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The Griffith Insurance Education Foundation Basic Principles of Risk Management & Insurance Faith R. Neale, Ph.D. Associate Professor of Risk Management.

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Presentation on theme: "The Griffith Insurance Education Foundation Basic Principles of Risk Management & Insurance Faith R. Neale, Ph.D. Associate Professor of Risk Management."— Presentation transcript:

1 The Griffith Insurance Education Foundation Basic Principles of Risk Management & Insurance Faith R. Neale, Ph.D. Associate Professor of Risk Management and Insurance Department of Finance Belk College of Business, UNC Charlotte 1 A Seminar for South Carolina State Legislators January 17, 2013

2 Seminar Overview  Overview of Insurance Market  Industry Overview  Ratemaking  Underwriting  Insurance Regulation The Griffith Insurance Education Foundation2

3 Why do we need insurance? Comply with law and manage risk  Comply with lender requirements  Auto, Home  Comply with state and federal law  State: auto liability limits, worker’s compensation  Federal: PPACA  Asset protection and financial security  Risk The Griffith Insurance Education Foundation3

4 What is insurance? “The pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk.” ARIA, 1965 The Griffith Insurance Education Foundation4

5 Characteristics of insurance  Risk transfer  The insurer promises to pay under certain conditions  Pooling of losses  Substitutes average loss of pool for actual loss  Law of Large Numbers  Payment of fortuitous losses  Sudden and accidental, unforeseen and unexpected  Indemnification  Restore to original financial position The Griffith Insurance Education Foundation5

6 Categories of Insurance  Personal and Commercial lines  Property/Casualty and Life/Health The Griffith Insurance Education Foundation6

7 Overview of Insurance Market The Griffith Insurance Education Foundation7

8 2011 P&C U.S. NPW by Line The Griffith Insurance Education Foundation Source: SNL Financial, Inc. 8

9 2011 Life/A&H U.S. NPW by Line The Griffith Insurance Education Foundation Source: SNL Financial, Inc. 9

10 The Griffith Insurance Education Foundation Source: SNL Financial, Inc. 10

11 Industry Overview The Griffith Insurance Education Foundation11

12 INDUSTRY CHARACTERISTICS Types of Private Insurers Form of Ownership Place of Incorporation Licensing Status Proprietary Cooperative Stock Cos Lloyds Mutual Cos Reciprocals DOMESTIC FOREIGN ALIEN Admitted Non- Admitted Surplus Lines Pools Syndicate Reinsurance Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation12

13 Surplus Lines  Distressed (risk or market)  Risk – Physician with drug use  Market – Compounding pharmacies  Unique or Unusual  Shamu, Hole-in-One coverage  High Capacity  Corporate jet, high rise  Product Innovation  Cyber Liability, EPL The Griffith Insurance Education Foundation13

14 INDUSTRY CHARACTERISTICS Public Insurers  Federal  National Flood Insurance Program  Social Security (OASDI), Medicare, Unemployment, Railroad Retirement Act  Terrorism Risk and Insurance Act (TRIA)  Crop Insurance  State  Wind (and hail) Pools, FAIR plans  Workers Compensation pools  Auto liability and health insurance pools The Griffith Insurance Education Foundation14

15 SC Wind and Hail Underwriting Association(JUA)  Residual property insurance market – insurer of last resort  Covers wind and hail in coastal “beach” areas  All insurers licensed to write property insurance are members.  All insurers that write property insurance share in the losses and profits of the association. The Griffith Insurance Education Foundation15

16 Characteristics of an (ideally) insurable risk  Large number of exposure units  Accidental and unintentional loss  Determinable and measurable  No catastrophic loss  Calculable chance of loss  Economically feasible premium The Griffith Insurance Education Foundation16

