Risk Management in General Insurance Business in India: July 2013

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Risk Management in General Insurance Business in India
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The IUP Journal of Financial Risk Management Vol. 10 No. 3, pp.62 – 82, (2013)
RISK MANAGEMENT IN GENERAL INSURANCE BUSINESS IN INDIA
T Joji.Rao1 & Krishan K. Pandey2†
ABSTRACT
Over the years the general insurance companies have been undertaking extensive risk management
activities to safe guard the investor as well as investment. In the present day scenario the two aspects
which are of great importance to the general insurance industry are firstly the opportunities in the
Indian general insurance market and the resulting focus of players on achieving business growth and
secondly the ongoing process of calibrated de-tariffing. Though de-tariffing has provided players with
significant opportunities in tapping markets and in coming times may result into providing even more
opportunities, it has placed the onus of correct pricing on the players themselves. This has resulted in
players preparing and emphasizing more on identifying risk parameters and pricing products based on
risks. The players under the immediate response to the pressure of a free market scenario, has
dropped the rates even in hitherto non-profitable businesses. An efficient risk assessment and
management in general insurance industry lays great emphasis due to entry of private players,
corresponding policy changes and the present day fact of unprofitable books, erosion of capital
resulting from unmanageable claim ratios.
Key Words: General Insurance, Risk Assessment, Risk mitigation, Asset Liability Management,
Enterprise Risk Management.
1. Introduction
Any sunrise industry faces a host of risks, both internal and external. Whereas for industries
already in existence for long, most of the risks are well identified and emerge from the internal
operations of the different players. An evolving industry usually faces higher risks from the
competitive and regulatory environments rather than internal operations. In a competitive
environment, achieving growth requires focus on sales and rapidly scaling up operations through
expansion of channels and increasing geographical presence. A higher amount of focus on sales
and business expansion has its own set of risks on business profitability. These risks could
adversely affect the business performance and even their survival. The general Insurance
companies due to their nature of business are at a receiving end both as a insurer and insured. The
success of the business hence lies in understanding the external and internal risks concerning the
general insurance business industry and the techniques adopted by the insurers as well as insured
to effectively manage their risks.
2. Literature Review
Being into the business of covering risks of other business and social entities the general
insurance players are exposed to financial and operative risks of self as well as of the insured. For
an effective risk management of the same proper identification of structural functions, their
insurability, adequacy, commercial viability holds the key to success. The risk may further be
minimized by risk distribution through pooling of micro insurance, appropriate quantification and
1
Energy Acres, CoMES, University of Petroleum and Energy Studies, Dehradun-248007, India.
2†
(Corresponding Author), Energy Acres, CoMES, University of Petroleum and Energy Studies, Dehradun-248007, India.
Email: krishan.pandey@gmail.com, www.krishan.hpage.com, Phone:+91-9458314387, +91-9760027312
1
http://www.iupindia.in/1309/Financial%20Risk%20Management/Risk_Management_in_General_Insurance.html
accurate estimation of results in case of occurrence of underwritten peril. In the process of risk
management the importance of information on risk transfer for effective mitigation and adaptation
by core business may not be overstated. Incorporating innovation, certification will further
provide depth to the instruments. Encouragement of public private partnership and a strong
financial, legal and political framework will provide the much needed support to further increase
the general insurance penetration and reducing the ever increasing claim ratio. Mendoza &
Ronald (2009), outlines a proposal for a regional risk sharing arrangement namely Asian rice
insurance mechanism (ARIM) which could form part of the region's long-term response to the
food security issue. It proposes that ARIM could serve as a regional public good by helping
countries in the region more efficiently by managing the risks related to volatile rice production
and trade, arising from emerging structural factors such as the rising and evolving food demand.
Further Lubken et al (2011) has discussed environmental risk, risk management and uncertainty,
and the dependence of environmental risk on social, scientific, economic, and cultural processes.
