Best's Review


Guide to Understanding
Insurance: Financial Protection From Risks

Insurers protect people against loss and risk, both of which play a large part in everybody’s lives.
  • February 2022

Insurance protects against the financial risks that are present at all stages of people's lives and businesses. Insurers protect against loss—of a car, a house, even a life—and pay the policyholder or designee a benefit in the event of that loss. Those who suffer the loss present a claim and request payment under the insurance coverage terms, which are outlined in a policy. Insurers typically cannot replace the item lost but can provide financial compensation to address the economic hardship caused by a loss.

EDITOR’S NOTE: This article is an excerpt from the 2021 edition of Best’s Guide to Understanding the Insurance Industry. The guide is an easy-to-follow introduction to the insurance industry for students, new employees, prospects and those who would like to learn more about the industry. It is available on Amazon.

All aspects of life include exposure to risk. Individuals and businesses are presented with a choice: accept the consequences of a possible loss, or seek insurance coverage in the event of a loss, reducing the exposure to risk. Those who don't procure insurance coverage are responsible for the full loss. Those who obtain coverage succeed in “transferring the risk” to another organization, typically an insurance company.

Purchasing insurance is the most common risk transfer mechanism for the majority of people and organizations. The money paid from the insured is known as the premium. In return, the insurer agrees to pay a designated benefit in the event of the agreed-upon loss.

By the Numbers

Insurance takes advantage of concepts known as risk pooling and the law of large numbers. Many policyholders pay a relatively small amount in premiums to protect themselves against a possible larger loss. When a sufficient number of insureds make that same choice, the funds available to pay claims increase and the chances of any single person or group exhausting the available funds grow smaller.

In risk pooling, insurers can accept a diverse and large number of risks, so long as many people participate in the insurance process, and the insured risks are individually unpredictable and infrequent. Although an insurer may accept risks from a large number of people, only a small portion of those are likely to suffer an insured financial loss during the period of insurance coverage. Risk pooling allows insurers to pay claims to the few from the funds of the many.

What insurers sell is protection against economic loss. These losses are outlined in contracts or documents known as insurance policies. Insurers that cover life and health usually do not cover property or liability, which is the domain of property/casualty insurers.

Life and health insurers cover three general areas:

  • Protection against premature death.
  • Protection against poor health or unexpected medical costs.
  • Protection against outliving one's financial resources.

Nonlife insurers, known as the property/casualty sector in the United States and Canada, in general offer two basic forms of coverage:

  • Property insurance provides protection against most risks to tangible property occurring as the result of collision, fire, flood, earthquake, theft or other perils.
  • Casualty, or liability, insurance is broader than property and is often coverage of an individual or organization for negligent acts or omissions.

A well-known form of casualty insurance, auto liability coverage, protects drivers in the event they are found to be at fault in an accident.

A driver found to be at fault may be responsible for medical expenses, repairs and restitution to other people involved in the incident.

Related: The View to 2022: Insurers Face New Year With Cautious Optimism

How Insurers Make Money

Insurance companies primarily make money in two ways: from investments and by generating an underwriting profit—that is, collecting premium that exceeds insured losses and related expenses.

It all begins with underwriting. Insurers, whether life or nonlife, must assess the risk and gauge the likelihood of claims and the value of those claims.

Insurance companies invest assets that are set aside to pay claims brought by policyholders. The interval between the time the insurer receives the premium and the time a claim against that policy is made is known as the “float.”

If an insurer has predominantly short-term obligations, asset portfolios should be relatively liquid in nature (i.e., publicly traded bonds, commercial paper and cash).

If the needs are long term, a portfolio containing fixed-income securities, such as bonds and mortgage loans, may also include preferred and common stocks, real estate and a variety of alternative asset classes.

Life insurers also establish separate accounts for nonguaranteed insurance products, such as variable life insurance or annuities, which provide for investment decisions by policyholders.

Property/casualty insurers traditionally have been more conservative with the asset side of their balance sheets, primarily due to the high levels of risk on the liability side. For example, catastrophe losses can wipe out years of accumulated premiums in some lines.

In the end, the insurer builds up a diversified portfolio of financial assets that will eventually be used to pay off any future claims brought by policyholders.

The global recession of the previous decade hurt nearly all aspects of the insurance industry, as many companies experienced declining revenues and investment losses. Companies that were trading riskier instruments such as credit default swaps suffered most severely.

Few winners emerged. However, the mutual insurance sector managed to remain somewhat unscathed by the downturn. Meanwhile, a chronic low interest rate environment limited the ability of life and other insurers to benefit from fixed investments such as bonds. That may be changing, depending on economic conditions that could spur higher inflation.

