Insurers and the Consumer
Insurers
The insurance market is the source of insurance products. Whether it involves life insurance, medical insurance, car insurance, or fire insurance, the type of insurer issuing the policy can be diverse. There are two basic classifications of insurers in the United States: (1) private insurers and (2) governmental insurers. Most government insurance involves medical coverage and types of savings accounts aimed at retirement. There is very little involvement in the property and casualty sector, although the impact is very important. Government insurance has been based on the philosophy that it will only provide services when the private sector is either unable or unwilling to do so. Usually the private insurance carriers fail to provide coverage because they feel the potential loss is too great for them to cover. The public may still desire a specific type of coverage even though the private companies do not want to provide it.
Government Sponsorship
Government insurance is usually divided into those having federal sponsorship and those having state sponsorship. For example, the state of Washington provided medical coverage for low income or uninsurable individuals who residing in the state and unable to secure medical coverage elsewhere. Although there is a cost for the coverage, the state picks up much of the expense charging the individuals less than it could be purchased for from private carriers. The federal government sponsors Medicare, which is medical coverage for those who are 65 years old or more. Medicare may be available to some who are not yet 65 years old if they have been disabled for at least two years. Both of these examples show how the state or federal government might sponsor insurance programs.
Private Sponsorship
The majority of insurance forms come from private companies rather than through the government. Privately owned companies consist of four primary types: (1) stock companies, (2) mutual companies, (3) Lloyd’s, and (4) reciprocal companies.
There are also privately owned companies of the stock type, self-insurance, and captive companies. The last two types are associated with organizations whose stock is publicly held.
Private Insurers
The “Demutualization of Mutual Property and Liability Insurers” by John Fitzgerald states that private insurers operate under a “certificate of authority” that is granted by several states. Various state laws permit organization of insurers either on a proprietary or on a cooperative basis. A proprietary company is Lloyd’s and also stock companies. Mutual and reciprocal companies are cooperative insurers.
Stock Companies
Stock companies have specific features that distinguish them. As indicated by the previous graph, by far the largest share of American property and liability insurance (home and auto insurance) is transacted by stock companies. Stock companies operate over a wide geographical area and usually they insure all types of properties, including fire, marine, casualty, surety, and multiple-line coverage. A down-side for these companies is the exposure they assume for the conflagration hazard in America’s large cities. A conflagration is a huge fire involving many buildings. Obviously, where buildings are packed together, a fire in one building has the potential of involving entire blocks or even entire neighborhoods. This would especially be true in older areas of a city. Due to this potential for huge losses, the stock insurers need a system that will provide them wide product distribution as well as a sound reinsurance program if they are to survive potentially disastrous losses. Stock companies try to operate in areas that offer profitable business. That means reasonable returns on their available capital.
Although it might be easy to assume that internet sales may change this, currently stock insurers rely on a large agency organization. That means they depend upon licensed agents and brokers to market their products. Some stock companies do use the direct writing approach. In such cases, the stock companies would rely upon salaried employees and mail order sales. We are seeing more of this and it is expected to continue to grow as insurers look for ways to minimize expenses. The availability of the internet and the consumer’s increasing use of it will certainly impact how sales are made in the future.
Perhaps the most significant feature of stock companies is their ownership. These companies are owned and controlled by stockholders who expect to profit on their ownership. They are a commercial company just like any other. Day-to-day control is held by the active management group because the stock holdings are often so widely distributed.
Liabilities do, of course, exist just as they would in any corporation. These are assumed by the insurer in its corporate capacity. The stockholders are not responsible for paying claims. Claims are covered by the assets of the corporation. Premiums are charged for the products (policies) sold, which is both the initial and final cost to the policyholder. This means the policy buyer pays to obtain the policy and, except for deductibles and copayments stated in the policy, the stock company then assumes liabilities that are covered by the contract sold. Consequences of both good and bad experience rest on the company alone – not the stockholders (except, of course, as it relates to the value of the stock).
Rating organizations are regulated by the state insurance departments, so there may be some variation from state to state. Even though there can be some variation, the basic functions are the same: (1) preparation of policy forms, (2) collection of statistics, and (3) development of loss costs or rates.
