Role of Insurance Companies:Indemnification, Insurerâ€™s business model

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Management of Financial Institutions - MGT 604

Lecture # 35

Role of Insurance Companies

Insurance, in law and economics, is a form of risk management primarily used to hedge

against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk

of a loss, from one entity to another, in exchange for a premium. Insurer, in economics, is

the company that sells the insurance. Insurance rate is a factor used to determine the

amount, called the premium, to be charged for a certain amount of insurance coverage.

Risk management, the practice of appraising and controlling risk, has evolved as a discrete

field of study and practice.

Principles of insurance

Commercially insurable risks typically share seven common characteristics.

1. A large number of homogeneous exposure units. The vast majority of insurance

policies are provided for individual members of very large classes. Automobile

insurance, for example, covered about 175 million automobiles in the United States

in 2004.[2] The existence of a large number of homogeneous exposure units allows

insurers to benefit from the so-called "law of large numbers," which in effect states

that as the number of exposure units increases, the actual results are increasingly

likely to become close to expected results. There are exceptions to this criterion.

Lloyd's of London is famous for insuring the life or health of actors, actresses and

sports figures. Satellite Launch insurance covers events that are infrequent. Large

commercial property policies may insure exceptional properties for which there are

no `homogeneous' exposure units. Despite failing on this criterion, many exposures

like these are generally considered to be insurable.

2. Definite Loss. The event that gives rise to the loss that is subject to insurance

should, at least in principle, take place at a known time, in a known place, and from

a known cause. The classic example is death of an insured on a life insurance policy.

Fire, automobile accidents, and worker injuries may all easily meet this criterion.

Other types of losses may only be definite in theory. Occupational disease, for

instance, may involve prolonged exposure to injurious conditions where no specific

time, place or cause is identifiable. Ideally, the time, place and cause of a loss should

be clear enough that a reasonable person, with sufficient information, could

objectively verify all three elements.

3. Accidental Loss. The event that constitutes the trigger of a claim should be

fortuitous, or at least outside the control of the beneficiary of the insurance. The loss

should be `pure,' in the sense that it results from an event for which there is only the

opportunity for cost. Events that contain speculative elements, such as ordinary

business risks, are generally not considered insurable.

4. Large Loss. The size of the loss must be meaningful from the perspective of the

insured. Insurance premiums need to cover both the expected cost of losses, plus the

cost of issuing and administering the policy, adjusting losses, and supplying the

capital needed to reasonably assure that the insurer will be able to pay claims. For

small losses these latter costs may be several times the size of the expected cost of

losses. There is little point in paying such costs unless the protection offered has real

value to a buyer.

5. Affordable Premium. If the likelihood of an insured event is so high, or the cost of

the event so large, that the resulting premium is large relative to the amount of

protection offered, it is not likely that anyone will buy insurance, even if on offer.

Further, as the accounting profession formally recognizes in financial accounting

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standards (See FAS 113 for example), the premium cannot be so large that there is

not a reasonable chance of a significant loss to the insurer. If there is no such chance

of loss, the transaction may have the form of insurance, but not the substance.

6. Calculable Loss. There are two elements that must be at least estimable, if not

formally calculable: the probability of loss, and the attendant cost. Probability of

loss is generally an empirical exercise, while cost has more to do with the ability of a

reasonable person in possession of a copy of the insurance policy and a proof of loss

associated with a claim presented under that policy to make a reasonably definite

and objective evaluation of the amount of the loss recoverable as a result of the

claim.

7. Limited risk of catastrophically large losses. The essential risk is often

aggregation. If the same event can cause losses to numerous policyholders of the

same insurer, the ability of that insurer to issue policies becomes constrained, not by

factors surrounding the individual characteristics of a given policyholder, but by the

factors surrounding the sum of all policyholders so exposed. Typically, insurers

prefer to limit their exposure to a loss from a single event to some small portion of

their capital base, on the order of 5 percent. Where the loss can be aggregated, or an

individual policy could produce exceptionally large claims, the capital constraint

will restrict an insurers appetite for additional policyholders. The classic example is

earthquake insurance, where the ability of an underwriter to issue a new policy

depends on the number and size of the policies that it has already underwritten.

Wind insurance in hurricane zones, particularly along coast lines, is another example

of this phenomenon. In extreme cases, the aggregation can affect the entire industry,

since the combined capital of insurers and reinsurers can be small compared to the

needs of potential policyholders in areas exposed to aggregation risk. In commercial

fire insurance it is possible to find single properties whose total exposed value is

well in excess of any individual insurer's capital constraint. Such properties are

generally shared among several insurers, or are insured by a single insurer who

syndicates the risk into the reinsurance market.

