Chapter 7

Financial Operatio
ns of Insurers

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Agenda

• Property and Casualty Insurers

– Financial Statements
– Measuring Financial Performance
• Life Insurance Companies
– Financial Statements
– Measuring Financial Performance
• Ratemaking in Property and Casualty Insurance
• Ratemaking in Life Insurance

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Financial Statements of Property a
nd Casualty Insurers

• Balance Sheet: a summary of what a company ow

ns (assets) and what it owes (liabilities)

Total Assets = Total Liabilities + Owners’ Equity

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Exhibit 7.1 ABC Insurance Compa
ny

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Financial Statements of Property a
nd Casualty Insurers

• The primary assets for an insurance compan

y are financial assets
• Insurers’ liabilities include required reserves
• A loss reserve is an estimated amount for:
• Claims reported and adjusted, but not yet paid
• Claims reported and filed, but not yet adjusted
• Claims incurred but not yet reported to the company

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Financial Statements of Property a
nd Casualty Insurers
• Case reserves are loss reserves that are establish
ed for each individual claim
– Methods for determining case reserves include:
• The judgment method: a claim reserve is established for each in
dividual claim
• The average value method: an average value is assigned to ea
ch claim
• The tabular method: loss reserves are determined for certain cla
ims for which the amounts paid depend on data derived from m
ortality, morbidity, and remarriage tables

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Financial Statements of Property a
nd Casualty Insurers
• The loss ratio method establishes aggregate
loss reserves for a specific coverage line
– A formula based on the expected loss ratio is us
ed to estimate the loss reserve
• The incurred-but-not-reported (IBNR) reserv
e is a reserve that must be established for cl
aims that have already occurred but that hav
e not yet been reported

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Financial Statements of Property a
nd Casualty Insurers
• The unearned premium reserve is a liability item th
at represents the unearned portion of gross premiu
ms on all outstanding policies at the time of valuati
on
– Its purpose is to pay for losses that occur during the poli
cy period
– It is also needed so that refunds can be paid to policyhol
ders that cancel their coverage
– It also serves as the basis for determining the amount th
at must be paid to a reinsurer for carrying reinsured polic
es
– The annual pro rata method is one method of calculating
the reserve
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Financial Statements of Property a
nd Casualty Insurers

• Policyholders’ surplus is the difference between an

insurance company’s assets and liabilities
– The stronger a company’s surplus position, the greater i
s the security for its policyholders

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Financial Statements of Property a
nd Casualty Insurers
• The income and expense statement summarizes r
evenues and expenses paid over a specified perio
d of time
• The two principal sources of revenue are premium
s and investment income
– Earned premiums are those premiums for which the serv
ice for which the premiums were paid (insurance protecti
on) has been rendered
• Expenses include the cost of adjusting claims, payi
ng the insured losses that occurred, commissions t
o agents, premium taxes, and general insurance e
xpenses
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Measuring the Performance of Pro
perty and Casualty Insurers
• The loss ratio is the ratio of incurred losses and loss adjust
ment expenses to premiums earned

• The expense ratio is equal to the company’s underwriting e

xpenses divided by written premiums

• The combined ratio is the sum of the loss ratio and the expe
nse ratio. A positive ratio indicates an underwriting loss

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Measuring the Performance of Pro
perty and Casualty Insurers
• The investment income ratio compares net investment inco
me to earned premiums

• The overall operating ratio is equal to the combined ratio mi

nus the investment income ratio
– This ratio measures the company’s total performance (underwriting
and investments)

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Financial Statements of
Life Insurers
• The balance sheet
– The assets of a life insurer have a longer duration, on a
verage, than those of property and casualty insurers
– Because many life insurance policies have a savings el
ement, life insurers keep an interest-bearing asset calle
d “contract loans” or “policy loans”
– A life insurance company may have separate accounts f
or assets backing interest-sensitive products, such as v
ariable annuities

