The Tools & Techniques of Insurance Planning and Risk Management, 3rd Edition

Index

GENERAL PRINCIPLES OF RISK AND INSURANCE

CHAPTER 1

INTRODUCTION

What is insurance? The insurance transaction is a purchase of a contract (called the insurance policy) that on behalf of the purchaser pledges the payment of a sum-certain amount (the premium) in exchange for a promise on behalf of the other party (the insurance company, or insurer) to provide restitution or indemnity arising from the occurrence of a loss. That is, the insurance transaction guards against the financial or economic repercussions arising from that occurrence.

Insurance is not wagering. When you gamble, you take a chance of losing money, but you also may break even or come out ahead. With insurance, on the other hand, there are only two possible outcomes: a loss or no loss. When you insure a home, it will either burn down or it won’t burn down. If you have insurance on it and there is a fire, the insurance will put you back in the same position you were in prior to the fire.

Some say that in purchasing insurance on a piece of real property (such as a home or business premises) or against some liability-producing event (such as physicians’ or attorneys’ malpractice), the purchaser is buying peace of mind with the knowledge that the economic hardship of a loss will be transferred to another party – the insurance company selling the coverage.

One classic definition of insurance is a device for reducing risk by combining a sufficient number of exposure units to make their individual losses collectively predictable.¹ In other words, the losses of the few are shared among the premiums of the many.

This is an illustration of the law of large numbers which is the primary underpinning to the insurance mechanism. This is the principle that allows insurance to operate. The rule says that the more exposure units in the mix, the easier it becomes to predict the group’s losses. Flip a coin three times and it might turn up heads each time. Flip a coin one million times and it will likely be more evenly split between heads and tails. Take thousands and thousands and thousands of similarly situated units (like home owners, for instance) and you will be able to predict the losses that will occur in the group – and create a pool of financial resources (paid premiums) that allows for payment of the individual members of the group’s losses – and allows the insurer to turn a profit on the transaction.

The law of large numbers mechanism highlights the risk-transfer aspect of insurance. Another aspect of the definition of insurance says that insurance is a risk management technique – a means of budgeting a relatively small, known amount up-front cost (the premium) in place of a large – and possibly catastrophic – unknown future event (a possible loss). Therefore, an adequate definition must include the transfer of risk to a third party (the insurer), the accumulation of a fund to pay the losses, and a large enough number of similar exposure units (the insureds).

Another element to introduce into the insurance mix is the idea of fortuitousness. Non-fortuitous loss (those losses that are certain to occur) may not be insured. It is the concept of fortuitous acts that are insurable – a loss may or may not occur, so it may be insured; if the loss is certain to happen, it generally may not be the subject of an insurance policy.

In sum, insurance companies promise to indemnify the customer for accidental losses caused by certain perils. In exchange, the customer promises to pay the premium. On an aggregate level, insurers receive premiums from many people who buy insurance and pool them. They invest those premiums to earn more money, to pay its employees, to pay losses, and to earn a profit.

USEFUL DEFINITIONS

The following definitions are terms that are commonly used in every type of insurance policy. Their meanings in the insurance context may be similar to, but slightly different from how one might use them in everyday language.

A policy is the document that describes the types of coverage offered to the person who purchased the insurance (who are in turn referred to as insureds or policyholders). The description of the coverage is often dense and technical, and includes definitions of the coverage provided as well as declarations by the policyholder about who and what will be covered in the event of a loss.

Indemnify is an important part of the insurance definition. It means, to make whole again. In other words, insurance puts the person back in the same position he or she was in prior to the loss – no better, no worse.

Example. Will’s 2012 Lexus (worth about $22,550) is damaged in an accident. The body shop estimates that it will cost $24,000 to fix it. If the insurer spends the $24,000 to repair the car, the insured will be better off after the loss than prior to it. When the insurer pays Will the $22,550 he is indemnified for his loss – he is paid an amount equal to what he lost. It’s a fair general statement that an item of property cannot be insured for more than it’s worth.

A premium is the amount of money that a policyholder pays the insurance company to provide a certain amount of coverage. Premiums are sometime paid all at once for coverage over a set period of time, or can be paid periodically to ensure ongoing coverage as described in the policy.

Peril, Hazard, and Risk: Not the Same Thing

Before proceeding, the terms peril, hazard, and risk should be defined. Although these three terms are often used synonymously by practitioners in the field, they do have differing technical meanings.

•    Risk may refer to uncertainty as to the outcome of an event when two or more possibilities exist, i.e., a building may stand or it may burn down. In property insurance, risk may also mean the physical units of property insured or the physical units of property at risk. For example, some might say, the only risk the underwriter wants to take is fire on pig iron under water, or that fireproof concrete block building is a good fire risk.

•    A peril, in property & casualty insurance terms, is a cause of a possible loss. For example, fire is a peril in property insurance, as is water damage, mold, earth movement, etc. A peril may be covered (coverage for the event is included under the policy) or excluded (coverage for the event is specifically excluded under the policy).

•    A hazard is a specific situation that increases the probability of the occurrence of loss arising from a peril or that may influence the extent of the loss. For example, fire, flood, and explosion are property perils – and liability itself is a peril under liability policies. Slippery floors, congested aisles, and oily rags in the open are hazards.

Non-Insurance Responses to Risk

People buy insurance to help them manage the risks in their lives. However, insurance is only one way to handle those risks. Some other methods of risk management are:

Retention – occurs when one does not purchase insurance and decides to assume the risk on his or her own. If a loss does not happen, the person saves the money that he or she would have spent on premiums.

A good example of retention is the decision not to purchase collision insurance on an older car. Retention requires that the insured do a careful analysis of what he or she can afford to lose. Some corporations use large retentions as a financial risk management strategy. For example, insurance coverage does not kick in until a loss has exceeded $25,000 or more. The insured saves on premium but has coverage for disastrous losses.

Avoidance – involves either not doing something at all or getting rid of it or not doing it any more. By relying on public transportation, one avoids the physical damage and liability risks of car ownership. By selling off a casino, a company is avoiding future losses from legislative changes that could negatively affect the casino.

Control – is the minimizing of hazards, the things that increase the chance of loss. By putting a burglar alarm in the car, the owner is using the technique of control.

