Chapter 6

Insurance
Company
Operations

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Agenda

• Most important insurance company

operations consist of:
– 1. Rating and Ratemaking
– 2. Underwriting
– 3. Production
– 4. Claim settlement
– 5. Reinsurance
– 6. Investments

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1. Rating and Ratemaking

• Ratemaking refers to the pricing of insurance and

the calculation of insurance premiums
– A rate is the price per unit of insurance
– An exposure unit is the unit of measurement used in
insurance pricing
premium  rate * exposure units
– Total premiums charged plus investment income must be
adequate for paying all claims and expenses during the
policy period
– Rates and premiums are determined by an actuary, using
the company’s past loss experience and industry statistics

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Underwriting

• Underwriting refers to the process of selecting, classifying,

and pricing applicants for insurance
• The underwriter: the person who decides to accept or reject an
applicant.
• A statement of underwriting policy establishes policies
that are consistent with the company’s objectives, such as
– Acceptable classes of business
– Amounts of insurance that can be written
• Top-level management in charge of underwriting decides
on the insurer’s underwriting policy
• A line underwriter makes daily decisions concerning the
acceptance or rejection of business
• The Underwriting Guide specifies the lines of insurance to be
written.
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Basic Underwriting Principles

• Important principles of underwriting:

– First principle: The primary objective of underwriting is to
attain an underwriting profit
– The second principle is to select prospective insureds
according to the company’s underwriting standards
– The purpose of underwriting standards is to reduce adverse
selection against the insurer
• Adverse selection is the tendency of people with a higher-than-
average chance of loss to seek insurance at standard rates. If not
controlled by underwriting, this will result in higher-than-expected
loss levels.
– Third principle: Having a proper balance within each
rate classification.
• A Below- average insured in an underwriting class should be
offset by an Above-average insured, so that on balance, the class
rate for the group will be adequate for paying claims and
expenses.
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 – Underwriting should also maintain equity among the
policyholders
• One group of policyholders should not unduly subsidize
another group
• A group of 20-year-old persons and a group 80-year–old
persons should not pay the same rate.

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Steps in Underwriting

• Underwriting starts with the agent in the field

• Agent as First Underwriter:
– Agents should know what types of applicants are acceptable, borderline,
or prohibited.
• Information for underwriting comes from:
– The application
– The agent’s report
– An inspection report
– Physical inspection
– A physical examination and attending physician’s report
– MIB (Medical Information Bureau) report
• After reviewing the information, the underwriter can:
– Accept the application
– Accept the application subject to restrictions or modifications
– Reject the application

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Production

• Production refers to the sales and marketing

activities of insurers
– Agents are often referred to as producers
– Life insurers have an agency or sales department
– Property and liability insurers have marketing
departments
• An agent should be a competent professional with
a high degree of technical knowledge in a
particular area of insurance and who also places
the needs of his or her clients first
• The key to insurer’s financial success is an effective
sales force.

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Agency Department

• Life Insurers have Agency or Sales

Departments responsible for:
– Recruiting and Training new agents
– Supervising general agents, branch office
managers, and local agents
• Property and Casualty Insurers have
Marketing Departments responsible for:
– Providing local agents in the field with technical
help and assistance in their marketing problems.
– Marketing activities.

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Claim Settlement

• The objectives of claims settlement

include:
–Verification of a covered loss
–Fair and prompt payment of claims
–Personal assistance to the insured

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Claim Settlement

• In the first objective:

– The claim process begins with a notice of loss
– Next, the claim is investigated
– Determine whether a specific person or property is
covered under the policy and the extend of the covered
loss.
– A claims adjustor determines if a covered loss has
occurred and the amount of the loss
– The adjustor may require a proof of loss before the claim
is paid
– The adjustor decides if the claim should be paid or
denied
– Policy provisions address how disputes may be resolved

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• In the second objective:
– The fair and prompt payment of claims should
be done
– Some laws prohibit unfair claims practices, such
as:
• Refusing to pay claims without conducting a
reasonable investigation
• Not attempting to provide prompt, fair, and equitable
settlements
• Offering lower settlements to compel insureds to
institute lawsuits to recover amounts due

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• In the third objective:
– he insurer should provide personal assistance to
the insured after a covered loss occur.
– EX: Assisting the agent in helping a family find
temporary housing after a fire occurs.

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Types of Claim Adjustor

• The person who adjusts a claim is a Claim

Adjustor.
• Claim Adjustor may be:
– Insurance Agent (limited amount of loss)
– Company Adjustor
– Independent Adjustor
– Adjustment Bureau
– Public Adjustor

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• Insurance Agent:
– Settles small claim cases with limited amount of loss
• Company Adjustor:
– A salaried employee who represents only one insurer
• Independent Adjustor:
– Offers his service to various insurance companies for a
fee
• Adjustment Bureau
– An organization specializing in adjustment service
– Used in catastrophic loss like Hurricane, etc
• Public Adjustor
– Represents the insured rather than the insurance
company.
– Paid a fee based on successful amount of claim

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Steps in Settlement of a Claim

• 1. Notice of Loss must be given

• 2. The Claim is Investigated
• 3. A Proof of Loss may be Required
• 4. A decision is made concerning payment

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• Step 1: Notice of Loss
– Notify the Insurer of Loss as soon as possible
after the loss occurs
• Step 2: Filing Proof of Loss
– A sworn statement by the insured that
substantiates the loss.
– The Proof of loss must indicate:
• The time and cause of the loss;
• The interests of the insured and others
• Other insurance that may cover the loss
• Other changes

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• Step 3: Decisions Concerning Payments
– Three possible decisions:
• The Claim can be paid
• The Claim can be denied
• Needed Dispute: negotiation on the amount to be
paid.
– In the case of dispute:
• Both the insured and insurer select a competent
appraiser
• Two appraisers select an umpire (or the court will
select the umpire)
• If the dispute is not resolved by the umpire, the
customer may file a complaint with the State
Insurance Department.

