Trieschmann, Hoyt & Sommer
Risk Management and the Insurance Industry
Chapter 22
©2005, Thomson/South-Western
Chapter Objectives
• Indicate the size of the insurance industry
• Describe how the insurance business is divided between
the private and public sectors
• Explain why personal insurance has a larger premium
volume than property insurance
• Identify and explain the differences between stock
companies, mutual companies, Lloyd’s associations, and
reciprocal insurers
• Indicate which types of insurance have the largest volume
• Explain how insurance guaranty funds operate
• Describe how insurance is distributed from insurers to
consumers and list the differences between types of
agents and brokers in insurance
• Described the global nature of risk management and the
insurance industry
2
The Field of Insurance
• Insurance coverages can be divided into various
opposing categories
– Personal (life and health) vs property (buildings,
homes, autos)
– Government (flood insurance) vs private (product
liability)
– Involuntary (Social Security) vs voluntary (fire
insurance)
• The categories are not mutually exclusive and
they overlap
• Figure 22-1 depicts the major classifications of
insurance and what they have in common with
each other
3
Figure 22-1: Major Classifications
of Insurance
4
Personal Coverages
• Those related directly to the individual
• The risk they cover is the possibility that
some peril may interrupt the individual’s
income, such as
– Death, accidents and sickness,
unemployment, and old age
– Insurance is written on each
• Private insurers are active in providing insurance
for death, accidents and sickness, and old age
• Governmental units are active in all categories
5
Property Coverages
• Directed against perils that may destroy property
• Property insurance is distinguished from
personal insurance
– Personal insurance covers perils that may prevent
one from earning money with which to acquire
property in the future
– Whereas property insurance covers property that is
already acquired
• Property insurance as used here includes fire, marine,
liability, casualty, and surety insurance
• Sometimes referred to as general insurance,
property/liability insurance, or property and
casualty insurance
6
Private and Public Insurance
• Private insurance consists of all types of
coverage written by privately organized
groups
– Consists of associations of individuals,
stockholders, policyholders, or some
combination of these
• Public insurance includes all types of
coverage written by government bodies or
operated by private agencies under
government supervision
7
Voluntary and Involuntary
Coverages
• Most private insurance comes under the
rubric of voluntary coverage
• A major part of government insurance is
involuntary coverage
– It is required by law that insurance be
purchased by certain groups and under
certain conditions
• Examples of required insurance include
automobile liability insurance and workers’
compensation insurance
8
Voluntary and Involuntary
coverages
• Table 22-1 shows the importance of
private passenger auto insurance
• Table 22 -2 shows that PPA made up 33.1
percent of total premiums in 1980 although
there has been a relative decline since
2000
– Due to the dramatic increases in commercial
lines insurance premiums during the hard
insurance market
9
Table 22 -1: Net Premium Written by Line of
Property Liability Insurance–2002
10
Table 22 -2: Private Passenger Auto as
a Percentage of Total P-L Premium
11
Stock Companies
• A corporation organized as a profit-making venture in the
field of insurance
• For companies organized in the United States
– A minimum amount of capital and surplus is prescribed by state
law to serve as a fund for the payment of losses and for the
protection of policyholders’ funds paid in advance as premiums
• Organized with authority to conduct certain types of
insurance business
• Some pay dividends to policyholders on certain types of
insurance
• Never issue what is called an assessible policy
– The insured can not assess an additional premium if the
company’s loss experience is excessive
• The stockholders are expected to bear any losses
– And they also reap any profits from the enterprise
12
Mutual Companies
• Organized under the insurance code of each state as a
nonprofit corporation owned by the policyholders
• Has no stockholders
• No profits are made
– Because any excess income is returned to the policyholder-owners
as dividends
• Or is used to reduce premiums, or retained to finance future growth
• The company is managed by a board of directors elected by
policyholders
• Many types of mutual organizations exist and operate under
different laws and with different types of businesses
13
Class Mutuals
• Operate in only a particular class of insurance
– Such as farm and property, lumber mills, factories, or
hardware risks
• Farm mutuals
– Specialize in farm property insurance
– Insure a large portion of farm property in some states,
primarily because of the specialized nature of the risks
• Factory mutuals
– Specialize in insuring factories
– Place emphasis on loss control
– Generally do not solicit small risks due to the relatively
high cost of inspection, engineering services, surveys,
and consultations that are provided by the organization
in an attempt to prevent losses before they occur
