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UNDERWRITING MANAGEMENT

MOHAMMAD IRSHAD M.A. ACII (LONDON) CHARTERED INSURER

HAILEY COLLEGE OF BANKING & FINANCE, UNIVERSITY OF PUNJAB

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CHAPTER - 1
FINANCIAL & LEGAL ENVIORNMENT
INTRODUCTION
This chapter describes the environment in which insurance organizations operate and the issues, influences and implications that arise from it.

A FINANCIAL SERVICES AUTHORITY (FSA)

WHAT IS FSA?
The FSA is the single super regulator established by the UK government. It is not only concerned with insurance but also with financial and investment activities. It is an independent body having statutory powers under the Act of the Parliament. It is funded by charges (fees) and levies on those it regulates.

WHY FSA WAS CREATED


It was created in response to EU Directive (Insurance Mediation Directive IMD) approved by the EU Parliament on 30.9.2002 with members countries given 2 years to implement it. Its objectives were; Tackle the inability of insurance intermediaries to operate freely throughout the Europe. To create a single market in insurance across Europe.

AIMS AND GOALS


Maintain confidence in the UK financial system. Promote public understanding of that financial system. Secure right degree of protection for consumers. Contribute to reducing financial crime.

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RISK-BASED APPROACH
FSA will carry out a risk assessment of all firms, examining factors such as its size, type and range of products sold, and who its customers are before deciding the level of risk it poses to the FSAs objectives.

AUTHORIZATION OF INSURERS
With effect from 14.1.2005 all existing and new insurers wishing to do business will have to obtain authorization from FSA otherwise it will be considered a criminal offence. FSA can refuse to grant authorization if; It believes that any director, controller or manager is not a fit and proper person. Insurer does not have sufficient financial resources.

POWERS OF INTERVENTION
FSA can intervene on the following grounds; To protect the policyholders against the risk that insurer might be unable to meet its liabilities/expectation of its policyholders. If it appears that insurer has broken a rule. Misleading or inaccurate information has been supplied. Reinsurance arrangement is not satisfactory. Director/Controller or Manager is not fit or proper person (as far as his honesty, reputation, competence and capabilities and financial soundness).

FSA POWERS INCLUDE;


Restrict new business. Control investment. Appoint a Trustee to control assets. Limit premium income. Require an actuarial report. Demand specified documentation. Suspend or terminate authorization.

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FSA HANDBOOK
It is collection of publication containing rules and guidance for regulated firms.

INSURANCE CONDUCT OF BUSINESS RULES (ICOB)


These rules are the requirements relating to the business processes involved in selling and administering general insurance e.g. Marketing. Sales. Providing literature to customers on products and Handling claims

B CAPITAL AND SOLVENCY


A company who wants to operate needs resources and at start-up it will face immediate costs of; Premises acquisition. Raw material or stock. Wages for employees. Utilities and service costs.

For insurance all the above considerations apply but insurance is a unique business. Insurance claims are accidental and outside the direct control of the policy holder. Due to certain techniques a certain level of claims costs can be predicted. But due to catastrophes such predictions/forecasts may not be stable. The matching of capital reserves to liabilities is a highly technical process. Factors which can influence are; Extent of reinsurance cover. Value of claims equalization reserves. The nature of the business accepted (higher risk business with more claims experience requires greater capital to save). Projected growth of the insurance portfolio.

SOLVENCY REQUIREMENT

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Ei09mba125 Insurance companies are required to maintain adequate financial resources with a minimum margin of solvency to guard against poor financial results due to; Adverse underrating results or Unexpected losses from investments.

Essential elements in a margin of safety test are; Application of a formula to premiums or claims to determine the required margin of solvency and Computation of assets less liabilities. Computation of above will tell whether insurer has sufficient available assets to cover the required margin of solvency.

LLOYDS CAPITAL BASE AND SOLVENCY


Lloyds is a society of members both individual and corporate, who underwrite insurance in groups, known as Syndicate. Syndicates are run by Managing Agents. Capital to Syndicates is provided by the Underwriting Members of Lloyds. Their liability is unlimited accepting insurance risks for profit or loss.

SOLVENCY
FSA has delegated substantial part of its Regulatory activity to the Council of Lloyds and focuses on a supervisory role. Solvency test of every Syndicate is conducted by a recognized Accountant approved by the Council of Lloyds and submitted to the Council. Underwriting member is required to show that their assets at Lloyds are sufficient to meet their underwriting liabilities. Over and above Lloyds will have to demonstrate that each member has sufficient assets plus solvency margin. Lloyds have also to show that it has sufficient centrally held assets to cover any aggregate shortfall from this test.

UNDERWRITING LLOYDS UNIQUE SYSTEM


All premiums received are paid into premium trust fund held by the Syndicates Managing Agents.

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Ei09mba125 Payments of claims, reinsurance premium and underwriting expenses are made from this fund. No payment may be made to members until all liabilities have been met. Members are individually liable for claims on their underwriting liabilities to the full extent of their assets over and above those in their trust fund.

CENTRAL FUND
There is a central fund in which members contribute annually, is available to pay valid claims if any member fails to pay. It is supported by a reinsurance program.

C STATUTORY AND LEGISLATIVE INFLUENCES


FINANCIAL SERVICES COMPENSATION SCHEME (FSCS)
This scheme compensates claimants where authorized persons are unable to pay claims against them in connection with related activities. In order to obtain compensation a claimant must be eligible. Eligible complainants are any person except; Directors and Managers of the relevant person in default. Close relative of person excluded above. Persons holding 5% or more of the capital of the relevant person in default. Auditor of the relevant person in default. Persons who are responsible for and have contributed to, the relevant person in default. Persons whose claim arises from transactions in connection with which they have been convicted by an offence of money laundering.

SALIENT FEATURES;
If the FSCS judges that a firm is in default it must pay compensation to all claimant affected by the default. FSCS may decide to reduce compensation if there is evidence to contributory negligence by the claimant. It also includes customers of insolvent intermediaries.
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FINANCIAL OMBUDSMAN SERVICE (FOS)


This service was started from 1.12.2001. Firms regulated by the FSA are required to be member of the FOS. FOS has two functions; Compulsory jurisdiction; & Voluntary jurisdiction.

All providers of long-term insurance in the UK will be required to be member of the FOS and subject to its compulsory jurisdiction. Those firms not subject to compulsory jurisdiction can opt for voluntary jurisdiction such as mortgage brokers, firm which sold travel and loan protection plans. With effect from January, 2005 FOS has extended to include Insurance Intermediaries.

MOTOR INSURANCE BUREAU (MIB)


MIB was established in 1946. Under the Road Traffic Act, 1988, insurers must be member of the organization, if they want to underwrite motor business in UK. It assist those injured by uninsured motorists and untraced drivers. MIB receives money from insurers to pay the claims. It is also issuing authority in the UK for International Motor Insurance Certificates (Green Covers).

D NON-STATUTORY ISSUES
ETHICS
Ethics means moral rights and wrongs of doing business. Any business would be likely to adopt a strongly ethical stance, and for many it is possible. However, for larger organizations such a strategy often results into difficult problems because shareholders oppose ethical action which impact on profit. Ethically insurers are under pressure to provide wide range of products for the widest possible market at reasonable premiums. It is also their responsibility to invest substantial funds for benefit of shareholders and policyholders. Unethical conduct can have negative consequences such as adverse publicity, diminish corporate creditability and lower staff morale. Ethical conduct can produce the opposite affect on the business.

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SOCIAL RESPONSIBILITY
Social responsibility of an insurer can be judged by the contribution it makes to society and the community from which its customers are drawn. It involves customer-friendly underwriting policies which seek to provide protection wherever possible. For industrial risks, it means providing advice on risk improvement program, to make uninsurable or undesirable risk into acceptable one. Moreover, insurers involvement in public health, education, the arts and a wide range of other community activities is worthwhile means of social involvement and favorable publicity.

MARKET AGREEMENT
There are many market agreements amongst insurers, as to how their underwriting activities/businesses are carried out on day to day basis. It covers various issues such as; Sharing or pooling of data, such as claims experience. Rules on the transfer of business between insurers. Cancellation requirements and mechanism for cooperation on issues of mutual interests.

E INTERNATIONAL BUSINESS
Due to globalization multinational companies expanded rapidly. The world-wide (internet) and satellite television has transferred attitude to international trade. There are four main considerations, insurer pay particular attention to when considering entering a foreign market; Availability and quality of local agents. Potential for a joint venture. Possibility of operating through a local company. Trading through a local subsidiary/opening a local branch.

F UNDERWRITING CYCLES
Insurance market cycles Higher profits (increased investments) Higher prices Capacity higher capacity For that class lower process

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Withdrawn Lower profits (or losses)

POINTS TO NOTE;
When insurances experience higher profits in a market sector or class of business there is a desire to increase investment in that class in order to accept more of the profitable business leading to more profit. As market-wide capacity increases premium levels are reduced as insurer strive to maintain market share. Reduced premium income affects profits and fixed costs increase. Capital available for investment and investment income reduced in line with premium income. Withdrawal of capacity will cause premiums to rise as supply of insurances reduces in relation to the demand for cover. This will leads to higher profits for insurers.

ECONOMIC CYCLE
Economic cycle also affects the insurers. In a recession, policyholders tend to be more claims conscious and their may be an increased likelihood of fraudulent claims. Increased claims are also likely, with correspondingly higher incidence of theft, malicious damage and arson fire claims.

WEATHER RELATED CYCLE


Due to increase in global warming there are number of catastrophes happening throughout the world and insurers have great concern about this situation as they are receiving claims on regular basis. Research for the UK government in 1996 found that coastal flooding alone resulting from sea level could produce losses of 250 million pounds for UK Property Insurers. There is now general acceptance that Worlds climate is undergoing permanent change, which means that the insurance market is increasingly likely to be exposed to natural perils such as flood and windstorm. Now the premium is increasing to cover against natural disaster.

SEASONAL INFLUENCE
Season changes have also affected the customers as well as insurers. Manufacturers and retailers will require seasonal stock increase perhaps over the Christmas, Easter of summer
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Ei09mba125 periods depending on the line of business in which they operate. It has been experienced that 20% increase in sum insured is required by the retailer for the period from November to January. Demand for private travel insurance and cover against rainfall ruining outdoor events is much greater during the summer. Motor insurance claims both accidental damage losses and third party claims would be accepted to be heavier during winter months due to icy roads and poor driving conditions.

MANAGING THE CYCLE


At the top of the insurance cycle, the so called hard market, prudent insurers can build-up reserves from high profit to meet with down turn in subsequent years. If losses occur at the beginning of the cycle rather than later, the insurer will not have accumulated sufficient funds to meet with this adverse situations. Insurers use highly complex computer models to quantify the future losses by keeping inflation into their minds especially in liability claims. Adverse position in cycle can also be maintained by selective underwriting or placing limits either through deductibles or reinsurance. Fixed costs such as rent of premises and salaried have an impact on unit cost per policy. It can be reduced by increasing the number of policies.