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Reinsurance

• Reinsurance is an arrangement by which the

primary insurer that initially writes the insurance
transfers to another insurer part or all of the
potential losses associated with such insurance
– The primary insurer is the ceding company
– The insurer that accepts the insurance from the ceding
company is the reinsurer
– The retention limit or net retention is the amount of
insurance retained by the ceding company
– The amount of insurance ceded to the reinsurer is known
as a cession
– Retrocession: the Reinsurer now reinsures part or all of
the risk with another insurer. The second reinsurer is
called: Retrocessionaire.

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Reasons for Reinsurance

• Reinsurance is used to:

– Increase underwriting capacity
– Stabilize profits
– Reduce the unearned premium reserve
• The unearned premium reserve represents the
unearned portion of gross premiums on all outstanding
policies at the time of valuation
– Provide protection against a catastrophic loss
– Retire from business or from a line of insurance
or territory
– Obtain underwriting advice on a line for which
the insurer has little experience
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Types of Reinsurance Agreements

• There are two principal forms of reinsurance:

– Facultative reinsurance is an optional, case-by-case method that

is used when the ceding company receives an application for
insurance that exceeds its retention limit
• Facultative reinsurance is often used when the primary insurer has an
application for a large amount of insurance

– Treaty reinsurance means the primary insurer has agreed to cede

insurance to the reinsurer, and the reinsurer has agreed to accept
the business
• All business that falls within the scope of the agreement is
automatically reinsured according to the terms of the treaty

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Types of Reinsurance Treaty

• Quota- Share Treaty

• Surplus – Share Treaty
• Excess –of - Loss Treaty
• Reinsurance Pool.

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• Quota-Share Treaty:
– The ceding insurer and reinsurer agree to share
premiums and losses based on some proportion.
– The ceding insurer’s retention limit is stated as
percentage rather than a dollar amount.
– The reinsurer pays ceding commission to the primary
insurer.
• Surplus –Share Treaty:
– The reinsurer agrees to accept insurance in excess of the
ceding insurer’s retention limit, up to some maximum
amount.
– Retention unit refers to a line and is stated in the dollar
amount.
– Share premiums and losses are based on the fraction of
total insurance by each party.

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• Excess-of-Loss Treaty:
– Used in catastrophic protection
– Losses in excess of the retention limit are paid by
reinsurer up to some maximum limit.
• Reinsurance Pool
– An organization of insurers that underwrites
insurance on a joint basis.
– Reinsurance Pool is formed because a single insurer
may alone may not have enough financial capacity
to write large amounts of insurance.
– Used in protecting: nuclear energy, oil refineries,
etc.

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Reinsurance Alternatives

• Some insurers use the capital markets as an

alternative to traditional reinsurance
• Securitization of risk means that an insurable risk
is transferred to the capital markets through the
creation of a financial instrument, such as a
futures contract
• Catastrophe bonds are corporate bonds that
permit the issuer of the bond to skip or reduce
the interest payments if a catastrophic loss occurs
– Catastrophe bonds are growing in importance and are
now considered by many to be a standard supplement to
traditional reinsurance.

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 – The bonds pay relatively high interest rates.
However if a catastrophe occurs, the investors
could forfeit the interest and even the principal,
depending on how the bonds are structured.
– Catastrophe bonds are purchased by
institutional investors seeking higher yielding,
fixed-income securities.

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Investments

• Because premiums are paid in advance, they can

be invested until needed to pay claims and
expenses
• Investment income is extremely important in
reducing the cost of insurance to policyowners and
offsetting unfavorable underwriting experience
• Life insurance contracts are long-term; thus, safety
of principal is a primary consideration
• In contrast to life insurance, property insurance
contracts are short-term in nature, and claim
payments can vary widely depending on
catastrophic losses, inflation, medical costs, etc
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Life Insurance Investments
• Funds available for investments are from:
– Premium income
– Investment Earnings
– Mature Investments that are reinvested.
• Two accounts in the asset’s structure of a life insurer:
general account and separate account.
• Because of long-term nature of life insurance, most
investments in general accounts are in bonds,
mortgages, and real estates.
• Investments of assets in the separate account are
mainly in stocks (high risk).

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Exhibit 6.1 Growth of Life Insurers’ Assets

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Exhibit 6.2 Asset Distribution of Life Insurers
2007

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Property and Casualty Insurance
Investments

• Investments in high-quality stocks which

can be quickly sold to pay claims.
• Investment objective of liquidity is
extremely important.

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Exhibit 6.3 Investments, Property/Casualty
Insurers, 2007 Investments by Type

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Other Insurance Company Functions

• The electronic data processing area maintains

information on premiums, claims, loss ratios,
investments, and underwriting results
• The accounting department prepares financial
statements and develops budgets
• In the legal department, attorneys are used in
advanced underwriting and estate planning
• Property and liability insurers provide numerous
loss control services such as advice on:
– Alarm system
– Automatic sprinkler system
– Fire prevention
– Loss-prevention activities

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