Since the market where economic agents work lacks the certainties that could determine ex ante the results that can be obtained from any financial transaction, one can derive that an element of risk is associated with any economic decision. As a consequence, given that risk is an essential component of any economic system, it is necessary to adopt behaviours that will take precautions in order to face events that could cause serious damage.The first step is to identify the risk and then to undertake an assessment of it (based on the aversion degree) to decide about its exposure and, in case of negative exposure, to find a way to avoid it, or to control it, or to transfer it to another subject. To prevent, control or transfer the risk are the three ways of managing it. The third way is the one that generates the concept of insurance company, through which, on the basis of a contract, the risk is moved to a third party. Indeed, following the payment of a premium¹, the insurance company undertakes the risk to compensate the damage that could be suffered as the result of the occurrence of an event foreseen by the insurance contract. In this way, it is possible to transform a situation of risk in a situation of certainty.
The basic principle of the insurance mechanism consists in bringing together people who have homogeneous risks in order to reduce the probability of experiencing substantial damage vis-à-vis an increased likelihood of incurring in much more limited disbursements. The need to have an always increasing number of subjects, who have homogeneous risk and who want to assure it, can be easily understood given that the insurance mechanism works according to the known "law of large numbers": by increasing the number of subjects that assure homogeneous and not related risks it is possible, given the premium paid by everyone, to reimburse those for whom the risky event takes place and to generate a profit in which reason the risk is managed. However, as the number of insured subjects increases, the difficulties in managing the risk also grow due to the complexity/difficulty of having a complete knowledge of every individual that intends to cover the risk by entering into an insurance contract. Therefore, it is clear that in order to manage third party risks there is a need to rely on specialized subjects, the so-called insurance intermediaries.
An insurance company must comply with the concept of "economic financial viability", under which the premiums collected should be sufficient to cover the costs of compensation, operating costs and to generate an adequate return on capital invested by shareholders. Therefore, the acquisition of premiums charged to the payment of benefits becomes an essential condition. Insurance companies experience the so-called inverted economic cycle: the company collects revenues well before supporting and knowing the exact amount of its costs². The activities of an insurance company develop along the following lines:
a) to quantify the premiums on the basis of assumptions concerning the probability of occurrence of the events against which policies have been estimated, as well as the level of final performance and of management costs;
b) to set aside part of the revenues as a reserve to face future liabilities;
c) to manage reserves in activities that could preserve their value over time though generating a minimum yield;
d) to develop appropriate management techniques in order to identify all risks that must be faced by an insurance company, given that insurance companies are characterized by certain revenues but uncertain costs.
Insurance companies have to deal with two different management sectors: the technical management and the financial one. In the first sector, experts evaluate different samples that can define various classes of risk to allow the insurance company to carry out its business in the most economic way, to define premium values, the type of distribution of policies and the establishment of the "risk portfolio" by providing claim management and liquidation of damage reimbursements.
Financial management is based on the management of funds acquired through premiums both for liquidity management (payments, operational costs, reimbursements paid to maintain the right balance between short term cash and related commitments) and for the management of real and financial investments made by equity or reserves, to ensure solvency over time.
According to some scholars³, with regard to monitoring and management of risks (risks that are mostly the same as those of bank intermediaries), insurance companies assume the same reference models that are applied to banking.
The main capability of an insurance company is to formulate correct predictions on the basis of which premiums should be calculated so that it would be possible to cover compensation and the management costs and to ensure a good level of revenue for the company. The premium paid is made up of two components: one called "pure-premium"⁴, which is used to deal with insurance benefits only, and another characterized by "uploads", which is that part used to cover operating costs and the generation of profit for the insurer.
Essential features for the risks to be insured are:
a) the high number of subjects exposed to the same risk;
b) the measurability of the risk: in order to determine the premium for the transfer of a risk, it is essential to know the probability of occurrence and the magnitude of the average loss possibly generated);
c) the homogeneity and independence of the insured risks:in order to be insured, two risks must be unrelated to each other;
d) the independence of the probabilities of occurrence of the risk from the behaviour of the insured subject (moral hazard);
e) the non-speculative nature of the risk: only the risks which, if occurring, involve economic damage to the insured subject can be insured.
Information is essential for a proper management of insurance companies and it is the basis for any management decision. To cope with adverse selection and moral hazard problems, insurance companies can try to know in more detail the behaviour of insured subjects and use measures to counteract and discourage these phenomena.
To this end, insurance companies should adopt adequate information systems similar to those applied by banks, also aimed at the resolution and/or minimization of the consequences of adverse selection and moral hazard⁵.
