REPORT

ON
COMMUNICATIVE
ENGLISH III

SUBMITTED BY:
NAME: MANIDEEP SEN
ROLL NO. : 172041038
REG. NO. : 1170254
DEPARTMENT: B.COM(H)
SEMESTER: 4th SEM
DAY SHIFT
 RISK MANAGEMENT IN GENERAL INSURANCE BUSINESS IN
INDIA

ABSTRACT

Over the years the general insurance companies have been undertaking extensive risk management

activities to safe guard the investor as well as investment. In the present day scenario the two aspects

which are of great importance to the general insurance industry are firstly the opportunities in the

Indian general insurance market and the resulting focus of players on achieving business growth and

secondly the ongoing process of calibrated de-tariffing. Though de-tariffing has provided players with

significant opportunities in tapping markets and in coming times may result into providing even more

opportunities, it has placed the onus of correct pricing on the players themselves. This has resulted in

players preparing and emphasizing more on identifying risk parameters and pricing products based on

risks. The players under the immediate response to the pressure of a free market scenario, has

dropped the rates even in hitherto non-profitable businesses. An efficient risk assessment and

management in general insurance industry lays great emphasis due to entry of private players,

corresponding policy changes and the present day fact of unprofitable books, erosion of capital

resulting from unmanageable claim ratios.

Key Words: General Insurance, Risk Assessment, Risk mitigation, Asset Liability Management,

Enterprise Risk Management.

1. Introduction

Any sunrise industry faces a host of risks, both internal and external. Whereas for industries

already in existence for long, most of the risks are well identified and emerge from the internal

operations of the different players. An evolving industry usually faces higher risks from the

competitive and regulatory environments rather than internal operations. In a competitive

environment, achieving growth requires focus on sales and rapidly scaling up operations through

expansion of channels and increasing geographical presence. A higher amount of focus on sales

and business expansion has its own set of risks on business profitability. These risks could

adversely affect the business performance and even their survival. The general Insurance
companies due to their nature of business are at a receiving end both as a insurer and insured. The

success of the business hence lies in understanding the external and internal risks concerning the

general insurance business industry and the techniques adopted by the insurers as well as insured

to effectively manage their risks.

 2. Literature Review
Being into the business of covering risks of other business and social entities the general

insurance players are exposed to financial and operative risks of self as well as of the insured. For

an effective risk management of the same proper identification of structural functions, their

insurability, adequacy, commercial viability holds the key to success. The risk may further be

minimized by risk distribution through pooling of micro insurance, appropriate quantification and
accurate estimation of results in case of occurrence of underwritten peril. In the process of risk

management the importance of information on risk transfer for effective mitigation and adaptation

by core business may not be overstated. Incorporating innovation, certification will further

provide depth to the instruments. Encouragement of public private partnership and a strong

financial, legal and political framework will provide the much needed support to further increase

the general insurance penetration and reducing the ever increasing claim ratio. Mendoza &

Ronald (2009), outlines a proposal for a regional risk sharing arrangement namely Asian rice

insurance mechanism (ARIM) which could form part of the region's long-term response to the

food security issue. It proposes that ARIM could serve as a regional public good by helping

countries in the region more efficiently by managing the risks related to volatile rice production

and trade, arising from emerging structural factors such as the rising and evolving food demand.

Further Lubken et al (2011) has discussed environmental risk, risk management and uncertainty,

and the dependence of environmental risk on social, scientific, economic, and cultural processes.

