«Protecting the poor A microinsurance compendium Edited by Craig Churchill Protecting the poor A microinsurance compendium Protecting the poor A ...»
1.2 Asset depreciation and default risk Investment income from the assets of an insurance company is an important source of overall income. An error in managing investments can therefore be a major cause for the failure of insurance companies. One common error is excessive exposure to assets that do not generate the expected interest and dividend payments. This is known as “asset default risk”.
In capital markets, asset quality is generally rated inversely to its promised returns; this reflects the situation that, all other things being equal, assets promising a high rate of return also carry a greater risk of default. High interest is often associated with a higher risk rating of the investment instrument.
So, prudent investors may prefer safer investments. However, an over-investment in perfectly safe investments could lead to erosion of real portfolio value over time, since returns are not much higher than (or may even be lower than) inflation rates. On the other hand, overexposure to high-risk investments could lead to a severe decline in portfolio value due to asset default. The challenge of good investment management is to achieve a balance between these two extremes through a diversified investment policy. The objective is to optimize investment returns while maintaining an adequate level of security and the required degree of liquidity so that assets can be available when required.
258 Microinsurance operations Most microinsurance schemes do not accumulate significant assets because they provide only short-term products, such as credit life or health insurance. However, for those offering long-term products, such as endowments and pensions, it is necessary to build up substantial assets since benefits are paid out in the distant future. Surplus accumulation of a successful programme over the years may be another significant source of assets.
Whatever the source, assets must be invested and monitored diligently.
Adequate controls have to be in place to ensure that funds are not diverted
for personal use by managers and the board of directors. Financial institutions usually introduce the following measures in their investment policy:
– permitted investments – permissible asset classes for diversification – maximum investment permitted with any one financial entity or in a particular asset – discretion permitted to persons responsible for investments – procedure for modifying policy – reporting requirements Even with a good investment policy in place, however, the choice of investments is very limited in many developing countries, which may also lead to problems.
There is sparse information in the case studies on how assets are managed.
Few microinsurers have built up substantial assets, although the exceptions include VimoSEWA (India), CARD MBA (Philippines), Delta Life and Grameen Kaylan (both Bangladesh). The first two have invested the majority of their assets in related organizations, which could lead to problems due to the covariant risk.
One microinsurer in India was granted funds to invest in order to generate interest revenue to cover operating expenses. These funds were all invested in the stock market. The picture seems rosy at the moment because the markets have risen substantially of late. This investment policy is however extremely risky due to lack of diversification by asset class and could come back to haunt the organization. Stock markets can be extremely volatile and some good luck is required to exit just before a major decline.
As the other extreme, an example of overly cautious investment policy is employed by ALMAO in Sri Lanka. Its investment strategy requires that 30 per cent of all assets be invested in treasury bills and the balance in fixed deposits. The yields of this portfolio are below the current inflation rate in Sri Lanka. Over time, this will erode the real value of the investments.
Risk and financial management 259 In summary, diversifying assets appropriately over different investment vehicles and durations is one of the most practical and important practices in managing the asset default risk.
1.3 Interest rates and investment mismatch risk Investment mismatch risk can be illustrated by an example. If an insurer offers a savings product that guarantees that deposits will double in five years, this guarantee can be fulfilled only if the insurer consistently earns a
14.8 per cent return on investment. Any insurance product that has an implied interest rate guarantee would require the insurer to match asset flow with liability flow at the correct investment earnings rate. Failure to do so exposes the institution to future losses if interest rates change. This is called investment mismatch risk.
Using the above example, an investment yielding higher than 14.8 per cent over five years is needed to meet obligations, to cover expenses, and to generate a surplus. Just how much higher depends on the efficiency and objectives of the insurer. The section below on investment management discusses this in more detail.
1.4 General contingencies and management risk Insurance operations always have to be actively and professionally managed.
Poor management can lead to eventual dissolution or bankruptcy. A lack of skills and understanding of how to operate the programme is a substantial risk for a microinsurer. This risk is compounded further if the board of directors is inadequately skilled in overseeing management (see Chapter 3.8).
Inadequate management and governance is perhaps the biggest risk for many microinsurance programmes (see Box 50). As described in Chapter 3.10, benchmarking can help to overcome some of this risk, though it can never be completely eliminated. For this reason, greater efforts should be made to increase the expertise of directors and managers.
Keeping the above risks in mind, the microinsurer has to manage its financial resources in such a way as to meet its obligations in a timely fashion. An essential function is to maintain appropriate accounting records and prepare financial statements, including balance sheets and cash flow statements.
