FIN 3610 General InsuranceChapter 6 – Insurance Company Operatio.docx

FIN 3610 General Insurance
Chapter 6 – Insurance Company Operations
Chapter 8 – Government Regulation of Insurance
Lecture Overview – Comments from Dr. Zietz
Insurance Company Operations and Government Regulation of
InsuranceInsurance Company Operations
The information contained in this next lesson,
which comes from Chapters 6 and 8, may be more fascinating to
some of you if you already have a specific interest in a
particular field of insurance. For example if you're in actuarial
science major, you will like the right making section. Many
students found they want to go into underwriting and there's a
good portion of the chapter on the underwriting steps and
different types of consideration to beginning the underwriting
process. Some students know right away that they're interested
in sales while others know for certain that is not their strong
interest. The production side of insurance covers again some of
the marketing topics that we had earlier, but it will also tell you
how professional organizations, such as the CPCU Chartered
Property and Casualty Underwriter and the CLU Chartered Life
Underwriter, are among others that encourage professionals
within the industry to continuously improve their skills and
knowledge by completing professional designations.
Another area within the insurance industry that is fascinating
and offers a great insight into many facets of the insurance
process is claims settlement. There are various types of
adjusters that are discussed in this chapter and the steps to the
adjusting process is fairly structured. Entering the insurance
industry through a claims position will provide insight into how
the insurance industry can operate successfully.
Reinsurance is kind of a term that many young professionals are

not fully able to grasp but it is a very key tool used to sustain
the insurance industry. Reinsurance, as noted on slide 15, is an
arrangement by which the primary insurer that initially writes
the coverage transfers to another insurer part of those potential
losses. The primary insurer is called the seating company, and
the company that accepts that seeded risk is the reinsure. This
process allows companies to increase their underwriting
capacity and reduce their reserves which may be more optimally
invested elsewhere.
Insurance Regulation
Chapter 8 brings up several very interesting topics concerning
the purpose of regulating the insurance industry and how the
regulation may be efficiently accomplished. I typically ask the
classroom students “what is the main reason for insurance
regulation?” Most of them, being new in their study of
insurance, say it is to keep the prices down. Then I respond by
asking: do you think we need regulation to ensure the price of
groceries is kept at a certain level? Do you think the price of a
car should be regulated by the federal government? So what
makes insurance different that results in needing regulation that
other industries do not need?
If you bought an insurance policy on your house, what is your
number one fear? If your house has a loss, the insurance policy
will pay you for that loss through that sharing process we
discussed. What would really keep you awake at night,
especially if you bought the coverage at a very cheap premium,
much cheaper than the other competitors? You probably should
be concerned that the price may not be enough to sustain that
group of insureds like we discussed in Chapter 1. So one of the
key reasons for the insurance regulation is to make sure the
insurance company is solvent. Should they write the coverage
too cheaply, perhaps there will be no funds available when that
person has the loss in the group.
Take some time and look up the development of
insurance regulation overtime. You need to go back and read

about Paul versus Virginia in 1868. The question has arisen for
many years even prior to that that insurance is or is not
interstate commerce. If insurance is deemed interstate
commerce, then a different set of regulations would apply. The
real question was, and still is, should states have the prerogative
of regulating insurers domiciled in their territory or should the
federal government have the right to regulate all insurers. As
with other types of laws, there has always been a propensity to
leave regulatory authority at the level of the consumer involved.
Specifically, state regulation has been going on for many years.
Then, read about the US versus Southeast Underwriters
Association case in 1944. This ruling overturned the palm the
Virginia case from decades earlier and helped decide that
insurance was in fact interstate commerce and should be
regulated by the federal government.
This interesting story continues because that ruling, US
versus Southeast Underwriters Association, only lasted for one
year when the McCarran Ferguson act 1945 gave the states the
authority to regulate insurance companies domiciled in their
states, but reserved the right for federal antitrust laws to kick in
if the states are unable to regulate activity.
Fast forward several decades to 1999, with the financial
modernization act. This changed the earlier law that had
prevented banks, insurance companies, and investment firms
from competing across state lines. A summary of this important
act is found on slide 6. Take some time to read about the
modernization act as it really changed the way a lot of financial
transactions are made today.
Continue reading through this chapter about the areas
that are regulated, the reasons for that regulation, and how you
would address the issue of insurance regulation if you were
helping draft a bill in the legislature. Be sure to read the
advantages and disadvantages of state versus federal regulation,
and how the ultimate goal of regulation, which is to ensure
solvency, is achieved. This is a very interesting chapter!

