INTRODUCTION TO INSURANCE - SELF STUDY MODULE

CONTENTS
MODULE DESCRIPTION
NUMBER
1 INTRODUCTION TO SELF STUDY MODULE
2 CONCEPTS AND NATURE OF INSURANCE BUSINESS
3 OVERVIEW OF INSURANCE COMPANY OPERATIONS
4 CONCEPTS AND NATURE OF REINSURANCE BUSINESS
5 INTRODUCTION TO RESERVING
6 GLOSSARY OF INSURANCE TERMS
Introduction
1. INTRODUCTION TO SELF STUDY MODULE
The objectives of this self study module are to enable the reader to gain
(i) an understanding of the concepts and nature of insurance business
(ii) a basic understanding and overview of the insurance company operations and main
technical difficulties likely to be encountered on insurance assignments.
(iii) an understanding of the concepts and nature of reinsurance business.
In view of the specialist content of this module, it is unlikely that a reader, with no previous experience of
insurance, will be able to complete the module in less than 10 hours.
Readers should refer to the Glossary of insurance terms attached wherever new terminology is
encountered.
This module deals with general insurance business only.
2. CONCEPTS AND NATURE OF INSURANCE BUSINESS
SELF STUDY MODULE
CONTENTS
2.1 WHAT IS INSURANCE ?
2.2 THE INSURANCE CONTRACT
2.3 PARTIES IN THE INSURANCE MARKET
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2 - CONCEPTS AND NATURE OF INSURANCE BUSINESS
2.1. WHAT IS INSURANCE?
2.1.1 Insurance is a social device enabling a member of the public to reduce the risks to which he is exposed
by spreading those risks over the insuring community. The insured will enter into a contract with an
insurer under which, in exchange for a premium payment, the insurer undertakes to reimburse the
insured for the financial loss arising as a result of certain specific perils during a stated period of time.
The premiums paid by all the insureds contracting with a particular insurer build up into a fund which is
available to meet claims made by individual insureds. If insurance is to be successful it is essential that
the fund is adequate to meet claims arising. This presupposes that it is possible to quantify the
likelihood of claims materialising so that premiums can be charged at an appropriate rate. The insurer
will normally benefit from any surplus on the fund or be called upon to make good any deficit.
Risk
2.1.2 Some degree of risk attaches to almost every kind of activity in which one can engage. The following
types of reaction to risk can be identified:
(a) Ignore. One may be unaware of a particular risk and therefore take no action to avoid it.
(b) Assume. One may be aware of a risk but deliberately take no action because the consequences
are not serious or the probability of the risk crystallising is so remote.
(c) Avoid. Do not indulge in the activity giving rise to the risk.
(d) Prevent. Take part in the activity but exercise measures to prevent the risk from crystallising.
(e) Mitigate. Accept that the risk may crystallise but take steps to minimise the adverse
consequences.
(f) Transfer. Accept that the risk may crystallise but transfer the financial consequences to
another party.
2.1.3 Insurance is an example of transfer of risk, whereby the insured is able to substitute a known cost for a
liability that may or may not crystallise to a greater or lesser extent. The insurer is then exposed to this
potential liability but he will have accepted a great many risks of a similar nature and the presupposition
which makes insurance possible is that not all these risks will give rise to a loss. The law of large
numbers applies. Thus although it is not possible to predict whether a particular car will be involved in
an accident, it is possible to make a reasonable estimate as to what proportion of cars out of a
population of, say, 100,000 will be involved in accidents in a period of twelve months. This proportion
will depend partly upon the competence of the drivers concerned and the areas in which they are
driving; hence one finds higher premium rates for young drivers, no claims bonuses and differential
rates according to postcode.
Premiums
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2.1.4 From what has just been said, it will be appreciated that an insurer will attempt to fix a premium rate
which is equitable in terms of the probability of a claim arising and the likely magnitude of such a claim.
While it is obviously undesirable from the point of view of policyholders to be overcharged for
premiums, undercharging is equally undesirable, since the insurance fund must be solvent if the transfer
of risk is to succeed in its objective. In life assurance, the use of actuarial science enables premiums to
be determined on the basis of the mortality pattern of a large sample of the population; in general
insurance rating techniques are less precise. While an insurer will have laid down tables of rates for
standard types of risk, in many cases it will be left to the underwriter (the officer or employee of an
insurer who has authority to accept risks on the insurer's behalf) to fix a premium rate on the basis of his
"feel" for a particular type of business.
2.1.5 After the initial premium has been paid there may, during the term of the contact, be some amendment to
the insurance arranged (for example, if the policyholder changes his car). Where this is the case there
will be an endorsement to the policy to evidence the change in the contract, and the insured may be
called upon to pay an additional premium if the circumstances warrant it. In general there is no right to a
return premium unless the contract specifically provides it. There are types of insurance, such as
employers' liability business, where the final premium cannot be determined at the beginning of the
period since it is based on the number of employees on the payroll during the policy year. In these
circumstances a deposit premium will be paid on inception with a subsequent adjustment premium
(additional or return) when the final amount is determined. If no return premium can arise, the original
payment will be referred to as a minimum and deposit premium.
2.1.6 For most types of insurance, the insured will need to renew the cover when the period of the contract
expires. The renewal represents a separate contract, and the insurer is normally free to alter the terms
(e.g. raising the premium) or refuse the risk altogether; the insured may also decide to seek another
insurer. A major exception arises with whole life or endowment life policies. Since the likelihood of
death increases with age, life cover effected for a period of twelve months would become increasingly
expensive as the policyholder aged. For this reason, the majority of life business is written as a
continuing contract with a level premium; this results in the policyholder paying relatively more in the
early years than is necessary to cover the underlying death risk, but benefiting from relatively cheap
cover in later years.
Claims
2.1.7 A claim can arise at any time during the period of an insurance contract. The fact that a claim payment
(effectively the insurer's cost of sales) is made after the premium (i.e. the insurer's sale) is received
represents an important distinction between insurers and trading or manufacturing companies, and
gives rise to special problems of profit determination. Delays can also arise in notifying the insurer of
incidents giving rise to claims. Such incidents are known as "incurred but not reported" claims (IBNRs)
up to the date of notification and "notified claims" thereafter. Although a policyholder will normally
notify a claim a soon as possible, certain types of claim may not become apparent for a number of years
(e.g. latent diseases such as asbestosis or damage to a ship which can only be detected in dry dock).
2.1.8 An insurer will need to be satisfied that a claim is valid in the sense that an incident which is covered by
the contract has in fact occurred during the term of the contract and has caused the insured to suffer
loss. There are two important principles involved:
(a) Indemnity. The purpose of a claim payment under an insurance contract is to restore the
insured to the financial position he occupied immediately before the event causing the loss
occurred. An insurance policy will state the sum insured, but this simply represents a maximum
which will only be paid out in full in the event of the total loss of the property concerned. For
example, if a ship is so badly damaged that the cost of restoring it would be disproportionate,
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the insurer may decide to treat it as a constructive total loss although in such cases the insurer
would assume the benefit of any proceeds arising from the salvage of the ship. There may be
cases where an insured has the option of claiming under an insurance policy or suing a third
party who was responsible for the loss. The insured could not do both since, contrary to the
principle of indemnity, this would result in his being better off as a result of the loss. If the
insured chooses to claim under the policy, then his right to sue the second party is subrogated
to the insurer who may thus seek to reimburse himself for the cost of the claim.
(b) Proximate cause, which was defined in Pawsey v Scottish Union and National as follows:
"Proximate cause means the active efficient cause that sets in motion a train of events which
brings about a result, without the intervention of any force started and working actively from a
new and independent source".
When a person effects an insurance policy on his house what he is insuring is not the house
per se, but loss arising from damage to the house caused by one of a number of specified
perils. An incident will only give rise to a claim payment is one of the specified perils is the
proximate cause of the loss. The proximate cause of the loss will not always be clear - what, for
example, is the position if a fire weakens a wall but leaves it standing and it is subsequently
blown down by a gale? This principle can be of considerable practical importance since many
policies refer to excepted perils (e.g. explosions under a fire policy), and no claim is payable if
one of the excepted perils is the cause of the loss. An insurer will normally set up a file for each
notified claim to house all relevant documentation and evidence progress in the negotiation
and settlement of the claim. It is clearly vital to maintain proper control over outstanding claims
records; at the year end an estimate of the total cost of outstanding claims will have to be
arrived at from the records and included in the accounts. The majority of claims will be
administered by an insurer in-house, although certain large or specialist claims may be dealt
with on behalf of the insurer by a loss adjuster (an independent and highly trained claims
expert).
2.2. THE INSURANCE CONTRACT
2.2.1 Under general contract law there are seven essential features of a contract:
(a) offer and acceptance;
(b) intention to create legal relations;
(c) formalities;
(d) consideration;
(e) capacity of the parties;
(f) genuineness of consent; and
(g) legality and possibility.
These must all be present in a contract of insurance.
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2.2.2 Offer and acceptance
Subject to any vitiating factor, a contract will come into being when an offer made by one party is
unconditionally accepted by the other party. It is important to distinguish the contract of insurance (i.e.
the agreement that the insurer will provide cover in exchange for a premium) from the policy which is
simply a document providing evidence of the existence of the policy and its terms. The precise moment
that a contract comes into being can be of considerable importance in determining whether an insurer is
liable on a risk. In most cases, the person seeking cover will make a request to the insurer to provide
insurance by completing a proposal form, and the insurer will consider whether or not to provide
insurance cover. The initial proposal may be construed as no more than an invitation to treat; the offer
will be made by the insurer when a premium rate is quoted and the prospective insured will accept or
reject the quoted premium.
2.2.3 Intention to create legal relations
There is usually no doubt as to this matter in the context of an insurance contract.
2.2.4 Formalities
There are a number of different types of formality that may need to be observed in order to form a valid
contract. Certain contracts are required to be made under seal, or made and evidenced in writing. Any
other contract may be made verbally and subsequently varied verbally (even if originally made in
writing). Contracts of marine insurance are required to be evidenced in writing and although there is no
similar legal requirement for other classes of business, in practice all contracts of insurance are
evidenced by a document known as the insurance policy setting out the terms of the contract. An
insurer will have a number of standard terms that are incorporated into all policies; any individual policy
will comprise these standard terms together with a schedule setting out such details as name of
policyholder, sum insured, etc. Pending issue of a formal policy, an insured may be issued with a "cover
note"; this is particularly important for the purposes of the Road Traffic Acts since a motorist must be
able to produce evidence of third party liability cover on his vehicle.
2.2.5 Consideration
Except in the case of a contract under seal it is necessary for each party to the contract to provide some
consideration (the law does not enquire into the adequacy of the consideration). The consideration
provided by the insured is the premium, while the consideration provided by the insurer is the promise
to pay a claim should the insured suffer a loss as a result of one of the perils insured against.
2.2.6 Capacity of the parties
In general contract law there are a number of circumstances where one of the parties is deemed to lack
contractual capacity (e.g. because he is a minor or was drunk or insane at the relevant time) and hence
any contract made is void. In the case of insurance a further positive condition needs to be satisfied: a
person making an insurance contract is required to have an insurable interest in the subject matter of the
insurance.
Thus yacht owner A could insure his own yacht against loss or damage at sea, but not that of yacht
owner B unless, for example, A had loaned B some money and had taken a fixed charge on B's yacht as
security. Insurable interest is one of the main distinctions between insurance and gambling.
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2.2.7 Genuineness of consent
There are a number of matters which can render a contract void or voidable including mistake,
misrepresentation and duress or undue influence. A misrepresentation is a false statement of fact made
by one party to the contract to the other party as a result of which the other party is induced to enter
into a contract. The consequences of misrepresentation vary according to whether or not it was
fraudulent or negligent. Usually silence cannot amount to a misrepresentation; however, insurance
represents an exception since the principle of utmost good faith (uberrima fides) applies to such
contracts. As a result each party to the contract is under a positive duty to disclose clearly and
accurately to the other all material facts relating to the proposed insurance. The inclusion of a
comprehensive list of questions on the proposal form which the prospective policyholder is called upon
to complete does not absolve him from this duty; if he is aware of some fact, not covered by the
questions, which would affect the judgement of a prudent underwriter in accepting or rejecting the
contract or fixing the premium rate, he must disclose this. Failure to disclose would enable the insurer to
repudiate the contract.
2.2.8 Legality and possibility
Certain contracts are illegal because they are expressly prohibited by statute or are regarded at common
law as being against public policy. For instance a policyholder cannot recover under a policy in respect
of a loss caused by his own criminal act.
2.2.9 The insurance contract - an example
Baron Scarpia has effected a number of insurance policies with your client, the Atavanti Insurance
Company, which have given rise to claims in recent months. On the basis of the following you are
required to advise your client whether there are any grounds for resisting the claims:
(a) Policy. Term assurance on the life of Angelotti, a political prisoner held in custody by Scarpia.
Claim. One week into the policy term Angelotti escaped and committed suicide to avoid
recapture.
(b) Policy. Fire insurance on the Baron's private residence.
Claim. Fire damage to the basement arising from a brazier having been overturned while
Scarpia was torturing suspects.

(c) Policy. General liability.
Claim. Spoletta, one of Scarpia's servants damaged a portrait by Cavaradossi in the course of
carrying out his duties.
(d) Policy. Property damage.
Claim. The walls of the Baron's castle were damaged by stray bullets from a firing squad.
There was a specific exclusion in the policy on this matter; however, 5 minutes before the
incident the Baron's broker spoke to the underwriter and agreed to cancel the exclusion for an
agreed additional premium. To date the policy endorsement has not been issued and the
additional premium has not been paid.
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(e) Policy. Whole life.
Claim. The Baron was assassinated by Tosca, an opera singer whom he was attempting to
seduce, and his illegitimate son, named as the sole beneficiary in both the Baron's will and on
the policy, is making the claim.
A suggested solution is set out overleaf.
2.2.10 Suggested solution
(a) The policy is invalid because Scarpia does not have an insurable interest in Angelotti's life.
(b) The policy will be voidable at the insurer's option as Scarpia failed to disclose the fact that his
basement was used as a torture chamber. This is a factor which would influence the likelihood
of fire and hence the premium rate to be charged.
(c) This appears to be a valid claim since Scarpia is legally responsible for the actions of his
employees in the performance of their duties.
(d) Despite the absence of a formal endorsement, the amendment to the contract has been effected
and the claim is payable, although the insurer has a counter-claim for the unpaid additional
premium.
(e) There is a death claim payable; however, as the contract was between Scarpia and Atavanti it is
Scarpia's executor who will have to claim and produce evidence of his death. The beneficiary is not
a party to the contract and therefore has no right to claim against Atavanti directly.
