Insurance Industry Basics

Contents
Industry basics .............................................................................................................................................. 2 Industry sectors............................................................................................................................................. 2 Life and annuity insurance ........................................................................................................................ 2 Property and casualty insurance............................................................................................................... 3 Specialty insurance ................................................................................................................................... 3 The business model ...................................................................................................................................... 4 Key stakeholders ........................................................................................................................................... 4 How money is made ..................................................................................................................................... 5 Competition .................................................................................................................................................. 5 Industry drivers ............................................................................................................................................. 5 Risk management...................................................................................................................................... 5 Regulatory compliance ............................................................................................................................. 5 Growth through emerging markets .......................................................................................................... 6 New product offerings .............................................................................................................................. 6 Types of challenges ....................................................................................................................................... 6 Competition .............................................................................................................................................. 6 Regulatory demands ................................................................................................................................. 7 Solvency regulation ............................................................................................................................... 7 Market regulation ................................................................................................................................. 7 Margin pressures ...................................................................................................................................... 8 Meeting customer expectations and lifestyles ......................................................................................... 9 Strategies for overcoming challenges ........................................................................................................... 9 Change in distribution channels ........................................................................................................... 9 Technology ............................................................................................................................................ 9 Mergers and acquisitions .................................................................................................................... 10 New products ...................................................................................................................................... 10 Sector trends ............................................................................................................................................... 11

Insurance Industry Basics

Industry basics The concept of insurance is almost as old as human society. In ancient civilization, if someone's home burned down, the other members of the community would band together to help rebuild it. Everyone felt duty bound to help in case their home was the next to burn. Over the years, insurance grew into the form we know today as it manages the risk to people and industry from the dangers of their current circumstances. People have been managing risk for many years. The first written account of an insurance policy is found in the Code of Hammurabi, in the 18th century BC, and was designed to forfeit debts owed due to catastrophe. Similarly, sailing merchants and caravans used insurance to protect themselves from the risks of pirates and treacherous natural terrain. And early health insurance by organized guilds in ancient Greek and Roman civilizations aided surviving members or helped to pay funeral expenses. In the last century, the insurance industry adapted to changing living and working conditions, introducing products such as automobile insurance. And more recently, changing governmental regulations have impacted the parameters by which the insurance industry operates. This allows other industries, including the banking industry, to offer similar insurance products. Insurance improves the investment climate and contributes to the economic growth of businesses and economies in a number of ways:

protecting the financial health of businesses encouraging domestic production and trade reducing the risk to major infrastructure projects developing capital markets by investing premiums

Industry sectors
The insurance industry classifies the different products it offers by sector. A universally agreed-upon classification of sectors does not exist, so an inclusive and simplified classification of three broad sectors will be used in this exploration. The three sectors of insurance coverage are

life and annuity insurance property and casualty insurance specialty insurance

Life and annuity insurance

Life and annuity insurance covers not only life and annuities, but also health and disability. In general, life insurance provides a death benefit, health insurance provides coverage for sickness and injury, disability insurance provides for the financial needs of individuals who can't work due to sickness or injury, and annuities provide income. Term life policies provide protection over a specific period of time and don't accrue equity. Whole life policies provide long-term financial protection. They typically build equity that pays cash benefits and therefore usually have higher premiums than term life policies.

Insurance Industry Basics

Health insurance policies can be divided into three broad categories:

fee-for-service managed care long-term care

The three types of policies differ in distinct ways, but they all cover an array of medical, surgical, and hospital expenses. Many policies also cover prescription drugs and offer some dental coverage. Only long-term care policies provide for the long-term health care needs of individuals, such as nursing home care. Disability Often referred to as disability income insurance, this insures a beneficiary's earned income against the risk that disability will make working, and earning, impossible. It includes paid sick leave, short-term disability benefits, and long-term disability benefits. Annuities Annuities, another type of life insurance product, provide income. An annuity pays periodic usually monthly income benefits for a specific period of time or over the course of the annuitant's (annuity holder's) lifetime. Annuity income benefits can also be transferred to a beneficiary upon the annuitant's death.

