SP7-01: Insurance companies Page 35
Chapter 1 Summary
The existence of general insurance is good for society as a whole and for individuals.
On one side of the balance sheet are free reserves and technical reserves. On the other we
have all the assets.
Technical reserves (or insurance reserves) might be split into:
Past events: – outstanding reported claims
– IBNR and IBNER
– re-opened claims
– claims handling expenses
Future events: – UPR
– AURR
Insurers may also hold catastrophe reserves or claims equalisation reserves.
The claims reserves might be shown as one amount for outstanding claims and one for
unexpired risks.
Claims reserves occur because there are reporting delays, settlement delays and premature
closure of claims files. Claims reserves are generally larger for long-tail classes of business.
Estimates for outstanding claims reserves are carried out by estimates of individual
outstanding claims or by using statistical methods for the totals. Individual estimates can’t
be used for IBNR.
Claims reserves are estimates. Therefore any work which is based on claims reserves should
recognise the uncertainty underlying the estimates. This uncertainty is generally greater for
long-tail classes.
UPR is the portion of premiums set aside to cover the claims and expenses for future
accounting periods for which premiums have already been received.
URR is a prospective assessment of the amount required as at the accounting date to cover
the claims and expenses from the unexpired risks.
AURR is the excess of URR over UPR, subject to a minimum of zero.
Free reserves are the excess of assets over technical reserves. They may also be referred to
as free assets, the solvency margin, shareholders’ funds or capital employed.
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Page 36 SP7-01: Insurance companies
Chapter 1 Summary continued
The size of free reserves is an important determinant of:
the amount of business the company can reasonably write
the size of risks written
the amount of risk within the investment strategy
the need for reinsurance.
Premium rating can involve techniques such as:
a burning cost approach
a frequency severity approach
modelling aggregate claims distributions
identifying appropriate rating factors eg using GLMs and other multivariate analyses
original loss curves, often used to price reinsurance contracts where past data is too
sparse to be credible.
Adjustments will be made to past data to ensure it remains a good predictor of future
experience. Further adjustments will be made to arrive at an ‘office premium’. For example:
allowance for reinsurance and investment income
loadings for profit and expenses
commercially-driven adjustments eg no-claims discounts, allowance for the
insurance cycle, policyholders’ reactions, the company’s strategic objectives and the
state of the insurance cycle.
Capital modelling is the process by which general insurers ensure they hold enough capital to
meet all their obligations subject to a given degree of confidence, and allocate this capital to
different areas of the business.
A good capital model will include assumptions on all aspects of the business which will affect
its future financial strength, and can be a considerably detailed exercise. It may include
stress testing, scenario testing and stochastic modelling.
The level of capital held by a general insurer will depend on the riskiness of the insurer’s
activities. Allowance should be made for the level of correlation between different risks.
The main influences on the investment strategy will be the currency, term, nature and level
of uncertainty of the liabilities (these factors are determined mainly by the classes of
business written), the size of the free reserves, and legislative factors.
The profit of an insurer is the excess of premiums and investment returns over claims and
expenses.
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SP7-01: Insurance companies Page 37
Chapter 1 Summary continued
Earned premiums, rather than written premiums, should be used to determine underwriting
profit. Similarly, we should use claims incurred rather than claims paid.
Claims incurred is claims paid plus the increase in outstanding claims reserves.
Underwriting profit equals earned premiums less claims incurred less expenses incurred.
The cashflow diagram is a useful way to study the mechanics of a general insurer. The
diagram includes all the main monetary flows:
premiums
claims
expenses (including commission)
investment (in & out)
reinsurance (in & out)
dividends (ie out to shareholders)
rights issues (ie in from shareholders)
tax.
Reinsurance can protect insurance companies from various risks that may otherwise be too
large for them to bear.
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