The Journal of Insurance Institute of India

Premium Sufficiency

Ensuring Insurers Are Around When Claims Come:

Premium Sufficiency Way!
In the trinity of shareholder,
policyholder and regulator the latter
is always a willing referee ready to
blow the whistle at the appearance
of any early warning signal to the
detriment of the policyholder. The
freeing of pricing in the Indian general
insurance industry and the resultant
competitive forces unleashed is one
such situation.
There are several nuances
that require granular attention.
The situation could have varying
degrees of implications for insurers
and reinsurers; privately owned or
sovereign backed; short tail or long
tail classes. Likewise listing or delisting of insurers and undercurrents
such as, say, degrees of inflation could
all have their shades of consequences.
The focus of this essay on Premium
Deficiency Reserve is generic in light
of the ongoing deliberations. Needless
to mention that adequacy of pricing
and governance are too intertwined.

Need for Premium Deficiency

Reserve (PDR)

Praveen Gupta
Managing Director & CEO
Raheja QBE General Insurance Co. Ltd.
5th Floor, Windsor House, Kailina, CST Road,
Mumbai - 400098.
Praveen.Gupta@rahejaqbe.com
Sulochana Enjeti
Appointed Actuary
Raheja QBE General Insurance Co. Ltd.
5th Floor, Windsor House, Kailina, CST Road,
Mumbai - 400098.
Sulochana.Enjeti@rahejaqbe.com

PDR in General Insurance Business in

India has been a much debated topic in
the recent months. With the issuance of
new draft regulation on the same as part of
Solvency regulations by IRDAI, it appears
that the topic has been able to generate the
importance it always deserved.
Intuitively, as the name suggests, PDR is
the reserve required to recognise deficiency
in the charged premiums. This goes on
the premises that if the premiums charged
were not sufficient to meet the claim and
expenses on the expired book of business
then it is likely that the unexpired premiums

may also not be sufficient to meet the claim

costs and expenses in the remaining tenure.
Primary sources of premium deficiency
include:
1. Claims overrun actual claims
behaviour being worse than expected
2. One-off large / catastrophic claims
adversely affecting the loss and hence
the combined ratio on the expired book
3. Actual expenses being higher than
budgeted in pricing
4. Deliberately and consciously
undercharging premiums owing to
competitive pressures and other
business considerations
5. A combination of the above

APRIL - JUNE 2016

Premium Sufficiency
More than the source of PDR, the
important consideration is the raison
dtre for determining and setting aside
PDR. Why is PDR determined? What is
the purpose? Is it plainly to make the
insurer aware that the premium charged
till date was insufficient? Is it to ensure
the insurer is adequately funded to thwart
the possibility of insolvency with a
certain degree of confidence? Or does
it also underpin an active corrective
measure to ensure that the future block
of business is charged appropriate /
adequate premiums?
It is important to understand the
implications of these questions from
business and regulation perspective and
an introspection of these questions could
possibly address the questions above.

Premium Deficiency Reserves

PDR has been a cause of concern ever
since Indian General Insurance industry
was opened for free pricing in 2007,
also called de-tariffing. Though the
industry probably was not unaware of the
underlying PDR arising from premium
undercuts and other competitive pressures,
the implications on the financial statements
were not as pronounced owing to line of
business classification prevailing at that
point in time.
With recent developments, PDR is being
debated and discussed with greater
fervour understandably due to the more
significant financial repercussions. The
three chiefly debated questions are:
1. Why the transition to recognising PDR
at the product level?
2. Why the disallowance of setting off
premium surpluses in products with
deficits in others?
3. Why mandate PDR even in products
where business is obligated and prices
controlled by a common authority?

APRIL - JUNE 2016

The Journal of Insurance Institute of India

Reserves Offset Conservatism

Whilst product level PDR primarily
helps identify loss-making products,
it could also help understand benefits
of diversification derived, particularly
by multi-line insurers. This puts forth
the argument of a possible set-off in
the inter-product PDRs. Intuitively, a
catastrophic or large-scale adverse event
could be potentially disastrous for a
mono-line insurer as it is more subject
to concentrated exposures as compared
with a multi-line one which, debatably,
could be able to better control losses and
safeguard its financial health. Besides, if
the insurer was able to write business in
less correlated or uncorrelated lines, the
time to recovery from such a shock event
could also be faster. Arguably, therefore,
the risk profile of the two types of
insures is significantly different (solvency
position and free reserves are important
considerations as well). If set-offs are
not allowed effectively this means two
insurers having the same portfolio size
for a particular line of business with
similar claims and operating ratios would
be required to set aside the same PDR
even if one was a mono-line insurer and
the other a multiline one (with possible
surpluses in other lines).
This argument coupled with the trend in
global best practices increasingly moving
towards more detailed capital management
analyses taking into consideration
diversification and concentration effects
could have possibly put this outlook for
PDR in a quandary of sorts!
But this argument could be seen at best
as one-sided as this does not consider the
basic question whats at stake?. Rationally
speaking, the statement insufficient
premiums could lead to insolvency may
appear to be a no-brainer. But this is more
than just stating the obvious.

A.M. Best May 2010 annual report on

Company Impairments cites deficient
loss reserves/inadequate pricing followed
by rapid growth as the major causes of
financial impairments in the P/C industry
over the period 1969-2010. Though financial
impairment does not mean insolvency, it
is a reasonable indicator of the long term
financial health of the company [1].
Also, Study of Insurance Company
Insolvencies from 1969-1987 to Measure
the Effectiveness of Casualty Loss Reserve
Opinions, issued in 1990, cites principal
cause of insolvency was under-reserving.
Under-reserving was noted in 58% of the
insolvencies, as per this report [1].
One cannot miss the common underlying
theme of these findings and the key
take-away is the cause for prudence
and conservatism. The age old adage of
erring on the safer side should hold the
industry in good stead!

