INTRODUCTION TO INSURANCE - SELF STUDY MODULE

CONTENTS

MODULE DESCRIPTIONNUMBER

1 INTRODUCTION TO SELF STUDY MODULE

2 CONCEPTS AND NATURE OF INSURANCE BUSINESS

3 OVERVIEW OF INSURANCE COMPANY OPERATIONS

4 CONCEPTS AND NATURE OF REINSURANCE BUSINESS

5 INTRODUCTION TO RESERVING

6 GLOSSARY OF INSURANCE TERMS

Introduction

1. INTRODUCTION TO SELF STUDY MODULE

The objectives of this self study module are to enable the reader to gain

(i) an understanding of the concepts and nature of insurance business

(ii) a basic understanding and overview of the insurance company operations and maintechnical difficulties likely to be encountered on insurance assignments.

(iii) an understanding of the concepts and nature of reinsurance business.

In view of the specialist content of this module, it is unlikely that a reader, with no previous experience ofinsurance, will be able to complete the module in less than 10 hours.

Readers should refer to the Glossary of insurance terms attached wherever new terminology isencountered.

This module deals with general insurance business only.

2. CONCEPTS AND NATURE OF INSURANCE BUSINESS

SELF STUDY MODULE

CONTENTS

2.1 WHAT IS INSURANCE ?

2.2 THE INSURANCE CONTRACT

2.3 PARTIES IN THE INSURANCE MARKET

12 - CONCEPTS AND NATURE OF INSURANCE BUSINESS

2.1. WHAT IS INSURANCE?

2.1.1 Insurance is a social device enabling a member of the public to reduce the risks to which he is exposedby spreading those risks over the insuring community. The insured will enter into a contract with aninsurer under which, in exchange for a premium payment, the insurer undertakes to reimburse theinsured for the financial loss arising as a result of certain specific perils during a stated period of time. The premiums paid by all the insureds contracting with a particular insurer build up into a fund which isavailable to meet claims made by individual insureds. If insurance is to be successful it is essential thatthe fund is adequate to meet claims arising. This presupposes that it is possible to quantify thelikelihood of claims materialising so that premiums can be charged at an appropriate rate. The insurerwill normally benefit from any surplus on the fund or be called upon to make good any deficit.

Risk

2.1.2 Some degree of risk attaches to almost every kind of activity in which one can engage. The followingtypes of reaction to risk can be identified:

(a) Ignore. One may be unaware of a particular risk and therefore take no action to avoid it.

(b) Assume. One may be aware of a risk but deliberately take no action because the consequencesare not serious or the probability of the risk crystallising is so remote.

(c) Avoid. Do not indulge in the activity giving rise to the risk.

(d) Prevent. Take part in the activity but exercise measures to prevent the risk from crystallising.

(e) Mitigate. Accept that the risk may crystallise but take steps to minimise the adverseconsequences.

(f) Transfer. Accept that the risk may crystallise but transfer the financial consequences toanother party.

2.1.3 Insurance is an example of transfer of risk, whereby the insured is able to substitute a known cost for aliability that may or may not crystallise to a greater or lesser extent. The insurer is then exposed to thispotential liability but he will have accepted a great many risks of a similar nature and the presuppositionwhich makes insurance possible is that not all these risks will give rise to a loss. The law of largenumbers applies. Thus although it is not possible to predict whether a particular car will be involved inan accident, it is possible to make a reasonable estimate as to what proportion of cars out of apopulation of, say, 100,000 will be involved in accidents in a period of twelve months. This proportionwill depend partly upon the competence of the drivers concerned and the areas in which they aredriving; hence one finds higher premium rates for young drivers, no claims bonuses and differentialrates according to postcode.

Premiums

22.1.4 From what has just been said, it will be appreciated that an insurer will attempt to fix a premium ratewhich is equitable in terms of the probability of a claim arising and the likely magnitude of such a claim. While it is obviously undesirable from the point of view of policyholders to be overcharged forpremiums, undercharging is equally undesirable, since the insurance fund must be solvent if the transferof risk is to succeed in its objective. In life assurance, the use of actuarial science enables premiums tobe determined on the basis of the mortality pattern of a large sample of the population; in generalinsurance rating techniques are less precise. While an insurer will have laid down tables of rates forstandard types of risk, in many cases it will be left to the underwriter (the officer or employee of aninsurer who has authority to accept risks on the insurer's behalf) to fix a premium rate on the basis of his"feel" for a particular type of business.

2.1.5 After the initial premium has been paid there may, during the term of the contact, be some amendment tothe insurance arranged (for example, if the policyholder changes his car). Where this is the case therewill be an endorsement to the policy to evidence the change in the contract, and the insured may becalled upon to pay an additional premium if the circumstances warrant it. In general there is no right to areturn premium unless the contract specifically provides it. There are types of insurance, such asemployers' liability business, where the final premium cannot be determined at the beginning of theperiod since it is based on the number of employees on the payroll during the policy year. In thesecircumstances a deposit premium will be paid on inception with a subsequent adjustment premium(additional or return) when the final amount is determined. If no return premium can arise, the originalpayment will be referred to as a minimum and deposit premium.

2.1.6 For most types of insurance, the insured will need to renew the cover when the period of the contractexpires. The renewal represents a separate contract, and the insurer is normally free to alter the terms(e.g. raising the premium) or refuse the risk altogether; the insured may also decide to seek anotherinsurer. A major exception arises with whole life or endowment life policies. Since the likelihood ofdeath increases with age, life cover effected for a period of twelve months would become increasinglyexpensive as the policyholder aged. For this reason, the majority of life business is written as acontinuing contract with a level premium; this results in the policyholder paying relatively more in theearly years than is necessary to cover the underlying death risk, but benefiting from relatively cheapcover in later years.

Claims

2.1.7 A claim can arise at any time during the period of an insurance contract. The fact that a claim payment(effectively the insurer's cost of sales) is made after the premium (i.e. the insurer's sale) is receivedrepresents an important distinction between insurers and trading or manufacturing companies, andgives rise to special problems of profit determination. Delays can also arise in notifying the insurer ofincidents giving rise to claims. Such incidents are known as "incurred but not reported" claims (IBNRs)up to the date of notification and "notified claims" thereafter. Although a policyholder will normallynotify a claim a soon as possible, certain types of claim may not become apparent for a number of years(e.g. latent diseases such as asbestosis or damage to a ship which can only be detected in dry dock).

2.1.8 An insurer will need to be satisfied that a claim is valid in the sense that an incident which is covered bythe contract has in fact occurred during the term of the contract and has caused the insured to sufferloss. There are two important principles involved:

(a) Indemnity. The purpose of a claim payment under an insurance contract is to restore theinsured to the financial position he occupied immediately before the event causing the lossoccurred. An insurance policy will state the sum insured, but this simply represents a maximumwhich will only be paid out in full in the event of the total loss of the property concerned. Forexample, if a ship is so badly damaged that the cost of restoring it would be disproportionate,

3the insurer may decide to treat it as a constructive total loss although in such cases the insurerwould assume the benefit of any proceeds arising from the salvage of the ship. There may becases where an insured has the option of claiming under an insurance policy or suing a thirdparty who was responsible for the loss. The insured could not do both since, contrary to theprinciple of indemnity, this would result in his being better off as a result of the loss. If theinsured chooses to claim under the policy, then his right to sue the second party is subrogatedto the insurer who may thus seek to reimburse himself for the cost of the claim.

(b) Proximate cause, which was defined in Pawsey v Scottish Union and National as follows:

"Proximate cause means the active efficient cause that sets in motion a train of events whichbrings about a result, without the intervention of any force started and working actively from anew and independent source".

When a person effects an insurance policy on his house what he is insuring is not the houseper se, but loss arising from damage to the house caused by one of a number of specifiedperils. An incident will only give rise to a claim payment is one of the specified perils is theproximate cause of the loss. The proximate cause of the loss will not always be clear - what, forexample, is the position if a fire weakens a wall but leaves it standing and it is subsequentlyblown down by a gale? This principle can be of considerable practical importance since manypolicies refer to excepted perils (e.g. explosions under a fire policy), and no claim is payable ifone of the excepted perils is the cause of the loss. An insurer will normally set up a file for eachnotified claim to house all relevant documentation and evidence progress in the negotiationand settlement of the claim. It is clearly vital to maintain proper control over outstanding claimsrecords; at the year end an estimate of the total cost of outstanding claims will have to bearrived at from the records and included in the accounts. The majority of claims will beadministered by an insurer in-house, although certain large or specialist claims may be dealtwith on behalf of the insurer by a loss adjuster (an independent and highly trained claimsexpert).

