Insurance Knowledge Aptitude Test Text Book (IKAT)

IKAT Version 1 For US Division GGB (US, AUS, CAN), GB (US), RPS, ARTEX, Lead Enrichment, Support The IKAT content has been curated using previous versions of course material provided by the 'Institutes Knowledge Group'. This is propitiatory material and is not to be forwarded outside the organization. Contents Assignment 1 01 Understanding Insurance Benefits and Costs of Insurance Major Roles of Insurance Common 02 Types of Personal and Commercial Insurance 09 Types of Private Insurers 13 Government Insurance Programs 17 Overview of Insurance Functions 21 Summary 25 Assignment 2 Insurance Regulation 27 Why Insurance Operations Are Regulated 28 Insurer Licensing 29 Insurance Rate and Form Regulation 33 Market Conduct and Solvency Regulation 35 Summary 41 Assignment 3 43 Insurer Financial Performance Understanding Insurer Financial Statements 49 Analyzing Insurer Financial Ratio Calculation 53 Knowledge to Action: Financial Ratios and Insurer Financial 59 Performance case Summary 63 Assignment 4 Marketing 64 Understanding Factors That Influence an Agency Relationship 65 Summarizing Types of Insurance Distribution Systems 69 Functions of Insurance Producers 75 Selecting Insurance Marketing Distribution Systems and Channels 79 Summary 84 Assignment 5 86 Underwriting and Rate-making Underwriting Activities 87 The Underwriting Process 90 Underwriting Management 96 Rate-making 99 Premium Determination 102 Summary 107 Assignment 6 Claims 108 Goals of the Claims Function 109 Claims Department Structure, Personnel, and Performance 111 The Claims Handling Process 116 Aspects of Property Insurance Claims 123 Aspects of Liability Insurance Claims 130 Good-Faith Claims Handling 133 Summary 137 Assignment 7 139 Risk Management Basic Purpose and Scope of Risk Management 140 Identifying and Analyzing Loss Exposures 141 Examining the Feasibility of Risk Management Techniques 148 Selecting, Implementing, and Monitoring Risk Management 153 Techniques. Benefits of Risk Management 160 Applying the Risk Management Process 163 Summary 166 Assignment 8 168 Loss Exposures Property Loss Exposures 169 The Basis for Legal Liability 175 Liability Loss Exposures 183 Personnel Loss Exposures 188 Net Income Loss Exposures 193 Ideally Insurable Loss Exposures 197 Summary 202 Assignment 9 204 Insurance Policies 206 Elements of a Contract 209 Distinguishing Characteristics of Insurance Policies 214 Insurance Policy Structure 218 Policy Provisions 224 Property Policy Provisions Liability Policy Provisions 231 Summary 239 Understanding Insurance Educational Objectives Outline After learning the content of this assignment, you should be able to: Benefits and Costs of Insurance Describe the benefits and the costs of insurance to individuals, organiza, Major Roles of tions, and society. Insurance Explain how insurance operates in different roles. Common Types :, Distinguish among the common types of personal and commercial of Personal and insurance. Commercial Insurance Describe the various types of private insurers providing property and liability insurance. Types of Private Insurers Describe United States federal and state government insurance programs. Government Distinguish among the following insurance functions: Insurance Programs Marketing OVerviewof Insurance Functions Underwriting Summary Claims Risk control Premium audit 1 Understanding Insurance BENEFITS AND COSTS OF INSURANCE Insurance is a prominent risk management technique, and several risk financ- ing measures involve the use of insurance to some degree. When potential techniques for meeting risk management goals are being assessed, the benefits and costs of insurance should also be carefully considered. Insurance can help individuals and organizations achieve risk financing goals, such as paying for losses, managing cash flow uncertainty, and complying with legal requirements. But beyond that, insurance provides several benefits to individuals, organizations, and society in general by encouraging an insured's loss control activities, providing insurers with a source of investment funds, and reducing social burdens by helping insureds recover after a loss. There are costs to insurance, however, ranging from premiums paid by insureds and insurers' operating costs, to opportunity costs and the possibility of increased losses. The Benefits of Insurance The best-known benefit of insurance, helping insureds regain their footing after a loss, is often considered its main purpose. Provided that the loss is to a covered loss exposure and involves a covered cause of lo.ss, an insurer will indemnify the insured, subject to any applicable deductibles and policy limits. While this benefit holds great importance, insurance provides numerous other benefits that insurance professionals should be aware of. Managing Cash Flow Uncertainty Insurance also enables an individual or organization to manage cash flow uncertainty. The insured can be confident that as long as a loss is covered, the financial effect on the insured's cash flow will be reduced to any deductible payments or any loss amounts that exceed the policy limits. The remainder of the loss will be paid by the insurer, reducing the variation in the insured's cash flows. Meeting Legal Requirements Insurance also helps an insured meet legal requirements that might apply, whether for personal or commercial insurance customers. For example, all states have laws that require employers to pay for the job-related injuries or I i/ 2 illnesses of their employees, and employers generally purchase workers com pensation insurance to meet this financial obligation. An example of a legal requirement for individuals is personal auto insurance, which is often required in states that have compulsory auto insurance laws for anyone who wishes to own or drive an automobile. Insurance can often be used or required to satisfy both statutory and con, tractual requirements, such as providing proof of insurance, that arise from business relationships. For example, building contractors are usually required to provide evidence of liability insurance before a construction contract is granted. Promoting Risk Control Insurance often provides an insured with the incentive to undertake cost, effective risk control measures. This incentive usually takes the form of risk-sharing mechanisms, such as deductibles, premium credit incentives, and contractual requirements, but it has also begun to take the form of collected data that can be used to prevent or limit losses before they happen. Internet of Things pol) For instance, with a growing number of devices connected to the Internet A network of objects that of Things, it is possible to use information gathered to monitor an insured transmit data to and from device's maintenance needs. If a manufacturer's most important piece of each other without human machinery is in danger of breaking down, proper use of collected data could interaction. notify the insured beforehand, enabling repairs or updates to be made before the situation progresses to an insured loss. Another example is the use of telematics in personal autos. By providing discounts to verified safe drivers, insurers can reduce the number of accidents; the amount of losses they have to pay; and, as a result, the premiums required of insureds. Risk control measures can save not only financial resources but also lives. Therefore, society as a whole benefits. Enabling Efficient Use of Resources Without insurance, people and businesses that face an uncertain future would have to set aside sufficient funds to pay for future losses. However, insurance makes it unnecessary to set aside a large amount of money to pay for the financial consequences of loss exposures that can be insured. ln exchange for a comparatively small premium, individuals and organizations can free up additional funds. A,, a result, the money that would otherwise be set aside to pay for possible losses can be used to improve an individual's quality of life or to contribute to the growth of an organization. Providing Support for Insureds' Credit Insurance can provide support for an insured's credit by facilitating loans to individuals and organizations. Insurance guarantees that the lender will be able to receive payment for the loan it has provided, even if the collateral for ►I> 3 the loan (such as a house or a commercial building) is destroyed or damaged by an insured event. Providing a Source of Investment Funds Having a robust insurance plan can help an insured financially because the funds that would otherwise be needed to pay for large potential losses can instead be invested in bonds, the stock market, or development projects. Similarly, insurers can invest the funds that they collect in premiums until they are needed to pay insureds' claims. These investments can provide money for projects such as new construction, research, and technology advancements. Investment funds promote economic growth and job creation that, in tum, benefit individuals, org-anizations, and society, as well as provide profit that allows insurers to keep insurance premiums at a reasonable level. Reducing Social Burdens Finally, insurance can help reduce social burdens. For example, the social costs of natural disasters, such as large hurricanes or coastal storms, are increased by uninsured losses suffered by individuals and organizations that can amount to billions of dollars. Insurance helps to reduce the burden on the state or federal government by indemnifying the affected parties. Compulsory auto insurance is another example, because it provides compensa- tion to auto accident victims who might otherwise be unable to afford proper medical care or who might be unable to work because of the accident. The Costs of Insurance Although insurance, on the whole, is a net benefit for insureds and society at large, it also comes with some costs, including these, Premiums paid by insureds Operating