Assignment 4, Chapter 6 and 8 NAME
___________________________
FIN 3610
1. a. Briefly explain the basic principles of underwriting.
b. Identify the major sources of information available to
underwriters
2. The regulation of the insurance industry is structured
differently from the regulation of many industries.
a. Explain three key reasons why the insurance industry is
regulated.
b. Discuss the most significant need for insurance regulation.
c.
3. Discuss and summarize the main outcome of each of the
following cases or laws with respect to insurance regulation:
a. Paul v. Virginia
b. South-Eastern Underwriters Association Case
c. McCarran-Ferguson Act
d. Financial Modernization Act of 1999
4. Delta Insurance is a property insurer that entered into a
surplus-share reinsurance treaty with Eversafe Re. Delta has a
retention limit of $200,000 on any single building, and up to
nine lines of insurance may be ceded to Eversafe Re. a building
valued at $1,600,00 is insured with Delta. Shortly after the
policy was issued, a severe windstorm caused $800,000 loss to
the building.

a. How much of the loss will Delta pay?
b. How much of the loss will Eversafe Re pay?
a. What is the maximum amount of insurance that Delta can
write on a single building under the reinsurance agreement?
Explain your answer.
5. For each of the following situations, indicate the type of
reinsurance plan or arrangement that the ceding insurer should
use, and explain the reasons for your answer.
a. Company A is an established insurer and is primarily
interested in having protection against a catastrophic loss
arising out of a single occurrence.
b. Company B is a rapidly growing new company and desires a
plan of reinsurance that will reduce the drain on its surplus
because of the expense of writing a large volume of new
business.
c. Company C has received an application to write a $50 million
life insurance policy on the life of the chief executive officer of
a major corporation. Before the policy is issued, the underwriter
wants to make certain that adequate reinsurance is available.
d. Company D would like to increase its underwriting capacity
to underwrite new business.
e.
6. Explain the difference between rebating and twisting as they
relate to the insurance industry.
Chapter 5: Types of Insurers and Marketing Systems
Lecture Overview – Comments from Professor Zietz
Let’s examine the different types of Insurers and
Marketing Systems through which Insurance is Available!
In this chapter, we will overview the use of private insurance in
the financial service industry; give examples of types of private

insurers; expand on agents and brokers; see examples of types
of marketing systems; and explaining group insurance
marketing.
There are a myriad of ways to classify insurance companies,
including the type of insurance coverage that it offers, the type
of insurance services that it offers, the ownership of the
company, and the location in which the company is domiciled.
The types of classifications of private insurers discussed in this
chapter include:
· Stock insurers
· Mutual Insurers
· Reciprocal Exchanges
· Lloyd’s associations
· Blue Cross and Blue Shield plans, and
· Health Maintenance Organizations.
These classifications may greatly influence things like how
much coverage the company can write and how much the
premiums or income is taxed. This chapter provides a great
overview of the differences between the corporate structures of
the company. Carefully peruse the information in the Exhibits
5.1-5.3 for some interesting details on these classifications.
Quick Question: What is the largest U.S. Property/Casualty
Company in Revenues?
How many of you thought it was Berkshire Hathaway? I’m sure
you were surprised by that ranking. Note that MetLife is the
largest U.S. Life and Health Insurance Company.
The second part of this chapters delves into the types of
marketing systems used in the distribution of insurance. If you
have had a marketing class, you’ll see some familiar
information. However, you will also see that the marketing
systems in insurance also use some new terms, including
Personal Selling Systems such as Career Agents, Multiple Line
Exclusive Agents, Independent agents, Personal Producing
General Agents, and Brokers. It is very important to note the
difference between these types of systems. The major

distribution systems for Property and Casualty (P/C) generally
include these types of systems:
· Independent agency system
· Exclusive agency system
· Direct Writers
· Direct response system
· Multiple distribution systems
If you find yourself in the insurance industry, perhaps wanting
to have your own business or agency, it will be important to
note the differences, including the advantages and
disadvantages of each of these.
The insurance industry offers a wide array of professional
career paths in the area of sales! We’ll talk more about other
career choices in the next chapter when we cover Insurance
Company Operations.
Assignment 3, Chapter 5 NAME
__________________________
FIN 3610
When appropriate, provide a citation and a copy of your source.
1. a. Describe the basic characteristics of stock insurers.
b. Describe the basic features of mutual insurers.
c. Identify the major types of mutual insurers.
2. Property and casualty insurance can be marketed under
different marketing systems. Compare the independent agency
system with the exclusive agency system with respect to each of
the following:
a. Number of insurers represented by the agent
b. Ownership of policy expirations
c. Differences in the payment of commissions

