Combined Chapters 6 and 8

Insurance Company Operations
• The most important operations of an insurance company

include the following:
– Rate making
– Underwriting
– Production
– Claims settlement
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Three Major Players
Insurance Company Operations
• Underwriter
• Actuary
• Adjudicator
Rating and Ratemaking (2 of 2)
– Total premiums charged must be adequate for paying
all claims and expenses during the policy period
– Rates and premiums are determined by an actuary,
using the company’s past loss experience and industry
statistics
– Actuaries also determine the adequacy of loss
reserves, allocate expenses, and compile statistics for
company management and state regulatory officials.
Underwriting (1 of 5)
• Underwriting refers to the process of selecting, classifying,
and pricing applicants for insurance
• A statement of underwriting policy establishes policies that
are consistent with the company’s objectives
• The underwriting policy is stated in an underwriting guide,
which specifies:
– Acceptable, borderline, and prohibited classes of business
– Amounts of insurance that can be written
– Territories to be developed
– Forms and rating plans to be used
– Business that requires approval by a senior underwriter
Red-Lining is Illegal
• The basic principles of underwriting include:
– Attain an underwriting profit
– Select prospective insureds according to the company’s
underwriting standards
▪ Reduce adverse selection against the insurer
▪ Adverse selection is the tendency of people with a
higher-than-average chance of loss to seek insurance at
standard rates; if it is not controlled by underwriting it will
result in higher-than-expected loss levels.
– Provide equity among the policyholders
▪ One group of policyholders should not unduly subsidize
another group
• The process of underwriting starts with the agent; this is
often called field underwriting
• Information for underwriting comes from:
– The application
– The agent’s report
– An inspection report
– Physical inspection
– A physical examination and attending physician’s report
– Medical Information Bureau (MIB) report
• After reviewing the information, the underwriter can:
– Accept the application and recommend that the policy
be issued
– Accept the application subject to restrictions or
modifications
– Reject the application
• Many insurers now use computerized underwriting for
certain personal lines of insurance that can be
standardized
• Other factors considered in underwriting include:
– Rate adequacy
– Availability of reinsurance
– Whether a policy can or should be cancelled or
renewed
Production (1 of 2)
• Production refers to the sales and marketing activities of
insurers
– Agents are often referred to as producers
– Life insurers have an agency or sales department
– Property and liability insurers have marketing departments
• The marketing of insurance has been characterized by a trend
toward professionalism
– An agent should be a competent professional with a high
degree of technical knowledge in a particular area of
insurance and who also places the needs of his or her
clients first
Production (2 of 2)
• Several organizations have developed professional
designation programs for insurance personnel:
– The American College: CLU, ChFC
– The American Institute for Chartered Property and
Casualty Underwriters: CPCU
– Certified Financial Planner Board of Standards, Inc.:
CF P
– National Alliance for Insurance Education and
Research: CIC
Agent Licensing
• Agents are required to be licensed in the state(s) in
which they are actively selling business.
– Continuing education requirements
Claims Settlement (1 of 3)
• The objectives of claims settlement include:
– Verification of a covered loss
– Fair and prompt payment of claims
– Provide personal assistance to the insured
• Some laws prohibit unfair claims practices, such as:
– Refusing to pay claims without conducting a
reasonable investigation
– Not attempting to provide prompt, fair, and equitable
settlements
– Offering lower settlements to compel insureds to
institute lawsuits to recover amounts due
• Major types of claims adjustors include:
– An insurance agent often has authority to settle small
first-party claims up to some limit
– A staff claims representative is usually a salaried
employee who will investigate a claim, determine the
amount of loss, and arrange for payment.
– An independent adjustor is an organization or
individual that adjusts claims for a fee
– A public adjustor represents the insured and is paid a
fee based on the amount of the claim settlement
• The claim process begins with a notice of loss, typically
immediately or as soon as possible after a loss has
occurred.
• Next, the claim is investigated
– An adjustor must determine that a covered loss has
occurred and determine the amount of the loss
• The adjustor may require a proof of loss before the claim is
paid
• The adjustor decides if the claim should be paid or denied
– Policy provisions address how disputes may be
resolved
Reinsurance (1 of 10)
• Reinsurance is an arrangement by which the primary insurer
that initially writes the insurance transfers to another insurer
part or all of the potential losses associated with such
insurance
– The primary insurer is the ceding company
– The insurer that accepts the insurance from the ceding
company is the reinsurer
– The retention limit is the amount of insurance retained by
the ceding company
– The amount of insurance ceded to the reinsurer is known
as a cession
– Retrocession is when a reinsurer insures part or all of a
risk with another insurer
• Reinsurance is used to:
– Increase underwriting capacity
– Provide protection against a catastrophic loss
– Retire from business or from a line of insurance or
territory
– Obtain underwriting advice on a line for which the
insurer has little experience
Exhibit 6.1 The Ten Most Costly
Catastrophes in the US ($ Millions) (1 of 2)
Blank Blank Blank Estimated Insured Estimated Insured