2.3. PARTIES IN THE INSURANCE MARKET
2.3.1 The basic relationship
The simplest relationship that can exist is that illustrated in the diagram below:
INSURED INSURER
This arises where a prospective policyholder approaches an insurer directly and affects a contract of
insurance.
2.3.2 The insured may be an individual, partnership or company. In the case of an insured carrying on a
business, the insurance premium is a cost which provides benefits (in the sense of additional security)
for a period normally of twelve months. If this period differs from the business's financial year it will be
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necessary to treat part of the premium as a prepayment at the year end. The auditor of a company needs
to consider whether the insurance arrangements are adequate.
2.3.3 The insurer with whom the insured is in direct relationship will be either an insurance company or a
branch or an agent of an insurance company. For very large risks more than one insurer may well be
involved. An insurance company will itself be in the place of an insured when:
(a) it insures its own property with another insurer; or
(b) it reinsures risks it has accepted (explained in detail in a later module).
2.3.4 Intermediaries
The role of an intermediary is to bring the two parties of the contract of insurance together.
The relationship is as follows:
AGENT
INSURED
BROKER

INSURANCE
COMPANY
Although the intermediaries are involved in the formation of the insurance contract they are not parties
to the contract as such. It is the insured and the insurer who acquire rights and duties as a result of the
contract and who are able to sue each other in the event of non-performance of the contract. An
intermediary can therefore drop out of the picture once the contract is in being, although as a matter of
convenience payments of premium will commonly be channelled through a broker who will also often be
called upon to assist the insured in making a claim.
2.3.5 The term "agent" is a little confusing since any intermediary must be acting as an agent of one of the
parties. The important distinction in the diagram is between agents who are simply representatives of
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an insurance company and whose function is to obtain as much business as possible for that company,
and brokers who are full-time independent intermediaries who act as agents for potential insureds. A
broker will "shop around" insurers to obtain the most appropriate insurance protection for his clients.
2.3.6 Any intermediary is normally remunerated by means of a commission from the insurer. Where premiums
are paid via a broker the broker will generally deduct his commission from the premium passed on to the
insurer. Use of a broker is almost indispensable in the placement of the larger risks which need to be
divided between a number of insurers. For such a risk the broker will summarise the details onto a
document known as a slip and visit various insurers, commencing with one or more which are
recognised as specialists ("leading underwriters") for the type of risk in question. Each insurer willing
to participate in a risk ("take a line") will place its stamp on the slip and indicate that proportion of the
risk that it will accept. The broker will continue touring the market until the slip has been fully
subscribed.
3. OVERVIEW OF INSURANCE COMPANY OPERATIONS
SELF-STUDY MODULE
CONTENTS
3.1 WHAT IS AN INSURANCE COMPANY ?
3.2 ORGANISATION OF INSURANCE COMPANIES
3.3 REVENUE ACCOUNTING
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3.1. WHAT IS AN INSURANCE COMPANY?
An insurance company is a body corporate which enters into contracts of insurance with persons
seeking insurance cover.
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3.2 ORGANISATION OF INSURANCE COMPANIES
3.2.1 Underwriting
The underwriter is the officer of an insurance company who makes the decision as to whether or not to
accept a risk and the premium rate applicable. In practice a company will have many underwriters and
deputy underwriters, each with their own field of specialisation and limits of authority. Underwriting
functions may be concentrated at head office or decentralised around a branch network. Underwriting
powers may be delegated to an agent if, for example, a company desires to accept business in a foreign
country but does not wish to establish its own branch there. Amendments to existing policies and
renewals of policies represent underwriting decisions similar in nature to the original acceptance of a
risk.
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3.2.2 Policy issue
For simple risks, the insurer will issue a standard policy with a schedule setting out the particular details
of the risk. As the policy provides written evidence of the underlying contract of insurance it is clearly
important that the details in the schedule accord with the information on which the underwriting
decision was taken. On larger and more complex risks placed by a broker, the company may be only one
of a number of participating insurers and it is likely that the broker will prepare a single policy on behalf
of the insurers concerned. In this case it is essential for the insurer to ensure that a closing advice has
been received from the broker in respect of each risk. This closing advice not only enables the insurer
to confirm that the contract has been finalised on the basis stated on the broker's slip, but also indicates
the proportion of the risk that the insurer is covering and hence the amount of premium receivable (since
the lines that insurers have signed for may need to be scaled down in the event of a broker's slip being
over-subscribed).
3.2.3 Pricing a policy
Probability of Loss
Insurance is a risk transfer mechanism, whereby the individual or the business enterprise can shift some
of the uncertainty of life on to the shoulders of others. In return for a known premium, usually a very
small amount compared with the potential loss, the cost of that loss can be transferred to an insurer.
Each risk the insurer takes on has a chance of resulting in a loss. In order to calculate the premium he
wishes to charge the insurer needs to know what the chance of loss is and the likely cost of that loss for
each risk he accepts. As the insurer accepts large numbers of similar risks he is able to use the law of
large numbers, i.e. probability theory, in setting his premiums.
An insurer will have enormous amounts of data showing the past trends in terms of numbers and value
of claims. This data will be analysed and premiums will be set accordingly.
For example:
A company insures drivers living in London. Past experience shows that in any given year one in three
drivers will have an accident, the average cost of which is UD600. What premium should be charged to
cover the cost of claims?
Answer:: 1/3 x UD600 = UD200
UD200 will reflect the pure risk premium. The insurer will need to add a margin to cover his
overheads and profit although he may also take into account investment income he will earn on the
UD200 before a claim is paid.
Of course future trends in claims cannot always be predicted by looking at past claims.
Another area where probability theory may not be a useful way of pricing policies is that of the
extremely specialised insurer.
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3.2.4 Premium collection
Credit control is essential in any commercial organisation but can assume particular importance for an
insurer who is mostly reliant on investment earnings to produce a satisfactory bottom line result. A
number of different situations can arise, for example:
(a) For endowment and whole life policies there is a level premium payable over an extended
period and it would be normal for the policyholder to effect a direct debit or standing order in
favour of the insurer.
(b) For some simple insurance contracts where there are clearly defined premium rates, a cheque
may be enclosed with the completed proposal form.
(c) For most other contracts agreed directly between the policyholder and the insurer, a single
premium will be payable at the start of the policy year.
(d) Some insurers offer an option to pay the premiums on certain types of annual contract by
monthly installments (normally at a higher rate).
(e) Credit terms may apply to business introduced by agents.
(f) An insurer will normally have a running account with each broker and agree periodic
settlements. It is notoriously difficult to reconcile an insurer's records with a broker's records
in view of the timing differences and the complexity of the balances.
(g) Some contracts may be underwritten for a deposit premium adjustable at a later date. Receipt
of the information to enable the adjustment premium to be calculated must be monitored.
Procedures will need to be sufficiently flexible to ensure that all these situations are properly handled.
3.2.5 Claims handling
As claim payments represent the major item of expenditure for an insurer it is obviously essential for the
insurer to establish the validity of a claim before agreeing to settle it. Procedures are relatively simple in
the case of a death claim on a life policy; provided that the premiums have been paid up, the amount of
the claim can be determined easily from the terms of the policy and the death certificate and grant of
probate would constitute sufficient evidence. Matters can be much more complex in general insurance,
particularly where a liability claim is involved, and it may often be unclear whether a claim falls within the
scope of a policy.
There are various circumstances that can give rise to a reduction in the amount of a claim payment or
otherwise enable the insurer to reimburse himself in part or full:
(a) An excess clause (or deductible) may provide that the policyholder will bear the first part of a
claim.
(b) The principle of particular average can lead to a claim payment being reduced by the fraction -
sum insured/full value of property - in the event of under-insurance.
(c) If a life company has made a loan on the security of a life policy, then the amount outstanding
will be deducted from any claim payment.
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(d) Salvage of the property on which a claim has been paid may be possible.
(e) Subrogation rights may enable the insurer to sue the party responsible for the accident.
(f) Other insurers may be called upon to make a contribution if a loss is covered by more than one
policy.
(g) Reinsurance contracts may give rise to recoveries (see below).
3.2.6 Reinsurance
An insurance company can enter into reinsurance contracts either as cedant or as acceptor or as both.
Facultative reinsurance accepted can be dealt with in much the same way as direct business, but special
treatment is required for inward treaties. Once a treaty has been entered into, the reinsurer will receive
periodic statements from the cedant dealing with both premiums and claims. There are time delays
inherent in any reinsurance accounting, but the receipt of treaty statements needs to be monitored to
ensure that there is a regular information flow.
The types of reinsurance protection available are outlined in the module concepts and nature of
Reinsurance business module. An insurance company will normally have a comprehensive
programme, designed to suit its particular needs, which is likely to involve most, if not all, of the
different types of contract. Claims of varying types and sizes will have widely differing implications as
to the reinsurance recoveries arising, and a company will need to establish procedures to ensure that all
potential recoveries are identified and the reinsurers advised without delay.
3.2.7 Investment
The investment function is no different in principle from that of a commercial concern. However, in view
of the time lag between the receipt of premiums and the payment of claims the quantity of funds
available for investment will be substantial.
3.3. REVENUE ACCOUNTING
3.3.1 An insurance company prepares annual accounts just as any other company will do. However, as well
as a balance sheet and profit and loss account an insurance company's accounts will generally include a
revenue account which deals with the underwriting transactions for the year. In the case of an
insurance company writing general business of a short term nature (e.g. motor or property insurance)
the revenue account will deal with premiums and claims arising on such policies during the accounting
period thus giving rise to the underwriting profit or loss for the year.
3.3.2 Premiums
Having established that the revenue account deals with the premiums and claims figures for the year, we
need to consider how such premiums and claims figures are determined. If an insurance company had a
31 December year end and issued a policy for a twelve-month period commencing 1 January then such a
policy would both incept and expire during the same accounting period. It would therefore be logical to
reflect the full amount of the premium receivable in the revenue account for the year. However, if the
policy commenced on 1 July and expired on 30 June, then on 31 December although the full amount of
the premium might have been received only half the period of cover under the policy would have
elapsed. If the whole of the premium were brought into account at 31 December then there would be no
income carried forward to the next accounting period to match with any costs arising from a claim in the
latter six months of the policy. It is necessary therefore to adopt a method of time-apportionment of
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premiums by reference to the period of cover involved, e.g. a premium of UD120 for a policy
commencing on 1 October 1998 would be dealt with in the year ended 31 December 1998 accounts as
follows:
3/12 x UD120 = UD30 earned in the year
9/12 x UD120 = UD90 treated as unearned at the year end and carried
forward to be recognised as premium income in the
1994 accounts
Although the unearned premium element can be computed separately for each policy and indeed, with
the advent of computer processing, this approach is adopted by some companies, there are two less
precise methods used for computing a provision for unearned premiums which are encountered in
practice.
3.3.3 The 24ths method is based on the assumption that, on average, policies incepting in a month run from
the middle of that month. Thus premium income is analysed by month of inception and at 31 December
23/24 of January premiums would be treated as earned and so on down to December where only 1/24 of
the premiums would be treated as earned. It is usual to recognise the fact that certain costs are incurred
in acquiring the insurance business in the first place of which the most obvious is commission paid to
intermediaries introducing the business. For this reason only the premium net of such costs is time-
apportioned; this is achieved by computing the provision on gross figures and then reducing it by a
percentage in respect of commission - usually, but not necessarily, 20%.
3.3.4 An alternative method for computing unearned premiums is the 40% basis. Two assumptions underlie
this method and the result attained will only be a crude approximation if the pattern of the company's
business differs substantially from that postulated. Policies are assumed to incept evenly throughout
the year so that an average policy commences on 1 July and would therefore be 50% unearned at the
year end. A 20% deduction for commission would reduce the 50% to 40% which gives this basis its
name. 40% is a generic term; 35%, 30% and various other percentages are sometimes encountered
where the policy acquisition costs are considered to be more than 20%.
3.3.5 EXAMPLE I - UNEARNED PREMIUMS
Godunov Insurance Co Ltd is a company that calculates its unearned premiums on the 24ths basis. A
month of inception analysis has been prepared for gross premiums on motor business underwritten in
the calendar year 1993 as follows:
Month cover commences: UD000
December 1997 and earlier 75
January 1998 888
February 768
March 864
April 912
May 936
June 960
July 984
August 1,008
September 1,032
October 912
November 936
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December 960
______
Total gross premiums 11,235
______
All these represent new business or renewals: there were no alternatives to existing cover during the
year.
(a) Calculate the provision for unearned premiums on the 24ths basis.
(b) Calculate the provision for unearned premiums on the 40% basis.
(c) It has subsequently been discovered that 2 cars had been omitted from the above:
(i) Mr Onegin insured his Lada for 12 months from April 1998 for a premium of UD20. He
changed his car for a Mercedes in October and this car was substituted on the policy
that month for an additional premium of UD60;
(ii) Mr Lensky is the nephew of the managing director. He insured his Rolls Royce for 12
months from April 1998 for a premium of UD80. In October he was disqualified from
driving. Being unwilling to let anybody else use his car he negotiated with the
company who agreed to pay him a return premium of UD40 to cancel the cover.
Calculate the unearned premium to be carried forward on each of these cars.
EXAMPLE I - UNEARNED PREMIUMS
A suggested solution is set out overleaf.
EXAMPLE I - UNEARNED PREMIUMS
SUGGESTED SOLUTION
UD000
(a) 75 x 0 0
888 x 1/24 37
768 x 3/24 96
864 x 5/24 180
912 x 7/24 266
936 x 9/24 351
960 x 11/24 440
984 x 13/24 533
1,008 x 15/24 630
1,032 x 17/24 731
912 x 19/24 722
936 x 21/24 819
960 x 23/24 920
_____
5,725
8
Less 20% 1,145
_____
Provision for unearned premiums 4,580
_____
(b) UD11,235,000 x 40% = UD4,494,000
UD
(c) (i) 12 month premium on Lada 120
12 month additional premium on
Mercedes 60 x 12/6 120
___
12 month premium on Mercedes 240
___
As the cover commenced in April the
unearned premium should be:
UD240 x 7/24 70
Less 20% 14
___
UD56
(ii) NIL since the company is not at risk during 1994.
3.3.6 Audit considerations
a) It should be noted that the 24ths and 40% methods are merely convenient methods of
approximating the amount which would arise if the unearned portions were calculated
separately on each premium. We must therefore ensure that the method used by our clients
are reasonable. Thus, it would not be appropriate for a client who writes a very substantial
amount of business in the last month of a financial year to use the 40% method since the result
would not approximate to the right answer. However the 24ths method in such
circumstances probably would still be reasonably accurate.
