Risk management and insurance

Part-II
Chapter-Six
FUNCTIONS OF INSURANCE COMPANIES
Chapter learning objectives:
At the end of this chapter you should able to:
 Explain the production/selling function of insurers
 Explain the rate making functions, objectives and
methods.
 Define underwriting its objectives, and information
required to undertake the function.
 Identify and explain steps in claim settlement
process and,
 Describe the investment function of insurers.
Although there are definite operational difference
between life insurance companies and property and
liability insurers; the major activities of all insurers may
be classified as follows:

o Production (selling)

o Underwriting (selection of risks)

o Rate making

o Claim settlement/Managing claims

o Investment

o Reinsurance(discussed in chapter seven)

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In addition to these functions, there are various other

activities common to most business firms such as accounting,
personnel management, market research and etc.

6.1. Production
One of the most vital needs of an insurance firm is securing a
sufficient number of applicants for insurance to enable the
company to operate. This function is often called production in
the context of the insurance industry. Production in an insurance
company corresponds to the sales function in an industrial firm.
Insurance is an intangible item and does not exist until a policy
is sold (or purchased by insured).

The production department of any insurer, sometimes called agency

department, is its sale or marketing division. It supervises the
relationships with agents or salaried representative of the
company (external portion of sales effort) in the field. In
addition, the production department recruits, trains and
supervises the agents or salespersons. In general, it renders
assistance to agents in technical matters.

6.2. Underwriting
Underwriting is the process of selecting and classifying
applicants for insurance/risks offered to the insurer (or which
can be covered by the insurance company). Unless the company
selects from among its applicants, the inevitable result will be
adverse to the company. Hence, the main responsibility of the
underwriter is to guard against adverse selection. Underwriter is
the person who decides to accept or reject an application.

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To this point it is important to understand that the goal of

underwriting is not the selection of risks that will not have
loss. It is to avoid a disproportionate number of bad risks,
thereby equalizing the actual loss with the expected ones. While
attempting to avoid adverse selection through rejection of
undesirable risks, the underwriter must secure an adequate volume
of exposure in each class. Moreover, he/she must guard against
congestion or concentration of exposure that might result in
catastrophe.

Underwriting starts with a clear statement of underwriting

policy. An insurer must establish underwriting policy that is
consistence with company objectives. The policy establishes the
framework within which the desk underwriter makes decision. It
specifies the line of insurance that will be written as well as
prohibited exposures, the amount of coverage to be permitted on
various types of exposure, the area of the country in which each
line will be written and similar restriction.

To perform effectively, the underwriter must obtain as much

information about the subject of the insurance as possible within
the limitation imposed by the time and the cost of obtaining
additional data.

There are four sources from which the underwriter obtains

information regarding the hazards inherent in an exposure:

o The application- containing the insured’s statements-

representation

o Information from the agent or broker

o Investigations-inspection report, especially if the

underwriter suspects moral hazard.

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o Physical examinations or inspections. e.g.

physicians(selected by insurer) may supply medical
report after physical examination.

The desk underwriter after obtaining sufficient information about

the subject of insurance must rule on the exposure accepting some
and rejecting other that do not meet the company underwriting
requirements. When a risk is rejected, it is because the
underwriter feels that the hazards connected with it are
excessive in relation to the rate.

Activity: 6-1
1.What justification is there for using the term
production in the insurance field to refer to
selling?
_________________________________________________
_________________________________________________
_________________________________________________
2.How does the underwriting department handle the
problem of adverse selection?
_________________________________________________
_________________________________________________
_________________________________________________

6.3. Rate Making

Rate making refers to the pricing of insurance. An insurance rate
is the price per unit insurance or exposure. Like any other
price, it is a function of the cost of production. However, in
insurance, unlike other industries the cost of production is not

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known when the contract is sold, and will not be known until
sometimes in the future, when the policy has expired.

One of the fundamental differences between insurance pricing and

the pricing function in other industries is that the price for
insurance must be based on a prediction.

The process of predicting future losses and future expenses, and

allocating these costs among the various classes of insured’s is
called ratemaking.

