Chapter 1: The Business of Insurance C16

1)      List the TWO (2) fundamental principles of insurance.

• 1) The premiums of the many are used to pay the losses of the few.
• 2) The premium shall be commensurate with the risk.
• Insurance fulfills a societal need.
• Provides consumers with financial security for particular types of accidental losses.  Also underpins the economy facilitating economic growth and societal development.
• Insurance is a promise to indemnify another person against the possibility of a loss.  Risk is transferred to the insurer.  The premiums of the many area used to pay the losses of the few.
• Significant claim is paid based on a nominal premium.

2)      Why would an insurer spread risks over diverse geographic areas?

·         Risks spread over a larger geographic area soften the burden of localized disasters on insurers.

·         For example, a severe windstorm in one part of the country would have a devastating effect on an insurer who had concentrated its risks in this one area.

3)      What is a risk pool?

·         A risk pool is a sharing and spreading of risk between insurers and reinsurers.

·         Formed risk pools are syndicates of insurance or reinsurance companies that have organized to underwrite a particular risk or group of similar risks.

4)      Explain the Law of Large Numbers.

·         A mathematical premise which states that the degree of uncertainty is reduced as the number of events increase.

·         Insurance relies on forecasts of loss certainty in a large group of similar risks.

·         Enough risks must be priced in such a way as to ensure that sufficient capital enters the pool of funds to accommodate what is being drawn out to pay for claims.

5)      Define adverse selection.

·         Describes the process by which potential policyholders use private knowledge of their own high level of risk when deciding whether or not to buy insurance.

·         High-risk individuals will try to buy lots of insurance and pay a comparatively high rate of premium if they are allowed.

·         Low-risk clients might not buy any insurance because the price is too high.

6)      In insurance, what is a tail.

·         Refers to the amount of time between an incident and the determination of a claim.

·         Short-tail lines are those where the injury becomes known quite quickly.

·         Long-tail lines are those which a claim may be separated from the circumstances that caused it by as many as 10, 15, 25 years or more.  Many products’ liability lines have long-tail exposures.

7)      Name TWO (2) concerns of Ontario automobile excess reinsurers that relate to the effects of long-tail liabilities.

·         Several reinsurers have pointed out the following problematic areas in the automobile insurance market in the Atlantic Canada, Ontario and Alberta provinces.

1.      Severe injuries

2.      Long-tail trends for prior accidents years

3.      Inadequate reserving at the primary insurance level

• Primary insurance companies rely on reinsurers to backstop auto coverage, particularly for catastrophic claims that can end up costing over $1 million.
• As of recent times, there have been relatively light catastrophic events which led to minor rate increases for reinsurance catastrophe treaties.
• Claims from two to five year have reinsurance layers.  There has been a general increase in the number of claims exceeding thresholds such as $2-5 million over the past 10 years.
• There are challenges in long-tail pricing because it is difficult to accurately predict the outcome of claims that have not yet occurred and that will remain open for years before final settlements are reached.
• Reinsurers have seen patterns of very late reporting of catastrophic injury claims by insurers and after being recognized and reported, they continue to develop adversely for years.

8)      List THREE (3) ways that insurance benefits society.

·         Insurance provides a certain freedom of action, encouraging activities to flourish in industry, commerce, not-for-profit organization and among ordinary members of society. (insurance allows activities to flourish)

·         1) Insurance industry facilitates growth but depends on growth of economy.

·         2) Insurance may facilitate borrowing towards the purchase of their house, car, boat, cottage or other asset.

·         3) The insurance industry also contributes to the economy by providing employment to thousand of Canadians.  Salaries, benefits and the costs of goods and services to operate a business represent large amounts of money being recycled into the economy.

·         4) P&C insurers hold large investment holdings; such investments are used to help finance governments and businesses.

·         5) Risk exposures are escalating.  As the planet becomes more crowded, weather becomes more erratic, values become more concentrated, technology becomes more advanced, our economies become more intertwined and societies become more litigious.

·         6) P&C companies are taxed heavily and include layers of transaction taxes that apply to insurance.  Unlike other financial services, insurance is taxed at the retail level thus they pay billions of dollars to various levels of government.

·         7) Insurers pay billions of dollars each year for medical treatment, rehab, lost wages, and repair to damaged property, etc which boosts the local economies.  This creates jobs, both directly through spin-offs, which generates even more tax income for various levels of income.

9)      Why is there a need for residual market mechanisms?

