CHAPTER 3 Insurance Functions CHAPTER OVERVIEW This chapter has two purposes: It provides a good explanation of what transpires in the offices of an insurance company, and it illustrates employment possibilities and career opportunities that may have great appeal to students. This chapter assumes that the student probably has heard about insurance agents but is unaware of the broad scope of the agent s duties. The difference between distribution in the life and nonlife insurance industry is stressed early in the chapter and reinforced by separate treatment of each. When this section of the chapter is completed, a good appreciation for the skills required to be an insurance agent should be understood. Likewise, the role of insurance brokers in both the property and liability and life areas is set forth. Two other company functions, loss settlement and underwriting, may have considerable appeal to students. As soon as a person understands that she is sharing losses with others, then she understands that there are two critical questions to ask of the insurer. The first is, how do you decide who we share losses with? That is the function of underwriting. The second question is, what are the procedures for evaluating claims? That is the function of loss adjusting. These functions are described, including their responsibilities. The current and controversial material in this chapter involves a discussion of the conflict between the individual s right to privacy and the insurer s right to make informed underwriting decisions. This is a continuing debate. We want to alert you to the material at the back of the chapter. There is also coverage of other insurance company functions, including rate making, the actuarial function, and reinsurance. There are also brief discussions of several miscellaneous business functions of insurance companies. A. INTRODUCTION examine internal functions of insurance companies to describe the necessary steps in delivering the product. In addition, this topic provides an overview of the careers students could pursue in the insurance industry. Employment in 50
Chapter 8/Insurance Functions 51 the insurance industry is substantial, with over two million people employed in the insurance industry. Over one million of those work in home offices, and about 700,000 work as agents, brokers, or service personnel. B. Insurance Agents and Brokers 1. Marketing product development, training, advertising and other activities that help in the sale of the insurance product are done at the home office by salaried specialists. Agents sell most of the insurance by contacting buyers personally. A lot of different agency arrangements have evolved for marketing insurance. The Internet is evolving into a marketing and sales tool and is used by many in the distribution chain. a. Insurance agent a person authorized to act on behalf of another person called the principal (insurance company). Note: Most insurance agents are actually independent contractors since they have signed an agency agreement spelling out the relationship between the insurance company and the agent. This contract controls the relationship. The law of agency is the default law spelling out the relationship between any agent and principal when there is no other prearranged agreement. b. Law of agency i. Scope of authority sets forth and limits agents actions. Some agents may bind insurers (in property area); some may not. Life insurance field agents do not have binding authority. ii. Duties of an agent include: loyalty (no self-dealing at principal s expense); honesty (forwarding all premiums, no aiding or abetting fraud); obedience (not submitting business that the insurer doesn t want, such as poor drivers or impaired lives). iii. Knowledge of the agent is considered knowledge of the principal (the insurer). This rule, which may be involved in cases of concealment of material facts from the insurer, has a different effect on insurance agents than on insurance brokers because the broker is the agent of the applicant.
