EFFECTUAL INSURANCE UNDERWRITING IN THIS DECISIVE JUNCTURE OF NEW NORMAL SITUATION

1. INTRODUCTION:

The coronavirus pandemic is savaging the global economy, resulting in widespread business closures, near-universal event cancellations, insurance executives are habitually working from home & busy in attending/responding the mails of bosses, insured, intermediaries, like brokers, Surveyors, etc., Event Managers are working on the cancellation of events, cancellation of orders and slowing of deliveries are obvious, and a general disruption of supply chains is evident. News reports indicate that the impacts are already being felt in virtually all industries. Travel, transportation, hospitality, education, health care, entertainment, and event planning are especially hard-hit, but most manufacturing and service activities are being disrupted. In recent days, the insurance industry had cut back on coverage available for pandemic diseases, introducing new or broadened exclusions and applying strict sub-limits to contain insurer exposure. Nonetheless, pockets of coverage continue to exist. So it is important now to make revised assessments of Insured business’s vulnerabilities and Indian Insurers need to resort to underwriting prudence and also to seriously depend on their underwriters’ acumen.

 

2. Market Discipline to be imbibed in underwriting:

Underwriting is a process of selecting policyholders by recognizing hazards, analyzing risks, determining pricing, deciding terms and conditions. It is a process of gathering information about a risk offered for insurance and deciding coverage with proper premium and terms. Functions like marketing, ratemaking, accounts and claims may be subcontracted to outside agencies, but not underwriting because of its fundamental importance to the success of the insurer. To develop and maintain a profitable book of business is the main purpose of underwriting. This comes from proper selection of risks. To achieve this purpose, the insurers (underwriters) must avoid adverse selection. Adverse selection occurs when the proposed risks present a higher-than average probability of loss. Underwriting control ensures no adverse selection at operating level and corporate underwriting policy is not giving adverse results.

Underwriting is a core insurance function. It is a methodological approach to ensure that the insurance business is conducted on sound lines and that risks offered for insurance are evaluated for loss potential on both frequency and severity over a period of time over which the liability may flow to the insurer. In short the underwriter does a proper exercise to evaluate the insurability of the risk and if the risk can be assumed, the price, terms and conditions at which the risk may be insured.

Underwriting is the process of:

1. Determining the level of risk presented by a proposer
2. Deciding whether to accept the proposal
3. Deciding the terms and price of the accepted proposal

Each underwriting decision involves balancing the insurer’s desire to earn premium often in competitive conditions with margins required to pay claims and expenses and also to ensure compliance with regulatory requirements.

Underwriting is essential in all forms of insurance. For example, an automobile insurer may charge higher rates to old models of vehicles, or may refuse coverage to drivers with a history of accidents. The underwriter may offer discounts for vehicles fitted with anti-theft devices or having membership of Automobile Association, etc. Fire insurers may inspect properties, offer reduced premiums for safety features such as hydrant or sprinkler systems, and so on.

3. Understanding Risk Sharing IN INSURANCE:

Understanding the concept of risk sharing or pooling will make it easier for everyone to understand the role of underwriting and risk classification in insurance.

All risks are not equal. For example, in the field of property and casualty insurance, wooden structures are at a greater risk of burning than stone structures. Therefore, a higher premium is required to insure a wooden structure. The same concept applies to life insurance. An individual with a serious illness such as cancer or diabetes is at a greater risk of premature death than an individual without the illness.

Since all risks are not equal, it would be inequitable to make all insured contribute the same amount. Thus, underwriting attempts to classify risks based upon their characteristics so that each insured in a specific class pays a premium in proportion to the risk involved.

The issue of fairness to the other participants is at the core of this risk classification (underwriting) process. When viewed from a perspective of fairness, proper risk classification becomes a central obligation of insurers to the policyholders who participate in their risk pools. This applies for all risks – life, assets or earnings.