2.2. THE INSURANCE CONTRACT

2.2.1 Under general contract law there are seven essential features of a contract:

(a) offer and acceptance;

(b) intention to create legal relations;

(c) formalities;

(d) consideration;

(e) capacity of the parties;

(f) genuineness of consent; and

(g) legality and possibility.

These must all be present in a contract of insurance.

42.2.2 Offer and acceptance

Subject to any vitiating factor, a contract will come into being when an offer made by one party isunconditionally accepted by the other party. It is important to distinguish the contract of insurance (i.e.the agreement that the insurer will provide cover in exchange for a premium) from the policy which issimply a document providing evidence of the existence of the policy and its terms. The precise momentthat a contract comes into being can be of considerable importance in determining whether an insurer isliable on a risk. In most cases, the person seeking cover will make a request to the insurer to provideinsurance by completing a proposal form, and the insurer will consider whether or not to provideinsurance cover. The initial proposal may be construed as no more than an invitation to treat; the offerwill be made by the insurer when a premium rate is quoted and the prospective insured will accept orreject the quoted premium.

2.2.3 Intention to create legal relations

There is usually no doubt as to this matter in the context of an insurance contract.

2.2.4 Formalities

There are a number of different types of formality that may need to be observed in order to form a validcontract. Certain contracts are required to be made under seal, or made and evidenced in writing. Anyother contract may be made verbally and subsequently varied verbally (even if originally made inwriting). Contracts of marine insurance are required to be evidenced in writing and although there is nosimilar legal requirement for other classes of business, in practice all contracts of insurance areevidenced by a document known as the insurance policy setting out the terms of the contract. Aninsurer will have a number of standard terms that are incorporated into all policies; any individual policywill comprise these standard terms together with a schedule setting out such details as name ofpolicyholder, sum insured, etc. Pending issue of a formal policy, an insured may be issued with a "covernote"; this is particularly important for the purposes of the Road Traffic Acts since a motorist must beable to produce evidence of third party liability cover on his vehicle.

2.2.5 Consideration

Except in the case of a contract under seal it is necessary for each party to the contract to provide someconsideration (the law does not enquire into the adequacy of the consideration). The considerationprovided by the insured is the premium, while the consideration provided by the insurer is the promiseto pay a claim should the insured suffer a loss as a result of one of the perils insured against.

2.2.6 Capacity of the parties

In general contract law there are a number of circumstances where one of the parties is deemed to lackcontractual capacity (e.g. because he is a minor or was drunk or insane at the relevant time) and henceany contract made is void. In the case of insurance a further positive condition needs to be satisfied: aperson making an insurance contract is required to have an insurable interest in the subject matter of theinsurance.

Thus yacht owner A could insure his own yacht against loss or damage at sea, but not that of yachtowner B unless, for example, A had loaned B some money and had taken a fixed charge on B's yacht assecurity. Insurable interest is one of the main distinctions between insurance and gambling.

52.2.7 Genuineness of consent

There are a number of matters which can render a contract void or voidable including mistake,misrepresentation and duress or undue influence. A misrepresentation is a false statement of fact madeby one party to the contract to the other party as a result of which the other party is induced to enterinto a contract. The consequences of misrepresentation vary according to whether or not it wasfraudulent or negligent. Usually silence cannot amount to a misrepresentation; however, insurancerepresents an exception since the principle of utmost good faith (uberrima fides) applies to suchcontracts. As a result each party to the contract is under a positive duty to disclose clearly andaccurately to the other all material facts relating to the proposed insurance. The inclusion of acomprehensive list of questions on the proposal form which the prospective policyholder is called uponto complete does not absolve him from this duty; if he is aware of some fact, not covered by thequestions, which would affect the judgement of a prudent underwriter in accepting or rejecting thecontract or fixing the premium rate, he must disclose this. Failure to disclose would enable the insurer torepudiate the contract.

2.2.8 Legality and possibility

Certain contracts are illegal because they are expressly prohibited by statute or are regarded at commonlaw as being against public policy. For instance a policyholder cannot recover under a policy in respectof a loss caused by his own criminal act.

2.2.9 The insurance contract - an example

Baron Scarpia has effected a number of insurance policies with your client, the Atavanti InsuranceCompany, which have given rise to claims in recent months. On the basis of the following you arerequired to advise your client whether there are any grounds for resisting the claims:

(a) Policy. Term assurance on the life of Angelotti, a political prisoner held in custody by Scarpia.

Claim. One week into the policy term Angelotti escaped and committed suicide to avoidrecapture.

(b) Policy. Fire insurance on the Baron's private residence.

Claim. Fire damage to the basement arising from a brazier having been overturned whileScarpia was torturing suspects.

(c) Policy. General liability.

Claim. Spoletta, one of Scarpia's servants damaged a portrait by Cavaradossi in the course ofcarrying out his duties.

(d) Policy. Property damage.

Claim. The walls of the Baron's castle were damaged by stray bullets from a firing squad. There was a specific exclusion in the policy on this matter; however, 5 minutes before theincident the Baron's broker spoke to the underwriter and agreed to cancel the exclusion for anagreed additional premium. To date the policy endorsement has not been issued and theadditional premium has not been paid.

6(e) Policy. Whole life.

Claim. The Baron was assassinated by Tosca, an opera singer whom he was attempting toseduce, and his illegitimate son, named as the sole beneficiary in both the Baron's will and onthe policy, is making the claim.

A suggested solution is set out overleaf.

2.2.10 Suggested solution

(a) The policy is invalid because Scarpia does not have an insurable interest in Angelotti's life.

(b) The policy will be voidable at the insurer's option as Scarpia failed to disclose the fact that hisbasement was used as a torture chamber. This is a factor which would influence the likelihoodof fire and hence the premium rate to be charged.

(c) This appears to be a valid claim since Scarpia is legally responsible for the actions of hisemployees in the performance of their duties.

(d) Despite the absence of a formal endorsement, the amendment to the contract has been effectedand the claim is payable, although the insurer has a counter-claim for the unpaid additionalpremium.

(e) There is a death claim payable; however, as the contract was between Scarpia and Atavanti it isScarpia's executor who will have to claim and produce evidence of his death. The beneficiary is nota party to the contract and therefore has no right to claim against Atavanti directly.

2.3. PARTIES IN THE INSURANCE MARKET

2.3.1 The basic relationship

The simplest relationship that can exist is that illustrated in the diagram below:

INSURED INSURER

This arises where a prospective policyholder approaches an insurer directly and affects a contract ofinsurance.

2.3.2 The insured may be an individual, partnership or company. In the case of an insured carrying on abusiness, the insurance premium is a cost which provides benefits (in the sense of additional security)for a period normally of twelve months. If this period differs from the business's financial year it will be

7necessary to treat part of the premium as a prepayment at the year end. The auditor of a company needsto consider whether the insurance arrangements are adequate.

2.3.3 The insurer with whom the insured is in direct relationship will be either an insurance company or abranch or an agent of an insurance company. For very large risks more than one insurer may well beinvolved. An insurance company will itself be in the place of an insured when:

(a) it insures its own property with another insurer; or

(b) it reinsures risks it has accepted (explained in detail in a later module).

2.3.4 Intermediaries

The role of an intermediary is to bring the two parties of the contract of insurance together.

The relationship is as follows:

AGENT

INSURED

BROKER

INSURANCE COMPANY

Although the intermediaries are involved in the formation of the insurance contract they are not partiesto the contract as such. It is the insured and the insurer who acquire rights and duties as a result of thecontract and who are able to sue each other in the event of non-performance of the contract. Anintermediary can therefore drop out of the picture once the contract is in being, although as a matter ofconvenience payments of premium will commonly be channelled through a broker who will also often becalled upon to assist the insured in making a claim.

2.3.5 The term "agent" is a little confusing since any intermediary must be acting as an agent of one of theparties. The important distinction in the diagram is between agents who are simply representatives of

8an insurance company and whose function is to obtain as much business as possible for that company,and brokers who are full-time independent intermediaries who act as agents for potential insureds. Abroker will "shop around" insurers to obtain the most appropriate insurance protection for his clients.

2.3.6 Any intermediary is normally remunerated by means of a commission from the insurer. Where premiumsare paid via a broker the broker will generally deduct his commission from the premium passed on to theinsurer. Use of a broker is almost indispensable in the placement of the larger risks which need to bedivided between a number of insurers. For such a risk the broker will summarise the details onto adocument known as a slip and visit various insurers, commencing with one or more which arerecognised as specialists ("leading underwriters") for the type of risk in question. Each insurer willingto participate in a risk ("take a line") will place its stamp on the slip and indicate that proportion of therisk that it will accept. The broker will continue touring the market until the slip has been fullysubscribed.

