FINANCIAL MARKETS

________________________________________________
CHAPTER 8 - Operations of Insurance Companies

Objectives:

a.) Discus the flow of funds of the operations of insurance

companies.
b.) Familiarize the six categories of the major insurance company
operations.
c.) Distinguish the interrelations between functions.
d.) Aware the loss preventions and loss control activities.
e.) Update competitive operations on the insurance markets.

The Flow of Funds of the Operations of Insurance Company

Insurance is a process of financial intermediation because the production cycle is
reversed. Payment is made before a service is provided.
Gross written premiums are used to pay commissions (Co) and administrative
expenses (Ca). The ultimate service is determined in the event of a loss. The payment
of claims (S) is sometimes considered as a measure of the service, or the output, of
an insurance company.
Because payments for claims are not necessarily made the same year the
premium payments have been received, the technical reserves (R) are the
commitments of the insurance company with respect to the insured parties.
Insurance companies apply two principal techniques: (1) the technique of
capitalization and (2) the technique of compensation.
1.) The technique of capitalization consists in holding a portion of the
premiums in reserve to be able to meet future commitments, for example in the
case of life insurance and annuities. Although the purpose of insurance is not to
save (at least in the usual meaning of that term, i.e. the transfer of purchasing
power from one period to another), it is clear that contracts of insurance based
on the technique of capitalization generate medium-term or long-term reserves
which could be invested in high-yield instruments of maturity equivalent to the
contract.

Page 1
 FINANCIAL MARKETS
________________________________________________
2.) The technique of compensation consists in using the premiums
collected during a budgetary year to cover immediately the claims incurred
within that period. Reserves are, in a simplified approach, claims that are
(or will be) due but are not paid during the budgetary period. In this case,
insurance operations may generate mainly short-term reserves.

The contribution of the insurance sector to the economy corresponds to the

investments of the reserves in all categories of financial assets and in real estate.
The return on these investments (F) is another major source of income for the
insurance companies. Insurance companies can increase their volume of assets by
reinvesting some or all of each year's gain from operations in the business. Gains
from insurance operations result whenever premium income exceeds the amount
needed to pay all expenses, claims, and to make proper provisions (reserves) for
the liabilities to policyholders.

DISCUSSION:
All premium payments are advance payments corresponding to
a certain insurance period, usually one year. During the
insurance period the policyholder may "report" claims to the
insurance company. There will always be a certain delay , the
"claim settlement period," before the company can make the
payments according to the contract. The ability of insurance
companies to meet their future obligations is vital and at any
time the "funds" available to the company should exceed the
promised payments:

Q > S + Co + Ca + ∆R ( ∆R = Rt - Rt-1 )

When the result from the insurance operation (the

underwriting result) is negative, the insurance company has to

Page 2
 FINANCIAL MARKETS
________________________________________________
use part of the investment income to overcome insurance
(underwriting) losses:

Q + j.F = S + Co + Ca + ∆R

For the long term survival of the company, the

investment income should be sufficient to maintain the capital
and surplus:

F = ra.A > j.F

An Overview of Insurance Operations

Following Webb et al.(1984), the major insurance company operations can be
regrouped in six categories:
• Product design and development
• Production and distribution
• Product management
• Services
• Administration
• Finance and investment
Six Categories of the Major Insurance Company Operations
Product Design and Development
Insurance policy innovations develop when competitive forces and consumer
demand encourage the companies to propose attractive alternatives. A recent
example in life insurance is the introduction in the early 80s of policy packages
like variable or universal life insurance as an answer to the "buy term and invest
the difference" argument or strategy of customers.
The standardization of insurance contracts in property and liability insurance
leaves a smaller place for new product development. However, the influence of
regulations or environmental changes is also a driving force causing product