Except in cases of very unusual distributions or non-standard period policies (eg. Marine cargo
policies), the 24ths method usually provides a reasonably accurate estimate and we might
therefore check the reasonableness of other methods by recalculating on the 24ths basis.
b) In the example above, a 20% deduction for policy acquisition costs was made. The reason for
making this deduction is to match expenses, incurred on or before issuing the policy, which
can fairly be spread over the same period as the premium. Such expenses include
agents/brokers commissions, survey or medical fees, administration costs in issuing the
policy etc. While it is possible to identify actual costs in some cases, insurance companies
normally recover from a pool of costs on a percentage basis. This is done with varying
degrees of accuracy and we must examine the resulting deferred costs for reasonableness. In
addition, it would be unacceptable to defer such costs unless the costs can be offset against
future income - ie. The unearned premiums and future investment income are sufficient to
9
absorb future claims and related expenses. This subject is discussed in further detail in 6.12
below.
3.3.7 Claims
Accounting for premiums has been based on the concept of matching income with (potential) costs. In
a similar manner the accruals concept suggests that the full cost of claims incurred in an accounting
period should be charged against the earned premium income of that period. Provision must therefore
be made to bring into account claims outstanding at the year end.
There are various stages through which a claim passes before it is finally agreed and settled by an
insurance company:
(a) the incident giving rise to the loss occurs;
(b) the claim is reported to the company;
(c) the claim is investigated and agreed; and
(d) the claim is settled.
Payment of claims
The situation with a direct insurer is straightforward with the insured sending claims details to the
insurer and the insurer taking one of three steps:
reject the claim
settle the claim
seek more information (this may include assessment by a loss adjuster)
There are two main considerations in the decision to settle a claim
1 Can the insured establish that he has suffered loss
The loss claimed must be verifiable. The insured cannot claim twice for the same loss under two
different policies. There may be terms which state that an insured must take steps to minimise the loss.
Some policies give replacement cost cover, while others only cover the value of the items lost at the
time of the loss.
2 The loss must be an insured loss
The loss must fall under the terms and conditions of the policy. The loss must occur within the period
of cover specified by the policy.
Once the insurer has agreed the loss they will issue a cheque to the insured. Even where a broker has
been used to place the insurance the claims may be settled directly with the broker merely passing
information between the insured and the insurer. Equally the broker may settle the claim once funds
have been collected from the insurers.
10
3.3.8 Thus claims dealt with in a financial period may be at any of the following stages :-
a) claims paid
b) claims agreed but not yet paid
c) claims reported but not yet agreed
d claims incurred but not yet reported ie. The event giving rise to the claim occurred but the
insurance company was not aware of that event. Such claims are referred to as IBNRs. The
need to provide for such claims is not immediately obvious. Since premium income is earned
on a time basis over the life of the policy, the accruals concept requires that a claim be
accounted for at the point of time when it is incurred, ie at the date of accident.
a&b) Claims paid and claims agreed but not paid generally pose few accounting problems,
however, points to watch are:-
i) Have the claims actually been agreed. Do payments represent payments on account
rather than settlements ?
ii) Have recoveries been correctly accounted for (salvage, reinsurance, excess
charges, recoveries from third parties) ?
iii) Have all adjustment expenses been accrued ?
c) Claims reported but not yet agreed are more difficult since they involve estimates.
Matters to consider are :-
i) Is the estimating procedure adequate ?
ii) Have recoveries been considered ?
iii) Have the effects of inflation been considered ?
iv) Have claims expenses been included ?
v) Have all reported claims been recorded ?
The approach is governed to some extent by the class of business. In categories of business where
claims are many but small. The company might apply an average settlement value to the number of
claims unagreed. The average settlement value would probably be based on previous experience.
In cases like this, the points to watch are :-
i) have all reported claims been recorded ?
ii) is the average used derived from a population which is representative of the
unagreed claims ?
iii) is the period used to calculate the average reasonable ?
- If too long, average value of recent settlements may be increased.
- If too short, may not be representative.
In categories of business where the claims are few but large estimates are likely to have been made in
detail individually.
d) The difficult area is IBNRs. Note that :
11
i) some form of provision for IBNRs is almost always required, even in short-tail
business such as motor comprehensive.
ii) the impact of IBNRs is different in different classes of business -contrast to motor
comprehensive customers where the insured, because he is certain of recovering, will
almost always report promptly, are motor third party customers (and probably other
third party type risks) where the insured stands to gain nothing by reporting the
accident.
iii) small and medium claims are likely to have a greater IBNR impact than large claims
a major disaster is news and also the insured is more likely to report the event
if there is a large sum of money involved.
iv) the source of business is also important. Consider the relative delays likely to occur
if the business is direct, through agents/brokers or reinsurance business.
v) reinsurance and other recoveries must be taken into consideration since it is the net
cost of claims incurred which requires provision.
The determination of IBNR provisions requires the use of statistics and subjective judgements. There
are a large number of statistical methods in use and an E & Y book loss Reserving Property/Casualty
Insurance details the methods commonly encountered. The following points about these statistical
analysis should be borne in mind :-
i) there is no correct method, all are estimates;
ii) all methods are dependent on the assumption that historical data can be used to
project future events and therefore usually require :
a) a relatively constant claims reporting pattern;
b) a relatively constant level of settlements;
c) relatively constant underwriting practices (ie. Claims are related to premiums in a
relatively constant manner taking a portfolio as a whole);
d) a large population allowing the law of large numbers to apply;
e) a number of years history to work with;
f) maintenance of historical data in a usable form.
It is evident from the above that for smaller clients, statistical analysis can at best only provide
a very rough indication of the provision required.
The example which follows is intended to provide an illustration of the sort of analysis which
might be used to project an IBNR provision. Note that while it is rather more simple than the
sort of analysis performed by large, well organised insurance companies, the basic approach
underlies a number of more sophisticated analysis.
3.3.9 Example
Harpies Insurance have asked you to help determine the IBNR requirement in their motor
portfolio. You have assembled the following information:
Third party Total
Comprehensive only
12
No of claims 7,920 1,340 9,260
Average delay between
date of accident and
date reported (in days) 7 141 26
Average gross value of
each claim UD 72 UD 395 UD 119
Average recovery (all
sources UD 38 UD 20 UD 35
Can you think of any way of using the above information to help ?
3.3.10 SUGGESTED SOLUTION
On average, all the claims notified for 7 days (comprehensive) and 141 days (TPL) will be
IBNRs - ( think about it - on average claims reported today occurred 141 days ago (TPL),
tomorrows - 140 days ago, etc).
Comprehensive TPL Total
Average number of claims 7,920 1,340 9,260
per day 365 365 365
= 22 = 4 = 25
Projected number of claims 22 x 7 4 x 141 25 x 26
not reported = 154 = 564 = 650
Projected cost of UD ( 72-38)x154 UD(395-20)x564 UD(119-35)x650
claims not reported = UD 5,236 = UD 211,500 = UD 54,600
If you performed the analysis on the basis of totals only, you might recommend UD 54,600; however if
you treated the two classes of business separately you would probably recommend UD 216,736 ! .
The possible weak points in the above analysis are too numerous to note comprehensively but the
dangers of not aggregating properly are evident.
3.3.11 Audit considerations
a) Our approach to auditing claims provisions must take into consideration the fact that no truly
accurate estimate is possible. We therefore need to satisfy ourselves that claims provisions
are adequate and reasonable. The determination of what would constitute a material error in
terms of claims provisions (and therefore income/shareholders funds) requires careful
consideration.
b) The determination of IBNRs and provisions for unagreed claims is an analytical process and
out audit procedures will usually also be analytical in nature.
13
3.3.12 Premium deficiencies.
In some circumstances, it is necessary to provide for claims which have not yet been incurred. If a
portfolio is unprofitable, unearned premiums may be insufficient to absorb likely future costs,
prudence would dictate that the expected losses be fully provided.
Where a premium deficiency exists, the first step would be to write off some or all of the deferred
acquisition costs. It is apparent from 2.3.2 above that in some clients records, this would be effected
by grossing up the unearned premiums (40% would become 50%). If unearned premiums are still
insufficient, the excess expected losses should also be provided.
In order to determine whether a premium deficiency exists, it is necessary to determine the profitability
of each portfolio. We would need to take into consideration the following :
( i ) IBNRs
( ii ) the extent to which the current year claims expense and premium income includes adjustments
to prior year estimates. Such adjustments should be excluded, in principle, from the
calculation of the profitability of the current year portfolio.
( iii ) investment income or, rather, notional investment income.
Provisions to cover future losses are sometimes accounted for separately but more often clients add the
provisions to unearned premiums, the resulting amount is often termed reserve for unexpired risk.
3.3.13 Other bases of accounting
The whole of this section has dealt with the annual basis of accounting. While most Middle East
insurers use this basis other bases do exist. The two which might be encountered are :-
a) Three year accounting
Under this method, the results are not determined or reported for three years. Thus 1998 accounts
report the underwriting results 1996, the balance arising for 1997 and 1998 eg. Premiums written, claims
paid etc. are carried forward as a fund in the balance sheet.
Points to note about this method are :
i) it is likely that all premiums will be earned and most losses reported by the end of the third
year,
hence there is normally no need to compute unearned premiums or deferred acquisition costs.
However, there is still likely to be an IBNR requirement.
ii) the auditor still needs to consider whether the fund in the balance sheet for the unclosed two
years is
adequate to cover additional claims; if it is not ie. The portfolio is loss-making, additional
provision is necessary which should be charged to income for the year.
iii) this method is often used in marine or aviation business and excess of loss business where the
determination of premiums is sometimes not effected until after the period of risk.
14
b) The treaty year method - the results reported in the financial statements - the closed treaty year
relate to the latest completed treaty year, ie. The treaty year and financial year are not coterminous
and results are determined on the basis of treaty years. This method is similar to the three year
basis but unearned premiums may need to be calculated. These are carried forward in the balance
sheet as part of the fund which includes the premiums etc. for the open period. Mainly used in
proportional reinsurance business.
4. CONCEPTS AND NATURE OF REINSURANCE BUSINESS
SELF STUDY MODULE
CONTENTS
4.1 INTRODUCTION
4.2. TYPES OF REINSURANCE
4.3 MISCELLANEOUS MATTERS
4.4 PROVISIONS COMMONLY ENCOUNTERED IN REINSURANCE TREATIES
-1-
4 - CONCEPTS AND NATURE OF REINSURANCE BUSINESS
REINSURANCE
4.1 INTRODUCTION
4.1.1 Insurance provides financial compensation to the insured in the event of unexpected injury, loss or
damage. The insurer maybe regarded as the custodian of a central fund into which all those wishing to
receive insurance protection pay an assessed contribution (a premium ). Insurance is therefore a means
of spreading the financial losses of individual members over the insured community as a whole.
4.1.2 Reinsurance continues this principle of spreading financial losses. It is the term given to the insurance
effected by an insurer in order to provide protection against the risk of claims arising on policies
underwritten by that insurer. An insurer may enter into reinsurance arrangements for one or more of the
following reasons:
i) to increase the insurers capacity to accept more or larger risks;

ii) to protect the insurer from the effects of catastrophies;
iii) to enable the insurer to retain only the part of a risk that he finds desirable (eg. A marine insurer
may reinsure against the possibility of a total loss but remain at risk for partial losses);
iv) to provide overall protection for an underwriting account;
v) to close an underwriting account.
4.1.3 The reinsurance taken out by the insurer (cedant) is a completely separate contract from the original
contract of insurance between the insured and the cedant. Thus the insured only has a claim on the
cedant; if the cedant should fail the insured has no recourse to the reinsurer. Conversely should the
reinsurer fail, the insured is not prejudiced and the full loss would then fall on the cedant.
4.1.4 It is important to stress the difference between reinsurance and co-insurance. Co-insurance is a form of
direct insurance in which more than one insurer contracts with the insured to underwrite the risks.
4.1.5 For example, 5 insurers may each take 20% of a risk and the insured would have a separate contract with
each insurer (although these separate contracts may be evidenced by a single policy). Each of those
insurers would then be able to reinsure all or part of its proportion (i.e. 20%) of the risk undertaken.
Co-insurance
INSURED


20% 20% 20% 20% 20%
A B C D
E
If A becomes insolvent, the insured can prove in the liquidation for As 20% share in the event of a claim. There
is no obligation for B, C, D or E to contribute towards the portion of the risk covered by A.
-2-
4.1.6 Reinsurance
INSURED
100%
A
B C D E
20% 20%
20%
20%
If B becomes insolvent then, in the event of a claim, A can prove in the liquidation of B, but is obliged to make
payment in full to the insured. Conversely, if A becomes insolvent, the insured can prove in the liquidation of
A, but cannot look behind A to make direct claims on B, C, D, E.
4.2 TYPES OF REINSURANCE
4.2.1 There are various types of reinsurance contract - each designed to offer a different form of protection
to the insurer. The following outlines the main types of reinsurance likely to be encountered in the
Middle East.
4.2.2 Facultative
This is the specific reinsurance of an individual risk. An insurer may take out facultative reinsurance if
the policy being written is too large an exposure in relation to the size of the other policies written by
that insurer. This reinsurance tends to be used sparingly as it tends to be expensive ( insurers would
not want to lay off part or all of a specific policy unless they thought it had a higher than average
risk).
For Example
Joe is a motor car insurer. He insures 1,000 cars a year and rates his premium on the basis that one in
three of these cars will crash and the average loss will be UD6,000. His premium rate per car is
UD2,000.
Part of the business that Joe insures is the fleet of 100 company cars belonging to Nuts and Bolts
Limited. Fred, the managing director of Nuts and Bolts Limited owns a McLaren F1 worth UD250,000.
He asks Joe to insure the car as part of the company car package. Joe agrees to do this as he does not
want to risk losing the 100 company cars.
However Joe now has a problem. He has never insured a car of this type and sop does not know how
likely they are to crash and how expensive the average claim will be if they do crash. Also as the car is
so different from the rest of his business the law of large numbers no longer applies and his profitability
is purely dependent on whether or not this one car has a bad accident.
He therefore decides to reinsure this car with Derek who specialises in insuring McLarens, Ferraris and
Lamborhinis. To Derek, Freds car will just be one of 800 other similar risks and so probability can be
applied. Derek charges Joe a premium. The contract between Derek and Joe is completely separate and
has no effect on the contractual relationship between Joe and Fred.