We all know that Insurance is a contract by which one party, the policyholder, pays a stipulated consideration, called premium, to the other party called insurer. In return, the insurer agrees to pay a defined amount of money or provide a defined service if the covered event occurs during the policy period. So Insurance is a risk transfer–cum–sharing or pooling of risks. It is created when people pool their contributions to create a common fund that is large enough to protect themselves from the effects of a loss which may affect any one or more of them. The loss could be of any type – life, disability, fire or more. If the risk of loss can be spread over a large group (the law of large numbers), the financial loss resulting from the loss to the members can be paid from the premium collected for the pool. This is in contrast to one person bearing the full brunt of economic loss without any financial backing. Thus, in insurance a large uncertain loss is replaced for a small certain loss of the premium.

 

4. PREMIUM FIXATION – THE ESSENCE OF UNDERWRITING:

Insurance is a trade that runs on premium collected from the policyholders. So those insurable risks have to be understood and differentiated in the interest of impartiality and equity. The simple fact is that practically no two risks may be equal in all respect. There are physical hazards involved and several objectives are inherent – such as variations in construction, occupancy, neighbourhood exposures, protective measures available and management attitudes relating to each risk to be underwritten. The underwriter therefore, has to excel in risk classification so that each insured pays the premium in proportion to the likely hood that a covered loss might strike it. Every insured has to share in the risk burden based on its risk load and that has to be properly assessed by an underwriter, who needs to keep reviewing the risk  so that any betterment in it to be rewarded and any increase in the risk exposure must be charged higher in proportion to the increase in the risk profile. The insurers assumes the risk that they takes on, by charging appropriate premium and settings the mandatory & voluntary excesses / deductibles, and deciding on the terms of coverage, conditions, exclusions and other restrictions in terms of warranty / limitations. If an insurer charges lesser than what is a proper risk-based premium across risks, it could become insolvent when large numbers of claims, whether owing to frequency &/or with higher magnitude/severity occur. This is not only against the interests of the insurers, but against the interests of the policyholders who will need indemnity in the imminent. On the other hand, if an insurer charges too much, it will lose business to its competitors. Charging a premium too low or too high is against the principles of insurance and it also violates the Regulatory Benchmarks set by IRDAI. The right balance in underwriting and pricing is sensitive, and the Actuary and Chief Underwriter of the insurer have to ensure that proper principles and practices are inserted in the insurer’s day-to-day activities under the supervision of their Board Members.

5. RISK APPRAISAL, assortment & selection:

Risk appraisal obviously is the starting point of the underwriter; using the acumen of the underwriter he/she must examine the insurance proposal from its insurability standard and subsequently assigning the risks to be accepted to the relevant & appropriate class to decide whether to be accepted with the discount or loading depending on its positive or negative aspects that prevails in reality. This process is obvious to avoid adverse selection. Adverse selection occurs when wrong information of the risk, in detrimental to the underwriter’s understanding the real risk exposure, as received from the insured being provided in the Proposal Form while that is accepted by the insurer. Underwriting depends on obtaining the correct/factual information submitted by the Proposer while filling the Proposal Form and evaluating the information that is elicited from that and finally applying his/her experience & knowledge to evaluate the proposed risk in its risk context and then deciding his action – whether to apply discount or loading on  the prescribed tariff/guideline rate. Underwriting involves examining material disclosures in the proposal forms, and other supplementary underside documents such as additional questionnaires, Inspection Reports, Valuation Reports, the market exposure/knowledge lying with the Insurer including data on similar risks and so on. Using analytics and other digital and technological tools are also becoming a requirement in this current era to arrive at the proper underwriting decisions.

6. Adverse selection TO BE ALWAYS AVERTED:

The most common risk of Indian General Insurance underwriting is adverse selection. If the two groups of dissimilar risk exposures were charged the same rate, problems would arise. Basically the rates should always reflect average loss costs. If we cover more number of perils (i.e. causes of losses) or more hazardous items – the rate should obviously increase. The insured even knowing that they represent higher risk but always want to enjoy lower rates. This phenomenon of selecting an insurer that charges lower rates for a specific risk exposure is known as ‘Adverse Selection’ because the insured know they represent higher risk, but want to enjoy lower rates. Adverse selection occurs when insurance is purchased more often by people/organizations with higher than average expected losses than by people/ organizations with average or lower than average expected losses. That is, insurance is of greater use to insured whose losses are expected to be high. So it is desired in underwriting that insurers may simply charge higher premiums to the insured with higher expected losses. Here comes the problem of intense competition in this free market underwriting. Often, however, the insurer simply does not have enough information to be able to distinguish completely among insured. Furthermore, the insurer wants to aggregate in order to use the law of large numbers. Thus, some tension exists between limiting adverse selection and employing the law of large numbers.

