Insurance is vital to a free enterprise economy. It protects society from the consequences of financial loss from death, accidents, sicknesses, damage to property, and injury caused to others. The person seeking to transfer risk, the insured (policyholder), pays a relatively small amount, the premium, to an insurance company, the insurer, which issues an insurance policy in which the insurer agrees to reimburse the insured for any losses covered by the policy. Insurance is the process of spreading the risk of economic loss among as many as possible subject to the same kind of risk and is based on the laws of probability (chance of a given outcome happening) and large numbers (enables the laws of probability to work).There are many perils (causes of loss) that society faces, some natural (e.g., earthquakes, hurricanes, tornados, flood, drought), some human (e.g., arson, theft, fraud, vandalism, contamination, pollution, terrorism), and some economic(e.g.,expropriation, inflation, obsolescence, depressions/recessions). Insurers are able to provide coverage for virtually any predictable loss.
Concepts of insurance evolved thousands of years ago. The Chinese, for example, divided their cargoes among many boats to reduce the severity of loss from the perils of the seas, while the biblical story of Joseph and the famine in Egypt illustrates the storing of grain during the seven good years to relieve shortages during the seven years of famine. Marine insurance emerged in London when ships sailed for the New World. Fire insurance arose from the great fire of London in 1666, in which 14,000 buildings were destroyed. In 1752 Benjamin Franklin founded the first mutual fire insurance company in the United States, the Philadelphia Contributorship for the Insurance of Houses from Loss by Fire. In 1759, he helped establish the first life insurance company, now known as the Presbyterian Ministers Fund. In 1887 the first auto-liability policy was written. Advancing technologies and a dynamic marketplace constantly change society's insurance needs. The insurance industry's goal is to respond to those needs with available and affordable insurance.
U.S. INSURANCE INDUSTRY
The U.S. insurance industry is comprised of approximately 1600 life (life/health) and 3000 nonlife (property/casualty) insurance and reinsurance companies; it is the world's largest insurance market, accounting for $736 billion or 34 percent of 1998's worldwide premiums of $2.2 trillion. Insurance is sold either directly by insurers (direct insurers)orthroughthe independent agency system, exclusive agencies, and brokers.
Based on the 1997 U.S. Bureau of Labor Statistics, the life and health insurance industry employed 909,000 persons and the property/casualty insurance industry, 635,000; 706,000 persons were engaged in agency or brokerage activities and in insurance service organizations.
Life/health insurance in the United States in 1998 represented 27.6 percent of the worldwide market, second to Japan's 28.6 percent and well ahead of the United Kingdom's 9.8 percent, which ranked third. A variety of life insurance (which provides income for a beneficiary at the insured's death), annuities (provides income for life for the annuitant), and health care products are offered. In 1997 Americans purchased $1.97 trillion of new life insurance; the average new policy totaled $97,358. Term policies and ordinary/whole life policies account for virtually all of the total life insurance in-force of $13.2 trillion. At the end of 1997, 373 million policies were inforce with an average size of $165,800 per insured household. Term policies provide "pure insurance" (no cash value) and maximally cost-effective protection to growing families.
Ordinary/whole life policies provide protection as well as building up cash values (investment component), which the policyholder can either borrow on or obtain by surrendering the policy. Life/health policies are sold on an individual or group basisthe employer or association receives the master policy and the insured members receive certificates of insurance). Annuities-fixed (predetermined amount) and variable (varies with investment returns) can be purchased by making a single payment or a series of payments. The annuity income can start immediately or at some future date. Different types of annuity contracts meet different needs. Today there is a strong demand for individual annuity products, driven by the movement of the baby boomers through the preretirement phase, increased life expectancy and the fear of outliving savings, and concerns about the long-term viability of Social Security. Health (medical, disability, long-term care) insurance plans are offered by insurance companies, managed health care organizations, and medical prepayment organizations. Long term care products provide for reimbursement for covered nursing home and home health care expenses incurred due to physical or mental disability. The top ten U.S. life insurance companies are shown in Table 1.
PROPERTY/CASUALTY (P&C) INSURANCE
The United States dominates the world in P&C insurance (also known as general insurance). In 1998 the U.S. generated 43.4 percent of worldwide P&C premiums, Japan was next with 10.3 percent and Germany third with 8.8 percent. P&C insurance is broken down into personal lines (auto/private passenger and homeowners) and commercial lines (farm, commercial auto, aviation, marine/ocean/inland, crime, surety, boiler and machinery, glass, commercial credit, workers' compensation, public liability (including environmental pollution), professional liability (directors and officers, errors and omissions), product liability, commercial multiple-line, nuclear, title, and surplus and excess lines insurance). The top ten U.S. P&C insurers are shown in Table 2.
