Management of an Insurance Enterprise

The insurance industry is essential to the world economy and many companies offer coverage for a wide range of risks that people and businesses face everyday. From a consumer's perspective, the transaction may be as simple as paying a premium every month in exchange for the piece of mind of knowing that recovery from a loss is possible. Within a complex framework of government regulation, an insurance company must evaluate risks and assign probabilities to determine a price for the protection sought. They need to invest funds and even seek to insure their own risks with other insurers. The marketplace demands efficiency and insurance companies are turning to technology to address the need. This article discusses the basic components on an insurer's business model and the fundamental forces that affect the management of an insurance enterprise.

Keywords Actuarial Science; Adjuster; Administrative Agency; Combined Ratio; Earned Premium; Float; Insolvency; Property & Casualty Insurance; Reinsurance; Retroceding; Statute; Underwriting; Underwriting/Insurance Cycle

Insurance & Risk Management > Management of Insurance Enterprise

Overview

Risk in some form is present in every act. Whether the risk is remote or closer to assured, disasters both natural and otherwise have the potential to destroy fortunes. The prospect of catastrophic loss can halt progress. Insurance companies address these concerns by spreading the economic impact of a loss over a large group of people. The products they provide are essential to the normal operation of our non-agrarian society. The insurance industry in the United States is composed of some four thousand companies that sell policies to protect against a wide variety of the risks faced by individuals, organizations and entities alike. The industry is also important to the economy as an employer of over two million people. This article discusses some of the major functions, challenges and techniques unique to the management of an insurance company.

Businesses have many basic functions and principles in common. Every business must produce something of value to the market, employ techniques to sell that product, and manage human resources with the appropriate knowledge, skills and abilities to complete the tasks. Each industry has a particular group of core efficiencies necessary for production and distribution to profit from its chosen product line. For example, General Motors, on a fundamental level, must be able to efficiently produce cars at a cost below the price a consumer is willing to pay for those cars. While there are certainly many other factors that determine the success of a company, it would be difficult to imagine a successful company that lacked expertise and efficiency in those areas fundamental to its nature. For an insurance company, the basic model to generate revenue involves two areas; underwriting and investing. The cost of administration and the total amount of claims paid are subtracted from the revenue centers to form the basic insurer business model. To employ this basic model, the insurance industry must operate within a legal framework of state and federal laws and regulation (Encyclopedia of Business & Finance, 2008).

An insurance company can make money in two basic ways.

• First, the insurance company can profit from underwriting. When an insurance company underwrites a risk they assume responsibility for an agreed amount of economic consequences arising from the occurrence of certain events. The premiums earned are applied toward potential profit once they become earned premiums. The amount of premium that is considered earned is a function of the time the insurance company has been exposed to loss under a given policy. For example, if a person purchases a one-year policy and 100 days have elapsed since the policy took effect, the insurance company has earned 100/365 of the total premium paid. Conversely, 265/365 of the premium paid is unearned. An insurance company makes an underwriting profit when the total of earned premiums exceeds the total claims under those policies.
• Second, there insurance company makes money by investing the premiums they receive. Insurance companies invest insurance premium payments as soon as they are received and leave those funds invested until claims are paid. The total amount of cash that an insurance company has on hand and not paid out in claims is called "float," or available reserve. While the company may not be able the keep the investments themselves, they are able to keep the interest that accrued on the funds while in the company's possession. For this reason, insurance companies are important investors in the economy, putting billions of dollars in credit and equity markets. The profits made from investing the "float" are an important source of income for insurance companies and can offset underwriting losses.

The other end of the business equation for an insurance company is largely composed of the underwriting administrative expense and losses incurred. The full equation in total profit earned by an insurance company is the underwriting profit plus the investment income less the losses incurred, or claims paid, and the underwriting expenses. Insurance company mangers have to apply this business model within a highly regulated industry, at both state and federal levels. Each of these areas will be discussed in more detail.

Underwriting

Underwriting is at the heart of the insurance business and it is likely the most difficult part of the business. An insurance policy distributes the economic losses arising from a specific type of risk to a group of people. The term derives from the times when the person assuming the risk actually signed their name on the contract under the risk assumed. In modern usage, it refers to a party who has assumed risk under an insurance policy. The term is also commonly used in investment banking and in that context; the underwriter assumes the risk of the sale of particular securities.

Underwriting is the assumption of a risk; the decision as to assume a particular risk involves a process of quantifying risks and then assigning a price for the assumption. That quantification is a prediction about the claims that will be made under a policy and pricing of the policies accordingly. To perform this prediction, insurers use actuarial science. Actuarial science is a formal mathematical discipline used to calculate the likelihood and frequency of occurrence of covered risks and therefore the funds required to provide the anticipated insurance benefits. For those interested in mathematics and statistics, many universities offer both undergraduate and graduate degree programs in the area.