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CHAPTER 2
STRUCTURE OF THE UNDERWRITING PORTFOLIO
INTRODUCTION
In this chapter it will be examined the processes which provide the insurance organizations with their direction and with the goals they strive (work hard) to achieve. For success in business, planning is always required. This planning process usually operates from the top down with greater detail at each level. Corporate objectives must fully recognize the business environment and the organizations capabilities. The role of underwriting management to achieve the corporate objectives involves; Establishing optimum portfolio size. Estimating the best time to expand or contract the accounts; Setting prices, terms and conditions designed to achieve business targets. Projecting and monitoring claims and administration costs. Optimally managing renewal retention; and The contribution of investment income.

The processes described above are continuous

A - UNDERWRITING POLICY AND CORPORATE OBJECTIVES


Strategic Management is the primary duty of the Board of Directors and senior executives of an organization. A deep understanding of where the organization is now, its core capabilities, strengths, weaknesses and the environment in which it operate combine with a clear vision of future direction.

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Ei09mba125 Underwriting Management examine the latest corporate objectives and ensure that the current underwriting policy is capable of delivering the results those objectives require. The policy is reviewed continuously, receiving special attention during the annual cycle. The objectives of an organization may be; Market leadership of selected business classes. 100% year on year growth over a 5 year period. Aggressive underwriting policy. More flexible (or inclusive) policy. Become brand leader. Company of choice for brokers.

B DISTRIBUTION CHANNELS
Multiple channels are used by the insurer to reach the largest possible market for their products. Commercial lines general insurance is still sold mainly through brokers. Intermediaries do not only place cover, they also handle certain claims, issue branded policies, carry out risk surveys and provide risk management services. The developments raise control and quality issues for underwriters. A single insurer may sell its product through; Its own sales force to brokers and other intermediaries. Through media advertising on television and in the press. Over the internet. By telephone through call centers, and Wholesale to bank assurance (banks and building societies) and other corporate connections, such as major retailers or affinity groups.

MULTIPLE DISTRIBUTION CHANNELS


Direct selling, without involving intermediaries, has increased in recent years. The standard wordings policies are usually sold through intermediaries who are tailored to the specific needs of individual clients. It is not suitable through call centers because it can create confusion.

PRICING;

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Ei09mba125 Using the standard policy costing as benchmark the net or pure price of the insurance can be calculated by carefully costing extensions to cover and optional modification. Then commission is added along with other expenses and profit.

UNDERWRITING CONTROL
For underwriting control three different approaches are required; For direct cases computerized underwriting is used almost exclusively. This system includes quotation and other information about the product for the customers. For more complex and larger cases individual underwriting will still be necessary. For wholesale schemes special underwriting skills are necessary to design policy cover, cost it, set premium levels and monitor the performance of this business.

C CONTRIBUTION OF RESEARCH
There are very few industries which are confident enough to design and launch new products before checking whether their customers will like them. Similarly few businesses (including insurance) are confident that the service they offer is so good that they do not need to seek customers feed back. There is too much data available in the market but it may leads to information overload and confusion. Such information is required to be analyzed very carefully.

DATA ACQUISITION AND PROCESSING


There is no ideal structure for carrying out the information-gathering activities or for subsequent implementation. Each organization will tailor it to suit its individual circumstances. Key considerations include; Degree of centralization versus devolution of underwriting activities. Alignment of underwriting to distribution channels. Top management structure. To process of new product development. Business mix of the portfolio and The division of responsibilities between underwriting and other functions such as marketing and development.

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Ei09mba125 The key criteria are to obtain the relevant information and channel it to those who are best able to analyze it efficiently and act on it. The data/information may be of two types available with the organization; Formal research conducted by specially trained staff. Useful information acquired by all the employees while carrying out their day to day activities. The first one is more focused and will be conducted on specific pre-planned questions for the help of senior management to make decision on policy changes or new product features and pricing. The second one is ad hoc and need careful filtering to make it needful. Such information is gathered when underwriters, claims handlers, surveys and sales staff interact with customers and agents.

SEGMENTATION
Segmentation means (a process of dividing into segment/section) customers, e.g. a community of lawyers is a segment in the society. There will be key inputs from; Investment department (returns on investment premiums are key pricing consideration) The marketing and development department (which may carry out a lot of the primary research affecting underwriting policy decisions). Claims department (which can use the experience gained in claims settlement to comment on product performances and highlight any unexpected development). Information technology system has facilitated the collection, storage and detailed analysis of data. Accurate customer segmentation identifies a distinct customer group that is relevant in deciding product specification and pricing.

DESIGN OF PRODUCT
Research into the cover to be provided is most relevant for personal insurances. It is less in complex commercial general insurance contracts (e.g. farm policies, shop policies, small businesses, and hotel). Such risk needs specific contracts after surveys, negotiations involving professional intermediaries. Most insurance products have basic terms and conditions which are common between insurers. For example home insurance buildings policies cover damage by fire, lightning, explosion, earthquake, storm, flood, riot, malicious damages etc. In such cases research will focus on what restrictions customers would accept in exchange for premium discounts or what extensions required by the customers. For example, policies were introduced some year ago with premium
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Ei09mba125 for household contents calculated on the basis of number of bedrooms with an upper limit instead of property sum insured. The ideal way is to anticipate the demand of product through research without it would be high risk approach. The most popular approach relies on an in-house expert having an idea which is developed subject to scrutiny of selected potential customers, later on. Depending on the reaction of that focus group, decision will be taken on either test marketing or full exist.

PRODUCT DIFFERENTIATION
The key to competitive advantage is product/service differentiation which may be exceptional, important to have or affordable. This must be getting known to the potential customers. But it is generally known that the average policyholder can; Name a mere handful of insurance companies. Find policy documentation (even plain English wordings) difficult to follow. Note that all motor insurance certificates have identical wordings; Struggle to comprehend rating systems, and Be uncertain that the intangible product is value for money.

Insurers normally in their advertisements claim best cover, best value and best service but customers have different experiences to judge such statements. Therefore insurer should concentrate on one or more differentiators to keep its position in the minds of the target customers. Insurer can adopt strategies for this as under; Quality price positioning (offer less expensive premium by excluding intermediary. Advantage positioning (classic car covers controlled by few market leaders is a good example). Product category positioning (Farm insurance handled by National Farmers Union Mutual Insurance). Competitor positioning (common approach where one insurer claims to be better than another).

D RESOURCE CAPABILITY
Resource capability means availability of expert underwriting and support staff in the insurance company. Experienced and qualified staff is required to deal with complex nature of risk profitably by satisfying the existing potential customers in the market. There is shortage of such
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Ei09mba125 staff due to the reasons, large scale merger, down sizing and centralized underwriting portfolio resulting into leaving experienced staff. The largest organizations will still buy in expertise when they needed especially for new class of business. It is very important that training of staff capable of dealing with the most complex risks clearly requires a long term training program supported by suitable work experiences otherwise these issues will clearly continue to impact on underwriting.

E IMPORTANCE OF ENTRY & EXIST COSTS


There are very few insurers who have monopolies in certain product, but there is lot of competition amongst them in many products. For example motor, where the cover is identical and choice of premium is available for the customers in the market. Ways to help and hinder new entrants Barriers to entry that exist for potential players in a market are as under; NATURAL MONOPOLY. There is a room for only one supplier of the goods/service. (rail track) LEGAL RESTRICTIONS. (Intermediaries are regulated in a different way). ECONOMIES OF SCALE. Those who are already in the market their unit cost are less). BRAND NAMES. Perception is that consumers are buying in top quality premium product. e.g. Virgin and Marks and Spenser. ADVERTISING. It helps brand names near the top of their market. SKILLS. Company who has not highly trained underwriters would not survive in the market. ESTABLISHMENT COSTS. Establishment of a new company required high funds at the inception. REINSURANCE. It will be very difficult for new entrant to get reinsurance service as compared to already in the market. INFORMATION TECHNOLOGY. With ever-increasing data compilations worldwide, and their availability from commercial and government sources, the chance of starting a new venture and finding that is rather impossible. GOVERNMENT REGULATION. New entrants may be required to gain licenses; put up minimum sums of capital; operate within a regulatory sphere; or suffer curtailment of capital and profit remittance. Page 16

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Ei09mba125 PREDATORY PRICING. A conventional technique where incumbents attack new or potential entrants to a market with price-cutting in the short term. Sometimes the mere threat of this technique is enough.

LEAVING A MARKET
Farmers buy tractors, oil companies build petrol stations and railway companies lay tracks and signals. On leaving the market tractors may be sold second hand, petrol stations may remove their tanks but railways have zero worth because steel is scrap. One significant component of insurance is staff and their removal depends on contract and employment legislation and often costly. Less expensive options are to redeploy, or incase of sale transfer them to new owner.

F RESERVING POLICY
Reserves are required by the insurance company to meet with the present and future liabilities of claims and maintain its solvency margin as required under legislation. If any company fails to meet these requirements become insolvent and ceases to operate in the market. Claims reserving process involves claims manager, underwriting managers, accountants and actuaries. Key factors in deciding an insurers chosen approach to reserving are; The purpose for which it is required; The volume of data; dThe class of business; The quality of data; The types of claim; and The insurers usual practice and preference.

The underwriting function will require the claims reserve information for the following reasons; To assess the overall financial performance of the underwriting accounts; To assess the relative profitability of the various classes of business; To assess the adequacy of premium rates which could cover future claims costs and company expenses; To facilitate reinsurance decisions; and Page 17

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Ei09mba125 To measure projected expansion plans against current capacity and prevailing market plans. At the annual business planning stage the underwriting management will be confronted with a large number of choices, including; Whether it is in the organizations interest to develop certain classes of business; Whether to stabilize or retrench others; The effects of hard or soft markets on risk exposure in relation to premium income; Exactly what basis should be employed for reinsurance; and Whether to develop new markets.

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CHAPTER 3
UNDERWRITING POLICY AND PRACTICE
Sound and effective underwriting policy and practice ensures profitable account development. Its aim should be selection of business and design of suitable products which could meet the customers requirements in the soft market.

A UNDERWRITING CONSIDERATIONS
POLICY TERMS
A key responsibility of underwriting management is to develop insurance policies (also referred to as products or contracts) which reflect the organizations underwriting philosophy
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Ei09mba125 and approach to business. Policy terms must satisfy all legal requirements and chosen ethical requirements.

STANDARD OR NORMAL TERMS


All insurers have standardized or normal policy wordings for each class of business which they transact. These wordings have evolved and developed over a long period of time. Certain policy wordings are still used which were being used centuries ago such as marine policy. Some wordings were recognized by the ABI which issued Recommended practice wording and procedure relating to Material Damage and Business interruption, commercial and industrial insurance (known as Blue Book). Such wordings are well understood by insurers and the market. In recent years insurer are trying towards simpler policy wordings, mainly for personal insurance using plain English. It includes descriptions of insurer and policy holder responsibilities, guidance on how to make claims, definition of key words and terms used.

POLICY CLAUSES
There are normally 4 parts which describe the main criteria of the policy terms; Operative clause; Exemptions (or exceptions) clause; Conditions clause; and The schedule.

OPERATIVE CLAUSE
This clause defines the terms of the contract and the extent of cover. It states; The subject matter of the insurance; The risks or perils covered; The period of insurance; and The requirement for premium to be paid.