costs of insurers Opportunity costs Increased losses The premiums paid by insureds are necessary to generate the funds insurers use for loss payments. Despite the fact that insurance premiums, by law, must not he excessive, insureds may believe that their premiums are too high, most likely because the benefits of insurance may be intangible unless the insured suffers a covered loss and the subsequent claim is paid. But, as noted previ- ously, if insurers can wisely invest the premiums they are paid, the resulting financial gains can be used to mitigate some of this cost for insureds. The operating costs incurred by insurers, unfortunately, cannot be reduced as easily. As with any other business, an insurer has operating costs that must be paid to continue the day-to-day operations of the company. Insurers' operating 4 costs include salaries, producers' commissions, advertising, building expenses, equipment, taxes, licensing fees, and so forth. The opportunity costs of insu4'!lce are that the capital and labor being used in the insurance industry could he used elsewhere and could create other pro ductive contributions to society. For insureds, the funds they use co pay their insurance premiums could be used for more immediate needs, such as new furniture or traveling, rather than protecting themselves from potential losses. Finally, the existence of insurance may encourage losses. Although insurers have an economic incentive to provide and encourage risk control measures, insureds may have an economic incentive to claim losses. Fraudulent claims increase costs for both insurers (in terms of payment for fraudulent claims and the costs of investigating and resisting fraud) and insureds (who pay increased premiums to help cover the costs of those who defraud insurers). MAJOR ROLES OF INSURANCE Almost every person, family, and organization needs insurance of some type to protect assets against unforeseen events that could cause financial hardship. Sometimes, insurance is required to satisfy a contractual obligation, such as when a homeowner buys insurance on a home to protect the mortgage com- pany's investment in the event the home is damaged or destroyed. Almost everyone needs insurance, but not everyone fully understands it. What exactly is insurance? One way to define insurance is to examine how it operates in each of these four major roles: As a risk management technique As a risk transfer system As a business As a contract Insurance as a Risk Management Technique Individuals, families, and organizations face loss exposures every day, many of which can have serious financial consequences. For example, a person aper ating an automobile may cause an accident, leading to thousands of dollars of damage to the property of others, plus medical expenses for the people involved. Businesses can also face an additional variety of loss exposures, such as damage to premises, injury to workers, and harm to customers from defective products or workmanship, but they also often have more risk man agement options available than personal insurance customers. Sometimes, it makes more financial sense for a person or an organization to retain some loss exposures. For instance, a flat tire is a nuisance and an 5 expense, but its financial impact is relatively minor. And because it is a common occurrence, purchasing insurance to cover the exposure could cost as much as a new tire. At the other end of the spectrum, however, are loss exposures with the poten- tial to create financial ruin-such as fires. Prudent persons and organizations must find ways to deal with these exposures other than retention. Several risk management techniques are available to help mitigate the finan- cial consequences of loss exposures. A person or an organization may choose to avoid a particular type of loss exposure. For example, a city dweller may avoid the loss exposures arising from the ownership, maintenance, and use of an automobile by not owning one and, insread, using public transportation or transportation network services. Loss exposures can also be controlled by loss prevention measures (such as the use of safety goggles and helmets by construction workers to reduce the frequency of injuries) and loss reduction measures (such as the placement of fire extinguishers in the home or work- place to reduce the severity of fire losses). Some loss exposures are not easy to retain, avoid, or control. For example, Ming lives sixteen miles from his workplace, and no public transportation is available. He also needs a car for shopping, running errands, and seeing friends-so owning and operating a motor vehicle makes sense for him. However, this creates loss exposures for Ming; the bodily injury or property damage that might result from his negligent operation of the automobile could reach hundreds of thousands of dollars. He cannot afford to retain such loss exposures, and it is not practical to avoid them. Though he may keep his vehicle well maintained and drive safely to control these loss exposures, he cannot guarantee avoiding or minimizing the finan- cial consequences of a serious accident. For Ming, the best risk management technique may be transfer, so that the financial consequences of loss will be borne by another party. Ming could use forms of noninsurance transfer, but insurance is probably the most economically viable choice for him. Personal insurance customers often have fewer risk management options than larger commercial insurance customers. The decision-making process used to determine which risk management tech- nique best suits an insured's needs has become more reliant on technology and big data. Insurance professionals can use an abundance of new data to analyze Big data an insured's history and needs. They can then recommend coverages, as well Sets of data 11lat are too as risk control and loss prevention techniques, that could make the recom- large to be gathered and mended coverages more affordable. This not only saves the insured money on analyzed by traditional methods. the policy premium, but helps the insurer keep claims costs down. Insurance as a Risk Transfer System Insurance enables a person, a family, or an organization to transfer the costs of losses to an insurer. The insurer, in tum, pays claims for covered losses from 6 the premiums it has collected and, in effect, distributes the costs of the losses among all its insureds. In that way, insurance is a system of both transferring and sharing the cosrs oflosses. By trarnferring the cosrs of their losses to insurers through an insurance policy, insureds exchange the possibility of a large loss for the certainty of a much smaller, periodic payment (the premium that the insured pays for insurance coverage). Insurers, in tum, pool the premiums paid by insureds and use those funds to pay insureds who incur covered losses. The total cost of losses is thereby spread (or shared) among all insureds. Insurers determine the total amount of premiums they must collect from insureds to cover future losses and expenses by considering past loss experi- Law of large numbers ence and the law of large numbers. Because insurers have large numbers A mathematical principle of independent exposure uni rs (the cars and houses of all their insureds, for stating that as the number example), they can predict the number of losses that all similar exposure units of similar but independent combined are likely to experience. exposure unils increases, the relative accuracy of predictions about future outcomes (losses) also Insurance as a Business increases. The insurance business can be divided into two sectors: property-casualty and Property-casualty life-health. The property-casualty insurance sector consists of homeowners, insurance automobile, and commercial general liability insurance. Life-health insurance, One of the two main sec1llrs meanwhile, consists of numerous types of insurance that cover the financial of the insurance industry, consequences of death, injury, and sickness. encompassing numerous types of insurance, most of Private insurers vary enormously in size and structure, the products they sell, which cover the financial and the territories they serve; collectively they represent a substantial segment consequences of damage 1ll one's own property or legal of business in the United States. Despite their size and number, however, pri- liability 1ll others. vate insurers do not fill every insurance need. In some instances, federal and state governments step ln to meet the property and liability insurance needs of the public. State governments closely regulate the business of insurance through their insurance departments, requiring private insurers to be licensed (for most types of insurance) in the states where they sell insurance. Because regula- tion of licensed insurers encompasses all insurer operations, state insurance regulators review insurance rates, policy forms, underwriting practices, claims practices, and financial performance. If an insurer does not fully comply with state regulations, regulators can revoke its license. State insurance regulators, insurance producers, stockholders, and insureds also need to be assured of an insurer's financial health. An insurer's revenue must, in the long run, match or exceed the amount it pays for claims and administrative expenses if the insurer is to remain 6.nandally viable. The primary sources of revenue for insurers are premiums and the income produced from investing premiums between the time they are collected and the time they are used to pay covered claims. Insurers' income streams need to overcome several expenses, ranging from claim payments and loss settlement 7 expenses to general expenses such as salaries, employee benefits, utilities, tele, phones, and computer equipment. However, the ability to pay these expenses and still make a reasonable profit is just one measure of an insurer's success. Insurance as a Contract An insurance policy is a