Case Study A Non-Life Insurance

Transcription

1 Case Study A Non-Life Insurance

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3 1. Background The readers of this case study should consider that they are in the first half of In 1991, the year considered here, the global economic situation is sluggish. General economic situation As a consequence, in the economy of the country concerned, growth is slowing down (GDP growth rate: +1.1%), corporate investment has been declining and unemployment is increasing. However, overall stability has been maintained, with inflation under control at 3.5% and a reduced trade deficit. Interest rates are high: the yield on seven-to-10-year government bonds is 8%, with an inverted yield and lower returns on long-term investments compared with short-term ones. The stock market index increases by 16% within the year, reflecting a mediocre picture: price volatility and low volume of transactions. In 1991, the turnover of the 626 insurance companies which are licensed in the country (147 in life insurance and 479 in non-life insurance) increases by 10%. Situation in the insurance market Developments are in fact contrasting. Personal insurance (life insurance, health insurance and non-automobile accident insurance) sees a sustained increase of +13%, while the growth of property insurance is levelling out at +5% due to a slowing-down in motor insurance and commercial property insurance. Thus the share of total turnover accounted for by personal insurance rises to 61%. The main risk categories of the non-life insurance market are, in order of size: motor insurance (38% of the total) third-party liability motor insurance has been compulsory since 1958, and in most cases is supplemented by optional motor damage insurance; property insurance (25% of the total) covers damage to private individuals property especially within multiple risks on dwelling contracts, damage to commercial property, and damage to agricultural property; health and accident insurance (20% of the total). The other categories, for example transport and general third-party liability, are much smaller. Overall, the non-life insurance market yields a low profit in the balance sheet (+2.4% of the premiums), which is decreasing. This profit is solely from capital gains (realised on sales of assets), and offsets the operating loss (-2.4% of the premiums). This loss is due to a high cost of claims, which cannot be compensated for either by premiums or by financial income which is stagnating. Following a year in which severe storms led to costly payouts for the insurers, the non-life insurance market continues to deteriorate in Concerning damage to private individuals property, the profit and loss account is balanced. However, there is an increase in large insurance claims for damage to IAIS Case Study A Non-life Insurance 3

4 industrial property and for industrial liability; but at the same time the current premiums are insufficient. In motor insurance, the annual increase in premiums (+3%) is well below the level needed to cover the increase in the cost of claims (+6% without administration costs). The number of vehicles is actually increasing, but only slowly at +2% a year more than four households out of five own a car. Moreover, the average motor premium increases by 1.3%, i.e. significantly less than inflation (3.5% a year), due to intense competition between insurers. 40% of the motor insurance market is held by mutual insurance companies which do not have intermediaries to pay commission to, thus allowing them a competitive management cost ratio (25% of premiums) compared with that of their competitors which do pay intermediaries (35% of premiums). The market is very concentrated: 17 out of 154 licensed motor insurers earn 75% of the premiums. With regard to the cost of claims in motor insurance: the number of bodily injury claims has fallen (-8%), offsetting the increase in their average cost (+5% a year); there is a strong increase in the average cost of material accidents (+7.5% a year), whereas their number decreases only slightly (-1.5% a year); the number of vehicle thefts is soaring at an alarming rate. Legal constraints and regulations applying to the insurance market Insurance companies must be licensed for each type of activity they perform, on the basis of business plans, and may not sell life and non-life insurance simultaneously. Two legal forms of company are allowed: the limited joint stock company; and the mutual insurance company, which may or may not pay intermediaries, and which, for non-life insurance, collects fixed or variable premiums. 1 Premiums are not regulated in non-life insurance. Technical provisions The technical provisions must be sufficient to allow insurance companies to meet all their obligations towards the insured or insurance policy beneficiaries. The companies must, at all times be able to justify the level of provisions. The provisions, which appear in the balance sheet on the liabilities side, are equal to the amount of liabilities resulting from concluded insurance agreements. Technical provisions are calculated without deducting the reinsurer s share transferred to specialised or non-specialised reinsurance companies. There are two kinds of technical provisions: provision for outstanding claims and unexpired risk provision. 1 Variable premiums the insurer may ask the insured persons to pay additional premiums at the end of the year if its resources are insufficient. Legally, the insured persons have to pay these additional premiums. 4 IAIS Case Study A Non-life Insurance

