Risk

Management
and
Reinsurance

Banking, Financial Services and Insurance Committee

The Institute of Chartered Accountants of India
New Delhi
This Publication has been prepared for use by the members of the Institute. The views expressed
herein do not necessarily represent the views of the Council of the Institute.
© THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

All rights reserved. No part of this publication may be reproduced, stored in retrieval system or
transmitted, in any form, or by any means, electronic, mechanical, photocopying, or otherwise,
without permission, in writing, from the publisher.

Month and Year of Publication

First Edition : October, 2003
Second Edition : February, 2005
Third Edition : July, 2005
Fourth Edition : October, 2008
Fifth Edition : February, 2020

E-mail : insurance@[Link]

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Price : Rs. 600/-

ISBN : 978-81-8441-028-0

Published by : The Publication Department on behalf of the Institute of Chartered

Accountants of India, ICAI Bhawan, Post Box No. 7100,
Indraprastha Marg, New Delhi - 110 002.
Printed at :

This book is also a Study Material for Paper-3 of the DIRM Course of the Institute of Chartered
Accountants of India.
FOREWORD
The Insurance sector has emerged as one of the fastest developing sectors in India. Its
sphere has enlarged to the extent that requires expert and specific domain knowledge to
protect and promote the economic interests of all the stakeholders. For Chartered
Accountants, the importance of updation of knowledge is of quintessential importance.
Multi-pronged strategies are being adopted by the Institute of Chartered Accountants of
India (ICAI) to facilitate the members and students to acquire technical and practical
knowledge in the field of insurance. The ICAI through its Banking, Financial Services and
Insurance Committee (BFSIC) conducts Diploma in Insurance and Risk Management
(DIRM) Course to equip professionals with expertise and competence in insurance and
pension sectors.
It is heartening to note that the Banking, Financial Services and Insurance Committee of
ICAI has taken the initiative to revise the Study Material of DIRM Course as a measure to
provide the latest possible technical inputs to the members who are pursuing the Course.
The material has been designed to provide an in-depth and comprehensive theoretical
knowledge as well as practical aspects, in a very practical and simplified manner.
I appreciate the efforts put in by CA. Dhiraj Kumar Khandelwal, Chairman, CA. Charanjot
Singh Nanda, Vice Chairman and other members of the Banking, Financial Services and
Insurance Committee of ICAI in bringing this revised Course material. I hope that the
members at large will make use of this material to the maximum possible extent for their
knowledge enrichment and in the overall interest of all stakeholders.

CA. Prafulla P. Chhajed

President, ICAI
PREFACE
Insurance, worldwide, is one of the most potent financial sectors. As per the published
data, the global direct insurance premiums surpassed the USD 5 trillion mark reaching
USD 5193 billion (6.1% of global GDP) in 2018 and it is expected to grow by 12-15 per
cent annually for the next three to five years. This growth means more scope and a larger
role for Chartered Accountants in the development and success of the industry.
It is our sincere belief that to enable the members of the Institute to play an appreciable
level of role in the insurance and pension sectors, they need to be provided with a general
framework for thinking about the effects of risk and a broad knowledge of risk
management and insurance. They need to be aware of the many public policy issues
related to risk, including legal liability and economic security issues apart from strong
conceptual foundation for understanding institutional details.
I wish to take the pleasant privilege of presenting before the members of the Institute the
revised study materials for Post Qualification Course on Diploma in Insurance and Risk
Management (DIRM). The study materials have been brought out in such a way that not
only members of the Institute pursuing the DIRM Course but also other stakeholders
would find it useful to acquire strong technical foundation in the areas of insurance and
risk management.
I wish to express my gratitude to CA. Prafulla P. Chhajed, President and CA. Atul Kumar
Gupta, Vice President, ICAI for their constant motivation to enable the Committee to move
forward on its various endeavours. I wish to place on record my sincere thanks to the
members and special invites of the Committee for their guidance and involvement in
bringing out this publication. We are grateful to Dr. V. Padmavathi, Associate Professor,
IFHE University, IBS – Hyderabad and Dr. V. Jayalakshmi, Associate Professor, Siva
Sivani Institute of Management, Hyderabad for writing this publication.
It is my sincere hope that the members of the Institute would find the contents of the book
professionally enriching. With humility I invite your constructive comments to further
improve the contents of the book.
CA. Charanjot Singh Nanda CA. Dhiraj Khandelwal
Vice Chairman, BFSIC Chairman, BFSIC
Date: 5th February 2020
CONTENTS
Foreword
Preface
Part A : RISK MANAGEMENT
CHAPTER-1 Introduction to Risk 3
CHAPTER-2 Introduction and Process of Risk Management 33
CHAPTER-3 Decision Making Under Conditions of Uncertainty 99
CHAPTER-4 Corporate and Enterprise Risk Management 126
CHAPTER-5 Risk Based Capital and Road to Solvency–II 152
CHAPTER-6 Corporate Governance 182
Part B: REINSURANCE
CHAPTER-1 Introduction to Reinsurance 223
CHAPTER-2 Reinsurance Regulations and Law in India 306
CHAPTER-3 Reinsurance Market 353
CHAPTER-4 Reinsurance Practice 397
CHAPTER-5 Reinsurance Accounting and Financials 443
APPENDIX 491
 Part A

RISK MANAGEMENT
 CHAPTER – 1
INTRODUCTION TO RISK
OUTLINE OF THE CHAPTER
1. Introduction
2. Risk and Uncertainty: Distinction
3. Risk, Peril, Hazard
4. Classification of Risk
5. Types of Risks
6. Sources of Risk

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Distinguish between Risk and uncertainty
• Understand the distinction between risk, peril and hazard
• Come to grips with various types of classifications of risk to which individuals /
organizations are exposed

Introduction
There is no generally or universally accepted definition of risk. It connotes different things
for different people. Some people use the term risk for insured items “this building is a
RISK MANAGEMENT AND REINSURANCE

poor risk”, some others to the chance of loss (the risk of loss in this venture or investment
is high) and yet others to the cause of loss (insurance is available against the risk of
burglary or risk of fire). Further, for economists and statisticians risk is associated with
variability (like variability of return on investment in an equity share of a corporation). Risk
is defined as variation in the range of possible outcomes. The greater the potential
variation, the greater the risk. Bernstein observes: “when we take a risk, we are betting on
an outcome that will result from a decision we have made, though we do not know for
certain what the outcome will be”.
People seek security. A sense of security may be the next basic goal after food, clothing,
and shelter. An individual with economic security is fairly certain that he can satisfy his
needs (food, shelter, medical care, and so on) in the present and in the future. Economic
risk (which we will refer to simply as risk) is the possibility of losing economic security.
Most economic risk derives from variation from the expected outcome.
One measure of risk, used in this study note, is the standard deviation of the possible
outcomes. As an example, consider the cost of a car accident for two different cars, a
Porsche and a Toyota. In the event of an accident the expected value of repairs for both
cars is 2500. However, the standard deviation for the Porsche is 1000 and the standard
deviation for the Toyota is 400. If the cost of repairs is normally distributed, then the
probability that the repairs will cost more than 3000 is 31% for the Porsche but only 11%
for the Toyota.
Modern society provides many examples of risk. A homeowner faces a large potential for
variation associated with the possibility of economic loss caused by a house fire. A driver
faces a potential economic loss if his car is damaged. A larger possible economic risk
exists with respect to potential damages a driver might have to pay if he injures a third
party in a car accident for which he is responsible.
Historically, economic risk was managed through informal agreements within a defined
community. If someone's barn burned down and a herd of milking cows was destroyed, the
community would pitch in to rebuild the barn and to provide the farmer with enough cows
to replenish the milking stock. This cooperative (pooling) concept became formalized in
the insurance industry. Under a formal, insurance arrangement, each insurance policy
purchaser (policyholder) still implicitly pools his risk with all other policyholders. However,
it is no longer necessary for any individual policyholder to know or have any direct
connection with any other policyholder.

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 INTRODUCTION TO RISK

Risk is a condition where there is a possibility of an adverse deviation from a desired

outcome that is expected or hoped for. There is no requirement that the possibility should
be measurable but only that it must exist.

Risk and Uncertainty

We often find the terms “risk” and “uncertainty” used interchangeably. However, a
distinction needs to be drawn between the two. Risk is the chance or probability, whether
high or low, that someone will be harmed by a hazard. Risk is often thought of in terms of
chance (or probability) of loss. Uncertainty falls into two broad categories. There are those
for which the probability of occurrence is calculable either on a priori
grounds or through the statistical analysis of a series of similar events that have occurred
in the past. The remainder does not lend them to such measurement either because their
occurrence follows no discernable pattern or because they are unique events. Professor
Frank Night called the first group risks, whereas the latter he described as uncertainties, in
his book Risk, Uncertainty and Profit. John Maynard Keynes a well known economist
considers that the element of surprise is an important element of a situation of uncertainty.
The importance of uncertainty arises from its influence on the process of decision-making
of individuals, businesses as also society.
While risk is a state of nature, uncertainty is a state of human mind. It is therefore
possible to consider a situation risky if a number of outcomes is possible and the actual
outcome that materializes is not known in advance. Thus, risk is defined as the relative
variation of the actual outcome from the anticipated or expected outcome. For instance,
for a manufacturing firm, the development of a new product is risky as the profits from the
sale of the product in the market are uncertain before the actual sale. Likewise, the
development of a new drug by a pharmaceutical company is characterized by risk because
of the range of possible outcomes with regard to the market reception for the drug.

Risk – Peril - Hazard

The concept of risk is to be distinguished from the terms ‘peril’ and ‘hazard’. ‘Peril’ is the
force that leads to a loss situation or ‘Peril’ is simply defined as the cause of loss e.g. Fire,
Burglary, Theft etc. (i.e. the force which lead to loss).
As per the insurance policy condition there may be three types of perils like:

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RISK MANAGEMENT AND REINSURANCE

1. Insured perils – which are covered under the basic policy – say, fire, riot, strike,
flood, inundation, etc. as covered in basic Fire Policy.
2. Extended Perils – which are covered with a little bit of extra premium along with the
basic cover. In Fire Insurance these are known as Add-on Covers but in other line of
business – say, Engineering or Motor Policies these extended perils are known as
extensions of the basic cover.
3. Perils not covered at all – those may be either the uninsured perils or the excluded
perils (as excluded specifically by inserting the printed conditions) specifically
stipulated in the policy copy itself.
Again as per the ‘origin’ of a loss is concerned, the perils may be divided into three types
as below:
1. Act of God Perils – Those are natural catastrophe or calamity –like flood, inundation,
storm, earthquake, landslide, rock slide, etc.
2. Process related Perils – These are the perils associated with the starting of the
operation of any plant / machine or any instrument being put to work – say whenever
we put any machine say a generator or transformer for electricity supply it may be
subjected to breakdown, overloading or short-circuit, etc. – all such perils are known
as operational perils.
3. Human related perils – These are absolutely related to Human being. Some of the
perils are absolutely organized by bad people- like theft, burglary, dacoity, riot/strike
& malicious damage. Even Terrorism damage covered by insurers is the gifts of
terrorists (a group of people.
Perils that cause damage to property may include theft, burglary, fire, hailstorm,
windstorm, lightning and earthquakes. An example of peril is: if Rama’s car is
damaged in a collision with Ramesh’s car, collision is the peril or cause of loss.
A Hazard is a pre-set condition – that may create or increase the chance of loss arising
from a given peril or under a given condition. Hazard means the potential to cause injury
or illness and can apply to substances, methods or machines. Three major types of
hazards are usually distinguished.
(a) Physical hazard

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 INTRODUCTION TO RISK

(b) Moral hazard and

(c) Morale hazard
Physical hazard: A physical condition that heightens the chance of loss is called physical
hazard. A large number of examples of physical hazard from our daily life can be cited,
such as defective electrical wiring in a cinema hall which increases the chance of fire, bad
and poorly maintained roads that increase the chance of motor accidents and defective
locking system on the main door of an apartment that increases the chance of theft. It is
any hazard arising from the Material, Structural, or Operational failures of the risk itself
apart from the persons owning or managing it.
Moral Hazard: Moral hazard is a condition characterized by defects in the character of an
individual such as dishonesty that increases the frequency of loss or severity of loss or
both. Moral hazard is a common occurrence in insurance and is not easy to control.
Examples: making a fraudulent insurance claim, submitting an insurance claim for an
inflated amount and setting fire to an insured godown stocked with inventory.
It is arising out of the fraudulent activities of either insured or insurers. It involves any
tendency for the presence of insurance to increase the probability of loss or its amount. An
extreme example would be an individual who previously burned his own property to collect
the insurance claim. Insurance may affect behaviour in that less effort is taken to avoid the
loss, or the costs of the loss are exaggerated. More examples may be incurred by an
insured person than incurred by the same individual without insurance. All are the example
of Moral hazards. Losses become larger for the insurer due to the existence of Moral
hazard. With a view to controlling moral hazard, insurers take a number of steps such as
careful underwriting practices, and by including a number of provisions in the insurance
policy such as exclusions, deductibles and riders. Moral hazard minimization is possible
only through the following methods (which are not available in Traditional Risk
Management process but these are the part of Enterprise Risk Management processes):
1. Loss experience rating.
2. Partial risk sharing.
3. Credits for loss control.
4. Claims investigation.
5. Criminal prosecution.

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RISK MANAGEMENT AND REINSURANCE

Morale Hazard: It relates the condition or situation as existing in the society. It is very
prominent & highly existent in Health Insurance- say, a person has three daughters named
Ganga, Jomuna, Swaraswati and he has taken medical / health insurance cover under his
Mediclaims policy only for his first two daughters and unluckily Swaraswati suffered an
accidental injury – so the person will admit his third daughter in the name of Ganga or
Jomuna – i.e. he will go for this kind of morale hazard. Again whenever a patient is taken
to a hospital – the first thing the hospital authority will ask is the details about a Medical
/Mediclaim policy hold by the person to be treated under that authority. If the sum insured
of the policy is found as Rs. 5 Lacs, he will be immediately admitted to ICU but if the sum
insured is seen as by the hospital authority as Rs. 50, 000/- the patient may be treated at
the corridor of the hospital.
Sometimes, a distinction is drawn between moral hazard and morale hazard. While, as
defined earlier, moral hazard refers to a deliberate dishonesty resulting in increasing the
frequency or severity of loss, morale hazard refers to carelessness or indifference to loss
because of the presence of insurance. Examples include leaving the main door of a house
open to make entry of a burglar easy, leaving car keys in an unlocked car door, and
carelessness in regard to maintenance of health because of existence of a health
insurance policy. Such careless acts increase the chance of loss.
Inception Hazards – That give rise to the loss incidents– which starts or originates the
loss incident like the perils of fire, explosion or collapse, etc. arising out of say,
Inception hazards Proximate cause / peril operated
Loose wiring Fire
Smoking Fire
Friction Fire
Overheating Fire / Explosion
Hot surfaces Fire
Welding Fire
Sparks (electrical / mechanical) Fire
Chemical action Fire / Explosion

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 INTRODUCTION TO RISK

Static electricity Fire

Lightning Fire / Collapse
Burner flames (boiler / oven / drier) Fire

Contributory Hazards – Those contribute to spread the loss like burning f a building may
take a disastrous situation if fire is subsequently passes on to the neighbouring building /
house due to –
1. Poor construction of buildings (inferior material/wood/timber/plastic skylights/ glass
facades);
2. False ceiling/internal partitions/wooden lining;
3. Located in a difficult terrain/crowded place;
4. High density fire load (Solvents/ Chemicals);
5. Ducts for air conditioning, dust, vapour;
6. Bad housekeeping, dry grass, congested layout;
7. Unattended area;
8. Absence of safety devices – like fire fighting equipment;
9. No fencing, no security arrangements, no lighting;
10. No proper waste disposal method;
11. No work permit system;
12. Possibility of riot, strike or vandalism, etc..
Special Hazards – Those which are giving raise hazardous situations –some are given as
below:
1. Bulk storages (coal in open, solvent tanks, LPG tanks);
2. Complex chemical processes (Refinery/ Fertilizer/ Solvent Extraction Units);
3. Spray painting operations;
4. Pulverizing operations;

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RISK MANAGEMENT AND REINSURANCE

5. Material susceptible to Spontaneous combustions;

6. Pollution and contamination risks, etc.
Political Hazards – Those which arise mainly from political risk i.e. connected to political
connections like that are mentioned below:
1. Terrorism;
2. War;
3. Rebellion, Mutiny;
4. Military coupe;
5. Confiscation;
6. Abandonment/ Government ban, etc.
Natural Hazards – The risks i.e. subject matters of insurance if exposed to the following
natural calamity like:
1. Flood, Storm, Cyclone, Hurricane, Inundation;
2. Earthquake, Volcanic eruptions;
3. Snow/ Frost/ Ice storms;
4. Landslides/ Rock slides;
5. Subsidence;
6. Forest fire/ Bush fire, etc.
Characteristics of An Insurable Risk
We have stated previously that individuals see the purchase of insurance as economically
advantageous. The insurer will agree to the arrangement if the risks can be pooled, but
will need some safeguards. With these principles in mind, what makes a risk insurable?
What kinds of risk would an insurer be willing to insure?
The potential loss must be significant and important enough that substituting a known
insurance premium for an unknown economic outcome (given no insurance) is desirable.

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 INTRODUCTION TO RISK

The loss and its economic value must be well-defined and out of the policyholder's control.
The policyholder should not be allowed to cause or encourage a loss that will lead to a
benefit or claim payment. After the loss occurs, the policyholder should not be able to
unfairly adjust the value of the loss (for example, by lying) in order to increase the amount
of the benefit or claim payment.
Covered losses should be reasonably independent. The fact is that one policyholder
experiences a loss should not have a major effect on whether other policyholders do. For
example, an insurer would not insure all the stores in one area against fire, because a fire
in one store could spread to the others, resulting in many large claim payments to be
made by the insurer.
These criteria, if fully satisfied, mean that the risk is insurable. The fact that a potential
loss does not fully satisfy the criteria does not necessarily mean that insurance will not be
issued, but some special care or additional risk sharing with other insurers may be
necessary.
Risk means the probability and consequences of occurrence of injury or illness. Risk will
depend on such factors as the nature of the hazard, the degree of exposure and individual
characteristics.

Classification of Risks
Risks are basically classified into four categories.
1. Pure Risk and Speculative Risks
2. Dynamic and Static Risks
3. Fundamental and Particular Risks
4. Subjective and Objective Risks

1. Pure Risk and Speculative Risks

A traditional classification of risk distinguishes between pure risk and speculative risk.
Pure risk exists when a situation is characterized by uncertainty as to whether or not loss
will occur. Pure risk does not admit the possibility of gain but only potentiality for loss or
status quo. Examples of pure risk include prospect of untimely and premature death, likely
damage to property by flood, earthquake, lightning and fire and catastrophic medical

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RISK MANAGEMENT AND REINSURANCE

expenses. Speculative risk is present when an event can result in either a gain or a loss or
status quo. Examples of situations involving speculative risk include individual’s decisions
to buy shares or investment decisions of business firms or business ventures and
investing in real estate.
Three prime reasons warrant the distinction to be drawn between pure and speculative
risks. While insurance companies basically insure pure risks, speculative risks are
generally not considered insurable, barring a few exceptions like institutional portfolio
investments. Speculative risks are voluntarily accepted because of its two-dimensional
nature in that they offer the possibility of gain.
Second, while the law of large numbers can be easily applied to pure risks, speculative
risks are not easily amenable to the application of law of large numbers which facilitates
prediction of future loss experience by insurance companies. A notable exception is the
efficient manner in which casino operators apply the law of large numbers to the
speculative risk of gambling.
Third, while the society is harmed by the presence of pure risk when a loss occurs, society
may benefit despite the occurrence of loss from a speculative risk. There is no doubt that
the society does not benefit from the loss arising from a pure risk situation. A company
developing a new technology to produce computers at a lower cost may benefit the society
as a whole while some existing computer companies may become bankrupt because of
this development, is an example in this regard.
However, it is possible that in some situations both pure and speculative risks may exist.
Likewise, some of the speculative risk decisions which are motivated by earning profit
might have an impact on pure risk exposures. For example, developing and introducing a
new product into the market by a manufacturing firm mainly entails speculative risk. In
addition, the decision might also lead to a pure risk exposure such as potential product
liability.
Another important point is to be noted. Not all pure risks are insurable. Therefore
sometimes a further distinction is drawn between insurable pure risks and uninsurable
pure risks. Insurable pure risks that individuals or business firms are exposed to can be
classified as follows:
(a) Personal Risks,

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 INTRODUCTION TO RISK

(b) Property Risks,

(c) Liability Risks, and
(d) Risks arising from the failure of others
(a) Personal Risks: Personal Risks consist of the possibility of loss of income or assets
as a consequence of a person’s loss of earning power. In general, the loss of theability to
earn income by a person is subject to four perils. (i) Premature death (ii) dependent old
age, (iii) sickness or disability, and (iv) unemployment.
(b) Property Risks: Anyone owning property faces property risks as it can be destroyed
or stolen. There are two types of losses relating to property risks. Direct loss or indirect
loss or consequential loss. An example of a direct loss relating to property is the loss
occasioned by a building destroyed by fire. The owner of the building suffers loss to the
extent of the value of the building. However, the owner of the building, besides losing the
value of the building, loses the use of the building during the period of reconstruction. This
is an instance of the indirect or consequential loss to the property. Thus the owner of the
building may face property risks, involving two types of losses:
(i) loss of the property itself, and
(ii) loss of the use of the property resulting in lost income or additional expenses.
Property Risks may be the direct losses or the consequential losses arising out of such
specific direct losses being covered under the affected insurance policy. These risks,
which are not individual in nature, can also be called pure risks arising from –
(i) The loss of the property
(ii) Loss of use of the property and
(iii) Additional expenses occasioned by the loss of the property.
(c) Liability Risks: Generally, the essence of the liability risk is the unintentional injury
of other persons or unintentional damage to their property through negligence or
carelessness. Liability may also result from deliberately intentional injuries or damage.
Laws stipulate that a person causing injury to another or causing damage to another’s
property is held responsible for the harm or damage caused. In addition, an employer or
other principal is responsible for the acts of omission or commission of agents or
employees and can be held vicariously liable for their negligence. Thus, liability risks

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involve the possibility of loss of present assets or future income as a consequence of

damages estimated or legal liability arising out of either intentional or unintentional acts or
the invasion of other’s rights.
Here the liability means ‘responsibility’ i.e. being responsible for –
(1) ‘Act of self’ or (2) ‘On behalf of those whose act, he/she is responsible’.
(d) Risks arising from others’ failures: A person’s failure to perform a service agreed
upon or his/her failure to meet an obligation which he/she undertakes to discharge and as
a consequence another person incurs a financial loss, there exists a risk. Examples of
such risks include a contractor’s failure to complete a building in time as per schedule or a
debtor’s failure to make payments as agreed upon.
Losses cover in insurance (as well as in Risk Management Processes) are given below:
• Property Damage
1. Buildings,
2. Plant & Machinery,
3. Furniture /Fixtures/Fittings,
4. Stock in process/open/ godown/ in transit,
5. Electrical installations/equipment/ancillaries,
6. Motor vehicles, etc.
• Liability
1. Public liability as per the statutory law (PLI Act, Third party liability, etc.).
2. Product liability as per common law, contractual liabilities (as per various
contractual obligations towards the customers, principals, other sub-
contractors, etc. as per Consumer Protection Act).
3. Professional liability in course of doing professional jobs.
4. Legal liabilities of the employers towards their employees.
5. Legal liability arising out of falling from height, breakdown & other malfunction
of Lift used for elevating the people or materials against the owner of the lift /
building (where it is installed).

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 INTRODUCTION TO RISK

6. Commercial Global Liabilities of the Logistic Companies (engaged for the

transit of various items).
7. Liabilities for Clinical Trials for the various medicines (manufactured by drug
manufacturers) before introduction of that drug in the market for public use.
8. Any other kinds of legal liabilities existing as the possibility may be faced by
any individuals, etc.
• Human -Life
1. Loss of life while engaged in professional duty,
2. Accidental death,
3. Bodily injury,
4. Collision with vehicle, etc.

2. Dynamic and Static Risks

Another classification of risk, cutting across pure and speculative categories, is the
division into static risks and dynamic risks. Dynamic risks arise from changes that take
place in every society; that is, economic, social, technological, environmental, and political
changes. Static risks are those that would exist in the absence of such changes.
Dynamic risks are closely related to the speculative risks whereas most pure risks are
examples of static risks.

3. Fundamental and Particular Risks

Fundamental risks are those which affect the whole of society or a major part thereof or
some groups, such as uncertainties arising out of the economic or political system or
natural catastrophes such as earthquakes and floods. They are impersonal in both cause
and effect. Particular risks on the other hand affect mainly the individual or firm and arise
from factors over which he or it may exert some control. This distinction assumes
importance as social insurance and government insurance programmes or government
subsidies may be necessary to deal with situations of fundamental risk. A particular risk is
a risk that does not affect the entire community or groups of persons within the economy
but affects only individuals. The individual deals with particular risks through the use of
insurance, loss prevention or some other technique of risk management.

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RISK MANAGEMENT AND REINSURANCE

Examples such as bank robberies and car thefts affect the particular individuals or firms
experiencing such losses. In contrast, a fundamental risk is a risk that affects a group of
persons, or the entire economy. Risks such as natural disasters, war, high inflation and
cyclical unemployment are some of the examples of fundamental risk. The recent Gujarat
earthquake is another example of fundamental risk.

4. Subjective and Objective Risks

A fourth classification of risk that we come across is dependent upon the criterion whether
it is based upon the state of mind of an individual or it is precisely observable -subjective
or objective risk. If the type of risk is more precisely observable and therefore measurable
it is referred to as objective risk. In this type of risk, the actual experience may differ from
the one expected. On the other hand, subjective risk basically emanates from a person’s
state of mind or mental attitude. As a particular individual’s perception of risk in a
particular situation may be different from another, there is a possibility of making different
decisions by two individuals in a situation that is seemingly identical. It is clear, therefore,
that it is not sufficient to know the degree of objective risk. We have to also learn the
attitude towards risk of a person who is acting on the basis of this knowledge.
Individuals, businesses and societies are increasingly subject to risk and have to cope
with it. Bhopal and Chernobyl, the Tsunami tragedy) illustrate how a single event may
impose serious harm on societies. The management of risk has become considerably
more complex and more important today than in the past. In most cases, our concern
about risk relates ultimately and exclusively to individuals, whether as members of
families, as owners, employees, or customers of businesses or as citizens.

Types of Risks
1. Actuarial risk
2. Asset risk
3. Pricing risk
4. Interest rate risk
5. Systematic risk
6. Liquidity risk

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 INTRODUCTION TO RISK

7. Operational risk
8. Legal risk
9. Credit risk

Actuarial risks
A contract of insurance, though basically meant for financial protection also offers several
other benefits to policyholders. For example, a life insurance policy may cover death,
incapacity/disability or injury but it may contain certain clauses and promises for loan,
surrender or other benefits.
All the promises and options are embedded in the insurance contract but is the insurer
charging enough premium to fulfill all their promises? This is actuarial risk. It is the risk of
charging too little premium and suffering lower cash flows, which is insufficient to fulfill
promises. Actuarial risk may arise from the following factors:
I. Risk from incorrect mortality or morbidity structured in the pricing. The actual
experience may be different from those built into the pricing of products. The
deviation may arise due to inexperience in assessing the loss or the loss projections
exceeding even in the conduct of normal business, which again depends on the
nature of risks insured.
II. Risk from loans and surrender options. Contracts of insurance provide several such
options to policyholders. Cash values are guaranteed in such options and these
promises are embedded in the contract features. These additional facilities and
options are important from the point of view of marketing the insurance products,
offer convenience to customers and also fulfill regulatory requirements.
Policyholders with such options of loan and surrender can demand cash value at any point
of time. These payments are made at book value. Risk arises when the market value of
assets that supports these payments is less than the book value, creating liquidity
problems. The timing of such withdrawal sometimes would complicate the situation, e.g.,
when the interest rate rises it results in decrease in market value.
Options of loan and surrender are more valuable to policyholders during rising interest
rates, yielding better returns for them than insurance policies.

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Asset risks
Assets of insurance companies consist of investments made by them. In due course of
managing the investment portfolio, assets are prone to risks, which may alter their value
as well as the returns generated from them.
The business of insurance companies is to provide risk coverage to the policyholders.
Premium is collected from the policyholders to provide risk coverage. The corpus or fund
so collected and accumulated is maintained as reserve liability for servicing the
policyholders.
Since the insurance companies promise to provide assured returns to policyholders in
respect of certain policies and satisfy the claims arising out of policies, the funds have to
be invested or lent out as loans and these investments/deployments form the assets of an
insurer. These assets have to generate adequate returns and supplement the regular
profits from insurance related operations.
Insurance company assets (investments and deployments as loans) are exposed to risks,
i.e.,
• Uncertainty with regard to safety of the invested funds
• Possible decrease in value of the assets due to unfavourable market movements
which may in turn adversely affect the generation of expected returns
• Possible default in the payment of interest and the principal by the borrower.
Asset risk arises when insurance companies are unable to meet claims of policyholders in
full or in time due to poor quality of its assets.
With gradual deregulation of the investment portfolio of the insurance companies, a higher
percentage of assets are at the disposal of insurers for investments in market instruments.
Even the type of instruments and investment avenues are growing in number. Hence the
risk management function is growing in importance in the insurance sector.
An effective strategy is therefore required to manage the assets and the liabilities of the
insurance companies. The majority of the assets of the insurance companies lie in gilts,
debt instruments, and equity instruments, which are susceptible to risk from adverse
market movements.
Since the insurers assure the safety of funds and the stability of returns, they have to
invest their asset portfolio in proper avenues bearing in mind these goals.

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 INTRODUCTION TO RISK

If this aspect of financial management is not handled properly the insurer may not be able
to meet his commitments to the policyholders and servicing their claims may become
difficult. The returns may fall and so also the value of investments.

Pricing risk
The price of a product should be adequate to pay for losses, fetch profits and balance the
risk and return profile, i.e., if the risk from a type of policy is higher, then the return should
also be correspondingly higher by appropriate fixing of premium. The product should be
competitive in the market with respect to its price, otherwise the insurer will lose market
share.
In addition, price should leave a profit margin after meeting the cost and servicing
expenses. If the margin is strained the returns are prone to be affected.
There is also a risk of the level of costs being maintained in future. If the costs of providing
insurance increase then the profit margins are strained.
Pricing risk would arise due to increase in value of liability due to inappropriate pricing that
would reduce the future cash inflows. There can be many reasons for decrease in cash
flows including that the mortality and morbidity rates are higher than anticipated, income
and return from investment are lower than expected.
Managing risk is difficult as information related to liabilities is not freely available
compared to assets.
All risks must be properly anticipated, assessed and quantified. A risk premium is added to
the price to set off or compensate for this and ensure a safe profit margin. Also, any
probable future change has to be taken into account and the company should be geared
up to handle this.

Interest rate risk

The changes in market interest rates can adversely affect an insurance company’s
financial condition. It affects value of both assets and liabilities of the insurer. There is a
risk of insolvency if the fluctuating interest rates affect assets more than liabilities.
Fluctuations in value of assets and liabilities have to be judged based on whether interest
rate increases or decreases.

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When interest rate increases the value of both assets and liabilities would decrease. Risk
arises when this decrease in value is more in liabilities than in assets resulting in reduced
capital.
When interest rate increases, there will be more surrender of policies and increase in
loans due to which the companies have to sell assets. In an already depressed market
such sales will fetch less value forcing more sale of assets.
When interest rate decreases, the value of both assets and liabilities will increase. The
risk arises when the value of liabilities increases more than the assets.
Policyholders will add more funds forcing the company to add assets purchasing them at
its value.
However such interest rate risk would be managed using classic management concepts
like duration, convexity, etc.
Interest rate risks can be of the following types:
Rate level risk - if the interest rates change (as administered by RBI), the income from
interest on invested securities also changes.
Volatility risk - The interest rates may also change due to fluctuations in market demand.
This may reduce the interest income from investments.
Price risk - There remains a threat that the value of a security may decrease if the interest
rates rise and vice versa.
Reinvestment risk - It may happen that if the interest rates go down, the interest income
received from previously made investments cannot be invested again at the same rate at
which the principal was originally invested. They have to be invested at a lower rate of
interest.
Inflation risk - If the changes in interest rates do not keep pace with the change in the rate
of inflation then the real rate of interest (the real income obtained after accounting for
charges for expenses and inflation) may be negative.
Distress sale - Investors may withdraw funds in times of adverse rate movements and this
in turn reduces the market value of funds.

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 INTRODUCTION TO RISK

Systematic risks
There are many economic factors that affect value of financial assets and liabilities.
Systematic risks cannot be eliminated totally but can be managed by hedging.
Interest rate is one major factor contributing to systematic risks, others are inflation,
foreign exchange, etc. because of variation in interest rates the values of assets and
liabilities vary as explained earlier. Interest rate also causes refinancing risk and
reinvestment risk.
Refinancing risk is the risk of cost of rolling over of an investment every year exceeding
the benefits. Reinvestment risk is the return from new assets being less than cost of
financing.

Liquidity risk
To service the claims of the policyholders the insurance companies need to have cash or
near cash (readily marketable) instruments. Lack of adequate liquidity may lead to
bankruptcy of the insurer if the amount of claims exceeds the amount of available funds.
Liquidity crisis may arise due to unforeseen large claims or loan surrenders from
policyholders during interest rate increase.
Liquidity risk management is about measuring and managing the liquidity needs, i.e., meet
any liability payments to the policyholders and avoid any adverse situations. The
maturities of the instruments invested and the assets should correspond to the liabilities
both with respect to the amount and timing of payout. The inflows of funds and the payouts
should be properly estimated for determining the amount of liquidity to be maintained. The
need for adequate liquid funds to service the claims is thus obvious.
It should be kept in mind that excess liquidity might reduce the profits as maintaining idle
cash deprives the insurer from profitably deploying the funds in investible instruments.
The invested assets should be diversified by investing in different types of instruments
belonging to different sectors and companies.
Besides, the required percentage of instruments should be readily marketable and at the
desired price, i.e., the instrument should be capable of being easily offloaded in the market
and at a price not less than its intrinsic value to ensure availability of liquid funds to
service the claims.

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If this aspect is overlooked, then such sticky investments may cause bottlenecks in
realising the values at the required time when demand for funds arise.
It should be noted that liquidity should be maintained vis-à-vis profitability though the two
may be inconsistent. For example long term securities generate higher profits but offer a
lower degree of liquidity while the short term securities offer higher liquidity but low
returns. Thus a proper balance depending on the asset liability portfolio has to be
maintained by the company.
Besides idle cash imparts liquidity but there is a cost associated with it in the form of
opportunity cost. Opportunity cost is the interest income lost on idle cash.

Operational risk
An insurance company faces risk from its own operations if the systemin placeis not
geared to handle the required challenges arising in due course of business. Operational
risk is the risk of loss resulting from inadequate systems and control, human error or
management failure.
The inefficiency may be in the process implemented, the business model adopted,
compliance to certain rules and practices, fraud committed by insiders or outsiders,
technology upgraded etc. Nowadays information technology systems and solutions failure
is an impediment to the normal functioning of the company.
The operational or procedural aspects should be efficient to meet any unanticipated
threats in future. Business practices always run the risk of becoming obsolete or being not
adequate to match any unanticipated or peculiar situation. They also need to comply with
legislation and regulations. The ability of management, decision-making abilities should be
upto the mark to face any unforeseen situations and allow the developments to take place
while keeping it under controllable limits.
The companies also face threat from external risks like properly gauging the current
market trends and altering the business strategies suitably. If the company is not geared
up for this, the market share may be eroded causing loss in revenues.

Legal risk
Legal risks are threats to an insurance company due to the technical intricacies of the law.

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 INTRODUCTION TO RISK

Legal risks may erupt from the following sources:

• In the implementation of individual contracts
• By a change in the legislation and regulations brought about by the government
• Any new verdicts given by the courts
An insurance company executes legal contracts to provide assurances. These are subject
to certain legal terms and conditions, which may be unique to a particular policy. These
commitments have to be adhered to by the company. Such terms and conditions may be
subject to changes over time or certain peculiar situations may develop for which no
stipulations would have been made at the time of selling the policy. These loopholes may
pose a threat to the insurance company and may cause unanticipated increase in
liabilities.
An insurance company faces risk from the change in regulations by the government. For
example, if a particular line of business is barred or if restrictions are imposed then the
company has to change its game plan to face the new rules.
Any change in the tax policies of the government pose a threat to the business and
revenues of the company. For example, service taxhas been replaced by GST on the
insurance premiums causing a shift in the type of policies sold (to single premium
policies). The scale down of benefits in section 80 C and taxability of maturity proceeds of
insurance policies as well as applicability of TDS on the same @ 1% has also affected the
insurance business.
The insurers face the threat of losing their reputation if the service is not upto the mark
and a dissatisfied client takes the matter to the court and the court pronounces an
unfavourable verdict. There is a risk from policyholder claims due to ambiguous
understanding of terms and conditions, overlooking any particular aspect, which may
creep up later and cause legal hurdles.
For example, the September 11, 2001 attacks on World Trade Center (twin towers) is a
case for review. The policyholders claimed that the devastation was caused by two
separate events since there were two towers each hit by two different planes. But the
insurers regarded it as a single event and declined to pay a double compensation for two
separate events.
Eventually the judgment confirmed it as a single event. Thus legal risks may pose a
serious threat to the normal profits of a company.

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Credit risk
Credit risk arises when the borrower of money by way of loan from the insurance
companies fail to pay. As stated earlier, insurance companies also invest in loans and
other securities. In addition to the loans becoming non recoverable, there may be
instances where the bonds/debentures purchased by the insurance company results in
default by the borrower.

Sources of Risk
Risk is having different meaning in different context as stated below:
1. To any common man it is “Exposure to Danger” – as our parents always state that
don’t mix with the unemployed local youth (who resorted to vandalism) since they
may harm us.
2. Whenever we go for marketing any insurance product we always harp on
“Uncertainty about a loss” (i.e. Any Financial Loss) – that means we always focus on
the fortuitous nature of the subject matter we cover – the loss may or may not
happen although there is always the possibility of a loss (but the loss should not be
sure to happen).
3. It is a fundamental fact or feature of life (our all Material Possessions is always
exposed to damage/ loss). In insurance market we cover ‘Direct Physical Loss &
indirect Losses like Liability & Loss of Profit of any Organization/ Individuals’.
4. Risk may also denote the property which is exposed to loss / damage and has
intrinsic value.
5. But the risk against any public policy or statutory law may not be covered.
6. In property damage the word ‘RISK’ is related to physical hazard but not the moral
/morale hazard. In General Insurance market, we also cover the risk related to
‘HUMAN NATURE (for both individual & collective in nature & arising from economic
& social conditions).
In 1901 Henry Marsh, one of the founders of Marsh & McLennan wrote a letter to a
prospective client: “Your problem is not insurance, it is risk”. In Insurance, as well as in
Risk Management parlance the definition of the word ‘RISK’ could be –

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 INTRODUCTION TO RISK

1. Associated with any material possession of anybody and is related to the insured
object ( like a house, factory, ship or car) under General Insurance policies;
2. Perils ( fire, storm, or collision)
3. Set of hazardous conditions (for example -the use or storage of flammable
materials).
4. Uncertainty about a loss – the moment loss is sure & certain – it may be termed as
moral hazard – say a person having detected a heart problem and suggested for
angioplasty approaches a known official of insurance company for Medical cover
(i.e. Mediclaim Policy) when the person is allowed to avail insurance cover then it is
not case of underwriting a risk but to be accepted as a moral hazard.
A classification of different sources of risk is suggested which consists of Operational /
Internal risk, Financial Risk and Strategic Risk
(a) Operational / Internal Risks: Operational / internal risks are those that arise from
the operations of an organization or from the activities of an individual. This type of risk is
associated with failures of a system, human errors, inadequate procedures and controls
and deficiencies in information systems. We may observe that individuals or organizations
have some control over them. Examples of this class of risks include automobile
accidents, strike by employees of a firm and work stoppages, loss of damage to property
as a result of fire, uncertainty about legal liability arising from production of defective or
faulty products.
(b) Financial Risk: Financial Risk arises from individuals or organizations using
financial institutions or ownership of financial instruments. Financial risks are those
occasioned by changes in interest rates, transactions involving foreign currency, share
issues, extension of business credit and employment and use of derivative instruments.
They are primarily external to the individual or business. Therefore, this type of risk is not
under the direct control of the individual or business. Individuals making investments, or
borrowing funds from a finance company to buy a car or a residential house or a firm
extending credit to its customer are some instance of financial risk.
(c) Strategic Risks: Strategic risks basically arise from economic, demographic,
political, technological and social factors that impact on individuals and businesses. A

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number of examples can be cited such as consumer preferences, legal system, regulatory
environment, terrorism and global warming. While it is not possible to control these factors
and risks involved, it is within the capability of individuals and businesses to take steps to
mitigate the deleterious effects of such risks.
It is necessary to state that such classifications of risks and sources of risks are largely
arbitrary. In fact, all risks, however classified, are subject to the same approach and
analysis of risk management. The ever broadening of the scope of risk management in
modern times lends support to the futility of such classification of risks. While historically
management of risk has been concerned primarily with situations whose outcomes involve
losses only, individuals, businesses and government have come to realize that this
fragmented approach to risk management is not efficient and what is needed is a
comprehensive, an integrated or holistic approach encompassing all risk exposures which
an individual or organization faces. For instance, corporates face a whole range of risks
such as financial, operational, business and insurable. The source of risk is not so
important as the impact of the risk exposure. Corporate earnings are disrupted, funding of
new investments might be adversely affected and even a threat of bankruptcy of the firm
may develop whether the risks are financial or insurable. Furthermore, it may not be
feasible to conveniently isolate the contribution by each source of risk as the risks might
not just add up. The risk tolerance level of a firm in regard to any particular risk is
influenced largely by its current level of exposure to other risks. A more elaborate
discussion of risk management and integrated risk management approach will be found in
later chapters.
Risk is not necessarily a bad thing. In fact, risk-taking is an essential component of a
competitive economy. At the same time, an important characteristic of risk is that some
losses will actually occur. There is a financial loss when a wage earner dies, or money is
stolen or a building is destroyed by fire. Such losses are examples of primary burden of
risk and the main factor prompting individuals and businesses to try to avoid risk or
mitigate its impact. Once an individual or organization or society is exposed to risk, there
is a need to manage the risk by suitable techniques. The process of management of risk is
discussed in the next chapter.

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 INTRODUCTION TO RISK

REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. One of the following is not true.
a. Risk is often thought of in terms of chance of loss.
b. The element of surprise is an important element of a situation of uncertainty.
c. The importance of uncertainty arises from its influence on the process of decision-
making.
d. Uncertainty is a state of human mind.
e. None of the above.
2. The relative variation of the actual outcome from the anticipated outcome is
known as:
a. Risk. b. Uncertainty.
c. Deviation. d. Digression.
e. None of the above.
3. The cause of the loss is defined as:
a. Uncertainty. b. Hazard.
c. Peril. d. Risk.
e. None of the above.
4. If Verma’s car is damaged in a collision with Valmiki’s car, such collision is
a. Uncertainty. b. Hazard.
c. Peril. d. Risk.
e. None of the above.
5. Defective wiring in a cinema hall which increases the chance of fire, is an
example of:

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a. Moral hazard. b. Peril.

c. Risk. d. Physical hazard.
e. None of the above.
6. If somebody is setting fire to an insured godown stocked with inventory, with
an intention to make undue profits, it is case of
a. Morale hazard b. Moral hazard.
c. Evil mind d. Adverse selection.
e. None of the above.
7. If you are keeping your main door open, so that burglars can make easy entry,
it is a case of:
a. Morale hazard b. Moral hazard.
c. Evil mind d. Adverse selection.
e. None of the above.
8. Damage to property by flood, earthquake or fire is a case of;
a. Pure risk b. Speculative risk.
c. Dynamic risk. d. Static risk.
e. None of the above.
9. Shaym purchases 500 RIL shares with intent to make profit. What risk is he
taking?
a. Pure risk b. Speculative risk.
c. Dynamic risk. d. Static risk.
e. None of the above.
10. Insurance companies generally insure-
a. Pure risk b. Speculative risk.
c. Society risk. d. a & b.
e. None of the above.

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 INTRODUCTION TO RISK

11. Dynamic risks are more closely related to:

a. Pure risk b. Speculative risk.
c. Dynamic risk. d. Static risk.
e. None of the above.
12. Risks which affect the whole society like natural catastrophes are examples of:
a. Dynamic risk. b. Fundamental risk
c. Particular risk d. Nature risk
e. None of the above.
13. When there is robbery in Horizon Bank and it lost Rs 1 crore, it is a case of :
a. Fundamental risk. b. Particular risk
c. Bank risk d. Dynamic risk
e. None of the above.
14. When there is a failure of a system, human errors, inadequate procedures and
controls, we call it as...
a. Objective risk. b. Operational risk.
c. Human risk. d. Systems risk.
e. None of the above.
15. The basis of modern insurance theory is:
a. Law of Large Numbers. b. Theory of Probability.
c. Utility Theory. d. All the above
e. None of the above.

Answers
1. e 2. a 3. c 4. c 5. d 6. b 7. a 8. a 9. b 10. a
11. b 12. b 13. b 14. b 15. d

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SECTION – B
Short & Essay Questions
1. Distinguish between risk and uncertainty.
2. What is hazard? Explain different hazards
3. Outline the difference between pure risk and speculative risk. Discuss the
importance of the distinction.
4. Explain the distinction between static pure risks and dynamic pure risks. Illustrate
with examples.
5. Give examples of static and dynamic speculative risks and explain the importance of
the distinction.
6. Distinguish between subjective and objective risks
7. Distinguish between Fundamental and Particular risks
8. Write a brief note on each:
a. Personal Risk b. Property Risk
c. Liability Risk d. Operational Risk
e. Financial risk f. Strategic Risk

SECTION – C
Case Studies
1. Mr Sunil Purushotam was awakened by a phone call at 2.30 am on a wintry
December night. Earlier that night the first major storm of the year has hit the
coast. Praveen, a risk manager, had gone to bed unaware of storm’s intensity
and was startled to discover that a devastation has been done. The voice on
the other end of the line belonged to a police officer, the night patrolling party,
who explained that there is no proper equipment to tackle the problem of
storm. Property has been damaged and many human lives were lost besides
some missing livestock. The district administration did not anticipate these
problems and therefore was running short on arrangements.

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Were that not bad enough, the officer concluded the call by noting that the
storm was really agonizing. Vehicles that can be used for rescue operations
are not available. Some private vehicle drivers are not cooperating and some
of them are drunk and behaving badly. Discuss.
Ans. This dramatic story unfolds how risk strikes us and how unprepared we are, more so
in a country like India, where risk management as a concept has not gone through
the minds of many. We live in a world of risk and uncertainty. Unexpected events
can and do occur and disruptive effects can be enormous. This example shows both
the tangible and intangible consequences of risk - a tragic loss has occurred, to be
sure, but the damage is not limited to physical injury and property damage. There
may be political implications in as much as the incident reflects poorly on
devastation management practices and relief operations. Certainly, the impact on
the victims’ families is much more than economic. The time the risk manager/district
administration spends attending to this matter could have more productive uses
elsewhere. Finally, the resources used to pay for the damages are public resources
that otherwise could have been used to carry out any welfare activity.
2. Over the years, the Olympic games have presented a host of interesting and
challenging exposures to loss. Revenues from the games typically come from
the sale of television broadcasting rights, ticket sales, and commercial
sponsorships. Identifying all of the risks associated with the Olympics is
always a major undertaking. In the past, more than one thousand official
vehicles have been required, ranging from vans and buses for shuttling
athletes and personnel to the various events, to ‘stretch’ limousines for
transporting visiting foreign dignitaries. Thus, the collision peril and its
associated losses must be recognized and managed. In planning for the 2000
summer games in Sydney, Australia, a total of 10,000 athletes were expected,
together with about 5000 officials, 50,000 volunteer workers and 9 million
spectators.
Sources of risk are carefully analyzed throughout the preparations for each
Olympics. Because many of the sports are inherently dangerous, the
possibility of personal injury to competitors as well as spectators is always
present. And the fact that some of the athletes may be young teenagers only
complicates the risk management challenge. The organizers of the Sydney

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Games were especially concerned about technological risks (such as

computer malfunctions that might interrupt electronic scoring systems),
security (including the threat of terrorism) and crowd control. Transportation
issues in Australia are also important. Arranging for a governmental guarantee
that train schedules would be disrupted by no more than 5 minutes even if an
individual committed suicide on the tracks solved one interesting risk
management problem.
Discuss.
Ans. Managing public risk of such a magnitude is real challenge. It requires lot of
planning and careful execution. Any glitch on any part can goof up the whole
operations and it may result in a catastrophic loss. Some very serious loss
exposures may not be obvious. For example, weather-related perils can force the
postponement of a ticketed event, such as the opening ceremony. The cancellation
of the television coverage contract, often the largest single source of revenue, would
be devastating. Such a cancellation actually did occur in 1980, when the United
States boycotted the Moscow Olympics to protest the Soviet invasion of Afghanistan

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CHAPTER – 2
INTRODUCTION AND PROCESS OF RISK
MANAGEMENT
OUTLINE OF THE CHAPTER
1. Introduction to Risk Management
2. Process of Risk Management
— Risk identification
— Evaluation of Potential Losses and Risk Assessment
— Selection of Appropriate Techniques for Treating Loss Exposures
— Selection of Appropriate Method for Handling Losses with Risk Management
Matrices.
— Implementation of Risk Management Programme and its Evaluation and
Review
3. The Job of Risk Manager

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Understand the Need for Managing Risks
• Describe the process of Risk Management
RISK MANAGEMENT AND REINSURANCE

• Determine the Objectives of Risk Management

• Identify and evaluate Potential Losses
• Distinguish between Frequency of Loss and Severity of Loss (Maximum
Possible Loss and Probable Maximum Loss)
• Understand the Concepts of Measures of Central Tendency, Dispersion and
Applications of Probability Distribution in evaluation of losses
• Identify the components of Risk Management
• Select Appropriate Techniques of Risk Management
• Assess the Importance of Implementing and Periodically Reviewing the Risk
Management Programme
• Understanding the job of risk manager.

Introduction to Risk Management

Risk management, according to Bernstein is the dividing line between modern times and
the past. According to him “The ability to define what may happen in the future and to
choose among alternatives lies at the heart of contemporary societies. Risk management
guides us to choose over a vast range of decision-making, from allocating wealth to
safeguarding public health, from waging war to planning a family, from paying insurance
premiums to wearing a seat belt, from planting corn to marketing cornflakes”.
Risk management is a process with the objective of identifying risk exposures faced by an
individual / organization with a view to selecting the best available technique for treating
such exposures.

Definition of ‘Risk Management’

1. Risk Management is ‘Economic Protection of Assets & Earnings against Probable
Losses’
2. Risk Management is a discipline concerned with the maintenance of financial
stability through cost effective methods of protecting assets and earnings
3. The Systematic appraisal of a Company, plant or operation using in many cases a
number of specialist skills and technique, so that risk can be quantified and specific
proposals can be made for reducing them.

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 INTRODUCTION AND PROCESS OF RISK MANAGEMENT

Risk Management is a managerial function or a technique concerned with the protection of

a firms/ organization’s assets, earnings or profits, legal liabilities and personnel
(employees) against unforeseen accidental / possible losses (that results / may result from
fortuitous events i.e. accidental happenings). Risk management is a systematic process
involving various steps like – ‘Risk Identification’, ‘Risk, ‘Risk Prevention / Avoidance/
Minimization, ‘Risk Control’, Risk Retention’ and ‘Risk Financing’. Purpose of Risk
Management is to find out:-
1. High frequency & low severity of losses (that are not economic to insure); &
2. Low frequency & high severity losses (where insurance is necessary).
Risk Management process is planning, arranging and controlling of activities and
resources in order to minimize the impact of uncertain events. Risk Management also can
be defined as a decision process for selecting and putting into practice those risk
management techniques which are most cost-effective for a particular organization. Now
Traditional Risk Management concept & process uses a lot of risk protection measures &
techniques in sequence typically involving the following (or equivalent) steps:
1. Identifying and analyzing loss exposures.
2. Examining the feasibility of alternative risk management techniques.
3. Selecting the apparently best technique (s) & Implementing the chosen technique (s)
4. Monitoring and improving the risk management programme.
According to Kenneth Arrow “the essence of risk management lies in maximizing the areas
where we have some control over the outcome while minimizing the areas where we have
absolutely no control over the outcome”.
The subject of risk management does not have a long history. It is reported by Ben Hunt
that “one of the earliest references to the term “risk management” was in 1956 in the US
when it was used in a Harvard Business Review article. The term started gaining currency
in 1970s. According to him “even the establishment [by corporations] of risk management
departments toward the end of 1980s and early in the 1990s did not herald a more
strategic approach to risk and its management….”Non-financial risk management
remained framed within the discipline of insurance purchasing. The spectrum of risks that
corporations wanted to manage still tended to be ‘insurable’ – physical hazards, liability
risks and so on”.

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The focus on risk management, particularly by corporate, has undergone remarkable

change over time. There has been a change in regard to concern with gravity of risk. The
corporate have become far less concerned with traditional “high frequency, low severity”
risks but have started devoting greater attention to risks that could lead to corporate
collapse and corporate bankruptcy.
Doherty observes that risk management is about insurance and hedging and biases the
use of both insurance and financial instruments to control the costs of corporate risk. For a
long time, corporate have used insurance to manage property, liability and other insurable
risks. Insurable risks expose the firm to volatility that is only on the downside – chance of
loss, not of gain. However, it was slowly recognized that insurance is not the only possible
strategy. To pay for losses, insurance provides the needed funds. With no insurance, the
firm could pay for losses by contracting a debt or raise fresh equity capital. It is
increasingly accepted that the source of risk is of no great importance. Furthermore, the
contribution of each source of risk cannot easily be isolated. As Doherty observes “risk
does not simply add up”. There is therefore a need to adopt a comprehensive approach for
managing risk. This comprehensive strategy for treating risk is referred to as “integrated
risk management” (IRM) or “enterprise risk management” (ERM). The topic of enterprise
risk management will be discussed at some length in a later chapter.
We may discuss here the process of management of pure risks. Whether the risk
exposures are by an individual or business concern, the steps generally taken for
management of such risks are the same. Rejda provides the following schematic
presentation of the risk management process.
The basic objective is the measurement of futuristic possibility of loss or damage (i.e.
finding the risk exposure through Risk Identification & Analysis) to various risks (i.e. the
subject matter of insurance - like a Factory, Godown, etc.) and the same is necessary for
the management of any organization to decide upon –the Loss Control (i.e. the physical
control of the possibility of loss through ensuring risk improvement measures &/or loss
minimization measures.
To understand the purpose of Risk Management let us take one incident -
1. Dan Hacking, one European city’s Risk Manager, was awakened by a phone call at
2.45 A.M. on a wintry November morning, when that night the first major snowstorm
of the year had hit the city. Earlier he had gone to bed unaware of the storm’s

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 INTRODUCTION AND PROCESS OF RISK MANAGEMENT

intensity and started to discover that over 21 inches of snow had fallen since 9.00
P.M.
2. At the other end of the line was the night shift police officer who explained that one
of the city’s snowplows had run into a station wagon. The snowplow driver was not
injured but tragically, the three station wagon passengers were killed.
3. The officer went on explaining that the plow driver was discovered to have had a
blood alcohol level well in excess of legal limits and the driver was also operating
the city vehicle with a suspended driver’s license – a suspension handed down six
months ago after his eighth conviction. The officer concluded the call by noting that
the accident clearly was the snow plow operator’s fault. The station wagon was
parked in a convenience store lot and the plow’s tracks plainly showed that it had
drifted off the road over the curb and a parking barrier, stopping only when it had
rammed the station wagon into a retaining wall. Preliminary evidence suggested that
the driver had lost consciousness behind the wheel.
4. Now the thoughts ran through his mind:
(a) How was the guy ever allowed to drive a plow?
(b) Was the city insured for such loss?
(c) What are the needs of the victims’ families?
(d) Did the city’s lack of a Driver Training Programme contribute to the accident?
(e) What are the public relations implications for the city?
(f) What could we have done differently?
This story offers a window to the world of the Risk Manager. It shows both the
tangible & intangible consequences of risk and the gamut of functioning of the Risk
Manager & the scope of Risk Management. It is a matter of common knowledge that
risk cannot be eliminated completely. Snow will continue to fall, people will continue
to drive cars and fortune will produce unexpected and unanticipated outcomes.
But can we not identify such a situation and forecast it and can we not analyze such
a situation and can we not exercise control when such a situation arises or may be
even before such a situation arises. Well – the answer is obviously –Yes! And to
seek the answer we enter into the realm of Risk Management.

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Risk management is simply a practice of systematically selecting cost effective

approaches for minimizing the effect of threat realization to the organization. All risks
can never be fully avoided or mitigated simply because of financial and practical
limitations. Therefore all organizations have to accept some level of residual risks.

The Process of Risk Management

The process starts with Risk Identification. The very basics of Risk Management rest with
the first step – The Risk Identification – since ‘Risk’ cannot be managed unless identified
and it is needed to ensure that the full range of significant risk is encompassed within the
Risk Management Process.
A scientific approach to risk management of pure risks involves a logical sequence of the
following six steps.

Risk Identification
Finding the exposures of the following risks in today’s scenario:-
Generally study of Risk Management is done from considering the worst possible
situation. Probability of catastrophic losses is always borne in mind all times / all
reasonable action is scheduled to be taken to combat these catastrophic losses.
In Risk Identification processes – the risks generally considered are:-
1. Environmental Risks;
2. Safety & Security Risks;
3. Transport Risks;
4. Liability Risks;
5. Material Storage , Procurement & dispatch risk;
6. Health Risks;
7. Operational risks –like fire /explosion/breakdown / accidental consequences.
But it should be clearly noted that neither insurance nor risk management covers risks like
improper housekeeping, uneconomic waste, labour unrest, political disturbances, etc.

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In property and casualty insurance, the insurer retains the right to make inspections and
surveys relating to the insurability of the risk and the premiums charged. For example, the
insurer may look for inherent structural defects and other hidden hazards. Inspections
provide the opportunity to develop a loss prevention program for the insured.
The verification of statements by a life insurance applicant, along with a summary of the
applicant's financial, moral and physical condition and any other relevant information,
obtained through insurance investigators, agency personnel or an independent source.
The product of this investigation is called an inspection report. The in-person evaluation of
an individual risk is done to determine whether it meets underwriting standards and to
gather pertinent underwriting information. An inspection may be performed by an agent or
by a loss control specialist employed by the insurer. It may result in recommendations for
loss prevention.
A workers' compensation insurer's requirement is verification of a payroll record. Workers'
compensation premiums are based on the business's gross payroll, so inspection is the
basis for the premium to be charged.
Risks can be identified into any one of the following categories:
1. Man
2. Machine
3. Material
4. Money
5. Environment
6. Legal
Risk identification techniques includes:
1. Physical inspection
2. Check lists
3. Organisation charts
4. Flow charts
5. Fault trees

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6. Hazard indices
7. Hazop (hazard & operability studies)
8. Hazan (hazard analysis).
The most important element of and the second step in the risk management process is the
identification of risks and exposures to loss. This involves a systematic and careful
analysis of all major and minor potential loss exposures. An essential prerequisite for a
conscious choice of appropriate and efficient methods for dealing with losses if they occur
is the recognition of all sources of possible losses. As is seen earlier, a loss exposure is a
potential loss that may be connected with a particular category of risk. As such, the
classification of loss exposures is the same as the one adopted for pure risks; that is,
losses associated with life, health, property and liability risks.
The following categorization of risks that can impinge on the financial security of an
individual or a business entity will be found useful.
a. Maintenance of a large Emergency Fund: Once it is agreed that prudence demands
that a fund has to be set aside for meeting emergencies, individuals and businesses
have to maintain a larger fund to meet unanticipated loss in the absence of
insurance industry.
b. Deprivation of certain goods and services : Because of the threat of liability law
suits, a number of firms may refrain from producing certain products. It is estimated
that out of approximately 250 firms around the world which were producing
childhood vaccines, only a few firms now remain in that business.
The approaches used for risk identification include use of loss exposure checklists, flow
charts, statistical analysis of historical loss data, analysis of financial statements and on-
site inspection.
Rejda provides checklists for various important types of loss exposures.
(i) Property loss exposures
• Building, plants, other structure
• Furniture, equipment, supplies
• Electronic data processing (EDP) equipment; computer software

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• Inventory
• Accounts receivable, valuable papers and records
Company planes, boats, mobile equipment
(ii) Liability loss exposures
• Defective products
• Environmental pollution (land, water, air and noise)
• Sexual harassment of employees gender discrimination against employees,
wrongful termination
• Premises and general liability loss exposures
• Liability arising from company vehicles
• Misuse of the internet and e-mail transmissions, transmission of pornographic
material
• Directors’ and officers’ liability suits
(iii) Business income loss exposures
• Loss of income from covered loss
• Continuing expenses after a loss
• Extra expenses
• Contingent business income losses
(iv) Human resources loss exposures
• Death or disability of key employees
• Retirement or unemployment
• Job-related injuries or diseases experienced by workers
(v) Crime loss exposures
• Holdups, robberies, burglaries
• Employee theft and dishonesty

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• Fraud and embezzlement

• Internet and computer crime exposures
(vi) Employee benefit loss exposures
• Failure to comply with government regulations
• Violation of fiduciary responsibilities
• Group life and health and retirement plan exposures
• Failure to pay promised benefits
(vii) Foreign loss exposures
• Plants, business property, inventory
• Foreign currency risks
• Kidnapping of key personnel
• Political risks
Changes taking place in industries that create new loss exposures must be followed.
Important issues of risk management include rising costs of litigation, increasing costs of
workers compensation and risk financing through accessing capital markets.

Evaluation of Potential Losses and Risk Assessment

Subsequent to identification of risk, the next step in the risk management process relates
to analyzing, evaluating and measuring the impact of losses on the individual or corporate
unit by estimating the potential frequency and severity of losses. While frequency of loss
relates to the probable number of particular losses that may occur during some given
period of time, severity of loss refers to the probable magnitude of losses that may occur,
if they occur. This will enable ranking of various loss exposures according to their relative
importance. A loss potential that is small even though frequent, is much less important
compared to potential loss exposures that are infrequent (such as destruction of a factory
by devastating fire or accidental deaths) but has a potential for bankruptcy. Thus, though
both frequency and severity have to be considered in the risk management process,
severity of course, is substantially more important. It is possible that a firm may become
bankrupt by a single catastrophic loss – the size of the loss from a single event can be

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truly crippling. In the risk management process, it is therefore necessary for estimating
maximum probable loss and maximum possible loss. The maximum probable loss is an
estimate of the worst loss that is likely to happen such as the loss that could likely to result
if lightning strikes an individual’s home or the firm’s building. The maximum possible loss
is an estimate of the worst possible loss that might result from the lightning. An example to
illustrate the difference may be in order. Suppose in a flood a firm’s plant is destroyed. It is
estimated that the cost of debris removal, costs for restoration of the plant, the cost of
replacement etc., will total Rs.2 crores. The maximum possible loss is thus Rs.2 crore. It is
also estimated that a flood causing more than Rs.1.5 crore of damage to the firm’s plant is
very unlikely. Such a flood is unlikely to occur more than once in 40 years, an infrequent
occurrence. Thus, the maximum probable loss is Rs.1.5 crore. Hence in the process of
risk management, it is necessary to examine two facets of loss exposures; namely,
possible severity of loss and the possible frequency or probability of loss. It is the size and
probability of the potential loss that influences what has to be done about a particular
exposure. Measurement of potential severity is required for classifying risks whether a
particular exposure to risk or loss is critical/important or unimportant.

Measuring severity of property loss exposures

There is no unique measure of severity. Instead, different measures of severity are
employed for different purposes. We may discuss here some of the measures. Richard
Prouty suggested that for each potential loss two measures of loss have to be estimated:
1. Maximum Possible Loss (MPL)
2. Probable Maximum Loss (PML)
The distinction between the two measures is based on the approach of the underwriting
department of insurance companies, particularly in regard to property insurance. Maximum
possible loss is the “worst loss that could occur”, assuming a worst scenario or the worst
combination of circumstances. In contrast, probable maximum loss is the likely loss,
assuming the “most likely” combination of circumstances.
The distinction between MPL and PML becomes clear with an illustrative example. It is
conceivable that a six-story building to be insured could be completely destroyed by fire or
could burn to the ground. However, it is highly unlikely if the fire is discovered in the
incipient stage and/or if the fire department promptly comes into action. Therefore,

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chances of a total loss are very remote as most losses are generally controlled. The
Probable Maximum loss (PML) or most likely loss is the most important estimate for
purpose of insurance. Thus, probable maximum loss is a useful concept. However, for a
firm having a single building, the important measure of severity is the maximum possible
loss.
Another measure of severity, which has been put forward by writers on insurance is the
concept of “loss unit”. The loss unit is the aggregate of “all financial losses that can result
from a single event, taking into consideration the various exposures.” A good example of
the concept relates to the estimation of total losses that might have occurred in the
bombing of the World Trade Centre (WTC) in 1994. It is estimated that the total property
damage and business interruption that resulted from the bombing is over 600 million U.S.
Dollars. The estimated loss does not include the loss of rental income during the
reconstruction period, workers’ compensation benefits payable to workers who might have
been injured or killed and the potential liability for injury to tenants and customers. The
loss unit in this case has to include the above items besides, of course the total value of
the building itself. Estimating the loss unit requires computing the maximum possible loss
for each of these exposures and then computing the total loss. It is said that the concept of
loss unit is “an attempt to alert management on the potential catastrophe that could result
under the worst possible conditions.”
Damage to property may result in two types of loss direct losses and indirect losses.
One thing needs to be made clear. Book values based on historical costs and “fictitious”
depreciation rates have little to do with the actual loss that an organization would suffer if
the property were damaged or totally destroyed. The severity of loss in case of damage
can be approximated by actual cash value or replacement cost of the property.
Actual Cash Value of a property is defined as current replacement cost less depreciation.
The other value that can be employed to measure the potential severity of property losses
is replacement cost  cost of reconstructing the building with like kind and quality.
Indirect loss or consequential loss consists of other financial losses that result from the
damage or destruction of the property. The owner a building of Rs. 50 lakh not only loses
the Rs. 50 lakh in value that the building represents, but also loses the use of the building
for the period of time it takes to rebuild it. The loss of the use of building is one form of
indirect or consequential loss. Traditionally, indirect losses are divided into two categories
 “time element” and “non-time element”. The former denotes indirect loss exposures in

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which the amount of loss is a function of time. In such cases, the loss arises from the
inability to use an asset and consists of reduction in income or additional expenses
necessitated by that loss of use. Other example includes business interruption and
leasehold interest exposure.
Non-time element indirect losses include losses that result from but are not a part of the
direct damage. For example, the owner of a building that is partially destroyed by fire may
suffer an additional loss, if the municipal laws require demolition of the undamaged portion
of the structure.
The measurement of the severity of loss of other loss exposures and legal liability
exposures bristle with many difficulties which we do not have to elaborate here.
(i) Methods of measuring severity of loss exposures:
The frequency and severity of losses need to be estimated for the purpose of evaluating
and managing risk exposures. This is done in a number of ways (Refer Annexure I at the
end of this chapter for the historical efforts on the assessment of risk). Probability
distribution and statistical techniques are now commonly used in estimating both loss
frequency and severity.
The principles of probability, which are fundamental to the mastery of risk also determines
the functioning of insurance.
(a) Theory of probability and its application: Probability concepts are used to
estimate:
• The average number of losses or average aggregate amounts of losses from a
specified peril in a given period.
• the variability around these averages of the number of losses or aggregate amount
of losses per period
• From 1 and 2, the likelihood that the number of losses or the aggregate amount of
losses in a given period will exceed a specified number or amount.
Probability concepts are of great value in other phases of the risk management process
such as analyzing accident frequency and severity rates, determining the reasonableness
of insurance premium or the adequacy of reserves established for risk retention and
selecting from among alternative risk management techniques on the basis of their
probable impact on the organization’s profit or efficiency.

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The probability of occurrence of an event or a fire accident is the same as the chance of
loss (say, due to fire). For computing the probability of an event, the number of times a
specific event occurs is divided by all possible events of that type. For example, a coin
tossed three times may turn up heads twice. The probability of head is 2/3 or 0.667. If
however, the coin were tossed 2,000 times, we may get the probability of a head, the
fraction closer to 0.5 or ½. Another example, If 300 accidents are observed to have
occurred to 6,000 cars in operation in a town, we can say that there is 0.05 probability of
an accident. (The probability is 300/6,000)
Generally we can state that if a random experiment (where the outcome is uncertain) is
performed n times and a particular event A is observed to occur in m of the n trials, then
the probability of the event occurring is P(A) = m/n
As mentioned above, probability is a long-term concept. In other words, theoretically an
infinite number of identical random experiments have to be performed. In practice,
however, it is generally possible to perform only a finite number of such experiments. As
such, the above equation (where n is a finite number) provides an estimate only of the
underlying probability.
It is to be noted that the random experiments (such as tossing a coin and observing car
accidents), have to be performed under identical conditions. However, in many practical
situations, inclusive of some areas of general insurance, it is rather difficult to repeat the
experiment in identical conditions. Even then, the concept of probability is found
significantly useful.
As already mentioned, a probability distribution associates a probability with each possible
outcome. For instance, the flipping of a coin yields the following probability distribution
(given that, there are only two outcomes; Head and Tail). Heads : 0.5, Tails : 0.5. In
general, a probability distribution is a “mutually exclusive and collectively exhaustive list of
all events that can result from a chance process and consists of the probability associated
with each event”. For the purpose of managing risk exposures, a general insurance
company has to monitor the events. (say, for example, losses) that occur to a fleet of cars,
to estimate how often losses of a particular size occur. The company may then use both
empirical and theoretical probability distributions to predict future losses.
(b) Measures of central tendency :
Typical values for a set of data are called “measures of central tendency”, They tell us
where the data are centered – the typical value for a set of data will be somewhere in the
middle of the set. Persons managing risk exposures are concerned with measuring the

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center of a probability distribution. While there are several types of such measures, mean
is the most important and widely used measure.
Mean is the arithmetic average for a set of data. The arithmetic average for a set of values
is obtained by adding up all the values and then dividing that total by the number of values
that are there: Denoting the mean by the symbol x, the mean is defined as the sum of n
(observations) measurements
x1, x2, x3, …………………,xn divided by n. That is,
𝑋1+𝑋2+𝑋3……..+𝑋𝑛
𝑥= n
To illustrate, the mean of the six numbers 3,5,7,10,13,16 is
3+5+7+10+13+16
6
=9
calculating the mean, equal weight is given to each observation.
In case some observations are to receive more weight than others, it is useful to employ
the concept of expected value, which is a special case of the mean and is similar to it.
Using the concept of probability, the expected value of a set of observations can be
obtained by multiplying each observation or event by the probability of its occurrence.
To illustrate the concept of expected value, assume that there is a group of buildings
located in a particular locality of a city. Assume further that the following hypothetical
probability distribution of loss is found to be applicable to the group.
TABLE 1: Calculation of Expected Value of Losses
Event Amount of loss if Probability of loss Amount of loss
event occurs (Rupees lakhs)
(Rupees lakhs)
A 5 0.30 1.5
B 10 0.25 2.5
C 30 0.20 6.0
D 40 0.15 6.0
E 55 0.10 5.5
Total (expected Value) 140 1 21.5
MEAN = Rs.140/5 = Rs.28 Lakhs

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As can be seen, to determine the expected value of losses, the general insurance
company multiples each amount of loss by its associated probability and then sums up.
The estimate of the expected value is Rs.21.50 lakhs. The value of the mean is Rs.28
lakhs (Rs.140 lakhs 5). The difference in the two values is because of the difference in
weights assigned to each amount of loss. While the mean places an equal weight on each
event, the expected value assigns different weights to the events A,B,C,D and E. Thus,
the expected value is a weighted average and reflects the best estimate of a long term
average loss for a given loss distribution.
The mean is the most widely used measure of the central tendency. It is also the most
reliable measure for purposes of inference. Further, it uses every value in the set of data
in its computation. Additionally, mean always exists and is unique. The prime weakness of
the mean is its sensitivity to outliers i.e. a value that is located far away from the rest of
the data set.
Another measure of central tendency is the median, which is the mid-point in a set of data.
It divides the set of data into two equal groups, after the values have been arranged from
lowest to highest. Median of a road is found in the center of the road. For the data given in
Table 3.2, the median is Rs.30 lakhs. Here, finding the median is relatively easy as there
are odd number of values. When there are even number of values in the data set (for
example, data in Table 3.2 are, say, Rs.5 lakhs, Rs.10 lakhs, Rs.30 lakhs, Rs.40 lakhs,
Rs.55 lakhs and Rs.76 lakhs), there is not a single value in the center. In this case, we
take the average of the two values in the center(Rs.30 lakhs +Rs.40 lakhs / 2 Rs.35
lakhs). The median for this set of data of losses is Rs.35 lakhs.
One of the advantages of median is, it is not affected by the outlying values or extreme
values. The mean is, of course, affected by the outliers. Median also always exists and is
unique like the mean. However, one weakness of median as a measure of central
tendency is its use of one or two values of the data set and not all of the values in its
calculation. The median as a measure of central tendency is highly useful in situations that
produce outliers.
The third measure of central tendency is the mode. The mode of a set of data is the value
(s) that occurs most frequently in the frequency distribution. Thus, if a firm incurs losses of
RS.25,000, Rs.30,000, Rs.30,000, Rs.40,000, Rs.40,000 Rs. 40,000 and Rs.50,000, the
mode would be Rs.40,000. The mode has a few weaknesses for quantitative data. First,
the mode may not be typical for a data set. Another weakness of the mode is that it may

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not exist. Sometimes, there is more than one mode for a set of data. It is observed that
mode is not as widely used as the mean or median in the process of risk management.
(c) Measures of dispersion
When we are trying to describe a set of data, measures of central tendency, though
important, are not adequate. It is possible that two sets of data may be centred in the
same location, but still be totally different sets of data. Another important characteristic of
the distribution to consider is how the data are dispersed or spread out. Variation from
what is expected denotes risk.
Standard deviation, represented by the Greek letter s, tells us how far from the center of
the data the values are on the average. Putting it differently, standard deviation is a
number that measures how close or distant a group of individual measurements is to its
expected value. For example, assume that of the employees a manufacturer of
engineering goods employs, 100 employees each year are injured. The loss from injuries
ranges from Rs.500 to Rs.25000 with a mean or loss expected value of loss of Rs.12,500.
Assume that there is another factory in which a group of 100 employees suffer injuries and
their range of the consequent losses is from Rs.11,000 to Rs.14,000 but also has an
average loss of Rs.12,500. A comparison of the difference between the losses of the two
groups of workers is meaningful. For this purpose a comparison of the standard deviation
of the two data sets of injuries is helpful, which clearly brings out the precise variation of
the loss due to the injuries.
Steps included in the calculation of standard deviation.
1. Find the mean
2. Subtract the mean from each individual value
3. Square the individual differences from the mean
4. Total the square of differences
5. The sum of the squared deviations is divided by the total number of measurements.
6. The resulting number is the mean of the squared deviation. This is known as
variance.
7. Standard deviation is obtained by taking the square root of the variance.

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An example to illustrate the calculations:

In Table 3.3 is furnished a list of daily volume of trading of shares for one week on a stock
exchange.
Table 2: Calculation of Standard Deviation of Trading Volume of Shares

Volume of Sales Mean Volume (In Deviation from Squared Deviation

(In thousands) thousands) Mean (In (In thousands)
thousands)
669 756.2 -87.2 7603.84
754 756.2 -2.2 4.84
752 756.2 -4.2 17.64
771 756.2 14.8 219.04
835 756.2 78.8 6209.44
3781 756.2 0 14054.80

3781
Mean = ———— = 756.2
5
14054.80
Variance = ————— = 2810.96
5
Standard Deviation = √2810.96 = 53.02
Variance : 2,810.96 thousand shares.
Standard Deviation is 53.02 thousand shares.
When the standard deviation is expressed as a percentage of the mean, the resulting
number is the coefficient of variation, which is one way to characterize the concept of
mathematical risk to an insurance company. This method is used to measure objective
risk. It may be noted that a high coefficient of variation indicates high risk while a low

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coefficient of variation signifies less risk. The coefficient of variation for the example in
Table 2.2 is
53.02
-------- x 100 = about 7 percent
756.2
(d) Theoretical probability distribution:
As stated earlier, one of the useful tools for evaluating the expected frequency of losses
and / or severity of losses is the probability distribution. Two types of probability
distribution – empirical and theoretical – are normally used for managing risk. The
observed events form the basis of an empirical probability [Link] risk management,
three theoretical probability distributions are widely employed. They are
1. Binomial Distribution
2. Poisson Distribution
3. Normal Distribution
1. Binomial Distribution: It is a discrete probability distribution. Suppose the
probability that an event will occur at any point in time is p. Then the probability that the
event will not occur is given by the equation, q = 1-p. Let us label the number of trials as n.
The probability of x successes in n trials is given by the formula.
n!
——— x px qn-x
x!(n-x)!
Where the expression n! is n factorial and refers to a successive multiplication of the
numbers n, n-1, n-2, ………… 2,1. Suppose the State Road Transport Corporation (SRTC)
desires to estimate the probability of a number of losses. It owns a fleet of 8,000 buses. By
using the binomial formula the SRTC authorities can compute the chance of 50 losses,
100 losses, 150 losses or any other number of losses. The losses can be calculated, once
p (probability of the loss) and q can be estimated.
In the case of the Binomial Model, the critical assumptions are that the probability of loss
is the same, for each exposure and the various exposures to loss are independent of one
another.

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2. Poisson Distribution : Another discrete theoretical probability distribution that is

used in risk management is the Poisson distribution. One can determine the probability of
an event, say, car accidents under the Poisson distribution using the following formula.
p = e –mmn
---------------
n!
Where p is the probability that an event n occurs
n is the number of events for which the probability estimate is required
m is the mean or expected loss frequency
e is the base of the natural logarithm, equal to 2.71828
Once the number of losses per year follows a poisson distribution, the time between
losses is said to have the “memory loss” property. That is, the amount of time that will
pass before the next loss occurs does not depend on the amount of time that has passed
since the last loss that occurred.
3. Normal Distribution: A very useful one, a normal distribution is a continuous
probability distribution, while the binomial and poisson distributions discussed earlier are
discrete distributions. A normal distribution is completely defined by its mean and standard
deviation. Figure 2 describes this

0 MEAN
Fig. 2.1. Normal Distribution

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The graph of a normal distribution is bell-shaped and symmetric. More values are located
near the center or mean. As we move from the center, there are fewer and fewer values.
The graph of the distribution continues in both directions without ever touching the
horizontal axis. Normal distributions are symmetric with respect to the mean. The area
underneath the curve above the horizontal axis is equal to 1. This property allows us to
represent the area underneath the curve to represent probabilities, the total of all
probabilities for a probability distribution is equal to 1. Further more, as a normal
distribution is symmetric the area under the right half of the cure as also the left half of the
curve is equal to 0.5.
The mean is the value on the horizontal axis where the graph reaches its peak. The
spread of the distribution is given by the spread of the observations. Let us take an
example, to illustrate the use of a normal probability distribution. Suppose, a general
insurance company has experienced in a year 500 losses with a mean value of Rs. 500
and a standard deviation of Rs. 150. Then the insurer can assume that about 213 or 68
percent of all losses will be within one standard deviation of the mean. Similarly, about 95
percent or 475 of all losses will lie within two standard deviations of the mean. Likewise,
about 99 percent of all observations of losses should be within three standard deviations
of the mean. For the purpose of risk management if the losses follow a normal distribution,
it can be assumed that these relationships hold. This will enable a risk manager to predict
the probability of losses being within a certain range of the mean.

Selection of Appropriate Techniques for Treating Loss Exposures

The next step in the process of risk management lies in selecting the appropriate
techniques for managing the loss exposures. The techniques are broadly classified as
follows:
(i) Risk control
(ii) Risk finance
(i) Risk Control
Controlling the risk by selecting those techniques that will reduce the frequency of loss
and reduce the severity of loss is Risk Control. Before deciding upon the specific risk
control measure to be adopted it is necessary to conduct a cost-benefit exercise. That is
an evaluation of the expected benefits and costs involved to determine whether the

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decision taken is economically sound or not. However, where there is no option in regard
to the risk control activity but is part of a contract or imposed by provision of law, cost-
benefit exercise has no place or validity.
Risk Control covers all those measures aimed at avoiding / eliminating / reducing the
chances of loss producing events. The purpose of risk control is to minimize the total cost
of risk to an organization whilst at the same time ensuring the long term economic survival
of the organization. To determine the total cost of risk the following must be taken into
consideration:
1. The cost of injury and damage;
2. The cost of handling and settling the loss;
3. The cost of any risk control measures;
4. The cost of any loss financing measures;
5. Any costs recovered from any loss financing measures that have been put in place
by the organization.
All risk control and financing measures cost money but some are more effective at
minimizing the total cost of risk than others. The risk control measures can be divided into
those that:
1. Eliminate or reduce the risk;
2. Prevent loss i.e. the risk occurs but no loss results;
3. Reduce the extent of the loss.
The amount of money spent can be kept to a minimum by providing for risk prevention
measures whenever possible during the early stages of the creation of potential hazard
and by implementing measures that change the level of risk. All risk control measures
involving taking preventative or controlling action before the loss can occur. In essence,
therefore, all risk control measures may be regarded as planning tools in that the
likelihood of loss is foreseen and the measures that are implemented are expected to
prevent or control the loss. Risk control measures cannot be implemented successfully
after the loss has occurred.
After all feasible steps have been taken to avoid risks / to reduce their frequency ------
there still remains the possibility of some loss producing events occurring which is dealt
with risk retention & risk transfer.

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The techniques of risk control available for individuals and others are classified under
three heads:
(a) Loss Avoidance
(b) Loss Prevention and
(c) Loss reduction
(a) Avoidance of Loss: By refraining to expose oneself to certain types of losses, one
can avoid loss. Transportation risk can be avoided by not flying, which might not be
always possible. Another example of loss avoidance is discontinuing an activity which an
individual might have been engaged in hitherto and which leads to a loss. For example,
after receiving a doctor’s advice that there is a risk of premature death by cancer, an
individual might completely stop smoking. Another example is the potential consequences
of an escape of a highly toxic gas may be so catastrophic that a chemical company may
decide to avoid the risk by ceasing to produce or use it. Another example is when a risk of
damage by flooding may be avoided by moving to another site well above recorded flood
levels. Likewise, discontinuance of any activity that may contribute to loss is loss
avoidance. However, one has to note that individuals are not always rational in making
decisions. Work of a number of writers such as H. A. Simon and Daniel Kahenman (both
winners of Nobel Memorial Prize for Economics) question the rationality assumption in
individual behaviour. Furthermore, it may not always be possible to avoid risky activities
fearing potential loss. Moreover, discontinuance of an activity which is involving a loss
exposure might still create a liability loss exposure from the transactions carried out
earlier. For example, withdrawal of a drug by a pharmaceutical company because the firm
has come to know of its dangerous side-effects may still create liability exposure on past
sale transactions.
Risk avoidance is the most drastic method of handling risk. It involves ceasing to
undertake the activity which creates the risk / danger. Performing it in another way / or at
some other place to avoid loss like –
1. Issue Bank Cheques instead of cash payment to avoid fraudulent activity.
2. After Bhopal gas tragedy Compulsory Public Liability Insurance Policy has become
mandatory for all organizations or firms dealing with the hazardous goods as per
P.L.I. Act, 1991.

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3. Avoid swimming if you have chance of drowning or if predicted by any astrologer for
the likely events.
4. Basically it leads to the elimination of a loss exposure by ceasing or never
undertaking an activity that produces the exposure. In making this decision, the
person or organization must weigh the potential value of the activity against the
potential loss.
(b) Prevention of Loss: It measures designed to reduce the probability that a loss will
occur. It is almost impossible, as observed above, to avoid most situations of risk as risk is
a part and parcel of everyday life. As such, individuals and families can take necessary
steps to reduce the probability of loss occurring, where feasible. Action can be taken to
ensure that loss frequency is reduced, where potential frequency of risk is high. Efforts at
loss prevention relating to auto accidents can be before the event (pre-event actions),
such as licensing, vehicle inspection and driver education programs.
Physical Control of Risk or Risk Control Measures involve:-
1. Risk management techniques to minimize the frequency or severity of accidental
losses or to make accidental losses more predictable.
2. Duplication of exposure units - A risk control technique that involves the
maintenance of a second set of assets in the form of back-up facilities, spare parts,
alternative suppliers, or duplicate records to be used in the event the initial assets
are damaged or destroyed.
The prevention and the minimizing of loss are the most effective means of reducing the
cost of risk apart from eliminating or reducing the risk itself. Risk and loss reduction is an
area that should be of vital concern to:
1. The management of each individual organization;
2. The insurance industry;
3. The community/ society as a whole.
There are a number of different means by which loss may be prevented or minimized:
1. Proactive – Prior to loss happening. These are means that aim at reducing the
chance of a loss occurring by:

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(a) Eliminating the possibility of its occurrence: avoiding the risk, e.g. using non-
flammable liquid in place of flammable liquid.
(b) Reducing the probability of its occurrence: improving the risk, e.g. clearing
waste at more frequent intervals.
2. Reactive – Upon a loss happening. These are concerned with:
(a) Detecting the occurrence and raising an alarm;
(b) Minimizing the effect and size of loss.
3. Responsive – These are concerned with limiting the effects of loss by:
(a) Minimizing the extent of loss;
(b) Maximizing the salvage;
(c) Effecting rehabilitation as soon as possible after the occurrence.
Loss prevention services may be conducted by:-
Survey, consultation or loss control management services provided to policyholders by an
insurer to reduce the likelihood of accidents.
(c) Loss Reduction: A loss control measure designed to reduce the severity of loss
occurrences. Loss reduction activities would be appropriate where the potential severity of
loss is important. The activities taken for reduction of risk severity would mitigate the loss,
though complete prevention of loss is not on the cards. A few examples of technique of
loss reduction to bring down loss exposures are given here.
1. As regards individual property loss exposures, total loss of property by fire can be
reduced, if not eliminated, by installing proper fire fighting equipment and devices
meant for early fire detection.
2. An important source of liability loss exposure for individuals and families is the
ownership and operation of a car. Compliance with state regulations and laws
relating to driving is an important first step in loss reduction activities. Periodic
servicing and regular maintenance of the car are other important steps in the
direction of loss reduction.
3. Even though it is not possible to avoid serious health risks, the effects of these can
be reduced by regular medical consultation and screening. The severity of loss from

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serious illness and disease can be brought down, even significantly, by timely
medical tests and early detection of the problem.
4. Individuals investing in equity shares and mutual funds for purposes of wealth
accumulation and retirement needs are invariably subject to investment risk. A risk
reduction technique that is appropriate for mitigating the investment risk is portfolio
diversification a la Markowitz, Tobin and Sharpe.
Risk reduction is a method employed to reduce either the probability of loss production/
producing events occurring or to reduce potential size of losses that do occur when it is
rarely possible to totally eliminate a loss / risk – like installing safety gadgets or fire
extinguishing appliances. Otherwise it is also known as Loss Prevention. It includes
contingency planning. It may involve the planning to minimize the extent of loss caused by
the occurrence of a loss producing events. It also involves training the employees/
associated people promptly with emergencies and to carry out quick salvaging operation
or making plans to ensure that any interruption to the business is kept to a bare minimum -
say – alternative power supply/ alternative material supply/ alternative manufacturing
facilities – to be made.
(ii) Risk Financing
Despite one’s best efforts, loss exposures can never be eliminated; one has to think of
financing losses, when losses happen. The question of sources of funds for repairing
losses is addressed to techniques of loss financing. Loss financing (and the various
sources of funds available for this purpose) is required to repair or replace damaged
property, to meet expenses involved in legal defense and any advance judgments or
award in cases of legal liability, to pay medical bills and other health care expenses and to
replace lost wages and taking care of the financial consequences of premature death or
loss of life.
Individuals might have got numerous risk-financing options which may, however, be
classified into three groups.
(a) Risk Retention
(b) Risk Sharing
(c) Risk Transfer

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Some writers view these as a “continuum of options”, risk retention being placed at one
end of the spectrum and transfer at the other end.
(a) Risk Retention: Meeting the loss costs by the individual or family by internalizing
them is called risk retention. The losses that are internalized would be financed out of
one’s own income or wealth. While the decision to retain a loss exposure and finance it
out of one’s own funds may be a conscious decision of the individual or family. Losses that
do occur when prior planning for their financing has been done are also retained. In many
cases, it may be a “default option” or an involuntary option if the option of loss transfer is
not available or is not affordable or if the individual is unaware of the loss exposure– all of
these may bound to happen. The expected cost of risk financing through the method of
risk retention involves an uncertain amount for which the individual or family must be
prepared. Retention is resorted to when no other risk management treatment is available
like when insurance coverage is not available or very expensive. Further, non-insurance
transfer may be unavailable. Thus, retention may in fact be a residual method. Retention
can be effectively used when the potential losses are highly predictable. It is also said that
“the more risk averse the less the retention”. It is the easiest & the cheapest way of
dealing with relatively small losses to pay them out of one’s own resources when they
occur. It includes the possibility to set aside a contingency fund to pay for the larger
losses. Please mind that such retention of risk may be either a deliberate decision or a
result of a failure to recognize that such risk when existed.
(b) Risk Sharing: Risk sharing as a technique of risk financing options available to
individuals and families is a blend of the other two financing options, namely risk retention
and risk transfer. Most non-life insurance contracts contain provisions for allocation of
losses between insurer and insured. Losses below a specified size to the borne by the
insured, are called deductible provisions. Further, deductibles operate on a ‘per loss’
basis, that is, the deductible provision is applicable for each loss event. Deductibles are
normally specified in rupee amount. However, in case of coverage of losses resulting from
floods and earthquakes, they are expressed as a percentage of the total value of the
insured’s property. In many health insurance policies, “aggregate” deductibles are
specified and the deducible operative in terms of the cumulative amount. In other words,
any loss during a policy period, in excess of the aggregate deductible amount (which is to
be borne by the insured), is the liability of the insurer.
As regards, provision of co-insurance, the allocation of losses between the insurer and the
insured is expressed on a percentage basis (say 80 percent of the covered losses by the

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insurer and 20 percent retained by the insured). Co-insurance as a form of loss sharing is
quite common in health insurance. It may also be noted that where health care claim is
large, sometimes, health insurance policies contain a provision restricting the loss-sharing
upto a specified level of covered loss. Disability insurers use a waiting period, called an
elimination period, as a loss sharing provision. For example, the insurance policy may
stipulate that the initial period of disability, say 15 days, is retained by the insured.
Risk sharing or loss sharing provision in an insurance policy achieves certain objectives. It
reduces the premium the insured has to pay. It is claimed that loss-sharing provision
improves the efficiency of mechanism of insurance. The cost of settling a small claim may
be disproportionately higher than the cost of settling a large claim. Loss sharing may
mitigate moral hazard as it works as an incentive for the insured to minimize the loss. Last,
but not the least, loss-sharing has a bearing on adverse selection. When an insurer offers
polices with different proportions of loss-sharing, insured with expectations of high losses
would naturally prefer lower retentions, while insured with expectations of low loss would
choose policies containing higher retentions.
(c) Transfer of Risk: While one end of the risk-financing continuum, as mentioned earlier,
is risk retention, the other end of the continuum is risk transfer. In risk transfer, the
financial impact of loss is shifted to another party. Risk transfer involves agreement by the
transferee to assume the loss or risk that the transferor is desirous of escaping. The
process of risk transfer involves a payment by the transferor to the risk bearer or
transferee. It is normally done through insurance. Through the process of transfer, the
degree of risk is sometimes reduced as the transferee may be in a position to predict loss
by applying the law of large numbers. Transfer of Risk can be through non-insurance or
insurance agreements.
It is the process by which the activities that creates risk is transferred – like -
1. Transferring of the process like – engaging a sub-contractor for processing
hazardous substances or the hazardous processes like spray painting / in a
marriage ceremony we now engage professional caterers for arranging the meals for
the guests & relatives – thereby the responsibility is transferred.
2. Transferring the activities by contract – like engaging a contractor for constructing
your house within your budget. Contractor should insure the entire project covering

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all the sources of damages, possible material losses and related third party liabilities
to others (even covering the contingencies related to his employees).
3. Insurance is the best method & adequate measures of risk transfer.
Under Risk Transfer, Risk financing is included which involves creating special / internal
funds to meet any unforeseen event. Insurance is always recognized as the best method
of risk financing.
In traditional Risk Management process the main focus is towards the objective of loss
control management that is to limit the total cost of losses to the lowest possible level by
implementing measures which are –
1. Prevent losses from occurring, for example by reducing the level of risk which might
cause a loss;
2. Protect people and /or property from loss;
3. Detect and limit the extent of any loss that may occur;
4. Maximize the recovery from any loss that has occurred.
To be fully effective it must take an overall coordinated approach so that the measures
which are implemented are fully integrated, one with the other, as well as with the
organization’s normal operating systems and procedures.
Measures to limit the extent of any loss and to minimize the recovery from loss are of two
basic types as narrated below:
1. Passive – like fire resisting construction, fire doors / other fire fighting measures or
use of less hazardous processes which are implemented before the loss and which
assist in containing loss or facilitate recovery without any further change of state;
2. Proactive – which may involve the measures to be adopted before the loss like the
items that are installed before loss occurred and which at the time of the loss
become active in reducing the possible extent of the loss, or maximize the recovery
e.g., sprinklers, burglar alarms and salvage operations.
The measures can also be classified as measures which:
(a) Reduce the probability of loss, such as fitting safety guards to machines and
removing possible sources of ignition;

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(b) Reduce the severity of loss, such as sprinklers, storage above the ground floor level
of goods susceptible to water damage and providing first aid facilities;
(c) Reduce both the probability and the severity of loss, such as education & training of
management and employees and the use of fire resistant building materials.
Every organization should prepare plans for preventing and coping with actual or
potentially severe loss situations covering both salvage operations and plans for plans for
carrying on the business of the organization following the occurrence of a major loss.
Contingency planning involves three elements:
1. The disaster plan – This is essentially preventive or, if these measures fail, the first
line of defense. This is concerned with identifying and assessing all of the major
hazards and implementing measures to control them before any incident has
occurred.
2. The emergency plan – That is set out in broad terms how each major emergency
should be handled once an emergency has occurred.
3. The crisis management plan – This is complementary to the disaster plan and is
designed to reduce the impact of the emergency by getting the business back into
operation as quickly as possible.
For any contingency plan to be fully effective, all three elements should be present and
integrated as a coordinated flow of action from pre-event to post-event. It will be seen that
in preparing contingency plans the organization will traverse most of the ground that it
would have covered if it had decided to implement the holistic approach of Risk
Management. Here comes the limitation of traditional Risk Management and therefore, the
Enterprise Risk Management, a relatively recent (being incorporated in the world during
1980s) but extremely effective approach to risk solutions and decision making, is under
active consideration at many forums world over. The Specialty Guide on Enterprise Risk
Management (ERM) prepared by members of ERM working Group of American Society of
Actuaries – Risk Management Section – is being considered the excellent elaboration of
the intricacies related to Enterprise Risk Management (ERM).
The Casualty Actuarial Society describes Enterprise Risk Management (ERM) in their
‘Overview of Enterprise Risk Management’ as - “….the discipline by which an organization
in any industry assesses, controls, exploits, finances and monitors risk from all sources for

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the purpose of increasing the organization’s short-term & long-term value to its stake
holders”.
Enterprise Risk Management (ERM) in business includes the methods and processes
used by organizations to manage risks and seize opportunities related to the achievement
of their objectives. ERM provides the basic framework in this new-age risk management
process, which essentially includes:
1. In identifying specific events, issues and circumstances relevant to the
organization’s objectives (i.e. by identifying various risks associated with the firm &
proactively addressing the related opportunities).
2. Assessing them in terms of likelihood and magnitude of impact.
3. Business enterprises protect and create value for their stakeholders, including
owners, directors, customers, employees, regulators, board members (in case of
PSUs), intermediaries, shareholders, etc., by determining a response strategy and
simultaneously monitoring progress.
4. Taking a risk based approach to managing the enterprise by integrating concepts of
strategy planning, operation management and internal control.
5. Evolving to address the needs of various stakeholders, who want to understand the
broad spectrum of risks facing complex organizations to ensure they are
appropriately managed.
Regulators, Debt-rating Agencies have increased their scrutiny on the risk management
processes of the organizations. The rating agencies have also increased their surveillance
on the topic of the Enterprise Risk Management. Say, the ratings of insurance companies
have always included the view of the company’s ability to manage its risks. In addition,
since the late 80s, the insurance industry was to implement the concept of the risk-
adjusted view of capital and earnings – following to step criticism of Malhotra Committee –
after the privatization & liberalization of insurance industry – the industry was one of the
first to implement the concept of the risk-adjusted view of capital and earnings. The main
difference is that companies, through new technology and advancements in the area of
Enterprise Risk Management, are becoming more capable of answering questions about
frequency and severity of both known and unknown risks affecting the enterprise. The
rating agencies are taking a more proactive approach at evaluating the strengths of an

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organization with respect to Enterprise Risk Management. The rating agencies are starting
to ask questions about companies’ internally developed economic models. The first
aspects of Enterprise Risk Management upon which rating agencies are focusing most of
their attention are underwriting profit, solvency margin, net worth, investment position &
related risks, liability or pricing risk and the area of risk transfer. ERM is an integrated
framework for managing credit risk, market risk, operational risk, economic capital and risk
transfer in order to maximize firm value.
ERM is also referred to as:
• Integrated Risk Management (IRM)
• Holistic Risk Management (HRM)
• Global Risk Management (GRM)
Enterprise Risk Management recognizes the interdependence of ‘Risks’ & follows:
1. Common measurement standard leading to common language globally
2. Accepts the common risk ‘currency’, interpretation as capital
3. Even in Insurance Companies we need immediate & successful implementation of
Enterprise Risk Management techniques.
Enterprise Risk Management uses ‘Integrated Framework’ encompassing the following
issues:
1. Capital Requirement
(a) Banks may choose one of the many approaches to calculate capital for credit,
market & operational risk
2. Supervisory Review Process
(a) Contains the key principles according to which bank supervision should be
done:
(i) Board and management
(ii) Risk management models and process
(iii) Internal control
(iv) Stress Testing

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(b) One of the targets is also to try motivating banks to hold capital buffers in
excess of the minimum requirement.
(c) Financial Supervision should be proactive before bank capital goes under the
minimum requirement
3. Market Discipline
(a) Includes recommendations and requirements especially regarding disclosure
information.
Evolution of Industry Practices (In Global Parlance) through the following stages:
• Credit Risk Management
• Financial Risk Management
• Enterprise Risk Management

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BASICS OF ENTERPRISE RISK MANAGEMENT (ERM):

Types of Risks come under the purview of Enterprise Risk Management ERM:
1. Operational Risks – like:
• Hazard
• Physical
2. Strategic Risks – like:
• Capital / resource allocation
• Industry / competitors
3. Technological Risks – like:
• Databases
• Security
• Confidential information
4. Stakeholder Risks.
5. Legal Risks – like:
• Compliance
• Regulatory
6. Financial Risks – like:
• Capital markets
• Credit risks

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• Taxes
7. Human capital Risks – like:
• Retention
• Training
8. Reputational Risks.
Basic Enterprise Risk Management (ERM) applications involve:
1. Executive reporting
2. Key risk indicators
3. Loss/incident tracking
4. Control self assessments
5. Early warning indicators
6. Risk mitigation projects tracking & ERM content management
Advanced Enterprise Risk Management (ERM) applications attains to:
1. Risk transfer
2. Economic capital
3. Scenario analysis
4. Shareholder value management.
Challenges of Enterprise Risk Management (ERM):
1. Data Availability requirements
2. IT Systems (non-networked environment, integration with legacy systems, software)
3. Change Management & Culture Shift (Risk and Corporate Governance systems,
Operational Risk Measurement and Management, Emphasis on independence of
risk from business etc.)
4. Analytical Skills (Modeling of default histories, Statistical analysis, Banking
knowledge, Value at Risk calculations, etc.)
5. Retention of Human resources (specifically resources related to implementation i.e.,
IT specialists, Risk specialists etc.)
Banks integrate Enterprise Risk Management into Business Processes and Value Drivers
as below:

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Enterprise Risk Management adopted by the Insurers uses ‘Integrated Framework’

consisting of the following measurements, management and strategies:

Performance
Measurement &
Management
Investment
Business
Strategy&Asset
Portfolio
Liability
Management Risk and
Management
Economic
Capital
Measurement
Limit Setting Pricing

Reinsurance
Optimisation

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Enterprise Risk Management encompasses a lot of issues as depicted below:-

Enterprise Risk Management Balancing the Hard and Soft side of Risk Management:

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ERM is driven by Best Practices, not by Regulations and proactive approach is

expected not the reactive one.