Risk management is an increasingly important function of insurance companies. The ability to manage risks and to minimize the financial and economic imbalances still allowing the solvency for the insurers constitutes a substantive point on which the management of an insurance company is founded.
The insurance risk relates mainly to the technical/insurance management, and it concerns the possibility that premiums collected are not sufficient to face the insured risk. The insurance risk assumes that at the date of the policy signature at least one of the following points is uncertain:
a) the occurrence of the event;
b) the time when the event will occur;
c) the economic impact for the insurer.
The risk that qualifies the contract as "insurance"⁶ must also be a pre-existing risk and it must exist independently of the contract.
A different risk from the insurance risk is the operational risk. The latter is related to incorrect operation of the internal business of the insurance or to misconduct or fraud of the insured.
The risks in financial management are related to the possibility that the value of assets held in the portfolio is inadequate at the time of the payment of benefits to the insured subject. The financial risk is different from the insurance risk and it is present each time the insurance company takes a credit risk, market risk, a foreign exchange risk, a risk of price variation/index of securities or commodities⁷.
Financial risk management does not present more specific evidence than that achieved by any other financial intermediary, such as a bank. Possible risk management techniques may be as follows:
a) techniques for integrated management of assets and liabilities;
b) technical risk avoidance through derivatives;
c) management techniques - called "reassurance" - that allow the company to rebalance the composition of their risk-portfolio to reduce the probability that any given event might cause damage such as to endanger its stability⁸.
The distribution channels of insurance products are agents, brokers, banks, the direct channel and the phone/internet channel. Agents operate on behalf of the insurance company while their remuneration is based on fees related to the volume of premiums collected and the various types of insurance coverage distributed. Brokers act as mediators between insurance companies and their customers not being bound by any agreement with any single insurance company. The distribution through the bank is a recent phenomenon, motivated by the need felt by these two types of intermediaries that include (a) distribution cost reduction, (b) implementation of joint sales strategies offering a complete range of products designed to meet all customer financial needs and (c) stimulation of cross-selling⁹ activities. The insurance products distributed through banks are mostly standardized products such life policies and unit linked index, civil liability car policies and death risks linked to the repayment of mortgage loans. This channel allows to take advantage of customer relationships already available to banks and to lower fees usually applied by banks vis-à-vis those applied by agents or brokers.
The direct channel is represented by insurance company employees while the use of the telephone channel and/or of the Internet is constantly increasing to sell the most standardized products such as civil liability car insurances.
Among the products that an insurance company can market, it is necessary to distinguish between insurable events depending on the length of human life and those depending on any other circumstances that may relate to any given subject. In the first case, we talk about life insurance; in the second case, we talk about indemnity insurance.
Hence, the insurance business is divided into two branches¹⁰: life insurance and indemnity insurance.
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¹ The premium paid is not to be regarded as a fee for the entitlement to a future refund, but rather as the price of a potential performance that would materialise only if the feared event occurred.
² Along a parallel with banking intermediaries that have an economic cycle opposite to that of insurance intermediaries a combination of the two budgets - the banking one, where a longer duration of assets is experienced , and the insurance one, which has instead a longer duration of liabilities - involves certain advantages in terms of ALM (Asset & Liabilities Management), See Ruozi (2004) "Economics and management of the bank," Egea publisher.
³ See Ruozi (2004), "Economics and management of the bank," Egea publisher.
⁴ An example of the determination of a pure premium can be done by assuming that you want to assure 1000 cars with an average 10% annual frequency of claims and an average refund cost of € 800 per claim; the requirements of the insurance company to guarantee coverage to all insured is 800 multiplied by 100 equivalent to € 80,000; as a consequence the premium will be equal to 80,000 divided by 1000, i.e. 80 Euros.
⁵ Financial conglomerates, the result of integration between banks and insurance companies, have access, through integrated information systems, to a complete operational management of their customers, thus providing banking and insurance products close to their needs.
⁶ A contract is defined as insurance when one party (the insurer) accepts significant risks by agreeing to indemnify the other party (the policyholder) when a specified uncertain event has adverse effects on the latter.
⁷ In general, non-life insurance firms are more exposed to the insurance risk, while life assurance companies are more exposed to the financial risk.
⁸ For a more detailed analysis, please refer to "reinsurance" techniques.
⁹ Cross-selling means that the bank and / or insurance selling services consist of multiple overlapping products: examples of such services are loans on real estate that include insurance on their repayment.
¹⁰ The term "branch" stands for "groupings" of homogeneous risks.

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Editor: Alberto Maria SORRENTINO
© 2009 ASSONEBB