Springer Texts in Business and Economics

Massimiliano Maggioni
Giuseppe Turchetti

Fundamentals
of the Insurance
Business
Springer Texts in Business and Economics
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Massimiliano Maggioni • Giuseppe Turchetti

Fundamentals of the
Insurance Business
Massimiliano Maggioni Giuseppe Turchetti
Institute of Management Institute of Management
University of Milano Sant’Anna School of Advanced Studies
Milano, Italy Pisa, Italy

ISSN 2192-4333 ISSN 2192-4341 (electronic)

Springer Texts in Business and Economics
ISBN 978-3-319-52850-2 ISBN 978-3-319-52851-9 (eBook)
https://doi.org/10.1007/978-3-319-52851-9

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Preface

As the title of this work indicates, Fundamentals of the Insurance Business is a

textbook about insurance and its industry. The main emphasis is on insurance
companies and the related managerial issues.

Scope of the Subject

The book has been written for students and professionals who wish to learn about
insurance starting from the fundamentals of the business. This work has also been
written having instructors in mind, who, like the authors, enjoy the challenges and
rewards of students and professionals classrooms. Having a reference manual that
contains all the relevant aspects of the insurance business to accompany the lessons
is certainly especially useful.
The reasons for studying insurance are varied. For some, study is undertaken in
preparation for a career in the field. Others study to improve their knowledge on the
subject in order to become more knowledgeable practitioners. For all the readers, this
textbook will become a companion to refer to during their journey into the insurance
sector or professional growth.

Important Features of the Textbook

The book has been written trying to keep together the following three objectives:

• To offer a comprehensive perspective on major issues in the insurance business.

• To combine theory and practice.
• To explain the insurance business in a “didactic” but rigorous way.

The book has been divided into four parts and 35 chapters. The organisation of
the parts is as follows:
Part I (Chaps. 1–10) describes the fundamentals of the business, how the industry
works, the authorities and the regulations. It presents the insurance products (for life,
non-life retail and non-life commercial lines).

v
vi Preface

Part II (Chaps. 11–17) explains the pricing and reserving for life and non-life
insurance. Reinsurance business is also illustrated.
Part III (Chaps. 18–25) describes business models and the organisational
structures in the industry, also including recent trends related to Insurtech. The
main processes of an insurance company (product development, underwriting,
claims settlement and investments) are presented. Marketing and distribution are
also described.
Part IV (Chaps. 26–35) defines the financial statement and introduces IFRS
principles. Solvency II calculation, ALM model and embedded value are explained
in detail. This part also describes management accounting, performance indicators
and the business plan in the insurance industry.
Each chapter begins with a list of learning objectives and includes, at the end, a
questions section that provides the reader with a self-test on the topics covered in the
chapter. This gives students an opportunity to determine whether or not they have
mastered the material covered in the chapter.
Words in bold appear throughout the text. The bold font is intended to alert the
reader to an important word and indicates a critical concept to remember. The
keywords section contains all the boldface words encountered in paragraphs. This
should help the reader to focus on the key concepts of each chapter.

Note on Methodology

Two brief warnings for readers. Firstly, as this is a manual, it is not a volume for
specialists seeking a particularly in-depth treatment on matters of their concern
(actuarial, legal, accountancy, business, etc.). For this, specialists may consult the
numerous excellent single-matter texts written on the various themes by scholars in
the various disciplines. Secondly, in order to provide a panorama that is as broad and
comprehensive as possible on the economy and management of an insurance
undertaking for readers with different training backgrounds, we have had of neces-
sity had to make certain simplifications even if this has meant not being at all times
“technically beyond reproach” in the eyes of specialists in the various sectors
covered.

Milano, Italy Massimiliano Maggioni

Pisa, Italy Giuseppe Turchetti
March 2024
Acknowledgments

Many people have provided support and encouragement as we have worked on this
textbook. We have welcomed the comments and criticisms made by each of them.
Many of whom are dear friends or successful business practitioners.
A special mention must be given to Marcello Ottaviani, consulting audit and
appointed actuary, who has shared many suggestions and ideas over several chapters
for improving the manuscript. Collaboration with Christopher Hayes enriched our
vision about many insurance issues, and we gratefully acknowledge his help and
unstinting support. A special mention is addressed to Leandro Giacobbi
(underwriting senior in non life business) for his technical contribution.
We are immediately grateful to all those who when utilizing this book will have
advice to give us concerning material that may be added or omitted. The online
version of the volume will indeed allow us to keep it fully up-to-date following
developments in regulations and the marketplace and offer further specific in-depth
comments on the matters covered in the various chapters. We hope that the manual
will be useful both to readers who are approaching the insurance business for the first
time and to those who wish to explore and deepen the various issues that
characterise it.

vii
Contents

Part I Fundamentals of Insurance Business

1 The Origins and Role of Insurance in Society . . . . . . . . . . . . . . . . . 3
1.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2 Insurance in History: Origin and Role . . . . . . . . . . . . . . . . . . . 4
1.3 The Origins of the Contract of Insurance . . . . . . . . . . . . . . . . 6
1.4 The Historical Development of Non-life Insurance . . . . . . . . . 8
1.5 The Historical Development of Life Insurance . . . . . . . . . . . . . 11
1.6 Social Insurance and the Development of Retirement
Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2 The Notion of Risk and Probability . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.2 Risk and Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.3 Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.4 Principle of Mutuality and Risk Pooling . . . . . . . . . . . . . . . . . 23
2.5 Conditions for Insurability . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.6 Selection of Risks and the Problem of Information
Asymmetries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.7 Attitude to Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.8 Behavioural Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
2.9 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 34
3 The Insurance Undertaking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.2 The Insurance Undertaking . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.3 The Inverse Production Cycle . . . . . . . . . . . . . . . . . . . . . . . . 37
3.4 Functions of an Insurance Undertaking . . . . . . . . . . . . . . . . . . 38
3.4.1 Technical Insurance Management . . . . . . . . . . . . . . 39
3.4.2 Technical Reserves . . . . . . . . . . . . . . . . . . . . . . . . . 40

ix
x Contents

3.4.3 Financial Wealth Management . . . . . . . . . . . . . . . . . 42

3.5 How the Insurance Machine Works? . . . . . . . . . . . . . . . . . . . 43
3.6 Insurance Undertaking and Risk Management . . . . . . . . . . . . . 45
3.7 The Modern Insurance Undertaking . . . . . . . . . . . . . . . . . . . . 47
3.8 The Lloyd’s of London Market . . . . . . . . . . . . . . . . . . . . . . . 48
3.9 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4 Regulation of the Insurance Industry . . . . . . . . . . . . . . . . . . . . . . . 53
4.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
4.2 Regulatory Context in Europe . . . . . . . . . . . . . . . . . . . . . . . . 54
4.3 Three Generation of Community Directives . . . . . . . . . . . . . . 55
4.4 Recent Developments at the Community Level . . . . . . . . . . . . 58
4.5 Regulation on Customer Protection and Distribution
of Insurance Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
4.6 Regulations on Risk Control and Corporate Management . . . . . 61
4.7 Supplementary Supervision for Financial Conglomerates . . . . . 62
4.8 Regulation of Supplementary Retirement Provision . . . . . . . . . 63
4.9 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Directives and Regulations: Chronological Order . . . . . . . . . . 65
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 66
5 Supervision and Other Authorities . . . . . . . . . . . . . . . . . . . . . . . . . 67
5.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
5.2 Supervision of Insurance and Reinsurance Undertakings . . . . . 68
5.3 European Supervision in the Matter of Insurances . . . . . . . . . . 69
5.4 European System of Financial Supervision . . . . . . . . . . . . . . . 73
5.5 The Bodies and Functions of EBA . . . . . . . . . . . . . . . . . . . . . 75
5.6 The Bodies and Functions of EIOPA . . . . . . . . . . . . . . . . . . . 76
5.6.1 Areas and Powers of Intervention . . . . . . . . . . . . . . 77
5.7 The Bodies and Functions of ESMA . . . . . . . . . . . . . . . . . . . . 78
5.7.1 Organization and Activities . . . . . . . . . . . . . . . . . . . 78
5.8 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Directives and Regulations: Chronological Order . . . . . . . . . . . . . . . . 79
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 79
6 The Insurance Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
6.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
6.2 Access to the Insurance Business . . . . . . . . . . . . . . . . . . . . . . 82
6.2.1 The Authorisation Procedure . . . . . . . . . . . . . . . . . . 84
6.2.2 The Registry of Licensed Insurance Undertakings . . . 86
Contents xi

6.3 Lines of Business (LoB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

6.4 Conditions Governing Insurance Business . . . . . . . . . . . . . . . . 92
6.4.1 System of Corporate Governance . . . . . . . . . . . . . . . 92
6.4.2 Life and Non-life Reserving . . . . . . . . . . . . . . . . . . 93
6.4.3 Principles in the Matter of Investments . . . . . . . . . . . 94
6.4.4 Solvency Margin Definition . . . . . . . . . . . . . . . . . . 95
6.5 Equity Investments in the Insurance Industry . . . . . . . . . . . . . 97
6.6 Insurance Groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
6.7 Financial Conglomerates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
6.8 The Reinsurance Business . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
6.9 Insurance Portfolio (Merger and Spin-Off Operations) . . . . . . . 101
6.10 Management of Insurance Crises . . . . . . . . . . . . . . . . . . . . . . 103
6.11 The Insurance Undertaking and Compulsory Insurance . . . . . . 104
6.12 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Directives and Regulations—Chronological Order . . . . . . . . . . 105
Directives and Regulations—Chronological Order . . . . . . . . . . 106
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 106
7 The Insurance Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
7.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
7.2 Definition of the Insurance Contract . . . . . . . . . . . . . . . . . . . . 108
7.3 Non-Life Insurance Contract . . . . . . . . . . . . . . . . . . . . . . . . . 109
7.4 Life Insurance Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
7.5 Insurable Interest and Insurable Value . . . . . . . . . . . . . . . . . . 110
7.6 Parties to an Insurance Contract . . . . . . . . . . . . . . . . . . . . . . . 113
7.7 Duties of the Policyholder . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
7.8 Duties of the Insurance Undertaking . . . . . . . . . . . . . . . . . . . . 115
7.9 Elements of a Valid Contract . . . . . . . . . . . . . . . . . . . . . . . . . 117
7.10 Concluding the Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
7.11 Recent Developments in Europe: Pre-contractual
Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
7.11.1 Non-Life Products Pre-Contractual Information:
IPID . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
7.11.2 Life Products Pre-Contractual Information KID . . . . 123
7.12 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
Directives and Regulations—Chronological Order . . . . . . . . . . 124
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 125
8 Life Insurance Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
8.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
8.2 Life Insurances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
8.3 Classification of Life-Insurance Products . . . . . . . . . . . . . . . . 129
xii Contents

8.4 Ordinary Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

8.4.1 Death Benefit Insurance Products . . . . . . . . . . . . . . . 132
8.4.2 Life Insurance Products for a Family Plan . . . . . . . . 134
8.4.3 Terms and Conditions for Life Insurance
Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
8.5 Financial Insurance Products . . . . . . . . . . . . . . . . . . . . . . . . . 139
8.5.1 Index-Linked Policies . . . . . . . . . . . . . . . . . . . . . . . 140
8.5.2 Unit-Linked Policies . . . . . . . . . . . . . . . . . . . . . . . . 142
8.5.3 Hybrid Products: Composite Life Insurance
Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
8.5.4 Variable Annuity Policies . . . . . . . . . . . . . . . . . . . . 145
8.6 Insurance Products for Professional Investors . . . . . . . . . . . . . 148
8.7 Retirement Provision Products . . . . . . . . . . . . . . . . . . . . . . . . 150
8.8 Health Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
8.8.1 Dread Disease Policy . . . . . . . . . . . . . . . . . . . . . . . 153
8.8.2 Long-Term Care Policy: LTC . . . . . . . . . . . . . . . . . 155
8.9 Classification of PRIIPs Insurance Products . . . . . . . . . . . . . . 157
8.10 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Directives and Regulations—Chronological Order . . . . . . . . . . 160
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 160
9 Non-Life Insurance Products: Personal Line . . . . . . . . . . . . . . . . . . 161
9.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
9.2 Non-Life Insurances Products . . . . . . . . . . . . . . . . . . . . . . . . 162
9.3 Personal Accident and Sickness Insurance . . . . . . . . . . . . . . . 164
9.3.1 Personal Accident Insurance . . . . . . . . . . . . . . . . . . 164
9.3.2 Healthcare Insurance . . . . . . . . . . . . . . . . . . . . . . . . 167
9.3.3 Smart Illness Policy and Telematics: WYOD . . . . . . 169
9.3.4 Insurance Product Covering Dental Treatment . . . . . 170
9.4 Insurances on Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
9.4.1 Underwriting and Reimbursement Methods for
Insurances on Property . . . . . . . . . . . . . . . . . . . . . . 171
9.4.2 Fire Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
9.4.3 Theft Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
9.4.4 Household Appliance Insurance . . . . . . . . . . . . . . . . 179
9.5 Liability Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
9.6 Personal Automobile Insurance . . . . . . . . . . . . . . . . . . . . . . . 180
9.6.1 Variables for Determining an Automobile Tariff . . . . 182
9.6.2 Automobile Insurance and Telematics: Black Box . . 189
9.6.3 Automobile Liability Insurance and Indemnification . 190
9.6.4 Automobile Insurance Comprehensive Policy . . . . . . 191
9.7 Comprehensive Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
9.7.1 Homeowner Insurance . . . . . . . . . . . . . . . . . . . . . . 194
9.7.2 Homeowner Insurance and Telematics: Home Box . . 195
9.8 Unemployment Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
Contents xiii

9.9 Travel Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198

9.10 Policy for Domestic Animals and Digital Pet Insurance . . . . . . 199
9.11 New Ways of Purchasing Guarantees: Instant Insurance . . . . . . 200
9.12 New Products: Parametric Policies . . . . . . . . . . . . . . . . . . . . . 201
9.13 Cover for Condominium Buildings . . . . . . . . . . . . . . . . . . . . . 202
9.14 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Directives and Regulations—Chronological Order . . . . . . . . . . . . . . . . 204
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 204
10 Non-Life Insurance Products: Commercial Line . . . . . . . . . . . . . . . 205
10.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
10.2 Commercial Insurance Products . . . . . . . . . . . . . . . . . . . . . . . 206
10.3 Insurance Products for Damage to Property . . . . . . . . . . . . . . . 207
10.3.1 Fire Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
10.3.2 Theft Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
10.3.3 Engineering Insurance . . . . . . . . . . . . . . . . . . . . . . . 211
10.3.4 Cyber Risk Insurance . . . . . . . . . . . . . . . . . . . . . . . 212
10.3.5 Contractors All Risks (CAR) and Erection All Risks
(EAR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
10.4 Business Liability Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 216
10.4.1 Businessowner Liability Insurance . . . . . . . . . . . . . . 217
10.4.2 Employers’ Liability Insurance . . . . . . . . . . . . . . . . 218
10.4.3 Product Liability Insurance . . . . . . . . . . . . . . . . . . . 219
10.4.4 Product Recall Insurance . . . . . . . . . . . . . . . . . . . . . 220
10.4.5 Environmental Pollution Risk Insurance . . . . . . . . . . 220
10.4.6 Professional Indemnity Insurance . . . . . . . . . . . . . . . 221
10.4.7 Directors & Officers (D&O) Liability Insurance . . . . 223
10.5 Comprehensive Business Insurances . . . . . . . . . . . . . . . . . . . . 224
10.6 Marine Aviation Transport Insurance (MAT) . . . . . . . . . . . . . 226
10.6.1 Coverage for Damage to Goods Carried . . . . . . . . . . 226
10.6.2 Liability of Parties Involved in Transport Activities . 227
10.6.3 Marine Insurance for US Market . . . . . . . . . . . . . . . 228
10.6.4 Hull (Ships and Aircraft) Insurance . . . . . . . . . . . . . 228
10.7 Business Credit Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10.8 Surety Bond Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.9 Insurance Covers for Employees . . . . . . . . . . . . . . . . . . . . . . 232
10.9.1 Business Accident Insurance . . . . . . . . . . . . . . . . . . 232
10.9.2 Creditor Protection Insurance (CPI) . . . . . . . . . . . . . 235
10.9.3 Key Person Insurance . . . . . . . . . . . . . . . . . . . . . . . 235
10.9.4 Business Travel Insurance . . . . . . . . . . . . . . . . . . . . 237
10.10 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
Directives and Regulations—Chronological Order . . . . . . . . . . 238
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 239
xiv Contents

Part II Pricing, Reserving and Reinsurance

11 Non-Life Insurance: Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
11.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
11.2 Probability and Equitable Premium . . . . . . . . . . . . . . . . . . . . . 244
11.3 Theory of Risk and the Problem of the Ruin of the Player . . . . 248
11.4 Calculating the Safety Loading and Net Premium . . . . . . . . . . 250
11.5 Multivariate Analysis in Determining the Premium . . . . . . . . . 252
11.6 Components of a Non-life Premium . . . . . . . . . . . . . . . . . . . . 254
11.7 An Example of Determining a Non-life Premium . . . . . . . . . . 257
11.8 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 259
12 Non-Life Insurance: Reserving . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
12.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
12.2 Technical Reserves and Claim Definition in Non-life Business . 262
12.3 Loss Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
12.4 Reserve for Losses Incurred but Not Reported at the
End of the Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
12.5 Claims Reporting Criterion . . . . . . . . . . . . . . . . . . . . . . . . . . 267
12.5.1 The Run-off Triangle . . . . . . . . . . . . . . . . . . . . . . . 267
12.5.2 The Lexis Diagram . . . . . . . . . . . . . . . . . . . . . . . . . 270
12.6 Deterministic Methods of Assessment of the Loss Reserve . . . . 272
12.6.1 The Grossing up Method . . . . . . . . . . . . . . . . . . . . . 274
12.6.2 The Chain Ladder Method . . . . . . . . . . . . . . . . . . . 275
12.6.3 The Fisher–Lange Method . . . . . . . . . . . . . . . . . . . 277
12.6.4 The Taylor Separation Method . . . . . . . . . . . . . . . . 281
12.6.5 The Bornhuetter–Ferguson Method . . . . . . . . . . . . . 282
12.7 Stochastic Methods of Assessment of the Loss Reserve . . . . . . 284
12.7.1 The Mack Model . . . . . . . . . . . . . . . . . . . . . . . . . . 285
12.7.2 Generalised Linear Models . . . . . . . . . . . . . . . . . . . 286
12.7.3 Bootstrapping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
12.8 Premium Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
12.9 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 296
13 Life Insurance: Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
13.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
13.2 Demographic Forecasts: Mortality and Survival . . . . . . . . . . . 298
13.3 The Financial Bases and Actualising Flows . . . . . . . . . . . . . . . 301
13.4 Technical Basis and Safety Loading . . . . . . . . . . . . . . . . . . . . 303
13.5 An Example of Determining a Life Premium . . . . . . . . . . . . . 305
13.6 Demographic Bases: Criteria for Selecting Risks . . . . . . . . . . . 307
13.7 Demographic Basis: Mortality Projection . . . . . . . . . . . . . . . . 312
Contents xv

13.8 Classification of Life Insurance on the Basis of Performance . . 312

13.8.1 Capital Performance . . . . . . . . . . . . . . . . . . . . . . . . 314
13.8.2 Income Performance . . . . . . . . . . . . . . . . . . . . . . . . 316
13.9 Components of a Life Premium and Expense Loadings . . . . . . 317
13.10 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 320
14 Life Insurance: Reserving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
14.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
14.2 Life Technical Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
14.3 Mathematical Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
14.4 Calculating the Mathematical Reserve . . . . . . . . . . . . . . . . . . 325
14.5 Progress of the Mathematical Reserve Over Time . . . . . . . . . . 327
14.6 Reserves for Future Expense and Additional reserves . . . . . . . 331
14.7 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 332
15 Life Insurance: How With-Profits Products Work . . . . . . . . . . . . . 333
15.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
15.2 With-Profits Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.3 Actuarial Equilibrium of Performance Adjustment . . . . . . . . . . 334
15.4 Elements of With-Profits Contracts . . . . . . . . . . . . . . . . . . . . . 336
15.5 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
16 Life Insurance: Other Components of Profit . . . . . . . . . . . . . . . . . . 341
16.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
16.2 Components of Insurance Profit and Margin . . . . . . . . . . . . . . 342
16.3 Demographic Profit and Financial Profit:
The Homans Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
16.4 Profit for Surrender and Expense Loading . . . . . . . . . . . . . . . . 347
16.5 Significance of the Components in Forming Profit . . . . . . . . . . 349
16.6 The Profit Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
16.7 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
17 Reinsurance and Coinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
17.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
17.2 Definition of Inwards and Outwards Reinsurance . . . . . . . . . . 356
17.3 Forms of Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
17.4 Proportional and Non-proportional Reinsurance . . . . . . . . . . . 359
17.5 Proportional Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
17.5.1 Quota Share (QS) Reinsurance . . . . . . . . . . . . . . . . 361
17.5.2 Surplus Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . 363
xvi Contents

17.6 Non-proportional Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . 366

17.6.1 Excess of Loss (XL) Reinsurance . . . . . . . . . . . . . . 368
17.6.2 Stop Loss Reinsurance . . . . . . . . . . . . . . . . . . . . . . 369
17.6.3 Comparison of Forms of Reinsurance . . . . . . . . . . . 370
17.7 Reinsurance Pools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
17.8 Reinsurance Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
17.8.1 Defining Reinsurance Guidelines . . . . . . . . . . . . . . . 371
17.8.2 Preparing a Plan of Reinsurance Cessions . . . . . . . . 371
17.8.3 Approval of the Plan and Related Audits . . . . . . . . . 372
17.9 Definition of Direct Coinsurance and Contribution . . . . . . . . . 372
17.10 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

Part III Business Models and Processes in the Insurance Industry

18 Business Models for Insurance Undertakings . . . . . . . . . . . . . . . . . 377
18.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378
18.2 Types of Organisational Structure . . . . . . . . . . . . . . . . . . . . . . 378
18.3 The Elementary Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
18.4 The Functional Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
18.5 The Divisional Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
18.6 The Matrix Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
18.7 The Network Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384
18.8 Comparing Organisational Structures . . . . . . . . . . . . . . . . . . . 385
18.9 The Hybrid Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388
18.10 Insurtech: The New Business Model . . . . . . . . . . . . . . . . . . . . 388
18.11 Insurance Processes and Activities . . . . . . . . . . . . . . . . . . . . . 390
18.11.1 The Value Chain . . . . . . . . . . . . . . . . . . . . . . . . . . 391
18.11.2 Insurance Activities and Processes . . . . . . . . . . . . . . 392
18.11.3 Components of the IT System . . . . . . . . . . . . . . . . . 394
18.12 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
19 Competences and Organisational Functions . . . . . . . . . . . . . . . . . . 399
19.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
19.2 The Organisational Structure of an Insurance Undertaking . . . . 400
19.2.1 Representing the Structure . . . . . . . . . . . . . . . . . . . . 401
19.2.2 Support Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402
19.2.3 Organisational Hierarchy . . . . . . . . . . . . . . . . . . . . . 403
19.3 Components of the Organisational Structure . . . . . . . . . . . . . . 404
19.4 Governing Body . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
19.4.1 Top Management . . . . . . . . . . . . . . . . . . . . . . . . . . 406
19.4.2 Administrative Body . . . . . . . . . . . . . . . . . . . . . . . . 406
19.4.3 Chairman . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
19.4.4 Managing Director . . . . . . . . . . . . . . . . . . . . . . . . . 407
19.4.5 General Manager . . . . . . . . . . . . . . . . . . . . . . . . . . 408
Contents xvii

19.5 Units for Coordination and Direction . . . . . . . . . . . . . . . . . . . 409

19.5.1 Planning and Strategic Control . . . . . . . . . . . . . . . . 409
19.5.2 Strategic Marketing . . . . . . . . . . . . . . . . . . . . . . . . 410
19.5.3 Management of Equity Investments . . . . . . . . . . . . . 410
19.5.4 Management of Intragroup Relations . . . . . . . . . . . . 410
19.6 Staff Units of the Governing Body . . . . . . . . . . . . . . . . . . . . . 411
19.6.1 Internal and External Communications/External
Relations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
19.6.2 Investor Relator . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
19.6.3 Legal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412
19.6.4 Company Secretary . . . . . . . . . . . . . . . . . . . . . . . . . 412
19.7 Service Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412
19.7.1 Management of Personnel . . . . . . . . . . . . . . . . . . . . 413
19.7.2 Management of Trades Union Relations . . . . . . . . . . 413
19.7.3 Organisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
19.7.4 Administration, Financial Statements and Fiscal . . . . 414
19.7.5 Management Control . . . . . . . . . . . . . . . . . . . . . . . 415
19.7.6 Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
19.7.7 Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
19.7.8 Information and Communication Technology (ICT) . . . 416
19.7.9 Property Management . . . . . . . . . . . . . . . . . . . . . . . 417
19.7.10 General Services . . . . . . . . . . . . . . . . . . . . . . . . . . . 418
19.7.11 Purchases Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418
19.8 Control Function Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
19.8.1 Risk Management Function . . . . . . . . . . . . . . . . . . . 419
19.8.2 Internal Audit Function . . . . . . . . . . . . . . . . . . . . . . 420
19.8.3 Compliance Function . . . . . . . . . . . . . . . . . . . . . . . 421
19.8.4 Actuary Function . . . . . . . . . . . . . . . . . . . . . . . . . . 421
19.8.5 Anti-money-Laundering Function . . . . . . . . . . . . . . 422
19.8.6 Complaints Management Function . . . . . . . . . . . . . . 423
19.8.7 Privacy Function . . . . . . . . . . . . . . . . . . . . . . . . . . 423
19.9 Technical Insurance Units . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
19.9.1 Pricing/Reserving Unit . . . . . . . . . . . . . . . . . . . . . . 424
19.9.2 Product Development . . . . . . . . . . . . . . . . . . . . . . . 424
19.9.3 Risk Underwriting . . . . . . . . . . . . . . . . . . . . . . . . . 425
19.9.4 Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
19.9.5 Claims Management . . . . . . . . . . . . . . . . . . . . . . . . 426
19.9.6 Technical Portfolio Management and Technical
Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428
19.9.7 Intermediary Accounting . . . . . . . . . . . . . . . . . . . . . 428
19.10 Sales-Distribution Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429
19.10.1 Commercial Unit . . . . . . . . . . . . . . . . . . . . . . . . . . 429
19.10.2 Commercial Planning . . . . . . . . . . . . . . . . . . . . . . . 429
19.10.3 Channel Management and Development . . . . . . . . . . 430
xviii Contents

19.10.4 Sales Force Inspection . . . . . . . . . . . . . . . . . . . . . . 430

19.10.5 Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
19.11 Coordination Committees . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
19.11.1 Executive Committee . . . . . . . . . . . . . . . . . . . . . . . 432
19.11.2 Investment Committee . . . . . . . . . . . . . . . . . . . . . . 432
19.11.3 ALM (Asset and Liability Management)
Committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
19.11.4 Product Committee . . . . . . . . . . . . . . . . . . . . . . . . . 433
19.11.5 Expense Committee . . . . . . . . . . . . . . . . . . . . . . . . 433
19.11.6 Risk Committee and Related Sub-committees . . . . . . 434
19.11.7 Audit Committee . . . . . . . . . . . . . . . . . . . . . . . . . . 434
19.11.8 Crisis Committee . . . . . . . . . . . . . . . . . . . . . . . . . . 435
19.12 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
Directives and Regulations: Chronological Order . . . . . . . . . . 435
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 436
20 Product Development Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
20.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
20.2 Stages of Product Development Process . . . . . . . . . . . . . . . . . 438
20.3 Product Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439
20.3.1 Preliminary Analysis of Competition . . . . . . . . . . . . 439
20.3.2 Benchmarking the Product . . . . . . . . . . . . . . . . . . . 440
20.3.3 Involving the Channel . . . . . . . . . . . . . . . . . . . . . . . 440
20.3.4 Product Concept Finalisation . . . . . . . . . . . . . . . . . . 440
20.4 Framework and Operating Model . . . . . . . . . . . . . . . . . . . . . . 441
20.4.1 Bill of Material of the Product . . . . . . . . . . . . . . . . . 441
20.4.2 IT Operating Model . . . . . . . . . . . . . . . . . . . . . . . . 442
20.4.3 Product Launch Scheduling . . . . . . . . . . . . . . . . . . . 443
20.5 Product Realisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
20.5.1 Pricing (Technical Bases) . . . . . . . . . . . . . . . . . . . . 444
20.5.2 Sales and After-Sales Processes . . . . . . . . . . . . . . . . 444
20.5.3 Contractual and Precontractual Documentation . . . . . 445
20.5.4 Functional Analysis and IT Parametrization . . . . . . . 445
20.5.5 Requirements and Selection of TPA . . . . . . . . . . . . . 445
20.5.6 Reinsurance Agreements . . . . . . . . . . . . . . . . . . . . . 446
20.6 Internal Corporate Validation of the Product . . . . . . . . . . . . . . 446
20.7 Product Presentation to the Sales Channels . . . . . . . . . . . . . . . 447
20.8 Product Release . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447
20.8.1 IT Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 448
20.8.2 Issue of the Formal Sales Kit and Training . . . . . . . . 448
20.8.3 Commercial Agreement with the Sales Channels . . . 448
20.9 POG: Product Oversight Governance . . . . . . . . . . . . . . . . . . . 449
20.10 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Regulations: Chronological Order . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 451
Contents xix

21 Underwriting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453

21.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454
21.2 Stages of Underwriting Process . . . . . . . . . . . . . . . . . . . . . . . 454
21.3 Underwriting Process for Insurance Products . . . . . . . . . . . . . . 455
21.3.1 Consideration of the Demands and Needs of the
Customer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455
21.3.2 The Quotation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456
21.3.3 The Proposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
21.3.4 Verification/Waiver of Underwriting Limits . . . . . . . 458
21.3.5 Issuing the Contract and the Release for
Premium Paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458
21.4 Underwriting Process for Industrial Risks . . . . . . . . . . . . . . . . 459
21.4.1 Acquisition of the Request . . . . . . . . . . . . . . . . . . . 460
21.4.2 Preliminary Assessment of the Request . . . . . . . . . . 460
21.4.3 Management of the Quotation and Verification
of Underwriting Limits . . . . . . . . . . . . . . . . . . . . . . 460
21.4.4 Sending the Quotation to the Distributor and the
Confirmation of Cover . . . . . . . . . . . . . . . . . . . . . . 461
21.4.5 Issuing the Contract and the Release for Premium . . . 462
21.5 Underwriting Process for Standardized Contracts . . . . . . . . . . . 462
21.5.1 Consideration of the Demands and Needs of the
Customer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463
21.5.2 Quotation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463
21.5.3 Processing Proposal . . . . . . . . . . . . . . . . . . . . . . . . 464
21.5.4 Issuing the Contract and Release for Premium . . . . . 464
21.6 Pre-contractual Documentation for Life and Non-Life Products 464
21.7 Management of Renewals . . . . . . . . . . . . . . . . . . . . . . . . . . . 466
21.7.1 Analysis and Management of Due Dates . . . . . . . . . 466
21.7.2 Management of Policies Falling Due . . . . . . . . . . . . 467
21.8 Technical and Administrative Endorsement . . . . . . . . . . . . . . . 467
21.8.1 Acquisition and Assessment of a Request
for Technical Endorsement . . . . . . . . . . . . . . . . . . . 468
21.8.2 Managing a Technical Endorsement . . . . . . . . . . . . . 468
21.9 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
Directives and Regulations – Chronological Order . . . . . . . . . . 469
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 469
22 Investment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471
22.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
22.2 Overall Approach: Premiums, Investments and Reserves . . . . . 472
22.2.1 Cycle of Activities in Financial Wealth
Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
xx Contents

22.3 Definition of Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474

22.3.1 Principles for Investments . . . . . . . . . . . . . . . . . . . . 475
22.4 Stages of Investment Process . . . . . . . . . . . . . . . . . . . . . . . . . 477
22.4.1 Characteristics of Investment Process . . . . . . . . . . . . 478
22.4.2 Activities of Treasury Process . . . . . . . . . . . . . . . . . 480
22.5 Types of Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481
22.6 Regulation of Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
22.7 The Case of the American Insurance Group . . . . . . . . . . . . . . 484
22.8 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Directives and Regulations – Chronological Order . . . . . . . . . . 485
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 485
23 Loss Event Management Process . . . . . . . . . . . . . . . . . . . . . . . . . . . 487
23.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488
23.2 Stages of Loss Event Management Process . . . . . . . . . . . . . . . 488
23.3 Loss Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488
23.3.1 Taking a Loss Report . . . . . . . . . . . . . . . . . . . . . . . 489
23.4 Screening of Loss Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
23.5 Opening and Quantifyng of the Loss Event . . . . . . . . . . . . . . . 490
23.6 Assessment of Loss Events . . . . . . . . . . . . . . . . . . . . . . . . . . 491
23.6.1 Requesting an Opinion of an Adjuster or a Medical
Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492
23.6.2 Escalation Process: Opinion from a Loss
Coordinator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492
23.6.3 Managing Special Treatment and Closing the Claim
File . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493
23.7 Settling Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493
23.7.1 Authorising Payment or Rejecting the Loss . . . . . . . 493
23.8 Procedure for an Automobile Civil Liability Claim . . . . . . . . . 494
23.9 Reimbursement Under a Life Policy . . . . . . . . . . . . . . . . . . . . 495
23.10 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Directives and Regulations—Chronological Order . . . . . . . . . . 497
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 497
24 Insurance Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499
24.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
24.2 Marketing of Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
24.3 Peculiarities of Insurance Marketing . . . . . . . . . . . . . . . . . . . . 502
24.4 Strategic Insurance Marketing . . . . . . . . . . . . . . . . . . . . . . . . 506
24.4.1 Macro-environment and Strategies . . . . . . . . . . . . . . 507
24.4.2 Segmentation, Positioning and Targeting . . . . . . . . . 508
24.5 Internal Insurance Marketing . . . . . . . . . . . . . . . . . . . . . . . . . 508
24.6 Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
Contents xxi

24.7 Price in Insurance Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . 510

24.8 New Trends in Marketing and Online Marketing . . . . . . . . . . . 511
24.9 Customer Relationship Management . . . . . . . . . . . . . . . . . . . . 513
24.10 Digital Marketing in Insurance Industry . . . . . . . . . . . . . . . . . 514
24.11 Customer Experience in Insurance Services . . . . . . . . . . . . . . . 517
24.12 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 518
25 Insurance Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
25.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
25.2 The Function of Insurance Distribution . . . . . . . . . . . . . . . . . . 520
25.3 From Intermediation to Distribution . . . . . . . . . . . . . . . . . . . . 521
25.3.1 Regulations on Insurance Intermediation . . . . . . . . . 523
25.4 Insurance Distribution Directive . . . . . . . . . . . . . . . . . . . . . . . 525
25.5 New Paradigm of Insurance Distribution . . . . . . . . . . . . . . . . . 527
25.6 Product Oversight Governance . . . . . . . . . . . . . . . . . . . . . . . . 529
25.7 Rules of Conduct for Distributors and Pre-contract
Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
25.8 Non-life Products Pre-contractual Information: (I)PID . . . . . . . 532
25.9 Life Products Pre-contractual Information KID . . . . . . . . . . . . 533
25.10 Pre-contractual Information for IBIPs . . . . . . . . . . . . . . . . . . . 534
25.11 Figures of Insurance Distributors . . . . . . . . . . . . . . . . . . . . . . 536
25.12 Distance Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538
25.13 Channel Strategies in Insurance Distribution . . . . . . . . . . . . . . 539
25.14 Bank Insurance in Europe and in the United States . . . . . . . . . 539
25.15 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540
Directives and Regulations—Chronological Order . . . . . . . . . . . . . . . . 541
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 541

Part IV Performance and Key Indicators

26 Financial Statements of an Insurance Undertaking . . . . . . . . . . . . . 545
26.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
26.2 Harmonising of European Regulations on Financial
Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
26.3 Purposes of Financial Statements . . . . . . . . . . . . . . . . . . . . . . 547
26.4 Account Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549
26.5 Components of Financial Statements . . . . . . . . . . . . . . . . . . . 551
26.6 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553
Directives and Regulations—Chronological Order . . . . . . . . . . 553
IFRS Principles—Chronological Order . . . . . . . . . . . . . . . . . . 553
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 553
xxii Contents

27 Introduction to IFRS and Consolidated Financial Statements . . . . . 555

27.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
27.2 IAS/IFRS Historical Development . . . . . . . . . . . . . . . . . . . . . 556
27.3 Introduction of the New IAS/IFRS Accounting Standards
to the Insurance Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 558
27.4 Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . 559
27.5 Components of Consolidated Financial Statements . . . . . . . . . 561
27.6 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567
Directives and Regulations—Chronological Order . . . . . . . . . . . . . . . . 567
IFRS Principles—Chronological Order . . . . . . . . . . . . . . . . . . 567
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 567
28 International Accounting Standards (IAS) and International
Financial Reporting Standards (IFRS) . . . . . . . . . . . . . . . . . . . . . . 569
28.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570
28.2 The Main Impacts of IAS/IFRS Standards on Insurance
Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570
28.3 Financial Instruments: Recognition, Measurement and
Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571
28.3.1 IAS 39: Classification of Financial Instruments . . . . . 572
28.3.2 IAS 39: Measurement of Financial Instruments . . . . . 573
28.3.3 IFRS 7: Financial Instruments: Disclosures . . . . . . . . 574
28.4 IFRS 9: Developing the Standard of Classification and
Measuring of Financial Instruments . . . . . . . . . . . . . . . . . . . . 575
28.4.1 IFRS 9: Classification and Measurement of Financial
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575
28.4.2 IFRS 9: Classification and Measurement of Debt
Instruments. Test of the Characteristics of the
Instrument and Business Model . . . . . . . . . . . . . . . . 576
28.4.3 IFRS 9: Classification and Measurement of Derivatives
and Capital Instruments at Fair Value . . . . . . . . . . . . 578
28.4.4 IFRS 9: Classification and Measurement of Financial
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578
28.4.5 IFRS 9: Impairment . . . . . . . . . . . . . . . . . . . . . . . . 579
28.4.6 IFRS 9: Hedge Accounting . . . . . . . . . . . . . . . . . . . 581
28.4.7 Deferment Option for Applying IFRS 9 to the
Insurance Industry . . . . . . . . . . . . . . . . . . . . . . . . . 581
28.5 IFRS 4: Insurance Contracts: Classification, Measurement and
Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582
28.5.1 IFRS 4: Classification of Products and Area of
Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582
28.5.2 IFRS 4: Separation of Components (the Unbundling) 584
28.5.3 IFRS 4: Liability Adequacy Test and Shadow
Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584
Contents xxiii

28.6 IRFS 17: Development of the Principle of Measurement of

Insurance Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585
28.6.1 The General Model: Building Block Approach . . . . . 585
28.6.2 IFRS 17: The Revenue Account and Accounting
Models for Non-life Business . . . . . . . . . . . . . . . . . 588
28.6.3 IFRS 17: The Revenue Account and Accounting
Models for Life Business . . . . . . . . . . . . . . . . . . . . 590
28.7 Other International Accounting Standards of Significance
for the Insurance Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . 593
28.7.1 IAS 38: Intangible Assets . . . . . . . . . . . . . . . . . . . . 594
28.7.2 IAS 36: Impairment of Assets . . . . . . . . . . . . . . . . . 594
28.7.3 IFRS 3: Business Combination . . . . . . . . . . . . . . . . 596
28.7.4 IAS 12: Income Taxes . . . . . . . . . . . . . . . . . . . . . . 597
28.7.5 IFRS 8: Operating Reporting . . . . . . . . . . . . . . . . . . 598
28.8 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599
Directives and Regulations—Chronological Order . . . . . . . . . . 599
IFRS Principles—Chronological Order . . . . . . . . . . . . . . . . . . 599
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 599
29 Solvency of an Insurance Undertaking . . . . . . . . . . . . . . . . . . . . . . 601
29.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602
29.2 Definition of the Solvency Requirement . . . . . . . . . . . . . . . . . 603
29.3 Historical Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
29.3.1 Solvency Prior to Solvency II . . . . . . . . . . . . . . . . . 604
29.3.2 A Cue from the Banking Industry: Basel II . . . . . . . . 604
29.3.3 Solvency II Introduction . . . . . . . . . . . . . . . . . . . . . 605
29.4 The Risks of an Insurance Undertaking . . . . . . . . . . . . . . . . . . 608
29.4.1 Insurance Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . 609
29.4.2 Market Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 611
29.4.3 Operational Risks . . . . . . . . . . . . . . . . . . . . . . . . . . 611
29.5 Pillar 1: Determination of the Amount of Required Capital:
Stress Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612
29.5.1 Minimum Capital Requirement (MCR) and Solvency
Capital Requirement (SCR) . . . . . . . . . . . . . . . . . . . 613
29.5.2 The Market Consistent Balance Sheet (MCBS) . . . . . 614
29.5.3 The Standard Formula . . . . . . . . . . . . . . . . . . . . . . . 615
29.5.4 The Internal Model and Undertaking Specific
Parameters (USP) . . . . . . . . . . . . . . . . . . . . . . . . . . 621
29.5.5 Own Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 622
29.5.6 Solvency Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623
29.6 Pillar 2: Governance and Risk Monitoring . . . . . . . . . . . . . . . 625
29.7 Own Risk and Solvency Assessment . . . . . . . . . . . . . . . . . . . 626
29.8 Pillar 3: Disclosure and Transparency (SFCR, RSR, QRT) . . . . 627
29.9 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629
xxiv Contents

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629
Directives and Regulations—Chronological Order . . . . . . . . . . 629
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 630
30 Solvency II’s Capital Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633
30.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634
30.2 Definition of Capital Model . . . . . . . . . . . . . . . . . . . . . . . . . . 634
30.3 Case Study: SCR of an Insurance Group . . . . . . . . . . . . . . . . . 634
30.4 Market Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637
30.5 Underwriting Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642
30.5.1 Life Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642
30.5.2 Non-Life Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
30.5.3 Health Non-SLT Underwriting Risks . . . . . . . . . . . . 652
30.6 Default Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 654
30.7 Aggregation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655
30.7.1 Aggregation of Market Risks . . . . . . . . . . . . . . . . . . 656
30.7.2 Aggregation of Life Risks . . . . . . . . . . . . . . . . . . . . 656
30.7.3 Aggregation of Non-Life Risks . . . . . . . . . . . . . . . . 657
30.7.4 Aggregation of Health Non-SLT Risks . . . . . . . . . . . 658
30.8 Final Calculation of SCR of an Insurance Group . . . . . . . . . . . 658
30.9 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659
Directives and Regulations—Chronological Order . . . . . . . . . . . . . . . . 659
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 660
31 Asset Liability Management (ALM) . . . . . . . . . . . . . . . . . . . . . . . . 661
31.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 662
31.2 Definition of Asset Liability Management . . . . . . . . . . . . . . . . 662
31.3 Embedded Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 663
31.4 Traditional Model of ALM . . . . . . . . . . . . . . . . . . . . . . . . . . 667
31.5 Risk Factors and Deterministic ALM/Stochastic ALM . . . . . . . 672
31.6 Definition of Model Point . . . . . . . . . . . . . . . . . . . . . . . . . . . 674
31.7 Techniques and Models for the Interest Rate . . . . . . . . . . . . . . 675
31.8 Strategic ALM and Operational ALM . . . . . . . . . . . . . . . . . . . 678
31.9 Replicating Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679
31.9.1 Methodology for a Replicating Portfolio Model . . . . 680
31.9.2 Limitations of Replicating Portfolios and Good
Replication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 682
31.10 Technical Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683
31.10.1 Proxy Models—General Features . . . . . . . . . . . . . . . 683
31.10.2 Proxy Models—One-Factor Equilibrium Model:
Vasicek . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683
31.10.3 Proxy Models—One-Factor Equilibrium Model:
Cox-Ingersoll-Ross . . . . . . . . . . . . . . . . . . . . . . . . . 684
31.10.4 Proxy Models—No-Arbitrage Models: Ho-Lee . . . . . 684
31.10.5 Proxy Models—No-Arbitrage Models: Hull-White . . 686
Contents xxv

31.11 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
For models forecasting the rate curve Basic bibliographic
references: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 687
32 Embedded Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689
32.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 690
32.2 Definition of Embedded Value . . . . . . . . . . . . . . . . . . . . . . . . 690
32.3 Definition of Adjusted Net Asset Value . . . . . . . . . . . . . . . . . 693
32.4 Calculating Value in Force . . . . . . . . . . . . . . . . . . . . . . . . . . . 695
32.5 Measuring the Creation of Value and Profitability . . . . . . . . . . 699
32.6 History and Development of Embedded Value . . . . . . . . . . . . 700
32.6.1 Traditional Embedded Value . . . . . . . . . . . . . . . . . . 700
32.6.2 European Embedded Value . . . . . . . . . . . . . . . . . . . 702
32.6.3 Market Consistent . . . . . . . . . . . . . . . . . . . . . . . . . . 705
32.6.4 A Comparison Between TEV, EEV and MCEV . . . . 709
32.7 New Business Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 711
32.8 Indicators for Embedded Value . . . . . . . . . . . . . . . . . . . . . . . 712
32.9 Annual Premium Equivalent . . . . . . . . . . . . . . . . . . . . . . . . . 713
32.10 Model for Determining Goodwill . . . . . . . . . . . . . . . . . . . . . . 714
32.11 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 716
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 716
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 717
33 Management Control in Insurance Industry . . . . . . . . . . . . . . . . . . 719
33.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
33.2 Definition and History of Management Control . . . . . . . . . . . . 720
33.3 Model of Management Control . . . . . . . . . . . . . . . . . . . . . . . 722
33.3.1 The Technical-Accounting System . . . . . . . . . . . . . . 723
33.4 An Approach for Cost Classification . . . . . . . . . . . . . . . . . . . . 724
33.4.1 Main Cost Configurations . . . . . . . . . . . . . . . . . . . . 725
33.5 Definition of Centre of Responsibility . . . . . . . . . . . . . . . . . . . 725
33.5.1 Guidelines for Defining a Cost Centre . . . . . . . . . . . 726
33.5.2 Organisational Centres . . . . . . . . . . . . . . . . . . . . . . 727
33.6 Attribution, Allocation and Imputation of Costs . . . . . . . . . . . . 728
33.7 Stages of Purchasing Process . . . . . . . . . . . . . . . . . . . . . . . . . 731
33.8 Definition of Activity-Based Costing (ABC) . . . . . . . . . . . . . . 732
33.8.1 Stages of the ABC Method . . . . . . . . . . . . . . . . . . . 733
33.8.2 Activity-Based Management (ABM) . . . . . . . . . . . . 734
33.9 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 736
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 736
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 736
34 Performance Indicators in the Insurance Business . . . . . . . . . . . . . 737
34.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 738
xxvi Contents

34.2 Analysis of Financial Statements . . . . . . . . . . . . . . . . . . . . . . 738

34.3 Analysis by Indices or Ratios . . . . . . . . . . . . . . . . . . . . . . . . . 739
34.4 Non-Life Business: Indicators . . . . . . . . . . . . . . . . . . . . . . . . 740
34.5 Life Business: Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . 741
34.6 Indicators for Technical Reserves . . . . . . . . . . . . . . . . . . . . . . 743
34.7 Indicators of Profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 744
34.8 Indicators of Capitalisation . . . . . . . . . . . . . . . . . . . . . . . . . . 746
34.9 Indicators of Solvency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 747
34.10 Indicators of Reinsurance Area . . . . . . . . . . . . . . . . . . . . . . . . 748
34.11 Technical Area: Performance Indicators . . . . . . . . . . . . . . . . . 748
34.12 Claims Management Area: Performance Indicators . . . . . . . . . 749
34.13 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751
35 Business Plan for an Insurance Undertaking . . . . . . . . . . . . . . . . . . 753
35.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 754
35.2 A Definition of Business Plan . . . . . . . . . . . . . . . . . . . . . . . . 754
35.3 Stages for Setting Out a Business Plan . . . . . . . . . . . . . . . . . . 755
35.3.1 Analysis of the External Context . . . . . . . . . . . . . . . 757
35.3.2 Strategic Visioning . . . . . . . . . . . . . . . . . . . . . . . . . 757
35.3.3 Business Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 758
35.3.4 Economic-Financial Plan . . . . . . . . . . . . . . . . . . . . . 758
35.3.5 Master Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 759
35.4 Different Approaches to the Budget . . . . . . . . . . . . . . . . . . . . 759
35.5 Components of Economic-Financial Plan . . . . . . . . . . . . . . . . 761
35.5.1 Sales Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 763
35.5.2 Head-Office Expenses Budget and Overhead Costs . . . 765
35.5.3 Budget of Personnel Costs . . . . . . . . . . . . . . . . . . . 767
35.5.4 Budget for the ICT Area . . . . . . . . . . . . . . . . . . . . . 767
35.5.5 Budget for the Finance Area . . . . . . . . . . . . . . . . . . 768
35.6 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 769
Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770
Suggestions for Further Study . . . . . . . . . . . . . . . . . . . . . . . . 770
 Part I
Fundamentals of Insurance Business
The Origins and Role of Insurance in Society
1

Abstract

The first chapter offers an overview of how insurance originated and evolved.
Historically, mutual solidarity has been the foundation of the concept of insur-
ance: giving mutual assistance to the needy, indemnification for those suffering
injuries from an economic damage, group solidarity in marine traffic etc. From
the tenth century the European population began to grow rapidly for at least three
centuries so there was a significant growth in maritime traffic in the Mediterra-
nean. One consequence was the birth of the first insurance contracts which
responded to the need for protection against the risk of loss of cargo or ship
during shipments. The first pre-insurance legal institutions were loans of maritime
exchange (bottomry) and contracts of commenda. The forms of mutual solidarity
described above represent archaic forms of insurance, and in the fourteenth
century, there was the passage from mutual insurance to insurance for a premium.
Since then and up until our time, four stages can be identified that mark out the
development and sophistication in covering insurance needs over the course
of time: the development of traffic and maritime routes, the growth in overland
commerce, the expansion of urbanization and the effects of the first industrial
revolution. The final paragraphs describe the different historical development of
life insurance.

Keywords
Mutual assistance · Indemnification between associates · Solidarity in marine
traffic · Contract of commenda · Insurance for a premium · Risks of marine
transport · Industrial revolution · Corpus iuris civilis · Wager on the duration of
the life · Gambling Act · Life annuity · Tontine · Mortality table—the
Northampton table · Value ascribed to the life of a person · Capitalisation · Pay As
You Go— PAYGO · Intergenerational pact

# Springer Nature Switzerland AG 2024 3

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_1
4 1 The Origins and Role of Insurance in Society

1.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the ways in which insurance originated and illustrate its role in
society.
2. Know the origins of the first insurance contracts.
3. Explain the history of the development non-life insurance.
4. Illustrate the way in which life insurance developed.
5. Recognise the factors that underlie modern insurance based on a calculation
of probability.
6. Know the history of the development of retirement provision systems.

1.2 Insurance in History: Origin and Role

Man has always felt a need for security. Since the beginning, individuals have
needed to meet the fear and anxiety tied to the uncertainty of their fate and
unfavourable economic consequences of events tied to chance, for self and
loved ones.
In primitive communities, such as the family, the tribe or the clan, forms of
assistance can be seen that aim towards sharing by those belonging to the community
with an individual struck by an adverse event. These were not of course insurance in
the modern sense, but rather forms of mutual solidarity in which the group took care
of the needs of an individual fallen on hard times as a consequence of something that
had happened.
Historically, mutual solidarity has been the foundation upon which the concept of
insurance has developed over the centuries. Ancient forms of mutual solidarity were
achieved through repairing the damage or supporting the needs of an individual,
spreading the weight of this over the whole of society or an entire group of
associates. During the course of history, mutual solidarity has found many
perspectives for expression: there was the giving of mutual assistance to the
needy, indemnification for those suffering injuries from an economic damage,
group solidarity in marine traffic etc. See Figure 1.1 for an outline of the three
different main areas.

" Definition The oldest response to a need for help of a needy person was the pact
of association in mutual assistance, called “affratellamento” (a sort of fellowship).
This was concluded in ancient civilisations where members exchanged a reciprocal
promise of protection.
1.2 Insurance in History: Origin and Role 5

Typology Beneficiary

1. Mutual solidarity Those who need help

2. Indemnification between Those who have suffered

associates economic loss

Taking part in a marine

3. Group Solidarity
“adventure”

Fig. 1.1 The three areas of mutual solidarity

Among ancient Greeks, there were some communities that provided for the
funeral expenses of needy families. Romans had institutions similar to corporations
aimed at protecting in times of need. The collegia funeraticia, for example were
funeral associations that dealt with burial rites for the deceased and subsidies paid to
widows and orphans. Additionally, for Roman soldiers, collegia militum were
widespread and were associations among servicemen intended to cover expenses
relating to the movements of the legions. Of Germanic origin on the other hand were
the guilds, which spread rapidly even in England. The purposes of these were of
various kinds: ensuring aid in cases of illness, inability to work, old age, help for the
family of the deceased, aid in purchasing the tools of a trade, and so on.

" Definition The theme of indemnification between associates is always

achieved through the associations but is distinct from mutual solidarity as it is
based on having common interests and a need for protection of the wealth of the
association from adverse events.

In Ancient Egypt, caravans shared losses suffered by one of their number

following raiding, and this too in India, Palestine and Mesopotamia. Associations
were set up with the same aim among fishermen to deal with the risk of losing their
boats. There were those arranged between shepherds and peasants against the risk of
loss of livestock. The navigators of the Persian Gulf, for example, by custom as a
group, supported the cost of reinstating a ship of anyone who no longer had one
following a shipwreck. In less remote times, people formed associations against the
theft and robberies they were the victims of as crusaders returned, by constituting a
common fund. In this way, they were able to cover the losses of those among
associates who were hit by losses.
The last of the three themes of mutual solidarity in ancient times concerned
solidarity in marine traffic. As compared to the previous ways of showing solidarity
6 1 The Origins and Role of Insurance in Society

set out above, the first by way of protection for the individual and the second with
aims of an indemnity kind, in this third group the risk was limited to the sea.

" Definition Solidarity in marine traffic was protection against the perils of
navigation during the time span of a specific voyage. Solidarity had the aim of
safeguarding the cargo or the ship or, again, reducing the impact of the risk run by all
those taking part in an agreement of mutual support.

This was so as to contribute to the loss from shipwreck and reinstatement within
the limit of what had been lost. The medieval conservagium was a convoy of ships
that made the voyage all together and any losses suffered during navigation, due to
piracy, for example were covered by a rudimentary insurance pact struck between
the ships on the voyage. A pact of germanamento, on the other hand, struck between
a merchant and a shipowner, foresaw that the ship and its cargo became a single item
for the purposes of sharing the risk during navigation and the cost of losses were
shared among the various participants in the expedition, based on the value of their
property.

1.3 The Origins of the Contract of Insurance

Since the tenth century, with the growth of maritime traffic, the birth of the first
insurance contracts was seen. These meet the need for protection from risks of loss of
cargo or the ships that were run by seagoing expeditions. The first pre-insurance
legal institutions to come into existence were loans of maritime exchange (bottomry)
and contracts of commenda.

" Definition A bottomry loan, which dates back further, foresaw an interest-
bearing loan granted to those carrying goods or capital by ship. The duration of
the contract was limited to a single voyage (or sometimes the outbound and return
voyages). Return of the loan was excluded if the goods were totally lost due to
shipwreck or attack. This clause allowed it to be affirmed that the interest received on
the loan was not usury, but rather an insurance premium.

" Definition A contract of commenda was a sort of bottomry loan but with the
further feature of creating a link between the party investing capital and the one
investing their labour. This form foresaw one party putting in capital while the other
undertook the voyage, taking charge of transporting the goods and investing the
capital sum in business operations for the duration of a single return voyage. The
lender bore all the risks of loss of the capital sum and was entitled to a greater part of
profits. The borrower bore all the risks pertaining to the activities of management and
pocketed the rest of the profits (usually a quarter of the total). During the contract,
third parties came into contact only with the borrower and could not bring in the
lender as jointly liable for any reason.
1.3 The Origins of the Contract of Insurance 7

Object Duration Terms & Conditions

Interest -bearing loan

Limited to a single Return of the loan
granted to those
Bottomry loan voyage (or sometimes excluded if the goods
carrying goods or
outbound and return) were totally lost due to
capital by ship
a harmful event

Marine insurance
contracts

Extended for the

Contract of Link between the All the risks of loss
duration of all the
party investing capital incurred by the lender.
commenda “adventure”. During
(lender) and the one High earnings in the
which, the borrower
investing labour case of success by the
invests the capital
lender
received

Fig. 1.2 The main marine insurance contracts

Note that the premium charge was settled in contract forms of a commercial
financial kind with the primary aim of avoiding any formula that might lead back to
envisaging the crime of usury. The special nature of contracts of this kind consisted
of an exchange of money or goods travelling under conditions of risk, with addi-
tional specific clauses such as safe on land, perils of the sea, at risk of persons. At this
stage of development, risk was still an additional clause to the main contract and was
not yet the subject matter of a self-contained independent one. See Figure 1.2 which
details the features of these contracts.
The forms of mutual solidarity described above represent archaic forms of
insurance. The passage from mutual insurance to insurance for a premium.

" Definition Insuring for a premium means underwriting the risks of others by
assessing their value and the possibility of a negative event occurring, is a modern
development of this activity.

Historians place the birth of insurance as a premium in the fourteenth century. At

that time, double-entry bookkeeping, bills of exchange and modern forms of cheque
were developed. Then too, the first series of regulations for marine transport and the
credit system became widespread. Business people no longer followed cargoes of
goods sent all over the world and began to become sedentary types. The transaction of
insurance so met a need for security tied to merchant traffic fully. Insurance became a
tool used between merchants. It spread rapidly and became rooted in business
practices. This was also because it was the merchants themselves providing the
insurance cover. The insurer belonged to the same social class as the insured. A
merchant, depending on whether he needed cover for the risks of his dealings, became
an insured. Otherwise, if others needed to cover a cargo, he/she would provide
insurance cover, exchanging roles based on business circumstances. His/her position
changed based on the speculative spirit of earning by taking on the risk of others.
As this was a long process that arose out of the practice of business dealings, a
dating with certainty the birth of the first contract of insurance has been found
difficult to determine by historians of insurance law. All are, however, agreed in
8 1 The Origins and Role of Insurance in Society

setting the birth of modern insurance in Italy. Although what has not been deter-
mined unequivocally, is the city that gave birth to it: either Genoa or Pisa.
The first contract can be traced in 1343 in Genoa1. This was a contract of
insurance disguised as a loan and drawn up by a notary. In Pisa in 1379 on the
other hand, there was an insurance agreement in the form of a true contract of
insurance. In it, the parties are clearly called insurers and it was drawn up as a private
rather than as a notary deed, and there was no form reference to other agreements.
Finally, in Pisa and Florence, differently from Genoa, in that historical period there
existed the figure of the matchmaker, a businessman who would procure insurance
contracts and assist the parties in writing up an insurance contract.
The true tool of insurance began life in the fourteenth century and spread in
subsequent centuries alongside developments in the economy. In the paragraphs that
follow the main historical stages of insurance in the property and life business will be
illustrated.

1.4 The Historical Development of Non-life Insurance

Insurance, as shown in the previous paragraph began around marine traffic in the
fourteenth century. Since then and up until our time, four stages can be identified that
mark out the development and sophistication in covering insurance needs over the
course of time: the development of traffic and maritime routes, the growth in
overland commerce, the expansion of urbanization and the effects of the first
industrial revolution. Figure 1.3 shows the four stages of the development of
non-life insurance.

" Definition In the period following the fourteenth century, insurance spread
throughout the Old World as a tool for securing wealth against the risks of marine
transport, from Italy to southern France and along the whole of the Iberian
Peninsula. In the 1600s, the centre for marine traffic was around France, England
and Holland and Atlantic routes.

The port of Amsterdam achieved primacy as the most important intermediary of

traffic between the Orient and the West, overtaking the city of Venice, whose decline
was tied to its geographical position, which was crucial only for routes within the
Mediterranean.

" Definition Later, around the seventeenth century, a need was felt to extend
insurance cover to risks other than maritime ones. This was to protect interests that

1
The first real insurance contract that we are aware of is a marine insurance stipulated on 18 March
1343 in Genoa. The text: [. . .] to protect in charge of Guglielmo Avedotto the load of ten bales of
clothes to be transported on the galea (boat) Santa Catalina. Against payment of 680 gold florins,
Amichetto Pinello ensured the journey, under the command of Valentino Pinello, son of Nicola,
from Porto Pisano to an unspecified port of Sicily [. . .].
1.4 The Historical Development of Non-life Insurance 9

New covers after

the first industrial
3
revolution

Risk related to
urbanisation
2

Cover for carriage

1 of goods and land-
based

Cover for
Insurance marine traffic
premium

Middle Ages 1400 1500 1600 1700 1800

Fig. 1.3 Stages in the development of property insurance

were new as compared to the carriage of goods. New covers to protect land trade
developed, such as the protection of credit from insolvency of a debtor, cover for
property and so on.

This passage marked an evolution towards land-based insurance. From a legal

standpoint, in 1484. The Ordinances of Barcelona for the first time dealt organically
with the discipline of insurance and were fundamental in its spread to other European
nations. Another important contribution was made to consolidating the entire matter
of insurance by the Ordonnance de la marine issued in 1681 during the reign of Louis
XIV and which was a model for the subsequent Code of Commerce of 1807. Based
on this code, other commercial codes would develop in the leading nations of the Old
World.
England has for centuries been the nation where insurance has had its greatest
development. As long ago as 1575, at the London Stock Exchange, a Chamber of
Insurance was set up where contracts of insurance were recorded and thanks to this,
clauses contained in the insurance policies tended to become uniform.

" Definition Concerning the urbanism, following the Great Fire of London which
devoured a large part of the city in 1666, insurance against fire appeared quickly and
new forms of prevention were launched.

In 1680 the insurance undertaking, the Fire Office, was founded, and in 1693 the
Friendly Society began life, and in 1696 the Hand-in-Hand insurance. Apart from the
first of these, the latter two were mutuals which remained in business for decades, the
Hand-in-Hand especially, which traded up until the early 1900s.
10 1 The Origins and Role of Insurance in Society

At this time, insurance undertakings began to develop new models for the
management of insurance business. Indeed, specific additional insurance clauses
were adopted foreseeing a sharing by insureds in the expenses for indemnifying
losses, and surety deposits were requested to meet the difficulties of that period in
history. Finally, losses caused by the break-out of fire were calculated and forecast
by reliable calculations. At that time in England, there were the first attempts made to
create joint-stock companies with aim of setting up insurance undertakings that
could insure a broad spectrum of risks. This was facilitated by new forms of
organisation and incorporation that allowed large amounts of capital to be gathered.

" Definition About the industrial revolution at the end of the 1700s and early
decades of the 1800s, this phenomenon changed the styles of life of society irrevers-
ibly and led to new needs for security in people. The insurers of the time thus found
themselves facing new risks and new demands from insureds.

In addition to marine trade and fires in dwellings, covers for fires in industrial
buildings became widespread, as too, insurance of installations and protection
against accidents at work. In parallel with the development of transport, cover for
the risks of railway accidents appeared. Towards the middle of the 1800s, many
other new lines of business of insurance developed: the risk of hail, credit insurance,
liability etc.
In the rest of Europe, insurance against fire spread after 1814 following the
Restoration. In France and Germany insurance undertakings were begun in mutual
form and with a fixed premium2. In subsequent decades, the French insurance
market witnessed a period of great development and new insurances with the spread
of covers against civil liability and business liability. In Germany too, towards the
end of the 1800s the development of insurance went in parallel with growth in rail
transport and river navigation. Again, in Germany, as early as the beginning of the
1900s, reinsurance grew especially, so much so that on the eve of the First World
War, German reinsurers represented almost half of the worldwide market for
reinsurance.
Across the Atlantic, insurance developed much later as compared to the Old
World. Up until the US Civil War (1861–1865) British insurers operated in North
America and continued to enjoy the trust of the Americans even in the subsequent
decades. The first American insurance undertakings started out as life insurers and
only later did non-life insurance become widespread. The burgeoning use of
automobiles and aircraft during the period between the wars accelerated the expan-
sion of insurance in the United States to cover automobile civil liability and covers
against accidents during air transport.

2
Among the most important, in France: Compagnie Royale d’Assurance contre les Incendies,
Assurance Mutuelle Immobilière of the Ville de Paris, Assurance Générales, Phénix, Royale; in
Germany: the Fire Insurance Bank at Gotha.
1.5 The Historical Development of Life Insurance 11

Phases

Modern life insurance

Life insurance
First demographic Statistical
basis theory

Tontine
Paying
Annuities
Life Annuities

Gambling
Gambling on person life

Middle Ages 1400 1500 1600 1700 1800

Fig. 1.4 Stages in the development of life insurance

1.5 The Historical Development of Life Insurance

The first contract “life” ( i.e. on human life) as we know of it, dates back to the
second half of the fifteenth. The contract was concluded in 1583 in London and
foresaw an indemnity for a sum of 382 and 1/3 pounds sterling in the event of the
death of William Gibbons for a duration of 12 months and a rate of premium of 8%.
However, in Europe, life insurance did not develop fully during the subsequent
centuries for various reasons.

" Definition On the one hand, the principles and rules of Roman Law, the corpus
iuris civilis, (denomination with which, from the medieval age onwards, the great
Justinian compilation of Roman law is indicated, a work of capital importance for
the juridical science of all times) were still in operation and according to which
placing a value on the life of a free man was forbidden, and on the other, the social
and economic structure of the time was closely tied to a concept of communities.

In summary, Roman communities were organized with a structure that was

impenetrable from the outside and with a concept of assets that belonged to the
entire community and not to one or more individual components. This meant that the
principles of an economic value for an individual’s human life and of safeguarding
his prospective ability to produce an income were missing3.
The historical development of life insurance in the Old World can be analysed
through three themes that set it apart: wagers, paying annuities and modern insurance

3
Under Roman law this was permitted only for the slaves.
12 1 The Origins and Role of Insurance in Society

based on probabilistic calculations. Figure 1.4 shows the three stages of the devel-
opment of life insurance.
For centuries, the risk of a premature death or the survival of an individual was
viewed by the same yardstick as a wager on the life of the person. In medieval times,
and even later during the Renaissance, contracts of wager on the duration of the
life of important personalities of the time such as reigning emperors, and even the
Pope, became customary. The improper use of life insurance was prohibited in
England in 1774 under the Gambling Act, a law governing games of chance. This
measure provided that insuring one’s own life or that of others was only possible if
the policyholder could claim an interest on the insured life. To aid in preventing this,
this measure required that any such policy include the names of the persons who
stood to benefit by it.
Concerning annuities, during the fifteenth and sixteenth centuries the first forms
of life annuity came into use and which, once purchased, gave the right to collect an
annual income for the entire life of the subscriber and often not only their own, but
also that of one or a number of family members.
The greatest spread of the providing of annuities was found in France around the
middle of the 1600s thanks to the banker originally from Naples, Lorenzo de Tonti, who
invented the so-called Tontines to finance the public expenditure of the French state.
The way a tontine worked was relatively simple. Each investor paid in a sum of
money that was then converted into a unit of measurement: a tontine. The funds
collected were invested and each investor received the profits deriving from the
investments up until they died. Investors were spilt into classes of age and upon the
death of each of them, their quotas of income still due were divided among the
remainder up until the last of the age class died. As time progressed and subscribers
died off, those surviving received a growing sum up until the last one remaining
alive of the participants got the entire income. In fact, each investor enjoyed an
increasing annuity. At the death of the last investor, the income returned to the State
which, via the tontines, financed public expenditure. After a few decades these
spread also to England, Germany, and Italy until the mid-1700s when state tontines
began to cease being subscribed and remained in use only as tontines started by
private individuals, especially in France and in Italy, into the twentieth century4.
Life insurance as we know it today began thanks to the development of mathemati-
cal and statistical studies applied to calculating the probability of death and survival.
The calculation of probabilities developed under the favourable influence of
tontines due to the special merits of the mathematicians Blaise Pascal, Pierre de
Fermat and Daniel Bernoulli. It was in those years the first mortality table was
created by Edmond Halley who, in 1693, published data on births and deaths in the
city of Bresalva for the period 1687–1691. The importance of the Halley table
consisted in allowing the number of deaths to be determined for each age starting
from birth. In truth, starting from the ratio applying between the number of births,
categories of age and number of deaths, the probability of death for each year can be
calculated.

4
Currently, legislation in several States prohibits tontine’s associations.
1.5 The Historical Development of Life Insurance 13

Thanks to new discoveries in calculating probabilities, probability calculation-

based insurance began. In 1705, the Amicable Society was the first insurance
undertaking to surmount the prohibitions set by the English authorities in life
insurance matters and begin to offer modern contracts of life insurance. The mor-
tality table called the Northampton Table thought up by Richard Price, on the
other hand, was used successfully in calculating the insurance premiums for the
English mutual, Equitable Assurances on Lives and Survivorships, which was
founded in 1762. For the first time, this mutual put its trust in a specialist to
determine technical insurance issues: an actuary.
The process of modernising life insurance was completed when the figure of the
actuary was introduced. From then on, insurance was no longer based on empirical
calculations but on a solid basis of actuarial mathematics. Historically, this took
place alongside the industrial revolution and the growth of transport, steam-driven
machinery and the railways. These innovations brought about deep changes in
economics and in the society of the time and contributed to changing the value
ascribed to the life of a person. From then on, human life in every person was to be
assessed according to principles of economic value and according to their prospec-
tive capacity to produce a flow of income in the future.
In the early 1800s in England, France and Germany, many life insurance
undertakings commenced activity, either as mutuals or in joint-stock company
form. Life insurance developed later in America, but the newly formed American
insurers, starting in the second half of the 1800s, saw remarkable growth, above all
following the creation of specific mortality tables for the populations of America
which were beginning to inhabit the new metropolitan areas.

The Titanic
The insurance of the Titanic One of the largest ships designed up to the time
and built by marine engineering in 1900s was the Titanic, tragically
shipwrecked in 1912 causing the loss of 1,500 human lives. The ship was
insured as early as 1911 even before it had been completed, by about
70 insurers, mostly English ones. Confident of the technology that ensured
the ship was practically unsinkable, the insurers gave cover for almost half of
its full value. On 14 April 1912 on its maiden voyage and following collision
with an iceberg in the North Atlantic, the ship went to the bottom in only two
and a half hours. Among the 1,500 victims, there were a number of the richest
men in the United States and the life insurers in America had to settle
reimbursements for several million dollars.

In the early years of the twentieth century, the insurance industry, in general,
continued to expand and succeed in overcoming, although with more than a few
adverse consequences, the inflationary crisis that was to strike leading States at the
end of the First World War. In the second half of the 1900s the market for insurance
14 1 The Origins and Role of Insurance in Society

grew exponentially, driven by increases in demography worldwide and general

improvements in standards of living.

1.6 Social Insurance and the Development of Retirement

Provision

In the Old World, during medieval times, the first significant forms of social
assistance were the Opere Pie (Charities) which were funded by contributions
from merchants. At that time indeed, there was a widespread custom of donating a
part of earnings to charities in order to give business an ethical cloak. These became
increasingly organised and institutionalised during the time of the crusades.
As the importance of the religious component grew in the Charities over the
centuries, so did the role of the Catholic Church. So much so, that they came to be of
fundamental importance in solidarity towards the needy in centuries to come.
Following the rise of the first nation States in Europe, the State became first the
supervisor and later the manager of social assistance. This was to become increas-
ingly public and ever less charitable, and the premise was created for social
insurances at the end of the 1800s.
In those years we witness the birth of the first public welfare systems put in place
by the States. State intervention aimed to guarantee protection, assistance and social
prevention through public policies.

" Definition As we will see below, public welfare provides benefits in areas such
as old-age pensions and subsidies for situations of hardship (e.g. illness, unemploy-
ment and disability).

Germany was the first country to establish the compulsory social insurance. In
1883, compulsory covers against illness were introduced, in 1884 insurance against
accidents at work and in 1889 covers for disablement and old age. In those years,
other countries such as Norway, the United Kingdom, Italy, France and Denmark
followed the example set by Germany. In the United States, obligatory protections
for old age, unemployment and cover for survivors were introduced in 1935, and in
1945, compulsory insurance against illness was set up.
The machinery underlying social insurance could be distinguished by the way it is
funded. There is a capitalisation system and a Pay As You Go (PAYGO) system.

" Definition Social security based on funding through a capitalisation retirement

provision system foresees contributions paid in by workers being invested in
interest-bearing assets used to fund the pensions for the same workers once they
become elderly and accrue a right to receive a pension. In this system, a redistribu-
tion over time of income is achieved in which a worker puts aside a part of his/her
income from work during his/her working life so as to be able to enjoy a good
standard of living once drawing a pension.
1.6 Social Insurance and the Development of Retirement Provision 15

Capitalisation Pay As You Go Capitalization

(PAYGO) System.

Social Insurance System

Period
Start between two End of XX
1890 World Wars century

Capitalisation of the Current workers’ Social insurance

workers’ payments payments to finance system reforms in
current pensions continental Europe

Fig. 1.5 The development of social insurance

" Definition Funding a Pay As You Go (PAYGO) pension system on the other
hand foresees contributions paid in by workers during the working period being used
to meet the pensions of workers who have already retired. The way this latter system
works applies a redistribution of income across generations. Workers in activity pay
the pensions of those who have already retired. The role of the State becomes one of
guaranteeing that an intergenerational pact is fulfilled: i.e. even workers who are
active, once they become elderly, will receive a pension funded by future
generations of workers5.

In Europe, pension systems are based on one or other of these systems. The
original systems were based initially on a capitalisation retirement provision system.
Later, States introduced a number of modifications made to meet the changed post-
war economic context. At that time indeed, there was: high inflation, a growing
number of provisions to be met (disablement and old-age pensions following the
war) and a broadening of social security protection for a wider category of workers.
For this reason, during the early stages of revision, the capitalisation pension system
was supplemented by a PAYGO system, which latter was later to become the norm.
The pay-as-you-go system remained in force throughout the post-war period.
In recent decades of twentieth centuries, a number of European States have begun
to take corrective action concerning pensions systems so as to ensure the stability of
balance of public finances in the future. For this reason, several countries have gone
back to capitalised pension provision. Figure 1.5 shows the development of social
insurance in Europe.
Among the most important reasons for going back to a capitalisation system are
demographic factors, trends in the economies of industrialised countries and tensions
in national debt. Concerning demographic factors, a lengthening of average lifespan
and falls in birth rates have changed the age structure of the population of

5
The system of pay-as-you-go financing is in a balanced position if the contributions paid in the
year are the same as the pensions paid in the year.
16 1 The Origins and Role of Insurance in Society

industrialised countries. There is now a progressive ageing of the population going

on and this is leading to problems that regard the intergenerational pact. A second
factor is the economic trend in European countries which are failing to maintain a
sustained economic cycle. This is creating problems in the labour market and
productivity in the entire industrial system. Finally, public finances are a great
burden to bear. States are now coming to grips with tight constraints of equilibrium
in finances and the costs of pensions which have grown dramatically in recent years.

1.7 Questions

1. What were the areas of mutual solidarity in ancient insurances?

2. What were the features of the first contracts of marine insurance?
3. What was the pathway along which insurance against loss developed? What
were the stages of this?
4. How did life insurance develop? Along what routes did this happen?
5. How does a PAYGO pension system work? Which the difference with
capitalisation system?

Suggestions for Further Study

Alborn T, Ann Murphy S (2013) Anglo-American life insurance, 1800–1914: what is life insur-
ance? Why should you insure? Selling life insurance to the public, 1st edn. Routledge, London.
https://doi.org/10.4324/9781315097251
Borscheid P, Haueter NV (2012) World insurance: the evolution of a global risk network. Oxford
University Press, Oxford
De Simone E (2003) Breve storia delle assicurazioni, Milano, Franco Angeli
Fanfani T (1998) L’assurance-vie en Italie entre initiative privée et monopole (XIXe siècle-début
XXe siècle), in Insurance in Industrial Societies: Economic Role, Agents and Market from 18th
Century to Day, Sevilla, Universidad de Sevilla, pp. 101–126.
Feldman GD (2006) Allianz and the German insurance business, 1933–1945. University Press,
Cambridge. isbn 9780521809290
Haueter NV (2013a) A history of Insurance – Swiss Re Corporate
Haueter NV (2013b) A history of UK Insurance – Swiss Re Corporate
Leonard A (2016) Marine insurance, Palgrave Macmillan UK. https://doi.org/10.1057/
9781137411389
Murray JE (2007) Origins of American health insurance: a history of industrial sickness funds. Yale
University Press, New Haven, CT
Pearson R (2004) Insuring the industrial revolution: fire Insurance in Great Britain, 1700–1850.
Routledge, London. isbn 9780754633631
Pearson R (2017) Insuring the industrial revolution: fire insurance in Great Britain, 1700–1850.
Taylor & Francis eBook, Aldershot. isbn 9781315252193
Pearson R (ed) (2010) The development of international insurance, 1st edn. Routledge, London.
https://doi.org/10.4324/9781315655925
Van Leeuwen MHD (2016) Mutual insurance 1550–2015. https://doi.org/10.1057/978-1-137-
53110-0
The Notion of Risk and Probability
2

Abstract

This chapter introduces the concept of risk. Many definitions have been offered to
explain what is meant by risk in the literature. Notion of probability is described
and differences between classical (or mathematical) probability, statistical
(or frequentist) probability and subjective probability are explored. The informa-
tion asymmetries between the insurer and the insured are defined. The reader can
learn the definition and examples of adverse selection; morale hazard and moral
hazard. In the paragraphs, it is explained that everyone has their own risk appetite.
Based on to the utility function of Von Neumann–Morgenstern it is possible to
determine the behaviour of individuals according to their attitude towards the
benefit/result obtained. Behavioural finance and cognitive psychology on
decision-making processes in conditions of uncertainty shown how often the
consumer, in complex situations, makes choices based on simplified judgement
mechanisms.

Keywords
Uncertainty · Classical or mathematical probability · Statistical or frequentist
probability · Subjective probability · Risk · Pure risk · Speculative risk ·
Fundamental risk · Particular risk · Personal risk · Property risk · Liability risk ·
Risk management · Risk assessment · Risk mapping · Risk mapping matrix ·
Principle of mutuality · Risk pooling · Conditions of insurability · Law of large
numbers · Information asymmetry · Adverse selection · Morale hazard · Moral
hazard · Utility function · Risk neutral individuals · Risk averse individuals · Risk
seeking individuals · Behavioural finance

# Springer Nature Switzerland AG 2024 17

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_2
18 2 The Notion of Risk and Probability

2.1 Learning Objectives

At the end of this chapter the reader should be able to:

1. Define the concept of risk and distinguish it types.

2. Be aware of the meaning of Risk Management and the activities that go
into it.
3. Identify risk management strategies and techniques for mitigating it.
4. Illustrate the principle of risk sharing and describe the conditions of
insurability.
5. Be aware of the concepts of information asymmetry, morale hazard, moral
hazard and adverse selection.
6. Explain the utility function model as it relates to risk.
7. Illustrate the concepts underlying behavioural finance.

2.2 Risk and Uncertainty

Aristotle defined risk as «something awful getting closer».

Many definitions have been offered to explain what is meant by risk in the
literature. Several Authors1 link the meaning of risk to the concept of uncertainty:
risk and uncertainty concern a loss coming about.

" Definition According to this definition, what is under uncertainty concerns

what arises in a particular circumstance assuming that something in the current
situation might change in the future and that the change will be a loss of a
monetary kind.

The main criticism directed against this definition is that it looks at the subjective
perspective of risk when it is defined in this way. Uncertainty is a condition that
individuals find themselves in, a frame of mind of doubt in the person concerning the
outcome of an event, at times worsened by lack of information, and is a mental
reaction by someone to the surrounding environment. Create a link between risk and
uncertainty it adds an element of subjectivity to the view taken of risk itself and it is
exceedingly difficult to measure and quantify something that is subjective.

1
See Rejda G. E., (1995) Principles of risk management and insurance, Harper Collins College
Publishers.
2.2 Risk and Uncertainty 19

Other Authors2 define the risk that is associated with an event as the objective
probability of what occurs (the current result of the event considered) differing
significantly from expectations (expected outcome).

Notion of Probability
There are several types of probabilities in the literature:
Definition: Classical or mathematical probability. This is given by the
ratio between the number of favourable cases compared to the number of
possible cases.
For example, what is the probability of getting heads by flipping a coin?
The odds of heads or tails are equally likely. The probability is therefore 50%.
Definition: Statistical or frequentist probability. This is used in all cases
in which the probability of an event must be estimated, but the possible results
and the probable results are not known. In this case the probability corresponds
to the relative frequency of a random event based on an infinite number of
observations under the same conditions. In simple terms, for a repeatable
event, the frequency corresponds to the number of times the event occurs
divided by the number of experiments performed.
Definition: Subjective probability. This represents the individual estimate
of the individual subject regarding the random event, influenced by the
information taken by an individual at a given time and according to his
expectations.

" Definition In summary, there is no doubt that a risk exists when an event will
occur in a given timeframe and that such an event is likely to have monetary effects.

As for uncertainty, this can be defined as a set of particular situations in which

whether chance events occur or not cannot be foreseen, nor can an estimate ex
ante be made of the probability of the event happening and its possible
consequences.
Risk can be classified into two broad categories: the first one takes in pure risks
and into the second fall speculative risks.
A risk can be defined as a pure risk when it concerns situations where there can
only be adverse outcomes: either there is loss or the starting conditions continue to
apply (neutral); examples of this are the risk of fire, or the risk of suffering a
theft, etc.

2
See Athearn J. L., (December 1971) What is risk? in The Journal of Risk and Insurance, Vol.
38, Issue 4, pp. 639–645; Hall C. P. Jr., (September 1957) The meaning of risk, in The Journal of
Risk and Insurance, 34, n.,3, pp. 459–474; Head G. L., (June 1967) An alternative to defining risk as
uncertainty, in The Journal of Risk and Insurance, Vol. 34, Issue 2, pp. 205–214.
20 2 The Notion of Risk and Probability

A speculative risk, on the other hand, is where it is possible for either loss or
profit to occur; for example, the purchase of shares on the stock exchange or a wager
on a horse race, etc. Assuming speculative risk is usually a choice and not the result
of uncontrollable circumstances.
The distinction that applies between the two categories is particularly important
since, generally, only pure risks may be insurable by an insurance undertaking, while
speculative risks cannot be.
A further classification is often met that makes a distinction between fundamental
and particular risks.
Fundamental risks are those that affect an entire economy or significant part of
this or risks that affect a large number of persons: for example, the risk of war, risk of
cyclical unemployment, or so-called catastrophe risks caused by natural disasters
such as floods or earthquakes, or technical catastrophes tied to the actions of humans,
such as large fires and nuclear risks, environmental risks, etc.
Particular risks are, however, risks that concern the individual and not society at
large, such as the theft of a car, fire to a dwelling, etc. In general, many catastrophe
risks may be insured by an insurance undertaking through adopting ad hoc risk
management techniques.
In summary, not all fundamental risks can be insured by an insurer and, in any
case, insurable fundamental risks require a complex insurance structure, while
particular risks can be included in the insurance coverage.
Pure risk, the one that is commonly insurable, is a threat to the economic and
financial security of an individual. In general, the following distinctions are made:

" Definition

• Personal risks, which are those that are tied to the person and their capacity to
produce: the main ones are the risk of premature death (when death of the person
leads to a reduction in family income to the extent that they cannot meet their
needs and any financial commitments taken on, such as schooling for children or
paying off a mortgage, etc.), risks of permanent disablement (accident of loss of
self-sufficiency) and illness, and the risk of unemployment/insufficient income.
• Property risks3, risks that concern direct and indirect damage to economic
goods. For example, for an individual, the risks associated with the damage or
theft of his property, damage from water pipes, patrimonial losses such as all
events that have in common result in a loss of money, etc. For a business insured
against risks of fire and subsequently damaged by fire, the damage represented by
unachieved profits caused by interruption of productive activity is considered
over and above the direct damage to the property damaged or destroyed.
• Liability risks, tied to negligent or culpable conduct of third parties causing
damage of an economic kind to the person or to property; a doctor sued by a
patient claiming to have suffered injury from alleged negligent conduct by the

3
Also called “real risks” (from the Latin word res).
2.3 Risk Management 21

professional person, for example, if held culpable by a judge, will be obliged to

pay damages; in liability risks, both the overall duration of litigation (it can often
take years to reach a judgement of acquittal or order to pay damages) and the
aggregate sum to be paid (a maximum value of damages cannot be established a
priori—which can be, however, be achieved with risks to property) are difficult to
predict.

2.3 Risk Management

In this paragraph we illustrate the main strategies for dealing with risk and we start
with how risk is identified and evaluated.

" Definition For this, what comes to our aid is risk management, which is the
discipline dealing with identifying and evaluating the exposure to the pure risks and
adopting the most fitting techniques for managing them.

Seeking out areas that are critical from a corporate standpoint—since they are
risky—allows a risk manager to identify sources of potential risks and so potential
losses, possible adverse events, their causes, whether they be natural events or those
of human origin, and whose effects would lead to the potential losses that are feared,
whether personal or economic, or losses from liability. The main available tools are
risk assessment, evaluation and mapping.

" Definition Risk assessment aims at identifying the potential losses. It consists of
filling in questionnaires, surveys and inspections, checking documents—from job
descriptions to financial statements, etc.

Once the assessment/identification stage has been concluded, the process of

evaluation defines frequency and severity. The evaluation is performed through
calculations estimating frequency of occurrence, extent of the loss in terms of
severity as the potential size of the loss from the event in a given time frame.
The risk mapping stage consists of a schematic setting out through which the
series of identified losses can be represented and ordered according to their relative
importance. This scheme is based on a matrix with graduated axes on an increasing
scale of values from one to five where one indicates the lowest value.
By measuring severity and frequency, losses can be measured, and four main
areas of intervention identified.
A risk mapping matrix is a matrix used to rank risk assessment output. Two
axes draw this matrix: the probability of risk and the severity. This is a visual
representation to signal risks and assist management decision making. See Figure 2.1
for a scheme of risk mapping matrix.
In the risk mapping matrix, there are several potential losses in the dark grey
squares to the upper right of the matrix featuring high severity and high frequency.
Potential losses that are of low frequency and low severity are on the other hand
22 2 The Notion of Risk and Probability

Fig. 2.1 Risk mapping

matrix
5

Severity
3

1 2 3 4 5
Frequency

placed to the lower left—in the white coloured squares. In the central areas of the
matrix, we find on the other hand, losses that are intermediate in nature: in the
medium grey section we find potential losses that feature one of the two high
dimensions (severity or frequency): these events have a meaningful impact on how
the party suffering them performs economically. In the final section, however–
shown in the light grey area—we find the losses featuring intermediate levels of
severity and frequency: in this case, the consequences of the event are not severe and
are often bearable. Based on the appetite for risk an economic party may have and its
evaluation, different methods of managing it may be adopted. Risks, and related
actions to manage and reduce them, can be placed on a continuum starting from the
area to the lower left and proceeding towards the upper right of the matrix. Different
management strategies will be adopted depending on which quadrant the potential
loss is to be found in.
Dealing with risk means adopting techniques and devices that aid persons and
firms to meet risks4. The four strategies of risk management are listed here below:

• Strategy 1—“Avoid the risk”, i.e., Escape from situations that are potentially
risky, such as no longer producing a product to avoid the risk of causing injury
from defective goods or avoiding driving a car so as to ward off a risk of accident.
As can readily be imagined, not all risks can be avoided, and this is often neither
practical nor desirable.

4
See Rejda G. E., (1995) Principles of risk management and insurance, Harper Collins College
Publishers, pp. 13–55.
2.4 Principle of Mutuality and Risk Pooling 23

Table 2.1 Techniques of risk management

Types of risk Frequency Severity of impact Technique of risk management
1 Low Low Retention
2 High Low Loss control and retention
3 Low High Insurance
4 High High Escape from risk

• Strategy 2—“Retain the risk”, i.e., assume the risk at own cost: a party–or firm—
decides to bear the economic consequences of loss should a feared event occur.
The retention technique is employed when it is not possible to insure against a
certain risk or when the estimated loss is thought to be minimal and purchasing
insurance is not worth the cost; or, finally, when, on the basis of corporate
experience in the past, the frequency and severity of the risk can be estimated
easily by a risk manager. In addition to the main advantage of saving the cost of
insurance premiums, retention is also an effective incentive for preventing risks:
against this, as they are chance events, it is always possible that costs of damage
that are much greater than those expected are incurred.
• Strategy 3—“Loss control”, which is implemented mainly via activities aimed at
reducing the probability of the event occurring (wherever possible), and reducing
the extent of any damage, so as to render making good the loss economically
acceptable for the firm.
• Strategy 4—“Insurance” consists of a transfer of the economic consequences of
the risk to an insurer. This strategy involves the transfer of risk from one party to
another.

To summarise the concepts set out above, Table 2.1 indicates the most appropri-
ate risk management technique according to the type of risk, as classified5 on a basis
of frequency and severity of impact.

2.4 Principle of Mutuality and Risk Pooling

Insurance is a tool that allows a transfer to be made to others of the economic

consequences of a risk. An insurer undertakes to pay the costs to its insureds if
chance events that are the subject matter of the insurance agreement occur.
The mechanism of insurance foresees a sharing of a loss suffered by a few among
a great number of parties exposed to the same risk. To achieve this, two factors are
needed: a deep awareness of the frequency of the risk considered occurring is

5
Table adapted from Rejda G. E., (1995) Principles of risk management and insurance, Harper
Collins College Publishers, p. 49.
24 2 The Notion of Risk and Probability

required, and this can be deduced from historical observation of this risk, and a large
number of parties being exposed to it.
Underlying risk management through the tool of insurance is the principle of
mutuality.

" Definition According to the principle of mutuality, individuals subjected to a

single risk contribute to setting up a fund intended to cover losses that a number of
participants may suffer by paying in a sum of money calculated in proportion to their
own specific risk.

From this fund, according to the principle of mutuality, also called a risk pool6,
the sums necessary to indemnify those who have been struck by an adverse event are
drawn.
Insurance is essentially a pooling, i.e., a sharing of risks.

" Definition Risk pooling consists in spreading the losses suffered by a few over
the entire group of participants so that, at the end of the process, the actual loss
becomes an average loss.

Risk pooling needs to involve and group together a large number of parties
exposed to the risk since, as will be seen more fully later, due to the properties of
the law of large numbers, it will thus be possible to predict the probability of future
events occurring.
A numerical example may clarify how risk pooling works.

Risk Pooling: Numerical Example

Let us suppose that 1,000 farmers agree to meet the risk of hail that could
damage their vines: anyone losing their harvest will be indemnified by the
others. Let us suppose that each vineyard is valued at 15,000 euro and that
each year, at least one vineyard is destroyed by hail. Without insurance, the
maximum loss for each farmer would amount to 15,000 euros; through a
pooling mechanism, a loss is shared across the entire group and if there is
hail, the loss for each farmer will amount to 15 euros (15,000/1,000).

In the way of working shown, it should be noted that all individuals who have
not suffered a loss event participate just the same in the mechanism of reimburse-
ment. Their payment in will indeed be used to cover the loss events of the other
insureds.

6
An English language term whose literal meaning is risk sharing arrangement.
2.5 Conditions for Insurability 25

2.5 Conditions for Insurability

" Definition Conditions for insurability represent the constraints that must be
respected in order to insure a risk on the part of the insurance undertaking. These
conditions, which are discussed below, are the following six: law of large numbers,
principle of Independence, qualitative and quantitative homogeneity, chance and
unforeseeable occurring, being equidistributional, measurable and quantifiable.

For all this to work, the insurer needs to be able to calculate the probability of a risk
occurrence very accurately.

" Definition To their aid comes the law of large numbers or empirical law of
chance, which indicates that if we subject an event with constant probability p to a
large number of tests n, this will occur a number of times v with relative frequency v/
n representing the approximate value of statistical probability p and the approxima-
tion grows as the number of tests rises.

See the equation below:

n large number of tests.

v number of times this will occur.
v/n relative frequency. In case of an infinite number of tests p approximately is the
statistical probability.

p = v=n ð2:1Þ

For many pure risks, an insurer can calculate the probability of occurrence and
severity of impact of a loss through an estimate of the average frequency and an
estimate of the average value of the loss based on observing past experience, when
this is based on a number of observations that is sufficiently large. In other words, an
insurer can estimate future risks and this estimate will be all the more accurate as the
number of observations grows.
For the properties of the law of large numbers to apply, risks need to refer to units
that are independent of each other and homogeneous.
A risk comes under the heading of the principle of independence when its
probability of occurring is not influenced by other risks happening and remains the
same even when other risks occur and the happening of one event has no effect on
the others. In sum, risks are independent when they have no bearing on each other.
Homogeneity is the requirement for risks to have the same characteristic. Homoge-
neity is considered both from the standpoint of quantity and of quality. Qualitative
homogeneity concerns the risk from the standpoint of frequency of occurrence: this
means risks that are of the same kind or generated by the same cause. Quantitative
homogeneity makes reference to values insured representing the undertaking given by
an insurer to insureds and beneficiaries: these sums must not be of sizes that are too
26 2 The Notion of Risk and Probability

different from each other. Otherwise the policy portfolio is unbalanced between
premiums and claims with negative consequences on technical performance. An insur-
ance undertaking may take advantage of systems such as coinsurance and reinsurance to
meet risks taken on in cases where they do not fall into homogeneous classes, or when
the risk underwritten is too high for the technical or economic capacity of the firm7.
Pure risks must have several fundamental features to be insurable. First of all, it
must be a risk that is subject to chance and be unforeseeable: a loss caused
intentionally cannot be indemnified and the law of large numbers applies only for
events brought about by chance.
Additionally, the units exposed to the same risk must be large in number
(equidistributional), for two reasons: (1) to allow the insurer to estimate losses
using the law of large numbers, (2) to be able to share costs of indemnity across
the broadest number of insureds—and consequently—be able to request a lower
contribution, in line with the industry.
Finally, it is important for the risk to come within the rules of what is measurable
and quantifiable, i.e., the insurer must be able to establish the cause, the time, place
and extent of the loss deriving from an adverse event so as to be able to decide
whether it falls into a type of risk covered by the cover or not and also decide the size
of the indemnity to settle. Additionally, when the risk is quantifiable, it is possible to
know how frequently it actually occurs. Another important requirement is that, in
order to be insurable, a risk must not be able to strike most of the insureds at once
(they cannot be catastrophe risks).
Figure 2.2 sets out graphically the fundamental features that a pure risk must have
to be an insurable risk.

2.6 Selection of Risks and the Problem of Information

Asymmetries

In the foregoing paragraph we saw that a pure risk can be insured at certain
conditions: a sufficiently large number of units exposed to the same risk that are
independent and homogeneous, arising from chance and being foreseeable, deter-
minable and measurable, not catastrophic. For a pooling mechanism to work prop-
erly an insurer needs to be able to select and classify risks underwritten so as to
calculate the premium properly on the basis of the individual risk assumed.
The workings of the insurance industry are a mechanism that is complex and
influenced by many different elements.
The insurance industry must deal with the information asymmetry.

" Definition Information asymmetry applies between the insurer and the
insured8 and creates problems in underwriting a contract of insurance.

7
See Chap. 17 for a treatment of these questions and where reinsurance and coinsurance are illustrated.
8
G. Turchetti, Innovazione e reti distributive nel settore assicurativo. Analisi teorica
e comportamenti strategici, Franco Angeli, 2000, pp. 79–81.
2.6 Selection of Risks and the Problem of Information Asymmetries 27

1. Law of large
numbers

2. Principle of
Independence
Qualitative

3. Homogeneity
Conditions for
insurability
Quantitative
4. Chance and
unforeseeable

5. Equidistributional

6. Measurable and
quantifiable

Fig. 2.2 Conditions of insurability of pure risks

Indeed usually, a client for insurance enjoys an information advantage over the
insurer concerning the risks they run. In other words, an individual party knows their
own situation in terms of exposure to the risk they wish to insure, whereas the insurer
does not have the same information. Information asymmetry is present both at the
stages leading up to concluding a contract of insurance, and later, when the insurance
cover is effective. When this asymmetry is ex ante, we have adverse selection. When
instead it is present after concluding the contract, we have morale hazard or moral
hazard. Unfair conduct refers to moral hazard. Therefore, note that the two terms
morale hazard and moral hazard have two different meanings.

" Definition The concept of adverse selection means the consequence deriving
from a situation of information asymmetry in which information relevant to the
contractual conditions is known to only one of the two parties.

This concept was introduced by Arrow through studies on the economy of

insurance and subsequently picked up by Akerlof in his classic contribution “The
Market for Lemons” where the used-car market is used to explain how information
asymmetry creates a situation in which one party (the seller of used cars) can find
themselves in a situation of relative advantage over the customer: the former is the
“strong party”, whereas the latter is the “weak party”. In the insurance industry, the
strong party is the insured: only they know their own riskiness, i.e., their exposure to
28 2 The Notion of Risk and Probability

a certain risk. Just as in the market for used cars, where among many good
automobiles there may be “lemons”9, in the same way among purchasers of an
insurance there may be lemons, i.e., parties with riskiness above the mean. An
insurer runs the risk of insuring the riskiest among many. To clarify what adverse
selection is, let us take a life business policy as an example. The health state of the
insured, his habits and lifestyle, the environment in which he works and the activity
he performs are all important elements for understanding his risk, but it is all
information that the insurer does not have. The latter will set the insurance premium
and cover based on the average features applying to a party of the same age and with
the same lifestyle as the assured. A policy concluded in this way will suit only
persons with a state of health that is worse as compared to the average, who will
insure at a price lower that their true profile: those who take advantage of insurance
no longer represent a chance sample of the original universe but will have been
selected adversely against the assurer. To deal with adverse selection an insurance
undertaking seeks to lead a customer into choosing an insurance policy that best
protects them for the risks they actually run. Imagine, for example, that the insurance
undertaking has only two types of customer, one of high risk, with risk greater than
average, and one of low risk, with a risk that is below average. An insurer could offer
two types of policy, one with low insurance premium, so as to lead “good”
customers into taking one out and be found not to be good value for the others—
because it offers cover that is too low; another type of policy, one for high-risk
customers, and which foresees a high insurance premium, commensurate with
higher risks. Adopting this strategy an insurer is able not only to cover risky
customers, but also others and associate the right premium to every risk.

" Definition Morale hazard refers to opportunistic behaviour of the insured once
the insurance contract has been concluded: it is a post-contract risk run by the
insurer. It arises when the insured does not adopt conduct and devices necessary
for the event not to appear.

For example, in an insurance cover against theft, morale hazard exists when the
insured, paradoxically, leaves home without locking the doors. In this case, an insurer
is not able to monitor the conduct held to by an insured during the relationship of
insurance. Conduct that is morally hazardous can reduce in cases of repurchase of
insurance, when past insurance history has a favourable bearing on future premiums:
applying a lower premium to a new policy, right-minded insureds are rewarded.