3. OVERVIEW OF INSURANCE COMPANY OPERATIONS

SELF-STUDY MODULE

CONTENTS

3.1 WHAT IS AN INSURANCE COMPANY ?

3.2 ORGANISATION OF INSURANCE COMPANIES

3.3 REVENUE ACCOUNTING

13.1. WHAT IS AN INSURANCE COMPANY?

An insurance company is a body corporate which enters into contracts of insurance with personsseeking insurance cover.

23.2 ORGANISATION OF INSURANCE COMPANIES

3.2.1 Underwriting

The underwriter is the officer of an insurance company who makes the decision as to whether or not toaccept a risk and the premium rate applicable. In practice a company will have many underwriters anddeputy underwriters, each with their own field of specialisation and limits of authority. Underwritingfunctions may be concentrated at head office or decentralised around a branch network. Underwritingpowers may be delegated to an agent if, for example, a company desires to accept business in a foreigncountry but does not wish to establish its own branch there. Amendments to existing policies andrenewals of policies represent underwriting decisions similar in nature to the original acceptance of arisk.

33.2.2 Policy issue

For simple risks, the insurer will issue a standard policy with a schedule setting out the particular detailsof the risk. As the policy provides written evidence of the underlying contract of insurance it is clearlyimportant that the details in the schedule accord with the information on which the underwritingdecision was taken. On larger and more complex risks placed by a broker, the company may be only oneof a number of participating insurers and it is likely that the broker will prepare a single policy on behalfof the insurers concerned. In this case it is essential for the insurer to ensure that a closing advice hasbeen received from the broker in respect of each risk. This closing advice not only enables the insurerto confirm that the contract has been finalised on the basis stated on the broker's slip, but also indicatesthe proportion of the risk that the insurer is covering and hence the amount of premium receivable (sincethe lines that insurers have signed for may need to be scaled down in the event of a broker's slip beingover-subscribed).

3.2.3 Pricing a policy

Probability of Loss

Insurance is a risk transfer mechanism, whereby the individual or the business enterprise can shift someof the uncertainty of life on to the shoulders of others. In return for a known premium, usually a verysmall amount compared with the potential loss, the cost of that loss can be transferred to an insurer.

Each risk the insurer takes on has a chance of resulting in a loss. In order to calculate the premium hewishes to charge the insurer needs to know what the chance of loss is and the likely cost of that loss foreach risk he accepts. As the insurer accepts large numbers of similar risks he is able to use the law oflarge numbers, i.e. probability theory, in setting his premiums.

An insurer will have enormous amounts of data showing the past trends in terms of numbers and valueof claims. This data will be analysed and premiums will be set accordingly.

For example:

A company insures drivers living in London. Past experience shows that in any given year one in threedrivers will have an accident, the average cost of which is UD600. What premium should be charged tocover the cost of claims?

Answer:: 1/3 x UD600 = UD200

UD200 will reflect the pure risk premium. The insurer will need to add a margin to cover hisoverheads and profit although he may also take into account investment income he will earn on theUD200 before a claim is paid.

Of course future trends in claims cannot always be predicted by looking at past claims.

Another area where probability theory may not be a useful way of pricing policies is that of theextremely specialised insurer.

43.2.4 Premium collection

Credit control is essential in any commercial organisation but can assume particular importance for aninsurer who is mostly reliant on investment earnings to produce a satisfactory bottom line result. Anumber of different situations can arise, for example:

(a) For endowment and whole life policies there is a level premium payable over an extendedperiod and it would be normal for the policyholder to effect a direct debit or standing order infavour of the insurer.

(b) For some simple insurance contracts where there are clearly defined premium rates, a chequemay be enclosed with the completed proposal form.

(c) For most other contracts agreed directly between the policyholder and the insurer, a singlepremium will be payable at the start of the policy year.

(d) Some insurers offer an option to pay the premiums on certain types of annual contract bymonthly installments (normally at a higher rate).

(e) Credit terms may apply to business introduced by agents.

(f) An insurer will normally have a running account with each broker and agree periodicsettlements. It is notoriously difficult to reconcile an insurer's records with a broker's recordsin view of the timing differences and the complexity of the balances.

(g) Some contracts may be underwritten for a deposit premium adjustable at a later date. Receiptof the information to enable the adjustment premium to be calculated must be monitored.

Procedures will need to be sufficiently flexible to ensure that all these situations are properly handled.

3.2.5 Claims handling

As claim payments represent the major item of expenditure for an insurer it is obviously essential for theinsurer to establish the validity of a claim before agreeing to settle it. Procedures are relatively simple inthe case of a death claim on a life policy; provided that the premiums have been paid up, the amount ofthe claim can be determined easily from the terms of the policy and the death certificate and grant ofprobate would constitute sufficient evidence. Matters can be much more complex in general insurance,particularly where a liability claim is involved, and it may often be unclear whether a claim falls within thescope of a policy.

There are various circumstances that can give rise to a reduction in the amount of a claim payment orotherwise enable the insurer to reimburse himself in part or full:

(a) An excess clause (or deductible) may provide that the policyholder will bear the first part of aclaim.

(b) The principle of particular average can lead to a claim payment being reduced by the fraction -sum insured/full value of property - in the event of under-insurance.

(c) If a life company has made a loan on the security of a life policy, then the amount outstandingwill be deducted from any claim payment.

5(d) Salvage of the property on which a claim has been paid may be possible.

(e) Subrogation rights may enable the insurer to sue the party responsible for the accident.

(f) Other insurers may be called upon to make a contribution if a loss is covered by more than onepolicy.

(g) Reinsurance contracts may give rise to recoveries (see below).

3.2.6 Reinsurance

An insurance company can enter into reinsurance contracts either as cedant or as acceptor or as both. Facultative reinsurance accepted can be dealt with in much the same way as direct business, but specialtreatment is required for inward treaties. Once a treaty has been entered into, the reinsurer will receiveperiodic statements from the cedant dealing with both premiums and claims. There are time delaysinherent in any reinsurance accounting, but the receipt of treaty statements needs to be monitored toensure that there is a regular information flow.

The types of reinsurance protection available are outlined in the module concepts and nature ofReinsurance business module. An insurance company will normally have a comprehensiveprogramme, designed to suit its particular needs, which is likely to involve most, if not all, of thedifferent types of contract. Claims of varying types and sizes will have widely differing implications asto the reinsurance recoveries arising, and a company will need to establish procedures to ensure that allpotential recoveries are identified and the reinsurers advised without delay.

3.2.7 Investment

The investment function is no different in principle from that of a commercial concern. However, in viewof the time lag between the receipt of premiums and the payment of claims the quantity of fundsavailable for investment will be substantial.

3.3. REVENUE ACCOUNTING

3.3.1 An insurance company prepares annual accounts just as any other company will do. However, as wellas a balance sheet and profit and loss account an insurance company's accounts will generally include arevenue account which deals with the underwriting transactions for the year. In the case of aninsurance company writing general business of a short term nature (e.g. motor or property insurance)the revenue account will deal with premiums and claims arising on such policies during the accountingperiod thus giving rise to the underwriting profit or loss for the year.

3.3.2 Premiums

Having established that the revenue account deals with the premiums and claims figures for the year, weneed to consider how such premiums and claims figures are determined. If an insurance company had a31 December year end and issued a policy for a twelve-month period commencing 1 January then such apolicy would both incept and expire during the same accounting period. It would therefore be logical toreflect the full amount of the premium receivable in the revenue account for the year. However, if thepolicy commenced on 1 July and expired on 30 June, then on 31 December although the full amount ofthe premium might have been received only half the period of cover under the policy would haveelapsed. If the whole of the premium were brought into account at 31 December then there would be noincome carried forward to the next accounting period to match with any costs arising from a claim in thelatter six months of the policy. It is necessary therefore to adopt a method of time-apportionment of

6premiums by reference to the period of cover involved, e.g. a premium of UD120 for a policycommencing on 1 October 1998 would be dealt with in the year ended 31 December 1998 accounts asfollows:

3/12 x UD120 = UD30 earned in the year

9/12 x UD120 = UD90 treated as unearned at the year end and carried forward to be recognised as premium income in the 1994 accounts

Although the unearned premium element can be computed separately for each policy and indeed, withthe advent of computer processing, this approach is adopted by some companies, there are two lessprecise methods used for computing a provision for unearned premiums which are encountered inpractice.

3.3.3 The 24ths method is based on the assumption that, on average, policies incepting in a month run fromthe middle of that month. Thus premium income is analysed by month of inception and at 31 December23/24 of January premiums would be treated as earned and so on down to December where only 1/24 ofthe premiums would be treated as earned. It is usual to recognise the fact that certain costs are incurredin acquiring the insurance business in the first place of which the most obvious is commission paid tointermediaries introducing the business. For this reason only the premium net of such costs is time-apportioned; this is achieved by computing the provision on gross figures and then reducing it by apercentage in respect of commission - usually, but not necessarily, 20%.