Indemnification

The technical definition of "indemnity" means to make whole again. There are two types of

insurance contracts; 1) an "indemnity" policy and 2) a "pay on behalf" or "on behalf of"[3]

policy. The difference is significant on paper, but rarely material in practice.

An "indemnity" policy will not pay claims until the insured has paid out of pocket to some

third party; i.e. a visitor to your home slips on a floor that you left wet and sues you for

$10,000 and wins. Under an "indemnity" policy the homeowner would have to come up

with the $10,000 to pay for the visitors fall and then would be "indemnified" by the

insurance carrier for the out of pocket costs (the $10,000).

Under the same situation, a "pay on behalf" policy, the insurance carrier would pay the

claim and the insured (the homeowner) would not be out of pocket anything. Most modern

liability insurance is written on the basis of "pay on behalf" language.

An entity seeking to transfer risk (an individual, corporation, or association of any type,

etc.) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by

means of a contract, called an insurance 'policy'. Generally, an insurance contract includes,

at a minimum, the following elements: the parties (the insurer, the insured, the

beneficiaries), the premium, the period of coverage, the particular loss event covered, the

amount of coverage (i.e., the amount to be paid to the insured or beneficiary in the event of

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a loss), and exclusions (events not covered). An insured is thus said to be "indemnified"

against the loss events covered in the policy.

When insured parties experience a loss for a specified peril, the coverage entitles the

policyholder to make a 'claim' against the insurer for the covered amount of loss as specified

by the policy. The fee paid by the insured to the insurer for assuming the risk is called the

'premium'. Insurance premiums from many insureds are used to fund accounts reserved for

later payment of claims--in theory for a relatively few claimants--and for overhead costs.

So long as an insurer maintains adequate funds set aside for anticipated losses (i.e.,

reserves), the remaining margin is an insurer's profit.

When is a policy really insurance?

An operational definition of insurance is that it is

the benefit provided by a particular kind of indemnity contract, called an insurance

policy;

that is issued by one of several kinds of legal entities (stock insurance company,

mutual insurance company, reciprocal, or Lloyd's syndicate, for example), any of

which may be called an insurer;

in which the insurer promises to pay on behalf of or to indemnify another party,

called a policyholder or insured;

that protects the insured against loss caused by those perils subject to the indemnity

in exchange for consideration known as an insurance premium.

In recent years this kind of operational definition proved inadequate as a result of contracts

that had the form but not the substance of insurance. The essence of insurance is the transfer

of risk from the insured to one or more insurers. How much risk a contract actually transfers

proved to be at the heart of the controversy.

This issue arose most clearly in reinsurance, where the use of Financial Reinsurance to

reengineer insurer balance sheets under US GAAP became fashionable during the 1980s.

The accounting profession raised serious concerns about the use of reinsurance in which

little if any actual risk was transferred, and went on to address the issue in FAS 113, cited

above. While on its face, FAS 113 is limited to accounting for reinsurance transactions, the

guidance it contains is generally conceded to be equally applicable to US GAAP accounting

for insurance transactions executed by commercial enterprises.

Does the contract contain adequate risk transfer?

FAS 113 contains two tests, called the '9a and 9b tests,' that collectively require that a

contract create a reasonable chance of a significant loss to the underwriter for it to be

considered insurance.

9. Indemnification of the ceding enterprise against loss or liability relating to insurance risk

in reinsurance of short-duration contracts requires both of the following, unless the

condition in paragraph 11 is met:

a. The reinsurer assumes significant insurance risk under the reinsured portions of the

underlying insurance contracts.

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b. It is reasonably possible that the reinsurer may realize a significant loss from the

transaction.

Paragraph 10 of FAS 113 makes clear that the 9a and 9b tests are based on comparing the

present value of all costs to the PV of all income streams. FAS gives no guidance on the

choice of a discount rate on which to base such a calculation, other than to say that all

outcomes tested should use the same rate.

Statement of Statutory Accounting Principles ("SSAP") 62, issued by the National

Association of Insurance Commissioners, applies to so-called 'statutory accounting' - the

accounting for insurance enterprises to conform with regulation. Paragraph 12 of SSAP 62

is nearly identical to the FAS 113 test, while paragraph 14, which is otherwise very similar

to paragraph 10 of FAS 113, additionally contains a justification for the use of a single fixed

rate for discounting purposes. The choice of an "reasonable and appropriate" discount rate is

left as a matter of judgment.