Action Points of Enterprise Risk Management as given below:

1. The business units to decide on strategy/ timeframe;
2. The strategy could be growth or consolidation;
3. The Finance/ Planning to decide on capital allocation to business units and assess
the risk as well as the return;
4. Risk Management to measure & monitor risks and enable estimation of risk
premium;
5. Risk Management should not be biased by consideration of profits or performance
evaluation.
Information Technology (IT) infrastructure will enable data being provided for various
analysis for risk evaluation and monitoring. Why do we care about managing capital? The
“Problem” with Capital is— a certain amount of capital is needed in order to promote

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solvency – thus, we need to be able to raise capital. But, if there is too much capital,
profitability (as measured by return on equity) will suffer – thus, we need to be able to
efficiently deploy capital.
FORECASTING FOR ORGANIZING ENTERPRISE RISK MANAGEMENT:

The term ‘risk’ is applied here to a situation in which the outcome is unknown but the
probability distribution from which the outcome is drawn is known. Uncertainty is related to
a situation where neither the outcome nor the distribution of outcome is known. The term
uncertainty may also be used in situation where the outcome may not even be identifiable.
Since organizations are the lifeblood of progress and productivity, they are prepared to
take risk. The question is not whether an organization should take risk but which risk it
should take and on what terms. Enterprise Risk management is in part about deciding this.
Risk management in fact, is the process of identifying analyzing and evaluating the risk
and selecting the best possible method for handling it. However, there is no standard
approach for risk management. Firstly this study attempts to present the important aspects
which the executives need to consider if they are to be able to adequately manage the
overall process of Enterprise Risk Management.
Forecasting and its approach: Forecasting is an attempt to predict the future. It is
important that all organizations should make their decisions with a view to what will
happen in future, but they must have an understanding of the limitations that any forecast
may be subject to. Evaluating the likely levels of errors in forecast is a problematic
exercise. There is the discipline of econometric forecasting where all the estimated

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equations are subject to statistical measures of how likely they are to be prone to errors,
but in general these measurements should not be taken too seriously. One must be
skeptical of the success of economics as a forecasting discipline.
What determines effective predictability? In this world, nothing is certain. There are many
different techniques and models for forecasting the future ranging from the qualitative
evaluation of the possible situation to the use of complicated statistical and mathematical
models. The output of some models is forecasts of the most likely to vision of a range of
possibilities. Often forecasts and targets in business are just different sides of the same
coin. Management by their actions is expected to influence the future. There are a range
of factors which influence the degree to which a situation can be forecast and these can
be portrayed as under:
1. The degree of past experience of the organization: There are decisions in business
of which the organization has extensive experience and decisions which are
organizationally unique. Of these two, in general, the former are more predictable
than the latter. For instance, in banking industry, if the interest rate changes in the
economy and a bank is considering how it should change the rates of interest on its
retail products, it will consider issues such as the market in which its products are
sold, the possible action of competitors and the impacts between the products which
the bank offers. Since most often interest rates change, the bank will have extensive
experience of the relationship involved, so it will be able to predict the impacts of its
policy with some degree of confidence. If on the other hand, one considers the
decision to launch a product which is totally new to the market place and of which
the bank has no past experience, prediction becomes more difficult. Therefore, the
degree of past experience may be a central factor in determining the levels of
predictability in a particular situation.
2. Environmental situation and its volatility: The more volatile a particular situation, the
more difficult it is to predict the future. For instance, in the case of sovereign risk, if
an investor is considering the alternatives of investing in a developing country or in a
least-developed country, there are obvious differences in the ability to forecast the
level of returns which may be obtained or the possibility of total loss of the
investment. The political, economic and financial environment in a developing
country is much more stable than that in a least-developed country and therefore
can more easily be forecast.

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3. Understanding of the issue: There are problems which are better understood than
others. Such problems are intrinsically easy to predict. If one considers a
comparison of forecasting competitor's reaction in a given situation or the probability
of default on a particular consumer loan for a finance company, prediction in the
case of the latter is easier. In the former case, the behavior of firms in oligopolistic
industries has always been problematic for economists. The theory of games has
just multiplied the myriad intellectual frameworks within which the analysis can be
conducted. It is thus sometimes very difficult to predict competitor behavior. On the
other hand, predicting losses on consumer lending, the technique of credit scoring
and performance scoring have been developed since 1960s which allows the
prediction of account delinquency with some degree of accuracy. There are thus
some situations which are simply more intrinsically easy to predict.
4. Nature of the situation to forecast: Predictability in some situations is more
intrinsically difficult than in other situations. Financial economists, for example,
express their inability to make precise forecast of the prices in financial markets. The
reason for this is that the holder of money would wish to hold on to rupees until the
higher price is achieved and buyers of rupees would wish to purchase immediately
at the lower price, thus supply declines, demand rises, so the price will rise. This
process can be characterized more generally. If new information which has an
influence on the market price becomes available to market participants, it will
immediately be incorporated into the price.
By a similar argument all the information available at any point in time will be incorporated
into price formation. Thus prices change as a result of new information. New information is
likely to have a random impact on future prices, so if current information is incorporated in
price, today's price is the best estimate of the future price. This process is general can be
applied to the financial markets to incorporate market trends.
Effective Methods applicable for business
The most common methods of forecasting that can be used in business are.
1. Delphic Method: The Delphic method is a panel consensus approach attempting to
use the collective experience and judgment of a group of experts. Such an approach
is particularly productive in areas where the organization has little comparable
historical data: for example, where an organization is launching a radically different

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product, or service or moving into an untested part of the market. In this method the
experts never actually meet and, typically, do not know who the other panel
members are. Each expert is given an initial questionnaire to complete relating to
the area under investigation. A summary is then produced from the entire
questionnaire and this summary is again distributed to other experts individually who
is given the opportunity of revising the responses to the questionnaire in the light of
the summary of the groups view. This process is repeated until either an adequate
consensus is reached or an agreed number of iterations have been completed.
2. Non-quantitative analysis method: This involves considering a situation and the
factors which motivate it and using this as the basis for making predications. If one
uses to forecast the levels of competition within a particular market, one might use
'five forces analysis technique' which views competition in terms of the behaviour of
certain actual and potential players in any market situation - competitors, suppliers,
customers, producers of substitutes and new entrants in that market.
These types of non-quantitative analysis is useful in situations in which there are
likely to be no runs of useful data, or in which, situations are challenging. If for
example, one wished to analyze the impacts of changing technology on a particular
market place this might be undertaken within a non-quantitative framework.
3. Statistical analysis method: These methods of forecasting the future in general have
their origins in economics or econometrics. They require high level of technical
competence to motivate them and their results are not uniformly satisfactory (ref:
1994, Paul Ormrod.). In fact one should always apply a reasonable test to the result
of elaborate statistical analysis. If the numbers are consistent with one's intuitive
view of a particular situation, one should accept the numbers.
Where the forecasts conflict with one's intuition, one should review the techniques
and the implications of one's forecasts. As a rule of thumb, in 90 percent of these
situations of conflict with intuition, intuitions is likely to be more correct and in 10
percent are very important because they provide insights which one did not have
before and may be vital in increasing knowledge of a particular situation (ref: Islam
and Meade, 1996).
4. Scenario modeling method: Scenario Modeling comprises establishing a model in
relation to how a situation is determined and then making different assumptions to

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predict the outcomes. Scenario modeling is as useful as the structural properties of

the model and the initial assumptions. It is commonly used by strategists and
management accountants and again should be treated with a degree of skepticism.
Scenario planning can be used to subject the key organizational assumptions to
serious scrutiny in regard to any predictions about the future. Standard methods of
forecasting for business related situations are far from entirely successful and
therefore should be regarded with skepticism. Management often has a better
understanding of the processes to be modeled than the individual modeler. One
should always ensure that models are explained as far as possible in non-technical
terms and not hidden behind technical expertise and jargon, so that more than the
modeler's expertise can be applied to the problem. Forecasting is an attempt to
predict the future and in relation to business one should be aware of the fact that
there is no uniform foolproof method. However, some methods in certain
circumstances are more likely to be accurate than in other situations. Understanding
the degree of uncertainty in relation to particular forecast is very important. This
requires considering all those factors which influence the forecast of an outcome
and the degree to which the forecast may be in error. All this will help in organizing
risk management.
Non-Insurance Transfers: They are techniques (other than insurance) by which a risk
exposure and its potential financial losses are transferred to another party who is in a
better position to exercise loss control. A number of instances of non-insurance transfers
can be cited. A computer lease agreement by a firm may contain a clause to the effect that
maintenance, repairs etc., of the computer are the responsibility of the computer firm. A
publishing firm may specify that the author and not the publisher is legally liable for
plagiarism, if any.
• Hold Harmless Agreements
• Incorporation
• Diversification
• Hedging
Hold Harmless Agreements: Many kinds of contracts, by incorporating appropriate
provisions, may transfer responsibility for some types of losses to some one else who is
not obligated to bear it. They are also called indemnity agreements. The clauses in the

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agreements may fix the responsibility for paying for various losses on some individual or
individuals. An example of this type of agreement: A house-owner including in the lease
agreement a clause making the tenant responsible for all injuries the guests may suffer
while on the leased premises. It is a case of shifting the responsibility for payment of
losses to the tenant without any actual reduction in the original risk because generally no
greater predictive ability in regard to potential losses can be expected on the part of the
tenant than on the house-owner.
Hedging Firms that enter into contracts to supply goods at a fixed price in the future face
the risk that a rise in prices between entering into the contract and the delivery date may
involve them in a loss. Hedging gives protection, say, to the Indian importers by allowing
them to forward purchase specific foreign currencies. Thus, regardless of the exchange
rate the importer’s liability will be limited to the cost of purchasing the currency.
As the other forms of risk transfer, namely incorporation and diversification have greater
relevance to business, they will be discussed in the chapter on Enterprise Risk
Management. Insurance, as a form of risk transfer is applicable to individuals, families and
businesses; it will be briefly discussed here as more exhaustive discussion in all its facets
will be found in the materials specifically devoted to insurance.
Insurance as Risk Transfer: Insurance is considered a special form of the technique of
risk-transfer. It is, on one side, an economic or social institution designed to perform
certain special functions and on the other, as a legal contract between two parties, the
insured (transferor) and the insurer (transferee). Taking the latter aspect first, in certain
situations, the best way to manage a particular risk, may be to purchase insurance. This is
because of the insurer’s ability to efficiently handle risk through the operation of law of
large numbers. It does not, however, imply that an automatic assumption that the only way
to handle a particular risk exposure is insurance. Such an assumption is not warranted.
Some of the corporate risk managers, in fact, use insurance as a last resort, when other
risk management techniques are not considered adequate by themselves.
The size of the potential loss determines the amount of insurance that should be
purchased, once a decision is made to transfer risk. If the amount of insurance is higher
than is required, then an individual or a firm may be saddling himself or itself with
unwarranted (and sometimes, may be unbearable and excessive costs). On the other side,
if the amount of insurance purchased is low, then the individual or firm may be saddled
with unnecessary costs. Commercial insurance is a technique of transferring risk from one
party (individual or business) for whom the risk is costly to another party who is willing and

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is able to bear the risk. Insurance is thus one of a number of available instruments for
hedging risk. It is an instrument for post loss financing. Purchase of medical insurance is
an appropriate strategy for controlling loss exposures that have a high severity of loss
coupled with a low probability of loss. It is not proposed to discuss here the important
principles underlying the mechanism of insurance, such as principle of indemnity, principle
of insurable interest, the concept of beneficiary, the principle of subrogation and the
principle of utmost good faith, as they are covered in material relating to insurance.
Insurance as an economic institution operates on the principle of risk pooling and risk
reduction, besides a mechanism of risk transfer. Pooling is the sharing of total losses
among a group. The aggregate amount of uncertainty is brought down facilitating risk
reduction by “combining under one management a group of objects or persons so that the
total losses to which the insured group is subject becomes predictable within narrow
limits”. Through this process, the overall risk for the group is reduced and the resultant
losses are pooled, generally through the method of payment of an insurance premium.
Thus, the insureds, through the mechanism of insurance, transfer specific risks to the
group and exchange a potentially large and uncertain loss for a relatively small certain
payment, i.e. the insurance premium.

Selection of appropriate methods for handling losses with risk

management matrix
For the purpose of determining the appropriate technique(s) for tackling losses, Rejda
suggests a matrix. The matrix classifies the various loss exposures on the basis of
frequency and severity.
TABLE : Risk Management Matrix

Type of Frequency of Severity of Appropriate Risk Management

Loss Loss Loss
1 Low Low Retention
2 High Low Loss Control and Retention
3 Low High Insurance
4 High High Avoidance

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As can be noticed, for the purpose of selection of the method for handling losses, both
severity and frequency of loss have to be considered. When the frequency and severity of
loss are low, (that is, where the loss is small and occurs infrequently such as loss of a
cheap transistor radio in the house or loss of the typist’s dictionary in the office) retention
is the most appropriate risk management technique. When the loss frequency is low and
severity is high (third type of loss exposure in the table), the most appropriate technique to
choose is insurance. Examples of this type of loss exposure include natural disasters,
explosions, fires, law suits and premature deaths.

Implementation of Risk Management Programme and Its Evaluation

and Review
The next step in the process of risk management by individuals and businesses is
implementation and monitoring of the programme to achieve the objectives. To achieve
the goal and to make the programme effective, a periodic review of the programme is
called in order to determine whether or not the objectives of the risk programme are being
realized. This step will be helpful in modifying the programme, if found necessary, in the
light of the record of experience.

The Job of Risk Manager

The job of risk management starts with the selection of appropriate method for handling
various exposures. Before selecting the method, the risk management can be broken
down into three elements which follow each other in a logical sequence:
- Risk assessment with risk mapping
- Risk control
- Risk financing
All the three are inter-related. Because of the conditions under which firms operate
change, the risk management process has necessarily to be dynamic. So in all the three
elements of the process there has to be continuing re-assessment and monitoring of the
results.

Risk assessment with risk mapping

Identification and measurement of potential severity and frequency of losses is the

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assessment of risk for individuals, businesses and society. Such assessment has to be
continuous and comprehensive. Risk assessment has to be an ongoing activity as
individuals and their environment are not static but dynamic and do change. A person’s
risk profile undergoes significant change when he or she marries and has children.
Likewise, a person’s inventory of assets grows with fresh acquisition of assets over time
and, as a result, his property risk profile changes over his life time. The legal environment
a person faces is altered by enactment of new statutes and changes in case law. Because
of these and other changes, individuals will have to continuously and suitably adjust their
risk management efforts.
A business organization’s exposures to loss is now managed by using a new risk
management technique called risk mapping making use of a matrix plotting in loss
frequency and loss severity.
The risk mapping technique might not be particularly useful for managing risk exposures of
individuals and families. However, it might be instructive to understand the technique with
a view to applying it while discussing the techniques of risk control and risk financing for
individuals and families. An illustrative risk map is depicted in Figure 3. Loss Severity is
shown on the horizontal axis and Loss Frequency on vertical axis. As defined earlier, loss
frequency measures the likelihood of occurrence of a loss event and loss severity
indicates the potential financial implication of the event.
Loss frequency can be categorized under three heads: (I) Rare Loss Event such as a
person’s house located in an earthquake zone that is likely to suffer loss rarely, say, once
in 50 years, (ii) Loss Event that occurs occasionally like damage to a person’s car that
may occur, may be once in 6 or 7 years and (iii) Frequent Loss event such as mild illness.
Potential financial consequences of a loss event may be of three types – financial
consequences such as loss of relatively cheap utensil of a family may be quite low or
relatively moderate such as the financial loss caused by the car damaged by the fall of a
branch of a tree and the loss of the use of the car by the owner and a catastrophic loss
potential such as total destruction of a house caused by fire.
We may make a brief assessment of the property, liability, life and health risk
exposures of individuals and their families. For their purpose, we can make use of Fig.3
Zone A located in the left hand corner includes, loss exposures that have a low expected
frequency as well as low financial impact for individuals. Example of a property loss of

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cheap utensil of a family marked as P1 in zone A. Another example is individuals most

frequently occurring minor health problems (flu, cold, headache etc.,) which do imply low
loss severity can be reduced in frequency of occurrence by taking appropriate action
aimed at loss prevention.
Loss exposures that can be mitigated by appropriate timely action are located in the lower
right-hand region. In zone B is included a loss of a number of household utensils, with the
same probability of occurrence but with estimated moderate severity of loss, marked P2.
The loss reduction activities will hopefully shift the consequences of loss to the left to the
moderate region from the catastrophic region.
The loss of a person’s two-wheeler we can classify as rather an unlikely event but severe
potential financial losses (Catastrophic consequences) – labeled P3 and shown in zone F.

H2
H1
LOSS
FREQUENCY
D G I

D3
Frequent S2
S1
C E H D2
H3
D1 F2
Occasional F1 P1

P2 L1 P3
Rare A B F L1
1
Low Moderate Catastrophic
LOSS SEVERITY
Fig. 3. Individual loss exposures risk mapping
For individuals and families, most liability loss exposures are not a common event.
However, the event may have a catastrophic loss potential (though actual loss may not be
high). L1 shown in zone F is an example of such a rare individual liability loss exposure

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with catastrophic consequences. A pertinent example of this type of loss exposures is the
ownership and/or use of a car.
A number of factors determine the potential loss of a person’s death and the impact varies
from individual to individual. For a university student (with no dependents), the financial
loss potential resulting from premature death might be low to moderate as indicated in the
diagram by D1 – located either in zone A or B. As a contrast, take the case of 40 years old
individual with a family comprising a spouse and two young children. The probability of
premature death and the chance of loss would definitely be higher and the potential
severity of loss may be catastrophic. Therefore, the placing of this loss exposure in zone
F, labeled D2, may seem to be appropriate. In the case of a retired person at age 65, the
probability of premature death is high but the financial consequences would be either
moderate or even low. This loss exposure can as well be represented by D3 in zone E.
Financial, operational and strategic risk exposures of individuals and businesses
The risk profile chosen by an individual influences the assessment of financial risks. There
can be significant variation in the investment risk related to retirement saving and/or
general investment for the purpose of wealth accumulation. Risk retention generally finds
a place in the lower left region implying low to moderate risk frequency as well as risk
severity. Individual investors who are highly risk – averse may decide to invest in risk-free
assets, yielding a lower return but characterized by almost no risk – rare loss frequency
and low loss severity (F1). Those individual investors who are less risk-averse and are
seeking higher return (though characterized by higher risk) might prefer investing in equity
shares. We can classify such investors in zone B (labeled F2) – potential low loss
frequency and moderate financial impact. The investors must, however, consider the
trade–off between the expected portfolio return and its financial risk. One thing is certain;
Investors desirous of securing higher return must be willing to accept relatively higher
investment risk.
While macroeconomic changes affect all individuals and families, the financial impact on a
particular individual is influenced by his specific circumstances. Impact of a downturn in
the economy – may be a recession – which would occur occasionally has a moderate
financial impact on the individual and family. It is labeled as S1 and is placed in zone E.
Similarly, exposure of unemployment risk might be placed in the same zone (zone E,
labeled S2). The frequency and severity will depend on the type of work he is engaged in

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or the nature of employment. Some jobs or occupations are subject to the influence of
changes in technology or trade while others are not affected very much.
Factors Determining Risk Financing Decisions
A number of factors are considered by individuals before making risk-financing decisions
or choosing the category appropriate to them out of the three available options, risk
retention, risk reduction and risk transfer. The factors include
• Expected cost
• Financial Position
• Degree of Risk Aversion
• External Constraints
The expected value and the variability of cost of various risk-financing options are prime
considerations in regard to the choice people make. The financial position of the individual
making the choice also influences his / her decision. The degree of risk aversion of the
individual will also be an influencing factor in the choice of risk-financing decision. Finally,
the choice of an individual of the type of risk financing he or she makes may be
constrained by external factors. e.g. Motor owners are constrained by legislation in many
countries to the purchase of motor vehicle insurance. Another example is the constraint
that insurance be purchased for the purpose of protecting the collateral. When financial
institutions extend credit or provide loans for home purchase or car purchase, they impose
a condition that the debtors purchase property insurance.

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Annexure I
HISTORICAL DEVELOPMENT OF THE CONCEPT OF RISK ASSESSMENT
The first notable step in providing a formal and mathematical basis for risk assessment is
the theory of probability which was taken in 1654 by two French mathematicians Blaise
Pascal and Pierre de Format to resolve a puzzle that had been teasing mathematicians as
well as gamblers for over 150 years. The puzzle is: How are the stakes between two
players in a game of chance is to be divided if the game is stopped before it comes to an
end and one player is ahead of the other. The solution they suggested was that the two
players share the stakes on the basis of the respective probability that each would win the
game. Though the response of Pascal and Fermat was to a puzzle in a game of chance,
their demonstration of the method of calculating the probability of each player’s chance of
a win was a vital intellectual breakthrough. In the next fifty years after 1654, a number of
innovations and discoveries that are useful as building blocks with the development of
tools of risk measurement were developed such as statistical sampling, tests of statistical
significance, various applications of probability theory to practical problems and early
efforts for defining normal distribution and standard deviation. The other major
components of the science of risk management as we understand today namely the notion
of utility and the concepts of regression to the mean and diversification have been
developed in course of time. The chronology of risk as suggested by Bernstein in his
article “The Enlightening Struggle against Uncertainty” is given below.
Historical efforts on Risk Assessment*:
• 1654 French Mathematicians Blaise Pascal and Pierre de Fermat analyze games of
chance, providing for the first time a formal and mathematical basis of the theory of
probability.
• 1662 English merchant John Graunt publishes tables of births and deaths in London
using innovative sampling methods. He estimates the population of London using
the technique of statistical inference.
• 1687 Edward Lloyd opens a coffee house in Tower Street, London. In 1696 he
launches Lloyd List, giving information on aspects of shipping from a network of
European correspondents.
• 1696 English mathematician and astronomer Edward Halley shows how life tables
can be used to price life insurance at different ages.

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• 1713 Swiss mathematician, Abraham de Moivre, proposes the concept of normal

distribution, the pattern in which a series of variables distribute themselves around
an average, from which he also derives the concept of standard deviation.
• 1738 Jacob Bernoulli’s nephew, Daniel Bernoulli, introduces the idea of utility:
decisions relating to risk involve not only calculations of probability but also the
value of the consequences to the risk taker.
• 1885 English scientist, Francis Galton, discovers regression to the mean, the
tendency of extremes to return to a normal or average.
• 1894 In Theory of Games and Economic Behavior, US academics John von
Neumann and Oskar Morgenstern apply the theory of games of strategy (in contrast
to games of chance) to decision making in business and investing.
• 1952 US economist, Harry Markowitz, demonstrates mathematically that risk and
expected return are directly related, but that investors can reduce the variance of
return on their investments by diversification without loss of expected return.
• 1970 US academics, Fischer Black and Myron Scholes, publish a mathematical
model for calculating the value of an option.
*Source: Bernstein, Peter L “The Enlightening Struggle Against Uncertainty”, in James
Pickford (2001) Executive Editor, Financial Times, Mastering risk volume 1: concepts,
Pearson Education Limited, Edinburgh Gate.

REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. One of the earliest references to the term 'risk management' was made in the
US when it appeared in this magazine;
a. The Harvard Business Review. b. The Business Week.
c. The Forbes magazine. d. The Life magazine.
e. None of the above.

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2. One of the following is not true.

a. The subject of risk management does not have a long history.
b. “The essence of risk management lies in making the areas where we have some
control over the outcome while minimizing the areas where we have absolutely no
control over the outcome”.
c. The focus of risk management, particularly by corporates, has undergone change
over time.
d. The corporates have become far less concerned with traditional’ high frequency,
low severity’ risks
e. None of the above.
3. One of the following is not a step in risk management process.
a. Identify potential losses.
b. Evaluate potential losses.
c. Select the appropriate technique for treating loss exposures.
d. Risk pricing
e. None of the above.
4. The approaches used for risk identification include use of -
a. Loss exposure check lists. b. Flow charts.
c. Statistical analysis of historical data. d. Analysis of financial statement.
e. None of the above.
5. According to Rejda, “Accounts Receivables”, can be classified as;
a. Property loss exposure. b. Liability loss exposure.
c. Business income loss exposure. d. Crime loss exposure.
e. None of the above.
6. According to Rejda, “Kidnapping of key personnel”, can be classified as;
a. Foreign Loss exposure

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b. Crime Loss exposure.

c. Human Resources Loss exposure.
d. Business Income loss exposure.
e. None of the above.
7. One of the following is not true.
a. Frequency of loss relates to the probable number of particular losses that may
occur during some given period of time.
b. Severity of loss refers to the probable magnitude of losses that may occur, if they
occur.
c. A loss potential that is small even though frequent, is much less important as
compared to potential loss exposures that are infrequent but has a potential for
bankruptcy.
d. Both frequency and severity have to be considered in the risk management
process.
e. None of the above.
8. One of the following is not a technique for treating loss exposures:
a. Hedging. b. Risk Financing.
c. Risk retention. d. Insurance.
e. None of the above.
9. One of the following is not true:
a. Commercial insurance is a technique of transferring risk from one party to another
for a price.
b. One can combine a large number of independent exposure units in one portfolio;
an insurance company is able to reduce the risk of its aggregate losses.
c. Firms that enter into contracts to supply goods at a fixed price in the future face the
risk that a rise in prices between entering into the contract and the delivery date
may involve them in a loss.
d. Retention refers to the financing of losses internally.
e. None of the above.

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10. Insurance is suggested in the following case:

a. Frequency of loss ñ low and severity of loss - low
b. Frequency of loss ñ high and severity of loss - low
c. Frequency of loss ñ low and severity of high - low
d. Frequency of loss ñ high and severity of loss - high
e. None of the above.
11. Probability can take values
a. - ∝ to ∝ b. - ∝ to 1
c. -1 to 1 d. 0 to1
12. Probability can expressed as:
a. ratio b. Proportion
c. percentage d. all the above
13. When rolling a die the probability that 3 occurs is equal to
a. ½ b. 1/3
c. 1/6 d. 1/5
14. Mean is a measure of
a. location (central value) b. dispersion
c. correlation d. none
15. Which of the following is measure of central value
a. Median b. Standard deviation
c. Mean deviation d. Quartile deviation
16. The average of 7 numbers 7,9,12, X, 5,4,11,9. The missing number is
a. 13 b. 14
c. 15 d. 8
17. Correct formula for variance of 'n' sample observations x1, x2.......... xn is:

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18. What is the formula for bionomial distribution?

19. The relationship between variance and standard deviation is

a. variance is the square root of standard deviation
b. standard deviation is the square of the variance
c. variance is equal to standard deviation
d. square of the standard deviation is equal to variance
20. The formula for the co-efficient of variation is
S.D. Mean
a. C.V. = Mean ∗ 100 b. C.V. = S.D.
∗ 100
Mean ∗S.D. 100
c. C.V. = 100
d. C.V. = Mean ∗ S. D.
21. The expected value of a set of possible outcomes equals to
a. E.V. = п. [Link] b. E.V. = ∑ [Link]
c. E.V. = п. Pi.x2i d. E.V. = ∑ Pi.x2i

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22. Given that pi = 0, .05, 0.08, 0.20 & 0.67 and their outcomes ni = 5, 7, 6, & 2
respectively, the expected value is
a. 6.35 b. 4.80
c. 3.35 d. 7.29
23. The risk averse utility function is given by
a. E.V. = ∑ [Link] b. E.V. = п Pi.U(xi )
c. E.V. = ∑ Pi.U(xi )2 d. E.V. = ∑ Pi.U(xi )
24. Variance of the following frequency of distribution is:
(a) Class Frequency
(b) 2-4 2
(c) 4-6 5
(d) 6-8 4
(e) 8-10 1 is approximately equal to
a. 2.5 b. 2.9
c. 5.0 d. None
25. The job of risk management can be broken down into following element/s.
a. Risk Assessment b. Risk Control.
c. Risk Financing d. All of the above
e. None of the above.
26. ______ comprises of identification and analysis of potential loss exposures
a. Risk Control b. Risk Dynamics
c. Risk Assessment d. Risk Initiation.
e. None of the above.
27. Making use of a matrix plotting in loss frequency and loss severity, is known
as

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a. Risk Analysis b. Risk Grid

c. Risk Mapping d. Risk Convergence
e. None of the above.
28. Loss frequency can be categorized under this / these head / s.
a. Rare Loss Event such as a person's house located in an earthquake zone that
is likely to suffer loss rarely
b. Loss Event that occurs occasionally like a damage to a person ís car
c. Frequent Loss Event such as mild illness
d. All of the above
e. None of the above.
29. One of the following is not true:
a. Financial consequences of relatively cheap utensil of a family may be quite low.
b. Financial consequences of damages caused to car are relatively moderate.
c. Financial consequences of catastrophic loss such as destruction of house are
high.
d. All of the above.
e. None of the above.
30. Individual investors who are risk averse would prefer investing in:
a. Stock Market b. Bond Market
c. Derivatives Market. d. Bank deposits.
e. None of the above.
31. Before deciding upon the specific risk control measures to be adopted it is
necessary to conduct_________ Exercise.
a. Risk Analysis. b. Risk Control
c. Cost Control d. Cost-Benefit
e. None of the above.

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32. The techniques of risk control available for individuals and others are
classified under this / these head / s.
a. Loss Avoidance. b. Loss Prevention.
c. Loss Reduction. d. All of the above.
e. None of the above.
33. After receiving a doctor’s advice that there is a risk of premature death by
cancer, an individual might completely stop smoking. It is
a. Loss Prevention b. Loss Avoidance
c. Loss Reduction d. Loss Understanding.
e. None of the above.
34. Most frequently occurring minor health problems (flu, cold, etc.) which do
imply low loss severity can be reduced in frequency of occurrence by taking
appropriate action. It is
a. Loss Prevention. b. Loss Avoidance
c. Loss Reduction d. Loss Understanding.
e. None of the above.
35. Individuals investing in equity shares and mutual funds for purposes of wealth
accumulation and retirement needs are invariably subject to investment risk. A
risk reduction technique that is appropriate for mitigating the investment risk
is portfolio diversification. It is
a. Loss Prevention. b. Loss Avoidance
c. Loss Reduction d. Loss Understanding.
e. None of the above.
36. Individuals might have got numerous risk-financing options which, may
however be classified as
a. None of these. b. Risk Retention.
c. Risk Sharing d. Risk Transfer
e. All of the above.

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37. One of the following is not a form of risk transfer:

a. Hold Harmless Agreements b. Incorporation.
c. Partnership d. Insurance
e. None of the above.
38. A number of factor/s is /are considered by individuals before making risk-
financing decisions.
a. Expected cost b. Financial position
c. Degree of risk aversion d. All of the above
e. None of the above.
39. A house owner includes in the lease agreement a clause making the tenant
responsible for all injuries the guests may suffer while on the leased premises.
It is ________form of risk transfer.
a. Hedging b. Insurance
c. Hold Harmless Agreement d. Diversification
e. None of the above.

Answers
1. a 2. d 3. d 4. e 5. a 6. a 7. e 8. e 9. e 10. c
11. d 12. d 13. c 14. a 15. a 16. c 17. a 18. c 19. d 20. a
21. b 22. c 23. d 24. b 25. d 26. c 27. c 28. d 29. e 30. d
31. d 32. d 33. b 34. a 35. c 36. e 37. c 38. d 39. c

SECTION – B
Short & Essay Questions
1. Outline the steps in the process of Risk Management
2. Explain the important objectives of Risk Management by Individuals / Organizations.

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3. Explain the process of risk identification.

4. Discuss the concept of loss exposure checklist, giving suitable examples.
5. Discuss a checklist that is useful for identifying property loss exposures.
6. How is potential loss evaluated?
7. Outline appropriate techniques for treating loss exposures.
8. Explain Rajda’s matrix for determining appropriate technique for tackling losses.
9. Discuss the two facets of loss exposures
10. Distinguish between Maximum Possible Loss (MPL) and Probable Maximum Loss
(PML). Illustrate with a suitable example
11. Distinguish between Direct and Indirect losses in case of Property loss.
12. Explain the concept of Probability
13. Distinguish between expected value and mean of a set of data

SECTION – C
Case Studies
1. You are the Risk Manager for a large multinational enterprise involved in the
manufacture of products through a hazardous process prone to pollute. Your
main operations are in Finland, a country known for its rigorous and costly
pollution, manufacturing and employee safety standards. Moreover, Finnish
workers are highly paid by world standards. One of your employees has
suggested the relocation of the most hazardous aspects of the manufacturing
process to a developing country in Africa. The employee argues that such a
move would be sound risk management because the costs of compliance
would be lower in the African country, which has less rigorous pollution,
manufacturing and worker safety laws. Moreover, because worker wages
would be lower, the costs of worker disability payments and other job-related
injuries and illnesses would be less. Finally, the employee notes that
unemployment is rampant in the African country and the government and
people would welcome the opportunity to work for the company.

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As the Risk Manager of the Multinational, your goal is to minimize volatility in

corporate cash flow and to do so at the lowest cost consistent with ethical
behaviour. If you maintain the hazardous operations in Finland, costs will
remain high. If you relocate them to the developing country, costs will
decrease and people will have more jobs.
What is your recommendation? Discuss.
Ans. The management of risk is a process with the objective of identifying risk exposures
faced by an individual/organization with a view to selecting the best available
technique for treating such exposures. The corporates have become far less
concerned with traditional high frequency, low severity risks but have started
devoting greater attention to risks that could lead to corporate collapse and
corporate bankruptcy. There is therefore a need to adopt a comprehensive approach
for managing risk. This comprehensive strategy for treating risk is referred to as
“integrated risk management” (IRM) or “enterprise risk management”. (ERM). To
achieve the goal and to make the programme effective, a periodic review of the
programme is called in order to determine whether or not the objectives of the risk
programme are being realized.
In the given case, the problem of relocation has to be viewed from risk angle also.
What kind of risks the company has to face when it is located in an African country?
What are the local laws? Is the government there positive to foreign investment? Do
they allow repatriation? How are their pollution laws? Is there any country risk? A
Risk Audit has to be conducted to identify potential sources of risk and then the
methods to address to those issues? What will be the financial outflow involved in
accepting any solution? Are there any health issues? Unless these things are
addressed and solutions found, it is premature to suggest to the Board any type of
solution.
2. Das and Associates is a management consulting firm with headquarters at
Mumbai and operations spread all over the country. The company was formed
in 2000 by its promoter director Anup Das. Das presently maintains 150
consultants and 100 employees working in supporting roles. The firm has
developed a reputation for being especially helpful in solving personnel and
financial management problems. As Das and his management team plan for
the future, they want to be very systematic in identifying key issues,

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opportunities and potential problems that may confront the company in the
years ahead. One area that has not received much attention to date is that of
pure risk exposures. Thus, Das has recently assigned one of his top
consultants to take on the responsibility for identifying all of the potential
risks confronting his firm. After the exposures have been identified, Das wants
to know the relative importance of each one. For example, is the risk of loss
due to fire potentially more damaging than the risk of adverse liability
judgments ? What losses are most likely to happen in a given year and how
much would probably be lost in each case? Can consistency be expected from
one year to the next? Das believes that it is impossible to make good risk
management decisions without first having answers to these and similar
questions. Discuss.
Ans. Human nature is fundamentally adolescent (e.g., “bad things would not happen to
me”) and short-sighted (e.g., tends toward immediate gratification instead of long-
term gratification). Disaster preparation and most other components of risk
management require leadership that is mature (e.g., “bad things happen all the time
and can happen to me as easily as to anyone else) and far-sighted (e.g., able to
delay gratification and make long-term investments for a greater good). To achieve
maturity and far-sightedness, many things are required over many years. Key among
those things are academic education and life experience that include the formation
of positive values, ethics and knowledge of the political, economic and business
conditions most likely to produce positive results from human nature.
The first step in the process of risk management by individuals, businesses and
society is the assessment of risk. Risk assessment comprises identification and
analysis of potential loss exposures. Such assessment has to be continuous and
comprehensive. As individuals as well as their environment are not static but
dynamic and do change, risk assessment has to be an ongoing activity. A business
organization's exposures to loss is now managed by using a new risk management
technique called risk mapping making use of a matrix plotting in loss frequency and
loss severity.
The second step in the risk management process is to control the risk by selecting
those techniques that will reduce the frequency of loss and reduce the severity of
loss. Before deciding upon the specific risk control measure to be adopted it is

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necessary to conduct a cost-benefit exercise. That is an evaluation of the expected

benefits and costs involved to determine whether the decision taken is economically
sound or not.
Despite one’s best efforts, loss exposures can never be eliminated; one has to think
of financing losses, when losses happen. The question of sources of funds for
repairing losses is addressed to techniques of loss financing. Loss financing (and
the various sources of funds available for this purpose) is required to repair or
replace damaged property, to meet expenses involved in legal defence and any
advance judgments or award in cases of legal liability, to pay medical bills and other
health care expenses and to replace lost wages and taking care of the financial
consequences of premature death or loss of life.
While one end of the risk-financing continuum, is risk retention, the other end of the
continuum is risk transfer. In risk transfer, the financial impact of loss is shifted to
another party. Risk transfer involves agreement by the transferee to assume the loss
or risk that the transferor is desirous of escaping. The process of risk transfer
involves a payment by the transferor to the risk bearer or transferee. It is normally
done through insurance.
Basing on the above analysis the consultants need to look at all dimensions and
estimate probable causes of risks, how to manage them and how to fund them in
case it really occurs.
3. In a cultivating land, the loss occurrence yearly, in rupees and the probability
of loss occurrence also are given. Find the mean amount of loss and expected
value of loss for 5 years.
Year Loss in rupees Probability of loss
1 6 lakhs 0.05
2 28 lakhs 0.18
3 30 lakhs 0.28
4 15 lakhs 0.35
5 58 lakhs 0.14
Total 137 lakhs 1

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 INTRODUCTION AND PROCESS OF RISK MANAGEMENT

Ans.

Year Loss in rupees Probability Amount of (loss x Prob.

of loss loss of loss)
1 6 lakhs 0.05 0.3
2 28 lakhs 0.18 5.04
3 30 lakhs 0.28 8.4
4 15 lakhs 0.35 5.25
5 58 lakhs 0.14 8.12
Total 137 lakhs 1 27.11
Mean amount of loss = 137/5 = 27.4
Expected amount of loss = 27.11
4. In a cricket team the runs scored between players are given below:
27, 53, 48, 98, 61, 52, 72, 40, 20, 31
What is the variance score between players?
Ans.

Scores Mean score Deviation from mean Squared deviation

score

27 55.2 - 28.2 795.24

53 55.2 - 2.2 4.84

48 55.2 - 7.2 51.84

98 55.2 42.8 1331.84

61 55.2 5.8 33.64

52 55.2 - 3.2 10.24

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72 55.2 16.8 282.24

40 55.2 - 15.2 231.04

20 55.2 - 35.2 1239.04

81 55.2 25.8 665.64

Total 552 0 5145.6

552
Mean score: 10
= 55.2
5145.6
Variance (σ) 10
= 514.56

514.6
S.D. (σ) = � 10
= 22.68

5. Find mean, median, & mode for the following data

42, 53, 71, 63, 82, 91, 48, 53, 67, 98, 53
Ans: Mean (x) = ∑xi
n
42+53+71+63+82+91+48+53+67+98+53
x = --------------------------------------------------------
11
721
= ------- = 65.55
11
Median = Arrange in increasing or decreasing order and in which mid value is
median
= x Median = 42, 48, 53, 53, 53 63, 67, 71, 82, 91, 98
= 63
Mode = Most repeated value. Where mode is 53

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CHAPTER – 3
DECISION MAKING UNDER CONDITIONS
OF UNCERTAINTY
OUTLINE OF THE CHAPTER
1. Introduction
2. Expected Value Rule and Decisions Involving Risk
3. Expected Utility Rule and Decisions Involving Risk
4. Expected Utility and Insurance
5. Maximization of Utility over Life Time and Demand for Insurance
6. Behavioral Economics and Demand for Insurance
7. Questions

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Understand the concept and application of Expected Utility
• Explain how rational risk-averse individuals and businesses purchase insurance
at actuarially fair premium
• Distinguish between risk-aversion, risk-loving and risk-neutrality
• Show how insurance purchase permits people to maximize life-time utility
• Understand the critique of rational decision-making
• Give a brief explanation of Prospect Theory and a few other new developments
in the subject.
RISK MANAGEMENT AND REINSURANCE

Introduction
Risk is implied by our inability to predict the future; as such, decision making by individuals
and businesses become complex and difficult. In the economic sense, risk refers to our
lack of knowledge regarding which several of the possible outcomes may prevail; it does
not refer to adverse quality of some outcomes such as losses instead of gains.
While it is generally agreed that people prefer more money to less, there is
no general behaviour pattern of the people in their response to risk. The preferences and
choices of people differ under conditions of uncertainty and risk, and may be influenced by
their economic circumstances and their personalities. We may discuss here decision rules
that can help individuals choose between risky alternatives.

Expected Value Rule and Decisions Involving Risk

To start with, we take up for discussion an example in which a choice is to be made
between the following prospects. Mohan has received arrears of salary amounting to
Rs.10,000. After consulting his friends, Mohan has zeroed on three alternative prospects:
Option A – Keep the amount in the form of currency ; that is doing nothing
Option B – Put the money in a bank as a fixed deposit for one year.
Option C – Invest the money in a mutual fund.
If Mohan keeps the amount in the form of liquid cash, at the end of the year he will have
Rs. 10,000. If he decides to deposit the money in the bank for one year which bears an
interest of 5 percent per annum, Mohan will have Rs.10,500 (Rs.10,000 + Rs.500 interest
for one year).
The third option offers two pay offs. Mohan will earn 30 percent on his investment in the
mutual fund for the year with a probability of 0.50 or a loss of 15 percent, again with a
probability of 0.50.
From the above information, we can set up Mohan’s pay off Matrix involving the three
alternative choices.

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Table 1. Mohan’s Payoff Matrix

OPTIONS PAY OFF IN ONE YEAR
A – Hold Cash Rs.10,000
B – Invest in F.D. Rs.10,500
Rs.13,000
0.5
C – Invest in a Mutual Fund
0.5 Rs.8,500
Mohan’s choice between Options A and B is simple enough and is based upon certainty.
The choice of Mohan is obvious; he chooses option B as the amount he obtains at the end
of the year from that option is higher than from option A. (Recall that people prefer more
money to less). However, the choice between B and C is not simple. In making a choice,
Mohan can make use of the statistical concept of excepted value. Intuitively, the expected
value is the average value that could prevail, on the average. The expected value (EV) of
a set of possible outcomes equals the sum of the outcomes each weighted by the
probability of its occurrence.
EVj = ∑ pi xi
i
Where :
EVj : Expected value of prospect j
pi : Probability of outcome xi
xi : Outcome i in money value.
In our above example, the expected value of alternative C, mutual fund investment, is the
average value that Mohan could obtain if he invested Rs. 10,000 in the mutual fund over a
number of years. The expected value of Mohan’s Option C is
EVC = 0.5 x Rs. 13,000 + 0.5 x Rs.8,500 = Rs.10,750
The expected values of Option A and B are Rs.10,000 and Rs.10,700 respectively.
If Mohan follows the expected value rule in making decisions, he would choose Option C,
as it yields the highest expected value. This choice is all right except that it ignores risk,

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which is an important factor that cannot be ignored. It is common knowledge that people
are averse to risk or would hate to lose.

Expected Value and Investment Risk Management

A common definition for investment risk is deviation from an expected outcome in absolute
terms or relative to something else like a market bench mark. That deviation can be
positive or negative, and relates to the idea of "no pain, no gain" - to achieve higher
returns in the long run you have to accept more short-term volatility. How much volatility to
accept depends on risk tolerance of an individual.
One of the most commonly used absolute risk metrics is standard deviation, a statistical
measure of dispersion around a central tendency. For example, during a 15-year period
from August 1, 2002, to July 31, 2017, the average annualized total return of the S&P 500
Stock Index was 10.7%. This number tells what happened for the whole period, but it
doesn't say what happened along the way.
The average standard deviation of the S&P 500 for that same period was 13.5%.
Statistical theory tells us that in normal distributions (the familiar bell-shaped curve) any
given outcome should fall within one standard deviation of the mean about 67% of the time
and within two standard deviations about 95% of the time. Thus, an S&P 500 investor
could expect the return at any given point during this time to be 10.7% +/- 13.5% just
under 70% of the time and +/- 27.0% 95% of the time.
In the language of Kahneman prospect theory, investors’ exhibit loss aversion - they put
more weight on the pain associated with a loss than the good feeling associated with a
gain. Thus, what investors really want to know is not just how much an asset deviates from
its expected outcome, but how bad things look way down on the left-hand tail of the
distribution curve. Value at risk (VAR) attempts to provide an answer to this question. The
idea behind VAR is to quantify how bad a loss on an investment could be with a given
level of confidence over a defined period of time. For example, the following statement
would be an example of VAR: "With about a 95% level of confidence, the most you stand
to lose on this $1,000 investment over a two-year time horizon is $200. The confidence
level is a probability statement based on the statistical characteristics of the investment
and the shape of its distribution curve. Of course, even a measure like VAR doesn't
guarantee that things won't be worse in spectacular debacles like "outlier events" After all,
95% confidence allows that 5% of the time results may be much worse than what VAR

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calculates. An example was the Russian government's default on its outstanding

sovereign debt obligations, an event that caused the hedge fund's performance to be
much worse than its expected value at risk.
Another risk measure oriented to behavioral tendencies is draw down, which refers to any
period during which an asset's return is negative relative to a previous high mark. In
measuring drawdown, we attempt to address three things: the magnitude of each negative
period (how bad), the duration of each (how long) and the frequency (how many times).
In addition to wanting to know, for example, whether a mutual fund beat the S&P 500 we
also want to know how comparatively risky it was. One measure for this is beta, based on
the statistical property of covariance and also called "market risk", “systematic risk”, or
"non-diversifiable risk". A beta greater than 1 indicates more risk than the market and vice
versa. Beta helps to understand the concepts of passive and active risk. Figure 1 below
shows a time series of returns (each data point labeled "+") for a particular portfolio R(p)
versus the market return R(m). The returns are cash-adjusted, so the point at which the x
and y axes intersect is the cash-equivalent return. Drawing a line of best fit through the
data points allows us to quantify the passive, or beta, risk and the active risk, which refer
to as alpha.
The gradient of the line is its beta. For example, a gradient of 1.0 indicates that for every
unit increase of market return, the portfolio return also increases by one unit. A manager
employing a passive management strategy can attempt to increase the portfolio return by
taking on more market risk (i.e. a beta greater than 1) or alternatively decrease portfolio
risk (and return) by reducing the portfolio beta below 1.
If the level of market or systematic risk were the only influencing factor, then a portfolio's
return would always be equal to the beta-adjusted market return. But this is not the case -
returns vary as a result of a number of other factors unrelated to market risk. Investment
managers who follow an active strategy take on other risks to achieve excess returns over
the market's performance. Active strategies include stock, sector or country selection,
fundamental analysis and charting. Active managers are on the hunt for alpha - the
measure of excess return. In our diagram example above, alpha is the amount of portfolio
return not explained by beta, represented as the distance between the intersection of the x
and y axes and the y axis intercept, which can be positive or negative. In their quest for
excess returns, active managers expose investors to alpha risk - the risk that their bets will
prove negative rather than positive. For example, a manager may think that the energy

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sector will outperform the S&P 500 and increase her portfolio's weighting in this sector. If
unexpected economic developments cause energy stocks to sharply decline, the manager
will likely underperform the benchmark - an example of alpha risk.
A note of caution is in order when analyzing the significance of alpha and beta. There
must be some evidence of a linear pattern between the portfolio returns and those of the
market, or a reasonably inclusive line of best fit. If the data points are randomly dispersed,
then the line of best fit will have little predictive ability and the results for alpha and beta
will be statistically insignificant. A general rule is that an r-squared of 0.70 or higher (1.0
being perfect correlation) between the portfolio and the market reasonably validates the
significance of alpha, beta and other relative measures.
The difference in fund manager pricing between passive and active strategies (or beta
risk and alpha risk respectively) encourages many investors to try and separate these
risks: i.e. to pay lower fees for the beta risk assumed and concentrate their more
expensive exposures to specifically defined alpha opportunities. This is popularly known
as portable alpha, the idea that the alpha component of a total return is separate from the
beta component.
For example a fund manager show as evidence a track record of beating the index by
1.5% on an average annualized basis then the investor considers that 1.5% of excess
return is the manager's value - the alpha - and the investor is willing to pay higher fees to
obtain it. The rest of the total return, what the S&P 500 itself earned, arguably has nothing
to do with the manager's unique ability. Portable alpha strategies use derivatives and other
tools to refine the means by which they obtain and pay for the alpha and beta components
of their exposure.
To conclude, Risk is inseparable from return. Every investment involves some degree of
risk, which can be very close to zero in the case of a treasury bills or very high for equities.
Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in
its different forms can help investors to better understand the opportunities, trade-offs and
costs involved with different investment approaches.

Expected Utility Rule and Decisions Involving Risk

To explore individual risk aversion and how EV Rule breaks down, consider the following :
“Consider a game in which one player (A) flips a fair coin. If the coin reveals heads, A

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pays the other player (B) 2 rupees and the game is over. If the coin lands on tails, it is
tossed again. If the second toss lands on tails, it is tossed again. If the second toss lands
heads, A pays (2)2 rupees to B and the game is over. If the second toss lands tails, the
coin is flipped again. Thus, the game continues until the first head appears and then A
pays B (2)n rupees, where n signifies the number of tosses required to reveal the first
head. Since a head will turn up eventually, B wants a long proceeding run of tails.
The problem is : how much will B be willing to pay to enter the game”?
The Expected Value of the gamble is
n
EV = ∑ pi xi
i=1
= 2(½) + 22 (½)2 + 23 (½)3 + ………….+ 2n (½)n
= 1+1+1+……………+………..
=∞
The game has an infinite expected value. However, individuals seem willing to pay only a
few rupees to play the game. This problem was formulated by Daniel Bernoulli, an 18th
century Swiss mathematician and physicist in an essay published in 1738. This problem
has come to be known as the St. Petersburg Paradox. Peter Bernstein considers
Bernoulli’s essay to be “…..one of the most profound documents ever written, not just on
the subject of risk but on human behaviour as well”.
As is clear, Bernoulli correctly observed that different people value risk differently. Some
are more venturesome than others. This has profound implications for human and
economic progress. If everyone values risk uniformly, most of investments, uncertain
business ventures and their activities characterized by risk would not be taken up. To
quote Bernstein again “think of what life would be like if everyone were phobic about
lightening, flying in airplanes or investing in start-up companies. We are indeed fortunate
that human beings differ in their appetite for risk”.
Further, Bernoulli postulated a systematic relationship between risk and wealth. According
to him, the satisfaction or utility derived from marginal increases in wealth is inversely
related to the level of wealth previously possessed. Applying the principle suggested by

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Bernoulli, and recalling that Mohan’s choice of option C has the highest expected value,
we may note that the potential gain from option C may not be high in terms of expected
utility or satisfaction, that he prefers option Cover option B.
Bernoulli’s ideas are carried forward by Economists to describe how individuals make
decisions under conditions of uncertainty. The term utility is a scale of measurement of
satisfaction derived from income or wealth and is used by economists to represent an
index of satisfaction derived from economic goods. A utility function constructed by
economists is used to map a particular level of wealth to a corresponding level of
satisfaction for an individual. By using the tool of utility function, we can outline an
individual’s attitude towards wealth and risk and quantify his risk and wealth preferences.
Essentially, individuals are risk averse. A person is considered risk-averse, if faced with an
uncertain situation, the displeasure from losing a given amount of money is greater than
the pleasure from gaining the same amount of money. A utility function for a risk-averse
individual exhibits the following two characteristics.
1. More wealth is preferred to less wealth. Increasing wealth gives increasing levels of
satisfaction; and
2. The incremental utility or satisfaction from unit increases in wealth decreases as
wealth increases. That is, for a poor person, an addition of Rs.200 to his/her wealth
will make a great impact on his/her wealth than the same increase of wealth to a rich
person. For the latter, the increase in wealth by Rs.200 will increase satisfaction, but
only marginally. This assumption is referred to in Economics as “law of diminishing
marginal utility”. The utility function that satisfies the above two characteristics is
depicted as OA in Figure 2. The shape of the utility function reveals a person’s
attitude towards risk.
Though, persons do not, in practice, know their utility functions, the underlying theory is
found useful.

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UTILITY

Fig. 2. Utility Function

A risk averse utility function

The expected utility rule substitutes utility values in risky prospects in order to select
among risky alternatives. This rule was developed in 1944 by John Von Neumann and
Oskar Morgernstern and is very useful for analyzing risky choices. The rule postulates that
individuals will choose the option with the highest expected utility value.
The expected utility of a set of risky outcomes equals the sum of the levels of utility at
each outcome weighted by the probability of each outcome. The following expression
gives the expected utility rule.
n
EUj = ∑ pi U (xi)
i=1

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where,
EUj : expected utility of prospect j
Pi : probability of outcome xi
U(xi) : Utility value of outcome xi or wealth level xi
The expected utility value is similar to the expected value rule discussed earlier. Whereas
expected utility is the weighted average of outcomes of a risky choice when those
outcomes are expressed as utility values, expected value is the weighted average of
money outcomes.
We may now apply the expected utility rule to the choice of Mohan out of the three
alternatives A,B and C.
Suppose Mohan’s utility function is the natural logarithm of wealth. The expected utility of
options B and C that Mohan faces are :
EUB = 1.0 U (Rs.10,700)
= 1.0 x 1n (Rs.10,700)
= 9.28
EUC = 0.5 U (Rs.13,000) + 0.5 U (Rs.8,500)
= 0.5 x 1n (Rs,13,000) + 1n (Rs.8,500)
= 9.26
Thus, we can predict that Mohan will prefer Option B over Option C, when he uses the
expected utility rule.

Insurance and the Expected Utility Rule

The example we have considered for the application of the expected utility rule relates to
individual’s choice among investment alternatives. The same rule is also applicable to
determine whether an individual will purchase insurance in order to minimize uncertainty.
By purchasing insurance policy, one pays a premium to avoid a risky outcome. Or,
purchase of an insurance policy involves the sacrifice of certain wealth in order to avoid
the possibility of a loss of wealth.

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 DECISION MAKING UNDER CONDITIONS OF UNCERTAINTY

Suppose Anand wishes to insure his home, Assume further that his total wealth is Rs.1200
of which Rs.1000 is the value of his home, the value of other assets being Rs.200. If the
house is burnt down in a fire accident resulting in a total loss, fire would reduce Anand’s
wealth to Rs.200 from Rs.1200. Suppose the probability estimate of fire is 0.25. Then,
value of Anand’s is total wealth will be either Rs.1200 or Rs.200 with respective
probabilities of 0.75 and 0.25. If Anand does not take insurance, his expected utility is
given by the equation.
EUN1 = 0.75 U (Rs.1200)+0.25 U (Rs.200)
Where the subscript N1 indicates no insurance purchase.
If, insurance is available, the expected value of the loss in case of fire is
EV = 0.25(Rs.1000) + 0.75(0) = 250.
If we ignore transaction costs involved in insurance purchase, an insurer charging a fair
premium (i.e. a premium equal to the expected value of loss) would make no profit / no
loss (or break even) if it held a large portfolio of such policies. The fair premium is also
referred to as actuarially fair premium or actuarial value of the insurance policy. Note that
the term “fair” premium does not indicate value judgment; it does not also suggest that any
other premium is unfair. Pure premium is the term used by actuaries for the fair premium.
Now the question is whether Anand should purchase insurance if it is offered at a fair
premium, (here Rs.250). If Anand chooses to insure his home, his wealth at the end of the
year is Rs.950 (Rs.1000 + Rs.200 – Rs.250), irrespective of whether or not fire accident
occurs during the year. Then, Anand’s expected utility would be
EUI = 0.25(Rs.950)+0.75 (Rs.950)
= 1.0 U (Rs.950)
= U (Rs.950)
Where EUI is expected utility for insurance.
If Anand chooses not to purchase insurance and does not part with the premium amount
of Rs.250, his end-of-year wealth will be either Rs.1200 (with no loss) or Rs.200 (with total
loss). His expected utility is
EUNI = 0.25 U (Rs.200) + 0.75 U (Rs.1200)

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The two positions can be represented as in the following diagram

Fig. 3. Anand’s Expected Utility with Insurance

As shown, EUI=U (Rs.950) is greater than EUNI suggesting that insurance at an

actuarially fair premium should be purchased. The straight line AB drawn from the two
positions on the utility curve corresponding to the alternative wealth levels when Anand
chooses not to insure represents all linear combinations of those two points and is called
the expected utility line. The position at which this line intercepts the expected wealth
(position C) represents the expected utility of not insuring. This result is a consequence of
using the same weights to calculated the expected utility and the expected value. If the
utility curve is concave from below (implying risk aversion), Point C tracing out the
expected utility of not insuring, will always lie below point D which identifies the expected
utility of insuring. We can state that a rational risk-averse individual will choose to insure if
the premium is equal to the expected value of loss or insurance is offered at an actuarially
fair premium. This result is known as the Bernoulli Principle.
We may note the equivalence between the attitude towards risk and the shape of the utility
function.

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Fig. 4. Risk Lover and Insurance

As can be seen, a convex utility function implies that for the individual marginal utility of
wealth increases as wealth increases. Then for this individual insurance is not attractive
since the marginal valuation of wealth is high when he pays the premium but low when he
receives a settlement of loss from the insurance company. Notice that EUNI represented
by position C is higher than EUI (denoted by Position D).
If the individual is risk-neutral i.e. he is neither averse to risk nor does he like risk, the
utility curve is linear. For the individual who is risk neutral, the expected utility from
insuring is exactly equal to that from not insuring. The choice of a risk-neutral individual
from a set of alternative risky prospects will be determined on the basis of their expected
values.

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Fig. 5. Risk indifference and insurance

Maximization of Utility over Life Time and Demand for

Insurance
It is useful to extend the analysis of individual decision-making under conditions of
uncertainty to the entire life time. Individuals allocate the time at their disposal in income-
producing activities (work) or taking time off from such activities (leisure). Whatever the
proportion of time spent on work and leisure, the income earned by him or her is allocated
between current consumption and future consumption or saving. The division of income
between consumption and saving will depend on a host of factors including the individual’s
level of income, demographic factors such as family size, economic factors and his/her
preferences.

Economic theories of consumption

Various theories of consumption have been put forward by economists. Such as
— Absolute Income Hypothesis,
— Relative Income Hypothesis,

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— Life Cycle Hypothesis and

— Permanent Income Hypothesis.
The economic theories of consumption assume that rational consumers seek to maximize
their lifetime utilities while allocating income between current consumption and saving.
This assumption implies that individuals divide their income between current consumption
and future consumption in a manner that results in optimizing their pattern of consumption
over life time.
One of the theories that has received wide acceptance is the life cycle hypothesis put
forward by Modigliani - Brumberg – Ando (MBA). This hypothesis recognizes that an
individual’s income will grow over time – low in the beginning when he or she starts
earning, reaching a peak in the middle or before retirement (voluntary or otherwise) and
little or no earned income after retirement. Despite such changes in income during the life
cycle, the individual would attempt to maintain an increasing or constant consumption
level (for further clarity refer Module 1 chapter 1). Research studies show that individuals
and families will find it difficult to accept reduction in consumption levels.
It is obvious that in early life, when income is low and consumption exceeds income,
individuals and families will meet the deficit by borrowing. (dissaving). The debt incurred in
the early period of the earning span is paid off when income increases and consumption
does not increase proportionately. As a consequence, there is accumulation of personal
savings from which the deficit incurred in the earlier period can be made good and
accumulate funds for post-retirement spending. In later life, when the individual retires and
income earnings stop or decline, the past savings will come in handy to meet the
expenditure and maintain or improve the accustomed standard of living.

Risk aversion and demand for insurance for individual risk

management
Recall that we showed above those risk-averse individuals can increase their utility by the
purchase of insurance. Yaari and Pissasides have shown that expected life time utility of
risk –averse individuals will increase by the purchase of life insurance. The purchased life
insurance will provide payments to the family on the death of the insured and annuity
payments to him during the period of retirement. That is, the pattern of consumption that
could be achieved if the time of death were known with certainty could be achieved

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through an appropriate use of personal life insurance. The individual life time pattern of
consumption, however, would be different and the utility or enjoyment or satisfaction would
be lower in the absence of life insurance.
Empirical evidence suggests that individuals characterized by high degree of risk aversion
tend to save more and purchase more insurance than those who are less risk averse. By
saving more and purchasing more insurance, the highly risk-averse individuals would
ensure that they are not exposed to the risk of insufficient income later in life. Technically,
a person who is risk averse prefers a certain amount of wealth to a risky situation that
yields the same expected wealth. For Example, suppose that Mr. Varma is asked whether
he would accept a 50-50- chance of winning Rs.1000 and losing Rs.1000. The expected
value of gamble is 0 (0.5 * 1000 +0.5 *-Rs.1000); thus the gamble does not change his
expected wealth. If Mr. Varma were risk averse he would not accept the gamble, because
the risk (uncertainty) created by the gamble makes him worse off. Note that Mr. Varma’s
aversion to risk implies that the possible loss of Rs.1000 hurts him more than the possible
gain of Rs.1000 benefits him. This is essence of risk aversion. People are averse to risk
because a loss of Rs. X hurts them more than a gain of Rs. X benefits them.
In order for Mr. Varma to accept the gamble he would need to be compensated for the
risk created by the gamble. Suppose that he would only accept the gamble if the odds
were changed so that there was a 60 per cent chance of winning Rs.1000 and a 40
percent chance of losing Rs.1000. Then the gamble would increase his expected wealth
by Rs.200 (Rs.1000 * 0.6 – Rs.1000 * 0.4). The Rs.200 in additional expected wealth is
the risk premium required to induce Mr. Varma to accept the gamble. All else being equal,
people are more risk averse will require a higher risk premium to induce them to accept
risk.
In contrast, if Mr. Varma were risk neutral, he would be indifferent between accepting the
original gamble and rejecting the gamble. The reason is that the gamble does not change
his expected wealth and uncertainty created by the gamble does not bother him. In other
words, a person who is risk neutral cares only about expected wealth. A risk-neutral
person therefore would not require a risk premium to accept risk.
These examples illustrate that risk-averse people require a risk premium to accept risk.
Similarly, risk-averse people are willing to pay a risk premium to reduce risk. Suppose for
example that Mr. Anurag has a 2 percent chance of losing Rs.10,000. Then his expected
loss is Rs.200 (0.02 *Rs.10, 000). If Mr. Anurag were risk averse, he would be willing to

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pay more than Rs.200 to eliminate the risk. However, if Mr. Anurag is risk neutral, the
most he would pay to eliminate risk is Rs.200. Risk aversion appears to be a characteristic
of most people as evidenced by their behavior when faced with risky scenarios. Most
people are willing to pay insurance premiums in excess of expected claim costs for
insurance; that is, they are willing to pay a risk premium. Also, most people require
additional compensation to induce them to accept or take on risk. For example, people
require higher expected returns to induce them to invest in common stocks rather than
government bonds, because stocks have greater risk.

Risk aversion and demand for insurance for business risk

management
Even though businesses are owned by individuals, business risk management may differ
in fundamental ways from individual risk management. The reason is that businesses
often are organized in a way that allows business owners to diversify business risk on their
own. One of the fundamental functions of the stock market is to allow investors in
corporations to diversify risk.
If the owners of a business are not well diversified, business insurance purchases will
reduce the owners’ risk. This reduction in risk is potentially an important benefit of
business insurance. Just as individual insurance is beneficial to risk-averse people,
business insurance is beneficial to risk-averse owners that are not diversified. Thus, most
small businesses and most privately held businesses will find that business insurance is
beneficial because it reduces the owners’’ risk.
When shareholders are well diversified, corporate activities to reduce the variability in
cash flows due to pure risk are largely redundant from the perspective of the shareholders,
who already have reduced their risk by diversification. Even when shareholders are well
diversified, corporate insurance still can benefit shareholders by
(1) Reducing the costs of purchasing claims processing and loss control services
The firm can purchase insurance not to reduce risk for shareholders but to obtain claims
processing and loss control services at the lowest cost. For Example a firm that provides
loss control services that also must pay losses has an additional incentive to identify and
undertake cost-effective loss control measures. A firm that provides claims processing
services that also must pay losses has an additional incentive to identify fraudulent claims.

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If the service and financial responsibility are not bundled, then a firm must expend some
resources monitoring the service providers or alternatively design a contract that provides
proper incentives. When monitoring is too costly and contract design efforts ineffective,
bundling the services with financial responsibility for paying losses can be the least costly
method of obtaining services.
(2) Reducing the expected cost of financing losses
The failure to reduce risk implies that there is a greater likelihood of large losses that must
be paid either from the firm’s internal funds or, if internal funds are not available, by raising
new funds through borrowing or issuing new securities. Significant costs can be incurred if
new securities have to be issued. Thus firms that are not likely to have the internal funds
to finance losses might prefer to purchase insurance to reduce the likelihood of incurring
the costs associated with issuing new securities to pay for losses.
(3) Reducing financing costs for new investment opportunities
By purchasing insurance to cover losses, a firm can reduce the likelihood that costly
external capital will be needed for new investment opportunities and thereby increase the
profitability of new projects (net of financing costs)
(4) Reducing the likelihood of financial distress and improving contractual terms
If a firm does not have the internal funds to pay losses that occur and cannot convince
banks or investors to provide new funds, then it will be forced into bankruptcy. Substantial
legal costs can be incurred when a firm liquidates or reorganizes. When a firm is in
financial distress, other claimants besides shareholders typically are harmed. To illustrate,
the plight of banks and investors who have lent money to a firm that now finds itself in
financial distress. Consequently, if a firm can reduce its risk, say through insurance,
lenders will be willing to contract with the firm at better terms. One benefit of risk reduction
from the shareholders’ perspective therefore is that it can improve the terms at which firm
can borrow money and also can improve the terms at which the firm contracts with other
claimants, such as employees, suppliers, lenders and customers etc.,
(5) Reducing expected tax payments
When tax rates are progressive a firm can lower its expected tax payments by reducing
the variability of it’s before –tax income by purchasing insurance. Taxable income is
volatile from year to year because of unexpected losses in some years. In years when

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losses are low and taxable income is high, the government takes a larger percentage of
the firm’s profits than in years when losses are high and taxable income is low. By
purchasing insurance, a firm essentially lowers its taxable income in years when losses
are low and increases taxable income in years when losses are high. This transfer of
taxable income is beneficial because it lowers tax payments in years when losses are low
by more than it increases tax payments in years when losses are high. Suppose XYZ corp.
has a tax rate of 34 percent if it has positive taxable earnings and a zero tax rate if it has
negative taxable earnings, which is an extreme form of progressivity in tax rates. XYZ
Corp. has a 0.02 probability that it will lose a lawsuit that will cost Rs. 30 million. Without
a lawsuit, XYZ’s taxable earnings equal Rs.10 million. As illustrated in table 3.2 XYZ
taxable earning are either Rs. 10 million or – Rs. 20 million. Without insurance, XYZ’s
after-tax earnings equal either Rs. 6.6 million (Rs.10 – Rs. 10 * 0.34) or – Rs.20 million,
implying that its expected after-tax earnings equal to 6.068 mn. (Rs. 6.6 * 0.98 – Rs. 20 *
0.02). Now suppose that XYZ purchases liability insurance with a Rs.30 million limit for a
premium Rs. 6,00,000. This policy has a zero premium loading because expected claim
costs equal Rs. 6,00,000 (0.02 * 30 mn.). Since the insurer pays the entire loss if it occurs,
XYZ’s taxable earnings will be Rs.9.4 million with certainty (Rs. 10 million minus the
insurance premium of Rs. 6,00,000). XYZ’s expected after-tax earnings therefore equal
Rs.6.204 million (Rs. 9.4 – Rs. 9.4 * 0.34), which is Rs. 1,36,000 (Rs. 6.204-6.068 mn.)
greater than without insurance.
Table 2
No law suit Loses due to Law suit
(Probability = 0.98) (probability = 0.02)
No Insurance
Taxable earnings Rs. 10 million — Rs. 20 million
After - tax earnings (at tax rate of 34%) Rs. 6.6 million — Rs. 20 million
Expected After - tax earnings. Rs. 6.068 million
(Rs.6.6 * 0.98 – Rs.20 * 0.02) =
Full Insurance (with a Rs.0.6 premium)
Taxable earnings Rs. 9.4 mn. Rs. 9.4 mn.

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After - tax earnings (at tax rate of 34%... Rs. 6.204 Rs. 6.204
9.4 - 0.34 * 9.4) =
Expected After-tax earnings. Rs. 6.204
(Rs. 6.6 * 0.98 – Rs.20 * 0.02) =

Behavioral Economics and Demand for Insurance

Utility theory provides a logical and consistent basis for making rational decisions by
individuals in uncertain situations. “The classical model of rationality specifies how people
should make decisions in the face of risk and what the world would be like if people did in
fact behave as specified”. Extensive research and experimentation by psychologists and
behavioural economist and behavioural finance theorists reveal that humans do not
always make rational decisions nor do they always behave consistently in a logical
fashion.
Two Israeli psychologists, Daniel Kahneman and Amos Tversky (Kahneman was awarded
Nobel memorial prize for Economics for 2002), who developed what they call Prospect
Theory, discovered behavioral patterns that had never been recognized by the proponents
of rational decision-making by humans. They ascribe these patterns to two human short-
comings.
1. Humans sometimes act on emotion that destroys self-control, an essential
prerequisite for rational decision-making.
2. People experience what psychologists call “cognitive difficulties”. In other words,
they often do not understand fully what they are dealing with.
A “prospect” means a lottery. The experiments conducted by Kahneman and Tversky
reveal how people make choices when faced with uncertain outcomes. They contend that
people exhibit risk-aversion when offered a choice in one setting and then display risk-
seeking when offered the same choice in a different setting. Rational human behaviour
specifies that the choice should be the same irrespective of the setting in which the choice
is offered. Further, humans treat costs differently from losses that are not compensated,
though their impact on wealth is the same. As Bernstein remarks “ the asymmetry between
the way we make decisions involving gains and decisions involving losses is one of the
most striking findings of Prospect Theory”.

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Kahneman and Tversky conclude on the basis of evidence collected from the experiments
that people are not risk-averse. Instead, they are loss-averse. People do not hate
uncertainty; rather they hate losing. They suggest that humans make decisions involving
possibility of gains and losses in ways different than implied by smooth concave utility
functions (discussed earlier). They substitute, instead of a utility function, a personal value
function for each individual that reflects his degree of satisfaction or enjoyment derived
from gains and losses from some reference point. We may recall that according to
Bernoulli the value of a risky opportunity for an individual to become richer is determined
by his or her pre-existing level of wealth. That is, the valuation of a risky opportunity
depends on the reference point from which the possible loss or gain will occur than on the
final value of wealth that would result. It is not how rich the individual is that motivates his
decision but whether that decision will make him richer or poorer. The reference point is
not static but can vary; it is susceptible to manipulation by advertisements.
Kahneman and Tversky employ the expression “failure of invariance” to describe
inconsistent choices when the same problem appears in different settings. To explain the
principle of invariances, let us take an example. Suppose Ravi prefers A to B, when the
choice set comprises A and B. Assume further that Ravi has now to choose between B
and C and he prefers B to C. Rational behaviour dictates that if Ravi is now offered a
choice between A and C, he will have to prefer A to C. This is the principle of invariance
which is the essence of the approach of Von Neumann and Mogernstern’s utility. If, Ravi
chooses C to A, instead of A to C, it is a case of failure of invariance.
Kahneman and Tversky suggest on the basis of their research work that the failure of
invariance is “both pervasive and robust”. “Invariance is normatively essential (in the
sense of what we should do), intuitively compelling and psychologically unfeasible”.
Kahneman and Tversky observe that the failure of invariance more often takes the form of
what is referred to as “mental accounting”. We may give a slightly modified example of
theirs to illustrate the concept of mental accounting. Suppose Anil wants to see a movie in
a theatre and has bought a ticket in advance for Rs.40. When he arrives at the cinema
theatre, he discovers, say, that he has lost the ticket. Would he buy another ticket and see
the movie?
Now suppose Anil has not made advance purchase but plans to buy the ticket when he
arrives at the theatre. When Anil approaches the booking counter, he finds that he has
Rs.40 less in his wallet than he thought he had when he left home. Would he still buy the
movie ticket?

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If Anil decides to buy the ticket and see the movie, the funds he is left with are reduced by
Rs.80, in both cases – i.e. whether he lost the ticket or lost Rs.40. If he decides to return
home without seeing the movie, he would be out only Rs.40 in both cases. In their
experiments, Kahnemann and Tversky found that most people would be reluctant to spend
Rs.40 to replace the lost ticket, while roughly the same number of people would be
perfectly willing to spend additional Rs.40 to buy the ticket even though they had lost (the
original) Rs.40. In one case it is cost and the other it is a loss. There should be no
difference other than in accounting conventions between a cost and a loss – a clear
example of a case of mental accounting.
There are other anomalies also that are present in human behaviour. Behavioural
economics puts forward explanations for financial behaviour that appears to be
inconsistent with utility theory. We may briefly discuss them here. David Bell, a
psychologist, suggests an explanation that is referred to as “decision regret”. As
mentioned earlier, humans are characterized by loss aversion – they hate to lose more
than they like to win. Therefore, people who made choices that eventually turn out to be
bad feel much worse about making such choices than they do about their failure to have
made “smart” choices. This phenomenon of “decision regret” suggests that people will
often delay making decisions about risk lest they should regret them subsequently.
Further, decision regret is the result of focussing on the investments or assets you might
have had, had you made the “right” decision.
Decision regret is not confined to a situation in which an investor sells a share and then
watch it “go through the roof”. It also embraces a situation in which an investor finds that
many of the shares he considered for possible inclusion in his portfolio but decided against
buying them are performing better than the shares he did buy. While it is not possible for
any investor to choose only top performers, many an investor suffers decision regret over
those forgone shares. Bernstein’s comment on this is insightful: “…………this kind of
emotional insecurity has a lot more to do with decisions to diversify…. – the more stocks
you won the greater the chance of holding the big winners. Further, investors are
prompted by a similar motivation to entrust their trading to active portfolio managers, such
as mutual fund managers, in spite of considerable evidence that most of the managers fail
to beat the prime market indexes over the long run.
Another explanation for financial behaviour that seems inconsistent with utility theory, is
called “endowment effect”, is put forward by Richard Thaler. It describes the tendency of

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people to set a higher selling price on an item that they own or endowed with than what
they would be willing to pay to purchase an identical item if they did not own it. The
endowment effect has been found to have a powerful influence on investment decisions
that could not be explained by the rational investor model.
To conclude, Prospect theory, Decision regret, endowment effect and such explanations
proffered by behavioural economists rely upon not real world experiences but on contrived
experiments. The explanations based upon experiments throws up evidence of repeated
patterns of “irrationality, inconsistency and incompetence” in the ways humans make
decisions and choices when faced with conditions of uncertainty. These developments
raise doubts about the efficacy and usefulness of economic models of behaviour based on
utility theory and the assumption of human rationality embedded in it. Kahneman and
Tversky question the assumption that “only rational behaviour can survive in a competitive
environment, and the fear that any treatment that abandons rationality will be chaotic and
intractable. They argue that the evidence suggests that “human choices are orderly
although not always rational in the traditional sense of the word” to which Thaler adds
“quasi rationality is neither fatal nor immediately self-defeating”. Further, there is no basis
for arguing that human behaviour is random and erratic, because orderly decisions are in
their nature orderly. Recognizing explicitly the phenomenon of uncertainty, humans
purchase insurance, accepting certain loss that they incur.
However, one has to note that there is a sharp contrast between generalizations based on
theory (as in the case with utility theory) and generalization based on contrived
experiments (as in the case of prospect theory and it’s off shoots). The latter lacks
mathematical precision and the resultant benefits that are true of the utility theory.

REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. According to Bernoulli, the satisfaction (or) utility derived from marginal
increases in wealth is related to the level of wealth previously possessed.
a. proportionally b. Equally
c. a&b d. Inversely

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2. According to the risk averse person: More wealth is preferred to less wealth;
increasing wealth gives __________levels of satisfaction.
a. decreasing b. increasing
c. equal d. none of the above
3. The premium equal to the expected value of loss is called ________ premium.
a. net premium b. net single premium
c. fair premium d. none of the above.
4. The degree of risk aversion of individuals crucially determines the given below
patterns.
a. consumption
b. savings
c. aggregate consumption and savings and life insurance consumption.
d. all of the above.
5. According to Bernoulli the value of a risky opportunity for an individual
to become richer is determined by his (or) her levels of wealth.
a. current b. future expected
c. pre-existing d. none of the above.
6. What is the formula for expected value of an event?
a. EV= ∑ PiXi b. EU = ∑ PiU (Xi)
c. пPi Xi d. None
7. Given that P1 = 0.25, P2 = 0.55, P3 = 0.20 and X1 =15,000 , X2 =20,000 and
X3 = 8,000 respectively, what is the expected value of the above values?
a. 17,350 b. 18,750
c. 16,350 d. none of the above
8. If the individual is risk neutral:
a. he likes risk
b. he dislikes risk
c. he is neither averse to risk nor does he like risk
d. none of the above

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Answers
1. d 2. b 3. c 4. d 5. c 6. a 7. c 8. c

SECTION – B
Short & Essay Questions
1. Define a pay-off matrix. Illustrate with an example.
2. Describe alpha and beta in the context of investment risk management
3. Explain expected utility rule. How is it different from expected value rule?
4. Explain the characteristics of the utility function of a risk-averse individual.
5. Using expected utility rule, show how the purchase of life insurance by an individual
can be justified.
6. Using expected utility rule, show how the purchase of insurance is justified for
business risk management.
7. Discuss the concept of Life time maximization of utility by an individual by the
various hypotheses put forward by economists to explain allocation of an individual’s
income between present and future consumption.
8. Name the various economic theories of consumption and briefly explain the demand
for insurance of risk-averse individuals with the help of those theories.
9. Name the two characteristics of utility function for a risk-averse individual exhibit?
10. Describe behavioural pattern of human shortcomings according to Daniel Kahneman
and Amos Tversky?
11. Explain the ‘Prospect Theory’.

SECTION – C
Case Studies
1. If you invested sum of money 2,00,000 in a private bank that will earn 20%
on your investment for one year with probability of 0.35 and a loss of 15% with
probability of 0.65, what is your expected utility?

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Ans. Given that C = 2,00,000

Earn 20% with probability - 0.35
Loss 15% with probability - 0.65
∴ the expected utility = ∑ Pi U (Xi)
earn = 2,00,000 X 0.20 = 40,000
loss = 2,00,000 X 0.15 = 30,0000
Based on utility function is the natural logarithm of wealth, the expected utility is
⇒ (Xi) = 2,00,000 + 40,000 = 2,40,000
(X2) = 2,00,000 - 30,0000 = 1,70,0000
⇒ E.U = 0.35 X U (2,40,000) + 0.65 X U (1,70,000)
= 0.35 X ln (2,40,000) + 0.65 X ln (1,70,000)
= 4.3359 + 7.8283
= 12.1642
2. Using the following scenario, describe why a risk-averse person would
purchase insurance.
Loss = Rs.5000 with probability of 0.1 and Rs.0 with probability 0.9. Premium
for full coverage = Rs.500
Ans. A risk-averse person would purchase full insurance coverage because the premium
equals the expected claim cost. This would eliminate risk without reducing the
person’s expected wealth.
3. What are the possible wealth outcomes at the end of a year, for a person with
Rs.1,00,000 in wealth and who faces a 5 percent chance of losing Rs.20, 000
due to law suit.
Analyze the possible wealth outcomes for the following scenarios
— If he does not purchase any insurance for liability coverage
— if he purchases insurance with a premium of Rs.5000 for Rs.10,000 of liability
insurance coverage

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Ans. The possible outcome of wealth of a person who is having Rs. 1,00,000 and the
probability of losing Rs. 20,000 at the end of year without insurance is uncertain. It
either will be Rs. 100,000 or Rs. 80,000, depending on whether he loses a lawsuit.
In fact, he is facing two possible outcomes for his wealth and he does not know
which outcome will occur. Given that the probability of a loss is 0.5, that person’s
expected level of wealth at the end of year is Rs. 90,000 (Rs. 1,00,000 * 0.5 +
Rs. 80,000 * 0.5). His actual wealth will be either Rs. 10,000 above the expected
outcome or Rs. 10,000 below the expected outcome. Thus, there is variability
around the expected value.
If he purchases Rs. 10,000 of liability insurance coverage at a price of Rs. 5000,
where the premium is paid at the end of the year so that we can ignore the time
value of money and thereby simplify the calculations. Note that the premium is equal
to the insurer’s expected claim costs (Rs. 5000 = 0.5 * Rs. 10,000). Thus, we also
are ignoring for simplicity the other factors of administrative costs and capital costs
that affect the fair premium. With this insurance coverage, if he does not have a
loss, his wealth will be Rs. 95,000 (Rs. 1,00,000 minus the premium). On the other
hand, if he has a loss, his wealth will be Rs. 85,000 (80,000 minus the premium of
Rs. 5000 plus the Rs. 10,000 reimbursement from the insurer). It is showing that the
purchase of insurance reduces wealth when no losses occur, but increases wealth
when losses do occur. By purchasing this insurance contract, he narrows the range
of possible wealth outcomes; he reduces the variability of wealth around the
expected level of wealth.
If he purchases Rs. 20,000 of liability insurance coverage (which is full insurance
coverage since the severity of the loss equals Rs. 20,000) at a price of Rs. 10,000, if
loss does not occur, his wealth will be Rs. 90,000 (Rs. 1,00,000 minus Rs. 10,000
premium). Even if a loss does occur also his wealth will be Rs. 90,000 (Rs. 80,000
minus the insurance premium of Rs. 10,000 plus the reimbursement from the insurer
of Rs. 20,000). Full coverage implies that wealth is the same regardless of whether
the loss occurs. His risk has been eliminated.

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CHAPTER – 4
CORPORATE AND ENTERPRISE RISK
MANAGEMENT
OUTLINE OF THE CHAPTER
1. Introduction
2. Corporate Risk Management (CRM)
— Objectives of CRM
— Types of Corporate Risks
— Risk Management and Firm’s Value
— Effect of Risk Management on expected cash flows
— Decisions of firms regarding Risk Control
3. Enterprise Risk Management
— Social Enterprise
— Handling Risks – Traditional Risk Management Techniques
4. Integrated Risk Management
— Integrated Risks
— Risks covered under ERM
 CORPORATE AND ENTERPRISE RISK MANAGEMENT

— ERM and New Risk Transfer Tools

— Enterprise Risk Management and Derivative Instruments.
5. Questions

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Understand the Concepts of CRM and ERM
• How business enterprises handle risk
• Identify New Financial Instruments including Derivative Instruments to Manage
Business Risks.

Introduction
Corporations and enterprises are terms commonly used in the business world. They both
refer to companies, but have different connotations that can affect how investors, lenders
and others think about these companies. In the case of a corporation, the company is
actually defined by a legal status according to Indian regulations. The term enterprise can
have more varied meanings. This chapter focuses on the Corporate Risk Management
(CRM) and Enterprise Risk Management (ERM)

Corporate Risk Management

A corporation is a legal body that a business can create when it grows large enough to
trade stock publicly. Not only does this give the business the ability to offer stock on the
popular markets and attract far greater numbers of investors to create more capital, but
the corporation is treated as a separate entity by the government. This means that any
lawsuits or legal actions taken against the business will affect only the corporation, not
those who own it. There are downsides to this, however, any income that the corporation
produces is taxed twice, once in the corporation and a second time when it passes into the
hands of the owner. Most large companies are corporations because of the related stock
benefits, but a number of regulatory, financial and structural rules are required of these
businesses.

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Corporate risk management refers to all of the methods that a company uses to minimize
financial losses.

The Objectives of Corporate Risk Management

The Objectives of Corporate risk management includes the following.
1. Protecting Shareholders: A corporation has at least one shareholder. A large
corporation, such as a publicly-traded or employee-owned firm, has thousands, or even
millions, of shareholders. Corporate risk management protects the investment of
shareholders through specific measures to control risk. For example, a company needs to
ensure that its funds for capital projects, such as construction or technology development,
are protected until they are ready to use.
2. Value of a firm: Another important objective of corporate risk management is to
increase the value of the firm to its shareholders or owners. The value of the firm is
defined is the discounted present value of its expected net cash flows – equal to cash
inflows minus cash outflows. Thus, the value of a firm is obtained by estimating the firm’s
expected cash flows (both incoming and outgoing to compute the net cash flows) and then
discount them using an appropriate discount rate. The appropriate discount rate is
generally taken by finance theorists as the rate of return an investor could expect to earn
on an alternative investment whose cash flows belong to the same risk class as the firm. It
is generally assumed that investors are risk averse. Hence, they desire a higher expected
rate of return on investment projects whose cash flows are uncertain. In other words, cash
flows that are more uncertain should have a higher discount rate.
As such, the risk of the cash flows influences the appropriate discount rate, which in
Economics is referred to as the opportunity cost of capital. Careful analysis reveals that
there are two key components in the opportunity cost of capital. The first component
represents the time value of money; that is, the return required to compensate investors
for the time value of money. The other component is the risk premium – additional
expected return needed to compensate investors for risk. Because investors are assumed
to be risk averse, the riskier the expected cash flows, the higher the risk premium required
by the investor.