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Financial Statements of
Life Insurers
• Policy reserves are a liability item on the balance s
heet that must be offset by assets equal to that am
ount
– State laws specify the minimum basis for calculating poli
cy reserves
• The reserve for amounts held on deposit is a liabilit
y representing funds that are owed to policyholders
and to beneficiaries
• The asset valuation reserve is a statutory accounti
ng account designed to absorb asset value fluctuat
ions not caused by changing interest rates

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Financial Statements of
Life Insurers
• Policyholders’ surplus is less volatile in the life insu
rance industry than in the property and casualty ins
urance industry
• Benefit payments, including death benefits paid to
beneficiaries and annuity benefits paid to annuitant
s, are the life insurer’s major expense
• A life insurer’s net gain from operations equals tota
l revenues less total expenses, policyowner dividen
ds, and federal income taxes

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Ratemaking in Property and Casua
lty Insurance
• State Laws Require:
– Rates should be adequate for paying all losses a
nd expenses
– Rates should not be excessive, such that policyh
olders are paying more than the actual value of t
heir protection
– Rates must not be unfairly discriminatory; expos
ures that are similar with respect to losses and e
xpenses should not be charged significantly diffe
rent rates

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Ratemaking in Property and Casua
lty Insurance
• Business Rate-Making Objectives include:
– Rates should be easy to understand.
– Rates should be stable over short periods of tim
e
– Rates should be responsive to changing loss ex
posures and changing economic conditions
– Rates should encourage loss prevention

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Ratemaking in Property and Casua
lty Insurance
• A rate is the price per unit of insurance.
• An exposure unit is the unit of measurement used in insuran
ce pricing, e.g., a car-year
• The pure premium is the portion of the rate needed to pay lo
sses and loss adjustment expenses
• Loading is the amount that must be added to the pure premi
um for other expenses, profit, and a margin for contingencie
s
• The gross rate consists of the pure premium and a loading e
lement
• The gross premium paid by the insured consists of the gross
rate multiplied by the number of exposure units

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Ratemaking in Property and Casua
lty Insurance
• There are three basic rate making methods in pr
operty and casualty insurance:
1. Judgment rating means that each exposure is individu
ally evaluated, and the rate is determined largely by th
e judgment of the underwriter
2. Class rating means that exposures with similar charac
teristics are placed in the same underwriting class, an
d each is charged the same rate

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Ratemaking in Property and Casua
lty Insurance
– Class rates are determined using two basic met
hods:
• Under the pure premium method, the pure premium c
an be determined by dividing the dollar amount of inc
urred losses and loss-adjustment expenses by the nu
mber of exposure units
• Under the loss ratio method, the actual loss ratio is c
ompared with the expected loss ratio, and the rate is
adjusted accordingly

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Ratemaking in Property and Casua
lty Insurance
3. Merit rating is a rating plan by which class rates
are adjusted upward or downward based on ind
ividual loss experience
• Under a schedule rating plan, each exposure is indiv
idually rated
– A basis rate is determined for each exposure, which is then
modified by debits or credits depending on the physical char
acteristics of the exposure
– Commonly used in commercial property insurance

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Ratemaking in Property and Casua
lty Insurance
• Under experience rating, the class or manual rate is adjusted up
ward or downward based on past loss experience
– The insurer’s past loss experience is used to determine the premiu
m for the next policy period
• Under a retrospective rating plan, the insured’s loss experience d
uring the current policy period determines the actual premium pai
d for that period
– A provisional premium is paid at the beginning of the policy period; t
he final premium is calculated at the end of the policy period
– Commonly used in workers compensation insurance

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Ratemaking in Life Insurance

• Life insurance actuaries use a mortality table or in

dividual company experience to determine the pro
bability of death at each attained age
• The annual expected value of death claims equals
the probability of death times the amount the insur
er must pay if death occurs

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Exhibit 7.2 ABC Insurance Compa
ny

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Insight 7.1 Profitability of Insurance Ind
ustry and Other Selected Industries

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