Financial Soundness
Purchasing insurance would serve no purpose if the insuring company were not financially sound, therefore able to pay their claims. Since the main objective of insurance is to shift the financial burden from the buyer to the insurer, financial soundness is obviously very important. The public often does not consider financial soundness when purchasing insurance (they assume this is considered for them by the state insurance department or their agent). While the states do regulate financial soundness buyers must still consider it as well. Obviously the selling agent should also consider financial soundness of the companies they represent. Surprisingly it is not unusual for agents to represent companies prior to any investigation at all of the company’s financial soundness.
As every career agent knows, our clients trust us to do the due diligence for them. A large surplus over and above liabilities is the ideal situation. Not only will it allow public confidence, but it also enables the company’s growth and permits flexibility in business decisions. The assets of the insurer must exceed its statutory reserves and other liabilities in order for them to remain solvent. Over and above the liabilities are the capital stock and the surplus. The two together constitute a fund available to policyholders in cases of extraordinary losses, commonly called the surplus to policyholders. Any contingency reserves set up by the company as a safety net would also be included in this category. The capital stock and surplus will hopefully grow. In fact, the company wants it to grow extensively large so that they may expand as desired while promoting confidence among their policyholders. Since it is desirable to select an insurance company that is financially strong, an unusually large surplus to policyholders should be a factor that is considered when choosing a company.
The individual states do try to monitor the financial safety of each company approved to do business in their state. This is a difficult task. While there are certainly guidelines that they follow, it still requires a lot of the state’s time to monitor each company. The actual laws governing financial strength will differ from state to state, but their goals are the same: insurer solvency. While the details of the laws differ, the fundamental aspects are pretty much the same in how they approach the issue. State Statutes prescribe the minimum number of citizens who may associate themselves and form an incorporated company. The application for a charter must specify, among other things: (1) the name of the corporation, (2) the class or classes of insurance that the company plans to write, (3) the plan or principle according to which the company is to be conducted, (4) the domicile of the company, (5) the amount and classes of capital stock, and (6) the general object of the company and the powers it proposes to have and exercise.
Once the charter is approved and issued, the incorporators open their books for the subscription of company stock. The par value of the shares and the method and time of payment are dictated by state law, which means some details may differ from state to state. Even if an insurer is incorporated and the capital stock completely described, the company must still secure a license from the state insurance department before it may actually engage in insurance business. This is true even in the state of domicile.
Stock companies must begin with a prescribed minimum amount of capital before a license will be issued by the state insurance department. The actual amount of capital may vary by state. The amount will also vary depending upon the kinds of insurance that will be written by the company. Some states additionally require that the stock company have paid-in surplus equal to 50 percent of the minimum paid-in capital requirement. For some kinds of business this requirement will be 100 percent of the minimum paid-in capital. Most states also require the company to keep an equal amount of capital invested in some prescribed manner. There may be additional deposit requirements that must be met before a license will be issued.
Let’s recap these requirements for stock companies:
· The company must have a prescribed amount of capital.
· Possibly an additional requirement of paid-in surplus equal to 50% of the minimum paid-in capital requirement.
· An equal amount of capital invested in a prescribed manner.
· Possibility of an additional deposit requirement.
Stock company assets are invested. Since stock companies have stockholders, the goal is a profit. This means there may be a sound investment return in addition to any underwriting profits. Therefore, there are two types of company activities: underwriting and investment. It is not unusual for the investment profit to far exceed the underwriting profit. Stockholders are usually paid from the profits of the investments rather than any profits made from underwriting. Underwriting profits would then be used to bolster the surplus of the insurer. In this manner, those insured are benefited by the increased surplus while the investors are benefiting from the investment proceeds. Of course, the investors also benefit any time a company can increase their surplus holdings since that also increases the financial strength of the company. Those who buy insurance from the company gain when a company’s strength increases because it increases the financial certainty of their contracts with the insurer. Market price of the company’s stock will also increase if the surplus held increases. Several states have adopted ratemaking rules that require investment return to be taken into consideration when developing rates. Surplus cannot be pulled from the company by stockholders and insurers cannot obtain new equity capital from the market. Bottom line: when a stock company grows in financial strength everyone wins.