They propagate that natural catastrophes reportedly derive from past patterns of resilience and
vulnerability. The role of insurance sector in reducing the impacts of global warming and the
challenges insurers and reinsurers face in dealing with the impact of climate change on their risk
management strategies has been studied by Kunreuther et.al (2007). The study has examined the
issues of attribution and insurability by focusing on natural disaster coverage. Phelan et al (2011),
have analyzed the adequacy of insurance responses to climate risk and has provided novel
critiques of insurance system responses to climate change and of the attendant political economy
perspective on the relationship between insurance and climate change. A complex adaptive
system analysis has suggested that ecologically effective mitigation is the only viable approach to
manage medium- and long-term climate risk - for the insurance system itself and for human
societies more widely. Another important component of commercial viability has been studied by
Akter et al (2009).The study has concluded that a uniform structure of crop insurance market does
not exist in Bangladesh. It emphasizes that the nature of the disaster risks faced by the farm
households and the socioeconomic characteristics of the rural farm communities need to be taken
into careful consideration while designing such an insurance scheme. Mauelshangen & Franz
(2011), discussed the nature of adaptation and decision-making in the insurance industry. They
have correlated the historic evaluation with contemporary concerns about global warming and
means of adapting insurance to compensate for associated losses. Erdlenbruch et al (2009), have
analyzed the consequences for risk distribution of the French Flood Prevention Action
Programme in France. Results of the survey have showed that the proposed policies may be
financially non-viable. Several more viable risk-sharing solutions are then discussed, involving
insurance schemes, state intervention and local institutions. Spatial pooling of micro-insurance
schemes may reduce these capital requirements. A Study by Meze-Hausken et al (2009) suggest
that spatial pooling may be an attractive option for micro-insurers, worthy of a detailed case-by-
case analysis when designing index-insurance schemes. Further Botzen et all (2009) have
examined the role of insurances to reduce uncertainty associated with climate change losses for
individuals. The estimation results have suggested that a profitable flood insurance market could
be feasible and the climate change has the potential to increase the profitability of offering flood
insurance. Rohland & Eleonora (2011) have discussed risk management and quantification of risk
in the aftermath of fire in the Swedish and international reinsurance industry. The study asserts
that characterization of fire as a man-made hazard misrepresents its overall risk as it ignores
natural causes of fire and associated risks. An another important study by DeMeo et al (2007)
talked about the importance of information on Environmental Risk Transfer and insurance options
2
for potentially responsible parties in case of liability of pollution, cleanup cost cap, and legacy
insurance. Further Phelan (2011) argues that unmitigated climate change threatens not just
measurable, increased likelihoods of extreme events, but over time, wholly unpredictable
frequencies for extreme weather events. It also raises concern over the continued provision of
insurance in a climate-changed world, for the insurance sector as well as the societies dependent
on insurance as a primary tool to manage financial risks. The research argues that ultimately, the
only viable way to insure against climate risks will be through effective mitigation of climate
change.
Sato et al (2010), emphasizes that for the insurance industry, climate change poses a great risk to
management since an increase in natural disasters leads to an increase in insurance payments. The
study suggests that insurance companies should contribute toward the realization of a low-carbon
society and a climate-resilient society through their core business by means of mitigation and
adaptation strategies. Further Owen Richard et al (2009) have discussed the aspects of risk
governance in the insurance industry to drive responsible technological innovation. The
researchers have suggested that innovation drives economic growth, fosters sustainable
development, and improves the health and well-being of individuals. The study also highlights the
relationship between responsible innovation and financial risk-taking, the role of regulation, and
the use of "data before market" legislation to increase corporate responsibility. Richter et al
(2010) has discussed the coverage enhancements of insurers for addressing insurance and risk
management exposures in the construction of sustainable buildings. The research states that
insurance firms should require Energy and Environmental certification for several nontraditional
