Faith R. Neale, Ph.D. Associate Professor of Risk Management and Insurance Department of Finance

1. Basic Principles of Risk Management & Insurance A Seminar for South Carolina State Legislators January 17, 2013 Faith R. Neale, Ph.D. Associate Professor of Risk Management and Insurance Department of Finance Belk College of Business, UNC Charlotte The Griffith Insurance Education Foundation

2. Seminar Overview • Overview of Insurance Market • Industry Overview • Ratemaking • Underwriting • Insurance Regulation The Griffith Insurance Education Foundation

3. Why do we need insurance? Comply with law and manage risk • Comply with lender requirements • Auto, Home • Comply with state and federal law • State: auto liability limits, worker’s compensation • Federal: PPACA • Asset protection and financial security • Risk The Griffith Insurance Education Foundation

4. What is insurance? “The pooling of fortuitouslosses by transfer of such risks to insurers, who agree to indemnifyinsureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk.” ARIA, 1965 The Griffith Insurance Education Foundation

5. Characteristics of insurance • Risk transfer • The insurer promises to pay under certain conditions • Pooling of losses • Substitutes average loss of pool for actual loss • Law of Large Numbers • Payment of fortuitous losses • Sudden and accidental, unforeseen and unexpected • Indemnification • Restore to original financial position The Griffith Insurance Education Foundation

6. Categories of Insurance • Personal and Commercial lines • Property/Casualty and Life/Health The Griffith Insurance Education Foundation

7. Overview of Insurance Market The Griffith Insurance Education Foundation

8. 2011 P&C U.S. NPW by Line The Griffith Insurance Education Foundation Source: SNL Financial, Inc.

9. 2011 Life/A&H U.S. NPW by Line The Griffith Insurance Education Foundation Source: SNL Financial, Inc.

10. The Griffith Insurance Education Foundation Source: SNL Financial, Inc.

11. Industry Overview The Griffith Insurance Education Foundation

12. INDUSTRY CHARACTERISTICSTypes of Private Insurers Form of Ownership Place of Incorporation Licensing Status Proprietary Cooperative Admitted Non-Admitted FOREIGN StockCos Mutual Cos SurplusLines ALIEN Lloyds Reciprocals DOMESTIC Pools Syndicate Reinsurance The Griffith Insurance Education Foundation Slide by Kevin Eastman, Georgia Southern University

13. Surplus Lines • Distressed (risk or market) • Risk – Physician with drug use • Market – Compounding pharmacies • Unique or Unusual • Shamu, Hole-in-One coverage • High Capacity • Corporate jet, high rise • Product Innovation • Cyber Liability, EPL The Griffith Insurance Education Foundation

14. INDUSTRY CHARACTERISTICSPublic Insurers • Federal • National Flood Insurance Program • Social Security (OASDI), Medicare, Unemployment, Railroad Retirement Act • Terrorism Risk and Insurance Act (TRIA) • Crop Insurance • State • Wind (and hail) Pools, FAIR plans • Workers Compensation pools • Auto liability and health insurance pools The Griffith Insurance Education Foundation

15. SC Wind and Hail Underwriting Association(JUA) • Residual property insurance market – insurer of last resort • Covers wind and hail in coastal “beach” areas • All insurers licensed to write property insurance are members. • All insurers that write property insurance share in the losses and profits of the association. The Griffith Insurance Education Foundation

16. Characteristics of an (ideally) insurable risk • Large number of exposure units • Accidental and unintentional loss • Determinable and measurable • No catastrophic loss • Calculable chance of loss • Economically feasible premium The Griffith Insurance Education Foundation

17. Ratemaking The Griffith Insurance Education Foundation

18. RATEMAKING OBJECTIVES INSUREROBJECTIVES REGULATORYOBJECTIVES Primary Objectives Adequate Low enough to be competitive.High enough to be profitable. Not Excessive Not Unfairly Discriminatory Secondary Objectives TYPES OF RATING LAWS 1. Prior Approval Laws (SC)2. File & Use Laws3. Use & File Laws4. Flex Rating Laws (SC with 7% band)5. Open Competition (No-File) Laws Stability Responsiveness Promote Loss Control Contingencies Simplicity Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation

19. The Actuary • What are actuaries? • Evaluate the financial consequences of future events • “Actuaries put a price tag on risk.” American Academy of Actuary • Functions in Insurance • Direct ratemaking operations • Loss development factors and trends • Set loss reserves (case inadequacies and IBNR) The Griffith Insurance Education Foundation