Types of Corporate Risks

The types of risks that a corporation must address every day can include hazard risks,

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financial risks, personal injury and death, business interruption/loss of services, damage to
a corporation's reputation, errors and omissions and lawsuits etc., the total risk that a firm
is exposed to can be categorized under two heads. The first type is called diversifiable risk
and the other types of risks are non-diversifiable risks
(a) Diversifiable Risks: This type of risk can be diversified away by investors by
holding diversified portfolios. When an investor invests in a diversified portfolio, the good
outcomes in the sense of higher returns of some firms tend to offset the bad effects or
lower returns of some other firms included in the portfolio. This is known as offsetting
effect which arises when the events, economic or otherwise, that affect one firm are not
correlated with the events that affect other firms. Such events are referred to as firm-
specific events such as labour strike in a firm, explosion at a plant of a firm, government’s
grant of a contract to a firm and so on. Diversifiable risk is also known as non-systematic
risk or firm-specific risk. It is to be noted that diversifiable risk does not affect the
opportunity cost of capital or required rate of return or appropriate discount rate.
(b) Non-Diversifiable Risks: Non diversifiable risks are due to events that affect all
firms in the economy. Examples of such type of risk include changes in the growth of the
gross national product, changes in interest rate, changes in inflation rate and so on. This
type of risk, called systematic risk or market risk, which is associated with general
economic activity, cannot be diversified away by investors on their own. Therefore,
investors investing in the firm exposed to this type of risk would need to be compensated
for the risk they take. As such, this type of risk does affect the opportunity cost of capital.
To prevent financial losses, a corporation engages in a certain amount of speculation. A
risk manager calculates the probability of each type of event that would damage the firm's
financial position and the consequences. Calculating the likelihood that something will
happen and its associated costs enables a risk manager to recommend ways to address
the most probable risks to senior management, the board of directors and owners of the
corporation.

Risk management and firm’s value

As outlined earlier, discount rate or opportunity cost of capital, which determines a firm’s
value comprises a risk-free rate plus a risk premium. A proxy for risk-free rate is the rate of
return on government bonds. The decisions of a firm do not have any impact on the risk-
free rate. Thus, risk management affects only the second component of the discount rate,

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namely risk premium which, in turn, is dependent on the amount of non-diversifiable risk or
market risk or systematic risk. This type of risk is reduced or mitigated by risk
management activities of a corporate unit or a firm, such as purchase of insurance or
expenditures incurred for loss control.
The insurance companies essentially insure pure risks which they can diversify by selling
insurance policy to many firms leading to risk reduction, as a result of the application of
law of large numbers. However, an argument is put forward that shareholders of a firm on
their own can reduce risks the firm is exposed to by holding well-diversified portfolios. This
argument tantamount to saying that purchases of insurance policies by firms would not
reduce a firm’s opportunity cost of capital and its value.
Further, firm-specific risks or diversifiable risks can be reduced by a firm by adopting loss
control measures. For example, product failures, work stoppages as a result of strikes by
workers or lock-outs by a firm, accidents in a factory or work places are unlikely to be
correlated across firms. The shareholders by holding a well-diversified portfolio can
mitigate the effects of such diversifiable risks. It can therefore be contended that a firm’s
activities aimed at loss control would not impact the firm’s opportunity cost of capital.
Let us carry the argument further in regard to non-diversifiable risk and attempts of risk
management by a firm. Non-diversifiable risks basically emanate from unexpected events
and adversely affect the value of all or most of the firms in the market. The occurrence of
such unexpected systematic events cannot be influenced by an individual firm’s actions.
However, a firm’s actions can affect the sensitivity of its cash flows to such events. For
instance, a firm can employ hedging mechanism against systematic risk. Two possible
effects can be identified. First, the opportunity cost of capital for the firm would tend to
decline as a result of hedging against systematic risk. Second, it may also adversely affect
the firm’s expected cash flows. It is, therefore, not clear what effect the reduction in non-
diversifiable risk would have on the value of the firm. There is a possibility that the likely
increase in the firm’s value as a result of reduction in the discount rate may be off set by
the hedge fee that the firm has to pay to the counter-party for accepting the systematic
risk, particularly when price in the market for non-diversifiable risk is fair.

Effect of risk management on expected cash flows

Risk reduction by a firm, if it has to result in augmentation of shareholder wealth, has to be
through increase in expected cash flows. The risk reduction may be brought about by

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purchase of insurance or loss control and hedging. We may take up for analysis here a
firm’s purchase of insurance to effect risk mitigation. While purchase of insurance when
insurance coverage is bundled with claim processing loss control services, may lower the
cost of obtaining such services and thus would have a positive impact on the firm’s
expected cash flows. Further, purchase of insurance by a firm may decrease the likelihood
of having to raise new funds in the capital market to pay for losses and to finance new
investment projects. Likewise, purchase of insurance by a firm may have a favourable
effect on the firm’s expected cash flow as a direct result of likely reduction in its expected
tax payments and indirectly by facilitating a higher use of debt financing resulting in its
increased tax deductions. Similarly, insurance purchase by a firm may lead to increase in
its expected cash flows through an improvement in terms of contract with other
stakeholders such as employees, customers, lenders of funds and firms’ suppliers and
through a reduction in expected bankruptcy costs.
As against the above advantages of risk reduction activities of a firm such as insurance
purchase, one has to reckon the principal disadvantage of the necessity of the firm paying
the loading on the insurance premium, ceteris paribus, adversely affecting its expected
cash flows.

Decisions of firms regarding risk control

An important risk control technique that firms generally adopt is to decide to accept the
uncertainty associated with a particular risk exposure. A number of benefits accrue to the
firm if it decides to retain the risk exposure. The main benefits may be discussed here
briefly. Factors affecting risk retention/ risk reduction by a firm are as follows
1. Avoiding High Premium because of Asymmetric Information: Insurance industry
is characterized by asymmetric information. No insurer can precisely estimate claim costs
for all potential buyers of insurance. As a result, some firms buying insurance may have to
pay premium that are high than that warranted by inherent risk. As insurers offer insurance
at the same premium to heterogeneous consumers and while consumers including
business firms could estimate their expected losses better than the insurers, there is
likelihood of adverse selection. While high risk buyers would tend to retain less risk and
transfer more risk to an insurance company, the lower expected loss firms would tend to
purchase less insurance coverage and retain more risk.

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2. Savings on Premium Loadings: Administrative expenses and profit loadings are

normally embedded in the premiums charged by insurance companies. Business firms if
they pay the premiums, suffer in reduction of expected cash outflows because of these
loadings. Firms to avoid paying such loadings prefer to retain the risk and save these
amounts. Retention of risk is not costless. The firm which is retaining the risk has also to
incur administrative costs which may be lower than those contained in the price charged
by the insurer. However, retention by the firm may mean lower negative effect on its
expected cash flows. The degree of competition in insurance markets determines the
potential savings in profit loadings.
3. Reducing Moral Hazard: As is well known, moral hazard is one of the main
problems in the insurance sector. Moral hazard crucially depends upon the behaviour of
insured, post-insurance purchase. Moral hazard can be reduced by insurer providing
incentives for insureds taking precautions after policies are purchased and by limiting the
insurance coverage through deductibles and other copayments, among others. Therefore,
firms tend to retain more risk, when there exists the potential problem of moral hazard.
There are some other factors which prompt firms to retain more risk such as reduction of
exposure to insurance market volatility such as savings in insurance prices and avoiding
implicit taxes arising out of insurance price regulation. Increased retention has costs as
well as benefits. One has to strike a balance between the two, namely benefits arising out
of savings on implicit and explicit loadings in insurance premiums and costs of increased
uncertainty regarding potential losses. The guideline for optimal decision in the context of
this trade-off is: “Retain reasonably predictable losses and insure potentially large,
disruptive losses.” A corporate risk manager is a multi-disciplinary professional with an
understanding of internal business processes and many financial instruments. This
professional might have a background in business management, finance, insurance or
actuarial science. Risk Managers might suggest solutions to a corporation to protect its
assets. For instance, they might recommend buying commercial liability insurance
coverage. Some risks that they calculate, as potentially damaging to the corporation, are
ignored while others are covered by this liability policy. They might recommend buying
other types of insurance, such as fire or fraud, after first weighing the costs versus the
benefits of each type of coverage.

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Enterprise Risk Management (ERM)

The term enterprise technically refers to all aspects of a business, especially a business
that has multiple departments or branches that focus on different activities. When
someone refers to the business enterprise, he usually is referring to the business as a
whole unit, including all partners and business operations, no matter how separate or
different these might be. When a business considers its ultimate strategy and value
offerings, it is considering the direction of the entire enterprise.
Enterprise is not restricted to a particular legal definition the way that corporation is.
Enterprise and corporation can be used interchangeably. Enterprise can also apply to
many other types of businesses. One common key difference is that a corporation is
always traded publicly on the stock market, while an enterprise may be private or have
only private stock offerings to certain people. Another key connotative difference is the
age and size of the business. Many people use the term enterprise to refer to starting
business ventures or new businesses that are trying to enter a market.

Social Enterprise
The business use of enterprise should not be confused with similar terms such as social
enterprise. A social enterprise is rarely an actual organization. It refers to a business
strategy in which a company focuses on improving social conditions as well as selling
products and services. This helps win the business favour among consumers and allows it
to have a positive impact. However, it says little about the structure of the business itself.
It is usually corporations that have the funds and influence to practice social enterprise.
Enterprise risk management (ERM) is the process of planning, organizing, leading, and
controlling the activities of an organization in order to minimize the effects of risk on an
organization's capital and earnings. Enterprise risk management expands the process to
include not just risks associated with accidental losses, but also financial, strategic,
operational, and other risks.
Risk management may be expressed in the truth: “prevention is better than cure” or “it is
better never to have suffered a loss than to so suffer and to collect under an insurance
policy”. The reason for this fundamental truth of risk management is that nothing can ever
repair or put right the effects of a casualty. In fact, at the extreme, the enterprise might fail

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entirely notwithstanding that it has the finest risk-financing programme it could ever
devise. There is ample evidence that a significant proportion of firms never fully recover
from the effects of a major fire and some have to be wound up within a short time even if
fully insured. The main reason is that in a competitive industry it is almost impossible to
recapture one’s former share of the market after a prolonged interruption of business. Are
duction in loss expectancies brought about by risk control measures will usually also
reduce the cost of the risk-financing programme.
Regardless of the techniques that may be employed at each stage, every risk
management programme must proceed according to the following logical sequence of
events if it is to stand any chance of success:
• all exposures to risk must be identified;
• all exposures need to be evaluated according to cause and effect, the aim being to
quantify probabilities and severities;
• the possibility of avoiding or eliminating any of the risks should be investigated, and
if feasible, appropriate steps should be taken;
• in the case of other risks, risk reduction measures need to be explored and
implemented;
• the residual risks need to be evaluated so that decisions can be taken about the
best methods of financing them; and finally
• the results of the whole programme need to be monitored and regularly reviewed in
the light of changing conditions .

Handling risks
Business enterprises face a number of types of risks – some called pure risks such as
property and liability risks and some other risks that are called financial risk such as
interest rate risk, foreign exchange risk and commodity price risk. The former that is “pure”
risks are often insurable and are characterized by only a downside potential i.e. chance of
loss. Insurable risks can be managed by insuring them. As discussed in the earlier
chapter, insurance is a source of finance to pay for losses, once they have occurred.
However, loss financing can be made from many other sources. The losses could be
financed from the firm’s cash flows or could be financed from the funds raised by

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borrowings or by issuing new equity to pay for losses. If the firm failed to insure its losses,
there are other methods available for the firm of financing losses, such as establishing a
subsidiary or a captive insurance company. Besides loss reduction, could complement
insurance and other strategies of risk management.
While traditional risk management techniques facilitate an appropriate technique or mix of
techniques to address to the set of pure risks, the recognition that the firms face risk
exposures other than pure risk exposure, particularly a number of financial risks that they
face call for an expansion of risk management strategy beyond the ambit of pure risk. The
usefulness of financial analysis for the purpose of risk has come to be slowly recognized.
Moreover, the theory and applications of risk management have become a constituent part
of the main stream corporate finance theory.
Financial analysts have seen the appropriateness and validity of viewing some aspects of
risk management, such as risk control and risk-financing, decisions as projects with net
present value. Risk control methods of diversification, hedging and incorporation are
particularly relevant for business enterprises. We can now discuss these three methods
not only as techniques of risk control but also yielding net present value to the firm.
Specifically, a project involving investment in loss control whose benefits exceed costs
associated with that investment is expected to yield a positive net present value and
should augment the value of the firm.
Diversification policy adopted by a business firm across various lines of businesses
and/or geographic locations, mainly from the angle of business synergies, economies of
scale and cost reduction, also helps the firm transfer risk across business units.
Furthermore, combining in one firm of different lines of business and / or different
geographical locations may help in the reduction of total risk exposure by the firm through
what is known as the portfolio effect of pooling individual risks with different co-variances.
Assume, that a business unit has production facilities at two different locations. Heavy
floods might have caused damage to the production facilities in Assam; it is highly unlikely
that the same floods would cause any damage to the second production facility located in
Andhra Pradesh.
Hedging is a means of transferring a speculative risk (say, risk of fluctuations in price) to
a third party – either a speculator or another hedger. For example, an oil company, to
protect itself against price risk (fluctuations in prices of jet fuel) enters into a futures
agreement with a counter-party, say a speculator. In effect, the speculator (counter-party)
is assuming the price risk associated with jet fuel transferred by an oil company which

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produces and supplies jet fuel to the oil market. If by the hedging agreement, the operating
profits of the oil company improve, the project involving transferring of price risk to a
speculator in the futures market yields net present value to the firm and should increase
the firm’s value.
In contrast to the above, finance theory seems to suggest that reducing or removing risk,
particularly insurable risks, has no value for a firm traded on stock exchanges. Share
holders in a publicly traded firm can eliminate or substantially reduce the firm-specific risk
by holding a diversified portfolio of different corporate shares. This is particularly true of
institutional shareholders, whose importance as a shareholder in large public companies
has been continuously increasing. The effect of risk shouldered by an uninsured corporate
unit on the portfolio of a single shareholder is negligible. This is very much true if the
uninsured risk of the firm is uncorrelated with the remaining risk in the portfolios of
shareholders.
An efficiently functioning capital market ensures that the risk of loss to a single firm is
diversified away. A firm’s uninsured losses are normally tax deductible according to
corporate tax laws and are thus diversified across all the nation’s taxpayers.
The economic reasons for the corporate business units engaging in firm-specific risk
management activities including risk transfer have been adduced by writers on the subject.
The reasons include:
1. Risk transfer confers benefits on the firm managing its risk exposure through risk
transfer by covering the potential bankruptcy costs.
2. While shareholders can achieve reduction in firm-specific risk through portfolio
diversification, the other stakeholders, such as employees, managers, customers
and input suppliers are not in such a comfortable position.
3. Risk transfer ensures that the cash flows will be available to meet the obligations to
debt holders and for future investment projects that enhance the firm’s value.

Integrated Risk Management

It is also to be noted that when evaluating risk management in regard to its effect on the
value of the corporation, the source of risk is relatively less important than its impact on
volatility of its earnings. From the perspective of the impact on the value of the firm and
the financial impact on the shareholders, it is immaterial whether the reduction in earnings

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of the business is a consequence of an increase in the prices of inputs, say, commodities,

or the reduction in earnings is the result of a fire damage to the corporate property. The
effort to initiate enterprise wide risk management emanates from this broader view that
has gained currency in recent years. The fact that a corporate unit faces a portfolio of
risks, irrespective of their nature and sources, dictates the need to adopt such a holistic
view of risk management. It is now well recognized that diversification within a portfolio of
a business unit’s risks can alter the risk profile by reducing the total risk in a fashion
similar to the reduction in the total risk achieved by adoption of the technique of
diversification of a portfolio of securities as suggested by investment theory a la
Markowitz, Sharpe and Jensen. Moreover, if a firm’s various risks are handled
independently, neglecting the benefits of diversification and ignoring the holistic approach
to risk management, it can lead to inefficient use of the firm’s resources.
Prior to the holistic approach for managing risk exposures by business enterprises,
traditional risk management tools, described in the earlier chapters, such as risk
avoidance, loss control, risk retention and risk transfer, used to be applied (even now
many firms apply) primarily to pure and hazard risks facing the enterprise. Further, the
firm’s activities relating to risk management more or less remained segmented and
relatively uncoordinated. The compartmentalization of risk management activities within a
firm may be illustrated: pure or hazard risk is managed by the traditional risk manager;
credit and monetary risk is handled by the corporate treasurer; marketing and public
relationship personnel focus on reputational risks; For handling operational and commodity
risk, strategic business units develop appropriate controls.
Furthermore, different tools of risk management used to be employed by firms to handle
different categories of risk. The techniques of insurance, captive insurance and retention
are normally confined to the handling of pure risks such as fire, product liability and
workmen’s compensation. New financial products – futures, options, swaps and other
derivative contracts are being used for managing financial risks, such as interest rate risk,
commodity price risk and foreign exchange risk.
For the firm as a whole using, what is called a “silo” approach or the method of entrusting
the process of risk management to different functional areas as outlined above, can result
in an inefficient method of risk management. Many types of risks to which a firm is
exposed may be independent of or relatively uncorrelated with each other. A process of
risk management that combines these risks produces a form of “natural hedging” with the
resultant benefits accruing to the firm. An example may be provided. An earthquake

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damage to a multinational company’s property in a country would less likely to have any
correlation with its exposure to interest rate or foreign exchange risk in a country located
in another part of the world. The total level of risk of the multinational company is reduced
when these risks are combined within the same company. The beneficial effects of this
“natural hedging” would not accrue to the company and it is likely the traditional “silo”
approach could reduce the overall efficiency of the firm’s risk management efforts.
Integrated risk management involves managing the corporate’s total risk, irrespective of
the nature, source and composition that determine its value and its ability to avoid
financial distress. Authors such as Doherty suggest integrated corporate or enterprise risk
management. Integrated risk management is defined by Ms. Muelbrock as “… the
identification and assessment of the collective risks that affect a company’s value, and the
implementation of a company-wide strategy to manage them.” She presents the
integration of risk management by firms in the following self-explanatory diagram.
Figure 1 Integrated risks

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Risks covered under Enterprise Risk Management

Some writers on Risk and Insurance provide the following sample list as the type of risks
covered by Enterprise Risk Management.
1. Damage to a crop affecting the quality, quantity or marketability of grain suppliers.
2. Technological changes that affect a firm’s strategic goals.
3. Temporary breakdown of an enterprises electronic data processing system.
4. Disruptions to the production activities of a firm by political upheaval.
5. Adverse commodity price changes
6. Changes in regulatory regime that adversely affects the business environment.
7. Lapses in due diligence relating to Mergers and Acquisitions.
Commercial insurance offerings include property and general liability, umbrella coverage,
automobile insurance, workers compensation, executive liability, professional liability,
crime coverage, and errors and omissions policies.

Enterprise Risk Management and New Risk Transfer Tools

During the last decade or so, there is a proliferation of a number of tools of risk transfer,
(as an alternative to insurance). It is true that they have not become widely used. They
include creation of captive insurance companies, finite risk or financial insurance, multi-
line/multi-year insurance, multi-trigger policies and securitization techniques.
1. Creation of captive insurance companies: A captive insurance company is owned
by a non-insurance business unit for the purpose of accepting the risk exposures of the
parent company. It is a captive of the parent because it is under the control of the latter.
The captive may be on shore (one domiciled in the country) type or off-shore type (in
another country in which there are less restrictive regulatory laws, in regard to minimum
capital requirements and investment allocation). Establishing a captive insurance
company, however, may take considerable time and substantial money may be required.
2. Finite risk insurance: Unlike traditional insurance contracts which are based on
spreading across a pool of similar risk exposures, finite risk insurance contracts are risk
transfer contracts based on the concept of spreading risk over time. In this type of

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contracts, the insured transfers limited extent of risk. The main objective of such contracts
is smoothing the losses during the contract period.
3. Multi-live/multi-year insurance contracts: Multi-live/multi-year insurance contracts
generally combine a number of risks and the policy period extends over multiple years.
The risks that are combined may be pure risks such as property, liability and auto risks or
combination of pure risks with financial risks.
4. Multiple – Trigger contracts: Multiple – Trigger contracts pool risks which together
could seriously affect the value of the firm. For the shareholders of a company the effect of
the risk on the firm’s earnings is important, not the source of risk. Multi-trigger policies
generally combine a pure risk with a financial risk. The policy is “triggered” and payment is
effected only, when the risky event in each category occurs. For example, an electric
power generation company might buy a policy that is “triggered” if one of the firm’s power
generation plants breaks down (the first risk), during a period when the power rates are
marked by considerable volatility (the second risk).
5. Securitization: The extensive risk transfer potential available in the country’s capital
markets is intended to be used by creating securitized contracts. Securitization is the
process of creation of securities such as bonds, derivative contracts such as futures
contracts, options contracts and swap contracts whose price movements are linked to an
insurance risk. Examples include catastrophe options, catastrophe equity puts,
catastrophe bonds and earthquake bonds.
6. Financial insurance: Financial insurance is a business arrangement that ensures
that a corporation engaging in certain types of transactions may recover losses if
counterparties (business partners) in these transactions do not meet financial promises.
For example, a firm may buy credit insurance to protect against the risk of loss arising
from a customer default. Financial insurance may also be used in securities exchange
transactions. As an illustration, a bank that signs a financial derivatives agreement with
counterparty based overseas may buy insurance coverage to protect against losses.
Financial insurance may be used to limit maximum losses that a company incurs in a
transaction if it buys coverage up to a certain threshold (80 percent coverage limits the
financial loss to 20 percent, for example).
Types of financial insurance products may vary, depending on the industry, the company
size and legal status. For example, a global investment bank that engages in buying and
selling multiple securities on financial exchanges may purchase insurance coverage for its

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credit and equity transactions. By doing so, the bank hedges against the risk of losses that
may arise if a business partner files for bankruptcy or the value of its stock portfolios
decreases by a certain percentage.
Financial insurance may be more critical in the global marketplace because international
business activities have risks that may not exist in domestic transactions. If, for example, a
large pharmaceutical company operating in 34 countries wants to expand in other regions,
it may face political or foreign exchange risks. The firm can, however, purchase coverage
from an international risk insurer to hedge those risks.
Financial insurance, as any type of insurance coverage, benefits the policyholder and the
economy. A company that purchases coverage in a credit transaction ensures that its
operating losses are limited in case of a partner's default or temporary inability to meet
financial commitments. In addition, senior managers know that an insurance company
performs credit checks for all business partners before providing coverage, which means
the risk of default is low. The economy also benefits from financial insurance because it
helps prevent "domino-effect" bankruptcies that may occur if a large company defaults and
its customers also file for bankruptcy.
As discussed earlier, risk affects corporate value, especially because of transaction costs
the firm faces in doing its business. These transaction costs, such taxes, cost of debt
capital and those associated with bankruptcy can be reduced by hedging risk.
The value of the firm is the expected present value of its future cash flows. Because of a
loss of asset by a firm as a result of, say, a fire accident, cash flows accruing from that
asset will be lost. It has now an option of continuing in business or go into liquidation.
Assume rationality dictates the decisions of the firm and that a firm can lose more than the
disposal value of its assets (in case it decides to go into liquidation) but not more than the
expected value of its cash flows. The joint stock form of organization limits the liability of
shareholders (firm’s owners) to the value of their equity. Furthermore, a country’s
bankruptcy laws limit individual liabilities.
A number of risk management possibilities get opened up once the firm is characterized
by limited liability. First, suppose a firm envisages potential liabilities that exceed its net
worth. It may decide to preserve the net worth by avoiding future growth of the risky
operation or spin off the risky operation into a separate unit. Contrast that with the
purchase of liability insurance. While limited liability externalizes costs to injured claimants

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(say liability claimants) ex-post, insurance effectively internalizes that cost exante. The
firm, of course, has to decide how much liability insurance it should buy.

Enterprise Risk Management and Derivatives Instruments

Among the risk management instruments commonly used by enterprises, hedging tools or
insurance are the most important. These devices permit the party holding some risky asset
to transfer that risk to another, called a counter-party. The asset value can be separate
from risk and the latter sold separately for a price. Risk is a traded commodity and is sold
in the market for risk. The two most familiar hedging devices are insurance and options.
Insurance, as a risk management tool available for centuries, has been discussed in the
earlier chapters. Options is a relatively new instrument of risk management and has
become a widely used one in recent times. Options belong to a class of instruments called
derivatives. Derivatives are financial instruments that are derived from other instruments.
Futures, Forwards and Swaps are other basic derivative instruments available in the
market. There exist also complex combinations of these basic types of derivatives. All of
them play a crucial role in risk management, to hedge interest rate, foreign exchange and
commodity price risk.
1. Forward or Futures contract: In a forward or futures contract, both parties offer to
perform (to buy or sell) as per the terms of the contract.
2. Options: While forward or futures contract is an obligation to buy or sell some asset
at a future date at an agreed price, an option is a choice to buy or sell the asset at some
future date at an agreed price. In an option contract, one party, namely, the option holder
has the option to buy or sell the underlying asset according to the terms of the contract.
The option may or may not be exercised; there is no obligation. The counter-party who
writes the option (called option writer) is obligated to sell the underlying asset, if the option
holder chooses to buy or buy the underlying asset if the option holder chooses to sell.
There are many different types of options:
(a) Call option: Options to buy an underlying asset is call option. A call option is an
option to buy an underlying asset, say equity shares. Abhijit holder of a call option –
has the right but no obligation to purchase, say 1000 shares of Hindustan Lever
Limited (HLL) at some future date, say, on 25th August,2005 at a fixed price, say
Rs.170, called exercise price or strike price. If the price of HLL at maturity (25th

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August, 2005) exceeds the exercise price, say, Rs.180 on that day, Abhijit, the
option holder, can exercise the option and buy 1000 HLL shares at Rs.170. Abhijit
makes a profit of Rs.180-170 multiplied by 1000, that is, Rs.10,000. Assume HLL
price on 25th August, 2005 is less than the strike price of Rs.170, say Rs.162. If
now, Abhijit exercises the option, he would be buying a share of HLL at Rs.170;
when he can buy the same in the market at Rs.162. As a rational investor, Abhijit
would simply not exercise the option; he would let the option expire worthless.
Let us consider the position of the option writer, say, Lakshmi. She has no choices
to make at maturity of the option. If Abhijit exercises the option to buy HLL share,
Lakshmi is obligated to honour that choice and sell 1000 HLL shares at the exercise
price of Rs.170. With a price rise, the option will be exercised by the option holder
and the writer will have to sell the share at the strike price. In the above example,
Lakshmi incurs a loss when the HLL price rises to Rs.180 and the strike price
contracted was Rs.170 – Rs.10 multiplied by 1000 shares. That is, Rs.10,000.
However, as Abhijit, the option holder has to purchase the call option from Lakshmi,
the option writer, say, at Rs.2 per share, the amount of Rs.2000 (Rs.2 x 1000) is
kept by Lakshmi whether or not the option is exercised by Abhijit. The net profit /
loss to the option writer, if the option is exercised is equal to (call option price +
strike price – price of the share at maturity) x No. of shares underlying the option
(b) Put option: Options to sell an underlying asset is put option. The put option holder
buys the right to sell an underlying asset at some future date (maturity date) for a
price agreed upon now – exercise price or strike price. The option – writer, the
counter party, sells the right to the put holder to sell the asset to the option-writer. If
the put option holder exercises his right to sell the underlying asset at maturity, the
option writer is obligated to buy the asset at the strike price. Whether the option
holder of a put would exercise the option or not depends upon the spot price of the
stock at maturity. If the spot price of the asset at maturity is above strike price, the
option holder will not exercise his option and the option expires worthless. On the
other hand, if the spot price at maturity is below the strike price, then the put option
holder will exercise the option and will sell the asset to the option writer at a price
higher than what he could get for it in the market. Whether option holder or option
writer gains in the transaction depends upon the strike price and price of the
underlying asset at maturity. However, one thing is clear. The profit of the option

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holder is a loss to the option writer and vice versa. We may also note that writing a
call is speculating on a downward price movement and writing a put is speculating
on an upward price movement of the underlying asset. Further, the call holder is
speculating on a rise in price of the underlying asset while the put holder is
speculating on a price fall.
(c) European Options: the options may be with a single exercise time (European
Options) and
(d) American Options: Options that can be exercised over a time period. We may
discuss here simple types of call and put options.
Risk managers, executives, line managers and middle managers, as well as all
employees, perform practices to prevent loss exposure through internal controls of people
and technologies. Risk management also relates to external threats to a corporation, such
as the fluctuations in the financial market that affect its financial assets. A corporation may
become insolvent if it hasn't bought insurance, implemented loss control measures and
used other practices to prevent financial loss. Insurance is no substitute for successfully
identifying measures to prevent losses, such as safety training to prevent worker injuries
and deaths.
Conclusion:
The use of derivatives for the purpose of managing financial risks, such as interest rate
risk, commodity price risk and foreign exchange risk is gaining prominence during the last
two – and – one half decades. It is increasingly realized that even for insurable risk (apart
from financial risk) derivatives can be profitably used. Insurance contracts themselves are
seen to be like derivatives. The structure of insurance contracts possesses an “option-like”
structure or a “forward like” structure. Actuarial techniques used for pricing insurance
policies are being employed to refine the pricing of financial derivatives.
Likewise, econometric techniques employed for pricing financial derivatives are found
increasing use in insurance pricing. We also find that financial engineers are creating new
types of instruments that can be used to hedge both financial risk and insurable risk and
these new instruments are being marketed in both insurance markets and capital markets
of developed countries. Many perceptive observers point out that insurance and financial
derivatives are becoming increasingly interchangeable and their respective markets
largely integrated.

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Compliance is different from ERM. Internal Auditors in their compliance procedure, play an
important role in monitoring ERM, but do NOT have a primary responsibility for its
implementation or maintenance. ”The operational disciplines which support a business
process (IT, HR, Facilities, Finance, Legal, Tax, etc.) all have professional standards, are
benchmarked by best practices and are subject to laws and regulations that govern their
activities in part or in whole. Comparing the level of adherence to these regulations, laws
and best practices is an essential compliance activity and one that the audit organization
is best skilled to undertake. A strategy for examining the conformity to required regulations
is essential and is often supplemented with control self assessments. This is fundamental
to good business practice; it is not risk management.

REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. One of the following is not true;
a. “It is better never to have suffered a loss than to suffer and collect under an
insurance policy”.
b. The enterprise might fail entirely not withstanding that it has the finest risk-
financing programme it could ever devise.
c. There is ample evidence that a significant proportion of firms never fully
recover from the effects of a major fire and some have to be wound up within a
short time even if fully insured.
d. A reduction in loss expectancies brought about by risk control measures will
usually also reduce the cost of the risk-financing programme.
e. None of the above
2. One of the following is not true;
a. all exposures to risk must be identified;
b. all exposures need to be evaluated according to cause and effect, the aim
being to quantify probabilities and severities;

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c. the possibility of avoiding or eliminating any of the risks should be

investigated, and if feasible the appropriate steps should be taken;
d. in the case of other risks, risk reduction measures need to be explored and
implemented;
e. None of the above
3. Business enterprises normally do not face this risk;
a. Interest Rate Risk b. Foreign Exchange Risk
c. Commodity Price Risk d. Personal Accident Risk
e. None of the above
4. One of the following techniques can be adopted by a business enterprise to
transfer risk:
a. Diversification b. Hedging
c. Incorporation d. A&B
e. All the above
5. An oil company, in order to protect itself from future price risk, enters into a
futures agreement with another party. It is a case of
a. Speculation b. Price Protection
c. Hedging d. Gambling
e. None of the above
6. A firm's uninsured losses are ultimately paid by
a. Managing Director b. Shareholders
c. Debtors of the company d. Tax payers in the society
e. None of the above
7. The economic reason/s for the corporate business units engaging in firm-
specific risk management activities
a. Risk transfer confers benefits on the firm managing its risk exposure through
risk transfer by covering potential bankruptcy costs.

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b. While shareholders can achieve reduction in firm specific risk through portfolio
diversification, the other stakeholders are not in such a comfortable position.
c. Risk transfer that the cash flows will be available to meet the obligations to
debt holders and for future investment projects that enhance the firm's value.
d. A&B
e. All the above
8. One of the following is not true;
a. Credit and monetary risk is handled by the Corporate Treasurer.
b. Reputation risk is handled by marketing and public relations personnel.
c. For handling operational and commodity risk, strategic business units develop
appropriate controls.
d. Financial risk is handled by CEO of the company.
e. None of the above.
9. One of the following is not financial risk:
a. Interest Rate Risk b. Price Risk
c. Credit Risk d. Foreign Exchange Risk
e. Operational Risk
10. An earthquake damage to a multinational company's property in a country
would less likely to have any correlation with its exposure to interest rate or
foreign exchange risk in a country located in another part of the world. This is
a. “Silo” approach b. ‘Natural hedging;
c. Diversification d. International Management
e. None of the above
11. Enterprise Risk Management normally does not cover one of the following
activities;
a. Technological changes that affect a firm's strategic goals
b. Temporary break down of an enterprise’s EDP system

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c. Changes in regulatory regime that adversely affect the business environment.

d. Stock market upheavals affecting the pricing structure of an enterprise
e. None of the above
12. This insurance is based on spreading risk over time.
a. Financial insurance b. Infinite risk insurance
c. Finite risk insurance d. Time risk insurance
e. None of the above
13. It is a process of creation of securities such as bonds, derivative contracts
(Futures, Options, Swaps etc.,) whose price movements are linked to an
insurance risk.
a. Securitization. b. Bonding
c. Factoring d. Forfeiting
e. None of the above
14. It is a choice to buy or sell the asset at some future date at an agreed price;
a. Option. b. Futures
c. Forwards d. Collar
e. None of the above
15. A call holder is always speculating on__________ in prices.
a. Rise b. Fall
c. Stability d. Fluctuation
e. None of the above

Answers
1. e 2. e 3. d 4. e 5. c 6. d 7. e 8. d 9. e 10. b
11. d 12. c 13. a 14. a 15. a

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SECTION – B
Short & Essay Questions
1. “Regardless of the techniques that may be employed at each stage , every risk
management programme must proceed according to the logical sequence of events
if it is to stand any chance of success”. Explain
2. Explain Diversification and Hedging as tools of handling risks.
3. Outline some of the risks covered under Enterprise Risk Management.
4. Explain the following:
a. Captive Insurance Companies.
b. Finite Risk Insurance.
c. Multi-year insurance contracts.
d. Multiple Trigger Contracts.
e. Financial insurance
5. “It is better never to have suffered a loss than to suffer and collect under an
insurance policy”. Discuss with special reference to business enterprises.
6. Discuss the usefulness of financial analysis for the purpose of risk management
incase of business enterprises.
7. Explain how each of the following help business enterprises in managing their
exposures to risk.
a. Incorporation
b. Diversification
c. Hedging
8. Distinguish between “silo” approach and “integrated” approach to risk management
of business.
9. “In case of a business enterprise what is important is the total effect of the risk
exposures it faces on its earnings rather than the source of risk.” Discuss.

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10. Discuss some of the new risk transfer tools that have developed in recent years.
11. Examine the importance of derivative instruments in the management of risk by
business enterprises.

SECTION – C
Case Studies
The global economy has become a reality for many firms. As international operations
expand, it is important for management to recognize that the same risk may result in very
different estimates for the maximum probable loss and maximum possible loss in different
countries. With differing loss frequency and severity estimates, the most appropriate risk
management techniques are also likely to vary from country to country. Several examples
illustrate this point.
In the United States, risk managers often concentrate much time and effort in identifying,
evaluating and managing liability exposures. However, the rest of the world is not as
litigious, thus making liability losses outside of the United States less problematical. The
analysis of potential property losses may also vary. For instance, the proliferation of very
old buildings through out Europe presents unique problems. In Pacific Rim countries, the
potential for catastrophic loss due to typhoons or other windstorms is very real. Risk
evaluation in countries experiencing frequent currency devaluation (such as Brazil) can
also be challenging, because property valuations become obsolete so quickly. Risks of
loss due to crime also vary considerably from one country to the next. For example, in
Eastern Europe and the former Soviet Union, deficiencies in the computer infrastructure
makes it nearly impossible to track stolen vehicles in the same way that it is possible in
most Western countries. And the risk of loss to employees due to kidnapping or other
violence is well known in many Latin American countries. Often, the dynamic risk of
political unrest merely exacerbates such problems, making the risk manager's job
continually challenging.
Discuss the challenges of Risk Managers in the light of changing global scenario and
Enterprise Risk Management practices.
Ans. The optimal RM Department reporting structure is difficult to define and can vary with
the size and scope of the business operation. While I agree in general, the wrong
reporting relationship can certainly undermine the RM department's effectiveness. In

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smaller organizations, the RM may need to report to the president or owner, because as
was said, every silo of an organization is touched by risk management and therefore there
exists the potential for special interests and conflicts by individual departments. Risk
management affects the overall business operations, therefore having it report through
HR, treasury, finance, or the general counsel is in most cases a formula for failure.
Risk manager must, above all, be a tough-minded individual able to communicate because
the task at hand is, in large part, selling the concept of risk management to VP-level peers.
The VPs are paid to grow revenue, while the risk manager is paid to prevent/limit loss.
There is a healthy tension here which, in the end, serves the organization best. If the risk
manager is not getting results, then find a risk manager tough enough for the job.
Investing more authority in an essentially weak player will only foster the wrong kind of
stress within the organization, and make life even more difficult for the risk manager.
Business enterprises face a number of types of risks - some called pure risks such as
property and liability risks and some other risks that are called financial risks such as
interest rate risk, foreign exchange risk and commodity price risk. The former that is “pure”
risks are often insurable and are characterized by only a downside potential, i.e. chance of
loss. Insurable risks can be managed by insuring them. The compartmentalization of risk
management activities within a firm may be illustrated: pure or hazard risk is managed by
the traditional risk manager; credit and monetary risk is handled by the corporate
treasurer; marketing and public relationship personnel focus on reputational risks; For
handling operational and commodity risk, strategic business units develop appropriate
controls. New financial products - futures, options, swaps and other derivative contracts -
are used for managing financial risks, such as interest rate risk, commodity price risk and
foreign exchange risk.
During the last decade or so, there is a proliferation of a number of tools of risk transfer,
(as an alternative to insurance). It is true that they have not become widely used. They
include creation of captive insurance companies, finite risk or financial insurance, multi-
line/multi-year insurance, multi-trigger policies and securitization techniques.
Among the risk management instruments commonly used by enterprises, hedging tools or
insurance are the most important. These devices permit the party holding some risky asset
to transfer that risk to another, called counter-party. The asset value can be separate from
risk and the latter sold separately for a price. Risk is a traded commodity and is sold in the
market for risk.

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CHAPTER – 5
RISK BASED CAPITAL AND ROAD TO
SOLVENCY–II
OUTLINE OF THE CHAPTER
1. Risk Based Capital
2. Why Risk Based Capital
3. Solvency
4. Solvency Requirements for Insurers
5. Risk based Regimes in other Countries
6. Solvency II
7. Risk based Solvency approach in Insurance Sector in India

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Distinguish between Risk based capital and Fixed capital standards
• Risk based regimes in other countries
• What is solvency
• Understand the aim of Solvency Regime
 RISK BASED CAPITAL AND ROAD TO SOLVENCY–II

• The gaps in Solvency I

• Solvency II as compared with Solvency I
• The present approach to risk-based Regulation in India

Risk Based Capital

Risk-Based Capital (RBC) is a method of measuring the minimum amount of capital
appropriate for a reporting entity to support its overall business operations in consideration
of its size and risk profile. RBC limits the amount of risk a company can take. It requires a
company with a higher amount of risk to hold a higher amount of capital. Capital provides
a cushion to a company against insolvency.
RBC is intended to be a minimum regulatory capital standard and not necessarily the full
amount of capital that an insurer would want to hold to meet its safety and competitive
objectives. In addition, RBC is not designed to be used as a stand-alone tool in
determining financial solvency of an insurance company; rather it is one of the tools that
give regulators legal authority to take control of an insurance company.

Why Risk Based Capital

Before RBC was created, regulators used fixed capital standards as a primary tool for
monitoring the financial solvency of insurance companies. Under fixed capital standards,
owners are required to supply the same minimum amount of capital, regardless of the
financial condition of the company. Companies had to meet these minimum capital and
surplus requirements in order to be licensed and write business in the state. As
insurance companies changed and grew, it became clear that the fixed capital standards
were no longer effective in providing a sufficient cushion for many insurers. In contrast to
fixed capital standards, risk-based capital varies the amount of capital a company must
hold based on its level of risk.

Solvency
As per the definition of business dictionary, Solvency means the financial soundness of an
entity that allows it to discharge its monetary obligations as they fall due, which is
measured by solvency ratios.

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There are two basic ratios that measure solvency. The current ratio is the total current
assets divided by the total current liabilities. The current assets are cash, accounts
receivable, inventory, and prepaid expenses. Other long-term assets like equipment aren't
considered in this ratio because it takes too long to sell them to get money to pay the bills,
and they won't sell for full value. In order to be solvent and cover liabilities, a business
should have a current ratio of 2 to 1, meaning that it has twice as many current assents as
current liabilities. This ratio recognizes the fact that selling assets to obtain cash may
result in losses, so more assets are needed.
The quick ratio uses only cash and accounts receivable, as these assets are the only ones
that can be used to pay off debts quickly, in the case of an emergency cash need. The
quick ratio is a 1 to 1 ratio, meaning cash and accounts receivable must equal the amount
of debt. This is a more difficult ratio to achieve.
Solvency is often confused with liquidity, but it is not the same thing. Liquidity is a short-
term measure of a business, while solvency is a long-term measure. Liquidity relates more
to short-term cash flow, while solvency relates more to long-term financial stability.
When analysing a company from an investment perspective it is important to assess from
both a quantitative and a qualitative perspective. Quantitative factors as was discussed
include calculating different ratios (debt/equity, current ratio, quick ratio), and considering
different financial metrics (net income, net assets). Whereas Qualitative factors of a
company are not purely numbers driven. Qualitative analysis can be far more subjective
and really depends on the company that is being looked at, and the purpose of the
analysis overall.

Solvency requirements for Insurers

One of the primary objectives of any business is solvency. Along with liquidity and viability,
solvency enables a business to keep going, to stay in business. This is much relevant to
insurance business. Imagine a burden on the insurance company in a situation where a
massive earthquake or natural calamity in a region. The insurer is obligated to pay the
claims, but what if it genuinely cannot? What if the company becomes insolvent?
The aim of a solvency regime is to ensure the financial soundness of insurance
undertakings, and in particular to ensure that they can survive difficult periods and to
protect policyholders (consumers, businesses) and the stability of the financial system as

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a whole. Solvency rules stipulate the minimum amounts of financial resources that
insurers and reinsurers must have in order to cover the risks to which they are exposed.
Equally importantly, the rules also lay down the principles that should guide insurers'
overall risk management so that they can better anticipate any adverse events and better
handle such situations. The solvency ratio is a crucial component to consider when
deciding whom to select as an insurer.
In India, insurers are required to maintain a minimum solvency ratio of [Link] ratio in
insurance business is being measured by its premium income.
Net assets ÷ earned premium net of reinsurance
The solvency ratio of an insurance company is the size of its capital relative to all the risk
it has taken, which is all liabilities subtracted from total assets. In other words, solvency is
a measurement of how much the company has in assets versus how much it owes. It is a
basic measure of how financially sound an insurer is and its ability to pay claims. It helps
investors measure the company’s ability to meet its obligations and is similar to the capital
adequacy ratio of banks.
Solvency in the insurance business is not as simple as it appears. The aspects which are
closely connected with the solvency in the insurance business are
1. The evaluation of liabilities;
2. The evaluation of assets;
3. The level of the premiums of long term policies and
4. Reinsurance.
All these should be in order for solvency position of an insurance [Link] Insurance
Regulatory and Development Authority, or IRDAI, has prescribed methods of valuation of
assets and liabilities. Based on these guidelines, the insurance companies have to
prepare a statement of solvency margin every quarter.

Risk based regimes in other countries

U.S.A: The National Association of Insurance Commissioner’s (NAIC) RBC regime began
in the early 1990s as an early warning system for U.S. insurance regulators. The adoption
of the U.S. RBC regime was driven by a string of large-company insolvencies that

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occurred in late 1980s and early 1990s. The NAIC established a working group to look at
the feasibility of developing a statutory risk-based capital requirement for insurers. The
RBC regime was created to provide a capital adequacy standard that is related to risk,
raises a safety net for insurers, is uniform among the states, and provides regulatory
authority for timely action. It has two main components: 1) the risk-based capital formula,
that established a hypothetical minimum capital level that is compared to a company’s
actual capital level, and 2) a risk-based capital model law that grants automatic authority
to the state insurance regulator to take specific actions based on the level of impairment.
The Risk Based Capital Formula was developed as an additional tool to assist regulators
in the financial analysis of insurance companies. The purpose of the formula is to establish
a minimum capital requirement based on the types of risks to which a company is
exposed. Separate RBC models have been developed for each of the primary insurance
types: Life, Property/Casualty, Health and Fraternal. This reflects the differences in the
economic environments facing these companies.
The risk factors for the NAIC’s RBC formulas focus on three major areas: 1) Asset Risk; 2)
Underwriting Risk; and 3) Other Risk. The emphasis on these risks differs from one
formula to the next. As a generic formula, every single risk exposure of a company is not
necessarily captured in the formula. The formula focuses on the material risks that are
common for the particular insurance type. For example, interest rate risk is included in the
Life RBC formula because the risk of losses due to changes in interest rate levels is a
material risk for many life insurance products.
Under the RBC system, regulators have the authority and statutory mandate to take
preventive and corrective measures that vary depending on the capital deficiency
indicated by the RBC result. These preventive and corrective measures are designed to
provide for early regulatory intervention to correct problems before insolvencies become
inevitable, thereby minimizing the number and adverse impact of insolvencies.
The NAIC - RBC formula generates the regulatory minimum amount of capital that a
company is required to maintain to avoid regulatory action. There are four levels of action
that a company can trigger under the formula: company action, regulatory action,
authorized control and mandatory control levels. Each RBC level requires some particular
action on the part of the regulator, the company, or both. For example, an insurer that
breaches the Company Action Level must produce a plan to restore its RBC levels. This
could include adding capital, purchasing reinsurance, reducing the amount of insurance it
writes, or pursuing a merger or acquisition.

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The NAIC - RBC system operates as a tripwire system that gives regulators clear legal
authority to intervene in the business affairs of an insurer that triggers one of the action
levels specified in the RBC law. As a tripwire system, RBC alerts regulators to
undercapitalized companies while there is still time for the regulators to react quickly and
effectively to minimize the overall costs associated with insolvency. In addition, the RBC
results may be used to intervene when a company is found to be in hazardous condition in
the course of an examination. The RBC system is periodically updated to meet the
changing regulatory environment.
Singapore: RBC framework in Singapore is that insurers to hold capital against their risk
exposures and this capital requirement is referred to as the Total Risk Requirement [TRR].
The risk exposures are grouped into three components: [a] Component 1 [C1]
Requirement relates to insurance risks. [b] Component 2 [C2] requirement is calculated
based on the insurer’s exposure to asset related risks such as market risk and credit risk.
[c] Component 3 [C3] requirement relates to asset concentration risks in certain types of
assets, counterparties or groups of counterparties. C3 charges are computed based on an
insurer’s exposure in excess of the concentration limits as prescribed under the Insurance
[Valuation & Capital] Regulations, 2004. This RBC framework relies on Fund Solvency
ratio [FSR] and Capital Adequacy Ratio [CAR] as indicators of solvency at the fund level
and at the company level. These indicators do not take into account factors like
confidence level and time horizon. In other words, this RBC framework does not rely on
measures like VaR or CTE to calibrate capital requirements.
European Union: Solvency I phase aimed at revising and updating the then EU solvency
regime. Solvency I margin requirements were established in 1973 in the EU under the
First Non-Life Directive (73/239/EEC) and in 1979 under the First Life Directive
(79/267/EEC). The third generation of life (92/96/EEC) and non-life (92/49/EEC) Insurance
Directives established the single market for insurance in the mid-1990s. The rationale for
EU insurance legislation is to facilitate the development of a Single Market in insurance
services, whilst at the same time securing an adequate level of consumer protection. The
third-generation Insurance Directives established an "EU passport" (single license) for
insurers based on the concept of minimum harmonization and mutual recognition. This
system relies on mutual recognition of the supervision exercised by different national
authorities according to rules harmonized to the extent necessary at the EU level. The
requirement for insurance undertakings to establish an adequate solvency margin is one
of the most important common prudential rules.

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But many Member States have concluded that the EU minimum requirements under
solvency I are not sufficient and have implemented their own reforms, thus leading to a
situation where there is a patchwork of regulatory requirements across the EU. This
hampers the functioning of the Single Market.

Solvency II
The loopholes in the fixed capital standards and the gaps in the solvency I paved the way
for Solvency II. Following an EU Parliament vote on the Omnibus II Directive on 11 March
2014, Solvency II came into effect on 1 January 2016.
The key objectives of Solvency II are as follows:
• Improved consumer protection: It will ensure a uniform and enhanced level of
policyholder protection across the EU. A more robust system will give policyholders
greater confidence in the products of insurers.
• Modernized supervision: The “Supervisory Review Process” will shift supervisors’
focus from compliance monitoring and capital to evaluating insurers’ risk profiles and
the quality of their risk management and governance systems.
• Deepened EU market integration: Through the harmonization of supervisory
regimes a single European market for financial services will be encouraged, which
enables an institution to absorb significant unforeseen losses and gives reasonable
assurance to policyholders.
• Increased international competitiveness of EU insurers: A “better managed and
more competitive insurance industry that can better perform its key function of
accepting and spreading risk” (Commissioner McCreevy).
In short, Solvency II is in line with Basel II which set the new capital adequacy framework
for banking sector.
The new 'Solvency II' rules replaced the old requirements of ‘Solvency I’ and focused more
harmonized requirements across the EU, to promote competitive equality as well as high
and more uniform levels of consumer protection.
The salient points of ‘Solvency II’ based on the public information is that it comprises
three pillars:

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• Pillar 1: Quantitative Requirements, which include assets, liabilities and capital

requirements, etc.
• Pillar 2: Qualitative Requirements, which include supervisory review, the ‘use test,’
etc.;
• Pillar 3: Market Discipline, which includes supervisory reporting, market disclosures,
etc.

Pillar 1: Financial Requirements (Quantitative)

1. Under Solvency II, assets and liabilities are to be valued under market consistent (or
arbitrage free) principles. More specifically:
• Assets are to be valued ‘at the amount for which they could be exchanged
between knowledgeable willing parties in an arm’s length transaction’ and
• Liabilities are to be valued ‘at the amount for which they could be transferred,
or settled, between knowledgeable willing parties in an arm’s length
transaction.’
Since insurance liabilities are not liquid, a ‘market value margin’ (or risk margin)
must be assessed in addition to the best estimate liability. This reflects the cost of
the capital (in respect of non-hedge able risks) that the liability requires.
2. Capital requirements: The primary interest of Pillar I concerns the capital
requirements-Minimum Capital Requirements (MCR) and Solvency Capital
Requirements (SCR).
(i) Minimum Capital Requirement (MCR), which is formula-based; and
(ii) Solvency Capital Requirement (SCR), which is risk-based. This is the
economic capital the insurer needs to hold to limit the probability of ruin to
0.5% over the next [Link] are two approaches to the SCR:
(a) Standard Capital Model, which is prescribed by The European Insurance and
Occupational Pensions Authority (EIOPA) 1 ; and

1The European Insurance and Occupational Pensions Authority (EIOPA) is a European

Union financial regulatory institution that replaced the Committee of European Insurance and
Occupational Pensions Supervisors (CEIOPS). It is established under EU Regulation 1094/2010

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(b) Internal Model, which is developed in-house by the insurance company, but is
subject to the regulator’s approval.
The figure below illustrates the relation between levels of capital requirements.

Levels of capital requirements

Solvency Capital Requirement (SCR) reflects a level of capital that enables an institution
to absorb significant unforeseen losses and that gives reasonable assurance to
policyholders and beneficiaries. Minimum Capital Requirement (MCR) is intended to be a
safety net and reflects a level of capital below which ultimate supervisory action would be
triggered. Technical Provisions represents the amounts set aside in order for an insurer to
fulfil its obligations towards policyholders and other beneficiaries. It may include some
element of prudence. The following figure shows a view on total capital requirement which
is independent of the level of any Prudence Margin
The SCR is the amount of capital required from shareholders and will depend on the level
of Prudence. The sizes of the prudence margin and the SCR are linked. In other words, if
the prudence margin is calibrated in such a way that it is relatively large (offering a
significant level of protection) the SCR should be calibrated to be relatively low and vice-
versa.
Prudence Margin is a starting point, the prudence margin on top of the best estimate of
liabilities should be calculated using a specific confidence interval e.g. 75% .The sizes of
the prudence margin and the SCR are linked. In other words, if the prudence margin is
calibrated in such a way that it is relatively large (offering a significant level of protection)
the SCR should be calibrated to be relatively low and vice-versa. Total Capital
Requirement is the amount required above the economic value of liabilities. Total Capital
Requirement should be based on the total balance sheet i.e. Volatility of liabilities,
volatility of assets, taking into account how they interact. Total Capital Requirement is
therefore independent of the level of any Prudence Margin
Pillar 2: Governance & Supervision
A risk management framework is the core of Pillar 2. Pillar II is needed, in addition to the
first pillar, since not all types of risk can be adequately assessed through solely
quantitative measures. Even for those risks that can be assessed quantitatively, their
determination for solvency purposes will require independent review by the supervisor or

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by a designated qualified party. Such review will enable supervisory intervention if an

insurer’s capital does not sufficiently buffer the risk.
The principal components of this framework are:
1. Own risk and solvency assessment (ORSA)
 ORSA requires insurance undertakings to determine their overall solvency
needs, beyond the capital adequacy requirements defined in Pillar I.
 The ORSA process should take into account the effects of all the material risks
such as underwriting, market, credit, reputational and strategic risks.
 It should also consider planned management activity and external factors such
as economic outlook.
 It should include a 3-5 year time horizon for the firm’s activities and risk
outlook.
2. Risk and capital management information
 Through Solvency II, the insurer will be required to improve the flow of risk
information to senior management through regular production of Risk and
Capital Management Information. Typically the management information will
include:
 Risk exposure against risk limits
 Sensitivity of risk metrics to risk drivers – financial and insurance
 Reverse stress test results, e.g. scenarios where the embedded value
operating profit falls by 10%, new business profit margin falls by 5%, etc.
3. Risk governance infrastructure This is predicated on three lines of defense:
• First line of defense (risk management)
• Second line of defense (risk oversight)
• Third line of defense (independent assurance)
Risk Management has primary accountability for day-to-day identification, control and
reporting of risk exposures in accordance with the strategies, policies and risk parameters
set by the Board.

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For Risk identification in the insurance business, it is clear that Risk is inherent in each
operation of an insurer and it includes many internal dependencies that require an
integrated approach to risk or solvency assessment.
Insurance risk: Insurance risks are the risks which are within the underwriting risk
category and are associated with both the perils covered by the specific line of insurance
(fire, death, motor accident, windstorm, earthquake, etc.) and with the specific processes
associated with the conduct of the insurance business. The sources of underwriting risk:
process, premium calculation, product design, claims retention, policyholder behaviour
and reserving risk.
Market Risk: Exposure to changes in level and volatility of financial securities are market
risks. They are broken down into: interest rate, inflation, equity, real estate, commodity
prices, exchange risk. Sources of market risks are interest rate volatility, price volatility,
exchange volatility, asset/liability mismatch risk, and reinvestment risk. Market risk relates
also to the value of derivative instruments, such as options, futures and swaps.
Credit risk: Risk of default or change in creditworthiness of debtors, counterparties (e.g.
on reinsurance contracts, derivative contracts or deposits given) and intermediaries where
institutions have claims are credit risks. Sources of credit risks are commercial credit,
invested asset, political and country risk. In order to limit the possibility for arbitrage of
credit risk from the banking to the insurance sector credit risk quantification follows as
closely as possible the one used by the banking regulator. Therefore, a credit risk charge
is calculated using an approach compatible to Basel II. This charge is then added to the
target capital for insurance and market risks. The internal model for credit risk have to be
calibrated to the same risk measure as used by Basel II, namely the Value at Risk on the
99% quantile.
Liquidity risk: Liquidity risk involves risk from limited availability of readily tradable
investments to cover the expected cash flows arising from its liabilities. Losses due to
liquidity risk can occur when company has to borrow unexpectedly or sell assets for an
unanticipated low price. The liquidity profile of a company is a function of both its assets
and liabilities. Sources of liquidity risk are cash calls following major loss events, a credit
rating downgrade, and deterioration of economy
Operational risk: Operational risk, for capital purposes, is defined as “the risk of loss from
inadequate or failed internal processes, people, and systems or from external events.

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Operational risks are difficult to quantify so a qualitative assessment approach will initially
be used. Capital requirements for these risks would be too arbitrary. Sufficient empirical
data are not yet available. However, banks are now compiling such data to comply with
Basel II. It is therefore conceivable that operational risk could be quantified in the future if
insurance companies were to compile relevant data.
Concentration risk: The risk of increased exposure to losses due to concentration of
investments or risk exposure in a geographical area, economic sector or individual
investments. Concentration risk may exist at either the legal entity level or the group level
(after the holdings of all legal entities have been consolidated) or both.
Companies can fail if they do not implement and ensure adherence to effective internal
control in the field of risk management. Insurers face much the same problems concerning
risk as banks. Managers must decide what risks to accept, and on what term to accept
them; what new risks to take on. They need to manage the risk.
Risk Measurement:
Internal control (risk oversight) function oversees and objectively challenges the execution,
management, control and reporting of risks. Independent assurance provides review of the
design and effectiveness of the overall system of internal control, including risk
management and compliance. Transformation of the practice of risk management consist
of the following issues: Development of new theory and its rapid translation into practical
applications (e.g. Black-Scholes option pricing model / Deflators etc., 2) and development
of risk management methodologies for measuring risk in practice (e.g. Value at Risk, Tail

2One of the most widely used closed form solutions for calculation of cost of guarantees. Black –
Scholes formula can be used to value the option component of insurance contracts. The Black-
Scholes model was developed as a tool to value stock options and requires the following
information: strike price, stock price, duration, volatility, risk free rate of interest. Many insurance
contracts with maturity guarantees can be thought of as an option on the underlying asset share.
For example an endowment policy is in-the-money at maturity if the guaranteed benefits exceed
the asset share. The mathematics involved in the formula is complicated and can be intimidating.
Variety of online calculators, and many of today's trading platforms boast robust options analysis
tools, including indicators and spreadsheets that perform the calculations and output the option
pricing values. Ex: [Link]

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Value at Risk, Risk Based Capital etc. 3.).

Pillar 3: Market discipline - Reporting & Disclosure

1. Supervisory reporting and public disclosure: Pillar 3 covers the supervisory
reporting and public disclosure aspects of the regime. Two disclosures are required from
the firms, both subject to external audit:
• Solvency and Financial Condition Report (SFCR), a public disclosure, and
• Regular Supervisory Report (RSR), a private report to the regulator.
The two documents above are similar in structure but distinct: the regulatory report
contains some additional confidential information like business strategies. Detailed
information is required to be disclosed covering the areas of business performance, risk
management, capital management, and system of governance, SCR, Assets and
Liabilities, Technical Provisions etc. Disclosures in SFCR and RSR are extensive and
subject to concepts of proportionality and materiality.
2. Proportionality & materiality principle: The detail of information should be
commensurate with the nature, scale and complexity of the risks. Firms are not required to
fulfil reporting or disclosure requirements that are not applicable to them. Materiality for
disclosure is the same as that defined in International Financial Reporting Standards.
Additional disclosures may be required upon occurrence of certain predefined events or
during enquiries.
The III Pillar brings in a “disciplinary effect” on corporate management and transparency in
markets. It defines principles for the disclosure of information to policyholders, investors,
rating agencies and other interested parties so they obtain a comprehensive picture of an
insurer’s risk.

3There are three methods of calculating Value at Risk (VaR): the historical method, the variance-
covariance method and the Monte Carlo simulation. VaR calculates the maximum loss expected
(or worst case scenario) on an investment, over a given time period and given a specified degree
of confidence.

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Structure:
EU legislation, through a standard framework, "Lamfalussy Process" a financial services
legislation termed the structure of Solvency II, as following four levels:
Level 1 – Primary legislation
This defines a proposal’s broad principles. Solvency II’s Level 1 is the “Solvency II
Framework Directive”, formally entitled the “Directive on the taking up and pursuit of the
business of insurance and reinsurance”.
The Solvency II Framework Directive was adopted and published in the Official Journal of
the EU in December 2009. Certain provisions of this Directive, including the
implementation deadline, were amended by the Omnibus II Directive. After much delay,
this was adopted by the Council of the EU on 22 May 2014, and with an EU Parliament
vote it came into effect on 1 January 2016. The Solvency II Framework Directive replaced
the EU’s existing insurance and reinsurance directives
Level 2 – Implementing measures
Solvency II Level 2 implementing measures spell out the detailed requirements that
insurers must meet. They are set out in Delegated Regulation 2015/35 of 10 October
2014, published in January 2015. This has direct effect in EU Member States, so does not
need to be transposed into national laws. There are Implementing Technical Standards
and Regulatory Technical Standards in addition.
Level 3 – Guidelines
Guidelines are one of the tools used to increase supervisory convergence. Guidelines are
not binding on Supervisory Authorities, but do present an opportunity to harmonise
outcomes from Supervisory Authority decisions as they are based on the ‘comply or
explain’ principle.
To help national supervisors to implement Solvency II, EIOPA is designing Guidelines and
Recommendations on how to put Solvency II’s detailed provisions into effect.
Level 4 – Post-implementation enforcement
After the deadline for implementation, the European Commission is responsible for
ensuring that member states are complying with the legislation. If they are not doing so,
the Commission has right take enforcement action.

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Solvency I vs. Solvency II

Solvency I phase aimed at revising the EU solvency regime, the Solvency II project has a
much wider scope. Solvency I has established minimum capital requirements, but still it
did not reflect the true risk faced by insurance companies. Solvency II harmonize the asset
and liabilities valuation techniques across EU. Even to mention different approaches to
value assets –historical or amortized cost and by market value. Following table shows the
basic differences of Solvency I and Solvency II.
Difference of Solvency I and Solvency II.
Solvency I Solvency II
1 Started in 1970s Came into effect on 1st January 2016.
2 ‘Prudent’ valuation of liabilities reflects Risk based approach
local accounting practices
3 Simplistic capital requirements Three pillar approach
4 Asset risk managed by quantitative Overall risk management
restrictions rather than capital
5 No provision for risk review Structure of EU insurance supervision
How the Solvency II requirements compare with Solvency I depend on a number of
company specific factors including
• Current levels of prudence margin in provisions
• Current levels of unrealized capital gains allowed for in Solvency I
• Actual level of risk and diversification
The following graph shows the differences of requirements of Solvency I and Solvency II.
'Solvency II' introduced economic risk-based solvency requirements across all EU Member
States. These new solvency requirements will be more risk-sensitive and more
sophisticated than in the past, thus enabling a better coverage of the real risks run by any
particular insurer. The new requirements move away from a crude "one-model-fits-all" way
of estimating capital requirements to more entity-specific requirements. Solvency II
requirements are more comprehensive than in the past. Solvency I requirements

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concentrate mainly on the liabilities side (i.e. insurance risks), Solvency II takes account of
the asset-side risks. The new regime will be a 'total balance sheet' type regime where all
the risks and their interactions are considered. In particular, insurers will now be required
to hold capital against market risk (i.e. fall in the value of insurers' investments), credit risk
(e.g. when third parties cannot repay their debts) and operational risk (e.g. risk of systems
breaking down or malpractice). These are all risks which are not covered under Solvency
I. However, experience has shown that all these risk types can pose a material threat to
insurers' solvency. Although one of the big steps forward under the new regime will be the
introduction of more risk sensitive solvency requirements and adopting the 'total balance
sheet' approach to measuring 1 solvency, the new regime also emphasizes that capital is
not the only (or the best) way to mitigate against failures. Under 'Solvency II', new rules
will for the first time compel insurers specifically to focus on and devote significant
resources to the identification, measurement and proactive management of risks. Together
with a greater focus on risks and their management, the new solvency system will also
adopt a more prospective focus. Whereas at the moment solvency requirements are based
on largely historical data, the new rules will require insurers also to think about any future
developments, such as new business plans or the possibility of catastrophic events which
might affect their financial standing.
Introduction of the "Own Risk and Solvency Assessment" (ORSA)" and the "Supervisory
Review Process" (SRP) enable supervisors to identify insurers at earlier stage which might
be heading for difficulties. Under the SRP, supervisors evaluate insurers' compliance with
the laws, regulations and administrative provisions adopted pursuant to this Directive and
its implementing measures. The new rules require insurers to disclose certain information
publicly to a far greater extent than currently is the case. This will bring in 'market
discipline', which will help to ensure the soundness and stability of insurers, as market
players will be able to exercise greater supervision over and offer greater competition to
other insurers. Insurers applying 'best practice' are more likely to be rewarded by lower
financing costs, for example. Finally, the new framework will strengthen the role of the
group supervisor who will have specific responsibilities to be exercised in close
cooperation with the solo supervisors. This will mean that the same economic risk-based
approach will be applied to insurance groups which can now be better managed as a
single economic entity. Furthermore, the new solvency provisions will foster and force
greater cooperation between insurance supervisors and will further supervisory
convergence.

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Risk based solvency approach in Insurance Sector in India

In reference to Office Order No. IRDAI/F&A/ORD/SOLP/263/12/2011, dated December
1st, 2011, IRDAI has constituted a Committee on “Road Map for Risk Based Solvency
Approach in Insurance Sector in India”. The Committee under the Chairmanship of P. A.
Balasubramanian, in 2014 has submitted the proposed approach to Risk Based Solvency
regime for the insurance sector.
As per the Report of the Committee on “Road Map for Risk Based Solvency Approach in
Insurance Sector”, The Indian solvency regime is based on a three factor based formula
approach which aims at capturing various risks associated with mathematical reserves and
asset risks on non-mandated investments. However, the third factor, which is applicable to
such assets, has been set to zero for computation of solvency requirements as sufficient
prudence is required in determination of valuation rate of interest, in particular. The regime
does not prescribe the methods of identification and quantification of various kinds of risks
to which an insurer is exposed, except to the extent that they give rise to margins for
adverse deviation in respect of valuation parameters for calculation of liabilities, or for
setting aside capital for the risks so identified. This framework is believed to be quite
conservative and strong, but this is principally due to the valuation of liabilities rather than
to the capital requirements. However, as per the report this solvency regime is not risk-
based as it does not provide for identification of the risks to which an insurer is exposed or
for setting aside capital for the risks identified. As a consequence, insurers with similar
liability profiles would have to maintain similar RSM irrespective of their quality of risk
management.
This report also believed that though IRDAI does not explicitly mandate a risk-based
approach to solvency, such as value at risk (VaR) or conditional tail expectation (CTE) to
capital requirements, Authority guided in that direction in mandating the estimation of
economic capital for the life and non-life insurers.
The recommendations of the committee on Quantitative Aspects are:
1. Adoption of a market consistent model for valuation: The absence of any
margins in the quantifications allows for a transparent approach to the capital
requirements.

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2. A value-at-risk approach to the capital requirements: It recommends that a

standard approach be adopted, with the structure and parameters of the stresses to
be specified by IRDAI, rather than an ‘internal model’ approach. For the valuation
model, the Committee has largely followed the approach of Solvency II.
3. Adoption, of ‘twin-peaks’ approach to solvency: whereby the current prudential
reporting structure would continue, and the new structure would operate in parallel.
The sole recommendations of the committee on Qualitative Aspects are on the standards
of governance of Insurance companies, in particular in the area of risk management.
If the ‘twin peaks’ approach is to be adopted, in addition to the existing framework, new
regulations would be needed to mandate the risk-based peak. Which include IRDAI
(Assets, Liabilities and Solvency Margin of Insurers), 2000, IRDAI (Actuarial Report and
Abstract) Regulations, 2000, IRDAI (Distribution of Surplus) Regulations, 2002, Section
64V(ii) of the Insurance Act, 1938, where it specifies particular measures of the liability in
respect of unexpired risks; and 5. Section 64VA(1A)(ii) where it specifies the required
margin of solvency of a general Insurance company.
With those recommendations and as per international practices, the IRDAI has proposed a
move towards a risk-based solvency approach to discourage insurance companies from
investing in riskier assets. In 2016, The Insurance Regulatory and Development Authority
of India has come up with a new set of norms for companies maintaining a solvency ratio,
based on each line of business. The health, motor and liability segments would be
required to maintain a higher ratio, as both the premiums and claims are high. It would be
less in engineering, aviation and fire. Available Solvency Margin (ASM) is calculated as
the excess of value of assets over that of liabilities. The solvency ratio is the ratio of the
ASM amount to that of the required margin. The higher the ratio, the more financially
sound a company would be considered. The required minimum solvency ratio is currently
150 per cent, to be maintained at all times. Sector officials said in segments like group
health where heavy discounts are an issue, a higher solvency ratio will aid in curbing this.
The ratio will be dependent on the amount of premium collections and on net incurred
claims. In life insurance, too, the required solvency margin for each line of product would
be different. The description of the latest regulation on assets, liabilities and solvency
margin is given below.
Insurance Regulatory and Development Authority of India (Assets, Liabilities, and
Solvency Margin of Life Insurance Business) Regulations, 2016: As per IRDAI

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NOTIFICATION 4, dated 13th April, 2016, Ref: [Link]. IRDAI/Reg/9/121/2016-Insurance

Regulatory and Development Authority of India (Assets, Liabilities, and Solvency Margin of
Life Insurance Business) Regulations, 2016 (came into effect from 1st April 2016).
Regulation 3, schedule I deals with Valuation of Assets. As per this schedule
1. The following assets shall be placed with value zero,
(i) Agents’ and Intermediaries’ balances and outstanding premiums in India, to
the extent they are not realized within a period of thirty days;
(ii) Agents’ and Intermediaries’ balances and outstanding premiums outside
India, to the extent they are not realizable ;
(iii) Sundry debts, to the extent they are not realizable;
(iv) Advances and receivables of an unrealizable character;
(v) Furniture, fixtures, dead stock and stationery;
(vi) Deferred expenses;
(vii) Debit balance of Profit and loss appropriation account balance and any
fictitious assets other than pre-paid expenses;
(viii) Reinsurer’s balances outstanding for more than ninety days;
(ix) Leasehold improvements
(x) Service Tax Unutilized Credit outstanding for more than ninety days;
(xi) Any other assets, which are considered inadmissible under Section 64V of the
Insurance Act, 1938.
2. All other assets of an insurer have to be valued in accordance with the Regulations
and other instructions issued by the Authority regarding Preparation of Financial
Statements and Auditor’s Report of insurance companies, Other Forms of Capital
and Investments, as applicable from time to time.
3. Statement of Assets: Every insurer shall prepare a statement of assets in Form
Assets AA of Insurance Regulatory and Development Authority of India (Actuarial
Report and Abstracts for Life Insurance Business) Regulations, 2016.

4Extracted from IRDAI Website

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Determination of Amount of Liabilities: Every insurer shall prepare a statement of the

amount of liabilities in accordance with Regulation 4, Schedule II in respect of life
insurance business.
1. Interpretation: In this Schedule, (1) “Valuation date”, in relation to an actuarial
investigation, means the date to which the investigation relates. (2) “Policy
Accounts” means funds earmarked for Variable Linked Business and Variable Non-
Linked Business.
2. Method of Determination of Mathematical Reserves:
Mathematical Reserves shall be determined for each contract by a prospective
method of valuation. This includes all
• prospective contingencies,
• reasonable expectations of policyholders (with regard to bonuses, including
terminal bonuses, if any,
• cost of any options and guarantees that may be available to the policyholder,
• insurer’s expected experience and shall include an appropriate margin for
adverse deviations (hereinafter referred to as MAD)
• “surrender value deficiency reserves” at the valuation date.
• The valuation method shall be “Gross Premium Valuation” except for the
following cases: (a) One year renewable group term assurances including
riders attached to group business wherein Reserves shall allow for Unearned
Premium, Premium deficiency and Incurred But Not Reported claims. (b)
Riders attached to individual products wherein the reserve shall be higher of
Gross Premium Valuation Reserve and Unearned Premium Reserve.
3. Policy Cash Flows: The gross premium method of valuation shall discount the
following future policy cash flows at an appropriate rate of interest,
a. premiums payable, if any, benefits payable, if any, on death; benefits payable,
if any, on survival; benefits payable, if any, on voluntary termination of
contract, and the following, if any, :- (a) basic benefits, (b) rider benefits, (c)
bonuses that have already been vested as at the valuation date, (d) bonuses
as a result of the valuation at the valuation date, and (e) future bonuses (one

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year after valuation date) including terminal bonuses (consistent with the
valuation rate of interest);
b. commission and remuneration payable, if any, in respect of a policy (this shall
be based on current practice of the insurer). No allowance shall be made for
non-payment of commission in respect of orphaned policies.
c. policy maintenance expenses, if any, in respect of a policy
d. allocation of profit to shareholders, if any,
4. Policy Options and Guarantees: Where a policy provides built-in options that may
be exercised by the policyholder, such as conversion or addition of coverage at
future date(s) without any evidence of good health, or guarantees, such as annuity
rate guarantees at maturity of contract, investment guarantees etc., the costs of
such options or guarantees shall be estimated and treated as special cash flows in
calculating the mathematical reserves.
5. Valuation Parameters: The valuation parameters shall constitute the bases on
which the future policy cash flows shall be computed and discounted. Each
parameter shall have to be appropriate to the block of business to be valued. An
Appointed Actuary shall take into consideration the following, (a) The value(s) of the
parameter shall be based on the insurer’s experience study, where available. If
reliable experience study is not available, the value(s) can be based on the industry
study, if available and appropriate. If neither is available, the values may be based
on the bases used for pricing the product. In establishing the expected level of any
parameter, any likely deterioration in the experience shall be taken into account; (b)
The expected level, as determined in clause (a) of this sub-para, shall be adjusted
by an appropriate Margin for Adverse Deviations (MAD), the level of MAD being
dependent on the degree of confidence in the expected level, and such MAD in each
parameter shall be based on the Actuarial Practice Standards / Guidance Notes
issued by the Institute of Actuaries of India, with the concurrence of the Authority (c)
The values used for the various valuation parameters should be consistent among
themselves.
• Mortality rates to be used shall be by reference to a published table, unless
the insurer has constructed a separate table based on its own experience:
Provided that such published table shall be made available to the insurance
industry by the Institute of Actuaries of India, with the concurrence of the

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Authority. Provided further that such rates determined by reference to a

published table shall not be less than one hundred percent of that published
table. Provided further that such rates determined by reference to the
published table may be less than one hundred percent of that published table
if the Appointed Actuary can justify a lower percent.
• Morbidity rates to be used shall be by reference to a published table, unless
the insurer has constructed a separate table based on its own experience:
Provided that such published table shall be made available to the insurance
industry by the Institute of Actuaries of India, with the concurrence of the
Authority: Provided further that such rates determined by reference to a
published table shall not be less than one hundred percent of that published
table. Provided further that such rates determined by reference to the
published table may be less than one hundred percent of that published table
if the Appointed Actuary can justify a lower percent.
• Policy maintenance expenses shall have regard to the actual expense
experience of the insurer. All expenses shall be increased in future years for
inflation; the rate of inflation assumed should be consistent with the valuation
rate of interest. Provided that appropriate additional provisions shall be made
if the actual experience has not been considered for the valuation. Provided
further that the above provision shall not be applicable to the life insurance
companies for the first five years from the date of commencement of the
business.
6. Valuation rate of interest, to be used by Appointed Actuary - (a) for the calculation
of the present value of policy cash flows referred to in para 3, shall not be higher
than the rates of interest, determined from prudent assessment of the yields from
existing assets attributable to blocks of life insurance business, and the yields which
the insurer is expected to obtain from the sums to be invested in the future, and
such assessment shall take into account- (i) the composition of assets supporting
the liabilities, expected cash flows from the investments on hand, the cash flows
from the block of policies to be valued, the likely future investment conditions and
the reinvestment and disinvestment strategy to be employed in dealing with the
future net cash flows; (ii) the risks associated with investment in regard to receipt of
income on such investment or repayment of principal; (iii) the expenses associated

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with the investment functions of the insurer; b) shall not be higher than, for the
calculation of present value of policy cash flows in respect of a particular category of
contracts, the yields on assets maintained for the purpose of such category of
contacts; c) in respect of non-participating business, shall recognize the risk of
decline in the future interest rates; d) in respect of participating business, shall be
based on the assumption (with regard to future investment conditions), that the scale
of future bonuses used in the valuation is consistent with the valuation rate of
interest.
(a) Lapse rate, if considered for valuation, should be a prudent assumption based
on past experience of the product or similar products; and shall have regard to
the expected future experience based on the nature of the products, target
market, distribution channel etc.
(b) Other parameters may be taken into account, depending on the type of
policy. In establishing the values of such parameters, the considerations set
out in this Schedule shall be taken into account.
(c) Reinsurance arrangement with an element of borrowing in the form of
deposit or credit of any kind from insurer’s reinsurers without the prior
approval of the Authority shall not be treated as credit for reinsurance for the
purpose of determination of required solvency margin.
(d) In case the mathematical reserve is calculated allowing for outgo in respect of
reinsurance premium and credit taken for claim recoveries from reinsurer, the
valuation basis and methods shall be as per this schedule
7. Applicability to Reinsurance: (1) This Schedule shall also apply to the valuation of
business in the books of reinsurers. (2) As regards the business ceded by insurers,
this Schedule shall be applicable to the net sums at risk retained by the insurer.
8. Additional Requirements for Unit Linked Business: (1) Reserves in respect of
Unit linked business shall consist of two components, namely, unit reserves and
general (non-unit) fund reserves. (2) Unit reserves shall be calculated in respect of
the units allocated to the policies in force at the valuation date using unit values if
applicable, at the valuation date. (3) General (non-unit) fund reserves shall be
determined using discounted cash flow method, which shall take into account of the
following, namely:- (a) premiums, if any, payable in future; (b) death benefits, if any,

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provided by the general (non-unit) fund reserve (over and above the value of units);
(c) management charges paid to the general(non-unit) fund; (d) guarantees, if any,
relating to surrender values or minimum death and maturity benefits; (e) Fund
growth rates and management charges. (The values of these parameters, along with
others, shall be determined in accordance with para 5); (f) Non-negative residual
additions, if any, (g) Any future negative cash flow shall be appropriately provided
for by setting up reserves; and negative reserves, if any, shall be set to zero.
Explanation: General (non-unit) fund reserve under unit linked policies shall be
considered as reserve for non-linked non-participating business for the purpose of
investment norms, distribution of surplus etc.
9. Additional Requirements for Variable Linked Business: (1) Reserve in respect of
variable linked business shall consist of two components, namely, policy account
reserves and general fund reserves. (2) Policy account reserves shall be the
balance in Policy Account on the date of valuation. (3) General fund reserves shall
be determined using discounted cash flow method, which shall take into account of
the following, namely:- (a) Premiums, if any, payable in future; (b) Death benefits, if
any, provided by the general fund (over and above the value of policy account); (c)
Management charges paid to the general fund; (d) Guarantees, if any, relating to
surrender values or minimum death and maturity benefits; (e) Policy account growth
rates and management charges. (The values of these parameters, along with others,
shall be determined in accordance with para 5); (f) Non-negative residual additions,
if any; (g) Any future negative cash flow shall be appropriately provided for by
setting up reserves; and negative reserve if any, shall be set to zero. Explanation:
General Fund Reserve under Variable Linked Business shall be considered as
reserve for non-linked non-participating business for the purpose of investment
norms, distribution of surplus etc.
10. Additional Requirements for Variable Non-Linked Business (Par and Non-Par):
(1) Reserve in respect of variable non-linked business shall consist of two
components, namely, policy account reserves and general fund reserves. (2) Policy
account reserves shall be the balance in Policy Account on the date of valuation. (3)
General fund reserves shall be determined using discounted cash flow method,
which shall take into account of the following, namely:- (a) Premiums, if any, payable
in future; (b) Death benefits, if any, provided by the general fund (over and above
the value of Policy account); (c) Management charges paid to the general fund; (d)

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Guarantees, if any, relating to surrender values or minimum death and maturity

benefits; (e) Policy account growth rates and management charges. (f) Non-
negative residual additions, if any, (g) Any future negative cash flow shall be
appropriately provided for by setting up reserves; and negative reserves if any, shall
be set to zero. (h) Future bonuses (one year after valuation date) including terminal
bonuses (consistent with the valuation rate of interest) (i) Allowance must be made
for tax, if any (j) Allocation of profit to shareholders, if any, where there is a specified
relationship between profits attributable to shareholders and the bonus rates
declared for policyholders. Explanation: General Fund Reserves under Variable
Non-linked Non-Participating Business shall be considered as reserve for non-linked
non-participating business for the purpose of investment norms, distribution of
surplus etc. Further, General Fund Reserves under Variable Non-linked Participating
Business shall be considered as reserve for non-linked participating business for the
purpose of investment norms, distribution of surplus etc. 10. Additional
Requirements for Provisions : The Appointed Actuary shall make aggregate
provisions in respect of the following, where it is not possible to calculate
mathematical reserves for each policy, in the determination of mathematical
reserves:- (1) Policies in respect of which extra premiums have been charged on
account of underwriting of substandard lives that are subject to extra risks such as
occupation hazard, over-weight, underweight, smoking history, health, climatic or
geographical conditions; (2) Lapsed policies not included in the valuation but under
which a liability exists or may arise; (3) Options available under individual and group
insurance policies; (4) Guarantees available to individual and group insurance
policies; (5) The rates of exchange at which benefits in respect of policies issued in
foreign currencies have been converted into Indian Rupees and what provision has
been made for possible increase of mathematical reserves arising from future
variations in rates of exchange; (6) Other, if any. 11. Statement of Liabilities: An
insurer shall furnish a statement of liabilities in accordance with the Insurance
Regulatory and Development Authority of India (Actuarial Report and Abstracts for
Life Insurance Business) Regulations, 2016.
Determination of Solvency Margin: Every insurer shall prepare a statement of solvency
margin in accordance with Regulation 5, Schedule III, in respect of life insurance business.
Interpretation: In this Schedule, (1) “Available Solvency Margin” means the excess of
value of assets (as furnished in form-AA specified under Insurance Regulatory

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Development Authority of India (Actuarial Report and Abstracts for Life Insurance
Business) Regulations, 2016) over the value of life insurance liabilities (as furnished in
form-H of Insurance Regulatory Development Authority of India (Actuarial Reports and
Abstracts for Life Insurance Business) Regulations, 2016) and other liabilities of
policyholders’ fund and shareholders’ funds; (2) “Solvency Ratio” means the ratio of the
amount of Available Solvency Margin to the amount of Required Solvency Margin as
specified in form-KT-3 of Insurance Regulatory Development Authority of India (Actuarial
Report and Abstracts for Life Insurance Business) Regulations, 2016. 2. Every insurer at
all time shall maintain its Available Solvency Margin at a level which is not less than higher
of fifty per cent of the amount of minimum capital as stated under Section 6 of the Act and
one hundred per cent of Required Solvency Margin failing which the Authority shall act in
accordance with sub-section (2) of Section 64VA of the Act. 3. “Control level of Solvency”
shall mean the level of solvency margin specified by the Authority in accordance with sub-
section (3) of Section 64VA of the Act on the breach of which the Authority shall act in
accordance with sub-section (4) of section 64VA of the Act without prejudice to taking any
other remedial measures as deemed fit. The control level of solvency is hereby specified
as a solvency ratio of 150 %. 4. Determination of Required Solvency Margin : Every
insurer shall determine the Required Solvency Margin, the Available Solvency Margin and
the Solvency Ratio as per Insurance Regulatory Development Authority of India (Actuarial
Report and Abstracts for Life Insurance Business) Regulations, 2016.

REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. ______________________ is a method of measuring the minimum amount of
capital appropriate for a reporting entity to support its overall business
operations in consideration of its size and risk profile.
a. Risk-Based Capital (RBC) b. Asset liability management
c. Assets under management d. Credit management
e. None of the above

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2. RBC limits the

a Credits b. Debits
c. Assets d. liabilities
e. amount of risk a company can take
3. ______________________ is calculated as the excess of value of assets over
that of liabilities.
a. Available Solvency Margin (ASM) b. solvency ratio
c. Liquidity ratio d. Debt/equity ratio
e. Asset liability management
4. ______________________ is the ratio of the ASM amount to that of the required
margin
a. ALM b. solvency ratio
c. Liquidity ratio d. Debt/equity ratio
e. Asset liability management
5. The quick ratio uses
a. only cash and accounts receivable
b. total current assets divided by the total current liabilities
c. debt/equity
d. Net assets ÷ earned premium net of reinsurance
e. None of the above.
6. In India, insurers are required to maintain a minimum solvency ratio of
a. 1.50. b. 2.50
c. 3.50 d. 1.00
e. None of the above
7. The solvency ratio in insurance business is being measured by
a. Net assets ÷ earned premium net of reinsurance

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b. Assets ÷ liabilities
c. Assets – liabilities
d. Liabilities – Assets
e. None of the above
Answers
1. a 2. e 3. a 4. b 5. a 6. a 7. a

SECTION – B
Short & Essay Questions
1. What is the difference between fixed capital standards and risk-based capital?
2. What is Solvency? Explain at least three solvency ratios.
3. Describe the risk based regime in the USA and in the European Union.
4. Describe the objectives and features of Solvency II.
5. Describe the differences of Solvency I and Solvency II
6. Discuss the Risk based solvency approach in Insurance Sector in India

SECTION – C
Case Studies
1. A lease agreement with Rent works India Private Limited for leasing Furniture
and Fittings was considered as operating lease instead of finance lease (as per
terms and conditions of the agreement).
Violation of point no.1 of Schedule A (Regulation3) of IRDAI (Preparation of
Financial Statements and Auditor's Report) Regulations, 2002 and violation of
Regulation 2 of IRDAI (ALSM) Regulations, 2000.
Submissions by the Life Insurer
Accounting Standard 19 Para 9(a) states that a lease can be classified as a
financial lease if the lessee can cancel the Agreement. However, agreement

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with Rent Works (Lessor) gives the option to cancel the lease only to the
Lessor; hence the lease is classified as an operational lease.
However, revised solvency computations submitted to the Authority,
considering the lease as financial lease, demonstrates that even then the
solvency margin was above the required solvency margin. It is to further to
submit that the value of the lease as on 31/03/2016 was NIL.
Ans. As per the termination clause 11 of the lease agreement as observed in the
inspection observation, if either party cancels the lease the Life insurer is required to
pay all losses associated with termination of lease agreement including liquidated
damages equal to the aggregate amount of the present value of all future rentals
payable under the agreement. This clause renders the lease as finance lease and
the accounting of the same should be in accordance with Accounting Standard
19. However, considering the demonstration given by the Life Insurer, no charges
are being pressed. The Life Insurer is advised to ensure continuous compliance with
the regulatory prescriptions mentioned herein while classifying such lease
agreements.
2. Under a policy issued under product Guaranteed Savings Insurance Plan, It
was observed that Advance premium of 7 years after allowing a discount on
the original premium (total Original premium Rs.350000 and collected premium
Rs. 294507) was collected. However, there is no provision of advance premium
payment option in the product's terms and conditions.
Violation of File and Use guidelines.
Submission by the Life Insurer
Advance premium option was provided as a service feature and in the interest
of the policy holders. It is to further submit to the Authority that collection of
premiums in advance, offers the following benefits to the policyholders:
The policy remains in-force and the policyholder continues to enjoy the policy
benefits.
The benefit of time value of money is passed on to the policyholder.
The Company while discounting the present value of advance premium
payments had provided interest rates comparable to rates under 10 year

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Government securities. The premiums were adjusted only on renewal due date
and commissions on these premiums were paid only when they were due and
not at the inception. It is further to submit that after the introduction of
Regulations 52 and 36 of IRDAI (Linked insurance Products) Regulations, 2013
and IRDAI (Non-Linked insurance Products) Regulations, 2013 respectively, on
advance premium, and subsequent clarification dated June 20, 2013, this
feature has been discontinued. Sample copies of proposal forms/
communications submitted to establish that the advance premium option was
at the request of the policyholders.
Ans. Considering the submissions made by the Life Insurer, no charges are being
pressed.
If we consider the Risk management Process in an Insurance company (as depicted
below) - It is nothing but a combination of- 1) Avoidance, 2) Prevention, 3) Risk
Sharing, 4) Reinsurance (as ART - alternative risk transfer), 5) Creating Fund &
Reserve Capital (to meet future liabilities and contingencies).

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CHAPTER – 6
CORPORATE GOVERNANCE
OUTLINE OF THE CHAPTER
1. Introduction
2. Structure and Composition of the Corporation
— Types of Boards
— Types of Board Structures
— Styles of Board
— Executive management process
— Executive committee of the board
3. Structure of Directors
— Roles of Directors
— Functions of Directors
— Duties, Responsibilities and Liabilities of Directors
4. Need for Corporate Governance
— Definition
— Nature of Corporate Governance (CG)
— Evolution of CG
— Factors that contributed Evolution of CG
 CORPORATE GOVERNANCE

— Evolution of CG in India
— Some of the steps of SEBI to strengthen CG:
— Introduction to Corporate Governance Committees (CGCs)
— Important Reports on CG published by CG Committees:
5. Corporate Governance - Companies Act
6. Corporate governance mechanism.
— Internal CG Mechanism
— External CG Mechanism
7. Insurance Business Risks and Corporate Governance
— Insurance business risks
— Insurance business risk management program
— A process for risk management
— Embedding risk management within the organisation
— Alternative methods for dealing with risks
8. Insurance Governance and Supervision
— Risk Assessment Framework
— IRDAI and corporate governance of outsourcing
— Corporate Governance guidelines for insurance Companies by IRDAI
9. Questions

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Structure of Corporation
• What is Corporate Governance
• Need for Corporate Governance
• Evolution of Corporate Governance in India
• Need for Corporate Governance in Insurance companies
• Role of IRDAI in Corporate Governance in Insurance companies

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Introduction
Corporate governance is commonly referred to as a system by which organisations are
directed and controlled. It is the process by which the company objectives are established
and monitored. Corporate governance is concerned with the relationships and
responsibilities between the board, management, shareholders and other relevant
stakeholders within a legal and regulatory framework. Transparency and accountability are
the most important elements of good corporate governance. In India, relevant legislation
for corporate governance framework is under Companies Act, 2013 and Ministry of
Corporate Affairs. Company registration, Articles of Association, Statutory reporting
requirements (Annual return; Annual accounts or financial statements; Directors’ report;
Directors’ remuneration report etc.,) are all as per Companies Act, 2013.
Risk-taking is a fundamental driving force in any business and entrepreneurship, the cost
of risk management failures is still often underestimated, both externally and internally,
including the cost in terms of management time needed to rectify the situation. Corporate
governance should therefore ensure that risks are understood, managed and, when
appropriate, communicated. Following the financial crisis, many companies have started to
pay more attention to risk management. This is, however, seldom reflected in changes to
formal procedures, except in the financial sector and in companies that have suffered
serious risk management failure in the recent past. It appears that most companies
consider that risk management should remain the responsibility of line managers. For
Corporate risk management, the directors have responsibility to determine the tolerance
level of risk to the company, ensuring a sound system of internal control to safeguard
shareholders’ investment and the company’s assets. For listed companies, the Listing
rules are enforced by SEBI, the capital market regulator. Risk management is particularly
is important for an insurance company. Many companies appoint compliance officers
whose function is separate from internal audit but intended to ensure adherence to
regulatory requirements in particular for insurance companies. In India IRDAI has
stipulated the appointment of compliance officers by insurance companies for the same
purpose. The focus of corporate governance is to establish effective and appropriate
oversight of the power that is given to the senior officers to run the affairs of the
organisation.