Adverse selection, then, can result in greater losses than expected. Insurers try to prevent this by learning enough about applicants for insurance to identify such people so they can either be rejected or put in the appropriate rating class of similar insured with similar loss probability. In this fierce competition in this Indian General Insurance market, underwriters have practically very limited scope in this direction where the demand now-a-days is to match the market or to quote for becoming L1to book the client’s insurance business.

Some insurance policy provisions are designed to reduce adverse selection. The pre-existing condition provision in health insurance policies is designed to avoid paying benefits to people who buy insurance because they are aware, or should be aware, of an ailment that will require medical attention or disable them in the near future. It is, therefore, desired by the underwriters that the insurance device should be suitable to all pure risks but ironically as a practical matter, many risks that are insured meet these requirements for insurability only partially or, with reference to a particular requirement, or not at all. Thus, in a sense, these requirements to be listed & be described the ideal requisites for insurability which would be met by the ideal risk. No insurer can safely disregard them completely. Any risk that is perfectly suited for insurance coverage in Indian market would basically need to meet the following requirements:

1. The number of similar exposure units would be large.
2. Losses that occurred would be accidental.
3. A catastrophe needs to be a remote possibility.
4. Losses would be definite and the probability distribution of losses would be determinable.
5. Insurance coverage cost would be economically feasible.

Actually the item no. 5 influences the consumer demand for insurance and looks at what is economically feasible & viable from the perspective of potential insured. Other requirements (i.e. item nos. 1 to 4) influence the willingness of insurers to supply desired insurance cover.

7. ISSUE OF FAIR PRICING IN INSURANCE MARKET:

In a free market society, an entity offering a product for sale should try to set a price at which the entity is willing to sell the product and the consumer is willing to purchase it. Determining the supplier-side price to charge for any given product is conceptually straightforward. The simplest model focuses on the idea that the price should reflect the costs associated with the product as well as incorporate an acceptable margin for profit. The following formula depicts this simple relationship between price, cost, and profit: Price = Cost + Profit.

This is however, true in case of a tangible product. It is also to be noted that for many non-insurancegoods and services, the production cost is known before the product is sold. Therefore, the initial price can be set so that the desired profit per unit of product will be achieved. However, Insurance is different from most products as it is a promise to do something in the future if certain events take place during a specified time period.  For example, insurance may be a promise to pay for the rebuilding of a home if it burns to the ground or to pay for medical treatment for a worker injured on the job. Unlike a can of soup, a pair of shoes, or a car, the ultimate cost of an insurance policy is not known at the time of the sale. This places the classic equation in a somewhat different context and introduces additional complexity into the process of price setting for an insurance company.

The price the insurance consumer pays is referred to as premium, and the premium is generally calculated based on a given rate per unit of risk exposed. Insurance premium can vary significantly for risks with different characteristics. The rating manual is the document that contains the information necessary to appropriately classify each risk and calculate the premium associated with that risk. The final output of the ratemaking process is the information necessary to modify existing rating manuals or create new ones. The earliest rating manuals were very basic in nature and provided general guidelines to the person responsible for determining the premium to be charged. Over time, rating manuals have increased in complexity. For some lines, the manuals are now extremely complex and contain very detailed information necessary to calculate premium. Furthermore, many companies are creating manuals electronically in lieu of paper copies. Before, understanding the complex process of insurance pricing and ratemaking, it is important to be familiar with some basic insurance terminology used in the pricing process for better understanding.

The basic economic relationship for the price of any product was given as follows:

Price = Cost + Profit.

