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Chapter 18
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Insurance Companies
News-bytes
T
here are some interesting facts from the insurance company point of view relating to the worst floods
which took place in the history of Mumbai in the last 100 years on 26/7.
Let me share with you what happened in the 26/7/05 rain disaster at Mumbai. All insurance companies
had to take care of their claims during such a tragedy. It was definitely a better situation for all those
people who had taken insurance covers than those who hadnt. Some newspaper reported that though
the damages were inflated, the insurers were forced to pay because of their commitment.
Generally, with a flood like situation, there are insurance claims made each year, but their surveyors are
more stringent than they were at the time of the major flood disaster like 26/7. Largely, 50% of the claims
come from the retailers and the shopkeepers, and about 40% from the wholesale stockists. The remaining
comes from owners of ground floor flats in low-lying areas. On normal flood days, there are claims from
car owners whose cars get damaged, as well. Typically, the average repair costs are claimed for falls
between Rs. 3000 to Rs. 10000, as quoted by Mahendra Dhruva, president of the Institute of Surveyors,
Valuers and Adjusters.
But, if the cars get submerged in water, then the claims become much heftier. When water seeps in, the
power steering gets damaged which costs Rs. 30000.Damaged upholstery cost anywhere between Rs
5000 to Rs. 20000. So, when deep flooding happens, the car damage claims go up by an average of four
times the normal flooding damages amount. The insurer also says that if the damages are below Rs.
3000, then it is better to avoid asking for the claim, since one loses out on valuable bonus points and the
premium amount could rise. Insurance had to shell out monies to the tune of Rs. 5000 crores in damaged
property claims. A senior official from the public sector insurance company mentioned in leading papers
that the company was still recovering, after almost 2 years, from such a huge outflow of funds, due to
indemnity provided during disasters of such a large magnitude.
The above-discussed article drives home two important points. Risk assessment is a major function of
an insurance company and the underwriter identifies this risk and calculates the premium to be paid.
Each situation carries a different risk, which needs to be considered and studied very carefully while
undertaking a policy. The second major point discussed is that insurance companies also need to cover
their risk with a reinsurer to tide over major fall-outs like the New York bombing by Al Qaeda. If this
werent the case, a lot of insurance companies would have been wiped out because of the claims that
opened due to 9/11 disaster.
Insurance companies (insurers) act as facilitators between groups of people who share similar risks. In
its simplest form, an insurance company collects premiums from policyholders (insureds), invests those
premiums, compensates for losses and shares some of the surplus with policyholders. Eventually,
insurers give policyholders some sort of a financial reimbursement, either upon the policyholders death
or when a policy matures.
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In India, insurance companies can be divided into two categories based on the lines of business they engage in:
Life Insurance Companies: These companies provide insurance for human life. They guarantee a
specific sum of money:
to a designated beneficiary upon the death of the insured, or
to the insured if he/ she lives beyond a certain age
General Insurance or Non-life Insurance Companies: These companies provide insurance for
property and profession/ business related liabilities.
No company can deal in both life and general insurance through a single entity.
Functions/operations of an Insurance Company
The important insurance company operations are:
Rate making
Underwriting
Production
Claims settlement
Reinsurance
Investments
Insurers also engage in other operations like customer service, to handle client queries and transactions;
and other internal departments such as human resources, accounts and administration.
Let us look at the major operations in more detail.
Rate Making
Rate making refers to the pricing of insurance. Insurance pricing differs significantly from the pricing of
other products in the sense that at the time of the sale of the insurance policy, the insurance company
does not know what the actual costs are going to be to service that policy. It is only after the period of
insurance has passed that the insurance company can determine the actual cost.
As a result, insurance companies have to determine their premiums on the basis of probabilistic and
statistical analyses. The person who determines rates and premiums for the insurer is known as the
actuary. Actuaries study past data to arrive at probabilistic figures for loss causing events and determine
the premium to be charged from persons seeking insurance.
