Insurers and the Consumer

Underwriting and Reinsurance

 

 

  In the insurance business, underwriting is a vital part of issuing contracts.  The success or failure of an insurer can rest on the ability of their underwriters to successfully gauge the profits and losses that any specific contract might produce.  Insurance requires an equitable distribution of cost among its participants.  Underwriters classify and rate each loss exposure estimating the amount of benefits the company is likely to pay out in claims. 

 

 

Pricing

 

  Any exposure can be underwritten if the price is right, but that does not mean that an insurer is necessarily interested in doing so.  Underwriting and pricing of insurance are interrelated – one function cannot be discussed without the other.

 

  Underwriting, and the related pricing, is something that both the insurer and the insured considers important.  The insurer must price at a level that makes the product profitable and the insured must be able to pay the price.

 

  From the consumer’s standpoint, underwriting is the process of accepting or rejecting applications.  From the company’s standpoint, it is much more complicated, of course.  Once an applicant’s risk is accepted, underwriting then progresses to the terms under which the contract would be issued.

 

  One might easily assume that the laws of probability would allow companies to accept all applicants.  Although that sounds reasonable, it actually would not work for the insurers.  Relying on the law of averages would be inefficient and unprofitable, since selection could not be guaranteed to be a mix of all variables.  For example, if it were possible, individuals would only purchase health insurance when they needed surgery.  As a result, relying on the law of averages would not work because all individuals would not participate – only those who felt they would receive benefits. 

 

  All applicants will not have the same loss expectancies.  Classification systems are established with different rates for each class.  One example of classification is by age, although there are also many other types of classification, depending upon the type of insurance involved.  Within classifications, there will be additional variations.  If an insurer is able to determine a method of eliminating insureds with higher-than-average loss expectancy within each class, they will earn higher underwriting profits on their business than those that accept all insureds indiscriminately.  Selective insurers can then lower rates, attract more business and increase overall profits.  Nonselective insurers will lose the better and more profitable insureds to the selective ones offering lower premium rates.  This is true for virtually any type of insurance.  If auto insurers can screen out the bad drivers and offer lower rates to the safe drivers, they will attract more applicants.  The bad drivers will be left with the insurers that do not screen their applicants better and this will drive up the rates as only the worst drivers are left with the company.  This is called adverse selection.  Adverse selection could be called “selection by buyers,” since they are the ones triggering the situation.  Most insurers are selective to some degree and try to have a mix of insureds.

 

  Consumer advocates and even some state governments feel that insurers are overly selective in their underwriting giving too much attention to statistical analysis, which has a social outcome.  An example of this involves fire insurance on business and homes.  In some areas of cities, losses are much higher compared to other areas.  Insurers were refusing to issue policies in some areas entirely stating the high likelihood of claims.  In some cities it was reported that health policies were hard to purchase due to the high claims from AIDES and HIV positive individuals.  The term actuarial equity often is used to describe the condition where each risk is charged a premium in accordance with its chance of loss.[1]  Federal and some state governments have mandated coverage or actually provided financial incentives to companies who will issue policies in high-risk areas.

 

  Consumer advocates feel insurers should spread risks over larger areas.  In the case of homeowners and business insurance, for example, they feel risk should be spread out over larger areas combining inner city addresses with suburbia addresses to equalize rates.  When this is done, those in lower risk areas pay a higher premium than statistics would call for in their region in order to lower the rates in inner city areas (subsidizing their rates).  Some consumer advocates also feel that tax dollars should be used to subsidize insurance in areas that have difficulty getting insurance.  There is good reason for these beliefs: if the inner city is to grow and overcome some of their social problems businesses must start up and grow employing the people who live there.  A business that cannot obtain insurance cannot get financial help from banks and other lending institutions (certain types of insurance are required before a loan is obtainable).  If the business can’t obtain financing, it can’t open.  If it can’t open, it can’t hire anyone.  Few people realize the role insurance plays in our lives. 

 

  If insurers were forced, without government subsidy, to insure all, rates would eventually move so high that self-insurance and risk assumption would be widespread.  Among those with less hazardous exposures only the most security minded of those required by creditors to do so would buy insurance at all.  Most would wait (since insurers were forced to insure all) until a loss was near to purchase a policy.  Again, this would be called Adverse Selection, with the insurer left with the short end of the stick.

 

  Underwriting decisions are not made lightly.  The decisions are made by specialists, such as engineers, statisticians, physicians, meteorologists, and economists.  The type of specialist used will depend upon the type of policy being underwritten.  An analysis of insuring agreements, limitations, exclusions and conditions is important in understanding insurance coverage.

 

  Underwriting involves the entire insurance process, although most people assume it is only used in the process of determining whom the company will and will not insure.  Before a specific contract is even offered to consumers the insurance company has underwritten the specific type of risk the contract will be insuring against.

 

  There are three primary purposes of underwriting:

 

 

  It is not possible to totally examine all aspects of underwriting since it is a complex business.  However, it is possible to understand the basics of underwriting and it is important that agents possess this understanding.  The field agent is the first contact in most cases.  He or she can determine much during the application process.  Some types of applications clearly dictate who is insurable.  The application form, in such cases, may even specify this.  For example, the application may state: “If the answer to any of the following questions is “no”, the applicant is not insurable under this form.”

 

  Since no two risks are totally identical, the insurance business is based on averages.  The insurance company must be sure that the risks they accept in each class are not generally below the average contemplated by the rate for the class and that the amount at risk in each case has primarily the same composition, structure, or character.  It is important that each risk is assigned as accurately as possible to its proper class.  While attaining equity is a regulatory requirement, it is also in the insurer’s best interest.