52 Chapter 8/Insurance Functions c. Insurance broker a representative with limited authority to find insurance for the buyer. Works for the insurance buyer and earns a commission, which is a percentage of the premium charged to the buyer. Used extensively in commercial insurance, and deals regularly with company risk managers. Brokers cannot bind insurance coverage. Note that the broker represents the insurance buyer. d. Licensing requirements are typically uniform for agents and brokers and usually involve educational requirements. e. Types of property and liability insurance agents and brokers i. Exclusive agents work for one insurer as a commissioned employee. Example: GEICO, State Farm. These companies are often called direct writers. ii. Independent agents own their own business and may represent many different insurers. They are compensated on a commission basis. Typical commission is 15 percent of the premium but varies by type of insurance. f. Life insurance agents and brokers i. They can be exclusive agents or independent agents. Exclusive agents are being used more frequently in life insurance marketing. Commission basis is different than in property and liability insurance. Life agents are actually soliciting agents because they are not able to bind insurance contracts. ii. Duties include sales motivation, counseling on tax and Social Security issues, continuing service and aiding in claims settlement. iii. Life insurance companies usually appoint general agents or branch managers who are given authority to recruit and train agents for a specified territory. Soliciting agents generally run their own business. iv. Involved in field underwriting and must avoid the appearance of the unauthorized practice of law
Chapter 8/Insurance Functions 53 2. Loss adjustors a. Investigate reported losses, determine amount of insurer s liability, or recommend denial of claims b. Most property loss adjustment is done by independent adjusters or adjustment bureaus because most losses occur at locations where home office employees are not close by. c. An adjuster is an agent of the insurance company and any waiver or estoppel on the part of the adjuster may affect the insurance company s right to deny or fight a claim. d. Loss adjusters may be employees of the insurance company, employees of independent adjustment bureaus (hired by insurance companies), or public adjusters. A public adjuster is an agent for the insured and usually from an independent adjustment bureau (needed to avoid conflict of interest issues). e. Reservation of rights used when insurers do not know if a claim is covered so insurer reserves rights to deny but proceeds as if the claim is covered with the right to later deny coverage if it is correct to do so. 3. Underwriters Typically home office employees who select and classify insureds. An important part of the selection process is rating (pricing) the exposure. This involves experience and judgment, in both life and property insurance, with the goal to categorize and price correctly. a. Good underwriting produces losses closely approximating expected losses. Overly strict underwriting means profitable business is turned down. Overly loose underwriting means financial problems and an uncompetitive product, or even bankruptcy. Underwriters must be alert to possibility of adverse selection. b. Property insurance underwriters look at the use of the property (commercial versus individual), location of property (rural versus urban), history of applicant (moral), and nearby hazards as well as the fire fighting capability in the area. Information from applicant (past losses included) and consumer credit reporting services (Equifax and others) are used in the underwriting process.
54 Chapter 8/Insurance Functions c. Life insurance underwriters must use judgment in assessing the health, occupation, and moral history of the applicant. Health records come from the applicant s doctor and the Medical Information Bureau (MIB). The use of genetic information is currently controversial. d. Privacy There is a conflict between an individual s right to personal privacy and an insurer s right to investigate applicants for the purpose of making good underwriting decisions. Recent federal laws have made clear that the individual s rights must be respected by insurers, for the good of society. However, it should be pointed out that if insurers are denied access to relevant information, the resulting adverse selection will be borne by all insureds (members of society), not by the insurers. Thus, a reasonable balance between these two conflicting rights is important. 4. Actuaries Mathematicians (statisticians) specializing in insurance calculations. a. Calculate rates, dividends, operating results, and loss reserves b. Help develop new policies and participates in securing regulatory approval for rates and policies 5. Other Insurance Company Occupations/ Business Functions a. Accountant problems with applying rules to insurance companies led to Generally Accepted Accounting Principles (GAAP) for insurance companies. Regulators require Statutory Accounting Principles (SAP). SAP produces very conservative statements that focus on solvency. Insurance companies that operate internationally use International Accounting Standards Board (IASB) rules known as International Financial Reporting Standards (IFRS). b. Attorney needed to represent the company in lawsuits, help in wording of insurance contracts, and deal with regulatory bodies, among other duties c. Financial managers prepare budgets, coordinate cash flows, and provide investment management
