IC 45 GI UNDERWRITING.pdf

IC-45 GENERAL INSURANCE UNDERWRITING Acknowledgement: This course has been prepared with the assistance of P. C. James B. V. Sastry A. K. Padhiari K. G. P. L. Rama Devi V. Peri R. Srinivasan Y. Priya Bharat B. V. Sastry A. S. Chaubal We also acknowledge Get Thro...

IC-45 GENERAL INSURANCE UNDERWRITING Acknowledgement: This course has been prepared with the assistance of P. C. James B. V. Sastry A. K. Padhiari K. G. P. L. Rama Devi V. Peri R. Srinivasan Y. Priya Bharat B. V. Sastry A. S. Chaubal We also acknowledge Get Through Guides, Pune for their contribution in preparing the study material. INSURANCE INSTITUTE OF INDIA G- Block, Plot No. C-46, Near Dhirubhai Ambani International School, Bandra Kurla Complex, Bandra (E), Mumbai – 400 051.  GENERAL INSURANCE UNDERWRITING IC-45 First Edition: 2010 All Rights Reserved This course is the copyright of the Insurance Institute of India, Mumbai. In no circumstances may any part of the course be reproduced. Published by Sharad Shrivastva, Secretary-General, Insurance Institute of India, G- Block, Plot C-46, Bandra Kurla Complex, Bandra (E) Mumbai – 400 051 and Printed at ……  PREFACE This course is designed for the use of candidates of the Associateship Examination (non-life) of the Insurance Institute of India. The course covers the Principles and Practice of underwriting in all classes of non- life insurance. Specifically, the course explains the meaning, objectives and process of underwriting, describes the tools of underwriting and different methods of rate making and examines the impact of IRDA Regulations on issues of rating, underwriting, policyholders' protection etc. Finally the course includes Research and Development and I.T. Applications in underwriting which reflect value additions to the course. Although the course covers the syllabus prescribed for the examination, it is desirable that candidates should read additional material such as text books, office manuals and operating instructions and insurance magazines etc. This will enrich their knowledge of the subject. The candidates are also recommended to collect and study specimen forms used in offices (e.g. Proposal, Policy, Claim forms and other forms relevant to the subject). This will provide a practical basis for their studies. The candidate may also avail of Oral Tuition Service wherever arranged by The Associated Institutes and the Postal Tuition Service provided by the Institute. These supplementary aids will help the student to improve their performance in the examination. The course should also prove useful to the general reader who desires to have knowledge of the subject covered.  CONTENTS Chapter No. Title Page No. 1 Introduction to Underwriting 1 2 Methodology and procedures of underwriting 22 3 Principles of ratemaking 35 4 Rating approaches in Pricing 52 5 File & Use of Regulations 79 6 Applications of File & Use Regulations 101 7 Tools of Underwriting 125 8 Types of Policies 150 Underwriting Profitability & Re underwriting 9 168 Strategies 10 Protection of Policyholders' Interest 187 Research and Development in Underwriting, 11 Rating and Product Innovation – Challenges 198 ahead 12 I.T. Applications in Underwriting 215 Glossary 236  IC - 45 General Insurance Underwriting CHAPTER 1 INTRODUCTION TO UNDERWRITING Chapter Introduction This chapter aims to provide you with an understanding of the concept of underwriting. You will also learn about the process of underwriting and different kinds of underwriting decisions. a) Understand the concept of underwriting. b) Learn about the process of underwriting. c) Learn about different kinds of underwriting decisions. 1  IC - 45 General Insurance Underwriting 1. Understand the concept of underwriting. [Learning Outcome a] 1.1 Introduction to insurance Insurance products have gained popularity in recent times as they offer security to individuals against financial losses that might occur due to some uncertain or unplanned events. Insurance is a contract between the insurer and a policyholder/insured, where the insured pays premium as consideration and insurer promises to pay a certain amount of money or provide a defined service if an uncertain event covered under the insurance policy occurs during the policy term. Let us first understand the various terms used in this definition: a) Insurer: refers to a company that designs, endorses and sells insurance policies to the individuals. b) Policyholder/insured: refers to an individual or an organisation who purchases an insurance policy from the insurer by paying premium. c) Premium: it is the amount that is calculated using actuarial techniques aimed at ensuring that the insurer earns profit even after payment of certain claims.. d) Uncertain event: the uncertain event has to be covered in the insurance policy that has been purchased by policyholder. Insurance can be taken against any of the following uncertain events: 9 Risk of death or disability due to natural or accidental causes 9 Risk of disability and sickness 9 Risk of loss of or damage to property due to natural or unforeseen events etc. Insurance can also be defined as follows: Insurance refers to the risk transfer cum-sharing mechanism, where risk of an individual is transferred to another, by way of pooling of risks among a group of individuals who are exposed to similar kinds of risk, in exchange for a premium. 2  IC - 45 General Insurance Underwriting Based on the above definition, the main features of insurance can be summed up as follows: 9 Risk transfer: Risk is transferred equitably among the group of individuals who are exposed to similar kinds of risk, in exchange for a small contribution called ‘premium’. The underlying principle is that, in a group, only few individuals (and not all) would sustain losses due to the occurrence of an uncertain event. 9 Pooling of Risk: Insurance is created when people pool their contributions to create a large enough common fund so as to protect themselves from the effects of a loss which may in turn randomly affect one or a few who have contributed to the pool. Whether the loss they are attempting to protect themselves from is loss of life, disability, assets, or whatever, the basic concept remains the same. 9 Law of large numbers: If the risk of loss can be spread over a large enough group (the law of large numbers), the financial loss resulting from the loss to the members can be paid from the premium collected from the pool, if the premium so collected reflects the risk affecting the group. This is in contrast to one person bearing the full brunt of economic loss without any financial backing. Thus, in insurance, a large and uncertain loss is reimbursed for a small loss by way of premium. 1.2 Introduction to General Insurance As per IRDA, “Insurance other than ‘life insurance’ falls under category of general insurance”. General insurance business in India can be broadly categorised as follows: 9 Insurance of property against fire, theft, etc. 9 Insurance of loss of income such as Loss of Profits or Business Interruption insurance, 9 Personal insurance such as accident and health insurance 9 Liability insurance that includes legal liabilities 1.3 Introduction to underwriting Underwriting is a core insurance function which can be defined as follows. Underwriting refers to the process by which insurability of the ‘risk’ is evaluated, which helps in taking decisions regarding acceptance or rejection of the risk. 3  IC - 45 General Insurance Underwriting Features of underwriting The main features of underwriting are as follows: a) To determine the level of risk presented by the proposer Underwriting is the process of determining the level of risk presented by a proposer and deciding whether to accept it for insurance and, if so, at what terms and at what price. b) To classifty risk based upon the risk characteristics Underwriting attempts to classify risks based upon their characteristics so that each insured in a specific class pays a premium in proportion to the likelihood that a covered loss may occur. Understanding the concept of risk sharing or pooling makes it easier to understand the role of underwriting and risk classification in insurance. The simple fact is that – ‘not all risks are equal’. When viewed from the perspective of fairness, proper risk classification becomes a central obligation of insurers to the policyholders who participate in their risk pools. This is true regardless of whether the risk being insured is for life, assets or earnings. In the field of property insurance, wooden structures are at a greater risk of burning than stone structures; hence, a higher premium is required to insure a wooden structure. An individual who suffers from a serious illness (e.g., cancer, diabetes etc.) is at a greater risk of premature death than an individual who does not have the illness. Since all risks are not equal, it would be inequitable if all persons who are to be insured are asked to contribute equal amounts. c) To ensure that the insurance business is conducted on sound lines Underwriting 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. 4  IC - 45 General Insurance Underwriting None of the insurance companies would wish to incur losses in excess of the amount of premium that they are getting! 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. In case of vehicle insurance, an insurance company might charge higher premium in the case of: 9 young drivers, 9 old models of vehicles, 9 drivers with a history of accidents In some cases, the insurance company may refuse coverage to drivers with a history of accidents. The underwriter may offer discounts for vehicles fitted with anti-theft devices. In case of property insurance, an insurance company may inspect propertieswith respect to their exposure to fire risk, theft risk etc. Accordingly, underwriters may offer reduced premiums for properties that have safety features such as sprinkler systems. 1.4 Purpose and Objectives of underwriting By purchasing an insurance policy, a policyholder transfers his risk to the insurance company against which he needs to pay a certain amount as premium. The main purpose and objective of underwriting is deciding level of acceptability, adequacy of premium & other terms for such a Risk Transfer. Rajiv Saxena had purchased motor insurance at the time of purchasing a car from ABC insurance company. As per the terms and conditions of the insurance policy, the insurance company would pay for the repairs if the car is damaged in an accident. Hence, by having an insurance policy, the financial losses that might arise due to accidents are reduced or eliminated. 5  IC - 45 General Insurance Underwriting The insurance company assumes the risk it takes on by charging premiums and setting deductibles. 9 If premium is kept low: If a company charges too little, it could become insolvent when large claims, whether by frequency or severity, are filed. 9 If premium is kept too high: If a company charges too much, it will lose business to its competition, and face regulatory hurdles as well. Hence, underwriters have the challenge to ensure that they correctly assess the risk and accordingly charge the appropriate premium. 1.5 Profile of an underwriter The profile of an underwriter may be understood by what he does in the insurance organization. Insurance companies are in the business to protect individuals and organizations from financial loss by assuming risk—risks of motor accident, property damage, illness and other occurrences. An insurer may lose business to competitors if the underwriter appraises risks too conservatively, or it may have to pay excessive claims if the underwriting decisions are too liberal. Profile of underwriters a) Underwriters have to 9 Analyse proposal forms and do background check on proposer. 