 

  The primary reason behind underwriting is to obtain a profitable distribution of policyowners.  The goal is a profitable distribution – not avoiding all claims.  Companies expect claims.  In fact, without claims, the insurance industry wouldn’t even exist.  If homes never burned, what would be the point in purchasing fire coverage?  If no one ever had a health claim, would anyone want to buy major medical insurance?  So, while companies expect to pay claims, they do not want to pay out more than they take in.  It is the cookie jar example: everyone puts two of his or her ten cookies into the jar.  Most will have enough cookies remaining (eight) to last the year.  However, a few will lose their cookies or have them stolen.  When this happens, they will remove enough cookies to cover their losses.  The goal is to have cookies left over in the jar at the end of the year.  Those remaining cookies are the company’s profits.

 

 

Selective Underwriting

 

  The nature of underwriting is inherently selective.  The underwriter’s job is to be selective so that the book of business that is produced has a desirable loss ratio.  This selectivity involves the class of risk that will be accepted, the kind of risk within the class, and the amount of potential liability acceptable on that risk.

 

The First Step in the Selection Process

  The first step in the selection process is the establishment of an underwriting policy, which is done by the management.  The underwriting policy will depend upon the company’s overall objectives, such as profit goals, relationship of underwriting profit to investment return and marketing philosophy.  Other factors may also be considered, depending upon the elements considered important.  The insurer’s underwriting policy affects all other company operations and is affected in return by other company components.

 

  Regardless of the company’s philosophy, its underwriting policy must be defined in terms of what is called line sheet or line guide.  This line sheet usually defines the classes of risks that are acceptable, prohibited, or borderline between the two.  For those risks that are acceptable or borderline, a limit of liability is typically indicated (either a specific limit or a series of guidelines), that takes into account the company’s reinsurance program.  The line sheet provides the “rules” for the day-to-day decisions of the individual underwriter.

 

  Premium rates definitely affect the selection process.  When the rate charged for a specific class of risks is more than adequate, the underwriter is able to accept risks that might not be accepted if the premium was considered low for the risks involved.  The underwriter’s acceptance or denial of an applicant will be partially based on the premium rate since that is a determining factor in the likelihood of a profit or loss.  On a type of risk contract that has been in place for some time, underwriters can see if the policy is making a profit or suffering a loss.  If that type of policy has been unprofitable, the underwriter will tighten the underwriting requirements and begin denying coverage to those that might have previously been accepted.

 

 

Level of Risk

  After gathering the relevant facts underwriters analyze the information to determine the level of risk involved.  The reliability of the information is very important since it determines whether the applicant receives the coverage or is denied it.

 

  When the application is reviewed, the underwriter must determine whether the applicant is a standard risk, preferred risk, or substandard risk.  A standard risk would be accepted for coverage.  The individual would be issued the standard coverage for the standard premium.

 

  If the application and following investigation shows the applicant to be a lower-than-average risk for loss experience, he or she may be classified as a preferred risk. Preferred risks usually receive standard coverage, but at a lower premium rate.

 

  In most non-standard issues, it is more likely that the applicant will be a substandard risk rather than a preferred risk.  A sub-standard risk is one that is likely to have higher-than-average losses.  Underwriters recognize that some of these risks can still be profitable, so selected sub-standard individuals are accepted.  Not all sub-standard risks will be accepted.  They will look at many elements to decide which ones are acceptable.  The applicant may have to pay higher rates or some conditions may be limited in the policy.  Exactly how this is handled will depend upon multiple factors, including the state laws where the policy is issued.  If state laws place requirements that the underwriters feel will prohibit making a profit, then the person will be denied coverage.  For example, if a specific state does not allow the insurer to exclude specific medical conditions in a major medical policy, the underwriter may choose to deny coverage entirely rather than cover an existing medical condition.

 

  Even if there are no state requirements limiting how the policy may be issued, some risks will be considered too great to insure.  Some risks are simply ineligible for coverage.  Insurers believe these applicants cannot be profitable at any feasible premium or with any reasonable policy modifications.  Therefore, they reject them.  It is important to note the words “feasible” premium and “reasonable” policy modifications.  Obviously, the applicant would not accept a policy if the premium rate was exorbitant or the restrictions in the policy outlandish.

 

 

Post-Selection

  Underwriting includes both pre-selection and post-selection.  Pre-selection involves gathering information relevant to the application originally taken.  Pre-selection underwriting determines whether or not an applicant is accepted or denied coverage.  Post-selection occurs after the policy has been issued.  Once the risk has been accepted, post-selection is the process of reviewing those already insured and dropping those that are no longer desirable risks.

 

  Most policies must be renewed on a yearly basis.  Some policies are guaranteed renewable (mostly in health care contracts), but others are reviewed prior to each anniversary date.  A very few policies never need renewal, continuing as long as premiums are paid.  Some states have requirements regarding policy renewability and agents must know their state laws.  Underwriters review renewal applications using techniques similar to those used when looking at new applications.  In addition, they review claims in the previous year to determine whether to cancel a policy before it expires.  One claim does not mean an automatic refusal to renew.  However, it should be noted that post-selection has several unique aspects to it.  Insurance companies receive constant criticism regarding their renewal process.  Social advocates feel insurers have a social obligation to provide insurance to anyone at affordable prices.  Even so, underwriters generally do have the right to refuse to renew an application.  As every agent knows, when an underwriter elects not to renew a policy, the frustrated policyholder will call them – not the underwriter.

 

  The insurer has several choices when refusing to renew a policy:

 

  1. The insurer can refrain from cancellation until the policy expires, then notify the agent that the contract will not be renewed.  The agent, if independent, will place the individual with a different company that will accept the risk, though probably at a higher premium rate.