5 The provisions for outstanding claims are the estimated values for expenses relating to the compensation itself and to the costs required to cover incurred but unpaid claims (both internal and external claims). Provisions for outstanding claims The provision for outstanding claims is calculated according to the year(s) in which the claims arose. Reported losses are calculated on a case-by-case basis, with the cost of each case including all individualised external expenses. The amount is then increased by a statistical estimate of the incurred but unreported losses. With regard to motor vehicle insurance, the claims incurred within the last two financial (reporting) years are calculated using the following two methods: by referring to the average cost of the claims incurred in the two previous financial (reporting) years; by adjusting the settlement rate of claims by an insurance company in a given year to the rate recorded in previous financial years. An individual valuation can also be performed, in which case the highest value is used. For those who are familiar with the European directive of 1991 on settlements in insurance companies, the unexpired risk provision has been divided into two provisions; (i) the provision for unearned premiums (which regulates the premiums covered by the period of insurance protection between the date of the financial statement and the nearest agreed expiry date) and (ii) the provision for unexpired risk in the strict sense of the term, used only if as a result of excessively low tariffs the provision for unearned premiums proves to be insufficient to cover future claims and related costs (in the case of entire agreements where premiums are paid in advance, they are used for covering the cost of claims and costs resulting from those agreements between the financial statement date and the nearest expiry date of the premium payment or the agreement itself). Unexpired risk provision Unexpired risk provisions are calculated by multiplying the premiums assigned for transfer by a coefficient. The premiums assigned for transfer are calculated pro rata in relation to each agreement category, agreement by agreement, or according to statistical methods. The coefficient is obtained by establishing a relationship between (i) the cost of claims and administrative costs borne in the last two financial years and (ii) the gross premiums earned in those two years. The coefficient is calculated separately for each insurance agreement category. The assets eligible for covering the technical provisions must be valued at their purchase price. The limits on these assets (as a percentage of the technical provisions they cover) range from 65% for shares to 40% for real estate to 10% for loans; for each securities issuer, the ceiling is 5% (state institutions excepted). IAIS Case Study A Non-life Insurance 5

6 Claims on reinsurers can cover gross technical provisions only if there are guarantees of recoverability (for instance, if reinsurers pledge assets as collateral off the insurer s balance sheet). 2 Solvency The solvency margin established by a non-life insurance company must be greater than the required solvency margin. After deduction of losses and intangibles shown on the assets side, the established solvency margin includes the following items: paid-up capital (or initial fund set up in the case of mutual insurance companies); half of the company s unpaid capital; free reserves unrelated to liabilities; unsettled profits; premium adjustment payments (in the case of mutual insurance companies with variable premiums) maximum of 50% of the required solvency margin; hidden reserves resulting from undervaluation of assets; resources obtained from issues of subordinate loans 3 maximum of 50% of own assets. Solvency margin The solvency margin is calculated according to annual premiums or average annual claim costs; the higher amount is always adopted. In calculations based on premiums, 16% of gross premiums assigned within the last financial year are multiplied by the reinsurance index obtained in the last financial year. This is calculated as a ratio of the losses to be covered by an insurance company (after allowing for reinsurance) to the amount of gross claims (before allowing for reinsurance). However, the ratio cannot be lower than 50%. In calculations based on claims, 23% of the average annual claims costs within the last three years are multiplied by the reinsurance index. The average annual costs for claims in the last three financial years are obtained by dividing the total of losses covered during those three years by 3, allowing for changes in the level of claims provisions to be covered in that period. Sanctions Insurance companies are permanently monitored, on file and on site, by the supervisory authority. If the supervisory authority detects problems, one or more of the following measures can be taken: restricting the free disposal of assets, appointing a temporary administrator, putting the company under the special surveillance of a supervisor who must be immediately informed of any decision made and of its application; as soon as the interests of policyholders appear likely to be put at risk, the company is required to submit a recovery programme for the supervisory authority s approval; that programme should provide all measures appropriate to restoring the company s stability 2 Reinsurers pledge assets as collateral reinsurers put assets in pledge off the direct insurer s balance sheet (they give them to it as security). 3 Subordinated loans loans which may be repaid only with the approval of the supervisory authority. 6 IAIS Case Study A Non-life Insurance

