The Business of Insurance,
Reinsurance, Regulation of
Insurance, Risk Management and
Public Policy
Dr. John F. Fitzgerald, Jr
CLU, 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%
Investments
Bonds
Common Stock
Other
P/C
70
18
12
L/H
75
5
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
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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 manmade
• 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
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Entry into new classes/ territories
Exit from classes/ territories
Underwriting expertise
Protect insurer against punitive or “bad
faith” damages
In/Reinsurance Distribution
Broker
Market
Insured
Primary
Insurer
Reinsurer
Direct
Market
Retrocession
Reinsurance Sources
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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
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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($)
$1M
Limits of
insurance
Primary
Insurer
Retention
0% or ($)
Reinsurance
Cession
100% or ($)
Percentage of
premiums &
losses shared
Comparing: QS & SS
Quota Share
A fixed percentage amount is
retained by the insurer and
ceded to the reinsurer
Surplus Share
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
Limits of
insurance
$1M
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
Remember- reinsurance “attachment” may apply
on one of many bases
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.
$1,000,000
Policy Limit
Reinsurer
pays
(indemnifies)
$750,000 of
the
settlement “in
excess of”
$250,000
Retained by
the insurer
Example: Clash Coverage
Dr. 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
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
Retention
$500,000 Retained by Insurer
Total Recovery
$2,500,000
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
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Maximum policy limit
Extra-contractual obligations
Loss adjustment expenses
Clash cover
Catastrophe exposure
Many More Reinsurance Issues
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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?
Financial
Analysis of
Primary
Insurers
Facultative
Certificate
& Treaty
Wording
Primary
Insurance
Pricing
Reinsurance
Underwriter
Loss
Exposure
& Primary
Coverages
Loss
Reserving
by Primary
Insurers
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
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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
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Financial solidity
Fair equitable treatment
Competitive market
National leader
Enforcement
Regulatory cooperation
Regulatory Philosophy II
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Improve and sustain
Encourage freedom
Self regulation
Loss prevention
Inform public
Timely response to change
Evaluate strategy
Regulatory Philosophy III
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Vision and mission
Recognize and monitor change
Innovation
Arbitration
Strengthen regional economy
P/C Insurer Impairments
Year
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
Insolvencies
Year
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
Rapid Growth
9%
2003-2005
Alleged Fraud
11%
Catastrophe
Losses
9%
Affiliate
Problems
8%
Deficient Loss
Reserves/InAdequate
Pricing
63%
Relevant Issues in Regulation
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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
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Fire protection
Zoning laws
Building codes
Public safety
Highway safety
Motor vehicle standards
Licensing (occupation)
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Workplace safety
Product safety
Sanitation
Pollution
Hazardous materials
Employment conditions
Education
Criminal law