 

  1. If circumstances warrant it, the insurer might terminate the policy as soon as possible.

 

 

Adverse Selection

 

  We have previously mentioned adverse selection.  It is natural that people only want to purchase insurance when they know they will need to use it (collect benefits).  However, insurers cannot operate without a mix – those who do not collect as well as those that do.  Some types of coverage are the most susceptible to loss.  An excellent example of a type of coverage that routinely experiences loss is dental insurance.  Most people would not buy dental insurance if they never visited the dentist.  They only buy it because they do see the dentist periodically.

 

  The prudent buyer knows he or she must shop around for the best buy regardless of the type of coverage being purchased. As consumers shop for the best price they will eventually purchase from the insurer offering the lowest price.  The lowest price can only be offered when they are selective; accepting only the best risks (those with the least likelihood of filing claims).  Eventually, the companies that accept higher risks will end up with those that are most likely to file claims.  In this way, the buyers are bringing about adverse selection.

 

 

Moral Hazard

 

  Underwriting physical characteristics of a risk are relatively simple since appropriate investigation of the facts is all that is necessary to determine the level of risk.  The harder part of underwriting involves the moral hazard, the human element in the insurance relationship.  The more serious impact has to do with those that might deliberately cause a claim or pad a legitimate claim. 

 

  Moral hazards come from a combination of moral weakness and financial difficulty.  One of the reasons it is hard to obtain insurance in some areas has to do with moral hazards.  Evidence suggested certain geographical areas had a high rate of obtaining money by filing false claims.  This happens for many reasons, but poverty stricken areas may have financial reasons for doing so.  Underwriters feel it often happens due to a combination of moral weakness and financial difficulty.  A fundamental rule of underwriting says that where moral hazard is suspected, the underwriter must turn down the application.  This is one reason why some areas must be subsidized by tax dollars in order to obtain insurance.  No reasonable premium rate would be adequate if an underwriter suspects that an insured is likely to commit arson because of overloaded inventories or to act in collusion with a fraudulent liability claimant.

 

  It is not easy to detect moral hazards fairly.  Unfortunately an ethical person may get painted with the same paintbrush, sometimes merely for living in an area that has a high degree of false claims.  It is not an easy task for the underwriter.  If there is any indication that a moral hazard exists (even if only by virtue of where the applicant lives), he or she will be denied coverage.

 

 

Morale Hazard

 

  There is moral and then there is morale.  Some underwriters feel people are less likely to take safety seriously when insurance is in place (because any loss would be covered).  Morale hazards (with an ‘e’) are essentially the absence of a desire to safeguard property or the absence of concern over the reasonable settlement of a liability or compensation claim.  Morale hazards reflect attitude more than a lack of morality.  When the insured exhibits no concern for preventing claims, it often becomes a moral hazard.

 

Example:

If a businessperson is suffering losses month after month, he may not actually set the building on fire, but feeling he cannot survive much longer, may do nothing to prevent a fire.  He may even allow conditions to exist that a prudent person would know could cause a fire.  In this example, a morale hazard becomes a moral hazard.

 

 

Competing in the Marketplace

 

  Underwriters must consider their competition. Even the agent submitting the business is considered.  An agent that submits and maintains a strong profitable block of business may be granted greater leeway when presenting an undesirable risk.  Underwriters learn to recognize those agents that can be relied upon to obtain full information and present all facts.  On the other hand, an agent that routinely submits incomplete applications (omitting pertinent medical information) may have a higher number of denials because the underwriter has little faith in their values.   When an agent omits required information, it is called “clean sheeting” because the agent is attempting to submit a clean application.

 

 

Redlining

 

  Redlining is the practice of underwriters refusing applications, canceling existing policies, or significantly changing the terms of contracts based solely on the geographic location of the risk.  It is not surprising that this is most likely to occur when the geographical area is thought by underwriters to produce a higher-than-average loss ratio.  A primary function of underwriters is to avoid losses above normal rates (excessive losses).  This is important since excessive losses affects all that are insured under similar types of policies.  Underwriting is very technical in nature and relies upon as much data as can reasonably be obtained.  The purpose is to make the type of policy under consideration profitable for the insurer and any stockholders that might exist.

 

  The downside of careful underwriting is the possibility of producing social problems.  Obviously if all are excluded in a particular geographical area, individuals who deserve to obtain a policy may be denied one. 

 

Example:

 

  Walter plans to open a small business.  In order to obtain a business loan he must be able to obtain various types of essential insurance, such as fire and casualty.  The location he has chosen is in a neighborhood that has a high amount of claims.  Therefore, the insurer feels it is an undesirable geographical area and denies Walter a policy.  This denial, if no other insurer is available, means that he will not obtain his business loan.  As a result, he will be unable to open his business.

 

  This has an effect on the neighborhood where he would have located his small business.  Walter had planned on hiring several people from the immediate area.  Therefore, the jobs that would have been created are not.  This has a social impact since those individuals may not have many chances for employment if other business opportunities have the same problems Walter did.

 

  Some states do not allow redlining.  Each agent must be aware of specific requirements and restrictions in their state.

 

 

The Underwriting Cycle

 

  On a fairly predictable schedule, underwriters move between strict and lax underwriting requirements.  This underwriting cycle is an aspect of the rate-selection interrelationship.  When underwriting standards are strict, insurers have increasing profits because undesirable risks are not accepted.  Management, seeing this, may take steps to increase their premium volume for additional profits.  In order to achieve this, underwriting may be relaxed thereby allowing in some insureds that would not previously have been acceptable.  In other words, underwriting standards are relaxed to some degree.  This causes additional claims as those with a higher likelihood of claims are accepted.  As a result, profits decline.  This brings about a tightening of underwriting standards, so the cycle begins again.

