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CHAPTER SIX

FUNCTIONS OF INSURERS
 Learning Objectives
After studying this chapter, you should be able
to:
 Explain the rate making function of insurers
 Define underwriting and explain the steps in
the underwriting process
 Describe the objectives of claim settlement
 Explain the reason for reinsurance and the
various types of reinsurance treaties
 Explain the importance of insurance
company investment
 Insurance Company operations are the most
important operations that enable the insurance
company to give (make) insurance service available
to the public and consist of the following:
 Rate Making: refers to the pricing of insurance.
 Insurance pricing differs considerably from the
pricing of other products.
 When other products are sold, the company
generally knows in advance what its costs of
production are, so that a price can be established to
cover all costs and yield a profit. However, the
insurance company does not know in advance what
its actual costs are going to be.
 Cont…
 The premium charged for the insurance may be
inadequate for paying all claims and expenses during
the policy period, because it is only after the period
of protection has expired that the company can
determine its actual losses and expenses. Of course,
the insurer hopes that the premium paid in advance
will be sufficient to pay all claims and expenses and
yield a profit.
 The person who determines the rates is known as
an actuary.
 In property and liability insurance, actuaries also
determine the rates for different lines of insurance.
 Rates are determined by the company’s past loss
experience and by industry statistics.
 Cont…
 An actuary is highly skilled mathematician who is
involved in all phases of insurance company
operations, including planning, pricing, and research:
 In life insurance the actuary studies important
statistical data on births, deaths, marriages, disease,
employment, retirements, and accidents.
 Based on this information, the actuary determines
the rates for life and health insurance polices. The
objectives are to calculate premiums that will
make the business profitable, enable it to compete
effectively with other insurers, and allow it to pay
claims and expenses as they occur.
 A life insurance actuary must also determine the
legal reserves a company needs for future
obligation.
 Cont…
 Underwriting: refers to the process of
selection and classifying applicants for
insurance.
 The underwriter is the person who decides to
accept or reject an application.
 The fundamental objective of underwriting is to
produce a profitable book of business.
 The underwriter constantly strives to select
certain types of applicants and to reject others
in order to obtain profitable portfolio.
 Cont…
 Statement of Underwriting Policy: Underwriting
starts with a clear statement of underwriting policy.
 An insurer must establish underwriting policy that is
consistent with company objectives.
 The objective may be a large volume of business with
low unit profits or a smaller volume at a larger unit
of profit.
 Classes of business that are acceptable, borderline, of
prohibited must be clearly stated. The amounts of
insurance that can be written on acceptable and
borderline business must also be determined.
 Cont…
 The insurer’s underwriting policy is determined
by top-level management in charge of
underwriting.
 The line underwriters-persons who make daily
decisions concerning the acceptance or
rejection of business- are expected to follow
official company policy.
 The underwriting policy is stated in detail in an
underwriting guide that specifies the lines of
insurance to be written; territories to be
developed; forms
Basic underwriting Principles
 The goal of underwriting is to produce a profitable
volume of business. To achieve this goal, certain
underwriting principles are followed.
 Three important principles are as follows:
◦ Selection of insureds according to the company’s
underwriting standards.
◦ Proper balance within each rate classification
◦ Equity among policy owners
 The first principle (Selection of insureds according to
the company’s) is that the underwriter must select
prospective insureds according to the company’s
underwriting standards. This means that the
underwriters should select only those insureds
whose actual loss experience will not exceed the
loss experience assumed in the rating structure.
Cont…
 The second underwriting principle (Proper balance
within each rate classification) is to have a proper
balance within each rate classification. This means that
a below-average insured, in an underwriting class
should be offset by an above-average insured, so that
on balance, the class or manual rate for the group as a
whole will be adequate for paying all claims and
expenses.
 A final underwriting principle (Equity among policy
owners) is equity among the policy owners. This means
that equitable rates should be charged, and that each
group of policy owners should pay its own way in
terms of losses and expenses.
