Insurance is commonly seen in your daily life. You must be holding one insurance policy or more to take care of your car, your house, and also your health and life. Though the word insurance looks very familiar, you may be puzzling when thinking about the following questions.
How does insurance work? Why is it effective in protecting you from various risks? How does an insurance company make money? Moreover, whether you are able to make money as insurance companies do, if you are willing to provide capital and undertake some risk?
This article is to solve all of the questions mentioned above and more beyond. Let’s start by looking at what is insurance and why we need it.
Insurance has a very long history. As early as around 2000 BC in Babylon, a merchant receiving a loan paid the lender extra money in exchange for exemption of loan payment if the merchant’s shipment were stolen. The loan lender used this extra fund collected from all loan borrowers to protect himself from potential losses of uncollectible loans incurred by a few unlucky merchants. In other words, loan borrowers benefited from this arrangement by sharing risks among a community, which is the fundamental of insurance.
With the development of society and economy, the need for insurance increased. Especially when shipping between the New World and Europe established rapidly for trade of exotic goods, the need of marine cargo insurance boosted to transfer risks associated with possible loss of shipment if the vessel was caught in a sea storm, fire, pirate, etc.
The discussion of insurance development won’t be complete without a mention of Lloyd’s of London. In the 17th century, a coffeehouse owned by Edward Lloyd was a popular meeting place for people seeking for marine cargo protection and people willing to take corresponding risks in exchange for premium. A sheet of ship and cargo information would be prepared, and the individuals who accepted that risk would write their names under the description of the risk. This action gave rise to an important term of insurance, underwriting, as a process of risk assessment to determine whether to accept or reject the risk. The coffeeshop later grew into Lloyd’s of London. Today Lloyd’s plays an essential and unique part in the insurance world. We will introduce more about it in part 2.1.3.
As briefly touched in the preceding part, the nature of insurance is to transfer and share risks.
We name the individuals (or companies in some insurance policies) who would like to transfer risks to other parties by paying a certain fee as insured, and the party who accepted such risks and associated fee as insurer. The reason why insureds avoid the risk is that possible extreme losses, such as a total loss of cargo in a storm, is fatal to an individual insured. In other words, the loss is too volatile to bear. In fact, when we are trying to measure risk as an abstract concept, volatility is its genuine representative to be captured. Insurers are not afraid to expose themselves to the same risk because they master the magic of pooling and the law of large numbers.
The essence of pooling is risk sharing, to spread losses incurred by the few over the entire group. The purpose of this process is to reduce the volatility in possible outcomes as usually measured by the standard deviation, i.e. deviation from the expected value of outcome. For example, assume that 2 ship owners, A and B, each own a ship with identical goods to be ferried valued at $10 million. There is a 10% chance that each ship will be attacked by pirate which results in total loss of the goods, and that an attack to either ship is an independent event. Ship owner B proposes to A to share the total loss of the 2 ships equally, no matter what happens to which ship in the voyage, i.e. pooling the risk. Below is the standard deviation of A’s loss under the 2 scenarios (to reject or to accept the proposal).
You can tell by the above table that the standard deviation decreases when the 2 ship owners pool (combine) their loss exposures. Actually, by doing similar calculation, you will find the standard deviation continues to drop as additional ship owners facing the same risk join in the pooling arrangement.
Can standard deviation drop to 0? Theoretically, the answer is yes! As the number of ship owner grows to infinity, the loss to individual ship owner would be $1M without any volatility. This is the law of large numbers, which states that the greater the number of exposures, the more closely will the actual results approach to its expected average value. According to this law, insurers underwrite a large number of similar risks to manage their risk exposure (i.e. reduce volatility), therefore they are willing to accept the risks insureds intend to transfer.
It is impossible to list out the benefits of insurance completely. Followings are the major ones that we believe worth noting to you.
Insurance allows the insureds to exchange the risk of an extreme loss for the certainty of smaller and affordable payments, i.e. premiums. As a result, the insureds are able to maintain a smooth and healthy cash flow. In the example illustrated in 1.2, assuming there is an insurance company formed to offer coverage (full loss indemnity, i.e. $10M) to all of the ship owners confronting the same pirate crisis, the premium charged would be roughly $1M (assuming the insurer incurs no cost and asks for no profit) for each time of good delivery, if the total number of ship owners is large enough. Ship owner A who unluckily suffered pirate attack in 2nd and 8th time in a 10-time delivery would see the cash flow smoothened after purchasing insurance.
As insurance permits the insureds to be restored to their former financial position after a loss occurs, they are less likely to turn to government and society for assistance, which saves public financial resources. At the same time, public’s worry and fear for losses are reduced which ease the society burden in another way.
