1. Ch 7: Financial Operations of Private Insurers (Ch26 of 11th)
Property and Casualty Insurers
Financial Statements
Measuring Financial Performance
Life Insurance Companies
Ratemaking in Property and Casualty Insurance
Ratemaking in Life Insurance
(Chap 8/27) The Financial Crisis and Insurers

2. Financial Statements of Property and Casualty Insurers
Balance Sheet: a summary of what a company owns (assets) and what it owes (liabilities)
Total Assets = Total Liabilities + Owners’ Equity
Exhibit 7.1 ABC Insurance Company

3. Financial Statements of Property and Casualty Insurers
The primary assets for an insurance company are financial assets
Insurers’ liabilities include required reserves
Liabilities can lead to lower returns
but also can lead to higher returns (Buffett Wins $224 Million Storm Bet With Florida)
A loss reserve is an estimated amount for:
Claims reported and adjusted, but not yet paid
Claims reported and filed, but not yet adjusted
Claims incurred but not yet reported to the company

4. Financial Statements of Property and Casualty Insurers
Case reserves are loss reserves that are established for each individual claim
Methods for determining case reserves include:
The judgment method: a claim reserve is established for each individual claim
The average value method: an average value is assigned to each claim
The tabular method: loss reserves are determined for certain claims for which the amounts paid depend on data derived from mortality and morbidity tables

5. Financial Statements of Property and Casualty Insurers
The loss ratio method establishes aggregate loss reserves for a specific coverage line
A formula based on the expected loss ratio is used to estimate the loss reserve
The incurred-but-not-reported (IBNR) reserve is a reserve that must be established for claims that have already occurred but that have not yet been reported

6. Financial Statements of Property and Casualty Insurers
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
Its purpose is to pay for losses that occur during the policy period
It is also needed so that refunds can be paid to policyholders that cancel their coverage
It also serves as the basis for determining the amount that must be paid to a reinsurer for carrying reinsured polices
The annual pro rata method is one method of calculating the reserve

7. Financial Statements of Property and Casualty Insurers
Policyholders’ surplus is the difference between an insurance company’s assets and liabilities
The stronger a company’s surplus position, the greater is the security for its policyholders

8. Financial Statements of Property and Casualty Insurers
The income and expense statement summarizes revenues and expenses paid over a specified period of time
The two principal sources of revenue are premiums and investment income
Earned premiums are the portion of the premiums for which insurance protection has been provided.
Expenses include the cost of adjusting claims, paying the insured losses that occurred, commissions to agents, premium taxes, and general insurance expenses

9. Exhibit 7.2 ABC Insurance Company: income and expense statement
IIR = 18/205 = 8.8%
LR = 147.6/205 =72%
ER = 64.64/206 =31.4%
CR =72%+31.4%=103.4%
OOR =103.4% - 8.8% = 94.6%

10. Measuring the Performance of Property and Casualty Insurers
The loss ratio is the ratio of incurred losses and loss adjustment expenses to premiums earned
The expense ratio is equal to the company’s underwriting expenses divided by written premiums
The combined ratio is the sum of the loss ratio and the expense ratio. A greater-than-one ratio indicates an underwriting loss

11. Measuring the Performance of Property and Casualty Insurers
The investment income ratio compares net investment income to earned premiums
The overall operating ratio is equal to the combined ratio minus the investment income ratio
This ratio measures the company’s total performance (underwriting and investments)
OPERATING RESULTS, PROPERTY/CASUALTY INSURANCE,

12. Financial Statements of Life Insurers
The balance sheet
The assets of a life insurer have a longer duration, on average, than those of property and casualty insurers
Because many life insurance policies have a savings element, life insurers keep an interest-bearing asset called “contract loans” or “policy loans”
A life insurance company may have separate accounts for assets backing interest-sensitive products, such as variable annuities

