The providers of commercial insurance are extraordinarily diverse. They vary in size, specialty and role in the industry.
Insurance Companies: Insurance companies can be categorized in many ways. One is by the size of their policyholder surplus or capital. The larger the policyholder surplus the more risk they can assume. The smallest companies have less than $1 million in surplus and the largest more than $2 billion. Most fall into the $250 million and under policyholder surplus category. Insurers can also be divided according to premiums, which are roughly equivalent to revenues. The largest have premiums in excess of $10 billion.
Most commercial insurers are stock companies owned by their stockholders, but some are mutuals, which are owned by their policyholders, and a few are reciprocal insurance exchanges. Reciprocals are an old form of insurance entity where members or subscribers provide insurance to one another; share profits, losses and expenses; elect a board; and appoint an attorney-in-fact, which may be an individual or a corporation, to manage the operation.
An insurance company may be a single entity or a holding company with subsidiaries. Subsidiaries may be organized to operate in a single state, sell different insurance products from the parent organization or cater to a nonstandard market. Some parent companies are domiciled outside the United States and some insurers have non-insurance related parents. Large commercial insurers generally operate in most states and some have global operations. Smaller or specialized insurers may focus on a specific geographical area or specific states.
With so many different kinds of businesses seeking insurance, it’s not surprising that insurers tend to specialize. Specialization facilitates the accumulation of expertise. In addition, insurance works best where an insurer has a large number of policyholders with similar exposures to loss. The more policyholders of the same type there are, the better the insurer is able to predict losses for that type and price the coverage accurately, according to a mathematical premise known as the law of large numbers.
The law of large numbers works best for personal lines insurers with thousands of similar auto and homeowners policies and in commercial lines for small Main Street type businesses. These smaller firms tend to be similar in size and loss exposures and are generally covered by a standard policy known as a Business Owners policy, (see Types of Policies). By contrast, larger firms vary widely in their exposure to loss. Nevertheless, many commercial insurers concentrate on certain types of businesses or insurance coverages or both. They may target firms in the energy or transportation fields, for example, building contractors or financial services institutions. They may be specialists in directors and officers liability insurance, medical malpractice liability insurance, surety bonds, crop insurance or workers compensation, sometimes covering other incidental risks as well. Many personal lines insurance companies offer commercial insurance but generally only to typically small, low-risk, kinds of businesses and many commercial insurance companies offer personal lines insurance as well as life insurance and other financial services products.
Commercial insurers that have been licensed or “admitted” to do business in a state by the state insurance department are generally willing to cover most business risks. (The term “risk” in the insurance industry can mean a peril insured against, such as the risk of fire, and also the entity insured.)
However, some risks are hard to place in the standard market because they don’t meet licensed companies’ underwriting criteria. Among the most difficult to place are: unusual or unique risks that are hard to price if the insurance industry has no prior experience with them, such as tattoo and body piercing shops when they first began to appear; risky or substandard risks, such as fire coverage for a business with a prior history of fires; businesses whose operations are very complex, such as an offshore oil rig; and exposures that require higher limits than most companies are willing, or able under regulatory guidelines, to provide. (To safeguard an insurer’s financial stability in the event of a total loss, insurers cannot devote more than a certain amount of their underwriting capacity to insure any one risk.) In such cases, part of the risk may be insured in the standard market and the remainder, or “excess” in the surplus lines market.
Surplus Lines: The surplus lines market, a group of highly specialized insurers that includes Lloyd’s of London (see Global Dimension/Lloyd's of London), exists to assume risks that licensed companies decline to insure or will only insure at a very high price, with many exclusions or with a very high deductible. To be eligible to seek coverage in the surplus lines market, a diligent effort must have been made to place insurance with an admitted company, usually defined by a certain number of “declinations” or rejections by licensed insurers, typically three to five. Many states provide an “export list” of risks that can be insured in the surplus lines which obviates the diligent search requirement.
The terms applied to the surplus lines market -- nonadmitted, unlicensed and unauthorized -- do not mean that surplus lines companies are barred from selling insurance in a state or are unregulated. They are just less regulated. Each state has surplus lines regulations and each surplus lines company is overseen for solvency by its home state (see (Regulation ). More than half of the states maintain a list of eligible surplus lines companies and some a list of those that are not eligible to do business in that state. In addition, depending on the state, the surplus lines agent or broker, who must be licensed, is responsible for checking the eligibility of the company.
