is called policyholders’ surplus. Policyholders’ ■ The assets of life insurance companies tend to be of
surplus consists of paid-in capital at stock companies, longer duration than the assets of property and casualty
plus retained profits from insurance operations and insurers. As a policyholder may borrow the cash value,
investments over time. Surplus represents a margin of life insurance policy loans are an asset for life insurers.
safety for policyholders. Life insurers maintain separate accounts for the assets
■ The major sources of revenue for an insurance company backing interest-sensitive products, such as variable
are premiums and investment income. The major annuities.
 REVIEW QUESTIONS -51

■ The major liability item for a life insurance company is ■ Life insurance actuaries determine the probability of
the policy reserve. Two other important reserves are the death in any given year, and based on this probability
reserve for amounts held on deposit and the asset valua- determine the expected value of the loss payment. These
tion reserve. expected future payments are discounted back to!the start
of the coverage period and summed to determine the net
■ A life insurer’s net gain from operations equals total
single premium. The net single premium may be leveled to
revenues, less total expenses, policyholder dividends,
convert to installment premiums. A loading for expenses
and federal income taxes.
is added to determine the gross premium.
■ Insurance rates are regulated to make sure they are
adequate, not excessive, and not unfairly discriminatory.
Business objectives of rating systems include simplic- KEY CONCEPTS AND TERMS
ity, responsiveness, stability, and encouragement of
Annual pro rata Loss ratio (128)
loss!control.
method (126) Loss ratio method
■ The rate is the price per unit of insurance and the Asset valuation (of determining loss
exposure unit is the measurement base used. The pure reserve (131) reserves) (126)
premium is the portion of the premium needed to pay Balance sheet (124) Loss ratio method
claims and loss adjustment expenses. The loading covers Case reserves (125) (of rating) (133)
expenses, profit, and other contingencies. The gross rate Class rating (133) Loss reserve (125)
is the sum of the pure premium and the loading element. Combined ratio (128) Merit rating (134)
■ Three major rating methods are used in property and Earned premiums (127) Net gain from
casualty insurance: judgment, class, and merit rating. Expense ratio (128) operations (131)
Experience rating (135) Overall operating
■ Judgment rating means that each exposure is individu- Exposure unit (132) ratio (129)
ally evaluated, and the rate is determined largely by the Gross premium (132) Policyholders’
underwriter’s judgment. Gross rate (132) surplus (126)
■ Class rating means that exposures with similar charac- Income and expense Pure premium (132)
teristics are placed in the same underwriting class, and statement (127) Pure premium method (133)
each is charged the same rate. The rate charged reflects Incurred-but-not-reported Rate (132)
the average loss experience for the class as a whole. (IBNR) reserve (126) Reserve for amounts held
Most personal lines of insurance are class rated. Investment income ratio (129) on deposit (130)
■ Merit rating is a rating plan by which class rates are Judgment rating (133) Retrospective rating (135)
adjusted upward or downward based on individual Loading (132) Schedule rating (134)
loss experience. It is based on the assumption that!the Loss-adjustment Unearned premium
loss experience of an individual insured will!differ sub- expenses (126) reserve (126)
stantially from the loss experience of other insureds.
■ There are three principal types of merit rating plans: REVIEW QUESTIONS
Schedule rating 1. a. What are the three major sections of a balance
Experience rating sheet?
Retrospective rating b. What is the balance sheet equation?

■ Under schedule rating, each exposure is individually 2. a. What types of assets appear on the balance sheet of
rated, and debits and credits are applied based on the an insurance company?
physical characteristics of the exposure to be insured. b. Why are the liabilities of a property and casualty
Experience rating means that the insured’s past loss insurance company difficult to measure?
experience is used to determine the premium for the next 3. a. What are the two major sources of revenue for a
policy period. Retrospective rating means the insured’s property and casualty insurance company?
loss experience during the current policy period deter- b. What are the major expenses of a property and
mines the actual premium paid for that period. casualty insurance company?
-52 C H A P T E R 1 / F I N A N C I A L O P E R AT I O N S O F I N S U R E R S