13. Financial Statements of Life Insurers
Policy reserves are a liability item on the balance sheet that must be offset by assets equal to that amount
State laws specify the minimum basis for calculating policy reserves
The reserve for amounts held on deposit is a liability representing funds that are owed to policyholders and to beneficiaries
The asset valuation reserve is a statutory accounting account designed to absorb asset value fluctuations not caused by changing interest rates

14. Financial Statements of Life Insurers
Policyholders’ surplus is less volatile in the life insurance industry than in the property and casualty insurance industry
Benefit payments, including death benefits paid to beneficiaries and annuity benefits paid to annuitants, are the life insurer’s major expense
A life insurer’s net gain from operations equals total revenues less total expenses, policyowner dividends, and federal income taxes
Measuring the Performance of Life Insurers
Pre-tax or after-tax net income vs. total assets
Rate of return on policyowners’ surplus (ROE)

15. Ratemaking in Property and Casualty Insurance
Transparency Master 1.2
Ratemaking in Property and Casualty Insurance
State Laws Require:
Rates should be adequate for paying all losses and expenses
Rates should not be excessive, such that policyholders are paying more than the actual value of their protection
Rates must not be unfairly discriminatory; exposures that are similar with respect to losses and expenses should not be charged significantly different rates

16. Ratemaking in Property and Casualty Insurance
Transparency Master 1.2
Ratemaking in Property and Casualty Insurance
Business Rate-Making Objectives include:
Rates should be easy to understand.
Rates should be stable over short periods of time
Rates should be responsive to changing loss exposures and changing economic conditions
Rates should encourage loss prevention

17. Ratemaking in Property and Casualty Insurance
A rate is the price per unit of insurance.
An exposure unit is the unit of measurement used in insurance pricing, e.g., a car-year
The pure premium is the portion of the rate needed to pay losses and loss adjustment expenses
Loading is 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

18. Ratemaking in Property and Casualty Insurance
There are three basic rate making methods in property and casualty insurance:
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

19. Ratemaking in Property and Casualty Insurance
Class rates are determined using two basic methods:
Under the pure premium 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
Under the loss ratio method, the actual loss ratio is compared with the expected loss ratio, and the rate is adjusted accordingly

20. Terminology Insurance Rate vs. Insurance Premium
Pure Premium vs. Gross Premium
Loading
Ex: Expected value of claims cost on a policy is $60 and expenses are assumed to be 40 percent of the premium, the final premium is $60 / (1-.4), or $100. Forty percent of the premium, or $40 is the loading fee.
Loss ratio: (losses + loss-adjustment expenses) / earned premiums
Expense ratio: (expenses incurred) / written premiums

21. Basic Pricing methods The pure premium approach: mostly for life
The loss ratio approach: mostly for non-life
Target Loss Ratio vs. Actual Loss Ratio
target loss ratio (R)
actual loss ratio (r)
rate change = (r - R) / R
Ex: The actuary for Apex Insurance Company has determined that Apex’s loss ratio for Car Insurance in Hong Kong Island is 75%. Apex’s desired loss ratio is 68%. Using loss ratio method for ratemaking, calculate the percentage rate change?

22. Ratemaking in Property and Casualty Insurance
Merit rating is a rating plan by which class rates are adjusted upward or downward based on individual loss experience
Under a schedule rating plan, each exposure is individually rated
A basis rate is determined for each exposure, which is then modified by debits or credits depending on the physical characteristics of the exposure
Commonly used in commercial property insurance

23. Ratemaking in Property and Casualty Insurance
Under experience rating, the class or manual rate is adjusted upward or downward based on past loss experience
The insurer’s past loss experience is used to determine the premium for the next policy period
Under a retrospective rating plan, the insured’s loss experience during the current policy period determines the actual premium paid for that period
A provisional premium is paid at the beginning of the policy period; the final premium is calculated at the end of the policy period
Commonly used in workers compensation insurance