As is the case in most industries, competition has caused the individual managements of stock insurers to make every effort to improve their financial standing. There is greater capacity for growth when there is a large surplus in the company. In addition, consumers are more aware today of the need for strong financial companies when purchasing policies. Some consumers seek out stock companies since they feel the self-interest of the company’s stockholders is more likely to be a guarantee that the insurer will be wisely and successfully managed.
Lloyd’s of London
Lloyd’s of London represents the largest body of individual underwriters in the world, writing in excess of $12 billion of annual premium volume. Approximately one-third of that volume is written in the United States. Hundreds of agents and subagents represent Lloyd’s of London around the world. Those located in some important areas are empowered to settle and pay claims. About 40 percent of the business transacted for Lloyd’s of London is marine insurance, with the balance in non-marine and aviation areas.
Marine insurance, despite its name, involves transportation in general – not just at sea. Marine insurance is an integral part of the creation of place utility, that is, the difference between the value of goods in the place of production versus their value at their place of consumption.[1]
Lloyd’s of London is a closed market with products placed through approximately 200 designated brokers who represent outside contact to over 17,000 underwriting members organized into around 180 syndicates. For a commission that averages about 5 percent of the premium, a “slip” is prepared containing all the necessary details of risk. This is presented to the underwriter specializing in that particular risk. The broker will go first to a specialist (called a “lead”) who is an authority in the type of risk being considered. This individual is recognized by the industry as a person who is especially knowledgeable regarding the particular coverage and appropriate rate. Acceptance of part of the risk by a “lead” underwriter is essential if the broker is to acquire an adequate participation by other syndicates to the point where the entire amount of risk is underwritten.
Like a stock exchange, Lloyd’s of London assumes no direct responsibility for the solvency of its underwriting members. Rather, it seeks only to provide the necessary facilities to its members for the convenient conduct of their business and to limit admission to people of recognized honesty and financial standing. Lloyd’s does make requirements of its members:
· The unlimited personal liability of each individual member.
· A minimum deposit proportionately increased if the underwriter’s annual account exceeds a stipulated amount.
· A trust deed signed by the underwriter, stipulating that all premiums and other underwriting monies, including investments, be placed in trust for the payment of underwriting liabilities and expenses, exclusively applicable to that purpose.
· An annual guarantee policy, as designated by the Board of Trade, or an equal amount in cash, furnished by the candidate for the amount of non-marine premiums written for the year.
· A compulsory annual audit of each underwriter’s account to determine ability to meet the financial obligations. These audit regulations have been approved by the Board of Trade.
It is unlikely that consumers (policyholders) will realize who the individual members of Lloyd’s of London are. However, since the previous rules are strictly enforced, the consumers are benefited. Even more beneficial to policyholders is the rigid code of discipline enforced by Lloyd’s on all its members.
Why would an agent want to be subjected to the rules that Lloyds of London imposes? Because simply using the name can mean a financial return. According to S.S. Huebner in good years there can be a return of 100 percent on working capital, while even bad years may produce a 10 percent return.
For over 300 years, Lloyds admitted only individuals as members. They insisted on unlimited liability as well. This worked until the late 1980s and early 1990s when severe underwriting losses left many members insolvent. Membership dropped from over 41,000 in 1991 to less than 17,000 in 1994.[2] At that time, in order to reverse the loss of representation, Lloyd’s opened its membership to corporate entities with limited liability. Individual members still have unlimited liability.
Transacting Lloyd’s of London Business
There are some particular aspects of how Lloyd’s conducts business that are important. These include:
· As long as the members of Lloyd’s conform to the requirements put on them, they may conduct as much underwriting as they can finance. They may write any type of risk they choose, which means a great variety of risks are underwritten. In the United States, risks that are considered extremely hazardous or unusual in nature have been underwritten. These are risks that few other insurers would even consider.
