CPCU CORE REVIEW 520, INSURANCE OPERATIONS

Transcription

1 CPCU CORE REVIEW 520, INSURANCE OPERATIONS Dylan H. Kim, CPCU, CFA 2nd Edition

2 COPYRIGHT CPCU Core Review 520, Insurance Operations. 2nd Edition. Copyright Dylan H. Kim, CPCU, CFA, All rights reserved. Published in 2014 by illi sharing corporation. Printed in the United States by CreateSpace, An Amazon.com Company. e-isbn: ISBN:

3 DISCLAIMER "CPCU and Chartered Property Casualty Underwriter are trademarks owned by The Institute. The Institute (formerly the American Institute of Chartered Property Casualty Underwriter) does not endorse, promote, review, or warrant the accuracy of the products or services offered by Illi Sharing." The CPCU Core Review 520 should be used in conjunction with the original readings such as Text, Review Notes, and Course Guide, as set forth by The Institute. The information contained in this Book covers topics contained in the readings referenced by The Institute and is believed to be accurate. However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success. The authors of the referenced readings have not endorsed or sponsored this book. The CPCU Core Review 520 may not be copied without written permission from the author. The unauthorized duplication of this book is a violation of global copyright laws and the CPCU Institute Code of Ethics. Your assistance in pursuing potential violators of this law is greatly appreciated. 3

4 NOTES FROM THE AUTHOR Dear CPCU candidates, Welcome! I am very pleased that you've completed a cost-to-benefit analysis and correctly concluded that this core review is well worth the purchase price. When all is said and done, you will have invested a couple of months with this subject and paid your hard-earned money to the CPCU Institute to take a onetime examination with either pass or non-pass. Now, that's pressure! Fear not, this book was written for you. It will help you attain your passing test score and reduce your stress level, as well. This book is unique in that it will not only prepare you to pass the CPCU test, but it will also help you save your time. In my about 10 years of teaching all the CPCU programs, I've taught hundreds of students who passed CPCU 520 exam with only 50~70 study hours. Today, former candidates continue to contact me to let me know that without my review work, they would not have scored as well as they did on their exams. Now, I've applied all that good experience to the writing of this book. In contrast to other test materials such as Text book, Review Notes, Course Guide, Quiz Me application, you'll find that all you need to know in order to have passing grade of 70% is summarized and focused in this single review. All the nut-and-bolts concepts and questions you need are inside to fully diagnose your knowledge and polish it up for test day. Listen, do you want to know the real key to passing the CPCU exam with the minimum study hours? The real key lies in developing your ability to grasp the whole, focus on the main concepts, analysis details in question and answer, and repeat. This review will help you have it all. However, it should be noted that this book is created as a teaching material for professionals, so it includes all the very intensive contents relating to the actual exam. That means it will be difficult to study alone if you are a beginner who have no experience in Property and Casualty insurance underwriting. If you are a beginner, you need to study Text Book first and can take advantage of this book as a final cleanup. For your information, CPCU Complete Review series by the same author will be coming soon for the very beginner to explain all the intensive contents of this book, CPCU Core Review, with easy examples and cartoons. Thank you and best of luck on the CPCU test! Dylan H. Kim, CPCU, CFA 4

5 CONTENTS CPCU 520 Exam Guide CPCU Program Description!7 CPCU Exam Information and Registration!9 Taking an Exam!11 SECTION 1. Insurance Operations Topic 1: Classification of Insurers!16 Topic 2: Insurer Goals!25 Topic 3: Insurer Functional Performance!34 SECTION 2. Insurance Regulations Topic 4: Overview of Insurance Regulations!44 Topic 5: Monitoring & Regulating Insurers!61 Topic 6: Market Conduct and Unofficial Regulators!75 SECTION 3. Insurance Marketplace Topic 7: Property-Casualty Insurance Marketing!82 Topic 8: Insurance Distributions Systems and Channels!88 SECTION 4. Underwriting Operations Topic 9: Underwriting Goals and Activities!102 Topic 10: Establishing Underwriting Policy!110 Topic 11: Underwriting Process and Measuring Results!117 SECTION 5. Risk Control and Premium Auditing Topic 12: Insurer Risk Control!128 Topic 13: Premium Auditing!134 SECTION 6. Claim Operations Topic 14: The Claim Function!146 Topic 15: Claim Handling Process!157 Topic 16: Framework for Coverage Analysis!168 SECTION 7. Actuarial Operations Topic 17: Insurer Ratemaking Goals!176 Topic 18: Ratemaking Methods and Process!182 5

6 Topic 19: Ratemaking Factors and Loss Reserves!190 SECTION 8. Reinsurance Operations Topic 20: Reinsurance and Its Functions!202 Topic 21: Types of Reinsurance!210 Topic 22: Alternatives and Reinsurance Design!223 SECTION 9. Business Needs and Information Technology Alignment Topic 23: Insurer and Information Technology!234 Topic 24: Types of Business Information Systems!243 Topic 25: Security and Control in Information Systems!249 SECTION 10. Strategic Management Topic 26: Insurer Strategic Management!256 6

