Teaching introductory concepts of insurance company management: a simulation game.

The article describes the learning objectives and outcomes of a computer game that simulates an insurance market. Students integrate accounting, finance, risk management and insurance, asset management and investment topics. Students experience competitive interaction in the product and bond markets and the intra-firm stresses of marketing, investment and production activities.

Introduction

This article describes an application of student-centered learning using software to simulate the operations of a property-liability insurance company. (1) The application is a decision-making game used in Risk Management and Insurance classes. The game simulates the operations of a property-liability insurance company and the competition of firms in the insurance market. Students develop an appreciation for the interaction of the decisions of insurance company managers operating under the simulated uncertainty of market and economic conditions.

Learning Objectives

Students develop an appreciation for the complexity of financial management decisions in the context of the ongoing operations of an insurance company. The game develops a feel for the interaction of management decisions and market stress. While it is not industry-specific, some insurance concepts are developed as part of the game -- and the game is more easily understood by those with an interest in the financial services industry.

Students develop an appreciation for the interaction between management forecasts of economic performance and firm-level investment outcomes. Students predict the stock market's performance in the following week in order to develop their current investment strategy. Bad forecasts may be penalized through the competitive nature of the game.

Students develop an appreciation for the interaction between intra-firm decisions affecting investment risk levels, product (underwriting) risk levels and product pricing. A firm that chooses extreme, but opposite, risk levels may perform well through luck, but a system shock may induce financial distress. However, a firm that "plays it safe" in balancing risk levels may not be able to compete effectively on product price.

Students develop an understanding of how managerial decisions affect a firm's performance in a multi-period setting. For example, firms that do not invest in advertising may achieve short run profit gains but will lose market share in later periods. Similarly, choosing a low price may attract a higher market share, but some of the losses (product expenses) will be paid in later time periods and will undermine future profitability.

The game is based on play by competing firms. Each firm makes strategic decisions that impact the values of the other firms through competition in the market for a homogeneous product, homeowners insurance. (2) The decision variables include product pricing, employee compensation schemes, advertising strategy, investment mix and risk strategy, and underwriting strategy. In each of the five weeks of the game, teams submit their selections (see Exhibit 1) and the rationale for their strategy. Their reasoning should reflect an understanding of interactions among variables and their expectation of the next week's stock market performance. Both firm investment returns and the aggregate level of market demand for homeowner's insurance policies are affected by stock market performance. Game results are a function of the selections made by the teams and the week's stock market performance.

Feedback to students consists of:

* a summary of the simulated annual results for the "industry," and

* program output reporting a simulated balance sheet and income statement for each firm.

Each week, teams also receive a relative ranking of selected performance variables and the team's points earned through that week (see Exhibits 2 and 3). Points earned by a team are a weighted average of selected performance variables from which deductions are made to recognize the firm's opportunity costs. Sufficient information is provided to permit each team to assess the strategic behavior of other teams. Though the instructor may assign a grade primarily on the outcome of the game, the authors suggest the grade also reflect the instructor's evaluation of the expected strategy reports submitted by students.

This article begins with an overview of the game structure. This discussion is followed by sections that provide greater detail about insurance operations, investment strategy, regulatory influences and, finally, a description of game scoring.

Game Structure

The game is organized around the two major functions of an insurance company:

* insurance operations and

* investments.

Each week, students select the values of six decision variables that affect insurance operations:

* sales promotion

* advertising

* price

* new business commission rate

* old business commission rate, and

* the choice of underwriting level (the primary determinant of the insurance company's operational risk level).

The firm's investment decisions involve the management of the stock-bond-cash mix and the risk levels of the insurance company's investment portfolio. The investment portfolio consists of three assets: cash, bonds, and common stocks. The impact of each variable on market share is determined by its value relative to the sum of the variable for all firms.

When an insurance company issues a policy, some of the associated expenses -- taxes, agent commissions, administrative expenses -- are charged immediately against the company's income. This charge decreases surplus at once while the premium collected is set aside in an unearned premium reserve to be recognized as income over the life of the policy. This statutory accounting procedure is an artifact of solvency regulation, however an implication is that as an insurance company writes more business, expenses must immediately be paid from surplus -- reducing the company's ability to write additional business. Companies experiencing rapid expansion are particularly susceptible to this regulatory solvency constraint created by the timing mismatch of expenses (which must be debited immediately) and income (which must be credited over time). These regulatory concerns aside, when a firm sells policies the premium income is available to service the various expenses of the firm and to generate investment income.

Insurance loss costs are determined by a combination of frequency (how many claims per unit), severity (average cost of each claim) and the total number of units insured. Insurers set aside loss reserves for claims which have been incurred but not reported (IBNR). As claims are reported to the company, these reserves are reduced. The game captures the uncertainty of actual versus expected losses by introducing a random error component in actual losses while reserves are calculated based on a fixed expected loss ratio derived from "historical" averages.

Insurance Operations

Homes can be statistically grouped into cohorts that experience similar within-cohort losses (frequency and severity of losses) but different between-cohort losses. The difference between the average losses of different groups occurs because people have different behavioral characteristics and homes have different construction and location characteristics. The game captures this underwriting-level effect with some simplifying assumptions by estimating the number of homes lost at different underwriting levels. (3)

Losses, Loss Adjustment Expenses and Pricing. The student selects a desirable underwriting level with knowledge of the expected loss and loss adjustment expenses associated with each underwriting level. The expected loss ratio ranges from 58 percent (level 1) to 90 percent (level 9) with incremental increases of four percent Actual losses have a random component that allows actual losses to range from 2 percent below to 3 percent above the expected loss ratio for that underwriting level. Thus, by chance a looser underwriting level could have better performance than the next underwriting level; this is demonstrated in Exhibit 4 which lists the expected loss ratio, actual loss ratio range, and expresses the expected loss ratio as a percentage of the number of policies. (4)

The loss ratio generally is the larger of two ratios, the loss ratio and the expense ratio -- the sum of which is called the combined ratio. The combined ratio is a standard industry measure of approximate firm operating profitability. The loss ratio is usually calculated as the ratio of losses incurred, including the expenses of settling loss claims, to premiums earned. The expense ratio is usually calculated as the sum of underwriting expenses incurred, including commissions, state premium taxes and overhead expenses. (5) In this game, the firm starts with an underwriting level of 7 and other values that suggest the firm requires 105.65 percent of premiums to cover its losses and underwriting expenses. (6) Though there are limitations in correctly interpreting the combined ratio, the 105.65 ratio value suggests that the firm with an underwriting level of 7 will lose $5.65 on each $100 policy written. Investment returns must be high for such a firm to both cover these losses and offer a sufficient return to investors.