Fred is happy as he only has to deal with Joe for all his motor insurance needs. Joe is happy because if
Fred crashes his car he can reclaim any large loss from Derek. Derek is happy as his business has
grown.
This type of reinsurance has the following drawbacks:
-3-
a) the insurer has no guarantee that a suitable cover can be obtained at an acceptable rate;
b) since enquiries and discussions are necessary, facultative reinsurance is cumbersome and not
suitable for a portfolio of many but small policies.
As a result, facultative reinsurance is generally used on a one-off basis particularly where protection
is not available under the terms of the insurers treaties.
4.2.3 Treaty Reinsurance
Under treaty reinsurance, the reinsurers agree in advance to reinsure automatically providing the policy
falls within the terms and scope of the treaty. Reinsurance treaties are normally drawn up to cover a
period of one or two years. The reinsurer is not normally aware of the individual risks reinsured
although most treaties allow the reinsurer to inspect the insurers bordereaux and policy documentation.
Most reinsurance treaties are obligatory in that the original insurer must cede and the reinsurer must
accept all risks falling into the class(es) of business covered by the treaty (however see
facultative/obligatory treaty reinsurance below).
Although the terms of individual treaties vary, most treaties fall into one of the following categories
4.2.4 Quota Share or Fixed Share Treaty
The reinsurer agrees to accept a fixed percentage of all risks falling within the scope of the treaty. The
reinsurer receives that percentage of the premiums and pays the same proportion of the losses arising
from the business protected. Quota share treaties normally include a specified maximum risk which the
reinsurers are prepared to accept so that the insurer may need to obtain additional protection where the
sum assured exceeds the maximum specified in the treaty. For example, a treaty may cover risks up to
UD 1 million and the insurers retention may be 15% :
Sum Insurers Reinsurers Balance
Assured Retention Share
i) UD 500,000 UD 75,000 UD 425,000 -
ii) UD 1,500,000 UD 150,000 UD 850,000 UD 500,000
The balance in (ii) is outside the treaty limit and the insurer would need to obtain additional
reinsurance protection for that part of the policy.
Premiums and losses would be shared proportionately. If a loss of UD l million arose under policy (ii)
above, it would be borne as follows (assuming the balance is reinsured facultatively):
Loss Insurers Treaty Reinsurers Facult. Reinsurers
Retention Share Share
UD 1,000,000 UD 100,000 UD 566,667 UD 333,333
Although premiums are shared proportionately, the insurer usually receives a commission, often
referred to as an overrider, from the treaty reinsurers paid out of their share of the premiums.
4.2.5 Surplus Treaty
The insurer retains an amount specified in the treaty; the reinsurers accept upto a maximum based on a
multiple of the retention. Treaties are normally arranged on the basis of so many lines. The following
examples will illustrate.
-4-
Example
i) The retention is UD 100,000 and the treaty has a first surplus of 10 lines and a second surplus of 10
lines. The insurer issues a policy in which the sum assured is UD 1,500,000.
The risk would be spread as follows :-
UD 000
Insurers retention 100
Reinsurers first surplus 1,000 ie 10 lines of UD 100,000
Reinsurers second surplus 400 ie 4 lines of UD 100,000
1,500 lines of UD 100,000
ii) Same as i) except that the retention is UD 50,000
UD 000
Insurers retention 50
Reinsurers first surplus 500 ie 10 lines of UD 100,000
Reinsurers second surplus 500 ie 10 lines of UD 100,000
Balance (see below) 450 lines of UD 100,000
1,500 lines of UD 100,000
The insurer has three options with respect to the balance :
i) he can retain the unaccomodated balance, since the treaty has been fully utilised;
ii) he can reinsure the balance facultatively;
iii) he can seek permission from the reinsurers to increase the size of the retention (and therefore the
size of the lines) or negotiate a third surplus.
In both examples above, the premium and any loss arising will be spread in proportion to the sum
assured and, once again, the reinsurer is likely to pay the insurer a commission from the premiums
ceded.
One more point about the above example is to note that the treaty specified a first surplus of 10 lines
and a second surplus of 10 lines rather than a single surplus of 20 lines which would appear to come to
the same result. Treaties are often arranged with more than one surplus because the commission
payable by the reinsurer is fixed at a different rate for each surplus. Thus, the commission might be 25%
of premiums ceded for the first surplus and 20% for the second surplus.
Surplus treaties, in the Middle East often permit scaling-down. The insurer is allowed to scale-down
the size of the retention and therefore the size of the lines.
Example
Maximum retention is UD 100,000. Treaty has a first surplus of 10 lines and a second surplus of 10 lines.
Insurer issues a policy in which the sum assured is UD 1,500,000.
i) Assuming the insurer wishes to retain the maximum
UD 000
Insurers retention 100
Reinsurers first surplus 1,000 (10 lines)
Reinsurers second surplus 400 ( 4 lines)
1,500
-5-
ii) Assuming the insurer wishes to retain UD 20,000
UD 000
Insurers retention 20
Reinsurers first surplus 200 (10 lines)
Reinsurers second surplus 200 (10 lines)
420
Balance (see below) 1,080
1,500
In this case the balance must be reinsured facultatively since the insurer has not used his maximum
retention. If the reinsurer were to retain any part of the balance, the size of the lines and thus the size of
the reinsurers shares would be affected.
Obviously, if the treaty permits scaling-down any number of possible distributions are possible
depending on the desired retention, whereas in the case of normal surplus treaties there is no choice.
Scaling-down is apparently uncommon in the developed insurance markets and the practice appears
to represent a concession to smaller, newer markets allowing the insurers a degree of flexibility while still
providing substantial reinsurance cover.
4.2.6 Excess of Loss Treaty
Excess of loss reinsurance protects the insurer against very large individual losses. Unlike quota share
and surplus treaties the excess of loss reinsurance is not based on the sum assured but on individual
claims. Excess of loss treaties are arranged in such a way that the insurer absorbs all but exceptional
losses. For example, if the treaty fixes the insurers retention at UD 100,000, all losses below this
amount would be paid by the insurer. Only where a loss excess UD 100,000 would the excess (or most
of it) be recovered from the reinsurers.
Note that the term retention in this case refers to losses whereas under quota share or surplus
treaties it refers to sums assured.
Excess of loss treaties are usually organised in layers. Thus, if the insurers retention is UD 100,000,
the reinsurers might be liable under the first layer for any excess up to UD 2,000,000. For protection
against catastrophic losses, a second layer might be arranged and the consideration payable by the
insurer would differ for each layer. The layers need not be continuous - first layer could cover losses
up to UD 2,000,000 and a second layer losses between UD 5,000,000 and UD 10,000,000. Presumably in
this circumstance the insurer is fairly confident that losses will either be less than 2 million or more than
UD 5 million.
The consideration paid by the insurer for this protection is usually in the form of a small percentage of
the insurers annual premium income from that class of business.
One other point to note about excess of loss treaties is that the insurer is normally required to meet part
of the cost of the excess. For instance, in the example above the insurer might be liable for 5% of the
excess in addition to the retention of UD 100,000. The insurer retains a financial interest in large losses
and is therefore less likely to underwrite poor risks or relax claims settlement policies.
Excess of loss protection is commonly used in the Middle East for liability insurance - public liability,
workmens compensation and product liability - where claims are usually comparatively small but can
be much larger if a major accident occurs.
4.2.7 Stop Loss
While excess of loss reinsurance protects the insurer against heavy individual losses, stop loss
reinsurance affords protection against heavy accumulated losses in a particular portfolio.
-6-
Example
Gross loss ratio retention is 75%. The reinsurers pay 90% of any excess. The results for the class of
business protected were :-
UD 000
Premium income 10,000
Losses 9,000
The gross loss ratio is 90% which is greater than 75% so a recovery is due. The amount recoverable
would be as follows :-
UD 000
Annual premium income 10,000
Imputed losses using gross loss ratio 7,500 ie 75% of premium
income
EXCESS 1,500 (IE 9,000 - 7,500)
Recoverable from reinsurers
90% of excess 1,350
Stoploss protects the insurer from heavy losses in a particular portfolio. For this protection, a
percentage of the insurers annual premium income from that class of business is paid to the reinsurer.
Stoploss treaties usually incorporate a maximum loss ratio (often 120%) to safeguard the reinsurers
against poor underwriting policies or a relaxation in claims settlement policies. In addition a monetary
maximum is usually specified to safeguard against any unusual growth in the portfolio as a whole.
4.2.8 Facultative/Obligatory Treaty
Fac/oblig treaties allow the ceding company to choose which risks to cede but are binding on the
reinsurer who must accept all risks ceded. This type of treaty would probably only be agreed where the
reinsurer either has a great deal of faith in the insurers judgement and/or where the reinsurer is very
keen to obtain the business.
The reinsurer receives that proportion of the premiums which relates to the share of the risk
underwritten and pays the same proportion of claims. The reinsurer usually pays the insurer a
commission based on a percentage of premiums ceded. Fac/oblig treaties are probably fairly common in
the Middle East due to the close ties that exist between many insurance companies.
4.2.9 Reinsurance Pools
Reinsurance pools are not common in the Middle East. They are used where the risks are exceptionally
heavy. Often the whole premium is ceded to the pool by those insurers who are members of the pool;
profits and losses being shared in agreed proportions.
4.3 MISCELLANEOUS MATTERS
4.3.1 Generally in treaty reinsurance, a number of reinsurers are parties to the agreement each sharing
proportionately in the premiums and losses arising under the agreement. There might be 10 reinsurers
each with a 10% interest in a treaty. One of the reinsurers might be responsible for negotiations and
correspondence with the insurer and is often termed the leading reinsurer.
4.3.2 Quota share and surplus reinsurance are often termed proportional since the insurer and reinsurers
share losses in the same proportion as they share premiums. Excess of loss and stop loss treaties are
often termed non-proportional since the sharing of losses bears no relation to proportions of premiums
originally received.
-7-
4.3.3 Co-insurance is sometimes encountered. This differs from reinsurance in that each of the co-insurers
has a contractual relationship with the insured in law, although in practice one insurer, the leading
insurer, might conduct all correspondence with the insured and issue the policy. In co-insurance if
one of the co-insurers fails, the insured would be directly prejudiced. Co-insurance is fairly common in
the Middle East especially where governments are the insured parties.
4.3.4 The term retrocession is sometimes encountered in the context of reinsurance matters. A retrocession is
a transaction where the risk reinsured is itself a contract of reinsurance.
4.3.5 A reinsurance policy may allow for the payment of a reinstatement premium after a claim has occurred
to continue the cover provided by the policy. Thus if the sum assured is UD 20 million and a loss of
UD 12 million arises, the reinsurers liability under the policy may fall to UD 8 million ie. The difference
between the sum assured and the claim. In order to reinstate reinsurance cover at UD 20 million an
additional premium may be payable to the reinsurers. The basis for calculating reinstatement premiums
will be specified in the policy. Reinstatement premiums are common in excess of loss treaties.
4.3.6 Reinsurance premiums are sometimes calculated on a burning cost basis. Where the premium
payable to the reinsurer is a variable percentage of the insurers premium income (excess of loss and
stop loss reinsurance) the actual amount payable may be calculated according to a formula specified in
the policy.
For example, under an excess of loss contract for motor claims greater than UD 10,000, the premium
payable to the reinsurer may be a minimum of 8% (see 3.4.6 below) and a maximum of 15% of the
insurers premium income. In order to establish what percentage is applicable, the cumulative total of
claims recoverable from the reinsurers is grossed up by a factor of, say, 100/70 ths (this is, in fact a
widely used factor), the resulting amount is expressed as a percentage of premium income. If this
percentage is less than 8%, 8% (the minimum) is payable, while if it exceeds 15%, 15% (the maximum)
is payable; however, where the percentage falls between 8% and 15%, the calculated amount is
payable.
Illustration UD
Premium income (PI) 5,000
Claims recoverable under X/L treaty 350
Claims gross up by 100/70 500
Since 500 is 10% of premium income (ie. Falls between 8% and 15%), 500 is the premium payable.
The reinsurers will make a 30% margin while the contract is burning (ie. The grossed-up claims fall
between 8% and 15% of PI), thereafter their margin falls and once claims exceed 15% of PI, their
outgoings exceed incomings.
4.3.7 Noted that the reinsurance protection of individual policies may be provided by a number of different
reinsurance contracts.
For example :
Sum assured UD 150 million
Insurers Reinsurers
retention shares
Quota share treaty 5 15 retention 25%, treaty maximum
UD 20 million
Surplus - 1
st
50 10 lines, retention
UD 5 million
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Surplus - 2
nd
50 10 lines retention
UD 5 million
Facultative (or _______ 30
fac/oblig) 5 145
In addition, the retention may be protected by excess of loss and ultimately stop-loss reinsurance.
Note that in the above example, the quota share treaty is used first then the surplus treat. It should be
pointed out that the structure of the reinsurance protection can be set up in a number of ways - the
surplus treaty can be within the quota share treaty.
Eg Sum assured - 150 million
Quota share - retention 25% maximum UD 200 million
Surplus - first surplus - 10 lines, retention UD 2 million
second - 10 lines, retention UD 2 million
UD million
Retention 2
1
st
surplus - 10 lines 20
2
nd
surplus - 7.75 lines 15.5
37.5 25%
Quota share reinsurers 112.5 75%
150
4.4 PROVISIONS COMMONLY ENCOUNTERED IN REINSURANCE TREATIES
4.4.1 Accounts
The insurer is normally required to account to the reinsurers periodically ( half yearly under
proportional treaties and yearly under non-proportional treaties are common). The account shows
premiums ceded, losses paid which are recoverable from the reinsurers, commission due from the
reinsurers, premium reserve adjustments (see below) etc. A net balance due to or from the reinsurers
is arrived at. Note that the statement of account may be the only information received by the
reinsurers. Information relating to individual policies or claims will not normally be passed on.
4.4.2 Cash loss limit
Generally, the insurer pays losses in the first instance and recovers the reinsurers share on preparing
accounts. However, if a heavy loss is incurred above the cash loss limit specified in the treaty the
insurer can apply to the reinsurers for immediate payment of their shares of the loss.
4.4.3 Loss advice limit
The insurer does not advise the reinsurers of individual losses included in their account. However
where an exceptionally large claim arises, treaties normally require that the insurer informs the reinsurers
before settlement. The reinsurers may want to review the claim documentation and assist in settlement
although they have no direct access to the insured. Reinsurance treaties usually set a maximum loss
which the insurer can settle without reference to the reinsurers, this the loss advice limit. The loss
advice limit is often but not necessarily the same amount as the cash loss limit.