Non-insurance transfer – is the transfer of risk to someone other than an insurer.

Example. When renting tools, the customer signs a form promising to bring them back in the same condition. If he or she does not, the storeowner will charge the customer for those tools. The storeowner has used a non-insurance transfer to protect his property.

VOLUNTARY INSURANCE

In today’s market, there are two broad types of insurers – social and voluntary. Voluntary insurers are insurers that offer types of insurance that are not mandatory, and cover a wide variety of risks. These are what most people think of as insurance companies, and they offer the most common types of commercially available insurance:

•    Property insurance protects policy holders against damage to their property from loss events such as fires, natural disasters, and accidents.

•    Liability insurance protects policy holders against liability that may be imposed on them through the legal system, such as liability arising from their driving conduct or actions they take as employers.

•    Health, disability, and long-term care insurance protect policyholders against the financial consequences of ill health. This can include payment of medical bills, rehabilitation services, and replacement of income lost due to illness.

•    Life insurance provides financial benefits to loved ones (or entities such as employers or charities) after the policyholders death. Due to the long time horizons involved in life insurance, policies have also grown to include investment-like vehicles including annuities.

These types of insurance can be purchased separately or together. For instance, a typical homeowners insurance policy (see Chapter 12) includes significant coverage against both property and liability risks. The art of insurance planning involves helping clients choose (1) which insurance products to buy, and (2) how to purchase them.

Types of voluntary Insurers

The voluntary market provides an endless variety of coverages that are designed to meet almost any need. The four types of voluntary insurers are governmental, cooperative, self, and for-profit.

1.    Governmental insurers offer voluntary coverage on risks that the private market may find too hazardous to insure. Such offerings include flood insurance, earthquake insurance, crime and fire insurance in the inner city, windstorm insurance in coastal states, crop insurance, and private passenger auto insurance for persons with very poor driving records. As examples, the National Flood Insurance Program offers flood insurance, California Earthquake Authority offers earthquake insurance, and the Texas Windstorm Insurance Association provides windstorm insurance to Gulf Coast property owners in Texas.

2.    Cooperative insurers are also referred to as fraternalinsurers. That is because they offer coverage only to their own members – such as a lodge, union, or religious organization. Fraternals are organized as not-for-profit companies. Examples of fraternal insurers include Thrivent Financial for Lutherans, Modern Woodmen of America, and Knights of Columbus.

3.    Self-insurance is different from no insurance. Self-insurers are companies that set up funds into which they make periodic payments. The self-insurance fund then pays losses for which the company is responsible. An advantage of self-insurance is that the company may incur lower costs than if it had purchased commercial insurance. Insurance companies are organized to earn a profit. The premiums that they collect go to pay for clients’ losses and the company’s expenses, such as salaries, office space, and supplies, as well as profit. The self-insurance payments do not include the charges for profit found in the premium from a commercial insurer. Companies that self-insure include Chevron, Costco Wholesale, Ford Motor, General Motors, International Paper, Tyson Foods, Wal-Mart Stores, and Walt Disney Company.²

In addition to lower costs, another advantage to self-insurance is that the company retains more control over its finances and operations.

In a true insurance program, the risk is transferred to a third party – the insurance company. In a typical self-insurance situation there is no real transfer of risk, but the risk is funded through the self-insurance program. For that reason, the preferred term is retention, as the organization retains its exposure to loss and pays losses out of that fund into which it has been making contributions.

4.    For-profit insurers are what most people think of as insurance companies. They are corporations (often publically traded and/or multinational) that offer various types of insurance with the goal of making a profit. Many for-profit insurers offer various types of financial services along with their traditional insurance products.

SOCIAL INSURANCE

Social insurers are government agencies that provide social insurance – protection against loss from unemployment, injuries, sickness, old age, and premature death. The three major types of social insurance are:

1.    Old Age, Survivors, and Disability (commonly known as Social Security);

2.    Workers compensation; and

3.    Unemployment compensation.

What distinguishes social insurance from voluntary insurance is that participation is mandatory. The premiums paid are required by law and may be collected via payroll deductions referred to as FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act). Employees and employers both pay into the Social Security fund. Some employers are required to purchase both workers compensation insurance and unemployment compensation insurance. Employees are not assessed for workers compensation coverage but they may pay an unemployment tax (FUTA).

Planning Note: Clients who have household employees such as housekeepers, maids, or babysitters may be required to withhold a specified amount for voluntary insurance.³

UNDERSTANDING THE NATURE OF RISK

While organizations face a multitude of complex risks, historically only event risk was deemed worthy of attention. Event risk is also known as insurable risk. Traditionally, insurers literally defined risk based on its insurability; if it can be insured, it’s either a good risk or a bad risk. If it cannot be insured, it’s a business risk, and thus considered just another cost of doing business.

Insurable risk is also known as fortuitous risk. Fortuitous risk connotes solely the risk of loss; it does not contemplate the notion that (conceptually) risk cuts both ways. For example, an investment in stocks represents both the risk of loss and the risk of gain, also known as speculative risk. While we generally do not associate the term risk with the possibility of a favorable outcome, that definition is just as valid as the fortuitous risk definition because each outcome represents deviation from the norm.

Regardless of the type, risk is just another way of defining volatility. The words risk and volatility are essentially synonymous. The presence of risk denotes uncertainty, and uncertainty denotes volatility. Volatility is expressed as deviation from the expected. For example, if losses are forecast to be 10 percent, the volatility associated with the loss forecast can be expressed as a range between 8 and 12 percent. We use the term risk to define the degree of volatility as well as recognize the fact that volatility exists. Consider event risk in this context. If first-dollar (no significant deductible) insurance is used to transfer a particular event risk—for example, the risk of fire destroying a building—the volatility associated with the peril of fire has been removed. Assuming the insurance coverage and limits are appropriate, the insured has incurred a cost (the premium) for reducing the financial consequence of the risk of fire to effectively zero.

Next, consider the volatility associated with the risk that the building could burn to the ground in the absence of insurance. Of course, the volatility of the event does not change regardless of who ends up paying for the loss, but, in this case, it’s the building owner who must understand the volatility and manage it.