20. ESTIMATING RATESPure Premium Method ESTIMATION PROBLEMS 1. Errors in Loss Reserves2. Inflation3. Credibility of Data SOLUTIONS 1. Loss Development2. Trending3. Credibility Factors Paid Losses PurePremium LossReserves GROSSRATE + Expenses Loading Profit Contingencies The Griffith Insurance Education Foundation

21. THE RATEMAKING PROCESSSteps in the Ratemaking Process Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation • The GriffithInsurance Education Foundation

22. Underwriting The Griffith Insurance Education Foundation

23. UNDERWRITINGDefinition & Objective DEFINITION The process of determining what loss exposures will be insured, for what amount of insurance, at what price, and under what conditions. OBJECTIVE To develop & maintain a profitable book of business by avoiding adverse selection. Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation

24. The Adverse Selection Problem • Definition: The tendency of higher-than-average risks to seek insurance. • Illustration: 2 risk types in population • Low risk: 1 in 10,000 die each year • High risk: 1 in 100 die each year • Insurer knows 50% of the population low versus high risk but can’t tell which is which • Is it feasible to create an insurance pool with both types in it? Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation

25. The Adverse Selection Problem (cont.) • Example life insurance pool: 2,000 people, $200,000 face value each • Expected loss per low risk (1/10,000)= $20 • Expected loss per high risk (1/100)= $2,000 • Expected loss for the pool = $2,020,000 • Per policy to break even= $2,020,000/2,000 = $1,010 • Will this insurance pool be feasible? • Will the low risk people want to buy it? • Will the high risk people want to buy it? • What if the pool gets more high risks than low risks? • How could another insurer enter the market and attract away all the low risks? Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation

26. Key Points about Adverse Selection • Risk pooling doesn’t work if the risk is too high • e.g. life insurance for fatally ill people; homeowners in disaster-prone regions • Risk pooling doesn’t work with too many high risks • Low risks aren’t willing to excessively subsidize the high risks  incentive to be uninsured • Insurers need to be able to identify risk type so that they can put similar risks together in a pool to make it fair and affordable • Insurers who don’t use available information to classify PHs will experience adverse selection • Competition will drive premiums to the appropriate level for risk type Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation

27. Tools to mitigate adverse selection • CLUE • Insurance (FICO) score • Property inspection • Medical information bureau (MIB) • MVR The Griffith Insurance Education Foundation

28. The “Moral Hazard” Problem • Definition: Dishonesty or character defects that increase the frequency or severity of loss because insureds can profit from a loss • Examples: • Faking accidents, disability • Exaggeration of claims • Failure to control losses (not locking car or house) – moral hazard • Intentional losses • Overutilization of insurance (e.g. health) Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation

29. Controls on Moral Hazard • Can’t insure in excess of the loss • Limits on underinsuring property • Careful claims adjusting • Deductibles and coinsurance • Waiting periods • Exclusions • Limits • Riders Slide by Vickie Bajtelsmit, Colorado State University The Griffith Insurance Education Foundation

30. Availability and/or Affordability • One of the primary disputes in insurance • Insurance supply is low (and/or) • Insurance cost is high • Conflict arises especially in hard to price markets such as high hazard areas, new exposures, unknown outcomes, catastrophes • Department of Insurance must ensure insurer solvency to protect the consumer The Griffith Insurance Education Foundation

31. Insurance Regulation The Griffith Insurance Education Foundation

32. REASONS FOR INSURANCE REGULATIONThree Primary Reasons TO PROTECT CONSUMERS Policy Forms Set coverage standards, specify policy language, disapprove unacceptable policies. Fraud Protect against misrepresentations by agents & unfair practices or dishonesty of insurers. Availability Restrictions on cancellation and non-renewal of coverage. TO MAINTAIN INSURER SOLVENCY Reasons for Solvency Regulation Insurance provides future protection, and insolvent insurers cannot fulfill their obligations.Large numbers of people are adversely affected when insurers become insolvent.Substantial funds held by insurers for the benefit of policyholders must be safeguarded. TO PREVENT DESTRUCTIVE COMPETITION Rate Competition Under-pricing leads to insurer insolvencies and shortages of insurance (as insurers withdraw from the market or stop writing new business). Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation

33. INSURANCE REGULATORY ACTIVITIESMajor Activities of Insurance Regulation Forming & Licensing Insurers Licensing Insurance Personnel Monitoring Insurer Solvency REGULATORY ACTIVITIES Regulating Insurance Rates Regulating Insurance Policies Monitoring Market Conduct Ensuring Consumer Protection Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation

34. Assets Bonds Stocks Cash Premium balances Reinsurance recovery Liabilities Losses Loss Adj Expenses Unearned Premiums PH Surplus Principal Balance Sheet Elements Policyholder Surplus = Assets - Liabilities Premiums-to-surplus (capacity) ratio must not exceed 300% or a 3-to-1 ratio of net premiums written to surplus. The Griffith Insurance Education Foundation

35. FUNCTIONS OF REINSURANCEBENEFITS FOR INSUREDS & INSURERS Benefits for Insureds Benefits for Insurers Stabilizes loss experience. All coverage can be obtained from one insurer, reducing the chance of coverage gaps & problems in loss collection. Increases large line capacity. Provides surplus relief.*** Reduces the chance of primary insurer insolvency.*** Protects against catastrophic losses.*** Allows small insurers to compete with large insurers, which should increase availability & reduce price.*** Provides underwriting assistance. Allows withdrawal from a territory or class of business. The Griffith Insurance Education Foundation

36. INSURANCE REGULATORY ACTIVITIESMonitoring Insurer Solvency Monitoring Insurer Solvency To reduce the risk of insolvency and to protect the public against loss when insurers fail. Reasons for Insolvency Methods to Ensure Solvency Liquidation of Insolvent Insurers Rapid premium growth. Require annual financial statements in a prescribed format & review. Insolvent insurers are placed into receivership by state ins. department Inadequate rates & reserves. Off-site monitoring: Administer FAST and IRIS. Excessive expenses. Rehabilitation, if possible. Conduct on-site field examinations (every 3-5 years). Lax controls over MGAs. If impossible to rehabilitate, the co. is liquidated according to the state’s insurance code. Uncollectible reinsurance. Establish financial requirements (e.g., minimum capital & surplus reqs). RBC Fraud. Control significant, broad-based, risk-related activities. Slide by Kevin Eastman, Georgia Southern University The Griffith Insurance Education Foundation

37. Primary avenues for HO insurance in South Carolina • Standard insurers • SC Wind and Hail Association (market of last resort) • National Flood Insurance Program • Surplus lines, cover all perils as above. Normally a higher premium. The Griffith Insurance Education Foundation

38. 2011 Direct Premiums Written, SC Source: SNL Financial, Inc.; SC Wind and Hail Assoc The Griffith Insurance Education Foundation

39. SC Homeowner MP Insurers Source: SNL Financial, Inc. The Griffith Insurance Education Foundation

40. Simple Combined Ratios, HO MP,SC(Includes only Losses + Loss Adjustment Expenses Ratio + Underwriting Expenses Ratio + Policyholder Dividend Ratio )* *Source: SNL Financial, Inc. See explanatory note on next slide The Griffith Insurance Education Foundation

41. Direct Simple Combined Ratios Explanatory note for the previous slide, #40: The purpose of slide #40 is simply to illustrate the volatility of losses and some of the challenges when estimating insurance rates. It does not contain sufficient information to evaluate the overall performance of an insurer or a rating structure. The combined ratio is the commonly used measure of underwriting performance. It’s breakeven point is 100. If a combined ratio is 105.2 then for every $1 an insurer is earning or writing in premiums, they are paying out approximately $1.05 in losses, expenses and PH dividends (though many insurers don’t pay PH dividends.) Some costs and expenses of a firm at the national level are not reported in the state level data. For example, the state level direct simple combined ratio does not include some adjusting and other expenses in the loss ratio and the expense ratio does not include general expenses and other acquisition and fields supervision expenses. As a result, the state level ratios will systematically understate the Loss Adjustment Expenses and Expense ratios. The Griffith Insurance Education Foundation

42. Net Yield on Invested Assets, % Source: SNL Financial, Inc. The Griffith Insurance Education Foundation

43. Premium ComponentsA Review • Pure premium • Expected loss • Loading • Expenses • Contingencies • Profit The Griffith Insurance Education Foundation

44. Factors that affect ratemaking • Loss estimation • Credibility of data, loss mitigation, exposure in high risk areas, increased costs • Delays in data collection and use • Regulatory lag, institutional lag • Change in the cost of claims • Global warming • Medical advancements (long term care) • Medical inflation (WC, liability claims) • Legal changes, hurricane loss mitigation The Griffith Insurance Education Foundation

45. Factors that affect ratemaking • Insurer’s projected expenses • Legal changes, wage/employee cost, reinsurance, non-cancellation regulations • Target level of profit and contingencies • Investment income, business conditions, unexpected disasters The Griffith Insurance Education Foundation

46. Questions? The Griffith Insurance Education Foundation