" Definition Moral hazard refers to behaviours or attitudes on the part of the
insured that increase the probability of a loss for the insurer. The risk is related to the
actual intentions of the insured. This concept is linked with a form of post-
contractual opportunism, in which a subject pursues his own interest to the detriment
of the insurer.

9
The English word lemon was used to indicate automobiles that were poor in quality.
2.7 Attitude to Risk 29

Table 2.2 Comparison of concepts: adverse selection, morale hazard, moral hazard
Adverse selection Morale Hazard Moral Hazard
Pre-contract Post-contract
Asymmetry between behaviours Failure to adopt behaviours suited Unfair
suited to limiting/avoiding the to limiting/avoiding the appearing behaviour in
appearing of an insurance risk of an insurance risk pursuing own
interests

Moral hazard, for example, can coincide with the simulation of accidents or
illnesses in order to obtain an unjustified or higher reimbursement following an
event10.
See Table 2.2 for a brief itemising of the concepts set forth above.

2.7 Attitude to Risk

Uncertainty concerning a choice concerns many of the decisions that individuals are
called upon to make what film to see at the cinema, which restaurant to dine at, which
insurance to take out, which online current account to open, etc. The question of the
attitude of individuals to risk has been broadly studied in economics: faced with the
uncertainty of an event taking place, economists have proposed economic models
describing the choices made by individuals.
The most widespread model is based on the Von Neumann–Morgenstern utility
function.

" Definition The concept of utility function looks at the benefit that a party might
obtain as the outcome of a choice, considering that these rewards, which are
monetary in kind are not certain but, due to uncertainty, may or may not arise.

The utility function describes with a mathematical formula how utility and the
reward/benefit/result behave together. A probability of occurring is associated with
each benefit or reward that a party might achieve: if this is an impossible event, the
associated probability is zero but if the benefit is certain and not a maybe, then its
probability will be equal to one and finally, if the event may occur but there is no
certainty—and so the benefit only might be achieved—the associated probability
will be of a value between zero and one. The Von Neumann–Morgenstern utility
function can provide us with information concerning the behaviour of individuals
facing a risk: a number will flee before risk, preferring solutions that are certain while
others will be more greatly attracted by situations of risk, preferring them to risk-free
contexts.
A numerical example may clarify the meaning of expected utility and propensity
for risk.

10
For this definition, the reader can see Vaughan, E. J., Vaughan, T. M. (2013) Fundamentals of
Risk and Insurance, 11th Edition, N J Wiley.
30 2 The Notion of Risk and Probability

?
Certainty
€50,000 €
Uncertainty

€100,000

€ 0.00

Certain choice Expected result

€ 50,000 € 50,000

Fig. 2.3 Decisions in a context of uncertainty: the lottery

The Concept of Utility: Numerical Example

Let us suppose that we are faced with two solutions: the first offers us receipt
of the sum of 50 thousand euros and represents our certain choice (probability
amounting to one); with the second we are offered the toss of a coin: if it comes
out heads we will receive nothing but, on the other hand, if it comes out tails
we will receive the sum of 100 thousand euros—the two events have the same
probability of occurring, which is 0.5. This problem can be set in another way:
we can choose to have an immediate certain result of 50 thousand euros or take
part in the toss of the coin and receive an expected result 50 thousand euros
(100,000  0.5 + 0  0.5).

Figure 2.3 shows a graphic representation of our lottery example.

" Definition Risk neutral individuals are those who are indifferent in choosing
between a certain result and an uncertain result with the same expected value.

In this case, the expected result of the toss of a coin is risky as compared to the
immediate 50 thousand euros, but risk neutral individuals are indifferent to one
solution or another.

" Definition For risk averse individuals, the benefit associated with the certain
result is greater than the benefit referred to in the expected result.

For instance, in economic terms this means the same as stating that—in the case
of the utility—of the certain result being greater than the utility expected from the
2.8 Behavioural Finance 31

lottery. To leave 50 thousand certain euros and take part in a lottery, a risk averse
party will wish to receive a greater benefit, such as to compensate the risk they run of
finding themselves in a worse condition, called risk premium.

" Definition Risk seeking individuals11 are individuals who love risk. They are
willing to pay to take part in the toss of the coin (their reward for risk is negative)
rather than receive 50 thousand euros immediately and certainly.

For these individuals, the utility of the certain result in this latter case is lower
than the utility of the lottery which gives the same expected value. The Von
Neumann–Morgenstern utility function sets out that the expected utility of a lottery
is equal to the average value of the distribution of the utility of simple results
weighted by the probability of each result appearing in the lottery. Graphically
(see Figure 2.4), the function we are speaking of has an upwards trend: the higher
results are preferred to lower results. Its curve is particularly important because it
describes the attitude of an individual facing a risk. When the function is concave,
i.e., the curve turns downwards, this identifies risk averse behaviour: vice versa,
when the function is convex, and the curve turns upwards, this shows a case of
propensity of risk; finally, when the function is a straight line, it describes
graphically the behaviour of someone who is risk neutral.
Going back to Figure 2.3, what will an individual do when faced with the choice
between collecting 50 thousand euros immediately or taking part in the toss of a
coin? The reply to this question is as follows: it depends on their propensity for risk.
If we have a “risk-taker”, they will accept taking part in the toss of a coin without
ado. If on the other hand we have someone who does not like risk, they will seek to
flee from the risk and accept collecting 50 thousand euros immediately, but not
necessarily! They may even accept taking part in the toss of the coin: it will all
depend on the reward for taking the risk. Always in the above case, if we have an
individual as risk neutral, the choice between one or other of the alternatives will be
simply of no importance when the certain result and the expected result of the lottery
are equivalent.

2.8 Behavioural Finance

The decision-making process of a potential insured is a process that is influenced by

the information they have available and the attitude they have to risk.

" Definition Behavioural finance and cognitive psychology offer further hints for
analysis as compared to classic economic theories that define a consumer as a
“rational economic agent”, who is perfectly informed and who, through a process
of logical decision making, assesses the risk, the probability of a certain event

11
In the literature these parties are also defined as Risk Prone.
32 2 The Notion of Risk and Probability

Example of concave curve:

Dotted curve: individual risk-averse function
B–C= 3 = premium for the risk
Example of linear curve:
Straight line: individual risk-neutral function
Example of convex curve:
long dash curve: individual risk-prone function
D – C = –2 = differential for risk-loving individual (pay to
participate in the lottery)

Fig. 2.4 Graphic representation of the Von Neumann–Morgenstern utility function

occurring, the reward offered, the benefits contained in the policy, restrictions of
cover, etc. so as to make a choice as to the best offer available in the industry12.

Studies of behavioural economics and cognitive psychology on decision-making

processes in conditions of uncertainty, and which refer mainly to the work of Kahneman
and Tversky13 tell us that a consumer will often make choices based on simplified
mechanisms of judgement when they come to find themselves in complex situations.
Faced with complexity, they have a tendency to simplify and reduce progres-
sively until the effort to decide is minimal14. In choices of an insurance kind, in
addition to the anxiety accompanying in general every choice to purchase a service
tied mainly to something intangible, a party has to deal with uncertainty regarding
the probability of the risk they run occurring, the unknown extent of any loss, etc15.
Generally, in judging the probability of the event that is the subject matter of
insurance cover, the tendency to simplify leads parties to make mistakes: in the
event of a loss event occurring, the insured tends not to renew the policy or seek to
obtain a lower premium from their insurer, convinced that two consecutive loss
events have an extremely low probability of occurring. Probability is often assessed
on the basis of a subjective memory concerning a certain event occurring, i.e., on the

12
Estelami H. (2007) Marketing Financial Services, Dog Ear Publishing; Theil M., (2003) the value
of personal contact in marketing insurance: client judgment of representativeness and mental
availability, in risk and management review, Vol. 6. No. 2, 145–157.
13
Kahneman, D. e Tversky, A. Prospect Theory: An Analysis of Decision Under Risk,
Econometrica, 47(2), 1979, 263–291.
14
Heuristics represents a simplification of reality, in explaining consumer behaviour when faced
with choices in complex situations and in which, additionally, it is not possible to find and process
all the information that would be necessary to make the right economic assessment.
15
Heuristics of representativeness: this is a judgement made as to relevance which gives rise to a
judgement as to probability: the entire set of possible values is not considered and the average value
replaces this and is reasoned upon; for example, where there is a distribution of probabilities, the
expected value is considered; an average value is taken as being representative of the entire
distribution; this attitude applies not only in calculating probability but also, for example, in
evaluating the extent of the loss.
References 33

basis of the ease of remembering a similar example that has already happened, with a
tendency towards generally underestimating the risk, and so under-insuring16.
Other criticalities concern limitations to the cognitive process of a consumer, who
will experience difficulty and suffer stress when doing even non-complex mathe-
matical calculations, but ones which are necessary for comparing the features of the
products there are on the market, and so only analyses few items at once. They will
additionally tend to give excessive value to, and favour, immediate consumption
over future benefits from an investment that is distant in time. In contexts where
consumers have to check long and complex documentation before signing a con-
tract, consumers tend to simplify the selection process, first by restricting the
attention they give to a single feature felt to be the most important—such as for
example the price (insurance premium), and then later adapt their selection by
analysing the other elements forming the offer17 (the limit of indemnity, clauses of
exclusions from cover, fiscal deductibility, etc.). Emotions, too, influence the ratio-
nal process of selection: an example of this is an attitude concerning risk: not always
is their aversion to risk; propensity for risk may change based on the manner of
presenting the offer and greater propensity for risk may arise to avoid the hardship
deriving from a certain loss, and aversion to risk when faced with the alternative of a
certain gain and an uncertain win.

2.9 Questions

1. What are the types of pure risk utilised in the literature?

2. What are the stages and tools of Risk Management?
3. What is the principle of mutuality?
4. Describe the conditions of insurability?
5. What is meant by morale hazard? what is the difference with moral hazard?
6. How are individuals typed as regards risk?
7. What are the criticalities relating to the theory of behavioural finance?

References
Athearn JL (1971, December) What is risk? J Risk Insur 38(4):639–645
Estelami H (2007) Marketing financial services. Dog Ear Publishing, Indianapolis, IN
Hall CP Jr (1957, September) The meaning of risk. J Risk Insur 34(3):459–474
Head GL (1967, June) An alternative to defining risk as uncertainty. J Risk Insur 34(2):205–214

16
Heuristics of availability, mental availability.
17
We are dealing with anchoring heuristics: starting with a stable point of reference and then
making adjustments and then reaching a final decision.
34 2 The Notion of Risk and Probability

Rejda GE (1995) Principles of risk management and insurance. Harper Collins College Publishers,
New York, NY
Theil M (2003) The value of personal contact in marketing insurance: client judgment of represen-
tativeness and mental availability. Risk Manage Rev 6(2):145–157
Turchetti G (2000) Innovazione e reti distributive nel settore assicurativo. In: Analisi teorica
e comportamenti strategici. Franco Angeli, Milan, pp 79–81
Vaughan EJ, Vaughan TM (2013) Fundamentals of risk and insurance, 11th edn. Wiley, New York

Suggestions for Further Study

Akerlof G (1970) The market for lemons: quality uncertainty and the market mechanism. Q J Econ
Abdellaoui M, Luce RD, Machina M, Munier B (2007) Uncertainty and risk. Springer-Verlag,
Berlin, Heidelberg. https://doi.org/10.1007/978-3-540-48935-1
Asmussen S, Steffensen M (2020) Risk and insurance. Springer, Berlin
Aven T, Baraldi P, Flage R, Zio E (2014) Uncertainty in risk assessment: the representation and
treatment of uncertainties by probabilistic and non-probabilistic methods. Willey, Chichester
Borghesi A, Gaudenzi B (2013) Risk management. Springer-Verlag, Mailand. https://doi.org/10.
1007/978-88-470-2531-8
Cappiello A (2020) The European insurance industry: regulation, risk management, and internal
control. Palgrave Macmillan, London
Hopkin P (2018) Fundamentals of risk management: understanding, evaluating and implementing
effective risk management. Kogan Page Publishers, New York. isbn:9780749483081,
0749483083
Zweifel P, Eisen R (2012) Insurance economics. Springer-Verlag, Berlin, Heidelberg. https://doi.
org/10.1007/978-3-642-20548-4
The Insurance Undertaking
3

Abstract

This chapter aims to explain how insurance works. The insurance undertaking
offers insurance cover to an insured and receives a premium by way of counter
performance. Differently from other productive sectors, the insurance sector also
plays a delicate social role. The basic function of an insurer consists in fact of
increasing the security of persons and undertakings by protecting individuals and
society against risks. This applies both in respect of events or situations that are
unknown and unforeseeable, that relate to old-age pensions and healthcare
insurance given the tension there is a number of state public accounts. The
equilibrium of an insurance undertaking is based on the economic and financial
issues of management. This equilibrium changes over time as the make-up and
trends of a portfolio of risks that an undertaking has built up over years is subject
to variation. Finally, an insurance undertaking is subjected to several risks as it
carries on its business: technical actuarial risks, financial risks and business risks.

Keywords
Insurance undertaking · Principle of mutuality · Inverse production cycle ·
Technical insurance management · Loss reserves · Mathematical reserve ·
Financial wealth management · Investment · Technical reserves · Insurance risk ·
Financial risk · Interest rate risk · Liquidity risk · Credit risk · Exchange rate risk ·
Operational risk · Lloyd’s market

# Springer Nature Switzerland AG 2024 35

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_3
36 3 The Insurance Undertaking

3.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Define the concept of insurance undertaking and its role in society.

2. Explain the specific nature of insurance business and the meaning of
inverse cycle.
3. Illustrate the characteristic features of an insurance undertaking: technical
management and financial wealth management.
4. Describe the three typical processes in technical insurance management:
underwriting risks, reinsurance and claims reimbursement.
5. Set out the typical processes of financial wealth management: investment
and disinvestment, management of invested assets.
6. Explain the workings of the insurance machine and the concept of the
technical reserves that must be set up by an insurer.
7. Show the risks that are peculiar to the activities of an insurance
undertaking.
8. Illustrate the factors of production that are specific to an insurance
undertaking.
9. Describe how the Lloyd’s of London market works.

3.2 The Insurance Undertaking

The survival of an insurance undertaking is tied to its capacity to produce income

over time and a capacity to offer services that meet the needs of clients at market
prices. In the insurance industry, this implies offering insurance services in return for
premiums that are worthwhile for the insurer and for the insured. For the former, it
means offering insurance covers at levels of premium that can ensure margins of
profit are achieved and for the latter it means receiving an insurance performance that
can meet expectations, both in terms of sum paid and in terms of the level of service
received.

" Definition An insurance undertaking is an economic party. Its main activity is

to underwrite a risk against payment of an insurance premium. The premium is
calculated on the basis of the estimated probability of the risk occurring and the
estimated average expected indemnity.

The aim of insurance is to transfer a risk to an insurer. An insured, by concluding

an insurance policy, transfers adverse economic consequences deriving from the
occurring of an event contemplated in the contract in return for payment of a sum of
3.3 The Inverse Production Cycle 37

money. The undertaking offers insurance cover to an insured and receives a premium
by way of counter performance.
An insurance undertaking is a tool by means of which the principle of mutuality is
achieved.

" Definition Indeed, based on a principle of mutuality an insurer shares the risk
underwritten over a number of insureds subject to the same risk that is large enough
so that it impacts to a minimum extent on them all and which is made up of the
premium.

These must be risks that are independent of each other, be qualitatively and
quantitatively homogeneous and be high in number, so that the law of large numbers
when estimating the likelihood of the event subjected to risk contemplated in the
policy applies sufficiently reliably1. Managing and transforming risks is thus the
production activity that is characteristic of the insurance industry. Alongside this and
of equal significance there is the activity of managing the investment of capital sums.
Differently from other productive sectors, the insurance industry also plays a
delicate social role. The basic function of an insurer consists in fact, of increasing the
security of persons and undertakings by protecting individuals and society against
risks. This applies both in respect of events or situations that are unknown and
unforeseeable, and also those that relate to old-age pensions and healthcare insurance
and other areas not covered by the welfare system2.

3.3 The Inverse Production Cycle

" Definition An inverse production cycle, which is typical of an insurance
undertaking is the first element to distinguish it from the production cycle of a
generic production undertaking. In reality, in most production undertakings, costs
are usually incurred that are tied to purchasing the factors needed to carry on
production activity and revenues for sales in the industry of goods/services are
achieved later, as the outcome of production. The production process of an insurance
undertaking runs backwards instead: first, revenues are recorded, and production
costs are incurred later.

This process in fact commences with the signing of the policy of insurance, which is
followed by the management of the policies there are in the portfolio and concludes
with the eventual settlement of claims. Figure 3.1 gives a simplified graphic repre-
sentation of the production cycle of an insurance undertaking. See how the inversion

1
For a look at these matters, see Chap. 2—The notion of risk and probability.
2
“Welfare” means the set of social policies with which a state guarantees protection, assistance, and
prevention. The welfare system usually relates to areas such as pensions, sickness, unemployment
and disability. For a discussion of the origins of welfare systems, see Chap. 1.
38 3 The Insurance Undertaking

REVENUES

• Purchase Input • Selling Output

Industrial
• Productive Process
firm

COSTS

REVENUES
• Services
• Production /Distribution
Insurance • Settlement of claims
• Policies issue
undertaking • Premium collections

COSTS

Fig. 3.1 The insurance production cycle compared to the production cycle of an industrial
undertaking

of the cost/revenue cycle is a key element as compared to the generic industrial

undertaking.

3.4 Functions of an Insurance Undertaking

In order to analyse the dynamics of the workings of an insurance undertaking in

greater detail, it is worthwhile breaking down the production cycle into two man-
agement areas: technical management and financial wealth management. These two
management areas are closely tied to and feed into each other.
Technical insurance management is what relates to the business of managing and
transforming risks on the part of the insurer, whereas financial wealth management
concerns all the activities of managing and investing the sums collected from
insureds in advance through issuing policies.
Technical management pursues the aim of ensuring correct industrial operation.
This means transforming the risks collected from the market in an efficient and
effective way. Financial wealth management aims to obtain financial returns from
the invested assets according to the principles of liquidity, profitability and security.
The main processes of technical insurance management are the following three:
underwriting of risks, reinsurance and settlement of claims.
On the other hand, the main processes of financial wealth management are the
following: investment/disinvestment and asset management.
The two managements are illustrated in detail in the rest of the chapter.
3.4 Functions of an Insurance Undertaking 39

3.4.1 Technical Insurance Management

" Definition Technical insurance management by an insurance undertaking is

what relates to the business of managing and transforming risks on the part of the
insurer. This can be broken down into three main processes: underwriting risks,
reinsurance and settlement of claims.

See Figure 3.2 for an outline of the processes.

The process of underwriting risks means selecting and analysing a risk, deciding
whether or not it is insurable (in terms of being independent, homogeneous etc.) and
proceeding to determining a premium.
The transfer of the risk to the insurer is the purpose of insurance. By signing an
insurance policy, the insured transfers the negative economic consequences deriving
from the occurrence of the event contemplated in the policy upon payment of the
premium.
In life insurance, the aim is to protect income security from the negative economic
consequences associated with the occurrence of various events related to the life of
the insured. For example, death, survival beyond a certain age and disability. In the
non-life business, the insurance protects the policyholder from the occurrence of
negative events, compensating for the damage suffered upon the occurrence of the
accident.
The insurance premium is the main source of revenue for an insurance undertak-
ing and determining it properly is the basis of corporate profitability. The premium
paid by an insured when taking out a policy of insurance needs to be of a sum that is
at least sufficient to cover the cost for settlements of claims and management costs
tied to the policy.
Once the premium has been paid, the undertaking given by the insured has been
fulfilled: from that time on the insurance cover begins to be effective. However, for

Technical insurance management

Risk undertaking

Reinsurance

Claims reimbursement

Fig. 3.2 Processes of technical insurance management

40 3 The Insurance Undertaking

the insurer there remains an obligation to keep the promise made, up until the time
the contract expires.
In order to have the funds available to meet the compensation at any time, an
insurer sets aside amounts of money called technical reserves. In the next paragraph,
this issue will be illustrated in detail.
Requirements of quantitative homogeneity are not always met when risks are
being underwritten. A number of types of risk, such as catastrophe risks, for example
are so large in size as not to be insurable by a single insurance undertaking alone. In
order to mitigate the risks underwritten, an undertaking may employ two tools:
reinsurance and coinsurance. The process of reinsurance is a procedure via which an
insurance undertaking can reduce its exposure by passing on a risk or a mass of
risks3. The undertaking taking on the risk is defined as a reinsurance undertaking. In
general, a reinsurer is an insurer who mainly insures risk from other insurers. When
passing on a risk by way of reinsurance, an insurance undertaking assigns a part of
the premium collected from the insured to its reinsurer; in exchange it receives
incoming commission on the contracts assigned and, if an insured loss event occurs,
it will receive an indemnity from the reinsurer. In the process of coinsurance, an
insurance undertaking shares the risk to be insured with other insurers, sharing the
risk and related premium proportionally in set quotas4. In this case, each insurer is
bound to pay the indemnity due solely in proportion to their respective quota.
If a loss event occurs, the insurer is bound to settle the loss. The process of settling
losses therefore concerns all the activities of assessing and indemnifying losses
suffered by an insured. This process begins with the report of a loss by an insured
and its verification of cover by the undertaking. Later, loss settlers deal with
quantifying and evaluating the loss. In cases of special losses or specific inquiries,
an expert is appointed, called an adjuster, who performs an activity of assessment
and estimate of values. Once the loss has been determined and the sum has been
negotiated with the insured, settlement and payment of the claim are proceeded to5.

3.4.2 Technical Reserves

The time interval between underwriting a risk and collecting an insurance premium
on the one hand, and the insurance performances featuring settlement of losses and
payment of the related indemnities on the other, can be shorter or longer.

" Definition In order to take into account this time displacement, lawmakers
impose upon an insurance undertaking: the considering of the actual accrual in
time of the risks that have given rise to the premiums written premiums (collected
and arrears) and a setting aside of the funds needed to meet future indemnities or

3
For a look at reinsurance see Chap. 17.
4
For a look at reinsurance see Chap. 17.
5
For claims reimbursement see Chap. 23.
3.4 Functions of an Insurance Undertaking 41

payment of the performances foreseen under the contract. The allocations and funds
set up by an insurance undertaking in order to abide by the above aims are called
technical reserves.

Technical reserves are of two kinds and so have a dual nature: on the one hand,
they take into account the actual time accrual of positive flows collected in advance,
and on the other they meet a future disbursement for loss events not yet paid or
performances still to be provided.
In the first case, technical reserves are defined as a premium reserve and make up
an allocation by an insurer for the fraction of premium not accruing to a period. The
second type in non-life business is called a loss reserve and, in life business, the
mathematical reserve.

" Definition Taking non-life business first, the loss reserves equal the sum that the
insurance undertaking sets aside each year in order to hold resources sufficient to
meet payment of all loss events that have already occurred in previous accounting
periods but have not yet been (fully) settled. It is an allocation, i.e. a debt of the
insurance undertaking towards assureds for loss events that have already occurred,
and to which are added the relative settlement expenses and the cost of representa-
tion that will be met in future accounting periods.

" Definition In life business, the mathematical reserves relate both to pure risk
contracts (i.e. indemnities for decease) and financial contracts that foresee a lump
sum or annuity at maturity. The basic element is the equivalence applying between
premiums and performances. Premiums are paid in by assureds in advance and lump
sums are paid by the insurance undertaking at a later date. In life business, technical
reserves consist thus of an allocation, a debt relating to performances that assureds
will demand at maturity or in the case of a loss event occurring and relating to a
premium paid in advance in the past. From the actuarial standpoint, the mathematical
reserve expresses the difference applying between the current value of commitments
made by an insurer to an assured and the current value of payments-in made by the
assured.

Here below each of the three reserves will be dealt with in detail. A premium
reserve means a posting in financial statements of quotas of premiums collected in
the period of accrual, but which refers to risks that will extend into the subsequent
period6.
The loss reserve means the setting aside at the end of the period of sums relating
to loss events reported during the current accounting period and previous ones, but
not yet paid out7.

6
For a detailed treatment of the premium reserve and an illustration of the methods of calculating it,
see Chap. 12.
7
For a detailed treatment of the loss reserve and an explanation of how it is assessed, see Chap. 12.
42 3 The Insurance Undertaking

Financial wealth management

Investments and disinvestment

Asset management

Fig. 3.3 Processes of financial wealth management

The mathematical reserve relates to posting a sum, fittingly calculated on insur-

ance and endowment contract premiums, to meet commitments made at maturity.
This allocation is called Mathematical since quantifying it is achieved using mathe-
matical actuarial formulas8.

3.4.3 Financial Wealth Management

" Definition Financial wealth management of an insurance undertaking is made

up of processes of investment and disinvestment of assets, and related management
of assets invested.

" Definition Investment refers to special transactions via which an insurance

undertaking implements lasting use of substantial volumes of financial means for
the purpose of achieving a flow of economic results over a shorter or longer period
of time.

See Figure 3.3 for an outline of the processes.

Financial wealth management can be split into two logical moments: one of
investments and management of investments, the other of release to meet requests
for indemnities, reimbursements for performances or surrender of policies.
According to this logic, the characteristic moments of financial management that
start out from transactions of premium collection, concern the asset cycle. In respect
of the liabilities cycle, this includes transactions of disinvestment in assets invested
in, and subsequent financial disbursement.
As has been seen, an insurance undertaking invests substantial sums deriving
from premium collections. In the insurance industry, the term investments is meant

8
For a detailed treatment of the mathematical reserve Chap. 14.
3.5 How the Insurance Machine Works? 43

the deployment of monetary flows towards financial and real assets. The transaction
is carried out with the purpose of earning a future income or a higher price at the time
of sale.
Financial wealth management is achieved by ensuring abidance by a principle of
liquidity for the insurance undertaking. Income must at all times be sufficient to
cover monetary outgoings. Liquidity is a requirement for being able at any time to
meet the undertakings given to insureds: the credibility of the undertaking depends
on this and, in the final analysis, the trust it enjoys in the industry.
Another important aim of financial wealth management is a principle of profit-
ability. The revenues from managing investments (in terms of coupons for interest
on bond securities, dividends on equity investments, rental income from property
ownership etc.) are used to bolster the results of technical insurance management.
The social role of insurance undertakings leads, finally, to activities of investment
of assets also needing to align with a principle of security in the investment of
capital. This, so that substantial guarantees for the benefit of insureds can be given.
These three guiding principles (liquidity, profitability and security) adopted by an
insurance undertaking when managing financial wealth are rules that States apply
and that operators in the insurance industry must abide by.
A further aim of investments in financial instruments and real assets is to cover
provisions that an insurer must make to meet reimbursements of claims and services
to insureds. These provisions are defined as technical reserves These have been dealt
with in the previous paragraph.
A fundamental principle of financial management is the distinction made between
assets intended to cover reserves and the concept of free capital. As already
illustrated a number of times, an insurance undertaking invests premiums collected
abiding by indications given under regulations. However, in respect of own funds,
the management of these investments follows a different dynamic. In detail, a
distinction is made between:

• Investments deriving from collections of premiums and intended to cover

reserves of assureds.
• Deployment of own equity in financial assets.

Own funds of an insurance undertaking are also called free capital. These
available funds may be invested following criteria that are less strict and are not
intended to cover technical reserves. See Figure 3.4 for a representation of process of
investments of reserves and free equity.

3.5 How the Insurance Machine Works?

Taken together the two characteristic managements, the technical insurance one and
the financial wealth one, allow an insurance undertaking to be looked at as if it were
a machine. The cogs of the insurance machine are made up of the main processes
seen above, and which make it work.
44 3 The Insurance Undertaking

Origin of the
Type of Investment Purpose
financial assets

Investments classified by
specific rules to cover Technical provision to
Premium collection
reserves protect policy holders

Own funds of the insurer

Equity and own invested with fewer Free Capital
funds of the insurer constraints

Fig. 3.4 A representation of investments of reserves and free equity

A specific feature of how the insurance machine works is the time interval
between collecting insurance premiums on the one hand and on the other, and
which may be shorter or longer in the business of insurance9. To take this time
displacement into account, lawmakers of leading states require insurers to take into
account the risk from premiums collected in advance and make the provisions
necessary to meet future settlement of claims. These provisions in money set aside
by an insurance undertaking are called technical reserves. Figure 3.5 shows an
example of how the insurance machine of an insurance undertaking works.
Technical reserves are of two kinds: on the one hand they take into account the
actual accrual of incoming flows collected in advance, and on the other they consider
the future outgoing flows of costs, i.e. the sums of claims not yet paid out.

" Definition In the first case, technical reserves are an estimate of the debt that the
insurer has towards its insureds at any given time. Technical reserves are therefore a
provision by an insurer relating to fractions of premium not yet earned. In the second
case, technical reserves have the purpose of valuing outgoing flows relating to costs,
i.e. settling claims. These latter are set up on the basis of an estimate of what the
insurance undertaking will have to pay out to its insureds at expiry of the insurance
contract, if we are dealing with life insurance. Instead, if we are dealing with the non-
life, when a loss event occurs for the presumable amount that the insurance under-
taking will have to pay out in the future. The sum set aside must be sufficient to cover
claims and all related future expenses.

9
Especially in the life business, where insurance covers run for many years.
3.6 Insurance Undertaking and Risk Management 45

Technical insurance Financial Wealth

management management
Risk
undertaking Investment

Disinvestment

Reinsurance

Claims Asset
reimbursement management

Technical
provision

Fig. 3.5 How the insurance machine works

As described above, the insurance mechanism is made up of two areas:

• The transfer and transforming of risk from a party to an undertaking.

• The financial intermediation that an insurance undertaking performs in financial
markets.

Transforming risks leads to sharing a loss suffered by a few parties over a greater
number of parties potentially exposed to the same risk. The mechanism of risk
transforming is the prevailing activity of non-life business.
In life business, on the other hand, the role of intermediation is played by the
insurer by linking parties with a surplus of money, typically families and individuals,
with parties with a financial deficit such as enterprises and the State.

3.6 Insurance Undertaking and Risk Management

The equilibrium of an insurance undertaking is based on the economic issues and

financial issues of management. The conditions that need to be met for achieving
equilibrium are trends in revenues, which need to be higher than costs, and the
financial dynamic, with incoming flows greater than outgoing ones. These dynamics
depend mainly on trends in risks in portfolio, trends in costs tied to technical
management and the return from activities of financial intermediation. General equi-
librium is attainable when the premiums collected are sufficient to cover the costs of
46 3 The Insurance Undertaking

claims, acquisition costs and organisational costs: in other words, the attainment of
technical equilibrium is a necessary condition for general equilibrium. However, this
important result is not sufficient in itself: in addition to the achievement of technical
profit, it is necessary to cover the general costs of the undertaking and to achieve a
satisfactory income. The equilibrium we are speaking of is an equilibrium that changes
over time as the make-up and trends of a portfolio of risks that an undertaking has built
up over years is subject to variation.
An insurance undertaking is subjected to a number of risks as it carries on its
business. These can be ordered into three broad groups: insurance risks, financial
risks and business risks.

" Definition Insurance risks concern a reserving risk, an underwriting risk, and
an operational risk. The first risk refers to variations in the cost of reserves following
on from new possible scenarios or new revaluations of losses that were not foreseen
when the original reserve was set up. In the second case, the risk relates to it being
possible for an adverse difference to arise between what was imagined when
calculating the premium, as compared to variables actually observed.

In particular, this type of risk appears when the expected frequency and average
cost used to calculate the premium diverge from the actual data observed. This can
take place when there are failings of an information type, insufficient data for making
calculations, and when errors are made in assessing the data available. Variances
between the expected frequency and average cost as compared to the data actually
observed may depend also on different trends in reality, caused by events that are
objectively unforeseeable.
We are dealing with reserving risk when there is a divergence between estimates
of the costs of losses as compared to actual data. In non-life business, this may occur
due to sudden fluctuations in loss experience (e.g. natural catastrophes), or in the life
business when demographic changes take place that do not reflect the demographics
previously imagined (e.g. the longevity risk). We speak of underwriting risk when
the premium applied under the policy is lower than actuarial projections. When this
occurs, there is variance between expected frequency and observed frequency10.

" Definition Financial risks are risks that are due to the uncertainty of markets
where the insurance undertaking operates. The main categories are the
following four: interest rate risk, liquidity risk, credit risk and exchange rate risk11.

Interest rate risk concerns the uncertainty there is in unexpected variations in

market rates. Variations in rates of interest may cause losses on the yield curve.
Additionally, difficulty may be created in managing the balance between assets and

10
For a look at underwriting risk and reserving, see Chap. 31— The solvency of an insurance
undertaking: Solvency II standard model.
11
For a detailed look at underwriting risk and reserving, see Chap. 31—The solvency of an
insurance undertaking: Solvency II standard model.
3.7 The Modern Insurance Undertaking 47

liabilities in the financial statements of an insurance undertaking in terms of flows

and due dates12. Liquidity risk appears when an insurance undertaking fails to
disinvest quickly enough, and without bearing losses in capital account, from
investments made in traded securities. Due to this risk an insurer may not be able
to meet its contract due dates. Credit risk concerns the uncertainty there is regarding
the capacity of an issuer counterparty to meet the obligation arising under the debt
they have Exchange rate risk is associated with the volatility of rates of exchange in
the currencies in which the insurance undertaking has invested. The securities can
have possible losses of value of investments made in foreign currency.

" Definition Operational risk comes essentially from inefficiencies in corporate

processes, errors of an organisational type, failures in systems of internal audit,
management of human resources and IT systems etc. Legal risks, mainly due to
irregularities in insurance contracts, and compliance risks, i.e. the non-compliance of
business activities with regulations, are also part of operational risk.

3.7 The Modern Insurance Undertaking

The way of doing business and the functional model of an insurance undertaking
have changed over the centuries. The insurance undertaking as we see it today is the
result of a long journey that began in the eleventh century.
In medieval times, the first contract forms of protection and transfer of risk
featured the involvement of single individuals, merchants, shipowners or bankers,
who personally took on the risk of another individual. The relationship of risk
transfer was one-to-one. In this relationship, managing the risk could only be
speculative in nature. Additionally, there was no knowledge of any technique
fundamental to insurance processes (such as, e.g. the theory of large numbers and
principles of diversification).
Later, during the course of the sixteenth century, the first associations among
partners for underwriting risk appeared. In these forms, each party shared in the
profits and costs in proportion to the money put in when setting up the association.
The structure of the association then featured scant separation and definition of the
wealth of partners and capital of the entrepreneurial adventure. In this activity
indeed, the capital paid in to meet risks insured was, on the one hand, split among
those taking part in the adventure and, on the other, not formally distinct from the
personal fortunes of the partners themselves.
In the seventeenth century, the joint-stock company appeared for the first time for
managing risks. This was the first form of company in which the capital of the
undertaking had its own substance, distinct from that of the partners in it. A lack of
basic techniques, statistical-actuarial methods, and their often mainly speculative

12
The techniques for managing equilibrium between assets and liabilities are defined as ALM. For a
look at this topic see Chap. 32—Techniques of Asset Liability Management.
48 3 The Insurance Undertaking

character, led to the failure of many of these activities. Additionally, a strong focus
on marine business increased the risks of bankruptcy. For this reason, while they
represented an initial important step towards an undertaking structure, the economic
importance of this phenomenon was limited.
Only during the 1800s did large insurance undertakings come to life. This took
place alongside the birth of large industries and the beginnings of a modern banking
system, which managed monetary wealth and extended credit to undertakings. The
purpose of this was to shield economic development from harmful events and
provide an underpinning for the economy. In the light of this new entrepreneurial
philosophy, in the first decade of the 1800s organisational structures emerged based
on statistical-mathematical theories which focused on managing and diversifying
risks. To all this was to be added a new context allowing insurers to manage large
volumes of risks. During this period, the setting up of the first joint-stock companies
in the insurance industry was witnessed.
In the twentieth century, the insurance undertaking had become an undertaking
carrying on a systematic underwriting of risks through an advanced production
process. The insurance undertaking became an operator in the advanced tertiary
sector. One of the critical factors was the management and development of technical
know-how and risk management.
Coming to our times, in the new millennium we are witnessing the appearance of
new business models. The insurance undertaking features the production of services
through using various factors of production and capital. Also, of fundamental
importance is the economic equilibrium for producing a profit at the end of an
accounting period for stakeholders.
Undertakings are often multinational in size and a key factor in their success is the
integration of four elements, which are: insurance, financial assets, business and
organisational techniques. Figure 3.6 shows the four factors that are key for an
insurance undertaking in our times.
These four factors meld and supplement each other differently from one undertak-
ing and another. Every undertaking features its own specific combination of these
factors. For example, an undertaking with strong technical-insurance skills will
feature a specific strategy in underwriting risks and managing its portfolio. This
approach can be supplemented by a certain strategy in managing the financial wealth
risk. From this kind of arrangement, a business model derives and is one that is
peculiar to it and gives rise to a specific operational model. Given these
characteristics, an undertaking will then operate in the industry with a specific
commercial set-up locally, a management of operational processes that is peculiar
to it, and with well-defined channels of distribution and consistent marketing policies.

3.8 The Lloyd’s of London Market

Alongside the traditional structures of the insurance industry, an atypical structure,

the Lloyd’s of London market is worth looking at in particular.
3.8 The Lloyd’s of London Market 49

Technical
Financial asset
insurance
management
management

Insurance undertaking

Business Organization

Fig. 3.6 Factors that are key for a modern insurance undertaking

" Definition Lloyd’s market is one of the most important insurance associations
in the world, although it is not an insurance undertaking. The special feature of this
business model is that it is a market within which a demand for insurance cover for
the most varied of risks and a supply of insurance, a quantifying and an assessment
of risk come together.

Its history dates back to 1688 when Edward Lloyd made his coffee house in
Tower Street in London a meeting point for businessmen of the time. Developing
gradually over the years, Lloyd’s of London is today one of the world leaders in
specialist insurance and reinsurance risks and has become one of the largest markets
for insurance in the world by income. For an understanding of how it works, the
outline is given in Figure 3.7, illustrating the structure of the Lloyd’s market.
The functional model can be split into three ideal parts. The first component is the
people who seek insurance cover from Lloyd’s. These are insurance undertakings
and individuals who need to insure against a specific risk. The second component in
the breakdown proposed, are insurance intermediaries accredited to proposing
business to Lloyd’s. Indeed, individual insureds (policyholders) do not have free
access but must of necessity deal with these intermediaries. They are mainly brokers
selected for their skills, financial reliability and reputation in the marketplace.
Brokers deal directly with underwriters, who are the parties who decide the
conditions at which their Syndicate will subscribe to the risk being assessed. The
Syndicates together with Members make up the third part of the Lloyd’s market.
Syndicates are groupings of underwriters. Members are, on the other hand, the
parties who bear the risks underwritten by Syndicates financially. Members may
be either large insurance groups operating in the international market listed on the
London Stock Exchange or even private individuals. For a lengthy period of its
history, within the Lloyd’s market, there were Names, who were rich individuals
who supported underwriting policies, covering the business with their personal
wealth (with unlimited liability). Since 1994, following a number of well-publicised
50 3 The Insurance Undertaking

Lloyd’s Members
Policyholders
(retail and
Insurance
individuals)
undertakings

Insurance Managing’s Agents

undertakings Syndicates
Lloyd’s Brokers and Names
other intermediaries Underwriters Individuals with
Member’s non-limited
(channels)
Other Insurers liability
agents

Insurance Business and cover requests Capitals and technical

provisions

Fig. 3.7 Outline of the workings of the Lloyd’s market

bankruptcies, the Lloyd’s market has allowed entry to undertakings with limited
liability and who have, over the years, replaced the Names in managing the business.
The structure and workings of Lloyd’s also foresees the figure of the Managing
Agent, which are firms dealing with managing one or a number of Syndicates, while
the Corporation of Lloyd’s is the body performing oversight of the market. Thanks to
this model of functioning, Lloyd’s underwrites risks that are of very disparate in
character: marine, aviation, catastrophe, energy sector, professional risk, nuclear
risks etc13.

3.9 Questions

1. Which activities are systematically carried by an insurance undertaking?

2. What is specific about insurance business?
3. What are the typical processes of technical insurance management?
4. What is meant by mathematical reserve?
5. What is the meaning of the word “investments”?
6. What is meant by technical reserves?
7. What are the three types of characteristic risk managed by an insurance
undertaking? And what are the sub-categories?
8. What form of insurance began in the seventeenth century? And what was its
peculiarity?
9. How does Lloyd’s of London market work?

13
See Lloyd’s, (2020) Lloyd’s quick guide: The Lloyd’s market. www.lloyds.com
Suggestions for Further Study 51

Suggestions for Further Study

Cappiello A (2020) The European insurance industry. Regulation, risk management, and internal
control. Springer, New York
Dorfman MS (2008) Introduction to risk management and insurance, 9th edn. Pearson, Boston
Lloyd’s (2020) Lloyd’s quick guide: the Lloyd’s market. www.lloyds.com
Madrid-Morales, D (2018) The power and the story: the global Battle for news and information by
John Lloyd (2017), London: Westminster papers in communication and culture, 13, 1, 48-53
Marx J, Van der Meer F (2016) Fundamentals of insurance. Van Schaik Publishers, Pretoria,
South Africa
Ottaviani G (ed) (2000) Financial risk in insurance. Springer, Berlin
Outreville JF (1998) Theory and practice of insurance. Springer, Boston, MA
Vaughan EJ, Vaughan TM (2013) Fundamentals of risk and insurance, 11th edn. Wiley, New York
Regulation of the Insurance Industry
4

Abstract

The chapter aims to explain the main sources of insurance legislation in Europe.
The first paragraphs offer the overview of the evolution of the insurance legislation,
as the current structure of legislation in the insurance industry is the outcome of a
long process of European harmonising started with the Treaty of Rome in 1957. As
explained in the chapter, the European approach of discipline of the insurance
industry had been first developed over three issues of directives (freedom of
establishment, freedom of services and home country control), and more recently
developed in a definitive set of regulations in four macro-areas: customer protection
and distribution of insurance products, risk control and corporate management,
supervision of insurance undertakings and pension provision.

Keywords
Freedom of establishment (FoE) · Freedom of services (FoS) · Home country
control · EU Regulations · EU Directive · Decision · Regulatory technical
standards (RTS) · Implementing technical standards (ITS) · Solvency II ·
IDD insurance distribution directive

4.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the reference regulations for the insurance industry in Europe.

2. Explain the functioning and the features of European regulatory instruments.

(continued)

# Springer Nature Switzerland AG 2024 53

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_4
54 4 Regulation of the Insurance Industry

3. Illustrate the main issues governed by regulations at a European level (four

macro-areas).
4. Describe the Development of regulations on the distribution of insurance.

4.2 Regulatory Context in Europe

After the Second World War there was a rapid and radical change in the regulatory
framework in which insurance undertakings operate in Europe.
This process of regulatory development at a national and supranational level
commenced with the Treaty of Rome in 1957 and continued through all the
intermediate stages of harmonising the legal systems of member states over the
years.
Pursuit of the aim of creating a single integrated European market for insurance
services led over the years to the emanating of many community directives aimed at
harmonising essential and necessary rules from achieving mutual recognition of
authorisations and systems of oversight. An efficient and integrated single market:

• Allows free movement of persons, services and capital.

• Permits every insurance undertaking of a member state to operate in the whole
territory of the Union.
• Allows all contracting parties easy access to the broadest possible range of
insurance products offered by the entire community market.
• Ensures proper protection of assureds and beneficiaries in all member states.

The current1 structure of legislation in the insurance industry is the outcome of a

long process of community harmonising.
Harmonising of regulation has concerned: the rules on access and carrying on of
insurance and reinsurance business and intermediation, ownership arrangements,
insurance groups, annual and consolidated accounts, safeguarding measures, recov-
ery and liquidation of undertakings, transparency and protection of assureds, over-
sight, rules on insurance contracts, compulsory policy for Motor Party Liability,
systems of indemnification, financial conglomerates, distance marketing of financial
services, international accounting standards and solvency regulations for insurance
undertakings.
The approach of community discipline of the insurance industry has developed
over three successive issues of directives (each of which containing separate and
specific norms within it for non-life insurance and special norms for life insurance).

1
Turchetti G., 2005, “Le tensioni irrisolte nel mercato RC Auto”, Economia e Politica Industriale,
Vol. 32, no. 3.
4.3 Three Generation of Community Directives 55

Table 4.1 Itemising of the waves of European Directives

Directive Life insurance Other insurances
First generation Directive 79/267/EEC Directive 73/239/EEC
Access to insurance business
and carrying it on
Second generation Directive 90/619/EEC Directive 88/357/EEC
Regimen of free provision of
services (according to
2 principles) home country
control vs
Risk country control
Third generation Directive 92/96/EEC Directive 92/49/EEC
Single administrative • New regulations for investments
recognition of an and technical reserves
undertaking in the • New audits
whole EU • Rules for access/carrying
on/audit of insurance business in
compliance with a principles of
home country control

4.3 Three Generation of Community Directives

The issuing over the years of community Directives in the financial services sector
has aimed to give life to a single space without internal borders where insurance
undertakings can carry on business freely. Lawmakers have pursued two areas:

• Allowing all citizens of the UE access to the widest possible range of insurance
offerings, while ensuring proper legal and financial protection for consumers.
• Ensuring recognition within the European economic area for each insurance
undertaking for carrying on business in the whole Union, both from the stand-
point of freedom of establishment (FoE) and from that of free provision of
services.

The issue of regulations can be summarised distinguishing between three waves,

and by sector (life insurance and other insurances). See Table 4.1 which itemises the
historical development of regulations.
“First generation” community directives: The first “non-life” Directive
(no. 73/239/EC), followed by the first “life” Directive (79/267/EC) achieved a first
stage of coordination between the various legal systems of individual member States
in the matter of access to and carrying on of the business of direct insurance by
introducing a principle of right of establishment:

• The ability to establish a secondary place of business in a foreign country.

• Authorisation to access to insurance activity being made subject to meeting
certain requirements set by law.
56 4 Regulation of the Insurance Industry

• Eliminating discretionary power of the administrative authority which

conditioned issue based on more generic “market economic needs”.

A prohibition was introduced for newly set up undertakings from carrying on

insurance in the life business and insurance in the non-life business jointly.
This directive defines the distinction between freedom of establishment and
freedom of services.

" Definitions Freedom of Establishment (FoE) means that an insurer (or a dis-
tributor with certain requirements) can establish itself in another country other than
its own within the European Union. This legislation abolished any discrimination
contained in previous national legislation. The firm is established in the State in
which the insurance products (or services) are provided under the same conditions as
the other domestic players already present.

" Definitions Freedom of Services (FoS) means that an insurance undertaking

(or a distributor with certain requirements) can carry out its business in another
country other than its own within the EU under the same conditions as parties who
reside there. This is allowed without having to establish itself in the State, where the
performance is provided.

In practice, a foreign entity (insurer or distributor) operating as freedom of

establishment (FoE) in a third country within the EU is obliged to open a represen-
tative agency or a secondary office in the country in which it has an interest in
operating. This request must be sent in advance to the Authority in its country of
residence. Subsequently, the Authority will forward this communication to the
Authority of the other country. On the other hand, a foreign entity that decides to
operate within freedom of services (FoS) must only appoint a representative resident
in the other country. Obviously, the two models are different in the stability of the
performance. In the case of right of establishment, the firm (insurer or distributor)
participates in the economic life of the State of establishment. For this reason, the
firm is subject to host country rules. In the case of freedom of services, the exercise
of business in the host State takes place only on a temporary basis. For this reason,
the firm is subject only to home country rules.
In the financial services sector, the home country control principle indicates
which legislation of a member state of the European Union should apply. The rule of
control by the country of origin aims to ensure freedom of movement of people,
goods, capital and ideas and to avoid discrimination within the EU based on
nationality of origin. According to this approach, the local Authority accepts a
redefinition of its sovereignty of territorial competence. The principle, on the other
hand extends the scope of the laws outside the state. At the same time, there is a
restriction of the intervention powers of a local Authority towards foreign subjects.
At the end of the eighties—beginning of the nineties, a “second generation” of
Community directives was issued, with the non-life Directive (88/357/EC) and the
4.3 Three Generation of Community Directives 57

life Directive (90/619/EC) the principle of freedom of provision of services. Here a

distinction was foreseen between “mass risks” and “large risks” in non-life business,
whereas for the life sector, the distinction concerned contracts concluded at the
initiative of the policyholder and those at the initiative of the undertaking.
Second-generation directives have regulated free provision of services. Through
free provision of services, it is foreseen that an insurance undertaking may carry on
business in another member state of the European Community at the same conditions
as apply to other parties who are resident, without having to establish itself for this in
the State where the service is provided. This directive foresees this in two forms:

" Definitions

• A principle of home country control, i.e. the insurance undertaking may carry on
business in every European country while remaining subject solely to control by
the body concerned in its country of residence.
• A principle of risk country control i.e., in this case application is foreseen of the
regulations and control of the member State where the service is provided.

In the early nineties “Third generation community directives (no. 92/49/EC

non-life” and 92/96/EC “life”) were enacted. These allowed complete implementing
to take place of the principle of freedom of services (FoS). Achievement of complete
openness in the marketplace was materially reached through the tool of a “single
authorisation”, an authorisation to access insurance business applying in the entire
territory of the Union. In this way, effect was given to the principle of “mutual
recognition” of administrative deeds issued by a member State, oversight of the
entire activity of an insurance undertaking is awarded exclusively to the member
State of the country of origin according to a principle of “home country control”.
Subsequent community directives have regulated aspects that are equally impor-
tant, such as insurance distribution, trade rules electronic insurance services, the
regulation of insurance groups, financial statements, reinsurance business, financial
conglomerates.
The only constraint on absolute freedom to conclude a policy of insurance with
any European insurer under freedom of establishment (FoE) or freedom of services
(FoS) remains a need to abide by the rules of public interest set by way of protection
of the interests of society in the stability and solvency of an insurance undertaking
since the material delivery of an insurance performance depends on this.
The three directives relating to life insurance business mentioned previously were
later brought together in a single consolidated in community directive, no. 83 dated
5 November 2002.
The rules governing harmonising individual and consolidated financial
statements for insurance undertakings were introduced by Directive 91/674/EC.
58 4 Regulation of the Insurance Industry

Table 4.2 Outline of the features of European regulatory instruments

Regulatory level Binding Applicability
Regulation Yes—mandatory Directly applicable in a country
Directive Yes—mandatory Freedom of choice of forms and
means of implementing
Decision Yes—mandatory Binding for recipients
Recommendation No—non-binding At a local level / of the union
Opinion No—non-binding At a local level / of the union

4.4 Recent Developments at the Community Level

A moment that was crucial in the development of a common philosophy among

Heads of government in respect of social and economic matters was had with the
extraordinary Council meeting in Lisbon2 of 23 and 24 March 2000.
In the document approved on that occasion, also called the Lisbon Strategy or
Lisbon Agenda, European leaders suggested a list of interventions held to be
necessary for improving the trend in European growth and render the economy of
the “old continent” the most competitive and dynamic in the world: the aim
expressly declared was, indeed, to make the Union the most competitive and
dynamic knowledge-based economy.
Concerning the common financial market, the Lisbon document augured that
greater efficiency and integration would be achieved. The final report of the Summit
additionally suggested achieving these two objectives through reforms rendering
European regulations homogeneous, promoting transparency and applying thrust to
undertakings towards better risk management.
Notwithstanding the fact that many of the indications given by Lisbon went
completely unmet, almost all the suggestions for reform of the financial and insur-
ance industry were followed through and became European directives and national
laws. In the following, more recent years indeed, a number of important directives
have been issued.
At a European level, the legal system in the financial services sector is based on five
regulatory levels: Regulations, Directives, Decisions, Recommendations and Opinions.
Each of these dispensations is more or less binding and foresees special manners of
application in the countries of the Union. Preliminarily, see Table 4.2 which provides an
outline of the regulatory levels considered according to the two areas set forth above.

" Definitions Regulations are mandatory and apply directly in the countries of the
Union. They may be implemented at a local level with no need for further deeds of

2
Following this encounter the Spring Council of the European, a summit between Heads of State
and Governments to be held every year in March and entirely given over to dealing with economic
and social issues became a fixture.
4.4 Recent Developments at the Community Level 59

implementing. Recourse to European Regulations is made in cases wherein there is a

need to achieve full harmonising over countries and reduce spaces for discretion at a
domestic level.

" Definitions With the instrument of a Directive, lawmakers set a number of

objectives of a general kind and turn to member countries binding them to achieving
these objectives and that are foreseen in the Directive itself. Freedom is left to
national sovereignty in choosing the form and means to be used for actual
implementing at a local level.

" Definitions A Decision impacts a smaller area. Its effects are mandatory in all its
elements, but solely in respect of recipients. Finally, with a Recommendation or an
Opinion, lawmakers foresee a situation that is non-binding. These latter are issued to
provide fuller in-depth cover on specific themes.

" Definition Alongside the five instruments indicated above, a number of technical
rules are issued ever more frequently for regulation or implementing. The purpose of
these is to illustrate in detail with workings of specific issues and to create an
operating standard that is homogeneous community wide. The first are defined as
Regulatory Technical Standards (RTS) whereas the second are called
Implementing Technical Standards (ITS).

In the financial service sector, RTSs and ITSs are prepared by bodies dedicated to
micro-supervision of the sector, the EIOPA (European Insurance and Occupational
Pensions Authority) for example3. The process of issue often occurs by degrees:
i.e. where there are guidelines in Regulations, RTSs are issued that allow for a
preliminary check to be carried out on operating constraints of the more complex
issues at a local level. Later, the European Commission adopts the RTSs through a
definitive set of regulations implemented in all member countries.
The issues governed by regulations at a European level may be listed under the
following four macro-areas:

1. Customer protection and distribution of insurance products (MIFID regulations

and subsequent amendments, Market Abuse, distance sales, Insurance Distribu-
tion Directive, PRIIPs products).
2. Risk control and corporate management (Solvency II regulations and IAS/IFRS
accounting standards).
3. Supervision of undertakings and supplementary supervision for insurance groups.
4. Top-up pension provision (Pan-European Pension Product—PEPP regulations
issued for individual pension plans at a European level).

In the next paragraphs, each of these four macro-areas are presented in detail.

3
For matters relating to Supervision in the insurance industry, see Chap. 5.
60 4 Regulation of the Insurance Industry

4.5 Regulation on Customer Protection and Distribution

of Insurance Products

In respect of customer protection, European lawmakers have issued various

regulations in the matter of transparency of contracts, pre-contract briefing docu-
mentation and manners of distribution. Regulations concern financial services and
insurance ones.
Directive 2004/39/EC—MIFID—The markets in financial instruments directive
and was issued by the Council and the European Parliament in 2004 in order to
create an efficient and secure financial market for investors. The Directive governed
financial markets with effect from 31 January 2007 up until 2 January 2018. On
3 January 2018 there came into force in the entire Union a new Directive 2014/65/
EC—MIFID II which, together with EU Regulations no. 600/2014 MiFIR or
Markets in financial instruments regulation, replaced previous European regulations.
The aim of lawmakers is to render rules for the financial intermediation sector
homogeneous at a European level. Today the market in the “old world” can for the
first time be held to be truly efficient in its depth of intervention.
Directive 2003/6/EC—Market Abuse of the European Parliament and the Coun-
cil dated 28 January 2003 is tied closely to the MIFID one and was conceived to
combat the abuses and manipulations that might occur in financial markets where
information is not given properly, clearly and in a timely manner. This directive is
repealed by regulation no. 596/2014 of the European Parliament and of the Council,
relating to market abuse.
Directive 2002/65/EC provides rules in respect of distance sales of financial
services to consumers via organised systems.

" Definition Directive 2016/97/EC—Insurance Distribution Directive IDD on the

distribution of insurance and approved on 20 January 2016 by the European
Parliament and the Council of the European Union, came into force on 1st October
2018 and lays down the rules that must be followed for creating and marketing
insurance products. This directive aims to redefine the role of insurance
intermediaries overall. The role of intermediary was replaced by one of distributor.

Rules of operation from the standpoint of a consultant in the best interests of the
customer were defined. Following this outline, Regulations 2017/2358 dated
21 September 2017 defined the rules concerning requirements in the matter of
governance and audit of a product for insurance undertakings and distributors of
insurance products. In these regulations, also called Product Oversight and Gover-
nance (POG) Regulations, a new process is defined for creating and auditing
insurance products shared between insurance undertakings and distributors in accor-
dance with a more general principle of contract transparency. The rules introduced
concern the whole process from the time of creating the product up until its sale. The
rules apply both to insurance distributors and insurers.
The rules introduced by the IDD Directive and the POG Regulations set forth the
information, the so-called IPID (Insurance Product Information Document), that
4.6 Regulations on Risk Control and Corporate Management 61

must be provided to consumers prior to taking out an insurance contract and gives
rules of conduct and transparency for distributors4.
Special focus is placed on insurance-financial products for which particular
compliances are foreseen. Regulations no. 2014/1286 dated 26 November 2014
introduce the compliances relating to documents containing key information for
PRIIP products. PRIIPs is the acronym for Packaged Retail Investment and Insur-
ance based Products. The new summary document required is called the Key
Information Document (KID). The value of PRIIPs is subject to fluctuations due
to exposure to variables of reference or return on one or a number of underlying
assets. PRIIPs feature a process of assembling aimed at creating investment products
that have exposures, characteristics or cost structures that are different as compared
with a direct holding. Within PRIIPs the following six categories of products can be
included: investment trust funds, insurance products with an investment component,
structured products and deposits, convertible bonds, derivatives, products issued by
SPV (Special Purpose Vehicles, i.e. companies set up specifically to issue special
products). As can be seen in the insurance industry, provisions apply solely to
insurance investment products.
In respect of customer protection, Directive 2004/113/EC—equal treatment
between men and women, introduced, in the early 2000s, a principle of equality of
treatments between men and women concerning access to goods and services.
Making this principle its own, the European Court of Justice, between 2011 and
2010, laid down gender equality and equality of conditions in calculating the price of
insurance policies. Following this regulatory leaning, since January 2013, the
insurance industry has no longer been able to enjoy the waiver initially foreseen so
as not to apply the principle of parity of treatment over the two sexes. Determining
tariffs must occur on the basis of an evaluation of risk based on pertinent and
accurate actuarial and statistical data irrespective of discrimination in connection
with sex.

4.6 Regulations on Risk Control and Corporate Management

In respect of risk control, lawmakers have reformed the supervision and manner by
which capital requirements that insurance undertakings must meet in order to
achieve authorisation to carry on business are calculated. Solvency II is the current
system of prudential supervision in the insurance industry of the European Union.

" Definition The Solvency II project, which was begun in 2005, reviewed and
improved the rules concerning prudential supervision of insurance undertakings in
the light of the profound changes that have taken place in the world of insurance. The
reform has concerned the rules determining the solvency margin, rules for premium
calculation, technical reserves and those concerning investments intended to cover
them, so as to design a system prudential rules for quantifying the risks that actually

4
For treatment of the new required pre-contract documents for non-life products, see Chap. 7.
62 4 Regulation of the Insurance Industry

bear upon individual insurance undertakings, and better measuring and management
of risks underwritten by these insurance undertakings.

This system foresees insurance undertakings carrying out an assessment and

quantifying of their risks. The value obtained is set against the own funds of the
insurance undertaking that can be designated to cover the risk. The ratio applying
between the two magnitudes determines the level of the solvency margin for an
insurance undertaking. The new regulations Solvency II came into force on 1st
January 2016 after a long period of quantitative testing carried out in the market. The
Regulatory reference is Directive 2009/138/EC (Solvency II) dated 25 November
2009—text coordinated with Omnibus II and subsequent amendments, which also
govern access to carrying on insurance and reinsurance business in the sector5.
This directive replaced the two previous directives from 2002, directive no. 2002/
12/EC (for life insurance undertakings) and directive no. 2002/13/EC (for non-life
insurance undertakings) governing the old system called Solvency I.
In respect of the new IAS/IFRS regulations on accounting standards, the declared
aim is to improve integration into the European industry and transparency in
carrying on the economic activity in member countries through comparability of
economic values of enterprises. European lawmakers considered that this aim could
be achieved by defining the rules for drawing up financial statements and issuing a
directive that obliged all States in the Union to upgrade their legislation in this sense.
Regulations 1606/2002/EC of the European Parliament and the Council dated
19 July 2002 introduced new rules for applying international accounting standards
to the sector of insurance services6.

4.7 Supplementary Supervision for Financial Conglomerates

In the matter of the supervision of insurance undertakings and supplementary

supervision, lawmakers have issued various rules on financial conglomerates. By
financial conglomerate is meant a group of undertakings that is active in a meaning-
ful way in the sectors of insurance and banking or investment services and which
includes at least one insurance undertaking and another operating in the banking
sector or investment services, and that has a regulated undertaking at its head
(e.g. being listed on a share market) or carries on business mainly in the financial
sector. The concept of conglomerate thus matches that of a group operating in a
number of sectors and potentially subject to control by more than one supervisory
authority7.
The rules on the supervision of undertakings are contained in two directives. The
first was originally Directive 2002/87/EC containing specific prudential governance

5
For treatment of the Solvency II matters, see Chaps. 29 and 30.
6
In respect of a treatment of IAS/IFRS accounting principles see Chap. 28.
7
For a treatment of supervisory models in Europe see Chap. 5.
4.8 Regulation of Supplementary Retirement Provision 63

for financial conglomerates in order to align it with that applicable to homogeneous

groups (that are characterised by an operational business of—respectively—bank-
ing, insurance or investment type) so as to achieve better coordination and greater
cooperation between the various supervisory authorities in member countries.
The second, Directive 2011/89/EC dated 16 November 2011, broadens the area
of intervention, and provides, instead, indications for supplementary supervision of
financial enterprises belonging to a financial conglomerate. This regulation brings
under general governance also companies with mixed financial investment so as to
allow application of sector consolidated/by group supervision in addition to supple-
mentary supervision, in respect of companies with financial or insurance equity
investment that, after expanding business into another financial sector, have become
companies with mixed financial equity investment.

4.8 Regulation of Supplementary Retirement Provision

At a European level, the project for reforming supplementary retirement provision has
foreseen introduction of individual pension covers at a European level, the so-called
Pan-European Pension Product—PEPP. A PEPP is a pension fund available to all
parties resident in the European Union. Regulations 2019/1238/EC dated 20 June
2019 define the aspects that are a feature of this product and set out the bases for a
single European market for personal pensions. A PEPP is supplementary to state,
category and personal pensions systems that apply in each individual nation. The key
dates for PEPP are as follow: the coming into force in August 2020 and marketing by
the end of 2021. Implementing regulations foresee a role for the EIOPA (European
Insurance and Occupational Pensions Authority)8 that has to deal with developing
operating standards, so-called Regulatory Technical Standards (RTS) and creating a
central registry for obtaining information on all PEPPs distributed in Europe.

Development of Regulations on the Distribution of Insurance

Intermediation of insurance concerns a series of activities pertaining to the
time when an insurance service is sold or the phases that lead up to this. An
intermediary is an active participant in submitting contracts, providing assis-
tance, giving advice, and performing activities in preparation for the taking out
of an insurance policy. They are involved in activities of concluding the
policies themselves and cooperating with the parties involved for various
reasons in the process of settling and claims handling phases and providing
the insurance performance.
The first set of regulations introduced was Council Directive 77/92/EEC
issued on 13 December 1976 and which was an important step forward as for

(continued)

8
For matters relating to Pan-European Pension Product—PEPP, see this chapter.
64 4 Regulation of the Insurance Industry

the first time a community level, governance defining insurance intermediaries

was introduced. However, very soon in the years that followed, this legislation
seemed to become obsolete and incomplete, and by then overtaken by the
realities of the market itself, since it governed only the professions of agent
and broker of insurance while leaving out all the other distribution channels,
such as bank insurance, distance selling etc. that had grown up over the years.
Later then, the governance was changed in a significant fashion through
issue of Directive 2002/92/EC on insurance intermediation by the European
Parliament and the Council on 9 December 2002. This directive introduced a
number of harmonising norms (common over all member States) concerning
access to and carrying on of insurance intermediation, single authorisation,
home country control and reciprocal recognition. Through this second direc-
tive, an important step forward was achieved by the figure of the intermediary
in the concept of intermediation activity.
The third and final stage in the process of regulation of insurance interme-
diation (that is here illustrated in a summary manner) was the issuing of the
most recent directive on insurance distribution—the Insurance Distribution
Directive (IDD) (EU) 2016/97 of European Parliament and Council on
20 January, which came from a need to achieve a minimum level of
harmonisation of rules at a community level and surmount regulatory
differences that were still around at a national level and were seen as an
obstacle to both setting in motion and carrying on the business of insurance
intermediation within the European market, and a limitation in consumer
protection in insurance products/services. This third directive led to going
from a concept of a business of intermediation to a notion of distribution.
An insurance intermediary is a party, either an actual person or a legal one,
that carries on a business of distributing insurance products for a
consideration.
Insurance distribution is defined as activities of advising on, proposing, or
carrying out other work preparatory to the conclusion of contracts of insur-
ance, of concluding such contracts, or of assisting in the administration and
performance of such contracts, in particular in the event of a claim, including
the provision of information concerning one or more insurance contracts in
accordance with criteria selected by customers through a website or other
media and the compilation of an insurance product ranking list, including price
and product comparison, or a discount on the price of an insurance contract,
when the customer is able to directly or indirectly conclude an insurance
contract using a website or other media9.

9
The definition contained in the directive on insurance distribution, IDD, (EU) 2016/97 of the
European Parliament and the Council on 20 January 2016 and amended in 2019.
Reference 65

4.9 Questions

1. What were the aims of a single integrated European market for insurance
services?
2. How many are the generations of directives? Explain the purpose of each
of them.
3. What is the difference between FoE and FoS?
4. What are the features and applicability of European regulatory instruments?
5. What is the scope of application of Regulation 2017/2358 issued in
September 2017?
6. Which are the new rules introduced by Directive 2009/138/EC (Solvency II)?
7. What are the characteristics of a financial conglomerate?
8. What is a Pan-European Pension Product—PEPP?
9. What are the purposes of each of three waves of distribution legislation?

Reference
Turchetti G (2005) Le tensioni irrisolte nel mercato RC Auto, Economia e Politica Industriale, 32(3)

Directives and Regulations: Chronological Order

Commission Delegated Regulation (EU) 2017/653 of 8 March 2017 Commission Delegated
Regulation (EU) 2017/653 supplementing Regulation (EU) No 1286/2014, on key information
documents for “PRIIPs” products
Council Directive 2004/113/EC of 13 December 2004 implementing the principle of equal treat-
ment between men and women in the access to and supply of goods and services
Council Directive 77/92/EEC of 13 December 1976 on measures to facilitate the effective exercise
of freedom of establishment and freedom to provide services in respect of the activities of
insurance agents and brokers (ex ISIC Group 630) and, in particular, transitional measures in
respect of those activities
Council Directive 90/619/EEC of 8 November 1990 on the coordination of laws, regulations and
administrative provisions relating to direct life assurance, laying down provisions to facilitate
the effective exercise of freedom to provide services and amending Directive 79/267/EEC
Council Directive 92/49/EEC of 18 June 1992 on the coordination of laws, regulations and
administrative provisions relating to direct insurance other than life assurance and amending
Directives 73/239/EEC and 88/357/EEC (third non-life insurance Directive)
Council Directive of 19 December 1991 on the annual accounts and consolidated accounts of
insurance undertakings (91/674/EEC)
Delegated Regulation (EU) 2017/2358 of 21 September 2017 Supplementing Directive (EU) 2016/
97 of the European Parliament and of the Council with regard to product oversight and
governance requirements for insurance undertakings and insurance distributors
Delegated Regulation (EU) 2017/2359 of 21 September 2017 Regulation supplementing Directive
(EU) 2016/97 with regard to information requirements and conduct of business rules applicable
to the distribution of insurance-based investment products
Delegated Regulation (EU) 2019/1935 of 13 May 2019 Regulation amending Directive (EU) 2016/
97 with regard to regulating technical standards adapting the base euro amounts for professional
indemnity insurance and for financial capacity of insurance and reinsurance intermediaries
66 4 Regulation of the Insurance Industry

Directive (EU) 2016/97 of the European Parliament and of the Council of 20 January 2016 on
insurance distribution (IDD)
Directive 2002/87/EC of the European Parliament and of the Council of 16 December 2002 on the
supplementary supervision of credit institutions, insurance undertakings and investment firms in
a financial conglomerate
Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on
insurance mediations
Directive 2009/138/EC of the European Parliament of 25 November 2009-Including further
modifications – taking-up and pursuit of the business of Insurance and Reinsurance (Solvency
II)
Directive 2011/89/EU of 16 November 2011 amending Directives 98/78/EC, 2002/87/EC, 2006/
48/EC and 2009/138/EC as regards the supplementary supervision of financial entities in a
financial conglomerate
Directive 83/349/EC of 13 June 1983 Seventh Council Directive of 13 June 1983 based on the
Article 54 (3) (g) of the Treaty on consolidated account
First Council Directive 73/239/EEC of 24 July 1973 on the coordination of laws, regulations and
administrative provisions relating to the taking-up and pursuit of the business of direct insurance
other than life assurance
First Council Directive 79/267/EEC of 5 March 1979 on the coordination of laws, regulations and
administrative provisions relating to the taking up and pursuit of the business of direct life
assurance
Fourth Council Directive of 25 July 1978 based on Article 54 (3) (g) of the Treaty on the annual
accounts of certain types of companies
Regulation (EU) 2019/1238 of 20 June 2019 Regulation of the European Parliament and of the
Council of 20 June 2019 on a pan-European Personal Pension Product (PEPP)
Regulation (EU) No 2014/1286 of 26 November 2014 Regulation on key information documents
for “PRIIPs” products
Second Council Directive 88/357/EEC of 22 June 1988 on the coordination of laws, regulations and
administrative provisions relating to direct insurance other than life assurance and laying down
provisions to facilitate the effective exercise of freedom to provide services and amending
Directive 73/239/EEC

Suggestions for Further Study

Biggs JH, Richardson JH (2014) Modernizing insurance regulation. Wiley, Hoboken
Marano P, Noussia K (2020a) Insurance distribution directive. Springer, Cham
Marano P, Noussia K (2020b) InsurTech: a legal and regulatory view. Springer, Cham
Marano P, Rokas I (2019) Distribution of insurance-based investment products. Springer, Cham
Marano P, Siri M (2017) Insurance regulation in the European Union: solvency II and beyond.
Springer, Cham. isbn 3319612166, 9783319612164
Marano P, Rokas I, Kochenburger P (2018) The “Dematerialized” insurance. Springer, Cham
Supervision and Other Authorities
5

Abstract

In this chapter, the reader can understand the models for macro and micro-
prudential supervision in the European financial market. In the sector, locally
we can observe different examples based on focus by subject, objectives, single
supervision etc. The European system of financial supervision is the result of a
long path, started with the Lamfalussy reform. That framework has been replaced
by the new reform de Larosière. The de Larosière reform introduced the current
architecture of European financial supervision. Based on this, the existing
European system of supervision of financial services in Europe foresees a
European Systemic Risk Board (ESRB). Near to this, three European Supervisory
Authorities (ESAs): European Banking Authority (EBA), European Insurance
and Occupational Pensions Authority (EIOPA), European Securities and Markets
Authority (ESMA) were instituted. For each of them the following paragraphs
describe in detail the bodies, the functions, the organization, the powers and the
mission.

Keywords
Macro-prudential supervision · Micro-prudential supervision · Supervision by
subject party · Supervision by objectives · Single supervision · Beneficiary ·
Lamfalussy report · de Larosière Report’s · European Systemic Risk Board
(ESRB) · Joint Committee · European Banking Authority (EBA) · European
Insurance and Occupational Pensions Authority (EIOPA) · European Securities
and Markets Authority (ESMA)

# Springer Nature Switzerland AG 2024 67

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_5
68 5 Supervision and Other Authorities

5.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the model for macro and micro-prudential supervision in the finan-
cial market.
2. Illustrate how the European system of financial supervision works.
3. Describe the bodies and the functions of the European Authorities.

5.2 Supervision of Insurance and Reinsurance Undertakings

Prudential oversight and the voluminous regulation of the financial services sector
meet a need to create and maintain conditions of stability and efficiency in financial
markets as well as safeguarding the interests of savers, investors, consumers,
assureds, undertakings and, more generally, the economic system of a country.
In this paragraph, the model of supervision will be analysed. The first classifica-
tion relates to its scope. For this reason, we make a distinction between macro-
prudential supervision and micro-prudential supervision.
The second classification distinguishes, within micro-prudential supervision,
between the various types of models of supervision.
Beginning with the first classification, by macro-prudential supervision is
meant a system of supervision of financial systems overall. This activity aims to
maintain stability, prevent systemic risks and intervene if there are crises in the
sector. Bodies of the central bank and national central banks of the countries usually
participate in macro-prudential supervision so as to keep the entire system under
view. By micro-prudential supervision on the other hand is meant supervision
exercised upon individual institutions, banks for example, and insurance
undertakings and financial intermediaries. This activity aims to control corporate
activity and carries out checks on all parties regulated so as to be certain that good
management is actually exercised.
Economic literature identifies more than one theoretical model for micro-
prudential supervision of the financial markets sector1.

" Definition The first model of supervision by subject party foresees that for
each individual category of financial intermediary there is an oversight Authority
with concern for the entire complex of activities that regard it.

1
Di Giorgio G., Di Noia C., (2001) Financial regulation and supervision in the Euro Area: a four-
peak proposal, in Warton WP.
5.3 European Supervision in the Matter of Insurances 69

If we follow the traditional distinction in the three sectors of the financial services
industry, we will have one distinct supervision authority for banks and the banking
sector, a second supervision authority for investment companies and trust funds and
a third for insurance undertakings and the insurance industry. Oversight authorities,
each with its own sector of concern, will control and supervise the intermediaries and
markets in their procedures for entry into the market, any exits (especially in
managing situations of company crisis) and monitoring through tools of control,
inspections and sanctions, matters of the workings of the activities performed by
financial intermediaries.

" Definition A model of supervision by objectives foresees a few authorities,

each of which is responsible for controlling a specific function, irrespective of the
type of financial intermediary they are and their home sector.

Following a by-objective or by-function logic, one oversight Authority will

supervise prudential regulation; another will be responsible for control over market
transparency and the conduct of banks, insurance and financial intermediaries in
their conduct with consumers; a third one will be set to safeguarding competition
both in the market overall and of individual financial intermediaries operating in it.

" Definition A third single supervision model foresees centralising all controls
headed by a single control authority, one that is separate from the central bank2.

Regarding Europe, this model has been adopted, for example by countries such as
the Germany, Austria, Canada, Denmark, Sweden and Norway.
Each of the models briefly illustrated here displays its own strengths and
criticalities. For example, supervision by subject party has been found to work
well in a financial context in which in each of the three sectors, banking, insurance
and securities intermediation, intermediaries that are well separated from each other,
operate. On the other hand, when growing integration of the various industries in the
financial sector leads to the creation, as frequently occurs, of financial
conglomerates—often on a supranational scale—it becomes difficult to define
clearly and univocally whether the subject party overseen is a bank, an insurance
undertaking, or a financial intermediary, so creating opportunities for regulatory
arbitrage and gaps in oversight.

5.3 European Supervision in the Matter of Insurances

" Definition The main aim of regulation is to have oversight in the matter of
insurance and reinsurance and adequate safeguarding of policyholders and
beneficiaries. By beneficiary is meant any actual or legal person holding a right

2
Central Bank usually has concern in the matter of monetary policy.
70 5 Supervision and Other Authorities

by virtue of a contract of insurance. The financial stability and equity and the
stability of markets are other aims of regulation and financial market supervision
and which should also be taken into account but without, however, losing sight of the
achievement of the main purpose in danger3.

In these terms, in the sixteenth consideration of the Solvency II directive, the

European Commission defines as the aims of supervision in insurance matters.
Likewise, the IAIS International Association of Insurance Supervisors, in defining
the aims of a system of regulation and supervision4, indicates maintaining an
insurance industry that is fair, healthy and stable for the benefit and protection of
the interests of assureds, beneficiaries and injured parties, and too contributing to the
stability of the financial system overall.
At a European level, in recent years important innovations have been brought in
the matter of supervision of the financial system overall.
A first reform of the system of financial supervision had been introduced in 2005
and was known as the Lamfalussy reform.

" Definition The Institutional framework of the Lamfalussy Report had traced a
sophisticated system of supervision for banking, insurance/pension fund
undertakings and security instruments based on four distinct levels of legislative/
regulatory operation. In summary, regulation output rested on a principle of interac-
tion between the various institutions operating within each level.

See Figure 5.1 for the framework designed by Lamfalussy.

The first level, of the concern of the European Commission, regarded regulatory
actions; the second level was assigned to various committees in the sector: the EBC
(European Banking Committee), EIOPC (European Insurance and Occupational
Pensions Committee), ESC (European Securities Committee) and FCC (Financial
Conglomerates Committee), the third level, that of technical supervision, was
assigned to international committees in which supervision authorities of the various
countries took part. CEBS (Committee of European Banking Supervisors), CEIOPS
(Committee of European Insurance and Occupational Pensions Supervisors), CESR
(Committee of European Securities Regulators) and finally, the fourth level foresaw
activity of verification and checks by the European Commission on the
implementing in each member state of the directives adopted at a community
level. Figure 5.2 describes the steps in the process and the players involved in the
reform proposed by Lamfalussy.
The 2008 financial crisis highlighted large-scale criticalities in the system of
financial supervision, especially in respect of coordination and cooperation between
the various national oversight authorities and uniform application of European rules.

3
See Directive 2009/138/EC of the European Parliament of 25 November 2009-Including further
modifications—taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II).
4
IAIS, Insurance Core Principles, Introduction, available via the IAIS website www.iaisweb.org.
5.3 European Supervision in the Matter of Insurances 71

European
ECOFIN
Parliament

Level 1 European
Political Commission

Level 2 ESC EIOPC EBC FCC Financial

Regulatory Securities Insurance Pension Banking Conglomerates

Level 3 CESR CEBS

Securities CEIOPS
Supervision Banking
communitarian bodies

Level 4
Implementation European Commission and Justice Court

Fig. 5.1 Lamfalussy process

In the Lamfalussy model, the expected players and their roles have been replaced by
a new reform.
For this reason, the European Commission has moved in the direction of a
revision of the entire oversight model5. National oversight authorities had indeed
shown themselves incapable of oversight in a globalised financial context. At the end
of 2008, the European Commission appointed a panel of experts led by Jacques de
Larosière to study and make proposals for reforming the system of European
financial supervision; the final report, known as the de Larosière Report and submit-
ted on 25 February 2009, was adopted as the basic document of reference for the
process of reforming the new European financial supervision coming into operation
in January 2011.

de Larosière Report
Definition: The de Larosière Report’s scope was to present the new archi-
tecture of European financial supervision6. Based on this, it covered mainly
three issues concerning:

(continued)

5
The most important criticalities detected by the European Commission regarding the financial
crisis which started in the United States in 2008 tied to sub-prime mortgages and which also caused
the bankruptcy of Lehman Brothers, are the following: lack of macro-prudential supervision, a lack
of cooperation between oversight and an incapacity to make common decisions in the matter, even
at a cross-border level of oversight, a lack of effective rules in terms of power to act and power to
sanction at a transnational level.
6
See the issued report containing the evidences: The high-level group of financial supervision in the
EU—chaired by Jacques de Larosière—Report—Bruxelles, 25 February 2009.
72 5 Supervision and Other Authorities

• Organization of the supervision of financial institutions and markets in

the EU.
• Reinforcement of European cooperation on financial stability oversight,
early warning and crisis mechanisms.
• Cooperation between EU supervisors and other global supervision
Authorities.

The de Larosière Group focused on the EU, but also covered aspects of new
reforms globally. After addressing the causes of the financial crisis, it brought
forward recommendations on regulation of financial markets.
The report is structured into four chapters: I. Causes of the financial crisis;
II. Policy and regulatory repair; III. EU supervisory repair; IV. Global repair.
At the end of the work, The de Larosière Report’s issued 31 recommend-
ations about the architecture of European financial supervision.
In detail, each of the four chapters analyses the following aspects:
Chap. I—Causes of the financial crisis. It analysed the main causes of the
EU (and global) financial crisis. What was striking was the complexity and
interconnectedness of a number of important factors that amplified the crisis.
The main failures were related to macroeconomic causes, lack of risk manage-
ment policies, failures of the system of the credit rating Agencies, weakness of
corporate governance, wrong incentives from regulatory level and poor coor-
dination between global institutions.
Chap. II—Policy and regulatory repair. It presented the Group’s views on
the priority areas that needed regulatory change. The main priorities were
stronger macroeconomic policy and macro-prudential analysis, reforming the
Basle 2 capital requirement process for bank capital7, review of the role of
credit rating agencies, strengthened governance of the IASB8, strengthened
sanctions/supervisory power etc.
Chap. III—EU supervisory repair. This area set out a project of reform in
the supervisory sphere, based on 2 main blocks:

• Set up of a new model of macro-prudential supervision—establish a new

function called the European Systemic Risk Council (ESRC).
• Set up of a new European System of Financial Supervision (ESFS)—
transform the Level 3 Committees established by Lamfalussy’s model
(CEBS, CEIOPS, CESR) into EU Authorities (EBA, EIOPA, ESMA).

(continued)

7
For further reading about the model Basel II, see Chap. 29 concerning Solvency Margin.
8
For IASB (International Accounting Standards Board), see Chap. 28—about new Accounting
Principles.
5.4 European System of Financial Supervision 73

Level Area Player Measure

European
Level 1 Political Directive
Parliament

European Implementing
Level 2 Reglementary
Parliament measures

Supervision European Consultation

Level 3
communitarian bodies Commission papers

European Commission
Level 4 Implementation and Court of Justice Local Rules

Fig. 5.2 Steps and phases of Lamfalussy legislative process

Chap. IV—Global repair. The Group proposed some necessary changes at

international level to ensure the avoidance of crises in the future, i.e. putting in
charge converging international financial regulation to the highest level
between the European level and global.

The European system of financial supervision has the main objective of ensuring
an adequate application of the rules to preserve financial stability, engender trust in
the financial system and ensure consumer protection.

5.4 European System of Financial Supervision

Currently, the European system of supervision of financial services foresees five

bodies and involvement of National Competent Authorities (NCAs). The main
bodies are European Systemic Risk Board (ESRB) and the three European Supervi-
sory Authorities (ESAs):

• European Banking Authority (EBA) is headquartered in Paris.

• European Insurance and Occupational Pensions Authority (EIOPA) based in
Frankfurt.
• European Securities and Market Authority (ESMA) headquartered in Paris.9

Besides these three authorities, a joint committee of supervision authorities is

available.

9
Originally the offices were in London. Following the United Kingdom’s exit from the European
Union (Brexit) in November 2017, the offices were moved to Paris in March 2019.
74 5 Supervision and Other Authorities

ESFS
European System of
Financial Supervision
Macro-
Micro-Prudential Supervision Prudential
Supervision

Joint committee of European Supervisory

Authorities

ESRB
EIOPA European
European ESMA Systemic
EBA
Insurance European Risk Board
European
and Securities
Banking
Occupation Markets
Authority
al Pension Authority
Authority

NCAS National Competent Authorities

Fig. 5.3 European System of Financial Supervision. Source: website EIOPA

Lastly, an active part in the control and supervision is carried out by the
Supervisory Authorities of each member States (NCAs—National Country
Authorities). Figure 5.3 graphically shows the structure and connections10 between
the various components within the European System of Financial Supervision.
The supervisory system is divided into two main areas: macro-prudential and
micro-prudential.

" Definition Regarding macro-prudential supervision, the European Systemic

Risk Board (ESRB) has the task of monitoring and measuring risks that could
potentially threaten financial stability operating at a macro-prudential supervision
level.

This body was set up following indications issued by the European Council in
July 2009.
Regarding micro-prudential supervision, the three European authorities (EBA,
EIOPA, ESMA) act together with the national oversight authorities and go to make
up a network of micro-prudential supervision, at the level of individual financial
intermediary and consumer protection.

10
Source: http://ec.europa.eu/internal_market/finances/committees/index_en.htm.
5.5 The Bodies and Functions of EBA 75

" Definition The Joint Committee is a joint board of European oversight

authorities. It has the function of being a forum where the three European oversight
authorities cooperate and ensure inter-sector uniformity for financial conglomerates,
bookkeeping and auditing of accounts, micro-prudential analysis of financial stabil-
ity, retail investment products, combating money laundering and finally, exchanges
of information and the development of relations with the European Systemic Risk
Board.

The activity and powers of each of the 3 prudential micro-supervisory bodies are
described below.

5.5 The Bodies and Functions of EBA

" Definition European Banking Authority—EBA is a body of the European
Union. It has been tasked with monitoring the European banking market since
1 January 2011. All the domestic banking supervisors of the European Union
participate in it. EBA replaced the Committee of European Banking Supervisors
(CEBS)11.

As of March 2019, the current offices were moved to Paris12.

The Authority’s goal is to protect the public interest by contributing to the
stability and effectiveness in the short, medium and long term of the financial
system. This purpose is for the benefit of the economy of the Union, its citizens,
and its businesses. The Authority operates in the business sector of banks, financial
conglomerates, investment firms, payment institutions and electronic money
institutions. The Authority is committed to:

• Improving the functioning of the internal market through effective and uniform
regulation.
• Guaranteeing the integrity, transparency, efficiency and smooth functioning of
financial markets.
• Strengthening international coordination in banking supervision.
• Preventing regulatory arbitrage and promoting equal conditions of competition.
• Ensuring that risks are properly regulated and monitored.
• Increasing consumer protection.

Concerning the governance structure, The President represents EBA externally.

The president also has the role of preparing the works and leading the discussions to

11
See Regulation (EU) No 1093/2010 of the European Parliament and of the Council of
24 November 2010 establishing EBA.
12
Previously the headquarter was in London. Due to the United Kingdom’s exit from the European
Union (Brexit), the offices have been moved to Paris.
76 5 Supervision and Other Authorities

the Board of Supervisors. The Executive Director is responsible for preparing the
Management Board meetings. He is committed to ensuring the Authority’s daily
operational work.
There are two governing bodies within the EBA: Board of Supervisors (BoS) and
Management Board. In the following paragraphs we will describe each of them.
The Board of Supervisors (BoS), which is the main decision-making body of the
Authority. This takes all the political decisions. For example, it is responsible for
adopting draft technical standards, guidelines, opinions and reports.
The Management Board has the role of ensuring that the Authority carries out its
mission and the tasks assigned to it. For this reason, it oversees preparing the annual
work programme, the annual budget, the staff plan and the annual report on the
activities carried out.
Decisions on specific issues relating to the resolution of financial institutions have
been delegated by the Board of Directors to the Resolution Committee (ResCo).

5.6 The Bodies and Functions of EIOPA

" Definition European Insurance and Occupational Pensions Authority—
EIOPA is a body of the European Union that has been tasked with monitoring the
European insurance market since 1 January 2011. All the insurance supervisors of
the European Union participate in it. The Authority replaced the Committee of
European Insurance and Occupational Pensions Supervisors (CEIOPS).

The offices are based in Frankfurt13.

Concerning mission and objectives, EIOPA is an institution with statutory powers
and legal personality.
The key responsibilities of the Authority are support of the stability of the
financial system, the transparency of financial markets and products and the protec-
tion of policyholders and beneficiaries of pension systems. EIOPA is responsible for
monitoring and identifying trends, potential risks and weaknesses at a micro-
prudential level, in cross-border and intersectoral situations.
The Authority’s goal is to protect the public interest by contributing to the
financial stability and effectiveness in the short, medium, and long term. This
purpose should make more stable the financial system, the economy of the Union,
its citizens and its businesses. The Authority operates in the sector of banks, financial
conglomerates, investors, payment institutions and electronic money institutions. In
detail, the objectives of the Authority are:

13
See Regulation (EU) No 1094/2010 of the European Parliament and of the Council of
24 November 2010 establishing EIOPA.
5.6 The Bodies and Functions of EIOPA 77

• Increase consumer protection and rebuild trust again in the financial system.
• Ensure a high, effective and consistent level of regulation and supervision. This
considers the different interests of all EU Countries and the different nature of
financial institutions.
• Harmonize and implement in a consistent way the rules for financial institutions
and markets across the European Union.
• Strengthen surveillance of cross-border financial groups.
• Promote coordinated European approach between Supervisors in the European
Union.

5.6.1 Areas and Powers of Intervention

EIOPA confers on the Council of Europe and the European Parliament. As required
by Solvency II Directive, each year EIOPA prepares for the European Commission a
periodic report. This document contains its recommendations on the methodology
for calculating the risk, for the insurance premium of the policies for all of Europe.
Insurance and reinsurance undertakings, financial conglomerates, institutions for
occupational pensions and insurance distributors are under the EIOPA power.
It can intervene for Corporate Governance, auditing and financial reporting
issues, provided that such actions by the authority are necessary to ensure the
effective and consistent application of these actions.
EIOPA’s powers are:

• Prepare Regulatory Technical Standards (RTS) and implementing standards

(draft regulatory technical standards and implementing technical standards),
immediately enforceable.
• Issue guidelines and recommendations.
• Take decisions against subjects addressed to the competent authorities, or to
financial institutions in specific cases.
• Develop common methodologies to evaluate the effect of product characteristics
and distribution processes in the EU Countries.

About organisation, EIOPA’s composition is quite like that of ESMA. The bodies
are as follows: A Supervisory Board, a Management Board, a President, an Execu-
tive Director and a Board of Appeal. EIOPA is required to promote the protection of
policyholders, workers who are members of the various types of pension schemes, as
well as current beneficiaries of these schemes, in addition to common tasks
with ESMA.
Finally, the European authority coordinates the supervisory work of the national
authorities of each EU Countries.
78 5 Supervision and Other Authorities

5.7 The Bodies and Functions of ESMA

" Definition European Securities and Markets Authority—ESMA is a body of
the European Union which, from 1 January 2011, is responsible for monitoring the
European financial market. All European Union banking supervisors participate in
ESMA. This Authority replaced the Committee of European Securities Regulators
(CESR).

The offices are based in Paris14.

ESMA is responsible for securities legislation and regulation. Its goal is to
improve the functioning of the financial markets in Europe, strengthening investor
protection and cooperation between the competent national authorities. The
approach behind ESMA is to establish “financial market supervision at European
level”. One of its main tasks is to regulate credit rating agencies.
Concerning objectives, the Authority contributes to safeguarding the stability of
the financial system of the European Union by ensuring the integrity, transparency,
efficiency and smooth functioning of securities markets, as well as improving
investor protection. In detail, its objectives are:

• Contribute to the development of a unique rule code in Europe on securities

legislation.
• Ensure homogeneous treatment of investors across the Union, allowing an ade-
quate level of investor protection through effective regulation and supervision.
• Promoting equal conditions of competition for financial service providers, as well
as ensuring the efficiency and effectiveness of supervisory costs for subsidiaries.
• Strengthen international cooperation in the supervisory sector.
• Implement the supervision of certain pan-European entities.
• Coordinate the actions of securities supervisors or take emergency measures
when a crisis exists.

5.7.1 Organization and Activities

The Board of Supervisors and NCAs is the main body. It validates decisions and
approves ESMA’s work.
Members of the Board of Supervisors are the Presidents of the regulatory
authorities of each of the Countries of the European Union. An observatory and
others designated by the European Commission participate to the Board.
One representative of the European Banking Authority, one for the European
Insurance and Occupational Pensions Authority, and one for the European Financial
Supervision System are also members.

14
See Regulation (EU) No 1095/2010 of the European Parliament and of the Council of
24 November 2010.
Directives and Regulations: Chronological Order 79

The Board of Supervisors deliberates by qualified majority vote, for decisions

relating to technical standards and guidelines. Daily activities concern the prepara-
tion of the proposals destined for the Supervisory Council. This task is performed by
the permanent committees. These committees are chaired by national
representatives, who are usually also members of the Supervisory Board. Each
permanent committee establishes an advisory working group, made up of operators
and final consumers. This working group contributes to the development of the
proposals.
When a document is intended for public consultation, (once adopted by the
Supervisory Council), this is published on the ESMA website. Usually, a public
hearing is organized. Its duration is variable. In this period, professional investors or
final consumers can formulate criticisms and proposals for changes, which the
authority reserves the right to notify and take into consideration in the decision-
making process.

5.8 Questions

1. Which are the possible models for supervision?

2. What does the Lamfalussy reform foresee? What are the differences with de
Larosière Report?
3. Which are the components of ESFS? Describe the structure and connections
between them.
4. What are the functions of EBA?
5. Which are the bodies of EIOPA?
6. What is ESMA?

Directives and Regulations: Chronological Order

Directive 2009/138/EC of the European Parliament of 25 November 2009-Including further
modifications – taking-up and pursuit of the business of Insurance and Reinsurance (Solvency
II)
Regulation (EU) No 1093/2010 of the European Parliament and of the Council of 24 November
2010 establishing EBA
Regulation (EU) No 1094/2010 of the European Parliament and of the Council of 24 November
2010 establishing EIOPA
Regulation (EU) No 1095/2010 of the European Parliament and of the Council of 24 November
2010 establishing ESMA
The high-level group of financial supervision in the EU – chaired by Jacques de Larosière –
Report – Bruxelles, February 25, 2009

Suggestions for Further Study

Amorello L (2018) Macroprudential banking supervision & monetary policy. Palgrave Macmillan,
Cham
80 5 Supervision and Other Authorities

Andenas M, Deipenbrock G (2016) Regulating and supervising European financial markets.

Springer, Cham
Di Giorgio G, Di Noia C (2001, January) Financial regulation and supervision in the euro area: a
four-peak proposal, in Warton WP
Liedtke PM, Monkiewicz J (2011) The future of insurance regulation and supervision: a global
perspective. Palgrave Macmillan, New York
Marcacci A (2022) Transnational securities regulation. Springer, Cham
Moloney N (2014) EU securities and financial markets regulation. Oxford University Press, Oxford
Monkiewicz J, Malecki M (eds) (2014) Macroprudential supervision in insurance. Springer, Berlin
The European Insurance Industry (2020) Regulation, risk management, and internal control.
Palgrave, Macmillan
Wymeersch E, Hopt KJ, Ferrarini G (2012) Financial regulation and supervision: a post-crisis
analysis. Oxford University Press, Oxford
The Insurance Business
6

Abstract

In this chapter, the fundamental aspects of insurance business are explored. The
main rules governing the authorisation and carrying on of insurance business are
described. The aspects concerning the legal form (corporate form, European
company etc.) are deepened. The authorisation procedure and related activities
(scheme of operations, single authorisation, cross-border business, registry etc.)
are explained. The reader can understand the classification of risks according to
classes of insurance underlying the lines of business (LoB), as required by the
European legislation. Then, the classes of risks (for life and non-life) and the
related classification are illustrated in detail. The following paragraphs illustrate
the three fundamental pillars to understand the functioning of the insurance
industry: solvency margin, technical reserves and investments in accordance
with the directive in force. The legal discipline of equity investments, of an
insurance group, and financial conglomerates is described. At the end, extraordi-
nary events (mergers and spin-off) and the crisis management of an insurance
undertaking are explained.

Keywords
European company · Scheme of operations · Authorisation procedure · Single
authorisation—home country control · Classes of insurance · Line of Business ·
Ancillary risk · System of corporate governance · Premium reserve · Loss reserve ·
Mathematical reserve · Prudent individual · Solvency Capital Requirement—SCR
or solvency margin · Own Funds (OF) · Solvency ratio or cover(age) ratio · Equity
investments or holdings · Dominant influence · Insurance holding enterprise ·
Financial conglomerate · Reinsurance · Insurance portfolio · Transfer of an
insurance portfolio · Merger · Spin-off or demerge · Extraordinary
administration · Revoking of authorisation · Obligation to take out insurance

# Springer Nature Switzerland AG 2024 81

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_6
82 6 The Insurance Business

6.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the main rules governing the authorisation and carrying on of

insurance business.
2. Illustrate the classes of risks (for life and non-life) and the classification for
lines of business.
3. Explain the concept and how the solvency margin works.
4. Describe the legal discipline of equity investments, an insurance group and
financial conglomerates.
5. Explain extraordinary events (mergers and spin-off) and the crisis manage-
ment of an insurance undertaking.

6.2 Access to the Insurance Business

The carrying on of insurance business is set aside under the law for an insurer. This
means that only insurance/reinsurance companies and no other types of enterprise or
other financial intermediaries may be authorised to systematically taking on risks in
return for a premium, which is the typical business done of an insurance/reinsurance
undertaking.
In addition to performing insurance activity in life and non-life business, which is
shown as the exclusive corporate purpose, insurance undertakings can also do
activities that are connected with and instrumental to the main one, such as invest-
ment activities for technical reserves. Finally, insurance undertakings are allowed to
carry on activities tied to managing forms of healthcare assistance and supplemen-
tary retirement provision.1
A general rule prohibits insurance undertakings from jointly carring on life and
non-life insurance business since they were authorised prior to the third wave of
regulation.2 This rule aims to avoid the operation of life insurance being influenced
unfavourably by operations in the non-life business and vice-versa; resources set
aside to meet commitments taken on in one business might be utilised to honour
undertakings deriving from the other business of insurance, so creating potentially
dangerous situations of bad management. Composite undertakings must abide by a
principle of separation of the two sets of operations, keeping assets, liabilities and

1
See article 6—Assistance in Directive 2009/138/EC (Solvency II).
2
For further information see Chap. 4 and First Council Directive 79/267/EEC of 5 March 1979 on
the coordination of laws, regulations and administrative provisions relating to the taking up and
pursuit of the business of direct life assurance.
6.2 Access to the Insurance Business 83

equity items distinct from each other so as to be able to identify their applications to
life or non-life operations.
In order to be able to carry on business, an insurance undertaking needs an
authorisation issued by the oversight Authority of the country of origin at the request
of the undertaking; authorisation is published in the specialised bulletin and applies
to the entire territory of the Union. Conditions and requirements that must be met for
issue concern: initial equity made available, arrangement of governance and
organisational structure, a three-year business plan and the suitability of shareholders
to ensure healthy and prudent management of the insurance undertaking just set
up. The requirements in the matter of access to carrying on insurance and reinsurance
business (Directive Solvency II) are as follows3:

• A legal form such as corporate form.

• Territoriality.4
• Holding of minimum of eligible basic own funds (absolute minimum coverage of
the minimum capital requirement and prospective coverage of the Equity
Requirement for Solvency).
• Submitting an initial plan describing the future activities and operations (a sort of
business plan called a scheme of operations).
• Meeting of requirements of integrity by holders of qualifying equity interests in
the capital of the undertaking and abidance by requirements of integrity, profes-
sional standing and independence of persons who perform functions of adminis-
tration, management and audit and other fundamental functions of an insurance
undertaking.
• An absence of close ties between the insurance undertaking and other parties
representing an obstacle to exercising oversight.
• An indication of the representative for settling losses for each of the member
states for insurance undertakings operating in motor vehicle liability.