Historically, insurance has been the only viable alternative for managing fortuitous risk. The primary goal of the insurance mechanism is to restore the insured to its pre-loss condition. However, since insurance can be a costly method of managing volatility, other, potentially more effective techniques, have emerged over the years. The remainder of this chapter will discuss risk management as it applies to fortuitous risk. Other chapters in this book will address more advanced risk management concepts that consider all aspects of risk.

A Brief History of Risk Management

Risk management has been recognized as a viable technique for mitigating the effects of fortuitous loss to corporations and public entities since the early 1960s. Prior to that time, risk was not considered to be worthy of management per se; it was generally handled by the purchase of insurance. The employee responsible for buying the insurance also had another primary function, for example, the treasurer, chief financial officer, safety manager or, in some cases, corporate counsel.

In the 1960s and 1970s reliance on insurance companies as sole providers of risk services began to wane. Visionary academicians such as Robert Hedges⁴ and George Head⁵ developed new ways of managing the myriad of risks faced by corporations and public entities. It was recognized that while insurance was an effective means of moving fortuitous risk off the balance sheet, there was no systematic approach to evaluating risk. The centerpiece of this research became known as the Risk Management Process.

THE RISK MANAGEMENT PROCESS

Managing risk does not mean that every conceivable loss has been analyzed and factored out; to the contrary, risk management is primarily focused on the firm’s ability to recognize and correct faulty and potentially dangerous operations, trends, and policies that could lead to a catastrophic loss.

Risk management is, by definition, a pre-loss exercise that reflects an organization’s post-loss goals (see Chapter 9, Claims Management Techniques). In the same way, financial planners review the potential risks (a pre-loss exercise) that could impact a client with the implied goal of minimizing the financial disruption of those risks to the client (post-loss goal) The risk management process does not occur in a vacuum; the degree to which risk is mitigated must be defined by the goals of the organization and the client.

The conventional risk management process is comprised of five distinct steps or activities.

1.    Identify actual and potential risks facing the organization or client.

2.    Quantify and analyze actual and potential risks relative to their impact on the organization or client.

3.    Evaluate potential treatment options, including specific risk control measures and risk financing techniques.

4.    Implement recommendations.

5.    Monitor the effectiveness of the chosen recommendations and make adjustments as necessary.

This chapter provides an overview of each step. Detailed discussions appear in later chapters.

Risk Identification

That which cannot be identified cannot be managed. Risk identification is the critical first step in determining exactly what constitutes a risk commensurate with the post-loss goals of the organization or client. In general, risks emanate from two major sources: assets and operations. These categories roughly define what are known as first party risks and third party risks. The expression first party connotes risks associated with owned assets, while the term third party indicates liability arising from operations.

Risks that must be financed or transferred (insured) in accordance with state law are generally considered baseline risks and should be the first to be identified. These include injury to employees (workers compensation) and statutory requirements to fund the legal liability for or derived from operating motor vehicles (third-party risks).

Financial planners should be aware of the minimal requirements for coverage for their clients. For instance in Illinois, the minimum requirements for personal auto insurance are 20/40/15 ($20,000 in bodily injury coverage for each individual/$50,000 total bodily injury coverage/$15,000 property damage coverage) whereas in Pennsylvania, the minimum requirements for personal auto insurance are 15/30/5. Chapter 11 covers more details on the meaning of these requirements.

Additional third-party risks include liability arising from operations, products, contractual obligations, and/or ownership of real property. As a general rule of thumb, third-party risks represent the greatest threat of financial loss to any organization. Automobile ownership represents both first- and third-party risks. Damage to the vehicle constitutes a first-party risk, while property damage or injury to persons (other than the driver) caused by operating the vehicle are third-party risks.

Quantitative Analysis

Risk quantification is accomplished through a variety of tools and methods. But, at its core, risk quantification means predicting the maximum and expected financial loss associated with each identified risk. For example, life insurance can be purchased to protect a surviving spouse in the event of premature death. The amount of life insurance can be based on the Human Life Approach, a Capital Needs Approach, or a Capital Preservation Approach. See Chapter 15 for further clarification.

While physical assets allow relatively easy risk quantification, risks such as public liability and worker safety are considerably more difficult to quantify. When measuring third-party risks, organizations often ask two questions: How much potential loss can we withstand as a result of this exposure?, and "How much potential loss can we withstand and still remain financially viable?" The answers to these questions will be dramatically different. Yet they help to form the parameters of the risk management process.

Evaluating Risk Treatment Options (Financing & Control)

Having identified and quantified a variety of loss exposures deemed important enough to warrant action, the risk manager or financial planner must identify the options available to treat the exposures. Treating identified loss exposures is accomplished through two means: risk financing and risk control.

Financing

The spectrum of risk financing options is extremely broad. However, each financing technique falls into one of two major categories: on-balance sheet (retention) and off-balance sheet (risk transfer).

Risks that remain on-balance sheet are known as retained risks. Those considered off-balance sheet have been transferred to an unrelated third-party, usually for financial consideration. Examples of on-balance sheet risks include insurance policy deductibles and self-insured loss exposures. Off-balance sheet transactions include insurance policies and contractual transfers of risk, among others.

The concept of self-insured differs significantly from that of uninsured. Self-insurance connotes managing the loss exposure, such as establishing a fund from which to pay losses (also known as active loss retention)—for a client this may simply consist of emergency reserves and investment assets. Uninsured simply means that nothing has been done to recognize the exposure from a financial standpoint. Neglecting coverage for uninsured motorist and underinsured motorist is an example. The term passive retention is also used in this context.

The primary example of off-balance sheet financing is insurance.

Control

Controlling risk means controlling the volatility inherent in organizational or individual life. For example, owning a boat represents a risk to its owners and operators. A boat without proper upkeep increases the potential for operator injury (increases volatility). Regular boat maintenance lowers the probability that the operator will become injured. Notice that the risk itself (owning and operating a boat) is not controlled; the likelihood that the risk will result in a loss is controlled (its volatility).

Transferring risks off-balance sheet does not constitute adequate risk control. This is because the transfer is not free. If the volatility of the transferred risk is not controlled, future transfer and/or financing costs will increase, along with the possibility that affordable (and available) financing and transfer options may become nonexistent. Using the boat ownership example, the boatowner operating the vehicle may be insured through a boatowner’s insurance policy (off-balance sheet). But, if the volatility associated with the boat is not controlled and people are repeatedly injured while using the boat for recreation, the boatowner insurance premiums will increase proportionately.

