Chapter 6 The Insurance Solution and Institutions

How Insurance Works

Insurance works through the following steps:

• Risk is transferred from an individual or entity (insured) to a third party (insurer).
• The third party (insurer) pools all the risk exposures together to compute potential future losses with some level of accuracy. The insurer uses various forecasting techniques, depending on the distribution of losses. One of the forecasting techniques was demonstrated in Chapter 4 "Evolving Risk Management: Fundamental Tools".
• The pooling of the risk leads to an overall reduction of risk in society because insurers’ accuracy of prediction improves as the number of exposures increases.
• Insurers pool similar risk exposures together to compute their own risk of missing the prediction.
• Insurers discriminate via underwriting—the process of evaluating a risk and classifying it with similar risks (see the box below, Note 6.10 "Fitting into a Lower Risk-Exposure Pooling Group"). Both the transfer of risk to a third party and the pooling lead to reduced risk in society as a whole and a sense of reduced anxiety.

Insurance or Not?

In the real world, a clear definition of what is considered an insurance product does not always exist. The amount of risk that is transferred is usually the key to determining whether a certain accounting transaction is considered insurance or not. A case in point is the product called finite risk. It was used by insurers and reinsurers and became the center of a controversy that led to the resignation of Hank Greenberg, the former chairperson and chief executive officer (CEO) of American International Group (AIG) in 2006. Finite risk programsFinancial methods that can be construed as financing risk assumptions. are financial methods that can be construed as financing risk assumptions. They began as arrangements between insurers and reinsurers, but they can also be arrangements between any business and an insurer. Premiums paid by the corporation to finance potential losses (losses as opposed to risks) are placed in an experience fund, which is held by the insurer. Over time, the insured pays for his or her own losses through a systematic payment plan, and the funds are invested for the client. This arrangement raises the question, Is risk transferred, or is it only an accounting transaction taking place? The issue is whether finite risk should be called insurance without the elements of insurance. The rule is that, if there is no transfer of at least 10 percent of the risk, regulators regard the transaction as a noninsurance transaction that has less favorable accounting treatment for losses and taxes.The interested student should also explore it further. In the case of AIG, the finite risk arrangements were regarded as noninsurance transactions. In early 2006, AIG agreed to pay $1.64 billion to settle investigations by the Securities and Exchange Commission and New York State Attorney General Eliot Spitzer, who brought charges against AIG. This recent real-life example exemplifies how the careful treatment of the definition of insurance is so important to the business and its presentation of its financial condition. For more information on finite risk programs, see “Finite Risk Reinsurance,” Insurance Information Institute (III), May 2005, at http://www.iii.org/media/hottopics/insurance/finite/; Ian McDonald, Theo Francis, and Deborah Solomon, “Rewriting the Books—AIG Admits ‘Improper’ Accounting Broad Range of Problems Could Cut $1.77 Billion Of Insurer’s Net Worth A Widening Criminal Probe,” Wall Street Journal, March 31, 2005, A1; Kara Scannell and Ian McDonald, “AIG Close to Deal to Settle Charges, Pay $1.5 Billion,” Wall Street Journal, February 6, 2006, C1; Steve Tuckey, “AIG Settlement Leaves Out Life Issues,” National Underwriter Online News Service, February 10, 2006. These articles are representative regarding these topics.

Discrimination: The Essence of Pooling

In order for the law of large numbers to work, the pooled exposures must have approximately the same probability of loss (that is, it must follow the same probability distribution, as demonstrated in Chapter 2 "Risk Measurement and Metrics"). In other words, the exposures need to be homogeneous (similar). Insurers, therefore, need to discriminateClassify exposures according to expected loss., or classify exposures according to expected loss. For this reason, twenty-year-old insureds with relatively low rates of mortality are charged lower rates for life insurance than are sixty-year-old insureds, holding factors other than age constant. The rates reflect each insured’s expected loss, which is described in the box “Fitting into a Lower Risk-Exposure Pooling Group.”