The Economics of Insurance

More than 2,603 single property/casualty companies and 752 single life/health insurance companies are included in AM Best's files for the United States and Canada. AM Best's global database includes information on more than 10,812 insurance companies worldwide. Insurers pay claims in property, liability, life, health, annuity, reinsurance and other forms of coverage. In the United States alone, the broader insurance industry provides employment to 2.8 million people.

Insurance organizations play a vital role in the U.S. and other economies. They protect individuals and businesses from financial loss. Money they receive as premiums is invested in the economy. Protection from financial loss provides a sense of security to individuals and businesses, which are freer to pursue business and personal opportunities with less worry about financial devastation. Businesses can afford to purchase real estate and equipment, to hire more employees and fund travel and expansion.

Premiums collected from insureds, often known as policyholders, are invested by insurance organizations until they are paid out. Investor Warren Buffett has famously championed the value of “float”—funds held by insurance companies until they must be paid—as an important source of investment capital. However, insurers must be cautious and risk-averse with the majority of their investments, both to satisfy regulators' demands and to be able at any moment to pay claims.

Insurance companies are large holders of bonds, particularly those issued by corporations and similar sources. They invest small portions of their available funds in stocks. Life insurers have traditionally played larger roles in real estate investments, although a portion of those investments has shifted from direct ownership of commercial properties to more liquid investments in real estate investment trusts and the like. Insurers have also funded mortgages for commercial borrowers and developers, who in turn use the money to build commercial centers, shopping centers, apartments, warehouses and houses.

The insurance industry is part of the larger financial services industry, which includes banks, brokerages, mutual funds, credit unions, trust companies, pension funds and similar organizations. Traditional barriers between industries have disappeared in part. Mutual funds can be sold by insurance companies and banks. Equities brokers handle cash management accounts. Banks have become active sellers of life insurance and annuities and other insurance products. Insurers themselves have developed products that include savings, protection and investment elements.

How Insurance Is Sold

Insurance is sold through a variety of channels, including face to face by insurance agents and brokers, over the internet, through the mail, by phone, in workplace programs and through associations and affinity groups.

Insurance agents generally represent the insurance company. Insurance brokers usually represent the insured client but can sometimes act as an insurance agent.

The insurance agent (or producer) can be a key component in the underwriting process by taking the role of intermediary.

Unlike the underwriter, the agent is positioned to meet with the applicant, ask pertinent questions and gauge responses. Information gathered from the interview may become the basis the underwriter uses in decision making. As a benefit to the consumer, many agents—called independent agents—represent several insurance companies, and may have a better view of each company's risk-selection threshold.

A “captive” or “tied” agent works primarily with a single insurer or a group of insurers, and may receive business leads or some sort of special preference for having that relationship. The insurer often offers benefits, such as health coverage, marketing support and training to the captive agent.

Generally speaking, insurance companies with a captive agent force also may see better policyholder retention. For starters, independent agents are less likely to follow policyholders from one state to another when they move; many independent agents are not licensed in multiple states. Larger insurance organizations may have the resources to track and follow an insured, and they may alert a new agent in the area to where the policyholder has moved.

In addition to agents, the following channels are used to get the business of insurance done:

Brokers: These producers do not necessarily work for an insurance company. Instead, the broker will place policies for clients with the carrier offering the most appropriate rate and coverage terms. The broker is rewarded by the carrier, often at a rate that differs than that paid to the carrier's agents.

Managing General Agents: These individuals or organizations are granted the authority by an insurer to perform a wide array of functions that can include placing business and issuing policies.

Agents are paid commissions based on the value and type of products they sell. Some insurers pay brokers additional compensation based on how the business performs.

Direct Sales: Direct selling of insurance to consumers through mail, internet or telephone solicitations has exploded in recent years. Insurance companies can bypass commissions by removing the agent from the transaction, although marketing and other associated costs can offset the savings.

Increasingly, online relationships are facilitated by traffic aggregators—basically an alternative term for price-comparison sites. The aggregator service links the consumer to the insurer. Aggregator companies receive a commission from product providers when a policy is sold. They also may charge a fee based on any click-through to those providers.

The aggregator service can present challenges: The site encourages consumers to select insurance policies based almost exclusively on price, and direct sales are a threat to the independent agent.

Important Functions of Insurance Organizations

Investment: Insurers look to investment managers to make sure they have the funds available to pay claims in a timely manner, match expected losses with investments that mature or become available at appropriate times and help generate income that will contribute to profits. Investment professionals handling insurance assets have an additional complication: Insurers are prohibited by state regulators from investing too heavily in riskier, more volatile instruments. For that reason most insurers are heavily weighted in bonds and similar instruments, and less heavily invested in stocks.

