How Do
Insurance Companies Operate?
Insurance
companies are generally organized in five broad departments: claims, finance,
legal, marketing and underwriting. Marketing and underwriting are the ?yes?
departments, while claims and finance are the ?no? departments. The legal
department is often the referee between these competing interests. Underwriters
seek to develop insurance products that can be sold to their customers for a
profit. Though many standard insurance policies are made up of form documents,
most underwriting departments will craft their own collection of forms and
endorsements to provide the marketing department with the ability to say yes to
customers and potential customers. While the underwriting and marketing
departments want to sign up as many insureds as possible to collect premiums,
the claims department manages claims when an insured seeks to recover on its
insurance assets.
The
underwriting department will say that it has no effect on a decision to pay a
claim, but this is not always so. When accommodation on a claim is requested by
a good customer, or by a broker that brings the carrier a lot of business, the
underwriting and marketing departments will sometimes intercede with the claims
department. The marketing and underwriting departments are judged by their
premium collections and retention ratios (i.e., the percentage of insureds who
renew their policies with that insurer), while the claims department is judged
by how little it incurs resolving claims. Thus, there is an inherent and
perpetual tension among these departments. These financial measures drive
insurance company management and profits, as well as the bonuses paid to
department management.
How Do
Insurance Companies Make Money?
Quite
succinctly, there are only three ways that an insurance company can make money:
(1) underwriting profit; (2) investments; and (3) reduced overall claims
expense. Examining each of these potential profit centers helps to explain
insurer motivation in claims handling.
An
underwriting profit occurs when an insurance company insures policyholders who
have few or no losses. By insuring these ?good risks,? the insurance company
takes in premiums but does not have to shell out any money for claims. If the
underwriting department has done its job, it has carefully underwritten
potential insureds for risk profiles that are favorable to the insurance
company?s complex underwriting models. These models typically contain numerous
complex factors about the type of business or service provided, number of locations
and employees, historic loss patterns, future anticipated claim trends and a
variety of nuanced categories that are unique to each insurer. When
underwriting standards become lax ? as they did in the early 1980s, with many
commercial liability insurers who later became insolvent as a result ? the
ultimate losses that pour in wipe away any underwriting profit and result in
underwriting losses. While risk evaluation and product pricing are carefully
regulated by state insurance commissioners, whether an insurance company can
generate an underwriting profit is to a certain extent beyond its control
because of the fortuitous nature of losses and the continuous expansion and
creativity of the plaintiff?s bar.
Investment
income, like underwriting profits, is also largely beyond the control of the
insurance companies. Insurers are scrutinized with respect to their investment
portfolios. State laws and the National Association of Insurance Commissioners
(NAIC) regulate total percentages of stock market and other riskier investments
in which an insurance company may invest. Because the financial security of
insurers is one of the paramount goals of insurance commissioners around the
country (as no one wants another AIG bailout), insurers simply are not permitted
to invest anything but a small percentage of portfolios in
high-risk/high-reward investments. Most of the insurance company portfolio
investments include bonds, short-term and other low-yield but ?safe? investing
vehicles. Insurance company investments are supposed to be boring and
ultimately safe for the insurance company and its investors and policyholders.
Reduced
overall claims expense is the third and final method by which an insurance
company can generate a profit. Notably, of the three factors, managing claims
expense is the only factor that is considerably within the control of the
insurance company. Keep in mind that the insurance industry is the largest
legalized gambling industry in the world. The nature of insurance is, at its
core, pure gambling. Insurance companies ?bet? that their underwritten insureds
will not have losses. Premiums essentially are set on the basis of: ?I?ll bet
you don?t have a loss this year? or ?I?ll bet you have only .001 losses this
year.? The actuaries within insurance companies are the oddsmakers. The claims
department can be seen as the leg-breakers in this gambling enterprise as they
are the insurance company?s enforcer. The insureds pay their premiums and
demand that the insurance company meet its obligations when a claim is
submitted. The claims department then plays the odds by stiff-arming insureds
whenever possible.
Think about
it from the insurance company?s viewpoint: If it receives 10 claims and denies
all of them, about six of those 10 insureds will simply go away. Of the
remaining four insureds, perhaps two will push back and the insurance company
will pay dimes on the dollar to negotiate a resolution. The remaining two
intrepid policyholders who pursue coverage through litigation will often
recover the most; however, the insurance company has succeeded in reducing its
overall claims expense by starting out with routine denials of all claims ?
just by playing the odds. By employing aggressive defense tactics in claims
handling and litigation management, the insurance companies increase their
chances of an insured abandoning its claim due to cost or frustration and
thereby increasing the insurer?s profits.
This is
unfortunately the model that most insurance companies are built upon. And
because overall claims management is viewed as the only profit factor that is
in the control of the insurance company, senior management typically pays close
attention to how aggressively their claims department handles policyholder
claims. One or two out of 10 claims going into coverage litigation might be
acceptable, but certainly eight or nine out of 10 would be unacceptable and
would dramatically impact the insurer?s profits. But if an insurer?s
?overexuberant? claims management tactics lead to negative regulatory
attention, this can not only result in an impact on profits but also cause
dramatic tension between underwriting and claims department management.
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