Insurance Organization

Providers of insurance may organize themselves in several different ways. In some societies, people informally group together and pool their funds to help each other in times of need. Some much larger, formal insurance organizations work in much the same way. Others operate for profit.


A. Stock Insurance Companies

Some insurance providers, such as Allstate Insurance Company, operate as corporations, the form of organization common to many large businesses that operate for profit. These kinds of insurance organizations, called stock insurance companies, sell stock to shareholders whose investment provides the capital for company operations. Stock insurance companies represent the largest number of insurance companies in operation, and nearly all newly formed insurance companies.


B. Mutual Insurance Companies

Historically, individuals seeking to share risk joined together without the motivation of earning profits. This principle carries on today in mutual insurance companies. Everyone who purchases insurance from a mutual company owns a small piece of that company. In contrast to the first small mutual insurance associations, however, today’s large mutual companies, such as State Farm insurance companies and Northwestern Mutual Life, compete against stock companies for business and generally operate much like those companies. Mutuals have boards of directors elected by policyholders, and excess income goes back to policyholders as dividends.


C. Reciprocals, Lloyd’s Associations, and Cooperatives

Other forms of insurance organizations include reciprocals, Lloyd’s associations, and cooperatives. These organizations serve an important role in making insurance available to specialized businesses. Most reciprocals and Lloyd’s associations do not sell insurance to individuals.

In reciprocal insurance organizations, also known as reciprocal exchanges or interinsurance exchanges, each policyholder is directly insured by all the others. Attorneys-in-fact (contractually bound agents) manage the affairs of reciprocals for the members, and members commonly know how much liability each member of the group assumes.

Lloyd’s associations, modeled after the longstanding British insurance association Lloyd's of London, are groups of businesses and individuals who come together to underwrite (assume a portion of risk for) specific types of insurance risks. Lloyd’s associations employ independent underwriters—agents who establish insurance rules, assess the qualifications of customers to purchase insurance, and set policy rates—to make insurance contracts on their behalf. Lloyd’s associations insure a wide variety of risks faced by international businesses and, in some cases, individuals.

Cooperative organizations are nonprofit membership groups maintained and operated for the benefit of their members and subscribers. Cooperatives are prohibited by law from paying dividends or distributing profits and are exempt from most forms of taxation. Many fraternal orders also provide insurance in the same manner as cooperatives.

Buying Insurace

People face many choices when buying insurance policies. They commonly choose an insurance provider based on several criteria. Some of the most important of these include: (1) the financial stability of the insurance company, (2) the price of policies, and (3) details of coverage and service.

Only a financially sound company can fulfill its promise to pay in all circumstances. Companies with proven records of stability can provide insurance security. Choice of a provider based solely on price, on the other hand, may result in poor service and coverage, even if the provider advertises comprehensive coverage and high quality service.

Policy prices vary significantly among companies, but competition usually forces most companies’ prices into a narrow range. The greater cost of some policies may pay off in the long run through better protection. Thus, a detailed examination of coverage in policies provided by different, well-regarded companies can help consumers make the best choice based on the risks they face, their needs, and their finances.

People seeking to buy insurance often use the services of an insurance agent or broker to assist in their purchase. Precisely what services these intermediaries provide, and what they can charge, varies somewhat from state to state in the United States and among provinces in Canada. But insurance agents and brokers typically help people choose among the hundreds of policies available and among the hundreds of companies that provide insurance. Some people, however, choose to buy insurance from direct providers, who sell policies without intermediaries. Direct-provider insurance may be purchased through the mail, by telephone, or via computer on the Internet.

Claims, Benefits, and Dividens

Insured individuals who have suffered losses and want to receive payments must notify their insurance company through a process called a claim. Insurance contracts always contain a condition that the insured must provide a proof of loss in order to be paid.

A claim begins when someone who suffers a loss completes and signs a statement describing exactly what happened that led to the loss. Most insurance claims require additional supporting evidence as well. For example, a person filing a life insurance claim must provide a copy of the policyholder’s death certificate. For a health or disability claim, the insured typically must provide a doctor’s report. Someone claiming damage to an automobile usually has to provide a repair estimate to the insurance company.

Once someone files a claim and provides necessary evidence, the insurance company’s claims representative, known commonly as a claims adjuster or claims service representative, reviews it. A claims representative verifies that a claimant (person filing a claim) is entitled to the payment requested.

First, the claims representative verifies that the claimant actually purchased an insurance policy from the company and paid a premium that covered the time period when the loss occurred. For example, if a policyholder misses payments, allowing a policy to expire, the insurer would make no payments on claims made after the policy’s expiration.

The claims representative also verifies that the terms agreed upon in the policy cover the specific claim, including the particular events that caused a loss. For example, standard policies to insure people’s homes generally cover damage from such natural events as lightning and storms. However, they do not cover damage from floods or earthquakes (those kinds of coverage are sold separately). Ultimately, careful claims processing assures that other members of a claimant’s insurance group pay out as little as possible in premiums to adequately cover valid claims.

Determining The Value of Insured Property

Although policies often set coverage as a fixed amount, the value of most items or services covered by insurance changes. When someone acquires a new car, for instance, it depreciates (loses part of its value) over time. Other items, such as houses and jewelry, may appreciate (increase in value). Insurance policies can include inflation protection for very valuable items, such as houses, to allow coverage to match such increases in value.