9 Identify and Assess the level of risk 9 Evaluate the risk of loss 9 Establish who can be given coverage 9 Decide on special terms and conditions that can be offered for accepting the risk 9 Determine the appropriate premium, and the terms and conditions for providing insurance cover. 9 Write policy wordings 9 Negotiate with insurance brokers and the proposer 9 Monitor account information 6  IC - 45 General Insurance Underwriting b) Underwriters use computer applications to manage the risks they underwrite more efficiently and accurately. These systems 9 analyse and rate insurance proposals, 9 recommend acceptance or rejection of the risk, and 9 adjust the premium rate in accordance with the risk With these systems, underwriters are better equipped to make sound decisions and avoid excessive losses. c) Role of internet The internet also plays an increasingly important role in the work being done by underwriters. Many insurers’ computer systems may now be linked to various databases on the Internet that allow immediate access to information - such as driving records in some countries, so that information necessary for determining a potential client’s risk can be accessed instantly and utilised effectively. Such access to real time information reduces the amount of time and paperwork necessary for an underwriter to complete a risk assessment. 1.6 Importance of underwriting Underwriting is important to different entities from different perspectives. a) Insurers For Insurance companies underwriting is a core activity. The underwriting capacity it has helps to offer value to consumers in terms of 9 Risk reduction, 9 Risk improvement and 9 Risk transfer. Underwriting is a key differentiator enabling the insurer to stay competitive, and at the same time, be solvent and profitable. b) Insured Underwriting also helps the insured to appreciate the magnitude of risk that is being proposed to be covered and the suggestions given to reduce the risk, which if implemented, helps to improve insurability and reduce various hazards. The underwriter’s opinion may determine how much the proposer has to pay for insurance, the terms of coverage, exclusions, discounts, and deductions. 7  IC - 45 General Insurance Underwriting c) Agents and brokers Underwriting is important to Brokers and Agents as it will match the needs of consumers with the standards set by insurers. It helps the intermediary to appreciate the philosophy of the insurer, help clients to improve their loss profile, give customer satisfaction and also help in business growth. d) Society Efficient underwriting by insurers paves the way for organized and sustained growth of risk taking in the country which significantly contributes to and supports the growth of the economy and provides social cushions in case of losses and catastrophes. It helps to improve the standards of safety and care and achievement of the economic and social goals of a country. The underlying principle of _____________ is that in a group, only few individuals (and not all) would sustain losses due to the occurrence of an uncertain event. A Law of large numbers B Underwriting C Risk Transfer D Broking 2. Learn about the process of underwriting. [Learning Outcome b] 2.1 Important factors in the process of underwriting As discussed earlier, underwriting is the process of determining whether a risk offered for insurance is an acceptable risk, and if so, at what rate the insurance cover will be accepted. Logically, therefore, insurers may not find it possible to accept every proposal. An insurer has to ensure that the underwriting process needs to be carried out meticulously. 8  IC - 45 General Insurance Underwriting Some important factors that need to be considered by an insurer in the underwriting process are: a) To maintain equity and sustainability An insurer has a responsibility to its current policyholders to ensure that it will be able to meet all the contractual obligations of its existing policies. If the insurance company issues policies on risks that are uninsurable or risks that require premiums higher than what the insurer charges, the insurer’s ability to meet its contractual obligations is jeopardized. b) To protect consumer’s long term interest An insurer with a profit motive may want to charge very high rates for risks that do not warrant such high rates. Such practices would result in loss to the policyholders on their investments in the long term. c) Regulation Regulation is another important factor in the underwriting process. In order to protect consumer’s long term interests and to protect policyholders against insolvency or other malpractices, an insurer is regulated by an insurance regulator in many countries. In India, the insurance regulator is the Insurance Regulatory and Development Authority (IRDA). IRDA, in tune with the best practices of insurance tradition, expects the insurer to establish reasonable, non- discriminatory standards for accepting risks. The premium rates for many types of insurance must be approved or should be within the framework of guidelines issued by the Regulator. 2.2 Process of underwriting The process of underwriting involves four basic functions: a) Selection of risks, b) Classification and rating, c) Policy forms, and d) Retention and reinsurance. The first three underwriting functions—risk selection, classification and rating, and policy selection—are interdependent. That is, the underwriter determines that a certain risk is acceptable upon which he proceeds to classify and rate the risk and issues the relevant policy. 9  IC - 45 General Insurance Underwriting The underwriter also performs a fourth, separate function before underwriting is complete: reinsurance. Diagram 1: Process of underwriting The first three processes are interdependent. By performing these four functions, the underwriter increases the possibility of securing safe and profitable distribution of risks in his books. a) Selection of risks In this step, the underwriter decides whether or not to accept a particular risk. It involves 9 securing factual information from the Proposer via the proposal form, 9 evaluating that information, and 9 deciding on a course of action Underwriting involves examining material disclosures in proposal forms, and supporting documents such as Inspection Reports, Valuation Reports/ appraisals or bills that certify the value of property, or medical reports that verify the health condition of an individual. b) Classification and rating Once the risk has been accepted, the underwriter then classifies and rates the risks. 10  IC - 45 General Insurance Underwriting Classification of risk The purpose of using classifications is to separate risks into homogeneous groups to which rates can be assigned. Several tentative classifications may be tried out before a final decision on classifying the risk is reached. Insurers may have their own classification and rating system compliant with the guidelines of the Regulator. Rating Rate making is the process of calculating a price to cover the future cost of insurance claims and expenses, including a margin for profit. To establish rates 9 Insurers look at past trends and changes in the current environment that may affect potential losses in the future. 9 Insurers utilise the expertise and skills of actuaries, who use the data collected by the insurer as per the actuary’s requirement and then use the findings to validate the rates and suggest the right rating practices. 9 Underwriters also use experts such as engineers and surveyors to make site inspection reports and evaluate the risks through their findings. 9 Upon a thorough examination of all the data, underwriters then decide the final rates and terms under which a proposal can be accepted. It should be remembered that ‘Rates’ are not the same as premiums. A rate is the price of a given unit of insurance. Rates vary according to the likelihood and potential size of loss. In earthquake insurance, rates would be higher near a fault line and for a brick house, which is more susceptible to damage, than for a concrete structure. Objective of rating The basic objective of rate makers is simply that the rates should be adequate and reasonable, both from the point of view of the insurer and the insured. 11  IC - 45 General Insurance Underwriting For insurer From the point of view of the insurer, 9 The rates in the aggregate must be sufficient to provide for the payment of claims, expenses and taxation and leave an adequate margin for catastrophes and profit. 9 It is also important that the rates in any class should not be excessive because the premium should be affordable and equitable to the consumer and the business should not be lost to a competitor making its own rates on a more reasonable basis. Unless these requirements are met, it is impossible to survive and grow in a dynamic insurance market. For insured From the point of view of the insured, reasonable rates imply that he should not be required to pay more than a sufficient sum to cover the hazards involved, together with a reasonable charge for expenses, catastrophes and profits. It is very difficult to determine an adequate amount of premium in principle, let alone on a case to case basis. There can be numerous factors that might affect the risk associated with an individual. Hence, it would be very difficult for an actuary to consider all those factors and accordingly rate them. Also it is interesting to note that in Life insurance, vast majority of lives are accepted at rates which involve only one factor, namely, ‘age’, although there are many other factors which are known to have some bearing on mortality. A rating structure should not be so complicated that it becomes difficult or expensive to apply. 9 For classes involving small units, the application of the system must be as standardised as possible. 9 For a class involving large size of individual units, greater complexities can be reasonably built in to produce greater rating accuracy. Fire rates can be considered reasonable if they take into account all major factors which affect the risk but ignore minor factors which would not result in more than a small variation in the estimated rate. 12  IC - 45 General Insurance Underwriting c) Policy forms After determining the acceptability of a risk and assigning proper classification and rating, the underwriter dealing with that particular class of risk, is ready to issue an insurance policy. The underwriter must be familiar with different types of policies available as well as be able to modify the form with additional necessary warranties, clauses, and special conditions as may be needed to fit the underwriting requirements so that the policy is issued correctly. d) Retention and reinsurance Reinsurance Reinsurance in simple terms is insurance of insurance. It is a mechanism used by insurers to spread risks in order to limit their exposure to claims which might arise on policies of insurance which they have issued.. Reinsurance ensures that no one insurer is overburdened while offering covers to policyholders. Catastrophes, large losses or a series of losses, new and unexpected liabilities, etc. can create risks & affect profitability of the insurer.Thus, a decision needs to be taken while underwriting on the amount that will be retained in the insurer’s books and on the method of appropriate reinsurance for the balance. Therefore, reinsurance becomes an essential part of underwriting as it is a tool to help the insurer to: 9 expand its underwriting capacity, 9 maintain earnings stability, and 9 reduce the requirements of creating large reserves Which of the following is incorrect? A Rates are the same as premiums. B A rate is the price of a given unit of insurance. C Rates vary according to the likelihood and potential size of loss. D Rate making is the process of calculating a price to cover the future cost of insurance claims and expenses. 