Insurance Companies

This chapter begins by describing the two most important types of insurance companies, the stock insurance company and the mutual insurance company. In the past decade, many large mutual insurers have changed their form to become stock insurers, and we describe this process called denaturalization. Next, we describe Lloyd's of London and several other forms of legal organization that insurers use in this country. The chapter concludes with a description of the insurance industry. The appendix to this chapter presents some of the author's research on the transformation of the insurance industry in Central and Eastern Europe from a state monopoly to a market based industry. This appendix highlights the role private insurance plays in a market economy

FINANCIAL SERVICES REGULATION IN THE UNITED STATES In November 1999, the Gramm Leach Bliley Act (GLB) (http//www. senate. gov/banking/conf/eotifrpt.htm), which is also known as the Financial Services Reform Act of 1999, became law in the United States. This act marks a milestone of sufficient importance to the insurance market that we must describe it before we can provide information about the different kinds of legal organizations that now sell insurance. One purpose of GLB was to allow banks, security dealers, and insurance companies to combine to form financial services holding companies. GLB allows banks to acquire insurance companies, insurance companies to acquire banks, banks to start their own insurance companies, and insurance companies to start banks. However, most of these combinations will be in the form of holding companies so that firewalls still will exist between capital flowing to and from the component parts. Also, in general, it will remain the responsibility of the individual states to supervise and maintain the solvency of insurance companies, while the federal government has the main responsibility for supervising and maintaining the solvency of the banks and security dealers. Because of their separate status for regulatory purposes, it is still possible to describe the characteristics of insurance companies, even when they are a component part of a larger financial services company.

Before presenting these descriptions, it is important to emphasize that regardless of its form of legal organization, the main function of an insurance company is to redistribute the cost of losses.

THE MOST IMPORTANT TYPES OF INSURANCE COMPANIES

(The most important types of insurance companies are the mutual insurance company and the stock insurance company. These types of insurers write either life or no life (property and liability) insurance coverages. Because of state laws regulating solvency and other matters, a single insurance company cannot sell both life and nonlife insurance. Insurance holding companies, however, can combine both life and nonlife insurance companies in one organization but must keep their operations separate. Thus, families of insurance companies can provide a broad range of coverage, including both life and nonlife, personal, and commercial coverage. Property insurers that provide more than one type of coverage, such as a company selling fire, inland marine, liability, workers' compensation, and automobile insurance, are called multiple line insurers.

STOCK INSURANCE COMPANIES

A stock insurance company is similar to all other corporations where stockholder owners provide the capital to establish and operate the corporation. These owners are entitled to the financial results, whether favorable or unfavorable. By exercising their right to vote, they elect the management of the corporation. Also, the owners may sell their shares (ownership interest) in the company if they choose to do so. The buying and selling of corporate shares is one of the hallmarks of a capitalistic economy. To buy or sell an interest in a publicly owned stock insurance company (a few of which have stock traded the New York Stock Exchange and many of which are listed in the NASD market), both. buyers and sellers would contact a representative of security brokerage firms.

MUTUAL INSURANCE COMPANIES

Mutual insurance companies are nonprofit corporations. The owners are the policyholders insured by the corporation. Policyholders of mutual insurance companies have rights similar to owners of profit making corporations. For example, they can vote to elect the directors of the corporation. The directors, in turn, appoint the management to operate the corporation. Policyholders can also vote on important business matters, such as changes in the corporation's bylaws, or changing the organization to a stock insurance company.

One significant difference between stock and mutual insurance companies is that it is possible to own an interest in the stock company and not purchase insurance from it. Also, it is possible to be insured by a stock insurer and not have an ownership interest in the company. Neither of these positions is possible in a mutual insurer.

A second significant difference between these two forms of insurers is that in a stock company, additional funds not provided by past or present insured’s, but by owners, can be used to absorb losses and expenses not covered by premiums. In some cases, these additional funds could prove to be a benefit to the insured of a stock company.

The major subcategories of mutual insurance companies are advance premium mutual, assessment mutuals, and factory mutuals.

While mutual insurance companies legally are nonprofit corporations, this does not mean that they are run inefficiently. Quite the contrary, many of these companies operate as efficiently as any profit making company. The author has had experience with several large mutual life insurers and has found them to employ the latest techniques in effective business management: As is typical of other forms of insurance companies, mutual insurers show considerable variation in performance.