260 Microinsurance operations
Over the years, the International Cooperative and Mutual Insurance Federation (ICMIF) has had several members that have experienced difficulties and even failed. A review of their experiences often exposes management and
governance problems, such as:
Company 1 started as an agency to serve the insurance needs of various affinity organizations5 and businesses – agricultural, marketing and financial – in a developing country with a centralized economy and a state insurer.
When the market was liberalized, the agency was converted into an insurer owned and controlled by the affinity organizations. The company lasted barely five years.
Company 2 was set up as the first mutual society after a 50-year break in a country in transition where the insurance industry, until the Second World War, had followed the mutuality tradition. A principal sponsor is a farmers’ organization. A persistent challenge has been competition from stock companies selling products at lower prices, particularly to farmers. The company is still struggling to survive – with a perpetual shortage of capital.
Established in the mid-seventies, Company 3 provided protection to middle- and low-income earners. Group life insurance showed early promise, but the company got into individual life insurance which is a significantly different product. The company mistakenly thought it needed a vast network of branches spread across the country in order to distribute the product. It died a long, slow death in the 1990s.
Company 4 is owned by a large number of savings and credit cooperatives and their national federation. Together they have controlled – and run – this insurer for a dozen years. Managers have come and gone through a revolving door rotated by the board of directors, whose ambitious forays into unfamiliar lines of business have not failed to oblige – with stunning losses.
2 Capital requirements Microinsurance programmes should aim to accumulate capital to deal with the risks discussed above. Since microinsurers generally start out with insufficient capital, the pricing actuary should initially increase the risk and uncertainty loadings described in Chapter 3.5. These loadings can be used to build up surplus and contingency reserves over time. Interest rate margins should be used to reduce the assumed and expected rates of return in pricing longerterm products – the margins can be used to at least partially fund asset default and mismatch risks. The premium rates should also include a small loading for catastrophe reinsurance, as discussed below.
Mathematical ruin theory can be used by actuaries to describe the capital needed for long-term solvency. In practice, modelling techniques are superior and can be easily customized for testing the long-term capital requirements of specific microinsurance programmes.
There is also the possibility of having too much capital. Although one could always create scenarios that consume all the accumulated capital, the question of scenario plausibility then arises. Commercial insurers in Canada are required to test their capital adequacy annually under all scenarios that the insurer is exposed to where there is at least 1 per cent probability of the scenario being realized.6 Life insurers are required to test their capital adequacy using five-year scenarios and non-life insurers use two-year scenarios.
MUSCCO and CARD MBA have accumulated significant capital due to very good current operating results. For MUSCCO, there is a possibility of higher future claims due to HIV/AIDS and the organization no longer has reinsurance, so capital accumulation is certainly justified. CARD MBA, on the other hand, has possibly accumulated too much capital over the years.
Microinsurers such as CARD MBA may have to consider reducing premium rates (or increase benefits) and determine a strategy to pay out excess capital equitably to clients and members.
3 Reserves The most general technical definition of a reserve is the actuarial present value of future liabilities less the actuarial present value of future premiums.
In practice, there are many different kinds of reserves on the books of insurers, generated by the features of their various insurance products and by the nature of their operations.
Like other insurers, most microinsurance programmes maintain reserves to ensure that they can pay their obligations when claims are submitted. To get a true picture of the financial condition of a programme, the reserves must be calculated using actuarially acceptable methods. They must then be reflected in the financial statements; the reserve levels are reflected as a liability in the balance sheet, while increases and decreases in reserve levels should be treated as an expense in the income statement.
Insurers often use proxy and simplified methods to estimate the true actuarial reserves, although regulators may prescribe the methodology and the limits of the assumptions that may be used. For example, the regulator may specify a mortality table and interest rate assumption to be used in the valuation of whole life products in the insurer’s annual report.
One of the most common microinsurance products is credit life. In the case of credit life, the future premium payable is usually zero because a single premium is collected by the microinsurer at the time the loan is issued. If the premium is collected up front, the accepted practice for reserve calculation is
Actuarial Reserves = Gross Unearned Premium Reserve (GUPR) + Incurred but not Reported Claims (IBNR) + Claims in Course of Settlement (CICS) + Provision for Adverse Deviation (PAD) A good practice for microinsurers is to calculate GUPR on a loan-to-loan basis at each reporting period. This applies to the other reserve components as well. PAD is usually determined at the discretion of the actuary. The method of calculating these values is beyond the scope of this chapter.
As mentioned above, to get a true picture of the financial condition, reserves must be calculated accurately and this is best achieved by a good actuarial system accessing a clean and current database. Software tools for calculating reserves should be programmed by an actuary. If a product has guarantees beyond one year, the reserves should be calculated directly by the actuary.