Understanding Your Insurance Premiums

Brandon: I’ve heard some talk within the insurance industry that we’re getting ready to go into (or we’re in the early stages) of a hard market. What is meant by a hard market? What is a soft market?

Mark Baker: A hard market is generally driven when the insurance company is not making a good rate of return on their premium to pay claims and expenses.

A soft market is generally when they have more money to invest into insurance exposure (i.e. coverages). Soft market is usually driven by a higher rate of return on interest. Profitable underwriting; meaning the accounts perform well for the premium they receive. Or a company cuts expenses through computerization or where they combine offices and lower staff.

A soft market is usually to the consumers benefit because they are looking for ways to put their money out there to get it working for them through insurance. Usually there is a cutting of expense or an increase of income via rate of return through the stock market or interest.

A hard market is when they turn around and they are not making as much money and they start pulling back in. If every dollar you put out there you lose a $1.01, how many dollars do you want to invest? That says we’re either losing money for lack of investment return or that our portfolio is not performing where we can pay expenses and get our benefit back (i.e. return on investment). Then they usually have to raise rates.

The first thing that happens is they start cutting out exceptions in a hard market. Something that isn’t in their wheelhouse…in a soft market they wouldn’t mind insuring it because they’re trying to get that money out there, get it in use. They will insure things they might not have a lot of comfort in or expertise in. So usually the first form of a hard market is doing away with exceptions and go back to their basics. They second thing is they start raising rates. And that runs until the cycle turns and they have money to invest again either through surplus or return.

READ MORE: 10 Ingredients That Impact Your Auto Insurance

Brandon: So a soft market, consumers may notice better rates? There may be more exceptions? It may be easier to find insurance with X, Y, and Z Company?

Mark: Exactly. In a hard market that risk (i.e. customer) that has a higher exposure would go to what we call an Excess Surplus Lines…a company that charges more for that exposure.

Brandon: What do you mean by exposure?

Mark: Amount of coverage…Use a restaurant for example. A restaurant has a high fire hazard because of the cooking. On the liability side they have a high hazard of slips and falls (the waitress spills coffee on someone). Or the food is not safe…maybe it’s contaminated or not prepared properly. A restaurant is one of those risks that has a little more exposure. In a soft market there will be more insurance companies willing to put their money into that. Because it’s not terrible. It’s not like a dynamite factory. When the market turns hard they will pull away from that. Let’s say they’re a company that insures a lot of contractors. That’s where they have a lot of expertise and comfort in. The insurance company may pull back on insuring restaurants and put their money in contractors that they know they have a comfort with. Then the restaurant has to find insurance through someone else who charges more for the exposure.

Brandon: In theory, it should be less expensive for say an accounting firm based on their exposure versus a restaurant?

Mark: Exactly. The chance of a fire is less. The chance of a General Liability claim is less on an office exposure (versus a restaurant).

If you have a manufacturing class, you have a chance of your product being defective and hurting someone or damaging someones property. Anytime you manufacture or build something you have a higher exposure than an office exposure.

Brandon: Talk about reinsurance and how hurricanes and wildfires affect people in Missouri. A lot of people voice their frustrations about these types of events impacting their insurance.

Mark: You have to go back to 101. Insurance is the law of large numbers. Everyone puts money into this pool (i.e. this insurance company). Then the ones that need it are paid out of that. If you live in Arizona, you won’t have ice damage. You probably won’t have hail. You won’t have weight of ice and snow. You won’t have some of the things we have here (in Missouri). We don’t have wildfires here, but California does. We have tornadoes here. They generally don’t. We don’t have hurricanes here. Where the southern coastal states do. All of that comes into play. What happens is you have a bad year when a lot of those things happen is the insurance company buys insurance called reinsurance.

There are two ways the insurance company buys reinsurance.

One is they could buy an Attachment Point. For example the terms of the policy maybe if the insurance company has a claim over $500,000 then the reinsurance company would come in and take the claim from the insurance company and finishes it.

Or let’s use the example of a $5,000,000 catastrophe (or whatever that Attachment Point maybe) within a specified time period the reinsurance company would come into play.

We’ve seen so many natural disasters of huge amounts it’s hitting the reinsurance companies. The fires, the hurricanes, the tornadoes. Like the tornado in Joplin, Missouri. If that tornado would have gone through the country it wouldn’t have been near as bad. But it went through Joplin. It was historic. It was terrible. Those losses got pushed off to the reinsurance company.

I don’t know if everyone would agree with me on this, but reinsurance companies don’t have a lot of exposure. It doesn’t take too long for the reinsurance company to build their surplus back. They may go to ABC Insurance Company and say,

“we spent $400 million on your recent losses. Your Attachment Point is $500,000 and your premium is ______. We are going to raise your premium a little and raise the Attachment Point from $500,000 to $1 million.”

That would make ABC Insurance Company on the hook for the first $1 million in claims (instead of $500,000). Plus their reinsurance will be the same or more. That will be greater exposure to the surplus of ABC Insurance Company. They will have to pay those claims out of their pocket before the reinsurance company will kick in to help.

It’s similar to what we do as a consumer. We pass off the financial exposure to the insurance company. We take our $500 and buy $50,000 worth of coverage. At $500 it takes a long time to get to $50,000.

Brandon: When the reinsurance goes up it gets passed along to the insurance company and then passed along to us (the consumer), correct?

