Insurance Industry is Capital Intensive and Claim Sensitive

Insurance industry is capital intensive and claims sensitive. Adequacy of capital for a successful insurance operation is a must. Insurance is an invisible trade. Being an intangible product, it embodies a pledge of protection. By default, insurance transaction relates to assumption of risk—that is reflected in collection of premium—and later paying off claims as and when arise and set aside some money as a residual for future servicing to policyholders. Its quality depends on a visible assurance of the ability to redeem this pledge, as much as on the intrinsic worth of the protection provided. It may sound simple but in reality, it is far more complex.

Insurance companies are balance-sheet-driven businesses. Investors use balance sheets to evaluate a company’s financial health. In theory, the balance sheet provides an honest look at a company’s assets and liabilities, enabling investors to make a determination regarding the firm’s health and compare results against the firm’s competitors. Because assets are better than liabilities, companies want to have more assets and fewer liabilities on their balance sheets.

Capital is a scarce commodity and it comes at a cost. Since debt capital appearing on the balance sheet involves constraint and cost, insurers often tend to increase their net worth to transact insurance business in a frequently competitive market by taking recourse to ‘Off-Balance Sheet Capital’ obtained through reinsurance and further down the line by retrocession.

Regulatory compliance requires an insurance company to arrange first a proper risk transfer mechanism which is known as reinsurance facility for shedding off the additional exposure beyond its limit of retention on any one risk. This is known as ‘Off-Balance Sheet Capital’ as this is a kind of capital that is not visible on the balance sheet but remains obscured that provides financial strength to the company to assume more risks to augment its business.

All claims that are reported during the period are not claims expenses. This is because some claims may not have been settled during the year and remained outstanding or some claims may not have been reported yet but have already incurred during the period or some are reported inadequately due to lack of information for which some ‘actuarial’ adjustment is made. This adjusted figure in claims is called ‘incurred claims’ for the accounting purpose.

The premium income received from policyholders during current financial year is not the real income to arrive at profit or loss. This is because some policies issued during the current year may yet to run till next year and so some adjustment is to be made to keep provision for policyholders to the extent of premium that is yet to expire. This is known as adjustment for ‘unexpired premium’.

An Insurance company derives its revenue from domestic as well as overseas operations against which part of the money is paid to reinsurers towards cost of protection against catastrophe losses or routine claims during the period under review. This is known as premium ceded to reinsurers and thus net income is taken into the books after adjustment of unearned premium.

There are many instances around the world where insurance companies have failed following inadequacy of capital and inefficient management. The purpose of insurance operation is to service the capital adequately and appropriately. If the adequacy of servicing relates to the probability of increase in shareholder’s value, its appropriateness concerns claims paying ability for which the capital is deployed.