Most people don’t understand how insurance companies operate. During a recent court case in which I provided expert testimony, a great deal of my time was spent helping the jury understand how insurance company operating structures work. The jury was made up of twelve individuals from every walk of life. There were students, housewives, business people, retirees and others. The one common thread was that none of them really understood even the most basic concepts about insurance.
Part of my job was to help the jury understand the insurance company distribution process, among other things. To accomplish this, I used a flip chart and compared an auto manufacturer to an insurance company.
In essence, insurance companies (also known as “insurers,” “carriers” and “primary insurers”) are much like car manufacturers. Both sell final products to consumers — one sells automobiles and the other insurance policies. Some common characteristics include: each industry has Product Development Departments, both keep their eyes on competitors and make product changes accordingly, and each is subject to government regulation.
Other similarities between auto manufacturers and insurance companies will be shared throughout this book to help you better understand the insurance industry.
As a starting point, understand that insurance companies are typically chartered as mutual or stock companies. A mutual company is owned by its policyholders (also referred to as “insureds”). A stock company is owned by its stockholders. There are pros and cons to each type of company charter.
The main advantage of a mutual company from an insurance consumer’s perspective is the possibility of receiving a “refund” in the form of a policy dividend if the insurance company’s profit-making results are better than anticipated. In other words, if the company makes money based upon the rate (price) it charges, after paying claims and other expenses, it can refund a portion of these profits to its policyholders. Such refunds may take the form of rate reductions or maintaining current insurance product pricing.
Realistically, while the mutual companies tout their structure and claim that their ability to reduce prices is a result of being owned by their policyholders, the prices they charge for their products are seldom lower than the prices charged by other types of insurance companies when comparisons are made on an “apples to apples” basis.
The main advantage of stock companies is that they do tend to be priced very competitively up front because they are encouraged to make a profit for their stockholders. Profits that are realized are typically paid out to the stockholders not the insurance policyholders. Stock companies have an additional advantage in that they can sell more stock if they need to raise capital for any reason. Over the years, a number of mutual companies have converted to stock companies in order to acquire other companies, to expand their product offerings and to grow the geographical territories in which they were conducting business.
Insurance companies can also be distinguished by the type of product distribution method they use. The three main distribution methods are: through an independent agency, through an exclusive agency, or through a direct writer.
In the independent agency system, agents sell the products of many different insurance companies. Basically, these agencies are individually- owned, profit-oriented businesses, much like a local appliance store that sells several different manufacturer brand names. In reality these independent agencies act as “manufacturer’s representatives” for insurance companies.
Using the auto manufacturer analogy, car makers distribute their products through auto dealerships. Each dealership is individually owned and may sell various brands of cars. Manufacturers and dealerships enter into contracts that detail the responsibilities of each party and manufacturers offer dealerships the opportunity to earn bonuses based upon sales numbers. All of these characteristics also hold true for insurance companies and the agencies that operate within the independent agency system.
Independent insurance agents advertise individually, as part of trade associations like the Professional Insurance Agents (PIA) and under the marketing umbrella of the insurance carriers they represent. Usually, the insurance agent and the insurance company share the cost of advertising. This type of arrangement is known as cooperative advertising, or “co-op advertising.” An example of this type of arrangement is an insurance agency that represents and sells insurance for CNA or Chubb.
Alternatively, exclusive agents (also referred to as “Captive Agents”) must place business with only one insurance company (referred to as the “Captive Company”), but often have the flexibility to run their offices as they see fit. Agents who exclusively represent one insurance company may be considered independent contractors by the insurance company (e.g. American Family Insurance) or they may be considered employees (e.g. State Farm and Liberty Mutual). Many exclusive agents are restricted by contract from submitting business to any other company unless the application is first rejected by the agent’s captive company.
For exclusive agencies, the marketing of insurance products is typically the responsibility of the insurance company, although exclusive agents can also mount their own marketing campaigns in order to gain name recognition in their communities.
Yet another method of insurance distribution involves direct writers. Here, insurance is sold by an employee of an insurance company and all business must be written exclusively with that insurer. The policies sold by employee agents are owned by these insurance companies. Therefore, when employee agents leave, they are not entitled to take the insurance policy (or the customer) with them.
In order to market their insurance products, many direct writing companies use television and print advertising, telephone, web-related or mail solicitation to sell their insurance products to the public. Many times, direct writers will combine several different sales methods to market their products. Examples of direct writer insurance companies include GEICO and USAA.