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Companies Act, 2013 1 reduced the content of the substantive portion of the related law
as compared to the Companies Act, 1956 (1956 Act). A statistical snapshot of this consists
Number of schedules : 7 Number of chapters: 29 Number of sections: 470
The 2013 Act introduced significant changes in the provisions related to governance. This
Act intends to improve corporate governance by requiring disclosure of nature of concern
or interest of every director, manager, any other key managerial personnel and relatives of
such a director, manager or any other key managerial personnel and reduction in
threshold of disclosure from 20% to 2%. The term ‘key managerial personnel’ has been
defined in the 2013 Act and means the chief executive officer, managing director,
manager, company secretary, whole-time director, chief financial officer and any such
other officer as may be prescribed.
• The 2013 Act has introduced certain significant amendments in preparation of
consolidated financial statements, additional reporting requirements for the directors
in their report such as the development and implementation of the risk management
policy, disclosures in respect of voting rights not exercised directly by the employees
in respect of shares to which the scheme relates, etc., in comparison with the
requirements of the 1956 Act.
• The provisions of the 1956 Act in relation to the transfer of a specified percentage of
profit to reserve is no longer applicable and thus, companies will be free to transfer
any or no amount to its reserves. Schedule II of the 2013 Act, relating to
depreciation defines the useful life of assets as against the depreciation rates
specified in the 1956 Act.
• The 2013 Act features some new provisions in the area of mergers and acquisitions,
are aimed at ensuring higher accountability for the company and majority
shareholders and increasing flexibility for corporates.
• The coverage of Sick Industrial Companies Act, 1985 (SICA) is limited to only
industrial companies, while the 2013 Act covers the revival and rehabilitation of all
companies, irrespective of their sector.
• The Corporate Social Responsibility Voluntary Guidelines which were introduced by
The Ministry of Corporate Affairs (MCA) in 2009, have been incorporated within the

[Link]/MinistryV2/[Link]

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2013 Act and have obtained legal sanctity. Section 135 of the 2013 Act, seeks to
provide that every company having a net worth of 500 crore INR, or more or a
turnover of 1000 crore INR or more, or a net profit of five crore INR or more, during
any financial year shall constitute the corporate social responsibility committee of
the board.
The Corporate Governance framework should clearly define the roles and responsibilities
and accountability within an organization with built-in checks and balances. The
importance of Corporate Governance has received emphasis in recent times since poor
governance and weak internal controls have been associated with major corporate
failures. Corporate governance has a different dimension as far as the insurance business
is concerned. On the one hand, insurers have to be prudent in protecting the
policyholders' interests as regards reasonableness in charging premiums; objectivity in
settling the claims and so on. On the other, they also have the responsibility of profitably
investing the policyholders' funds. This demands that insurers additionally have to be
sensitive to the management styles of the organizations where thefunds are being lodged.
To this extent, they have a dual function to [Link] governance practices for
maintenance of solvency, sound long term investment policy and assumption of
underwriting risks on a prudential basis are more important in the emergence of insurance
companies as a part of financial conglomerates. Sound Corporate Governance in the
insurance sector with emphasis on overall risk management across the structure is
necessary to prevent any contagion effect and to ensure financial stability in the economy.
In this context, thorough understanding of the structure and composition of the
corporation, types of boards, roles of directors, need for corporate governance, nature and
evolution of corporate governance and latest guidelines of IRDAI on Corporate
Governance of insurance companies are necessary. It is discussed in the following lines.

Structure and Composition of the Corporation

A body of people acting as one individual for administration or business purposes is a
corporation. The composition (types) and the size of the Board play a crucial role in the
effective functioning of the corporation. The composition of the Board can be changed to
improve the functioning of the corporation.

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Types of Board
1. Executive Directors (Hold positions of both Director and Executive of an
organization)
2. Non-Executive Directors (They don’t hold executive positions & are outside
directors without promoters link)
3. Nominee Directors (of Banks, FIs, major shareholders)
4. Representative Directors (Similar to Nominees but represent stakeholder groups
like employees, customers)
5. Alternate Directors (Substitutes to Original Directors)
6. Shadow Directors (They influence Board without being formally present on the
Board)

Types of Board Structures

• All-Executive Board (It will have all Executive Directors only and no outside directors
E.g. Family-owned businesses and subsidiaries)
• Majority Executive Board (Executive Directors will have a majority and Outside
Directors represent interests of stakeholder groups like major shareholders,
employees, customers, Banks, FIs etc.)
• Majority Outside Board (This will have a majority of outside, Non-Executive
Directors)
• Two-Tier Supervisory Board (It addresses the concerns for separating Executive
Management from Non-Executive Directors. It has two separate Boards: The Non-
Executive Supervisory Board and the Executive Management Board. The former
monitors the plans/performance of the latter).

Executive management process

• The Executive Management of a company is generally comprised of the Chief
Executive, Executive Directors and the Key-Managers involved in day-to-day
management of the company. They are professionals with substantial experience in

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the concerned professional areas in related industries, both within India and across
the world (in case of MNCs).
• The executive management team is guided in the execution of the Company's
strategy by the Board of Directors comprising individuals who have distinguished
themselves in the private and public sectors.
• It directly reports to the Board and administers the day-to-day affairs of the company
as per the powers delegated to it by the Board.

Executive Committee of the Board

The Executive Committee is responsible for exercising all of the powers and authority of
the Board of Directors during intervals between Board meetings, except for those powers
delegated to the other committees of the Board.

Styles of Board
Depending on the way the Boards function, their commitment to effective decision making
and concern for interpersonal relations, the Boards may be categorized as:
• Rubber Stamp Boards (Gives little importance to good interpersonal relations or
decision making. Board ratifies whatever decisions CEO takes. Ex. Subsidiary Cos.)
• Representative Boards (They accord high priority to effective decision making and
less or no priority to good interpersonal relations among board members)
• County Club Boards (Maintain cordial interpersonal relations but concern for
decision making is least)
• Professional Boards (Give high importance to both interpersonal relations and
effective decision making)

Structure of Directors
Roles of Directors
1. Performance Role: In this, director performs various activities aimed at improving the
overall performance of the corporation like: A source of know-how, expertise and
external information; and caters to needs of the corporation for networking,

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representing and adding status. Outside directors act as “specialists” in different

functions like finance – including banking and investment, marketing, law,
engineering, HR, environment and general management. Some time they act with
the media on behalf of the corporation).
2. Conformance Role: In this, the director is concerned with ensuring that the company
follows the policies and procedures laid down by the board. This is done thru
executive management and involves monitoring and evaluating their own
performance. The independent evaluation of top management’s performance
overcomes the danger of adoption of a narrow vision of the executive board.
3. Strategic Role of Directors (Board):To supervise the quality of strategic thinking of
the top management/executive committee and take corrective measures to guide
them to develop strategies to achieve corporate goals. To develop strategy in the
following three levels:-
• Systematic Level Strategy (Boards shall develop knowledge based on
national/global environment to guide the company)
• Structural and Portfolio Strategy (Taking decisions regarding structure of the
co. and the business it should enter into)
• Implementation Strategy (To decide whether the strategies are feasible and to
implement such policies and strategies properly)
To make policies/strategies which cover all functional areas like marketing, finance,
operations, customer relations and R&D and monitoring and Supervisory Role to ensure
right strategic direction are included in the strategic role of directors

Functions of Directors
• To take responsibility for the performance of Co.
• To promote interests of shareholders
• To oversee performance of Co., CEO, top managers.
• To see accurate reports on financial performance are provided to stakeholders
• To provide adequate strategic guidance to the co.

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• To maintain good relations with the stakeholders

• To enact various performance and conformance roles.

Duties of Directors
• Exercise care in the discharge of functions as directors
• Attend board meetings & pay attention to co.’s affairs
• Not to be negligent and not commit legal wrongs
• Act in the best interests of Co. & stockholders/customers
• Not to misuse power
• Protect interests of creditors
• Maintain confidentiality
• Not to make secret profits and make good loss, if accrued due to breach of duty, of
negligence.
• Not to exercise powers for a collateral purpose.
• Not to waste company assets.

Responsibilities of Directors
• Responsibilities to shareholders (Through policies and proceedings and monitoring
top management’s performance)
• Obligation to maintain honesty and integrity.
• To give the shareholders regular reports and accounts, besides being honest with
the shareholders in their dealings and decisions that will benefit the organization.

Liabilities of Directors
1. Misrepresentations in offer documentations and annual accounts
2. Failure to refund subscription monies to investors
3. Contravention of Law

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Need for Corporate Governance

It has become an active subject of academic and policy debate for a quiet a long time in
many of the advanced countries particularly in Japan, UK, USA &Germany. The
international competitiveness and successful functioning of companies in these countries
has of late, altered company owners and managers in the developing and transition
economies to the fact that effective corporate governance has been highlighted by
international agencies like OECD (Organisation for Economic Co-operation and
Development) and the World Bank. In particular, the WB has been in the process of
formulating a draft code on corporate governance for developing countries that would
review the principles of effective governance, built on international guidelines, assess
governance practices from these and developed countries
Corporate Governance has become an important issue in recent years following a number
of very public company failures due to the abuse of position by senior officers and the lack
of adequate internal controls. These failures have resulted in a number of government
initiatives for reports and recommendations for codes of best practice. It has been
recognized that insurance is an activity that needs to be regulated by the state. The
reasons for this are to protect policyholders from exposure to insolvent insurers and to
ensure the desired transfer of risk occurs. To avoid such failures, regulation was
introduced with IRDAI Act, 2000.
Corporate Governance is concerned with the formulation of long-term objectives and plans
and the proper management structure (organization, systems and people) to achieve
them. At the same time, it entails making sure that the structure functions to maintain the
corporation’s integration and responsibility to its various constituencies.
Corporate Governance relates primarily to the selection and conduct of senior officers of
an organization and their relationship with the owners (Shareholders), employees and
others who have an interest in the organization, often known as stakeholders. It
encompasses the means by which members of the Board and senior management are
held accountable and responsible for their actions. It includes corporate discipline,
transparency, independence, accountability, responsibility, fairness and social
responsibility. It also includes compliance with legal and regulatory requirements. It
establishes standards of business conduct and ethical behavior of Directors and senior
management. The board is the Focal Point of the Corporate Governance System. The

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significant owners, board members, senior management, auditors and actuaries of an

insurer are fit and proper their roles. They should possess the appropriate Integrity,
Competency, Exposure and Qualifications and there is a requirement of an on-site
inspection by the supervisory Authority.

Definition
“Corporate Governance (CG) is defined as the systems and frameworks by which
organizations are directed and controlled. CG is concerned with standards, systems,
processes, controls, accountabilities and decision-making at the heart of and at the
highest levels of, an organization”. Good CG and the guidance that comes with it, provides
an organization with clear accountabilities. Individual officers will have the confidence to
carry out their jobs efficiently and know what standards are expected of them. This in turn
leads to increased confidence in and respect for the work.
“CG is the system by which business corporations are directed and controlled. CG
structure specifies the distribution of rights and responsibilities among different
participants in the corporation, such as, the board, managers, shareholders and other
stakeholders and spells out the rules and procedures for making decisions on corporate
affairs. By doing this, it also provides the structure through which the company objectives
are set and the means of attaining those objectives and monitoring performance”………..
(OECD).
“CG is the sum of those activities, which make up the internal regulations of the business
in compliance with the obligations placed on the firm by legislation, ownership and control”
Cannon Behind the formal systems of corporate governance lie the core values of an
organization.

Nature of Corporate Governance (CG)

CG is a set of structural arrangements that are emerging in free market economies to align
the management of companies with the interest of their shareholders (in particular) and
other stakeholders and society at large. CG addresses 3 basic issues: (i) Ethical Issues
(Frauds, bribes, gifts, etc. to potential customers for achieving the goal of maximizing long
term owner value) ; (ii) Efficiency Issues (concerned with performance of management);
and (3) Accountability Issues (arising out of stakeholders’ need for transparency of
management in conduct of business”. Scope of CG is limited to ensuring stable income
levels for shareholders

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Evolution of CG
In the beginning (a few decades ago), the government was expected to ensure good CG
and conduct. Most shareholders believed that stringent government controls would
prevent malpractices of the corporations for fear of punishment. However, there was soon
a growing realization that Govt. was not always the best guardian of public interest.
Shareholders began to feel the need for market driven CG that would be more democratic
and flexible. This led to the birth of self-imposed CG within the corporate system. The
active participation of various stake holders like shareholders, FIs, etc. have strengthened
the CG mechanism and helped to evolve beyond a set of static rules.

Factors that contributed to the evolution of CG

1. Responsibility for ensuring good corporate conduct shifted from Govt. to a free-
market economy.
2. Active participation of individual and institutional investors.
3. Increasing competition in global economy.
4. The enhanced competition in the Global economy has compelled corporations to
perform better by going in for cost-cutting, corporate restructuring, M&As,
downsizing, etc. All these activities can be carried out successfully only if there is
proper CG.
5. Thus, market forces, active individual and institutional investor participation and
enhanced competition have helped CG to evolve beyond a set of static rules.

Evolution of CG in India
In India, the concept of CG is still in nascent stage. Recommendations of
Kumaramangalam Birla and CII Committees are the first steps in India towards ensuring
better CG. Prior to the above recommendations, SEBI had taken various steps to
strengthen CG in India.

Some of the steps of SEBI to strengthen CG

1. Strengthening of disclosure norms for IPOs following the recommendations of Y H
Malegam Committee.

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2. Providing information in directors’ Reports for utilization of funds and variations

between projected and actual use of funds as per Companies Act. (Cash Flow and
Funds Flow statements in Annual Reports)
3. Declaration of Quarterly Results
4. Mandatory appointment of Compliance Officer for monitoring the share transfer
process and ensuring compliance with various rules and regulations.
5. Timely disclosure of material and price sensitive information (All material events
having bearing on performance of company)
6. Dispatch of one copy of Balance Sheet to every Household and Abridged Balance
Sheet to all shareholders.
7. Issue of guidelines for preferential allotment at market related prices
8. Issue of regulations providing for a fair and transparent framework for takeovers and
substantial acquisitions.

Introduction to Corporate Governance Committees (CGCs)

Codes are a set of written rules, which are accepted as general principles which state how
people in a particular organization or a country should behave. A regulation is an official
rule that lay down how things should be done. CGCs have developed several CG codes
and regulations which are intended to control, guide or manage the behavior or conduct of
individual’s working in corporates/organizations.

Important Reports on CG published by CG Committees

A. Foreign Committees:
• OECD Committee
• Cadbury Committee
B. Indian Committees:
1. Kumara Mangalam Birla Committee
2. Ganguly Committee
3. Naresh Chandra Committee

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4. CII Committee
5. Malegam Committee
C. Companies Act (Legal Framework for CG)

Cadbury Committee Report (CCR)

Under the Chairmanship of Adrian Cadbury (May 1991), a committee was set up by
Financial Reporting Council, London Stock Exchange to look into the financial aspects of
Corporate Governance. It submitted its report on May 27, 1992, whose recommendations
are as follows:-
1. There should be separation of roles of Chairman and CE.
2. Non-executive directors should act independently while giving judgments on issues
of strategy, performance, allocation f resources and designing codes of conduct.
3. Majority of directors should be independent non-executive directors and should not
have any financial interests in the company.
4. The director’s term should not exceed 3 years, which can be extended with
shareholders’ approval.
5. There should be full transparency relating to directors emoluments. There should be
a judicious mix of salary and performance related pay.
6. A Remuneration Committee made of fully or largely of non-executive directors,
should decide on the pay of the executive directors.
7. The interim company report should give the balance sheet information and be
reviewed by the auditor.
8. There should be a professional and objective relationship between the board and
executives.
9. Information regarding the audit fee should be made public and there should be
regular rotation of auditors.
The recommendations of CCR were widely accepted by the corporates in UK and they
became a reference point for many other committees, which were set up by various
governments all over the world.

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OECD Report Recommendations (ORR)

OECD is an international organization for economic co-operation and development. In
June, 1998, the OECD constituted an Ad-hoc Task Force on CG, with key representatives
from all member countries and other international organizations including World Bank and
provided recommendations (principles) primarily aimed at governments, but also provided
guidance to SEs, investors, private corporations, national commissions on corporate
governance as they deal with best practices, listing requirements and codes of conduct.
The principles by OECD fall into 6 broad areas
1. Ensuring the basis for an effective CG
2. The rights of shareholders and key ownership functions
3. The equitable treatment of shareholders
4. The role of stakeholders
5. Disclosure and transparency
6. The responsibility of the board
1. Ensuring the basis for an effective CG: For promoting transparent and efficient
markets, be consistent with rule of law and for articulating the division of
responsibility among different supervisory, regulatory and enforcement authority.
2. The rights of shareholders and key ownership functions: CG shall protect and
facilitate the exercise of share-holders’ rights
3. The equitable treatment of shareholders: CG shall ensure equitable treatment of
all share-holders including minority, foreign shareholders including redressal for
violation of their rights)
4. The role of stakeholders: CG shall recognize rights of stakeholders– cooperation
between stakeholders and corporation.
5. Disclosure and transparency: Timely and accurate disclosures as to all material
matters final situation, performance, ownership and governance
6. Responsibility of the Board: 1. Strategic guidance of the company; 2. Effective
monitoring of management; and 3. Board’s accountability to shareholders)

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Thus the above 6 principles advocate for the following three:-

(i) For sound financial system
(ii) Basis for cooperation between OECD and Non-OECD countries
(iii) To underpin the CG component of World Bank and IMF reports on the observance
on Standards and Codes.

Kumara Mangalam Birla Committee (KMBC)

KMB Committee was instituted by SEBI in 1999 to suggest measures to promote and raise
the standards of CG in India.

Objectives
1. To suggest amendments to listing agreements by cos. with SEs and other measures
and improving CG in listed cos. regarding disclosures and responsibilities of
independent/outside directors.
2. Draft a code of best practices.
3. To suggest safeguards within cos. to deal with insider information and insider
trading.

Recommendations of KMBC Report

KMBC identified the shareholders, Board & Management as the constituents that have a
key role to play in CG and tried to identify their roles & responsibilities in ensuring effective
CG. Its important recommendations are as follows:-
1. Board should have an optimum combination of both Executive and Non-Executive
Directors and at least 50% of Board should comprise Non-EDs and one-third of
Board should comprise of independent directors where Chairman is non-executive
and at least half of the Board should be independent in case of Executive Chairman
2. A qualified & independent Audit Committee should be appointed to enhance
financial disclosures and transparency.
3. A Remuneration Committee for deciding remuneration and compensation package
including pension rights to EDs.

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4. A Board Committee to look into shareholder issues, share transfers & redressal of
complaints.
5. CG section of Annual Report (AR) to deal with remuneration paid to directors and on
level of compliance by the co.
6. Board Meetings should be held at least 4 times in a year with a maximum time gap
of 4 months between 2 meetings.
7. All co. related information like qly results, etc. may be put on co’s website.
8. No director should be a member in more than 10 committees or act as Chairman of
more than 5 committees across all cos. in which he is a director.
9. Disclosures to be made to the Board by the management relating to all material,
financial & commercial transactions, where they have personal interest.
10. Half-yearly declaration of financial performance should be sent to each household of
shareholders.
11. FIs can have nominees on the boards of borrower companies to protect their
interests as creditors. The Nominee Directors should take an active interest in the
activities of the Board and assume equal responsibilities, as any other director on
the Board.
12. A separate section on compliance with mandatory recommendations should form
part of the report and details of non-compliance should be highlighted.
13. A certificate from the auditors on compliance should form part of the AR and copies
of ARs should be sent to the SEs.

Dr. A.S. Ganguly Committee

The Consultative Group of Directors of Banks and Financial Institutions (FIs) was set up
by RBI, under the Chairmanship of Dr. A.S. Ganguly, to review the Supervisory Role of
Boards of Banks/FIs and to obtain feedback on the functioning of the Boards vis-à-vis
Compliance, Transparency, Disclosures, Audit Committees, etc. and to make
recommendations for making the role of Boards more effective with a view to minimizing
risks and over-exposure.

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Objectives of the Committee

To produce a list of recommendations after review of the existing framework of Boards of
Banks and FIs and benchmarking them with International Best practices (enunciated by
Basel Committee on Banking Supervision) and other Committees to the extent applicable
to Indian Environment

Naresh Chandra Committee on Corporate Audit and Governance

(2002)
Following the corporate scandals of the US, the Department of Corporate Affairs (DCA),
Government of India set up the Naresh Chandra Committee to examine various corporate
governance issues. Many recommendations of the report were incorporated in the
Companies (Amendment) Bill 2003.

Objectives of the Committee

1. To review the performance of Corporate Governance
2. To determine the role of companies in responding to rumour and other price
sensitive information circulating in the market,
3. To enhance the transparency and integrity of the market.

Narayana Murthy Committee Report (2003)

The Committee was constituted by SEBI to review the performance of corporate
governance in the country as well as to determine the role of companies in responding to
rumour and other price sensitive information circulating in the market in order to enhance
the transparency and integrity of the market. The Committee submitted its report to SEBI
in February 2003

Malegam Committee Report

The Reserve Bank of India on January 19, 2011 released on its website the Report of the
RBI Sub-Committee of its Central Board of Directors to study Issues and concerns in the
micro finance institutions (MFI) Sector. The Sub-Committee has recommended creation of
a separate category of NBFCs operating in the microfinance sector to be designated as
NBFC-MFIs. To qualify as a NBFC-MFI, the Sub-Committee has stated that the NBFC

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should be “a company which provides financial services pre-dominantly to low-income

borrowers, with loans of small amounts, for short-terms, on unsecured basis, mainly for
income-generating activities, with repayment schedules which are more frequent than
those normally stipulated by commercial banks” and which further satisfies the regulations
specified in that behalf. The Sub-Committee has also recommended some additional
qualifications for NBFC to be classified as NBFC-MFI. These are:
a. The NBFC-MFI will hold not less than 90% of its total assets (other than cash and
bank balances and money market instruments) in the form of qualifying assets.
b. There are limits of an annual family income of Rs.50,000 and an individual ceiling on
loans to a single borrower of Rs.25,000
c. Not less than 75% of the loans given by the MFI should be for income-generating
purposes.
d. There is a restriction on the other services to be provided by the MFI which has to
be in accordance with the type of service and the maximum percentage of total
income as may be prescribed.
The Sub-Committee has recommended that bank lending to NBFCs which qualify as
NBFC-MFIs will be entitled to “priority lending” status. With regard to the interest
chargeable to the borrower, the Sub-Committee has recommended an average “margin
cap” of 10 per cent for MFIs having a loan portfolio of Rs. 100 crore and of 12 per cent for
smaller MFIs and a cap of 24% for interest on individual loans. It has also proposed that,
in the interest of transparency, an MFI can levy only three charges, namely, (a) processing
fee (b) interest and (c) insurance charge.
The Sub-committee has made a number of recommendations to mitigate the problems of
multiple-lending, over borrowing, ghost borrowers and coercive methods of recovery.
These include :
a. A borrower can be a member of only one Self-Help Group (SHG) or a Joint Liability
Group (JLG)
b. Not more than two MFIs can lend to a single borrower
c. There should be a minimum period of moratorium between the disbursement of loan
and the commencement of recovery

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d. The tenure of the loan must vary with its amount

e. A Credit Information Bureau has to be established
f. The primary responsibility for avoidance of coercive methods of recovery must lie
with the MFI and its management
g. The Reserve Bank must prepare a draft Customer Protection Code to be adopted by
all MFIs
h. There must be grievance redressal procedures and establishment of ombudsmen
i. All MFIs must observe a specified Code of Corporate Governance
For monitoring compliance with regulations, the Sub-Committee has proposed a four-pillar
approach with the responsibility being shared by (a) MFI (b) industry associations (c)
banks and (d) the Reserve Bank.
While reviewing the proposed Micro Finance (Development and Regulation) Bill 2010, the
Sub- Committee has recommended that entities governed by the proposed Act should not
be allowed to do business of providing thrift services. It has also suggested that NBFC-
MFIs should be exempted from the State Money Lending Acts and also that if the
recommendations of the Sub-Committee are accepted, the need for the Andhra Pradesh
Micro Finance Institutions (Regulation of Money Lending) Act will not survive.
The Sub-Committee has cautioned that while recognising the need to protect borrowers, it
is also necessary to recognise that if the recovery culture is adversely affected and the
free flow of funds in the system interrupted, the ultimate sufferers will be the borrowers
themselves as the flow of fresh funds to the microfinance sector will inevitably be reduced.
The Reserve Bank of India in October 2010 set up a Sub-Committee of its Central Board
of Directors to study the issues and concerns in microfinance sector, under the
Chairmanship of Shri Y H Malegam, a senior member on the Reserve Bank’s Central
Board of Directors. Other members of the Sub-Committee included Shri Kumar Mangalam
Birla, Dr. K C Chakrabarty, Deputy Governor, Smt. Shashi Rajagopalan and Prof. U R
Rao. Shri V K Sharma, Executive Director, Reserve Bank of India was the Member
Secretary to the Sub-Committee

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Corporate Governance – Companies Act

The CG under Companies Act deals with:
(i) Appointment of Directors and MD,
(ii) Holding Board Meetings at regular intervals
(iii) Disclosure of interest by Board in dealings with the company and
(iv) Maintenance of accounts, audit, auditors’ report and directors’ report and so on.

Board of Directors
(a) Appointment: Board of Directors are the representatives of the shareholders. They
are selected by the shareholders and appointed as per AOA. They should be
individuals only. The Cos’ Act defines the role and responsibilities of the directors.
(b) Position of a Director: He acts as a trustee, an agent and a managing partner,
having some qualification shares, if required by AOA.
(c) Disqualification of a Director: He should not be of unsound mind, insolvent, or
convicted by a court.
(d) No. of Directors: Public Limited Co: At least 3; Pvt. Ltd. Co: At least 2; and the
minimum and maximum should be specified by the company in AOA.

Powers of the Board

• To make calls on shareholders on unpaid shares
• To issue debts
• To borrow money otherwise than on debts
• To invest funds in the co.
• To grant loans
• To fill casual vacancies in the Board
• To recommend the rate of dividend subject to
• Approval of AGM

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• To invest in the shares of any other co.

• Powers with consent of AGM only: (To remit a debt due by a director; powers to
borrow in excess of capital and reserves; and to appoint sole selling agents).

Duties of Directors
• Fiduciary: Fiduciary means in trust, or as per the powers held. Directors are not to
exceed power & authority, to act honestly and with good faith, etc.
• Duties of Care: Exercise reasonable care, act with best skills and expertise, perform
his duties as he does for his own affairs.
• Statutory Duties: To reveal his financial interests in the contracts, to the Board, not
to enter into a contract with a co. belonging to his relatives for sale, purchase and
supply of goods.
• Other Duties: To attend Board meetings, convene AGM and not to delegate duties to
others.

Liabilities of the Director

Directors incur liabilities for not carrying out their duties diligently and honestly. Their
liabilities are:
• Unlimited liability: If provided in Memorandum of Agreement (MOA) of limited cos.
• For breach of Fiduciary duties: Fiduciary means in trust or as per the powers held.
• Personal liabilities: To identify if the directors use companies’ funds for personal use
and recover the money.
• Criminal Liabilities: They include untrue statements and mistakes in prospectus,
violation of deposit rules, for being un discharged insolvent, defaults in distributing
dividends, failure to supply information to auditors, providing wrong information to
Company law board (CLB), Govt., etc., for contributions to political parties and for
acting as director after removal, etc.

Removal and Remuneration of Directors

A. Removal: Directors can be removed by shareholders, CLB and CG. by:-

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a. Ordinary Resolution
b. On Recommendation of CLB
c. CLB can terminate when it receives an application for removal or
mismanagement of a Director.
B. Remuneration (To MD, Working Time Directive (WTD)): (i) Fees for Board Meetings;
(ii) Fixed remuneration on monthly basis or commission on Net Profit @ maximum of
5% (for MD); 10% (for all directors put together). Other directors can be paid either
on a monthly, quarterly, annual basis with approval of Govt. and commission not
exceeding 1% of Net Profit.
The Managing Director (MD):
A MD is a director who is entrusted with substantial powers of management as given
below:
1. Appointment of MD: He can be appointed (i) By agreement; (ii) By resolution of
Board; and (iii) by virtue of Memorandum of Association (MOA)/ Articles of
Association (AOA).
2. Remuneration to MD: It should not exceed 5% of Net Profit. Maximum limit is 10% of
NP for all directors.
3. Resignation of MD: His resignation will be effective from date of acceptance by the
BD and thereafter he can continue as an ordinary director.
4. No. of cos. in which MD can act as MD: Any number of Private companies, if they
are not subsidiaries of Public companies. He can be MD of only 2 companies, if they
are subsidiaries of Public companies.
5. Tenure: 5 years & he can be reappointed for one more term, if it is a Public or its
subsidiary company.

Corporate Governance Mechanism

Internal CG Mechanism
A. Board of Directors: The primary function of the Board is to take responsibility for
the performance of the company, to promote its interests on behalf of shareholders,

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to whom it is accountable. Board overseas the performance of the co., its CEO and
top managers. It monitors corporate performance with reference to goals, objectives
and targets. The Board provides strategic guidance to the co. It studies the future
trends so that the co. has necessary funds for future growth and development. The
Board has to maintain good relations with the stake-holders and run the company on
ethical grounds. Its important roles include: Strategic role; Policy Making role; and
monitoring and supervisory role. The designing and structure of the Board shall be
suitable to the co. for its efficient functioning.
B. Functional committees of the board: The board relies on independent outside
directors to monitor management performance. Such committees are:
(a) Audit Committee: It consists of independent directors who report to the
board. These committees act as a link between the board and external
auditors. Its functions are:
• To sort out audit problems
• To review interim & final accounts
• To inform board about effectiveness of internal controls, quality of
financial reporting, audit fees, selection and replacement of auditors.
(b) Remuneration Committee: Board sets up this committee to objectively review
the remuneration packages of the EDs and other top managers. The
committee, made up of independent directors, chalks out a reasonable and
transparent remuneration policy and checks unreasonable increase of
executive remuneration.
(c) Nomination Committee: It is set up to select the new non-executive directors
and is headed by the Chairman and shortlists and interviews the final
candidates.
C. Codes of Conduct: A code is a set of rules, which are accepted as general
principles, or a set of written rules, which state how people in a particular
organization or country should behave. A regulation is an official rule that lays down
how things should be done. Both codes and regulations are a set of rules or
principles or standards that are intended to control, guide, or manage the behavior
or conduct of individuals working in an organization. Various CG Committees like

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Cadbury Committee, Kumara Mangalam Birla Committee, CII and OECD have
developed various codes which spell out various self-regulatory rules for guiding
conduct or behavior.
a. Self-Regulatory Codes: These are self-regulatory rules for guiding conduct or
behavior and they do not direct or control behavior by some official authority.
International Capital Market Group (ICMG) listed the following codes:-
• In self-regulation, it is possible to impose ethical standards which go
beyond statutory legislation.
• Self-regulators are directly accountable to members of their group and
understand issues facing the group; and identify complex regulatory
problems at an early stage and develop suitable solutions.
• Self-regulations operate in an atmosphere of willingness to accept them.
They have built-in systems of checks & balances and are more
comprehensive than official regulations.
D. Whistle Blowers: The Company may establish a mechanism for employees to
report to the management concerns about unethical behavior, actual or suspected
fraud or violation of the company’s code of conduct or ethics policy. This mechanism
could also provide for adequate safeguards against victimization of employees who
avail of the mechanism and also provide for direct access to the Chairman of the
Audit committee in exceptional cases. Once established, the existence of the
mechanism may be appropriately communicated within the organization.

External CG Mechanism
A. Regulators: The external CG mechanism shall ensure that the co. shall comply with
all relevant laws, regulations and codes. It also includes that the Board and
executive management shall comply with the rules and regulations of all Regulators
such as SEBI, RBI, IRDAI and also strictly comply with the provisions of the
Companies Act etc.
B. Gate-Keepers: In the wake of a series of corporate governance disasters in the US
and Europe viz. Enron, WorldCom, Tyco, Parmalat and Satyam Computers recently
- one question has not yet been addressed. A number of gatekeeping professions -
auditors, attorneys, securities analysts, credit-rating agencies and independent

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directors - exist to guard against these governance failures. Yet clearly these
watchdogs did not bark while corporations were looted and destroyed. This requires
deeper examination in regard to the evolution, responsibilities and standards of
these professions. Obviously these gatekeeping professions had failed and many
reforms are needed to set them right. The institutional changes and pressures had
caused gatekeepers to underperform or neglect their responsibilities and certain
feasible changes are required to restore gatekeepers as the loyal agents of
investors
C. Institutional Investors (IIs):
• IIs such as large Pension Funds, Insurance Cos., Mutual Funds, Unit Trusts
and other FIs have become the largest shareholders in many countries, having
significant shareholdings in the companies in which they invest.
• This has resulted in growing influence of IIs in their investee Cos. and they are
now increasingly interested in CG, as good CG increases corporate efficiency
leading to good returns to IIs and other shareholders.
• The ‘tools’ of governance include one-to-one meetings, voting, focus lists and
rating systems.
• The evidence as to whether ‘good’ corporate governance impacts on corporate
performance is rather mixed but, looking at it another way, good governance
can help to ensure that companies do not fail. Also, a company with good
corporate governance is more likely to attract external capital flows than one
without.
D. Corporate Raiders:
• Corporate Raider is a person or co. that is offering or executing a hostile
takeover by buying shares directly from shareholders. If a firm makes an offer
to shareholders to acquire a publicly-traded company after the board of
directors refuses, or if it bypasses the board completely, one refers to the
acquiring firm as a corporate raider. Often, the corporate raider does not
actually intend to take over the target co., but is simply trying to force the
board of directors to repurchase shares at a premium to their market value. A

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corporate raider that accumulates more than 5% of a company's outstanding

shares must register with the SEBI. It is also known simply as a raider.
• Corporate Raider is a person or organization that acquires a substantial
holding of the shares of a co. in order to take it over or to force its
management to act in a desired way.
E. Greenmail:
• Greenmail or greenmailing is a corporate acquisition strategy for generating
large amounts of money from the attempted hostile takeovers of large, often
undervalued or inefficient companies.
• Greenmailing is a variant of the corporate raid strategy of asset stripping.
However, once having secured a large share of a target company, instead of
completing the hostile takeover, the green mailer offers to end the threat to the
victim company by selling his share back to it, but at a substantial premium to
the fair market stock price. Whilst benefitting the predator, the company and
its shareholders are impoverished.
F. Asset Stripping: It refers to the sale of selected assets of an acquired company
generally for the purpose of raising money to pay off some of the debt incurred in
financing the acquisition.
G. Hostile Takeover: This is an acquisition of a firm despite resistance by the target
firm's management and board of directors. The takeover code, which governs
takeover norms in India, is set for a major overhaul. SEBI Takeover Code
Committee is likely to consider big ticket changes like hike in 15% trigger limit and a
100% open offer are being considered. Under the current Takeover Code, with the
acquisition of 15% or more of the voting rights of the target company, open offer for
additional 20% shares is mandatory. This restricts the acquirer to make large
investments in the co., where controlling the company is not an objective, limiting
the acquirer to below 15% so as to avoid an open offer. This is especially a big
hindrance in private equity deals wherein private equity intends to acquire more than
15% without any intention of running the companies.
An option may be considered wherein this limit could be raised to 25% which will ease
fund raising for India Inc. Also, this limit of 15% does not converge with the limits followed

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globally by countries such as Hong Kong (35%), UK (30%), Malaysia (33%) and Singapore
(30%).
However, in India, there are many listed cos. where promoter shareholding is less than
40%. Hence, even if the limits are raised, adequate protection should be provided in the
case of cos. with low promoter shareholdings.

Insurance Business Risks and Corporate Governance

Insurance business Risks
Business risk is generally defined as the threat posed by an event or action to a business's
ability to achieve its ongoing objectives. For many insurers the primary objective will be
maximization of profit, so business risk can be thought of as anything that will prevent the
company making as much profit as possible. Since the opposite of huge profits is huge
losses and companies making huge losses will generally go out of business, business
risks can be considered as being forces pushing a company in the direction of going
concern problems. This will not mean that a business risk will automatically lead to going
concern problems. If a company is performing well and suffers a 4% drop in sales it will
inevitably make less profit but is unlikely to go out of business. Consequently, the
importance of corporate governance and assurance continues to increase and the most
significant aspect of this topic is risk management. Consequently, risk management has
been catapulted from being a useful tool to becoming the very pulse of the organization
and the yardstick by which management is judged.

Insurance business Risk management program

Most insurers will now have introduced a formal program to evaluate and record their most
significant risks and will have senior management commitment. Risks that may be
identified include:
• Loss of IT systems, e.g. frequent down-time.
• Breach of systems security, e.g. hacking on internet.
• Poor prioritization of systems development.
• Failure of partner/third party relationships, e.g. in performance delivery.

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• Failure in effectively managing relationships.

• Loss of key personnel, e.g. technical insurance expert.
• Damage to reputation, e.g. loss of trust from mis-selling, demonstrating unfairness to
customers, fines, non-compliance with legal requirements etc.
• Loss of competitive advantage by failing to innovate.
• People issues, e.g. moral issues, lack of resources leading to stressful situations.
• Lack of management information or poor, inaccurate management information which
cannot be relied upon.
• Financial statement could be wrong, for example, the amount of disclosures could
be wrong.
Examples of other business risks are fire, flood, litigation, IT viruses or anything that could
have a damaging impact on the business.
Part of evaluating the processes is to mitigate the threats and determine the exposures
and this should also help to identify and exploit opportunities.
The main responsibility for both risk management and implementation of the actions from
the risk management programme rests with operational management. They are, in this
respect, as in other situations, the first line of defence.
The programme has to be a self-assessment process, whereby management takes
accountability and responsibility for the risk under its control and should, therefore, be held
to account for demonstrating that such risks are being appropriately managed. There will
often by a requirement for them to sign off on an annual basis that this is the case.

A process for risk management

To properly manage risk, it is necessary to first identify and then assess the risks the
business faces. Example areas to assess are strategic, operational, financial and
environmental. Mast worthwhile strategies are likely to carry some degree of risk,
therefore such areas need to be carefully assessed.
Having conducted the risk assessment, it is then necessary to rank the risks by
importance. In risk mapping, the probability of the risk is platted an one axis and its

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potential impact on the other. An example is provided below.

Low probability but high impact High probability and high impact
Low probability and low impact High probability but low impact
The top right-hand corner shows the risks that have the highest priority.
The impact of risk is not just risk in financial terms; it can also impact on a business's
reputation. A good example of this is the recent problems that Arthur Anderson had as the
auditors for the US conglomerate Enron. As a result, Arthur Anderson last all credibility
and the business failed.
For each risk identified, it is necessary to decide on a course of action. Here a business
can accept it, transfer it, reduce it or take steps to avoid it altogether. Insurance, financial
derivatives and outsourcing are ways of transferring risk. A business can reduce or avoid
risk by reducing its exposure or pulling out of a particular market. However, what is equally
important is to make sure that the cost of action is not going to be higher than the cost of
the risk itself.
For most strategy proposals, it is important to undertake some form of analysis of the
financial risks involved in the strategy options. A number of types of analysis can be
undertaken:
 Cash flow analysis - this analysis is essential. A business can report good levels of
profitability at the same time as going bankrupt through lack of cash.
 Break-even analysis - this is also a useful approach. It calculates the volume sales
of the business required to recover the initial investment in the business. Here the
important point is to explore whether this volume is reasonable or not.
 Company borrowing requirements - the impact of some strategies could severely
impact on the funds required from other financial institutions and/or shareholders.
 Financial ratio analysis -liquidity, asset management and similar checks on
organisations can be usefully undertaken. It can be said that a company should
know in detail about its own areas, however, key customers and suppliers should
also be considered. The effect of a key supplier or customer going out of business
could be a real problem when the company is stretching itself financially.
 Currency analysis - this is important for international organisations as a major shift
in currencies could quickly wipe out the profitability of an overseas strategy option.

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 Sensitivity analysis - this is not only useful but is regarded as a part of basic
strategy evaluation. It explores the 'What if?' questions for their impact on the
strategy under investigation. The basic assumptions behind each option, for
example, pricing, growth, currency fluctuations etc. are varied and the impact is
measured a return on capital employed, cash and other business objectives. The
results of all sensitivity analyses can provide those selecting the strategies with a
useful estimate of the risks involved.
Risk management as it stands cannot be outsourced, it remains the responsibility of the
organisation's management and it is not something that a company just does once. It
needs to be an ongoing process, it will need to be regularly updated and communicated ta
all those pea pie that need to know.
Risk management is also an exercise commonly conducted within projects. Here the
project team will identify the risks and issues that could be a barrier to being able to
achieve their objectives according to plan, budget and timescales. Having identified the
risks, the team will develop contingency plans to use should the risk materialise. By having
these ready for use, they will be ready to quickly address the risks should they arise.

Embedding risk management within the organisation

This has to be positioned by senior management if it is to succeed. They will need to
ensure that strategic actions required are implemented by:
 Linking the output into the planning and budgeting processes. The benefits to this
are that it helps to improve the planning process, reduces the chance of surprises,
enhances achievement of objectives, enhances consistency and ensures more
informed decisions.
 Sharing best practice with other teams. This encourages people to think and
promotes positive cultural change.
 Working with other teams to address exposures identified in business interface; will
help to break down 'silos' and enhances communication.

Alternative methods for dealing with risks

Risks can be managed in a variety of ways and the directors need to try to balance the
effectiveness of the method they select against the cost. Risk management may be
achieved by:

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 transferring the risk, e.g. insurance, reinsurance or outsourcing;

 avoiding the risk by changing the company's business e.g. not diversifying into a
new product;
 introducing controls to manage the risk, e.g. business continuity plans (see below);
 deciding to accept the risk, particularly low impact/low likelihood risks as the cost of
dealing with the risk may exceed the benefit gained.
All firms no matter what their size need to ensure they develop a business continuity plan.
Business continuity is about looking at 'what if' scenarios, for example, what if the country
was affected by a flu pandemic or a terrorist threat? Have we got a contingency plan that
will ensure that the business will continue to function efficiently with little or no disruption
to staff, customers and suppliers?
At a high level, the business will need to establish a key skills database so that individuals
are identified within the organisation who can provide cover across the critical business
functions. This information will need to be circulated internally. The firm will also need to
re-evaluate their home and flexible working policies to ensure that employees can connect
to the office from home so that the business is able to maintain critical cover for the vital
operations. There will need to be company-wide access, to the web, audio and data
conferencing services. These measures will ensure that there is a seamless interaction
between the office, its staff, suppliers and customers.
The firm also needs to liaise with key customers and suppliers to ensure that any
contingency plans are dovetailed and that in the event of a disaster all parties understand
exactly who and how key personnel can be contacted.

Insurance governance and supervision

Risk Assessment Framework
Being part of a corporate governance process the regulatory risks that the IRDAI is
concerned with are:
 Financial failure;
 Misconduct;

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 Consumer understanding;
 Fraud or dishonesty;
 Market abuse;
 Money laundering;
 Market quality.
The firm risk assessment framework involves a series of structured stages that are
designed to focus the Regulator’s attention on the risks that matter and then to help them
devise a risk mitigation programme to address those risks.

IRDAI and corporate governance of outsourcing

If a firm outsources any aspects of its business, that part of the business cannot escape
the requirements of the IRDAI. This has particular relevance to claims handling as many
companies have outsourced this work to companies outside the insurance sector.
The main justification for State control is to protect the public, but this aim is also
accompanied by one relating to socially desirable measures. In the following list, the first
three items relate to protection and the last three to social measures:
• Maintain solvency: Perhaps the greatest step taken by legislation was to introduce
solvency margins that were related to premium income. In this way, a ratio was
established between the margin and the amount of business undertaken. This
prevented certain people, with fraudulent aims, from providing insurance and acted
as a continual monitor on those already transacting it.
• Equity: The term equity has been used, but equally suitable would have been
morality, fairness or reasonableness, as each implies the fact that an element of
fairness must exist between companies and policyholders. The insurance contract is
one of considerable complexity and it is essential that controls exist for the
protection of policyholders.
• Competence: Both the buying and selling of insurance are unlike many other forms
of product purchasing. A tangible product is not being purchased; a promise to
provide indemnity, an exact compensation, is what is being bought and sold. Those
who deal in such promises must be competent persons and able to fulfill their

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pledges when the need arises. Therefore, regulations are necessary in the
management of insurance and investment business.
• Insurable interest: Insurable interest is one of the basic doctrines of insurance.
Governments have found it necessary to introduce legislation in order to eradicate
any element of gambling. It was not acceptable that unscrupulous persons could
benefit by effecting policies of insurances where they had no financial interest in the
potential loss, other than the profit they would make if it occurred.
• Provision of certain forms of insurance: An element of intervention has been in
evidence where forms of cover have been made compulsory, as in the case of
employers' liability and third party motor accident injuries. The intervention is not in
the provision of cover by government, but in establishing the nature of the cover to
be granted.
• National Insurance: For some areas of social risk, the Government's intervention
has been total and it has assumed the responsibility for providing certain covers.
This has been the case in areas such as unemployment, sickness and widows'
benefits; the State carries the risk under the national scheme.

Corporate Governance guidelines for insurance Companies by

IRDAI
The objective of the guidelines is to ensure that the structure, responsibilities and
functions of Board of Directors and the senior management of the company fully recognize
the expectations of all stakeholders as well as those of the regulator. The structure should
take steps required to adopt sound and prudent principles and practices for the
governance of the company and should have the ability to quickly address issues of non-
compliance or weak oversight and controls. These guidelines therefore amplify on certain
issues which are covered in the Insurance Act, 1938 and the regulations framed
thereunder and include measures which are additionally considered essential by IRDAI for
adoption by insurance companies.
The Authority had initially issued Guidelines on Corporate Governance for insurance
companies vide circular dt. 5th August, 2009. The Authority had also issued separate
guidelines for appointment of reappointment and remuneration of MD/CEO/ WTD as well
as other Key Management Persons (KMPs), as also the Appointment of statutory auditors

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of insurers through various circulars. In view of the extensive changes to the governance
of companies brought about by the Companies Act, 2013, it was decided to review the
various guidelines of the Authority relating to the governance of insurance companies.
After due consultation with the industry representatives and other stakeholders and
professionals, the Authority has drawn out the revised Guidelines on Corporate
Governance for insurance companies. The revised guidelines combine the stipulations
regarding the Corporate Governance practices, appointment of MD/CEO/ WTD and other
KMPs as well as the appointment of statutory auditors of insurers. These are applicable
from FY 2016-17 onwards. These guidelines shall be applicable to all insurers granted
registration by the Authority except that:
(i) reinsurance companies may not be required to have the Policyholders' Protection
Committee; and
(ii) branches of foreign reinsurers in India may not be required to constitute the Board
and its mandatory committees as indicated herein.
All insurers are advised to ensure compliance with the guidelines in the following major
structural elements of Corporate Governance in insurance companies:-
• Board of Directors – Composition - Role & Responsibility - Fit & Proper Criteria -
Disclosures about Meetings of the Board & its Committees
• Control functions
• Delegation of functions of the Board –Mandatory Committees - Audit - Investment -
Risk Management - Policyholder Protection Committee - Asset Liability Management
(in case of life insurance companies) - Other Committees - Nomination and
Remuneration Committee - Corporate Social Responsibility - With Profit – ethics
(Non Mandatory Committee)
• Key Management Persons - MD/CEO/Whole-time Director - Appointed Actuary -
Statutory Auditors
• Disclosure Requirements
• Outsourcing Arrangements
• Interaction with & Reporting to the Authority (IRDAI)
• Whistle Blower Policy
• Evaluation of Board & Independent Directors

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The latest IRDAI Guidelines for Corporate Governance for insurers in India, Ref.:
IRDAI/F&A/GDL/CG/100/05/2016 Dated: 18th May, 2016 is attached to this chapter for
further reference.

REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. In India, relevant legislation for corporate governance framework is under
a. Companies Act, 1956 b. Board of Governors
c. Board of Directors d. Nominated directors
e. None of the above
2. For listed companies, the Listing rules are enforced by
a. RBI b. SEBI
c. IRDAI d. III
e. ICAI
3. In pursuance of the statutory mandate provided under the Companies Act,
1956, the Central Government prescribes accounting standards in consultation
with
a. The National Advisory Committee on Accounting Standards (NACAS)
established under the Companies Act, 1956.
b. RBI
c. SEBI
d. ICSI
e. NASCOM
4. The major objectives of IRDAI
a. Protect the interests of the policyholders and to regulate, promote and ensure
orderly growth of the insurance industry
b. Warnings and penalties to insurance companies

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c. Giving licenses to insurance companies

d. Giving licenses to insurance agents
e. Registration of corporate agents
5. The gatekeeping profession to guard against the governance failures.
a. Auditors and credit-rating agencies
b. Board of governors
c. Board of directors
d. Executive body
e. Non- executive body
6. ----------- is a person or co. that is offering or executing a hostile takeover by
buying shares directly from shareholders.
a. Corporate Raider b. Important shareholder
b. Publicly-traded company d. Privately-traded company
e. None of the above

Answers
1. a 2. b 3. a 4. a 5. a 6. a

SECTION – B
Short & Essay Questions
1. Discuss the structure and composition of the “Corporation”
2. Describe the Roles and functions of Directors
3. Describe the Duties, Responsibilities and Liabilities of Directors
4. Describe the need for and nature of Corporate Governance
5. Describe the evolution of corporate governance in India and discuss the
recommendations of various committees for good corporate governance.
6. What are the major areas of CG deals under Companies Act

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7. Distinguish the Internal and external Corporate Governance Mechanism

8. What are the risks specific to Insurance business? How good Corporate Governance
Mechanism helps to manage risks in Insurance business?
9. Describe the Corporate Governance guidelines for insurance Companies by IRDAI.

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 Part B

REINSURANCE
CHAPTER – 1
INTRODUCTION TO REINSURANCE
OUTLINE OF THE CHAPTER
1. Introduction
2. History of Reinsurance
3. Concept & Nature of Reinsurance
4. Reinsurance Value Chain
5. Functions of Reinsurance
6. Basics of a Valid Reinsurance Contract
7. Reinsurance Theory
8. Types of Reinsurance
9. Categories of Reinsurance
10. Difference between Coinsurance and Reinsurance
11. Common Terms
12. PML Underwriting
13. Inward Reinsurance Contracts
14. Business Strategy
15. Retrocession Arrangements
16. Reciprocal Trading
17. Questions
RISK MANAGEMENT AND REINSURANCE

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Understand the concept, need and function of a Reinsurance contract
• Differentiate between the different types of reinsurance contract
• Evaluate Premium sharing and claim liability under different varieties
• Know and understand the common terms in reinsurance
• Explain the coverage of Accident and Liability Reinsurance in Motor, Personal
Accident, Burglary, Jewelers block
• Comprehend scope of legal exposures to third parties and public, from products
sold etc.
• Describe the concept and coverage of Life Reinsurance
• Understand the intricacies of Inward Reinsurance business, Retrocession
Arrangements and Reciprocal Trading

Introduction
Reinsurance holds a greater role in the realm of insurance as primary insurers can latch
on to the business of insurance in an unshackled way as the risks they are exposed to,
constantly make them to look back with caution. Reinsurance provides them cushion
through risk transfer and a source to share their liability and increases their ability to
undertake huge risk exposures and undertake claims. Without reinsurance cover, it is
obvious that large claims might jeopardize the viability of individual insurers or even the
entire insurance system.
The simplest definition of Reinsurance may be found in the German Commercial Law
which states that “Reinsurance is the insurance of the risk borne by the insurer”
Reinsurance would not be possible without the existence of insurance and conversely,
insurers could not exist if it were not for reinsurers.
Reinsurance is an insurance of insured risk where the insurer retains a part and cedes the
balance of a risk to the reinsurer. This is done to facilitate a greater spread and reduce
liability on the part of the insurer. In other words, reinsurance is insurance of insured risk

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taken by insurance companies to protect their liability commitments beyond their net
capacity. It is the foundation on which the whole edifice of insurance rests. This is a widely
used risk transfer mechanism and provides the backbone to insurance industry.
Reinsurance is one of the major risk and capital management tools available to primary
insurance companies. furthermore, the period from the date of occurrence of an accident
to final settlement of the claim often extends to a number of years. In addition it is
sometimes impossible to judge to any accurate degree the maximum possible loss in
advance in dealing with risks which have possibility for high aggregation of limits for total
indemnity.
Therefore, an original insurer arranges reinsurance with a reinsurer who accepts part of
the risk of loss. The reinsurer may be another insurer who either accepts reinsurance in
addition to his direct insurance underwriting or he may be a specialist company who only
transacts reinsurance business, the insurer may effect either ‘direct’ with the reinsurance
company or through an intermediary – a reinsurance broker.
The progress in science and technology brought in its wake many revolutions the way in
which the companies operate today, thus making insurers to face more complex risks, with
substantial values at single locations and demanding special types of cover. The stakes
involved are considerable and in money terms very huge. The changing legal system and
the increasing court awards, the increasing number of potential liabilities and the
depreciation of the money are affecting in a cumulative fashion the cost of claims today.
Reinsurers help the industry to provide protection for wide range of risks. Practically all
classes of insurance can be reinsured. Virtually each insurer world-wide reinsures a part
of all business underwritten by him.
“Although the primary purpose of reinsurance is to avoid too large a risk concentration
within one company, it may be used to take advantage of the underwriting judgment of the
reinsurer, to transfer all or certain classes of substandard business to reduce the strain on
surplus caused by writing new business, to stabilize the overall mortality or morbidity
experience of the ceding company or in the case of newly organized small companies, to
obtain advice and counsel on underwriting procedures, rates and forms.”…Dr. Skipper. Jr.
Reinsurance business operations require considerable skill and expertise. With
competition among reinsurers growing, it is all the more challenging. From the cedent
company point of view certain aspects need consideration.

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a) Historic relationships: Cedent companies often prefer a reinsurance company which

is reputed and financially sound with a large customer base spread over a wide
geographical area. It is assumed that such companies can serve customers well.
However, there are cases wherein the small companies also carried on the business
successfully with exponential growth in their business.
b) Security: The cedent company, like a typical policyholder, is equally concerned with
the security and therefore it chooses a standard and established reinsurer.
c) Quality of service: The quality of service offered by a reinsurer also matters a lot.
The insurers and reinsurers have a duty to their respective shareholders to show
profits. Therefore, they are equally concerned with risk they undertake and its
financial consequences.
d) Pricing of the deal: The business offered to a reinsurer depends on the pricing deal
negotiated and settled. Reinsurance comes at a cost to the primary insurer and a
prudent analysis must be undertaken to see that the benefits and costs involved in
taking a reinsurance policy provide protection to the reinsured.
The reinsurers should, at the same time, think in terms of their business prospects and not
ending up in losses. Therefore, they may prefer a retrocession policy to cover up their risk.
A retrocession is placed to afford additional capacity to the original reinsurer’s risk.
Reinsurers should have strong focus and consider the industry’s competition and
dynamics to meet the requirements of their customers.

History of Reinsurance
In the early days of insurance, as there is no facility of reinsurance, an insurer accepted
only those risks that could be entirely handled by him. The origin of reinsurance dates
back to the fourteenth Century when the Lombardians began to develop the concept of
reinsurance. The need for reinsurance was first felt in marine business, where there was a
concentrated risk with a recognized catastrophe hazard. The oldest known contract with
the legal characteristics of a reinsurance contract occurred in Genoa in 1370. Soon marine
insurance developed rapidly and became a common practice throughout Europe. The
earliest statutory reference to reinsurance was an Ordinance of Louis XIV in 1681, when it
was promulgated that “it shall be lawful to the insurers to make reassurance with other
men of those effects which they had themselves previously insured”. Marine reinsurance

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was permitted by British legislation only when the insurer died or became insolvent or
went bankrupt. This prohibition continued until 1864. Fire reinsurance appears to have
developed much later. The first fire reinsurance was found in a royal concession granted
to the Royal Chartered Fire Insurance Company of Copenhagen in 1778. One of the
earliest recorded fire reinsurance transactions took place in 1813 when the Eagle Fire
Insurance Company of New York assumed all of the outstanding risks of the Union
Insurance Company, but it was never really executed, as the insurer did not avail this
facility. However, in the year 1821 a fire reinsurance treaty was executed between the
National Assurance Company, Paris (the reinsurer) and the United Proprietors of Belgium.
It is the Supreme Court of New York, in the year 1837 that provided real boost to
reinsurance by upholding the contract of reinsurance in the case of New York Browery
Insurance Company, the cedent and the New York Fire Insurance company, the reinsurer.
One of the earliest reinsurance companies are the Cologne Reinsurance Company
established in 1846 and started operations six years later. The Company is still in
existence and is thus the oldest professional reinsurance company. The Swiss
Reinsurance company which started its business in 1863 is the first reinsurance company
to be founded in Switzerland. The Munich Reinsurance company was formed in 1880. The
disruption of the two world wars resulted in London developing into a substantial
reinsurance market. The development was further aided by Lloyds’ increased involvement
in reinsurance and the spread of excess of loss covers which were predominantly written
by Lloyds. Of the total business written at Lloyds now, reinsurance constitutes a significant
proportion.
Now reinsurance has spread all over the world especially for offshore risks, wide bodied
jets, satellite and petrochemical risks. Development of reinsurance exchanges in the USA
and tax concessions in Bermuda, Panama, Hong kong and Singapore have also helped in
the development of reinsurance.
In the beginning, reinsurance was done mostly in the area of facultative transactions. With
the progress of industry and commerce in 19th Century the innovative forms of coverage
came into operation, giving rise to automatic forms of reinsurance known as treaties,
which became an indispensable part of a company’s operations today. By the time of
World War-I, proportional treaties became the main vehicle replacing facultative
reinsurance that proved costly to administer and slow to operate besides being inflexible.
The invention and technique of excess of loss cover was the most significant development

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in reinsurance in the past 100 years. This form of reinsurance filled a real gap for property
policies which were extended to cover catastrophe hazards.
By 1850 there were already 306 insurance companies in 14 countries. In 1900, this
number reached 1272 in 26 countries and in 1910, 2540 in 29 countries. Today more than
10,000 insurance companies are working in over 100 countries in addition to some 2600
agencies.
In brief the history of reinsurance is summarized in the given in the table below:
History of Reinsurance

1370 First recorded reinsurance contract covering a ship sailing from Genoa to
Bruges.
1688 Opening of Lloyd’s Coffee House in London, which became a leading
reinsurance market.
1820 First fire reinsurance treaty in Germany.
1852 Cologne Re – the first independent reinsurance company – began writing
business following the Great Fire of Hamburg in 1842.
1863 The predecessors of UBS and Credit Suisse formed Swiss Re in Zurich
following a large fire in Glarus, which destroyed two-thirds of the town.
1880 Munich Re was established in Germany.
1885 The first excess of loss reinsurance was sold by Cuthbert Heath at Lloyd’s.
1906 The San Francisco earthquake demonstrated the ability of the reinsurance
market to fund catastrophic losses.
1967 Berkshire Hathaway bought National Indemnity, its first reinsurance
business.
1985/86 ACE and XL were established in Bermuda.
1993 Bermuda’s Class of ’93 was capitalised with over $3.5 billion following
Hurricane Andrew in August 1992. New reinsurance companies included
Renaissance, Partner and Tempest (now part of Chubb).

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1998 Piper Alpha North Sea offshore platform disaster was one of the triggers of
the ‘LMX spiral’ that almost caused the Lloyd’s market to collapse.
2001 The Class of ’01 (AWAC, Arch, Aspen, AXIS, Endurance, Montpelier and
Platinum) raised more than $8 billion following the 9/11 terrorist attacks.
2005 Following Hurricanes Katrina, Rita and Wilma (and Charley, Francis Ivan
and Jeanne the year before) the reinsurance industry was recapitalised with
the Class of ’05. New companies including Ariel, Lancashire and
Validusraised over $5 billion. In addition to this, several London Market
companies followed Catlin in capitalising Bermuda-based entities and
investors used sidecars on a large scale to access the reinsurance market.
2011 Record losses for the reinsurance industry following a series of loss events
including floods in Thailand, tornadoes in the US and earthquakes in Japan
and New Zealand. No new reinsurers were established but the inflows to
insurance-linked funds accelerated.
2012 Hurricane Sandy caused significant destruction in the US North East.
2015 A record 19% of property catastrophe limit was ‘alternative’ capital including
catastrophe bonds and collateralised reinsurance.
(Source: Hedging Hurricanes by Adam Alvarez, www. [Link])

Concept & Nature of Reinsurance

Reinsurance as its name implies, has developed from insurance and the extent of its use
will depend not only upon the amount but also upon the characteristics of he risks to be
underwritten by the direct insurer. Thus, the volume of reinsurance which can usefully be
transacted depends primarily upon the volume of direct business available at any given
time.
Reinsurance may be defined as a contractual arrangement under which one insurer,
known as the primary insurer, transfers to another insurer, known as the reinsurer, some
or all of the losses to be incurred by the primary insurer under insurance contracts it has
issued or will issue in the future. Reinsurance is a contract of indemnity, even in life
insurance and personal accident insurance.

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The primary insurer is sometimes referred to as the ceding insurer, ceding company,
cedent, or reinsured.
Reinsurers also may reinsure some of the loss exposures they assume under reinsurance
contracts. Such a transaction is known as retrocession. The insurer or reinsurer to which
the exposure is transferred is known as a retrocessionaire and the reinsurer transferring
the exposure is called the retrocedent.
Retrocession agreements do not differ greatly in detail from reinsurance agreements.
In almost all cases, the reinsurer does not assume all of the liability of the primary insurer.
The reinsurance agreement usually requires the primary insurer to keep or retain a portion
of the liability. This is known as the insurer’s retention and may be expressed as a
percentage of the original sum insured or a specified quantum.
In other words, reinsurance is insurance of the insured risk taken by insurance companies
to protect their liability commitments beyond their limit.

How Does Reinsurance Work?

When a primary insurer meets its reinsurance needs by entering into multiple
contracts with more than one reinsurer, the resulting package of agreements is
known as a reinsurance programme. The advantage of a programme rather than a
single reinsurance contract with a single reinsurance company are flexibility and
control for the company. The ceding company retains maximum flexibility to adapt
the programme as its needs change over time. Naturally, the programme is also
designed to be as cost effective as possible for the ceding company.

Reinsurance Value Chain

A reinsurance company insures insurance companies. Insurance companies buy
reinsurance for two related reasons: as an alternative to capital and to reduce the volatility
of their results. A single building, oil rig, or board of directors can be insured by multiple
insurers each of which may in turn buy reinsurance from multiple reinsurers. Reinsurers
themselves buy cover called retrocession. This web of contracts, enables very large
claims to be absorbed by a global network of companies.

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The simplified schematic on the below shows the traditional reinsurance hierarchy. The
policies that link each entity represent a promise to pay certain losses. Rating agencies
such as AM Best and S&P provide a guide to each entity’s ability to pay. In recent years,
insurance-linked funds have been participating at every stage of the reinsurance chain.
Figure
Reinsurance Value Chain

Nature of Reinsurance Contract

Reinsurance contract is always a contract of indemnity, even in life and personal accident
insurance, because it protects the insurer from a diminution of his property, caused by
insurance policy obligations. Whereas insurance us a contract between the insurer and the
insured, reinsurance is a separate contract between the insurer and the reinsurer. Each of
these contracts are independent of the other.
Factors which influence the results of reinsurance:
1. Risks emanating from the Insured (Original Risk): these risks are also known as
technical risk run by granting a cover through an insurance policy. There is also
contractual risk originating from a fraudulent, unjustified exaggerated claim.

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2. Risks emanating from the insurer or the reinsurer: these include improper business
administration (negligence, incapacity) on the part of the insurer which can increase
the risk run by the reinsurer. Deficient underwriting practices or methods, hastily
business development of business, inefficient technical assistance, can influence the
results.
3. Risks beyond the control of the contractual parties: these risks include exchange
risk, inflation, fiscal risks in countries facing deficit budgets. Investment budgets,
technical reserves when carefully planned can mitigate these risks.
4. Risks inherent to reinsurance: As a reinsurer must work on a basis as possible and
consequently grant cover to as many companies as possible, the reinsurer runs the
risk of accumulation of exposure from any single event or risk.
5. Uberrima Fides: a reinsurance contract is essentially based on the principle of
Utmost good faith. In mutual interest a cedent must provide the reinsurer with
detailed information on his portfolio both during the negotiations preliminary to the
conclusion of the treaty and then for the period of its validity.
6. Insolvency of Ceding Insurer: The reinsurer as per the contract of reinsurance
follows the fortune of the insurer from the technical point of view. He shares only the
insurance fate of the insurer and not the commercial fate. Even in case, the insurer
becomes insolvent, the reinsurer as per the agreement has to pay the entirety of his
share of loss, after deducting balances due to him, whilst the insure pays a partial
compensation to his insured.
7. Insolvency of the Reinsurer: The reverse situation occurs in this case. The ceding
insurer is fully responsible for the total amount due to the insured irrespective of the
fact that he cannot recover the share of reinsurer or any part of it.
Under ideal conditions, the contractual relationship between a reinsured and its reinsurer
is a long-term, mutually beneficial relationship. The mutual obligations found in the
reinsurance contract are derived from the principles of fairness and good faith, which
culminate in the standard of ‘utmost good faith’ between the reinsured and reinsurer.
Indeed, reinsurance agreements are often referred to as ‘honorable engagements’,
generally intended to be viewed as statements of industry custom and understanding and
concerned above all with perceived intention of the parties rather than the strict
interpretation of contract provisions.

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Adverse Selection: conscious and deliberate submission by a reinsured company to a

reinsurer of those risks, segments of risks, or coverage that appear less attractive for
retention by the reinsured.
Primary: In reinsurance, this term is applied to the nouns: insurer, insured, policy and
insurance and means respectively:
• The insurance company which initially originates the business – the ceding
company;
• The policy holder insured by the primary insurer;
• The initial policy issued by the primary insurer to the primary insured;
• The insurance covered under the primary policy issued by the primary insurer to the
primary insured (sometimes called ‘underlying insurance’).
Reinsurance premium: Consideration paid by a ceding company to a reinsurer for the
coverage provided by the reinsurer.
Treaty: A reinsurance contract under which the reinsured company agrees to cede and the
reinsurer agrees to assume a particular class or classes Insurance business automatically.

FUNCTIONS OF REINSURANCE
Reinsurance is needed because of severe natural catastrophes, like floods. The reasons
for increasing reinsurance demand by primary insurers include:
• Risk of random fluctuation: e.g. Actual loss may differ from the expected loss
• Risk of error: e.g. Misjudging probability and severity of losses
• Risk of change: e.g. Probability and severity change in the course of time
• Expanding the scope of primary insurers
• Underwriting capacity — wherein an insurer can take on higher commitments with
reinsurance
• Substitute equity easier for insurers to complying with solvency regulation Balance-
sheet continuity
• Reinsurance covers can stabilize annual accounts of insurers

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• Aim is to provide “added value” for the primary insurer

• Product development
• Example: Insurer has no past experience on his own such as training
• Example: Development of East European insurance markets in Claims management
• Example: Infrequent and very large claims
Therefore, the functions of reinsurance can be summarized as follows:

1. Stabilization of Loss Experience

The primary insurer, despite the best forecast of losses, may yet find the loss ratios to be
erratic, in the sense that there will be some years when the losses are least, but in other
years the losses may be substantial. Such an inconsistent trend may make the insurance
business risks and rather unprofitable. Profits are necessary to attract and retain capital
and to increase the capital and surplus.
When a primary insurer purchases reinsurance, its losses are limited to retention. With
reinsurance, whenever the loss exceeds retention, the primary insurer does not have to
bear the excess loss as it is already reinsured and mathematically the primary insurer’s
loss level will stabilize at the planned level.
The following table illustrates how reinsurance provides the primary insurer stability in its
underwriting results through reinsurance.
Stabilization of Loss experience of a Primary Insurer for a Line of Business
Years Actual Loss Amount reinsured Stabilized Loss level
(Rs. in thousands) (Rs. in thousands) (Rs. in thousands)
1 200 - 200
2 450 50 400
3 260 - 260
4 160 - 160
5 820 420 400
6 740 340 400
7 330 - 330

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8 185 - 185
9 120 - 120
10 215 - 215
Average Annual Losses Rs. 3,48,000.
The aggregate loss over a ten-year period is Rs. 34,80,000 or an average of Rs. 3,48,000
each year. If a reinsurance agreement were in place to cap losses to Rs. 4,00,000, the
primary insurer’s loss experience would be limited to the amounts shown in the ‘stabilized
loss level’ column.

2. Large-line Capacity
Large line capacity refers to an insurer’s ability to provide a higher limit of insurance on a
single loss exposure. In the commercial and industrial world, there are many items of
property, which are of high value, say exceeding Rs. 100 cores. Instances are: a high rise
building, a ship, an aircraft and so on.
Individually, many primary insurers would be unable to retain such a large amount of
insurance on a single loss exposure without reinsurance. Besides, governments regulate
the capacity of insurance and put a cap on the amount of insurance an individual insurer
can write on a single loss exposure. In practice, the limit varies, but it may be stated that
generally state regulators in the US prohibit a primary insurer from writing an amount of
insurance in excess of 10 percent of its policy holder’s surplus on any one loss exposure.
However, when the primary insurer has the reinsurance facility, he can write a large line,
keeping his retention within his stipulated maximum in relation to its capital and surplus
and reinsuring the balance of the risk.

3. Financing Surplus Relief

In practice, as if by convention, most insurers limit the amount of premiums they can write,
making it a function of the policyholders’ surplus. For example, if the net written premiums,
after deducting premiums on reinsurance ceded, exceed the policyholders’ surplus by a
ratio of more than 3 to 1, it means the insurers have exceeded their capacity. In other
words, a ratio below 3 to 1 is favorable.

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In the case of the insurer with growth targets, the premium to surplus ratio will tend to go
over 3 to 11. This is because there will be shrinkage of the surplus resulting from the
prepaid expense portion of the unearned premium as agent’s commission is charged
against surplus.
According to insurance regulations in force, every insurer is required to establish an initial
unearned premium reserve equal to the total premium for the policy and then recognize
the income over the life of the policy. The insurer has to charge the expenses immediately
against income and does not amortize them throughout the policy period since most of
these expenses are incurred at the inception of the policy. Since the insurer has not yet
earned any income, initial expenses are paid out of surplus. This is referred to as the
surplus drain as a result of growth in written premium.
The financing function of insurance is called surplus relief because of the reduction of the
surplus drain, by using reinsurance.
Example 1 1
A ceding company wants to create surplus relief and strengthen its balance sheet. The
reinsurer agrees to assume 50% quota share of all premiums and losses. The reinsurer
will pay 30% commission on the premium assumed.

Balance Sheet before the Quota Share

Liabilities / Surplus Assets
Unearned Premium Reserve 80,00,000 Cash/ Premium 80,00,000
Other 1,20,00,000 Other 1,40,00,000
Surplus 20,00,000
2, 20,00,000 2, 20,00,000
Balance Sheet After the Quota Share
Liabilities / Surplus Assets
Unearned Premium Reserve (2) 40,00,000 Cash/ Premium (1) 52,00,000

1 Adapted from Munich Re- A Basic Guide to Facultative and Treaty Reinsurance

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Other 1,20,00,000 Other 1,40,00,000

Surplus (3) 32,00,000
1,92,00,000 1,92,00,000

Notes
1 80,00,000 Cash before
- 40,00,000 Paid to reinsurer (50%)
+ 12,00,000 Commission from reinsurer (30%)
52,00,000
2 Unearned premium reserve (before) less 50% ceded to reinsurer
3 20,00,000 Surplus before
+ 12,00,000 Commission from reinsurer (30%)
32,00,000 Surplus after

4. Catastrophe Protection
Catastrophe is a large loss to the community, resulting from such natural disasters as
earthquakes, hurricanes, plane crashes, industrial explosions, terrorist attacks etc. This is
a fundamental risk spread over the community. The September 11 attack in New York in
USA is a case in point. Total industry losses usually reach several crores of rupees for one
such catastrophe and, without reinsurance support, the primary insurer cannot write large
amounts of catastrophe insurance. Since catastrophes are major causes of the instability
of losses, one may say that this purpose of reinsurance is closely related to the purpose of
stabilizing loss experience.

5. Underwriting Assistance
In general, reinsurers have good expertise in underwriting different classes of insurance all
over the world. This expert knowledge available with the reinsurer can be beneficially
shared with many small and medium sized primary insurers. This service of reinsurers is
very important in all fields of insurance. Reinsurers must be careful in offering advisory
services and have to ensure that they do not reveal proprietary information obtained
through confidential relationships with other primary insurers.

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6. Withdrawal from a territory or class of business

Many a time, a primary insurer will be under pressure to withdraw from a region or class of
business. There are strategic disadvantages in pulling out of a territory, as this is likely to
affect its future business.
That is why in the modern day, primary insurers, in spite of pulling out of a region try to
place 100% reinsurance. This process of reinsuring all losses for an entire class, territory
or book of business is known as portfolio reinsurance.

Basics of A Valid Reinsurance Contract

The legal principles which as applicable to a contract of insurance between insurers and
insured are applicable to a contract of reinsurance between reinsurers and the reinsured.
The following basic criteria must be met by a reinsurance contract.
a) Contract of Reinsurance is a contract of insurance.
b) It is a separate contract distinct from original contract of insurance. The persons or
firms insured by the primary insurer are not parties to the contract and usually have
no rights under the reinsurance contract.
c) It is a contract of indemnity on the same risk as the original contract of insurance.
d) Both contracts are in existence at the same time.
e) There must be transfer of risk from one party to another.
f) Reinsurance must be between two insurance entities.
g) The insurance operators are recognized by regulators.
h) All the transactions between a ceding company and a reinsurer must be conducted
on the principle of ‘utmost good faith’.
The availability of reinsurance makes it possible for policyholders to obtain all of their
insurance from one insurer instead of buying it in bits and pieces from several insurers.
This simplifies the problems of buying insurance. The availability of reinsurance helps to
maintain the solvency of primary insurers with obvious advantages to policyholders.
Reinsurance makes it possible for small insurers to compete effectively against larger
ones, thus increasing the options available to buyers of insurance.

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Types of Reinsurance Business

There are two approaches that reinsurers adopt for securing business:
1. Direct writing
2. Through Brokers
Reinsurance companies solicit reinsurance business directly through their employees as
well as through reinsurance broking companies.
Similarities and differences between insurance and reinsurance:
Similarities Differences
1. Principle of utmost good faith 1. Liability of reinsurers is several, not joint.
2. Principle of indemnity 2. Broad scope of reinsurance agreements.
3. Conditional contracts 3. ‘Follow the fortunes’ principle.
4. Contract of adhesion. 4. Not a contract of adhesion.

Reinsurance Theory
Definition of Reinsurance 2 1F1F

Reinsurance refers to a mechanism that an insurer uses to obtain protection against some
or all risks associated with the insurance policies it issues. Typically, this process involves
an assuming reinsurer who, for a consideration, indemnifies the ceding or direct insurer
against some or all of the loss it may incur under a policy or policies it has issued. From
here on, the term “insurer” is used to mean the direct or ceding insurer and the term
reinsurer is self-explanatory.
Several important consequences flow from this definition:
• Direct insurer liability to policyholder. The direct insurer remains fully liable tothe
policyholder to whom policies were issued. In general, policyholders areunaware of
any reinsurance arrangements. If the direct insurer defaults or fails, policyholders do
not have a direct claim on reinsurers.

2Insurance Supervision Core Curriculum International Association of Insurance Supervisors (IAIS).

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• Risk transfer. Reinsurance transfers risk undertaken by the direct insurer.

Establishing whether the risk is transferred properly requires identifying the risk(s)
transferred, quantifying the risk(s) transferred, quantifying the considerations and
benefits involved and assessing whether the risk(s) transferred and considerations
involved are appropriate to each other. The term reinsurance does not include
specific insurance that an insurer may take out to address risks it has not
underwritten, such as workers’ compensation insurance taken out by the insurer to
cover injuries to employees. It is also possible that the insurer may choose to “self-
insure” such risks if doing so is legally permitted and if the appropriate expertise,
controls and processes are in place. Issues relating to self-insurance are not
pursued here.
• Retrocession. A reinsurer may transfer to other reinsurers some of the risk
assumed. This is a common occurrence. Conceptually there is little difference
between a retrocession by a reinsurer to another reinsurer and reinsurance between
a direct insurer and a reinsurer, except that the retrocession is a transaction
between “peers.”
• Alternative processes. The risk transfer process does not necessarily require the
involvement of another (re)insurer. Other risk transfer approaches may serve the
same purpose as reinsurance in certain circumstances. This module focuses on
reinsurance, although some alternatives are mentioned.
• Process risks: The implementation of reinsurance arrangements contains a number
of risks that need to be considered. Reinsurance basis risk is the risk that there
insurance cover might prove insufficient for the risk in question because the need for
reinsurance has not been precisely identified. This may occur if the insurer
incorrectly identifies the need for reinsurance or incorrectly describes the need to
reinsurers. This might occur if relevant clauses in the reinsurance contract are
inappropriate or omitted. Also, the wording of reinsurance contracts may be
incompatible with the underlying insurance contracts, particularly in harder
reinsurance markets when greater exclusions may be applied.
• Operational risk-is the risk that the people, process, or systems on which the
management and execution of the reinsurance process depend will fail or be
inadequate.

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• Outsourcing risk- may also arise. Reinsurance arrangements are subject to the
same risks as other outsourced functions. These risks may be exacerbated when a
reinsurer is domiciled outside the supervisor’s (and, most likely, the direct insurer’s)
jurisdiction.
• Reinsurance credit risk- While the insurer may pass risk to the reinsurer, the
insurer takes on some risks, of a different nature, as a consequence. In particular,
the insurer takes on the risk that its reinsurer might fail and so void the reinsurance
coverage.
• Specialization: A given insurer may be a direct insurer for certain risks, but are
insurer for other risks. This gives rise to the use of the terms outward reinsurance
and inward reinsurance (sometimes called reinsurance assumed) to describe the
two directions in which the reinsurance arrangement may flow. While insurers may
be specialist reinsurers or specialist insurers, it is not uncommon for insurance
entities to be involved with both outward and inward reinsurance. From a
supervisory perspective, it is important to recognize the different issues relating to
whether the entity is seeking or providing reinsurance to other insurers.

Types of Reinsurance
There is no single kind of reinsurance that effectively serves all purposes. Several kinds of
reinsurance have developed to serve the various functions listed in the preceding chapter.
While reinsurance contracts can be categorized in several ways, one basic categorization
is between facultative reinsurance and treaty reinsurance. In facultative reinsurance, the
primary insurer and reinsurer negotiate reinsurance contract for each risk separately.
There is no compulsion for the primary insurer that it should purchase reinsurance on a
policy that it does not wish to insure. Likewise, there is no obligation on the part of the
reinsurer to reinsure proposals submitted to it. The reinsurer has the option of either
accepting or declining a proposal. Facultative reinsurance may be either proportional or
non-proportional.
Facultative reinsurance is now widely used for reinsuring hazardous risks not covered by
treaty arrangements, for the purpose of reducing the insurance in certain area, for
reducing the treaty reinsurers’ liability, to augment risk capacity and to get advice of the
reinsurer on risks that are considered new and complicated.

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In the treaty reinsurance there is a prior agreement between the primary insurer and
reinsurer whereby the former reinsures certain lines of business in accordance with the
terms and conditions of the treaty and the latter agrees to accept the business that falls
within the scope of the agreement. An obligation is imposed that all policies that come
within the terms of the treaty are required to be placed with the reinsurer. Similarly, the
reinsurer cannot decline risks that come within the terms of the treaty.
Given that the treaty reinsurance guarantees a definite amount of reinsurance protection
on every risk which the primary insurer accepts, treaty reinsurance works out to the
cheaper than the facultative reinsurance.
Though there seems to be a clear distinction between facultative and treaty reinsurance,
there are some insurance contracts, called facultative treaties, which are hybrid in nature.
The Reinsurance Association of America defines a facultative treaty as “a reinsurance
contract under which the ceding company has the option to cede and the reinsurer has the
option to accept or decline classified risks of a specific business line. The contract merely
reflects how individual facultative reinsurance shall be handled”. Sometimes a facultative
treaty is referred to as facultative obligatory treaty or automatic facultative treaty. Under
this, the primary insurer may submit risks within a specified class which the reinsurer is
obligated to accept, if ceded. As this type of reinsurance provides plenty of opportunities
for adverse selection, reinsurers exercise abundant caution in selecting primary insurers.
The Facultative Obligatory Treaty which is not very common is a combination of facultative
and treaty forms of reinsurance.

Proportional and Non-Proportional Reinsurance

Another system of classifying reinsurance is dependent upon the way in which the
obligations under a reinsurance contract are divided between the reinsurer and the
primary insurer. Pro-rata reinsurance or proportional reinsurance and excess of lossor
non-proportional reinsurance are the two approaches for sharing losses.
Under Pro-rata or proportional reinsurance (also called participating reinsurance) the
premium as well as the losses are shared between the primary insurer and reinsurer in the
agreed proportions. For instance, if the reinsurer covers 25 per cent of the risk under a
given policy, he also receives 25 per cent of the premium and has to pay 25 per cent of
each loss under the policy, irrespective of the size of the loss. Under pro-rata insurance

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treaties, the primary insurer receives from the reinsurer a ceding commission in order to
cover his expenses and possibly an allowance for profit.

Excess of Loss Reinsurance or Non-Proportional Reinsurance

Under this, no amount of insurance is ceded. This reinsurance arrangement will not come
into effect until the primary insurer has sustained a loss exceeding his retention under the
contract and is covered by the excess of loss agreement.
It is to be noted that both facultative reinsurance and treaty reinsurance can be written as
a pro rata or excess of loss or a combination of the two.

Various ways of classifying Reinsurance

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Various Types of Reinsurance

Categories of Reinsurance
Excess of loss reinsurance written on a facultative basis is always per risk or per policy
excess basis. Per occurrence and aggregate excess of loss reinsurance relate to a class
of business, a territory, or the primary insurer’s entire book of business rather than a
specific policy or a specific loss exposure. A financial reinsurance agreement can be
written for any of the above types of reinsurance.

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Categories of Reinsurance

Adopted from Micheal W. Elliott, Bernard L. Webb, Howard N. Anderson and Peter R Kensicki,
Principles of Reinsurance Vol.1 (Malvern, PA: Insurance Institute of America, 1955), pp. 5, 148
Source: Webb. B.L; [Link]., Insurance Operations, Vol. 2, Second Edition, American Institute for
Chartered Property Casualty Underwriters, Malvern, PA., 1997
Treaty Reinsurance
Treaty reinsurance has become popular with primary insurers because of its several
advantages over facultative reinsurance. As the reinsurer has to necessarily accept all
business that falls within the terms of the treaty, the primary insurer, with no prior
consultation with the reinsurer, can underwrite, accept and reinsure such business on
each application submitted to him. Because of the absence of prior negotiations with the
reinsurer, the transaction cost on each policy is lower under treaty reinsurance than under
facultative reinsurance.
As shown in above figure Treaty Reinsurance is subdivided into
(i) Pro Rata or Proportional Reinsurance Treaties and
(ii) Excess of Loss Reinsurance Treaties
Pro-rata reinsurance whether belonging to property or liability reinsurance involves sharing
of agreed proportion of original premium and the claims. The excess of loss reinsurance is

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considered loss effective in this regard. The greater effectiveness of pro-rata treaties lies
in two directions.
(i) The practice of paying ceding commission which is not common under excess of
loss treaties.
(ii) The premium for a pro-rata treaty is likely to be a larger percentage of the of the
original premium that in the case of an excess of loss treaty
There are two kinds of treaties in the pro rata category; namely
(a) Quota Share Treaty Reinsurance and
(b) Surplus Share Treaty Reinsurance
Similarly there are three general classes of excess of loss treaties (sometimes referred to
as non-proportional treaties). They are
a) Per risk excess treaty or per policy excess treaty
b) Per occurrence of loss treaty
c) Aggregate excess treaty

Quota Share Treaty

In Quota share contracts the Cedent binds himself to retain and cede a fixed proportions
of all the business it underwrites up to a fixed amount within the class or classes subject to
the treaty. Even the smallest risks are reinsured.
For example, if the Ceding Company shall retain for own account 40% of all burglary
business, with an underwriting limit of Rs. 50,000 per risk, the Cedent shall reinsure with
the Reinsurer, who agrees to accept a 60% share of all burglary business. The reinsurer
receives the same percentage of the premium less the ceding commission as it does of
the amount of insurance and pays the same percentage of each loss. In the U.S. Quota
Share treaties are much more common with property coverages than liability coverages.
The advantages of the system are particularly appropriate in the following cases:
1. When a company commences business in a line of business for which no statistics
exist; here the Reinsurer participates in the underwriting of each policy, large and
small and pays in the same proportion its share of the losses.

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2. To simplify administrative work and reduce cost.

3. If the loss ratio is uncertain and cannot be corrected immediately quota share
reinsurance provides relief for a limited period of time.
An example of quota share treaty is given below:
Assume that ABC Insurance Company has purchased from XYZ Reinsurance Company a
quota share treaty a retention of 30 percent and a cession of 70 percent with a limit of Rs.
8,00,000. Policy No.1 insures a building for Rs. 2,00,000 for a premium of Rs. 800. A loss
of Rs. 50,000 is reported. Policy No.2 insures a building for Rs. 3,00,000 for a premium of
Rs. 1,500. A loss of Rs. 80,000 is reported. Policy No.3 insures a building for Rs. 4,00,000
for a premium of Rs. 1,700. A loss of Rs. 90,000 is reported. Show how the insurance,
premiums and losses under these policies will be divided between the primary insurer and
reinsurer.
Division of insurance, premium and losses under quota share treaty
ABC Insurance Co. XYZ Reinsurance Total
(30 percent) Company
(Rs.) (70 percent)
(Rs. )
Policy No.1
Insurance 60,000 1,40,000 2,00,000
Premium 240 560 800
Loss 15,000 35,000 50,000
Policy No.2
Insurance 90,000 2,10,000 3,00,000
Premium 450 1,050 1,500
Loss 24,000 56,000 80,000
Policy No.3
Insurance 1,20,000 2,80,000 4,00,000
Premium 510 1,190 1,700
Loss 27,000 63,000 90,000

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It is seen that the share of the primary insurer and the reinsurer in insurance, premium and
loss remains the same in each policy, the rupee amount of retention by the primary insurer
increases as the amount of insurance increases.
The Quota Share Treaty has the main disadvantage of ceding by primary insurer of a large
share of presumably profitable business. Another disadvantage is it is not effective in
stabilizing underwriting results as it does not influence the primary insurer’s loss ratio.
Surplus Share Treaty
Surplus share treaty is also a pro-rata or proportional reinsurance. Under a surplus treaty,
the ceding company decides the limit of liability (rupee amount) which it wishes to retain
on any one risk or risks and reinsures only the surplus over and above its own net
retention. If the sum insured under the policy is within the net retention of the company,
there will be no cession to the reinsurer. Thus, the company will be able to retain for its
own account such risks.
It is usually arranged in terms of number of lines of retention. The amount retained by the
ceding company for its own account is called the net retention or a line. Thus a surplus
treaty may be of ten or twenty lines capacity, which means that the ceding company can
assume cover on risks with sums insured ten or twenty times its own retained line.
The following illustrative example is helpful for our understanding:
ABC insurance company has purchased from XYZ Reinsurance company a surplus treaty
with a retention of Rs. 2,00,000 and a limit of Rs. 20,00,000. This is referred to as a ten-
line surplus treaty. The primary insurer (ABC Insurance Company) will cede coverage upto
ten times the retention amount. The given below illustrate how the surplus share treaty
would apply to the same three policies shown below table:

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Division of insurance, premium and losses under surplus share treaty

ABC Insurance XYZ Reinsurance Total

Co. (percent) (Percentage ceded) (Rs.)
(Rs.) (Rs. )
Policy No. 1
Insurance 2,00,000 (100%) 0 (0%) 2,00,000
Premium 800 0 800
Loss 50,000 0 50,000
Policy No. 2
Insurance 2,00,000 (66.67%) 1,00,000 (33.3%) 3,00,000
Premium 1,000 500 1,500
Loss 53,333 26,667 80,000
Policy No. 3
Insurance 2,00,000 (50%) 2,00,000 (50%) 4,00,000
Premium 850 850 1,700
Loss 45,000 45,000 90,000

As is seen in case of Policy No.1, there is no ceding as the amount of insurance is equal
to Rs. 2,00,000 retention. For Policy No.2, the proportion in which premium and losses are
shared between ABC Company and XYZ company is determined by retention divided by
the insurance amount. Similarly with Policy No. 3.
It is again seen that under a surplus share treaty for insurance amounts above the
retention, the rupee amount of retention remains constant while the percentage retention
decreases as the amount of insurance increases.
The main advantage to the primary insurer of the surplus share treaty is the avoidance of
ceding insurance on small loss exposures as he can afford to retain them. The primary

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disadvantage in comparison with quota share treaty to the increased administrative

expense.
Characteristics of Surplus Share Treaty and Quota Share Treaty

S. Surplus share treaty Quota share treaty

No.
1. Often property only. Both property and casualty.
2. Sharing of percentage isvariable. Sharing of percentage isfixed.
3. Individual cessions. No individual cessions.
4. Reinsurer’s premium is thepercentage Reinsurer’s premium is the percentage
of the original premium less a of thepremium less a negotiated ceding
negotiated ceding commission. commission.
5. Provides large line capacity. Provides a limited line capacity.
6. Premiums and losses are settled by Premium and losses are settled by
account. account.

Given below is an example on calculation of premium in a surplus share treaty.

Munich insurance company entered into two surplus treaty contracts with the reinsurers.
The first surplus treaty consisted 10 lines with a maximum liability of Rs. 30,00,[Link]
second surplus treaty consists of 20 lines with a maximum liability of Rs. 50,00,000.

Risk Risk gross sum Insured Retention Applicable

(Rs.) (Rs.)
1 2,00,000 2,00,000
2 3,00,000 1,00,000
3 12,00,000 2,00,000
4 30,00,000 4,00,000
5 65,00,000 2,00,000

Calculate the cessions to first surplus treaty and to second surplus treaty.

