Page 95 - India Insurance Report 2023- BIMTECH

India Insurance Report - Series II 83

Adoption of Risk-Based Capital in the

Insurance Industry – Usher in a

Paradigm Shift

- Anurag Rastogi
10 FIAI, FIA, FIII, Elected Council Member, Member of few Committees and
Chairman of its Education Committee, Institute of Actuaries of India

1. Why Need of Capital for Insurers/Reinsurers?

All commercial activities need capital. Let us take the example of a soap manufacturer. This soap
manufacturer, at the time of setting up the business, will require capital for land, machinery, raw materials
and labour. When the business grows, and he needs to increase manufacturing capacity, he will need
more capital for bigger land, more machinery and more labour.

Let us now look at insurance companies. Insurers do not manufacture any tangible product. Hence,
they do not need large land parcels or heavy machinery. Rather, they develop insurance products which
are nothing more than a promise that if the policyholder were to suffer a loss due to the occurrence of
an event defined in the insurance contract, the insurer will make good the loss or will pay a fixed agreed
benefit amount. Insurers collect premiums from the buyers of this promise (insurance product/insurance
policy), which is based on the probability of occurrence of loss and the expected claims outgo per loss.

This is where insurance differs from other commercial activities significantly. Most businesses know
the cost price of the goods or services they are selling. They can add all the overheads and can arrive at
the sale price after factoring a reasonable profit margin. As against this, the insurance companies, at the
time of fixing the insurance premium rates, do not know the cost price of the insurance policy, meaning
the number and amount of claims they will have to pay for all the policies they have sold to the customers.
Insurers/their actuaries estimate the number of claims and the expected claim amount per policyholder.
This potential/expected outgo forms the basis for insurers/their actuaries fixing the premium rates for
end customers after adding other overheads and some profit margin. The premiums thus charged are a
very small fraction of the total value of risk carried by insurers. In theory, the premiums are expected to
be sufficient to meet all claims costs and expenses and leave some profit for insurers. However, the
claims costs and all other expenses are “expected” costs or just intelligent actuarial estimates of what
the future outgoes could potentially be. These costs, particularly the claims costs, could be significantly
different than the expected costs for various reasons. The worrying part is the chance of actual claims
cost exceeding the estimated claims costs due to various reasons. Some of these are listed below:

 Higher expected/estimated incidence rates than those assumed in fixing the premiums;