Chapter 8/Insurance Functions 55 6. Reinsurance a. Smooth loss ratios or limit dollar loss on any one exposure b. Primary (writing) insurer cedes part of the loss and premium to the reinsurer. c. Can be facultative (by the case) or treaty (automatic) d. Can be pro-rata arrangement, excess-of-loss arrangement, or catastrophe reinsurance IV. ANSWERS TO REVIEW QUESTIONS 1. What duties do principals owe their agents? What duties do agents owe their principals? The law defines several duties agents owe their principals. Among these are the duty of loyalty (agents must not further their own interest at their principal s expense), the duty not to be negligent, and the duty to obey instructions. If the agent has an interest in matters that are adverse to the principal s interest, the agent must inform the principal. An agent cannot serve two principals having adverse interests unless both principals consent. The agent has the duty to inform the principal of all relevant information and to keep a proper account of all money or other assets. The agent has a duty of reasonable care, meaning the agent should not attempt to do business the agent cannot perform properly. The principal has the duty of paying for the agent s services and honoring all other agreed on commitments to the agent. 2. Explain the basis for conflict between the insurance agent and the home office underwriter. In practice why are such conflicts often not a problem? An insurance agent is compensated based on the quantity of insurance sold, which translates into more income for the agent. The underwriter is judged primarily on the quality of his work and is expected to produce a group of insureds whose actual losses closely match those expected by the insurer. The agent may like to see the insurer accept exposures that the underwriter feels should be declined or accepted at a substantially increased premium. If an application is not accepted, the agent will be upset because considerable time may have been spent on the case, with a consequential loss of income. On the other hand, if the agent sells large volumes of poor business, the insurer would be upset and cancel the agent s contract. While individual cases might produce friction
56 Chapter 8/Insurance Functions between the agent and the underwriter, in the long run they both are working toward producing acceptable exposures. 3. Describe the differences between an insurance agent and an insurance broker. Are these differences important to the insurance consumer? The insurance agent generally represents the insurer and is authorized to act on its behalf. The agent s knowledge, acts, and omissions will be attributed to the insurer. The insurance broker represents the insured and is authorized to find an insurer willing to accept the risk at a price the insured is willing to pay. His knowledge is attributed to the insured, not the insurer. Thus, knowledge conveyed by an insured to a broker is not considered automatic knowledge of the insurer, whereas information supplied by an insured to an agent is considered knowledge of the insurer. The difference to the consumer between an agent and a broker can be important in some cases. Adding some confusion is the fact that brokers sometimes act as agents of an insurer when they accept premiums or deliver policies, and in some states the legal distinction of a broker does not exist. In those states, all people selling insurance coverage are considered agents, to protect consumer interests. 4. Why do life insurance agents and property insurance agents have different grants of authority? Property insurance agents often have the authority to bind their companies to an insurance contract, whereas life insurance agents never have this authority. This difference arises due to the fact that insurers may cancel property insurance contracts, while life insurance contracts become noncancellable and incontestable in a relatively short period of time. Therefore, life insurers want tight control over who becomes an insured. In addition, a medical examination is a typical prerequisite before a life insurance contract becomes effective; since most life insurance agents are not qualified to give this examination, they cannot bind their insurers. 5. Describe the differences between an independent agent and a direct writer. An independent agent represents several insurance companies and owns his book of business. A direct writer (exclusive agent) represents only one insurance company and
Chapter 8/Insurance Functions 57 does not own the book of business. This ownership right to the book of business may cause differences in the way agents are compensated and differences in the agents marketing strategies. 6. Evaluate the success of direct marketing and e-commerce in insurance marketing. One need only watch a little television or open an Internet browser to find an advertisement for an insurance product. While the financial facts are yet to be known, it is clear that the insurance industry believes that these are successful marketing strategies. 