Principles of Risk Management and

Insurance
Fourteenth Edition

Chapter 6
Insurance Company
Operations

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Learning Objectives
6.1 Explain the rate-making function of insurers.
6.2 Explain the steps in the underwriting process.
6.3 Describe the sales and marketing activities of insurers.
6.4 Describe the steps in the process of settling a claim.
6.5 Explain the reasons for reinsurance and the various
types of reinsurance treaties.
6.6 Explain the importance of insurance company
investments and identify the various types of investments
of insurers.

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Insurance Company Operations
• The most important operations of an insurance company
include the following:
1) Rate making
2) Underwriting
3) Production
4) Claims settlement
5) Reinsurance
6) Investments

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(1) Rating and Ratemaking (1 of 2)
• Ratemaking refers to the pricing of insurance and the
calculation of insurance premiums
– A rate is the price per unit of insurance
– An exposure unit is the unit of measurement used in
insurance pricing
Premium = rate × exposure units
The actuary must calculate premiums that will
(1) allow the company to pay claims and expenses as
they occur,
(2) enable the company to compete effectively with other
insurers
(3) make the business profitable

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Rating and Ratemaking
– Total premiums charged must be adequate for paying
all claims and expenses during the policy period
– Rates and premiums are determined by an actuary,
using the company’s past loss experience and
industry statistics
– Actuaries also determine the adequacy of loss
reserves, allocate expenses, and compile statistics for
company management and state regulatory officials.

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(2) Underwriting
• Underwriting refers to the process of selecting, classifying,
and pricing applicants for insurance, The underwriter is the
person who makes those decisions
• A statement of underwriting policy establishes policies that
are consistent with the company’s objectives
• The underwriting policy is stated in an underwriting guide,
which specifies:
– Acceptable, borderline, and prohibited classes of business
– Amounts of insurance that can be written
– Territories to be developed
– Forms and rating plans to be used
– Business that requires approval by a senior underwriter

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 The basic principles of underwriting
1. Attain an underwriting profit: This requirement leads to the second
principle
2. Select prospective insureds according to the company’s
underwriting standards
– Reduce adverse selection against the insurer: In other words,
the underwriters should select only those insureds whose actual
loss experience is not likely to exceed the loss experience assumed
in the rating There is an old saying in underwriting: “Select or be selected
against.”
– Adverse selection: is the tendency of people with a higher-than-
average chance of loss to seek insurance at standard rates; if it is
not controlled by underwriting it will result in higher-than-expected
loss levels.
3. Provide equity among the policyholders
– One group of policyholders should not unduly subsidize another
group

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Underwriting process
• The process of underwriting starts with the agent; this is
often called field underwriting. The agent is told what
types of applicants are acceptable
• Information for underwriting : In addition to field underwriting by the
agent, the under writer requires certain information in deciding
whether to accept or reject an applicant for insurance. Important
sources of information include the following:
– The application
– The agent’s report
– An inspection report
– Physical inspection
– A physical examination and attending physician’s report
– Medical Information Bureau (MIB) report

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Application: The type of information required depends on
the type of insurance requested. In property insurance, the
application provides information on the physical features of
the building, and loss control features such as a sprinkler
system. In life insurance, the application indicates factors
such as the age, gender, weight, occupation, personal and
family health history, hazardous hobbies (for example,
skydiving), and the amount of insurance requested

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Agent’s report: Many insurers require the agent or broker to
give an evaluation of the prospective insured. In property
insurance, the agent or broker may submit an application
that does not completely meet the underwriting standards of
the company. In such cases, the agent’s evaluation of the
applicant is especially important. In life insurance, the
agent may be asked how long he or she has known the
applicant, the applicant’s estimated annual income and net
worth......

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 Inspection report: In property insurance, the company may
require an inspection report by some outside agency,
especially if the underwriter suspects moral hazard. An
outside firm investigates the applicant for insurance and
makes a detailed report to the company.
In life insurance, the report may provide information on the
applicant’s financial condition, marital status, outstanding
debts or delinquent bills, any drinking or drug problems, and
additional information as well.

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Physical inspection: In property and casualty insurance,
the underwriter may require a physical inspection before the
application is approved. For example, in workers’
compensation insurance the inspection may reveal unsafe
working conditions such as dangerous machinery, violation
of safety rules (for example, failure to wear goggles when
using a grinding machine), or an excessively dusty or toxic
plant.
Physical examination: In life insurance, a physical exam
may be required, especially for higher policy limits, to
determine the applicant’s physical characteristics such as
overall health and abnormalities of blood pressure, heart,
respiratory system, or other parts of the body. An attending
physician’s report may also be required, which is a report
from a physician who has treated the applicant in the past.