14
General Writing Mutuals
• One that accepts many types of insureds
• Require an advanced premium calculated on roughly the
same basis as that of a stock insurer
• Operate in several states or even internationally
• May or may not pay a refund of the portion of the
premium of the dividend if experience warrants it
• Many mutuals insist on relatively high underwriting
standards
– Taking only the best risks so that a dividend will more likely be
paid
• Some mutuals are both participating and deviating
– They plan to cut the initial rate somewhat below stock company
levels and to pay dividend if warranted
15
Fraternal Carriers
• Designed as a nonprofit corporation, society, or voluntary
association, without capital stock, organized and carried
on solely for the benefit of its members and their
beneficiaries
• Have a lodge system with a ritualistic form of operation
and a representative form of government that provides
for the payment of benefits in accordance with definite
provisions in the law
• As charitable, benevolent associations, they usually are
exempt from taxation
• Some of the largest mutual insurers have converted to
stock firms including
– Metropolitan, Prudential, and John Hancock
16
Reciprocals
• Sometimes called an interinsurance exchange
• Like a mutual in that both are formed for the purpose of
making the insurance contract available to policyholders
at cost
• Basic differences exist between the legal control and
capital requirements of reciprocals and mutuals
– In a reciprocal, the owner-policyholders appoint an individual or
a corporation known as an attorney-in-fact to operate that
company, as opposed to the board of directors
– A mutual is incorporated with a stated amount of capital and
surplus
• Whereas a reciprocal is unincorporated with no capital as such
• Operate mainly in the field of automobile insurance
17
Lloyd’s Associations
• An organization of individuals joined together to
underwrite risks on a cooperative basis
• Each member assumes risks personally and does not
bind the organization for these obligations
• Each investor is individually liable for losses on the risks
assumed to the fullest extent of personal assets
– Unless the liability is intentionally limited
• Similar to reciprocals in that each underwriter is an
insurer
– However, a reciprocal is composed of individuals who are both
insurers and insureds at the same time
• Whereas a Lloyd’s association is a proprietary organization
operated for profit
18
London Lloyd’s
• Lloyd’s started in 1688 in London as an informal
group of merchants taking marine risks
• Their operations are now worldwide
– Operate extensively in the United States largely in the
surplus line market
• Consist of risks that domestic insurers have rejected for one
reason or another
• In 2004 nearly 66 underwriting syndicates
existed
– Groups of names that combine their resources and
employee manager
• Who determines which risks to insure
19
Relative Importance of Private
Insurers
• Thousands of insurance companies
operate in the United States
• However, most of that business is done by
relatively few insurers
• The leading states for property-liability
insurers are Vermont, Texas, New York,
and Pennsylvania
– For life insurers the leading states are
Arizona, Texas, and New York
20
Relative Importance of Private
Insurers
• Stock companies tend to dominate as underwriters of
various lines of property-liability insurance
• Mutuals enjoy their greatest markets in the fields of
personal automobile and workers’ compensation
insurance
• Lloyd’s and reciprocals account for only a small share of
the total property-liability insurance market
• In the field of life and health insurance, there are more
than twelve times the number of stock companies than
mutuals
• In property-liability insurance, mutual companies have
grown more rapidly than stock insurers
– Mutuals have tended to specialize in types of insurance for
which the markets have been growing most rapidly
– Mutuals have used cost-cutting methods that generally have
made the product available at lower rates
21
Insolvency of Insurers
• Insurance institutions are not backed by a
federal agency in the same way bank deposits
are protected
• The danger of loss from insolvent propertyliability insurers has been recognized by the
establishment in all states of guaranty funds
– These funds must reimburse the policyholders for any
losses caused by bankrupt insurers
• Subject to stated deductibles and maximum loss limits that
vary from state to state
• The funds are supported by assessments against other
insurers operating in the same state
22
Insolvency of Insurers
• Various reasons exist for property-liability
insolvencies including
– Inadequate pricing
• Usually discovered when loss reserves are
insufficient to pay claims
– Rapid growth
– Fraud
– Overstatement of the value of certain assets
23
Employment in Insurance
• The insurance industry employed
approximately 2,222,000 persons in 2002
• Most of the jobs are salaried positions
• Fewer than 1/3 are in marketing or
distribution
– This contradicts the frequently-held opinion
that most jobs in insurance are in sales
24
Ownership of Insurance
• Data from the Insurance Information Institute
reveals that the property-liability insurance
industry has been able to reach most U.S.