exposures such as vegetative roofing, rainwater runoff, and alternative energy generation systems
before they provide green coverage. Dlugolecki et al (2006) puts the reasons for market failure of
global general insurance sector as absence of reliable risk data, and volatility in the event costs,
high prices, a misperception of the true risk, an expectation of government aid after disasters, and
exclusion from financial services. It proposes that a public-private partnership may prove
instrumental in resolving this. Cottle & Phil (2007) proposes that despite a low intrinsic fire risk
across most of Southeast Asia, especially Indonesia, commercial fire losses are unacceptably
high, and could be reduced substantially within the current financial legal and political framework
within which forestry companies operate. Using commercial and unidentified data the author
then demonstrates that commercial growers in Indonesia have a high annual rate of forest fire loss
and may also have a significant catastrophe fire exposure.
The above discussed studies show that the general insurance industry in its every sphere of
activity is exposed to uncertainty. Hence there is a need for a comprehensive study of these risk
factors and devising an implementable management strategy for the same. The present study aims
at identifying the risk factors the general insurance industry is exposed to and methodology and
tools for their effective quantification, mitigation and management.
3. Risks in General Insurance business
Players in the general insurance business are likely to be exposed to varieties of financial and
non-financial risks like capital risk, enterprise risk, asset liability management risk, insurance risk,
operating risk and credit risk arising out of the nature of business and the socio economic
environment in which they operate.
3.1 Financial risk
Insurance business basically being financial business in nature attracts financial risks in the forms
of capital structure risk, capital (in)adequacy risk, exchange rate risk, interest rate risk,
investment risk, underwriting risk, catastrophic risk, reserve risk, pricing risk, claims management
3
risk, reinsurance risk, policy holders and brokers risks, claims recovery risk and other debtors
risk. Insurance business undertakes various plans to manage the financial risk by adopting
techniques like interest rate hedging and reserving determined through financial modeling with
the inherent ‘model risk’ given that such financial models may fail to predict the real outcomes
within an acceptable range of error.
3.2 Non financial risk
Non financial risk management has assumed greater significance in the recent years due to (i) the
growing volume of operational losses, (ii) the industry’s increasing reliance on sophisticated
financial technology with the latter’s associated probability of failure at times, (iii) the ever
increasing pace of changes in the deregulated insurance regime and (iv) the globalization process
paving the way for the entry of global players. In addition to these, the ‘volatility’ factor which
affects the future cash inflows of the general insurance business and consequently its value, given
that ‘the value of an insurance company is the present value of its future net cash inflows
adjusted for the risks it undertakes’ is the other dimension of non financial risk the insurance
business is confronted with. Studies have proved that a major source of volatility is not related to
financial risks but the way in which the company operates. Hence the operating risk may arise
either from inadequate or failed internal processes such as employment practices, workplace
safety, and internal fraud or from external events such as external fraud and damage of physical
assets from natural disaster and other uncontrollable events. The different types of financial and
non financial risks faced by the general insurance industry have been given in Chart 1
4
Chart 1: Financial and non financial risks affecting general insurance business in India
Risk Factors
Financial Risk Non Finan
Capital Risk
• Capital structure risk Ent
• Capital adequacy risk • Reputa
• Parent
Asset/ Liability management risk • Compe
• Exchange rate risk
• Interest rate risk
• Investment risk
Op
Insurance risk • Regula
• Underwriting risk • Busine
• Catastrophic risk • IT Obs
• Reserve risk • Proce
• Pricing risk • Regula
• Claims management • Out so
Credit risk
• Reinsurance risk
• Policy holders risk
• Brokers risk
• Claims recovery risk
• Other debtors risk
4. Risk management mechanism in general insurance business
The risk management mechanism adopted by the insured in the general insurance business
broadly takes the form of ‘enterprise risk management’, whereas that of the insurer broadly
assumes the ‘risk based capital management’ and ‘reserving’. The details of these risk
management techniques may be given in the form of a chart as in Chart 2.
5
Chart 2: Risk management mechanism

