Insurance and Economic Development - Assignment Example

? Part I: Insurance and Economic Development Insurance and its effect on entrepreneurial attitude, innovation and investment in the economy Investment in finance terminology refers to a monetary or financial asset purchased with the thought or idea that the asset will induce income or be appreciated in value in the future and provide capital gains. This is a phenomenon which is used practically all over the globe in almost every genre of business. Insurance companies are entities that provide insurance to individuals and other companies. These parties receive disbursements against losses incurred and they get financial protection from the insurance companies. The way the insurance company makes payments more easy and convenient to the insured is that it pools in the risks of various customers of different individual risks and invest in relevant financial assets such as bonds, stocks, real estate, mutual funds etc. This enables the insurance company to establish a suitable correlation of risks and returns so as to reduce the overall risk. Considering the nature of the service provided by insurance companies, they ensure financial protection for individual investors who then are ready to invest in their willing ventures without any fear of liquidation or insolvency. This aspect fosters entrepreneurial attitude that is creation of new businesses takes place and innovation is triggered in the market by those who are insured. This ultimately accelerates investment in the economy which in turn enhances economic development as the productive capacity of the firms and the economy as a whole increase. This further enhances living standards of people and per capita income also rises. The entrepreneurs are willing to take risk as they get protected financially with the help of insurance companies which pool in risk of versatile clients. Firms get willing to take additional risks, invest in Research & Development (R&D) and search for and exploit more investment opportunities in the market. This is quite of an effective benefit for insured companies as they enhance their market position and stabilize their status among competition. The market today is filled with new and attractive opportunities and businesses, the thing to do is to go and exploit them and this is possible only if a company is ready to take risks which are in turn enabled if they are insured. Uninsured companies, on the other hand, are not able to reap out the benefits of innovation and tapping into new markets. This is because they have not created a framework for risk mitigation which is present when a firm is insured. Uninsured companies invest less of their earnings in innovation and so they participate less in domestic as well as global markets leading to less acclaimed market share. 2. Insurance and its contribution to consumption and economic stability Consumption is the spending of resources particularly money to acquire something. In financial terms, it is discussed alongside savings as they are two totally opposite concepts. Savings means to save money for the future; this concept is tried to being implemented in almost every country as this leads to benefits for the economy. Consumption trends vary between people and between their life stages. These two imperative concepts make up the standard of living of people in an economy. To produce an optimal standard of living, there should be a balance between consumption and saving patterns. Consumption patterns are one of the igniters of economic development, growth and the wellbeing of the dwellers of a country. Insurance is a helping tool for people to smoothen their consumption throughout their lives. Regardless of any insurance type, this service works as a security border for households as it provides financial protection; with its help they can stabilize their consumption throughout their life time. The added advantage of this is that in times of income fluctuations, consumption remains unwavering. Property or home and damage insurance shield the status of clients in unfavorable circumstances such as fire breakouts in homes or offices etc. Casualty or health and accident insurance gives out resources when they are needed the most. Life insurance is a long-term form of insurance which secures relatives of the insured person from financial encumbers and bad times in case of death. This type of insurance can also provide income in the form of a lump sum payment or annuities at the time of retirement. Overspending and over saving both hinder the formation of an optimum lifetime standard of living for people. This anomaly is resolved with the induction of insurance, it helps clients to redesign their consumption patterns and smooth them out instead of indulging in practices such as overspending or over saving, both of which can lead to adversity in the future. Insurance provides a shield for clients’ expenditures and so they can figure out their consumption limits in a better way. The cost of an insurance service is not a big hurdle as there is a little down payment with premium installments as per the convenience of the client and in return they are benefitted with financial protection along with consumption smoothing throughout their life time. As consumption comprises of 70-80% of the total GDP of a country, its smooth running will definitely lead to economic development as well as economic stability. The correlation between these two indicators will be favorable. Part II: Insurance Companies’ Finances Horizon