4.4.4 Premium reserve (Premiums withheld from reinsurers)
Proportional reinsurance treaties usually include provision whereby the insurer retains some portion of
the premiums payable to the reinsurers as shown in the account. When the next account is drawn
up the reserve is adjusted so that the balance retained is based on that portion of the premiums payable
in the new account. Interest is usually payable to the reinsurers on the balance retained.
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4.4.5 Profit commission
There is often a provision in reinsurance treaties whereby the insurer is entitled to an additional
commission if the portfolio is exceptionally profitable to the reinsurers. The calculations are sometimes
quite complex and may not be based on profit in the accounting sense.
4.4.6 Minimum or deposit premium
Non-proportional treaties often include a minimum premium which may be payable in advance and is
therefore often termed a deposit premium.
The above terms are intended to be a guide to the provisions most commonly encountered in
reinsurance treaties which are important as far as accounting is concerned. Other important clauses may
exist and it is vital that the auditor thoroughly understands the clients treaties not only so that he can
verify account balances but also so that transactions can be tested for compliance with the treaties
since the clients exposure to loss could be considerably increased if a treaty had been breached.
5. INTRODUCTION TO RESERVING
SELF STUDY MODULE
CONTENTS
5.1 ELEMENTS OF THE CLAIMS PROVISIONS
5.2 TYPES OF RESERVING METHODS.
(PRACTICAL EXAMPLES, TRIANGULATIONS, ULR)
5.3 USE OF E & Y ACTUARIAL
5.4 THE AUDIT OF CLAIMS PROVISIONS
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5.1 - ELEMENTS OF THE TECHNICAL PROVISION
The basic accounting concept of matching means that for each sale accounted for we should also account
for the cost of that sale to determine the true gross margin.
Similarly for an insurer for each premium written in the year the insurer should make allowance for the
potential claims cost that would attach to those premiums. The claims cost will be made up of claims
actually settled and claims that the insurer expects to settle in the future. This liability for future claims on
policies that have been written is referred to as a claims provision or reserve.
The claims provisions for an insurer will be made up of the following:
(1) Case estimates on claims (often referred to as outstanding claims) that have been reported to the
insurer but not settled, these are usually referred to as case estimates as they are calculated on a
case by case basis. The case estimate will include the direct costs of settlement such as assessor
fees.
(2) Claims estimates for claims that have been incurred but have not been reported to the insurer -
referred to as the IBNR, these will generally be calculated statistically using actuarial techniques.
(3) An estimate of the indirect costs, such as claims department overheads, that will be incurred in
settling outstanding claims. These are referred to as the provision for claims handling expenses.
Reinsurance recoveries
We have been concentrating on the calculation of the gross technical provisions. The reinsurance
programme needs to be applied against the gross claims to determine if any reinsurance recoveries can be
made. Reinsurance is covered in more detail in a separate section.
5.2 TYPES OF RESERVING METHODS
5.2.1 Case Estimates
With this method an estimate of the likely ultimate settlement cost is made in respect of each notified claim
on a case by case basis. Such estimates are regularly updated to reflect the latest available information.
The outstanding claims reserve at an accounting date therefore consists of the sum of the estimates for all
notified outstandings.
Case estimates can be made either internally or externally, i.e. by the companys claims staff or by third
parties such as loss adjusters. Loss adjusters are independent professionals who act as consultants to
insurance companies in assessing the true extent and value of any loss resulting in a claim against them.
Making claims estimates involves a combination of technical knowledge, experience and subjective
judgement.
There are two major problems with this method of reserving for outstanding claims.
1. Because of the inherent uncertainties, individual case estimates can be difficult to calculate. The
seriousness of claims, especially in liability insurance, may not emerge for several years.
2. In some classes of business, where there are a large number of claims, or where the time lag to
settlement is significant causing the accumulation of large numbers of outstanding claims, the
method may be impractical because of the sheer volume of claims to be estimated.
Thus other methods with a statistical base have been developed.
2
5.2.2 Statistical Methods
Statistical methods are used to project future claim settlement experience based on past settlement
patterns. Two basic methods can be identified.
1. Based on claims paid to date
At any accounting date, the development of cumulative paid claims over a number of years is used to
project the ultimate total liability. This method is based on the development pattern of claims.
2. Based on average cost per notified claim
Where the average cost per notified claim (adjusted for inflation) is applied to the number of claims
outstanding.
Any statistical method will be affected by changes in the underlying claims. Thus changing conditions
that are likely to cause future experience to differ from that of the past must be identified and their effect
on settlement patterns examined.
It is normal practice to arrive at the IBNR provision by means of statistical techniques based on previous
experience. This is because it is normally impracticable to evaluate these provisions by waiting a
sufficiently long time for the claims to be reported and reserving on a case by case basis.
Any statistical method must be applied separately to homogenous divisions of business written (e.g.
class of business, currency).
You will readily appreciate from the nature of reserving described above that there is a significant degree
of judgement used in estimating ultimate reserves. Although the base data to assist with this process is
largely derived form routine data processes the ultimate reserve is derived from an accounting estimation,
with all the susceptibility that this entails.
Most clients will use some form of triangulation technique in calculating future liabilities.
We shall now look at some practical examples of the reserving methodologies used by general insurance
companies.
A TRIANGULATIONS
Triangulations are used to project future claims settlement loses based upon historical data.
The basic assumption used when projecting reserves is that history repeats itself.
The assumptions that follow from this are broadly as follows:
Business written in different underwriting years is similar; and
Claims settlement will therefore be similar.
For example, if traditionally an insurer finds that its motor account is settle after three years that that 20%
of claims are settled in the first year, 70% are settled in the second year and 10% in the third year then it
will assume that the same pattern can be applied to the current year.
If, therefore, in 1997 it receives UD2,000,000 of premiums and pays UD120,000 worth of claims on these
policies it will expect.
3
(i) in 1998 claims of UD420,000
(UD120,000 x 70 %)
20 %
(ii) in 1999 claims of UD60,000
(UD120,000 x 10 %)
20 %
Total claims expected are therefore UD600,000. As UD120,000 of claims have already been settled the
outstanding claim is UD480,000.
Triangulations are simply a pictorial representation of that process.
A typical triangulation will look like this:
Development years
(cumulative
claims paid UD000s)
Underwriting Year Year 1 Year 2 Year 3 Year 4 Year 5
1992 100 254 303 310 310
1993 105 240 310 311 312
1994 98 253 315 320
1995 110 260 307
1996 105 256
The triangulation can be read as follows:
(i) For premiums written in 1992 UD100,000 claims were paid by the end of the first year.
(ii) In the second year of development a further UD254,000.
The triangulation demonstrates a pattern of settlement with the bulk of claims settling in the first two years
and negligible movement after three years.
Development factors can be calculated which can then be used to predict the development of the more
recent years.
For example, if we look at the development from year 1 to year 2 we can see a pattern arise:
Underwriting year Year 1 Year 2 Development factor
1990 100 254 254 100 = 2.54
1991 105 240 240 105 = 2.29
1992 98 253 253 98 = 2.58
1993 110 260 260 110 = 2.36
The average development factor from year 1 to year 2 is 2.44.
Therefore for the 1994 year we would expect in 1995, year 2, to have paid cumulatively
105 x 2.44 = UD256,000 of claims i.e. to pay an additional UD151,000.
As the triangulation shows the total cost is normally only settled after 3 years therefore we would also
need to calculate the development factor from year 2 to 3 to determine the final cost.
4
There are however several limitations with triangulations which need to be understood:
History does not always repeat itself;
Business written in different years may not be comparable;
Impact of changes in premium rates (e.g. if rates have fallen 50%, claims might be 50% higher as a
percentage of premiums);
When does the business tail-off? (Data may be too immature for accurate projection);
Impact of changes in the reinsurance programme;
Some types of business cannot be projected using triangulation techniques (e.g. asbestos/pollution
claims);
Data limitations (data may be inaccurate); and
Catastrophe losses may distort the data.
B PROJECTED LOSS RATIOS
The triangulations we have looked at so far have been based on analysis of paid or incurred claims
development factors.
Another common method is the use of projected loss ratios.
This method allows changes in the level of or rate of premiums to be taken account of rather than looking
at claims in isolation.
Loss ratios are based on paid claims data or incurred claims data (i.e. paid claims plus outstanding claims)
Loss ratio - Claims
Premiums
A loss ratio of more than 100% is not good as claims paid out are more than the premium income received.
A simple example will illustrate how loss ratios work:
Underwriting Development Year
Year 1 2 3
1994 Premiums written 100 150 160
Claims incurred 30 70 112
1995 Premiums written 120 180
Claims incurred 30 70
1996 Premiums written 125
Claims incurred 40
Underwriting Development Year
year 1 2 3
1994 Projected loss ratio 30 47 70
1995 Projected loss ratio 25 39
1996 Projected loss ratio 32
5
Development factors are then calculated in the same manner as previously explained.
C CATASTROPHE LOSSES
A number of syndicates and companies specialise in catastrophe reinsurance. This is a method whereby
insurers reinsured each other to such an extent that the same losses go back and forth between these
entities until one (or more) of them runs out of reinsurance cover.
Provisions for losses arising form natural catastrophes can not be calculated by the use of triangulations.
This is because the size of the loss to the insurer is determined by his aggregate exposure to claims arising
from a single event together with the level of his own reinsurance protection available.
Where insurers are exposed to Catastrophe claims, the key issues are to assess the potential maximum
exposure to these events from the aggregation of claims and then calculate a probable maximum loss
(PML). The available reinsurance programme can then be applied to this loss.
Important issues to consider are:
Adequacy of systems to calculate a PML;
Availability of reinsurance;
Security of reinsurance (any allowance for bad debts);
Patterns of development of previous catastrophes;
Margin of error allowed with client assumptions; and
Materiality.
5.3 USE OF E & Y ACTUARIAL
E & Y actuarial department must be involved in all general insurance audits, although the level of
involvement can vary from very little to extensive, depending on the circumstances.
A profile document for each audit client has been developed and is completed as part of the planning
process.
This gives an overview of the client to be used as a base for deciding the level of actuarial involvement.
e.g.
(i) Agreed limited involvement (e.g. provision of benchmarks).
(ii) Involvement limited to provision of benchmarks, high level review of approach to reserving and ad
hoc support.
(iii) Review of client actuarial reports
terms of engagement
methodologies employed
key assumptions
reperformance of methods on the largest classes
(iv) Stand-alone Ernst & Young actuarial review of the provisions.
6
The use of E & Y actuarial for (iii) and (iv) is becoming increasingly important as our clients use their
own in house or external actuaries to project reserves.
5.4 THE AUDIT OF TECHNICAL PROVISIONS
Introduction
In order to audit technical provisions in an efficient and effective manner we need to gain a sound
understanding of the clients business, evaluate the systems of control, and assess the clients reserving
process.
A sound understand of the business is necessary if we are to identify the areas of audit significance and
therefore the areas in which our audit procedures should be concentrated.
An accurate evaluation of the systems of control will enable us to plan the appropriate audit procedures
and extent of testing.
An assessment of the clients reserving process will determine the extent of audit work to be performed.
5.4.1 Understanding the Business
An understanding of the nature of the business is perhaps more critical to the audit of technical
provisions than to any other area of the audit. The reserves are extremely subjective, based on a large
number of assumptions. Any background information we can obtain to help us critically assess these
assumptions, and therefore the reserves, must of assistance.
Information you may wish to obtain as part of the planning stage of the audit would include:
External Factors
Supply and demand for insurance.
Social factors, e.g. more litigious society.
Legal factors, e.g. legal interpretation of policies.
Specific factors affecting cost of claims.
Regulation, e.g. discounting, minimum reserves.
Internal Factors
Type of risk written, recent changes.
Policy terms, e.g. deposit premiums, reinstatements, claims made or losses occurring basis.
Direct or reinsurance business.
Lead of following underwriter.
Use of binding authorities/covers.
Motivations of underwriter/agent.
Methodology adopted.
Historic reserving experience.
Knowledge and experience of underwriting staff.
Catastrophe exposure.
In general terms we would wish to consider some of the following factors when assessing the overall
control environment:
7
Management operating style.
Organisation structure and methods of assigning authority and responsibilities.
Preparation of premium income budget.
Monitoring of budget versus actual.
Control over deputies and third parties by underwriter.
Preparation of quarterly accounts.
5.4.2 Evaluate the Reserving Process and Control Environment
Assessment of the controls in establishing a technical provisions. Some control issues to be considered
include:
Resources
Are adequate resources available to establish technical provisions in an efficient and timely
manner.
Knowledge of the underlying business is important in ensuring the appropriate technical
reserves are established, however input from a variety of disciplines is important.
Accurate and complete data
The reliability of the base data used to determine technical provisions is crucial. Need to
ensure data is being recorded correctly and updated on a timely basis (and is consistent with
the data reflected in the financial statements).
Appropriate methodology
Looking at the appropriateness of the methodologies used and underlying assumptions.
Consistency of applied methodologies or reasons for change.
The availability of alternative approaches.
The frequency of setting technical provisions.
Reasonable results
Assessment of the reasonableness of the level of reserves. Are they within a range of
outcomes, the ability of management/the board understanding and challenging the results.
The level of review and approval.
5.4.3 Illustrative Audit Procedures
1. Analytical Review Procedures (ARPs)
The following list sets out examples of circumstances where analytical review techniques may be
appropriate. The particular circumstances of each client will be a factor in determining the extent to which
these criteria are appropriate and whether other criteria apply:
Analysis of loss reserve amounts and loss ratios (e.g. by class of business or other relevant
analysis).
8
Surplus/deficit review for closing year by class of business as a % of Net Premium Income (NPI)
focuses on profitable classes
Comparison of loss ratios (by class of business) with other companies in the market.
In addition we may have to consider the following:
Actuarial reports obtained by either our client or ourselves;
Market reports (including lawyers and loss adjusters reviews, intelligences, etc.);
The firms in-house memos and newsletters on insurance topics; and
Changes in business written/policy terms over time, e.g. the move to claims made policies is likely
to affect reserves.
Audit procedures will need to be developed to ensure the statistical data can be reconciled to the
accounting records.
2. Audit procedures will need to be developed to ensure the statistical data used in the reserving
process can be reconciled to the accounting records.
3. Test a representative sample of outstanding claims to determine whether reserve estimates per the
database are consistent with information the claims file which is valid and up to date, and are
recorded in the proper period. Also review whether the database reflects periodic revisions in, or
updates to, reserve amounts.
4. Test the accumulation, accuracy and completeness of statistical/analysis of historical loss data in the
reserving database.