17 Ratemaking The Griffith Insurance Education Foundation17

18 RATEMAKING OBJECTIVES INSURER OBJECTIVES Primary Objectives Secondary Objectives Low enough to be competitive. High enough to be profitable. Stability Responsiveness Promote Loss Control Contingencies Simplicity REGULATORY OBJECTIVES Adequate Not Excessive Not Unfairly Discriminatory TYPES OF RATING LAWS 1. Prior Approval Laws (SC) 2. File & Use Laws 3. Use & File Laws 4. Flex Rating Laws (SC with 7% band) 5. Open Competition (No-File) Laws The Griffith Insurance Education Foundation Slide by Kevin Eastman, Georgia Southern University 18

19 The Actuary  What are actuaries?  Evaluate the financial consequences of future events  “Actuaries put a price tag on risk.” American Academy of Actuary  Functions in Insurance  Direct ratemaking operations  Loss development factors and trends  Set loss reserves (case inadequacies and IBNR) The Griffith Insurance Education Foundation19

20 ESTIMATING RATES Pure Premium Method GROSS RATE Pure Premium Loading Paid Losses Loss Reserves Expenses Profit Contingencies ESTIMATION PROBLEMS 1. Errors in Loss Reserves 2. Inflation 3. Credibility of Data SOLUTIONS 1. Loss Development 2. Trending 3. Credibility Factors + The Griffith Insurance Education Foundation20

21 THE RATEMAKING PROCESS Steps in the Ratemaking Process STEPDESCRIPTION Step 1Collect Statistics Step 2Adjust Statistics Step 3Calculate the Statewide Average Rate Step 4Calculate the Territorial & Class Relativities / Rates Step 5Prepare & Submit the Rate Filing Step 6Follow-Up to Obtain Necessary Regulatory Action Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation 21

22 Underwriting The Griffith Insurance Education Foundation22

23 UNDERWRITING Definition & Objective DEFINITION The process of determining what loss exposures will be insured, for what amount of insurance, at what price, and under what conditions. OBJECTIVE To develop & maintain a profitable book of business by avoiding adverse selection. The Griffith Insurance Education Foundation Slide by Kevin Eastman, Georgia Southern University 23

24 The Adverse Selection Problem  Definition: The tendency of higher-than- average risks to seek insurance.  Illustration: 2 risk types in population  Low risk: 1 in 10,000 die each year  High risk: 1 in 100 die each year  Insurer knows 50% of the population low versus high risk but can’t tell which is which  Is it feasible to create an insurance pool with both types in it? The Griffith Insurance Education Foundation Slide by Vickie Bajtelsmit, Colorado State University 24

25 The Adverse Selection Problem (cont.)  Example life insurance pool: 2,000 people, $200,000 face value each  Expected loss per low risk (1/10,000)= $20  Expected loss per high risk (1/100)= $2,000  Expected loss for the pool = $2,020,000  Per policy to break even= $2,020,000/2,000 = $1,010  Will this insurance pool be feasible?  Will the low risk people want to buy it?  Will the high risk people want to buy it?  What if the pool gets more high risks than low risks?  How could another insurer enter the market and attract away all the low risks? The Griffith Insurance Education Foundation Slide by Vickie Bajtelsmit, Colorado State University 25

26 Key Points about Adverse Selection  Risk pooling doesn’t work if the risk is too high  e.g. life insurance for fatally ill people; homeowners in disaster-prone regions  Risk pooling doesn’t work with too many high risks  Low risks aren’t willing to excessively subsidize the high risks  incentive to be uninsured  Insurers need to be able to identify risk type so that they can put similar risks together in a pool to make it fair and affordable  Insurers who don’t use available information to classify PHs will experience adverse selection  Competition will drive premiums to the appropriate level for risk type The Griffith Insurance Education Foundation Slide by Vickie Bajtelsmit, Colorado State University 26

27 Tools to mitigate adverse selection  CLUE  Insurance (FICO) score  Property inspection  Medical information bureau (MIB)  MVR The Griffith Insurance Education Foundation27