Underwriting
An insurance companys main business is that of underwriting or writing insurance policies. The insurers
underwriters identify and calculate the risk of loss from policyholders; establish appropriate premium
rates; and write policies that cover this risk. An insurance company may lose business to competitors if
the underwriter appraises risks too conservatively, or it may have to pay excessive claims if the underwriting
actions are too liberal.
Each insurance company uses its own set of underwriting guidelines in order to determine whether or not
the company should accept a proposal. In life insurance, this decision process sometimes requires that
applicants provide further medical evidence. Applications often are supplemented with medical reports
and reports from actuarial studies.
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The applicant may be required to provide the following information (for life insurance) to enable underwriters
assess mortality risk and determine appropriate premiums:
1. Age
2. Gender
3. Height and weight
4. Health history (and often family health history)
5. The purpose of the insurance (such as for estate planning, or business or for family protection)
6. Marital status and number of children
7. The amount of insurance the applicant already has, and any additional insurance he/she proposes to
buy (as people with far more life insurance than they need tend to be poor insurance risks)
8. Occupation (some are hazardous, and increase the risk of death)
9. Income (to help determine suitability)
10. Smoking or tobacco use (this is an important factor, as smokers have shorter lives)
11. Alcohol (excessive drinking seriously hurts life expectancy)
12. Certain hobbies (such as race car driving, hang-gliding, piloting non-commercial aircraft)
13. Foreign travel (certain foreign travel is risky)
Underwriters then must decide whether to issue the policy and, if so, the appropriate premium to charge.
In making this decision, underwriters serve as the main link between the insurance company and the
insurance agent.
The underwriters can decide to make a counteroffer in which the premiums have been increased, or in
which various exclusions have been stipulated, which restrict the circumstances under which a claim
would be paid. Some companies use automated underwriting systems to encode these rules, and reduce
the amount of manual work in processing proposals.
Life insurance companies each have their own extensive policies and procedure manuals they are supposed
to follow in determining whether or not, to issue an individual, a life insurance policy, and in pricing that
policy.
Most underwriters specialize in one of the three major categories of insurance: life, health, and property
and casualty. Life and health insurance underwriters may further specialize in group or individual policies.
Property and casualty underwriters usually specialize in either commercial or personal insurance and
then by the type of risk insured, as in fire, homeowners, automobile, marine, or liability insurance, or
workers compensation.
Production
In case of insurance companies, the term production refers to sales and marketing activities. Life
insurance products are distributed primarily through a direct-selling system or through an agency system.
Direct-selling
In a direct-selling distribution system, the insurer deals individually with customers, through its own
employees. A number of marketing techniques are used including direct response and sales through
company-run agencies.
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Agency
Under an agency system, the insurance company contracts with third parties, or agents, to sell its
policies in exchange for a commission. Agents may be captive to a particular insurer, selling only that
insurers policies. Agents may also be independent, offering an array of policies from various insurance
companies.
Presently, direct selling through own agents and third party agents is the most common means for
distribution of insurance policies. However, alternative channels such as bancassurance, brokers and
other third party tie-ups are likely to gain prominence.
Claims settlement
The claims division of an insurance company performs the verification of a covered loss, ensures fair
and prompt payment of claims and provides assistance to the insured. The claims process is as below:
Step 1: Claims Reporting
Rules regarding reporting of claims are typically outlined in the policy document. This includes the
following instructions:
Filing claims in a timely fashion
Co-operation in the investigation and providing the company with all relevant information and documents
To authorize the company to handle necessary inspections and assess the extent of damage prior to
any repairs or replacement
The insurance company sends an appropriate claim form (when the loss reporting is made in writing) to
the claimant (policyholder/ beneficiary). The claim form pertains to the type of policy under consideration
and is sent within a reasonable period of time.
This form is prepared either by an individual insurance company or at the national level, by companies or
supervisory authorities. The company also communicates information on how to comply with the terms
of the policy and legitimate requirements of the company.
All claims payable by an insurance company are subject to the production of proof of the claim event.
