Rule based Underwriting to Risk based Underwriting- New Journey

DRIVING INTO A DETARIFF ZONE

(A journey from rule-based underwriting to risk-based decision making)

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With the dawn of first January 2007 free pricing regime in non-life insurance has kicked in. Market has been given a free play with proper regulatory mechanism to control deviation. Free pricing in insurance sector is a global trend. Developed nations operate insurance in liberated market. Asia is also driving towards the detariff zone. It has brought in shifts in market share, created polarization and stirred up a wave of consolidation. In Japan it was a phased process over two years (July 98- June2000). It led to product innovation where insurers even introduced saving linked motor policies. While insurers initially resisted lowering prices intense competition eventually led to a price decline. Chinese Regulators adopted the trial and error method to usher the free rating system. Following a pilot project in Giandong motor rates were deregulated in rest of China from January 2003. While the motor loss ratio increased from 50 to 60% the price for motor cover declined to 16%. In our country since liberalization and with the entry of private players price decontrol was much in demand. Having chosen a competitive business model and yet retaining a tariff structure that governs the product feature and pricing was much debated both by the consumers and the providers who were prohibited to exercise their full choice. The insurance sector kept gaining the momentum after deregulation and in FY 2005-06 it achieved record Gross Direct Premium of Rs. 20387.61 crore with a robust growth of 16%. In order to put competition on top gear IRDA published the road map for detariffing well in advance to give sufficient time to the general insurers in the country to gear themselves for a truly liberalized regime. Insurers took this opportunity and time to collect data and to train their professional underwriter to meet the challenges of the competition. Things are changing at fast pace and will continue to change from now as the market is thrown open to real competition. In free market action and forces of aggressive competitors determine the prices but unscientific slashing of the rates may put insurers in real difficulties. Detariffing entails moving from rule-based underwriting systems and practices to risk-based decision making. It is essentially an acknowledgement of business reality and an attempt to differentiate the risk exposure. It means that pricing of insurance product is left to insurers based on their analysis and perception of risk. Transition from administrated pricing to risk based pricing has not remained smooth globally. It will not remain smooth here too it is known because in competitive excitement of procuring the business pricing component is the first victim. Competition is expected to carve down the fat margins that insurers were enjoying despite the liberalization of the market. Products in erstwhile tariff constitute 70% of Rs. 20,000 crore non-life market The rates for these protected products will head to south for sure but the market is not expected to experience the price-cut it faced when marine cargo segment was detariffed in 1994. It will have its initial problems but since there is no support and cross subsidy available to fire and engineering sector the price-dip will not go sharply down to unrealistic level.

Insurers should rate risks scientifically by prudent underwriting if they wish to maintain their solvency ratio without going back to their shareholders. Failure to do so may splash their balance sheets in red, their solvency margins down and this would also affect their reinsurance treaties. In the transition there may be few instances where the companies may come under severe strain in order to compete but detariffing is a logical step in the evolution of general insurance sector in the country. It will encourage technical rating, adoption of better risk management practices, elimination of cross-subsidisation leading to independent pricing for each segment of business. Consumer will benefited much from flexibility in pricing. This flexibility will enhance the competition with many players driving in. Free market is set to bring two major developments (a)- Transition from administrated pricing to risk based pricing. This has been made effective from 1^st of January and (b)- Product differentiation, which will represent the second phase of detariff regime. Competition will be fierce and insurers will have to transform suitably to meet the demand of dynamic environment.