citizens who own homes or autos
• Roughly 95 percent of homeowners indicated
that they had purchased property or liability
insurance on their homes and possessions
• Some type of life insurance is owned by
approximately 75 percent of Americans
25
Direct Distribution in Life Insurance
• Life insurance is distributed in two main ways
– Salaried group insurance representatives
– Individual insurance agents who usually work on
commission
• Life insurance is also sold by direct contact with
the consumers in advertising, mail order, or the
internet
– The insurer maintains a one-on-one relationship with
the insured
• Independent intermediaries usually are not involved
26
Group Insurance
• Life insurers offer many of their products
on a group basis
– Under contracts covering groups of persons
rather than individuals
• Customers from group coverage are
generally business firms
• Persons employed to sell and service
businesses usually receive a salary and
bonus
27
Individual Agents
• Policies sold to individuals are usually
handled by persons known as agents,
underwriters, or financial planners
• The agent or underwriter contacts the
ultimate consumer and reports directly to
the insurer or intermediary who in turn
reports to the insurer
• The authority of the underwriter or agent is
limited
28
Individual Agents
• A general agent in life insurance is an individual
employed to hire, train, and supervise agents at
lower levels
– Sometimes collects premiums and remits them to the
insurer’s home office
– Not an independent intermediary in the sense that a
typical wholesaler is
• General agent does not exercise final control over the
issuance terms of the contract
– The company normally is not bound by the general agent in
putting a contract in force
• The general agent exercises no control over the amount of
premium, has no investment in inventory, does not own any
business written, and has no legal right to exercise any
control over policyholders once he or she leaves the
employment of the company
29
Reasons for Direct Distribution in
Life Insurance
• The system of direct distribution has
grown up in life insurance because of
several basic factors
– The insurer’s need to maintain close control
over the policy product
– The insurer’s need to exercise control over
sales promotion and competition
– The infrequent purchase of life insurance
– The agent’s ability to make a better living
through specialization
30
The Changing Environment in the
Life Insurance Company
• From the 1950s to 1987 individual life insurance new
premiums maintained respectable growth greater than,
or equal to, the rate of inflation
– Real growth in new premiums was occurring
• Beginning in 1987 that pattern ceased
– In 1988 new premiums actually declined
• Changes in U.S. demographics have contributed to the
shifting of business volume away from individual life
insurance
– As the overall population aged, people became more interested
in financial products that were accumulation centered
• Rather than protection and accumulation
• These changes have meant that life insurers increasingly find
themselves competing with banks and mutual fund companies for
consumers’ investment dollars
31
Direct Writing in Property-Liability
Insurance
• In some lines, independent intermediaries
have been eliminated
– Contract is marketed directly from the insurer
to the insured through either exclusive agents
or employees who work on salary and
commission
• They solicit prospects, take care of paperwork, and
serve as the insurer’s direct contact with the
insured
32
Direct Writing in Property-Liability
Insurance
• An exclusive agent of a direct writer represents
only one insurer
– Does not own business written and generally does
not handle loss claims or collect premiums
– Receives a commission but it is a lower percentage
than the commissions allowed independent agents
– The main tasks of the exclusive agent are to
• Sell new business
• Keep in contact with customers
• Served as a communications link between the insurer and
the insured
33
Direct Writing in Property-Liability
Insurance
• Direct writers have their greatest volume in the
field of automobile insurance
• They have been able to sell insurance at lower
cost to the final consumer
• Innovations have occurred in automobile
insurance including
– Continuous policies, lower agents’ commissions,
direct billing from the insurer to the customer and
specialized adjusting offices to handle claims
34
Indirect Distribution (American
Agency System)
• The insurance is not sold directly by the insured
to the policyholder but rather is sold through a
system of intermediaries
