A lawyer's perspective: How an insurance company makes money

I.

INTRODUCTION

This article offers a basic overview of the key factors that impact a U.S.-based, stock property and casualty insurance company's profitability. While it refers to accounting and actuarial principles, this overview is not intended to be an exhaustive survey of the accounting or actuarial field. Although it is one lawyer's perspective, it is also not a review of precedent or legal developments about accounting for profit and loss. The purpose of this overview is to provide other lawyers and non-accountant insurance people with a context for the issues and problems that arise in any discussion of insurance company profit and loss.

Publicly held property and casualty insurance companies provide loss protection to insureds in exchange for premiums. If earned premiums exceed the sum of:

* losses,

* commissions to agents or brokers,

* other operating expenses, and

* policyholders' dividends,

underwriting profits are realized.

The "combined ratio" is a frequently used measure of property and casualty underwriting performance. On the basis of Generally Accepted Accounting Principles ("GAAP"), the combined ratio is the sum of:

(1) the ratio of incurred losses and associated loss expenses to earned premiums (the loss and expense ratio), and

(2) the ratio of expenses incurred for sales commissions, premium taxes, administrative and other operating expenses to earned premium (the expense ratio), and

(3) the ratio of policyholders' dividends to earned premium (the policyholder dividend ratio).

Each of these three ratios is expressed as a percentage. When the combined ratio is over 100%, underwriting results are not profitable.

Because varying periods of time normally elapse between the receipt of premiums and the payment of claims and certain related expenses, funds become available for investment by the insurance company. The combined ratio does not reflect such investment income from these funds, nor does it reflect investment gains and losses. Results from non-insurance business and federal income taxes are also not reflected in the combined ratio. Such items, when added to underwriting profits or losses, produce net income or loss.

A. A Case Study

A case study on the "Reliable Insurance Company" (included as Appendix A) provides an example of a hypothetical stock insurance company. In a simplified format, and from a non-accounting perspective, it lays out key factors that impact profitability, including:

* the insurance marketplace,

* the natural environment, i.e., hurricanes, earthquakes,

* social factors, i.e., unemployment, medical costs,

* court decisions,

* business organizational structure,

* reinsurance,

* product mix,

* distribution channels,

* competition, and

* geographic spread.

While there may be other factors that could impact an individual insurer, this approach provides an excellent look at the key leverage points for profit and loss for a property and casualty insurer.

II.

PREMIUMS

Unless an insurer receives revenue, it would be meaningless to discuss profitability. Revenue for an insurance company can assume several different forms: premiums (the contract price for an insurance policy); fees for "fronting" policies, which are generated in self-insurance programs; and revenue generated by sold services, such as claims services. The combined ratio is considered only against premium revenue; however, the other forms of revenue can determine a company's overall profits.

Seemingly, premiums and other fees are set in an illogical fashion. While the cost of many manufactured products is generally known before the product is sold, the cost of the service sold by an insurance company is not known in advance of the sale. It is not until after the fact, after losses have occurred, that an insurer will truly know the cost of goods sold.

State insurance regulations delineate standards for how premiums or rates are set. Similar to utilities, rates are subject to review by a state agency. In this case, the state insurance department or commissioner will review rates. On some occasions, public hearings are held. It is not until an insurance department approves a rate filing that a specific premium can be set for a policy.

To determine the propriety of the rate filing, an insurer will rely on actuarial projections of future costs. Again, like many utilities, insurers cannot increase rates to pay for past losses.

An insurer's ability to charge the rate or premium that it believes is appropriate for the class of business or individual risk is also influenced by the competitive marketplace. When a so-called "soft" market exists, the financial capacity to offer insurance exceeds customer needs to purchase insurance. Supply exceeds demand, and pressure is placed on insurers to lower prices in order to attract customers. As with any system, soft markets can generate prices that are inadequate to pay future losses. When that point is reached, a company may not only face unprofitability, it may even face insolvency. When prices go up, the market is said to "harden."

In a so-called "hard" market, the financial capacity to offer insurance is insufficient to meet the needs of customers. Demand exceeds supply, and the ability to charge higher prices to cover future losses is more prevalent. In such a hard market, insurance regulation may place an artificial ceiling on the prices that an insurer is able to charge. In those cases, if the insurer is unable to make a profit, it may choose to exit the market for that particular line of business rather than to absorb additional losses.