Page 3
 FINANCIAL MARKETS
________________________________________________
changes and propositions for new types of coverage (for example, the air and
water pollution legislations in most of the developed countries).
Product design and development is a primary responsibility of
the management of a company. Before producing and distributing a new coverage (for
example, medical and hospitalization coverage for domestic animals) the following
steps must be considered:
1.) Nature of the market, size, predicted response
2.) Expected losses, pricing and underwriting problems
3.) Legal and regulatory problems
4.) Start-up costs, promotion and advertising
5.) Production and distribution system
6.) Predicted competition
7.) Public relations implications
8.) Strategic planning

Product and Distribution

The marketing department of an insurance company includes the sales functions
and the sales management and is one of the basic strategic functions. The
importance of the sales is evident. The salesperson, the agent or the broker is
usually referred to as the producer. The nature of the business and
the choice of the distribution system will also influence the promotion and
advertising policies of the company.
Sales management involves the sales strategy of the company and the
motivation of the producers. Only the largest insurance companies can afford to
appeal simultaneously to all segments of a national economy. Most insurers,
especially smaller companies, must concentrate their sales efforts on selected
geographic, demographic, or industrial segments of the market, or concentrate on
a limited range of coverages in order to use their limited resources effectively
(Webb et al., 1984, p. 76). Of course, specialization places a limit on an insurer's
potential for growth.

Page 4
 FINANCIAL MARKETS
________________________________________________
Product Management
Product management regroups the operations that deal with the pricing of
insurance (the rate-making department ), the selection and classification of risks
to be covered by insurance (the underwriting department ) and, the fair and prompt
payment of claims ( the claims department ).
Rate-making is the determination of the proper premium to be charged for each
insurance coverage. It refers to the pricing of insurance contracts and
covers the production cost plus a margin for profit. The basic requirements are
the classification of risks on the basis of selected characteristics and the proper
use of statistics available to the company. The statistical and actuarial operations
or functions are an important factor in the insurer's capability to compete in a
market.
Underwriting is the process of selecting and classifying the insurance proposals
according to the rate-maker hypotheses. The objective is not the selection of risks
that will not generate losses but to avoid adverse selection and the
misclassification of risks. Sound underwriting is the major factor in the future
profitability of insurance operations.
The underwriting policy of an insurance company determines the nature and
size of the business of a company. There are four major factors affecting the
underwriting policy of a company: (1) the financial capacity of the company, (2)
the regulatory framework concerning the maximum production capacity, (3) the
technical skills and abilities of the personnel (the know-how) and, (4) the
availability of reinsurance. Once the company's underwriting policy has been
established it is implemented through staff and line underwriting functions
Claims adjustment and settlement is the raison d'être of insurance. It is
obviously important that the insurance company pays for the losses of the
claimant, fairly and promptly, but it is equally important that the company avoid
overpayments or even unjustified payments. It seems like a simple task but it is
in many cases a very complicated process. The insurance company's image is
often determined by the way the company deals with the claimants. Some
practices are probably largely responsible for the poor image of the insurance

Page 5
 FINANCIAL MARKETS
________________________________________________
business in the eyes of the public, a behavior referred to as "unfair claims
settlement practices."
Michelbacher and Roos (1970, p. 107) argued that the person responsible for
determining the fair payment "must have a broad understanding of human nature;
he must be sincere and have the highest integrity; he must be firm but at the same
time understanding; he must be a detective, a lawyer, a psychologist, a gentleman,
and above all, an ambassador of goodwill and a good public relations."
The process of settling a claim is referred to as an adjustment and the person
in charge is the adjuster. Adjusters are salaried employees of the company,
independent adjusters or specialized adjustment bureaus. Insurance producers
(agent but more generally brokers) play also an important role in the handling of
insurance claims, mainly for the payment of small losses. The insurance industry
has also entered into claims handling agreements to deal with controversies
among insurance companies concerning the payment of claims. Finally, the
adjustment of claims will often requires specialist expertise like legal advice or
engineering expertise.

Services
The major service activities provided by insurance companies are legal services,
loss control and risk management services, policyholders' services and producer,
consumer, and employees education.

