Insurance Law as a Tool of Risk Management

Introduction:   

Any industry or a company faces a lot of risks any time. Most of the risks are well defined and arise from the internal processes. A budding industry or a company generally faces increasingly fierce competition comes with increased risks. Focusing on the sales and business expansion aspects carries the risk of the profitability of our own business. There are high chances that these risks affect the efficiency and viability of the business. The success of any business is measured by understanding the internal and external risks associated with the general insurance industry.

Risks in General Insurance Business

In the general insurance business, people are exposed to a plethora of financial as well as non-financial risks. For example; other debtor risks like the capital adequacy risk, exchange rate risk, investment risk, management risk, adoption risk, natural disaster risk, reserve risk, bond management risk, brokerage risk and credit risk arising from the nature of the business and the socio-economic environment in which the business is conducted.

Financial Risks

Mainly insurance activity deals with the monetary aspect and is usually affected by financial risks such as the capital structure risk, capital adequacy risk, exchange rate risk, interest rate risk, investment risk, underwriting risk, catastrophic risk, reserve risk, pricing risk, claims management risk, reinsurance risk, policyholders and broker risks, claims recovery risk and other debtors risk. The industry or a particular company is expected to be prepared for any kind of risks and they plan to manage these kinds of financial risks by using techniques such as hedging interest rates and fees.

Non-Financial Risks

Non- financial risk management believes to have a greater significance in recent years;

• The operational losses only increasing.
• The industry relies on increasingly sophisticated financial technology.
• A quick call to the insurance system.
• The globalization process has opened the way for global players.

Risk Identification

Accurate understanding and identification of risks require careful understanding and analysis. Risk identification is essential to manage specific risks. The risk identification process includes identification of the risks and evaluating the loss that could take place. There are two important components included in the risk identification schedule, namely:

1. Maintenance procedure- the risk identification process should consider the scope of the maintenance process and monitor the skills of the technicians on duty.
2. Physical factors- physical factors are those factors which lack care and monitoring of the working environment or the industry. It is necessary to lead an operational study which helps participants identify bad events with their imaginations to see the way of malfunction.

Risk Evaluation

Once all the risks have been recognized, the next step is to evaluate the loss incurred due to the malfunctioning which is called the ‘risk quantification’. This value is very easy to measure only in lost buildings or any unlikely or undesirable event. The risk assessment process consists of determining the level of loss, also known as the ‘loss frequency’ which is the most difficult step. The advantage of a correct risk assessment is that the insurer can perform a risk assessment by providing relevant information and defining the actual conditions.

Risk Avoidance and Risk Retention

Risk avoidance is a non-performance of an activity that could carry risk factors. Risk-retention involves acceptance of all the losses incurred. Unavoidable and non-transferred risks are retained by default. This consists of risks that are large such as a war. Whereas on the other hand risk retention is for the tiny risks that have been incurred. Risk transfer occurs only when the procedure of creating the risks is transferred. An example of risk transfer could be the subcontracting of hazardous work outside the production area.

Risk control- risk control involves taking precautionary measures even before the risk actually takes place and it also includes reducing the fire hazard. To reduce the risks that are incurred, the mitigation plan is developed. The main purpose of this mitigation plan is to describe how to deal with the risks and the steps needed to minimize those risks.

Risk Management Techniques used by an Insurer

There are two types of risk management techniques that an insurer adopts, namely:

1. Risk-based capital or money management- This kind of management is basically a rule that establishes a minimum regulatory capital for financial organizations. The insurance regulators are not responsible for the risk management of individual players, but it gives a greater focus on observing the behaviour of players in protecting the interests of the consumer.

• Role of the board of directors- The board of directors is responsible for the company’s risk management policy. The board helps the organization in reviewing and approving of risk management; it reviews the content and frequency of board reports and regularly reviews audit operations to ensure that the company’s risk management policies are being applied.
• Role of management- Generally, in any industry, the management is responsible for implementing risk management and control program. The management’s responsibilities include developing a risk management philosophy and approving it by the board of directors, establishing procedures for monitoring governance programs, managing and controlling risks, and ultimately developing communication channels.
• Capital margin and payouts– The main reason for capital margins and payouts is to pay off accounts receivable to maintain dividends and to invest in potential growth opportunities. The settlement of the claims depends on the firm’s solvency margins. As per the IRDA rules 2000, both the general and life insurance companies need to maintain a solvency margin. The life insurance companies need to maintain a 150% solvency margin.

2. Reserving- Reversing is the process in which the cost or time reverse is used to manage the unidentified risks.

• Unearned premium reserves (UPR)- Unearned premium reserves can be defined as the proportion of premiums received which relates to the future period. It is also assumed that the risk is uniform for the duration and that the liabilities that arise out after a while. When inflation is high, both the cost and the loss rate change. If UPR is accepted as inadequate, then an additional reverse is required. Therefore the insurer needs to create an extra reserve to offset all the shortfalls. In simple words, an unearned premium is the portion of an insurer’s total premiums that are collected in advance by an insurance company.
• Unexpired risk reserve- To manage the risk associated with non-payment of premiums in the future, individual insurance companies create unexpired reserves.
• Outstanding claims reserve (OCR)-  The outstanding claims clauses emphasize the commitment of insurers to cover outstanding claims and outstanding claims. The method used to obtain outstanding claims is to first consider the following-
  • The certainty of the claim.
  • The approximate time required to finish the settlements
  • The rate of inflation on claims costs between the accounting date and the date of settlements.
  • The judicial trends in claims settlements.
• Incurred but not reported resources (IBNR)- The IBNR reserve is the evaluated liabilities for the unknown claims that arise from the incidents that happened before the yearend but hasn’t been notified to the company during the accounting tenure or period.
• Catastrophe reserves- The catastrophe reserve is that which is made to meet any uncontrollable risk factor bothering the insurer. Catastrophe insurance protects businesses and residences against natural disasters like earthquakes, floods, etc. and even the man-made destructions. Flood insurance is unique in that it is available through the federal government.
• Claims equalization reserves- Claims equalization reserves are prepared to smoothen the effects of the year to year fluctuations. The provision is created on the basis of the former experience of the prevalence of claims and the ‘profitability density function’ of this particular risk. The equalization reserve is a long-term reserve that an insurance company keeps to prevent cash-flow depletion in case of significant unforeseen catastrophes. The claims equalization reserve is a balance sheet item showing funds an insurance company has set aside in order to smooth fluctuations in the cost of claims.
• Reserving provisions and IRDA- The IRDA highlights the focus on balance in the method of reserve estimations wherever sufficient data is available. The IRDA also stresses on gathering all the applicable details for each class of business from all the insurers so that the combined or merged industry data can be used for reserving purposes for the classes where availability of data is insufficient.

Conclusion

This particular study was to recognize the risks, the insurer and insured re prone to, specifically in India. Through this research, it is evident that both the insurer and the insured in India face many risks varying from financial to non-financial in nature. The financial risk is classified as capital risk, liability management risk, insurance risk as well as credit risk. Whereas on the other hand, non-financial risks include catastrophe risk, reserve risk, claims management risk and credit risk.

---

References:

• Akter S, Roy B, Choudhury S and Aziz S (2009) – Mitigation and adaptation strategies for global change.
• https://www.protechtgroup.com/blog/non-financial-risk-why-the-big-focus
• https://www.investopedia.com/terms/c/catastrophe-insurance.asp
• https://moneyterms.co.uk
• https://www.mindtree.com/blog/principle-based-reserving-life-insurers-sneak-peek
• https://www.irmi.com/term/insurance-definitions/incurred-but-not-reported