As mentioned, the first requirement indicated in the law for issue of authorisation
is the legal form: insurance business can be carried on in the form of a joint-stock
company (in accordance with domestic rules) or a European company.5 The form of
a joint-stock company foresees there being a subdivision of capital into shares and a
recognition of the legal personality of the insurer.

" Definition A European company is a type of company that allows insurers who
operate jointly in a number of member States to carry on insurance business by

3
See Article 18—Conditions for authorisation—as indicated in Directive 2009/138/EC
(Solvency II).
4
The head and administrative office of the insurance undertaking needs to be located in European
Union.
5
See Article 17—Legal form of the insurance or reinsurance undertaking—Directive 2009/138/EC
(Solvency II).
84 6 The Insurance Business

adopting a type of universally recognised enterprise without having to go through

machinery of reciprocal recognition of authorisations.

This is admitted:

• When it starts life via the merger of a number of companies operating in different
member states.
• When a European holding company is set up with functions of unitary manage-
ment of a number of insurance companies operating in more than one member
state.
• When a number of companies constitute a commonly controlled company,
known as an affiliated European company.
• When a European company sets up an affiliated European company.
• And, finally, when it comes about from a transaction transforming a joint-stock
company that has controlled a company operating in another member state for at
least 2 years.

An insurance undertaking must submit the scheme of operations (a sort of

business plan) to the oversight Authority.6

" Definition The scheme of operations (a sort of business plan) meets a need to
illustrate the operational and structural characteristics of the entrepreneurial initiative
being set in motion, for which lines of business of insurance authorisation is sought,
a budget for setting-up expenses, organisation and structure of the distribution
network, criteria it is intended to apply in reinsurance transactions, procedures for
issuing policies and for taking on and selection risks to be underwritten, loss
settlement structures and arrangement and organisation of internal auditing, risk
management and compliance functions.

Additionally, the business plan must include forecasts over a three-year period of
the treasury situation, forecasts concerning the financial means needed to cover
technical reserves and the solvency margin, management expenses other than
setting-up expenses as well as details of forecasts of performances to deliver in life
business and loss events to be settled in the non-life business.

6.2.1 The Authorisation Procedure

" Definition The authorisation procedure foresees that after submitting the
request by an insurance undertaking, in cases of favourable outcome of opening
proceedings, the oversight Authority of the country will issue an authorisation order.
The next step is the enrolment of the undertaking in the registry of enterprises.

6
For the scheme of operations See Article 18—as indicated in Directive 2009/138/EC (Solvency II).
6.2 Access to the Insurance Business 85

Following this compliance, the oversight Authority of the country enrols the under-
taking in the registry of insurance undertakings and publishes the authorisation
order.

Once it has obtained authorisation from the oversight Authority of the country an
insurance undertaking may carry on its business also in other EU countries, notifying
the oversight Authority of the country of this.

" Definition Principles of single authorisation and home country control apply.
This means that no further authorisations are required, as the one from the native
oversight Authority of its country applies throughout the territory of the EU.

This by virtue of rules of access and carrying on insurance business are in force in
the various harmonised countries. Imagining that the project for expansion abroad of
an EU insurance undertaking entails establishing a permanent branch office, for
instance, operating under a regimen of Freedom of Establishment (FoE) in the
notification given to the oversight Authority, the insurance undertaking must prepare
a scheme of operation showing the risks and obligations that it intends to take on and
documents regarding a general representative of the undertaking abroad. Concerning
the risks to be taken on, if these do not fall within the lines of business already
insured in domestic business. The insurance undertaking will first have to apply to
the native oversight Authority of its country for a request to expand into new lines of
business and seek authorisation to operate in additional lines of business. The
process foresees the oversight Authority of the country sending a notice to the
oversight Authority in the host country. Finally, the domestic insurance undertaking
may commence operations abroad only after it receives notice from the oversight
Authority of the host country.
Cross-border business, when it is based on actions that are occasional when
compared to freedom of establishment (FoE),7 is carried on under a regimen of
freedom of services (FoS). In this case, prior notice given to the oversight Authority
of the country is required indicating the country in which the insurance undertaking
will operate and the obligations that it intends to take on and, in its turn, the oversight
Authority of the country will communicate with the oversight Authority of the host
country.
A further compliance for the oversight Authority of the native country in the
authorisation procedure consists of notifying the EIOPA (European Insurance and
Occupational Pensions Authority) of any authorisation that the oversight Authority
of the country has issued with an indication of the lines of business and risks and any
enabling in freedom of establishment or freedom of services in other member states.8

7
It was clarified some time ago that the main distinction applying between cross-border business
under a regimen of freedom of services (FoS) and freedom of establishment (FoE) lies in the
occasional or permanent nature of the business done.
8
For supervision at the European level and the areas of intervention of EIOPA—see Chap. 5.
86 6 The Insurance Business

6.2.2 The Registry of Licensed Insurance Undertakings

EIOPA (European Insurance and Occupational Pensions Authority) publishes the

information regarding registered financial institutions within its area of competence.
These items of information are regularly updated and easily accessible by the
public.9
The Register of Insurance undertakings is a representation of the information
provided by the respective NCAs National Competent Authorities. Each NCA is
responsible for authorisation and/or registration of an insurance undertaking and for
publishing a register of insurance undertakings on their website.
Enrolment of an insurance and reinsurance undertaking with the registry is the
final step in the process of authorisation: once enrolled, an undertaking is free to
commence its business.
Usually, the registry of insurance undertakings is available on the website of the
oversight Authority of the native country. The website contains information on
authorised insurance undertakings: the lines of business it carries on, its legal
form, its home group, details of issue of authorisation for insurance and reinsurance
business. Any differences between the information published by EIOPA and the lists
available in the national public registries may particularly be due to different
underlying national legal frameworks.

6.3 Lines of Business (LoB)

" Definition The risks are classified according to classes of insurance. Each class
is a category according to a homogeneous series of risks or transactions that describe
the business that the insurance undertaking may carry on upon issue of authorisation.

In accordance with the Directive 2009/138/EC (Directive Solvency II), the risks to
be covered are classified into 18 classes.10 See Table 6.1 for the list and the
description of each class of non-life insurance.
In addition to the aforementioned classes, an insurance company may be licensed
for more than one class of non-life insurance. Permissions that cover multiple classes
simultaneously have some specific names defined by the Directive. See Table 6.2 for
a description of the authorisations granted for more than one insurance class.11
Concerning life business, risks pertaining to life insurance are grouped into
different classes.12 In accordance with the Directive 2009/138/EC (Directive

9
See Article 8 of See Regulation (EU) No 1094/2010 of the European Parliament and of the Council
of 24 November 2010 establishing EIOPA.
10
See Annex I of the Directive—Classes of non-life insurance.
11
It should be considered that each oversight Authority of the Member States is free to decide on
further combinations of risks.
12
See Annex II of the Directive—Classes of non-life insurance.
6.3 Lines of Business (LoB) 87

Table 6.1 Classification of risks according to classes of insurance

Class number Underlying risks
1. Accident (including industrial injury
Fixed pecuniary benefits
and occupational diseases)
Benefits in the nature of indemnity

Combinations of the two

Injury to passengers
2. Sickness
Fixed pecuniary benefits

Benefits in the nature of indemnity

Combinations of two
3. Land vehicles (other than railway All damage to or loss of:
rolling stock)
Land motor vehicles

Land vehicles other than motor vehicles
4. Railway rolling stock All damage to or loss of railway rolling stock
5. Aircraft All damage to or loss of aircraft
6. Ships (sea, lake and river and canal All damage to or loss of:
vessels)
River and canal vessels

Lake vessels

Sea vessels
7. Goods in transit (including All damage to or loss of goods in transit or baggage,
merchandise, baggage and all other irrespective of the form of transport
goods)
8. Fire and natural forces All damage to or loss of property (other than
property included in classes 3, 4, 5, 6 and 7) due to:

Fire

Explosion

Storm

Natural forces other than storm

Nuclear energy

Land subsidence
9. Other damage to property All damage to or loss of property (other than
property included in classes 3, 4, 5, 6 and 7) due to
hail or frost, and any event such as theft, other than
that included in class 8
10. Motor vehicle liability All liability arising out of the use of motor vehicles
operating on the land (including carrier’s liability)
11. Aircraft liability All liability arising out of the use of aircraft
(including carrier’s liability)
12. Liability for ships (sea, lake and All liability arising out of the use of ships, vessels or
river and canal vessels) boats on the sea, lakes, rivers or canals (including
carrier’s liability)
13. General liability All liability other than those referred to in classes
10, 11 and 12
14. Credit
Insolvency (general)

Export credit

Instalment credit

Mortgages

Agricultural credit
15. Suretyship
Suretyship (direct)

Suretyship (indirect)
(continued)
88 6 The Insurance Business

Table 6.1 (continued)

Class number Underlying risks
16. Miscellaneous financial loss
Employment risks

Insufficiency of income (general)

Bad weather

Loss of benefits

Continuing general expenses

Unforeseen trading expenses

Loss of market value

Loss of rent or revenue

Other indirect trading loss

Other non-trading financial loss

Other forms of financial loss
17. Legal expenses Legal expenses and costs of litigation
18. Assistance Assistance for persons who get into difficulties while
travelling, while away from their home or their
habitual residence

Table 6.2 Description of authorisations granted for multiple classes of insurance

Simultaneous authorisation Multiple class of insurance
Accident and health insurance (a) Classes 1 and 2
Motor insurance (b) Classes 1 (fourth indent), 3, 7 and 10
Marine and transport insurance (c) Classes 1 (fourth indent), 4, 6, 7 and 12
Aviation insurance (d) Classes 1 (fourth indent), 5, 7 and 11
Insurance against fire and other damage to property (e) Classes 8 and 9:
Liability insurance (f) Classes 10, 11, 12 and 13
Credit and suretyship insurance (g) Classes 14 and 15

Solvency II), the classes are nine. The risks underlying each class are described in
Article 2 (3) of the Directive, which applies to life insurance business when the risks
are on a contractual basis. See Table 6.3 for the list and the description of each class
of life insurance.
Each oversight Authority is free to decide, in accordance with this classification,
which classes apply to the domestic environment.
As for the formulas used in the calculations required by Solvency II, the classes
illustrated above are grouped differently. Non-life insurance risks are divided into
12 Lines of Business (LoB). Life insurance risks are split into nine Lines of
Business.

" Definition Line of Business is a general term that refers to a risk or a set of
related homogeneous risks that can occur in a particular situation. The insurance
covers for this type of risk are similar. The term also has a regulatory and accounting
definition to meet a statutory set of insurance policies.
6.3 Lines of Business (LoB) 89

Table 6.3 Description of classes of life insurance

Classes of life insurance
I. The life insurance referred to in (i) Life insurance which comprises assurance on survival
points (a)(i), (ii) and (iii) of Article to a stipulated age only, assurance on death only,
2(3). assurance on survival to a stipulated age or on earlier
death, life assurance with the return of premiums, marriage
assurance, birth assurance.
(ii) Annuities.
(iii) Supplementary insurance underwritten in addition to
life insurance, in particular, insurance against personal
injury including incapacity for employment, insurance
against death resulting from an accident and insurance
against disability resulting from an accident or sickness.
Excluding those referred to in II and III.
II. Marriage assurance, birth
assurance.
III. The insurance referred to in (i) Life insurance which comprises assurance on survival
points (a)(i) and (ii) of Article 2(3). to a stipulated age only, assurance on death only,
assurance on survival to a stipulated age or on earlier
death, life assurance with the return of premiums, marriage
assurance, birth assurance.
(ii) Annuities.
Which are linked to investment funds.
IV. Permanent health insurance, (iv) Types of permanent health insurance not subject to
referred to in point (a)(iv) of Article cancellation (currently existing in Ireland and the United
2(3) Kingdom).
V. Tontines, referred to in point (b) (i) Operations whereby associations of subscribers are set
(i) of Article 2(3). up with a view to capitalising their contributions jointly
and subsequently distributing the assets thus accumulated
among the survivors or among the beneficiaries of the
deceased (tontines).
VI. Capital redemption operations, (ii) capital redemption operations based on actuarial
referred to in point (b)(ii) of Article calculation whereby, in return for single or periodic
2(3). payments agreed in advance, commitments of specified
duration and amount are undertaken.
VII. Management of group pension (iii) Management of group pension funds, comprising the
funds, referred to in point (b)(iii) management of investments, and in particular the assets
and (iv) of Article 2(3). representing the reserves of bodies that affect payments on
death or survival or in the event of discontinuance or
curtailment of activity.
(iv) The operations referred to in point (iii) where they are
accompanied by insurance covering either conservation of
capital or payment of a minimum interest.
VIII. The operations referred to in The operations carried out by life insurance undertakings
point (b)(v) of Article 2(3). such as those referred to in Chapter 1, Title 4 of Book IV
of the French ‘Code des assurances.
IX. The operations referred to in Operations relating to the length of human life which are
Article 2(3)(c). prescribed by or provided for in social insurance
legislation, in so far as they are affected or managed by life
insurance undertakings at their own risk in accordance
with the laws of a member state.
90 6 The Insurance Business

Table 6.4 Lines of business for direct and proportional reinsurance business
Segmentation of non-life insurance
1. Medical expense insurance
2. Income protection insurance
3. Workers’ compensation insurance
4. Motor vehicle liability insurance
5. Other motor insurance
6. Marine, aviation and transport insurance
7. Fire and other damage to property insurance
8. General liability—Third-party liability
9. Credit and surety insurance
10. Legal expenses insurance
11. Assistance
12. Miscellaneous financial loss

For non-life business, the lines of business (LoB) are foreseen under Solvency II
directive can be separated out into two macro-categories:13

• Direct insurance and proportional reinsurance.

• Non-proportional reinsurance.14

Risks relating to the first macro-category are grouped into 11 homogeneous lines
of business. Table 6.4 contains a listing of non-life lines of business.
Lines of business for non-proportional reinsurance are the four that follow: See
Table 6.5 containing details of risks.
For life insurance, the Lines of Business (LoB) foreseen under Solvency II
regulations can be classified according to the following four lines of business15:

Table 6.5 Lines of business of non-proportional reinsurance

Classification of lines of business Segmentation of non-life insurance
1. Illness 1. Non-proportional health reinsurance
2. Civil liability 2. Non-proportional casualty reinsurance
3. Marine, aviation and 3. Non-proportional marine, aviation and transport
transport reinsurance
4. General real property 4. Non-proportional property reinsurance

13
Reference is made to Article 80—“Segmentation” of Directive 2009/138/EC dated
25 November 2009.
14
Reinsurance is dealt with in Chap. 17. For the purposes of this paragraph, it is worthwhile
explaining the concept of proportional reinsurance where the conditions of the reinsurance contract
follow those of the original contract. Non-proportional reinsurance to the contrary features
conditions and terms that are specific to a reinsurance contract as different from the original contract
of insurance.
15
See Article 80—“Segmentation” of Directive 2009/138/EC dated 25 November 2009—text
coordinated with Omnibus II and subsequent amendments “In the matter of access to carrying on
insurance and reinsurance business (Solvency II)”.
6.3 Lines of Business (LoB) 91

1. Contracts that foresee sharing in profits by the assured.

2. Contracts whose financial risk is borne by the policyholder.
3. Other contracts that do not foresee sharing in profits by the assured.
4. Life contracts are ceded by way of reinsurance.

Lines of Business (LoB) indicate a homogeneous series of risks or businesses

featuring the same kind of underlying risk. Each of the four categories set out above
may be further split into four additional segments (thus becoming, in point of fact,
16 lines potentially):

• Contracts whose main risk is decease.

• Contracts whose main risk is survival.
• Contracts whose main risk is lack of self-sufficiency or risk of epidemic.16
• Policies of accumulation and savings (such as, e.g. retail investment and pack-
aged insurance products17).

There is also a classification specific to health products. Concerning the classifi-

cation of underlying risks to health products, lines of business may be divided into
the following categories:

• SLT Health, i.e. a SLT Health contract drawn up on technical bases similar to life
insurance (i.e. long term18).
• Non-SLT Health, i.e. a “Non-SLT Health” contract drawn up as a contract
technically similar to non-life (i.e. short-term).

In its turn, each of these two categories may be further subdivided into types of
predefined products, such as, for example:

• In respect of SLT Health contracts, it is possible to distinguish between

sub-categories depending on the performances that the insurance undertaking
covers (i.e. duration, type of income, kind of reimbursement and payment of a
lump sum).
• for non-SLT contracts further segmentation is possible that is specific to non-life
obligations (i.e. accident risk, illness and workman’s compensation).

16
In the English literature the risk is defined with the term morbidity risk.
17
For a treatment of this type of life product see Chap. 8. These products are products whose value
is subject to fluctuations due to exposure to variables or returns on one or a number of underlying
assets. They feature a process of packaging aimed at creating an investment product with exposures,
features or cost structures that are different from a direct holding of financial instruments.
18
The acronym SLT “Similar to Life Techniques”. For this reason, a distinction is made between
non-SLT and SLT contracts.
92 6 The Insurance Business

An insurance undertaking, that has obtained authorisation for a risk for a line or a
group of lines held to be the main risk, may cover an ancillary risk from another line
not included in an authorisation.

" Definition By ancillary risk is meant a risk connected to the main one. It is a risk
included in another such class which is: (a) connected with the principal risk,
(b) concerned with the object, which is covered against the principal risk and
(c) the subject of the same contract insuring the principal risk.19

6.4 Conditions Governing Insurance Business

The conditions for carrying on insurance and reinsurance business are the rules of
prudential supervision and set to ensure conditions of healthy and prudent manage-
ment of insurance undertakings while performing insurance activity.20 They regard
multiple aspects of insurance business: responsibility of the administrative, manage-
ment or supervisory body, system of governance, public disclosure, qualifying
holdings and duties of auditors. In addition, the directive provides rules on deter-
mining tariffs and rate of interest that can be guaranteed in life business; determining
tariffs in cover for automobile liability. Furthermore, detailed rules on technical
reserves and the economic requirements of solvency are in place. Certain principal
features are described in the coming paragraphs.

6.4.1 System of Corporate Governance

The board of directors is the body of the insurance undertaking that is ultimately
responsible under the law for abidance by laws, regulations and community rules.
An insurance undertaking must equip itself with an effective system of governance
that is able to allow healthy and prudent management which measures up to the
nature, reach and complexity of insurance business.

" Definition The essential features that a good system of corporate governance
that measures up to the nature and complexity of managing an enterprise must have
are a transparent organisational structure with clear and suitable separation of roles
and responsibilities of functions; requirements of professional standing, integrity and
independence of the persons who hold roles of responsibility; laying down of the
four fundamental functions of good corporate governance; internal audit, compli-
ance, actuarial and risk management.

19
See Article 16—Ancillary risks—Directive 2009/138/EC (Solvency II).
20
For these topics, see Chapter IV—Conditions governing business—from Section 1 to Section 6—
Articles 40–72 of Directive 2009/138/EC (Solvency II).
6.4 Conditions Governing Insurance Business 93

Claims
Activities Premium Premium Asset settlement -
collection investment management provision of
benefits

Cash Flow Assets =

Revenues - cash Run off
segregated Return on assets reserves =
for insurance
divestment of
reserves
assets

Time

Fig. 6.1 Investment/asset and reserve management activities

Concerning the management of risk, an undertaking must set up an effective

system of risk management to pursue “strategies, processes and procedures of
reporting that are necessary to identify, monitor, manage and report on an ongoing
basis, the single and aggregate risk that an insurance undertaking is or might be
exposed to, and the interdependency between risks”.
The management system must include the main areas of business of an insurance
undertaking and which are:

• Subscribing to and constitution of technical reserves.

• Integrated asset-liability management.
• Investments, especially derivative financial instruments, and similar
commitments.
• Management of risks of liquidity and accumulation.
• Management of operational risk.
• Reinsurance and other risk mitigation techniques.

6.4.2 Life and Non-life Reserving

The basic production cycle of an insurance undertaking is inverted. Revenues are

collected prior to costs tied to managing a policy in its portfolio and indemnification
being incurred. Furthermore, the provision of the amount to be settled in the future
for claims involves forming technical reserves. An insurance premium is collected at
the time a contract is concluded, whereas the risk insured begins to run with effect
from that time forward, for a shorter or longer period of time, which depends on the
particular characteristics of the risk taken on. See Figure 6.1 which graphically
illustrates the relationship between investment/asset and reserve management
activities.
In carrying on the typical business of operating an insurance undertaking it
usually occurs that there is a lack of overlap in time between duration of the
insurance contracts in a portfolio and the duration of an accounting period; for this
94 6 The Insurance Business

reason, at the end of each year an assessment of insurance performances that the
insurance undertakings has committed itself to meet in the future and which are the
sums (life insurance) and loss events to pay to assureds and injured parties (non-life
insurance) becomes necessary.
As was shown previously,21 in order to explain the concept of reserve, reference
is made to the duty that an insurance undertaking has concerning setting aside funds
called technical reserves. This setting aside allows the actual time accrual of risks
that have generated premiums collected to be taken into account and have the funds
available needed to meet future indemnities or payments of performances foreseen
under contracts.
Technical reserves are of two kinds and so have a dual nature: on the one hand
they take into account the actual time accrual of positive flows collected in advance
and on the other they meet a future disbursement for loss events not yet paid or
performances to be provided.

" Definition The first type is defined premium reserve and makes up an allocation
by an insurance undertaking relating to the fraction of premium already collected but
not accruing to the period. The second type relates to a debt that the insurance
undertaking has towards assureds. This reserve is called loss reserve in non-life
business, whereas for life business it is called mathematical reserve.

" Definition A loss reserve in non-life business matches the sum that an insurer
sets aside each year to have resources sufficient to meet payments of all loss events
occurring in previous accounting periods, but not yet (fully) settled. This reserve
represents the debt that the insurance undertaking owes to assureds for loss events
occurring and that will be paid in the future (given the time needed to manage and
settle losses).

" Definition For life business, the mathematical reserve is based on the equiva-
lence applying between premiums and performances. Premiums are paid in by
assureds in advance whereas performances (revalued lump sum or annuity) are
paid by the insurance undertaking at a later time. The mathematical reserve is thus
an allocation of a debt relating to performances that assureds will demand at
maturity.

6.4.3 Principles in the Matter of Investments

Sums matching the insurance premiums collected in advance as compared to bearing

related costs, are intended in part to make up technical reserves; these are large sums
that insurance undertakings have available for long periods of time and that it must

21
For a treatment of the principles relating to reserves see Chap. 3.
6.4 Conditions Governing Insurance Business 95

deploy by investing in financial instruments with characteristics that are set forth
under law.
Insurance undertakings are called upon to follow the standards of a prudent
individual in asset investment activities.

" Definition The standard of a prudent individual,22 brought in under Solvency

II, foresees that an insurance undertaking invests assets so as to:

• Identify, measure, monitor, manage, control and report connected market risks.
• Ensure characteristics of security, liquidity, yield and quality of the portfolio
overall are achieved.
• Ensure they are available for use.
• Render investments in derivative instruments contribute to reducing the level of
aggregate risk of the portfolio.
• Render investments in instruments not listed in regulated markets are kept at
prudent levels.
• Abide by a principle of insurance principle of diversification of portfolio
(by issuer, specific geographic areas, by belonging to a group of undertakings).

Assets held by an insurance undertaking and intended to cover technical reserves

must be invested in the best interests of assureds, policyholders and beneficiaries all
the time considering the nature of the risks taken on, commitments and duration.
They are kept separate from the aggregate equity of the undertaking and utilising
them is confined exclusively to meeting the contract obligations of the insurance
undertaking.

6.4.4 Solvency Margin Definition

As was dealt with previously, an insurance undertaking features an inverse produc-

tion cycle, i.e. collection of premiums prior to payment of loss events. This peculiar-
ity of the business leads, on the one hand, to managing and investing sizeable
monetary flows and on the other, the setting up of specific technical reserves to
meet possible future debts towards assureds.23
In the industrial sector, a potential uncertainty is failure to collect revenues
sufficient to cover production costs that have already been incurred. Conversely, in
the insurance industry, risk relates to the arising of unexpected future costs greater
than premiums already collected. In both cases, the consequences deriving from this
uncertainty generate a risk of insolvency for the insurance undertaking.

22
See Article 132—Prudent person principle—of Directive 2009/138/EC (Solvency II).
23
For an in-depth treatment of the model of functioning of an insurance undertaking see Chap. 3
where the principles underlying technical reserves are illustrated.
96 6 The Insurance Business

In order to minimise the danger of crisis situations in the sector of insurance

services, lawmakers have foreseen a duty placed upon market operators to equip
themselves with special equity—financial funds as a form of guarantee for ensuring
business continuity.

" Definition Materially, insurers are required to abide by a number of minimum

requirements as to their capital. Equity compliances required to match a capital made
up of own funds of the insurance undertaking protecting assureds in cases of
insolvency. This economic magnitude is in reality a sort of “security fund” called
required Solvency Capital Requirement—SCR or solvency margin.24

The sum of the requirement that every insurance undertaking must set up is
determined according to precise rules set by lawmakers. In Europe, current regula-
tion foresees that two methods may be adopted in determining the capital require-
ment. (1) a standard formula that is the same for all undertakings; (2) a customised
formula for the individual insurer.25 The difference between the two formulas resides
in the fact that the first one is simplified but demands meeting a requirement that is
higher in order to take into consideration that fact that this formula can be applied to
all insurance undertakings in the territory of Europe and for all lines of insurance
business. The second formula on the other hand is customised and calibrated for each
insurance undertaking. In this case, it is necessary for the calculation to be approved
by lawmakers and leads to a commitment in terms of design that is significant for an
insurance undertaking that has chosen to apply it. On the other hand, it does have the
advantage of the sum of the capital requirement being lower as compared to that
foreseen under the standard formula, as it is calculated on an itemised basis and not
on sector averages.

" Definition Capital set as a guarantee by an insurance undertaking is called Own

Funds (OF).

Once the solvency requirement (the so-called SCR explained above) has been set,
an insurance undertaking compares it against the level of capital available so as to
measure the extent to which it is covered.

" Definition The ratio applying between own funds and capital required is called
the Solvency ratio or Cover(age) ratio,26 and equates to:

24
The concept of solvency margin is dealt with in detail in Chaps. 29 and 30.
25
It should be noted that a mixed form of the two methods is possible. For a detailed explanation of
the methods of calculation for Solvency II see Chap. 29.
26
For a treatment of these themes see Chap. 29.
6.5 Equity Investments in the Insurance Industry 97

Own Funds
Required
Solvency
Margin

Solvency Ratio =
Own Fund/
Solvency margin

Fig. 6.2 Relationship between required solvency margin and own funds

Solvency Ratio = OF=SCR ð6:1Þ

As can easily be discerned, the greater this is, the better capitalised an insurance
undertaking is, as it holds a value of own funds greater than the guarantee capital
requirement demanded by regulations.

Conversely, in cases of values lower than 1, an insurer is unable to abide by the

requirements demanded. If this were to occur, the insurance undertaking ought not to
operate and it would be necessary for the supervisory authority to intervene with
various actions to protect stakeholders.27
See Figure 6.2 which illustrates graphically the relationship applying between
solvency margin (or solvency requirement—SCR illustrated above) and available
capital or own funds.

6.5 Equity Investments in the Insurance Industry

" Definition Equity investments or holdings are shares, quotas of capital or other
financial instruments that grant the holder administrative rights in an enterprise or
special rights.

27
Themes relating to corporate crises are illustrated in this chapter in forthcoming paragraphs.
98 6 The Insurance Business

In the matter of share investments, it is possible for insurance undertakings to acquire

equity investments in the capital of other undertakings, widening it also to the
purchase of investments in the capital of insurers carrying on a business not directly
allowed for an insurance undertaking. In order to safeguard the stability of insurance
undertakings, authorisation procedures, disclosure obligations and powers to request
information and make inspections on the part of sector oversight are foreseen.

" Definition In respect of the notion of control we consider the law which speaks
of a majority of votes that can be cast in an ordinary general meeting or votes that are
sufficient to exercise a dominant influence, which occurs when on the basis of
agreements or holding of equity interests, a party has the right to appoint or revoke
directors or the oversight board.

We have further instances of dominant influence in cases wherein there are

insurance, reinsurance, financial and organisation ties such as to pass on profits or
losses, coordinate management of the insurance undertaking in which an equity
interest is held with management of other undertakings with the aim of pursuing a
common purpose, award greater powers as compared to those of other interests held
or award the power to choose directors and managers to parties other than holders of
equity interests.28
The general criterion used by the oversight Authority of the country for issuing
authorisation is ensuring healthy and prudent management of an insurance under-
taking referring both to the financial stability of the plan of acquisition and the
qualities displayed by the potential purchaser. If these do not apply, or there is
suspension or revocation of authorisations, voting rights may not be exercised.
They are indeed allowed to take control or acquire substantial equity interests as
long as these transactions do not lead to a danger to the stability of the investing
undertaking itself having regard to oversight Authority of the country, which the
nature and trend in the business carried on by the company invested in: the scale of
the investment, the need to diversify and disperse investments in connection with the
equity of insurance undertaking such as to ensure fitting levels of security, quality,
liquidity and return on these.
The important innovation concerns it being possible for insurance undertakings to
acquire with their own free capital.

" Definition Free capital is the part of assets non bound to hedging technical
reserves, even controlling interests in insurers carrying on businesses other than
those allowed to insurance undertakings directly.29

28
Meeting of requirements of integrity is also needed for holders of equity investments and a lack of
these leads to it being impossible to exercise the right to vote and other rights deriving from the
interests held.
29
See Chap. 3—for further explanation about free capital.
6.6 Insurance Groups 99

6.6 Insurance Groups

The legal discipline of groups is based on the rules contained in the community
directive 98/78/EC in respect of additional supervision of insurance undertakings
belonging to insurance groups.
An insurance group may be one of two kinds: participating undertaking
exercising centralised coordination or alternatively an insurance holding company.30

" Definition Participating undertaking exercising centralised coordination is

one that has an EU insurance undertaking as parent and EU, community or extra-
community insurance undertakings as controlled companies, EU, community or
extra-community reinsurance undertakings and/or enterprises serving a purpose or
insurance holding enterprises—wherever they have their place of business.

" Definition An insurance holding enterprise is defined as a controlling enter-

prise that has as its main or exclusive company purpose the taking on of controlling
equity interests in insurance/reinsurance undertakings, the managing and drawing
value from these equity interests and that, in addition, among the controlled
undertakings there is at least one EU insurance or reinsurance undertaking.31

A parent undertaking, whether an insurance or a reinsurance undertaking, or an

insurance holding enterprise must meet the criteria of nationality of control and
independence if it is to be able to exercise the functions of direction and coordination
of a parent of group of companies, which implies:

1. Having a place of business in European Union.

2. The equity interest being one of control.
3. That in its turn it is not controlled by an insurance or reinsurance undertaking or,
alternatively, by insurance holding enterprises that can be held already to be a
parent company.

Excluded from the perimeter of an insurance group are banking companies,

financial intermediation companies and savings management companies linked by
equity interest to insurance undertakings.
The legal discipline on insurance groups meets a need to submit insurance groups
to additional oversight as compared to the individual insurance and reinsurance
undertakings making it up.
The powers of the oversight Authority of the country over groups concern it being
possible to make inquiries, request information, have documents produced, perform

30
For this section see Title III—Supervision of insurance and reinsurance undertakings in a group—
articles from 212 to 266—Directive 2009/138/EC Solvency II.
31
Do not confuse with a MFHC—Mixed Financial Holding Company. This latter is governed
instead by rules on financial conglomerates.
100 6 The Insurance Business

checks and verification and issue regulations aimed at ensuring “stable and efficient
management of the group” on specific matters such as procedure of risk management
and internal audit.32

6.7 Financial Conglomerates

Financial intermediaries, whether banks, insurance undertakings or investment

enterprises, have adopted strategies of aggregation between companies in recent
decades that have led to the birth of groups of enterprises in which there are firms
carrying on non-homogeneous financial businesses, not only banking business, not
only insurance business and not only securities intermediation businesses.
These corporate groups are known as financial conglomerates: after a series of
company acquisition transactions, a group takes on the features of a financial
conglomerate when its growth in scale is noteworthy, the business carried on within
it belong to different financial sectors and the enterprises that form part of a group
began life in different countries and the structure of the group acquired overall is
international in operation.

" Definition A financial conglomerate is defined as a group of companies whose

main business is financial in type and of which at least one insurance undertaking
and at least one bank or investment enterprise form part of it.

From the standpoint of organisation, in financial conglomerates there is a holding

company which in many cases mainly performs an activity of coordination and
direction of the entire group and holds the equity investments of the insurance,
banking and financial undertakings.
Concerning risk management in financial conglomerates, risks that typically
weigh upon each of the enterprises making them up are to be found:

• A risk of conflict of interest deriving from there being within a financial con-
glomerate of banks, asset management and investment banks at the same time.
• Double gearing, double counting of capital can occur with intra-group loans in
order to make the aggregate capital of the financial conglomerate appear greater.
• Regulatory arbitrage, when there is a risk of possible shifting of assets from one
sector to another or from one country to another where equity requirements or
regulatory rules are less strict or over oversight controls are less severe.
• Contagion risk and reputational risk; it may happen that any losses recorded by an
enterprise and resulting adverse effects on the reputation and loss of trust in
individual intermediaries spread to other components of a financial conglomerate.

32
See Title III—Supervision of insurance and reinsurance undertakings in a group Articles 212–266
of Directive 2009/138/EC (Solvency II).
6.9 Insurance Portfolio (Merger and Spin-Off Operations) 101

• Further difficulties over and above those of simpler structures in risk control
activities.

Current legislation of financial conglomerates is contained in Directive 2011/89/

EU of the European Parliament and of the Council as regards the supplementary
supervision of financial entities in a financial conglomerate.33

6.8 The Reinsurance Business

" Definition Reinsurance business is an activity that concludes with the accep-
tance of risks ceded by an insurance and reinsurance undertaking; an insurer
transfers a risk or part of it to a third party, a reinsurer.

As a rule, between an assured—whose risk borne by an insurer (known as reinsured

or cedant) is ceded—and the reinsurer (cessionary) there is no kind of relationship.
Everything is concluded between insurer and reinsurer.
As for insurance undertakings, reinsurance business is set aside solely for rein-
surance undertakings; in addition to reinsurance business, undertakings such as these
may carry on businesses that are connected to or for the purpose of reinsurance
business. Businesses that are connected to or for the purpose of reinsurance business
are activities processing statistical or actuarial analyses of risks or activities of
research for clients of the reinsurance undertaking, activities of a holding company
or activities connected with the banking, insurance, or investment services sector.34

6.9 Insurance Portfolio (Merger and Spin-Off Operations)

Extraordinary operations of an insurance undertaking bring about profound changes

in the organisational arrangements of the undertaking.
A first type of extraordinary operation concerns matters of transfer of an insur-
ance portfolio.

" Definition The insurance portfolio of an insurance undertaking is defined as the

series of insurance contracts, including the payables and receivables tied to these
contracts, that display a common distinctive element such as can be found in
belonging to a single or a number of lines of business, a distribution channel of
collection, a type of policyholder, a territorial area and in any common element that
will allow identification to be made of the overall relations ceded; a portfolio may be
made up solely of loss events.

33
This Directive amended the previous ones (Directives 98/78/EC, Directive 2002/87/EC, Directive
2006/48/EC).
34
Legal discipline of reinsurance business was reformed by Directive 2005/68/EC.
102 6 The Insurance Business

" Definition Transfer of an insurance portfolio consists of a passing from one

insurance undertaking (the cedant) to another (cessionary undertaking) of contracts
via a contract of cession, or conferment in kind.35 In the first case, the cedant
insurance undertaking will transfer the portfolio in return for setting a price of
cession; in the second case, consideration for the cession is an equity investment
in shares.

" Definition Merger is an operation that allows a larger undertaking to be created

through concentrating a number of undertakings in a single party from the economic
and legal standpoints.

In a merger in the strict sense, two or more insurance undertakings go to making

up a new insurance undertaking, one created ex novo. In merger by incorporation,
one of the undertakings taking part in the merger survives in the industry and brings
into itself the other undertakings, which then cease to exist. In general, the equity of
the undertaking emerging at the end of the merger process is the sum of the equity of
the undertakings that have taken part in the operation.

" Definition Spin-off or demerge is the opposite operation to merger. By spin-off,

separation out is achieved of the equity of an undertaking into two or more
undertakings, either already existing or newly set up. If the equity of the original
undertaking is completely redistributed among the other undertakings, then the
insurer spin-off will cease to exist.

Merger and spin-off operations involving EU insurance undertakings are subject

to preliminary investigation by the oversight Authority of the native country, which
will issue authorisation after having checked that the project does not go against
healthy and prudent management of the insurance undertakings concerned in the
operation. The oversight Authority will also verify the conditions of the solvency
margin and assets hedging technical reserves and the overall equity and economic
situation of the undertakings taking part in the operation, both prior and subse-
quently to the date of the merger or spin-off.

6.10 Management of Insurance Crises

Non-abidance by rules in respect of the correct provision of technical reserves and

solvency margin will make an insurance undertaking subject to a risk of imbalances
in operations. An insurance undertaking may find itself in serious difficulties when
technical reserves set aside are found to be inadequate or insufficient to meet
commitments made, when net equity is found to be lower than the solvency margin
or the guarantee quota, or when a corrected solvency situation is found to be

35
See Article 39—Transfer of the portfolio of Directive 2009/138/EC (Solvency II).
6.10 Management of Insurance Crises 103

unfavourable. In all these cases, insurance law foresees adopting a series of

safeguarding and recovery measures to protect the interests of assureds.36
If the breaches concern rules in respect of technical reserves and assets intended
to cover them, the oversight Authority of the country will set a fitting term, by the
end of which the insurance undertaking must implement the compliances required. If
the insurance undertaking fails to comply with the term set, the oversight Authority
of the country may appoint a commissioner with powers for carrying out individual
acts that are necessary for elimination of the breaches.
When an insurance undertaking finds itself in a situation of criticality and thus the
rules in respect of the solvency margin are not abided by, the oversight Authority of
the country will request submission of a plan of operational recovery; if the solvency
margin is found to be lower than the guarantee quota, the insurance undertaking will
be called upon to submit a plan of short-term financing along with the measures
adopted for recovery of its financial position.
In cases of serious non-abidance by the law, the oversight Authority of the
country may order appointment of a commissioner to carry out individual acts that
are necessary to bring the situation back to normal.

" Definition When there are serious irregularities in the administration and in cases
of serious breaches of administrative law or articles of association regulating the
business of the insurance undertaking, or grave equity losses are foreseen, extraor-
dinary administration may be ordered.

This procedure causes dissolution of the administrative and control bodies of the
insurance undertaking. Administrative functions of the undertaking are performed
by extraordinary commissioners, whereas the management board performs functions
of the board of auditors. The procedure lasts a maximum 12 months which may be
extended for a period not in excess of 12 months.
When the irregularities in administration or the breaches of legislative, adminis-
trative or articles of association provisions or losses foreseen are of exceptional
seriousness, the law foresees putting an insurance undertaking into compulsery
administrative liquidation. In this case, in addition to forced liquidation, it will
also order revoking of the authorisation to carry on insurance business.
In addition to forced administrative liquidation of an insurance undertaking,
revoking of authorisation may also be ordered when the undertaking does not stay
within the limits imposed in the authorisation order.

" Definition The procedure of revoking of authorisation can happen when the
insurance undertaking no longer abides by the scheme of operations, when the
conditions for access to insurance business are no longer met, when the insurance
undertaking is gravely non-compliant with provisions or has failed to complete the

36
See Chapter VII—Insurance and reinsurance undertakings in difficulty or in an irregular situa-
tion—Articles 136—144 of Directive 2009/138/EC (Solvency II).
104 6 The Insurance Business

measures foreseen within the term set and, finally, when the judicial authority
declares that a state of insolvency applies.

6.11 The Insurance Undertaking and Compulsory Insurance

Compulsory insurance mainly concerns circulation on road of motor vehicles and

circulation on water of watercraft. As is well-known, in order to circulate (navigate)
in the European Union with these conveyances, one needs to have obligatorily
concluded a policy of civil liability to third parties for injuries that might be caused
by loss events, with an insurance undertaking.
From the standpoint of insurance undertakings, the law foresees an obligation to
take out insurance.37

" Definition Obligation to take out insurance means that insurer may not fail to
conclude a contract of insurance once they have received a proposal from a potential
assured that is compliant with the policy conditions and tariff that the undertaking
actually has the onus of setting in advance for a generality of risks.

The law allows an insurance undertaking the chance to carry out checks and
verification of the accuracy of the information that a potential assured provides prior
to concluding a policy through queries to public databases like the public automobile
registry and the national archive of vehicles so as to prevent and combat fraud in the
area of insurance. Undertakings are also allowed the chance to make inspections
upon a vehicle to be insured: in this case, the law grants a potential assured the right
to a reduction of the tariff price. Significant reductions in a tariff premium must be
granted also if electronic devices that record the activity of a vehicle, such as black
boxes and the like, are installed.
In this regard, in several Countries, the oversight Authority of the country
manages a loss event database that is fed by information that insurance undertakings
sent via IT flow concerning reports of losses received. The loss event database can be
consulted by insurance undertakings, judicial bodies and public administrations with
concern in the matter of preventing and combating fraud in compulsory automobile
insurance.

6.12 Questions

1. What are the requirements for a European company?

2. What does single authorisation mean?
3. How many are the classes of insurance for non-life business?
4. How many are the Line of business? Describe each of them.

37
See Article 179—Related obligations. in the section Compulsory insurance of Directive 2009/
138/EC (Solvency II).
References 105

5. What is a system of corporate governance in the insurance industry?

6. How do you explain the investment process and related reserves
management?
7. How is the solvency margin calculated?
8. What is the concept of dominant influence?
9. What are the main differences between financial conglomerate and insurance
group?
10. What are the reasons for revoking the authorisation of an insurer?

References
Benink HA (2013) Financial integration in Europe. Springer, Dordrecht
Marano P, Noussia K (2022) The governance of insurance undertakings. Springer, Cham

Directives and Regulations—Chronological Order

Directive (EU) 2016/97 of the European Parliament and of the Council of 20 January 2016 on
insurance distribution (IDD)
Directive 2011/89/EU of 16 November 2011 amending Directives 98/78/EC, 2002/87/EC, 2006/
48/EC and 2009/138/EC as regards the supplementary supervision of financial entities in a
financial conglomerate
Directive 2009/138/EC of the European Parliament of 25 November 2009-Including further
modifications - taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II)
Council Directive 2004/113/EC of 13 December 2004 implementing the principle of equal treat-
ment between men and women in the access to and supply of goods and services
Directive 2002/87/EC of the European Parliament and of the Council of 16 December 2002 on the
supplementary supervision of credit institutions, insurance undertakings and investment firms in
a financial conglomerate
Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on
insurance mediations
Council Directive 92/49/EEC of 18 June 1992 on the coordination of laws, regulations and
administrative provisions relating to direct insurance other than life assurance and amending
Directives 73/239/EEC and 88/357/EEC (third non-life insurance Directive)
Council Directive of 19 December 1991 on the annual accounts and consolidated accounts of
insurance undertakings (91/674/EEC)
Council Directive 90/619/EEC of 8 November 1990 on the coordination of laws, regulations and
administrative provisions relating to direct life assurance, laying down provisions to facilitate
the effective exercise of freedom to provide services and amending Directive 79/267/EEC
Second Council Directive 88/357/EEC of 22 June 1988 on the coordination of laws, regulations and
administrative provisions relating to direct insurance other than life assurance and laying down
provisions to facilitate the effective exercise of freedom to provide services and amending
Directive 73/239/EEC
Directive 83/349/EC of 13 June 1983 Seventh Council Directive of 13 June 1983 based on the
Article 54 (3 ) (g) of the Treaty on consolidated account
First Council Directive 79/267/EEC of 5 March 1979 on the coordination of laws, regulations and
administrative provisions relating to the taking up and pursuit of the business of direct life
assurance
106 6 The Insurance Business

Fourth Council Directive of 25 July 1978 based on Article 54 (3) (g) of the Treaty on the annual
accounts of certain types of companies
Council Directive 77/92/EEC of 13 December 1976 on measures to facilitate the effective exercise
of freedom of establishment and freedom to provide services in respect of the activities of
insurance agents and brokers (ex ISIC Group 630) and, in particular, transitional measures in
respect of those activities
First Council Directive 73/239/EEC of 24 July 1973 on the coordination of laws, regulations and
administrative provisions relating to the taking-up and pursuit of the business of direct insurance
other than life assurance
DIRECTIVE 2013/36/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 26
June 2013 on access to the activity of credit institutions and the prudential supervision of credit
institutions and investment firms

Directives and Regulations—Chronological Order

Regulation (EU) 2019/1238 of 20 June 2019 Regulation of the European Parliament and of the
Council of 20 June 2019 on a pan-European Personal Pension Product (PEPP)
Delegated Regulation (EU) 2019/1935 of 13 May 2019 Regulation amending Directive (EU) 2016/
97 with regard to regulating technical standards adapting the base euro amounts for professional
indemnity insurance and for financial capacity of insurance and reinsurance intermediaries
Delegated Regulation (EU) 2017/2358 of 21 September 2017 Supplementing Directive (EU) 2016/
97 of the European Parliament and of the Council with regard to product oversight and
governance requirements for insurance undertakings and insurance distributors
Delegated Regulation (EU) 2017/2359 of 21 September 2017 Regulation supplementing Directive
(EU) 2016/97 with regard to information requirements and conduct of business rules applicable
to the distribution of insurance-based investment products
Commission Delegated Regulation (EU) 2017/653 of 8 March 2017 Commission Delegated
Regulation (EU) 2017/653 supplementing Regulation (EU) No 1286/2014, on key information
documents for “PRIIPs” products
Regulation (EU) No 2014/1286 of 26 November 2014 Regulation on key information documents
for “PRIIPs” products

Suggestions for Further Study

Benoît C, Del Sol M, Martin P (2021) Private health insurance and the European Union. Palgrave
Macmillan, New York. https://doi.org/10.1007/978-3-030-54355-6
Dorfman MS (2008) Introduction to risk management and insurance, 9th edn. Pearson, New York
Turchetti G (2000) Innovazione e reti distributive nel settore assicurativo. Analisi teorica
e comportamenti strategici. Franco Angeli, Milano
Vaughan EJ, Vaughan TM (2013) Fundamentals of risk and insurance, 11th edn. Wiley,
Hoboken, NJ
The Insurance Contract
7

Abstract

In this chapter, the contract of insurance is explained. The differences existing

between a non-life insurance contract and a life insurance contract are explored.
The obligation foresees that an insurer undertakes a risk in return for consider-
ation in the form of an insurance premium. An assured is obliged to the payment
of the premium and for the truth and accuracy of the information given.
In non-life insurance contract, the settlement of a claim is bound by an
indemnity principle according to which the insurer will pay only if the loss occurs
and to the precise extent this is suffered by the assured. In life insurance contract,
the insurer will pay a lump sum or an annuity upon the occurring of an event tied
to the life of the assured. The involved parties (insurer, policyholder, assured and
beneficiary) are explained.
Contractual documentation foresees some standard documents, such as pro-
posal form, acceptance, policy, scheduled, endorsement, certificate of insurance
(if required Health History Questionnaire (HHQ).
In the end, the current developments in Europe are illustrated. The paragraphs
describe the life product classification (PRIIPs, IBIPs, PRIPs) and the related new
pre-contractual documents required (KID and IPID for non-life business).

Keywords

Function of indemnity · Non-life contract of insurance · Life insurance contract ·

Provision for life principle · Principle of indemnity · Insurable interest · Insurable
value · Over-insurance · Under insurance · Proportional rule · Gambling Act ·
Policyholder · Assured · Beneficiary · Insurer · Instalment interest · Care, custody
and control (CCC) · Consideration · Excess · Franchise · Self-insurance · Waiting
period · Contract of an aleatory type · Insurability conditions · Conditions of
exclusion · Named perils vs. all-risks · Contract · Policy · Endorsement ·
Certificate of insurance · Proposal form · Health History Questionnaire (HHQ) ·

# Springer Nature Switzerland AG 2024 107

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_7
108 7 The Insurance Contract

General conditions of policy · Particular conditions of policy · Unfair contract

terms (UCTs) · PRIIPs · IBIPs · PRIPs · KID · IPID

7.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Be aware of the definition of an insurance contract

2. Know the difference there is between a life insurance contract and a
non-life insurance contract
3. Recognise conditions for insurability underlying a contract
4. Know who the subjects involved in an insurance contract are and be
acquainted with their obligations
5. Explain current developments in European regulations concerning insur-
ance contracts
6. Illustrate the PRIIPs products

7.2 Definition of the Insurance Contract

In a non-life insurance contract, an insurance undertaking agrees, in return for

payment of a premium, to indemnify an assured up to agreed limits in respect of a
loss they have from a loss event. However, a life insurance contract foresees a duty
for the insurer to pay a lump sum or an annuity upon the occurring of an event
concerning human life.
From this definition of the contract, three important elements can be identified,
and which characterise an insurance agreement. We can indeed recognise:

1. The two specific areas of insurance: non-life insurance and life insurance.
2. A commitment by the insurer to pay a sum of money or to provide services at any
time a number of conditions were to apply.
3. The main obligation for the policyholder is to pay the premium.

From this initial description it can be understood that it performs two fundamental
functions: an indemnification function and a provision for life function.
7.4 Life Insurance Contract 109

7.3 Non-Life Insurance Contract

" Definition The function of indemnity of a non-life insurance contract concerns
protecting the wealth of an assured. By insuring, this party protects self from loss
caused by an adverse event from a risk run.

Indemnification is bound by the general principle of the insurance

contract—Indemnity Principle - according to which the insurer will pay only if the
loss occurs and to the precise extent this is suffered by the assured.

" Definition A non-life contract of insurance aims to indemnify whole the assured
in respect of the loss suffered following a loss event occurring. A fundamental
element is the interest of the assured in indemnification of the loss.

If this interest fails to apply, the contract is null and void. The risk pertains to an
event that, should it occur, would cause loss to the person, to the goods or the wealth
of the assured. The loss may be caused by natural events such as, for example hail or
illness or could arise from culpable (not wilful) conduct of the assured for which a
liability towards third parties might come to apply.

7.4 Life Insurance Contract

" Definition A life insurance contract is a contract from which a duty arises for
an assured to pay a premium to the insurer while the latter undertakes to pay a lump
sum or an annuity to a beneficiary if an event tied to human life occurs and which
may be decease or survival of the assured at a certain age and set forth in the policy.

The provision for life function of life insurance relates to the protection given by the
insurer against risks of early death, survival beyond a certain date and disablement of
the assured.

" Definition A provision for life principle applies which establishes that the
benefit by the insurer is due based on premiums paid in, as the existence of a
necessity to apply or a loss to the assured or their heirs or the beneficiary of the
insurance policy is not necessary in this case.

Events tied to human life may cause a future need to have sums of money
available to arise, and this is the main reason driving the taking out of life insurance.
In insurances for cases of death, the assured protects their heirs, their family, from
the risk of early death from which there may derive, if they die, the main source of
family income ceasing to apply. At the same time, insurance for cases of survival
also offer protection from the risk of the assured continuing to live as age progresses,
the capacity to produce earnings reduces to an increasing extent, and a need arises to
have available economic resources in old age that can maintain a standard of living
unchanged over time.
110 7 The Insurance Contract

7.5 Insurable Interest and Insurable Value

As seen above, non-life insurance protects the wealth of an assured mainly by

performing a function of protecting the whole of wealth. An assured insures so as
to transfer adverse economic consequences arising from a loss event.
At the same time, a loss is the prerequisite for, and limited to, the insurance. For
insurance to produce the effects for which it has been taken out, it is necessary for the
loss event included among those covered under the contract to occur but, the loss is
also the maximum limit of indemnity. Indeed, no gain or illegitimate profit can
derive for the assured from a loss event occurring.

" Definition The principle of indemnity therefore implies that an insurer may not
pay an indemnity to the assured greater than the value of the loss suffered, or a case
of unjustified gain would arise for the assured.

" Definition Insurable interest is the main cause of the agreement, both for a
non-life insurance contract and a life insurance contract. Insurable interest is any
interest a person has in a possible subject of insurance, such as a car or home.1

We can begin by dealing with the non-life insurance contract. For an insurance
agreement to be valid, it is necessary for an economic relationship to exist binding
the assured to the item considered under the insurance contract.
Insurance protection for a certain item of property can arise not only when dealing
with the owned property but rather it is even sufficient for there to be a right of
enjoyment or a liability towards the item itself.
In detail, we speak of a concurrent interest of the assured when there is a right of
any kind enjoyment or guarantee or usufruct on the part of the assured. On the other
hand, we call it an indirect interest when a third party has any liability for the
wholeness of the goods of others, such as, for example the interest of a carrier of an
item carried. In this case, a carrier is liable for any loss of or damage to an item.

" Definition Loss caused by a risk event is the injury to the economic interest of
the assured on the item. The insurable value, i.e. the initial value of the item,
represents the value of this interest and must appear in the contract of insurance.

Based on the insurable value, an insurer calculates the sum insured that will
determine the insurance premium. It may happen that the value of the item insured
changes over time and that the insurable value and sum insured no longer match. In
this case, we may have two situations: over-insurance or underinsurance.

1
For this definition see Kaplan (2015) Glossary of Insurance Terms (7th Edition)—Kaplan Finan-
cial Education.
7.5 Insurable Interest and Insurable Value 111

" Definition There is over-insurance when the value declared in respect of the
item is greater than the actual value; in the event of the item diminishing in value, if
an accident occurs, the insured obtains a refund equal to the actual value at the time
of the event (insurable value).2

In cases of future goods, the value is calculated in connection with the presumable
value of realisation at the time of collection or maturity. For the future, it is possible
to obtain the correlative reduction in premium.
The opposite case is one of possible underinsurance.

" Definition In underinsurance, assessment of the value insured is found to be

lower as compared to the actual value of the item (insurable value). In this condition
there is not enough insurance carried to cover insurance value. Insurance is thus
partial when insured covers only a part of the value of the item that is the subject
matter of the cover at the time of taking the policy out, underestimating the severity
of the damage.

In cases of underinsurance, the insurer will be liable for losses in proportion to the
assured part.

Proportional Rule/Average
The proportional rule (called Average) is based upon the principle that when
a loss event occurs, the insurer will meet losses in proportion of the value
insured as compared to the actual value, unless otherwise agreed.
The proportional rule is thus a rule in accordance with which the assured
will bear any part of the loss in proportion to the difference between the actual
value (found at the time the loss event occurs) and that insured. An insurance
undertaking will, indeed only cover the part of the value actually insured 1.
Whereas the assured will remain self-insured for the value of the loss event
that is not adequately insured.
If there is underinsurance, or when at the time the loss event occurs, the
value shown in the policy is found to be lower that the actual value, the
proportional rule limits the sum of the settlement paid out by an insurance
undertaking. Taking up the concepts set out in previous paragraphs, there is
underinsurance when the value insured is lower than the value actually
insurable. Let us recall that the actual insurable value is the sum representing
the value of the item to be protected, whereas the value insured is the sum
reproducing insurable value in the policy.

(continued)

2
When an insured has purchased coverage for more than the actual value of the insurable value, this
situation could constitute a moral or morale hazard, such as having so much disability income
insurance in force that it becomes profitable to be disabled. For the moral hazard or morale hazard
see Chap. 2.
112 7 The Insurance Contract

This set up derives from the fact the insurance premium is quantified on the
value insured and, so, a situation of underinsurance leads to paying a premium
that is insufficient to meet the obligation borne by the insurer. Consequently,
in respect of the part of the premium not paid, the assured is uninsured (self-
insured).
In this case, the assured is not indemnified for the entire sum of the loss , but
rather receives an indemnity reduced in proportion to the ratio applying
between the value insured and the actual insurable value of the item at the
time the loss event occurs.
This set up limits the application of underinsurance to direct insurances
protecting property, whereas it is not possible to apply it to insurances on civil
liability and against personal accident.
A typical case would be a policy taken out several years ago on a building
with a value insured that has never been updated in subsequent periods, and
the insurable value, either due to inflation or costs of materials to rebuild it
have increased by 33%. See Table 7.1. for a numerical example.

Table 7.1 Proportional rule, numeric example

Parameter Amount
Actual insurable value at the inception 100,000
Inflation and increased reconstruction costs from the 33%
policy inception date to the date of the claim
Actual insurable value at the date of the claim 100,000 ∙ (1+33%) = 133,000
Underinsurance amount 133,000 – 100,000 = 33,000
Loss 10,000
Indemnity paid 7,519

The amount of the loss settled reduced by applying the proportional rule in
cases of underinsurance is given by the following formula:

actual loss
ðvalue insured=actual insurable valueÞ

¼ indemnity to be settled 10, 000
ð100, 000=133, 000Þ ¼ 7, 519 ð7:1Þ

This rule works only in cases of partial loss. In reality, in cases of total loss,
the indemnity is the same as the insured value itself due precisely to applying
the rule.
This is a fundamental rule for settling loss events as the first activity that is
performed by the adjuster appointed by the insurance undertaking consists of

(continued)
7.6 Parties to an Insurance Contract 113

calculating the “pre-existing value”, i.e. the actual insurable value. This so as
to ascertain whether there is any need for a proportional reduction of the
indemnity.3

For a contract of life insurance, interest in the person assured was set forth by
enacting of the Gaming Act in 1774 by the English Parliament This order
promulgated by King George III states for the first time that it is legitimate to insure
the life of another provided that the policyholder has an interest in it. The
consequences of this law were crucial in the development of insurance in continental
Europe. Since that time there has been a net criterion for distinguishing between life
insurance and wagers. As with non-life business, in this case too, the interest must be
specific, current, legitimate and economic. A relationship that is merely of affection
or moral is of no relevance.

7.6 Parties to an Insurance Contract

In a contract of insurance, four distinct parties can be identified: the policyholder, the
assured, the beneficiary and the insurer.

" Definition The policyholder is the party taking out the contract and who
undertakes to pay the insurance premium. The policyholder is the person in actual
possession of an insurance policy. Often this word is used loosely to refer to the
policyowner and/or assured.

" Definition The assured is a subject (person or thing) upon whom the risk that is
the subject matter of the cover bears: in non-life business, they will be the bearer of
the interest to be protected, whereas in the life business, they will be the party
subjected to the risk of early death or survival.

" Definition The beneficiary is the party receiving the performance of the insurer.
The beneficiary is the person who may become eligible to receive benefits under an
insurance policy.

" Definition The insurer is an operator who is organised in a stable manner and
who transfers the risks of assureds in return for a consideration commensurate with

3
It should be noticed that where high rates of inflation apply, insurance undertakings may issue
contracts where an adjustment to the rate of inflation over the previous 12 months is added to the
sum insured at each anniversary date with a related automatic renewal premium adjustment In the
area of “Corporate” insurance, there is also frequently a clause waiving the rule of average via
which this will not be applied if the sum insured is found to be insufficient by a certain percentage
not in excess of 20%.
114 7 The Insurance Contract

the likelihood of the events to which the risks refer occurring. Risks subject to
transfer may be linked to indemnification for a loss or payment of a lump sum or an
annuity or render services.

When the policyholder and the assured are separate figures, there is a case of
insurance on behalf of another. In this case, the policyholder insures the interest of a
third party rather than insuring their own interest. The policyholder must meet all the
obligations contained in the contract, whereas the rights belong to the area of the
assured. A typical example is group life policies that an employer takes out on behalf
of their employees: the policyholder for the policy is the employer, whereas the
employees are the assureds.

7.7 Duties of the Policyholder

The main performance of the policyholder is the payment of the insurance premium.
The insurance premium is made up of the pure premium and loadings: the first
component is set aside as reserve by the insurer to form the available funds needed
for indemnification. Loadings, on the other hand, are to cover future costs in respect
of managing the contact just taken out (for example commissions of acquisition and
premium collection, policy management expenses, loss settlement and a part of
profit for the undertaking).
According to the principle of indivisibility, the premium must be paid in full and in
advance. It is possible to foresee it is possible to break up the premium on a periodic
basis (i.e. monthly, quarterly, etc.). In this case, the policyholder achieves an advan-
tage of a financial kind through a disbursement spread out over time (but remember
that the validity of the contract is in any case tied to the entire sum being paid).

" Definition Where instalments are paid, an insurer may apply instalment inter-
est. These interests correspond to the interest rate that applies to the premium in the
event that the split payment is accorded to the insured. Applying this is achieved by
an addition made to the sum of the premium instalment.

Failure to pay the premium brings about the suspension of insurance cover. It
should be noted that an insurance contract is effective with effect from the time when
the policyholder receives acceptance of the proposal for the contract from the
insurer. This contract produces no effects as to insurance cover until the premium
is actually paid.

" Definition Concerning the principle of Care, Custody and Control (CCC) of a
property, most liability insurance contracts exclude the cover for damage or destruc-
tion to property in the care, custody and control of an insured. This cover is excluded
from liability policies because two main reasons: the insured either have some
ownership interest in such property (In this case, they are better covered through
property insurance) or they are a bailor of the property (and can better cover this
bailment exposure through an appropriate policy).
7.8 Duties of the Insurance Undertaking 115

7.8 Duties of the Insurance Undertaking

The performance of the insurer lies in preparing all the activities and conditions
aimed at meeting an obligation of a pecuniary nature if due. Payment of the
indemnity in non-life business and the lump sum or annuity in life business, or
provision of services is indeed but one of the activities making up the performance of
the insurer.

" Definition Consideration is the exchange of value on which a contract is based.

In insurance, the consideration offered by the insured is usually the premium and
the statement contained in the application. The consideration offered by the insurer is
the promise to pay in accordance with the terms of the contract.

Payment of the indemnity is subject to the risky event occurring. The uncertainty
refers both to the possibility of the event occurring and the future time when it
happens. The sole exceptions are certain life insurances.
In a number of insurances, the performance of the insurer may be a performance
in kind (or services) rather than a performance in money. This is typical in assistance
insurances, where the insurer proceeds to reinstate the loss (for example a break-
down truck service or services of medical consultation, etc.).
Finally, there are certain clauses limiting the performance of the insurer, known
as excesses, franchise and self-insurance.

" Definition An excess leaves a part of the loss to be borne by the assured. An excess
foresees the insurer covering the damage caused by a loss event only above a certain
threshold shown in the policy. For this reason, the excess is a system that is designed to
eliminate small and be an incentive to the insured to take care of the property.4

Consequently, the excess corresponds to the portion of an insured loss that will be
borne by the insured before any recovery may be made from the insurer

" Definition Where what is called a deductible applies, the insurer will not meet
losses below a certain sum but will meet losses above this sum in full.

A excess is a part of the loss borne by the assured. Indeed, an excess will foresee
that an insurer will cover a injury caused by a loss event only for the part that
exceeds a certain threshold as shown in the policy. It leads to there being no
indemnity below a certain sum. Above that sum however, the indemnity is for the
full, remaining amount (e.g. from a loss of Euro 1,000, an “excess” of Euro 200 may
be deducted and Euro 800 paid as indemnity).
If there is self-insurance, the insurer will settle the loss in the full amount set out
in the contract but there will be a part (usually a percentage of all losses) of the whole

4
For this definition see Rubin H. W. (2013) Dictionary of Insurance Terms (6th Edition)—Barrons.
116 7 The Insurance Contract

Table 7.2 Outline comparison between the excess and self insurance
Amount borne by the
Parameters insured Indemnity
Loss ascertained gross of excesses and self-insurance = 2,000
Without excess Zero 2,000
Absolute excess Euro 500 500 1,500
Franchise Euro 2,500 2,000 Zero
Franchise Euro 500 Zero 2,000
Self-insurance 10% subject to a minimum of 100 200 1,800
Euro
Self-insurance 10% subject to a minimum of 500 500 1,500
Euro

loss that must remain borne by the assured. It may exist alongside an excess as per.
e.g. 10% or 20% of Euro 100/200/300 etc.)
A further alternative is that of applying a franchise; this foresees paying no
indemnity unless the loss exceeds a specific figure, but the indemnity will still be
paid without deduction if it does exceed the stated sum. So, a policy with a Euro 200
franchise, will pay nothing up to 200 euros, but a loss of 500 euros will be paid out
for full amount (i.e. no deduction).
In Table 7.2 an outline is given comparing the two ways of applying an excess or
franchise and self-insurance.

" Definition Self-insurance expresses a percentage, for example 10% 20%, that
the insured will bear in respect of any loss.

In addition to the types of deductibles illustrated above, there is also another type
known as the waiting period or elimination period (sometimes is also called proba-
tionary period). This form of deductible is usually found in disability insurance.

" Definition The waiting period is the period between the beginning of a disabil-
ity and the start of disability insurance benefits. Subsequently, benefits are usually
paid only for costs incurred after the end of the elimination period.5

The longer is the elimination period in a policy, and the lower is the premium.

5
This clause is put in place to protect the insurer and avoid incurring policyholders who sign a
contract in anticipation of an imminent claim (for example medical treatment).
7.9 Elements of a Valid Contract 117

7.9 Elements of a Valid Contract

A contract of insurance is a contract of an aleatory type. The performance of the

insurer is subject to a future loss event outside the control of the parties occurring.
The risk is the fundamental component of the insurance contract and is the causal
element present in both cases of insurance: non-life insurance and life insurance.
If the risk has never existed or if it ceases to apply prior to the contract being
concluded, the contract of insurance is actually null and void.
If the risk ceases to apply after the contract has been concluded, the contract is
dissolved. A reduction or a worsening of the risk leads, in the former case, to a
reduction in the premium, whereas in the latter case, the insurer may seek an increase
in the premium paid at the start of the period of insurance or may even withdraw
from the contract.

" Definition A risk is insurable when there is the possibility of a loss to a person
(individual or thing) or an event relating to human life. These include being
definable, accidental in nature, and part of a group of similar risks large enough to
make losses predictable. The insurance undertaking also must be able to come up
with a reasonable price for the insurance.6

Concerning the event that may cause a loss in an insurance sense, it may have
natural causes, as when, for example hail or frost destroys the entire harvest of a
farmer, or the loss may derive from culpable conduct, such as to prejudice the wealth
or the person of the assured. If the event that has caused the loss is brought about by
culpable conduct on the part of the policyholder the beneficiary or the assured, this is
an uninsurable loss. In order to be insurable, the risk must necessarily foresee the
effective probability that a harmful event may occur.
In defining the risk insured that will be taken on by the insurer, we consider, both
the circumstances that will accompany the event and the circumstances that, if
applying, will exclude the performance of the insurer.

" Definition In essence, the insurability conditions are the circumstances of the
risk deemed to be essential for effectiveness of insurance cover.

The latter concern risks excluded from the contract agreement.

" Definition Conditions of exclusion concern so-called “causal” limitations that

are often adopted to exclude from cover several risks that usually form separate and
stand-alone insurance agreements.

Indeed, every contract lists in detail all cases where the cover does not operate by
type of event. For this reason, they are also called exclusion or limitation clauses.

6
For this definition see Kaplan (2015) Glossary of Insurance Terms (7th Edition)—Kaplan Finan-
cial Education.
118 7 The Insurance Contract

Several items making up the risk are generic in nature, and others are particular.
While the generic elements can be measured by statistical methods for quantifying
risk, particular ones can be drawn from statements made by the policyholder at the
time of taking the first steps towards concluding the contract. These subjective
elements are important for the aggregate quantification of the risk that an insurer
will insure, above all in determining the insurance premium.
Another important type of insurance policy is the named peril contract. A named
peril contract is an insurance policy that provides coverage on losses incurred or
events explicitly named on the policy. Comprehensive insurance offers a combina-
tion of coverages contained in a single contract. Usually, the named peril coverage
may be purchased as a less expensive alternative to a comprehensive coverage.

7.10 Concluding the Contract

A contract is an agreement entered into by two or more persons, under which one or
more of them agree for a consideration to do or refrain from doing acts in accordance
with the wishes of the other party(ies).

" Definition In insurance, contract is an agreement by which an insurer agrees for

a consideration, to provide benefits, reimburse losses or provide services for an
insured.7

A contract of insurance requires an exchange of consent between the parties. The

effectiveness of the insurance contract remains anchored to payment of the premium,
unless otherwise agreed between the two parties.
The contract becomes binding because it causes an obligation borne by the
policyholders to execute performances to arise. It is a contract that has a duration,
and the obligations arising under the contract extend over time. It should be noted
that in non-life insurance contracts, duration is generally shorter than for life
insurance contracts.
Finally, the contract is one that is for a consideration as the policyholders act not
in a spirit of generosity but for a return.
In respect of the criteria for drawing up insurance contracts, one general principal
is that of maximum transparency. For this reason, the contract and any other
documentation delivered by the insurer to the assured must be drawn up in a clear
and full manner. Clarity and exhaustivity imply an itemised and complete descrip-
tion is given of the event that will be insured, any circumstances that will limit the
space and time boundaries of the risk, and the limits and exclusions from
performances on the part of the insurer.
The policy is the document containing the contract of insurance.

7
For this definition see Kaplan (2015) Glossary of Insurance Terms (7th Edition)—Kaplan Finan-
cial Education.
7.10 Concluding the Contract 119

" Definition Policy is the written statement of contract effecting insurance, or

certificates thereof, by whatever name called, and including all clauses, riders,
endorsement and papers attached thereto and made a part thereof.

Other documents that may be added to the policy are policy endorsements
containing clauses that are additional to the general clauses contained in the policy.

" Definition Endorsement is a written form attached to an insurance policy that

alters the policy coverage, terms or conditions. Sometimes called a rider.

" Definition A certificate of insurance contains details of the policy, and which
has the function of documenting the fact that there is actually a policy.

Recently, with the use of blockchain technology, the certificate of insurance has
in many States been dematerialised. All data are available in a digital fashion: proof
of payment having been made, policy details, policyholder, the name of the insur-
ance undertaking and data identifying the item insured, etc.

" Definition In contracting practice, the proposal form for insurance is in the
standard of a pre-printed form provided by the insurer and which the policyholder
fills in. Often, within the proposal form there is series of questions that has the
purpose of highlighting the information needed by them for defining the risk to be
insured.

The accuracy of the information contained in the proposal for the contract is
important because based on this, and regarding the risk, an insurer determines
whether or not the risk is insurable and performs the calculations needed to deter-
mine the premium.

" Definition The Health History Questionnaire (HHQ) is the document

containing all the information necessary to know the health status of the insured
person. This document consists of a set of survey questions that help insurance
undertaking to understand the population they are covering.

This questionnaire for health or life insurance cover could take about 15 min. This
examination entails questions such as lifestyle habits like exercising, smoking,
drinking and drug use. Here the pre-contractual risk and any previous illnesses
emerge, which will be excluded from policy conditions.
Inaccurate statements made by the policyholder consist of information that gives
a representation of the risk that is different from what it actually is. Non-disclosure,
on the other hand, consists of missing out on information regarding the
circumstances of the risk. Both these cases have consequences on the insurance
agreement. Sometimes, inaccurate statements and non-disclosure may be of such a
degree that the insurer is willing to provide insurance only at different conditions or
would not have accepted the risk. The law makes a distinction depending on whether
120 7 The Insurance Contract

or not there is wilful act or negligence in the conduct of the policyholder. If the
policyholder, using normal diligence, could merely not be aware of the real
conditions of the risk, the insurer may withdraw from the contract. In the other
case, where the policyholder acts with the intent of deceiving the insurer, the contract
may be declared null and void by the latter.

" Definition The general conditions of policy are the rules governing all insur-
ance contracts of one insurer and concerning the same type of risk in a uniform
manner.

" Definition The particular conditions of policy, on the other hand, are prepared
by the insurer to govern a number of particular risks in a uniform manner.

Both the former and the latter types of contract conditions are drawn up by the
insurer and included in the policy form.

" Definition The unfair contract terms (UCTs) in an insurance contract are those
that, good faith notwithstanding, lead to there being a significant imbalance borne by
the policyholder in the rights and obligations deriving from the contract.

If they are recognised as being unfair, these contract clauses are deemed null and
void, irrespective of any specific approval in writing from the policyholder.8

7.11 Recent Developments in Europe: Pre-contractual

Information

Over the course of the last few years, various regulations have concerned the
distribution of insurance and the information of a pre-contract kind to be provided
to a policyholder.
Directive 2016/97/EC dated 20 January 2016 IDD (Insurance Distribution Direc-
tive) on the distribution of insurance came into force on 1 October 2018 and had as
its subject matter a global redefining of the role of insurance intermediaries, held
more strictly to operating from an advisory standpoint in the best interests of the
customer and according to a more general principle of contract transparency. The
regulations concern both life and non-life business.
KID (Key Information Document) was introduced for pre-contractual informa-
tion for life products. This document is the same for all countries of the European
Union and drawn up in accordance with a single model of reference. It is the

8
It should be noted that annulment operates in respect of the individual clause to the advantage of
the policyholder, thus saving the contract overall.
7.11 Recent Developments in Europe: Pre-contractual Information 121

Table 7.3 Products included in the PRIIPs category.

PRIIPs Not PRIIPs
1. Mutual funds (UCITS funds benefit from a 3 year 1. Shares
exception from the entry into force of the Regulation) 2. Bonds
2. Insurance-based investment products (Unit-linked, 3. Non-structured deposits
with-profit policies, etc.) 4. Life insurance contracts and
3. Structured products and deposits indemnity insurances contracts
4. Convertible bonds 5. Non-life insurance contracts
5. Derivatives 6. Pension funds
6. Products issued by SPVs

pre-contract briefing document foreseen under PRIIP regulations.9 The rules apply
with effect from 1 January 2018.

" Definition PRIIPs is the acronym for Packaged Retail Investment and
Insurance-based investments Products. PRIIPs are products whose value is sub-
ject to fluctuation due to exposures to variables of reference or return on one or a
number of underlying assets. They feature a process of packaging aimed at creating
investment products that have exposures, features and cost structures that are
different as compared to a direct holding.

In Table 7.3 an outline of products included in the PRIIPs category is shown.

In general, therefore, the following do not fall into the category of PRIIPs:

• Assets directly held such as shares in companies or sovereign debt.

• Deposits exposed solely to rates of interest.
• Non-life insurance products, life insurance contracts (if performances foreseen
under the contract are due solely in cases of decease or disability due to injury,
illness or infirmity).10
• Personal and professional or corporate pension products recognised under
national law with the main purpose of offering an investor an annuity during
retirement.
• Unit trusts intended for institutional (and non-retail) investors.

The KID provides retail investors with the information needed to take an
informed decision on the investment and compare different PRIIPs so as to enhance
transparency for the benefit of policyholders.
Concerning pre-contract information for non-life products, art 20 of the IDD
Directive foresees an (I) DIP: the acronym stands for (Insurance) Product Informa-
tion Document. This is a Europe-wide standardised pre-contract briefing document

9
On 9 December 2014, Regulations (EU) N 1286/2014 were published in the Official Gazette of
the European Union dated 26 November 2014 in the matter of a Document containing key
information applicable to Packaged Retail Insurance Investment Products (“PRIIPs Regulations”).
10
For example a Term Life Policy or a disablement policy.
122 7 The Insurance Contract

foreseen for non-life insurance products and carrying the main items of information
on the product following the same logic as applies to the KID. The model (graphic
template) of reference is to be found in the attachment to delegated regulations of the
Commission no. 1469/2017.
Here below in the treatment, both templates are illustrated in detail:

7.11.1 Non-Life Products Pre-Contractual Information: IPID

The IDD Directive for non-life insurance products imposes the drawing up of a
document known as an IPID.

" Definition IPID (Insurance Product Information Document) must contain a

summary of the fundamental characteristics of the contract. The document must be
drawn up in accordance with a pre-set template approved by the European Commis-
sion.11 For IPIDs too, European regulations define the specific section that must be
dealt with.

Within the IPID must be contained the name and the logo of the party making the
policy. In respect of length, an IPID may take up two pages of A4 format. If more
space were necessary, the printed version may very exceptionally take up three A4
pages.
The sections and individual topics that must be set out are as follows (note the
simple language))

1. What type of insurance is it?

2. What is insured?
3. What is not insured?
4. Are there limits to cover?
5. Where does the cover apply?
6. What obligations do I have?
7. When and how must I pay?
8. When does cover start, and when does it end?
9. How can I cancel the policy?

Finally, it is required for each of the nine sections to be distinguished by an icon

placed at the beginning, which allows a consumer to understand the content of the
actual section in a visual manner.

11
According to this logic of the KID the template of reference is to be found in the delegated
regulations of the Commission no. 1469/2017.
7.11 Recent Developments in Europe: Pre-contractual Information 123

7.11.2 Life Products Pre-Contractual Information KID

For life business, new European regulations have simplified the pre-contract product
briefing by introducing the KID (Key Information Document). The KID is a
summary document with key information that is the same across Europe. As we
have illustrated above, this document is foreseen under regulations for PRIIPs
products.

" Definition The KID (Key Information Document) has to contain key informa-
tion needed for orienting an investor in choices of informed investment. It must Be a
short document, three A4 sizes side at a maximum (if printed) and clear, synthetic
but comprehensible.12 The KID must allow comprehension to be achieved at a
glance of all the elements qualifying the financial product: risks, costs, potential
earnings and losses.

It must additionally facilitate a comparison being made with other similar

products and include summary indications on the features of the PRIIP.
The KID must indeed include a summary indicator of the risk covered by a text
explanation of the indicator and must also explain, in text, the risks that are
especially relevant for the subject PRIIP if this is not sufficiently explained by the
summary indicator of risk.
The KID must also contain performance scenarios that are fitting and set out the
hypotheses made for achieving them.
The KID must be prepared in the language of the Member States and distributed
for the purpose of ensuring retail investors understand it.
The KID is a pre-contract briefing document. Therefore, it must be delivered
fittingly in advance (in good time) of the decision to invest so as to allow under-
standing of the important information of the PRIIP and to take it into account at the
time the decision is made.13
Fittingly in advance is based on:

1. Customer needs
2. Experience and knowledge in the matter of investment
3. Urgency (for example to purchase the investment at a specific price)
4. Complexity of the products

12
The template of reference is attached to the delegated regulations (UE) 653/2017, containing
technical norms for implementation (RTS Regulatory Technical Standards) as set forth in the
PRIIPs regulations.
13
PRIIPs (Packaged Retail Investment and Insurance-based investments Products) include,
conceptually, two categories: 1) Insurance investment products, i.e. insurance products whose
performance depends on underlying assets (Insurance-Based Investment Products). 2) PRIPs
(Packaged Retail Investment Products). For a detailed explanation, see Chap. 8
124 7 The Insurance Contract

The intermediary must take into account these factors, as indicated by the
undertaking, so as to establish the period of time the investor needs.
The KID must be delivered to all retail customers, i.e. a customer is not a
professional client.14

7.12 Questions

1. What are the differences between a non-life contract and a life contract?
2. What does insurable interest mean?
3. How proportional rule works?
4. Which are the parties involved in an insurance contract?
5. What is a consideration?
6. What kind of clauses limit the performance of the insurer?
7. What is a policy?
8. Which is the function of Health History Questionnaire (HHQ)?
9. What are the products included in the PRIIPs category?

References
Kaplan (2015) Glossary of insurance terms, 7th edn. Kaplan Financial Education, La Crosse
Rubin HW (2013) Dictionary of insurance terms, 6th edn. Barrons, Hauppauge

Directives and Regulations—Chronological Order

Delegated Regulation (EU) 2017/2358 of 21 September 2017 Supplementing Directive (EU) 2016/
97 of the European Parliament and of the Council with regard to product oversight and
governance requirements for insurance undertakings and insurance distributors
Delegated Regulation (EU) 2017/2359 of 21 September 2017 Regulation supplementing Directive
(EU) 2016/97 with regard to information requirements and conduct of business rules applicable
to the distribution of insurance-based investment products
Commission implementing Regulation (EU) 2017/1469 of 11 August 2017 laying down a
standardised presentation format for the insurance product information document (IPID)
Commission Delegated Regulation (EU) 2017/653 of 8 March 2017 Commission Delegated
Regulation (EU) 2017/653 supplementing Regulation (EU) No 1286/2014, on key information
documents for “PRIIPs” products
Directive (EU) 2016/97 of the European Parliament and of the Council of 20 January 2016 on
insurance distribution (IDD)
Regulation (EU) No 2014/1286 of 26 November 2014 Regulation on key information documents
for “PRIIPs” products
Proposal for Regulation of the European Parliament and of the Council on KID Key Information
Documents for investment products (July 3, 2012)
Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on
insurance mediations

14
It should be remembered that definition picks up what is set forth in previous Directive MIFID II.
References 125

Suggestions for Further Study

Dorfman MS (2008) Introduction to risk management and insurance, 9th edn. Pearson, London
MacDonald Eggers P, Picken S (2017) Good faith and insurance contracts, 4th edn. Informa Law
from Routledge, London
Marano P, Noussa K (2020) Insurance distribution directive. Springer, Cham
Marano P, Noussa K (2021) Transparency in insurance contract law. Springer, Cham
Vogenauer S, Weatherill S (2006) The harmonisation of European Contract Law: implications for
European private laws, business and legal practice. Bloomsbury Publishing, London
Life Insurance Products
8

Abstract

This chapter illustrates the main life insurance products. Different types of cover
have been divided into four macro-categories, based on the individual’s needs,
and the characteristics of each are described:

1. Covers for the risk of death include “traditional” life insurance policies with
death benefit: ordinary life insurance, Term life insurance and decreasing term
policy.
2. Accumulation and savings consist of two main areas: life insurance products
for family planning and financial insurance products.
3. Retirement provision products describe pension funds and Pan-European
Pension Product (PEPP). Capitalisation system and PAYGO system.
4. Protection of health places special focus on health policies similar to life
products (SLT Health), based on the duration of the covered risk. Serious
illness (Dread Disease), Long-term care (LTC) and Activities of Daily Living
(ADLs).

A special section describes the insurance products for professional investors,

such as Portfolio bonds (or wrapper products), Reverse Mortgage (or Equity
release), impaired life annuity (or enhanced annuity), preferred lives, Longevity
bonds, Constant Proportion Protection Insurance (CPPI). Finally, the
classifications of PRIIPs insurance products and IBIPs are illustrated.

Keywords
Life insurance contract · Demographic risk · Financial risk · Ordinary life
insurance · Term life insurance · Decreasing term policy · Waiting period ·
Accidental death clause · Endowment life insurance · Family income policy ·
Adjustable life insurance · Universal life insurance · Variable life insurance ·

# Springer Nature Switzerland AG 2024 127

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_8
128 8 Life Insurance Products

Universal variable life insurance · Assured · Health History Questionnaire

(HHQ) · Suicide · Natural premium · Surrender · Paid up · Return of premiums ·
Loan on policy · Living benefit · Group life insurance · Index-linked policy ·
Guaranteed capital index-linked policy · Unit-linked policy · Hybrid or composite
insurance products · Variable annuity policy · Option roll-up/option ratchet ·
Portfolio bonds (or wrapper products) · Reverse Mortgage (or Equity release) ·
Impaired life annuity (or enhanced annuity) · Preferred lives · Longevity bonds ·
Constant Proportion Protection Insurance (CPPI) · First, Second, Third Pillar
(pension system) · Capitalisation system · PAYGO system · Fixed contributions ·
Defined benefit funds · Closed pension funds · Open pension funds ·
Pan-European Pension Product (PEPP) · Dread Disease policy · Long-Term Care
insurance (LTC) · Activities of Daily Living (ADLs) · PRIIPs · IBIPs

8.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the life insurance products.

2. Distinguish between different categories: death covers; accumulation and
savings; retirement provision products; protection of health.
3. Recognise the main features of each type of life products.

8.2 Life Insurances

By a contract of life insurance, an insurer undertakes, in return for a premium, to pay

a lump sum or an income if an event pertaining to human life occurs.

" Definition Summarising, we can say that life insurance contract is a system of
risk sharing under which contributions are accumulated and redistributed to meet the
economic consequences of the uncertain duration of life. Life insurance is a protec-
tion against the death1 of an individual in the form of payment to a beneficiary. In the
event of the death of an insured, the face value and any additional coverage
associated with a policy, minus outstanding policy loans and interest, is paid to the
beneficiary.

1
Usually, a death certification is required by an insurance undertaking for a beneficiary to receive
the death payment.
8.3 Classification of Life-Insurance Products 129

" Definition The main risk in life insurances is the demographic risk (of a
premature death or longevity) of the assured occurring and which gives rise to the
need to ensure their family has an alternative source of income, or the demographic
risk of ageing of the assured with the attendant need to accumulate savings to ensure
continuity in their standard of living beyond a certain age, when the capacity for
work is drastically reduced.

The demographic risk is not the only risk an insurer needs to manage in life
insurances. An insurance undertaking needs also to manage the financial risk. The
insurer will use the technical reserves formed through collecting policy premiums in
markets by investing them.

" Definition Financial risk, on the one hand, is related to trends of the financial
market, and the possibility of deriving capital losses from investment activities and
divestment. On the other hand, the insurer has to guarantee rates of return to
assureds. In this case, the financial risk is linked to the risk of encountering a loss
if the rate of interest promised to the assured at the inception of the insurance
relationship is higher than the interest earned from deploying funds in markets.

There is a precise mechanism in a number of forms of life insurance that foresee

the insurer transferring interest accruing over the course of insurance contracts on
premiums deployed to the assured or, in a more extended form, the profits that the
insurer generates in its insurance business.
The mix of these two types of risk (demographic and financial) is at the basis of
the insurance technique of life insurance products. During the chapter, we will
analyse this relationship according to the products offered.

8.3 Classification of Life-Insurance Products

Life insurance products can be classified in various ways. Each classification allows
the workings of contract conditions to be understood. The two main classifications
are based on the technical characteristics of the product or on the insurance needs to
which the product meets.
As for the classification based on technical features, this includes five factors:

1. Duration of performance: whole of life or term life.

2. Type of profit distribution with-profits or no profit.
3. On basis premium payment: single, annual/regular, limited.
4. Type of performance: lump sum or annuity.
5. Number of insured: individual or group.
130 8 Life Insurance Products

Duration of Type of profit On basis premium Type of Number of

performance distribution payment performance insured

• Whole life • With profits • Single • Lump sum • Individual

• Term life • Without • Annual/regular • Annuity • Group
profits • Limited

Fig. 8.1 Classification of life products based on the technical features

Finally, it should be noted that regulations have introduced a further classification

for life products: PRIIPs and not PRIIPs.2
Figure 8.1 shows graphically an outline with the five possible classifications of
life insurance products.
Compared to the previous classification, for commercial purposes, a classification
as needed is often used. The following four needs can be distinguished:

1. Covers for the risk of death; in this category fall “traditional” policies with death
benefit.
2. Accumulation and savings; in this category are to be found two purposes:
products for family planning and financial insurance products.
3. Retirement provision products; in this category pension funds (closed and
open) fall.
4. Protection of health; in this category come covers against serious illness (Dread
Disease) and support for long-term care (LTC).

In Figure 8.2, this classification is shown by the needs of the product.

In order to simplify exposition, here below in the text, life insurance products will
be described according to this second classification based on the needs of each
contract.

8.4 Ordinary Life Insurance

In most countries, life insurance policies have traditionally been given favourable tax
treatment. The tax advantages of these insurance contracts concern:

2
For PRIIPs and not PRIIPs products, see below in this chapter.
8.4 Ordinary Life Insurance 131

Life insurance products

Accumulation and
Death benefit savings Retirement Health

Family Plan Financial insurance

products

Whole life Closed or Open

Term life Index Linked Dread Disease
Pension funds

Pan-European
Endowment Unit Linked Pension Product - Long Term Care
PEPP

Universal life / Composite (or

Variable life hybrid) products

Variable annuity

Fig. 8.2 Life products classified by needs

• The annual interest earnings on the cash values generally accumulate on a

tax-deferred basis (until the contract is surrendered).
• The proceeds payable at the insured’s death are generally income with a
favourable tax treatment (or even tax-free) to the beneficiary.

In some insurance undertakings, ordinary policies refer only to permanent types

of life insurance. A permanent insurance product has some type of cash value
accumulation: for instance, a policyholder has a life insurance contract that will
pay a face value if death occurs anytime the policy is in force. On the other hand, as
time goes on, its cash value increases. If the policy is surrendered before the death
benefit becomes payable, the policyowner receives the cash value rather than the
death benefit.

" Definition Ordinary life insurance is a policy that remains in full force and
effect for the life of the insured. With premium payment being made for the same
period.

Conversely, term life insurance does not build any cash value accumulation.
Therefore, it has no cash surrender value. Only death benefits are paid if the
insurance contract is in force at the time of the insured’s death. In this type of policy,
the premiums are fully paid up within a stated period. For examples a 20-payments
132 8 Life Insurance Products

life insurance policy has 20 annual premium payments. No further premiums must
be paid.

8.4.1 Death Benefit Insurance Products

Decease insurance policies cover the risk of the assured dying by guaranteeing
economic support to members of the family from the risk of the main source of
family income ceasing.

" Definition Term life insurance is a form of life insurance that covers the insured
person for a certain period of time, the “term” that is specified in the policy. It pays a
benefit to a designated beneficiary only when the insured dies within that specified
period, which can be 1, 5, 10 or even 20 years.

This contract foresees that the insurance performance is made up of payment of a

single lump sum upon the decease of the assured if this event occurs within a pre-set
number of years indicated in the policy. Premiums can be paid in a single sum (this
will give rise to a single premium term insurance) or annually for the entire duration
of the cover, but not after the decease of the assured if this occurs (in this case, it will
be an annual premium term policy). Term life policies are renewable, but premiums
increase with age.
Therefore, term policies aim to ensure maintenance of a standard of living and
meet lower income deriving from the early decease of the person by providing for
the sustenance of the family group.
A special case of this insurance cover is the decreasing term policy.

" Definition The decreasing term policy is used to cover a creditor for a debt
against the risk of the early death of the debtor. With this insurance, a policyholder/
debtor covers instalments of debt still to be paid to the creditor/beneficiary in the
event of an early death.

In practice, this type of policy is used in connection with bank loans made and
through contracts of consumer credit.
Usually, these policies require a waiting period.

" Definition Waiting period means a period of time that elapses between the date
of stipulation of the policy and the effective date of the guarantee.

This is used by the insurer to protect itself from the payment of claims that are too
close in time to the date of subscription.
Table 8.1 illustrates an example of a Term policy with the types of guarantees for
the capital expected in the event of death.
8.4 Ordinary Life Insurance 133

Table 8.1 Example of a Term policy

Conditions Description
Guarantee • Term policies pay out the face value of the designated beneficiaries in the
policy by the policyholder in the event of decease of the assured during the
contract period.
Cover • If decease does not occur during the duration of the contract, the performance
is not paid out, and premiums are retained by the insurer.
• The sum of the premium is calculated based on age, contract duration, face
value and state of health (such as smoking).
Eligibility for • Usually, elderly persons, those suffering from alcoholism, drug addiction and
cover mental, or other illnesses with high death risk, are excluded.

For some products, settlement is foreseen of an additional sum over and above
that assured in cases of decease from accident.

" Definition Accidental death clause is a benefit in addition to the death lump
sum paid to the beneficiary in the event of death due to accident. Double indemnity
foresees that twice the face value of the policy will be paid to the beneficiary. On the
other hand, in triple indemnity, three times the face value is payable.

For example this cover foresees:

• Face value—in the event of decease of the assured from any cause, the face value
will be settled to the designated beneficiaries chosen at the time of taking out
(500k €).
• Double indemnity—in the event of death from accident, payment is foreseen of a
twice face value (1,000k €).
• Alternatively, triple indemnity—in the event of death from accident, payment is
foreseen of a three time of the face value assured (1,500k €).

See Table 8.2 for the details of the guarantees illustrated above.

Table 8.2 Detail of accidental death clause for a Term policy

Double Triple
Guarantees Face value indemnity indemnity
Limit € 500,000 € 1,000,000 € 1,500,000
Waiting 6 months (0 days in case of medical None None
period examination)
134 8 Life Insurance Products

" Definition Accidental death and dismemberment (AD&D) insurance usually

takes the form of a clause to a life insurance policy. AD&D is a policy or a provision
in a disability income policy that pays either a specific amount or a multiple of the
weekly disability benefit, in the case of an assured’s accidental death or dismember-
ment, which is the loss—or loss of use—of body parts or functions.3

8.4.2 Life Insurance Products for a Family Plan

Life insurance policies for the family plan meet needs to face up to several risks of
lack of economic resources tied to an event of the death of an income earner (the
main source of family revenue) or of the assured surviving beyond a certain age,
usually at the end of the working life of the person involved.
Four types of life insurance products that are suitable for a family plan will be
described in the coming paragraphs. Our description will begin with whole of life
insurance. Next, the explanation will illustrate endowment life insurance, family
income policy, Adjustable life insurance. In the end, universal life insurance and
variable life insurance will be described.

" Definition Endowment life insurance combines protection against premature

death with a savings account. This product foresees the payment of a lump sum to
beneficiaries of the assured when the latter dies. These are solutions that are
especially suited to anyone who has accumulated a certain patrimony and wants to
transfer it to their heirs.

Usually, premiums are fixed and guaranteed and remain level throughout the
policy’s lifetime. On the side of insurance commercial offering, there are two types
of whole life insurance policy:

• Ordinary whole life insurance policy. As discussed above, in this contract, the
insured must pay the premium to his/her insurance undertaking till his/her death.
The assured cannot utilise the insured amount because this amount will be
returned after to the beneficiary.
• Convertible whole life insurance policy: This type of contract can be converted to
endowment life insurance policy after a certain time. It is suitable for those
policyholders who have lower income at present, and they expect an increase in
future income.

Endowment life insurance is the result of combining an insurance policy on

“decease” and a “survival” insurance policy. These offer a guarantee of a contract
under which an insured receives the face value of the policy if the individual survives
the endowment period. If the insured does not survive, a beneficiary receives the face
value of the policy. As the reader can imagine, an endowment policy is the most

3
For accident insurance, see Chap. 9.
8.4 Ordinary Life Insurance 135

Table 8.3 An example of a family income policy

Specified Face
period value Guarantees
20 years € If the insured dies 10 years into the If the insured dies after
100,000 specified period 20 years (the specified
period)
• The beneficiary receives a monthly • The beneficiary receives
income for the remaining 10 years only the face amount.
• At the end of the 10 years, the
beneficiary also receives € 100,000

expensive type of life insurance. In this type of insurance, the assured pays the
premium for a certain time, and after some time he/she receives the insured amount.
Commonly, endowment life insurance lasts 10, 15, 20 years and more. The insured
must pay the premium either till the end of the assured period or until the death of the
assured whichever is earlier.
Endowment insurance is a good answer in order to set aside money regularly and
with guaranteed safety so that enough is available for a family’s risks of lack of
economic resources tied to an event of the death of an income earner or of the
assured surviving. An efficient plan for the asset allocation of the family income is
critical. On the side of insurance commercial offering, the family income policies
help address these issues.

" Definition A family income policy is a contract combining whole life and
decreasing term insurance. A monthly income is paid to a beneficiary if an insured
person dies during a certain period. At the end of that period, the full-face amount of
the policy is also paid to a beneficiary.

It is designed to provide income for the household while the children are still
young. If an assured person dies after the specified period, only the face amount of
the policy is paid. Table 8.3 illustrates an example of a family income policy with the
types of guarantees expected.
Another well-known group of insurance products is adjustable life insurance,
universal life insurance, variable life insurance, and the universal variable life
insurance (a combination under the same contract of variable and universal life
insurance). In the following paragraphs, these insurance products will be illustrated.

" Definition Adjustable life insurance is a cover under which the face value,
premiums and plan of insurance can be changed at the discretion of the policyholder
in free manner, without additional policies being issued:

• Face value can be increased or decreased (obviously for increasing coverage, the
insured must provide evidence of insurability).
• Premium and length of time they are to be paid can be increased or decreased.
Unscheduled premiums can be paid on a lump sum basis.
136 8 Life Insurance Products

" Definition Universal life insurance can be considered an “unbundled” life

insurance contract. Since there is a clear equation for how the premium is split.
The premium is paid into the policy. Interest is paid on the amount of money
accumulated in the policy. From that accumulation of money is deducted the
mortality cost and the cost of any policy clause provisions. The contract is extremely
flexible. This is an important advantage for the assured: premiums are flexible not
fixed, protection is adjustable not fixed and insurance undertaking’s expenses and
other charges are specifically disclosed to the policyholder.

The mortality cost increases with age, as do term insurance premiums. The
premium is usually flexible within limits, and the policy will continue if there is
sufficient money in the policy to pay the mortality and other clause costs.
Universal life policy is referred to as an unbundled contract because its three basic
elements (investment earnings, pure cost of protection and insurer expenses) are
separately identified both in the policy and in an annual report to the policyholder.
Some oversight Authority request clear disclosure for this report. It should show
several items of information about policy status: death benefits, option selected,
specified amount of insurance in force, cash value surrender, transactions made each
month, expenses charged, guaranteed and excess interest credited to the cash value
account.

" Definition Variable life insurance is a policy that combines protection against
premature death with a savings account that can be invested in stocks, bonds and
money market mutual funds at the policyholder’s discretion. It is an investment-
oriented whole life insurance policy that provides a return linked to an underlying
portfolio of securities.

The portfolio is typically a group of mutual funds, established by the insurer as a

separate account, with the policyholder given some investment discretion in
choosing the mix of assets among, say, a common stock fund, a bond fund, and a
money market fund. Variable life insurance offers fixed premiums and a minimum
death benefit. The better the total return on the investment portfolio, the higher the
death benefit or surrender value of the variable life policy.

" Definition Universal variable life insurance is a contract combining features of

universal life insurance and variable life insurance under the same contract. The
excess interest credited to the cash value account depends on the investment results
of a separate account (equities, bonds, real estate, etc.).

Benefits are variable based on the value of equity investments and premiums and
benefits are adjustable at the option of the assured. The policyholder, in fact, selects
the account into which the premium payments are to be made.
8.4 Ordinary Life Insurance 137

8.4.3 Terms and Conditions for Life Insurance Products

In life insurances, the (life) assured is the person to whom the life risk considered
under the policy refers. The insurance contract may concern the life of the policy-
holder and in this case, the person of the assured and policyholder are one and the
same, or the risk to insure concerns the life of a third person. In this latter case, if the
policy is for decease, the written consent of the third party is required for it to be
valid—as indeed it is upon them that the risk of early decease weighs.
The policyholder is obliged to pay the first premium in full; if, on the other hand
they do not make the payment in subsequent years, the contract is resolved, and the
insurer may withhold premiums already collected unless conditions arise to permit
requesting surrender the policy with partial return of premiums paid or reduction of
the face value.

" Definition In assessing the risk in life insurances, the assured is usually required
to fill in a Health History Questionnaire (HHQ) through which the insurer is able
to obtain the information needed to select the risk and reach a determination of a
premium that takes into account the specific riskiness of the assured. This will
concern age, gender and lifestyle items such as the profession carried on, sports
that may be engaged in, place of residence, state of health and, finally, economic
circumstances.

Professional changes of the assured occurring during the period of the contract are
of concern only if they lead to a worsening of the risk: they may bring about a change
being made to the contact by reducing the face value or increasing the premium, or,
at worst, resolution of the contract.