Insurance Corporation – HIC Part A 1. Balance Sheet and Policyholders’ Surplus The following table represents HIC’s Balance Sheet and its policyholder’s surplus as at January 1, 2010: HORIZON INSURANCE CORPORATION (HIC) - BALANCE SHEET (as of January 1, 2010) Assets Amounts (In US $000) Liabilities and Surplus Amounts (In US $000) Assets Liabilities Bonds $350,000 Loss Reserves $170,000 Common Stock $115,000 Unearned Premiums $125,000 Commercial Buildings $30,000 Loss Adjustment Expenses $25,000 Cash and money market investment $18,000 Commission Payable $11,000 Mortgage related securities $40,000 Total invested assets $553,000 Total Liabilities $331,000 Premiums Receivable $35,000 Surplus and Capital Office Equipment $3,000 Paid-in Capital $26,000 Unassigned Surplus $234,000 Total Policyholders' Surplus $260,000 Total Assets $591,000 Total Liabilities & Surplus $591,000 HIC’s total policyholder’s surplus comes out to be $260 million after deducting total liabilities from total liabilities and surplus. 2. Unassigned Surplus Computation Considering if the paid-in capital is 10% of the total policyholder’s surplus, the unassigned surplus turns out to be $234 million ($260 million - $26 million) as depicted in the above table. 3. Investment of Unassigned Surplus For insurance companies, the amount of surplus is an imperative determining agent for the level of business that they can extract and exploit. The higher the surplus amount made up of paid-in capital and unassigned surplus, the better for an insurance company and also a means of greater security for its policyholders. As casualty refers to an accident or emergency, funds should always be present and ready for dispatching to customers or policyholders. So a casualty insurance company should invest in funds that are less risky in nature and provide assured and consistent streams of cash flows to it. On the other hand, property insurance is given but the chances of claims are very low though there can be annuity payments or a maturity payment at the end of the tenor. HIC, as a property and casualty insurance company should invest in assets that have an unequal correlation which will reduce the overall as well as standalone risk of the investment assets. The assets should include: Bonds: These investments are less risky and provide a consistent and regular stream of cash flows in the form of interest. Bonds are of short term as well as long term nature; for HIC as a property and casualty insurance company, both types of bonds should be bought to get a reduced risk and a reliable and favorable overall return. Government bonds are almost risk-free and they comprise of T-Bills (short-term: less than a year) and Treasury Bonds (more than one year). Real Estate: Investment should be carried out in relevant and profitable construction projects including buildings, flats, plots, factories and other REITs (Real Estate Investment Trusts). Mortgage related securities: These should also be invested in to enable the insurance policies to property clients are easily and effectively run. Common Stock: Investments in Common Stock is relatively riskier as they are prone to fluctuations in the concerned stock markets in which they are listed. However, stocks of less riskier nature or of blue chip companies which provide regular dividends to shareholders are a good choice to invest for HIC. Part B 1. Income Statement The Income Statement for Horizon Insurance Corporation for the year ended December 31, 2010 has been prepared as follows: HORIZON INSURANCE CORPORATION - INCOME AND EXPENSE STATEMENT (for the year ended December 31, 2010) Particulars Amounts (In US $000) Amounts (In US $000) Revenues Premium Written $180,000 Premium Earned $185,000 Investment Income Interest $12,000 Dividend $2,000 Rental Income $400 Capital Gain from securities $800 Total Investment Income $15,200 Total Revenue $200,200 Expenses Net Losses Incurred $115,000 Loss Adjustment Expenses $10,000 Total Loss and Loss Adjustment Expenses $125,000 Commissions $12,000 Premium Taxes $4,000 General Insurance Expenses $35,000 Total Underwriting Expenses $51,000 Total Expenses ($176,000) Net Income Before Taxes $24,200 Fed Income Tax (30%) ($7,260) Net Income $16,940 1. Description of the main components of the Income Statement Revenues: For an insurance company, its revenues are its cash inflows and there are two principal fonts for these cash inflows: Premiums, and Investment Income Premiums are the major source of revenue or cash injection into the business as they pertain to the sole business of insurance companies. These premiums earned are the faction of total premium for which insurance security or protection is made available. Premiums are yielded time to time as they are paid by clients in advance and most of the payments are made as per the client’s discretion so they pool in irregularly. The component of premium earned constitutes more than 92% of the total revenue of HIC. Investment Income is the income generated through investments in financial assets that are mostly carried out consuming the unassigned surplus of insurance companies. The income is classified into their respective investment classes i.e. interest income is generated from bonds; dividends from stocks, rental income from real estate investments, and capital gain arise both from stocks and real estate while selling them. Expenses: In contrast to the revenues, the expenses are the cash outflows of an insurance company. Here as well, there are two main constituents of expenses, listed as follows: Total Loss and