7 CPCU 520 Exam Guide CPCU 520 EXAM GUIDE CPCU Program Description Note: The following information refers to the CPCU Experience Booklet from The Institute. CPCU Course Descriptions The current program stands at eight examinations four foundation courses, one elective course and three concentration courses. The core courses continue to reflect the broad-based curriculum of the early program risk management and insurance principles, operations, regulation, statutory accounting, law, and finance. The elective course increases the relevancy to the individual allowing study in a functional area of their choosing and provides opportunity to earn cross-credit from other Institutes programs. The concentration courses allow students to deepen their understanding of either commercial lines or personal lines insurance. The core principles of education, ethics, and experience remain strongly intact. Foundation Courses CPCU 500 Foundations of Risk Management and Insurance CPCU 520 Insurance Operations: Overview of Insurance Operations, Insurance Regulation, Insurance Marketing and Distribution, The Underwriting Function, Underwriting Property and Liability Insurance, Risk Control and Premium Auditing, The Claim Function, Adjusting Property and Liability Claims, Actuarial Operations, and Reinsurance. CPCU 530 Business Law for Insurance Professionals CPCU 540 Finance and Accounting for Insurance Professionals Commercial Concentration Courses CPCU 551 Commercial Property Risk Management and Insurance CPCU 552 Commercial Liability Risk Management and Insurance CPCU 553 Survey of Personal Insurance and Financial Planning Personal Concentration Courses CPCU 555 Personal Risk Management and Property-Casualty Insurance CPCU 556 Financial Planning CPCU 557 Survey of Commercial Insurance 7

8 CPCU Core Review 520 Insurance Operations Elective Courses AAI 83 Agency Operations and Sales Management AIC 34 Workers Compensation and Managing Bodily Injury Claims AIC 31 Property Claim Practices* AIC 32 Liability Claim Practices* ARe 144 Reinsurance Principles and Practices ARM 56 Risk Financing AU 67 Strategic Underwriting Techniques* CPCU 560 Financial Services Institutions ERM 57 Enterprise-Wide Risk Management: Developing and Implementing CPCU Ethics Requirement The Institutes believe that the study of ethics is essential to the professional practice of risk management and insurance. By separating the ethics component, students will be able to more effectively study ethics and achieve a greater understanding of the science and art behind ethical decision-making in the context of the insurance business. The CPCU ethics requirement is satisfied by completing the online module, Ethics and the CPCU Code of Professional Conduct (Ethics 312), or by having credit for CPCU 510, prior to March 15, CPCU Experience Requirement The CPCU experience requirement is two years. The two-year experience requirement applies to all CPCU students and candidates who qualify for the class of 2010 and beyond, regardless of when the individual started in the program. 8

9 CPCU 520 Exam Guide CPCU Exam Information and Registration Note: The following information refers to the CPCU Registration Booklet from The Institute. Exam Dates Testing Windows for Computer Administered Institutes Exams January 15-March 15 April 15-June 15 July 15-September 15 October 15-December 15 Exam Format Exams are administered on computer. Computer administered exams are preceded by an optional 30-minute tutorial and are followed by a brief survey. Category Number and Type of Questions Time Limit ARe, ARM multiple-choice questions 2 hours CPCU multiple-choice questions 1.5 hours CPCU 520, 530, 540, 551, 552, 553, 555, 556, and multiple-choice questions 2 hours CPCU short essay questions 3 hours All the above exams have passing grade of 70 percent. Testing Centers Computer exams are administered at Prometric Testing Centers and at Institutes-approved on-site testing centers, usually an employer facility. Prometric centers are located in more than 420 cities worldwide. Log on to to find a center. Examinees must arrive at Prometric Testing Centers at least 30 minutes before a scheduled appointment for check-in. Registering for an Exam Online Phone (800) (Monday Friday, 8 am to 6 pm EST) Fax (610) Mail 720 Providence Rd., Suite 100, Malvern, PA

10 CPCU Core Review 520 Insurance Operations Exam Fee CPCU 520, Oct 15 - Ded 15, 2015 for example Institutes Approved On-Site Testing Centers Prometric Test Center Early Registration Prometric Test Center Standard Registration Register through Dec 15, 2015 Register on or before Oct 15, 2015 Register after Oct 15, 2015 Exam Fee: $240 $260 $330 Registrations Dec 15, 2015 Oct 15, 2015 Dec 12, 2015 accepted through: Cancellation deadline Dec 15, 2015 You must cancel 3 or more business days prior to your scheduled Prometric appointment Cancellation $135 $175 $175 Forfeiture Cost to Transfer: $85 $110 $110 You must cancel 3 or more business days prior to your scheduled Prometric appointment Payment The Institutes accept American Express, Diners Club, Discover, MasterCard, and VISA. Mailed registrations also may be paid by check or money order. Fees are nonrefundable and nontransferable and must be paid in U.S. currency. Scheduling a Computer-Administered Exam Appointment Schedule your appointment when you know you will be ready to sit for the exam. Prometric will charge a $50 fee to students who reschedule their appointments within 3 to 12 business days of a test date. Also, scheduling an appointment far in advance and then canceling could deprive another examinee of a desired testing date and time. Be considerate of others. Still, we also recommend scheduling the exam appointment early in the testing window in case the exam must be rescheduled or retaken. To locate a Prometric Testing Center and schedule an appointment, log on to or call (877) Prometric s international phone numbers are listed below. 10