13  IC - 45 General Insurance Underwriting 3. Learn about the different kinds of underwriting decisions. [Learning Outcome c] 3.1 Types of underwriters An insurance company may issue policies for many different types of insurance. However, most underwriters perform their responsibilities as specialists. An underwriter may underwrite only property policies, or only liability policies, or in another case, only motor or retail insurance and so on. Diagram 2: Types of Underwriters 14  IC - 45 General Insurance Underwriting 3.2 Underwriting decisions When evaluating risks, underwriters can take any of the following decisions: a) Policy to be issued on a preferred basis, b) Policy to be issued on a standard basis, c) Policy to be issued on a substandard basis or d) Proposal to be declined. Diagram 3: Underwriting decisions in Risk Evaluation a) Policy to be issued on a preferred basis If a proposal falls within the lowest risk boundaries of underwriting standards, the policy is issued on a preferred basis. Preferred rate represents the lowest rates offered by an insurer for its coverage. Rates offered on a preferred basis must adhere to the insurance regulations applicable to them, just as rates offered on a substandard and standard basis must. Insurance regulators do not want insurers to offer rates that are so low that the insurer cannot meet its contractual obligations to pay covered claims. b) Policy to be issued on a standard basis Proposers who are issued policies with standard rates fall within the normal boundaries of underwriting standards for that type of policy. 15  IC - 45 General Insurance Underwriting Underwriters base their determination that a policy should be issued on a standard basis on an analysis of the characteristics of the risk represented by the Proposer. c) Policy to be issued on sub-standard basis The decision to issue a policy on a substandard basis occurs when a risk is not deemed to be outside underwriting standards, but is considered to be of high risk within those standards. The insurer generally has the following three basic options when it offers a substandard policy to a Proposer. 9 Issue the policy with a higher premium than would be required for a standard policy: The insurer may charge a higher premium to Proposers who are considered to be of higher risk than those who would be considered a standard risk as long as those higher rates fall within certain parameters. The rate cannot be discriminatory. The insurer must charge the same rate to every insured having similar characteristics. 9 Issue the policy with limited benefits: Insurers may respond to substandard proposers by offering a policy with limited policy benefits or lower policy limits. Again, the insurer may limit benefits as approved through the ‘file and use’ guidelines of the Regulator. Dealing with substandard Proposers by limiting policy benefits is common in commercial coverage. 9 Issue the policy with certain exclusions: Another option an insurer may have is to offer a substandard Proposer a policy that excludes coverage for certain property and insured or operations that are deemed too high a risk for the insurer to cover. As with the other options discussed, such exclusions must be allowable under the regulations. An insurer may offer to provide liability coverage for all business operations except for that portion that has potential pollution liability that is too high for the insurer to cover. d) Proposal to be declined Insurers decline proposals for insurance when they find that the proposal represents a risk that falls outside of their established underwriting standards. 16  IC - 45 General Insurance Underwriting These underwriting standards take into consideration many items, such as 9 regulations that require the insurer to establish adequate rates, 9 laws that mandate that certain factors cannot be used to decline a proposal, or 9 the proposal is contrary to various insurance principles and practices such as those of insurable interest, utmost good faith or indemnity Proposals which are against public good and violate the laws of the country would also be not insurable. 3.3 Monitoring of underwriting decisions Once a policy is issued, underwriters continue to monitor the policy from an underwriting perspective. Such monitoring is done at 9 policy renewal, or 9 at periodical intervals such as every six or twelve months, or 9 as and when a claim occurs. Depending upon the type of policy and its provisions, rates & terms of cover may be varied at renewal; or in extreme cases, the insurer may make the decision not to renew the policy. Changes in rates or the decision not to renew are only made if allowed by policy provisions and applicable regulations, if any, made by the Regulator. If a proposal falls within the lowest risk boundaries of the underwriting standards, then which of the following decisions can be taken by an underwriter? A Policy to be issued on a preferred basis. B Policy to be issued on a standard basis. C Policy to be issued on a substandard basis. D Proposal to be declined. 17  IC - 45 General Insurance Underwriting Summary ¾ Insurance is created when people pool their contributions to create a large enough common fund so as to protect themselves from the effects of a loss which may randomly affect one or a few who have contributed to the pool. ¾ As per IRDA, “Insurance other than ‘life insurance’ falls under the category of general insurance”. ¾ Underwriting is the process of determining the level of risk presented by a proposer and deciding whether to accept the risk and, if so, at what terms and at what price. ¾ The main purpose and objective of underwriting is Risk Transfer. By purchasing an insurance policy, the policyholder transfers his risk to the insurance company against which he needs to pay a certain amount as premium. ¾ Underwriting is a key differentiator enabling the insurer to stay competitive, and at the same time be solvent and profitable. ¾ Underwriting is important to Brokers and Agents as it will match the needs of consumers with the standards set by insurers. ¾ The three underwriting functions—risk selection, classification and rating, and policy selection—are interdependent. That is, the underwriter determines that a certain risk is acceptable upon which the underwriter proceeds to classify and rate the risk and issues the relevant policy. ¾ The purpose of using classifications is to separate risks into homogeneous groups to which rates can be assigned. ¾ ‘Rates’ are not the same as premiums. A rate is the price of a given unit of insurance. Rates vary according to the likelihood and potential size of loss. ¾ Reinsurance ensures that no one insurer is overburdened while offering covers to policyholders. Answers to Test Yourself Answer to TY 1 The correct answer is C. The underlying principle of risk transfer is that in a group, only a few individuals (and not all) would sustain losses due to the occurrence of an uncertain event. 18  IC - 45 General Insurance Underwriting Answer to TY 2 The correct answer is A. Rates are not the same as premiums. Answer to TY 3 The correct answer is A. If a proposal falls within the lowest risk boundaries of the underwriting standards, then the underwriter can issue the policy on a preferred basis. Self-Examination Questions Question 1 ABC insurance company is a new entrant in the insurance market. As a marketing strategy, it has decided to accept the risk at lower premium rates as against the prevailing market rates. What could be the repercussions of this? A The insurance company will lose business to competitors B It will face regulatory hurdles C The insurance company could become insolvent when large claims, whether by frequency or severity, are filed. D It will earn profit by maximizing sales. Question 2 ___________ensures that no one insurer is overburdened while offering covers to policyholders. A Risk pooling B Risk sharing C Underwriting D Reinsurance 19  IC - 45 General Insurance Underwriting Question 3 Which of the following decisions is incorrect when a risk is not deemed to be outside underwriting standards, but is considered to be of high risk within those standards? A Issue the policy with a higher premium B Issue the policy with limited benefits C Issue the policy on a preferred basis D Issue the policy with certain exclusions Question 4 Which of the following is the insurance regulator in India? A The RBI B The IRDA C The Government of India D The Department of ministry and finance Question 5 According to ______________________, if the risk of loss can be spread over a large enough group, the financial loss resulting from the loss to the members can be paid from the premium collected in the pool, if the premium so collected reflected the risk affecting the group. A Risk transfer B Risk sharing C Pooling of risk D Law of large numbers 20  IC - 45 General Insurance Underwriting Answers to Self-Examination Questions Answer to SEQ 1 The correct option is C. The insurance company could become insolvent when large claims, whether by frequency or severity, are filed. Answer to SEQ 2 The correct answer is D. Reinsurance ensures that no one insurer is overburdened while offering covers to policyholders. Answer to SEQ 3 The correct answer is C. If a proposal falls within the lowest risk boundaries of the underwriting standards, then only the underwriter can issue the policy on a preferred basis. Answer to SEQ 4 The correct answer is B. The IRDA is the insurance regulator in India. Answer to SEQ 5 The correct answer is D. According to the law of large numbers, if the risk of loss can be spread over a large enough group, the financial loss resulting from the loss to the members can be paid from the premium collected in the pool, if the premium so collected reflected the risk affecting the group. 21  IC - 45 General Insurance Underwriting CHAPTER 2 METHODOLOGY AND PROCEDURES OF UNDERWRITING Chapter Introduction This chapter aims to provide you with an understanding about the various steps involved in the underwriting process. a) Understand the underwriting procedure. 