This general economic formula can be tailored to the insurance industry using the basic insurance terminology outlined in the preceding section. Premium is the “price” of an insurance product. The “cost” of an insurance product is the sum of the losses, claim-related expenses, and other expenses incurred in the acquisition and servicing of policies. Underwriting profit is the difference between income and outgo from underwriting policies, and this is analogous to the “profit” earned in most other industries. Insurance companies also derive profit from investment income, although at this juncture this aspect of profit for the insurers is relatively drab.

The goal of ratemaking is to assure that the fundamental insurance equation is appropriately balanced. In other words, the rates should be set so that the premium is expected to cover all costs and achieve the target underwriting profit. Thus, a rate provides for all costs associated with the transfer of risk. There are two key points to consider in regards to achieving the appropriate balance in the fundamental equation:

1. Ratemaking is the current prospective.
2. Balance should be attained at the aggregate and individual levels.

8. Ratemaking is THE CURRENT Prospective:

As stated earlier, insurance is a promise to provide compensation in the event a specific loss event occurs during a defined time period in the future. Therefore, unlike most non-insurance products, the costs associated with an insurance product are not known at the point of sale and as a result need to be estimated. The ratemaking process involves estimating the various components of the fundamental insurance equation to determine whether or not the estimated premium is likely to achieve the target profit during the period the rates will be in effect.

It is common ratemaking practice to use relevant historical experience to estimate the future expected costs that will be used in the fundamental insurance equation; this does not mean actuaries are setting premium to recoup past losses. As per the principle in the CAS Statement of Principles Regarding Property and Casualty Insurance Ratemaking” states that “A rate is an estimate of the expected value of future costs”. Historic costs are only used to the extent that they provide valuable information for estimating future expected costs. When using historic loss experience, it is important to recognize that adjustments will be necessary to convert this experience into that which will be expected in the future when the rates will be in effect. For example, if there are inflationary pressures that impact losses, the future losses will be higher than the losses incurred during the historical period. Failure to recognize the increase in losses can lead to an understatement of the premium needed to achieve the target profit.

There are many factors that can impact the different components of the fundamental insurance equation and that should be considered when using historical experience to assess the adequacy of the current rates.

The following are some items that may necessitate a restatement of the historical experience:

1. Rate changes
2. Operational changes
3. Inflationary pressures
4. Changes in the mix of business written
5. Law changes

The key to using historical information as a starting point for estimating future costs is to makeadjustments as necessary to project the various components to the level expected during the period the rates will be in effect. There should be a reasonable expectation that the premium will cover the expected losses and expenses and provide the targeted profit for the entity assuming the risk.

When considering the adequacy or redundancy of rates, it is important to ensure that the fundamental insurance equation is in balance at both an overall level as well as at an individual or segment level. Equilibrium at the aggregate level ensures that the total premium for all policies written is sufficient to cover the total expected losses and expenses and to provide for the targeted profit. If the proposed rates are either too high or too low to achieve the targeted profit, the company can consider decreasing or increasing rates uniformly. In addition to achieving the desired equilibrium at the aggregate level, it is important to consider the equation at the individual risk or segment level. Principle 3 of the CAS “Statement of Principles Regarding Property and Casualty Insurance Ratemaking” states “A rate provides for the costs associated with an individual risk transfer” (CAS Committee on Ratemaking Principles, p. 6). A policy that presents significantly higher risk of loss should have a higher premium than a policy that represents a significantly lower risk of loss. For example, in workers compensation insurance an employee working in a high-risk environment (e.g., a steel worker on high-rise buildings) is expected to have a higher propensity for insurance losses than one in a low-risk environment (e.g., a clerical office employee). Typically, insurance companies recognize this difference in risk and vary premium accordingly. Failure to recognize differences in risk will lead to rates that are not equitable.

 

Rate making is the determination of what rates, or premiums, to charge for insurance. A rate is the price per unit of insurance for each exposure unit, which is a unit of liability or property with similar characteristics. For instance, in property and casualty insurance, the exposure unit is typically equal to ₹100 of property value, and liability is measured in ₹1,000 units. Life insurance also has ₹1000 exposure units. The insurance premium is the rate multiplied by the number of units of protection purchased.