· The brokers present the risks to the various underwriting desks. They are presented by use of a “slip.” A “slip” is the proposal of insurance. Each accepting underwriter signs his or her initials to the slip and indicates thereafter the amount of liability that they are willing to assume.
· The underwriters take their responsibility seriously. They do not sign slips without great consideration. Each underwriter is careful to spread his or her risks widely so that the amount of risk assumed by each is not too large. The risk assumed must bear the proper relation to the underwriter’s resources.
· If the slip has been initialed (accepted) by the requisite amount of insurance required the policy might then be considered issued. There will be a policy printed, of course, but it is only the final formality.
· The insurance contract might be issued with merely the official numbers of the various syndicates on the contract and without including in the policy all of the names comprising each syndicate.
Most of the policies issued by Lloyds’ of London are standard types for standard risks. However, the public perceives Lloyds’ as issuing only those for unusual or dangerous risks. That is not surprising since they do insure what no other company will. It is those unusual cases that make the news. Lloyds’ of London has insured the death of a king, the outbreak of war, the entrance of a country into an existing war, the termination of a war, the winning of a specified political party, and the adoption of tariff regulations by a foreign government. In fact, these types of policies have been referred to as wagers or betting at Lloyd’s. Even though they might be referred to as bets or wagers, the company only insures what it considers to be legitimate insurance risks. There is no doubt that they are genuinely risky and certainly unusual in the normal insurance sense. However, the insured had a real need for protection and Lloyd’s was able to provide it.
What many Americans may not realize is that Lloyd’s has served as the experimental market for the development of new types of coverage that other companies also eventually insured. Typically, Lloyd’s has generated the data required by other companies before they are willing to take on the risk.
Because Lloyd’s has always been a free market, insurance rates are not affected. As a result, it would be very difficult for insurers of any nation to come together for the purpose of raising rates. Because of the way Lloyd’s works, in the absence of legislation against the exportation of insurance abroad, anyone is free to insure with Lloyd’s, which avoids monopoly rates at home. Some might argue that it is due to Lloyds’ of London that a free world insurance market exists.
Lloyds’ of London also handles the placement of excess or surplus lines. In fact, they are famous for doing so. Excess or surplus lines are coverages for which a standard market is not readily available. Non-admitted insurance is insurance placed with an insurer that is not licensed to transact business in the state in which the risk is located. Excess business refers to the placement of a portion of a risk with a non-standard carrier in participation with a standard carrier. The primary (standard) carrier may only be able to retain limits up to a specified amount, so the excess must be placed elsewhere. The “excess business” is layered above the standard policy to provide the amount of protection desired by the insurance buyer. The term surplus insurance is used when an entire portion of a placement is made independent of the standard insurer. This may happen when the class of business is not considered acceptable by the standard underwriter, or the desired form of coverage is not available.
Self-Insurance
Self-insurance has always existed, but as insurance rates (especially in some areas) increased, self-insuring has become more prominent. Large corporations, municipalities, and public entities are most likely to do so, although anyone may choose to. When a company self-insures they assume the insurance of their own risk exposures; that is, no transfer of risk to an outside underwriter is made. In a broad sense, many Americans are self-insured in some areas, especially healthcare. They may not intend to be self-insured, but if no insurance policy exists, they are by default.
Under a true self-insurance, the entity aims to pursue all of the scientific principles and methods practiced by the commercial insurer. True self-insurance is not practiced by default, but rather by rational intention. An adequate and liquid fund is maintained solely for the purpose of covering losses; it is specifically an insurance fund. Just as would be done with a standard insurance policy, adequate premiums are paid into the insurance fund on a regular basis. Loss prevention activities still are pursued (perhaps more so) to prevent losses. Large companies may create an insurance department whose job is to oversee sound insurance principles and loss prevention.
While there are no hard-and-fast rules for self-insuring, to succeed it is important to follow some guidelines. These include, but may not be limited to the following:
1. The number of people involved in the self-insured plan must be sufficiently large enough to make the application of the law of large numbers applicable.
