The Business of Insurance, Reinsurance, Regulation of Insurance, Risk Management and

Public Policy

Dr. John F. Fitzgerald, JrCLU, CPCU, CIC

The Business of Insurance

Business of Insurance

• #1 Concern- 28% of Small Business• Satisfied Consumers

Structure Types

• Life• Health• Property-Liability

Forms & Insurers

• Form– Stock– Mutual

• Insurers– Life-Health 1200– Property- Liability 2700

Distribution System

• Independent Agents– Agent, broker, solicitor, surplus lines

• Exclusive Agents• Direct Writers• Direct Response– Web– Internet– Mail

Market Share

• Personal Lines– Agencies 30%– Direct 70%

• Commercial Lines– Agency 70%– Direct 30%

InvestmentsP/C L/H

Bonds 70 75Common Stock 18 5

Other 12 10

Liabilities

• Unearned premium reserves (UPR)• Loss reserves (2/3 of liabilities)– Reserve for accidents or events that have already

occurred– Three types of loss reserves:• Settled but not yet paid• Reported but not yet settled• Incurred but not yet reported (IBNR)

Statutory Accounting Principles (SAP) (Insurance Accounting)

• GAAP v. SAP– Going concern v. liquidation– Expenses recognized immediately while revenues

must be accrued– Admitted v. non-admitted assets– Conservative securities valuation

• Assets – Liabilities = Net worth

Functional Areas

• Sales and marketing• Underwriting- selection of risks• Claims- paying and reserving for losses• Product development• Ratemaking (actuarial) – pricing of policies• Investments• Risk management services- loss control, data

management, etc.• Accounting, Legal, IT

Reinsurance

What is Reinsurance?

• Defined:–Insurance for insurance companies

• Retrocession–Insurance for reinsurers

Why is Reinsurance Purchased?

• Several “Needs” May Exist–Capacity– Stability–Catastrophe Protection–Premium Growth– Enter/Exit Classes of Insurance

Reinsurance and Its Function

• Basic terms and concepts• Reinsurance functions:

• Increase large-line capacity• Provide catastrophe protection• Stabilize loss experience• Provide surplus relief• Facilitate withdrawal from a market segment• Provide underwriting guidance

Capacity

• Unusual risk or “large line”• Regulations affecting insurers– The 10% rule

• Management of line size (limits) within insurance portfolio

Stability

• Desire to limit the fluctuation in results due to random variation in losses

• Predictability in loss ratio• Need to comfort shareholders,

policyholders, regulators, and investors

Catastrophe Protection

• Protect against adverse affects of a catastrophic event natural or man-made• Multiple policies involved in single

loss or event

Premium Capacity

• Also referred to as “Surplus Relief”• Arises from conservative nature of insurance

accounting principles (SAP)• New/Growing insurers need to “finance” the

premiums they write• Measure = Leverage Ratio• Net Premiums Written: Policyholders’ Surplus

Other Functions

• Entry into new classes/ territories• Exit from classes/ territories• Underwriting expertise• Protect insurer against punitive or “bad

faith” damages

In/Reinsurance Distribution

Insured Primary

Insurer Re-insurer

Retro-cession

DirectMarket

BrokerMarket

Reinsurance Sources

• Professional reinsurers• Reinsurance departments of primary insurers• Reinsurance pools, syndicates, and associations• Reinsurance professional and trade associations– Intermediaries and Reinsurance Underwriters

Association (IRU)– Brokers & Reinsurance Markets Association (BRMA)– Reinsurance Association of America (RAA)

Types of Reinsurance

• Facultative• Treaty• Other (Hybrid/Financial)

Facultative Reinsurance

• Individual risk review/underwriting• Certificate issuance• Treaty protection/Hazardous risks• Hybrid agreements• Advantages/Disadvantages

Treaty Reinsurance

• Groups of policies, class/line of business, or entire portfolio

• Obligatory reinsurer acceptance• Pooling effect• One agreement

Forms of Reinsurance Agreements• Proportional (Pro Rata)–Principal of sharing- premium, limits, and

losses–Reinsurance applications:• Quota Share- Fixed percentage sharing• Surplus Share- Fixed dollar amount retained,

yielding variable percentages• Variations

Proportional Reinsurance

• Sharing Concept- QS (%) & SS($)

PrimaryInsurerRetention

ReinsuranceCession

Percentage of premiums & losses shared

100% or ($)0% or ($)

$1M

Limits of insurance

Comparing: QS & SSQuota Share Surplus ShareA fixed percentage amount is retained by the insurer and ceded to the reinsurer