Insurance Premium = Rate X Number of Exposure Units Purchased.

The difference between the selling price for insurance and the selling price for other products is that the actual cost of providing the insurance is unknown until the policy period has lapsed. Therefore, insurance rates must be based on predictions rather than actual costs. Most rates are determined by statistical analysis of past losses based on specific variables of the insured. Variables that yield the best forecasts are the criteria by which premiums are set. However, in some cases, historical analysis does not provide sufficient statistical justification for selling a rate, such as for earthquake insurance. In these cases, catastrophe modeling is sometimes used, but with less success. Actuaries set the insurance rate based on specific variables, while underwriters decide which variables apply to a specific insurance applicant.

Because an insurance company is a business, it is obvious that the rate charged must cover losses and expenses, and earn some profit. But to be competitive, insurance companies must also offer the lowest premium for a given coverage.  Moreover, all states have laws that regulate what insurance companies can charge, and thus, both business and regulatory objectives must be met.

The primary purpose of ratemaking is to determine the lowest premium that meets all of the required objectives. A major part of ratemaking is identifying every characteristic that can reliably predict future losses, so that lower premiums can be charged to the low risk groups and higher premiums charged to the higher risk groups. By offering lower premiums to lower risk groups, an insurance company can attract those individuals to its own insurance, lowering its own losses and expenses, while increasing the losses and expenses for the remaining insurance companies as they retain more of the higher risk pools. This is the reason why insurance companies spend money on actuarial studies with the objective of identifying every characteristic that reliably predicts future losses.

Note that both the ratemaking and the underwriting must be accurate. If the rate is accurate for a particular class, but the underwriter assigns applicants that do not belong to that class, then that rate may be inadequate to compensate for losses. On the other hand, if the underwriting is competent, but the rate is based on an inadequate sample size or is based on variables that do not reliably predict future losses, then the insurance company may suffer significant losses.

The pure premium, which is determined by actuarial studies, consists of that part of the premium necessary to pay for losses and loss related expenses.

Loading is the part of the premium necessary to cover other expenses, particularly sales expenses, and to allow for a profit.

The gross rate is the pure premium and the loading per exposure unit and the gross premium is the premium charged to the insurance applicant, and is equal to the gross rate multiplied by the number of exposure units to be insured.

The ratio of the loading charge over the gross rate is the expense ratio.

Pure Premium = Total Amount of Losses Incurred per year / Number of Exposure Units

Example: An average loss of ₹ 10 million per year per 10,000 automobiles yields the following pure premium:

Pure Premium = ₹ 10,000,000 / 10,000 = ₹ 1000 per Automobile per Year

Gross Rate = Pure Premium + Loading

The loading charge consists of the following aspects:

1. Commissions and other acquisition expenses
2. Premium taxes
3. General administrative expenses
4. Contingency allowances
5. Profit

Loading charges are often expressed as a proportion of premiums, since they increase proportionately with the premium, especially commissions and premium taxes. Hence, the loading charge is often referred to as an expense ratio. Therefore, the gross rate is expressed as a percentage increase over the pure premium:

Gross Rate = Pure Premium

                      1 – Expense Ratio

Example: If the Pure Premium is ₹700 and the expense ratio is 30%, then:

Gross Rate = ₹ 700 / (1 – 0.3) = ₹700/0.7 = ₹ 1000

Gross Premium = Gross Rate x Number of Exposure Units

Expense Ratio = Load / Gross Rate

Other business objectives in setting premiums are:

1. Simplicity in the rate structure, so that it can be more easily understood by the customer, and sold by the agent;
2. Responsiveness to changing conditions and to actual losses and expenses; and
3. Encouraging practices among the insured that will minimize losses.

The main regulatory objective is to protect the customer. A corollary of this is that the insurer must maintain solvency in order to pay claims. Thus, the 3 main regulatory requirements regarding rates are that:

1. Rates are to be faircompared to the risk revelation;
2. Premiums must be adequateto maintain insurer’s solvency;
3. Premium rates are not to be biased—the same rates should be charged for all members of an underwriting class with a similar risk profile/exposure.