If the two groups of dissimilar risk exposures were charged the same rate, problems would arise. As previously stated, rates reflect average loss costs. Thus, a company charging the same rate to both twenty-year-old insureds and sixty-year-old insureds would charge the average of their expected losses. The pooling will be across ages, not by ages. Having a choice between a policy from this company and one from a company that charged different rates based on age, the sixty-year-old insureds would choose this lower-cost, single-rate company, while the young insureds would not. As a result, sixty-year-old policyholders would be overrepresented in the group of insureds, making the average rate insufficient. The sixty-year-old insureds know they represent higher risk, but they want to enjoy lower rates.

This phenomenon of selecting an insurer that charges lower rates for a specific risk exposure is known as adverse selection because the insureds know they represent higher risk, but they want to enjoy lower rates. Adverse selection occurs when insurance is purchased more often by people and/or organizations with higher-than-average expected losses than by people and/or organizations with average or lower-than-average expected losses. That is, insurance is of greater use to insureds whose losses are expected to be high (insureds “select” in a way that is “adverse” to the insurer). On this basis alone, no problem exists because insurers could simply charge higher premiums to insureds with higher expected losses. Often, however, the insurer simply does not have enough information to be able to distinguish completely among insureds, except in cases of life insurance for younger versus older insureds. Furthermore, the insurer wants to aggregate in order to use the law of large numbers. Thus, some tension exists between limiting adverse selection and employing the law of large numbers.

Adverse selection, then, can result in greater losses than expected. Insurers try to prevent this problem by learning enough about applicants for insurance to identify such people so they can either be rejected or put in the appropriate rating class of similar insureds with similar loss probability. Many insurers, for example, require medical examinations for applicants for life insurance.

Some insurance policy provisions are designed to reduce adverse selection. The suicide clause in life insurance contracts, for example, excludes coverage if a policyholder takes his or her own life within a specified period, generally one or two years. The preexisting conditions provision in health insurance policies is designed to avoid paying benefits to people who buy insurance because they are aware, or should be aware, of an ailment that will require medical attention or that will disable them in the near future.Recent health care reforms (HIPAA 1996) have limited the ability of insurers to reduce adverse selection through the use of preexisting-condition limitations.

Many Similar Exposure Units

As noted, an insurance organization prefers to have a large number of similar units when insuring a possible loss exposure. The concepts of mass and similarity are thus considered before an insurer accepts a loss exposure. Some insurance is sold on exposures that do not possess the requirements of mass and similarity, but such coverage is the exception, not the rule. An example is insurance on the fingers of a concert pianist or on prize-winning racehorses. When there are no masses of exposures, the coverage is usually provided by specialty insurers. Lloyd’s of London, for example, is known for insuring nonmass exposures such as Bruce Springsteen’s voice. The types of insurers will be discussed in Chapter 7 "Insurance Operations".

Accidental Losses

The risks assumed by an insurer must involve only the possibility, not the certainty, of loss to the insured. Insurable losses must be accidental or fortuitousA matter of chance.; that is, they must be a matter of chance. Ideally, the insured should have no control or influence over the event to be insured. In fact, this situation prevails only with respect to limited situations. As mentioned in Chapter 1 "The Nature of Risk: Losses and Opportunities", intangible and physical hazards influence the probability of loss. Prediction of potential losses is based on a probability distribution that has been estimated by observing past experience. Presumably, the events observed were, for the most part, fortuitous occurrences. The use of such estimates for predicting future losses is based on the assumption that future losses will also be a matter of chance. If this is not the case, predictions cannot be accurate.