They propagate that natural catastrophes reportedly derive from past patterns of resilience and

vulnerability. The role of insurance sector in reducing the impacts of global warming and the

challenges insurers and reinsurers face in dealing with the impact of climate change on their risk

management strategies has been studied by Kunreuther et.al (2007). The study has examined the

issues of attribution and insurability by focusing on natural disaster coverage. Phelan et al (2011),

have analyzed the adequacy of insurance responses to climate risk and has provided novel

critiques of insurance system responses to climate change and of the attendant political economy

perspective on the relationship between insurance and climate change. A complex adaptive

system analysis has suggested that ecologically effective mitigation is the only viable approach to

manage medium- and long-term climate risk - for the insurance system itself and for human
societies more widely. Another important component of commercial viability has been studied by

Akter et al (2009).The study has concluded that a uniform structure of crop insurance market does

not exist in Bangladesh. It emphasizes that the nature of the disaster risks faced by the farm

households and the socioeconomic characteristics of the rural farm communities need to be taken

into careful consideration while designing such an insurance scheme. Mauelshangen & Franz

(2011), discussed the nature of adaptation and decision-making in the insurance industry. They

have correlated the historic evaluation with contemporary concerns about global warming and

means of adapting insurance to compensate for associated losses. Erdlenbruch et al (2009), have

analyzed the consequences for risk distribution of the French Flood Prevention Action

Programme in France. Results of the survey have showed that the proposed policies may be

financially non-viable. Several more viable risk-sharing solutions are then discussed, involving

insurance schemes, state intervention and local institutions. Spatial pooling of micro-insurance

schemes may reduce these capital requirements. A Study by Meze-Hausken et al (2009) suggest

that spatial pooling may be an attractive option for micro-insurers, worthy of a detailed case-bycase
analysis when designing index-insurance schemes. Further Botzen et all (2009) have

examined the role of insurances to reduce uncertainty associated with climate change losses for

individuals. The estimation results have suggested that a profitable flood insurance market could

be feasible and the climate change has the potential to increase the profitability of offering flood

insurance. Rohland & Eleonora (2011) have discussed risk management and quantification of risk

in the aftermath of fire in the Swedish and international reinsurance industry. The study asserts

that characterization of fire as a man-made hazard misrepresents its overall risk as it ignores

natural causes of fire and associated risks. An another important study by DeMeo et al (2007)

talked about the importance of information on Environmental Risk Transfer and insurance options for
potentially responsible parties in case of liability of pollution, cleanup cost cap, and legacy

insurance. Further Phelan (2011) argues that unmitigated climate change threatens not just

measurable, increased likelihoods of extreme events, but over time, wholly unpredictable

frequencies for extreme weather events. It also raises concern over the continued provision of

insurance in a climate-changed world, for the insurance sector as well as the societies dependent

on insurance as a primary tool to manage financial risks. The research argues that ultimately, the
only viable way to insure against climate risks will be through effective mitigation of climate

change.

Sato et al (2010), emphasizes that for the insurance industry, climate change poses a great risk to

management since an increase in natural disasters leads to an increase in insurance payments. The

study suggests that insurance companies should contribute toward the realization of a low-carbon

society and a climate-resilient society through their core business by means of mitigation and

adaptation strategies. Further Owen Richard et al (2009) have discussed the aspects of risk

governance in the insurance industry to drive responsible technological innovation. The

researchers have suggested that innovation drives economic growth, fosters sustainable

development, and improves the health and well-being of individuals. The study also highlights the

relationship between responsible innovation and financial risk-taking, the role of regulation, and

the use of "data before market" legislation to increase corporate responsibility. Richter et al

(2010) has discussed the coverage enhancements of insurers for addressing insurance and risk

management exposures in the construction of sustainable buildings. The research states that

insurance firms should require Energy and Environmental certification for several non traditional

exposures such as vegetative roofing, rainwater runoff, and alternative energy generation systems

before they provide green coverage. Dlugolecki et al (2006) puts the reasons for market failure of

global general insurance sector as absence of reliable risk data, and volatility in the event costs,

high prices, a misperception of the true risk, an expectation of government aid after disasters, and

exclusion from financial services. It proposes that a public-private partnership may prove

instrumental in resolving this. Cottle & Phil (2007) proposes that despite a low intrinsic fire risk

across most of Southeast Asia, especially Indonesia, commercial fire losses are unacceptably

high, and could be reduced substantially within the current financial legal and political framework

within which forestry companies operate. Using commercial and unidentified data the author

then demonstrates that commercial growers in Indonesia have a high annual rate of forest fire loss

and may also have a significant catastrophe fire exposure.

