chapter 6: financial operations of i nsurers

Chapter 6

FINANCIAL OPERATIONSOF I NSURERS

By: Marya sholevar

PROPERTY AND CASUALTY INSURERS

To understand the financial operations of an insurance company, it is necessary to examine the insurer’s financial statements. Two important financial statements are the balance sheet and the income and expense statement.● A balance sheet is a summary of what a company owns

(assets), what it owes (liabilities), and the difference between total assets and total liabilities (owners’ equity) .

● This financial statement is called a balance sheet because the two sides of the financial statement must be equal:– Total assets = Total liabilities + Owners’ equity

PROPERTY AND CASUALTY INSURERS

● The primary assets for an insurance company are financial assets. An insurance company invests premium dollars and retained earnings in financial assets.

● Liabilities: An insurer is required by law to maintain certain reserves on its balance sheet. Because premiums are paid in advance, but the period of protection extends into the future, an insurer must establish reserves to assure that premiums collected in advance will be available to pay future losses.

● A property and casualty insurer is required to maintain two principal types of financial reserves:

– Loss Reserves– Unearned Premium Reserve

Liabilities: Loss Reserves

● A loss reserve is the estimated cost of settling claims for losses that have already occurred but that have not been paid as of the valuation date . More specifically, the loss reserve is an estimated amount for (1) claims reported and adjusted but not yet paid, (2) claims reported and filed, but not yet adjusted, and (3) claims for losses incurred but not yet reported to the company .

● Loss reserves in property and casualty insurance can be classified as case reserves, reserves based on the loss ratio method, and reserves for incurred but not reported claims.


● Case reserves are loss reserves that are established for each individual claim when it is reported .

● Major methods of determining case reserves include the following: the judgment method, the average value method, and the tabular method.

● Under the judgment method, a claim reserve is established for each individual claim. The amount of the loss reserve can be based on the judgment of someone in the claims department or estimated using a computer program.


● When the average value method is used, an average value is assigned to each claim. This method is used when the number of claims is large, and the average claim amount is relatively small.

● Under the tabular value method, loss reserves are determined for claims for which the amounts paid depend on life expectancy, duration of disability, and similar factors.– The loss reserve is called a tabular reserve because the duration

of the benefit period is based on data derived from mortality and morbidity tables.

Liabilities:Loss Reserves

● The loss ratio method (loss reserves) establishes aggregate loss reserves for a specific coverage line. Under the loss ratio method, a formula based on the expected loss ratio is used to estimate the loss reserve.

● The expected loss ratio is multiplied by premiums earned during a specified time period.

● The incurred-but-not-reported (IBNR) reserve is a reserve that must be established for claims that have already occurred but have not yet been reported to the insurer .

Liabilities: Unearned Premium Reserve

● The unearned premium reserve is a liability item that represents the unearned portion of gross premiums on all outstanding policies at the time of valuation .

● An insurer is required by law to place the entire gross premium in the unearned premium reserve when the policy is first written, and to place renewal premiums in the same reserve.


● Purpose of the unearned premium reserve:– The fundamental purpose,pay for losses that occur during

the policy period– Premium refunds can be paid to policyholders in the

event of coverage cancellation .– If the business is reinsured, the unearned premium

reserve serves as the basis for determining the amount that must be paid to the reinsurer for carrying the reinsured policies until the end of their terms .


● Calculate the unearned premium reserve by annual pro rata method: Under the annual pro rata method , it is assumed that the policies are written uniformly throughout the year.

● For purposes of determining the unearned premium reserve, it is assumed that all policies are written on July 1, which is the average issue date. Therefore, on December 31, the unearned premium reserve for all one-year policies is one-half of the premiums attributable to these policies.

Policyholders’ Surplus

● Policyholders’ surplus is the difference between an insurance company’s assets and liabilities . It is not calculated directly—it is the “balancing” item on the balance sheet.

● If the insurer were to pay all of its liabilities using its assets, the amount remaining would be policyholders’ surplus.

● Surplus can be thought of as a cushion that can be drawn upon if liabilities are higher than expected.

● Surplus represents the paid-in capital of investors plus retained income from insurance operations and investments over time.

● The level of surplus is also an important determinant of the amount of new business that an insurance company can write.

Income and Expense Statement

● The income and expense statement summarizes revenues received and expenses paid during a specified period of time .

● Revenues are cash inflows that the company can claim as income. The two principal sources of revenues for an insurance company are premiums and investment income.

