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Basics of General Insurance
Basics of General Insurance
Most insurers today are shareholder owned (proprietary) companies. There are still, however,
many policyholder owned (mutual) insurance groups.
The financial position of an insurance group can be described using a balance sheet. Balance
sheets show a listing of a business's (1) assets and (2) liabilities.
On the asset side, insurance companies hold various items, such as :
The policyholder liabilities (reserves) of a short term insurer's balance sheet typically consists
of :
The liabilities can be shown as an aggregate amount for outstanding claims as well as an
aggregate amount for unexpired risks.
In addition to the above , some (re)insurers also hold reserves with respect to potential
catastrophes and so-called claims equalization reserves.
Outstanding Claims
Outstanding claims liabilities exist as a result of delays between the occurrence of the loss
event and the reporting of the event (reporting delays => IBNR reserves) as well as delays
between the reporting and settling of claims (settlement delays => outstanding case reserves).
Premature closing of claims result in re-opened claims, and this results in reserves for future
potential re-opened claims.
Reserves are typically larger for classes of insurance where delays between loss events and
settlement are the longest (eg. Product Liability).
Case reserves are only made for reported claims. They are not made for unreported claims.
Statistical methods are used to estimate the amount of 'incurred but not reported' (IBNR)
claims.
Claims reserves are only estimates. As such, care must be taken to allow for the assumptions
and uncertainty associated with the reserve estimates. Uncertainty is usually greater for
'longer tailed' classes of business (e.g. Product Liability).
Unexpired Risks
Unexpired risk reserve (URR) is a prospective assessment of the amount that needs to be set
aside in order to provide for claims and costs that will result out of unexpired future periods
of cover. This could be greater than the corresponding amount of premiums charged (UPR).
Unearned premium reserves (UPR) are premiums which have been set aside because the
corresponding period of insurance cover has not yet elapsed. E.g. Premiums received in 2007
in respect of insurance cover in 2008 will not add to the 'earned premium' of the insurer in
2007, but will be set aside in a reserve (UPR).
AURR is the amount by which the URR exceeds the UPR (if any). If AURR > 0, it suggests
that premium rates were originally set too low (at loss making levels).
Shareholder capital
Shareholder capital (aka free capital / free assets / solvency margin / shareholder funds /
capital used ) is the amount by which assets exceed policyholder liabilities.
The main influences on the investment strategy of a short term insurer are :
When calculating profit, one needs to use earned premium (as opposed to received), and
incurred losses (as opposed to paid).
Incurred losses equal paid losses plus the change in reserves (claims reserves at yearend less
claims reserves at the beginning of the year).
Underwriting profits equal earned premium less incurred claims less incurred costs.
Cash flow
Inflow :
premiums
investment income (dividends from shares / interest from bonds)
capital inflow (from shareholders)
reinsurance receipts (recoveries)
Outflow :
claims
costs
investment made in shares / bonds
distribution payments (dividends) to owners (shareholders) and creditors
(bondholders) of the insurer
tax to the government
reinsurance payments (premiums)
Reinsurance
Reinsurance protects insurers against claims and losses from events which could otherwise
threaten the continued existence of the insurance company.
Premium rating
Premiums are the amounts paid by policyholders to insurers for protection against
unintentional and accidental losses. The starting point with premium calculation is normally
the determination of expected claims outgo (aka the risk premium).
Experience rating is an approach adopted where the premium charges depends (at least in
part) on the policyholder's past claims experience. It can be applied retrospectively (where
premiums charged for past periods of cover are adjusted) or prospectively (where premiums
are determined for future periods of cover). Experience rating can be applied with reference
to either claims frequency or claims size.
The risk premium
The risk premium is the amount of premium needed to cover the expected claim amount of a
policy. It is defined as :
Risk premium = expected number of claims x expected claim amount per claim
For the purpose of analysis, data is typcally grouped into homogeneous groups.
Internal data is often more appropriate than external data, although knowledge about market
experience and competitors' premium rates is very important as well.
Proposed premium rates should allow for circumstances expected during the period of cover.
Abnormal data features, changes in cover provided, and trends in claims size as well as
claims frequency should be allowed for (adjustments made).
A so-called burning cost approach is often adopted whereby the actual cost of losses incurred
during a previous period is expressed as an annual rate per unit of insured value (exposure).
This is an example of an experience based approach to rating.
The office premium (also known as gross premium) is the theoretically correct premium that
insurance companies charge policyholders.
A theoretical office premium could take the risk premium as a starting point and adjust it to
include loadings for commission, office expenses, unanticipated losses, reinsurance cost. The
office premium should also allow for investment income earned from the investment of
premium income (discounting).
The basic office premium formula is given as :
where
• OP = Office Premium
• RP = Risk Premium
• FE = Fixed Expenses
• CF = Expected Claims Frequency
• CE = Expected Claims Expenses
• k = contingency factor for expenses arising from poor investment, over-
run expenses, etc
• d = contingency factor for claims variability
• c = commission as a percentage of Office Premium
• v = variable expenses as a percentage of Office Premium
• p = explicit profit criterion as a percentage of Office Premium
The basic office premium calculation formula is to demonstrate how premium formulas are
built up and is not only way that premium rating process is done. The formula may be more
complicated with additional items such as investment income, reinsurance, tax, etc. The level
of complexity depends on how much adjustment is made to the risk premium.
Reserving
Reserves are required to cover outstanding claims as well as unexpired risks.
Most statistical methods use a tabulation of claims payments by origin period (rows) and
development period (columns). Assumptions regarding the stability of the past claims
development pattern as well as whether or not the pattern will continue into the future are
made.
Statistical method can be applied to various aspects of the claims experience that are
sufficiently stable over time and measurable (e.g. claims count or claims size development).
In practise, statistical methods can be flawed by problems that can distort the results :
• Errors in the data
• Large claims
• Inflation
• Latent claims
• Catastrophes
• Changes in procedure (claims reporting, settlement)
• Changes in the mix of business written (e.g. liability vs material damage
cover)
• Insufficient or inadequate data
These problems do not, however, mean that statistical methods are useless. In practise,
adjustments are often made to compensate for such problems.
The Basic chain ladder method is based on the assumption that the proportion of claims from
a given origin period belonging to each development period remains constant.
The Basic chain ladder method implicitly assumes that past inflation will continue into the
future. The Inflation adjusted chain ladder method can be used to make explicit assumptions
about future inflation levels.
There are also variants of the chain ladder method that assume a stable average cost per
claim. These methods require development tables for claims count as well as tables for
average claims cost.
The Bornheutter Ferguson method uses an assumption regarding the claims development
pattern, as well as an assumption regarding the ultimate claims for each origin period. The
estimate of ultimate claims is typically made using a loss ratio assumption. For each origin
year : the loss ratio assumption is then divided into an historic and future component –
relative to the reserving date (using the assumptions regarding claims development pattern
stability).