The value of damaged property can be difficult to determine. Insurance policies often contain a promise to pay the value of an item at the time of its damage or loss, also known as its actual cash value. Publicly available resources, such as used automobile price guides, track the average market value of some used items. Insurance policies may also allow the replacement of used items with comparable used items, such as used cars purchased from classified advertisements or used car dealers.

For most types of destroyed property insurance usually covers the actual cash value of the damaged item toward the price of a new replacement. The policyholder must pay the difference. Assume, for example, that a refrigerator lasts 15 years on average. If a house fire destroys a five-year-old refrigerator, its owner loses two-thirds of the appliance’s use—that is, two-thirds of its total value. An insurance policy covering the actual cash value of the property will pay two-thirds of the cost of a new refrigerator.

Replacing used property with new items, especially in larger losses such as house fires, can create considerable financial burdens. To relieve property owners of the risks posed by large unexpected expenditures, many policies offer an option to purchase replacement cost coverage. This option, which increases a policy’s premium, pays the full cost to replace used property with new items in the event of a loss.

Insurance Policies And Coverage

An insurance policy covers the insured party (known also as the insured or the policyholder) for a specified period of time, called a term. When choosing an insurance policy, a person must decide what type of coverage to buy. This means deciding at what dollar amount of loss the coverage will begin (known as the deductible) and at what amount coverage ends (known as the policy limit). Both influence the cost of a policy, which is expressed as the price of a regular, repeated payment (known as the premium).

Different types of insurance policies provide different amounts of coverage. They also provide coverage in different ways. Some policies, such as life insurance, determine an amount of coverage in advance. An insurance company pays the full amount of such a policy, called its face value, whenever a covered loss occurs. Most other types of insurance policies determine how much to pay according to what kinds of losses policyholders experience. Such policies specify a maximum amount they will pay. For example, a policy covering a home against fire for $100,000 would pay for damages up to $100,000, but no more.


A.Policy Term

Policy terms commonly range from six months to many years. At the end of that term, the seller and buyer may agree to renew the contract if they wish. Only permanent life insurance does not specify a finite term. These policies, also called ordinary life insurance or whole life insurance, commit the insurance company to provide coverage for the lifetime of the person insured.


B. Policy Limit

Insurance policies also specify an amount at which coverage ends, known as the policy limit. Most types of insurance specify the limit as a dollar amount written in the contract. For example, an automobile insurance policy with $10,000 of collision coverage pays up to $10,000 for damage caused by an accident. For property insurance, the policy limit may not exceed the value of the property, which may either be a fixed amount or an amount based on figures such as the costs of replacing property.


C. Deductible

Insurance policies generally include an initial amount of expense that an insured person must pay when a loss occurs. This expense is known as the policy’s deductible. The deductible is the amount of loss a policyholder agrees to pay without protection from an insurance company.
Selecting a $500 deductible on auto insurance, for instance, equals an agreement to pay up to $500 for damage to a car in the event of an accident. Under such an agreement, the insurance company will pay for losses exceeding $500. Therefore, if someone holding such a policy has an accident costing $1000 to repair, the insurance company will pay $500 toward that repair.
The premium for an insurance policy varies according to the level of its deductible. For example, a policy with a $500 deductible costs less than one with a $250 deductible, because the lower the deductible, the more the insurance company has to pay for a loss.


D. Premium

An insurance company sets a policy’s premium by multiplying a rate for each unit of insurance coverage by the total amount of coverage being purchased. Assume, for example, that term life insurance for 35-year-old men has a rate of $1.10 for $1000 of coverage for one year. Based on this rate, a 35-year-old father who wants $500,000 of coverage to protect his family in the case of his death will pay a premium of $1.10 times 500, or $550 for one year of coverage. Most people pay insurance premiums once or twice a year. Other people choose to make automatic monthly payments to their insurance company from a bank account.

Actuaries, experts in determining insurance rates, compute insurance rates using information not available to consumers. To compute rates, they first estimate expected losses in the coming year, based on statistics from previous years. Next they figure how much money will be needed to pay for those losses. They then divide that amount by the number of people needing insurance protection.

Consider, for example, the risks faced by 1000 people, each of whom just purchased a $25,000 car. Using statistics from past losses, an insurance company predicts that 10 of the 1000 cars will be destroyed in accidents during the next year, and 65 will be damaged. The company estimates that payments to cover the damage and destruction to these 75 cars will cost a total of $450,000. If the company collects $450 that year from each of the 1000 car owners, it should have almost exactly the funds it needs to cover those 75 out of 1000 car owners who experience losses.

In this example, each car owner would actually have to pay more than $450 to support part of the costs of the insurance company’s operations, leave some profit for the company, and leave some room for error in the company’s estimates. Also, 925 of the people who buy the insurance will have no accidents and will make no claims. Their payments will go to cover the losses of the 75 people who have accidents. But since none of the 1000 car owners knows whether or not they will have an accident, they each agree to pay the premium, even though it may go toward paying for a portion of someone else’s losses.

Although this example of computing premiums appears fairly simple, real life examples prove far more complicated. For instance, different cars have different repair costs. Car owners drive different distances and have different driving habits. Each accident can result in a different kind and degree of damage. In addition, car insurance policies typically cover much more than just damage to the driver’s automobile. By U.S. state laws, for instance, drivers generally must have some coverage for damage they cause to other cars and for medical care for other drivers and passengers injured in an accident. Taking all of these factors into consideration, the task of determining insurance rates becomes quite complex. Actuaries use statistical calculations and computer programs to make these computations.