● Earned premiums represent the portion of the premiums for which insurance protection has been provided .

Income and Expense Statement

● Expenses Partially offsetting the company’s revenues were the company’s expenses, which are cash outflows from the business.

● The major expenses for an Insurance Company:– Adjusting claims – Paying the insured losses– Underwriting

Measuring Profit or Loss

● A simple measure that can be used is the insurance company’s loss ratio and expense ratio.

● The loss ratio is the ratio of incurred losses and loss adjustment expenses to premiums earned .

● Loss ratio= (Incurred losses+Loss adjustment expenses)/Premiums earned

● The expense ratio is equal to the company’s underwriting expenses divided by written premiums .

● Expense ratio=Underwriting expenses/Premiums written


● The combined ratio is the sum of the loss ratio and expense ratio.

● The combined ratio is one of the most common measures of underwriting profitability. If the combined ratio exceeds 1 (or 100 percent), it indicates an underwriting loss. If the combined ratio is less han 1 (or 100 percent), it indicates an underwriting profit .

● A property and casualty insurance company can lose money on its underwriting operations, but still report positive net income if the investment income offsets the underwriting loss.


● The investment income ratio compares net investment income to earned premiums .

● Investment income ratio = Net investment income/Earned preminus

● To determine the company’s total performance (underwriting and investments), the overall operating ratio can be calculated.

● The overall operating ratio is equal to the combined ratio minus the investment income ratio .

● Overall operating ratio = Combined ratio - Investment income ratio

LIFE INSURANCE COMPANIES

● Balance Sheet: The balance sheet for a life insurance company is similar to the balance sheet of a property and casualty insurance company.

● The Assets of a life insurance company are primarily financial assets.

● Differences between the assets of property and casualty insurance and life insurance :

– Average duration of the investments:life insurance company investments, on average, should be of longer duration than property and casualty insurance company investments.

– Savings element in cash-value life insurance:Permanent life insurance policies develop a savings element over time called the cash value, which may be borrowed by the policyholder.

– Life insurance company may have separate account assets:Life insurers use separate accounts for assets backing interest-sensitive products, such as variable annuities, variable life insurance, and universal-variable life insurance.


● Liabilities: Policy reserves are the major liability item of life insurers. Major Liabilities in life insurance are Policy reserves, reserve for amounts held on deposit and the asset valuation reserve.

● Policy reserves are a liability item on the balance sheet that must be offset by assets equal to that amount .

● Policy reserves are considered a liability item because they represent an obligation of the insurer to pay future policy benefits.

● Policy reserves are often called legal reserves because state insurance laws specify the minimum basis for calculating them.


● The reserve for amounts held on deposit is a liability that represents funds owed to policyholders and to beneficiaries .

● The asset valuation reserve is a statutory account designed to absorb asset value fluctuations not caused by changing interest rates .

● Policyholders’ surplus is the difference between a life insurer’s total assets and total liabilities.

● Income and Expense Statement:The major sources of revenues are premiums received for the various products sold and income from investments.


● Income and Expense Statement:Investment income can take the form of periodic cash flows and realized capital gains or losses.

● Claims payments are a major expense such as:– Death benefits paid to beneficiaries, Annuity benefits paid to

annuitants,Matured endowments paid to policyholders,Benefits paid under health insurance policies,Surrender benefits to policyholders who choose to terminate their cash-value life insurance

● A life insurer’s net gain from operations (also called net income) equals total revenues less total expenses, policyholder dividends, and federal income taxes

● Measuring Financial Performance: pre-tax or after-tax net income could be compared to total assets and the rate of return on policyholders’ surplus, similar to a return on equity (ROE) ratio.

RATE MAKING IN PROPERTYAND CASUALTY INSURANCE

● Objectives in Rate Making: rate-making goals can be classified into two categories: regulatory objectives and business objectives.

● Regulatory Objectives :The goal of insurance regulation is to protect the public.In general, rates charged by insurers must be adequate, not excessive, and not unfairly discriminatory.

● The first regulatory requirement is that rates must be adequate. This means the rates charged by insurers should be high enough to pay all losses and expenses .


● The second regulatory requirement is that rates must not be excessive. This means that the rates should not be so high that policyholders are paying more than the actual value of their protection .

● The third regulatory objective is that the rates must not be unfairly discriminatory. This means that exposures that are similar with respect to losses and expenses should not be charged significantly different rates .


● Business Objectives:Insurers are also guided by business objectives in designing a rating system. The rating system should meet all of these objectives: simplicity, responsiveness, stability, and encouragement of loss control.

