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Operations of Insurance Companies: January 1998
Operations of Insurance Companies: January 1998
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OPERATIONS OF 12
INSURANCE COMPANIES
Objective
This chapter examines the organizational patterns and major functions of
insurance companies without regard to their corporate form.
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DISCUSSION:
All premium payments are advance payments corresponding to
a certain insurance period, usually one year. During the
insurance period the policyholder may "report" claims to the
insurance company. There will always be a certain delay , the
"claim settlement period," before the company can make the
payments according to the contract. The ability of insurance
companies to meet their future obligations is vital and at any
time the "funds" available to the company should exceed the
promised payments:
Q > S + Co + Ca + ∆R ( ∆R = Rt - Rt-1 )
When the result from the insurance operation (the
underwriting result) is negative, the insurance company has to
use part of the investment income to overcome insurance
(underwriting) losses:
Q + j.F = S + Co + Ca + ∆R
For the long term survival of the company, the
investment income should be sufficient to maintain the capital
and surplus:
F = ra.A > j.F
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3
Graph 12.1
A Flow of Funds Model of the Operations
of Insurance Companies
4
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DISCUSSION:
Product design and development is a primary responsibility of
the management of a company. Before producing and
distributing a new coverage (for example, medical and
hospitalization coverage for domestic animals) the following
steps must be considered:
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5
Product Management
Product management regroups the operations that deal with the pricing of
insurance (the rate-making department ), the selection and classification of risks
to be covered by insurance (the underwriting department ) and, the fair and prompt
payment of claims ( the claims department ).
Rate-making is the determination of the proper premium to be charged for each
insurance coverage. It refers to the pricing of insurance contracts (Chapter 9) and
covers the production cost plus a margin for profit. The basic requirements are
the classification of risks on the basis of selected characteristics and the proper
use of statistics available to the company. The statistical and actuarial operations
or functions are an important factor in the insurer's capability to compete in a
market.
Underwriting is the process of selecting and classifying the insurance proposals
according to the rate-maker hypotheses. The objective is not the selection of risks
that will not generate losses but to avoid adverse selection and the
misclassification of risks. Sound underwriting is the major factor in the future
profitability of insurance operations.
The underwriting policy of an insurance company determine the nature and
size of the business of a company. There are four major factors affecting the
underwriting policy of a company: (1) the financial capacity of the company, (2)
the regulatory framework concerning the maximum production capacity, (3) the
technical skills and abilities of the personnel (the know-how) and, (4) the
availability of reinsurance. Once the company's underwriting policy has been
established it is implemented through staff and line underwriting functions (see
Table 12.1).
6
Table 12.1
The Underwriting Functions
Staff Underwriting functions Line Underwriting functions
Table 12.2
The Claim Processing Cycle
1. Loss reporting: - Notice of loss
- Proof of loss
Services
The major service activities provided by insurance companies are legal services,
loss control and risk management services, policyholders' services and producer,
consumer, and employees education.
Administration
The major administrative functions related to insurance operations are quite
similar to the administrative functions of any other organization. They include
general management and strategic planning, personnel administration and
management, branch office management, accounting, and public relations.
After an insurance company has been organized with initial surplus funds it
can commence its operations. The net worth (the policyholders' surplus) is the
excess of assets over liabilities. The potential sources of earnings are the profits
resulting from the insurance operations (the underwriting profit) and the
investment earnings. Each year, insurance companies can increase their surplus
funds and/or distribute dividends to stockholders or to policyholders (in the case
of mutuals). However, most of the insurance companies preferably increase their
surplus to be able to finance their growth.
The investment department manages the company's portfolio of financial
assets but the investment strategy is determined by the top management. In many
countries, the investments of insurance companies are also regulated and carefully
supervised.
said that "the actuaries may be thought of as having the rate-making function,
whereas underwriters have the rating function, i.e., the application of rates."
(Denenberg et al, 1974, p. 589).
_____________________________________________________
DISCUSSION:
Commercial and industrial buildings are assigned individual
rates by the underwriter according to the type of loss exposure.
The rates are determined through the application of a rating
schedule fixed by the rate-making department.
Basic rate (one storey building, town class 3 ) $0.48 per $1,000
Charges:
Walls, non standard, combustible panels + 20%
Floor poor quality mortar + 5%
Wooden parts in ceiling + 5%
Area over 10,000 square feet + 10%
Credits:
No basement - 10%
Fire extinguishers - 5%
Rate of building unoccupied $0.60
Occupancy charge + 50%
Rate of building occupied $0.90
External exposure + 25%
Management:
Charge for poor housekeeping + 5%
Smoking not forbidden + 5%
Flat building rate $1.22
The basic rate for the class of business is modified, either upward or
downward, by the underwriter following the analysis of the information
provided by the producer or his own investigation.
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Underwriting and Claims
During the claim adjustment process, the adjuster may notice defects that need to
be remedied immediately to decrease the probability of loss. An adjuster may also
discover moral or morale hazard problems such as illegal or hazardous use of
property, poor housekeeping. The underwriting department, after a loss and a
close investigation, may also question whether or not the coverage should be
continued. However, what has been called "claims underwriting" is often
detrimental to the reputation of an insurance company.
10
Market competition may take many forms: reduction in price, improvement in the
quality of the product, provision of complementary services, advertising, real and
unreal product differentiation and obstructions of competitors' operations. The
possibilities can be classified as positive competition, whereby the seller improves
the attractiveness of his own products; and defensive competition, in which the
seller adopts a strategy that detracts from his competitors' products or restricts the
competitors' ability to operate profitably.
11
Summary
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References
Denenberg, H.S., Eilers, R.D., Melone, J.J. and R.A. Zelten, Risk and Insurance
, Englewood Cliffs, NJ: Prentice Hall, Inc., 2nd ed., 1974.
Michelbacher, G.F. and N.R. Roos, Multiple-Line Insurers: Their Nature and
Operation , New York: McGraw-Hill Book Co., 1970.
13
1
A well known joke among insurers describes the process of managing an insurance company as the conduct of an automobile.
The driver, the director of the sales department, is driving very fast and the front passenger, the chief underwriter, is trying to
reduce the speed of the car by using the hand brake.
The third passenger on the rear seat, the actuary, is the one who knows where they are going and he is trying to indicate the
direction by looking through the rear glass.
2
In recent years, because of high interest rates available on the financial markets, it became obvious that many insurance
company had realized the importance of cash management. The volume of business became the first priority without proper
control on the underwriting quality. This has been criticized in many circles as a practice of "cash-flow underwriting."
3
For a detailed analysis and examples of the loss control activities see Webb et al. (1984, Chap. 11).
4
The case of Japan is very interesting. Product competition is regulated by the Government and ruled by the market.
Competition does not exist because a new product developed by one company has to be approved by the trade association of
insurance companies before it can be offered to the public.