Risk Assessment

To help individuals and businesses manage risk, providers of insurance must have ways of determining what kinds and degrees of risk different people and businesses face. To do this, insurers rely on the basic principle of grouping together similar risks. By examining the risks faced by a variety of individuals and businesses, insurers can establish common risk profiles (patterns of characteristics). With this information, an insurer can quickly determine what kind of insurance to offer someone applying for a policy, and how much it will cost to insure that person’s risks.

Every insurer employs underwriters to assess the insurance risk posed by applicants for insurance, and to group applicants into classes based on similar risk profiles. For example, companies that insure cars and their drivers categorize teenage drivers as a class separate from older drivers. Studies have shown that teenagers have many times more crashes than other age groups.

Individuals or businesses whose profiles indicate a statistically average class of risk or lower can usually easily qualify for insurance at reasonable prices. Those whose profiles indicate higher than average risk must pay higher prices for insurance, or they may have a difficult time getting insured at all. When applicants present too much risk, all insurance companies may decline to insure them.

The Importance of Insurance

Insurance benefits society by allowing individuals to share the risks faced by many people. But it also serves many other important economic and societal functions. Because insurance is available and affordable, banks can make loans with the assurance that the loan’s collateral (property that can be taken as payment if a loan goes unpaid) is covered against damage. This increased availability of credit helps people buy homes and cars. Insurance also provides the capital that communities need to quickly rebuild and recover economically from natural disasters, such as tornadoes or hurricanes.

Insurance itself has become a significant economic force in most industrialized countries. Employers buy insurance to cover their employees against work-related injuries and health problems. Businesses also insure their property, including technology used in production, against damage and theft. Because it makes business operations safer, insurance encourages businesses to make economic transactions, which benefits the economies of countries. In addition, millions of people work for insurance companies and related businesses. In 1996 more than 2.4 million people worked in the insurance industry in the United States and Canada.

Insurance companies perform a type of monetary redistribution—they collect premiums and eventually redistribute that money as payments. Depending on the type of insurance, redistribution can take anywhere from a few months to many decades. Because of this delay between collecting and paying out funds, insurance companies invest their funds to bring in extra revenues. Such investments help businesses and governments finance their operations, and profits from those investments support the operations of insurance companies. With these investment earnings, insurance companies can keep rates much lower than would otherwise be possible.

Not all effects of insurance are positive ones. The possibility of earning insurance payments motivates some people to attempt to cause damage or losses. Without the possibility of collecting insurance benefits, for instance, no one would think of arson, the willful destruction of property by fire, as a potential source of money.

Reason For Insurance

In life, losses are sometimes unavoidable. People may become ill and lose income or savings to pay off medical bills. Individuals or their relatives may die of illness or accidents. People’s homes or other property may suffer damage or theft. People also may accidentally cause injury to others or damage to the property of others.

No one knows in advance when a loss will occur or how serious that loss will be. The uncertainty surrounding potential losses is known as risk. Insurance offers a way for people to replace risk with known costs—the costs of buying and maintaining insurance policies.

Assume a person buys a new car for $25,000. Its owner faces the possibility that, at some point, the car will suffer damage in an accident. But how could the owner budget in advance for a loss of unknown cost? The cost to repair or replace the car in the event of an accident could range from the price of a bottle of touch-up paint to as much as $25,000. If the accident injures someone, the costs of medical care could be much higher. Through the mechanism of insurance, however, the car owner can share the risk of an accident with others who face the same risk.

Insurance pools (combines) risks shared by many people, thereby reducing the risks faced by a group. People pay to buy insurance coverage (protection from risk). In exchange, all policyholders (people who own insurance policies) receive a promise that the group of policyholders—as represented by the insurance organization—will pay when any policyholder experiences a covered loss.

The reduction in risk brought by insurance relies on a mathematical concept called the law of large numbers. That law states that the ability to predict losses improves with larger groups. Using calculations based on statistics, experts known as actuaries can accurately predict the losses of a large population, even without knowing when or how any one individual will experience loss.

Insurers distinguish between two types of risk: speculative risk and pure risk. Speculative risk offers both the potential for gain and the potential for loss. People who invest in the stock of companies, for example, take speculative risk. An increase in stock prices produces a gain, while a decline in stock prices produces a loss. Pure risk, by contrast, creates the potential only for loss. Although pure risks do not necessarily result in losses, they never result in gains.

Historically, insurance dealt only with pure risks, and most people still buy insurance to cover pure risks. No one, for instance, experiences a gain when they go a full year without an auto accident. However, some insurance companies now help businesses finance large losses including those incurred on speculative risks, such as the international exchange of currency. Also, in the 1990s financial markets and some professions outside insurance, such as the field of environmental impact and damage assessment, began to expand into risk management for the first time.

Introduction of Insurance

Insurance, legal contract that protects people from the financial costs that result from loss of life, loss of health, lawsuits, or property damage. Insurance provides a means for individuals and societies to cope with some of the risks faced in everyday life. People purchase contracts of insurance, called policies, from a variety of insurance organizations.

Almost everyone living in modern, industrialized countries buys insurance. For instance, laws in most states require people who own a car to buy insurance before driving it on public roads. Lenders require anyone who finances the purchase of a home or car with borrowed money to insure that property. Business partners take out life insurance on each other to make sure the business will succeed even if one of the partners dies.

