Chapter 3 Quiz

Twenty questions: fifteen multiple choice and five short answer. Try them closed-book, then check the key in the collapsed block at the bottom. The combined ratio and the admitted/surplus distinction are the highest-yield ideas — be sure you can compute and explain both.

Multiple choice

1. A stock insurer is owned by: - A) its policyholders - B) its shareholders - C) its subscribers, who insure one another - D) the state guaranty fund

2. In a mutual insurer, the owners are: - A) outside investors who buy shares - B) the attorney-in-fact and the managing agents - C) the policyholders themselves - D) the reinsurers backing the company

3. A reciprocal insurer (reciprocal exchange) is run on the subscribers' behalf by: - A) a board of shareholders - B) an attorney-in-fact - C) a managing general agent - D) the state insurance department

4. Which statement about the agent/broker distinction is correct? - A) An agent represents the insured; a broker represents the carrier. - B) An agent represents the carrier and may have binding authority; a broker represents the insured. - C) Both legally represent the insured; only the title differs. - D) Both legally represent the carrier; only the compensation differs.

5. A managing general agent (MGA) is best described as: - A) a reinsurer that assumes catastrophe risk from the cedent - B) a wholesaler that serves only retail brokers - C) an intermediary to whom an insurer delegates underwriting authority for a defined class of business - D) a rating agency that grades financial strength

6. A wholesaler (wholesale/surplus-lines broker) primarily serves: - A) the insured directly - B) the retail agent or broker who needs to place a hard-to-place risk - C) the reinsurer - D) the state regulator

7. AM Best is: - A) a state regulator that licenses insurers - B) the federal insurance guaranty fund - C) a rating agency that assesses an insurer's financial strength (ability to pay claims) - D) the largest reinsurer in the world

8. A premium dollar has exactly three destinations. They are: - A) losses, dividends, and taxes - B) losses, expenses, and profit - C) commissions, reserves, and reinsurance - D) claims, surplus, and float

9. The loss ratio is: - A) underwriting expenses ÷ premium - B) incurred losses (and loss adjustment expense) ÷ earned premium - C) premium ÷ surplus - D) investment income ÷ premium

10. The combined ratio, in its simplest common form, equals: - A) loss ratio − expense ratio - B) loss ratio × expense ratio - C) loss ratio + expense ratio - D) loss ratio + expense ratio − investment income

11. A combined ratio of 104% means the insurer: - A) made a 4-cent underwriting profit per premium dollar - B) paid out \$1.04 in losses and expenses per \$1.00 of premium — an underwriting loss - C) earned a 4% return on its investment portfolio - D) is insolvent and must be taken over by the regulator

12. During a soft market, you would typically expect: - A) scarce capacity, rising prices, and tightening terms - B) plentiful capacity, falling prices, and loosening terms - C) no change in price but stricter terms - D) a frozen market in which no new business is written

13. Which sequence correctly describes part of the underwriting cycle? - A) Losses fall → capital exits → prices rise - B) Underwriting profit attracts capital → capacity grows → carriers cut prices to compete → the market softens - C) A catastrophe occurs → prices fall → capacity grows - D) Expenses rise → loss ratio falls → combined ratio falls

14. A risk goes to the surplus-lines (non-admitted) market when: - A) it is a small, standard risk easily priced at filed rates - B) the insured prefers the protection of the state guaranty fund - C) it is too large, hazardous, novel, or catastrophe-exposed for an admitted carrier to write at filed rates - D) the admitted carrier wants a lower premium tax

15. Compared with an admitted carrier, a surplus-lines carrier: - A) must file its rates and forms with the state and is backed by the guaranty fund - B) has freedom of rate and form but is generally not backed by the state guaranty fund - C) is prohibited from writing catastrophe-exposed property - D) is owned by its policyholders by law

Short answer

16. A book earns \$5,000,000 in premium, incurs \$3,300,000 in losses and loss adjustment expense, and runs \$1,400,000 in underwriting expenses. Compute the loss ratio, the expense ratio, and the combined ratio, and state whether the underwriting made or lost money and by how much in dollars.

17. In two or three sentences, explain why the combined ratio is called "the most important number in insurance" and why "we'll make it up on volume" is a dangerous response to a combined ratio above 100%.

18. Explain how a carrier's distribution channel (direct writer vs. independent agency) can produce a difference in its expense ratio even when two carriers have identical loss experience.

