Lecture 2

Class: FY BSc
Subject : Non-Life Insurance – Principles, Products and Practices
Subject Code: PUSASQF2.5
Chapter: Chapter 2
Chapter Name: Basic Terminology, Profitability and Reinsurance

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Today’s Agenda
1. Introduction
1. Terminology in GI

2. Reinsurance
1. Terminology with Reinsurance

3. Profitability

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1 Introduction
All insurance excluding life insurance falls under general insurance. Non-life insurance is a broad category,
including protection on both people and things. Non-life insurance is also called General Insurance.

We will now look at the various terms involved in the general insurance industry.
We will look into the concept of profitability, reinsurance and profitability after reinsurance.

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1.1 Terminology in GI
• Premium - Premium is an amount paid periodically to the insurer by the insured for covering his risk.

• Insurance claim - A claim is a formal notice to an insurance company that you have suffered a loss that you
believe entitles you to compensation.

Items in Balance Sheet

• GWP - Gross written Premium - Gross written premiums are the total revenue from a contract expected to be
received by an insurer before deductions for reinsurance or ceding commissions.

• GIC: Gross Incurred Claim - Gross claims incurred comprise all payments made in respect of the financial year
plus the provision for the claims but minus the provision for claims for the preceding financial year.

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1.1 Terminology in GI

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1.1 Terminology in GI

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2 What is Reinsurance?

• What do you understand

by reinsurance?
• Why is there a need of
reinsurance?

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2 Reinsurance
Reinsurance is a form of insurance purchased by insurance
companies in order to mitigate risk. With reinsurance, the
company passes on some part of its own insurance liabilities
to the other insurance company.

Insurers purchase reinsurance for four reasons: To limit

liability on a specific risk, to stabilize loss experience, to
protect themselves and the insured against catastrophes,
and to increase their capacity

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2.1 Terminology with Reinsurance
• NWP: Net Written Premium - Net premiums written is the sum of premiums written by an insurance
company over the course of a period of time, less premiums ceded to reinsurance companies, plus any
reinsurance assumed.

• Earned Premium - The premium collected by an insurance company for the portion of a policy that has
expired. In other words, the earned premium is what the insured party has paid for a portion of time in which
the insurance policy was in effect, but has since expired.

• Net Earned Premium - means the Net Written Premiums recorded during the Experience Period, plus the
unearned premium reserves at the beginning of the period, minus the unearned premium reserves at the end
of the period.

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2.1 Terminology with Reinsurance
• NWP: Net Written Premium - Net premiums written is the sum of premiums written by an insurance
company over the course of a period of time, less premiums ceded to reinsurance companies, plus any
reinsurance assumed.

• Example

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3 Profitability
• Profit & Loss (P&L) statement indicates the profitability of an organization

• Profitability states the surplus or deficit as generated by an entity by its various activities.

• Surplus indicates the excess of gross inflow (income) over gross outflow (expenses) & deficit indicates vice
versa.

Main purpose of P&L:

• Monitor & measure the profits of a unit
• Help to understand the functioning & business performance
• Understand the impact on product profitability, vertical or channel profitability
• Decision making & implementation

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3.1 Operating cycle of non-life industry
Income spread over policy
period to cover claims
Earnings
for the
period
Reinsurance support with Payments made to
GIC, Swiss re, Scor etc Claims net clients for Fire,
of Marine, Motor, Health
Reinsuran
reinsuranc etc
ce
e

Total
U/W result
expenses
Brokers, Agents, Online,
Direct sales etc Underwriti
Net
ng
Commissi
(GWP)
ons
Comm. paid to channels for
procuring business less comm.
Operating received on reinsurance cededv
Expenses of employees, Infra, expenses
Sales & Marketing etc

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3.2 GWP – Sharing (Example)
Client has paid Rs 1000 as premium for risk & following mandate is provided for sharing the risk by the client.
Scenario 1

Scenario 2

Scenario 3
•100% mandate with •XYZ Insurance as • XYZ Insurance as
XYZ Insurance. leader with 70% share follower with 30%
& Oriental as 30% share & Oriental as
•Ans. :- Rs. 1000 share as follower. 70% share as leader.
premium will be part
of XYZ Insurance GWP •Ans. :- Rs. 700 • Ans. :- Rs. 300
premium will be part
premium will be part
of XYZ Insurance GWP
& rest will be part of of XYZ Insurance
oriental. GWP & rest will be
part of oriental.

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3.2 GWP
Premium is accounted on the basis of risk start date & policy / endorsement booking date whichever is later.

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3.3 Premium Ceded
• Reinsurance premium ceded (RI ceded) represents portion of the gross written premium payable to
reinsurance entities based on “reinsurance arrangements”. Reinsurance arrangement helps an insurance
company to spread risk & expand capacity.