7 and financial position (for instance, raising premiums, cancelling agreements, adapting reinsurance, reducing overheads, increasing capital, issuing subordinated loans, collecting additional premiums, changing the financial policy). The supervisory authority may instruct an insurance company to carry out a particular measure within a set time period. If an insurance company fails to comply with a legal requirement or a statute in the area covered by an audit, or if its activities undermine its ability to meet the obligations it has assumed, or if it has failed to follow an order, the supervisory authority can impose one or more of the following disciplinary actions on the company or its management, depending on the severity of the violation: reprimand; ban on certain activities; temporary suspension of one or more members of the management; transfer of all or part of the portfolio of insurance contracts; partial or complete withdrawal of licence. In all these cases, the supervisory authority will issue its decision after conducting a thorough investigation during which persons responsible for the company s management will be questioned. The supervisory authority can order publication of the sanction at the expense of the company sanctioned. 2. Description of troubled company (non-life insurance) Set up in 1860, Company A is a mutual insurance company with variable premiums, paying intermediaries on a commission basis. General introduction It is well established in the region in which its head office is located, where it generates more than half of its turnover. Traditionally specialising in property insurance (40% of the turnover), the company has independently developed a strong motor insurance portfolio during the last 10 years (also 40% of the turnover); it has thus increased its total production by almost half. The current management team has been in office since The balance sheet and profit and loss account have changed as follows during the past four financial years: IAIS Case Study A Non-life Insurance 7

8 Balance sheet (in thousands of national currency units) Assets prov. Start-up expenses Investments 85, , ,109 94,547 Share of technical provisions incumbent on reinsurers 18,880 20,167 27,266 33,454 Claims on policyholders and intermediaries 9,619 9,706 11,723 10,780 Current claims on reinsurers 960 1, ,578 Short-term assets 4,986 6,684 10,494 19,430 Total 119, , ,174 Liabilities prov. Start-up fund 2,500 2,500 2,500 2,500 Reserves 11,127 13,472 12,915 (1,739) Own funds 13,627 15,972 15, Provisions for losses and expenses 310 1, Medium and long-term debts 4,255 20,323 24,291 32,706 Technical provisions 93,049 95, , ,262 Short-term debts 8,681 7,275 11,984 9,125 Total 119, , , ,174 Figures in brackets indicate negative amounts. Profit and loss account (in millions of national currency units) 1987 % of turnover 1988 % of turnover 1989 % of turnover 1990 % of turnover 1991 prov. % of turnover Turnover Claims Commissions Overheads Financial income Reinsurance balance Operating profit (1.9) (2.3) (1.8) (2.0) (4.3) (5.3) (6.6) (6.1) (14.6) IAIS Case Study A Non-life Insurance

9 Exceptional profit Net profit (0.9) (1.1) (2.2) (2.0) (14.6) (14.6) Figures in brackets indicate negative amounts. The company employs 45 staff. To compete with companies that do not pay intermediaries, Company A has for several years been endeavouring to reduce its overheads. Operation and management The computer system is overloaded, limiting the ability to communicate effectively with agents, as well as leading to duplication of certain operations. The company lacks statistical data for assessing its technical provisions. The accounting operations often require more time than is usual for such a company. The operations network consists of 80 agents based mainly in Company A s local region; they are paid on a commission basis, the rates being in line with those current in the market for companies paying intermediaries. In property insurance, the portfolio mainly consists of private individuals risks, which represent the company s traditional business activity and on which the company has based its recent expansion in motor insurance. Operation of Company A This portfolio is of good quality but is declining slightly, since the premiums of the contracts sold in recent years are lower than those of older contracts with similar guarantees and clients. The company has rightly kept away from the market for risks associated with large firms; it insures only a few small or medium-sized firms, for which competition from the large brokers is not too fierce. This particular part of the portfolio is relatively small, as is the part covering agricultural risks, for which the tariffs are apparently too low. In motor insurance, Company A has been licensed since 1970, but has been expanding mainly since the early 1980 s. Three tariffs are offered: a general tariff, available to all policyholders this is the traditional tariff offered by companies selling their products through agent networks and represents less than 10% of the company s motor insurance portfolio, by number of contracts; a tariff intended for proficient drivers set at 40% below the general tariff, it represents more than half of the portfolio; a tariff reserved for very good drivers who have all their insurance contracts with the company set at 55% below the general tariff, it represents 40% of the portfolio. IAIS Case Study A Non-life Insurance 9