Property Losses Property Losses
Rank Date Peril Dollars When Occurred In 2016 dollars
1 Aug 2005 ust Hurricane Katrina $ 41,100 $ 49,793
2 Sep 2001 tember Fire, explosion: World Trade 18,779 24,987
Center, Pentagon terrorist
attacks
3 Aug 1992 ust Hurricane Andrew 15,500 24,478
4 Oct 2012
ober Hurricane Sandy 18,750 19,860
5 Jan 1994
uary Northridge, CA earthquake 12,500 18,880
6 Sep 2008 tember Hurricane lke 12,500 14,036
7 Oct 2005
ober Hurricane Wilma 10,300 12,479
Exhibit 6.1 The Ten Most Costly
Catastrophes in the US ($ Millions) (2 of 2)
Blank Blank Blank Estimated Insured Estimated Insured

Property Losses Property Losses
Rank Date Peril Dollars When Occurred In 2016 dollars
8 Aug 2004 ust Hurricane Charley 7,475 9,348
9 Sep 2004 tember Hurricane Ivan 7,110 8,891
10 Apr 2004
il Flooding, hail and wind 7,300 7,875
including the tornadoes that
struck Tuscaloosa and other
locations
1
Property coverage only. Excludes flood damage covered by the federally administered National Flood
Insurance Program.
2
Adjusted for inflation through 2016 by I SO using the G DP implicit price deflator.
Note: Data are from the Property Claim Services (P CS) unit of ISO, a Verisk Analytics company.
Source: “Facts+Statistics: U.S. Catastrophes,” Insurance Information Institute (2018). Accessed at
www.iii.org/fact-statistic/facts-statistics-us-catastrophes, May 2018.
This source is periodically updated. Reprinted with permission.
• There are two principal forms of reinsurance:
– Facultative reinsurance is an optional, case-by-case
method that is used when the ceding company receives an
application for insurance that exceeds its retention limit
▪ Often used when the primary insurer has an application
for a large amount of insurance
– Treaty reinsurance means the primary insurer has agreed
to cede insurance to the reinsurer, and the reinsurer has
agreed to accept the business
▪ All business that falls within the scope of the agreement
is automatically reinsured according to the terms of the
treaty
• There are two basic methods for sharing losses:
– Under the Pro rata method, the ceding company and
reinsurer agree to share losses and premiums based
on some proportion
– Under the Excess method, the reinsurer pays only
when covered losses exceed a certain level
• Under a quota-share treaty, the ceding insurer and the
reinsurer agree to share premiums and losses based on
some proportion
Example: assume that Apex Fire Insurance and Geneva Re
enter into a quota-share arrangement by which losses and
premiums are shared 50-50
If a $100,000 loss occurs, Apex Fire pays $100,000 to the
insured but is reimbursed by Geneva Re for $50,000
• An excess-of-loss treaty is designed for protection against a
catastrophic loss
– A treaty can be written to cover a single exposure, a single
occurrence, or excess losses
Example: Apex Fire Insurance wants protection for all windstorm

losses in excess of $1 million. Assume Apex enters into an
excess-of-loss arrangement with Franklin Re to cover single
occurrences during a specified time period. Franklin Re agrees to
pay all losses exceeding $1 million but only to a maximum of $10
million.
If a $5 million hurricane loss occurs, Franklin Re would pay $4
million.
Net Ratio
• Earned Premiums/Paid Claims + Operating Expenses
• Most Property & Liability companies have a ratio of
approximately .85 to .92
• How does a Property & Liability company make money?
Investments
• Because premiums are paid in advance, they can be
invested until needed to pay claims and expenses
• Investment income is extremely important in reducing the
cost of insurance to policyowners and offsetting
unfavorable underwriting experience
Important Functions Performed by
Other Insurance Companies
• Information systems are extremely important in the daily
operations of insurers.
– Computers are widely used in many areas, including
policy processing, simulation studies, market analysis,
and policyholder services.
• The accounting department prepares financial statements
and develops budgets
• In the legal department, attorneys are used in advanced
underwriting and estate planning
• Property and liability insurers also provide many loss
control services
Reasons for Insurance Regulation
• Maintain insurer solvency
• Compensate for inadequate consumer knowledge
• Ensure reasonable rates
• Make insurance available
Historical Development of Insurance
Regulation (1 of 4)
• Insurers were initially subject to few regulatory controls.
• State legislatures first granted charters to new insurers;
insurance commissions were first created in 1851.
• In Paul v Virginia (1868), the Supreme Court ruled that
ersus
insurance was not interstate commerce, and that the