• Proportional ceding – indicates premium & claims shared in same ratio between insurance company &
reinsurance company as per the arrangements

• Non proportional ceding - indicates where the claims is shared in excess of specified amount by reinsurance
company

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3.3 Premium Ceded - Example
Example - Premium received from client – INR 1000 for Sum insured INR 1,000,000
Reinsurance arrangement
Proportional treaty – GIC Quota Share arrangement - 10% of risk

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Reinsurance – In depth

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Reinsurance – In depth
Proportional Reinsurance : the direct writer (original insurance company) & the reinsurer share the cost of
all claims . This is of two types –

1. Quota share reinsurance – Reinsurer and writer share all premiums and losses according to a fixed
percentage.

For example, Bajaj Allianz enters into a reinsurance contract with Munich Re with retained proportion of 80%.
This means Bajaj Allianz pays 80% of the claim amount and gets to keep 80% of the premium received.
Munich Re has to pay 20% of the claim amount and receives 20% of the premium.

Retained Proportion denotes by α. Let X be the gross claim amount, Y be the net claim amount paid by the
insurer and Z be the claim amount paid by the reinsurer. Y = α X and Z= (1- α) X

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Reinsurance – In depth
2. Surplus share reinsurance: A surplus share treaty is a reinsurance treaty in which the ceding insurer retains
a fixed amount of policy liability and the reinsurer takes responsibility for what remains. Surplus share treaties
are considered pro-rata treaties and are most commonly used with property insurance.

For example: HDFC Ergo forms a surplus share reinsurance contract with Swiss Re and underwrites policies
with a coverage of Rs 50,00,000 with retention of Rs 20,00,000 . The remaining 30,00,000 are ceded to
reinsurer.

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Reinsurance – In depth
Non-Proportional Reinsurance : Under a non-proportional reinsurance arrangement, the direct writer pays a
fixed premium to the reinsurer. The reinsurer will only be required to make payments where part of the claim
amount falls in a particular reinsurance layer.

1. Individual excess loss : reinsurer makes a payment when the claim amount for an individual claim exceeds a
specified excess point or retention.

For example: Apollo enters into a reinsurance treaty with Swiss Re and reinsurance layer is fixed at 50 lac to 1
crore.
Y=X ; X < 50 lac Z= X – 50 lac ; 50 lac < X < 1 crore
Y = 50 lac ; 50 lac < X < 1 Crore Z = 50 lac ; X > 1 crore
Y = X – 50 Lac ; X > 1 crore

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Reinsurance – In depth
2. Stop Loss Reinsurance : The reinsurer is liable for the insured's losses incurred over a certain period that
exceed a specified amount or percentage of some business measure, such as earned premiums written, up
to the policy limit. Under this kind of policy, the direct writer (insurance company) agrees to carry the full
burden of the loss up to a limit, L and claim amount exceeding L is paid by the reinsurer.

For example : Acko enters into a reinsurance contract with Munich Re and the contract indicates that the
insurance company , Acko is responsible for losses up to $500,000, but that the reinsurance company,
Munich Re is responsible for anything above that limit.

Y=X;X<L Z=X-L;X>L
Y=L;X>L

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Understand the following Terminology
• Start date - the date the policy is activated.
• End date - the date at which the policy term ends.
• Accident year - A policy year is based on policies with effective dates in a twelve
month period. So, policy year 2019 data are those policies with effective dates
between 1/1/19 and 12/31/19.
• Financial year - Accident year data is based on accidents that occur within a twelve
month period. Thus, accident year 2019 is based on those accidents that occurred
between 1/1/19 and 12/31/19.
• Reporting year : The year in which claim incurred before is reported to the insurance
company.
• Net claims incurred : The amount of claims incurred during an accounting period after
deducting reinsurance recoveries.
• Claims Reported : Claims reported to the company.

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Understand the following Terminology
• Incurred But Not Reported (IBNR) is a type of reserve account used in the insurance industry as the provision
for claims and/or events that have transpired, but have not yet been reported to an insurance company.

• Incurred Loss Ratio - The percentage of losses incurred to premiums earned.

• Reinstatement Clause - When the amount of reinsurance coverage provided under a treaty is reduced by
the payment of a reinsurance loss as the result of one catastrophe, the reinsurance cover is automatically
reinstated usually by the payment of a reinstatement premium.

• Reinstatement Premium - A pro rata reinsurance premium is charged for the reinstatement of the amount
of reinsurance coverage that was reduced as the result of a reinsurance loss payment under a catastrophe
cover

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3.4 Unexpired Risk Reserve
Unexpired risk reserve (URR) is the net written premium attributable to succeeding accounting period for
unexpired portion of the risk.

Basis
• Over the contract period ( 1/365 days basis or 1/12 basis)
• Period of risk (where risk pattern is not uniformly spread between over the contract period)

It is bifurcated under 3 head in P&L

• URR charge
• Previous year release
• Current year release

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3.4 URR – Case study
GWP = Rs 1,400
RI Ceded = Rs 200
NWP = Rs 1,200
Policy Period = Oct 01, 2009 to Sep 30, 2010
Case 1 :- at the end of the date

One date is expired so

URR Charge = NWP * Unexpired period / Policy period
So, URR Charge = 1,200 * 11 / 12 = 1,100

The charge as created above will be reserve as future income which will be converted to URR release as
income over the policy period.
In above example every date Rs 100 will be released as URR Release over next 11 dates

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3.5 Net earned Premium
Net earned premium (NEP) indicates the difference between the written premium & unexpired portion of the risk

Earned premium = Net premium - URR

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3.6 Reinsurance Commission
Reinsurance commission (RI Comm.) reinsurance company compensates some portion of acquisition cost &
administrative expenses as incurred by insurance company. The compensation as paid by the reinsurance
company is called reinsurance commission.

