Chapter 6

Insurance
Company
Operations
Agenda

• Rating and Ratemaking

• Underwriting
• Production
• Claims settlement
• Reinsurance
– Alternatives to Traditional Reinsurance
• Investments
• Other Insurance Company Functions

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Rating and Ratemaking

• 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

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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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Underwriting

• Underwriting refers to the process of selecting,

classifying, and pricing applicants for insurance
• 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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Underwriting Principles

• The basic principles of underwriting include:

– Attain an underwriting profit
– Select prospective insureds according to the
company’s underwriting standards
• Reduce adverse selection against the insurer
• Adverse selection is the tendency of people with a
higher-than-average chance of loss to seek insurance
at standard rates. If not controlled by underwriting,
this will result in higher-than-expected loss levels.
– Provide equity among the policyholders
• One group of policyholders should not unduly subsidize
another group

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Steps in Underwriting

• Underwriting starts with the agent

• Information for underwriting comes from:
– The application
– The agent’s report
– An inspection report
– Physical inspection
– A physical examination and attending physician’s
report

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Steps in Underwriting

• 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
• Many insurers now use computerized
underwriting for certain personal lines of
insurance that can be standardized

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Underwriting Considerations

• Other factors considered in underwriting

include:
– Rate adequacy
– Availability of reinsurance
– Whether policy can or should be cancelled or
renewed

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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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Claim Settlement

• The objectives of claims settlement include:

– Verification of a covered loss
– Fair and prompt payment of claims
– Personal assistance to the insured

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Types of Claims Adjustors

• Major types of claims adjustors include:

– An insurance agent often has authority to settle
small first-party claims up to some limit
– A company adjustor is usually a salaried
employee who will investigate a claim, determine
the amount of loss, and arrange for payment.
– An independent adjustor is an organization or
individual that adjusts claims for a fee
– A public adjustor represents the insured and is
paid a fee based on the amount of the claim
settlement

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Steps in Claim Settlement

• The claim process begins with a notice of

loss, typically immediately or as soon as
possible after a loss has occurred.
• Next, the claim is investigated
– An adjustor must determine that a covered loss
has occurred and determine the amount of the
loss
• The adjustor may require a proof of loss
before the claim is paid
• The adjustor decides if the claim should
be paid or denied
– Policy provisions address how disputes may be
resolved

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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
– Finally, the reinsurer in turn may reinsure part or all
of the risk with another insurer. This is known as a
retrocession. In this case, the second reinsurer is
called a retrocessionaire.

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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. It permits the insurer’s liabilities for existing
insurance to be transferred to another carrier; thus,
policyholders’ coverage remains undisturbed.
– Obtain underwriting advice on a line for which the
insurer has little experience

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Types of Reinsurance Agreements

• 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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Methods for Sharing Losses

• 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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Methods for Sharing Losses

• 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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Methods for Sharing Losses
• 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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Methods for Sharing Losses

• If a $5000 loss occurs:

Apex Fire $200,000 (1 line)

Geneva Re $800,000 (4 lines)
Total Underwriting Capacity $1,000,000
$500,000 policy issued
Apex Fire $200,000 (2/5)
Geneva Re $300,000 (3/5)
$5000 loss occurs
Apex Fire $2000 (2/5)
Geneva Re $3000 (3/5)

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Methods for Sharing Losses

• 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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Methods for Sharing Losses

• 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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Other Insurance Company Functions

• 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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