Chapter 4

INSURANCE COMPANY
OPERATIONS

By:Marya Sholevar
 INSURANCE COMPANY
OPERATIONS
The most important insurance company operations
consist of the following:
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Ratemaking
●
Underwriting
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Production
●
Claim settlement
●
Reinsurance
Insurers also engage in other operations, such as
accounting, legal services, loss control, and
information systems.
 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, which varies by line of insurance.
●
The person who determines rates and premiums is
known as an actuary . An actuary is a highly skilled
mathematician who is involved in all phases of
insurance company operations, including planning,
pricing, and research.
 RATING AND RATEMAKING
●
Rating is a process of multiplying a rate determined
by actuaries by the number of exposure units, and
then adjusting by various rating plans.
●
In life insurance, the actuary determines the
premiums for life and health insurance policies and
annuities also determine the legal reserves a
company needs for future obligations.
●
In property and casualty insurance, actuaries also
determine the rates for different lines of insurance
and also determine the adequacy of loss
reserves,allocate expenses, and compile statistics for
 RATING AND RATEMAKING
●
In life insurance, the actuary studies important
statistical data on births, deaths, marriages, disease,
employment, retirement, and accidents.Based on this
information, the actuary determines the premiums
for life and health insurance policies and annuities.
●
The objectives of calculate premiums are make the
business
●
profitable, enable the company to compete
effectively with other insurers, and allow the
company to pay claims and expenses as they occur.
 UNDERWRITING

Underwriting refers to the process of selecting,

classifying, and pricing applicants for insurance .
The underwriter is the person who decides to accept
or reject an application.
Statement of Underwriting Policy:Underwriting
starts with a clear statement of underwriting policy.
●
An insurer must establish an underwriting policy
that is consistent with company objectives.
 UNDERWRITING
●
The insurer’s underwriting policy is determined by
top-level management in charge of underwriting.
●
The underwriting policy is stated in detail in an
underwriting guide that specifies the lines of
insurance to be written; territories to be developed;
forms and rating plans to be used; acceptable,
borderline, and prohibited business; amounts of
insurance to be written; business that requires
approval by a senior underwriter; and other
underwriting details.
 Basic Underwriting Principles

1.Attain an underwriting profit:The primary

objective of underwriting is to attain an
underwriting profit. The objective is to produce a
profitable book of business.
2.Select prospective insureds according to the
company’s underwriting standards:the
underwriters should select only those insureds
whose actual loss experience is not likely to exceed
the loss experience assumed in the rating structure
with purpose of reducing adverse selection against
the insurer.
 Steps in Underwriting

After the insurer’s underwriting policy is established,

it must be communicated to the sales force. Initial
underwriting starts with the agent in the field.
●
Agent as First Underwriter
●
Collecting Informations
●
Making an Underwriting Decision
 Agent as First Underwriter
●
Agent as First Underwriter:This step is often
called field underwriting. The agent is told what
types of applicants are acceptable, borderline, or
prohibited.
In property and casualty insurance, the agent often has
authority to bind the company immediately. Thus, it
is important that the agent follow company policy
when soliciting applicants for insurance.
In life insurance, the agent must also solicitapplicants
in accordance with the company’s underwriting
policy.
 Collecting Informations

The underwriter requires certain information in

deciding whether to accept or reject an applicant for
insurance. Important sources of information:
●
Application. The type of information required
depends on the type of insurance requested.In
property insurance, provides the physical features of
the building and in life insurance provides age;
gende...
●
Agent’s report. Many insurers require the agent or
broker to give an evaluation of the prospective
insured. In life agent may be asked how long he or
 Collecting Informations
●
Inspection report. In property insurance, the
company may require an inspection report by some
outside agency, especially if the underwriter
suspects moral hazard.In life insurance, the report
may provide information on the applicant’s financial
condition, marital status,...
●
Physical inspection. In property insurance and
casualty insurance, the underwriter may require a
physical inspection before the application is
approved.
●
Physical examination. In life insurance, a physical
 Making an Underwriting Decision