This cycle of decreasing prices followed by increasing prices is often referred to as the insurance cycle. Historically, the insurance cycle was considered to last approximately seven years. Today, however, commentators question whether and for how long the insurance cycle exists, since lower and lower prices have existed in excess of the "typical" seven year cycle. Today's market can be characterized as a soft market with very little signs of shifting. Thus, pricing pressures can impact the revenue stream of an insurer and affect its potential profitability.

In addition to prices and future losses, the costs of doing business will impact an insurer's profitability. High costs may be reflected in commissions, overhead costs, or loss adjustment expenses. A good example of high costs, to which many lawyers can relate, is the increasing cost of litigating disputed claims. This cost alone has driven up the costs of doing business at a rate greater than almost any other cost. While medical provider costs have also increased at a significant rate, these expenses are more likely to be reflected in loss costs as opposed to loss adjustment expenses.

Even though the ability to price its products appropriately is a complex one, the difficulty of determining price is greatly outweighed by other rules and principles which an insurance company must follow to stay in business. These rules and principles are discussed in the following sections.

III.

ACCOUNTING PRINCIPLES

Many generally accepted accounting principles ("GAAP") affect the conduct of business as well as how profits and losses are reported by property and casualty insurance companies. GAAP rules are promulgated by the Financial Accounting Standards Board ("FASB"). The applicable accounting rules are set forth in Statements of Financial Accounting Standards ("SFAS").

Additional accounting policies and procedures are established by companies that follow GAAP rules. These additional accounting procedures likewise insure that all financial transactions are processed according to the GAAP rules.

GAAP rules are not the only external rules that apply to property and casualty companies, however. The American Institute of Certified Public Accountants ("AICPA") produces guides by which insurance companies are audited. These guides provide insights and procedures followed by many property and casualty insurance companies. The principal guide for property and casualty organizations is the AICPA Industry Audit and Accounting Guide, entitled "Audits of Property and Liability Insurance Companies," together with its amendments.

Furthermore, for publicly traded companies, the Securities and Exchange Commission ("SEC") promulgates accounting rules and regulations which are principally related to SEC financial reporting requirements. Finally, the Emerging Issues Task Force ("EITF") of the FASB produces external reporting documents which also must be followed. A reference list of significant accounting rules and guides is included in Appendix B.

IV.

RESERVES

Losses include not only the actual amounts paid on claims, but also the reserves that recognize liabilities for unpaid losses. Reserves represent estimates of future amounts needed to pay claims and related expenses, including events that are not as yet reported to the company. This latter group of reserves are for claims that are often referred to as "incurred but not reported" claims ("IBNR").

Except for a class of small claims that are typically settled quickly, a "case reserve" is established by claims personnel for the estimated amount of the ultimate payment once the claim is reported to the company. The estimate reflects the informed judgment of the claims person, his or her supervisor, or claims management. The claims person uses his or her experience and knowledge regarding the nature and value of the specific claim to estimate the ultimate payment. Case reserves are generally reviewed by others within the claim organization as well, particularly as the size or complexity of the loss escalates. As additional information becomes available, and the claim proceeds toward resolution, these estimates are often updated, both upwards and downwards.

"Bulk reserves" are another form of reserve that is established on an aggregate basis. There are multiple purposes for which a bulk reserve is established. These include: (1) provision for losses incurred but not yet reported to and recorded by the insurer; (2) provision for the estimated expense of settling claims, including legal and other fees and general expenses of administering the claims adjustment process; and (3) adjustment for the fact that, in the aggregate, case reserves may not accurately estimate the ultimate liability for reported claims. As part of the process of establishing bulk reserves, historical claims data and other information is reviewed. Consideration will be given to the anticipated impact of various factors, such as legal developments, economic conditions, and changes in social attitudes. Overall insurance industry experience is likewise often considered.

Expense reserves are established to accrue both allocated and unallocated claims expenses. Allocated claims expenses are those expenses that can be identified with a specific claim, such as legal fees, expenses related to expert witnesses, or billings from outside, independent adjusting firms. The accuracy in projecting these kinds of claim expenses can often be attributed to the relationships that claims handlers have with the firms providing those services. For example, the explanation of how litigation plans of action and budgets for legal expenses are used will depend on the level of communication with the law firm involved. On a case-by-case basis, these projections are used to assess the overall potential legal and related litigation fees.