– Comparable to the wholesaler-retailer system in
tangible goods marketing
• The independent agent is an autonomous, local
intermediary in the property insurance business
– As the “retailer,” the independent agent deals with the
final consumer of insurance
– The independent agent usually represents 10 to 30 or
more separate insurers and has authority to bind
these insurers on most of the contracts written
35
Brokers vs Agents
• Brokers operate in a manner similar to local
agents
– Legally brokers represent the consumer, not the
insurer
• If the customer asks a broker to obtain
insurance, the broker must contact with the
insurer before coverage is binding
• Agents may bind coverage immediately
– Because they are the legal representatives of the
insurer
– Many brokers also hold agency contracts
36
Is the American Agency System
Doomed?
• Those insurers and their agents committed to the
traditional long channel of distribution have become
concerned over the future of their business
– Since direct writers have been growing in market share until
recently
• Table 22-3 shows that while direct writers have taken a
significant portion of the personal lines market
– Insurers using independent agents have maintained their
dominance in commercial insurance lines
• Although the volume of business undertaken by local
independent agents is usually relatively small this is not
the case for national brokers
– Table 22-4 shows the name and size of the five largest brokers
37
Table 22-3: Market Share (%) by
Distribution System
38
Table 22-4: Five Largest Brokers in
the World, 2002
39
Outlook for the Agency System and
Direct Writing
• Direct writing has grown fastest in lines for which there is
a mass market for a standardized product that requires
little continuous service
– These conditions do not exist in all areas of insurance,
particularly in the commercial market
• Thus, it is extremely doubtful that direct writers will capture that
market
• It seems unlikely that the independent agency system
will be replaced by direct writing unless the property
insurance business becomes much more concentrated
than it is now
• While direct writers continue to gain market share in the
property-liability field, the life insurance industry is going
in the opposite direction
40
Direct Response
• Some insurance is sold without agents or other
intermediaries through the direct response
technique
– Customers are found through advertising on
television, radio, newspapers, magazines, direct mail,
etc.
– This is the area where the internet appears to have
the greatest potential
– No sales agents are employed
– The policies tend to be fairly standardized and more
specialized and less costly
• Examples include accident insurance, hospital indemnity,
term life, automobile, homeowners, and short-term disability
income contracts
41
Mass Merchandising
• A method of distributing property-liability insurance
directly to consumers through employer payroll
deduction
• Premiums are usually cheaper because of various
economies in mass merchandising
• Employers do not normally contribute to the premium on
behalf of employees
• They have not become extremely popular
– Independent agents have generally opposed the adoption of
such plans
• Because many agents depend on individually issued personal-lines
business for their livelihood
– The element of adverse selection exists
• Which has often produced poor underwriting experiences
42
Globalization of Risk Management
and the Insurance Industry
• A globalization of business has occurred due to
– Advances in technology and improvement in
transportation
– Reduced trade barriers in many countries
• Firms and organizations that do business
internationally face differences in their loss
exposure and in the risk-handling methods they
use
• Globalization and differences in future growth
potential have led many insurers to reevaluate
the focus of their business and to consider
expansion overseas
43
Global Risk Management
• Almost all organizations have some employees
who travel overseas
• These activities can give rise to unique
exposures that are not faced if the firm operates
exclusively within its own home country
– Exporting goods and services overseas
– Manufacturing or importing products from overseas
– Hiring part-time or permanent employees overseas
44
Global Risk Exposure
• Some kinds of risk exposure faced by international firms
are the same as those faced by firms that do business
only in their home country
– For example, fire, natural disasters, or damage to goods in
transit
• Many of these exposures can be altered in both
frequency and severity by differences in various parts of
the world