11 CPCU 520 Exam Guide Region Contact Center Region Contact Center North America U.S. & Canada Latin America & Caribbean Korea China Europe Middle East & North Africa Hong Kong Southeast Asia Africa India Japan Australia & New Zealand Taking an Exam Note: The following information refers to the CPCU Registration Booklet from The Institute. Exam Policies: Identification You must present valid, unexpired identification that contains BOTH a photograph and a signature. The name on your ID must exactly match your name as it appears on the examination confirmation notice. If, for example, your identification and confirmation notice do not match because you recently married, bring the original copy of your marriage license. Contact The Institutes at least one week before your appointment if you have any questions about proper ID. If you are denied admission to a testing center because of a question about your ID, immediately call The Institutes at (800) or (610) Do not leave the testing center without calling The Institutes. Examinee Conduct CPCUs and CPCU candidates are subject to the CPCU Code of Professional Conduct. The CPCU code is available at Canons.pdf. CPCUs, along with all other persons taking Institutes exams, are subject to The Institutes Code of Academic and Professional Integrity. The Institutes Code is available at Furthermore, you will not be permitted to sit for an exam if you do not agree to abide by the Rules of Conduct statement at the beginning of exam administration and will forfeit the registration fee. 11

12 CPCU Core Review 520 Insurance Operations Prohibited Items Food and drink, jackets and hats, study materials, notes, dictionaries, and any form of electronic device, with the exception of an acceptable calculator (see below), are expressly prohibited. Medical or dietary needs that are taken to a Prometric Testing Center must be submitted to the Institutes for prior approval by Prometric, at least one month before the anticipated testing date. Send a full explanation of your needs to assessments@theinstitutes.org. A PDA or cell phone cannot be used in place of an acceptable calculator. Lockers are available at Prometric Testing Centers for storing personal items. Do not bring anything to a Prometric Testing Center that you hesitate to place in a locker. Prometric Testing Centers reserve the right to ask examinees to turn out their pockets. Provided Items for Electronic Exams Scratch paper and a pencil will be provided and will be collected at the end of the exam. Answers written on scratch paper, but not entered into the computer, are not graded. Ear plugs and a basic calculator are available upon request at Prometric Testing Centers. Use of a Calculator Based on the content of their study materials, examinees should determine for themselves whether they need a calculator during an examination. Although a financial calculator is not required for an exam, use of any solar- or batterypowered calculator that does not have alphabetic keys for typing words and that does not contain paper tape is permitted during an exam. Business/financial calculators including those that are programmable meeting these criteria are permitted. A PDA or cell phone is not an acceptable calculator. Prometric will provide a basic calculator if requested. Call the Institutes (800) if you encounter a problem concerning use of an acceptable calculator. Problems During the Exam Raise your hand if you encounter a problem during the exam. You may not communicate with anyone other than the test administrator. Breaks No scheduled breaks are provided. However, examinees may visit the restroom. When doing so, you will be required to sign out and then sign in again. You must return to your exam within five minutes, and the examination clock will continue to run. Communication with anyone other than a test administrator is prohibited. 12

13 CPCU 520 Exam Guide Prometric s Test Security Procedures Security at Prometric Testing Centers is very stringent. You could be asked to turn your pockets out to ensure they are empty. Cameras and video recording are in constant use. Test Center administrators circulate within the testing room at least every 30 minutes. Scratch paper is collected at the end of the exam and shredded. Information About Computer-Administered Exams Demo Exam For a hands-on demonstration of computer delivered essay or objective exam questions, visit The Institutes Web site at Click on Exam Preparation/Grade Information under the Examinations tab and download the exam demo software to your computer. Taking an Institutes exam on a computer does not require special computer skills. For objective exams, you can use a mouse or the keyboard to indicate an answer. To select your answer by using the keyboard, hold down the Alt key and then press the A, B, C, or D key. When taking an essay-style exam, enter your answers using the computer keyboard. Shortcuts commonly associated with Word processing software are not available. You can Mark for Review any questions that you want to come back to later. You can set the review screen to show several options, such as which questions were answered and marked or just those that remain unanswered. You can practice Mark for Review with the Demo Exam. Clicking on the Reference tab will allow you to access documents and formulas that will assist in answering exam questions. The tab will not appear in all exams and will display only in Part B of an examination. Not every exam calls for reference material. Exam Grading Multiple-Choice Exams: As soon as you complete the exam, you will receive an unofficial pass/nonpass notification, unless grading is delayed. Essay Exams: Essay exams are returned to The Institutes for grading. As many as three graders may independently review an exam to determine the final score. Grades are available within one month of the test date, unless grading is delayed. When registering, please provide The Institutes with a current address to ensure prompt grade notification. A notice sent to your preferred address will inform you that an official grade report is available on The Institutes website. Be advised that spam filters and firewalls could result in the inability to deliver the grade notification. 13

14 CPCU Core Review 520 Insurance Operations 14

15 SECTION 1. INSURANCE OPERATIONS Topic 1: Classification of Insurers Topic 2: Insurer Goals Topic 3: Insurer Functional Performance 15

