What's Going On?

What is going on? Part 1 of 3

What is going on with the insurance industry?

This is a question that I am fielding regularly now from clients, friends and relatives. They have seen their insurance rates increase like never before. They are watching horrific scenes from around the country of damages caused by hurricanes, tornados and wildfires. Therefore, they quickly surmise that the rate increases they are having to pay are an attempt by insurance carriers to have them pay for the catastrophic losses. This makes sense, but is not true.

I will not endeavor to provide a course in insurance statutory accounting principles (SAP) in this article. As many of us know, the work of actuaries is highly complex and based upon a whole lot of data and historic results. But a real quick profit and loss explanation is appropriate to start my discussion and make my point.

A key metric for insurance companies is the combined ratio. A combined ratio or COR, is fairly easy to calculate and is used to measure the financial health and profitability of an insurance company. ?A COR is measured by comparing premiums earned (again, premiums received and premiums earned are even different numbers which is unique to the insurance industry) to the amount the company pays out in claims, known as indemnity, and the expenses to run the company. Expenses to run the company are similar to any organization: office space leases, cost of equipment, salaries and benefits, office supplies and the list goes on and on.

Incurred Losses + Expenses

Combined Ratio: _____________________________

Earned Premium

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Any number in the above equation below 100, is a sign that the insurance company is profitable. I will not say healthy because many numbers can be manipulated in a short term to provide a picture that may not be accurate. If a carrier’s COR exceeds 100, that is an indication that they are paying out more than they are bringing in. For example, for every $100 an insurance carrier receives in earned premium, they are paying out over $100 in claims and other expenses. This is not uncommon for shorter periods of time due to high severity results or a deliberate decision to keep premiums lower when a carrier is trying to grow in a particular market. But it cannot be sustained without eventually impacting a carriers’ reserves and eventually their solvency.

Let’s take a look at the 2 numerators in the equation above. First, Incurred Losses. When a covered loss occurs and is reported, the insurance adjuster investigates, evaluates, negotiates and makes a payment for the damages, commensurate with policy language. Let’s stick with first party property damages for this explanation.? Property damages for this explanation include automobile claims and homeowner claims. What do we all know about the cost of parts for cars and materials for construction? The prices have gone up, and in some cases way up. Supply chain disruptions caused a scarcity of parts and materials that led to higher prices. In addition, with cost of energy, specifically gasoline increased significantly. The cost of all goods that need to be transported; therefore, have seen price increases. In addition, labor costs have increased as the collision repair technicians and the contractors all need higher wages to try to beat back inflationary pressures on their wages. What is impacting incurred losses is not different than what we are seeing in all facets of our economy from grocery stores to restaurants to the price of durable goods.

Now let’s take a look at the second numerator in the above equation, Expenses. There are a lot of expenses that any company has to pay in order to deliver their goods or services. For insurance carriers, the biggest expenses are salaries and benefits. These usually account for well over 80% of a companies budgeted, non-indemnity, expenses. The same pressures that are causing claim costs to escalate and impacting incurred losses are impacting the expense portion of this ratio. Attracting, training and retaining skilled workers is getting more expensive. Outsourcing work is rising, but that’s expensive as well. All of these additional labor related costs, as well as, equipment, rent, energy are adding up to make this equation top heavy.

Finally, we’ll look at earned Premium. Again, this is a topic that could take up many pages explaining how premiums are determined, filed and put into action. But for this brief overview I will make a few key points about earned premiums. Many states have a Departments of Insurance (DOI). Many states, like California, require carriers to ask the DOI permission before they can adjust the premium to reflect the costs of claims and the cost of doing business. For a variety of reasons, a DOI Commissioner can decline a carrier’s request. Perhaps it’s an election year or the commissioner see’s themselves as a consumer advocate and wants to be known for holding the insurance industries’ feet to the fire. One quick point here, the primary role of any insurance commissioner is to ensure the insurance companies admitted in their jurisdiction remain solvent if/when a significant loss event(s) occur. But that may not get one re-elected, so they frequently lose sight of their primary obligation to the people. We are seeing insurance companies reduce their footprint – the number of policies they will write – in some areas and states. This often occurs with homeowner coverages. This is in part due to catastrophic weather exposure, but also due to catastrophic regulatory exposure.

When a rate increase is granted, or administered if approval is not required, it takes time for the impact to be realized. For example, if the price of widget is approved, the retailer can raise the price tomorrow. But in case of an insurance carrier, the new rates apply in the next policy term, which can be 12 months away. Also, the premium must be ‘earned’ not just received to be applied to the COR. For example, if a policyholder pays an annual $1200 premium on January 1, only $100 is earned on January 31, and another $100 earned on February 28, and so on throughout the year. So, while the carrier is paying the current costs of claims and salaries, it’s still receiving premium based upon loss and expense results from months or years earlier.

Please don’t shed a tear for the insurance companies. I am not trying to solicit sympathy for my industry peers. I merely want to provide a little context to what is going on. The insurance industry is receiving some bad press right now, but not all of it is deserved.

I know, as I hear several times a week, it hurts to make an insurance premium payment that is 20%, 25%, 30% higher than it was last time for a product you didn’t use. In some cases, carriers are opting not to offer coverage that you have had for years. That hurts too, and constricts the options which ultimately causes higher premiums as well, as homeowners seek a new company to insure them.

The finances of insurance carriers is quite complex and well beyond what I can capture in this space. The economic pressures that are impacting us all are the same pressures that are impacting insurance carriers.

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End of part 1

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