Is there a bright line test?

Neither FAS 113 nor SAP 62 defines the terms reasonable or significant. Ideally, one

would like to be able to substitute values for both terms. It would be much simpler if one

could apply a test of an X percent chance of a loss of Y percent or greater. Such tests have

been proposed, including one famously attributed to an SEC official who is said to have

opined in an after lunch talk that a 10 percent chance of a 10 percent loss was sufficient to

establish both reasonableness and significance. Indeed, many insurers and reinsurers still

apply this 10/10" test as a benchmark for risk transfer testing.

It should be obvious that an attempt to use any numerical rule such as the 10/10 test will

quickly run into problems. Implicit in the test is keeping the 10/10 that either are upper

bonds for the comment made by the SEC official therefore, the rest of this paragraph doesn't

apply. Suppose a contract has a 1 percent chance of a 10,000 percent loss? It should be

reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10

test.

It does not appear that any brightline test of reasonableness nor significance can be

constructed.

Excess of loss contracts, like those commonly used for umbrella and general liability

insurance, or to insure against property losses, will typically have a low ratio of premium

paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called

the rate on line for historical reasons related to underwriting practices at Lloyd's of London,

will typically be low for contracts that contain reasonably self-evident risk transfer. As the

ratio increases to approximate the present value of the limit of coverage, self-evidence

decreases and disappears.

Contracts with low rates on line may survive modest features that limit the amount of risk

transferred. As rates on line increase, such risk limiting features become increasingly

important.

"Safe harbor" exemptions

The analysis of reasonableness and significance is an estimate of the probability of different

gain or loss outcomes under different loss scenarios. It takes time and resources to perform

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the analysis, which constitutes a burden without value where risk transfer is reasonably self-

evident.

Guidance exists for insurers and reinsurers, whose CEO's and CFO's attest annually as to

the reinsurance agreements their firms undertake. The American Academy of Actuaries, for

instance, identifies three categories of contract as outside the requirement of attestation:

Inactive contracts. If there are no premiums due nor losses payable, and the insurer

is not taking any credit for the reinsurance, determining risk transfer is irrelevant.

Pre-1994 contracts. The attestation requirement only applies to contracts that were

entered into, renewed or amended on or after 1 January 1994. Prior contracts need

not be analyzed.

Where risk transfer is "reasonably self-evident."

"Risk transfer is reasonably self-evident in most traditional per-risk or per-occurrence

excess of loss reinsurance contracts. For these contracts, a predetermined amount of

premium is paid and the reinsurer assumes nearly all or all of the potential variability in the

underlying losses, and it is evident from reading the basic terms of the contract that the

reinsurer can incur a significant loss. In many cases, there is no aggregate limit on the

reinsurer's loss. The existence of certain experience-based contract terms, such as

experience accounts, profit commissions, and additional premiums, generally reduce the

amount of risk transfer and make it less likely that risk transfer is reasonably self-evident."

- "Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note,"

American Academy of Actuaries, November 2005. ...

Risk limiting features

An insurance policy should not contain provisions that allow one side or the other to

unilaterally void the contract in exchange for benefit. Provisions that void the contract for

failure to perform or for fraud or material misrepresentation are ordinary and acceptable.

The policy should have a term of not more than about three years. This is not a hard and fast

rule. Contracts of over five years duration are classified as `long-term,' which can impact

the accounting treatment, and can obviously introduce the possibility that over the entire

term of the contract, no actual risk will transfer. The coverage provided by the contract need

not cease at the end of the term (e.g., the contract can cover occurrences as opposed to

claims made or claims paid).

The contract should be considered to include any other agreements, written or oral, that

confer rights, create obligations, or create benefits on the part of either or both parties.

Ideally, the contract should contain an `Entire Agreement' clause that assures there are no

undisclosed written or oral side agreements that confer rights, create obligations, or create

benefits on the part of either or both parties. If such rights, obligations or benefits exist, they

must be factored into the tests of reasonableness and significance.

The contract should not contain arbitrary limitations on timing of payments. Provisions that

assure both parties of time to properly present and consider claims are acceptable provided

they are commercially reasonable and customary.

Provisions that expressly create actual or notional accounts that accrue actual or notional

interest suggest that the contract contains, in fact, a deposit.

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Provisions for additional or return premium do not, in and of themselves, render a contract

something other than insurance. However, it should be unlikely that either a return or

additional premium provision be triggered, and neither party should have discretion

regarding the timing of such triggering.