Risk management mechanism
Insured Ins
Risk based
• Man
• Cap
Enterprise risk management margin
• Planning • Risk
• Risk tracking and
reporting
• Implementation • Une
• Tools • Une
• Risk management • Out
• Incu
reserv
• Cat
• Cla
4.1 Risk management mechanism adopted by the insured
It is of utmost importance for any organization to minimize its exposure to risk of loss arising out of
unforeseen events like the natural calamities, earthquake, flood, fire, theft, and so on. To ensure that
a risk minimization and mitigation mechanism is in place that the insured need to go for an effective
risk management drive. The technique available to the insured for such risk management is known as
the enterprise risk management.
4.1.1 Enterprise Risk Management (ERM)
ERM is the process of planning, organizing, leading, and controlling the activities of an organization
in order to minimize the effects of risk on an organization’s capital and earnings. As regulators and
markets around the world judge companies on their risk management effectiveness, ERM is rapidly
becoming a standard industry practice for managing risk.
6
(I) Scope of enterprise risk management: Enterprise risk management takes a vast field of loss
possibility and breaks it down into a number of more manageable categories. Apart from the core
financial risks inherent to the business, enterprise risk for an insured may be classified into strategic
risk and operational risk as described below:
A. Strategic risk
Strategic risk occurs based on corporate decisions that have an impact over time. Growth strategy,
executive decision making, mergers and acquisitions, and approaches to capital management are all
areas of strategic risk. The very act of strategic planning represents an attempt to manage strategic
risk, but such efforts can be greatly enhanced by an enterprise risk management approach. A simple
example of strategic risk is the entrance by a player into a new product line with inadequate
operational expertise. The failure to anticipate the strategic moves of competitors is itself a strategic
risk. Strategic risk management may include risk-adjusted pricing, capital budgeting, hedging,
investments, and risk-adjusted performance measurement through the creation and use of financial
reporting systems.
B. Operational risk
Operations refer to all the activities of a company in their day to day activities. Operational risk arise
out of activities that may hinder or bring a company’s operations to a halt such as natural disasters,
labor problems, fraud perpetrated from within the company, and data problems. In India, there is an
increasing awareness of the need to manage operational risk as it is intimately related to the other
areas of risk.
(II) Components of ERM strategy: The components of ERM strategy include planning, risk
tracking and reporting, implementation and the tools of ERM implementation. The components are
described as follows:
A. Planning
Irrespective of the company’s strategy to hire a risk management team, outsource enterprise risk
management, or simply work with a team of current employees; ERM begins with an audit of an
organization’s potential liabilities with special attention to their severity. This risk plan is reviewed
periodically and adjusted in the light of changing conditions and ongoing risk management efforts.
Another element of planning is to define a company’s risk tolerance and propagate it to decision-
makers throughout the enterprise. If a risk is highly unlikely and not particularly severe, it may be just
left alone.
B. Risk tracking and reporting
Another key element of ERM is to track risks over time to see how well they are being managed and
to deal with the trends early. Comparing them to each other is not as important as establishing a
baseline that can be tracked across reporting periods. Insured need to continually remind them that
just because a risk cannot be effectively quantified or compared to others does not mean it should be
discounted or excluded from the ERM plan. Even if the financial impact of a risk is difficult to
measure, its occurrence can still be recorded and tracked. After the relative severity and likelihood of
various risks is assessed, a mitigation plan is developed. In other cases, a mitigation strategy for one
risk could actually increase the likelihood or severity of another risk, and in such case the trade-off
must be examined carefully.
While ERM might increase a company’s reserve or liability coverage requirements, its goal is to
provide the optimum preparation for adverse events. In some cases, an ERM framework will reduce
certain costs by reducing the double-counting of risks by previously undertaken risk management
efforts. In any case, under ERM a broader variety of risks is likely to be considered.
7
C. Implementation
The insured takes into account the objectives, scope, organization, and tools of enterprise risk
management to establish an ERM framework and its implementation. For an ERM strategy to be
successful, it is important to prioritize the objective according to company needs.
D. Tools: Some of the specific tools that are important for implementing ERM are:
i. Risk audit guides: These guides can be used for risk mapping of individual risks, risk
assessment workshops, and risk assessment interviews. The risk assessment interviews are very
effective at uncovering how the business actually works.
ii. Stochastic risk models: Stochastic model is a rigorous mathematical model used to simulate
the dynamics of a specific system by developing cause-effect relationships between all the
variables of that system. This plays a vital role in quantifying the risk components, its severity
and the required risk management efforts to offset the risk.
iii. Risk monitoring reports: These can include regular reports to managers, Boards, and
relevant external stakeholders such as the regulators and investors. This may be more formal
where the reports are more likely to go to the executive committee and the board of directors and
may be informal when such reports are likely to go for frequent adjustment in actions.
4.2 Risk management process: Having said the risk management mechanism as above, it would be
appropriate to highlight the ‘processes of risk management that may be adopted by the insured to
make it more effective. Chart 3 which depicts the logical sequence of such a risk management
process is an attempt in this direction.
Chart 3: Risk management process
8
Underwriting
Risk Risk R
avoidance assessment rete
Risk Role of
identification risk manager inve
Loss prevention Risk Ca