In a number of states, surplus lines companies are also monitored by surplus lines organizations, known as “Stamping Offices,” which, among their many functions, assist their state’s department of insurance in the regulation and oversight of surplus lines insurers. They also evaluate insurers for eligibility to do business in the state and review insurance policies obtained by surplus lines agents or brokers for their clients.
The amount of business insured in the surplus lines market has grown over the years but also tends to fluctuate, depending on the insurance cycle, (see Market Conditions/Underwriting Cycle). Not surprisingly, surplus lines companies thrive in hard markets when certain kinds of coverage that are available in soft markets from standard insurers, such as nursing home insurance, may be more difficult to obtain. (In the insurance industry, in a hard market the price of coverage increases and insurers are more selective about the risks they assume because capital and, hence, underwriting capacity is limited.)
The Residual Market: Businesses that cannot obtain insurance in the standard market may have another choice, depending on the type of insurance they need, where they are located and why they have been rejected for coverage. If they are looking for property coverage and are considered high risks because of conditions beyond their control, they may be eligible for insurance under state-run programs known collectively as the “residual,” “involuntary” or “shared” market because all property insurers doing business in the state share in the premiums and losses.
For properties along the coast where the risk of windstorms is high, there are Beach and Windstorm Plans, in some states known simply as Windstorm Plans. For businesses in urban areas with high crime rates, there are FAIR (Fair Access to Insurance Requirements) Plans, property pools created by Congress after the urban riots of the 1960s to ensure the availability of property insurance. Eligibility for property coverage under FAIR Plans extends to businesses in areas prone to brush fires in California. In coastal areas vulnerable to hurricanes in some Eastern states, FAIR Plans provide windstorm coverage.
In addition, since auto liability insurance is mandatory in all states, all 51 jurisdictions provide auto insurance programs for businesses that have difficulty obtaining auto insurance in the standard market. Most are assigned risk plans, where all auto insurers in the state are assigned residual market applicants on a rotating basis according to their market share. A few states have somewhat different arrangements to ensure that nobody has to drive without liability insurance.
Workers compensation insurance is also available from the residual market. The mechanism used to handle the workers compensation residual market varies from state to state. In the six states with a monopolistic state workers compensation fund, where the state provides workers compensation insurance to all employers, all businesses are insured through that fund. In most states with a competitive state fund (an entity that competes for business with private insurers), the fund accepts all risks rejected by the voluntary market, thus eliminating the need for assigned risk plans. In states without a competitive fund, insurers may be assigned applicants based on their market share and service those employers as they would employers that came to them through the voluntary market, through a system known as direct assignment. They may also participate in the residual market through a pooling arrangement in which all participating workers compensation insurers share the premiums and the losses.
Before a firm can be offered workers compensation coverage through the assigned risk plan, in most states the applicant must have been rejected in the voluntary market by two insurers. The firm's application for coverage is sent directly to the plan's administrator, which either assigns the business to one of the direct assignment insurers or insures it in the pool.
Just as businesses are able to transfer risk to insurers, known as primary insurers in the insurance community, insurers are able to transfer or “cede” some of the risk they assume in insuring businesses to other insurance companies, known as reinsurers. By transferring some of the risk primary insurers reduce their liability for losses, which allows them to write more insurance. Some insurers are heavily reinsured, others are not.
Reinsurers reimburse primary insurers for losses, according to the terms of the reinsurance contract, either on a shared or proportional basis, with the primary insurer and reinsurer sharing both the losses and the premiums collected from the commercial policyholder, or on an “excess-of-loss” basis, with the reinsurer assuming losses above a certain level for a fee. Reinsurers also spread the risk they have assumed as a result of the reinsurance transaction by selling off slices and layers of risk to other reinsurers all over the world.
Reinsurance is an international business. (See Top Ten Global Reinsurers in the Ranking Section).
Distribution At the retail level, commercial insurance is distributed by insurance agents and brokers who work for organizations that are part of the distribution system, insurance agencies and brokers. Recently, however, the lines between agencies and brokers have become blurred. Traditionally, agents have represented the insurance company and brokers have represented the client. Agents and brokers are known as producers. Agents may be captive agents selling policies written by a single insurer, the agent’s employer, or an independent agent selling policies from a number of different insurers. Independent insurance agencies have a larger portion of the commercial lines business than captive agencies -- about two-thirds. For personal lines, the ratio is reversed.
It is the broker’s responsibility to seek out appropriate insurance coverages for the client and obtain the best overall price, terms and conditions. Brokers are most often associated with large or complex commercial lines risks.