Insurance makes up part of the broader financial services industry. In the United States in the late-1990s, more than 5500 insurance companies offered a wide range of policies and services. Some large companies sell virtually every type of insurance available in the marketplace. Smaller companies may specialize in a specific geographic region or type of insurance. In 1997 more than 300 Canadian companies sold some form of insurance.

Kind of Mortgage

The two most common mortgages in the United States are the fixed-rate mortgage and the adjustable-rate mortgage. With a fixed-rate mortgage, the interest rate stays the same over the life of the loan. With an adjustable-rate mortgage (ARM), the interest rate can change at the end of pre-determined intervals, such as every six months or every year. The interest rate is tied to changes in a published index that reflects the current interest rate. One widely-used index is the interest rate of United States Treasury bonds. If the index has gone up at the end of the adjustment period, the mortgage rate goes up, and thus the borrower's payment also goes up. Conversely, if the index has gone down, the mortgage rate goes down, and the mortgage payment goes down. Neither the lender nor the borrower can influence or predict in which direction the index will move. Most ARMs have a maximum interest rate cap.

Other, less common mortgages include the balloon mortgage and the graduated payment mortgage. A balloon mortgage is a short-term loan. The borrower makes payments for some period of time and then makes one large payment at the end. The graduated payment mortgage starts out with low monthly payments, which gradually increase over time before stabilizing.

In the United States certain government programs make it easier for borrowers to obtain a mortgage by lessening the risks for the lenders. Programs administered by the Federal Housing Administration (FHA) help low- and moderate-income borrowers obtain loans for housing by providing insurance for lenders against borrower default. The borrower pays for the mortgage insurance by paying a fee to the FHA. If the borrower defaults, the FHA will compensate the lender should the house sell for less than the amount of the mortgage debt. The Veterans Administration (VA) administers programs that guarantee loans made to qualified veterans. If the borrower defaults, the VA repays the lender a specified part of the mortgage loan. Other agencies buy mortgages from lenders and sell them to investors. The money the lender receives from the sale can be used to issue additional mortgages. These agencies include the Federal National Mortgage Association (FNMA or “Fannie Mae”), the Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”), and the Government National Mortgage Association (GNMA or “Ginnie Mae”).

Repaying A Mortgage

Mortgage payments consist of two parts: payments for interest and for principal. Interest is the fee for using the lender's money. Principal is the amount of the loan still owed. A portion of each payment pays interest and the remaining portion reduces the principal. The process of paying off the principal while paying interest is called amortization.

When a homeowner begins to repay his or her mortgage almost all of each monthly payment pays for interest. This changes as the loan ages, even though the amount paid each month may not change. Each month's payment reduces the principal by a small amount, therefore less interest is owed the next month. Since less interest is owed, more of the payment can be used to reduce the principal. Gradually less of each month's payment is needed to pay interest, and more goes to reduce the principal.

For example, if a person borrows $80,000 at 8.0 percent for 20 years to buy a home, he or she will make monthly payments of about $669.15. Out of the first month's payment, about $533.33 pays interest on the principal ($80,000 × 8 percent interest per year ÷ 12 months per year = $533.33). The balance of the monthly payment, $135.82, reduces the principal. The second month's payment is based on the new principal of $79,864.18. This time, $532.43 goes toward interest ($79,864.18 × 8 percent ÷ 12 months) and $136.72 reduces the principal. The relationship between the amount of each monthly payment that goes to interest and principal changes over time. The first 13 years of a 20-year mortgage—or about two-thirds its life—pays back half the principal. During the last seven years, more and more of the monthly payment goes to reduce the principal until the debt is completely paid. At the end of the 20-year, $80,000 mortgage, the borrower will have made 240 monthly payments totaling about $160,500.

Getting A Mortgage

A borrower can obtain a mortgage from a bank, credit union, or other lender. Most lenders require the borrower to have a certain amount of money to use as a down payment toward the purchase of the house. For example, if an individual wants to buy a home priced at $100,000 and the lender requires a down payment of $5000, the individual will apply for a loan of $95,000 to pay for the difference.

A lender requires detailed information about borrowers to assess their ability and willingness to repay a loan. For example, a borrower will be asked about income, employment history, and credit history. The lender will also inquire about any debts, such as a car loan or credit card balances.

Before the lender agrees to a loan, an appraisal of the property by a qualified third party is required. The appraisal provides an estimate of the property's value. The lender wants to be certain that the property is worth at least as much as the loan in case of foreclosure.

If all requirements are met, the lender agrees to the loan. The loan agreement specifies the current interest rate and the loan's repayment terms. The terms of repayment specify how much the regular payments will be, how frequently they will be made, and over how many years. The interest rate and the duration, or life, of the mortgage determine the amount of the payment. Payments are usually made monthly. The life of the mortgage can be 15, 20, 30, or even 40 years.

To accept the loan the borrowers must sign a promissory note that obligates them to repay the mortgage debt. The borrower also promises to keep the property insured against fire and other hazards, and to pay any property taxes that may be owed. If the borrower fails to keep any of these obligations, the loan is considered to be in default, and subject to foreclosure.