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 As part of the physical exam, a life insurer may request a
report from MIB Group (formerly the Medical Information
Bureau). The MIB Group is an organization of life insurance
companies; members submit to MIB Group information
about health impairments that is disclosed on life insurance
applications. This information is available upon request to
other member companies if a person subsequently submits
an application for life insurance.

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 Making an underwriting decision
• After reviewing the information, the underwriter can:
– Accept the application and recommend that the policy be
issued
– Accept the application subject to restrictions or
modifications
– Reject the application, the rejection should be based on a
clear failure to meet the insurer’s underwriting standards.
• Many insurers now use computerized underwriting for
certain personal lines of insurance that can be
standardized, such as auto and homeowners insurance. It
promotes faster, more efficient underwriting decisions.

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 Underwriting (5 of 5)
• Other factors considered in underwriting include:
❑Rate adequacy: If rates are adequate, underwriting
profits are higher, and underwriting is more liberal.
Conversely, when rates are inadequate, underwriting
losses occur, and underwriting becomes more restrictive.
❑Availability of reinsurance: Availability of reinsurance
may result in more liberal underwriting. However, if
reinsurance cannot be obtained on favorable terms,
underwriting may be more restrictive.
❑Whether a policy can or should be cancelled or
renewed: In life insurance, policies are not cancellable.
In property and casualty insurance, most policies can be
cancelled or not renewed.

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(3) Production
• Production refers to the sales and marketing activities
of insurers
– Agents are often referred to as producers
– Life insurers have an agency or sales department
– Property and liability insurers have marketing
departments

• The marketing of insurance has been characterized by a

trend toward professionalism
– An agent should be a competent professional with a
high degree of technical knowledge in a particular area
of insurance and who also places the needs of his or
her clients first
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Production
• Several organizations have developed professional
designation programs for insurance personnel:
– The American College: C L U, C h F C
– The American Institute for Chartered Property and
Casualty Underwriters: C P C U
– Certified Financial Planner Board of Standards, Inc.: C
FP
– National Alliance for Insurance Education and
Research: C I C

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(4) Claims Settlement
• The objectives of claims settlement include:
– Verification of a covered loss
– Fair and prompt payment of claims
– Provide personal assistance to the insured

(1) verify that a covered loss has occurred:

This step involves determining whether a specific person
or property is covered under the policy, and the extent of
the coverage.

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• (2) Fair and prompt payment of claims
If a valid claim is denied, the fundamental social and
contractual purpose of protecting the insured is defeated.
Also, the insurer’s reputation may be harmed, and the sale
of new policies may be adversely affected. Fair payment
also means that the insurer should avoid excessively large
claim settlements and should resist the payment of
fraudulent claims, because each of them will ultimately result
in higher premiums.
the National Association of Insurance Commissioners’ Unfair
Claim Settlement Practices Model Act, which “sets standards
for the settlement and disposition of insurance claims.”

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Some unfair claim practices prohibited by these laws include
the following:
▪ Refusing to pay claims without conducting a reasonable
investigation
▪ Not attempting to provide prompt, fair, and equitable
settlements
▪ Offering lower settlements to compel insureds to institute
lawsuits to recover amounts due
▪ Misrepresentation of material facts or policy provisions by
insurers that pertain to a coverage issue

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(3) provide personal assistance to the insured after a
covered loss occurs.
The insurer should also provide personal assistance after a
loss occurs; the person settling the claim truly is an
ambassador for the company. For example, although most
individuals who suffer a fire loss will have only one during their
lifetime, an adjuster deals with fire losses on a regular basis
and has a wealth of knowledge that will be helpful to the
insured.
Thus, a claims adjuster can reduce a family’s stress and
enhance the insurer’s reputation by helping a family find
temporary housing and advising on other needs after a fire
occurs.
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Parties Involved in Claims Settlement

• Major types of claims adjustors include:

1. An insurance agent: often has authority to settle
small first-party claims up to some limit
2. A staff claims representative is usually a salaried
employee who will investigate a claim, determine the
amount of loss, and arrange for payment. also known
as a staff adjuster

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3. An independent adjustor is an organization or individual
that is not part of an insurance company and adjusts
claims for a fee, for example it may be used when a
catastrophic loss (such as a hurricane) occurs and a
large number of claims are submitted at the same time.
4. A public adjustor represents the insured and is paid a
fee based on the amount of the claim settlement.
A public adjuster may be employed by the insured if a
complex loss situation occurs and technical assistance is
needed and in those cases where the insured and insurer
cannot resolve a dispute over a claim.