Small Possibility of Catastrophe

The possibility of catastrophic loss may make a loss exposure uninsurable. A catastrophic lossLoss that could imperil the insurer’s solvency. to an insurer is one that could imperil the insurer’s solvency. When an insurer assumes a group of risks, it expects the group as a whole to experience some losses—but only a small percentage of the group members to suffer loss at any one time. Given this assumption, a relatively small contribution by each member of the group will be sufficient to pay for all losses. It is possible for a large percentage of all insureds to suffer a loss simultaneously; however, the relatively small contributions would not provide sufficient funds. Similarly, a single very large loss would also require large contributions. Thus, a requisite for insurability is that there must be no excessive possibility of catastrophe for the group as a whole. Insurers must be reasonably sure that their losses will not exceed certain limits. Insurers build up surpluses (net worth) and contingency reserves (funds for future claims) to take care of deviations of experience from the average, but such deviations must have practical limits. If losses cannot be predicted with reasonable accuracy and confidence, it is impossible to determine insurance premium rates, the size of surpluses, or the net worth required.

Catastrophic losses may occur in two circumstances. In the first, all or many units of the group are exposed to the same loss-causing event, such as war, flood, tornado, mudslide, forest fire, hurricane, earthquake, tsunami, terrorist attack, or unemployment. For example, if one insurer had assumed the risk of damage by wind (hurricane) for all houses in the Miami, Florida, area, it would have suffered a catastrophic loss in 1992 when many structures were damaged simultaneously by Hurricane Andrew (and in fact several insurers were unable to withstand the losses). The 2005 hurricanes, which caused the largest-ever insured losses, are an example of a megacatastrophe that affected many units. These are examples of exposure units that suffer from the same cause of loss because of geographic proximity. Exposure units are susceptible to dependent lossWhen loss to one exposure unit affects the probability of loss to another. when loss to one exposure unit affects the probability of loss to another. Thus, fire at one location increases the probability of fire at other homes in the area: their experience is dependent. In the early days of insurance in the United States, many fire insurance companies concentrated their business in small areas near their headquarters. This worked in New York City, for example, until a major fire devastated large sections of the city in 1835. Because of their concentrated exposures, several insurers suffered losses to a large percentage of their business. The insurers were unable to pay all claims, and several went bankrupt.

A recent example of catastrophe exposure is the case of the risk of mold. Mold created a major availability and affordability issue in the homeowner’s and commercial property insurance markets in the early 2000s. The Wall Street Journal article, “Hit With Big Losses, Insurers Put Squeeze on Homeowner Policies,” reported massive exclusions of mold coverage because of the “avalanche of claims.”Jeff D. Opdyke and Christopher Oster, “Hit With Big Losses, Insurers Put Squeeze on Homeowner Policies,” Wall Street Journal, May 14, 2002.

A second type of catastrophe exposure arises when a single large value may be exposed to loss. September 11, 2001, represents such catastrophic loss. Tremendous value was concentrated in the towers of the World Trade Center. The possibility of a human-made catastrophe of such magnitude was not anticipated. Private insurers stopped short of calling the terrorist attacks “acts of war”—which would have been excluded from coverage—and honored the policies covering the World Trade Center and the lives of the victims. However, one consequence was the industry’s action to immediately exclude terrorism coverage from new policies until the Terrorism Risk Insurance Act (TRIA) of 2002 provided stop-gap coverage from the federal government. When insurers and reinsurers (the insurers of the insurance companies) see the peril as having a far higher probability than previously perceived, they know that they can no longer accurately predict future losses, and their immediate reaction is to exclude the peril. Because of regulation and oversight (see Chapter 8 "Insurance Markets and Regulation"), however, the industry cannot make policy changes instantaneously.Insurance is regulated by the states, a topic that will be covered in more detail in Chapter 7 "Insurance Operations". When private insurers can no longer provide coverage, a solution may be to create pools such as those described in the box below, “Who Should Insure Against Megacatastrophes?” More on this topic and on reinsurance will be explained in Chapter 7 "Insurance Operations".