" Definition In cases of suicide by the assured, the law of several EU countries
lays down that the Insurer is bound to meet the performance only if this occurs later
than 2 years after taking out the policy.

Other cases of death of the assured which, according to custom, are not covered
by insurance, concern wilful conduct of the policyholder or the beneficiary, the
assured taking part in crimes and, unless special conditions apply, war risk and
flight risk.
In determining the insurance premium, based on demographic tables and other
specific issues of the sub-population that are expected as assureds, an insurance
undertaking calculates the probability of survival or early death of individual
assureds linked to their age.4
As age increases, the statistical probability of the death of individuals increases,
and in the same way the sum of premiums.

4
For the determination of the life premium, see Chap. 13.
138 8 Life Insurance Products

" Definition The natural premium5 requested of the assured should increase;
equality of the obligations of the two parties is thus maintained. A progressive
increase of the premium would go to covering the progressive increase over time
of the risk insured.

The premium actually paid is, however usually level for the entire duration of the
contract. This allows the insurance undertaking to set aside the part of the premium
in excess over the risk run during a particular year for the future when, given the
trend in the laws of mortality, the risk run will be greater than the level premium
amount. The excess of premiums collected, set aside, and reinvested by the insurer,
goes towards forming the mathematical reserve.6
In insurance life contracts, three main actions by the policyholder are possible:
surrender, reduction of the policy and loan on the policy. These benefits are
nonforfeiture values. These values, the policyholder cannot forfeit by law even if
he ceases to pay the premiums.

" Definition Surrender of the policy is the early resolution of the insurance
contract with the collection of the lump sum already accruing, which the assured
requests from the insurer. The cash surrender value is the amount of cash owed to an
insured who surrenders cash value. Such surrender causes a consequent termination
of all insurance benefits.

Not all types of life insurance policy can be surrendered; it is actually possible to
request it in cases where the insurance performance is “certain” because it is tied to
conditions in the life of the assured that will surely occur, and any uncertainty
concerns only the time when payment will be made by the insurance undertaking.
The assured may request the surrender of the policy once a minimum period has
passed with effect from the time it was taken out. It is important that the mathemati-
cal reserve for the contract has been constituted and, often, it is possible to request
surrender only after 2 or 3 years after concluding the contract, since the first
premiums the insurer collects are usually applied to covering acquisition and
management costs of the policy.7

" Definition An insured may request the policy be paid up, in all cases where he is
no longer able to pay the annual premiums over the duration of the contract of life
insurance. Consequently, this policy has not matured by either death or endowment
originally provided for in the contract.

5
In life business natural premium or pure premium are the same concept. For the calculation of pure
premium, see Chap. 13.
6
For mathematical reserve, see Chap. 14.
7
For instance, in USA, since the depression 1930s, insurers have reserved the right to delay
payment of a cash surrender value up to 6 months.
8.5 Financial Insurance Products 139

This paying-up allows the life contract of insurance to be kept on as the perfor-
mance of the insurer will, as a result, be recalculated on the basis of the premiums
paid in prior to paying-up and which will be held to be a single premium. Also, in
respect of paying-up of the policy, as applies for the right of surrender, forming the
mathematical reserve must have taken place.

" Definition Both in the case of income and of lump sum, a return of premiums
clause is often included in contracts foreseeing reimbursement of the quota of
premiums paid but not earned up until the time of the decease if the assured dies
earlier.

In detail, this clause on a life insurance policy provides that, in the event of the
death of the insured, within a specified period, the policy will pay out in addition to
the face amount, an amount equal to the sum of all premiums paid to date.

" Definition A loan on the policy is a clause that allows the assured to obtain a
loan for a value equal to, or lower than, the surrender value: in the event of
non-payment of interest or non-return of the loan, the insurer may offset its credit
against the capital sum accruing.

" Definition Living benefit is an option under some life insurance policies by
which the insurer provides discounted policy proceeds (face amount, cash value and
dividends, if any) to a terminally ill insured. This permits the insured to meet the
extraordinary living, medical or hospice expenses. Also known as accelerated death
benefits.

Group life insurances (or group contract), differently from individual policies,
feature including a number of contracts concerning several parties who have
characteristics, such as, for example belonging to one professional category in
common under a single policy. Group policies are ones where the policyholder is
a single party, whereas the assureds are a group of persons. Group contracts usually
foresee cover operating in the event of death or permanent disablement that an
employer concludes for the benefit of their employees.

8.5 Financial Insurance Products

Insurance contracts that tie (link) a part of performance of the insurer to parameters
of a financial kind are an important part of life insurance policies. “Linked policies,”
mainly combining a fund’s unit evaluation or a trend in a share index with traditional
policies, have, over time, found favour with savers more interested in share markets
and in a financial context where interest rates are trending downwards. On the part of
insurers, they can efficiently manage the capital allocation strategies required after
140 8 Life Insurance Products

Index linked contract

Derivative + Bond
+ Decease cover + Loadings

Fig. 8.3 Outline of an index-linked contract

the introduction of the Solvency II regime and rules for determining regulatory
capital.8
The financial risk of these products is usually supported by the insured. There-
fore, the need for the allocation of capital to cover financial risk by the insurance
undertaking, according to regulatory requirements, is lower than with traditional life
products.
This type of policy has a prevalent financial content, and a reduced insurance
component, which is generally confined to return of the capital invested increased by
a few percentage points, if not just return of the market value of the financial assets
invested, perhaps increased by a few percentage points in the event of early decease
of the assured; at times, financial or event covers are included (death or maturity).
The rules of payment for the event of death depend on local specifics also in
consideration of rules separating investment contracts from insurance ones.
These insurance contracts can be split into the following categories: index-linked,
unit-linked policies, hybrid products (or composite) and variable annuity. In the
continuation, the reader will be able to read the characteristics of each of these four
insurance products.

8.5.1 Index-Linked Policies

" Definition Index-linked policies are life insurance contracts with a pre-set
duration, generally with a single premium, the performance of which is directly
linked to the current value of market indices such as stock exchange indices, baskets
of shares, rates of inflation, derivatives (The imagination applied in defining possible
baskets is extremely vast, and covers almost any item available in capital markets,
and even outside these), etc. with the addition, oftentimes, of a bond that provides a
less risky investment component of the capital invested.

See Figure 8.3 for the outline of an index-linked contract.

8
For Solvency II, see Chap. 30.
8.5 Financial Insurance Products 141

Basically, the contract works as if 100 euros were invested in two parts: the
largest of 80% is invested in the bond. While the residual part covers: the loadings,
the death guarantee, and the cost of the option linked to the index as required by the
terms and conditions of the policy.
At the inception of the contract, this capital amounts to the premium paid in the
net of loadings and the part of the premium needed to give the insurance cover to be
paid out in the event of decease. This capital is a percentage of the basket or a pre-set
sum. Products have a single and contractually fixed maturity (5 years, 10 years, etc.).
Performances are provided by the value of the reimbursement of the underlying
that have recorded a return during the period of cover of the policy, plus reimburse-
ment of the bond, which is usually a Zero-Coupon Bond. The value of the invest-
ment made in this way is influenced by the market trend of the underlying indices
and will appreciate if the value of the indices is found to have risen. Often, the
component tied to the index is a derivative of the index, which will give a return only
if the underlying index returns a performance according to certain rules defined in
the derivative. In this way, it happens that if the performance is favourable, there is
reimbursement value of the derivative, otherwise, the assured will obtain only the
reimbursement value of the bond.
In index-linked polices, a guarantee of return of capital invested is not generally
foreseen, either during the contract or at its maturity, but after recent occurrences of
default of large financial companies9 which were issuers of derivatives present in
these contracts, insurers that have continued selling index-linked products have tried
to include guarantees of capital clauses, to avoid their assureds running risks that are
too great.

" Definition Guaranteed capital index-linked policies have a mechanism at their

base that foresees a minimum performance, return at maturity of the capital invested,
or the obtaining of a predetermined financial return, plus a guarantee against default
of the issuer.

This specific form is little used given the costs that the insurance undertaking
must incur to be able to guarantee capital, also in the light of the limited trust that
investors now have following the matters that concerned the defaults mentioned
above.
Index-linked subscription is only possible during the issue period. Usually, the
insurer acquires the structured financial instruments underlying index-linked policies
from specialist intermediaries or directly from large financial institutions, thus de
facto rendering the sale of these instruments in tranches (for instance € 50 million, €
100 million, etc.); i.e. when issuing the security. Insurers engage in sales campaigns

9
This refers especially to the bankruptcy of Lehman Brothers Holding inc. which occurred in 2008
and three Icelandic banks a few months later, in additional to Greece the next year and other minor
issuers.
142 8 Life Insurance Products

to distribute the entire security purchased from the counterparty during a predefined
period.
There are various types of option that are a feature of index-linked policies:

• A Plain Vanilla option gives the right to receive the difference between a pre-set
final value of the underlying index and its market value. If the market value is
actually higher, it becomes a kind of “call” (right to buy) option; if it is lower, it
can be seen as a “put” (right to sell) option.
• An Asian option grants the right to receive the difference between a pre-set value
of the reference index and the average of values recorded by the index in the
period of observation (reducing the implicit volatility of the underlying asset).
• An Exotic options are other types of possible options, even the most complex.
They are based on different baskets, the pay-off of which is based on the route that
the market value of the basket has followed (path dependent); it is also possible to
combine various types of option so as to ensure diverse performances that can
meet the taste of the saver in terms of their risk/return profile.

8.5.2 Unit-Linked Policies

" Definition Unit-linked policies are life insurance contracts with performance
tied to and dependent upon units in one or a number of unit trust investment funds, or
funds internal to the insurance undertaking itself, funds into which the premium paid
in by the policyholder, net of loadings, is invested.

The invested capital, at inception, is equal to the premium paid by the assured net of
the insurer’s loadings and part of the premium for the insurance decease coverage.
Generally, unit-linked policies guarantee a lump sum either in the event of
decease as for index-linked policies, or in a percentage or fixed form, and very
often they are whole of life, i.e. they have no maturity but can be concluded even by
surrender in addition to claim. There are different forms that are less widespread of
unit-linked policies with maturity and with payment of a lump sum in the event of
survival.10
Any guarantees of minimum return in unit-linked policies concern the lump sum
in the event of death, lump sum in the case of survival, or both. In unit-linked
products, there is always insurance cover for pay out of a lump sum to beneficiaries
in the event of the death of the assured.
For unit-linked policies too, the distinction applies in respect of the party upon
which the financial risk weighs, between non-guaranteed and non-guaranteed
products. In the former, unfavourable variations in the units purchased, with possible
losses in the capital account, impact the insurance performance. In those that are
guaranteed, there is a financial guarantee for the return of the capital invested, at

10
For forms of contract see below in this paragraph
8.5 Financial Insurance Products 143

maturity or upon an occurrence, or return of the capital invested appreciated by a

minimum return set forth in the policy. It can be noted that where there are financial
guarantees, investments in securities change systematically.
Depending on the line of investment taken by the reference fund chosen, various
types of unit-linked policies can be discerned:

• Monetary line (generally government securities).

• Bond line (government securities and bonds).
• Equity line (domestic and international shares).
• Balanced line (containing a mix of the foregoing categories).

Very often, assureds may make investments in a number of investment lines

simultaneously, dividing the insurance premium into its components of interest.
Over the course of the contract, the assured may also make switches (i.e. changes)
between lines of investment.
The forms of contract usually offered in the insurance industry are whole of life or
endowment forms. The former does not, therefore, foresee a contract maturity, and
so the contract can be interrupted in the event of the death of the assured or
surrender; this translates into it being possible for assureds to have the option of
surrender, and settlement of their performances, at any time, if and when the
conditions of their investments favour disinvestment. The latter type foresees a
contact maturity upon the attainment of which a lump sum is paid if the assured
survives.
The main advantages offered by unit-linked policies, and that have led to a certain
interest being taken by savers, are11:

• Yield: The particularity of being tied to more dynamic and less traditional
investment formulas together with full payment of the yield achieved to the
assured make the policy a product that is potentially more profitable, albeit riskier.
Riskiness is, however mitigated by the leave to switch and the professional
management of the fund.
• Flexibility: It is possible to choose types of fund and various combinations of
these to invest premiums in, making the policy more flexible as regards the
characteristics of the risk-return profile of the policyholder: additionally, they
can manage timings of additional premium payments, adapting these to flows in
their available funds, and review their investment by transferring units.
• Transparency: The value of the fund units is disclosed periodically in financial
dailies (and also via digital systems that are increasingly present in the insurance
savings industry); this allows the assured to follow the trends of funds over time,
monitor the value of the policy and compare this with other investment solutions
offered in the marketplace.

11
Turchetti G., Innovazione e reti distributive nel settore assicurativo, Milano, Franco Angeli, 2000,
pp. 19–76.
144 8 Life Insurance Products

• Completeness: They can combine demands and advantages of insurance with

those of finance: the build-up of a capital sum over time obtained by the
countervalue of the units and cover against risks of death contained in the policy.
This feature applies only to products that actually have a significant risk insurance
component; otherwise, the product without this is just like a unit trust
investment fund.

8.5.3 Hybrid Products: Composite Life Insurance Policies

" Definition Hybrid or composite insurance products are contracts of life insur-
ance that combine two components: one traditional and the other financial.12 The
traditional part is represented by a traditional with-profits life policy (specifically a
policy for survival with a deferred capital performance). The financial part consists
of unit-linked products. The first component is invested in a separate account and
represents the quota part of the lump sum covered. The second part is invested in
lines of investment with the aim of seizing opportunities for return from financial
markets (on this part, there is no financial guarantee).

For this reason, they are referred to as hybrid.

Most of the products offered in the marketplace foresee payment at the time of
taking out of a single premium or a plan of recurring premiums. Also foreseen is the
option to modify the allocation between the two investment components over time.
In summary, therefore, the product features the fulfilling of a number of needs: a
quota devoted to fixed income and return of the principal invested at a certain, pre-set
date and a quota that is more dynamic and aimed at pursuing favourable results over
the medium-long term.
The highly widespread dissemination of these products in Europe has been linked
to two phenomena: a context of persistently low rates of interest and requirements
for cover for risks imposed by Solvency II regulations. In order to face up to a
changing economic environment, various operators have proposed these new
solutions for investment that are alternatives as compared to traditional ones with
the goal of:

• Minimising economic requirements for setting aside the lump sum required from
managing the financial risk under a separate account (Unit-linked products have
requirements that are much lower).
• Seizing market opportunities for assureds.

From the technical standpoint, the principal invested in a separate account is

revalued and consolidated annually based on the return from the separate account

12
It should be noted that the first products were developed in France at the start of the 2000s.
8.5 Financial Insurance Products 145

itself. The part of premiums flowing into the unit-linked insurance funds quotas is
valued periodically, based on trends in underlying assets.
In general, it is possible to select an option of aggregate annual settlement of
performance by means of a coupon. In the event of decease, the insurance undertak-
ing must reimburse a performance that is the sum of: the sum of the guaranteed lump
sum tied to the trend in separate account, revalued, and the counter value of the
quotas assigned for the part of premium invested in unit-linked products.
Several insurance undertakings foresee automatic gradual reallocation of the
principal over the two components so as to balance the principal invested initially
by the combination chosen at the time of taking out.

8.5.4 Variable Annuity Policies

These products developed and became enormously widespread in Europe, and in

other countries like Japan. Firstly, they developed in the English insurance market
and, later on, the continent in other countries (France, Germany).13

" Definition Variable annuity policies are insurance/financial products that

invest premiums paid by the policyholder in internal or external funds of the
insurance undertaking. Allocation of the funds is shared in different percentages
over the various lines (bonds, shares, etc.). Similarly, to unit-linked contracts,
premium payments are used to purchase accumulation units, their number depending
on the value of each unit.

Forms of pure investment and fixed income lines are also foreseen.
As compared to unit-linked products, a policyholder may choose the performance
(either in lump sum form or income form) and the type of insurance cover (death,
living, etc). The cost of the insurance cover is quoted explicitly by the insurer. The
risks covered may be a mix of:

• Decease of the policyholder/assured.

• Possibility of surrender at a pre-set time (i.e. after 5, 10, 15 years).
• Contract expiry (i.e. at 21st year).
• Payment of coupons at pre-set times.
• Longevity risk via insurance of an annuity for a pre-set initial sum.

All the covers set out above allow for insurance of the principal invested and/or
the income. It is also possible to guarantee a certain pre-set rate of revaluation (roll-
up option) or one defined at each contract anniversary date (ratchet option).

13
The origins of Variable Annuities date back to the 1950s when the Teachers Insurance and
Annuities Association—College Retirement Equity Fund (TIAA-CREF) introduced them into the
US market (1952), to finance pensions. In USA they are known as Variable dollar Annuities. They
spread during the 70s and 80s and recorded great development in the early 90s.
146 8 Life Insurance Products

Unit Linked + Guaranties

• Connected to a family of internal / external • Offer the customer the opportunity to

funds purchase financial guaranties
• The return on funds reflects financial market
trends

Fig. 8.4 Basic structure of a Variable Annuity product

We can summarise by stating that during the accumulation phase, the product
functions in much the same way as a unit-linked financial insurance product,
whereas in the choice of performance pay out option phase, a variable annuity
allows for a vast range of choices.
Concerning the percentages of loadings for the contract, it is necessary to
consider all the variables in play. Cost of cover may also impact significantly, so
as to eat into the return achieved.
Variable annuities have been an example of product innovation and have com-
bined the typical advantages of unit-linked products with the covers offered by
traditional insurance products. Indeed, in unit-linked products, insurance cover
tends to be given solely for the mortality risk and for sums that are typically not
significant. Additionally, unit-linked products feature a high degree of rigidity that
does not allow customising for individual assureds. The covers given apply for all
assureds in the aggregate.
On the other hand, in Variable Annuities, the insurance undertaking takes on a
number of risks, among which is the financial risk and the mortality risk if the
assured requests this, i.e. they have been designed to offer greater flexibility,
transparency and meet the various insurance and financial needs of an assured.
Indeed, they may modify the allocation of their portfolio in accordance with their
needs and expectations by changing, for example the expiry of the death cover,
pre-set sums for surrender, the presence of a guaranteed minimum, etc. They may
additionally make switches between covers and/or various funds over the course of
the life of the contract, and the assured is allowed to modify their initial choices by
including or excluding, a posteriori, any financial guarantees, or other options such
as, for example the possibility of foreseeing pay out of the insurance performances in
the form of an income (with various choices applying) rather than as a lump sum.
Figure 8.4 shows the combination of the characteristics of unit-linked products
with the guarantees offered by traditional insurance products.
There are a number of types of Variable Annuity product in the marketplace and
the following are the most widespread:

• GMAB (Guaranteed Minimum Accumulation Benefits), foreseeing a minimum

variable performance at a pre-set maturity. They can therefore be considered a
medium/long-term investment product.
• GMIB (Guaranteed Minimum Income Benefits): this is a guaranteed annuity
income with a minimum value. Cover is provided exclusively in the event of
8.5 Financial Insurance Products 147

conversion into income. The sum to be converted into income may be defined in
various ways (in the same way as a GMAB). The income is guaranteed
irrespective of the trend in financial markets and mortality. This product can be
considered a pension type of product.
• GMWB (Guaranteed Minimum Withdrawal Benefits): this offers partial surren-
der defined as a percentage of the single premium up to an aggregate maximum of
the single premium. This product too, like the GMIB, can be considered a pension
type of product. The duration of the cover can be extended to the whole life of the
assured.
• GMDB (Guaranteed Minimum Death Benefit): this covers a minimum lump sum
in the event of the decease of the assured and so makes the Variable Annuity into
a product defending any heirs.

For all the products shown above, cover always foresees settlement, when the
conditions foreseen arise, of the countervalue of the units purchased or a minimum
guaranteed sum, whichever is the greater. This minimum guaranteed sum is usually
tied to premiums paid (a single premium, perhaps increased by additional payments
in or recurring pre-set payments).
Further guarantees that are often offered by Variable Annuities products are roll-
up or ratchet or a combination of the two.

" Definition In the former case, a roll-up option guarantees that the minimum sum
will be equal to the sum of premiums paid appreciated on the basis of a pre-set rate of
return. The case of a ratchet option, on the other hand, foresees the minimum
guaranteed sum being compared, at each contract anniversary date (often three-
yearly, rarely annually or ten-yearly) against the countervalue of the units. If this
latter sum is greater, it becomes the new minimum guaranteed sum.

Other Recently Constituted Financial Products

The introduction of other innovative financial products has been seen in recent
years. Their level of diffusion and penetration into the industry is different
depending on the individual type of product and the countries where they have
been marketed., Here below, those that have had the greatest diffusion among
the most widespread products are shown. The reader will see the following
described: portfolio bonds or wrapper products, reverse mortgage, impaired
life annuity, preferred lives.
Definition Portfolio bonds (or wrapper products) are life insurance
products with single or recurring premium and foresee structures where
multiple savings and investment solutions can be foreseen. They are called
“wrapper” because all the savings and investment solutions of an individual
are in essence “aggregated” in a single type of an insurance type instrument.

(continued)
148 8 Life Insurance Products

Within these products, practically any financial asset can be kept, provided it is
not a commodity and provided it is listed.
Insurance covers relate to performance in the event of death. Recently,
these products have found usage also since avoidance of taxation that is
achieved through offshore companies operating in low or zero tax regimes.14
Definition Products of Reverse Mortgage (or Equity release) type fore-
see payment of a sum, or series of sums, guaranteed by an owned item of real
property that the insurance undertaking will inherit upon the decease of the
policyholder.
Reverse mortgages became widespread in America, as they were a special
type of loan for dwellings allowing the owner to convert the value of the
property into cash.
Definition An impaired life annuity (or enhanced annuity) product is
essentially a conventional income offering a higher level of return for the
beneficiary. In order to benefit from the advantages of this product, the state of
health of the assured or their medical history must be such as to justify life
expectancy less than the average of the population.
In practice, a discount on income policies is allowed to assureds whose
health is not good.
In the same way, for decease type products, we can speak of preferred lives
products, i.e. risks highly selected on the basis of several variables in the habits
and state of health of assureds.
Definition In particular, preferred lives insurance products are offered to
assureds whose likelihood of death is lower than the average of the population
as they enjoy excellent health and display life habits that are better than
average.
It is a product that is widespread in the USA, where almost all term death
policies are of this type.

8.6 Insurance Products for Professional Investors

One of the risks that life insurance and pensions fund undertakings can find
themselves exposed to is the duration of the life of the assured being greater than
expected (so-called longevity risk).

" Definition Longevity bonds15 are a sort of securitisation of the longevity risk,
these products are a useful tool for covering this risk. This process allows the transfer

14
Recently, these products have also been used as a tax avoidance. This can occur through the use of
offshore companies operating in markets with reduced or no taxation.
15
Longevity bond type products and other instruments are not insurance products, but rather
financial products that foresee flows whose sums depend on demographic events.
8.6 Insurance Products for Professional Investors 149

of the purely demographic risk to capital markets by issuing securities tied to

mortality rates.

The basic idea is that investors, and so insurance undertakings, can purchase
securities with return tied to the actual mortality that occurs. If greater longevity
arises (and so lower mortality) as comparted to expectations, they will receive a
greater return and vice versa. In this way, an insurer is “covered” against the
longevity risk or a part of it. Among securities connected with mortality, the most
evolved in financial markets are longevity bonds, survivor swaps and q-forwards.
The main incentive for an investor in purchasing these securities lies in the diversifi-
cation of portfolio that is possible. It does, however need to be noted that these
securities are not yet significantly widespread, either due to the problem of
reconciling the demands of transferors of risk and investors and it being impossible
to obtain an unequivocal price for the longevity risk due to non-completeness of the
market.
Longevity bonds can be divided into two main categories: so-called “principal at
risk longevity bonds” belong in the first group, whereas “coupon-based longevity
bonds” come into the second group. In the first case, investors who decide to
purchase the securities need to meet the risk of losing the capital invested (wholly
or in part) based on trends in mortality. In the second case, on the other hand, it is not
the actual capital that is “at risk,” but the coupons guaranteed that can undergo
variation depending on the mortality that arises.

" Definition Financial products founding on the approach CPPI (Constant Pro-
portion Protection Insurance)16 protect themselves for the premium invested
without providing an actual guarantee by the insurer. This is possible because the
asset allocation policy maintains a risky asset component equal to the product via a
“buffer,” i.e. the present value of the portfolio minus the minimum guaranteed value
and a predetermined or variable multiplier.

CPPI are products based on a strategy of dynamic asset allocation achieved by

means of investing a capital sum over two asset classes: an asset with a low level of
risk (typically a government bond security or a monetary security) and a risky asset
(which may be equity, hedge fund, investment funds, shares, etc.).17 Usually, a
manager implements a strategy of diversification: in markets with favourable invest-
ment trends, it is made in risky assets with the opportunity for high returns, whereas
in markets with an unfavourable trend, the investment is allocated to securities and
instruments that are safer and with returns that are more stable. Although CPPI

16
CPPI products became widespread after the middle of the 1990s, but the idea underlying this
method of financial management is much older and dates to the 1970s
17
The links to commodity indices is not allowed by European regularity Authorities however,
linking performances to a basket of shares relative to companies operating in the sector of the
extraction of commodities is allowed.
150 8 Life Insurance Products

products were developed for a broad base of small and medium investors, they are
now widespread among pension funds and insurance undertakings as the structure
ensures stable future cash flows that fit in well with what clients seek from these
insurance products.
The basic workings are quite simple and consist of variable allocation between
the two assets depending on what occurs in the financial market. If the value of risky
assets increases, the proportion of these assets also increases (defined by multiplier
m—see formula below 8.1) and vice versa. It may happen that in cases where the
market loses ground, the value of the fund is given only by the bond security. To
work effectively, CPPI products require the amount of investment in the quota of
risky assets to be properly identified. To achieve this in a fund, managed on CPPI
lines, what is commonly called the “buffer” needs to be identified at all times and
which is the relative variation between the value of the wealth invested (NAV18) and
the minimum final wealth (actualised as at today) that it is wished to protect (MIN).
The quota of the value of the fund under CPPI management allocated to risky assets
will be given by a multiplier m of the buffer, where m is a positive number. The
choice of the degree of aggressiveness (represented by the m multiplier) is crucial for
defining the dynamic allocation mechanism.
The investment in risky assets is thus represented by the following formula:

NAV  MIN
equity ¼ m : ð8:1Þ
NAV
For this type of product too, there are a number of variants, also with ratchet
mechanisms i.e. with mechanisms for consolidating the protected value.

8.7 Retirement Provision Products

A pension fund is an instrument that aims to ensure retirement income. Pension

depending on countries, it may also be called pension plan or pension scheme.
The three-pillar pension system is widespread in continental European countries.
The following paragraphs illustrate how its model works.
The first pillar is the mandatory one. Usually, the first pillar should cover basic
living expenses adequately. The first pillar is the general mandatory public pension
for old age, seniority, disablement and survivors, paid out by public and private
social security entities. It is a Pay As You Go (PAYGO) system or capitalisation
system.19 This pillar is financed by contributions from employees.

18
Net Asset Value (NAV) represents the value of the assets of an entity net of the value of its
liabilities. The term is commonly used in connection with funds as the related quotas are reimbursed
at their net worth value.
19
For a definition of the two systems (PAYGO and capitalization) see Chap. 1.
8.7 Retirement Provision Products 151

" Definition Social security based on funding through a capitalisation retirement

provision system foresees contributions paid in by workers being invested in
interest bearing assets used to fund the pensions for the same workers once they
become elderly and accrue a right to receive a pension.

In this system, a redistribution over time of income is achieved in which a worker

puts aside a part of their income from work during their working life so as to be able
to enjoy the same standard of living once drawing a pension.

" Definition Funding a Pay As You Go—PAYGO pension system, on the other
hand foresees contributions paid in by workers during a year being used to meet the
pensions of workers who have already retired. The way this latter system works
applies a redistribution of income across generations.

Workers in activity pay the pensions of those who have already retired. The role
of the State becomes one of guaranteeing that an intergenerational pact is fulfilled:
i.e. that even workers who are active, once they become elderly, will receive a
pension funded by future generations of workers.
The second pillar aimed at ensuring levels of retirement provision that are higher
than the mandatory system. In several countries, it is compulsory for employees and
is financed by both employees and employers.
The third pillar is made up of individual pension forms. This pillar consists of
private pension schemes provided by the private sector. They are optional and
financed entirely by the insured person. Often less taxation or fiscal benefits are
expected.
In general, pension funds can be divided into defined contribution schemes and
defined benefit schemes.

" Definition In the former, the fixed contributions that will be paid into the fund
are set at the time of sign-up and the final performance will be determined as a result.

" Definition On the other hand, for defined benefit funds, the final performance is
set in terms of pension income that will be paid out to a worker once the right to a
pension has been attained, and contributions will vary based on the returns of the
fund over time in order the guarantee the performance promised.

Another important distinction is the one identifying different types of funds also
based on the country of reference.
Closed pension funds have been instituted for the benefit of employee workers in
a single category, sector, area, etc. They are funds closed to entry into the fund by
workers of other categories. Generally, promoter parties may be trades unions,
corporations of workers, professional associations, representatives of enterprise;
the institutional sources for the funds are agreements and group contracts, even of
a single-firm type. In closed funds, differently from what happens in individual
152 8 Life Insurance Products

contributions, payments in adding to the fund are set forth at the time of collective
bargaining and are paid by the employer and the worker.
Open pension funds are aimed at groups of workers who do not meet the
requirements for sign-up to a closed fund. Promoter parties are savings management
insurers, banks, insurance undertakings and securities trading intermediaries. Open
pension funds can be for sign-up by groups or individuals. The former just described
in their main features form a part, as already mentioned, of the second pillar; pension
funds open to individual sign-up, on the other hand, are part of the third pillar.
The reader will recall the European project for reforming supplementary retire-
ment provision that has foreseen the introduction of a Pan-European Pension
Product—PEPP.

" Definition A Pan-European Pension Product (PEPP) is a pension fund avail-

able to all parties resident in the European Union. Regulations 2019/1238/EC dated
20 June 2019 defined the guidelines of this product. PEPP is supplementary to state,
category and personal pensions systems that apply in each individual nation.20

8.8 Health Products

These are insurance covers that foresee performance by the insurance undertaking in
cases of alteration in the state of health that impact adversely on the capacity to
produce income of the assured or that concern cover for medical expenses, assistance
or care.
In general terms, insurance covers that concern health is not easy to classify as
being part of the life line of business (LoB) and of the non-life line of business since
the separation between these two categories is not always clear. In general,
separating is preferred between so-called policies written with techniques similar
to life insurance (SLT Health21) and policies underwritten with techniques similar to
Non-life (Non-SLT Health). Usually, the discriminating principle is the duration of
the risk (one-year versus multi-periodic) deriving from the method by means of
which technical provisions are assessed.22
Long-Term Care and Dread Disease fall under the life health line of business.
Long-term care insurance foresees cover for the risk of the assured no longer being
self-sufficient and needing assistance tied to senile disablement. The loss of self-
sustainability codified internationally is tied to incapacity—and a resulting degree of
dependence—to carry out a number of elementary daily activities, such as bathing,
dressing, and undressing, eating, and drinking, going to the bathroom, moving about
one’s dwelling, getting from bed to an armchair and back. These conditions are

20
For further explanation about PEPP, see Chap. 4 where this product has been well described.
21
SLT means Similar to Life Techniques. Non-SLT means Non-Similar to Life Techniques.
22
This classification comes from the secondary regulations under Solvency II (Technical Specifica-
tion for the Preparatory Phase Part I).
8.8 Health Products 153

quantified under the ADL (Activities of Daily Living) index23, and the sum of the
instalment paid out will normally be commensurate with the index measuring the
degree of lack of self-sustainability that has struck the assured.
Dread disease insurance covers cases of extremely serious sickness and foresees
payment of a pre-set lump sum; it is not of an indemnity type but aims to give
support of a financial kind to the beneficiary whilst alive. This type of insurance can
be offered either as stand-alone insurance cover or combined with other kinds of
policy. However, this latter way is more widespread than the former, since this has
been found to be more attractive from the marketing standpoint: in the stand-alone
version, the assured may not receive the insurance performance if the sickness that
strikes him is not among those expressly foreseen in the policy. Concerning com-
bining dread disease insurance with other policies, these may be life insurance
covers against death.

8.8.1 Dread Disease Policy

Dread Disease policies aim to provide a lump sum for use insurance cases of
surviving a Dread Disease. The insurer, in return for a premium, undertakes to
grant an assured settlement of a pre-set indemnity if diagnosed with a Dread Disease.

" Definition A Dread Disease policy can respond to the need for protection in the
case of a diagnosis of a Dread Disease by paying out an economic indemnity to be
able to meet treatment and rehabilitation with greater ease, or in the case of death.
About performances, Dread Disease provides payment of the entire face value to
the assured in case of:

• Diagnosis of one of the 6 Dread Diseases (see Table 8.4).

• Decease from illness or accident.

The premium varies based on four elements: the age of the assured, smoker/non-
smoker, face value, duration of the cover. Usually, elderly persons, those suffering
from alcoholism, drug addiction and mental, or other illnesses with high death risk,
are excluded and not eligible for cover.
The most frequent Dread Disease are the following six: cancer, stroke,
myocardial infarct, aorta-coronary artery bypass surgery, transplant of main organs,
kidney failure. These pathologies are the ones that cause the most mortality among
the world’s population.
Combining a Dread Disease policy with a life policy may be of an advance type
or an additional type based on the performance by the insurer when the serious or

23
Another index that is widely used to classify the dependence of a person is the IADL (Instrumen-
tal Activities of Daily Living) index: preparing meals, cleaning the home, bathing, and dressing,
taking medication, making purchases, managing savings, using the telephone, and visiting places
beyond walking distance.
154 8 Life Insurance Products

Table 8.4 Dread Disease—Example of definitions and main exclusions

Cover
limits of
indemnity Definition Main exclusions Waiting period
Cancer Diagnosis of a malignant • Carcinoma in situ 6 months
tumour after stage T1N0M0) (T0N0M0) (3 months with
featuring uncontrolled growth “in situ” tumours, dysplasia facultative
and spread of malignant cells and all pre-malignant forms medical
with the invasion of healthy (except for an in situ tumour examination)
tissue. of the breast)
Cancer includes leukaemia, • Papillary carcinoma of the
malignant lymphoma thyroid gland confined to the
including cutaneous organ
lymphoma, Hodgkin’s disease, • Leukaemia of degree A
malignant neoplasm of bone according to the Binet scale
marrow and carcinomas.
Stroke Necrosis of cerebral tissue due • Transient Ischaemic attack
to an inadequate flow of blood (TIA)
or haemorrhage that has as a • Injuries from trauma to
consequence the following cerebral tissue or blood
conditions: vessels
• Appearance of new • Secondary haemorrhage in
neurological symptoms a pre-existing cerebral injury
compatible with stroke
• Arising of new neurological
deficits that persist in an
ongoing manner for at least
60 days after diagnosis of a
stroke.
• New detections under CAT
and MRI if carried out in the
course of clinical diagnosis
Myocardial Definitive diagnosis of acute • Unstable angina pectoris
infarct myocardial infarct: necrosis
(death) of a part of the cardiac
muscle due to obstruction of
blood flow
Aorta- An open-heart operation to • Percutaneous transluminal
coronary correct stenosis or obstruction coronary angioplasty
artery of one or a number of coronary (PTCA)
by-pass arteries by inserting a bypass
surgery
Transplant Inclusion in an official waiting • The transplant of other No waiting
of main list or undergoing a transplant organs, tissue or cells period is
organs as recipient of one of the • Partial transplant or use of foreseen
following entire human stem cells
organs: heart, lung, liver,
kidney, pancreas or bone
marrow
Kidney Terminal kidney failure at final • Transient kidney failure No waiting
failure stage requiring regular period is
haemodialysis or peritoneal foreseen
dialysis
8.8 Health Products 155

profoundly serious disease foreseen in the policy appears. In the former case, in
return for a modest increase in premium as compared to the individual life insurance
against death, the insurer will pay out part of the face value foreseen for decease of
the assured when the illness occurs, while the remaining part will cover the death
risk. The additional type will, on the other hand, foresee insurance performance if the
disease appears, while the death cover will remain for the face value. As compared to
the former, this latter solution has problems of moral hazard: if the decease of the
assured were to occur after the appearance of the serious illness, the Insurer will be
bound to pay out two sums assured. For this reason, waiting periods of a few months
have often been introduced into Dread Disease covers.
As an example, Table 8.4 shows the definition of the 6 Dread Disease usually
envisaged by this insurance product.

8.8.2 Long-Term Care Policy: LTC

" Definition Long-Term Care insurance (LTC) foresees cover for the risk of an
assured not being self-sufficient. They need assistance tied to senile disability. Loss
of self-sufficiency codified at an international level is found tied to incapacity (and a
consequent degree of dependency) to autonomously perform several elementary
quotidian acts.

Deemed to be non-self-sufficient are persons who find themselves totally physically

and permanently, clinically ascertained, unable to perform most of the usual actions
of daily life.
The insurance undertaking undertakes to pay out a monthly income if a state of
lack of self-sustainability arises. Payment of a one-off lump sum amounting together
with the first instalment of income can be added. This is paid at the time of the non-
self-sustainability arising to meet initial expenses. The premium varies based on
several elements: the age of the assured, smoker/non-smoker, face value, profes-
sional activity and lifestyle.
In case of non-self-sustainability, performances are as follow:

• Payment of a monthly annuity income when a state of Non-self-sustainability

arises.
• Payment of a one-off lump sum amounting together with the first instalment of
income.

The duration of the premium payment plan lasts a minimum of 5 years and a
maximum of 25 years (in this sense, the recommended age for taking out is around
40 years). Payments are no longer owed in the event of the decease of the assured or
with effect from the date of the notice of loss of self-sufficiency. The contract
generally foresees it being possible to reduce or be suspended. Following interrup-
tion in payment of premiums, a contract may be reactivated.
156 8 Life Insurance Products

Table 8.5 Example of the four activities of the daily life

ADLs Description
Bathing The ability to bathe or get in and out of the bathtub or shower independently and
without the help of a third person
Eating The ability to feed oneself by getting food into the body and to drink
independently. Food can be prepared by others
Dressing The ability to put on and remove all items of clothing and any braces or artificial
limbs without help from a third person
Transferring The ability to move around your home on flat surfaces, to get in and out of bed,
chair or wheelchair without help from a third person

Usually excluded are persons over 70 years of age and non-self-sustainability

deriving from doing dangerous sports, mental disturbances of non-organic origin
(i.e. psychoses, neuroses, anxiety-depressive syndromes, etc.)
LTC policies aim to protect against a loss of self-sustainability of the assured:

• Incapacity to perform activities of daily life: bathe, eat, move about, dress,
continence, personal hygiene.
• Cognitive disability: deriving from Alzheimer’s disease or similar disabling
senile dementias of organic origin, diagnosed through specific clinical tests and
such as to justify constant assistance by a third person.

" Definition A state on non-self-sustainability is assessed based on activities of

daily living so-called ADLs, which are basic activities that an individual must be
able to carry out alone, every day, to be able to be held to be autonomous.

A person is held not to be self-sustainable when they find themselves in the total
and permanent physical impossibility, clinically ascertained, of being able to carry
out 3 out of 4 (or 4 out of 6—see below) customary daily life activities. The list of
daily life activities is shown in Table 8.5.
The second approach is based on six ADLs. In this case, inability to perform four
activities is required for non-self- sustainability. The list of daily life activities is as
follows:

1. Bathing, i.e. the capacity to maintain a reasonable level of personal hygiene (for
example wash, shave, comb hair, etc.)
2. Eating, i.e. the capacity to take food autonomously, even with food prepared by
others, and drink without the aid of a third person.
3. Moving, i.e. the capacity to pass from bed to a chair or wheelchair and back
without the aid of a third person.
4. Getting dressed, i.e. the capacity to put on, take off, tie, and untie all types of
garment.
5. Continence, i.e. the capacity to control bodily functions or in any case urinate and
move bowels so as to maintain a satisfactory level of personal hygiene.
8.9 Classification of PRIIPs Insurance Products 157

6. Person hygiene, i.e. the capacity to bathe in a bathtub or shower (or even to get
into and out of a bathtub or shower).

Several insurers cover cognitive disablement. If an assured suffers from a cogni-

tive deficit, the gravity of the deficit must be quantified by a doctor (for example a
psychiatrist, neurologist, etc.) through a “Mini Mental State Examination” (Folstein
M.M.S.E.). The M.M.S.E. is a neuropsychological test used for the evaluation of
intellectual efficiency disorders and the presence of cognitive impairment. A score
lower than 15 is an indicator of cognitive deficit, such as to justify constant
supervision.
About the covers foreseen this type of policy is an insurance product designed for
those people who wish to protect their future by ensuring for themselves economic
self-sufficiency necessary for sustaining costs of assistance and care without having
to depend on or persons close to them.

8.9 Classification of PRIIPs Insurance Products

On 9 December 2014, the so-called PRIIPs regulations were published in the Official
Gazette of the European Union and wherein the notions of PRIIPs products were
defined and specific information was given concerning the pre-contract information
that must be provided to customers to allow an easy understanding to be had of the
essential features of these products.24 The rules apply with effect from
1 January 2018.

" Definition PRIIPs is the acronym standing for Packaged Retail Investment
and Insurance-based investments Products. PRIIPS are products whose value is
subject to fluctuations due to exposure to variables of reference or return on one or
several underlying assets. They feature a process of packaging aimed at creating
investment products that have exposures, characteristics or cost structures that are
different as compared with a direct holding.

See Figure 8.5 for the products included in the PRIIPs category.
Specifically, in respect of the offering of insurance products, the following do not
come under the heading of PRIIPs:

1. Non-life insurance products, life insurance contracts (should the performance

foreseen under the contract be due only in the event of decease or disability due to
accident, illness or disability).

24
See Regulations (EU) N 1286/2014 dated 26 November 2014 in the matter of the document
containing key information applicable to Packaged Retail Investment and Insurance-based
investments Products (“PRIIPS” Regulations”).
158 8 Life Insurance Products

PRIIPs Not PRIIPs

1. Mutual funds (UCITS funds benefit from a 1. Shares

3 years exception from coming into force 2. Bonds
of the Regulation) 3. Non-structured deposits
2. Insurance-based investment products (Unit- 4. Life insurance contracts and indemnity
linked, with profit policies, etc.) insurances contracts
3. Structured products and deposits 5. Non-life insurance contracts
4. Convertible bonds 6. Pension funds
5. Derivatives
6. Products issued by SPV

IBIPs PRIPs

Fig. 8.5 Products included in the PRIIPs category

2. Personal and professional pensions products recognised under national law with
the main purpose of offering an investor an annuity during retirement.

As can be seen in nature or products indicated in the Figure 8.5, within PRIIPs the
two categories of products can be found:

• Insurance investment products, i.e. insurance products whose performance

depends on underlying assets IBIPs (Insurance-Based Investment Product).
• PRIPs (Packaged Retail Investment Product).

PRIIPs = IBIPs þ PRIPs: ð8:2Þ

" Definition IBIPs (Insurance-Based Investment Product) are characterised by the

fact that25:

1. The sum due to an investor is “subject to fluctuations due to exposure to variables

of reference or return on one or a number of underlying assets that are not
acquired directly by a retail investor.”
2. They have a maturity or surrender value where such maturity or surrender value is
exposed wholly or in part, directly or indirectly, to market fluctuations.”
In detail, several life insurance products fall under IBPs products, for instance:

25
IBIPS, i.e. insurance-based investment products. These are defined in IDD Directive (article
2, par. 1 no. 17).
References 159

• A large part of insurance products on life such as with-profits policies are

included. On the other hand, it should be recalled that term life policies are
excluded.
• Financial insurance products such as unit-linked and index-linked policies and
also composite or hybrid policies are included.

Key Information Document26 (Acronym is KID) has been introduced for describ-
ing the information of a pre-contract kind for PRIIPs products.
Note that by difference within the PRIPs (Packaged Retail Investment Product),
the reader will find Mutual funds (UCITS funds benefit from a 3-year exception from
the entry into force of the Regulation), structured products and deposits, convertible
bonds, derivatives, products issued by SPV.

8.10 Questions

1. What is the classification of life products based on the technical features?

2. What is the definition of ordinary life insurance?
3. What risk cover a term life insurance, and how does it work?
4. How does the universal life insurance work? Describe the differences in
comparison with Variable life insurance
5. How does the surrender for a life policy work?
6. What are the features of an index-linked? Explain the differences with a unit-
linked
7. Which kind of advantages are offered by a Variable annuity respect a
traditional insurance product?
8. What is a Reverse Mortgage?
9. How does a CPPI work?
10. Which are the differences between PAYGO system and capitalisation
system?
11. Which is the definition of Dread Disease policy and the six most frequent
pathologies?
12. What are the activities of daily living so-called ADL?

References
Rubin HW (2013) Fachbegriffe Versicherungswesen / Dictionary of insurance terms. Springer
Nature
Turchetti G (2000) Innovazione e reti distributive nel settore assicurativo. Milan, Franco Angeli, pp
19–76

26
For a treatment of pre-contract documents see Chap. 7.
160 8 Life Insurance Products

Directives and Regulations—Chronological Order

Regulation (EU) 2019/1238 of 20 June 2019 Regulation of the European Parliament and of the
Council of 20 June 2019 on a pan-European Personal Pension Product (PEPP)
Directive (EU) 2016/97 of the European Parliament and of the Council of 20 January 2016 on
insurance distribution (IDD)
Proposal for Regulation of the European Parliament and of the Council on KID Key Information
Documents for investment products (July 3, 2012)

Suggestions for Further Study

Becker U, Reinhard H-J (2018) Long-term care in Europe: a juridical approach. Springer,
New York, ISBN 3319700812, 9783319700816
Borda M, Grima S, Kwiecien I (eds) (2020) Life insurance in Europe. Risk analysis and market
challenges. Springer, New York
Coughlan G et al (2013) Longevity risk and hedging solutions. In: ed. Dionne G. (ed) Handbook of
insurance. Springer, New York, pp 997–1035
Cont R, e Tankov P (2009) CPPI constant proportion portfolio insurance in presence of jumps in
asset prices, in “Mathematical Finance”. luglio 19(3):379–401
Davidoff T (2013) Long-term care insurance. In: Dionne G (ed) Handbook of insurance. Springer,
New York, pp 1037–1059
Gatzert N et al (2013) New life insurance financial products. In: Dionne G (ed) Handbook of
insurance. Springer, New York, pp 1061–1095
Kaplan (2015a) Glossary of insurance terms, 7th edn. Kaplan Financial Education, La Crosse
Kaplan (2015b) Introduction to life insurance, 2nd edn, 3rd rev. Kaplan Financial Education, La
Crosse
Marano P, Noussia K (2021) Insurance distribution directive. Springer, Cham
Marano P, Rokas I (eds) (2019) Distribution of insurance-based investment products.
Springer, Cham
McGee A (2016) Life assurance contracts. Routledge-Cavendish, London
Morrisey MA (2013) Health insurance in the United States. In: Dionne G (ed) Handbook of
insurance. Springer, New York, pp 957–995
Pitacco E (2004) Health insurance. Springer, Oxford. https://doi.org/10.1007/978-3-319-12235-9
Rubin HW (2013) Dictionary of insurance terms, 6th edn. Barrons, Hauppauge
Turchetti G (2008a) The interaction of public and private systems in healthcare provision: the Italian
case of intramoenia, in “Health and Aging”, Geneva Association Information Newsletter, aprile.
International Association for the Study of Insurance Economics
Turchetti G (2009) The interaction of public and private systems in healthcare provision: the Italian
two-faced janus, in “European Papers on the New Welfare”, 11 (gennaio), pp. 110–122
Turchetti G, Micera S, Cavallo F, e Dario P (2011) Technology and innovative services: towards a
“mega market response” to ageing, in “IEEE Pulse”, 2, 2, marzo/aprile, pp. 27–35
Non-Life Insurance Products: Personal Line
9

Abstract

This chapter describes the non-life insurance products for individuals and
families. For a better understanding, types of cover have been divided into five
macro-categories and description provided:

1. Personal accident and sickness insurance includes personal accidents,

healthcare and care of dental treatment; description of wearable device and
Internet of Things (IoT) included.
2. Insurances on the property consist of fire, theft, cover for household appliance.
3. Liability insurance describes civil liability protection and actions brought by a
party against the assured for alleged torts or breaches of contract.
4. Personal automobile insurance includes civil liability (or Motor TPL) and
property covers. The section also describes the variables for determining the
tariff, property covers for damage, principles for damage indemnified and
telematic services.
5. Homeowners insurance is a comprehensive insurance (i.e. All-risk policy)
covering risks that might strike the home and family, including the Internet
of Things (IoT) and related smart devices.

Finally, a miscellanea of risks is illustrated (i.e. unemployment insurance,

travel insurance, pet insurance and Condominium insurance). Concerning reim-
bursement, different formulas are explained. Replacement cost value (RCV),
Actual Cost Value (ACV), Current market value (Open Market Valuation OMV).

Keywords
Non-life insurance · Personal line · Accident · Accident insurance · Disability ·
Permanent Disability (PD) · Dismemberment · Temporary disability (TD) ·
Schedule injury · Illness · Healthcare insurance · Daily hospital cash benefit ·
Reimbursement of medical expenses · Health History Questionnaire (HHQ) ·

# Springer Nature Switzerland AG 2024 161

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_9
162 9 Non-Life Insurance Products: Personal Line

Waiting period · Wearable device · Internet of Things (IoT) or smart devices ·

Dental care insurance · Dental History Questionnaire (DHQ) · Fire · Fire
insurance · FLEXA · Replacement cost value (RCV) · Actual Cost Value (ACV) ·
Current market value (or Open Market Valuation OMV) · Fire legal liability
insurance · Theft · Absolute First Loss Insurance (AFL) · Relative Loss Insurance
(RL) · Policies for multimedia devices · Extended Warranty Insurance Policies ·
Good Asset protection · Income protection policy · Credit Protection Insurance ·
theft insurance · Scheduled personal property · Extended Warranty
(EW) insurance · Liability · Liability insurance · Civil liability insurance · Care,
custody, and control (CCC) · Compulsory insurance · Personal automobile
insurance · Automobile liability or Motor TPL · Insurance certificate · Green
card · Automobile insurance policy · Advanced Driver Assistance Systems
(ADAS) · Usage-Based Insurance (UBI) · Pay As You Drive (PAYD) · Pay How
You Drive (PHYD) · Black box · Special damages · General damages · Punitive
damages · Comprehensive insurance or all-risk policy · Homeowner insurance ·
Home box · Unemployment insurance · Creditor Protection Insurance (CPI) ·
Travel insurance · Pet insurance · Telematic device · Condominium association’
insurance · Pay Per Use (PPU) · GAP (Guaranteed Asset Protection) · Instant
Insurance · Parametric policy · Trigger · Oracle

9.1 Learning Objectives

At the end of this chapter the reader should be able to:

1. Know the full range of non-life insurance products for Personal lines
segment
2. Understand the differences between the various classifications
3. Describe the non-life insurance products in their specific characteristics
4. Explain all the guarantees, the underwriting procedures, and the reimburse-
ment practices of non-life insurance products

9.2 Non-Life Insurances Products

Non-life insurance forms a very heterogeneous series of covers.

" Definition A non-life insurance offers protection for the wealth of an assured.
The latter, by taking out a non-life policy, insures so as to transfer the economic
consequences that would impact adversely on his available wealth and expenses tied
to the occurring of the loss event.
9.2 Non-Life Insurances Products 163

Non-life insurance provides payments for making good a loss. The cover applies
for unfavourable consequences linked directly to a loss event that occurs.

" Definition Personal lines refer to insurance for individuals and their family.
These protections cover the property and the lifestyle of an individual. Some of these
products are required by law (i.e. automobile insurance), while some others are
optional. Each person (and their family) may choose an optional coverage according
to their risk appetite.

Concerning the main categories of coverages, these can be classified into the
following five classes: personal accident and sickness insurance, property insurance,
liability insurance, personal automobile insurance, comprehensive insurance (i.e. all
risks policies). In the end, a collection of risks is illustrated. These coverages protect
everyone’s different interests (i.e. unemployment insurance, travel insurance, pet
insurance and Condominium insurance, etc.).
1) Health insurance is a cover against the risks of personal accident and sickness.
Accident or sickness may cause a disability status (that may be total, partial,
permanent, temporary or a combination of these). In case of personal accident, the
insurer reimburses a benefit based on the degree of disability. On the other hand, in
case of sickness, the insurance undertaking reimburses the whole or a part of the risk
of incurring medical expenses. Insurances of personal accident and sickness insur-
ance are personal accidents, healthcare and care of dental treatment.
2) Property insurance offers cover against the damage that certain items of the
property of the assured may suffer because of the loss event occurring. Theft of
jewellery kept at the home of the assured and committed by semi-professional
thieves who when entering break doors and windows, is a loss event that will be
followed by making whole the damage suffered. In this category are included: fire
insurance, theft insurance and cover for household appliances.
3) Liability insurance includes insurance covers against injuries from civil liabil-
ity. The insurable interest is not the individual item of property. The protection is,
rather, directed towards the entire wealth of the assured and possible reductions in
value deriving from suddenly appearing expenses and debts. The insurer will
indemnify the assured for actions brought by a party against the assured for alleged
torts or breaches of contract.
4) In respect of insurance products for automobiles, the commercial offering in
the market protects the assured against any losses involving automobiles. Various
coverages are available depending on the demands and needs of the insured. The
main insurance solutions are liability cover for bodily injury liability, property
damage liability, physical damages coverage in cases of collision and comprehen-
sive policies.
5) A homeowner insurance policy covers the typical risks that potentially might
strike the home and family. The risks usually covered are as follows: protection for
the owner of their personal property, protection against civil liability for injury
caused to third parties and coverage in case of domestic accidents.
164 9 Non-Life Insurance Products: Personal Line

The remaining risks concern unemployment insurance, travel insurance, pet

insurance and condominium insurance.

9.3 Personal Accident and Sickness Insurance

These policies provide protection for an assured in the event of an accident, illness
(meaning any alteration of their state of health) and care of dental health. Later, all
the covers, method of underwriting, and manner of reimbursement under these
insurance products will be illustrated.

9.3.1 Personal Accident Insurance

" Definition A personal accident insurance policy provides protection for an

assured from the direct and exclusive consequences of a disability. Accident insur-
ance is a type of insurance that pays benefits for losses caused by accidental injury,
accidental death. Some clauses also pay related health expenses.

" Definition An accident is an event due to a fortuitous, violent and external cause
(all these criteria must be met). The subject event must produce injuries that are
objectively observable and that lead to temporary disability, permanent disability or
even death.

These features are essential and must always apply together for an accident to be
indemnifiable.

• Fortuitous, i.e. it occurs in an accidental, unforeseen, and inevitable way.

• Violent, i.e. it appears suddenly in the organism (in this sense, the arising of a
degenerative process typical of an illness is excluded).
• External, i.e. coming from the outside towards the human organism (in this
meaning too, an illness tied to a cause endogenous to the organism is excluded).

" Definition Disability due to an accident is a condition that incapacitates a person

in some way so that he or she cannot carry on normal pursuits. Insurance products on
sale indemnify an assured following an accident. Disability income policies vary
substantially. Disability may be total, partial, permanent, or temporary or a combi-
nation of these.

Table 9.1 shows the possible combination of each state of disability covered
under an accident policy.
In the following paragraphs, the reader will understand the Permanent Disability
(PD) and the Temporary Disability (TD), i.e. situations that have serious
consequences on the standard of living of the assured and their family. This principle
9.3 Personal Accident and Sickness Insurance 165

Table 9.1 Combination of guarantees for disability state

Disability
state Permanent Temporary
Total Total permanent disability—TPD Total temporary disability—TTD
• Individual may never be able to work • Individual is expected to make a full
again recovery and return to work.
• Compensation based on a financial • Compensation paid is usually a daily
sum or annuity payable to a worker allowance which is determined on the
with a particular injury basis of the insured’s income.
Partial Partial permanent disability—PPD Partial temporary disability—PTD
• Individual is still able to work, but • Individual is temporarily precluded
not with the skill and efficiency from performing a certain set of job
demonstrated prior to the injury skills but can still work at a reduced
• Compensation based on the level.
percentage of loss of physical integrity • Compensation paid is usually a daily
applied to the sum insured allowance reduced to 50% (or of the
percentage of perfoming’s loss) which
is determined on the basis of the
insured’s income.

ties the accident to a limitation, even a partial and temporary one, in working life,
leading to a loss of income.

" Definition Permanent Disability (PD). In this case, the capacity of an assured to
carry on any work reduces or is lost in a definitive manner and irremediably. This
may occur due to loss of a limb (from an anatomical functional standpoint) or an
organ of the body. We can distinguish between total or partial.

" Definition Dismemberment the loss of (or the loss of use of) specified members
of the body resulting from accidental bodily injury.1

This cover usually refers to a general capacity to carry on a profession and not a
capacity to perform their own profession specifically. Assessment of the degree of
disability is done on the basis of a table for this with percentage points.

" Definition Temporary Disability (TD). This status leads to it is impossible to

carry on one’s occupation for a defined period of time. We can distinguish between
total or partial. Partial disability leads to it being possible for an assured to perform
activities to a limited extent in respect of their profession. In this case, what is
considered is the professional activity set out in the policy. “Definition ends.”

In the process of underwriting an accident product, an insurance undertaking lays

down objective limits/covenants and subjective limits/covenants for accepting
the risk.

1
For Accidental death and dismemberment (AD&D) insurance, see Chap. 8.
166 9 Non-Life Insurance Products: Personal Line

These limits/covenants relate to types of risk not sought by the undertaking.

These are usually risks tied to particular professions that are excluded from standard
conditions (for example risks tied to hazardous professions: operating agricultural
machines, motorcycle races, etc.) or risks tied to alterations to the psycho-physical
condition of the individual (e.g. drunkenness, hallucinations following drug use,
etc.). Subjective limits, on the other hand, mainly concern the age of the assured
(in general 75 years of age) and certain statuses of the person such as, for example
alcoholism, drug addiction, AIDS, etc.
Concerning Permanent Disability assessment criteria, assessment is done
according to the financial sum shown in the scheduled injury.

" Definition This schedule injury (sometimes called a body part list) lists the
number of weeks of compensation (or financial sum) payable to a worker with a
particular injury. For every part of the body that may be injured, there is a listed
financial sum that will be paid.

For example a worker who loses his right severed index finger or all use of this is
eligible for x weeks of compensation. Depending on the legislation of the country,
the amount of 1 week of compensation is calculated as a matter of law or as
established by law. The schedule injury may be used for various purposes. There
are national tables or profession specific or customised tables. These may be
prepared by each insurance undertaking on the basis of its own past experience or
propensity for risk in the accident line of business.
Concerning Permanent Disability assessment criteria, the European approach can
be different. Assessment of the degree of Permanent Disability is often done
following specific criteria. A list of injuries is set out and each injury is matched
with a percentage of disability presumed to derive from this. Reimbursement is
calculated as the amount of the maximum sum insured multiplied for this percentage.
The following case is presented by way of example:

• Injury: break of median meniscus.

• % of Permanent Disability indicated in the table: 15%.
• Excess: 5%.
• Sum insured: € 150,000.
• Sum of indemnity: [15%
(5% excess)]* € 150,000 ¼ € 15,000.

Consistent with this approach, if the degree of disability is severe, for example
above 50%, the insurer usually reimburses the insured sum in full (it is considered a
total loss).
The tables that may be used can be of various types. There are national tables or
profession specific or customised tables. These may be prepared by each insurance
undertaking on the basis of its own past experience or propensity for risk in the
accident line of business.
9.3 Personal Accident and Sickness Insurance 167

9.3.2 Healthcare Insurance

" Definition In the insurance sense, lllness means any alteration to the state of
health not depending on an accident, usually due to an organic cause. In a forensic
medical sense, it can be defined as a chronic or acute morbidity process, localised or
diffuse, and which brings about a reduced functioning of the organism.

The commercial offering of healthcare insurance has developed greatly in recent

years, and the products offered today cover a broad range. In addition to a multiform
variety of covers, healthcare policies of the latest generation ever more frequently
provide assistance and services (such as, for example booking for the healthcare
service, availability of an immediate medical consultation, home-assistance, second
opinion, etc).

" Definition Healthcare insurance policies are based on a principle of payment of

costs incurred by an assured of two types: a daily benefit or reimbursement of
expenses incurred of any kind.

• A daily hospital cash benefit provides a lump sum amount daily in case of
hospitalization.
• A reimbursement of medical expenses usually covers all expenses incurred:
specialist services (tests, diagnostic inquiries, examinations, etc), expenses for
hospital care during hospitalisation or surgery (in theatre or out-patients—day
hospital).

" Definition A daily hospital cash benefit is in respect of each day for which an
assured is unable to work. The aim of this cover is to reimburse a loss of earnings by
the assured during their “period of shut-down” or for meeting additional expenses
that are not covered by reimbursement of a health insurance.

" Definition The reimbursement of medical expenses incurred by an assured can

happen in respect of three types/events shown above, or a combination of these:

• Reimbursement of expenses for hospitalisation.

• Reimbursement for expenses for surgery (i.e. costs for operating theatre and fees
for professional persons). This type also foresees reimbursement of expenses
incurred prior to the operation (such as, for example tests, diagnostic inquiries
specialists’ services performed in the period leading up to the operation of the
admission date).
• Reimbursement of medical expenses for specialists’ examinations, even without
hospitalisation or surgery.
168 9 Non-Life Insurance Products: Personal Line

Table 9.2 Outline of healthcare insurance products

Insurance covers Events insured/Insurance performances
Hospital cash • Indemnity for surgery for disease or accident, usually indicated in the
benefit policy; a daily hospital cash benefit in cases of non-surgery
Hospitalisation • Reimbursement of expenses for hospital care during hospitalisation or
surgery
Medical expenses • Reimbursement of expenses incurred by an assured in cases of
hospitalisation, day hospital, surgery, out-patients’ performances
Surgery • Reimbursement of expenses incurred at the time of major surgery made
necessary due to illness
Assistance and • Home-assistance service following accident or disease suffered by the
services assured: medical advice online, attendance of a general practitioner, a nurse,
medication
• Assistance during travel such as the sending of a doctor or ambulance for
transport to hospital, healthcare return home or sending of medication while
travelling
• A number of operators also offer the sending of a babysitter, carer or
home-help

Concerning the manner of reimbursement, insurance products usually foresee an

indirect form and a direct form. The indirect form is based on reimbursement in
arrears of receipts for medical expenses submitted by the assured to the claims office
of the insurance undertaking. The form of direct indemnity is based on the delivery
of healthcare services by an independent provider network to the insurance under-
taking. These structures deliver the services to the assured and are reimbursed
directly by the insurance undertaking. In this way, an assured pays out nothing.
The method is possible thanks to an agreement reached between the insurance
undertaking and a network of health sector players.
In respect of the value of the services to be reimbursed, an insurance undertaking
usually proposes two alternative methods:

• In full method, i.e. all expenses are reimbursed 100% for the entire sum incurred
during the illness.
• Tariff method, i.e. the undertaking reimburses services on the basis of a specific
scale included in the policy conditions. Any excess amount is borne by the
assured.

The main covers provided by an illness product are shown in Table 9.2. Many
policies there are on the market offer a combination of a number of covers so as to
form a package of insurance services that is as complete as possible.
The process of underwriting the risk on the part of an insurance undertaking
foresees filling in a Health History Questionnaire (HHQ) on the part of a proposer for
insurance.

" Definition In a Health History Questionnaire (HHQ), all the information

needed for knowing the precontract state of risk and any previous illnesses that
9.3 Personal Accident and Sickness Insurance 169

will be excluded from the conditions of the policy will be asked for. In the light of the
information found in the questionnaire, an undertaking will decide whether or not to
underwrite the risk and define the conditions at which it will conclude the policy.

In a number of cases, it may even decide not to underwrite the risk.

An important feature of illness contracts is a waiting period.

" Definition Waiting period means the period of time falling between the date the
policy is concluded and the actual commencement of cover.2

In this case, the commencement of cover is put back for a period so as to avoid
imminent recourse to medical care as soon as the contract is concluded.
In respect of determining the premium, an insurance undertaking will usually
consider various parameters. These are the age of the assured, the gender (to which
certain pathologies are tied), weight to height ratio, the profession and healthcare
history. In cases of policies for family groups, determining the premium also
considers the make-up of the family (for example minor children, etc.).

9.3.3 Smart Illness Policy and Telematics: WYOD

Insurance undertakings are taking up the challenges deriving from recent trends in
technology and ongoing changes in consumer lifestyles. In the healthcare area, we
are witnessing a paradigm shift: from the offering of illness policies to an offering of
new insurance solutions combined with innovative services devoted to health and
wellbeing.
For this reason, the recent insurance offering alongside traditional insurance
products proposes new programmes developed from a logic of wellbeing. An insurer
now proposes becoming a partner encouraging and rewarding healthy behaviour in
its customers who are interested in having a healthier lifestyle. The goal is to break
with the old “vicious circle” of reimbursement of healthcare services for assureds
who are ill as compared to a new “virtuous circle” for new healthy customers who
are seeking salutary wellbeing and physical fitness.
The policy foresees traditional insurance covers combined with additional
services. These services are managed through a dedicated app and via wearable
device. The acronym WYOD means “wear your own device.”

" Definition A wearable device is an electronic device that is can be worn (usually
on the wrist) and which has the function of detecting, monitoring and notifying data
to the dedicated app.

2
This waiting period is also called “period of suspension.”
170 9 Non-Life Insurance Products: Personal Line

These devices communicate data and information on the activities and physical
condition of an assured.
Wearables are usually provided by the insurance undertaking and are sent to the
domicile of an assured. They are devices that are clinically approved and are
acquirable without difficulty in the industry. Among the most widespread devices
are to be found:

• A wristband (which can be worn all day) that monitors activities performed, the
number of steps taken, the distance walked, and calories burnt.
• An instrument for measuring blood pressure that performs the function that is
typical of a professional sphygmomanometer.
• A wireless wrist pulsometer allowing vital parameters to be known, such as blood
oxygen saturation (SpO2), frequency of pulse and perfusion pressure.

All the devices are connected to the dedicated app, which keeps and files all the
data communicated relating to the activities performed and the condition of health of
an assured. The data are processed and allow for updating programmes in the
software to increase the wellbeing of the customer.
In this case, we are speaking of the Internet of Things (IoT).

" Definition Internet of Things (IoT) or smart devices are devices, equipment,
installations and systems that are recognisable, thanks to the Internet. The typical
features consist of identifying, connecting, positioning, the capacity to process data
and capacity to interact with the outside environment.

The database of information gathered provides a wealth of information that can

allow an insurer to develop new statistical models in respect of customer
healthcare risk.

9.3.4 Insurance Product Covering Dental Treatment

" Definition A dental care insurance is a solution allowing complete protection

for dental health. An insurance undertaking reimburses the assured in respect of
odontology expenses actually incurred during the course of the insurance cover for
odontology services admitted for reimbursement.

Prior to underwriting the contract, the filling in of a Dental History Questionnaire

(DHQ) is asked for or a prevention examination at a dental practice.

" Definition The aim of Dental History Questionnaire (DHQ) is to gather

information concerning the history of the assured and exclude pre-existing
pathologies.
9.4 Insurances on Property 171

For this product, a waiting period is also foreseen with effect from the com-
mencement date of the policy. During the waiting period, a number of covers are not
operative (for example a filling is not reimbursable prior to 3 months, dental
implantology is not indemnified during the first 6 months, etc.) Normally, care
deriving from the accident is included without any time constraint.
Among the performances foreseen included are:

• Check-up examination with a sitting for removal of plaque.

• Simple and complex extraction of tooth and root and in bone inclusion.
• Filling for simple, deep and complex caries with reconstruction with composite or
amalgam.
• Devitalising or complete endodontic treatment for any number of canals.
• Gnathology, i.e. selective total or partial grinding.

Within treatments, general odontology examinations, anaesthesia, peri-apical

individual X-rays, and bite wing required for the performances indicated above are
included.
Reimbursement for the performance may take place in one of two ways. The first
formula is direct service. This means a network of independent provider dental
practices that provide various services for the care and prevention of teeth and
reimbursed directly by the insurer. The second formula foresees the assured sending
invoices with releases with details of the performances carried out. After fitting
checks, the undertaking will proceed to reimbursing the expenses incurred
(withholding an excess usually). This latter method is defined as the indirect form.

9.4 Insurances on Property

Insurances on the property provide protection for an assured against the risk of fire,
risk of theft, an extension of cover for household appliances. In coming paragraphs,
covers tied to the protection of property, methods of underwriting and manners of
reimbursement foreseen for these insurance policies are illustrated.

9.4.1 Underwriting and Reimbursement Methods for Insurances on

Property

In this paragraph, the methods of underwriting and manners of reimbursement

foreseen for the Property policies are illustrated.
The different ways in which an insurance undertaking proceeds to reimburse an
insured for the damage suffered are the following two solutions: actual cash value
(ACV) or replacement cost value (RCV).
172 9 Non-Life Insurance Products: Personal Line

• Actual cash value (ACV) is the amount equal to the replacement cost minus
depreciation and obsolescence of a damaged or stolen insured item at the time of
the loss. Actual cash value (ACV) is the difference between the replacement cost
value of an item insured and its depreciation.

Actual cash value ðACVÞ ¼ ðReplacement cost
depreciation
obsolescenceÞ

• Replacement cost value (RCV) refers to the amount of money an individual has
currently to spend to replace the insured item with a new one or another with
similar characteristics. Under the replacement cost formula, an insurance under-
taking proceeds to reimbursing a value that amounts to the cost of reconstruction
or the cost of replacement. The replacement cost value is equal to what it would
cost to replace an insured item at today’s cost (in this sense the term “new value”
is used).

Replacement cost value or new value ¼ ðreplacement value or reconstruction costÞ

For example, let's say you purchased an equipment for € 10,000 and it was
damaged in a fire and it’s impossible to repair it. The equipment was four years
old and had lost 30% of its value due to obsolescence. This means that the equipment
has depreciated by € 3,000. At the time of the loss the ACV of the equipment
amounted to € 7,000.
Let’s continue our example to define the RCV. The new equipment, similar to the
damaged one, is now worth € 11,000 and therefore, this amount should represent the
RCV. The use of the conditional is necessary because the sum insured reported in the
policy constitutes the maximum possible compensation. Consequently, in relation to
the sum insured reported in the policy we will have two different scenarios:

1. Sum insured reported in policy € 11,000 = Replacement cost value (RCV) €

11,000
2. Sum insured reported in policy € 10,000 = Replacement cost value (RCV)
reduced from € 11,000 to € 10,000

Scenario no. 2 is usually the most common scenario, as the policyholder defines
the sum insured as equal to the value of the item (€ 10,000). In the event that the cost
of replacement is higher than the sum insured, the insured bears the risk of a shortfall
(€ 1,000).
In summary, if, you have actual cash value (ACV), the insurer will pay the cost
to repair or replace the damaged insured object, applying the amount equal to its
depreciation in the case of total damage or its percentage in case of partial
damage. The insurance undertaking usually calculates the depreciation based on
the condition of the insured item on the date of the loss. On the contrary, if you
9.4 Insurances on Property 173

have a policy with replacement cost value (RCV), the insurance undertaking will
pay the cost to repair or replace the damaged insured item without deducting its
depreciation.
It is necessary to specify that for certain insured items (for example fine arts,
collectible cars), it is not possible to apply the ACV and RCV formulas, but it is
preferable to use the Current market value.

• Current market value or Open Market Valuation (OMV) refers to the price an
object would be worth on the open market or the value that a willing buyer is
willing to recognize for a particular object. Concretely, the value is what the
highest bidder is willing to pay for this specific object.

Current market value ¼ ðValue at which the purchase transaction can take placeÞ

To make easier understanding of the process, see Figure 9.1 which shows the
logical steps for determining the methods of underwriting and manners of
reimbursement.
In the Table 9.3 we propose for the most frequent insured items, in case of total
damage, the methods for determining the ACV and the RCV.

Contract with Sum insured equal to actual

ACV value
yes
Contract with Sum insured equal to actual
Can the item be RCV value and replacement value
Underwriting Activity replaced?

no Contract with Sum insured equal to current

OMV market value

Damage breakdown:
•ACV amount
•RCV amount
Correct
evaluation
Amount OMV
Reimbursement Calculation of value After verifying terms&conditions
Activity at date of loss

Under-
insurance Under-insurance principle
calculation

Fig. 9.1 Underwriting and reimbursement methods

Table 9.3 Comparison between settlement methods (replacement cost vs new value)
174

Value
at the
Type of Determination of Sum Policy Determination of % time Damage Amount Addition
property the sum insured insured coverage the damage Depreciation of loss amount for ACV for RCV
Building Cost of expenses 20,000 Replacement Like the 15% 17,000 Total 17,000 3,000
necessary for the Cost Value determination of the (20,000)
complete (RCV) sum insured
reconstruction of the
building
Machinery, It is equal to the 5,000 Replacement Like the 5% 4,750 Total Total 250
equipment replacement cost Cost Value determination of the (5,000) (5,000)
and with new ones of the (RCV) sum insured
furniture same or equivalent
use, quantity,
characteristics and
9

functionality
Goods It is equivalent to 10,000 Actual Cash It is equivalent to 10% 9,000 Total 9,000 –
their production cost value (ACV) the value in relation (10,000)
or the cost of to the nature,
purchasing them quality and possible
from third parties commercial
devaluation or
revaluation
Car (first It is defined by 30,000 RCV for a Like the 20% 24,000 Total 24,000 6,000
option) specialized specific time determination of the (30,000)
magazines in (Range 6 sum insured
relation to the model months -
and registration date 2 years)
Car (second It is defined by the 50,000 Actual Cash It is equivalent to 10% 50,000 Total 50,000 –
option) insured's declaration value (ACV) the commercial (50,000)
Non-Life Insurance Products: Personal Line

value
9.4 Insurances on Property 175

9.4.2 Fire Insurance

" Definition By fire is meant a phenomenon of intense combustion with flame

affecting the physical property. From a standpoint of insurance, fire is considered to
be such when it appears outside a specific fireplace and may self-extend and
propagate.

" Definition In most states, a fire insurance covers damages deriving from the
following risks: fire, lightning, explosion and aircraft. The cover is for direct
physical damage caused to items insured following these events.

A common combination of risks is the FLEXA formula.

" Definition A FLEXA guarantee covers Fire, Lightning, Explosion, Aircraft.3

This coverage is generally available in those countries where there is British/USA
influence. This provides cover against the following basic risks: fire and lightning;
explosion, excluding nuclear incidents; falling aircraft and related impact.

On a separate basis, insurers may offer cover against additional risks: flood,
earthquake, war risks, terrorism4 (and other damage caused to the items insured by
the release of fumes gases and vapours).
The standard fire policy has four sections: (1) declaration, (2) insuring agreement,
(3) terms and conditions, (4) exclusions.
About section (1) declaration, this chapter contains the description and location of
the property insured. Assessment of the risk by an insurance undertaking begins with
an analysis made of the construction features of the building. Above all,
the combustibility of the materials used is considered, and then the use made of
the buildings and, finally, the contents there are. For this purpose, when underwriting
the risk, the undertaking gathers technical information in respect of the type and
nature of the materials with which the building is constructed, the materials from
which it the vertical load-bearing structures have been made, the load-bearing
structure of the roof, the covering of the roof, external walls, and the horizontal
air-space between the floors of the building are classified.
Regarding section (2) insuring agreement, this contains the premium amount and
the obligations of the parties. Steps the assured must take in the event of loss due to
fire are described. About section (3) terms and conditions, this contains the clauses
determining the coverage. The last section (4) exclusions contains perils not covered
under the policy.

3
FLEXA is an acronym for Fire, Lightning, Explosion, Aircraft.
4
Usually included in the insurance is damage caused by order of the Authorities for the purpose of
impeding and averting the spread of fire. Expenses of demolition and clearance, carriage to waste
site of materials left over following fire are usually excluded.
176 9 Non-Life Insurance Products: Personal Line

Concerning reimbursement, the formulas foreseen by insurance undertakings are

the following three: replacement cost value (RCV), actual cash value (ACV), and
current market value (or Open Market Valuation OMV).

" Definition Replacement cost value (RCV) refers to the amount of money an
individual has currently to spend to replace the insured property. Under the replace-
ment cost formula, an insurance undertaking proceeds to reimbursing a value that
amounts to the cost of reconstruction or the cost of replacement. This value differs
from the actual value of the asset as it leads to payment being made of all the
expenses necessary to reconstruct the building or replace a new personal item (with
the same characteristics and features as the damaged one).

" Definition Actual Cash value (ACV) is the amount representing the replace-
ment cost of a damaged or destroyed property with comparable new property, at the
time of the loss, minus depreciation and obsolescence. With regard to buildings,
there is a tendency for the actual cash value to closely match the market value of the
property.5

" Definitions Current market value (or Open Market Valuation OMV) refers
to the price an asset would be worth on the open market or the value that a willing
buyer will give to a particular property. Concretely, the value is what the highest
bidder is willing to pay for the asset.

In rental properties, fires can cause major disputes between landlords and tenants.
Fire legal liability refers to who is ultimately responsible for paying for damages
related to a fire. Fire legal liability insurance is the coverage of a tenant’s liability
for damage by fire to the rented premises the tenant occupies. The policy insures all
direct physical damage caused to the items insured, even if owned by third parties.
For the tenant, this cover is usually provided as an exception to policy exclusions
applicable to the property. For the landlord, fire damage legal liability is included
under their commercial general liability policy.

9.4.3 Theft Insurance

" Definition By theft is meant the act of stealing. It is a crime against property
committed by a party abstracting the property of others in order to achieve an
unfair gain.

5
For artistic or antique properties, the value may appreciate over time. To receive full coverage such
items must be specifically assessed in the policy.
9.4 Insurances on Property 177

" Definition A theft insurance policy is a contract that covers certain items
against specific harmful events such as theft, robbery, burglary, damage done by
thieves, bag snatching, etc. This policy thus covers the assured for direct physical
damage suffered in the event of theft of the items insured.

The words theft can have many different meanings depending on where (the
country) it is defined. An insurer within a contract of insurance, therefore, needs to
define cover offer very precise.6
The underlying contract principle foresees the items insured being kept in a place
that is inaccessible. The crime must take place:

• By breaching external defences, by breaking or lock-picking of the means of

protection or using false keys.
• By a route different from the ordinary one, for example by overcoming obstacles
or deploying cunning means.
• By entry in another clandestine manner.
• By robbery, even if initiated off the premises, achieved mainly within the
premises.

A theft policy foresees a number of specific techniques by which all covers are
made effective. We can list the following three requirements that must be met: the
construction characteristics of the premises, the security features of the means of
locking and the features of preventive measures.
Regarding the construction features of the premises, it is necessary for the
building to have external walls, floors and coverings constructed with lasting
materials (such as stone, masonry, concrete, reinforced concrete, anti-shock glaz-
ing). If the underwriter of the insurer finds non-compliance of the premises with what
is required under the policy, an insurance undertaking may pay the assured only a
percentage of the sum foreseen for settling the loss by applying self-insurance.
Regarding systems of protection, these can be divided into:

• Human protection systems made up of a watchman service.

• Prevention systems signal the presence of intruders so as to avert injuring action
and cause them to flee. Among these, there are alarm installations, anti-robbery
installations, video-surveillance, etc.
• Passive protection systems that prevent attempts at intrusion, for example
armoured doors, grilles, security cabinets, safes, etc.

6
Note that robbery and burglary have a different meaning according to the local law. Note that
among the exclusions, worth mentioning are theft by sleight of hand, i.e. theft committed by a thief
with skill such as to elude the attention of the victim. In this case indeed, one of the requirements of
insurability is not met i.e. overcoming, or breaching means of protection.
178 9 Non-Life Insurance Products: Personal Line

At the end of the process of risk underwriting, an insurer will assess various
parameters (based on the geo-location) such as the place where the risk is located
(analysing percentages of thefts on a national basis), the type of zone (residential as
compared to industrial), the type of building (an urban context as opposed to a rural
one), the construction features and presence of protection systems.

" Definition Scheduled personal property is an endorsement that extends cover-

age beyond the standard protection. It provides extra coverage for listed articles and
allows a policyholder to purchase additional coverage for specific items of property
and the amount of coverage listed.

Theft policy foresees two types of covers: Actual Cash Value (ACV) or Replace-
ment Cost Value (RCV). Policyholders would usually be reimbursed for the replace-
ment cost value rather than actual cash value, as these amounts frequently differ.

" Definition Actual Cash Value (ACV) reimburses for the amount the stolen item
is currently worth. Actual cash value is computed by subtracting depreciation from
replacement cost, while depreciation is figured by establishing an expected lifetime
of an item and determining what percentage of that life remains. This percentage,
multiplied by the replacement cost, provides the actual cash value.

" Definition Replacement Cost Value (RCV) reimburses the amount it would
cost to replace the same product in the current market. Under replacement cost
coverage, the insurer would pay the amount required to replace the covered item
with a like kind new one. For instance, if a camera is stolen, a replacement cost
policy will reimburse the policyholder the full cost of replacing it with a new camera
of like kind.

Table 9.4 shows the comparison between the two types of cover provided:
Absolute First Loss Insurance (AFL) and Relative Loss Insurance (RL).

Table 9.4 Comparison of Absolute First Loss Insurance (AFL) and Relative Loss Insurance (RL)
Scenario n. 2: Value B less
Scenario n. 1: than Value C 50%
Value B = Value C underinsurance
RL AFL RL AFL
A. Insured value 100 100 100 100
B. Insured value for an a A.C.V 200 0 200 0
insurance policy
C. Value of assets declared per policy 200 200 400 400
at the moment of claim
D. Certained damage 80 80 80 80
E. Indemnity 80 80 40 80
9.5 Liability Insurance 179

9.4.4 Household Appliance Insurance

" Definition Extended Warranty (EW) insurance extend assistance and repair
for household appliances. These cover any breakdown to the item insured for a
pre-set period which is subsequent to the end of the legal guarantee (24 months).

Cover indeed commences once the period of legal guarantee offered by the producer
terminates. An insurer, in to return for payment of a premium, undertakes to offer
repair for breakdowns and malfunctioning of products such as:

• White or (large) goods: refrigerator, washing machine, freezer, dish-washers,

washer-dryer, vacuum cleaner, air-conditioners, etc. (an either free-standing or
encased).
• Small household appliances: blenders, fryers, ice-cream makers, fruit presses,
fans, etc.
• Brown household appliances or electronic equipment: cameras and video-
cameras, tablets, computers, TV sets, etc.

Cell phones are usually excluded from these policies. The reason is tied to their
widespread use by people and their frequent use throughout the day. These features
bring about a significant likelihood of accidental falls that require intervention from
assistance and repair, which is not covered.
This type of contract foresees all repairs being entrusted to a network of assistance
centres distributed throughout the country. Among the services included, there are:
pick-up and re-delivery of the product repaired or a house call, if the product cannot
be transported. If repair of a household appliance is not possible or repair times are
greater than 60 days, usually replacement or issue of a purchase voucher is foreseen.

9.5 Liability Insurance

" Definition Liability means an individual is held bound to bear the cost of an
injury to another party’s interest. Liability means the obligation of the responsible
individual to repair the injury caused. In insurance it concerns the circumstances in
which one party’s property is damaged or destroyed, or that party incurs bodily
injury as the result of the negligent acts or omissions of another party.

" Definition A contract of liability insurance holds an assured harmless in respect

of what they may be held bound to indemnify to a party as a consequence of an
accident brought about through their liability. The insurance undertaking covers the
wealth of the assured in the event of injury involuntarily caused to third parties.

Within personal lines, the main insurance products that cover risks are the following:
180 9 Non-Life Insurance Products: Personal Line

1. Civil liability insurance.

2. Personal automobile liability (or motor third-party liability—TPL).
3. Homeowner liability7.

" Definition Third-party insurance provides cover for an assured in a civil liability
suit for alleged negligent acts or omissions, even if the suit is without foundation.
Civil liability insurance protects the wealth of an assured from damages for injuries
that they may cause to others during the period covered by the insurance. The cover
also protects the interests of the injured party by ensuring they collect damages even
in the event of the party liable not having wealth available against which to make
recourse.

" Definition Care, Custody and Control (CCC) is an exclusion common to

several contracts of liability insurance. This formula removes cover for damage to
property in the care, custody or control of the insured. Some legal systems lay down
that goods or the risk of damage to goods in the Care, Custody and Control is being
equivalent to ownership.

Compulsory insurances are covers that by law must be taken out when certain
circumstances apply. These are not exactly insurance of civil liability required by the
law of a particular state, but rather imposition or obligation to insure. For instance,
many countries impose automobile liability policies deriving from the circulation of
motor vehicles and watercraft. In several European Countries, the obligation to
insure civil liability concerns circulation on roads of motor vehicles and motorcycles
along with the navigation on the water of watercraft.8

9.6 Personal Automobile Insurance

" Definition Personal automobile insurance is a policy tied to the use and
ownership of automobiles. It can be split into two broad categories:

• A personal automobile liability (or motor third-party liability—TPL) is a cover-

age protecting the driver and the owner against the risks of attack upon the wealth
of the assured by third parties injured during circulation on roads by the vehicle.
• Comprehensive automobile risks include various insurance coverages for numer-
ous events that may cause damage to the vehicle in cases of impact, fire, theft and
atmospheric phenomena. Within this category, other coverages are also to be

7
For the definition of personal automobile liability and homeowner liability.
8
For the compulsory motor insurance See Directive 2009/103/EC—Civil liability insurance for
motor vehicles.
9.6 Personal Automobile Insurance 181

found those covering physical injury to the driver, roadside assistance, legal
protection, etc.

" Definition In particular, automobile liability or motor third-party liability

(Motor TPL) is the insurance cover for the liability of the driver and the owner.
This policy covers both material damage and bodily injury that may be caused to any
party (person or item) if an accident occurs during the circulation of a motor vehicle.

Note that in this handbook, automobile liability or motor third-party liability (Motor
TPL) will be used with the same meaning.
It should be noted that the aim of lawmakers in issuing these rules is twofold: to
cover the wealth of the assured against the actions of injured third parties on the one
hand and, on the other, to ensure protection for the injured party or any victims there
might be.
Circulation must be taken to mean either movement of the vehicle or occupation
of roads for public use or areas deemed equivalent to roads.9
For every automobile liability policy, delivery of a package of documents is
foreseen. The documents issued by the insurance undertaking are the following: the
insurance certificate (and, if required, the coupon for display), the green card, the
automobile insurance policy. In various countries, these documents are available in a
dematerialised version.

" Definition The insurance certificate is delivered by the undertaking at the time
the premium is paid. It is security proving that the obligation to insure has been met.
It must show the period of insurance for which the premium has been paid and in
respect of which the undertaking is bound to the cover.

For the coupon (which used to be displayed on the windscreen of the car)
dematerialisation has been foreseen of the hardcopy thanks to the adoption of
electronic or telematic systems that have allowed register and control of the obliga-
tion to insure being met in a paperless fashion.

" Definition The green card is a certificate of insurance that is recognised inter-
nationally and attests that cover applying abroad and allows a vehicle to enter and
circulate in a foreign country by being compliant with automobile liability insurance
in the country visited.10

9
Note that in several State, the obligation to assure a vehicle even in the case of it remaining
stationary or is not being used, is foreseen.
10
It is no longer necessary to have an International Motor Insurance Certificate (Green card) when
travelling to countries covered by EU, see EU Directive 2009/103/EC relating to insurance against
civil liability in respect of the use of motor vehicles and as approved by the commission of the
European Communities.
182 9 Non-Life Insurance Products: Personal Line

" Definition Automobile insurance policy is the contract document governing

relations between assured and the insurance undertaking. Within this document, the
following are indicated: policyholder, vehicle, duration, type of cover, sum of
premium and any instalment plan for this.

In many European Union states, the law lays down the limits of indemnity for
insurance by providing that the contract of insurance may not foresee cover below a
minimum sum defined under the law. The sum of the limit of indemnity is specific
for injuries to persons (irrespective of the number of victims) and for damage to
property (in this case too, irrespective of the number of victims). The sum or limit of
indemnity is adjusted automatically by law periodically.

9.6.1 Variables for Determining an Automobile Tariff

In order to calculate an automobile tariff, an insurance undertaking considers a large

number of features, both those of the vehicle and those of the assured, so as to weigh
the actual risk. The tariff to have the assured pay is determined through sophisticated
statistical analyses that aim to define a sum that is as closely as possible commensu-
rate with the real characteristics of the risk insured while abiding by a principle of
mutuality.
In determining the calculation of the premium of an automobile tariff, an insur-
ance undertaking will usually analyse 18 variables (or factors) that underlie the
relationship between risk and price. The variables can be grouped into to following
four macro-classifications:

• Variables tied to the vehicle.

• Variables tied to persons.
• Variables tied to habits.
• Variables linked to policies covering other automobile risks.

Here below, there is a detailed presentation of the 18 variables and the four
categories used to calculate an automobile tariff. See Table 9.5, which contains a
summary outline of the variables and related categories.11

Factors Tied to the Vehicle

The category of vehicle-related factors is the first. These show the insurance
characteristics of the vehicle and are the starting point for determining the tariff.

11
In addition to the 18 variables listed in the table, an across-the-broad factor common to all
variables used for determining the value of a Motor TPL tariff is the limit of Indemnity, i.e. the sum
of maximum reimbursement that an insurance undertaking pays in the event of a loss event
occurring. The cost of the tariff is indeed directly proportional, not only to the 18 factors, but
also to a sum of the value of the limit of maximum reimbursement. For a treatment of the limit of
indemnity see the paragraph relating to the treatment of Motor TPL policies.
9.6 Personal Automobile Insurance 183

Table 9.5 The 18 variables used to calculate an automobile tariff and relative categories
Variables linked to
Factors tied to the Factors tied to policies covering other
vehicle Factors tied to person habits automobile risks
1. Power of the 7. Sex 14. Driving 17. Availability of
vehicle in HP or KW 8. Age of owner— style garaging
2. Type of vehicle driver 15. Possessing 18. Alarm e anti-theft
(fuel) 9. Residence or several device
3. Safety equipment territory vehicles
4. Vehicle age 10. Occupation 16. Number of
5. Annual km/mi 11. Civil status road-traffic
covered 12. Seniority of licence infractions
6. Use of the vehicle 13. Exclusive driving/
other drivers

Among the main factors determining the insurance risk, there are, indeed, to be
considered the peculiarities of the vehicle to which the insurance will apply.

1. Power of the Vehicle in HP or KW

Engine power is among the characteristics of the vehicle that have a bearing on
the price of insurance. The underlying statistical reason is based on a principle that
the greater the power, the greater the potential risk of an accident. Normally, the
value of the “power” of the engine (i.e. cubic capacity) is shown on the document
allowing the automobile to circulate in the national territory. To estimate power,
insurance assessments refer to two units of measurement, the KW or the HP. The
standard unit of measurement in Europe is the Kilowatt (acronym KW). Usually,
however, carmakers and enthusiasts on the other hand, use the term horsepower.
Horsepower is an expression of power in terms of engine performance (such as
maximum speed, acceleration and torque). Horsepower is indicated by the initials
(acronym) HP.12

2. Type of Vehicle (or Fuel)

The fuel used in the vehicle is a further factor underlying the calculation of the
tariff. A general rule is based on a link between the cost of fuel and the use made of
the vehicle. Greater use made increases the potential risk of an accident. Following
this principle, an automobile with a diesel engine will pay more as compared to a
vehicle fuelled by petrol or an electrical automobile. The reason behind this is the
fact that, at this time, electric and hybrid automobiles are intended mainly for urban
use with short journeys with the less potential risk of accident. On the other hand, a
vehicle fuelled with gas is intended by the owner to cover more kilometres/miles as

12
The formula for converting horsepower to kilowatts is very simple: 1 kW equates to 1.36
horsepower.
184 9 Non-Life Insurance Products: Personal Line

compared to a petrol-fuelled automobile and so is potentially more liable to have an

accident.

3. Safety Equipment

A third variable to be considered is the safety equipment and electronic driving

assistance systems called ADAS (Advanced Driver Assistance Systems). The under-
lying principle is that in the event of an accident occurring a vehicle equipped with
safety equipment may limit the extent of damage done and so reduce the sum of
damages for the insurance undertaking. All these devices lower the cost of insurance
as they make accidents less likely. Among the devices considered are ABS, airbags,
black boxes, etc.

" Definition Advanced Driver Assistance Systems (ADAS) equipment is made

up of electronic driver assistance systems developed to improve the safety of a car.
ADAS is an acronym that indicates and groups together a series of devices that are
able to assist and facilitate car driving even in emergency situations.

Going into details, ADAS systems are numerous devices such as, for example
adaptive cruise control to regulate speed based on traffic, automatic emergency
braking, lane-change alert, automated signage recognition, etc. Within these, devices
are also included that are less technological such as, for example rain sensors to
activate windscreen wipers automatically, dusk sensors to turn lights on automati-
cally, parking sensors, etc.

4. Vehicle Age

The underlying logic of this parameter is based on the fact that the tariff for a
vehicle registered recently is lower than one for a more dated vehicle. This because a
recent vehicle usually has equipment and features that are safer and more efficient as
compared to one designed and homologated with safety standards earlier than those
of the latest generation.

5. Annual km/mi Covered

The variable tied to annual km/mi covered foresees a tariff that increases
depending on the kilometres/miles run. The statistical principle underlying this
suggests that greater use increases the potential risk of an accident. Indeed, a
conveyance intended to cover a greater number of kilometres/miles annually has
periods of circulation on roads greater as compared to a vehicle that covers but a few
kilometres/miles and so potentially more liable to have accidents. For this reason, the
automobile tariff will be dearer for a vehicle with a higher number of kilometres/
miles covered.
9.6 Personal Automobile Insurance 185

6. Use of the Vehicle

This factor distinguishes the aims of the use of the conveyance: professional use
or recreational use. If a driver uses an automobile for work (i.e. professionally), use
is more frequent and normally daily. In this case, the potential risk of accident is
higher. On the other hand, in cases of recreational use, costs of insurance reduce as
the type of use is more occasional in nature, and this suggests a lower potential risk
of accident. In cases of recreational use, the automobile tariff will thus be lower.

Factors Tied to Person

The second category is the one related to factors tied to person. These express socio-
demographic features that matter from the insurance standpoint for a Motor TPL
tariff. Using these variables as a starting point, calculation of a price for insurance
and estimating the potential risk tied to the driver of the vehicle is carried out.

7. Sex

This variable considers the relationship applying between the number of

accidents occurring and the sex of the driver. The rationale is, thus, not to be sought
in the gender of the policyholder (male vs. female) but in statistics pertaining to the
number of accidents occurring during the period of observation. The development of
this factor and its relationship with the risk of accident has undergone a number of
changes over time.
During the first phase, the tariff for a contract of automobile insurance was based
on the sex of the policyholder (gender). Indeed, on the basis of numerous sector
statistics of the time, women were felt to be more careful when driving, and the
number of accidents caused was lower as compared to those brought about by men.
Indeed, justification for this was to be sought in the lower number of kilometres/
miles covered. In the early 2000s, Directive 2004/113/EC introduced a principle of
parity of treatment between men and women in respect of access to goods and
services. Following on from this principle, between 2011 and 2012, the European
Court of Justice laid down parity of gender and equality of conditions in calculating
insurance estimates also for the insurance industry. In this way, gender was
eliminated as a factor with a bearing on calculating an automobile tariff. Following
this direction taken in regulation, after January 2013, Motor TPL tariffs for young
women came to cost more as compared to those applied to men. Materially, today, it
can be stated that the factor tied to sex and related potential risk of accidents
occurring are calculated item by item depending on the loss history of the population
of assureds of each insurance undertaking. An average value for the sector favouring
one gender over another is not therefore available.

8. Age of Owner—Driver

The variable tied to age is based on a principle that younger people have less
driving experience. For this reason, a young driver has a potentially greater risk of
186 9 Non-Life Insurance Products: Personal Line

accident. The tariffs for a younger driver are thus dearer as compared to those for an
adult. On this principle, depending on national legislation, various considerations
arise. In a number of States, the age of the policyholder is considered and is normally
the same as the owner of the vehicle. The policyholder is not necessarily the same as
the actual driver (think, for example of a policy taken out of a father on behalf of a
son). A further reflection relates to the age threshold deemed “critical.” In a number
of countries, this threshold is 25 years (whereas in other countries, the limit is
higher). According to this principle, a person aged less than this is felt to be a
party with potentially higher risk of accident. For this reason, the automobile tariff
for a younger person will be more costly.

9. Residence or Territory

A further factor with a bearing on calculating an automobile tariff is the place of

residence where the conveyance is registered or the residence of the policyholder.
Zones of greater risk are those where there is a greater number of accidents and
where greater traffic intensity applies (also in terms of the density of vehicle per
inhabitant). The underlying statistical principle is that the more the zone is at risk, the
higher the tariff price. For this reason, usually, zones covered by high-speed roads
with a high concentration of vehicles are more dangerous than out-of-town residen-
tial zones with low-traffic roads.

10. Occupation

The profession is a parameter used in determining a price for an automobile tariff.

The underlying principle is based on the fact that a job for which much road travel is
done increases the potential risk of accident. In order to understand the impact that
derives from the type of profession, we should consider a comparison made between
a job that is done mainly in one place (for example a clerical profession) as compared
to a job such as a commercial agent. In this latter case, an automobile can be felt to be
an actual office space as such, and an element of the job done and without which it
would be practically impossible to go about one’s business.13 For this profession, the
price of an automobile insurance will be higher as compared to that for a fixed
location job.

11. Civil Status

The variable tied to family status is based on a principle that a person with a
family group drives a vehicle with greater prudence as compared to a “young
single.” The underlying logic is that a family man, when carrying members of his
family group, will drive responsibly and keep a higher degree of attention upon the

13
According to a number of statistics, on average a commercial agent might cover up to 60,000 km
per year.
9.6 Personal Automobile Insurance 187

road. Additionally, it is usually felt that a good family man sets in motion a series of
precautions prior to beginning a long journey, such as, for example checking that the
car is in good shape, serviced according to a maintenance plan, etc. For all these
reasons, it is felt that a family man driver is less of a potential risk of accident. In this
case, an automobile tariff for a family man will be less costly as compared to one for
a “young single.”

12. Seniority of Licence

The variable of seniority of licence suggests there being a relationship between

the potential risk of accident and the time when a driving licence was issued. It could
be stated that the less time one has driven, the greater is the likelihood of causing an
accident. Drivers with less experience of driving have less ability in driving a car as
compared to an expert driver. For this reason, a driver with a licence issued recently
has a potential risk of accident that is higher. The tariffs for “newbie” licence holders
are therefore dearer as compared to those for a driver with 10 years of experience and
with a career of good driving.