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For instance, the primary documents for processing a life insurance claim are:
Intimation of the claim event, in writing and in the companys specified format, signed by the claimant
(beneficiary/ nominee/ assignee/ legal heir). This intimation needs to mention the following:
A statement that the claim event (death/ accidental death/ permanent disability/ critical illness) has
occurred
Details of the policy under which the insured is covered
Date of the claim event
Place of occurrence of the claim event (hospital/ residence etc) and the address of such place
Cause of the claim event with supporting documents
Proof of the claim event with supporting documents (e.g., original death certificate in case of death
claim / hospital reports in case of critical illness claim etc)
Original policy document
Proof of age of the insured, if this has not been previously admitted by the company
Step 2: Receipt of Claims by the Company
The claimant would contact the insurance companys claims department with the completed form. The
company would acknowledge receipt of the claim form.
If the claim cannot be settled quickly, the insurance company would provide an indicative time to the
claimant.
If it appears that the claim is not covered by the insurance policy, the company sends a notification as
soon as possible to the claimant, explaining why it is not covered.
Step 3: Claim Files and Procedures
The company creates a claim file with the indicative information.
Claim filing number
Policy number
Name of the policyholder / claimant / beneficiary
Summary sheet showing developments / review of the claim
Type of insurance concerned
Opening date of the file
Date of loss
Preparing date
Description of the claim
Information of a claimant
Assessment date
Electronic and/or paper copy of the adjustors and investigators
Identify the adjuster
Estimated cost of damage
Dates and amounts of payments
Date of denial, if applicable
Name of intermediary, if applicable
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Date of file closure
Documents regarding contracts with the policyholder / claimant / beneficiary
Step 4: Claims Assessment
The insurance company assesses the damage and communicates the same through a written estimate.
The insurer sends a copy of the document used to set the amount of compensation to the claimant.
When a final payment or offer of settlement is made, the company explains the following to claimant:
Purpose of payment/ settlement
Basis used for payment/ settlement
The insurance company states explicitly to the claimant the reasons for:
Denial of claim
Offering an amount different from the amount claimed
Step 5: Complaints and Dispute Settlement
When the claimant files a complaint in case of a disagreement on settlement amount or non-fulfillment of
the claim by the insurer:
If the claimant is dissatisfied with the final response that he/ she has been sent by the company, he/ she
can activate an internal appeals process.
The claimant can also appeal to the dispute settlement procedures available outside the company (for
example, the handling of complaints by the supervisory authorities). In case of a dispute, the claimant
should be informed by the company of the existence of these appeal procedures. In some instances, a
claims dispute can result in litigation and is then settled in civil courts.
Reinsurance
Reinsurance is the means by which an insurance company (called the reinsured, ceding company or
cedant) shares the risk of loss with another insurance company (called the reinsurer). The reinsurer is not
directly involved in issuing insurance policies but only assumes a portion of the risk of many insurers.
There are many reasons an insurance company will choose to buy reinsurance. Some of these include:
Risk transfer: The main use of reinsurance is to allow the ceding company to assume risks greater
than its size would otherwise allow, and to protect itself against catastrophic losses. For instance, if
an insurance company can write policies with a maximum coverage of only Rs. 10 million, it can
reinsure (or cede) the amount in excess of Rs. 10 million to reinsurers.
Reinsurance is also particularly useful for an insurance company to protect itself against large catastrophic
losses, such as those arising out of hurricanes or other natural calamities or even terrorist activities.
Income smoothing: Reinsurance can help to make an insurance companys results more predictable
by absorbing extraordinary losses.
Arbitrage: An insurance company may purchase reinsurance coverage at a rate lower than what it
believes is the true cost for the underlying risk. This is possible in a soft pricing scenario, when both
insurance and reinsurance pricing are relatively low.
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There are two types of reinsurance:
Proportional
Under proportional reinsurance, the reinsurer assumes a stated percent share of each policy the insurer
writes and then shares in the premiums and losses in that same proportion. Premiums and losses are
shared on a pro rata basis
For instance, an insurance company might purchase a 50% proportional reinsurance; in this case they
would share half of all premiums and losses with the reinsurer.
