Basic Principles of Risk Management and Insurance

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Basic Principles of Risk
Management & Insurance
A Seminar for South Carolina State Legislators
January 17, 2013
Faith R. Neale, Ph.D.
Associate Professor of Risk Management and Insurance
Department of Finance
Belk College of Business, UNC Charlotte
The Griffith Insurance Education Foundation
1
Seminar Overview
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
Overview of Insurance Market
Industry Overview
Ratemaking
Underwriting
Insurance Regulation
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2
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

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Asset protection and financial security

Risk
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3
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
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4
Characteristics of insurance

Risk transfer

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The insurer promises to pay under certain conditions
Pooling of losses

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Substitutes average loss of pool for actual loss
Law of Large Numbers
Payment of fortuitous losses

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Sudden and accidental, unforeseen and unexpected
Indemnification

Restore to original financial position
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5
Categories of Insurance

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Personal and Commercial lines
Property/Casualty and Life/Health
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6
Overview of Insurance Market
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2011 P&C U.S. NPW by Line
The Griffith Insurance Education Foundation
Source: SNL Financial,8Inc.
2011 Life/A&H U.S. NPW by Line
The Griffith Insurance Education Foundation
Source: SNL Financial,9Inc.
2011 U.S. Net Premiums Written
$175B
$502B
P&C
Life
A&H
$576B
The Griffith Insurance Education Foundation
10Inc.
Source: SNL Financial,
Industry Overview
The Griffith Insurance Education Foundation
11
INDUSTRY CHARACTERISTICS
Types of Private Insurers
Form of
Ownership
Proprietary
Place of
Incorporation
Cooperative
Admitted
FOREIGN
Stock Cos
Mutual Cos
ALIEN
Lloyds
Licensing
Status
NonAdmitted
Surplus
Lines
Reciprocals
DOMESTIC
Pools
Syndicate
Reinsurance
The Griffith Insurance
Education Foundation
12
Slide by Kevin Eastman, Georgia Southern University
Surplus Lines

Distressed (risk or market)
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Unique or Unusual
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Shamu, Hole-in-One coverage
High Capacity

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Risk – Physician with drug use
Market – Compounding pharmacies
Corporate jet, high rise
Product Innovation

Cyber Liability, EPL
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13
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
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14
SC Wind and Hail
Underwriting Association(JUA)



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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.
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15
Characteristics of an (ideally)
insurable risk
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

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Large number of exposure units
Accidental and unintentional loss
Determinable and measurable
No catastrophic loss
Calculable chance of loss
Economically feasible premium
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16
Ratemaking
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RATEMAKING OBJECTIVES
INSURER
OBJECTIVES
REGULATORY
OBJECTIVES
Primary Objectives
Adequate
Low enough to be competitive.
High enough to be profitable.
Not Excessive
Not Unfairly
Discriminatory
Secondary Objectives
TYPES OF RATING LAWS
Stability
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
Responsiveness
Promote Loss Control
Contingencies
Simplicity
Slide by Kevin Eastman, Georgia Southern University
The Griffith Insurance Education Foundation
18
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)
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ESTIMATING RATES
Pure Premium Method
ESTIMATION PROBLEMS
Pure
Premium
GROSS
RATE
Paid Losses
Loss Reserves
1. Errors in Loss Reserves
2. Inflation
3. Credibility of Data
SOLUTIONS
1. Loss
Development
2. Trending
3. Credibility Factors
+
Expenses
Loading
Profit
Contingencies
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20
THE RATEMAKING PROCESS
Steps in the Ratemaking Process
STEP
DESCRIPTION
Step 1
Collect Statistics
Step 2
Adjust Statistics
Step 3
Calculate the Statewide Average Rate
Step 4
Calculate the Territorial & Class Relativities / Rates
Step 5
Prepare & Submit the Rate Filing
Step 6
Follow-Up to Obtain Necessary Regulatory Action
Slide by Kevin Eastman, Georgia Southern University
The
The Griffith
Griffith Insurance
Insurance Education
Education Foundation
Foundation
21
Underwriting
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22
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.
Slide by Kevin Eastman, Georgia Southern University
The Griffith Insurance Education Foundation
23
The Adverse Selection Problem


Definition: The tendency of higher-thanaverage risks to seek insurance.
Illustration: 2 risk types in population


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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?
Slide by Vickie Bajtelsmit, Colorado State University
The Griffith Insurance Education Foundation
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The Adverse Selection Problem (cont.)