Definite Losses

Losses must be definite in time, place, and amount because, in many cases, insurers promise to pay in dollar amounts for losses if they occur during a particular time and in a particular geographical area. For example, the contract may cover loss by fire at a specified location. For this contract to be effective, it must be possible to determine when, where, and how much loss occurred. If this cannot be established, it is impossible to determine whether the loss is covered under the terms of the contract. The fact that pain and suffering is hard to measure in dollar terms increases the insurer’s risk when calculating rates for liability insurance. One other reason the requirement of definiteness is essential is that it is necessary to accumulate data for future predictions. Unless such data can be accurate, they cannot provide the basis for useful predictions.

Determinable Probability Distribution

For an exposure to loss to be insurable, the expected loss must be calculable. Ideally, this means that there is a determinable probability distribution for losses within a reasonable degree of accuracy. Insurance premium rates are based on predictions of the future, which are expressed quantitatively as expected losses. Calculation of expected losses requires the use of estimated probability distributions (discussed in detail in Chapter 2 "Risk Measurement and Metrics").

Probability distributions based on experience are useful for prediction; however, only when it is safe to assume that factors shaping events in the future will be similar to those of the past. For this reason, mortality (death) rates during times of peace are inappropriate for estimating the number of insured deaths during times of war. Similarly, the introduction of new technologies such as foam blanketing makes past experience of fire damage a poor indicator of future experience. Yet, because the technology is new and no theory exists as to what the losses ought to be, actuaries have little information on which to base lower rates. The actuary must use subjective estimates as well as engineering information to develop proper rates.

When the probability distribution of losses for the exposure to be insured against cannot be calculated with reasonable accuracy, the risk is uninsurable. An example of purported uninsurability due to inability to predict losses is the nuclear power industry. Insurance experts convinced government officials in 1957 that the risk of loss caused by an incident at a nuclear power site was too uncertain (because of lack of experience and unknown maximum severity) for commercial insurers to accept without some government intervention. As a result, the government limited the liability of owners of nuclear power plants for losses that could arise from such incidents.

Economic Feasibility

For insurance to be economically feasibleWhen the size of the possible loss must be significant to the insured and the cost of insurance must be small compared with the potential loss. for an insured, the size of the possible loss must be significant to the insured, and the cost of insurance must be small compared to the potential loss. Otherwise, the purchase of insurance is not practical. If the possible loss is not significant to those exposed, insurance is inappropriate. Cost-benefit analysis is needed for the insurers to determine if the rates can be feasible to insureds. Also, the analysis in Chapter 3 "Risk Attitudes: Expected Utility Theory and Demand for Hedging" regarding the actuarially fair premiums a risk-averse individual would be willing to pay is important here. For catastrophic coverage, the insurer may determine through capital budgeting methods and cash flow analysis that it cannot provide low enough costs to make the coverage feasible for insureds.

Retention (bearing the financial loss by oneself) of many risks is almost automatic because the loss would not be a burden. If all the people who own automobiles were wealthy, it is doubtful that much automobile collision insurance would be written because such losses would not be significant to the wealthy owners. Insurance is feasible only when the possible loss is large enough to be of concern to the person who may bear the burden.

The possible loss must also be relatively large compared to the size of the premium. If the losses the insurer pays plus the cost of insurer operations are such that the premium must be very large in relation to the potential loss, insurance is not economically feasible. From the viewpoint of the insured, when the expected loss premium is high relative to the maximum possible loss, internal budgeting for the risk is preferable to insurance. The use of deductibles (a form of retention) to eliminate insurance reimbursement for frequent small losses helps make automobile collision premiums economically feasible. The deductible eliminates claims for small losses. Small automobile collision losses have such high probability and the cost of settling them is so great that the premium for covering them would be very large compared to the size of actual losses. For example, if a policy with a $200 deductible costs $85 more than one with a $500 deductible, you may consider $85 too large a premium for $300 of lower deductible. Insurance is best suited for risks involving large potential losses with low probabilities (described in Chapter 3 "Risk Attitudes: Expected Utility Theory and Demand for Hedging"). Large losses are key because insureds cannot pay them, and low probabilities for large losses make premiums relatively small compared with the possible losses. In other situations, insurance may not be economically feasible for the person or business facing risk.