A second important difference between the pricing of insurance

and pricing in other industries arises from the fact that
insurance rates are subject to government regulation. The main
reason why government interferes on insurance is because
insurance is vested on public interest.

6.3.1. Objective of ratemaking

Rate making objective can be classified in two basic categories:
i. Regulatory objective-the goal of insurance regulation is to
protect the public. Enacted laws require that insurance
rates must not be excessive (for exorbitant prices are not
in the public interest), must be adequate (high to pay all
loss and expenses) and must not be unfairly
discriminatory**.

**Rates must not be discriminatory means that exposures that are

similar with respect to losses and expenses should not be charged
substantially different rates.
ii. Business objective-insurers are also guided by
certain business objectives in designing a rate
system. The rating system should also meet the
following objectives.
- Simplicity-easy to understand so that
producers can quote premium with a minimum

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time and expense. In addition, policy

purchasers should easily understand how their
premiums are determined so that they can take
active steps to reduce insurance cost.
- Stability-the rates should be relatively
stable overtime, so that the public is not
subjected to wide variations in cost from year
to year.
- Responsiveness- rates should be sufficiently
responsive to changing loss exposure and
changing economic condition to avoid
inadequacies in the event worsening loss
experience.
- Encouragement of loss control-rating system
should encourage loss control activities that
reduce both loss frequency and severity. In
other words, rate should provide some
incentive for the insured to prevent loss.

6.3.2. Basic definition of Rate making

A “rate” is the price charged for each unit of
protection or exposure.
Pr ice Price
Rate= =
Unitof exp osure Exposure

A “premium” is determined by multiplying the rate by

the No of units of protection purchased.

Premium = Rate X No of units of protection Purchased

Or
The insurance rate is the amount charged per unit of
exposure. Thus, premium will be:

Premium = Insurance Rate X No of units of exposure

The units of protection to which a rate applies differ

for various lines of insurances (e.g. life insurance,
fire insurance, and etc)

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Example-1
In life insurance, if the rate is 25 birr per 1,000 birr (or for
each 1,000 birr in protection) of face amount of insurance, the
premium for a 10,000 birr policy is:
Birr 25
Pr emium= xBirr 10 , 000=Birr 250
Birr 1, 000

Example:-2
If you have the rate $0.25 per $100 of face amount of insurance,
how much premium will you pay for $10,000,000 value of an
exposure for protection if the type of insurance is life
insurance?
$ 0 .25
Pr emium= x $ 10 , 000 , 000=$ 25 , 000
$ 100
The premium is designed to cover two major costs:
a. The expected potential loss and
 Is also known as pure premium-includes only
potential losses.
b. The cost of doing business
 Is also known as operating expenses and profit margin or: is also known as
loading==> the additional cost that the insured should cover. May include:
 Agent expenses
 Commissions
 General Company Expenses
 Taxes
 Allowance for profits etc.

TotalExpectedLoss ExpectedLoss
Pure Pr emium= =
TheN o . ofExposure ExposureUnits

Gross premium = Pure Premium + Loading

Loading is usually expressed as a percentage of the expected
gross premium.

The general formula for the gross premium, the amount charged
customer, is:

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Pure Premium Pure Pr emium

Gross Pr emium= =
1−LoadingPercentage LossRatio

Loss ratio = 1- Loading percentage

Example 1
In automobile insurance if an insurer expects to pay 600,000 birr
of collision loss claims in a given territory, and there are
3,000 autos in the insured group,
a) What will be the pure premium for collision?
b) If 30 of the automobiles belong to Ato Hailu how much pure
premium will the insurer demand Ato Hailu to pay for his
autos’ being protected?
c) If the loading percentage is 20%, how much will the Gross
Premium be?
d) What will be the total amount of money to be paid by Ato
Hilu for his automobiles?