contract between the insurer and the insured where the insured transfers the possible costs of covered losses to the insurer. In return for the premiums paid by insureds, insurers promise to pay for the losses covered by the insurance poltcy, which reduces the uncertainty or insecurity an insured may have about paying for potential losses. Insurance policies enable individuals, families, and organizations to protect their assets and minimize the adverse financial effects oflosses, and the contractual nature of insurance policies gives legal force and protection to the rights and responsi- bilities of all of the parties. Insurance policies must meet the same requirements as any other valid con- tract. That is, they must entail an agreement between competent parties for a legal purpose that involves the exchange of consideration. Additionally, insurance policies have certain special characteristics, including these: A contract of utmost good faith-Both parties to an insurance contract, Utmost good faith the insured and the insurer, are expected to be ethical in their dealings Anabligafon to act in with each other. complete honesty and to disclose all relevant facts. A contract of adhesion-Because the insurer wrote or chose the policy and the insured generally has no say, if the policy wording is ambiguous, a Contract of adhesion court will generally apply the intetpretatlon that favors the insured. Anycontract inwhich one party must either accept the A contract of indemnity-Insurance does not necessarily pay the full agreement as written by the amount necessary to restore an insured who has suffered a covered loss to other party or reject it. the same financial pcsition, but the amount the insurer pays is directly Contract of indemnity related to the amount of the insured's loss and will not enable the insured Acontract in which the to profit from the loss. insurer agrees, inthe event of a covered loss, to pay an When structuring an insurance policy, insurers use one of two approaches: amount directly related to self-contained or modular. Self-contained policies usually include both the amount of the loss. property and liability coverages in a single document, such as the Insurance Setvices Office, Inc. (ISO) Personal Auto Policy. Modular policies, mean- while, combine coverage forms and other documents to tailor a policy to the insured's needs. Commercial package policies and businessowners policies, for example, are modular policies. » 8 COMMON TYPES OF PERSONAL AND COMMERCIAL INSURANCE T h e coverage provided by personal and commercial insurance policies enables individuals, families, and businesses t o protect their assets and minimize the adverse financial effects o f loss. Personal insurance policies cover individuals and families against their per- sonal (nonbusiness) loss exposures, while commercial insurance policies cover for-profit businesses or not-for-profit organizations against their commercial loss exposures. S e e the exhibit " Ty p es oflnsurnnce Polides--An Example." Types of Insurance Policies-An Example Rob and his wife, Laurie, own a sandwich shop in a suburban shopping center. They also own a home and two cars. Rob and Laurie are concerned that damage to their business or home could result in substantial financial loss. They nave contacted their insurance agent to discuss these concerns and to design an insurance program to meet their personal and commercial needs. The insurance agent will determine Rob and Laurie's insurance policy needs by examining their loss exposures. Because Rob and Laurie have both personal and commercial loss exposures, they will need both personal and commercial insurance policies. The personal insurance policies will cover losses arising out of Rob and Laurie's personal loss exposures related to the ownership of the home and cars. For loss exposures arising from the sandwich shop, Rob and Laurie will need commercial insurance policies. [DA00422] Personal Insurance Personal insurance policies fall into these general categories: Property insurance protects a n insured's assets b y covering the cost o f repairing or replacing property that is damaged, lost, or destroyed. If net income is lost o r extra expenses are incurred because o f a loss, those may b e covered, too. Liability insurance provides for payment o n behalf o f the insured for injury to others or damage to others' property for which the insured is legally responsible. It also covers the cost t o defend the insured, up to the policy limit, against claims or suits alleging that the insured is legally responsible for injury or damage that the policy covers. ► l> 9 Life insurance replaces the income-earning potential lost through death. It also helps to pay expenses related to an insured's death. Health insurance protects individuals and families from financial losses caused by sickness and accidents. Disability insuranc; is a form of health insurance that replaces an insured's income if the insured is unable to work because of illness or injury. Personal insurance may be further divided into specific types of policies. See the exhibit "Common Types of Personal Insurance." Common Types of Personal Insurance Homeowners Personal auto Personal watercraft Personal umbrella Life insurance Health insurance Annuities [OA07568] Property and Liability Insurance A homeowners policy provides property and liability coverage for individu- Homeowners policy als and families. The property coverage protects an insured's home and its Policy 1hat covers most of contents for damage caused by fire, wind, and other causes of loss. Most 1he property and liability homeowners policies also include coverage for the theft or destruction of the loss exposures that arise out of residential property home's contents. In addition, homeowners policies include personal liability ownership and occupancy, coverage for allegations of negligence. as well as property and liability loss exposures that A personal auto policy (PAP) covers liability losses occurring from bodily individuals and families may injury to another person or damage to the property of others that results from have while they are away an auto accident for which the insured is liable. It also covers vehicle damage from their residences. resulting from a collision, while Other Than Collision coverage covers the Personal auto policy (PAP) vehicle for fire, theft, wind, contact with an animal, and other causes of loss. An insurance policy that The personal liability coverage in the homeowners policy and the auto covers an individual or a family against loss liability coverage in the PAP exclude or limit coverage for operation of most exposures arising out of the watercraft. Therefore, a person who owns a boat may need a separate personal ownership, maintenance, or watercraft policy that covers both legal liability and phy s ical damage. use of automobiles. Juries often award large sums of money in liability cases, and many home- owners have significant assets to protect. Because this may require some insureds to have higher limits of insurance than those available under per- sonal liability or personal auto coverage, personal umbrella liability policies ► 10 provide an additional layer of liability coverage. Typical limits for a personal umbrella policy range from $1 million to $2 million, but higher limits are available if necessary. Life and Health Insurance The main purpose of life insurance is to replace the income,earning poten- tial of a family's primary wage earner who died, but it also helps pay expenses related to an insured's death. There are two main categories of life insurance: term life insurance, which lasts for a defined period of time and does not accrue cash value, and permanent life insurance, which offers lifetime protec, tion and does accrue cash value over time. With health coverage, various forms of health insurance can be purchased on an individual or a group basis. Medical insurance covers medical expenses that result from illness or injury. Disability income insurance provides periodic income payments to an insured who is unable to work because of sickness or injury. Long-term care insurance provides coverage for nursing-home care and home healthcare. Commercial Insurance Loss exposures that arise from business operations can be covered under com, mercial insurance policies. See the exhibit "Common Types of Commercial lnsurance. 11 Common Types of Commercial Insurance Commercial package Business owners Commercial auto Commercial property Commercial inland marine Commercial crime Commercial general liability Ocean martne Professional liability Environmental liability Commercial umbrella liability Workers compensation l))A07569] 11 Many business organizations purchase a commercial package policy (CPP) or a businessowners policy (BOP), both of which provide business owners with property, crime, and liability coverages. In the past, a business owner would have had to purchase several separate policies, rather than just one, to get all of the necessary coverages. Commercial auto insurance covers an insured's legal liability resulting from the insured's ownership, maintenance, or use of an automobile. Legal costs to defend the insured are also included, up to the policy limits. Auto physi- cal damage coverage provides protection for the loss of use of or damage to a vehicle listed on the policy because of a covered cause of loss, such as fire, theft, or collision with an animal. Commercial property insurance covers damage to buildings and/or their contents resulting from tire, vandalism, and other causes of loss. Coverage is generally limited to property located on or near the insured's premises. Ocean marine insurance covers ships and their cargo against losses like fire, lighming, and "perils of the sea." Most cargo that travels by water is insured as "ocean marine" or "wet marine." Car g o transported by land is typically called "inland marine" or "d r y marine.