 Steps in Underwriting:
 Agent as first underwriter: This is often
called field underwriting; the agent is told what
types of applicants are acceptable, borderline,
or prohibited.
 For example, in auto insurance, an agent may
be told not to solicit applicants who have been
convicted for drunk driving, who are single
drivers under age 21, or who are young drivers
who own high-powered sports cars. In
property insurance, certain exposure, such as
bowling alleys and restaurants, may have to be
submitted to a company underwriter for
approval.
Cont…
 In property and liability insurance, the agent often
has authority to bind the company immediately,
subject to subsequent disapproval of the application
and cancellation by a company underwriter.
 Thus, it is important that the agent follow company
policy when soliciting applicants for insurance.
 To encourage a submission of only profitable
business, a contingent or profit-sharing commission
is often paid based on the agent’s favorable loss
experience.
 In life insurance, the agent must also solicit applicants
in accordance with the company’s underwriting
policy.
 The agent may be told not to solicit applicants who
are drug addicts, active alcoholics, or persons who
work in hazardous occupations.
Cont…
 Sources of underwriting Information:
 The underwriter requires certain types of
information in deciding whether to accept or reject
an applicant for insurance.
 The type of information varies by type of insurance.
 In property insurance, both the physical features of
the property and personal characteristics of the
applicant must be considered.
 Physical features include the type of construction,
occupancy of the building, quality of fire protection,
water supply, and exposure from surrounding
buildings.
Cont…
 With respect to personal characteristics of the
applicant, information that reveals the presence of
moral hazard is particularly important.
 The underwriter wants to screen out applicants who
may intentionally cause a loss or inflate a claim
beyond its actual value. Thus, the applicant’s present
financial condition, past loss record, living habits, and
moral character are especially important in the
underwriting process.
 Underwriting information can be obtained from a
wide variety of sources.
 The most important sources include the following:-
 Cont…
 Application
 Agent’s report
 Inspection report
 Physical examination and attending physician’s
report
 Medical information Bureau (MIB)
 The application is a basic source of underwriting
information.
 The application varies depending on the type of
insurance.
 For example, in life insurance, the application will
show the individual’s age, sex, weight, and occupation,
personal and family health history, and any hazardous
hobbies, such as sky diving.
 Cont…
 An agent’s report is another source of
information. Most companies require the agent
to give an evaluation of the prospective insured.
 For example, in life insurance, the agent may be
asked to state how long he or she known the
applicant, so estimate the applicant’s annual
income and net worth, to judge whether the
applicant plans to lapse or surrender existing
life insurance, and to determine whether the
application is the result of the agent’s
solicitation.
Cont…
 An inspection report may be required,
especially if the underwriter suspects moral
hazard.
 An outside firm investigates the applicant for
insurance and makes a detailed report to the
company.
 The report may include the applicant’s present
financial condition, drinking habits, marital
status, and amount of outstanding debts,
delinquent bills, policy record, felony
convections, and additional information, such as
whether the applicant has ever declared
bankruptcy.
 Cont…
 A physical inspection may also be required
before an application for property and liability
insurance is approved.
 The agent or company representative may
physically inspect the building or plant to be
insured, and submit a report to the
underwriter, in workers compensation
insurance, an inspection may reveal unsafe
working conditions, such as dangerous
machinery, violation of safety rules, such as not
wearing goggles when a grinding machine is
used; and an excessively dusty or toxic plant.
 Cont…
 A final source of underwriting information in
life insurance is a Medical Information Bureau
(MIB) report, companies that belong to the
bureau report any health impairments, which
are then recorded and made available to
member companies.
 For example, if an applicant for life insurance
has high blood pressure, this information would
be recorded in the MIB files, which are coded
and do not reveal the decision made by the
submitting company.
 Making an Underwriting Decision:-
 After the underwriter evaluates the information, an
underwriting decision must be made.
 There are three basic underwriting decisions with
respect to an initial application for insurance:-
 Accept the application
 Accept the application subject to certain
restrictions or modifications
 Reject the application
 The underwriter can accept the application and
recommend that the policy be issued.
