Insurance companies provide many products with different levels of complexity that were designed for different groups of people and businesses and other organizations. Different underwriting criteria and different distribution systems may result in large differences in losses and other costs that must ultimately be reflected in the price of the charge.
Moreover, the insurance industry is highly fragmented, and because insurance companies are largely regulated by states, insurance policies issued by the same insurer may have different requirements and provisions in the different states. Auto insurance, for instance, can differ widely in both prices and the coverage provided, in different states, even from the same insurance company.
Insurance Company Competition
Insurance companies not only compete with each other, but they also compete with the government, risk retention groups, and self-insurance. The government often provides insurance for risks that private insurers are unwilling to cover or cannot cover, such as floods, hurricanes, and earthquakes. States also provide insurance in some areas to increase competition, most notably workers compensation, since businesses often decide what state they will do business in based on costs.
Insurance companies also compete with risk retention groups (RRGs) that provide coverage for groups with specific liability risks, such as medical malpractice. Moreover, unlike insurance companies, RRGs are governed by federal law and by the law of their state of domicile, so they can operate in all 50 states without the complexity and cost of complying with state regulations other than the state of their domicile. And generally, RRGs select the states with the most permissible laws governing their group, which helps to lower their cost of operation. Vermont is currently the most popular domicile. RRGs may be organized as stock or mutual companies or as reciprocal exchanges, but the insured must also own the insurer, as required by federal law. Consequently, the insured have greater control over costs and can benefit from any savings that would otherwise be profit to private insurance companies.
Many large businesses and organizations also self-insure for many of their employee benefits, such as health coverage, which increases competition for insurance companies. However, many self-insurers use the services of insurance companies to manage insurance program, including the filing of claims.
Insurance companies generally compete on price and by the quality of the services that they provide.
The price of insurance, like most other things offered for sale, is determined by the cost of production and the amount of competition within the industry. The revenue from selling insurance covers:
- losses and loss adjustment expenses
- acquisition expenses
- administrative expenses
The major portion of insurance revenue is used to cover losses and related adjustment expenses. The major difference in prices among different insurance companies is in their ability to predict future losses and their ability to charge the appropriate premium to each underwriting class, which also must be well-defined and accurate.
Acquisition expenses consist mostly of marketing costs, such as for advertising, and for commissions paid to insurance brokers and agents. Some forms of insurance, such as auto insurance and term life insurance, are sold directly, rather than through brokers or agents, which helps reduce the premium. However, many types of insurance are more complex, with a greater number of variables, such as commercial property and casualty insurance or variable life insurance, the virtually requires the use of a broker or agent.
Administrative expenses are mostly fixed costs, that do not very much with the amount of premium written, such as for offices and computer equipment.
Like most other companies, insurance companies also pay taxes, but every state also assesses a premium tax that is assessed as a percentage of the amount of premium and passed on to the insurance buyer as a hidden tax, since they are never itemized.
Profit is what remains after all expenses have been paid. Every insurance company projects a profit, but the actual amount of profit earned will depend on the amount of losses, since this is both the most significant and variable factor.
Underwriting standards are an important determinant of profitability and what prices insurance companies can charge for their products. If an insurance company can select individuals or businesses that have lower than average losses, then it will earn a higher profit with lower prices. This, in turn, will impose greater losses on its competitors, by leaving individuals or businesses with average or higher than average losses to its competitors.
Insurance companies also compete on the quality of the provided services, including broader coverage and prompt servicing of claims. Additionally, property and casualty insurers may also offer property inspections and loss prevention services.
The main source of information and the 1st point of contact for insurance applicants is through insurance brokers and agents, and through websites, either the website of the insurance company, of their brokers and agents, or from 3rd parties, especially those that compare premium quotes from many insurers.
Insurance applicants also judge insurance companies based on their brokers and agents who usually provide necessary information in selecting the best insurance coverage. Insurance agents work for particular companies, so they can only offer products offered by the companies. Insurance brokers, on the other hand, works for the insurance applicant and can sell insurance from many companies. Agents and brokers will generally analyze insurance needs of the applicant, then recommend coverage required to satisfy their needs. Insurance agents can only select products from the companies, but insurance brokers can choose from a wide variety of companies, so they can probably offer the best prices and the most precise coverage. Brokers and agents also often helped process loss claims for applicants, so their competency in processing claims will also be used by the insured to judge the quality of the company.
Websites can also be a major factor in competition. Websites of insurance companies can greatly improve the quality of their services by providing an online means to:
- make payments/change contract provisions
- get proof of insurance
- add or subtract coverage
- file a claim and view its progress
Insurance company websites can also provide the types of policies that they offer and their specific provisions.
Websites can provide interactive questionnaires that allow insurance applicants to select the best available policy for their needs. The insured can also use an interactive website to see how the price of their insurance varies by selecting or deselecting specific provisions in the contract or by changing the amount of coverage for specific incidences, such as for uninsured motorist coverage. Using agent or broker for this information would take longer and it is easier for the insured to see the specific ways that the policy can be changed, since the possibilities are often presented in a drop-down box on the website.
Most major insurance companies also have their own mobile app, where users can view their for policy information, file a claim, view its progress, and provide proof of insurance. For instance, most states require proof of auto insurance when the drivers pool over by the police, and states are now allowing showing the ID card on the mobile phone as a proof of insurance.
Insurance websites by 3rd parties have also increased competition by providing insurance quotes for many companies. An insurance applicant simply enters the information needed to determine the premium.
Insurance Cycles: Soft and Hard Markets
A soft insurance market occurs when underwriting standards are looser and premiums are lower than in hard insurance markets. Because insurance market is competitive, when companies become profitable, they start adopting a more lenient underwriting criteria and lower their premiums to grab more market share. Other insurance companies react by adopting the same policies, to prevent their shares taken away or to increase their market share. Eventually, the cell propagated cycle comes to an end as losses start to mount, leading to the hard insurance market of stricter underwriting criteria and higher premiums.
Although insurance companies recognize the cycle, they cannot change it, since companies in a competitive industry are forced to be price takers rather than price makers.
Cash flow underwriting
Property and liability insurers often make most of their profit from investments. Consequently, these insurers often maximize their premium income by loosening their underwriting standards, with the hope that the investment return from the premium income will more than make up for any losses incurred because of the lower underwriting standards and premiums. This is referred to as cash-flow underwriting: maximizing cash flow that can be invested at the expense of underwriting profits. Hence, the prices of insurance will often depend on the performance of the investment markets, such as stock market. Soft insurance markets will tend to prevail when the financial markets are doing well; otherwise, a hard insurance market is more likely.