4. a. How is the combined ratio of a property and casu- Death benefits paid 6,000,000
alty insurance company calculated, and what does Net investment income 3,000,000
the combined ratio measure? Commissions paid 5,900,000
b. How is it possible for a property and casualty General insurance expense 2,500,000
insurance company to be profitable if its combined Surrender benefits paid 800,000
ratio exceeds one (or 100 percent)? Annuity benefits paid 1,600,000
5. Name three ways in which the assets of a life insur- 3. A large casualty insurer writes a substantial amount
ance company differ from the assets of a property and of private passenger auto insurance. An actuary ana-
casualty insurance company. lyzed claims data for a specific class of drivers for a
6. What do the reserves on a life insurance company’s recent one-year policy period. The claims data showed
balance sheet represent? that the insurer paid out $30 million for incurred
losses and loss-adjustment expenses for each 100,000
7. What are the major categories of expenses for a life cars insured for one year. Based on the pure premium
insurance company? method, calculate the pure premium.
8. a. What are the major regulatory objectives that must 4. For the past calendar year, a property insurer reported
be satisfied in insurance rate making? the following financial information for a specific line
b. What are the major business objectives? of insurance:
9. In the context of rate making, explain the meaning of: Premiums written $25,000,000
a. rate Expenses incurred 5,000,000
b. exposure unit Incurred losses and
c. pure premium loss-adjustment expenses 14,000,000
d. gross premium Earned premiums 20,000,000
10. Briefly describe the following methods for determining a. What was the insurer’s loss ratio for this line of
a class rate: coverage?
a. pure premium method b. Calculate the expense ratio for this line of coverage.
b. loss ratio method c. What was the combined ratio for this line of coverage?
11. Explain the following methods of merit rating: 5. a. Why are property and casualty insurance compa-
a. schedule rating nies required to maintain loss reserves?
b. experience rating b. Briefly explain the following methods for determin-
c. retrospective rating ing loss reserves:
1. judgment method
2. average value method
APPLICATION QUESTIONS 3. tabular method
1. Based on the following information, determine the c. What is the incurred-but-not-reported (IBNR)
policyholders’ surplus for XYZ Insurance Company: loss reserve?

Total invested assets $50,000,000

Loss reserves 40,000,000
Total liabilities 70,000,000 INTERNET RESOURCES
Bonds 35,000,000 ■ The American Academy of Actuaries is a public policy
Unearned premium reserve 25,000,000 and communications organization for all actuaries in
Total assets 90,000,000 the United States. Their site provides timely studies on
2. Based on the following information, determine Mutual important insurance problems and issues. Visit the site at
Life Insurance Company’s gain from operations before actuary.org
income taxes and dividends to policyholders:
■ The American Council of Life Insurers is a Washington
Total premium income $20,000,000 DC–based trade association representing the interests
Licenses, taxes, and fees 580,000 of member companies. The council prepares The Life
 NOTES -53

Insurers Fact Book annually, and this excellent resource insurance industry and advises other organizations on
is available online. Visit the site at risk financing and self-insurance. Visit the site at
acli.com towerswatson.com
■ The American Society of Pension Professionals & Actuaries
is an organization formed to educate pension actuaries,
consultants, and other professionals in the employee SELECTED REFERENCES
benefits field. Visit the site at
Black, Kenneth, Jr., and Harold D. Skipper, Jr. Life
asppa.org
Insurance, 13th ed., Upper Saddle River, NJ: Prentice
■ The Casualty Actuarial Society is a professional organiza- Hall, 2000, chs. 27–30.
tion that promotes education in actuarial science and
Graves, Edward E., ed. McGill’s Life Insurance, 8th ed.,
provides statistics on property and casualty insurance.
Bryn Mawr, PA: The American College, 2011.
Visit the site at
The Insurance Fact Book 2012, New York: Insurance
casact.org
Information Institute, 2012.
■ The Conference of Consulting Actuaries is an organization
The Life Insurers Fact Book 2011, Washington, DC:
that consists of consulting actuaries in all disciplines.
American Council of Life Insurers, 2011.
Visit the site at
ccactuaries.org Myhr, Ann E. and James J. Markham. Insurance Operations,
Regulation, and Statutory Accounting, 1st ed., Malvern,
■ The Insurance Information Institute is an excellent pri-
PA: American Institute for Chartered Property Casualty
mary source for information, statistics, and analysis
Underwriters / Insurance Institute of America, 2003.
on topics in property and casualty insurance. Visit the
site at Webb, Bernard L., et al., Insurance Operations and
iii.org
Regulations, 1st ed., Malvern, PA: American Institute
for Chartered Property Casualty Underwriters/
■ Insurance Journal, The National Property Casualty Insurance Institute of America, 2002.
Magazine, is a free online journal that provides local
and national news on the property and casualty insur- Wiening, Eric A. Foundations of Risk Management and
ance industry. Breaking news and current developments Insurance, 1st ed., Malvern, PA: American Institute
are sent daily to subscribers. Visit the site at for Chartered Property Casualty Underwriters/
Insurance Institute of America, 2002.
insurancejournal.com