The above discussed studies show that the general insurance industry in its every sphere of

activity is exposed to uncertainty. Hence there is a need for a comprehensive study of these risk

factors and devising an implementable management strategy for the same. The present study aims
at identifying the risk factors the general insurance industry is exposed to and methodology and

tools for their effective quantification, mitigation and management.

3. Risks in General Insurance business

Players in the general insurance business are likely to be exposed to varieties of financial and

non-financial risks like capital risk, enterprise risk, asset liability management risk, insurance risk,

operating risk and credit risk arising out of the nature of business and the socio economic

environment in which they operate.

3.1 Financial risk

Insurance business basically being financial business in nature attracts financial risks in the forms

of capital structure risk, capital (in)adequacy risk, exchange rate risk, interest rate risk,

investment risk, underwriting risk, catastrophic risk, reserve risk, pricing risk, claims management risk,
reinsurance risk, policy holders and brokers risks, claims recovery risk and other debtors

risk. Insurance business undertakes various plans to manage the financial risk by adopting

techniques like interest rate hedging and reserving determined through financial modeling with

the inherent ‘model risk’ given that such financial models may fail to predict the real outcomes

within an acceptable range of error.

3.2 Non financial risk

Non financial risk management has assumed greater significance in the recent years due to (i) the

growing volume of operational losses, (ii) the industry’s increasing reliance on sophisticated

financial technology with the latter’s associated probability of failure at times, (iii) the ever

increasing pace of changes in the deregulated insurance regime and (iv) the globalization process

paving the way for the entry of global players. In addition to these, the ‘volatility’ factor which

affects the future cash inflows of the general insurance business and consequently its value, given

that ‘the value of an insurance company is the present value of its future net cash inflows

adjusted for the risks it undertakes’ is the other dimension of non financial risk the insurance

business is confronted with. Studies have proved that a major source of volatility is not related to

financial risks but the way in which the company operates. Hence the operating risk may arise

either from inadequate or failed internal processes such as employment practices, workplace

safety, and internal fraud or from external events such as external fraud and damage of physical
assets from natural disaster and other uncontrollable events.

4. Risk management mechanism in general insurance business

The risk management mechanism adopted by the insured in the general insurance business

broadly takes the form of ‘enterprise risk management’, whereas that of the insurer broadly

assumes the ‘risk based capital management’ and ‘reserving’.

4.1 Risk management mechanism adopted by the insured

It is of utmost importance for any organization to minimize its exposure to risk of loss arising out of

unforeseen events like the natural calamities, earthquake, flood, fire, theft, and so on. To ensure that

a risk minimization and mitigation mechanism is in place that the insured need to go for an effective

risk management drive. The technique available to the insured for such risk management is known as

the enterprise risk management.

4.1.1 Enterprise Risk Management (ERM)

ERM is the process of planning, organizing, leading, and controlling the activities of an organization

in order to minimize the effects of risk on an organization’s capital and earnings. As regulators and

markets around the world judge companies on their risk management effectiveness, ERM is rapidly

becoming a standard industry practice for managing risk.

(I) Scope of enterprise risk management: Enterprise risk management takes a vast field of loss
possibility and breaks it down into a number of more manageable categories. Apart from the core

financial risks inherent to the business, enterprise risk for an insured may be classified into strategic

risk and operational risk as described below:

A. Strategic risk

Strategic risk occurs based on corporate decisions that have an impact over time. Growth strategy,

executive decision making, mergers and acquisitions, and approaches to capital management are all

areas of strategic risk. The very act of strategic planning represents an attempt to manage strategic

risk, but such efforts can be greatly enhanced by an enterprise risk management approach. A simple

example of strategic risk is the entrance by a player into a new product line with inadequate

operational expertise. The failure to anticipate the strategic moves of competitors is itself a strategic

risk. Strategic risk management may include risk-adjusted pricing, capital budgeting, hedging,

investments, and risk-adjusted performance measurement through the creation and use of financial
reporting systems.