– Most of the deaths from natural disasters are in developing
countries
• While most of the property damage resulting from natural disasters
occurs in industrial nations
– Fire loss potential is much greater in countries with poor
infrastructure and lower-quality building standards
45
Global Risk Exposure
• Global firms also face unique kinds of loss exposure that
arise as a result of conducting business in multiple
countries, including
– Terrorism, kidnapping, political instability, uncertain legal
environment, currency risk, import/export restrictions, technology
and communications, financial markets’ weaknesses, and
substandard infrastructure
• The inability to assess risk accurately due to an absence
of information in some underdeveloped countries can be
one of the biggest challenges that a risk manager of a
global firm faces
– Additionally, the lack of a well-developed insurance industry can
lead to an absence of high quality risk management services
such as
• Claims handling, loss assessment, loss control
46
Global Risk Exposure
• The rate of insurance in business and the use of insurance
by individuals can differ dramatically around the globe
• Tax treatment of insurance differs from country to country
• Local laws in some countries require the purchase of certain
types of insurance
– And it either requires that insurance be purchased from a locally
admitted insurer or disallows tax-favored treatment if the insurance is
purchased from a nonadmitted insurer
• The attitude toward risk management can also differ
• Customary limits of coverage can vary significantly
• Some religious beliefs discourage arrangements involving
the payment of interest and often limit the purchase of
insurance
• Significant reliance upon government social insurance
programs reduces the demand for private life and health
insurance and annuity products in a number of countries
47
Global Insurance Programs
• A global firm can rely primarily on nonadmitted
insurance on a worldwide basis
– Buy insurance in their home country and arrange for
coverage wherever they do business
• Easy to administer and leaves the decision-making in the home
country
• Disadvantages include
– It may be illegal in some countries
– Favored tax treatment of insurance premiums and loss payments
may be lost
– The insured does not have a local insurer to provide claims and
other services overseas
48
Global Insurance Programs
• A global firm can leave the insurance program
design and the purchase of insurance to the
firm’s management in each of the countries in
which it does business
– Has the advantage of meeting any local laws
regarding admitted insurance and compulsory
coverage requirements
• Can preserve favorable tax treatment for premium and loss
payments
– Has the disadvantage in that the approach tends to
lead to a very inefficient program structure if the firm
does business in a number of countries
• Also, coverage limits and terms often differ significantly
across countries and can lead to to important gaps in
protection
49
Global Insurance Programs
• A global firm can use a global controlled master
program
– A global insurer works through its own subsidiaries or
partner insurers in each of the countries in which the
insured corporation does business to provide unified
coverage
– Will involve locally admitted subsidiaries or partners
which assures that the program meets the laws and
requirements related to compulsory and admitted
insurance
• These subsidiaries or partners provide local expertise in
managing claims and assessing risk
50
Globalization of the Insurance
Business
• Table 22-5 provides market share data for the six largest
insurance markets in the world
• Perhaps the biggest driver of the increasing international
focus of the insurance business is
– The globalization of the firms that buy insurance and purchase
risk management services from insurers
• Multinational firms are becoming increasingly
sophisticated regarding risk management practices
– They demand the ability to combine and integrate their risk
management programs on a global basis
– They increasingly demand high quality risk management
services wherever they do business
• Such as claims management and loss control
51
Table 22-5: Percentage Share of
World Insurance Market, 2002
52
Globalization of the Insurance
Business
• An additional important factor in the
expansion of U.S. and European insurers
overseas
– The recognition that insurance markets in
industrial countries do not offer the same
opportunities for growth in the next ten years
– The emerging economies in eastern Europe
and the Pacific Rim offer double-digit growth
potential in insurance demand
53