INSURANCE

Insurance is vital to a free enterprise economy. Insurance is the process of spreading risk of economic loss among as many people or entities as possible who are subject to the same kind of risk; it is based on the laws of probability (chance of a given outcome happening) and large numbers (which enables the laws of probability to work). Society faces many perils (causes of loss)—some natural (e.g., earthquakes, hurricanes, tornados, flood, drought), some human (e.g., arson, theft, fraud, vandalism, contamination, pollution, terrorism), and some economic (e.g., expropriation, inflation, obsolescence, depressions/recessions).

Availability of insurance allows individuals and businesses to purchase policies that provide protection from financial loss attributable to death, accidents, sicknesses, damage to property, and injury caused to others. The person or organization seeking to transfer risk—the insured (policyholder) pays a relatively small amount (the premium) to an insurance company (the insurer), which issues an insurance policy in which the insurer agrees to reimburse the insured for any losses covered by the policy. Insurers are able to provide coverage for virtually any predictable loss.

EARLY HISTORY

The concept of insurance was introduced thousands of years ago and has evolved over many centuries. The Chinese, for example, divided their cargoes among many boats to reduce the severity of loss from the perils of the seas, while the biblical story of Joseph and the famine in Egypt illustrates the storing of grain during the seven good years to relieve shortages during the seven years of famine. Marine insurance emerged in London when ships sailed for the New World. Fire insurance arose from the great fire of London in 1666, in which 14,000 buildings were destroyed. In 1752 Benjamin Franklin (1706–1790) founded the first mutual fire insurance company in the United States, the Philadelphia Contributorship for the Insurance of Houses from Loss by Fire.

U.S. INSURANCE INDUSTRY

The U.S. insurance industry is made up of approximately 5,000 companies that provide insurance coverage of various types, with combined annual revenue of about $1 trillion. The industry is highly concentrated with the fifty largest companies holding more than 60 percent of the market. Within product segments, concentration is even higher.

The three broad categories of insurance are property and casualty, which generates about 60 percent of annual industry revenue; health, generating about 12 percent; and life, which generates 10 percent. Within the property and casualty segment, commercial insurance accounts for 60 percent of revenue. Because of the very different insurance issues involved in each, many agencies handle only one type of insurance. Agencies may also specialize in selling to individuals, businesses, or groups.

Insurance is sold either directly by insurers (direct insurers) or through the independent agency system, exclusive agencies, and brokers. There are about 130,000 insurance agency offices, with the largest insurance agencies holding only 20 percent of the total market. The industry is highly fragmented.

An insurance agent works on the insurance company's behalf, while an insurance broker represents the customer's interests. Many agencies, especially on the commercial side, function as brokers.

The insurance industry employed about 2.3 million wage and salary workers in 2004. Insurance carriers accounted for 62 percent of jobs, while insurance agencies, brokerages, and providers of other insurance-related services accounted for 38 percent of jobs. In addition, about 151,000 workers in the industry were self-employed in 2004, mostly as insurance sales agents.

LIFE/HEALTH INSURANCE

Many insurance companies provide a variety of both life and health insurance policies. The two types, however, will be briefly discussed separately here.

Life Insurance

Life insurance is purchased to protect dependents against financial hardship when the insured person, the policyholder, dies. Many life insurance policies provide for the accumulation of savings that can be used in time of financial hardship. The Survey of Consumer Finances by the Federal Reserve Board revealed that 69 percent of American families owned some type of life insurance in 2001. Americans purchased $3.1 trillion of new life insurance coverage in 2004, which was 5 percent more than in 2003. By the end of 2004, total life insurance coverage in the United States reached $17.5 trillion, which was an increase of 3 percent from 2003.

Health Insurance

The majority of people in the United States, 245.3 million (84.3 percent of the population) had some health insurance coverage in 2004. There were 45.8 million (15.7 percent) of the population without health coverage. These figures from a U.S. Census Bureau report were based on a broad classification of health insurance coverage defined operationally as:

Private health insurance is coverage by a plan provided through an employer or union or purchased by an individual from a private company. Government health insurance includes the federal programs Medicare, Medicaid, and military health care; the State Children's Health Insurance Program (SCHIP); and individual state health plans. People were considered "insured" if they were covered by any type of health insurance for part or all of the previous year, and everyone else was considered uninsured. (DeNavas-Walt, Proctor, and Lee, 2005, p. 16)

Most insured people (59.8 percent) were covered by a health insurance plan related to employment for some or all of 2004. This proportion was lower than in 2003 (60.4 percent). The percentage of people covered by health insurance provided by the government increased between 2003 and 2004 from 26.6 to 27.2 percent; government insurance includes Medicare, Medicaid, and military health care. Medicaid coverage rose by 0.5 percent in 2004, while the percentage of people covered by Medicare remained unchanged, at 13.7 percent.