states rather than the federal government had the right to
regulate the insurance industry.
Regulation (2 of 4)
• In U.S. v South-Eastern Underwriters Association
ersus
(1944) the Court ruled that insurance was interstate

commerce when conducted across state lines and was
subject to federal antitrust laws
• The McCarran-Ferguson Act (1945) states that
continued regulation and taxation of the insurance
industry by the states are in the public interest
– Federal antitrust laws apply to insurance only to the
extent that the insurance industry is not regulated by
state law
Regulation (3 of 4)
• The Financial Modernization Act (1999) changed
federal law that earlier prevented banks, insurers, and
investment firms from competing outside their core area
– State insurance departments regulate insurers
– State and federal bank agencies regulate banks
– The Securities and Exchange Commission (SEC)
regulates the sale of securities
– The Federal Reserve has umbrella authority over
bank affiliates that engage in underwriting insurance
Methods for Regulating Insurers
• The three principal methods used to regulate insurers are:
– Legislation, through both state and federal laws
– Court decisions, e.g., interpreting policy provisions
– State insurance departments
What Areas Are Regulated? (1 of 10)
• All states have requirements for the formation and
licensing of insurers
– Licensing includes minimum capital and surplus
requirements
– A domestic insurer is domiciled in the state
– A foreign insurer is an out-of-state insurer that is
chartered by another state, but licensed to operate in
the state
– An alien insurer is an insurer that is chartered by a
foreign country, but is licensed to operate in the state
• Insurers are subject to financial regulations designed to
maintain solvency
– Assets must be sufficient to offset liabilities
– Admitted assets are assets that an insurer can show
on its statutory balance sheet in determining its
financial condition
– States have regulations that address the calculation of
reserves
– An insurer’s surplus position is carefully monitored by
state regulators
• Life and health insurers must meet certain risk-based
capital (RBC) standards
– Insurers must hold a certain amount of capital,
depending on the riskiness of their investments and
insurance operations
– An insurer’s RBC depends on asset risk, underwriting
risk, interest rate risk, and business risk
– A comparison of the company’s total adjusted capital
to the amount of required risk-based capital
determines whether company or regulatory action is
required
Exhibit 8.1 Corrective Action Levels for
Life Insurers
RBC Ratio (%) Zone Action
125% and above Adequate None
100% to 124% Red flag Insurer must conduct trend