16 SECTION 1. Insurance Operations Topic 1: Classification of Insurers CPCU 520 Review Notes / Assignment 1. Overview of Insurance Operations / EO 1 1.a. Structure: Types of Insurers Legal Form of Ownership Place of Incorporation Licensing Status Insurance Distribution Systems and Channels Proprietary Insurers Stock Insurers Lloyd's of London American Lloyds Insurance Exchanges Cooperative Insurers Mutual Insurers Reciprocal Insurance Exchanges Fraternal Organizations Other Cooperatives Other Insurers Pools Government Insurers A domestic insurer A foreign insurer An alien insurer A licensed insurer (admitted insurer) An unlicensed insurer (nonadmitted insurer) Independent agency and brokerage marketing system Direct writer marketing system Exclusive agency marketing system 1.b. Stock Insurer, Mutual Insurer 1 A stock insurer is owned by shareholders (stockholders) who elect a board of directors to supervise operations. Dividends from equity investments of insurers are returned to shareholders. 2 Mutual companies are belonging to policyholders who elect a board of directors. Benefits besides those normally added onto the surplus returned to policyholders as dividends. 16

17 Topic 1: Classification of Insurers 1.c. Lloyd's of London Lloyd's of London is a meeting place for London insurers. Lloyd s is a marketplace of hundreds of underwriting syndicates, each in effect a miniinsurer. Lloyd s sets standards for its members, but does not deliver the policy itself. Each syndicate is managed by an underwriter who decides which risk to accept. Generally, a risk underwritten at Lloyd s is going to be shared by a lot of syndicates. 1.d. Reciprocal Insurance Exchanges An unincorporated band of individuals or organizations (subscribers) that consent to pool risks with the intention of paying the cost of retained losses. Also referred to as inter-insurance exchanges, they are managed by an attorney-in-fact. Subscribers have contingent liability (several and proportionate) for paying off the losses of the reciprocal. 1.e. Domestic Insurer, Foreign Insurer, Alien Insurer 1 A domestic insurer is incorporated within a specific state. 2 A foreign insurer is insurance company whose domicile is within a state apart from the one in which the firm is writing business. 3 An alien insurer is created in accordance with the legal requirements of a foreign country. 1.f. Licensing Status An insurer's state license authorizes it selling insurance in the state. A license shows that the insurer has met the state's minimum standards for financial strength, competence, and integrity. Nonadmitted insurer (unlicensed insurer) is a company not licensed by a specific state to sell and service insurance policies within that state. 17

18 SECTION 1. Insurance Operations 1.g. Key Terms Proprietary Insurer: For-profit insurance company, such as a mutual or stock company or Lloyd's of London association. Cooperative Insurer: A Mutual insurance company issuing insurance to its members on a nonprofit basis. Examples of these associations include fraternal societies, unions, and employee membership groups. Insurance exchange: Reinsurance marketplace modeled after Lloyd's of London. Like Lloyd's, the New York Insurance Exchange is a market for hard-toplace risks and for the placement of excess or surplus lines. Fraternal organization: An organized society of men associated together in an environment of companionship. They have group coverage for members of a fraternal association, usually on a nonprofit basis. Residual market: Insurance market systems serve as a coverage source of last resort for the insured have been rejected by voluntary market insurers. Pools: Association of insurers who share premiums and losses in order to spread risk. Fair Access to Insurance Requirements (FAIR) plan: Type of insurance pool offered to inner-city business owners who cannot purchase property insurance through conventional means. Surplus line broker (excess line broker): Insurance producer who is licensed to place coverage with an insurance company that is not licensed to do business in the state of domicile of the broker. The excess line coverage must be unavailable from a company licensed in the broker's state. 18

19 Topic 1: Classification of Insurers 1.1. Forms of Ownership of Property-Casualty Insurers Which of the following statements is not true with regard to the various forms of ownership of property-casualty insurers? I. Stock insurance and mutual insurance companies belong to policyholders. II. The main reason that the cooperative insurers are formed would be to earn profits for their owners. III. Lloyd s and insurance exchanges are each samples of the insurance marketplace. IV. Most pools are needed by law are underwritten by state governments. V. Federal and state governments provide insurance for risks which might be important however, not commercially insurable. (A) III only (B) III and V (C) I, II, and IV (D) All of the above Answer I. Stock insurance companies are owned by the shareholders (stockholders). II. The main reason that cooperative insurers are formed is to provide insurance protection to its policyholders at minimum cost. IV. A syndicate pool issues a joint (or syndicate) policy to the insured, listing all pool members and specifying the part of insurance in which each member is responsible. Inside a reinsurance pool, a pool member issues the policy to the insured, as well as other pool members reinsure an agreed proportion from the policy's insured loss exposures. The correct answer is (C) I, II, IV only. 19

20 SECTION 1. Insurance Operations 1.2. Proprietary Insurers Which of the following statements is incorrect regarding proprietary insurers? I. Stock insurers are the most typical form of proprietary insurer in the United States. These insurers belong to their shareholders. II. Lloyd's is not technically an insurer. However, it offers the physical and procedural facilities for its members to write insurance. III. Lloyd s of London is a marketplace, similar to a stock exchange. Members are investors who are aiming to profit from the insurance operations. IV. An insurance exchange is actually a proprietary insurer comparable to Lloyd's since it works as an insurance marketplace. V. The insurance exchange manager is referred to as an attorney-in-fact. Subscribers empower the attorney-in-fact to handle all the functions require to operate the insurance exchanges. (A) I and II only (B) IV only (C) V only (D) III, IV, and V only Answer V. The manager of reciprocal insurance exchanges is called an attorney-in-fact. The subscribers empower the attorney-in-fact to manage all the functions necessary to operate the reciprocal. The correct answer is (C) V only. 20