19. Describe the underwriting cycle feedback loop in your own words, beginning at the top of a hard market and explaining why a soft market's underpricing is what eventually hardens the market again.

20. Harbor Steel arrived through the broker Meridian Risk Partners and sits near the admitted/surplus- lines boundary because of its catastrophe exposure and loss history. State who Meridian legally represents, and name the one thing that will decide whether the account can be written on admitted paper or must go to surplus lines.

Answer key (click to expand) **Multiple choice** 1. **B** — shareholders supply the capital, bear the risk, and take the profit. (§3.1) 2. **C** — in a mutual, the policyholders are the owners; profits are retained as surplus or returned as dividends. (§3.1) 3. **B** — an attorney-in-fact administers a reciprocal exchange on the subscribers' behalf for a fee. (§3.1) 4. **B** — an agent represents the carrier (and may bind it); a broker represents the insured. (§3.2) 5. **C** — an MGA holds delegated underwriting authority for a defined class, which is why carriers must audit them. (§3.2) 6. **B** — the wholesaler serves the retail broker, placing hard-to-place (often surplus-lines) risks; it does not deal with the insured directly. (§3.2) 7. **C** — AM Best is the insurance-specialist rating agency assessing financial strength (claims-paying ability). (§3.3) 8. **B** — losses, expenses, and profit; investment income is earned separately on the float. (§3.4) 9. **B** — incurred losses and loss adjustment expense divided by earned premium. (§3.5) 10. **C** — loss ratio + expense ratio. (§3.5) 11. **B** — \$1.04 paid out per \$1.00 in: an underwriting loss before investment income. (Note that an underwriting loss is not the same as insolvency — option D overstates it.) (§3.5) 12. **B** — soft market: plentiful capacity, falling prices, loosening terms. (§3.6) 13. **B** — profitability attracts capital, capacity grows, carriers cut price to compete, and the market softens. (§3.6) 14. **C** — surplus lines exists for risks the admitted market won't write at filed rates: large, hazardous, novel, or catastrophe-exposed. (§3.7) 15. **B** — freedom of rate and form, but generally outside the guaranty fund. (§3.7) **Short answer** 16. Loss ratio = 3,300,000 ÷ 5,000,000 = **66%**. Expense ratio = 1,400,000 ÷ 5,000,000 = **28%**. Combined ratio = 66% + 28% = **94%**. The underwriting **made money** — \$0.06 of underwriting profit per premium dollar, or **\$300,000** on \$5,000,000 of premium (5,000,000 − 3,300,000 − 1,400,000). (§3.4–§3.5) 17. The combined ratio is the one number that says, without spin, whether the *underwriting* made or lost money: below 100% a profit, above 100% a loss, before any investment income. Volume multiplies whatever combined ratio you are running rather than improving it, so "making it up on volume" on a 100%+ book just grows the loss; the losses on underpriced business also arrive years later as the claims develop, so the problem compounds out of sight. (§3.5) 18. Acquisition expense — dominated by commission paid to independent agents — is a large component of the expense ratio. A direct writer reaches customers through its own captive agents, call center, or website and pays no independent-agent commission, so its acquisition cost (and therefore its expense ratio) is structurally lower. Two carriers with the same loss ratio can therefore post different combined ratios purely because of how they distribute. (§3.2, §3.4) 19. At the top of a hard market, underwriting is profitable, which attracts new capital and capacity; to win business, carriers cut prices and loosen terms, softening the market. The losses on that underpriced business do not arrive immediately — the loss ratio develops over years — so carriers keep competing the price down. Eventually the underpriced losses develop, the combined ratio climbs past 100%, capital exits, capacity shrinks, and with less capacity chasing the same risks, prices rise and terms tighten — the market hardens, profitability returns, and the loop begins again. (§3.6) 20. Meridian legally represents **Harbor Steel** (the insured) — a broker shops the market on the buyer's behalf. Whether the account can be written on admitted paper or must be exported to surplus lines will be decided by **the price and terms your admitted carrier can offer at its filed rates** given the catastrophe exposure and loss history — i.e., whether the risk can be made acceptable with deductibles, a roof endorsement, and loss-control subjectivities within the admitted market, or whether it needs the freedom of rate and form of the surplus-lines market. (§3.2, §3.7, The Underwriting File)