INTRODUCTION:

The success of any business, general insurance business not being an exception, depends largely on how well the business is able to manage its risk complexion. The risk complexion in itself varies in nature and magnitude from business to business, industry to industry and time to time. A change in the business environment results in a corresponding change in the risk complexion of the business and its overall performance. The changes introduced in the insurance business sector in India in general and in the general insurance business in particular during the late nineties as a fall out to the Government of India’s ongoing economic perestroika with the opening up of the sector to private players and foreign joint ventures have expectedly brought both challenges and opportunities for the players in the sector with a corresponding changes in their risk complexion and performance.

This is particularly so when the private players backed by their foreign counter parts in the form of alliances and joint ventures with large capital base and exposure to IT and ITES to their advantage rolling out variety of products according to the varied need of customers and the state players, namely, the General Insurance Corporation Ltd, National Insurance Corporation Ltd, New India Insurance Ltd, Oriental Insurance Company Ltd, United India Assurance Ltd with their long experience and expertise in the insurance business not falling far apart.

Against the above backdrop, the present paper attempts to identify the nature and magnitude of risks to which general insurance business in India as whole are exposed to and how such risks are being managed by these businesses.

Risks in General Insurance business:

Based on the data collected from secondary sources on all the fourteen players in the general insurance business in India including the five public sector players, namely, General Insurance Corporation Ltd, National Insurance Corporation Ltd, New India Insurance Ltd, Oriental Insurance Company Ltd, United India Assurance Ltd and the nine private sector players, namely, Royal Sundaram Insurance Co Ltd, Reliance General Insurance Ltd, Iffco Tokio General Insurance Ltd, TATA - AIG General Insurance Ltd, Bajaj Allianz General Insurance Ltd, ICICI Lombard General Insurance Ltd, Cholamandalam MS General Insurance Ltd, HDFC CHUBB General Insurance Ltd, Future Generalia General Insurance Ltd and Universal Sompo General Insurance Ltd., it is observed that the players are exposed to a variety of financial and non-financial risks. These risks range from capital risk, asset liability management risk, insurance risk and credit risk under the financial risks category and enterprise risk and operating risk under the non financial risks category.

Financial risks for the general insurance businesses assume the forms of capital structure risk, capital inadequacy risk, exchange rate risk, interest rate risk, investment risk, underwriting risk, catastrophic risk, reserve risk, pricing risk, claims management risk, reinsurance risk, policy holders and brokers’ risks, claims recovery risk and other debtors’ risk (Daugard and Valentine,1999; Bruce,et.al,2003; Cummins, et.al,2008). The non financial risks for the general insurance businesses assume two broad forms- enterprise risk and operational risk. The various financial and non financial risks involving general insurance businesses in India are depicted in Fig.1.1.

Management of risk in General Insurance business:

General insurance businesses put in place various plans to manage the financial risks by adopting techniques like interest rate hedging and reserving, determined through financial modeling amid the inherent ‘model’ risk in so far as these financial models may fail to predict the real outcomes within an acceptable range of error.

Management of non financial risk has assumed greater importance in recent past owing mainly 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. Besides, 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 businesses are confronted with. Studies have proved that the major source of volatility in general insurance business is not related to financial risks but to operational risks, i.e., the way the insurance businesses operate(Gorvett,2001;Peter,2008). Operational risks arises from inadequate or failed internal processes such as the employment practice, workplace safety, and internal fraud, and from external events like external fraud and damage of physical assets caused by natural disaster and other uncontrollable events( Marc,2003;CAS 2007).

Techniques of risk management:

Risk management techniques adopted by the insurer in general insurance business takes the form of ‘risk based capital management’ and ‘reserving’ (Kanan, 2005; Laxmanan, 2007; Sharma, 2007, Laxmi, 2008). On the other hand the risk management technique of the insured takes the form of ‘enterprise risk management’. Each of these techniques along with their components has been depicted in Fig.1.2. The present paper delimits its scope to include discussion on the techniques as adopted by the insurers only.