10 The medium tariff is lower than that offered by competitors not using intermediaries and applying the same kind of risk discrimination. Moreover, the policyholders that have been allowed the most favourable tariffs may stick with them when they incur damages for which they are responsible. With this tariff structure, Company A has increased the number of vehicles it insures from 14,000 in 1985 to 20,000 in In a very competitive motor insurance market, this could only be achieved by focusing on the least profitable segments of the market; statistically speaking, Company A s motor insurance portfolio comprises fewer good drivers and more medium-ability drivers than the market in general. But, since Company A s policyholders are slowly opting for more favourable tariffs, the average premiums of Company A s motor insurance contracts have grown little compared with those of its direct competitors. Company A s other products (legal protection, top-up health insurance, etc.), which complete its range, generate a fair, though modest, turnover. These are mostly managed by other insurers which have developed a partnership with Company A in these matters. Company A s reinsurance 4 The general reinsurance programme consists of a 15% quota-share agreement and two excess-of-loss agreements, offering unlimited cover for incidents exceeding 2 million units. In property insurance, there is a surplus reinsurance agreement of 6.3 million units (plus twice this amount payable by the reinsurers). Because the results from previous financial years have been unfavourable to the reinsurers, the costs of reinsurance guarantees have increased for Company A (fall in the commissions received on quota-share and excess-of-capital agreements, increase in the rates of premiums paid for excess-of-loss agreements). 4 Quota-share reinsurance agreements This is a general system related to the entire risk in a sector of the insurance industry under which a direct insurer cedes to a reinsurer the same percentage of premiums for which it obtains the same percentage of claims costs and the payment of a reinsurance commission. The reinsurance commission ensures that the reinsurer shares the insurer's costs; the latter adopts as its sole responsibility sales of policies and management of the entire risk. The commission plays an important role in the equalisation of results, which in turn allows adjustment of both parties share of the profits and losses on the insurance activity. The following commissions can be applied: fixed commission (percentage of ceded premiums); moving rate (based on the ratio of claims to the reinsurer s premiums); fixed commission with the ceding company sharing in the reinsurer s profit. Excess-of-loss agreement Here, the reinsurer intervenes at the level equal to the loss amount. The insurer sets the maximum amount which it can retain in the event of a loss: retention (priority or franchise). The reinsurer commits to returning part of each loss where the amount is higher than the retained amount. The premium transferred to the reinsurer by the direct insurer is not in proportion to the initial premium, but dependent upon statistical calculations based on the losses which require intervention by the reinsurers. Such a system is used especially in liability insurance and generally for all risks covered by unlimited guarantees. 10 IAIS Case Study A Non-life Insurance

11 The cession ratio (premiums ceded to reinsurers/premiums gross of reinsurance) has risen from 28% in 1987 to 31% in In property insurance, the claims ratio (cost of claims compared with earned premiums) has been generally moderate, except in 1990 when there were severe storms. The claims Balance threshold and claims ratio of Company A in property insurance (gross of reinsurance, in %) vate individuals s ustrial risks icultural risks al property risks Balance threshold* Claims ratio end Balance threshold Claims ratio end Balance threshold Claims ratio end Balance threshold Claims ratio end alance threshold ratio corresponding to the maximum claims ratio in excess of which the tariff generates losses. It increases together the financial ratio and decreases together with the management expense ratio. In motor insurance, the claims ratio is high and becoming worse, and will not be able to reach a technical balance: Balance threshold and claims ratio in motor insurance (in %) or damage rd-party liability al motor insurance Balance threshold Claims ratio Balance threshold Claims ratio Balance threshold Claims ratio On the one hand, the frequency of motor accidents has not fallen, compared with the general downward trend seen across the market as a whole. On the other hand, the average cost of claims (compared with premiums) has not decreased either. IAIS Case Study A Non-life Insurance 11