Example is that under motor policy, authorized driver, vehicles and their contents. The risk or perils covered are those which cause injury, destruction loss or damage. Certain perils may be excluded for some or all policyholders and also limits in sum insured or indemnity may be appeared for others. Poor or adverse risks are not desirable unless insurer specializes in underwriting of such risks i.e. proficient in balancing the risk exposure with the adequacy of premium received.
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Ei09mba125 The operative clause should define perils to be covered in detail or explained in a separate sheet as enclosure. Each peril or risk involved is entirely represented so that underwriter could analyze it and charge appropriate premium. Example is fire, storm and flood under property policy. --Period of insurance is normally 12 months.

EXCEPTIONS (OR EXCLUSIONS) CLAUSE


Exclusions may be war risk or existing damage. The criteria for exclusions are selected after assessing whether; Excluding particular cover available elsewhere in the market will harm sales initiative; Such cover would price a product out of its targeted segment; and Optional inclusion should be offered at an enhanced premium.

CONDITIONS CLAUSES
It describes the policy holder rights and obligations. It includes equity, market practice and need to ensure policyholder cooperation in reducing or avoiding loss. For example the policy holder must take all reasonable steps to prevent loss of or damage to the property insured

SCHEDULE
It describes the precise subject matter of the policy (name and address of the policy holder) and sum insured/limit of indemnity together with the premium.

VARIATIONS IN POLICY TERMS


If the risk falls outside the underwriters target criteria but for which the standard terms are generally appropriate, modification is made by using endorsements, warranties, excess for deductibles as well as premium loading.

EXCESSES, DEDUCTIBLES, LOADINGS AND INCENTIVES


POLICY EXCESSES Main points are; In excess, policy holder agree to bear the first agreed amount of any claim which is for mutual benefit both for him and insurer. It results into reduction in premium while eliminating small claims with administrative savings as well as reduced claims costs for the insurer.
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Ei09mba125 Policy holder also benefits where they would not claim such as in motor claims no claims discount even there is not excess applied. Compulsory excesses are applied to enable insurers to keep their premiums competitive by excluding all or part of claims of unacceptable high frequency e.g. excess applied to motor vehicle windscreen claims. POLICY DEDUCTIBLES A deductible is an amount borne by the insured in each claim in return for a premium discount. It is usually much larger than an excess and found in commercial contracts. PREMIUM LOADINGS By setting a level of premium commensurate with the degree of risk for standard cover, a benchmark (minimum premium to be charged) is established. Establishing this benchmark is a critical part of the underwriting process. Standard or normal premium does not signify low hazard but merely that is appropriate to that category of risk. An underwriter will examine in detail all aspect of the subject matter to be insured and the degree of hazard of each risk covered before deciding the usual premium is appropriate or whether it should be increased or decreased. The proposers occupation and proposed use of the vehicle will be considered. Certain occupations attract higher terms, due to lifestyle and resultant hazard exposure. Vehicles mileage which differs markedly from the average is also a factor and whether the vehicle is garaged is relevant to the theft risk. Loading in premium is applied to reflect the underwriters assessments that the enhanced degree of hazard or risk presented by the cases under consideration justifies increase in the premiums applicable to standard risk. INCENTIVES Certain incentives are given by the insurer to the insured and others. Main points are; The purpose of incentive is to attract new customers or retain existing ones in the face of market competition. All incentives have a cost that must be justified within the costing of the product involved. One common incentive in the shape of reduced premium is the long term agreement (LTA) in exchange for a commitment from the policyholder to keep the policy with the
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Ei09mba125 same insurer for an agreed number of years. The advantage to the insurer is a saving in acquisition cost by retaining business, while the policyholder saves money. Another incentives is the No Claim Discount (NCD) in motor insurance. This discount is awarded on a sliding scale increasing each year up to maximum of 5 years if policyholder does not make a claim. Discount of 65% are common. People do not intend to have motor accidents but insurer believes that in addition to discouraging small claims, NCD may encourage policyholders to be more careful. Profit commission is another incentive offered to intermediaries, linked to the profit made on the relevant business over and above commission. Another incentive is volume commission to intermediaries who offered agreed volume of business. Free gifts, e.g. clocks, watches, pens etc. are awarded by the insurer to the policyholders who keep the insurers name before the recipients.

FIRST LOSS INSURANCE


First loss policies are usually required by proposers who consider that any loss occurring from an insured peril will not be more than a small percentage of the total value at risk. For example, where an historic building would be replaced by one of cheaper modern construction if total loss occurs. If loss occurs, insurer pays up to the sum insured without consideration of total value at risk if it is accurately declared to them. Following a loss the sum insured can be reinstated at an additional premium. This type of cover is only available on property for perils including fire, storm, floods, impact and theft.

SCHEME UNDERWRITING
Personal insurances market is the existence of scheme to provide insurance for affinity groups. Groups may be; Members of specific charities. Non-profit making organizations such as National Trust. Customers of banks, building societies. Store chains. Solicitors.

INSURANCES OFFERED ARE;

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Ei09mba125 Home insurance. Motor insurance. Personal accident insurance. Credit insurance. Travel insurance. Commercial insurance packages.

Due to strong competition in the market for such schemes, it is essential to predict performance accurately and price competitively which may be smaller profit margins than on other business.

B INTERNAL AND EXTERNAL CONSTRAINTS


Internal and external constraints which operate on underwriting policy are as under; Scope of cover Limits to cover Market position New business growth Reinsurance retention

SCOPE OF COVER EXTERNAL CONSTRAINTS;


There are four conditions implied by law in the subject matter of the insurance; The insured has an insurable interest in the subject matter of the insurance. Both parties have observed the utmost good faith in their negotiations leading up to the contract. The subject matter of the insurance is actually in existence, and The subject matter of insurance can be identified.

In addition to above, legislation, case law, regulations and code of practice also apply. Some are specific to a class of business e.g. Employers Liability (compulsory insurance) Act, 1969 and the Road Traffic Act, 1960 and 1988 and both are compulsory. Doctrine of Utmost Good Faith (Uberrima fides) is that an insured person must disclose all material facts. That is those facts; Which would influence the judgment of a prudent (reasonable) underwriter in fixing the premium or determining whether or not he will accept the risk offered to him. Page 23

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Ei09mba125 A number of judges have criticized insurers on the grounds that the principle has been too severely applied by them. The ABI Statement of General Insurance Practice (1986) agreed by supporting insurers, provided (amongst other things) that an insurer would not unreasonably reject a claim or invalidate a policy, in particular, on the grounds of non-disclosures or misrepresentations would not be used unless it was; A material fact, A fact within the knowledge of the proposer, A fact which the proposer could reasonably expected to disclose.

Insurer can only provide cover for classes of business they are authorized to write by the FSA.

INTERNAL CONSTRAINTS;
These are; The insurers executives may be unwilling to write a particular class of business either in particular or general market because of the balance of risk and premium anticipated does not make good enough use of available capital. Lack of positive evidence of sufficient demand for a particular risk. Commercial liability insurer does not accept processes using the application of heat. Some builders risk are acceptable under certain restrictions while other or not. Sometime territorially, it may be prudent to restrict underwriters to those risks where they have demonstrated their expertise. Sometime policy may be exclude certain risk, such as Caribbean windstorm if they seem to have to great or potential for causing large aggregate losses. Those insurances which may be underwritten and those which must be excluded may encompass; Territorial limitations; Sum insured limitations(line limits) by risk; Sum insured limitations by zone; Maximum indemnity limits per insured event; Maximum annual aggregate limit of indemnity; Limits of estimated maximum loss (EML) as a percentage of sum insured; and risks from companies involved in

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Ei09mba125 Restrictions on eligibility for cover, by product, of personal or commercial customers with different attributes (age, occupation, trade classification etc.).

LIMITS TO COVER EXTERNAL CONSTRAINTS


It is the requirement of all insurers to maintain adequate financial resources and a minimum margin of solvency to guard against poor financial results.

INTERNAL CONSTRAINTS;
It is the limits on capacity, the extent of the reinsurance program in place and on the expertise to provide for the cover. Underwriting Management, will, therefore, set specific limits for current underwriting policy in terms of gross and net maximum sums insured estimated minimum losses (EML) and limits of indemnity.

MARKET POSITION EXTERNAL CONSTRAINTS;


It arises from market competitions and the insurers position in particular market or market segment. If position is strong then it will be difficult to further expand. If another insurer has better or monopoly position then for entry of new insurer requires, superior cover better rates or better service (or combination of these).

INTERNAL CONSTRAINTS;
What is the strength and effectiveness of the marketing function and the extent to which it integrates and coordinates with the underwriting function?

NEW BUSINESS GROWTH EXTERNAL CONSTRAINTS;


Solvency requirement together with strength of competitors.

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Ei09mba125 If there is not adequate financial strength, expertise and administrative competence, professional intermediaries, risk managers and customers will cease to place new business.

INTERNAL CONSTRAINTS;
Restrictive underwriting practices (terms and pricing) compared with competitors; Lack of effective marketing or access to distribution channels; Poor sales performance by the in-house sales force and/or intermediaries; and Deliberate decisions to restrict acceptance due to risk aggregation in certain geographical locations (e.g. earthquake) or by customer type (e.g. young drivers). Sudden unanticipated flows of business may create pressures which cannot be handled in the short term without proper administrative support.

RETENTION INTERNAL CONSTRAINTS;


Different acceptance criteria are set out for different classes of business, different territories, and sometime for different contracts or product.

EXTERNAL CONSTRAINTS;
Even the largest insurers will, on occasion, be unwilling to retain 100% of a risk or an account because they perceive the exposure involved is not acceptable such a large risk (e.g. a chemical manufacturer).

C LIAISON WITH CLAIMS FUNCTION


Liaison between the claims and underwriting management functions should be mandatory, not optional. It is required for the setting of underwriting policies and during implementation, monitoring and revision. Underwriting Management also involves other organizational functions such as personnel, finance, information technology, marketing, risk survey and improvement and sales. However, relationship between claims and underwriting is pivotal.
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Ei09mba125 As claims occur, the claims function through its claims handlers can monitor; The nature of claims, particularly those factors not captured by the insurers management information systems; How effectively underwriting policy is being implemented (addressing issues such as risk acceptance), Customers with an exceptional or above average number of claims; Whether policy wordings are producing unanticipated claims; and Whether added value services might be appropriate.

Claims hander can give warning of deteriorating claims experience under individual polices. For example 3 claims from one insured in a year could result in non-renewal or change of terms or increased premium. The claim handler should notify the underwriter if the renewal is imminent. Liaison between claims and underwriting has played a crucial role in countering insurance fraud. Special market anti fraud system such as the Motor Insurance Anti-fraud & Theft Register (MIAFTR) and the Claims and Underwriting Exchange (CUE) have an example of this. Ex-gratia payment policy should ensure that; Claimants feel they have been treated equitably. The insurer (and reinsurer) is satisfied that any payment is justified, and The overall approach is consistent.

The ultimate responsibility for deciding whether a policy is a valid contract and what it covers lies with the underwriters who wrote it. The same is true of ex-gratia payment.