● Simplicity:The rating system should be easy to understand so that producers can quote premiums with a minimum amount of time and expense.

● Rates should be Stable over short periods of time so that consumer satisfaction can be maintained.

● Rates should also be Responsive over time to changing loss exposures and changing economic conditions.

● Loss-control efforts are designed to reduce the frequency and severity of losses. This point is important because loss control tends to keep insurance affordable.

Basic Rate-Making Definitions

● A rate is the price per unit of insurance . ● An exposure unit is the unit of measurement used in insurance

pricing .● The pure premium refers to that portion of the rate needed to pay

losses and loss-adjustment expenses . ● The loading refers to the amount that must be added to the pure

premium for other expenses,profit, and a margin for contingencies . ● The gross rate consists of the pure premium and a loading element

.● The gross premium paid by the insured consists of the gross rate

multiplied by the number of exposure units .

Rate-Making Methods

● There are three basic rate-making methods in property and casualty insurance:– Judgment rating– Class rating– Merit rating

● Schedule rating● Experience rating● Retrospective rating

● Merit rating, in turn, can be broken down into schedule rating, experience rating, and retrospective rating.

Rate-Making Methods

● Judgment rating means that each exposure is individually evaluated, and the rate is determined largely by the judgment of the underwriter .

● Class rating means that exposures with similar characteristics are placed in the same underwriting class, and each is charged the same rate .

● The major advantage of class rating is that it is simple to apply. Also, premium quotations can be quickly obtained. As such, it is ideal for the personal lines market.

● Class rating is also called manual rating .

Rate-Making Methods

● There are two basic methods for determining class rates: the pure premium method and the loss ratio method.– The pure premium can be determined by dividing the dollar

amount of incurred losses and loss adjustment expenses by the number of exposure units .

● Pure premium=Incurred losses and loss adjustment expenses/Number of exposure units

● The final step is to add a loading for expenses, underwriting profit, and a margin for contingencies.

● The expense loading is usually expressed as a percentage of the gross rate and is called the expense ratio.

● Gross rate =Pure premium/(1 - Expense ratio)

Rate-Making Methods

– Loss Ratio Method. Under the loss ratio method, the actual loss ratio is compared with the expected loss ratio, and the rate is adjusted accordingly.

– The actual loss ratio is the ratio of incurred losses and loss-adjustment expenses to earned premiums.

– The expected loss ratio is the percentage of the premium that can be expected to be used to pay losses.

– Rate change=(A-E)/E● where A = Actual loss ratio● E =Expected loss ratio

Rate-Making Methods

– Merit rating is a rating plan by which class rates (manual rates) are adjusted upward or downward based on individual loss experience .

● Merit rating is based on the assumption that the loss experience of a particular insured will differ substantially from the loss experience of other insureds.

● There are three types of merit rating plans: schedule rating, experience rating, and retrospective rating.– Under a schedule rating plan, each exposure is individually rated. – Schedule rating is used in commercial property insurance for large,

complex structures, such as an industrial plant. Each building is individually rated based on several factors, including construction, occupancy, protection, exposure, and maintenance.

Rate-Making Methods

– Construction refers to the physical characteristics of the building.

– Occupancy refers to the use of the building.– Protection refers to the quality of the city’s water supply and

fire department. It also includes protective devices installed in the insured building.

– Exposure refers to the possibility that the insured building will be damaged or destroyed by a peril, such as fire that starts at an adjacent building and spreads to the insured building.

– Maintenance refers to the housekeeping and overall upkeep of the building.

Rate-Making Methods

● Under Experience rating , the class or manual rate is adjusted upward or downward based on past loss experience . The most distinctive characteristic of experience rating is that the insured’s past loss experience is used to determine the premium for the next policy period .– Rate change=((A-E)/E)*C

● where A = Actual loss ratio● E =Expected loss ratio● C=Credibility factor

● Under a Retrospective rating plan, the insured’s loss experience duringthe current policy period determines the actual premium paid for that period .

RATE MAKING IN LIFEINSURANCE

● Life insurance actuaries use a mortality table or individual company experience to determine the probability of death at each attained age.

● The probability of death is multiplied by the amount the life insurer will have to pay if death occurs to determine the expected value of the death claims for each policy year.

● These annual expected values are then discounted back to the beginning of the policy period to determine the net single premium (NSP). The NSP is the present value of the future death benefit.

chapter 6: financial operations of i nsurers

Education