Actuarial: Insurance is based on probability and statistics. Actuaries are skilled in both areas and use their training to help insurers set rates, develop and price policies and coverage, determine reserves for anticipated claims and develop new products that provide coverage at a profit. Actuaries must pass extensive exams to earn their formal designations. Actuaries play influential roles in all sectors of insurance, including property/casualty, life, health and reinsurance. The role of actuaries grows as noninsurance industries—such as hedge funds, risk modelers and capital markets participants—become involved in developing risk products and programs.

Underwriting: At the heart of insurance is the art and science of assuming risk. Underwriters use a combination of data gathering and analysis, interviewing and professional knowledge to evaluate whether a given risk meets the insurer's standards for prudent evaluation. Their job is to evaluate whether given risks can be covered and, if so, under what terms. Underwriting departments often have the authority to accept or reject risks. Perhaps the most significant responsibility of underwriters is to determine premium that recognizes the likelihood of a claim and enables the insurer to earn a profit. Some of the process has been automated, such as when auto and homeowners insurers access information like driving and property records. Applicants for life insurance and some forms of health coverage may be asked to obtain medical evaluations.

Claims: Sometimes called the actual “product” that insurance companies deliver, claims departments usually operate in two areas: at the offices of the insurer and in the field through claims adjusters. Claims are requests for payment based on losses believed by the policyholder to be covered under an insurance policy. Claims personnel evaluate the request and determine the amount of loss the insurer should pay. Requests for claims payment can come directly to insurers or be handled by agents and brokers working directly with the insured. Claims adjusters can work directly for an insurer or operate as independent businesses that can work for multiple insurers. Claims adjusters often have designated levels of authority to settle claims. Adjusters serve as claims investigators and sometimes conduct elaborate investigations in the event of suspected fraudulent claims.

Insurance Entities

Ownership of traditional insurance companies generally comes in two structures, mutual and stock, although insuring entities may take a number of other forms, including reciprocal exchanges and risk retention groups. Mutual insurers are owned by and run for the benefit of their policyholders. Relative to insurance companies with shareholder ownership, mutual insurers have less access to the capital markets to raise money. Many mutual insurance companies have been formed by people or businesses with a common need, such as farmers. Mutuals pay a return of premium or “policyholder dividend” back to the policyholder if the company has strong financial results and a lower-than-expected level of claims. Policyholders also have the ability to vote on company leadership and have a say in certain corporate governance issues.

Reciprocal insurance companies resemble mutual companies. Whereas a mutual insurance company is incorporated, the reciprocal company is run by a management company, referred to as an attorney-in-fact.

Related: UK Regulator Warns Insurers to Closely Monitor Risk, Sets Deadline for Stress Testing

Many mutuals were able to grow during the credit crunch of the late 2000s. Their growth is limited, however, because capital has to be generated internally, as there are no shares to sell. Some top former mutual insurance companies, including Metropolitan Life and Prudential, have demutualized to become shareholder-owned public companies. Typically, demutualization is done to raise capital or expand operations. Other companies, including Pacific Life and Liberty Mutual, took an intermediate step and became part of a mutual holding company structure.

A holding company structure, employed primarily in the United States, provides easier access to the capital markets, whereby shares can be sold to help raise capital. The holding company owns a significant amount, if not all, of another company's or other companies' common stock. Many insurance companies are part of a holding company structure, with the publicly traded parent company owning stock of the subsidiary or the controlled insurance company or companies.

Captive insurance companies are formed to insure the risks of their parent group or groups, and sometimes will insure risks of the group's customers. Captive insurers have become more high profile in recent years after many U.S. states and some international jurisdictions adopted legislation and rules encouraging captives to locate in their domiciles.

A risk retention group is a liability insurance company owned by its policyholders. Membership is limited to people in the same business or activity, which exposes them to similar liability risks. The purpose is to assume and spread liability exposure to group members and to provide an alternative risk financing mechanism for liability. These entities are formed under the Liability Risk Retention Act of 1986.

Structural differences between stock and mutual insurance companies affect business decisions. Stock companies have to answer to owners and policyholders, so if management's investment strategies are carried out with shareholder expectations in mind—seizing opportunities for growth and profit—they may be acting at the expense of policyholders. Mutuals, on the other hand, are owned by the policyholders, so the focus likely will be on affordability and dividends.

Observers have struggled to make meaningful comparisons of profitability generated by public and mutual companies. One thing is certain, however: No particular organizational structure is a cure-all for poorly conceived or executed strategies.

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