■ The Insurance Services Office (ISO) provides statistical

information, actuarial analysis and consulting, policy NOTES
language, and related information to organizations in
1. Simplified versions of the financial statements are
the property and casualty insurance markets. Visit the
presented in this chapter. In practice, the financial
site at
statements are more complex. Insurers are required
iso.com to use statutory accounting rules for the financial
■ The Society of Actuaries is a professional organization statements prepared for regulators. Financial state-
that educates and qualifies individuals to become actu- ments may also be prepared using Generally Accepted
aries, provides continuing education programs, and Accounting Principles (GAAP). Statutory accounting
enforces a professional code of conduct. Membership is conservative and emphasizes insurer solvency.
is obtained by successful completion of a rigorous set of 2. For a detailed discussion of loss reserves, see Bernard L.
exams leading to the designation of Associate or Fellow Webb, et al., Insurance Operations and Regulation,
in the Society. Visit the site at 1st ed. (Malvern, PA: American Institute for Chartered
soa.org Property Casualty Underwriters/Insurance Institute of
■ Towers Watson is one of the world’s largest actuarial America, 2002), ch. 12.
and management consulting firms. The company 3. Under statutory accounting, expenses are recognized
provides a substantial amount of information on the immediately while premium income is earned over
-6. C H A P T E R 1 / F I N A N C I A L O P E R AT I O N S O F I N S U R E R S

a period of time. An insurance company, therefore, American Institute for Chartered Property Casualty
is immediately placed in a negative position when Underwriters, 1992), p. 119.
it writes a policy as acquisition expenses must be 11. Bernard L. Webb, Connor M. Harrison, and James J.
charged immediately. Surplus can also be considered Markham, Insurance Operations, 2nd ed., Vol. 2
from a leverage perspective. Obviously, the more (Malvern, PA: American Institute for Chartered
coverage written per dollar of surplus, the greater the Property Casualty Underwriters, 1997), pp. 89–90.
policyholder leverage.
12. The basic rate-making methods are discussed in
4. This section is based on Eric A. Wiening, Foundations some detail in Webb et al., Chs. 10 and 11. Also see
of Risk Management and Insurance, 1st ed., Malvern, Bernard L. Webb, J. J. Launie, Willis Park Rokes, and
PA: American Institute for Chartered Property Norman A. Baglini, Insurance Company Operations,
Casualty Underwriters/Insurance Institute of America, 3rd ed., Vol. 2 (Malvern, PA: American Institute for
2002. The author drew heavily on the material pre- Property and Liability Underwriters, 1984), chs. 9
sented in ch. 5, especially pp. 5.21 through 5.26, in and 10.
preparing this section.
13. An equivalent method for determining the final rate
5. The observant reader may note that the denominators is to divide the pure premium by the permissible loss
in the loss ratio and the expense ratio are different— ratio. The permissible loss ratio is the same as the
premiums earned for the loss ratio and premiums writ- expected loss ratio. If the expense ratio is .40, the
ten for the expense ratio. This version of the combined permissible loss ratio is 1 # .40, or .60. Thus if the
ratio is called the “trade basis” combined ratio. A pure premium of $66 is divided by the permissible
second version, the “statutory” combined ratio, uses loss ratio of .60, the resulting gross rate is also $110.
earned premiums in both denominators. Although the
statutory combined ratio is mathematically correct,
Pure premium $ 66
Gross rate = = = $ 110
the trade basis better matches income and expenses. Permissible loss ratio .60

6. Combined ratios were provided by 2012 Best’s 14. Earned premiums, as discussed earlier in the chapter,
Aggregates and Averages—Property and Casualty, are premiums actually earned by a company during
p. 368. The investment income increase and sur- the accounting period, rather than the premiums writ-
plus! decline are from pages 80 and 81 of the same ten during the same period.
publication. 15. The credibility factor, C, refers to the statistical reli-
7. As shown in the table on page 39 of The Insurance ability of the data. It ranges from 0 to 1 and increases
Fact Book 2012 (New York: Insurance Information as the number of claims increases. If an actuary
Institute). believes that the data are highly reliable and can accu-
rately predict future losses, a credibility factor of 1
8. See Kenneth R. Black, Jr. and Harold D. Skipper, Jr.,
can be used. However, if the data are not completely
Life Insurance, 13th ed. (Upper Saddle River, NJ:
reliable as a predictor of future losses, a credibility
Prentice Hall, 2000), pp. 914–915 for a discussion of
factor of less than 1 is used.
these and other life insurer policy reserves.
9. As shown in the table on page 39 of The Insurance
Fact Book 2012, New York: Insurance Information Students may take a self-administered test on
Institute. this chapter at
10. Robert J. Gibbons, George E. Rejda, and Michael W. www.pearsonhighered.com/rejda
Elliott, Insurance Perspectives (Malvern, PA: