Archive for Reinsurance

How Insurance Shares Risk Across The Population And Aims For Fair Premiums

Insurance Blog often gets unusual requests, more proof that Insurance is not grey and boring, the latest being particularly unusual so we thought we’d rise to the challenge.

A mature student friend of ours was struggling with his first year accountancy exams when asked to write an essay on the following, so he thought he’d approach us for some answers and help writing his assignment.

1.Explain how Insurance shares risk across the population?
2.What is a fair insurance premium?
3.How can adverse selection prevent Insurance being available at a fair premium?
4.What strategies do insurance companies follow to reduce the problem of adverse selection?

So we farmed it out to our technical expert Dave Healey and this is what he came up with.

The Primary Functions Of Insurance As A Service Industry

By Dave Healey

There are three primary functions of Insurance which determine how Insurance companies operate and how the public interacts with these companies.

The first is as a risk transfer mechanism, whereby the individual or business can shift some of the uncertainty of life onto the shoulders of others. In return for a known premium, usually a very small amount compared to the potential loss, the cost of that loss can be transferred to an insurance company. Without Insurance there would be a great deal of uncertainty experienced by both the individual and the enterprise, not only as to how and whether a loss would occur, but also to the extent and size of the potential loss.

The second primary function is the establishment of the common pool. The Insured’s premium is received by the Insurer into a fund or pool for that type of risk, and the claims of those suffering losses are paid out this pool. Applying Bernoulli’s ‘Law of Large Numbers’, because of the large number of clients that any particular risk fund or pool will have, Insurance companies can predict with high accuracy the amount of claims or losses that might be suffered over a period of time. The will be some variations in losses over different years and Insurance companies include an element of premium to build up a reserve, to pay for additional losses in bad or catastrophic years. Therefore in principle, subject to the limitations of the type of cover bought, the client should not have to pay additional premiums into the common fund after a loss or claim.

The third primary function of Insurance is to provide fair and equitable premiums. Assuming that a risk transfer mechanism has been set up through a common fund or pool, the contributions paid into the fund should be fair to all parties participating. Each party wishing to insure and paying into the fund will bring with it varying degrees of risk. To avoid adverse selection and provide equitable premiums each risk is broken down into various components and rating factors that can be priced individually on a statistical scale of probability determined by Actuaries. Therefore those who present the greater statistical risk will pay more into the common fund for the same cover, when their individual premiums are calculated.

Insurance companies employ underwriters to reduce the problem of adverse selection and protect the fund. The underwriters will determine parameters of the hazard and value of a risk that is acceptable for the fund, and decline risks that fall outside these parameters. In fixing a fair level of premium they must also take into account the contributions made by others into the common fund and price accordingly.

Underwriters and insurance companies will employ many techniques to deter or price adverse selection out of the risk pool. These typically include exclusions to cover in the form of policy wordings and additional conditional clauses, exempting the risk under certain conditions. They will employ all types of mechanisms and devices to install fear into the population to increase the size of the risk pool and attract the niche or sector of the market that they are aiming for. For example large marketing campaigns aimed at the ‘safe’ sector e.g. women drivers who are statistically less likely to claim. On the Internet, Insurance companies employ automated underwriting that excludes cover to everything that does not fit the desired risk pool parameters.

Ultimately the Government can in certain cases decide the size of the risk pool through leglislation and compulsory insurance as is the case for car insurance where it is illegal to drive without cover and business insurance where it is illegal to trade without liability insurance cover.

Insurance companies can also take further risk transfer from the insurer to a reinsurer (reinsurance) laying of some of their exposure as a mechanism for adverse risk control.

We originally published the Article at:

Well there’s obviously a lot more to write on this subject so if some of you FCII fellows out there who read this blog  wish to contribute, feel free to leave your comments on the questions!

“One event away from a hard market” says Willis CEO

“One event away from a hard market” says Willis CEO

By Insurance blogger Kris Oldland

It appears that somebody else has spotted some of those fabled green shoots as Tony Ursano CEO of Willis capital markets and advisory, a unit of Willis Group Holdings made bold predictions that their will be significant increase in Mergers & Acquisitions (M&A) activity within the insurance industry as we move into 2010.

With the soft market creating a greater need for growth, diversification and specialization as insurers fiercely fight for every competitive edge, Insurance Mergers and Acquisitions deals may soon prove to be a much more valid alternative than perhaps they have been, throughout what has been a year of consolidation at best for most of the industry.

Citing key factors such as the increasing importance of the size and scale of companies for ratings agencies, investors and clients alike, Ursano sees the level of M&A activity increasing as financing capacity and terms begin to improve, more positive valuations increase confidence and markets begin to stabilize once again.

A bold statement indeed, especially when we consider that throughout the current year we have seen the average price of M&A deals fall to just 1.09 times the book value. It seems a lot longer than a year ago that M&A activity was a frequent occurrence and the average price in a deal was a whopping 2.46 times book value doesn’t it? The big question is can we really expect the market to come good again just as quickly as it fell apart?

Whilst maintaining such a positive outlook Ursano is no fool and he also remains cautiously realistic, as you would expect from a man in his position, as he reminds us that over 50% of insurance deals have “failed to create shareholder value”. Ursano again cited a number of factors including difficulties assessing the profitability of the target, the volatile nature of financing markets and of course the cyclical nature of the insurance markets as being responsible for the unsuccessful ventures.

However such caution is more to do with the nature of the M&A process rather than the external current external economic factors. If well thought out, thoroughly researched and expertly executed, an M&A deal can of course succeed on a shareholder level. The odds are further improved by a deal which has not only financial but also strategic benefits.

Companies looking to develop their position within the sector through acquisition need to ensure that the deal is positioned correctly and not just a reactionary move. Net earnings, return on equity and book value per share all need to be showing to justify the expense, but also there should be strong reasoned thought behind the strategic benefits to the acquisition. It is also imperative that there is total transparency of loss reserves available and committed financing placed upfront.

Of course one position that is often criminally neglected is ensuring that there is enough incentive to maintain appropriate staffing levels after acquisition – particularly the key management personnel that have made the target company such an interesting and compelling prospect in the first place.

Mr. Ursano certainly seems to think that the next chapter for the industry is not too far away. “We are one event away from a hard market” he said adding that the fantastic strains that are currently being placed on profitability and returns, alongside the reduced investment income now available in the sector and valuations being at an all-time low are creating a buyers market. With over 50 insurance and re-insurance companies trading at below their stated book value Ursano believes it could only take one major investment to “catapult the industry into a hard market.” We can but hope that he is right.

Whatever the next year holds however we can be certain of one thing in 2010 – the rules have changed this time round and it’s going to be one heck of an interesting year.


Thanks for that very useful insight Kris! You can find out more about what businesses are for sale in the Insurance world and register your interest by visiting Insurance Broker Buyers and Insurance Broker Sellers