Driving into a detariff zone is a progressive step towards a free general insurance market that carries with it the opportunities, challenges and risky propositions. Initially the market may behave unpredictably but in long run only genuine players will remain in bazaar and the market will attain its level following principle of demand and supply. New scenario will see the development of actuarial science, risk management, loss prevention and cautious underwriting. In addition to service and expertise the competition will also be for pricing and product innovations. There can be a kind of unhealthy competition among the insurance operators with the beginning of detariff era but regulator has taken many steps to ensure smooth transition from regulated pricing to competitive pricing in the sector. Regulator has cautioned that it will keep a vigil on the progress and will step in to resolve the problem if there are any turbulences. Before abolition of tariff regulator has set certain guidelines and rules for all players in the industry. It includes the underwriting philosophy of the company approved by its Board, IRDA’s right to question terms and right to issue directions if product or its pricing is not appropriate. The file and use requirement for new products will have to be more accountable with justified rating & proper product plan. Data support and role of actuaries has also been defined to ensure that business is transacted along proper lines. Before bringing the free pricing to effect fears of all sectors have been considered after a long thoughtful process of deliberations from all concerned. Motor portfolio that hit a roadblock and which was a cause of worry for all the players has also been tackled in best possible manner. A change in the rule has suddenly changed the interest in the game. The new pooling arrangement limiting the premium income and corresponding damage to individual balance sheet has suddenly made even the traditional commercial vehicle T.P. cover an attractive segment.

This paper now discusses the impact of free pricing on different segments that followed administrated pricing in the erstwhile tariff.

IMPACT ON FIRE AND ENGINEERING PORTFOLIO

Fire and Engineering portfolios have remained most chased profitable segments for insurance providers. Profit margin on these segments would now be put to severe strain due to competitive pressures. At present fire portfolio is the second largest segment having 18.4% of market share of the non-life business. In FY 2005-06 premium for this segment was Rs 3751 Crore. Engineering segment in India is having 4.2% of total general insurance premium. In FY 2005-06 engineering premium colleted by Indian insurers was Rs. 856 crore. These portfolios have developed in India to a large extent as a lender driven market. Bank’s and Financial Institutions have been the major drivers of wealth creation and insurance as a necessary collateral has grown alongside. In competitive scenario such banks, which have already taken the new role of corporate agents, will have better negotiating power to gain major reduction in pricing for proper insurance. Tariff free regime is expected to open up new opportunities and it will also present new challenges to insurers. Small and marginal customers desiring property coverage will get nominal benefits as insurers will offer them rule-based underwriting products depending upon their internal guide tariffs on class-based pricing. These rates are expected to be 20% lower than the former tariff rates. Those who are watchful will also be able to negotiate further discounts in shape of claim-experience and discretion discount that is now available with the underwriters as per the policy of their company. In retail, the targeted segments will be charged lesser than non-targeted segments. The individual rated products will, however find many chasers and clients seeking cover for these products will be able to find attractive price tags for coverage of their risks. In long term deregulation is beneficial but in short term it may cause price wars and turmoil. Gainers, in free pricing regime, would be large corporate who have volume and the clout to secure heavy reduction in rates. They are capable of negotiating substantial price reduction in fire and engineering segment. There is a threat that reinsurers will also be forced to support such price wars. Initially companies would see higher loss ratios and proper reserving would be required to maintain the solvency. Should companies resort to under cutting premia to uneconomic levels they would be brought back by the losses they may face? Though the regulator has conveyed that premiums will not be allowed to drop below 20% beyond the current levels on renewals but the initial reports, after the demise of tariff, suggests that premium for all categories have dropped much beyond 20% deviation permitted by the IRDA in fire segment. With relaxed claim experience discount FEA discount and discretionary discount fire product is available upto 35-40% cheaper than one-time tariff rates. Engineering portfolio is also facing rigid competition but the segment has initially maintained the fall in rates within the expected margin.