3. You have just learned that “the number of life insurers has
declined sharply during the past decade because of the increase
in company mergers and acquisitions, demutualization of
insurers, and formation of mutual holding companies.”
a. How many life insurers are there currently in the U.S.? How
many life insurance companies were there in 1970? Provide a
citation and a copy of your source.
b. Why have mergers and acquisitions among insurers increased
over time?
c. What is the meaning of demutualization?
d. Briefly explain the advantages of demutualization of a mutual
life insurer.
e. What is a mutual holding company?
f. What are the advantages of a mutual holding company to an
insurer?
4. Commercial Insurance is a large stock property and liability
insurer that specializes in the writing of commercial lines of
insurance. The board of directors has appointed a committee to
determine the feasibility of forming a new subsidiary insurer
that would sell only personal lines of insurance, primarily
homeowners and auto insurance. The new insurance company
would have to meet certain management objectives. One
member of the board of directors believes the new insurer rather
than as a stock insurer. Assume you are an insurance consultant
who is asked to serve on the committee. To what extent, if any,
would each of the following objectives of the board of directors
be met by formation of a mutual property and casualty insurer?
Treat each objective separately.
a. Commercial Insurance must legally own the new insurer.
b. The new insurer should be able to sell common stock
periodically in order to raise capital and expand into new
markets.
c. The policies sold should pay dividends to the policyholders.
d. The new insurer should be licensed to do business in all
states.

Chapter 3: Introduction to Risk Management
Welcome back to General Insurance and now to Risk
Management Topics!
In this chapter we will define the meaning of risk
management (RM); explain the objectives of risk management;
explain the steps in the risk management process; expand on the
benefits of risk management; and explain how the risk
management process can be used on a personal level.
You have probably discovered by now that the field of
insurance and risk involves much more than just paying an
insurance agent to cover your losses. Insurance involves a great
deal of mathematics and structured arrangements to operate
successfully. I mentioned in Chapter 1 that there are several
definitions of risk. Risk definitions are often broken down in
dichotomies of risk such as Pure vs Speculative and Objective
vs Subjective. The study of risk and its management is
definitely a science.
In this chapter we expand on the management of risk by going
through the basic risk management process. On slide 3 you will
see an important definition:
Risk Management is a process that identifies loss exposures
faced by an organization and selects the most appropriate
techniques for treating such exposures.
You will note that the above definition includes two steps in the
RM process: 1) identifying loss exposures; and 2) selecting the
most appropriate technique. There are also two other steps, so
let’s put these steps all in order:
1. Identifying potential losses
2. Analyzing and measuring the loss exposures

3. Selecting the appropriate combination of techniques for
treating the loss exposures; and
4. Implementing and monitoring the RM program.
It is important to memorize those steps as you move forward to
understanding what tasks and skills are needed to successfully
complete the RM process.
Keep in mind that not all organizations have the same goals.
Obviously, you know of for-profit companies whose goal is to
maximize the value of its owners. Non-profits may have a
myriad of goals, including serving under-privileged children or
spreading a religious message. Regardless of the ultimate goal,
the objectives of the risk manager may vary throughout the RM
process.
An interesting observation may be found by a little role playing.
Imagine for a moment that you are the RM of a large airline.
Let’s presume your company is a publicly held company and
your job is to help manage risk so as to maximize the value of
company to the shareholders. This would include incorporating
the risk appetite of your Board of Directors into your decisions.
Perhaps your company has very little or no debt and can afford
to absorb a certain level of risk. Your sub-goal may be to keep
up with the growth of the company by observing how risks
change.
Now, let’s say that you became the RM back in August of 2001.
Imagine that one of your planes was involved in the tragic
events of 9/11. What was your immediate goal on 9/12?
Keeping up with growth of the company was definitely NOT
your immediate concern. I spoke to an airline RM a month after
9/11 who commented that their immediate goal was to “keep
planes in the air.” In other words, to keep the company moving
and surviving. You’ll note on slides 4 and 5 that these goals
will definitely be fluid with changes that occur in the firm. A
good risk manager needs to be able to handle aggregate risk for
their organization while many of the variables will be changing.