After the underwriter evaluates the information, an

underwriting decision must be made. There are three
basic underwriting decisions with respect to an
initial application for insurance:
●
Accept the application:
●
Accept the application subject to certain
restrictions or modifications
●
Reject the application
Many insurers now use computerized underwrit ing
for certain personal lines of insurance that can be
standardized, such as auto and homeowners
Other Underwriting Considerations

●
Rate adequacy and underwriting . Property and
casualty insurers are more willing to underwrite new
business for a specific line if rates are considered
adequate.
●
Reinsurance and underwriting . Availability of
reinsurance may result in more liberal underwriting.
However, if reinsurance cannot be obtained on
favorable terms, underwriting may be more
restrictive.
●
Renewal underwriting. In life insurance, policies
are not cancellable. In property and casualty
 PRODUCTION
●
The term production refers to the sales and
marketing activities of insurers. Agents who sell
insurance are frequently referred to as producers .
●
Life insurers have an agency or sales department.
This department is responsible for recruiting and
training new agents and for the supervision of
general agents, branch office managers, and local
agents.
●
Property and casualty insurers have marketing
departments. To assist agents in the field, special
agents may also be appointed.
 PRODUCTION
●
Professionalism in Selling means that the modern
agent should be a competent professional who has 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 professional agent identifies potential insureds,
analyzes their insurance needs, and recommends a
product to meet their needs. After the sale, the agent
has the responsibility of providing follow-up service
to clients to keep their insurance programs up to
date. Finally, a professional agent abides by a code
of ethics.
 PRODUCTION
●
Chartered Financial Consultant (ChFC) desig-
nation for professionals who are working in the
financial services industry.
●
Chartered Property Casualty Underwriter
(CPCU) is professional designation programs for
agents and other personnel in property and casualty
insurance.
●
The Certified Financial Planner (CFP)
designation is granted by the Certified Financial
Planner Board of Standards, Inc.
●
Many agents in property and liability insurance have
 CLAIMS SETTLEMENT
●
Every insurance company has a claims division or
department for adjusting claims. This section of the
chapter examines the basic objectives in adjusting
claims, the different types of claim adjustors, and
the various steps in the claim-settlement process.
●
Basic Objectives in Claims Settlement:
– Verification of a covered loss
– Fair and prompt payment of claims
– Personal assistance to the insured
 Basic Objectives in Claims
Settlement
●
The first objective in settling claims is to verify that
a covered loss has occurred . This step involves
determining whether a specific person or property is
covered under the policy, and the extent of the
coverage.
●
The second objective is the fair and prompt
payment of claims . If a valid claim is denied, the
fundamental social and contractual purpose of
protecting the insured is defeated. Also, the insurer’s
reputation may be harmed, and the sales of new
policies may be adversely affected.
●
 Basic Objectives in Claims
Settlement
●
Fair payment means that the insurer should avoid
excessive claim settlements and should resist the
payment of fraudulent claims, because they will
ultimately result in higher premiums.
●
Some unfair claim practices prohibited by these laws
include the following:
– Refusing to pay claims without conducting a reasonable
investigation.
– Not attempting in good faith to provide prompt, fair, and
equitable settlements of claims in which liability has
become reasonably clear.
– Compelling insureds or beneficiaries to institute lawsuits
 Types of Claims Adjustors
●
The person who adjusts a claim is known as a
claims adjustor . The major types of adjustors
include the following:
– Agent
– Company adjustor
– Independent adjustor
– Public adjustor
●
An insurance agent often has authority to settle
small first-party claims up to some maximum
limit.he insurer, such as a small theft loss by the
insured. The insured submits the claim directly to
 Types of Claims Adjustors
●
A company adjustor can settle a claim. The
adjustor is usually a salaried employee who repre-
sents only one company. After notice of the loss is
received, the company adjustor will investigate the
claim, determine the amount of loss, and arrange for
payment.
●