Market based pricing has its own tricks that largely depends on systematic database and actuarial calculations based on pure risk formulae. Absence of statistical data would compel insurers to price risks on assumption either with conservative element built into it or they will be forced to follow the rates of any of its forceful competitor. Presence of brokers will put more pressures on underwriters. Competition is still young in India, just seven years old, and market needs the protection from regulator in initial days. Regulator is expected to chip in the role that a guard plays in protection of young plant till it attains maturity. There are comfortable margins in erstwhile tariff rates. These margins were used to cross subsidise the other segments like motor, health and marine. Pricing of fire and engineering segment will surely go down but providers should watch the trend and should not indulge in the price wars. They should ensure that their database is properly aligned with key rating factors. A risk should be judged on its own merits and detariffing will force insurers to scale up their risk assessment capability and give the underwriting function its due importance in insurance process. Competitive dynamics will force to eliminate cross subsidisation provided to other segments but ability to respond suitably to the dynamics of the market will depend on scientific rating, adoption of better risk management practices leading to independent pricing for fire and engineering lines based on pure risk plus loading for procurement cost, expenses and margins permitted by the marketing force. It should be remembered that India is a tropical country. Floods and cyclones are quite natural here. It is also a seismically active zone hence prone to natural disasters. Any thing below the pure rates just to beat or meet the competition may turn disastrous.

In short run the competitive forces may force the insurance providers of property line to operate on cash-flow basis. Except in Japan most of developed countries follow cash flow underwriting resulting in underwriting losses and survival on investment income. This, however can not be the part of business strategy in long run.

IMPACT ON MOTOR PORTFOLIO

Motor insurance has retained its position as largest and fastest growing portfolio having 42.6% of general insurance premium. In FY 2005-06 the premium collected by motor insurance providers in India was Rs. 8685 Crore. Public sector companies wrote 81% of total motor premium as under:

Rs in Crore

New India	National	Oriental	United India	Public Sector Companies	Total premium in Motor sector
2476.40	1848.93	1538.65	1138.16	7002.19	8685

 The above figures clearly depicts that this segment has not attracted the private players. It appears to be the simplest to underwriters but the experience of Indian market during the last 2 decades has been anything but satisfactory. The problem of industry is unlimited T.P. liability and the trend of court awards that is making motor insurance as a whole unviable. Entire industry is losing heavily on auto insurance especially in commercial vehicle segment. The revenue bleeding is so severe in this segment that it forced private players to remain away from it and even the public sector companies started cautious underwriting for truckers and old commercial vehicles. It is pertinent to note here that third party risk coverage is mandatory in our country and non-availability of cover was going to multiply the problems to all concerned. There was a fear that once the market is thrown open for free pricing of this sector the insurers will gang up to fix very high tariffs. These problems posed major challenge before the Regulator and after a thoughtful process regulator addressed this problem with an incredible solution by creating common pool. With new rules of underwriting the T.P. premium the outlook of insurers has suddenly changed in the very first week of the opening of the market and the OD segment has also been left free for its independent rating based on underwriting experience of the insurers.

For motor third party risks IRDA has now set up a ‘Third Party Pool’ where all T.P. liabilities will be underwritten and claims will also met out of the same pool. All the insurers will continue to underwrite motor T.P. premium and process the claims as before but all this will be in account of the pool. T.P. cover to all vehicles is to be granted as per the IRDA approved rates for the pool business and all insurers registered to carry on general insurance business or general re-insurance business have to collectively participate in a pooling arrangement to share in all motor third party insurance business underwritten by any of the general insurers in the country. The pooling of business among all insurers will be achieved through a multi-lateral reinsurance arrangement between the underwriting insurer and all the other registered insurers carrying general insurance business and general insurance reinsurers. The participation of GIC in the pooled business will be 20% of motor business that is ceded to it by all insurers as statutory reinsurance cession under section 101 A of Insurance Act. The remaining business after such cession to GIC will be shared among all registered general insurers writing motor insurance business in proportion to gross direct general insurance premium in all class of general insurance underwritten by them in that financial year. Defining these rules regulator has estimably left no scope for refusal or temptation to charge higher premium for third party segment. There will be no agency commission or brokerage payable in respect of this segment. The real icing is the fact that underwriting insurer will now get reinsurance commission of 10% on premium ceded by it to all other insurers and reinsurers. These directions under Section 34 of Insurance Act for Motor Third Party insurance have well taken care of several complaints regarding the non-availability of T.P. insurance especially for commercial vehicles. This was in public interest and Regulator has ensured that all insurers who were expressing difficulty in underwriting unless they were permitted to charge the rates they consider appropriate have suddenly found it an attractive portfolio to chase now. Regulator has reasonably hiked the erstwhile tariff rates by 33 to 34% for private cars (for cars more than 1500 cc the hike is of 257%) and for other class of vehicles by 122 to 150%.

