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: http://EzineArticles.com/?expert=Dave_Healey

http://EzineArticles.com/?The-Primary-Functions-Of-Insurance-As-A-Service-Industry&id=6292397

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!

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3. The Hidden Costs of Uninsured Drivers in Your Car Insurance Premiums

The Insurance Industry which is at the top of the triangle of the money market distribution, is renowned for it’s slow reaction to change.
You’ve only got to ask a dynamic young business analyst or insurance product underwriter how difficult it is to implement solutions that would ultimately bring an Insurance Company competitive advantage……
Insurance Companies are naturally cautious and are able to absorb external change over time through their ability to control the provision of products and the levels of competition within the market.
They do this by controlling the rates at which they sell their products to the retail market through various differing distribution channels.
The rates that Insurance Companies set for Insurance are typically determined by the levels of profit that the investment side of the company is making.

This level of profit is ultimately determined by the Base Interest Rate set by the Government above which the Insurance Companies can not only sell you products with hiked up rates such as mortgages and pensions, but much more importantly make the bulk of their profits from reinvesting your money in very large chunks, for guaranteed long term profits.
For example ,the current Government borrowing deficit of 165 billion pounds sterling has mostly been underwritten by Global Insurance Companies buying up the bonds.

Incredibly the money was borrowed, to bail out many of the private corporations who created the recession but who are now profiting from the debt.

Even more incredibly the Insurance Companies are crying ‘Please don’t tie us in with the banks – We’re not the baddies’!

Well I’ve got news for you Insurance companies!
Thanks to the policies followed by all those chairmen of the Insurance Companies throughout the 1990′s of agglomeration, Cartels, price fixing and that word that they now pretend never existed ‘Banc-Assurance‘ …

You are the bad boys- You and the Banks are the same thing!

And where are all those Chairman of the Bank Assurers who created and introduced risk into the Economy now?
Yes, all sitting pretty in the House of Lord’s, unelected and having further say ion the Country’s future. Outrageous!

Back to the point, Insurance Companies must now adjust to the new economics.
In the past they have had the arrogance to talk about fixed seven year cycles between hard markets where they can increase the rates to high profit levels and soft markets where wider levels of competition keep the prices down. At the end of the day the volume of business is exactly the same and the levels of claims homogeneous, so why the fluctuations?

Purely for profit!

Now though these very same companies are stuck between a rock and a hard market as they no longer have either the control over the flow of money or thanks to Global business and The Internet, the number of entrants able to enter the market,

In the past when Insurance Companies were making losses or wanted to make super-profit, the Insurance market would Cartel like, hike it’s prices across the board. A so called hard market. They are no longer in a position to do this!
Furthermore the profits they make from their investment vehicles are down due the Interest rates sensibly being held low by the Bank of England.
It won’t be long before the Insurance Company shareholders start screaming when they don’t get the dividends they expect or deserve! The Insurance Companies are already moaning about how incredibly unfair the Base Rate is to their investment vehicles!

Remember these are the same people – The Banks – who would like to charge you 15% on your mortgage debt and make super profits – if they thought they could get away with it. They’re already charging you more than that on your Credit Cards!

The Car Insurance Market is traditionally the first to harden it’s rates, with you and me the motorist suffering, but with increased number of distribution channels and the ability to shop around, it would be a foolish insurer who hardened his rates and expected to keep his book of business in the current economy.

You can expect similar resistance to unfair and unwarranted commercial insurance premium hikes, especially when the business had carried out good risk management and claims loss prevention.
Why should they pay more?
Because they are in a poorly managed risk pool?
Shop around Shop owners!

If the collective Insurance industry try to impose a hard market on the public during a recession they will create untold social problems as individuals and businesses under insure and health and safety practices go out the window.

Insurance Companies have to develop a real sense of social responsibility not just some hyped up marketing blurb about planting tress or paying to brand yourselves with Athletics and Football!

Insurance Companies have got to learn to be symbiotic and not Parasites on the State and it’s People! Restricting their profits would be a good place to start!

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2. UK Car Insurance Rates Must Harden As Loss Making Companies Claims Reserves Run Dry!
3. Insurance Companies Blame 2009 Losses on Personal Accident & Bodily Injury Claims

There has been a mixed bag of results in the insurance world this week as a variety of insurance companies have announced how they have fared across the last year.
One of the biggest impacts on the industry was the phenomenal upsurge in the rising cost of bodily injury claims – partly as a result of the recession and partly due to the increase in claims farmers.

Kris Oldland gives Insurance Blog a roundup of the 2009 UK Insurance results so far……….

The insurance arm of part nationalised bank Royal Bank Scotland was heavily hit with profits collapsing by 90% with £448m reserves being set aside for bodily injury (BI) claims.
The group which includes Direct Line, Churchill, Privilege and NIG – posted a drop in net income from £584m in 2008 to £54m last year. Chief executive Paul Geddes claimed that considering their size and risk exposure, 2009 was always likely to be a tough year saying that being “twice as big as anybody else, when the market sneezes we catch a cold.”

Of course many of the major operators within the personal lines market were hit particularly badly by the rising cost in BI claims although RSA managed to reduce the damage to just £30m by taking early action to counter the rising costs.
UK Chief Exec Adrian Brown admitted that “The hit to our result is fairly small compared with some of the other numbers being thrown around.”
He added “When it comes to bodily injury costs, you have to be massively up to date on claims; they are one of the things you have to watch like hell when you are cutting expenses and headcount.”

Another company that felt the impact of rising personal injury claims was the specialist car insurance company Equity Red Star who had a strong full-year profit of A$113m eroded away by bodily injury claims. Insurance Australia group (IAG) who own the company put a statement to market that read “A lower margin of 6.6% reflected reserve strengthening for prior-year bodily injury claims and weaker investment returns, both of which have been felt across the UK industry.”

Meanwhile Allianz have grown their operating profit in the last year by 5% climbing to £203m in the last year while the combined ration improved from 95.2% to 92.9% despite the obviously tough trading conditions.
A large part of the success has been down to Allianz’s hard line stance on driving rate rises of 24%. Chief executive Andrew Torrance predicted more of the same in 2010 commenting that “It remains a priority for in 2010 to increase premium rates to a level that provides an adequate return on the cost of capital.”

Other insurers posting impressive results for 2009 were Amlin and Hiscox who both had strong years due in large to the reasonably benign hurricane season.

Amlin were able to post combined operating ratio improvement from 76% to 72% although their results were padded out slightly by £174.1m in reserve releases whilst Hiscox insurer tripled profits before tax from £105.2m to £320.6m, in what chairman Robert Hiscox described as a “vintage” year.

Another Lloyd’s insurer to triple profits in 2009 thanks to the kind hand dealt by mother nature last year was Brit who increased profits to £171m although an uplift in investment returns of £137.4m last year from £7.4m in 2008 certainly would of helped also.

……..So it looks like a lot of people will be seeking big bonuses?

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