21 Topic 1: Classification of Insurers 1.3. Cooperative Insurers Which of the following statements is incorrect regarding cooperative insurers? I. Mutual insurers would be the largest quantity of insurance cooperatives and offer low-cost insurance to their policyholders, who are the owners of the insurer. II. Mutual company s policyholders have voting rights comparable to those of a stock company's stockholders, and, they elect the insurer's board of directors that designates officers to control the business. III. A reciprocal insurance exchange, commonly known as simply as a reciprocal, is made up of a series of private contracts in which subscribers, or members of the group, consent to insure each other. IV. When a company or a band of affiliated organizations forms a subsidiary to supply all or part of its insurance, the subsidiary can be described as fraternal organization. (A) I and III only (B) II and IV only (C) III only (D) IV only Answer IV. The subsidiary is regarded as a captive insurer. Fraternal organizations resemble mutual insurers, however they combine a social function making use of their insurance function. They mainly write life and health insurance. The correct answer is (D) IV only. 21

22 SECTION 1. Insurance Operations 1.4. Place of Incorporation & Licensing Status Which of the following statements is true with regard to the place of incorporation or the licensing status? I. A licensed insurer is incorporated within a specific state or, if they are not incorporated, is created under the laws of that state. II. A foreign insurer is actually a domestic insurer which is licensed to do business in states apart from their resident state. III. An unlicensed insurer is incorporated or formed out of the country. IV. A domestic insurer is an insurer that has been attained a license to perform in a particular state. V. An alien insurer hasn't been granted a license to work inside of a given state. (A) II only (B) III only (C) I, IV, and V only (D) All of the above Answer I. A domestic insurer is incorporated within a specific state or, if not incorporated, is formed under the laws of that state. III. An alien insurer is incorporated or formed in another country. IV. A licensed insurer (admitted insurer) is an insurer that has been granted a license to operate in a particular state. V. An unlicensed insurer (nonadmitted insurer) has not been granted a license to operate in a given state. The correct answer is (A) II only. 22

23 Topic 1: Classification of Insurers 1.5. Proprietary Insurers Which of the following statements is not true with regard to the Proprietary Insurers? I. The only unincorporated insurers permitted in the majority of states are insurance exchanges. II. Insurance pools do the job either in the form of syndicate or through reinsurance. III. Reciprocal insurance exchanges comprise of a series of private contracts in which subscribers or members of the group agree to insure each other. IV. Insurer KB is a proprietary insurer that acts as an insurance marketplace. Its members underwrite any insurance or reinsurance purchased, and members are primarily partnerships or corporations with limited liability. Insurer KB members belong to syndicates and delegate day-to-day operations to the syndicate manager. In cases like this, insurer KB is an insurance exchange. V. Because of the chance of an environmental pollution exposure resulting in extensive losses, several insurers in a particular state have joined together to insure the exposure because no single insurer was willing to insure the entire risk. This particular insurance arrangement is typical of a reciprocal exchange. (A) I and III only (B) I and V only (C) II and III only (D) II and IV only Answer I. The only unincorporated insurers permitted in most states are reciprocal insurance exchanges. V. This insurance arrangement is typical of an insurance pool. The correct answer is (B) I and V only. 23

24 SECTION 1. Insurance Operations 1.6. Forms of Ownership of Property-Casualty Insurers Which of the following statements is true with regard to the various forms of ownership of property-casualty insurers? I. Federal and state governments provide insurance for exposures that are significant however, not commercially insurable. II. Because Nancy has had many driving accidents as a result of her own carelessness, she has been unable to find private insurers prepared to provide her with automobile insurance. In most states, Nancy could possibly purchase high risk auto insurance through a fraternal organization. III. Smith owns Smith's Guns that is in a high criminal activity area of his city. Smith has made an effort to obtain coverage through several insurers in his area but has been unsuccessful. He wants building and contents coverage. Smith has been advised that he should obtain coverage through a FAIR plan that is federally run plans with cost spread among private insurers in the state. IV. Hyundai Chemical (Hyundai) has been unable to obtain liability coverage for its products. Insurers consider Hyundai to be uninsurable. Hyundai risk manager, Johanna, believes that their company can cover the losses and fund them. In this case, Johanna can be considering a captive for Hyundai. (A) I and II only (B) II and III only (C) I and IV only (D) III and IV only Answer II. In most states, Nancy would be able to purchase high risk auto insurance through a residual market plan. III. FAIR plans are state-run plans with cost spread among private insurers in the state The correct answer is (C) I and IV only. 24