The top ten U.S. private life/health companies, ranked by revenues, are shown in Table 1.

PROPERTY/CASUALTY INSURANCE

A wide range of types of property and casualty insurance are provided by U.S. companies. The American Insurance Association (AIA) is the leading trade association for this segment of the insurance industry. There are 435 insurers in the AIA who write more than $120 billion in premiums each year. Member companies provide all types of property-casualty insurance, including personal and commercial auto insurance, commercial property and liability coverage for small businesses, workers' compensation, homeowners' insurance, medical malpractice coverage, and product liability insurance.

The property insurance marketplace faces many significant challenges, including skyrocketing water-damage claims and manmade catastrophes (terrorist attacks), in addition to the more traditional challenges associated with catastrophic natural disasters. The AIA's Web site (http://www.aiadc.org) lists current issues, as the association describes itself as active in "shaping public policies affecting an increasingly complex insurance marketplace." This association, however, while providing publications for purchase, has limited information for the inquiring citizen. The top ten U.S. property and casualty insurers by revenue are shown in Table 2.

ORGANIZATION OF COMPANIES

Insurers primarily operate as stock (owned by stockholders) or mutual (owned by policyholders) companies,

mutual meaning that they are legally owned by policy-holders and consequently do not issue stock. Other forms of structure are pools and associations (groups of insurers), risk retention groups, purchasing groups, and fraternal organizations (primarily life and health insurance). An insurer within a given state is classified domestic, if formed under that state; foreign, if incorporated in another state; or alien, if incorporated in another country.

FUNCTIONS

The key functions of an insurer are marketing, underwriting (issuing policies), claims (investigation and payment of legitimate claims as well as defending against illegitimate claims), loss control, reinsurance, actuarial, collection of premiums, drafting of insurance contracts to conform with statutory law, and the investing of funds. Underwriters are expert in identifying, understanding, evaluating, and selecting risks. Actuaries play a unique and critical role in the insurance process: They price the product (the premium) and establish the reserves.

The primary goal of an insurer is to underwrite profitably. Disciplined underwriting combined with sound investing and asset/liability management enables an insurer to meet its obligations to both policyholders and stockholders. Underwriting combines many skills—investigative, accounting, financial, and psychological. While some lines of business (e.g., homeowners and auto insurance) are underwritten manually or class rated, many large commercial property and casualty risks are judgment rated, relying on the underwriter's skill, experience, and intuition.

PRODUCT AND RATINGS

An insurance policy varies among states and classes of business; nevertheless, there are features common to all policies.

• Declaration page: Names the policyholder, describes the property or liability to be insured, type of coverage, and policy limits
• Insuring agreement: Describes parties' responsibilities during the policy term
• Conditions of the policy: Details coverage and requirements in event of a loss
• The exclusions: Describes types of property and losses not covered; the states and insurers continually work together to make the policy more readable

Rating organizations include: A. M. Best, Moody's, and Standard & Poor's. Each of these rating organizations provides information about specific companies.

ROLE OF GOVERNMENT

Federal and state governments play important roles, as noted earlier, in relation to health insurance and in managing large social insurance programs, such as Social Security, unemployment compensation, federal deposit insurance, and pension benefit guaranty. In these areas, the government acts either as a partner or competitor to the insurance industry, or as an exclusive provider. Federal and state governments also manage property and casualty programs, such as "all-risk" crop, crime, flood, and workers' compensation.

REINSURANCE

Reinsurance is critical to the insurance process; it brings capacity, stability, and financial strength to insurers. The purpose of reinsurance is to spread large risks and catastrophes over as large a base as possible. It is the assumption by one insurance company (the reinsurer) of all or part of a risk undertaken by another insurance company (the cedent). It enables an insured with a sizable risk exposure to deal with and receive coverage from one insurer, rather than dealing with a number of insurers.