D RISK
CLASSIFICATION AND CATEGORIZATION OF RISK;
Profitable underwriting depends on accurate risk assessment. Underwriting Management identifies the risks associated with a class of business, evaluate the degree in terms of severity and frequency and then cost the potential claims.
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POINTS TO NOTE; Risk assessment process requires relevant and detailed statistical data which is available from internal and external sources. Internal data is extracted from the insurers own policy and claims record. Externally, insurers exchange data between them. In public domain metrological data is available. The data must be in manageable format for judgment of the insurer.

Underwriter considers the features and characteristics of the data to assess the range of risks within a particular class of business such as; Underwriter classifies the risk in group to present a similar degree of hazard. For example property insurance grouping will be according to trades of section of trades and by cover (fire, theft, flood etc.). The establishment of classification is first step in the process. After that underwriter identify different aspects to present a full picture .e.g. for property insurance, building construction, sum insured, location, quality of housekeeping etc.

ACCEPTANCE AND RENEWAL CRITERIA;


The insurer must identify the terms and conditions under which it will accept a new policy or renew existing one. Important points are; Underwriting guidelines are issued by the management for commercial risks. For personal lines there is much greater degree of computerized underwriting with detailed guidelines provided for complex, large or non-standard risks. Insurer set parameters of acceptability based on claims history, criminal record, trade or occupation. To maintain healthy business, it is essential that underwriting management regularly audits both new and renewal acceptance.

RISK IMPROVEMENT AND SURVEY CRITERIA


Surveys are conducted by the insurer for the staff which risk is acceptable and which is not. The survey represents an opportunity for insurer to work with the policyholder to improve the risk. Surveys are also made to know whether there is any opportunity for the insurer to reduce
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Ei09mba125 the premiums based on claims received. If surveys are not conducted regularly there may be a problem for the insurer. For example previously office risks were considered very favorably. But by the passage of time it has been revealed that in most of the cases it has become uninsurable due to theft cases, repeated strain injury, liability claims and occupational stress liability claims.

E EXPOSURE
In case of change in the existing contracts or underwriting a new class of business, it is essential to consider the potential impact of single risks and single events. The accumulation of risks during the insurance year must be identified, analyzed and quantified so that an objective judgment can be made on whether to proceed or not.

F MARKET CONDITIONS
Market conditions can be judged as under; HARD MARKET A hard market is one where premium rates are up and insurer are able to select which new business they wish to underwrite. Poor quality risks become difficult to place and if accepted terms may be harsh. SOFT MARKET A soft market is one where there is more capacity than demand and insurer have to compete strongly for the business that is available. Rates fall and policyholders are able to get cover on terms that the policyholder and/or intermediary demands, rather those preferred by the insurer.

G BINDING AUTHORITIES AND LINE SLIPS


Under binding authority, carefully selected agents may accept risks of a particular class, on behalf of the insurer, within defined limits. The insurer sets very precise limits and rules for the operation of this authority including maximum limit and limits to accept non-standard business.

POINTS TO NOTE; It is advantageous for agent, he will receive increased commission, greater authority and ability to make immediate decision on risk acceptance. It is also beneficial for insurer that more business is written and some element of administration is removed. Page 29

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H ACCEPTANCE SLIPS
Slips are used in very large risks where single insurer may not be able to accept 100% risk. It is practice in Lloyds market in certain cases and in conventional market also. There is always a lead underwriter who accepts the risk on a slip at the first instance by mentioning the percentage of risk acceptable to him. Other will follow until 100% risk is accepted.

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CHAPTER 4
MANAGEMENT OF EXPOSURES
INTRODUCTION
Underwriters have an important role in assessing the quantitative and qualitative aspects of risk proposed to them. Underwriter has to ensure that the exposures (amounts such as sum assured, that represent a potential claims against the insurer) brought to the pool and rated against equitable standards. Underwriter is responsible to control the exposure.

A MEASURING EXPOSURES
Insurers classify exposure by policy type and or class of business. Property account is exposed to catastrophe (storm, flood, and earthquake) and noncatastrophe (fire, theft, impact) risks. Pecuniary account includes business interruption (loss of profit), personal accident and life insurance risks. Liability account will have exposure to property damage, personal injury and financial risks. Steps have to be taken to measure the extent of all the above losses. Moreover, individual peril can create liabilities across different types policies.

SINGLE RISK
For example, calculating the maximum exposure for any one single fire risk is not a case of simply adding together the sum insured at a single location. It invites assessing the estimated maximum loss (EML) that is likely to occur.

EML
It is an amount often expressed as a percentage of the total sum insured as well as an absolute amount, reflecting the worst financial affect that the maximum foreseeable loss would have. An EML could be 100% of the sum insured but it often less.

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Ei09mba125 It is possible to identify all exposure as a single fire risk for both material damage and business interruption. This exposure can be under separate policy and the gross exposure is determined by adding all those separate exposures together after applying EML percentage. Assessment of EML must be accurate otherwise it will create problems for the insurer. It is important not to overstate EML, as this can result in gross retention being on the higher side and ultimately ceding to reinsurers premiums, which could be retained. Conversely underwriting will over expose to the insurer and reinsurer also.

ESTABLISHING AND EML/SINGLE RISK EXPOSURE


Underwriting requires skills such as processing factual information and subjective judgment and experience in interpreting data in relation to the risk that the proposer or insured wishes to insure/transfer. Data provided by the proposer/insurer can be supplemented with information obtain from other sources in respect of that specific risk. Risk information can be obtained from the following sources; Insurance market data (ABI, Swiss Re, IUA etc.); Own company data (claims experience for class of risk etc.). Public sources data (government statistics, local authority statistics etc.) Trade publications (chamber of commerce statistics etc.); Own risk register; Surveyors report on the specific risk; Information on the specific risk from own staff, brokers; Proposer special reports (e.g. medical, specialist, engineer etc.) and Proposal form/application form.

Guidelines should be issued to surveyors on the method of EML assessment; surveyors are encouraged to use their own judgment and experience in risk assessment. Some insurers fix certain key factor on the assessment to a point/grading system for EML but measurement is always subjective.

EXAMPLE: PROPERTY RISK


When measuring a companys commitment, there are two dimensions to consider on a property risk: The sum insured under one or several policies covering one or more interests: for example, if the risk in a furniture depository or a warehouse, an insurer needs to
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Ei09mba125 aggregate its potential liability under all policies covering different interests insured at the same premises; The nature of the risk and its vulnerability to a range of different perils the size of the maximum potential loss related to the total value at risk (sum insured) determined by: 1. the materials used in its construction; 2. the size and height of the building; 3. its fixed fire and sprinkler protection; 4. premises contents nature, distribution, combustibility and content; 5. use of location hazardous processes and substances; 6. susceptibility of contents to smoke, beat and water; 7. explosion from any source; 8. hazards from gas or corrosive materials; 9. concentration of any values in a small area; and 10. management and housekeeping capability. Reinsurers invariably insist that the same net retention is used on any non-fire perils.

NON-FIRE PERILS
Similar evaluation is applied to the assessment of non-fire perils. The same principles are applied when considering risks whether the insurer is the lead office or not, although the survey reports have been produced by other insurers and brokers. Internal underwriting controls in the form of branch audits and branch referrals are also involved.

RISK ACCEPTANCE
Once the EML has been calculated, an underwriting decision must be taken on the acceptability of the risk within the gross account. This is influenced by the extent to which the risk, when added to others within the underwriters book of business, will aggregate to produce too high an exposure from a single risk; or from an event involving other risks likely to be affected by the same flood, storm, earthquake etc. An important part of a underwriters skill is to quantify overall values at risk to take a view on the amount that can be retained within the net account, and to decide whether use of one of several risk transfer arrangements should be made so that the possible net loss to the insurer is reduced to a manageable level.

SINGLE EVENTS

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Ei09mba125 Many individual losses can result from one catastrophic event, affecting a large number of policies. Part of an insurers strategy to spread risk and smooth out losses includes writing a range of different classes of business. However, a natural peril, such as windstorm, can cause losses across different policy types, for example, household, commercial,fire,motor,marine and aviation. Insurers have to acknowledge such possibilities and seek the financial stability that catastrophe reinsurance protection can offer.

B SEASONAL AND CYCLICAL INFLUENCES


SEASONAL INFLUENCES
Seasonal demand needs the increase in sums insured at risk (e.g. retailers stock during Christmas period) or specific demand for certain covers (e.g. travel policies in summer). Moreover during summer season the number of visitors from different countries of the world visit UK on holidays, therefore, stocks have to be increased many fold and there will be a need to uplift the sums insured. Seasonal risk also describes the increased risk under annual policies (e.g. claims under motor policies due to adverse driving conditions during the winter months).

ECONOMIC CYCLE
Inflation tends to follow a booming economy and affects property values so sums insured may become inadequate. Similarly court awards rise and may render limits of indemnity inadequate.

WEATHER-RELATED CYCLES
Due to global warming weather is changing in many parts of the world. Rising temperatures are expected to increase flooding, coastal erosion and subsidence. Severity of windstorm incidents is also increasing. These all are of concern for the insurer as losses may be on very higher side.

C AGGREGATION
MEASURING AGGREGATION OF SINGLE EVENTS

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Ei09mba125 Measuring aggregation of single events is now essentially required both for the benefit of reinsurer and insurer as the natural disasters are increasing day by day. There are the six stages involved for measurement. Classify aggregations according to type of policy, class of business, risk or peril; Access zonal aggregation by geographic territory, radius or band; Carry out event simulation relating hypothetical events to known exposures to gauge the effect of , for example, flooding in the Thames basin or windstorm in section of the Gulf of Mexico; Make a statistical extrapolation based on past events that could recur, adjusting the financial consequences for current and future conditions; Acknowledge that single events can create exposure clashes in unrelated accounts and make an allowance for the effect these multi-exposures can have in depressing retention levels; and Quantify the effect of single event on separate account aggregations arising from, say, an earthquake, on exposures in motor, property, marine, life and pecuniary accounts. The first stage is to assess maximum loss which could occur due to catastrophe and then underwriters should identify any single risk exposure that is known along with business written by other department or companies within the same insurance group. Thereafter insurer can forecast the likely future cost of post losses.

AGGREGATION OF SINGLE RISKS


The purpose of aggregation of single risks means risk registration in the property record. It is an essential underwriting process for identifying and measuring accumulation.

AGGREGATION OF LOSSES IN ONE YEAR


Under one account e.g. motor insurance there may be losses under different accounts e.g. a company car fleet can expect own vehicle damage, damage to the other car, injury to the passengers of other car and liability claims can arise, damage to the property of third party again liability claim can arise. All such loss exposures should be aggregated, which exercise is required to decide the retention level and business to be passed to the reinsurer.

D ENABLING CAPACITY

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Ei09mba125 Enabling capacity can be increased by taking measured that an insurer can take to maximize his ability to underwrite risks, whilst marinating the balance between financial capacity and exposure/claims liabilities.