Property and casualty insurance

Property and casualty insurance providers perform an essential function in today's economy. By covering losses from disasters, accidents, and lawsuits, property and casualty insurers protect policyholders from property damage and liability, providing the means for victims to resume their lives and businesses, and continue contributing to the economy. Each component of property and casualty insurance represents a different type of coverage. Property insurance Property insurance provides coverage for property from natural hazards such as floods, earthquakes, tsunamis, and wildfires; and hazards of human origin such as terrorism and theft. Casualty insurance Property and casualty insurance provides protection against injury and property damage and includes automobile, homeowners', and commercial insurance. Generally included in property and casualty insurance, liability insurance protects the policyholder from financial responsibility for injuries to others or for damage to the property of others.

Specialty insurance
Specialty insurance focuses more closely on helping policyholders preserve their financial interests, and provides coverage for any risk the insurer is willing to take. Specialty policy types include:

Surety bonds Surety bonds ensure the trustworthiness of contractors. The insurer providing the surety bond vouches for the trustworthiness of contractors by putting its money on the line. If a client's contractor fails to perform or causes a loss to the client, the insurer is obligated to have the work completed or pay for the loss up to the bond "penalty." Financial guarantee insurance Financial guarantee policies assure lenders of the creditworthiness of borrowers by guaranteeing the principal and interest payments on municipal obligations or bonds. This benefits the investors, or lenders, by lowering the risk of the bond or loan. Credit insurance Credit insurance, used primarily for short-term trade receivables, protects the policyholder typically a vendor from the protracted default of clients on their

Insurance Industry Basics

obligations to pay for products or services. Credit insurance covers losses above and beyond standard bad-debt reserves set aside during accounting. Mortgage insurance Mortgage insurance protects financiers typically banks from protracted default. In the event of a default and foreclosure, the mortgage insurance covers the lender for any resulting loss up to a specified amount. Reinsurance Reinsurance protects insurers from catastrophic losses essentially, it's insurance for insurance companies. Reinsurance policies provide benefits that enable insurers to recover capital quickly, limit losses, and stabilize cash flow after a disaster strikes. As such, risk is shared by both the insurer and the reinsurer , decreasing the likelihood of insurer bankruptcy in the face of catastrophe.

The business model

The insurance industry business model contains two types of activities: primary and support. Primary activities make up the company's value chain and support activities support the value chain. Support activities may include corporate services, finance, human resources, or information systems and technology. A value chain describes the company's product offering from start to finish. An organization that serves more than one type of market may have multiple value chains. The seven primary activities depict the company's value chain as an end-to-end process: 1. Marketing: The first step in the value chain process is marketing. At this point, a business must determine which policies it will offer. 2. Risk Modeling: As part of marketing, a business must determine the policy mix and pricing strategy. To determine how premiums will be calculated for each policy, the business must also perform risk modeling. Using the information gathered from risk modeling, the business can then determine the actual prices for each policy. 3. Sales: The business is now in a position to begin selling its insurance policies to customers. Selling involves quotations, proposals, risk assessments, and commission calculations. Commissions are paid to all parties involved in the distribution channel. 4. Policy Administration: Having sold a policy, the next step is to write the policy. 5. Billing: Customers can be billed once their policies have been written. 6. Claims: Customers who have paid their premiums may at some point make a claim. This activity is optional, however, as customers may never make a claim. 7. Customer Service: The customer service activity involves serving the needs of customers until their policies expire.

Key stakeholders
Many people contribute to the running of an insurance company. Aside from shareholders, the key stakeholders in the insurance value chain are:

Consumers who buy insurance products. Investors that support insurance companies by purchasing insurance company stock. Insurance carriers that provide insurance coverage through policies and accept the risks covered by the policies. These are generally large insurance companies, including direct insurers and reinsurers. Partners who couple with insurance companies to share profits and losses. Partners include reinsurers, institutional investors, and trade partners. Partners also include the insurance agencies and brokerages that distribute insurance products. Outside networks that include those that perform professional services for insurers. They include appraisers, insurance bureaus, reinsurers, claims adjusters, and firms providing consulting, claims processing, and data collection services. Regulators and auditors that help secure the financial health of the insurance industry. Regulators implement and enforce regulations, while auditors ensure adherence to finance and accounting standards. Vendors that supply the goods insurers require performing business activities. Examples include software distributors and administrative goods suppliers.