techniques control an
Chart 3 clearly indicates that an effective risk management process from the insured’s point of view
should necessarily include risk identification, risk assessment, risk avoidance & retention, risk
improvement & mitigation using appropriate techniques, implementation of the recommendations and
periodic review of the risk management programs.
4.2.1 Risk identification
The risk identification activity broadly involves an in-depth understanding of the industry, the areas
and markets it serves, its activities, range of products, social, legal and economic environment in
which it operates and other physical and natural hazards associated with the company’s operations.
Developing and exercising proper checklist for identifying these hazards is part of risk management
process.
Risk identification is important in managing the risk, which deals with source and problem analysis
as depicted in Chart 4 When either source or problem is known, the events that a source may trigger
or the events that can lead to a problem can be investigated. For example, major explosion in a mini
steel plant may affect business continuity of the unit; the stakeholders withdrawal during a project
9
may endanger funding of the project; fire damage caused to a chemical firm due to missing lightening
arrestor may result in major material damage; flood damage to a pump station of irrigation project
due to a facility located in a low lying area might delay the project completion schedules; and a
delayed or missed inspections may result in failure to identify these factors.
Chart 4: Risk Identification
Risk identification
Insured companies Prob

Source analysis profile
Extent and Moral factors Ph

regularity
Maintenance and Insured's R

safety standards attitude
As risk identification process involves identifying the risk factors and evaluating the potential loss
that might take place, it is more important for the insured to pay special attention on the following
two most important components as contained in the risk identification chart:
A. Maintenance procedures: The risk identification procedure must take into account the
identification of the nature and extent of maintenance procedures, their regularity and the skills of the
technicians undertaking the work. It is equally important to conduct non destructive testing along
with the regular maintenance testing. A study of moral factors by means of appropriate interviewing
10
of the people in plant or by observations may be undertaken to obtain multiple indicators of moral
hazards in the risk.
B. Physical factors: Physical factors are essentially sensory, visual signs of lack of due care and
control of the working environment to avoid damage. A clean, tidy and uncluttered work environment
not only denotes pride of possession but more importantly, a culture of loss avoidance. Business
interruption susceptibility of an organization depends on the kind of service that the organization
provides. Thus there is a need to conduct periodic hazard and operability study which will help in
detecting any predictable undesirable event by using the imagination of members to visualize the
ways of conceivable malfunctioning.
4.1.2. Risk Assessment
Once risks have been identified, they must then be assessed as to their potential severity of loss and
probability of occurrence, called ‘risk quantification’. These quantities can be either simple to
measure, in the case of the value of a lost building, or impossible to know for sure in the case of the
probability of an unlikely event occurring. The fundamental difficulty in risk assessment is
determining the rate of occurrence, i.e., the ‘loss frequency’. Proper risk assessment helps the
underwriter to apply judgment to the risk by securing material information and by determining the
actual conditions. The process of risk assessment may be depicted in Chart 5
Chart 5: Process of risk assessment
Risk assessment
Extent of physical Working Con

damage conditions
Monitoring of Quantification of Max

deviation from normal risk inte
operations
The risk assessment process as shown in Chart 5 consists of measuring the extent of physical damage,
the consequential loss and quantification of risk after taking into account the maximum probable
11
interruption time. Once risks are identified and assessed, the techniques to manage the risk are
applied to avoid or retain the risk.
4.1.3 Risk avoidance and risk retention
Risk avoidance is non-performance of an activity that could carry risk. For example, the risk of
potential damage to a control room in a petrochemical complex can be avoided by making the control
room blast proof; potential damage by flood to a pharmaceutical warehouse could be avoided by
shifting warehouse to a higher elevation. For the insurers, avoidance may seem the answer to all
risks; but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk
may have resulted in. Not entering a business to avoid the risk of loss also avoids the possibility of
earning profits.
Risk retention involves acceptance of loss. All risks that are not avoided or not transferred are
retained by default. This includes risks that are so large or catastrophic that they either cannot be
insured against or the premiums would be infeasible. War is an example since most property and risks
are not insured against war, so the loss attributed by war is retained by the insured. Risk retention is a
viable strategy for small risks that can be absorbed and where the cost of insuring against the risk
would be greater over time than the total losses sustained. True self insurance is risk retention for an
insured. For example a large and financially strong firm may create a self insurance fund to which
periodic payments are created. Risk retention pools are technically retaining the risk for the group,
but spreading it over the whole group involves transfer among individual members of the group. This
is different from traditional insurance, in that no premium is exchanged between members of the
group up front, but instead losses are assessed to all members of the group. Risk transfer means
causing another party to accept the risk, typically by contract or by hedging. Insurance is one type of
risk transfer that uses contracts. Risk transfer takes place when the activity that creates the risk is
transferred. Other times it may involve contract language that transfers a risk to another party without
the payment of an insurance premium. Liability among construction or other contractors is very often
transferred this way. Other examples of risk transfer could be subcontracting a hazardous operation
outside the manufacturing facility.
4.1.4 Risk reduction and control
Risk improvement and mitigation is an important task of risk management which involves methods
that reduce the severity of the loss. For example, the sprinkler system designed to put out a fire to
reduce the risk of loss by fire. For the risk reduction, a mitigation plan is prepared. The purpose of
the mitigation plan is to describe how this particular risk will be handled and what, when, by who and
how will it be done to avoid it or minimize consequences if it becomes a liability. Loss prevention in
risk management further aims to eliminate or to reduce these losses. The process of risk reduction and
control has been shown in Chart 6.
Chart 6: Risk reduction and control
12
Risk reduction and control
Loss prevention
Loss control mi
and avoidance
General techniques Causes of loss

and work procedures Stru
analysis
Loss prevention Spa

Policy conditions
measures ident
4.1.5 Implementation of the recommendations
Implementation of the recommendations for risk mitigation should be properly undertaken so as to
ensure effective management of risk by the insured.
4.1.6 Periodic review of the risk management programs