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Solution:

Risk Gross sum Retention [Rs.] Cessions to 1st Cessions to 2nd

insured [Rs.] surplus treaty surplus treaty
[Rs.] [Rs.]
1 2,00,000 2,00,000 Nil
2 3,00,000 1,00,000 2,00,000 Nil
3 12,00,000 2,00,000 10,00,000 Nil
4 30,00,000 4,00,000 26,00,000 Nil
5 65,00,000 2,00,000 20,00,000 40,00,000
Balance of Rs. 3,00,000 has to be arranged facultatively.
Excess of Loss or Non-proportional Treaties
Non-proportional reinsurance arrangements are characterized by a distribution of liability
between the cedent and the reinsurer on the basis of losses rather than sums insured, as
in case of proportional arrangements. In fact, no insurance amount is ceded under excess
of loss treaties; what is ceded is losses and premiums.
As compensation for the cover granted, the Reinsurer receives part of the original
premiums and not part of the premium corresponding to the sum reinsured as in
proportional reinsurance.
The following common characteristics differentiate them from proportional treaties.
1. The size of cession is not determined case by case.
2. Administrative costs are substantially reduced.
3. Usually there is no profit commission.
4. Reinsurance premium is worked out on the basis of exposure and past loss
experience.
There are three general classes of excess of loss treaties.
(i) Per risk or per policy excess
(ii) Per occurrence excess or per loss excess and
(iii) Aggregate excess

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A per risk excess treaty is applicable to property insurance; the retention and limit apply
separately to each risk insured by the primary insurer. A per policy excess treaty applies to
liability insurance; the retention and limit apply separately to each policy sold by the
primary insurer. The retention under each of these policies is specified as a rupee amount
of loss. Further, the reinsurer is obligated for all or part of a loss to any single exposure in
excess of the retention and up to the accepted reinsurance limit.
Per occurrence excess of loss reinsurance gives indemnity against loss sustained in
excess of the net retention of the primary insurer, subject to the reinsurance limit,
irrespective of the number of risks involved in respect of one accident, event or
occurrence. This kind of reinsurance when applied to property coverage is called
catastrophe excess and when applied to liability coverage is called clash cover.
Aggregate excess treaties, also called excess of loss ratio or stop loss treaties are not
common. They are used generally in crop hail insurance and for small insurers in other
lines.
Characteristics of Non-Proportional (Excess of Loss) Treaties
Per Risk Per Occurrence Aggregate (Stop Loss)
Negotiated rate exposure Negotiated rate exposure Negotiated rate exposure
basis, usually no basis, usually no basis, usually no
commission commission commission
Premiums are settled by Premiums are settled by Premiums are settled by
annual adjustment of annual adjustment of annual adjustment of
deposit premium deposit premium deposit premium
Usually minimum premium Usually minimum premium Usually minimum premium
Losses settled individually Losses settled by Losses settled annually
catastrophe or event
Retention is for each Retention is usually above a Retention and limit is stated
risk/building/location minimum of two full – risk as a loss ratio
losses
Usually has a per Often has a co-insurance Often has a co-insurance
occurrence limitation provision when the provision when the
reinsured shares in the loss reinsured shares in the loss
above the retention above the retention

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Rating for Excess of Loss Covers

One concept which is frequently used in calculation of rate for excess of loss covers
(either per risk or per policy) is BURNING COST. The burning cost is computed by the
ratio of actual past losses over some time period, say, five years, to their corresponding
premium (written or earned) for the same period. This ratio is used in assessing a portfolio
of business and in determining rate of premium for renewal. This can also be termed as
experience rating. The burning cost will give the rate of premium, which is just sufficient to
cover the losses suffered by the reinsurers. This is then loaded by the underwriter for a
reserve in case of worsening of loss experience, catastrophic element, acquisition costs
and profit margin. The loading factor normally used is 100/70 or 100/80. An example of
burning cost calculation will clarify the concept better.
(GNPI – Gross Net Premium Income; the usual rating base for excess of loss reinsurance.
It represents the earned premium of the primary insurance company for the lines of
business covered net, meaning after cancellation, refunds and premiums paid for any
reinsurance protecting the cover being rated and gross meaning before deducting the
premium for the cover being rated.) In an excess of loss cover the rate of premium is
100/70th of the average burning cost of incurred claims for the current and previous years.
Rate to be applied to GNPI.
Year GNPI Incurred losses
1980 1,000,000 8,000
1981 1,200,000 20,000
1982 1,500,000 40,000
1983 1,800,000 50,000
Minimum rate of premium is 3%. Calculate premium for the year 1983.
Solution
Year GNPI Incurred losses to XL cover paid Loaded BC
+ o/s losses with
(1) (2) (3) (4) (5)
1980 1,000,000 8,000 0.8 11,143

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1981 1,200,000 20,000 1,667 2,381

1982 1,500,000 40,000 2,667 3,810
1983 1,800,000 50,000 2,778 3,969
Total 5,500,000 118000 2,145 3,064
Hence the rate of premium would be 3.064 and amount of premium
1,800,000 x 3.064 = Rs. 55,152

Per Occurrence Loss Cover-72 Hour Clause

“Loss Occurrence” means all individual losses arising out of and directly occasioned by
one catastrophe. This will be limited to:
72 consecutive hours as regards a hurricane, a typhoon, windstorm, rainstorm, hailstorm
and or tornado
72 consecutive hours as regards earthquake, seaquake, tidal wave and or volcanic
eruption
168 consecutive hours and within the limits of any one State as regards riots, civil
commotions and malicious damage
168 consecutive hours for any other catastrophe of whatever nature and no individual loss
from whatever insured peril which occurs outside these period or areas, shall be included
in that “loss occurrence”
An example will help to clarify this further:
Shilpa insurance company has taken an excess of loss cover for Rs. 20,00,000 in excess
of Rs. 10,00,000 per event with two reinstatements. A hurricane causes a loss ofRs.
90,00,000 in a period of 10 days. If there is no hour’s clause, then the whole occurrence
will be treated as one event and the recovery from excess of loss reinsurers will be limited
to Rs. 20,00,000. In all such events it will become extremely important to determine the
exact date of loss. So, assuming the dates, which are fixed by the surveyors are correct
the position may be as under:
1. First period of 72 hours 30,00,000
2. Second period of 72 hours 35,00,000

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3. Third period of 72 hours 20,00,000

4. Fourth period of 24 hours 5,00,000
Calculate reinsurance payment
Solution:
1. Rs.30,00,000 – 10,00,000 = Rs. 20,00,000
2. Rs. 35,00,000 – Rs. 10,00,000 = Rs. 25,00,000 but only Rs. 20,00,000 payable
since it is the maximum liability per event.
3. Rs. 20,00,000 – Rs. 10,00,000 = Rs. 10,00,000
4. Loss is borne by the company since it is within the deductible.
Thus, the total recovery is Rs. 50,00,000 by treating each 72 hours period as one event.

Working Excess of Loss Cover

The aim of this cover is to relieve the insurer of losses, which surpass the amount he has
decided to retain for own account on any accepted risk.
Example
The company has decided to retain Rs. 1,00,000 on all textile factories in its portfolio (i.e.
Rs. 1,00,000 on the sum of the risks which make up each factory – Furniture, Machines,
Raw Materials, Semi Finished and Finished products). It protects its retention with an
excess of loss cover of Rs. 60,000 excess Rs.40,000, which means that the reinsurer pays
up to Rs. 60,000 after the cedent has paid at least Rs.40,000. If a loss of Rs. 75,000
occurred in a factory, the cedent would pay its share, i.e. Rs.40,000 and the reinsurer
would reimburse him Rs. 35,000.
The working of excess loss cover is most commonly used in the fire (and allied perils)
branch as well as marine cargo.

Cover Per Event (Catastrophe Excess of Loss)

It offers the insurer protection against the accumulations resulting from numerous losses
caused by the same event (cyclone, earthquake). In general, it protects the retention
against catastrophes.

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Example
Storm causes Rs. 1,000 losses of Rs. 3,000 on policies covering private houses, which
are all retained within the companies’ retention. The company having concluded an excess
of loss reinsurance cover on its retention for an amount of Rs. 20,00,000 excess Rs.
5,00,000. In other words the reinsurer has to bear Rs. 20,00,000. The total loss would be
distributed in the following manner:
Rs
Total Loss 30,00,000
Cedents loss retention 5,00,000
Reinsurance cover 20,00,000
Balance Non reinsured (amt.- borne by the cedent) 500,000

Pricing of Proportional Treaties 3

To recap, a proportional treaty is an agreement between a reinsurer and a ceding
company (the reinsured) in which the reinsurer assumes a given percent of losses and
premium. The simplest example of a proportional treaty is called “Quota Share”. In a quota
share treaty, the reinsurer receives a flat percent, say 500, of the premium for the book of
business reinsured. In exchange, the reinsurer also pays 50% of losses, including
allocated loss adjustment expenses, on the book. The reinsurer also pays the ceding
company a ceding commission which is designed to reflect the differences in underwriting
expenses incurred. On the other hand, a “Surplus Share” treaty allows the reinsured to
limit their exposure on any one risk to a given amount (the “retained line”). The reinsurer
assumes a part of the risk in proportion to the amount that the insured value exceeds the
retained line, up to a given limit (expressed as a multiple of the retained line, or “number”
of lines).

3Compiled from Basics of Reinsurance Pricing, by David R. Clark, FCAS

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Example:
Retained Line: $100,000
1st Surplus : 4 lines ($400,000)

Risk Insured value 1st surplus 1st surplus percent

Retained Reinsured
portion portion
1 50,000 50,000 0 0%
2 100,000 100,000 0 0%
3 250,000 100,000 150,000 60%
4 500,000 100,000 400,000 80%
5 1,000,000 100,000 400,000 40%
6 10,000,000 100,000 400,000 4%

It is important to remember that this is not excess insurance. The retained line is used to
establish the percent of the risk reinsured. Once the ceded percent is calculated, the
reinsurer is responsible for that percent of any loss on the risk. Other types of proportional
treaties include fixed and variable quota share arrangements on excess business (e.g.
commercial umbrella policies). For these contracts, the underlying business is excess of
loss, but the reinsurer takes a proportional share of the ceding company’s book.
The following steps should be included in the pricing analysis for proportional treaties:

Step 1: Compile the historical experience on the treaty.

Assemble the historical premium and incurred losses on the treaty for five or more years.
If this is not available, the gross experience (i.e. prior to the reinsurance treaty) should be
adjusted “as if” the surplus share terms had been in place, to produce the hypothetical
treaty experience. Because a surplus share treaty focuses on large risks, its experience
may be different than the gross experience.
The treaty may be on a “losses occurring” basis for which earned premium and accident
year losses should be used. Alternatively, the treaty may be on a “risks attaching” basis,

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which covers losses on policies written during the treaty period. For risks attaching
treaties, written premium and the losses covered by those policies are used.

Step 2: Exclude catastrophe and shock losses.

Catastrophe losses are due to a single event, such as a hurricane or earthquake, which
may affect a large number of risks. Shock losses are any other losses, usually affecting a
single policy, which may distort the overall results. For property contracts, catastrophes
are generally defined on a per occurrence (multiple risk) basis, whereas shock losses are
large losses due to a single risk. For casualty contracts, catastrophes may include certain
types of claims impacting many insureds (e.g. environmental liability), whereas shock
losses would represent a single large settlement on a single policy.

Step 3: Adjust experience to ultimate level and project to future

period.
The first step is to develop the historical losses to an ultimate basis. If the treaty
experience is insufficient to estimate loss development factors, data from other sources
may need to be used. Depending on the source of these factors, adjustments for the
reporting lag to the reinsurer or the accident year / policy year differences may need to be
made. The next step is to adjust historical premiums to the future level. The starting point
is historical changes in rates and average pricing factors (e.g. changes in schedule rating
credits). Rate level adjustment factors can be calculated using the parallelogram method
for “losses occurring” treaties. The impact of rate changes anticipated during the treaty
period must also be included. This is an area requiring some judgment, as these percent
may not actually have been filed or approved at the time the treaty is being evaluated. If
the premium base is insured value (for property), or some other inflation sensitive base,
then an exposure inflation factor should also be included in the adjustment of historical
premium. Finally, the losses need to be trended to the future period. Various sources are
available for this adjustment, including the amounts used in the ceding company’s own
rate filings.

Step 4: Select the expected non-catastrophe loss ratio for the

treaty.
If the data used in Step 3 is reliable, the expected loss ratio is simply equal to the average

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of the historical loss ratios adjusted to the future level. It is worthwhile comparing this
amount to the ceding company’s gross calendar year experience, available in their Annual
Statement and to industry averages.

Step 5: Load the expected non-catastrophe loss ratio for

catastrophes.
Typically, there will be insufficient credibility in the historical loss experience to price a
loading for catastrophe potential. However, this amount is critical to the evaluation of
property treaties.
A few approaches are used:
a) Average catastrophe loads based on the ceding company’s projected distribution of
premium by state. These loadings may be based on the ceding company’s rate
filings, IS0 circulars, or simply default selections made by the reinsurer.
b) If there is an occurrence limit on the treaty, estimate the average number of times it
is likely to be exhausted in a year. For example, if the treaty has a $25,000,000
occurrence limit which is expected to be hit once every five years, then a $5,000,000
catastrophe load should be added.
c) “Spread” historical catastrophe losses over a longer period. For example, if the
ceding company’s experience shows a large amount for hurricane Andrew, then that
amount should be adjusted to the current cost and exposure level and then spread
over, say, ten years instead of five years. The historical catastrophes may need to
be adjusted to the current exposure and cost level.
d) Use the expected catastrophe amount from a catastrophe simulation model. These
examples are, of course, intended for property proportional treaties. For casualty
proportional treaties, a loading may still be needed to reflect the potential for large
losses not reflected in the historical experience.

Step 6: Estimate the combined ratio given ceding commission and

other expenses.
After the total expected loss ratio is estimated, the other features of the treaty must be
evaluated. These include:

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1. Ceding Commission - often on a “sliding scale” basis

2. Reinsurer’s general expenses and overhead
3. Brokerage fees (where applicable)
If the reinsurer’s business is produced through a broker, there is typically a fee paid by the
reinsurer as a percent of treaty premium. If the reinsurer markets the business directly to
the ceding company, there is no brokerage fee, but the general expense loading may be
higher. Finally, the reinsurer must evaluate whether or not the projected combined ratio on
the treaty is acceptable. The evaluation of treaty terms should take into account potential
investment income and the risk level of the exposures to determine if they meet the target
return standard of the reinsurer. A separate section of this study note will give an overview
of approaches to making this evaluation.

Difference Between Coinsurance and Reinsurance

Coinsurance, a form of reinsurance, is a system whereby reinsurer shares direct
responsibility for a risk with one or more insurance companies. The Cedent’s liability is
limited to the amount it underwrites on the original policy.
The system is used especially for covering big industrial risks and certainly has many
advantages. However, to apply it to the underwriting of thousands of medium and small
risks would only mean high administrative costs and inconvenience.
In co-insurance the relationships are between the primary insured and each insurance
company separately. If one company/insurer fails to pay its share of a claim, the others
are not liable to pay more than their share of claims. In other words, their liability is limited
to extent of share accepted by them individually.
Reinsurance is basically passing on the risk to some other insurer and therefore it does
not absolve the insurance company from making payment irrespective of receipt of
payment from reinsurer. In reinsurance the reinsured has a contractual relationship with
the reinsurers. The insurer must pay valid claims, even if he fails to recover from his
reinsurers.

Common Terms
It is essential at the outset to understand the meanings of some common terms in
reinsurance.

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Admitted reinsurer – A reinsurer licensed or authorized to conduct business in a given

jurisdiction. Also known as authorized reinsurance. The alternative is a non-admitted
reinsurer.
Aggregate excess of loss reinsurance – A form of reinsurance which stipulates
participation by the reinsurer when aggregate losses for the primary insurer exceed a
certain level.
Assuming company – The company that assumes some part of a primary risk: The
reinsurer.
Bordereau: a report furnished periodically to the reinsurer by the reinsured providing
details of risks, premium and/or losses.
Cede: to give away or transfer all or part of risk to another company or companies.
Catastrophic reinsurance – An excess of loss reinsurance contract that indemnifies the
ceding company for the accumulation of losses in excess of a stipulated sum arising from
a single catastrophic event in a series of events.
Ceding commission – An amount in excess of the premium, paid by a reinsurer to a
primary insurer as part of a reinsurance transaction and meant to offset the primary
insurer’s policy acquisition costs.
Ceding company – The company that buys reinsurance cedes (transfers) a percentage of
its risk to a reinsurer. The ceding company can be a primary insurer or another reinsurer.
Also referred to as a cedent.
Clash cover – Also known as a contingency cover, it is an excess of loss reinsurance
contract. It comes into play when two or more policies of the primary insurer are involved
in the same occurrence, workers’ compensation involving accidents affecting two or more
people, or expenses (ECO XPL).
Commutation - Provision for estimation payment and discharge for future obligations for
reinsurance loss or losses regardless of the continuing nature of certain losses.
Contingent Commission (profit commission) - An allowance payable to the ceding
company in addition to the normal ceding commission allowance. It is a predetermined
percentage of the reinsurer’s net profits after a charge for the reinsurer’s overhead,
derived from the subject treaty.

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Direct written premium - Aggregate amount of recorded originated premiums, other than
reinsurance, written (but not necessarily collected) during the year, including retrospective
audit premium collections but excluding return premiums
Excess – The liability not retained by the primary insurer. Therefore, excess is the total
liability less the retained liability. Used in non-proportional or excess-of-loss reinsurance
agreements.
Excess per risk reinsurance – The percentage of risk retained by the ceding company
may be different for each risk transferred.
Excess of loss reinsurance – also known as non-proportional reinsurance. The contract
specifies an amount (the attachment point) and the reinsurer pays only after the ceding
company’s losses on the contract exceed that amount. It is the opposite of proportional or
pro rata reinsurance.
Extra-contractual obligations (ECO) – Applies to liabilities of the reinsured that arise as
a direct result of its claims handling and not covered under other provisions of the
reinsurance contract.
Facultative reinsurance – A type of reinsurance, distinguished from treaty reinsurance
because the reinsurer retains the faculty (ability) to accept or reject each individual loss
presented to it by the primary insurer.
Finite risk reinsurance – Form of reinsurance in which the time value of money is
considered in developing the premium and which has loss containment provisions. One of
the primary objectives of this type of reinsurance is to enhance the cedant’s financial
statements or operating results.
Funds withheld – In order to comply with government regulations, the ceding company
retains unearned premium reserves or outstanding loss reserves, or both, on risks it cedes
to a reinsurer.
Letter of credit – A banking instrument used by the ceding company to secure amounts
recoverable from non-admitted reinsurers in order to comply with statutory requirements.
(Frequently abbreviated as "LOC.")
Loss adjustment expense – As specified in the reinsurance contract, expenses directly
allocated to the claim as opposed to overhead.

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Line: the amount of retention of the direct insurer; Reinsurer may accept one or more
lines or fraction of a line
Non-admitted reinsurer – A reinsurance company that is not licensed or authorised to
conduct business in a given jurisdiction. Absent certain security considerations, credit for
reinsurance is generally denied by the ceding company’s governing regulatory authorities.
The alternative is an admitted reinsurer.
Overriding Commission: It is the commission payable to the ceding company in addition
to the original commission to take care of overhead expenses and often including a profit
margin.
Profit commission: an additional commission payable by the reinsurers to the ceding
company as a percentage of profits derived from the business.
Portfolio: the liability of an insurer for the unexpired portion of the policies in force or
outstanding losses or both for a particular segment of the insurer’s business.
Per occurrence – An excess of loss agreement covering loss occurrence from anevent,
disaster or catastrophe which gives rise to many individual losses.
Policyholder’s surplus – The amount by which assets exceed liabilities. It is comprised
of special surplus funds, common and preferred capital stock, gross paid in and
contributed surplus, assigned funds and excludes common and preferred treasury stocks.
Portfolio reinsurance – The ceding company transfers an entire portfolio of business to a
reinsurer. The block of business transferred may be a group of policies in force or a group
of outstanding losses.
Primary insurer – A company that sells insurance to businesses and individuals and buys
reinsurance to cede (transfer) a percentage of its risk to a reinsurer.
Pro rata reinsurance – The primary insurer and reinsurer share the risk and revenue
according to an agreed percentage. This is a proportional agreement, the alternative to an
excess-of-loss agreement.
Quote share reinsurance – A proportional reinsurance contract in which the reinsurer
assumes a fixed percentage of each risk.
Reinsurer – The company that accepts a percentage of a primary insurer’s risk through a
reinsurance agreement.

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Retention – the amount of liability the ceding company keeps for its account of a risk.
Retrocession – The reinsurance of reinsurance. The ceding reinsurer is called the
retrocedent and the assuming reinsurer is called the retrocessionaire. When a reinsurer
(retrocedent) cedes all or part of the reinsurance risk it has assumed to another reinsurer
(retrocessionaire).
Reinstatement: A provision in an excess of loss reinsurance contract, (specially
catastrophe and clash covers) that stipulates for a reinstatement of a limit that is reduced
by the occurrence of a loss/losses.
Reserves: the portion of premiums/losses retained by the insurer for the due performance
of the obligations of the reinsurer under the treaty.
Slip: a document showing details of reinsurance proposed to be offered which is
circulated to the reinsurers by the brokers/ceding company.
Sliding scale commission – A predetermined formula under which the commission that is
payable by the reinsurer to the ceding company varies inversely with the actual loss
experience.
Stop loss reinsurance – A form of reinsurance that stipulates participation by the
reinsurer when aggregate losses for the primary insurer exceed a certain level.
Surplus share reinsurance – A proportional reinsurance contract in which the ceding
company sets a retention limit and the reinsurer takes all the risk above that limit (the
surplus).
Treaty – A type of reinsurance whereby the assuming company agrees to accept all risks
of a certain type. The alternative is facultative reinsurance.

PML Underwriting
We have discussed about retention and retention limits of the insurance companies in
terms of Sum Insured.
The degree of hazard in respect of fire risk of a first class residential building is less
compared to fire risk in a cotton ware house. Further the frequency of fire losses in the
case of cotton ware houses is much greater than in a residential building. If we follow
“Sum Insured” basis of underwriting the primary insurer will retain the same volume of sum

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insured for a superior risk and a hazardous risk. However it will be advantageous for the
primary insurer to retain more on a superior risk where the chances of total loss is smaller
and retain less of hazardous risk.
Therefore, a way has been evolved by companies over a period to relate the retention to
probable maximum loss (PML) estimates rather than to the sum insured. The main
advantage of this basis is that risks are evaluated in terms of their loss potential. Usually
PML assessment will be made by risk engineer after inspection of the various steps
involved in the process and accumulation of risk in an industrial unit.
The advantages of PML underwriting to the primary insurance companies are
1. It gives them greater capacity to handle large risks.
2. It helps them to retain a lot more premium for net account than would be possible
otherwise.
However this method of underwriting on PML basis suffers from following defects:
1. In respect of mega industrial risk, it is very difficult to have an objective evaluation of
the process involved and its impact on PML assessment.
2. Primary insurers will have a tendency to depress the PML estimate so as to
accommodate the values within the automatic reinsurance arrangements.
3. If the evaluation is haphazard or unscientific, it will result in the company having to
carry a liability much in excess of its intention and this may have serious
repercussions on reinsurers as well.
PML underwriting is normally practiced in the case of major fire, Industrial All Risk and
project insurance policies.

1. Property & Liability Reinsuracne Contracts

Property insurance is the business of operational contracts of insurance against risk of
loss or damage to material property like damage to machinery, buildings, stock, personal
belongings or household goods, money etc.,
The types of property risks amenable to reinsurance are:
• Money insurance – all risks
• Goods in transit – damages/loss

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• Business Interruption – effects on turnover/profits

• Engineering – risks of collapse of machinery
• Fire and Material damages – ‘All Risks’, riot, earthquake etc.
• Theft of Property – Burglary risk
Property reinsurance principally deals with many classes of original insurance business.
The reinsurance contracts cover normally all those aspects which are covered in the
original policy which may be physical loss or damage to real and personal property and
the financial consequences arising out of losses/damages in respect of various areas
outlined above.
Under the provisions of the Insurance Act 1938, a fixed percentage of each and every risk
underwritten in India should be reinsured with GIC of India. This is called ‘Statutory
Cessions’ and currently it is 10%. After meeting this mandatory requirement any surplus is
ceded to others. The net retention of each company, after statutory cessions, is protected
by Excess of Loss cover arrangements made by each company.
Certain important areas are explained here.

2. Engineering Reinsurance
The engineering insurance normally covers the machinery – erection to operation. The
protection of insurance is provided at construction stage and operational stage.

Construction stage
1. Contractors’ All Risk insurance (CAR)
2. Erection All Risk insurance (EAR)
3. Marine Cum Erection insurance (MCE)
4. Contracts Works insurance (CW)
5. Advance Loss of Profits (ALOP)/Delay in Start Up (DSU) insurance
The construction stage policies are issued for the period of the project and they are all
one-time policies.

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Operational Stage
1. Machinery Insurance (MI)/Machinery Breakdown Insurance (MB)
2. Boiler and Pressure Plant (BPP) insurance
3. Machinery Loss of Profits (MLOP) insurance
4. Contractors’ Plant and Machinery (CPM) insurance
5. Civil Engineering Completed Risks (CECR) insurance
6. Electronic Equipment (EE) insurance
7. Deterioration of Stocks (DOS) insurance
The operational stage policies are annual policies renewable at expiry.
In engineering insurance even though claims are small there is a risk of catastrophe.
There could be claims following accidents to plant and machinery, damage to property,
interruption in production on account of many factors involving machinery. Fire or floods
can also cause damage to machinery. Mumbai floods (2005) is an example, which
affected many factories in Raighad district of Maharashtra.
The usual reinsurance methods adopted for engineering reinsurance are Facultative
reinsurance, Treaty reinsurance (Quota Share treaty and Surplus Treaty) and Excess of
Loss reinsurance. The highly exposed risks should be covered under Facultative
reinsurance and the most frequent method is the surplus – quota share or surplus. The
ceding company has to basically think about its retention strategy for reinsurance
program. The factors that need consideration to draw out a proper retention strategy are –
size of the portfolio, probability of loss, size of loss, capital, reserves and rate of return,
premium rates, cost of reinsurance and investment policy. By evaluating the types of risks
underwritten and the hazard in their locations, a ceding company sets different retentions
according to the degree of exposure to loss involved. Evaluating risks in this manner is
called setting up a table of limits.
Usually the reinsurer provides the policy wordings and rating guidelines with the
corresponding underwriting instructions. If an insurer wants to accept any risk outside the
scope of the rating principles, the insurer should obtain the reinsurer’s approval. The
reinsurer may also reserve the right to take part in the claims settlement.

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3. Fire Reinsurance
The Proportional Treaty agreement is well suited for fire reinsurance in view of the large
number of risks involved. For ceding company the result net of reinsurance remains stable
over a period of time. The net retained business can be appropriately covered. In an year
of higher than average losses in large risks, a larger recovery can be made from
reinsurers.
Fire insurance risk business is vulnerable to losses arising on a single large risk from
natural perils and to an abnormal increase in aggregate losses during a particular period.
Therefore, it would be necessary for an insurer to avail of any of the main forms of excess
of loss covers as follows:
• Facultative excess of loss to limit commitment on a single risk.
• A working ‘risk’ excess of loss treaty as an alternative to proportional treaty.
• A catastrophe excess of loss cover to protect against accumulation of losses from
one event on net account.

4. All Risks Property Package Reinsurance

This is normally obtained to cover a range of diverse activities. It deals with multi- line/
multi-location/ multi-occupancy exposures which is otherwise reinsurable under different
departments. It is a package cover. It is not a spread of risks of similar nature but a
combination of various exposures, which are competitively priced. This is normally
available under facultative arrangement. The insurer has to select a combination of
facultative and excess of loss covers while ensuring that the net retention is not unduly
burdensome.

5. Casualty Reinsurance
Casualty insurance is a broad field of insurance and covers whatever is not covered by
fire, marine and life insurers. It includes automobile, liability burglary and theft, workers
compensation, glass and health insurance. It is basically US way of looking at general
insurance and is used synonymous to liability insurance. It covers the indemnification of
the first party – the insured party; in the event that it is legally liable to pay compensation

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to a third party. The different considerations of underwriting that are applicable in the case
of property reinsurance are equally applicable to casualty reinsurance.

6. Marine Reinsurance
The marine risks were one of the earliest known risks, which were covered under
reinsurance. Marine insurance can be done in two ways – cargo and hull; the former
covers the merchandise and the later the body of ship, its machinery etc., reinsuranceis
available separately for each.
In India, section 9 of the Marine Insurance Act, 1963 states that an insurer under a
contract of marine insurance has an insurable interest in his risk and may reinsure in
respect of it. Reinsurance is effected with the objective of:
Reduction of an underwriter’s line on any particular risk to a desirable amount that he can
retain on his own account;
• To offload all or part of an undesirable risk;
• To protect against catastrophe loss;
• To increase market capacity by spreading the risk over the international market and
creating reciprocity – an exchange of business for comparable business from
another insurer;
• To provide an underwriting capacity, which can also mean ability to participate in
risks which are not otherwise available;
• To stabilize the underwriting results of a company.
The marine insurance is typical in the sense that the items to be covered under insurance
are mobile and in some cases travel at high speed. Two cargo vessels may be moving in
opposite direction somewhere in the world and in a short time come closer almost
bordering on collision. A marine underwriter may not see the goods / ships that he is
insuring and only good faith forms the bedrock of their business to avoid frauds etc., The
range of values and items requiring marine insurance is enormous and amounts may at
times be colossal. The vessels and cargoes can be totally lost and the insurer, unless he
goes for reinsurance, can land in bankruptcy after a major loss.

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The better way for a reinsurer to reduce the impact of war risks is to reinsure on a
proportional basis and protect the retained amount by seeking protection under an
aggregate excess loss cover relating to all losses taking place during a particular year.
Sometimes it is difficult to get claims settled easily, on account of administrative and legal
hassles. And to tackle such situations tonners have come into existence. They were
developed in the reinsurance market as a means of purchasing reinsurance exceeding an
aggregate value of insurance or a certain tonnage. However tonners could not survive on
account of legal problems.

7. Cargo Reinsurance
Cargo risks are normally covered from initial warehouse to the final destination and the
risk exposure is less if an event occurs outside the coverage. The reinsurer should be able
to pinpoint the actual cargo and the risks insured. The cargo business is normally covered
by Marine open Covers. The insurer would automatically accept from his assured all
shipments falling within the scope of the Open Cover up to an agreed amount per
vessel/conveyance. It is quite possible that, when a number of open covers are issued,
several clients may be shipping full lines perhaps by the same vessel and an insurer may
not know the full extent of his cargo commitments on a vessel before the risk commences.
Often the name of the carrying vessel may not be known, or known only after completion
of the voyage. Therefore, problems arise in accumulation control.
While containerization with several high limits can be aggregated on a single ship and thus
reduce the incidence of theft, there are instances where the whole container along with the
cargo have been robbed thereby leading to more complicated problems like major claims.
The combination of cargo and hull insurance values are, at times, so fabulous that it
becomes impossible for a single reinsurer to assume the total loss and hence go for
sharing or retrocession.
It is not possible for an underwriter with general cargo account to protect himself against
unduly large commitments on any particular vessel by means of facultative reinsurance
alone. Facultative reinsurance is effected only in special cases for specific risks, while
general protection is obtained by treaty reinsurance arrangements. The underwriting of
cargo insurance calls for care in choosing the retention limits considering the premium
income for the year. It should bear a reasonable ratio to the total income so as to protect
against the company’s profit being wiped off with a single loss. Alternatively, Quota Share

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arrangements can be sought when there is a need to create reciprocal treaties. For
valuable items like diamonds and gold, it is usual to reinsure these risks separately under
Surplus and other treaties and facultatively when the treaty limits are exceeded.
In recent times, non-proportional reinsurance gained popularity as there is increasing use
of Excess of Loss treaty under which a company can fix a limit up to which it can absorb
all the risks. Only when the net loss exceeds this pre-determined retention limit does the
reinsurer’s role comes into play. On the other hand, an Excess of Loss Treaty may protect
the ceding company’s gross lines/net lines after cessions to Surplus/Quota Share.
Normally, the Excess of Loss reinsurance is placed in layers. It protects the ceding
company’s net retained account where the ceding company’s basic reinsurance
arrangements are on proportional basis, to reduce the impact of accumulations and
catastrophe exposures.

8. Hull Reinsurance
Hull risks cover the body of a ship, its machinery, docks and also others like vessels,
coasters, barges and yachts etc. However it mainly deals with items relating to body of a
ship. Hull insurance broadly falls into two categories viz., ocean-going vessels, including
bulk carriers and tankers and local crafts such as barges, lighters, launches, tugs,
dredgers, trawlers etc., Marine cargo business in most of the countries around the world is
ocean transit and air-transit but in India the inland transit like rail, road or water ways
constitute a substantial portion.
In hull insurance, the insurer is certain of his commitments as the value of each vessel or
fleet can be clearly estimated as a result of which open covers ( as in cargo insurance)
can be avoided. In case of total loss the demand is for facultative reinsurance in hull
reinsurance. Depending on the gradation of the vessel, the cedent should determine his
retention limits, taking into account the various aspects of the vessel like age,
performance, sea-worthiness etc. Above the net retention limit, excess of loss facility
should be obtained to reinsure the risk. As with cargo interests, the present trend is away
from proportional treaties towards excess of loss methods of protection. However, even
though Quota Share and Surplus treaties are encouraged, the emphasis is growlingly on
excess of loss arrangements, particularly for ‘catastrophe’ covers. Wherever the excess of
loss is the selected method of protection, the agreement is to pay the excess of an
ultimate net loss to the ceding company in respect of each and every loss or series of
losses arising out of the same ‘loss occurrence’.

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It is suggested that the hull insurer should take care to obtain reasonably high reinsurance
limits since the hull policy may cover liability risks in addition to physical damage to the
vessel. He should endeavor to obtain most extensive coverage at a cost which leaves him
scope for making profits on his retained portion.

9. Aviation Reinsurance
As the capital required in aviation is high, very few private entrepreneurs enter this area
and it is dominated by government undertakings. Insurance in the aviation face speculiar
challenges because of fabulous amounts involved and the loss of human life adding to the
monetary commitment under accepted policies. The aviation insurance market is truly
international as risks are placed in all countries through exchange of reinsurance. This
makes for a competitive and free market on worldwide basis. In order to limit their risks
insurers have always shown a tendency to spread risks as widely as possible. Even
though initially London was the nerve center of aviation insurance, slowly it is giving way
to countries in Europe like France, Germany and Switzerland. Reinsurance plays a major
part in aviation insurance, as around 80 per cent of any aircraft will be reinsured.
According to Economic Times, Dec. 14, 2001 - the year 2001 turned out to be the worst in
aviation insurance history. The aviation insurance business has received claims
amounting to $ 4.8 billion during the calendar year, which has been enough to wipe out at
least four years of average premium income. Hull claims which represent claims on
account of damages to the aircraft, account for less than half a billion dollars. Most of the
claims ($4.3 bn) are on account of liability claims, which mostly include compensation to
relatives of passengers killed in air crashes. Airline losses have not stopped with the
September 11, 2001 incident. After the terrorist attacks in US there have been five major
incidents in November 2001 itself. Indian Airlines, which renewed its policy after the
attacks, had to pay a renewal premium of $17 million, which is $3 million higher than the
rates for the previous year.
Aviation insurance encompasses three areas – Hull, Liability and Personal accidents.
Broadly it covers loss of/or damage to the aircraft, third party liability and passenger
liability. In aviation insurance, facultative covers are normally sought because of the
changes in aircraft sizes and passenger liability. The reinsurer often places certain clauses
under the facultative cover:
• To control claims negotiation and settlements;

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• To determine the details of the original policy wordings;

• To discover the original policy rates or premiums.
A reinsurer involved in airlines business faces the problems of accumulation of risk. This
occurs in two ways. The first is the risk of two or more aircraft being at the same place.
Whether on ground, at airports or while flying along the air corridors, there is a risk of
collision. The second type of accumulation arises from insurance policies, particularly
those for airline hull and liability and aviation products liability. These accumulations are
severe and unquantifiable and only an actual loss evidences the potential. This calls for
maintenance of detailed records in a comprehensive manner so that sufficient levels of
excess of loss or other suitable cover may be put in place. The underwriting of aviation
insurance needs a closer scrutiny due to high values in insurance and reinsurance.
The main forms of coverage for airline risks are placed on a policy for the operator’s whole
fleet. There used to be separate policies for hulls and liabilities but over the years
combined hull and liability policies came into vogue to save on administrative costs. Hull
war risks are normally covered under a separate insurance policy where the values are the
same as under the Hull All Risks. This coverage can also be provided on the Hull All Risks
policy as a separate section. In many insurance markets, aviation business is pooled.
These pools are formed by local companies to unite their efforts to solve technical and
capacity problems.
Normally the reinsurers exclude the following under the policies:
• Hull war is not generally acceptable under treaties. It is protected under a separate
reinsurance program
• Policies exceeding a period of twelve months
• Inward Treaties
• Tonners
• Brokers, binders and Line Slips: except line slips where risk are rated by a leading
London underwriter
• Profit commission. Good Experience Return or Deductible Insurances

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10. Accident and Liability Reinsurance

An accident is an event, which is wholly unexpected, not intended or designed. It does not
include the cumulative result of a series of small incidents. It may be noted that while
suicide and murder or homicide following grave provocation are not accidents, homicide or
murder without provocation, frostbite, snakebite and drowning are accidents. The purpose
of personal accident insurance is to pay a fixed compensation for death or disability
resulting from accidental bodily injury. The basic coverage of the policy is, if at any time
during the currency of this policy, the insured shall sustain any bodily injury resulting solely
and directly from accident caused by external violent and visible means, then the
insurance company shall pay to the insured or his legal personal representative(s), as the
case may be, the sum or sums set forth in the policy, if resulting in specified contingencies
such as death, permanent disablement etc.
The purpose of Liability Insurance is to provide indemnity to the insured in respect of
financial consequences of a legal liability. Whenever liability arises under Civil Law,
compensation becomes payable. Besides there may be legal costs awarded against the
insured and also legal costs of defense of the claim incurred by the insured. Civil liability
may arise under a) Law of Tort e.g. negligence and b) Statutory Law (Public Liability
Insurance). Liability Insurance comprises the following policies:
• Policies under Public Liability Insurance Act, 1991.
• Public Liability for Industrial and Non-Industrial risks.
• Products Liability.
• Professional Indemnities for Doctors, Chartered Accountants, Solicitors etc.
• Employer’s Liability (Workmen’s Compensation Policy).
• Directors and Officers Liability policy.
• Vendors of Software Liability.
• Stock Exchanges, Banks and Financial Institutions Liability etc.
The form of reinsurance, in these cases, normally adopted is mostly the Quota Share in
conjunction with a working excess of loss. Personal accident requires reinsurance for high
net worth individuals and for accumulation as in a single aircraft. These are addressed

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through a combination of working and catastrophe excess of loss reinsurances. In India, it

is not the practice to include personal accident insurance for excess of loss covers and
these risks were entirely retained by the local insurers. Catastrophes like Gujarat
earthquakes, Mumbai floods and terrorist attacks on WTC made insurers to reconsider this
approach.
Experience of other insurances differs from country to country. The risk of burglary
exposure, for example, is attended to differently within a country and between countries.
At one extreme a simple guard provides security and considered as adequate and at the
other extreme there is electronic surveillance, frisking and restricted access as can be
observed in software companies. The Law and Order situation differs depending upon the
seriousness and extent of attention by political leadership and government. The values
involved and size of assets involved are material to consideration given these variations.
In case of software exports, particularly to USA, for example a different situation arises
wherein the overseas vendor requires insurance protection for a fabulous amount. Indian
market requires reinsurance to support the transaction. Reinsurers will provide protection
if they have investigated the proposal and found the risk as reinsurable. The risk is
evaluated on the basis of reliability of Indian exporters and the jurisdiction of USA, litigious
country. Detailed proposals are required to be completed for all professional, public and
product liability covers. The information as provided is scrutinized for vulnerable risk
exposures. The cover is negotiated with appropriate restrictions and rating.

11. Life Reinsurance

Life reinsurance differs from other classes of reinsurance. The nature of risks assumed by
the life insurance has necessitated the development of various forms of reinsurance. The
proportion of total life insurance premiums reinsured is small in comparison with most of
the non-life insurance classes. The demand for life reinsurance arises on account of a)
difference in the number of deaths and b) death strain. Life insurer’s mortality risks arises
on account of uncertain calculations of death claims made by him with the help of mortality
tables. However in practice, the actual number may differ resulting in wide dispersion.
Such divergence will have impact on the earnings of a Life Insurance Company.
The cost to a life insurance company in case of a claim is the sum assured plus bonus, if
allowed. Cost minus reserves applicable to the policy gives the amount of ‘Death Strain’.
This results in creating an impact on operating results. Life insurers generally seek
reinsurance to reduce the impact of such death strain on operating results of the company.

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Three life reinsurance plans are in general use under both facultative and automatic
agreements.
Coinsurance Plan: The reinsurer assumes a proportionate share of the risk according to
the terms that govern the original policy. The reinsurer is liable for an amount determined
by the size of the insurance assumed in relation to the original insurance amount. Thus, if
the reinsurer has accepted one-half of the original insurance, it becomes liable for one-half
of any loss. In return for this guarantee, the reinsurer receives a pro-rata share of the
original premium less a ceding commission and allowance. These payments reimburse the
direct-writing company for an appropriate share of the agent’s commissions, premium
taxes paid and a portion of the other expenses attributable to the reinsured policy. Also,
the reinsurer reimburses for a proportionate share of any dividends paid. In general, the
reinsurance contract is a duplicate of that entered into between the direct-writing company
and the policy owner. The ceding company and the reinsurer share the risk (premiums and
claims) according to agreed proportions; with the reinsurance rates derived from the
original rates charged the policy owner.
Yearly Renewable Term Plan: Under this the reinsurer assumes the reinsured policy’s
net amount at risk in excess of the ceding company’s retention. The ceding company pays
premium on a yearly renewable term basis. This plan is particularly appropriate for smaller
ceding companies because it results in larger assets for these companies and is simpler to
administer than coinsurance plan. Thus, for policies with declining net amounts at risk,
decreasing amount reinsurance is purchased every year. If a loss occurs, the reinsurer is
liable for the amount that it assumed that year and the ceding insurer is liable for its
retention plus the full reserve on the reinsured portion of the policy. Premium rates for
yearly renewable term reinsurance are established independently of the premium charged
to the policyholder.
Modified Coinsurance Plan: In the interest of permitting a company to retain control over
the funds arising out of its own policies, a modified coinsurance plan has been developed.
Under this arrangement, the ceding company pays the reinsurer a proportionate part of the
gross premium, as under the conventional coinsurance plan, less commissions and other
allowances, premium taxes and overhead allocable to reinsured policies. At the end of
each policy year, the reinsurer pays to the ceding company a reserve adjustment that is
equal to the net increase in the reserve during the year, less one year’s interest on the
total reserve held at the beginning of the year. The net effect of the plan is to return to the
ceding company the bulk of the funds developed by its policies. Modified coinsurance can

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be considered as yearly renewable term on a calendar year basis because the reinsurer,
after paying the reserve adjustment, cash surrender values and commissions and
allowances, is left with only the risk premium. Aside from the reserve adjustment, the
modified coinsurance plan follows that of the regular coinsurance plan.
A key element, under life reinsurance, is in assessing the true value of assets recoverable
from a reinsurer. A direct insurer who relies too heavily on one reinsurer faces a
substantial risk of default. A life insurer who totally depends on reinsurance and retains a
small percentage of his total portfolio is generally considered to be an increased risk to the
insuring public. Very little reinsurance is affected by Life Insurance Corporation of India. Its
reinsurance is a surplus treaty, which takes sum insured exposures on individuals in
excess of US $ 100,000. The substantial part of LIC’s business is not reinsured. Key man
insurance and accumulation are two risk exposures of significance to a life insurer for
arranging his reinsurance.
Key man insurance protects business debts of a firm, which is dependent on a key
individual for continuing its business. In view of which the sum insured would not be
related to the value of a person but the value of loss to his firm in case of his leaving the
company and the premium is paid by the firm is treated as business expense. This has
become a big controversy in India and IRDAI suspended operation of this policy for some
time.
Accumulation is when several people are affected by a loss and there is an accumulation
of insured persons; also, where several policies arranged in respect of one and the same
individual are affected, one speaks of a policy accumulation. Accumulation control is
therefore essential to determine need for reinsuring.

Inward Reinsurance Contracts

In recent times, the trend of direct insurers undertaking inward business is on the rise as it
results in increase of gross premium and net retained premium. Inward reinsurance
business is defined as “the insurance business taken up by a direct insurer or reinsurer
from the cedent in turn for share in the premium volume generated by the cedent or on a
fee basis”. The growing reinsurance market kindled new hopes for many insurance
companies, which traditionally carry insurance business, to undertake inward reinsurance
business along with their main line of business. In a retrocession arrangement a reinsurer
(the retrocedent) cedes all or part of the reinsurance risk it has assumed to another
reinsurer (the retrocessionaire).

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As the market for inward reinsurance is yielding attractive returns, many kinds of
companies all over the globe are jumping into the fray of inward reinsurance.
However, the company taking up inward reinsurance should look at its competence in
terms of market knowledge, research facilities, sound actuarial practices and knowledge of
changing risk profiles in the market.

Objectives of Inward Reinsurance

Any reinsurance company would, in addition to ceding their business, also accept some
reinsurance business. Some of the reasons why companies go for inward reinsurance are
as follows:
• To increase the gross premium and net retained premium
• To achieve a lower expense ratio by maintaining the volume of premium income as
ceding reduces the premium income
• To obtain a better and wider spread of business
• To counteract the drain of foreign exchange caused by ceding of premium
• To earn an investment income which may be derived from the cash flow.
After examining all the pros and cons a company has to devise an appropriate corporate
strategy for its underwriting policy. It can write lines for its net account or it can write larger
shares and create a retrocession treaty to take care of the surplus over its net retention.
Some considerations the company should keep in mind while finalizing its inward
Insurance programme for the year are as follows:
• Treaty or facultative: Facultative involves more administrative work as each offer will
be scrutinized. Treaty is less expensive but it requires a thorough knowledge of the
market and treaty clauses.
• Territorial scope: If the company wants a greater geographical spread then it should
underwrite foreign business keeping in view the political and economic conditions of
the country.
• Direct or brokers: If the company has experienced staff direct business can be
solicited. However, this will involve travel expenses to procure business. So initially
it is better to place business through a broker.

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• Class of business: The company should decide whether it wants to underwrite

property business, which is on an annual basis, or casualty business.
• Acceptance limits: Keeping in mind the financial standing and premium income of
the company, the acceptance limit should be large enough to make it attractive for
the brokers and ceding companies to offer business.
• Finally, IRDAI has brought in certain norms for acceptance of inward business,
which have to be adhered to while designing the inward programme.

Business Strategy
A business strategy is required to support any insurer or reinsurer to transact reinsurance
business and all logistical help should be available to carry out the task. Intimate
knowledge of the international markets, skills in reinsurance area are basically essential in
restricting or excluding acceptances.
The reinsurer should study the market conditions with due focus on expected spread of
risks and volume of business. There has been dramatic changes in the methods and forms
of reinsurance at international level compared to traditional methods of doing business.
The reinsurance capacity has undergone rapid changes and the capacity is also available
from capital markets.
Reinsurer should aim at writing a large line to attract business with quality and to keep his
costs of acceptance economical. Nearly 90 percent of global reinsurers depend on some
form of retrocessional protection as a means both to cede a portion of their risk and to
stabilize their earnings. The reinsurer has to cope with financial problems like delayed
remittances and exchange of losses. Besides the tool of credit rating, gathering
information first hand would assist for diligence in writing inward reinsurance.
Some important dimensions in business strategy are as follows:
1. The companies should have clarity on the basis of underwriting – should it be
reciprocal or non-reciprocal?
2. An insurer or reinsurer accepting reinsurance business has two options opento him
– gross or net lines. He can write such shares as can be retained by him without
retrocession or he can write larger shares and create a retrocession treaty to take
care of the surplus over his net retention.

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3. Undertaking facultative reinsurance business involves more administrative work and

the amount of premium is relatively small and the insurer needs to have thorough
knowledge of tariffs and other market conditions. In treaty reinsurance business the
premium volumes can be built up.
4. Insurers need to be clear on how much will be proportional and what amount will be
non-proportional. Reinsurance companies should exercise the choice carefully.
5. Opting for wider geographical areas and spread will result in growing volumes and at
the same time bring new types of business. Therefore, the market conditions will
certainly impact the profitability of the reinsurer.
6. Reinsurer can procure business from various sources. It can be by granting an
underwriting or binding authority to another company or agency to write business. It
may accept business through brokers.
7. The acceptance limit should be sufficiently large to make it more attractive for the
ceding companies and brokers to offer business. Companies need to stay within
their financial limits to avert any kind of financial crisis subsequently.
8. The company should lay down guidelines for accepting business.

Retrocession Arrangements
A retrocession is both the unit of insurance that a reinsurance company cedes to a
retrocessionaire and the document used to record the transfer of risk from a reinsurer to a
retrocessionaire. After making acceptance, decision, underwriting decision has to be
taken. The accepting insurer or reinsurer may retain it wholly for his net account or
retrocede a part of the acceptance to a retrocession arrangement, if any, or even arrange
a specific retrocession on an individual acceptance with another reinsurer. Retrocession is
required by a leads underwriter who lead quotes on a reinsurance proposal. The larger is
his acceptances, the higher is the confidence of his underwriters. Retrocession is also
required to support reinsurance offers, which may otherwise be scarce in the absence of
retrocession. When there is excess capacity, lead underwriters yield to broker pressure to
offer lower and retrocession support is in offing.

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Reciprocal Trading
The mutual exchanging of reinsurance, often in equal amounts, from one party to another,
the object of which is to stabilize overall results, is the essence of reciprocity.
Ceding insurers tend to protect the experience of the treaty by not fully utilizing the treaty
capacity for more serious risks or arranging an excess of loss cover to protect the treaty
portfolio to take the benefit of reciprocal reinsurance trading. These parties are ready to
offer adjustments in commission, profits and reciprocity terms to keep the treaty
exchanges balanced.
The benefits that accrue from reciprocal exchange are:
(a) it enables the ceding insurer to add to his net premiums and net profits;
(b) it provides a wider spread for the net retained portfolio of the insurer with an
improved balance thus ensuring greater stability in profits.
The reciprocal reinsurance trading is very much prevalent in fire insurance and it is not
that much evident in cargo business, barring a few instances. Reciprocal reinsurance
tends to take place in the same area of both the insurers.
One can think of more than 100 percent premium reciprocity to balance the exchange of
profits when dealing with markets of lower average profitability. It can be said that a
ceding insurer with a treaty carrying an average 10 per cent profitability can expect to
receive 200 percent premium reciprocity from a reinsurer whose treaty has an average
profitability of 5 percent. However, the reciprocating insurer has a much better balance for
his treaty and is able to conclude short of 100 percent profit reciprocity in consideration for
the steady results. Profit is normally subject to fluctuations and therefore, accepting a
large premium reciprocity from a treaty may be fraught with danger. It is preferable to
increase profit commission to reduce the net profit ceded. A large premium reciprocity
adds to the net premium of the ceding insurer and has other advantages flowing from it
such as creation of larger reserves and reduction of tax on profits consequently.
Finally one should consider the impact of brokerage cost on the result of reciprocal profit
from the inward treaty when examining the terms of any treaty exchange through
intermediary.

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Regulations
IRDAI regulations state that all life and non-life insurers in India can write inward
reinsurance business from other domestic insurers and from overseas, provided that they
have a well-defined underwriting policy. The insurer shall ensure that decisions on
reinsurance business are exercised by persons with necessary knowledge and
experience. The insurer shall file with the IRDAI a note on his underwriting policy stating
the classes of business, geographical scope, underwriting limits and profit objective. The
insurer is also required to file any changes to the note as and when a change in
underwriting policy is made.

Combining Quota-Share and Excess of Loss Treaties on the

Reinsurance of An Independent Risks 4
When an insurance company seeks reinsurance for n independent risks (a risk refers to a
single policy or a group of policies) or for n independent lines of insurance) and has a
choice between a pure quota-share treaty, an excess of loss treaty or any combination of
the two, for any of the risks.
The way this combination operates is as follows:
• first the quota share contract will apply, so that the insurer shall remain responsible
for no more than its share--established by the contract--of any claim that may occur
for that risk;
• afterwards, the excess of loss contract applies, so that, by no means, shall the
insurer (of course considering only that part for which it remains responsible after
the quota-share contract) pay more than a certain fixed amount of any claim that
takes place.
The problem consists of determining the optimal retention limits for each risk, in each of
the two forms of reinsurance. "Optimal" in the sense those limits that maximize the
adjustment coefficient and, therefore, minimize the upper bound to the risk probability.

4Information cited from article authored by Lourdes Centeno and Onofre Simoes, Iseg,
Untversidade Tbcmca de Lisboa, PortugalS

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REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. The agreement between the primary insurer and reinsurer is known as:
a. Coinsurance b. Under Insurance
c. Over Insurance d. Reinsurance
e. None of the above
2. The other names for primary insurer;
a. Insured b. Ceder
c. Cedent d. Proposer
e. None of the above
3. Reinsurance is a contract of –
a. Indemnity b. Securitisation
c. Aleatory contract d. Both A & B
e. Both A & C
4. An insurer’s ability to provide a high limit of insurance on a single loss
exposure, is called;
a. Solvency syndrome b. Exposure Barrier
c. Large-line Capacity d. Over Capacity
e. None of the above
5. Which one the following can be classified as one of the primary functions of
reinsurance?
a. Stabilizing of loss experience
b. Minimizing the effects of catastrophe
c. Increasing the capacity

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d. All of the above

e. None of the above
6. The process of reinsuring all losses for an entire class, territory or book of
business is known as
a. Catastrophe Reinsurance b. Disaster insurance
c. Portfolio Reinsurance d. Large-line capacity
e. None of the above
7. At law, the policy holders do not have direct access to the reinsurers. However
there is an exception and it is
a. Provision of Subrogation b. Cut-through Endorsement
c. Pre-emptive Clause d. All of the above
e. None of the above
8. Reinsurance contract under which the ceding company has the option to cede
and reinsurer has the option to accept a risk of a specific business line is
called…….
a. Facultative Reinsurance b. Treaty Reinsurance
c. Proportional Reinsurance d. Optional Reinsurance
e. None of the above
9. What does the word “ treaty” mean in Treaty Reinsurance
a. An agreement between two parties b. Bulk Insurance policy
c. Single Insurance policy d. Ceding
e. None of the above
10. Under this the primary insurer cedes a fixed, predetermined percentage of
every risk to the reinsurer within the class or classes subject to the treaty.
a. Surplus Share Treaty b. Excess of Loss Treaty
c. Quota Share Treaty d. Stop Loss Treaty
e. None of the above

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11. In surplus reinsurance, the retained business is called

a. Margin b. Line
c. Treaty d. Loss Ratio
e. None of the above
12. The form of excess of loss reinsurance which indemnifies the reinsured
against the amount by which the reinsured losses incurred during a specific
period exceed either an agreed amount or agreed percentage is called
a. Stop-Loss Reinsurance b. Excess of Loss reinsurance
c. Quota Share Reinsurance d. Proportional Reinsurance
e. None of the above
13. This is the similarity between insurance and reinsurance
a. Liability of reinsurers is several and not joint
b. Principle of utmost good faith
c. Principle of Indemnity
d. Both B & C
e. Both A & B
14. The sum of all individual losses directly occasioned by any one disaster,
accident or loss or series of disasters arising out of one event, which occurs
within one State.
a. Catastrophe Loss b. Disaster syndrome
c. Loss Occurrence d. Hurricane clause
e. None of the above
15. The primary insurer sends a report of reinsured business every month /
quarter known as ‘bordereau’ to reinsurer. Such ‘bordereau’ contains
a. Premium details. b. Details of policies
c. Details of claims d. A&B
e. A, B & C

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16. One of the following is not a benefit of Treaty Reinsurance;

a. No need to offer each and every risk to Reinsurer.
b. Automatic protection for insurer.
c. Administrative convenience.
d. Premium concession
e. None of the above
17. The kind of treaty where the cedent company retains the risks till a certain
limit and reinsures only the part that is above its net retention is
a. Excess of Loss Treaty b. Stop Loss Treaty
c. Quota Share Treaty d. Surplus Treaty
e. None of the above
18. It is an agreement under which the reinsured and the reinsurer are obliged to
cede and accept a certain percentage of the risks.
a. Excess of Loss Treaty b. Stop Loss Treaty
c. Quota Share Treaty d. Surplus Treaty
e. None of the above
19. Under this agreement the reinsured limits the amount that it is ready to lose.
The reinsured relieves the excess amount which is in excess of its loss
retention.
a. Excess of Loss Treaty b. Stop Loss Treaty
c. Quota Share Treaty d. Surplus Treaty
e. None of the above
20. Under this agreement the reinsurer indemnifies the reinsured against the
amount by which the reinsured loss incurred during a particular period
exceeds either an agreed amount or an agreed percentage or some other
percentage.

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a. Excess of Loss Treaty b. Stop Loss Reinsurance

c. Quota Share Treaty d. Surplus Treaty
e. None of the above
21. The reinsurance in which the reinsurance limit and the reinsurer’s loss limit
apply ‘per risk’ is called
a. Per occurrence reinsurance b. Per risk reinsurance
c Catastrophe reinsurance d. Aggregate reinsurance
e. None of the above
22. One of the following is not a characteristic of Quota Share Treaty
a. Sharing of percentage is fixed.
b. No individual cessions
c. Premiums and losses are settled by account.
d. Individual cessions
e. None of the above
23. One of the following is not a characteristic of Pro-rata reinsurance.
a. Liability is based on predetermined percentage
b. It is proportional treaty
c. There is sharing of risks.
d. It is non-proportional treaty
e. None of the above
24. It offers the insurer protection against the accumulations resulting from
numerous losses caused by the same event (cyclone, earthquake)
a. Pro rate reinsurance b. Peril reinsurance
c. Cover per event d. Both (a) & (b)
e. None of the above

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25. A ‘line’ is equal to the ceding company’s retention. Where, a ceding insurer
has a ten line surplus treaty on the basis of a maximum retention of Rs 5000,
the capacity of the treaty to absorb liability over and above retention would be
a. Rs 50,000 b. Rs 55,000
c. Rs 5,000 d. Rs 1,00,000
e. None of the above
26. One of the following is not true;
a. There must be identity of views between the contracting parties in case of
reinsurance contracts.
b. The parties to the contract should not have any legal disabilities.
c. There must be consideration for the contract.
d. Wordings of the reinsurance agreement are agreed between the cedent and the
reinsurer beforehand.
e. None of the above
27. One of the following is not true;
a. Other than facultative reinsurance, all other agreements between the ceding
primary insurer and the reinsurer are written.
b. Treaty wordings have come to occupy an important place in the study of
reinsurance.
c. Treaty wordings are standardized throughout the world.
d. They include agreements on the follow up of accounting procedures.
e. None of the above.
28. “The liability of the Reinsurer in respect of reinsurance allotted hereunder
shall commence simultaneously with that of the company as soon as the
retention of the company on any one risk as defined by its limits, records,
practice or instructions is exceeded”. This clause is known as:

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a. Operative clause
b. Attachment of Cessions clause
c. Exclusions clause
d. Reserves clause
e. None of the above
29. “All acceptances hereunder shall be at the same gross rates, terms and
conditions as and to follow the settlement of the company and the Reinsurer
shall follow the fortunes of the company in regard to the cessions in which the
reinsurer by virtue of this agreement takes part”
a. Operative clause b. Follow the Fortunes clause
c. Exclusions clause d. Reserves clause
e. None of the above
30. “In no event shall this agreement protect the company in respect of : war and
civil war obligatory reinsurances. Any loss or liability accruing to the
company, directly or indirectly and whether as insurer or reinsurer, from any
pool of insurers or reinsurers formed for the purpose of covering atomic or
nuclear energy risks”
a. Operative clause
b. Attachment of Cessions clause
c. Exclusions clause
d. Reserves clause
e. None of the above
31. Which of the following clauses ensures that the reinsured does not change its
underwriting practices with regard to the business covered by the treaty?
a. Change of law clause
b. Costs clause
c. Currency clause

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d. Change of underwriting policy clause

e. None of the above
32. Which of the following clauses allows the reinsured to effect other
reinsurances in priority?
a. Recital clause b. Records clause
c. Operative clause d. Net retained lines clause
e. None of the above
33. The reinsurers hereby agree to indemnify the company for that part of the
ultimate net loss which exceeds the amount stated in item… of the schedule
on account of each and every loss occurrence and the sum recoverable under
this agreement shall be up to but not exceeding the amount stated in item… of
the schedule, ultimate net loss on account of each and every loss occurrence’
a. Operative clause b. Insuring clause
c. Exclusions clause d. Reserves clause
e. None of the above
34. “If during the currency of this agreement any balances under any other treaty
or treaties between the company and the reinsurer remain unpaid by one
party, the other shall be entitled to: retain the balance due hereunder until full
payment has been made under the other treaty or treaties: or adjust such
balance against the amount due from the other party
a. Reserves Clause b. Adjustment Clause
c. Set-off Clause d. Alterations Clause
e. None of the above
35. Arbitration clause for disputes provides for appointment of – arbitrator/s.
a. 1 b. 2
c. 3 d. 4
e. 5

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Answers
1. d 2. c 3. e 4. c 5. d 6. c 7. b 8. a 9. a 10. c
11. b 12. a 13. d 14. c 15. d 16. d 17. d 18. c 19. a 20. b
21. b 22. d 23. d 24. c 25. a 26. e 27. c 28. b 29. b 30. c
31. d 32. d 33. b 34. c 35. b

SECTION – B
Short & Essay Questions
1. What is a major difference between reinsurance and primary insurance?
Ans: A major difference is that a reinsurance program is tailored more closely to the
buyer, so there does not exist an “average” reinsured or “average” reinsurance
price.
2. What is the paradox of reinsurance pricing?
Ans: The paradox of reinsurance pricing is that a ceding company will not want to buy a
reinsurance contract that can be precisely priced.
3. How does surplus-share reinsurance differ from excess-of-loss reinsurance?
Give a numerical example for each type of reinsurance.
Ans: For surplus-share reinsurance, the retained line determines the reinsurer’s
proportional share of the risk. For instance, if the retained line is $100,000 on an
insured value of $500,000, then the reinsurer will share in ($500,000 -
$100,000)/$500,000 = 80% of any loss, no matter the amount of the loss.
By contrast, an excess-of-loss reinsurance agreement would involve a fixed
retention below which the ceding insurer absorbs all losses and the reinsurer’s
obligation to pay is only triggered if the total loss amount exceeds the retention. For
instance, in a treaty for $400,000 in excess of $100,000, the reinsurer will only pay
for losses of size X in excess of $100,000 and would pay an amount of (X -
$100,000), up to $400,000 in total.

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4. For a 6-line surplus-share reinsurance treaty with a retained line of $150,000,

how much will the reinsurer pay for a $500,000 loss on an insured value of
$750,000?
Ans: The retained line is $150,000 and the reinsured portion could be up to $150,000*6 =
$900,000. For an insured value of $750,000, the reinsured portion will be $750,000 -
$150,000 = $600,000, so the proportional share of the reinsurer’s involvement in any
loss would be $600,000/$750,000 = 80%. The reinsurer would thus pay 80% of the
$500,000 loss, or $400,000.
5. For a 6-line surplus-share reinsurance treaty with a retained line of $150,000,
how much will the reinsurer pay for a $500,000 loss on an insured value of
$1,600,000?
Ans: The retained line is $150,000 and the reinsured portion could be up to $150,000*6 =
$900,000. For an insured value of $1,600,000, the full reinsurance portion of
$900,000 will be utilized, since $1,600,000 - $150,000 = $1,450,000 > $900,000.
The proportional share of the reinsurer’s involvement in any loss would be
$900,000/$1,600,000 = 56.25%. The reinsurer would thus pay 56.25% of the
$500,000 loss, or $281,250.
6. Why do companies go for inward reinsurance?
Ans: Some of the reasons why companies go for inward reinsurance are asfollows:
• to increase the gross premium and net retained premium
• to achieve a lower expense ratio by maintaining the volume of premium
income as ceding reduces the premium income
• to obtain a better and wider spread of business
• to counteract the drain of foreign exchange caused by ceding of premium
• to earn an investment income which may be derived from the cash flow.
7. What are the considerations a company should keep in mind while finalizing
its inward program of reinsurance?
Ans: Some considerations the company should keep in mind while finalizing its inward
programme for the year are as follows

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• Treaty or facultative –facultative involves more administrative work as each

offer will be scrutinized. Treaty is less expensive but it requires a thorough
knowledge of the market and treaty clauses.
• Territorial scope-if the company wants a greater geographical spread then it
should
• underwrite foreign business keeping in view the political and economic
conditions of the country.
• Direct or brokers – if the company has experienced staff direct business can
be solicited.
• However this will involve travel expenses to procure business. So initially it is
better to place business through a broker.
• Class of business- the company should decide whether it wants to underwrite
property business, which is on annual basis or casualty business.
• Acceptance limits-keeping in mind the financial standing and premium income
of the company
• the acceptance limit should be large enough to make it attractive for the
brokers and ceding companies to offer business.
8. Do you agree that reinsurance contracts are aleatory in nature? If so, explain
how?
Ans: All the legal principles that govern an insurance contract will be applicable to a
reinsurance contract as well like insurer and reinsurer should have the legal capacity
to contracts and there must be consideration for the contract. Reinsurance contracts
are aleatory in the sense that premium share to the reinsurer will be small compared
to the reinsurance payments that will be made by the reinsurer in the event of a
claim.
9. What are the functions of reinsurance?
Ans: There are six different functions of reinsurance that have been broadly recognized:
• Stabilisation of loss experience.
• Large-line capacity
• Financing (Surplus relief)

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• Catastrophe Protection
• Underwriting Assistance
• Withdrawal from a territory or class of business.
10. Explain Facultative Reinsurance and Treaty Reinsurance.
Ans: Facultative is optional – not compulsory. The primary insurer need not insure every
business. He need only reinsure when there is lack of capacity regarding a particular
class of insurance e.g aviation insurance. Facultative reinsurance is defined as
reinsurance contract under which ceding company has the option to cede and
reinsurer has the option to accept a risk of a specific business line. Facultative can
be either proportional or non-proportional. It plays a very important role in Aviation
Hull, Oil and Space industry. Whereas under Treaty Reinsurance the primary insurer
is obliged to cede and the reinsurer is obliged to accept part or all of the classes of
business covered by the treaty. The treaty can be either proportional or non-
proportional basis. The treaty does not require the ceding company to provide the
details of the risks individually but some times a bordereaux is provided.
11. What is proportional and non-proportional reinsurance?
Ans: In proportional reinsurance, the cession accepted by the reinsurer has a certain
fixed or agreed proportion to the retention of the primary insurer. Similarly, when
claim occurs, the loss is settled between the primary insurer and the reinsurer in the
same proportion as their acceptance of sum insured. Proportional contracts can be
facultative, quota-share treaty, surplus treaty, facultative obligatory treaty, open
cover and pools. It is also known as Participating Reinsurance or Pro rata
reinsurance. Under non-proportional reinsurance, the distribution of liability between
the cedent and the reinsurer is based on loss and not on the amount insured. There
is no proportionate sharing of loss but an amount is decided and any loss beyond
that amount is paid by the reinsurer. Some of the non-proportionate contracts are
excess of loss treaty and stop-loss treaty.
12. Explain the Excess of Loss Reinsurance.
Ans: In this type of reinsurance, no insurance amount is ceded under excess of loss
treaties, but only losses and premiums. The reinsurance premium is negotiated by
line and by insurer. There are no ceding commissions under excess of loss treaty.
The excess reinsurer is only responsible for losses that exceed the retention and fall
within the coverage provided by the reinsurance contract. The excess of loss covers

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are two types: a) per risk cover b) Per event covers / Catastrophe covers. The
purpose of per risk cover is to reduce or replace the normal proportional
reinsurance. These treaties are referred to as underwriting or working covers. The
reinsurer has to pay any loss on an individual risk in excess of the ceding company’s
retention. The reinsurer is liable for all or part of loss to any one exposure in excess
of the retention and up to the agreed reinsurance limit. Catastrophe covers / Per
Event covers: this cover indemnifies the reinsured company for the amount of loss in
excess of a specified retention with respect to accumulation of losses resulting from
a catastrophic event or a series of events.
13. Explain Quota Share Treaty.
Ans: In Quota share contracts the cedent binds itself to retain and cede fixed proportions
of all the business it underwrites up to a fixed amount. For example, if the Ceding
Company shall retain for own account 40% of all burglary business, with an
underwriting limit of 50,000 per risk. The Cedent shall reinsure with the Reinsurer,
who agrees to accept a 60% share of all burglary business.
The advantages of the system are particularly appropriate in the following cases:
• When a company commences business in a line of business for which no
statistics exist; here the Reinsurer participates in the underwriting of each
policy, large and small and pays in the same proportion its share of the losses.
• In order to simplify administrative work and reduce cost.
• If the loss ratio has got out of the Cedent’s control and cannot be corrected
immediately without endangering the relationship with the clientele. Under
these
circumstances Cedent would conclude quota share reinsurance as a relief for
a limited period of time.
14. Differentiate between Proportional and Non proportional treaties.
Ans: Non-proportional reinsurance arrangements are characterized by a distribution of
liability between the Cedent and the reinsurer on the basis of losses rather than
Sums Insured, as in case of proportional arrangements. As compensation for the
cover granted, the Reinsurer receives part of the original premiums and not the part
of the premium corresponding to the sum reinsured as in proportional reinsurance.
The following common characteristics differentiate them from proportional treaties.

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1. The size of cession is not determined case by case.

2. Administrative costs are substantially reduced.
3. Usually there is no profit commission.
4. Reinsurance premium is worked out on the basis of exposure and past loss
experience.
15. Differentiate between Surplus Share Treaty and Quota Share Treaty
Ans:

Surplus share treaty Quota share treaty

1. Often property only. 1. Both property and casualty.

2. Sharing of percentage is variable. 2. Sharing of percentage is fixed.
3. Individual cessions. 3. No individual cessions.
4. Reinsurer’s premium is the 4. Reinsurer’s premium is the
percentage of Original premium less percentage of the original
a ceding commission ceding
commission
5. Premiums and losses are settled by 5. Premiums and losses are settled
account. by account.
16. Differentiate between Pro-rata and Excess of Loss Reinsurance.
Ans:

Pro-rata Excess of loss

1. Liability is based on predetermined 1. Liability in excess of the Cedent’s

Percentage. retention.
2. It is a proportional treaty. 2. It is a non-proportional treaty.
3. There is sharing of risks. 3. Risks that are above retention are not
shared.
4. This treaty focuses on the size of 4. This treaty focuses on the size of the
the risk. loss.

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5. Rate is calculated as the percent of 5. There is a separate rate, with the

original premium less the ceding commission or without commission.
commission.
6. Premiums and losses are settled by 6. Settlement of premiums account and
account or bordereau. the settlement of losses individually.
17. Outline the characteristics of Non-proportional treaties.
Ans:
S. Per risk Per Occurrence Aggregate (stop loss)
No.
1. It is negotiated on rate It is negotiated on Rate Rate exposure basis and
exposure basis and exposure basis and there is no commission.
there is no commission. there is no commission.
2. Premiums are settled by Premiums are settled by Premiums are settled by
annual adjustment of annual adjustment of annual adjustment of
deposit premium. deposit premium. deposit premium.
3. Premium is minimum. Premium is minimum. Premium is minimum.
4. Losses are settled Losses are settled by Losses are settled
individually. catastrophe or event. annually
5. Retention is for each Retention is usually Retention and the limit
risk or building or above a minimum of two stated as a loss ratio.
location. Full-losses.
6. It has per occurrence It has a co-insurance It has a co-insurance
limitation. shares the provision when the above retention. Loss
loss reinsured shares the
above retention
18. Under what circumstances will the reinsurance agreement get terminated?
• Either party shall be at liberty to terminate it as at 31st December in any year
by giving not less than 90 days ‘previous notice in writing. Unless the parties

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otherwise agree, the Reinsurers will remain liable for all reinsurances ceded
under this agreement until their natural expiry.
• In the event of War (whether declared or not) arising between India and the
country in which the Reinsurers reside or carry on business or are
incorporated, this Agreement shall be automatically terminated forthwith.
• If during the period of this Agreement, postal and/or telegraphic
communications should be rendered impossible as a consequence of War,
warlike operations, blockade, revolution, civil war or other similar event for a
period exceeding thirty (30) days, the Company shall be entitled to terminate
this Agreement forthwith without giving notice.
• Either party shall have the right to terminate this Agreement immediately by
giving the other party notice:
• If the performance of the whole or any part of this Agreement be prohibited or
rendered impossible de jure or de facto in particular and without prejudice to
the generality of the preceding words in consequence of any law or regulation
which is or shall be in force in any country or territory or if any law or
regulation shall prevent directly or indirectly the remittance of any or all or any
part of the balance or payments due to or from either party.
• If the other party has become insolvent or unable to pay its debts or has lost
the whole or any part of its paid up capital or has had any authority to transact
any class of insurance withdrawn or canceled or suspended or made
conditional.
• If there is any material change in the ownership or control of the other party.
• If the country or the territory in which the other party resides has its head
office or is incorporated shall be involved in armed hostilities with any other
country whether war be declared or not or is partly or wholly occupied by
another power.
• If the other party shall have failed to comply with any of the terms and
conditions of this Agreement.

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19. Explain the Accounting of Losses.

Ans: Preliminary loss advices shall be sent by the Company to the Reinsurer in respect of
all losses where the proportion of the reinsurers sharing in the Agreement is
estimated to exceed the amount stated in the Schedule. Furthermore, the Company
shall furnish the Reinsurer an estimate of outstanding losses as at 31st December of
each year. When the proportion of a loss and or expenses falling upon all the
reinsurers sharing in this Agreement amounts to or exceeds the amount specified in
the Schedule, the reinsurers shall be liable to pay its proportion within 21 days of
demand. The Company shall debit all other losses and/or loss expenses in the
accounts of the quarters in which the losses and/or loss expenses are settled. Any
loss or claim or compromise thereof and all expenses including fire extinguishing
expenses shall be settled by the Company without reference to the reinsurer and
such settlements including ex gratia payments shall in all cases be unconditionally
binding upon the reinsurer. The Company at its sole discretion may commence,
continue, defend, compromise, settle or withdraw from any actions, suits and
prosecutions and generally do all such matters relating to any loss or claim which in
its judgment may be advantageous and the payment of all expenses and allowances
in connection therewith shall be shared by the reinsurer in proportion to its
participation. The Reinsurer shall share in proportion to its participation in all
amounts which may be recovered by the Company in respect of any loss or claim.”
20. What do you understand by Insuring clause?
Ans: “The Reinsurers hereby agree to indemnify the Company for that part of the ultimate
net loss which exceeds the amount stated in item … of the Schedule on account of
each and every loss occurrence and the sum recoverable under this Agreement
shall be up to but not exceeding the amount stated in item … of the Schedule,
ultimate net loss on account of each and every loss occurrence. The underlying loss
stated in item … of the Schedule shall be retained net by the Reinsured subject only
to underlying excess catastrophe reinsurances as specified in item … of the
Schedule.”
21. Explain the importance of Treaty wordings.
Ans: Written agreements are more easily enforceable than verbal ones and so every
insurance contract is written, satisfying all the legal principles on which insurance is

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founded and the points of law to satisfy the definition of a legal contract.
Reinsurance is similar to an insurance contract and hence it is important that the
wordings of the reinsurance agreement are agreed between the cedent and the
reinsurer beforehand. Other than facultative reinsurances, all other agreements
between the ceding primary insurer and the reinsurer are by means of written and
agreed treaties and therefore, the treaty wordings have come to occupy an
important place in the study of reinsurance. However, it is recognized that the treaty
wordings are not standardized and the different countries and reinsurers have
adopted their own typical wordings for treaties. At the same time, the general
conditions are fairly uniform for all treaties but the special conditions are distinct
exercises depending on particular needs of the contracting parties and also the
individual classes of insurance. Again, the proportional and non-proportional treaties
have separate distinct wordings, which have some special features characteristic of
the type of treaty. One other interesting feature of all treaty wordings is that they
include agreements on the follow-up accounting procedures, which actually make
implementation of the treaty much easier.
22. What is dispute resolution mechanism available for company and reinsurer?
Ans: “Incase of any disputes between the company and the reinsurers regarding the
interpretation of the agreement or the rights with respect to any transaction involved
either before or after the termination, disputes as such shall be dealt with the single
arbitrator appointed in writing by both the parties. If incase of any failure to agree
upon the single arbitrator it can be referred to two arbitrators of which one is
appointed in writing by each of the parties. Incase of any disagreement between the
two arbitrators an umpire is appointed by the arbitrators. These arbitrators or the
umpire are required to be appointed in 30 days after such a requisition of arbitrators
made by the parties. These are appointed in writing by the chairman of the Bombay
Regional Committee of the tariff advisory committee. Such appointed arbitrators or
umpires are required to interpret their agreement as a honorable engagement and
make their award and serve the purpose. The decision of these arbitrators or the
umpires is the final and binding as the case may be inclusive of allocation of costs
on both the parties.

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SECTION – C
Case Studies
1. New Star insurance company has purchased from MumRe Reinsurance
company a Quota Share Treaty with a Rs 250,000 limit and a retention of 25
percent and a cession of 75 percent. New Star has written three policies.
Policy A insures building A for Rs 10,000 for a premium of Rs 100, with one
loss of Rs 8000. Policy B insures building B for Rs 100,000 for a premium of
RS 1000, with one loss of Rs 10,000. Policy C insures building C for Rs 150,000
for a premium of Rs 1500, with one loss of Rs 60,000. Rahul khanna, the new
Reinsurance Manager, feels that Surplus Share Treaty is better than Quota
Share Treaty as it will be limiting the claim exposure of New Star Insurance
and there is more liability in the court of MumRe. Assuming that New Star has
purchased a Surplus Share Treaty with a retention of Rs 25,000 and a limit of
Rs 250,000 ( a ten-line surplus treaty), show your calculations under two
reinsurance arrangements.
Ans.
QUOTA SHARE TREATY
Division of Insurance Premium and Losses
New Star MumRe TotalRs. Insurance
(25%) (75%)
Policy A
Insurance 2500 7500 10,000
Premium 25 75 100
Loss 2000 6000 8,000
Policy B
Insurance 25,000 75,000 100,000
Premium 250 750 1000

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Loss 2500 7500 10,000

Policy C
Insurance 37,500 112,500 150,000
Premium 375 1125 1500
Loss 15000 45000 60,000
SURPLUS SHARE TREATY
Division of Insurance, Premium and Losses
Retention Rs 25,000 and Limit Rs 250,000
New Star MumRe Total RsInsurance
(%) (%)
Policy A
Insurance 10,000 (100%) 0 (0%) 10,000
Premium 100 0 100
Loss 8000 0 8,000
Policy B
Insurance 25,000 (25%) 75,000 (75%) 100,000
Premium 250 750 1000
Loss 2500 7500 10,000
Policy C
Insurance 25,000 (16.67%) 125,000 (83.33%) 150,000
Premium 250 1250 1500
Loss 10,000 50,000 60,000
Thus under Surplus Share Treaty New Star insurance company can limit the
payment of premium and also reduce loss exposure.
2. Munich insurance company entered into two surplus treaty contracts with the
reinsurers. The first surplus treaty consisted 10 lines with a maximum liability

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of Rs. 30,00,[Link] second surplus treaty consists of 20 lines with a

maximum liability of 50,00,[Link] claims filed are as under: Show
calculations of premium as per surplus treaty.
Risk Gross Sum Insured Retention applicable
1 Rs. 2,00,000 Rs.2,00,000
2 Rs. 3,00,000 Rs.1,00,000
3 Rs. 12,00,000 Rs.2,00,000
4 Rs. 30,00,000 Rs.4,00,000
5 Rs. 65,00,000 Rs.2,00,000
Ans.
Risk Gross sum Retention [Rs] Cessions to 1st Cessions to 2nd
insured [Rs] surplus treaty surplus treaty
1 Rs. 2,00,000 Rs.2,00,000 Nil
2 Rs.3,00,000 Rs.1,00,000 Rs.2,00,000 Nil
3 Rs.12,00,000 Rs.2,00,000 Rs.10,00,000 Nil
4 Rs.30,00,000 Rs.4,00,000 Rs.26,00,000 Nil
5 Rs.65,00,000 Rs.2,00,000 Rs.20,00,000 Rs.40,00,000
Balance 3,00,000 has to be arranged Facultatively.
3. Rakshak Insurance was prepared to bear any claim up to Rs 3,00,000. It
estimated the maximum exposure per event to be Rs 12,00,000. Rakshak
Insurance entered an excess of loss reinsurance contract with Takat
Reinsurance to meet the balance of any claim up to further Rs 9,00,000 in
excess of Rs 3,00,000 per risk. On account of a cyclone the town suffered
heavy damages and several houses were badly hit. 60 houses of the insured
were damaged. Subsequently 60 claims of each Rs 3,60,000 were filed with
Rakshak.
Show the calculations relating to –
(a) retention amount by the insured
(b) recoverable amount from the excess of loss reinsurance.

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Ans.
Number of houses 1 (Rs) 60 (Rs)
Payment to Primary Insured 3,60,000 2,16,00,000
Retained by Rakshak 3,00,000 1,80,00,000
Recovery from Takat 60,000 36,00,000

4. Dunhill, a subsidiary of a bank, employed a consultancy firm to advise

investors about switching from corporate to pension plans. Dunhill was
insured under a banker’s composite insurance policy issued by the defendant
insurers. Under this policy, the insurers agreed to indemnify the company in
respect of its legal liability from any third party claim. Over a period of years,
there were substantial claims by investors who had changed their pensions
and who had suffered losses as a result. It was alleged that the consultancy
firm had provided incorrect advice. For the purpose of a claim on insurers, the
company submitted that the claims by investors were a series of claims that
resulted from a single act or omission, namely, a failure on the part of their
own management to train properly the consultancy firm so as to be able to
give investors best advice. Insurers argued that it was the failure on the part of
the consultancy firm in each case to give proper advice to the investor, rather
than the failure on the part of management to provide proper training to the
consultancy firm. Discuss.
Ans. The aggregation clause requires one to ask a matter of common sense whether the
series of claims and questions was the result of an act or omission of that kind. In
common sense terms, all of the third party claims resulted from a failure on the part
of management to provide the training required to enable the consultancy firm to
give proper advice to investors. The proper course would be to identify the
dominant, efficient, or real cause of the loss. In the absence of agreement to the
contrary, the presumption would be that the policy was intended to provide cover
where an insured peril was the dominant, efficient, or real cause of the loss, but not
otherwise. Here, the policy provided cover against losses caused by a range of acts
and omissions committed by officers and employees of the insured. It was not
difficult to envisage circumstances in which a single act or omission on the part of

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one officer or employee might give rise to claims of a sufficient size to exceed the
deductible when aggregated. Whether that failure should be regarded as a single act
or omission on the part of the insured or as a related series of acts or omissions
does not matter. In either case, the insured is entitled to the claims.
5. Carona Insurance entered into a reinsurance contract with Lawson
reinsurance company. The definition of loss in the treaties provide that a
“disaster and / or casualty” included all loss ‘resulting from a series of
accidents, occurrences and / or causative incidents having a common origin
and /or being traceable to the same act….. shall be considered as having
resulted from a single accident..’. Carona insurance settled claims, which
covered multiple sites in multiple geographic jurisdictions, by allocating the
sites as separate occurrences under its underlying insurance policies. Later
Carona sought recovery from Lawson. Carona treated each settlement for each
insured as a single ‘disaster and/or casualty’ under the terms of the applicable
excess of loss reinsurance treaties. Lawson Reinsurance did not accept
Carona’s allocation. Was Lawson right in rejecting Carona’s allocation?
Ans. Carona’s allocation of settlements did not fall within the ‘disaster and/or casualty’
language of there insurance treaties. Carona’s interpretation of the ‘common origin’
language in the treaties was not valid as the words ‘series of modify’ ‘common
origin’. ‘Aggregation’ was proper only if the occurrences had a common origin. Here,
the claims could not be aggregated since they did not have a common origin. Thus,
Lawson Reinsurance was right in rejecting Carona’s allocation.

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CHAPTER – 2
REINSURANCE REGULATIONS AND LAW
IN INDIA
OUTLINE OF THE CHAPTER
1. Introduction
2. Reinsurance Regulations in India
3. IRDAI Guidelines on Reinsurance
4. Constitution of Reinsurance Expert Committee
5. Cross Border Reinsurers Approval (CBR)
6. Reinsurance Contracts and Treaties
7. Proportional Treaty Wordings
8. Non-proportional Contract Clauses
9. Arbitration and Mediation
10. Monitoring of the Reinsurance Programs of Primary Insurers
11. Insurer’s Perspective
12. Failures and Reinsurance
13. Abuses of Reinsurance
14. Supervision of Reinsurance
15. Supervision of Reinsurance Companies
16. IRDAI Reinsurance Initiatives
17. Questions
 REINSURANCE REGULATIONS AND LAW IN INDIA

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Getting acquainted with Reinsurance Regulations in India
• Knowing IRDAI Regulations
• Understanding Principal contract related strategies
• Appreciating Salient features of Arbitration
• Understanding Treaty Wordings

Introduction
The law of reinsurance is based primarily on the law of contract. In India, IRDAI has
prescribed regulations for the reinsurance sector for general as well as life insurance. The
principal contract related statutes and regulations govern the insolvency, offset and
intermediary clauses, which appear in both treaties and facultative certificates. Treaty
wordings are reinsurance agreements entered into in writing between the ceding insurer
and his reinsurer and embody the terms and conditions of the treaty.
Until recently, reinsurers were not subject to the extent of regulations generally imposed
on the insurers, that is, until a few scandals involving some reinsurers and reinsurance
brokers rocked the industry. The reasons that have resulted in regulating insurers chiefly
were to protect insured from unfair trade practices of some insurers and also possible
insolvency of insurers, apart from unreasonable premium rates.
However, recently many countries have felt the need to impose some regulations on
reinsurers for the overall health of the insurance industry.
For instance, in the U.K., the Department of Trade requires the primary insurers to
annually report on the following:
a) The names and addresses of all reinsurers to whom business has been ceded
during the year;
b) Any connection (other than the reported reinsurance) between the primary insurer
and any of its reinsurers;
c) The amount of premium payable to each reinsurer; and
d) Any indebtedness of a reinsurer to the primary insurer at the end of the year.

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The reinsurance rules relating to the Indian context are discussed separately in the next
section.
In the United States, reinsurers as well as licensed alien reinsurers have to keep solvency
margin almost along the lines prescribed for primary insurers and must follow reserves,
investment, capital and surplus requirements and annually or sometimes every quarter file
financial statements with State regulatory authorities.
Pricing is not directly regulated though the regulation of primary insurer’s rates could affect
the reinsurance pricing.
Another important regulation relates to a contingency when a primary insurer goes
bankrupt. The regulation by means of an insolvency clause provides that the insolvency of
the primary insurer will not affect the liability of the reinsurer for losses under the
reinsurance contract: the reinsurer will make payment to the liquidator or the receiver of
the insolvent primary insurer for the benefit of their creditors, namely the insured.
Another important regulation is through an intermediary clause whereby the risk of
insolvency of the reinsurance broker is passed on to the reinsurer so any default by the
reinsurance broker either to transmit the reinsurance premium to the reinsurer or pass on
reinsurance claims payments to the primary insurer will be made good by the reinsurer
since it is now established that the reinsurance broker is an agent of the reinsurer and not
the primary insurer.
Reinsurance brokers are regulated much less in the U.S. However, some States, notably,
New York, have required reinsurance brokers to be licensed. According to New York
Regulation 98, the following regulations apply to the reinsurance brokers:
• Reinsurance intermediaries act in a fiduciary capacity for all funds received in their
professional capacity and must not mix them with other funds without the consent of
the insurers and reinsurers they represent;
• Reinsurance intermediaries shall have written authorization from the insurers
and reinsurers they represent, spelling out the extent and limitations of their
authority;
• The written authority above must be made available to the primary insurers or
reinsurers with which the intermediary deals;
• No licensed intermediary shall procure reinsurance from an unlicensed reinsurer
unless the reinsurer has appointed an agent for the service of process in New York;

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The intermediary must make full written disclosure of:

• Any control over the broker by a reinsurer,
• Any control of a reinsurer by the intermediary,
• Any retrocession of the subject business placed by the intermediary and
• Commissions earned or to be earned on the business.
Records of all transactions must be retained for at least ten years after the expiration of all
reinsurance contracts.

Reinsurance Regulations in India

In India, the Insurance Regulatory and Development Authority of India (IRDAI) has
prescribed regulations for the reinsurance sector for general as well as life insurance and
we summarize below these regulations. (The test of the Regulations is reproduced in
Annexure I to the Chapter)
The IRDAI (General Insurance-Reinsurance) Regulations, 2000 are as follows.
• The first chapter defines such special terms as cession, facultative, Indian reinsurer,
pool, retrocession, retention and treaty.
• The second chapter describes the procedure to be followed for reinsurance
arrangements:
i) Clause 3-1 states the objectives of a reinsurance program as;
■ To maximize retention within the country;
■ Develop adequate capacity;
■ Secure the best possible protection for the reinsurance costs incurred;
■ Simplify the administration of business.
ii) Clause 3-2: Every insurer shall maintain the maximum possible retention
commensurate with its financial strength and volume of business. The
Authority may require an insurer to justify its retention policy and may give
necessary directions to ensure that the Indian insurer is not merely fronting for
a foreign insurer.

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iii) Clause 3-3: Every insurer shall cede such percentage of the sum insured on
each policy for different classes of insurance written in India to the Indian
reinsurer as may be specified by the Authority in accordance with the
Insurance Act, 1938 in this regard.
iv) Clause 3-4: The reinsurance program of every insurer shall commence from
the beginning of every financial year and every insurer shall submit to
the Authority, his reinsurance programs for the forthcoming year, 45 days
before the commencement of the financial year.
v) Clause 3-5: Within 30 days of the commencement of the financial year, every
insurer shall file with the Authority a photocopy of every reinsurance treaty slip
and excess of loss cover note in respect of that year together with the list of
reinsurers and their shares in the reinsurance arrangement.
vi) Clause 3-6: The Authority may call for further information or explanations in
respect of the reinsurance program of an insurer and may issue
necessary directions.
vii) Clause 3-7: Insurers shall place their reinsurance business outside India with
only those reinsurers who have over a period of the past five years counting
from the year preceding for which the business has to be placed, enjoyed a
rating of at least BBB (with Standard & Poor) or equivalent rating of any other
international rating agency. Placements with other reinsurers shall require the
approval of the Authority. Insurers may also place reinsurances with Lloyd’s
syndicates taking care to limit placements with individual syndicates to such
shares as are commensurate with the capacity of the syndicate.
viii) Clause 3-8: The Indian reinsurer shall organize domestic pools for reinsurance
surpluses in fire, marine hull and other classes in consultation with all insurers
on basis, limits and terms, which are fair to all insurers and assist in
maintaining the retention of business within India as close to the level
achieved for the year 1999-2000 as possible.
ix) Clause 3-9: Surplus over the domestic reinsurance arrangements class wise
can be placed by the insurer independently with any of the reinsurers
complying with sub regulation (7) subject to a limit of 10% of the total
reinsurance premium ceded outside India being placed with any one reinsurer.

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Where it is necessary in respect of specialized insurance to cede a share

exceeding such limit to any particular reinsurer, the insurer may seek the
specific approval of the Authority giving reasons for such cession.
x) Clause 3-10: Every insurer shall offer an opportunity to other Indian insurers
including the Indian reinsurer to participate in its facultative and treaty
surpluses before placement of such cessions outside India.
xi) Clause 3-11: The Indian reinsurer shall retrocede at least 50% of the
obligatory cessions received by it to the ceding insurers after protecting the
portfolio by suitable excess of loss covers. Such retrocession shall be at
original terms plus an overriding commission to the Indian reinsurer not
exceeding 2.5%. The retrocession to each ceding insurer shall be in proportion
to its cessions to the Indian reinsurer.
xii) Clause 3-12: Every insurer shall be required to submit to the Authority
statistics relating to its reinsurance transactions in specified forms together
with its annual accounts.
xiii) Clause 4: Inward Reinsurance Business: Every insurer wanting to write
inward reinsurance business shall have a well-defined underwriting policy for
underwriting inward reinsurance business. The insurer shall ensure that
persons with necessary knowledge and experience make decisions on
acceptance of reinsurance business. The insurer shall file with the
Authority a note on its underwriting policy stating the classes of
business, geographical scope, underwriting limits and profit objective. Any
change in underwriting policy shall also be filed.
xiv) Clause 5: Outstanding Loss Provisioning: Every insurer shall make outstanding
claims provisions for every reinsurance arrangement accepted on the basis of
loss information advices received from Brokers/Cedants and where such
advices are not received, on an actuarial estimation basis.
In addition, every insurer shall make an appropriate provision for incurred but not reported
(IBNR) claims on its reinsurance-accepted portfolio on actuarial estimation basis.
It is interesting to note that the IRDAI’s rules for reinsurance of life business are almost
wholly along the lines of its regulations in the matter of general insurance business. In

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other words, the general prescription seems to be that there will be maximum retention
within the country and overseas placements of reinsurance will be based on satisfactory
rating of those reinsurers, either according to Standard & Poor or other reputed rating
agencies.

IRDAI Guidelines on Reinsurance

OBLIGATORY CESSIONS TO INDIAN REINSURERS NOTIFICATION-2016 F. No
IRDAI/RI/18/130/2016 — In exercise of the powers conferred by Sub-section (2) of the
Section 101A of the Insurance Act 1938, the Authority, after consultation with the Advisory
Committee constituted under section 101B of the Insurance Act 1938 and with the
previous approval of the Central Government, hereby makes the following notification
namely:-
The percentage cessions of the sum insured on each General Insurance Policy to be
reinsured with the Indian Reinsurer shall be 5% in respect of insurance attaching during
the year 1st April, 2015 to 31st March, [Link] 101A(4) provides that a notification
under sub-section (2) of Section 101A of the Insurance Act, 1938 may also specify the
terms and conditions in respect of any business of re-insurance required to be transacted
under this section and such terms and conditions shall be binding on Indian re-insurers
and other insurers.
In pursuance of the power conferred by Section 101A of the Insurance Act, 1938 the
Authority in consultation with the Advisory Committee constituted under section 101B of
the Act hereby specifies the percentage and terms and conditions for the reinsurance
cessions to the “Indian Reinsurer” in compliance with section 101A of the Act.
Class Limit of cession in sum Commission
insured
Fire, IAR Large Risks Rs 750 crores sum insured a) Minimum 15% for all
(MD+LOP)per risk classes
Marine Cargo/DSU Rs 50 crores sum insured b) except Oil & Energy,
Insurance per Aviation,
policy/bottom/sending c) Group Health and
Motor TP
Marine Hull Rs 50 crores sum insured

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per vessel d) Minimum 10% for group

War & SRCC Rs 50 crores sum insured health.
per vessel e) Minimum 5% for Motor
TP
Motor No Limit*
f) Anything over and
Workmen’s No Limit* above this can be as
Compensation mutually agreed
General Aviation Hull No Limit* between GIC and the
Insurance Company.
General Aviation Liability No Limit*
All Liability products Rs 25 crores per policy
excluding financial including USA/
liability Rs 50 crores per policy
excluding USA
Financial, Credit and Rs 50 crores sum insured
Guarantee Lines, per policy
mortgage insurance,
special contingency
policies etc.
Other Miscellaneous No Limit*
Machinery Breakdown, Rs 100 crores per risk
Boiler Explosion and
related loss of profits
Contractor’s All Risks, Rs 500 crores per risk
Erection All Risks, (MD+LOP)
Advance Loss of Profits,
DSU Insurance
Oil & Energy Rs 50 crores SI per risk 5%
Crop/Weather Insurance Rs 50 crores SI 15%
Aviation (Airlines) No Limit* Average Terms

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Profit Commission
1. Sliding scale of Profit commission based on the total obligatory portfolio of the
company
2. Profit commission is payable if Loss Ratio is less than 78%
3. Surplus to be calculated after factoring
• Incurred loss % (to be worked at the end of 3 Financial years)
• Management Expenses at 2%
• Profit at 5%
• Commission at 15%
• Loss Ratio at 50% to 78%
4. No profit commission is payable if the loss ratio is equal to or more than 78%.
5. Surplus to be shared between the direct insurer and GIC on 50% : 50% basis.
6. Profit commission shall not exceed 14%
* Note: In respect of classes with “No Limit” on cessions marked by an asterisk above, the
“Indian Reinsurer” may require the ceding insurer to give immediate notice with
underwriting information of any cession to it exceeding an amount per risk specified by it.
Cessions in excess of such limits will be binding subject to the notice and information been
given
(GENERAL INSURANCE) REINSURANCE REGULATIONS - 2016
The IRDAI on 13th May, 2016, issued the General Insurance - Reinsurance Regulations,
2016, vide F. No. IRDAI/Reg/15/127/2016., read with sections 14 and 26 of the Insurance
Regulatory and Development Authority Act, 1999, the Authority, in consultation with the
Insurance Advisory Committee, made the following regulations-
I. Short Title and Commencement
1. These regulations may be called the Insurance Regulatory and Development
Authority of India(General Insurance - Reinsurance) Regulations, 2016.
2. These Regulations replace the Insurance Regulatory and Development Authority
(General Insurance - Reinsurance) Regulations, 2013.