The discipline uses a number of related fields, including probability, statistics, finance and economics. An actuary analyzes a variety of data to determine the range and probability of the range of risks associated with a covered event and to calculate an insurer's overall exposure under a given policy. For example, mortality rates are important to compute risks and premiums for a life insurance policy. When an insurance company terminates a particular insurance policy the amount of total premiums collected (the earned premium less the administrative expense and total claims paid) equal the underwriting profit for that policy. Insurance companies make money on some policies and lose on others.

After the insurance company assumed risks and paid claims, the measure used to compute and report its profit or loss is called the combined ratio. This ratio is a relationship between income from premiums, claims paid, administrative expenses and dividends distributed. A ratio under 1.00 indicates a profit and a ratio over 1.00 indicates a loss. For example, a combined ratio of .97 means the insurance company made a 3% underwriting profit and a ratio of 1.15 indicates a loss of 15%. The percentages refer to a percentage of each dollar received in premiums; in the above example, a loss of three cents and gain of fifteen cents for each dollar of premium paid. This ratio is reported on company financial statements and to government regulatory agencies.

Underwriting profits vary according to internal company actuarial predictions and actual events. For example, natural disasters, as in the case of a hurricane or earthquake can cause significant claims of which insurance companies are bound to pay. Other times, underwriting may be profitable. Between 1998 and 2003, property and casualty insurers lost over 140 billion; while in the first quarter of 2005, the same sector reported record underwriting profits of over $7 billion on a combined ratio of approximately .92 ("P/C underwriting," 2005).

Investing

The investing income is very important to the overall profitability of an insurance company. In the United States for five years ending in 2003, property and casualty insurance companies had an underwriting loss of approximately $140 billion. However, for that same period, insurance companies reported profits of over $68 billion. These profits were made on investing the float and are dependent upon the condition of the financial markets. Profits derived from the float may be difficult to maintain during times of economic depression; poor economic conditions generally translate to high insurance premiums. The general tendency for insurance profits to fluctuate over time is commonly referred to as the underwriting or insurance cycle. For property and casualty insurers, property losses due to natural disasters cause volatility in the cycle. On the other hand, automobile lines tend to be more profitable due to reliable statistics that are greatly aided by advances in computer technology.

Underwriting Expenses & Claims Handling

From the perspective of the customer, claims handling is the critical function of an insurance company. When a customer suffers a loss, they want to be compensated with all possible speed. From the perspective of the insurance company, mangers must balance the customer's expectations of rapid resolution and satisfaction with administrative expenses, overpayment leakages and fraudulent insurance practices. To satisfy the needs of speed and reliability, insurance companies turn to technology deployed both in the field and over the internet. A range of portable communication technology can be deployed in the field so that adjusters may assess and process claims more rapidly and efficiently than ever before. An adjuster armed with a laptop computer, portable printer, and scanner can evaluate a claim and enter information directly into the insurance company's system without the need for duplicate work, as is the case with paper forms. Once the adjuster has completed the evaluation, they can then print the estimate and issue a check on-site.

The internet also offers the insurance company an opportunity for increased efficiency; both in terms of data entry and accuracy. Once information is entered on a website and added to an insurance company's database, it is unlikely that information need ever be reentered. The internet also allows a greater degree of control over the type and amount of data entered. A website can be programmed to insist on certain information of a particular form and react to information by leading the consumer to additional information that may be required or beneficial; paper lacks these dynamic qualities.

Insurance companies may then pass on the savings from increased efficiency to the consumer in the form of lower premiums and increased customer service, which help business. Management techniques and systems of this kind are employed by individual companies for their own benefit. However, that does not mean that insurance companies are alone; insurance companies share risk through a practice called reinsurance.

Reinsurance

The fundamental purpose and defining feature of insurance is the distribution of risks over a large base. For example, the costs of a car accident suffered by one insured are spread to all insured paying premiums under the policy. The same principle applies to insurance companies who spread risks to other companies with the use of reinsurance. Reinsurance is when one insurance company assumes all or part of a risk already undertaken by another insurance company. The portion of the risk that exceeds the primary insurance company's coverage is said to have been layed-off, or ceded, to the reinsurer. Reinsurers may also reinsure a part of the risk assumed from the primary insurer. This practice is called retroceding.