All of the events that would give rise to claims under the contract cannot have materialized

prior to the inception of the contract. If this "all events" test is not met, then the contract is

considered to be a retroactive contract, for which the accounting treatment becomes

complex.

Insurer's business model

Profit = earned premium + investment income - incurred loss - underwriting expenses.

Insurers make money in two ways: (1) through underwriting, the process by which insurers

selects the risks to insure and decide how much in premiums to charge for accepting those

risks and (2) by investing the premiums they collect from insureds.

The most difficult aspect of the insurance business is the underwriting of policies. Using a

wide assortment of data, insurers predict the likelihood that a claim will be made against

their policies and price products accordingly. To this end, insurers use actuarial science to

quantify the risks they are willing to assume and the premium they will charge to assume

them. Data is analyzed to fairly accurately project the rate of future claims based on a given

risk. Actuarial science uses statistics and probability to analyze the risks associated with the

range of perils covered, and these scientific principles are used to determine an insurer's

overall exposure. Upon termination of a given policy, the amount of premium collected and

the investment gains thereon minus the amount paid out in claims is the insurer's

underwriting profit on that policy. Of course, from the insurer's perspective, some policies

are winners (i.e., the insurer pays out less in claims and expenses than it receives in

premiums and investment income) and some are losers (i.e., the insurer pays out more in

claims and expenses than it receives in premiums and investment income).

An insurer's underwriting performance is measured in its combined ratio. The loss ratio

(incurred losses and loss-adjustment expenses divided by net earned premium) is added to

the expense ratio (underwriting expenses divided by net premium written) to determine the

company's combined ratio. The combined ratio is a reflection of the company's overall

underwriting profitability. A combined ratio of less than 100 percent indicates profitability,

while anything over 100 indicates a loss.

Insurance companies also earn investment profits on "float". "Float" or available reserve is

the amount of money, at hand at any given moment, that an insurer has collected in

insurance premiums but has not been paid out in claims. Insurers start investing insurance

premiums as soon as they are collected and continue to earn interest on them until claims

are paid out.

In the United States, the underwriting loss of property and casualty insurance companies

was $142.3 billion in the five years ending 2003. But overall profit for the same period was

$68.4 billion, as the result of float. Some insurance industry insiders, most notably Hank

Greenberg, do not believe that it is forever possible to sustain a profit from float without an

underwriting profit as well, but this opinion is not universally held. Naturally, the "float"

method is difficult to carry out in an economically depressed period. Bear markets do cause

insurers to shift away from investments and to toughen up their underwriting standards. So

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a poor economy generally means high insurance premiums. This tendency to swing between

profitable and unprofitable periods over time is commonly known as the "underwriting" or

insurance cycle. [6]

Property and casualty insurers currently make the most money from their auto insurance

line of business. Generally better statistics are available on auto losses and underwriting on

this line of business has benefited greatly from advances in computing. Additionally,

property losses in the US, due to natural catastrophes, have exacerbated this trend.

Finally, claims and loss handling is the materialized utility of insurance. In managing the

claims-handling function, insurers seek to balance the elements of customer satisfaction,

administrative handling expenses, and claims overpayment leakages. As part of this

balancing act, fraudulent insurance practices are a major business risk that must be managed

and overcome.

Gambling analogy

Both gambling and insurance transfer risk and reward.

Gambling transactions offer the possibility of either a loss or a gain. Gambling creates

losers and winners. Insurance transactions do not present the possibility of gain. Insurance

offers financial support sufficient to replace loss, not to create pure gain.

Gamblers can continue spending, buying more risk than they can afford to pay for.

Insurance buyers can only spend up to the limit of what carriers would accept to insure;

their loss is limited to the amount of the premium.

Gamblers, by creating new risk transfer, are risk seekers. Insurance buyers are risk avoiders,

creating risk transfer in terms of their need to reduce exposure to large losses.

Gambling or gaming is designed at the start so that the odds are not affected by the players'

conduct or behavior and not required to conduct risk mitigation practices. But players can

prepare and increase their odds of winning in certain games such as poker or blackjack. In

contrast to gambling or gaming, to obtain certain types of insurance, such as fire insurance,

policyholders can be required to conduct risk mitigation practices, such as installing

sprinklers and using fireproof building materials to reduce the odds of loss to fire. In

addition, after a proven loss, insurers specialize in providing rehabilitation to minimize the

total loss.

Insurance, the avoiding, mitigating and transferring of risk, creates greater predictability for

individuals and organizations.

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