13. Exclusive Driving/Other Drivers

The variable tied to exclusive driving considers the number of drivers who may
drive one vehicle insured. In this case, it is suggested that exclusive driving
(i.e. allowing only the owner party of the conveyance to drive) reduces the potential
risk of accident. Conversely, driving by a number of parties, each with different
characteristics (in terms of age and experience) may expose and insurance undertak-
ing to a risk of loss events caused by drivers with differing characteristics. Think, for
example of a family group (father, mother, offspring) driving a single, family car.
According to this logic, a link is foreseen between the exclusivity of driver and costs
of the automobile policy. Exclusive driving allows the automobile tariff to be
reduced as compared to an option of driving by a number of drivers.

Factors Tied to Habits

The third category is factors tied to habits and vehicle driving style. These express
the way a vehicle is driven and form the starting point for determining the tariff.
Among the main factors determining the insurance risk, there are indeed to be
considered the styles and habits of the driver of the vehicle.

14. Driving Style

An analysis of driving style is an important factor in preventing situations of

danger for a driver. This type of check allows an identification and prevention of
risky driving by monitoring various parameters such as; accelerating, braking, speed
in corners, swerves, sudden lane changes, etc. The principle underlying this factor is
that risky driving may lead to a greater number of accidents and potential injuries. In
recent years, thanks to technology, insurance undertakings have been able to detect
188 9 Non-Life Insurance Products: Personal Line

these data in real time. This has been made possible, thanks to installing a techno-
logical device on vehicles14 (called black box). The device is a satellite GPS
positioning device that provides data relating to the position of the vehicle (global
positioning), speed, manners of accelerating/decelerating. The variable tied to
driving style allows better drivers to be favoured by applying a lower automobile
tariff based on actual conduct while circulating. Conversely, a driver who is less
prudent may receive an increase in their tariff when renewing his/her automobile
policy in the light of evidence detected during the period of observation.

15. Possessing Several Vehicles

The factor that considers the number of vehicles possessed is based on the
suggestion of a lower use made of a second—third vehicle. Indeed, where a number
of vehicles are used by one driver, the second vehicle is usually less used as
compared to the main one. This factor supposes that the use of the main vehicle is
more frequent and normally daily, as compared to that of the secondary vehicle. In
this case, the potential risk of accident is higher for the main vehicle. Conversely, on
the other hand, costs of insurance reduce for the second vehicle as the type of use
made is more occasional, and so suggests a lower risk of potential accidents.

16. Number of Road-Traffic Infractions

In a number of countries, the parameter of the number of road-traffic infractions

committed in the preceding period is also considered. This mechanism foresees the
assured being favoured when they have not been found responsible for an infraction.
Conversely, in cases where their conduct has been sanctioned by an infraction of the
road-traffic code, they are penalised with a more costly tariff. The mechanism
functions thanks to cooperation between insurance undertakings and traffic police
authorities.

Variables Linked to Policies Covering Other Automobile Risks

The fourth category includes factors used to quote the price of policies to cover other
automobile risks.15 The two parameters used are the availability of a garage and the
installation of an alarm, i.e. conditions that allow for the vehicle being protected. The
presence of these factors allows saving to be made in the tariff.

17. Availability of Garaging

This parameter foresees that if the automobile is kept in a garage or an enclosed/

supervised area, the tariff is lower as compared to a situation of parking on the street.

14
For the discussion of this topic, see the paragraph dedicated to “MTPL insurance and telematics—
Black Box.”
15
For a discussion of this topic, see the specific paragraph “The Automobile insurance product.”
9.6 Personal Automobile Insurance 189

The underlying suggestion is that if the automobile is parked on a public road, the
risk of it being involved in an accident is greater. For this reason, the tariff will be
lower in cases where the vehicle is kept garaged.

18. Alarm and Anti-Theft Device

The presence of an anti-theft device on the vehicle serves to protect the vehicle
from theft. At this time, various types of anti-theft device for automobiles are
available in the market: mechanical, electronic and satellite ones. The underlying
principle of this factor is based on the fact that the presence of an alarm system
discourages thieves from attempting theft. Therefore, the risk that the vehicle can be
stolen is lower in the case where an alarm is installed. The tariff price will be lower in
cases where there is a system of alarm present on the vehicle.

9.6.2 Automobile Insurance and Telematics: Black Box

" Definition Technology now allows new customised Usage-Based Insurance

(UBI), i.e. based on actual use made of a vehicle. The most traditional foresee a tariff
for mileage, also known as Pay As You Drive (PAYD).

The more innovative is on the other hand tied to a principle of Pay How You Drive
(PHYD). The new approach differs from traditional insurance, which seeks to
differentiate and reward of drivers who are “safe” by giving them lower premiums
and/or bonuses based on the prior history of rather than actual behaviour when
circulating.

" Definition Current Automobile Liability products foresee it is possible to com-

bine the policy with a technological device (called a black box). The device is a
satellite GPS provided on loan for use by an assured and installed on the vehicle.
Through the black box, the position of the vehicle is recorded (global positioning—
longitude and latitude), speed, movement in acceleration/deceleration and any
impacts.16

The database of information gathered will allow insurance undertakings to

develop new predictive statistical models that can assess the quality of a risk based
on the driving style of the driver. Together with the black box, insurance
undertakings offer a series of useful services based on the use of a dedicated app
providing:

16
In respect of black boxes, what was explained in respect of the IoT (Internet of Things) should be
recalled: i.e. devices that thanks to the Internet, allow connection, localisation, interaction and data
processing to be done. For this reason, they are defined as smart devices.
190 9 Non-Life Insurance Products: Personal Line

• Indications on driving style (real time alerts in cases of dangerous driving of

possible prevention of unsafe situation arising, for example dropping off to sleep
etc.).
• Information on travel statistics and infotainment (i.e. alerts on traffic and weather,
location and saturation of parking, points of interest, etc.).
• Diagnosis and state of maintenance of the vehicle (monitoring in real time of
essential parts will be monitored in real time).
• In the event of an accident occurring, allowing accurate reconstruction of the
dynamic (with automatic SOS service and timely sending of rescue to place).
• Theft prevention systems (alerts regarding positioning and traceability of the
automobile if stolen, possible remote locking/unlocking of the car, etc.).

On the same scenario with respect to Pay As You Drive (PAYD) solutions, Pay
Per Use (PPU) proposals are developing in the market where more attention is given
to the kilometers driven by the insured than to the driving style. Ultimately, these are
giving offers dedicated to those who have a car for personal use with a decidedly low
monthly mileage.
These operations are, in fact, marked by the search for new customers on a target
with low mileage and, therefore, low claim frequencies, and by the fact that the
liking of the device constitutes an additional element on the positivity of the
customer/driver with respect to compliance with the laws governing the movement
of vehicles.
Also along these lines, similar offers are emerging for dealer/dealer vehicle fleets
where the lack of daily use of the car or motorcycle resulting from the device
recognizes a reduction in the annual premium.

9.6.3 Automobile Liability Insurance and Indemnification

" Definition Concerning defining the loss, for automobile liability insurance, what
is meant is a more or less serious and evident diminishing of the value or efficiency
suffered by the assured as a consequence of the loss event. The loss may concern
property, persons or bodies. Causes may be fortuitous or voluntary.

For the loss, it is necessary to consider both the prejudice suffered by an assured and
a quantification of the amount of the actual loss. Indemnification for the loss
concerns damage to property and injuries to the person.
Damage caused to property is generally assessed by an insurance claims adjuster.
An insurance claims adjuster is a party dealing professionally with inquiring into and
estimating losses, not only deriving from the circulation but also from theft or fire to
the vehicle or watercraft insured.
In order to determine the value of the indemnity required for a loss suffered by a
vehicle, insurance undertakings can use one of two formula: actual cash value
(ACV) or replacement cost value (RCV). While ACV is the standard formula in
automobile insurance, some insurers, on the other hand, do offer RCV.
9.6 Personal Automobile Insurance 191

" Definition Actual cash value (ACV) is computed by subtracting depreciation

from replacement cost. Depreciation is figured by establishing the expected lifetime
of the vehicle and determining what percentage of that life remains. This percentage,
multiplied by the replacement cost, provides the actual cash value. In the case of an
insured vehicle that is totally destroyed in an accident, for example the insurance
undertaking would typically pay the actual cash value of the vehicle after determin-
ing its replacement cost and subtracting factors such as depreciation and wear
and tear.

" Definition Replacement Cost Value (RCV) replaces the car with one of the
same make, model, specification, mileage, age and condition. Replacement is
performed regardless of how old the vehicle is or the amount of depreciation it has
suffered over the years.

For injuries to persons, these may be classified following various approaches.

Various types of damages can be awarded to an injured party: special damages or
general damages. Note that, in certain law systems (such as the United States and
Canada) punitive damages can also be imposed.
Special damages consist in reimbursement of all expenses that the insured person
has borne as the consequence of an accident (for example medical expenses, out of
pocket expenses, etc.). Costs of repairing damaged or destroyed property are
included. Special damages also refer to loss of a capacity to produce economic
income. Loss of current and projected income is considered as a consequence of
temporary disability or permanent disability. In quantifying this amount, various
issues are considered: the capacity to produce income in the future, loss of earnings
during the period of illness.
General damages represent a reimbursement for damages that do not readily
lend themselves to quantitative measurement commonly knowns “pain and
suffering.” These damages are also defined as non-economic losses. They are a
series of consequences of injury that do not have a direct economic impact. For
example they may concern the psycho-physical area and therefore materialise in
pain, suffering, anxiety, etc.
In certain law systems (such as United States and Canada) punitive damages
(or exemplary damages) consist of a payment for damages over and above what it is
needed for indemnity due to what is held to be negligence by a defendant and what is
especially serious. The underlying reason is that, in the event of non-contractual
liability and gross negligence, the injured party is awarded further compensation
over and above what is necessary to merely compensate for the injury suffered.

9.6.4 Automobile Insurance Comprehensive Policy

The automobile product, in addition to containing cover against obligatory civil

liability, has for some time been made up of a series of coverages enriching the
192 9 Non-Life Insurance Products: Personal Line

policy in order to make it more competitive and suited to meet the insurance
demands and needs of the most variable of clients.

" Definition An automobile insurance comprehensive policy aims to protect the

assured against a series of adverse events that might create economic prejudice to the
assured’s car.

The insurance undertaking covers the loss to the insured’s automobile for all
physical damages, in excess of a deductible amount, except due to collision. Within
this category, there is:

• Insurance against fire—all direct physical damage caused to a vehicle by fire,

lightning or bursting of the fuel tank.
• Insurance against theft—all direct physical damage deriving from theft and
robbery. Cover applies both for the entire vehicle insured and a number of
individual parts. Covers apply in the event of there being actual taking away
and cases of attempted theft.

In the market for newly registered cars purchased with financing formulas
(leasing or banking) with monthly payments, it is increasingly common in the
insurance comprehensive policy to require a guarantee called GAP (Guaranteed
Asset Protection).
This guarantee comes in the market with many variations, but in summary, GAP
(Guaranteed Asset Protection) can present two alternative solutions:

• GAP Finance or Shortfall, which indemnifies the difference between the out-
standing loan debt and the commercial value of the car at the time of the accident.
• GAP Return to Invoice or Back to Invoice, which indemnifies the difference
between the invoice price and the commercial value of the car at the time of the
claim.

Regardless of the formula chosen, therefore, the car owner is preserved from loss
of value of the car. There is often a constraint that the GAP guarantee is perfected
only and exclusively at the time of the purchase of the car with the simultaneous
acquisition of the Fire and Theft guarantees.
The benefit to the insured is the ability to avoid, in the event of loss of the owned
vehicle, the cost of paying off the financing and the difference in value to purchase a
replacement car in the event of theft or total damage.

" Definition The scheduled personal property is an endorsement that extends

theft coverage beyond the standard protection. It provides extra coverage for listed
articles and allows a policyholder to purchase additional cover for specific
accessories and the amount of coverage listed.
9.7 Comprehensive Policy 193

Table 9.6 Outline of optional coverages for automobile comprehensive insurance policy
Insurance coverages Events insured
Accident to the driver Indemnity in the event of a personal accident to the driver
resulting directly from circulation on roads
Atmospheric events Indemnify of direct physical damage that the vehicle suffers
following certain atmospheric events indicated in the contracts
Social-political events and Indemnify for damage suffered by the vehicle as a consequence
acts of vandalism of acts of terrorism, strikes, riots, etc.
Glazing Indemnify of glass breakage caused to the vehicle by chance
events
Licence withdrawal Payment of a daily benefit in cases of suspension of licence for a
maximum number of days in a year
Legal protection Reimbursement of legal expenses incurred by the assured to
enforce their rights in and out-of-court.
Assistance Aid in cases of the assured being in a situation of difficulty such
as, for example road rescue or substitute automobile, recovery of
the vehicle, medical advice, etc.

Collision cover foresees that, in the event of accidental damage being suffered by
the vehicle of the assured due to impact with another vehicle or against an obstacle
(collision), the insurer will pay for all physical damage, in excess of a deductible
amount.
Table 9.6 shows an outline of special or optional coverages that can be included
in an automobile insurance comprehensive policy.

9.7 Comprehensive Policy

Insurance undertakings operating on the market offer insurance solutions which

contain a series of covers according to the logic of comprehensive policy. A
comprehensive product is an insurance policy with the main aim of achieving
solutions that are ever better suited and adaptable to meet the demands and needs
of the insurance of customers.
Insurance needs go from the cover of risks tied to road traffic to risks tied to
dwelling and daily life, economic stability, protection against accidents and risks of
illness, as well as when travelling, taking part in sports, etc.
The insurance offering for the individuals/families’ segment is made up of
policies of various types of comprehensive contracts.

" Definition With a comprehensive insurance offers a combination of covers

contained in a single contract. With this solution, a base version of the insurance
product is usually foreseen with the possibility of adding optional covers.

The commercial comprehensive formula typically foresees modular solutions

that, as chosen by an assured, go to providing covers for different risks. Below,
we will deal with illustrating three insurance solutions: a policy for Homeowner
194 9 Non-Life Insurance Products: Personal Line

(or homeowner package policy—HPP), a policy for travel and a policy for domestic
animals (known as Pet Insurance).

9.7.1 Homeowner Insurance

Homeowner insurance policy is solution within which a combination of several

covers is included. They offer a policyholder the advantage of purchasing a single
insurance policy and with payment of an aggregate price for the whole package as an
alternative to purchasing individual policies.

" Definition Homeowner insurance policy covers the typical risks that poten-
tially might strike the house and the family. The insurance solution can also be called
a Homeowner package policy (HPP). These perils can be divided into four
categories:

1. Protection for the owner of their personal property (for example the content,
valuable objects, etc.) from events like theft and fire.
2. Protection against civil liability for injury caused to third parties (in this case, we
are said to be speaking of personal civil liability).
3. Cover for the health and physical wholeness of family members for domestic
accidents.
4. Cover against risks of legal disputes and assistance for the home in situations of
daily emergency.

Usually, in policy conditions, by the family unit is meant all members of the
family and persons living in a stable manner at that domicile.17 An optional cover
also includes all the persons who are occasionally involved in caring for the home
and persons (for examples, home-help, servants, babysitters, etc. provided they are
properly hired).
The assured may customise a Homeowner insurance policy by selecting the
deductibles and limits of indemnity best suited to their security needs. The policy
usually foresees basic covers for fire, other property damage, and water damage.
Other optional covers concern theft, head of family civil liability, domestic
accidents, legal protection and assistance.
Additionally, losses occurring as a consequence of the earthquake and of flood
can be included or not, depending on local regulation, but are not typically covered
by Homeowner package policy (HPP). The assured can purchase separate insurance
policies to help protect home and belongings against those types of risks.
Cover applies to risks relating to the habitual (main) and/or occasional dwelling
of the assured, including outhouses and enclosures, installations serving the build-
ing, parks and gardens (even with tall trees) located within the country.

17
Depending on the State’s law, the sons are included under 18 or 21 year (age of majority).
9.7 Comprehensive Policy 195

In detail, the covers protecting the ownership of the house and objects of value
from events such as fire and theft are:

• Damage of the physical structure of the house due to fire, lightning, windstorm,
hail, explosion, smoke, frost and other atmospheric events (snow or sleet),
vandalism, soci-political events, and malicious mischief, escape of water due to
breakage of piping, breakage of glass.
• Damage of belongings inside the home, (such as furniture, household appliances,
etc.).
• Damage from piped water due to accidental breakage of pipes (water, sanitary and
heating installations) search for breakage, repair and reinstatement.

Cover for theft and robbery gives indemnity for direct physical damage caused by
the subject matter event. Also included are damaging and acts of vandalism, damage
and breakage caused by thieves.
Civil liability to third parties foresees a coverage in the event a suit is brought
against the insured because of bodily injury and/or property damage resulting from
the acts or non-acts of the insured. Liability protection defends and covers the
assured if someone sues or files a claim against him/her after being injured on the
assured’s property or the policyholder damages someone else’s property.
Under a Homeowner package policy (HPP) it is additionally possible to insure
legal protection, i.e. cover for expenses of out-of-court and in-court counsel in cases
in which the policyholder or any member of the family of the assured needs legal
assistance to defend their interest.
Homeowner insurance policy is activated where there are situations of emer-
gency. In general, the assured notifies an assistance operations centre which sends a
skilled technician to attend. Cover is for the provision of assistance services in cases
where the assured find themselves in difficulty: for example the attendance of a
plumber, an electrician or smith, or sending a physician home or transport by
ambulance.

9.7.2 Homeowner Insurance and Telematics: Home Box

With recent trends in offerings, various operators have innovated the comprehensive
Homeowner policy by adding various features based on the use of technology. The
areas of cover and applications offered by the policies have remained general
unaltered. New services of assistance have been added based on home automation
devices and sensors that are installed in the dwelling and managed by a
dedicated app.
Sensors are for detecting potential alarms and preventing the befalling of adverse
events to contents and real property. Intelligent sensors are connected to appliances
and notify the occurring of electrical phenomena, flooding, and spreading of smoke,
loss of power or break-in by thieves in real time, alerting the assured in a timely
manner thanks to the dedicated app.
196 9 Non-Life Insurance Products: Personal Line

" Definition All the sensors are connected to a device called a Home box equipped
with an emergency key allowing the assured to contact the assistance operations
centre. When an event occurs, the assured receives a notification on his/her
smartphone.

The sensor kit and the Home box arrive directly at the home of the assured. It is all
easily installed. Once connected to the electricity socket, the Home box device
detects and communicates with the sensors positioned in the dwelling.
The home box device and sensors fall into the category of the Internet of Things
(IoT).

" Definition Internet of Things (IoT) are devices that, thanks to the Internet can
be recognised and notify information. The typical features of these sensors consist of
identifying, connecting, locating and a capacity for processing data alongside inter-
action with the exterior environment.18

A telematic Homeowner policy foresees traditional basic covers protecting

contents, the building, and cases of injury to third parties. It is possible to increase
and extend the level of protection with optional covers.

9.8 Unemployment Insurance

" Definition Unemployment insurance provides protection from events that can
compromise the capacity to repay instalments over the duration of a loan such as, for
example mortgages, current accounts, personal loans.

The best-known product is Creditor Protection Insurance (CPI). This a sort of all-risk
product that pays money in accordance with certain eligibility requirements.

" Definition Creditor Protection Insurance (CPI) policies aim to protect a client
and a bank (the lender) in cases wherein it might become difficult to make loan
repayment instalments on a regular basis. An insurance undertaking, in return for
payment of a premium, undertakes to cover the assured (the lender) via reimburse-
ment of the instalments or residual debt of a loan.

A CPI policy gives protection in cases where a debtor dies, or becomes gravely
ill, permanently or temporarily disabled, unable to work, loses his/her job or is
hospitalised. This type of insurance thus safeguards a lender who will be repaid the
debt owed by the insurer if the debtor becomes insolvent. The protection of a

18
For this reason, they are also defined smart devices i.e. “intelligent objects.”
9.8 Unemployment Insurance 197

mortgage is surety for a creditor bank (And for this reason, it is called creditor
protection). A CPI policy usually foresees payment of a single premium in advance.
The events covered under the policy, and which may befall a debtor, are as
follows:

• Decease, it repays the residual debt up to a maximum amount.

• Permanent Disablement (PD) from accident, it repays the residual debt up to a
maximum amount.
• Dread Disease,19 it repays the residual debt up to a maximum amount.
• Temporary Disablement (TD) from accident or illness, it repays mortgage
instalments.
• Loss of Employment for private sector employee workers, it repays mortgage
instalments.
• Hospitalization, it means a daily hospital cash benefit for a sum per day of
hospitalisation subsequent to a predefined and for a maximum period (for exam-
ple 365 days).

The Table 9.7 shows an example of the typical guarantees and performances for
the CPI product.

Table 9.7 Outline of the Creditor Protection Insurance Policy (CPI)

Waiting
Cover Performance Excess period Limit
Decease Reimburses the sum of the residual None None Residual
debt at the time of the loss event debt
Permanent occurring Threshold None Residual
Disablement based on the debt
(PD) injury
Dread disease Reimburses a lump sum None 90 day Lump
sum
Temporary Indemnity equal to the monthly 30 day None Monthly
Disablement instalments falling due during the indemnity
(TD) period
Loss of 30 days 180 days Monthly
employment indemnity
Hospitalisation Daily hospital cash benefit 3 days 90 days 365 days

19
Dread Disease includes the following illnesses: stroke, cancer, heart attack, coronary pathology
requiring surgery, terminal kidney failure, transplant of main organs (heart, heart and lungs, liver,
pancreas, kidney). For the discussion of the Dread Disease insurance product see Chap. 8.
198 9 Non-Life Insurance Products: Personal Line

9.9 Travel Insurance

" Definition Travel insurance covers an assistance service and various insurance
covers during a period when the assured in travelling. Assistance usually applies
wheresoever worldwide 24 hours a day, via the services provided by the assistance
operations centre of the insurer. The covers foreseen consist of:

• Healthcare assistance while travelling with cover for costs and medical expenses
in cases of illness or accident (included medical evacuation and repatriation).
• Protection for luggage and personal effects (i.e. lost or delayed baggage).
• Legal protection, i.e. reimbursement of legal expenses for contract disputes
occurring while travelling.
• Cover for civil liability while travelling for the sums to an assured is bound to pay
by way of damages for injuries involuntarily caused to third parties or property.
• Optional covers such as reimbursement for trip cancellation and cover for
accidents suffered by an assured during the period of travel.

Specifically, healthcare assistance covers all costs and medical expenses worldwide
(usually limits of indemnity are different, depending on geographical area). The
services covered by an insurer go from taking on the assured at the time of illness or
accident abroad up to constant monitoring of hospital stay, including organising
return to home with healthcare companioning or prosecution of the journey.
Various insurance undertakings cover all medical, hospital and pharmaceutical
expenses in cases of illness or accident, with direct payment to the hospital facilities
forming part of an international network. Often, the return of the assured’s remains
to home country in cases of death overseas can be purchased as an optional cover.
Luggage and personal effects protection cover insures direct physical damage
suffered in the event of theft, fire, robbery or snatching. In cases of handover of
luggage to a carrier, misplacement and/or damage is reimbursed. A number of
policies also foresee indemnification for delayed baggage by a carrier at the airport
of destination of the outward journey.
Protection for legal defence while travelling covers reimbursement of expenses
that an assured must bear for contract disputes with tour operators, travel agencies,
carriers and hotel facilities while travelling.
By means of the cover for reimbursement for cancellation of journey, penalties
applied by an operator for cancellation are reimbursed (tour operators, travel
agencies, hotel facilities) or airline and sea-line companies in cases of journey
cancellation. The causes of cancellation must be tied to illness or accident of one
of the travellers or in the event of being unable to reach the place of departure
following serous calamity. Indemnity is usually subject to an excess and/or self-
insurance being applied.
The territory of cover is generally global, i.e. covering the country of origin, own
continent and worldwide.
In the event of a loss event occurring, an assured must contact the assistance
operations centre by telephoning a freephone number or through a dedicated app so
as to set in motion rescue attendance. In cases of a request made for reimbursement
9.10 Policy for Domestic Animals and Digital Pet Insurance 199

of medical expenses incurred in advance by the assured it is necessary to send all the
documentation to the insurance undertaking through dedicated channels.

9.10 Policy for Domestic Animals and Digital Pet Insurance

In recent years, the attention paid to domestic animals and their needs (food, health
and lifestyle) has greatly gained importance20 and represents a strong growth
phenomenon. Domestic animals (pets) have become the new life companions and
are taking on a front line role in daily life.
For this reason, and to meet new trends, many insurance undertakings have
broadened their offering to this area. Lately, covers for domestic animals have
become widespread in the marketplace.

" Definition A Pet insurance (or policy for domestic animals) offers insurance
cover for:

• Reimbursement of veterinary expenses following accident or illness of the animal.

• Civil liability for recourse of third parties for injuries caused to third parties
(person, property, animals) by the pet.
• Legal protection for disputes.

Additionally, a number of products offer an assistance service via telephone

providing veterinary advice and services of a general kind for the care of a domestic
animal. Lastly, some insurance undertakings offer the possibility of combing a
dedicated app and a telematic device.

" Definition The telematic device is a geo-positioning collar useful for seeking
out the animal and monitoring its daily movements (in this sense, the insurance
product can be defined “digital Pet insurance”).

The policy is usually devoted to those dogs and cats carrying a distinctive
microchip for the animal and that is compliant with obligatory vaccinations. Cover
is annually based and takes into account limits as to breed (for example illness
typical of certain breeds, such as hip dysplasia for the German shepherd are
excluded) or age (animals over 10 years of age are generally not insurable).
Cover for reimbursement of veterinary expenses following accident or illness
holds the owner of the pet harmless in respect of veterinary expenses incurred
following accidents or illness. Expenses in cases of surgery are covered (veterinary
surgeon’s fees, operating theatre, operating materials, etc.) and any fees for the
hospital stay. Additionally covered are veterinary medical services, tests and diag-
nostic inquiries, physiotherapy/rehabilitation.

20
In this sense a Pet Economy is spoken of, i.e. the global business revolving around domestic
animals.
200 9 Non-Life Insurance Products: Personal Line

Cover for third-party civil liability reimburses an assured (and members of his/her
family) in cases of civil liability attaching for injuries caused by the pet that have as a
consequence death or bodily injury to persons or other animals. Damage to the
property of third parties is also covered.
Legal protection cover represents the assured in cases of dispute for events in
daily life pertaining to the ownership and custody of a pet.
An assistance service provides veterinary advice and useful information for daily
life for the animal (such as school, training, toileting and breeding, etc.). Alongside a
service of telephone assistance, a dedicated app foresees managing the technological
device and allows consultation of the digital clinical charts of the pet. The techno-
logical device, which is hooked up to the collar, allows for various features via the
dedicated app, such as:

• Information relating to the movements of the domestic animal, remotely viewable

in real time.
• Activation of a virtual enclosure, sending notifications if a virtual barrier is
surmounted by the pet.
• Geo-positioning for situations of emergency/rescue.
• A schedule of customisable feeding depending on the daily movement detected.

9.11 New Ways of Purchasing Guarantees: Instant Insurance

The term instant insurance is used in the marketplace to define the purchase of
insurance policies for situations that expose the insured to a risk for an extremely
short time frame and that also occurs in completely unexpected ways.
One can summarize the purpose of instant insurance policies by comparing them
with traditional policies that are structured to cover against risks for long periods of
time, with no possibility of interruption or modification. In contrast, instant insur-
ance policies are designed to cover a risk for a limited time, coinciding with a
particular event or situation, such as a trip, a concert, or a move.
Another qualifying element of instant insurance lies in the timing of activation,
since, as their name suggests, they can instead be taken out very quickly, at any time
and from anywhere via smartphone, tablet or PC. This is why there are increasing
offerings from digital insurance service companies specializing with their IT infra-
structure on this new insurance market.
The guarantees are extremely diverse with an ever-changing range of offerings.
Coverages include, for example, guarantee from the risk Theft of an automobile,
reimbursement of any medical expenses incurred as a result of an accident during a
trip, insurance for theft during a vacation period, and so on.
The proposed premium, being a limited period of time, is always low, however, it
should be noted that the insurance offer is always very limited compared to tradi-
tional coverage.
9.12 New Products: Parametric Policies 201

9.12 New Products: Parametric Policies

Parametric policies are a new insurance product distinguished by an algorithm,

stated in the policy, that determines compensation in the event of a claim when an
objectively quantifiable parameter exceeds a certain threshold (known as a trigger),
also predetermined in the policy itself.
Therefore, compared with traditional policies, where compensation is paid on the
basis of an expert report documenting the damage suffered, in the parametric policy
the insured does not have to prove that he or she has suffered a loss.
Compensation is not commensurate with the actual damage suffered and is based
on a predetermined “lump sum” amount, but at the same time, failure to exceed the
parameter, even in the case of damage suffered by the insured, does not entitle the
insured to any compensation.
In parametric policies, the so-called oracle, that is, the person, third and indepen-
dent of the insurer and the insured, who measures changes in the parameter, assumes
a significant role.
For example, in parametric policies linked to climate risk, the parameter of rainy
days in a season could be devolved to the oracle “national weather bureau,” if the
latter presents a statistic with 100 rainy days at the insured site and the trigger is
50 days, the policy will provide automatic indemnification for days above the
trigger.
The reasons why the market is increasingly turning to the parametric policy is
because of lower operating and administrative costs that result in a more advanta-
geous premium. In addition, these insurance products are distinguished by clarity
regarding the amount to which the insured is entitled in the event of a claim and
speed in the payment of compensation.
The main areas of application of parametric assurance to date include:

• Protection against natural disasters such as earthquakes, cyclones and hurricanes,

phenomena whose insurability with parametric products is supported by weather
data measured over a specific period.
• Protection for agricultural crops against damage and loss caused by air pollution,
drought conditions.
• Hail damage, again supported by meteorological data measured over a specific
period.

Then there are other areas where the use of parametric products is beginning to be
experimented with:

• Coverage of profit losses of production activities, for example, as a result of

system outages due to cyber attacks, bad weather, or pandemics.
• Covers for falling occupancy rates of hotel or restaurant rooms, such as a result of
adverse weather conditions.
202 9 Non-Life Insurance Products: Personal Line

It should be emphasized that the Regulatory Authorities are scrutinizing these

new products very carefully to prevent them from functioning as derivative financial
products in which hedging can be a tool for betting on the occurrence of an event
without having a specific interest to protect and thus collecting an amount linked to
the occurrence of the event without having actually suffered a loss.
A second aspect under observation concerns the application of the indemnity
principle of insurance for parametric policies because the total amounts collected in
the event of a claim must not exceed the amount of the loss. In fact, for the indemnity
principle, the insurance contract must have a purely compensatory purpose for the
damage suffered, and it is clear that the occurrence of the claim cannot constitute an
opportunity for enrichment for the insured himself; in such an eventuality.

9.13 Cover for Condominium Buildings

In several European Countries, in cases of a flat located in a Condominium, in

addition to a policy on the individual private dwelling, there are also Condominium
association insurance policies. Depending on the law of the state, these contracts are
generally taken out by the manager of the Condominium.

" Definition The Condominium association insurance policy is a product ensur-

ing cover for the ordinary risks of Condominium buildings. The insurance product is
a comprehensive policy. The basic cover offered by these policies consists of fire,
other property damage, and civil liability to third parties. The purpose of this policy
is to protect the structure of the building and common areas from possible events
inherent to the risks described above.

This policy, however, may not extend to the inside of the personal property. The
structure of a Condominium consists of bare walls, floors and ceiling. The common
areas of the building generally include shared spaces such as hallways, clubhouses,
elevators, roof, basement, courtyards or walkways, etc.
Concerning the indemnity in the event of fire, the formula usually foreseen by an
insurance undertaking is Replacement Cost Value (RCV).

" Definition Replacement Cost Value (RCV) calculates the indemnity on the
basis of the cost, which is normal in this area for a Condominium of the same type
and in a comparable location. Based on this formula, the value of the item insured is
that at the time the loss event occurs.

About other property damage, this policy covers water damage caused by burst
pipes, rain and melting snow. Depending on the local regulation, the insurance may
not cover sewer or drain backup or flooding, which would require additional
coverages or policies. Analysing the optional covers, cover for other property
damage foresees reimbursement deriving from breakage of plate glass and glazing
in the common parts of the building.
9.13 Cover for Condominium Buildings 203

Table 9.8 Outline of the Condominium association’s insurance policy

Insurance covers Events insured/Insurance performances
Water damage Damage caused by the escape of water due to breakage of pipes
Atmospheric events Wind, hail, frost, and other atmospheric events
Socio-political events and Damage suffered as a consequence of acts of vandalism, riots,
acts of vandalism etc
Search for breakages Expenses incurred to search for breakages
Solar panels Damage to solar panels caused by events foreseen in the policies
Catastrophes Cover for damage from earthquake, flood and inundation
Assistance In situations of emergency for the common parts of the
Condominium, sending of a skilled technician is foreseen such
as, for example a smith/doorframe man, plumber, electrician
heating/gas technician

In respect of civil liability cover, indemnity is foreseen for damage in respect of

which as assured is civilly liable. Injuries may be caused involuntarily to third parties
as a consequence of an accident occurring in connection with ownership of the
building or the fixed installations intended for managing the real property. It is a
cover that foresees indemnification of injuries caused to third parties (for example
fall of an aerial from the roof, an automatic gate impacting a vehicle, spillage of
water due to the breakage of a Condominium pipe, etc.). Condominium policies
often include guest medical protection, which will help protect financially if some-
one requires medical treatment resulting from an accident in the building (i.e. if a
guest is injured after slipping and falling in the common areas). In this case, the
Condominium association’s insurance policy covers the liability protection such as
legal or medical costs.
Table 9.8 shows the main covers (basic and optional) referred to for a condomin-
ium association insurance product.
On the other hand, the reader should not confuse a condominium policy with a
Homeowner insurance. The latter usually covers things inside of the personal
property, like kitchen cabinets, appliances, bathroom fixtures, and any plumbing
and wiring in the personal unit. As explained in the previous section, this contract
includes the following coverages:

• Protection for personal belongings against covered losses.

• Coverage for damage to the interior of a personal unit resulting from certain
causes.
• Additional living expenses, i.e. if the householder is victim of a fire or another
disaster covered by the policy.
• Liability protection to help protect the householder if he/she is sued or if he/she is
found at fault after someone has an accident in the personal unit.
204 9 Non-Life Insurance Products: Personal Line

9.14 Questions

1. What are the non-life insurances classifications?

2. Which is the difference between Temporary Disability (TD) and Permanent
Disability (PD)?
3. Which are the four covers of healthcare insurance product?
4. What are the damaging events covered by a fire policy?
5. For theft insurance, what are the differences between Actual Cash Value
(ACV) and Replacement Cost Value (RCV)?
6. Who is the beneficiary in a CPI policy?
7. What is the package of documents required for a Motor TPL policy?
8. What are the variables for determining an automobile tariff?
9. Which are the typical covers for a comprehensive Homeowner policy?
10. What is pet insurance?
11. What are the covers for a Condominium association’s insurance policy?

Directives and Regulations—Chronological Order

Directive 2009/103/EC - Civil liability insurance for motor vehicles
Council Directive 2004/113/EC of 13 December 2004 implementing the principle of equal treat-
ment between men and women in the access to and supply of goods and services

Suggestions for Further Study

Dionne G, Laberge-Nadeau C (1999) Automobile insurance: road safety, new drivers, risks,
insurance fraud and regulation. Springer, Cham. https://doi.org/10.1007/978-1-4615-4058
Kaplan (2015) Glossary of insurance terms, 7th edn. Kaplan Financial Education, La Crosse
Kaplan (2019) Property and casualty principles, 5th edn. Kaplan Financial Education, La Crosse
Rubin HW (2013) Dictionary of insurance terms, 6th edn. Barrons, Hauppauge
Salvini, P., Bertolini, A., Pagliai, T., Morachioli, A., Acerbi, G., Trieste, L., Cavallo, F., Turchetti,
G. Dario, P. (2016), On robots and insurance, in International Journal of Social Robotics.
Turchetti G, Daraio C (2004) How deregulation shapes market structure and industry efficiency.
The case of the Italian motor insurance industry, The Geneva Papers on Risk and Insurance
29(2):203–219
Turchetti, G. e Geisler, E. (2010), Economic and organizational factors in the future of telemedicine
and home care, in A. Coronato e G. DePietro (ed.), Pervasive and Smart Technologies for
Healthcare, IGI Global, Hershey (Pennsylvania, USA).
Turchetti G, Spadoni E, e Geisler, E. (2010) Health technology assessment. Evaluation of biomedi-
cal innovative technologies, IEEE Engineering in Medicine and Biology Magazine, May/June
29(3):70–76
Turchetti G, e Geisler, E. (2013) Home healthcare services: An educative case for the development
of a service-dominant-logic approach in the marketing of high tech services. In: Cinquini L, Di
Minin A, Varaldo R (eds) New models of business and value creating: Service science.
Springer, Milano
Non-Life Insurance Products:
Commercial Line 10

Abstract

This chapter illustrates insurance products for commercial line. For a better
understanding, types of cover have been divided into four macro-categories and
described.

1. Property and Liability. Property includes insurance for damage to property

(i.e. Fire, Theft, Property, “All Risks” coverages C.A.R. and E.A.R). Liabil-
ity includes insurances for Businessowner liability, Employers’ Liability,
Product Liability and Product recall, insurance product covering environ-
mental pollution risk, Professional indemnity and Directors and Officers
(D&O).
2. Marine, Aviation and Transport (MAT) includes covers for commercial trans-
portation both for damage to hulls (vessels or airplanes) and damage to goods
carried and liabilities of the parties concerned.
3. Business credit and Surety bond. Business credit offers protection against the
risk of debtor insolvency. Surety bond meets the need of an enterprise to back
a commitment received by a party identified as assured. Policies can be
divided based on the subject matter of the obligation.
4. Covers for employees mainly include products concerning the protection of
employees of an enterprise (accident, key person dead, reimbursement of a
loan granted by a credit institution to a firm itself and cover for business
trips).

# Springer Nature Switzerland AG 2024 205

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_10
206 10 Non-Life Insurance Products: Commercial Line

Keywords

Fire · Fire insurance · FLEXA · Replacement cost value (RCV) · Full value · Wear
and tear · New for old · Theft · Theft insurance · Scheduled personal property ·
First Loss · Engineering insurance · Actual Cash Value (ACV) · New
Replacement Value (NRV) · Business interruption formula · Boiler and
machinery insurance · Cyber risk · Cyber risk insurance · Contractor’s All Risks
(CAR) · Cross liability · Erection All Risks (EAR) · Liability · Liability
insurance · Occurrence basis · Claims Made basis · Care, custody and control
(CCC) · Businessowner liability insurance · Employers’ liability insurance ·
Product liability insurance · Product recall insurance · Pollution liability
insurance · Professional indemnity insurance · Medical malpractice · Directors &
Officers (D&O) liability insurance · Wrongful acts · Comprehensive business
insurances · Legal protection insurance · Assistance insurance · Marine Aviation
Transport insurance (MAT) · Marine insurance · Cargo insurance · Open Cargo ·
Cargo time (or voyage based) · Marine insurance certificate · Transport liability
insurance · Ocean Marine insurance · Inland Marine insurance · Hull insurance ·
Aviation insurance · Business credit insurance · Export Credit Agency (ECA ·
Surety · Bond · Surety bond insurance · Immediate execution · At definitive loss ·
Commercial surety bond · Accident · Business accident insurance · Disability ·
Creditor Protection Insurance (CPI) · Key Person insurance · Business travel
insurance

10.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the range of insurance products and solutions for commercial line.
2. Illustrate the insurance guarantees of the various products.
3. Recognise the differences between policies covering liability.
4. Explain the covers for all the risk lines.

10.2 Commercial Insurance Products

Policies set aside for enterprises concern protection of means of production, of

property (buildings and goods) and intangible property (i.e. reputational risk) and
covers for injuries caused to third parties.
Concerning the four macro-categories of coverages, these can be classified as
follows:
10.3 Insurance Products for Damage to Property 207

1. Property and Liability. The Property group includes insurance products for
damage to property. Under it fall products such as Fire, Theft, Property, “All
Risks” coverages C.A.R. (Contractors’ All Risks) and E.A.R. (Erection All
Risks). The Business Liability grouping includes insurances for Businessowner
liability, Employers’ Liability, Product Liability and Product recall, insurance
product covering environmental pollution risk, Professional indemnity and
Directors and Officers (D&O).
2. Marine, Aviation and Transport (MAT). This type includes covers for commer-
cial transportation. Covers apply both for damage to hulls (vessels or airplanes)
and damage to goods carried and liabilities of the parties concerned.
3. Business credit and Surety bond. Business credit insurance offers protection
against the risk of debtor insolvency. Surety bond insurance meets the need of
an enterprise to back a commitment received by a party identified as assured.
Policies can be divided on the basis of the subject matter of the obligation.
4. Insurance covers for employees. This type mainly includes insurance products
concerning the protection of the employees of an enterprise (accident, decease of
a key person, reimbursement of a loan granted by a credit institution to a firm
itself and cover for business trips).

10.3 Insurance Products for Damage to Property

The offer devoted to the world of business is made up of insurance products

developed ad hoc to protect risks tied to carrying on the business of an enterprise
with specific solutions.
The relevance given by entrepreneurs to individual types of risk varies depending
on the sector they belong to and the class of scale of the enterprise. The choices made
for the transfer of insurance risk depend too on the availability of a market for
products suited to meeting the needs for the cover of corporate activity.
The following paragraphs illustrate coverages related to the protection of firm
assets from damage and unexpected events that may arise as a result of the occur-
rence of risks.

10.3.1 Fire Insurance

" Definition By fire is meant a phenomenon of combustion with flame or glow

affecting the physical property. From a standpoint of insurance, fire is considered to
be such when it appears outside a specific fireplace and may self-extend and
propagate.

By means of a fire policy, enterprises obtain cover against the economic loss that
might strike if this were to occur.
208 10 Non-Life Insurance Products: Commercial Line

" Definition A fire insurance policy covers all direct physical damage caused to
the items insured following fire, lightning, explosion and aircraft. Insurance addi-
tionally covers damage caused to the items insured by the release of fumes gases and
vapours. Optional coverage may include wind, hail, frost and other atmospheric
events.

A common combination of risks is the FLEXA formula.

" Definition A FLEXA guarantee covers Fire, Lightning, Explosion, Aircraft.1

This coverage is generally available in those countries where there is British/USA
influence. This provides cover against the following basic risks: fire and lightning,
explosion, excluding nuclear incidents, falling aircraft and related impact.

Also included in the cover is loss caused to the items insured by order of
authorities for the purpose of impeding or confining the fire. It is possible to include
indirect losses, reconstruction expenses, liability for third-party recourse, etc. in the
cover.
Assessment of the risk by an insurance undertaking is done taking into account
various features such as the nature, scale, structure and use of the buildings insured
and those close by. Concerning the enterprise, other elements are also considered,
such as, for example the kind of processing done, the nature of the materials used,
fire protection and security systems. For all these issues, the evaluation is often made
following a careful Risk Assessment.
Concerning indemnity, the formula usually foreseen by insurance undertakings is
Replacement Cost Value (RCV).

" Definition Replacement cost value (RCV) refers to the as new value of the
insured object at the time of the loss event. This value determines the compensation
to be paid within the scope of the sum insured in the event that the object in question
cannot be repaired at a lower cost.2 According to the usual contractual agreement,
the replacement value could be different depending on the insured object.

For instance, the RCV for buildings is the normal value for a building of the same
or similar type and with the same or comparable purpose in the same or comparable
location. Any loss in value is deducted except under the formula new for old. For
furniture or other household contents, RCV is equal to the new purchase price or
repair cost. In case of destruction of goods, RCV represents the value on the market,
which is normal in that area. For finished products, the value is the price of
purchasing the product elsewhere from a comparable supplier.

1
FLEXA is an acronym for Fire, Lightning, Explosion, Aircraft.
2
For further insights, see Galey G. - Kuhn M. (2009) Fire Insurance—Technical publishing
Property—Swiss Re Corporate.
10.3 Insurance Products for Damage to Property 209

Based on the principle of ensuring that the sum insured is correct,3 the insured
sum should correspond to the value of the insured property at the time of the loss
event.

" Definition Full value is the amount at the current value. An assumption made
about natural depreciation is required when the contract is signed. Thus, for contents,
the current value equals the new price of a comparable object less wear and tear and
ageing.

" Definition Wear and tear is the damage stemming from routine use of the
property. Any item is expected to deteriorate somewhat over time from normal use.4

A second, different way for full value insurance is the formula new for old. This
formula is less frequently applied in contracts.

" Definition The formula New for old is used for items of property that lose their
value very quickly, for instance, equipment and vehicles. Additionally, all products
that have no new replacement value, such as natural products, are insured at current
value.

10.3.2 Theft Insurance

" Definition By theft is meant an act of stealing as defined. It is a crime against

property committed by a party abstracting the property of others in order to achieve
an unfair gain.

" Definition A theft insurance policy covers the assured against loss (direct and
physical) suffered in the event of theft of the items insured. Also covered are adverse
events brought about by robbery, burglary, bag snatching and damage done by
thieves, etc.

The words theft can have many different meanings depending on where it is defined.
An insurer within a contract of insurance, therefore, needs to define cover offer very
precisely.5 The main contract conditions foresee that the items insured be kept in
places that are locked.
The reader may meet a number of words, such as burglary robbery and simple
theft. Each of these terms will have a different meaning depending on local usage.
To quote the premium for underwriting a contract, an insurance undertaking
generally assesses various items such as location (comparing the percentage of thefts

3
For further insight about this rule, see Chap. 7.
4
Remember Wear and tear is not considered an insurable risk. Usually is under exclusions.
5
Note that robbery and burglary have a different meaning according to the local law.
210 10 Non-Life Insurance Products: Commercial Line

with the national average), the type of zone, (industrial or commercial as compared
to rural), the type of building (isolated as compared to centrally located), the
presence of neighbours, the type of property (with a number of entry points, floor
level, etc.) the presence of security systems. For this reason, the policy quotation is
often delivered after a process of Risk Assessment on the part of the insurer’s
underwriter.
A standard theft insurance contract has four sections: (1) declaration, (2) insuring
agreement, (3) terms and conditions, (4) exclusions.
In respect of section (1) declaration, this chapter contains a description of the
property insured. For this reason, a detailed endorsement that extends coverage
beyond standard protection is usually included.

" Definition Scheduled personal property is a form listing the articles covered by
the policy. It allows a policyholder to purchase additional cover for specific objects
and for a specific limit of cover.

Regarding section (2) insuring agreement, this contains the premium amount and
the obligations of the parties. For instance, any steps the assured must take in the
event of loss due to theft are described. About section (3) terms and conditions, this
contains the clauses determining the theft cover. The last section (4) exclusions
contain perils not covered under the policy.
In recent years, tariff and contract conditions have been modified greatly in the
sense of granting insurance cover even where the means of defending the site insured
are not those as prescribed contractually and foreseeing larger deductibles if theft has
been made possible by this very lack of the specific feature of the site.
The covers foreseen are of two types: Replacement Cost Value (RCV) or at
First Loss.

" Definition Replacement Cost Value (RCV) reimburses the value of the new
replacement item in the event of a claim. This coverage covers the amount that must
be spent to replace or restore an item of identical type, quality and functionality in
new condition. The principle is that policyholder has to be made good as if no loss
had occurred. For instance, if the goods are stolen, a replacement cost policy will
reimburse the policyholder the full cost of replacing them with a new goods of
like kind.

" Definition The First Loss estimates what a maximum fact and amount to (for
example for insuring a commercial vehicle), the sum insured therefore represents a
part of the full value (or a part of the full value).

The two formulations obviously have different costs. For this reason, the rate for
the Replacement Cost Value (RCV) formula is higher than the one for First Loss.
The First Loss formula is preferred when the property to insure is of significant
scale but the event to be insured will certainly have a limited impact on the wealth of
the assured. This is quite frequently the case in the cover for theft of stock. A firm
10.3 Insurance Products for Damage to Property 211

may indeed determine exactly what loss might realistically encounter as total loss
events are extremely rare (i.e. the theft of all goods contained in a large store).

" Definition The full value formula foresees the sum insured is equal to the real
value of the items. If, at the time of the loss event, the sum insured is found to be
lower than the actual value of the item, an insurance undertaking will reimburse a
lower amount. Basically, if the value of the stolen property at the time of a loss is
greater than the insured value, the policyholder will be underinsured by the differ-
ence in value.

10.3.3 Engineering Insurance

" Definition Engineering insurance covers accidental breakdown that might

occur during the use of the equipment or installations (in use or owned) of an
assured. These contracts have the purpose of indemnifying direct, sudden and
accidental physical damage that might arise following said risks occurring.6

A breakdown insurance policy normally covers the following specific cases:

• Damage attributable to defects in materials or other causes such as errors in

design,7 manufacture or erection/construction.
• Errors attributable to human nature (for example lack of skill or negligence).
• Damage that is a consequence of natural events such as frost, ice and snow etc.
• Incidents arising from non-functioning of equipment or instruments for command
or control.
• Damage due to electrical phenomena, for example short circuit or lightning.

Reimbursement of the damage depends on the sum insured. This value is a policy
parameter used to establish the indemnifiable amount. The insured sum is different
according to business line and can be classified into the following three formulas8:

• For material damage ¼ Actual Cash Value (ACV) or New Replacement

Value (NRV).

6
In the United States, in addition, an engineering insurance, covering a large spectrum of items, is
boiler and machinery insurance policy. This insurance provides cover against losses from break-
down of plant production equipment, electrical equipment, boilers, pressure vessels, heating and
cooling equipment. In addition to material damages, this coverage can be extended to include the
consequential events to breakdown such as absence of power generation, lack of refrigeration
systems, etc.
7
It should be noted that for cover of a “prototype,” issue is required of a specific policy whereas
breakdown to machinery due to a design error falls under this heading.
8
See also Bommelli, M. (2000) Machinery Insurance—Swiss Re Corporate.
212 10 Non-Life Insurance Products: Commercial Line

• For business interruption ¼ Gross profit/additional cost.

• For special cover ¼ First Loss Policy.

" Definition Actual Cash Value (ACV) is the value of an equipment or an

installation at the time of the loss. To determine the actual cash value, an amount
is deducted from the new replacement value (NRV) of an item. The amount takes
into account a number of factors: the use, age and condition of the item. Payment of
the actual cash value should enable the policyholder to obtain a reasonable replace-
ment for the destroyed or lost item.

The ACV underlying principle of the formula is that the service life of an item of
equipment or machine can usually be defined. During this period, a machine will
perform normal service efficiently and will generate products of commercially
acceptable quality. Based on this approach, prevention and programmed mainte-
nance will make sure that the equipment is always kept in good repair.

" Definition Replacement Cost Value (RCV) is the replacement cost of the
insured machine with a new one of the same type and specification. Indemnity is
paid in the amount that must be spent to replace with an item of identical type,
quality and features in as new condition. Normally the procurement, freight and
installation costs are included.

Some contracts foresee the formula New for Old. The New for Old formula is
applicable when repair of damaged property is not worthwhile or in case of total loss.
The formula is applicable also when the repair cost is above the Actual Cash Value.

" Definition Business interruption in the context of Engineering insurance usu-

ally means that an item of machinery will be halted for a period of time due to
breakdown. In this case, it is often possible to agree a sum insured representing the
maximum lost output plus any additional costs of working during this period over
and above the physical loss suffered.

" Definition The First Loss estimates what a maximum fact and amount to (for
example for insuring a commercial vehicle), the sum insured therefore represents a
part of the full value (or a part of the full value).

10.3.4 Cyber Risk Insurance

In addition to the damage indicated above, in current times, great attention is being
paid to the risk associated with computer piracy.
10.3 Insurance Products for Damage to Property 213

" Definition Cyber risk means the risk of facing economic/financial losses as a
result of accidental events or malicious actions that concern the IT system of a firm
(hardware, software, databases, etc.).

These risks can usually cause the following types of damage:

• Direct and material damage to IT (architecture, network, server, PC and computer

systems).
• Damage from business interruption.
• Claims for damages from third parties (for instance, customers and suppliers who
have been damaged by the loss or the removal of sensitive data, etc.).
• Reputational damage.
• Emerging costs for professional services to restore the situation.
• Ransom or material damage suffered to restore functionality antedate the claim.

In the event of a ransom request, some insurance undertakings require that

restoration work be carried out by specialist IT technicians first. Only after the actual
impossibility of solving the problem has been ascertained is the payment of the
amount requested allowed.

" Definition The IT risks that a Cyber risk insurance can cover are as follows:

• Business interruption, for example following a hacker attack.

• Theft of valuable data.
• Installing of malicious software.
• Criminal fraud through electronic channels.
• Identity theft.
• Forwarding of sensitive data.
• Errors and criminal activities by employees who transmit confidential information
or damage the reputation of the firm.

Concerning other performances that may be included, some insurers often provide
crisis management following a cyber-attack. In this case, Cyber risk insurance,
usually, covers both costs for forensic services and costs of communication with
the media.
Here below a general listing is offered of the most common performances
provided by Cyber risk policies in the event of a loss event occurring:

• Prevention service: an assessment of the risk of intrusion into the IT system of the
assured is performed. Operating systems and application software are updated.
Protection of the IT system (i.e. antivirus) and configuration of a reinstatement
system (i.e. back-up on a periodic basis) are carried out.
• Assistance cover: attendance by the insurance undertaking (through skilled
technicians) to resolve malfunctioning caused by viruses and reinstatement of
damaged data to the same conditions as applied at the last previously available
and useable corporate back-up.
214 10 Non-Life Insurance Products: Commercial Line

• Business interruption loss: indemnification of the assured for the adverse eco-
nomic impact arising from total interruption of activity due to non-availability of
an IT system caused by an IT attack. For each day of total inactivity, a sum of
daily benefit will be paid out.
• Refund of cyber-crime losses: indemnification of sums illicitly abstracted from
the assured by a third party via electronic transfer following unauthorised access
to the bank accounts of the assured.
• Protection of the assured against injuries caused to third parties following breach
of privacy: indemnification of what the assured is held bound to pay following a
claim from third parties for unauthorised access, theft or disclosure of sensitive
information and/or personal data contained in the IT system of the assured.
• Third-Party Liability deriving from multimedia activities: reimbursement of the
damages that the assured must pay to be civilly liable following a claim for
defamation or reputational injury.
• Reputational injury: damages for expenses incurred by the assured in the period
immediately after an IT attack for advice from experts who manage the protection
of their image and reputation.
• Cover for expenses of legal representation: via reimbursement of expenses
incurred or legal services by an affiliated network of lawyers.

10.3.5 Contractors All Risks (CAR) and Erection All Risks (EAR)

" Definition Contractors All Risks (C.A.R.) is an insurance product that covers
all the risks of the contractor. The policy gives cover against damages suffered by the
work under construction as well as for Third-Party Liability during the activities of
the building site. The sum insured under C.A.R. policy should represent the value of
the construction, including additional expenses (i.e. freight, customs duties, etc.).
This should represent the current replacement value of the items when constructed.

The contract period should be identical with the project period (i.e. from site
installation up to testing and hand over).
The policy will cover all direct physical damage, except for what is expressly
excluded. The policy will be extended to third-party liability for damage to persons
or property.9
In detail, the policy covers several problems that could occur during this type of
activity. The most frequent covers are the following:

• Damage due to fire, theft, earthquake, landslides, floods and hurricanes, subsi-
dence of the ground and errors in execution.
• Costs incurred for the repair or replacement of damaged goods.
• Damage to existing plant, deriving from events not attributable to the contractor.

9
See also Domke, A. (1999) Standstill covers under CAR and EAR insurance –Swiss Re Corporate.
10.3 Insurance Products for Damage to Property 215

• Demolition and clearing costs, caused by design errors.

• Extraordinary costs of night work and overtime.

In addition, the contractor is protected against damage unintentionally caused to

third parties (due to death, personal injury and property damage) during construction
activities.
C.A.R. may be supplemented by additional guarantees such as the protection of
the contractor, the client, and the subcontractor in the event of third-party liability.
For this type of contract, a special extension is foreseen to the third-party liability
cover via which all parties who are explicitly cited in the contract are deemed to be
third parties vis-à-vis each other.

" Definition This particular cover is called cross liability (for a plurality of
assureds). Cover foresees that in cases of there being a plurality of insured parties
(contractor, subcontractors, direction of work, etc.) for the purposes of the third-
party liability cover, these parties and persons who are their employees, are deemed
to be third parties vis-à-vis each other as if they had each concluded a separate
insurance.

C.A.R. can be signed for both public and private works. In many European
Countries this policy is mandatory if a construction site is opened following the
awarding of a public tender.

" Definition Erection All Risks (E.A.R.) is an insurance product that covers all
the risks of assembling, disassembling and final testing. These activities concern an
individual items of equipment or entire production lines for industrial plants. The
sum insured usually matches the fully erected value of the project to be installed
(including all additional expenses, such as transport, customs duties and assembly
cost). The value should be equal to the current replacement value of the items when
erected. The product is specific for all firms that produce, sell and assemble plants
under a “Turn-Key” formula.

The period is usually the same as the project period (from, i.e. mobilisation up
until testing and hand over). This product is an all risks policy that covers all material
and direct damage, except that expressly excluded. The policy is extended to third-
party liability for damage to persons or property. For this type of contract, a special
extension is foreseen to the third-party liability cover via which all parties who are
explicitly cited in the contract are deemed to be third parties vis-à-vis each other.

" Definition This guarantee is called cross liability (for a plurality of assureds)
and covers the liability incurred by one insured as the result of their damaging
another insured when both insureds are covered under the same contact. Each
insured should be treated as a separate entity under a cross liability clause.
216 10 Non-Life Insurance Products: Commercial Line

The most frequent covers applying are the following:

• Assembly and disassembly of permanent and temporary installations.

• Damage to pre-existing installations on which work is carried out in the
construction site.
• Demolition and clearing costs following an accident.
• Damage to machinery and construction equipment used during the activities.
• Third-party liability after completion of the equipment.
• Extraordinary costs of night work and overtime.

10.4 Business Liability Insurance

" Definition Liability arises when a party does not abide by rules of private law
governing relations between citizens. A legal duty to perform or not perform a
specified act is not met. Due to this circumstance, the property of a party is damaged
or destroyed, or this party incurs bodily injury as the result of a negligent act or
omission of another party.

" Definition The function of liability insurance is thus to hold an assured harm-
less in respect of what they may be held bound to pay to indemnify to a party as a
consequence of an accident brought about and for which they are liable. The
underlying principle is a simple one; on the one hand, protection of the wealth of
the assured and on the other protection for an injured party by ensuring damages are
paid even in the case of the party liable not having sufficient wealth.

The main insurance products that cover the risks of business-related liability are the
following:

1. Businessowner liability.
2. Employers’ liability.
3. Products liability and Product recall.
4. Environmental pollution risk.
5. Professional indemnity.
6. Directors & Officers (D&O) liability.

For liability policies, two different schemes for determining validity usually apply
concerning the period of cover for loss events. Several policies foresee backward-
looking cover while others feature forward-looking cover.
The backward-looking cover formula is called Occurrence Basis.

" Definition This formula, Occurrence Basis, covers the injuring consequences
arising from an event that occurred during the validity of the policy, but which may
even be reported later than the expiry of the insurance contract.
10.4 Business Liability Insurance 217

" Definition The Claims Made Basis refers to an insurance formula specific to
liability insurance. When this clause is present in a policy, all claims submitted
during the contractual validity period are accepted. Acceptance is unrelated to the
time the insurance contract issued and the possibility that the damage has occurred
even before the commencement of validity is admitted, provided that the insured is
unaware of this.

Later it will be seen how, typically, Employers’ liability is a policy based on an

Occurrence formula. On the other hand, Products liability, Product recall, Environ-
mental pollution risk, Professional indemnity, and Directors & Officers (D&O)
liability are, usually, Claims Made type insurances.

" Definition Care, Custody and Control (CCC) is a principle in most liability
insurance contracts. This clause excludes damage or destruction to property in the
care, custody and control of an insured from cover. This cover is excluded from
liability policies because the insured either has some ownership interest in such
property (and better covered through property non-liability insurance), or they are a
bailor of the property (and can better cover this bailment exposure through an
appropriate bailee policy).

10.4.1 Businessowner Liability Insurance

" Definition In general, the Businessowner liability insurance protects against

any injury that may be caused to a third party in the performance of the business
activity. Also included are activities related to this, such as subcontract or mainte-
nance work. In addition to the insured, the covers provided by this product include
the activities performed by its employees in the event of claims for damages are
made by third parties.10

In several countries, Businessowner liability insurance is included in comprehensive

business insurances. These comprehensive policies offer coverage to a business for
bodily injury, personal injury and property damage caused by its operations,
products, or injuries that occur on its premises.11
Comprehensive policies are specialised according to market, as are the covers
designed, for instance, for:

10
In this type of policy, the insurer often sets a time limit for claims reporting that is more limited
than under the local regulation of each country.
11
For instance, Commercial General Liability Insurance (CGLI) is the specific name for a policy in
the US insurance market that provides is a broad type of coverages for liability insurance for general
business risks.
218 10 Non-Life Insurance Products: Commercial Line

Commercial
Property
Insurance
Commercial General
Property Liability
Insurance Insurance
General
Liability
Insurance

Fig. 10.1 Coverages offered by a Businessowner policy (BOP)

• Manufacturers and contractors liability whose principal liability loss exposure

derives from business operations, products or completed operations.
• Storekeepers liability insurance whose cover aims to protect against bodily injury
and property damage liability resulting from ownership, use, and/or maintenance
of the insured business premises, completed operations and products.

A Businessowner liability insurance is often combined with protection for the

property. A policy that offers protection for all major property and liability risks in
one package is called Business Owners Policy (BOP). These packages are typically
designed for small and mid-sized businesses and offer a broad range of covers. This
kind of policy combines two covers together (property and liability) See Figure 10.1
for a representation of the coverages included in a BOP.

10.4.2 Employers’ Liability Insurance

" Definition Employers’ liability insurance provides cover for the liability a firm
has towards its own employees. If the firm has failed to adequately guard workers
from physical harm, this policy takes the field and defends the firm.12 The main
purpose of Employers’ liability insurance is to hold an employer harmless from the
claim of an injured worker.

It should be noted that in almost all countries, the mandatory cover is foreseen
against accidents at work, and related premiums are paid into a state body. In a

12
Note that this insurance is typical of European countries. The principle is linked to the concept of
welfare and to the strong protection of workers set in many European legislations.
10.4 Business Liability Insurance 219

number of European countries (for example in Italy), however, lawmakers have set
further rules protecting workers. In the event of a loss event occurring, the state body
may exercise a right of recourse to recover sums settled if the accident while at work
can actually be charged against the enterprise due to a breach in rules foreseen for the
protection of workers. In these countries, therefore, in order to protect the wealth of
the enterprise, Employers’ liability insurance contains a clause holding the enterprise
itself harmless in respect of any legal action taken by the State.
These policies usually foresee the Occurrence Basis formula. In this case, the
insurance undertaking covers claims following the injury that has originated during
the validity of the policy, but which may have been reported later than the expiry of
the insurance contract.

10.4.3 Product Liability Insurance

" Definition Product liability insurance covers the responsibility that a producer
bears for injury caused by defective products. Also included are products considered
insufficiently safe, due to manufacturing and marketing defects (choice of distribu-
tion channels, presentation to the public, instructions for use, etc.).

Within this category, third parties, whether consumers or other manufacturers who
use the product within their production process are included. Please note that
manufacturing activities also include:

• Design and development of the product.

• Manufacture of the product.
• Preparation of instructions.

This policy is based on a principle of Claims Made, i.e. the insurance undertaking
covers losses in respect of all reports of loss event submitted during the period of
validity of the contract, even if referring to events occurring prior to the commence-
ment of the policy, provided that the enterprise insured is unaware of them. This
product covers an insured manufacturer for claims after a manufactured product has
been sold and/or the claims results from an operation which a manufacturer has
completed.
Products liability insurance takes as its regulatory reference the directive in the
matter of the liability of a manufacturer approved on 25 July 1985 by the European
Community (85/374/EEC) and implemented subsequently by the laws of the mem-
ber states of the EU. The principle of the directive is for a liability of a strict kind
taking into account what is laid down under art. 1, according to which: “a manufac-
turer is liable for injury caused by a defect in their product.” Indeed, an injured party
need only prove the connection existing between product and injury, and the
producing firm is then bound to prove not being liable for what has occurred.
Additionally, the directive extends this liability to the entire supply chain of
production and sale, thus seeking to protect the final customer, who may take action
220 10 Non-Life Insurance Products: Commercial Line

against any or all parties involved, such as the manufacturer of the finished product,
the producer of the raw material or a single component of the good and anyone
applying their name, brand or distinguishing mark and so presenting self as actual
producer of the good.
Thus, a Products liability insurance has two aims in connection with the good to
be insured: cover vis-à-vis the final customer as required under the directive, and
protection against injuries caused by the product to another producing firm.
For this reason, ever more frequently, enterprises with sales to the public of goods
that are potentially injuring impose upon the entire chain of its suppliers taking out a
Products Liability policy suited to acting in the event of recourse vis-à-vis the actual
party liable for the injury.

10.4.4 Product Recall Insurance

" Definition Product recall insurance is often linked to and/or included in a

Products Liability insurance and consists in holding the assured harmless in respect
of expenses incurred to recall a product that is potentially injuring, whether defective
or not.

It is a cover that requires one of the following situations to arise after delivery to third
parties and/or putting on the market of the product for it to be activated:

• The products made subject to recall have caused injury to third parties due to
death, bodily injury and/or damage to property due to a defect in manufacture
and/or conceiving of the products described in the policy.
• A chance that what is described in the foregoing point might occur.
• An order from authorities given because the products of the assured, being
defective, bring about a failure in the security that can legitimately be expected.

This cover is taken out on a scale that is significant in the automotive business
where in recent years, there have been numerous recall campaigns set in motion for a
defect in a component of a vehicle. Given the fact that it is not possible to know the
specific vehicle involved, a large number of cars may be called back in, so incurring
enormous costs.

10.4.5 Environmental Pollution Risk Insurance

Environmental pollution risks are transversal risks that can affect different sectors
and several firms operating in different productive sectors. The risk is widespread. In
daily activities, a firm is often exposed to the possibility of polluting even
unwittingly.
10.4 Business Liability Insurance 221

" Definition Pollution liability insurance provides cover for loss or damages
resulting from unexpected releases of pollutants. A mandatory condition for the
activation of this contract is that accidental breakage, following which the polluting
event is determined. The philosophy underlying is to avoid the intentionality or
failure of the operator to comply with good practice. These coverages are typically
excluded in general liability and property insurance policies.

The most frequent damage causes can be:

• Discharge of non-standard waste that contaminates waters.

• Spills of pollutants due to human errors during loading and unloading operations
with consequent contamination of air, surface and underground water, soil and
subsoil.
• Pollutant emissions into the atmosphere of fine dust.
• Fire and its related consequences of reclamation and compensation of third parties
residing in the surrounding area and injured.
• Run-offs from storage areas (in the event that the designated areas are not
waterproofed).
• Leaks from underground tanks or pipes.

In many countries of the EU, there is a domestic consortium (or Pool) for liability
for environmental impairment, grouping together various insurance and reinsurance
undertakings. This Pool usually provides guidelines in respect of the reference
outline for a policy for liability for environmental impairment.
For this policy, the cover is of a Claims Made type, i.e. prior cover. In this case, all
adverse consequences occurring prior to the commencement of the policy are
covered, provided that the report of the loss event is made during the period of
validity of the policy.
The firm’s liability includes the burden of prevention activities and the costs of
restoring the original situation. Usually, insurance products covering pollution risk
can be distinguished between:

• An insurance policy that covers the costs of clean-up for the restoration of the
previous environmental conditions.
• An insurance product which insures damage to third parties due to the ingestion,
absorption or inhalation of polluting substances emitted by the insured’s factory
or site and introduced into the air, surface and ground water and into the soil.
• An insurance product for environmental damage, which protects against damage
to the environment, as the common heritage of the population residing in the area.

10.4.6 Professional Indemnity Insurance

" Definition A Professional indemnity insurance provides cover for a profes-

sional person.13 This cover has the purpose of eliminating or reducing consequences
222 10 Non-Life Insurance Products: Commercial Line

deriving from claims by a party who has suffered injury as a consequence of

practising a profession.

This coverage is for specialists in various professional fields. Since a basic liability
policy does not protect against situations arising out of business or professional
pursuits.14
In practice, the insurance market splits intellectual professions into three macro-
categories for which specific covers are intended:

• Liberal professions,15 for example qualified accountants, bookkeepers, lawyers,

attorneys, professional, agents, consultants.
• Technical professions, for example engineers, architects.
• Healthcare professions, for example physicians, surgeons, dentists and many
figures operating in the healthcare sector.

This policy is based on a principle of Claims Made, i.e. the insurer covers all
claims submitted during the period of validity of the contract, even reports for
injuries prior to the commencement of the policy.

Medical Malpractice
Definition By medical malpractice is meant all loss events injuring a patient
and deriving from a lack of skill of a doctor and/or a healthcare facility that had
them in their care.
Liability insurance for negligence covers the professional person and
defends legal actions brought against him and compensates for damages
established by the court (subject to the limits of the policy).
In order to meet this issue, in recent years, there have been risk management
functions in healthcare facilities devoted to managing the healthcare risk.16
Technological innovation, socio-cultural changes and the adoption of the
Claims Made insurance model instead of the Occurrence one have all
contributed to bringing about the changes made along the way in developing
management of the healthcare risk in a modern manner.

(continued)

13
Note that Professional Indemnity is a European insurance product. On the other hand, in the USA,
the Errors and Omissions (E&O) liability insurance is widespread. This policy is generally available
to the various professions that require cover for negligent acts and/or omissions resulting in bodily
injury, personal injury, and/or property damage liability to a client.
14
In some countries, validity of the policy is subject to proper enrolment of the professional person
in the relative professional registry.
15
A liberal profession indicates an occupation that requires substantial proficiency in complex skills
in the liberal arts or sciences that cannot be delegated to assistants.
16
See Comandé—Turchetti, G. (ed) (2004) La responsabilità sanitaria. Valutazione del rischio
e assicurazione, Cedam, Padova.
10.4 Business Liability Insurance 223

From the insurance standpoint, the high cost of damages paid out, and
which translates into insurance premiums, has been one of the main obstacles
to the development of the market and the widespread use of insurance covers
for the healthcare sector. Additionally, a number of medical specialisations
have been held to be high-risk and have difficulty in finding insurance cover
for the liability of the professionals involved.

10.4.7 Directors & Officers (D&O) Liability Insurance

" Definition Directors & Officers (D&O) liability insurance covers injuries to
third parties (typically shareholders) deriving from alleged errors in judgement,
breaches of duty and wrongful acts committed by senior management in connection
with their activities carried out on behalf of the firm. Cover will apply to senior
management, including Chief Executive Officers, General Managers, Members of
the Board of Directors and others.

According to this definition, negligent acts or omissions, errors or misstatement or

misleading statements are always included. Usually, a large deductible is requested.
The cover may also foresee reimbursement to the firm itself, if permitted by local
law. The policy may deem the firm itself and its partners, controlled and associated
companies and corporate creditors to be third parties.
Within the cover, wrongful acts are deemed insurable.

" Definition Wrongful acts may be misstatements or breaches of duty by an

officer or director of an enterprise which results in a lawsuit against the enterprise.
Wrongful acts specifically exclude dishonesty, theft, libel and slander.

On the other hand, intentional injury and acts of wilful misconduct are not
insurable.
The reimbursement promised by the insurer, in case of any claim, is as follows:

• Damages awarded by a sentence or an in-court or out-of-court settlement.

• Legal defence costs.
• Any advertising and communication costs.

Some insurers also offer reimbursement of punitive or exemplary damages that

may be imposed by judges upon individual named directors.
224 10 Non-Life Insurance Products: Commercial Line

Table 10.1 Outline of comprehensive business insurance policy

Insurance
covers Events insured/Insurance performances
Fire All direct physical damage caused to items insured following fire, lightning,
collapse and explosion. Insurance additionally covers damage caused to items
insured by the release of fumes gases and vapours
Theft All material and direct damages resulting from theft, burglary, robbery
Engineering All material and direct damages deriving from accidental failures during the use
of equipment or of the installations (in use or owned)
Liability Injuries caused to third parties as a consequence of an accident for which the
assured may be liable
Legal Reimbursement of costs of disputes tied to the entrepreneurial activity
protection
Assistance Help in a situation of difficulty such as a fortuitous event.
Property damage restoration and/or clean-up services

Conditions are Claims Made, i.e. the policy covers all loss events reported during
the validity of the insurance contract, occurring even at a time prior to commence-
ment of the insurance cover.

10.5 Comprehensive Business Insurances

" Definition Comprehensive business insurances cover loss arising from any
fortuitous cause except any that are specifically excluded.17 The underlying
approach is to cover a broad spectrum of causes of loss in a single policy. This
provides an “all inclusive” insurance solution.

These policies represent a flexible response given to the demand for insurance
protection from different sectors. These solutions allow an assured to benefit from
cover for multiple risks while signing a single contract. In Table 10.1 an example of
the covers that make up a comprehensive business insurance is shown.
For completeness, two guarantees are described in the following paragraphs: legal
protection and assistance. While for all the other covers, reference can be made to
what has already been discussed in their sections.

" Definition Legal protection insurance foresees assistance by the insurer in

in-court or out-of-court matters in which the assured is involved to defend their
interests.18 Regulations foresee that the assured may choose their own counsel to

17
This kind of policy is in contrast to “named perils coverage” The named perils cover applies only
to losses arising out of causes that are listed as covered.
18
For the purpose of achieving indemnification in respect of injuries suffered or in defending a
claim made against them, provided this is not made by the undertaking providing the insurance
cover for legal protection.
10.5 Comprehensive Business Insurances 225

represent their rights and interests. A contract of legal assistance may foresee the
provision of a sum of money or performance in kind.

In this type of insurance, the risk that is the subject matter of the cover is the
in-court or out-of-court dispute, and the right to performance arises together with the
debt for expenses.
For the European area, this cover is important for criminal representation for
culpable crimes and offences, such as accidents to persons outside the firm (for
example for maintenance technicians) in respect of whom the legal representative of
the firm is made subject to a criminal trial. Another situation is criminal representa-
tion in the matter of safety at work, privacy, etc. For example when a customer of a
firm believes that their personal data have been disseminated without their consent to
other business enterprises.

" Definition Assistance insurance covers where an insurer undertakes to provide

immediate help if the enterprise assured finds itself in a situation of difficulty such as
a fortuitous event.

A fortuitous event may indeed give rise to a need that is not strictly speaking tied
to the injury suffered. Just think of a breakdown to an alarm system, an Assistance
policy may provide a perimeter surveillance service for a limited time period.
Another type of event is a breakdown to an electrical installation requiring the
intervention a technician on a holiday period. Usually, the insured contacts an
assistance-operations centre by telephone to a freephone number.
In assistance insurance, an insurer may meet its obligation by paying a sum of
money or by providing a service (performance in kind and not in money). If the
performance is a direct one by an assistance service, performance in kind therefore,
the insurance undertaking may follow one of two possible routes: utilising an
internally organised structure, or an external one. In the first case, the persons
responsible, staff, IT systems, equipment assistance-operations centre, etc. are
owned by the insurance undertaking. In the second case, there is outsourcing. The
organisational structure manages the loss event by ensuring access to requests for
help and delivery of the assistance service in a timely and uninterrupted manner
(round the clock for 365 days).
Another useful service is property damage restoration and/or clean-up. Clean-up
firms set in motion all the measures needed to limit the loss following a loss event
occurring by reinstating goods and facilities to their previous state as quickly as
possible. Their actions are aimed mainly at clean-up services for buildings,
installations and hard copy archives. The area of the services offered relates to a
number of activities such as:

• First-aid on the site of the disaster.

• Attendance at the place of the loss and taking action to secure it.
226 10 Non-Life Insurance Products: Commercial Line

• Decontamination and sanitising of a building, machinery and any

non-perishable stock.
• Reinstatement to working order of equipment and machinery.

10.6 Marine Aviation Transport Insurance (MAT)

Under MAT coverages, all the transportation risks are included.

" Definition Marine Aviation Transport insurance (MAT) means the cover of
risks comprising maritime shipping, commercial aviation and transit risks (whether
the transit is by sea, inland water, land or air, or any combination thereof).

In several countries, MAT insurance also includes space launching and freight
(including satellites).
According to another point of view, MAT insurance concerns a heterogenous
group of insurance covers (in any case concerning transport business). With MAT
insurance an insurance undertaking offers the following coverages: the goods being
transported and/or the vehicle transporting the goods (so-called hulls, i.e. ships and
aircraft) and any liability of parties involved in transport activities.
Marine insurance is the best-known transport insurance.

" Definition Marine insurance is a policy primarily concerned with means of

transportation and goods in transit.19

MAT insurance is often offered for cross-country transits. Below all these types
of covers will be illustrated.

10.6.1 Coverage for Damage to Goods Carried

A policy for damage to goods carried protects an assured from risks of events that
might befall items that are in transit. The events may be fortuitous. Cover concerns
losses caused to items during transport irrespective of the conveyance used: hold of a
ship, a railway train or in an aeroplane or even road carriage. The policy covers the
actual value of the item travelling. This value must therefore be indicated in the
contract document.

19
For the reader. Note that, in the US insurance market, the meaning is different. Marine (single
word) means ocean transportation (so-called Ocean Marine Insurance) while Inland Marine refers to
transportation and goods in transit by land (so-called Inland Marine Insurance).
10.6 Marine Aviation Transport Insurance (MAT) 227

To be able to quote the risk and issue a contract,20 an insurance undertaking

usually assesses various items such as, the type of goods (fragility, perishability, etc.)
packing, stretch of travel, value insured, etc.

" Definition Cargo insurance is a policy usually based on Lloyd’s standard

English language conditions (if international or agreed so in advance), while in
some territories, local language wordings may be used that are similar but not
necessarily identical. Contracts may be per single shipment, but so-called open
covers are widely used too. Generally, these are used, so cover will apply automati-
cally to all shipments of a similar type with effect from an inception date and until
cancelled by either party subject to a notice period.

Cargo insurance will usually be based on a journey from one point to another
(destination) and include any interim storage along the way. Hull insurance may be
taken out on a time or voyage basis to suit the circumstances of the assured
(shipowner/charterer, etc.).

" Definition Marine insurance certificate is a blank insurance document. This is

issued by an insurer for a single shipment under an open cargo policy. The insurance
undertaking can issue this certificate when required to provide evidence of the cover
for a particular shipment.

10.6.2 Liability of Parties Involved in Transport Activities

Before explaining the concept of liability, all the parties involved in transport
activities will be described. The participating parties are four in number: sender,
consignee, shipper and carrier. See the following detail:

• Sender, i.e. the party commissioning the carriage.

• Consignee, i.e. the party who has normally acquired the item that is subject to
transfer.
• Shipper, i.e. the enterprise taking care of all the activities relative to the carriage.
They deal with choosing the carrier or directly perform the activities of transfer of
the good (in this case, we are dealing with a shipper/carrier).
• Carrier, i.e. the subject performing the transport of goods or person from one
place to another. Taking charge of the carriage, a carrier assumes an obligation
towards the sender and the consignee to transport, have custody of, and deliver
the good entrusted.

20
It should be noted that usually the rate of premium, differently from other lines of business, is
expressed in percent and not per thousand.
228 10 Non-Life Insurance Products: Commercial Line

" Definition Transport liability insurance offers coverage for third-party liability
that each of the above subjects is potentially exposed to during the transport
operations.

For the carrier, on the other hand, it is necessary to make a distinction between
cover for the good and the actual liability of the carrier. When the carrier is asked to
insure the good, the policy is for the benefit of others. In the other case, they are
liable in accordance with what is laid down under the domestic law (on carrier
liability) to reimburse any damage.
During daily operations, grounds for exemption from liability may be as follows:
causes of force majeure, inherent vice of the good, flaw in packaging, inevitability
and non-foreseeability of the event, damage occurring during activities of loading/
unloading performed by the sender/consignee.

10.6.3 Marine Insurance for US Market

" Definition Ocean Marine insurance is a coverage in the event of a marine loss.
Marine loss is damage or destruction of a ship’s hull and the ship’s cargo (freight) as
the result of the occurrence of an insured peril. Perils insured against include
collision of the ship with another ship or object, the ship sinking, capsizing or
being stranded, fire, piracy, and other events regarding the property.

Wear and tear of the ship and war risks usually are excluded.

" Definition Inland Marine insurance refers to property damage or destruction of

an insured’s property and liability exposure of an insured for damage to or destruction
of someone else’s property in their care custody, or control21 (CCC). The insured (the
shipper) needs this insurance because the carrier (who can also be the insured and
purchase inland marine insurance) may be found not at fault for damage to a property.
Perils covered include fire, lighting, windstorm, flood, earthquake, theft, etc.

10.6.4 Hull (Ships and Aircraft) Insurance

" Definition Hull insurance provides indemnification for damage caused to or a

loss of an insured vessel or aircraft. This guarantee indemnifies owners for damage
suffered by a hull (vessel or aircraft). Hull refers to the main body of a ship or an
aircraft. This definition includes bottom, sides, engines and other fittings (in case of
ship also the deck22).

21
For a definition of the principle of Care, Custody and Control (CCC) see the paragraph about
Business liability insurance in this chapter.
22
Note that for vessels, the masts are not included.
10.7 Business Credit Insurance 229

For the issue of these contracts, an insurance undertaking usually assesses the risk on
the basis of numerous elements among which are: year of construction of the vessel,
construction materials, gross tonnage, classification of the ship in navigation
registries, limits of navigation, etc. The cover is usually subject to a deductible,
depending on the type of vessel and its age.
Covers are generally based on the market value of the ship. Hull insurance covers
the market value of the ship and, at the same time, additional costs associated with
replacement beyond market value. Marine insurance, differently from other
insurances, is governed mainly by a code of navigation, and their discipline is
very much influenced by practices in certain countries, especially England.

" Definition Aviation insurance covers the operation of aircraft and the risks
involved in aviation.23

Coverage for hull losses and physical damage is often offered based on a detailed
assessment. This coverage often foresees a deductible, which depends on the type of
aircraft, and its age. Hull coverage is normally written on the value of the aircraft
determined at policy inception and the amount listed in a schedule. A property
schedule is a form listing the articles covered by the policy. If the aircraft suffers a
total loss, the insurer pays the agreed value less the applicable deductible. If the
aircraft suffers a partial loss, the insurer generally will pay no more than the value of
each damaged item.

10.7 Business Credit Insurance

" Definition Business credit insurance is intended to protect an enterprise’s
accounts receivable from a total or partial loss. A condition necessary is a loss due
to credit risks such as protracted default, insolvency or bankruptcy.24 This insurance
solution can be offered by private insurance undertakings and by a governmental
Export Credit Agency (ECA).

" Definition An Export Credit Agency (ECA) can be a private body or quasi-
governmental institution. It acts as an intermediary between national governments
and parties exporting, to issue export insurance solutions and guarantees for
financing. Their role and activities are performed at an institutional level. According
to European law, they cannot interfere with internal trade within a country’s borders.

23
Aviation insurance also provides cover for liability for passenger injuries and environmental and
third-party damage caused by aircraft accidents.
24
This policy is a Property & Casualty insurance. It should not be confused with such product as
Creditor Protection Insurance (CPI). In such policies, an insurer, in return for payment of a
premium, undertakes to guarantee that an enterprise will make reimbursement of a debt from a
loan. The lender entity is set as beneficiary and will receive reimbursement. See below for the CPI.
230 10 Non-Life Insurance Products: Commercial Line

In general, insurers conclude contracts with an enterprise (in this case, a creditor) in
one of two forms: a global form (i.e. foreseeing cover for all accounts receivable) or a
form per homogeneous groups.
Business credit insurance has the purpose of protecting the fulfilment of a credit
owed. The parties involved are an insurance undertaking and an enterprise insured.
The insured enterprise protects itself from the potential risk of a debtor becoming
insolvent due, for example to protracted default or bankruptcy. In some countries,
the policy will also cover failure to pay after a certain date.
In this type of cover, insurance commences with effect from the time when the
credit, protected by the insurance agreement, arises. Generally, insurance foresees
mandatory self-insurance in the form of a percentage of the indemnity which remains
borne by the policyholder (enterprise).
Taking out this type of contract foresees a preliminary assessment by the insur-
ance undertaking. For this purpose, the following factors are analysed: the scale class
of the assured, insolvencies reported by the policyholder in the most recent period
(compared with the average for the sector), geographic area (also to be understood as
country risk), the goods sector, the scale of self-insurance borne by the assured. All
these elements determine the rate of premium at which the cover may be granted.
In the global form, the premium is usually charged monthly and is calculated as a
percentage of sales for that month or as a percentage of all outstanding receivables.
In the form per homogeneous groups, the premium rate reflects the average credit
risk of the insured portfolio of debtors. In addition, credit insurance can also cover
single transactions or trade with only one debtor.
The value of the indemnity, foreseen in case of a loss event, is equal to the failing
to be collected (including any legal expenses) net of recoveries/partial payments
received and of the self-insurance foreseen in the policy.

10.8 Surety Bond Insurance

In order to deal with this insurance product, it is worthwhile to refer to what is laid
down in legislation.

" Definition A surety is a real guarantee that foresees a deposit in money or other
real property on the part of a party (debtor) for the benefit of another party (creditor).
The surety is given in order to guarantee the fulfilment of an obligation.

Similarly, a bond is a contract that foresees payment by way of guarantee given

by a guarantor.

" Definition A surety bond insurance is a contract by which one party agrees to
make good the default or debt of another. Actually, three parties are involved:
principal, obligee and surety.
10.8 Surety Bond Insurance 231

" Definition The principal or policyholder (debtor) is the one who is obligated to
fulfilling and who pays the policy premium and in the event of their failing to fulfil, a
loss event is caused. They are the ones who will undergo recourse by the insurer.

" Definition The obligee or assured (creditor) is the one who, in the event of
failure to fulfil on the part of the policyholder, claims from the surety-insurance
undertaking.

" Definition The surety or insurance undertaking is the one issuing the guaran-
tee, collecting the premium and paying any claim there may be.

The above parties may be anyone: private firms and Public Bodies.
This contract has the purpose of protecting the meeting of an obligation
contracted by one party vis-à-vis another. The obligation guaranteed may arise
following a breach of primary obligations, provided they are foreseen in a regulatory
provision or in a contract. Insurance guarantees in the surety line of business fulfil
the same legal-economic function as a surety in money or other real property and as a
bond guarantee that a certain party (policyholder) is held bound to set up for the
benefit of another (beneficiary).
An insurance undertaking is usually willing to issue a contract only after having
ascertained both that the technical and legal premises of the risk apply and having
carried out an assessment of the economic and asset situation of the principal.
Differently from other lines of business, payment of claims may be subject to
immediate execution, or at a definitive loss.25 In case of immediate execution, the
obligee (assured) is the entity that determines the amount of indemnity in this type of
policy. The payment is reimbursed upon their request without the intervention of a
loss adjuster (insurer), this is similar to a bank guarantee.
In case of definitive loss, this type of policy is subject to the intervention of a loss
adjuster (insurer) at the time of a loss, which will quantify it and determine the
indemnity amount.
These policies have a heterogeneous component of bond types.

" Definition A commercial surety bond consists in different types of guarantees

(deriving from obligations under the law, from obligations between private
individuals and from guarantees ordered by the public officials).

See the following list of the main commercial surety bonds:

• Proper performance of works: in this case, an insurance undertaking issues a bond

to guarantee contracts for performing works for the supply of goods or services.

25
For surety bond, the legislation of several European countries only provides for only the case of
immediate execution.
232 10 Non-Life Insurance Products: Commercial Line

In the event of non-compliance of time and performance, of obligations

established by contract, the obligee (assured) will be indemnified.
• Proper presentation of tender offer: in this case, the insurer guarantees that the
awarded party will sign the final contract. This policy in no way guarantees the
performance of the work awarded.
• Guarantee for customs operations: in this case deferring payment of part of the
customs duties is possible to subject to presenting a guarantee in the form of an
immediate execution insurance policy for an amount equivalent to the taxes and
duties involved.
• Returnable deposit/bond, which is necessary to perform a contract: in cases of
rental, the insurer issues a guarantee for the benefit of the landlord party (obligee)
for cases of a failure to pay rent on the part of the policyholder (principal).

10.9 Insurance Covers for Employees

Insurance covers for employees are generally policies offered to give a flexible
response to the demand for protection of people who work for a firm.

10.9.1 Business Accident Insurance

" Definition Business accident insurance products indemnify the assured for the
direct and exclusive consequences of a disability. Cover pays benefits for losses
caused to an entrepreneur or a manager by a series of injuries that can occur both
during work and in private life.

" Definition An accident is an unplanned, unexpected and undesigned event that

occurs suddenly. The event has to be out of the control of the insured and result in an
injury. The loss must be due to pure chance according to the odds of the laws of
probability. The event subject must produce injuries that are objectively observable
and that lead to disability or even death.

" Definition Disability due to an accident is a condition that curtails to some

degree a person’s ability to carry on normal pursuits. A disability may be partial or
total, temporary or permanent (or a combination of these).

In the case of medium-large enterprises, this cover is often linked to worker’s

compensation benefits. Usually, this is a plan provided by employers for the benefit
of employees.26 On the other hand, for corporate companies, this type of insurance

26
The policy also foresees it being possible to insure for a various figures temporary period, such as:
interns or persons visiting the firm for any cause.
10.9 Insurance Covers for Employees 233

may fall under a personal agreement relating to a package of special corporate

benefits for a senior management figure.
If this cover is intended for a medium-small enterprise (SME), the assured is often
the same as the policyholder, and so they can be self-employed workers, professional
persons and sole proprietors.
In the event of death from accident, payment of the sum insured is foreseen. Some
contracts foresee that the indemnity may not be added to anything already received
for Permanent Disablement (PD).
In cases of Permanent Disablement (PD) from accident, the capacity of the
assured to perform any work reduces or is lost definitively and irremediably. Two
outcomes are possible:

• Total Permanent Disability (TPD), when the assured may never be able to work
again.
• Partial Permanent Disability (PPD), when the assured is still able to work, but not
with the skill and efficiency demonstrated prior to the injury.

For Permanent Disablement (PD) reimbursement, the policy indemnifies a com-

pensation based on a financial sum payable to a worker with a particular injury.
In case of Temporary Disablement (TD) from accident, the assured is temporarily
unable to carry on their profession. Two status are possible:

• Total Temporary Disability (TTD), when the assured is expected to make a full
recovery and return to work.
• Partial Temporary Disability (PTD), when the assured is temporarily precluded
from performing a certain set of job skills but can still work at a reduced level.

For Temporary Disablement (TD) reimbursement, the policy indemnifies a com-

pensation that is a percentage of wages until the worker returns to their job (for TTD
status) or the difference between the two earning levels (for PTD status).
Table 10.2 illustrates a possible example of each state of disability covered under
an accident policy.
For calculation of the premium, the amount depends on the category of the
policyholder/assured (tied to the riskiness of the profession) and the cover option
chosen (which combination of disability states). Professions are split into riskier
professions and less risky professions. A listing, by way of example and not an
exhaustive, one of the types of profession split according to risk is as follows.
Medium-high risk classes (the level of risk is tied to the manual nature of the
profession):

• Farmers, breeders, woodsmen, fishermen, butchers and the like.

• Entrepreneurs or craftsmen in the building sector, decorators, painters and
the like.
• Plumbers, electricians, woodworkers, glaziers and the like.
234 10 Non-Life Insurance Products: Commercial Line

Table 10.2 An example of covers for business accident insurance

Permanent Disability (PD) Temporary Disability (TD)
Coverage Total Partial Total Partial Death
Benefit Compensation Compensation Compensation Compensation Pay out of
based on a based on paid is usually a is based on the the entire
financial sum number percentage of difference sum
payable to a of weeks of wages until the between the insured.
worker with a compensation worker returns two earning The
particular payable to a to the job levels indemnity
injury worker with a may not be
particular added to
injury anything
already
received for
permanent
disablement
(PD)

• Carriers, messengers, couriers and the like.

• Smiths, lathe-operators and the like.

Low-risk classes (the level of risk is tied to the intellectual nature of the
profession):

• Merchants, shopkeepers.
• Representatives, consultants, agents of commerce, promoters.
• Professional persons (lawyers, accountants, dentists, doctors).

The European approach can be different. The assessment of the degree of

permanent disability is often carried out following specific criteria. A list of injuries
is drawn up, and each injury is associated with a percentage of disability that is
presumed to result from it. The reimbursement is calculated as the amount of the
maximum sum insured multiplied by this percentage. The following case is
presented as an example:

• Injury: break of median meniscus;

• % of Permanent Disability indicated in the table: 10%
• Excess: 5%
• Sum insured: € 100,000.
• Sum of indemnity: [10%  (5% excess)]* € 100,000 ¼ € 5,000.

Consistent with this approach, if the degree of disability is severe, for example
above 50%, the insurer usually reimburses the insured sum in full (it is considered a
total loss).
The tables that may be used can be of various types. There are national tables or
profession specific or customised tables. These may be prepared by each insurance
10.9 Insurance Covers for Employees 235

undertaking on the basis of its own past experience or propensity for risk in the
accident line of business.

10.9.2 Creditor Protection Insurance (CPI)

" Definition Creditor Protection Insurance (CPI) policies aim to ensure that a
firm “can sleep easily” when taking on a financial commitment with a lender entity.
An insurer, in return for payment of a premium, undertakes to guarantee that an
enterprise signing up to the policy will make reimbursement of the instalments or the
outstanding debt from a loan. By means of this cover, the lender entity is set as
beneficiary and will receive reimbursement.

These policies are an insurance solution to cover medium/long-term mortgage and

unsecured loans granted by a credit institution to a firm. This kind of contract can
guarantee sole-proprietor firms and partnerships and joint stock companies. A CPI
policy usually foresees payment of a single premium in advance.
The events covered under the policy, and which may befall a debtor, are as
follows:

• Decease, it repays the residual debt up to a maximum amount.

• Permanent Disablement (PD) from accident, it repays the residual debt up to a
maximum amount.
• Temporary Disablement (TD) from accident or illness, it repays mortgage
instalments.

The details of the guarantees can usually be summarised as indicated in

Table 10.3.

10.9.3 Key Person Insurance

" Definition A Key Person insurance is an insurance solution thought up to

ensure business continuity for a firm in the event of loss of one or a number of
key people.27 Key person insurance is a policy on the life of a key employee whose
death would cause the enterprise financial loss. The insurance is owned by and
payable to the employer.28 The enterprise is the beneficiary of the plan.

27
This type of life insurance is also known as key man insurance or business life insurance.
28
Remember that in most countries, the cost of key man life insurance is not tax deductible. Firms
can only deduct key man insurance premiums if they are considered to be part of the employee’s
taxable income, in which case the employee is typically the beneficiary.
236 10 Non-Life Insurance Products: Commercial Line

Table 10.3 An example of covers—CPI

Covers Performances
Decease Reimburses the sum of the residual debt at the time of the loss event
Permanent disablement occurring
(PD)
Temporary disability Indemnity equal to the monthly instalments falling due during the
(TD) period

Some contracts offer coverage also for accidents causing permanent disablement
(PD) or for critical illness diagnosis.
Key person means a key resource for the firm or managers who determine the
firm’s competitive advantage over competitors. The product offers cover for serious
unforeseen events that could prejudice the progress of the firm.
Through its legal representative or a delegate, a firm takes out the contract, so
insuring one or a number of key people (for instance, up to a maximum of five29). In
the event of a loss event occurring, the insurer will indemnify most of the sum
insured to the firm, also paying a quota part to the assured/s (the key person)
involved or, in cases of decease, their heirs.
Performance consists of settlement of the sum insured in cases of decease,
permanent disablement (PD) or critical illness diagnosis of the key person. The
covers foreseen are:

• Decease: following decease of the assured, during the contract period (term
insurance) for any cause, the sum assured will be settled to the firm and to the
designated beneficiaries chosen at the time of taking out.
• Permanent Disablement (PD) from accident: when the capacity of the assured to
perform any job diminishes or is lost in a definitive and irremediable fashion.
• Critical illness: settlement of a pre-set indemnity if the insured is diagnosed with a
critical illness.

Regarding Permanent Disablement (PD), this condition renders the key person
unable to perform certain activities so that he or she cannot carry on normal pursuits.
The policy indemnifies the assured following an accident. Permanent disablement
(PD) may be total or partial. In the event of Total Permanent Disability (TPD), the
key person may never be able to work again. On the other hand, in the event of
Partial Permanent Disability (PPD), the key person is still able to work, but not with
the skill and efficiency demonstrated prior to the injury. Indemnity is based on a
financial sum payable to the firm depending on the severity of the particular injury.

29
The number depends on the size of firm.
10.9 Insurance Covers for Employees 237

Table 10.4 An example of the covers for a Key person insurance

Cover Indemnity Waiting period
Decease Insurer will pay out a cash lump sum if the None
named key person dies (term insurance)
Permanent Insurer will indemnify a financial sum None
disablement depending on severity of the particular injury
(PD)
Critical illness Insurer will pay a pre-set indemnity if the 6 months (0 days with
diagnosis insured is diagnosed with a critical illness medical examination)

Concerning the coverage of critical illness, the insurer, in return for a premium,
undertakes to grant an assured a settlement for the most frequent critical illnesses.
Usually, these are the following six: cancer, stroke, myocardial infarct, aorta-
coronary artery by-pass surgery, transplant of main organs, kidney failure.30
In practice, these policies foresee a waiting period. i.e. a period between the
diagnosis of critical illness and the commencement of insurance benefits. Subse-
quently, benefits are usually paid only for costs incurred after the end of this period.
See Table 10.4 for the details of the guarantees illustrated above.

10.9.4 Business Travel Insurance

" Definition A business travel insurance covers risks when travelling on busi-
ness, outside the municipality of residence. This policy offers covers for risks that
might happen during the course of a business trip.

For instance, the insurance covers most risks concerning business equipment, along
with medical expenses, loss and cancellation.
Usually, the following covers are foreseen:

• Assistance while traveling (through an assistance-operations centre) to request

medical support.
• Reimbursement of expenses for medical examinations and pharmaceuticals.
• Accident or an indemnity in the event of accident occurring on board a convey-
ance (for example train, aeroplane, taxi, bus, etc.).
• Indemnity for cases of theft, snatching, robbery or failure to hand back luggage.
• Reimbursement for expenses for immediate necessities incurred following delay
in hand back of luggage.
• Protection for technological work-tools (for example PC, tablet, cell phone, etc.).
• Reimbursement for expenses for lengthening of stay.
• Aircraft delay and rescheduling of trip.

30
See Chap. 9 for further insight about critical illness or dread disease insurance.
238 10 Non-Life Insurance Products: Commercial Line

For the policy activation, the employee usually, notifies an assistance-operations

centre by calling a freephone number or through a dedicated app. Covers are for the
provision of assistance services during the trip and when the assured find themselves
in difficulty. The territory of cover is generally global, i.e. covering the country of
origin, own continent and Whole World.