Premium Reset Corrective Steps:

PDR must be seen as not only a curative
but also a preventive i.e. an effective tool to
correct future premiums. If PDR is mandated
for existing business without the necessary
freedom / mandate to the insurer / price
controller to accordingly revise the premiums
of new business written, then the same could
have an avalanching effect on reserves. In
such circumstances, a product level PDR
becomes more result-oriented if coupled with
mandated premium revisions in that product
to negate the impact of future PDR. This
would ensure prudent evaluation of net worth
on one hand with an onus on the insurer/
price controller to correct the observed
mispricing on the other. Mere setting aside
of PDR without the insurer/price controller
obliged to correct its future premiums could
appear to be a lopsided approach of only
focusing on the existing illness without
encouraging future wellness.

The Journal of Insurance Institute of India

Premium Sufficiency

Other Practical Considerations

12. Taxation: Accounting best practice

for recognising PDR - as a P&L entry
(with a possible tax-shield?) or as a
direct Balance Sheet double - entry?
13. Nature of PDR Estimate: Fixed / point
estimate or a range estimate with a
given level of confidence.
14. The Carrot and the Stick: If
PDR could be seen as a tool to
disincentivize irrational and cut-throat
pricing, a measurable tool may also be
essential to incentivise insurers that
consistently adhere to a disciplined
and rational pricing approach despite
the market pressures.

If setting aside PDR is crucial, it is equally

imperative that PDR be determined on a
scientific and holistic basis and not simply
applying mathematical factors derived
from combined ratios. This calls for an
actuarial analysis and the prerequisite for
this is bringing about standardization and
consistency in the industry as regards
treatment of various factors that are expected
to have a direct bearing on the quantum and
accounting of PDR estimated, including:
1. Large Claims / Catastrophic Events:
This could have impacted the expired
book but how appropriate would it be
to assume the same would recur in
the unexpired book? These should be
excluded while assessing PDR?
2. Single Claims or Multiple Claims: In
case of benefit driven policies / policies
that terminate on the first valid claim,
PDR would not be applicable (viz.,
Personal Accident / Critical Illness) and
considered accordingly.
3. Uniform Versus Varying Earning
Patterns in Case of Multi-Year
Policies: These are instances where
risk is not uniformly spread across the
term of the policy (especially longer
term policies) whereas UPR is set
aside on 1/365th method. Since PDR
is a factor of UPR, the same could
get underestimated if the UPR is
underestimated in the first place.
4. PDR Based on Underwriting Year to
Consider Price Corrections: Having
the PDR analysed by an Underwriting
year block would help identify
premium, expense and claim trends
across various years.
5. One-Off Expense Overruns (Importantly
Capital Expenditure): Since PDR takes
into account incurred expense, capital
expenditure strain is more pronounced
on the business written in that year and

subsequent years till full amortization

whereas the realistic benefit could be
significantly longer term.
6. Instalment Premiums: These are the
in-force policies whereas instalment
premiums payable in the next financial
year may not appear in the UPR as on
the end of the current financial year.
7. Product Packaging Issues: A
packaged portfolio with multiple
products could have a profitable
experience yet give rise to PDR if split
into the product lines for reporting.
This ambiguity needs to be addressed.
8. Contract Duration: PDR implications are
more significant in case of longer term
policy contracts where premiums are
locked in for longer periods. However,
such contracts also benefit from
investment income over a longer term.
Should discounting be considered?
9. Reinsurance and Premiums Ceded:
PDR on a gross and net basis would
help the insurer identify whether a price
was low or the premiums ceded to
reinsurer were high (particularly excess
of loss reinsurance arrangements).
10. Strength of Claim Reserves: PDR
tends to have a negative bias against
insurers whose reserves are more
prudent. More conservative claim
reserves would mean a higher
loss ratio potentially indicating
a greater possibility of a PDR
arising. Conversely, insurers under
provisioning for claims may need to
set aside a lower PDR. This anomaly
needs to be addressed.
11. Controlled Price Regimes: There
needs to be a common understanding
on the need for determining PDR in
cases where prices are not determined
by the insurer, be it the burning cost
price floors or the Motor Third Party
Tariffed rates.

Conclusion: The recent regulations

on PDR are a welcome move. Having
a PDR at a product level is aligned
with practices in mature markets. US
GAAP and SAP also requires evaluating
PDR in homogeneous groups and also
explicitly disallows any offsets between
groups. It is, however, important to
bring about common understanding and
appreciation of the application aspects
and potential consequences across the
industry. Moreover, the sustained pricing
pressures necessitate vigilance.
Property and Casualty Insurance
Compensation Corporation (PCICC), Canada,
research demonstrates that inadequate
pricing is by far the most pervasive
insolvency risk factor. This finding highlights
the critical importance of the product pricing
decisions taken by the senior managements
of insurance companies. As the governance
of Indian insurance business comes under
increased scrutiny, the boards of insurers
will be under spotlight. If competitive forces
mean policyholder pays low price, the
shareholder must set aside segment-wise
cushion so as to ensure insurers are around
when claims come!

[1] Paper on Property Casualty Insurance Company Inolvencies September 2010 American Academy
of Actuaries P/C Financial Soundness / Risk Management Committee

APRIL - JUNE 2016