The reinsurance company usually pays a commission on the premiums back to the insurer in order to
compensate them for costs incurred in sourcing and administering the business (usually 20-30%). This
is known as the ceding commission.
Non-proportional (excess of loss)
Non-proportional reinsurance, also known as excess of loss reinsurance, comes into force if the loss
suffered by the insurer exceeds a certain amount, called the retention amount.
An example of this form of reinsurance is where the insurer is prepared to accept a loss of Rs. 10 lakhs
for any loss which may occur and purchases a layer of reinsurance of Rs. 40 lakhs in excess of Rs. 10
lakhs. If a loss of Rs. 30 lakhs occurs, the insurer pays the Rs. 30 lakhs to the insured, and then
recovers Rs. 20 lakhs from its reinsurer.
However, if a loss of Rs. 60 lakhs occurs, the insurer pays the same amount to the insured and then
recovers Rs. 40 lakhs from the reinsurer (the maximum amount reinsured). The insurer can further
protect itself against losses above Rs. 50 lakhs by purchasing a second layer of reinsurance for losses
above that amount.
Reinsurance treaties can either be written on a continuous or term basis. A continuous contract
continues indefinitely, but generally has a notice period whereby either party can give its intent to
cancel or amend the treaty.
A term agreement has a built-in expiration date. It is common for insurers and reinsurers to have long
term relationships that span many years.
Reinsurance companies themselves also purchase reinsurance and this is known as a retrocession.
They purchase this reinsurance from other reinsurance companies, who are then known as
retrocessionaires. The reinsurance company that purchases the reinsurance is known as the retrocedent.
Investments
Insurers derive revenues from two main sources: premiums and investment income. Insurers collect
payments in the form of premiums from people who face similar risks. Earned premiums are typically an
insurers primary revenue source. At the time of issue of a policy, it is recorded on the insurers books as
a written premium. Then, over the life of the policy, the premium is earned, or recognized as revenue.
A part of the earned premiums are set aside to cover policyholder claims and are transferred to a loss reserve.
The second-largest component of insurer revenues is investment income. This is derived from investing the
funds set aside for loss reserves and from policyholders surplus or shareholders equity. An insurance
company invests this corpus in a number of investment vehicles such as equity, debt, corporate bonds etc.
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These revenues need to provide for a variety of expenses:
Commission paid to the insurance broker, agent, or salesperson for selling a policy; this is usually
deducted immediately from the collected premium.
The largest expense facing a property-casualty insurer is losses, also referred to as policyholder
claims. Funds are also used to pay claims-related expenses, including insurance adjusters fees and
litigation expenses.
Insurers also face expenses related to the underwriting process, such as salaries for actuarial staff.
Like most other companies, insurers incur various other operating expenses and interest costs.
Broadly speaking,
Insurance company income = Underwriting Profit + Investment Income
The combined ratio is a measure of an insurance companys overall underwriting profitability.
Loss Ratio = Losses due to policyholder claims
Expense Ratio = Salaries of actuarial staff and other underwriting expenses
Example:
Lets assume the following details for an insurance company
Losses due to policyholder claims = Rs. 1 crore
Expenses = Rs. 50 Lakhs
Net premium written = Rs. 1.5 crore
Combined ratio = (1 + 0.5) / 1.5 * 100 = 100%
Underwriting Profits x Losses
Thus, if an insurance companys combined ratio is less than 100%, it makes an underwriting profit. If its
combined ratio is more than 100%, the company makes an underwriting loss.
Very few insurance companies globally are able to make significant underwriting profits and many make
losses in their underwriting business. Also, with the impending de-tariffing of non-life insurance business
in India, competition will intensify and premium rates may see a dip, making it difficult to maintain
profitability of the underwriting business.
Therefore, investment income is a key driver of profitability for most insurers. The company can make a
profit irrespective of underwriting losses, if its investment income is higher. Investment decisions at an
insurance company are made very prudently, with significant investments in risk-free government bonds
or other low risk-low return investments. Investments often have to be made within the limits set by the
regulatory authority for various vehicles.
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