An independent adjustor can also be used to adjust
claims.An independent adjustor is an organization or
individual that adjusts claims for a fee.Property and
casualty insurers often use independent adjustors
when a catastrophic loss occurs in a given
geographical area.
 Steps in Settlement of a Claim
●
There are several important steps in settling a claim
– Notice of loss must be given.
– The claim is investigated.
– A proof of loss may be required.
– A decision is made concerning payment.
●
Notice of Loss The first step is to notify the insurer
of a loss. A provision concerning notice of loss is
usually stated in the policy. A typical provision
requires the insured to give notice immediately or as
soon as possible after the loss has occurred.
 Steps in Settlement of a Claim
●
Investigation of the Claim :After notice is
received, the next step is to investigate the
claim.The most important questions include the
following:
– Did the loss occur while the policy was in force?
– Does the policy cover the peril that caused the loss?
– Does the policy cover the property destroyed or damaged
in the loss?
– Is the claimant entitled to recover?
– Did the loss occur at an insured location?
– Is the type of loss covered?
 Steps in Settlement of a Claim
●
Filing a Proof of Loss: An adjustor may require a
proof of loss before the claim is paid. A proof of loss
is a sworn statement by the insured that substantiates
the loss.
●
Decision Concerning Payment: After the claim is
investigated, the adjustor must make a decision con-
cerning payment. There are three possible decisions.
– The claim can be paid . In most cases, the claim is paid
promptly according to the terms of the policy.
– The claim can be denied . The adjustor may believe that
the policy does not cover the loss or that the claim is
fraudulent.
 REINSURANCE
●
Reinsurance is an arrangement by which the
primary insurer that initially writes the insurance
transfers to another insurer (called the reinsurer) part
or all of the potential losses associated with such
insurance .
●
The primary insurer that initially writes the
insurance is called the ceding company .
●
The insurer that acceptspart or all of the insurance
from the ceding com pany is called the reinsurer .
●
The amount of insurance retained by the ceding
company for its own account is called the retention
 Reasons for Reinsurance
●
The most important reasons include the following:
– Increase underwriting capacity
– Stabilize profits
– Reduce the unearned premium reserve
– Provide protection against a catastrophic loss
●
Reinsurance also enables an insurer to retire from a
territory or class of business and to obtain
underwriting advice from the reinsurer.
 Reasons for Reinsurance
●
Increase Underwriting Capacity:The company
may be asked to assume liability for losses in excess
of its retention limit. Without reinsurance, the agent
would have to place large amounts of insurance with
several companies or not accept the risk.
●
Stabilize Profits: An insurer may wish to avoid
large fluctuations in annual financial results. Loss
experience can fluctuate widely because of social
and economic conditions, natural disasters, and
chance. Reinsurance can be used to stabilize the
effects of poor loss experience.
●
 Reasons for Reinsurance
●
The unearned premium reserve is a liability item on
the insurer’s balance sheet that represents the
unearned portion of gross premiums on all
outstanding policies at the time of valuation .In
effect, the unearned premium reserve reflects the
fact that premiums are paid in advance, but the
period of protection has not yet expired. As time
goes on, part of the premium is considered earned,
while the remainder is unearned. It is only after the
period of protection has expired that the premium is
fully earned.
●
Reduce the unearned premium reserve:
 Reasons for Reinsurance
●
Provide Protection Against a Catastrophic Loss:
Reinsurance can provide considerable protection to
the ceding company that experiences a catastrophic
loss. The reinsurer pays part or all of the losses that
exceed the ceding company’s retention up to some
specified maximum limit.
●
Other Reasons for Reinsurance:
– An insurer canu use reinsurance to retire from the
business or from a given line of insurance or territory.
– Reinsurance permits the insurer’s liabilities for existing
insurance to be transferred to another carrier; thus,
policyholders’ coverage remains undisturbed.
 Types of Reinsurance
●
There are two principal types of reinsurance: (1)
facultative reinsurance and (2) treaty 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 Reinsurance is not automatic.
●