3.3.4 An alternative method for computing unearned premiums is the 40% basis. Two assumptions underliethis method and the result attained will only be a crude approximation if the pattern of the company'sbusiness differs substantially from that postulated. Policies are assumed to incept evenly throughoutthe year so that an average policy commences on 1 July and would therefore be 50% unearned at theyear end. A 20% deduction for commission would reduce the 50% to 40% which gives this basis itsname. 40% is a generic term; 35%, 30% and various other percentages are sometimes encounteredwhere the policy acquisition costs are considered to be more than 20%.

3.3.5 EXAMPLE I - UNEARNED PREMIUMS

Godunov Insurance Co Ltd is a company that calculates its unearned premiums on the 24ths basis. Amonth of inception analysis has been prepared for gross premiums on motor business underwritten inthe calendar year 1993 as follows:

Month cover commences: UD000

December 1997 and earlier 75January 1998 888February 768March 864April 912May 936June 960July 984August 1,008September 1,032October 912November 936

7December 960______

Total gross premiums 11,235______

All these represent new business or renewals: there were no alternatives to existing cover during theyear.

(a) Calculate the provision for unearned premiums on the 24ths basis.

(b) Calculate the provision for unearned premiums on the 40% basis.

(c) It has subsequently been discovered that 2 cars had been omitted from the above:

(i) Mr Onegin insured his Lada for 12 months from April 1998 for a premium of UD20. Hechanged his car for a Mercedes in October and this car was substituted on the policythat month for an additional premium of UD60;

(ii) Mr Lensky is the nephew of the managing director. He insured his Rolls Royce for 12months from April 1998 for a premium of UD80. In October he was disqualified fromdriving. Being unwilling to let anybody else use his car he negotiated with thecompany who agreed to pay him a return premium of UD40 to cancel the cover.

Calculate the unearned premium to be carried forward on each of these cars.

EXAMPLE I - UNEARNED PREMIUMS

A suggested solution is set out overleaf.

EXAMPLE I - UNEARNED PREMIUMS

SUGGESTED SOLUTIONUD000

(a) 75 x 0 0888 x 1/24 37768 x 3/24 96864 x 5/24 180912 x 7/24 266936 x 9/24 351960 x 11/24 440984 x 13/24 5331,008 x 15/24 6301,032 x 17/24 731912 x 19/24 722936 x 21/24 819960 x 23/24 920

_____

5,725

8Less 20% 1,145_____

Provision for unearned premiums 4,580_____

(b) UD11,235,000 x 40% = UD4,494,000

UD

(c) (i) 12 month premium on Lada 12012 month additional premium on Mercedes 60 x 12/6 120

___

12 month premium on Mercedes 240___

As the cover commenced in April the unearned premium should be:

UD240 x 7/24 70Less 20% 14

___

UD56

(ii) NIL since the company is not at risk during 1994.

3.3.6 Audit considerations

a) It should be noted that the 24ths and 40% methods are merely convenient methods ofapproximating the amount which would arise if the unearned portions were calculatedseparately on each premium. We must therefore ensure that the method used by our clientsare reasonable. Thus, it would not be appropriate for a client who writes a very substantialamount of business in the last month of a financial year to use the 40% method since the resultwould not approximate to the right answer. However the 24ths method in suchcircumstances probably would still be reasonably accurate.

Except in cases of very unusual distributions or non-standard period policies (eg. Marine cargopolicies), the 24ths method usually provides a reasonably accurate estimate and we mighttherefore check the reasonableness of other methods by recalculating on the 24ths basis.

b) In the example above, a 20% deduction for policy acquisition costs was made. The reason formaking this deduction is to match expenses, incurred on or before issuing the policy, whichcan fairly be spread over the same period as the premium. Such expenses includeagents/brokers commissions, survey or medical fees, administration costs in issuing thepolicy etc. While it is possible to identify actual costs in some cases, insurance companiesnormally recover from a pool of costs on a percentage basis. This is done with varyingdegrees of accuracy and we must examine the resulting deferred costs for reasonableness. Inaddition, it would be unacceptable to defer such costs unless the costs can be offset againstfuture income - ie. The unearned premiums and future investment income are sufficient to

9absorb future claims and related expenses. This subject is discussed in further detail in 6.12below.

3.3.7 Claims

Accounting for premiums has been based on the concept of matching income with (potential) costs. Ina similar manner the accruals concept suggests that the full cost of claims incurred in an accountingperiod should be charged against the earned premium income of that period. Provision must thereforebe made to bring into account claims outstanding at the year end.

There are various stages through which a claim passes before it is finally agreed and settled by aninsurance company:

(a) the incident giving rise to the loss occurs;

(b) the claim is reported to the company;

(c) the claim is investigated and agreed; and

(d) the claim is settled.

Payment of claims

The situation with a direct insurer is straightforward with the insured sending claims details to theinsurer and the insurer taking one of three steps:

reject the claim

settle the claim

seek more information (this may include assessment by a loss adjuster)

There are two main considerations in the decision to settle a claim

1 Can the insured establish that he has suffered loss

The loss claimed must be verifiable. The insured cannot claim twice for the same loss under twodifferent policies. There may be terms which state that an insured must take steps to minimise the loss. Some policies give replacement cost cover, while others only cover the value of the items lost at thetime of the loss.

2 The loss must be an insured loss

The loss must fall under the terms and conditions of the policy. The loss must occur within the periodof cover specified by the policy.

Once the insurer has agreed the loss they will issue a cheque to the insured. Even where a broker hasbeen used to place the insurance the claims may be settled directly with the broker merely passinginformation between the insured and the insurer. Equally the broker may settle the claim once fundshave been collected from the insurers.

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3.3.8 Thus claims dealt with in a financial period may be at any of the following stages :-

a) claims paidb) claims agreed but not yet paidc) claims reported but not yet agreedd claims incurred but not yet reported ie. The event giving rise to the claim occurred but the

insurance company was not aware of that event. Such claims are referred to as IBNRs. Theneed to provide for such claims is not immediately obvious. Since premium income is earnedon a time basis over the life of the policy, the accruals concept requires that a claim beaccounted for at the point of time when it is incurred, ie at the date of accident.

a&b) Claims paid and claims agreed but not paid generally pose few accounting problems, however, points to watch are:-

i) Have the claims actually been agreed. Do payments represent payments on accountrather than settlements ?

ii) Have recoveries been correctly accounted for (salvage, reinsurance, excesscharges, recoveries from third parties) ?

iii) Have all adjustment expenses been accrued ?

c) Claims reported but not yet agreed are more difficult since they involve estimates. Matters to consider are :-

i) Is the estimating procedure adequate ?ii) Have recoveries been considered ?iii) Have the effects of inflation been considered ?iv) Have claims expenses been included ?v) Have all reported claims been recorded ?

The approach is governed to some extent by the class of business. In categories of business whereclaims are many but small. The company might apply an average settlement value to the number ofclaims unagreed. The average settlement value would probably be based on previous experience.

In cases like this, the points to watch are :-

i) have all reported claims been recorded ?ii) is the average used derived from a population which is representative of the

unagreed claims ?iii) is the period used to calculate the average reasonable ?

- If too long, average value of recent settlements may be increased.

- If too short, may not be representative.

In categories of business where the claims are few but large estimates are likely to have been made indetail individually.

d) The difficult area is IBNRs. Note that :

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i) some form of provision for IBNRs is almost always required, even in short-tailbusiness such as motor comprehensive.

ii) the impact of IBNRs is different in different classes of business -contrast to motorcomprehensive customers where the insured, because he is certain of recovering, willalmost always report promptly, are motor third party customers (and probably other third party type risks) where the insured stands to gain nothing by reporting theaccident.

iii) small and medium claims are likely to have a greater IBNR impact than large claimsa major disaster is news and also the insured is more likely to report the eventif there is a large sum of money involved.

iv) the source of business is also important. Consider the relative delays likely to occurif the business is direct, through agents/brokers or reinsurance business.

v) reinsurance and other recoveries must be taken into consideration since it is the netcost of claims incurred which requires provision.

The determination of IBNR provisions requires the use of statistics and subjective judgements. Thereare a large number of statistical methods in use and an E & Y book loss Reserving Property/CasualtyInsurance details the methods commonly encountered. The following points about these statisticalanalysis should be borne in mind :-

i) there is no correct method, all are estimates;

ii) all methods are dependent on the assumption that historical data can be used toproject future events and therefore usually require :

a) a relatively constant claims reporting pattern;b) a relatively constant level of settlements;c) relatively constant underwriting practices (ie. Claims are related to premiums in a

relatively constant manner taking a portfolio as a whole);d) a large population allowing the law of large numbers to apply;e) a number of years history to work with;f) maintenance of historical data in a usable form.

