October 30, 2024
Insurance is one of the most highly regulated industries in our economy. From required loss ratios in the health insurance industry to risk-based capital requirements, compliance is always top of mind for insurers. Even the types of investments an insurer can make are regulated. All these regulations and compliance requirements are established in an effort to instill public confidence in the insurance industry. Insureds want to know that the premiums they are paying actually provide them with the safety and security promised in their policies. Without that promise fulfilled in the form of claims expenses paid when insureds need it most, insurance becomes little more than a Ponzi scheme.
All these efforts to ensure the future and longevity of insurance companies can be condensed into one word: sustainability. Ensuring that insurance companies will be around for the long haul requires effort from management, governance, auditors, regulators and more. Different challenges arise every day within the insurance industry and new innovations combined with tried-and-true compliance and management approaches are required to address them.
The simple mechanics of an insurance company are to charge premiums to a group of individuals, pool those resources and risks together and be available to pay the insureds’ valid claims based on the insurance policies in force. A few things need to be true for this model to work, including:
The pricing of insurance policies, i.e. premiums, are one of the most influenceable factors in an insurance company’s efforts to remain sustainable. There are external factors at play with premiums including market competition and overall economic health of insureds, but insurance companies can leverage their option to evaluate premiums and policies and make adjustments as necessary. If losses are larger than the premium income coming in, an insurance company can face insolvency very quickly. Some of the tools available to insurance companies to address underpriced premiums are increasing premiums, non-renewing problematic policies on an individual basis and eliminating entire lines of high-loss coverage. Recent increases in wildfire activity and subsequent insurance losses in California have resulted in increased premiums, elimination of policies, and even some insurance companies withdrawing and eliminating lines of business altogether within California. Hurricanes and storms in Florida have had the same effect, driving Citizens Property Insurance Corp, the insurer of last resort, to the brink of insolvency. The option to raise premiums is limited by the economic disposition of the insureds. If an insurance company is unable to raise premiums sufficiently to ensure the sustainability of lines of business, insureds individually or in the aggregate will lose coverage. At times, the federal government has stepped in to bridge the gap between insurers and insureds, such as with the National Flood Insurance Program, in order to maintain the availability of vital coverage for insureds.
In addition to adjusting premiums, another tool used by insurance companies to improve loss ratios is to encourage and reward loss prevention activities. This is common in workers compensation lines of business where insurance companies will provide loss prevention training and services in an effort to maintain safety and minimize claims. Minimizing valid claims expense is much more difficult than increasing premiums but has value in maintaining sustainable insurance practices.
In addition to efforts to reduce claim occurrences, activities can be performed to reduce claim expenses and costs as well. Insurance companies often require bids on services or repairs related to claims to ensure that costs are valid and reasonable. Overpaying for repairs or services on claims has a negative effect on loss ratios. The ultimate responsibility of the insurance company is to make an insured whole for valid claims according to the policy held. Replacing the engine of a Toyota Corolla with a Koenigsegg engine is outside the scope of an insurance policy and results in costs well in excess of what was anticipated during the underwriting of the policy. Efforts to ensure claim expenses are reasonable also allow premiums to remain competitively priced while fulfilling promises to insureds.
Insurance companies also have another resource that is not available to individual insureds - economies of scale. The pooling of resources from each individual insured allows insurance companies to potentially gain higher investment returns on the aggregate policy premium than would be available to the individual insured. These returns compounded over years of underwriting profit (premiums > claims + operating expenses) allow insurance companies to build reserves for significant or unusual claim years. It is unreasonable to expect underwriting profit every year without fail from an insurance company. There is too much variability in claims, loss events and in the world in general to be able to perfectly underwrite policies each year. This is why the fiscal management and prudent investing of premium profits is so vital to the sustainability of insurance companies. Conversely, a year or two of poor investment performance coinciding with high losses can drain an insurance company’s reserves. This is why investment regulations and restrictions can seem so strict for insurance companies. Conservatism in investing, including appropriate diversification and terms of investments, may mean sacrificing potential high returns on risky assets, but allows for a higher probability of long-term sustainability.
While there are external forces at play in the insurance industry, such as natural disasters and the economy, management and governance of an insurance company are ultimately responsible for the longevity and sustainability of the company. They make the decisions on premiums, how to manage claims, what investments to make, etc., in an effort to maintain liquid available funds to fulfill responsibilities to insureds. The mismanagement or lack of oversight from governance can result in illiquidity and insolvency, leading to the failure of the insurance company and failure to fulfil the promises made to insureds. As the ultimate goal of an insurance company is to take care of their insureds, the insurance industry has other parties who are involved in ensuring the solvency of insurance companies whether through external audits, industry benchmarks (i.e. AMBest Ranking), or regulatory oversight. Through effective management and governance combined with appropriate external oversight, insurance companies are able to continue providing coverage and peace of mind to the communities they serve, solidifying public confidence in the sustainability of insurance.
For additional guidance about this topic please contact one of our insurance specialists today. Larson and Company has developed a suite of services specifically to serve the needs of companies of all sizes in a wide range of industries.