° Commercial inland marine insurance covers mobile equipment and property used away from the insured premises by commercial enterprises. This coverage protects goods in domestic transit and property used in transportation and communication, as well as property used on job sites, such as backhoes and other mobile equipment. Commercial crime insurance protects the insured against theft of job-site con- tents, such as cash registers, computers, and inventory. It also insures money that might be stolen in a robbery during business hours or in a burglary that occurs while the business is closed, and it can cover theft of employer property by employees. Commercial general liability (CGL) insurance offers broad protection Commercial general against claims alleging that the insured is legally liable for bodily injury or liability (CGL) insurance damage to the property of others. For example, a retail store could be responsi- Insurance tllat covers many ble if a customer falls on the.store's wet floor and is injured. Also, if a customer of the common liability loss exposures laced by an is injured by a product the store sold, the CGL policy might cover defense organization, including its costs as part of the store's legal liability. Even if a suit is groundless, the CGL premises, operations, and policy offers protection and peace of mind to the business owner. products. Professional liability insurance covers professionals such as accountants, attor- neys, or consultants for hann resulting from errors or omissions arising out of their professional practices. It also covers doctors, professional trainers, and other healthcare professionals, such as physical therapists, for injury to their customers or patients that results from their errors or omissions. Environmental liability insurance offers business owners protection against environmental damage that may occur as a result of business operations. It can help protect business owners from remediation and cleanup obligations triggered after an environmental incident, such as a leaking fuel tank. This 12 type of coverage is desirable for businesses because the COL policy will not cover most pollution-related claims. Commercial umbrella liability c;overage is similar to the personal umbrella coverage. It provides additional limits beyond those provided by the COL, commercial auto, and other policies and protects the insured in the event of a large liability loss. It may also "drop down" to cover losses not insured under the underlying policies if the causes of loss are not specifically excluded in the umbrella policy. Wolkers compensation Workers compensation insurance pays the cost of medical care, lost wages, insurance and other state-mandated benefits when employees are injured on the job or Insurance 1hat provides acquire a job-related illness, such as asbestosis. Because employers are required coverage for benefits an by law to pay certain benefits to injured or ill employees, these benefits employer is obliga!Bd are payable regardless of who caused the injury or illness. In return for this to pay under workers compensation laws. no-fault coverage, the employee generally loses the right to sue his or her employer. Apply Your Knowledge A finn of computer-systems consultants would most likely purchase which one of the following types of coverage to protect them in the event that they provide incorrect advice that causes financial injury to a customer? a. Commercial general liability insurance b. Business auto insurance c. Environmental liabiliry insurance d. Professional liability insurance Feedback: d. Professional liability insurance covers professionals such as accountants, attorneys, or consultants for errors or omissions arising out of their professional practices. TYPES OF PRIVATE INSURERS Numerous kinds of private (nongovernment) insurers provide property and liability coverage for individuals, families, and organizations. Private insurers may be classified based on a variety of factors, including their fonn of ownership. Proprietary insurers are fanned to earn a profit for their owners, while cooperative insurers are fonned to provide insurance at a minimum cost to their owners, who are the policyholders. Within these broad 13 classifications are different types of private insurers, and we'll go over the dif- ferences and similarities among these: Stock insuters Mutual insurers Reciprocal insurance exchanges Lloyd's Surplus lines insurers Captive insurers Reinsurance companies Stock Insurers Many of the largest property-casualty insurers in the United States are stock Stock insurer insurers. One of the primary objectives of a stock insurer is returning a profit Aninsurer 111atis owned by to its stockholders. These companies have been able to attract and retain Its stockholders and formed stockholders by the expectation of investment returns. The stock form of as a corporation for the ownership provides financial flexibility for the insurer. For example, a stock purpose of earning a profit for the stockholders. insurer can raise funds for expansion by selling additional shares of common stock. Stockholders have the right to elect a board of directors, which has the authority to appoint a chief executive officer (CEO) and control the insurer's activities. Mutual Insurers Mutual insurers include some very large national insurers and many more Mutual insurer regional ones. While classified as cooperative insurers, mutual insurers, like Aninsurer that is owned stock insurers, generally seek to earn a profit. To share profits, mutual insurers by its policyholders and pay dividends to policyholders as a return of a portion of premiums paid. The formed as a corporation for policyholders of a mutual insurer have the right to elect a board of directors the purpose of providing insurance to them. that performs the same functions as the board of directors of a stock insurer. Some mutual insurers have converted to stock insurers through a process called demutualization. Some mutual insurers have the right to charge insureds an assessment, or additional premium, after the policy has gone into effect. Such an assessment might be made after the insurer has endured a series of losses from a cata- strophic event, such as a hurricane. These insurers are known as assessment mutual insurance companies, and they are less common than in the past. Reciprocal Insurance Exchanges Each member of a reciprocal insurance exchange, or interinsurance exchange, is both an insured and an insurer. Because a redprocal's members, called sub- scribers, are not experts in running an insurance operation, they contract with 14 an individual or organization to operate the reciprocal; this manager is called an attorney-in-fact. An agreement (known as a subscription agreement) authorizes the attorney-in-fact to act on behalf of the subscribers to market and underwrite insurance covel"age, collect premiums, invest funds, and handle claims. The existence of an attorney-in-fact is one of the main features that distinguish a reciprocal from other types of insurers. Reciprocals make up a small percentage of the insurance companies in the U.S., but they include some major national and international insurers. Small regional reciprocals also operate on a state-by-state basis. Lloyd's Lloyd's (Lloyd's of London) Lloyd's (formerly Lloyd's of London) is an insurance and reinsurance mar- Anassociation of investors, ketplace whose operation resembles that of a stock exchange. Lloyd's is an grouped in syndicates, unincorporated association. Members of Lloyd's are investors that hope to who are representad by earn a profit from insurance operations that occur at Lloyd's. Each individual underwriters to write investor, called a "Name," belongs to one or more groups called syndicates. insurance and reinsurance. Lloyd's has earned a reputation for accepting applications for unusual types of insurance, such as insuring the legs of a famous athlete against injury. However, the bulk of Lloyd's business does not involve such exotic coverages. Lloyd's functions as an alien insurer in the U.S. Underwriters at Lloyd's have licenses in the U.S., and it's usually one of the largest writers of premiums in the surplus lines market. Lloyd's is also a reinsurer in the U.S.1 Surplus Lines Insurers When new or unusual insurance needs arise, producers and consumers often Surplus lines insurer tum to surplus lines insurers. Surplus lines insurance consists of insurance Anonadmitted insurer lllat coverages unavailable in the standard market ( usually because of pricing is eligible to insure risks difficulties or an inability to meet underwriting requirements). For example, lllat have been exported by consider the case of a restaurant that has a history of grease fires in its kitchen. a surplus lines licensee in Its standard market insurer has decided not to renew its policy because of poor accordance with a surplus lines law. loss experience, and no other standard market insurer will accept an applica- tion for coverage. A surplus lines insurer may be willing to write insurance for this restaurant with a premium substantially higher than a standard market insurer would charge. Also, as new insurance needs arise, the surplus lines market responds. Producers and consumers often tum to the surplus lines market when they have an immediate need for a new type of coverage. Surplus lines insurers can often respond quickly to these developing needs, while standard market insur- ers may take longer to analyze the need for new or revised coverage, and to Nonadmitted insurer file policy forms and rates for state approval. Aninsurer not authorized by the state insurance Surplus lines insurers mirror stock insurers in how they are organized. Surplus department to dobusiness lines insurance is written by nonadmitted insurers. Nonadmitted insur- within that state. ers are not required to file their rates and policy forms with state insurance 15 departments, providing them with