test
75% to 99% Company action Insurer must file plan with regulator outlining corrective
steps
50% to 74% Regulatory action Regulator must examine insurer and order corrective steps
35% to 49% Authorized control Regulator may seize insurer if necessary
Below 35% Mandatory control Regulator must seize insurer
Source: “Insurance Companies’ Risk-Based Capital Ratios,” The Insurance Forum, Vol. 39, No. 8
(August 2012), p 73. ©2012. Reprinted with permission.
age
• The purpose of investment regulations is to prevent
insurers from making unsound investments that could
threaten the company’s solvency and harm the policy
owners
– Laws generally place a limit on the proportion of
assets in a specific asset category, such as real estate
• Many states limit the amount of surplus a participating life
insurer can accumulate, rather than pay as dividends
• Each insurer must file an annual report with the state
insurance department in the states where it does
business
• The state insurance department assumes control of
insurance companies that they determine to be
financially impaired
– All states have guaranty funds, guaranty laws and
guaranty associations that pay the claims of
policyowners of insolvent insurers
– The assessment method is the major method used
to raise the necessary funds to pay unpaid claims
• Rate regulation takes a variety of forms across states
– Forms of rate regulation for property and casualty insurance
include:
• Prior approval law • Flex-rating law
• Modified prior approval law • State-made rates
• File-and-use law • No filing required
• Use-and-file law
• State insurance commissioners have the authority to
approve or disapprove new policy forms before the
contracts are sold to the public
– Insurance contracts are technical and complex
– Purpose is to protect the public from misleading,
deceptive, and unfair provisions
• Sales practices are regulated by the laws concerning the
licensing of agents and brokers
– All states require agents and brokers to be licensed
– All states require agents to obtain continuing education
to upgrade their knowledge and skills
• Insurance laws prohibit a variety of unfair trade practices,
such as misrepresentation, twisting, and rebating
– Twisting is the inducement of a policy owner to drop
an existing policy and replace it with a new one that
provides little or no economic benefit to the client
– Rebating is the practice of giving an individual a
premium reduction or some other financial advantage
not stated in the policy as an inducement to purchase
the policy
• State insurance departments typically have a complaint division
for handling consumer complaints
– Most complaints involve claims
• Information is provided to consumers on insurance department
websites and in brochures
• Insurers pay numerous local, state, and federal taxes
State Versus Federal Regulation (1 of 4)
• Proponents for federal regulation argue that federal
regulation:
– would provide uniformity in state regulations
– is more effective in negotiations of international
insurance agreements
– is more effective in the identification and treatment of
systemic risk
– Would enable insurers to become more efficient
What is the NAIC
• Advantages of state regulation include:
– Quicker response to local insurance problems
– Federal regulation could lead to a dual system of
regulation and increase costs
– Poor quality of federal regulation, e.g., in the banking
industry
– Reasonable uniformity of laws can be achieved by the
model laws of the NAIC
– Greater opportunity for innovation
– Unknown consequences of federal regulation
• Shortcomings of state regulation include:
– Inadequate protection of consumers
– Improvements needed in handling complaints
– Inadequate market conduct examinations
– Insurance availability
– Regulators overly responsive to the insurance industry
• Should the McCarran-Ferguson Act be repealed?
• Critics of state regulation argue:
– The insurance industry no longer needs broad antitrust
exemption
– Federal regulation is needed because of the defects in
state regulation.
• Counterarguments include:
– The insurance industry is already competitive.
– Small insurers may be harmed.
– Insurers may be prevented from developing common
coverage forms
Current Issues in Insurance Regulation (3 of 6)
• The Federal Insurance Office (FIO) has the authority to:
– Monitor all aspects of the insurance industry
– Identify gaps in insurance regulation and identify
issues that contribute to systemic risk
Current Issues in Insurance Regulation (6 of 6)
• Another approach to insurance regulation is an optional
federal charter
– Proposals would allow insurers to choose either a
federal or state charter.
– Proponents argue that national insurers are at a
competitive disadvantage under the present system.
– Opponents suggest this creates a dual system of
insurance regulation which will increase the cost of
insurance regulation
Describe the Issues Related to Insolvency
of Insurers (1 of 3)
• Insolvency of insurers continues to be an important regulatory concern
• Reasons for insolvencies include:
– Inadequate rates
– Inadequate reserves for claims
– Rapid growth and inadequate surplus
– Mismanagement and fraud
– Bad investments
– Problems with affiliates
– Overstatement of assets
– Catastrophe losses
– Failure of reinsurers to pay claims
Describe the Issues Related to Insolvency
of Insurers (3 of 3)
• The principal methods of ensuring solvency are:
– Minimum capital and surplus requirements
– Risk-based capital standards
– Reserve requirements
– Restrictions on investements
– Review of annual financial statements
– Field examinations
Explain the Purpose of Market Conduct
Regulation (1 of 3)
• Market conduct refers to the marketing practices of
insurers and agents that involve interaction with insureds,
claimants, or consumers.
• Practices include:
– Sales of insurance policies
– Advertising of insurance products
– Underwriting and rating
– Collection of premiums
– Policy renewals, termination, and changes
– Claims settlement
Explain the Purpose of Market Conduct
Regulation (2 of 3)
• Regulators are concerned that certain industry practices
may have an adverse effect on policyholders,
beneficiaries, claimants and insurance consumers
• Concerns include:
– Misrepresentation of coverage
– Excessive sales pressure
– Denial of legitimate claims
– Improper termination of policies

Combined Chapters 6 and 8

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Combined Chapters 6 and 8

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Insurance Company Operations

• The most important operations of an insurance company

Blank Blank Blank Estimated Insured Estimated Insured

Blank Blank Blank Estimated Insured Estimated Insured

Example: Apex Fire Insurance wants protection for all windstorm

insurance was not interstate commerce, and that the

(1944) the Court ruled that insurance was interstate

RBC Ratio (%) Zone Action

125% and above Adequate None

100% to 124% Red flag Insurer must conduct trend

35% to 49% Authorized control Regulator may seize insurer if necessary

Below 35% Mandatory control Regulator must seize insurer

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