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3. These regulations shall come into force on the date of their notification in the Official
Gazette.
II. Definitions
In these regulations, unless the context otherwise requires:
(a) ‘Act' means the Insurance Regulatory and Development Authority Act, 1999 (41 of
1999);
(b) 'Authority' means the Insurance Regulatory and Development Authority of India
established under sub-section (1) of section 3 of the Act;
(c) ‘Cedant’ means (i) an insurer who underwrites and issues an original, primary policy
to an insured and contractually transfers (cedes) a portion of the risk to a reinsurer
or (ii) a reinsurer who cedes part of contracted risk to a retrocessionaire.
(d) 'Cession' means the part of insurance passed to a reinsurer by the insurer which
issued a policy to the original insured or part of contracted risk ceded by a reinsurer
to a retrocessionaire;
(e) 'Cover note' is a written document issued by the reinsurer or the reinsurance broker
authorized by it, detailing the terms and conditions of the contract;
(f) ‘Cross Border Reinsurer’ means an insurer/ reinsurer who is not registered in India
as an insurance company or reinsurance company or foreign reinsurer branch but,
does reinsurance business with Indian Insurers/ Indian reinsurer, foreign Reinsurer
branches.
(g) 'Facultative Reinsurance ' means reinsurance of a part of a single policy/risk in
which cession is negotiated separately and the reinsurer and the cedant have the
option of accepting or declining each individual submission;
(h) ‘Financial Year’ for the purpose of these regulations shall be the period starting from
1st April to 31st March.
(i) ‘Fronting’ means a process by which a direct insurer cedes most of or all of the
insurance risk to a reinsurer.
(j) ‘Foreign Reinsurer Branch’ means a branch of a Foreign Reinsurer who has been
granted certificate of registration by the Authority under the Insurance Regulatory
and Development Authority of India (Registration and Operations of Branch Offices

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of Foreign Reinsurers other than Lloyd’s) Regulations, 2015 or Insurance Regulatory

and Development Authority of India (Lloyd’s India) Regulations, 2016, as amended
from time to time.
(k) ‘Indian Insurer’ for the purpose of these regulations means an Indian Insurance
company who has been granted certificate of registration by the Authority under the
Insurance Regulatory and Development Authority (Registration of Indian Insurance
Companies) Regulations, 2000 notified from time to time to carry out general
insurance business or health insurance business.
(l) ‘Insurance segments’ for the purpose of these regulations, shall mean the following
(i) Fire;
(ii) Marine;
(iii) Health (including Personal Accident & Travel);
(iv) Motor;
(v) Miscellaneous;
(vi) Any other segment (under miscellaneous segment) which contributes more
than 10 per cent of the Gross Written Premium of the Miscellaneous segment
of business;
(vii) Any other segment as may be specified by the Authority from time to time
(m) Pool' means any joint underwriting operation of insurance or reinsurance in which
the participating insurer/s or reinsurer/s assume a predetermined and fixed share in
all business written;
(n) 'Retrocession' means the transaction whereby a reinsurer cedes to another insurer
or reinsurer all or part of the reinsurance it has previously assumed;
(o) 'Retention' means the portion of the risk which an insurer/reinsurer assumes for his
own account;
(p) 'Reinsurance contract' is the legally binding document on all the parties that provides
a complete, accurate and definitive record of all the terms and conditions and other
provisions of the reinsurance contract;
(q) 'Treaty' means a reinsurance arrangement between the cedant and the reinsurer,

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usually for one year or longer, which stipulates the technical particulars and financial
terms applicable to the reinsurance of defined class or classes of business;
(r) Words and expressions used and not defined in these regulations but defined in the
Insurance Act,1938 (4 of 1938) or the General Insurance Business Nationalisation
Act, 1972 (57 of 1972) or Insurance Regulatory and Development Authority Act,
1999 (41 of 1999), rules made thereunder shall have the meanings respectively
assigned to them in those Acts or rules as the case may be.
III. Reinsurance Arrangements: Objectives & Procedures
1. Objectives
The Reinsurance Programme of every Indian Insurer/ Indian Reinsurer/Foreign
reinsurer branch shall be guided by the following objectives to:
(a) Maximize retention within the country;
(b) Develop adequate capacity;
(c) Secure the best possible reinsurance protection/ coverage required to protect
the interest of the policy holder/insurer at a reasonable cost
(d) Simplify the administration of business.
2. Retention policy
(a) Every Indian insurer/Indian reinsurer/foreign reinsurer branch shall maintain
the maximum possible retention commensurate with its financial strength,
quality of risks and volume of business.
(b) Every Indian insurer/Indian reinsurer/ foreign reinsurer branch shall formulate
a suitable retention policy for each insurance segment. In case the insurance
segment consists of more than one product, retention policy for each product
shall be separately defined.
(c) The Authority may require an Indian insurer/Indian reinsurer/foreign reinsurer
branch to justify its retention policy and may give such directions as
considered necessary in order to ensure that the Indian insurer/ Indian
reinsurer/foreign reinsurer branch is not merely fronting for a Cross Border
Reinsurer.

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3. Obligatory Cession: Every insurer shall cede such percentage of the sum assured
on each policy for different classes of insurance written in India to the Indian
reinsurer/s as may be specified by the Authority in accordance with the provisions of
Part IVA of the Insurance Act, 1938.
4. Reinsurance program
(a) The reinsurance programme of every Indian insurer/Indian reinsurer/ foreign
reinsurer branch shall commence from the beginning of every financial year.
(b) Every Indian insurer/Indian reinsurer/ foreign reinsurer branch shall submit to
the Authority, its board approved reinsurance programme along with retention
policy for the forthcoming year, 45 days before the commencement of the
financial year.
(c) If any amendment is made in the Reinsurance program subsequent to it being
filed with the Authority, the Indian insurer/ Indian reinsurer/ foreign reinsurer
branch, shall file with the Authority, the Final Reinsurance Program, together
with the approval of the Board of Directors within 30 days of the
commencement of the financial year.
(d) The final reinsurance program of the Indian insurer/Indian reinsurer/foreign
reinsurer branch shall include but not limited to, the following:
(i) The parameters considered for fixation of retention limits for every
product of each insurance segment
(ii) Proposed retention limits on every product of each Insurance Segment
along with corresponding retention limits in the previous year.
(iii) Levels of Net retention ratio on each Insurance Segments for previous
three years.
(iv) Insurance Segment wise, product wise actual premium income for the
last financial year and the projected premium income for the forthcoming
financial year.
(v) Structure of Reinsurance program with details of Proportional
arrangements for each Insurance Segment( including treaty capacity,
retention limits, Estimated premium, Reinsurance commission, Event

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limits etc.) and Non-proportional Arrangements (including EGNPI, Cover

limits, Deductible, XL premium, Reinstatement provisions etc.)
(vi) Statement of Reinsurance cost (in terms of quantum as well as
percentage to Gross Written Premium) giving details of Gross Written
premium, premium ceded on proportional arrangements and ceded on
non-proportional arrangements. The statement shall include projected
costs for the forthcoming year and the actual costs for the previous two
years.
5. The Indian insurers/Indian reinsurers/foreign reinsurer branches shall ensure that
the reinsurance arrangements in respect of catastrophe accumulations are
adequate, by using various realistic disaster scenarios. The catastrophe modelling
report and the basis on which the quantum of catastrophe protection is purchased
for the forthcoming year may be detailed in the Reinsurance program and shall be
approved by their Board of Directors. A synopsis of the report, shall be filed with the
Authority along-with the final reinsurance programme.
6. Every Indian insurer/Indian reinsurer / Foreign Reinsurer Branch shall within 30 days
of the commencement of the financial year, file with the Authority a copy of every
reinsurance treaty contract wordings and excess of loss cover note in respect of that
year together with the list of all reinsurers, their ratings and their shares in the
proportional & non-proportional reinsurance arrangement.
7. Every Indian Insurer/Indian reinsurer/foreign reinsurer branch shall file with the
Authority any new reinsurance arrangement, giving full details, documentation,
reasons for such an arrangement together with the approval of the Board of
Directors within 15 days of approval of the Board. The Indian insurer/Indian
reinsurer/foreign reinsurer branch shall further ensure that the renewal of such are
insurance arrangement coincides with the financial year.
8. The Authority may, if necessary, call for further information or explanations in
respect of there insurance programme. The Authority may also, if necessary, direct
the Indian insurer/Indian reinsurer/foreign reinsurer branch to carry out changes to
the reinsurance programme filed with it and the Indian insurer/Indian
reinsurer/foreign reinsurer branch shall incorporate such changes forthwith in their
reinsurance programme and submit the revised program to the Authority.

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9. Cross Border Reinsurers:

(i) Eligibility Criteria: Every Indian Insurer/Indian reinsurer/foreign reinsurer
branch shall place their reinsurance business outside India with only those
cross border reinsurers based on the following eligibility criteria:-
(a) The cross border reinsurer is a legal entity in its home country, regulated
and supervised by its home regulators/ supervisors.
(b) The financial strength, quality of the management and adequacy of
technical reserving methodologies of the cross border reinsurer should
be monitored by its supervisory authority, in the home country.
(c) The cross Border reinsurer having at least a credit rating of BBB (with
Standard & Poor) or equivalent rating of an international rating agency
for immediately preceding three years.
(d) The Cross Border Reinsurer should be registered and/or certified by the
home regulator of the country of domicile, with which the Government of
India has signed Double Taxation Avoidance Agreement.
(e) The Cross Border Reinsurer having solvency margin/capital adequacy
not less than as stipulated by the home regulator for previous three
continuous years.
(f) The past claims performance of the cross border reinsurer is found to be
satisfactory.
(g) Any other requirements as stipulated by the Authority from time to time.
(ii) Reinsurance placements with Cross Border Reinsurers, not fulfilling the above
stated eligibility criteria shall require prior approval of the Authority. Under
such circumstances, the Indian insurer/Indian reinsurer/foreign reinsurer
branch shall, seek approval from the Authority stating sufficient reasons and
justifications as to why they propose to place reinsurance business with a
cross border reinsurer which does not fulfil the stated eligibility criteria. All
such placements shall be reported to the company’s board.
(iii) The procedure to be followed for filing information regarding the Cross border
reinsurers, participating the reinsurance programs of the Indian Insurer/Indian
reinsurer/foreign reinsurer branch shall be governed by the guidelines issued
by the Authority, in this regard from time to time

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10. Based on necessity and / or Indian market appetite for a class of risk / product, the
Indian Reinsurer/s and/ or Foreign Reinsurer’s Branch/ shall organise domestic
pools, in consultation with all Indian insurers and / or foreign reinsurer branches on
matters relating to objective, basis, limits and terms which are fair to all
stakeholders. The arrangements so made shall be submitted to the Authority within
three months of the formation of such pools, for approval. The Authority, wherever
necessary, shall also advise the Indian reinsurer to organise domestic pools, in
collaboration with Foreign Reinsurer’s Branches, (if required). These regulations
shall equally be applicable for all reinsurance arrangements of the pool. The pool
Administrator shall submit the returns, details of Reinsurance arrangement,
statements on the performance of the pool, in the manner and periodicity as
stipulated by the Authority from time to time.
11. Cession limits:
(a) Surplus over and above the domestic reinsurance arrangements can be
placed with any of the cross border reinsurers, complying with regulation 3(9).
(b) Such placements are subject to the insurance segment-wise limits stipulated
under regulation 3 (11) (e) of these regulations. These limits define the
maximum reinsurance cession that can be made to any particular Cross
border reinsurer under any insurance segment.
(c) These cession limits are applicable on reinsurance placements made to Cross
Border reinsurers by the Indian insurer/s and retrocession arrangements made
by the Indian Reinsurer/s to Cross Border reinsurers
(d) The cession limits shall also be applicable on all retrocession arrangements
made by foreign reinsurer branches with Cross Border Reinsurers.
(e) Insurance segment wise limit of the total reinsurance premium that may be
placed with any one cross border reinsurer shall be as follows:
Rating of Reinsurers Overall Limit of cession allowed
(as per Standard & Poor (Proportional, Non proportional &
and applicable to other equivalent Facultative arrangements)
international rating agencies)
BBB & BBB+ of Standard & Poor 10%

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Greater than BBB+ and upto & 15%

including A+ of Standard & Poor
Greater than A+ of Standard & Poor 20%
Explanation: The above percentages are to be calculated insurance segment wise,
on the total reinsurance premium ceded in India & outside India.
Where it is necessary in respect of any insurance segment to cede a share
exceeding the limits specified under regulation 3(11)(e), to any particular cross
border reinsurer, the Indian insurer/Indian reinsurer/foreign reinsurer branch shall
seek specific approval of the Authority giving reasons for such cession.
12. Order of Preference for cessions by Indian Insurers, shall be governed by the
stipulations made under the Insurance Regulatory and Development Authority of
India (Registration and operations of Branch offices of Foreign Reinsurers other than
Lloyd’s) Regulations, 2015.
13. Any repatriation of surplus generated by the operation of the branch office of the
foreign reinsurer shall be governed by the Insurance Regulatory and Development
Authority of India (Registration and operations of Branch offices of Foreign
Reinsurers other than Lloyd’s) Regulations, 2015 or the Insurance Regulatory and
Development Authority of India (Lloyd’s India) Regulations, 2016, whichever is
applicable.
14. The foreign reinsurer branch shall ensure that they maintain the minimum retention
limits stipulated under the Insurance Regulatory and Development Authority of India
(Registration and operations of Branch offices of Foreign Reinsurers other than
Lloyd’s) Regulations, 2015 or the Insurance Regulatory and Development Authority
of India (Lloyd’s India) Regulations, 2016, whichever is applicable, at all times.
IV. Inward Reinsurance Business
(i) Every Indian insurer wanting to write inward reinsurance business shall have a well-
defined underwriting policy approved by its Board of Directors for underwriting
inward reinsurance business.
(ii) The Indian insurer shall file with the Authority, at least forty five days before the
commencement of each financial year, its inward reinsurance underwriting policy

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stating the classes of business/insurance segments, geographical scope,

underwriting limits and profit objective.
(iii) The Indian insurer shall ensure that decisions on acceptance of inward reinsurance
business are made by persons with necessary knowledge and experience.
(iv) The Indian insurer shall also file with the Authority any changes to the inward re
insurance underwriting policy as and when a change is made duly approved by its
Board of Directors.
V. Outstanding Loss Provisioning
1. Every Indian insurer/Indian reinsurer/foreign reinsurer branch shall make
outstanding claims provisions for every reinsurance arrangement accepted on the
basis of loss information advices received from Brokers/Cedeants and where such
advices are not received, on an actuarial estimation basis.
2. In addition, every Indian insurer/Indian reinsurer/foreign reinsurer branch shall make
an appropriate provision for incurred but not reported (IBNR) claims on its
reinsurance accepted portfolio on actuarial estimation basis.
VI. Every Indian insurer/Indian reinsurer/foreign reinsurer branch shall be required to
submit to the Authority information and returns relating to its reinsurance
transactions in such forms and manner as the Authority may stipulate from time to
time or require together with its annual accounts.
VII. Power of the Authority to issue clarifications:
In order to remove any doubts or the difficulties that may arise in the application or
interpretation of any of the provisions of these Regulations, the Chairperson of the
Authority may issue appropriate clarifications or guidelines as deemed necessary.

Constitution of Reinsurance Expert Committee

The Insurance Regulatory and Development Authority of India (IRDAI) has notified various
Regulations, Guidelines, Circulars over the years, pertaining to Reinsurance Business.
The enactment of Insurance Laws (Amendment) Act, 2015 has brought about changes in
the Reinsurance market in India by facilitating the entry of Foreign Reinsurance Branches
(FRBs) and Lloyd’s India Branch, Lloyd’s Syndicates & Service Companies. Insurance

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Offices in IFSC (SEZ) have also been set up. In view of these developments it has been
decided to carry out a comprehensive review of the existing framework for reinsurance
activities including reporting requirements for the various entities.
Consequently, the Authority set up a Reinsurance Expert Committee comprising of experts
from all fields with the following objectives:
1. Review the current regulatory framework for Reinsurance and make suitable
recommendations.
2. Study international regulatory framework and practices relating to Reinsurance
Pools, Alternative Risk Transfer (ART) and such other mechanisms and make
appropriate recommendations for India.
3. Study the existing guidelines for SEZ and make necessary recommendations in the
context of various Reinsurance activities.
4. Make specific recommendations and devise formats for reports and returns required
to be submitted to IRDAI.
The Committee would be expected to interact with all relevant stakeholders — Cedents,
Reinsurers, Retrocessionaires, Brokers, Customers etc. before arriving at its
recommendations. It may form sub-committees if required.

Cross Border Reinsurers Approval (CBR)

The Insurance Regulatory and Development Authority of India (IRDAI) has granted special
approval to 23 Cross Border Reinsurers (CBR) for the year 2016-17. This will allow Indian
insurers to make reinsurance placements with a large number of reinsurers.
Cross-border reinsurers are those who do not have a physical presence in India but
carry on reinsurance business with Indian insurance companies. The approvals were given
on the basis of submissions made by CBRs and the recommendations made by the
insurers and GIC Re in line with the guidelines issued by the authority last month. The
approved CBRs include

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IRDAI Approved List of Cross Border Reinsurers (CBR)

CBR Name Place

Ingosstrakh Joint Stock Insurance Co. # Russia
Asian Reinsurance Corporation Thailand
CICA Re Kenya
Republican Unitary Enterprise # Belarus
Anadolu Anonim Turk Sigorta Siketi # Turkey
Zep Re Kenya
FAIR Aviation Pool Morocco
Baoviet Insurance Corporation # Thailand
Partner Reinsurance Company Ltd. Bermuda
Misr Insurance Company Egypt
GIC Bhutan Re Bhutan
East Africa Re # Kenya
Royal Insurance Corporation Bhutan
Covea Cooperations France
Vietnam National Reinsurance Corporation Vietnam
Equator Re Bermuda
Indonesia Re Indonesia
PICC Re China
Source: IRDAI Guidelines, 2016
Reinsurance assumes significance as it is important to maintain solvency of the insurer
and to ensure that the claims/other clauses are honoured as and when they arise. In the
year 2015-16, the regulator had recognised 244 reinsurers and 90 Lloyds Syndicates. In
2014-15, 238 reinsurers and 87 Lloyds Syndicates were recognised. It is likely that the

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authority may give more approvals in future. The onus of placing reinsurance business
with registered CBRs is on the Indian insurers or reinsurers and they will have to ensure
that the cross-border reinsurer meets the requirements as specified by the regulator.
Within the country, the General Insurance Corporation of India is designated as the ‘Indian
Reinsurer’ which entitles it to receive obligatory cessions of 5 per cent from all the direct
non-life insurers.

Reinsurance Contracts and Treaties

An insurance is a transfer, a business and a contract: a transfer of risks from the insured
to the insurer, a business, meaning a commercial activity with profit as the goal and a
contract, meaning an agreement enforceable at law. Written agreements are more easily
enforceable than verbal ones and so every insurance contract is written, satisfying all the
legal principles on which insurance is founded and the points of law to satisfy the definition
of a legal contract. These legal features of a contract are:
• There must be consensus ad idem, namely, that there must be identity of views
between the contracting parties.
• The parties to the contract must not have any legal disabilities, that is, say, they
must not be minors.
• There must be consideration for the contract as a contract without consideration is
void ab initio (from the beginning).
• There must be an offer from one party that must be accepted by the other party to
result into a contract.
Reinsurance is similar to an insurance contract and hence it is important that the wordings
of the reinsurance agreement are agreed between the cedeant and the reinsurer
beforehand. The contract may relate to one particular reinsurance and be expressed in a
reinsurance policy, or as was often called in fire insurance, a guarantee policy but
nowadays is more commonly called as facultative reinsurance. Or it may provide for the
reinsurance of a number of risks and be expressed in the form of a treaty. The insured
under the direct policy has no interest in or right over the reinsurer since he has no privy of
contract. The reinsurer is certainly liable in respect of his share of any claim made by the
insured, but his liability is to the insurer and to the insurer only. The insured may have an
interest indirectly in knowing that his insurer is supported by sound reinsurers.

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In recent years the increasing complexities in reinsurance has demanded for a greater
degree of attention to the problems of disclosure and materiality. The ordinary rule as to
disclosure of material facts operates only up to the time the contract is concluded but
under a treaty something more may be required.
Other than facultative reinsurances, all other agreements between the ceding primary
insurer and the reinsurer are by means of written and agreed treaties and therefore, the
treaty wordings have come to occupy an important place in the study of reinsurance.
However, it is recognized that the treaty wordings are not standardized and different
countries and reinsurers have adopted their own typical wordings for treaties. At the same
time, the general conditions are fairly uniform for all treaties but the special conditions are
distinct exercises depending on particular needs of the contracting parties and also the
individual classes of insurance. Again, the proportional and non- proportional treaties have
separate distinct wordings, which have some special features characteristic of the type of
treaty. One other interesting feature of all treaty wordings is that they include agreements
on the follow-up accounting procedures, which actually make implementation of the treaty
much easier.
We give below the treaty wordings generally followed by the insurers in India.

Proportional Treaty Wordings

1. Operative Clause
“The Company binds itself obligatorily to cede and the Reinsurer binds itself obligatorily to
accept by way of reinsurance a percentage stated in the schedule of the first
surplus over and above the amount retained by the Company for its own account on all
insurances and /or facultative reinsurances written in the Fire Department of the Company
and emanating from all parts of the world except the United States of America and
Canada. Within the scope of this Agreement, the Company may cede hereunder on any
one risk up to ……… times its net retention and not exceeding an amount equivalent to
Rs…………
The Company shall be the sole judge of what constitutes one risk and unless otherwise
hereafter provided shall fix its net retention without reference to the Reinsurer in
accordance with the usual net retentions of the Company.”

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2. “Attachment of Cessions” Clause

“The liability of the Reinsurer in respect of reinsurance allotted hereunder shall commence
simultaneously with that of the Company as soon as the retention of the Company on any
one risk as defined by its limits, records, practice or instructions is exceeded.”

3. “Follow the Fortunes” Clause

“All acceptances hereunder shall be at the same gross rates, terms and conditions as the
ceding company and to follow the settlement of the Company and the Reinsurer shall
follow the fortunes of the Company in regard to the cessions in which the Reinsurer by
virtue of this Agreement takes part.”

4. “Exclusions” Clause
“In no event shall this Agreement protect the Company in respect of: War and Civil War
Obligatory Reinsurances.
Any loss or liability accruing to the Company, directly or indirectly and whether as Insurer
or Reinsurer, from any Pool of Insurers or Reinsurers formed for the purpose of covering
Atomic or Nuclear Energy risks.”

5. Accounting Clause
“Accounts embodying all transactions under this Agreement shall be rendered quarterly by
the Company to the Reinsurer as soon as possible after the close of each quarter which
shall be deemed to close on the 31st March, 30th June, 30th September and 31st
December respectively.
The Reinsurer shall confirm the accounts within fifteen days of receipt and the balances
on either side shall be paid within fifteen days after receipt of such confirmation.”

6. Commission and Profit Commission

The Reinsurer shall pay to the Company a commission as specified in the Schedule upon
the net premiums (gross premiums less returns and cancellations) together with an
additional commission, as specified in the Schedule, on the profits derived from this
Agreement and computed at the 31st December in each year as follows:

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Income
1. Premium reserve for previous year
2. Losses outstanding for previous year
3. Net premiums for the current year
Outgo
• Premium reserve of 40% of the net premium for the current year.
• Commission, taxes, fire brigade charges etc.
• Losses paid during the year.
• Reinsurers’ expenses being 5% of item 3 of “Income”. Losses outstanding at the end
of the current year.
• Deficit, if any, from the previous year’s profit commission statement.
The excess, if any, of Income over Outgo shall be deemed the net profit of the Reinsurer
and profit commission shall be calculated thereon.
In the event of termination, profit commission on the net profit in respect of the year in
which such termination takes place shall be calculated in like manner. Thereafter, when
the whole of the liabilities hereunder have been liquidated a final profit commission
statement shall be rendered to include all transactions subsequent to the date of
termination and the profit commission share on the preceding account shall be adjusted
accordingly.”

7. Loss Advices and Accounting of Losses

Preliminary loss advices shall be sent by the Company to the Reinsurer in respect of all
losses where the proportion of the reinsurers sharing in the Agreement is estimated to
exceed the amount stated in the Schedule. Furthermore, the Company shall furnish the
Reinsurer an estimate of outstanding losses as at 31st December of each year.
When the proportion of a loss and/or expenses falling upon all the reinsurers sharing in
this Agreement amounts to or exceeds the amount specified in the Schedule, the
reinsurers shall be liable to pay their proportions within 21 days of demand. The
Company shall debit all other losses and/or loss expenses in the accounts of the quarters
in which the losses and/or loss expenses are settled.

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Any loss or claim or compromise thereof and all expenses including fire extinguishing
expenses shall be settled by the Company without reference to the reinsurer and such
settlements including ex-gratia payments shall in all cases be unconditionally binding upon
the reinsurer. The Company at its sole discretion may commence, continue, defend,
compromise, settle or withdraw from any actions, suits and prosecutions and generally do
all such matters relating to any loss or claim which in its judgment may be advantageous
and the payment of all expenses and allowances in connection therewith shall be shared
by the reinsurer in proportion to its participation.
The Reinsurer shall share in proportion to its participation in all amounts which may be
recovered by the Company in respect of any loss or claim.”

8. Reserves Clause
“The Company shall be entitled to retain Premium Reserve at the percentages specified in
the Schedule as security for the due performance of the obligations of the Reinsurer under
this Agreement. The Premium Reserve shall be retained at the percentage specified in the
Schedule in each quarterly account and shall be based upon the net premiums of the
relative quarter and of the three preceding quarters after deduction of the reserve of the
corresponding quarter of the previous year.
The Company shall pay to the Reinsurer interest on premium reserve at the rate specified
in the Schedule less tax, such interest to accrue from the date on which the respective
amounts are credited to the premium reserve.”

9. Premium and Loss Portfolios

“The Company may at its option require the Reinsurer to assume liability for its
proportion of risks current at the date of this Agreement in consideration for which the
Company shall credit the Reinsurer with an amount equal to a percentage as specified in
the annexed Schedule of the net premiums without deduction of commission
appearing in the four quarterly accounts immediately preceding the date on which this
Agreement commences.
In the event of the Company exercising the aforementioned option, the Reinsurer shall
also be credited with the proportion of 90% of the estimated losses outstanding as at the
date of inception for which the Reinsurer shall assume liability for all settlements of such
losses outstanding. Should the total payments in respect of such losses differ materially

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from the amount credited to the Reinsurer in accordance herewith, the Company
shall have the right to effect the appropriate adjustment.
The term ‘net premium’ in the aforementioned paragraph is understood to mean original
gross premiums less only return premiums. The provisions of this Article may also be
applied in the event of any increase or decrease of the Reinsurer’s proportion under this
Agreement.”

10. Commencements and Termination Clause

“This Agreement shall incept on the date stated in the Schedule and shall remain in force
indefinitely, but either party shall be at liberty to terminate it as at 31st December in any
year by giving not less than 90 days ‘previous notice in writing. Unless the parties
otherwise agree, the Reinsurers will remain liable for all reinsurances ceded under this
agreement until their natural expiry.
In the event of war (whether declared or not) arising between India and the country in
which the Reinsurers reside or carry on business or are incorporated, this Agreement shall
be automatically terminated forthwith.
• If during the period of this Agreement, postal and/or telegraphic communications
should be rendered impossible as a consequence of war, warlike operations,
blockade, revolution, civil war or other similar event for a period exceeding thirty (30)
days, the Company shall be entitled to terminate this Agreement forthwith without
giving notice.
Either party shall have the right to terminate this Agreement immediately by giving
the other party notice:
• If the performance of the whole or any part of this Agreement be prohibited or
rendered impossible de jure or de facto in particular and without prejudice to the
generality of the preceding words in consequence of any law or regulation which is
or shall be in force in any country or territory or if any law or regulation shall prevent
directly or indirectly the remittance of any or all or any part of the balance or
payments due to or from either party.
• If the other party has become insolvent or unable to pay its debts or has lost the
whole or any part of its paid up capital or has had any authority to transact any class
of insurance withdrawn or cancelled or suspended or made conditional.

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• If there is any material change in the ownership or control of the other party.
• If the country or the territory in which the other party resides has its head office or is
incorporated shall be involved in armed hostilities with any other country whether
war be declared or not or is partly or wholly occupied by another power.
• If the other party shall have failed to comply with any of the terms and conditions of
this Agreement.
During the term of a notice of cancellation and until its expiry the reinsurers shall accept
new cessions and renew existing cessions in the same manner and in all respects as if no
such notice has been given.”

Non-Proportional Contract Clauses

Some typical wordings are given below:

1. Terms of Agreement
“This Agreement shall apply only to losses occurring during the period commencing on the
date stated in item … of the Schedule and expiring on the date stated in item….. of the
Schedule, both days inclusive.
If the Agreement should expire or be terminated while a loss occurrence covered
hereunder is in progress it is understood and agreed that, subject to the other conditions
of this Agreement, the Reinsurers hereon are responsible as if the entire loss or damage
has occurred prior to the expiration of this Agreement, provided that no part of that loss
occurrence is claimed against any renewal of this Agreement.
In the event of this Agreement not being renewed, this Agreement, at the option of the
Company (provided it is exercised on or before the expiry date hereof and provided there
is prior agreement of both parties to the additional premium payable), shall be extended to
apply to any loss occurrence or loss occurrences:
Which are covered by any policy or policies of insurance or insurances, the inception date
or dates of which fall prior to the expiry date of this Agreement.
And which take place during the twelve months period immediately following the expiry
date of this Agreement.”

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2. Insuring Clause
“The Reinsurers hereby agree to indemnify the Company for that part of the ultimate net
loss which exceeds the amount stated in item … of the Schedule on account of each and
every loss occurrence and the sum recoverable under this Agreement shall be up to but
not exceeding the amount stated in item … of the Schedule, ultimate net loss on account
of each and every loss occurrence.
The underlying loss stated in item … of the Schedule shall be retained net by the
Reinsured subject only to underlying excess catastrophe reinsurances as specified in item
… of the Schedule.”
3. Definition of loss occurrence has been dealt with earlier.
4. The term ‘ultimate net loss’ shall mean the sum actually paid by the Company in respect
of any loss occurrence including expenses of litigation, if any and all other loss expenses
of the Company (excluding, however, office expenses and salaries of the company) but
salvages and recoveries, including recoveries from other retrocession, other than
underlying reinsurances provided for herein, shall be first deducted from such loss to
arrive at the amount of liability, if any attaching hereunder.

5. Net Retained Lines

“This Agreement shall only protect that portion of any insurance or reinsurance which the
Company retains net for its own account combined with cessions made by them to their
Quota Share Reinsurers. Reinsurer’s liability hereunder shall not be increased due to the
inability of the Company to collect from any other Reinsurers (other than the aforesaid
Quota share Reinsurers) any amounts which may have become due from them whether
such inability arises from the insolvency of such other Reinsurers or otherwise.”

6. Premium clause
“The Company shall pay a Deposit Premium of the amount stated in item … of
the Schedule and same shall be paid in the manner prescribed in item … of the
Schedule.
As soon as possible after the expiry of this Agreement, the above Deposit Premium shall
be adjusted to an amount equal to the rate stated in item … of the Schedule applied to the
Company’s premium income, as defined hereunder, subject, however, to a Minimum

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Premium of the amount stated in item … of the Schedule. The payment of any adjustment
due between the parties shall be made at once.”

7. Reinstatement Clause
“In the event of any portion of the indemnity given hereunder being exhausted, the amount
exhausted shall be automatically reinstated from the time of commencement of any loss
occurrence to the expiry of this Agreement and a pro rata additional premium calculated
on the premium hereunder in the manner stated in item … of the Schedule shall be paid
by the Company upon the amount of such loss reinstated, but nevertheless the
Reinsurer’s liability shall never be more than the limit of liability as stated in item … of the
Schedule in respect of any one loss occurrence not more than the amount as stated in
item … of the Schedule, in all, during the term of this Agreement.”

8. Inspection Clause
“The Reinsurers may at any time during normal working hours inspect and take copies of
such of the Company’s records and documents which relate to business covered under
this Agreement. It is agreed that the Reinsurers’ right of inspection shall continue as long
as either party has a claim against the other arising out of this Agreement.”

9. Errors and omissions Clause

“No error or inadvertent omission on the part of the Company shall relieve the reinsurer of
liability in respect of losses hereunder provided that such errors and/or omissions are
rectified as soon after discovery as possible.”

10. Alterations Clause

“This Agreement may be altered at any time by mutual consent of the parties by
Addendum and such addendum shall be binding on the parties and be deemed to be an
integral part of this Agreement.”

11. Set-off Clause

“If during the currency of this Agreement any balances under any other treaty or treaties
between the Company and the Reinsurer remain unpaid by one party, the other shall be
entitled either to: Retain the balance due hereunder until full payment has been made

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under the other treaty or treaties; or Set off such balance against the amount due from the
other party.”

12. Underwriting Policy Clause

“The Company undertakes not to introduce any change in its established acceptance and
underwriting policy in respect of the classes of business to which this Agreement applies
without prior approval of the Reinsurers and any reinsurance arrangements relating
thereto shall be maintained or be deemed to be maintained unaltered for the purpose of
this Agreement.”

13. Intermediaries Clause

“All correspondence and settlement of accounts pertaining to this Agreement shall be
through the intermediaries specified in item … of the Schedule.”

14. Arbitration clause for disputes

“Incase of any disputes between the company and the reinsurers regarding the
interpretation of the agreement or the rights with respect to any transaction involved either
before or after the termination, disputes as such shall be dealt with the single arbitrator
appointed in writing by both the parties. If incase of any failure to agree upon the single
arbitrator it can be referred to two arbitrators of which one is appointed in writing by each
of the parties. Incase of any disagreement between the two arbitrators an umpire is
appointed by the arbitrators.
These arbitrators or the umpire are required to be appointed in 30 days after such a
requisition of arbitrators made by the parties. These are appointed in writing by the
chairman of the Bombay Regional Committee of the tariff advisory committee. Such
appointed arbitrators or umpires are required to interpret their agreement as an honorable
engagement and make their award and serve the purpose.
The decision of these arbitrators or the umpires is final and binding as the case may be
inclusive of allocation of costs on both the parties. This clause is present in every treaty.

Arbitration and Mediation

Arbitration means the reference of a matter in disputes to the judgment of a person
selected by the parties to the dispute. Arbitration is thus a private process of resolution of

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disputes and it is commonly resorted to because it is less formal, less expensive and less
time consuming than proceedings in law. More commonly, the arbitration process has
employed private bodies to settle controversies in which the decision reached is final and
binding. In spite of the best care taken to prepare the contract documents certain disputes
may arise leading to unnecessary litigation. To address such problems normally arbitration
clause is incorporated in the contract. The companies involved in reinsurance business
may prefer independent arbitration to avoid impact on reputation and public gaze.
The salient features of arbitration:
• No difference shall be referable to arbitration if the company has disputed or not
accepted liability under the policy.
• The arbitrators are normally experts in the practice area of dispute.
• A sole arbitrator may be agreed to by the parties in writing; if not agreed, each party
can approach an arbitrator after receipt of written notice of the other party.
• The place and time of the arbitration can be arranged to suit the parties.
• Any disagreement between the two arbitrators shall be referred to an umpire and
such umpire is generally appointed before entering in to the agreement.
• The agreement cannot extend to disputes between the parties for which some other
contractual mechanism is established to resolve such disputes.
The Arbitration Clause
It should be well drafted considering all the matters and its ramifications. It should contain,
inter alia, the manner of appointment of arbitrator, his qualifications and experience,
the period for which the appointment has to be made and the cost of arbitration, which will
be at the discretion of arbitrator(s).
Arbitration is governed by law which is known as Arbitration Act 1940 which was
subsequently repealed by the Arbitration and Conciliation Act, 1996 which is ‘ an Act to
consolidate and amend the law relating to domestic arbitration, international commercial
arbitration and enforcement of foreign arbitral awards as also to define the law relating to
conciliation and for matters connected therewith or incidental thereto’.
Unless otherwise agreed, the arbitration tribunal shall consist of persons with no less than
ten years experience in insurance or reinsurance field.

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The tribunal shall have all powers to make orders in respect of pleadings, discovery,
inspection of the documents, examination of witnesses etc. All costs of arbitration shall be
fixed by the tribunal and it will also decide by whom it is to be paid.
The award of arbitration tribunal shall be in writing and binding upon the parties who agree
to carry out the same. If any of the parties fails to carry out any award the other party may
apply for its enforcement to a court of competent jurisdiction.
Majority of the reinsurance contracts/treaties contain arbitration clauses so that disputes
can be avoided at a later date and settled amicably and privately. When interpreting
reinsurance contracts, the starting point, should be to look at the tribunal, which will
resolve any disputes between the parties and the law, which will be applied.
The arbitration law may vary from country to country and therefore parties must be clear
as to which law they are applying.
Finally it is to be stated that at times some arbitration can become as complex and rigid in
its formality and costs, as any proceedings in a court of law. It is a matter of dispute
whether to go court or seek arbitration as the best forum to resolve disputes. During the
enforcement there are difficulties that some people challenge an arbitration award. There
are those who plead that the courts have wider coercive powers and that litigation makes
for greater certainty. The general criticism against arbitration is that it is fraught with
complexity, costs and delay. The competent man constituting arbitration tribunal is more
important in case of reinsurance as it has universal dimensions.
Mediation
The mediation process involves the use of an impartial third party to encourage a
satisfactory compromise to the dispute. The mediator, typically an experienced trial
attorney or retired judge, who has no binding authority, uses his/her skills to diffuse the
dispute or find alternative solutions. Mediation is fast developing method in the resolution
of reinsurance disputes, particularly in the London Market. In the last 20 years the number
of reinsurance disputes going to litigation/arbitration have been growing phenomenally.
Therefore, an alternative and quick method was evolved. There are very few issues,
which are unsuitable for mediation. Most of the mediations involve rights of avoidance,
issues of coverage, construction issues and issues as to the conduct of intermediaries.

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As the mediation is another successful mode to operate, the ceding companies and
reinsurers are likely to consider the inclusion of ‘mediation clause’ in their wordings.
However mediation process itself is not cheap, as perceived by some, but its speed is the
key to achieving cost advantage. The mediation can succeed provided that certain
precautions are taken and where the parties engage in the process in good faith the
results are reassuring.

Monitoring of the Reinsurance Programs of Primary

Insurers 1
The International Association of Insurance Supervisors (IAIS) provides guidance on
monitoring the reinsurance programs of primary insurers. Additionally, supervisors
typically prepare their own criteria for assessing reinsurance programs.
A key principle is that the primary insurer must take responsibility for its reinsurance
program as well as assess the soundness of the reinsurance companies with which it does
business. The supervisor must ensure that such responsibilities are properly carried out.
In the process of monitoring an insurer’s reinsurance program, the supervisor should
consider the following issues:
• Strategic framework: Verify that the board of the insurer has approved and
regularly reviews its reinsurance strategy and that this reinsurance strategy is
consistent with the insurer’s business plan and risk profile. This may include the
supervisor retaining the right to approve the insurer’s reinsurance strategy.
However, the supervisor should recognize that the choice of reinsurance cover is a
business decision of the insurer within the context of its overall reinsurance strategy.
• Insurer implementation: Obtain assurance that senior management has
implemented the reinsurance policies and procedures in compliance with the
reinsurances trategy and has sufficient controls in place to demonstrate compliance.
• Data: Receive sufficient financial and statistical information to be able to evaluate
the impact of the insurer’s reinsurance program. Such information should be of
sufficient quality to permit the supervisor to assess its integrity and quality.

1International Association of Insurance Supervisors (IAIS) & World Bank material on Core
Curriculum for Insurance Supervisors

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• Appropriateness of regular analysis of reinsurance: For example, regimes using

a responsible actuary approach, including an annual financial condition report,
require that an actuarial analysis of the reinsurance program and experience be
provided.
• Continuous coverage: Be assured that the insurer maintains adequate reinsurance
cover at all times. In particular, this may be relevant at times when the insurer is
establishing new or re-establishing prior reinsurance covers.
• Confidentiality of insurer information: Verify that confidential information obtained
by the insurer on its policyholders remains confidential.
• Remedial powers: Have appropriate remedial powers to address deficiencies
identified in the reinsurance program. This may include a requirement that insurers
in form the supervisor if material problems arise with its reinsurance program.

Insurer’s Perspective
From the perspective of an insurer, security of reinsurance can be viewed in terms of the
appropriateness of placing business with the reinsurer. As noted, the insurer is
responsible for conducting appropriate risk assessment and assuring itself of the financial
soundness of there insurer. The supervisor is responsible for ensuring that such
responsibilities are properly carried out. Issues to consider in this process include the
following
• Consistency of approach: Appropriate and up-to-date board and senior
management reinsurance policies must be consistent with the insurer’s risk appetite
and approach and be reflected in reinsurance contracts.
• Legal and statutory framework: Understanding the framework is especially
important if the reinsurer is not domiciled in the same jurisdiction as the insurer.
• Financial assessment: Appropriate and documented criteria are needed to assess
the financial condition and credit risk of reinsurers.
• Business practices: It is important to understand the reinsurer’s underwriting and
claims practices (understanding the underwriting and claims policies and procedures
of the reinsurer and how they will integrate with the insurer’s practices and
reporting), the use of alternative risk transfer tools and the investment policy,
including the use of derivatives.

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• Management: It is important to evaluate the expertise, quality and stability of

management of the reinsurer.
• Structural indicators: Indicators of importance include ownership structures,
affiliates and group (assessment of any affiliated companies and other members of
any group to which the reinsurer belongs).
Reinsurers should apply similar criteria when considering retrocessions.

Failures and Reinsurance

Insurers and reinsurers can and do, fail for a variety of reasons. At a summary level,
perhaps 5–10 percent of insurer failures can be attributed to the failure of reinsurance in
some form and perhaps up to a further 5–10 percent can be attributed to causes(in
particular, catastrophes) that could, or perhaps should in retrospect, have been reinsured.
It is also possible that insurers or reinsurers near failure may be “rescued” in some way—
for example, through being acquired—and it is difficult to obtain information on the impact
of reinsurance in such cases.
Work has been done in the European Union on the causes of failures and near failures of
insurers (see MacDonnell 2002; Sharma and others 2002). From the reinsurance
perspective, a couple of comments are relevant. First, the primary causes of insurer
failures are inadequate management and inadequate internal controls in the great majority
of cases. Moreover, reinsurance risk is a common trigger for problems. From a
supervisory perspective this suggests that monitoring the insurer’s reinsurance programs
and the quality of the reinsurers is important.
From the reinsurer perspective, Swiss Re (2003) identifies 24 mostly European and U.S.
reinsurers that went bankrupt in the period 1980–2003.
The causes of these failures include the following (some failures were attributed to
multiple causes):
• Insufficient capital (in eight, or a third, of the cases)
• Insufficient IBNR or other technical provisions (four cases)
• Fraud (for cases)

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• Catastrophic events (four cases)

• Poor underwriting (three cases)
• London market excess (LMX) losses (three cases)
• Over exposure to a high-risk (London) market (two cases)
• Risky assets (one case)
• Mismanagement (one case)
• Default of retrocessionaire (one case).
The great majority of these causes were internal to the reinsurers and so subject to
influence by the reinsurer and also, potentially, by their supervisor. Other reinsurers—
some of them significant players—went out of business for various reasons not included in
this list.
In the context of credit risk in reinsurance failure, Swiss Re (2003) offers the following
comment:
Whereas in life insurance (with the exception of the United States) reinsurance is not a big
credit risk, in non-life insurance it is significantly higher. As the primary insurers have
generally diversified their reinsurance cessions, even the share of a big reinsurer ought
not to come to more than 4 percent of the non-life insurance balance sheet. So the
possible bankruptcy of an individual reinsurer does not hold any systemic risk.
Thus, in assessing the reinsurance programs of insurers, supervisors should consider the
level of diversification of the reinsurance program.

Abuses of Reinsurance
An example of an abuse of reinsurance is “fronting,” where an insurer, often with minimal
capital of its own, is established with a view to reinsuring the great bulk of the risks
underwritten.
This type of arrangement poses several significant problems:
• No incentive for the direct insurer. There is moral hazard in that the direct insurer
has no or little incentive to underwrite or administer claims properly, as reinsurance
commissions probably outweigh any losses that may arise from the low level of
retention.

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• Inappropriate ownership structure: Major problems may arise when the reinsurer
also owns the fronting company or vice versa. An incentive for fronting may be an
agent or broker seeking to capture not only commissions but also reinsurance
profits, without the usual capital requirements or skills and experience to deal with
adverse experience. In the event of a failure by there insurer, the full obligation for
the direct insurance contracts reverts back to the insurer.
A review of retention levels is the key to detecting and addressing fronting. In
general, reinsurers expect insurers to retain a significant amount of risk in order to
provide an incentive to manage their insured business well and there may also be
supervisory constraints on the level of retention required. In general, insurers tend to
seek to develop long-term relationships with their reinsurers. If a supervisor finds
that a particular insurer does not seem to do this, further investigation may be
warranted.
Reinsurance issues have been involved in a number of high-profile failures and
some are noted here:
• HIH Group in Australia: The HIH Royal Commission has established the role of
abuses of reinsurance and financial reinsurance agreements in the failure of HIH
Group in 2001. The situation was compounded by the existence of “side letters,”
unknown to the supervisor and other parties, that voided some of the terms of the
treaty. Also, the directors of the company may have been unaware of the side
letters, calling into question the quality of the overall corporate governance of HIH.
• Gerling in the United States: Gerling’s U.S. subsidiaries failed due to credit losses,
the September 11 terrorist attacks and asbestos losses. Gerling’s other reinsurance
subsidiaries provided support, which, in turn, caused them to fail, even though they
raised additional capital. This illustrates the risk of group contagion.
• Independent Insurance Company Limited in the United Kingdom: This
significant and fast-growing non-life insurer closed to new business in June 2001
and went into receivership. While the major cause of its demise appears to be under
reserving, some of the company’s reinsurance arrangements appear to have been
questionable.
• Reliance National in the United States: This insurer fronted large amounts of
workers’ compensation carve-out business. A reinsurance spiral behind it collapsed,

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leaving the company unable to pay claims. The subsequent loss of reputation then
caused healthy non-U.S. companies in the group to fail.
• Cardinal Insurance in the United States: This insurer obtained stop-loss cover at
very low premium rates, virtually ensuring that it made a profit no matter how bad
the business experience. The reinsurer argued that the reinsurance cover was
obtained in a fraudulent way and did not pay the claims. Cardinal was liquidated.

Supervision of Reinsurance
Reinsurance checklists are useful for helping supervisors to review the reinsurance
programs of insurers. Checklists typically include review of the following items:
• Reinsurance program
• Retention levels
• Security of reinsurance
• Specific reinsurance contracts
• Credit taken for reinsurance.
Some other issues that may warrant further consideration are considered below.
Mandated coverage and prior approval
Some jurisdictions have national reinsurers and require all insurers to take out a certain
minimal amount of reinsurance cover with these national reinsurers. Independent of the
reasons for establishing national reinsurers, this approach may carry a number of risks,
including market concentration risk and capability risk (adequate skills, resources and
experience) for the national reinsurer. This issue may be especially significant in
jurisdictions with limited competition among reinsurers. Commonly, the national reinsurer
is a state-owned or related entity. As such, although it may formally be under the same
supervisory regime as other reinsurers, there is a risk that the supervisor’s influence and
powers will be diminished.
In some jurisdictions, approval of reinsurance arrangements is subject to the prior
approval of the supervisor. In principle, this raises the question of moral hazard for the
supervisor, in that insurers may become dependent on and rely on the supervisor’s

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assessment of the proposed reinsurance arrangements when it is more appropriate for the
insurer (in particular, its senior management) to take responsibility for them. There is also
the implication that the supervisor has sufficient in-house expertise and sufficient detailed
knowledge of the insurer’s business objectives, position, systems and products to be able
to fully assess the proposed reinsurance arrangement. These conditions maybe hard to
fulfill in practice.
From the perspective of prudential risk management, leaving aside other criteria, it is
preferable to have a competitive reinsurance market in which insurers can choose where
to place their reinsurance business.
Other parties
Supervisors can use other parties to support their assessment of reinsurance and
reinsurers, just as they can in the broader context of supervision.
Independent professionals—in particular, actuaries operating under a strong
professional code of conduct—should be able to provide independent assessments of
reinsurance arrangements and solvency, both of insurers and reinsurers. In jurisdictions
where the actuarial profession is well developed, the use of the responsible actuary
concept can deliver this assistance. Supervisors can use actuaries who are independent
of both the supervisor and the entity in question to perform assessments of reinsurance
arrangements, provided the supervisor has the legal power to demand such assessments.
Other professionals, such as accountants, independent underwriters, legal experts and so
on may also provide valuable input regarding the assessment of reinsurance
arrangements.
Ratings agencies may also be useful sources of information. While the primary role of
ratings agencies is not to provide a supervisory or pseudo-supervisory service, the fact
that a consistent set of evaluation criteria is applied to both insurers and reinsurers
suggests that there is value in considering the relative ratings assigned to insurers and
reinsurers, as well as noting the trends in the ratings attained by entities. There is some
evidence, put forward by some of the ratings agencies, that the movement in insurer and
reinsurer ratings has an element of predictability with regard to entities becoming
distressed. Access to the causes of movements in the ratings of insurers and reinsurers
may provide valuable insights for supervisors in addition to access to the ratings
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Supervision of Reinsurance Companies

IAIS provides guidance on the supervision of reinsurers. As an overall approach, IAIS
(2003a, para. 7) states: The principles apply to the supervision of insurers and reinsurers,
whether private or government-controlled insurers that compete with private enterprises,
wherever their business is conducted, including through e-commerce. The term insurer
refers to both insurers and reinsurers. Where the principles do not apply to
reinsurers(such as consumer protection), this is indicated in the text. From the reinsurer’s
perspective, doing business with the ceding insurer is essentially analogous to an insurer
doing business with its policyholders. As such, essentially, the same supervisory regime
should apply.
In particular, IAIS (2002a) provides two principles.
• Principle 1: The supervision of reinsurers should reflect the distinct characteristics
of the reinsurance business in four areas: (a) technical provisions, in which
reinsurers may need to address specific issues in the development of technical
reserves, (b) investments and liquidity, in which reinsurers may need to emphasize
the management of currency risk and liquidity to reflect their operations in multiple
countries and the size of potential claims, (c) capital requirements, in which
reinsurers may need to hold higher levels of capital to address diversification and
underwriting risk, investment issues, retrocessions, taxation, operational risk
particular to reinsurers and increased volatility of results and (d) corporate
governance, in which, given the increased risks of reinsurance, reinsurers should
have commensurately stronger risk management and corporate governance in
place.
• Principle 2: Except as noted in principle 1, reinsurers should be supervised in the
same way as insurers. These minimum requirements for the supervision of
reinsurers anticipate the development of a global approach to the supervision of
reinsurers, placing the onus on the home supervisor of the reinsurer. The typical
cross-border operations of reinsurers make the effective supervision of reinsurers
more difficult.
Supervisors should acknowledge some specific practical issues for reinsurers,
particularly those that write non-life reinsurance:

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• Pricing: Pricing can be more difficult for reinsurers than for insurers due to limited
availability of data and the impact of complicated layers of reinsurance.
• Volatility: Reinsurers price in the tails of claims distributions and these maybe
longer tailed, more volatile and less homogeneous than in regular insurance;
consequently the payment patterns of non-proportional reinsurance maybe
considerably different than the payment patterns of the underlying direct insurance.
• Time frame: There may be lengthy time delays between the occurrence, reporting
and settlement of any covered loss events, placing more importance on the
estimation of IBNR and IBNER provisions.
• Insurer risks: The reinsurer may be exposed to flaws in the insurer’s underwriting
and claims processes and pricing policies (for example, for co-insurance and other
situations where the reinsurer “follows the fortunes” of the insurer), with less ability
to influence them.
• Credit ranking: Reinsurers may find that they rank below other creditors in the case
of bankruptcy of an insurer and they may not be able to offset funds owed against
funds due in the liquidation process.
These issues suggest that reinsurers may encounter some issues not encountered by
insurers and so it may be prudent for them to hold higher levels of capital for adverse
experience.
Where insurers or reinsurers are part of a larger group—for example, captives—the
insurance supervisor should consider the risk of contagion from other members of the
group. Many aspects of reinsurance, from the perspectives of both the insurer and the
reinsurer, are not covered in this module but are covered in other modules. For example,
the determination of liabilities and capital adequacy are covered in ICPs 20 and 23 and the
behaviour and supervision of reinsurance intermediaries are covered in ICP 24.

IRDAI Reinsurance Initiatives

The reinsurance program of each non-life insurer is required to be guided by the basic
tenets of maximizing retention within the country; developing adequate reinsurance
capacity; securing the best possible protection for the reinsurance costs incurred; and
simplifying the administration of business. Every life insurer is required to draw a program

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of reinsurance in respect of lives covered by it. The profile of the reinsurance program,
duly certified by the Appointed Actuary, is required to be filed with the IRDAI, giving details
of the reinsurer(s) with whom the insurer proposes to place business. Every insurer is
required to furnish the reinsurance program to the IRDAI at least forty-five days
before the commencement of each financial year. In addition, every insurer is required to
file copies of the treaty slips and cover notes, furnishing details of the proportionate share
of the reinsurers, within 30 days of the commencement of the year. The Authority reserves
the right to seek any clarifications and if necessary, give directions.
The Authority is particularly concerned that insurers while ceding abroad do so only after
utilization of the national capacity and on competitive international terms. Also, the
business placed with any one re-insurer should not be excessive. Thus, every insurer is
required to offer an opportunity to other Indian insurers, including the Indian reinsurer to
participate in its facultative and treaty surpluses before placing such cessions outside
India. Insurers are also required to place their reinsurance business outside India with only
those re-insurers who have over a period of past five years counting from the year
preceding for which the business has to be placed, enjoyed a rating of at least BBB (with
Standard & Poor) or equivalent rating of any other international rating agency. Placement
with any other reinsurer requires approval of the Authority. Surplus over and above the
domestic class-wise reinsurance arrangements can be placed by the insurer
independently subject to a limit of 10 percent of total reinsurance premium ceded outside
India being placed with any one reinsurer. Where it is necessary to cede a share
exceeding such limits to any particular reinsurer, the insurer needs to seek the specific
approval of the Authority.
Introduction of brokers has helped the direct insurers to secure facultative placements
abroad, especially in aviation, energy and petrochemical risks. GIC, the national re-
insurer, extends the additional facilities to insurers besides managing obligatory cessions
by participating in a) companies surplus treaties; b) market surplus treaties; and c)
facultative acceptances protecting their net account through excess of loss arrangements.
GIC as a member of the Federation of Asian Insurers and Reinsurers (FAIR) Pool is
able to extend additional facilities in the Indian market.

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REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. One of the following is not true:
a. The Dept. of Trade, UK requires the primary insurers to annually report the
amount of premium payable to each reinsurer.
b. In the US, reinsurers have to keep solvency margin almost along the lines
prescribed for primary insurers.
c. In US, the reinsurers have to file financial statements with State Regulatory
Authorities quarterly.
d. Pricing is not directly regulated.
e. None of the above
2. One of the following is not true:
a. The regulation by means of an insolvency clause provides that the insolvency
of the primary insurer will not affect the liability of the reinsurer.
b. The reinsurer will make payment to the liquidator or the receiver of the
insolvent primary insurer for the benefit of their creditors.
c. The risk of insolvency of the reinsurance broker is passed on to the reinsurer
so any default by the reinsurance broker will be made good by the reinsurer.
d. Reinsurance broker is an agent of primary insurer.
e. None of the above.
3. The intermediary must make full written disclosure of:
a. Any control over the broker by a reinsurer.
b. Any control of a reinsurer by the intermediary.
c. Any retrocessions of the subject business placed by the intermediary
d. Commissions earned or to be earned on the business;
e. None of the above

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4. Records of all transactions must be retained for at least------years after the

expiration of all reinsurance contracts.
a. 5 b. 7
c. 10 d. 12
e. None of the above
5. In India the following authority administers regulations on insurance industry.
a. Ministry of Finance, Union Govt. b. RBI
c. IRDAI d. PFRDA
e. SEBI
6. One of the following is not an objective of reinsurance regulations in India.
a. to maximize the retention within the country.
b. Develop adequate capacity’
c. Secure the best possible protection for the reinsurance costs incurred.
d. Simplify the administration of business
e. None of the above.
7. Regulations relating to placement of reinsurance business outside India:
a. those reinsurers who have a period of the past 5 years enjoyed a rating of at
least BBB (with S&P)
b. Rating of any international agency equivalent of S&P
c. Placement can be done with reinsurance agency in USA.
d. Prior permission of IRDAI should be obtained.
e. None of the above.
8. Which of the following Acts are relevant to reinsurance cases?
i. Indian Contract Act.
ii. Indian Arbitration Act.
iii. Insurance Act.

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a. only (i) b. only (ii)

c. Both (i) and (ii) d. Both (ii) and (iii)
e. All of the above
9. Every insurer shall cede such percentage of the sum insured on each policy
for different classes of insurance written in India to the Indian reinsurer. What
is that percentage?
a. 15 b. 20
c. 30 d. 40
e. None of the above
10. The Indian reinsurance agency is:
a. EXIM bank b. ECGC
c. GIC d. LIC
e. IRDAI
SECTION A (Answers)
Answers
1. e 2. d 3. e 4. c 5. c 6. e 7. d 8. e 9. b 10. c

SECTION – B
Short & Essay Questions
1. Examine reinsurance regulation scenario in UK and USA briefly.
Ans. In the U.K., the Department of Trade requires the primary insurers to annually report
on the following:
a. The names and addresses of all reinsurers to whom business has been ceded
during the year;
b. Any connection (other than the reported reinsurance) between the primary
insurer and any of its reinsurers;

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c. The amount of premium payable to each reinsurer; and

d. Any indebtedness of a reinsurer to the primary insurer at the end of the year.
In the United States, reinsurers as well as licensed alien reinsurers have to keep
solvency marginal most along the lines prescribed for primary insurers and must
follow reserves, investment, capital and surplus requirements and annually or
sometimes every quarter file financial statements with State regulatory authorities.
2. “Reinsurance intermediaries act in a fiduciary capacity for all funds received
in their professional capacity and must not mingle them with other funds in
USA” Explain the role of intermediaries.
Ans. Reinsurance intermediaries shall have written authorization from the insurers and
reinsurers they represent, spelling out the extent and limitations of their authority;
The written authority above must be made available to the primary insurers or
reinsurers with which the intermediary deals; No licensed intermediary shall procure
reinsurance from an unlicensed reinsurer unless there insurer has appointed an
agent for the service of process in New York; The intermediary must make full
written disclosure of Any control over the broker by a reinsurer, Any control of a
reinsurer by the intermediary, Any retrocessions of the subject business placed by
the intermediary and Commissions earned or to be earned on the business;
3. Briefly explain reinsurance regulations in India.
Ans. In India, the Insurance Regulatory and Development Authority has prescribed
regulations for there insurance sector for general as well as life insurance. The
IRDAI (General Insurance-Reinsurance) Regulations, 2000 are as follows. The first
chapter defines such special terms as cession, facultative, Indian reinsurer, pool,
retrocession, retention and treaty. The second chapter describes the procedure to
be followed for reinsurance arrangements Clause3-1 states the objectives of a
reinsurance program as to maximize retention within the country; Develop adequate
capacity; Secure the best possible protection for the reinsurance costs incurred;
Simplify the administration of business.
4. State important provisions of Clause 3 – IRDAI Regulations on reinsurance.
Ans. Clause 3-2: Every insurer shall maintain the maximum possible retention
commensurate with its financial strength and volume of business.

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Clause 3-3: Every insurer shall cede such percentage of the sum insured on each
policy for different classes of insurance written in India to the Indian reinsurer.
Clause 3-4: The reinsurance program of every insurer shall commence from the
beginning of every financial year and every insurer shall submit to the Authority, his
reinsurance programs for the forthcoming year.
Clause 3-5: Within 30 days of the commencement of the financial year, every insurer
shall file with the Authority a photocopy of every reinsurance treaty slip.
Clause 3-6: The Authority may call for further information or explanations in respect
of there insurance program of an insurer and may issue necessary directions.
Clause 3-7: Insurers shall place their reinsurance business outside India with only
those reinsurers who have over a period of the past five years counting from the
year preceding for which the business has to be placed, enjoyed a rating of at least
BBB (with Standard & Poor) or equivalent rating of any other international rating
agency. Placements with other reinsurers shall require the approval of the Authority.
Clause 3-8:The Indian reinsurer shall organize domestic pools for reinsurance
surpluses in fire, marine hull and other classes in consultation with all insurers on
basis, limits and terms which are fair to all insurers.;
Clause 3-10: Every insurer shall offer an opportunity to other Indian insurers
including the Indian reinsurer to participate in its facultative and treaty surpluses
before placement of such cessions outside India.

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CHAPTER – 3
REINSURANCE MARKET
OUTLINE OF THE CHAPTER
1. Introduction
2. Constituents of Reinsurance Markets
3. Reinsurance Brokers
4. Global Reinsurance Markets
5. Regional Reinsurance Corporation
6. Captives Insurance Companies
7. Indian Reinsurance Market
8. Reinsurance Administration
9. Claims Settlement
10. Claims Reporting and Claim Reserving
11. Questions

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Know the Reinsurance market all over the world
RISK MANAGEMENT AND REINSURANCE

• Understand Reinsurance brokers and their functions

• Understand Global Reinsurance Markets
• Explain the role of Captives
• Understand Claim settlement, claims reporting and claim reserving
• Acquaint with Inspections and auditing by Reinsurers

Introduction
Reinsurance Market is spread all over the world with major reinsurers being concentrated
in Europe and West. Reinsurance Brokers are intermediaries between insurers and
reinsurers and they operate on a large scale and present in all developing markets.
Players like Munich Re, Swiss Re and Berkshire Hathaway, the leading players in the
world, dominate global Reinsurance Markets.
Market is a place where buyers and sellers interact with each other or an arrangement
which facilitates interaction between buyers and sellers to do the business, which includes
exchange of goods and services for money. A strong insurance and reinsurance market is
an essential element of economic progress as industry can take calculated risks with a
backup support of insurance. The global insurance industry is being shaped by a number
of external drivers of change. Reinsurance is sold by a reinsurance Company and bought
by ceding company.
It is difficult to define the boundaries of reinsurance market in a geographical sense but
the reinsurance is spread over the different parts of the world. Since it is usual that
reinsurance acceptances may not be completed within the local market, the world
reinsurance market must be used. Presently, clients are not contended with only
traditional reinsurance solutions. Some of them wish to take a more far reaching and all-
embracing view of risk management.

Constituents of a Reinsurance Market

1. Insurers (Reinsured)
2. Reinsurance Brokers
3. Reinsurers – Reinsurance Reinsurer (Retrocedent)

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4. Reinsurer of Reinsurer (Retrocessoionaire) – Retrocession

5. The Arbitration Factor
6. Infrastructure Facilities
7. Domestic Markets
8. Locational Advantage
9. Foreign Reinsurers

Factors that characterize Advanced Reinsurance Markets

Several factors characterize advanced reinsurance markets in the world. Let us discuss
some of the main features:

Stability Factor
The performance of reinsurers depends on many factors such as economic, social and
political stability. If the economy is turbulent, then there will be an adverse affect on the
performance of reinsurance companies. There should also be a consistency not only in
regulatory environment but also in legal environment so that it would be helpful for the
augmentation of the reinsurance market.
As reinsurance is not a daily business, both the parties to the reinsurance contract should
be sure that the market remains stable and they are not affected by the changes in the
market.

Availability of Knowledge Capital

For the reinsurance market to be thriving, there should be personnel with widespread
knowledge about the industry. Tasks, like underwriting which the reinsurer has to take on,
depend upon the proficient knowledge of the staff possess.

Matured Financial Markets

The scope for the reinsurers to raise the required resources depends upon the maturity of
the country’s financial markets. If the financial markets are matured, then reinsurance
markets will be very much benefited. The reinsurers can easily access the market and can
maintain their business.

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Role of Economy
The economies, which have high inflation, are not favored as it adversely affects the
reinsurer’s costs like staffing cost etc. Reinsurers are prone to setting up their shops in a
steady market.

Arbitration Factor
In reinsurance if any dispute arises then it is referred to arbitration. If the market provides
good arbitration facilities with appropriate legal framework, then the disputes between the
parties can be settled easily. Hence, arbitration plays a very significant role in the
development of reinsurance industry.

Infrastructure Facilities
As reinsurance is a global industry and reinsurance players are from developed countries,
the markets should have excellent infrastructure facilities.

Domestic Markets
If the insurance players generate good business in the domestic market reinsurers will be
interested in expanding their operation. And domestic insurers will get competitive terms
for their placement. Professional reinsurers are normally interested in developing
insurance in underdeveloped countries if the legal system and regulatory environment is
not adverse.

Locational Advantage
Location plays a very important role in case of reinsurance business. If the country has
well-developed reinsurance market, then reinsurance business can be expanded to the
countries that are less developed.

Role of foreign Reinsurers

If there are foreign players in the reinsurance market then it would be helpful for the
domestic players in that they would have better knowledge of various techniques like
underwriting, marketing etc. of the foreign players. This would lead to the development of
the domestic reinsurance industry.

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Reinsurance Brokers
Just as there may be brokers for primary insurers who act as intermediaries between the
insured and the insurer, there are reinsurance brokers who are go-betweens to primary
and reinsurers. The percentage commission paid by the reinsurers to the reinsurance
brokers is relatively small, compared to the commission paid to the insurance brokers and
is sometimes as low as one percent of the reinsurance premium.
When there are reinsurance brokers, the premium payments and loss payments as well as
premium refunds pass through them. When primary insurers do not have expertise to
place reinsurance directly, they need the services of the reinsurance brokers. Large
reinsurers also use reinsurance brokers as a matter of course. However, if primary
insurers go direct to reinsurers, they may be able to reduce the reinsurance cost to some
extent.
Although reinsurance brokers obtain their commission from the reinsurers, they have a
duty to observe the principle of utmost good faith, which means they must reveal to the
reinsurers all material facts concerning the risks, which they obtained from the primary
insurers. The market share of the reinsurers combined in the United States is estimated at
75%, which shows the predominance of the reinsurance brokers in the reinsurance
market. Generally, reinsurance brokers handle treaty reinsurances in preference to
facultative reinsurance.
Reinsurance Pool: A reinsurance pool (or syndicate or association) is an association of
reinsurers banded together to underwrite reinsurance jointly. Some pools write
reinsurance for only members. Some others write for non-members as well. Industrial
insurers may form a pool to write specific risks that require large capacity. Specialized
pools are also formed for energy insurance and the like.

Global Reinsurance Markets

Now the reinsurance markets are able to penetrate much faster across the world and new
markets are emerging with the advancement of technology and availability of Internet. In
fact even the US insurers buy more than half of their reinsurance requirements from non-
admitted alien reinsurers, who are located in many countries of the world, including Russia
and China. However, Britain, Bermuda and Switzerland together account for the largest
share.

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The reinsurance industry all over the world generates approximately $150 billion in ceded
premiums. More than 75 percent of the ceded premiums originate from North America and
Western Europe. The North American market represents the largest single source
providing more than 50 percent of the total. Asian market is a follower of trends and
attitudes developed in advanced countries. Regional integration worked well in Europe.
However, integration has yet to take shape in Asia.
Almost all global and regional reinsures of the west got impacted on account of WTC
attack losses, which were estimated at around $ 80 billion.
In the world of reinsurance, it would be interesting to observe at global level, two
reinsurance companies namely Munich Re (Germany based) and Swiss Re (Switzerland
based), which have more than a century of history of operations to their credit, have
developed phenomenally.
MUNICH RE: The business generated by this company is dependent on the domestic
insurance sector and most of its business is generated internally from the German market.
The focus has slowly shifted to outside markets after exploiting the German markets to the
full extent.
SWISS RE: It occupies a prominent position in the Swiss insurance market and is very
popular name in the world of insurance. It is one of the oldest reinsurance firms in the
world. Since the Swiss market is of small size, the business generated by this company
depends to a certain extent on the domestic markets and the rest is generated from the
international markets. As an international player it has withstood the intense competition in
the field and expanded across the global markets.

Current Global Status

As per the latest update from Aon Reinsurance Market Outlook Report, 2017, the
Reinsurance capital continued to climb, increasing 5.3 percent to USD 595 billion through
nine months at September 30, 2016. While traditional reinsurance capital increased 4.7
percent during the period, alternative capital increased by only 9.6 percent, the smallest
growth it has reported in 5 years. This result further suggests that traditional capacity is
using all the tools at its disposal in order to stave off market share growth from alternative
capital. Overall demand increased for the industry, but growth has been isolated to few
regions and lines of business. For January 2017 renewals, some insurers in the US and

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Europe looked to secure additional property catastrophe capacity as terms and conditions
continued to move in their favor and/or they looked to meet new regulatory requirements
and evolving rating agency thresholds. While growth in new lines such as mortgage and
cyber also continues, slow insurance growth in many regions with low primary insurance
penetration saw stable reinsurance demand. Importantly, further evidence of insurer
appetite for growth is surfacing in the form of investments in innovative insurer
technologies in both organic and inorganic forms.
Beyond demand increases, insurers in a number of global regions also looked to increase
the proportion of protection provided on a multi-year basis as reinsurers in turn looked to
lock in participations. Insured catastrophe losses ended 2016 at USD 53 billion, slightly
above the 10 year average for the first time since 2012 and sixth in insured catastrophe
loss activity over the last 25 years. Despite this, uninsured losses continue to highlight the
protection gap in coverage for emerging markets. In addition, macro catastrophe loss
impacts on the reinsurance market were mitigated by the higher contribution in loss
activity from perils like severe convective storm, flood and fire that typically result in lower
ceded losses. As we look to future 2017 renewals, the pick-up of M&A activity in Q4 2016
and potential interest rate increases could signal potential capacity restrictions. Our
expectation is that these impacts will be slow to manifest and enough excess capital
remains in the market to continue the trend for better terms and conditions for insurers
seen at January 2017.
Note: Aon Benfield estimates that global reinsurer capital rose by 5.3 percent to a new
high of USD595 billion over the nine months to September 30, 2016. This calculation is a
broad measure of the capital available for insurers to trade risk with and includes both
traditional and alternative forms of reinsurer capital. Equity capital available to support
reinsurance underwriting is at peak levels and debt continues to be available on very
favorable terms. As a result, ample capacity currently exists to meet expected reinsurance
demand.

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Change in Global Reinsurer Capital

Source: Aon Benfield Analytics, Aon Reinsurance Market Outlook, January 2017

Rise in Alternative Capital

Insurance risk continues to attract capital market investors. Expected returns have
declined, but remain attractive relative to other available opportunities and low correlation
with other asset classes (except in the most extreme scenarios) remains a key
consideration. Alternative capital rose by 9.6 percent to USD 78 billion over the nine
months to September 30, 2016, principally reflecting additional deployment into
collateralized reinsurance structures. Certain maturing catastrophe bonds did not renew
during 2016 and, as a result, new issuance fell to USD 6.0 billion, from USD 6.9 billion in
2015.

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Alternative Capital Deployment

Source: Aon Securities, Inc. Aon Reinsurance Market Outlook, January 2017

New Capacity
Regulatory change and capital availability is resulting in new reinsurance company
formations in rapidly developing markets such as China and India. New carriers in the final
stages of launching include Qianhai Re, Nine Merchants Re and ITI Re. At Lloyd’s, four
new syndicates have been launched for 2017, three of which can be regarded as truly
innovative. All four are backed to some extent by traditional Lloyd’s Names. The overall
underwriting capacity of the Lloyd’s market exceeds GBP30 billion for the first time in
2017. The increase of 10 percent relative to 2016 largely reflects the impact of Sterling
devaluation since the Brexit vote—more than 50 percent of Lloyd’s business is
underwritten in US Dollars.
As per the S& P Ratings Global Reinsurance 2016 Report, more promising growth
prospects are developing in emerging life insurance regions, especially in the Asia-Pacific
region. These under penetrated life insurance markets could grow significantly in the next
few years as the economies develop and insurance penetration rates rise. Emerging
market life insurance premiums, including in the Asia-Pacific region, grew by about 8%in
2015, while the world life insurance market grew by only 1%-2%. (Table.8.1). In these

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countries, there is younger demographics, increasing wealth and improving health care,
which should point to improved mortality overtime. What’s more, the primary writers and
reinsurers should benefit from good diversification given the small face amounts versus
more developed markets. The other trend that is seen in the primary companies is a
higher level of protection-type products being sold in emerging markets given their
younger demographics and lower wealth. Some of the reinsurers are working closely with
primary writers to develop new products and sales and in exchange retain a percentage of
the business underwritten. There are ample opportunities for the sector to support product
development, underwriting, claims handling and to finance acquisition costs. Business
opportunities include mortality, morbidity and longevity business, with some emphasis on
morbidity, although this can vary widely between the regions. The main growth drivers will
likely be China, Southeast Asia and India.
GDP Growth in Key Regions

Real GDP (% change)

2015 2016 2017
Eurozone 1.6 1.7 1.3
Asia-Pacific* 5.4 5.3 5.3
U.S. 2.4 2.0 2.4
*Includes Australia, Japan and emerging markets in Asia.
Source: Global Reinsurance Peer Review, S & P Global Ratings, 2016

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Top Five Life Reinsurance Product Mix 2015

Source: Global Reinsurance Peer Review, S & P Global Ratings, 2016

A Gradually Changing Risk Profile

Given the growth opportunities in emerging markets and the potential increase in longevity
and morbidity business, the share of “traditional” mortality business from mature markets
will likely shrink. Growth in emerging markets- bears therisk that companies will write
business with less underwriting experience and data. Moreover, volatility could arise from
different regulatory regimes, legislation and political risks in emerging regions. The
potential growth in longevity and morbidity is also adding further new risks for the industry
and longevity risk is not always diversifiable from mortality business in the regions. This
could change the risk profile of the industry gradually and potentially increase capital
requirements, in our view.
The industry, however, has developed strong risk management capabilities in the past few
years and is well advanced in underwriting, claims handling and product development
(Chart 1). Given the global nature of the business, the industry can draw on global
underwriting experience that will help to minimize underestimation of new risks.

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Top Five Global Life Reinsurers Enterprise Risk Management Scores*

Company ERM Score

Munich Reinsurance Co. Very Strong
Hannover Ruesk SE Very Strong
Reinsurance Group of America Inc Adequate, strong risk controls
SCOR SE Very Strong
Swiss Reinsurance Co. Ltd. Very Strong
*S&P Global Ratings assessment
Source: Global Reinsurance Peer Review, S & P Global Ratings, 2016
The Report views the enterprise risk management (ERM) of four of the five top global
reinsurance players as very strong (Table 8.2), while the fifth, Reinsurance Group of
America, also exhibits strong risk controls. The four Europe-based players have installed
very sophisticated strategic risk management tools, including fully fledged internal
economic capital models. In addition, these four are composite reinsurance groups that
also write property/casualty reinsurance. Their mixed portfolios add significant
diversification benefits given that life and property/casualty reinsurance in particular is
highly uncorrelated.

Mergers and Acquisitions (M&A)

After a relatively subdued first nine months, corporate M&A activity in the specialty
insurance and reinsurance markets picked-up strongly in the final quarter of 2016. Further
sector consolidation is considered likely in 2017, given current market dynamics.

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Specialty M&A Transactions announced in 2016

Source: Aon Benfield Analytics, Aon Reinsurance Market Outlook, January 2017

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Global Reinsurer Rankings

The following exhibit shows the world’s 20 largest reinsurers, ranked by consolidated
gross premium written in 2016.
Reinsurance Financial Strength Ratings

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Source: Global Reinsurance Peer Review, S & P Global Ratings, 2016

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Top 40 Reinsurance Company Rankings

Source: Global Reinsurance Peer Review, S & P Global Ratings, 2016

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From the exhibits, it is obvious that there is a certain geographic diversity in top reinsurers,
with 5 headquartered in the United States, 2 each in Germany, UK and Switzerland and
France and the rest in other parts of the world.

Insurer Financial Strength Ratings

An insurer rated ‘BBB’ or higher is regarded as having financial security characteristics
that outweigh any vulnerabilities and is highly likely to have the ability to meet financial
commitments.
AAA
An insurer rated ‘AAA’ has EXTREMELY STRONG financial security characteristics. ‘AAA’
is the highest Insurer Financial Strength Rating assigned by S&P Global Ratings.
AA
An insurer rated ‘AA’ has VERY STRONG financial security characteristics, differing only
slightly from those rated higher.
A
An insurer rated ‘A’ has STRONG financial security characteristics, but is somewhat more
likely to be affected by adverse business conditions than are insurers with higher ratings.
BBB
An insurer rated ‘BBB’ has GOOD financial security characteristics, but is more likely to be
affected by adverse business conditions than are higher rated insurers.
An insurer rated ‘BB’ or lower is regarded as having vulnerable characteristics that may
outweigh its strengths. ‘BB’ indicates the least degree of vulnerability within the range;
‘CC’ the highest.
BB
An insurer rated ‘BB’ has MARGINAL financial security characteristics. Positive attributes
exist, but adverse business conditions could lead to insufficient ability to meet financial
commitments.

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B
An insurer rated ‘B’ has WEAK financial security characteristics. Adverse business
conditions will likely impair its ability to meet financial commitments.
CCC
An insurer rated ‘CCC’ has VERY WEAK financial security characteristics and is
dependent on favourable business conditions to meet financial commitments.
CC
An insurer rated ‘CC’ has EXTREMELY WEAK financial security characteristics and is
likely not to meet some of its financial commitments.
R
An insurer rated ‘R’ is under regulatory supervision owing to its financial condition. During
the pendency of the regulatory supervision, the regulators may have the power to favour
one class of obligations over others or pay some obligations and not others. The rating
does not apply to insurers subject only to non financial actions such as market conduct
violations.
NR
An insurer designated ‘NR’ is NOT RATED, which implies no opinion about the insurer’s
financial security.
Plus (+) or minus (-)
Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus or minus sign to
show relative standing within the major rating categories.
Reciprocity: There is a practice of reciprocal reinsurance among primary insurers, whereby
two or possibly more primary insurers enter into an agreement under which each cedes to
the other an agreed percentage of its business. In most reciprocal reinsurance
arrangements, similarity of business is a prime consideration. Again normally, they do not
compete in the same market area. In the modern day, reciprocal reinsurance is not widely
practiced.

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The London Market

The reinsurance market in London consists of the Lloyd’s, other reinsurers in London,
Direct insurers accepting inward reinsurance business, underwriting agents and brokers
writing reinsurance on behalf of other insurers and contact offices writing business for
overseas insurers for placement in the London market. Of late, there has been a marked
trend in the formation and development of Regional and State Reinsurance Corporations
such as Caisse Centrale De Reassurance in France, the Instituto Nationale de
Assicurazioni in Italy and the Asian Re in Bangkok.

Regional Reinsurance Corporation

To take care of domestic needs, two reinsurance corporations were formed in the country,
which would be helpful for the growth of the domestic reinsurance industry. They are:
1. State Reinsurance Corporation
2. Regional Reinsurance Corporation
The setting up of a Regional Reinsurance Corporation is equally important as setting up of
a State Reinsurance Corporation, since the regional Reinsurance Corporation is set up
based on the geographical factor. Generally, a regional reinsurance corporation caters to
the needs arising among a group of neighboring countries. These corporations were
proposed to be set up across the different developing nations of the world. For example
one such corporation is the Asian Reinsurance Corporation, set up in Bangkok. The major
participants of this corporation are India, China, Bhutan, Thailand, Philippines,
Afghanistan, South Korea, Bangladesh and Sri Lanka.
The setting up of a regional reinsurance corporation mainly depends on certain common
features, which the member countries must have due to the binding proximity with or to
each other. The common features of these countries are as follows:
1. Common physical boundaries among the member countries.
2. Well-developed communication between member countries.
3. Well-developed economic trade ties between member countries, leading to free flow
of trade.
4. Common customs, ethnic identity and language.

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The regional reinsurance corporations have the liberty to choose their own market place to
locate their headquarters. The setting up of headquarters depends largely on factors such
as well-developed accessibility, excellent communication facilities, well-established
commercial backup etc. The backing of good banking system will enable the corporation to
have smooth functioning.
The regional reinsurance corporations end up with a good business in hand by involving
compulsory cessions from its members. On the other hand, the corporations can get
exposed to risks arising from member nations. In order to avoid such happenings they get
protection through retrocession covers from other markets. The regional reinsurance
corporations manage their portfolio, which is spread over different countries through
various retrocession covers, which are:
• Proportional covers
• Non-proportional covers
• By trading outward covers through traders and generating inward covers.
• Non-reciprocal inward reinsurance accounts, a part of which may be retroceded
back to the member nations.
Under the regional reinsurance corporations reinsurance cover may be issued to the
domestic company too.
Characteristics of a regional reinsurance corporation
The two main characteristics of a regional reinsurance corporation are:
1. The company is owned through a non-insurance business group with common
interest. The interest may be of a single – parent shareholder or a group of
shareholders.
2. As the name goes all the risks written are ‘captive’. The risks are somehow related
to the shareholders or to the third party risk which the shareholders control.

Captive Insurance Companies

Captive insurers operate from such tax havens as Bermuda, catering to the reinsurance
requirements of parent companies situated in Europe, America and elsewhere.

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The insurance companies formed by large commercial or industrial establishments,

essentially to take care of their own insurance needs, are called captives. These captives
play a major role in fulfilling the insurance needs of the parent companies and help the
money flow inside the periphery of the business group. The captives form their bases in
places where the investors are given tax concessions by the local governments. There are
over 4000 captive insurers operating world-wide with nearly 35% of them located in tax
havens like Bermuda, Luxembourg, Guernsey, Cayman Islands, Bahamas, Hawaii, Isle of
Man, Barbados, Dublin, Vermont, Singapore and other locations.
The captives were established since 1960’s but there was good development sincea
decade ago.
A captive insurance company normally provides coverage at a lower cost compared to the
companies in insurance industry generally. The stocks controlled by the company depend
on either one interest or a group of interests covered related to the business operations.
The captive insurance company can be a non-resident, non-admitted or a foreign insurer.

Types of captives
The various kinds of captives can be branched out as follows:
Single Parent Captives
Single parent captives are also called ‘pure’ captives. These provide coverage to single
owners who hold the company. A risk manager or finance officer at the parent company
monitors them.
Association captives
An established association generally forms this kind of captive. The coverage is provided
to its members. In this the ownership vests with the association or the individual members.
The financial expert at the association level looks after the operation or this responsibility
is outsourced to a management company, consultant or a broker.
Industry captives
An industry captive is owned by industries with similar specific insurance problem. The
shareholders to whom the company is required to report appoint a board of directors.

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Agency captives
An agent or group of agents owns this type of company. These are formed such that their
clients can participate in the programs.
Rent-A-Captives
The risks of the members are insured by this type of captive. The investment income and
underwriting profits are returned to the insureds. Certain companies rent their surplus to
institutions in order to establish a self-insurance program but not their own captive.
Protected cell companies
These are special category of rent-a-captives. They shield their capital and surplus from
other renters in the captive as long as the rent-a-captive ‘s owner remains solvent.

Benefits of captives
The corporations and groups who want to take financial control and manage risks by
underwriting their own insurance than paying premiums to the third-party insurers can opt
for captives. Captive is nothing but a tool to such organizations.
The benefits of captives are as follows:
• Provides insurance for certain exposures, which other insurance companies might
not provide.
• Enables retention of the premiums within the group by the parent company.
Operating costs are reduced.
• There is an improved cash flow.
• There is an increase in coverage and capacity. Better investment as well as
investment income.
• There is a direct reach to wholesale reinsurance markets.
• There is flexibility in underwriting and funding.
• There is a greater control over claims.
• Availability of smaller deductibles for operating units.
• There is an additional negotiating leverage with underwriters.

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• Availability of incentives for loss control.

The captives adopt their own methods in order to protect their business exposures.
• They generally retain smaller losses in their own account and they reach out for
excess of loss exposure in cases of larger loss exposures.
• In order to spread their portfolio in a better way, they write inward reinsurance
business.
• There is a reinsurance pool organized for their clients.
• There is also a reciprocal and non-reciprocal reinsurance arrangement.

Indian Reinsurance Market

In India prior to nationalization, there were 44 foreign insurers and 63 domestic companies
operating. As there was no reinsurance market in India they used to access the
international reinsurance industry for their reinsurance needs.
After nationalization of the insurance industry, five companies started taking care of the
general insurance needs. They are:
1. General Insurance Corporation of India
2. National Insurance Company Limited
3. The New India Assurance Company Limited
4. Oriental Insurance Company Limited
5. United India insurance company Limited
General Insurance Corporation of India (GIC) (with its subsidiaries) has been the erstwhile
monarch of non-life insurance for almost three decades. After the change in the role as
‘national reinsurer (National Re), the GIC delinked its subsidiaries and entry of foreign
players through joint ventures have changed the outlook of the whole general insurance
industry in India.
Prior to nationalization, there were 55 non-life domestic insurers and each company had
its own reinsurance arrangement. After nationalization, all these companies were brought
under the aegis of GIC and four subsidiaries were formed, with GIC as holding company.

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There was a huge jump in the Indian reinsurance market and GIC became the ‘National
Reinsurer’.
GIC undertakes both domestic reinsurance and international reinsurance. Domestic
reinsurance is provided to the direct general insurance companies in the domestic market.
GIC, as per IRDA statute, receives cession of 10% on each policy. As per IRDA regulation
GIC will retrocede at least 50% of the obligatory cessions received to the ceding insurers
after protecting the portfolio by suitable excess of loss covers. Such retrocession will be at
original terms plus an overriding commission to National Re not exceeding 2.5%. The
retrocession to each ceding insurer will be in proportion to his cessions to National Re. It
leads many of domestic companies’ treaty programs and facultative placements. GIC is
also emerging as an international player in the reinsurance market by providing
reinsurance facilities to companies in Afro-Asian region – SAARC countries, South East
Asia, Middle East and Africa.

Reinsurance Administration
Reinsurance administration deals with the routine details of handling a case from the
stage the ceding company seeks reinsurance. Ceding company and reinsurer have
several mutual obligations and expectations in the administration of the reinsurance
business. There is expectation of the other to conduct business in an orderly and ethical
manner, to establish and maintain a clear, accurate exchange of information and not fail to
provide all those services, which are contractually arranged.
For the success of a reinsurance program, both the primary insurer and the reinsurer must
make joint efforts. They both have duties as well as rights under the treaties or let us say,
reinsurance contracts.

Role of the Primary Insurer

The primary insurer must conduct his underwriting operations satisfactorily within the
guidelines and expectations of the treaty so that the reinsurer has no surprises coming in
the form of large losses. Moreover, the primary insurer must notify promptly all large
losses and the reinsurer must be given the opportunity to participate in investigation of
such losses.
The primary insurer has the freedom to underwrite individual risks and adjust individual
claims once clear cut underwriting policies are contemplated under a treaty. We

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conventionally use a phrase “FOLLOW THE FORTUNES”, it means the reinsurer is

normally bound by the primary insurer’s actions in the underwriting and claims matters.
The primary insurer must have a good or well designed information system to be able to
furnish all necessary information in time for the reinsurer to be able to control losses
wherever possible and to discharge their obligations under the treaty professionally. The
more important data that should be capable of being made available from a good
information system used by the primary insurer will include the following:
• Direct premium data to calculate the reinsurance premium payable to the reinsurers;
• Data for individual losses needed to apply treaty limits and excess retentions; Codes
for catastrophe losses;
• Codes for identifying occurrences under casualty ‘clash’ coverage;
• Data to determine the portion of policy(ies) ceded to each surplus share reinsurer;
• Separate data on retention, limits, rates and the reinsurer involved for each
facultative placement;
• Information on risks included in the treaty but not ceded for preserving profitability of
the treaty;
• Data on risks excluded under the treaty but underwritten by the primary insurer so
as not to include the same in the reinsurance bordereau.
An accurate and efficient information system helps the credibility of the primary insurer
and helps the renewal of treaties. The primary insurer must make available his books of
account for inspection if required by the reinsurer.
The primary insurer must send quarterly bordereaux to the reinsurers, which contain
detailed statistics of premium, commission and losses paid and outstanding as at the end
of each quarter. However, in the modern day, most primary insurers send a current
account statement to the reinsurers, giving details of premiums ceded, ceding
commission, net premiums ceded, losses paid, loss expenses paid and losses outstanding
and also a summary from which the amount due to the reinsurer will be evident.
A final point in the matter of dispute resolution is that whereas in former times, disputes
between the primary insurers and reinsurers were generally resolved through direct
negotiations or arbitration, nowadays, both the parties are not averse to go to courts to
resolve disputes.

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Role of the Reinsurer

One would think that the reinsurers have very little to do except collecting reinsurance
premium and paying claims and brokerage commission to brokers and ceding commission
to the primary insurer. Maybe this is so when the treaty relationship is smooth. In fact,
some reinsurers minimize their work by preferring large retentions with the possibility of no
claims being presented at all.
On the contrary, the reinsurers may be engaged in auditing the underwriting and claims
practices of the primary insurer so as to ensure that these are done satisfactorily and as
expected. Again, whenever the losses are large, the reinsurers may like to participate in
the in the claims settlement process. Normally reinsurers incorporate claims –control or
claims cooperation clause in the facultative contracts for claims the exceeding prescribed
limit (major claims). Many a time, the primary insurers, both on underwriting and claims
issues, openly consult the reinsurers.
We have already seen how the reinsurers, not only help in stabilizing loss exposures but
also positively assist the primary underwriters in underwriting by sharing their expertise.

Chain of Activities
The chain of activities in administration would include:
• Negotiating and drafting treaties:- the product features must be properly understood
at the time of negotiation so that treaties signed are free from disputes
subsequently.
• Underwriting cases:- wherever there are any special terms & conditions in
underwriting they should be brought to the notice of reinsurer, particularly in case of
automatic reinsurance.
• Paying premiums:- the agreed premiums need to be properly calculated and paid to
reinsurer.
• Modifying policies:- whenever there are changes in policies both insurer and
reinsurers should maintain reinsurance in force on mutually agreed and fair terms.
• Paying Claims:- the reinsurer will pay his share of claim to the ceding company in a
single amount or as per agreement provided that all conditions are properly
complied with.

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• Recapturing Coverages:- whenever a ceding company raises its retention limit, the
insurer should inform a reinsurer of his intention to recapture ceded business if the
insurer intends to that. If the insurer fails to inform reinsurer the insurer will forfeit its
right to recapture the reinsured coverage.
• Evaluating in-force reinsurance:- periodical review of reinsurance is required to see
that everything is moving according to agreed treaty provisions.