B. Operational risk

Operations refer to all the activities of a company in their day to day activities. Operational risk arise

out of activities that may hinder or bring a company’s operations to a halt such as natural disasters,

labour problems, fraud perpetrated from within the company, and data problems. In India, there is an

increasing awareness of the need to manage operational risk as it is intimately related to the other

areas of risk.

(II) Components of ERM strategy: The components of ERM strategy include planning, risk
tracking and reporting, implementation and the tools of ERM implementation. The components are

described as follows:

A. Planning

Irrespective of the company’s strategy to hire a risk management team, outsource enterprise risk

management, or simply work with a team of current employees; ERM begins with an audit of an

organization’s potential liabilities with special attention to their severity. This risk plan is reviewed

periodically and adjusted in the light of changing conditions and ongoing risk management efforts.

Another element of planning is to define a company’s risk tolerance and propagate it to decision makers
throughout the enterprise. If a risk is highly unlikely and not particularly severe, it may be just

left alone.

B. Risk tracking and reporting

Another key element of ERM is to track risks over time to see how well they are being managed and

to deal with the trends early. Comparing them to each other is not as important as establishing a

baseline that can be tracked across reporting periods. Insured need to continually remind them that

just because a risk cannot be effectively quantified or compared to others does not mean it should be

discounted or excluded from the ERM plan. Even if the financial impact of a risk is difficult to

measure, its occurrence can still be recorded and tracked. After the relative severity and likelihood of

various risks is assessed, a mitigation plan is developed. In other cases, a mitigation strategy for one

risk could actually increase the likelihood or severity of another risk, and in such case the trade-off

must be examined carefully.

While ERM might increase a company’s reserve or liability coverage requirements, its goal is to
provide the optimum preparation for adverse events. In some cases, an ERM framework will reduce

certain costs by reducing the double-counting of risks by previously undertaken risk management

efforts. In any case, under ERM a broader variety of risks is likely to be considered.

C. Implementation

The insured takes into account the objectives, scope, organization, and tools of enterprise risk

management to establish an ERM framework and its implementation. For an ERM strategy to be

successful, it is important to prioritize the objective according to company needs.

D. Tools: Some of the specific tools that are important for implementing ERM are:

i. Risk audit guides: These guides can be used for risk mapping of individual risks, risk

assessment workshops, and risk assessment interviews. The risk assessment interviews are very

effective at uncovering how the business actually works.

ii. Stochastic risk models: Stochastic model is a rigorous mathematical model used to simulate

the dynamics of a specific system by developing cause-effect relationships between all the

variables of that system. This plays a vital role in quantifying the risk components, its severity

and the required risk management efforts to offset the risk.

iii. Risk monitoring reports: These can include regular reports to managers, Boards, and

relevant external stakeholders such as the regulators and investors. This may be more formal

where the reports are more likely to go to the executive committee and the board of directors and

may be informal when such reports are likely to go for frequent adjustment in actions.

4.2 Risk management process: Having said the risk management mechanism as above, it would be

appropriate to highlight the ‘processes of risk management that may be adopted by the insured to

make it more effective. effective risk management process from the insured’s point of view

should necessarily include risk identification, risk assessment, risk avoidance & retention, risk

improvement & mitigation using appropriate techniques, implementation of the recommendations and

periodic review of the risk management programs.

4.2.1 Risk identification

The risk identification activity broadly involves an in-depth understanding of the industry, the areas

and markets it serves, its activities, range of products, social, legal and economic environment in

which it operates and other physical and natural hazards associated with the company’s operations.
Developing and exercising proper checklist for identifying these hazards is part of risk management

process.