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How money is made
A concise and simplified representation of the revenue and cost flow of the insurance business model is: Profit = earned premium + investment income - incurred loss - underwriting expenses. Money comes from earned premium and investment income and goes to incurred loss and underwriting expenses. Earned premium, a source of income, is the total of all the premium payments received by an insurer for the current coverage period. Premiums are not considered "earned" until the policy period they cover is over. Investment income is the residual income generated as a result of investing premiums in the capital markets. Investment income also includes annuity considerations and asset earnings. Incurred loss is the sum of all claims paid, adjusted by the change in claims reserve and related claim expenses for the same accounting period. Incurred loss contributes to cost flow. Finally, underwriting expenses include all the costs associated with a policy, including commissions and the portion of administrative, general, and other expenses attributable to underwriting.

Competition
As potential purchasers of insurance, customers want to feel there is a big, powerful company securing their assets. Larger companies tend to project a sense of satisfaction and security. This size advantage has had an impact on smaller companies, despite the fact that they often provide service on par with the larger, more established international players. Regardless of the size of the company, it's important to identify some of the biggest industry leaders and their areas of specialization. In times of mergers, absorbs, and split-offs, it's not always easy to keep track of the top players. This list of industry leaders is divided into three main sectors:

property and casualty insurance life insurance companies specialty insurance

Industry drivers What factors are driving today's insurance industry? The key business drivers of the industry are risk management, regulatory compliance, growth through emerging markets, and new product offerings. Risk management Risk, in all its forms, is a primary concern for insurance companies, as their success is entirely dependent on proper risk management. By studying risk at the enterprise level, instead of in isolation, insurance companies are able to construct frameworks to transfer or distribute risk. Regulatory compliance In terms of its impact on the insurance industry, complying with regulations is another important driver. Insurers have two main challenges in this respect: controlling the costs of complying with regulations training staff to ensure compliance
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Insurance Industry Basics

Many insurance executives claim that regulation is one of the largest factors impacting their profits. Failure to comply with local or national regulations is also a major concern, as it can result in stiff fines, poor public relations, and loss of investor confidence. As with risk management, insurers must adopt an enterprise-wide approach, developing processes to monitor and document risks. Controlling the cost of compliance is essential to preserving profits. One of the major challenges presented by regulatory compliance is finding and training the right people. Proper training can go a long way toward ensuring compliance. Growth through emerging markets More than ever before, insurance companies are attempting to grow globally. As growth through mature markets in Europe and North America slows, emerging markets like South and East Asia become more attractive, and insurers are looking to launch their core products and services in these markets. Countries with growing middle class populations and relatively stable economies offer tremendous opportunities to insurance companies. Offering products and services to these countries is, potentially, less risky than expanding into new product lines in a heavily saturated, mature market. Some of this growth may involve mergers and acquisition strategies to gain a foothold in desired countries. Insurance companies must overcome language differences, cultural conflicts, and protectionism when being introduced into a new market. New product offerings Insurance companies must also meet changing customer needs by introducing new products. An aging population in Europe, North America, Japan, and other locations is initiating a shift of client assets from equity based securities to annuities and other fixed income assets. The insurance industry must adapt to changing demographics to capitalize on the products consumers want. As baby boomers begin withdrawing trillions of dollars in retirement assets, insurance companies are faced with a unique opportunity to capture market share from asset management firms and brokerage houses. The main factors and key business drivers of the insurance industry are: risk management, regulatory compliance, growth through emerging markets, and new product offerings. Types of challenges
The insurance industry, as with any industry, faces numerous challenges. The four most significant challenge areas are

competition regulatory demands margin pressures meeting customer expectations and lifestyles

Competition
Market convergence is a real challenge to traditional insurance companies. In addition to competing with other insurance companies, they must now compete with other non-traditional insurance companies. Industries as diverse as financial institutions and supermarket chains are now looking to offer insurance products to their clients.

