Risk Management in General Insurance

Business in India
T Joji Rao* and Krishan K Pandey**

Over the years, the general insurance companies have been undertaking extensive risk management
activities to safeguard 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 provide 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, have
dropped the rates even in hitherto non-profitable businesses. An efficient risk assessment and
management in general insurance industry is very important due to the entry of private players,
corresponding policy changes and the present-day fact of unprofitable books and erosion of capital
resulting from unmanageable claim ratios. The present study attempts to identify the various risk
management tools applied by the general insurance companies in India and performs a time series
analysis of the performance of general insurance business in India in the post-liberalization and post-
privatization era.

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 environment 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 its survival. The general
insurance companies due to their nature of business are at the receiving end both as 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.

* Head CCE-AU, University of Petroleum and Energy Studies, Dehradun 248007, India.
E-mail: jojirao2003@gmail.com
* * Assistant Dean Research and Associate Professor, University of Petroleum and Energy Studies, Dehradun
248007, India; and is the corresponding author. E-mail: kkpandey@ddn.upes.ac.in

©
62 2013 IUP. All Rights Reserved. The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013
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 and 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 reduce the ever-
increasing claim ratio.
Mendoza (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. He 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 and Mauch (2011) discuss 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. Kunreuther and Erwann
(2007) study the role of insurance sector in reducing the impacts of global warming and the
challenges that insurers and reinsurers face in dealing with the impact of climate change on
their risk management strategies. The study examines the issues of attribution and insurability
by focusing on natural disaster coverage. Phelan et al. (2011) analyze the adequacy of insurance
responses to climate risk and provide 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 suggests 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 is studied by Akter et al. (2009).
The study concludes 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. Mauelshagen (2011) discusses
the nature of adaptation and decision making in the insurance industry. He correlates the
historic evaluation with contemporary concerns about global warming and means of adapting
insurance to compensate for the associated losses. Erdlenbruch et al. (2009) analyze the
consequences for risk distribution of the French Flood Prevention Action Program in France.
The results of the survey show that the proposed policies may be financially unviable. Several

Risk Management in General Insurance Business in India 63

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) suggests that spatial pooling
may be an attractive option for micro-insurers, worthy of a detailed case-by-case analysis
when designing index-insurance schemes.
Further, Botzen et al. (2009) examine the role of insurances in reducing the uncertainty
associated with climate change losses for individuals. The estimation results suggest 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 (2011) discusses 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 the associated risks.
Another important study by DeMeo et al. (2007) talks 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 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 and Seki (2010) emphasize 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 towards 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 et al. (2009) discuss the
aspects of risk governance in the insurance industry to drive responsible technological
innovation. The researchers suggest 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) discuss 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 and Hoekstra (2006) state the reasons for market failure of global general
insurance sector as absence of reliable risk data, volatility in the event costs, high prices,
misperception of the true risk, expectation of government aid after disasters, and exclusion
from financial services. The study proposes that a public-private partnership may prove
instrumental in resolving these. Cottle (2007) proposes that despite a low intrinsic fire risk

64 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

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 in which the 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 discussion shows 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, 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 the
methodology and tools for their effective quantification, mitigation and management.

Objectives
1. To study the various risk management tools applied by the general insurance
companies in India;
2. To identify the factors affecting the investment volumes of general insurance
companies in India; and
3. To suggest a predictive model for investments.

Data and Methodology

The study performs a time series analysis of the performance of general insurance business in
India in the post-liberalization and post-privatization era for a period of eight years from
2000-01 to 2009-10. The data pertains to all public sector and private sector players in the
general insurance business dealing with the products in the category of fire, marine and
miscellaneous as stipulated by the IRDA.
Variables: Keeping in view the overall objectives of determining the different factors that
drive the general insurance investments in India and also the factors that govern the risk
management profile of the general insurance business, the variables that have been identified
and used in the study are: net claims, net premiums, commission, operating expenses, gross
underwriting profit or loss, net profit, current assets, current liability, net liquidity, net assets,
net liabilities, net solvency, and net investments.
Data is analyzed to empirically establish the nature and the degree of interrelationship
that exists among the different variables (namely, net investments, net premiums, net claims,
commission, operating expenses, underwriting profit, current assets, current liabilities and
net profit) that determine the performance of general insurance business in India. An
econometric analysis is also performed to identify the most influencing variables that
determine the performance of general insurance investments. The techniques that are used
for determining the association are correlation, factor analysis and regression analysis.

