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 . All Rights Reserved. 62 2013 IUP 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 muchneeded support to further increase the general insurance penetration and reduce the everincreasing 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 regions 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 riskfor 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
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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
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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.
Non-Financial Risk
Operational Risk Regulatory Risk Business Continuity Risk IT Obsolescence Risk Process Risk Regulatory Compliance Risk Outsourcing Risk
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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 nonfinancial risks faced by the general insurance industry are presented in Figure 1.
Insured
Insurer Risk-Based Capital Management Managements Role Capital and Solvency Margins Risk-Based Capital Reserving Unearned Premium Reserves Unexpired Risk Reserves Outstanding Claims Reserve Incurred but not Reported Reserves Catastrophe Reserves Claims Equalization Reserves
Enterprise Risk Management Planning Risk Tracking and Reporting Implementation Tools Risk Management
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 riskadjusted 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 companys 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.
While ERM might increase a companys 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 companys 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 insureds 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 companys 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,
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Underwriting
Risk Avoidance
Risk Assessment
Risk Retention
Risk Identification
Loss Investigation
Risk Control
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.
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Source Analysis
Problem Analysis
Moral Factors
Physical Factors
Insureds Attitude
Risk Qualification
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
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Working Conditions
Consequential Losses
Quantification of Risk
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.
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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 Control
Loss Minimization
Structured Planning
Policy Conditions
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 insurers 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.
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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
Consequences
Probability
In the context of risk-based capital management technique, the role of board of directors and the management is worth mentioning.
Role of Management
The management of each general insurance company is responsible for developing and implementing the companys 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 managements 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
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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.
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.
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.
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.
years 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.
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
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Analysis of Variance
Source Regression Residual Error Total Source Claims Solvency Durbin-Watson Statistic = 2.07415. df 2 5 7 SS 63,132,228 2,165,435 65,297,663 df 1 1 Seq SS 63,129,174 3,054 MS 31,566,114 433,087 F-Value 72.89 p-Value 0.000
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
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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.
References
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