Chapter 6 discusses the financial operations of property and casualty insurers, focusing on key financial statements such as the balance sheet and income and expense statement. It details the nature of an insurer's assets, liabilities, including loss reserves and unearned premium reserves, and explains methods for measuring underwriting profitability using loss and expense ratios. Additionally, it contrasts these financial operations with those of life insurance companies, emphasizing differences in asset duration, policy reserves, and income sources.

1. Chapter 6
FINANCIAL OPERATIONS
OF I NSURERS
By: Marya sholevar

2. PROPERTY AND CASUALTY
INSURERS
To understand the financial operations of an insurance
company, it is necessary to examine the insurer’s
financial statements. Two important financial
statements are the balance sheet and the income and
expense statement.
● A balance sheet is a summary of what a company
owns (assets), what it owes (liabilities), and the
difference between total assets and total liabilities
(owners’ equity) .
● This financial statement is called a balance sheet
because the two sides of the financial statement
must be equal:

3. PROPERTY AND CASUALTY
INSURERS
● The primary assets for an insurance company are
financial assets. An insurance company invests
premium dollars and retained earnings in financial
assets.
● Liabilities: An insurer is required by law to
maintain certain reserves on its balance sheet.
Because premiums are paid in advance, but the
period of protection extends into the future, an
insurer must establish reserves to assure that
premiums collected in advance will be available to
pay future losses.
● A property and casualty insurer is required to

4. Liabilities: Loss Reserves
● A loss reserve is the estimated cost of settling
claims for losses that have already occurred but that
have not been paid as of the valuation date . More
specifically, the loss reserve is an estimated amount
for (1) claims reported and adjusted but not yet
paid, (2) claims reported and filed, but not yet
adjusted, and (3) claims for losses incurred but
not yet reported to the company .
● Loss reserves in property and casualty insurance can
be classified as case reserves, reserves based on
the loss ratio method, and reserves for incurred
but not reported claims.

5. Liabilities: Loss Reserves
● Case reserves are loss reserves that are established
for each individual claim when it is reported .
● Major methods of determining case reserves include
the following: the judgment method, the average
value method, and the tabular method.
● Under the judgment method, a claim reserve is
established for each individual claim. The amount of
the loss reserve can be based on the judgment of
someone in the claims department or estimated
using a computer program.

6. Liabilities: Loss Reserves
● When the average value method is used, an
average value is assigned to each claim. This
method is used when the number of claims is large,
and the average claim amount is relatively small.
● Under the tabular value method, loss reserves are
determined for claims for which the amounts paid
depend on life expectancy, duration of disability, and
similar factors.
– The loss reserve is called a tabular reserve because the
duration of the benefit period is based on data derived
from mortality and morbidity tables.

7. Liabilities:Loss Reserves
● The loss ratio method (loss reserves) establishes
aggregate loss reserves for a specific coverage line.
Under the loss ratio method, a formula based on the
expected loss ratio is used to estimate the loss
reserve.
● The expected loss ratio is multiplied by premiums
earned during a specified time period.
● The incurred-but-not-reported (IBNR) reserve is
a reserve that must be established for claims that
have already occurred but have not yet been
reported to the insurer .

8. Liabilities: Unearned Premium
Reserve
● The unearned premium reserve is a liability item
that represents the unearned portion of gross
premiums on all outstanding policies at the time of
valuation .
● An insurer is required by law to place the entire
gross premium in the unearned premium reserve
when the policy is first written, and to place renewal
premiums in the same reserve.

9. Liabilities: Unearned Premium
Reserve
● Purpose of the unearned premium reserve:
– The fundamental purpose,pay for losses that occur during
the policy period
– Premium refunds can be paid to policyholders in the
event of coverage cancellation .
– If the business is reinsured, the unearned premium
reserve serves as the basis for determining the amount
that must be paid to the reinsurer for carrying the
reinsured policies until the end of their terms .

10. Liabilities: Unearned Premium
Reserve
● Calculate the unearned premium reserve by annual
pro rata method: Under the annual pro rata method
, it is assumed that the policies are written uniformly
throughout the year.
● For purposes of determining the unearned premium
reserve, it is assumed that all policies are written on
July 1, which is the average issue date. Therefore,
on December 31, the unearned premium reserve for
all one-year policies is one-half of the premiums
attributable to these policies.

11. Policyholders’ Surplus
● Policyholders’ surplus is the difference between an
insurance company’s assets and liabilities . It is not
calculated directly—it is the “balancing” item on the
balance sheet.
● If the insurer were to pay all of its liabilities using its
assets, the amount remaining would be
policyholders’ surplus.
● Surplus can be thought of as a cushion that can be
drawn upon if liabilities are higher than expected.
● Surplus represents the paid-in capital of investors
plus retained income from insurance operations and
investments over time.