 

  Of course, this is difficult for agents, since an applicant that was accepted last month may be turned down this month under current tighter underwriting standards.  The public may also realize that Uncle Joe was given a policy while Cousin Mae, who lives just down the street from him, was denied a policy even though their health was basically the same.  It is usually the agent that must face their frustration.  Unfortunately, consumers seldom direct their dismay directly to the insurer.

 

  Many states are seeing another aspect of this underwriting cycle: those who purchased long-term care policies.  Within a year’s time, many of the issued policies virtually doubled in cost.  Some of the policies had been carried for years.  Since those who purchase such policies tend to be older and generally on fixed incomes, such price increases causes great public distrust of insurers.  It appears to the consumers that they were treated unfairly and perhaps even lied to.

 

Example:

  Geraldine bought a long-term care nursing home policy eight years ago.  The cost was $984 per year.  Geraldine is on a fixed income since she is retired.  After paying for the coverage for eight years, she is faced with a doubling in her premium, from the $984 per year to $1,912 per year.  This means that she must either greatly reduce the benefits she wanted or come up with a great deal more money to continue the policy.  She feels she has little choice: she lets the policy lapse.  Over the eight-year period, she paid $7,872 in premium, none of which is refundable to her.  It will not matter that she did not collect a single penny in benefits.

 

  It is also likely that Geraldine is now nearing a time in her life when such policy benefits would be used, since her health has been steadily declining.  As a result, it appears to Geraldine and her children that the insurer purposely led her on with affordable premiums only to increase them at the point when they might have to pay benefits.  Obviously, this brings about consumer mistrust of insurers, which will affect all companies – not just the insurer Geraldine purchased her policy from.

 

 

What Are We Insuring Against?

 

  It is generally felt that insurance companies are the best score keepers there are.  They are likely to know multiple elements of any single risk.  The question is: how do they know so much about various types of risk?

 

  First, it is necessary to define the term, risk, as it is used for insurance purposes.  Risk is defined as the uncertainty of loss.  In other words, a person may or may not experience a loss; there is no way of knowing what will happen.  Insurance risk relates to a loss that is financial in some way.  Obviously, having an insurance policy will not solve all problems associated with the loss, but it may lessen the financial aspect of it.

 

  It is virtually impossible to insure every element of life.  While it might be possible to insure every financial element, the premiums to do so would be so outrageous that no one would want to do so.

 

  Every person is exposed to some type of risk.  Even Charlie Brown had daily risk: he never could be sure whether Lucy would pull away the football at the last moment, causing him to fall.  Charlie never seemed to be injured in the fall, but that would be the risk he would insure against (physical injury and the resulting medical costs).

 

  Lucy would need a policy covering her loss if Charlie Brown sued and won for the injuries she caused him.  Additionally, Lucy might need insurance in case she was sued for bad advice (remember the booth she had for dispensing psychological wisdom?).  Insurance agents have much in common with Lucy.  They give financial advice, which may cause lawsuits if the end results are not as desired.

 

  One might suppose that all financial loss is uncertain, but that’s not true.  We have some financial loss that is expected and planned for.  For example, insurance premiums are a planned financial loss.  We know that our car insurance will cost a set amount of money each month.  That is a planned financial loss since we do not anticipate receiving any of that premium back.

 

  Business owners also have a certain amount of financial loss that is expected.  For example, a storeowner knows that shoplifting will be a part of his or her business (not a desired part, but still an existing part).  The business therefore builds the expected shoplifting loss into the price of the goods they sell.  It only becomes an uncertain loss when the amount of shoplifting exceeds what is expected to occur.

 

  Some people desire and seek risk, but the type of risk they seek is not necessarily financial.  It may be exposure to physical risk, although if injury is the result, then financial loss will follow if the individual does not have a medical policy that will cover the cost of care.

 

  Some individuals enjoy entering into financial risk.  These are the people who start up risky business adventures or seek some type of financial goal that is difficult to achieve (like those who seek out sunken ships in the hope that treasure of some kind will be found).

 

  Most of us think we avoid financial risk.  Of course, that is not totally possible.  Even opening a savings account at our local bank carries with it the risk of inflation.  If we deposit $100 but inflation reduces its value to $90, then we have willingly entered into financial risk.  Thousands of Americans enter into risky financial ventures every year without realizing it.

 

 

The Economic Burden of Risk

 

  While there are many elements of economic burdens of risk, the one that agents may be most aware of are the reserve funds set aside by insurers to protect consumers.  We are referring to the insurance guaranty fund.

 

  Insurers also set aside funds within their own company to protect consumers.  Insurance companies must be able to pay their policyholders when they request money from their policies.  Presumably, the insurers could do better if they did not have to have these liquid funds available (perhaps by investing in a long-term venture).

 

  Perhaps the greatest economic burden of risk is seen in the costs of goods and services that we purchase.  If the storeowner did not have to cover the cost of shoplifting, for example, he or she could lower the cost of the items sold.  If insurers did not have to include the cost of settling fraudulent claims, premiums could be lower.

 

  Additionally, society could likely have more services available if some types of service were not perceived as “too risky” to warrant the investment of savings.  There is a shortage of risk capital in most countries, and that is certainly true here in the United States.  Especially some geographic areas suffer because the insurers consider the losses too great in some locations.

 

  Perhaps the greatest risk burden of all is the medical field.  The burden of risk has become so great that many physicians are having difficulty obtaining malpractice insurance and when it is available, the premiums are astounding ($10,000 per month premium is common and many types of practice run considerably higher).  Obviously, the doctors and other medical personnel must make up the cost of these premiums by charging more for their services.  For those without personal insurance, it may also mean that they will be turned away since the physicians cannot be certain that payment for their services will be received.  This brings about an interesting point: if an individual does not have the means of transferring risk to another entity (the insurer), it may reduce the amount of services they can obtain.