Risk control is the most important risk management activity. Without effective risk control, financing and transfer techniques become virtually meaningless or prohibitively expensive.

Risk control is comprised of two main activities—risk prevention and risk reduction. Risk prevention is only feasible if the person, thing, service, product, or operation capable of causing a loss is effectively removed or neutralized. In the above example, ownership of a boat can be avoided. So prevention is a reasonable risk control option. Risk reduction is most often associated with the notion of risk control. With a few precautions—such as regular boat maintenance and operator training—the risk of operator injury can be reduced.

Risk Administration—Monitoring and Adjusting

The final step in the risk management process is program oversight. Nothing remains static, especially the risks encountered by successful organizations. They must be monitored and adjusted continuously. (See Practice Standard 600 of the Financial Planning Practice Standards).

Continuous monitoring requires a structured approach that includes regular program reviews performed in conjunction with a reliable information. This step also should include planning for future contingencies such as market changes or changes with the client such as marriage, divorce, birth of a child, death of a loved one, etc.

Importance of Risk Management to the Organization

Risk management is an integral part of a successful organization’s overall management strategy as well as an integral part of a client’s wellbeing. In order to survive (and thrive) in today’s competitive economic environment, simply transferring every known risk via insurance is not a viable option. Risk management has proven that the excessive use of insurance can be an extremely expensive and inefficient use of capital. Since capital is the lifeblood of any organization as is cash flow to a client, it must be managed effectively. Risk management’s most fundamental contribution has been to provide senior management with an array of techniques designed to manage risk, and, by doing so, manage capital as well. While insurance plays a critical part, it is by no means the lone or lead actor. In fact, in the most sophisticated risk management programs, insurance plays a relatively minor role.

Large and complex organizations usually employ risk managers, and clients usually employ insurance agents and financial planners. The primary duty of a risk manager is to design and execute a management regimen in accordance with the pre-loss and post-loss goals of the organization and the process summarized in this chapter. Since risk management is a reflection of an organization’s culture, it must be considered in every important decision. The risk manager must have complete and unconditional support from senior management. Because risk permeates every facet of the organization, only senior management has the authority to enforce the requirements set forth in a comprehensive risk management program.

A risk management program can be costly to develop and implement. Senior management will lend its support only if the benefits are perceived to outweigh the costs. Likewise, clients will consider a long term care program that involves insurance only if the benefits outweigh the premium costs. The costs associated with risk management must be considered investments, because in most cases the benefits are only realized after an extended period of time. It is true that the initial costs may appear excessive given the minimal (if any) short-term return on investment. Senior management therefore must be willing to focus on long-term results.

It is extremely difficult to measure tangible benefits against a nonevent (i.e., the catastrophic loss did not occur due to our highly effective risk management program). Yet this is the challenge facing all risk managers and financial planners. Clients may subjectively base their decision to purchase insurance on how they feel an event is likely to happen to them.

TRADITIONAL RISK MANAGEMENT VS. ENTERPRISE RISK MANAGEMENT

In this chapter we have broadly defined risk management in its traditional and historical context—that is, relative to specific events, either first-party (loss or damage to owned assets) or third-party (loss or damage to third parties and/or their property for which the organization is held liable). Traditional risk management has historically been closely related to the insurance industry. The risk manager position evolved from the insurance buyer since insurance was such an important component of risk management. However, organizational life is not static, and neither is the risk management function.

Large, complex organizations employ two separate and distinct forms of risk management—event (insurance) risk management as discussed thus far, and financial risk management. Financial risk management, as the name implies, is designed to protect the financial assets of an organization from risks that the insurance industry cannot assume. These risks include interest rate movements, commodity price fluctuations, credit risk, and foreign currency exchange (FX) risk. The processes used to manage these risks are similar to those discussed in this book, but the risk management techniques employ financial hedges created in the capital markets. Some of these hedging techniques also are used to address traditional event risk. This process is known as securitization. Conversely, the insurance industry is beginning to create insurance-based products that replicate the effects of a financial hedge for certain noncore financial risks. This is known as insuratization. These phenomena have become jointly known as convergence—the convergence of the insurance and capital markets.

The evolving convergence movement has spawned a new generation of risk management that attempts to combine event and financial risk into an entirely new discipline—Enterprise Risk Management (ERM). In addition to event and financial risk, ERM addresses so-called business risk. Business risk includes that which cannot easily be quantified, financed, or transferred. Examples include operational risks and strategic risks.

CHAPTER ENDNOTES

1.     Mehr, Robert Irwin; Principles of Insurance (Richard D. Irwin, Inc., Homewood, Ill. 1973), p.3.

2.     See the National Council of Self-Insurers (www.natcouncil.com/org.html) for more information about self-insurance.

3.     See IRS Publication 926, Household Employer’s Tax Guide.

4.     See Mehr, Robert Irwin and Hedges, Robert Atkinson; Risk Management In The Business Enterprise, (Literary Licensing, LLC 2012).

5.     See Head, George L. Essentials of Risk Management, Third Edition (Ins. Inst. Of America, 1997).

INSURERS AND THEIR MARKETS

CHAPTER 2

INTRODUCTION

Insurance is one of the principal means by which a risk manager transfers the financial uncertainty of losses resulting from such risks as damage to property, employee dishonesty, or risk of liability arising out of the insured’s operations. As noted in Chapter 1, the term risk management has historically been closely related to the purchase and management of insurance, which transfers insurable risk to the insurance company for financial consideration—the premium.

Increasingly, the term risk management has been used to describe techniques for dealing with a variety of commercial and financial risks that are in addition to insurable risks. Despite this, insurance remains a key component of the risk management program of many businesses.

Insurance is a risk-transfer mechanism. Property and casualty insurance companies can be grouped into four types:

1.    stock insurance companies

2.    mutual insurance companies

3.    reciprocal exchanges

4.    Lloyd’s associations

A fifth type of mechanism is a risk retention group (RRG). RRGs are not insurance companies but, rather, associations that have the primary goal of assuming and spreading the liability risks of its group members.

Stock and Mutual Companies

Stock and mutual companies are the most prevalent type of traditional insurance mechanism.

