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Small-Business-Insurance
Principles of
insurance
Commercially
insurable risks
typically share
seven common
characteristics.
1. A large number of
homogeneous exposure
units. The vast
majority of
insurance policies
are provided for
individual members
of very large
classes. Automobile
insurance, for
example, covered
about 175 million
automobiles in the
United States in
2004. The existence
of a large number of
homogeneous exposure
units allows
insurers to benefit
from the so-called
“law of large
numbers,” which in
effect states that
as the number of
exposure units
increases, the
actual results are
increasingly likely
to become close to
expected results.
There are exceptions
to this criterion.
Lloyd's of London is
famous for insuring
the life or health
of actors, actresses
and sports figures.
Satellite Launch
insurance covers
events that are
infrequent. Large
commercial property
policies may insure
exceptional
properties for which
there are no
‘homogeneous’
exposure units.
Despite failing on
this criterion, many
exposures like these
are generally
considered to be
insurable.
2. Definite Loss.
The event that gives
rise to the loss
that is subject to
insurance should, at
least in principle,
take place at a
known time, in a
known place, and
from a known cause.
The classic example
is death of an
insured on a life
insurance policy.
Fire, automobile
accidents, and
worker injuries may
all easily meet this
criterion. Other
types of losses may
only be definite in
theory. Occupational
disease, for
instance, may
involve prolonged
exposure to
injurious conditions
where no specific
time, place or cause
is identifiable.
Ideally, the time,
place and cause of a
loss should be clear
enough that a
reasonable person,
with sufficient
information, could
objectively verify
all three elements.
3. Accidental Loss.
The event that
constitutes the
trigger of a claim
should be
fortuitous, or at
least outside the
control of the
beneficiary of the
insurance. The loss
should be ‘pure,’ in
the sense that it
results from an
event for which
there is only the
opportunity for
cost. Events that
contain speculative
elements, such as
ordinary business
risks, are generally
not considered
insurable.
4. Large Loss. The
size of the loss
must be meaningful
from the perspective
of the insured.
Insurance premiums
need to cover both
the expected cost of
losses, plus the
cost of issuing and
administering the
policy, adjusting
losses, and
supplying the
capital needed to
reasonably assure
that the insurer
will be able to pay
claims. For small
losses these latter
costs may be several
times the size of
the expected cost of
losses. There is
little point in
paying such costs
unless the
protection offered
has real value to a
buyer.
5. Affordable
Premium. If the
likelihood of an
insured event is so
high, or the cost of
the event so large,
that the resulting
premium is large
relative to the
amount of protection
offered, it is not
likely that anyone
will buy insurance,
even if on offer.
Further, as the
accounting
profession formally
recognizes in
financial accounting
standards, the
premium cannot be so
large that there is
not a reasonable
chance of a
significant loss to
the insurer. If
there is no such
chance of loss, the
transaction may have
the form of
insurance, but not
the substance. (See
the U.S. Financial
Accounting Standards
Board standard
number 113)
6. Calculable Loss.
There are two
elements that must
be at least
estimable, if not
formally calculable:
the probability of
loss, and the
attendant cost.
Probability of loss
is generally an
empirical exercise,
while cost has more
to do with the
ability of a
reasonable person in
possession of a copy
of the insurance
policy and a proof
of loss associated
with a claim
presented under that
policy to make a
reasonably definite
and objective
evaluation of the
amount of the loss
recoverable as a
result of the claim.
7. Limited risk of
catastrophically
large losses. The
essential risk is
often aggregation.
If the same event
can cause losses to
numerous
policyholders of the
same insurer, the
ability of that
insurer to issue
policies becomes
constrained, not by
factors surrounding
the individual
characteristics of a
given policyholder,
but by the factors
surrounding the sum
of all policyholders
so exposed.
Typically, insurers
prefer to limit
their exposure to a
loss from a single
event to some small
portion of their
capital base, on the
order of 5 percent.
