As we enter another market cycle of a "hard market" I am reminded that we have a large group of clients and industry associates who have not had firsthand experience of a market cycle and may need some explanation of what is occurring and why.
Most of us understand that a hard market is an effort for insurance companies to return to profitability. Higher premiums and elimination of policyholders that have had high losses is the obvious actions underway but these steps are only part of the actions underway.
A period of unprofitability for the industry is not something that happens overnight, and is a result of many factors, NOT just because we underpriced our product. Our lack of profit is not the only symptom of a "soft market" rather it is a result of a series of events put into place by external factors.
The purpose of this article is to explain how and why insurance companies can "run out of product to sell". Yes, insurance companies can sell out of insurance.
Because insurance is an intangible most people cannot understand or conceive how an insurance company can run out of insurance. The reality is, however, that an insurance company is one of the most heavily regulated industries in the world. The "amount" of insurance an insurance company can sell is limited by a myriad of laws.
The same laws regulating what, when and how insurance companies can write are designed to protect the public by making sure the money is available at the time of a claim.
Insurance company accounting requirements specified in law are extremely complex, boring and completely understood only by attorneys, regulators, and insurance industry accountants. Having explained that, I will NOT bore you to tears with technical requirements that you really do not want to know about.
I will, however, oversimplify this explanation so that you can easily see what is currently happening in the insurance market and how that is driving the changes.
VALUE OF MONEY
Logic and common sense tell us that to be profitable an insurance company must collect more premiums than they must pay in claims and expenses, however, that is not necessarily true. The missing factor is investment income. To ensure solvency of the insurance companies state laws require the insurance companies to establish reserves, or monies that have been identified as liabilities of the insurance company. Insurance companies customarily take your premiums at the time you purchase a policy and do not pay claims until sometime in the future with that money. With the right investments the insurance company can supplement their income by investing those premiums in bonds, stocks, and other investments until it is necessary to pay for the claims. Some claims are not paid for several months, or years, and as such provide the insurance company with a great deal of investment income. With this knowledge you can now understand that during times for high yield investments insurance companies can collect less in premium than they pay in claims as long as the investment income will make up the difference. Simply stated, the investment income supplements premiums and in times of high interest and market yield can enable insurance companies to lower their premiums. Indeed, in times of extreme yield insurance companies compete for premium dollars as a means to enable them to further their investment income.
ROLE OF RESERVES
Remember the intense governmental regulation to ensure the solvency of insurance companies? A huge element of insurance company solvency is "reserves" that are mandated by statute.
I will save you the pain of an 18-week course in insurance company accounting practices, and give you a crash course on reserves and how they relate to the current insurance market.
First, you must understand that an insurance company cannot show dollars collected today for premiums as earned income. The insurance company must show a $365. premium collected today as $1 of earned premium and $364. of unearned premium. The following day the insurance company can show an additional 1/365 of the premium or another $1 as being earned. In reality the policyholder can cancel their policy and request the unearned premium be returned to them. Insurance is a prepaid expense of the policyholder until such time as the policy is "used" at the rate of 1/365 per day on an annual policy.
By statute the unearned premiums is a liability of the insurance until it has been "earned" by the insurance company. These monies are called unearned premium reserves.
Another reserve that insurance companies must establish is for claims that they are aware of, but have not yet been paid. Once a claim has been reported to the insurance company they must establish a reserve for that claim. They must estimate how much money they think will be required to pay their liability for this claim. This is just one of the many reserves they must maintain for claims. The logic behind this tactic is that this money is owed to the future recipient of the claim, and as such has been "spent" or "used". Again…The Insurance Company is holding money owed to others, so this is a liability. This does not, however, prevent the insurance company from investing these sums in the marketplace and making investment income from the fiduciary funds. The interest income goes toward the income of the insurance company.
There is yet another claims reserve that few people know about or truly understand called the "IBNR" reserves or money set aside to pay claims for future claims that have not yet been identified. This is an acronym for "Incurred But Not Reported" claims. An example of a claim of this nature is an injury that has occurred but the injured persons have not been identified – i.e. a vitamin manufacturer that has been producing a contaminated product that has slowly impacted the health of its consumers. The consumers have been injured, but the injury has not been identified yet, and the insurance company has not been informed of the injuries and/or claimants. At the end of every policy the insurance company knows there is the potential for claims yet to be paid which have not been reported to them. By law, the insurance company must establish a "reserve" for these claims, and reflect those as a liability.