Reinsurance is an important tool for managers because it allows for increased capacity, stability and financial strength. With reinsurance, an insurance company may assume large risks that it would otherwise not be able. Reinsurance increases stability because it allows a company to make accurate predictions as to potential future liability. Reinsurance is also important to consumers seeking significant coverage because it allows them to deal with one company as opposed to shopping around. Reinsurance unifies the insurance industry around the globe and losses incurred in one can be felt in many other places. For example, Western Europe is an important source of worldwide reinsurance and the Caribbean is an important foreign source for the United States.

Regulation & Control

The insurance industry is governed by a blend of statutes, administrative agency regulations, and court decisions at both the state and federal levels. State laws typically seek to protect insureds by controlling premium rates, preventing unfair insurer practices, and guarding against the financial insolvency of insurers. Federal law permits states to exercise regulatory control over insurance; provided state laws and regulations do not conflict with federal antitrust laws on rate fixing, rate discrimination, and monopolies.

Most states have created agencies to administer state statutes and promulgate rules to address procedural details that are missing from the statutory framework. As an initial matter, to do business within a state, an insurer must register and obtain a license from that state. The registration process is usually managed by the same state administrative agency charged with the responsibility of enforcing the statute and developing rules and regulations. To carry out their enforcement responsibilities, administrative agencies develop a range of rules and regulations. For example, states may require reporting related to company financial stability, define acceptable types of policies, and review the competence and ethical standards of insurance company employees. All the regulations are designed and implemented to fulfill the goals of the consumer protection goals outlined in state statutes.

Legislatures pass laws that are often enforced and developed by agencies in the executive branch. Consistent with the doctrine of separation of powers built into our system of government, the judicial branch has the authority to review and interpret the activities and enactments of both legislatures and agencies. In this way, the courts have an important role in determining what the law means and how it applies to everyday life. Statutes and regulations attempt to control behavior in relatively broad areas and the application of those rules can be ambiguous, disputed or unfair when applied to a specific set of facts. In such a case, the parties often turn to the courts for resolution. When a court decides a dispute between an insurance company, insured, or third party, it must interprets statutes and regulations as applied to each case. Each of those interpretations becomes a precedent that will apply to future cases with similar facts. The sum of all court decisions is called case law. Case law is always changing in response to factual variations and insurance companies must be vigilant to ensure that their practices and policies are in accord with the current law in the states in which they operate.

Case law joins with statues and administrative regulations to form a comprehensive and complex set of controls on the insurance industry. Insurance companies in violation of the law may be fined or may have their license to do business suspended or revoked. Court's may impose significant costs and fees on insurance companies found to have unreasonably denied coverage or failed to defend their insured.

Terms & Concepts

Actuarial Science: Branch of knowledge dealing with the mathematics of insurance, including probabilities. It is used in ensuring that risks are carefully evaluated, that adequate premiums are charged for risks underwritten, and that adequate provision is made for future payments of benefits.

Adjuster: (or Claims Adjuster) A person who investigates the extent of damage or injury to determine the insurance company's liability and propose a settlement.

Administrative Agency: A governmental entity created by legislation to enforce the law and develop rules and regulations to that end. Administrative agencies are generally part of the executive branch of government.

Combined Ratio: A number used to reflect and report the degree of profit or loss with respect to underwriting profit of an insurance company; does not take into account investment income.

Earned Premium: The amount of premium that corresponds to the elapsed period of time the insurer was exposed to risk. That portion of the premium represents the coverage already provided.

Float: The accumulated premiums paid before losses are incurred.

Insolvency: A financial condition when assets are inadequate to pay obligations.

Property and Casualty Insurance: Insurance policies written to cover losses related to property and legal liability to third parties arising from injury related to the property.

Reinsurance: A practice common in the insurance industry whereby one insurance company assumes part or all of a risk underwritten by another insurance company.

Retroceding: The practice whereby a reinsurer lays-off a risk assumed from the primary insurer.

Statute: A law passed by a legislature; either state or federal.

Underwriting: In the context of insurance, means to assume liability for certain events. In the context of investment banking, refers to guaranteeing the sale of certain securities.

Underwriting/Insurance Cycle: Generally refers to the fluctuations in the profitability of the insurance industry.

Bibliography

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Suggested Reading

Actually, I'm an actuary. (2007).Career World, 36(3), 5. Retrieved January 25, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=27330267&site=ehost-live

Insurance regulation is broken, needs fixing. (2007). Business Insurance, 41(25), 8. Retrieved January 26, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25564470&site=ehost-live

Rappaport, A. (1999). Life insurance assets will grow faster than policies in force. Best's Review / Life-Health Insurance Edition, 100(7), 31. Retrieved January 25, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25002459&site=ehost-live