Basic Principles of Risk Management Insurance A Seminar

Basic Principles of Risk Management & Insurance A Seminar for South Carolina State Legislators January 17, 2013 Faith R. Neale, Ph. D. Associate Professor of Risk Management and Insurance Department of Finance Belk College of Business, UNC Charlotte The Griffith Insurance Education Foundation 1

Seminar Overview § § § Overview of Insurance Market Industry Overview Ratemaking Underwriting Insurance Regulation The Griffith Insurance Education Foundation 2

Why do we need insurance? Comply with law and manage risk § Comply with lender requirements § § Auto, Home Comply with state and federal law § § § State: auto liability limits, worker’s compensation Federal: PPACA Asset protection and financial security § Risk The Griffith Insurance Education Foundation 3

What is insurance? “The pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk. ” ARIA, 1965 The Griffith Insurance Education Foundation 4

Characteristics of insurance § Risk transfer § § The insurer promises to pay under certain conditions Pooling of losses § § § Substitutes average loss of pool for actual loss Law of Large Numbers Payment of fortuitous losses § § Sudden and accidental, unforeseen and unexpected Indemnification § Restore to original financial position The Griffith Insurance Education Foundation 5

Categories of Insurance § § Personal and Commercial lines Property/Casualty and Life/Health The Griffith Insurance Education Foundation 6

Overview of Insurance Market The Griffith Insurance Education Foundation 7

2011 P&C U. S. NPW by Line The Griffith Insurance Education Foundation 8 Source: SNL Financial, Inc.

2011 Life/A&H U. S. NPW by Line The Griffith Insurance Education Foundation 9 Source: SNL Financial, Inc.

2011 U. S. Net Premiums Written $175 B $502 B P&C Life A&H $576 B The Griffith Insurance Education Foundation 10 Source: SNL Financial, Inc.

Industry Overview The Griffith Insurance Education Foundation 11

INDUSTRY CHARACTERISTICS Types of Private Insurers Form of Ownership Proprietary Place of Incorporation Cooperative Admitted FOREIGN Stock Cos Mutual Cos ALIEN Lloyds Licensing Status Non. Admitted Surplus Lines Reciprocals DOMESTIC Pools Syndicate Reinsurance The Griffith Insurance Education Foundation 12 Slide by Kevin Eastman, Georgia Southern University

Surplus Lines § Distressed (risk or market) § § § Unique or Unusual § § Shamu, Hole-in-One coverage High Capacity § § Risk – Physician with drug use Market – Compounding pharmacies Corporate jet, high rise Product Innovation § Cyber Liability, EPL The Griffith Insurance Education Foundation 13

INDUSTRY CHARACTERISTICS Public Insurers § § Federal § National Flood Insurance Program § Social Security (OASDI), Medicare, Unemployment, Railroad Retirement Act § Terrorism Risk and Insurance Act (TRIA) § Crop Insurance State § Wind (and hail) Pools, FAIR plans § Workers Compensation pools § Auto liability and health insurance pools The Griffith Insurance Education Foundation 14

SC Wind and Hail Underwriting Association(JUA) § § Residual property insurance market – insurer of last resort Covers wind and hail in coastal “beach” areas All insurers licensed to write property insurance are members. All insurers that write property insurance share in the losses and profits of the association. The Griffith Insurance Education Foundation 15

Characteristics of an (ideally) insurable risk § § § Large number of exposure units Accidental and unintentional loss Determinable and measurable No catastrophic loss Calculable chance of loss Economically feasible premium The Griffith Insurance Education Foundation 16

Ratemaking The Griffith Insurance Education Foundation 17

RATEMAKING OBJECTIVES INSURER OBJECTIVES REGULATORY OBJECTIVES Primary Objectives Adequate Low enough to be competitive. High enough to be profitable. Not Excessive Not Unfairly Discriminatory Secondary Objectives TYPES OF RATING LAWS Stability 1. Prior Approval Laws (SC) 2. File & Use Laws 3. Use & File Laws 4. Flex Rating Laws (SC with 7% band) 5. Open Competition (No-File) Laws Responsiveness Promote Loss Control Contingencies Simplicity Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation 18

The Actuary § What are actuaries? § Evaluate the financial consequences of future events § “Actuaries put a price tag on risk. ” American Academy of Actuary § Functions in Insurance § Direct ratemaking operations § Loss development factors and trends § Set loss reserves (case inadequacies and IBNR) The Griffith Insurance Education Foundation 19

ESTIMATING RATES Pure Premium Method Pure Premium GROSS RATE Paid Losses Loss Reserves ESTIMATION PROBLEMS 1. Errors in Loss Reserves 2. Inflation 3. Credibility of Data SOLUTIONS 1. Loss Development 2. Trending 3. Credibility Factors + Expenses Loading Profit Contingencies The Griffith Insurance Education Foundation 20