·         Residual market mechanisms are established by the automobile insurance industry to provide a last resort insurance facility for consumers.  Non-for-profit Facility Association (FA).

·         Quebec operates its residual market independently.

·         This ensures that insurance coverage is available even to those who are considered a high risk and unattractive to mainstream insurers.

·         Every insurer licensed to write auto liability insurance in FA industries is required to be a member of the organization and to follow rules set by the Board of Directors regarding the scope, terms and standards of coverage to be provided.

·         The FA does not issue insurance policies, instead it designates certain companies to provide specific services and this includes claims handling.

10)  In property and casualty insurance, what are the two traditional methods of distribution, and how do they differ?

·         Independent broker/agents: Most insurance business written in Canada has been placed through brokers which has its roots in the British system. 

·         The size of the country and its sparse and dispersed population has made broker-based business a practical option.  Economical and efficient way for insurers to market their products.

·         Direct response method: hybrid direct write of distributing insurance directly to consumers by using different types of media to encourage customers to respond to insurance marketing campaigns.  Consumers call toll free to a centralized call centre for advice or to purchase insurance.

·         Certain traditional insurers have chosen to adopt this approach for at least some of the business they write.

11)  List FOUR (4) perceived advantages of the direct response method?

·         1) Consumers remain in control of the sales process

·         2) Professional advice with no commission costs or fees paid

·         3) Technology-enabled sales and service (telephone, internet, etc)

·         4) Extended hours of access for consumers

12)  What are FOUR (4) basic functions of reinsurance?

·         1) Financing -> frees up capital that would otherwise be tied up to meet obligations.

·         2) Stabilization -> used to keep operational results within reasonable parameters w/o fluctuating dramatically.

·         3) Capacity -> insurer might require the ability to insure businesses that are beyond their resources.  For competitive reasons, they may want to accept a large share of a risk being written by several insurers to that it can have a say in its terms and conditions.  An insurer might also want to cater to the needs of its big producers, thus may require reinsurance for some risks that it has not otherwise positioned itself to write.

·         4) Resource protection against catastrophes -> protects resources and investment position and limits problems with regulatory authorities, shareholders and reinsurers.

13)  Describe ONE (1) obstacle to deploying capital into Canada.

·         1) Canada is not the most capital-friendly jurisdiction in the world.

·         2) Complex mark-to-market tax scheme for insurer’s investment portfolios.  Any security held at the end of the tax year is treated as if it were sold and reacquired at its fair market value.  The government benefits from accelerated tax revenues when valuation gains in investments are made.

·         3) Extensive multi-tiered regulatory system requires multiple licences and several labour-intensive filing to be completed each year.

14)  Why did catastrophe reinsurance rates not increase as much as expected after the 1998 ice storm in Ontario and Quebec?

·         Firming of rates often comes from the retrocession market (reinsurance for the reinsurers) and reinsurers must have to either hold on to more risk or pay significantly more for retrocession protection.  This has an inflationary effect on reinsurance rates which tends to flow down to the primary side to firm rates.

·         While Canada may have a catastrophe-free year and overall loss experience is good; reinsurers in the country may find their retrocession costs soaring due to high loss experience or extraordinary events in other parts of the world.

·         Catastrophe rates did not increase after the 1998 ice storm in Ontario and Quebec because several billion-dollar natural loss events occur around the world ever year and the ice storm was just one of many in 1998.

15)  Why is undercutting a problem in the property and casualty insurance industry? What is an alternative solution to undercutting in an oversaturated market?

·         Canada has a large number of general insurers and seems ideal from a competition perspective for the consumers.  However it appears that very few consumers really shop around in order to find the lowest premium possible.

·         Over 200 companies vie for a piece of the P&C market.

·         Undercutting to gain market share violates the 2^nd principal of insurance: the premium shall be commensurate with the risk.

·         Undercutting can take two forms 1) decreases in prices 2) more liberal policy terms and conditions.

·         Insurers undercut in fear that their market shares will shrink and never recover.

·         When many players are involved in the industry, more capital is available which means more capacity and more capacity means more competition.  With abundant capital and fierce competition, companies may feel pressure to make poor business decisions.

·         SOLUTION: 1) price discipline determined by sound underwriting and actuarial practices.

16)  Identify FIVE (5) new areas of challenge that the insurance industry faces.

1)      Globalization

2)      Rapid advances in technology

3)      Public image issues

4)      Volatile investment markets

5)      Increasingly severe weather

6)      Growing competition

7)      Mounting shareholder and regulatory scrutiny

8)      Downloading and offloading by government.