 

 

Types of Risk

 

  Although we have stated that risk is the uncertainty of loss, there are different types of risk.  For our purposes, we are including objective risk and subjective risk.  Objective risk may also be called statistical risk.  This refers to the variation that occurs when actual losses differ from expected losses.  That is why it is often called statistical risk, since these types of losses are used for statistical information.  It may be measured statistically in some way, with variations noted and analyzed.

 

  Subjective risk refers to the mental state of a person who experiences doubt or worry as to the outcome of a financial venture or a specific event.  It is often defined as a psychological uncertainty that comes from the individual’s mental attitude or state of mind.  Agents often refer to this as “risk tolerance” meaning that each person has a different degree or ability of tolerance for investment risk taking.  Even though agents recognize that people have different levels of comfort when it comes to investment risk, it is nearly impossible to measure these attitudes scientifically and to predict risk-taking ability.  Each agent must assess the situation personally and attempt to place their clients in investment vehicles that the consumer is comfortable with.  As we know, if the consumer is not comfortable with the vehicle suggested by the agent, he or she is likely to abandon the investment at the first ripple of risk.

 

  Both objective risk and subjective risk are concerned with events that may or may not produce economic loss or an involuntary parting of value.

 

 

Determining Degrees of Risk

 

  Our clients often want to know the “degree of risk” that a specific investment has.  We might want to compare investments to the dial on our stove.  At lower temperatures, the burner or oven is cooler; at higher temperatures it is hotter.  Considering the lower temperatures to be the least risky and the higher temperatures to be the most risky, we could set up an analysis that most consumers could understand.

 

  Investment comparison is often compared to a pyramid with the most secure investments being on the bottom and the most risky being at the top.  Whatever we use, it is important that our clients understand the amount of risk they are facing prior to investing.

 

  It also depends upon what type of risk we are referring to.  A high degree of subjective risk exists when a person experiences great mental uncertainty as to the frequency of occurrence of some event that may cause a loss, as well as the amount or severity of this possible loss.  Realize that subjective risk may not be connected to the actual possibility of loss – merely to the perception of such loss.

 

  Objective risk varies according to the ratio of probable variation of actual loss from probable loss.  For example, once Joe hits a tree with his vehicle, the loss is certain so the objective loss has a probable variation of zero (there can be no variation if the loss has already occurred).  This would also be true if the loss absolutely cannot occur.  For example, if Joe is not able to drive his vehicle at all because the engine has been removed for repair, then no moving loss can happen because the vehicle is parked in the garage and will remain there (loss could still happen if the garage collapsed, but a moving loss with Joe driving could not happen).  Since no moving loss is possible, the probable variation for loss is zero.  That means the objective risk is zero.

 

 

Probability of Loss

 

  There is a difference between risk and probability.  Probability refers to the long-run chance of occurrence or the relative frequency of some event.  Probability may be referred to as “chance of loss.”  As insurers look at probability, they want to know how likely the probability is that a loss will occur to a specific insured person or a specific insured object.  Probability only has meaning when applied to the chance of occurrence among a large number of events.

 

  Risk, on the other hand, is a very broad concept.  Objective risk can be measured in a meaningful way (as underwriters do every day) in terms of large groups, which then produces statistical information.  It is this statistical information that allows underwriters to determine the amount of premium that should be charged for covering a specified risk.  It should be noted that the size of the group when determining this is very important.  If the number of objects or people within the group is too small, the range of probable variation is so large that it is not possible to get an accurate determination.

 

  Probability is generally studied through the concept of a probability distribution.  Using this concept tells the total loss, but also shows variations in the losses.

 

 

The Law of Large Numbers

 

  Every agent should be familiar with the law of large numbers since insurance rating is based on this.  This is a basic law of mathematics, which states that as the number of exposure units is increased, the more certain it is that actual loss experience will equal probable loss experience.  In fact, the level of risk will diminish (lessen) as the number of exposure units increases.  A single individual, therefore, has a much higher risk of loss than does a group as a whole.  When an individual joins such a group, he or she can purchase insurance protection at a reasonable rate whereas the cost would be prohibitive if only one person were seeking coverage.  When an insurer can secure a large enough base, with all paying in premium, it becomes profitable for the insurer despite losses.  The increasing base of paying policyholders is the reason it becomes profitable.

 

 

Risk Information

 

  We can see why such elements as objective risk and the law of large numbers play a part in underwriting.  It allows insurers to determine the amount of premium that must be charged to cover losses and make a profit.  Although insurers keep lots of statistical information, it is the insurance application that underwriters first consider.  The application supplies the information necessary to initially consider the risk. 

 

  The type of application required by the insurer will depend upon the type of insurance being sought.  In fire insurance, for example, a formal written application may or may not be required.  Most types of health insurance always require a specific application.  In all cases, the point of the application is to provide the insurer with necessary information for underwriting.  The main underwriting offices are typically equipped with tables, charts, and other displays indicating the amount of coverage on the books for various geographical areas (sometimes as small as one city block).  An experienced underwriter can look at the tables and charts, which generally use specific symbols indicating specific levels of existing business and risk, and know immediately how the application fits in.  Some types of insurance, if allowed in the state, will also use credit reports to help determine the insured’s potential risk.  Many states are restricting use of credit ratings as they relate to issuing policies.  Why would an insurer care about an individual’s credit standing?  There are two sides to this issue.  Consider the following:

 

The Insurer’s View:

  Darrell has a very poor credit rating and has most of his life.  When he applies for automobile insurance, the insurer will likely consider him high risk.  Since he has a history of not paying his bills, wage garnishment, and other credit problems, the insurer feels he is a prime candidate to file false claims.  Fraudulent claims are very difficult to prove.  In most cases, the insurer ends up paying claims even when they feel they are fraudulent.  Therefore, the insurer feels their best defense is to deny policies to those individuals most likely to experience financial problems.  Otherwise, they are forced to raise premiums for everyone when the cause lies with the few filing false claims.