12. Income and Expense Statement
● The income and expense statement summarizes
revenues received and expenses paid during a
specified period of time .
● Revenues are cash inflows that the company can
claim as income. The two principal sources of
revenues for an insurance company are premiums
and investment income.
● Earned premiums represent the portion of the
premiums for which insurance protection has been
provided .

13. Income and Expense Statement
● Expenses Partially offsetting the company’s
revenues were the company’s expenses, which are
cash outflows from the business.
● The major expenses for an Insurance Company:
– Adjusting claims
– Paying the insured losses
– Underwriting

14. Measuring Profit or Loss
● A simple measure that can be used is the
insurance company’s loss ratio and
expense ratio.
● The loss ratio is the ratio of incurred
losses and loss adjustment expenses to
premiums earned .
● Loss ratio= (Incurred losses+Loss
adjustment expenses)/Premiums earned
● The expense ratio is equal to the
company’s underwriting expenses divided

15. Measuring Profit or Loss
● The combined ratio is the sum of the loss ratio and
expense ratio.
● The combined ratio is one of the most common
measures of underwriting profitability. If the
combined ratio exceeds 1 (or 100 percent), it
indicates an underwriting loss. If the combined ratio
is less han 1 (or 100 percent), it indicates an
underwriting profit .
● A property and casualty insurance company can lose
money on its underwriting operations, but still report
positive net income if the investment income
offsets the underwriting loss.

16. Measuring Profit or Loss
● The investment income ratio compares net
investment income to earned premiums .
● Investment income ratio = Net investment
income/Earned preminus
● To determine the company’s total performance
(underwriting and investments), the overall
operating ratio can be calculated.
● The overall operating ratio is equal to the
combined ratio minus the investment income ratio .
● Overall operating ratio = Combined ratio -
Investment income ratio

17. LIFE INSURANCE COMPANIES
● Balance Sheet: The balance sheet for a life insurance company is
similar to the balance sheet of a property and casualty insurance
company.
● The Assets of a life insurance company are primarily financial assets.
● Differences between the assets of property and casualty insurance and
life insurance :
– Average duration of the investments:life insurance company
investments, on average, should be of longer duration than
property and casualty insurance company investments.
– Savings element in cash-value life insurance:Permanent life
insurance policies develop a savings element over time called the
cash value, which may be borrowed by the policyholder.
– Life insurance company may have separate account assets:Life
insurers use separate accounts for assets backing interest-sensitive
products, such as variable annuities, variable life insurance, and

18. LIFE INSURANCE COMPANIES
● Liabilities: Policy reserves are the major liability
item of life insurers. Major Liabilities in life
insurance are Policy reserves, reserve for amounts
held on deposit and the asset valuation reserve.
● Policy reserves are a liability item on the balance
sheet that must be offset by assets equal to that
amount .
● Policy reserves are considered a liability item
because they represent an obligation of the insurer to
pay future policy benefits.
● Policy reserves are often called legal reserves
because state insurance laws specify the minimum

19. LIFE INSURANCE COMPANIES
● The reserve for amounts held on deposit is a
liability that represents funds owed to policyholders
and to beneficiaries .
● The asset valuation reserve is a statutory account
designed to absorb asset value fluctuations not
caused by changing interest rates .
● Policyholders’ surplus is the difference between a
life insurer’s total assets and total liabilities.
● Income and Expense Statement:The major sources
of revenues are premiums received for the various
products sold and income from investments.

20. LIFE INSURANCE COMPANIES
● Income and Expense Statement:Investment
income can take the form of periodic cash flows and
realized capital gains or losses.
● Claims payments are a major expense such as:
– Death benefits paid to beneficiaries, Annuity benefits
paid to annuitants,Matured endowments paid to
policyholders,Benefits paid under health insurance
policies,Surrender benefits to policyholders who choose
to terminate their cash-value life insurance
● A life insurer’s net gain from operations (also called
net income) equals total revenues less total
expenses, policyholder dividends, and federal
income taxes

21. RATE MAKING IN PROPERTY
AND CASUALTY INSURANCE
● Objectives in Rate Making: rate-making goals can
be classified into two categories: regulatory
objectives and business objectives.
● Regulatory Objectives :The goal of insurance
regulation is to protect the public.In general, rates
charged by insurers must be adequate, not excessive,
and not unfairly discriminatory.
● The first regulatory requirement is that rates must
be adequate. This means the rates charged by
insurers should be high enough to pay all losses and
expenses .

22. RATE MAKING IN PROPERTY
AND CASUALTY INSURANCE
● The second regulatory requirement is that rates
must not be excessive. This means that the rates
should not be so high that policyholders are paying
more than the actual value of their protection .
● The third regulatory objective is that the rates
must not be unfairly discriminatory. This means
that exposures that are similar with respect to losses
and expenses should not be charged significantly
different rates .