Summary of Insurable Risks

Table 6.1 "Examples of Insurable and Uninsurable Risks" provides an analysis of the insurability characteristics of a few common perils and risks. The first column lists the requirements for insurability that we have just discussed. Note that the risk of flooding is not considered insurable because of its potential for catastrophe: many exposures can suffer losses in the same location. Thus, flooding is covered by the federal government, not by private insurers. Hurricanes, though similar to floods, are covered by private insurers, who obtain reinsurance to limit their exposure. After a catastrophe like Hurricane Andrew, however, many reinsurers became financially strapped or insolvent.

The second example in Table 6.1 "Examples of Insurable and Uninsurable Risks" is the peril/risk of fire. Fire is an insurable risk because it meets all the required elements. Even this peril can be catastrophic, however, if fires cannot be controlled and a large geographical area is damaged, such as the large fires in Colorado and Arizona in 2002. Disability is another type of peril that is considered insurable in most cases. The last example is the risk of terrorism. As noted above, it is no longer considered an insurable risk due to the catastrophic element associated with this peril since the September 11, 2001, attack.

Insurance companies use cost-benefit analysis to determine whether they should bring a new product to the market. In Chapter 4 "Evolving Risk Management: Fundamental Tools", you learned about the time value of money and computation for such decisions.

Personal, Group, or Commercial Insurance

Personal insuranceInsurance that is purchased by individuals and families for their risk needs. Such insurance includes life, health, disability, auto, homeowner, and long-term care. is insurance that is purchased by individuals and families for their risk needs. Such insurance includes life, health, disability, auto, homeowner, and long-term care. Group insuranceInsurance provided by the employer for the benefit of employees. is insurance provided by the employer for the benefit of employees. Group insurance coverage includes life, disability, health, and pension plans. Commercial insuranceProperty/casualty insurance for businesses and other organizations. is property/casualty insurance for businesses and other organizations.

An insurance company is likely to have separate divisions within its underwriting department for personal lines, group lines, and commercial business. The criterion to assign insureds into their appropriate risk pool for rating purposes is different for each type of insurance. Staff in the personal lines division are trained to look for risk factors (e.g., driving records and types of home construction) that influence the frequency and severity of claims among individuals and families. Group underwriting looks at the characteristics and demographics, including prior experience, of the employee group. The commercial division has underwriting experts on risks faced by organizations. Personnel in other functional areas such as claims adjustment may also specialize in personal, group, or commercial lines.

Life/Health or Property/Casualty Insurance

Life/health insuranceInsurance that covers exposures to the perils of death, medical expenses, disability, and old age. covers exposures to the perils of death, medical expenses, disability, and old age. Private life insurance companies provide insurance for these perils, and individuals voluntarily decide whether or not to buy their products. Health insurance is provided primarily by life/health insurers but is also sold by some property/casualty insurers. All of these are available on an individual and a group basis. The Social Security program provides substantial amounts of life/health insurance on an involuntary basis.

Property/casualty insuranceInsurance that covers property exposures such as direct and indirect losses of property caused by perils such as fire, windstorm, and theft. covers property exposures such as direct and indirect losses of property caused by perils like fire, windstorm, and theft. It also includes insurance to cover the possibility of being held legally liable to pay damages to another person. Before the passage of multiple-line underwriting laws in the late 1940s and early 1950s, property/casualty insurance had to be written by different insurers. Now they frequently are written in the same contract (e.g., homeowner’s and commercial package policies, which will be discussed in later chapters).

A private insurer can be classified as either a life/health or a property/casualty insurer. Health insurance may be sold by either. Some insurers specialize in a particular type of insurance, such as property insurance. Others are affiliated insurers, in which several insurers (and sometimes noninsurance businesses) are controlled by a holding company; all or almost all types of insurance are offered by some company in the group.