22  IC - 45 General Insurance Underwriting 1. Understand the underwriting procedure. [Learning Outcome a] 1.1 Underwriting skills Underwriting needs a combination of various skills. Before the underwriter accepts the risks, he would be expected to: 9 Visualise potential risks: Clearly visualise the property or interest to be insured and the variety of potential risks that can cause losses to them 9 Estimate probability of peril operation: Estimate the probability of operation of peril to be insured in relation to both 'frequency' and 'severity' of losses 9 Estimate liability: Estimate the extent of liability that may arise due to the operation of a peril and the claims processing implications The underwriter can then decide on whether to accept the risk or otherwise. If the underwriter decides to accept the risk, then the next step would be to decide the rates, terms and conditions. Here the skills of the underwriter play a vital role. It is a quality that can be acquired through a continuous learning process, adequate training, field exposure and deep insights. The knowledge of causes of fire in fire insurance and the geography, climatic conditions, port/road conditions, types of risks etc. encountered by goods in transit or storage in marine insurance and so on. Once the risk is accepted, the policy, which is a legal document, is to be drafted without any ambiguity. It would be worthwhile to remember that any ambiguity in an insurance policy will always be viewed against the insurer, since it is drafted by him. 1.2 Classification of underwriting of risks Broadly the underwriting of risks can be classified into the following broad categories based on the subject matter that is being covered under the policy: a) Property risks such as a manufacturing plant, machinery and building b) Business interruption risk c) Personnel risks such as policies relating to personal accident insurance and health insurance 23  IC - 45 General Insurance Underwriting d) Liability risks like motor third party liability, public liability, product liability etc. e) Risks of Householders, Shopkeepers etc. which are covered under Package policies. Considering the nature of risks, different methods are followed for underwriting of new business and renewal business. Diagram 1: Broad classification of underwriting of risks 1.3 Underwriting of new business Acceptance of new business is one of the main underwriting functions. This is done based on the knowledge and skills of the underwriter who is authorised to do so. Where the insurance is complex or is of high value, senior officer will either assist or underwrite such risks. Each insurer has its own manuals of underwriting instructions. Broadly speaking, these instructions and guidelines may cover the following: a) acceptance of simple risks irrespective of sum insured; b) acceptance of certain specified risks up to specified sums insured; c) acceptance of certain classes of business with prior approval of the controlling office; d) acceptance of risks subject to specific underwriting safeguards; e) acceptance / rejection of sub-standard risks; f) rejection of risks 24  IC - 45 General Insurance Underwriting 1.4 Scrutiny of the proposal A completed proposal form gives: 9 details of the insured, 9 details of the subject matter, 9 type of cover required, 9 details of the physical features both favourable and adverse including type and quality of construction, elevation, age, presence of firefighting equipments, the type of security etc. 9 previous insurance and 9 claims history Diagram 2: Proposal Form The insurer also may arrange for pre-acceptance survey of the risk depending on the nature and value of the risk. Based on the information available in the proposal and in the risk inspection report, additional questionnaire and other documents which may be obtained, the insurer takes underwriting decisions. 25  IC - 45 General Insurance Underwriting 1.5 Limit of acceptance The limit of acceptance is basically the limit of sum insured up to which the operating office can underwrite the risk without referring to the Controlling Office. As a matter of precaution, the companies allow their operating offices to underwrite the class rated products whereas the controlling office may prefer to underwrite the individually rated and exposure rated products. Viewed in another perspective, insurers generally allow their operating offices to underwrite classes of business where the claims experience does not vary to a large extent unless affected by catastrophic losses. Examples of these classes are personal line insurances like motor policy, mediclaim policy and householder’s policy etc. Limits of acceptance could also be dependent on the type of assets or persons to be covered or geographical areas where the risks are not normal or standard. Thus depending on the underwriting standards adopted by each insurer the limits of acceptance can vary across various parameters. 1.6 Acceptance subject to controlling office approval Generally speaking, approval of the Controlling Office is necessary before acceptance of certain classes of business based on the size or complexity of the business or both. Some of these classes could be: a) Aviation b) Fire and Machinery Loss of Profit Insurance c) Industrial All Risk Policy d) Public Liability, Products Liability etc. e) Jeweler’s block beyond a specific sum insured f) Contractor's All Risk / Erection All Risk etc. 1.7 Acceptance of extra-hazardous risks Proposals relating to certain risks that are found to be more claims prone owing to physical hazard may have to be referred to the Controlling Office before acceptance together with the following particulars: a) Completed proposal form b) Risk inspection report, additional questionnaires c) Other premium income received from the same client and agent separately for fire, marine and miscellaneous classes d) Past loss experience e) Reasons as to why the proposal is required to be accepted 26  IC - 45 General Insurance Underwriting There are risks which may be regarded as extra-hazardous. Normally such risks are to be declined. These risks are commonly referred to as Declined Risks. Nevertheless, some of these risks are accepted subject to fixing of appropriate rate of premium and imposing loss minimising restrictive conditions, clauses and warranties in the policies. Some examples of such risks in different classes of business are: a) Fire 9 Ammunition works 9 Camphor boiling works 9 Celluloid and celluloid articles factories 9 Explosive factories and premises 9 Fire wood / bamboos in the open 9 Fireworks factories and premises 9 Match factories and matches in transit b) Marine 9 Bullion (gold), currency notes over specified limits 9 Bulk cargo on terms wider than I.C.C.(C) 9 Cement in bags on terms wider than I.C.C.(C) 9 Deck cargo on terms wider than I.C.C.(C) 9 Galvanised iron sheets on terms wider than I.C.C.(C) 9 Second-hand machinery against breakage 9 Oil in second hand drums against leakage and contamination 9 Perishable goods and sea foods etc. 9 Salt on terms wider than I.C.C.(C) 9 Sugar against 'all risks' terms c) Miscellaneous 9 Burglary: Jewelers, dealers in precious stones, curios and antiques, gold and silver smiths 9 Cash-in-transit: Proposals involving large carrying without adequate escort arrangement 9 Fidelity guarantee: Employees remunerated on commission basis 9 Workmen’s compensation insurance: Fireworks / gun powder / explosives manufacturers, collieries and mines of all descriptions, quarries of all descriptions 27  IC - 45 General Insurance Underwriting 1.8 Acceptance of risks subject to underwriting safeguards Certain risks are allowed to be accepted by the operating offices provided certain loss minimising measures are taken. 9 Special perils (flood etc.) under fire insurance policy may be accepted subject to inspection of the risk and satisfactory flood prevention measures. 9 Consequential loss (fire) policy may be granted only to clients, whose books of accounts are regularly audited by a reputed firm of auditors. 9 In motor insurance, acceptance of 'Own Damage' risks is subject to the specified year of manufacture of the vehicle being acceptable. This specification varies from one class of vehicle to another. Older vehicles may be accepted subject to inspection of the vehicle and imposition of excess. 9 Certain types of vehicles may be covered only for 'Act only' risks. Imposition of exclusions in marine insurance In marine insurance, acceptance of some types of proposals is subject to imposition of exclusions. Examples are: Proposal for Exclusion Asbestos cement pipes and Breakage is excluded sheets Transformers Breakage is excluded and excess imposed on leakages Refrigerators and air Denting and scratching are excluded conditioners Cargo in paper bags Tearing and bursting of bags is excluded Glass Breakage, scratching and chipping and denting is excluded Sanitary ware Breakage, chipping and denting is excluded Second hand machinery Breakage is excluded Oil in second hand drums Leakage and contamination is excluded Motor spare parts, ball Theft, pilferage and non–delivery is excluded bearing Motor vehicles Denting and scratching excluded 28  IC - 45 General Insurance Underwriting In marine insurance, the cargo carrying vessel is an important underwriting factor. Whereas normal rates are charged for cargo carried on vessels which conform to standards prescribed (e.g. liner vessels not over certain years old), extra rates are charged if the vessel is over certain years of age (overage) or the tonnage is below the prescribed limit (under-tonnage). 1.9 New Business Procedure The procedure dealing with acceptance of business and issue of documents such as cover notes, policies etc. in all classes of insurance have certain common features. These features may be considered under the following headings: Provisional Acceptance 9 Declined risks: The proposals are examined in the light of the standards adopted for the acceptance of risks by the insurer. Risks which are regarded as extra hazardous are declined. Each company in their Corporate Underwriting Policy spells out the list of declined risks. 9 Limits of acceptance: Reference is also made to the limits of acceptance to ensure that the sum insured accepted is within these limits. These limits vary according to the type of risks and are determined on the basis of reinsurance arrangements. 9 Reinsurance arrangement: If the sum insured exceeds these limits, it is necessary to arrange reinsurance before acceptance. This is done at the Corporate Office level. 9 Inspection report: At this stage, the question of inspecting the risk is often considered. If the risk is large or involves complicated features, acceptance is decided on the basis of an inspection report. Pre-acceptance inspection of risks is common in fire, burglary, public liability and engineering insurances etc. 9 Issue of cover note / policy: If the risk is acceptable, the premium is quoted and, on receipt of the premium, cover notes/policies are issued. 29  IC - 45 General Insurance Underwriting Issue of policies 9 Policy preparation and stamping: When complete particulars of the risk are available the policy is prepared and stamped in accordance with the Indian Stamp Act. 9 Recording details: The policies are numbered in serial order and entered in the premium register. The policy number is also entered in the cover note register against the relevant cover note number, if a cover note has been issued. 9 In marine open policies, in addition to the policies, certificates serially numbered are issued which may be required in respect of specific consignments. The certificate incorporates such information as policy number, name of the insured, sum insured, terms of insurance and details of premium etc. 9 In motor insurance, in addition to the policy, a certificate of insurance is issued. This document is required to be issued under the provisions of the Motor Vehicles Act, 1988, as evidence of insurance cover in respect of legal liabilities to third parties compulsorily insurable under the Act. 9 Renewal: The policies are entered in a renewal register or an expiry register according to the date and month of renewal to facilitate the procedure of inviting renewal at the appropriate time. 1.10 Underwriting of renewal business Annual cover: Most non-life insurance covers are granted on an annual basis. The period of insurance (i.e. date of commencement of insurance and the date of expiry) is clearly stated in the policy. The insurance contract, unless otherwise stated, expires at midnight, of the date of expiry. Renewal is not automatic: The preamble of a policy usually states that the indemnity thereunder applies during the period of insurance named in the schedule or any subsequent period in respect of which the insured shall have paid and the insurer shall have accepted the premium required for renewal of this policy. From this it is clear that renewal of the policy is not automatic. It depends upon the consent of the insurers to renew the policy and the payment of premium. 