It is evident from the above that for smaller clients, statistical analysis can at best only providea very rough indication of the provision required.

The example which follows is intended to provide an illustration of the sort of analysis whichmight be used to project an IBNR provision. Note that while it is rather more simple than thesort of analysis performed by large, well organised insurance companies, the basic approachunderlies a number of more sophisticated analysis.

3.3.9 Example

Harpies Insurance have asked you to help determine the IBNR requirement in their motorportfolio. You have assembled the following information:

Third party TotalComprehensive only

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No of claims 7,920 1,340 9,260Average delay betweendate of accident anddate reported (in days) 7 141 26

Average gross value ofeach claim UD 72 UD 395 UD 119

Average recovery (allsources UD 38 UD 20 UD 35

Can you think of any way of using the above information to help ?

3.3.10 SUGGESTED SOLUTION

On average, all the claims notified for 7 days (comprehensive) and 141 days (TPL) will beIBNRs - ( think about it - on average claims reported today occurred 141 days ago (TPL), tomorrows - 140 days ago, etc).

Comprehensive TPL Total

Average number of claims 7,920 1,340 9,260per day 365 365 365

= 22 = 4 = 25

Projected number of claims 22 x 7 4 x 141 25 x 26not reported = 154 = 564 = 650

Projected cost of UD ( 72-38)x154 UD(395-20)x564 UD(119-35)x650

claims not reported = UD 5,236 = UD 211,500 = UD 54,600

If you performed the analysis on the basis of totals only, you might recommend UD 54,600; however ifyou treated the two classes of business separately you would probably recommend UD 216,736 ! .

The possible weak points in the above analysis are too numerous to note comprehensively but thedangers of not aggregating properly are evident.

3.3.11 Audit considerations

a) Our approach to auditing claims provisions must take into consideration the fact that no trulyaccurate estimate is possible. We therefore need to satisfy ourselves that claims provisionsare adequate and reasonable. The determination of what would constitute a material error interms of claims provisions (and therefore income/shareholders funds) requires carefulconsideration.

b) The determination of IBNRs and provisions for unagreed claims is an analytical process andout audit procedures will usually also be analytical in nature.

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3.3.12 Premium deficiencies.

In some circumstances, it is necessary to provide for claims which have not yet been incurred. If aportfolio is unprofitable, unearned premiums may be insufficient to absorb likely future costs, prudence would dictate that the expected losses be fully provided.

Where a premium deficiency exists, the first step would be to write off some or all of the deferredacquisition costs. It is apparent from 2.3.2 above that in some clients records, this would be effectedby grossing up the unearned premiums (40% would become 50%). If unearned premiums are stillinsufficient, the excess expected losses should also be provided.

In order to determine whether a premium deficiency exists, it is necessary to determine the profitabilityof each portfolio. We would need to take into consideration the following :

( i ) IBNRs

( ii ) the extent to which the current year claims expense and premium income includes adjustmentsto prior year estimates. Such adjustments should be excluded, in principle, from thecalculation of the profitability of the current year portfolio.

( iii ) investment income or, rather, notional investment income.

Provisions to cover future losses are sometimes accounted for separately but more often clients add theprovisions to unearned premiums, the resulting amount is often termed reserve for unexpired risk.

3.3.13 Other bases of accounting

The whole of this section has dealt with the annual basis of accounting. While most Middle Eastinsurers use this basis other bases do exist. The two which might be encountered are :-

a) Three year accounting

Under this method, the results are not determined or reported for three years. Thus 1998 accountsreport the underwriting results 1996, the balance arising for 1997 and 1998 eg. Premiums written, claimspaid etc. are carried forward as a fund in the balance sheet.

Points to note about this method are :

i) it is likely that all premiums will be earned and most losses reported by the end of the thirdyear, hence there is normally no need to compute unearned premiums or deferred acquisition costs. However, there is still likely to be an IBNR requirement.

ii) the auditor still needs to consider whether the fund in the balance sheet for the unclosed twoyears isadequate to cover additional claims; if it is not ie. The portfolio is loss-making, additionalprovision is necessary which should be charged to income for the year.

iii) this method is often used in marine or aviation business and excess of loss business where thedetermination of premiums is sometimes not effected until after the period of risk.

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b) The treaty year method - the results reported in the financial statements - the closed treaty yearrelate to the latest completed treaty year, ie. The treaty year and financial year are not coterminousand results are determined on the basis of treaty years. This method is similar to the three yearbasis but unearned premiums may need to be calculated. These are carried forward in the balancesheet as part of the fund which includes the premiums etc. for the open period. Mainly used inproportional reinsurance business.

4. CONCEPTS AND NATURE OF REINSURANCE BUSINESS

SELF STUDY MODULE

CONTENTS

4.1 INTRODUCTION

4.2. TYPES OF REINSURANCE

4.3 MISCELLANEOUS MATTERS

4.4 PROVISIONS COMMONLY ENCOUNTERED IN REINSURANCE TREATIES

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4 - CONCEPTS AND NATURE OF REINSURANCE BUSINESS

REINSURANCE

4.1 INTRODUCTION

4.1.1 Insurance provides financial compensation to the insured in the event of unexpected injury, loss ordamage. The insurer maybe regarded as the custodian of a central fund into which all those wishing toreceive insurance protection pay an assessed contribution (a premium ). Insurance is therefore a meansof spreading the financial losses of individual members over the insured community as a whole.

4.1.2 Reinsurance continues this principle of spreading financial losses. It is the term given to the insuranceeffected by an insurer in order to provide protection against the risk of claims arising on policiesunderwritten by that insurer. An insurer may enter into reinsurance arrangements for one or more of thefollowing reasons:

i) to increase the insurers capacity to accept more or larger risks; ii) to protect the insurer from the effects of catastrophies;

iii) to enable the insurer to retain only the part of a risk that he finds desirable (eg. A marine insurermay reinsure against the possibility of a total loss but remain at risk for partial losses);

iv) to provide overall protection for an underwriting account;

v) to close an underwriting account.

4.1.3 The reinsurance taken out by the insurer (cedant) is a completely separate contract from the originalcontract of insurance between the insured and the cedant. Thus the insured only has a claim on thecedant; if the cedant should fail the insured has no recourse to the reinsurer. Conversely should thereinsurer fail, the insured is not prejudiced and the full loss would then fall on the cedant.

4.1.4 It is important to stress the difference between reinsurance and co-insurance. Co-insurance is a form ofdirect insurance in which more than one insurer contracts with the insured to underwrite the risks.

4.1.5 For example, 5 insurers may each take 20% of a risk and the insured would have a separate contract witheach insurer (although these separate contracts may be evidenced by a single policy). Each of thoseinsurers would then be able to reinsure all or part of its proportion (i.e. 20%) of the risk undertaken.

Co-insurance

INSURED

20% 20% 20% 20% 20%

A B C D E

If A becomes insolvent, the insured can prove in the liquidation for As 20% share in the event of a claim. Thereis no obligation for B, C, D or E to contribute towards the portion of the risk covered by A.

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4.1.6 Reinsurance

INSURED

100%

A

B C D E20% 20% 20% 20%

If B becomes insolvent then, in the event of a claim, A can prove in the liquidation of B, but is obliged to makepayment in full to the insured. Conversely, if A becomes insolvent, the insured can prove in the liquidation ofA, but cannot look behind A to make direct claims on B, C, D, E.

4.2 TYPES OF REINSURANCE

4.2.1 There are various types of reinsurance contract - each designed to offer a different form of protectionto the insurer. The following outlines the main types of reinsurance likely to be encountered in theMiddle East.

4.2.2 Facultative

This is the specific reinsurance of an individual risk. An insurer may take out facultative reinsurance if the policy being written is too large an exposure in relation to the size of the other policies written by that insurer. This reinsurance tends to be used sparingly as it tends to be expensive ( insurers would not want to lay off part or all of a specific policy unless they thought it had a higher than average risk).

For Example

Joe is a motor car insurer. He insures 1,000 cars a year and rates his premium on the basis that one in three of these cars will crash and the average loss will be UD6,000. His premium rate per car is UD2,000.

Part of the business that Joe insures is the fleet of 100 company cars belonging to Nuts and BoltsLimited. Fred, the managing director of Nuts and Bolts Limited owns a McLaren F1 worth UD250,000. He asks Joe to insure the car as part of the company car package. Joe agrees to do this as he does notwant to risk losing the 100 company cars.

However Joe now has a problem. He has never insured a car of this type and sop does not know howlikely they are to crash and how expensive the average claim will be if they do crash. Also as the car isso different from the rest of his business the law of large numbers no longer applies and his profitabilityis purely dependent on whether or not this one car has a bad accident.