Insurance Industry Basics

Consumers today are often unable to distinguish a bank from an insurance company. In many jurisdictions, changes to the insurance industry have resulted in a situation where virtually all of the top financial service players support banking, retirement planning, and insurance. The same can be said of other non-traditional insurers. For example, in the United Kingdom, large supermarket chains such as Tesco and Sainsbury's are selling insurance products. Global competition is also presenting a significant competitive challenge for insurers. As crossborder barriers come down, insurers will be able to grow by expanding into both developed and emerging markets. But with the opportunity to expand comes increased competition as nondomestic financial services companies from around the world add competition to domestic markets.

Regulatory demands
Every country has its own unique regulations regarding insurance, and many of these regulations can change from region to region within a country. As companies move into emerging markets, the cost associated with local regulations has the effect of limiting growth opportunities. Also, government regulations have an impact on insurer's core business processes. As an example, one US law disallows the use of genetic testing as the basis for premiums and enrollment eligibility.

Solvency regulation
Solvency regulation also known as insolvency affects the insurance industry by impacting the financial stability of a licensed company. When a company is licensed, the commissioner certifies the company with regard to its financial stability and the soundness of its methods of operation. To qualify for its license, the insurance company making the application must possess a certain amount of capital. The exact amount required varies by country or region and depends on the type of business the firm will conduct or whether the company is a stock or mutual carrier. The commissioner also seeks to ensure that the company's operators are worthy of the public's trust and will consider personal characteristics, competence, and experience of the company organizers, promoters, and incorporators before granting the license application. The key to protecting policy-holders from insurer insolvencies is proper financial reporting. Insurance regulators rely on the analysis of various insurer reports and financial examinations to detect potentially troubled companies. As a result, insurers must comply with significant regulatory reporting requirements. Capital requirements are essential in detecting potentially troubled companies. These risk-based capital (RBC) requirements determine the amount of capital an insurer needs, depending on the specific risks that insurer faces. These are risks associated, for example, with underwriting and the insurer's investment portfolio. RBC standards enable regulators to identify an insurer who lacks sufficient capital to support the risks it has assumed. Due to the unique business model of insurance collecting money in advance for a product to be delivered at some time in the future laws have been put in place to ensure that insurers maintain the proper amount of reserves. Life insurers must maintain policy reserves on outstanding policies; these reserves are reported as liabilities in their financial statements. The importance of these reserves to the financial stability and solvency of an insurer becomes more obvious when considering the reserves as true liabilities. These reserves, or liabilities, are a measurement of what a company owes its policyholders, and these debts must be offset by assets. If a company's reserves are understated, the net worth of the company is overstated. To ensure that insurers make acceptable investments with their clients' money, local insurance codes often spell out the particular investments permitted to each type of insurance company in that locality. These rules are necessary, as an insurer's promises to its customers depend on the value of its investments.

Market regulation
Market regulation impacts the insurance industry in a number of ways:

unfair trade practices regulatory standards that insurance contracts must uphold to protect the customer regulations on the agents selling the contracts regulation on policy rates

Insurance Industry Basics

Many jurisdictions have legislation preventing unfair trade practices or other deceptive acts. These regulations generally prohibit unfair discrimination in underwriting, misrepresentation, false advertising, and rebating. Rebating consists of directly, or indirectly, giving any portion of the premium or any other consideration to an insurance customer in order to encourage that customer to purchase insurance. Due to the generally complicated nature of insurance contracts, they are subject to regulatory standards and must contain certain required provisions. In most cases, they must be approved by a regulatory authority to ensure that customers are not mistreated due to unfair provisions that may be "hidden" in the contract. Due to the technical complications in the insurance product, it is essential that insurers understand the contracts they are selling. Many jurisdictions require insurers to prove, by examination, that they understand the contracts they sell. Policy rates must also be regulated to ensure the solvency and equity of the policies. In most jurisdictions, regulations exist to monitor insurance rates to make certain that rates are adequate, not excessive, and not discriminatory. Adequate rates are sufficient to pay any losses that may occur and cover the company's expenses. While the rates must be adequate, they must not be excessive due to the nature of the service insurance provides. As a product that helps ensure society's well-being, insurance must be affordable to everyone. Policy rates must also be free of discrimination, where an insurer charges a substantially different rate to two different customers who have the same degree of risk.