Solution
TotalExpectedLoss $ 600,000
Pure Pr emium= = = $ 200 / aut .
a) ExposureUnit 3000 auts

b) 30 autos x $ 200 / aut = $6,000

Pure Premium $ 200 / aut

Gross Pr emium= = =$ 250 / aut .
c) 1−LoadingPercentage 1−0 .2

d) 30 aut x $ 250 = $ 7,500/aut or

Gross premium, which is the amount charged to customer is

computed as follows:

Pure premium = $6,000 =$7,500

1-loading percentage 1-0.2

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6.3.3. Rate making Methods

There are two basic approaches to ratemaking: Class and
individual rating approaches/methods.

o Manual or Class Rating

The manual or class rating method sets rates that apply uniformly
to each exposure unit falling within some predetermined class or
group. Everyone falling within a given class is charged the same
rate.

Example:
 A class rate might apply to all types of dwelling of
a given kind of construction in a specific city.
 Rates which apply to all individuals of a given age
and sex.

The major areas of insurance that emphasize use of manual rate

making method include life, automobile, residential fire, etc.
for instance, in life insurance the central classifications are
by age and sex. In automobile insurance the loss data are broken
down territorially by type of automobile, by age of driver, and
major use of automobile. In each cases it is necessary only to
find the appropriate page in manual to find out what insurance
rate is to be, hence the term,” manual rate making”

Class rating is the most common approach in use by the insurance

industry today.

 Advantage of the class rating system

It permits the insurer to apply a single rate to a large number
of insured’s, simplifying the process of determining their
premiums. Because, the rate maker does not decide the premium,
but apply the already decided premium.

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o Individual Rating
Sometimes called merit-rating method. This method is used when
the characteristics of the unit to be insured Vary so widely.
Hence, the method is used when it is desirable to depart from the
manual or class approach and calculate rates on a basis that
attempt to measure more precisely the loss-producing
characteristics of the individual. Each insured is charged a
unique premium based largely upon the judgment of the person
setting the rate. This rating is supplemented by whatever
statistical data are available and by knowledge of the premium
charged to similar insured’s. There are four approaches to
individual merit rating:

o Judgment rating: each insured is charged a unique

premium based largely upon the judgment of the person
setting the rate (underwriter).

o Schedule rating: under this method each exposure is

individually rated. A basis rate is determined for each
exposure, which is then modified by debits or credits
for undesirable and desirable physical features. The
physical characteristics of each schedule –rated
exposure determine the exposures rate.

o Experience rating: under this approach the class or

manual rate is adjusted upward or downward based on past
loss experience. The most distinctive feature of this
approach is that the insured’s past loss experience is
used to determine the premium for the next policy
period.

o Retrospective rating: in this approach the insured’s

loss experience during the current policy period

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determines the actual premiums paid for that period.

Under this rating plan the insured is charged a minimum
and maximum premium. This is a deposit premium charged
at the inception of the policy and then adjusted after
the policy period has expired, to reflect actual loss
incurred. If actual losses during the current policy
period are small, the minimum premium is paid. If losses
are large, the maximum premium is paid. The actual
premium paid generally will fall somewhere between the
minimum and maximum premium, depending on the insured’s
loss experience during the current policy period.

Activity: 6-2
Dear learners! We hope you understood rate making
function, its objectives and methods of rate making.
Then, answer the following questions.
1. Distinguish between a rate and a premium in
insurance.
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2. Distinguish between experience rating and
retrospective rating’
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3. The Ethiopian Insurance Corporation develops a pure
premium of 75 Br. for residential fire insurance at
the airport region. The expense and profit

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allowance is calculated to be 25% of the gross

premium. What should be the gross premium?
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6.4. Claim settlement

The basic purpose of insurance is to provide indemnity to the
members of the group who suffer losses. This is accomplished on
the loss-settlement process, but it is sometimes a great deal
more complicated than just passing out money. The payment of
losses that have occurred is the function of the claims
department.

Life insurance companies refer to those employees who settle

losses as “claim representatives”, or “benefit representatives.”
The nature of the difficulties frequently encountered in the
property and liability field is evidenced by the fact that
employees of the claims department in the field of property and
liability insurance are called “adjusters”-individual who
investigate loss, determine the liability and the amount of
payment to be made. The major types of adjusters include: agent,
company adjusters, independent adjusters and public adjusters.