He therefore decides to reinsure this car with Derek who specialises in insuring McLarens, Ferraris andLamborhinis. To Derek, Freds car will just be one of 800 other similar risks and so probability can beapplied. Derek charges Joe a premium. The contract between Derek and Joe is completely separate andhas no effect on the contractual relationship between Joe and Fred.

Fred is happy as he only has to deal with Joe for all his motor insurance needs. Joe is happy because ifFred crashes his car he can reclaim any large loss from Derek. Derek is happy as his business hasgrown.

This type of reinsurance has the following drawbacks:

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a) the insurer has no guarantee that a suitable cover can be obtained at an acceptable rate;

b) since enquiries and discussions are necessary, facultative reinsurance is cumbersome and notsuitable for a portfolio of many but small policies.

As a result, facultative reinsurance is generally used on a one-off basis particularly where protectionis not available under the terms of the insurers treaties.

4.2.3 Treaty Reinsurance

Under treaty reinsurance, the reinsurers agree in advance to reinsure automatically providing the policyfalls within the terms and scope of the treaty. Reinsurance treaties are normally drawn up to cover aperiod of one or two years. The reinsurer is not normally aware of the individual risks reinsuredalthough most treaties allow the reinsurer to inspect the insurers bordereaux and policy documentation.

Most reinsurance treaties are obligatory in that the original insurer must cede and the reinsurer mustaccept all risks falling into the class(es) of business covered by the treaty (however seefacultative/obligatory treaty reinsurance below).

Although the terms of individual treaties vary, most treaties fall into one of the following categories

4.2.4 Quota Share or Fixed Share Treaty

The reinsurer agrees to accept a fixed percentage of all risks falling within the scope of the treaty. Thereinsurer receives that percentage of the premiums and pays the same proportion of the losses arisingfrom the business protected. Quota share treaties normally include a specified maximum risk which thereinsurers are prepared to accept so that the insurer may need to obtain additional protection where thesum assured exceeds the maximum specified in the treaty. For example, a treaty may cover risks up toUD 1 million and the insurers retention may be 15% :

Sum Insurers Reinsurers BalanceAssured Retention Share

i) UD 500,000 UD 75,000 UD 425,000 -ii) UD 1,500,000 UD 150,000 UD 850,000 UD 500,000

The balance in (ii) is outside the treaty limit and the insurer would need to obtain additionalreinsurance protection for that part of the policy.

Premiums and losses would be shared proportionately. If a loss of UD l million arose under policy (ii) above, it would be borne as follows (assuming the balance is reinsured facultatively):

Loss Insurers Treaty Reinsurers Facult. ReinsurersRetention Share Share

UD 1,000,000 UD 100,000 UD 566,667 UD 333,333

Although premiums are shared proportionately, the insurer usually receives a commission, oftenreferred to as an overrider, from the treaty reinsurers paid out of their share of the premiums.

4.2.5 Surplus Treaty

The insurer retains an amount specified in the treaty; the reinsurers accept upto a maximum based on amultiple of the retention. Treaties are normally arranged on the basis of so many lines. The followingexamples will illustrate.

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Example

i) The retention is UD 100,000 and the treaty has a first surplus of 10 lines and a second surplus of 10lines. The insurer issues a policy in which the sum assured is UD 1,500,000.

The risk would be spread as follows :-

UD 000

Insurers retention 100Reinsurers first surplus 1,000 ie 10 lines of UD 100,000Reinsurers second surplus 400 ie 4 lines of UD 100,000

1,500 lines of UD 100,000

ii) Same as i) except that the retention is UD 50,000

UD 000

Insurers retention 50Reinsurers first surplus 500 ie 10 lines of UD 100,000Reinsurers second surplus 500 ie 10 lines of UD 100,000Balance (see below) 450 lines of UD 100,000

1,500 lines of UD 100,000

The insurer has three options with respect to the balance :

i) he can retain the unaccomodated balance, since the treaty has been fully utilised;

ii) he can reinsure the balance facultatively;

iii) he can seek permission from the reinsurers to increase the size of the retention (and therefore thesize of the lines) or negotiate a third surplus.

In both examples above, the premium and any loss arising will be spread in proportion to the sumassured and, once again, the reinsurer is likely to pay the insurer a commission from the premiumsceded.

One more point about the above example is to note that the treaty specified a first surplus of 10 linesand a second surplus of 10 lines rather than a single surplus of 20 lines which would appear to come tothe same result. Treaties are often arranged with more than one surplus because the commissionpayable by the reinsurer is fixed at a different rate for each surplus. Thus, the commission might be 25%of premiums ceded for the first surplus and 20% for the second surplus.

Surplus treaties, in the Middle East often permit scaling-down. The insurer is allowed to scale-downthe size of the retention and therefore the size of the lines.

Example

Maximum retention is UD 100,000. Treaty has a first surplus of 10 lines and a second surplus of 10 lines. Insurer issues a policy in which the sum assured is UD 1,500,000.

i) Assuming the insurer wishes to retain the maximum

UD 000

Insurers retention 100Reinsurers first surplus 1,000 (10 lines)Reinsurers second surplus 400 ( 4 lines)

1,500

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ii) Assuming the insurer wishes to retain UD 20,000

UD 000

Insurers retention 20Reinsurers first surplus 200 (10 lines)Reinsurers second surplus 200 (10 lines)

420Balance (see below) 1,080

1,500

In this case the balance must be reinsured facultatively since the insurer has not used his maximumretention. If the reinsurer were to retain any part of the balance, the size of the lines and thus the size ofthe reinsurers shares would be affected.

Obviously, if the treaty permits scaling-down any number of possible distributions are possibledepending on the desired retention, whereas in the case of normal surplus treaties there is no choice.

Scaling-down is apparently uncommon in the developed insurance markets and the practice appearsto represent a concession to smaller, newer markets allowing the insurers a degree of flexibility while stillproviding substantial reinsurance cover.

4.2.6 Excess of Loss Treaty

Excess of loss reinsurance protects the insurer against very large individual losses. Unlike quota shareand surplus treaties the excess of loss reinsurance is not based on the sum assured but on individualclaims. Excess of loss treaties are arranged in such a way that the insurer absorbs all but exceptionallosses. For example, if the treaty fixes the insurers retention at UD 100,000, all losses below thisamount would be paid by the insurer. Only where a loss excess UD 100,000 would the excess (or mostof it) be recovered from the reinsurers.

Note that the term retention in this case refers to losses whereas under quota share or surplustreaties it refers to sums assured.

Excess of loss treaties are usually organised in layers. Thus, if the insurers retention is UD 100,000, the reinsurers might be liable under the first layer for any excess up to UD 2,000,000. For protectionagainst catastrophic losses, a second layer might be arranged and the consideration payable by theinsurer would differ for each layer. The layers need not be continuous - first layer could cover lossesup to UD 2,000,000 and a second layer losses between UD 5,000,000 and UD 10,000,000. Presumably inthis circumstance the insurer is fairly confident that losses will either be less than 2 million or more thanUD 5 million.

The consideration paid by the insurer for this protection is usually in the form of a small percentage ofthe insurers annual premium income from that class of business.

One other point to note about excess of loss treaties is that the insurer is normally required to meet partof the cost of the excess. For instance, in the example above the insurer might be liable for 5% of theexcess in addition to the retention of UD 100,000. The insurer retains a financial interest in large lossesand is therefore less likely to underwrite poor risks or relax claims settlement policies.

Excess of loss protection is commonly used in the Middle East for liability insurance - public liability, workmens compensation and product liability - where claims are usually comparatively small but canbe much larger if a major accident occurs.

4.2.7 Stop Loss

While excess of loss reinsurance protects the insurer against heavy individual losses, stop loss reinsurance affords protection against heavy accumulated losses in a particular portfolio.

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Example

Gross loss ratio retention is 75%. The reinsurers pay 90% of any excess. The results for the class ofbusiness protected were :-

UD 000

Premium income 10,000Losses 9,000

The gross loss ratio is 90% which is greater than 75% so a recovery is due. The amount recoverablewould be as follows :-

UD 000

Annual premium income 10,000

Imputed losses using gross loss ratio 7,500 ie 75% of premiumincome

EXCESS 1,500 (IE 9,000 - 7,500)Recoverable from reinsurers90% of excess 1,350

Stoploss protects the insurer from heavy losses in a particular portfolio. For this protection, apercentage of the insurers annual premium income from that class of business is paid to the reinsurer. Stoploss treaties usually incorporate a maximum loss ratio (often 120%) to safeguard the reinsurersagainst poor underwriting policies or a relaxation in claims settlement policies. In addition a monetarymaximum is usually specified to safeguard against any unusual growth in the portfolio as a whole.