VIRTUOUS CIRCLE
It means growth in areas with a perceived profit potential will be attractive because increased policy volumes will probably reduce unit cost (reducing overheads etc.) which in term allows premium reductions. Measures that can be taken to maximize ability to underwrite risks are; USE OF LAYERED COVERS AND DEDUCTIBLES Sometimes, as insurer may wish to, or is obliged to, accept a block of business with potential liabilities far in excess of its maximum capacity for any one risk. A valued customer might expect the insurer to accept all of their business without question or the insurer may want to write the entire risk as a way of avoiding competition. EXAMPLE OF LIABILITY RISKS A large petrochemical manufacturer approaches insurer A to provide a public liability limit of 500m pounds any one accident. Insurer A is able to retain 10m pounds ground up for its own account and calculates that it is unlikely that any one incident would produce total payments in excess of 50m pounds. The possible effect of the layering process is as follows; first 10m pounds with insurer A; 10% of the next 40m pounds with insurer A plus 90% with a panel of proportional reinsurers; Next 100m pounds with specialist reinsurer X; Next 150m pounds with specialist reinsurer Y; Next 175m pounds with specialist reinsurer Z; and Last 25m pounds with insurer A.

Each layer of the package would be priced by the insurer or reinsurer concerned.

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Ei09mba125 With the first layer, insurer A would calculate the whole premium in the normal way, but in the knowledge that the entire 10m pounds could be involved in a loss and an incident could cost up to 50m pounds. For the next layer, when other insurers are introduced they would prepare their own premium calculation to compare with the premium put forward by insurer A in preparing the calculation, they would put it together in the normal way and view the first layer of 10m pounds as being similar to a deductible on their cover. They would not be called upon to meet any claims payments until a loss exceeds 10m pounds. The next layer is expressed as 40m pounds in excess of 10m pounds and insurers or reinsurers participating in this layer would acknowledge that their interest in losses would only commence at 10m pounds, for 90% of amounts upto to 50m pounds. The pricing structure would allow for this. The premium for the next layer, 100m pounds over 50m pounds, would again be arrived at in the same way. However, since the loss potential is diminishing, a lower sum might be anticipated even though the width of the layer is greater. Once the last 28m pounds layer is reached, insurer A is sufficiently confident that the possibility of losses reaching this level is very small. Therefore, it is prepared to participate again, as in the worst possible circumstances its total exposure, 39m pounds, would be within its financial capacity. The likelihood of that last layer being involved in a loss would be considered remote but the high variability of risk at that level required risk capital and hence justifies the further premium charged. The loss potential has considerably diminished, so the premium for this layer will be reduced. Excesses and deductibles The difference between an excess and a deductible (apart from one of scale, where the excess will usually be a lower amount) is that the former is often imposed by underwriters as either standard or specific to a particular case as a condition of acceptance without premium discount. A deductible is an amount borne by the insured in return for a premium discount. The following example shows how the insurer, or the customer, might benefit; EXAMPLE Customer A is a multinational and has a global insurance program providing material damage all risks cover on its manufacturing plants throughout the world.
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Ei09mba125 It whishes to carry a 100,000 pounds deductible on each and every loss instead of insurer its standard policy excess of 5,000 pounds. Insurer B is prepared to allow a premium reduction of 250,000 pounds for this facility. Based on its most recent five year loss experience and a newly implemented risk control package, customer A estimates that its total annual claims falling between 5,000 pounds and 100,000 will be 200,000 pounds. Therefore it accepts the deal, anticipating a saving of 50,000 pounds; that is, 250,000 less 200,000 pounds. Consider the following scenarios at the end of the period of insurance; Actual annual total of losses falling between excess and deductible; 180,000 pounds Premium saved Losses not recoverable Benefit to customer A 310,000 pounds Losses not paid Premium not collected Benefit to insurer B 310,000 pounds 250,000 pounds 60,000 pounds 250,000 pounds 180,000 pounds 70,000 pounds

Actual annual total of losses falling between excess and deductible;

GROSS AND NET ACCEPTANCE LIMITS


If an insurer has operated for some time and built up technical reserves (funds of money put aside to pay for future losses, added to by unearned premiums and depleted by claims payments), it follows that the insurer can absorb larger losses than a younger insurer which has had less time to accumulate reserves. Sound practice dictates that not all of the insurers surplus should be distributed as dividend to shareholders; instead, the longer-term objective must be to increase reserves 8which, in turn, increase the net underwriting capacity. A gross acceptance limit is that amount of a risk which the insurer is able to manage, taking into account the balance of the portfolio and the availability of reinsurance. A net acceptance limit is that amount which the insurer retains for its own account after recourse to reinsurance. The reinsurance arrangements are defined by the insurers net acceptance limits and can relate to the whole of a risk, a block of business, or a part.

Example
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Ei09mba125 Underwriter K has a gross acceptance limit on good quality marine cargo business of US$. Of this amount US$50,000 is retained for the syndicate that underwriter K represents. US$150,000 is reinsured, being within the capacity of their ten-line surplus treaty arrangement. A surplus treaty measures its capacity in lines, where each line is equal to the insurers gross retention. A70% quota share treaty is applied to the US$50,000 in order to involve other network members, leaving underwriter K with a net acceptance of US$15,000. Insurers with small and perhaps unbalanced accounts are obliged to set acceptance limits in accordance with their restricted financial resources. While all insurers, large or small, are constrained by solvency margin requirements and regulatory legislation, there is scope for a cautious or an adventurous business stance. Small, newly formed insurers may put more of their capital at risk by setting their acceptance levels at a higher level. This may help to attract reasonable volumes of business in their chosen market.

CO-INSURANCE
Co-insurance is a means of spreading the risk whereby the organizing company (called the lead office) issues a policy covering a risk but only retains a percentage of the risk. Important points to note; The reasons for using co-insurance are, possibly the risk is thought, by the leading office to be too large for it to accept or it may be felt the risk insured is too hazardous to justify retaining 100% or client has preferred to involve several insurers. Since the lead office not only handles most of the administration but also is responsible for the initiating negotiations, surveys, premium calculations and subsequent policy changes (endorsements), all co-insurers will pay 5% of their share of the premium to it. The co-insurers are responsible for ensuring that policy terms and conditions and premium levels accord with their own underwriting; policies and practices.

ALTERNATIVE FINANCIAL INVESTMENTS


There are certain alternative instruments which allow risk transfer.

CAPTIVE INSURANCE COMPANIES.


DEFINITION; A Captive insurance company is a limited purpose company, established and owned by a noninsurance parent to transact, in the main, the insurances of its parent company or subsidiaries thereof. It is not large enough to carry all the risk itself so a sizeable amount of reinsurance is
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Ei09mba125 usually required. The captive may retain a percentage of the risk or a fixed proportion. The balance, usually the majority of the risk, is reinsured. Captives may also write reinsurance themselves, possibly for other captives and usually on a small scale. There are currently about 5,000 captive insurers globally.

TYPES OF CAPTIVE INSURERS


Single-parent captives; These companies benefits from; 1. lower operating costs than traditional insurers, 2. direct access to reinsurance; 3. full retention (by the parent company)of investment income and profits; and 4. freedom to outsource support services. Potential disadvantages include; 1. additional administration costs for the parent company; 2. vulnerability exceptional losses; 3. the opportunity costs involved in setting up the operation; and 4. there may also be tax implications.

Group captives; Group captives, as the name shows, service a number of different organizations and are jointly owned by them. They enjoy the benefit of single-parent captives, but also a wider spread of exposure and the reduction in overheads that (usually) accompanies larger volumes of business. Disadvantages include; 1. poor loss experience as one or more of the participants can produce unwelcome financial repercussions for all; and 2. there are also potential problems in managing the operation so that all participants are satisfied.

Protected-cell captives (PCCs); The funds (assets and liabilities) of each user are physically and legally held separately. They seek to achieve the advantages of the single-parent captives and the operating cost advantages of group captives, but without the cross-account exposure of the latter.

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ADVANTAGES FOR PARENT COS. & INSURERS


Greater flexibility in arranging their insurance programs. Insurance of deductibles carried under traditional covers; Direct access to reinsurance; Reduced premiums and potential to accumulate funds; Availability of cover not found (or only in very restricted form) in the retail market; First-hand involvement in claims settlements, with potential benefits in operating processes and accident preventing; Some insulation against the hard markets with their resultant high premiums; and Greater risk control

For insurers the benefits can be; Less pressure to accept accommodation business, which they would rather not write, even for valued connections; Potentially better risk management through greater policyholder involvement; and Possible opportunities for reinsurance.

SOLVENT SCHEMES FOR ARRANGEMENT;


These schemes are arrangements between insurers and their policyholders. Under the schemes solvent insurers can exit from discontinued business with the consequent release of capital and possibly, a saving in run-off costs. Policyholders benefit because they are immediately paid in full the estimated value of their claims. The basis of the arrangements is an aggregate assessment of all existing and future claims at a given date, facilitating a final distribution. The schemes are legally binding on all policyholders (and creditors) or any class thereof, if the necessary majority vote in favor of the proposed arrangement and the High Court grants approval.

D AVAILABILITY OF REINSURANCE
Insurers use reinsurance to limit their potential maximum exposure by ceding part to another party (reinsurer). Main points are;
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Ei09mba125 In property insurance, insurer often use proportional and/or excess of loss treaties to allow a higher gross exposure to be accepted as single fire risk. Insurer also arrange catastrophe protection for the whole account against the risks of accumulated loss following major events such as storms, floods, earthquakes, major fire and explosions. Reinsurance applies where an insurer willingly or unwillingly accepts more than its normal capacity. Treaty reinsurance will not require details of all individual risks written by the reinsured. Stop loss cover is a non-proportional reinsurance arrangement whereby annual losses over an agreed amount for specified class of business are covered up to a fixed upper limit. Reinsurance serves a number of vulnerable functions; it enhances the capacity of primary insurers, stabilizes the activities of the insurance industry by spreading risks and provides insurers to obtain a greater return on capital employed.

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CHAPTER -5
IMPLEMENTATION OF OPERATIONAL CONTROL
INTRODUCTION
The main purpose of underwriting management is that high level objectives set forth by the higher Management to get known to all working at front line for decision making and to apply uniformity in all cases. In practice there may be lot of difficulties which can be faced, as under; It is not practically possible to grant one set level of authority to all underwriting staff, because of their level of experience, e.g. senior underwriter at head office may have more acceptance limit than a clerk. There are number of distribution channels and have underwriting authority. Levels of this authority vary as compared to in-house underwriters. Even in well-managed insurance companies consistent and effective 1control through several level management results substantial difficulties.

A AUTHORITY LIMIT
ESTABLISHING A CONTROL STRUCTURE ELEMENTS OF UNDERWRITING CONTROL;
The essential elements of the insurance underwriting process can be as under; Identification or risk; Measurement of risk by average and maximum size and frequency of occurrence; Setting parameters for risk selection; Limiting risk exposure by individual policyholders and in aggregate across the portfolio; Preparing a detailed legal contract (the insurance policy) which sets out clearly the subject matter of each insurance and the risks insured, together with conditions and exclusions; and
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Ei09mba125 Pricing risks and incorporating acquisition and operational expenses, together with a profit margin, into the premium.

DIFFERENCE BETWEEN UNDERWRITING AUTHORITY AND UNDERWRITING LIMIT;


Authority is extent of decision making given to individual underwriter or group of underwriters. Limits refer to exact parameters on type of business and gross and net acceptance limits,

DETERMINING AN APPROPRIATE FRAMEWORK OF UNDERWRITING AUTHORITY


Underwriting authorities are developed to support, the objectives and activities of other areas of the insurer, including marketing, sales and claims. The customers in the market have expectations about the speed of response and the extent of decision making authority by the insurers staff. If the underwriting authority does not take needs of the market, e.g. (by implementing unrealistic limitations) may harm the insurers ability to achieve business plans.