To rate vehicles for own-damage section, the insurers are now free to charge differential rates. The O.D. segment is a profitable segment on current rates and insures have opted to reduce the OD rates by 20% in private car and two-wheeler segment. Commercial vehicles are also enjoying 10 to 15% discount in OD section in normal case and in case of fleet owners, automobile manufacturers & dealers, financers handling large volumes further discounts to an attractive extent are available from all insurers. Old vehicles are subject to loading charged by few insurers. Insurers have not attempted to made much changes in the rating factors at present but in near future RFRS (risk factor rating system) like profile of driver, occupation, use of vehicle, incidence of theft, repair costs will contribute a lot in deciding the price of insurance. People who clock fewer Kms on their dashboards will be able to wrangle more discounts. Sloppy & slack driving will become expensive. Existing IDV based pricing will soon be outdated and it will be replaced with statistically based pricing. The insurance premium may soon play a major role in deciding which vehicle one should buy.

Maruti Udhyog Limited, the largest car buyer, which holds 54% of market share, could be the first to come up with a strategy to gain lower rates by reducing cost of its spare parts. It already had a series of meetings with PSU’s and private insurers to understand the rating factors for judging motor insurance premium. It is learnt that MUL is working with one of the public sector company for procuring a software solution from a UK based Software Company to generate a database on motor insurance claims. Automobile Industry, so far has been selling its products on the basis of celebrity endorsements, alleged ratings by media without independent third party verifications, self-promoted claims related to safety features. It has got away with it because Indian market is relatively uninformed one. Insurance sector has also practiced universal rates in erstwhile tariff system. Practice in western parts of the globe is different where differential rating is charged to different models and substantial reduction in rates is offered only for vehicles equipped with safety features like driver and passenger side air bags, side impact airbags, automatic seat belts, ABS brakes, fraction control and fog lamps.

IRDA is planning to set up a rating agency to evaluate safety features of cars with the objective of helping general insurers to determine differential pricing while insuring different models. This facility will be established in Tamil Nadu, which has offered to give 50-acre land for this purpose.

IMPACT ON OTHER SEGMENTS

Non-Tariff products will also take the heat and impact of free pricing in property segment. Insurers today are free to trade these non-tariff portfolios on self-developed product features to differentiate it with other products in market at their own rates. The major impact of free pricing will be seen in the Marine and Health sector, which at present are cross-subsidised by former tariff covers. Health insurance has its strong presence in the non-life market with 11% of market share. Marine portfolio has a market share of 6.3% of total general insurance premium.

Insurance providers, till today, were offering the marine cover at throwaway prices while negotiating the fire and engineering covers. Health covers were also made available to the corporate clients at very attractive terms on very low rates. Now when the market forces will take away the cross-subsidy facility insurers will be forced to re-look at these rates, which are expected to move north the moment pressure of squeezed margins is felt in property portfolio. Rationalisation of rates in these sectors will be directly proportional to the sensitive exposure of these risks on their pure risk experience. Insurers should also gross up the designated pure risk rates for these lines to cover their administration and procurement expenses and expected profit margins according to their best underwriting judgement.

Insurers are free to have their own product features and pricing in health segment. Innovation is the buzzword for the long run sustainability. Industry understands the utility of the product differentiation when there exist many players in the market. So new variety of products and services is the need of industry. Competition has already given medical insurance concept a whole new dimension by including pre and post hospitalisation reimbursement coverage for pre-existing illness, tie ups with hospitals and TPA’s for dispensing the policy. Today there are wider covers and standalone specific covers covering the major surgeries available in health segment. It is important to understand the fine print.