12 The technical provisions The forms submitted to the regulator pertaining to payments of claims and provisions for outstanding claims by financial year show, for each given year of occurrence, the changes in the ratio cost of claims/earned premiums from financial year to financial year. 5 Property insurance (in %) Financial year Year of occurrence Third-party liability motor insurance (in %) Financial year Year of occurrence There is a surplus of provisions if, in a given column of the table, the ratio decreases; there is a shortfall in provisions if it increases. The cost of the claims incurred, estimated in a given financial year, is the total of settled claims plus provisions for outstanding claims, related to the same group of claims. Thus, the provisions appropriated for incurred losses are estimated separately by financial year and related to the year the loss occurred. Since the idea behind the indicator is to measure the losses which have occurred, it is possible to verify the estimation methods employed by an insurance company by examining how the ratios of the expenses appropriated to cover the losses incurred in a given year have changed in successive financial years. If they have increased considerably, the level of provisions set in the initial operating years (after the year in which the losses occurred) was insufficient to settle the resulting claims; on the other hand, if the ratios have been falling or have stabilised, it means that the level of provisions (still sufficient) had been set prudently and has been adjusted over time to arrive at the precise amount required to cover the claims. 12 IAIS Case Study A Non-life Insurance

13 Total motor insurance (third-party liability and damage, in %) Financial year Year of occurrence Action already taken by the supervisory authority As for all insurers in the market, Company A sends a complete file of information to the supervisory authority in June each year. This includes the balance sheet of the last financial year; profit and loss account; list of investments; forms detailing loss ratios; payments and technical provisions per class of activity; coverage of technical provisions by eligible asset items; minimum solvency margin; and solvency margin established. In motor insurance, material claims are settled quickly. There is thus the need to detect unfavourable developments promptly, and so forms on loss ratios, payments and technical provisions are sent as early as March. All these documents are systematically analysed by the supervisory authority. In 1991, the accounts for financial year 1990 which are heavily unbalanced in the area of property insurance due to the storms in Company A s region are received and analysed by the supervisory authority. A first on-site inspection is then performed during the summer of The conclusion is that a close watch should be kept on the company s progress. Although the company has ambitious plans, its motor insurance prospects are mediocre and its financial position is very precarious. When the forms are examined in March 1992, the motor insurance figures for loss ratios, payments and provisions pertaining to the financial year 1991 indicate that the 1991 results will be very worrying, to the point of endangering solvency. An in-depth on-site inspection is carried out in April 1992, i.e. before the settlement of the 1991 accounts. The report produced following this inspection makes the following comments: The distribution network suffers from reduced competitiveness (concerning prices) and from weaknesses, notably computer-related, which hamper the company s operations in comparison with its competitors. The traditional property insurance portfolio is of good quality, but its prospects are rather unfavourable and its growth has declined. IAIS Case Study A Non-life Insurance 13

14 This traditional portfolio has been unbalanced by the recent growth in motor insurance, which was more rapid, and not well managed, in the less profitable segments of the market. This deterioration has lasting effects which hamper the company in the competitive field of motor insurance. As the result for diversification activities is not unfavourable, this may be a source of useful commercial and financial support. The reinsurance programme does not elicit any particular comment from the technical standpoint. Whether for motor insurance or for property insurance, Company A assesses claims provisions file by file. For property insurance, this assessment is prudent the submitted forms show that the ratio cost of claims/earned premiums pertaining to any given year of occurrence falls and then stabilises from one financial year to the next. As regards motor insurance, the forms show the reverse situation, indicating an undervaluation of claims provisions in the first years following the occurrence. In 1991, 40 million provisions were already constituted pertaining to the previous years of occurrence and a shortfall of 13 million appears. With regard to bodily injury claims in third-party liability motor insurance, the on-site inspection reveals that the company does not make any provision for incurred but not yet registered claims (IBNR), or use any statistical correction to its file by file assessments of claims. Given the small size of its motor insurance portfolio, this leads to an average cost of claims which is highly unstable from one financial year to the next and insufficient compared with the market. Changes in the average cost of bodily injury claims in third-party liability motor insurance (in national currency units) Market 35,514 38,227 41,099 45,817 49,492 Mutual companies with intermediaries 41,563 43,951 47,415 50,039 54,436 Company A 27,068 29,495 47,660 34,950 42,521 26,242 To correct this, it would be realistic to raise the average cost of bodily injury claims in 1991 to 36,000 national currency units, thus increasing the provision for outstanding claims by 3.7 million units. To illustrate this amount, the supervisor outlines four different statistical approaches: 1. He observes that, over the last few financial years, the rate of settlement of claims made in the financial year corresponding to the year of occurrence seems to have increased in relation to the total estimated cost of claims. 14 IAIS Case Study A Non-life Insurance