Unallocated claims expenses are those expenses associated with the overall claims settlement process that cannot be identified with a specific claim. Such expenses would include salaries, rent and other overhead expenses of managing a claims department.

Similar to the establishment of bulk reserves for IBNR claims, expense reserves are also established for the cost of settling such claims. Unallocated expense reserves are estimated in accordance with appropriate actuarial principles.

The estimation of losses and the entire reserving process for individual cases, for bulk reserves, and for expenses, is complex. For individual case reserves, claims handlers rely on factual investigations, liability evaluations, applicable coverage, and legal opinions. For bulk and expense reserves, actuaries examine historic patterns and use statistical techniques to determine the appropriate reserves.

V.

RATINGS

In addition to accounting and actuarial principles that are applied to insurance companies, certain insurers are also rated by nationally recognized rating agencies. Those agencies who rate insurers include A.M. Best, Moody's, Standard & Poor's, and Duff & Phelps.

While the significance of ratings varies from agency to agency, companies which are assigned ratings at the top end of the agency's range have, in the opinion of the rating agency, the strongest capacity for the payment of claims or the repayment of debt. Companies at the lowest end of the range have the weakest capacity. Ratings tend to be reviewed routinely by the rating agencies. They may be changed at any time within the discretion of the ratings agency.

Since insurance ratings represent the opinions of the rating agencies on the financial strength of a company and its capacity to meet the obligations of its insurance policies, strong or weak ratings can significantly impact revenue streams. This is particularly important to customers who are sensitive to those ratings. As an example, many municipalities are required by law to purchase insurance only from strongly-rated companies. On the other hand, customers for personal automobile or homeowners policies tend to have less sensitivity to the ratings of the companies from whom they purchase their insurance.

VI.

REINSURANCE

To protect against losses greater than the amount an insurer is willing to retain on any one risk or event, insurers will often purchase reinsurance. However, this approach is not universal, nor is it wholly consistent from year to year by any particular direct insurer. This lack of universality (or inconsistency) may be partially explained by the decision to retain all or only part of the premium. With the purchase of reinsurance, the direct insurer1 forgoes a portion of the premium it receives from its customers. This portion is "ceded" to the reinsurer who is then obligated to pay all, or a portion, of some losses.

A direct insurer's right to collect the reinsurance for its losses is governed by the contracts between the direct insurer and the reinsurer. Typically, the collectibility of reinsurance is more a function of the solvency of the reinsurer rather than disputes about contract interpretation. Nevertheless, just as litigation can delay the payment of direct claims, disputes about reinsurance contract interpretation can delay the payment of reinsurance. Since the explosion of asbestos claims in the early 1980's, disputes about reinsurance contract interpretation have become more prevalent. Such reinsurance disputes can affect the collectablility of reinsurance, without providing an offset for the ceded premium already provided to the reinsurer.

1 The term "direct insurer" should not be confused with the term "direct writer." In the reinsurance discussion, a direct insurer is the insurer who underwrites the policy that is reinsured. A direct writer refers to an insurer who, in the underwriting process, uses a direct distribution channel (i.e., no external broker or agent) in dealing with its customers.

GERALDINE F. PRUSKO*

*The comments contained in this paper do not reflect the opinions or policies of CIGNA Property and Casualty or any of its affiliates. The material reflects solely the author's view and the responsibility for any errors or misstatements is solely the author's own.

Geraldine F. Prusko is senior vice president and chief claims officer of CIGNA Property & Casualty. Ms. Prusko has responsibility for claims management, loss control services, and premium audit. She has held a variety of assignments at CIGNA, including asbestos, environmental, long-term exposure, and reinsurance claims management. Prior to joining CIGNA Property & Casualty, she held various positions in the insurance industry and maintained an active trial practice for many years. Ms. Prusko is a graduate of Temple University (B.A., 1970) and earned her J.D. from Temple University School of Law in 1975. She is a member of the bar associations of Massachusetts, Pennsylvania, the U.S. District Court for the Eastern District of Pennsylvania, the Third Circuit Court of Appeals and the United States Supreme Court.

Copyright Federation of Insurance & Corporate Counsel Spring 1998
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