greater flexibility than that o f standard (or admitted) insurers. Still, surplus lines insurers are subject to regulation. Some states maintain lists o f nonadmitted insurers that are approved to accept business from the state; others keep lists o f nonadmitted insurers that are not approved. S e e the exhibit " T h e Rise o f lnsurtech Companies." The Rise of lnsurtech Companies Emerging technologies have led to the growth of insurtech (that is, the coupling of insurance and technology) companies. These companies can assist traditional insurers with offering innovative new products and seivices. Categories of insurtech companies include these: Microinsurance-firms offering insurance to economically disadvantaged and other traditionally underseived segments of the population that are united in lisk pools whose members are connected to the insurer through web:enabled platforms on cell phones and other devices Firms that facilitate the use of sensors, Internet of Things (lo11-enabled devices, and other data-capture technology to help insurers and brokers more accurately assess and price individual risks Peer-to-peer insurance-Firms that use web-enabled platforms to facilitate the formation of self-selected risk pools whose members (usually friends, relatives, or like-minded individuals) pool premiums and collectively pay for members' insured losses On-demand insurance (also known as need-based insurance)-Firms that use web-enabled customer interfaces and sensor technology to offer coverage that allows near-total customization for customers [DA12776) Captive Insurers Captive insurers have become a n important alternative in the insurance- Captive insurer buying decisions o f corporations. A captive helps eliminate problems some An insurer formed primarily corporations face when necessary or desired insurance coverage is unavailable to cover 1he loss exposures or costs more than the corporation is willing or able to pay. Captives might b e of tts parent or members. able to provide insurance coverage at a lower cost than other private insurers because acquisition costs are eliminated. A premium paid to a captive remains within the corporate structure until it is used to pay claims, which contributes to a n improved cash flow for the organization. Apply Your Knowledge Eastfork Insurance is a private insurer that provides property and liabil- ity insurance to businesses. Its goal is to make a profit. In the past year, it achieved its goal by collecting more in premiums than it paid in losses and expenses. Now, Eastfork Insurance will provide dividend payments to its policyholders. 16 An insurance company that operates like this is classified as a: a. Stock insurer b. Mutual insurer c. Surplus lines insurer d. Captive insurer Feedback: b. Eastfork Insurance is a mutual insurer because, while its goal is to make a profit, it will use that profit to pay dividends to its policyholders rather than stockholders. Reinsurance Companies Reinsurance Some private insurers provide reinsurance. One of the most important rea- Toe transfer of insurance sons a primary insurer might buy reinsurance is that reinsurance permits the rtsk from one Insurer primary insurer to transfer some loss exposures to the reinsurer. For example, to another through a an insurer that writes a latge amount of property insurance in an area where con!raG!ual agreement under which one insurer (the tornadoes commonly occur can use reinsurance to reduce its exposure to relnsurer) agrees, in return windstorm losses. for a reinsurance premium, to indemnify another insurer Reinsurance also enables a small insurer to provide insurance for large (the primary insurelj for accounts (such as large national or multinational corporations) whose insur- some or all of the financial ance needs would otherwise exceed the insurer's capacity. For example, consequences of certain consider a primary insurer that writes a commercial liability policy for a large loss exposures covered by company that manufactures sports helmets. Because the potential for large the primary's insurance liability losses resulting from injuries caused by defective helmets is great, policies. the primary insurer might contract with a reinsurer to cover all of its liability losses for this insured over a certain amount, such as $1 million. Now, the primary insurer and the reinsurer share the liability loss exposures for this insured. GOVERNMENT INSURANCE PROGRAMS In some cases, property-casualty insurance for certain loss exposures can be obrained only through government insurance programs. The United States federal government and individual state governments provide certain insurance programs for various reasons. Government can participate in these programs as an exclusive insurer, as a partner with private insurers, or as a competitor to private insurers. Some government property- casualty insurance programs are administered by state governments, while others are operated at the federal level. 17 Reasons for Government Insurance Programs Government insurance programs exist for these main purposes: To fill unmet needs in the private insurance market To facilitate compulsory insurance purchases To provide efficiency in the market and convenience to insureds To achieve collateral social purposes Fill Unmet Needs in the Private Insurance Market When private insurers are unable or unwilling to satisfy certain insurance needs, government programs can provide insurance to meet legitimate public demands. By offering such programs, the government provides protection against loss that would otherwise not be provided. Facilitate Compulsory Insurance Purchases Another reason federal and state governments are involved in insurance is to facilitate compulsory insurance purchases. For example, workers compensa- tion insurance has proven to efficiently manage workplace injuries. However, it is possible that some employers would not purchase workers compensation insurance if they were not required to do so. Because states require employers to purchase this insurance (or provide proof of self-insurance), they must have a mechanism to ensure that workers compensation insurance is available at a reasonable cost. Another example is personal automobile liability insurance. As auto liability coverage is required in almost all states, each state has some type of mechanism in place to provide insurance for those drivers who cannot obtain coverage at a reasonable price in the private market. In the workers compensation and auto liability insur- ance markets, most consumers obtain coverage through private insurers. Provide Efficiency in the Market and Convenience to Insureds Two related rationales for government involvement in insurance are providing efficiency in the market and providing convenience to insureds. In economic terms, these two rationales are essentially the same. Providing convenience to insureds, by reducing either the time or the resources they need to expend to obtain the desired insurance coverage, adds to the efficiency of the market. Legislators often find it is more efficient to establish government insurance plans for particular purposes than to invite and analyze bids from private insurers and then supervise and regulate the resulting plans. When insurance provided by the government is compulsory, spending money on marketing or paying sales commissions (two large expenses for insurers) is unneces- sary. Governments sometimes try to avoid sales costs by setting up their own 18 distribution channels. Alternatively, as is the case with the National Flood Insurance Program (NFIP), they market through established insurance pro- ducers who also market other insurance. Achieve Collateral Social Purposes The government may participate in insurance to accomplish social goals because insurance is often seen as a social good. By making use of the pooling mechanism, insurance can reduce risk to society. This is beneficial both to society and to the overall economy. An issue arises when individuals do not have an incentive to purchase insur- ance, even though it would benefit society. If, for example, an organization conducted a cost-benefit analysis and determined that workers compensation insurance was too expensive, it would not want to purchase the insurance. However, workers compensation laws encourage injury prevention and injured workers' rehabilitation. Therefore, the government provides incen- tives for the purchase of insurance through a combination of regulation and provision of insurance at a reasonable price. Organizations respond to these measures by purchasing insurance, which, as well as benefiting the organiza- tion, benefits society. Level of Government Involvement There are three levels at which the government can participate in an insur- ance program: The govemment can be an exclusive insurer either because of law or because no private insurer offers a competing plan. For example, in a few states, all employers must obtain their workers compensation insurance from the state-owned insurer (called an exclusive, or monopolistic, fund). Government partnerships with private insurers can develop when pri- vate insurers are no longer able to adequately provide coverages they had typically offered previously. The NFIP is an example of a partnership under which the federal government underwrites the insurance policy but private insurers and insurance producers deliver the policies to consumers. The private insurers take a percentage of the premium as a sales commis- sion and pass the remainder of the premium on to the NFIP. Government involvement may also take the form of operating an insur- ance plan in direct competition with private insurers. This rype of involvement often evolves when the private insurance market has not failed, but is not operating as efficiently as regulators prefer. Examples include the competitive workers compensation funds offered in some states. 