25 Topic 2: Insurer Goals Topic 2: Insurer Goals CPCU 520 Review Notes / Assignment 1. Overview of Insurance Operations / EO 2, 3 2.a. Structure: Major Goals of Insurer Major Goals of Insurer Earn a Profit Meet Customer Needs Comply With Legal Requirements Diversify Risk Fulfill Their Duty to Society 2.b. Earn a Profit Insurers generate income by charging policyholders a "premium" for insurance. Insurers invest the part of premiums which are not necessary to pay operating costs (called surplus). These investments produce income by means of interest, dividends and investment gains. Return on investment generates extra earnings. 2.c. Meeting Customers' Needs Meet the requirements of customers can frequently conflict with the goal of profit as providing quality insurance at a price the customer are able to afford that may not create the profit that the insurer would need to attract and retain capital. Provide training, using automated call centers, and maintaining information technology can even be costly and could conflict with the achievement on the objective of short-term profits, but not long term. 2.d. Comply With Legal Regal Requirements Legal compliance promotes good trustworthiness of the insurer in the market and the ability of the insurer to obtain capital and customers. 2.e. Diversify Risk Risk diversification is usually a new goal for property-casualty insurers because of catastrophe losses which has increased during the last decade. High concentrations of losses in some geographical areas highlight the demands to spread the risk over a wider geographical area and various forms of insurance policies. 25

26 SECTION 1. Insurance Operations 2.f. Fulfill Their Duty to Society. Insurers taking part in philanthropic activities and setting up employee benefit plans enhances employees job satisfaction and emotional well-being. Moreover, these activities play a role in employee retention and attract qualified candidates of these organizations. 2.g. Structure: Insurer Constraints Internal Constraints Efficiency Expertise Size Financial Resources Other Internal Constraints External Constraints Regulation Rating Agencies Public Opinion Competition Economic Conditions Insurance Marketing and Distribution Other External Constraints 2.h. Efficiency Lack of efficiency can be the result of poor management, insufficient capital, not enough information technology, incapacity to alter to change, or other causes. Inefficiency, particularly in information technology and customer service, can prevent the insurer adequately meet the requirements of its customers. 2.i. Size Large insurers can engage in economies of scale and possibly convey more financial resources to update technology or reach other markets. An advantage on a small insurer would be that it can be more agile, letting it to respond quickly to a new trend or a change in external environment. 2.j. Regulations Regulation might be extended to insurance rates and forms. In the event the rate increases filed are not authorized by the regulator, the insurer probably won't achieve its profitability objectives. Policy form approval and time limitations linked to the filing procedure help keep an insurer to completely meet customer needs. 26

27 Topic 2: Insurer Goals 2.k. Competition Cycles while in the soft market, the competitive pressure to cut back prices, it is hard for insurers to meet their profitability targets. Low profits may impact the ability of insurers to attain social goals. Excessive competition usually leads some insurers not to abide by the rules, which makes insurers incapable of meet their legal and regulatory objectives. 2.l. Insurance Marketing and Distribution Insurers distribute their products through various sorts of distribution systems using several types of sales and distribution channels in promoting products and services and get in touch with existing and potential policyholders. Each distribution system or channel meets the demands of some customers, and each is unable to meet the needs of others. 2.m. Key Terms Soft market: One side of the market cycle which is seen as a significantly lower rates, high limits, flexible contracts, and high accessibility to coverage. Hard market: One side on the market cycle that is described as high rates, low limits, and restricted coverage. 27

28 SECTION 1. Insurance Operations 2.1. Insurer Goals Which of the following statements is incorrect with regard to an insurer s goals? I. The objective of diversifying risk would not often conflict with the goal of generating a profit. II. A proprietary insurer must make competitive profits to get the capital necessary to operate. III. The aim of meeting customers' needs often conflict with the objective of earning a profit. IV. Expenses related to compliance with state insurance regulations are minimal. V. All corporations have an obligation in promoting the well-being of society. At least, this obligation necessitates the insurer to stay away from causing any public harm. (A) II only (B) I and III only (C) IV only (D) None of the above Answer IV. The insurance business is highly regulated, and the expenses related to compliance is usually substantial. The correct choice is (C) IV only. 28

29 Topic 2: Insurer Goals 2.2. Insurer Goals Which of the following statements is most true with regard to an insurer s goals? I. Under certain situations, a cooperative insurer can acquire additional capital by borrowing funds using surplus notes. These notes normally can be repaid only from policyholder surplus. II. As being a marketable product, insurance is an intangible product. The insurance customer receives an insurance policy, but what the customer actually purchases is really a transfer mechanism. III. Diversifying risk is an emerging goal for property-casualty insurers as a consequence of the increase in catastrophe losses that have occurred over the past decade. IV. Dongbu Insurance Company has recently contributed funds to their state insolvency fund and in addition paid expenses of numerous filings for their company. Dongbu's adhering to legal requirements goal presents a conflict between the profit goal and reducing operating expenses. (A) I and II only (B) II and III only (C) III and IV only (D) I and IV only Answer I. These notes can usually be repaid only from profits. IV. The insurance industry is highly regulated, and the expense associated with compliance can be substantial. To the extent that these expenses increase the cost of insurance, they create a conflict between the insurer's profit goal and the insurer's goal of meeting customers' needs. The correct answer is (B) II and III only. 29

