Commercial insurance is sometimes fraught with tension arising from the competing interests of corporate policyholders and insurance companies. In part one of this two-part essay, Jim Leonard, our guest columnist and former insurance company executive, describes how insurance companies operate and what drives their agenda.
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 odds makers. 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 “over exuberant” 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.
*This essay originally was published on March 7, 2019 by Barnes Thornburg. All rights remain reserved by James Leonard and his firm.
**Our group euphemistically refers to insurance companies as “premium collection companies,” as insurers are typically very efficient when it comes to collecting premiums, but not nearly so when it comes to paying claims.
***Important factors in calculating an insurer’s potential underwriting profit are the cost and recoverability from reinsurance. Because reinsurance is a complex subject that could be the sole topic of this magazine, suffice it to say that virtually every insurer has reinsurance treaties with other insurance companies who insure the risks of the ceding insurer. By insuring their losses, through reinsurance, insurance companies can temper their annual losses with reinsurance recoveries. Like all other insurance, reinsurance carries premiums which must be factored into the insurance companies’ profit margins and their risks on various lines of business.