Fig.1.1: Financial and non financial risks affecting general insurance business in India

Financial Risks				Non financial Risks
1	Capital risk	i	Capital structure risk	1	Enterprise risk	i	Reputation risk
1	Capital risk	ii	Capital inadequacy risk			ii	Parent risk
2	Asset/Liability Management risk	i	Exchange rate risk			iii	Competitor risk
		ii	Interest rate risk	2	Operational risk	i	Regulatory risk
		iii	Investment risk			ii	Business continuity risk
3	Insurance risk	i	Underwriting risk			iii	IT obsolescence risk
		ii	Catastrophic risk			iv	Process risk
		iii	Reserve risk			v	Regulatory compliance risk
		iv	Pricing risk			vi	Outsourcing risk
		v	Claims management risk
4	Credit risk	i	Reinsurance risk
		ii	Policy holders risk
		iii	Brokers risk
		iv	Claims recovery risk
		v	Other debtors risk

Fig.1.2: Risk management techniques of general insurance businesses in India from the insurers’ perspective.

Risk based capital management		Reserving
i	Management role	i	Unearned premium reserves
ii	Capital and solvency margins	ii	Unexpired risk reserves
iii	Risk based capital	iii	Outstanding claims reserves
		iv	Insured but not reported reserves
		v	Catastrophe reserves
		vi	Claims equalization reserves

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 unique operational risks associated with insurance business over and above any other risks that are inherent to financial institutions in general. Though the insurance regulatory authority, namely, the IRDA in India , does not undertake the responsibility of managing risks of individual players, it (IRDA) certainly gives emphasis on monitoring the conduct of the players in dealing with these risks in order to protect the interest of the customers.

In the context of the ‘risk based capital management technique’, the role of board of directors and the management as specified by the IRDA is worth mentioning.

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, the board of directors usually empowers the management to develop and implement risk management programs and to ensure that these programs remain adequate, comprehensive and prudent. Notwithstanding this, the board of directors has to ensure that the material risks are appropriately managed. To do this, the board has to-

1. review and approve the management’s (a) risk philosophy, and (b) the risk management policies, review periodically management reports demonstrating compliance with the risk management policies;

2. review the content and frequency of management’s reports to the board or to its committee;

3. review the quality and competency of management personnel appointed to administer the risk management policies; and

4. to see that ‘audit’ regularly reviews the operations to establish that the company’s risk management policies and procedures are being adhered to.

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 will vary from one company to another, the common managerial responsibilities shall be-

1. to develop and recommend the management’s risk philosophy and policies for approval by the board of directors;

2. to establish procedures adequate to the operations, and to monitor and implement the management programs;

3. to ensure that risk is managed and controlled within the relevant management program;

4. to ensure the development and implementation of appropriate reporting system,

5. to ensure a prudent management and control of the existing and potential risk exposure;

6. to ensure that there is a regular ‘audit’ of the operation of the management program; and

7. to develop lines of communication for the timely dissemination of management policies and procedures and other management information to all individuals involved in the process.

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 that the company is able settle the claims, maintain dividends, and invest in potential growth opportunities, besides supporting other risks in case of need. Settlement of the claims depends on the firm’s solvency margins. The present solvency margin called the required solvency margin (or RSM) as prescribed by IRDA 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 per cent 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 go for such averaging. Besides the statutory provisions, IRDA requires maintenance of 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 also 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.

Risk based capital (RBC):

The RBC concept emerged in the global insurance market in the early 1960s especially in the US( Thomas,2005). 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 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 may 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.

Reserving:

The financial condition of an insurance company cannot be adequately assessed without a 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 maintaining general reserves, also maintain a number of technical reserves which may be divided into six categories, such as 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. Brief explanations of each of these reserves along with their significance are as follows:

Unearned premium reserves:

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).

Unexpired risk reserve:

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.

Outstanding claims reserve:

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.

Incurred but not reported reserves:

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 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.

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.

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.

CONCLUSION:

Risks in general insurance business in India are found to be ranging from financial to non financial in nature. The financial risks take the form of capital risk, asset/liability management risk, insurance risk and credit risk whereas the non financial risks take the form of enterprise risk and operational risk. The capital risk includes capital structure risk and capital inadequacy risk. 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. The enterprise risk includes reputation risk, parent risk, competitors risk whereas the operational risk includes regulatory risk, business continuity risk, IT obsolescence risk, process risk, regulatory compliance risk and outsourcing risk.

The risk management mechanism found prevalent in the general insurance business for the insurer 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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Received on 10.08.2011 Accepted on 28.10.2011

Asian J. Management 2(4): Oct.-Dec., 2011 page 186-190