Where the loss can
be aggregated, or an
individual policy
could produce
exceptionally large
claims, the capital
constraint will
restrict an insurers
appetite for
additional
policyholders. The
classic example is
earthquake
insurance, where the
ability of an
underwriter to issue
a new policy depends
on the number and
size of the policies
that it has already
underwritten. Wind
insurance in
hurricane zones,
particularly along
coast lines, is
another example of
this phenomenon. In
extreme cases, the
aggregation can
affect the entire
industry, since the
combined capital of
insurers and
reinsurers can be
small compared to
the needs of
potential
policyholders in
areas exposed to
aggregation risk. In
commercial fire
insurance it is
possible to find
single properties
whose total exposed
value is well in
excess of any
individual insurer’s
capital constraint.
Such properties are
generally shared
among several
insurers, or are
insured by a single
insurer who
syndicates the risk
into the reinsurance
market.
Insurer’s business
model
Profit = earned
premium + investment
income - incurred
loss - underwriting
expenses.
Insurers make money
in two ways: (1)
through
underwriting, the
process by which
insurers select the
risks to insure and
decide how much in
premiums to charge
for accepting those
risks and (2) by
investing the
premiums they
collect from
insureds.
The most difficult
aspect of the
insurance business
is the underwriting
of policies. Using a
wide assortment of
data, insurers
predict the
likelihood that a
claim will be made
against their
policies and price
products
accordingly. To this
end, insurers use
actuarial science to
quantify the risks
they are willing to
assume and the
premium they will
charge to assume
them. Data is
analyzed to fairly
accurately project
the rate of future
claims based on a
given risk.
Actuarial science
uses statistics and
probability to
analyze the risks
associated with the
range of perils
covered, and these
scientific
principles are used
to determine an
insurer's overall
exposure. Upon
termination of a
given policy, the
amount of premium
collected and the
investment gains
thereon minus the
amount paid out in
claims is the
insurer's
underwriting profit
on that policy. Of
course, from the
insurer's
perspective, some
policies are winners
(i.e., the insurer
pays out less in
claims and expenses
than it receives in
premiums and
investment income)
and some are losers
(i.e., the insurer
pays out more in
claims and expenses
than it receives in
premiums and
investment income).
An insurer's
underwriting
performance is
measured in its
combined ratio. The
loss ratio (incurred
losses and
loss-adjustment
expenses divided by
net earned premium)
is added to the
expense ratio
(underwriting
expenses divided by
net premium written)
to determine the
company's combined
ratio. The combined
ratio is a
reflection of the
company's overall
underwriting
profitability. A
combined ratio of
less than 100
percent indicates
underwriting
profitability, while
anything over 100
indicates an
underwriting loss.
Insurance companies
also earn investment
profits on “float”.
“Float” or available
reserve is the
amount of money, at
hand at any given
moment, that an
insurer has
collected in
insurance premiums
but has not been
paid out in claims.
Insurers start
investing insurance
premiums as soon as
they are collected
and continue to earn
interest on them
until claims are
paid out.
In the United
States, the
underwriting loss of
property and
casualty insurance
companies was $142.3
billion in the five
years ending 2003.
But overall profit
for the same period
was $68.4 billion,
as the result of
float. Some
insurance industry
insiders, most
notably Hank
Greenberg, do not
believe that it is
forever possible to
sustain a profit
from float without
an underwriting
profit as well, but
this opinion is not
universally held.
Naturally, the
“float” method is
difficult to carry
out in an
economically
depressed period.
Bear markets do
cause insurers to
shift away from
investments and to
toughen up their
underwriting
standards. So a poor
economy generally
means high insurance
premiums. This
tendency to swing
between profitable
and unprofitable
periods over time is
commonly known as
the "underwriting"
or insurance cycle.
Property and
casualty insurers
currently make the
most money from
their auto insurance
line of business.
Generally better
statistics are
available on auto
losses and
underwriting on this
line of business has
benefited greatly
from advances in
computing.
Additionally,
property losses in
the US, due to
natural
catastrophes, have
exacerbated this
trend.
Finally, claims and
loss handling is the
materialized utility
of insurance. In
managing the
claims-handling
function, insurers
seek to balance the
elements of customer
satisfaction,
administrative
handling expenses,
and claims
overpayment
leakages. As part of
this balancing act,
fraudulent insurance
practices are a
major business risk
that must be managed
and overcome.
- Courtesy Wikipedia
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