 A second option is to accept the application
subject to certain restrictions or modifications
Cont…
 Several examples illustrate this second type of decision.
 Before a crime insurance policy is issued,
◦ the applicant may be required to place iron bars on
windows or install an approved central station
burglar alarm system; the applicant may be refused a
homeowners policy and offered a more limited
dwelling and contents policy;
◦ a large deductible may be inserted in a property
insurance policy; or
◦ a higher rate for life insurance may be charged if the
applicant is substandard in health.
◦ If the applicant agrees to the modifications or
restrictions, the policy then issued.
Cont…
 The third decision is to reject the application.
However, excessive and unjustified rejection of
applications reduces the insurer’s profitability
and alienates the agents who solicited the
business.
 If an application is rejected, 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
automobile and homeowners insurance. As a
result, underwriting decision can be expedited.
 Other Underwriting Considerations:
 Other factors are also considered in underwriting.
They include the following:
 Rate adequacy and underwriting. When rates are
considered:
◦ adequate for a class, insurers are more willing to
underwrite new business.
◦ inadequate, prudent underwriting requires a
more conservative approach to the acceptance
of new business, if moral hazard is excessive, the
business generally cannot be insured at any rate.
Cont…
 Reinsurance and underwriting: - Availability of
reinsurance facilities may result in more liberal
underwriting. However, if reinsurance cannot be
obtained on favorable terms, the underwriting may
be more restrictive,
 Renewal underwriting:-
◦ In life insurance, policies are not cancelable.
◦ In property and liability insurance, most policies can be
canceled or not renewed.
◦ If the loss experience is unfavorable, the insurer may
either cancel or not renew the policy.
◦ Most states have placed restrictions on the insurer’s
right to cancel.
Production
 production refers to the sales and marketing
activities of insurers.
 Agents who sell insurance are frequently referred to
as producers.
 This word is used because an insurance company can
be legally chartered, personnel can be hired, and
policy forms printed, but nothing is produced until a
policy is sold.
 The key to the insurer’s financial success is an
effective sales force.
 Agency Department life insurers have an agency or
sales department.
 This department is responsible for recruiting and
training new agents and for the supervision of
general agents, branch office managers, and local
agents.
Cont…
 Property and liability insurers have marketing
departments, to assist agents in the field, special
agents may also be appointed, and a special
agent is a highly specialized, technician who
provides local agent s in the field with technical
help and assistance with their marketing
problems.
 For example, a special agent may explain a new
policy form or a special rating plan to agents in
the field.
 In addition to development of an effective sales
force, an insurance company engages in a wide
variety of marketing activities.
Cont…
 These activities include :
◦ the development of marketing philosophy and
the company’s perception of its role in the
marketplace;
◦ identification of short-run and long-run
production goals;
◦ marketing research;
◦ development of new products to meet the
changing needs of consumers and business firms;
◦ developing new marketing strategies; and
◦ advertising the insurer’s products.
Claim Settlement
 Every insurance company has a claims division or
department for settling claims.
 This section examines the basic objectives in
settling claims, the different types of claim
adjusters, and the various steps in the claim-
settlement process.
 Basic Objectives in Claim Settlement: From
the insurer’s viewpoint, there are several basic
objectives in settling claims:-
◦ Verification of a covered loss
◦ Fair and prompt payment of claims
◦ Personal assistance to the insured
Cont…
 The first objective in settling claims is to verify
that a covered loss has occurred.
 This involves determining whether a specific
person or property is covered under the policy,
and the extent of the coverage.
 The second objective is the fair and prompt
payment of claims.
 If a valid is denied, the fundamental social and
contractual purpose of protecting the insured is
defeated.
 Also, the insurer’s reputation may be harmed,
and the sales of new policies may be adversely
affected.
Cont…
 Fair payment means that the insurer should
avoid excessive claim settlements and should
resist the payment of fraudulent claims, since
they will ultimately result in higher premiums, if
the insurer follows a liberal claims policy, all
policy owners will suffer because a rate
increase will become necessary.