Insurers primarily operate as stock (owned by stockholders) or mutual (owned by policyholders) companies. Today, many mutual companies are changing to stock companies (demutualizing) to facilitate the raising of capital. Other forms of structure are pools and associations
Top Ten U.S. Life Insurers Ranked by Life Insurance In-Force 1998
|Metropolitan Life Insurance||$1,545,453|
|Prudential Insurance Company of America||1,013,109|
|Connecticut General Life Insurance||543,369|
|Northwestern Mutual Life Insurance||536,379|
|Transamerica Occidental Life||498,247|
|New York Life Insurance||440,527|
|Aetna Life Insurance||385,525|
|Lincoln National Life Insurance||367,155|
|State Farm Life Insurance||347,430|
(groups of insurers), risk retention groups, purchasing groups, and fraternal organizations (primarily life and health insurance). An insurer within a given state is classified domestic, if formed under that state, foreign, if incorporated in another state, or alien, if incorporated in another country.
The key functions of an insurer are marketing, underwriting, claims (investigation and payment of legitimate claims as well as defending against illegitimate claims), loss control, reinsurance, actuarial, collection of premiums, drafting of insurance contracts to conform with statutory law, and the investing of funds. Underwriters are expert in identifying, understanding, evaluating, and selecting risks. Actuaries play a unique and critical role in the insurance process; they price the product (the premium) and establish the reserves.
The primary goal of an insurer is to underwrite profitably. Disciplined underwriting combined with sound investing and asset/liability management enables an insurer to meet its obligations to both policyholders and stockholders. Underwriting combines many skillsinvestigative, accounting, financial, psychological. While some lines of business (e.g homeowners, auto) are underwritten manually or class rated, many large commercial property and casualty
Top Ten U.S. Property/Casualty Insurers Ranked by Net Premiums Written (NPW) 1998
|NPW* (in millions)||Combined Ratio**|
|* Net premiums written includes only premiums written by domestic companies.|
|**A combined ratio of less than 100.0 indicates an underwriting profit.|
|State Farm Group||$34,755.3||108.2|
|Allstate Insurance Group||19,072.1||95.5|
|American International Group||10,727.9||99.5|
|Farmers Insurance Group||10,316.4||101.7|
|CNA Insurance Group||10,044.0||115.2|
|Travelers Property Casualty Group||8,209.8||102.3|
|Berkshire Hathaway Insurance Group||7,731.8||95.7|
|Liberty Mutual Insurance Group||7,197.2||117.0|
|The Hartford Insurance Group||6,028.4||105.9|
risks are judgment rated, relying on the underwriter's skill, experience and intuition.
PRODUCT AND RATINGS
The Insurance Policy varies among states and class of business; however, there are common features.
- Declaration Page: names the policyholder, de scribes the property or liability to be insured, type of coverage, and policy limits.
- Insuring Agreement: describes parties' responsibilities during the policy term.
- Conditions of the Policy: details coverage and requirements in event of a loss.
- The Exclusions: describes types of property and losses not covered. The states and insurers continually work together to make the policy more readable.
A. M. Best is the key rating organization of the industry. The Best's Ratings range from the excellent category (A++ and A+) to the lowest categories (under regulatory supervision), F (in liquidation), and S (rating suspended). Other important rating organizations are Moody's and Standard and Poor's.
ROLE OF GOVERNMENT
Federal and state governments play important roles in managing large social insurance programs, such as social security, medicare, unemployment compensation, federal deposit insurance, and pension benefit guaranty. In these areas the government acts either as a partner or competitor to the insurance industry, or as an exclusive provider. Federal and state governments also manage property and casualty programs, such as "all-risk" crop, crime, flood, and workers' compensation.
Reinsurance is critical to the insurance process; it brings capacity, stability, and financial strength to insurers. The purpose of reinsurance is to spread large risks and catastrophes over as large a base as possible. It is the assumption by one insurance company (the reinsurer) of all or part of a risk undertaken by another insurance company (the cedent). It enables an insured with a sizable risk exposure to deal with and receive coverage from one insurer, rather than dealing with a number of insurers. The portion of the risk that exceeds the primary insurer's retention level is layed-off (ceded) to a reinsurer. The reinsurer can further reinsure a part of the risk assumed; this is called retroceding. If the reinsurer agrees to share losses arising from only one risk, the agreement is known as facultative reinsurance; if the reinsurer agrees to share losses arising from more than one risk, usually a whole line or book of business, the agreement is known as treaty reinsurance. Western Europe is the largest provider of worldwide reinsurance. The Caribbean, including Bermuda, is the largest foreign supplier of reinsurance to the United States. The financial strength of the reinsurer is most important, since the direct writer is always primarily responsible for payment of losses.