30  IC - 45 General Insurance Underwriting Renewal notice: It is important to note that there may be no strict legal obligation on the part of insurers to renew the policy or even to invite renewal. However, as a matter of courtesy and good business policy, insurers issue a renewal notice to the insured, usually a month in advance of the date of expiry. If for any reason, they are not interested in the renewal of the policy, they give previous notice to the insured to that effect. Renewal methods Renewal of policies can also be utilised to review underwriting results and take corrective steps. ¾ There are a number of renewal methods that can be incorporated in policy conditions such as: ¾ Non-cancelable renewals: Renewals are assured and without any changes ¾ Guaranteed renewals: Changes not usually made in the terms of the policy but premium rates can vary based on underwriting results ¾ Non-renewable for stated reasons such as on reaching a specified age ¾ Optionally renewable: Subject to re-evaluation of risk by the insurer which can include review of premium and modification of the terms and conditions. Many insurance products such as health for instance, are matters relating to the life and dignity of human beings and hence renewals need to be handled with great sensitivity. Courts can take an adverse view of practices that appear detrimental to the protection of the consumer. Weighty reasons, such as those based on grounds of fraud or misrepresentation and not merely on the basis of random individualised claim experiences may need to be cited in case of a legal dispute. Regulations have also come into force in some countries where refusal of renewal is regulated. Renewal is normally deemed to constitute a fresh contract and the duty of utmost good faith is revived, although in many insurance cases a fresh proposal form is not required to be completed by the insured. Renewal, of course, is effected subject to payment of premium. A fresh policy is issued specifying the terms and conditions of the further period insurance. Under certain types of insurances, adjustment of premium has to be made at renewal. For example, under money-in-transit insurance, the premium is calculated on basis of the actual amount of money in transit during the period of insurance. If premium so calculated differs from the provisional premium then premium shortfall is collected or excess premium refund is made, as the case may be. Similar practice is also followed in fire and marine declaration policies and workmen's compensation insurance. 31  IC - 45 General Insurance Underwriting Reinsurance programme: Insurers formulate their reinsurance programme well in advance for the new financial year and file it with Insurance Regulatory and Development Authority (IRDA).Within the broad framework of the reinsurance programme, the insurer operates its day to day reinsurance activities. (This topic is dealt with in Chapter 7) (Note: The step by step procedure described above is based on manual operations. With the use of IT applications, the process is made automatic based on software design for the purpose). At the time of underwriting a proposal, the underwriter has to estimate the probability of operation of peril to be insured in relation to ________. A Frequency of losses B Severity of losses C Both frequency and severity of losses D None of the above Summary ¾ Before accepting the risk the underwriter is expected to visualise potential risks, estimate the probability of peril operation and estimate the extent of liability. ¾ The underwriting of risks can be classified into the following broad categories: property risks, business interruption risk, personnel risks, liability risks, package policies. ¾ The underwriter scrutinises the proposal and may arrange for pre-acceptance survey of the risk depending on the nature and value of the risk. ¾ The limit of acceptance is basically the limit of sum insured (SI) up to which the operating office can underwrite the risk without referring to the Controlling Office. ¾ Generally speaking, approval of the Controlling Office is necessary before acceptance of certain classes of business based on the size or complexity of the business or both. ¾ Risks regarded as extra-hazardous are normally declined. These risks are commonly referred to as Declined Risks. ¾ Certain risks are allowed to be accepted by the operating offices provided certain loss minimising measures are taken. 32  IC - 45 General Insurance Underwriting ¾ If the sum insured exceeds limits of acceptance, it is necessary to arrange reinsurance before acceptance. This is done at the Corporate Office level. ¾ Renewal of general insurance policies is not automatic. It depends upon the consent of the insurers to renew the policy and the payment of premium. ¾ Renewal methods include: non-cancelable renewals, guaranteed renewals, non-renewable, optionally renewable. ¾ Insurers formulate their reinsurance programme well in advance for the new financial year and file it with Insurance Regulatory and Development Authority (IRDA). Answers to Test Yourself Answer to TY 1 The correct answer is C. At the time of underwriting a proposal, the underwriter has to estimate the probability of operation of peril to be insured in relation to both 'frequency' and 'severity' of losses. Self-Examination Questions Question 1 Which of the following is true for reinsurance programme? A The insurer needs to formulate their reinsurance programme well in advance for the new financial year. B The insurer needs to formulate their reinsurance programme on a half yearly basis C The insurer needs to formulate their reinsurance programme on a quarterly basis D The insurer needs to formulate their reinsurance programme on a monthly basis 33  IC - 45 General Insurance Underwriting Question 2 Approval of the _________ is necessary before acceptance of certain classes of business based on the size or complexity of the business or both. A Branch manager B Controlling office C Regional office D Corporate office Question 3 Extra hazardous risks that are normally not accepted by the insurer are commonly referred to as ________. A Rejected risks B Forbidden risks C Declined risks D Prohibited risks Answers to Self-Examination Questions Answer to SEQ 1 The correct option is A. The insurer needs to formulate their reinsurance programme well in advance for the new financial year. Answer to SEQ 2 The correct answer is B. Approval of the Controlling Office is necessary before acceptance of certain classes of business based on the size or complexity of the business or both. Answer to SEQ 3 The correct answer is C. Extra hazardous risks that are normally not accepted by the insurer are commonly referred to as declined risks. 34  IC - 45 General Insurance Underwriting CHAPTER 3 PRINCIPLES OF RATE MAKING Chapter Introduction This chapter aims to provide you with an introduction to the basic principles of rate making and related issues. a) Understand the concept of ratemaking. b) Learn about the process of ratemaking. 35  IC - 45 General Insurance Underwriting 1. Understand the concept of ratemaking. [Learning Outcome a] 1.1 Underwriting General insurance is a complex subject. To make it relevant to customers and to make it profitable for their insurers, underwriters need to examine thoroughly all the risk factors affecting the subject matter offered for insurance. Underwriting is the process of 9 classifying the subject matter according to their degree of insurability 9 evaluation of risks to which they are exposed 9 to decide on their acceptance to decide on terms and conditions and 9 charge appropriate rates of premium 1.2 Ratemaking The purpose of ratemaking is to set the prices of insurance products sold in such a manner that it will provide sufficient income to pay for 9 the projected claims based on both experience and exposures, 9 all expenses that the insurer will incur in the selling and administration of the product In addition insurers would like to build a margin for adverse deviation and a reasonable return on the capital employed. There is also another requirement for ensuring proper ratemaking. The rates of insurers are subject to regulatory review. The regulatory standards in India are set in the “File and Use” guidelines and other regulatory directions given from time to time by the insurance regulator i.e. IRDA. The standard for the regulator is that the rate shall not be inadequate, excessive or unfairly discriminatory as between risks of similar type and quality. 1.3 Objectives of a premium rating system There are subsidiary objectives while developing a premium rating system apart from the above mentioned. These are: a) Stability: Rates should remain stable over a period of time 36  IC - 45 General Insurance Underwriting b) Responsiveness: Rates should respond to changes in loss exposures. Both objectives appear contradictory but are desirable and can be reconciled if the price normally remains within predictable bands; and should not swing too far owing to an unlikely extreme severe event. c) Contingencies:It should provide for contingencies, whereby some loadings are built in for the unknown and the unknowable; d) Incentive(s) to insured: It should offer necessary incentive to the insured, that is, incentives should be built into the rates to encourage the insured to avoid losses and in case of a loss to minimise the loss costs. Diagram 1: Objectives of Premium Rating System 1.4 Types of rating Rating can be 9 Generic rating: it will be rated as per an internal manual or guidelines prepared by the insurer for risks of the same class or category, or 9 Individual rating: there can be individual experience based rates or where experience is not available, based on the analysis of exposure made by the underwriter. 37  IC - 45 General Insurance Underwriting Though ratemaking for risks as per in-company manuals, involves the use of mathematical and statistical data and tools, it also requires 9 understanding of risks and their behaviour 9 the use of sound judgement acquired through experience and knowledge, 9 the economic, technological, social, political and other factors which had an impact in the past on the underwriting results and may also influence possible losses in the future. Rate makers necessarily need to appreciate that rates which have been adequate in the past need not be so in the future. Review of rates Formulation of rates will need to be subjected to review both from within the insurer and from outside. 9 Internally the review is required in the light of competitive forces at play in the market. 9 Externally the review will be done by the regulator. In some cases the government also may intervene to make the rates acceptable to the public. 