30 SECTION 1. Insurance Operations 2.3. Internal Constraints Which of the following statements is incorrect with regard to internal constraints insurers face? I. In extraordinary instances, the inefficiency can result in insolvency along with a consequent failure to meet legal and regulatory goals. II. Lacking expertise could prevent an insurer from generating a profit or meet the needs of customers, or it may possibly force the insurer to do not achieve its goals. III. The economic strain of the past decade, and particularly these tough economic times that began at the end of 2007, have caused some insurers to suffer financial resources reduced by underwriting losses, investment losses, or both. IV. Newly created insurer may possibly not have the name recognition required to achieve its profitability targets, even though it has the expertise and financial resources to achieve this. V. Each distribution system or channel meets the demands of some customers, and each is unable to meet the needs of others. (A) II and III only (B) I and IV only (C) V only (D) All of the above Answer V. Insurance marketing and distribution is external constraint. The correct answer is (C) V only 30

31 Topic 2: Insurer Goals 2.4. External Constraints Which of the following statements is incorrect regarding external constraints insurers face? I. Inflationary cycles throughout the economy are not proven to adversely affect insurers. II. Large insurers could benefit economies of scale and may convey more financial resources to update technology or reach other markets. III. The regulation imposes an essential constraint for insurers, requiring significant staff and financial resources that can inhibit the ability of the insurer to meet up with its profitability targets. IV. Rating agencies now require insurers to raise their capital to take care of higher catastrophe risk. V. Hard cycles are seen as periods of decreased competition and rising rates producing increased profitability. (A) I and II only (B) III and IV only (C) V only (D) None of the above Answer I. Insurers is usually adversely affected during inflationary cycles too. Inflation affects the expense of insurance losses through increased medical costs, construction costs, and also other loss-related costs. II. Size is internal constraint. The correct answer is (A) I and II only. 31

32 SECTION 1. Insurance Operations 2.5. Insurer Constraints Which of the following statements is not true with regard to constraints insurers face? I. Rating agencies are adding new demands when assessing insurers' financial health. While many other exposures can impact solvency, no single exposure can affect policyholder security more instantaneously than catastrophes. II. Insurance industry underwriting cycles are generally known as either hard cycles or soft cycles. Competition is motivated in personal insurance by highly standardized products that customers view as commodities. III. Regulation is surely an external constraint that may prevent insurers from meeting their established goals. IV. Insurer s size is an internal constraint that may prevent an insurer from meeting nearly every one of its goals. V. To uphold their current ratings, well-managed and highly rated insurers typically must maintain capitalization levels in excess of the minimum amounts required. (A) I and II only (B) II and IV only (C) III and IV only (D) III and V only Answer III. The insurer's competition is an external constraint that may prevent insurers from meeting their established goals. IV. Efficiency is an internal constraint that might prevent an insurer from meeting all of its goals. The correct answer is (C) III and IV only. 32

33 Topic 2: Insurer Goals 2.6. Insurer Constraints Which of the following statements is not true with regard to constraints insurers face? I. Insurer Lotte is small but has a specialty insurance market for high-value vehicles. In rivaling a larger insurer with a broader market, insurer Lotte can be more nimble, permitting it to respond quickly to an emerging trend or change. II. Meritz Insurance Company received national mass media coverage for its denial of claims during a recent hurricane. This demonstrates an internal constraint for meeting insurer goals. III. Hanwha Insurance Company's website is not interactive and doesn't provide rate quotations on line. This situation shows an internal constraint of efficiency. IV. MG Insurance now markets insurance but is lacking in the brand recognition of their only insurance competitor, Green. This demonstrates an external constraint of public opinion. V. An insurer develops a new policy specifically designed for the construction industry. The insurer is anxious to promote this product which will increase its writings and boost its profits. The policy form is not approved in time to meet the product's planned introduction date. This illustrates an external constraint of regulation. (A) I and II only (B) III and V only (C) II and IV only (D) I and V only Answer II. This illustrates an external constraint of public opinion. IV. A newly established insurer might lack the name recognition necessary to achieve its profit goals even if it has the expertise and financial resources to do so. This is an example of other internal constraints. The correct answer is (C) II and IV only. 33

34 SECTION 1. Insurance Operations Topic 3: Insurer Functional Performance CPCU 520 Review Notes / Assignment 1. Overview of Insurance Operations / EO 4, 5 3.a. Structure: Measuring Insurer Performance Meeting Profitability Goals Meeting Customer Needs Premium and Investment Income Underwriting Performance Overall Operating Performance Estimation of Loss Reserves Complaints and Praise Customer Satisfaction Data Insurer's Retention Ratio and Lapse Ratio Insurer-Producer Relationships State Insurance Department Statistics Consumer Reports Meeting Legal Requirements Meeting Social Responsibilities 3.b. Premium Growth Premium growth, or lack thereof, should be evaluated considering current market conditions. An insurer must ask whether or not the growth is the result of a competitive advantage, relaxed underwriting, low insurance rates, or a mixture of these factors. Slower growth in comparison to the industry average and significantly beyond the industry average might point to problems. 3.c. Underwriting Performance The formula for calculating the gain or loss of underwriting is usually expressed as the following: the net underwriting gain or loss = earned premiums - (incurred losses + underwriting expenses). Three specific ratios are widely used to evaluate the performance of the insurer's underwriting: the loss ratio (incurred loss / earned premiums), the expense ratio (expenses / written premiums), and the trade basis combined ratio (loss ratio + expense ratio). 34