15 Rate of settlement of motor insurance claims by Company A (in %) Rate of settlement of claims* at the end of financial year N Year of occurrence N-3 N-2 N-1 N e of settlement of claims at the end of: ate of settlement of claims at the end of year N for claims occurring in N-k = the percentage, for all claims occurring in, of the total payments made at the end of year N compared with the total estimated cost of claims. The rate of settlement of motor insurance claims in the year in which they occurred (N-k), as observed in N, is the relation between the total claims settled in the period between N-k and the end of N and the estimated total cost of those claims. It is referred to as the k -year rate, or the percentage of the cost of claims settled within k years of their occurrence. The percentage is only an estimate since the cost of claims is also an estimate due to the fact that it includes provisions for incurred claims (estimated outstanding claims) and their changes from one financial year to the next. If the methods for estimating provisions for incurred claims are constant, experience shows that the rate reached in successive operating years preceding the k year is also more or less constant. If the rate declines, it means that the company has adopted more careful methods for calculating provisions for outstanding claims. If the rate rises, it should be presumed that the company has considerably liberalised its methods for calculating provisions for outstanding claims. This suggests that, if one makes a correction by taking past experience into account, the amount remaining to be paid is underestimated by some 4 million national currency units. 2. In order not to be burdened with unusually large claims, the supervisor draws up a table showing how the total costs of the claims incurred in a given year, with a predetermined maximum (500,000 national currency units), change from financial year to financial year: IAIS Case Study A Non-life Insurance 15

16 Total cost of claims (in thousands of national currency units) At the end of the financial year Year of occurrence , ,156 14, ,345 14,111 14, ,223 11,196 16,328 15, ,173 10,561 14,817 16,532 17, ,357 10,003 15,477 18,327 20,224 A difficulty is observed between the first and the second financial year, indicating (without the distorting effect of individual large claims) a lack of provisions in the order of 1.5 to 2 million units, which should be related to the lack of a provision for incurred but unregistered bodily injury claims in third-party liability insurance. If one adds a realistic amount for large claims, the total shortfall becomes 3.5 to 5 million units. 3. The supervisor compares, with the market in general, the change over the last few financial years in the proportion of claims made under third-party liability motor insurance which relate only to bodily injuries. Ratio of bodily injury third-party liability claims to the total of third-party liability motor insurance claims in (in %) Company A Market He observes that figures for this particular section fall suddenly for Company A in 1991, without the market experiencing a similar fall. By extrapolating observations from the past, he arrives at a shortfall of 4 million national currency units. 4. Eventually, Company A s motor insurance ratio technical provisions/ premiums is inferior to that of the market in general, especially in third-party liability, which further reinforces the suspicion of a shortfall in provisions (this remark cannot be determining and does not provide any precise figures; indeed, the structures of motor insurance portfolios and the management of claims may vary considerably from one company to another). 16 IAIS Case Study A Non-life Insurance

17 Ratio of technical provisions to premiums in the market and in Company A (in %) Motor damage insurance Third-party liability motor insurance Total motor insurance mpany A (1991) ket (1990) Due to the deterioration of the ratio cost of claims/earned premiums from one financial year to the next, the supervisor considers that Company A s provisions for current risks should be increased by 2 million units. 6 The supervisor records that the worsening trend in motor insurance results, as well as the 1990 storms, have lead to large technical losses, which have cut into Company A s financial wealth. This has resulted in a drop in the financial yield much sharper than the slow decline in the general expense rate. The balance threshold has therefore risen, while the loss ratio has kept on increasing, leading to the significant loss in 1991 which was underestimated because of the shortfall in provisions. At the end of 1991, Company A no longer fulfils the regulatory solvency margin requirement, as the following calculation made by the supervisor shows (in thousands of national currency units): Solvency Margin Calculation (in thousands of national currency units) vency margin on the balance sheet 15,415 mate of losses (14,603) dden reserves resulting from underestimation of assets 400 hortfall in technical provisions (net of reinsurance) 2,500 % of possible premium increases 6,081 % of the subordinated loan 2,500 nstituted solvency margin 7,252 vency margin requirement 13,290 culated on premiums 12,161* culated on claims 13,290 atio of cost of claims net of reinsurance to cost of claims gross of reinsurance = 69.3% Calculation of the provision for current risks the parts of the premiums to be carried forward beyond the end of the financial year (assessed file by file or using a presumptive method) are multiplied by a predicted ratio of cost of claims and management expenses compared with premiums. (See 1. Background; Legal constraints and regulations applying to the insurance market.) IAIS Case Study A Non-life Insurance 17