1.5 Making the rating structure All rates are based on various risk exposures that the subject matter of insurance may be faced with. However the rate for use through a manual begins with the basic exposure unit, e.g. a residential house. In fire insurance, there can be various rating factors involved such as a) the type of construction, b) the age of construction, c) the height of the building, d) the proximity to other buildings, e) the nature of locality etc. Rating Factors 9 The relevant elements that are used to add up the rates make the rating plan and the various specific elements in it are referred to as rating factors. 9 These rating factors can help to reflect the identified differences in loss propensity. 38  IC - 45 General Insurance Underwriting 9 By ensuring that all the relevant rating factors are taken into consideration, it can be ensured that the rates are not inadequate, excessive or unfairly discriminatory as between risks of similar type and quality. 9 If there is failure to consider the adverse features of a risk, the rate will be too low. If the competing insurance company’s factor in the negatives and the insurer’s underwriter does not, then the insurer falls prey to adverse selection. 1.6 Frequency and severity of losses While assessing the risk characteristics, the rating plan broadly looks at risks on two sides of a matrix which has 9 on one side the frequency of losses and 9 on the other the severity of losses For example, the frequency of losses to buildings may be noted where more combustible materials are stored or where the building construction and maintenance is of low standard. Similarly, in case of floods it is related to houses in low lying areas. In respect of severity persons having high value contents tend to have larger losses than those residences that have fewer contents and so on. The regulatory standards in India are set in the ______ guidelines and other regulatory directions given from time to time by the insurance regulator. A File and Use B Fill and File C File and Upload D Download and File 2. Learn about the process of ratemaking. [Learning Outcome b] 2.1 Process of Ratemaking The basic method of forming rates generally follows one of the two basic approaches: a) pure premium method b) loss ratio method 39  IC - 45 General Insurance Underwriting a) Pure premium method A simple illustrative example is given below to introduce the concept of pure premium, followed by mathematical equations in subsequent paragraphs. In a small town loss experience of 1000 insured cars each valued at Rs. 5 lacs by theft shows that over a period of say 10 years, on average 5 cars are stolen. The pure premium is expressed in the formula L x 100 V Where, L is losses V is value of all the cars Losses = Rs. 5 lac x 5 = Rs. 25 lacs Values = Rs 5 lacs x 1000 = Rs. 50 lacs 25,00,000 x 100 = 0.5% 50,00,00,0 00 The pure premium (i.e. the premium which is sufficient only to pay losses) is Rs 2500/- (0.5% of the value per car) Pure premium is also known as the “Burning Cost”. In arriving at the final rate of premium the pure premium is loaded to provide for the following 9 Business Procurement costs e.g. agency commission, brokerage etc. 9 Expenses of management 9 Margin for unexpected heavy losses and 9 Margin for reasonable profit for insurers 40  IC - 45 General Insurance Underwriting Mathematical Equation The formula for pure premium method is P+F R= 1−V −Q Where, R= Rate per unit of exposure P = Pure premium F = Fixed expense per exposure V = Variable expense factor Q = Profit and contingencies factor b) Loss ratio method The loss ratio method is used to indicate rate changes rather than rates per se. The formula for this is R = A X Ro Where, R = Indicated rate Ro = Current rate A = Adjustment factor which is equal to W/T Where W = Experience loss ratio T = Target loss ratio The target loss ratio is obtained by the following ratio 1−V −Q T= 1+G Where, G = Ratio for non-premium related expenses to losses Q = Profit and contingencies factor V = Premium related expense factor 41  IC - 45 General Insurance Underwriting Experience loss ratio is obtained by the formula L W= ERo Where, L = Experience losses E = Experience period earned exposure Ro = Current rate If the data is based on consistent assumptions, the results produced by both methods should normally be comparable. There are, however, differences between the two methods: Pure Premium Method Loss Ratio Method Based on exposure Based on premium Does not require existing rates Requires existing rates Gives indicated rates Gives indicated rate changes It is important that the data and assumptions used are based on logical and consistent factors. Thus: a) Selection of the experience period: The most recent loss experience period must be used. The loss experience period must contain sufficient loss experience so that the results have the necessary statistical significance or credibility. Finally where the business is subject to catastrophic losses, the experience period must be representative of the average catastrophic incidence. b) Difference in coverage should be treated separately e.g. in motor vehicle insurance – private car, three wheelers, taxis, goods vehicles, passenger vehicles etc. c) Wherever there are basic limits, the premium needs to be adjusted for the increased limits, if any, based on the change factors. d) Where the experience period extends over several years the rate may change often. However the earned premium underlying the loss ratio calculations must be on a current level rate basis. Thus past premium must be brought to the current rating level. This may be done by using good rating software. e) In general the internal guideline rates should be based on direct premium that is before reflection of reinsurance commission and loss data. 42  IC - 45 General Insurance Underwriting 2.2 Trended, Projected Ultimate Losses Trended, projected ultimate losses are of paramount importance in the rate making exercise. The projection can be on a pure loss basis or on allocated loss adjustment basis. However, as often the unallocated loss adjustment data is not available, such costs are treated as part of the expenses loading. Of significant importance is the method and techniques for projecting unpaid and unreported losses to their ultimate settlement values. Usually this is done through what is known as the loss development method. The loss development method is based on the assumption that claims move from the unreported to the reported and from unpaid to paid in a pattern which is sufficiently uniform so that past experience can be used to predict future development. Losses are arranged by accident year and accident year age. The resulting data form a triangle of known values. Diagram 2: Loss Development Method In the triangle 9 the horizontal movement to right represents the claims development over time 9 the vertical line downward represents change in exposure level and 9 the positive-sloped diagonal represent the evaluation data 43  IC - 45 General Insurance Underwriting Link ratio The next step is to make the development history arithmetically. The resulting ratio is known as age to age development factor or link ratio. The age to age factors are then multiplied to generate age to ultimate factors which can then be applied to the latest diagonal to yield projected ultimate values. Trend in severity An important trend affecting ratemaking data is the trend in severity. Inflation, court awards, medical inflation and such other costs are factors, which cause upward trends in loss severities. Frequency is also subject to trend. Frequency factors can change due to court interpretations and can also reduce owing to legislation such as the mandatory use of seat belts in motor vehicles. Where sufficient internal claims experience is not available, external data can be used. Various sources of statistical data are available from the industry as well as from outside. 2.3 Loading Factors There are expenses such as commission, taxes (service tax) and expenses of management which are generally paid on the basis of direct written premium. Profit as an element of insurance pricing relates to the reward expected by the insurer for doing the business and is determined by 9 company’s profit objective, 9 rate of investment return and 9 regulatory approach to profits being made by insurers Contingency loading represents a provision for adverse deviation or a risk loading. There are two risk elements in ratemaking known as a) parameter risk and b) process risk a) Parameter risk is the risk associated with selection of the parameters underlying the applicable model of the process. Thus selecting the wrong development factor can lead to under-pricing. b) Process risk is the risk associated with the projection of future contingencies, which are inherently variable. 44  IC - 45 General Insurance Underwriting 2.4 Individual Risk Rating Where individual risks are large enough so that their experience is to some extent ‘credible’, individual rating of such risks can be considered. Individual rating is normally done for various reasons such as 9 the price charged to the large risk is charged more realistically or 9 to encourage and motivate more risk control programs or 9 to reflect the modification, if any, in the design of cover specially provided Types of individual risk rating systems There are two types of individual risk rating systems: a) Prospective and b) Retrospective a) Prospective Systems Prospective systems use past experience so as to determine the costs of coverage for the future. b) Retrospective Systems Retrospective systems use the actual experience of the period to determine the final cost of that period. Retrospective systems are more responsive to experience changes than prospective systems. It is less stable as the experience can be more volatile, but it can motivate the insured to implement additional risk control programs. All individual rating systems consider both experience and change in exposure, if any, when the rating is done. Experience is relevant only when the credibility factor exits, and where necessary experience is lacking, exposure indicators need to be used. 2.5 Experience Rating All large individual risk rating is a form of experience rating as they need to reflect the entity’s actual experience or the features that may affect the experience. Experience rating is ideal when, with appropriate adjustments, the past experience is predictive of the future. 45  IC - 45 General Insurance Underwriting Thus losses need to be adjusted to reflect 9 economic and social inflation 9 changes in the number, size and types of units 9 changes in policy limits, terms and conditions Social inflation means changes in the attitude of society whereby such items as change in litigation mentality, the change in judicial activism and trend of awards and legislation by the various Government arms directly or indirectly affect the frequency and cost of claims. The experience component must be related to the exposures affecting the entity rated. The following combinations are usually used: a) Actual paid losses to expected paid losses b) Reported losses and expected losses c) Projected ultimate losses d) Projected ultimate losses for the experience period adjusted to the current exposure and inflation levels The length of the experience would ideally be 5 years. To reduce the effect of unusual ranges due to catastrophic losses, experience rating plans limit per occurrence limits on such losses. 