 

The Consumer’s View:

  While it is true that Darrell has had multiple financial problems throughout his life, he has never defrauded an insurance company.  In addition, his driving record is good.  Furthermore, Darrell does not feel that having financial problems is any indication of a person’s personal integrity.  He considers himself to be an ethical person, despite his shortcomings with money.  In fact, he may be right.  Whether or not a person is experiencing a financial difficulty does not necessarily mean false claims will be filed.  Those caught doing this are often not having financial problems.

 

  The type of insurance has a great deal to do with underwriting procedures.  Obviously, life insurance will consider who is likely to die while auto insurance will look at who is likely to have an accident.  Some types of insurance have less to do with risk and more to do with personal habits of the insured individual.  Fire insurance, for example, is personal in nature and moral and/or morale hazards stem directly from the insured.  It has little to do with the property being insured.

 

  As we know, the insurance process is based on the law of averages so the insurer must secure an adequate volume of business overall to produce dependable average results.  In order to avoid a catastrophe hazard, business must be written in multiple types of insurance, avoiding excessive coverage for a single type of risk or in a specific geographical location.  If existing policies were primarily for a town in Florida and primarily on mobile home parks, a single catastrophe could cause serious financial harm to the insurer.

 

  Of course, insurers are well aware of the dangers of becoming too specialized in the policies they issue.  Companies typically protect themselves by having two underwriting limits:

 

 

  These limitations are called line limits.  The actual dollar limit that is placed on the lines will depend upon the company’s financial abilities.  Surplus and capital will be considered along with their reinsurance limitations.  Obviously, a company with $25 million in surplus will not be affected by a $100,000 loss but a company with only $200,000 in surplus could be severely crippled by the same loss.

 

  Some types of insurance are especially affected when a natural catastrophe happens.  Therefore, insurers look at the possibilities of nature when issuing such things as homeowner policies and some types of business insurance.  A major fire in a large community must also be considered.  In California wildfires can wipe out entire communities.  If a single insurer carried most of the policies in the area affected, it could have serious consequences for the company.  In parts of the country where such fires happen regularly, insurers maintain careful conflagration line limits by subdividing cities into districts and perhaps even dividing it block by block, depending on the statistics they have.  Records are maintained regarding all possible risks showing current status of the amounts at risk in relation to the limits established.  A new applicant may be denied for no other reason than the amounts of insurance acceptable for the area have already been reached.

 

  Many national companies have discontinued the use of line limits since their risk is spread out over the entire country.  However, even they may sometimes establish line limits in specific key areas that are known for heavy losses.  In fact, a number of companies that had discontinued line limits reinstated the practice following several catastrophic events that caused severe insurer losses.

 

 

Deductible Clauses

 

  Many types of policies have deductible clauses.  Medical contracts may have several types of deductibles (on the hospital, for office visits, and on prescriptions).  Long-term care policies have “elimination periods”, which are deductibles expressed as days not covered.  Most fire policies have deductible clauses that are classified into two broad categories:

 

  1. Those that are intended to eliminate small, frequent losses, and

 

  1. Those that are used in connection with self-insurance programs.

 

  The dollar amount of deductible clauses vary, sometimes even within the same policy forms.  Medical and long-term care contracts allow the insured to determine how much of a deductible they wish to carry.  The same is true with automobile policies and homeowner contracts.

 

  It should not surprise us to know that higher deductibles equate into lower premiums being charged.  The reason for this has to do with more than the fact that the insurer is not liable for small losses.  The cost of processing small maintenance claims is also very expensive.  Therefore, the insurer saves in two ways: on the claim itself and also on the processing of the claim.  Additionally, it can be difficult on small claims to distinguish between the actual loss that is covered by the policy and the depreciation loss that comes from normal wear and tear (which is not covered).

 

  There is another advantage to deductibles in some types of policies.  When the insured knows small claims are not covered by his or her policy, he or she is likely to be more careful to avoid small claims.  That means deductibles decrease the moral and morale hazard.  Some types of policies require deductibles.  While the insured may be able to choose the amount of the deductible, they may not eliminate it entirely.  Insurers feel deductibles will reduce negligence on the part of the insureds.  When an insured individual knows he or she is responsible for the first dollar amounts of loss, he or she is more likely to avoid such losses by being careful or avoiding specific situations entirely.

 

  The actual amount of the deductible may be small or large.  Several large national insurers offer coverage with deductibles as large as $50,000.  It may be possible to obtain an even higher deductible for some types of coverage.  The insured would cover any loss that is less than the stated deductible.  Any amount above the stated deductible amount would then be covered under the policy.

 

  In many casualty lines, large industrial and commercial companies routinely choose very large deductible amounts.  In the past, there has been a strong bias against the use of deductibles in the liability field.  That has been changing in favor of deductibles.

 

 

Reinsurance

 

  What is Reinsurance?  Reinsurance may be defined as the practice whereby the original underwriter transfers liability under the policy, in part or whole, to some other underwriter or group of underwriters.  The second underwriter or group of underwriters is called the reinsurer.  The contract of reinsurance is made solely between the insurers.  The insured individual has no right to make a claim against the reinsurer in case of loss.  Even so, the insured has a financial interest in the reinsurance practice.  Since the insurance company the insured initially entered into a contract with is dependent upon the financial strength of the second company, the insured can be affected by the strength (or lack of it) of the reinsurer.  In basic terms, the reinsurer has “insured the insurance”.  Failure on the reinsurer’s part to meet a loss could cause the original insurer to also fail to meet their obligation in covering an insured loss.