Risk identification is important in managing the risk, which deals with source and problem analysis.
When either source or problem is known, the events that a source may trigger

or the events that can lead to a problem can be investigated. For example, major explosion in a mini

steel plant may affect business continuity of the unit; the stakeholders withdrawal during a project
may endanger funding of the project; fire damage caused to a chemical firm due to missing lightening

arrestor may result in major material damage; flood damage to a pump station of irrigation project

due to a facility located in a low lying area might delay the project completion schedules; and a

delayed or missed inspections may result in failure to identify these factors. As risk identification process
involves identifying the risk factors and evaluating the potential loss

that might take place, it is more important for the insured to pay special attention on the following

two most important components as contained in the risk identification chart:

A. Maintenance procedures: The risk identification procedure must take into account the

identification of the nature and extent of maintenance procedures, their regularity and the skills of the

technicians undertaking the work. It is equally important to conduct non destructive testing along

with the regular maintenance testing. A study of moral factors by means of appropriate interviewing of
the people in plant or by observations may be undertaken to obtain multiple indicators of moral

hazards in the risk.

B. Physical factors: Physical factors are essentially sensory, visual signs of lack of due care and

control of the working environment to avoid damage. A clean, tidy and uncluttered work environment

not only denotes pride of possession but more importantly, a culture of loss avoidance. Business

interruption susceptibility of an organization depends on the kind of service that the organization

provides. Thus there is a need to conduct periodic hazard and operability study which will help in

detecting any predictable undesirable event by using the imagination of members to visualize the

ways of conceivable malfunctioning.

4.1.2. Risk Assessment

Once risks have been identified, they must then be assessed as to their potential severity of loss and

probability of occurrence, called ‘risk quantification’. These quantities can be either simple to

measure, in the case of the value of a lost building, or impossible to know for sure in the case of the
probability of an unlikely event occurring. The fundamental difficulty in risk assessment is

determining the rate of occurrence, i.e., the ‘loss frequency’. Proper risk assessment helps the

underwriter to apply judgment to the risk by securing material information and by determining the

actual conditions. The risk assessment process of measuring the extent of physical damage,

the consequential loss and quantification of risk after taking into account the maximum probable
interruption time. Once risks are identified and assessed, the techniques to manage the risk are

applied to avoid or retain the risk.

4.1.3 Risk avoidance and risk retention

Risk avoidance is non-performance of an activity that could carry risk. For example, the risk of

potential damage to a control room in a petrochemical complex can be avoided by making the control

room blast proof; potential damage by flood to a pharmaceutical warehouse could be avoided by

shifting warehouse to a higher elevation. For the insurers, avoidance may seem the answer to all

risks; but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk

may have resulted in. Not entering a business to avoid the risk of loss also avoids the possibility of

earning profits.

Risk retention involves acceptance of loss. All risks that are not avoided or not transferred are

retained by default. This includes risks that are so large or catastrophic that they either cannot be

insured against or the premiums would be infeasible. War is an example since most property and risks

are not insured against war, so the loss attributed by war is retained by the insured. Risk retention is a

viable strategy for small risks that can be absorbed and where the cost of insuring against the risk

would be greater over time than the total losses sustained. True self insurance is risk retention for an

insured. For example a large and financially strong firm may create a self insurance fund to which

periodic payments are created. Risk retention pools are technically retaining the risk for the group,

but spreading it over the whole group involves transfer among individual members of the group. This

is different from traditional insurance, in that no premium is exchanged between members of the

group up front, but instead losses are assessed to all members of the group. Risk transfer means

causing another party to accept the risk, typically by contract or by hedging. Insurance is one type of

risk transfer that uses contracts. Risk transfer takes place when the activity that creates the risk is

transferred. Other times it may involve contract language that transfers a risk to another party without
the payment of an insurance premium. Liability among construction or other contractors is very often

transferred this way. Other examples of risk transfer could be subcontracting a hazardous operation

outside the manufacturing facility.

4.1.4 Risk reduction and control

Risk improvement and mitigation is an important task of risk management which involves methods

that reduce the severity of the loss. For example, the sprinkler system designed to put out a fire to

reduce the risk of loss by fire. For the risk reduction, a mitigation plan is prepared. The purpose of

the mitigation plan is to describe how this particular risk will be handled and what, when, by who and

how will it be done to avoid it or minimize consequences if it becomes a liability. Loss prevention in

risk management further aims to eliminate or to reduce these losses.