2. The amount of coverage per unit should be reasonably small and uniform. It is not necessary to completely self-insure. Some companies find it more reasonable to self-insure only the less valuable items and use outside insurance where a single loss could materially deplete or exhaust the insurance fund, or cripple the company financially. It is becoming increasingly common for companies to self-insure initially with outside policies covering losses at some point. For example, a company may choose to self-insure the first $50,000 of losses with an outside company covering losses greater than that amount. This is called the excess loss approach. The company may also elect to use a share basis. In this case, the company assumes the first stated amount of loss (often $5,000) then share losses on a 50-50 percent basis. Share basis plans may also have a stop-loss point where an outside policy would begin to pick up all excess losses. Some plans may have a specific dollar amount that they are liable for. When this point is reached, the outside insurer picks up all losses. The advantage is that the self-insured knows exactly how much they are liable for in any given year.
Seldom will companies self-insure for especially hazardous risks. It is more likely that they will self-insure the less hazardous type leaving the highly hazardous risks to outside companies. It is important that any portion that is self-insured does not impact other areas of the business adversely. Any single event (loss) that could affect multiple areas of the business should be considered before self-insurance is attempted. A fire, for example, that could completely destroy a manufacturing company is probably not a prudent risk for self-insurance unless that possibility has been considered.
When self-insurance does seem advisable, the self-insurance fund should be created as quickly as financially possible. Many economic advisers state that the fund should be established prior to switching from outside insurance to self-insurance. Often this is accomplished by decreasing the liability assumed by outside companies gradually while also gradually increasing the self-insurance fund. Even when the fund is built up, the more successful self-insuring companies have continued to build up the fund’s strength to excessive levels. This allows catastrophic losses to be absorbed without injury to either the company or its insurance fund.
Some companies and municipalities have misjudged losses in comparison to the premiums being paid to outside companies. Too much emphasis was placed on the dollar amounts of premium paid out over a long period – ten or twenty years. They compared twenty-year premium payouts to twenty-year losses and concluded they would save money by self-insuring. Unfortunately, they did not consider the potential of initial losses in the first couple of years. Losses can quickly deplete the fund, even when built up over several years. While it certainly can be economic to self-insure, there is also something to be said for knowing specifically what a company or municipality is liable for – which is not possible when self-insuring.
An insurance fund should never be diverted to any other use. Sadly, many companies have had trouble keeping their insurance fund separate. The temptation is great when other areas of the business suffer a downturn to use insurance funds to bolster the business.
Self-insurance is nearly always used because the company or other entity believes it will save money. It is true that commercial insurance involves the costs of commissions, premium taxes, and other taxes levied on commercial insurers. In addition the commercial insurers desire to make a profit. All of this is factored into the premium costs. Some types of losses are not likely, though they do exist, and therefore must be insured against. The opportunity to retain funds versus paying out premiums is always a temptation and certainly important in the self-insuring consideration. However, the rare loss may be catastrophic and far exceed premiums paid out – even over a twenty-year period. All of this must be carefully considered.
Self-insurance succeeds best where the risks involve frequent, but small losses. The severe losses, even though infrequent, are less likely to be successfully handled by self-insured programs.
Businesses have found they prefer to have at least part of the liability risk insured by professional insurance companies. The arms-length settlement of liability claims seems to go better when handled by an outside insurance company. This is especially true if the claim involves an employee.
Captive Insurance Companies
Historically self-funding healthcare and other types of insurance was most effective for large corporations with at least 1,000 employees. However, with the rising costs for healthcare over the past ten years, self-funding is on the rise. It is now estimated that the average self-funded plan covers 500 employees or less and that 59% of companies in the U.S. self-fund part of their healthcare, though not necessarily all of it. The parent corporation most often owns the captive, although several non-insurance companies may go together to form a jointly owned captive. The point of having the captive company is for the purpose of handling the insurance risks of the parent company or group of companies.
Employers may self-administer their health plan, but many find it advantageous to contract with a third party for assistance in claims adjudication and payment. Third-party administrators prove many services beyond claim payment, such as access to preferred provider networks and prescription drug card programs. Sometimes the administrator is an insurance company with contracts called “administrative services only” or ASO contracts. Many say the biggest advantage of self-funded plans is the ability to see where the claim money is going. Knowing the detailing of medical claims allows employers to control costs by shifting their buying patterns.