A fixed dollar amount of retention is selected by the insurer resulting in variable percentages of retention and cession

All policies included in the agreement are reinsured according to the specified percentages

Policies with limits less than the retention are retained 100% by the reinsured company

Used in property and casualty classes of insurance

Used most frequently in property insurance

Types of Reinsurance

• Pro Rata Reinsurance– Quota share reinsurance– Surplus share reinsurance

• Excess of Loss Reinsurance– Per risk excess of loss– Catastrophe excess of loss– Per policy excess of loss– Per occurrence excess of loss– Aggregate excess of loss

Forms of Reinsurance Agreements

• Non-Proportional (Excess of loss – XOL)–Principal of indemnification–Reinsurance applies:• Per risk/Per occurrence/Per claim• Per policy• Catastrophe- Property• Clash- Casualty• Aggregate or Stop Loss

“Excess of Loss” Non-Proportional Reinsurance

• Indemnification Concept

Remember- reinsurance “attachment” may apply on one of many bases

$1MLimits of insurance

Attachment Point

Reinsurance reimbursement for the amount of loss in “excess of” the retention

Primary Reinsurance Amount

Reinsurance indemnifies for a loss in excess of the primary retention

Example: Excess of Loss (XOL)

Dr. A, an orthopedic surgeon, failed to properly treat a fracture of the left femur. The patient was a high school athlete and suffered permanent injury to his leg.

Dr. A had a $1,000,000 policy limit (claims-made) at the time of the medical incident and the insurer was able to settle the case for $1,000,000.

The insurer had an Excess of Loss Reinsurance agreement in place for $750,000 “excess of” $250,000 per claim.

Reinsurer pays (indemnifies) $750,000 of the settlement “in excess of”

$1,000,000 Policy Limit

$250,000 Retained by the insurer

Example: Clash CoverageDr. A was involved in another case with two of his associates that was settled

for a total of $3,000,000, with fault apportioned equally among the three doctors ($1M each).

Each doctor was covered under a $1,000,000 policy limit at the time of the medical incident.

The insurer had in place a Per Occurrence Clash reinsurance agreement for $5,000,000 “excess of” $500,000 per medical incident.

Limits Dr. A Dr. B Dr. C Total Recovery

Loss $1,000,000 $1,000,000 $1,000,000

Reinsurance Limit $5,000,000 “in excess of”

Paid loss:$833,333

Paid loss:$833,333

Paid loss:$833,333

$2,500,000

Retention $500,000 Retained by Insurer

Alternative to Traditional Reinsurance

• Finite risk reinsurance• Capital market alternatives to traditional and

non-traditional reinsurance

Reinsurance Program Design

• Factors affecting reinsurance needs– Growth plans– Types of insurance sold– Geographic spread of loss exposures– Insurer size– Insurer structure– Insurer financial strength– Senior management’s risk tolerance

Factors Affecting Retention Selection

• Maximum amount the primary insurer can retain

• Maximum amount the primary insurer wants to retain

• Minimum retention sought by the reinsurer

• Co-participation provision

Factors Affecting Reinsurance Limit Selection

• Maximum policy limit• Extra-contractual obligations• Loss adjustment expenses• Clash cover• Catastrophe exposure

Many More Reinsurance Issues

• Basis of “Attaching” Coverage• Contract Wording/Documentation• Pricing Issues (Primary & Reinsurance)• Trends and Emerging Issues• And much more…

Reinsurance Regulation

• Contract certainty• Credit for reinsurance transactions

Finally: What do Reinsurance Underwriters Really Do?

Reinsurance Underwriter

Financial Analysis of

Primary Insurers

Loss Exposure & Primary Coverages

Loss Reserving by Primary

Insurers

Primary Insurance

Pricing

Facultative Certificate &

Treaty Wording

Regulation of Insurance

Federal Regulation

• Advantages of Federal Regulation–Uniformity of laws–Greater efficiency–More competent regulation

State Regulation

• Advantages of State Regulation–Greater responsiveness to local needs–Uniformity of laws by the NAIC–Greater opportunity for innovation–Unknown consequences of federal

regulation–Decentralization of political power

Evolution of Insurance Regulation

• Paul v. Virginia• Sherman Antitrust Act• South-Eastern Underwriters Association

Decision• McCarran-Ferguson Act• ISO and the Attorneys General Lawsuit• Gramm-Leach-Bliley Act

Reasons for Insurance Regulation I

• Maintain Insurer Solvency– Nature of the insurance promise– Ripple effect of insolvencies