10.10 Questions

1. Which are the four macro-categories of coverages for the commercial line?
2. Which is the definition of fire?
3. What are the kinds of damage reimbursement tied to theft insurance?
4. What is the damage covered by the engineering insurance?
5. How does C.A.R. insurance works?
6. What are the risk covered by E.A.R. insurance?
7. What is the difference between Occurrence e Claims Made Basis?
8. What are the liabilities covered by Environmental pollution risk?
9. What are the risks guaranteed by D&O insurance?
10. What damages are covered by a cargo insurance?
11. Which are the parties of a surety bond insurance?
12. Which are the four disability combinations in Business accident insurance?
13. What are the covers of a Key Person insurance?

References
Bommelli M (2000) Machinery insurance. Swiss Re Corporate, Zurich
Comandé G, Turchetti G (eds) (2004) La responsabilità sanitaria. Valutazione del rischio
e assicurazione, CEDAM, Padova
Domke A (1999) Standstill covers under CAR and EAR insurance. Swiss Re Corporate, Zurich
Friedman JP (2000) Dictionary of business terms, 3rd edn
Galey G, Kuhn M (2009) Fire insurance – technical publishing property. Swiss Re Corporate,
Zurich
Rubin HW (2013) Fachbegriffe Versicherungswesen / Dictionary of insurance terms. Springer
Nature

Directives and Regulations—Chronological Order

Directive 2004/35/EC of the European parliament and of the council of 21 April 2004 on environ-
mental liability with regard to the prevention and remedying of environmental damage
Council Directive of 25 July 1985 on the approximation of the laws, regulations and administrative
provisions of the Member States concerning liability for defective products (85/374/EEC)
References 239

Suggestions for Further Study

Friedman JP (2000) Dictionary of Business Terms Third Edition
Hodgin R (ed) (2014) Professional liability: law and insurance. Lloyd’s Commercial Law Library,
London
Kaplan (2015) Glossary of insurance terms, 7th edn. Kaplan Financial Education, La Crosse
Kaplan (2019) Property and casualty principles, 5th edn. Kaplan Financial Education, La Crosse
Leonard A (ed) (2016) Marine insurance. Springer, New York
Rubin HW (2013a) Dictionary of insurance terms, 6th edn. Barrons, Hauppauge
Rubin HW (2013b) Fachbegriffe Versicherungswesen / Dictionary of Insurance Terms. Springer
Nature
 Part II
Pricing, Reserving and Reinsurance
Non-Life Insurance: Pricing
11

Abstract

This chapter explains the approach for calculating a non-life insurance premium.
The reader can follow the pricing procedure step by step. The method begins from
the frequency of an event occurring and the average cost of loss events. These two
factors contribute together to defining the first step, also called an equitable
premium. A safety loading is then added to this first kind of premium. This
kind of premium is defined as net premium and is the basis of insurance
technique. During this chapter, other safety loadings are presented that by way
of addition are added to the net premium. Each of these safety loadings has the
purpose of covering management expenses and acquisition costs of contracts. At
the end of this addition operation, it is possible to know the final value of the
premium. In the paragraphs that follow, each of these components is analysed in
detail. Multivariate analysis in determining the premium is explained: from the
frequency to the equitable premium, from safety loading to additional charges,
illustrating with simple examples the process adopted for their formulation.

Keywords
Statistical probability · Frequency · Law of large numbers · Mathematical
expectation · Equitable premium · Problem of the ruin of the player · Subjective
probability · Criterion of expected utility · Loss frequency index · Safety loading ·
Net premium · Multivariate analysis · Compound coefficient · Loading for
acquisition expenses · Loading for collection expenses · Loading for management
expenses · Loading for remuneration of own capital · Financial factor · Interest for
instalments · Issue rights · Technical premium · Taxable premium · Gross
premium

For this chapter, a special acknowledgement goes to Marcello Ottaviani (consulting audit and
appointed actuary).

# Springer Nature Switzerland AG 2024 243

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_11
244 11 Non-Life Insurance: Pricing

11.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Explain the methodology for determining the insurance premium

2. Explain the notion of equitable premium and illustrate the components
underpinning its calculation
3. Set out the theory of the ruin of the player
4. Describe the concept of net premium inclusive of safety loadings as
compared to equitable premium
5. Explain the notions underlying multivariate analysis and the concept of
basic premium
6. Calculate the real value of an insurance premium starting from the equation
underpinning the calculation

11.2 Probability and Equitable Premium

In the area of insurance, the concept utilised of probability is statistical probability.

" Definition The statistical probability is, in this specific case, the probability of
an event that is equal to the percentage of times that specific event would occur in an
infinitely long series of repetitions (or “trials”) of the same situation (or “sample”).

" Definition Frequency means the number of events within an observed sample
on which a certain event is displayed. Statistical frequency, if it is to be reliable,
requires a meaningfully high number of observations to be made.1

By way of support to the foregoing we can cite the law of large numbers.

" Definition Law of large numbers2 describes the behaviour of the mean of a
sequence of aleatory variables n which are independent of each other and identically
distributed (e.g. n tosses of the same coin) as the number of events in the sequence
tends towards infinity (n).

1
A distinction is made between absolute and relative frequency. The first is the number of
observations made that fall into each class of observation. The second is found by dividing each
absolute frequency by the total number of statistical units. Relative frequency varies from 0 to 1 and
its total is 1. Multiplying by 100 gives percentage frequency.
2
On this theme see Chap. 2 where the law of large numbers which is also called the empirical law of
chance or theorem of Bernoulli is looked at.
11.2 Probability and Equitable Premium 245

Table 11.1 Example law of large numbers

Number of tosses “Heads” comes up Frequency “heads”
10 7 0.70 = 70%
100 58 0.58 = 58%
1,000 522 0.52 = 52%

In other words, thanks to the law of large numbers, we are able to state that a mean
calculated on a sample that is sufficiently broad converges upon the mean of the
whole population. In general terms, via the law of large numbers, it can be said that
as the number of tests carried out increases, the value of the frequency tends towards
the theoretical value of the probability. Let’s begin with a simple example: let’s flip a
coin 10 times, 100 times, 1,000 times and check how many times “heads” comes
up. Table 11.1 shows the results obtained.
We observe that while deviations from the theoretical value increase in number
the value of the frequency is close to that of the probability (0.5 = 50%). So for
10 throws the gap is 2 (7–5), for 100 the gaps are 8 and for 1,000 they are 22, and, at
the same time, the frequency goes from 0.70 to 0.58 and then to 0.522. If we increase
the number of launches again, we will see that the value of the frequency gets ever
closer more to that of probability (0.50).

" Definition Mathematical expectation3 of a real causal variable X is a number E

(X) representing the expected value or average expected value in an aleatory event,
defined as the centre of probability distribution.

For example, in tossing a coin, the average value expected is the sum of the
amount to win and the amount in case of not winning, both multiplied by their
probability of occurrence. So as to understand the concept more fully, we can take
the following example: if heads we win 100, if tails 0. The expected value of the
game is 50, which is the sum of wins and losses weighed on the basis of probability
(50% for each case):

Expected value in the heads or tails game

: EðX Þ = 100 0, 5 þ 0 0, 5 = 50 ð11:1Þ

Another simple and intuitive example consists of the game of throwing perfect
die, where winning is the same as the value of the sides of the die. The possible result
for each of the sides of the die is according to a convention of a chance variable that
values [1]–[2]–[3]–[4]–[5]–[6] can assume, each with probability p = 1/6. The
expected average value of this chance variable will be 3.5. The result found is
determined by the following sum:

3
In literature, mathematical expectation can also be called expected value or expectation or mean
expectation.
246 11 Non-Life Insurance: Pricing

Expected value of the throw of a die

: ð1 1=6Þ þ ð2 1=6Þ þ ð3 1=6Þ þ ð4 1=6Þ þ ð5 1=6Þ
þ ð6 1=6Þ = 3:5 ð11:2Þ

In general, therefore, the mathematical expectation or expected value of a discrete

chance variable4 (i.e. one that assumes only a number that is finite or a countable
infinity of values) is given by the sum of the possible values it can assume, each
multiplied by the probability of the event actually occurring. In practice, the calcu-
lation is given by:

• The sum of the possible values that the discrete variable can take on.
• The multiplication between each of the values of the variable and the probability
that the event itself actually occurs, i.e. the weighted average of possible
outcomes.5

In non-life insurance, the events that are the subject matter of observation consist
of risks transferred by the assured to the insurance undertaking in exchange for
payment of a premium. Indeed, the characteristic activity of an insurance undertak-
ing consists of gathering a quantity of premiums sufficient at least to cover the total
of indemnifications it is bound to make.
The first step to be taken in calculating the premium that must actually be paid
over by an assured is to identify the equitable premium;

" Definition Equitable premium6 is the same as the expected value of a loss
caused by the probability of the event insured occurring.

If the sole source of chance lies in the occurring or otherwise of the event and the
sum of the loss produced, we will have:

Equitable premium : Π = p x ð11:3Þ

Where:

4
By discrete chance variable we mean a variable that takes on only a finite number or a countable
infinity of values.
5
What is described above applies only to a discrete variable. Where there is a continuous chance
variable we must turn to the theory of measure and the Lebesgue–Stieltjes integration. For this
integration, see Evgen’evich Shilov, G., and Gurevich, B., L. (1978) Integral, Measure, and
Derivative: A Unified Approach, Dover Publications, ISBN 0-486-63519-8.
6
In this chapter, the term “just premium” will be used to indicate the expected value of indemnifi-
cation and the term “net premium” to indicate the just premium to which a safety loading has been
added.
11.2 Probability and Equitable Premium 247

Π = the equitable premium

p = the probability or the frequency of the insured event occurring
x = the sum insured or the cost of the loss event

As can be seen the equitable premium is the same as the expected value of
indemnification made by the insurer.

Numerical Example
Let us take a pricing for the cover of the risk of fire to a dwelling with a sum
insured of € 10,000 and probability of this loss occurring based on empirical
studies or statistics of 0.001, i.e. that it occurs at a frequency of once out of
1,000 times during the period of cover by insurance.
In this case, according to the principle of equivalence, the expected value of
indemnification by an insurer is the same as the commitment made by the
insured. The premium for a cover of the risk of fire to their dwelling is thus
priced at € 10.0.

Thus, we have the following formula:

Example of equitable premium : Π = € 10, 000 0:001 = € 10:0 ð11:4Þ

Indeed, by applying this premium, the price of the cover in question becomes so
equitable that neither of the two parties actually gains an advantage. Economically,
for the insurer, reimbursing the cost of the fire to the dwelling for € 10,000 is exactly
the same as collecting € 10 before knowing how events will develop. So, the insurer
loses or gains depending on whether the event covered by insurance occurs or not.
Thus, insurance, if we leave aside its social significance, is no more than a wager
organised by the two parties. An insurer manages a large number of contracts and so
the premium is calculated in such a way that each contract of insurance has features
of a fair wager with regard to the sums insured; overall, there should be no loss
nor gain.
A number of factors apply that modify this equation and which are tied to
subjective human nature (subjective probability) and the conduct of each economic
party in conditions of uncertainty (criterion of expected utility), and which will be
looked at in the next paragraph.
248 11 Non-Life Insurance: Pricing

11.3 Theory of Risk and the Problem of the Ruin of the Player

What was stated in the foregoing paragraph, i.e. that with an equitable premium an
insurer on average should not have either loss or gain, is not confirmed by the theory
of risk and the problem of the ruin of the player theorised by the Italian mathemati-
cian De Finetti in the second half of the twentieth century.7

" Definition The classic problem of the ruin of the player posited by De Finetti
can be summarised as follows: in a fair wager between two players who play a
potentially infinite series of games, if one of the two is much richer than the other,
one that initially has a much smaller sum available is in practice certain to end up
ruined.

In other words, when playing against equals, the richer one wins in the end.
Therefore, since the market is made up of many parties and the insurance undertak-
ing is made up of a more limited number of these, the market is certainly richer than
the insurer: continuing to play fairly in an infinite series, an insurance undertaking
will encounter certain ruin.
Everything obviously changes if the game is not fair, i.e. if one of the two players
has an advantage over the other.8 It is not a coincidence that De Finetti himself
formulated two examples of a game with conditions that were not fair, but which did
however allow the game to be played: this is the position of the bank in the game of
roulette, which has the advantage of there being a 0, and indeed the case of an
insurance undertaking, which adds an element (or loading) for safety to the equitable
premium.
To set the problem properly, in addition to determining the fair premium, let us
consider another two elements that apply during the process of defining the value of
an insurance premium.
Since the outcome of an insurance event is uncertain and its probability
non-identifiable a priori (as in the case of the toss of a coin) except through observing
the event directly a concept of subjective probability is defined.

" Definition Subjective probability expresses the degree of faith that a party has
that the event will occur.9 It can be defined as the price that they would deem it fair to
pay to receive 1 (one) if the event occurs and 0 (zero) if the event does not occur.

7
For the theorem of the “ruin of the player” see De Finetti B., Emanuelli F., Economia delle
assicurazioni, Torino, UTET, 1967 e De Finetti B., La teoria del rischio e il problema della “rovina
dei giocatori”, n. 1–2, 1939.
8
Naturally, only a case where the game is not fair in favour of the player with a lower sum is worth
considering, as in the contrary case, accelerating the ruin of the player with less capital is all that
occurs.
9
For a look at subjective probability, see Chap. 2.
11.3 Theory of Risk and the Problem of the Ruin of the Player 249

To render the definition materially applicable, a criterion of consistency is added:

the probability of the events must be attributed in such a way that a certain win or a
certain loss cannot be obtained, or rather, it can be said that the events insured cannot
be certain. Probability, in this case, is a subjective event and can vary based on
whoever interprets the results. Finally, subjectivity in interpreting the results is to be
assessed by referring to the propensity for risk of the individual.10

" Definition A second concept is tied to a criterion of expected utility11

according to which, every contract must be found advantageous or at least indifferent
for the parties involved. The premium sought must indeed fulfil a function of utility
for the insurer for whom accepting the aleatory transaction must not be less than the
utility attributed to the gain in the situation prior to concluding the contract.

On the other hand, the assured is a risk-averse party, willing to accept the
imposition of the premium for as long as the greater charge under the contract is
advantageous for them.
In classic theory, an insurance contract in other words reproduces a commitment
between a risk-averse subject and a risk-neutral subject, with which the latter takes
on the risk of an uncertain situation by ensuring the risk-averse individual a given
certain value, in exchange for a certain payment (premium).
An insurance undertaking, thanks to the establishment of a very large number of
relationships with different subjects (diversification) and the law of large numbers, is
able to neutralise the effects of uncertainty. An equitable insurance contract is a
contract that guarantees the insured the expected value in the event of an adverse
situation or, equivalently, that establishes a cost of insurance (premium) equal to the
expected loss connected to negative events.
This approach for determining insurability or price for a certain cover applies
only in theory, since insurers, as mentioned above, adopt an approach which is rather
different. In particular, they come together in committees that the various corporate
functions, such as the technical function, actuaries and marketing take part in, so as
to have a plurality of views converge and reach a single intent, producing an
insurance contract at suitable conditions.

10
By way of example, so as to understand the concept more fully, just consider that if probability is
0.001, i.e. that it occurs at a frequency of once in 1,000 times, many individuals would be willing to
wager a small sum to win a significant amount, but few would stake the entire sum they have
available with the prospect of winning an even greater sum.
11
Defined too as a notion of Bernoullian utility or risk aversion. Bernoulli highlighted the concept,
which is apparently obvious, that there is no equivalence between the monetary value of goods and
the value that the holders of these attribute to them. For this concept, see also the look taken in
Chap. 2.
250 11 Non-Life Insurance: Pricing

11.4 Calculating the Safety Loading and Net Premium

It is intuitive then that an insurer cannot and must not, if they wish to ensure future
corporate continuity, play fair with the market, or they will ruin themselves. So, they
will add a loading to the equitable premium so as to ensure they have a margin. Here
below we will illustrate the ways in which this operation takes place.
In non-life insurance, the additional amount is usually calculated by adding a
percentage quota or a fixed quota to the equitable premium. To illustrate this
operation, the definition of equitable premium is picked up again and is represented
by formula (11.3). The equivalence shows the connection there is between the
probability of the event, which is the frequency at which loss events occur, and
the sum insured, which in reality is the same as the cost of actual losses.
Given what is illustrated above, the equitable premium can be represented as a
function of two indices: loss frequency and the average cost of losses.

Equitable premium :
Π = p ðfrequency of lossesÞ x ðaverage cost of lossesÞ ð11:5Þ

Numerical Example
To explain the concept of “year-risks”, let’s assume a portfolio of 5 policies
with these effective and expiry dates:

1. Policy effective: January 1st – year 1—expiry: December 31st – year 1 = 1

risk for the year 1
2. Policy effective: July 1st – year 1—expiry: June 30th – year 2 = 1/2 risk
year 1
3. Policy effective: December 1st – year 1—expiry: November 30th – year
2 = 1/12 risk of the year 1
4. Policy effective: January 1st – year 1—expiry: February 28 – year 1 = 1/6
risk of the year 1
5. Policy effective: June 1st – year 1—expiry: August 31st – year 1 = 1/4 risk
year 1

Total risks for the year 2022: 1 + 1/2 + 1/12 + 1/6 + 1/4 = 2.

" Definition The first indicator, i.e. the probability of losses occurring, has been
indicated as the loss frequency index F(s) and is given by the ratio between the number
of losses and the year-risks calculated with the pro-rata temporis method. The year-risks
because the reference period is at least one complete calendar year, to avoid effects.

Claims frequency index : p = F ðsÞ = number of losses=year - risks ð11:6Þ

11.4 Calculating the Safety Loading and Net Premium 251

Equitable Premium

Expected value of
indemnifications

x
Frequency of losses Average cost of losses

Fig. 11.1 Components of an equitable premium

" Definition The second indicator, the average cost of losses, is given by the ratio
between the sum of the amounts paid (total and partial) and added to reserves and the
number of losses in the period considered. “Definition ends”.

See Figure 11.1.

In reality, when calculating the average cost, a standardisation of the average cost is
always applied through what is called “elimination of the effect of high-value claims
(peak claims)”. Indeed, the average cost observed, even for portfolios that are not very
small, can be strongly influenced by the presence or absence of individual loss of
particularly high amounts; it is therefore considered necessary to sterilise this possible
source of data distortion by capping the cost of losses above a pre-preset threshold
(which will generally depend on the size of the insurance undertaking’s portfolio).
The analysis of the historical trend of the two indices and their comparison also
allow the insurer to obtain the value of the premium to be used to evaluate the
insured risk in the financial year yet to come. Over time, in light of the variations that
occur, the two parameters are continuously modified and revised, and also take into
consideration the environmental context and the expected and current specific
dynamics of the economy.
The safety loading12 is determined through the worsening of the equitable
hypotheses, with the aim of covering the maximum possible cost caused by
deviations between expected value and real value.
According to the classic treatment, the net premium is therefore obtained by
adding the safety loading to the equitable premium. The latter is also defined as the
indifference premium which makes the operation indifferent for the insurer and
therefore free from the risk of loss of earnings (see Figure 11.2).
Essentially, the safety loading is equal to the positive difference between net
premium and the equitable premium. This difference quantifies in monetary units in
time t0 the aversion of an insurer to the risk inherent in the insurance operation.
The safety loading can be expressed as a percentage of the net premium. Indeed,
the simplest and most widespread method is based on a principle of proportion

12
In the literature, the safety loading is also called the safety margin.
252 11 Non-Life Insurance: Pricing

Net Premium

Safety loading + Equitable Premium

Expected value of
indemnifications

Fig. 11.2 Net premium and safety loading

according to which the loss experience is represented by the expected value of total
indemnifications E(x * p) and the safety loading α is a sum that is proportional to this
amount. This is a principle of calculation that is adopted frequently in insurance
practice due to its simplicity.
So:

Principle of proportion : Π’ = Eðx pÞ ð1 þ αÞ ð11:7Þ

Where:

Π = the net premium

E(x * p) = the expected value shown by the product of the sum insured and the
probability of the loss occurring
α = the safety loading. With α > 0

What has been indicated can be illustrated starting from the formula (11.4). The
value of the net premium is represented below:

Π’ = € 10, 000 0:001 = € 10:0 ð1 þ 0:20Þ = € 12:0 ð11:8Þ

In reality, insurance undertakings include a loading that is different from the

safety loading determined according to the classic set-up, so as to consider the
strategic/commercial aspect the insurance undertaking intends to pursue in its
industrial arrangements.

11.5 Multivariate Analysis in Determining the Premium

The premium to be paid by insureds may be customised through sophisticated

statistical analyses with the aim of defining a sum that is as nearly as possible
commensurate with the features of the risk of an insured while still keeping to a
11.5 Multivariate Analysis in Determining the Premium 253

Table 11.2 Example of variables for multivariate analysis

Factor Amount/value
Base premium € 450.00
Territory 0.6044
Limit of indemnity 1.0904
No-claims discount 0.5439
Instalment plan 0.9712
Fuel 1.0245
Power rating in HP/KW 2.5249
Age of vehicle 0.9992
Type of driving 0.9919
Use 1.0004
Age of owner 1.300
Deductibles 0.9942
Compound coefficient 11,540
Tariff premium (final simulation) € 519,30

principle of mutuality To achieve this, the relationship applying between the various
features of insureds and their risks must be determined so as to set sums of premiums
that differentiate between classes of insureds that are as homogeneous as possible.
This type of verification involves the analysis of the technical parameters (frequency,
average cost, loss/premiums ratio) for each individual variable of the tariff.
The compound coefficient has been calculated by multiplying all the intermedi-
ate coefficients that concern the individual variables of the analysis together. So, it is
made up of the product of all the parameters that are connected directly or indirectly
with each other.
To achieve the objective of finding meaningful relationships between variables,
two approaches are adopted. One a priori and one a posteriori. The first lets us group
objects together according to the degree of similarity found among them and the
following techniques are used in particular: cluster analysis and factor analysis.13
A further example is the application of statistical methods which feedback for
each dependent variable (age, type of car, region of car use, etc.) a value for the
significance in respect of an independent variable (sum of loss) and the contribution
that this variable makes in explaining the loss sum event. Table 11.2 shows an
example for the calculation of variables for multivariate analysis.
In Table 11.2, base premium generally means the average premium of tariff to
cover the needs to meet the insurance undertaking’s future commitments. Generally
speaking, it could be the net premium (Figure 11.2), but each insurance undertaking
inserts variables to make the premium more or less conservative according to its
technical needs.

13
Cluster analysis serves to reduce the number of observations made, whereas factor analysis aims
to reduce the number of variables, as it is based on the relationship between them. Both are usually
applied ex ante to the data so as to slim down the process of data analysis.
254 11 Non-Life Insurance: Pricing

In addition to the analyses previously described (customising a priori), there is a

further customising (a posteriori) that is based on the loss experience relative to the
number of losses reported by the assured.
The analyses a posteriori may have some problems of low numbers and signifi-
cance in the statistical samples and, from this, a problem of reduced mutuality
between the assureds. Indeed, when the number of risk classifications is increased,
low numbers are obtained, and this can lead to low statistical reliability. An insurer
must therefore weigh the advantages and disadvantages of multivariate analysis
carefully so as not to be left with samples that are numerous, but too different
from each other, and so have offsetting effects or, contrariwise, with risk
classifications that are very well defined but too numerous and so not statistically
significant.

11.6 Components of a Non-life Premium

The processing illustrated up to this point has allowed a definition to be reached of

the concept of equitable premium and the safety loading added by an insurance
undertaking to meet variances between expected values and unexpected ones.
In reality, the premium that is sought from an insured includes other items such as
loadings to meet expenses incurred by the insurance undertaking, return on capital,
the financial factor, interest for instalments, rights relative to issue costs and fiscal
and para-fiscal charges. Finally, it needs to be considered that a number of insureds
can obtain discounts thanks to a business policy adopted by the insurance undertak-
ing. The total of all these components gives a final value to the gross premium agreed
between the parties. See Figure 11.3 for the components of a non-life insurance
premium.

Acquisition costs

Collection expenses Expense

loadings
Management expenses

Remuneration of own capital

Components
Financial Factor

Interest for instalments

Issue right

Fiscal and para-fiscal charges

Expected profit / Mark up

Fig. 11.3 Components of a non-life premium

11.6 Components of a Non-life Premium 255

Expense loadings consist of a quota applied to the net premium to meet manage-
ment costs that an insurer bears in carrying on its business as an insurance undertak-
ing.14 These include:

" Definition 1. The loading for acquisition expenses is the quota of the premium
that meets expenses concerning payment of the commission for acquisition paid to
the intermediary at the time the contract is taken out.

" Definition 2. The collection expense loading serves to cover the expenses for
the service of premium instalment collection after the first premium. This is a
recurring expense that appears over the whole course of the contract if this is longer
than 1 year. Under this heading the various expenses concerned in the process of
issuing releases and accounting the security are also considered.

" Definition 3. The management expenses loading is the quota of the premium
intended to meet the expenses of managing the contract and all the operating costs of
the insurance undertaking.

In addition to the loadings thus determined, it is possible to foresee a further quota

remunerating own capital invested in the insurance undertaking, being the loading
for remuneration of own capital. This quota, where it is applied, amounts to the
rate of interest on principal allocated, and is equal to the average rate of the cost of
capital in the industry or the shareholder/parent insurance undertaking.
The financial factor represents a discount allowed to the client. It matches the
sum of financial income that the undertaking gains from investing the advance
payments of premium as compared to the time of paying out losses. Indeed, during
the period between collection of the premiums and indemnification of losses,
resources acquired are invested by the insurance undertaking in financial assets. A
portion of this income therefore accrues to the benefit of the insureds. Where
contracts are multi-year, this component can reach significant values.

" Definition The interest for instalments corresponds to the rate of interest
applied to the premium in the event of the insured being allowed to pay by
instalments. This is applied by addition to the sum of the premium instalment.

In Table 11.3 an example of a rate of increase tied to the periodic delay in

premium payment applied to fractions of the premium is shown.

" Definition Issue rights are a reimbursement of costs incurred by the sales
network for activities in underwriting and issuing the contract. This item also serves
to cover activities of setting up and collecting documents to be sent to the insurance
undertaking (where required).

14
In the literature, loadings are often defined as accessories or additionals to the premium.
256 11 Non-Life Insurance: Pricing

Table 11.3 Example of rate of increase for non-life premiums

Periods Rate of increase
Annual 0%
Half-yearly 2%
Quarterly 3%
Monthly 4%

Their sum is defined as a set figure, usually a value expressed in euros and
irrespective of the sum of the premium collected. These amounts are added to the
sales commission and may be retroceded wholly or in part by the insurer to the sales
network.

" Definition The fiscal and para-fiscal charges are the taxes paid by the assured
to the insurance undertaking applying to the value of the premium. They are then
paid by the insurer to the State as collection agency.

The sum of all these components gives rise to the gross premium, i.e. the premium
owed by the policyholder after applying any taxes there may be. In practice,
insurance undertakings often introduce mechanisms to make tariffs flexible: these
indeed allow their networks of intermediaries to apply various discounts to clients of
a certain importance. These discounts fall outside strictly actuarial schemes and aim
to keep an existing portfolio and acquire new contracts.
In Figure 11.4, the economic make-up leading to creating a gross premium is
represented. Different configurations of premium can be seen, such as technical
premium and taxable premium. At each stage further elements as compared to the
previous one are added or subtracted. See Figure 11.4 for the components of a gross
non-life insurance premium.

" Definition The technical premium is the sum of all the components prior to the
commercial discount applied, i.e. the value of the net premium, loadings, remunera-
tion of capital, financial factor and any interest for instalments, in addition to rights
for issue.

" Definition The undertaking’s mark-up represents the mark-up or expected

profit that the undertaking adds to the total costs during the premium calculation
process. The setting of this value takes place according to an additive approach
(i.e. adding a margin over total costs).

" Definition The taxable premium is the same as the technical premium after
deducting all discounts agreed. Finally, the gross premium is the taxable premium
increased by taxes and para-fiscal charges set by law.
11.7 An Example of Determining a Non-life Premium 257

Equitable
Premium
Net Premium
Safety loading

Acquisition
costs

Expense Collection
loadings expenses
Technical
Premium
Management
Taxable expenses
Premium Remuneration
Gross of own capital
Premium
Fiscal and - Commercial - Financial Factor
para-fiscal discount
charges
Interest for
instalments

Issue right

Expected profit
/ Mark up

Fig. 11.4 Components of a gross non-life premium

11.7 An Example of Determining a Non-life Premium

Here below the equation underlying an automobile liability tariff is illustrated. The
process is made up of five steps. In order to explain the example, at each of the five
steps, the factors used and related algebraic operations are illustrated, along with the
technical/insurance sense of this. Note that in corporate practice, the starting point
comprises the actual data the undertaking has.15 See table 11.4 below.
The first step determines the average cost of losses, starting from the cost for the
period just run and rectified to take into account all the items of distortion and so as
to find a cost adjusted for future expectations for the period of application of the new
tariff (t + 1).
The second step does the same as the first, in respect of the frequency of losses.
Step 3 determines the fair premium while considering a further element, i.e. the
financial return from technical reserves (index 12). In reality, the undertaking
collects premiums from insureds in advance as compared to when it actually pays
losses and so calculates an average discount value based on patterns of loss payment
on the basis of what has actually occurred in past years, or through making an
estimate.

15
To simplify, data that are purely for illustration are used.
258 11 Non-Life Insurance: Pricing

Table 11.4 Automobile liability tariff calculation

Step 1 Average cost of losses (paid and 1 €
outstanding) year t 5,385.00
Standardisation of largest losses 2 0.950
Adjustment of sums reserved 3 1.031
Projection to period of tariff application t + 1 4 1.060
Defence costs 5 1.020
Average cost of losses in the period of tariff 6 = 1×2×3×4×5 €
application t + 1 5,702.61
Step 2 Frequency of losses with follow-through 7 0.062
year t
Correction for IBNR losses 8 1.120
Correction for reopened losses 9 1.023
Projection to period of tariff application t + 1 10 0.932
Frequency of losses in the period of tariff 11 = 7×8×9×10 0.067
application t + 1
Step 3 Financial return on technical reserves 12 0.012
“Equitable” premium 13 = 6×11×(1–12) € 374.71
Step 4 Loadings
– f which acquisition 14 12,0%
– of which settlement 15 3,0%
– of which overhead 16 6,0%
Safety loading 17 5,0%
Total loadings 18 = 14 + 15 26.0%
+ 16 + 17
Undertaking’s mark-up (or expected profit) 18 bis 15,0%
Contribution for the uninsured vehicle 19 0.026
Step 5 Tariff premium (tariff requirement) period 20 = 13× € 537.95
t+1 (1 + 18 + 18bis + 19)
Average portfolio premium period t 21 € 491.97
Technical adjustment for current year 22 0.0354
Correction for claims/no claims 23 0.0340
Average portfolio premium period t + 1 24 = 21 × (1 + 22 + 23) € 526.11
Shortfall (or surplus) 25 = 1–20/24 (2.2%)

Step 4 takes the value of the equitable premium so as to render it to tariff, adding
the loadings for expenses and para-fiscal charges. This step is taken so as to have a
value that can be compared with the premiums in portfolio for the next step. The
value of premium found is called requirement, because it shows the cost that the
insurer must actually incur in meeting the costs of expected losses of assureds.
Step 5 compares the requirement with the average tariff premium observed for the
previous year, adjusted on the basis of technical assumptions made for trends in costs
of losses and other non-technical issues, among which being the impact of trends in
no-claims discounts. The coefficient obtained is used to perform rectifications to the
pricing of the insurance undertaking.
References 259

In the example shown above, a shortfall of 2.2% of the premium applied can be
seen, and to correct this expected technical loss, the undertaking will have to carry
out a review of a number of tariff parameters which can be applied to a number of
classes of insureds or to all of them through interventions carried out on the base
premium.

11.8 Questions

1. What is meant by equitable premium?

2. According to the theorem of De Finetti, how can the ruin of the player with lower
capital available be avoided?
3. What is meant by frequency?
4. How is the safety loading defined?
5. What is the purpose of multivariate analysis?
6. Is a loading for loss event charges foreseen among the components of a non-life
premium?
7. What is meant by interest for instalments?
8. What is the difference between taxable premium and gross premium?

References
De Finetti B, Emanuelli F (1967) Economia delle assicurazioni. UTET, Torino
Evgen’evich Shilov G, Gurevich BL (1978) Integral, measure, and derivative: a unified approach,
Dover Publications. ISBN 0-486-63519-8

Suggestions for Further Study

Daboni L (1989) Lezioni di tecnica attuariale delle assicurazioni contro i danni. Edizioni LINT,
Trieste
Härdle WK, Simar L (2003) Applied multivariate statistical analysis. Springer
Johnson RA, Wichern DW (2007) Applied multivariate statistical analysis, 6th edn. Prentice Hall
Mikosch T (2009) Non-life insurance mathematics. Springer
Ohlsson E, Johansson B (2010) Non-life insurance pricing with generalized linear models. Springer
Parodi P, Raton B (2015) Pricing in general insurance. Chapman and Hall/CRC
Non-Life Insurance: Reserving
12

Abstract

In this chapter, the reader can learn the concept of an insurance claim. Starting
from this notion the run-off triangle is explained, i.e. the scheme representing
claims that underlies the estimation of reserve amounts. The following paragraphs
present reserve valuation methodologies, distinguishing between deterministic
and probabilistic or stochastic methods. Deterministic methods are based on
forecasting the value of the claims reserve through a projection into the future
of expected costs, and using assumptions inferred from time series. In the course
of the discussion, among the most important ones are presented: grossing up,
chain ladder method and Fisher Lange method. In addition, the main outlines of
Taylor’s separation method and the method of Bornhuetter and Ferguson are
described. The stochastic methods are based on a probabilistic distribution of
results. These include the Mack method, GLM models and bootstrapping. In the
end, the evaluation principles for premium technical reserve are explained.

Keywords
Loss reserve · Reserve for losses IBNR · Reserve for losses IBNER · The run-off
triangle · Deterministic methods · Grossing up method · Chain ladder method ·
Fisher Lange method · Taylor’s separation method · Bornhuetter–Ferguson
method · Stochastic methods · Mack model · Generalised linear models ·
Bootstrapping · Premium reserve

For this chapter, a special acknowledgement goes to Marcello Ottaviani (consulting audit and
appointed actuary).

# Springer Nature Switzerland AG 2024 261

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_12
262 12 Non-Life Insurance: Reserving

12.1 Learning Objectives

At the end of this chapter, the reader should be able to know:

1. The role of the technical reserves in the contest of non-life insurance.

2. The main evaluation principles of technical reserves and methods for
calculation.
3. The main differences in the methods used to calculate loss technical
reserves.
4. The evaluation principles for premium technical reserve.

12.2 Technical Reserves and Claim Definition in Non-life

Business

The purpose of non-life insurance contract is to compensate the insured for the loss
suffered as a result of the occurrence of a claim.

" Definition A claim is defined as a future and uncertain event that results in a
damaging consequence.

As a result of such an event, the insurer is obligated to pay compensation for the
loss or benefit specified in the contract. Consistent with requirements of local
regulations, the insurer may also be obligated for damages resulting from malicious
claims, or grossly negligent ones, caused by the insured himself or by persons for
whose act the insured is liable for.
In non-life insurance business, technical reserves represent a provision that the
insurance undertaking makes to comply with the accrual principle and the liability to
policyholders. Technical reserves can be classified into two macro types: claims
reserves and premium reserves.
The former represents the amount that the insurance undertaking sets aside at the
end of the period to meet payments for all claims that have already occurred in
previous periods and have not yet been (fully) settled. The second corresponds to a
provision at the end of each period made by the insurance undertaking using part of
the premiums paid by policyholders. The provision takes into account the portion of
the premiums pertaining to the following period.
More in detail, in addition to the claims reserve, which accounts for most of the
values involved, there are also the IBNR reserve and additional reserves. The IBNR
reserve considers an estimate of claims incurred but not yet reported. There are two
additional reserves in non-life lines of business, all of which are based on the
peculiarities of insurance products and the risks associated with them, for example,
12.3 Loss Reserve 263

Provision for indemnities and

direct expenses
Loss provision

Provision for settlement expenses

IBNR (Incurred But

Not Reported)
Non-life
technical
provisions

Premium provision

Additional reserve

Fig. 12.1 Technical reserves for non-life business

equalisation reserve, senescence reserve, and profit-sharing reserve. See Figure 12.1
for technical reserves for non-life business.
In the paragraphs that follow, the features of these technical reserves and, where
worthwhile, also the method of calculation will be dealt with in detail.

12.3 Loss Reserve

" Definition The loss reserve is made up of the sum that the insurance undertaking
sets aside, as at the date of the financial statements (but may be calculated as at
another date), to meet payments of all losses that have already occurred in previous
accounting periods, but not yet (fully) settled. It is a reserve, i.e. a debt towards
assureds for losses and costs of representation that have occurred plus related
settlement expenses, that will be settled in future accounting periods.

The loss reserve is determined by a series of assessments made within the insurance
undertaking and which come from adjusters who deal with the report from assureds
and who evaluate, with their experience and loss trend of previous years, the extent
of the loss and the validity of these sums based on the characteristics of the loss event
or contract conditions of the policy. Adjusters follow every loss event up and until
they are finally closed naturally. Over this lapse of time which may last a number of
years, the loss assessment is reviewed, even significantly when there is new infor-
mation concerning the status of the loss event or updating of the expected time of
settlement or management costs for this loss event. An insurance undertaking, in
parallel with this, also deals with a series of assessments based on the loss portfolio
in the aggregate, which exploits statistical methods. This activity is carried out in
264 12 Non-Life Insurance: Reserving

order to check whether the value of the reserve is aligned with the trend of losses
paid and/or reserved in the past, having taken care to consider the effects of inflation
and any changes in settlement policies. This approach is called loss reserve recalcu-
lation by actuarial methods.
Starting from the amount estimated by the claim department, the principles to be
applied to making the loss reserve assessment are accrual, analysis, objectivity, and
prudence.
Here we can introduce the principle of accrual, which—both for premiums and
for losses—relate to any year (accounting period) and are said to accrue to it when
the cost of what is paid in the year plus the value remaining as reserve at the end of
the year is identified. A loss may be paid fully, partially, or not paid at all. The
amount of accrued claims is equal to the sum of:

1. Payments made to settle claims for the year.

2. Change in the amount of claims reserve during the year (i.e. the algebraic
difference between incoming reserve and outgoing reserve)

By moving the loss reserve therefore, it is possible to calculate the value to apply
to losses accruing in financial statements. Indeed, these can be obtained by adjusting
the sum of indemnifiable events for the year (indicated by Lp = losses//premiums (t),
irrespective of the year of occurrence. To this value must be added the value of the
loss events that have been paid during the year (Lp(t)), plus the value of those not yet
settled at the time of closing financial statements (Vt), and from which the value of
losses not yet settled at the start of the year and occurring in prior years (Vt-1) must be
subtracted. Loss events accruing Lc(t) can thus be indicated as the algebraic sum of
these three items.

Lc ðt Þ = Lp ðt Þ þ V t - V t - 1 ð12:1Þ

In detail:

Lc(t) = Claims incurred during the year.

Lp(t) = Claims paid in the year =120.
Vt = Next year’s claims reserve = 50.
Vt-1 = Claims reserve attributable to the previous year = 40.

Following a numerical example, you would have:

accrual claims = 130 = 120 þ 50 - 40

The method of calculation of the loss reserve based on principle of analysis

requires that for each individual loss event reported and not yet paid, a sum has to be
set as reserve, analytically, based on past experience (analysis performed by
adjusters). The calculation is made difficult by a series of factors, such as
non-determination of the loss, which in a number of cases can be seen only at the
12.3 Loss Reserve 265

end of a certain period, monetary increase of the value of the loss (not only due to
inflation, but also, for example, due to changes in indemnity tables of losses for
injuries) and variations in the criteria of judgement on the part of judicial authorities.
So, it will be understood that efficient technical management, one that uses careful
monitoring of the speed of settlement, is of fundamental importance in mitigating
increasing costs of loss events.
The principle of objectivity implies using all the information that is available
and relevant in estimating the future cost that the undertaking will have to bear.
The principle of prudence requires the undertaking to direct estimate of the
reserves towards values that are higher than necessary so as to ensure there is a
capacity of the undertaking to meet unexpected increases in future costs.
Finally, the loss reserve has to be valued at final cost, which is represented by:

• The total sum due to the beneficiary, including representation costs or legal fees
incurred by the beneficiary itself.
• Settlement expenses (ALAE—allocated loss adjustment expenses), i.e. the exter-
nal expenses incurred in managing or identifying the loss event, such as the
adjuster, counsel, etc.
• Indirect expenses (ULAE—unallocated loss adjustment expenses) which are the
remaining costs, external or internal, incurred in managing losses but that are not
directly attributable to an individual loss.

Another two phenomena need to be considered in order to understand the

dynamics in trends in claims reserves: losses without claim and reopened losses.
Every loss that is reported by and assured requires the insurance undertaking to
apply a figure to the claims reserve. If the insurance undertaking later assesses the
sum of this claim not to be due, it will close the loss without claim. In the event that
later the assured maintains that this loss is owed and to demonstrate this provides
new supporting items, the insurance undertaking would then be obliged to reopen the
claim. This kind of loss is called reopened loss.
The concept is here introduced of speed of settlement,1 i.e. the ratio of the number
of losses settled to the number of losses occurring in a specific year (up until when
these are fully dealt with). A number of risks feature a speed of settlement that is
rather low, i.e. only after many years are all losses in a generation settled (these are
called long tail). This is the case for example in the civil liability risk (this is mainly
due to the difficulty in determining the actual amount of the injury in the short term
and there frequently being civil court cases just for determining liability). Other lines
of business on the other hand feature settlement processes that are very rapid and so
the reserves will be decreased more quickly as compared to those of other lines of
business (this case is called short tail); a typical example is that of the assistance line
of business where, for example, a vehicle that has broken down calls a tow-truck

1
For a detailed explanation (with numerical example) of speed of settlement, see Chap. 33.
266 12 Non-Life Insurance: Reserving

Fig. 12.2 Breakdown of the number of losses paid over the years (long tail and short tail)

paid for by the insurance (so almost instantly). By way of example, Figure 12.2
represents the speed of settlement of two insurance products with short and long tail.
It should be noted that, obviously, both curves reach 0, i.e. 100% of losses settled;
the essential difference is that in the case of long tail losses, the process of settlement
is slower (only after 10 years have all losses relating to the generation looked at been
settled), whereas in the case of short tail all losses have been settled usually after
5 years.
If we analyse the value of average reserves (which is the sum reserved by the
number of losses reserved) we will see that for long tail lines of business, we often
see a phenomenon, i.e., that the average value of what is reserved tends to rise. This
is due to the fact that, usually, losses that are paid over the long term are the more
“serious” ones, which also need more time to be assessed.

12.4 Reserve for Losses Incurred but Not Reported at the End
of the Period
" Definition IBNR (incurred but not reported) are claims for which the event
has occurred, but the report has not yet been filed.

In cases wherein loss events are accounted for by year of occurrence, and not by year
of reporting, a phenomenon of so-called late loss events IBNR (incurred but not
reported) arises. When it is not always possible to receive all reports of loss events in
time to draw up financial statements, a reserve is posted to take this into account. The
reasons this occurs are both technical and behavioural, mainly for it being impossible
for insurance undertaking to verify whether a loss event has occurred or otherwise,
but even simply due to the lack of timeliness on the part of the assured. One example
may be a loss event from piped water (which passes through the plumbing of a
12.5 Claims Reporting Criterion 267

condominium) that appears months after the breakage. Another is poisoning from
asbestos, where the symptoms and physical injury may appear even 10 years after
exposure (during the year when insurance cover applied). Even mere forgetfulness is
something that has been found to occur. Another example is claims that occur in the
last days of the year and are not reported until the following year.
Calculation of the IBNR reserve is performed mostly together with the IBNER
loss reserve (incurred but not enough reported). This reserve is calculated to check
any inadequacy of reserves defined by settlers.

" Definition IBNER (incurred but not enough reported) are claims for which
the original estimate was incorrectly made. In this case, the value could be changed
and/or increased as a result of an estimation process.

In a number of countries, local regulations require values for both reserves to be

shown and in this case an adequate method needs to be adopted.

12.5 Claims Reporting Criterion

There are numerous methods in the literature to represent the trend of claims. This
chapter discusses the two most popular ones. The first one is the run-off triangle
method. The second one consists of the Lexis diagram. In the next paragraphs, each
of them is explained in detail and with relevant examples.

12.5.1 The Run-off Triangle

The losses of an insurance undertaking are typically assessed by year of occurrence,2

so the number and amount of losses is not certain as at the date of financial
statements. Indeed, reports of loss events may be made a number of years after
occurrence. This phenomenon is due to the fact that even if the loss occurred the
effects may appear after quite some time, or the assured has not been able to report it
in a timely manner for specific reasons or ones tied to the actual loss. In these cases,
in addition to the unknown element of the cost of the loss, there is the unknown
factor of the occurrence of the loss, especially when financial statements of an
insurance undertaking must be closed at the end of the year, when much information
is not yet available. Additionally, as losses are closed and reopened due to final
payments, a further assessment uncertainty arises that has to be duly considered. The
characteristics that we have just described impose the use of the several magnitudes
for proper assessment of potential liabilities:

2
The classification of losses by year of occurrence is the most widespread in several countries.
268 12 Non-Life Insurance: Reserving

Table 12.1 Run-off triangles in reserving

Ci,j D0 D1 D2 D3 D4
A1—Yyyy C1,0 C1,1 C1,2 C1,3 C1,4
A2—Yyyy C2,0 C2,1 C2,2 C2,3
A3—Yyyy C3,0 C3,1 C3,2
A4—Yyyy C4,0 C4,1
A5—Yyyy C5,0

• Number of losses reported.

• Number of losses filed without claim.
• Number of losses paid.
• Number of losses reopened.
• Number of losses reserved.
• Sum of losses paid, finally or partially.
• Sum of reserved losses.

Through these magnitudes it is possible to reconstruct the past course and make
hypotheses about the future trend of claims, for each undertaking and by group of
losses. This is possible using the run-off triangles, which are the starting tool for
applying statistical methods for calculating loss reserves.

" Definition The run-off triangle is an outline with dual entry to represent the data
relating to losses, by splitting them up by generation (year of report or occurrence) in
one sense, and in the other by year of development (or management), which shows
the “seniority” of losses.

The number of years in the development depends on the line of business

concerned; in long tail lines of business this can reach 15 years and beyond.
Triangles may contain several magnitudes:

• The sum or number of losses paid.

• The sum or number of losses paid plus those reserved (also called incurred).

The first are used when loss payments are homogeneous over a long enough period
of time.3 The choice is dictated by the fact that the value of incurred losses feeds back
estimates that are more stable due to offsetting. This offsetting has between the value
of paid amounts and that of reserved amounts taken together. Indeed, over time, for an
increase in sums paid in respect of a certain generation, generally, there might be a
matching reduction in sums reserved and vice versa (see Table 12.1).
Let us suppose we have a triangle containing data on paid losses. In the generic
cell of row i and column j, there will be element Cij referring to a loss occurring in

3
When losses are non-homogeneous, the sum reserved is also used.
12.5 Claims Reporting Criterion 269

the ith (calendar year) generation and settled in the jth development year (after
j years from its occurrence, and so in calendar year i + j). The data included in
individual cells Cij may be in an incremental form (Pi.j) or cumulative (Dij) and
feature the following relations between cells:

• Incremental form Ci,j = Pi,j .

• Cumulative form Ci,j = Di,j = Di,j-1 + Pi,j .

By way of example, the cells on the upper part of the triangle represent data on
losses (reported and managed). The cells of the diagonal represent information in
respect of the latest financial statements year:

• If they are data of paid, the diagonal represents paid for the current year.
• If they are cumulative paid (as in the example) the diagonal represents the sum
paid up until the current year.
• If they are incurred data, the diagonal represents the value of paid plus reserved.

The cells of the lower triangle, not filled in here, refer to future development years
for which data are not yet available. The run-off triangle’s aim is to estimate these
data by analysing available past data and completing the compiling of the lower
triangle. In this way, a matrix of data will be obtained as a final outcome and where
the upper triangle is made up of data that are actually available for the past and the
lower one is made up of forecasts of future data. Reading the triangle by line allows
the behaviour of the undertaking on losses of the ith generation for each year of
development to be observed; doing this by column allows the behaviour of the
undertaking during the jth year of development to be observed for the various
generations.
In accordance with table 12.2, it can be seen that during year A1, the sum paid for
losses occurring during this year amounts to 786 euros; 1410 euros on the other hand
is the sum paid up until the development year A1 always referring to losses occurring
during year A1. If, on the other hand, it is wished to obtain the value actually paid
only in development year D1 with losses occurring in year A1, a subtraction
1410–786 = 624 will have to be done. The same reasoning can be extended to
subsequent years of development for subsequent generations of losses.

Table 12.2 Run-off triangle for losses cumulatively paid

D0 D1 D2 D3 D4
A1 786 1,410 2,216 2,440 2,519
A2 904 1,575 2,515 2,796
A3 995 1,814 2,880
A4 1,220 2,142
A5 1,182
270 12 Non-Life Insurance: Reserving

Fig. 12.3 Run-off triangle

Paid

Sum to be paid

By construction, the data highlighted in bold italic (light grey cell) are the latest
data available at the time of assessment (in this case the diagonal) and the cells that
are missing have to be estimated since they refer to the future. In Figure 12.3, a
conceptual example of run-off triangle has been represented.
Figure 12.3 represents the conceptual diagram of the operation of a run-off
triangle. The grey-coloured upper part corresponds to the past and final data. The
diagonal separating the two triangles corresponds to the last available year’s data,
while the white-coloured triangle corresponds to the future values to be estimated by
the actuarial reserving through estimation methods. Based on the estimate, the
insurance undertaking determines the amount to be reserving.
The methodologies used for estimating the lower part of the triangle (or for
determination of the loss reserve) are split into two macro-categories: deterministic
methods and stochastic methods. Deterministic methods allow an itemised value
identifying the sum of the expected reserve to be set, given the assumptions that are a
feature of the method used. What these methods do not provide, however, is an
estimate of the variability of the reserve, which can on the other hand be obtained by
the use of stochastic methods, which work by using a probabilistic distribution of
the reserve. The next paragraphs will discuss these methodologies in detail.

12.5.2 The Lexis Diagram

Progress in a claim develops mainly over 2 phases: opening (t0) which takes place
when the event is reported to the insurance undertaking up and the closure of same
(tn) which coincides with payment of the indemnity.
This linear structure, leaving out any reopening of claims subsequent to closing,
can be represented on a system of Cartesian axes. In this case, along the ordinate axis
the development year of the claims is shown and on the abscissa the year of opening/
generation. See Figure 12.4 representing the different status of a claim.
The direction runs parallel to the bisector of the quadrant so as to represent,
simultaneously, historic and individual time. Indeed, in the period subsequent to the
one of the year of occurrence, a claim still open will have accrued 1 year of
development. During subsequent periods, there are 2 years of delay, and so
on. Finally, the point indicates closing of the claim and so has the date as coordinate
on the abscissa, i.e. the period when payment of the claim was made.
12.5 Claims Reporting Criterion 271

t0 tn

Fig. 12.4 Development of a claim

Dmax

t0 t1 tn

Fig. 12.5 Representation of the estimated claims closure period

Moving on to an aggregated representation, and utilising the Lexis diagram of a

group of claims, we can take as t the time when the valuation is made and the
diagonal arrow represents the cumulative amount, whereas horizontal line Amax
describes, on the basis of historical data of the insurance undertaking, the maximum
period of development for closing claims. In Figure 12.5, the group of claims at the
time of valuation t has already been completely closed in t1 and prior to the
maximum period of development of the insurance undertaking (year D5).
With the Lexis diagram, an aggregate representation can be developed when, at
time t, the group of claims displays positions that are still open. At this point,
assuming claims will be settled by the time the threshold of the maximum period
is reached, the time (tp–t) for completely closing of the claims considered can be
foreseen. See Figure 12.6, where the line between the two points (tp–t) represents the
claims settlement period.
272 12 Non-Life Insurance: Reserving

Dmax

t0 t1 tn

Fig. 12.6 Representation of estimated claims payout period

Grossing Up
Concatenated

Chain Ladder

Average Cost Fisher Lange

Deterministic

Method of Separation Taylor’s separation

Methods for assessing

the loss reserve

Bornhuetter e Ferguson

Stochastic

Fig. 12.7 Deterministic methods for assessing the loss reserve

12.6 Deterministic Methods of Assessment of the Loss Reserve

" Definition There are three main categories of deterministic methods:
concatenated methods, average cost methods, and methods of separation.

See Figure 12.7 representing the deterministic methods for assessing the loss
reserve.
Concatenated methods, such as the chain ladder method and grossing up
method, begin with data relative to the past experience of the undertaking in order
12.6 Deterministic Methods of Assessment of the Loss Reserve 273

to estimate link ratios in payments of losses. The underlying assumption foresees

that future development in losses occurring is in accordance with the same dynamics
as was observed in the past. They are usually utilised for losses that occur frequently
and are on average of small size (a typical example is motor TPL). Average cost
methods, such as the Fisher–Lange, seek to estimate the speed of loss settlement.
This evidence will then be used to spread their average cost over the various years of
development. Finally, separation methods (such as the Taylor method) are based
on separate assessment of all the effects that have a bearing on the loss reserve
(generation year, development year, calendar year). A further method that can be
classified separately is that proposed by Bornhuetter and Ferguson.
From the practical standpoint, no method can be thought of as being “perfect” and
each of them features pros and cons. To assess the consistency of a loss reserve
therefore, it is necessary to apply the largest number of methods possible and check
that there are no anomalies in the different approaches. If incongruities do come to
light it will be necessary to seek out the causes that underlie this result.
For a number of insurance lines of business, the analytical method is not always
sufficient to ensure the adequacy of sums set aside by the insurance undertaking.
Among these lines of business are the so-called “mass lines of business”, i.e. those
featuring a high number of contracts (and, as a result, losses) that are fairly homoge-
neous. In these cases, alongside the analytical method a synthetic method based on
an approach of a statistical-actuarial kind is used. This method is based on a forecast
for the loss reserve by making a projection of expected costs into the future by
making assumptions drawn from the historical series of losses for the insurance
undertaking, or other markets, fittingly adjusted (in the case of an insurance under-
taking commencing its business. The historical series, for these to be useful for this
projection, need to be high in number, independent (i.e. they must not display
correlation with each other) and homogeneous. Losses are therefore split into
homogeneous groups, i.e. by line of business, year of occurrence and, where
necessary, product. Examples from this category are the civil liability lines of
business (Motor TPL) and in general all the lines of business that have long historical
series and are relatively stable. It is unlikely that a line of business based on
catastrophe risks can have statistical estimates that are reliable, due to the lack of
robustness in statistical data. In the absence of robust data, or a lack of continuity in
historical series due to mergers or acquisitions of firms or insurance portfolios, or
repeated changes in loss settlement policy, problems of estimation arise that need to
be faced especially carefully by the actuary.
In forthcoming paragraphs, a number of deterministic methods, the main ones, are
shown, which are used to make statistical assessments of the loss reserve.
For the following two methods (grossing up and chain ladder), the numerical
examples are based on the data presented in Table 12.2.
274 12 Non-Life Insurance: Reserving

12.6.1 The Grossing up Method

The grossing up method calculates a number of coefficients, called development

factors, whose function is to describe the dynamic of claims in terms of delay in the
payment of indemnities.
Indeed, the grossing up method takes the development of claims paid in prior
insurance years in their development over a medium-long term (at least 5 years) into
consideration while at all times working from the date of occurrence of the loss events.
This therefore places us in a claims run-off triangle and, picking up Table 12.2,
we can count in the most senior year (year A1), which is a mature insurance year as
the paid out has practically fully taken up sums placed as reserves, the difference
between the sum of payments of indemnities occurring in year A1 accumulating
shown in insurance year D4 (i.e. the fifth year) and the sum of claims settled in the
year of occurrence (year A1).
From this analysis, an average development factor that will subsequently be
applied to estimate the expected development of future claims emerges.
The method is developed in the following three steps:

1. The year with the most seniority of claims (year A1) is taken into account. The
difference between the sum of cumulative payments reported in year D4 (the fifth
year) and the amount of claims settled in the year of occurrence furthest back in
time (year D0).
2. Calculation of the development factor:
– Claims amount (A1, D0) = 786
– Claims amount (A1, D4) = 2,519
– Difference (D4–D0) = 2,519–786 = 1,733
– Ratio of difference of claims to final total claims (D4–D0)/D4 = (2,519–786)/
2,519 = 68.80%
– Development factor (1–68.80%) = 31.20%
This means that 1,733 of the payments (68.80% of the total) were not made in the
same year (year D0) but were “deferred” into future years (until year D4).
As a result, only 31.20% are paid in year D0 (1–68.80%) of the total claims
paid for claims that occurred in that year. The 31.20% coefficient is considered
the development factor.
3. Estimation of Future Claims

Following Table 12.2, the development factor is applied to the series of claims in
year A5. It is assumed that the amount of claims incurred in the first year of
occurrence (A5, D0), i.e. 1,182, corresponds to 31.20% of the amount that will be
settled from there to 5 years, i.e. 1,182/31.20% = 3788.
The estimate of the value of the last year of the triangle is based on the develop-
ment factor calculated with the time series with greater seniority of claims.
The grossing up method is a somewhat rudimental method as it pays no attention
to what happens in the meantime. The method is little used but can become an
interesting index for portfolios that remain homogeneous over time and with short
tail claims.
12.6 Deterministic Methods of Assessment of the Loss Reserve 275

If in reality, the percentage of payments in the year of occurrence for an insurance

year settles in a range 30–33%. In the absence of variations in underwriting and
settlement policy, the same range can be expected to apply.

12.6.2 The Chain Ladder Method

The main deterministic method for calculating the loss reserve is the chain ladder
method which is the go-to method for estimating loss reserves since it is simple to
implement.
This method foresees determining so-called link ratios (development factors)
found through assuming that in the future claims will behave in the same way as has
been observed in previous generations. In other words, it is assumed that the ratio
applied between accumulated claims paid in two consecutive years of development
(link ratios) will be the same for each generation.
First of all, claims (as the aggregate reserved or paid out incurred) are shown in a
triangle where the rows represent the years of occurrence of the loss events and
columns represent years of development. For example, 1,410 represents the sum of
paid and reserved relative to claims occurring in the A1 year, after 2 years (year D1)
have passed. In order to avoid situations that are anomalous between insurance
years, development factors mj will be used and which can be built up in different
ways, depending on the reliability of the data available or the granularity it is wished
to consider. The method described, which is more prudent, calculates development
factors as a weighted mean of the individual link ratios determined over each past
generation. See Table 12.3 where link ratios are calculated.
Resuming Table 12.3:

– m1 = Link ratio A1 over A0: (1,410 + 1,575 + 1,814 + 2,142)/

(786 + 904 + 995 + 1.220) = 1,78,
– m2 = Link ratio A2 over A1: (2,216 + 2,515 + 2,880)/
(1,410 + 1,575 + 1,814) = 1,59,
– m3 = Link ratio A3 over A2: (2,440 + 2,796)/(2,216 + 2,515) = 1.11,
– m4 = Link ratio A4 over A3: (2,519)/(2,440) = 1.03.

Table 12.3 How link ratios are calculated

D0 D1 D2 D3 D4
A1 786 1,410 2,216 2,440 2,519
A2 904 1,575 2,515 2,796
A3 995 1,814 2,880
A4 1,220 2,142
A5 1,182
Link ratios m1 = 1,78 m2 = 1,59 m3 = 1,11 m4 = 1,03
276 12 Non-Life Insurance: Reserving

Table 12.4 Lower triangle loss reserve by chain ladder method

D0 D1 D2 D3 D4 Reserves Gi
A1 2,519 0
A2 2,796 2,880 84
A3 2,880 3,197 3,293 413
A4 2,142 3,406 3,780 3,894 1,752
A5 1,182 2,104 3,345 3,713 3,825 2,643
mj 1.78 1.59 1.11 1.03
Total reserve 4,891

Table 12.5 Triangle estimate of reserves split over the various development years
D0 D1 D2 D3 D4 Reserves Gi
A1 0 0
A2 84 84
A3 317 96 413
A4 1,264 375 113 1,752
A5 922 1,241 368 111 2,643

By way of example, the cumulative sum of paid out and reserved estimated for
development year D4 relative to loss events occurring in A5 is given by
1,182 × 1.78 × 1,11, 1,03 = 3,825 and so on for the other sums. The last column
of Table 12.4 reports the value of the reserve to be set aside.
At this point for the sake of simplicity, and imagining that all claims are settled
within 5 years at the latest, and consequently the final cost is the same as the values in
column year D4, the loss reserve relative to a generation year will be given by the
difference between the sum of losses incurred accumulated as at the end of the period
of deferment considered (last column of the completed triangle) and the sum actually
paid out and reserved as at the date of valuation (values of the diagonal highlighted
in bold). For example, the reserve to be set aside for generation (year A2) is equal to
(estimated amount—amount incurred) = 2,880–2,796 = 84.
The total loss reserve is given by the sum of the reserve estimated for each
generation year. The total loss reserve to be set aside will thus be given by
83 + 413–1,752 + 2,643 = 4,891.
A rate of actualising could be added to this sum to bring sums projected into the
future to the current date, but this depends on the regulations applying and the
system for calculating (civil, IFRS, Solvency II or the like, etc.). The final step will
be to compare the reserve calculated by the chain ladder method and the estimate
made with the inventory method (by the claims settlers of the insurance undertaking)
so as to check on the fit between the two quantities and calculate the difference. See
Table 12.5 which shows the annual values calculated for estimating the reserve.
In addition to what has been shown, the chain ladder method foresees the use of
corrective factors to obtain the final cost of claims for each generation. The first
correction consists in inserting a “tail factor” for each year by adding a further
12.6 Deterministic Methods of Assessment of the Loss Reserve 277

column to the table to take into account the claims which, at the valuation date, have
not yet been settled. It is an appropriate intervention in long tail portfolios or in
situations deriving from absolutely contingent situations. This phenomenon is due to
the fact that the number of years that the triangle foresees is not sufficient to
completely explain the phenomenon of dismantling of claims.
In such cases, a significant variation in the selected “tail factor” can lead to large-
scale valuation consequences with the risk of underestimating the sum to be set aside
as a reserve.
By way of example, the sum accumulated of paid and reserved estimated in
development year 4 in respect of losses occurring in A5 is given by 1.182 ∙ 1.78 ∙
1.59 ∙ 1.11 ∙ 1.03 = 3.825. In cases wherein closing off of losses is foreseen as being
much longer, a «tail factor» is applied of 1.15 and so the new evaluation is 1.182 ∙
1.78 ∙ 1.59 ∙ 1.11 ∙ 1.03 ∙ 1.15 = 4.398.
The main limitation of this method resides in the fact that, as stated, it imagines a
progression in payments made remaining the same for each year of generation; this
may lead to a major distortion of the reserve if events arise that change a policy of
payment/reserving of an insurance undertaking noticeably (e.g. due to changes in
reference populations or the coming into force of new regulatory areas, or there
being special generations that have suffered from specific events, etc.)
Another limitation of chain ladder is that implicitly it considers the effect of
inflation in the area of building up link ratios. If inflation is very volatile, or expected
future inflation is different from what is actually observed, it will be necessary to
make corrections for this reason so that the method can be found adequate.

12.6.3 The Fisher–Lange Method

" Definition The Fisher–Lange method, which was introduced in 1974,4 is a

method for estimating a loss reserve based on the product of the number of losses
and their average cost. A different logic from that or chain ladder is used therefore,
which works for loss sums paid and/or reserved. This approach requires first of all
identification of the triangle of numbers of losses reported and then an estimate of
average costs for each year of generation.5

The information needed for applying the method is broader in scope than that
required by the chain ladder. In particular, Fisher–Lange needs the following
input data:
• Total number of losses reported by year of generation.
• Run-off triangle of the number of losses paid.

4
Fisher W.H., Lange J.T., (1974) Loss reserve testing: a report year approach, PCAS.
5
This approach was defined for markets for which classification of losses is carried out by report
and not by occurrence, but it can also be used in the second case through a two-step process: first
losses reported are assessed and later those that are reported subsequently, even if this practice is a
little complicated and may lead to results that are difficult to explain.
278 12 Non-Life Insurance: Reserving

• Run-off triangle of the number of losses reserved.

• Run-off triangle of the number of losses filed without claim.
• Run-off triangle of reopened losses.
• Run-off triangle of the sums of losses.

All the data have to be in incremental form. Additionally, since the model
foresees a historical analysis based only on the number of losses, and not their
cost, inflation must be considered explicitly in projecting expected costs. To project
the number of losses, the logic that the number of losses shifts from one year to the
next, due to those paid, reopened, and filed without loss, is applied.
Two indicators are identified and that will be used to determine the expected
number of future losses. The first indicator is as follows:

rp
i,j þ Si,j - Si,j
Sris ss
Rcwp
i,j = ð12:2Þ
Sris
i,j

where:

i,j = number of reserved losses

Sris
Srp
i,j = number of reopened losses
i,j = number of losses with no claim.
Sss

Rcwp
i,j represents for each generation i and for each development year j the
likelihood of a loss with claim given by the number of losses reserved plus the
balance of reopened ones and those with no claim. A ratio in excess of 100% denotes
a number of reopened losses greater than the number of losses with no claim; i.e. for
each loss reserved in any given period, a greater number of losses to be settled in the
future is to be expected due to the reopening of losses greater in number than those
with no claim.
The second index is:

Spag
i,j
i,j =
Rcss ð12:3Þ
Sden
i,j

where:

Spag
i,j = number of paid losses

i,j = number of reported losses

Sden
Rcss
i,j is calculated for each generation i and for each development year j and it
represents the number of losses paid per each loss reported.

Once the two index triangles have been obtained for each year of generation and
development, a single, summary, index ((Rcorr)) is proceeded to each development
12.6 Deterministic Methods of Assessment of the Loss Reserve 279

Table 12.6 Triangle with parameters Rcwp

i,j

D0 D1 D2 D3 D4 D5 D6
A1 114.50% 104.61% 113.28% 125.86% 105.88% 100.00% 102.50%
A2 112.91% 113.05% 122.11% 118.87% 127.27% 106.12%
A3 121.45% 109.31% 114.04% 113.94% 109.29%
A4 119.37% 110.22% 117.47% 111.62%
A5 120.59% 102.28% 102.14%
A6 110.42% 104.93%
A7 128.92%
Rcwp
j 118.31% 107.40% 113.81% 117.57% 114.15% 103.06% 102.50%

Table 12.7 Triangle with parameters Rcss

i,j

D0 D1 D2 D3 D4 D5 D6
A1 100.00% 15.51% 6.06% 2.64% 1.66% 0.59% 0.33%
A2 84.49% 10.62% 3.39% 1.74% 0.85% 0.29%
A3 83.31% 10.75% 3.83% 1.98% 0.83%
A4 83.22% 10.85% 4.04% 1.54%
A5 81.92% 10.20% 2.90%
A6 82.33% 7.06%
A7 87.05%
Rcss
j 86.05% 10.83% 4.04% 1.97% 1.12% 0.44% 0.33%
Rcss
j corr 82.11% 10.34% 3.86% 1.88% 1.07% 0.42% 0.31%

year j. Usually this information is summarised through an average (simple or

weighted) of all generations, or a subset of these, taking into account the fact that
the method of synthesis depends greatly on what has happened to the insurance
undertaking in past years in terms of settlement policy and other events tied to losses.
See Table 12.6 and 12.7 representing the factors obtained for each year of generation
and development.
When the synthesis of parameters has been determined as a simple average of the
parameters per generations (by column), the parameter Rcss j , representing the speed
of settlement (i.e. how quickly reserved losses are paid over time), is adjusted to
make the sum of the values equal to 100% so as not to give rise to more losses than
are actually paid.
From the product of these two items for the number of losses reserved as at the
assessment date, we obtain:

cwp
NSSi,j = Rcss
j ∙ R j ∙ Si,T - i
ris
ð12:4Þ

where:
280 12 Non-Life Insurance: Reserving

Table 12.8 Triangle with numbers NSSi, j

D0 D1 D2 D3 D4 D5 D6
A1 34
A2 51 38
A3 98 39 29
A4 122 69 27 20
A5 239 116 66 26 19
A6 400 149 73 41 16 12
A7 4,063 512 191 93 53 21 16

Table 12.9 Vector of average costs CMi, j

D0 D1 D2 D3 D4 D5 D6 D7
CMi, j 2,041 2,971 4,668 6,659 6,196 3,756 5,067 7,310

i,T - i = vector of the number of losses reserved in the year of assessment

Sris

See Table 12.8 which shows the numbers calculated with the method explained
above.
The index expresses the number of expected losses to be settled in future years of
development.
The average cost of losses for each generation is determined in the same way as is
used for the other two indicators:

CSpagj,j
CM i,j = ð12:5Þ
Spag
j,j

where:

CSpag
i,j = cost of losses paid (cumulatively per generation)
pag
Si,j = numbers of losses paid

See Table 12.9 reporting the vector of average costs calculated as explained by
the above formula.
The vector of expected future costs is obtained through multiplying the number of
expected losses by their cost (duly calculated by year of development as per the two
indicators shown above).

FCSi,j = NSSi,j ∙ CM j ð12:6Þ

Table 12.10 represents a triangle with inflated values.

The future cost of losses (FCL) is then multiplied by an endogenous and exoge-
nous inflation factor, and possibly actualised (depending on the regulations of
reference in the country) to allow the current value of these payments.
12.6 Deterministic Methods of Assessment of the Loss Reserve 281

Table 12.10 Triangle with inflated FCSi, j values

D0 D1 D2 D3 D4 D5
A1
A2 260
A3 372 203
A4 761 264 144
A5 1,601 737 256 139
A6 1,880 1,015 466 162 88

iþj-T -1 iþj-T -1
Reserve = FCSi,j ∙ 1 þ infl j ∙v ð12:7Þ
i, j

where:

inflj= endogenous and exogenous inflation factor

vi + j - T - 1= factor of financial actualisation

The value of the reserve of the example shown amounts to 26,459 without
considering actualising, i.e. with actualising at zero. This sum is given by the sum
of the individual cells in Table 12.9 which indicate expected payments in develop-
ment years. Any actualising must be performed by year of projection, and so by
diagonal.
The advantages and disadvantages of this method are both to be sought in the
greater complexity as compared to other methods. On the one hand, the model,
breaking down the assessment of the number of losses and the average cost, may
capture the issues and dynamics that other methods ignore; on the other hand, the
model requires much more information and may lead more easily to a number of
distortions.

12.6.4 The Taylor Separation Method

" Definition The Taylor separation method is based on the same approach as the
chain ladder to which a further assessment is added according to the method of
expected cost (calculated via the loss ratio), with a coefficient of credibility assigned
by year of generation.

This is a representation of the method.

BF = CL j ∙ w j þ ELR j ∙ EP j ∙ 1 - w j ð12:8Þ
j

Where:
282 12 Non-Life Insurance: Reserving

CLj represents the vector of payments calculated by the chain ladder method.
ELRj represents the vector of payments calculated by the expected cost method.
EPj represents the premiums accruing by year of generation.
wj the coefficient of credibility assigned to each year of generation (values between
0 and 1).

If we look at the expected cost component of losses, we find values for payment
EPj can be factorised thus:

Pi,j = ni ∙ μ ∙ δ j ð12:9Þ

where ni represents the number of losses of the ith generation and is given by the sum
of the number of losses settled in year i and the number of losses reserved at the end
of this year; δj is the factor that represents the cost of losses based in respect of the
projection year, irrespective of the year of generation; and μ is the inflation factor.
The model sets itself the aim, in particular, of “separating” the effects given by the
development of generations (by number) from that of the projection year (for costs).
This method foresees estimating the parameters ni and δj starting from the data
available in the triangle through numerical estimation methods. The parameters are
invariant, the former for development year and the second by year of generation.
They may be calculated through methods of synthesis such as averages or through
methods of maximum likelihood or ordinary least squares. Once these parameters
have been obtained, and an assumption on inflation has been drawn, the loss reserve
for each generation and total loss reserve can be obtained.

12.6.5 The Bornhuetter–Ferguson Method

" Definition The Bornhuetter–Ferguson Method uses information in respect of

loss ratio, i.e. the relationship between the sum owed for losses accruing (paid and
reserved) and premiums accruing, together with standard techniques of projection
(in the original version the same link ratios as for chain ladder are used).6

The main unknown factor of the model is the final generation cost, i.e. the cumula-
tive sum matching the last development year. Differently from the chain ladder
method however, this unknown factor is not the final result but rather the starting
point. Indicating with Pi accruing premiums for the jth generation, and with LRi the
loss ratios for the generation, an estimate can be obtained of the final cost of the
generation as:

6
Faculty and Institute of Actuaries Claims Reserving Manual v.1 (09/1997) Section G.
12.6 Deterministic Methods of Assessment of the Loss Reserve 283

U li = LRi ∙ Pi ð12:10Þ

It should be noted that loss ratios for the generation are data that are fully
available as they refer to information in respect of losses reserved that by definition
are estimated sums for future paid amounts. Once an estimate of the final cost for
each generation has been obtained, calculation of the lag factor is proceeded to by
working backwards beginning with development factors of the chain ladder. In the
traditional version of the BF method, these are found via the reciprocal of develop-
ment factors of the base chain ladder, assuming that the part of losses still to be
settled is a multiple of what has already been settled by year k:

n
1
zi = ð12:11Þ
j=i
mj

Where:

z = lag factor,
i = accident year,
j = development year,
n = number of losses,
mj = estimation of development factors according to the chain ladder base.

Using the magnitudes identified, an estimate of the reserve for each generation of
losses can be calculated.

i = U i ð1 - znþ1 - i Þ
RBF ð12:12Þ
l

We now give an example using the ratios obtained previously via the chain ladder
method. For an analysis of the obtained values, see Table 12.11 reporting the
calculation of reserves in accordance with the Bornhuetter–Ferguson method.
The total reserve to be set aside will thus be 4,914. We therefore have an estimate
that is slightly more prudent as compared to the one obtained with the chain ladder

Table 12.11 Calculation of reserves in accordance with the Bornhuetter–Ferguson method

Sum of 1–Lag
premiums Estimate Estimate of Lag factor B. F.
Year of accruing of loss final cost factor (e) = 1– Reserves
occurrence (a) ratio (b) (c) = (a) * (b) z (d) (d) (c) * (e)
A1 2,389 101.30% 2,519 0
A2 2,870 102.10% 2,930 0.97 0.03 88
A3 3,252 97.80% 3,180 0.87 0.13 413
A4 3,982 98.20% 3,910 0.55 0.45 1,759
A5 3,868 99.40% 3,845 0.31 0.69 2,653
Tot 16,360 16,285 4,914
284 12 Non-Life Insurance: Reserving

method (4,891). The reserve relating to generation A1 is nil due to the assumption
that losses are settled within 5 years at the latest and so by definition this generation
has concluded being dealt with. If a tail factor were to be assumed for this generation,
a sum reserved relating to the tail factor would be had.
There are also variations to the traditional method among them being Cape Cod
and the Benktander. The Cape Cod method estimates initial loss ratio considering
the cost of losses as a proportion of the premium consumed (net accrued premiums
by development factor); the Benktander method, mainly following the Bornhuetter–
Ferguson method for the first years of development; and the chain ladder method for
subsequent ones allows an estimate of the loss reserve to be obtained weighting the
loss experience gradually.

12.7 Stochastic Methods of Assessment of the Loss Reserve

Deterministic methods presented previously are particularly useful in obtaining an

itemised estimation of the reserve starting from available historical data. The limita-
tion of these methods is however the lack of an indication relative to the variability of
the estimate made, which allows an interval of confidence to be identified. In other
words, they do not provide a forecast error, i.e. a quantification of the extent to which
the actual estimate can reasonably vary from forecast data. An estimate of the
forecast error allows the reserve to be fittingly adjusted if needed, so as to cover
possible adverse scenarios. It is possible to determine the extent of this uncertainty
via two approaches:

• The first one based on identifying a suitable distribution of probability for the
value of the reserve.
• The second one via closed formula methods operating with the use of estimated
parameters for the actual calculation data for the reserve.

It is important to underline the fact that in stochastic assessments a number of

types of risk need to be considered:

1. Model risk, which quantifies the risk to be assigned to the use of an unsuitable
statistical estimation model (e.g. if a probability distribution that does represent
the data adequately is used).
2. Parameter risk, i.e. the risk tied to the accuracy of the estimate of the parameters
of the model (e.g. a parameter that is badly gauged in respect of past experience).
3. Process risk, which concerns the dispersion that is intrinsic to the estimated
probability distribution.

See Figure 12.8 for a representation of the stochastic methods for assessing the
loss reserve.
The following paragraphs discuss some stochastic methodologies used in insur-
ance practice.
12.7 Stochastic Methods of Assessment of the Loss Reserve 285

Deterministic

Methods for assessing the

loss reserve

Mack Poisson Logarithmic

Generalised Linear Model Poisson Over-Dispersion

Stochastic
(GLM) (POD)

Bootstrapping
Gamma Logarithmic

Fig. 12.8 Stochastic methods for assessing the loss reserve

12.7.1 The Mack Model

Thomas Mack7 extended the traditional chain ladder deterministic model to his own
stochastic version, which allows calculation, through applying a closed formula, of
the standard error (standard deviation) of the estimate of the loss reserve, by
exploiting the basic assumptions of the deterministic version of the model.

" Definition The Mack model has also been defined as the distribution-free
chain ladder as it does not make any assumption in respect of distribution, but
rather calculates the first two moments (mean and variation) of cumulative
payments. In particular, the basic assumption made is that payments referring to
different generations are independent of each other and that the mean and variation
in cumulative payments, conditioned by those relative to the immediately preceding
development year, are proportional to these. The mean matches that obtained
through the traditional chain ladder model exactly and so the mean of the distribution
of the stochastic model is the same as that of the deterministic model.

In respect of the variability, this is obtained via the following formula:

n-j 2
1 Si,jþ1
σ 2j = Si,j -λj ð12:13Þ
n-j-1 i=1
Si,j

7
Mack, T., Distribution-free calculation of the standard error of chain ladder reserve estimates.
ASTIN Bulletin 23, 213–225, 1993.
286 12 Non-Life Insurance: Reserving

with j = 1. . . n – 2, and with λj the mean of the generation, i.e. the calculation made
with chain ladder, Si, j are the cumulative payments of generation j in development
year i. Given that the formula for estimating σ 2j (for each past generation) applies for
j up to n - 2, to estimate ω2n-1 using alternatives is necessary. One method is to
extrapolate this value starting from the series σ21, σ22,. . ., σ2n-2 which is usually
decreasing exponentially in type. As an alternative it can be obtained via the
relationship

σ 2n - 3 σ 2n - 2
= ð12:14Þ
σ 2n - 2 σ 2n - 1

In this case we will have:

σ 4n - 2 2
σ 2n - 1 = min ,σ ð12:15Þ
σ 2n - 3 n - 3

which will be the estimate of the mean standard deviation for each past generation.
Deviation from the forecast for development year can be estimated as:

n-1
σ 2k 1 1
σ 2i = S2i ∙ n þ ð12:16Þ
k = n - iþ1 λ2k Si,k n - k
Sq,k
q=1

and from these an estimate obtained of the deviation of the reserve for the sum of
years of development but taking into account the correlation there is for each year.

12.7.2 Generalised Linear Models

" Definition Generalised linear models (GLM) are a generalisation of the linear
model wherein, differently from the latter, the dependent variable, i.e. the variable
that is the subject matter of study, is not necessarily distributed according to a
normal.

The relationship between the dependent variable and independent variables is given
by the following relationship:

g½EðY Þ = gðμÞ = α þ βX ð12:17Þ

where:

g = link function
E(Y ) = estimated value “Y”
12.7 Stochastic Methods of Assessment of the Loss Reserve 287

X = independent variable
Y = dependent variable
μ = average
β = unknown parameters
α = additive aggravating factor, with α > 0

Thus, there is a relationship of a linear kind between the independent variables

X and a fitting transformed one g() of the expected value of the dependent variable.
From the general form, it is possible to obtain various specific models by selecting a
function (called a link) g() and the structure of the errors.
In the area of insurance, generalised linear models (GLM) are used mainly for
tariffs but have also found applications at the loss reserve determination stage. The
various models are characterised by type and probability distribution assigned to
independent variables (X), and additionally by the form of the link function. With a
dependent variable Y, both the amount of incremental payments Pij and the number
of losses occurring can be described. Explication variables that are generally adopted
are the year of occurrence and year of development, like the other models shown
above. The parameters of the model are estimated starting from triangle data through
the maximum likelihood estimation (MLE) procedure.
The most widely used model is the Poisson-logarithmic model, which foresees
variable Y being distributed according to a Poisson distribution and the link function
being logarithmic. The model can be used to estimate incremental sums of paid
amounts of the lower triangle starting from the data of the upper triangle. It has been
shown analytically that the Poisson-logarithmic model reproduces the estimates of
the chain ladder. Notwithstanding this, the model may not be suitable, at a theoretical
level, for describing trends in incremental payments as the Poisson distribution
features mean and variation that are equal. For this reason, the Poisson model is
used more frequently with Poisson over-dispersion, which foresees variation pro-
portional to the mean through a suitable parameter.
The limitation of the approach to estimation through GLM is that it provides only
means, variance and co-variance of future payments and not a “complete” distribu-
tion of probability. In order to overcome this limitation, simulation procedures
presented in forthcoming paragraph are used.

12.7.3 Bootstrapping

An alternative route to applying closed formulas is a simulation approach. This

technique can be found to be very potent as, by aiming to identify an entire
distribution of the reserve, it allows the calculation of percentiles and moments of
an order superior to the second one (asymmetry, kurtosis, etc.). In the actuarial area,
and especially in that of loss reserve estimation, the bootstrapping technique
introduced in 1979 by Bradley Efron is a point of reference.
288 12 Non-Life Insurance: Reserving

" Definition Bootstrapping is a rapidly implemented iterative method that is an

efficient tool in seeking the distribution of probability of the loss reserve, starting
simply from the information contained in the run-off triangles. The robustness of the
result depends on the number N of iterations that it is decided to perform; normally N
is of the order of tens of thousands.

The bootstrapping technique was introduced in order to obtain an estimate of the

standard deviation of a statistic s(x) relative to a sample of data x = (x1,. . ., xn). In
order to achieve this, the bootstrap sample *x = (*x1,. . .,*xn), i.e. a random sample of
data created via n extractions with repetition of the original data (simulations). In this
way, N bootstrap samples 1x,. . ., Nx have to be created, each of which will number n
and the respective replication s(1x),. . ., s(Nx) of the original statistic s(x).
Keeping the theoretical basis of the Poisson over-dispersion (ODP) model and
supplementing this with the simulation potential of bootstrapping, England and
Verrall developed an alternative, simple, and effective method to obtain an estimate
of the mean and an estimate of the standard deviation through statistics calculated on
a sample of pseudo-data.
By way of example, the bootstrapping procedure is schematized in the following
13 calculation steps—from the cumulative data development factors mj from the
chain ladder base are obtained.

1. The cumulative data are obtained starting from the development factors mj of the
basic chain ladder.
2. A new upper triangle of cumulative data is obtained wherein the diagonal is the
same whereas the upper data are obtained by dividing the values on the diagonal
by the development factor associated with the development years; proceeding
backwards, each line of the upper triangle is completed from time to time. The
data obtained are called cumulative pseudo-data. The results, starting from the
data of Table 12.2, are reported in Table 12.12 representing the cumulative
pseudo-data.
3. De-accumulating the data of the triangle, a triangle can be obtained with the
incremental sums (incremental pseudo-data). For this, see Table 12.13 reporting
incremental pseudo-data.

Table 12.12 Cumulative pseudo-data

D0 D1 D2 D3 D4
A1 778 1,386 2,203 2,446 2,519
A2 890 1,584 2,519 2,796
A3 1,018 1,811 2,880
A4 1,203 2,142
A5 1,182
Development factors 1.78 1.59 1.11 1.03
12.7 Stochastic Methods of Assessment of the Loss Reserve 289

Table 12.13 Incremental pseudo-data

D0 D1 D2 D3 D4
A1 778 607 818 242 73
A2 890 694 935 277
A3 1,018 794 1,069
A4 1,203 939
A5 1,182
Development factors 1.78 1.59 1.11 1.03

Table 12.14 Pearson coefficients

D0 D1 D2 D3 D4
A1 0.27 0.68 -0.40 -1.18 0.66
A2 0.47 -0.88 0.17 0.24
A3 -0.71 0.90 -0.08
A4 0.48 -0.54
A5 0.00

4. The Pearson residuals8 for the triangle from the foregoing point are calculated: for
each cell, the pseudo-incremental data obtained previously are subtracted from
the value of the original incremental, and all this is set against the square root of
the pseudo value

C i,j - mi,j
r Pi,j = ð12:18Þ
mi,j

where the Ci,j are cumulative paid amounts and the mi,j the pseudo-data just
calculated.
For example, for the first cell there will be ð786p- 778Þ
778
= 0:27. The final result is
reported in Table 12.14 where the obtained Pearson coefficients are shown.

8
The expression “Pearson residuals” (or standardized residuals) indicates the residual divided by an
estimate of its standard deviation. The standardized residuals have a mean of 0 and a deviation
standard equal to 1.
290 12 Non-Life Insurance: Reserving

5. Scale parameter Φ is calculated by the formula:

2
r Pi,j
i, jn - iþ1
ϕ= ð12:19Þ
2 nðn þ 1Þ - 2n þ1
1

where the numerators are the sum of the squares of the Pearson coefficients and n is
the number of data observed (in this example, 15). The scale parameter will later
serve to obtain an estimate of forecast error.

6. The Pearson residuals are adjusted using the multiplication factor.

DðDþ1Þ

DðDþ1Þ
2
= 2, 5 ð12:20Þ
2 - 2D þ1

where D represents the dimension of the run-off triangle, which in our case is 5. The
result is represented in Table 12.15 reporting the rectified Pearson coefficients.

7. The iterative loop commences and is to be repeated N times.

8. The random remixing operation (in the 15 positions present in the triangle) of
the rectified Pearson coefficients previously obtained is performed. A possible
extraction may be analysed in Table 12.16 reporting the remixed rectified
Pearson coefficients.

Table 12.15 Rectified Pearson coefficients

D0 D1 D2 D3 D4
A1 0.68 1.70 -1.00 -2.95 1.65
A2 1.18 -2.20 0.43 0.60
A3 -1.78 2.25 -0.20
A4 1.20 -1.35
A5 0.00

Table 12.16 Remixed rectified Pearson coefficients

D0 D1 D2 D3 D4
A1 0.43 -1.35 -1.00 0.68 1.18
A2 1.70 0.60 -1.78 1.65
A3 -2.20 0.68 -0.20
A4 2.25 -2.95
A5 1.20
12.7 Stochastic Methods of Assessment of the Loss Reserve 291

9. For each cell of the upper triangle, the values of the incremental pseudo-data are
calculated drawing Ci, j from the Pearson factor formula, i.e.

C  i,j = mi,j ∙ r Pi,j þ mi,j ð12:21Þ

The result of this calculation is reported in Table 12.17 where incremental

pseudo-data simulation are shown.

10. Totalling the incremental pseudo-data, the relative triangle of cumulative

payments is obtained. In Table 12.18, this result is shown.

11. The chain ladder method is applied to the triangle obtained under the foregoing
point, estimating the lower triangle of cumulative payments.
12. The relative estimate of the reserve for each generation is calculated, along with
the total one.
13. The result obtained is saved and the iteration is recommenced.

The aggregate of all the results calculated makes up the basis of the data upon
which it is possible to calculate the best estimate of the total reserve and that per year
of generation, as the arithmetic mean of all the simulations. Additionally, the
standard deviation of the bootstrap matches that of the N reserves estimated,
which makes up an estimate for the deviation of the model. In this regard, the two
authors propose an analytical approximation carried out with the product between

Table 12.17 Incremental pseudo-data simulation

D0 D1 D2 D3 D4
A1 791 574 789 253 83
A2 941 710 880 305
A3 947 813 1,062
A4 1,281 848
A5 1,223

Table 12.18 Cumulative pseudo-data simulation

D0 D1 D2 D3 D4
A1 791 1,365 2,154 2,406 2,490
A2 941 1,651 2,531 2,836
A3 947 1,760 2,822
A4 1,281 2,130
A5 1,223
292 12 Non-Life Insurance: Reserving

the scale parameter and the best estimate of the total reserve and then added to the
estimate variance component to obtain the forecast error.

EP = ϕ ∙ R þ σ ðRÞ2 ð12:22Þ

where R is the value of the reserve and σ is the standard deviation calculated on the
findings of the simulation method of the values of the reserve.
Later, the two authors extended the procedure so as to replace the analytical
calculation of the process error with a simulation calculation, reach a distribution of
the loss reserve and increase the quantity of information obtainable from the starting
data, such as the asymmetry of the distribution of the reserve and its percentiles,
considerably. The idea is to use the lower triangle of incremental pseudo-data at each
iteration as a parametric basis to extract the possible coming to light of distributions

chosen a priori. More specifically, for each individual cell Ci,j ðper i þ j > t þ 1Þ a
payment will be valued from a chosen distribution, which will have mean equal to
 
C i,j and variance Φ  Ci,j , where Φ is the scale parameter already calculated. The
iterative loop will then be supplemented with a further step to be included prior to the
penultimate step.
The mean of the N reserves obtained (by year of generation and total) will provide
the best estimate, to be compared with that deriving from applying the chain ladder
base. The standard deviation of the N samples will be the estimate of the forecast
error.
It is possible to use various types of distribution to extract data, but it would
anyway be worthwhile and preferable to make assessments with assumptions of
distributions so as to then compare the result obtained. Usually, the distributions
used most frequently are the normal, the lognormal and the Poisson. Alternatively, to
the latter, a negative binomial or a gamma can be used, as they provide similar
results.

12.8 Premium Reserves

" Definition Reserve for unearned premiums or premium reserve consists of a
provision by the insurance undertaking to be able to meet its commitments to its
policyholders. The premium reserve is set aside using part of the premiums paid by
policyholders at the end of each period, taking into account the part.9

Essentially, in the most common cases of annual contracts, a premium issued at the
beginning of the month of March is valid for 12 consecutive months. Considering
the number of 12 months, the contract covers the subsequent 10 months up until the

9
This type of technical reserve is similar to the concept of mathematical reserve in life insurance
(see Chap. 14).
Appendix 293

end of the calendar year, and 2 months of the subsequent year represents the value of
the premium reserve that is entered in the balance sheet in financial statements. This
reserve is normally calculated according to a law of straight-line writing down,
applying the so-called pro-rata temporis method; i.e. in our example, two-twelfths
of this premium are posted as reserve.
Alongside the concept of premium reserve, with this simple example, we have
also introduced the concept of earned premium, which can be defined by using the
following expression:

Pearned = Rstarting þ Pissued - Rending ð12:23Þ

which indicates that the value of premiums earned is given by premiums issued net
of any variation in the premium reserve. In detail:

Rstarting = Prior year’s earned premium reserve = 50

Pissued = Total premiums issued in the year = 120
Rending = Reserve of premiums earned in the following year = 20

Following the numerical example, you would have earned

premiums = 150 = 50 + 120–20.
The final premium reserve is a minus value of issued premiums as, as just seen in
the example, it accrues to the subsequent year. Contrariwise, the incoming premium
reserve accrues premiums issued in the previous year to the current year and so has a
plus value. This formula also applies in cases of a single premium applying for a
number of years; indeed, at the beginning of the second year the incoming premium
reserve accrues to the current year plus subsequent years, and the value of the
outgoing reserve accrues to years subsequent to the current one, thus leaving the
value of the premium for the current year alone as residual value.

12.9 Questions

1. What is the reserve for losses IBNR?

2. List the main deterministic methods of assessment of the loss reserve.
3. What are the principles for the Taylor separation method?
4. Explain how it works a generalised linear models.

Appendix

Comparative table between the five main deterministic methods presented in the
chapter.
294 12 Non-Life Insurance: Reserving

1. Model Grossing up
Type of • Concatenated
calculation
Approach • Assesses the difference between the final value of payments as compared to
the initial one
Portfolio • A homogeneous portfolio over time with short tail claims
Evaluation • The simple structure renders it applicable to run-off triangles without long
elements tail loss events and with limited sums paid out
Complexity • Low

2. Model chain ladder

Type of • Concatenated
calculation
Approach • Based on the assumption that future trends in expected loss events are the
same as those seen in past generations
Portfolio • A portfolio with relevant historical data so as to be able to apply correctives
deriving from recurring situations (long tail claims or inflation)
Evaluation • Based on link ratios per year of development (weighted mean year on year).
elements The model offers solutions of interest for portfolios that are consolidated. To
be avoided in start-up businesses or variations in policies of settlement or
reserving
Complexity • Average

3. Model Fisher–Lange
Type of • Average cost
calculation
Approach • The development of the run-off triangle is found in the product of the number
of loss events and their average cost, fittingly corrected for the effects of
endogenous inflation (claim inflation) and exogenous (economic) inflation
Portfolio • A portfolio with historical data so as to be able to calculate average costs,
speed of settlement and reopening exactly. In order to obtain an estimate of the
reserve this method it is necessary to have available data that are numerically
greater as compared to the chain ladder method
Evaluation • This is found to be best applied in portfolios with a high number of loss
elements events for each insurance year. It can be affected by distortions arising from
contingent situations (non-recurring high-point loss events)
Complexity • High
References 295

4. Model Taylor’s separation

Type of • Separation
calculation
Approach • Development of the run-off triangle is determined based on the assumption
that disposing of loss events will occur obeying a law that is the same for each
generation
• It is wished to separate out the law governing the development of loss events
from the noise surrounding them
Portfolio • A portfolio with relevant historical data so as to be able to calculate
development according to the expected cost method. The model seeks to
“separate out” the effects created by the development of generations
(by number) from those of the year of projection (for costs)
Evaluation • This method has been developed in order to estimate, not so much the
elements deferment between occurrence and settlement (IBNR loss events) but rather
between the report and payment out. The purpose of the method is to provide
an estimate of the quantities that may cause a break and to be able to construct
a proper run-off triangle. Excellent for consolidated portfolios
Complexity • High

5. Model Bornhuetter and Ferguson

Type of • Bornhuetter and Ferguson
calculation
Approach • Based on a chain ladder structure cost of the latest generation, being the sum
accumulated matching the latest year of development. The aim is to define
rules for calculating the “final” loss ratio per generation year. The result that it
is sought to obtain is given by the final cost per generation, being the
accumulated sum matching the latest year of development
Portfolio • A portfolio with event historical data as, unless there are distortions due to
exceptional loss occurrences (at the time, for example, of natural calamities,
economic crises, terrorism or other catastrophe events), it is reasonable to
expect a certain consistency in technical trends overall and recorded year on
year
Evaluation • The method identifies an indicator in the loss ratio that is ideal for the
elements technical trend and is applicable in parallel with other relevant indices, for
example, the combined ratio. It is a method for fine-tuning chain ladder
analyses
Complexity • High

References
Fisher WH, Lange JT (1974) Loss reserve testing: a report year approach. Proc CAS 60:189–207
Mack T (1993) Distribution-free calculation of the standard error of chain ladder reserve estimates.
ASTIN Bulletin 23:213–225
296 12 Non-Life Insurance: Reserving

Suggestions for Further Study

Bornhuetter R, Ferguson R (1972) The actuary and IBNR. ASTIN Bulletin
Daboni L (1989) Lezioni di tecnica attuariale delle assicurazioni contro i danni. Edizioni LINT,
Trieste
England PD, Verral RJ (2002) Stochastic claims reserving in general insurance. Presented to the
Institute of Actuaries
Faculty and Institute of Actuaries (09/1997) Claims Reserving Manual, vol. 1
Kotz S, Johnson NL (1992) Breakthroughs in statistics - methodology and distribution. Springer
Taylor G (2006) Separation method encyclopedia of actuarial science. John Wiley & Sons, Ltd.
https://doi.org/10.1002/9781118445112.stat04383
Life Insurance: Pricing
13

Abstract

The aim of this chapter is to explain the calculation of insurance premium in life
insurance. The premium is determined by two factors: financial factor and
demographic factor. The financial factor depends on the expected value of the
economic disbursement foreseen when an event occurs. This event is based on the
duration of human life, due to death or survival of one insured. Additionally, it
takes into account the interest generated between when it is paid and when any
performance is met. The demographic factor is based on mortality tables, which
contain the rate of mortality and likelihood of survival. The combination of these
two factors defines the first level of premium. A safety loading is then added to
this premium. Then further explicit loadings are charged. They have the purpose
of covering management expenses and acquisition costs of the contracts. In the
paragraphs that follow, the classification of life insurance on the basis of perfor-
mance is explained. The actuarial formulas for Capital performance insurance
products (term life and deferred capital) are explained. In the end, the actuarial
formulas for annuity insurance products are detailed.

Keywords
Mortality tables · Population tables · Selected tables · Statistical basis ·
Demographic basis · Technical rate · Current value · Expected current value ·
Actuarial value · Just premium · Principle of equity · Pure premium · Technical
basis · Safety loading · Rate of safety loading · Demographic–financial tables ·
Self-selection · Additive impairment method · Multiplicative impairment
method · Lexis point · Rectangularisation · Term Life (TL) · Deferred Capital
(DC) · Ordinary mixed · Capitalisation · Immediate annuity · Deferred annuity ·
Acquisition expenses loading · Collection expenses loading · Management

For this chapter, a special acknowledgement goes to Marcello Ottaviani (consulting audit and
appointed actuary).

# Springer Nature Switzerland AG 2024 297

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_13
298 13 Life Insurance: Pricing

expenses loading · Loading for remuneration of own capital · Management fee ·

Taxable premium

13.1 Learning Objectives

At the end of this chapter the reader should be able to:

1. Know the significance of survival and mortality in the contest of life

insurance
2. Define the hypothesis at the base of premium calculation
3. Explain the different components of life premium
4. Calculate life insurance premium

13.2 Demographic Forecasts: Mortality and Survival

In order to define the technical bases that are necessary for calculating a life
premium, at least two types of information are needed:

• Demographic forecasts, which are needed in order to take into account the
likelihood of life or death of the assured;
• Rate of interest to be applied so as to actualise the flows relating to the sequence
of income and outgo expected over the life of the contract.

The rate of interest is applied based on deferment over a period of several years
between payment of the premium by the assured and the performance by the insurer.
The probabilities underlying the calculation of the premium are closely tied to
the likelihood of the death or survival of the assured. For assessing the likelihood of
death or survival, reference is usually made to mortality tables, which hold data that
express the dynamic of mortality in a certain society.
A table holds the likelihood of the death of an individual occurring within 1 year
based on the age attained. It is based on observing the frequency of mortality of a
group of persons statistically, for example the population of a country or a subset of
this. For a representation by way of example, see the mortality table for the European
male population in Table 13.1.
The columns of the mortality table represent the demographic bases for calcu-
lating a life insurance premium:
13.2 Demographic Forecasts: Mortality and Survival 299

Table 13.1 Mortality table of resident male population (Example)

x Lx dx 1.000 qx 1.000 Px
0 100.000 328 3,282 96,718
1 99.672 24 0,237 99,763
2 99.648 17 0,168 99,832
... ... ... ... ...
50 96.496 264 2,739 97,261
51 96.232 288 2,998 97,002

• x = the age of the person.