5. Review the methodology on which IBNR is determined. Is it consistent with prior years or are
circumstances such that a consistent basis does not apply? Is the basis reasonable given business
mix, currencies, settlement patterns, etc?
6. Review the performance of brought forward reserves and determine the reasons for significant
surpluses and deficiencies. Consider the impact of these results on the current reserving exercise.
This review effectively re-performs the prior years reserving based upon up-to-date information to
determine how accurate that reserving was. If for example an insurer had claims carried forward of UD1
million and these were settled for UD800,000 this would suggest that the reserving was overly
conservative.
An example will illustrate the process:
UD
Reserves brought forward 1,000
Claims paid (800)
Claims carried forward (300)
Deficit (100)
A review of surpluses/deficits over time may give us some indication of how accurate the reserving
process is especially if there is a standard methodology and the business is of the low value, high volume
variety. For example if a client always tends to make deficits we may consider an increase in the provision
would be appropriate depending on the materiality.
7. Consider changes in underwriting standards, business patterns or premium rates during the current
year.
9
8. Consider significant changes in underwriting processing that could affect loss payout patterns or
cause processing backlogs.
9. Review the basis of the clients reserve estimates and challenge it in the light of:
Recent trends in frequency and severity.
Changes in number of risks.
Adequacy of database used and method of estimation.
Changes in nature of business or reinsurance coverages.
Recent catastrophes.
10. Consider how any lump sum, special claims settlements, bulk reserves or other arrangements have
been accounted for in establishing the reserves.
11. Determine the impact of changes over time in reinsurance protection arrangements on the reserve
projections.
12. Compare our own projections, where performed, with clients projections and consider the
implication of significant variances on proposed reserves.
13. Where outstanding claims data is provided by intermediaries or market claims offices, check that the
data has been incorporated into the reserving database (i.e. completeness). Consider the
appropriateness of the clients procedures for reviewing the data.
14. Consider the implications of any special or unusual reinsurance agreements.
15. Has recognition been made of additional costs of liabilities which may arise on recognitions of
benefits under reinsurance protections (e.g. reinstatement premiums).
16. Where actuarial projections have been taken into account, review the appropriateness of the basis on
which the review has been performed, the reasonableness of assumptions taken into account and
test the accuracy and completeness of the database on which the projections have been performed.
17. Check posting of summaries to general ledger and consider accounts disclosure.
18. Consider the impact of currency movements on the reserving methodology and proposed reserves.
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GLOSSARY OF INSURANCE TERMS
Introduction
Though certain of these terms may not be in use in the Middle East insurance industry they are included to
provide an overview of the general terms used in the industry worldwide.
A1 Lloyds Registers highest classification for sea-worthiness of a vessel. The designation A means that
the vessels hull is strong and seaworthy and the designation 1 means that her rigging and gear are in perfect
order.
Accepting company - see Ceding company.
Accident year The calendar or accounting year in which an accident or loss occurred.
Accounting class The principal subdivisions of general business which are used in completing the
Department of Trade return. There are eight classes for direct and facultative business, defined in terms of the
seventeen general business classes:
1. Accident and Health
2. Motor vehicle, damage and liability
3. Aircraft, damage and liability
4. Ships, damage and liability
5. Goods in transit
6. Property damage
7. General liability
8. Pecuniary loss
and separate classes for: 9. Non-proportional treaty reinsurance
10. Treaty reinsurance
Active Underwriter The person who conducts underwriting.
Actuarial valuation A valuation by an actuary of future liabilities discounted back to the present time using
statistical probability tables to evaluate the incidence of liabilities.
Additional premium A further premium payable by the insured as a result of a policy endorsement.
Agent A person acting on behalf of the insurer who introduces business in consideration for a commission
(contrast this with a broker). Do not confuse with underwriting agent or Lloyds agent.
Annuity A periodic payment made for an agreed period of time (usually up to the death of the recipient) in
return for a cash sum. The cash sum can be paid as one amount or as a series of premiums. If the annuity
commences immediately after the payment of the sum it is termed an immediate annuity. If it is to commence at
some future date it is termed a deferred annuity.
Assurance A term interchangeable with Insurance.
Assured The person whose life is insured or in whose favour a policy is issued.
Average A clause in non-marine insurance policies (mostly for fire business) whereby, in the event of under
insurance, the claim paid out by the insurer is restricted to the same proportion of the loss as the sum insured
under the policy bears to the total value of the insured item. For average on marine insurance policies see under
loss.
- 2 -
Binding authority An authority granted by an underwriter to an agent (known as a coverholder) whereby
that agent is entitled to accept insurance business on behalf of the underwriter within certain limits. The
coverholder deals with premium collection, the issue of certificates and the servicing of claims, and has full
power to commit the underwriter within the terms of the authority.
Bonus In Life assurance - a grant to a with-profit policyholder out of the profits of a Life Fund. This may
take the form of a cash sum but more normally forms an addition to the policyholders sum assured (see also
No claims bonus).
Bordereau A detailed list of premiums or claims prepared by cedants or coverholders (see Binding
authority) for circulation to underwriters to advise them of risks covered and claims incurred. A bordereau is
normally prepared monthly or quarterly.
British Insurance Association A trade association which all insurance companies authorised by the
Department of Trade to transact business in the United Kingdom are eligible to join.
British Insurance Brokers Association A professional organisation formed by an amalgamation of four
earlier trade associations to represent the interests of insurance brokers.
Broker See Insurance broker.
Brokerage Commission received by a broker usually from the insurer, in consideration for placing the
business.
Burning cost A method of calculating the premium for reinsurance whereby within certain limits the
reinsurance premium paid by an insured or ceding company is related to the claims made under the policy. The
adjustment factor works to the advantage of the reinsurer until the maximum level of reinsurance premium is
reached. There is a minimum and a maximum premium payable usually expressed as a percentage of the ceding
companys underlying premiums. Within these limits, if the ceding company makes a claim the reinsurer will
collect an additional premium calculated in accordance with a formula contained in the policy. When the
maximum premium has been paid the reinsurer has full liability for further claims with no recourse.
Captive insurance company An insurance company set up by a large concern for the sole purpose of
insurance all or part of the risk exposures of its parent. Captives are set up as a result of dissatisfaction with
what the normal insurance market has to offer in terms of rating, service or cover available, and are frequently
situated in locations offering tax advantages.
Cancellation Termination of a policy before it is due to expire. In most cases this will result in a return
premium being paid by the insurer to the insured. (See also surrender).
Capacity The maximum premium income which a syndicate can accept, taking into account the premium
limits of participating Names.
Case reserve A provision made by an insurer where he considers that liability could or will arise on a loss
notified to him. This may be a known amount or an estimated amount dependent upon the facts available at the
time.
Catastrophe An event (such as a hurricance, flood, windstorm or earthquake) which results in substantial
claims being made on an insurer.
Ceding company An insurance company which offloads or reinsures business with a reinsurer or accepting
company.
Chartered Insurance Institute (CII) A professional educational body, membership of which is open to
anyone wholly or mainly engaged or employed in insurance.
Claim Injury or loss to the insured arising so as to cause liability to the insurer under a policy he has issued.
- 3 -
Claim file A file set up by an insurer to contain all details and correspondence relating to a claim and the
negotiation of its settlement.
Claims expenses Expenses relating directly to the settlement of claims (e.g. motor assessors fees, court
fees, etc.).
Claims handling expenses Expenses incurred in the settlement of claims which cannot be related to specific
claims. These include such items as salaries, costs and overhead expenditure incurred in relation to a claims
department.
Closed year Within the basis of three or more years accounting, a year for which no further adjustments are
to be made and final accounts or profit statements can be prepared. This can be done only after providing for all
outstanding claims. At Lloyds the closed year is usually the third year of an account.
Closing instructions or closing advice An advice sent by a broker to an insurer, informing him of the actual
proportion of a risk that he has been allocated and actual premium he will receive as a result of acceptance of the
risk when the slip was initialled. If the slip was over-subscribed by underwriters a pro rata scaling down will take
place in the brokers office.
Co-insurance This occurs where more than one insurer is in direct contractual relationship with the insured
for part of the same risk. Acceptance of a risk by a Lloyds syndicate represents co-insurance by each member of
the syndicate.
Collective policy A form of policy for several co-insurers sharing the same risk. The policy is issued by
the leading insurer in the joint names of all co-insurers. On renewal a collective renewal receipt is issued for
all co-insurers.
Contribution The principle or policy clause governing the manner in which the cost of claims arising on risks
covered by two or more policies are shared between the insurers concerned.
Convertible currency Any currency other than Sterling, United States Dollars or Canadian Dollars.
Cover Note A document issued to an insured, pending the final preparation of the policy, confirming
details of the insurance cover placed.
Declaration A statement by the insured giving details of the risks required to be covered. This may be
incorporated in the proposal form or made later. If made later, the policy will be issued subject to declaration
and will be endorsed with the details of the declaration.
Deferred premiumThat part of a premium which, following agreement with underwriters, is payable by
installments, usually quarterly or half yearly.
Deposit retained by ceding company (Reserve) Amounts due to reinsurers under a reinsurance policy but
which are retained by the original insurer to help finance the reinsurers proportion of claims. This is usually
such proportion of the premium which it is agreed, at the time the contract is made, shall be retained.
De-restricted premiums See Restricted premiums.
Direct and facultative Term used to refer to direct insurance business and inwards facultative reinsurance
business and inwards facultative reinsurance business.
Direct dealing An arrangement whereby certain motor syndicates at Lloyds deal directly with provincial
firms of brokers. It is necessary for the premiums payable to be guaranteed by a Lloyds broker.
Direct premiums (or direct business) Premiums written either directly with the public or through a broker or
agent, as distinct from indirect business where the person accepting the business is a reinsurer and accepts
business from a direct insurer or ceding company.
- 4 -
Earned premium The proportion of a premium relating to a period of risk which has expired.
Endorsement Documentary evidence of a change in the wording of or cover offered by an existing policy is
written on restricted terms.
Endowment assurance See Life assurance.
Equalisation reserve An amount set aside to prevent exceptional fluctuation in the amounts charged to
revenue in subsequent years in respect of claims arising due to the occurrence of events of an exceptional nature
(e.g. catastrophes).
Estimated future liability In the Lloyds solvency test on an open year, an estimate of the provision required
by a Lloyds syndicate to meet claims, unexpired premiums and other adjustments likely to arise in the future, as
a result of risks accepted for that year. The basis of calculation is laid down in the Instructions for the Guidance
of Lloyds Auditors.
Excess The first portion of a loss or claim which is borne by the insured.
Excess of loss reinsurance A type of reinsurance whereby an insurer limits his loss for a specific risk
(Facultative) or class(es) of risk (Treaty), beyond and up to specific limits. The lower limit is called his
retention. The premium payable is usually a percentage of the underlying premiums accept by the insurer for the
risk or class (es) covered, but it may be a moving percentage (see Burning cost). This form of reinsurance
may be placed to cover any one loss (or each and every loss), in which case claims are made on the reinsurer
for the aggregate amount that any individual loss paid out exceeds the retention. Because of the wide range of
cover required Excess of loss reinsurance is usually arranged in layers.
Excluded company A company not subject to the Insurance Companies (Solvency: General Business)
Regulations 1977. The most important class of such companies is specialist reinsurers.
Ex gratia payment A payment made by an insurer to a policyholder where there is no legal liability.
External company An insurance company whose head office is situated in a country outside the
European Economic Community.
Facultative/obligatory treaty A reinsurance arrangement under which the credit company can choose which
risks to cede and the reinsurer must accept all risks offered.
Facultative reinsurance The reinsurance of an individual risk, used by an insurer to limit his maximum
liability on that risk.
For declaration only (F D O) The issue of a policy with no premium charge being made or specific
insurances stated. Subsequent declarations are then made during the currency of the F D O policy.
Fronting The acceptance of insurance or reinsurance business with the intention of passing it on largely or
wholly to another insurer or reinsurer.
Fund For a particular class or classes of risk, the balance of premiums less claims an expenses after taking
into account any transfer to or from profit ensure that at a given date the balance of a fund is not less than the
aggregate of the estimated liabilities appertaining to it).
General average loss See Loss.
Global return The collective return required by the Department of Trade to be made for Lloyds a return
covering all the syndicates audited by that firm. These returns are consolidated by Lloyds and give rise to the
published Lloyds market underwriting results.
Gross net premium income A confused term sometimes found in reinsurance policies . An interpretation of
its use may be given in a policy.
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Gross premium income A confused term, sometimes applied to gross written premiums less return premiums
but at Lloyds applied to gross written premiums net of commission but before deduction of return premiums.
Guarantee fund A solvency yardstick, defined as one-third of the required margin of solvency. If a
companys margin of solvency falls below the guarantee fund, it must submit a short-term financial scheme to
the Department of Trade.
Hull policy Insurance of the actual vessel or aircrafts, as distinct from the goods or merchandise carried.
Inception date The date on which, under the terms of a policy, an insurer commences to be at risk.
Incidental business Business written by a syndicate formed to underwrite one class of business which falls
into another class. This is permissible within laid down limits.
Incurred but not reported losses (IBNR) A term used for claims arising from accidents or events which have
already occurred but of which the insurer has not been advised.
Incurred claims or losses The total, under the normal accrual concept, of paid and outstanding claims arising
in a period. The term is also used in the context of claims statistics where for given accident or policy years the
incurred claims are compared to earned premiums for each class of insurance, in order to asses the profitability of
the underwriting.
Incurred claim/loss ratio Incurred losses expressed as a percentage of earned premiums.
Indemnity A principle whereby the insurer seeks to place the insured in the same position after a loss as he
occupied immediately before the loss (as far as possible). The principle does not apply to life assurance.
Indemnity commission Commission paid by a life company to an insurance broker on terms which provide for
a clawback in whole or part is the policy lapses within a specified period of time.
Industrial Assurance A type of life assurance business where premiums are collected weekly or fortnightly
from the policyholder at his home. Only a few companies (most notably the Prudential) carry on Industrial
Assurance business.
Institute clauses Standard clauses used in the insurance of all main forms of marine hull and cargo and air
cargo insurance written in London and adopted by many underwriters outside the United Kingdom.
Institute of London Underwriters (I L U) An organisation which promotes and protects the interest of
company marine underwriters. It provides similar services for its members as Lloyds Policy Signing Office and
Lloyds Central Accounting do for members of Lloyds.
Instructions for the guidance of Lloyds Auditors A document on blue paper issued annually by the
Committee of Lloyds with the approval of the Department of Trade. It gives instruction and guidance to firms
on the Lloyds Panel of Auditors concerning the Lloyds solvency test. See also Lloyds audit regulations.