2.6 Composite Rating Composite rating is a tool to rate large complex risks and where detailed inspection and audit is carried out. Instead of rating different coverages using different exposure bases, all applicable coverages are rated using one, composite exposure base. The composite rate is based on historical exposures. Estimated exposures are used if exact exposures are not available. The composite rate is used to determine the deposit premium based on the estimated composite exposure base and the final premium is based on the inspected/audited composite exposure base. Conclusion Regulators have important concerns relating to rate making which may include the following: a) Rates shall not be excessive, inadequate or unfairly discriminatory. 46  IC - 45 General Insurance Underwriting b) Normally a rate will not be considered excessive in a competitive market. Rates will be considered excessive if they are likely to produce a profit that is unreasonably high in relation to past and prospective loss experience, or if expenses are high in relation to services rendered. c) A rate is inadequate if together with the investment income attributable to it, the insurer fails to satisfy that the rate will cover projected losses and expenses. d) A rate can considered unfairly discriminatory in relation to another in the same class if it inequitably reflects the differences in expected losses and expenses. Similarly for a risk or group of risks the discounts, credits or surcharge among the risks do not bear a reasonable relationship to the expected losses or expenses unfair discrimination may be held against the rates filed. e) As to rating criteria due credit must be given for past and prospective loss and expense experience, to catastrophe hazards and contingencies, to events and trends, to loadings for leveling rates over a period of time etc. f) Risks may be classified in reasonably traditional ways. g) The expense provision included in the rates must reflect the operating methods of the insurer and its actual or anticipated expense experience. h) The rates may contain provisions for contingencies and reasonable profit. In a city loss experience of 1000 bikes each valued at Rs. 75,000 by theft shows that over a period of say 10 years, on average 2 bikes are stolen. How much will be the pure premium? A Rs 15 B Rs 150 C Rs 1500 D Rs 500 47  IC - 45 General Insurance Underwriting Summary ¾ Underwriting is the process of classifying the subject matter according to their degree of insurability, based on the evaluation of risks to which they are exposed, to decide on their acceptance and to charge appropriate rates of premium. ¾ Objectives of a premium rating system include stability of rates, responsiveness of rates to changes in loss exposures, should provide for contingencies, should offer necessary incentive to the insured etc. ¾ Rating can be generic or individual ¾ Formulation of rates will not end with the rate makers themselves but need to be subjected to review both from within the insurer and from outside. ¾ While assessing the risk characteristics, the rating plan broadly looks at risks on two sides of a matrix which has 9 on one side the frequency of losses and 9 on the other the severity of losses ¾ The basic internal tariff or manual method of forming rates generally follows one of the two basic approaches: pure premium method or loss ratio method. ¾ Pure premium is loaded to provide for the following: procurement costs, expenses of management, margin for unexpected heavy losses and margin for reasonable profit for insurers. ¾ The loss ratio method is used to indicate rate changes rather than rates per se. ¾ An important trend affecting ratemaking data is the trend in severity. ¾ There are two risk elements in ratemaking known as: parameter risk and process risk. ¾ There are two types of individual risk rating systems: Prospective and Retrospective. ¾ Composite rating is a tool to rate large complex risks and where detailed inspection and audit is carried out. 48  IC - 45 General Insurance Underwriting Answers to Test Yourself Answer to TY 1 The correct answer is A. The regulatory standards in India are set in the File and Use guidelines and other regulatory directions given from time to time by the insurance regulator. Answer to TY 2 The correct answer is B. The pure premium will be calculated as follows: Loss = 75,000 X 2 = Rs. 1,50,000 Value = 75000 X 1000 = Rs 7,50,00,000 1,50,000 X 100 7,50,00,00 0 0.2% 0.2% of Rs 75,000 will be Rs 150 Self-Examination Questions Question 1 While assessing the risk characteristics, the rating plan broadly looks at risks based on ___________ A Frequency of losses B Severity of losses C Both of the above D None of the above 49  IC - 45 General Insurance Underwriting Question 2 In a small town loss experience of 1000 cars each valued at Rs. 5 lacs by theft shows that over a period of say 10 years, on average 5 cars are stolen. Calculate the pure premium per car. A Rs 250 B Rs 2500 C Rs 500 D Rs 5000 Question 3 The _________ is used to indicate rate changes rather than rates per se. A Loss ratio method B Pure premium method C Both the above D Neither of the above Question 4 ____________ use past experience so as to determine the costs of coverage for the future. A Prospective systems B Retrospective systems C Both the above D Neither of the above 50  IC - 45 General Insurance Underwriting Answers to Self-Examination Questions Answer to SEQ 1 The correct option is C. While assessing the risk characteristics, the rating plan broadly looks at risks based on frequency of losses and severity of losses. Answer to SEQ 2 The correct answer is B. The pure premium will be Rs 2500. Answer to SEQ 3 The correct answer is A. The loss ratio method is used to indicate rate changes rather than rates per se. Answer to SEQ 4 The correct answer is A. Prospective systems use past experience so as to determine the costs of coverage for the future. 51  IC - 45 General Insurance Underwriting CHAPTER 4 RATING APPROACHES IN PRICING Chapter Introduction This chapter aims to provide you with an understanding of the rating approaches in pricing of insurance products. You will learn about the different premium methods that are used by insurance companies. a) Understand the concept of insurance pricing and its importance. b) Learn about premium rating methods - the class rating method. c) Learn about premium rating methods - the individual rating method. 52  IC - 45 General Insurance Underwriting 1. Understand the concept of insurance pricing and its importance. [Learning Outcome a] 1.1 Introduction The insurance sector is different from other commercial sectors as it does not offer any tangible physical product. 9 Insurance companies merely make a contractual promise with the customer for future payment if a certain event occurs and is covered under the policy term. 9 In terms of pricing a product, the industrial sector bases it’s pricing on production and manufacturing costs, whereas in the insurance industry, the price for insurance products results from the estimate of future obligations. 9 The insurance industry estimates any future payments it may have to make based on actuarial methods. 1.2 Insurance pricing Insurance pricing is also known as rate making. Insurance pricing or rate making refers to the process of determining the rate that can be charged by an insurance company for providing insurance cover to policyholders. Theoretically, the insurance pricing or premium rate should be determined mathematically and statistically with the principle of law of large numbers and by using a credible process of loss forecasting based on an analysis of the probability, frequency and severity of loss for the risk that is to be covered. Rate Rate can be defined as the price per unit of insurance against each exposure unit. 53  IC - 45 General Insurance Underwriting The business of insurance presumes an exposure to loss. Insurance companies need to ensure that the rates that are charged by them are able to cover all losses and expenses and help them earn some profit. There can be following 2 cases with respect to rate making: 9 No possibility of loss: if there is no possibility of any future loss, then there will be no need for insurance. 9 Possibility of loss: If an entity does have an exposure to loss, it is desirable that the cost of transferring that loss, or the risk premium, to another party is proportional to the expected loss, which is assumed to vary with the exposure. Hence, there is a need to devise ways and methods for arriving at the most appropriate premium rate corresponding to the expected losses. 1.3 Rate adequacy measurement In insurance business, rate adequacy measurement is quite complicated because the insurer cannot foresee the actual costs at the time of selling the policy. Price is estimated through loss forecasting methods based on a sound statistical framework. If the insurer fails to achieve the targeted number or volume of business and if the actual claim costs, especially for catastrophic losses, are more than statistically projected, the price (premium) received may not be sufficient to pay all claims and expenses during the policy period. The rating pattern for general insurance products can vary across products or portfolios for insurance companies due to: 9 The peculiarities of the individual products themselves, 9 The availability of historical data concerning premium and claims statistics, 9 The nature and characteristics of exposure units that produced these statistics. 1.4 General insurance products as per ‘file and use’ IRDA guidelines There are different premium methods that have been devised and used in general insurance. The methods for determining the rate can be quite different for liability insurance as against property and other insurance due to the peculiarities of these businesses. 54  IC - 45 General Insurance Underwriting Liability insurance: In Motor third party insurance in India, the claim settlement duration can extend anywhere from 3-10 years. These claims are further exposed to court award inflation. Property and other insurance: In insurance like property, Motor Own damage, Marine Cargo, Personal lines of insurance etc., the loss settlement periods will be shorter, and at the worst, may not be expected to exceed 12 months. Hence the benchmark rating principle for arriving at the premium rate cannot be the same for liability insurance as for normal property insurance. The file and use guidelines of IRDA classify all general insurance products into two major categories based on the rating plan that is used in rate making for these products. These are: 9 Class rated products- include all such insurance products of the insurer, for which premium is determined via grouping, classifying and loss making factors that can be easily identified and quantified. 9 Individual rated products- include all such insurance products where premium is determined based on an individual’s exposure to loss. Diagram 1: File and use guidelines of IRDA 55  IC - 45 General Insurance Underwriting These two major categories of products are further sub-divided under file and use guidelines as follows: 1. Class rated products: These are further classified as a) Internal Tariff rated products All such general insurance products that can be sold by an insurance company with rates, terms and conditions as per the internal tariff guide of the insurance company. Examples of internal tarriff rated products are: 9 Motor insurance 9 Health insurance 9 Personal accident insurance b) Packaged or customised products These general insurance products are specifically designed to suit the requirements of an individual customer. The terms, conditions, rates and scope of insurance cover etc. are specially customised to meet the individual’s needs. 