Stock insurance companies are owned by the stockholders and are organized as for-profit corporations. The capital for the stock insurance company comes from the stockholders, and any profits or losses from their operation are enjoyed by or borne by the stockholders.

Mutual insurance companies are owned by their policyholders. The objective of the mutual insurance company is to reduce policyholders’ premiums. Profits in excess of the premiums charged are returned to the policyholders in the form of lower rates or as a dividend. In reality, a dividend is a return of premiums that are in excess of the amounts needed to cover losses and operating costs. In addition, policyholders of a mutual company participate in electing the board of directors.

Mutual insurance companies cannot sell shares of stock to the capital markets, as stock companies can. Therefore, it is more difficult for mutual companies to raise capital than for stock insurers. There are two basic methods available to overcome this disadvantage: merger and demutualization. Merger is the consolidation of two or more companies into a single company.

Demutualization is the conversion of a mutual insurance operation to a stock insurance structure, a technique that has been used primarily by life insurance companies. Demutualization begins with a plan that is subject to state insurance department review as to its fairness to mutual company policyholders. A significant part of the demutualization process deals with valuing and fairly distributing the company’s equity among its policyholders. Demutualization statutes generally permit state insurance regulators to determine the appropriate method.

Reciprocal Exchanges

In concept, reciprocal exchanges, which also are described as inter-insurance exchanges, are unincorporated arrangements in which one policyholder agrees to participate in insuring all other policyholders. In exchange, the other policyholders insure that policyholder. In practice, a reciprocal exchange (often called a reciprocal) is usually managed by an attorney-in-fact who is authorized by the policyholders to collect premiums in advance, to transact reciprocal agreements with new customers, and to otherwise manage the operations of the reciprocal.

Lloyd’s Associations

Lloyd’s associations are yet another approach to providing insurance. Lloyd’s of London, which is the most famous Lloyd’s association, provided ocean marine insurance in the late seventeenth century. Lloyd’s of London is not an insurance company. It provides facilities, sometimes called the underwriting room, where insurance can be transacted with its members. Lloyd’s brokers transact insurance by approaching syndicates and asking them to underwrite a percentage of particular risks. The Lloyd’s broker continues around the underwriting room collecting underwriting commitments until 100 percent of the risk is placed.

REGULATION

Insurance companies are regulated on a state-by-state basis. Each state has an insurance department, which is headed by an insurance commissioner. The primary responsibility of insurance commissioners is to provide consumer protection by regulating and monitoring the solvency of insurance companies. State insurance departments also regulate the coverage wording and structure of insurance policies that are admitted to do business in their jurisdictions, as well as monitoring the conduct of the companies doing business there.

State insurance commissioners joined together more than one hundred years ago to form the National Association of Insurance Commissioners (NAIC). Commissioners of the District of Columbia and four U.S. territories also are members of the NAIC, which coordinates the regulation of multistate insurers and facilitates the development of uniform practices and policies when appropriate. See Financial Strength below for Information about some of the methods used by these regulators to monitor insurance company financial strength and solvency.

CHOOSING AN INSURANCE ARRANGEMENT

Several factors should be considered when judging the quality of an insurer. Among these are its:

•    organizational structure;

•    status as an admitted or nonadmitted company (if a traditional insurance company is chosen);

•    financial strength;

•    size;

•    claims-paying philosophy; and

•    risk management support services.

Organizational Structure

As noted in the introduction to this chapter, there are four basic organizational structures: stock company, mutual company, reciprocal exchange, and Lloyd’s associations. Reciprocal exchanges and Lloyd’s associations write a substantial amount of business in certain classes of business and geographical areas. Often, the differences in an insurer’s organizational structure are not as important as other factors, such as its licensure in a particular jurisdiction or financial strength. However, there are some differences. For example, many stock insurance companies offer dividends on certain types of policies (typically life insurance) if the loss exposure to a particular group of policies is more favorable than originally anticipated. These dividends can be refunded to the policyholder or used to reduce the cost of the insurance coverage. However, mutual companies tend not to offer dividends, instead choosing to offer reduced premiums for future policies.

Admitted and Nonadmitted Insurers

Insurance companies are either admitted or nonadmitted on a state-by-state basis.

Admitted companies are licensed to conduct business within a given state and are subject to state regulation and guaranty funds. Nonadmitted companies are not licensed in particular states or territories and are not directly regulated by the states in which they are not admitted.

Companies are further classified as:

•    domestic insurance companies, which are domiciled and licensed in a state.

•    foreign companies, which are domiciled in a state other than where the coverage is being written. If the foreign companies are licensed in a state in which they are not domiciled, they are called admitted foreign companies; if not, they are simply nonadmitted companies.

•    alien insurance companies, which are domiciled in another country. If licensed in a state, they are called admitted alien insurance companies in that state; if not, they are nonadmitted alien insurance companies.

Example. If Rock Solid Insurance Company (RSIC) is domiciled in Georgia (i.e., it was chartered in Georgia), it is a Georgia domestic company. If RSIC is also licensed in Florida, it is an admitted foreign insurer in Florida. If it is not licensed in Alabama, it is a nonadmitted insurer in Alabama.

Assume RSIC has a foreign subsidiary, Slippery Rock Limited, which is domiciled in Denmark and licensed in only one state, Georgia. In Georgia, Slippery Rock is an admitted alien insurer; in Alabama it is a nonadmitted alien insurer.

It is usually easy to locate information and ratings about admitted foreign, admitted alien, and domestic insurance companies from state insurance departments or one of the insurance company rating services. It is more difficult to locate information about nonadmitted alien insurers.

One method of gathering information is to contact the NAIC. Its International Insurers Department (IID)¹ tracks non-U.S. insurers that want to do business in the United States surplus or excess lines market. Alien insurers may apply to the IID for placement on its quarterly list. In some states, appearance on the IID list is the only way by which an alien insurer may become eligible to write surplus or excess lines business; in others it is just one method by which such insurers can gain eligibility.

Other states use the listing as a major element of their qualifying criteria. Maintaining an IID listing requires a continuation of minimum capital and surplus, establishment of a trust fund in favor of U.S. policyholders, and annual financial filings. The fact that an insurer is on the IID list does not guarantee that it is solvent. However, it does mean that it has deposits in the United States to protect its policyholders.