Insurable interest For a contract of insurance to be valid the (potential) policyholder must have an
interest in the insured item to the extent that its loss, death, damage or destruction would cause him
pecuniary loss. This is called insurable interest and must exist as follows:
Marine insurance - at the time of the loss.
Life assurance - at the time the policy is taken out.
Other insurances - at the time the policy is taken out and also
at the time of the loss.
Insurable value The value of the insurable interest which the insured has in the insured occurrence or event.
It is the amount to be paid out by the insurer (assuming full insurance) in the event of total loss or destruction
of the item(s) insured.
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Insurance Acts The principal Acts in force are the Insurance Companies Act 1974 which consolidated
existing legislation and the Insurance Companies Act 1981 which amends and in part replaces the 1974 Act.
Detailed requirements are specified by Regulations issued under powers contained in the Act by means of
Statutory Instruments.
Insurance broker An insurance intermediary who advises his clients and arranges their insurances.
Although he acts as the agent of his client, he is remunerated by a commission from the insurer. A broker is a
full time specialist with professional skills in handling insurance business.
Insurance Brokers Registration Council (I B R C) A council of seventeen, established by the Insurance
Brokers (Registration) Act 1977 (a Private Members Bill based on proposals prepared by BIBA) to regulate the
broking industry. When the Act is fully implemented (1 December 1981) the use of the term insurance broker
will be confined to individuals and companies that have respectively registered and enrolled with the Council.
Insurance Companies
Mutual A company where the policyholders are entitled to share distributable profits in
proportion to the amounts and conditions of their policies. Historically most mutuals
started off as employers co-operatives where the employers were all in the same
trade, e.g. Iron Trades Mutual Insurance Co Ltd.
Proprietary A limited liability company with a subscribed capital, whose shareholders have the
ultimate right to the profits of the company.
Insured The person whose life or property is insured or in whose favour the policy is issued.
Insurer An insurance company or Lloyds underwriter who in return for a consideration (a premium)
agrees to make good in a manner laid down (in the policy) any loss or damage, suffered by the person paying
the consideration, as a result of some accident or occurrence. (See Life assurance).
Knock for knock A standing agreement between two insurance companies designed to avoid legal actions.
This arrangement applies to motor vehicle policies and under it each company agrees to pay for the damage to
the vehicle of their respective insured without regard as to who was to blame for the accident.
Lapse The cancellation of a policy at renewal date as a result of non-payment of the renewal premium.
Layers A term used in connection with insurance policies on larger risks whereby the risk is placed in
sections rather than altogether. For example, the liability on a chemical works insured for UD30 million might be
placed first layer up to UD5m. second layer over UD5m. up to UD15m. third layer over UD15m. up to UD30m.
Different underwriters will probably be involved with each policy and different premium rates will almost
invariably apply to each layer.
Leading underwriter (or Leader) An underwriter (usually a specialist in the field of the insurance
concerned) who is the first to take a portion of a risk and quote on appropriate rate of premium. On a large risk
the broker will if possible select two or three specialists to lead, their reputations being such that other
underwriters have confidence in accepting portions of the risk and the slip can be fully subscribed.
Life assurance General term applied for insurance of persons lives where the contract is not one of
indemnity but of an ultimate claim. The risk element is the period before a claim is made. Types most common:
Endowment Period assurance with a guaranteed sum payable by the assurer at maturity
or on earlier death.
Whole Life Sum assured payable only upon death of the assured for which premiums are
generally paid to the date of death.
Term Period assurance where the sum assured is only payable if death occurs
within the period.
Decreasing term A form of assurance where the sum assured decreases as time goes on.
Instances of this are mortgage protection cover and family income benefit.
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Convertible term A Term policy where the assured has the right during the term of the
policy to convert it to a whole life or endowment policy.
In all the above contracts the terms may be for a flat sum assured or for a sum plus a share in the profits of the
invested fund of which the premiums paid form part. These latter are termed with-profit policies. See also
bonus.
Line The proportion of a risk accepted by an insurer. Also used to refer to the amount which an insurer has
fixed as his maximum exposure for any one risk.
Line slip An arrangement entered into between Lloyds underwriters and brokers whereby, for a given
type of risk, the broker only needs to approach the leading and second underwriter who will accept or reject each
risk on behalf of all the underwriters concerned in their agreed proportions. This is an administrative
convenience where a broker is placing a large number of similar risks with same group of underwriters.
Lloyds Agent a representative of the Committee of Lloyds forming part of a worldwide network for the
provisions of shipping and aviation intelligence. Contrast with Underwriting Agent.
Lloyds audit A rather misleading term used to describe the annual solvency test carried out on each
underwriting member of Lloyds to enable a certificate to be furnished to the Secretary of State in accordance
with section 73 of the Insurance Companies Act 1974. The Lloyds audit is a separate responsibility from the
audit of a Lloyds syndicate.
Lloyds audit regulations A letter on white paper, sent annually by Lloyds audit department to all panel
auditors, amplifying and explaining the instruction for the guidance of Lloyds auditors.
Lloyds Aviation Underwriters Association An association concerned with technical matters affecting
Lloyds underwriters on aviation syndicates.
Lloyds broker A broker approved by the Committee of Lloyds and thereby entitled to enter the underwriting
room at Lloyds and place business direct with underwriters. Lloyds brokers must meet the Committee of
Lloyds stringent requirements as to integrity and financial stability. They have to file annually a special audit
certificate with the Committee of Lloyds concerning their financial position.
Lloyds Central Accounting (L C A) A central accounting facility provided by the Corporation of Lloyds
enabling syndicates and brokers to receive or pay money centrally on a fixed day each month. Effectively this
provides Lloyds syndicates with a brokers ledger accounting service since all business signed each day is
processed for the account of each syndicate and each broker.
Lloyds Central Fund A fund set up to meet any underwriting deficit of Lloyds members whose Lloyds
deposit, premiums trust fund balance, reserves and personal assets prove inadequate to meet his liabilities to
policyholders. All Lloyds underwriters make annual contributions to this fund.
Lloyds Committee A committee of sixteen members who are elected by members of Lloyds to serve a
four year term. This committee conducts the affairs of the Corporation of Lloyds, assisted by a central
administration service.
Lloyds Corporation A society incorporated under the Lloyds Act 1871 which provides services and
premises for the transaction of insurance business. It does not carry on insurance business and is not itself
liable for insurance business transacted within its premises.
Lloyds deposit A deposit of investments or cash made by an underwriter before he can become a member of
Lloyds. It is held in trust for policyholders by the Corporation of Lloyds under a Deposit Trust Deed which
entitles the member, as beneficial owner, to receive the dividends or interest. The amount of the deposit
determines the level of premium income a member may write. Overseas members are required to deposit more
than U.K. residents.
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Lloyds Motor Underwriters Association An association representing Lloyds syndicates engaged in
motor insurance. It is particularly concerned with problems arising under the insurance requirements of the
various Road Traffic Acts.
Lloyds Policy Signing Office (L P S O) A central service provided by the Corporation of Lloyds under
the auspices of the Committee of Lloyds. Its main functions are to:
check transactions and number them
sign policies on behalf of underwriters
take down entries
process syndicate reinsurances
produce daily tabulations of transactions and periodic settlement statements
provide special schemes (as required)
provide statistics, manuals, circulars, advices, etc.
operate Lloyds Central Account.
Lloyds solvency test See Lloyds audit
Lloyds underwriter A person who is an underwriting member of Lloyds, subscribing to Lloyds policies
issued in accordance with the Insurance Companies Acts. He (or she) would have satisfied the Committee of
Lloyds as being a fit person to be a Member of Lloyds and also have undergone a stringent enquiry into
personal wealth. A substantial Lloyds and also have undergone a stringent enquiry into personal wealth. A
substantial Lloyds deposit would have been made and various Trustee arrangements entered into. Throughout
the period of his membership the whole of a Names personal assets are at risk and his or her liability is
unlimited.
Lloyds Underwriters Non-Marine Association (LUNMA) An association concerned with technical and
other matters affecting Lloyds Underwriters on non-marine syndicates.
Lloyds Underwriters Non-Marine Claims Office (LUNCO) An association, to which most Non-Marine
syndicates at Lloyds belong which operates a scheme to simplify settlement of claims. Where several
syndicates are involved, the broker, instead of agreeing a claim with each of them will show the claim to the
leading underwriter and then present it to LUNCO which (for claims within certain limits) will act on behalf of the
underwriters, keeping them informed of their individual liabilities by means of LUNCO cards.
Lloyds Underwriters Association An association concerned with technical and other matters affecting
Lloyds underwriters on marine syndicates.
Lloyds Register of Shipping An unincorporated association of bodies who maintain an accurate classified
register of mercantile shipping, yachts and certain installations. It is governed by a committee consisting of
representatives appointed by interested parties such as merchants, shipowners, underwriters, etc. Its original
purpose was to provide a survey and classification service with regard to seaworthiness of vessels so as to
assist underwriters and shipowners in rating of premiums for insuring such vessels. Today its activities are
worldwide and embrace the survey of oil regs and land installations of turbines, generators, etc.
London Market The whole of the insurance market in London comprising Underwriters Brokers and Agents:
involving probably either directly or indirectly, all the major insurance risks of the world the market
operates on the basis of brokers showing the risks to the various Lloyds underwriters and/or insurance
companies and/or underwriting agencies. Claims are also paid through the brokers as most of the underwriters
have no direct contract with the general public.
Long tail A term used to describe insurance business (e.g. medical malpractice liability) where it is known
from experience that notification and settlement of claims will take many years.
Long term business amount The aggregate of a companys long term business liabilities less a laid down
deduction by reference to which the value at which certain long term business assets may be included in the
Department of Trade return is restricted.
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Long term agreement An agreement whereby, in return for a discount on the premium, the insured makes a
binding commitment to offer the business for renewal for a number of years.
Loss Another term for a claim.
Actual total loss Where the item insured is actually destroyed or so damaged as to cease to
be useable.
Constructive total loss Where the item insured is reasonably abandoned on account of its actual
total loss being inevitable or where its preservation or repair would cost more
than its actual value when preserved or repaired.
General average loss An extraordinary sacrifice or expenditure voluntarily and reasonably made or
incurred in time of common peril, for the purpose of preserving all other
property imperilled in a common adventure.
Particular average loss A loss caused by some peril or occurrence which has been insured against.
Loss adjuster An independent and highly trained claims expert, who acts as a consultant to insurers in
assessing the true extent and value of any loss which has resulted in a claim being made against them. Although
paid a fee by the insurer, a member of the Chartered Institute of Loss Adjusters is required to act with claimants
legitimate interests in mind.
Loss cost Another term for Burning cost.
Minimum reserve a nominal provision made where a claim has been notified to an insurer but insufficient
details have been supplied to enable him to reasonably assess his liability thereon.
Name Another term for an underwriting member of Lloyds - see Lloyds Underwriter.
Net premiums A confused term - often used to mean gross premiums less return premiums and reinsurance
premiums, but equally often (particularly with Marine) commission deducted as well.
No claims bonus (or discount) A rebate of premium given to an insured person by an insurer where no
claims have been made by that insured person. Very common in motor insurance.
Non-proportional reinsurance see Proportional reinsurance.
Obligatory Treaty see Reinsurance Treaty.
Open market Used to refer to a risk that is individually placed in the market as opposed to one that is
covered under a binding authority, line slip or treaty.
Open year Where a three or more years basis of accounting is adopted an open year is the 1
st
, 2
nd
or 3
rd
year where adjustments are still being put through, no profit has been ascertained and a reinsurance to close has
not been arranged. (Compare with closed year).
Outstanding losses or claims The total of losses or claims which have been advised but a given time are still
outstanding and as such are only estimated amounts.
Overriding commission An additional commission payable to important agents who introduce a large
volume of profitable business to an insurance company. It can also apply to a special commission received by
the ceding company on a quota share reinsurance scheme as a contribution towards the ceding companys
expenses.
Overseas Deposits Deposits required under local legislation to be made by insurers in overseas countries for
the security of policyholders in those countries.
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Paid losses or claims The total of claims or losses which haven been settled during a given period.
Particular average loss see Loss
Period of risk The period during which the insurer can incur liability under the terms of the policy.
Personal reserve A reserve of cash or investments held on behalf of a Name by his Lloyds underwriting
agent to provide funds to meet future losses. Normally this reserve is built up by the agent, in accordance with
the underwriting agency agreement, setting aside a proportion of a Names past profits, but a Name may put up
funds direct from other sources. A personal reserve is in addition to amounts set aside in any Special Reserve
Fund which the Name may have.
Policy A document detailing the terms and conditions applicable to an insurance contract and constituting
evidence of that contract. It is issued by an underwriter for the first period of risk. On renewal a new policy may
not be issued but the same conditions would apply and the current wording would be evidenced by the renewal
receipt.
Policy proof of interest (PPI) A PPI policy is one under which the insurer agrees to pay the policyholders
claims whether or not the latter has a proved insurable interest.
Policy Signing and Accounting Centre A company limited by guarantee providing for its members policy
signing and central accounting services in a similar way to the Institute of London Underwriters and Lloyds
Policy Signing Office/Lloyds Central Accounting.
Policy year A term relating to the basis upon which certain loss statistics are based. It relates to the
calendar or accounting year in which the commencement is date of the policy falls, and may include policies of
varying lengths. The term is also used to denote the period between anniversary dates of a policy
Portfolio transfer The transfer of liability for unearned premium or outstanding claims from one insurer to
another. The most common times for portfolio transfers are either at the inception or termination of a reinsurance
treaty or where an insurer or reinsurer is retiring from a particular class of business or territory. Once the
portfolio transfer is agreed the insurer ceding it will have no further liability for the business covered by the
portfolio. The term can also be used in connection with long term premiums when a risk spans more than one
period of account and part of the premium is carried forward to subsequent years of account.
Pooling An arrangement whereby several insurers share business in agreed proportions. Several of the
pool members may write business on their own account and then reinsure it with the pool. In a pooling
arrangement, premiums, claims, commission, expenses and interest earned on pool monies are all shared out in
the agreed proportions.
Premium The consideration paid for a contract of insurance.
Premium/expense ratio A recognised and useful ratio whereby expenses are related to net premiums earned.
Premium limit The amount of premiums at Lloyds a Name is allowed to underwrite in the course of a
calendar year. Each Names premium limit is related to the amount of his Lloyds deposit. Any Name who
exceeds his premium limit is required to establish a Special Deposit with the Committee of a minimum of 50p for
every UD1 of the net excess.