Although competition would compel businesses to meet these objectives anyway, the states want to regulate the industry enough so that fewer insurers would go bankrupt, since many customers depend on insurance companies to avoid financial calamity. The main problem that many insurers face in setting fair and adequate premiums is that actual losses and expenses are not known when the premium is collected, since the premium pays for insurance coverage in the immediate future. Only after the premium period has elapsed, will the insurer know what its true costs are. Larger insurance companies have actuarial departments that maintain their own databases to estimate frequency and the monitory amount of losses for each underwriting class, but smaller companies rely on advisory organizations or actuarial consulting firms for loss information.

Some other factors that influence the process of ratemaking include:

1. Management Expenses: As mentioned earlier, these expenses are that an insurer will have to incur as he runs the business and include salaries, travel and accommodation, office expenses etc.
2. Commissions: This is particularly relevant in the corporate insurance market which globally tends to use professional brokers as distributional channels. As insurance products are not customized, hence requires tailoring and customization. Hence, commissions can range up to 17.5 % as of now in India.
3. Claims expenses: In addition to paying out claims, the claims department has some expenses in handling of claims that include use of expert witness, qualified surveyors etc.
4. No Claims Bonus / Malus: In motor insurance covers, there is recognized scale of discounts for risks having no claims – being rewarded as the ‘No claims Bonus’. This is used in many countries to encourage the insured to drive carefully and if there is a small claim, to consider treating that as “self insured” rather than jeopardizing his no claim bonus, which can be substantial after 4 years of claims free driving. As per the Indian practice, with the stipulated ‘Sun Set Clause’ when the insurer settles a claim, the insured losses all previously accumulated No Claim Bonus. However, he can again continue to earn no claim bonus for claims free years at subsequent renewals.
5. Loading / Malus: There is also a reverse scenario where insurers load the premiums as per a published schedule when the claims experience is bad. Such loading of premium when the claims experience is poor is known as Loading / Malus. Conditions when such loadings are done and the amount of loading are disclosed in advance. In many countries, certain caps are imposed on the loading. Indian Motor Insurance, for instance, caps some loadings at 100% and some types of loadings at 200%.
6. Trends: The insurer needs to collate the historical information relating to losses / claims and exposures. However, it is critical that notice is taken of trends – past, present, and future that will affect the assumptions coming from these statistics. This should be done in a structural format and there are a number of areas that need to be considered by the portfolio underwriters. Some of these indicators or trends can be:
   1. Inflation: in certain classes, the claims costs and exposures will not be consistent as regards inflationary impact. Example hotels may be rated on the number of bedrooms as regards the Public Liability Risk – rejected claims experience should take into account inflationary changes.
   2. Political environment: Changes in the political landscape can change a country or a part of the country from a high hazard (crime risks) to a low hazard over a relatively short period of time and vice versa. Moreover, issues such as terrorism have significantly increased over the past 20 years.
   3. Technology: Over the last 3 decades, technology has vastly improves the safety standards in many industries, by reducing manual interventions. For examples. Printing industry has introduced computerized presses, and just-in-time strategy, improving fire risks safety is some improvements.
   4. Legal changes: Changes in the legal environment, litigation costs can change significantly the claims costs and payouts.
   5. Attractiveness: Items such as mobile phones, Laptops are attractive in the first year but with the falling prices and greater availability move them into commodity areas and relatively unattractive mode in comparison.
   6. Miscellaneous: These include climatic changes, global warming and their likelihood of impact on flood risks etc.

9. FINALLY WHILE SUMMING UP:

 Pricing or the appropriate Rate Fixing is very significant to the success of any insurance venture. Underwriting profits needs to be the consistent objective at this Corona affected backdrop of the Indian Insurance Market. The basic pricing premiums in: claims out –leads to pure premium. Pure premium needs adjustment for all the working expenses and normal outgoings of any insurer. Technical rate and book rate are critical for long term underwriting profits.  Operational premium issues include rating, catastrophe loading and commercial discounting, but when survival is the focus – Insurers can never be ignorant about this critical need of the underwriting prudence and simply now drastically depend on their underwriters’ acumen.