Margin pressures

declining underwriting profits increasing costs slowing premium growth Claims caused by natural catastrophes, such as hurricanes, earthquakes, floods, wildfires, and tornadoes, are a major reason for declining underwriting profits. Insurers set aside reserves for natural catastrophes, but due to the uncertainty of these events, reserves can quickly be depleted. Increasing costs related to operations, compliance, and technology and infrastructure have also begun to place pressure on profit margins. Operating costs have risen primarily due to increased competition, which requires insurers to spend more on value-generating activities such as marketing, product development, and achieving operational efficiency. They may also be spending more on mergers and acquisitions. Compliance is costing insurers money and represents a source of margin pressure. As insurers work toward compliance, they must look for ways to minimize the costs and maximize the benefits associated with compliance. Insurers are spending more on technology and infrastructure. Competition and compliance have led many insurers to seek competitive advantage through product innovation and operational efficiency achieved by technological and infrastructure advances. Slowing premium growth is also a cause of margin pressure. Slowing premium growth is attributed to these factors:

Soft market conditions, brought about by the wide variety of insurance companies to choose from, have lowered prices and slowed premium growth. Rate suppression by regulators who prevent insurers from charging prohibitive risk-based premiums is contributing to slow premium growth. This applies only to terrorism risk and natural catastrophe insurance lines. A slowing economy can reduce exposure growth. Exposure growth is the demand for insurance that comes from economic activity. For instance, decreasing new home construction and new car sales, a result of rising interest rates, reduces exposure growth and therefore the demand for

Insurance Industry Basics

insurance remains the same or declines. When demand is constant or declining, premium rates are not likely to rise. Premium leakage, or premiums lost, can be partially attributed to the growing tendency for consumers to invest in alternative forms of risk transfer. Also, premium leakage occurs when insurers drop their coverage in high risk areas, eliminating not only property and casualty premiums, but also the opportunity for earning premiums in other lines. Both of these trends decrease demand for insurance and therefore discourage growth in premium rates.

Meeting customer expectations and lifestyles

Insurers are becoming increasingly aware of a gap between consumer expectations and what they are providing to consumers. This gap poses significant marketing challenges for insurers. Of particular importance are the challenges associated with meeting consumer expectations and dealing with increased competition. Consumers are more demanding and sophisticated than ever before. To meet their ever-increasing expectations, insurers need to ensure their marketing efforts allow them to meet consumer expectations for online capability, one-stop shopping, and products representative of their needs. In different countries, socio-cultural factors shape the perceptions of insurance products. In Asia, life insurance products are seen primarily as savings instruments a view that aligns with a cultural tendency to save. In countries with sizeable Muslim populations, the concept of insurance may be frowned upon by certain Islamic scholars who consider it to be improper for use in Islamic communities. As a result, demand for insurance is generally low in Islamic regions.

Strategies for overcoming challenges

The insurance industry has, in recent years, been faced with a number of challenges. Increased costs due to regulations, new forms of competition, and changing customer demand are just a few of the challenges insurers face today. This situation requires a strategy on the part of the insurance industry to both survive these challenges and to thrive in the future. Strategies include

change in distribution channels technology mergers and acquisitions new products

Change in distribution channels Distribution channels are essentially the networks that insurance companies use to reach prospective customers and provide services to existing customers. In the past, the insurance industry used a basic distribution model that involved one distribution channel with the agent as the central point of contact. More recently, the insurance industry changed to a multi-channel model. By using many different types of distribution channels to provide services, they could in effect customize the way they interact with customers. This use of multiple channels has resulted in a situation where many channels are quite broad in scope in order to cast the widest net possible for customers. At the same time, there remains a need for unique, specialized channels to adequately serve specific product segments. The rapid explosion in Internet usage has caused a major shift in distribution channels in the insurance industry. Customers can now be reached directly using online channels that not only streamline operations, but also result in significant cost savings by bypassing agents and thereby alleviating margin pressures. Technology Insurance companies use IT systems and processes to contain costs and remain competitive. Upgrading these systems and processes is an important way to:

provide quick compliance to regulatory changes

Insurance Industry Basics

remain competitive by using the Internet to offer new online products and create new distribution channels react to margin pressures by containing costs and preventing money laundering respond to customer expectations