Claim Settlement
A broker or the cedent notifies the claim to reinsurer on a daily basis, by post or
electronically. The procedure differs from treaty to treaty based on individual agreements.
If it is a pro-rata treaty, the primary insurer sends monthly bordereau to the reinsurer,
detailing the premiums due to the reinsurer and claims due from the reinsurer. The primary
insurer will remit the difference to the reinsurer when the premiums exceed the losses and
if the losses exceed the premiums, the reinsurer remits the difference to the primary
insurer. If at any time, there are some exceptionally large losses, the nit is the convention
for the reinsurer to remit the losses to the primary insurer before the end of the reporting
period.
In the case of excess loss treaties, as soon as losses exceed the retention, intimation is
given and the reinsurer pays on being given proof of settlement, which is simplya
statement of losses paid by the primary insurer, together with estimates of current
reserves.
In the case of aggregate excess loss treaties, the reinsurers are known to make initial
payments say sixty days after the end of the accounting year. If it is clear that the losses
will exceed the retention, then payments may be made before the end of the year.

Claims Reporting
Claims administration presupposes the primary reinsurer to maintain proper claim records
so that it can estimate its liabilities on individual contracts. In order to properly monitor
recording of claims information is made in proper format. At times it may so happen, due
to poor maintenance of records, lot of time may pass between the date of loss occurrence
and date of claim notification to the reinsurer. Proper recording facilitates determination of

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funds, which will be needed to meet the company’s obligations. Claims administrator will
be able to cull out all the information like cedent, broker, peril class of business, location of
cedent, period of cover, sum insured, limit and reinsurance arrangements – from records
whenever a claim is received. The data required can be obtained in coded format to avoid
inconsistencies. There could be cases where lot of supplementary information is required,
particularly in respect of serious and large claims. Here the objective is to collect more
information on those cases that materially have an effect on the overall results of the
treaty. By providing comprehensive information the insurer can avoid possible points of
difference and confusion with reinsurer. If the reinsurer has his own proportional
retrocession treaties, then accounting information relating to claims can be built up as a
part of processing retrocession accounts. However, where the reinsurer has his own
excess of loss protection covering a specific class of business or the whole account, then
he is concerned with aggregations of specific claims arising from several treaties,
proportional or non-proportional. In such cases it will have to maintain a record of all claim
advices from specific claims.

Claim Reserving
The reserves are meant to meet claims in future and the reserves need to be maintained
by cedent company and reinsurer. Every insured risk needs to be supported by
maintenance of reserves. They have to be maintained on an ongoing basis and when risks
are reinsured, the reinsurer also agrees to establish reserves for its proportionate share of
each risk. Reserves are calculated basing on estimates of expenditure in case of likely
claims. The insurance company sets reserves to meet indemnity costs. In addition to such
reserves, reserves for defense and loss adjustment expenses are also posted by the
insurance company. The reinsurer sets reserves for the economic damage posted by the
ceding carrier. The ceding carrier normally settles the claims and reinsurer helps him to do
this job efficiently. The ceding carrier should settle the entire claim in fairness to his
reinsurers. The total reserve exists at all times in the books of the ceding carrier. Normally
reinsurers do not set reserves below the amount reported by the cedent. If the reinsurer
wants to post a larger amount, the excess amount is considered as an additional case
reserve and such reserve is in the reinsurer’s books but not posted in the cedent’s books.

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Incurred but not Reported (IBNR)

It denotes the liability for future payments on losses, which have already occurred but
have not yet been reported in the reinsurer’s records. This definition may be extended to
include expected future development on claims already reported. Thus, technically IBNR
covers the field from:
a) Those individual losses that have occurred but have not been reported to the insurer
or reinsurer.
b) That amount of loss that may arise from a known loss which has been reported as
an event but which has not been recorded in full to its ultimate loss value (known as
loss development).
Sometimes, reinsurers may end up with overpayment of claims. Such payments can be
avoided by addressing senior management focus and initiating proper claims handling
methods.

REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. Why is a reinsurer most likely to exclude losses arising from some territories
under a worldwide reinsurance treaty?
a. Court settlements lead to uncertainty when quantifying claims costs.
b. Currency fluctuations cause variations in premium and claim payments.
c. Money laundering restrictions prohibit payments to some territories.
d. Making claim payments in the currency of certain territories is prohibited.
2. Compliance with the Sarbanes-Oxley Act (2002) is essential for reinsurers
based in which market?
a. Australia b. Bermuda
c. London d. US

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3. In a soft reinsurance market, it may not be possible to price a non-proportional

reinsurance in away which allows for
a. administration costs b. investment income
c. reinsurance taxation d. underwriting profit
4. A reinsurer seeking to manage the underwriting cycle should
a. Actively review its portfolio by the application of risk selection techniques.
b. Allow investment income to determine reinsurance rates.
c. Gear staff remuneration to business volumes rather than profit.
d. Maintain long-term relationships and avoid cancelling established business.
5. During a soft market, a reinsurer makes a decision to withdraw its
participation on a treaty due to unsustainable premium rates. The main
disadvantage is that -
a. Any claim recoveries that are due to the reinsurer will no longer be payable.
b. By withdrawing from a treaty, the reinsurer will automatically lose other
profitable business.
c. It may prove difficult to participate on the treaty in future when market
conditions become more favourable.
d. The reinsurer’s retrocession programme will become more expensive.
6. A casualty reinsurance underwriter requests information on the aggregated
loss potential from environmental liability and products claims. Which type of
contract is the reinsurer most likely to be considering writing?
a. Non-proportional facultative b. Proportional facultative
c. Non-proportional treaty d. Proportional treaty
7. The usual method of reinsurance for fidelity guarantee business is
a. facultative b. quota share
c. stop loss d. surplus
8. A reinsurer concerned about the impact of inflation can minimise its exposure
to long-tail liability claims by including

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a. an aggregate extension clause b. a claims series clause

c. a commutation clause d. an indexation clause
9. A space insurer has discovered that a launch manifest has changed resulting
in two insured satellites being launched at the same time. As a result the
insurer has an unacceptably high per launch exposure. To limit the exposure,
the insurer would most likely purchase which type of reinsurance?
a. Facultative b. Stop loss
c. Excess of loss d. Quota share
10. A marine reinsurance underwriter’s single largest unit value at risk will usually
result from which business sub-class?
a. Cargo b. Energy
c. Hull d. Liability
11. A forest fire causes extensive property damage over a period of 10 days.
Construction workers’ negligent practices may have been the source of
ignition. A multi-line insurer reviews its potential exposures and identifies
risks written in its property, motor and liability accounts, which are protected
by separate treaties. Which of these treaties, if any, will allow the insurer to
determine the start and end dates of the occurrence?
a. All of the treaties b. Motor and property only
c. Property only d. None of the treaties
12. How does Lloyd’s assist in the management of the underwriting cycle for
syndicate reinsurers?
a. The Council of Lloyd’s will use the central fund to support reinsurers struggling
in a soft market.
b. The Franchise Board sets minimum standards for Lloyd’s brokers which
prevent significantly sub-standard risks being introduced into the market.
c. The Lloyd’s Market Association helps reinsurers in a soft market by conducting
market-wide marketing campaigns.
d. The Performance Directorate sets risk management and profitability targets to
ensure underwriting quality remains high at all times.

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13. Which of the following is NOT an operating goal of an insurer?

a. Comply with legal requirements b. Concentrate risk
c. Meet customer needs d. Earn a profit
e. Fulfil its duty to society
14. What are the three core functions that exist within a typical insurer?
a. Accounting, actuarial and underwriting
b. Actuarial, claims and underwriting
c. Accounting, marketing and distribution and sales
d. Claims, marketing and distribution and underwriting
e. Actuarial, marketing and distribution and sales
15. Which of the following is an ethical obligation insurers have with regard to
using their superior knowledge of loss control and prevention?
a. Earn a profit.
b. Provide funds for government sponsored disaster relief programs.
c. Decline coverage for exposures that may have a loss.
d. Assist in preventing or reducing accidental losses.
e. Discourage risk-taking in business and personal activities.
16. Which of the following is NOT a reason that a court of law may find an insurer
to be guilty of bad faith claim settlement practices if it has denied payment of a
claim?
a. Failing, without legal cause, to fulfil a contractual promise
b. Mishandling the claim resulting in financial detriment to the insured or third
party claimant
c. Failing to comply with the implied duty of good faith claim settlement
d. Denying a claim for which coverage was neither provided nor intended in the
contract of insurance
e. Failing to deal with the claimant fairly and in good faith

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17. Betty Smith is an avid golfer. While teeing off at her golf club recently, she
sliced her shot and hit her golfing partner, Susan Jones, in the face causing
Susan to suffer a laceration, severe pain and temporary loss of vision in one
eye. Betty immediately contacted her insurance agent, reported the mishap
and inquired about coverage under her homeowners’ insurance policy. The
agent in turn reported the claim to the insurance company. In settling the
claim, which step would NOT be followed by the insurer’s representative?
a. Identify the insurance policy covering Betty Smith.
b. Acknowledge receipt of the claim to the agent.
c. Advise Susan not to contact an attorney.
d. Determine if the loss occurred during the policy period.
e. Document and file all information concerning the claim.
18. It is an association of reinsurers banded together to underwrite reinsurance
jointly.
a. Lloyd’s Club b. Reinsurance Pool
c. Society of Reinsurers d. World Re Federation
e. None of the above
19. One of the following is not true;
a. Some reinsurance pools write reinsurance for only members.
b. Industrial insurers may form a pool to write specific risks.
c. Specialized pools are also formed for energy insurance.
d. A&B
e. None of the above
20. Lloyd’s was originally developed as
a. Center for Marine insurance b. Center for Aviation insurance.
c. Center for General insurance d. Center for Life insurance.
e. None of the above

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21. This is the largest reinsurance company of the world.

a. Munich Re b. Swiss Re
c. Employers Re d. American Re
e. None of the above.
22. Most of the top reinsurers are located in;
a. Switzerland b. Germany
c. United States of America d. Britain
e. Japan
23. One of the following is not true:
a. In the modern days reciprocal reinsurance is not widely practiced
b. The reinsurance market in London is constituted of Lloyds.
c. The percentage commission paid by the reinsurers to the reinsurance brokers
is relatively high.
d. B&C
e. None of the above.
24. AXA Re is associated with which country?
a. Netherlands b. Germany
c. USA d. France
e. Japan
25. Generally reinsurance brokers prefer this method of reinsurance.
a. Facultative reinsurance b. Excess of Loss Reinsurance.
b. Treaty Reinsurance d. Quota share cover
e. None of the above
26. Identify the factor which is not contributing to the success of reinsurance
market:
a. Availability of knowledge capital b. Matured financial markets

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c. Infrastructure facilities d. Domestic markets

e. Interest rates
27. After nationalization of the insurance industry, five companies have taken care
of general insurance needs. Identify the odd man out.
a. General Insurance Corporation of India.
b. Life Insurance Corporation of India
c. Oriental Insurance Company.
d. United India Insurance Company.
e. National Insurance Company.
28. The setting up of a Regional Reinsurance Corporation depends on certain
common features. One of the following is not true:
a. Countries must have common physical boundaries.
b. Countries must have well-developed communication between member
countries.
c. Countries must have common currency.
d. Must share common customs, ethnic identity and language.
e. None of the above.
29. The insurance companies formed by large commercial or industrial
establishments, essentially to care of their own insurance needs:
a. In-house Insurance b. Self-Insurance
c. Captives d. Private Agencies
e. None of the above
30. Tax concessions by the local governments are a major attraction to:
a. In-house Insurance b. Self-Insurance.
b. Captives d. Private Agencies.
e. None of the above

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31. This provides coverage to the single owners who hold the company.
a. Pure Captives b. Associate Captives
c. Beneficiary Captives d. In-house Enterprises
e. None of the above
32. One of the following is not a benefit of captives.
a. Operating costs are reduced
b. There is improved cash flow
c. There is a direct reach to wholesale reinsurance markets
d. There is greater control over claims
e. None of the above
Answers
1. a 2. d 3. d 4. a 5. c 6. c 7. a 8. d 9. a 10. b
11. b 12. d 13. b 14. d 15. d 16. d 17. c 18. b 19. e 20. a
21. a 22. c 23. c 24. d 25. c 26. e 27. b 28. c 29. c 30. c
31. a 32. e

SECTION – B
Short & Essay Questions
1. “Reinsurance Market is spread all over the world with major reinsurers being
concentrated in Europe and West”. Explain global reinsurance market.
2. What is Regional Reinsurance Corporation? Explain its features.
3. Explain the main features of Indian reinsurance market.
4. What do you understand by term ‘captives’? Discuss briefly various types of
captives.
5. Outline the benefits of captives.

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6. What is the role of primary insurer and reinsurer in case of reinsurance

administration?
7. Explain the chain of activities involved in reinsurance administration.
8. Explain claim settlement and claim reporting activities.
9. Mention any top ten reinsurance brokers in the world.
Ans. Company Country of Domicile
Munich Re Germany
Swiss Re Switzerland
Employers Re United States
General re/Cologne Re Group United States
Assicurazioni Generali S.p.A. Italy
Hanover Re Group Germany
Lincoln National Re United States
Gerling Global Re Group Germany
SCOR Group France
Tokio Marine & Fire Ins. Group Japan
10. Explain the role of reinsurance brokers.
Ans. Just as there may be brokers for primary insurers who act as intermediaries between
the insured and the insurer, there are reinsurance brokers who are go-betweens to
primary and reinsurers. The percentage commission paid by the reinsurers to the
reinsurance brokers is relatively small, compared to the commission paid to the
insurance brokers and is sometimes as low as one percent of the reinsurance
premium. When there are reinsurance brokers, the premium payments and loss
payments as well as premium refunds pass through them. When primary insurers do
not have expertise to place reinsurance directly, they need the services of the
reinsurance brokers. Large reinsurers also use reinsurance brokers as a matter of
course. However, if primary insurers go direct to reinsurers, they may be able to
reduce the reinsurance cost to some extent. Although reinsurance brokers obtain

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their commission from the reinsurers, they have a duty to observe the principle of
utmost good faith, which means they must reveal to the reinsurers all material facts
concerning the risks, which they obtained from the primary insurers. The market
share of the reinsurers combined in the United States is estimated at 75%, which
shows the predominance of there insurance brokers in the reinsurance market.
Generally, reinsurance brokers handle treaty reinsurances in preference to
facultative reinsurance.
11. Outline the features of a successful reinsurance market:
Ans. The features that exemplify the reinsurance market are as follows:
1. Stability factor.
2. Availability of Knowledge Capital.
3. Matured Financial Markets.
4. The Role of Economy.
5. The Arbitration Factor.
6. Infrastructure Facilities.
7. Domestic Markets.
8. The Location Advantage.
9. The Role of Foreign Reinsurers.
12. What is the Regional Reinsurance Corporation? Outline their role.
Ans. Generally, a regional reinsurance corporation caters to the needs arising among a
group of neighboring countries. These corporations were proposed to be set up
across the different developing nations of the world. The setting up of regional
reinsurance mainly depends on certain common features, which the member
countries are bound to have due to the binding proximity with or to each other. The
regional reinsurance corporations have the liberty to choose their own market place
to locate their head quarters. The head quarters may be set up depending on the
factors such as well developed accessibility, excellent communication facility, well-
established commercial backup etc. The backing of good banking system will enable
the corporation to have a smooth functioning. The regional reinsurance corporations

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end up with a good business in hand by involving compulsory cessions from its
members. The corporation can also get exposed to the risks arising from the
member nations. In order to avoid such happenings they get protection through
retrocession covers from other markets. The regional reinsurance corporations
manage their portfolio, which is spread over different countries through various
retrocession covers they are:
• Proportional covers
• Non-proportional covers
• By trading outward covers through traders and generating inward covers.
• Non-reciprocal inward reinsurance accounts, a part of which may be retroceded
back to the member nations.
13. What is Captive? Explain various types of Captives.
Ans. The insurance companies formed by large commercial or industrial establishments,
essentially to take care of their own insurance needs, are called captives. These
captives play a major role in fulfilling the insurance needs of the parent companies
and help the money flow inside the periphery of the business group. The various
kinds of captives can be branched out as follows:
Single Parent Captives: Single parent captives are also called as ‘pure’ captives.
This provides coverage to the single owners who hold the company. A risk manager
or financial officer at the parent company monitors them.
Association captives: An established association generally forms this captive. The
coverage is provided to its members. In this the ownership vests with the association
or the individual members. The financial expert at the association level looks after
the operation or this responsibility is outsourced to a management company,
consultant or a broker.
Industry captives: The industry captive is owned by industries with similar specific
insurance problem. A board of director is appointed by the shareholders to whom the
company is required to report.
Agency captives: An agent or group of agents owns this particular company. These
are formed such that their clients can participate in the programs.

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Rent-A-Captives: The risks of the members are insured. The investment income
and underwriting profits are returned back to the insureds. Under this the surplus of
certain companies are given on rent in order to establish a self-insurance program
and not their own captive.
Protected cell companies: These are special category of rent-a-captive since they
shield their capital and surplus from other renters in the captive until the rent-a-
captive’s owner remains solvent.
14. What are benefits of Captives?
Ans. The corporations and groups who want to take a financial control and manage risks
by underwriting their own insurance than preferring to pay premiums to the third-
party insurers can opt for captives. Captive is nothing but a tool to such
organizations. The benefits of captives are as follows:
• Provides insurance for certain exposures, which other insurance companies
might not provide.
• Enables to retain the premiums within the group by the parent company.
• Operating costs are reduced.
• There is an improved cash flow.
• There is an increase in coverage and capacity.
• Better investment as well as investment income.
• There is a direct reach to wholesale reinsurance markets.
• There is flexibility in underwriting and funding.
• There is a greater control over claims.
• Availability of smaller deductibles for operating units.
• There is an additional negotiating leverage with underwriters.
• Availability of incentives for loss control.

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SECTION – C
Case Studies
1. The weather has a substantial influence on the economy — from the risk of a rainy
summer for beer garden proprietors to the dependency of energy suppliers on the
weather. Weather derivatives offer a range of tools for these industries to hedge
against previously uninsurable weather risks.
Hedging against a cold summer
"When the temperature in Britain rises by 3°C, daily beer consumption increases by
10%", says the UK Met Office in a study — a very telling example that shows how
much a particular industry's turnover can be affected by the weather. Meteorological
research institutes estimate that more than 80% of all economic activities are
weather-dependent. In other words, a huge variety of industries are involved —
fashion companies, breweries, construction firms, ice-cream producers and
especially energy suppliers. When national utility monopolies in the USA were
turned into independent energy companies, demand increased for protection against
the impact of the weather. Instruments for hedging weather risks were sought and
what more obvious idea than to use the tools of the capital market?
Explain how Munich Re is offering weather derivatives.
Ans. Objective of weather derivatives
A weather derivative differs from a customary derivative in that it is not based on
tradable reference items such as shares, share price indices, bonds or exchange
rates but on predetermined index data, such as the temperature. It follows that the
purpose of a weather derivative is to hedge volume risks rather than price risks,
since a rising or falling turnover need not affect the price. In a cold summer, for
instance, it is not usual for the price of ice-cream to suddenly fall — the ice-cream
industry's decrease in turnover is due to the lower sales volume, then, not to a price
reduction. In these cases, weather derivatives provide volume compensation. A
similar situation exists in future-oriented fields like renewable energy: particularly in
the first few years, when high investment costs have to be recouped, a lack of wind
or too little solar irradiation might reduce the volume of electricity generated to such
an extent that the financing of the venture is jeopardised. Weather derivatives can
then provide important balance-sheet protection.

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From single trigger to multiple trigger

Of course there are also many industries where the weather has an impact on both
the volume and the price, such as the oil industry. If a winter is warmer than
average, people heat less — there is a fall in the sales volume and the price of fuel
oil. In such cases, "cross-hedging" is recommended, a mixture of weather derivative
and classic commodity derivative, which also hedges against a decrease in turnover
as a result of price reductions. Within the framework of integrated risk management,
Munich Re offers multiple-trigger models that cover several risks simultaneously.
What constitutes bad weather?
The most widespread trigger used for weather derivatives is the temperature.
However, other triggers are agreed on sometimes as well, such as certain amounts
of precipitation, wind, sunshine or snowfall. Weather derivatives are usually
concluded for one season only, but we also offer our clients contracts that are valid
for a shorter or longer period.
Munich Re's know-how
Optimally designing and deploying weather derivatives for clients requires geo
scientific expertise combined with know-how in statistical methodology and
knowledge of the capital markets. Munich Re has been offering extensive weather
and climate consultancy services for over 30 years and assess over 500 weather
risks a year. Besides this, they have a sufficiently diversified portfolio which they
actively manage, thus meeting all the requirements for successful business with
weather derivatives.
2. The insurance industry has a number of critical cogs that allow it to work properly.
One of the most important cogs in the mechanism is the reinsurance market. And
like the primary insurance market, the last few years have proven to be quite
challenging for reinsurers. A long list of issues has shaped the current reinsurance
marketplace. Among the more significant contributing factors were: 9/11, a
prolonged soft insurance market, low returns on investment income and the need for
general reserve strengthening. Current state of the market Financial results for the
reinsurance market are similar to those of the general insurance market.

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For example, financial results for the first quarter of 2004 show a marked
improvement in profitability. The combined ratio for the reinsurance industry as
reported by the Reinsurance Association of America is 94, better than last year's
healthy 96.4. This continues a trend of steadily improving results over the past few
years. Despite this rosy present, many experts are still concerned about the long-
term prospects for the reinsurance industry. Standard & Poor's is one of the more
vocal critics of reinsurers' future financial conditions. It continues to report that the
outlook for the reinsurance industry remains negative. This basically means that
ratings downgrades for U.S. reinsurers are expected to exceed upgrades in the
current year. Discuss.
Ans. Poor financial results over the past few years have required a number of changes in
the way reinsurers approach their core business, as well as operational aspects in
their underwriting. Following is a review of some of the more interesting changes, as
well as a report on several key trends that will have a profound impact on the
industry in the future.
Risk securitization
It's obvious that the reinsurance market is undergoing rapid changes in the nature of
its core business practices. For the most part, this has been caused by the
convergence of the financial markets. Leading the change in core business practices
is the securitization of risk. A recent study by Guy Carpenter found that in 2003 the
catastrophe bond (CAT bond) market had significant growth. The primary purpose of
CAT bonds is to provide a mechanism for reinsurers to raise capital to cover
catastrophic claims. An additional purpose, however, is to offer portfolio
diversification strategy to institutional investors. Up to this point, the most popular
CAT bonds were associated with property risk such as windstorm and earthquake
exposures in the United States, but now there is growing interest in other types of
applications. Current possibilities include such diverse areas as securitizing life
insurance portfolios and non-property exposures such as workers compensation and
terrorism. A number of other innovative applications are also being reviewed for
financial viability. While many in the insurance community see the value of the CAT
bond approach, much of the current movement is being driven by investors looking
for higher yield investment vehicles. Among other reasons for the increasing
attention are:

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• Investors are becoming more comfortable with the securitization approach.

• The structure of securitizations is becoming more standardized.
• Time and cost involved in completing a securitization have been greatly
reduced.
Both Guy Carpenter and Swiss Re predict significant growth in securitizations near
term. As innovation and consumer acceptance continues in this market segment,
one would expect to see this trend of the gradual blending of the financial service
products to accelerate. At this point, most industry experts and rating agencies are
painfully aware of the potential problem associated with questionable recoverable
and are implementing reductions in their listings of future recoverable. As a result,
some companies are taking more of the risk internally, while seeking to place
business with higher rated reinsurance companies when they do choose to use that
market. An additional failsafe mechanism is a National Association of Insurance
Commissioners (NAIC)- USA rule that requires insurers to reduce reinsurance
recoverable by20% for those that are overdue by more than 90 days. Accordingly,
there has been an overall trend to move the reinsurance business to more highly
rated reinsurers. This, of course, has the predictable effect of placing premium
pricing on financially sound reinsurers. It is expected that this trend will persist over
the next few years as the industry continues to struggle with adequate amounts of
capital.

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CHAPTER – 4
REINSURANCE PRACTICE
OUTLINE OF THE CHAPTER
1. Introduction
2. Setting Retentions
3. Setting Reinsurance Limits
4. Cost of Reinsurance
5. Reinsurance Negotiations
6. Reinsurance Commissions
7. Designing and Arranging a Reinsurance Program
8. Reviewing A Program
9. Questions

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Fixing the goals of reinsurance
• Factors determining the reinsurance needs of a primary insurer
• Choice of retention
RISK MANAGEMENT AND REINSURANCE

• Setting the reinsurance limits

• Determining the reinsurance cost
• Gathering of information required in reinsurance negotiations
• Examining typical questions to consider in assessing the underwriting policy of
a primary insurer
• Understanding the kinds of commission involved in reinsurance transactions
• Underwriting factors that a reinsurance underwriter must consider
• Designing of and arranging a reinsurance program
• Understanding Indian Reinsurance Program

Introduction
In practice, there cannot be a specific type of reinsurance that tackles the impact of loss
frequency. The factors determining the reinsurance needs of a primary insurer are many.
In practice, most of the primary insurers try to be specific in fixing their goals and therefore
negotiate on limits, commissions and work on cost of reinsurance.
The primary insurers benefit from a well-planned and well-executed reinsurance program
in more ways than one. Reinsurance helps stabilize loss experience, provide capacity and
provide surplus for growth. Reinsurance is especially useful in financing catastrophic
losses. A good reinsurance program can only be executed with assistance from reinsurers,
brokers and consultants. A reinsurance plan must take into account the primary insurer’s
needs and be based on a thorough understanding of the reinsurance market. By the
primary insurer’s needs, we mean how much large line capacity is desired, how much
stability of losses is expected, or in other words, what is the variance in expected losses
and how much surplus relief is needed. There are two considerations to be taken:
• Firstly, the primary insurers must continue to be solvent, and
• Secondly, primary insurers must be able to pursue the future growth plans.
The management’s attitude to the stability of losses must be considered. For example, in
the case of mutual insurers, the policyholders may be prepared to accept lower short-term
profits and hence greater loss ratio volatility than stock insurers. While the reinsurers look
at the underwriting profit, the primary insurer must also consider the stability of investment

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profit when designing the reinsurance program since that would make variations in
underwriting results more acceptable.
In practice, most primary insurers try to be specific in fixing their goals. Such goals might
include, say,
• Not allowing increase in the net loss ratio to exceed five percentage points on
account of catastrophic losses:
• Providing a single risk capacity of at least Rs.10 billion for commercial property
insurance and Rs.5 billion for commercial liability insurance, and
• Automatic treaties or increase the surplus by Rs.5 billion.
The factors determining the reinsurance needs of a primary insurer are many. But the
more important of them are the following:
• Kinds of Insurance written
• Exposures subject to catastrophic loss
• Volume of Insurance written
• Available Financial Resources
• Stability and Liquidity of Investment Portfolio, and
• Growth Plans
Kinds of Insurance Written: Based on the insurance written by the primary insurer, it is
possible to gauge the stability of loss frequency and of loss severity. In practice, there
cannot be a specific type of reinsurance that tackles the impact of loss frequency. On the
other hand, having an aggregate excess treaty (since it puts a cap on the primary insurer’s
loss ratio) can reduce the impact of severe losses. However for large individual losses,
both surplus and per risk excess treaties are effective.
Exposures subject to catastrophic loss: The primary insurer must assess the history of
catastrophic losses both in terms of individual natural disasters and in terms of
geographical distribution of its insured properties. Usually, however, reinsurers themselves
have such historical records and are in a better position to price reinsurance for different
primary insurers.

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Volume of Insurance written: If the primary insurer has written a large volume of
business, then the Probable Maximum Loss (PML) is predictable with some accuracy
since the law of large numbers will operate. However, this is a gamble since the law of
large numbers is inapplicable in the case of catastrophes.
Available financial Resources: There are two possible scenarios. In the first, the primary
insurer with a weak surplus position needs a highly stable net loss ratio and might require
the use of pro-rata reinsurance to provide surplus relief. On the contrary, the primary
insurer with a very strong surplus position can risk a more volatile net loss ratio. However,
the quality of the surplus as indicated by the invested assets is also important.
Stability and Liquidity of Investment Portfolio: This is an everyday investment
consideration since investment of funds must also consider the need for liquidity at short
notice; that means, investment must be in readily marketable securities. Besides, since
return is not a more important consideration than liquidity, investment must not be in
shares or stocks with wide fluctuations in the short term.
Growth Plans: A rapidly growing insurer needs surplus relief more than an insurer with
less rapid growth. In this process, many profitable lines will be ceded to reinsurer in the
short run but that is a strategy for surviving in the long run while achieving the growth
potential.
Typically, a reinsurance underwriter valuates an entire book of business, as well as the
stability, practices and pricing of the primary insurance company. In particular, there
insurance underwriter must evaluate the loss exposures covered by the primary insurance
company and the specific terms of that coverage. In the case off acultative reinsurance,
the underwriter is evaluating all of this as well as a specific risk.

Setting Retentions
The choice of retention depends on the type of treaty, which, in turn, depends on the
needs of the primary insurer. The setting of retention varies depending on the type of
treaty. In other words, the basic reason for choosing one type of treaty in preference to
another is supported by the following example. For example, if the primary insurer prefers
a pro-rata treaty when compared to an excess treaty the reason could be that a pro-rata
treaty provides surplus relief. Therefore, the important factor in the setting of retention
must be the amount of relief needed.

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The amount of surplus relief received will be a function of the percentage of premiums
ceded and the percentage ceding commission received.
On the other hand, the principal purpose of an excess of loss treaty is to stabilize loss
exposures, besides providing large-line capacity. It may be seen readily that providing
large-line capacity is a function of treaty limit rather than the retention. Therefore, the true
consideration in setting the retention of an excess of loss treaty is the size of loss the
primary insurer can absorb without affecting the policyholder’s surplus or the net loss ratio.
That amount, in turn, is a function of the premium volume and the policyholder’s surplus of
the primary insurers. It is logical that the primary insurer should retain that part of its
aggregate losses that is reasonably stable and predictable and should cede that part that
is not reasonably stable. Losses are stable and predictable when the maximum probable
variation is not likely to affect the insurer’s loss ratio or surplus beyond expectations and
hence unacceptable to the management. Hence, retention is related first to the frequency
of losses and secondly to the probability of a very large loss occurring. In all these
calculations, the cost of reinsurance and the role of reinsurers in setting retentions cannot
also be overlooked. For example, reinsurers sometimes insist on a lower retention than
what is designed by the primary insurer. Retention also depends on the number of treaties
the primary insurer may carry.

Levels of retention
In general, insurers do not seek to transfer more risk to reinsurers than is efficient. The
decision regarding the efficient or optimal level of retention for an insurer is often complex
and subject to judgment; it can change over time as business objectives and conditions
vary. There is a balance to be drawn between the cost of the reinsurance cover and the
capital required to support the portfolio.
On the one hand, the desirable amount of retention depends on three elements:
a) the insurer’s current level of risk aversion (usually measured by a certain probability
of failure, over a fixed time period, that the board of the insurer approves as
acceptable, such as a probability of failure of 0.1 percent over one year),
b) the amount of capital the insurer is prepared to put at risk to support the portfolio
and

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c) the variability of claims results expected from the portfolio, in terms of both size and
time of occurrence.
On the other hand, the desired level of retention needs to be balanced against:
a) the cost of the reinsurance cover considered desirable,
b) the availability of the desired cover,
c) practical issues in implementing the desired cover and
d) any minimum retention criteria.
Insurers and reinsurers may set “per risk” and “per event” risk retention limits as well as
consider blocks of business in aggregate. For example, Sten house (2002) gives the long-
standing position of the Australian supervisor in this regard:
• Per risk retention. Not more than 5 percent of net tangible assets, with a maximum
of 3 percent considered more prudent, especially as the size of the insurer grows
• Per event retention. Not to exceed the amount of net tangible assets over the
insurer’s statutory minimum solvency. This seeks to ensure that the insurer can
withstand extreme claims without breaching statutory solvency. This is shown in the
discussion of maximum event retentions.
Ideally, risk retention should also be related to the ability of the insurer to access relatively
liquid funds (noting that tangible assets may include illiquid assets). A standard approach
is to assess the level of retention required for a “typical” insurer—the “base” retention—
and then to adjust this to apply to different classes of business and to determine more
appropriate retention levels for a particular insurer.
Theoretical approaches to assessing retention levels generally depend on the
mathematics of risk theory and are based on established actuarial models. A mathematical
derivation, using risk theory, of (approximate) excess-of-loss retention covers is given in
Hart, Buchanan and Howe (1996).
In practice it is not always possible to apply theoretical approaches—for example, due to
inadequate data, particularly in the case of reinsurers. Approximations, experience,
established practice and judgment can all play a major role in the assessment and pricing
of reinsurance cover. Prices quoted for reinsurance cover may vary for a number of
reasons, including:

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• The reinsurer’s willingness to do business with a particular insured

• The reinsurer’s willingness to offer a particular type of coverage
• The general reinsurance marketplace and competitive issues
• The amount of claims variation cover inherent in the reinsurance risk transfer.
Reinsurers are generally reluctant to provide unlimited coverage, except for statutory
classes of business, such as workers’ compensation and motor bodily injury, where the
insurer is required to provide unlimited cover. Unless additional layers of cover are put in
place, risks in excess of the reinsurance limit are the responsibility of the insurer.
For the main classes of reinsurance, the following limits generally apply:
• Quota share. Limits are seldom imposed.
• Surplus. The overall limit is often a matter of administrative convenience, based on
the business the insurer expects to write and may be coupled with facultative cover.
• Excess of loss. The overall limit is driven by the maximum sum insured or the
probable maximum loss (PML), which may be assessed by the insurer or based on
industry data and discussions. An understanding of the assumptions and processes
used to set the probable maximum loss is usually central to the supervisor’s
understanding of reinsurance programs.
• Catastrophe. The limits may be based either on industry practice and analyses or
on rules of thumb. A pragmatic approach given in Hart, Buchanan and Howe(1996)
is that the catastrophe limit is between two and four times the probable maximum
loss for a catastrophe zone.
In all cases, depending on the size of the portfolios and other insurer-specific needs,
comparing the limits of retention and reinsurance cover with industry practice is a useful
starting point for reviewing a particular insurer’s retention limits. Supervisors are well
placed to assess (and perhaps promulgate) industry practices and may also use
information collected by industry bodies and professional groups such as actuaries. A
supervisor should expect an insurer to provide documentation of and give clear
explanations supporting its decisions with regard to, levels of retention and reasons for
changes from year to year. Moreover, reinsurance policies and so related risk appetites,
often must be considered and approved by the insurer’s board of directors. Such

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processes should generate appropriate documentation for review. In jurisdictions where a

responsible actuary regime is in place—more commonly for life insurers—annual financial
condition reports are required and copies of these confidential documents must be
provided to the supervisor. Supervisors should expect financial condition reports to contain
a discussion of reinsurance arrangements, specifically their adequacy and
appropriateness from an actuarial perspective. Such information and analysis are
potentially valuable sources of information when provided in accordance with professional
guidelines.

Retentions for Catastrophic exposures

The theoretical approach to setting catastrophe retentions is the same as that used to set
excess-of-loss retentions. However, since the risks involved are in the (extreme) tails of
the claims distributions and these distributions are poorly understood, it is common to rely
on judgment and assumptions regarding experience in setting catastrophe retentions. A
rough rule of thumb given in Hart, Buchanan and Howe (1996) is that catastrophe
retentions are often set at two to five times the basic excess-of-loss retention level, with
the lower multiple usually being associated with higher basic retentions. Catastrophe
covers generally have quite tight definitions of what constitutes an event, particularly
regarding the time frame of an event; they clearly specify the number of claims required
before the cover is triggered. As with other insurance and reinsurance cover, catastrophe
covers may contain limits to their continuity or the number of events claimable before the
cover ceases. Because the reinsurer is taking on the more extreme variability of result in
the typically poorly understood tails of claims distributions, catastrophe cover may be
relatively expensive.
In some countries there is a direct link between the insurer’s management of catastrophe
risk and capital requirements and its holding of catastrophe reinsurance. For example, in
Australia, non-life insurers are required to hold a specific maximum event retention (MER)
component in their minimum capital requirements. The MER is the largest loss an insurer
will be exposed to (taking into account the probability of that loss) due to a concentration
of policies, after netting out any reinsurance recoveries. The MER must also include the
cost of one reinstatement premium for the insurer’s catastrophe reinsurance.

Minimum levels of retention

The reinsurer must consider not only the ongoing business objectives of the insurer but

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also the question of “moral hazard” if the insurer retains only a small portion of the risk.
Consequently it is common for reinsurers to insist, as a matter of prudence, that insurers
retain a “reasonable” amount of their underwritten risks. There are no fixed rules regarding
appropriate minimum retention levels and these may vary depending on the circumstances
of the individual insurer.
However, supervisors have some tools for assessing reasonable levels of risk.
• Industry information. From statistical information collected on an ongoing basis,
industry norms by line of business should be available. Insurers who deviate far from
these norms, especially toward lower retention limits, are likely to be reviewed in
some detail.
• Specified minimums. Supervisors may set minimum levels of retention with varying
degrees of rigidity. For example, the Australian supervisor, APRA, would normally
allow a non-life insurer to cede up to 60 percent of the insurer’s total business
written (and in the case of captive insurers, up to 90 percent).
• External information. According to Swiss Re (2003), retention limits for nonlife
reinsurance worldwide are about 80 percent, with some variance depending on line
of business and in some cases allowance being made for the needs of small
companies. McIsaac and Babel (1995) recommend that minimum retention rates, on
average, be set at no less than 25 percent, which in aggregate is consistent with the
results in Swiss Re (2003).
• Life insurers. Given the typically higher retention limits for life insurance, minimum
retention limits might be considerably higher for life insurance before taking into
account any particular circumstances.
Impact of reinsurance and risk transfer
The accounting treatment applied is of crucial importance to assessing the financial impact
of reinsurance. Different accounting treatments may lead to significantly different reported
financial results. Further, the accounting treatment of reinsurance arrangements may well
flow through and affect income tax calculations.
Accounting standards may lead to the development of products specifically designed to
take advantage of specified accounting treatments. As an example, U.S. statutory
accounting does not allow immediate recognition of the equity in unearned premium

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provisions. Consequently, some insurers purchase proportional reinsurance treaties with

ceding commissions as a surplus relief mechanism. Also, U.S. statutory accounting does
not allow discounting of claims provisions, which creates an incentive to achieve the effect
of discounting indirectly through the purchase of claims portfolio transfers. There is an
argument that insurance business, especially long-tailed business, which remains in place
over a number of years and accounting periods and has significantly uncertain cash flows,
is not always well served by accounting practices that presume that all transactions are
short term and have a measure of certainty. The issues around matching and spreading or
smoothing transactions over a number of years can be significant and generate material
issues. In general, accounting standards must be followed and insurers and supervisors
rely both on the financial results provided and on the external audit typically required.
Given the importance and extent of this reliance on external auditors, some supervisors
require specific approval of “approved” auditors. Accounting standards should evolve over
time to reflect changes in environment and practice and there may be significant changes
with the introduction of international financial reporting standards in 2005–[Link] is an
ongoing responsibility of insurers, reinsurers and supervisors to remain abreast of
supervisory developments and current professional standards. While these issues are just
as relevant for insurers as for reinsurers, the issues may be heightened for reinsurers
domiciled offshore, which may increase the difficulty of obtaining information. Supervisors
therefore need to understand the accounting regime in their own jurisdiction and, if
needed, have the power to require additional statistical and other information from insurers
and reinsurers they regulate. In the context of reinsurance (as in general insurance), it is
useful to require gross rather than net data. That is, even if amounts may be offset against
each other, they should be reported separately. It should be expected that the accountants
and actuaries will interact with one another when reporting information to supervisors. In
some cases, accounting entries may be used to record items directly; in others, actuaries
may include provisions in their calculations(report items indirectly).

Setting Reinsurance Limits

There should be fairly high limits to cover a good majority of the loss exposures and the
limits must be considered along with retention. Large limits are sought especially in pro-
rata and per risk or per policy excess treaties. Setting the reinsurance limits depends on
cost considerations since reinsurance costs increase in direct proportion to reinsurance

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limits, keeping the retention constant. However, the treaty reinsurance costs must be
weighed against other recurring costs in facultative placements such as the premium,
administrative expense and inconvenience and uncertainty associated with facultative
reinsurance. However, while setting the reinsurance limits only the volume of the premium
is considered and not the premium loading.
Limit Setting for a Catastrophe treaty is even more difficult in practice since one cannot
predict a large loss merely based on historical records. Therefore, in reinsuring
catastrophes, concentration of loss exposures must be carefully analyzed.
In the case of aggregate excess treaty, the reinsurance limit must be set at an amount
adequate to cover the higher loss ratio that the primary insurer may expect to sustain, but
the reinsurance premium for such a limit must be acceptable.
To estimate a large loss in future is not easy. However, there will be greater variation in
loss ratios for a property insurer than for a liability insurer and it is clear that the variance
in the loss ratios is, in part, a function of the lines of insurance written.
It is also understood that there will be greater variation in loss ratios for a similar insurance
with a lower premium volume. Similarly, a primary insurer who is having a business in
major parts of the country will be less vulnerable to loss ratio fluctuation than a regional
insurer.
In the exercise of setting the reinsurance limit, the terms of several treaties must be
compared and the limits kept flexible. For example, the limit for an aggregate excess
treaty can be lowered if adequate catastrophe reinsurance is carried. Again the limit of a
catastrophe can be lower if it applies only to the retention of the primary insurer after
recoveries from pro - rata reinsurance, rather than to the direct losses.

Cost of Reinsurance
The reinsurance cost includes the premium paid to the reinsurer and losses recovered or
to be recovered under the reinsurance agreement. A primary insurer should pay its own
losses and the reinsurer’s expenses and profit under any treaty, if the treaty is continued
over a fairly long period. That is why the amount included in the premium for the
reinsurer’s expenses and profit is an important factor in assessing the reinsurance cost.
There is a certain loss of investment income to the primary insurer, since reinsurance
involves transfer of some loss reserves and unearned premiums from the primary insurer

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to the reinsurer. Consequently, the assets offsetting these reserves are invested. And
such a transfer of assets results in loss of investment income to the primary insurer. Such
a loss of investment income may be greater under a pro-rata treaty than under the excess
treaty since the reinsurance premium for a pro-rata treaty is usually greater. Thus, the loss
of investment income may also become an additional cost of reinsurance. The cost of
administering the reinsurance program varies depending upon the type of reinsurance. For
instance, since facultative placements are individual and separate, the cost of
administration in these cases is greater than in the case of treaties. Like-wise, pro - rata
treaties cost more to administer than excess treaties.
Finally, the profit or loss on insurance assumed under reciprocal arrangement mustalso
form part of the reinsurance cost.

Reinsurance Negotiations
Negotiations depend on several factors but chiefly the nature of the primary insurer and
the reinsurer and the kind of reinsurance transacted.
Information needed: The primary insurer must first compile some basic necessary
information. The favorable reinsurance terms and rates depend on the thoroughness of
the data compiled by the primary insurer.
The information required in reinsurance negotiations is different for treaties and for
facultative reinsurance. In treaties, the reinsurer will look for information concerning the
management and underwriting operations of the primary insurer. But in facultative
reinsurance negotiations, the details of individual loss exposures are more important than
the general operations of the primary insurers.
Before signing a reinsurance treaty, the reinsurer must be satisfied about the integrity of
the primary insurer, his management characteristics, underwriting policies, underwriting
results and financial condition. The moral hazard of the primary insurer must be
considered since numerous frauds have occurred.
The underwriting staff of the primary insurer must have demonstrated capability and
experience. In the event of the primary insurer becoming insolvent, depending on the cut
through endorsements in place, the policy holders will have direct access to the reinsurers
and if in the meanwhile, the courts have given awards, compelling the reinsurers to
deposit their share of loss, the reinsurers will be facing double liability and this could injure

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their financial interests. Besides, a reinsurance treaty signifies a long-term relationship

and the primary insurer’s bankruptcy may lead to disastrous situation.
The underwriting policies and underwriting results of the primary insurer are important
considerations in every reinsurance negotiation. Here are some typical questions to
consider in assessing the underwriting policy of a primary insurer.
1. What are the classes of business the primary insurer is writing?
2. Is the primary insurer basically concentrating on personal lines, commercial,
industrial or others?
3. What is his geographic area of operation?
4. How satisfactory are the primary insurer’s underwriting guidelines?
5. Are there gross line limits and net line limits in keeping with his financial strength?
6. Are the primary insurer’s loss control and loss adjustment practices adequate for the
classes of business written?
7. Have the primary insurer’s underwriting results been satisfactory in the lines covered
by the proposed reinsurance treaty?
8. Does the primary insurer anticipate any substantial changes in his management,
marketing or underwriting practices?
9. Are the primary insurer’s rates adequate for the risks covered under the treaty?
Reinsurers are also interested in ascertaining the terms of other reinsurances the primary
insurer is having. The idea is to find out if reinsurance is sought only for the benefit of the
primary insurer or if it also protects the interests of the reinsurer.
Again, the most recent loss experience of the primary insurer is to be considered as that
will reflect the underwriting policy, that tells of the selection of risks, rating and commission
terms. It is not the level of the loss ratio that is important but the reinsurer is interested in
knowing about its stability or volatility over time. Distribution of both losses and amounts of
insurance by size must also be considered, especially for arranging a per risk or per policy
excess treaty.
Since reinsurance negotiations are two-sided, even the primary insurer must collect
enough information, concerning the solvency of the reinsurer, his satisfactory claims

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practices, the competitiveness of rates and also the licensing in the territory where the
primary insurer operates.

Reinsurance Commissions
There are two kinds of commission involved in reinsurance transactions, namely:
• Ceding commissions paid by the reinsurer to the primary insurer, and
• Brokerage commissions paid by the reinsurer to the reinsurance broker.
Ceding commissions are said to compensate to some extent the initial costs of
acquisition of the primary insurer as well as the cost of servicing the business. The
negotiation of the ceding commission depends on the administrative expenses of the
primary insurer as well as the reinsurer’s estimate of the premium volume and the loss
experience expected under the treaty being negotiated and also in practice the market
situation of demand for and supply of reinsurance. Treaties also provide for retrospective
adjustment of the ceding commission based on a variance of the loss ratio from expected
loss.
After the expected loss ratio is estimated for a proportional treaty, the Actuary’s work is
not yet done. There will often remain disagreement between the ceding company and
reinsurer about the loss ratio and the appropriate ceding commission. In theory, a
reinsurer should “follow the fortunes” of the ceding company, but in practice their results
may be quite different. Reinsuring a profitable insurer is no guarantee of profits for the
reinsurer. In the negotiations to resolve these differences, adjustable features are often
built into the treaty.

(a) Sliding Scale Commission

A common adjustable feature is the “sliding scale” commission. A sliding scale
commission is a percent of premium paid by the reinsurer to the ceding company which
“slides” with the actual loss experience, subject to set minimum and maximum amounts.
For example:
Given the following commission terms:
Provisional Commission : 30%

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Minimum Commission : 25% at a 65% loss ratio

Sliding 1 : l to 35% at a 55% loss ratio
Sliding 5 : 1 to a Maximum 45% at a 35% loss ratio
Then the results may follow, for different loss scenarios,
Actual Loss Ratio Adjusted Commission
30% or below 45.0%
35% 45.0%
40% 42.5%
45% 40.0%
50% 37.5%
55% 35.0%
60% 30.0%
65% or above 25.0%

In a “balanced” plan, it is fair to simply calculate the ultimate commission for the expected
loss ratio. However, this may not be appropriate if the expected loss ratio is towards one
end of the slide. For example, if the expected loss ratio is 65%, the commission from a
simple calculation is 25%, producing a 90% technical ratio (i.e. the sum of the loss and
commission ratios). If the actual loss ratio is worse than65%, the reinsurer suffers the full
amount but if the actual loss ratio is better than65% the reinsurer must pay additional
commission.

(b) Profit Commission

A profit commission subtracts the actual loss ratio, ceding commission and a “margin” for
expenses from the treaty premium and returns a percent of this as additional commission.
For example:
Actual Loss Ratio 55%
Ceding commission 25%
Margin 10%

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Reinsurers Profit 10% (100%-55%-25%-10%)

Percent Returned 50%
Profit commission 5% (10% profit times 50%)
Like the sliding scale commission, this should be evaluated using an aggregate
distribution on the loss ratio. Also like the sliding scale commission, there is some
ambiguity concerning the handling of carry forward provisions.
Examples:
1. Provide a formula for the Reinsurer’s Profit Commission (RPC), using the
following variables:
• ALR = Actual Loss Ratio
• CC = Ceding Commission
• M = Margin for Expenses
• PR = Percent Returned (as percent of reinsurer’s profit)
Solution
Reinsurer’s Profit Commission = PR*(100% – ALR – CC – M)
2. Suppose the following is known about a reinsurance treaty:
The actual loss ratio is 43%.
The ceding commission is 30%.
The reinsurer’s margin for expenses from the treaty premium is 6%.
The percent returned from the profit to comprise the reinsurer’s profit commission is
41%.
Calculate the Reinsurer’s Profit Commission (RPC) as a percentage of premium.
Solution
Using the formula
RPC = PR*(100% –ALR – CC – M) = 41%*(100% - 43% - 30% - 6%)
= 41%*21% = RPC = 8.61%.

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3. What two similarities are noticed regarding the estimation of the reinsurer’s
profit commission and the sliding-scale ceding commission?
Solution
(i) Each type of commission should be evaluated using an aggregate distribution
on the loss ratio.
(ii) For both types of commission, there is some ambiguity regarding the handling
of carry forward provisions.

(c) Loss Corridors

A loss corridor provides that the ceding company will reassume a portion of there insurer’s
liability if the loss ratio exceeds a certain amount. For example, the corridor may be 75%
of the layer from a 80% to a 90% loss ratio.
If the reinsurer’s loss ratio is 100% before the application of the loss corridor, then they
will have net ratio of 92.5% after its application, calculated as:
Before After
Corridor Corridor
Below corridor 80.0% 80.0% 100% capped at 80%
Within corridor 10.0% 2.5% 10% minus 75% of 90%-80%
Above corridor 10.0% 10.0% 100% minus 90%
Total Loss Ratio 100.0% 92.5%
As above, the proper estimate of the impact of the loss corridor should be made using an
aggregate distribution. The probability and expected values for the ranges below, within
and above the corridor can be evaluated.
Range of loss Average in Range Probability LR is in Loss Ratio Net of
Ratios Range Loss Corridor
0% - 80% 64.1% .650 64.1%
80% - 90% 84.7% .156 81.2%
90% or above 103.9% .194 96.4%
0% or above 75.0% 1.000 73.0%

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For this example, the expected loss ratio is 75.0% before the application of the loss
corridor. Even though this is less than the 80% attachment point for the corridor, the
corridor still has the effect of lowering the reinsurer’s expected loss ratio. Many variations
on these features can be used with a proportional treaty. This should serve to illustrate
that the Actuary’s job is not finished after the expected loss ratio is calculated.
Examples
1. For instance, there might be a loss corridor of 60% of the layer from a 75% to a
95% loss ratio. Suppose the reinsurer’s loss ratio prior to the application of
the corridor is 110%.
Ans. Then, after the application of the corridor, the reinsurer’s loss ratio would be 110%-
60% * (95%-75%) = 98%.
2. Suppose a reinsurance treaty involves a loss corridor of 36% between a 50%
and an 80% loss ratio. Before the application of the corridor, the reinsurer’s
loss ratio is 97%. What is the reinsurer’s loss ratio after the application of the
corridor?
Ans. We consider situation before and after the application of the corridor.
Before After Calculation
Corridor Corridor
Loss Ratio Below Corridor 50% 50% Capped at 50%
Loss Ratio Within Corridor 30% 19.2% 30%-36%*(80%-50%)
Loss Ratio Above Corridor 17% 17% 97% - 80%
TOTAL LOSS RATIO 97% 86.2%

Thus, the reinsurer’s loss ratio after the application of the corridor is 86.2%.
3. Suppose a reinsurance treaty involves a loss corridor of 36% between a 50%
and an 80% loss ratio.
Ans. You also have the following analysis of loss ratios prior to the application of the
corridor, using an aggregate distribution:

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Range of Loss Ratios Average Loss Ratio in Probability of Being in

Range Range
0%-50% 43% 0.344
50%-80% 72% 0.366
80% or above 101% 0.29
ALL 70.43% 1
Calculate the overall average loss ratio using this aggregate loss distribution, after
the application of the loss corridor.
Ans.
Range of Loss Average Loss Ratio in Range Probability of
Ratios Being in Range
0%-50% 43% (Does not change) 0.344
50%-80% 72% - 36%*(72%-50%) = 64.08% 0.366
80% or above 101% - 36%*(80%-50%) = 90.2% 0.29
ALL 0.344 * 43% + 0.366*64.08% + 0.290 * 1
90.2% = 64.40328%
Thus, the loss corridor has reduced the reinsurer’s loss ratio to 64.40328%.
4. What is a carry forward provision for a ceding commission? Give a brief
numerical example of how such a provision would work.
Ans. A carry forward provision is a clause in the reinsurance contract that allows
subsequent years' ceding commissions to be modified by any of the primary
insurer's prior-year loss amounts in excess of the loss ratio corresponding to the
minimum ceding commission.
For instance, if the minimum ceding commission is 10%, corresponding to an 80%
loss ratio and the ceding company's loss ratio in Year X is 85%, then the loss
amount corresponding to the excess 5% of losses may be used in calculating the
Year (X+1) loss ratio for ceding-commission purposes.

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Reinstatements
Reinstatement in an insurance policy means that, when coverage terms are reset after the
insured files a claim. Reinstatement clauses typically do not reset a policy's coverage limit,
but do allow the policy to restart coverage for future claims. In regards
to insurance, reinstatement allows a previously terminated policy to resume active
coverage. In case of nonpayment, the insured may be required to provide evidence of
eligibility, such as taking a medical examination for life insurance, or pay
the insurance company for the missed premium dates.

Reinstatement Premium
Reinstatement premiums are the premiums for the restoration of the insurance or
reinsurance limit of a contract to its full amount after a loss occurrence by the insured or
reinsured and principally relate to our property catastrophe reinsurance contracts.
Reinstatement premiums are the premiums for the restoration of the insurance or
reinsurance limit of a contract to its full amount after a loss occurrence by the insured or
reinsured and principally relate to our property catastrophe reinsurance contracts.
In a typical reinsurance contract, the reinsurer agrees to indemnify the ceding insurer up to
the stated limit of reinsurance coverage. Depending on the type of reinsurance contract
and the coverage that is provided, that limit could be on a ‘per occurrence or per risk
basis’, or it could be in the aggregate, or it could be some combination of limits. The
reinsurance limit may include defense costs, or defense costs may be outside the stated
limit of the reinsurance contract. There may be what is called a sublimit for certain special
risks, like windstorm or earthquake, which comes within the overall aggregate limit of the
reinsurance contract if there is one. At the end of the day, a reinsurer generally tries to
limit its liability under the reinsurance contract to an ultimate limit after which the
reinsurer's liability terminates (at least on a per occurrence or per risk basis if an
aggregate limit is not contained in the contract). Usually what happens when the ceding
insurer has ceded the maximum dollar amount of losses to the reinsurer under the
relevant reinsurance limit is an important area to be focused upon.
If the reinsurance agreement has an aggregate limit, without any relief in the reinsurance
contract, the ceding insurer is now essentially without reinsurance and must bear the
remaining losses on its own if it does not have additional reinsurance protection for those
losses. Where the reinsurance agreement has a per occurrence limitation, the ceding

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insurer becomes responsible to bear the loss that exceeds the per occurrence limit on its
own for losses arising out of that occurrence and is left without reinsurance on additional
claims arising out of the same occurrence should the occurrence limit be exhausted by
other claims. The ceding insurer only gets the reinsurance limits it pays for, but no ceding
insurer wants to run out of reinsurance protection if it can help it.
Typically, as the reinsurer pays losses ceded to the reinsurance contract, the limit of the
reinsurance contract depletes. Once the payment of losses reaches the limit, there is no
more reinsurance recovery available. Just like an insurance policy exhausting its limits, a
reinsurance contract with a per occurrence or aggregate limit may exhaust as well. This
exhaustion of limits could occur midyear, leaving the ceding insurer without reinsurance
protection for the remainder of the year. If the ceding insurer has no excess or catastrophe
reinsurance covering the same losses, the additional losses will be kept net by the ceding
insurer. This may play havoc with the ceding insurer's finances.
In the property reinsurance arena, this could be particularly problematic. A property treaty
written on a per occurrence basis could have its limits exhausted very easily by an
accumulation of claims arising out of one occurrence. Under those circumstances, the
ceding insurer would have no ability to cede additional claims arising out of that same
occurrence. Where there is a likelihood of an accumulation of a significant number of
individual claims arising out of the same occurrence, a ceding insurer would want to have
the ability to reinstate the per occurrence limit.
Therefore, the solution to running out of reinsurance limits is to insert a clause that
automatically or permissively allows the limits to reset once exhausted. This is called
reinstatement. Often, the limit will replenish only after it is fully exhausted and only for the
remainder of the contract period. The replenishment of the limit (the reinstatement) may
be a one-time right, may require a premium payment (a reinstatement premium), or may
trigger on the request of the ceding insurer and the agreement of the reinsurer.
Reinstatement typically has no application to a proportional or quota share reinsurance
contract, which typically is based on a percentage of sharing premiums and losses
between the ceding insurer and the reinsurer. Reinstatements are more common in
property reinsurance contracts written on an excess basis, although they do appear in
other contexts.
In fact, Strain defines reinstatement as: The restoration of the reinsurance limit of an

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excess property treaty to its full amount after payment by the reinsurer of loss as a result
of an occurrence. (Robert W. Strain, ed., Reinsurance (Strain Pub. & Seminars Inc.,
1997).
The applicability of reinstatement to property treaties written on a per occurrence basis
makes sense. An occurrence (e.g., an earthquake) often generates multiple individual
claims. An occurrence limit can easily be wiped out by large numbers of individual claims,
leaving the ceding insurer without reinsurance coverage for those claims arising from the
same occurrence that are ceded after the occurrence limit is exhausted. A reinstatement
clause allows the per occurrence limit to reset and pick up those additional claims under
that same occurrence (of course limited to the new reinstated limit), which otherwise would
not be reinsured under that reinsurance contract.
In some property reinsurance contracts, reinstatements are provided for free and can
apply as many times as necessary. In other reinsurance contracts, one reinstatement is
allowed subject to the ceding insurer paying the reinstatement premium. The number of
reinstatements allowed, the cost of those reinstatements and the manner in which the
reinstatement will be applied is all subject to negotiation.

Reinstatement Clauses
A wide variety of reinstatement clauses are used in the industry. Typically, ceding insurers
will want at least one free reinstatement of the reinsurance limit. In many cases, one free
reinstatement is given based on tradition, market power and long-standing business
relationships. Reinsurers, of course, would prefer to have an additional premium paid for
any additional restated limit. In some cases, a reinstatement clause is not needed because
the limits automatically reset for each occurrence. But where there is the risk of exhausting
the per occurrence limits because of multiple losses arising out of the same occurrence,
ceding insurers would want the ability to reinstate the limits.
In conclusion, in property excess reinsurance, allowing the ceding insurer to reinstate the
reinsurance limits is typical. What is not typical is the number of reinstatements allowed,
the cost of the reinstatement and the manner in which the reinstatement premium is
calculated. Clear contract wording and careful negotiation to obtain the reinstatement
needed for the risks reinsured is the key to managing a reinsurance contract and making
sure the ceding insurer has the proper reinsurance coverage.
In simple terms, in a non-proportional

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Examples
1. Problem BRP-118. You have the following information about a catastrophe excess-
of-loss reinsurance treaty for the annual term encompassing the entire year 2022:
Annual premium: $4,000,000
Occurrence limit: $50,000,000
Date of loss: September 1, 2022
Loss amount: $35,000,000
Reinstatement provision: 120%
(a) Calculate the reinstatement premium after the loss if the reinstatement
provision is pro rata as to amount, but not pro rata as to time.
(b) Calculate the reinstatement premium after the loss if the reinstatement
provision is pro rata as to amount and pro rata as to time.
(c) Why are most reinstatement premiums for catastrophe excess-of-loss treaties
not pro rata as to time?
Ans.
(a) If the reinstatement provision is pro rata as to amount, but not pro rata as to
time, then we only need to consider the fraction of the annual premium
corresponding to the proportion of the loss amount to the occurrence limit,
multiplied by the percentage in the reinstatement provision.
Reinstatement premium = ($35,000,000/$50,000,000)*$4,000,000*120% =
$3,360,000.
(b) If the reinstatement provision is pro rata as to amount and to time, then a
further reduction of the reinstatement premium is needed to account for the
time during which the new coverage will be effective - i.e., from September 1,
2022, until the end of 2022, or 4/12 = 1/3 years. Thus, the reinstatement
premium is $3,360,000*(1/3) = $1,120,000.
(c) Most reinstatement premiums for catastrophe excess-of-loss treaties are not
pro rata as to time because many catastrophes, such as hurricanes, occur
seasonally, so a pro rata approach to time does not take into account the
actual exposure to risk during the remainder of the treaty period.

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Brokerage Commissions
Brokerage Commission is an amount paid to a broker for insurance or reinsurance
placement and other services. Brokers generally represent the ceding company and
receive compensation in the form of commission, and/or other fees, for placing the
business and performing other necessary services. The brokerage commission is almost
always paid by the reinsurer. Typically, the broker will collect premiums and handle
disbursements of claims payments. Brokerage commission varies between 2% and 5% of
the reinsurance premium for pro rata treaties and 5% and 10% for Excess of Loss (EOL)
treaties.

Designing A Reinsurance Programme

Underwriting factors that a reinsurance underwriter must consider:
The reinsurance underwriter must assess the loss exposures that are covered by the
ceding company and he must also assess the explicit terms of that coverage.
The following are the underwriting factors to be considered by the reinsurance underwriter
about the primary insurer:
1. Financial status
2. Loss exposure
3. Coverage
4. Risk retained
5. Premium pricing
6. Contract wording
In the event of a loss covered by are insurance contract, the reinsurer pays the amount
owed to the entity holding the reinsurance contract, typically a primary insurer or another
reinsurer. Part of the expectation of the ceding company is that this payment willbe timely,
since in many cases its solvency is at stake.
The ceding company is therefore obliged to inform the reinsurer(s) about both actual and
potential losses. Normally, the ceding company pays the claimant(s) first and is
reimbursed by the reinsurer(s). The lapse of time between payment to the claimants and

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reimbursement by the reinsurer is usually stipulated in there insurance contract. The

reinsurance Actuary is also most likely to be called upon to help quantify the risk on the
contract to verify that these criteria are met. Timing risk as well as underwriting risk should
be evaluated. Guidelines for what is “significant” remain to be clearly established.

Designing and Arranging a Reinsurance Program

Like primary insurance, reinsurance is a mechanism for spreading risk. A reinsurer takes
some portion of the risk assumed by the primary insurer (or other reinsurer)for premium
charged. Most of the basic concepts for pricing this assumption of risk are the same as
those underlying ratemaking for other types of insurance.
A major difference between reinsurance and primary insurance is that a reinsurance
program is generally tailored more closely to the buyer; there is no such thing as the
“average” reinsured or the “average” reinsurance price. Each contract must be individually
priced to meet the particular needs and risk level of the reinsured. This leads to what
might be called the pricing paradox:
If you can precisely price a given contract, the ceding company will not want to buy
it.
That is to say, if the historical experience is stable enough to provide data to make a
precise expected loss estimate, then the reinsured would be willing to retain that risk. As
such, the “basic” pricing tools are usually only a starting point in determining an adequate
premium. The Actuary earns his or her money by knowing when the assumptions in these
tools are not met and how to supplement the results with additional adjustments and
judgment. Developing a financially sound reinsurance program must take into account the
unique risks that an insurer faces
Therefore, both the parties to the contract should have a proper understanding regarding
underwriting of business. The insurer needs thorough knowledge about the reinsurance
and also the insurer should design a reinsurance plan for his business. Therefore, the
insurer as well the reinsurer while considering large business, should know the following:
• Sources of business.
• Different classes of reinsurance or insurance.

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• Geographical distribution of business.

• Identification of exposures.

1. Sources of Business
A reinsurer should identify the areas where he can get business. Reinsurer can acquire his
business from different sources such as
1. Domestic Direct Insurance Companies
2. Foreign Direct Insurance Companies
In case of domestic direct insurance business, foreign exchange will not have any effect
on the business. Acquisition costs are low in this type of company .It can also be easily
manageable.
In case of foreign direct insurance business acquisition costs are high; maintenance costs
are also high. It is difficult to adapt to different market situations prevailing in different
countries.

2. Classes of Reinsurance
As the characteristics of different classes of reinsurance vary, necessary study must be
done. The type of reinsurance required for the insurer depends upon the exposures
involved. The reinsurance program should be prearranged for each class of insurance
separately.

3. Geographical distribution of business

Since the risk factors affecting the loss experience vary for every region. The results will
be more stable if the portfolio is distributed broadly. There will be growth in business if the
economy is growing steadily.

4. Identification of Exposures
While designing a reinsurance program, risks that are involved in a portfolio should be
studied. This helps the reinsurer in building risk profile. The major factor in deciding
retention is the underwriting criteria, which are applicable to a particular class of business.
The company should protect its retained portfolio of business so that the underwriter can
distribute his acceptances to the company’s reinsurance protection.

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Reviewing A Program
Reinsurance companies should review their reinsurance program to approve changes in
the type of business, inflation, regulation, loss experience etc.
Review program for non-proportional contracts are generally done annually.
In case of proportional contracts, review or renewal starts earlier and should consider the
following while reviewing its reinsurance business.
1. When to change a reinsurer?
2. Changes in underwriting the policy and its business.
To decide whether to continue with the existing reinsurer the following should be given
utmost importance:
• Technical competence
• Reputation
• Financial strength
• Long-term relationship with the company (can be obtained by continuing with one
reinsurer)
• Adequate reinsurance protection must be given by the company
• Ceding company’s credit risk, because the ceding company might not be able to
make the payment of additional premium.
• Ceding company’s annual statement.
Example
1. Indian Reinsurance Program
As outlined earlier, following are the objectives of the common reinsurance program,
which was in effect from 1973:
1. Maximize retention within the country.
2. Develop adequate capacity.
3. Secure the best possible protection for the reinsurance costs incurred.
4. Simplify the administration of business.

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Both the parties should take into account all the above factors while designing a
reinsurance programme.
Given below is a case study of a small insurance company.
Name : Mumbai Insurance Co. Ltd.
Authorised Capital : Rs. 100 crores
Paid up Capital : Rs. 25 crores
Commencement of Operations : 1st April, 2001
Business operations : Initially the company wants to write Fire business
only in Mumbai. Later on it plans to expand its
operations to other classes and other areas of
Maharashtra.
Fire Underwriting guidelines : Type of Business accepted – private dwellings,
office premises, retail outlets, wholesale outlets
and non-hazardous mfg business.
Sum Insured : not more than Rs.10 crores.
Construction, coverage & rates as per Indian tariff.
Projected Gross premium Income
Year Premium Rs. (crores)
2001-02 17.50
2002-03 40.00
2003-04 60.00
2004-05 80.00
2005-06 100.00
Design a reinsurance programme for the company for the year 2001.
Solution: This involves:
1. Fixing the net retention per policy/risk for the company.
2. Choosing the right method of insurance for the company and fixing the limits.

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1. Net Retention
Maximum net retention per risk is normally not more than 5% of the paid up capital
and free reserves in the case if fire business. However the loss retention per event
should not be more than 1% (paid up capital + reserve). In the case of small
companies whose portfolios are still unbalanced have to fix retentions related to
their financial capacity: They may be forced to put at risk a proportionately more
significant portion of their capital than the larger companies i.e. up to 5% of capital
and free reserves.
Keeping this in mind, the net retention per risk for this company is fixed at 4% of its
paid up capital and loss retention at 1%.
Paid up Capital Rs. 25 crores
Net Retention per Risk Rs. 1 crore (@ 4%)
Net loss retention per event Rs. 25,00,000
2. Reinsurance Protection
Since this is a newly formed company with no previous underwriting experience, it is
advised that the company should initially arrange a Quota Share Treaty (with 10
lines).
Net Retention = Rs. 1 crore
Obligatory cession to GIC – 10% (Statutory)
Maximum surplus Reinsurance acceptance limit = Rs. 10 crores.
The total automatic capacity available for the company would be Rs.12.22 crores as
detailed below:
Obligatory Cession - 10.00% 1.22 Cr
Net retention - 8.18% 1.00 Cr
Quota share treaty - 81.82% 10.00 Cr
----------- ------------
100.00% 12.22 Cr
----------- ------------

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Premium for QS Treaty (2001-02) = Rs. 14.3185 crores

(81.82% of Rs.17.50 crores)
Premium for Net Retained A/C = Rs. 1.4315 crores (8.18% of Rs.17.50)
When the company’s income increases in the following years, it may review net
retention limit. Later on the company may decide to switch over to a surplus treaty.
The company should also protect its net retained account (premium Rs.1.35 crores)
under an excess of loss arrangements against catastrophic losses such as
earthquake, hurricane, windstorm, rainstorm, riot, civil commotion, malicious
damage etc.
The company may avail excess of loss cover for a limit of Rs.10 crores with a loss
deductible of Rs. 25 lakhs.
Thus one must review the Reinsurance programme every year with actual losses
incurred especially catastrophe losses, regulations, inflation, changes in type of
business etc.
One should also decide when to change a reinsurer keeping in mind the changes in
its underwriting policies
2. What are the six main steps for pricing a proportional reinsurance treaty?
Solution:
The six main steps for pricing a proportional reinsurance treaty are as follows:
1. Compile the historical experience on the treaty.
2. Exclude catastrophe and shock losses.
3. Adjust experience to ultimate level and project to the future period.
4. Select the expected non-catastrophe loss ratio for the treaty.
5. Load the expected non-catastrophe loss ratio for catastrophes.
6. Estimate the combined ratio, given the ceding commission and other
expenses.
3. There is a “finite risk” reinsurance agreement which has a $5,000,000 annual
premium and covers an occurrence limit of $15,000,000. (The rate on line, the ratio

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of premium to the full possible loss on the contract, is therefore 33.333333 %.) The
profit commission on this agreement is 70% after a 15% margin on the annual
premium. The premium is also adjustable, and, in the event of a loss, the additional
premium is equal to 60% of the amount of (Loss + Margin – Annual Premium).
a) Convert this agreement into an economically equivalent (for the reinsurer)
traditional reinsurance agreement, where there is a fixed premium and no
profit commissions exist.
b) What is the rate on line of the traditional reinsurance agreement in part (a)?
Answer
a) We shall first consider the annual results of “finite risk” reinsurance agreement
under the scenarios of no losses and one full loss.
Loss-Free Scenario One Full Loss
(a) Premium $5,000,000 $5,000,000
(b) Loss $0 $15,000,000
(c) Margin = (a)*0.15 $750,000 $750,000
(d) Profit Commission = Max $2,975,000 $0
(0, 0.7*((a)-(b)-(c)))
(e) Additional Premium = Max $0 $6,450,000
(0, 0.6*((b)+(c)-(a)))
(f) Underwriting Result for $2,025,000 -$3,550,000
Reinsurer = (a)-(b)-(d)+(e)

An economically equivalent contract would also produce an underwriting result of

$2,025,000 for the reinsurer under a loss-free scenario and a result of -$3,550,000 if
there was one full loss.
The way to achieve this would be to charge a premium of $2,025,000 (which would
become profit in entirety if no loss occurred) and to cover a maximum loss of
$2,025,000 + $3,550,000 = $5,575,000.
The resulting traditional reinsurance agreement would look as follows:

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Loss-Free Scenario One Full Loss

(a) Premium $2,025,000 $2,025,000
(b) Loss $0 $5,575,000
(c) Underwriting Result for $2,025,000 -$3,550,000
Reinsurer = (a)-(b)
b) The rate on line is equal to the ratio of premium to the full possible loss on the
contract, which, in the case of the traditional reinsurance agreement from part (a),
would be $2,025,000/$5,575,000 = 81/223 = 36.32286996%.

REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. Which of the following statements is true?
a. A good reinsurance program can be executed with assistance from reinsurers,
Brokers and consultants.
b. A reinsurance plan must take into account the primary insurer’s needs.
c. The primary insurers must continue to be solvent.
d. A&B
e. A, B & C
2. One of the following is not a factor determining the reinsurance needs.
a. Kinds of insurance written b. Volume of insurance written
c. Available financial resources. d. Business volume of client
e. None of the above
3. Law of large numbers is not applicable in one of the following cases.
a. Motor reinsurance b. Catastrophes
c. Marine insurance d. Life insurance
e. None of the above

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4. The important factor in setting of the retention

a. Stability b. Liquidity of investment
c. Amount of relief needed d. Growth plans.
e. None of the above.
5. The principal purpose of an excess of loss treaty is
a. stabilize loss exposures b. providing large line capacity
c. stabilize earnings d. A&B
e. A, B & C
6. Setting reinsurance limits depends on
a. Company considerations b. Cost considerations
c. Financial strength of the reinsurer d. Financial strength of the client
e. None of the above.
7. While setting the reinsurance limits this factor is not considered
a. Volume of the premium b. Premium loading
c. Reinsurance cost d. All the above.
e. None of the above
8. One of the following is more vulnerable to loss ratio fluctuation.
a. National level primary insurer b. Regional insurer
c. Marine insurer d. Life Insurer
e. None of the above.
9. The reinsurance cost includes
a. Operating expenses b. Premium paid to reinsurer
c. Losses recovered / to be recovered d. A&B
e. B&C
10. One of the following is not true:
a. Transfer of assets results in loss of investment income to the primary insurer.

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b. Such a loss of investment income may be greater under pro-rata treaty.

c. Reinsurance premium for a pro-rata treaty is usually lower.
d. Loss of investment income may also become an additional cost of reinsurance.
e. None of the above.
11. Negotiations for reinsurance depend on several factors. One of the following is
not one among them.
a. The nature of the primary insurer b. The reinsurer
c. Kind of reinsurance transacted d. Interest rates
e. None of the above.
12. In facultative reinsurance negotiations, one of the following is important
a. the reinsurer b. the primary insurer
c. details of individual loss exposures d. underwriting operations.
e. None of the above.
13. One of the following is not true in assessing the underwriting policy of a
primary insurer.
a. The classes of business the primary insurer is writing.
b. How satisfactory are the primary insurer’s underwriting guidelines?
c. Are their gross line limits and net line limits in keeping with their financial
strength?
d. The primary insurers’ rates are not adequate for the risks covered under the
treaty.
e. None of the above.
14. These are the commissions involved in the reinsurance transaction.
a. Ceding Commission b. Brokerage Commission
c. Settlement Commission d. A, B & C
e. A&B
15. The premium registered in the books of an insurer at the time a policy is
issued, is called

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a. Earned premium b. Unearned premium

c. Written premium d. Registered premium
e. None of the above
Answers
1. e 2. d 3. b 4. c 5. d 6. b 7. b 8. b 9. e 10. c
11. d 12. c 13. d 14. e 15. c

SECTION – B
Short & Essay Questions
1. A primary insurer – Prose covers an insurance risk of Rs. 500 lakh. Prose
retains 10% of the risk to retention and cedes the balance 90% to x Reinsurers
and x in turn retrocedes 50% of his acceptance (45% of 100%) to y. Calculate
the net claim of each assuming that a claim has been reported for Rs. 50 lakhs.
Ans.
Prose : (Rs.)
Total claims : 50,00,000
Less: recoverable from reinsurer : 45,00,000
--------------
Net claim 5,00,000
--------------
X Reinsurer:
Share of claim from Prose : 45,00,000
Less: recoverable from retrocessionaire : 22,50,000
--------------
22,50,000
--------------
Y Retrocessionaire:
Share of loss from X : Rs. 22,50,000

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2. A Pru life company keeps the first Rs. 2,00,000 of each claim and cedes the
next 5,00,000 to the reinsurer.
(a) Calculate the cedent’s retention and ceding amount on a policy of Rs.
4,00,000.
(b) Calculate the retention and ceding amounts on a Rs. 5,00,000 policy.
Ans.
(a) On the policy amounting Rs.4,00,000, the cedent keeps 2/4 i.e. ½ of the claim.
i.e. Rs. 2,00,000 and the reinsurer has ½ i.e. Rs. 2,00,000.
(b) On the policy amounting Rs. 5,00,000 the cedent keeps 2/5 of the claim. i.e.
Rs.2,00,000 and the reinsurer has 3/5 i.e. Rs. 3,00,000.
3. Prudential insurance was reinsured by swarn reinsurance. The contract
consisted of five surplus lines of each Rs. 2 million. The retention of prudential
insurance is Rs. 2 million. The risk written and the sum insured by prudential
insurance were as follows:
Risk Sum insured
1 Rs.15,000,000
2 Rs.12,000,000
3 Rs.30,000,000
4 Rs.18,000,000
5 Rs.25,000,000
Calculate the shares of both the prudential insurance and swarn reinsurance.
Ans.
Risk Sum Retention Amount Reinsurers Amount
insured Percentage [%] Percentage [%]
1 Rs.15,000,000 Rs. 2,000,000 13.33 Rs.13,000,000 86.67
2 Rs.12,000,000 Rs. 2,000,000 16.67 Rs. 10,000,000 83.33
3 Rs.30,000,000 Rs. 2,000,000 6.67 Rs. 28,000,000 93.33
4 Rs.18,000,000 Rs. 2,000,000 11.11 Rs.16,000,000 88.89
5 Rs.25,000,000 Rs. 2,000,000 8 Rs.23,000,000 92

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4. Shah insurance entered into a contract with the Brit Reinsurance Company.
The reinsurance arranged was for Rs. 13,00,000 in excess of Rs. 3,00,000 per
risk. The claims received were as follows:
Claim Amount of claim
1 Rs. 3,00,000
2 Rs.10,00,000
3 Rs.14,00,000
4 Rs.11,00,000
Calculate the retention by shah insurance company. Calculate the recovery
from Brit Reinsurance Company.
Ans.
Claim Payment to Retention Recovery from Brit
reinsurance (Rs.) reinsurance (Rs.) insured (Rs.)
1 3,00,000 3,00,000 Nil
2 10,00,000 3,00,000 7,00,000
3 14,00,000 3,00,000 11,00,000
4 11,00,000 3,00,000 8,00,000

5. The stag insurance company entered into a reinsurance contract with the
delite Reinsurance Company regarding the commercial property reinsurance.
The insurer enters into a ten-line surplus treaty. The company also retains up
to the following:
Offices Rs. 5,00,000
Retail outlets Rs. 6,00,000
warehouses Rs. 7,00,000
Factories Rs. 4,00,000
Miscellaneous Rs. 3,00,000

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Calculate the maximum coverage under the reinsurance.

Ans. The maximum coverage under the treaty is as follows:
Particulars Retention [Rs.] Ten-line surplus limit.
[Rs.]
Offices 5,00,000 50,00,000
Retail outlet 6,00,000 60,00,000
Warehouses 7,00,000 70,00,000
Factories 4,00,000 40,00,000
Miscellaneous 3,00,000 30,00,000
6. The ‘Time’ insurers are retaining the following amounts in commercial
property account and enter a five-line first surplus treaty and six-line second
surplus treaty. The company’s retention is Rs. 2,00,00,000 on any risk. The
sum insured is given as follows:
Risk Sum insured [Rs.]
1 8,00,00,000
2 7,00,00,000
3 10,00,00,000
4 15,00,00,000
5 12,00,00,000
Ans.
Risk Sum insured Company’s First surplus Second
[Rs.] retention [Rs.] treaty share surplus treaty
[Rs.] share [Rs.]
1 8,00,00,000 2,00,00,000 60000000 Nil
2 7,00,00,000 2,00,00,000 50000000 Nil
3 10,00,00,000 2,00,00,000 80000000
4 15,00,00,000 2,00,00,000 100000000 30000000
5 12,00,00,000 2,00,00,000 100000000 Nil

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7. The people’s insurance company underwrites its fire business on PML basis.
find how a risk with the sum insured of Rs. 1100 crores is placed on the
following reinsurance facilities. The risk engineers have assessed the PML of
the risk as Rs.110 crores (10%).
Maximum retention Rs.3 crores regardless of the risk
First surplus treaty 20 lines with a maximum limit of 30 crore PML
Second surplus treaty 40 lines of Rs. 50 crores PML
Third surplus treaty 10 lines with a limit of 10 crore PML
Ans. PML = Rs. 110 crores
Net retention = Rs. 3 crores PML
First surplus treaty = Rs. 30 crores PML
Second surplus treaty = Rs. 50 crores PML
Third surplus treaty = Rs. 10 crore PML
The balance i.e. the facultative reinsurance = Rs. 17 crores PML
8. The stump insurance company has a gross retention of Rs. 50,00,000 including
50% of quota share treaty and a 10 line surplus treaty. The balance will be
placed on facultative terms. Assuming that the company has accepted a risk of
Rs.10,00,00,000 and the risk suffered a loss of Rs.1,20,00,000, allocate the loss
to the reinsurer.
Ans.
Reinsurance distribution: (Rs.)
Net retention (2.50%) 25,00,000
QST (2.50%) 25,00,000
Surplus Treaty - 10 lines (25%) 2,50,00,000
FAC (70%) 7,00,00,000
-----------------
10,00,00,000
-----------------

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Allocation of Loss:
Loss amount – Rs.1,20,00,000 (Rs.)
Net retention (2.50%) 3,00,000
QST (2.50%) 3,00,000
Surplus Treaty (25.00%) 30,00,000
Facultative (70.00%) 84,00,000
------------------
1,20,00,000
------------------
9. Pallavi insurance company has taken an excess of loss cover from Ram
reinsurance company paying 30,00,000 excess of 20,00,000 with a provision
for two reinstatements at 60% of final earned premium. A loss occurred and
the cover should entail a recovery of 100,000. Calculate the reinstatement
premium payable to the reinsurers. earned premium is 80000 for the year.
Ans.
100,000
————— * 80,000 * 60/100 = 1,600
30,00,000
10. Suresh insurance company writes fire business consisting of simple risks. The
Insurance Company is ready to bear any claim up to Rs. 1,00,000. so, the
company arranges an excess of loss arrangement treaty to meet the balance of
any claim in excess of Rs. 1,00,000 per risk up to further 2,00,000. The
following are the details of the claims:
Claim Payment to Insured Retained by ceding Recovery from
company excess of loss
Reinsurers
1 1,00,000 1,00,000 Nil
2 2,00,000 1,00,000 1,00,000
3 3,30,000 1,00,000 + 30,000 2,00,000

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Will the reinsurer pay for all the claims, if claims payment is -100000,
200000,330000?
Ans. As the recovery from the reinsurers is limited to Rs. 2,00,000 per risk, so for claim 3
the ceding company will retain the balance 30,000. So the ceding company’s net
retained loss will be Rs. 1,30,000 in case of claim 3. In this case there is inadequate
protection due to incorrect estimation of the exposure per event.
11. In an excess of loss cover, the rate is 100/60th of the average burning cost of
incurred claims for the current and previous years, subject to a minimum
rateof 3% and a maximum rate of 7%. Rate to be applied on GNPI. Calculate the
premium for the year 1991.
Year GNPI Incurred losses to
cover
1989 4,00,000 20,000
1990 8,00,000 30,000
1991 10,00,000 15,000
Total 22,00,000 55,000
Ans.
55,000
Burning cost = ——————— * 100 = 2.5%
22,00,000
Rate = 2.5 * 100/60 = 4.167%
Excess of Loss Premium payable for year 1991 = 4.167% * 10,00,000= 41670
12. In an excess of loss cover, the rate is 100/80th of average burning cost of
incurred claims for the following years, subject to a minimum rate of 2% and a
maximum rate of 5%. The claims incurred are as follows:

Year GNPI Incurred losses to cover

1980 4,00,000 25,000

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1981 12,00,000 12,000

1982 15,00,000 10,000
Total 31,00,000 47,000
Calculate the premium for the year 1981?
Ans. 47,000
Burning cost = —————— *100 = 1.51%
31,00,000
Rate = 1.51% * 100/80 = 1.89%
Since the rate obtained is less than the minimum rate i.e. 2%, therefore minimum
rate will apply.
14. Consider an excess of loss cover paying 30,00,000 excess of 20,00,000 with
provision of two reinstatements at 60% of final earned premium. The contract
period is 1-1-1991 to 31-12-1991 and the loss has occurred on 31-4-1991. A
loss of 60,000 should be recovered. Calculate the reinstatement premium
payable to the reinsurer? earned premium is 80000 for the year.
Ans. 60,000 (Loss recovery)
————————————— * 80,000 * 60/100 = 960
30,00,000 (Cover limit)
15. What are the factors determining the reinsurance needs of a primary insurer?
Ans. The important factors are:
• Kinds of insurance written
• Exposures subject to catastrophic loss
• Volume of insurance written
• Available financial resources
• Stability and liquidity of investment portfolio, and
• Growth plans.
16. Explain the concept of ‘Setting Retentions’.

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Ans. The choice of retention depends on the type of treaty, which in turn depends on the
needs of the primary insurer. The setting of retention varies depending on the type
of treaty. In other words the basic reason for choosing one type of treaty in
preference to another is supported by the following example. For example, if the
primary insurer prefers a pro-rata treaty when compared to an excess treaty the
reason could be that a pro-rata treaty provides surplus relief. Therefore, the
important factor in the setting of retention must be the amount of relief needed. The
amount of surplus relief received will be a function of the percentage of premiums
ceded and the percentage ceding commission received.
17. Explain the process of setting reinsurance limits.
Ans. Setting the reinsurance limits depends on cost considerations since reinsurance
costs increase indirect proportion to reinsurance limits, keeping the retention
constant. However, the treaty reinsurance costs must be weighed against other
recurring costs in facultative placements such as the premium, administrative
expense and inconvenience and uncertainty associated with facultative reinsurance.
However, while setting the reinsurance limits only the volume of the premium is
considered and not the premium loading. Limit Setting for a Catastrophe treaty is
even more difficult in practice since one cannot predict a large loss merely based on
historical records. Therefore, in reinsuring catastrophes, concentration of loss
exposures must be carefully analyzed. In the exercise of setting the reinsurance
limit, the terms of the several treaties must be compared and the limits can be kept
flexible. For example, the limit for an aggregate excess treaty can be lowered if
adequate catastrophe reinsurance is carried. Again the limit of a catastrophe can be
lower if it applies only to the retention of the primary insurer after recoveries from
pro-rata reinsurance, rather than to the direct losses.
18. Cost of Reinsurance is an important element in finalizing reinsurance deal.
Explain the cost of reinsurance.
Ans. The reinsurance cost includes the premium paid to the reinsurer and the losses
recovered or to be recovered under the reinsurance agreement. A primary insurer
should pay its own losses and the reinsurer’s expenses and profit under any treaty,
if the treaty is continued over a fairly long period. That is why the amount included in
the premium for the reinsurer’s expenses and profit is an important factor in
assessing the reinsurance cost. Loss of investment income may be greater under a

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pro-rata treaty than under the excess treaty since the reinsurance premium for a
pro-rata treaty is usually greater. Thus, the loss of investment income may also
become an additional cost of reinsurance. The cost of administering there insurance
program varies depending upon the type of reinsurance. For instance, since
facultative placements are individual and separate, the cost of administration in
these cases is greater than in the case of treaties. Similarly pro-rata treaties cost
more to administer than excess treaties. Finally, the profit or loss on insurance
assumed under reciprocal arrangement must also form part of their insurance cost.
19. What are the typical questions to be considered in assessing the underwriting
policy of a primary insurer?
Ans. The classes of business the primary insurer is writing;
If they are primarily concentrating on personal lines, commercial, industrial or others;
Their geographic area of operation;
How satisfactory are the primary insurer’s underwriting guidelines?
Are their gross line limits and net line limits in keeping with their financial strength?
Are the primary insurer’s loss control and loss adjustment practices adequate for the
classes of business written?
Have the primary insurer’s underwriting results been satisfactory in the lines covered
by the proposed reinsurance treaty?
Does the primary insurer anticipate any substantial changes in its management, marketing
or underwriting practices?
Are the primary insurer’s rates adequate for the risks covered under the treaty?

SECTION – C
Case Studies
1. Himalayan Insurance Company is a large insurance company. It specializes in
personal lines insurance, motor insurance and mortgage insurance. Its annual direct
premium volume is Rs 2000 crores. Its business is spread all over the country, with
the proportion of its business in any one state being approximately the same as that
state’s proportion of the nation’s population. Its policy holders surplus is Rs 1200

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crores. Its investment portfolio consists mostly of Government Bonds and high-grade
industrial and utility bonds. The insurance company normally holds about Rs 500
crores in treasury bills, high rated Commercial Paper and other short term assets.
Investment in equity stocks account for only 5 percent of its invested assets and less
than 10 percent of policy holders’ surplus. The insurance company has shown an
operating profit every year for the last one decade. An analysis of the geographic
spread of its business exposures indicates that losses in excess of Rs 500 crores in
any one catastrophe are very unlikely.
Examine the reinsurance planning process of Himalayan Insurance Company.
Ans. After reviewing all of the available data, it is suggested that the Himalayan Insurance
Company does not require any reinsurance. Its large premium volume, wide spread
of small individual risks,strong surplus position and stable, liquid investment portfolio
would enable it to cope with any lossratio variation it might reasonably expect to
occur, including catastrophes.
2. Dharma Insurance company has annual direct written premiums of Rs 100 crores
and policy holders’ surplus of Rs 50 crores. It has averaged 10 percent annual
growth over the past decade and expects to continue to grow at about the same
rate. Its combined ratio has exceeded 100 percent each year for the last decade,
averaging 102 percent for the period. It has reported an operating profit each year
for the last decade, but the profit has been small in some years. A high rated
portfolio of bonds and other fixed-income securities accounts for about 95 per cent
of its invested assets. The balance consists of carefully selected preferred and
equity stocks. The Dharma writes commercial motor insurance, general liability, fire
and allied lines of insurance. It writes small to medium- sized commercial and
industrial risks. A survey of its outstanding policies showed that about 95 percent of
its liability policies had occurrence limits of Rs1.0 crore and less and about 95
percent of other policies proved coverage of Rs 1.5 crore or less. Management has
decided to set its treaty limits to cover those amounts and to depend on facultative
reinsurance for the policies with greater limits. The Dharma does not need surplus
relief, so no pro rata reinsurance will be purchased. Discuss.
Ans. Per risk or per policy excess treaties will be purchased for both liability and property
insurance. Management may decide that the insurer can afford to assume individual
losses upto 0.5 per cent of direct written premium, or 1.0 per cent of policy holders

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surplus. Consequently the retention under both the liability and other treaties will be
set at Rs 50 lacs per loss. Treaty limits will be Rs50 lacs for liability and Rs 1.0 crore
for mortgage losses. Thus, the primary insurer’s retention and the treaty limits will
fully cover about 95 percent of all policies issued. The properties insured by the
primary insurer are spread widely across the country, but several areas have high
concentrations of values subject to catastrophe losses. The worst tragedy can occur
in coastal areas where losses could go up to Rs 5.0 crore. A catastrophe treaty with
a limit of Rs 5.0 crore and a retention of Rs 50 lacs will be purchased to cover the
exposure.

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CHAPTER – 5
REINSURANCE ACCOUNTING AND
FINANCIALS
OUTLINE OF THE CHAPTER
1. Introduction
2. Special Nature of Reinsurance Accounts
3. Main Types of Reinsurance Arrangements
4. Format of Annual Accounts
5. Loss and loss Adjustment Expense Accounting
6. Reinsurance Accounting Basics
7. Impact of Ceded Reinsurance on Financial Statements
8. Deposit Accounting
9. Questions

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Understand the primary Objective of the reinsurance accounting
• Evaluate reinsurance accounting with respect to technical, financial and legal
implications
RISK MANAGEMENT AND REINSURANCE

• Explain the concept of loss and loss adjustment accounting

• Study the impact of ceded reinsurance on financial statements of the insurer
• Calculate loss and loss adjustments
• Evaluate the need for deposit accounting

Introduction
The objective of the reinsurance accounting is to record the business, control the funds
and maintain proper books and records for the benefit and information of all stakeholders
both internal and external. Special nature of Reinsurance Accounting is concerned with
technical, financial, legal and underwriting aspects of reinsurance.
Premiums, expenses and losses will have effects on both sides of a treaty but these have
to be considered on all overall basis of reinsured and reinsurers. It is imperative for
reinsurance firm to have proper accounting and financial management so that it can safely
settle accounts and create confidence with regulators. The insurance regulators in
countries all over the world, including India, have prescribed regulations for insurance and
reinsurance accounts and methods of treating certain assets and liabilities. In this
connection, IRDAI regulations relating to various items need to be examined.

Special Nature of Reinsurance Accounts

Reinsurance accounting is comprehensively connected with technical, financial, legal and
underwriting aspects of reinsurance. The significance of accounting for reinsurance
techniques must be understood and appreciated with reference to the class of business,
the type or combination of types of reinsurance methods used and the forms of
arrangements as placed directly or through brokers. Legal issues and tax matters are
significant to reinsurance accounting. Mind-blowing perils like natural perils such as
devastating floods, chilling windstorms and life shattering earthquakes became insurable
because of sharing of risk through reinsurance. It is not profit or earnings that can count in
these risks since one loss in 25 to 30 years can wipe out the entire profits accumulated
over a period of time. It is reinsurance that is so special to motivate insurers to venture
into these kinds of businesses.
A long-standing relationship with the reinsurer can be maintained only if proper accounts

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are rendered by the ceding company. The actual must be reconciled with past trends for
renewal of the reinsurance business.