4.1.5 Implementation of the recommendations

Implementation of the recommendations for risk mitigation should be properly undertaken so as to

ensure effective management of risk by the insured.

4.1.6 Periodic review of the risk management programs

Risk is a relative measure and from insurer perspective it is important to map the risk consequence

with probability in a risk coordinate system. The probability of risk occurrence and

the consequences , the risk factor can be subjected to four decision making areas namely high

consequences and low probability area, low consequences and high probability area, high

consequences and high probability area, and low consequences and low probability area. Managing

the risk in high probability and high consequence is the worst possible case. Total risk value in this

case is highest, because there is increased potential of events with large consequences. Low

consequence and high probability is the most common quadrant of risk management, because this is

the lowest threshold of a loss which is normal in nature. These may be arising out of minor repairs,

replacement and minimum business inconvenience. Low consequence and low probability is the

objective of risk based continuous improvement.

4.3 Risk management techniques adopted by the insurer

The risk management mechanism adopted by the insurer in the general insurance business broadly

falls into two categories: ‘risk based capital management’ and ‘reserving’. It may not be out of

context to mention here again that included in the ‘risk based capital management technique’ category
are the management role, capital and solvency margins, and risk based capital; and in the ‘reserve’

category of risk management techniques included are the unearned premium reserves, unexpired risk
reserves, outstanding claim reserves, incurred but not reported reserves, catastrophe reserves and

claims equalization reserve.

4.3.1 Risk based capital management technique

The insurance business, unlike other financial institutions, faces unique challenges in risk

management. Assuming the risks of others and guaranteeing the payments of claims based upon

perils that are random and uncertain are the kind of operational risks found as additional and unique

to the insurance business over and above any other risks inherent to the financial institutions in

general. Though the insurance regulatory authority, i.e., the IRDA, does not undertake the

responsibility of risk management of the individual players, it gives greater emphasis on monitoring

the conduct of the players in dealing with the risks to protect the interest of the customers.

In the context of risk based capital management technique, the role of board of directors and the

management is worth mentioning.

A. Role of the board of directors

The board of directors of each general insurance player is ultimately responsible for the company’s

risk management policies and practices. In delegating its responsibility, a board of directors usually

empowers the management with developing and implementing risk management programs and

ensuring that these programs remain adequate, comprehensive and prudent. The board of directors

should ensure that material risks are being appropriately managed. To ensure this, the board should:

1. review and approve management’s risk philosophy, and the risk management policies

recommended by the company’s management;

2. review periodically management reports demonstrating compliance with the risk management

policies;

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

4. review with management the quality and competency of management personnel appointed to

administer the risk management policies; and

5. See that the audit regularly reviews operations to assess whether or not the company’s risk

management policies and procedures are being adhered to and to confirm that adequate risk
management processes are in place.

B. Role of management

The management of each general insurance company is responsible for developing and implementing

the company’s management program and for managing and controlling the relevant risks and the

quality of portfolio in accordance with this program. Although the management responsibilities of

one firm will vary from another firm, the managerial responsibilities in common shall be-

1. Developing and recommending the management’s risk philosophy and policies for approval

by the board of directors;

2. Establishing procedures adequate to the operations, and monitoring and implementing the

management programs;

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

4. Ensuring the development and implementation of appropriate reporting system ,and a prudent

management and control of existing and potential risk exposure;

5. Ensuring that audit regularly reviews the operation of the management program;

6. Developing lines of communication to ensure the timely dissemination of management

policies and procedures and other management information to all individuals involved in the

process.

C. Capital and solvency margin

The capital for general insurance business does not mean legal capital alone but includes valuation

margin available with the insurer. The reasons for holding such capital are to enable the company

settle the claims, maintain dividends, and invest in potential growth opportunities and also to support

other risks should there be a need. Settlement of the claims depends on the firm’s solvency margins.

The present solvency margin as prescribed by the IRDA called the required solvency margin (or

RSM), is 20% of the net premiums or 30% of net incurred claims whichever is higher, subject to a

reduction by 0.5 to 0.9 for reinsurance depending upon the insurance segment of fire, marine and

miscellaneous. This formula is similar to the provisions applicable under the European Union

legislation during early 1990s. The European Union legislation used a three year average net incurred

claims basis for calculation of solvency margin whereas IRDA does not provide for such averaging.