Example life insurance pool: 2,000 people,
$200,000 face value each

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Will this insurance pool be feasible?
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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 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?
Slide by Vickie Bajtelsmit, Colorado State University
The Griffith Insurance Education Foundation
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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
Slide by Vickie Bajtelsmit, Colorado State University
The Griffith Insurance Education Foundation
26
Tools to mitigate adverse
selection





CLUE
Insurance (FICO) score
Property inspection
Medical information bureau (MIB)
MVR
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27
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)
Slide by Vickie Bajtelsmit, Colorado State University
The Griffith Insurance Education Foundation
28
Controls on Moral Hazard
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Can’t insure in excess of the loss
Limits on underinsuring property
Careful claims adjusting
Deductibles and coinsurance
Waiting periods
Exclusions
Limits
Riders
Slide by Vickie Bajtelsmit, Colorado State University
The Griffith Insurance Education Foundation
29
Availability and/or Affordability

One of the primary disputes in insurance



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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
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30
Insurance Regulation
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REASONS FOR INSURANCE REGULATION
Three Primary Reasons
TO PROTECT CONSUMERS
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.
TO MAINTAIN INSURER SOLVENCY
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.
TO PREVENT DESTRUCTIVE COMPETITION
Rate
Competition
Under-pricing leads to insurer insolvencies and shortages of insurance (as insurers
withdraw from the market or stop writing new business).
Slide by Kevin Eastman, Georgia Southern University
The Griffith Insurance Education Foundation
32
INSURANCE REGULATORY ACTIVITIES
Major Activities of Insurance Regulation
Forming & Licensing Insurers
Licensing Insurance Personnel
Monitoring Insurer Solvency
REGULATORY
ACTIVITIES
Regulating Insurance Rates
Regulating Insurance Policies
Monitoring Market Conduct
Ensuring Consumer Protection
Slide by Kevin Eastman, Georgia Southern University
The Griffith Insurance Education Foundation
33
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
Premiums-to-surplus (capacity) ratio must not exceed 300% or a
3-to-1 ratio of net premiums written to surplus.
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34
FUNCTIONS OF REINSURANCE
BENEFITS FOR INSUREDS & INSURERS
Benefits for
Insureds
All coverage can be obtained from one insurer,
reducing the chance of coverage gaps & problems in
loss collection.
Benefits for
Insurers
Stabilizes loss experience.
Increases large line capacity.
Provides surplus relief. ***
Reduces the chance of primary insurer insolvency.***
Protects against catastrophic losses.***
Allows small insurers to compete with large insurers,
which should increase availability & reduce price.***
Provides underwriting assistance.
Allows withdrawal from a territory or class of business.
The Griffith Insurance Education Foundation
35
INSURANCE REGULATORY ACTIVITIES
Monitoring Insurer Solvency
Monitoring Insurer Solvency
To reduce the risk of insolvency and to protect the
public against loss when insurers fail.
Reasons for Insolvency
Rapid premium growth.
Inadequate rates & reserves.
Methods to Ensure Solvency
Require annual financial statements
in a prescribed format & review.
Excessive expenses.
Off-site monitoring: Administer FAST
and IRIS.
Lax controls over MGAs.
Conduct on-site field examinations
(every 3-5 years).
Uncollectible reinsurance.
Fraud.
Establish financial requirements (e.g.,
minimum capital & surplus reqs).
RBC
Liquidation of Insolvent Insurers
Insolvent insurers are placed into
receivership by state ins.
department
Rehabilitation, if possible.
If impossible to rehabilitate, the co.
is liquidated according to the
state’s insurance code.
Control significant, broad-based, riskrelated activities.
Slide by Kevin Eastman, Georgia Southern University
The Griffith Insurance Education Foundation
36
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 Foundation
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2011 Direct Premiums Written, SC
$97M
$46M
Standard Insurers
$1.3B
Wind & Hail Pool
Excess & Surplus
This does not include flood premiums.
The Wind and Hail Association
includes commercial property.
Source: SNL Financial, Inc.; SC Wind and Hail Assoc
The Griffith Insurance Education Foundation
38
SC Homeowner MP Insurers
160
147
140
120
100
116
109
117
124
128
135
138
107
80
60
40
20
0
Source: SNL Financial, Inc.
The Griffith Insurance Education Foundation
39
Simple Combined Ratios, HO MP,SC
(Includes only Losses + Loss Adjustment Expenses Ratio + Underwriting
Expenses Ratio + Policyholder Dividend Ratio )*
RANK Mkt Shr
1 24.65
2 11.63
3
7.16
4
6.76
5
6.47
6
5.72
7
4.19
8
3.54
9
3.06
10
2.80
State Farm
Allstate
Nationwide
Travelers
USAA Insurance
SC Farm Bureau
Liberty Mutual
Farmers Insurance
AIG
Munich-American
2009
65.21
70.03
70.74
78.42
37.02
71.68
63.21
62.44
42.71
62.28
2010
79.05
85.93
78.54
100.16
41.72
86.49
83.17
62.09
35.95
70.26
2011
92.12
124.53
116.63
141.53
69.64
107.31
116.40
79.01
39.15
88.94
11
2.76
Auto-Owners
82.91
97.19
146.61
Total
78.74
State Average
64.26
76.15
97.08
*Source: SNL Financial, Inc. See explanatory note on next slide
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Direct Simple Combined Ratios
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.
The Griffith Insurance Education Foundation
41
Net Yield on Invested Assets, %
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Source: SNL Financial, Inc.
The Griffith Insurance Education Foundation
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Premium Components
A Review

Pure premium


Expected loss
Loading



Expenses
Contingencies
Profit
The Griffith Insurance Education Foundation
43
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 Foundation
44
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 Foundation
45
Questions?
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46
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