Loss Adjustment Expenses, and Total Underwriting Expenses Total Loss and Loss Adjustment Expenses include net losses incurred which are the payments made to insure losses that incurred throughout the year and the loss adjustment expenses which are used to adjust the losses by the insurance company. These expenses take out a majority portion of total expenses of around 71%. Total Underwriting Expenses are incurred to guarantee clients their insured amounts or policies and they comprise of commissions, premium taxes payable and general insurance expenses. This head of expenses constitute a lesser proportion of total expenses (around 29%). After deducting the total expenses from total revenue, the net income before tax came about out to be US $24.2 million. As the tax rate was not given, an average percentage of 30% has been taken and the bottom line or the net income turned out to be US $16.94 million. 2. Evaluation of HIC’s performance using the Combined Ratio and the Overall Operating Ratio A combined ratio is computed to assess an insurance company’s overall underwriting performance’ it has two constituents, the Loss Ratio and the Expense Ratio. The Loss Ratio is calculated as follows: Loss Ratio or LR = (Incurred Losses + Loss Adjustment Expenses) / Premiums Earned Loss Ratio for HIC comes out to be: LR = (US $115 million + US $10 million) / US $185 million LR = 125 / 185 LR = 67.57% The smaller the loss ratio the better for the company and an ideal LR should hover between 65% and 75% therefore the loss ratio for HIC is quite favorable. Expense Ratio or ER = Underwriting Expenses / Premiums Earned The ER for HIC is computed as follows: ER = US $ 51million / US $185 million ER = 27.57% Here as well, a low ratio is preferable and an ideal Expense Ratio should vary between 25% and 40% therefore, with an ER of 27.57%, HIC is quite efficient in utilizing its underwriting expenses to earn premiums. Combined Ratio = Loss Ratio + Expense Ratio Combined Ratio = 67.57% + 27.57% Combined Ratio = 95.14% The combined ratio of HIC comes out to be 95.14%. Combined ratio is one of the most commonly used indicators of underwriting profitability and an ideal figure is less than 100% which depicts an underwriting profit. The figure computed for HIC is a quite favorable one and it shows that HIC is earning on its underwriting expenses. HIC is only paying out US $95.14 in expenses and claims after earning a whole US $100 in premiums so this proves HIC’s efficiency in profiting from underwriting expenses. Overall Operating Ratio To assess an insurance company’s overall operating performance in terms of underwriting and investment both, the overall operating ratio is computed. The formula of which is shown below: Overall Operating Ratio = Combined Ratio – Investment Income Ratio Investment Income Ratio is calculated as: Net Investment Income / Earned Premium Investment Income Ratio = US $15.2 million / US $185 million Investment Income Ratio = 8.22% The higher the investment income ratio, the better performance of a company is depicted. The Overall Operating Ratio comes out to be = 95.14% - 8.22% Overall Operating Ratio = 86.92% An overall operating ratio less than 100 depicts an overall profitability for a company so is the case with HIC which has earned an overall operating ratio of 86.92%. This means that the investment income was enough to offset the underwriting loss for HIC. 3. Class Rating and Merit Rating There are various methods to develop rates for insurance for clients; among them class and merit rating occupy the most popular positions. Class Rating An underwriting class is established which contains all exposures or policies of clients which are similar in attributes and a same rate is levied upon each of the policies. As in this rating method, a pool is made up of similar exposures; the rate created and charged replicates the average loss experience. Class rating, also known as group rating, takes into account the postulation that the prospective losses to be insured will be based on the same category of aspects. For instance, insurance pertaining to home owners bifurcates into the material used for construction, the size and age of the home, and other materials such as protective devices comprising of fire extinguishers and smoke detectors. In class rating, all homes coming under these attributes are put into the same group or class and charged the same rate. Apart from property or home insurance, class rating is applied in workers compensation, car insurance, life and health insurance. There are two procedures to compute class rates, listed as follows: Pure Premium Method, and Loss Ratio Method Pure Premium is calculated as follows: (Incurred Losses + Loss Adjustment Expenses) / Number of units of exposure If we assume that the Incurred losses and loss adjustment expenses constitute a figure of US $42 million and the exposure units are 700,000, then the pure premium will come about to be = US $42,000,000 / US $700,000 = PP = US $60. The pure premium will be used to compute the gross rate in class rating. Gross Rate = Pure Premium / (1 – Expense Ratio) Gross Rate = $60 / (1 – 0.42), supposing the expense ratio is 42% of the gross rate. Gross Rate = $60 / (0.58) Gross Rate = US $103.45 The final rate charged will be US $103.45. Loss Ratio Method: In this procedure, the actual loss rate and the expected loss rate is compared and the insurance rate is adjusted relatively. Actual Loss Ratio = (Incurred Losses + Loss Adjustment Expenses) / Earned Premiums The second factor to be considered, the