Risk is a relative measure and from insurer perspective it is important to map the risk consequence
with probability in a risk coordinate system. Chart 7 highlights the risk coordinate system.
Chart 7: Risk coordinate system
13
Consequences
Probability
It may be well observed from Chart 7 that taking into account the probability of risk occurrence and
the consequences , the risk factor can be subjected to four decision making areas namely high
consequences and low probability area, low consequences and high probability area, high
consequences and high probability area, and low consequences and low probability area. Managing
the risk in high probability and high consequence is the worst possible case. Total risk value in this
case is highest, because there is increased potential of events with large consequences. Low
consequence and high probability is the most common quadrant of risk management, because this is
the lowest threshold of a loss which is normal in nature. These may be arising out of minor repairs,
replacement and minimum business inconvenience. Low consequence and low probability is the
objective of risk based continuous improvement.
4.3 Risk management techniques adopted by the insurer
The risk management mechanism adopted by the insurer in the general insurance business broadly
falls into two categories: ‘risk based capital management’ and ‘reserving’. It may not be out of
context to mention here again that included in the ‘risk based capital management technique’ category
are the management role, capital and solvency margins, and risk based capital; and in the ‘reserve’
category of risk management techniques included are the unearned premium reserves, unexpired risk
14
reserves, outstanding claim reserves, incurred but not reported reserves, catastrophe reserves and
claims equalization reserve.
4.3.1 Risk based capital management technique
The insurance business, unlike other financial institutions, faces unique challenges in risk
management. Assuming the risks of others and guaranteeing the payments of claims based upon
perils that are random and uncertain are the kind of operational risks found as additional and unique
to the insurance business over and above any other risks inherent to the financial institutions in
general. Though the insurance regulatory authority, i.e., the IRDA, does not undertake the
responsibility of risk management of the individual players, it gives greater emphasis on monitoring
the conduct of the players in dealing with the risks to protect the interest of the customers.
In the context of risk based capital management technique, the role of board of directors and the
management is worth mentioning.
A. Role of the board of directors
The board of directors of each general insurance player is ultimately responsible for the company’s
risk management policies and practices. In delegating its responsibility, a board of directors usually
empowers the management with developing and implementing risk management programs and
ensuring that these programs remain adequate, comprehensive and prudent. The board of directors
should ensure that material risks are being appropriately managed. To ensure this, the board should:
1. review and approve management’s risk philosophy, and the risk management policies
recommended by the company’s management;
2. review periodically management reports demonstrating compliance with the risk management
policies;
3. review the content and frequency of management’s reports to the board or to its committee;
4. review with management the quality and competency of management personnel appointed to
administer the risk management policies; and
5. See that the audit regularly reviews operations to assess whether or not the company’s risk
management policies and procedures are being adhered to and to confirm that adequate risk
management processes are in place.
B. Role of management
The management of each general insurance company is responsible for developing and implementing
the company’s management program and for managing and controlling the relevant risks and the
quality of portfolio in accordance with this program. Although the management responsibilities of
one firm will vary from another firm, the managerial responsibilities in common shall be-
1. Developing and recommending the management’s risk philosophy and policies for approval
by the board of directors;
2. Establishing procedures adequate to the operations, and monitoring and implementing the
management programs;
3. Ensuring that risk is managed and controlled within the relevant management program;
4. Ensuring the development and implementation of appropriate reporting system ,and a prudent
management and control of existing and potential risk exposure;
5. Ensuring that audit regularly reviews the operation of the management program;
6. Developing lines of communication to ensure the timely dissemination of management
policies and procedures and other management information to all individuals involved in the
process.
15
C. Capital and solvency margin