Private or Government Insurance

Insurance is provided both by privately owned organizations and by state and federal agencies. Measured by premium income, the bulk of property/casualty insurance is provided by private insurers. Largely because of the magnitude of the Social Security program, however, government provides about one-third more personal insurance than the private sector. Our society has elected to provide certain levels of death, health, retirement, and unemployment insurance on an involuntary basis through governmental (federal and state) agencies. If we desire to supplement the benefit levels of social insurance or to buy property/casualty insurance, some of which is required, private insurers provide the protection.

Voluntary or Involuntary Insurance

Most private insurance is purchased voluntarily, although some types, such as automobile insurance or insurance on mortgages and car loans, are required by law or contracts. In many states, the purchase of automobile liability insurance is mandatory, and if the car is financed, the lender requires property damage coverage.

Government insurance is involuntary under certain conditions for certain people. Most people are required by law to participate in the Social Security program, which provides life, health, disability, and retirement coverage. Unemployment and workers’ compensation insurance are also forms of involuntary social insurance provided by the government. Some government insurance, such as flood insurance, is available to those who want it, but no one is required to buy it.

Insurers’ Corporate Structure

Lloyd’s of London: A Global Insurance Exchange

Lloyd’s of LondonThe oldest insurance organization in existence. is the oldest insurance organization in existence; it started in a coffeehouse in London in 1688. Lloyds conducts a worldwide business primarily from England, though it is also licensed in Illinois and Kentucky. It maintains a trust fund in the United States for the protection of insureds in this country. In states where Lloyd’s is not licensed, it is considered a nonadmitted insurer. States primarily allow such nonadmitted insurers to sell only coverage that is unavailable from their licensed (admitted) insurers. This generally unavailable coverage is known as excess and surplus lines insurance, and it is Lloyd’s primary U.S. business.

Lloyd’s does not assume risks in the manner of other insurers. Instead, individual members of Lloyd’s, called Names, accept insurance risks by providing capital to an underwriting syndicate. Each syndicate is made up of many Names and accepts risks through one or more brokers. Surplus lines agents—those who sell for excess and surplus lines insurers—direct business to brokers at one or more syndicates. Syndicates, rather than Names, make the underwriting decisions of which risks to accept. Various activities of Lloyd’s are supervised by two governing committees—one for market management and another for regulation of financial matters. The syndicates are known to accept exotic risks and reinsure much of the asbestos and catastrophic risk in the United States. They also insure aviation.

The arrangement of Lloyd’s of London is similar to that of an organized stock exchange in which physical facilities are owned by the exchange, but business is transacted by the members. The personal liability of individual Names has been unlimited; they have been legally liable for their underwriting losses under Lloyd’s policies to the full extent of their personal and business assets. This point is sometimes emphasized by telling new male members that they are liable “down to their cufflinks” and for female members “down to their earrings.” In addition to Names being required to make deposits of capital with the governing committee for financial matters, each Name is required to put premiums into a trust fund that makes them exclusively encumbered to the Name’s underwriting liabilities until the obligations under the policies for which the premiums were paid have been fulfilled. Underwriting accounts are audited annually to ensure that assets and liabilities are correctly valued and that assets are sufficient to meet underwriting liabilities. Normally, profits are distributed annually. Following losses, Names may be asked to make additional contributions. A trust fund covers the losses of bankrupt Names. A supervisory committee has authority to suspend or expel members.

Seldom does one syndicate assume all of one large exposure; it assumes part. Thus, an individual Name typically becomes liable for a small fraction of 1 percent of the total liability assumed in one policy. Historically, syndicates also reinsured with each other to provide more risk sharing. The practice of sharing risk through reinsurance within the Lloyd’s organization magnified the impact of heavy losses incurred by Lloyd’s members for 1988 through 1992. Losses for these five years reached the unprecedented level of $14.2 billion. Reinsurance losses on U.S. business were a major contributor to losses due to asbestos and pollution, hurricanes Hugo and Andrew, the 1989 San Francisco earthquake, the Exxon Valdez oil spill, and other product liabilities.