23. RATE MAKING IN PROPERTY
AND CASUALTY INSURANCE
● Business Objectives:Insurers are also guided by
business objectives in designing a rating system.
The rating system should meet all of these
objectives: simplicity, responsiveness, stability,
and encouragement of loss control.
● Simplicity:The rating system should be easy to
understand so that producers can quote premiums
with a minimum amount of time and expense.
● Rates should be Stable over short periods of time so
that consumer satisfaction can be maintained.
● Rates should also be Responsive over time to
changing loss exposures and changing economic

24. Basic Rate-Making Definitions
● A rate is the price per unit of insurance .
● An exposure unit is the unit of measurement used
in insurance pricing .
● The pure premium refers to that portion of the rate
needed to pay losses and loss-adjustment expenses .
● The loading refers to the amount that must be added
to the pure premium for other expenses,profit, and a
margin for contingencies .
● The gross rate consists of the pure premium and a
loading element .
● The gross premium paid by the insured consists of

25. Rate-Making Methods
● There are three basic rate-making methods in
property and casualty insurance:
– Judgment rating
– Class rating
– Merit rating
● Schedule rating
● Experience rating
● Retrospective rating
● Merit rating, in turn, can be broken down into
schedule rating, experience rating, and retrospective
rating.

26. Rate-Making Methods
● Judgment rating means that each exposure is
individually evaluated, and the rate is determined
largely by the judgment of the underwriter .
● Class rating means that exposures with similar
characteristics are placed in the same underwriting
class, and each is charged the same rate .
● The major advantage of class rating is that it is
simple to apply. Also, premium quotations can be
quickly obtained. As such, it is ideal for the personal
lines market.
● Class rating is also called manual rating .

27. Rate-Making Methods
● There are two basic methods for determining class
rates: the pure premium method and the loss ratio
method.
– The pure premium can be determined by dividing the
dollar amount of incurred losses and loss adjustment
expenses by the number of exposure units .
● Pure premium=Incurred losses and loss adjustment
expenses/Number of exposure units
● The final step is to add a loading for expenses, underwriting
profit, and a margin for contingencies.
● The expense loading is usually expressed as a percentage of the
gross rate and is called the expense ratio.
● Gross rate =Pure premium/(1 - Expense ratio)

28. Rate-Making Methods
– Loss Ratio Method. Under the loss ratio method, the
actual loss ratio is compared with the expected loss ratio,
and the rate is adjusted accordingly.
– The actual loss ratio is the ratio of incurred losses and
loss-adjustment expenses to earned premiums.
– The expected loss ratio is the percentage of the premium
that can be expected to be used to pay losses.
– Rate change=(A-E)/E
● where A = Actual loss ratio
● E =Expected loss ratio

29. Rate-Making Methods
– Merit rating is a rating plan by which class rates
(manual rates) are adjusted upward or downward based
on individual loss experience .
● Merit rating is based on the assumption that the loss experience
of a particular insured will differ substantially from the loss
experience of other insureds.
● There are three types of merit rating plans: schedule
rating, experience rating, and retrospective
rating.
– Under a schedule rating plan, each exposure is
individually rated.
– Schedule rating is used in commercial property insurance
for large, complex structures, such as an industrial plant.
Each building is individually rated based on several

30. Rate-Making Methods
– Construction refers to the physical characteristics of the
building.
– Occupancy refers to the use of the building.
– Protection refers to the quality of the city’s water supply
and fire department. It also includes protective devices
installed in the insured building.
– Exposure refers to the possibility that the insured
building will be damaged or destroyed by a peril, such as
fire that starts at an adjacent building and spreads to the
insured building.
– Maintenance refers to the housekeeping and overall
upkeep of the building.

31. Rate-Making Methods
● Under Experience rating , the class or manual rate
is adjusted upward or downward based on past loss
experience . The most distinctive characteristic of
experience rating is that the insured’s past loss
experience is used to determine the premium for the
next policy period .
– Rate change=((A-E)/E)*C
● where A = Actual loss ratio
● E =Expected loss ratio
● C=Credibility factor
● Under a Retrospective rating plan, the insured’s
loss experience duringthe current policy period
determines the actual premium paid for that period .

32. RATE MAKING IN LIFE
INSURANCE
● Life insurance actuaries use a mortality table or
individual company experience to determine the
probability of death at each attained age.
● The probability of death is multiplied by the amount
the life insurer will have to pay if death occurs to
determine the expected value of the death claims for
each policy year.
● These annual expected values are then discounted
back to the beginning of the policy period to
determine the net single premium (NSP). The NSP is
the present value of the future death benefit.