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Wednesday, October 1, 2008
Reserves and underwriting

Most businesses present their financial position by subtracting all costs from gross income and ending up with a profit (or loss) before tax. Their balance sheet will show assets (hopefully) more than liabilities, having made adjustments for depreciation of equipment against the year’s income. And that’s about it in a nutshell.

But when it comes to insurance it is far more complicated. That’s because the income for the year of a short term insurer isn’t really its income, while its claims paid aren’t really all the claims; so working out its ‘profit’ for the year is tricky, and depends on the accurate calculation of various reserve requirements to provide for future liabilities. Make a mistake and a company appearing to be very profitable could be heading for financial distress.
There are several types of reserves put aside to keep an insurer’s books in order, aside from any normal business reserves such as for taxation, or property valuation adjustment. There are four reserves gathered together under ‘Technical Reserves’:
UPR (Unearned premium reserve) – or ‘Unexpired risk reserve’: the UPR is a portion of the premiums received as relate to a future period of insurance, that is, for unexpired risks, also referred to as an ‘advanced premium reserve’.
Unexpired risk provision: this is additional to the unearned premium provision for business risks to which the insurer remains exposed into the next accounting period. It is an estimate of future claims that may exceed the earned premiums on those risks. It may be tucked away in the UPR.
Claims outstanding, or ‘Loss reserve’: these are claims reported but not yet paid out. They may also be referred to as claims intimated but not finalised.
IBNR (Incurred But Not Reported) reserve: also termed ‘claims incurred but not reported’. These reserves are based on previous years’ experience to provide for losses resulting from insurable events that have already occurred during the period of insurance, but that the insurance company concerned has not yet been notified. Quite a few of the claims will arrive within a month or so after the expiry of the policy. But there are complications arising from so-called ‘long-tail’ business where it can take more than a year to present a final claim. This usually arises from product liability, marine and professional indemnity insurance, for instance.

Other reserves include:
Contingency reserve: this is a legal requirement, and is a portion set aside to cover abnormal losses arising from such events as floods, earthquake or other natural catastrophes; events that could take place once in a decade or two years running. It is used to ‘smooth out’ the annual claims experience, and protect the insurer from an exceptional claim. It might also be referred to as a ‘Claim fluctuation reserve’.
Retained reserve: a portion of reinsurance premiums due to a reinsurer may be retained as collateral security for the performance of said reinsurer’s obligations under a treaty.
Claims incurred: these are claims paid out for the period, less outstanding claims and IBNRs at the beginning of the period, plus outstanding claims and IBNRs as at the end of the period.
When all the reserves have been accounted for, then the bottom line can be calculated, the net profit after tax revealed and a share dividend declared. Occasionally you will see a credit from reserves, because the company concerned has reviewed its business and decided its outstanding risks were lower, so this figure would increase the bottom line profit.

Getting the underwriting figure

While annual reports are usually very comprehensive some of them (and especially the unaudited interim reports) may not directly divulge all the information. One interesting and useful figure is the underwriting performance. Did the company, for example, make an underwriting profit or an underwriting loss? This question refers to the results of the company’s insurance business, and does not relate to other income streams, for example, investment returns, capital adjustments, property valuations, or disposal or purchase of assets.
The final profit/loss figure given, of course, is after these items have been taken into account, and after dividends have been paid out and any tax on profits accounted for. But while insurance claims are noted, together with management expenses, commissions and of course, the gross premium income, the underwriting figure may not be readily apparent.
Here is an example of how to work this out, using the June 2008 interim figures of Zurich Insurance, as explained by the company’s finance department.
At first glance Zurich made a profit before tax of R376 million for the 2007 year. However, a look at the ‘Other Income’ figure shows that R389 million of this was as a result of investments, asset adjustments and commissions received. This would suggest an underwriting loss of about R11m (R389m – R376m) not a profit from its insurance business.
However, it gets complicated because the R11m loss would be incorrect. Reinsurance commissions earned need to be included, while expenses relating to investments must be excluded.
The second table shows the correct picture, an underwriting profit for the year of R101,3 million.
Start off with the expenses. The gross acquisition costs are essentially brokers’ commissions and sales staff costs. So the amount recovered from reinsurers (they must also share in the commission expenses for the business they get) must be deducted: R609,3 million less R109,3 million = R499,9 million. Now the internal staff administration and technical costs need to be added, which gives us R809,1 million. Add this to the net insurance claims of R2 436,7 million to get the total insurance costs of R3 245,2 million. Deducting this from net earned premium of R3 347,3 million illustrates the underwriting position. By Nigel Benetton

Copyright © Insurance Times and Investments® Vol:21.9 1st October, 2008
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