The massive losses wiped out the fortunes of many Names. In 1953, Lloyd’s consisted of 3,400 Names, most of whom were wealthy citizens of the British Commonwealth. By 1989, many less wealthy, upper-middle-class people had been enticed to become Names with unlimited liability, pushing the total number of Names to an all-time high of 34,000 in 400 syndicates. By mid-1994, only about 17,500 Names and 178 underwriting syndicates (with just ninety-six accepting new business) remained. As a result of the mammoth total losses (and bankruptcy or rehabilitation for many individual members), Lloyd’s had reduced underwriting capacity and was experiencing difficulty in attracting new capital. What started in a coffeehouse was getting close to the inside of the percolator.

Among Lloyd’s reforms was the acceptance of corporate capital. By mid-1994, 15 percent of its capital was from twenty-five corporations that, unlike individual Names, have their liability limited to the amount of invested capital. Another reform consisted of a new system of compulsory stop-loss insurance designed to help members reduce exposure to large losses. Reinsurance among syndicates has ceased.

Other forms of insurance entities that are used infrequently are not featured in this textbook.

Banks and Insurance

For decades, savings banks in Massachusetts, New York, and Connecticut have sold life insurance in one of two ways: by establishing life insurance departments or by acting as agents for other savings banks with insurance departments. Savings banks sell the usual types of individual life insurance policies and annuities, as well as group life insurance. Business is transacted on an over-the-counter basis or by mail. No agents are employed to sell the insurance; however, advertising is used extensively for marketing. Insurance is provided at a relatively low cost.

Many savings and loan associations have been selling personal property/casualty insurance (and some life insurance) through nonbanking subsidiaries. Commercial banks have lobbied hard for permission to both underwrite (issue contracts and accept risks as an insurer) and sell all types of insurance. Approximately two-thirds of the states have granted state-chartered banks this permission. At this time, national banks have not been granted such power.An exception: national commercial banks in communities of less than 5,000 have, for many years, had the right to sell insurance.

In November 1999, State Farm Mutual Automobile Insurance Company opened State Farm Bank. At the time of this writing, State Farm has banking services in eleven states—Alabama, Arizona, Colorado, Illinois, Indiana, Mississippi, Missouri, New Mexico, Nevada, Utah, and Wyoming—and plans to expand to all fifty states. The banking division benefits from State Farm’s 16,000 agents, who can market a full range of banking products.Mark E. Ruquet, “Insurer-Bank Integration Stampede Unlikely,” National Underwriter, Property & Casualty/Risk & Benefits Management Edition, April 23, 2001.

The U.S. Supreme Court approved (with a 9–0 vote) the sale of fixed-dollar and variable annuities by national banks, reasoning that annuities are investments rather than insurance. Banks are strong in annuities sales.

Captives, Risk Retention Groups, and Alternative Markets

Risk retention groups and captives are forms of self-insurance. Broadly defined, a captive insurance companyA company that provides insurance coverage to its parent company and other affiliated organizations. is a company that provides insurance coverage to its parent company and other affiliated organizations. The captive is controlled by its policyholder-parent. Some captives sell coverage to nonaffiliated organizations. Others are comprised of members of industry associations, resulting in captives that closely resemble the early mutual insurers.

Forming a captive insurer is an expensive undertaking. Capital must be contributed in order to develop a net worth sufficient to meet regulatory (and financial stability) requirements. Start-up costs for licensing, chartering, and managing the captive are also incurred. And, of course, the captive needs constant managing, requiring that effort be expended by the firm’s risk management department and/or that a management company be hired.