7. What purpose does a reservation of rights letter serve? In some instances, particularly losses involving liability claims, insurers initially may not be sure if the insured s claim is covered. In such situations, insurers may assume the liability unconditionally, may deny the claim outright, or may pursue the claim but reserve the right to deny coverage at a later point when adequate information becomes available to make an informed decision. If an insurer decides to take the third route, it must give the insured adequate notice of the insurer s reservation of rights and carefully meet other legal formalities. Letters informing the insured that the insurer is reserving certain rights are not denials of coverage. They represent notice from the insurer to the insured that the insurer is not certain that coverage exists but plans to proceed with the loss adjustment, and perhaps the legal defense, as if the coverage existed. Certain events may occur in the future that may cause the insurer to reevaluate its position. Without notice the insurer is reserving its rights, courts might well find an insurer acted in bad faith if it began paying the cost of a legal defense but later ended those payments, or even sought to recoup the expenses it already paid. It might also be considered bad faith if the insurer did not inform the insured that, despite paying for a legal defense, it reserved the right not to satisfy a settlement or legal judgment. 8. Should a good job of loss adjusting always involve the claims adjuster negotiating the lowest possible dollar amount of claims settlement? A good job of loss adjusting results in fair settlements: settlements fair to both insured and insurer. No insurer would benefit from the bad public relations generated by consistently settling claims
58 Chapter 8/Insurance Functions inadequately. Furthermore, the insurance commissioner s office might become involved if an insurer s claims settlement practices were abusive. On the other hand, accepting all claims, no matter how inflated, would be very costly to all insureds, and the adjuster must not accept such inflated claims. 9. What incentives does the insurer have to settle claims fairly? Insurers want to settle claims fairly because to do so means that a good reputation will be established, lawsuits will be avoided, and insurance commissioners will not be investigating complaints. Insurers know and expect a certain number of losses to occur, and they are ready to pay their insureds in these cases. Nevertheless, the insurer must resist fraudulent or inflated claims that would unfairly benefit some insureds at the expense of all the others. Sometimes drawing the line between the claims to be resisted and those to be paid is very difficult, and sometimes insurers are in error. Yet insurers have several incentives to settle claims fairly, and no legitimate reason to do otherwise. 10. Why do insurance companies hire independent loss adjustment bureaus? In many cases insurers write insurance covering people or property that may be a long distance from the insurer s operations when the loss occurs. In such a case, it is more logical for the insurer to hire an independent adjuster than send one of its home office employees to adjust the loss. Since there are so many insurers and so many possible locations for losses, using an independent adjuster is frequently the only logical and financially efficient way to settle claims. Other reasons for hiring independent adjusters include: It can be cheaper and more efficient to use an adjustment bureau (even for losses occurring near the insurer) than to train and staff a home office adjustment department; and in the case of large disasters, a company may have an insufficient number of its own adjusters to handle the work promptly. 11. Why must the underwriter be concerned about adverse selection? Adverse selection occurs when poor risks (those loss exposures more likely to experience loss than an average exposure ) succeed in purchasing insurance at rates not fairly reflecting the cost of the risk transferred. When bad drivers, for auto insurance, or people with serious heart ailments, for life or medical insurance, try to purchase
Chapter 8/Insurance Functions 59 insurance at standard rates, it is up to the insurance underwriter to prevent such adverse selection. The result of adverse selection is a pool of insureds that exhibit a higherthan-average loss experience, causing the company to raise premiums. The good insureds will find cheaper insurance elsewhere, and the poor risks will tend to remain. This in turn increases the average loss statistics, and again, premiums must be raised. Continuation of this process logically concludes with the termination of the pool or the poor risks paying their higher fair share. 12. Describe the functions carried out by actuaries in most insurance companies. The key functions performed by actuaries are the setting of rates for the various product lines, the establishment of proper reserves, and the certifications of the company s financial statements. 13. What are the reasons that reinsurance is so widely purchased by insurers? The essential reasons that primary insurers buy reinsurance are to protect their expected loss ratios, to limit the loss on any one contract or occurrence, or to protect against catastrophes. 14. What is the difference between a facultative and a treaty reinsurance arrangement? Facultative reinsurance is sought by the ceding insurer on a case-bycase basis. The reinsurance underwriter might reject some of the cases submitted. Treaty reinsurance is an automatic arrangement, where all of the business submitted by the ceding insurer will be accepted. 15. What does 25, excess of 15 mean in a reinsurance arrangement? This means that the ceding insurer will pay the first $15,000 of each loss, then the reinsurer will pay the next $25,000 of each loss. 16. What type of exposures would encourage a life insurance company to purchase catastrophe reinsurance? Events such as the 9/11 event in New York, where large numbers of persons are exposed to a catastrophe in a small geographic area, would encourage such purchases. Companies writing flight insurance might also consider this purchase.