UNDERWRITING STAFF EXPECTATIONS;


Underwriting staff always expect that they shall be given underwriting authority to the extent they can perform their functions successfully and efficiently. Low level of authority may demotivate them and conversely too much authority without proper training can cause demotivation and can result into acquisition of business which has not been properly priced or underwritten. Some managers may be reluctant to increase the underwriting authority due to fear of its misuse. However, if the authority is increased it should be monitored by certain control procedures, such as; Understanding each individuals experience and knowledge; Periodic review of their application of underwriting authority; Appropriate training; and Measurement of risks by the internal audit team.

Head office or Regional office underwriters, who are involved in more complex cases, have the highest authorities. Similarly major branches underwriters have also the same authority as of

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Ei09mba125 head office. Small branches should have authority according to the needs of the market, normally less than major branches. For delegating authority there is a role of training and acquiring professional qualifications. CII is playing its role with appropriate study units and diplomas. Global business also requires appropriate authority by the underwriters to meet with the demands in those countries where they operate.

CONTROL PROCEDURES;
An underwriting control framework sets limits to the underwriting authority of each subsidiary, branch, head office manager and individual underwriters through out the organization. Framework should be properly documented so that each underwriter is aware of the extent of their personal authority to avoid inadvertently accepting risks that are outside that authority. For example, (not to accept risk for more than 12 months without approval of head office). For small organizations underwriting authority may be; Maximum gross and net line limits; Territorial scope; Classes of business to be accepted; and A list of excluded authorities, e.g. 1. appointment of managing general agents with delegated authority; 2. long-term policies; 3. reinsurance acceptances; 4. any risks, such as war risks or terrorism, excluded from all currently issued policies; 5. fronting for other insurers. For larger organizations with branch structure underwriting guidelines may be; Premium rates to be applied to each standard risk with detailed classifications table. Endorsement wordings to restrict cover; Detailed directions on pricing, e.g. property theft risks in certain districts may be accepted only subject to a requirement that locks of an accepted standard are fitted to all external doors and windows. Underwriting by computerized systems provide alternative route to control and uniform and standard underwriting. This approach has made the biggest impact on personal lines with high volume. Control framework for underwriting operations may fall under the following headings;

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Ei09mba125 Control of underwriting acceptance through a system of underwriting authority limits and guidelines; Control of exposure aggregation through a system of risk identification measurement and control requirements, including reinsurance; Control of pricing through limits of authority and price monitoring; Control of insurance cash flow through formal procedures for premium collections (sometimes maintained as a separate, distinct function); Control of agency authority through contractual requirements; Control of claims handling procedures through claim payment authority limits and guidelines (some claims/underwriting functions are rigidly separated); Control of claims reserving through independent actuarial analysis; Control of regulatory compliance through independent review; An overall independent assessment system to audit compliance with the controls listed above.

CONTROL OF UNDERWRITING RISK ACCEPTANCE; UNDERWRITING AUTHORITY;


Underwriting authority is the extent of decision making given to an individual underwriter or group of underwriters. This limit may vary due to; Class of business and risk profile; The insurers attitude to the risk in general; Insurers confidence in the ability of each underwriter. Growth and profitability objectives; The classes of business it wants to underwrite; Its reinsurance protection Skills, experience and knowledge of each underwriter.

Insurer determines the underwriting authority to be given to the individual keeping in view;

Too restrictive authority may results into an insurer from achieving the business objectives and too lenient will threaten its success. The right balance between these two is required. Example of underwriting authority in commercial theft insurance may be; Maximum sum insured 100,000 pounds Page 46

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Ei09mba125 Excluded goods Ferrous metal & computing equi Maximum aggregate discount (For size, security and claims Experience) off the insurers Book rates; 30% Jewellery, precious metals, non-

In response to market needs, insurers increasingly want to allow front line staff to make most decisions. This means that insurers need to establish systems of control which, whilst not inhibiting the application of individuals; underwriting authority, allows management the opportunity to ensure that the correct underwriting decisions are made. The methods of control will depend upon the individual circumstances in each insurer, with reliance usually placed on exception reports generated by computer systems, using information recorded by the underwriters. This is created to highlight decisions which appear outside an individuals underwriting authority, allowing management the chance to identify and address potential errors or training needs.

LIMITATION OF UNDERWRITING AUTHORITY / UNDERWRITING GUIDELINES


Underwriting authority can be decided on the basis of all or a combination of following factors; PREMIUM RATES; Rates published in underwriting guidelines manual for use to provide quotation on behalf of the insurer. Underwriter may be given authority to vary them by % shown in the said manual. In non-standard case underwriters allowed using judgment method using rules developed by the insurer. AGGREGATE PREMIUM; A maximum premium, either across all classes or with different limits per class of risk, may be fixed as an authority limit for individual cases to be decided by the individual underwriter or for the total premium which may be accepted in a given accountancy period. Note that unlimited premium authority may be possible from writing due to the absence of regulatory approval. CLASS OF BUSINESS; Authority which was given by the FSA to underwrite business in the market i.e. one risk or contribution of various risks. Page 47

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Ei09mba125 TYPE OF BUSINESS; Within each class of business what type of business is preferred e.g; Actively seeking motorcycle business, whilst most motor insurers avoid it; Insuring cargo business rather than marine hull; Commercial property insurance preferred to commercial liability.

Points to note; The insurer may balance the risk portfolio by ensuring that the premium income and potential profit is kept within parameters. Each insurer determines its preferred risk profile and may reject business that does not meet the set criteria.

FRONTING;
Fronting means to accept the risk on behalf of another company who is not authorized to write the insurance directly or may not be sufficiently well known to market the insurance successfully. Fronting is used in many countries, where the level insurers are trying to develop their local market but yet have no expertise to underwrite complex and high valued risks such as petroleum refineries. TERMS AND CONDITIONS; The creation and maintenance of policy wordings cover two principal areas; Standard policy wordings, with a range of pre-printed endorsements and warranties to suit the needs of individual risks; Policy wordings specifically written for a particular risk or orange of risks, usually introduced by a single customer The first group comprises the majority of customer needs, e.g. policies for providing motor insurance. Each insurer develops its own approach to the wordings it uses with regard to its competitive position, the risk it is prepared to accept. The later group of policy wordings requires the underwriter to reflect the unusual or unique aspect of the risk in policy wordings written e.g. a major civil engineering contract where new and unproven technological solutions are incorporated into the contract works. Standard policy wordings endorsements and warranties are widely available to an insurers staff with underwriting authorities.
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Ei09mba125 Underwriters should have access to instructions detailing procedures and standards that apply to; New, mid-term and renewal underwriting; Risk classifications; Policy period and authority to extend; Layering of risk/acceptance of re-insurance inwards.

Standard policy deductibles may be variable depending on individual authorities. For unacceptable risk insurer provide guidelines to underwriter e.g. asbestos liabilities.

CONTROL OF EXPOSURE AGGREGATION RISK MEASUREMENT


Insurance risks are expressed in terms of the expected frequency and cost of claims and the potential variability of those measures in a particular accounting year.

IDENTIFICATION AND CLASSIFICATION OR RISK


Risk aggregation can be classified in many ways. The following classifications are intended to help students to appreciate the subject through a logical approach; The close proximity of risks insured on separate policies, such as the goods of several different companies stored in the same transit warehouse, or the personal accident risk of several individuals traveling on the same aircraft. The spreading from one building to an adjacent building, or pollution/disease spreading. Natural catastrophes such as storm or earthquake affecting many properties, vehicles, caravans and boats in one geographical zone. Zonal aggregation such as a violent storm tracking across several regional zones. Other events such as an aircraft crashing into a built-up area, rioting or explosion; all three affecting many properties as well as having further potential to aggregate with cover under personal accident, life and liability insurances. As well as risk aggregation arising from individual accidents (bullets 1 and 2) and from specific events (bullets 3-5) there exist the possibility of several such accidents or events in a single accounting period. This can be classified as annual risk aggregation.
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Ei09mba125 Risks which can become pervasive (increase gradually) over a longer period, such as economic recession, which leads to; 1. a substantial increase in theft and other crime-related claims for a period of several years until the economy turns; and 2. a manifold increase in credit risk or an increase in unemployment affecting creditor, trade credit, mortgage indemnity and mortgage payment protection insurances. Other pervasive risks include gradually developing diseases such as deafness affecting Employers Liability Insurer and physical abuse effecting Personal Lines insurers.

Retrospective risk which arises from legislation and/or social inflation. These risks might apply to a liability insurance portfolio including motor where the total estimated settlement cost of all reported claims outstanding can be several times the premium from a single years trading because such claims may take many years to settle. Few insurers have a solvency margin as high as 100% of premium to absorb retrospective risk of this magnitude.

Social inflation: Courts may increase liability awards at a much higher rate than the rate of inflation. High inflation can be as serious as recession, or more so far a long-tail insurer.

Operational controls are needed to establish an effective process for classifying the risks arising under all policies which each separate geographical zone in which the insurer operates, under each of the headings above. Once all risks have been classified, the central framework requires underwriters to identify the maximum claim potential for each classification per zone. However annual and longer term pervasive e risk aggregation is usually controlled centrally by the insurers actuarial function or by employing a specialists risk measurement consultancy which may be supplied as part of the service offered by a major reinsurer or reinsurance broker.

RISK CONTROL
There are four stages of risk control as under; Initial measurement of gross aggregate exposure. A centralized functional head, such as the insurers general insurance actuary, who maintains the comprehensive risk classification and receives updated measures of each aggregation on a regular basis.

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Ei09mba125 To ensure that each gross risk aggregation is limited so that it bears a sustainable ratio to the insurers solvency margin. In other words, the insurer uses the process to determine how large a loss event can be sustained without needing to raise more capital. To limit the insurers net risk exposure to the level sustainable from current capital.

Operational control to limit gross and net risk aggregation can be summarized as follows; Restricting exposure (or premium written) for a geographical zone/business class. Pricing to encourage shifts in the portfolio from high aggregations of risk towards zones or business classes with low current aggregates. Imposing annual policy aggregate limits to restrict the aggregation from any one claim limits, for example professional indemnity covers up to 250,000 pounds any one claim, limited to 1,000,000 in the policy period. Accepting some risks only in proportion to less exposed risks, such as allowing an agent to issue only one policy in an exposed zone for every ten issued elsewhere. Accepting some risks as part of a package only, for example insuring liability only if the property risk is insured at the same time. Imposing minimum deductibles or excesses for certain risks. In extreme circumstances, withdrawing from a class of business in a certain territory. This is more likely where government regulation prevents using other methods, such as bullets 1-6 above.

REINSURANCE CONTROLS
Insurer set lower net acceptance limits for each type of risk satisfying their gross acceptance criteria. The difference between gross and net limits is achieved through reinsurance protection. An example of the application of reinsurance is provided by the following; Sum insured, for a wide-bodied jet airliner, of 30m pounds. The insurers gross acceptance limit is 5m pounds for an individual airliner; and The insurers net acceptance limit is 1m pounds for an individual airliner.