19 Common Examples of Federal and State Programs The final distinction among government property-casual t y insurance pro- grams is whether a state government or the federal government is involved with the program. Common examples of federal government insurance plans include NFIP and federal crop insurance. Examples of state government insurance programs include workers com- pensation plans, residual auto plans, and beach and windstorm plans. See the exhibit "Examples of Property-Casual t y Insurance Offered by State Governments." Examples of Property-Casualty Insurance Offered by State Governments Plan Characteristics of Government Plan Relationship to Private Insurance Fair Access Make basic property insurance available to Organization varies by state. Typically it is to Insurance property owners who are otherwise unable to an insurance pool through which private Requirements obtain insurance because of their property's insurers collectively address an unmet need for (FAIR) Plans location or any other reason. property insurance on urban properties. Does not replace normal channels of insurance; is only for consumers who could not obtain coverage in the private market. Workers Helps employers meet their obligations under Private insurers provide workers compensation Compensation state statutes to injured workers. insurance. Insurance State government can operate as an exclusive insurer, as a competitor to private insurers. or as a residual market. Beach and Make property insurance against the windstorm Organization varies by state: some states Windstorm cause of loss available to property owners who are insurance pools of private insurers; other Plans are otherwise unable to obtain insurance because states are ultimately guaranteed with taxpayer of their property's location. funds. Does not replace normal channels of insurance; is only for consumers who could not obtain coverage in the private market. Residual Auto Make compulsory automobile liability coverage Organization varies by state. Typically it is Plans available to high-risk drivers who have difficulty an insurance pool through which private purchasing coverage at a reasonable rate in the insurers collectively address an unmet need for private market. compulsory auto liability coverage. Does not replace normal channels of insurance; is only for consumers who could not obtain coverage in the private market. [DA07628] ► 20 OVERVIEW OF INSURANCE FUNCTIONS While insurers are known for selling insurance policies and paying claims, they also do much more than mat. Insurers will always look to protect their customers, but they must balance this goal with that of earning a profit. To accomplish this balance, insurers perform multiple functions: Marketing Underwriting Claims Risk control Premium audit While many insurers have established departments for each of these func- tions, some of the functions may be performed by individual producers, actuarial firms, third-party administrative firms, or other outside entities. Additionally, individual insurers may use different terms for these functions in the course of their daily routines. Whatever name they go by and whoever may perform them, the efficient interaction of these functions is vital to the survival and continued success of an organization. Marketing Marketing determines the products or services customers want and need. The marketing function contributes significantly to an insurer's goals of meeting customers' needs and making a profit while doing so. A successful marketing program usually has these components: Market research that helps determine the needs of potential costomers Advertising that informs customers about the insurer's products and services Use of social media platforms to interact effectively with customers Selection of appropriate marketing systems Training to prepare the sales force to meet customer needs Setting sales goals and implementing strategies for achieving them Underwriting Motivating, managing, and training the sales force to meet customer The process of selecting needs insureds, pricing coverage, detennining Insurance policy terms and conditions, and then Underwriting moni!Oring the underwriting The role of the underwriting function is to determine how much coverage decisions made. the insurer should offer for a given loss exposure, as well as at what price and 21 under what conditions the coverage should be offered. Underwriters typi- cally follow the underwriting process, which involves gathering the necessary information to make an underwriting decision, making the decision, and then implementing it. Underwriters must carry out a variety of activities to apply the underwriting process. These underwriting activities are central to the underwriting process: Selecting insureds Pricing coverage Determining policy terms and conditions Underwriters carefully screen potential insureds to determine which ones to insure. They make their selections by applying the underwriting criteria set by the insurer to the loss exposures of customers who have applied for insurance policies. A successful underwriting function ensures that those applicants who are selected receive the level of coverage that adequately reflects their loss exposures at the appropriate price. Increasingly, underwriters can rely on advances in technology to help them complete their tasks more quickly and more accurately. The use of artificial intelligence has grown, providing almost immediate review of information used by underwriters, such as risks present at a potential insured's worksite or coverages that might suit a client better than the policy currently being offered. After a potential insured has been approved, underwriting determines the price for the insurance being offered. The goal is to charge a premium that is commensurate with the loss exposure. The premium should be adequate to enable the total premiums paid by a large group of similar insureds to pay the losses and expenses of that group while also allowing the insurer to earn a reasonable profit. Selection of insureds and pricing of coverage are intertwined with a third underwriting activity: determining policy terms and conditions. T11is sets cer- tain qualifiers in place, some that exclude coverage in certain circumstances and others that outline the responsibilities of insureds in the instance of loss of or damage to insured property (such as notifying authorities if a crime occurred). Claims Insurers expect to pay claims-without them, insurance would be unneces- sary. When policyholders purchase insurance, they are buying protection for the potential financial consequences of covered losses. The insurer's claims function is responsible for keeping the promise to make payments to or on behalf of the insured for covered losses by providing prompt and professional loss adjustment services. 22 When evaluating a claim, the adjuster typically applies a claims handling process that includes these six activities: 1. Acknowledging a claim anq assigning it to a claims representative 2. Identifying the policy 3. Contacting the insured or the insured's representative 4. Investigating and documenting the claim 5. Determining cause of loss and loss amount 6. Concluding the claim Because more than half of what insurers spend goes to the claims function, its proper and efficient performance is important to an insurer's profitability. The growi use of data mining has helped insurers determine the average length of time each step in the claims process takes, providing an oppor- tunity to improve efficiency where needed. Additionally, data mining can supply information that helps an insurer identify potential fraud or subroga- tion opportunities, enabling the insurer to assign such cases to experienced representatives. Business process Business process management (BPM) can pe applied to the claims rum- management (BPM) dling process to improve customer service, efficiency, and cost-effectiveness. A systematic, Iterative plan To achieve its goal of optimizing the claims handling process, BPM begins to analyze and improve with exploratory anal y s is of the current process and then develops models for business processes through llte-cycle phases to achieve improvement. Data analysis is used in gathering intelligence as well as devel- long-term goals and client oping models. satisfaction. Risk Control From an economic viewpoint, controlling risks is preferable to insuring them because it generally costs less to do so. For example, installing handrails along an elevated walkway would probably cost less than paying the medi- cal expenses for anyone who falls off it. As a practical matter, insurance and Risk control risk control are likely to be used jointly for most large loss exposures, because A conscious act or decision preventing all losses is seldom possible. not to act that reduces the frequency and/or severity The risk control function supports underwriters in selecting which loss expo- of losses or makes losses sures to insure. Risk control representatives can use predictive analytics and more predictable. other technology to obtain information beyond what the insurance applica- tion provides to underwriters; in tum, this can help improve decision making. Additionally, risk control professionals can work directly with insureds, pro- viding suggestions as to which loss control techniques would be most effective at lowering the amount of risk they face and, as a result, helping to lower the insured's premiums. 