35 Topic 3: Insurer Functional Performance 3.d. Overall Operating Performance The formula for overall gain or loss from operations is expressed the following: overall gain or loss from operations = net underwriting gain or loss + investment gain or loss. The investment income ratio, overall operating ratio, and return on equity tend to be more specific measures of an insurer's operational performance. 3.e. Insurer's Retention Ratio and Lapse Ratio 1 Retention ratio is the percentage of expiring insurance policies that an insurer renews. 2 Lapse ratio is calculated by dividing how many policies that lapse throughout a period from the total number of policies written at the start of the period. 3.f. Meeting Legal Requirements Three sources to measure the success of an insurer to meet legal requirements are 1 the state insurance department's market conduct regulation; 2 state listings of regulatory actions taken against insurers; 3 summary information regarding insurer financial strength and financial ratings furnished by financial rating agencies, including any outstanding legal actions relating to the organization. The outcomes of these measurements are indicative of how an insurer matches its legal obligations. 3.g. Structure: Insurer Functions Core Functions Supporting Functions Other Common Functional Areas Marketing and Distribution Underwriting Claims Risk Control Premium Auditing Actuarial Reinsurance Information Technology Investments Accounting and Finance Customer Service Legal and Compliance Human Resources Special Investigation Units (SIUs) 3.h. Marketing and Distribution Marketing and distribution would be to figure out what products or services customers need and want, product advertising (communicating their value to clients), and deliver these to customers. 35

36 SECTION 1. Insurance Operations 3.i. Underwriting The underwriting function decides whether and under what conditions the insurer would prefer to supply insurance products and services to prospective customers. The aim of underwriting would be to write a profitable book of business for the insurer, which assists the goal of profit of the insurer. 3.j. Claims The objective of claims function would be the promise of the insurer to cover an amount to, or with respect to the insured if an insured event occurs. Claims function is operated by employees who definitely are competent in the skills needed to evaluate and settle claims and negotiate or litigate the settlement of claims by or up against the insured throughout the claims process. 3.k. Key Terms Earned premium: The part of the premium that relates to the expired portion of the policy. While insurance premiums tend to be paid in advance, insurers typically "earn" the premium at a pace through the entire time period of the contract. The unearned part of the premium which has been paid is held in the "unearned premium reserve. Incurred losses: The total amount of paid claims and loss reserves connected with a particular time period, commonly a policy year. Underwriting expense: The costs incurred by the insurer in deciding if they should accept or reject a risk; can include meetings with insureds or brokers, actuarial study of the historical loss or physical inspections exhibitions. Premium audit: An audit on the basic exposure for any insurance policy (i.e. payroll, sales or the quantity of vehicles) after the end of the insurance period to figure out the actual (audited) exposure to enable a final calculation of the premium and premium taxes. Book of business: Total amount of insurance upon an insurer's books at any given time. Special Investigation Units (SIUs): These units are positioned up to combat against insurance fraud, including any deliberate deception perpetrated against an insurer or insurance producer to be able to financial gain. 36

37 Topic 3: Insurer Functional Performance 3.1. Performance Ratios Which of the following statements is incorrect with regard to the insurer s performance ratios? I. Loss ratio = incurred loss / earned premiums II. Expense ratio = expenses / written premiums III. Trade basis combined ratio = loss ratio + expense ratio IV. Retention ratio is the percentage of expiring insurance policies that an insurer renews. V. Lapse ratio is calculated by dividing the number of policies that expire throughout a period by the final number of policies written at the outset of that period. (A) I and II only (B) III and IV only (C) V only (D) All of the above Answer The correct answer is (D) All of the above 37

38 SECTION 1. Insurance Operations 3.2. Ratio Calculation Insurance company Apex and Hatch have the following year-end financial results: Apex Hatch Written premium $300 $200 Earned premium $250 $180 Underwriting expenses $120 $40 Incurred losses $150 $100 Loss adjustment expenses $50 $35 Which of the following statements is incorrect with regard to the performance ratios of Apex and Hatch? I. Apex s expense ratio on a trade basis is 40% II. Apex s loss ratio is 80% III. Hatch s expense ratio on a trade basis is 38% IV. Hatch s combined ratio (trade basis) is 95% (A) I and II only (B) III only (C) IV only (D) All of the above Answer Apex: expense ratio (trade basis) = 120/300 = 40%, loss ratio = (150+50)/250 = 80%, combined ratio = 40% + 80% = 120% Hatch: expense ratio (trade basis) = 40/200 = 20%, loss ratio = (100+35)/180 = 75%, combined ratio = 20% + 75% = 95% The correct answer is (B) III only 38

39 Topic 3: Insurer Functional Performance 3.3. Meeting Profitability Goals Which of the following statements is incorrect with regard to the insurer s profitability goals? (A) The main difference between underwriting gain or loss and the gain or loss from operations is the fact that operating gain or loss includes investment income. (B) In 2012, a property casualty insurer experienced a combined ratio of 113% after dividends, and a ratio of investment income by 10%. The insurer's operating ratio to the year 2001 is 103%. (C) Rapid premium growth is usually a reliable indicator on the financial success of an insurer. (D) To figure out profitability, an insurer should look into how its premium growth is achieved. Answer An insurer should consider whether growth resulted from a competitive advantage, relaxed underwriting, inadequate insurance rates, or a combination of these factors. The correct answer is (C). 39