Example
Premium ceded to the reinsurer i.e. RI ceded Rs. 100
Reinsurer is paying 10% as RI commission as reinsurance premium ceded
So RI commission (RI Comm.) = ?

RI commission = RI ceded * Commission rate RI commission = 100 * 10% = 10

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3.7 Acquisition Cost
Acquisition cost / Commission paid indicate the cost paid to various channel as a percentage to premium for
acquiring the business.

Example
Premium collected from the client i.e. GWP Rs. 1000
Lets assume that business is sourced through agents & Acquisition cost is 10%

Acquisition cost - ?

Acquisition cost = GWP * Acquisition cost Acquisition cost = 1000 * 10% = 100

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3.8 Claims
Claims - is the demand made by insured under the policy issued by the company in the event of loss. It
comprises the following:

Claims incurred

• Claims paid – These are the claims paid to the client for the period for which p&l statement is drawn

• Claims settlement cost – Insurance company may appoint surveyor, to assess the loss as reported by the
client. The cost/ fees paid to surveyor or lawyer is called claims settlement cost. It is also included as part
of claims part if settled to the client for P&L statement period.

• Salvage - In insurance circles, this term commonly refers to the scrap value of damaged property. In
property insurance, salvage value.

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3.8 Claims
• P&L statement is prepared for a given period. Sometime it is possible that claims reported may not get paid to
the client / insured. In such a situation insurance company creates the reserve as claims reserve or provision
for claims settlement cost , any increase or decrease in the reserve for the period for which P&L statement is
drawn is reported as provision for reserve or provision for claims settlement cost.

• Claims incurred but not reported (IBNR) & incurred but not enough reported (IBNER) provision. It is estimated
by actuary.

• Gross claims incurred = Summation of Claims paid + Survey fees paid + reserve + IBNR – Salvage is called
Gross claims incurred.

• Net claims incurred = Net claims incurred is arrived after deducting the claims recovery from reinsurer under
various proportional as well as non proportional arrangement. It indicates the loss retained by the company

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3.9 Underwriting Result & Profit
Underwriting result (U/w result) indicates the surplus / deficit from the insurance business without considering
the investment income

U/w result = Earned premium – Claims – Cost of acquisition + Reinsurance commission - operating expenses

Profit
• Profit before tax (PBT) = Underwriting result + Investment income

• Profit after tax (PAT) = PBT – Tax %

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3.9 Underwriting Result & Profit - Example

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3.10 Combined Ratio
Combined ratio - indicates the profitability of an insurance company from its insurance business. It does not
include the impact of investment income impact. Following is the formula for the calculation of the combined
ratio.

Combined ratio = Loss ratio +net commission ratio + expense ratio

A value greater than 100% means the company is paying out more than what it is taking in and a value less than
100% means it is taking more than it is paying out.

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3.11 Loss Ratio
Loss ratio - The percentage of losses (claims) incurred to premium earned during the period. It is indicator of as
insurer’s underwriting discipline and skill at mitigating risk

Loss ratio = Incurred losses / Earned premium

Example: Calculate the loss ratio ??

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3.11 Loss Ratio
Loss ratio = 75.00%

What does it indicate ????

Interpretation

Net basis - It indicate that company is paying back 75% of earned premium to its client & only 25% is left to
meet the net acquisition cost & other operating expenses.

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3.12 Net Commission Ratio
Net commission ratio – represent the cost of obtaining the insurance business. It includes the intermediaries'
commission net of reinsurance commission other related expenses which relates to acquisition of business

Net commission ratio = (Acquisition cost – RI commission ) / NWP

Example: Calculate the net commission ratio?

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3.12 Net Commission Ratio
Net commission ratio = 7.50%

What does it indicate ????

Interpretation

Net basis - It indicate that company is incurring the Rs 7.5 of every Rs 100 retained premium as net cost to
acquire the business. Higher reinsurance commission indicates efficiency in ratio.

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3.13 Expense Ratio
Expense ratio – It is calculated as underwriting expenses divided by net written premiums, the expense ratio
measures an insurer's efficiency

Operating exp ratio = Operating expenses / NWP

Example: Calculate the expense ratio ??

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3.13 Expense Ratio
Expense ratio = 18.75%

What does it indicate ????

Interpretation

Net basis - It indicate that company is spending the Rs 18.75 of every Rs 100 of written premium. Lower the ratio
higher the efficiency. Some company has low expense ratio due to economies of scale.

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Combined ratio vs U/w result
Combined ratio of 95% with negative
underwriting at policy inception will
result in underwriting surplus of Rs. 5
with 95% combined ratio at the end
of policy

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