Regardless of who pays for it, the marketing of insurance products has changed over the past several years and it is constantly evolving. For example, telephone marketing was prevalent in the past. But with the advent of “do not call” lists in several states, insurance companies are now focusing on other methods. Internet marketing has seen exponential growth. Almost unheard of a few years ago, thingssuch as blogs,website enhancements
(including the tracking of visitors), twitter postings (tweets), Facebook and the use of other types of social media have become commonplace. Some companies are even testing the sending of targeted cell phone advertisements to potential insurance customers.
Insurance agents, themselves, are also using the internet in a variety of ways in order to generate new leads, and hopefully, new sales.
Before leaving the area of insurance product distribution, it is critical that a frequent cause of consumer confusion be made clear. Some insurance agents refer to themselves as insurance agents and others refer to themselves as insurance brokers. What is the difference?
Insurance agents have signed contracts to represent insurance companies and to sell the products offered by these insurance companies. As a result, legally, they have a dual fiduciary responsibility to both the insurance companies they represent and to the customers that buy the insurance policies that they sell.
Insurance brokers technically represent their customers, not insurance companies. While there remains a legal differentiation between insurance agents and insurance brokers, in practical terms there is no difference. Insurance brokers today have signed contracts in effect with a multitude of insurance companies, just as independent insurance agents do.
Examples of insurance brokers include Aon, Marsh USA and A.J. Gallagher & Co. Some well-known larger insurance agencies include SIAA (Hampton, NH), Lockton Companies (Kansas City, MO) and Mesirow Financial (Chicago, IL).
Please note that the words “agent” and “broker” will be used interchangeably in this book since both terms refer to a representative who sells for an insurance company.
The insurance business came under scrutiny several years ago when Eliot Spitzer, then the State of New York’s Attorney General, investigated a case of bid-rigging. The situation in Mr. Spitzer’s case involved a large insurance brokerage that was controlling which insurance companies would provide bids, as well as the prices that the insurance companies would charge for the coverages requested. In direct conflict with a broker’s legal duty to their customers, this brokerage acted in the best interest of the insurance company and itself. How? The insurance brokerage was positioning itself to receive the highest possiblecommissions from insurance companies by restricting the
consumers’ access to other insurance companies and/or by increasing the prices consumers paid. As a result of the Attorney General’s investigation, the area of contingent commissions in the insurance industry became a matter of public concern.
Auto makers often offer some type of bonus to dealerships that sell their cars. This may be in the form of a dealer holdback, or some other incentive. Likewise, insurance companies pay contingent commissions not only to insurance brokers, but agents as well, on an annual basis, predicated upon their performance during the prior twelve-month period. These commissions are paid when certain specific criteria are met. These criteria generally include things such as:
Monetary growth (measured by insurance policies sold)Number growth (growth on a “per policy” basis compared to last year)Loss ratio results (dollars paid out in claims divided by the amount of money paid for an insurance policy. Typically, a pure loss ratio of less than 50% is desirable)Policy retention percentages (how many policies an insurance agent kept at the date the insurance renewed. A number higher than 80% is decent)Miscellaneous other factors, such as a block of insurance policies moved from one insurance carrier to another (known as a “book of business rollover”); premium growth in specific industries or at specific agency office locations, etc.As a result of public backlash, several large insurance agencies and brokers (but not all of them) decided to no longer accept contingent commissions. Today, many of the agencies and brokers that refused to accept contingent commissions have re-evaluated this position and now once again accept these payments. The reasoning behind their change of heart differs, but some agencies felt that as long as they fully disclose their potential to obtain contingent commission income (what they consider “transparency”), it was acceptable to once again enter into some type of additional commission agreements with insurance carriers. Other insurance agencies and brokers never did stop taking bonus commission dollars and continued to accept these “enhanced commissions” from insurance carriers with the blessing of their
customers. Many other consumers, though, remained unaware of this potential conflict of interest and how it might affect the cost of their insurance.
An important caveat to purchasers of insurance: the bid-rigging type of situation that was exposed by Eliot Spitzer in the past is still a concern today. Part of the reason for this is the insurance placement process itself. Agents and brokers continue to be in control of which insurance companies are involved in the insurance bidding process. In addition, they present the ultimate insurance proposal (coverages and prices) to their customers.
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