18 4. Questions for readers (supervisors) 1. Taking account of the range of measures and sanctions available to the supervisory authority (see 1. Background; Legal constraints and regulations applying to the insurance market), what suggestion(s) can you make for best safeguarding the interests of Company A s policyholders: a. in the short term, on a financial level? b. in the medium and long term, on a technical level? 2. Could you describe important principles for supervising insurance companies (please refer to the IAIS Core Principles and Core Principles Methodology : you can download them from IAIS web site ( Additional information for this case study 1. Reinsurance Quota-Share agreement This is a general system related to the entire risk in the insurance industry under which a direct insurer cedes to a reinsurer a given percentage of premiums for which the insurer accepts the same percentage of corresponding claims costs and the payment of a reinsurance commission. The reinsurance commission ensures that the reinsurer participates in the cedent's costs; as its sole responsibility, the latter adopts sales of policies and management of the entire risk. The commission plays an important role in the equalisation of results, which in turn allows participation of both parties in the profits and losses on insurance activity. The following commissions can be applied: fixed commission (percentage of assigned premiums); moving rate (based on the ratio of claims to reinsurer's premiums); fixed commission with the participation of the assigning company in the reinsurer's profit. Excess of loss agreement Here, the reinsurer intervenes only above an agreed amount in respect of losses. The insurer sets the maximum amount which he can retain in the event of a loss: retention (priority or franchise). The reinsurer commits to returning part of each loss in the amount higher than the retained amount. 18 IAIS Case Study A Non-life Insurance

19 The premium transferred to the reinsurer by the direct insurer is not in proportion to the initial premium but dependent on statistical calculations based on the losses which require the reinsurer's intervention. Such a system is used especially in liability insurance as well as where all risks are covered by unlimited guarantees. 2. Changes in the ration cost of claims/earned premiums (claims ratio) in the year the loss occurred, throughout consecutive financial years. The cost of the claims incurred, estimated in a given financial year, is the total of settled claims and provisions for outstanding claims, related to the same group of claims. Thus, the provisions appropriated for incurred losses are estimated by financial year and are related to the year the loss occurred. Since the idea behind the indicator is to measure the losses which have occurred, there is the possibility to verify the estimation methods employed by an insurance company by means of a closer examination of how the ratios of the expenses appropriated to cover the losses incurred in a given year have evolved in successive financial years. If their increase is considerable, the level of provisions set in initial operating years (after the year in which the losses occurred) was insufficient to settle the resulting claims; on the other hand, if the ratios have been falling or have stabilised, it means that the level of provisions (still sufficient) had been set carefully and has reached the precise amount required to cover the claims. 3. Coverage rate of motor vehicle claims The coverage rate of motor vehicle claims in the year in which they occurred (N-k), as observed in N, is a relation between the total claims settled in the period between N-k and the end of N and the estimated total cost of those claims. It is referred to as the k -year rate, or a percentage of the cost of claims, paid within k years since their occurrence. The percentage is only an estimation since the cost of claims is also an estimation due to the fact that it includes provisions for incurred claims (estimated outstanding claims) and their changes in particular financial years. If the methods for estimating provisions for incurred claims are constant, experience shows that the rate reached in successive operating years preceding the k year is also more or less constant. If the rate declines, it means that the company adopted more careful methods for calculating provisions for outstanding claims. IAIS Case Study A Non-life Insurance 19

20 If the rate rises, it should be presumed that the company considerably liberalised the methods for calculating provisions for outstanding claims. 20 IAIS Case Study A Non-life Insurance