 

  Obviously, most policyholders are not going to be aware of the elements of reinsurance, but agents do need to be aware of the possibilities.  Career agents do not want their clients to have problems when claims arise.

 

  Why is Reinsurance Used?  Considering the problems that could arise with reinsurers, why would a company enter into such an agreement?  The stability of modern insurers, including their ability to cope with large conflagrations, earthquakes, and windstorm catastrophes, as well as individual risk factors, is largely due to their policy of limiting the amounts of insurance that they retain net for their own account.[2]  This brings about a need for reinsurance facilities.  Two different groups of reinsurers have developed:

 

 

 

  So, one group of insurers has developed solely for the purpose of reinsurance and the second group is insurance companies that also write direct business, but have also branched out in the reinsurance market.

 

  Reinsurance was designed to provide greater stability by providing a wide spread of business.  This is a technical function of the insurance industry.  By accepting many risks and scaling down through the use of reinsurance, the first company is able to accept a larger amount of risk.  The uncertainty that risk brings is reduced through the application of the law of large numbers (through use of reinsurance).  While line limits may still be applicable, the risk may be spread out to a greater degree.

 

  Reinsurance enables insurers to accommodate a single risk capacity to a larger degree, with the knowledge that they can protect themselves against unexpected staggering losses due to a catastrophic occurrence.  Insurers often face the problem of being asked to accept a higher amount of risk of a particular type that they would normally decline, but because it comes from an established client, they feel obligated to issue.  Reinsurance allows them to accept the risk.

 

  Sometimes it is as simple as wanting to insure an entire risk with as little trouble as possible.  For example, some business entities may ship enough cargo to fill an entire ship.  It is easiest and the least trouble to be able to place coverage with one or just a few carriers rather than negotiate coverage with numerous insurance companies.

 

  Reinsurance is often considered “financing.”  When a company issues a policy, it must pay the commission to the agent and any other acquisition costs associated with the policy’s issue.  As much as 35% of the original policy premium may go to immediate costs in the property and casualty field.  Even so, the insurer is required by law, at the inception of the policy, to reserve 100% of the premium as unearned premium reserve.[3]  The assets that offset the liability are charged against the insurer’s surplus account, which means a reduction in surplus.  The amount of these prepaid costs is called equity in the unearned premium reserve.  It will be earned over the period of the policy.  When the original issuer of the policy turns to reinsurance for a portion of their new business, they are being proportionately reimbursed by the reinsurer for their expenses.  This lessens the drain on their surplus funds.

 

  There are different forms of reinsurance.  One form involves the assumption by a reinsurer of all the risks of a liquidating company or one that wants to withdraw from a specific line or geographical area.  Although many types of reinsurance must be approved by the state insurance department, if allowed, the insurer may be able to retire from a particular type of risk or from a specific territory.  This transfer of risk protects the policyholders, the insurer is able to retire from the particular line or area, and the liquidation is easily accomplished.

 

  Each involved party has an ethical responsibility to the other parties.  The presumption is that the ceding company is acting in good faith toward the reinsurer; its motive must be as represented whether that happens to be reducing a line of insurance or withdrawing from a particular geographical area.  It is not ethically responsible to attempt to unload a base of business that is undesirable due to low premium rates or other conditions without fully disclosing all facts.

 

 

Pro Rata and Excess of Loss

 

  There are two basic forms of reinsurance: Pro Rata and Excess of Loss.

 

Pro Rata

  Pro Rata means: “proportion”.  It is sometimes called proportional reinsurance.  Pro Rata includes all forms of reinsurance that participate proportionately in insurance, premiums, and losses.  The direct-writing company reinsures a portion of a risk, pays that proportion of the original premium, less commission to the agent, and recovers from the reinsurer the same proportion of loss.

 

  There are two forms of Pro Rata reinsurance.  The first is quota share and the second is surplus or surplus share. 

 

  Quota share reinsurance covers a percentage of a company’s business, a specific line of business, or a specific territory of business.  Financing is a major function of quota share reinsurance.  In addition there is an element of underwriting capacity and stabilization, and also some catastrophe protection.  This type of reinsurance works well when a company faces a decrease in surplus due to a rapid increase in new business.  Quota share reinsurance may be a single cession transaction or a continuing application applying to both new business and renewal business.

 

  Surplus reinsurance is used to gain additional underwriting capacity.  The company keeps all small policies and cedes the surplus of large policies.

 

 

Excess of Loss

  Excess of Loss reinsurance pays only the part of the loss that exceeds a specifically determined deductible or retention.  It will be defined as either a specific dollar figure or some determined amount or percentage.  The reinsurance premium is generally set as a percentage of the original premium and loss.  This may be called non-proportional reinsurance.  There is no specific cession of liability on each risk as there is in Pro Rata reinsurance.  It is purely a contract of indemnity.

 

  Excess of loss reinsurance may be arranged to pay on a risk basis, on an occurrence basis, or on an aggregate basis.  When it is paid on a risk basis the direct-writing company recovers losses in excess of a retention that is applied to each risk involved in the loss.  When it is paid on an occurrence basis, the insurer recovers losses in excess of a retention that is applied to each loss without regard to the number of risks involved.  When excess of loss reinsurance is paid on an aggregate basis, the company recovers losses that in the aggregate exceed a retention in a given time period (usually a year).  There are many variations possible when it comes to reinsurance, so there is not necessarily a set formula or format.