A Web site run by the National Association of Mutual Insurance Companies (NAMIC), a trade, association of mutual property insurance companies.(http://www. namic.org/) The NAMIC describes' itself as "a full service national trade association with more than 1,300 member companies underwriting 40 percent ($123.3 billion) of the property/casualty insurance premium in the United States. NAMIC's membership includes four of the seven largest property/casualty carriers, every size regional and national property/casualty insurer and hundreds of farm mutual insurance companies.

This site contains information about recent insurance legislation and other areas of interest to mutual insurance companies and their insureds.

ADVANCE PREMIUM MUTUAL

In terms of volume of insurance written, the most important kind of mutual insurance company is the advance premium mutual. Under the advance premium system, policyholders pay their premiums when their insurance begins and become eligible for a dividend when the insurance period ends. Mutual insurance companies pay dividends only when they have favorable, operating results. Favorable operating results occur when the insurance company experiences fewer losses or lower expenses than it predicted or has greater. investment earnings than 'projected. If a mutual insurance company experiences greater losses or expenses than predicted, its ability to pay dividends is diminished. For example, if a mutual life insurance company were to incur substantial losses on its investments, or experience an unusually high number of losses, the insured owner's dividends would be lower. If it continued to experience I large losses, the insurer's surplus account eventually would be depleted. When individuals or business firms purchase insurance from a mutual insurance company, they become owners and share in the financial outcome of ownership, both favorable and unfavorable. Advance premium mutual insurance companies, however, cannot assess their policyholders for unmet claims, as can assessment mutuals,

In the case of mutual life insurance companies, favorable operating results are the norm. As a rule, a built in dividend arises because the annual premium is higher than needed to pay all expected losses and expenses. When, as anticipated, fewer losses occur than were predicted, the policyholder receives a dividend, Unlike dividends from profit making corporations, this dividend does not represent new income to the policyholder; rather, it represents the return of part of the premium. In this sense, the initial premium from a mutual company has a safety factor that can be returned to the policyholder if nothing unexpected occurs during the year. The Internal Revenue Service calls the dividends paid by mutual insurance companies a return of premium and they are not subject to federal income tax.

ASSESSMENT MUTUAL

Assessment mutuals do much less business than advance premium mutuals. Under the assessment system, insured members may or may not pay a premium when the insurance period begins, but they become liable to pay their fair share of the insurance company's losses and expenses when the period ends. An insured's liability in an assessment mutual may or may not be limited, and potential purchasers from such a company should determine their maximum liability before purchasing insurance.

The advance premium and the assessment mutual systems contrast in the following way. Insureds pay a relatively large premium at the beginning of the policy period to an advance premium mutual with, of course, the potential of receiving a dividend at the end of the period. With an assessment mutual, insureds usually pay a relatively small premium at the beginning of the policy period, with a liability for a relatively large payment at the end of the period. While most advanced premium mutual insurance companies have given up the right of assessment, those companies that have not given lip this right have the right to assess in the case of company failure. Consequently, if the insurer becomes bankrupt, current policyholders will be required to contribute to meet any unmet obligations. This "assessment" is not the same as in " assessment" mutuals where the company plans to charge an assessment at the end of the year reflecting a fair share of the claims paid during the year.

FACTORY MUTUAL

The factory mutual is a third type of mutual insurance company. An important distinction of this type of insurer is that it provides substantial loss prevention services, including regular inspection of the insured premises. Only those exposures meeting rigid safety and construction qualifications (for example, those with fire sprinkler systems) can qualify for coverage. Risk managers call this type of exposure a highly protected risk. Only a limited number of exposure units large, well constructed, carefully maintained exposures are eligible for insurance by the factory mutual.

Many factory mutuals have required the advance deposit of the entire premium for multiyear policies. When the opportunity cost of tying up funds is high, this makes the insurance coverage more expensive. Nevertheless, because of selective underwriting standards, the losses and, hence, the insurance costs may be significantly lower for firms able to get insurance from a factory mutual. Readers can find more information about factory mutual insurance at (hap. Ilwww.finglobal.com).

PERPETUAL MUTUAL

Perpetual mutuals are of historical significance. Although a few companies still operate on the perpetual basis, they are not a relevant factor in the insurance marketplace. The perpetual mutual requires each insured to contribute a large initial premium, with no future premiums required. The insurance pool is run from the earnings on the initial deposit, Ibis is the type of insurance operation organized by Ben Franklin in Philadelphia in the eighteenth century.