expected loss ratio is the premiums that can be expected to be used pay to insure losses in the future. Let’s illustrate through an example, suppose for an insurance facility, the incurred losses and the loss adjustment expenses are up to $810,000 and the earned premiums are $1,000,000 then the actual loss ratio will come about to be 81%. If the expected ratio projected is 70%, the insurance rate charges must be increased by the following percentage: Rate Change = (Actual Loss Ratio – Expected Loss Ratio) / Expected Loss Ratio Rate Change = (A – E) / E Rate Change = (81% - 70%) / 70% Rate Change = 15.71% For the Loss Ratio method of determining the class ratio, the insurance rate charged currently must be increased by 15.71% as per this example. Merit Rating In the merit rating method, past loss experiences are taken into account and rates are altered up or down accordingly. Merit rating is mainly used for general and liability insurance policies. The procedure to compute a merit rate is through experience rating. Each and every individual policyholder’s rate or the class rate is regulated according to the past loss experience. This is used to determine the direction of fluctuations in the policyholder’s premium for the next period. The loss experience for the last three years is examined and used to figure out the next policy year’s premium. The class rate for the policy period is reduced if the insured client’s past loss experience is better than the average for the class as a whole. If the case is the opposite that is if the loss experience is worse than the class average then the class rate is escalated. To find out the intensity of a rate change, a credibility factor is used to adjust the loss experience based on the volume of experience. The formula for computing the premium change in merit rating is almost the same as class rating but with the inclusion of a credibility factor. The formula is as follows: Premium Change = {[(A – E) / E] * C} Let’s take an example of a retail firm which has taken an experience-rated general liability insurance policy. Suppose the annual premiums are up to US $35,000 and the expected loss ratio is 32%. If the actual loss ratio over the years preferably three is 23% and the credibility factor (c) is 0.28, the company will be granted a reduction in the premium up to: Premium Change = {[(23% – 32%) / 32%] * 0.28} Premium Change = -0.07875 or -7.875% Considering this, the premium change for the next policy period will be Premium Change = US $35,000 * (1 – 0.07875) = US $32,243.75 Premiums can be de-escalated by favorable loss experience so experience rating or merit rating induces financial incentive to reduce losses for companies. 4. Computation of Pure Premium and Gross Rate per unit for HIC (a) Pure Premium = (Incurred Losses + Loss Adjustment Expenses) / Number of units of exposure PP = $20,000,000 / 100,000 Pure Premium = $200 (b) Gross Rate per unit of coverage = Pure Premium / (1 – Expense Ratio) Gross Rate = $200 / (1 – 0.2757) Gross Rate = $200 / (1 – 0.2757) Gross Rate = $200 / (0.7243) Gross Rate = $276.129 5. Why an insurance company can lose money from its underwriting operations and yet report profits on its income statement? An insurance company can lose money from its underwriting operations and still report profits or a positive bottom line on its income statement. This is possible if the investment income generated by the company offsets the underwriting loss. This is determined by the investment income ratio which is a ratio of net investment income to the earned premiums; this percentage should be as high as possible as it is beneficial for insurance companies in offsetting underwriting losses. An underwriting profit is also figured out if the combined ratio of a concerned year is below 100%. In case of losing money from its underwriting operations, a company still makes profits just in the same way as a normal manufacturing company incurs losses from its core operations in some certain periods but offsets or reduces them through other income generated through sources such as interest income from bonds, dividends from stocks, rental income from property or real estate and capital gain from stock and properties while selling them off. References Mishra, A. 2010. Does Insurance sector foster economic growth? Retrieved December 27, 2011, online, from, http://www.humanresourcespeople.com/profiles/blogs/does-insurance-sector-foster Haiss, P. and Sumehi, K. 2006. The Relationship of Insurance and Economic Growth – A Theoretical and Empirical Analysis. Paper for presentation at the 2006 EcoMod Conference, Hongkong, June 28-30, 2006. Retrieved December 27, 2011, online from, http://www.ecomod.org/files/papers/1454.pdf  Pietersz, G. 2011. Premium Earned. Retrieved December 27, 2011, online, from, http://moneyterms.co.uk/premium_earned/ IRMI 2011. Written Premium. Retrieved December 27, 2011, online, from, http://www.irmi.com/online/insurance-glossary/terms/w/written-premium.aspx Insurance Quote Compared.com 2009. What does Combined Ratio mean? Retrieved December 27, 2011, online, from, http://www.insurancequotecompared.com/combined_ratio.html Med India2011. Operating Ratio: Insurance Glossary. Retrieved December 27, 2011, online, from, http://www.medindia.net/insurance/operating-ratio-iris.htm Auto Health Home Insurance 2003. Underwriting Expense Ratio. Retrieved December 27, 2011, from, http://www.autohealthhomeinsurance.com/glossary/underwriting-expense-ratio.html US Business http://activemedia-guide.com/busedu_insure.htm Read More