Risk Management in General Insurance Business in India 65

Risks in General Insurance Business
Players in the general insurance business are likely to be exposed to a variety of financial and
non-financial risks arising out of the nature of business and the socioeconomic environment
in which they operate.
Financial Risk: Insurance business basically being financial business in nature attracts
financial risks in the form of capital risk, asset/liability management risk, insurance risk, and
credit 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.
Non-Financial Risk: Non-financial risk management has assumed greater significance in
the recent years due to: (1) the growing volume of operational losses; (2) the industry’s
increasing reliance on sophisticated financial technology with the latter’s associated
probability of failure at times; (3) the ever increasing pace of changes in the deregulated
insurance regime; and (4) 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 that 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, operating risk may arise either from inadequate
Figure 1: Financial and Non-Financial Risks Affecting General Insurance
Business in India

Risk Factors

Financial Risk Non-Financial Risk

Capital Risk
• Capital Structure Risk
• Capital Adequacy Risk Enterprise Risk
• Reputation Risk
• Parent Risk
Asset/ Liability Management • Competitor Risk
Risk
• Exchange Rate Risk
• Interest Rate Risk
• Investment Risk
Operational Risk
Insurance Risk • Regulatory Risk
• Underwriting Risk • Business Continuity Risk
• Catastrophic Risk • IT Obsolescence Risk
• Reserve Risk • Process Risk
• Pricing Risk • Regulatory Compliance Risk
• Claims Management Risk • Outsourcing Risk

Credit Risk
• Reinsurance Risk
• Policyholders Risk
• Brokers Risk
• Claims Recovery Risk
• Other Debtors Risk

66 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

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. The different types of financial and non-
financial risks faced by the general insurance industry are presented in Figure 1.

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 assumes
‘risk-based capital management’ and ‘reserving’. The details of these risk management
techniques are given in Figure 2.

Figure 2: Risk Management Techniques

Risk Management Mechanism

Insured
Insurer

Risk-Based Capital Management

• Management’s Role
• Capital and Solvency Margins
Enterprise Risk Management • Risk-Based Capital
• Planning
• Risk Tracking and Reporting
Reserving
• Implementation
• Unearned Premium Reserves
• Tools
• Unexpired Risk Reserves
• Risk Management • Outstanding Claims Reserve
• Incurred but not Reported Reserves
• Catastrophe Reserves
• Claims Equalization Reserves

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, the insured need to
go for an effective risk management drive. The technique available to the insured for such
risk management is known as Enterprise Risk Management (ERM).

Enterprise Risk Management

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.

Risk Management in General Insurance Business in India 67

Scope of ERM
ERM 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:
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
ERM 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.
Operational Risk: Operations refer to all the day-to-day activities of a company. Operational
risk arises out of activities that may hinder or bring a company’s operations to a halt such as
natural disasters, labor 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.

Components of ERM Strategy

The components of ERM strategy include planning, risk tracking and reporting,
implementation, and the tools of ERM implementation.
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.
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. The 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.

68 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

 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.
Implementation: The insured takes into account the objectives, scope, organization and
tools of ERM to establish an ERM framework and its implementation. For an ERM strategy
to be successful, it is important to prioritize the objective according to the company’s needs.
Tools: Some of the specific tools that are important for implementing ERM are:
• 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.
• 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.
• 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.
Risk Management Process: Having defined 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. The logical sequence of such a risk management process,
depicted in Figure 3 is an attempt in this direction.
It clearly indicates that an effective risk management process from the insured’s point of
view should necessarily include risk identification, risk assessment, risk avoidance and
retention, risk improvement and mitigation using appropriate techniques, implementation
of the recommendations and periodic review of the risk management programs.
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 a part of risk management process.
Risk identification is important in managing the risk, which deals with source and problem
analysis as depicted in Figure 4. 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,

Risk Management in General Insurance Business in India 69

 Figure 3: Risk Management Process

Underwriting

Risk Avoidance Risk Assessment Risk Retention

Role of Loss
Risk Identification Risk Manager Investigation

Cause Analysis
Loss Prevention Risk Control
and Feedback
Techniques

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 the facility located in a low-lying area
might delay the project completion schedules; and 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:
1. 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 nondestructive 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.