• lx = the average number of survivors at precise age x, of the sample selected1;
normally by convention set at l0 = 100,000.
• dx = the average number of deaths occurring between age x and age x + 1. This is
thus the number of survivors to age x less the number of survivors to age x + 1 in
the sample selected.

Number of deceases : dx = lx - lxþ1 : ð13:1Þ

For example, d(x_50 years) = l(x_50 years) - l(x + 1_51 years) = 96.496 - 96.232 = 264

• qx = rate of mortality, represents the likelihood of a person aged x to die within

1 year. This is given by the ratio applying between the number of deaths in that
year and the number of survivors.

Rate of mortality : qx = dx =lx : ð13:2Þ

For example, q(x_50 years) = d(x_50 years)/l(x_50 years) = 264/96.496 = 0.002736 *

1.000 = 2,736

• lx = likelihood of survival, represents the likelihood of a person aged x to be

alive after 1 year.

Likelihood of survival : px = lxþ1 =lx : ð13:3Þ

1
Note that by convention the initials lx and dx match the first letters of the terms in English life and
death.
300 13 Life Insurance: Pricing

For example, p(x_50 years) = l(x_51 years)/l(x_50 years) = 96.232/96.496 = 0,99726 

1.000 = 997,26.
As can be seen intuitively, the likelihood of survival is complementary to the
likelihood of dying ( px = 1 - qx). For example, 1 - q(x_50 years) = p(x_50 years) 1 -
0,002736 = 0,99726.
After illustrating all the addenda to the algorithm, the survivors and the likelihood
of death are tied to this relationship:

Relationship between survival and mortality : lxþ1 ¼ lx - lx qx ¼ lx ð1 - qx Þ

ð13:4Þ

For example, l(x + 1_51 years) = l(x_50 years * (1 - q(x_50 years)) = 96.496  (1 -
0,002736) = 96.232
Mortality tables are usually of two types: population tables and selected tables.
The first ones are called population tables, and cover the whole country, split by
gender, male and female.2 These are numerical tables prepared by the national
institute of statistics or other institutions at the time of a population census and
which, starting from a theoretical population of l0 = 100,000 individuals of age zero,
indicate for each age, the number of survivors (lx), the number of deceases (dx), and
the likelihood of death (qx). The tables for the domestic population are of two kinds;
those that analyse the population in a single year or limited period of time, and those
that follow a generation (or cohort) over time until it disappears naturally. The two
methods give rise to different results and are used to describe the phenomena of
mortality and survival, respectively.
The second ones are selected tables built upon the basis of the hands-on experi-
ence of the insurer and deriving from the features of the assureds’ portfolio of each
undertaking split by type of cover or performance offered. The reason for building
up these tables is to be found in the wish to have data available in respect of the
specific mortality of a group of assureds as compared to another. However, in many
cases, given the high cost of these analyses, insurance undertakings prefer to utilise
national bases that are modified through the use of one or a number of correction
parameters, also called table discounts, so as to be able to adjust them overall to
what is happening in respect of the risk of their own assureds.
To synthesize, the statistical basis or demographic basis is thus made up of
mortality and survival tables that consider a certain number of individuals. This
statistical probability estimates how many people will survive/die by the end of each
year and through this what the potential performances of the insurance undertaking
will be.

2
Note that following Directive 2004/113/EC of 13 December 2004 implementing the principle of
equal treatment between men and women of December 2012, it is no longer possible to use the sex
element as a deciding factor in assessing risk and defining insurance premiums and individual
performances. For a treatment of this theme see later in this chapter.
13.3 The Financial Bases and Actualising Flows 301

13.3 The Financial Bases and Actualising Flows

The second component necessary for determining a premium consists of determin-

ing the financial bases for actualising expected flows. Life insurance contracts can
indeed be represented as a series of inwards flows, premiums collected, and out-
wards flows, insurance performances delivered, and expenses incurred. A distribu-
tion of these flows can be classified by referring to two dimensions:

• The aleatory nature of the date when a flow will occur and if it appears.
• The extent or size of the flow itself.3 In general, in life business, this second risk
does not apply because of the sum insured is predefined by the policy conditions
at the time it is taken out. In the non-life business, on the other hand, it is one of
the main risks applying.

In respect of the aleatory dimension, flows are uncertain as they depend on the
duration of the life of the party assured while the interval usually covers a period of
time of the number of years between the date when the premium is paid and the date
of disbursement of the performance, apart from a number of products applying
generally to groups of assureds which are typically for 1 year.
Concerning the size of outwards flows, contracts mainly foresee performances
with a certain pre-set sum (for example a sum insured of € 100,000) or performances
set in a manner that is fixed (for example 2% of the sum insured).
The actualisation component is tied to the inverted production cycle of
insurances. Insurance business places the insurance undertaking in a position to
invest the premium received from the assured and gain an income from this for the
entire aleatory duration of the contract up until outgoing flow appears.
The estimated rate, on the basis of actualising, is the same as the rate of interest
through which the insurance undertaking actualises the sums paid in advance by the
assured. This rate is given by the insurer to the assured when the contract is taken out
and applied for the entire multi-year duration of the policy. In other words, this rate is
the financial value awarded by the insurance undertaking for the fact that premiums
are paid in advance in respect of a multi-year contract. In particular, this rate of
interest is referred to as the technical rate.4
Actualising flows leads to determining the current value, i.e. the value obtained
from the sum of every possible flow actualised applying a fitting rate of interest. In
order to explain this concept more fully, the formula for actualising the premium can
be analysed:

Annual factor of premium actualising : v ¼ ½1=ð1 þ iÞn ð13:5Þ

3
For the sake of simplicity of treatment, reference will be made in this paragraph only to cases of
contracts of insurance whose performance depends on the duration of the life of the assured.
4
See below for a look at technical bases.
302 13 Life Insurance: Pricing

v = 1 / 1 + 4% = 0.962
v = 1 / (1 + 4%)2 = 0.925
where

• i indicates the annual rate of interest.

• v represents the annual actualising factor and
• n the time that separates us from the event.

Under a regime of compound interest Pv is thus the value of a principle (P) payable
in 1 year and Pv2 is that for a principal payable in 2 years and so on.
Bringing together the expected value and current value leads to defining the
expected current value or actuarial value of the flows from an insurance contract.5
The expected actuarial value of a contract, therefore, considers three sets of bases:
demographic hypothesis,financial hypothesis and expected current value.
If the bases adopted for calculating the premium are realistic, the current expected
value of flows is the same as the equitable premium, i.e. the premium by means of
which the assured transfers the risk that an event may occur (which may occur in the
future) to an insurer, in exchange for a sum they pay when taking out the insurance.6
This premium is net of any additional margin and abides by a principle of equity.
This principle foresees, in calculating this premium, that the actuarial value of
premiums paid by the assured at the time the contract is taken out and the actuarial
value of the performance applying at this time, is the same.7
Called, Z the current value of the earnings of the insurer where:

Π = the single equitable premium paid by the assured

Y = the current aleatory value of the performances

Current value of earnings of the insurer : Z = Π - Y ð13:6Þ

which due to the principle of equity must be

Principle of equity : E ðZ Þ = 0 ð13:7Þ

therefore, the equitable premium can be represented as follows:

5
For a treatment of actuarial value see Pitacco E., Olivieri A., Introduction to Insurance Mathemat-
ics, Springer, 2nd ed. 2015.
6
In life business, a loss is the same as the request for a performance (lump sum or annuity) that
might be settled in the future.
7
Here we follow Pitacco E., Olivieri A., Introduction to Insurance Mathematics, Springer, 2nd
ed. 2015, according to whom the pure premium is the premium c valued in accordance with a
principle of equity.
13.4 Technical Basis and Safety Loading 303

Expected value of the performance delivered by the insurer : Π = EðY Þ ð13:8Þ

Note that the condition of equity is applied in the foregoing equation between
addenda.
The equitable premium, one in which there should be no losses nor gains, would
lead inevitably to it being impossible for the insurance undertaking to meet possible
adverse results deriving from variances in mortality as compared to that expected,
and fluctuations in the rate of interest. To avoid this happening, the result of the
equation shown above is changed to the benefit of the insurance undertaking. So, a
greater charge is added to the pure premium so as to ensure that the insurer has a
further margin.
For these reasons, a pure premium,8 obtained by adding together the equitable
premium and the further safety loading is adopted. The pure premium is defined also
as the indifference premium which renders the transaction indifferent for the insurer
and so without any risk of loss of earnings. For an explanation of safety loadings, see
the next paragraph.

13.4 Technical Basis and Safety Loading

The technical basis comes from the two sets of fundamental bases upon which the
life premium is built up, i.e. the probability of an insured event occurring (demo-
graphic basis) and an actuarial rate (financial basis). In other words, survival function
and actuarial rate make up the so-called technical basis. The technical bases in their
turn can be separated out into two types, based on the purpose required of the
actuarial evaluation: first-order bases (assessment of pricing) and second-order bases
(assessment of yield).9
The second-order technical basis or TB2 (q, i) is a realistic basis founded on
actual experience and includes within it the values of probability and financial rate,
which reflect the true expectations of the insurer. The purpose of this basis is to
produce a reliable forecast of expected incoming flows and outgoing disbursements.
This basis is then used to assess the actual return as the market and population
referred to change over time. This basis follows the same trend since it is a
representation of reality. As insurance undertakings put different premiums on the
market it is necessary to monitor whether or not the real basis exceeds the one
adopted in calculating the premium.
The first-order technical basis or TB1 (q*, i*) is the basis that takes into account
a probability of the prudential event occurring and so leads to levels of premium that

8
For a look at pure premium, we follow Pitacco E., Olivieri A., Introduction to Insurance
Mathematics, Springer, 2nd ed. 2015. Other Authors have a different view. The product of
likelihood and the value insured is the same as the pure premium, rather than the just premium
recognised in most of the literature.
9
For a definition of technical bases see Pitacco E., Olivieri A., Introduction to Insurance Mathemat-
ics, Springer, 2nd ed. 2015.
304 13 Life Insurance: Pricing

are higher than those that we would have with a second-order basis. This basis is the
one usually used to calculate the amount of the premium.
The risk of there being a divergence between estimated probability (TB 1) and
what actually (TB 2) arises can be attributed to the following factors:

• Dispersion of the distribution of claims in number and amount.

• Fluctuation in the actual extent of relative frequency due to exceptional
circumstances in trends in risk.
• Insufficient statistical data upon which the rate of relative frequency is calculated
• Changes in the factors that can have a bearing on the frequency or monetary
impact of claims (inflation, economic-social factors, etc.).

By means of this machinery, it is implicitly possible to hold a margin within

premiums that can meet possible movements in the mortality curve, in longevity or
rate of interest as compared to those realistically expected. The first-order technical
basis is used, along with fitting adjustments and reasoning that we will mention later
in this chapter, in determining a safety loading within the premium.
Essentially, the safety loading amounts to the difference added to the pure
premium and the equitable premium. This difference quantifies in monetary units
in time t0 the aversion on the part of the insurer to the risk that is contained in a
transaction to insure a potential loss.10 In reality, this loading is adopted by the
insurance undertaking on the basis of assessments made not only of the risk but also
the return and its own commercial experience. Indeed, the loading cannot exceed
certain thresholds that would make the product unmarketable but cannot be so low as
to lead to a risk of technical loss being made by the insurance undertaking. The
values that lie between these, if plus, depend on the strategic choice made by the
insurance undertaking based on questions of marketing and risk.

Difference between pure premium and just premium : L = P - Π, ð13:9Þ

where
L = the loading
P = the pure premium
Π = the single pure premium
The safety loading is often expressed as a percentage of the pure premium, as the
rate of safety loading.

Formula of the rate of safety loading : ℓ = L=P: ð13:10Þ

The insurer does not have to declare the safety loading to the assured, differently
from expenses which must on the other hand usually be shown at the time the
contract is taken out.

10
See Ottaviani G., L’impresa di assicurazione, Giuffre, Milano, 1981, page 79 and ff . . .
13.5 An Example of Determining a Life Premium 305

13.5 An Example of Determining a Life Premium

Algebraically, determining the equitable premium is achieved by combining the two

components, demographic and financial. So as to facilitate the calculation, in
actuarial mathematics coefficients called commutation symbols are used, which
derive from the product of demographic factors and financial factors whose results
make up demographic–financial tables are based on the mortality tables and the
choice of an actuarial rate called technical rate.
For insurances on survival, the commutation symbols are linked to the average
number of survivors lx, at the age of the individual x and technical rate i, v annual
discount rate:

Endowment Insurance ¼ Dx ¼ lx vx ¼ lx ð1 þ iÞ - x ð13:11Þ

ω-x
Annuity Insurance = N x = Dxþ1 , ð13:12Þ
i=0

ω-x
Annuity insurance ðwith arithmetical growthÞ = Sx = N xþ1 , ð13:13Þ
i=0

where ω represents the maximum age relative to the demographic table.

Here is a number of examples of pure premium calculations in certain forms of
survival insurance using commutation symbols.

nEx = Dx + n/Dx (endowment insurance)

äx = Nx/Dx (annuity insurance)
(Iä)x = Sx/Dx (annuity insurance with arithmetical growth)

On the other hand, for insurance on decease, the commutation symbols are linked to
the average number of deceases dx, at the age of the individual x and the technical rate i:

Term Life Insurance = C : C x = dx vxþ1 = dx ð1 þ iÞ - ðxþ1Þ , ð13:14Þ

ω-x
Whole life insurance = M : M x = Cxþ1 , ð13:15Þ
i=0

ω-x
Sum of whole life insurance = R : Rx = M xþ1 , ð13:16Þ
i=0

where v, as already seen in formula (13.5), represents a capitalising factor amounting

to 1/(1 + i).
Here is a number of examples of pure premium calculations in certain forms of
decease insurance using commutation symbols.
/nAx = (Mx - Mx + n)/Dx (term life insurance)
Ax = Mx/Dx (whole life insurance)
306 13 Life Insurance: Pricing

Table 13.2 Table of commutation symbols, male

x lx dx Dx Nx Cx Mx
0 100,000 328 100,000 4,661,783 323 31,106
1 99,672 24 98,199 4,561,783 23 30,783
2 99,648 17 96,725 4,463,584 16 30,760
... ... ... ... ... ... ...
50 96,496 264 45,836 1,144,299 124 28,925
51 96,232 288 45,035 1,098,463 133 28,801
52 95,944 317 44,237 1,053,428 144 28,669
53 95,627 343 43,439 1,009,191 154 28,525
54 95,284 383 42,644 965,752 169 28,371
55 94,901 425 41,845 923,109 185 28,202
... ... ... ... ... ... ...
108 2 1 0.40 0.60 0.20 0.20
109 1 0 0.20 0.20 – –

(IA)x = Rx/Dx (decease insurance with sum assured growing arithmetically)

Table 13.2 shows data and commutation symbols supposing a technical rate
i = 1.5%, referring to mortality tables of the resident male population.
Beginning with the demographic–financial table, let us suppose having to calcu-
late the table of premium rates for a term life with constant sum assured and constant
annual premium based on the age of the assured x and duration of the insurance n.11
Given the characteristics of the term life and relative commutation symbols, the
premium rating table can be obtained by applying the rate of premium formula:

M x - M xþn
Formula for the rate of premium = ð13:17Þ
N x - N xþn
As we can see, the formula is given by the ratio applying between the difference
in the cumulative sum of those deceased (actualised at a rate i) and the difference in
the cumulative sum of survivors (actualised at rate i) over a certain period n.
To understand the application of the formula for calculating the rate of premium,
an example is given below:

x = 50 n=5 i = 1:5% l50 = 96:496 d50 = 264:

D50 = l50 1=ð1 þ iÞ50 = 96, 496 1=ð1 þ 1:5%Þ50 = 45, 836 ð13:18Þ

109 - 50
N 50 = D50þ1 = 1, 144, 299 ð13:19Þ
i = 50

11
To simplify the exercise and complete the subsequent premium rating table, the following
characteristics have been imagined: minimum duration of the contract 5 years and maximum
duration 20 years (5 < n < 20). insurance age not less than 18 years and not over 75 years at
expiry of the contract.
13.6 Demographic Bases: Criteria for Selecting Risks 307

C50 = d50 1=ð1 þ iÞ51 = 264 1=ð1 þ 1:5%Þ51 = 124 ð13:20Þ

109 - 50
M 50 = C 50þ1 = 28, 925: ð13:21Þ
i = 50

D55 = l55 1=ð1 þ iÞ55 = 94, 901 1=ð1 þ 1:5%Þ55 = 41, 845 ð13:22Þ

109 - 55
N 55 = D55þ1 = 923, 109 ð13:23Þ
i = 55

C55 = d55 1=ð1 þ iÞ56 = 264 1=ð1 þ 1:5%Þ56 = 185 ð13:24Þ

109 - 55
M 55 = C55þ1 = 28, 202 ð13:25Þ
i = 55

Rate of Equitable Premium = ðM 50 - M 55 Þ=ðN 50 - N 55 Þ

= ð28, 925 - 28, 202Þ=ð1, 144, 299 - 923, 109Þ = 3:267 ð13:26Þ

Table 13.3 indicates the rates of premium to be applied to every intersection

between age of the assured and duration of the contract. In the event, for example of
an assured aged x = 50 years and a term life policy for duration n = 5 years, the
value of the annual advance premium for sum assured C = € 100,000 comes from
the following formula:
Premium paid = Rate of premium x C = 3:267 × € 100, 000 = € 3, 267 ð13:27Þ

It needs to be remembered that the premium indicated in formula (13.27) is the

equitable premium and so loadings are to be added in.

13.6 Demographic Bases: Criteria for Selecting Risks

Studying the notion of demographic bases still further,12 the possible events that
insurer may run into at the time of concluding the contract, self-selection and
non-selection are analysed.13
In cases of insurances with performance, for survival type, self-selection may
occur. self-selection means that probably persons who are in good health decide to
insure themselves as they expect to be able to benefit in old age from the sum
accumulated previously (and the longer their old age is, the more they will benefit).

12
For the concept of selected tables see what is treated in the foregoing paragraph.
13
Both phenomena fall within the broader concept of adverse selection. For treatment of this see
Chap. 2.
308 13 Life Insurance: Pricing

Table 13.3 Table of rates of annual premium for a term life cover with constant sum assured
x/n 5 6 ... 10 11 ... 15 16 ... 19 20
18 0.456 0.464 ... 0.491 0.496 ... 0.517 0.526 ... 0.555 0.565
19 0.478 0.486 ... 0.506 0.510 ... 0.536 0.545 ... 0.575 0.587
... ... ... ... ... ... ... ... ... ... ... ...
40 1.231 1.294 ... 1.596 1.688 ... 2.106 2.232 ... 2.659 2.820
41 1.353 1.423 ... 1.761 1.860 ... 2.325 2.463 ... 2.932 3.111
... ... ... ... ... ... ... ... ... ... ... ...
50 3.267 3.450 ... 4.278 4.521 ... 5.678 5.982 ... 7.044 7.463
51 3.609 3.809 ... 4.723 5.007 ... 6.237 6.572 ... 7.768 8.214
... ... ... ... ... ... ... ... ... ... ... ...
55 5.388 5.682 ... 7.074 7.429 ... 9.181 9.692 ... 11.342 11.952
56 5.952 6.304 ... 7.767 8.157 ... 10.111 10.662 ... 12.450
57 6.609 6.982 ... 8.527 8.982 ... 11.124 11.719 ...
... ... ... ...
68 19.235 20.099
69 21.074 22.105
70 23.079

In this case, in effect, statistics prove that these assureds have a rate of mortality that
is lower than the average of the population in general. The phenomenon, in which
the sensations of the assured are a significant condition in taking out the contract is,
indeed, defined self-selection by the assured.
In cases of policies for decease, on the other hand, it often occurs that individuals
whose state of health is not as good as the general population seek these covers. For
this reason, people with a likelihood of dying greater than the average of the
population as a whole, insure, and in so doing, act against the insurer. If this situation
arises it is defined as anti-selection or adverse selection.
In both cases, if this occurs systematically, the insurance undertaking would be
exposed to adverse variances between expected and actual probability, which could
compromise its equilibrium and future continuity. For this reason, an insurer, by
building up selected tables, takes into account the probability of an adverse event
different from the one expected on the average in the population occurring. In both
cases, therefore, for products for survivorship and decease, probabilities of survival
that have a correction as compared to those drawn from the general populations are
utilised.
In Europe, a further distinguishing factor in determining premiums for life
contracts, for contracts taken out before 2012, was gender. This principle was
based on recognition, and application, of the fact that a different rate of mortality
existed between men and women in the same population. After 2012 this arrange-
ment changed following the European Directive which invalidated this principle and
required the pursuit of an objective of parity of treatment between men and women
13.6 Demographic Bases: Criteria for Selecting Risks 309

in calculating insurance premiums and relative performances.14 The gender direc-

tive, requires a unisex demographic basis to apply. This basis may be defined on

• The basis of a prevailing risk and adopting, according to the tariff applying, a
table for males or one for females, with possible correcting factors.
• The basis of weighted risks, i.e. imagining a prudent mix of assureds of both sexes
representing an estimate of a theoretical population assured.

Introducing a unisex tariff, i.e. one that did not discriminate on the basis of sex,
led in effect to passing from a standpoint of technical equilibrium in an individual
contract to a standpoint of mutuality of the risks of the assureds of both genders over
the whole portfolio. The use of factors of risk tied to gender is still possible only to a
small extent and only where these are true risk factors, such as pathologies that are
specific to gender (for example breast cancer for women in sickness risk, etc.).
In addition to the parameters seen above, in selecting risks properly, further
classes of risk are usually adopted in insurance undertakings such as the health
risk tied to state of health, occupational or special risks, risks that depend on the
lifestyle and profession carried on, and hazardous sports practised and/or journeys
made, and finally the risk of financial capacity connected with the economic status of
the assured.
In order to be able to select risks according to the categories indicated above, an
insurer needs a series of items of information that the assured must provide and
submit to examination by the undertaking. Normally, this information is gathered by
means of a proposal form that allows all the types of risk of foreseen to be identified.
In order to detect the health risk a health history questionnaire is usually used, or
a series of queries15 prepared by the insurer and put to the would-be assured, and in
which detailed information is requested as to the state of health, accidents and
illnesses suffered, after-effects remaining, family history and habits, etc. Sometimes
the would-be assured also undergoes a medical examination and verification is done
of diagnostic tests performed.16
Occupational or special risks are analysed by gathering information in respect
of the lifestyle, profession, and any habits the assured may have. Verification of

14
See Council Directive 2004/113/EC of 13 December 2004 implementing the principle of equal
treatment between men and women.
15
This form must be filled in by each proposer concerned with taking out a life contract. This comes
from Greek; anamnesis means reminiscence. The anamnesis of the state of health distinguishes
between; family (information concerning the state of health or decease of parents), physiology (birth
and growing-up), remote pathology (health precedents that are in the distant past) and proximate
pathology (illness that is current).
16
It is usual to exclude all illnesses that were pre-existing when concluding the contract from
policies (for example, deformities, mental illnesses, etc.).
310 13 Life Insurance: Pricing

Fig. 13.1 Types of risk Risk normal or

standard

Risk weighted or
sub-standard
Type of risks

Deferred Risk

Rejected Risk

these is necessary for assessing the selection of the risk properly relating to
individuals with a high degree of exposure to accident risks.17
Analysing the financial capacity risk allows it to be understood whether or not
the sum requested for the future indemnity is compatible with the true financial status
of the assured.18 In order to gather this information, the insurance undertaking will
often request specific documentation, such as the financial position of the individual,
an estimate of their wealth, an income tax return and analysis from the risk centre in
respect of any situations of insolvency there may be, etc.
At the end of these analyses and having had the opinion of own medical advisor
and own specialists, the insurer will decide whether or not to provide the cover and at
what terms. There are four possible risk profiles: normal risk (or standard risk),
weighted risk (or sub-standard risk), deferred risk and rejected risk. Figure 13.1
represents the types of risk.
A risk is defined as normal or standard if there are no factors leading to thinking
the individual is more greatly exposed to the mortality risk as compared to the
average. In this case, the risk does not display impairment of profile due to health
and/or non-health reasons. Since the risk is normal, the cost of the performances
covered is the same as the theoretical average one foreseen in building up the normal
premium, and so the amount of the premium requested matches the form chosen, age
and contract duration at standard conditions.
A risk is defined as weighted or sub-standard if there are variables, such as, for
example, lifestyle or the occupation of the assured, which typically lead to additional
mortality risk. In this case, the risk displays, for health and/or non-health reasons, a

17
Risks deriving from sporting activities held to be dangerous such as, for example, skydiving,
pot-holing, scuba-diving using a respirator, mountaineering with rock-climbing above the third
degree on the U.I.A.A. scale, ski-jumping, bob-sleigh, boxing, judo, hang-gliding, etc., are usually
excluded.
18
It has been found that where there is an economic situation that is inadequate to take out an
insurance on decease, the risk of fraud increases as the sum assured increases.
13.6 Demographic Bases: Criteria for Selecting Risks 311

Additive model Multiplicative model

q(M)
q(A)

q q

x x+n Age x x+n Age

Fig. 13.2 Types of model of impairment: additive and multiplicative

super-mortality translating into a greater cost of the performances covered by the

insurer and which thus leads to a request for a greater premium.
In a number of situations, there may be a deferred risk when it is necessary
before underwriting, to make further checks after a certain period of time such as, for
example, in a financial situation that is precarious, or an illness is developing.
Finally, there may be requests for cover where the risk profile is so great that it
does not come within the limits the insurance undertaking is willing to accept and, in
this case, the cover is denied, and the risk is rejected.
The methods for dealing with impairment of risk consist of changing the demo-
graphic basis underlying the mortality curve so as to represent impaired values.
There are various probabilistic models available to apply: the additive impairment
method and the multiplicative impairment method. Figure 13.2 represents
graphically the types of model of impairment: additive and multiplicative. With
the additive impairment method through which a constant value is added to the
general probability to account for greater mortality. So:

Additive impairment factor = qxþt = qxþt þ α, ð13:28Þ

where
qx + t = the probability of decease for a person aged x + t
α = additive impairment factor. With α > 0.
As compared to the other method the multiplicative impairment method, the
probability of mortality increases incrementally as general probability increases.
Using the same variables, we have the following formula:

Multiplicative impairment factor = qxþt = ð1 þ βÞ  qxþt : ð13:29Þ

β = multiplicative impairment factor. With β > 0.

312 13 Life Insurance: Pricing

13.7 Demographic Basis: Mortality Projection

To look at future trends in the probability of death and longevity in the European
population, the development that this has undergone during the past century can be
analysed. It is meaningful to observe the values for the average number of survivors
(lx) detected in the censuses taken from 1881 to 2011. In Figure 13.3, by way of
example, the curves for mortality tables for each of the detections are shown.
From an initial reading, it can be seen that the number of survivors increased
progressively for the various ages and there was a general lengthening of the average
life span. However, a number of features common to all mortality tables remained
constant over time. Looking at infantile mortality, for example, there is a hump or
slight peak in mortality in the post-adolescent age group; finally, the highest point of
concentration of mortality in the elderly and defined as the Lexis point.19 This is the
highest point on the decease curve. In other words, the age at which the greatest
number of deaths occurred, leaving infants aside.
One of the causes of the mortality dynamic that we see between 1881 and 2011
can be linked mainly to a progressive reduction in the likelihood of dying. The trend
can be analysed in the light of two well-know phenomena that explain the develop-
ment of the mortality table: rectangularisation and expansion of the curve.
Figure 13.4 represents the development of the survival function.
Rectangularisation shows the development of the survival function towards a
rectangular shape, which is the reason why all points tend towards the same Lexis
point. This means that there is a concentration of deaths at one age; taken to the
extreme, if the form were rectangular, the entire population would die at the same
age. The expansion phenomenon, on the other hand, implies the fact that the
highest point of mortality concentration is moving progressively to the right,
i.e. there is an ongoing lengthening in the average life span. During the years
analysed, there was a significant effect of rectangularisation and at the same time a
slight extension effect.

13.8 Classification of Life Insurance on the Basis of Performance

It is usual to classify forms of insurance on the duration of human life according to

performance into two macro-categories: capital performances and income
performances. Figure 13.5 shows the types of performance by forms of life
insurance.

19
The Lexis point matches age x with which the maximum value of the density function is
associated (or decease curve). See Pitacco E., Olivieri A., Introduction to Insurance Mathematics,
Springer, 2nd ed. 2015.
13.8 Classification of Life Insurance on the Basis of Performance 313

Life table – Survivors {lx} (survival functions)

100,000

80,000

60,000
Ix

40,000

20,000

0
0 10 20 30 40 50 60 70 80 90 100 110

Age

Life table – Deaths {dx} (curves of deaths)

50,000

40,000

30,000
dx

20,000

10,000

0
0 10 20 30 40 50 60 70 80 90 100 110

Age

Year 1881 Year 1901 Year 1931 Year 1951

Year 1961 Year 1971 Year 1981 Year 1992
Year 2002

Fig. 13.3 Representation of survival and mortality functions

314 13 Life Insurance: Pricing

Fig. 13.4 Representation of the development of the survival function

13.8.1 Capital Performance

Within this macro-category, three types of policy can be distinguished: Term Life,
Deferred Capital, Ordinary mixed, Capitalization.
The following notation applies:

Tx = aleatory residual duration of life

Y = current aleatory value of payment
E(Y ) = expected current (actuarial) value of payment Y
C = capital insured
v = annual discount rate
qx = rate of mortality

13.8.1.1 Term Life

Term Life (TL) is one of the most common forms of insurance and covers the
likelihood of death for a period of time. The beneficiary will receive the sum insured
at the time of any decease of the assured (usually payment takes place at the end of
the year of the decease):

C vxþtþ1 if Tx < n
Y¼
0 otherwise ð13:30Þ
EðYÞ ¼ C v qx þ v 2
1=1 qx þ . . . . . . ¼ C n Ax

n indicates the term: term n years

13.8 Classification of Life Insurance on the Basis of Performance 315

Term Life

Deferred Capital
Capital
Performance
Ordinary mixed

Type of Capitalization
performance

Immediate Annuity
Income
Performance
Deferred Annuity

Fig. 13.5 Types of performance by forms of life insurance

Ax indicates the value of the performance with a unitary sum insured (note that if
the technical rate i = 0 the result is 1Ax = qx).
A whole life performance is the same form as the term one with the sole
difference that the index n term is ω - x, i.e. up until the maximum age of the
mortality table. The formula is as follows:

C vxþtþ1 if Tx < n
Y¼
0 otherwise ð13:31Þ
EðYÞ ¼ C v qx þ v qxþ1 þ . . . . . . ¼ C n Ax
2

13.8.1.2 Deferred Capital

Deferred Capital (DC) foresees a lump sum payable after n years if the assured is alive.
This is a not very widely used form of insurance from the commercial standpoint,
except where it is associated with Term Life to form a mixed type of policy. It serves to
set up a capital sum and costs less than a certain capital sum, as there is the aleatory
part given by the probability of survival. For the same capital sum, the lower is the age
of the individual and the shorter the duration, the more the policy costs for the assured
(since the likelihood of receiving the capital sum is greater).
316 13 Life Insurance: Pricing

C vxþtþ1 if Tx < n
Y¼
0 otherwise ð13:32Þ
EðYÞ ¼ S v PrfT x > ng ¼ C vn n px ¼ Cn Ex
n

Factor nEx represents “coefficient of actuarial discount” as it is made up of the

coefficient of annual discount rate multiplied by the likelihood of survival up until
the expiry of the insurance.

13.8.1.3 Ordinary Mixed

Ordinary mixed is a combination of Term Life (TL) and Deferred Capital (DC). For
this reason, any combination of one or a number of insurances for survival with one or
a number of insurances for death is called mixed insurance. Insurances of a mixed kind
can be looked at as a portfolio of two policies: Deferred Capital and Term Life with the
same sum insured, so the insurer pays a lump sum either in the case of survival or
decease of the assured. An ordinary mixed insurance is one of the most widely sold
products in the market for life insurance: it provides protection (TL) and savings (CD).
It is defined as:

Y ¼ C v min ftþxþ1; ng E ðY Þ ¼ C n Ax þ n Ex ¼ C Ax,n - j ð13:33Þ

Note that if the technical rate is equal to 0% formula (13.33) becomes:

C ðn Ax þn E x Þ ¼ C qx þ qxþ1 þ . . . þ qxþn þn px ¼ C

since without the financial basis, the assured would either be alive at expiry or
have died during the period of the contract (and there are no other cases possible).
The financial risk, therefore, renders the risk of mortality in fact neutral.

13.8.1.4 Capitalisation
Capitalisation foresees that the policyholder be paid a lump sum C with certainty at
expiry or at the term of a duration n. This irrespective of the length of their life.
Technically, this is not actually an insurance contract. Taking out this type foresees a
sum that the insurer undertakes to return, capitalised. This means that the capital paid
in has been increased by the quota of interest accruing during the period of
investment. The value as of the date of concluding the contract is:

Y ¼ C vn ð13:34Þ

13.8.2 Income Performance

An annuity is a performance that foresees periodic payment of a monetary sum

provided the assured is alive: no performance is foreseen in the case of decease of the
13.9 Components of a Life Premium and Expense Loadings 317

assured. Within these macro-category two kinds of policy can be distinguished:

immediate annuity and deferred annuity.

13.8.2.1 Immediate Annuity

With an immediate annuity, the assured is guaranteed payment of an instalment at
every pre-set due date up until their death. Payment of the annuity is immediate and
commences with effect from the date it is concluded. Instalments may be constant or
variable and due dates may be periodic (annual, for example) or pre-set in advance.
An annuity may be looked at as a deferred capital sum: in cases of advance annuity
with constant instalments and periodic payments of a unitary sum we have:

Y ¼ 1 þ 1 E x þ 2 E x þ 3 E x þ . . . þ ω–x - 1 E x ¼ €
ax ð13:35Þ

where the instalments of the annuity are different from 1 and equal to R, the
coefficient will be multiplied by R.

13.8.2.2 Deferred Annuity

A Deferred annuity foresees the lifelong income being paid out after a certain period
of deferment. This form of insurance, therefore, implies there being two contract
stages: a period of deferment (during which performances are not paid out) and the
period of enjoyment (when performances are delivered). The formula is:

Y ¼ €axþm  m E x ð13:36Þ

m = period of deferment
This form is the equivalent of an advanced annuity multiplied by an actuarial
discount factor mEx which defers performance for m years.
Alongside the forms set out above, manners of payment of annuity in advance,
deferred and by instalments are frequent. Cases of an immediate or deferred
advanced annuity mean that payment of instalments takes place at the beginning
of the year. On the other hand, where there is deferred performance, instalments are
delivered all at year end. Annuities paid in instalments foresee payments made
periodically over the year.

13.9 Components of a Life Premium and Expense Loadings

The premium paid by the policyholder includes, in addition to the pure premium
(i.e. the equitable premium with a safety loading), other items as well, such as
expense loadings. The total of all these components gives a final value to the gross
tariff premium paid by the policyholder. Figure 13.6 represents the configuration of
the life premium.
The costs incurred by an insurer over the course of the contract for activities of the
firm are included in the premium by means of specific increases to the amount of the
pure premium. These charges are in fact defined as expense loadings.
318 13 Life Insurance: Pricing

Demographic
hypothesis
Equitable Premium
Financial
hypothesis
Pure Premium

Safety Loading /
technical basis

Premium paid Taxable Premium

Acquisition Costs

Collection expense
loading
Expense loadings

Management
expense loading

Loading for
remuneration of
own capital

Expected profit /
Mark up

Fig. 13.6 Components of the life premium

Determining them is based on precise criteria of a technical-actuarial kind. In this

way, all the various categories of expenses to be charged to the contract are
identified,20 for example, management expenses, acquisition expenses and those
for collection of annual premiums. Figure 13.6 provides the detail of the components
of the life premium.
The acquisition expense loading is the quota of the premium for the purpose of
meeting expenses concerning payment of the commission for acquisition, i.e., the
commission paid to the intermediary at the time the policy is taken out. Within this
type of loading all other costs pertaining to the pre-sales stage, such as expenses for
health inquiries and costs tied to the process and structure for issuing the contract, are
accounted for.
The collection expense loading serves to cover the expenses for the service of
premium instalment collection after the first premium. This is a recurring expense
that appears over the whole course of the policy. This commission is often withheld
directly by the distributor and forms an expense that is thus covered at the time it
arises for as long as premiums are paid. Under this heading, the various expenses
concerned in the process of issuing releases and accounting the security are also
considered.

20
The analytical method determining the expense loading on the basis of precise criteria of a
technical-actuarial kind is defined as the “rational method” by Pitacco E., Olivieri A., Introduction
to Insurance Mathematics, Springer, 2nd ed. 2015.
13.9 Components of a Life Premium and Expense Loadings 319

The management expenses loading is the quota of the premium intended to meet
the expenses of managing the contract. These expenses are commensurate with the
peculiarities of the various types of insurance contract there are; for example, the
costs incurred in managing a single premium term life insurance are different as
compared to those for ordinary mixed insurance with an annual premium. Overhead
of the undertaking is made up of headings that cannot be directly attributed to
individual contracts or can be attributed only through methods of so-called allocation
to contracts.
In addition to the loadings thus determined, it is possible to foresee a further quota
remunerating own capital invested in the undertaking, being the loading for remu-
neration of own capital. This quota, where it is applied, amounts to the rate of
interest on principal committed and is equal to the average rate of the cost of capital
in the industry or the shareholder - parent insurance undertaking.
Periodic payment of premiums may take place rather than annually, on the basis
of instalments recurring half-yearly, quarterly, or monthly. In this case, the insurer
determines the fractions (or instalments) of premium to be paid periodically and
applies a rate of increase tied to the greater delay allowed for the collection of the
premium. Table 13.4 shows an example of a rate of increase tied to the periodic delay
in premium payment applied to fractions of the premium.
The undertaking’s mark up represents the margin that the insurer adds to its
total costs during the premium calculation process. The setting of this value takes
place according to an additive approach (i.e. a percentage margin or a fixed value is
added to the total amount of costs).
Another type of loading is the one used for products whose yield is linked to the
performance of a financial investment in addition to having the same types of
loading as traditional products, also foresee an annual commission for managing
the fund, the so-called management fee, amounting to a percentage of the capital
paid in and explicitly charged against the assured.
The sum of all these components gives rise to the taxable premium, i.e. the
premium owed by the policyholder before applying any taxes there may be. It should
be borne in mind that these loadings do not necessarily reflect the expenses actually
incurred for acquiring and managing the contract. Besides, it would not be possible
to attribute point by point the actual management expenses for every type of product.
The percentage charges are defined on the basis of actuarial, commercial and
strategic criteria. Any gap between actual expenses and those estimated will deter-
mine the profit or loss from loading.

Table 13.4 Example of rate of increase for life premiums

Periods Rate of increase
Annual 0%
Half-yearly 2%
Quarterly 3%
Monthly 4%
320 13 Life Insurance: Pricing

13.10 Questions

1. Explain what is safety loading

2. What are three products which guarantee capital performance?
3. Which are the components of the life premium?

References
Olivieri A, Pitacco E (2015) Introduction to insurance mathematics. Springer, New York. https://
doi.org/10.1007/978-3-319-21377-4
Directive 2004/113/EC of 13 December 2004 implementing the principle of equal treatment
between men and women

Suggestions for Further Study

De Finetti B, Emanuelli F (1967) Economia delle assicurazioni. Turin, UTET

Heo W (2017) The demand for life insurance - dynamic ecological systemic theory using machine
learning techniques. Springer, New York
Ottaviani G (1981) L’impresa di assicurazione. Giuffre, Milan
Promislow SD (2010) Fundamentals of actuarial mathematics, 2nd edn. Wiley, Hoboken, NJ
Life Insurance: Reserving
14

Abstract

This chapter explains the concept of life technical reserves. In the life business,
the generic reference made to technical reserves includes various types of
reserves, among which the mathematical reserve is the most significant. The
mathematical reserve expresses a debt towards assureds under contracts issued
in the past for performances that may still be demanded by assureds in the future.
At the beginning of the discussion, the principle of equivalence between
premiums and performances is illustrated. The three methods for calculating the
mathematical reserve are presented: the prospective method, the retrospective
method and the recurring method. For each method, the actuarial formula are
described. In the paragraphs that follow, for better comprehension, the progress of
the mathematical reserve over time graphs are illustrated.
Then, the components of the reserves for future expenses are described in
the last part of the chapter. Reserve assessment criteria are illustrated in the
final part.

Keywords
Technical reserves in life business · Mathematical reserve · Single premium term
life insurance · Annual premium term life insurance · Single premium endowment
insurance · Annual premium endowment insurance · Whole of life insurance with
a single premium · Immediate annuity with a single premium · Reserves for future
expense

For this chapter, a special acknowledgement goes to Marcello Ottaviani (consulting audit and
appointed actuary).

# Springer Nature Switzerland AG 2024 321

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_14
322 14 Life Insurance: Reserving

14.1 Learning Objectives

At the end of this chapter the reader should be able to:

1. Know how technical reserves in Life insurance are determined

2. Be able to calculate the mathematical reserves
3. Describe the progress of the mathematical reserve over time
4. Define the components of the future expense reserve

14.2 Life Technical Reserves

Technical reserves in life insurance are debts towards assureds under contracts
issued in the past. They express the value of the performances that may still be
demanded by assureds for claims, maturities, surrender or other forms of payment,
net of any annual premiums foreseen, yet to be collected, under the contract. In the
life business, the generic reference made to technical reserves includes various types
of reserves, among which the mathematical reserve is the most significant. Many
other reserves are foreseen in the financial statements of insurance undertakings
depending on the accounting criteria used for the mathematical reserves (so-called
additional reserves defined by the accounting rules or ones that are specific to
insurance products). While there is quite a lot of variation in approach in countries
around the world, a number of considerations may be made of a general kind so as to
include the greatest number of cases of interest, but without going into the specifics
of each of these cases. Figure 14.1 represents the types of technical reserves in Life
insurance.

Mathematical
Reserves

Technical Additional
provisions in the Reserves
Life insurance

Reserves for
future expense

Fig. 14.1 Types of technical reserves in life insurance

14.3 Mathematical Reserve 323

14.3 Mathematical Reserve

The basic concept upon which actuarial mathematics is built and is at the base of the
standards governing insurances is the equivalence between premiums and
performances. Premiums are paid in by assureds and sums insured are paid out by
the insurance undertaking. The concept of mathematical reserve arises from the
fact that, as a collection of the premium occurs at all times in advance as compared to
possible paying out of the performances of the insurance undertaking, a need is
generated for a reserve to meet the cost that the insurance undertaking will incur.
Payment of these sums and the timing when they will have to be paid out, as well as
even the amount to pay out, may be uncertain. Additionally, since the financial
statements of insurance undertakings foresee the setting up of a mathematical reserve
as at the date of the financial statements, which does not have to be the date when the
contracts with assureds are signed, the insurance undertaking must be able to
represent the debt being formed with assureds at that date.
Among the reserves in the non-life business, what can be thought of as being
likened to the mathematical reserve is the premium reserve, which is of the same
kind, i.e. it represents the debt not yet paid off of a premium paid in the past, but
which is still in force following assessment of this reserve.
The mathematical reserve consists therefore in a setting aside to meet a debt in
respect of performances that assureds would call-in in cases of losses occurring or
performance due at a future time and relating to one or a number of premiums, or a
fraction of these, collected in the past. Therefore, the mathematical reserve expresses
the difference applying between the current value of the commitments made by the
insurer to the assured and the current value of payments-in made by the assured. In
essence, the mathematical reserve is described in the following expression:

V =C-P ð14:1Þ

where V is the amount of the mathematical reserve C represents the performances to

the assured and P the premiums (relating to these performances) which it is foreseen
that the assured will pay in the future.
The risk of survival by the assured varies over time, given that the likelihood
depends on age. The premium that is actually paid represents the average value of the
different likelihoods of the event insured (survival, death or other events tied to
human life). If the assured were forced to pay annual premiums consistent with the
expected risk for that year, these would be referred to as natural premiums. These
premiums would typically be for increasing values in the case of death risk, since the
risk grows with age.
In reality, an insurer usually applies constant average premiums deriving from the
average of all single, or natural, premiums (greater initially and then less) over the
life of the contract.
To illustrate how a natural premium progressed, the example of a term life
insurance can be used. It can be seen that there is a difference between the amount
of the natural premium, i.e. the premium calculated on the basis of the actual
324 14 Life Insurance: Reserving

Fig. 14.2 Progress of the 5

natural premium as compared
to the average premium
4

0
0 1 2 3 4 5 6 7 8 9

Average Premium Natural Premium

likelihood of decease of the assured for the current year as compared to the value of
the average premium given by the average of natural premiums over the entire
duration of the policy. The average will be greater than the natural premium in the
early years of the contract and lower during the later ones. This progression can be
seen in Figure 14.2.
However, if the natural premium were to be used in this contract for each year the
contract runs, it would not be necessary to calculate the mathematical reserve, in
accordance with what was stated above.1
A further element of analysis that needs to be applied is one relating to the risk
component and savings component in life insurance premiums. The premium can be
broken down into these two components: the risk premium and savings premium.
The first is the part of the premium (non-constant in accordance with what was just
stated above) intended to cover the risk of the death of the assured during the period
the premium refers to. The second component, the savings one, is the share of the
premium that is set aside and capitalised in the mathematical reserve. The savings
premium must be calculated so that the sums set aside, increased by the financial
interest accruing, allow the insurer to have a reserve available at all times for cases of
surrender or early decease of assureds.
Figure 14.3 represents, graphically on the Cartesian axes, the conceptual trend of
the mathematical reserve.

1
The principles of non-life insurance could be applied in determining a reserve for fractions of the
premium and which are typically calculated with pro-rata methods, i.e. through linear interpolating
to take into account the difference in time between the contract date and date the reserve is
calculated in financial statements.
14.4 Calculating the Mathematical Reserve 325

Premium

Savings Premium

Savings Premium Constant Average Premium

Mathematical Provision Mathematical Provision

– in Excess - Deficit

Fig. 14.3 Conceptual representation of the trend of the mathematical reserve

During the early period, the quota share of savings premium will be greater than
the risk premium as the assured pays in a premium that is greater than the actual risk
they are exposed to. During the later time, this initial excess payment will be used to
cover the death risk of the assured, which will actually be higher than that paid in
later years.

14.4 Calculating the Mathematical Reserve

The value of the mathematical reserve is calculated following a pre-set process of an

actuarial kind. The methods for assessing are three in number: the prospective
method, the retrospective method and the recurring method underlying each of the
methods an analytical process is adopted, evaluating each individual contract.
The prospective method, which is also the most widespread, defines the amount
of the mathematical reserve on the basis of premiums and future performances as at
the assessment date. To understand how this works, a simple example is given. Take
X as the vector of premiums (annual) foreseen and Y as the vector of performances
foreseen (in respect of all annual premiums foreseen). The principle of financial
matching, as at the time the contract is concluded, foresees the value of premiums
V(X) being equal to the value of performances owed V(Y ). So:

Vtx(0,X) = Vty(0,Y)
Vtx = values of the flow (X) of premiums at time t = 0
Vty = values of the flow (Y) of performances at time t = 0
t = 0 date the contract is concluded
326 14 Life Insurance: Reserving

The mathematical reserve of the policy at time t, subsequent to its conclusion, is

given by the difference applying between the value of residual performances in
t minus the value of residual pure premiums. So:

tVx = V ðt, Y Þ - V ðt, X Þ ð14:2Þ

It can be seen that, by construction, as at the conclusion date the mathematical

reserve is nil, as the policy has been constructed in equilibrium (i.e. the premiums
equate to expected performances). If we take time t = 0+, i.e. an instant after payment
of the first premium, the mathematical reserve equals zero (for the reasons just set
out) plus the value of the first premium which is assumed to have just been paid, and
so the value of expected premiums V(0+,X) will be lower than V(0,X) of the very
premium paid.
The retrospective method, which is much less widespread defines the amount of
the mathematical reserve on the basis of the difference between the total of premiums
paid by the assured and the total of the performances paid by the insurance
undertaking. The reserve found via this method is referred to as a retrospective
mathematical reserve. This method gives rise to the same values as the prospective
method.
In the foregoing example, what happens is that the value of the reserve at time
zero, i.e. prior to payment of the first premium, the reserve equals zero, as neither
premiums nor performances have yet been paid. Following payment of the first
premium (so at 0+) the reserve amounts to the same as the first premium according to
the definition just seen, consistently with the values shown in the prospective case. A
generic case can be represented with this expression:

tV x = ½U p ð0, t Þ - U a ð0, t Þ  Dð0, t Þ, ð14:3Þ

where
U p(0,t) = the accumulation of premiums paid by the assured
Ua(0,t) = the accumulation of performances paid by the insurance undertaking
D(0,t) = the coefficient of revaluation taking into account both financial and
demographic risks
The recurring method is used mainly to verify the accuracy of the calculation
and not as an actual calculation. This method makes use of the same assumptions as
of the prospective method, basing the valuation of the reserve at the end of a specific
period (usually 1 year) and not the entire residual period. The recurring mathematical
reserve thus matches the amount of the mathematical reserve, at time “t + 1”, which
may be determined on the basis of the value of the reserve itself at time “t”, through a
recurring formula.
The generic formula is as follows:

ðV s þ PÞ ∙ ð1 þ iÞ - C ∙ qxþs
V sþ1 = ð14:4Þ
pxþs
14.5 Progress of the Mathematical Reserve Over Time 327

The equation shows the equilibrium that applies between the reserve at time s(Vs)
plus premiums (P) both capitalised for 1 year (which are an entry in the profit and
loss account of the insurance undertaking) and the sum insured in the case of a claim
(C), weighted by the likelihood of a claim (q) or a performance. The defined amount,
is equivalent to the reserve that must be made in the following year (Vs + 1) in the
event of survival by the assured.
The different ways to assess the reserves used for management purposes by an
insurance undertaking are of three types: one that contains only pure premiums, one
that contains pure premiums and management expenses still to be borne and one
complete with every component, i.e. commissions and brokerage too. It can be seen
that the mathematical reserve also containing the commissions component is lower
than or equal to the reserve including management expenses. The reason for this is
that, if commissions were paid in a lump sum, the insurance undertaking would find
itself advancing costs that it would recover in later-year premiums. So, the reserve
for commissions to be amortised would be negative in value and would reduce the
value of the mathematical reserve. On the other hand, in cases of single premiums, or
cases of payments of commissions being entirely covered by loadings to premiums
collected, the reserve would be nil, and the mathematical reserve would be the same
as the complete one.
In certain countries, expressing the reserve net of payment of commissions is not
allowed, as this would expose the insurance undertaking to a risk of not recovering
these sums from relative premiums in the event of heavy losses or surrenders by
assureds.

14.5 Progress of the Mathematical Reserve Over Time

The progress over time of the mathematical reserve varies significantly depending on
the types of insurance contract. The actual features of the contract, the types of
performance and duration, are important areas for determining the amount and trend
of this reserve. Later in this paragraph, a profile over time and the sum required by a
number of contracts with different features are presented by way of example, and the
progress of mathematical reserves in the various life insurances is analysed
graphically.
A first comparison is made between two term insurances for death for a 10-year
duration, the first with a single premium and the second with an annual premium.
For the single premium insurance, at the time it is concluded, the reserve is at its
maximum amount, the premium is set aside and invested. However, the reserve
reduces as time passes due to the use made of this reserve to meet the payment of
claims. The non-linear trend of the reduction is due to the favourable effect of
interest earned applied to the premium. In cases of insurances with an annual
premium, the trend of the reserve is due to an accumulation of annual payments of
premiums and the favourable effects of interest earned on them. It can be seen that in
this form of insurance, since it does not foresee a financial performance at maturity
and leads to a reduced amount of mathematical reserve. It can be stated that a term
328 14 Life Insurance: Reserving

Fig. 14.4 Single premium 25

term life insurance

20

15

10

0
0 1 2 3 4 5 6 7 8 9 10

Fig. 14.5 Annual premium 5

term life insurance 4
3
2
1
0
0 1 2 3 4 5 6 7 8 9 10

life insurance has a risk premium but not a savings premium and so the value of the
reserve is affected by this feature. Figure 14.4 represents a single premium term life
insurance and, on the other hand, Figure 14.5 graphically reports an annual premium
term life insurance.
The second comparison relates to an ordinary endowment insurance with both
types of premium payment, i.e., single premium and annual premium. The
progress of the mathematical reserve is profoundly different from the previous
case. The first case shows a growth trend given exclusively by the financial effect,
not offset by the demographic one, which acts against it. The second case shows
instead a positive linear increase due to capitalisation of the annual, or periodic,
premium. This contract requires a significant sum of the mathematical reserve, which
is the savings value. The value of the reserve is close to the sum insured, differing
solely if there is a technical rate included.
Figure 14.6 represents a single premium endowment insurance and, on the other
hand, Figure 14.7 graphically reports an annual premium endowment insurance.
A life insurance that covers death on a whole-of-life basis with a single pre-
mium, and where payment of the performance is certain, displays a trend in the
mathematical reserve that is similar to that for the ordinary term endowment policy
analysed above. The duration of the contract and related forming of the reserve
14.5 Progress of the Mathematical Reserve Over Time 329

Fig. 14.6 Single premium 1,200

endowment insurance
1,000

800

600

400

200

0
0 1 2 3 4 5 6 7 8 9 10

Fig. 14.7 Annual premium 1,200

endowment insurance
1,000

800

600

400

200

0
0 1 2 3 4 5 6 7 8 9 10

obviously extends over a longer lapse of time, and in this period the likelihood of
death is also greater than the effect of financial return, which gives rise to a downturn
in the later years of protection. For the savings component, the same considerations
as were made for contracts in an endowment form apply. The contract is in a
different form but for the same kind of performance. Indeed, a lump sum is paid in
a certain fashion during the course of the duration of the contract. What is uncertain
is the time when this will be paid. Figure 14.8 represents the trend for a whole-of-life
insurance with a single premium.
Where there is an immediate annuity subject to a single premium, the reserve
has a decreasing trend due to payment of annuity instalments on a recurring basis.
The decrease is partly mitigated by the revaluation of the mathematical reserve, but
which always counts for less given its continuing reduction. Figure 14.9 shows the
trend for a deferred annuity with a single premium.
330 14 Life Insurance: Reserving

1,250

1,000

750

500

250

0
0 5 10 15 20 25 30 35 40 45 50 55 60 65

Fig. 14.8 Whole-of-life insurance with a single premium

1,600
1,400
1,200
1,000
800
600
400
200
0
0 5 10 15 20 25 30 35 40 45

Fig. 14.9 Immediate annuity with a single premium

Other types of trends in reserves are related to linked contracts (unit linked and
index linked). These are actually investments in funds or specific securities and their
trend depends on the financial performance of the underlying asset. In any event,
they are typically investment contracts, and the savings component is prevalent. If
there is any cover for death, this is drawn either in a recurring fashion from the value
of the quotas of the contracts or in a lump sum at the time the contract is signed. In
the first case no mathematical reserve is formed for the life cover, whereas in the
second, the reserve is formed for a term contract for pure life cover with a duration
equal to the main one.
14.6 Reserves for Future Expense and Additional reserves 331

From analysing the trends set out, it can be seen that contracts with a certain
performance, such as endowment, whole-of-life, or Linked forms, require a greater
sum for mathematical reserve as compared to pure risk contracts (term life contracts)
for which the value of the performance is exhausted at the end of the contract and the
related risk disappears.

14.6 Reserves for Future Expense and Additional reserves

The reserve for future expenses is found by considering the difference between the
current value of the total sum of expenses that the insurer must still bear, and the
value of loadings already collected or to be collected. Under the heading of
expenses, all types of expenses are included: acquisition, collection and manage-
ment, tied to the contract among these loadings, the ones contained in any future
premiums to be collected are also considered, as well as financial income intended to
cover management expenses.
The reserve for expenses is formed in two cases: where there is a time difference
between collection and payment of the expenses (for example in a single premium
contract) or where there is a difference in the assumptions made when calculating the
premium, and those that appear later. The first case is a technical matter where an
insurance undertaking must set aside a sum of loading that has to be enough to meet
the expenses to be incurred over the life of the contract. The second case is a question
of management, and where the assumptions defined at the commencement of the
contract no longer apply, to meet new costs bearing upon the contract itself.
There are some cases where there is no reserve for future expenses. The loadings
for acquisition expenses for contracts with a single premium are met one-off and do
not generate a reserve. Certain annual premium contracts too may foresee a manage-
ment loading to cover expenses of the year, and so in this case they do not generate
an expense reserve. A further case arises where management loadings are drawn
periodically from financial management and used to meet related expenses (i.e.
management fees). More complex is cases of term annual premiums relating to a
contract that runs for a number of years. Loadings drawn from premiums serve, in
part, to cover expenses for the year, but a part of them also serves to cover the period
during which the premiums will have ceased but the contract is still in force.
Additional reserves may be adopted for different reasons. The simplest is one of
a risk insured that has increased in such a way as to exceed the assumptions made
during pricing such as, for example, that of mortality (i.e. even in the case of
longevity), the rate of interest (where there are guaranteed minima), the surrender
rate (where bonuses at maturity of the contract are foreseen).
Other reasons for having to post an additional reserve are:

• Inadequacy of reserves for management expenses (where the costs assumed when
defining the loadings are no longer in line with the true corporate costs);
332 14 Life Insurance: Reserving

• Changes in the relationship between male and female assureds (as community
regulations forbid pricing by gender, an assumption in respect of the distribution
of males and females must be made, and if this were to change significantly, the
value of the reserve must be adjusted);
• Arrival of other unforeseen risks;

14.7 Questions

1. List the different types of Technical reserves in Life insurance.

2. Describe the concept of Mathematical reserve.
3. Can you explain the method for calculating mathematical reserve?
4. Which are the components of the reserves for future expense?

Reference
Olivieri A, Pitacco E (2015) Introduction to insurance mathematics. Springer, New York. https://
doi.org/10.1007/978-3-319-21377-4

Suggestions for Further Study

Fisher WH, Lange JT (1973) Loss reserve testing: A report year approach. In Proceedings of the
Casualty Actuarial Society 60: 189–207
Koller M (2012) Stochastic models in life insurance. Springer, Berlin, Heidelberg
Zillmer A (1863) Contributions to the theory of life insurance reserves (Beitrage zur Theorie der
Prámienreserve), Stettino
Life Insurance: How With-Profits
Products Work 15

Abstract

The chapter starts with the definition of with-profits life insurance products. These
products foresee an annual increase in the capital sum or annuity insured through
awarding part of the profits earned from the investment of assets in funds. The
formula of the actuarial equilibrium of performance is explained. In the following
paragraph, the reader can learn the three elements distinguishing a with-profits
contract. They are the technical rate, the minimum guaranteed return and the profit-
sharing clause. At the end of the chapter, a numerical demonstration is offered for
ease in comprehending the mechanics of how the revaluation of performances works.

Keywords
With-profits insurances · Rate for revaluation · Technical rate · Minimum
guaranteed return · Profit-sharing clause · Cliquet form

15.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know how with-profits insurance products work

2. Understand actuarial equilibrium of performance adjustment for these
insurance products
3. Explain the key elements of with-profits contracts

For this chapter, a special acknowledgment is for Marcello Ottaviani (consulting audit and
appointed actuary).

# Springer Nature Switzerland AG 2024 333

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_15
334 15 Life Insurance: How With-Profits Products Work

15.2 With-Profits Insurance

With-profits insurances are life insurance products well known in several European
countries. These products foresee an annual increase in the capital sum or annuity
insured through awarding part of the profits earned from the investment of premiums
paid by the assured. The aim of these products is to conserve the value of the capital
sum over time and meet competition from financial products. The products enable a
savings function alongside a reserve for life function and were introduced mainly to
cover assureds against a loss of value of a capital sum due to inflation.
Premiums for with-profits insurances may be of any kind: single, recurring
(periodic) or annual. Recurring premiums may be either constant or with revaluation.
If they are recurring revalued, the capital sum or annuity with grow from year to
year, also on the basis of a revaluating of the premium the assured will pay in. If on
the other hand, payment on the part of the assured is constant in amount, the capital
or annuity will grow only on the basis of the profits actually awarded to the assured.
A fundamental aspect of with-profits insurance is the manner in which consoli-
dation takes place of the performances that lead to conditions of acquisition and
capitalising for the assured of interest earned year on year. A number of contracts
may foresee coupons to be paid annually to assureds, others foresee recapitalising of
profits through increasing the capital sum.

15.3 Actuarial Equilibrium of Performance Adjustment

Taking a contract of life insurance that commenced at T = 0 and will terminate at

T = n, actuarial equilibrium in any generic instant 0 ≤ t ≤ n is found in the reserve
available Vt and the actuarial value of the performance offered Perf(t,n) net of what
the assured must still pay P(t,n) being equal:

V t = Perf ðt, nÞ - Pðt, nÞ ð15:1Þ

For the purposes of illustration, let us take one of the more widespread products,
an endowment policy with constant annual premiums; it is possible to rewrite the
equation as follows:

V t þ P  äxþt,n - t = C  Axþt,n - t , ð15:2Þ

where Vt is the available reserve at t, P is the pure premium that is paid for n years
(and the factor äx + t,n-t is the actuarial value of a temporary, immediate and early
income), x is the age of the assured at the date the policy was taken out and C is the
capital sum insured and is multiplied by actuarial value Ax + t,n-t representing the
likelihood of paying a lump sum for death for n years and a capital in the event of
survival at the nth year, if alive, or an endowment policy.
15.3 Actuarial Equilibrium of Performance Adjustment 335

Let us imagine that an individual aged x = 40 takes out an ordinary endowment

policy for duration n = 15 years with annual premiums payable up to expiry and
with capital sum insured of 10,000. As technical bases for the first order technical
rate i = 2% and a generic mortality table are utilised, and the following result will
be had:

• Single premium for performance in the case of

death = C15A40 = 10,0000.01917 = 191.7.
• Single premium for performance in case of
survival = C15E40 = 10,0000.725483 = 7,254.8.

Adding together the two components the single premium S.P. = 7,446.50 is
found. The annual premium is given by:

P = S:P:=15€a40 = 7, 446:50=13:0 = 572:81: ð15:3Þ

Now it is wished to find the actuarial equilibrium given by the formula (15.2) after
5 years from taking out the policy, i.e. when the assured will be 45 years of age. The
mathematical reserve is given by:

V 5 = C  ð10 A45 þ 10 E 45 Þ–P15€a40 = 10, 000  ð0:017 þ 0:805Þ–572:81

 9:10 = 3, 007:429: ð15:4Þ

Formula (15.2) will thus give 3,007.429 + 572.819.10 = 10,000(0.017 + 0.805).

Now let us imagine that the assured has the right to an increase in the capital sum
assured amounting to rate ic. It is easy to see that this increase must be balanced by an
increase in the first element of the equation. In particular, equilibrium can be
achieved through a revaluation of the reserve (rate iv), or an increase in the premiums
to be paid in the future (rate ip), or both. Equilibrium will thus be found by:

V t ð1 þ iv Þ þ P  äxþt,n - t 1 þ ip = C  Axþt,n - t ð1 þ ic Þ ð15:5Þ

It can be shown that conditions of actuarial equilibrium are met when ic is the
same as the weighted average iv e ip. If it is wished not to let any additional cost fall
upon assured (premiums remaining constant) the revaluation rate of the reserve iv
must be greater than the revaluation of the capital sum ic. Application of the
adjustment takes place on a recurring basis, usually annually.
Going back to the foregoing example, when the capital sum insured is revalued at
rate ic = 2% then rates iv e ip must be consistently calibrated. Among possible
extreme cases, there is a possibility of either applying full charge to the insurance
(revaluation of the reserve only), to the assured (revaluation of premiums, but this is
just a case for study), or both, using the same rate for reserves and for premiums.
Rewriting (15.5) with data found previously we will have:
336 15 Life Insurance: How With-Profits Products Work

Table 15.1 Rates for revaluation of an endowment policy

Charge to the insurance Charge to the assured Charge to both
iv 5.47% 0 2%
ip 0 3.15 2%
ic 2% 2% 2%
Future premiums 572.81 590.86 584.27

3, 007:429ð1 þ iv Þ þ 572:81  1 þ ip  9:10

= 10, 000  ð1 þ 2%Þ  ð0:017 þ 0:805Þ: ð15:6Þ

In Table 15.1, the rates found in the three cases previously are set out.
In the first case, revaluation of the reserve notwithstanding, the assured will
continue to pay premiums in the sum set forth initially (572.81) whereas in the
second case they will have to contribute “personally” to the revaluation of the capital
sum by paying in future premiums in a sum amounting to 590.86(572.83.15%). If
the charge for revaluating the capital sum falls both on the assured and the insurer
(in the example given through the same rates of revaluation being applied for capital
sum, reserve and premiums) future premiums must amount to 584.27(572.812%).
It can be seen that in the case of a single premium being paid, the increase in the
capital sum insured must be balanced solely by the rate of revaluation of the reserve
(ic = iv) as the actuarial value of future premiums will be nil.

15.4 Elements of With-Profits Contracts

The three elements distinguishing a with-profits contract are the technical rate, the
minimum guaranteed return, and the profit-sharing clause. Here below in this
paragraph, the three elements are described singly, and a numerical demonstration
is offered for ease in comprehending the mechanics of how the revaluation of
performances works.
The technical rate is the fixed rate of interest awarded by the insurance under-
taking as a preliminary to the policyholder at the time they pay the premium. This is
the financial rate with which the insurance undertaking discounts future economic
flows. The aim of setting out this rate specifically is tied to achieving higher capital
sums on the part of the assured, by reverse reasoning, achieving lower premiums as
compared to the capital sum insured. Imagining, for example, a deferred capital
contract (n years) with capital sum insured C and, leaving aside expenses and
loadings, the pure single premium will be given by:

SP = C  ð1 þ iÞ - n  lxþn =lx : ð15:7Þ

If the capital sum C is set at 10,000, the duration of the contract at 15 years, the
age of the assured being 40 years and using technical rate i = 0.02 and a generic
mortality table we find a premium of:
15.4 Elements of With-Profits Contracts 337

SP = 10, 000 ð1 þ 2%Þð - 15Þ  ð96, 279=98, 561Þ = 7, 258:1 ð15:8Þ

This sum is the same as the single premium in respect of the performance in the
case of survival of the foregoing endowment policy (all the hypotheses made have
remained unaltered).
Imagining a technical rate of 0.05 the new single premium will be:

SP = 10, 000  ð1 þ 5%Þð - 15Þ  ð96, 279=98, 561Þ = 4, 698:8 : ð15:9Þ

As can be seen, for the same capital sum insured, as the technical rate increases
the premium that the assured has to pay reduces.1
The minimum guaranteed return is the guaranteed rate of interest foreseen in
the contract. In general, the determining of this rate already takes into account what
is awarded to the policyholder. It is a rate of interest upon which the policyholder
can count, irrespective of trends in the management of assets invested by the
insurance undertaking. The fact of there being a minimum guaranteed return
means that the financial risk is borne by the insurance undertaking.
There are various types of guarantee provided by an insurance undertaking, being
the following:

• A guarantee in the Cliquet form applies to the sum found at the end of the
previous year (or period), acting so that the sum accrued is never eroded by future
losses and that each individual gain made by the assured moreover benefits from
it being possible to capitalise it further at the minimum guaranteed rate.
• A guarantee of event; if the assured surrenders the contract, they receive no
bonus, but do receive the minimum guaranteed sum in cases of occurrence (which
is typically the death of the assured or expiry of the contract).

The guarantees may either be univocally defined at the commencement of the

contract or maybe decided upon during the course of actually paying out under the
contract. For example, in a number of countries, rates of return are defined each year
for the subsequent one as a commitment made to assureds.
In most cases, guarantees are given at the commencement of the contract and last
until its end, save for a number of cases where it is possible for the percentage of this
rate to be modified unilaterally.
The profit sharing clause is the percentage of return that the insurer retrocedes to
the policyholder. This is calculated on the total yield on the investment. For a better
understanding see the example:

• 80% retrocession rate = means that the insurer retrocedes 80% of the yield (or
profit) to the policyholder.

1
This concept extends to life policies described in Chap. 13. To reduce the insurance risk, insurers
often use a technical rate of 0%.
338 15 Life Insurance: How With-Profits Products Work

• 20% retention = means that 20% of the yield is retained by the insurance
undertaking. There are numerous thresholds on the insurance market (90%,
80%, 70% etc). They depend on the commercial policy of the each insurer.

The concept underlying them is a simple one; since a policy foresees that a
premium is paid at the commencement of a contract and performance may be paid
if a certain event materialises, the time that the premiums remain available to the
insurance undertaking will generate interest, and so this interest, perhaps together
with other types of revenue that the insurance undertaking earns, is actually shared
with the assureds. This revenue may, be of a financial kind or a demographic kind
(in most cases) or tied to other phenomena through which an insurance undertaking
might achieve profits.
The underlying logic of profit-sharing may be:

• Contract agreement.
• At the discretion of the insurance undertaking.

Other specific items may be listed for sharing of profits, and which concern the
rules under which these profits can be assigned to assureds:

• Profits are awarded annually.

• Profits are awarded only in certain occurrences, such as the death of the assured or
termination of the contract.

In a number of cases, insurance undertakings foresee a minimum cost to be

withheld from sums managed so as to pay management expenses and ensure a
constant return. This withdrawal is applied to gross returns from management, but
only in the event that the operation is able to ensure both the minimum for the
assured, and that for the insurance undertaking.
As mentioned above, here an example of revaluation of capital sum insured in a
policy with a deferred capital sum revalued after 1 year, for a product with premiums
that can be revalued (rates ic, iv, ip are the same). The hypotheses are, with the
exception of the technical rate, the same as previous examples i.e., age of the assured
x = 40, duration of the policy n = 15, capital sum insured C = 10,000 with
premiums payable up until expiry and a generic mortality table, for calculating the
premiums, while two separate cases are presented for the technical rate: the first sets
out a technical rate of 1.5% and the second one, 0%.
As can be seen in Table 15.2, if a technical rate of 0% is used, the revaluation of the
capital sum is higher; the difference will however also be in the calculation of the
premiums (from commencement) that the assured will have to pay; in this case,
indeed, expected future performances will not be actualised in finding these premiums.
If the policy foresees constant periodic premiums, revaluation of the capital sum
will be lower due to the effect of the foregoing paragraphs. For example, by
indicating as ρt the percentage of revaluation awarded in respect of the t-th year.
Considering the example with technical rate I set at 0%, the revalued capital sum
after the first year will be:
Suggestions for Further Study 339

Table 15.2 Calculation of the revaluation of the capital sum

Elements of a contract that can
Numerical magnitudes Numerical magnitudes
be revalued
Initial capital sum Euro 10,000 Euro 10,000
Initial premium 581.4 656.6
Rate of return awarded to the 4.5% 4.5%
assured
Rated of profit-sharing 75% 75%
Technical rate 1.5% 0.0%
Minimum guaranteed return 2.0% 2.0%
Annual extent of guaranteed (2% - 1.5%) = 0.5% 2.0%
revaluation
Annual extent of entitled (4.5%*75% - (4.5%*75%) = 3.375%
revaluation 1.5%) = 1.875%
Revalued capital sum Euro 10,000* Euro 10,000*
(1 + 1.875%) = 10,187.5 (1 + 3.375%) = 10,337.5

C1 = 10, 000  ð1 þ 3:375%Þ = 10, 337:5 ð15:10Þ

As can be seen, the capital sum insured is found to be lower; this is due to the fact
that the premiums still to be paid (and which are still 14 years’ worth) are not
revaluated (lower future revenues for the insurance undertaking). The impact on the
capital sum insured decreases as the revaluation date goes up (many premiums will
have already been paid).
As can be seen in this case, from the revalued capital sum that there would be if
premiums were revalued, revaluation in respect of the initial capital sum C is taken
away for the fraction of the period running from the tth anniversary up to the end of
the contract (if the premiums are payable up until expiry of the cover):

15.5 Questions

1. What are the three elements distinguishing a with-profits contract?

2. How do you calculate the actuarial equilibrium of performance adjustment for
with-profit insurance products?
3. Explain the technical rate.

Suggestions for Further Study

Laurent J, Norberg R, Planchet F (eds) (2016) Modelling in life insurance – a management
perspective. Springer, New York
Promislow SD (ed) (2015) Fundamentals of actuarial mathematics, 3rd edn. Wiley, Chichester
Life Insurance: Other Components of Profit
16

Abstract

This chapter explains the components of profit for life insurance products. The
components of profit are four: demographics, financial, surrender and expense
loadings. Regarding the realistic assumptions for expected mortality and the
expected rate of interest, the actuarial equilibrium is demonstrated by the Kanner
equation. In the following paragraph, the Homans formula is analysed in detail.
This equation breaks down the insurance profit into demographic profit and
financial profit. Then the reader can learn the factors underlying profit for
surrender and expense loading. In the chapter, a numerical demonstration is
offered for ease in comprehending the mix and the importance of each component
in forming expected profit. Several graphs are presented to increase the reader’s
understanding. At the end of the chapter, the concept and formula of the profit
margin are explained. The profit margin is a measurement tool for the expected
profit from a life insurance product, typically a newly issued one.

Keywords
Kanner equation · Homans formula · Demographic profit · Financial profit ·
Surrender profit · Expense loadings · Profit margin

For this chapter, a special acknowledgement is for Marcello Ottaviani (consulting audit and
appointed actuary).

# Springer Nature Switzerland AG 2024 341

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_16
342 16 Life Insurance: Other Components of Profit

16.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the four main components of life insurance profit: demographics,

financial, surrender and expense loadings
2. Explain the Homans formula: which split into demographic profit and
financial profit
3. Describe the factors underlying profit for surrender and profit for expense
loading
4. Understand the mix and the importance of the individual component in
forming expected profit
5. Know how the profit margin works

16.2 Components of Insurance Profit and Margin

In this paragraph, the formation of insurance profit relating to a generic life policy
will be analysed. Analysis of the formation of profit is carried out considering four
main components: demographics, financial, surrender and expense loadings. Fig-
ure 16.1 represents the components of insurance profit.
Underlying the concept of expected demographic profit and expected financial
profit there is a basic technical first-order definition which is used in determining the
insurance premium and which features a certain level of prudence and standard
values. On the other hand, second-order technical bases representing realistic

Fig. 16.1 Components of

insurance profit Demographics

Financial

Insurance profit

Surrender

Expense loadings
16.2 Components of Insurance Profit and Margin 343

assumptions for expected (actual) mortality and an expected (actual) rate of interest,
respectively. The profit is determined thanks to the difference between the value of
the two hypotheses (or technical bases).
Assuming that the mathematical reserve and the premium have been calculated
on the same prudent technical bases (i annual likelihood rate of interest and qx annual
likelihood of decease for an assured aged x) actuarial equilibrium is achieved if the
Kanner equation is abided by:

ðV t þ PÞ ð1 þ iÞ - V tþ1 - ðC - V tþ1 Þqxþt = 0 ð16:1Þ

For each year of management t, it is the initial reserve Vt and premium P assumed
collected at the start of the year and revalued by the annual rate of interest (called the
technical rate), that make up year-end available funds. They meet the certain
commitment to setting up the final reserve and a chance commitment to supplement
the reserve should prior decease of the assured occur (which it is assumed will take
place at year-end)1. The value C-V is also defined as capital at risk as, indeed, it
represents what the insurance undertaking has to pay out in addition to the available
reserve in the event of the death of the individual in year t + 1. It should be noted that
the equation applies for any type of traditional policy, for example level term with-
profits endowment, whole of life or endowment. In level term endowment, the sum
insured for the event of decease will be 0 (so C = 0) and so risk capital will be
negative. This type of policy is indeed subject to the risk of survival and in the event
of the prior death of the assured the insurance undertaking will have available the
entire reserve accumulated at year-end and the contract will be closed off.
But the equation shown above applies only in the event that the assumptions
made in respect of mortality and finance are fully borne out in practice, which is
really a long way from the wishes of an insurance undertaking that expects to earn
for the risk that it runs. The first-order technical basis will indeed be different from
the realistic basis and so the equation will no longer be abided by. Indicating with i*
the expected rate of interest and by q* the expected likelihood of decease, the
equation can be rewritten as:

ðV t þ PÞð1 þ i Þ - V tþ1 - ðC - V tþ1 Þq xþt = u tþ 1 ð16:2Þ

where u*t-1 represents the expected insurance, profit created between year t and year
t+1. The expected profit built-up will be positive, whereas the profit that is actually
achieved may also be negative, as a return may be experienced below the technical
one, or there may be over(under) mortality giving rise to a technical loss. In the next
paragraphs, reference will be made to expected profit or achieved profit depending
on whether we are looking at the commencement of a period or its end.

1
Rewriting the equation as (Vt + P)(1 + i) = Vt + 1 (1-qx + t) + C qx + t it can easily be seen that the
commitment of the Insurer at year end will be given by the final reserve in the events of survival of
the assured during the year and the sum insured in the event of decease.
344 16 Life Insurance: Other Components of Profit

16.3 Demographic Profit and Financial Profit: The Homans

Formula

An interesting issue in insurance management relates to the breakdown of insurance

profit. This breakdown has, in particular, the goal of highlighting how profit has been
formed.
The equation that allows us to break down the insurance profit into demographic
profit and financial profit is known as the Homans formula. This formula can be
obtained by simply subtracting Eq. (16.1) from (16.2):

½ðV t þ PÞði  - iÞ þ ðC - V tþ1 Þ qxþt - q xþt = utþ1 : ð16:3Þ

The first addendum, [(Vt+P)(i*-i)], represents the financial profit expected

during year t. It is equal to the difference between the realistic rate and the technical
rate for the value of the reserve including premium at the commencement of the year.
Obviously, as (Vt+P) is always non-negative, there will be profit when the rate of
interest actually achieved exceeds the technical one and if the contrary is true, there
will be a financial loss.
The second addendum, [(C-Vt+1)(qx+t-q*x+t)], on the other hand, represents
demographic profit during a generic year t; this profit is given by the product
between capital at risk and the difference between the first order likelihood of
decease and the realistic one. Differently from financial profit, there is no univocal
relationship between qx+t and q*x+t in the sense that the sign of the profit depends on
the sign of the capital at risk. Indeed, for contracts tied to the life risk, such as
immediate annuities or products of level term endowment and which are subject to
the risk of longevity, insurers gain when the actual mortality is higher than the first-
order one (TB1). Indeed, the capital at risk under these contracts is negative, since
the sum assured for the event of death is nil. Vice versa, for the products for the risk
of death, i.e. term life, whole of life and endowment (these latter only in cases of a
technical rate being different from zero2) they are subject to mortality risk.
To sum up what has just been described, we explain two examples. in the case of
a level term with-profits endowment, where the capital at risk is negative, prudence
lies in the fact that through the calculation of premium, the insurance undertaking
uses a mortality table with a likelihood of decease lower than the expected one. For
pure term life policies on the other hand, or endowment polices, (where the capital at
risk is positive), prudence applies in calculating the premium and reserves, when
expected mortality is overestimated.

2
In cases of endowment or whole-of-life policies having a technical rate equal to zero, the capital at
risk is also nil, being equal to the rate of premium, and so the capital assured is identical to the
mathematical reserve. For this type of contract, the mortality risk indeed does not apply.
The sole risk that arises is the loss of earnings due to the fact that as mortality increases the mass
of the reserves to be managed will reduce, so there will be fewer clients for the insurance
undertaking and so fewer expected gains.
16.3 Demographic Profit and Financial Profit: The Homans Formula 345

Table 16.1 Trend in financial and demographic profit for an ordinary endowment insurance

1 ut (financial 2 ut (demographic 1 ut (financial

t Vt profit) profit) profit)
1 1,020.43 6.4 9.0 15.36
2 2,040.66 11.5 8.2 19.64
3 3,059.24 16.5 7.2 23.72
4 4,074.63 21.6 6.0 27.58
5 5,085.17 26.6 4.6 31.20
6 6,089.10 31.7 2.9 34.58
7 7,084.58 36.6 1.1 37.69
8 8,069.62 41.5 -1.0 40.56
9 9,042.15 46.4 -3.2 43.16

Now other examples will be shown relating to an endowment type policy (the
same sum insured covered for decease and for survival) and a term life policy.
Features of an endowment policy:

• Age of the assured at the time of taking out the contract x = 40.
• Annual premiums up until expiry.
• Sum insured amounting to C = 10,000.
• Duration of the contract n = 10.
• First order technical bases (i; q) = (2%; qx).
• Second-order technical bases (i*; q*) = (5%; 90% qx).
• The annual premium drawn using the first-order technical basis amounts to
P = 1,020.4.

Table 16.1 shows the results relative to the breakdown of the expected profit and
the value of the mathematical reserve over the life of the policy.
Figure 16.2 shows graphically the trend in financial profit compared with the
trend of demographic profit for an ordinary endowment insurance.
It can be seen that the expected financial profit has a growth trend. This is due to
the fact that the mathematical reserve of an endowment policy with annual premium
grows. The trend in the demographic profit, on the other hand, for this type of
contract with annual premiums, has a reducing trend as the capital at risk decreases
until it is written off at the expiry of the policy. The aggregate profit displays a
growth trend, and the financial one is predominant as to sum.
A term life policy (TLP) displays different features from the endowment policy
set out above. In this case, the sum insured C = 10,000 is payable only in the event of
decease.
The annual premium drawn using first-order technical bases amounts to P = 26.7.
At the same conditions applying it is logical to expect a lower premium as compared
to the endowment policy as the sum insured is payable only in cases of decease and
so a savings component does not have to be capitalised. Table 16.2 shows the results
relative to the breakdown of profit and the mathematical reserve over the life of the
policy.
346 16 Life Insurance: Other Components of Profit

50.0 10.0
45.0
8.0
40.0
35.0 6.0

30.0
4.0
25.0
2.0
20.0
15.0 0.0
10.0
-2.0
5.0
0.0 -4.0
1 2 3 4 5 6 7 8 9

Financial Profit Demographics Profit

Fig. 16.2 Trend in financial and demographic profit for an ordinary endowment insurance

Table 16.2 Trend in financial and demographic profit for a term life insurance

1 ut (financial 2 ut (demographic ut (total

t Vt profit) profit) profit)
1 13.0 1.0 3.0 4.0
2 25.4 1.3 3.2 4.5
3 36.9 1.6 3.5 5.1
4 47.2 1.8 3.9 5.7
5 56.0 2.1 4.2 6.3
6 63.0 2.2 4.5 6.8
7 68.6 2.4 5.1 7.5
8 71.3 2.5 5.5 8.0
9 72.0 2.5 6.1 8.5
10 70.1 2.4 6.7 9.1
11 65.0 2.3 7.4 9.7
12 56.1 2.1 8.2 10.3
13 43.0 1.7 9.4 11.2
14 23.3 1.2 10.1 11.3
15 0.0 0.7 11.0 11.7

Figure 16.3 shows graphically the trend in financial profit compared with the
trend of demographic profit for a term life insurance.
In this case, it can be seen that financial profit has a growth trend at first and then
decreasing. This trend is due to the trend in the reserve of a term life policy with
annual premium, which typically accumulates part of the premium in the early years
and then, when the natural premium becomes greater than that paid by the assured,
the reserve tends to be consumed up until it is nil in the final year. The values for
financial profit compared to those for the endowment policy are much lower since
16.4 Profit for Surrender and Expense Loading 347

12.0

10.0

8.0

6.0

4.0

2.0

0.0
t Financial Profit Demographics Profit

Fig. 16.3 Trend in financial and demographic profit for a term life insurance

the mathematical reserve for a term life policy is much lower for the same sum
insured, as the savings component is missing. Demographic profit on the other hand
displays a growth trend due to the growing trend in the likelihood of decease.

16.4 Profit for Surrender and Expense Loading

The Homans formula seen in the foregoing paragraph allows the profit created to be
broken down into financial and demographic profit. However, in insurance practice,
there are other factors that determine the creation of profit. The main ones among
these are the profit deriving from loadings for expenses and the profit from surrender.
The expected annual profit for a generic policy in force at time t, assuming that
premiums, sums insured and rates of interest may vary over time, is given by:

u tþ1 = ðV t þ PTtþ1 - E tþ1 Þð1 þ i tþ1 Þ - C tþ1 q xþt - Rtþ1 p xþt r  tþ1
- V tþ1 p xþt ð1 - r  tþ1 Þ ð16:4Þ

where PTt+1 represents the tariff, premium paid at the commencement of the year,
Et+1 expenses at the commencement of the year, p*x+t the expected likelihood of
survival and r*t+1 the expected likelihood of surrender.
Expected profit is thus made up of what the undertaking “possesses” at the start of
the year (i.e. the mathematical reserve and the tariff premium collected, from which
expenses that will be incurred during the year are to be subtracted) then capitalised at
the expected rate of interest, minus the sums that it has to pay out at year-end
(i.e. capital C in the case of decease and surrender value R in the event of
surrender) minus the final reserve in the event of survival ( p*x+t) with no surrender
made (1-r*t+1).
If the tariff premium PTt+1 is broken down into pure premium Pt+1 and expense
loadings Ht+1 and Eq. (16.1) is subtracted from Eq. (16.4) we will have:
348 16 Life Insurance: Other Components of Profit

Table 16.3 Trend in penalties for a whole of life policy on decease (example)

Single premium paid

Surrender Up to 8.000 From 8001 to 20,000 More than 20,001
year euros euros euros
2–5th 5% 4% 3%
6-10th 4% 3% 2%

u tþ1 = ðV t - Ptþ1 Þði tþ1 - itþ1 Þ þ ðCtþ1 - V tþ1 Þ qxþt - q xþt

þ ðV tþ1 - Rtþ1 Þp xþt r  tþ1 þ ðH tþ1 - E tþ1 Þð1 þ i t Þ ð16:5Þ

It can be seen that expected annual profit is made up of four addenda:

• Financial profit (Vt-Pt+1)(i*t+1-it+1).

• Demographic profit (Ct+1-Vt+1)(qx+t-q*x+t).
• Surrender profit (Vt+1-Rt+1) p*x+t r*t+1.
• Profit for expense loading (Ht+1-Et+1)(1+i*t).

The first two addenda are the same as in the Homans formula given in the
foregoing paragraph.
Profit from surrender is given by the difference between the mathematical
reserve that the insurance undertaking has available at the end of the contract and
the value that it has to pay out to the assured if they should decide to surrender. This
value is weighted in respect of the expected likelihood of surrender and the expected
likelihood of survival. The difference between the surrender value and the mathe-
matical reserve may be due, for example, to there being penalties. The surrender
value is set as in the following equation:

Rt = C t  ð1 - at Þ ð16:6Þ

where at represents the penalty.3 Most often, traditional products have a higher
penalty in the early years, decreasing over time. The reason for this is that the
insurance undertaking wishes to ensure a minimum gain for itself over time, and so it
disadvantages, through the use of penalties, anyone leaving the insurance manage-
ment in advance.
The rates of penalty may vary based on sums insured or premiums paid in bands.
For example, at may take on the values of Table 16.3.
The expense loading profit is given simply by the difference between the loading
for expenses incorporated into the premiums and the expected sum of expenses
Assuming the following hypothesis

3
Models that are even more complicated maybe foreseen, or that simply have different approaches,
the most disparate, depending on how creative the insurance undertaking that designs them is, and
local business rules.
16.5 Significance of the Components in Forming Profit 349

Table 16.4 Table of acquisition expenses and management expenses (example)

Management
Type of life Acquisition expenses as
Management expenses expenses as a
product % of premiums
as a % of reserves fixed sum
Traditional 0.30% 0.50% 0.6
With-profits 0.35% 0.20% 4.0
Financial product 1.08% 0.31% 5.5
(i.e. unit-linked)

• Premiums are collected at the commencement of the year.

• Expenses are incurred at the start of the year.4

if we look at the year-end, as in the examples shown here, this value has to be
capitalised at the expected rate of interest.
Expenses are split between acquisition and management.5 Usually, acquisition
expenses are reallocated to insurance contracts as a percentage of premiums and/or
as a fixed sum. Whereas management expenses are reallocated as a percentage of
reserves and/or as a fixed sum. Management expenses to allocate to the cost of
handling a claim or surrender or another form of pay-out made to assureds or third
parties are often identified. Additionally, expenses vary in form and level depending
on the type of tariff. Table 16.4 shows a possible example of expense calculation
relating to a hypothetical insurance portfolio made up of traditional with-profits and
unit-linked policies.

16.5 Significance of the Components in Forming Profit

A numerical example will now be shown, as per the Homans formula, relative to a
traditional non-with-profits endowment policy. For the sake of simplicity, a constant
rate of interest will be assumed. The features of an endowment policy are the same as
were seen in the foregoing example; additionally, it is assumed that:

• Tariff premium = Pure premium/(1–5%) = 1,020.4/(1–5%) = 1,074.1.

• Acquisition costs = 50.
• Management expenses of 30 Euros for each management year.
• Likelihood of surrender of 5% annual fixed, but tables are often used per year of
non-duration of the policy.

The results of the analysis are included in Table 16.5.

4
A robust assumption, given that in reality these will arise in a fairly uniform manner during the
year.
5
Collection expenses, which also ought to be considered among insurance undertaking costs, relate
to a premium collection. In cases of annual premiums, if there is no specific loading, these costs are
included in management expenses. In the case of a single premium, these expenses are held to be
acquisition expenses.
350 16 Life Insurance: Other Components of Profit

Table 16.5 Impact of components in forming the profit for an ordinary endowment policy
4ut
(profit
1ut 2ut 3ut (profit for ut (total
Expense Tot (financial (demographic for expense profit)
loading expenses profit) profit) surrender) loading) (C + D = E +
t Vt (A) (B) (C) (D) (E) (A–B) (A–B))
1 1,020.4 0,0 50.0 0.0 0.0 0.0 -50,0 -50.0
2 1,937.6 48.0 28.2 6.4 9.0 2.0 19.8 37.1
3 2,758.0 45.1 26.5 10.9 7.4 2.8 18.6 39.6
4 3,487.6 42.3 24.9 14.9 5.4 3.4 17.4 41.1
5 4,132.4 39.7 23.3 18.5 3.3 3.9 16.4 42.0
6 4,697.8 37.2 21.9 21.7 1.2 4.3 15.3 42.5
7 5,189.0 34.9 20.5 24.4 -0.7 4.6 14.4 42.7
8 5,610.9 32.7 19.2 26.8 -2.3 4.9 13.5 42.9
9 5,968.3 30.6 18.0 28.9 -3.5 5.1 12.6 43.0
10 6,265.6 28.6 16.8 30.6 -4.4 5.2 11.8 43.2

As can be seen, the trend of the pure mathematical reserve is different from that of
the foregoing example, without assumed surrender. The loading for expenses
decreases due to the law of disposal as it is for every other flow during the
development years. The profit is calculated as the difference between the tariff
premium and the pure premium. The trend in expenses follows the same trend
with the exception of the first year where payments for other expenses occur. In
the first development year costs that the insurance undertakings bear in acquiring
contracts, in part due to commission to pay to the sales network and in part internal
costs of developing the product. The expected profit from surrender also rises due to
the growth in the pure mathematical reserve.6
Figure 16.4 represents the trend and the amount of these profits as a graph.
Figure 16.5 shows aggregate profits.
Finally, from the data shown above it is possible to obtain information in respect
of expected monetary ingoing cash flow, which arises from items of income such as
annual or additional premiums or other forms of payment from assureds. By way of
outgo, payments to assureds can be identified as can losses and surrender or due to
maturity, coupons under contracts that foresee this, and instalments of annuities, or
in general, any form of payment to assureds. Payments of expenses and commissions
is another item to be included in technical outgoing cash flows.
Figure 16.6 represents graphically the trend in total expected Cash Flow by policy
in force.
As can be seen, expected annual cash flows for this product with an annual
premium, are all positive with the exception of the final year. This is due to the
payment of the lump sum at maturity, which is obtained by adding together the
premiums paid over the years of accumulation. If we had analysed an endowment
insurance with annual premium, cash flows would all have been negative except for

6
In the first year, the expected annual profits for surrender is nil due to the assumption that the policy
cannot be surrendered during the first year of effect.
16.5 Significance of the Components in Forming Profit 351

35,0

30,0

25,0
20,0
15,0
10,0
5,0
0,0
2 3 4 5 6 7 8 9 10
–5,0
–10,0

Financial Profit Demographics Profit

Surrender Profit Expense loadings Profit

Fig. 16.4 Trend in profits for an ordinary endowment policy (from the second year)

60

40

20

0
1 2 3 4 5 6 7 8 9 10

-20

-40

-60

Fig. 16.5 Trend in total expected profit by policy issued

the first when the single premium representing the sole setting aside to be reserved
for the entire duration of the contract is paid.
Such a different trend between expected profits and cash flows is due to the fact
that in the former, the issue of accrual is included (represented by the mathematical
reserve) in the model of assessment, whereas in the latter only the pure cash issue is
assessed.
352 16 Life Insurance: Other Components of Profit

2,000

1,000

0
1 2 3 4 5 6 7 8 9 10
-1,000

-2,000

-3,000

-4,000

-5,000

-6,000

-7,000

Fig. 16.6 Trend in total expected Cash Flow by policy in force

16.6 The Profit Margin

The profit margin is a measurement tool for the expected profit from an insurance
product, typically a newly issued one. This tool is mainly used for the purpose of
measuring the robustness of the profit for the insurance product prior to its being
marketed.
The profit margin consists of projecting all expected cash lows, assessed an
instant before issue of the relative premium. The projection is extended to the entire
duration of the contract with the main aim of determining the current value of the
future profit generated, i.e. the value that will be created by the contracts that the
insurance undertaking will be able to issue over time.
The assessment made of the profitability may be carried out even ex-post,
i.e. even after issue of the product. In this case, the analysis is made for verifying
whether or not the products in production are still adequately profitable so as to be
able to understand which need to be upgraded and allows an analysis to be made of
the sensitivity of the profitability of the products as underlying assumptions
may vary.
The two methods shown, i.e. the traditional one (Homans) and the one for cash
flows (Profit margin) come to the same result if properly implemented. The essential
difference is that the second method allows asset and financial statements issues that
broaden the assessment concept to be included. Additionally, in profit margin
smaller time steps are generally used (such as a month) and in this way, there is an
advantage of being able to place the effects of interactions between premiums,
expenses and performance in each time frame and calculate the balance between
income and outgo each year.
16.6 The Profit Margin 353

An example of the flows generated by profit margin could be as follows (bearing

in mind that the amounts of information that a complete profit margin can contain
may run to the hundreds, over calculation steps and data required).
Flows required:

• Collectable premiums (annual, recurring, and additional).

• Return on assets (to be attributed to mathematical reserves).
• Variation in the mathematical reserve (representing a cost for the insurance
undertaking, if plus).
• Variation in the reserve for management expenses.
• Expenses (acquisition and management).
• Losses for decease.
• Total surrenders.
• Partial surrenders.
• Lump sums payable at policy maturity.
• Coupons payable (to assureds).
• Sums withheld from the yield of the fund (that the assets covering the mathemati-
cal reserve are invested in).
• Management commissions to be paid to the fund manager.
• Commissions to be paid to the distribution network.
• etc.

In the simplest cases, profit margin uses a vector of financial assumptions

developed on the basis of an sales plan, or other activities the insurance undertaking
carries on in planning. In the by now most widespread of cases where profit margin
includes an integrated management model of liabilities and assets,7 (the model will at
the same time provide cash flows of share and bond securities) useful for determin-
ing the rates of revaluation and mathematical reserves, and the cash flows connected
with these.
Another important issue, and one that must be underlined in the assessment made
of expected profits, is the process of determining the assumptions made. This is just
as important as that of calculations since industrial decisions are made from technical
- financial assumptions. Indeed, if it is seen that one type of product displays, for
example, an especially high tendency towards being surrendered, the insurance
undertaking may foresee penalties for early exit.
In order to represent the profitability of an undertaking in summary form, the
profit margin makes use of specific indicators. The main ones among these are:

• Total profit PVFP (Present Value Future Profits) which is the current value of
annual industrial profits.

7
For Asset and Liability Management Model (called ALM) see Chap. 31.
354 16 Life Insurance: Other Components of Profit

• The ratio between PVFP (Present Value Future Profits) and initial costs (typically
acquisition expenses, but also the cost of capital required8), which quantifies the
yield from the sum invested.
• The profit margin, which is given by the ratio of profit to actuarial value of annual
tariff premiums (also called APE—Annual Premium Equivalent). This index is
also found useful when comparing the profitability between products with masses
of premium different from each other.
• The internal yield (TIR Total Internal Return) which is the rate of discount that
renders total expected profit nil.
• The Payback Period, which is the period necessary (with effect from the policy
issue date) for covering the accumulation of losses and changing sign finally from
negative to positive.

16.7 Questions

1. How many are the main components of insurance profit?

2. Which are the components of the Homans formula?
3. What are the factors underlying profit for expense loading?
4. What is profit margin?

Suggestions for Further Study

Homans S (2016) Life insurance premiums & reserving. Wentworth Press, Sydney. isbn-10:
1372963456
Olivieri A, Pitacco E (2015) Introduction to insurance mathematics. Springer International Publish-
ing, Berlin. https://doi.org/10.1007/978-3-319-21377-4

8
See Chap. 30 regarding Solvency II for a definition of required capital.
Reinsurance and Coinsurance
17

Abstract

This chapter aims to introduce reinsurance and explain how it works. The
paragraphs describe the nature of reinsurance that may be divided into outwards
reinsurance and inwards reinsurance. The reader will understand the types of
contracts for treaties. The contracts can be put into two categories: facultative
reinsurance, obligatory reinsurance. In the paragraphs that follow, the methods of
transfer of risks and losses are described. Reinsurance makes a distinction
depending on whether the method is proportional or non-proportional. Each
type of reinsurance is analysed in detail with numerical examples and graphs.
Proportional reinsurance (Quota Share reinsurance and Surplus reinsurance) takes
place through a sharing of risks, whereas non-proportional reinsurance (Excess of
loss reinsurance and Stop loss reinsurance) is based on the reimbursement of the
loss suffered. Then, the process of reinsurance in an insurance undertaking is
presented. At the end of the chapter, coinsurance is described.

Keywords
Reinsurance · Cedant or reinsured · Cessionary or reinsurer · Reinsurance
inwards · Reinsurance outwards · Retrocession · Facultative reinsurance · Treaty
reinsurance · Cut-through · Follow the fortune · Proportional reinsurance ·
Reinsurance commission · Quota share (QS) reinsurance · Surplus reinsurance ·
Capacity · Non-proportional reinsurance · Priority · Layer · Excess of loss
(XL) reinsurance · Stop loss reinsurance · Reinsurance pool · Direct coinsurance ·
Contribution work

For this chapter, a special acknowledgement goes to Andrea Folegani (reinsurance business
practitioner).