Main Types of Reinsurance Arrangements

Proportional Treaty Accounts
Most of the present day treaties are ‘blind’ – meaning thereby that the ceding company
supplies no details of individual cessions to the reinsurer. The reinsurer receives quarterly
or periodical accounts that give details about the premium, claims etc., There is no
standard format of the treaty contract. A specimen is given below:
The first step in reinsurance accounts is preparation of treaty accounts.
Ceding Company : ABC insurance Company
Treaty : First Surplus Fire Treaty
Period : 1st Quarter 2008
Reinsurer : XYZ Reinsurance Ltd.
Reinsurer’s share : 1% Currency US$
100% account Debit Credit
Premiums 60000
Portfolio premium entry at 1-1-2008 70000
Portfolio loss entry at 1-1-2008 24000
Commission at 45% 27000
Taxes and Charges 1800
Excess of loss premium 450
for common account @ .75%
Claims paid 35000
Common account excess of
Loss recoveries 0

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Premium reserve retained @40% 24000

Premium reserve released 0
Interest on reserve released 0
Tax deducted on interest 0
Credit for cash loss paid 2000
Balance due to reinsurers 67750
Total 156000 156000
Balance due to XYZ Reinsurance Co. Ltd. @1% 677.50
Some ceding insurers divide the account into two parts- the first part called the technical
account showing items relating to the reinsurer’s share of the technical result for the
period and the second part called the financial account which include the balance brought
forward from previous account, premium and loss reserves and interest thereon, loss
settlements made, cash loss credit and the final balance which is due for settlement. It is
not necessary that all the items appearing in the above specimen should appear in the
account for each accounting period. For example, portfolio premium and loss entries will
appear in the first quarter’s account and portfolio premium and loss withdrawals in the last
quarter account.
Premiums
The premium may change according to local practice, the terms of contract or the class of
business. In some markets gross premium may be subject to deduction of such items as
license fees, fire brigade charges, local taxes etc., while in some other cases it may be
separately accounted. With marine and aviation business, it is usual for premiums to be
accounted net of original acquisition costs and therefore only subject to a relatively low
reinsurance overriding commission. Provision is made for payment of a minimum and
deposit premium based upon an estimated total net premium and the deposit premium will
be subject to an adjustment premium when the ceding insurer’s final premium income
becomes known. The deposit premium is usually paid in quarterly installments. It can also
be paid annually in advance.

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Brokerage
Where a reinsurer receives a share of a treaty through a broker, he will normally agree to
pay brokerage. The broker will either include his brokerage in the actual statement of
account for the business or render a separate statement for brokerage due. The
percentage of brokerage payable is applied to the premiums written on a gross, net or
partial net basis and this must be clearly stipulated in the treaty agreement.

Non-Proportional Treaty Accounts

The requirements for preparation of accounts under non-proportional treaties vary from
proportional treaties and simple in nature. Losses are usually dealt with on a cash loss
basis and are payable by individual reinsurers upon the rendering of appropriate
information by the ceding insurer. Therefore accounts under non-proportional treaties are
substantially in respect of premiums. They are not subject to premium or claim reserves or
profit commission.
Premium
The premiums to be paid by cedent to reinsurer is based on the rate specified in the
contract and the rate will be applied to the ceding insurer’s total net premium after ceding
to proportional reinsurances.
Example:
From: Broker
Reassured: ABC Insurance Co. Ltd.
Fire Excess of Loss Cover 2004
10,000,000 XS 5,000,000
The following premium will be credited in your books. Please make necessary entries in
your books.
Currency: U.S. $
Minimum & Deposit Premium 2007 300,000
Less: Brokerage @10% 30,000
270,000

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Payable in 4 Equal installments of 67,500

On 1st January, 2007
On 1st April, 2007
On 1st July, 2007
On 1st October, 2007
Your 10% share amounts to 6750
Payable in 4 equal installments of 1687.50
Foreign Exchange
Normally the unit of currency expressed in treaty agreements is the domestic currency of
the ceding company concerned. For the purpose of conversion of various foreign
currencies, companies adopt rates of exchange at the average rates for each quarter for
compliance with Accounting Standard-11. This is used at the time of transfer of their share
of premium or recovery of claims from the reinsurer.

Calculation of Profit Commission

We have read about commission in the first chapter on reinsurance. Commission is
received when the primary insurer cedes premium to reinsurers. Over and above this
commission some treaties also allow for profit commission. This commission is based on
the profits of the treaty. Profit commission is an additional percentage payable to a ceding
insurer on profitable treaties in accordance with an agreed formula. It is therefore an
incentive for ceding insurers to produce profitable business. Profit commission will be
worked out on accounting year basis in the case of clean cut treaties (Fire and Accident
Proportional treaties) and on underwriting year basis in the case of others.
Accounting Year basis
A profit commission on an ‘Accounting Year’ basis requires all transactions for the same
treaty period, without reference to underwriting year, to be included in the same profit
commission statement. Items to include on debit side – commissions, claims,
Miscellaneous charges, premium reserve carried forward, loss reserve carried forward,
allowance for reinsurer’s expenses and profit for the year and credit side – premium
reserve brought forward, loss reserve brought forward and premiums. A profit commission

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on accounting year basis would not be adjusted in subsequent years as long as the treaty
continues without cancellation.
Underwriting Year basis
A profit commission on an ‘underwriting year’ basis requires all transactions of an
underwriting year, without reference to accounting year, to be accounted to the same year
for the purpose of determining the profit of that underwriting year. Given below is an
example on calculation of profit commission (PC), which will help in understanding the
concept better.

ABC INSURANCE LTD.

MARKET FIRE POOL Rs.
Profit as at 31/03/2004 207,161,000
Premium 767,898,000
PC Terms 15% Pc on Profit Up to 10% of Premium & 75% of
balance
Calculate Profit Commission
Answer
15% PC up to 10% on Premium
10% on Premium 76,789,800
@15% on above 11,518,470 (A)
75% of Balance
Profit 207,161,000
Less 10% Premium 76,789,800
Balance 130,371,200
@75% on Balance 97,778,400 (B)
Commission (A+B) 109,296,870

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Format of Annual Accounts

The format to be followed by the respective reinsurer for preparing revenue accounts at
the end of year published reports in different countries is prescribed by the local insurance
laws. In India, Revenue Account as well as Balance Sheet should be prepared as per
Insurance Act and IRDAI Regulations. The Insurance Regulatory and Development
Authority (Preparation of Financial Statements and Auditor’s Report of Insurance
Companies) Regulations, 2000 covers the whole gamut of preparation of final accounts of,
not only insurance companies, but also reinsurance companies. There is a provision for
audit of annual accounts and specified number of copies to be furnished to the IRDAI.
The ceding company’s accounting year may differ from that of the reinsurer because of the
time required to transfer information for a given period of cover. For reinsurers wishing to
calculate their results more rapidly, estimates are made for the accounts of ceding
companies for the last sum received by the insurer or reinsurer as a consideration for
covering risk.
The reinsurance companies are required to maintain the following records, inter alia,
others.
a) Record of insurance companies with which common and facultative reinsurance
arrangements of reinsurance treaties are entered into.
b) Record of facultative reinsurance ceded and accepted.
c) Information on security level of reinsurers is to be monitored and maintained.
d) Total placement to each reinsurer is required to be monitored and reported to IRDAI.

Closing Proportional Treaty Accounts

A reinsurer finds a major problem with preparation and rendering of proportional treaty
accounts by insurers to reinsurer. It consequently leads to problems of ascertainment of
profit or loss on each of its acceptances at the end of the financial year. Certain classes of
business such as marine, motor and other liability business with a long tail present
problems in estimating outstanding provisions for claims. Thus only two quarters
premiums and claims may be advised and accounted for in the books of reinsurer for a
particular year and the remaining two quarters would get accounted in the following year.
Therefore, it may not be possible to match the accounted figures with the treaty year

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results. But over a period, these two sets of figures should match with each other, unless
outstanding claims provisions made in the books of the reinsurer are substantially different
from the actual outstanding claims.

Closing non-proportional Treaty Accounts

The treaty year is the same as the reinsurer’s accounting year in case of non-proportional
accounts. The main problem with this is the long duration of claims reporting with eventual
cost of claims not being known for many years. Many reinsurers overseas operate their
non–proportional account on funded basis to overcome the above problem. Each year the
fund is examined to ensure its adequacy with regard to outstanding claims. Any deficit
arising in the fund must be replaced by a transfer from revenue reserves.
In assessing surplus, each treaty year would normally be assessed after three years and
any surplus arising then would be transferred to revenue reserves. A surplus is not
normally removed from a fund until three years after the year to which it relates, since
there would be inadequate information available before the expiration of three years.

Closing of Annual Accounts

Every insurance company while closing its annual accounts at the end of the year
examines all claims outstanding with respect to inward treaties in the books in order to
make a reasonable estimate for provisions to be made in the revenue account so that it
can present as accurate as possible. Based on the estimates made for gross claims, the
company will work out the outstanding claims position in respect of its various outgoing
treaties, which will be included in the annual accounts as well as advise to the respective
reinsurers.
The basic premise of all accounting issues is the following:
• Assets – Liabilities = Equity (sometimes labeled “net assets” or “surplus”)
• Revenue – Expense = Income (with expense including incurred losses and
underwriting expenses for an insurance company).

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Loss and Loss Adjustment Expense Accounting

Loss accounts
The basic accounting transactions involving losses are
• Paying claims
• Increasing or decreasing claim reserves
These two items affect the income statement through incurred losses, which equals paid
claims (or “losses”) plus the change in loss reserves, or
Incurred losses = paid losses + (ending loss reserves - beginning loss reserves)
There may be several loss reserve accounts in a company’s ledger. All companies’
ledgers will generally have the categories of case reserve (the estimate of unpaid claims
established by a claim adjuster or the claim system 1) and IBNR (the reserve for “Incurred
But Not Reported” claims), as several jurisdictions require that these amounts be
disclosed separately in annual financial reports.
Other accounts that may be set up include:
• Bulk reserve – This reserve represents the estimated deficiency in the aggregate of
case reserves for known claims. If forced to assign it to either case reserves or IBNR
reserves, some will assign it to case reserves, as it represents reserves for claims that
have already been reported. Others will assign it to IBNR, as it represents an aggregate
calculation above claim adjuster estimates not reliably assignable to an individual claim.
• Additional Case Reserve – This represents an additional reserve for an individual
claim, above the level set up by the claim adjuster. It is most common for claims under
assumed reinsurance contracts, where the case reserve comes directly from the ceding
company, as it allows the assuming company to record a different estimate for the value of
a claim than the ceding company.
Companies may or may not also set up loss reserve accounts for reopened claims,
anticipated subrogation or salvage recoveries, deductible recoveries (where the full loss is

1Note that some claim departments define the case reserve as their estimate of the ultimate value
for the claim, including amounts paid-to-date. This can occur even when the term is used to
represent unpaid amounts only among the actuaries in the same company.

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paid by the insurer who then bills the insured for the deductible), expected legal defence
costs, etc.. Note that the above amounts may be positive or negative. For example, bulk
reserves could be negative if it is assumed that case reserves will be redundant in the
aggregate. Case reserves for a claim could be negative if it is assumed that amounts paid-
to-date on a claim are greater than the ultimate value and that some future recovery of
paid amounts is expected.

Loss cycle
Incurred losses reported in financial statements are typically broken out into two pieces,
the initial estimate of incurred losses for the most recent exposure period and changes in
the estimate of incurred losses for prior periods. This can frequently be translated in
summary form into:
• Incurred losses for the current accident year
• Changes in incurred loss estimates for prior accident years
There are also two general approaches to the initial recognition of losses for the current
accident year – those based on actual claim activity and those based on accrual of
estimated incurred losses based on the level of earned exposure. The following tracks the
life-cycle of incurred claims for each of these approaches, first when initial reserves are
based on actual claim activity and then when initial reserves are estimated based on the
estimated earned exposure.
Actual claim activity
Under this approach, the incurred losses for the most recent exposure period are initially
set based on the actual claim activity, with possible additional loss reserves established to
allow for IBNR claims or any expected deficiency/redundancy in claim adjuster reserves.
For subsequent valuations of the same group of claims, changes in claim adjuster
estimates directly impact incurred losses and aggregate reserves such as bulk and IBNR
reserves are run off over time based on studies of historical data or other actuarial studies.
The following tracks the accounting entries resulting from claims for accident month
January 2006 for a hypothetical company/line of business, from initial valuation to the final
payment for the accident month.
The following (simplifying) assumptions were made in the following example:

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• All claims are reported within 4 months of the loss event.

• Earned premium for the month is $100.
• Each claim is worth $10, half paid in the month of reporting, half in the subsequent
month.
• The initial IBNR is set based on 30% of earned premium, run off evenly over the
following three months.
• No bulk reserve is necessary (beyond that which may be implicit in the IBNR
calculation).
Example 1 - where Reserving is based at inception on actual claim activity

The above displays the life-cycle for a particular accident month. The financials for a
particular accounting month will reflect various accident months with transactions or
outstanding reserves during that month.

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The establishment of the initial reserves for an exposure period based on actual activity is
most typical where most of the claims are reported relatively quickly and settled quickly,
such as for certain property lines in many jurisdictions. Such an approach is not possible if
claims are reported slowly and/or where the initial claim adjuster estimates are not
sufficiently reliable indicators of ultimate payout.
For product lines with slower reporting and/or payment patterns or where the initial case
reserves are less reliable at initial valuation, it is common to set the initial incurred loss
estimate based on an “a priori” estimate of loss exposure for the period. The following is
an example of such an approach where the initial estimate of incurred losses is based on
an expected loss ratio times earned premium.
Accrual of estimated incurred losses based on the level of earned exposure
The following (simplifying) assumptions were made in the following example:
• Claim activity is tracked and reserves set by accident year.
• Earned premium for the 2006 calendar year is running $1,000 a month.
• Based on an analysis of pricing and loss trends and expected underwriting,
management expects a 60% loss ratio for the 2006 accident year.
• Only two loss reserve accounts are maintained, case and IBNR.
• These two reserve accounts are further split in two AY buckets, the current AY
(which is 2006 in this example) and all prior ones.
In this illustration, management determines the incurred losses for the current AY based
on earned premium for the period and performs regular reserve reviews to determine if
prior accident year estimates should be changed.
The illustration shown has such a change in estimate for prior years.

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It is possible for an insurer to use one of the above approaches for some of its lines and
the other approach for its other lines. It may use both approaches on the same line, basing
the reserves early in an accident year on a loss ratio times earned premium and then
moving to reserving based on actual claim experience once the actual claim data becomes
more credible. It may also choose to use one method for some loss types and the other
method for other loss types for the same product line. The choice is generally up to the
insurer, unless the applicable accounting rules and/or insurance laws/regulations dictate a
particular reserve estimation method.

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Paid losses versus cash payment

The above accounting illustrations include entries for paid losses. Non-accountants may
believe that “paid losses” means the same thing as cash paid to claimants. In most cases,
it does, but there may be lags and estimates involved.
When a claim adjuster writes a check to a claimant, this may not result in a simultaneous
paid loss transaction in the accounting system. For example, if an adjuster is writing
checks to policyholders in the middle of a catastrophe zone, there may not be the ability to
instantly record the payment in the claim accounting ledger. Instead, the necessary detail
to record the payment in an accounting ledger may not be entered until days later.
When a payment is made but the corresponding entry (e.g., “paid losses”) has not yet
been made, the payment is registered to a “suspense” account. Growth in the claim
suspense account would normally signify some backlog in the clearing of records in the
claim system, or an influx of claim activity that has yet to be recorded as paid losses due
to the need to incorporate additional details (such as including all the requisite claim
coding fields).
Booking lags can also generate differences between what is recorded in paid losses and
true cash transactions. For example, a company that closes one of its subsidiary ledgers
st
prior to the actual calendar year closing date (such as a November 30 closing of a claim
st
ledger for December 31 reporting) may be required by their accounting rules to estimate
the paid that occurred between the subsidiary ledger closing and the accounting “as of”
date. These estimated paid would be trued up once the actual values are known.
Recoverable amounts
Many insurance operations have various types of recoverable or cash offsets to paid
claims. These recoverable can vary by jurisdiction and product. Some common types of
recoverable or offsets include:
• Salvage & subrogation
• Ceded reinsurance
• Deductibles (Note that this refers to deductibles under which the insurer pays the
entire claim and then seeks reimbursement from the insured for the amount of
deductible. It does not refer to deductibles where the insurer only pays the portion of
the claim above the deductible)

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These items are generally recorded as negative paid losses. But the timing of the negative
paid entry may not match the actual cash transaction. For example, items that require
billing someone for the recoverable amount may be recorded as “negative paid” when the
bill is sent.
The following illustrates such a transaction:

There are several possible approaches for an accounting system if the billed amounts are
later determined to be unrecoverable. The accounting may require a reversal of the
original recoverable entries (such as is required in U.S. statutory reporting for ceded
reinsurance). The accounting may also require a write-off of the recoverable balance in a
different income statement account (such as “other income”, such as currently occurs for
U.S. statutory reporting as of 2007 for billed deductible recoverable amounts).

Accounting for discounted reserves

The use of discounted reserves creates its own issues in designing an accounting system,
in that the ultimate paid losses will be recorded at nominal value, more than the recorded
discounted loss reserves. The accounting system must therefore determine how to treat
the increase in the reserve due to the amortization of discount.

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The current approach used in many jurisdictions for this situation is to record the increase
due to discount amortization as incurred losses. This may show up as reserve
strengthening in certain reports, unless accompanied by adequate disclosure.
An alternative approach (not yet widely used for insurance loss accounting) is to record
the income statement impact of increasing loss reserves due to discount amortization as
interest expense. Where interest expense is reported together with interest income, this
would result in incurred losses staying at the initial discounted value, unless incurred loss
estimates change. It would also result in lower investment income than occurs in many
current insurance accounting systems.

Self-insurer issues
Current insurance accounting systems do not cover the liability for events that are self-
insured. Instead, the liability for these items may fall under more generic accounting
requirements that apply to all businesses. For example, the liability for many of these
items in the U.S. would be covered by FAS 5 and for those following IASB standards the
applicable accounting rule is IAS 37. These rules generally require amounts to be reliably
estimable before they are booked and a self-insurer may or may not have sufficient
volume to allow for reliable estimation of their aggregate self-insured liabilities. It may also
occur that reported claims can be estimated reliably enough to meet the accounting
recognition requirements, but IBNR claims cannot.
Where the self-insured liabilities are related to employees, such as workers compensation
or self-insured employee health insurance, special accounting rules designed for
employee benefits may apply. This is the case under FASB and IASB rules currently.
Further discussion of such rules is beyond the scope of this study note.

Reinsurance Accounting Basics

Assumed Reinsurance accounting
In general, the accounting rules applicable to insurers writing direct insurance contracts
also apply to those writing assumed reinsurance contracts. That said, there may
occasionally be differences, such as different risk transfer rules and different definitions of
loss versus loss expense.

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(a) Risk transfer rules

Currently in the U.S., certain rules exist regarding the amount of risk transfer required for a
contract to be coded as reinsurance (as opposed to being accounted for as a deposit –
note that deposit accounting is discussed later in this study note). The risk transfer rules
may apply to all reinsurance contracts, or only to the ceded reinsurance accounting (and
not the assumed reinsurance accounting for the same contract). The same risk transfer
rules may or may not apply with regard to insurance contracts. Complications can also
exist where one contract “reinsures” a portfolio of contracts which include both insurance
and non-insurance contracts.
(b) Loss adjustment expense
It is common for reinsurance contracts covering tort liability insurance risks to include
coverage for legal defence costs. These are frequently coded as loss adjustment
expenses and are frequently reported separately from losses by the ceding company. But
the assuming company may record such costs as assumed losses on their books. Hence,
the categorization of defence costs (and other such expenses) may shift between loss
expense and loss when going from the ceding company to the assuming company. This
will distort analyses of loss versus loss expense on a combined direct writer plus reinsurer
basis.

Ceded Reinsurance Accounting

There are two general approaches to ceded reinsurance accounting currently in existence:
1. Treating the ceded reinsurance entries as negatives of the direct or assumed
reinsurance entries, or
2. Treating the purchase of reinsurance as the purchase of an asset.
These approaches may sometimes be combined in a single accounting system. For
example, U.S. GAAP treats ceded reinsurance premiums and losses as negative
premiums and negative losses for income statement purposes, but ceded loss reserves as
an asset rather than as an offset to a liability for balance sheet purposes.
(Note: The following example assumes that the relative entries in an account are added
together to get a total. For example, if a company writes $100 in direct premium and then
cedes $10 in premium, it assumes that the premium entries are +$100 and -$10. These

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values are then ADDED to get the net of $90. There are some accounting systems that
record ceded entries as positive values and that always subtract ceded values in
calculating totals for an account. In such a system the premium entries would be +$100
and +$10 and the user of the information would have to know to SUBTRACT ceded
amounts from direct and assumed amounts.)

If the accounting instead required segregated reporting of the impact of ceded

reinsurance, it may require that it be treated as a net expense in the calculation of
underwriting income. In the above example, the net cost of ceded reinsurance would be $1
(equal to an earned premium cost of $20, less recoveries of $13 for losses and $6 for
expenses).

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Commutation Accounting – Ceded and Assumed

The commutation of a reinsurance agreement ends the remaining obligations of either
party to the other under the agreement. It can occur either due to a commutation clause
written into the original contract, or through negotiation between the parties in executing
and/or resolving disputes under the contract, but the accounting is typically the same.
A commutation does not negate the original contract. Instead, it finalizes obligations under
the contract, generally via a fixed payment or series of fixed payments from the reinsurer
to the reinsured.
The final payment (or series of payments) is typically accounted for as a paid loss.
Consistent with the finalization of all remaining obligations, all other balance sheet entries
are removed. As the final payment is typically based on the economic value remaining in
the contract, it generally reflects the time value of money, hence it would normally be less
than a full undiscounted loss reserve. 2
For example, assume that ceding company A and assuming company B entered into a
commutation that finalizes their obligations/rights under a contract, in return for a final
payment from B to A of $100. Assume that prior to the commutation, A had recorded a
ceded loss reserve under the contract (accounted for as a negative loss reserve) of -$150

2This may not always be the case. Where the commutation reflects the economic value of the
future payments otherwise due under the reinsurance contract, the economic value would also
include an adjustment for risk. This risk adjustment would increase the economic value, offsetting
the reduction for the time value of money, in some cases resulting in a value greater than the
expected undiscounted recoveries.

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and that B had recorded an assumed loss reserve of +$110. (The final value of $100
reflects both the time value of money and a compromise as to expected future payments.)
The income statement impact of the commutation for the two companies would be the
following:
Ceding Company (A)
Paid losses -100
Change in loss reserves +150
Incurred losses 50
Assuming Company (B)
Paid losses +100
Change in loss reserves -110
Incurred losses -10
Reinsurance reporting lags
Reinsurance contracts include language regarding reporting requirements of the ceding
company to the assuming company. These reports serve multiple purposes. One is to
effect the necessary paid transactions under the contract, including ceded premiums and
losses according to the policy terms. Another is to enable the assuming company sufficient
data to perform its own reserve analysis (either for the particular contract or contract
claims, or for the assuming company’s portfolio of contracts or claims). A third is to enable
the assuming company to meet its own accounting requirements.
There can be significant lags in the filing and receiving of these reinsurance reports. The
lags can be the result of time necessary for the ceding company to accumulate the data
required to be reported. They may also be due to the need to coordinate input from
multiple parties, such as where the ceding entity is a pool and the pool administrators
must first collect the relevant data from all the pool members before submitting reports to
the pool reinsurers. Delays can also be caused by multiple handoffs and consolidations,
such as occurs for some retrocession contracts where first the ceding companies must
report to their reinsurers, who then must process the data before submitting their report to
retrocessionaires (with multiple layers of retrocessionaires possible). Delays of several
years have been observed for higher level retrocession contracts involving parties from
multiple countries and/or continents.

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Some accounting paradigms require the assuming company to record estimated

transactions where the lags and the dollars involved are material. This may involve
recording estimated premiums, losses and expenses (including estimated “paid” losses)
based on anticipated or historical experience. These estimates could be trued up once the
actual values are known or improved estimates are available.

Bordereau reporting
For certain reinsurance contracts, such as many facultative or individual claim excess of
loss contracts, the ceding companies report includes individual claim (and possibly
premium) transaction detail. But for certain contracts, the reporting is done in summarized
form instead. Such summarized reports are called “bordereaus”.
Bordereau reports may or may not include product line detail or type of loss detail. Some
only include high level summary data of subject losses and premiums, with additional
detail only available through special request or inspection (with the ability or inability to do
so depending on the contract terms). The level of detail in the bordereau reports can
directly impact the level of detail in the assumed company’s accounting records. For
example, if no line-of-business splits are available in the bordereau, the assuming
company cannot report its assumed share except on a highly summarized line of business
basis. It also will be unable to split the subject losses into various categories unless the
detail in the bordereau supports such reporting.

Retroactive versus Prospective Reinsurance

Some reinsurance paradigms distinguish between reinsurance bought to cede future
losses (“prospective reinsurance”) and reinsurance bought to cede past losses
(“retroactive reinsurance”). The accounting described above represents the typical
accounting rules for prospective reinsurance.
One example of a retroactive reinsurance contract is a loss portfolio transfer, whereby an
insurer cedes all the loss reserves from an existing portfolio of claim liabilities to a
reinsurer. Another example is an adverse development cover, whereby an insurer buys
reinsurance to protect it in case an existing portfolio of claim liabilities develops adversely
beyond a certain level.

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Historically, different rules for retroactive reinsurance were put in place where the main
insurance accounting paradigm did not allow discounting. Prior to these special retroactive
reinsurance rules, some companies were reportedly using retroactive reinsurance to
generate earnings, as they would be able to cede existing loss reserves (held at
undiscounted values) for a ceded premium that reflected the time value of money. Hence,
special rules were implemented for retroactive reinsurance to prevent or limit such
potential for abuse.
Retroactive reinsurance accounting generally requires that the recoveries under the
contract be held on a present value basis, with exceptions. They may also require
separate disclosure of the benefits or impact of such contracts, so that any distortion of
these contracts on the ceding company’s financial statements can be isolated.
Where such rules exist, exceptions are sometimes incorporated into the rule whereby
certain contracts are excluded from the present value or special disclosure requirements.
When this occurs, it is typically said that “prospective accounting applies” to the retroactive
reinsurance contract.

Impact of Ceded Reinsurance on Financial Statements

The following examples provide of how ceded reinsurance impacts an insurer’s financial
statements and key financial metrics for the following six principals of reinsurance:
1. Increase large line capacity
2. Provide catastrophe protection
3. Stabilize loss experience
4. Provide surplus relief
5. Facilitate withdrawal from a market segment
6. Provide underwriting guidance
These examples examine the impact to the ceding company on the following:
• Surplus
• Loss reserves

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• Unearned Premiums
• Leverage ratios
• Income statement
The financial statements shown in the examples follow the SAP convention of offsetting
ceded liabilities against gross liabilities.

1. Increase large line capacity

This example deals with the situation where a company is only willing to expose itself to a
certain amount of loss per policy, but portions of its potential market demand greater
coverage.
Beginning Assumptions (the “Without” column):
• XYZ insurance company writes homeowners insurance. It is unable or unwilling to
write policies for homes with insured values over $500,000 without a suitable
reinsurance program.
• XYZ writes $1 million of annual premium for this market, in a steady state with a
level premium volume. The loss ratio is 75%. The only expense is commissions,
which equal 20% of premium.
• Loss reserves = $750,000 and surplus = $1.5 million. Since XYZ is in a steady state,
reserves and surplus are constant throughout the year.
• XYZ holds cash equal to 10% of gross loss reserves, agent balances equal to 10%
of premium and the remainder of its assets in bonds. The bonds and cash earn
investment income at a rate of 5%.
• There are no income taxes.
Altered Assumptions (the “With” column):
• XYZ buys a “surplus share” pro rata reinsurance treaty that cedes premiums and
losses for higher valued homes, with the ceding percentage for each policy equal to
the excess of the home value over $500,000 divided by the total home value. (For
example, for a home worth $625,000, the ceded percentage would be 125/625, or
20%.)

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• This is the only reinsurance purchased by XYZ.

• The altered assumptions again reflect level premium volume and a steady state, in
which XYZ has been writing identical business over a period of years.
• With access to the higher-value market, XYZ writes 40% more business and
achieves $1.4 million in gross written premium. However under the treaties it cedes
$300,000 of premium.
• The loss ratio remains 75% on both net and ceded business. However reserves
increase relative to loss, because claims on more expensive properties take longer
to develop.
• The expense ratio remains 20% of net written premium. The reinsurer pays a ceding
commission to compensate for commissions on ceded business, so there is no net
additional commission on ceded premium.
• Agent balances remain equal to 10% of premium, of which a portion, equal to the
percent of premium ceded, is due to the reinsurer.
• It is assumed that only a small increase in surplus, matching the increase in current
year income.
Example – 1

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Analysis of impact (from Exhibit 1)

• Surplus – We assumed no impact on surplus other than earnings on additional
business opportunities. In reality, given the additional premium and reserves and
reinsurance collectability risk, the ceding company may desire (or be forced to) hold
more surplus to support these greater risks. Alternatively, it could decide to reduce
volume to retain the same level of surplus relative to risk.
• Loss reserves – Both gross and net loss reserves increase, partly due to increased
premium volume and partly due to the nature of new business being pursued, with
slower development on larger claims.
• Unearned Premiums – increase, but remain the same in proportion to premium
• Leverage ratios – Net leverage ratios increase slightly because of the change in
business model. Gross leverage ratios begin to differ materially from the net
leverage ratios and reinsurance leverage becomes important due to the purchase of
reinsurance.
• Income statement – Little changed on a net basis, but over time the riskier book and
changing cost of reinsurance may introduce greater volatility.

2. Provide Catastrophe Protection

This example deals with the situation where the company desires to reduce its potential
loss from a catastrophic event.
Beginning Assumptions (the “Without” columns)
• ABC insurance company is in the same situation as XYZ insurance company in
Exhibit 1, prior to the purchase of reinsurance. Hence, the “without” column in
Exhibit 1 also applies to Exhibit 2, unless a catastrophe event occurs.
• If a cat event occurs, ABC incurs an additional $500,000 in loss, of which $50,000 is
paid by the end of the year and the remainder is reserved.
Altered Assumptions (the “With” columns)
• ABC buys a catastrophe treaty on January 1st, for 5% of gross premium, that pays
for losses from a single event in excess of 10% of premium. This premium is

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payable at the start of the year. (Note that this assumption leaves zero ceded
unearned at December 31st. Ceded unearned would be greater than zero if the
ceded reinsurance policy term had not yet expired.)
• This is the only reinsurance purchased by ABC.
• If a cat event occurs, ABC incurs an additional $500,000 in loss. This activates the
cat treaty and the reinsurer assumes responsibility for the excess of event losses
over 10% of premium, or $500,000 minus $100,000 = $400,000. Non-cat loss levels
are unaffected by this event.
• Once again only 10% of the cat losses are paid by year-end, with the rest paid the
following year. Note that the reinsurer does not begin paying until paid losses
exceed 10% of premium, so the entire $400,000 of ceded loss is ceded reserve.
• The cat treaty has a mandatory reinstatement premium provision, with the
reinstatement premium due once the cat treaty attachment is reached on a paid
basis. This reinstatement premium charge is 2% of gross premium.
• The only surplus change is due to the change in underwriting results.
Example – 2

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Analysis of impact (from Example 2)

• Surplus – Buying the cat reinsurance decreases surplus if no cat event occurs, due
to the cost of reinsurance. But it can substantially mitigate the risk of significant
drops in surplus if large cats occur. Note that the cost of the reinsurance in the event
of a cat includes both the original premium and the reinstatement premium.
• Loss reserves – Net reserves are not impacted unless a covered cat event occurs.
In that case, gross loss reserves can increase significantly for a relatively short
period of time (i.e., the length of the cat payout pattern). Net reserves will return to
normal levels sooner than gross reserves, as the retained portion of the cat is
generally paid first before the ceded portion of the cat.
• Unearned Premiums – Little to no change (depending on the cat reinsurance policy
term and accounting date), as cat reinsurance is normally a limited portion of total
premium.
• Leverage ratios – If no cat event occurs, the biggest impact may be from reduced
surplus in the denominator of many leverage ratios. If a cat does occur, then gross
ratios and net ratios are significantly impacted without the reinsurance, while only
the gross ratios are significantly impacted with the reinsurance (with the exception of
ceded reinsurance leverage ratios). In general, ceded reinsurance leverage (i.e.,
ceded balances3 as a percent of surplus) can be significantly impacted in the period
after a major cat, prior to the runoff of the resulting cat loss reserves.
• Income statement – Investment income is reduced by purchasing reinsurance. But
underwriting income is substantially protected, with the loss limited to the original
ceded premium, plus the retention and reinstatement premium if a covered cat
occurs. (This assumes that the cat stays within the maximum limit of the cat
reinsurance program.)

3Ceded balances are those balance sheet values arising from ceded reinsurance. In the above
examples, they include ceded loss reserves and ceded unearned premiums. In a real-life example,
they would also include reinsurance recoverables from amounts billed but not yet collected.

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3. Stabilize loss experience

This example deals with the situation where loss experience may fluctuate from year to
year more than management desires. Management desire may in turn be driven by capital
provider demands, or management may wish to simplify the capital management process
(including the determination of shareholder dividends).
Beginning Assumptions (the “Without” columns):
• DEF insurance company is in the same situation as XYZ insurance company in
Exhibit 1, prior to the purchase of reinsurance. The “normal losses without” column
reflects a “normal” loss year with a loss ratio of 75%, as per Exhibit 1.
• However, this example also recognizes the possibility that a “high” loss year may
occur, with a loss ratio of 125%. If a high loss year occurs, DEF incurs an additional
$500,000 in loss, of which $50,000 is paid by the end of the year and the remainder
is reserved.
Altered Assumptions (the “With” columns):
• DEF buys an aggregate excess of loss treaty for the entire book on January 1st, for
10% of gross premium, that returns 90% of losses above a loss ratio of 100%. The
reinsurance premium is payable at the start of the year. (Note that this assumption
results in zero ceded unearned at December 31st Ceded unearned would be greater
than zero if the ceded reinsurance policy term had not yet expired.)
• This is the only reinsurance purchased by DEF.
• In the high loss example, DEF incurs an additional $500,000 in loss for a loss ratio
of 125%. This activates the aggregate excess treaty and the reinsurer assumes
responsibility for 90% of losses above a loss ratio of 100%, or ($1,250,000 minus
$1,000,000) * 90% = $225,000.
• Once again only 10% of the additional losses (over and above “normal” losses) are
paid by year-end, with the rest paid the following year. Note that the reinsurer does
not begin paying until paid losses exceed 100% of premium, so the entire $225,000
of ceded loss is ceded reserve.
• The only surplus change is due to the change in underwriting results.

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Analysis of impact (from Example 3)

Example 3

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• Surplus – The expected value of surplus is lower after buying reinsurance, but with
less period to period variation. The reduction is caused by the expected net cost of
reinsurance. Note that while the expected impact of surplus is a reduction, the
impact from year to year may vary between reductions and increases as gross
losses are lower or higher than expected.
• Loss reserves – Stabilizing loss experience net of reinsurance generally translates
into stabilizing net of reinsurance loss reserves. Gross reserves reflect the full
volatility of year-to-year results, but net reserves should be smaller and more stable.
(They may also be easier to estimate, as the situations that cause loss experience to
fluctuate may also cause claim liability estimation to be more difficult.)
• Unearned Premiums – Reduced on a net basis due to the purchase of reinsurance,
unless (as in our example) the reinsurance is purchased with a single effective date
and the accounting date being used is the reinsurance expiration date.
• Leverage ratios – These ratios on a net basis should be more stable but slightly
higher (due to reduced surplus), assuming there is a positive net cost of the
reinsurance.
• Income statement – Underwriting results over time would be expected to be lower,
due to the net cost of the reinsurance and investment income would be lower. But
the underwriting results from year-to-year should be more stable.

4. Provide surplus relief

This reinsurance deals with the situation where leverage ratios are higher than desired.
Reinsurance is therefore purchased with the intent of reducing leverage ratios net of
reinsurance.
Beginning Assumptions (the “Without” column):
• XYZ insurance company here is in the same situation as XYZ insurance company in
Exhibit 1 prior to the purchase of reinsurance, except that it has fewer bonds and
therefore only has $500,000 in surplus. Altered Assumptions (the “With” column):
• XYZ buys reinsurance with a 50% quota share, in order to reduce its net premium to
surplus and net reserves to surplus leverage ratios. This is a straight quota share,

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with 50% of premiums and losses ceded, with a ceding commission of 20%
(consistent with the gross expense ratio).
• This is the only reinsurance purchased by XYZ.
• The altered assumptions once again reflect a steady state with consistent gross and
ceded premium from year to year.
• The only surplus change is due to the change in underwriting and investment
income during the year.
Example – 4

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Analysis of impact (from Example 4)

• Surplus – Liabilities decrease because half of the losses and unearned premium are
ceded, but assets decrease because of the cost of the reinsurance. The net effect in
our example is a small decline in surplus, since the ceded business was profitable.
This quota share reinsurance would only increase surplus if the business was being
written at a loss.
• Loss reserves – Net reserves are a fixed percentage of gross reserves.
• Unearned Premiums – Net reserves are a fixed percentage of gross reserves.
• Leverage ratios – Net leverage ratios are significantly improved, although ceded
reinsurance leverage ratios are significantly increased. Hence, the insurer’s
solvency becomes more reliant on its reinsurers’ solvency. Note that ceding half the
gross business does not halve the net leverage ratios, due to the impact of the
cession on surplus. While premiums and loss reserves drop in half, surplus does not
stay constant. Hence, a cession of more than 50% would be required to obtain a
50% reduction in net premium and reserve ratios to surplus.
• Income statement – Underwriting income is cut in half and investment income is
significantly reduced.

5. Facilitate withdrawal from a market segment

This example deals with the situation where management wants to exit a market and is not
willing to wait until the runoff of existing obligations.
Beginning Assumptions (the “Beginning Balance” and “Without” columns):
• XYZ insurance company here is in the same situation as XYZ insurance company in
Exhibit 1 except that it stopped writing new business at the beginning of the current
year. The beginning balances come from Exhibit 1, “without” column.
• Written premium for the current year therefore drops to zero. XYZ continues to earn
premium and incur losses, on business written during the prior year.
• The accounting paradigm does not recognize Deferred Acquisition Costs, so XYZ
incurs a zero expense ratio on runoff earned premium.

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• XYZ earns investment income on the average of beginning and ending cash and
bonds.
• All loss reserves as of the beginning of the year (for events occurring in earlier
years) are closed and paid at the reserve amount before the end of the year.
• Half of all losses occurring during the year are paid by the end of the year.
• Surplus changes, during the year, only due to underwriting and investment income.
Altered Assumptions (the “With” column):
• XYZ buys prospective reinsurance on January 1st to cede 100% of the remaining
unearned premium and all losses occurring after the beginning of the year. A ceding
commission is included to cover the commission portion of the unearned premium,
which XYZ paid during the previous year.
• XYZ does not buy retroactive reinsurance. Once again all loss reserves as of the
beginning of the year (for events occurring in earlier years) are closed and paid by
XYZ at the reserve amount before the end of the year.
• Surplus changes, during the year, only due to underwriting and investment income.
Note: This example assumes withdrawal from all business. These results would
need to be combined with results from ongoing businesses to see the combined
balance sheet and income statement impact.
Example – 5

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Analysis of Impact (from Example 5)

• Surplus – Liabilities decline to zero as losses and unearned premium are ceded, but
assets decrease because of the cost of the reinsurance. The net effect, once again,
is a small decline in surplus, since the ceded business was profitable. However
surplus will be less volatile if there are unexpectedly large or small losses during the
runoff year.
• Loss reserves – Gross reserves are unchanged, but net reserves disappear, hence
exposure to the volatility of net reserve estimates disappears.
• Unearned Premiums – Gross reserves disappear over the year as the business runs
off. Net reserves disappear immediately when the unearned premium is ceded.
• Leverage ratios – Net leverage ratios are zero, hence the only remaining insurance
risk is reinsurance collectability risk. Hence, surplus that was supporting the runoff
business should now be free to support existing or new business, subject to
supporting the residual reinsurance collectability risk.
• Income statement – Underwriting results reflect a profit because the ceding
commission offsets expenses which were paid the previous year. This profit is
slightly smaller than if the business had not been ceded. However the risk in the
results is now greatly reduced (and limited to the risk in reinsurance collectability
and in investment results).

6. Provide underwriting guidance

This reinsurance function arises in the situation where management wishes to enter a new
market, or believes that it must be in one market to support another of its markets, but
does not feel comfortable with its expertise in that new market. It therefore heavily
reinsures its writings in that new market, relying on the reinsurer’s expertise in pricing and
underwriting that market correctly. No numeric example will be provided for this situation.
It is conceptually equivalent to Exhibit 1 wherein reinsurance creates new business
opportunities for the insurer. The impact on surplus and income will depend on the
profitability and volume (after reinsurance cessions) of the new business.

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Deposit Accounting
Deposit accounting for a contract generally observes the following rules:
• The accounting is done on an individual contract-by-contract basis and not on a
portfolio basis, even if the resulting contract-by-contract amounts are reported on a
summary basis in financial reports.
• The amount(s) received for a contract is recorded as a deposit liability, with no
revenue or expense impact (and therefore no impact on income).
• The deposit liability is increased due to additional receipts and usually investment
income credits of some sort and decreased due to payments.
• As such, the deposit generally represents a present value of future payment
obligations.
• Deposit accounting may be required by accounting paradigm for what might
otherwise be an insurance (or reinsurance) contract under the following conditions.
(Note that whether a particular accounting paradigm requires deposit accounting
under these conditions can vary significantly from one accounting paradigm to
another.)
• No risk transfer.
• Timing risk transfer only, but no transfer of amount risk – i.e., where the amount to
be paid until the contract is considered fixed or subject to minimal uncertainty, but
uncertainty exists as to the timing of the payment.
• Retroactive reinsurance, subject to exceptions.
Three general forms of deposit accounting currently observable are bank deposit
approaches, prospective approaches and retrospective approaches

Bank deposit approach

This is the simplest of the three deposit accounting approaches to be discussed. Under
this approach, the initial deposit grows with credited interest at a rate whose calculation is
determined in advance (and with possible additional deposits depending on the contract
terms) and declines with withdrawals. The defining characteristic is that the ending deposit

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for a reporting period is dependent solely on the beginning balance, the credited rate for
the period and any deposits or withdrawals during the period. The credited rate may be
fixed or variable, dependent on market rates or based on non-market events or rates, but
the method of its calculation is generally set in advance.

Prospective approach
The defining characteristic of this approach is that the current value of the deposit is set
equal to the present value of future payments, irrespective of the initial deposit or past
payments. The interest rate is generally a market rate, which may be based on risk-free
rates and may be locked-in at inception such that it does not change over time.
(Conceptually, it is also possible for a prospective method to use a market rate that is
updated for each reporting period.)
Under this approach, the deposit value will change with the amortization of interest and
with a change in projected future losses (and with a change in the discount rate, if the rate
is not locked-in by the accounting paradigm).

Retrospective approach
The defining characteristic of this approach is that the deposit is a function of the initial
deposit, all past payments and the current estimate of all future payments. Under this
method the interest rate is the rate for which the discounted value of past payments and
estimated future payments would equal the initial deposit. The interest rate can change
whenever the estimated cash flows under the contract change. This method could also
conceivably generate a negative rate if applied to a contract where the projected outflows
no longer exceed the initial inflows. Whereas the prospective approach only cares about
future (except possibly for an interest rate locked-in in the past), the retrospective
approach cares about all the flows since inception, past and future. Under this approach,
the deposit value and discount rate are subject to change whenever the projected cash
flows since inception are changed.

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REVISION QUESTIONS
SECTION – A
Multiple Choice Questions
1. One of the following is not true
a. For the success of reinsurance both the primary insurer and the reinsurer must
make joint efforts.
b. They both have duties as well as rights under the treaties.
c. The primary insurer must conduct his underwriting operations satisfactorily.
d. Both A & B.
e. A,B & C
2. In case of large losses investigations are conducted by
a. Primary Insurer
b. Reinsurer
c. Police
d. A&B
e. None of the above
3. “Follow the Fortunes” means
a. Take as much reinsurance as possible
b. The reinsurer is normally bound by the primary insurer’s actions in the
underwriting and claims matters.
c. The reinsurer need to follow the reinsurance rules and not primary insurer’s
actions.
d. A&B
e. None of the above

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4. The reinsurer will be able to control losses only under following

circumstances
a. Primary insurer has professional staff.
b. There is well designed information system with primary insurer.
c. There is good communication system.
d. A&B
e. None of the above
5. One of the following is not true
a. Direct premium data to calculate the reinsurance premium payable to the
reinsurer.
b. Data for individual losses needed to apply treaty limits and excess retentions;
c. Codes for identifying occurrences under casualty ‘clash’ coverage;
d. Information on risks included in the treaty but not ceded for preserving
profitability of the treaty.
e. None of the above.
6. Now a days the primary insurers are sending information through this
statement to reinsurers instead of bordereaux
a. Statement of Statistics b. Current Account Statement
c. Ceding statement d. Scrip
e. None of the above
7. Disputes between primary insurer and reinsurer are normally settled through
a. Direct negotiations b. Arbitration
c. Courts d. All of the above
e. None of the above
8. One of the following is not true
a. Reinsurers have very little to do except collecting reinsurance premium;

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b. Some reinsurers minimize their work by preferring large retentions with the
possibility of no claims being presented at all.
c. Reinsurers may be engaged in auditing the underwriting and claims practices
of the primary insurers.
d. A&B
e. None of the above.
9. What is the purpose of collecting and analyzing a large amount of data by
reinsurers?
a. Obtain better terms b. Balance cessions
c. Solidify relationship d. A&B
e. All of the above
10. “Probable Maximum Loss” is an assessment by
a. The cedent b. The reinsurer
c. The surveyor* d. The broker
e. None of the above.
Answers
1. e 2. d 3. b 4. b 5. e 6. b 7. d 8. a 9. e 10. c

SECTION – B
Short & Essay Questions
1. Outline the role of Primary Insurer in reinsurance administration.
Ans. The primary insurer must conduct his underwriting operations satisfactorily within the
guidelines and expectations of the treaty so that the reinsurer has no surprises
coming in the form of large losses. More, the primary insurer must notify promptly all
large losses and the reinsurer must begiven the opportunity to participate in
investigation of such losses. The primary insurer has the freedom to underwrite
individual risks and adjust individual claims once clear-cut underwriting policies are

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contemplated under a treaty. We conventionally use a phrase “FOLLOW THE

FORTUNES”. It means the reinsurer is normally bound by the primary insurer’s
actions in the underwriting and claims matters. The primary insurer must have a
good or well designed information system to be able to furnish all necessary
information in time for the reinsurer to be able to control losses wherever possible
and to discharge their obligations under the treaty professionally.
2. The more important data that should be capable of being made available from
a good information system used by the primary insurer should include certain
elements. Highlight them.
Ans.
(a) Direct premium data to calculate the reinsurance premium payable to the
reinsurers;
(b) Data for individual losses needed to apply treaty limits and excess retentions;
(c) The above data for accounting purposes;
(d) Codes generated for catastrophe losses;
(e) Codes for identifying occurrences under casualty ‘clash’ coverage;
(f) Data to determine the portion of policy/ies ceded to each surplus share
reinsurer;
(g) Separate data on retention, limits, rates and the reinsurer involved for each
facultative placement;
(h) Information on risks included in the treaty but not ceded for preserving
profitability of the treaty;
(i) Data on risks excluded under the treaty but underwritten by the primary insurer
so as not to include the same in the reinsurance bordereau;
An accurate and efficient information system helps the credibility of the primary
insurer and helps the renewal of treaties. The primary insurer must make available
his books of account for inspection by the reinsurer.
3. Outline the role of reinsurer in the context of reinsurance administration.

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Ans. One would think that the reinsurers have very little to do except collecting
reinsurance premium and paying claims and brokerage commission to brokers and
ceding commission to the primary insurer. Maybe this is so when the treaty
relationship is smooth. In fact, some reinsurers minimize their work by preferring
large retentions with the possibility of no claims being presented at all. On the
contrary, the reinsurers may be engaged in auditing the underwriting and claims
practices of the primary insurer so as to ensure that these are done satisfactorily
and as expected. Again, whenever the losses are large, the reinsurers may like to
participate in the investigation of the same, both to see that proper procedures are in
place and to find out the underwriting implications. Many a time, the primary
insurers, both on underwriting and claims issues, openly consult there insurers. The
reinsurers, not only help in stabilizing loss exposures but also positively assist the
primary underwriters in underwriting on account of their superior experience and
expertise.
4. Explain how claims are settled under different methods of reinsurance.
Ans. The procedure differs from treaty to treaty based on individual agreements. If it is a
pro rata treaty, the primary insurer sends a monthly bordereau to the reinsurer,
detailing the premiums due to the reinsurer and claims due from the reinsurer. The
primary insurer will remit the difference to the reinsurer when the premiums exceed
the losses and if the losses exceed the premiums, the reinsurer remits the difference
to the primary insurer. If at any time, there are some exceptionally large losses, then
it is the convention for the reinsurer to remit the losses to the primary insurer before
the end of the reporting period. In the case of excess treaties, as soon as losses
exceed the retention, intimation is given and there insurer pays on being given proof
of settlement, which is simply a statement of losses paid by the primary insurer,
together with estimates of current reserves. In the case of aggregate excess
treaties, the reinsurers are known to make initial payments say sixty days after the
end of the accounting year. If it is clear that the losses will exceed the retention,
then payments may be made before the end of the year.
5. Explain Closing of Accounts in case of a reinsurance company.
Ans. Every insurance company while closing its annual accounts at the end of the year,
examines all claims outstanding with respect to inward treaties in the books in order
to make a reasonable estimate for provisions to be made in the revenue accounts,

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so that it can present as accurate a picture as possible. Based on the estimates

made for gross claims, the company will work out the outstanding claims position in
respect of its various outgoing treaties, which will be included in the annual accounts
as well as advise to the respective reinsurers. Profit and loss account as well as
Balance Sheet is as per Insurance Act and IRDAI regulations.

SECTION – C
Case Studies
1. Utkal Insurance company has reinsurance arrangements with Great Eastern
reinsurance company, Kolkatta. The premiums to be paid by cedent to
reinsurer is based on the rate specified in the contract and the rate will be
applied to the ceding insurer’s total net premium after ceding to proportional
reinsurances.
MARKET FIRE POOL Rs.
Profit as at 31/03/2004 207,161,000
Premium 767,898,000
PC Terms 15% PC on Profit up to 10% of Premium
& 75% of balance
Calculate Profit Commission.
Ans.
15% PC up to 10% on Premium
10% on Premium 76,789,800
@15% on above 11,518,470 (A)
75% of Balance
Profit 207,161,000
Less 10% Premium 76,789,800
Balance 130,371,200
@75% on Balance 97,778,400 (B)
Commission (A+B) 109,296,870

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2. The Janapriya Insurance company issued its policy in the name of a consumer
group and issued certificates of insurance covering group members. The
Surya Re -reinsurer and its wholly owned subsidiary, the Janapriya, entered
into a reinsurance contract where the reinsurer reinsured 100% of the
janapriya’s liability under all of its policies. The reinsurance contract
contained a customary ‘no third party beneficiary’ clause, which provided that
only the reinsurer, cedent and the consumer group had rights under the
reinsurance contract. The reinsurer and the cedent also entered into an
administrative services agreement that required the reinsurer at its expense to
provide all services of administration for all of the cedents policies, including
actuarial, underwriting, compliance, legal, accounting, issuance etc,. When the
cedent denied the certificate holder’s claim, the certificate holder sued the
cedent and the reinsurer. The reinsurer moved for summary judgment,
dismissing the action on the ground that there was no contractual relationship
with the certificate holder upon which liability could be established against the
reinsurer.
Discuss the implications.
Ans. Cedent – Janapriya – could not delegate its duty to its insured and the reinsurance
agreements provided that they do not benefit third parties like the certificate holders.
It is important to note that the reinsurer is really the certificate holder’s insurer. A
reasonable conclusion might be drawn from the administrative services agreement
that the cedent was simply fronting for there insurer in the provision of health and
accident insurance by the reinsurer to the public. The agreement suggested,
realistically, that all that the cedent was doing was providing insurance policy and
certificate forms bearing its name and address and perhaps a sales organization, but
that the reinsurer was responsible for and did perform all other aspects of insurance
undertaken in the cedent’s name. Hence, the certificate holder’s claim is justified
and there insurer’s motion for summary judgment should be denied.

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Important Terms in Reinsurance

Admitted Reinsurance - A company is “admitted” when it has been licensed and
accepted by appropriate insurance governmental authorities of a state or country. In
determining its financial condition a ceding insurer is allowed to take credit for the
unearned premiums and unpaid claims on the risks reinsured if the reinsurance is placed
in an admitted reinsurance company.
Arbitration Clause – It is the language providing a means of resolving differences
between the reinsurer and the reinsured without litigation. Usually, each party appoints an
arbiter. The two thus appointed select a third arbiter, or umpire and a majority decision of
the three becomes binding on the parties to the arbitration proceedings.
Bordereau (plural Bordereaux) - A form providing premium or loss data with respect to
identified specific risks which is furnished the reinsurer by the reinsured.
Burning Cost - A term most frequently used in spread loss property reinsurance to
express pure loss cost or more specifically the ratio of incurred losses within a specified
amount in excess of the ceding company’s retention to its gross premiums over a
stipulated number of years.
Cancellation - (a) Run-off basis means that the liability of the reinsurer under policies,
which became effective under the treaty prior to the cancellation date of such treaty, shall
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continue until the expiration date of each policy; (b) Cut-off basis means that the liability of
the reinsurer under policies, which became effective under the treaty prior to the
cancellation date of such treaty, shall cease with respect to losses resulting from accidents
taking place on and after said cancellation date. Usually the reinsurer will return to the
company the unearned premium portfolio, unless the treaty is written on an earned
premium basis.
Capacity - The percentage of surplus or the dollar amount of exposure that an insurer or
reinsurer is willing to place at risk. Capacity may apply to a single risk, a program, a line of
business, or an entire book of business.
Catastrophe Reinsurance – It is a form of reinsurance that indemnifies the ceding
company for the accumulation of losses in excess of a stipulated sum arising from a
catastrophic event such as conflagration, earthquake or windstorm. Catastrophe loss
generally refers to the total loss of an insurance company arising out of a single
catastrophic event.
Cede - When a company reinsures its liability with another, it “cedes” business.
Ceding Commission - The cedant’s acquisition costs and overhead expenses, taxes,
licenses and fees, plus a fee representing a share of expected profits - sometimes
expressed as a percentage of the gross reinsurance premium.
Ceding Company - The original or primary insurer; the insurance company which
purchases reinsurance.
Claims-Made Basis - A form of reinsurance under which the date of the claim report is
deemed to be the date of the loss event. Claims reported during the term of the
reinsurance agreement are therefore covered, regardless of when they occurred. A claims
made agreement is said to “cut off the tail” on liability business by not covering claims
reported after the term of the reinsurance agreement - unless extended by special
agreement. See Occurrence Basis.
Commission - In reinsurance, the primary insurance company usually pays the reinsurer
its proportion of the gross premium it receives on a risk. The reinsurer then allows the
company a ceding or direct commission allowance on such gross premium received, large
enough to reimburse the company for the commission paid to its agents, plus taxes and its
overhead. The amount of such allowance frequently determines profit or loss to the
reinsurer.

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Commutation Clause - A clause in a reinsurance agreement, which provides for

estimation, payment and complete discharge of all future obligations for reinsurance
losses incurred regardless of the continuing nature of certain losses such as unlimited
medical and lifetime benefits for Workers’ Compensation.
Contingent Commissions (or Profit Commission) – It is an allowance payable to the
ceding company in addition to the normal ceding commission allowance. It is a pre-
determined percentage of the reinsurer’s net profits after a charge for the reinsurer’s
overhead, derived from the subject treaty.
Contributing Excess - Where there is more than one reinsurer sharing a line of insurance
on a risk in excess of a specified retention, each such reinsurer shall contribute towards
any excess loss in proportion to his original participation in such risk. Example: Retention
$100,000, Reinsurer A accepts one-half contributing share part of $1,000,000 in excess of
said $100,000. Reinsurer B accepts remaining one-half contribution share part of
$1,000,000.
Earned Premium - (1) it is that part of the premium applicable to the expired part of the
policy period, including the short-rate premium on cancellation, the entire premium on the
amount of loss paid under some contracts and the entire premium on the contract on the
expiration of the policy. (2) That portion of the reinsurance premium calculated on a
monthly, quarterly or annual basis which is to be retained by the reinsurer should there
cession be canceled. (3) When a premium is paid in advance for a certain time, the
company is said to “earn” the premium as the time advances. For example, a policy written
for three years and paid for in advance would be one-third “earned” at the end of the first
year.
Errors and Omissions Clause - A provision in reinsurance agreements which is intended
to neutralize any change in liability or benefits as a result of an inadvertent error by either
party.
Excess of Loss - A form of reinsurance under which recoveries are available when a
given loss exceeds the cedant’s retention defined in the agreement.
Ex Gratia Payment - A payment made for which the company is not liable under the terms
of its policy. It is usually made in lieu of incurring greater legal expenses in defending a
claim. It is rarely encountered in reinsurance as the reinsurer by custom and for practical
reasons follows the fortunes of the ceding company.

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Expense Ratio - The percentage of premium used to pay all the costs of acquiring, writing
and servicing insurance and reinsurance.
Experience - (1) the loss record of an insured or of a class of coverage. (2) Classified
statistics of events connected with insurance, of outgo, or of income, actual or estimated.
(3) What figures show to have happened in the past?
Experience may be compiled on different bases to provide various means of appraisal, viz.
Accident Year, Calendar Year, or Policy Year, but, for underwriting purposes, should
always compare earned premium with incurred losses after the latter have been modified
by an allowance for loss development and incurred but not reported losses (I.B.N.R.).
Extra Contractual Obligations (ECO) - A generic term that, when used in reinsurance
agreements, refers to damages awarded by a court against an insurer which are outside
the provisions of the insurance policy, due to the insurer’s bad faith, fraud, or gross
negligence in the handling of a claim. Examples are punitive damages and losses in
excess of policy limits.
Facultative - Facultative reinsurance means reinsurance of individual risks by offer and
acceptance wherein the reinsurer retains the “faculty” to accept or reject each risk offered.
Financial Reinsurance – It is a form of reinsurance which considers the time value of
money and has loss containment provisions. One of its objectives is the enhancement of
the cedant’s financial statements or operating ratios, e.g., the combined ratio; loss
portfolio transfers; and financial quota shares are examples.
Flat Rate - In reinsurance, a percentage rate applied to a ceding company’s premium
writings for the classes of business reinsured to determine the reinsurance premiums to be
paid the reinsurer.
Following the Fortunes - The clause stipulating that once a risk has been ceded by the
reinsured, the reinsurer is bound by the same fate thereon as experienced by the ceding
company.
Incurred Loss Ratio - The percentage of losses incurred to premiums earned. ( the
meaning of the word ‘Loss’ is same as ‘Claim’s Experience’).
Inflation Factor - A loading to provide for increased medical costs and loss payments in
the future due to inflation.

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Intermediary – It is a third party in the design, negotiation and administration of a

reinsurance agreement. Intermediaries recommend to cedants the type and amount of
reinsurance to be purchased and negotiate the placement of coverage with reinsurers.
Intermediary Clause – It is a provision in reinsurance agreements which identifies the
intermediary negotiating the agreement. Most intermediary clauses shift all credit risk to
reinsurers by providing that:
1. The cedant’s payments to the intermediary are deemed payments to the reinsurer;
and
2. The reinsurer’s payments to the intermediary are not payments to the cedant until
actually received by the cedant.
This clause is mandatory in some states.
Layer - A horizontal segment of the liability insured, e.g., the second $100,000 of a
$500,000 liability is the first layer if the cedant retains $100,000 but a higher layer if it
retains a lesser amount.
Lead Reinsurer - The reinsurer who negotiates the terms, conditions and premium rates
and first signs on to the slip; reinsurers who subsequently sign on to the slip under those
terms and conditions are considered following reinsurers.
Letter of Credit - A financial guaranty issued by a bank that permits the party to which it
is issued to draw funds from the bank in the event of a valid unpaid claim against the other
party; in reinsurance, typically used to permit reserve credit to be taken with respect to
non-admitted reinsurance; and alternative to funds withheld and modified coinsurance.
Loss Adjustment Expense - All expenditures of an insurer associated with its
adjustment, recording and settlement of claims, other than the claim payment itself. The
term encompasses both allocated loss adjustment expenses (ALAE) which are loss
adjustment expenses identified by a claim file in the insurer’s records, such as attorney’s
fees; and unallocated loss adjustment expenses (ULAE), which are operating expenses
not identified by claim file, but functionally associated with settling losses, such as salaries
of claims department.
Loss Development - The difference between the original loss as originally reported to the
reinsurer and its subsequent evaluation at a later date or at the time of its final disposal. A
serious problem to reinsurers who, being involved in the more serious cases, must
frequently wait many years for the final disposition of a loss.

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Loss Event – It is the total losses to the ceding company or to the reinsurer resulting from
a single cause such as a windstorm.
Loss Ratio - Proportionate relationship of incurred losses to earned premiums expressed
as a percentage.
Non-Admitted Reinsurance - A Company is “non-admitted” when it has not been
licensed and thereby recognized by appropriate insurance governmental authority of a
state or country. Reinsurance is “non-admitted” when placed in a non-admitted company
and therefore may not be treated as an asset against reinsured losses or unearned
premium reserves for insurance company accounting and statement purposes.
Occurrence - An adverse contingent accident or event neither expected nor intended from
the point of view of the insured. With regard to limits on occurrences, property catastrophe
reinsurance agreements frequently define adverse events having a common cause and
sometimes within a specified time frame, for example 72 hours, as being one occurrence.
This definition prevents multiple retentions and reinsurance limits from being exposed in a
single catastrophe loss.
Offset Clause - A provision in reinsurance agreements which permits each party to net
amounts due against those payable before making payment; especially important in the
event of insolvency of one party which ceases to remit amounts due to the other.
Participating or Pro Rata Reinsurance - Includes Quota Share, First Surplus, Second
Surplus and all other sharing forms of reinsurance where under the reinsurer participates
pro rata in all losses and in all premiums.
Peril - This term refers to the causes of possible loss in the property field - for instance:
Fire, Windstorm, Collision, Hail, etc. In the casualty field the term “Hazard” is more
frequently used.
Per Risk Excess Reinsurance - Retention and amount of reinsurance apply “per risk”
rather than on a ‘per accident or event or aggregate basis’.
Policy Year – It is the year commencing with the effective date of the policy or with an
anniversary of that date.
Pool - An organization of insurers or reinsurers through which particular types of risks are
underwritten with premiums, losses and expenses shared in agreed ratios.

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Portfolio Reinsurance - In transactions of reinsurance, it refers to all the risks of the

reinsurance transaction. For example, if one company reinsures all of another’s
outstanding Automobile business, the reinsuring company is said to assume the “portfolio”
of Automobile business and it is paid the total of the unearned premium on all the risks so
reinsured (less some agreed commission).
Portfolio Run-off – It is just the opposite of Return of Portfolio - permitting premiums and
losses in respect of in-force business to run to their normal expiration upon termination of
a reinsurance treaty.
Premium, Deposit - When the terms of a policy provide that the final earned premium be
determined at some time after the policy itself has been written, companies may require
tentative or “deposit” premiums at the beginning which are readjusted when the actual
earned charge has been later determined.
Premium, Pure - The portion of the premium calculated to enable the insurer to pay
losses and, in some cases, allocated claim expenses or the premium arrived at by dividing
losses by exposure and in which no loading has been added for commission, taxes and
expenses.
Premium (Written/Unearned/Earned) - Written premium is premium registered on the
books of an insurer or reinsurer at the time a policy is issued and paid for. Premium for a
future exposure period is said to be unearned premium for an individual policy, written
premium minus unearned premium equals earned premium. Earned premium is income for
the accounting period, while unearned premium will be income in a future accounting
period.
Professional Reinsurer - A term used to designate a company whose business is
confined solely to reinsurance and the peripheral services offered by a reinsurer to its
customers as opposed to primary insurers who exchange reinsurance or operate
reinsurance departments as adjuncts to their basic business of primary insurance. The
majority of professional reinsurers provide complete reinsurance and service at one
source directly to the ceding company.
Profit Commission – It is a provision found in some reinsurance agreements which
provides for profit sharing. Parties agree to a formula for calculating profit, an allowance
for the reinsurer’s expenses and the cedant’s share of such profit after expenses.

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Quota Share - The basic form of participating treaty whereby the reinsurer accepts a
stated percentage of each and every risk within a defined category of business on a pro
rata basis. Participation in each risk is fixed and certain.
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.
Reinsurance - The practice whereby one party called the Reinsurer in consideration of a
premium paid to him agrees to indemnify another party, called the Reinsured, for part or
all of the liability assumed by the latter party under a policy or policies of insurance which
it has issued. The reinsured may be referred to as the Original or Primary Insurer, or
Direct Writing Company, or the Ceding Company.
Reinsurer – It is any insurer or reinsurer assuming the risk of another under contract.
Retention - The net amount of risk which the ceding company or the reinsurer keeps for
its own account or that of specified others.
Retrocession – It is basically a reinsurance of reinsurance. Example: Company “B” has
accepted reinsurance from Company “A” and then obtains for itself, on such business
assumed, reinsurance from Company “C”. This secondary reinsurance is called a
Retrocession. The transaction whereby a reinsurer cedes to another reinsurer all or part of
the reinsurance it has previously assumed.
Retrospective Rating - A plan or method which permits adjustment of the final
reinsurance ceding commission or premium on the basis of the actual loss experience
under the subject reinsurance treaty - subject to minimum and maximum limits.
Risks - A term used to denote the physical units of property at risk or the object of
insurance protection and not Perils or Hazard. Reinsurance by tradition permits each
insurance company to frame its own rules for defining units of Risks. The word is also
defined as chance of loss or uncertainty of loss.
Salvage and Subrogation – It is a method by which the rights of the insured which, under
the terms of the policy, automatically transfer to the insurer upon settlement of a loss.

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Salvage applies to any proceeds from the repaired, recovered, or scrapped property.
Subrogation refers to the proceeds of negotiations or legal actions against negligent third
parties and may apply to either property or casualty coverages.
Self-Insurance - Setting aside of funds by an individual or organization to meet his or its
losses and to absorb fluctuations in the amount of loss, the losses being charged against
the funds so set aside or accumulated.
Sliding Scale Commission - A ceding commission is the commission which varies
inversely with the loss ratio under the reinsurance agreement. The scales are not always
one to one: for example, as the loss ratio decreases by 1%, the ceding commission might
increase only 5%.
Slip - A binder often including more than one reinsurer. At Lloyd’s of London, the slip is
carried from underwriter to underwriter for initialing and subscribing to a specific share of
the risk.
Special Acceptance - The facultative extension of a reinsurance treaty to embrace a risk
not automatically included within its terms.
Spread Loss - A form of reinsurance under which premiums are paid during good years to
build up a fund from which losses are recovered in bad years. This reinsurance has the
effect of stabilizing a cedant’s loss ratio over an extended period of time.
Stop Loss - A form of reinsurance under which the reinsurer pays some or all of a
cedant’s aggregate retained losses in excess of a predetermined dollar amount or in
excess of a percentage of premium.
Subject Premium - A cedant’s premiums (written or earned) to which the reinsurance
premium rate is applied to calculate the reinsurance premium. Often, subject premium is
gross/net written premium income (GNWPI) or gross/net earned premium income
(GNEPI), where the term “gross/net” means gross before deducting reinsurance premiums
for the reinsurance agreement under consideration, ;but net after all other adjustments,
e.g., cancellations, refunds, or other reinsurance. Normally, subject premium refers to
premium on subject business. Also known as base premium.
Surplus – It is the excess of assets over liabilities. Statutory surplus is an insurer’s or
reinsurer’s capital as determined under statutory accounting rules. Surplus determines an
insurer’s or reinsurer’s capacity to write business.
Surplus Share - A form of proportional reinsurance where the reinsurer assumes pro rata

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responsibility for only that portion of any risk which exceeds the company’s established
retentions.
Treaty - A general reinsurance agreement that is obligatory between the ceding company
and the reinsurer containing the contractual terms applying to the reinsurance of some
class or classes of business, in contrast to a reinsurance agreement covering an individual
risk. Treaty means an agreement, which may be automatic with details or without details to
be submitted to the reinsurer. It can be sometimes blind treaty. Just about all insurers,
whether they are companies, Lloyd’s syndicates or mutual associations, need reinsurance.
It protects the insurer’s capital base against the adverse effects of large individual losses
or irregular loss patterns such as may be caused by natural catastrophes. Another way of
looking at it is that reinsurance supplies the insurer with a form of capital that can be
called upon in case of a large loss or losses that would otherwise deplete the insurer’s
own capital.
Ultimate Net Loss - This term usually means the total sum which the assured, or any
company as his insurer, or both, become obligated to pay either through adjudication or
compromise and usually includes hospital, medical and funeral charges and all sums paid
as salaries, wages, compensation, fees, charges and law costs, premiums on attachment
or appeal bonds, interest, expenses for doctors, lawyers, nurses and investigators and
other persons and for litigation, settlement, adjustment and investigation of claims and
suits which are paid as a consequence of the insured loss, excluding only the salaries of
the assureds’ or of any underlying insurer’s permanent employees.
Unearned Premium – It is that portion of the original premium that applies to the
unexpired portion of risk. A fire or casualty insurer or reinsurer must carry a reserve
against all unearned premiums as a liability in its financial statement, for if the policy
should be canceled, the company would have to pay back the unearned part of the original
premium.
Working Layer - The first layer above the cedant’s retention wherein moderate to heavy
loss activity is expected by the cedant and reinsurer. Working layer reinsurance
agreements often include adjustable features to reflect actual underwriting results.
Deficit - As used in reinsurance, any excess of charges over credits at the end of any
accounting period (which excess shall be a charge in the computation of the contingent
commission for the succeeding period, or in computing various experience-rated
reinsurance arrangements).

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Deposit Premium -When the terms of a treaty provide that the ultimate premium is to be
determined at some time after the treaty has been written, the reinsurer may require a
tentative or a deposit premium at the beginning. The tentative premium is readjusted when
the actual earned charge has been determined. It is also known as Advance Premium.
Direct Action Statute – It is a provision in a state's law allowing a third party to cut
through the insured or insurer to the insurer or reinsurer.
Direct Writer-In reinsurance, a reinsurer which negotiates with a ceding company without
benefit of an intermediary or [Link] insurance, a primary insurer that sells insurance
through licensed agents who produce business essentially for no other organizations.
Direct Written Premium-The gross premium income (written instead of earned) of a
primary company, adjusted for additional or return premiums but before deducting any
premiums for reinsurance ceded and not including any premiums for reinsurance
assumed.
Domestic Company-An insurer conducting business in its domiciliary state from which it
received its charter to write insurance, as opposed to a foreign company (which is an
insurer conducting business in a state other than its domiciliary state), or an alien
company (which is an insurer domiciled outside the U.S. while conducting business within
the U.S.).
Drop-Down Coverage-In reinsurance, a method of structuring the retention and limit of a
particular layer of a property catastrophe excess reinsurance program so that, in the event
that a loss (or losses) exhausts the reinsurance limit in a stated lower layer, the
unexhausted limit of the highest upper layer would drop down to respond to subsequent
loss(es) during the same contract period as a replacement for the lower layer. Such a
method is often referred to as "top-and-drop" coverage. For example, if the first layer of
$10 million xs (excess) $10 million in a program of $140 million xs $10 million were
exhausted, the top layer (for this example, $10 million xs $140 million) will drop down and
provide $10 million xs $10 million for a negotiated number of additional occurrences.
Another use of drop-down coverage may occur within the first catastrophe layer, wherein
the loss retention in a contract drops after the first loss and the layer limit then expands.
For a different example, if the first layer coverage were $1 million xs $1 million and a loss
in excess of $1 million occurred, provision would be made for the retention to drop to a
lesser amount, such as $750,000 and for the limit to expand to $1,250,000 for the second
and subsequent losses in the same period, but subject to the annual aggregate limit as
negotiated.

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Common Clauses in Reinsurance Contract

1. OPERATIVE CLAUSE
This clause describes the business coming under the scope of RI contracts.
 It brings the obligatory nature of reinsurance(i.e. the insurer binds himself to cede
and reinsurer binds himself to accept)
 It states the business to be covered
 It states the method of cessions
 It states the territorial scope
 It expresses the maximum liability of net retention under treaty in number of lines as
well as in amount.
 The insurer is sole judge to identify his own risks and determine the limit of his
retention.
2. RETENTION CLASUE
This clause protects –
 The net retention by working excess of loss cover
 Right to effect priority cessions
 Common account excess of loss protection
3. COMMENSEMENT AND TERMINATION CLAUSE
This clause deals with
 Commencement of reinsurance
 The manner and circumstances in which it can be terminated
4. NOTICE OF CANCELLATION AT AN ANNIVERSARY DATE (NCAD)
It is a general practice of major reinsurers to make their acceptance subject to “notice of
cancellation at an anniversary date” (NCAD). This provision is an automatic notice to
cancel at anniversary date relieves to the reinsurer from the trouble of observing the notice
period mentioned in the RI contracts where he is unsure about the his procedures for
reviewing the treaty acceptance. This provision is rectified or resorted in facultative

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acceptance with period exceeding one year as there would be no provision for cancellation
in such arrangement.
5. TERMINATION: EXITING AN AGREEMENT WITH PNC
Annual contracts run through their contract period and expire on the day as agreed
between the parties. In case of the contract of treaties for an indefinite period, the
agreement will specify the notice period. It is a common practice of reinsurers to send
PNC (PROVISIONAL NOTICE OF CANCELLATION) as a way of termination of contract. It
enables reinsurer to review the arrangement and decide on his continuation for the
ensuing/following year. These considerations are for cancellation under normal
circumstances.
6. TERMINATION: EXITING AN AGREEMENT WITHOUT NOTICE
This clause provides the automatic cancellation of RI contracts without notice under
certain extraordinary circumstances. In case of a war between country of residence of
ceding insurer and country of residence of reinsurer, the agreement will be automatically
terminated without any notice.
7. SUDDEN DEATH CLAUSE
This is a special type of “Termination: Exiting without any notice” [Link] case of some
special circumstances (such as insolvency of one of the parties, failure to observe the
terms of the agreement etc.), the agreement can be terminated immediately by the other
party through this clause.
8. ALTERATIONS: BY MUTUAL CONSENT
The salient features of this clause are –
 Possibility of making amendments
 Consent of both parties
 Addendum forming the bindings on parties.
9. INSOLVENCY: OF OTHER REINSURERS
This clause states that the loss to the reinsurer will not increase due to inability of ceding
insurer to collect from another reinsurer.

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10. ACCESS TO RECORDS INSPECTION BY REINSURER

This clause gives reinsurer the right to inspect any book or record of the ceding insurer
which are relevant to the business reinsured. This inspection must be carried out by an
appointed representative at the reinsurer’s expense during normal office hours and this
right remains available to the reinsurer so long as any liability under RI remains unsettled
due to dispute between parties subject to arbitration.
11. ERRORS & OMISSIONS A SAFETY DEVICE
This clause states that any unintentional delays, errors or omissions on the part of ceding
insurer shall not invalidate the liability of reinsurer on such delays, errors or omission,
provided that such errors/omissions are rectified as soon as possible after discovery.
12. INTERMEDIARIES BROKER’S ROLE
This clause is used to identify the broker of reinsurance transactions by his name and
address, provided that the broker is the link for all communications and settlements
between the insurer and reinsurer.
Most intermediary clause shifts all credit risks to reinsurer by providing –
a. The ceding insurer’s payment to the intermediary be deemed payments to the
reinsurer
b. The reinsurer’s payment to the intermediary is not payments to the ceding insurer
until actually received by him.
This clause is not in used if the reinsurance is directly placed.
13. ARBITRATION TO AVOID COURT PROCEEDINGS
This clause shows the intention of parties to resolve the disputes which are arising from
the interpretation of agreements or the rights with respective to any transaction involved
whether before or after the termination of agreement by arbitration rather than court
action.
A dispute can be referred to a single arbitrator, or two arbitrators, one to be appointed by
each party. In case of disagreement between arbitrators, an Umpire is appointed by a
mutually agreed authority. In the event of failure to appoint the arbitrators by the parties or
failure to appoint Umpire by the arbitrators within a specified time, an Umpire would be
appointed by a mutually agreed authority.

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As per this clause, the arbitrators and umpire are required to interpret an agreement as an
honorable engagement and they should make their award with a view to effect the general
purpose of the agreement in a reasonable manner rather than in accordance with the
literal interpretation of the language. The decision of arbitrators or umpire would be final
and binding on both parties. The place for arbitration should be specified.
14. JURISDICTION CLAUSE
The jurisdiction clause in an agreement would subject jurisdiction to the ceding insurer’s
country. In case of failure of arbitration, the court proceeding would need to be initiated in
the country of ceding insurer.
It might be much administrative inconvenience of the reinsurer. Therefore, it is initially
avoided by the process of arbitration.
15. SET-OFF CLAUSE
This clause permits each party to net/clear amount due against those payable before
making payment. This settlement method is important in the event of insolvency of one
party which stops to remit the amounts due to the other.
16. ACCOUNTING CLAUSE
This clause is used for rendering of accounts and settlement of balances of accounts
between parties in reinsurance agreement.
The salient features of this clause are –
 After the close of relevant accounting period, how soon the accounts are to be
rendered to the reinsurers.
 How and when the accounts to be confirmed and the balance settled.
 Any special provision regarding separate account for specified currencies.
 Provision for rendering accounts on underwriting year basis.
17. CURRENCY CLAUSE
Generally, the unit of currency expressed in a treaty agreement is the domestic currency
of concerned insurer. Treaty agreement provides the accounting and settlement process
through domestic currency, but the original currencies will form the basis of liability of
reinsurer.

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For the purpose of accounting in various foreign currencies, ceding insurer adopts the rate
of exchange at the beginning of the year. During the year, if there is a fluctuation of more
than 10% in exchange rate, then an option is provided to use the revised rate of exchange
from that date. The reinsurance account will be rendered on that basis.
Some ceding insurers render separate accounts for separate currencies within same
treaty. This will involve additional administrative work, but minimize the impact of
fluctuation of rate of exchange.
18. LOSS ADVICES AND ACCOUTNING OF LOSSES
This clause deals with all the aspect of losses affecting the reinsurance and covers the
following points-
 Losses will be debited to the reinsurer in the accounts
 CASH LOSS REQUEST: if any individual loss exceeds an agreed sum, the ceding
insurer can request for immediate settlement of loss by the reinsurer for his share.
 PRELIMINARY LOSS ADVICE: When a loss reaches an agreed amount (often same
figure as for cash loss), the ceding insurer should provide an advice to inform the
reinsurer, even if the ceding insurer does not request for any special settlement.
 The ceding insurer has right to adjust, compromise and settle claims. The reinsurer
follows the settlement and liable for his proportion of all loss adjustment expenses
(excluding insurer’s salaries and overhead). The reinsurer shares proportionately in
recoveries, if any.
 Requirements for advising outstanding losses at anniversary date.

Special Clauses in Reinsurance Contract

1. BUSINESS COVERED ATTACHMENT OF CESSION PROPORTIONAL
This clause is used in respect of automatic forms of RI such as treaty. This clause states
that
 RI will automatically apply simultaneously and automatically with liability of ceding
insurer while his retention exceeds with reference to surplus RI.
 In case of quota share, the cession would be simultaneously and automatically with
liability of ceding insurer

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 If a loss occurs in between the time of acceptance of risk and entry of cession in RI
register, the ceding insurer will retain the loss not less than the amount which he
normally retains as per his rules and practices for the risk of that particular class
This clause also includes,
 The RI is restricts to the business as covered as appearing in operative clause.
 Specific exclusion of categories of risks and individual hazards.
 Exclusion of war and nuclear risks except the risk of war in marine and personal
accident
 Exclusion of terrorism and sabotage as this risk is covered by separate pool
 Obligatory reinsurances and retrocession.
2. BUSINESS COVERED INSURING CLAUSE NON-PROPORTIONAL
This clause states
 In what circumstances, a recovery is available to the ceding insurer
 The extent of recovery
Two essential factors under a non-proportional RI are
 The ceding insurer sustained a loss covered by RI
 Such loss exceeded a previously agreed threshold, called – ‘deductible’
Hence, this clause specify –
(i) The amount of deductible
(ii) The reinsurer’s limit of liability
(iii) The basis on which RI is applied, namely deductible and limit linked to the basis of –
a. ‘each loss each risk’ – risk excess of loss (If coverage is on this basis, there
may be a maximum limit per loss occurrence)
b. ‘each loss occurrence’ – Catastrophe excess of loss(If coverage is on this
basis, there may be an annual aggregate linked to reinstatement provision)
c. ‘in the aggregate each annual period’ – stop loss and aggregate excess of loss

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The ceding insurer arranges layered excess of loss cover. On a particular layer, the
reinsurer considers only the deductible in respect of this layer; he does not have any
interest if the ceding insurer has or has not recovered the amounts due from
reinsurers of underlying layers. However, this clause must clearly specify the
position of the reinsurers for each layer.
3. UNDERWRITING RETENTION AND LIMITS
The reinsurer makes an acceptance based on the information provided by the ceding
insurer during negotiations in respect of his limits, retention and other related matter. If the
ceding insurer introduces any change in his business during currency of the contract, the
consent of reinsurer is necessary for the continuation of the reinsurance arrangement.
4. ORIGINAL CONDITIONS
 Conditions of reinsurance treaty will be same as original policy
 Premium will be at same rate as received by insurance company
 Does not apply to the insurance company’s financial losses and reinsurer is liable for
its share of loss only.
5. FOLLOW THE FORTUNES CLAUSE
This clause states that the reinsurance contract is fully subject to same terms and
conditions as of insurance contract.
It means – the reinsurer will follow the same terms and conditions in reinsurance
agreement as which ceding insurer sets in insurance contract with insured. In real
meaning, reinsurer and insurer share the same interest.
Exception – the alternative risk financing method of ‘financial reinsurance’ is an exception
of this traditional method. In this case, the reinsurer will follow the ceding insurer’s fortune
in latter’s business in its entirety.
6. NET RETAINED LINES PROTECTING NET RETENTION
This clause allows the ceding insurer to effect other reinsurances in priority so that there is
an additional treaty which protects the net account only.
According to this clause, the liability of reinsurer will not be increased due to inability of
ceding insurer to collect any amount due from other reinsurers when such inability arises
from insolvency of such other reinsurers.

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7. ULTIMATE NET LOSS AMOUNT FOR XL RECOVERY.

8. LOSS OCCURANCE DEFINATIONS
The ‘loss occurrence’ would mean all individual losses arising out of and directly
occasioned by one catastrophe.
The duration and extent of any loss occurrence would be limited to-
 72 consecutive hours with reference to a hurricane, typhoon, windstorm, rainstorm
or tornado
 72 consecutive hours with reference to earthquake, seaquake, tidal wave or volcanic
eruption
 168 consecutive hours with reference to riot, civil commotion or malicious damage.
 168 consecutive hours for any other catastrophe of whatever nature.
The ceding insurer may choose the date and time when any such period of consecutive
hours commences.
If any catastrophe is of greater duration, the ceding insurer may divide the catastrophe into
two or more “loss occurrences”, provided no two periods overlap and no period
commences earlier than the date and time of happening of first recorded individual loss to
the ceding insurer in that catastrophe
In liability excess of loss, the concept of what constitute a single loss is more complicated
and the following common methods are adopted in this regard,
(i) The claims for occupational disease are aggregated into one occurrence for all
employees of one insured.
(ii) The claims arising from the manufacture / from the distribution of one faulty batch /
from the lot of a product are considered as one occurrence.
(iii) Fidelity losses, covered on a ‘loss discovered basis’, can be limited to the acts of
individual or more than one if acting in collusion.
(iv) Independent act of embezzlement would be regarded as separate loss for the
purpose of reinsurance.

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9. REINSTATEMENT RESTORING DIMINUTION IN COVER/ REINSTATEMENT

CLAUSE
The amount of limit of cover is being reduced after settlement of a loss. As per this clause,
this reduced limit of cover will be automatically reinstated from the time of commencement
of loss occurrence until the expiry of agreement. Premium will be charged as agreed.
If there is any limitation on reinsurer’s liability during any contact period, this clause will
show –
(i) The extent of reinstatement (expressed as a multiple of per loss limit or an amount)
(ii) Whether the reinstatement is free or subject to an additional premium
(iii) How such premium is to be calculated
(iv) Whether the reinstatement provisions will apply equally on all class of business
covered by the treaty.
10. DOWNGRADE CLUASE PROTECTING REINSURANCE SECURITY
This clause allows reinsured canceling the reinsurance contract if the reinsurer is
downgraded by the rating organizations.
11. CUT THROUGH CLAUSE
It is a provision in a reinsurance contract that makes liable to the reinsurer to pay directly
to the original insured its share of losses covered by reinsurance, even if the ceding
company becomes insolvent before paying his part of these losses.
The cut through clause can be used in another situation, where the reinsurer is not
licensed in a particular country and intends to retain all risks from the original policy. The
reinsurer makes the draft of the cut through clause in such a way that when the reinsurer
makes payment to third party he will not be required to make payment to the reinsured or
a statutory receiver.
Generally, the cut through provision is taken in the form of clause or endorsement
attached with reinsurance agreement.
12. HOURS CLAUSE
This clause incorporates a time limitation to define the duration and the extent of loss
occurrence arising out of or directly occasioned by one catastrophe.

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The duration and extent of any loss occurrence would be limited to-
 72 consecutive hours with reference to a hurricane, typhoon, windstorm, rainstorm
or tornado
 72 consecutive hours with reference to earthquake, seaquake, tidal wave or volcanic
eruption
 168 consecutive hours with reference to riot, civil commotion or malicious damage.
 168 consecutive hours for any other catastrophe of whatever nature.
If any catastrophe is of greater duration, the ceding insurer may divide the catastrophe into
two or more “loss occurrences”, provided no two periods overlap and no period
commences earlier than the date and time of happening of first recorded individual loss to
the ceding insurer in that catastrophe.
13. INDEX CLAUSE
The priority of the company and the maximum liability of reinsurer as set out in the
reinsurance agreement shall retain their relative values which exist at the date specified in
the schedule(s). At the time of claim payment, the change in monetary value shall be
ascertained from the latest available index as follows: IMF wage index.
During the payment of any claim, the priority of the company and maximum liability of the
reinsurer shall be increased or decreased in proportion to the increase or decrease in the
index from the date of commencement of this agreement to the time of payment of the
claim, provided such index fluctuation should be 10% or more. If such fluctuation is less
than 10%, this clause shall not be applied.
14. CLAIM CO-OPERATION CLAUSE
In occurrence of a claim in excess of limit, it is condition precedent to any liability to pay
under RI contract that – the reinsured shall, immediately upon becoming aware of such
occurrence, inform the lead reinsurer the right to co-operate with reinsured in the
adjustment of the claim or in the investigation of the occurrence and/or to appoint a
representative to do so on their behalf.
Claims Co-operation Limit: INR ______________ Estimated Gross Claim amount.

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15. CLAIM CONTROL CLAUSE

Whereas this policy is subject to reinsurance, it is agreed that the reinsurers shall have
complete control of the adjustment of all claims indemnifiable under the policy and the
reinsurer shall receive immediate notification from the insurers about any claim or possible
claim indemnifiable under this policy.
In the event of any legal proceedings, the reinsurers agree to follow the fortunes of
insurers and shall consider themselves bound by local laws, precedents and practices.
16. POLITICAL RISKS EXCLUSION CLAUSE
This clause states that the reinsurance excludes the loss, damage, cost or expenses of
whatsoever nature directly or indirectly caused by/resulting from/ in connection with any of
the following regardless of any other cause or event contributing concurrently or in any
other sequence to the loss.
(i) War, invasion, act of foreign entry, hostilities or warlike operations, civil war.
(ii) Permanent or temporary dispossession resulting from confiscation, commandeering
or requisition by any lawfully constituted authority.
(iii) Mutiny, civil commotion assuming the proportion of or amounting to a popular or
military uprising, insurrection, rebellion, revolution, military or usurped power, martial
law or state of siege or any of the events or causes which determine the
proclamation or maintenance of martial law or state of siege.
(iv) Any act of terrorism
This endorsement also excludes the loss, damage, cost or expenses of whatsoever nature
directly or indirectly caused by/resulting from/ in connection with any action taken in
controlling, preventing, suppressing or any way relating to points (i), (ii), (iii) and (iv) as
mentioned above. If reinsurer denies any claim by reason of this exclusion, the burden of
proving contrary shall be upon reinsured.
17. TERRORISM EXCLUSION CLAUSE
Notwithstanding any provision to the contrary within this insurance it is agreed that this
insurance excludes loss, damage cost or expense of whatsoever nature directly or
indirectly caused by, resulting from or in connection with any act of terrorism regardless of
any other cause or event contributing concurrently or in any other sequence to the loss.

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For the purpose of this endorsement an act of terrorism means an act, including but not
limited to the use of force or violence and / or the threat thereof, of any person or group(s)
of persons whether acting alone or on behalf of or in connection with any organisation(s)
or government(s), committed for political, religious, ideological or similar purpose including
the intention to influence any government and/or to put the public, or any section of the
public in fear.
The warranty also excludes loss, damage, cost or expenses of whatsoever nature directly
or indirectly caused by, resulting from or in connection with any action taken in controlling,
preventing, suppressing or in any way relating to action taken in respect of any act of
terrorism.
If the Company alleges that by reason of this exclusion, any loss, damage, cost or
expenses is not covered by this insurance the burden of proving the contrary shall be upon
the insured. In the event any portion of this endorsement is found to be invalid or
unenforceable, the remainder shall remain in full force and effect.
18. TERRORISM DAMAGE COVER ENDORSEMENT
When the insured opts for Terrorism Damage cover by paying additional premium as
provided under item no (6) above, cover will be granted by attaching the following
endorsement:
"It is hereby declared and agreed that in consideration of payment of additional premium
of Rs._______, the Terrorism Damage Exclusion Warranty of the Riot, Strike, Malicious
Damage provision forming part of the within mentioned policy stands deleted. The
expression/s "terrorism and/or act of terrorism" shall have the same meaning/s as
contained in Terrorism Damage Exclusion Warranty.
This endorsement does not cover loss of or damage caused by:
(i) Total or partial cessation of work or the retardation or interruption or cessation of
any process or operations or omissions of any kind.
(ii) Permanent or temporary dispossession resulting from confiscation, commandeering,
requisition or destruction by order of the Government or any lawfully constituted
Authority.
(iii) Permanent or temporary dispossession of any building or plant or unit of machinery
resulting from the unlawful occupation by any person of such building or plant or unit
or machinery or prevention of access to the same.

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(iv) The incidents like burglary, housebreaking, theft, larceny or any such attempt or any
omission of any kind of any person (whether or not such act is committed in the
course of a disturbance of public peace) in any action taken in respect of an act of
terrorism.
Additionally the following are excluded from terrorism cover-
(i) loss or damage, cost or expenses of whatsoever nature directly or indirectly caused
by, resulting from or in connection with any action taken in controlling, preventing ,
suppressing or in any way relating to action taken in respect of any act of terrorism.
(ii) If the Company alleges that by reason of this exclusion, any loss, damage, cost or
expenses is not covered by this insurance the burden of proving the contrary shall
be upon the insured.
The limit of coverage under this endorsement shall not exceed Rs. _______ (insert here
the overall liability limit for Material Damage + Loss of Profit). In respect of several
insurances within the same compound / location with all the Indian insurers, the maximum
aggregate loss (MD+LOP) payable per compound /location shall be Rs.2000 Crores (per
location limit of terrorism cover as stand increased w.e.f. 2017 & as currently applicable).
If the actual aggregate loss suffered at one compound / location is more than
Rs.2000Crores, the amounts payable under individual policies shall be reduced on pro
rata basis.
The coverage under this endorsement is subject to an excess of Re. 0.5% of the total sum
insured subject to a minimum of Rs. ______ (insert Rs. 25000 or Rs. 1 lakh as applicable)
for each and every claim in respect of both material damage and loss of profits combined."

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