Administration
The major administrative functions related to insurance operations are quite
similar to the administrative functions of any other organization. They include
general management and strategic planning, personnel administration and
management, branch office management, accounting, and public relations.

Finance and Investment

The major sources of assets of an insurance company are classified as funds
contributed by the owners and reserves to meet the liabilities of an insurance

Page 6
 FINANCIAL MARKETS
________________________________________________
company towards its policyholders. An initial minimum capital and surplus funds
are required in all countries to establish an insurance company. The initial capital
and surplus of a stock company are provided by the stockholders. The initial
contribution in a mutual company is usually referred to as guaranteed capital.
After an insurance company has been organized with initial surplus funds it
can commence its operations. The net worth (the policyholders' surplus) is the
excess of assets over liabilities. The potential sources of earnings are the profits
resulting from the insurance operations (the underwriting profit) and the
investment earnings. Each year, insurance companies can increase their surplus
funds and/or distribute dividends to stockholders or to policyholders (in the case
of mutual). However, most of the insurance companies preferably increase their
surplus to be able to finance their growth.
The investment department manages the company's portfolio of financial
assets but the investment strategy is determined by the top management. In many
countries, the investments of insurance companies are also regulated and carefully
supervised.

Interrelations between Functions

The departments or divisions of an insurance company are interdependent to a
very large extent. Production and product management depend heavily on each
other although they may have conflicting objectives.
1.) Marketing and Underwriting
The mathematical principles which govern the insurance business
(the law of large numbers) gain credibility when the volume of business
increase. It is therefore evident that the sales function is important.
However, the volume of sales per se does not assure a profit in any
insurance line, and is not necessarily consonant with the objectives of an
insurer's underwriting department.
Underwriters often criticize the marketing department because the
sales intermediaries or representatives tend to ignore the underwriting
policy of the company and their responsibility to apply this policy. On the

Page 7
 FINANCIAL MARKETS
________________________________________________
other hand, if the underwriting department is too restrictive in its
acceptance and classification of risks, the business will be lost to
competitors.
2.) Rate-making and Underwriting
Among all the functions of insurers, underwriting is most
interrelated with the rate-making activities. When the rates have been
computed, the underwriter must still determine into which of the classes, if
any, the proposal for insurance coverage should be affected. It is common
for the underwriter to classify the risks into standard risks, preferred risks,
substandard risks and uninsurable risks.
While the rate-maker is interpreting statistical experience, rates
should also take into account the informed judgment of experienced
underwriters relative to the hazards incorporated in the coverage. As a
result of this distinction, it has been said that "the actuaries may be
thought of as having the rate-making function, whereas underwriters have
the rating function, i.e., the application of rates.
3.) Underwriting and Claims
During the claim adjustment process, the adjuster may notice
defects that need to be remedied immediately to decrease the probability
of loss. An adjuster may also discover moral or morale hazard problems
such as illegal or hazardous use of property, poor housekeeping. The
underwriting department, after a loss and a close investigation, may also
question whether or not the coverage should be continued. However, what
has been called "claims underwriting" is often detrimental to the reputation
of an insurance company.
4.) Marketing and Claims Department
Both departments are directly involved with the public and are
mainly responsible for the reputation or image of the company. In both
situations, the payment of the premium and the claim for the
reimbursement of a loss, it is the producer who is the intermediary

Page 8
 FINANCIAL MARKETS
________________________________________________
between the policyholder and the company. However, he has to
deal with two departments with different objectives.

Loss Prevention and Loss Control Activities

Services by insurance companies in the domain of loss prevention and loss
control are directed toward lowering the frequency and severity of losses. This is a
fundamental requirement since lower claims implies higher expected profits and
a corresponding reduction in insurance premiums. This means also a better
competitive position on the market.
Loss control services may also be used as a marketing tool and the loss
control specialist becomes an important source of underwriting information.
Many insurance companies are extending their loss control activities as a result of
the demand of customers, particularly commercial and industrial firms, because
of the increasing complexity of handling the risks. In the United States, the rapid
increase in both the frequency and the severity of products liability claims has
been a major factor in the involvement of insurers.
Insurance companies are perceived as better informed and better able to cope
with the problem and provide the adequate expertise. Many insurance companies
have developed risk management services to provide inspection and risk analysis
to insured on a fee basis. In addition, insurance companies also provide
information and guidelines through books and manuals which are published by
the companies themselves or more often by the trade association of insurance
companies or by the producers ( mainly brokers) trade association.