THE RATEMAKING PROCESS Steps in the Ratemaking Process STEP DESCRIPTION Step 1 Collect Statistics Step 2 Adjust Statistics Step 3 Calculate the Statewide Average Rate Step 4 Calculate the Territorial & Class Relativities / Rates Step 5 Prepare & Submit the Rate Filing Step 6 Follow-Up to Obtain Necessary Regulatory Action Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation 21

Underwriting The Griffith Insurance Education Foundation 22

UNDERWRITING Definition & Objective DEFINITION The process of determining what loss exposures will be insured, for what amount of insurance, at what price, and under what conditions. OBJECTIVE To develop & maintain a profitable book of business by avoiding adverse selection. Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation 23

The Adverse Selection Problem § § Definition: The tendency of higher-thanaverage risks to seek insurance. Illustration: 2 risk types in population § § Low risk: 1 in 10, 000 die each year High risk: 1 in 100 die each year Insurer knows 50% of the population low versus high risk but can’t tell which is which Is it feasible to create an insurance pool with both types in it? Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation 24

The Adverse Selection Problem (cont. ) § Example life insurance pool: 2, 000 people, $200, 000 face value each § § § Will this insurance pool be feasible? § § Expected loss per low risk (1/10, 000)= $20 Expected loss per high risk (1/100)= $2, 000 Expected loss for the pool = $2, 020, 000 Per policy to break even= $2, 020, 000/2, 000 = $1, 010 Will the low risk people want to buy it? Will the high risk people want to buy it? What if the pool gets more high risks than low risks? How could another insurer enter the market and attract away all the low risks? Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation 25

Key Points about Adverse Selection § Risk pooling doesn’t work if the risk is too high § § e. g. life insurance for fatally ill people; homeowners in disaster-prone regions Risk pooling doesn’t work with too many high risks § § Low risks aren’t willing to excessively subsidize the high risks incentive to be uninsured Insurers need to be able to identify risk type so that they can put similar risks together in a pool to make it fair and affordable § § Insurers who don’t use available information to classify PHs will experience adverse selection Competition will drive premiums to the appropriate level for risk type Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation 26

Tools to mitigate adverse selection § § § CLUE Insurance (FICO) score Property inspection Medical information bureau (MIB) MVR The Griffith Insurance Education Foundation 27

The “Moral Hazard” Problem § Definition: Dishonesty or character defects that increase the frequency or severity of loss because insureds can profit from a loss Examples: § § § Faking accidents, disability Exaggeration of claims Failure to control losses (not locking car or house) – moral hazard Intentional losses Overutilization of insurance (e. g. health) Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation 28

Controls on Moral Hazard § § § § Can’t insure in excess of the loss Limits on underinsuring property Careful claims adjusting Deductibles and coinsurance Waiting periods Exclusions Limits Riders Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation 29

Availability and/or Affordability § One of the primary disputes in insurance § § Insurance supply is low (and/or) Insurance cost is high Conflict arises especially in hard to price markets such as high hazard areas, new exposures, unknown outcomes, catastrophes Department of Insurance must ensure insurer solvency to protect the consumer The Griffith Insurance Education Foundation 30

Insurance Regulation The Griffith Insurance Education Foundation 31

REASONS FOR INSURANCE REGULATION Three Primary Reasons TO PROTECT CONSUMERS Policy Forms Fraud Availability Set coverage standards, specify policy language, disapprove unacceptable policies. Protect against misrepresentations by agents & unfair practices or dishonesty of insurers. Restrictions on cancellation and non-renewal of coverage. TO MAINTAIN INSURER SOLVENCY Reasons for Solvency Regulation Insurance provides future protection, and insolvent insurers cannot fulfill their obligations. Large numbers of people are adversely affected when insurers become insolvent. Substantial funds held by insurers for the benefit of policyholders must be safeguarded. TO PREVENT DESTRUCTIVE COMPETITION Rate Competition Under-pricing leads to insurer insolvencies and shortages of insurance (as insurers withdraw from the market or stop writing new business). Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation 32

INSURANCE REGULATORY ACTIVITIES Major Activities of Insurance Regulation Forming & Licensing Insurers Licensing Insurance Personnel Monitoring Insurer Solvency REGULATORY ACTIVITIES Regulating Insurance Rates Regulating Insurance Policies Monitoring Market Conduct Ensuring Consumer Protection Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation 33

Principal Balance Sheet Elements Assets Liabilities Bonds Stocks Cash Premium balances Reinsurance recovery Losses Loss Adj Expenses Unearned Premiums PH Surplus Policyholder Surplus = Assets - Liabilities Premiums-to-surplus (capacity) ratio must not exceed 300% or a 3 -to-1 ratio of net premiums written to surplus. The Griffith Insurance Education Foundation 34

FUNCTIONS OF REINSURANCE BENEFITS FOR INSUREDS & INSURERS Benefits for Insureds All coverage can be obtained from one insurer, reducing the chance of coverage gaps & problems in loss collection. Reduces the chance of primary insurer insolvency. *** Benefits for Insurers Stabilizes loss experience. Increases large line capacity. Provides surplus relief. *** Protects against catastrophic losses. *** Allows small insurers to compete with large insurers, which should increase availability & reduce price. *** Provides underwriting assistance. Allows withdrawal from a territory or class of business. The Griffith Insurance Education Foundation 35