The need for timely and accurate compliance with regulatory requirements makes it important for insurance companies to have robust IT systems in place. System modernization is essential to ensure compliance with new and future regulation, and to avoid regulatory fines. Mergers and acquisitions Mergers and acquisitions, for some insurance companies, can provide a competitive advantage by enabling insurers to quickly expand into emerging or lucrative markets. Consolidation, through merger and acquisition, has proven to be an effective insurance strategy, helping insurers face the challenges posed by margin pressure and increased competition. Increasing margin pressures are likely to provide the greatest incentive for consolidation. Margins have been declining for some time and tactical acquisitions and mergers can help insurers fight margin pressure by providing insurers with a number of competitive advantages, including

economies of scale increased customer base improved synergistic capabilities increased fiscal power

The potential economies of scale associated with consolidation include shared fixed costs, better bargaining power with partners, and increased cost savings. Insurance companies may acquire very small players or even companies from an entirely different industry to tactically gain competitive advantage. For example, an insurance company might acquire a startup finance software developer to gain competitive advantage from technological prowess. An increased customer base strengthens an insurer's financial stability. Simply put, having more customers increases the potential for greater revenues from invested premiums and underwriting profits. Consolidation in the global marketplace can allow insurers to globalize operations quickly and easily. By merging with or acquiring international firms, insurers quickly expand their global presence and influence, expanding into new markets and reaching more customers. Consolidation provides insurers with the means to quickly improve their synergistic capabilities. These could be skills, operations, technology, or infrastructure-related capabilities. For example, the deployment of databases and e-commerce platforms is often a long and costly process. By merging with a company that has already implemented more advanced solutions, an insurer can quickly overcome a technological deficit with little operational downtime. By combining assets, merging insurance companies substantially increase their fiscal power, fortifying weak balance sheets and protecting each company from hostile takeovers by other competitors. Increased fiscal power further benefits insurers by widening investment options. Newly combined assets can be put to work in a variety of markets, spreading out risk and balancing returns. New products Another strategy for overcoming industry challenges is to introduce new products to customers. Insurance companies are always looking for new products to offer their customers. These products are introduced for many reasons:

to counter recent risks for example, a natural disaster, such as a tsunami to take advantage of the latest technology, due to customer demands or expectations to provide availability of capital, as a reaction to a competitor's actions to differentiate the company from a competitor to adapt to recent regulatory changes There are a number of issues companies must consider when introducing new products:

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Insurance Industry Basics

the needs of the insured and their brokers trends in the world marketplace and what the insurance implications of those trends might be the manner in which new products are developed, which often stems from changes in the legislative or regulatory environment the new market opportunities that can be identified by paying close attention to the market needs that follow catastrophes

Sector trends
Three of the biggest trends in the insurance industry are:

Use of technology For insurers, technology is fast becoming a tool in staff management, as the industry faces growing challenges in attracting and retaining the right talent. Insurers, like other industries, have begun to use the Internet to attract qualified talent that may have previously been geographically out of range. Expansion into emerging markets The insurance industry appears to have reached a saturation point in North America and many Western European countries. The fact that major insurance products have been available in these markets for quite some time means that the majority of customers already have all the insurance they need. This situation has placed limits on the insurance industry's ability to innovate and grow in these traditional markets. Bancassurance Bancassurance, as the name suggests, is the marketing and distribution of insurance products through existing banking networks. The insurance products sold through these banking channels can range from life insurance (for example, endowments, annuities, and investment-linked insurance) to non-life or general insurance (for example, automobile insurance).

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