 Most states have passed laws that prohibit
unfair claim practices. Some unfair claim
practices prohibited by lows include the
following:
1. Refusing to pay claims without conducting a
reasonable investigation based on all available
information.
Cont…
2. Not attempting in good faith to effect prompt, fair,
and equitable settlements of claims in which liability
has become reasonably cleat.
3. Compelling insured’s to institute litigation to recover
amounts due under an insurance policy by offering
substantially less than the amounts ultimately
recovered in actions brought by such insured’s.
 A third objective is to provide personal assistance to
the insured after a covered loss occurs.
 Aside from any contractual obligations, the insurer
should also provide personal assistance after a loss
occurs.
 For example, the claims adjustor could assist the
agent in helping a family find temporary housing after
a fire occurs.
Types of Claims Adjustors:
 The person who adjusts a claim is known as
a claims adjustor.
 The major types of adjustors include the
following:
 Agent
 Company adjustor
 Independent adjustor
 Adjustment bureau
 Public adjustor
Cont…
 An agent often has authority to settle small first-party
claims up to some maximum limit.
 The insured submits the claim directly to the agent, who
has the authority to pay up to some specified amount.
 This approach to claim settlement has three advantages:
◦ it is speedy,
◦ it reduces adjustment expenses, and
◦ it preserves the policy owner’s good will.
 A company adjustor
 The adjustor is usually a salaried employee who
represents only one company.
 After notice of the loss is received, the company
adjustor will investigate the claim, determine the
amount of loss, and arrange for payment.
Cont…
 An independent adjustor
 An independent adjustor is a person who offers
his or her services to insurance companies and
is compensated by a fee.
 The company may use an independent adjustor
in certain geographical areas where the volume
of claims is too low to justify a branch office
with a staff of fulltime adjustors.
 An independent adjustor may also be used in
highly specialized areas where a company
adjustor with the necessary technical skills and
knowledge is not available.
Cont…
 An adjustment bureau
 is an organization for adjusting claims that is supported
by insurers that use its services.
 Claims personnel employed by an adjustment bureau are
highly trained individuals who adjust claims on a full-time
basis.
 is frequently used when a catastrophic loss, such as a
hurricane, occurs in a given geographical area, and a large
number of claims are submitted at the same time.
 A pubic adjustor
 represents the insured rather than the insurance
company and is paid a fee based on the amount of the
claim settlement.
 A public adjustor may be employed by the insured if a
complex loss situation occurs and technical assistance is
needed, and also in those cases where the insured and
insurer cannot resolve a dispute over a claim.
 Cont…
 There are several important steps in settling a claim:
 Notice of loss must be given.
 The claim is investigated.
 A proof of loss may be required
 A decision is made concerning payment
 Notice of loss: The first step is to notify the insurer
of a loss.
 A provision concerning notice of loss is usually
stated in the policy.
 A typical provision requires the insured to give
notice immediately or as soon as possible after the
loss has occurred.
Cont…
For example,
 the homeowners policy requires the insured to give
immediate notice;
 a medical expense policy may require the insured to
give notice within 30 days after the occurrence of a
loss, or as soon afterward as is reasonably possible;
and
 the personal auto policy requires that the insurer
must be notified promptly of how, when, an d where
the accident or loss happened.
 The notice must also include the names and
addresses of any injured persons and of witnesses.
 Cont…
 the next step is to investigate the claim.
 An adjustor must determine that a covered loss has
occurred and must also determine the amount of
the loss.
 A series of questions must be answered before the
claim is approved. The most important questions
included the following?
◦ Did the loss occur while the policy was in force?
◦ Does the policy cover the peril that caused the loss?
◦ Does the policy cover the property destroyed or
damaged in the loss?
◦ Is the claimant entitled to recover?
◦ Did the loss occur at an insured location?
◦ Is the type of loss covered?