6.4.1. Steps in settlement of claims

In determining whether to pay or contest a claim, the adjuster
follows a procedure with four main steps:
i. Notice of Loss
ii. Investigation
iii. Proof of loss

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iv. Payment or denial of the claims

I. Notice of Loss
The first step in the claim process is the notice by the insured
to the company that a loss has occurred. It can be informed
orally or in written form. In order to avoid unnecessary
problems, the notice is better to be given in written form. In
most cases the contract requires that the notice be given
“immediately” or “as soon as practicable”. The insured may also
be expected to notify someone other than the insurer. Under theft
insurance, for example, the insured must tell the police as well
as the insurer about the loss.

II. Investigation
The investigation is designed to determine if there was a loss
covered by the policy.
Following the loss, the insured should assist the loss adjuster
in the investigation. The adjuster must determine:
 Whether the loss actually occurred
 Whether it is covered by the contract, and
 The extent of the loss

III. Proof of Loss

After giving notice, the insured is required to file a
proof of loss. This is a sworn statement that the loss
has taken place, and states the amount of the claim and
the circumstance surrounding the loss. The adjuster
normally assists the insured in the preparation of this
document.
IV. Payment or Denial

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If all goes well, the insurance company draws a draft

reimbursing the insured for the loss. If not, it denies
the claims.
6.5. Investment Function
When an insurance policy is written, the premium is
generally paid in advance for periods varying from six
months to five or more years. These advance payments
for premiums gives rise to funds held for policyholders
by the insurer, funds that must be invested in some
manner. These funds should not remain idle, and it is
the responsibility of finance department or a finance
committee of the company to see that they are properly
invested. The investment income that is earned
subsidizes the unfavorable underwriting experience and
is therefore a factor in rate making in this field.

Note that, not all the money collected by the insurer

is to be invested. A certain proportion of it should be
kept aside to meet future claims.

Activity: 6-3: answer the following questions.

1.Describe the steps in claim settlement process.
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2.Why those all money collected by the insurers
should not be put in investment
venture?-------------------------------------------
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Chapter summery
Dear learners! Though there are other activities
common to most business firms such as accounting,
personnel management, market research and so on, we
have so far emphasized the basic functions of
insurers. That is, Insurers secure a sufficient
number of applicants to enable the company to
operate (production function), select and or
classify an applicant for insurance (underwriting
function), predict future losses and future
expenses and allocating these costs among various
classes of insured’s (rate making function), invest
the premium paid in advance in some business
venture (investment function) and provide indemnity
to the members of the group who suffer losses
(claim settlement function). When an insurance
policy is written, the premium is generally paid in
advance. These advance payments for premiums gives
rise to funds held for policyholders by the

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insurer, which must be invested in some manner

(investment function).

Self test questions!!

Dear student! Have you gone through the above texts,
and then let you single out and circle the best letter
of your choice.

##Awash Insurance, expects to pay Br.400, 000 for

collusion loss claims in west Oromia on its automobile
insurance policy. To cover the anticipated losses,
Br.100 is required to be paid on each auto in the
insured group. The company policy is to charge 25% of
the pure premium for cost of doing business.
Based on the above information answer question 1-3

1. If 25 autos belong to Obo Doni, how much pure

premium will Awash insurance demand Obo Doni to pay?
A.Br.2, 500
B.Br.4, 000
C.Br.100
D.Br.2000
E.None
2. How much is the gross premium per auto?
A.Br.100 B. Br. 1,250

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C.Br.115 D. Br.215
E.Br. 125
3. How much should Obo Doni pay to the insurance
companies on his twenty-five autos in the insurance
pool and
A.2,500 Br. C. 2, 000 Br.
B.4,000 Br. D. 3, 000 Br
E. None

4. Which of the following is not considered as a

factor in determining the insurance rate.
A.The right to subrogated to insured’s right of
recovery
B.Inevitability of premium collected in advance
C.Characteristics of the subject matter
D.Rate regulation to protect the insurer’s
solvency and the insured’s unequal knowledge
relative to an insurer
E. None
5.Insurance companies function of securing a
sufficient number of applicants to enable the
company to operate is termed as:
A.Underwriting
B.Reinsurance
C.Selling
D.Rating
E.Selection

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Answer key
1. A 2.E 3.E 4.E 5.C

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