There is no time for a Risk Management to become complacent!
This chapters provides more details on the processes involved
with completing each RM
step. Pay careful attention to the specific RM techniques as
those will be used throughout the RM process.
FIN 3610 Assignment 2
Name_______________________
Chapter 3
Please remember that you must do your own work. Any
plagiarism will result in a grade of zero for all students
involved. Please use your own words even if you are using the
textbook for answers. Always provide a citation when a
reference is used.
1. a. What is the definition AND purpose of Risk Management?
b. Explain the steps in the risk management process. Which step
is the most important?
2. You have just opened a children’s day care that can care for
up to 100 children per day. You are concerned about liability
exposures as well as earning enough revenue to be profitable.
For each of the following risk management techniques, describe
a specific action using that technique that may be helpful in
dealing with the day care’s liability exposure. Be specific.
a. Avoidance:
b. Loss prevention
c. Loss reduction
d. Duplication
e. Separation
f. Diversification
g. Non Insurance Transfer

3. a. Describe the reasons a company may establish a captive
insurer?
b. Explain the advantages of using a captive insurer in a risk
management program.
c. Provide a real-life example of a large captive (include
citation).
4. Avoidance is a risk-control technique that can be used
effectively in a risk management program.
a. What is the major advantage of using the technique of
avoidance in a risk management program?
b. Is it possible or practical for a firm to avoid all potential
losses? Explain your answer.
Chapter 2: Insurance and Risk
General Risk and Insurance topics get interesting!
Here in Chapter 2, we will define and explain the basic
characteristics of insurance; characterize the ideally insurable
risk; explain the relationship between adverse selection and
insurance; compare insurance to gambling and hedging; give
examples of kinds of insurance; and expand on the benefits and
costs insurance can have on society as a whole.
Let’s start with a good, thorough definition of Insurance. When
I took my first insurance course, back in the middle ages
(hopefully you just laughed!) the only definition I remembered
from the class was that “Insurance is the Transfer of Risk.” It
was only later in grad school when I was caught using that
definition that I realized that Insurance does, in fact, transfer
risk, but it is not THE transfer of risk. Transferring risk is just
one of several risk management tools for handling risk, just like
risk avoidance and risk control. The best definition of risk that
includes all of the important elements is:

Insurance is a device for sharing, pooling, reducing, and
transferring, risk by combining a sufficient number of exposure
units to make individual losses collectively predictable.
Note that “sharing” means to divide or distribute in shares.
When one joins an insurance pool, then he or she should be
consciously aware that the process assumes some responsibility
for contributing toward the total losses of the pool.
The above definition of insurance is consistent with the
definition in the text that states (I’ve added the information in
parentheses): “Insurance is the pooling (grouping together) of
fortuitous (accidental or occurring by chance) losses by transfer
of such risks to insurers, who agree to indemnify (compensate
or put back into a pre-loss condition) insureds for such losses,
to provide other pecuniary (financial) benefits on their
occurrence e, or to render services connected with the risk.”
If you recall the pooling of homes in the example from Chapter
1, you will probably note that Insurance is really a business use
of the law of large numbers. Insurance provides a way to reduce
risk by correctly applying the law of large numbers. The
definitions used have elements that are mandatory for the
concept of insurance to work.
Now that you’ve reviewed the essential processes needed to
make insurance work correctly, ponder this question:
How would you respond to someone who says “I’ve never had a
loss so my money was all down the drain?” Post your comments
in the discussion forum!
As you continue through the chapter through the benefits and
social costs of insurance as well as the probability analysis
information, you will now better understand why insurance
requires correct statistical, called actuarial, skills to make sure
the pool of funds is sufficient to pay the claims.

Chapter 1: Risk and Its Treatment
Welcome to General Insurance!
In this chapter we will go over and explain the definitions of
risk and different classifications of risks; peril versus hazard;
personal risks and commercial risks; what the burden of risk is
on society; techniques for managing risk; as well as explaining
a few terms that we will be using in this course.
This course is probably your first exposure to many of the
insurance and risk terms that we cover this semester. I expect
you will find that will be surprised at how you look at many
terms and ideas regarding the insurance product are vastly
different after going through this class. For example, I like to
start out asking the students to provide their pre-class definition
of risk. Many of them say “it’s the chance of something bad
happening,” or “the possibility of a negative outcome.” You’ll
find that these definitions are actually incorrect. While you’ll
find three definitions of different types of risk on slide 3, please
start thinking of risk as:
Risk: The possibility of a deviation between actual and expected
outcomes.
This definition contains the same elements as the definition
given in slide 3 “uncertainty concerning the occurrence of a
loss,” but let’s look at the deviation needed between actual and
expected outcomes. The following example really sets the
groundwork for fully understanding Risk and the elements
necessary to make the insurance product work successfully.
Assume that you own a house that has a 1/100 probability of
total fire loss. You cannot predict whether your house will burn.
Perhaps you then become a property investor and own 100
homes. You may assume that if your 1/100 probability is correct