70 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

 Figure 4: Risk Identification Chart

Risk Identification

Insured Companies’ Problem Analysis

Source Analysis Profile

Extent and Moral Factors Physical Factors

Regularity

Maintenance and Insured’s Risk Qualification

Safety Standards Attitude

2. 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.
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 process of risk
assessment is depicted in Figure 5.
The risk assessment process consists 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.
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

Risk Management in General Insurance Business in India 71

 Figure 5: Process of Risk Assessment

Risk Assessment

Extent of Physical Working Consequential

Damage Conditions Losses

Monitoring of Deviation Quantification Maximum Probable

from Normal Operations of Risk Interruption Time

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 made. 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 in this way. Other examples of risk transfer could be
subcontracting a hazardous operation outside the manufacturing facility.

72 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

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 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 whom 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. The process of risk reduction and control
is shown in Figure 6.

Figure 6: Process of Risk Reduction and Control

Risk Reduction and Control

Loss Prevention and Loss Loss

Avoidance Control Minimization

General Techniques and Causes of Loss

Work Procedures Analysis Structured Planning

Loss Prevention Policy Spare Capacity and

Measures Conditions Identifying Alternatives

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.
Periodic Review of the Risk Management Programs: Risk is a relative measure and from the
insurer’s perspective it is important to map the risk consequence with probability in a risk
coordinate system. Figure 7 highlights the risk coordinate system.
It is observed that taking into account 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.

Risk Management in General Insurance Business in India 73

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

Figure 7: Risk Coordinate System

High Consequences High Consequences

and and
Low Probability High Probability
Consequences

Low Consequences Low Consequences

and and
Low Probability High Probability

Probability

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 are the unearned premium
reserves, unexpired risk reserves, outstanding claim reserves, incurred but not reported
reserves, catastrophe reserves and claims equalization reserve.

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.

74 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

 In the context of risk-based capital management technique, the role of board of directors
and the management is worth mentioning.

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, the 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 auditor 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.

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 usually vary from that of another firm, the managerial
responsibilities in common should 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 the auditor regularly reviews the operation of the management
program; and

Risk Management in General Insurance Business in India 75

 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.

Capital and Solvency Margin

The capital for general insurance business does not mean legal capital alone, but also 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 as well as 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, known as the Required Solvency Margin (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 on the insurance segment of fire, marine and miscellaneous. This
formula is similar to the provisions applicable under the European Union Legislation during
the 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 the 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.

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 (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

76 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

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; there is 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 discourage conservative reserving among insurers.
It is worth mentioning 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 industry-wide
acceptability.

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 six categories, namely, Unearned Premium
Reserves (UPR), Unexpired Risk Reserve (URR), Outstanding Claims Reserve (OCR), Incurred
But Not Reported (IBNR) Reserves, catastrophe reserves, and claims equalization reserves.

Unearned Premium Reserves

UPR 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.

Unexpired Risk Reserve

URR is created by the insurer to manage the risk arising out of the non-receipt of future
premiums. It is estimated by multiplying with unearned premiums the ratio of the claims
incurred in the year to the premiums earned in the same year. The probability of collection of
premiums over the coming years may be impacted by inflation, experience of risk groups, and

Risk Management in General Insurance Business in India 77

the proportion of total premium in the earnings. Over and above, a prudent fluctuation
margin may be added to the above to minimize the impact of errors associated with the
estimation process.

Outstanding Claims Reserve

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 with respect to all outstanding claims on an accounting
date after taking into consideration the following:
• The certainty of the claim;
• The likely time needed to complete settlements;
• The rate of inflation on claims costs between the accounting date and the date of
settlement; and
• The judicial trends in claims settlements.

Incurred But Not Reported Reserves

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 reserve. 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.