The actual transfer of funds and property takes place at the closing. At the closing the lender transfers money to the borrower for buying the house and the borrower signs the mortgage documents. The borrower also pays the lender any fees associated with borrowing the money. These might include origination costs for creating and processing the loan, fees for obtaining reports on credit history, and fees for obtaining an appraisal.

Introduction of Mortgage

Mortgage, legal instrument that pledges a house or other real estate as security for repayment of a loan. By providing a guarantee that the loan will be paid back, a mortgage enables a person to buy property without having the funds to pay for it outright. If the borrower fails to repay the loan, the lender may foreclose on the property—that is, force the sale of the house to recover the amount of the loan (see Foreclosure).

The mortgage lending process has two instruments, a note and a mortgage. The note specifies the financial terms of a loan agreement. The mortgage contains a legal description of the property and a statement that pledges the property as security for the loan. However, the word mortgage commonly refers to both parts of the loan agreement as a whole.

Goverment Control

When the foreign exchange needs of a country exceed total receipts from abroad, and it is unable to receive foreign credits, the exchange value of the currency of the country tends to decline. Under these conditions, the government has the alternative of allowing freedom of transactions in foreign exchange and permitting its currency to depreciate, or of abandoning free transfer of currency by the establishment of exchange control. The aim of such control is to limit the demand for and to increase the supply of foreign exchange in order to maintain a stable exchange rate. Control usually provides for allocating foreign exchange only for approved imports and requires that all or part of the foreign exchange derived from exports or other sources be given to the central bank in exchange for local currency. Since the worldwide depression of the early 1930s, many countries, particularly the developing ones with limited exchange reserves, have periodically instituted foreign exchange controls. To help resolve the unbalanced international payments situation after World War II (1939-1945), the United Nations established in 1946 the International Monetary Fund and the International Bank for Reconstruction and Development. The fund promotes currency stability and removal of foreign exchange restrictions by granting member nations foreign exchange loans to cover temporary deficits in their international accounts. The bank grants long-term foreign currency loans to member countries for specific projects.

Price Fluctuation

Foreign exchange is a commodity, and its price fluctuates in accordance with supply and demand; exchange rates are published daily in the principal newspapers of the world and on the World Wide Web. By international agreement fixed exchange rates with a narrow margin of fluctuation existed until 1973, when floating rates were adopted that fluctuate as supply and demand dictate. Foreigners need dollar exchange to pay for goods imported from the United States, for services supplied by Americans, for interest and dividends earned by American capital invested abroad, for the purchase of securities in the United States, and for other types of transactions. Americans buy foreign exchange for similar reasons. Payments for services that must be made by one nation to another include freight charges, insurance premiums, commissions, and travel expenses.

New York City merchants importing goods from the United Kingdom buy drafts on London from their banks. These drafts, or bills of exchange, create a supply of dollars and a demand for pounds. At the same time, other American merchants sell goods to persons in the United Kingdom and receive drafts payable in pounds that they desire to convert into dollars. The foreign exchange banker buys the pounds from the American exporters and sells them to the importers who need pounds in exchange for their dollars.

Ordinarily, and without government restrictions, the rate of exchange, or the price of the currency of one country in terms of that of another, will depend on overall supply and demand and on the relative purchasing power of the two currencies—that is, on the competitive position of the two countries in world markets. At times, speculation in foreign exchange by dealers, brokers, or others becomes a major influence on exchange rates.

Introduction of Foreign Exchange

Foreign Exchange, currency and money claims, such as bank balances and bank drafts, expressed in the equivalent value in foreign money. Thus, a pound sterling note is money in the United Kingdom, but it is foreign exchange in the United States. A deposit of $1,000 in an American bank to the account of a French company constitutes that amount of foreign exchange in France. The term foreign exchange is also used to refer to transactions involving the conversion of money of one country into that of another or to the international transfer of money and credit instruments.

The use of foreign exchange arises because different nations have different monetary units, and the currency of one country cannot be used for making payments in another country. Because of trade, travel, and other transactions between individuals and business enterprises of different countries, it becomes necessary to convert money into the currency of other countries in order to pay for goods or services in those countries. The transfer of money values from one country to another and the determination of the price at which the currency of one country will be surrendered for that of another constitute the main problems of foreign exchange.

The Marketing Profession

As marketing has become increasingly more complex, a need has arisen for professional marketers trained in the social sciences who also possess statistical, mathematical, and computer backgrounds. Many colleges and universities now have programs designed to train marketing executives. Courses are offered at the undergraduate and the graduate level in such specialized fields as advertising, administrative practices, financial management, production, human relations, retailing, and personnel administration.

In recent years, as many U.S. manufacturing industries such as steel and automobiles have been weakened because of foreign competition, marketing departments have become increasingly responsible for generating profitable sales volume. Thus, their stature in top-level business decision-making has been enhanced. This trend gives every indication of continuing in the foreseeable future. As competition continues to increase and businesses become even more diversified, the marketing profession is likely to provide more personnel in the ranks of top management.

Specialized Marketing Developments

The success of specialized marketing developments has caused many older organizations to revise their operating methods. In recent years, for example, franchise distribution has become an important force in retailing. Under this plan, the retailer is given the right to sell, within a certain area, without competition from another retailer dealing in the same product.