Besides the statutory provision, IRDA requires maintenance of the solvency margin at 150% of the
level defined in the regulations as a market practice while granting license. The IRDA solvency

norms imply a uniform risk profile across all companies and do not consider the risks to which

individual companies are exposed.

The solvency margins are calculated by deducting liabilities from the available assets. Valuation of

assets and liabilities for determination of the solvency margin however is subject to several

assumptions relating to the future market conditions. The solvency margin should always be positive

and should be at or above the prescribed level to ensure that liabilities are met at all times. The timing

of asset proceeds and discharge of liabilities is equally important. In order to achieve a higher

solvency margin, measures like charging of appropriate premiums, retaining adequate reserves,

investing prudently and managing risk accumulations may be undertaken by the players.

D. Risk Based Capital (RBC)

The RBC concept emerged in the global insurance market in the early 1960s especially in the US. At

present, as a part of the RBC model, an authorized capital level (or ACL) is prescribed by the

regulator to be observed by each insurer. The regulator has also prescribed corrective and remedial

actions in case of any failure on the part of the insurer to observe the stipulation depending on the

level of the ratio between the insurer’s actual free capital and the ACL. For example, when the

insurer’s actual free capital to the ACL ratio falls below 70%, the insurer shall be totally controlled

by the regulators and if the ratio falls between 100% and 150%, the regulators shall perform an

examination of the insurer and issue necessary corrective orders.

The US system of RBC has been criticized on the ground that the actions laid down in the regulations

against different action levels are rigid; the policyholders may have to pay additional premium to

service additional capital; several other risks have not been incorporated in the system; losses due to

derivatives is not included; calculation of risk factors is arbitrary; no consistent conceptual framework

for calculation of risk charges as factors derived from past industry experience may not be suitable

for the calculation of future distribution; management risk which is an important component of

operational risk has been excluded from the purview of risk assessment; and the solvency levels

required to be maintained discourages conservative reserving among insurers.

Mentioned may be made that in India a system of RBC is yet to be put in place although a debate for

the purpose is on. However when such a model is developed for use by the Indian general insurance
business, care needs to be taken to ensure optimal risk coverage by overcoming the above said

limitations associated with the US RBC model. While doing so the developed RBC model be tested

by factors such as company size, growth rate, product range, geographical region, reliance on

reinsurance and asset portfolio for the industry wide acceptability.

4.3.2 Reserving

The financial condition of an insurance company cannot be adequately assessed without sound loss

reserve estimates sufficient to meet any outstanding liabilities at any point of time. The estimation

process involves not only complex technical tasks but considerable judgment as well. It is important

for the insurance company to understand the data before embarking on the task of estimating loss

reserve which has a significant impact on the financial strength and stability of the company.

The general insurance companies apart from the general reserves maintain a number of technical

reserves which can be divided into following six categories, namely, unearned premium reserves

(UPR), unexpired risk reserve (URR), unexpired risk reserve (URR), outstanding claims reserve

(OCR), incurred but not reported reserves (IBNR), catastrophe reserves, and claims equalization

reserves. A brief explanation of each of these reserves along with their significance has been given as

follows;

A. Unearned premium reserves (UPR)

Unearned premium reserves is the proportion of premiums received which relates to the future period.

It is assumed that the risk is uniform over the duration of the policy and the liability arising out of the

risk can be met by reserving a pro rata amount of the balance of the premium after deducting initial

expenses. In the circumstances of high inflation, changes in expenses and widely fluctuating claims

ratio; the expected claims liability under the unexpired risks can differ significantly from the UPR

provision. If the UPR is regarded as inadequate, an additional reserve is necessary. The insurer

therefore needs to create extra reserve to offset the shortfalls in the UPR by creating an additional

unexpired risk reserve (or AURR).