24. Ratemaking in Life Insurance
Life insurance actuaries use a mortality table or individual company experience to determine the probability of death at each attained age
Expected future payments are discounted back to the start of the coverage period and summed to determine the net single premium or level installment premiums
The annual expected value of death claims equals the probability of death times the amount the insurer must pay if death occurs

25. Ch 8/27 Reasons for Insurance Regulation
Transparency Master 1.2
Ch 8/27 Reasons for Insurance Regulation
Maintain insurer solvency
Compensate for inadequate consumer knowledge
Ensure reasonable rates
Make insurance available

26. The Financial Crisis and Insurers
The recent financial crisis has affected financial institutions in different ways
Banks were more negatively impacted as they issued the sub prime mortgage loans
Insurers were not heavily involved in sub prime lending
Insurers did not securitize the bad mortgage loans and mortgage debt was not a significant share of insurers’ investment portfolios
Insurers were most affected by the sharp decline in the value of their investment portfolios 26

27. Solvency Regulation
Insurers are subject to financial regulations designed to maintain solvency
Assets must be sufficient to offset liabilities
Admitted assets are assets that an insurer can show on its statutory balance sheet in determining its financial condition
States have regulations that address the calculation of reserves
An insurer’s surplus position is carefully monitored by state regulators 27

28. Solvency Regulation
Life and health insurers must meet certain risk-based capital standards
A risk-based capital (RBC) standard means that insurers must have a certain amount of capital, depending on the riskiness of their investments and insurance operations
An insurer’s RBC depends on:
Asset risk
Underwriting risk
Interest rate risk
Business risk
A comparison of the company’s total adjusted capital to the amount of required risk-based capital determines whether company or regulatory action is required 28

29. Implementation of RBC Requirements
Essential aspects of RBC
Riskier activities require more capital
Insurer’s activities (e.g., how much is invested in junk bonds, amount of reinsurance, etc.) are plugged into a formula, which determines the insurer’s dollar value of RBC
Example: activities  RBC = $100 million
actual capital = $80 million
Regulatory action depends on the ratio of actual capital to RBC

30. Regulatory Actions Based on RBC
Back

31. RBC Example for Hypothetical P-L Insurer
Insurer writes $30 million of auto liability premiums this year, but only $15 million is earned this year
Expected claim costs = $20 million
$10 million incurred this year
$5 million in paid losses
$5 million in incurred losses, but not paid
$10 million incurred next year
Expenses = $10 million

32. RBC Example for Hypothetical P-L Insurer
Assets
$7.5 million in US government bonds
$15 million in investment grade corporate bonds
$2.5 million in stock
$25 million in total assets
No receivables & no off-balance sheet risk

33. RBC Example for Hypothetical P-L Insurer
What is surplus?
Assets = $25 million
Policyholder liabilities:
Loss reserve (losses incurred, but not paid) = $5 million
Unearned premiums reserve = $15 million
Total = $20 million
Surplus = $5 million

34. RBC Example for Hypothetical P-L Insurer
Calculating RBC

35. RBC Example for Hypothetical P-L Insurer
Covariance Adjustment
Idea:
risk factors reflect risk of individual activities
actual risk depends on correlation across activities
Implementation:
square each required RBC amount
sum the squares
take square root of sum

36. RBC Example for Hypothetical P-L Insurer

37. RBC Example for Hypothetical P-L Insurer
Finally,
Calculate ratio of accounting capital to RBC:
Surplus / RBC = 5 / = 95.6%
Regulatory Response (see Table)

38. Solvency Regulation
The purpose of investment regulations is to prevent insurers from making unsound investments that could threaten the company’s solvency and harm the policyowners
Laws generally place a limit on the proportion of assets in a specific asset category, such as real estate
Many states limit the amount of surplus a participating life insurer can accumulate, rather than pay as dividends 38

39. Insight Annual Ranking of Automobile Insurance Complaints in New York State (based on 2007 data) (cont.) 39

40. Insight Annual Ranking of Automobile Insurance Complaints in New York State (based on 2007 data) 40