Under the McCarran-Ferguson Act of 1945, state insurance departments bear the primary responsibility to oversee insurance companies' operations to protect policyholders from insurer insolvency and unfair treatment. In doing so, they license insurers, agents, and brokers; enforce statutory accounting requirements; and conduct examinations of the financial position and market conduct of insurers. The examination is assisted by the Insurance Regulatory Information System (IRIS) Ratios, which test insurers' overall profitability, liquidity, and reserve strength. State insurance departments work with the National Association of Insurance Commissioners (NAIC) to develop and promote laws and regulations that serve as model laws, with the state legislatures, which pass the laws and set the budgets; with the courts, which interpret insurance regulations and policy wording; with Congress and the U.S. General Accounting Office, which periodically evaluate state insurance regulation; and with professional, trade, and consumer groups.
Because the insurance market has many sellers and buyers, little product differentiation, and freedom of entry and exit, it is highly competitive. This is especially true in the P&C segment, where the leading company accounts for only 12 percent of the market and the top ten companies combined comprise only 44 percent. While demand for insurance grows steadily over time, with the increase in exposures and legal requirements, the supply of insurance, because it is financial and flexible, can be easily shifted in and out of the market. This attracts capital during periods of high interest and stock market strength because of high profit expectations from investing underwriting cash flows.
This excess capacity in the insurance industry has led to consolidation and convergence with capital markets and financial service institutions. Insurance companies seek to operate more efficiently and improve their communication and distribution systems. Combining insurance with other financial products and services is perceived to provide better sources for customers.
AN INDUSTRY IN TRANSFORMATION SECURITIZATION
With population growing in coastal, as well as hurricane, and earthquake-prone areas in the United States and scientists predicting a 100 percent chance of a major earthquake in the century before 2010, the insurance industry is faced with a potential mega disaster earthquake or hurricane that could produce insured losses in the $75,000,000,000 to $100,000,000,000 range. Losses of that magnitude would wreak havoc to the industry (see Table 3 for a list of the ten largest catastrophes as of 1999). In 1996, the industry started to securitize its catastrophe risk by packaging insurance risk as securities that could be traded in the capital markets, whose combined $26 trillion is 80 times greater than the capital of the insurance industry. To date, the industry has been successful in selling more than $4 billion worth of catastrophe-linked securities; it plans to build on these successes and continue to spread catastrophe risks to the capital markets through the issuance of catastrophe securities. As the insurance industry continues to converge with the capital markets and the financial services industry, other lines of business are likely to be securitized.
While reinsurers have always had an international presence and brokers have moved in that direction, primary insurers, with one notable exception, have been reluctant to expand internationally. The rapid growth of computer technology, however, has transformed the world into one global economy, in which U.S. and foreign insurers must, along with all other businesses, compete.
The insurance industry continues to explore new distribution systems, including the Internet and formation of alliances with banks and other financial services organizations in an effort to become more efficient and focused on the customer, who today places as much importance on service and convenience, as on price.
"The Art of Underwriting," "Memo from MRG," Contact (New York, American International Group), 1982, p 5-9,24.
Best's Aggregate & Averages-Property/Casualty, (Oldwick, N.J., A. M. Best Company), 1999.
Best's Insurance Reports-Life/Health, (Oldwick, N.J., A. M. Best Company), 1999, p. A87.
"Chasing the Markets," Board Member-Special Supplement (Brentwood, TN: Board Member Inc), 1998, p. 4-9.
"Convergence 101," Special Report, The Insurance Tax Review, November 1998.
"Disaster Relief," Best's Review Property/Casualty, (Oldwick, N.J., A. M. Best Company), April 2000.
Insurance Operations, Volumes I and II, (Malvern, Pennsylvania, American Institute For Chartered Property Casualty Underwriters (CPCU), First Edition, 1992.
Let the Trumpet Resound, Lawrence G. Bandon, CPCU (Malvern, Pennsylvania, CPCU-Harry J. Loman Foundation) 1996.
Life Insurance Fact Book, (Washington, D.C., American Council of Life Insurance), 1998.
"Securitization Frontierland," Best's Review Property/Casualty, (Oldwick, N.J., A. M. Best Company), July 1999.
Sharing the Risk, (New York: Insurance Information Institute), Revised, Second Edition, 1985.
Statistical Abstract of the United States, (Washington, D.C., U.S. Census Bureau), 1999, p. 515, 540, 541.
Swiss Re. sigma No.2/2000, sigma No. 7/1999 (Zurich, Swiss Reinsurance Company).
"Top 250 Property/Casualty Insurers by Net Premiums Written," Best's Review Property/Casualty, (Oldwick, N.J., A. M. Best Company), July 1999.
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