Underwriting
and investing
The business model is to
collect more in premium and investment income than is paid out in losses, and
to also offer a competitive price which consumers will accept. Profit can be
reduced to a simple equation:
Profit = earned premium +
investment income - incurred loss - underwriting expenses.
Insurers make money in two ways:
1. Through underwriting, the process by which insurers select the risks
to insure and decide how much in premiums to charge for accepting those risks;
The most complicated aspect of the insurance
business is the actuarial science of
ratemaking (price-setting) of policies, which uses statistics and probability to approximate the rate of future claims
based on a given risk. After producing rates, the insurer will use discretion
to reject or accept risks through the underwriting process.
At the most basic level, initial ratemaking
involves looking at the frequency and severity of
insured perils and the expected average payout resulting from these perils.
Thereafter an insurance company will collect historical loss data, bring the
loss data to present value, and compare
these prior losses to the premium collected in order to assess rate
adequacy. Loss ratios and
expense loads are also used. Rating for different risk characteristics involves
at the most basic level comparing the losses with "loss relativities"
- a policy with twice as many losses would therefore be charged twice as much.
More complex multivariate analyses are
sometimes used when multiple characteristics are involved and a univariate
analysis could produce confounded results. Other statistical methods may be
used in assessing the probability of future losses.
Upon termination of a given policy, the amount of
premium collected minus the amount paid out in claims is the insurer's underwriting profit on
that policy. Underwriting performance is measured by something called the
"combined ratio which is the ratio of expenses/losses to premiums. A
combined ratio of less than 100 percent indicates an underwriting profit, while
anything over 100 indicates an underwriting loss. A company with a combined
ratio over 100% may nevertheless remain profitable due to investment earnings.
Insurance companies earn investment profits on "float". Float, or
available reserve, is the amount of money on hand at any given moment that an
insurer has collected in insurance premiums but has not paid out in claims.
Insurers start investing insurance premiums as soon as they are collected and
continue to earn interest or other income on them until claims are paid out.
TheAssociation of British
Insurers (gathering 400 insurance companies and 94% of UK
insurance services) has almost 20% of the investments in the London Stock Exchange.
In the United States, the underwriting loss of property and casualty insurance companies
was $142.3 billion in the five years ending 2003. But overall profit for the
same period was $68.4 billion, as the result of float. Some insurance industry
insiders, most notably Hank Greenberg, do not
believe that it is forever possible to sustain a profit from float without an
underwriting profit as well, but this opinion is not universally held.
Naturally, the float method is difficult to carry
out in an economically depressed period. Bear markets do cause
insurers to shift away from investments and to toughen up their underwriting
standards, so a poor economy generally means high insurance premiums. This
tendency to swing between profitable and unprofitable periods over time is
commonly known as the underwriting, or insurance, cycle.
Claims
Claims and loss handling is the materialized
utility of insurance; it is the actual "product" paid for. Claims may
be filed by insureds directly with the insurer or through brokers or agents. The insurer may require that the claim be
filed on its own proprietary forms, or may accept claims on a standard industry
form, such as those produced by ACORD.
Insurance company claims departments employ a
large number of claims adjusters supported
by a staff of records management and data entry clerks. Incoming claims are classified based on
severity and are assigned to adjusters whose settlement authority varies with
their knowledge and experience. The adjuster undertakes an investigation of
each claim, usually in close cooperation with the insured, determines if
coverage is available under the terms of the insurance contract, and if so, the
reasonable monetary value of the claim, and authorizes payment.
The policyholder may hire their own public adjuster to negotiate the settlement with the
insurance company on their behalf. For policies that are complicated, where
claims may be complex, the insured may take out a separate insurance policy add
on, called loss recovery insurance, which covers the cost of a public adjuster
in the case of a claim.
Adjusting liability insurance claims is
particularly difficult because there is a third party involved, the plaintiff, who is under no contractual obligation to cooperate
with the insurer and may in fact regard the insurer as a deep pocket. The adjuster must obtain legal counsel for the
insured (either inside "house" counsel or outside "panel"
counsel), monitor litigation that may take years to complete, and appear in
person or over the telephone with settlement authority at a mandatory
settlement conference when requested by the judge.
If a claims adjuster suspects under-insurance,
the condition of average may
come into play to limit the insurance company's exposure.
In managing the claims handling function,
insurers seek to balance the elements of customer satisfaction, administrative
handling expenses, and claims overpayment leakages. As part of this balancing
act, fraudulent insurance practices are
a major business risk that must be managed and overcome. Disputes between
insurers and insureds over the validity of claims or claims handling practices
occasionally escalate into litigation (see insurance bad faith).
Marketing
Insurers will often use insurance agents to initially market or underwrite their
customers. Agents can be captive, meaning they write only for one company, or
independent, meaning that they can issue policies from several companies. The
existence and success of companies using insurance agents is likely due to
improved and personalized service.
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