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 the residual income of the
insurance company after taking into account the operating expenditure and provisions.
Catastrophe reserve in the long run equates the accumulated catastrophe loadings in
premiums without impacting the financial stability of the insurer.

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 analyze current

78 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

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.

Empirical Evidence of Impact of Investment

The study of risk factors, risk management process and mechanisms adopted by both insurer
and insured reinforces the belief that risk management is a dynamic function which needs a
flexible approach in line with the changing market, industry and regulatory environment.
The impact of external economic factors may lead to imbalance in performance of individual
companies in terms of premium, claims, operating expenses and profitability. This in turn
may have an impact on the risk management mechanism and tools adopted for mitigation
and management of the same. The study undertook an empirical analysis to identify the
relation between the variables of performance and investment.
A study of correlation over the segments and sectors is conducted to understand the
nature of relationship between investment and other variables, and the findings are as follows:
• Over the sectors, investment has a strong positive correlation with
– Operating expense
– Claims (Overall and Public Sector)
• Over the sectors, investment has a strong negative correlation with
– Underwriting profit
– Claims (Private Sector)
In the empirical study, investment is considered as the dependent variable and premium,
claim, commissions, operating expenses, underwriting profit, net profit, liquidity, and solvency
as the independent variables.
Factor analysis reveals that 92.16% of information has been used in this study. It is a fairly
good amount of data contribution to the present study as it involves estimation of investment
as well as finding relationship between investment and other macroeconomic variables through
regression analysis. Through factor analysis using principle component (varimax rotation)
method the variables, premium, claims, commissions, operating expenses, net profit, and
solvency are identified as important.
In order to analyze the extent to which the factors determine the performance of general
insurance business a multiple regression is fitted for the overall general insurance sector
dealing with the segments of fire, marine and miscellaneous. This is done to identify the
predictive value of the most significant variables as found through factor analysis in
determining the investment performance of the insurance business.
The regression equation with the corresponding estimated value of the variables
determining the investment performance of general insurance business as a whole is as follows:
Investment = – 1985 + 0.773 Claims + 0.016 Solvency

Risk Management in General Insurance Business in India 79

 Table 1: Regression Results (Overall)

Predictor Coef. SE Coef. t-Value p-Value VIF

Constant –1,985 1,071 –1.85 0.123
Claims 0.77334 0.07115 10.87 0 1.226
Solvency 0.0161 0.1917 0.08 0.936 1.226
S = 658.093; R = 96.7%; R (Adj.) = 95.4%; R (Pred) = 90.13%.
2 2 2

Analysis of Variance
Source df SS MS F-Value p-Value
Regression 2 63,132,228 31,566,114 72.89 0.000
Residual Error 5 2,165,435 433,087
Total 7 65,297,663
Source df Seq SS
Claims 1 63,129,174
Solvency 1 3,054
Durbin-Watson Statistic = 2.07415.

The regression output as shown in Table 1 depicts the predictive model. The model
explains that investments of the insurance company are impacted by claims made and solvency
maintained by the insurance company. The investments of any insurance company in India
may be forecasted by using the regression model suggested above. Further, the variance output
with a p-value of zero, endorses the model results to be significant. Also note that none of the
significant variables as identified by the factor analysis has been omitted in the regression
analysis. The predictive model has given the output only on the basis of two most significant
variables, namely claims and solvency.

Conclusion
Efficient risk assessment and management in general insurance industry is very important
due to entry of private players, corresponding policy changes and the present-day fact of
unprofitable books, and erosion of capital resulting from unmanageable claim ratios. The
present 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 complexities 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, while the non-financial risk includes enterprise risk and operational risk.
The risk management mechanism found prevalent in the general insurance industry for
the insured is 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. Further, regression analysis reveals

80 The IUP Journal of Financial Risk Management, Vol. X, No. 3, 2013

that claims and solvency play an important role in defining the volume of investments and the
corresponding risk mitigation strategy to be adopted by the insurance player. Hence, effective
management of claims may prove to be a panacea for the companies incurring huge underwriting
losses, thus ensuring an edge in the fiercely competitive deregulated environment. 

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