Workmen Compensation Insurance has also been set free from the ambit of tariff. The public sector companies wrote Rs 294.11 crore premium in this sector in FY 2005-06 and New India, alone, booked Rs 201.22 crore premium. This sector will not face the blaze of the competition, as it is specialised cover with not so many chasers in the market. Premium for Shopkeepers and Householders policy and other package covers like Office Umbrella, Kissan package etc will also see reduced rates as most of them includes erstwhile tariff rates for fire and engineering sections built in their packages.

IMPACT ON DISTRIBUTION

Distribution business will also change in free competitive market. Insurers will be forced to quote lower rates and pay procurement cost to intermediaries at higher/same rates that will push up their costs. Market will experience large number of intermediaries who will act as bridge between the insured and the insurers. Institute of Brokers is expected to take big leap by capturing 30-35% of business like in other parts of the world in next three to five years. At present brokers are leading intermediaries (Table-1) world over and the broking insurance is picking the pace in Indian market as well (Table-2).

TABLE-1: SHARE OF BROKERS IN INSURANCE BUSINESS

USA	INDONESIA	BRITAIN	AUSTRALIA	SPAIN
65%	50%	40%	20%	15%

TABLE: 2               BROKERAGE PAID IN BY GENERAL INSURANCE PROVIDERS 2004-05 (Rs in Crore)

NATIONAL	NEW INDIA	ICICI LOMBARD	ORIENTAL	UNITED INDIA	BAZAJ ALLIANZ	OVERALL
26.62	19.82	15.78	13.91	13.25	10.04	124

 Brokers, in competitive scenario will be bulk purchasers of insurance on behalf of their several customers and they will be able to extract better deal and price as opposed to single buyer. Brokers perform their best in free market and where they have knowledge and expertise to negotiate best competitive deal. They have definite role in creating risk awareness, widening customer base and development of insurance business. In tariff conditions they were perceived as cost burden as they were not able to bring value addition to their clients. Now the situation has taken a different shape particularly when in PSU’s role of development officers has diminished a lot.

The agency distribution system of general insurance products is perhaps a century old. If we believe the survey conducted by FICCI the agents will remain the key factor of the distribution business as the brokers have not got the desired recognition till date. Public sector companies are rebuilding the agency force to meet the challenges of new scenario. The key to success for any insurer will be how it manages its relationship with the distribution channel in free market.

CONCLUSION

Insurance in India started without regulations in the 19^th Century. It was a typical story of colonial era. It was in 1938 when Insurance Act was enacted to give it a legal shape. After independence LIC was nationalized in 1956 and General Insurance was nationalized in 1972. Only in 1999 private players were allowed back into business with maximum of 26% of foreign holding. Liberalisation got a new meaning and wave with the decision of regulator to set rates free in the general insurance business. In second phase, next year, the product features and wordings will also be free from regulations. Development of insurance industry to present stage is through smooth transition and there is no reason to depart from this tradition. Insurers need to change proactively at this crucial time. It is not the time to wait until they are forced on to the defensive side. One thing is clear if you wish to succeed in competitive era either embrace the change as ally or run the risk of being strangled by events.

The road is bumpy with many speed breakers ahead but the journey from rule based underwriting to risk based decision-making calls for safe and sensitive driving in detariff zone. All that is needed is to maintain the essential characteristics of insurance business so that insurers do not find themselves at the cross roads without a road map looking trifle lost and sorry. Doing business with a strong sense of values is a win-win game for all. In intense competition when you deal price sensitivity at the same time you need to match your pace with that of market and companies with innovative mechanism and lean cost structure take the lead ahead of their competitors.  Look at the other encouraging factors growing GDP, economy galloping at almost 8-9% a year, percentage of people below the poverty line is coming down, industrial progress is tremendous, people are becoming insurance conscious and industry is poised for good growth. Challenge is exciting for insurers let us wish all of them a good driving experience.

VINAY VERMA

Divisional Manager, Oriental Insurance

(Views in the article are in individual capacity of the author and are not in his official capacity.