that you will have one loss. However, with such a small sample
size, you could easily have 2 losses, meaning your expectation
deviated 100% from the number of actual losses. Then perhaps
you become a mega property investor and own 1000 similar
homes. Keep in mind, we need all of these homes to be
homogeneous for that 1/100 probability to be remotely
accurately. Should you own 1000 homes, you should expect 10
losses. Should an extra loss occur (11 losses) when your
expectation deviated only 10% from the number of actual
losses. Continue this exercise with more houses, say 100,000,
when you will expect 1,000 losses. One extra loss would lead to
a deviation of only .1% from expected losses. Thus, is
illustrated how the concept of insurance utilizes the law of large
numbers (sample must be unbiased, without adverse selection,
etc.) and units must be homogeneous to match the 1/100
probability of loss. Ultimately, risk (the deviation between
actual and expected losses) is reduced!
# Exposures
Expected Loss
Actual Loss
Deviation
1
?
100
1
2
100%
1,000
10
11
10%
10,000
100

101
1%
100,000
1,000
1,001
.1%
Let’s think briefly about the variables that may interrupt this
process. Let’s say that instead of you owning all of these
homes, we open up this process to MTSU students in this class.
If there is only 1 student, it would be impossible to predict or
plan for the outcome of that single house. We’d just probably
buy insurance on the house if we were the owner. Now, let’s
assume that there are 100 students in this class, each having
identical homes in the same geographic area. Let’s also say that
each home is worth $100,000. We should expect one of those
houses to burn. So, we’d all agree to put $1,000 in a pot, and
we’d have $100,000 available to pay for whoever the unlucky
one of use is who incurs the fire. Everyone is happy and the
owner of the house that burned “gets” the funds to rebuild his
house as it was.
That’s sounds great, UNLESS we are off on our prediction.
What happens to the pot if we actually have TWO houses burn,
versus one? Obviously, we don’t have enough money in the pot
to pay for two losses. We could have charged $2,000 per person,
but perhaps none of us would have been willing to spend that
much in premiums. So, let’s look exactly at the RISK in this
deviation: We expected one loss; we had two losses, so that’s a
100% deviation between actual and expected outcomes. How
should we proceed with this scenario?
The only reasonable way to make this pot be large enough to
cover our losses is to increase our sample size. So, the next line
in the above table shows that we add more houses to our pool,
let’s say 1,000 homeowners join our pool. We would then
expect to have 10 losses and we would charge premiums
accordingly. However, if we are off in our projection by 1 loss,

then we are only off by 10% (the percentage difference between
10 and 11 is 10%). So we have reduced the risk, which is
actually just that deviation between actual and expected losses.
Consider the problems that may occur in this scenario. Suppose
a student joins our class who has a history of having multiple
fire losses, or even worse, whose house is already on fire!
Would you be willing to let him join the pool? Would you want
to ask anyone who wants to join the pool if they have had prior
fire losses? Would you think that the rules for joining the pool
should prevent someone from joining if they are severely upside
down on their mortgage? Clearly, we’d want the pool of
homeowners to have similar loss probabilities if they are all
paying that $1000 annual premium.
I hope this example sparks some ideas in your mind about how
to structure that pool of homeowners’ risks to charge just the
right amount of premium that will cover any losses that may
occur. You’ll find that the slides in this chapter take you
through the basic classifications of risk and the costs and
benefits of having this pool work successfully.
FIN 3610 Assignment 1
Name_______________________
Chapters 1 and 2
Please remember that you must do your own work. Any
plagiarism will result in a grade of zero for all students
involved. Please use your own words even if you are using the
textbook for answers. Always provide a citation when a
reference is used.
1. Provide a complete definition of Insurance and briefly
discuss the essential elements of the definition.

2. The Law of Large Numbers is used in the development of
insurance rates. Explain how this statistical tool is important to
the success of insurance.
3. Briefly define and discuss risk as it relates to insurance.
Provide an example of how insurance reduces risk.
4. Provide an example of the following terms:
a. Physical Hazard
b. Moral Hazard
c. Morale Hazard
5. How does enterprise risk management differ from traditional
risk management?
6. Identify an appropriate risk management technique, or
combination of techniques, that would be appropriate for
dealing with the following risk exposures.
a. A student may not be able to finish school as his financial aid
is discontinued.
b. A family head may die prematurely because of a heart attack.
c. An individual’s home may be totally destroyed in a hurricane.
d. A new car may be severely damaged in an auto accident.
e. A negligent motorist may be ordered to pay a substantial
liability judgment to someone who is injured in an auto
accident.
7. List and briefly describe the six characteristics of an ideally
insurable risk:
a.
b.
c.
d.
e.
f.

8. Explain the concept of adverse selection as it relates to
insurance. Provide an example of adverse selection.
9. Explain the two major differences between insurance and
gambling.
10. How have you practiced risk management today? Be
specific.

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