4.2.8 Facultative/Obligatory Treaty

Fac/oblig treaties allow the ceding company to choose which risks to cede but are binding on thereinsurer who must accept all risks ceded. This type of treaty would probably only be agreed where thereinsurer either has a great deal of faith in the insurers judgement and/or where the reinsurer is verykeen to obtain the business.

The reinsurer receives that proportion of the premiums which relates to the share of the riskunderwritten and pays the same proportion of claims. The reinsurer usually pays the insurer acommission based on a percentage of premiums ceded. Fac/oblig treaties are probably fairly common inthe Middle East due to the close ties that exist between many insurance companies.

4.2.9 Reinsurance Pools

Reinsurance pools are not common in the Middle East. They are used where the risks are exceptionallyheavy. Often the whole premium is ceded to the pool by those insurers who are members of the pool; profits and losses being shared in agreed proportions.

4.3 MISCELLANEOUS MATTERS

4.3.1 Generally in treaty reinsurance, a number of reinsurers are parties to the agreement each sharingproportionately in the premiums and losses arising under the agreement. There might be 10 reinsurerseach with a 10% interest in a treaty. One of the reinsurers might be responsible for negotiations andcorrespondence with the insurer and is often termed the leading reinsurer.

4.3.2 Quota share and surplus reinsurance are often termed proportional since the insurer and reinsurersshare losses in the same proportion as they share premiums. Excess of loss and stop loss treaties areoften termed non-proportional since the sharing of losses bears no relation to proportions of premiumsoriginally received.

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4.3.3 Co-insurance is sometimes encountered. This differs from reinsurance in that each of the co-insurershas a contractual relationship with the insured in law, although in practice one insurer, the leadinginsurer, might conduct all correspondence with the insured and issue the policy. In co-insurance ifone of the co-insurers fails, the insured would be directly prejudiced. Co-insurance is fairly common inthe Middle East especially where governments are the insured parties.

4.3.4 The term retrocession is sometimes encountered in the context of reinsurance matters. A retrocession isa transaction where the risk reinsured is itself a contract of reinsurance.

4.3.5 A reinsurance policy may allow for the payment of a reinstatement premium after a claim has occurredto continue the cover provided by the policy. Thus if the sum assured is UD 20 million and a loss of UD 12 million arises, the reinsurers liability under the policy may fall to UD 8 million ie. The differencebetween the sum assured and the claim. In order to reinstate reinsurance cover at UD 20 million anadditional premium may be payable to the reinsurers. The basis for calculating reinstatement premiumswill be specified in the policy. Reinstatement premiums are common in excess of loss treaties.

4.3.6 Reinsurance premiums are sometimes calculated on a burning cost basis. Where the premiumpayable to the reinsurer is a variable percentage of the insurers premium income (excess of loss andstop loss reinsurance) the actual amount payable may be calculated according to a formula specified inthe policy.

For example, under an excess of loss contract for motor claims greater than UD 10,000, the premiumpayable to the reinsurer may be a minimum of 8% (see 3.4.6 below) and a maximum of 15% of theinsurers premium income. In order to establish what percentage is applicable, the cumulative total ofclaims recoverable from the reinsurers is grossed up by a factor of, say, 100/70 ths (this is, in fact awidely used factor), the resulting amount is expressed as a percentage of premium income. If thispercentage is less than 8%, 8% (the minimum) is payable, while if it exceeds 15%, 15% (the maximum) is payable; however, where the percentage falls between 8% and 15%, the calculated amount ispayable.

Illustration UD

Premium income (PI) 5,000Claims recoverable under X/L treaty 350Claims gross up by 100/70 500

Since 500 is 10% of premium income (ie. Falls between 8% and 15%), 500 is the premium payable.

The reinsurers will make a 30% margin while the contract is burning (ie. The grossed-up claims fallbetween 8% and 15% of PI), thereafter their margin falls and once claims exceed 15% of PI, theiroutgoings exceed incomings.

4.3.7 Noted that the reinsurance protection of individual policies may be provided by a number of differentreinsurance contracts.

For example :

Sum assured UD 150 million

Insurers Reinsurersretention shares

Quota share treaty 5 15 retention 25%, treaty maximumUD 20 million

Surplus - 1st 50 10 lines, retentionUD 5 million

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Surplus - 2nd 50 10 lines retentionUD 5 million

Facultative (or _______ 30 fac/oblig) 5 145

In addition, the retention may be protected by excess of loss and ultimately stop-loss reinsurance.

Note that in the above example, the quota share treaty is used first then the surplus treat. It should bepointed out that the structure of the reinsurance protection can be set up in a number of ways - thesurplus treaty can be within the quota share treaty.

Eg Sum assured - 150 millionQuota share - retention 25% maximum UD 200 millionSurplus - first surplus - 10 lines, retention UD 2 million

second - 10 lines, retention UD 2 million

UD million

Retention 21st surplus - 10 lines 202nd surplus - 7.75 lines 15.5

37.5 25%Quota share reinsurers 112.5 75%

150

4.4 PROVISIONS COMMONLY ENCOUNTERED IN REINSURANCE TREATIES

4.4.1 Accounts

The insurer is normally required to account to the reinsurers periodically ( half yearly underproportional treaties and yearly under non-proportional treaties are common). The account showspremiums ceded, losses paid which are recoverable from the reinsurers, commission due from thereinsurers, premium reserve adjustments (see below) etc. A net balance due to or from the reinsurersis arrived at. Note that the statement of account may be the only information received by thereinsurers. Information relating to individual policies or claims will not normally be passed on.

4.4.2 Cash loss limit

Generally, the insurer pays losses in the first instance and recovers the reinsurers share on preparing accounts. However, if a heavy loss is incurred above the cash loss limit specified in the treaty theinsurer can apply to the reinsurers for immediate payment of their shares of the loss.

4.4.3 Loss advice limit

The insurer does not advise the reinsurers of individual losses included in their account. Howeverwhere an exceptionally large claim arises, treaties normally require that the insurer informs the reinsurersbefore settlement. The reinsurers may want to review the claim documentation and assist in settlementalthough they have no direct access to the insured. Reinsurance treaties usually set a maximum losswhich the insurer can settle without reference to the reinsurers, this the loss advice limit. The lossadvice limit is often but not necessarily the same amount as the cash loss limit.

4.4.4 Premium reserve (Premiums withheld from reinsurers)

Proportional reinsurance treaties usually include provision whereby the insurer retains some portion ofthe premiums payable to the reinsurers as shown in the account. When the next account is drawnup the reserve is adjusted so that the balance retained is based on that portion of the premiums payablein the new account. Interest is usually payable to the reinsurers on the balance retained.

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4.4.5 Profit commission

There is often a provision in reinsurance treaties whereby the insurer is entitled to an additionalcommission if the portfolio is exceptionally profitable to the reinsurers. The calculations are sometimesquite complex and may not be based on profit in the accounting sense.

4.4.6 Minimum or deposit premium

Non-proportional treaties often include a minimum premium which may be payable in advance and istherefore often termed a deposit premium.

The above terms are intended to be a guide to the provisions most commonly encountered inreinsurance treaties which are important as far as accounting is concerned. Other important clauses mayexist and it is vital that the auditor thoroughly understands the clients treaties not only so that he canverify account balances but also so that transactions can be tested for compliance with the treatiessince the clients exposure to loss could be considerably increased if a treaty had been breached.

5. INTRODUCTION TO RESERVING

SELF STUDY MODULE

CONTENTS

5.1 ELEMENTS OF THE CLAIMS PROVISIONS

5.2 TYPES OF RESERVING METHODS.(PRACTICAL EXAMPLES, TRIANGULATIONS, ULR)

5.3 USE OF E & Y ACTUARIAL

5.4 THE AUDIT OF CLAIMS PROVISIONS

15.1 - ELEMENTS OF THE TECHNICAL PROVISION

The basic accounting concept of matching means that for each sale accounted for we should also accountfor the cost of that sale to determine the true gross margin.

Similarly for an insurer for each premium written in the year the insurer should make allowance for thepotential claims cost that would attach to those premiums. The claims cost will be made up of claimsactually settled and claims that the insurer expects to settle in the future. This liability for future claims onpolicies that have been written is referred to as a claims provision or reserve.

The claims provisions for an insurer will be made up of the following:

(1) Case estimates on claims (often referred to as outstanding claims) that have been reported to theinsurer but not settled, these are usually referred to as case estimates as they are calculated on acase by case basis. The case estimate will include the direct costs of settlement such as assessorfees.

(2) Claims estimates for claims that have been incurred but have not been reported to the insurer -referred to as the IBNR, these will generally be calculated statistically using actuarial techniques.

(3) An estimate of the indirect costs, such as claims department overheads, that will be incurred insettling outstanding claims. These are referred to as the provision for claims handling expenses.