State Guaranty Associations

One of the primary disadvantages of using nonadmitted companies is that in most cases they do not participate in state guaranty associations.

State guaranty associations provide mechanisms to pay for covered claims filed against insolvent insurers in an effort to avoid catastrophic financial losses by the policyholders of those insolvent insurers. Property and casualty insurance companies that are covered by guaranty associations must belong to the guaranty association of a particular state as a condition of their authority to transact business in that state. Guaranty associations assess member insurers based upon their proportion of premiums written on covered lines of business in that state compared with total premiums written in the state.

Representatives for Admitted and Nonadmitted Insurers

Agents and brokers, often referred to as retail agents or brokers because they arrange coverage between individuals or businesses and insurance companies, represent admitted carriers.

Nonadmitted companies usually are represented by surplus lines brokers, which must be licensed to offer nonadmitted coverage. Surplus lines brokers may be referred to as wholesalers because they usually broker coverage between retail agents or brokers and nonadmitted carriers. Most states levy surplus-lines taxes on the premiums written by nonadmitted carriers. These carriers are not subject to the state guaranty funds. Therefore, in the event of insolvency, businesses that are insured by nonadmitted carriers are not able to tap the guaranty fund for protection. Additional information on surplus lines laws is available from the individual state insurance departments or the National Association of Professional Surplus Lines Officers, Ltd.²

Financial Strength

It is critical to carefully evaluate the financial strength of insurers being considered for coverage. A number of companies publish financial strength ratings. Each of these companies has its own rating scale and publishes detailed reports in areas such as management, the use of reinsurance, the states in which they are licensed to transact insurance, and the nature of the insurers’ operations.

Note that unless a financial planner has adequate training to analyze a company’s financial strength, reliance on these rating agencies or reports by a financial analyst as evidence of financial strength will be necessary. Principle 3 of the CFP Board’s Code of Ethics & Professional Responsibility requires the planner to recognize the limitations of their knowledge.

There are other methods to gauge financial strength—some are subjective and others, objective. Risk managers may read trade publications and build networks of information to spot changes in insurance company operations. For example, if an insurer suddenly decided to become a large-scale reinsurer of California earthquake coverage, past ratings of that company would tend to lose their meaning.

The financial strength of carriers is one of the most critical elements in choosing an insurance company. It is prudent to consult the financial evaluations published by more than just one rating agency before placing business with a carrier. Additional information on insurance company financial strength is available in each company’s respective annual statements and should be readily available on the company’s website.

Despite the fact that insurance carrier financial strength is monitored by multiple rating organizations, some insurance company failures have not been anticipated. When insurance companies become insolvent, the claims that are the subject of their coverage policies are not paid.

See Chapter 6 and Appendix A for a more detailed discussion of how to evaluate the financial strength of an insurer, including sources of information that can help an advisor or client make an informed decision.

Size and Reserving Practices

While bigger isn’t always better, larger insurance companies typically have broader risk pools and are less likely to be vulnerable to events that unexpectedly cause large losses that have the potential to put their ability to play claims at risk. The NAIC’s Research & Actuarial Department maintains several lists of the top twenty-five insurers in the certain segments of the insurance market.³

Establishing realistic reserves for unpaid claims is not a simple task, but it is critical to a company’s financial adequacy because they represent the amount of money that would be needed to pay all claims against the insurer. Reserves include both future estimated payments for claims that already have been filed and future estimated payments for claims that have occurred but have not yet been reported. When claim reserves are understated, the company’s surplus will be overstated. Conversely, overstated reserves diminish surplus. IRIS uses two ratios to test for the accuracy of loss reserves. They use both a one-year reserve development to policyholders’ surplus ratio and a two-year reserve development to policyholders’ surplus.

Claims-paying Philosophy and Risk Management Support Services

Some insurance companies are well known for their philosophy of erring in favor of their insureds in situations in which coverage is not clear-cut. Other insurers have a reputation for contesting claim payments whenever possible. An insurance company’s claims-paying philosophy can only be measured subjectively.

While there are no standardized rating systems for data sets for evaluating these types of subjective qualities, advisors should be aware of insurance customer satisfaction surveys that are available from J.D. Power & Associates, Consumer Reports, and the Better Business Bureau. However, risk managers may seek complaint history from State Department of Insurance websites.

INSURER INSOLVENCIES AND STATE GUARANTY FUNDS

Individual states have passed legislation creating guaranty funds to protect the policyholders of insolvent companies. These guaranty associations, which also are referred to as guaranty funds, provide mechanisms to pay for covered claims filed against insolvent insurers in an effort to protect their policyholders from catastrophic financial loss. All states and territories other than New York have created post-assessment guaranty associations, which assess solvent insurers for funds to pay claims after an insolvency of another insurer has occurred. The New York Security Fund and certain funds that cover only workers compensation policyholders are considered preassessment guaranty funds, which means that assessments are made prior to a specific insolvency occurring.

For instance, the maximum amount of protection provided by Florida Life & Health Insurance Guaranty Association for any one person is:

•    Life Insurance Death Benefit: $300,000 per insured life.

•    Life Insurance Cash Surrender: $100,000 per insured life.

•    Health Insurance Claims: $300,000 per insured life.

•    Annuity Cash Surrender: $250,000 for deferred annuity contracts per contract owner.

•    Annuity in Benefit: $300,000 per contract owner.⁴

Property and casualty insurance companies that are subject to guaranty association regulations must belong to the guaranty association of a particular state as a condition of their authority to transact business in that state. Guaranty associations assess member insurers based upon their proportionate share of premiums written on covered lines of business in the applicable state. The National Conference of Insurance Guaranty Funds (NCIGF) provides information on state guaranty funds at its Web site.⁵ According to the NCIGF, New Jersey is the only state that has a surplus lines guaranty association, so businesses placing insurance with nonadmitted surplus lines carriers in states other than New Jersey are not eligible for guaranty fund payments.