The capital for general insurance business does not mean legal capital alone but includes valuation
margin available with the insurer. The reasons for holding such capital are to enable the company
settle the claims, maintain dividends, and invest in potential growth opportunities and also to support
other risks should there be a need. Settlement of the claims depends on the firm’s solvency margins.
The present solvency margin as prescribed by the IRDA called the required solvency margin (or
RSM), is 20% of the net premiums or 30% of net incurred claims whichever is higher, subject to a
reduction by 0.5 to 0.9 for reinsurance depending upon the insurance segment of fire, marine and
miscellaneous. This formula is similar to the provisions applicable under the European Union
legislation during early 1990s. The European Union legislation used a three year average net incurred
claims basis for calculation of solvency margin whereas IRDA does not provide for such averaging.
Besides the statutory provision, IRDA requires maintenance of the solvency margin at 150% of the
level defined in the regulations as a market practice while granting license. The IRDA solvency
norms imply a uniform risk profile across all companies and do not consider the risks to which
individual companies are exposed.
The solvency margins are calculated by deducting liabilities from the available assets. Valuation of
assets and liabilities for determination of the solvency margin however is subject to several
assumptions relating to the future market conditions. The solvency margin should always be positive
and should be at or above the prescribed level to ensure that liabilities are met at all times. The timing
of asset proceeds and discharge of liabilities is equally important. In order to achieve a higher
solvency margin, measures like charging of appropriate premiums, retaining adequate reserves,
investing prudently and managing risk accumulations may be undertaken by the players.
D. Risk Based Capital (RBC)
The RBC concept emerged in the global insurance market in the early 1960s especially in the US. At
present, as a part of the RBC model, an authorized capital level (or ACL) is prescribed by the
regulator to be observed by each insurer. The regulator has also prescribed corrective and remedial
actions in case of any failure on the part of the insurer to observe the stipulation depending on the
level of the ratio between the insurer’s actual free capital and the ACL. For example, when the
insurer’s actual free capital to the ACL ratio falls below 70%, the insurer shall be totally controlled
by the regulators and if the ratio falls between 100% and 150%, the regulators shall perform an
examination of the insurer and issue necessary corrective orders.
The US system of RBC has been criticized on the ground that the actions laid down in the regulations
against different action levels are rigid; the policyholders may have to pay additional premium to
service additional capital; several other risks have not been incorporated in the system; losses due to
derivatives is not included; calculation of risk factors is arbitrary; no consistent conceptual framework
for calculation of risk charges as factors derived from past industry experience may not be suitable
for the calculation of future distribution; management risk which is an important component of
operational risk has been excluded from the purview of risk assessment; and the solvency levels
required to be maintained discourages conservative reserving among insurers.
Mentioned may be made that in India a system of RBC is yet to be put in place although a debate for
the purpose is on. However when such a model is developed for use by the Indian general insurance
business, care needs to be taken to ensure optimal risk coverage by overcoming the above said
limitations associated with the US RBC model. While doing so the developed RBC model be tested
by factors such as company size, growth rate, product range, geographical region, reliance on
reinsurance and asset portfolio for the industry wide acceptability.
16
4.3.2 Reserving
The financial condition of an insurance company cannot be adequately assessed without sound loss
reserve estimates sufficient to meet any outstanding liabilities at any point of time. The estimation
process involves not only complex technical tasks but considerable judgment as well. It is important
for the insurance company to understand the data before embarking on the task of estimating loss
reserve which has a significant impact on the financial strength and stability of the company.
The general insurance companies apart from the general reserves maintain a number of technical
reserves which can be divided into following six categories, namely, unearned premium reserves
(UPR), unexpired risk reserve (URR), unexpired risk reserve (URR), outstanding claims reserve
(OCR), incurred but not reported reserves (IBNR), catastrophe reserves, and claims equalization
reserves. A brief explanation of each of these reserves along with their significance has been given as
follows;
A. Unearned premium reserves (UPR)
Unearned premium reserves is the proportion of premiums received which relates to the future period.
It is assumed that the risk is uniform over the duration of the policy and the liability arising out of the
risk can be met by reserving a pro rata amount of the balance of the premium after deducting initial
expenses. In the circumstances of high inflation, changes in expenses and widely fluctuating claims
ratio; the expected claims liability under the unexpired risks can differ significantly from the UPR
provision. If the UPR is regarded as inadequate, an additional reserve is necessary. The insurer
therefore needs to create extra reserve to offset the shortfalls in the UPR by creating an additional
unexpired risk reserve (or AURR).
B. Unexpired risk reserve (URR)