B. Unexpired risk reserve (URR)

Unexpired risk reserve is created by the insurer to manage the risk arising out of the non receipt of

future premiums. It is estimated by multiplying with the unearned premiums the ratio of the claims

incurred in the year to the premiums earned in the same year. The unearned premiums also allows for
inflation and changes in experience in the various risk groups and their relative proportion of the total

premium. Over and above, a prudent fluctuation margin may be added to the above to minimize the

impact of errors associated with the estimation process.

C. Outstanding claims reserve (OCR)

OCR is maintained by the general insurance companies to meet the outstanding liability for claims

which have already been reported and not settled. The commonly used method to estimate OCR is to

obtain estimates in respect of all outstanding claims on an accounting date after taking into

consideration the following:

i. The certainty of the claim;

ii. The likely time needed to complete settlements;

iii. The rate of inflation on claims costs between the accounting date and the date of

settlements; and

iv. The judicial trends in claims settlements.

D. Incurred but not reported reserves (IBNR)

The IBNR reserve is the estimated liabilities for the unknown claims arising out of incidents occurred

prior to the year end but have not been notified to the company during the accounting period. In

practice, the provision for future development on known claims, which is called as incurred but not

enough reserved (IBNER) is included in IBNR. The average cost of an IBNR claim often differs from

that of currently reported claims. The insurance companies hence develop the ratio of average cost of
an IBNR claim to average cost of reported claims, for different classes of business on the basis of

historical data in order to measure the effectiveness of the IBNR reserves.

E. Catastrophe reserves

The catastrophe reserves are created to meet any unprecedented and/or uncontrollable risk factor

affecting the insurer. These reserves are created out of taxed income after taking into account the

operating position and the effect of provision upon the presentation of its results. Catastrophe reserve

in the long run equates the accumulated catastrophe loadings in premiums without impacting the

financial stability of the insurer.

F. Claims equalization reserves

Claims equalization reserves are made to smooth out the effects of year to year fluctuations in the
incidence of larger claims such as the unusual floods in Mumbai in 2005 and in Surat in 2006. The

provision is created based on past experience of the frequency of claims and the ‘probability density

function’ of this risk. Claims equalization reserve is not created to meet an inevitable liability.

Reserving provisions and IRDA

The IRDA emphasizes on uniformity in method of reserve estimations wherever sufficient data is

available. Besides, standard reporting formats have been devised to analyse current year's

transactions and to build up cumulative data for the amounts and number of claims settled. IRDA

further emphasizes on collecting all relevant information for each class of business from all insurers

so that the consolidated industry data can be used for reserving purposes for those classes where

availability of data is insufficient.

 5. Conclusion
The study was developed to identify the risks to which the insured and the insurer are subject to,

especially in India and the mechanism through which these risk complexions are effectively managed.

The study reveals that both the insured and the insurer in India generally face risks ranging from

financial to non financial in nature. The financial risks for both of them are classified as capital risk,

asset/liability management risk, insurance risk and credit risk, whereas the non financial risk include

enterprise risk and operational risk. The capital risk includes capital structure risk and capital (in)

adequacy risk. Whereas the asset liability management risk includes exchange risk, interest rate risk

and investment risk. Similarly the insurance risk includes underwriting risk, catastrophe risk, reserve

risk, claims management risk and the credit risk includes reinsurance risk, policy holders and broker’s

risks, claims recovery risk and other debtor’s risk. In the same manner the enterprise risk includes

reputation risk, parent risk, competitors risk and the operational risk includes regulatory risk, business

continuity risk, IT obsolescence risk, process risk, regulatory compliance risk and out sourcing risk.

The risk management mechanism found prevalent in the general insurance industry for the insured are

in the form of enterprise risk management comprising of planning, risk tracking and reporting,

implementation, tools and risk management. Whereas for the insurer it is in the form of risk based

capital management and reserving, with the former consisting of management role, capital and

solvency margins, and risk based capital and the later consisting of unearned premium reserves,

unexpired risk reserves, outstanding claim reserves, incurred but not reported reserves, catastrophe

reserves and claims equalization reserve.

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