Ignoring the difficult problem of evaluating an insurance company’s financial strength and attempting to rely merely on the state guaranty association could be a serious mistake. As noted in the appendix, the scope of state guaranty fund coverage is limited. Even if policyholders of an insolvent insurer do fall within the scope of a state guaranty fund, a protracted delay in collecting claim payments from a fund is a problem for any policyholder. For a large corporation the often relatively small amount of coverage and the frequent presence of net worth provisions reduce the relevancy of such funds to the entity. A guaranty fund is only a stopgap to prevent catastrophic financial losses for policyholders; a fund does not diminish the need for due diligence in studying the financial strength of individual insurance companies.

REINSURANCE

Reinsurance is a concept under which one insurer transfers part or all of certain risks that it has agreed to insure to one or more other insurers. Reinsurance is used by insurance companies for many reasons, including:

•    stabilizing loss ratios and underwriting results;

•    protecting against overwhelming financial impact from catastrophes;

•    increasing policyholders’ surplus;

•    increasing capacity; and

•    exiting a line of business.

The insurer that purchases reinsurance is called the ceding insurer or ceding company. The ceding insurer also may be called the primary insurer, the direct insurer, the cedant, or the reinsured. The insurance company that accepts the transfer of risk is called the reinsurer, assuming insurer, or assuming company.

Example. ABC Property Insurance Company, which writes property insurance for commercial establishments. ABC wants to retain responsibility for only the first $25,000 of each claim on each property it insures. Therefore, ABC will enter into a treaty with Property Reinsurance Company, in which ABC cedes losses above $25,000 to Property Re on each of the properties it insures.

There are two basic types of reinsurance: treaty and facultative.

Treaty Reinsurance

A treaty is a contract governing what portion and types of risks are ceded (transferred by contract) to the reinsurer. It is negotiated between the ceding company (primary insurer) and the reinsurance company. Under a treaty, the reinsurer automatically assumes part of each risk that meets the criteria of the treaty. The reinsurance coverage becomes effective at the time that direct insurance covered by the treaty is written.

The automatic nature of treaty reinsurance tends to eliminate some of the reinsurer’s exposure to adverse selection that may occur in connection with facultative reinsurance. This is because treaty reinsurance is automatic and does not offer the opportunity to cede only unusually difficult risks. All risks that fall within the dictates of the treaty must be ceded and accepted.

Facultative Reinsurance

Facultative reinsurance is negotiated separately as direct insurers underwrite risks. The direct insurer is not obligated to cede any risks, and the reinsurer is not obligated to accept any risk. Facultative reinsurance may be used to permit writing a risk that is larger than the direct insurer wants to assume, even after taking the carrier’s treaty reinsurance into account; to protect a treaty; to obtain more competitive pricing; or to obtain coverage for a special exposure that the primary insurer cannot cover.

Under facultative reinsurance, the reinsurer has no obligation to accept any offered business. Facultative reinsurance is used to reinsure specific policies rather than an entire book of business. The primary reasons that direct insurers use facultative reinsurance are:

•    to provide coverage for areas that are excluded in the company’s treaty reinsurance;

•    to protect a treaty when a direct insurer wants to write an exposure that poses higher than average risk;

•    to provide coverage for limits that exceed treaty maximums;

•    to provide large line capacity on a single risk;

•    to provide additional stabilization of loss experience; or

•    to provide a pricing advantage.

Reinsurance Pools

Reinsurance pools have been used when the potential loss of a risk exceeds any one company’s ability to underwrite the risk. Under this arrangement, a number of companies combine resources and assume a percentage of the risks submitted to the pool. For example, this arrangement might be used in aviation insurance where the loss of a single passenger jetliner could produce a multimillion-dollar loss.

Areas of Impact

Reinsurance is a cost of doing business that the ceding company must pass along to its policyholders. The reinsurance company’s surplus is also subject to being reduced by the impact of heavier than anticipated losses or a decline in the value of its investments. Other factors also affect reinsurers, including the fact that catastrophic losses tend to accumulate in the reinsurance market. In addition, inflation can have a larger impact on reinsurance companies than on ceding companies. For example, if a reinsurer covered only losses in excess of $100,000, its participation in a loss of $101,000 would be $1,000 without inflation. An inflation rate of 1 percent would increase the loss over time to $102,010, and the reinsurance company would be required to pay $2,010. This would increase the reinsurer’s participation more than 100 percent. Another factor that could affect reinsurers that hold assets in a foreign currency is a drop in the exchange rate. This would have the effect of reducing its surplus relative to premiums written expressed in U.S. dollars.

Reinsurers can deal with adverse conditions by raising rates, restricting coverage, reducing the number of risks that they will write, and negotiating higher retentions with ceding companies. Factors such as these may sharply influence both pricing and availability of coverage in the direct market. When many of these factors deteriorate at the same time, the effect on policyholders can be dramatic.

During such periods of high prices and restricted capacity a number of offshore insurers have been created to meet the insurance needs of large corporations. After obtaining its initial seed capital such insurers may maintain a safe ratio of premiums written to surplus by requiring that new policyholders purchase an amount of the insurer’s stock at least equal to the premium which its paid.

PREMIUMS AND PRICING OF INSURANCE

One of the goals of state insurance regulation is to produce rates that are adequate, reasonable, and not unfairly discriminatory. Rates must be adequate so that insurers remain solvent and have the resources to pay claims. The requirement for reasonable rates is to make insurance affordable and prevent price gouging. Insurance underwriting by its nature is discriminatory. The rate for fire insurance on a building with sprinklers would reasonably be expected to be lower than the rate for buildings without such protection. This difference in rates would not be deemed to discriminate unfairly, especially if it can be supported by previous loss statistics.

One problem for the insurance industry is how to properly price its products. The use of class or manual rates has its limitations. Under the manual rate system, a rate classification is established for specific types of exposures in specific geographic territories. For actuarial purposes the classification is used to track premiums and losses for the types of insureds falling within the classification. For automobile insurance, the rate classification would include factors such as the type of vehicle, annual miles driven, use of the vehicle, and age of the driver. The applicant for insurance falling within the class is then charged a premium based upon his classification. No matter how detailed the rate classification is, however, there will be differences among the drivers within the rate grouping that cannot be recognized in the classification. For example, some drivers in the classification may drive defensively while others may drive aggressively. Even though the rate category does not explain everything about a given exposure, the underwriter can achieve a loss ratio close to what is expected by underwriting a large number of risks in each class.