Unexpired risk reserve is created by the insurer to manage the risk arising out of the non receipt of
future premiums. It is estimated by multiplying with the unearned premiums the ratio of the claims
incurred in the year to the premiums earned in the same year. The unearned premiums also allows for
inflation and changes in experience in the various risk groups and their relative proportion of the total
premium. Over and above, a prudent fluctuation margin may be added to the above to minimize the
impact of errors associated with the estimation process.
C. Outstanding claims reserve (OCR)
OCR is maintained by the general insurance companies to meet the outstanding liability for claims
which have already been reported and not settled. The commonly used method to estimate OCR is to
obtain estimates in respect of all outstanding claims on an accounting date after taking into
consideration the following:
i. The certainty of the claim;
ii. The likely time needed to complete settlements;
iii. The rate of inflation on claims costs between the accounting date and the date of
settlements; and
iv. The judicial trends in claims settlements.
D. Incurred but not reported reserves (IBNR)
The IBNR reserve is the estimated liabilities for the unknown claims arising out of incidents occurred
prior to the year end but have not been notified to the company during the accounting period. In
practice, the provision for future development on known claims, which is called as incurred but not
enough reserved (IBNER) is included in IBNR. The average cost of an IBNR claim often differs from
that of currently reported claims. The insurance companies hence develop the ratio of average cost of
17
an IBNR claim to average cost of reported claims, for different classes of business on the basis of
historical data in order to measure the effectiveness of the IBNR reserves.
E. Catastrophe reserves
The catastrophe reserves are created to meet any unprecedented and/or uncontrollable risk factor
affecting the insurer. These reserves are created out of taxed income after taking into account the
operating position and the effect of provision upon the presentation of its results. Catastrophe reserve
in the long run equates the accumulated catastrophe loadings in premiums without impacting the
financial stability of the insurer.
F. Claims equalization reserves
Claims equalization reserves are made to smooth out the effects of year to year fluctuations in the
incidence of larger claims such as the unusual floods in Mumbai in 2005 and in Surat in 2006. The
provision is created based on past experience of the frequency of claims and the ‘probability density
function’ of this risk. Claims equalization reserve is not created to meet an inevitable liability.
Reserving provisions and IRDA
The IRDA emphasizes on uniformity in method of reserve estimations wherever sufficient data is
available. Besides, standard reporting formats have been devised to analyze current year's
transactions and to build up cumulative data for the amounts and number of claims settled. IRDA
further emphasizes on collecting all relevant information for each class of business from all insurers
so that the consolidated industry data can be used for reserving purposes for those classes where
availability of data is insufficient.
5. Conclusion
The study was developed to identify the risks to which the insured and the insurer are subject to,
especially in India and the mechanism through which these risk complexions are effectively managed.
The study reveals that both the insured and the insurer in India generally face risks ranging from
financial to non financial in nature. The financial risks for both of them are classified as capital risk,
asset/liability management risk, insurance risk and credit risk, whereas the non financial risk include
enterprise risk and operational risk. The capital risk includes capital structure risk and capital (in)
adequacy risk. Whereas the asset liability management risk includes exchange risk, interest rate risk
and investment risk. Similarly the insurance risk includes underwriting risk, catastrophe risk, reserve
risk, claims management risk and the credit risk includes reinsurance risk, policy holders and broker’s
risks, claims recovery risk and other debtor’s risk. In the same manner the enterprise risk includes
reputation risk, parent risk, competitors risk and the operational risk includes regulatory risk, business
continuity risk, IT obsolescence risk, process risk, regulatory compliance risk and out sourcing risk.
The risk management mechanism found prevalent in the general insurance industry for the insured are
in the form of enterprise risk management comprising of planning, risk tracking and reporting,
implementation, tools and risk management. Whereas for the insurer it is in the form of risk based
capital management and reserving, with the former consisting of management role, capital and
solvency margins, and risk based capital and the later consisting of unearned premium reserves,
unexpired risk reserves, outstanding claim reserves, incurred but not reported reserves, catastrophe
reserves and claims equalization reserve.
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RISK MANAGEMENT IN GENERAL INSURANCE BUSINESS IN INDIA

T Joji.Rao1 & Krishan K. Pandey2†

Financial Risk Non Finan

Chart 2: Risk management mechanism

Chart 3: Risk management process

Loss prevention Risk Ca

Chart 4: Risk Identification

Insured companies Prob

Extent and Moral factors Ph

Maintenance and Insured's R

Extent of physical Working Con

Monitoring of Quantification of Max

Chart 6: Risk reduction and control

Risk reduction and control

General techniques Causes of loss

Loss prevention Spa

4.1.6 Periodic review of the risk management programs

Chart 7: Risk coordinate system

C. Capital and solvency margin

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