23 Premium Audit When commercial insurance policies are written, it is not uncommon for the premium to be calculated using a loss exposure measurement that could change during the policy period (usually one year). Therefore, the pre- Premium audit mium audit function, which occurs at the end of a policy period, determines Methodical examination of whether any adjustments to the premium are required, based on the insured's a policyholder's operations, actual loss exposures during that period. records, and books of account to determine the For example, the premium of a workers compensation policy, which covers actual exposure un s and expenses when an employee is injured on the job, is based on the total premium for insurance coverages already provided. amount of the insured employer's payroll. However, because of new hires, raises, terminations, and retirements during the policy period, the employer won't know the actual size of its payroll until the end of the policy period. Only after the policy period is completed can the insurer and the insured determine how much the actual premium should be. Apply Your Knowledge For each of these activities, identify the insurance function that is most closely associated with it: Determining the premium for a new customer's personal auto policy a. Underwriting b. Risk control c. Marketing d. Premium audit Feedback: a. This activity is an underwriting function. Visiting a prospective insured's factory to inspect the fire suppression system a. Marketing b. Risk control c. Premium audit d. Claims Feedback: b. This activity is a risk control function. Advertising a new policy program for small businesses a. Risk control b. Premium audit C. Marketing d. Claims Feedback: c. This activity is a marketing function. 24 Reviewing an insured's payroll records for the preceding year at the end of a policy period a. Risk control b. Marketing c. aaims d. Premium audit Feedback: d. This activity is a premium audit fimction. Determining the cause and amount of a policyholder's loss a. Marketing b. Underwriting c. Claims d. Risk control Feedback: c. This activity is a claims function. SUMMARY Insurance can help individuals and organizations achieve risk financing goals, such as paying for losses, managing cash flow uncertainty, and comply- ing with legal requirements. It also provides several benefits to individuals, organizations, and society in general by encouraging an insured's loss control activities, enabling efficient use of resources, providing support for insureds' credit, providing insurers with a source of investment funds, and reducing social burdens by helping insureds recover after a loss. There are costs to insurance, such as the premiums paid by insureds, operating costs of insurers, opportunity costs, and the possibility of increased losses. Insurance may be viewed as a risk management technique, as a risk transfer system in which the insured transfers the risk of financial loss to the insurer, as a business, and as a contract between an insured and an insurer that states which losses the insured is transferring to the insurer and expresses the insur- er's promise to indemnify the insured for those possible losses in exchange for a stated regular payment by the insured. Many types of property-casualty insurance policies cover personal loss expo- sures, which are mainly related to an insured's residences, personal vehicles, or owned watercraft, while a variety of life and health poltcles protect the health, medical well-being, and lives of families and individuals. Commercial insurance policies often combine liability and property coverages into a single CPP or a BOP, providing protection for a wide array of loss exposures. ► l> 25 Different types of private insurers provide property and liability coverage to people and businesses. Private insurers can be classified as stock insurers, mutual insurers, reciprocal insurance exchanges, Lloyd's, surplus lines insurers, captive insurers, and reinsurance companies. Government insurance programs exist to fill unmet needs in the private insurance market, to facilitate compulsory insurance purchases, to provide efficiency in the market and convenience to insureds, and to achieve col- lateral social purposes. There are three levels at which the government can participate in an insurance program-as an exclusive insurer, as a partner with a private insurer, or as an insurer that competes with private insurers. Government-run insurance programs may operate at the state or federal level. Like many businesses, insurers pursue their goals by segmenting operations into functional areas, or departments. These departments cooperate to serve the primary functions of making insureds financially whole again after a loss and creating a profit for the insurer. An insurer's key functions are marketing, underwriting, claims, risk control, and premium audit. Each department must interact effectively with other departments for the insurer to achieve its goals. 26 Insurance Regulation Educational Objectives Outline After learning the content of this assignment, you should be able to: Why Insurance Operations Are Explain why insurance operations are regulated. Regulated Explain how individual states in the United States regulate the licensing Insurer Licensing of insurers. Insurance Rate and I> Summarize the regulation of insurance rates and policy forms by individ, Form Regulation ual states in the United States, Market Conduct and Explain how the individual states in the United States regulate insurance Solvency Regulation marketing activities and insurer solvency. Summary 27 Insurance Regulation WHY INSURANCE OPERATIONS ARE REGULATED When purchasing insurance, consumers may have many questions and concerns about whether the coverage they are purchasing will really protect them. Insurance regulation is meant to address many of these concerns. Insurance consumers' concerns include whether the policy forms give them the coverage they expect and need, whether the price is appropriate, and whether the insurer will have the resources needed to pay losses that may occur months or even years after a policy has been purchased. To protect indi- viduals, organizations, and entire communities from these kinds of problems, all of the states in the United States regulate insurance. Regulation varies considerably from state to state. However, most states focus their regulatory efforts on the same key areas of insurer operations: licensing, insurance rates, insurance policies, market conduct, and insurer solvency. Insurers are regulated primarily for three reasons: To protect consumers To maintain insurer solvency To prevent destructive competition Protect Consumers Insurance is regulated to protect consumers. Many insurance policies are complex legal documents that may be difficult for some consumers to analyze and understand. Regulators help protect consumers by reviewing insurance policy forms to determine whether they benefit consumers. Regulators can set coverage standards, specify policy language for certain insurance coverages, and disapprove unacceptable policies. Insurance regulators also protect consumers against fraud and unethical market behavior by insurers and producers, such as selling unnecessary insur- ance, misrepresenting coverage to make a sale, or refusing to pay legitimate claims. Regulators try to ensure that insurance is readily available, especially the insurance that is viewed as a necessity. For example, all states try to make personal auto insurance available by restricting the rights of insurers ro cancel or refuse to renew personal auto insurance policies. 28 Maintain Insurer Solvency Solvency Insurance is regulated to maintain insurer solvency. Insurance regulators try The ability of an insurer to to maintain and enhance the fiuancial condition of private insurers for several meet its financial obligations reasons: as they become due, even tl10Sll resulting from insured Premiums are paid in advance, and the period of protection extends into losses that may be claimed the future. If an insurer becomes insolvent, future claims might not be several years in the future. paid even though the premium has been paid. Consumers may find it dif- ficult to evaluate insurers' financial ability to keep their promises. Regulation is needed to protect the public interest. Large numbers of individuals are adversely affected when insurers become insolvent. For example, an unusually large catastrophe that affects a large area can make an insurer's financial ability to pay claims uncertain, such as when Hurricane Andrew struck Florida in 1992 and caused seven insurer insolvencies. Insurers hold substantial funds for the ultimate benefit of policyholders. Government regulation is necessary to safeg u ard such funds. Despite regulatory reviews, insurers have become insolvent. However, sound regulation minimizes the number of insolvencies. Prevent Destructive Competition Insurance is regulated to prevent destructive competition. Therefore, regula- tors are responsible for determining whether insurance rates are adequate. At times, some insurers price their policies too low in an effort to attract cus- tomers away from higher-priced competitors. This practice drives down price levels in the whole insurance market. Therefore, when insurance rate levels become inadequate, some insurers may not collect enough money to pay all of their insureds' claims and may become insolvent. Other insurers might lose so much profit that they withdraw from the market or stop writing new business. An insurance shortage can then develop, and individuals and organizations might be unable to obtain the coverage they need. For example, following periods of intense competition among insurers, phar- maceutical companies have found it difficult to obtain commercial liability insurance to cover the risk of product defects in the drugs they manufacture. INSURER LICENSING Most insurance companies must be licensed by the state insurance department before they are authorized to write insurance policies in that state. In the United States, insurers are licensed as domestic insurers in the states where they are domiciled. When insurers wish to operate in additional states, they become licensed as foreign insurers. Insurers domiciled outside the U.S. 29 are licensed as alien insurers. Surplus lines insurers typically operate through a specially licensed producer. In addition to requiring that insurance companies (most commonly