Reinsurance has made possible greater face amounts of life insurance coverage, even though the total number of policies fell in the early years of the twenty-first century. An applicant who is an unusual risk and is seeking a policy can be accommodated by being granted a policy with the insurer who can in turn transfer part of the risk to a reinsurer. Reinsurance can limit the investment risk inherent in high asset concentration from single products, such as annuities. As noted in Life Insurers Fact Book:

In 2005, 85 percent of life insurers with life premiums ceded at least some of those premiums as reinsurance. Among insurers with accident and health premium, 82 percent ceded accident and health premium; … only 40 percent of insurers doing annuity business … ceded annuity considerations. (American Council of Life Insurers, 2005, Chapter 6)

REGULATION

Insurance companies are overseen by state insurance regulators, whose authority is comprehensive. Insurance companies must meet risk-based capital standards, adhere to investment guidelines, and undergo regular on-site financial examinations. Companies must provide such information as changes in officers and directors, as well as quarterly and annual financial statements that are signed and attested to by company officers. Company financial policies are reviewed on actuarial and accounting standards.

Each state determines the company and licensing requirements, product filing rules, market conduct exams, and laws and regulations to ensure solvency and protection of consumers.

State insurance departments work with the National Association of Insurance Commissioners (NAIC) to develop and promote laws and regulations that serve as model laws, and with the state legislatures, which pass the laws and set the budgets. NAIC is the organization of insurance regulators—from the fifty U.S. states, the District of Columbia, and the four U.S. territories—that has as its mission the protection of public interest, the promotion of competitive markets, the facilitation of fair and equitable treatment of insurance consumers, and the improvement of state regulation of insurance.

State insurance departments also work with the courts, which interpret insurance regulations and policy wording; the U.S. Congress and the U.S. Government Accountability Office, which periodically evaluate state insurance regulation; and professional, trade, and consumer groups.

COMPETITION

Because the insurance market has many sellers and buyers, little product differentiation, and freedom of entry and exit, it is highly competitive. This is especially true in the property and casualty segment. While demand for insurance grows steadily over time, with the increase in exposures and legal requirements, the supply of insurance, because it is financial and flexible, can be easily shifted in and out of the market. This attracts capital during periods of high interest and stock market strength because of high profit expectations from investing underwriting cash flows.

CHALLENGES FACED BY THE PROPERTY/CASUALTY SEGMENT

Property/casualty firms have faced additionally significant challenges since Hurricane Katrina in 2005, including a daunting claims-adjusting environment and litigation. The AIA has endeavored to aid companies addressing the challenges and issues surrounding natural disasters on the Gulf Coast. One outcome from the Katrina disaster was renewed attention to improving building codes and building code enforcement.

GLOBALIZATION

Globalization is reshaping much of the business world, including the insurance world. The NAIC is one group that has increasingly been involved in insurance regulation in the international arena. NAIC has provided leadership in the International Association of Insurance Supervisors and in the International Accounting Standards Board. NAIC hosted an international symposium on the topic "State Insurance Regulators: Meeting Tomorrow's Global Challenges Today," in February 2006. The symposium addressed financial services markets and key regulatory developments in Europe, Latin America, China, and India. Leading regulators from several countries participated in the program, which aimed to advance the setting of global standards and to reduce differences in insurance supervision.

SOURCES FOR INFORMATION

A number of insurance-related organizations provide information for persons interested in learning more about insurance. These organizations include, in addition to the NAIC, some of the following:

American Council of Life Insurers:

The American Council of Life Insurers is a Washington, D.C., trade association that has as members companies that offer life insurance, long-term care insurance, disability income insurance, reinsurance, annuities, pensions, and other retirement and financial protection products. Its annual Life Insurers Fact Book is an especially useful reference.

America's Health Insurance Plans:

America's Health Insurance Plans is a national association representing approximately 1,300 members, who provide health benefits to more than 200 million Americans. The primary purpose of this association is to represent the interests of its members on legislative and regulatory issues at both federal and state levels.

AIA:

The AIA is an advocate group for the companies that sell property/casualty insurance. As noted earlier, its free information is limited, but some current insurance issues receive particular attention from the association's leadership and committees.

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Anand Shetty

Edward J. Keller Jr.