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Steps in Settlement of a Claim
1- The claim process begins with a notice of loss, typically
immediately or as soon as possible after a loss has
occurred.
2- Next, the claim is investigated the Claim
An adjustor must determine that a covered loss has
occurred and determine the amount of the loss. A series
of questions must be answered before the claim is
approved. Is the person an insured under the policy?
– ■ Did the loss occur during the policy period?
– ■ Is the cause of loss (peril) covered under the policy?
– ■ Is the damaged property covered under the policy?
– ■ Is the full amount of loss or damages covered under
the policy?
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■ Is the location where the loss occurred covered under the
policy?
■ Are there any exclusions that apply to the loss?
■ Does any other insurance apply to the loss?
the insured has a contractual obligation to cooperate with the
insurer in the investigation of a claim. Failure of the insured
to cooperate in the claim investigation may result in denial of
the claim
3- The adjustor may require a proof of loss before the claim
is paid
4- The adjustor decides if the claim should be paid or
denied, There are three possible decisions:
• Policy provisions address how disputes may be resolved
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(a) The claim can be paid as submitted. In most cases, the
claim is paid promptly according to the terms of the policy.
(b) The claim can be denied. The adjuster may believe that
the policy does not cover the loss or that the claim is
fraudulent.
(c) the claim may be valid, but there may be a dispute
between the insured and insurer over the amount to be
paid.
When there is disagreement over the claim settlement,
consumers may file a complaint with the state insurance
department. The National Association of Insurance
Commissioners (NAIC) has a website that permits consumers
to check the complaint record of individual insurers.

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(5) Reinsurance
• Reinsurance is an arrangement by which the primary
insurer that initially writes the insurance transfers to
another insurer part or all of the potential losses
associated with such insurance
– The primary insurer is the ceding company
– The insurer that accepts the insurance from the ceding
company is the reinsurer
– The retention limit is the amount of insurance
retained by the ceding company
– The amount of insurance ceded to the reinsurer is
known as a cession
– Retrocession is when a reinsurer insures part or all of
a risk with another insurer
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Reinsurance
• Reinsurance is used to:
– Increase underwriting capacity
– Stabilize profits
– Reduce the unearned premium reserve, which
represents the unearned portion of gross premiums on
all outstanding policies at the time of valuation
– Provide protection against a catastrophic loss
– Retire from business or from a line of insurance or
territory
– Obtain underwriting advice on a line for which the
insurer has little experience

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Exhibit 6.1 (1 of 2)
The Ten Most Costly Catastrophes in the US ($ Millions)
Blank Blank Blank

Estimated Insured Estimated Insured

Property Losses Property Losses
Rank Date Peril Dollars When In 2016 dollars
Occurred
1 Aug 2005 ust Hurricane Katrina $ 41,100 $ 49,793
2 Sep 2001 tember Fire, explosion: World 18,779 24,987
Trade Center, Pentagon
terrorist attacks
3 Aug 1992 ust Hurricane Andrew 15,500 24,478
4 Oct 2012ober Hurricane Sandy 18,750 19,860
5 Jan 1994 uary Northridge, CA earthquake 12,500 18,880
6 Sep 2008 tember Hurricane lke 12,500 14,036
7 Oct 2005ober Hurricane Wilma 10,300 12,479

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Exhibit 6.1 (2 of 2)
The Ten Most Costly Catastrophes in the U S ($ Millions)
Blank Blank Blank

Estimated Insured Estimated Insured

Property Losses Property Losses
Rank Date Peril Dollars When Occurred In 2016 dollars

8 Aug 2004 ust Hurricane Charley 7,475 9,348

9 Sep 2004 tember Hurricane Ivan 7,110 8,891
10 Apr 2004il Flooding, hail and wind 7,300 7,875
including the tornadoes that
struck Tuscaloosa and other
locations

1
Property coverage only. Excludes flood damage covered by the federally administered National Flood
Insurance Program
2
Adjusted for inflation through 2016 by ISO using the GDP implicit price deflator.
Note: Data are from the Property Claim Services (PCS) unit of ISO, a Verisk Analytics company.

Source: “Facts+Statistics: U.S. Catastrophes,” Insurance Information Institute (2018). Accessed at

www.iii.org/fact-statistic/facts-statistics-us-catastrophes , May 2018.
This source is periodically updated. Reprinted with permission.

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Reinsurance
• There are two principal forms of reinsurance:
– Facultative reinsurance is an optional, case-by-case
method that is used when the ceding company
receives an application for insurance that exceeds its
retention limit
▪ Often used when the primary insurer has an
application for a large amount of insurance
– Treaty reinsurance means the primary insurer has
agreed to cede insurance to the reinsurer, and the
reinsurer has agreed to accept the business
▪ All business that falls within the scope of the
agreement is automatically reinsured according to
the terms of the treaty
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Reinsurance
• There are two basic methods for sharing losses:
– Under the Pro rata method, the ceding company and
reinsurer agree to share losses and premiums based
on some proportion
– Under the Excess method, the reinsurer pays only
when covered losses exceed a certain level