Competitive Operations on the Insurance Markets: Differences Between Life and

Non-life Companies
Market competition may take many forms: reduction in price, improvement in the
quality of the product, provision of complementary services, advertising, real and
unreal product differentiation and obstructions of competitors' operations. The
possibilities can be classified as positive competition, whereby the seller improves
the attractiveness of his own products; and defensive competition, in which the

Page 9
 FINANCIAL MARKETS
________________________________________________
seller adopts a strategy that detracts from his competitors' products or restricts the
competitors' ability to operate profitably.
In insurance business, the nature of competition is affected by the nature of
the operations of the companies and by the segmentation of the market.
Traditionally and/or because of regulation restrictions, the insurance market is
divided between life and non-life operations, but even within these two categories,
the buyers of insurance are different and many insurance companies specialize on
some types of coverage or on selected geographic, demographic segments of the
population. Because it takes time to develop a new product or to differentiate
from competitors, product competition is not really available on a short term basis
for both life and non-life insurers.
Distribution efficiency is one of the most important factor to determine the
competitive position of insurance companies. In individual lines of business,
companies with the most rapid growth or expansion of markets share in Europe
or North America, have been those willing to exploit weaknesses in the
"traditional" marketing structure. The marketing strategy of a company depends
on the distribution system. Direct advertising in the public of a product or of a
company name and image is possible for life insurance companies represented by
agents. Because many property and liability insurance companies rely on the
agency system or the brokerage system to market standardized products, direct
advertising is not possible. Only direct writers can benefit from direct advertising.
Service to the policyholder has proven to be an important competitive tool
for insurers. In life insurance, the quality of the service depends on the agent and
can be appreciated by the public when the product is sold. In homeowners or
automobile insurance, the service is only appreciated when there is a loss and
often a long time after the policyholder has paid for the service. It takes a long
time before the reputation or image of a company is established on the market. In
commercial property and liability insurance, loss control services are developed
to enhance the image of a company.
Because there is no real product competition available, property and liability
insurance companies engage in periodical price competition. But just as the

Page 10
 FINANCIAL MARKETS
________________________________________________
products tends toward clusters with a large number of companies having the same
product, so also do prices tend to move together because there are driven by the
distribution system. It does not appear that price competition is such an important
issue in life insurance.

REFERENCES:

Keith Pilbeam (2010) Finance and Financial Markets, Palgrave (ISBN

978-0230233218)

Howells P., Bain K. (2008). Financial Markets and Institutions. Financial

Times, Prentice Hall.

Madura J. (2008). Financial Markets and Institutions. Prentice-Hall

International. 6.

Mishkin F. S., Eakins S. G. (2006). Financial Markets and Institutions.

Addison-Wesley.

Valdez, S. (2006). Introduction to Global Financial Markets, Palgrave

Macmillan.

LINKS
TOPICS LINKS FOR VIDEO
The Flow of Funds of the Operations of https://youtu.be/qjXgpJpSlCc
Insurance Company
An Overview of Insurance Operations https://youtu.be/-g-jV94s9Uo
Six Categories of the Major Insurance https://youtu.be/mWMCdk9tNz4
Company Operations
Interrelations Between Functions https://youtu.be/CiVZPrTZS88
Loss Preventions and Loss Control https://youtu.be/rd0zzNdmJ6s
Activities
Competitive Operations on the Insurance https://youtu.be/heHmtqhWL2w
Markets: Difference Between Life and
Non-Life Companies

Page 11