PRICING CONTROLS
Pricing policy is concerned with achieving balance between insurers objectives of profitability and retaining the volume of business in each class of business.

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Ei09mba125 Profitability is measured in terms of earned premium plus related investment income less business acquisition and administrative expenses, reinsurance premiums, commission payable, levies, costs of membership of mutual organizations, claims payment and the cost of handling claims. Standard rates are published for internal underwriters or where the insurer allows delegated authority e.g. intermediaries. Rates variations are allowed to underwriters up to maximum amount specified as per his authority. Non-standard rates are used where published standard rates are not available and are used by only experienced and knowledgeable underwriters. A lot of information is available for the Management to measure that rates are reasonable and can be charged in the light of trends in claims experience.

MANAGEMENT INFORMATION AND PERFORMANCE MONITORING


Information is usually retained in a computer based system for use by the concerned and analyzes it as per requirements. Management information in addition to determine underwriter decisions is used for performance measurement such as; Individual policy, class or portfolio segment performance, Agent or regional performance; and Individual underwriter performance.

The intention behind performance measurement is to identify trends. Positive trends can be encouraged, for example, by encouraging an agent to place more business of a preferred class with the insurer, or to address negative trends such as poor performance from a geographical area of a particular class of business.

COLLECTION OF PREMIUMS
Timely collection of premiums by an insurer is very important for profitability and to avoid b ad or doubtful debts. Late payment of premiums reduces the investment income. For personal line business, premiums should be paid at least before the insurer is prepared to go on risk. Commercial line insurance insured may justify a 30 days credit period. Largest account may be able to receive 3 months credit from the insurer, so that the broker can grant credit to their customers.

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AGENCY APPOINTMENT
The selection and recruitment of agencies is very important to the underwriters performance and profitability of insurer. In selecting and recruiting agents, insurers are seeking; Agents who will provide worthwhile volumes of potentially profitable business, to allow the insurer opportunity to achieve its overall business objectives; Agents who will represent the insurer and its customers in a manner consistent with any legislative and regulatory requirements which exist in the country, e.g. the current ABI Code of Practice for Sales of General Insurance, which is replaced by FSA jurisdiction in January, 2005. To minimize exposure to bad and doubtful debts, recognizing that the agent may hold on credit significant aggregate premium due to be paid to the insurer; Agents who are prepared to work within the terms of trade agreed with the insurer. Each insurer has a standard agency terms based on past experience feedback from intermediaries and of other insurers. But it differs from insurer to insurer.

DELEGATED AUTHORITY Underwriters authority is delegated to the insurance brokers, insurance company agents, banks and building societies. Delegated authority allows the insurer to avoid duplicate efforts. Such authority may involve; Quotation; Acceptance of new business within standard guidelines and issuance of related policy documentation; Administration of mid-term adjustments, and Renewals for personal lines and smaller commercial lines business.

Delegated authority enables the distribution channels to provide a faster service to customers. It is to ensure that the delegated authority not results into accepting the unacceptable risks. Therefore, appropriate control is required which comprise? Sampling a percentage of the transactions undertaken by each business introducer so that the insurers own staff can check that the underwriting decisions are within the delegated authority and agree with the decisions which they would have made in identical circumstances;

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Ei09mba125 Regularly visiting the business introducers offices to audit files on which delegated underwriting has been exercised and reviewing as described above; and Involving the business introducers staff in insurer-arranged training programs to ensure that a consistent approach to underwriting exists between both groups of staff.

REGULATORY COMPLIANCE
Insurance is subject to general legislation in all countries and often also to insurance specific legislation. Typical legislation states the competence and capability required of directors and senior officials of insurers and business introducers. There is a requirement for insurers as to the minimum solvency fund and, in some countries, restrictions as to the type or nature of assets that can be included within the solvency fund calculation. Authority to trade may require government permission based on an application to the appropriate government agency. In many countries, policy wordings are subject to the approval of national or local governmental agencies. In addition, the type of risks which are insurable may be controlled by government decision. Legislation such as the UKs Companies Acts and Insurance Companies Acts (the latter of which was replaced by the Financial Services and Markets Act 2000) requires insurers to make annual returns of financial information in a prescribed format within certain timescales after the close of the annual trading period. Failure to comply with legislation can result in the insurer being fined, if found guilty, and in certain circumstances, the directors and senior officials being banned from continuing in their roles. In the extreme, the insurer can be forced to cease to trade.

AUDITING UNDERWRITING POLICY

PROCEDURES Having set the authorities, an insurer must put procedures in place to ensure that the authorities are used correctly. TRAINING

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Ei09mba125 Training is required while giving the authority or is there is any change. An example is continuous professional development (CPD) scheme required by the holder of CII qualifications.

USE OF AUTHORITIES Internal delegated authority may be; The same authority to everyone who occupies a certain job level. This has the advantage of simplicity. However, the disadvantage is that some staff may not yet be sufficiently experienced to use the authority fully in the way intended. Authority is allocated to an individual on the basis of their skills and experience. If the individual occupies a job in which they can be fully effective only with more authority, this becomes an issue for training and personal development. This personal underwriting authority approach is often preferred as it meets the needs of both the insurer and individual member of staff. DELEGATION At head office level authority may be 100% to the underwriters in each class of business. Down the level authority is not 100% but restricted for each tier. UPWARD REFERRAL Upward referral is used for decisions falling outside the authority of someone lower in the hierarchy of experience. The referral process needs to operate in a manner which ensures that a prompt response on the referred case is given to the intermediary or customer otherwise there will be an adverse effect of losing the business to a competitor. MONITORING Monitoring of given underwriting authority is very essential for successful and profitable business. Within a team a number of monitoring approaches are available, which are as under; Establishment of best practice guidance notes for underwriters; Additional authorization signatures on cases or risks outside individual underwriter acceptance criteria; Self-audit at renewal; and Page 55

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Ei09mba125 Profitability review of business acquired. Answer local underwriters questions; Analyze data to identify trends and potential areas for action. Seek answers to local review findings; Evaluate staff for career development purposes; Strengthen the relationship between head office and branches; Refer issues to other interested areas, e.g. surveyors; Advise on training for branch staff; Consider the effectiveness of national guidelines on underwriting strategy and tactics; Promote good practice and procedure.

Reviews by the head office team provide an opportunity for the following additional activities;

AUDITORS The application of underwriting authority is also addressed by the insurers internal and external auditors. Auditors may not have detailed underwriting knowledge; they perform a useful role in giving the board an independent view. The qualification for external auditors is usually set out by legislation. The external auditors are appointed at each annual general meeting of the company, to report to company members not the companys directors on the company accounts that they have examined. In the UK, they have legal responsibilities in the following areas; Ensuring that full and accurate accounts, which present a true and fair view of the companys financial performance, are produced within six months of the end of the financial year; Qualification of any accounts which they believe does not reflect a true and accurate picture of the financial health of the company. If the auditors are not satisfied as to the underwriting performance of the insurer, this would be disclosed to the management and board of the insurer in the management letter from the auditors, which accompanies their official signing off of the annual accounts. The management letter would detail all matters of policy or principle and major concerns which arise as a result of the audit. Major concerns would include, the example, underwriting rates which appear to be inadequate in the light of claims experience. In reviewing underwriting performance, auditors examine the adequacy of claims reserves, including IBNR reserves, and relate them to the underwriting results published. They comment on the run-off of previous years reserves and
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Ei09mba125 the impact that such favorable or unfavorable run-offs have on the current years trading performance.

AUTOMATED UNDERWRITING SYSTEMS


Insurers are increasingly using automated underwriting systems to process new business applications, mid-term adjustments and renewals. There is considerable cost involved in developing automated underwriting systems. However, there are many advantages for the insurer. The insurer can apply a consistent underwriting approach. Information is still keyed into the system manually. The system supplies the underwriting rules and acceptance eligibility held in its memory. It allows insurers to concentrate on acquiring and servicing customers. Underwriters are employed to monitor the performance of the portfolio and to recommend changes in the underwriting rules and acceptance criteria to the management. Presently automated underwriting indicates that the use of manual underwriting, other than for the more complex risks, may be ending. UK insurers are accepting substantial volume of private motor business through brokers using automated underwriting rules held on the brokers computer systems. When the quotation is accepted these cases are transferred to the insurer by Electronic Data Interchange (EDI) and are accepted for policy issue by the insurer without any re-underwriting. Once a customer has made a purchase decision, the details required by the insurer, are captured on the brokers system, are transferred to the insurers system. The transfer is usually made overnight. The information transferred is used to create customer and risk records without the need for re-keying information. This allows lower unithandling costs and ensures that common records exist between the broker and insurer. Sometime, the insurer allows the broker to produce insurer authorized policy documentation on receipt of the EDI transferred information.

IMPORTANCE OF AUDITING UNDERWRITING POLICY


By properly auditing underwriting policy, management can determine whether targets and goals are being achieved and why, it can then be decided how to maximize and accruing benefits or minimize any disadvantages, by reacting promptly.

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CHAPTER - 6
BUDGETING AND MONITORING RESULTS
INTRODUCTION
Insurers issue policies for 12 months or more to the policy holders to provide financial assistance for future unexpected losses. In these respect insurers requirements are; Managing a general insurance account. Selection of class of business Design of products. Establishing the price Managing the exposure (risk of future losses). Implementation of operational control.

For above mentioned activities insurers work on past data and other modern techniques. I.T. has played a very vital role in analyzing the data and reaching at results. Predictions are always estimated and not exact and adjustments are made for unpredicted or catastrophe losses such as creating special reserves over and above predicted results. In spite of all this insurers are required to monitor their accounts on day to day basis and on annual basis and this are done by budgeting and monitoring results to compare. I.T. is helpful fir instant data on business results and to take prompt corrective price or other action.

TRENDS
MONITORING RESULTS AGAINST BUDGETS For monitoring results against budget accurate information on account performance and results is required. CLAIMS DATA In present days a lot of claims data is provided to Claims Management and Underwriting Management but the results in such data may not be up to date or correct. However, by the use

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Ei09mba125 of corrective measures and timely action, deviations can be kept within acceptable limits. Claims data is normally based on; Actual payments made on settled claims. Estimates on claims notified but not settled. Incurred but not yet reported claims.

INTERPRETATION Interpretation of data means comparison of monthly claims costs against budgeted targets and to decide whether corrective action should be taken. CORRECTIVE ACTION If the results are unexpected on any account, whether corrective action should be taken such as change in premium. But it should be kept in view that such action should not harm competitiveness in the market.

IMPLICATION FOR CLAIMS MANAGEMENT In this respect attention of the insurer is required for claims handling functions and staff training and development. Any significant trend in claims costs will therefore be matched with appropriate action. IMPLICATIONS FOR UNDERWRITING MANAGEMENT For underwriting management trends in claims costs influence number of decisions such as; Whether or not to accept particular risks. The terms and conditions to apply. The proportion of risk to underwrite (with or without reinsurance) and The premium required.