• Protect Consumers/Inadequate Consumer Knowledge– Complex contracts– Difficult to compare and determine monetary value– Important to maintain consumer impact and

competitive incentive

Reasons for Insurance Regulation II

• Prevent Destructive Competition• Insure Reasonable Rates– Adequate, not excessive, not unfairly

discriminatory• Make Insurance Available– Essential coverages (auto)– Government insurance programs (unemployment)

Financial Regulation

• Minimum capital and surplus requirements• Admitted assets- those that state law allows

an insurer to who on its statutory balance sheet in determining its financial condition

• Reserves- liabilities (state prescribes methods for calculating)

• Surplus- difference between assets & liabilities (determines amount of business allowed)

Rate Regulation I

• All states (except Illinois) have laws requiring rates to be adequate, reasonable (not excessive), not unfairly discriminatory

• Types of rating laws (Property/Casualty):– State-made rates- state determines and all insurers

in state must use (Texas and Massachusetts for auto rates)

– Mandatory bureau rates- rating bureau determines and all insurers must use some deviations (North Carolina)

Insurance Regulatory Activities: Regulating Insurance Rates

• Insurance rate regulation goals–Adequate–Not excessive–Not unfairly discriminatory

• Types of rating laws

Rate Regulation II

• Types of rating laws:– Prior approval- rates must be filed and approved by

the state insurance department before they can be used (majority use, but problem of delays)

– File-and-use- companies are required only to file the rates with state officials (who may later disapprove) & and use immediately

– Open competition- no filing laws though may have to furnish schedules and supporting data to state officials

– Flex rating laws- prior approval only required if rate change exceeds a predetermined range—e.g., 5%

Insurance Regulators

• State Insurance Departments– The Insurance Commissioner– State Regulation Funding

• The National Association of Insurance Commissioners (NAIC)– Model Laws and Regulations– Accreditation Program

• Federal Regulation

Insurance Regulatory Activity: Licensing Insurers and Insurance Personnel

• Licensing Insurers– Domestic insurers– Foreign insurers– Alien insurers– Nonadmitted

insurers– Risk retention groups

• Licensing Insurance Personnel– Producers– Claims

representatives– Insurance

consultants

Insurance Regulatory Activities: Monitoring Insurer Solvency

• Methods to maintain solvency• Liquidation of insolvent insurers• State guaranty funds• Reasons for insolvency

Insurance Regulatory Activities: Regulating Insurance Policies

• Legislation• Policy rules, regulations, and guidelines• Courts

Insurance Regulatory Activities: Market Conduct and Consumer Protection

• Monitoring market conduct–Producer practices–Underwriting practices–Claim practices

• Market analysis• Ensuring consumer protection

Unofficial Regulators in Insurance

• Financial rating organizations• Insurance advisory organizations• Insurance industry professional and trade

associations• Consumer groups

Regulatory Philosophy I

• Financial solidity• Fair equitable treatment• Competitive market• National leader• Enforcement• Regulatory cooperation

Regulatory Philosophy II

• Improve and sustain• Encourage freedom• Self regulation• Loss prevention• Inform public• Timely response to change• Evaluate strategy

Regulatory Philosophy III

• Vision and mission• Recognize and monitor change• Innovation• Arbitration• Strengthen regional economy

P/C Insurer ImpairmentsYear Number of Impairments

1995 15

1996 12

1997 31

1998 18

1999 19

2000 49

2001 50

2002 49

2003 35

2004 18

2005 13

2006 15

2007 4

Number of Life/Health Insurer InsolvenciesYear Number of Insolvencies

1995 2

1996 4

1997 5

1998 6

1999 11

2000 10

2001 3

2002 2

2003 4

2004 6

2005 1

2006 0

2007 1

Reasons for P/C Insurer Impairments

Deficient Loss Re-serves/In-Adequate

Pricing63%

Affiliate Problems9%

Catastrophe Losses9%

Alleged Fraud11%

Rapid Growth9%

2003-2005

Relevant Issues in Regulation

• Convergence in financial services• Natural catastrophe issues (coverage, response, etc.)• Growth of the Internet• Insolvencies• Quality of regulation• Deregulation of commercial lines• Speed to market• Agent/broker compensation• Underwriting information (CLUE, insurance scores)

Risk Management and Public Policy

Managing Risk through Legislation

• Fire protection• Zoning laws• Building codes• Public safety• Highway safety• Motor vehicle standards• Licensing (occupation)

• Workplace safety• Product safety• Sanitation• Pollution• Hazardous materials• Employment conditions• Education• Criminal law