Many consumers now find it more desirable to rent products than to purchase them outright. For example, a homeowner may find it preferable to rent an electric floor polisher when needed, rather than purchase the appliance at the list price, use it only infrequently, and then have to provide storage space within the home. Another item consumers have found easier and less expensive to rent is the automobile. The renting of equipment also figures in large industry. Corporations are finding it to their economic advantage to rent computers and office and industrial machinery, thereby assuring themselves of product servicing and repair and allowing a changeover, without great expense, to newer equipment models as they become available.

Businesses must strive daily to outdo competitors. The methods available to businesses for distinguishing their commodity from others in the market are subject only to their ingenuity. Such methods may include product improvement, a unique promotional campaign, a new twist in servicing, a change in distribution channels, or an enticing price adjustment.

Forces Affecting Modern Marketing

Of all the forces affecting modern marketing, perhaps none is more important than globalization. Since the 1980s, technological advances such as global telephone and computer networks have reduced geographic and even cultural distance. As a result, companies can now buy supplies and produce and sell goods in countries far from their home offices. Products conceived in one country are now being manufactured and then sold in many others. For example, Sony (Japan), Nestlé (Switzerland), Bic (France), and Volkswagen (Germany) have become household words around the world.

Although being able to market goods far from home presents corporations with many new opportunities, it also means they face new competition. Local companies that never even considered international competition now find foreign competitors stocked on shelves right alongside their own products. Some economists argue that local companies should be protected from such competition through legislation that regulates the flow of goods through trade barriers and other measures. Others oppose such regulation, arguing that it only raises prices for consumers. See also Free Trade.

Globalization, however, is only one force changing the way companies market their products or services. Another involves changes in the very interests and desires of consumers themselves. Consumers today are more sophisticated than those of past generations. They attend school for a much longer period of time; they are exposed to newspapers, magazines, motion pictures, radio, television, and travel; and they have much greater interaction with other people. Their demands are more exacting, and their taste changes more volatile. Markets tend to be segmented as each group calls for products suited to its particular tastes. “Positioning” the product—that is, determining the exact segment of the population that is likely to buy a product, and then developing a marketing campaign to enhance the product’s image to fit that particular segment—requires great care and planning. This type of campaign is known as target marketing.

Competition also has sharply intensified, as the number of firms engaged in producing similar products has increased. Each firm tries to differentiate its products from those of its competitors. Profit margins, meaning the profit percentages made by a business per dollar of sales, are constantly being lessened. Although costs continue to rise, competition tends to keep prices down. The result is a narrowing spread between costs and selling prices. An increase in a business’s sales volume is necessary to maintain or raise profit.

Another force affecting modern marketing is the influence of the consumer rights or consumer protection movement. This movement insists on safe, reputable, and reliable products and services. Both consumer groups and government agencies have intensified their scrutiny of products, challenging such diverse elements as product design, length and legitimacy of warranty, and promotional tactics. Warranty and guarantee practices, in particular, have been closely examined. New legislation has generally defined and extended the manufacturer’s responsibility for product performance.

Environmental concerns have also affected product design and marketing, especially as the expense of product modification has increased the retail cost. Such forces, which have added to the friction between producer and consumer, must be understood by the marketer and integrated into a sound marketing program.

Even the way a firm handles itself in public life—that is, how it reacts to social and political issues—has become significant. No longer may a corporation cloak its internal decisions as private affairs. The public’s dissatisfaction with the actions and attitudes of a firm has sometimes led to a reduction in sales; conversely, consumer enthusiasm, generated by a firm’s intentional establishment of a good public image or public relations, has led to increased sales.

Marketing Research

Marketing research helps businesses identify consumer needs and wants so a company can develop and promote products more successfully. Such research also provides the information upon which important advertising and marketing decisions are based.

There are two types of research: qualitative and quantitative. To gain a general impression of the market, consumers, or the product, companies generally start with qualitative research. This approach asks open-ended rather than yes or no questions in order to enable people to explain their thoughts, feelings, or beliefs in detail. One of the most common qualitative research techniques is the focus group in which a moderator leads a discussion among a small group of consumers who are typical of the target market. The discussion usually involves a particular product, service, or marketing situation. Focus groups can yield insights into consumer perceptions and attitudes, but the findings cannot be applied to the whole market, because the sample size is too small. Focus group results, then, are suggestive rather than definitive.

The insights generated by a focus group are often explored further through quantitative research, which provides reliable, hard statistics. This type of research uses closed-ended questions, enabling the researcher to determine the exact percentage of people who answered yes or no to a question or who selected answer a, b, c, or d on a questionnaire. One of the most common quantitative research techniques is the survey in which researchers sample the opinions of a large group of people. If the sample group is large enough and is representative of a particular group, such as executives who use cell phones, statisticians consider the findings statistically valid, which means that if all consumers in that particular category could be surveyed, the findings would still be the same. This means that quantitative findings are conclusive in a way that qualitative findings cannot be.

Service and Marketing

Marketing efforts once focused primarily on the selling of manufactured products such as cars and aspirin. But today the service industries have grown more important to the economy than the manufacturing sector. Services, unlike products, are intangible and involve a deed, a performance, or an effort that cannot be physically possessed. Currently, more people are employed in the provision of services than in the manufacture of products, and this area shows every indication of expanding even further. In fact, more than eight in ten U.S. workers labor in such service areas as transportation, retail, health care, entertainment, and education. In the United States alone, service industries now account for more than 70 percent of the gross national product (GNP, the total of all goods and services produced by a country) and are expected to provide 90 percent of all new jobs by 2012.