To justify these costs, the parent company considers various factors. One is the availability of insurance in the commercial insurance market. During the liability insurance crisis of the 1980s, for example, pollution liability coverage became almost nonexistent. Chemical and other firms formed captives to fill the void. Today, there is a big push for captives after the losses of September 11. Another factor considered in deciding on a captive is the opportunity cost of money. If the parent can use funds more productively (that is, can earn a higher after-tax return on investment) than the insurer can, the formation of a captive may be wise. The risk manager must assess the importance of the insurer’s claims adjusting and other services (including underwriting) when evaluating whether to create a captive. Insurers’ services are very important considerations. One reason to create a captive is to have access to the reinsurance market for stop-loss catastrophic coverage for the captive. One currently popular use of captives is to coordinate the insurance programs of a firm’s foreign operations. An added advantage of captives in this setting is the ability to manage exchange rate risks as well as the pure risks more common to traditional risk managers. Perhaps of primary significance is that captives give their parents access to the reinsurance market.

Captive managers in Bermuda received many inquiries after September 11, 2001, as U.S. insurance buyers searched for lower rates. The level of reinsurance capacity is always a concern for captive owners because reinsurers provide the catastrophic layer of protection. In the past, reinsurance was rather inexpensive for captives.Lisa S. Howard, “Tight Re Market Puts Heat On Fronts,” National Underwriter, Property & Casualty/Risk & Benefits Management Edition, March 4, 2002.

A special form of self-insurance is known as a risk retention groupA group that provides risk management and retention to a few players in the same industry who are too small to act on their own..President Reagan signed into law the Liability Risk Retention Act in October 1986 (an amendment to the Product Liability Risk Retention Act of 1981). The act permits formation of retention groups (a special form of captive) with fewer restrictions than existed before. The retention groups are similar to association captives. The act permits formation of such groups in the United States under more favorable conditions than have existed generally for association captives. The act may be particularly helpful to small businesses that could not feasibly self-insure but can do so within a designated group. An interesting example of the risk retention group in practice is the one formed recently by the airline industry, which suffered disproportional losses as a result of September 11, 2001. A risk retention group designed to cover passenger and third-party war risk liability for airlines gained regulatory approval in Vermont.“Vermont Licenses Industry-Backed Airline Insurer,” BestWire, June 11, 2002. The risk retention group for airlines is named Equitime, and it was formed by the Air Transport Association (ATA), a Washington, D.C.-based trade group, and Marsh, Inc. (one of the largest brokerage firms worldwide). Equitime offers as much as $1.5 billion in combined limits for passenger and third-party war risk liability. Equitime’s plan is to retain $300 million of the limit and reinsure the balance with the federal government. The capitalization of this risk retention group is through a private placement of stock from twenty-four airlines belonging to the ATA and about fifty members of the Regional Airline Association.Sue Johnson, “Airline Captive May Be Formed in Second Quarter,” Best’s Review, March 2002. See also the document created by Marsh to explain the program along with other aviation protection programs (as of August 14, 2002) at http://www.marsh.se/files/Third%20Party%20War%20Liability%20Comparison.pdf.

Alternative markets are the markets of all self-insurance programs. Captives and group captives will see steady growth in membership. In addition, governmental risk poolsPools formed for governmental entities to provide group self-insurance coverage. have been formed for governmental entities to provide group self-insurance coverage such as the Texas Association of School Boards (TASB), municipals risk pools, and other taxing-authorities pools. TASB, for example, offers to the Texas school districts a pooling arrangement for workers’ compensation and property, liability, and health insurance. Public risk pools have a large association, the Public Risk Management Association (PRIMA), which provides support and education to public risk pools.For detailed information about PRIMA, search its Web site at http://www.primacentral.org/default.php.

Government Insuring Organizations

Federal and state government agencies account for nearly half of the insurance activity in the United States. Primarily, they fill a gap where private insurers have not provided coverage, in most cases, because the exposure does not adequately meet the ideal requisites for private insurance. However, some governmental programs (examples include the Maryland automobile fund, state workers’ compensation, insurance plans, crop insurance, and a Wisconsin life plan) exist for political reasons. Government insurers created for political goals usually compete with private firms. This section briefly summarizes state and federal government insurance activities.