28 The “Moral Hazard” Problem  Definition: Dishonesty or character defects that increase the frequency or severity of loss because insureds can profit from a loss  Examples:  Faking accidents, disability  Exaggeration of claims  Failure to control losses (not locking car or house) – moral hazard  Intentional losses  Overutilization of insurance (e.g. health) The Griffith Insurance Education Foundation Slide by Vickie Bajtelsmit, Colorado State University 28

29 Controls on Moral Hazard  Can’t insure in excess of the loss  Limits on underinsuring property  Careful claims adjusting  Deductibles and coinsurance  Waiting periods  Exclusions  Limits  Riders The Griffith Insurance Education Foundation Slide by Vickie Bajtelsmit, Colorado State University 29

30 Availability and/or Affordability  One of the primary disputes in insurance  Insurance supply is low (and/or)  Insurance cost is high  Conflict arises especially in hard to price markets such as high hazard areas, new exposures, unknown outcomes, catastrophes  Department of Insurance must ensure insurer solvency to protect the consumer The Griffith Insurance Education Foundation30

31 Insurance Regulation The Griffith Insurance Education Foundation31

32 REASONS FOR INSURANCE REGULATION Three Primary Reasons TO PROTECT CONSUMERS TO MAINTAIN INSURER SOLVENCY TO PREVENT DESTRUCTIVE COMPETITION Policy Forms Fraud Availability Set coverage standards, specify policy language, disapprove unacceptable policies. Protect against misrepresentations by agents & unfair practices or dishonesty of insurers. Restrictions on cancellation and non-renewal of coverage. Reasons for Solvency Regulation Insurance provides future protection, and insolvent insurers cannot fulfill their obligations. Large numbers of people are adversely affected when insurers become insolvent. Substantial funds held by insurers for the benefit of policyholders must be safeguarded. Rate Competition Under-pricing leads to insurer insolvencies and shortages of insurance (as insurers withdraw from the market or stop writing new business). The Griffith Insurance Education Foundation Slide by Kevin Eastman, Georgia Southern University 32

33 INSURANCE REGULATORY ACTIVITIES Major Activities of Insurance Regulation REGULATORY ACTIVITIES Forming & Licensing Insurers Licensing Insurance Personnel Monitoring Insurer Solvency Regulating Insurance Rates Regulating Insurance Policies Monitoring Market Conduct Ensuring Consumer Protection The Griffith Insurance Education Foundation Slide by Kevin Eastman, Georgia Southern University 33

34 Principal Balance Sheet Elements Assets Bonds Stocks Cash Premium balances Reinsurance recovery Liabilities Losses Loss Adj Expenses Unearned Premiums PH Surplus Policyholder Surplus = Assets - Liabilities The Griffith Insurance Education Foundation Premiums-to-surplus (capacity) ratio must not exceed 300% or a 3-to-1 ratio of net premiums written to surplus. 34

35 FUNCTIONS OF REINSURANCE BENEFITS FOR INSUREDS & INSURERS Benefits for Insureds Benefits for Insurers All coverage can be obtained from one insurer, reducing the chance of coverage gaps & problems in loss collection. Reduces the chance of primary insurer insolvency.*** Allows small insurers to compete with large insurers, which should increase availability & reduce price.*** Stabilizes loss experience. Increases large line capacity. Provides surplus relief. *** Protects against catastrophic losses.*** Provides underwriting assistance. Allows withdrawal from a territory or class of business. The Griffith Insurance Education Foundation 35