As the scale of the policyholder activities increases, the unique factors of its operations begin to influence the premium that should be charged. For example, no two trucking firms are exactly the same even if they operate in the same territory. The problem for the underwriter is to decide how much weight should be given to the expected losses using the class rates and how much weight shall be given to the insured’s actual loss experience. The use of an insured business’s own record of past losses to influence the determination of future premiums is the concept behind experience rating. Actuaries have developed a variety of credibility tables to assist the underwriter in determining the appropriate experience-rated premium for a particular risk. The factors in the credibility tables vary from 0.00 for very small risks to 1.00 for very large risks.

State Regulations

State insurance rate regulation takes a number of forms. States with prior approval laws require the insurer to file its rates with the insurance regulators and obtain approval before using the rates. States with file and use laws require the insurers to file their rates with regulators for review. Under this type of regulation the insurance company can begin to use filed rates without first obtaining approval. If, after review, the regulators do not approve the rates, they may stop their use. Flex-rating laws allow insurers to reflect changes in conditions by filing rates with regulators and then adjusting them up or down within a preset range without prior approval. Open competition laws allow insurance companies to set their own rates. Under this type of law insurers must maintain records of rating structures for review by regulators. Many states exempt very large insureds from rate regulation and allow insurers to use their judgment.

Experience Rating

Experience rating is when an insurer examines a policyholder’s past claims experience to determine the appropriate premium. The use of experience rating makes it important for the insured and the insurer to jointly review the claims record to be sure that there are no errors in the calculation of the modification. Similarly the insurer’s workers compensation summary of loss data should be reviewed prior to its filing with the workers compensation-rating bureau.

The computation of the experience modification for workers compensation coverage is more complicated because it allows for the introduction of factors to dampen the impact of losses, favorable or unfavorable, which are sustained by smaller policyholders. Workers compensation experience rating is discussed in Chapter 28.

Retrospective Rating

Another approach to pricing is to use retrospective rating to adjust the policy premium based upon losses for the current year. Under this arrangement, the policy is issued with a retrospective premium agreement that sets the parameters for determining the ultimate policy premium. The agreement sets out a standard or deposit premium, a minimum premium, and a maximum premium as well as placing a limit on the amount of losses to be included in the formula as a result of any one event. The standard or deposit premium in an incurred loss retrospective program is usually the premium that would be calculated based on manual rates. The minimum premium is the least that the insured will ultimately pay, even if losses are exceptionally low. The maximum premium is the most that the insured will ultimately pay when losses are worse than expected.

For example, the minimum premium might be set at 80 percent while the maximum premium might be set at 130 percent of the deposit premium. In such an arrangement there may be a cap on the amount that the insured must pay on each claim. For instance, only the first $25,000 of loss from any one event might be included in the retrospective premium adjustment formula. The retrospective premium adjustment formula might be as simple as:

Premium = (fixed dollar charge) + [(included losses) × (loss conversion factor)]

At policy inception the insured pays the standard or deposit premium. The insurance company adjusts and pays losses as the policy period unfolds. After the policy expires, the terms of the retrospective premium agreement are applied to actual losses to produce the final premium. The insured then is billed for any additional premium that is earned because of claims. If claims are better than expected, the insured may receive a return premium credit.

Retrospective rating is used for larger businesses that want—or are forced to—share their risks with an insurance company. Some businesses choose retrospective rating because their claims are under control and they believe they ultimately will pay less than under a guaranteed cost program. Other businesses may be forced to accept a retrospectively rated policy because their losses are not under control and insurance underwriters do not want to lose money on the account.

WHERE CAN I FIND OUT MORE?

1.    American Institute for Chartered Property Casualty Underwriters (AICPCU) and the Insurance Institute of America (IIA), www.aicpcu.org/.

2.    Independent Insurance Agents and Brokers of America, www.iiaba.org.

3.    The Council of Insurance Agents & Brokers, ciab.com.

CHAPTER ENDNOTES

1.     NAIC International Insurers Department, www.naic.org/1misc/aboutnaic/about/about13.htm.

2.     www.napslo.org/.

3.     Available at www.naic.org/research_actuarial_dept.htm.

4.     Florida Life & Health Insurance Guaranty Association, Frequently Asked Questions, available at: www.flahiga.org/faq.cfm.

5.     www.ncigf.org.

ASSESSING RISK EXPOSURES

CHAPTER 3

INTRODUCTION

The impact of risk on the financial health of an individual or business cannot be overstated. Good financial planning and a strong business model will not—by themselves—make up for a lack of risk management strategy and foresight. Risk is nothing more than uncertainty. In the long run, unchecked uncertainty can ruin an individual’s financial portfolio and prevent a business from functioning properly or meeting its shareholders’ expectations.

Conversely, too much risk aversion can have an equally detrimental effect on an individual’s financial health and a company’s profits. For example, purchasing costly and excessive insurance limits squanders resources and erodes earnings. Routinely avoiding business opportunities because they may expose the company to an unaccustomed level of risk restricts profitability and growth and can force shareholders to sell their interests in favor of better-performing investments The best advisors are those that are able to identify and measure risk to find the optimal mixture of risk retention and risk transfer for their clients.

Before proceeding, the terms peril, hazard, risk, and indemnify should be defined. Although these three terms are often used synonymously by practitioners in the field, they do have differing technical meanings.

Risk may refer to uncertainty as to the outcome of an event when two or more possibilities exist; i.e., a building may stand or it may burn down. There is a risk. In property insurance, risk may also mean the physical units of property insured or the physical units of property at risk. For example, some might say, the only risk the underwriter wants to take is fire on pig iron under water, or that fireproof concrete block building is a good fire risk.

A peril, in property & casualty insurance terms, is a cause of a possible loss. For example, fire is a peril in property insurance, as is water damage, mold, earth movement, etc. A peril may be a covered peril (coverage is included under the policy) or an excluded peril (coverage is specifically excluded under the policy).

A hazard is a specific situation that increases the probability of the occurrence of loss arising from a peril or that may influence the extent of the loss. For example, fire, flood, and explosion are property perils – and liability itself is a peril under liability policies. Slippery floors, congested aisles, and oily rags in the open are hazards.

Indemnify means to make whole again. In other words, insurance puts the person back in the same position he or she was in prior