Captive insurance companies are basically self-insurance taken one step further. Why would a company or group of companies wish to do this? There are several reasons, but perhaps the most obvious has to do with taxation. The Internal Revenue Service will not permit corporate allocations to a self-insurance fund count as a pretax business expense. Premiums paid to an insurance company do receive favorable tax status. Under specific circumstances, premiums paid to a captive insurer may receive a tax deduction as well. This makes it possible, under specific criteria, for a parent company to directly insure a risk with its own captive and receive a favorable tax status. In some cases, a fronting company is used. The corporation being insured obtains an insurance policy from a domestically licensed insurance company, which then reinsures the bulk of the risk with the corporation’s own captive.[3] The fronting company usually underwrites a part of the risk and provides some of the essential services. This enables the corporation or group of corporations to meet state laws and pay premium taxes.
Some of the same reasons exist for using captives as for using self-insurance. The cost is perceived to be lower, utilization of allocated capital until a loss is paid, provision of a stable insurance market, higher emphasis on loss prevention, broader or specified forms of coverage, all risk coverage without exclusions, and special circumstances insured. Many captive companies have begun to accept the risks of insurers, which have increased the world insurance capacity. This also forms a new profit center for the parent company.
Several states have enacted legislation that specifically allows non-insurance companies to form captive insurance companies. These states want to keep the premium paid at home and not in a foreign country like Bermuda. This allows those states to collect state premium tax. The success of those states is reported to be modest. Ultimately, whether the captives remain in the states or in a foreign country will depend upon several factors, including the business climate of other countries, and the quality of managerial and underwriting personnel outside of the states.
Risk-Retention Groups (RRG)
Two federal laws are credited with the creation of a new class of captive insurance companies. The two laws are The Product Liability Risk Retention Act of 1981 and The Liability Risk Retention Act of 1986. The Risk-Retention Groups authorized by the two acts are not different from other companies in legal form. They may be stock companies, mutuals, or reciprocal exchanges. They are chartered under the laws of the various states.
The primary difference between RRGs and other insurance companies is in the way they are regulated. An RRG is regulated by the state in which it is chartered, but it can operate in all states. Federal law exempts RRGs from state regulation of policy forms and rates and some other state laws and rules. The risk-retention group must be owned by its policyholders and can only write liability insurance. The owner-insureds of an RRG must be in a similar business or activity with respect to the liability they insure with the RRG.
Alternatives
Alternatives will continue as business entities look for ways of controlling costs. Currently there are five major alternatives to conventional insurance. Besides self-insurance and captives, there are also compensating balances, retro-note, and paid-loss retro. All of these are types of cash-flow plans. The two most widely used plans of the five are the self-insuring plans and the captives.
In compensating balance plans, the insured company or group of companies pays the standard premium to an insurer and obtains a retrospectively rated insurance policy. The insurer will subtract a service charge for loss adjusting and loss prevention, state premium taxes, and other general administrative expenses, plus a profit. The balance of the premium is placed in a bank of the insured’s choice. The insured can then withdraw a part of its balance up to the amount deposited.
In paid-loss retro and retro-note plans the insured also receives a retrospectively rated insurance policy. The difference from the compensating balances plan is that the insured pays the insurer in cash only for the service, claims, administrative charges, the first year paid losses, and the insurer’s profit. Depending upon which of the two retro plans used, the insured then pays the balance between the expenses and standard premium by means of a promissory note or by a letter of credit. The paid-loss retro plan uses a letter of credit whereas the retro-note plan uses a promissory note.
While the intent is basically the same as that of the self-insurance or captives, the emphasis is on cash-flow loss payments, especially in times of high interest rates. Some states feel, however, that these plans are circumventing insurance regulatory laws, so they are reviewing them. Many states either have, or will be, initiating regulations regarding these plans.
Thank you,
United Insurance Educators, Inc.
2014