Reinsurance is not automatic. The primary insurer
negotiates a separate contract with a reinsurer for
each loss exposure for which reinsurance is desired.
●
Advantage of Facultative reinsurance
– Flexibility because it can be tailored to fit any type of
 Types of Reinsurance
●
Disadvantages of Facultative reinsurance:
– There is some uncertainty because the primary insurer
does not know in advance whether a reinsurer will accept
any part of the insurance.
– There can also be a problem of delay because the policy
will not be issued until reinsurance is obtained.
– Finally, during periods of poor loss experience,
reinsurance markets tend to tighten, and facultative
reinsurance may be more costly and more difficult to
obtain.
 Types of Reinsurance
●
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.
●
Advantages of Treaty reinsurance
– It is automatic, and no uncertainty or delay is involved.
– It is also economical, because it is not necessary to shop
around and negotiate reinsurance terms before the policy
is written.
●
 Methods for Sharing Losses
●
There are two basic methods for sharing losses: (1)
pro rata and (2) excess-of-loss.
●
Under the pro rata method, the ceding company and
reinsurer agree to share losses and premiums based
on some proportion.
●
Under the excess-of-loss method, the reinsurer pays
only when covered losses exceed a certain level.
●
The following reinsurance methods for the sharing
of losses are examples of both methods:
1-Quota-share treaty 2-Surplus-share treaty 3-
Excess-of-loss reinsurance 4-Reinsurance pool
 Methods for Sharing Losses
●
Quota-Share Treaty Under a quota-share treaty, the
ceding company and reinsurer agree to share
premiums and losses based on some proportion.The
ceding company’s retention is stated as a percentage
rather than as a dollar amount.
●
Premiums are also shared based on the same agreed-
on percentage.However, the reinsurer pays a ceding
commission to the primary insurer to help
compensate for the expenses incurred in writing the
business.
●
The major advantage of quota-share reinsurance is
 Methods for Sharing Losses
●
Surplus-Share Treaty Under a surplus-share
treaty,the reinsurer agrees to accept insurance in
excess of the ceding insurer’s retention limit, up to
some maximum amount.
●
The retention limit is referred to as a line and is
stated as a dollar amount .
●
Under a surplus-share treaty, premiums are also
shared based on the fraction of total insurance
retained by each party.
●
The principal advantage of a surplus-share treaty is
that the primary insurer’s underwriting capacity on
 Methods for Sharing Losses
●
Excess-of-loss reinsurance is designed largely for
protection against a catastrophic loss. The reinsurer
pays part or all of the loss that exceeds the ceding
company’s retention limit up to some maximum
level.
●
Excess-of-loss reinsurance can be written to cover
– (1) a single exposure,
– (2) a single occurrence, such as a catastrophic loss from a
tornado,
– (3) excess losses when the primary insurer’s cumulative
losses exceed a certain amount during some stated time
period, such as a year.
 Methods for Sharing Losses
●
A reinsurance pool is an organization of insurers
that underwrites insurance on a joint basis .
●
Reinsurance pools have been formed because a
single insurer alone may not have the financial
capacity to write large amounts of insurance, but the
insurers as a group can combine their financial
resources to obtain the necessary capacity.
●
The method for sharing losses and premiums varies
depending on the type of reinsurance pool.
– First, each pool member agrees to pay a certain
percentage of every loss.
 ALTERNATIVES TO
TRADITIONAL REINSURANCE
●
Many insurers and reinsurers are now using the
capital markets as an alternative to traditional
reinsurance.
●
Some insurers and reinsurers are using the capital
markets to gain access to the capital of
institutional investors.
●
Securitization of Risk: means that an insurable risk
is transferred to the capital markets through the
creation of a financial instrument, such as a
catastrophe bond, futures contract, options contract,
or other financial instrument.
 ALTERNATIVES TO
TRADITIONAL REINSURANCE
●
Catastrophe bonds are an excellent example of the
securitization of risk. Catastrophe bonds are
corporate bonds that permit the issuer of the bond to
skip or reduce scheduled interest payments if a
catastrophic loss occurs.
●
The bonds are complex financial instruments issued
by insurers and reinsurers and are designed to
provide funds for catastrophic natural disaster
losses.
●
Catastrophe bonds are typically purchased by
institutional investors seeking higher-yielding,