Besides the direct loss indemnity, insurance companies also play an active role loss prevention. For example, property and casualty insurers strongly support the following important loss-prevention activities:
- Highway safety and reduction of auto accidents and deaths
- Fire prevention
- Reduction of work-related injuries and disease
In terms of legal ownership and structure, the insurance companies can be classified as stock insurers, mutual insurers, Lloyd’s of London, captives, reciprocal insurance exchanges, pools, government insurers, etc. We will introduce the first 3 types in this article as more than 90% of insurers are organized in these forms.
Stock insurers are the most prevalent type of insurer. These insurers are owned by their stockholders who have purchased stocks to supply capital needed for forming and running business. In exchange, stockholders gain return on their investment in the form of stock dividends or increased stock value. Stockholders have the right to elect the board of directors, which has the authority to control the insurer’s activities.
Most of the top insures are stock insurers, such as AXA, Ping An, Allianz.
The owners of the mutual insurers are the policyholders. In general, mutual insurers are initially formed by individuals (or companies) who are in need of certain insurance coverage unfilled by market, so as to close such gap and protect each other mutually. Policyholders enjoy the profit of company as dividend income. A mutual insurer issues no common stock, so it has no stockholders.
A well-known mutual company is Liberty Mutual.
We’ve briefly touched the formation of Lloyd’s in 1.1. Lloyd’s has a couple of outstanding characteristics.
First, Lloyd’s is not an insurer. It is a marketplace for its member to underwrite insurance business. You can regard it as the New York Stock Exchange, but for trading insurance products instead of securities.
Second, the member of Lloyd’s are corporations, limited partnerships, and individuals. Members must meet stringent financial requirements, including required capital supply to support its underwriting. Premiums are consolidated as trust fund to pay for claims and expenses. In addition, members must also deposit extra funds if premiums are insufficient to cover the claims, and the venture is a loss. Besides, a central guarantee fund is set up to manage the risk of any member going bankrupt hence unable to pay claims.
Finally, Lloyd’s is famous for providing coverage for many unusual or difficult loss exposures, such as a prize for a hole-in-one at a golf tournament. Its members underwrite much of the global marine and aviation insurance.
In the past centuries, Lloyd’s has witnessed the birth of insurance solutions for managing a bunch of unique and novel risks, which we believe accredit to its open-market principle and advanced rules of capital and reserving to guarantee the smooth payments of claims. Therefore, we borrowed the idea of Lloyd’s in the design of Nsure.
An insurance policy has its lifespan with a set of transactions, as shown in the below diagram.
An official application for an insurance policy usually starts with quoting process. A quote is an estimate of premium when a customer contacts the insurance company asking for the coverage and costs associated with a certain risk he would like to manage. If the customer has further interest in buying a policy, he has to fill out an application, which is then sent to an insurance company underwriter.
Underwriting refers to the process of selecting, classifying, and pricing applicants for insurance. After the underwriter evaluates the information of application, an underwriting decision must be made to either accept the application with or without certain restrictions or modifications to the coverage and premium, or reject the application.
Underwriters are provided with a rating table from actuaries, which can be used to come up with a standard premium for the insured. You can think of their roles in this way – actuaries first classify insureds into groups by certain characteristics and then set premium for standard risks of those groups; while underwriters set premium for an individual insured by finding out how different it is from the standard risk.
The standard premium coverage is the starting point of underwriting, from where underwriters are expected to evaluate the information of the insured further, and make a decision of whether accept or decline the application. Underwriters can also make a counteroffer by adjusting the premium and/or coverage of the policy, to ensure the actual loss experience is not likely to exceed the loss experience assumed in the pricing procedure.
After the underwriter accepts the application as a standard risk, or the insured accepts the counteroffer, an insurance policy is issued. An insurance contract is not coming into effect until policy issuance.
After receiving a notice of loss from the insured, the claims department settles a claim with the following steps. First, the claims department must check if all information related to the loss examination is received, and appoint a loss adjuster to investigate the claim. An adjustor may require a proof of loss before the claim is paid. After the claim is investigated, the adjustor must make a decision on whether pay (in total or partial) or deny the claim payment.
Insurance is an industry having long been actively regulated. Especially after the financial crisis in 2008 and the associated bailout of AIG, the regulation of is tightened.
The primary reason for insurance regulation is to maintain the solvency of insurers. As an insurer receives premiums (cash inflow) in advance and pay claims (cash outflow) in the future, the insurance protection paid could be worthless if the insurer goes bankrupt. Furthermore, since insurance plays a key role in providing financial security for the society, severe social and economic costs are incurred when giant insurers become insolvent. Therefore, the financial strength of insurers must be carefully monitored.
There are many perspectives for regulator to monitor the solvency level of an insurer, and one of the key items is capital. Remember that capital reflects the excess value a firm holds in assets over liabilities. It represents a financial cushion against hard times. Though the requirement of capital appears in different names varied by regulation authorities (e.g. Solvency II SCR, RBC), the underlying concept is the same, which is a Minimum Capital Requirement (MCR) representing a bottom line to withstand the possible downside of all risks an insurer is facing. A failure of meeting MCR could result in a seize in business.