Mark: It has to.

Brandon: No one wants to talk about it, but tell us how insurance companies make money.

Mark: Let’s talk about the two types of insurance companies first. There is a Mutual Company and a Stock Company.

A Mutual Insurance Company is owned by its policyholders. The idea of a Mutual Company is that it has to remain profitable to provide insurance for its members (i.e. policyholders).

A Stock Insurance Company has to do the same as a Mutual Company, but it also has to pay increased stock value/dividends to the stockholders. Sometimes you will have a Stock Company that has a limitation on the number of owners so it may not be as big as one that is publicly traded or has a lot of stockholders. A Stock Company is generally bigger and have more access to cash because they have the investment of the stockholders. So if they get to a point where they need money they can sell stock. Which a Mutual Company can’t do.

A Mutual Company is based on its performance within its policyholders.

They both derive money different ways. Everyone thinks premiums pay claims. They don’t. There is also the expense of the product, management, product distribution, building maintenance, the field person and adjusters car. Those types of things. Those expenses usually run 25% – 40%…the cost to do business. Let’s say you use 25% for expenses. That leaves $0.75 of every premium dollar to pay claims. Now let’s say their combined loss ratio and expense ratio reaches $1.00. That means the insurance company would be at their break-even mark. If you invested $1 billion today, what would you get? 2 points? Maybe 2.5 points? It’s not a real lucrative investment. For the insurance company to put money back to take care of inflation…the cost of material goes up when a car is fixed, a roof is put on a house, a fire, or wind damage. They have to build inflation in.

It use to be said that if you maintained a breakeven 100% loss ratio and expense ratio (total) and you’re making a couple of points on it, you’re barely making it. Back in the day when investments were 12% – 15% that insurance company could afford to go into a 105% – 107%, even up to 110% loss ratio and expense ratio because they were making another 5 points on their investments. That is a soft market.

When a hard market happens those investments come down. If that trend is at 110% loss and expense ratio and the insurance company is making 2% on their return instead of 15%, now they are losing 8%. That means the insurance company is losing $0.08 on every dollar and they have a $5 billion invested. What’s your choice? Cut benefits or increase prices?

Brandon: So Insurance Companies make money with Underwriting Profit and Investment Profit?

Mark: Yeah. The Underwriting Profit can go up or down based on the return they make through investments and growth. The insurance company could cut expenses too. That’s what you see a lot of companies do. Not just insurance companies. For instance, a company may decide to consolidate from 40 offices to 20 and get rid of so many employees.

Look at Sprint. They’re a perfect example. Sprint is bought by T-Mobile. They won’t keep two corporate headquarters. Do they need two Presidents, two Vice Presidents, etc? They will get rid of part of that and combine part. Someone is going to lose. Those expenses go to the bottom line. That may help prevent raising rates. If one isn’t doing as well as the other they combine expenses and increase profitability.

Brandon: Let’s circle back…you were talking about a Mutual Insurance Company versus Stock Insurance Company. Is one better than the other?

Mark: No. They each have their own place. Historically, Stock Companies are bigger…AIG, Travelers, Aetna, The Hartford…companies that have been in business for many years. Nationwide is a Mutual Company. Auto-Owners is a Mutual Company. Nationwide is a company with over $21 billion in assets. They are a big company. If you compare that to AIG or The Hartford, that might be $500 billion.

The strength of a Stock Company is if they need an influx of cash they sell off stock. Or they cut benefits or their dividends back.

Brandon: As far as how they pay claims or take care of a customer is one any better than the other?

Mark: No. There is always more than one way to look at something. A Mutual Insurance Company will tell you, “I owe more responsibility to my client because my client is my owner/boss. But when it gets in the trenches that employee doesn’t think that way. He/she knows they have to do their job.

Brandon: Tell me about reserve requirements that are put on insurance companies?

Mark: These are easy questions with a lot of answers.

When a claim happens, the insurance company looks at the maximum total they may pay. Let’s say you wreck a car and the replacement value is $20,000. Until that car claim is settled they may put a reserve on it of $20,000. Thinking they may have to total it. Maybe it can be repaired for $10,000. A mechanic friend of mine says, “I can’t see through steel.” You don’t know what’s there until you tear it apart. They get an estimate…”it’s probably repairable…it won’t be totaled.” The mechanic starts fixing the car. The insurance company puts money in reserve for the things they can’t see.

Where it really comes into play is something like a General Liability claim where someone is injured and we don’t know what those future medical costs may be or disability that’s associated with the accident. They will reserve _____ of dollars for future bills. They try to determine what the maximum dollar amount of the claim will be to because that affects the loss ratio we talked about earlier. There are some generally accepted numbers that determine whether an insurance company is stable based on the amount of premiums written versus the amount of reserves or surplus. A surplus for an insurance company is like a savings account for you and I. It’s money/asset you have sitting there that you don’t intend to use.

Reserve requirements other than claims would be…that ratio between the premiums written

Typically in the insurance industry, if you have (for example) $1 billion in premiums and you have a third of that in surplus, you’re considered to be good because not every policyholder is going to cancel at the same time. Some of the best insurance companies like Cincinnati Insurance is about a 1-to-1. Which means they have been able to keep money in their hands to be able to take care of claims. You don’t need insurance the day you buy it. You need insurance when you have the claim. So you want to make sure the insurance company has the financial strength to take care of it.