Underwriting An Illusion

As India starts inching towards privatising insurance, one issue that has repeatedly been debated is the continuous underwriting losses incurred by insurance companies. The popular perception now states that insurance companies are only profitable because of investment income. They are unable and have been unable to generate any operating profit from their business activities.

This raises the question: what constitutes profitability for an insurance company? The first step towards answering this question is to understand the various operational heads in the revenue accounts of a typical insurance company. The main elements of insurance operations are premium income on the revenue side and claims and management expenses on the expense side. Management expense refers to the sum total of expenses incurred in business development (marketing/commission) to servicing (administration and staff salaries).

 

Given this operational element, let us assuming the revenue/cost structure of an insurance company as below:

Premium 100

Less: Claims 60

Management expenses 25

This implies that the insurance company can generate what accountants call an operating surplus. Given competitive conditions, however, insurers take on risks with claims ratios, which are as high as 80 per cent. This gives rise to the basic question of why an insurance company would take on a risk that actually result in no operating profit situation. To answer this, one needs to understand the insurance accounting system from the viewpoint of actual cash flows. This is depicted in the form of a proforma cash flow statement.

From a cash flow point of view, premium is generated in the form of daily cash inflows. Management expenses are structured, in the sense that their timing and amount can be predicted. The third element in the structure -- that of claims -- is slightly more complicated. Given the nature of operations, there is a certain time lag between when the claim is incurred and the time of actual cash outflow.

All these ensure that there is a certain float in terms of premium and incurred-but-not -paid claims which can be put to productive use by the insurance company. For example, the structure of the money markets are such that at the year-end, March 31, call money rates tend to increase drastically. By managing float money at this point in time investment managers in insurance companies are able to substantially increase earnings from investment income.

While there is an opportunity to augment returns by considering returns earned by managing float money, this is low compared to the overall investment income. Insurance companies are in a position to generate huge amounts of investment income due to the basic structure of accounting, which can be understood by depicting the revenue account for a particular class of business.

Revenue Account

Claims paid premium income

Management Expenses

Salary

Rent

Commission

Reserve Strain (%of incremental premium)

Current insurance legislation provides that for every Rs 100 of premium earned anywhere between 50 to 100 per cent has to be provided as reserve strain. Reserve strain means an amount to be kept aside to pay future claims due to unexpired risk. This may be explained as follows: A non life insurance contract is a yearly contract, whereby on up-front payment of a pre-determined sum of money the insurance company agrees to make good any financial loss due to the happening of a certain event. Such contracts are entered into by the company throughout the year, but the insurance company would close its books at a predetermined date. Therefore, as at the year-end, there would be a set of contracts where the risk would not yet have expired. So, a certain percentage of the current years revenue has to be provided for these risks. In India, the practice is to set aside a fixed percentage of premium for this purpose. As mentioned, this could be as high as 100 per cent of premium as is the case with Marine Hull

insurance contracts. This practice explains the apparent incidence of continuous operating losses in the books of the insurance companies.

From a cash accounting point of view, the amount provided as reserve strain is invested in different securities. Currently, the regulatory regime permits 55 per cent of such amounts to be invested in market securities and the remainder to be invested in government and approved securities. To understand the significance of reserve strain, consider a company with an equity base of Rs 50 crore with premium income growth of 50 per cent, 33 per cent and 25 per cent thereafter. The table below shows how investment income progresses.

By year 5, on a premium base of Rs 150 crore, the company has an investment portfolio with a face value of Rs 75 crore. Assuming a return of even 12 per cent , this gives an investment income of Rs 10 crore.

It is this investment that offsets the underwriting losses so that insurance companies can continue to show a net profit. The current accounting practice provides for reserve strain in the underwriting account, while investment income generated out of the reserve strain does not appear in this account - but is booked in the consolidated profit and loss account.

It is due to this distorted structure of accounting that insurance operations can technically never show an operating surplus. But, to say that insurance companies are continuously incurring operating losses and are therefore inefficient is equally incorrect. Such a perception presumes a basic dichotomy in the two functions of insurance - underwriting and funds management. What needs to be stressed is the linkage between growth rate in and the amount of premium income. The greater the premium income, the greater the amount invested and therefore the greater the investment income.

This analysis also reveals how important the entire investment function is to the overall operation of an insurance company, since it essentially acts as an income-stabilising factor. It also explains why, in the Indian context, when insurance is not opened to foreign companies, potential players are entering funds management; a sector where foreign participation is allowed.

There is another aspect to the above train of thought- which is that insurance companies in India have often cited a consistent run of underwriting losses as an alibi to raise premium rates. Insurance companies have argued that since they are incurring underwriting losses, they need to increase their premium rates to ensure that they are in a position to generate operating surpluses.

In such a situation, the only consideration for any regulatory authority is whether the benefit of investment income - out of the reserve strain - should be passed on to the consumer or whether it should continue to reside as hidden reserves in the books of the insured.

There is however no gainsaying the fact that investment income is directly related to the skills of the fund manager and so the role of the insurance company in managing these funds cannot be under-emphasised.

To conclude, while on the one hand public perception about the so-called inefficiency of the insurance companies should be corrected, on the other hand, any proposal to raise premium rates upwards needs to be considered with more scrutiny.

(The authors are with the insurance practice of KPMG. The views expressed here are their own and not of the organisation they

represent.)