◦ Is the claim fraudulent?
Filing a proof of loss:
 A proof of loss may be required before the
claim is paid.
 A proof of loss is a sworn statement by the
insured that substantiates the loss.
 For example, under the homeowners policy, the
insured may be required to file a proof of loss
that indicates the time and cause of the loss,
interest of the insured and others in the
damaged property, other insurance that may
cover the loss, and any change in title or
occupancy of the property during the term of
the policy.
Cont…
 Decision Concerning Payment After the claim is
investigated;
 the adjustor must make a decision concerning payment.
There are three possible decisions.
1. The claim can be paid. In most cases, the claim is paid
promptly according to the terms of the policy. The claim
can be denied.
2. The adjustor may believe that the policy does not cover
the loss, or that the claim is fraudulent.
3. The claim may be valid, but there may be a dispute
between the insured and insurer over the amount to be
paid.
- In the case of a dispute, a policy provision may specify
how the dispute is to be resolved.
- For example, if a dispute arises under the home owner’s
policy, both the insured and insurer select an
independent appraiser.
Investments
 The investment function is an extremely important
function in the overall operations of insurance
companies.
 Since premiums are paid in advance, they can be
invested until needed to pay claims and expenses.
 Life insurance investments have an important
economic and social impact on the nation.
 First, life insurance contracts are long-term in
nature, and the liabilities of life insurers extend over
long periods of time, such as 50 or 60 years.
 Most life insurance investments are therefore long-
term in nature, and the primary investment
objective is safety of principal.
REINSURANCE
 There are many risks in all classes of business which
are too great for one insurer to bear solely on his in
account.
 Reinsurance is a method created to divide the task
of handling risk among several insurers.
 Naturally, the insuring public wishes to effect cover
with one insurer and the insurer who in these
circumstances accept a risk greater than he
considers it prudent to bear, reinsures all or part of
the risk with other direct insures or with companies
which transact reinsurance business only.
 Reinsurance may be defined as the shifting by a
primary insurer, called the ceding company, of a part
of the risk it assumes to another company, called the
re-insurer.
Cont…
 That portion of the risk kept by the ceding company is
known as the line, or retention, and varies with the
financial position of the insurer and the nature of the
exposure.
 When a re-insurer passes on risks to another re-insurer,
the process is known as retrocession.
 It is not good business to refuse to write insurance in
excess of the retention amount, imaging the displeasure
of the applicant and particularly of the producer when
the application is rejected or accepted in part.
 For these and other reasons insurers, commonly insure
that portion of their liability under their contracts in
excess of their retention with one or more insurers.
This process is called reinsurance, the originating insurer
is the “primary insurer” or “direct insurer”, and the
accepting insurer is the “reinsurer”.
 Methods of Reinsurance
1. Facultative reinsurance is reinsurance on an
optional basis.
 There is no advance agreement between the
ceding company and the re-insurer regarding
the sharing of risks and premiums.
 Under this arrangement a primary insurer, in
considering he acceptance of a certain risk,
shops around for reinsurance on it, attempting
to negotiate coverage specifically on this
particular contract.
 Each risk, which is offered, is described and this
is shown to the prospective re-insurers who
are free to accept or decline as they see fit.
2. Automatic Treaty
 Under an automatic reinsurance treaty the ceding
insurer agrees to pass on to the re-insurer all
business included within the scope of the treaty the
re-insurer agrees to accept this business, and the
terms e.g., the premium rates and the method of
sharing the insurance and the losses-of the
agreement are set.
 The ceding company is required to cede some
certain amounts of business, and the re-insurer is
required to accept them.
 The ceding company known in advance that it will be
able to obtain reinsurance for all exposures that
meet the conditions specified in the treaty.
 The amount that the ceding company keeps for its
own account is known as its retention, and the
amount ceded to others is known as cession.
 Forms of Reinsurance
The most important types of reinsurance
treaties include:
 Quota-share reinsurance
 Surplus- share reinsurance
 Excess of loss reinsurance
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