Premiums Trust Fund The fund of a Lloyds syndicate representing the balance on the open year (s) of
account which are held in trust under the terms of a premiums trust deed, as security for policyholders. The
Fund is available for the payment of claims and syndicate expenses and ultimately when an account has been
closed for the payment to the Names of their profit.
Profit commission A commission based upon profit (as defined). Two specific cases are:
(a) the commission received by a working Lloyds underwriter and/or underwriting agent as part of his
remuneration from the Names;
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(b) the commission received by a ceding company where its business ceded to a particular reinsurer has been
profitable.
Proportional Reinsurance A term used to cover surplus and quota share reinsurance whereby the original
insurer and his reinsurers share losses in the same proportions as they share premiums. Contrast non-
proportional reinsurance (e.g. Excess of Loss or Stop Loss) where the sharing of losses bears no relation to the
proportions of premiums originally received.
Proof of Loss A sworn statement given by the insured to the insurer setting out the date and description of
the occurrence giving rise to the claim and the amount of loss or damage incurred.
Proposal Form A form sent by an insurer to a person requiring insurance so as to obtain sufficient
information to allow the insurer to decide whether or not to accept a risk and what conditions to apply if it is
accepted.
Protection and Indemnity club (P & I club) A shipowners or other transport operators mutual marine
assurance association. P & I clubs specialise in liability covers and insure the balance of collision risks
(normally one quarter) not covered by a company or Lloyds policy.
Pure year figures Figures (of premiums, claims, etc.) which relate only to business written in a particular
underwriting account year. Figures relating to any element of earlier years reinsured into that year are excluded.
Quota share reinsurance A treaty, normally obligatory, whereby for a particular class or classes of business
an insurer cedes and a reinsurer accepts a specific proportion of underlying premiums received by the insurer.
Claims are shared between the insurer and reinsurer in the same proportion as premiums. It is a means whereby
one underwriter can participate in the fortunes or misfortunes of another underwriter.
Reinstatement An entitlement, in consideration of the payment of an additional premium, to continue a
policy for a further period of indemnity after a claim has occurred. The calculation of the additional premium will
be laid down in the policy and may be limited to one or more reinstatements. Policies with reinstatement clauses
are found in marine, fire and property insurance business, particularly in connection with Excess of loss
reinsurance.
Reinsurance to close A term used mainly in connection with Lloyds syndicates to describe the transfer, in
consideration for a premium, of the outstanding liability so that a result on the closed year may be ascertained.
The transfer is usually transacted with the subsequent open year of the same syndicate, or the next but one year
(odds into odds/evens into evens).
Reinsurance The insuring again by the insurer of a risk or class of risks he has accepted. Such an
arrangement does not affect the rights of the insured.
Reinsurance Treaty Reinsurance of a block of business or whole account for a particular class or classes of
business. This can be either obligatory (or automatic) or not. Under an obligatory treaty the original insurer
must cede and the reinsurer must accept all risks for the class(es) covered by the treaty.
Reinsurance premium The consideration paid by an insurer for a contract of reinsurance whereby the
reinsurer agrees to indemnify the ceding company against part or all of the risk attaching to a policy issued by
the original insurer.
Reinsurance recovery A claim on a reinsurer for recovery of the reinsured part of a claim payable or paid by
the original insurer.
Renewal The process of continuing an insurance from one period of risk to a succeeding one.
Required margin of solvency The solvency margin an insurance company is required to maintain, failing
which it must submit to the Department of Trade a plan for the restoration of a sound financial position. For
general business, the required margin is normally the greater of the two sums resulting from the application of the
laid down Premium Basis and Claims Basis of calculation.
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Reserve premium That proportion of a premium, receivable under a contract of reinsurance, which is
retained by the ceding insurer under the terms of the policy to help finance the reinsurers share of the cost of
settling claims.
Restricted premium A transaction in respect of a convertible currency amount payable in U..S.$ (and to a
lesser extent sterling) taken down by Lloyds Policy Signing Office at a notional amount before the actual rate of
exchange is known. Restricted premiums are not included in Lloyds Central Accounting Settlement. When the
actual rate of exchange becomes known the premium becomes de-restricted and is included in the Lloyds
Central Accounting System for settlement.
Retained premium Another term for Reserve premium.
Retention The amount of liability on any one risk retained by an insurer after taking into account all his
reinsurance arrangements.
Retrocession Reinsurance of indirect business.
Return premium A premium refund payable to the insured as a result of cancellation of a policy or
endorsement.
Risk The peril or hazard insured against.
Risk group A subdivision of an accounting class, comprising direct and facultative risks insured by an
insurance company as part of the business carried on in a particular country which, in the opinion of the
directors of the company, are not significantly dissimilar. Subject to certain immateriality exemptions, specified
information about each risk group must be included in the Department of Trade return.
Room A market name for the underwriting room at Lloyds.
Run-off A term used to describe the settlement of an underwriting account (or part thereof) over a period
of years. This settlement pattern or run-off, when available for many years consecutively, provides probably
one of the best statistical bases for insurers to use when assessing the estimated liabilities on open years. When
using run-off statistics care should be taken to ascertain firstly, whether they are based on policy years or
accident years and secondly, whether the content of the underwriting account (or part thereof) being examined
has remained fairly constant in character over the period. Often run-off statistics are based on incurred
settlements and if this is the case further care should be taken to see that the basis of estimating outstanding
claims has remained constant throughout the period being examined.
Salvage A recovery of all or part of the value of an insured item on which a claim has been paid. The insurer
will normally take over the salvage and obtain salvage moneys to reduce the cost of the claim.
Schedule The part of a policy containing information peculiar to that particular risk. The greater part of a
policy is likely to identical for all risks within a class of business covered by the same insurer.
Short tail A term used to describe business where it is known that in the main claims will be notified and
settled quickly. In Lloyds this term tends to be applied only to Non-Marine and Aviation accounts, where
there is not indemnity for legal liability within the risks.
Slip A London Market term used to describe the document used by a broker to set out details of a risk to be
shown to insurers. If the insurer agrees to accept the risk or part of its, he initials the slip and signifies
proportion of the risk he is writing. The share may ultimately be scaled down by the broker, but it cannot be
increased without the insurers agreement.
Special settlement A transaction through Lloyds central accounting system where settlement is required by
brokers or underwriters quickly, so that the normal credit terms have to be by-passed.
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Solvency margin The amount by which the value of an insurance companys admissible assets exceeds the
amount of its liabilities, including prospective and contingent liabilities. Insurance brokers are subject to
solvency requirements imposed by Lloyds and IBRC.
Spread loss treaty A form of stop loss reinsurance covering a period in excess of one accounting period.
Stability clause A clause sometimes found in excess of loss reinsurance contacts whereby the insurers
retention is tied to the cost of living or other index. The change in the insurers retention as a result of
movement of the index is effective when the reinsurer pays the claim and not when the claim is notified.
Stop loss A means whereby an insurer arranges to limit his loss for a whole account or class of business.
An insurer may arrange for a stop loss in excess of 90% m of his net retained premiums for a particular class of
business. The amount by which claims after deduction of reinsurance recoveries exceed 90% of his net retained
premiums is recoverable from his reinsurers. Usually there is a limit written into the policy so that whilst the
insured may collect excess of 90% he is limited to a further, say 10% so that thereafter the insured is again
liable.
Statement of Particulars The annual return which a practising insurance broker or enrolled body corporate
is required to submit, together with the audited accounts, to the Insurance Brokers Registration Council within
six months of the year end. Lloyds brokers do not complete a Statement of Particulars, making an equivalent
return to Lloyds instead.
Sub-agency agreement The agreement entered into between a members agent and a managing agent when
the former places one of his Names on a syndicate managed by the latter.
Subrogation In contracts of indemnity the right of an insurer to stand in the place of the insured and avail
himself of all the rights and remedies of the insured, whether already enforced or not.
Sum assured The sum for which a life is assured and upon which premiums are based.
Surplus treaty A treaty under which an insurer reinsures liability, on various risks, surplus to the maximum
he wishes to retain. This differs from a quota share in that it does not relate to all risks in a class of insurance.
For example, an insurer who restricts his maximum possible liability is say UD25,000 and who accepts a risk
where the maximum possible liability is say UD35,000 will, for a strict pro rata share of the premium, reinsure the
UD10,000 surplus liability under a surplus treaty. Because most surplus treaties have a clause restricting the
maximum liability covered by the treaty to a multiple of the insureds own retention, insurers very often arrange
several layers of surplus treaty. This enables them to accept large risks and still restrict their own maximum
possible liability to their required amount.
Surrender Cancellation of a long term policy before it reaches maturity, usually involving the payment by
the insurer of a surrender value. The surrender value will amount to the total premiums paid under the policy
less an allowance for expenses and the cost of insurance for the death of the assured during the duration of the
cover. Depending on the length of time the policy has been in force there may be an allowance for interest, etc.
earned by the premiums.
Syndicate A term used to describe a number of Lloyds underwriters whom a n agent has joined in business
for a common purpose. Each syndicate has an active underwriter who is authorised to write business on its
behalf. A member of a syndicate is still a principal in his own right and is personally liable for the fixed
percentage of each risk that is accepted by the syndicate. He is not liable for debts of other syndicate members.
Syndicate stamp A document setting out the Names of and share taken by the members of a Lloyds
underwriting syndicate. It defines the constitution of the syndicate for each year of account and must be
registered at Lloyds.
Taking down processing of a policy by Lloyds Policy Signing Office whereby all transactions types
(premiums, claims, etc.) are recorded and allocated to the underwriters and brokers according to the closing
instructions on the slip. The term is also applied by company underwriters when noting the details of a Slip or
claims file for record purposes.
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Tariff insurer A member of the Fire Offices Committee (F O C) which, for a number of risks, fixes
minimum rtes below which its members may not quote.
Technical reserves Reserves (or more strictly provisions) held to meet underwriting liabilities. The term
covers unearned premium reserves, unexpired risk reserves, outstanding claims (both notified and IBNR),
claims expenses reserves, funds and equalisation reserves.
Term assurance See Life assurance.
Third party A person claiming against an insured. In insurance terminology the first party is the insurer and
the second party is the insured.
Tonner reinsurance A form of total loss only reinsurance of vessels over or between specified tonnages.
Tonner policies are normally effected on a policy proof of interest basis and without benefit of salvage to the
insurer and may not be a legally enforcable form of insurance contract.
Treaty See Reinsurance treaty
Tribunal A body operated by the Lloyds associations for the purpose of vetting potential holders of
binding authorities in certain countries outside the United Kingdom.
Twenty-fourths method See unearned premium reserve.
Unearned premium That proportion of a premium which relates to the portion of a risk which has not yet
expired.
Unearned premium reserve The total amount at a given point in time, of an insurers net unearned
premiums. By convention this is calculated after making an allowance for commission. For convenience,
insurance companies now mostly use what is known as the twenty-fourths method of calculation for unearned
premium reserves. This assumes that all policies commence on the 15
th
day of each month and the appropriate
twenty-fourths of the premiums attaching to policies commencing in each month is carried forward as unearned
premiums.
Unexpired risk reserve An amount set aside, in excess of the unearned premium reserve, to cover the
liability of unexpired policies. This is commonly used where an insurer has increased his premium rates thereby
indicating that the premiums written at the old rates were not profitable and thus the amount of unearned
premium reserve carried forward on these premiums will not be adequate.
Underwriter See Lloyds underwriter. The term also relates to an official of an insurance company who
accepts business on the companys behalf.
Underwriting agent An agent appointed by a Name under the terms of an underwriting agency agreement
to manage his underwriting affairs at Lloyds on his behalf. There is a distinction between a Managing Agent (
who manages one or more syndicates) and a Members Agent (who acts for his Names in other capacities and
may place them on syndicates run by a Managing Agent), although the majority of Agents act in both
capacities. An underwriting agent must have complied with the requirements of the Committee of Lloyds for
conducting an Underwriting Agency at Lloyds.
Underwriting agency agreement A contract between an underwriter and an underwriting agent which lays
down the powers, remuneration and profit commission of the agent.
Unit linked policy A type of life assurance policy where the benefits are expressed in terms of units, the
value of which varies according to the value of some specified assets.
Utmost good faith Insurance contacts are contracts of utmost good faith (uberrimae fidei), which means
that the proposer has a duty to disclose, clearly and accurately, all material facts relating to the proposed
insurance. Any breach of this duty entitles the insurer to repudiate liability.
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Voyage policy Insurance operative from the post of departure to destination, irrespective of any time element.
Warranty A statement made by the insured as absolutely true. Also a very strict condition in a policy.
With-Profits In life assurance a with-profits policy carries the right to participate in the profits of the
Life Fund of which its premiums form part.
GLOSSARY OF TERMS
APPENDIX - ABBREVIATIONS
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AIOA Aviation Insurance Offices Association
AOA Accident Offices Association
AP Additional premium
ASLO Associated Scottish Life Offices
BIA British Insurance Association
BIBA British Insurance Brokers Association
CII Chartered Insurance Institute
CTL Contructive total loss
DOT Department of Trade
EFL Estimated future liability
EML Estimated maximum loss
FDO For declaration only
FFA Fellow of the Faculty of Actuaries
FIA Fellow of the Institute of Actuaries
FIRTO Fire Insurers Research and Testing Organisation
FOC Fire Offices Committee
FPA Fire Protection Association
IBNR Incurred but not reported
IBRA Insurance Brokers (Registration) Act 1977
IBRC Insurance Brokers Registration Council
IIC Institute of Insurance Consultants
ILOA Industrial Life Offices Association
ILU Institute of London Underwriters
LATF Lloyds American Trust Fund
LAUA Lloyds Aviation Underwriters Association
LCA Lloyds Central Accounting
GLOSSARY OF TERMS
APPENDIX - ABBREVIATIONS
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LCTF Lloyds Canadian Trust Fund
LIA Life Insurance Association
LMUA Lloyds Motor Underwriters Association
LMX London market excess
LOA Life Offices Association
LPSO Lloyds Policy Signing Office
LTA Long term agreement
l/u leading underwriter
LUA Lloyds Underwriters Association
LUNCO Lloyds Underwriters Non-Marine Claims Office
LUNMA Lloyds Underwriters Non-Marine Association
MAT Marine, Aviation and Transport
MIB Motor Insurers Bureau
PA Personal accident
P & I Protection and Indemnity
PHI Permanent Health Insurance
PPI Policy proof of interest
PSAC Policy Signing and Accounting Centre
PTF Premiums Trust Fund
R/I Reinsurance
ROA Reinsurance Offices Association
RP Return premium
SRF Special reserve fund
tba to be agreed
TLO Total loss only