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Chapter 9

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FIN 512
Giulio Iacobelli

Chapter 9: Insurance Operations Insurance operations have many facets that are unique to the insurance industry Insurance operations encompass the following: - Underwriting- the process of selecting and classifying applicants for insurance - Claims settlement- the process of validating and paying claims - Production- the sales and marketing activities of insurers - Rate making- the process of setting insurance premiums Insurance companies have many kinds of liabilities that are primarily large reserves for future claims The liabilities for life and health insurers in particular are extremely long-term compared to the liabilities of other financial institutions and other industries Accounting practices and investment restrictions in the insurance industry reflect the special nature of their liabilities Underwriting: is the process of selecting and classifying risk exposures in order to determine the appropriate rate to charge policyholders in various categories of risk - Insurance companies have underwriting principles by which they select and categorize applicants for insurance - Underwriting Principles: underwriting principles provide guidelines so insurance companies can do the following: 1. Select insureds according to the companys underwriting standards. 2. Have a proper balance within each rate classification. While insurers try to put similar risk exposures together in the same category, some risk exposures will produce higher losses than average while others produce fewer. In both auto and home insurance, we saw that there are many criteria that insurers use to categorize policyholders. A priori (before the event), an insurer cannot know whether or not it has classified each policyholder correctly. However, the insurer attempts to classify insureds so that the actual loss experience will not vary greatly from the expected loss experience. 3. Provide equity among policyholders so that one group of policyholders does not unduly subsidize another group. If, on average, 20-year-old men have higher accident rates than 50-year- old men, the insurer will charge a 20-year-old man a higher premium even though it cannot know for certain that the final cost for the 20-year-old will be higher than for the 50-year-old. The insurer knows that the actual loss experience for an individual will be different from the expected loss experience for the group but it attempts to minimize the difference. - The principle of adverse selection states that those who have a greater-than-average risk of producing a loss tend to try to seek insurance more often than people who are average or less-than-average risk - This is particularly true in group insurance plans when employees have a choice about participating- those employees who are most likely to make a claim will, if given a choice, join a group insurance plan since they cannot get other insurance elsewhere or cannot get it at a better rate - Thus, while group insurance is cheaper than individual insurance, due to adverse selection it is not as cheap as one might expect since underwriters adjust group rates to reflect this adverse selection - Rate Categories: insurance companies have categories for policyholders and a potential policyholder may be unacceptable at one rate but acceptable at a higher rate. Generally, insurers charge the least premium they can to remain competitive and still charge each policyholder an appropriate premium. Standard rates are charged to policyholders who meet the companys average underwriting standards. Policyholders who are more risky will be charged a surcharge, as they are sub-standard risks. The obvious example is charging smokers more than non-smokers for both disability and life insurance policies. These policies are called rated policies since the insured presents a higher than normal risk due to occupation, a hobby, or their health. The surcharge might be a flat rate- 10% or $50, for example Some policyholders fall in the preferred-risk category- having smoke detectors and/or fire extinguishers in ones home or living close to a fire station might put a homeowner in this category since these can reduce the size of the loss if not the frequency - Process of Underwriting: There are 3 steps in the underwriting process: 1. The application is filled in by the potential policyholder although the agent or broker may actually fill in the blanks based on information provided by the applicant. The applicant is expected to provide full, complete information- misinformation or deliberately omitted information can be the basic for voiding a policy at a later date. 2. The agent or broker may be able to provide additional information or validate the information on the application if the agent or broker has been involved with the applicant before. If the applicant is not known and the agent or broker has a reputation with the insurer of providing reliable applicants, the insurer may accept an applicant that would otherwise be rejected. 3. Additional information can be solicited from an external source: It is the norm for insurance companies to obtain a report from a provincial motor vehicle licensing agency to check on the driving history and current status of applicants. They may or may not re-check at the time of renewal. Insurers can send inspectors to check the premises or to do drive-by inspections to see if the general description is correct for a homeowners policy They also can ask for a medical report from ones family doctor, which will include a question about how long the applicant has been a patient of the doctor If the policy is renewable or cancellable, the renewal underwriting process will re-check the assumptions under which the policy was written. At this point, the insurer may cancel the policy if possible, or may renew but at a higher rate or with a higher deductible. Claims Settlement: - Settling claims is called loss adjustment and involves Verifying that a loss is covered Providing fair and prompt payment of claims while resisting unjust claims and overpayments, and Assisting the insured by, for instance, helping the insured find temporary living space after a fire - The employees in a claims department are called Claims representatives or benefit representatives in life and health insurance companies, and Adjusters in property and liability insurance where claims require more assessment and evaluation (except for disability claims, which require a great deal of monitoring and assessment) - It is the job of the adjuster to assess the facts of the claim and the extent of the coverage - There are several types of adjusters in addition to the employees of insurance coverage: Some agents can settle small claims Independent adjusters work for several insurance companies on a contract basis Adjustment bureaus are adjusting organizations and are often used for catastrophic losses such as tornados where there are many losses to settle Public adjusters represent the insurers, not the insurer. Their fee is based on the amount of the settlement - In health and disability insurance, there can be coverage by more than one insurer, for instance through group plans of both spouses. In this circumstance, there are co-insurance requirements that decide which insurer pays how much. - The primary insurer pays first and the excess insurer pays above the policy limits of the primary insurer There is often a coordination-of-benefits provision in group insurance policies to prevent double payments. If a person is covered under more than one policy, his or her own insurer is usually primary. The maximum that can be paid is 100% of the expense. For children, there is often a birthday rule- the insurer of the parent whose birthday occurs first during the year is primary. - Contribution by equal shares means that when there is more than one insurer, each insurer pays equally to the limits of the coverage - Pro rata liability clause means that when two or more policies are in place, each pays in proportion to the total amount of insurance - The second payor means the amount of the benefit is reduced by the amount of benefit under other policies covering the same risks. For example, employment insurance benefit is second payor to Canada Pension Plan disability benefit and Workers Compensation but not to individual policies. Thus, if a person is collecting EI benefits, CPP disability benefits or Workers Comp benefits are subtracted from the E
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