Services, like products, require marketing. Usually, service marketing parallels product marketing with the exception of physical handling. Services must be planned and developed carefully to meet consumer demand. For example, in the field of temporary personnel, a service that continues to increase in monetary value, studies are made to determine the types of employee skills needed in various geographical locations and fields of business. Because services are more difficult to sell than physical products, promotional campaigns for services must be even more aggressive than those for physical commodities.

Distributing the Product

Some products are marketed most effectively by direct sale from manufacturer to consumer. Among these are durable equipment such as computers, office equipment, industrial machinery and supplies, and consumer specialties such as vacuum cleaners and life insurance. The direct marketing of products such as cosmetics and household needs is very important. Formerly common “door to door products,” these are now usually sold by the more sophisticated “house party” technique.

Many types of products and services now use direct mail catalogs or have a presence on the World Wide Web. Because many people are extremely busy, they may find it simpler to shop in their leisure hours at home by using catalogs or visiting Web sites. Comparison shopping is also made easier, because both catalogs and e-commerce sites generally contain extensive product information. For retailers, catalogs and the Web make it possible to do business far beyond their usual trading area and with a minimum of overhead. More than 95 percent of the leading 1,000 companies in the United States sell products over the Internet.

Television is a potent tool in direct marketing because it facilitates the demonstration of products in use. Direct sale of all kinds of goods to the public via home-shopping clubs broadcasting on cable television channels is gaining in popularity. Some companies also use telephone marketing, called telemarketing, a technique used in selling to businesses as well as to consumers. Most consumer products, however, move from the manufacturer through agents to wholesalers and then to retailers, ultimately reaching the consumer. Determining how products should move through wholesale and retail organizations is another major marketing decision.

Wholesalers distribute goods in large quantities, usually to retailers, for resale. Some retail businesses have grown so large, however, that they have found it more profitable to bypass the wholesaler and deal directly with the manufacturers or their agents. Wholesalers first responded to this trend by changing their operations to move goods more quickly to large retailers and at lower prices. Small retailers fought back through cooperative wholesaling, the voluntary banding together of independent retailers to market a product. The result has been a trend toward a much closer, interlocking relationship between wholesaler and independent retailer.

Retailing has undergone even more changes than wholesaling. Intensive preselling by manufacturers and the development of minimum-service operations, such as self-service in department stores, have drastically changed the retailer’s way of doing business. Supermarkets and discount stores have become commonplace not only for groceries but for products as diversified as medicines and gardening equipment. More recently, warehouse retailing has become a major means of retailing higher-priced consumer goods such as furniture, appliances, and electronic equipment. The emphasis is on generating store traffic, speeding up the transaction, and rapidly expanding the sales volume. Chain stores—groups of stores with one owner—and cooperative groups have also proliferated. Special types of retailing, such as vending machines and convenience stores, have also developed to fill multiple needs. See Retailing.

Transporting and warehousing merchandise are also technically within the scope of marketing. Products are often moved several times as they go from producer to consumer. Products are carried by rail, truck, ship, airplane, and pipeline. Efficient traffic management determines the best method and timetable of shipment for any particular product.

Relationship Building

In the past, most advertising and promotional efforts were developed to acquire new customers. But today, more and more advertising and promotional efforts are designed to retain current customers and to increase the amount of money they spend with the company. Consumers see so much advertising that they have learned to ignore much of it. As a result, it has become more difficult to attract new customers. Servicing existing customers, however, is easier and less expensive. In fact, it is estimated that acquiring a new customer costs five to eight times as much as keeping an existing one.

To retain current customers, some companies develop loyalty programs such as the frequent flyer programs used by many airlines. A marketer may also seek to retain customers by learning a customer’s individual interests and then tailoring services to meet them. Amazon.com, for example, keeps a database of the types of books customers have ordered in the past and then recommends new books to them based on their past selections. Such programs help companies retain customers not only by providing a useful service, but also by making customers feel appreciated. This is known as relationship building.

Sales Promotion

The purpose of sales promotion is to supplement and coordinate advertising and personal selling; this has become increasingly important in marketing. While advertising helps build brand image and long-term value, sales promotion builds sales volume. Sales promotions are designed to persuade consumers to purchase immediately by providing special incentives such as cash rebates, prizes, extra product, or gifts. Promotions are an effective way to spur sales, but because they involve discount coupons and contests with valuable prizes, they are also expensive and so reduce profits.

Direct Selling

Where advertising reaches a mass audience, personal or direct selling focuses on one customer at a time. That kind of individual attention makes direct selling expensive, but it also makes it effective. As the costs of personal selling have risen, the utilization of salespeople has changed. Simple transactions are completed by clerks. Salespeople are now used primarily where the products are complex and require detailed explanation, customized application, or careful negotiation over price and payment plan. But whether the sale involves an automobile or a customized computer network, personal selling involves much more than convincing the customer of the product’s benefits. The salesperson helps the customer identify problems, works out a variety of solutions, assists the buyer in making decisions, and provides arrangements for long-term service. Persuasion is only part of the job. A much more important part is problem solving.

Because the selling process has become much more complicated, most companies now provide extensive training for the sales force. The average length of the initial training program is four months. A training program for new members of the sales force teaches them about such matters as company history, selling and presentation techniques, listening skills, the manufacture and use of the company’s products, and the characteristics of both the industry and its customers. Moreover, because the sales force plays such a critical role in the marketing process, most companies provide on-going training for all members of the sales force to help them deepen their product knowledge and improve their interpersonal and negotiating skills.