2. Individual rated products. These are further classified as a) Individual experience rated products These include products where rates, terms and conditions, are determined depending on the actual past experience of the insurance company relating to claims. Examples of individual experience rated products are: 9 Cargo insurace 9 Hull insurance 9 Health insurance b) Exposure rated products These include general insurance products where rates, terms and conditions are determined after evaluating the exposure to loss relating to certain risk, independent of the actual claim experience with that risk in the past. 56  IC - 45 General Insurance Underwriting Natural disaster risk such as earthquake, flood, tsunami etc. a) Insurance of large risks These include general insurance products that are specifically designed for individual large clients. The rates, terms and conditions for these policies are driven by prevalent international market standards. As prescribed by IRDA large risk includes: 9 Insurance worth a total sum insured of Rs 2500 crore or more at one location for property insurance, material damage and business interruption combined 9 Rs 100 crore or more per event for liability insurance Internal tariff rated products is an example of _____________ A Class rated products B Individual rated products C Exposure rated products D Insurance of large risk 2. Learn about premium rating methods - the class rating method. [Learning Outcome b] 2.1 Introduction to premium rating methods The premium rating methods used by insurers can be classified on the basis of the approach used for products classified under file and use guidelines of IRDA. Hence, different premium rating methods include: a) Class rating method 9 Pure premium method 9 Loss ratio method b) Individual or merit rating method 9 Schedule rating method 9 Experience rating method 57  IC - 45 General Insurance Underwriting Diagram 2: Premium rating methods 2.2 Class rating method In class rating method, risks with similar characteristics are placed in the same class and charged the same rate, in line with a pre-defined tariff. All industries manufacturing textiles are grouped together and will be charged the same rate, in line with a pre-defined tariff. Class rating method can be applied only when: 9 Factors that might cause losses can be easily identified and quantified 9 Statistics on these factors is available and is accurate The accuracy on the estimate of future losses depends upon the accuracy of the statistics available. If the past data is not reliable, then an estimate on the future losses would also not be realistic. Class rating method can be effectively applied for determining the premium for general insurance products that are sold to individuals, as: 9 Statistical data is easily available for such products. 9 Also, the customer base for such products is large; hence, owing to large numbers, statistical data will also be more reliable. 58  IC - 45 General Insurance Underwriting In India, Motor and fire tariff are the best examples of class rating method where all the risks are classified into particular categories or classes and rated accordingly. 9 Motor tariff: All Honda City vehicles in Mumbai will be assigned a single rate 9 Fire tariff: All cement manufacturing units will be rated as a single unit. Methods of class rating The methodology of the class rating method is easy to apply but can be quite difficult to calculate. Following 2 methods can be used to calculate the premium under the class rating method: Diagram 3: Methods of Class Rating a) Pure risk premium method Process of determining premium under this method is as follows: 1. Determine the factors that might causes losses All the factors that might affect the insurance product are selected and their loss making effect is studied. In motor/vehicle insurance, the following factors can be selected for rating: 9 The make and model of the vehicle 9 Vehicle age etc. 59  IC - 45 General Insurance Underwriting 2. Collect data on these loss making factors over a period of time Collect data for all rating factors over a suitable time period. The time period should be long enough to ensure that there is adequate data for credible analysis but it should not be so long that past data is no longer relevant to the future. 3. Calculate pure premium The pure risk premium is the product of claim frequency and claim severity per unit of exposure. Hence, pure premium can be calculated as follows: Pure Premium = Actual loss + Loss adjustment expenses Number of Exposure units 4. Calculate gross premium Pure risk premium is then loaded for expenses, inflation, commission, etc. to arrive at the gross premium that is charged to the customer. [Gross Premium = Pure risk premium + load ] b) Loss ratio method As against pure risk premium method, in loss ratio method, premium is adjusted on the basis of actual loss experience of the insurance company. Hence, loss ratio can be calculated as follows: Loss Ratio = (Losses + Loss adjustment expenses) over the premium charged 2.3 Analysis of class rating method The class rating system demarcates risks on the basis of loss-producing characteristics into identifiable, specific classes, representing the average expected costs (both claims and administrative) for that particular class. However, it can be seen in real time situations that risks within the same classification have widely varying loss experiences. Within a class, there may be sub-classes or favourable or adverse features based on the risk differences. Hence, the class rating approach for all categories of risk may not be appropriate to fully describe the characteristics of risks in terms of premium rate. Hence to overcome shortcomings of the class rating method, insurers popularly use the Individual rating method. 60  IC - 45 General Insurance Underwriting In which of the following methods is the premium adjusted on the basis of actual loss experience of the insurance company? A Pure risk premium method B Loss ratio method C Experience rating method D Merit rating method 3. Learn about premium rating methods – the individual rating method. [Learning Outcome c] 3.1 Introduction to Individual or merit rating method Throughout the world, owing to the vast progress made by information technology, the current trend is to rate a risk according to its ‘individual merit’ or based on a ‘small sub-segment of the overall population’. Individual rating is also based on the class rating method, but the difference is that the premiums are adjusted according to the actual losses of the individual customers. For an insurer, the primary goal of individual risk rating is to price the coverage provided more accurately than if the rates were based only on manual or class rates. 3.2 Main features of Individual or Merit Rating Method Main features of Individual or merit rating method are as follows: a) Individual risk rating supplements class rates by modifying the group rates in whole or in part to reflect an individual entity’s experience. b) An individual risk rating system should appropriately balance risk sharing and risk bearing 9 The costs for small entities whose experience is not credible should be determined solely based on risk sharing. 9 Very large entities whose experience is credible might have their premium costs solely based on risk bearing. 9 Entities in between these extremes should base their costs on a weighting of risk sharing and risk bearing. 61  IC - 45 General Insurance Underwriting c) Individual or merit rating approach was devised to identify and recognize the individual risk differences in the determination of premium rates. d) In individual rating, the discovery of the appropriate rate depends on the claim experience of the specific business applicant. In other words, it measures the extent to which a particular risk deviates from the average of its class. e) Individual rating approach tries to identify the characteristics peculiar to the risk and modifies the average rate for that particular class based on identified characteristics like past claims experience. 3.3 Methods of determining individual or merit rating Individual or merit rating can be determined using the following 3 methods 9 Schedule rating method 9 Experience rating method 9 Exposure rating method 3.4 Schedule rating method In schedule rating method, the class rate is increased or decreased in the form of percentage debits and credits, depending on exposure to loss making factors for a certain individual. These credits and debits are sometimes applied before and sometimes after experience rating. There may be a limit to the total debit or credit that an entity can receive. The premium rate that is communicated to the policyholder is derived only after adding these debits and credits to the premium for the class. Schedule rating method can be applied in case of property insurance where each exposure is individually rated or class rate is modified in view of desirable or undesirable physical features such as: 9 Location of the property 9 Size 9 Present condition of the property 9 Construction 9 Occupancy 9 Operating Methods 9 Protection or safety measures 9 Other exposures 9 Housekeeping & Maintenance 9 Loss Prevention or control Measures 9 Management outlook and attitude towards Loss prevention / control measures 62  IC - 45 General Insurance Underwriting Schedule rating plan A schedule rating plan gives 9 Rate credits for good physical and other features of a risk and 9 Loading of rate for risk aggravating or bad features. The additional characteristics include 9 physical hazards, 9 moral hazard, 9 existence of safety programme, 9 improved technology, 9 management control, 9 compliance of corporate governance and Government regulations etc. These are applicable to the particular businesses in a specified class. The main features of schedule rating method are as follows: a) Schedule rating method is the only individual risk rating system that does not directly reflect an entity’s claim experience. b) In theory, schedule rating method recognizes characteristics that are expected to have a material effect on an entity’s experience which may not have actually reflected in that experience. These characteristics could result from: 9 recent changes in exposure such as the addition of a swimming pool in an apartment complex or 9 risk control programmes such as the recent implementation of a new programme c) Schedule rating is also used for entities that are too small to qualify for experience rating. d) Schedule rating systems usually take the form of percentage credits and debits. 63  IC - 45 General Insurance Underwriting 3.4 Experience rating method It is another type of merit rating method where class rate or schedule rate is further adjusted upward or downward based on the past loss experience of the particular client for a reasonable period (generally 3 to 5 years). In this method: 9 If the insured’s loss experience is better than average for the particular class of clients, the class rate is further reduced. 9 If the loss experience is worse than the class average, the rate is increased. 64  IC - 45 General Insurance Underwriting Experience rating takes both claim size and claim frequency into account for arriving at