Reinsurance recoveries

We have been concentrating on the calculation of the gross technical provisions. The reinsuranceprogramme needs to be applied against the gross claims to determine if any reinsurance recoveries can bemade. Reinsurance is covered in more detail in a separate section.

5.2 TYPES OF RESERVING METHODS

5.2.1 Case Estimates

With this method an estimate of the likely ultimate settlement cost is made in respect of each notified claimon a case by case basis. Such estimates are regularly updated to reflect the latest available information. The outstanding claims reserve at an accounting date therefore consists of the sum of the estimates for allnotified outstandings.

Case estimates can be made either internally or externally, i.e. by the companys claims staff or by thirdparties such as loss adjusters. Loss adjusters are independent professionals who act as consultants toinsurance companies in assessing the true extent and value of any loss resulting in a claim against them. Making claims estimates involves a combination of technical knowledge, experience and subjectivejudgement.

There are two major problems with this method of reserving for outstanding claims.

1. Because of the inherent uncertainties, individual case estimates can be difficult to calculate. Theseriousness of claims, especially in liability insurance, may not emerge for several years.

2. In some classes of business, where there are a large number of claims, or where the time lag tosettlement is significant causing the accumulation of large numbers of outstanding claims, themethod may be impractical because of the sheer volume of claims to be estimated.

Thus other methods with a statistical base have been developed.

25.2.2 Statistical Methods

Statistical methods are used to project future claim settlement experience based on past settlementpatterns. Two basic methods can be identified.

1. Based on claims paid to date

At any accounting date, the development of cumulative paid claims over a number of years is used toproject the ultimate total liability. This method is based on the development pattern of claims.

2. Based on average cost per notified claim

Where the average cost per notified claim (adjusted for inflation) is applied to the number of claimsoutstanding.

Any statistical method will be affected by changes in the underlying claims. Thus changing conditionsthat are likely to cause future experience to differ from that of the past must be identified and their effecton settlement patterns examined.

It is normal practice to arrive at the IBNR provision by means of statistical techniques based on previousexperience. This is because it is normally impracticable to evaluate these provisions by waiting asufficiently long time for the claims to be reported and reserving on a case by case basis.

Any statistical method must be applied separately to homogenous divisions of business written (e.g. class of business, currency).

You will readily appreciate from the nature of reserving described above that there is a significant degreeof judgement used in estimating ultimate reserves. Although the base data to assist with this process islargely derived form routine data processes the ultimate reserve is derived from an accounting estimation, with all the susceptibility that this entails.

Most clients will use some form of triangulation technique in calculating future liabilities.

We shall now look at some practical examples of the reserving methodologies used by general insurancecompanies.

A TRIANGULATIONS

Triangulations are used to project future claims settlement loses based upon historical data.

The basic assumption used when projecting reserves is that history repeats itself.

The assumptions that follow from this are broadly as follows:

Business written in different underwriting years is similar; and

Claims settlement will therefore be similar.

For example, if traditionally an insurer finds that its motor account is settle after three years that that 20%of claims are settled in the first year, 70% are settled in the second year and 10% in the third year then itwill assume that the same pattern can be applied to the current year.

If, therefore, in 1997 it receives UD2,000,000 of premiums and pays UD120,000 worth of claims on thesepolicies it will expect.

3(i) in 1998 claims of UD420,000(UD120,000 x 70 %) 20 %

(ii) in 1999 claims of UD60,000

(UD120,000 x 10 %) 20 %

Total claims expected are therefore UD600,000. As UD120,000 of claims have already been settled theoutstanding claim is UD480,000.

Triangulations are simply a pictorial representation of that process.

A typical triangulation will look like this:

Development years (cumulativeclaims paid UD000s)

Underwriting Year Year 1 Year 2 Year 3 Year 4 Year 5

1992 100 254 303 310 3101993 105 240 310 311 3121994 98 253 315 3201995 110 260 3071996 105 256

The triangulation can be read as follows:

(i) For premiums written in 1992 UD100,000 claims were paid by the end of the first year.

(ii) In the second year of development a further UD254,000.

The triangulation demonstrates a pattern of settlement with the bulk of claims settling in the first two yearsand negligible movement after three years.

Development factors can be calculated which can then be used to predict the development of the morerecent years.

For example, if we look at the development from year 1 to year 2 we can see a pattern arise:

Underwriting year Year 1 Year 2 Development factor

1990 100 254 254 100 = 2.541991 105 240 240 105 = 2.291992 98 253 253 98 = 2.581993 110 260 260 110 = 2.36

The average development factor from year 1 to year 2 is 2.44.

Therefore for the 1994 year we would expect in 1995, year 2, to have paid cumulatively 105 x 2.44 = UD256,000 of claims i.e. to pay an additional UD151,000.

As the triangulation shows the total cost is normally only settled after 3 years therefore we would alsoneed to calculate the development factor from year 2 to 3 to determine the final cost.

4There are however several limitations with triangulations which need to be understood:

History does not always repeat itself;

Business written in different years may not be comparable;

Impact of changes in premium rates (e.g. if rates have fallen 50%, claims might be 50% higher as apercentage of premiums);

When does the business tail-off? (Data may be too immature for accurate projection);

Impact of changes in the reinsurance programme;

Some types of business cannot be projected using triangulation techniques (e.g. asbestos/pollutionclaims);

Data limitations (data may be inaccurate); and

Catastrophe losses may distort the data.

B PROJECTED LOSS RATIOS

The triangulations we have looked at so far have been based on analysis of paid or incurred claimsdevelopment factors.

Another common method is the use of projected loss ratios.

This method allows changes in the level of or rate of premiums to be taken account of rather than lookingat claims in isolation.

Loss ratios are based on paid claims data or incurred claims data (i.e. paid claims plus outstanding claims)

Loss ratio - Claims Premiums

A loss ratio of more than 100% is not good as claims paid out are more than the premium income received.

A simple example will illustrate how loss ratios work:

Underwriting Development Year Year 1 2 3

1994 Premiums written 100 150 160Claims incurred 30 70 112

1995 Premiums written 120 180Claims incurred 30 70

1996 Premiums written 125Claims incurred 40

Underwriting Development Year year 1 2 3

1994 Projected loss ratio 30 47 70 1995 Projected loss ratio 25 39 1996 Projected loss ratio 32

5Development factors are then calculated in the same manner as previously explained.

C CATASTROPHE LOSSES

A number of syndicates and companies specialise in catastrophe reinsurance. This is a method wherebyinsurers reinsured each other to such an extent that the same losses go back and forth between theseentities until one (or more) of them runs out of reinsurance cover.

Provisions for losses arising form natural catastrophes can not be calculated by the use of triangulations. This is because the size of the loss to the insurer is determined by his aggregate exposure to claims arisingfrom a single event together with the level of his own reinsurance protection available.

Where insurers are exposed to Catastrophe claims, the key issues are to assess the potential maximumexposure to these events from the aggregation of claims and then calculate a probable maximum loss (PML). The available reinsurance programme can then be applied to this loss.

Important issues to consider are:

Adequacy of systems to calculate a PML;

Availability of reinsurance;

Security of reinsurance (any allowance for bad debts);

Patterns of development of previous catastrophes;

Margin of error allowed with client assumptions; and

Materiality.

5.3 USE OF E & Y ACTUARIAL

E & Y actuarial department must be involved in all general insurance audits, although the level ofinvolvement can vary from very little to extensive, depending on the circumstances.

A profile document for each audit client has been developed and is completed as part of the planningprocess.

This gives an overview of the client to be used as a base for deciding the level of actuarial involvement.

e.g.

(i) Agreed limited involvement (e.g. provision of benchmarks).

(ii) Involvement limited to provision of benchmarks, high level review of approach to reserving and adhoc support.

(iii) Review of client actuarial reports

terms of engagement

methodologies employed

key assumptions

reperformance of methods on the largest classes

(iv) Stand-alone Ernst & Young actuarial review of the provisions.

6The use of E & Y actuarial for (iii) and (iv) is becoming increasingly important as our clients use theirown in house or external actuaries to project reserves.

5.4 THE AUDIT OF TECHNICAL PROVISIONS

Introduction

In order to audit technical provisions in an efficient and effective manner we need to gain a soundunderstanding of the clients business, evaluate the systems of control, and assess the clients reservingprocess.A sound understand of the business is necessary if we are to identify the areas of audit significance andtherefore the areas in which our audit procedures should be concentrated.

An accurate evaluation of the systems of control will enable us to plan the appropriate audit proceduresand extent of testing.

An assessment of the clients reserving process will determine the extent of audit work to be performed.

5.4.1 Understanding the Business

An understanding of the nature of the business is perhaps more critical to the audit of technicalprovisions than to any other area of the audit. The reserves are extremely subjective, based on a largenumber of assumptions. Any background i