With the increasing complexity of business problems and products, effective sales solutions often require more knowledge than any one person can master. As a result many companies now use sales teams to service their largest and most complicated accounts. Such teams might include personnel from sales, marketing, manufacturing, finance, and technical support.

Advertising

Advertising is often used to make consumers aware of a product’s special low price or its benefits. But an even more important function of advertising is to create an image that consumers associate with a product, known as the brand image. The brand image goes far beyond the functional characteristics of the product. For example, a soft drink may have a particular taste that is one of its benefits. But when consumers think of it, they not only think of its taste, but they may also associate it with high energy, extreme action, unconventional behavior, and youth. All of those meanings have been added to the product by advertising. Consumers frequently buy the product not only for its functional characteristics but also because they want to be identified with the image associated with the brand.

By adding meaning to a product, advertising also adds value. For example, when Philip Morris Companies Inc. purchased Kraft Foods, Inc. in 1988 for nearly $13 billion, Philip Morris paid 600 percent more than Kraft’s factories and inventory were worth. Over 80 percent of the purchase price was for the current and future value of the Kraft brand, a value that was created in large part by advertising. Advertising plays such an important role in promoting products and adding value to brands that most companies spend considerable sums on their advertising and hire specialized firms, known as advertising agencies, to develop their advertising campaigns.

Advertising is most frequently done on television, radio, and billboards; in newspapers, magazines, and catalogs; and through direct mail to the consumers. In recent years, numerous advertising agencies have joined forces to become giant agencies, making it possible for them to offer their clients a comprehensive range of worldwide promotion services.

Pricing The Product

The two basic components that affect product pricing are costs of manufacture and competition in selling. It is unprofitable to sell a product below the manufacturer’s production costs and unfeasible to sell it at a price higher than that at which comparable merchandise is being offered. Other variables also affect pricing. Company policy may require a minimum profit on new product lines or a specified return on investments, or discounts may be offered on purchases in quantity.

Attempts to maintain resale prices were facilitated for many years in the United States under federal and state fair trade laws. Since 1975, however, these laws have been nullified, thereby prohibiting manufacturers from controlling the prices set by wholesalers and retailers. Such control can still be maintained if the manufacturers wish to market directly through their own outlets, but this is seldom feasible except for the largest manufacturers.

Attempts have also been made, generally at government insistence, to maintain product-price competition in order to minimize the danger of injuring small businesses. Therefore, the legal department of a marketing organization reviews pricing decisions.

Tailoring The Product

Merchandise that is generally similar in style or design, but may vary in such elements as size, price, and quality is collectively known as a product line. Most marketers believe that product lines must be closely correlated with consumer needs and wants.

Firms tend to change product items and lines after a period of time to gain a competitive advantage, to respond to changes in the economic climate, or to increase sales by encouraging consumers to buy a new model. For example, if the economy weakens, a manufacturer might use cheaper parts to make a product more affordable. Sometimes, however, manufacturers will alter the style rather than the quality of the item. Hemlines on dresses, for example, might go up or down, or the appearance or functionality of an automobile might be altered. The practice of changing the appearance of goods or introducing inferior parts or poor workmanship in order to motivate consumers to replace products is known as planned obsolescence. Some people object that this practice leads to waste or can be unethical. Manufacturers reply that consumers are conditioned to expect such changes and welcome the variety they offer, or they deny that poor quality was intentional.

The popularity of all products eventually wanes. In fact, successful products go through what is called a product life cycle, which describes the course of a product’s sales from its introduction and growth through maturity and decline. Some fad products such as Beanie Babies go through all four stages in a very short period. For others, such as phonograph records, the stages extend over decades.

Because products are always aging and sales of even the most successful products eventually decline, firms must continually develop and introduce new items. One study found that over 13,000 new products are introduced each year. But despite the millions of dollars that United States and Canadian companies invest in product research and consumer testing, it is estimated that more than 30 percent of new products fail at launch and 60 percent are never fully accepted by consumers and disappear after a few years. The high failure rate influences the pricing of successful products because profits from these products must help cover the development costs of products that fail.

Microsoft ® Encarta ® 2008

Introduction of Marketing

Marketing, the process by which a product or service originates and is then priced, promoted, and distributed to consumers. In large corporations the principal marketing functions precede the manufacture of a product. They involve market research and product development, design, and testing.

Marketing concentrates primarily on the buyers, or consumers. After determining the customers’ needs and desires, marketers develop strategies that are designed to educate customers about a product’s most important features, persuade them to buy it, and then to enhance their satisfaction with the purchase. Where marketing once stopped with the sale, today businesses believe that it is more profitable to sell to existing customers than to new ones. As a result, marketing now also involves finding ways to turn one-time purchasers into lifelong customers.

Marketing includes planning, organizing, directing, and controlling the decision-making regarding product lines, pricing, promotion, and servicing. In most of these areas marketing has overall authority; in others, as in product-line development, its function is primarily advisory. In addition, the marketing department of a business firm is responsible for the physical distribution of the products, determining the channels of distribution that will be used, and supervising the profitable flow of goods from the factory or warehouse.

Microsoft ® Encarta ® 2008. © 1993-2007 Microsoft Corporation. All rights reserved.