 

  Excess of loss reinsurance may give protection as a working cover, emphasizing loss frequency, or as a catastrophe cover, emphasizing loss severity.  Which one is used will depend upon the size of the retention in relation to the exposure.  Working covers serve the reinsurance function of capacity and stabilization and catastrophe covers provide some capacity but primarily are used for catastrophe protections.  There is seldom any “financing help” in Excess-of-loss reinsurance.

 

  Although each form of reinsurance is designed for specific circumstances, most reinsurance programs work best when it uses both excess-of-loss and pro rata reinsurance forms.  It is important to note that we have not gone into reinsurance extensively.  This is a complicated field and few agents have need for extensive information.

 

 

Shopping for Reinsurance

 

  Obviously, the direct-writing company must find a reinsurer willing to go into a business relationship with them.  This is a specialized field.  There are two major reinsurance markets available to the direct-writing insurer: reciprocity with other direct insurers, or reinsurance specialists that deal exclusively with reinsurance.  There are reinsurance brokers that bridge the gap between those seeking such services and those willing to supply the service.

 

  In reciprocity reinsurance, the normal practice is for one insurer to require an equal share of another insurer’s business of the same type in return for theirs.  Therefore, it is necessary that the ceding company only give a share of its reinsurance to a reinsurer that is able to offer business in return.

 

  For reciprocity reinsurance to be successful, some conditions must exist.  First, it is necessary to have a matching premium on the products being exchanged.  In other words, the two companies want the premium of the ceding company to match as nearly as possible to the reinsurer so that neither insurer’s gross premium volume will fluctuate to any significant degree.  In addition, the matching of premium volume should yield an equitable exchange of profits for each company.

 

  Since it appears that the two companies are merely swapping business, what is the point of reciprocal reinsurance?  There is actually a benefit to this practice.  The primary objectives of reciprocity are:

 

 

 

 

  When a company that is a specialist in reinsurance (reinsurance specialist) is used, it may be through either one that does nothing else or a company that writes direct-insurance but also offers reinsurance to others.  When the company is a specialist in reinsurance, it does not practice reciprocity.  Even though the company may also write direct business, in order to be considered a specialist in the reinsurance field it must provide this service as either its sole business or its principal business.  Reinsurance would never be a side business for a specialist.

 

  Many consider reinsurance from a reinsurance specialist to be the best avenue for such services.  Since it is either their sole business or their primary business, the company is likely to be experienced and understand the market well.  Because the company has dealt with hundreds of other companies, they are probably technically competent, meaning they understand the laws and procedures of such transactions.  Because it is their sole or primary business, there is generally flexibility, and the reinsurance company will keep all information private, never disclosing anything to a competitor.

 

  Perhaps the greatest advantage to a reinsurance specialist is that they will stand by the ceding company as long as practical.  A reciprocity reinsurer will not give the same guarantees.

 

  Why would a ceding company prefer a reciprocity reinsurer?  The only significant reason has to do with profits.  Reinsurance specialists will require a profit for themselves.  While we all know you get what you pay for, a ceding company that is having financial strains may not want to provide the profit the specialist requires.  Reciprocity reinsurance is, however, the oldest form of reinsurance between the two types.

 

 

Brokers

 

  A reinsurance broker plays a significant role in the reinsurance industry.  The purpose of the broker, often called an intermediary, is to provide the direct-writing company choice.  The broker will offer an array of reinsurers, knowledge of the industry, and hopefully impartial and experienced counsel as well.

 

  Not all reinsurers are located in America.  Many of the reinsurers are outside of the United States.  In such a case, an intermediary (broker) provides a significant function.  The two parties typically deal with the intermediary rather than directly with each other.  The brokers are accustomed to dealing internationally, so they will be well informed on the practices of the major reinsurance markets, plus have other information regarding loss experience, know which companies have strength in specific markets, the most attractive treaties available, and the major catastrophe hazards that are present.  Because he or she is well versed in international markets, they can assure their clients that they are getting the best or standard agreements available.

 

  Brokers may also be used for reciprocal reinsurers.  He or she will be able to deal with all of the company’s reciprocal reinsurers.  Even if multiple reciprocal reinsurers are used, which is commonly the case, the broker can offer the direct-writing insurer his or her expertise.  In effect, the broker provides the direct-writing company with a professional reinsurance department.

 

  The reinsurance broker earns his or her living from the commissions they collect for their services, interest earnings on the premium, and loss float.  The intermediary’s primary service is to provide indemnity at minimum cost.  They are marketing specialists.  When the intermediary provides extensive services, including underwriting, claims, accounting, statistical, rehabilitation, and so forth to his or her clients, he or she is improving the customer’s underwriting results, which in turn improves the broker’s income.

 

 

What Else is Available?

 

  Not all companies use reinsurers.  There are two basic alternatives to their use: (1) refusing additional applications past a certain point or refusing to accept some types of risk or additional policies on an already insured risk.  Of course, this means the insurer is limiting their company’s growth.  A related problem to cutting off new applications involves a loss of field staff.  A company may, for example, begin to refuse a particular type of risk but still be accepting applications for other types of risk.  The field agent may feel that he or she wants to place their clients business in one location (with a single insurer).  Therefore, they place no business at all with the insurer that began to limit their application acceptance.  This means that the insurer suffers a loss of new business in areas where they desire it.

 

  (2) A second alternative is for the insured to purchase multiple policies.  In the direct-damage fields, multiple policies are similar in that all share losses from the first dollar on a pro rata liability basis.  This is called policy layering.

 

Thank you,

United Insurance Educators, Inc.

2014

 


[1] Fundamentals of Insurance by Robert I. Mehr

[2] Property and Liability Insurance, 4th edition

[3] Underwriting and Reinsurance by Huebner