stock, mutual, or reciprocal exchange insurers) be licensed, states also generally require that certain individual insurance professionals, such as producers and claims representatives, be licensed. Insurer's Licensing Status A n insurer's licensing status in a given state may assume any one of several forms: that of a domestic insurer, a foreign insurer, or an alien insurer. Domestic Insurer Licensing standards vary among these several forms. For example, a domestic AnInsurer doing business In insurer's license generally has no expiration date, whereas licenses of a foreign the jurisdiction in which it is incorporated. insurer and an alien insurer generally must be renewed annually. Foreign insurer AAinsurer licensed to Becoming Licensed as a Domestic Insurer operate in a state but Domestic insurers usually must meet the conditions imposed on corporations incorpora1lld in another engaged in noninsurance activities as well as some additional conditions state. imposed on insurers. An applicant for a domestic insurer license must apply Alien insurer for a corporate charter and provide specific information, including (but not An insurer domiciled in limited to) these items: a country other than the United States. The insurer's form of ownership The names and addresses of the individual incorporators The name of the proposed corporation and the territories and types of insurance it plans to market The insurer's total financing, including authorized capital stock (the total number of shares, if any, that a corporation can sell to raise money), and its policyholders' surplus Forms of Ownership Insurers can be classified by legal form of ownership. The three most common forms of insurer ownership in the U.S. are stock insurance companies, mutual insurance companies, and reciprocal insurance exchanges. Insurers formed for the purpose of making a profit for their owners are typi- cally organized as stock insurers. Stockholders supply the capital needed to form the insurance company or the additional capital the insurer needs to expand its operations. Stockholders expect to receive a return on their investment in the form of stock dividends, increased stock value, or both. Stockholders have the right to elect the beard of directors. The board of directors creates and oversees corporate goals and objectives and appoints a chief executive officer (CEO) to carry out the insurer's operations. 30 A mutual insurer is a corporation owned by its policyholders. Because a traditional mutual insurer issues no common stock, it has no stockholders. Its policyholders have voting rights similar to those of a stock company's stockholders, and, like stockhotders, they elect the insurer's board o f direc- tors. Although initially formed to provide insurance for their owners, mutual insurers today generally seek to earn profits in their ongoing operations, just as stock companies do. A mutual insurer needs profits to ensure the future finan- cial health o f the organization. Mutual companies include some large national insurers and many regional insurers. A reciprocal insurance exchange, also referred to as a reciprocal, is organized as an unincorporated association of members, called subscribers, that agree to insure one another and share profits and losses. The term "reciprocal" comes from the reciprocity of responsibility of all subscribers to each other. Each member of the reciprocal is both an insured and an insurer. Because the sub- scribers are not experts in running an insurance operation, they contract with an individual or organization to operate the reciprocal. This manager, called an attorney-in-fact, is typically a corporation with a board o f directors that manages the reciprocal. See the exhibit "Forms oflnsurer Ownership." Forms of Insurer Ownership Type of Insurer Form of Ownership Management Stock insurer Corporation owned by its Board of directors, elected stockholders by stockholders Mutual insurer Corporation owned by its Board of directors, elected policyholders by policyholders Reciprocal insurance Unincorporated association Attorney-in-fact chosen by exchange of subscribers subscribers [DA07488] Capital and Surplus Information about capital stock and surplus is important to licensing regula- tors because it indicates the insurer's financial soundness. A domestic insurer that is also a stock insurer must meet certain minimum capital and surplus requirements, which vary widely by state and by amounts and types of insur- ance written. A domestic insurer that is also a mutual insurer has no capital derived from the sale of stock. Therefore, the minimum financial requirement applies only to surplus. Most states require mutual insurers to have an initial surplus equal to the minimum capital and surplus requirement for stock insur- ers writing the same type of insurance. 31 Becoming Licensed as a Foreign or an Alien Insurer In the U.S., an insurer is typically licensed as a domestic insurer in one state and as a foreign insurer in all other states where it wishes ;o operate. Less commonly, an insurer is domiciled outside the U.S. and is licensed as an alien insurer in the U.S. stares where it wishes to operate. To be licensed in an additional state (that is, as a foreign insurer), an insurer first must show the regulator in the additional state that it has satisfied the requirements imposed by its home state (its state of domicile, or the state where it is a domestic insurer). A foreign insurer also must generally satisfy the minimum capital, surplus, and other requirements imposed on domestic insurers within the state in which it is seeking to be licensed. Alien insurers must satisfy the requirements imposed on domestic insurers by the state in which they want to be licensed. Additionally, they must usually establish a branch office in any state and have funds on deposit in the U.S. equal to the minimum capital and surplus required. The funds on deposit are available, if necessary, to pay claims asserted against the alien insurer through the U.S. legal system. See the exhibit "Licensing Status of a Hypothetical Insurer. 0 Admitted Insurers and Nonadmitted Insurers Insurers that are licensed to do business in a state, whether as domestic, for, eign, or alien insurers, are collectively referred to as admitted insurers. Under Admitted insurer special circumstances, insurers that are not licensed in the particular state, An insurer to which a state referred to as nonadmitted insurers, may be permitted to sell insurance within insurance department has that state. A nonadmitted insurer may be an admitted insurer in other states, granted a license to do business within that state. or it may even be an alien insurer. Nonadmitted insurers are frequently referred to as surplus lines insurers. Surplus lines insurers are usually permitted to sell only insurance that is not readily available from admitted insurers because of specialty, risk, or several other factors. Under surplus lines laws, a nonadmitted insurer is permitted to Surplus lines law transact business only through a specially licensed surplus lines producer. The A state law fllat permits nonadmitted insurer must still meet some of the regulatory requirements of any producer with a surplus a licensed insurer, but these do not typically include restrictions on rates and lines license issued by that state to procure insurance policy forms, from an eligible Sllrplus lines insurer Hthe applicant Producers and Claims Representatives cannot obtain flle desired type of insurance in the In addition to licensing insurers, all states require licensing of certain insurer admitted market. representatives or employees. Agents, brokers, and claims representatives are often required to pass an examination on insurance laws and practices to earn a license. These examinations 1 along with continuing education requirements 1 are an attempt to ensure that these insurance professionals have a minimum level of insurance knowledge and meet ethical standards. 32 Licensing Status of a Hypothetical Insurer Insurer A, a regional insurer domiciled in Ohio, is licensed as a domestic insurer In Ohio and as a foreign insurer in its other states of operation. Licensed as domestic insurer D Licensed as foreign insurer [DA07504] INSURANCE RATE AND FORM REGULATION Individual states in the United States regulate insurance rates to strike a balance between reasonable profits for insurers and reasonable prices for consumers. Additionally, states regulate insurance policy forms to ensure that they are readable, understandable, and fair. A solvent, profitable insurance market that provides insurance products at affordable rates is important to the citizens of every state. From coverage on their homes and autos to workers compensation, individuals need insurance. Organizations of all types and sizes cannot operate without insurance. Because insurance is important and often required for individuals and businesses, states enact laws to ensure that rates are sufficient for insurers and reasonable for consumers. In addition to being able to afford to purchase insurance, consumers also need to be able to understand the insurance products they purchase, Therefore, 33 states typically regulate insurance policy forms to enable consumers to read and understand them. Most states review policy provisions to ensure that they are fair and reasonable. There are, however, certain types of insurance, such as coverage for complex commercial organizations or unique risks, exempted from regulation. Insurance Rate Regulation Setting insurance rates is the regulatory area that may receive the most public attention. It is imporrant to insurers that rates allow them to collect sufficient premiums to pay for the insured losses that occur, to cover the insurer's costs of operating, and to allow a reasonable profit. When deciding to approve or disapprove an insurer's request for a rate, a state

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