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Reinsurance
• Under a quota-share treaty, the ceding insurer and the
reinsurer agree to share premiums and losses based on
some proportion
Example: assume that Apex Fire Insurance and Geneva Re
enter into a quota-share arrangement by which losses and
premiums are shared 50-50
If a $100,000 loss occurs, Apex Fire pays $100,000 to the
insured but is reimbursed by Geneva Re for $50,000

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Reinsurance
• Under a surplus-share treaty, the reinsurer agrees to
accept insurance in excess of the ceding insurer’s
retention limit, up to some maximum amount
Example: assume that Apex Fire Insurance has a retention
limit of $200,000 (called a line) for a single policy, and that
four lines, or $800,000, are ceded to Geneva Re. Assume
that a $500,000 property insurance policy is issued. Apex
Fire takes the first $200,000 of insurance, or two-fifths, and
Geneva Re takes the remaining $300,000, or three-fifths.

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Reinsurance
• For example, if a $5000 loss occurs:

Insurance Company Retention Limit

Apex Fire $200,000 (1 line)
Geneva Re $800,000 (4 lines)
Total Underwriting Capacity $1,000,000
Blank

$500,000 policy issued

Apex Fire $200,000 (2/5)
Geneva Re $300,000 (3/5)
Blank

$5000 loss occurs

Apex Fire $2000 (2/5)
Geneva Re $3000 (3/5)

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Reinsurance
• An excess-of-loss treaty is designed for protection
against a catastrophic loss
– A treaty can be written to cover a single exposure, a
single occurrence, or excess losses
Example: Apex Fire Insurance wants protection for all
windstorm losses in excess of $1 million. Assume Apex
enters into an excess-of-loss arrangement with Franklin Re
to cover single occurrences during a specified time period.
Franklin Re agrees to pay all losses exceeding $1 million but
only to a maximum of $10 million.
If a $5 million hurricane loss occurs, Franklin Re would pay
$4 million.

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Reinsurance
• A reinsurance pool is an organization of insurers that
underwrites insurance on a joint basis
• Reinsurance pools work in two ways:
– Each pool member agrees to pay a certain percentage
of every loss.
– Each pool member pays for his or her share of losses
below a certain amount; losses exceeding that amount
are then shared by all members in the pool.

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Reinsurance
• Some insurers use the capital markets as an alternative to
traditional reinsurance
• Securitization of risk means that an insurable risk is
transferred to the capital markets through the creation of a
financial instrument, such as a catastrophe bond or futures
contract
• Catastrophe bonds are corporate bonds that permit the
issuer of the bond to skip or reduce the interest payments
if a catastrophic loss occurs
– Catastrophe bonds are growing in importance and are
now considered by many to be a standard supplement
to traditional reinsurance.

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(6) Investments
• Because premiums are paid in advance, they can be
invested until needed to pay claims and expenses
• Investment income is extremely important in reducing the
cost of insurance to policyowners and offsetting
unfavorable underwriting experience
• Life insurance contracts are long-term; thus, safety of
principal is a primary consideration
• In contrast to life insurance, property insurance contracts
are short-term in nature, and claim payments can vary
widely depending on catastrophic losses, inflation, medical
costs, etc

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Exhibit 6.2
Growth of Life Insurer Assets

Notes: Data are from ACLI tabulations of National Association of Insurance

Commissioners (NAIC), used by permission.
Notes: NAIC does not endorse any analysis or conclusions based on use of its data. Data
represent U.S. life insurers and, as of 2003, fraternal benefit societies.
Source: American Council of Life Insurers, Life Insurers Fact Book, 2017, Figure 2.1.
Reprinted with permission.

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Exhibit 6.3
Asset Distribution of Life Insurers, 2016

Notes: Data are from ACLI tabulations of National Association of Insurance

Commissioners; data used by permission.
Notes: NAIC does not endorse any analysis or conclusions based on use of its data. Data
represent U.S Life Insurers and fraternal benefit societies.
Source: American Council of Life Insurers, Life Insurers Fact Book, 2017, Figure 2.2.
Reprinted with permission.

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Exhibit 6.4
Investments, Property/Casualty Insurers, 2016

Notes: Data are from SNL Financial LC. Cash and invested net admitted assets, as of
December 31, 2016.
Source: The Insurance Fact Book, 2018, p 63. Insurance Information Institute. Reprinted
with permission.

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Important Functions Performed by
Other Insurance Companies
• Information systems are extremely important in the daily
operations of insurers.
– Computers are widely used in many areas, including policy
processing, simulation studies, market analysis, and
policyholder services.

• The accounting department prepares financial statements and

develops budgets
• In the legal department, attorneys are used in advanced
underwriting and estate planning
• Property and liability insurers also provide many loss control
services

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Copyright

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