Past claims data helps in predicting future losses and allowance is given for other factors such as inflation etc. To enable underwriting management to respond to claims trends it requires; Whether or not to accept particular risks; The terms and conditions to apply; The proportion of risk to underwrite (with or without reinsurance); and The premium required. Page 59

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Ei09mba125 To enable underwriting management to respond to claims trends it requires; Good lines of communication between claims and claims trends it requires; Procedures for identifying potential claims problems before renewal; Supportive IT systems which present clear and accessible data to claims and underwriting functions and facilitate joint and separate action; and Strong internal reviews procedures so that likely claims can be anticipated before any policies are issued following amendments to company underwriting terms and conditions.

PREMIUM CHANGES
When rates or exposures change, premium income can be expected to follow. The correlation between underwriting decision-making and premium levels can be weaker than expected because of the effect on buyer behavior. Benchmarking, where the underwriter predicts then effect of the change, provides a sound basis for monitoring the actual impact. RATE CHANGES Premium rates can change over period and average premium is measured by underwriting period (week, month, quarter etc.). For example, in private motor insurance, policyholders and vehicles age, while drivers move up and down the NCD scale and may attract renewal discounts. One way to keep premiums low is to reduce the cover benefits purchased so deductibles can be increased or limits of indemnity reduced. EXPOSURES Since every action involves a reaction; a key to success is to maintain a momentum of continuous change which achieves the desired market position by anticipating the effects of past actions and customers reaction to them. Example of some changes and their possible impact are given below as a sample; Household rating based on bedroom count. Where the number of bedrooms is used as a measure of household insurance exposure rather than sum insured, it is likely that those policyholders with expensive houses but few bedrooms will be more likely to remain with the insurer than those with smaller houses but many bedrooms. Therefore, the average premium will fall following a change from a sum insured basis to a bedroom basis. This problem can be met with by distribution of customers on
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Ei09mba125 geographical basis i.e. houses at more expensive areas should be charged more premium. It is very important to assess exposure in meaningful ways. Those insurers who did understand how exposure was changing realized that their premium rates were falling in real terms and were able to take corrective action before it was too late.

MONITORING RESULTS
USES OF MONITORING

COMPARING ACTUAL PERFORMANCE TO BUDGET An important reason for monitoring is to compare performances achieved with budget targets. Setting of performance objectives for insurance accounts presents substantial problems which mean that it is crucial to appraise progress at regular and frequent intervals to detect variances. TARGETING SPECIFIC BUDGET AREA Performance is required to be monitored at several levels and or locations, and it can vary due to; Organizational structure Division of responsibilities, Nature of departments and other units, Special project activities.

Therefore results will be monitored by a number of different individuals for markedly different reasons. MOTIVATION OF STAFF Targets are set for the most staff members i.e. a business centre is tasked to achieve 10 million pounds gross written premium income. Therefore, for motivation staff should be provided with incentives which will generate commitment to achieving goals and targets. STRATEGY AND PLANNING Budgetary activity is primarily focused on the annual planning cycle, but from day one the flow of information also makes an invaluable contribution to future strategy, policy and business planning.
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REPORT CONTENTS
ITEMS TO BE MONITORED Different levels of management within and insurance company will be making different types of decisions and will need to be provided with the appropriate support material. For example, a board level directors will be concerned with general levels of profitability, control of downside risk (e.g. through catastrophe reinsurance) and strategy implementation. Board and senior management will compare results with budgets. At the operational level, measurement will be against benchmarks, targets and last year/month/week. BOARD LEVEL REPORTING Board reporting will tend to be net of all commissions and reinsurance, although some data will be available at more than one level. It will be available at least quarterly and possibly monthly, especially where information systems are sufficiently powerful. Items to be monitored are; Growth; gross and net; Loss ratio; gross and net; Underwriting margin; Business mix; by class, by distribution channel, geographically; Exposure accumulations; Competitive positioning; how the company measures up to competitors; Profit expressed as a percentage of capital; and Solvency: the relationship between capital and exposure to risk, usually expressed in terms of premium income. REPORTING TO UNDERWRITING MANAGERS Growth by product; Retention rates; New business flow analysis; Lapse flow analysis; Loss ratios; Claims by type; Reserve consistency; Rate changes; Commission rates; Page 62

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Ei09mba125 Expense ratios; Exposure accumulations; and Market share.

OPERATIONAL DATA This level requires regular reporting, at least monthly and often weekly. A relatively small number of measures are involved, as follows (usually gross of reinsurance and commission); Loss ratio by underwriter; Class; Loss ratio by agent; New business; Lapses; Retentions; Rate increases; and Work backlogs (new business/claims/outstanding post)

TECHNIQUES FOR MONITORING UNDERWRITING RESULTS


ACTUAL LOSS RATIOS The term actual mean the values extracted from the computer system or claim files without further adjustment or analysis. Paid loss ratios are more objective than reported loss ratios since reported include case estimates. The data being considered should be relatively homogeneous, i.e. it should only contain claims with similar characteristics. Therefore, it is preferable to separate data by major types of claim. BENCHMARKING The information available with the underwriter should of such nature to understand whether the underwriting is on track to deliver the plan and whether there needs to be a change in underwriting policies or in what underwriting action is being carried out. The basis of benchmarking is to generate a set of expected values for a given monitoring period. ULTIMATE LOSS RATIOS

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Ei09mba125 Ultimate loss ratios mean those ratios which are difference between actual loss ratios minus those ratios which have to be transferred under the reinsurance program. More sophisticated IT systems will not only produce results net of reinsurance (i.e. gross written premium and net earned premiums) but also comparable claims data. RATE CHANGES Tracking the average rate, comparing the premium received for a portfolio of renewals compared with income from the same policies twelve months ago, provides some indication of potential profitability levels. Tracking the premiums and rates obtained for renewed business compared with lapsed and new business can provide an insight as to the likely level of profitability being generated by current underwriting. Modern computer systems allow such comparisons to be made very quickly, possible on a daily basis. Where the premium exceeds the claims, the underwriting is profitable while, where the premium is less than the claims, the underwriting is unprofitable. REVENUE STATEMENTS Certain information if required for tracking underwriting decision making. However, additional information is required such as fixed and variable expenses and investment for revenue statements. SEGMENTAL REPORTING Dimensions reporting system include results by year, class, product, underwriter, branch, agent and territory. A multi-dimensional report covering the business written by a particular underwriter by class, separated by year, may be appropriate. Large claims and the definition of what constitutes a large claim become smaller as the extent of detail becomes greater. One solution is to focus on claim frequency on the assumption that the average claim is a random variable independent of the factors by which reporting is being undertaken. Level underwriting results are monitored; they should always support the question: so what do we need to do now?

DIFFERENT TYPES OF MONITORING PERIOD


There are four main types of monitoring period, namely: Policy year; Underwriting year; Calendar year (most commonly used in practice); and Page 64

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Ei09mba125 Accounting year.

Example data Policy details Policy period Policy A 1/7/00-30/6/01 1/7/01-30/6/02 1/7/02-30/6/03 Premium 1,000 1,500 2,000 Date of loss 1/12/01 1/3/02 Claim details Value 100 250

Policy B

10/4/99-9/4/00 10/4/00-9/4/01 10/4/01-9/6/02 10/6/02-9/4/03

5,000 4,000 5,000 4,500

1/7/99 1/2/00 1/5/01 28/2/03

1,000 2,500 10,000 3,000

Policy year tracking is suitable for addressing the performance of individual policies; its form is attractive for this purpose as the information being considered would be familiar to both policyholder and underwriter. At this level of detail, the information would only meaningful for larger policies. POLICY A SUMMARY: Period 1/7/00-30/6/01 1/7/01-30/6/02 1/7/02-30/6/03 Total Premium No. 1,000 1,500 2,000 4,500 0 2 0 2 Claims Value 0 350 0 350

UNDERWRITING YEAR The underwriting year is the year in which a policy incepts or renews. Using the two policy example underwriting results will come as under; Underwriting Year No. of Policies 5,000 Premium No. of Claims 2 3.500 70% Page 65 Claims value Loss ratio

1/1/99-31/12/99 1

HAILEY COLLEGE OF BANKING & FINANCE, UNIVERSITY OF PUNJAB

Ei09mba125 1/1/00-31/1200 2 5,000 6,500 6,500 0 3 1 0 10,350 3,000 0% 159% 46% 1/1/01-31/12/01 2 1/1/02-31/12/02 2

CALENDAR YEAR
Under the calendar year basis of monitoring results, claims are allocated to the relevant year on the basis of the date of loss.

Calendar year 1999 2000 2001 2002 2003

No. of claims 1 1 2 1 1

Value 1,000 2,500 10,100 250 3,000

ACCOUNTING YEAR It is similar to the calendar year. The period will depend on the financial year, for example, it may be 1 October -30 September rather than 1 January -31 December.

USE OF INFORMATYION DERIVED FROM MONITORING


The prime use of the information is to improve the business. Information must pass the so what? test: the information itself should drive action. Some examples of possible ways in which the monitoring should be used follow: GENERAL PRICING LEVELS Information is required for underwriting decisions to improve future decision making as well as identify corrective action required. Also this can be reinforced by comparing the actual outcome of events with those assumed for planning or budgeting purposes, with a view to taking corrective pricing action. Business is dependent on the supply of capital and its ability to continue to have access to that capital is dependent on the level of returns being generated. The extent to which pricing levels support that capital should be continually reviewed in order to answer questions concerning the

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Ei09mba125 viability of the business, as well as any remedial action required or opportunistic activities identified to exploit the particular profitable segments. MARKETING OPPORTUNITIES Maximizing the price where monitoring shows that the insurer is extremely competitive and could attract nearly as much business with slightly higher prices. Opportunities which have been overlooked by competitors in generating profit may also be discovered as well as the chance to develop specific products which will attract business in such areas.

DEFENDING PROFITABLE SECTORS The information systems should identify those areas which are particularly profitable and therefore potentially vulnerable to competition. Responsive action will include the introduction of extended policy periods to retain clients for longer. DIFFERENTIAL PRICING The information system should enable pricing to become more accurate and hence improve risk selection and reduce the extent of anti-selection through charging inadequate prices for higher risks

IDENTIFYING TRAINING AND DEVELOPMENT NEEDS


Training of underwriters is required in those areas within the business which would benefit from additional training. ALLOWANCES Allowances include pipeline premium and incurred but not reported (IBNR) claims. PIPELINE PREMIUMS It is the allowance for the difference between the premium currently debited for a portfolio of risks and that ultimately expected to be received. Sometime credit period is given to the insured due to competition in the market. Pipeline premiums may be due to mid-term changes and adjustments for changes in exposure or claims related adjustments. INCURRED BUT NOT REPORTED CLAIMS (IBNR)

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Ei09mba125 IBNR claims are those which the insurer has not yet received but which will be presented in due course, since the incidents that will generate the claims have already occurred. For example, a motor accident on 30 December, the policyholder may have been injured and be in no position to present a claim until released for hospital a week later. IBNR numbers and values have to be estimated by references to historical claims reporting and development trends. INCURRED BUT NO ENOUGH REPORTED CLAIMS (IBNER) It covers deficiencies in the system of claims reporting. It covers shortfalls in provisions for outstanding claims reserves. These would occur where the company suffers late notification of reserves, where amounts reported are understated or when the insurer has insufficient information on which to assess adequate reserves.

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