INSURANCE REGULATORY ACTIVITIES Monitoring Insurer Solvency To reduce the risk of insolvency and to protect the public against loss when insurers fail. Reasons for Insolvency Rapid premium growth. Inadequate rates & reserves. Methods to Ensure Solvency Require annual financial statements in a prescribed format & review. Excessive expenses. Off-site monitoring: Administer FAST and IRIS. Lax controls over MGAs. Conduct on-site field examinations (every 3 -5 years). Uncollectible reinsurance. Establish financial requirements (e. g. , minimum capital & surplus reqs). RBC Fraud. Liquidation of Insolvent Insurers Insolvent insurers are placed into receivership by state ins. department Rehabilitation, if possible. If impossible to rehabilitate, the co. is liquidated according to the state’s insurance code. Control significant, broad-based, riskrelated activities. Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation 36

Primary avenues for HO insurance in South Carolina § Standard insurers § § § SC Wind and Hail Association (market of last resort) National Flood Insurance Program Surplus lines, cover all perils as above. Normally a higher premium. The Griffith Insurance Education Foundation 37

2011 Direct Premiums Written, SC $97 M $46 M Standard Insurers Wind & Hail Pool $1. 3 B Excess & Surplus This does not include flood premiums. The Wind and Hail Association includes commercial property. Source: SNL Financial, Inc. ; SC Wind and Hail Assoc The Griffith Insurance Education Foundation 38

SC Homeowner MP Insurers 160 147 140 116 120 109 117 124 128 135 107 100 80 60 40 20 20 1 2 Q 13 11 20 10 20 09 20 08 20 07 20 06 20 05 20 19 96 0 Source: SNL Financial, Inc. The Griffith Insurance Education Foundation 39

Simple Combined Ratios, HO MP, SC (Includes only Losses + Loss Adjustment Expenses Ratio + Underwriting Expenses Ratio + Policyholder Dividend Ratio )* RANK Mkt Shr 1 24. 65 2 11. 63 3 7. 16 4 6. 76 5 6. 47 6 5. 72 7 4. 19 8 3. 54 9 3. 06 10 2. 80 State Farm Allstate Nationwide Travelers USAA Insurance SC Farm Bureau Liberty Mutual Farmers Insurance AIG Munich-American 2009 65. 21 70. 03 70. 74 78. 42 37. 02 71. 68 63. 21 62. 44 42. 71 62. 28 2010 79. 05 85. 93 78. 54 100. 16 41. 72 86. 49 83. 17 62. 09 35. 95 70. 26 2011 92. 12 124. 53 116. 63 141. 53 69. 64 107. 31 116. 40 79. 01 39. 15 88. 94 11 2. 76 Auto-Owners 82. 91 97. 19 146. 61 Total 78. 74 State Average 64. 26 76. 15 97. 08 *Source: SNL Financial, Inc. See explanatory note on next slide The Griffith Insurance Education Foundation 40

Direct Simple Combined Ratios Explanatory note for the previous slide, #40: The purpose of slide #40 is simply to illustrate the volatility of losses and some of the challenges when estimating insurance rates. It does not contain sufficient information to evaluate the overall performance of an insurer or a rating structure. The combined ratio is the commonly used measure of underwriting performance. It’s breakeven point is 100. If a combined ratio is 105. 2 then for every $1 an insurer is earning or writing in premiums, they are paying out approximately $1. 05 in losses, expenses and PH dividends (though many insurers don’t pay PH dividends. ) Some costs and expenses of a firm at the national level are not reported in the state level data. For example, the state level direct simple combined ratio does not include some adjusting and other expenses in the loss ratio and the expense ratio does not include general expenses and other acquisition and fields supervision expenses. As a result, the state level ratios will systematically understate the Loss Adjustment Expenses and Expense ratios. The Griffith Insurance Education Foundation 41

Net Yield on Invested Assets, % 5 4 3. 5 3 2. 5 2 1. 5 1 0. 5 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: SNL Financial, Inc. The Griffith Insurance Education Foundation 42

Premium Components A Review § Pure premium § § Expected loss Loading § § § Expenses Contingencies Profit The Griffith Insurance Education Foundation 43

Factors that affect ratemaking § Loss estimation § § Credibility of data, loss mitigation, exposure in high risk areas, increased costs Delays in data collection and use § § Regulatory lag, institutional lag Change in the cost of claims § § Global warming Medical advancements (long term care) Medical inflation (WC, liability claims) Legal changes, hurricane loss mitigation The Griffith Insurance Education Foundation 44

Factors that affect ratemaking § Insurer’s projected expenses § § Legal changes, wage/employee cost, reinsurance, non-cancellation regulations Target level of profit and contingencies § Investment income, business conditions, unexpected disasters The Griffith Insurance Education Foundation 45

Questions? The Griffith Insurance Education Foundation 46