Brokers may also become “wholesalers” who act as intermediaries between retail brokers or agents and insurance company underwriters. To be able to transact business with surplus lines insurers, wholesale brokers must be licensed as surplus lines brokers in the state where the policyholder or the risk to be insured is located. Wholesale brokers may also work with other wholesale brokers in the London Market, (see Lloyd’s and the London Market), or elsewhere to secure coverage.
Wholesale brokers may also be managing general agents, who are given authority by insurers to underwrite and “bind” insurance -- provide temporary coverage until an insurance policy can be issued. Managing general agents, who have a close relationship with the insurance companies they work with, may also handle claims and even help in the placement of reinsurance contracts.
Managing general agents may also arrange so-called program business which is specialty insurance for homogeneous groups of policyholders, such as members of a specific industry. These programs, often offered and endorsed by trade associations, may provide coverage at lower prices. As insurers seek out niche products, programs are increasingly available to a wide range of businesses and organizations from bed and breakfast inns to churches. Programs may also provide specially tailored liability insurance for professionals, such as vocational or physical rehabilitation specialists who work part or full time out of a home office. To be successful, a program must generate a sufficient volume of premium and the risks within each program must be relatively homogeneous.
Insurance company employees, whether they work for standard, surplus lines or reinsurance companies, are compensated the same way that employees in other industries are compensated, with bonuses and other incentives in many companies for outstanding contributions to the organization.
Producers and others in the retail and wholesale distribution system are compensated in a variety of ways. Captive insurance agents are compensated by their insurance company employers, while independent agents are compensated by the insurers with whom they have placed business. Independent agent commissions may be calculated based on the business received, and percentages may differ among insurers and for different types of coverage. Independent agents may also receive contingent commissions, not unlike incentives provided in other industries to their sales force, for a high volume of business or business that was especially profitable.
Brokers may receive compensation from several sources: fees paid by their policyholder clients; commissions paid by the insurer with whom business is placed, calculated as a percentage of premium charged; and contingent commissions paid by insurers based on the profitability and/or volume of the business. Some of the largest commercial lines brokers have recently discontinued the practice of using contingent commissions as incentives. Since the broker represents the client not the insurer, the existence of commissions paid by the insurer must be disclosed to the client.
Managing general agents are compensated entirely by the insurer, often based on the outcome of the business generated.
Risk management deals with loss exposures -- circumstances that exist inside or outside a company’s operations that have the potential to cause a loss. A major incident such as a fire or explosion at a manufacturing plant or hurricane force winds that lift the roof off the building could shut down operations. On the liability side, a lawsuit, if successful, could jeopardize a company’s financial well-being.
Large companies generally employ risk managers to manage the risk of loss. It is the risk manager’s responsibility to anticipate, evaluate and minimize the adverse impact of all possible losses. Strategies for controlling losses include avoidance -- avoiding the activity that could produce a loss altogether if the activity, product or service can’t be modified; loss control techniques, such as limiting access to warehouses to reduce the incidence of theft; and transferring the financial consequences of potential losses to an insurance company.
Once a decision has been made to purchase insurance, the risk manager selects an appropriate agent or broker to solicit bids. In the process, the risk manager must supply the broker with all the necessary information about the company that commercial lines underwriters might need to evaluate the risk. The risk manager is also responsible for all other aspects of implementing the insurance contract, from handling claims as a representative of the company to dealing with adjustments to loss sensitive programs, see (Types of Polices/Loss Sensitive Programs). Where the company decides to retain some of the risk itself rather than buy insurance, the risk manager may hire actuaries to determine appropriate loss reserves, (see Financial Reporting/Reserves), a claims adjustment service to manage claims and legal experts to deal with litigation.
The risk manager generally reports to the company’s chief financial officer. In a large organization, there is generally a risk management department. In small companies, the risk management function may be handled by the treasurer or owner of the business.
Rating agencies—private firms that evaluate insurance companies’ financial strength—play an important part in the insurance marketplace. The ratings issued by these agencies represent their opinions of an insurer’s' financial condition and its ability to meet its obligations to policyholders. Rating downgrades are watched closely and can significantly affect an insurer's ability to attract and retain business.
A.M. Best, Standard and Poor’s, Moody’s Investors Services, Weiss Ratings and Fitch are among the major rating agencies. Each has its own methodology. Among the factors they consider are:
- Company earnings over a period of years to assess stability and sources of profits and control over expenses
- Capital adequacy and operating leverage (Capital is the cushion that allows a company to keep its commitments even if the value of its assets falls or its liabilities increase.)
- Investment performance and investment risk management
- The strength of an insurer’s reinsurance program (an important cushion in the event of a catastrophe.)
- Management’s ability, experience and integrity.