36 INSURANCE REGULATORY ACTIVITIES Monitoring Insurer Solvency Monitoring Insurer Solvency Methods to Ensure SolvencyLiquidation of Insolvent Insurers To reduce the risk of insolvency and to protect the public against loss when insurers fail. Establish financial requirements (e.g., minimum capital & surplus reqs). RBC Require annual financial statements in a prescribed format & review. Off-site monitoring: Administer FAST and IRIS. Insolvent insurers are placed into receivership by state ins. department Rehabilitation, if possible. Conduct on-site field examinations (every 3-5 years). If impossible to rehabilitate, the co. is liquidated according to the state’s insurance code. Reasons for Insolvency Rapid premium growth. Inadequate rates & reserves. Lax controls over MGAs. Excessive expenses. Uncollectible reinsurance. Fraud. Control significant, broad-based, risk- related activities. The Griffith Insurance Education Foundation Slide by Kevin Eastman, Georgia Southern University 36

37 Primary avenues for HO insurance in South Carolina  Standard insurers  SC Wind and Hail Association (market of last resort)  National Flood Insurance Program  Surplus lines, cover all perils as above. Normally a higher premium. The Griffith Insurance Education Foundation37

38 2011 Direct Premiums Written, SC The Griffith Insurance Education Foundation Source : SNL Financial, Inc.; SC Wind and Hail Assoc 38

39 SC Homeowner MP Insurers The Griffith Insurance Education Foundation Source : SNL Financial, Inc. 39

40 Simple Combined Ratios, HO MP,SC (Includes only Losses + Loss Adjustment Expenses Ratio + Underwriting Expenses Ratio + Policyholder Dividend Ratio )* The Griffith Insurance Education Foundation RANKMkt Shr200920102011 124.65State Farm65.2179.0592.12 211.63Allstate70.0385.93124.53 37.16Nationwide70.7478.54116.63 46.76Travelers78.42100.16141.53 56.47USAA Insurance37.0241.7269.64 65.72SC Farm Bureau71.6886.49107.31 74.19Liberty Mutual63.2183.17116.40 83.54Farmers Insurance62.4462.0979.01 93.06AIG42.7135.9539.15 102.80Munich-American62.2870.2688.94 112.76Auto-Owners82.9197.19146.61 Total78.74State Average64.2676.1597.08 *Source : SNL Financial, Inc. See explanatory note on next slide 40

41 Direct Simple Combined Ratios The Griffith Insurance Education Foundation41 Explanatory note for the previous slide, #40: The purpose of slide #40 is simply to illustrate the volatility of losses and some of the challenges when estimating insurance rates. It does not contain sufficient information to evaluate the overall performance of an insurer or a rating structure. The combined ratio is the commonly used measure of underwriting performance. It’s breakeven point is 100. If a combined ratio is 105.2 then for every $1 an insurer is earning or writing in premiums, they are paying out approximately $1.05 in losses, expenses and PH dividends (though many insurers don’t pay PH dividends.) Some costs and expenses of a firm at the national level are not reported in the state level data. For example, the state level direct simple combined ratio does not include some adjusting and other expenses in the loss ratio and the expense ratio does not include general expenses and other acquisition and fields supervision expenses. As a result, the state level ratios will systematically understate the Loss Adjustment Expenses and Expense ratios.

42 Net Yield on Invested Assets, % The Griffith Insurance Education Foundation Source : SNL Financial, Inc. 42

43 Premium Components A Review The Griffith Insurance Education Foundation  Pure premium  Expected loss  Loading  Expenses  Contingencies  Profit 43

44 Factors that affect ratemaking  Loss estimation  Credibility of data, loss mitigation, exposure in high risk areas, increased costs  Delays in data collection and use  Regulatory lag, institutional lag  Change in the cost of claims  Global warming  Medical advancements (long term care)  Medical inflation (WC, liability claims)  Legal changes, hurricane loss mitigation The Griffith Insurance Education Foundation44

45 Factors that affect ratemaking  Insurer’s projected expenses  Legal changes, wage/employee cost, reinsurance, non-cancellation regulations  Target level of profit and contingencies  Investment income, business conditions, unexpected disasters The Griffith Insurance Education Foundation45

46 Questions? The Griffith Insurance Education Foundation46


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