# Springer Nature Switzerland AG 2024 355

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_17
356 17 Reinsurance and Coinsurance

17.1 Learning Objectives

At the end of this chapter the reader should be able to:

1. Define reinsurance and how reinsurance works

2. Explain forms of reinsurance proportional and non-proportional
3. Distinguish the contracts forms (between treaties and facultatives)
4. Illustrate the process of reinsurance
5. Define coinsurance

17.2 Definition of Inwards and Outwards Reinsurance

As already dealt with previously, the business of an insurance undertaking is

essentially the taking on of risks and standing in for assureds in return for payment
of premiums. However, in certain cases, the risks taken on can be felt to be excessive
for the technical insurance balance or lead to a breach of requirements of capital
solvency foreseen under regulation. In this case, an insurer, behaving like any other
risk-averse party would, turns in its turn to the industry to insure itself.
Reinsurance is a process of transfer of part of risks or reimbursement of losses
affecting another party. By means of this transaction, an insurance undertaking
reduces its exposure to risk, a mass of risks or an entire line of business. Through
reinsurance, an insurer thus achieves considerable benefits, both in its technical
insurance balance, especially in the qualitative-quantitative homogeneity of sums
insured, and in capital balance and availability of financial resources1. An undertak-
ing that transfers part of its risks to another party is defined as the cedant or
reinsured party. The undertaking accepting the risk transferred from the original
insurance undertaking is called the cessionary or reinsurer.
The reinsurance undertaking ensures a risk or mass of risks underwritten by
another insurer without any taking on direct obligation towards the assureds. This
is because the liability in respect of the original risk remains attached to the cedant
undertaking. In reinsurance, in other words, the risk is taken on directly by an
insurer, who meets the obligation to indemnify the assured. Indeed, in a contract
of reinsurance, no relationship applies between a reinsurer and the assured2.
Between the two parties, insurer and reinsurer, no legal bond applies, as insurance
and reinsurance are the subject matter of two contracts that are completely distinct.
This idea is set out in Figure 17.1.
The process of reinsurance may be divided into outwards reinsurance and inwards
reinsurance. Outwards reinsurance is the business of ceding risks to other

1
For the impact of reinsurance on the solvency margin and capital resources, see Chap. 30.
2
See later. Save for a number of cases where a cut-through clause applies.
17.2 Definition of Inwards and Outwards Reinsurance 357

Insurer
Insured undertaking Reinsurer

Insurance
Reinsurance
contract
contract

Fig. 17.1 Outline of how reinsurance works

reinsurers. It is a process that plays a primary role in the strategy of an undertaking

and aims to manage the technical insurance risk. It is widely used in non-life
business but is also found, albeit to a more limited extent, in the life business. Its
main function is to reduce the volatility of losses and reducing the aggregate
exposure of an undertaking. From this there derives greater underwriting capacity
for new business on the part of the ceding undertaking and greater offsetting of the
risks it bears as they become more homogeneous. Inwards reinsurance on the other
hand is the accepting of the risks of others on the part of the cessionary or reinsurer
undertaking. In this case, the business is carried on by a reinsurance undertaking that
collects a multitude of risks spread over a broad area, both from the standpoint of
geography and in respect of the type and scale of risk.
Retrocession consists of transferring risk from a reinsurance undertaking to
another reinsurance undertaking: Types of retrocession contracts and related
conditions are usually similar to those of a contract of primary reinsurance. A
reinsurance undertaking that in its turn reinsures risks from another reinsurer is
called a retrocessionaire.
Lastly, the process of reinsurance can be analysed depending on the role played
by the parties. According to this approach, a distinction is usually made in the
process of reinsurance between direct and indirect reinsurance. Direct reinsurance
takes place when an insurance undertaking cedes part of risks taken on directly to the
reinsurance undertaking. Indirect reinsurance on the other hand takes place when a
reinsurance undertaking cedes part of the risks taken on indirectly to another
reinsurance undertaking (in this case the process is retrocession, as dealt with above).
A further function of reinsurance is the optimising of capital balance in the ceding
undertaking. This optimising is achieved thanks to the fact that reinsurance, by
impacting upon the level of exposure to risks of the primary insurer, reduces the
quota of solvency margin required and related equity resources required to meet
these. Indeed, according to current regulatory systems, insurers must constitute a
minimum threshold of capital resources to meet the risk of a lack of solvency in the
insurance undertaking. The values of the solvency margin required to avoid the risk
of a lack of capacity to meet future commitments are defined via a formula calculated
on values net of reinsurance. If risks are ceded and transferred, the solvency margin
required must be reduced on the basis of the obligations transferred to a reinsurer. It
can thus be understood how ceding premiums and related reserves allow the cedant
undertaking to reduce the requirement called for by the solvency margin. Reducing
358 17 Reinsurance and Coinsurance

this value leads to reducing capital resources required to hedge them and thus allows
savings to be made in the cost of capital.

17.3 Forms of Reinsurance

The types of contracts can be put into three categories: facultative reinsurance,
obligatory reinsurance and facultative-obligatory reinsurance for one or both parties.
Treaty reinsurance represents the contractual document which establishes terms and
conditions of the relationship between the cedant and the reinsurer. This document is
signed by both parties and sets out in detail the terms of the reinsurer’s participation.
In general, treaty is used to indicate the coverage of a mass of risks or of an entire
business. Otherwise, for the reinsurance of a single risk, underwritten from time to
time, specific reinsurance contracts are developed ad hoc for each single risk.
The first kind, facultative reinsurance, provides the cedant and the reinsurer
with the option to transfer a specific risk. This adapts itself to non-standard risks and
foresees the insurer offering a specific risk to a reinsurer who may, or may not,
accept the risk. As these are individual risks, the reinsurer has the right to have the
same data made valuable as have led to the cedant originally underwriting it. The
insurer cannot, therefore, hold self-covered up until actual acceptance is given by the
reinsurer. The problem of the time delay between proposal and acceptance is
obviated through a reserveal acceptance called “given cover in course of post”
which is however subject to a condition of resolution if there is non-acceptance of
the proposal on the part of the reinsurer3. In the absence of acceptance, the risk will
be borne by the insurer. On the one hand, facultative reinsurance may appear
disadvantageous both due to the issue just mentioned, and for the complex docu-
mentation the reinsurer needs in order to assess the risk, but on the other, it is also
used in cases where the occasional nature and exposure of the risk lead to the volume
of business concerned being such as not to justify the setting up of a open obligatory
contract.
Obligatory reinsurance or treaty reinsurance developed later to surmount the
limits imposed by individual risks. An insurer undertakes to transfer to the reinsurer
all the risks whose connotation is in line with what is indicated in the reinsurance
contract, and the reinsurer is obliged to take them on. The connotation grouping risks
may concern a certain category of risk, a certain territorial area or have a pre-set
exposure or limit of indemnity. Automatic operation is well defined; each time the
insurer accepts risks with the same features as are set out in the reinsurance treaty it
can be deemed held covered without waiting for the cessionary are to assess and
select risks.

3
This model, which was admitted previously, is no longer feasible in a number of European
countries (for example, in the UK following Contract Certainty set forth by the English Authority,
the FSA.
17.4 Proportional and Non-proportional Reinsurance 359

In insurance practice, there is also a mechanism defined as “special acceptance

under treaty”. When a risk does not display all the features needed for automatic
cession, instead of defining a facultative cover, the reinsurer may be asked to be able
to include the risk under the treaty anyway.
It may happen that a relationship of reinsurance displays connotations of one or
other of the examples given. In this case, we have a facultative-obligatory reinsur-
ance either for one of the parties or for both. If the reinsurance is facultative for the
insurance undertaking, which may offer any risk underwritten while the reinsurer is
obliged to accept it.
In some reinsurance treaties there may be an arrangement of a bouquet of
treaties in the sense of “bundle” and taken to mean participation of the reinsurer
in contracts of a number of lines of business, even if not ones that are homogeneous.
Although not obligatorily uniform, a participation of this kind by a reinsurer is
dictated by a concept of balance in the outcome of the relations, including the entire
technical management.
It is important to describe the cut-through mechanism. The cut-through clause
allows the original insured to be compensated directly, through reinsurance and not
through the cedant. The assumption of responsibility by the reinsurer towards the
original insured is a strong exception to the doctrine of the legal relationship between
the cedant and the reinsurer. This case is allowed under specific and exceptional
cases, such as the liquidation of the cedant.
Often reinsurance contracts have a multi-year duration. This entails the establish-
ment of the two subjects of long-term relationships identified with the contract clause
follow the fortune: the fortune of the cedant and the fortune of the reinsurer follow
the same way.

17.4 Proportional and Non-proportional Reinsurance

As regards the methods of transfer of risks and losses, reinsurance makes a distinc-
tion depending on whether it is proportional or non-proportional. Proportional
reinsurance takes place through a sharing of risks, whereas non-proportional rein-
surance is based on a sharing of losses. In the first case, the position of the reinsurer
follows the same fate as that of the insurer as it participates proportionally in its
profits and losses. The second type, on the other hand, features an insurance
function, in the strict sense of a reinsurer reimbursing a loss suffered. Figure 17.2
describes the two types of reinsurance.
The forms of proportional reinsurance that are possible are two in number: one in
variable percentage, the other based on a fixed value or threshold. The first one is
called pure quota or Quota Share (QS) and foresees that the cedant and the reinsurer
taking on a proportional quota of premiums and losses. The second called excess or
Surplus is tied to a sum in absolute terms in respect of the risk insured and which
indicates the part in excess not retained by the insurer.
360 17 Reinsurance and Coinsurance

Quota share

Proportional Sharing of risks

Surplus

Forms of
reinsurance

Excess of Loss

Non-proportional Sharing of losses

Stop Loss

Fig. 17.2 Types of forms of reinsurance

In the two non-proportional methods, the loss that has occurred is paid by the
reinsurer. The first method is called individual excess or Excess of Loss (XL) and
usually concerns catastrophic spikes. In the second form, called aggregate excess or
excess of loss ratio or Stop Loss, the cover offered by the reinsurer does not refer to a
single loss or event, but rather to an accumulation of loss events that strike the entire
protected portfolio of risks.
In the coming paragraphs, the four methods indicated above will be treated in
detail.

17.5 Proportional Reinsurance

As indicated above, proportional reinsurance implies a proportional sharing taking

place between insurer and reinsurer of premiums underwritten by the cedant in
variable percentage or absolute value.
An amount of reinsurance is set forth in the contract which may refer to one of the
following parameters: percentage value of insurable risks (Quota Share) or absolute
value or threshold above which the risk is ceded (Surplus).
Operational peculiarities of proportional reinsurance consist of:

• Transfer of the portfolio of risks from the cedant to the cessionary. In this case,
cession of the related quota of premium a reserve and claims reserve is also
performed.
• Split of premiums between the two parties, as too, claims handling.
• Payment of a commission by the reinsurer to the cedant (and profit sharing, if
foreseen). This sum is intended to cover the acquisition costs of the cedant and
contributes to reducing administration expenses.
17.5 Proportional Reinsurance 361

Transfer of the portfolio of risks

Payment of a commission
Insurer Reinsurer
Cedant Cessionary
Variable reinsurance commission

Reimbursement of losses

Fig. 17.3 How proportional reinsurance works

In return for the cession of the premiums by the cedant the process of reinsurance
foresees that reinsurance undertaking awards a commission to the cedant4.
Figure 17.3 provides an outline explaining how proportional reinsurance works.
The reinsurance commission is usually a pre-set percentage that the reinsurance
undertaking reimburses to the cedant to cover its costs of acquisition (for instance,
commissions for salesforces), possibly augmented by a supplement for management
charges. Where multi-year contracts are ceded or in cases of significant commercial
efforts being made by the cedant, an additional start-up reinsurance commission is
sometimes applied, and which is paid by the reinsurer for newly constituted
portfolios for the purpose of contributing to the business and organisational
disbursements of the cedant. In general, this start-up contribution is in any case
limited in timeframe. If payment of the commission by the reinsurer is tied to the loss
experience underlying the premiums ceded, there is a variable reinsurance com-
mission, which is a reimbursement of a commission as a ratio of the claims
experience actually arising and which allows a reinsurer to reward or penalise a
cedant for is underwriting policy.
It should be noted that transfer and cession of risks by an insurer to another
reinsurer leads to costs. These costs may relate to reimbursement for consultancy
services provided in managing policies aimed at making risk homogeneous and of a
technical-administration kind, (i.e. activities supporting the undewriting phase, . . .)
given by the reinsurer.

17.5.1 Quota Share (QS) Reinsurance

Quota Share (QS) reinsurance foresees the ceding of a percentage of risk by the
cedant. The reinsurer takes on a proportional quota of exposure of premium and pays

4
This is true only in proportional reinsurance.
362 17 Reinsurance and Coinsurance

Table 17.1 Example of how quota share proportional reinsurance works

Scenario 1 = Scenario 2 = Scenario 3 = Scenario 4 =
LR 50% = 500,000 LR 80% = 800,000 LR 100% = 1,000,000 LR 150% = 1,500,000
Cedant Reinsurer Cedant Reinsurer Cedant Reinsurer Cedant Reinsurer
(30%) (70%) (30%) (70%) (30%) (70%) (30%) (70%)
Total written 300,000 700,000 300,000 700,000 300,000 700,000 300,000 700,000
premium
Acquisition cost -200,000 -200,000 -200,000 -200,000
per sales network
(20%)
Incurred losses -150,000 -350,000 -240,000 -560,000 -300,000 -700,000 -450,000 -1,050,000
Reins. comm for 175,000 -175,000 175,000 -175,000 175,000 -175,000 175,000 -175,000
the Cedant (25%
of cession)
Net result 125,000 175,000 35,000 -35,000 -25,000 -175,000 -175,000 -525,000
including
Reinsurance

Scenario without Reinsurance

– Total written premium = 1.000.000
– Acquisition cost per sales network (20%) = 200.000
– Incurred losses = 500.000
– Net result without Reinsurance = 300.000

the same percentage quota of every loss. This form thus foresees a proportional
sharing, by the cedant and the reinsurer, of all risk reinsured under a given contract.
This form features the three following aspects.

• Each risk is shared in the same pre-set proportion between retention and cession
(for example, 80% e 20%, 40% e 60%, etc.).
• The reinsurer will receive the same proportion of total premiums for all the risks
reinsured under the contract.
• The reinsurer will pay the same proportion of all losses as may strike the risks
reinsured under the contract. Table 17.1 shows an example of how quota share
proportional reinsurance works.5

Quota Share reinsurance may be applied to each individual risk. Figure 17.4
shows an example of how this type of contract works.
Table 17.2 provides a simple numerical example for the proportional cession of
risk under a Quota Share contract.
This form of reinsurance is useful for reducing the maximum exposure in absolute
terms for the undertaking but does not achieve a policy for selecting risks. It is
therefore defined as “non-technical reinsurance”. Its extreme ease of application,
together with its low administration and management costs lead, however, to its
being applied by a reinsurer to benefit an insurance undertaking of limited scale and
that does not have a technical-insurance apparatus available. From the standpoint of
the reinsurer, Quota Share reinsurance, therefore, remains the most advantageous

5
As can be seen in Table 17.1, a Quota Share contract does not allow the balance of the portfolio to
be improved. Indeed, the loss ratio remains the same and the net result improves only thanks to the
reinsurance commission collected by the cedant.
17.5 Proportional Reinsurance 363

200.000
180.000 cession
160.000 retention
140.000
120.000
100.000
80.000
60.000
40.000
20.000
-
1 2 3 4 5 6 7 8 9 10

Fig. 17.4 Example of proportional cession of risk under a Quota Share contract. Reinsurance
under Quota Share—QS: 30% retention 70% cession

Table 17.2 Proportional cession of risk under a Quota Share contract

Risk Insured sum Retention Cession
1 185.000 55.500 129.500
2 174.000 52.200 121.800
3 163.000 48.900 114.100
4 159.000 47.700 111.300
5 106.000 31.800 74.200
6 74.000 22.200 51.800
7 53.000 15.900 37.100
8 39.000 11.700 27.300
9 27.000 8.100 18.900
10 20.000 6.000 14.000
Total 1,000.000 300.000 700.000
Reinsurance under Quota Share—QS: 30% retention 70% cession

economically thanks to the fact that the subject matter of the contract is all the risks
in the portfolio of the cedant, including those with low claims experience. In this
form of reinsurance, the reinsurer thus shares significantly in the insurance opera-
tion. This is the form of insurance that more than any other allows a reinsurer to share
the fortunes of the cedant in the proportions set forth under the contract. Among the
disadvantages that there are for the insurance undertaking we can mention, on the
other hand, that seeking low exposure leads to a large-scale cession of premiums.
Additionally, there is no reduction in the heterogeneous make-up of the portfolio as
the cedant achieves only a general and proportional lowering of all risks taken on and
not only those felt to be excessive.

17.5.2 Surplus Reinsurance

The second type of proportional reinsurance is reinsurance in excess or surplus.

Excess or Surplus reinsurance refers to risks that exceed the sum retained by the
364 17 Reinsurance and Coinsurance

cedant as set forth in the contract. In this case, the cessionary takes on risks whose
sum in absolute terms exceeds a certain threshold (which is the reason for the term in
excess).
The cedant may set forth that all risks up to a certain sum, for example 40,000,
maybe retained without fearing having to pay losses. The reinsurer receives a part of
the risk exceeding the value of 40,000 up to a determined maximum6. The sums that
the cedant is willing to hold are called its line (40,000 in our example). The capacity
of a contract in excess is expressed as a multiple of lines. For example, if the
reinsurer were to determine a maximum limit amounting to four lines, the maximum
reinsurance capacity would amount to 160,000.
The mechanism underlying the sharing of premium and loss exposure between
insurer and cessionary is the ratio applying between the part retained and the part
ceded of each risk insured. The proportion applying between the scale of the risk and
the amount of the line leads to there being a percentage between line and the cession
that varies. The percentage of cessions are made one by one for each risk. The quotas
of the cedant and the reinsurer vary from cession to cession and are not fixed. Losses
are shared between the two parties base on the percentage quota applying to the
original risk.
Proportionality is thus not achieved over a totality of business, but rather in
respect of each risk in absolute terms. If, for example, it is decided in advance to
conclude a surplus at 40,000, the reinsurance undertaking will operate only where
the risk arising exceeds this limit. Figure 17.5 shows an example of how this type of
contract works.
Table 17.3 provides a simple numerical example for the proportional cession of
risk in excess.

200,000
180,000
over capacity
160,000
140,000
cession

120,000 surplus line

100,000
80,000
60,000
40,000
20,000
-
1 2 3 4 5 6 7 8 9 10

Fig. 17.5 Example of proportional cession of risks in excess. Surplus: line < 40,000;
ceded > 40,000. Maximum limit: 160,000

6
Determination of the maximum sum depends on the agreement reached between cedant and
reinsurer. There may be no defined limit.
17.5 Proportional Reinsurance 365

Table 17.3 Proportional cession of risks in excess

Risk Insured sum Surplus line Ceded Over capacity
1 185,000 40,000 120,000 25,000
2 174,000 40,000 120,000 14,000
3 163,000 40,000 120,000 3,000
4 159,000 40,000 119,000
5 106,000 40,000 66,000
6 74,000 40,000 34,000
7 53,000 40,000 13,000
8 40,000 40,000
9 26,000 26,000
10 20,000 20,000
Total 1,000,000
Surplus: line < 40,000; ceded > 40,000. Maximum limit: 160,000

In practice, for each risk, the ratio ceded to the reinsurer is calculated as follows:

%reinsurance ¼ 1 - ½ðsurplus line þ over capacityÞ=

sum insured for each risk ð17:1Þ

The figures in Table 17.3 can be used to explain some numerical examples for a
better comprehension.
In the case of risk #7, the calculation of the percentage share ceded to the reinsurer
is as follows:

%reinsurance ¼ ½1 - ð40,000=53,000Þ ¼ 1 - 75:5% ¼ 24:5%: ð17:2Þ

This result indicates that the cedant retains 75.5% of the premium and risk. The
reinsurer bears 24.5% of the risk. In the event of a claim, the reinsurer will reimburse
the claim for 24.5% of the amount.
Risk #4 presents a different situation, the percentages are:

%reinsurance ¼ ½1 - ð40,000=159,000Þ ¼ 1 - 25:2% ¼ 74:8%: ð17:3Þ

These percentages indicate that the cedant retains 25.2% of the premium and the
risk, while the reinsurer bears 74.8% of the risk and will reimburse this percentage in
the event of an accident.
Finally, risk #1 shows a case where the collected premium is higher than the
capacity of the reinsurer. The percentage of reinsurance is 64.9%, i.e.:

over capacity ¼ ðrisk#1 - capacityÞ ¼ 185,000 - 160,000 ¼ 25,000 ð17:4Þ

%reinsurance ¼ 1 - ½ð40,000 þ 25,000Þ=185,000Þ ¼ 1 - 35:1%

¼ 64:9%: ð17:5Þ

The percentage thus calculated is the multiplication factor for defining the quota
of premiums and losses borne by the reinsurer.
366 17 Reinsurance and Coinsurance

Table 17.4 Example of proportional cession (% cedant and % reinsurer)

Risk % surplus line % ceded % over capacity
1 21.6% 64.9% 13.5%
2 23.0% 69.0% 8.0%
3 24.5% 73.6% 1.8%
4 25.2% 74.8% 0.0%
5 37.7% 62.3% 0.0%
6 54.1% 45.9% 0.0%
7 75.5% 24.5% 0.0%
8 100.0% 0.0% 0.0%
9 100.0% 0.0% 0.0%
10 100.0% 0.0% 0.0%

As can be seen in Table 17.4, the commitment of the reinsurer is proportional to

the quota of risk ceded to it, as a ratio of the total sum insured. This type of
reinsurance, while being more complex, is more advantageous for an insurance
undertaking as it allows a portfolio to be made more quantitatively homogeneous.
On the other hand, it is more disadvantageous for the cessionary, which finds itself
having to cover only risks that have a premium amount above a certain threshold.

17.6 Non-proportional Reinsurance

As already mentioned above, non-proportional reinsurance foresees reimburse-

ment of claims by the reinsurer. This principle is one that is fundamental for a clear
understanding of how this type of reinsurance works. Graphically, non-proportional
reinsurance can be represented with a line dividing the amount of a claim into two
parts. This line is said to be priority or excess. See Figure 17.6 for a representation
of the priority as it refers to a loss.
Different from what takes place in proportional reinsurance, where risks
underwritten are considered, in non-proportional reinsurance the accent is placed
on the extent of losses that might occur. In non-proportional reinsurance, the
reinsurer is called into play only if a loss exceeds the agreed priority. Any loss,
however large or small it might be, below the value of the priority falls within the
lower part. Only if the loss exceeds the priority is this borne by the reinsurer for the
part not retained (in our example, the loss is for 700, the priority is 600, and so the
reinsurer is obligated to reimburse the difference between 700 and 600, i.e. 100).
In non-proportional covers, capacity is the maximum part exceeding the priority
that the reinsurer undertakes to reimburse the cedant in the event of loss (in the
example 1,000).
Summarizing Figure 17.6, the values involved are the following:

Priority = 600
Capacity = 400
Loss = 700
17.6 Non-proportional Reinsurance 367

No cover

plafond = 1,000

Capacity = 400
loss = 700
Reimbursement =100
Priority or Excess= 600

Retention = 600

Fig. 17.6 Manner in which non-proportional reinsurance works. Priority: 500; Capacity: 1,000;
Loss event: 700

Reimbursement = 100
Plafond = 1,000

Reinsurance covers are often divided into a number of bands. Each band is called
a layer and operates in succession.7 Each layer is placed one above the other.
Consequently, the sum of the priorities and reinsurance cover of the first layer is
the priority of the second layer and so on. The plafond represents the sum of the
priorities of all layers. This mechanism allows a cedant to enjoy a broader distribu-
tion of reinsurance covers. It allows a number of reinsurers to possibly take part in
the cover for a loss, each for the layer of its concerns, thus spreading the total risk.
The process called layering indicates a chronological progression of intervention
in non-proportional protections. Each layer is identified by an ordinal number (First-
Second-Third etc.) and indicates that the non-proportional protection for the cedant
is spread over a number of bands. Each layer is made up of a priority and a limit of
cover or capacity. Figure 17.7 represents the layer mechanism.
For determinng the cost in non-proportional reinsurance, the reinsurer calculates
its consideration as an actual quotation of the element underlying the cover requested
(i.e. homogeneous trends are statistics for contracts by line of business, exposure by
geographic areas, aggregate catastrophe accumulations, etc.) One of the methods
used in determining the amount of the premium required is based on a scheme of
calculation known as burning cost, i.e. pure premium before loadings. A burn cost
is found through the ratios applying between losses borne by the non-proportional
cover divided by the volume of premiums for risks, mass of risks or lines of business
referred to. This indicator is the main item of data that allows a technical rate to be
determined for a non-proportional cover, with the addition of a coefficient of the
desired loading. For the explanation of the burning cost, see the example shown in
Table 17.5.

7
In practice, the French term meaning band is also found, i.e. tranche.
368 17 Reinsurance and Coinsurance

No
Sum of priorities (plafond)
plafond = 1,000
Maximum cover
3 layer = 100
900 Priority - 3 layer =
limit of cover of the second layer
2 layer =150
750 Priority - 2 layer =
limit of cover of the first layer
1 layer =150
600 Priority - 1 layer
Retention = 600

Fig. 17.7 Layer mechanism

Table 17.5 Example of determination of % burning cost rate

Loss
Nbr losses by date Incurred average Cost for the Cedant Burning
Year of occurrence losses Cost (premium paid) cost rate
Y1 5 190,000 38,000 453,146,192 0.04%
Y2 8 7,435,527 929,441 435,973,282 1.71%
Y3 7 6,723,686 960,527 420,036,741 1.60%
Y4 12 12,537,271 1,044,773 442,185,054 2.84%
Y5 7 4,897,404 699,629 461,070,516 1.06%
Y6 – – – 434,881,370 0.00%
Y7 5 5,811,992 1,162,398 424,094,309 1.37%
Y8 – – – 394,694,220 0.00%
Y9 6 6,173,875 1,028,979 367,432,358 1.68%
Y10 4 2,511,054 627,763 338,523,177 0.74%
Total 54 46,280,808 857,052 4,172,037,219 1.11%
Note: Burning Cost Rate 1.11%
Loading to be added: 1) Safety Loading for business Long Tail 2) Losses IBNR 3) Inflation 4)
Capacity not used, but made available 5) Management costs 6) Cost of capital allocation

17.6.1 Excess of Loss (XL) Reinsurance

The first type of non-proportional reinsurance is called excess of single loss or

Excess of Loss (XL). The sum retained by the cedant in respect of each loss is
defined as priority or excess8 whereas the sum borne by the reinsurer in respect of
each loss after deducting the priority is defined as the capacity. This is also the
maximum limit up to which the reinsurer reimburses losses to the cedant.

8
This form of reinsurance was originally designed to be a special technique for meeting catastrophe
risks and ended up becoming a contract in normal use.
17.6 Non-proportional Reinsurance 369

An important feature of this type of reinsurance is the distinction made for cover
per risk as compared to cover per event. Excess of Loss per risk (WXL/R)
reinsurance serves to limit losses in respect of each risk. If an event concerns various
risks, there will be different losses borne by the reinsurer. In this case, for each risk
struck, the cedant retains its priority and the reinsurer intervenes only in respect of
sums above that. This type of cover is called a working cover, and this indicates that
the cover is activated by a single risk. The priority of working cover contracts is
usually set at a fairly low level. In this way, an insurer protects itself against a high
number of losses of a certain amplitude over the course of the year.
Excess of Loss per event (XL/E) reinsurance serves to limit loses per event. In
this case, all loss events recorded during the course of the same event are
accumulated and the cedant retains the priority once only. Given that we are dealing
with aggregate losses, in determining the participation of the reinsurer we need to
add together all the individual losses unleashed by the event. Catastrophe Excess of
Loss (Cat XL) covers against losses deriving from catastrophes (for example,
earthquake, storm, etc.,). In this case, the cat cover serves to cover catastrophe
events and not operating loss experience.
The main benefits of Excess of Loss reinsurance consist of protection certain
against loss exceeding the priority, the possibility of the cedant retaining a high
volume of premiums, low administration costs. Conversely, the disadvantages of this
method are, for the reinsurer, difficulty in quotation, above all for catastrophe Excess
of Loss events. Additionally, if the contract foresees reinstatement, a reinsurer may
be called upon to pay the capacity more than once, whereas, for the cedant, a greater
frequency of losses below the priority is borne in full.

17.6.2 Stop Loss Reinsurance

The second type of non-proportional reinsurance is called Stop Loss. This does not
concern only catastrophic spikes as does Excess of Loss but rather refers to the
aggregate of losses in insurance operations over a period of time.
In Stop Loss reinsurance, excess does not refer to a single loss or event, but rather
to the accumulation of losses striking an entire protected portfolio of risks. The
reinsurer intervenes therefore over the total of losses that exceed a maximum amount
in absolute value. It bears a certain percentage of losses exceeding a determined loss
ratio (LR). Only when a maximum amount or pre-set percentage of indemnities paid,
and premiums collected are exceeded does the contract take effect. This type of
reinsurance is certainly more efficient for the insurer than Excess of Loss as it
protects not only against catastrophic spikes but also covers increases in frequency
in losses of medium and small scale and so an accumulation of losses. As can be
seen, with this type of cover, a primary insurer may indeed block loss for an
accounting period at a certain level and not exceed this.
In this type of contract, usually, both a maximum percentage value both an
amount in absolute terms are fixed. This double limit protects the reinsurer from
high-risk exposure.
370 17 Reinsurance and Coinsurance

17.6.3 Comparison of Forms of Reinsurance

After presenting the features of each type of reinsurance, it is possibile compare the
features and benefits for the cedant:

• Quota Share: reduces exposure but does not improve balance.

• Surplus: reduces exposure ad improves balance.
• Excess of Loss reduces exposure to the value of the priority, which becomes an
absolute limit in the event of a loss occurring.
• Stop Loss is a cover against a high frequency of medium and/or small losses.

Thus, an effective reinsurance strategy definition depnes on:

• Analysis of the risks portfolio;

• Mantain a risk neutral position.

17.7 Reinsurance Pools

Reinsurance pools are organisations set up by a group of reinsurance undertakings

with subject matter the management of risks that, due to their very nature or gravity,
must be shared in quota so as to reduce individual exposures on catastrophic risks
(for example, nuclear risks, pollution risks, terrorism risk, etc.). Indeed, the potential
for loss tied to these types of risk could exceed the financial capacity of a single
operator in the industry. The level of risk is potentially high, and a high degree of
specialisation is generally required.
A pool is usually set up in a public/private sector partnership and allows
optimising to be achieved in the capacity to cover risks. Only the reinsurer that
has issued the policy is liable towards the assured, irrespective of any sharing of risk
within the pool. Participating in a pool leads to uniformity in tariffs by those
adhering, and automatic sharing of risks provided that the activity does not violate
norms protecting competition.

17.8 Reinsurance Process

The process of reinsurance in insurance undertakings is in three stages that foresee:

• Defining the strategy for containing the level of risk and portfolio balance to
achieve.
• Preparation of a plan of operation of cessions.
• Approval by the Board of directors of the undertaking and subsequent implemen-
tation of related auditing.
Figure 17.8 represents the phases for the process of reinsurance
17.8 Reinsurance Process 371

Defining reinsurance Preparing a plan of Approval of the plan and

guidelines reinsurance cessions related audits

Fig. 17.8 Process of reinsurance

Issues relating to each of these three stages are illustrated in the below paragraphs.

17.8.1 Defining Reinsurance Guidelines

Defining guidelines identifies the aims of reinsurance and provides indications

concerning the level of net retention of risks by the cedant. in this phase. It
additionally indicates the features of reinsurance cover that the insurance undertak-
ing intends to conclude and determines criteria for selecting reinsurers.
Following numerous defaults by reinsurers that there have been over the years,
special emphasis is placed on criteria for selecting and evaluating reinsurers. In order
to avoid this peril, undertakings usually define procedures that assess the following
aspects carefully:

• Structure and shareholding of reinsurers, and their possibly being part of an

international group.
• Economic-capital and financial solidity of reinsurers, rating level (awarded by an
international Agency) and solvency rating.
• Maximum limit of risks transferred to each individual reinsurer, also based on the
duration of risks ceded (for example long-tail business).
• Levels of counterparty risk accumulations and amounts of creditor positions in
effect with reinsurers (for collectability of credits).
• Actual experience of a reinsurer concerning the risk ceded, above all in the areas
of specialist treaties or facultative cessions.

This final point is sometimes undervalued, but in reality, it is an element of great

importance and large global reinsurance groups may provide individual domestic
insurers with a broader vision and advice on the various solutions that there are in the
reinsurance industry for meeting a special type of need.

17.8.2 Preparing a Plan of Reinsurance Cessions

Once the guidelines set out in the foregoing point have been validated, drawing up is
proceeded to of a plan of operations for reinsurance cessions. This latter usually
contains the following four items:
372 17 Reinsurance and Coinsurance

• Type of reinsurance adopted (for example, proportional treaties, non-proportional

treaties, any facultative cessions) with details by line of business and category of
insurance.
• Percentage of cession of premiums and risks, level of net retention (in the case
that this can be applied depending on the type of reinsurance contract) with details
by line of business and category of insurance.
• Population registry of reinsurance undertakings and reinsurance intermediaries/
brokers used.
• Any recourse to non-traditional contracts of reinsurance.

Often, in cases of facultative reinsurance, the plan provides information needed

for an understanding of the strategy that an undertaking intends to adopt and
illustrates the costs and benefits deriving from expected underwriting.
Together with the plan of cessions, an analysis is also prepared of catastrophe
exposures (for example, earthquake risks, flooded, nuclear, etc.).
Finally, if the plan has contracts of reinsurance different from traditional ones, a
copy of the contract documentation or draft contract is attached so as to have
available all contract conditions and briefing elements needed.

17.8.3 Approval of the Plan and Related Audits

At the end of this process, the Board of directors of the undertaking approves the
plan and validates the strategy of risk cession and maintenance of portfolio balance.
From this point on, the functions of audit have responsibility for verifying
consistency with the strategy set in advance and the actual plan of cessions as well
as the criteria used for selecting reinsurers. Special attention is given to an exhaustive
and timely updating of creditor positions in effect with reinsurers. Any variance
there may be from what is laid down in the plan of cessions must be promptly
reported to the Board of directors of the undertaking.

17.9 Definition of Direct Coinsurance and Contribution

Coinsurance is insurance of the same risk by a number of insurers. If there is a loss,

each of the co-insurers must meet the indemnity due in proportion to the quota of
insurance that concerns it. Coinsurance may be of two types: direct coinsurance and
indirect coinsurance (contribution) (For the representation of Coinsurance, see
Figure 17.9).
The first form, i.e. direct coinsurance, occurs when the insurance of risks
relating to the same items and/or persons is shared among a number of insurers in
determined shares. The contract signed by all insurers is a single one. If there is a
loss, each insurer must pay the indemnity due only in proportion to its respective
quota. Technically, there is a list of the insurance undertakings with an indication of
17.9 Definition of Direct Coinsurance and Contribution 373

Insurer A

Fire risk for One insurance

direct coinsurance Insurer B
house policy

Insurer N

Assured

One insurance policy Insurer A

Fire risk for

contribution One insurance policy Insurer B
house

One insurance policy Insurer N

Risk transfer

Fig. 17.9 How direct coinsurance and contribution work

their relative quotas of the risk9 the total of which must come to 100%. This is a
so-called coinsurance schedule. This listing forms an integral part of the policy.
Each insurer risks or undertakes to pay a loss up to the quota that it has accepted and
that is indicated in the policy. The first insurer on the list and that issues the contract
where this schedule appears is called the leader. The contracting undertaking is
called the leader since it leads the other co-insurers in managing the contract,
whereas the other undertakings that follow in the schedule are called co-insurers.
The leading undertaking is usually the one ensuring the largest quota and managing
the contract including the function of premium collection at the due date, and paying
indemnities, crediting and debiting the other undertakings with what is of their
concern.
A contract scheduled in quotas between coinsurance undertakings generally
foresees a single leader party. However, there may be cases where a special interest
applies in having multiple and shared leadership. In this case, there is an alternate
leadership, i.e. a special form of participation in coinsurance in quotas of risk and
where the original leader undertaking called upon to manage the contract alternates
in its functions with a second undertaking. The other insurance undertaking, called
joint leader, may take part in managing the contract at the same time and so be
awarded the same functions as the leader. The reasons underlying this operation can
be found in the fact that the joint leader undertaking has committed to sizeable
participation. The second form, i.e. contribution, arises when the insurance for the
same risk and on the same items is with different insurers under different policies. In
this case, we have insurance with different insurers, as there is no agreement
between insurance undertakings prior to concluding the policy. Each policy has been
concluded at a different time and with different insurers, even if not necessarily by

9
The term is in common use and means the extent of the participation of the undertaking in a risk
taken on in coinsurance. Indeed, it is normal practice to define the process and “participating in
quotas and/or underwriting a quota of x%”.
374 17 Reinsurance and Coinsurance

the same policyholder, but rather on the same risk. If there is a loss, a report needs to
be made to all insurers, from each of which the assured may claim indemnity as per
the contract, provided the aggregate sums collected do not exceed the amount of the
loss. In a number of jurisdictions, if there is a wilful omission in reporting, loss of
indemnity is foreseen in all the contracts. If the sum of indemnified exceeds the
amount of the loss, each insurer must pay only its “rateable proportion” based on the
indemnity calculated in accordance with its own contract, excluding any joint
liability with other insurers. Contribution leads therefore to a charge on the assured
to manage the loss which increases proportionally as the number of insurers
increases.
As compared with reinsurance, which has dealt with previously, coinsurance is
something the policyholder of the policy is aware of and there is actually a legal
relationship between the policyholder and the individual co-insurers (either because
they are part of a single contract or because they are individual counterparties in
different contracts). In reinsurance, on the other hand, there is no legal relationship
between the policy policyholder and the reinsurer.

17.10 Questions

1. What is the definition of reinsurance?

2. Indicate the three types of contract of reinsurance.
3. What is meant by cut-through?
4. Explain how the surplus reinsurance treaty works.
5. What is the meaning of indirect coinsurance (contribution)?

Suggestions for Further Study

Brahin P, Chatagny JM (2015) The essential guide to reinsurance. Swiss Re Corporate, Zurich
Clark DR (2014) Basics of reinsurance pricing, actuarial study note FCAS. https://www.casact.org/
library/studynotes/clark6.pdf
Robert Merkin R (ed) (2007) A guide to reinsurance law. Informa Law from Routledge, London
Swiss Re (2010) The Essential Guide to Reinsurance. Zurich, Swiss Re
Turchetti G, Cannizzo S, e Trieste L (2012) Natural and man-made disasters: challenges and
international perspectives for insurance. In De Guttry A, Gestri M, e Venturini G (a cura di),
International disaster response law. Springer Verlag
 Part III
Business Models and Processes
in the Insurance Industry
Business Models for Insurance
Undertakings 18

Abstract

This chapter aims to illustrate the business models of the insurance industry.
There are five business models for insurance undertakings in the insurance
industry: an elementary structure, a functional structure, a divisional structure, a
matrix structure and a network structure. Each of these five structures has its own
peculiarities and related advantages and disadvantages. Alongside the five models
shown, a hybrid structure is also illustrated, and which arises from combining
those that already exist. Furthermore, the new "insurtech" business model that is
changing the traditional approach is described.
Dealing with these continues by explaining the concept of process is
explained. We then move on to a description of the value chain. This model
allows us to describe the structure of an organisation as a series of processes and
activities (primary and supporting) that are linked together. Primary activities
contribute directly to creating an output, whereas supporting activities do not
contribute directly to creating an output but are rather needed for this to be
produced.
Finally, the chapter concludes by dealing with the IT system of an insurance
undertaking. This is presented as a series of information technologies, IT infra-
structure and applications that allow the activities and processes of an insurance
undertaking to be managed in an automated fashion.

Keywords
Organisational structure · Elementary structure · Functional structure · Divisional
structure · Matrix structure · Network structure · Hub · Hybrid structure ·
Insurtech · Process · Activity · Value chain · Primary activity · Support activity ·
IT system

# Springer Nature Switzerland AG 2024 377

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_18
378 18 Business Models for Insurance Undertakings

18.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Define the concept of organisational structure

2. Describe the characteristics of the five different types of structure (elemen-
tary, functional, divisional, matrix and network)
3. Know the peculiarities of and differences between the different structures
and explain the hybrid structure
4. Describe the definition of the new business model “insurtech”
5. Illustrate the meaning of insurance process and activity
6. Explain the value chain (primary activities and secondary activities)
7. Present a schematic of insurance business through the value chain
8. Set out the components of the IT system of an insurance undertaking

18.2 Types of Organisational Structure

" Definition Organisational structure of an insurance undertaking means the
model of division of labour applying within a corporate situation. A division of
labour requires a defining of relationships between organisational units and identifi-
cation of the roles assigned to each unit.

In the insurance industry, no differently from what occurs in the industry sector, the
organisational models that are most widely adopted are standard ones. The models
begin with elementary types and move on to becoming more complex structures.
The models applying in practice are five in number and, as can be seen in Figure 18.1,
start with an elementary structure and a functional structure. The divisional, matrix
and network structures are then at a higher organisational level.
The elementary model and the functional one are typically adopted in contexts
that are more static and with but a few products, whereas the divisional model is
generally used when series of factors directly connected with the process of growth
of the undertaking arise, such as, an increase in volume and management complex-
ity. Finally, the matrix and the network models apply where the objective is to
increase the efficiency and effectiveness of the undertaking and put the excellence of
individual corporate units to good use. Just the same, a number of external factors,
such as the dynamics of the environment and strategic needs of the undertaking may
impact choices in organisational structure.
In forthcoming paragraphs, the features of each of the five models mentioned
above will be illustrated.
18.3 The Elementary Structure 379

Organizational
complexity
Network
Structure
Matrix
Structure
Divisional
Structure
Functional
Structure
Elementary
Structure

Phases Start Up Single product Market Production efficiency Focus on the

Single channel presence Commercial effectiveness Excellence

Fig. 18.1 Types of organisational structure

18.3 The Elementary Structure

" Definition An essential feature of the elementary structure is that it has a
division of labour based on a principle of technical specialisation, aggregating
together organisational units exclusively by common concerns and technical
direction.

A typical example is the creation of specialist operating units for the activity of
underwriting, the process of settling claims, management of the commercial net-
work, accounting activity, etc. Figure 18.2 represents the outline of the elementary
structure.

Directive
Top Management level

Technical Commercial Operational

Service Units …
Insurance Units Sales Units units

Fig. 18.2 Elementary structure

In this model, there are only two governance body levels found: a directive level,
which performs a function of economic-financial governance at the head of the
organisation, and an operational level, which coordinates and monitors the activities
of underlying structures. The underlying structures are made up of operational units
composed of individual persons engaged or resources who have the same skills and
380 18 Business Models for Insurance Undertakings

specialisations. An elementary structure is generally the outcome of non-formal

agreements rather than a representation of a codified organisational chart. Addition-
ally, there is no specific functional chart applying, with details of tasks and
attributions of individual roles. This characteristic is one of its strong points, as it
ensures that this structure has a great deal of operational flexibility.
An elementary structure is to be found mainly at the start-up stages of insurance
undertakings when organisational processes are still being defined at the various
levels. Therefore, it is typically widespread among small organisations.
The main characteristics of an elementary structure are two in number. On the one
hand, its limited structure leads to a low degree of formalising both vertically and
horizontally. There is a high degree of centralising and usually has a sole head. In
this model, more complex functions, such as staffing, are not to be found. Solutions
such as decentralising or outsourcing of a number of very specialist activities, and
ones that are non-essential to the functioning of the industrial activity, are present
(such as a control function1) so as to keep the structure lean and flexible.
On the other hand, a family (or clan) reasoning, favoured by a restricted group,
leads to a high degree of cohesion and a sense of parity-equality in the treatment of
staff. This has indisputable advantages from the standpoint of a limited operational
group but cannot apply (and loses its added value of bonding between members) in
larger groups or at the mature stage of an insurance undertaking.

18.4 The Functional Structure

" Definition In a functional structure, the organisational unit of reference is the
function, which is typically identified as, and aggregates, a series of activities of the
same kind and which are sequential and complementary to each other. Thus, the
same functions as in the elementary structure are found here formally (Underwriting,
Claims Settlement, Commercial, Administration, etc.) are found here formally, but
with a significance and complexity that are quite different.

Figure 18.3 represents the outline of the functional structure.

A functional model, although it represents a level of complexity that is greater
than the elementary model, is still a simple form of organisational arrangement for an
insurance undertaking. This model ensures the start-up and governance of the
characteristic activity, as far as management of average complexity. However, as
the range of products or the diversification of corporate business in different sectors

1
The possibility of doing this is admitted under the regulations of a number of countries. This
possibility relates to the size and operating features of the undertaking and the kind of business it
carries on.
18.4 The Functional Structure 381

Directive
Top Management level

Technical Commercial Sales Other Areas Functional

Insurance Area Area … model

Risks
Claims Operational
Underwriting … Sales Marketing … … …
settlement units

Fig. 18.3 Functional structure

increases, it becomes no longer able to meet the management needs of the

undertaking.
A functional model allows a good level of coordination and internal control to be
achieved within a single functional area, but the marked specialisation that
characterises each area may be an obstacle to the need for inter-function integration
and flexibility. For this reason, it is not suited to where market conditions are
changing continuously. In this sense, the model does not favour development and
growth in knowledge and professional abilities via inter-function exchanges. Staff
development is strictly guided along lines of vertical specialisation on own duties.
A functional structure is governed by a typical hierarchical ladder. All functional
heads report to top management.
A functional structure foresees a high degree of division of labour. For this
reason, it is found to be very efficient for corporate activities that are critical
(typically: sales, underwriting and claims management) and so is suited above all
to controlling costs and reducing waste to a minimum. It represents an ideal
arrangement for environments that are stable and which are generally straightfor-
ward, with market demands that are constant and that allow simple economies of
scale to be achieved in production and distribution. A high degree of centralising of
responsibilities and rigorous defining of organisational procedures are sufficient to
keep to a good state of efficiency at this level.
The limits of the functional model however derive from the very features of the
structure just described. Firstly, each function risks pursuing maximum efficiency
for itself, but not for the entire undertaking and to the detriment of overall
optimising. On the contrary, especially where there are insurance undertakings that
are larger, this structure may lead to difficulties in inter-function coordination with
resultant conflicts between the various functions. Finally, potentially adverse
influences on the attitudes of persons need to be borne in mind; a highly structured
scheduling of the work of each function may mortify the creative capabilities of staff
involved or generate conflicts between groups that are in some way adversary to
each other.
382 18 Business Models for Insurance Undertakings

18.5 The Divisional Structure

" Definition A divisional structure foresees as a unit of reference a division,
which is understood as being an autonomous body that is independent in respect of
the decisions that are the concern of its area of reference. In this model a high degree
of decentralising in decision-making and operation is widespread. Divisions are set
up to manage products or markets of reference autonomously.

Divisions are in general constituted on the basis of homogeneous profit centres. Each
division is characterised by there being a person responsible and by being placed in a
well-defined manner in the corporate organisational chart. Thus, a division is an
autonomous business unit, which is sufficiently small as to be flexible, but large
enough to exercise independent control over most of the factors that have a bearing
on its results. Figure 18.4 represents the outline of the divisional structure.
From the standpoint of operation and decision-making, divisions enjoy a high
degree of autonomy and their own mission, although they rely on corporate top
management in determining objectives to be achieved.
Adopting a divisional model is recommended when it is necessary to have
customised oversight in managing specific products and markets. In essence, in
order to improve the response to the product and the market, the undertaking splits
up internally, creating ad hoc divisions. This means that the criterion for an insurance
undertaking applying a divisional structure depends on the specifics of its business
once a certain substantial size has been reached. In general, creating a new division
for markets allows one of the three areas of reference, client segments, distribution
channels and geographic areas, to be governed to the best advantage. This latter case
is the typical one applying to multinational insurance undertakings.
As divisions contain numerous functions within them and have a high degree of
autonomy with respect to top management, it can be said that every small division is
like a stand-alone undertaking. For this reason, a divisional structure will often
encounter problems of coordination between the various divisions, as achieving
general objectives does not always mean maximising divisional profit. Other issues
can arise also from a lack of coordination between divisions and top management, or
from duplication of functions and roles in each division.

Directive
Top Management level

Division Division Other Division Divisional

Product A Market B … model

Technical Commercial Technical Commercial Operational

… … … …
Insurance Sales Insurance Sales units

Fig. 18.4 Divisional structure

18.6 The Matrix Structure 383

18.6 The Matrix Structure

" Definition A matrix structure has the purpose of maximising jointly both the
objectives of functional units and those of a planning vision. A matrix structure may
be defined as a sort of modified functional organisation, with the difference that the
work of direction is carried out on the basis of two different criteria (a functional one
and a planning one). The matrix foresees there being two separate managers, but
ones who are jointly responsible for achieving objectives.

It is not a coincidence that this system of multiple management is called two-boss

management since it features the presence of a hierarchical functional head and a
specialist project head. Therefore, within the matrix, staff always report to two
heads. A matrix structure is represented by two axes: a functional one (for example
claims settlement, Marketing etc.) and one relating to the subject matter to be
governed. For the matrix structure, see the representation in Figure 18.5.
In reality, usually, the subject matter to be governed via the second axis is usually
one of these four: client segment (corporate, small business, retail, etc.), distribution
channel (agent, brokers, online, etc.), the product (personal lines, asset protection
etc.), geographic area (domestic market, foreign market, USA, etc.). This latter
aspect is often present in multinational insurance undertakings.
A structure of this type is able to ensure broad flexibility of resources, without
duplications of roles and functions. On the other hand, the risks deriving from

Top Directive
Management level

m t
ai en
Cl lem
tt
se
units

Fig. 18.5 Matrix structure

384 18 Business Models for Insurance Undertakings

conflicts between managers increase as a single final umpire may indeed be missing.
In this model, a culture informed by collaboration is found to be essential, and without
which the risk of privileging one aspect over another is a trap that can be fallen into.
For this reason, promoting coordination and strengthening flexibility is critical to
success. Finally, as this structure is typical of large groups, a constant problem that
should not be underrated may be that of a decision-making chain that is too long.

18.7 The Network Structure

" Definition A network structure features a system of connections (called nodes)
within which various organisational units operate. Rather than speaking of an insur-
ance undertaking in the strict sense, in these cases, it is truer to refer to an aggregation
of insurance undertakings. This structure can be described schematically as a net with
many nodes which relate to a central coordination, even via intermediaries.

The system is only slightly hierarchical and very participative. Figure 18.6
graphically represents network structure.
The central node coordinates the others using traditional hierarchical tools to a
lesser extent (for example, procedures, organisation charts, etc.) while referring more
to common strategies (for example, mission, planning, reporting, marketing, etc.). In
its turn, each node carries out operating activities and coordinates with other nodes

Products
development
Claims
(Country B)
settlement
(Country C)

Commercial -
Sales
(Country D)
Top
Underwriting risks, Management
Portfolio management
(Country A)

Service Units
(Country E)
Coordination
Units
(Country F)

Fig. 18.6 Network structure

18.8 Comparing Organisational Structures 385

via a common operational platform. Each node counts within the network according
to its own importance in the various processes and not based on its size.
This type of undertaking works effectively when there is good integration
between economic and social issues. A network organisation is applicable either to
a large multinational undertaking, or to networks of domestic insurance
undertakings, either to systems of the regional economy or industrial districts. In
all cases, the local aspect is in any event basic, though in a different way. For
example, for large multinational insurance undertakings, when choosing the location
of its various nodes, checking upon two factors is discriminating: economic, fiscal or
labour cost advantages, and local excellence.

" Definition According to this reasoning, each node is a hub, i.e. an operating unit
whose excellence is recognised and for which there are economic advantages. A
typical example is the research and development centres located in countries where
that is a good education system, but staff labour cost is low all the same.

The virtues and flaws of the network structure concern its essential aspect:
complexity. On the one hand, this type of structure is able to bear a high level of
complexity, thanks to a multiplying of coordination centres and production units. On
the other, becoming ungovernable, duplicating costs and difficulties in
communications are the greatest limits this type of structure has. Growth in know-
how is another feature of a network structure. This is possible thanks to a capacity for
self-governance and the creative process of operating units of excellence in the
absence of a strong central authority.

18.8 Comparing Organisational Structures

During the various stages of their development, insurance undertakings often go

through the entire range of five types of the organisational structure illustrated above.
Table 18.1 brings together the main features of each structure and for comparison, so
as to allow an understanding of the different impacts on functions of the business.
Comparing the five structures is done by analysing the way a number of types of
organisational unit work. Six types of the organisational unit will be analysed:
technical-insurance, commercial, coordination, service control and inter-function
committees2.

2
The organisational units (OU) analysed are as follows:
1. Technical-insurance unit: product development, underwriting risks, portfolio management and
settling claims
2. Commercial units: sales and marketing
3. Coordination unit: strategic marketing
4. Service unit: management control, financial statements and fiscal administration, finance
5. Control unit: risk management
6. Inter-function committees
Table 18.1 Table of comparison between types of organisational structure
386

Functional
Elementary structure structure Divisional structure Matrix structure Network structure
Prevailing aim and Start-up Single product— Market presence Production efficiency Putting excellence to
stage of undertaking single channel commercial good use
effectiveness
Product development Units common to the Specialisation of Units replicated in each Highly specialised units Each unit is a hub of
(tech.-ins. OU) whole undertaking the units of product division depending on the excellence (this leads to
Underwriting risks centred under the manufacture specific skills that localising in a certain
(tech.-ins. OU)) responsibility of a key provide their services/ area) locally there is only
Portfolio person products to commercial the minimum presence
management units required by the context
(tech.-ins. OU) and regulatory
compliances.
Claims settlement
(tech.-ins. OU)
18

Sales (Comm. OU) Specialisation of Units that receive

Marketing activities of services/products from
(Comm. OU) contacts with the technical units. Units
market distinguished based on
the channel or segment
where present
Strategic marketing Units present in an Directly serving Directly serving top Directly serving top
(Coord OU)) informal unstructured top management management management
fashion
Management control Units that are Positioning in line Services provided to all Services provided to all
(Serv. OU) accessory to the or staff of top divisions (at times divisions
Admin. Fin. primary business management replicated within
Statements, fiscal depending on its individual divisions for
(Serv. OU) importance analysis of results up to
Finance (Serv. OU) the margin of concern)
Business Models for Insurance Undertakings
 18.8

Risk management Units with specific Services provided Services provided to all Services provided to the Units tightly bound
(Contr. OU) concerns—often to the whole divisions whole undertaking locally due to regulatory
outsourced undertaking constraints
Role of committees Present in an informal Set up to facilitate Coordination of Decision-making tool for Decision-making tool for
unstructured fashion and ensure inter- activities between operational choices and operational choices and
function relations divisions (top-down conflict resolution conflict resolution
alignment of strategy
and bottom-up
collection of indications)
Comparing Organisational Structures
387
388 18 Business Models for Insurance Undertakings

Directive
Top Management level

Technical Commercial Sales Functional

Insurance Area Area Model

Risks
Claims Operational
Underwriting … Sales Marketing …
settlement units

Division Division Division Divisional

Product A Market B Market … Model

Fig. 18.7 Hybrid structure

The table can be read either horizontally or vertically. Horizontal reading

highlights the differences in working for each organisational unit depending on the
type of structure in which it finds itself. Vertical reading allows a short description to
be had of how a type of structure functions.

18.9 The Hybrid Structure

" Definition Within the insurance panorama, there also exists a hybrid structure
that arises from combining those that already exist. The one that is most widespread
comes about from the union between a functional structure and a divisional structure.

In this case, a number of units come into a functional scheme, whereas others fall
into a divisional one. Figure 18.7 graphically represents this model.
This structure allows the efficiency that is typical of the functional model to be
achieved while holding on to the commercial efficacy that is peculiar to the divi-
sional model.

18.10 Insurtech: The New Business Model

Digital transformation and new technologies are changing the traditional insurance
industry: Big Data, Artificial Intelligence (AI), Blockchain, Internet of Things (IoT),
spot insurance and Apps are some of the most important new trends that are
changing the business (production, management and distribution) of insurance
services to customers.
18.10 Insurtech: The New Business Model 389

The neologism insurtech comes from the union of two words insurance and
technology, thus identifying a new business model that is based on innovation in the
insurance industry: software, applications, start-ups, products and services.
The approach underlying insurtech takes its cue from the financial world, which
previously coined the term fintech (finance and technology). Insurtech is therefore
very similar to fintech, both in terms of impact on traditional insurance undertakings
in the industry and in terms of the technological fundamentals.
Insurtech means a new business model driven by a Hi-Tech approach for the
insurance industry. Application of new technologies in the insurance industry is one
of the pillars of insurtech. The innovation concern the entire supply chain of the
industry: insurance undertakings, distributors and other competitors (for example,
claims, settlement firms, etc.). An insurtech player is characterized by a strong
technological feature, an insurance revenue model, and a set of tools and technologies
that aim to increase the efficiency and effectiveness of insurance products.
From an operational point of view, insurtech can be, by way of example only:

• An application (App) that allows to offer temporary policies for a short period of
time based on the customer's needs (geolocation and spot insurance in real time).
• A solution that allows to sign policies in a safe and transparent way thanks to
Blockchain technology.
• A digital platform that, through facial recognition, is able to offer a personalized
insurance package.
• A chat box that offers assistance in the event of a claim through the use of tablets
or smartphones and which is based on automatic image recognition technology.

Insurance undertakings that are exploring the technological innovation have

initiated both redesigning the internal value chain and identifying new areas of
competition in the industry.
With regard to organizational processes, the impacts within insurtech
undertakings concern:

• Operational efficiency on core processes (for example, robotic automation, image

recognition, blockchain, IoT etc.).
• New decision-making processes to support management choices (for example,
Artificial Intelligence (AI), virtual assistant etc.).
• New organizational structures (for example, research and development (R&D)
units, talent gardens, innovation farms etc.).
• Management of traditional sales channels towards the integration of a new
omnichannel strategy.

With regard to the identification of new areas of competition in the industry,3

usually they are the following three:

3
For the explanation of new technology-based insurance products, see Chap. 9 (see the paragraphs
smart illness policy and telematics, Automobile insurance and telematics, homeowner insurance
and telematics, etc.).
390 18 Business Models for Insurance Undertakings

1. Welfare/health: offering of insurance solutions integrated with new services (for

example, devices, online reservations, prevention, etc.) and technological
products (wearable).
2. Mobility: management of transportations and provision of services (i.e. travel
planning) and intelligent solutions for the different mobility.
3. Home/domotics: offering of insurance solutions integrated with technologies
device (i.e. homebox) for improving the quality of life and safety in the home.

As for the success stories, Lemonade is a US insurtech start-up in the non-life

business. The company is only virtual and the contact points are possible via mobile
device. Lemonade's AI-powered App allows customers to get a personalized quote,
sign up and be insured in just 90 seconds. Similarly, customers can ask questions and
get a claim settled in just three minutes. Another example is Ping An Insurance,
China's largest online insurance undertaking. Ping An Insurance relies entirely on
technology and offers technology platforms and services for its clients. In particular,
the new digital technologies consist of:

• Artificial intelligence (AI) applied in health care and services for smart cities (for
example, technologies for the face recognition and medical images, etc).
• Blockchain that allows the management of all data flows through a proprietary
technology, a platform and dedicated algorithms.
• Cloud computing that supports all services efficiently and securely for the entire
insurer and its customers.

18.11 Insurance Processes and Activities

" Definition In a corporate situation, a process is defined as a sequence of
activities aimed at achieving a common objective. A process commences with one
or a number of inputs which are then transformed, activity after activity, so as to
produce an output. At each transformation, value is added. Changes in the input are
made by the use of corporate resources (persons, materials and structures).

" Definition An activity is a series of elementary operations that are performed to

modify an input. Activities consume economic resources4. Activities may be split
into three: interventions upon physical objects, operations upon information systems
decisions taken.

The information flow is a series of data and knowledge used for the performance of
a process. In cases wherein a corporate function involves a number of parties, the
flow serves to coordinate the activities performed by each of them.

4
For a definition of activity see the Activity Based Costing method dealt with in Chap. 33.
18.11 Insurance Processes and Activities 391

Firm Infrastructure
Support Activities

Human Resource Management

Technology Development

Procurement

Outbound Logistics

Marketing & Sales

Inbound Logistics

Operations

Services
Primary Activities

Fig. 18.8 Michael Porter’s value chain

18.11.1 The Value Chain

" Definition The value chain is a model that allows the structure of an
organisation to be described as a series of processes and activities5 that are linked.
In this model, a corporate organisation is described as a series of nine activities, of
which five are primary and four are supporting.6

See Figure 18.8 for a schematic representation.

" Definition Primary activities are those that contribute directly to creating out-
put, product or services for a productive undertaking. These are the typical activities
for which an undertaking is recognised externally. They represent the heart of the
undertaking. In economic terms, if the cost incurred for goods and services is
subtracted from the value of primary processes, the margin is found.

In an insurance undertaking, the following five are primary activities: inwards

logistics, operational activities, outwards logistics, marketing and sales, after-sales
services.

5
Reference is made to the model put forward by Michael Porter in 1985 and made known through
the best-seller Competitive Advantage: Creating and Sustaining Superior Performance.
6
In the text by Porter, the concept of process was not set out, but rather only that of activity. The
concept of corporate process would be introduced into the literature only later, in 1991. See Lynch
R. L., Cross K. F., (1991) Measure Up – The essential guide to measuring business performance,
London, Mandarin.
392 18 Business Models for Insurance Undertakings

Inbound logistics includes all activities for managing the flow of physical goods
into the organisation and related flows of inputs that feed into operational activities.
Operations foresee transforming inputs into finished products: preparation,
processing and transforming.
Outbound logistics includes all activities for managing the flow of physical
goods outwards from the organisation and flows that carry the results of operational
activities to the market.
Marketing and sales include all activities of promotion of the product and service
in the marketplace, also including management of the sales process (e.g. advertising,
promotion, special offers, salesforce incentives, etc.).
Services include all the activities after sales that are of support to the client.

" Definition Supporting activities do not contribute directly to creating an output

but rather are needed for this to be produced. In an insurance undertaking, support
activities are as follows: human resource management, purchasing, technology
development and infrastructural activities.

Human Resource Management includes all the activities relating to personnel

such as: search, selection, hiring, training, education, refreshing, growth, mobility,
compensation, reward systems, contract negotiation etc.
Procurement activities are the whole series of activities dealing with acquiring
resources needed for producing output and running the organisation.
Technology development contains all the activities aimed at improving product
and processes. These activities are identified in general with the process of develop-
ment and improvement of the product/service.
Firm Infrastructure include other activities such as planning, accounting,
finance, organisation, legal affairs, direction and coordination, etc.
Drawing on the value chain model, in the next paragraph, two schematic
presentations of the processes and activities in the insurance business are proposed.

18.11.2 Insurance Activities and Processes

Representing the insurance business by way of processes follows the Porter value
chain and breaks the activities for producing insurance products and services down
into primary and secondary ones. See Figure 18.9 for a chart: Primary activities
consist of 6 macro-categories, and there are 13 secondary ones.
Among primary activities, the first macro-category is made up of: product
development and launch, client needs analysis and quoting. Activities are distin-
guished between those that are typical of an insurance undertaking at a management
level and those that are tied to channels of distribution for promoting the product.
The second macro-category is made up of: sales, offers, underwriting, issue and
collection. The third is the handling of claims and settling of life insurance
performances. The fourth category concerns calculating reserves. The fifth relates
to portfolio management (releases, technical accounting, intermediary accounting,
18.11 Insurance Processes and Activities 393

Management of finance, treasury and investments

Management of reinsurance
Marketing (strategic, operating and product)
Administration of Financial Statements and tax
Support Processes

Planning and management control

Management of information systems
Management of human resources
Corporate management and organisation
Legal support (corporate, secretarial and product)
Control systems (risk management, internal audit, compliance, Actuary, AML)
Internal and external reporting and communication
Management and control of outsourcing
Direction and coordination

Products Portfolio
Sales
Primary processes

Development Claims Managements

Channel
and Launch Offering settlement (release, support
Customers Underwriting Life Reserving technical, (training,
demands & performances calculation accounting Administrative
Issuing
Needs Analysis settling distributors Audits, …)
Collection accounting,
Quotation
archiving, …)

Fig. 18.9 The value chain of insurance activities

archiving, etc.) Finally, the sixth concerns assistance given to channels by activities
such as training, online control, etc.
Support activities, on the other hand, include all processes needed for the
undertaking to function but not necessarily linked to primary activities. These
consist of the following 13 processes:

• Management of finance, treasury and investments.

• Management of reinsurance.
• Marketing (strategic, operating and product).
• Administration of Financial Statements, fiscal.
• Planning and management control.
• Management of information systems.
• Management of human resources.
• Corporate management and organisation.
• Legal support (corporate, secretarial and product).
• Control systems (risk management, internal audit, compliance, Actuary, AML).
• Internal and external reporting and communication.
• Management and control of outsourcing.
• Direction and coordination.

A further schematic view distinguishes the business between activities market

oriented (pre-sales, sales and after-sales) and support activities. Figure 18.10 shows
this set-up.
As can be seen in the schematic diagram in Figure 18.10, the activities included
are the same as in the representation of the value chain described above but grouped
differently.
394 18 Business Models for Insurance Undertakings

Pre-sales Sales Post-sales

1. Proposal
1. Products Development 2. Underwriting 1. Claims settlement - Life
and Launch 3. Issuing
performances settling

2. Customers demands & 4. Collection 2. Reserving calculation

Needs Analysis 3. Portfolio Managements
3. Quotation (release, technical,
accounting distributors
accounting, archiving, …)

4. Channel support (training,

Administrative Audits, …)

support activities
1. Management of finance, 6. Management of information systems 10. Control systems (risk management, internal
treasury and investments 7. Management of human resources audit, compliance, Actuary, AML)
2. Management of reinsurance 8. Corporate management and organisation 11. Internal and external reporting and
3. Marketing (strategic, operating 9. Legal support (corporate, secretarial and communication
and product) product) 12. Management and control of outsourcing
4. Administration of Financial 13. Direction and coordination
Statements and tax
5. Planning and management
control

Fig. 18.10 Stages of insurance business and processes

18.11.3 Components of the IT System

" Definition The IT system of an insurance undertaking is a series of information

technologies, IT infrastructure and applications that allow the activities and pro-
cesses of an insurance undertaking to be managed in an automated fashion.

Continuing in this paragraph, the architecture that is typical of an IT system of an

insurance undertaking is presented, and its components described in detail. Fig-
ure 18.11 representation of an example of IT system in the insurance business.
The front end (and interaction with channels) consists of the series of access
points that an insurance undertaking makes available for operations on the products
and services it offers. From the technical standpoint, it is usually the IT support that
is used both by the staff of the undertaking, by the distributors, and by the client for
accessing the services on an ongoing and delocalised basis. This is the interface that
manages and sends inputs necessary for the data entry and tariffs for products.
The tariff engine processes tariffs and manages the different types of product. By
means of this module, the customised price of products can be calculated according
to client requests. Management of derogations and underwriting blocs is included.
Finally, it contains all technical information such as, for example, formulas, rules,
covers, tariffs, etc.
The client population register includes a census of clients and their univocal
identification. It manages both information of a strictly population register type, such
as name, surname and fiscal code, and information with an impact on the tariff such
as date of birth, place of residence, etc.
18.11 Insurance Processes and Activities 395

Front end and interaction with channels

Portfolio
Customers data
Management
Tariff engine Customer Archiving
Technical
Relationship
accounting
Management - CRM

Claims settlement

Collections and payments

General accounting/ Distributors accounting

Finance

Risk Management system Reinsurance

Datawarehouse

Management Reporting / Reporting for Regulator

Fig. 18.11 The architecture of the components of an IT system

The CRM (Customer Relationship Management) module makes it possible to

manage clients at all stages of the process (from pre-sales to after-sales). This module
is supplemented by marketing policies and commercial initiatives. It is used to
prepare campaigns and analyse client needs.7
Portfolio management includes a series of operations to manage the portfolio of
policies and archiving of related documents. The portfolio is fed directly by
operations of channels via delivery of new policies and/or modifications made to
existing policies. The data it contains are recorded by technical accounting.
Technical accounting is the module that makes it possible to manage accounting
and non-accounting items connected with variations occurring in the policy portfo-
lio. The system foresees the reconciling and closing of technical items between the
management portfolio and the general accounting of the undertaking.
Documentary management provides support for the operation of processes of
pre-sales and after-sales in terms of document flows between the client, the sales
channel and the insurance undertaking. It makes the pre-contractual documentation
necessary for developing the offer available to the front-end.
The claims system includes all the support functions for managing losses. There
is a specific workflow foreseen for all stages; reporting, case file opening, verifica-
tion and setting-up, negotiation and settlement.

7
For an explanation of the CRM approach, the reader can see Chap. 24—Marketing.
396 18 Business Models for Insurance Undertakings

The collections and payments module provides the undertaking with all the data
needed for tying the premiums issued to the flow of payments. Financial outgoes of
the undertaking are determined by payment of claims, payment of capitals or
annuities or disbursement for invoices from suppliers.
The general accounting module allows accounting detection of administration
and management events for the undertaking. Accounting is fed automatically

• By the technical system for data referring to collections and payments for policies.
• By the finance and treasury system for data concerning securities and investments.

This module additionally allows two summary prospects to be drawn up: the balance
sheet and the profit and loss account. Intermediary accounting enables the manage-
ment of commissions to be paid to the sales network.
The finance management system is based on three platforms: trading in securities,
accounting for securities and calculation of their market value. The system is often
supplemented by modules for Asset Management concerning pricing and in respect
of the population register of all assets.
The Risk Management module enables risks to be identified and assessed. It
permits their being monitored and reporting to corporate management. Within this
system, analyses of Asset Liability Management and capital cover by line of
business in accordance with Solvency II regulations are carried out.
The outgoing reinsurance module allows the series of transactions needed for
managing reinsurance treaties to take place. From the operational standpoint, both
the cession plan and calculation of the technical items of the statement between
reinsurers and insurance undertaking are managed here.
The data warehouse is fed by all the IT management systems set out above. This
permits a broad view to be had of all the information there is and makes it easy to
produce reports, even extraordinarily complex ones. The reporting system allows an
analysis to be made of results relating to the resources used and revenues achieved
by the insurance undertaking. Usually, a processing of data, and statistics in line with
what is required by corporate strategy, are foreseen within the module.
The system producing the regulatory forms allows the information required by
the oversigh Authority to be prepared.

18.12 Questions

1. What is meant by organisational structure?

2. What are the characteristics of the elementary structure?
3. Explain the advantages and disadvantages of the functional structure.
4. Describe the advantages of a divisional structure.
5. What is meant by the concept of two boss management?
6. Explain the meaning of hub and how the network structure works.
7. What are the characteristics of a hybrid structure?
8. What is the definition of insurtech?
Suggestions for Further Study 397

9. What are the support activities in the value chain for an insurance
undertaking?
10. What transactions enable the front end of an insurance undertaking?

Suggestions for Further Study

Porter M (1985) Competitive advantage: creating and sustaining superior performance. Free Press
MacMillan, New York
Nicoletti B (2016) Digital Insurance: Business Innovation in the Post-Crisis Era Palgrave
Macmillan:2016
Competences and Organisational Functions
19

Abstract

This chapter begins by defining an organisational chart. This chapter describes in

detail the activities and roles played by each of the components of the
organisational structure. It commences with a description of the governing
body. After this, two other types are described: the organisational units of
coordination and direction and staff organisational units. The former oversees
the achieving of strategic guidelines defined by Top management. The latter deal
with managing relations outside the insurance undertaking with bodies and
institutions.
Special attention is given to describing the activities performed by the
functions of control, which inquire into actual achieving of the objectives set by
the apex through monitoring the various activities of the undertaking.
Lastly, service organisational units, technical insurance organisational units
and commercial-distribution organisational units are described.
Finally, the activities and tasks of coordination committees and which watch
over collegial decisions, mainly of a technical and institutional kind, are
explained.

Keywords
Organisational chart · Functional chart · Internal regulations · Job description ·
Internal corporate circular · Governing body · Unit of coordination and direction ·
Unit of staff of the of governing body · Service units · Control function units ·
Technical-insurance unit · Sales-distribution unit · Coordination committees

For this chapter, a special acknowledgement goes to Maurizia Cecchet (HR Director in insurance
industry)

# Springer Nature Switzerland AG 2024 399

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_19
400 19 Competences and Organisational Functions

19.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Define the concept of organisational structure

2. Explain what an organisational chart is
3. Illustrate how an organisational hierarchy works
4. Describe the roles and activities of the units of an insurance undertaking

19.2 The Organisational Structure of an Insurance Undertaking

The organisation of an insurance undertaking is made up of a series of characteristics

that allow it to function and are one of the strengths of the undertaking, describe it
and distinguish it in the industry and from competitors.
The scale of the firm is one of the most important aspects of the organisation:
insurance undertakings need to achieve high volumes of production in order to fully
perform their function of taking on risks and to be able to fully pool risks and benefit
from the law of large numbers. Large size is a benefit both in terms of stability and
solvency for an insurance undertaking and a guarantee vis-à-vis assureds; it is a
decisive factor in defining external growth strategies.
Organisation structure is one of the strategic variables available to corporate
management in achieving its corporate mission: the type of organisation that the
undertaking decides to equip itself with impacts both on operations and results and
conditions the way it relates with the outside environment.
Defining the organisational structure of an insurance undertaking requires
identifying all the factors that, at different levels, fit together to make it work.
We speak of the organisational structure of an insurance undertaking when all the
parties taking part in carrying on its business are framed in accordance with
principles of a division of labour and operational coordination; items that need to
be clarified from the general standpoint (i.e. in a system) are relations of formal
dependency, organisational units and operating models.
Identifying and laying out relationships of formal dependency means indicating
hierarchies of staffing in the insurance undertaking and specifying the various evils
of connection and range of action (including a span of control, i.e. the areas of
hierarchical reporting for managers and supervisors).
A grouping of personnel within operational units, each of which must perform
specific functions in accordance with the hierarchies indicated.
Finally, visibility needs to be given to operation mechanisms that move the
framework just set out: they watch over the effectiveness of coordination, integration
and communication between organisational units so that complex objectives can be
achieved.
19.2 The Organisational Structure of an Insurance Undertaking 401

The three factors just indicated should not be taken in isolation but are rather here
distinguished solely for the sake of clarity of illustration: within an insurance
undertaking the various organisational units interact and communicate via
hierarchies and based on models that allow them to be coordinated.

19.2.1 Representing the Structure

The document that is generally used to set out the manner of interaction between the
various organisational units in an insurance undertaking is a corporate organisational
chart.

" Definition An organisational chart is no more than a graphic representation of

an organisational structure using geometrical figures (generally rectangles) linked by
lines: the former indicate the organisational units and the lines then visualise the
hierarchical relationships between them.1

Within the figures, the name of the unit and the name(s) of the persons responsible
must always be indicated; depending on the size of the undertaking (or the purpose
of the document); other information may be given in the boxes: for example, the
names of the staff, or specific further operational details.2 The organisational chart
on the vertical layout of the undertaking: it clearly indicate relationships of super-
and sub-ordination. An organisational chart thus remains valid if it has a certain
degree of completeness and detail of the elements that make up the undertaking, but
it cannot define all the micro-components: it is a tool of summary aimed at
displaying arrangements in general.
Beyond the overall setting out of this representation—which may appear as a
pyramid, flag, tree or a mix of these—the manner in which the figures used in the
organisational chart as connections remain the same for each graphic solution as they
have a univocal solution: vertical linking indicates hierarchical dependency and
horizontal liking, a parity of level; this applies irrespective of actual relationship.
Two organisational units may occupy the same hierarchical level but never actually
collaborate directly.
While an organisational chart shows the vertical scale of an insurance undertak-
ing, a horizontal display is achieved by the functional chart.

" Definition Functional chart is a graphic tool indicating and systemising all the
functions performed by an insurance undertaking and showing the essential
connections that create the overall structure. The graphic grid is thus not quite
different from the organisational chart, but the boxes simply match the various
functions and indicate areas of activity, range and tasks.

1
Note that “functional” relationships are represented with a dotted line.
2
In this second case, use tends to be made increasingly of a specific document, the functional chart.
402 19 Competences and Organisational Functions

In this case, too, different purposes and scale of undertaking lead to greater
complexity in the document: each function—especially if it is a “macro” function-
may foresee a number of sub-functions when going into detail and that describe
content with greater precision, or more simply show more in-depth detail, such as the
concerns, special assignments, technical-scientific responsibilities that the function
actually requires.
These outlines are certainly similar, especially from the standpoint of the
graphics, but in order to understand an organisation in all its complexity, it is always
worth bearing in mind the differences there are in content between representing
responsibilities (organisational chart) and representing functions (functional chart).

19.2.2 Support Tools

" Definition In complex insurance and reference is often made to a document

called internal regulations where what the principles from which the undertaking
draws inspiration, the values it abides by and the purpose or purposes it operates to
achieve, are formally set out: in other words, what its mission is.

From a practical standpoint, on the other hand, the regulations translate the insurance
undertaking values into rules of conduct for everyone working and collaborating
with the undertaking in whatever capacity. The expression “in whatever capacity”
itemises the very fact that all the categories involved (managers, employees,
collaborators, representatives, etc.) will have rights, duties and specific
responsibilities listed in the document. The regulations additionally lay down
guidelines for conduct and the role and relationship to be held to on the part of the
undertaking with all parties it has relations with. In addition to being an explicit
invitation to abide by the rules and regulations applying in other places where
employees might find themselves working, internal regulations in general indicate
the main legal references in matters of labour, safety, privacy protection and trade
union rules. The regulations are usually updated and disseminated by the insurance
undertaking (through notice boards, internal newsletters and intranet).

" Definition The job description for each role on the other hand is a corporate
document with the purpose of making official and highlighting in a written form, the
functions and tasks that individual units deal with.

Via this document, which is much more technical than the previous one, it is
sought to reduce the impact of chance on the organisation of work to a minimum by
specifying what the main duties are (and how they must be performed); the very fact
that each person engaged deals mainly with a series that is more or less specific of
codified tasks, ought to represent a guarantee of acquiring specific skills. Increas-
ingly often in recent years, the range of the job description has extended to issues of
conduct and relationships. It has become a document from which a worker may draw
not only indications and suggestions for technical/professional areas of their work
19.2 The Organisational Structure of an Insurance Undertaking 403

but even the manner in which they relate to others and expectations as to conduct tied
to their role.3
Management of communicating variations and updates is done via internal
corporate circulars.

" Definition Internal corporate circulars refer to notices deriving from needs in
management, supervision and updating of the organisational structure of the under-
taking and which require an updating of the organisational chart, changes and/or
introductions to roles and responsibilities. They additionally indicate the adoption of
new structural, functional and internal operating models as well as the setting up of
working or project parties.

Internal corporate circulars are documents through which modifications to admin-

istrative procedures and work processes of organisational units are notified. These
documents are archived with a progressive numbering for internal protocol and form
a continual updating of the organisational chart.

19.2.3 Organisational Hierarchy

The hierarchy of the various organisational units is achieved in general according to

the following order of corporate levels (starting from the apex and working down-
wards): Top Management, Area, Department, Functions and Office. Figure 19.1
represents the outline of levels of hierarchy.
By Top Management of an insurance undertaking is meant both the process of
defining the objectives and the guidelines for pursuing them, and its collection of
managers (i.e. the persons who take on responsibility for the process indicated). This
function is carried out by those responsible via the taking of decisions as to the use of
resources (physical and human) available; specifically, in the traditional vision, this
function performs tasks of planning, organisation, guidance, coordination and audit4.
Going down one step in the hierarchy, all the activities carried on within an
undertaking are grouped schematically into Areas (or macro-areas) that, based on
the type of business which refer to a specific areas of action. Since we are here
dealing with groupings that are very general, the most common macro-areas are
administration, sales.
Within each area it is possible to identify various Departments, each of which
will group together all the activities that concur in achieving a process that is

3
Note the difference between job description and function chart. The former highlights the
functions and tasks of each unit. The second, on the other hand:

• Represents the map of interactions that define the process within the insurance undertaking.
• Outlines the areas of competence and responsibilities of each organisational unit.
4
See Crainer, S., Dearlove, D. (2003) The Ultimate Business Guru Book. The Greatest Thinkers
Who Made Management, Capstone Publishing.
404 19 Competences and Organisational Functions

Top Management

Areas (or macro-areas)

Departments

Functions

Office

Fig. 19.1 Levels of hierarchy

homogeneous (or part of it) and are aimed at producing an output. This is a way that
the different performances supplied by macro-areas indicated above are formalised
exactly what “services” the administration offers, what there is in respect of sales,
and so on. Since every department heads up a process—so further reducing the span
of action, the function is then reached, and this consists of a series of homogeneous
activities that are grouped together on the basis of the skills needs to perform them.
Here, we can make a general distinction between three types of function: 1) “line or
characteristic functions, 2) i.e. the typical activities of the undertaking: management
creation and selling products or services 3) “support or secondary functions, which
include all the infrastructure activities needed for these activities to be properly
carried out, and “service or staff functions”, whose task is essentially to provide
e-services of assistance and support to the various activities.
Finally, the last level is the office which, represents an “organisational item
characterised by being assigned of a single role and made up of one or more persons
and equipped with capital tools to perform tasks assigned by a division of labour”.

19.3 Components of the Organisational Structure

In complex insurance undertakings, organisational units may be grouped together for

each of the five levels indicated in the foregoing paragraph.
As we deal with this below, the typical components of an organisational structure
will be illustrated (units and mechanisms) irrespective of the level they occupy in the
corporate hierarchy. So, the activities, responsibilities and duties of each component
will be described as if it were a generic organisational unit.
There’s no distinction between a life and a non-life undertaking when dealing
with organisational units except where it is of fundamental importance to underline a
peculiarity there may be. Here, we will describe the typical units of a single and
19.3 Components of the Organisational Structure 405

Units for coordination

and direction

Governing Coordination
Body committees
Audit
functions Staff Units of the
Governing Body

Departmental Technical - Insurance Sales – Distributions

units units units

Fig. 19.2 Components of an organisational structure

individual insurance undertaking while not considering whether it is part of a group

of companies. Where we have the typical organisational units of an insurance group
(for example, equity investment management, management of intragroup relations,
etc.), these will be specifically described and explained in the next paragraphs.
Finally, where there are sales channels, the typical activities of an insurance under-
taking will be described referring specifically both to traditional systems (network
and agents), and multichannel support of innovative systems.
Figure 19.2 represents the components that are typical of the structure of an
insurance undertaking.
As can be seen in the figure, the essential components of an organisational
structure, and that will be analysed later, are:

1. The governing body, which makes up the top management of the undertaking
and directs it through a complex series of decisions that determine its progress
and development
2. Organisational units for coordination and direction, which superintend the
creation of strategic guidelines as defined by top management and provide the
support needed for management
3. Staff organisational units of the governing body assigned to managing
relations of the undertaking with bodies and institutions and auditing of regu-
latory compliances
4. Audit functions, which see to it that the objectives set by top management is
actually achieved through monitoring the various corporate activities and are
performed in abidance by legal rules applying
5. Departmental organisational units, that do not perform functions that are
peculiar to insurance business but watch over the proper working of any kind
of undertaking, dealing with personnel, trades unions relations, Financial
Statements, Internal Auditing, etc.
406 19 Competences and Organisational Functions

6. Technical insurance organisational units, that conversely take care of activities

that are typical of an insurance undertaking from development to creating the
products and services provided
7. Sales-distributions organisational units, that define policies and objectives for
sales and coordinate sales channels
8. Coordination committees, that watch over collegial decisions, mainly of a
technical and institutional kind

19.4 Governing Body

" Definition The governing body is usually made up of four players: The Admin-
istration Body (Board of Directors or Supervisory Council, Management Board), the
Chairman, Managing Director and General Manager.

19.4.1 Top Management

Within the governing body, in particular, Top Management is made up of the

Managing Director and General Manager and senior manager of the insurance
undertaking which performs takes of management supervision.

19.4.2 Administrative Body

The tasks of the Administrative Body are usually grouped into three areas: 1) inter-
nal audit activities, 2) insurance management 3) decisions, and management of
investments. In respect of internal audit, which is the main function, this is carried
out on various fronts At a general level, on the one hand, the Administrative Body
approves the organisational arrangements of the undertaking as well as the assign-
ment of tasks and responsibilities to organisational units, taking care that these are
sufficient over time, it sees to it that suitable processes of decision making are
adopted and formalised and that a fitting separation of functions is implemented; it
approves, while taking care that it is sufficient over time, the system of delegation of
powers and responsibilities, also taking care to avoid any excessive concentration of
powers in an individual party and setting up tools for verification over how delegated
powers are exercised. On the other, it defines, where the case may apply directives
and criteria for the circulation and gathering of data and information needed for
taking the right decisions and exercising supervision, It also defines directives in the
matter of internal audit in order to verify complete and timely flows of related
briefings.
Vis-à-vis Top Management, it checks that this implements the system of internal
audits and risk management properly in accordance with the directives issued and
assesses its functioning and fitness for purpose; it requires being periodically
informed as to the effectiveness and adequacy of them directives for adopting
19.4 Governing Body 407

corrective measures in a timely manner; it identifies special events or circumstances

that require immediate intervention on the part of Top Management.
In respect of the management of personnel, on the other hand, it agrees policies of
recruitment, incentivising, assessment and training; it defines directives in the matter
of subsystems of internal audit (reviewing at least once a year and dealing with
upgrading it to match developments in corporate operations and exterior conditions);
in respect of insurance management and choices, it prepares multi-year plans and the
business plan of the undertaking; at least once a year, it defines and assesses, for the
purposes of any review to be made, strategies and polices in underwriting, assess-
ment and management of the most significant risks, consistently with the level of
capital adequacy of the undertaking, on the basis of the results of processes for
identifying and assessing risk, it sets levels of risk tolerance and reviews them at
least once a year.
Concerning investment management, it approves the standards and strategies for
investment, ensuring its compliance with legal regulations current in the matter of
asset and liability management.

19.4.3 Chairman

The Chairman usually has roles of representation and promotion of the undertaking,
which make up a peculiarity of this function as compared to that of the Managing
Director. From a strictly operational, standpoint, this person is responsible for the
organisation of the departments and offices of their concern and staff under them and
must be made aware in advance of multi-year plans and the business plan of the
undertaking prepared by the Board of Directors: If they hold specific delegated
powers, the ones assigned to them by the Administrative Body are of

• An administration-management kind i.e. chairing and directing general meetings

of shareholders, setting the agenda for meetings of the Board of Directors,
overseeing execution of resolutions of the Collegial Bodies of the undertaking,
also on the basis of results highlighted by the Internal Audit Function.
• Directive kind i.e. giving execution to decisions of the general meeting and Board
of Directors in respect of what is of their concern, superintending the progress of
the undertaking itself.
• Legal kind i.e. representing the insurance undertaking before third parties and in
judgement with leave to appoint attorneys and lawyers - unless foreseen other-
wise for the Managing Director (and in relations with Institutional Bodies).

19.4.4 Managing Director

The Managing Director is responsible for directing an insurance undertaking, in

agreement with the direction and strategic lines defined by the Board of Directors
and plays the role of a legal representative to meet legal obligations. Vis-à-vis the
408 19 Competences and Organisational Functions

Board of Directors, they are responsible for proper management of the insurance
undertaking (in agreement with corporate strategies and budget objectives defined
by it) so ensuring complete and timely briefing and an adequate system of reporting
on corporate progress. In detail:

• They implement policies of taking on, assessing and managing risks (defining
operating limits to assign to individual structures), so ensuring monitoring is done
of exposures and there is abidance by limits defined, and building up emergency
plans (what is called a Contingency Plan) for the larger sources of risk that are felt
to be significant.
• They define guidelines for development and approve the budget of the insurance
undertaking in agreement with the direction provided, and propose powers of
attorney for employees.
• They additionally check that the Board is periodically informed as to the effi-
ciency and adequacy of the system of internal audit and risk management and
bring to implement its directives in respect of any corrective action taken.

Vis-à-vis general management of the undertaking, they approve the marketing of

new insurance products in abidance by policies and defined risk limits; they monitor
corporate progress on the basis of a briefing provided by Management Control, and
its financial management; they ensure the functioning and overall adequacy of
organisational arrangement, the system of internal auditing and risk management,
proposing initiatives aimed at improving these. Finally, in a capacity as a legal
representative, they manage relations with Institutional Bodies (sector Authorities,
etc.) and internal bodies ensuring that the information given to these is reliable,
timely and pertinent.

19.4.5 General Manager

The General Manager supervises corporate management and is responsible for

executing the resolutions of administrative bodies and management of current
business. They are responsible for personell management through direction, coordi-
nation and audit of the organisational units included in the corporate organisational
chart. They have the task of performing a number of activities:

• Drawing up the budget of an insurance undertaking, in agreement with the

strategic aims defined, and submitting it for approval to the Board of Directors.
• Defining and planning the marketing policies of the insurance undertaking best
suited to achieving development objectives.
• Control over the process of defining and marketing new insurance products and
monitoring trends in results from sales and technical ratios against forecasts.
• Defining policies for loss settlement in agreement with the strategic aims of the
insurance undertaking approved by the Board of Directors.
19.5 Units for Coordination and Direction 409

• Watching over the drawing up of periodic position of closing (quarterly, half-

yearly and annual financial statements) and the approval of financial statements.
• Detailed defining, on the basis of direction defined by the Board of Directors, of
organisational arrangements of the insurance undertaking, tasks and
responsibilities of organisational units and relative decision making processes.

They are responsible for reporting to the Board of Directors on corporate prog-
ress, both in economic and management terms. They are charged with highlighting
any variances from development objectives defined and any management
criticalities that may have come to light. They deal with coordinating and auditing
organisational units that report directly to General Management; they ensure that
there is a high level of service for the activities managed by outside suppliers; they
watch over defining and updating of contract agreements. They additionally ensure
proper application of legal rules concerning safety and management of complaints,
taking advantage of the organisational structure with concern for operational man-
agement of any issues in the matter.

19.5 Units for Coordination and Direction

" Definition The units for coordination and direction of an insurance undertak-
ing perform activities needed for achieving strategic guidelines defined by Top
Management and provide the support necessary for directing and monitoring the
progress of operations. In particular, a distinction is made between Planning and
Strategic Control and Strategic Marketing, Management of Equity Investments, and
Management of Intragroup Relations.

19.5.1 Planning and Strategic Control

Planning and Strategic Control deals with making a contribution to defining the
multi-year strategic plan of an insurance undertaking, checking on the consistency of
budget and operating plans with medium-long term (3–5 years) objectives; the
strategic plan being understood to mean the process through which action to be
taken for achieving future objectives is defined.
It develops analyses of scenarios to support strategic decisions—It carries out
analyses of domestic and foreign competition in terms of positioning and business
strategies—It actively seeks out opportunities for developing of lines of business and
prepares feasibility analyses for projects—It assists the Managing Director in
analysing and assessing new alliances and partnerships.
This organisational unit is additionally called upon, on the one hand, to lead to
individual and organisational conduct that is in line with achieving corporate
objectives and on the other, to measure and control progress in the economic-
financial performance of the firm. It assists in defining a corporate reward system
by setting objectives on the basis of the Strategic Plan and collaborating in
410 19 Competences and Organisational Functions

determining quantitative performance indicators to be assigned to individual corpo-

rate units.

19.5.2 Strategic Marketing

Strategic Marketing defines the marketing plan of the insurance undertaking. From
the standpoint of analysis, it studies market interactions with the firm. Identifying in
quantitative, qualitative and dynamic terms what the needs it intends to meet are with
its skills and who the recipients of its products are. To perform these functions fully,
the activity of study and research must continuously monitor the insurance industry
in order to detect any innovations in the matter of sales channels and systems.
From the sales standpoint, strategic marketing integrates with various distribution
channels and deal with developing agreements of partnership. Additionally, it seeks
to set up relations with bodies and insurance undertakings aimed at defining innova-
tive agreements of joint distribution.

19.5.3 Management of Equity Investments

Management of Equity Investments researches and analyses opportunities for

development via external lines of the business, consistently with the strategic
settings of the strategic plan. It supports Senior Management in defining the strategic
framework of alliances and partnerships and deals with carrying out transactions of
extraordinary finance. In respect of performing operations of extraordinary finance,
these usually foresee:

• An analysis being carried out of the objectives in connection with the main issues
of economy-finance, capital, business, corporate governance, company
structure, etc.
• Drawing up the business plan of the target, stand-alone and in synergy with
existing structures, and defining the manner of carrying out the transaction.
• Development of financial models for valuations.
• Coordination of the activities of outside advisors, negotiating the main transna-
tional issues.
• Drawing up all the internal documentation relating to the process of approving
transactions.

19.5.4 Management of Intragroup Relations

Where we have insurance groups, Management of Intragroup Relations deals

with providing controlled companies strategic and operational aims and further
provisions that they must abide by. Through these units, flows of information are
managed—information that is of general significance for the Insurance Group or is
19.6 Staff Units of the Governing Body 411

of specific interest to the controlled company. The unit supplies indications

concerning rules defined, processes, procedures, policies and audit systems within
the group.

19.6 Staff Units of the Governing Body

" Definition Staff units of the governing body deal with managing the relation-
ship the insurance undertaking has with other bodies and institutions and auditing of
regulatory compliances. Managing external relations and communications means
taking care of the image that the insurance undertaking intends to provide for itself
systematically, firstly via monitoring all activities dealing with divulging data and
information to outside parties. In particular, distinctions can be made between
outside Relations, external Communications, internal Communications, Investor
Relations and Company Secretariat.

19.6.1 Internal and External Communications/External Relations

At a supervisory level, external Relations and external Communications control

the drafting of articles and press briefings and coordinating the various events that
present activities or initiatives to the financial community and mass media. As a
specific activity, on the other hand, it promotes the image of the insurance undertak-
ing to partners, customers and the financial community. They manages relations with
the various parties involved: means of communications, institutional, associations
(category and others) and bodies. Communications also see to it that standards of its
concern (for example, corporate identity) are properly disseminated and executed,
and it prepares, updates and publishes corporate documentation over dedicated
channels (for example, internet portals, internet, etc.). Internal communications
has objectives that are different from those of external communications and deals
with disseminating information, operating guidelines and messages from Top Man-
agement within the undertaking. These activities allow all information that is
essential to the life of a firm to be channelled and disseminated in a homogeneous
manner and according to shared standards. Usually, internal communications is
assigned responsibilities such as drawing up the periodical of internal information
(the so -called house organ), updating and managing the intranet website, preparing
internal corporate events and initiatives for employee aggregation.

19.6.2 Investor Relator

If the insurance undertaking is listed on a stock exchange, the role of Investor

Relator may be foreseen. This unit is expressly appointed to manage relations with
investors; it represents the company with the financial community so as to promote
its value with investors by communicating strategy, choices and movements in the
412 19 Competences and Organisational Functions

industry. The aim is always the same: when communication succeeds in being broad,
timely and above all perceived as being “close”, but without giving up its reliability,
it is very much appreciated by the public and the trust won translates in this sector
into a market that is more liquid for securities and a broader shareholder base.

19.6.3 Legal

The Legal organisational unit, i.e. dealing with regulatory compliances under the
law according to the legislation applying and, secondly, supervisory bodies, fall
under staff organisational units. Usually, Legal assists Top Management and the
various organisational units in resolving legal and regulatory issues tied to the
business of an insurance undertaking. It provides legal protection for the undertaking
in criminal, civil and administrative cases, either directly or through external coun-
sel. It deals with legal issues arising from contracts, agreements and transactions of
any kind, interacting with other organisational units of the firm. It supervises the
drafting of contract conditions for contracts and insurance products sold by the
undertaking. It deals with institutional relations with the control Authorities. It
deals with and supervises the management of legal issues in litigation with Third
Parties, both in-court and out-of-court, directly, or by turning where needed to the
support of outside counsel.

19.6.4 Company Secretary

The Company Secretary ensures that the activities of the secretariat to Collegial
Bodies and further insurance undertaking compliances in abidance with the law and
internal regulations are executed. In detail: it ensures proper execution of
compliances in company matters, in abidance by provisions under the law, relations
with the control Authorities and other regulatory authorities. It deals with
compliances in respect of general meetings of shareholders of the insurance under-
taking. It prepares and deals with the compliances necessary for allowing acceptance
of offices by Directors and Internal Auditors. It deals with relations with members of
Collegial Bodies and convenes, organises and minutes their meetings; in collabora-
tion with the organisational units concerned, it draws up documentation and deeds
concerning topics that are subject to resolution. It conserves deeds and forwards
them in copy to the organisational units concerned with the resolutions passed. It
deals with keeping corporate books.

19.7 Service Units

" Definition Service units carry out activities that are non-specific and are peculiar
to the characteristics of the insurance business but are of fundamental importance
because they allow the insurance “machine” to function properly. The units are the
19.7 Service Units 413

following in particular: Management of personnel, Management of trades unions

relations, Organisation, Fiscal matters and Financial Statements Administration,
Management control, Finance, Investments, Treasury, Information and Communi-
cation Technology (ICT), Property Management, General Services and Purchases.

19.7.1 Management of Personnel

Management of personnel deals with defining and ensuring achievement of man-

agement policies, and evaluation recruiting development of the personnel of the
undertaking. This unit aims to detect the qualitative-quantitative needs of personnel
for the insurance undertaking through mapping the skills already present in staff so
as to optimise the process of selection and introduction. Upon these analyses, career
plans and systems for efficient selection of candidates for hiring to vacant positions
are developed. Management of human resources is ensured through systems of
incentives of various kinds and which increase the fidelity of employees: variable
compensation policies tied to achieving a specific objectives (directly deriving from
the overall objectives of the insurance undertaking); preparing training sessions
aimed at improving both technical skills and interpersonal approaches; mechanisms
for corporate benefit (car, telephone, catering, nursery, etc.). To this organisational
unit additionally apply concerns in preparing contracts of hire and everything
regarding the administration management of personnel, such as recording presences,
holidays, illness, notification of promotions, relations with trades unions, healthcare,
reimbursement of costs incurred, etc. This unit is also responsible for managing the
existing personnel of the undertaking: resignations, pensioning, and dismissals. It
does not have concern for drawing up corporate salary slips, which is assigned to the
administration of financial statements and fiscal matters, or (now in the majority of
cases) it is awarded in outsourcing to expert firms specialising in salaries and
contributions.

19.7.2 Management of Trades Union Relations

Always in the area of managing human resources, an activity of Management of

trades union relations is also included, which deals with relations with worker
representatives (who are present under the law in a firm as an intermediary party
between undertaking and employees) on questions tied to discipline, safety and
regulatory compliance of practices and working environments, and regulates the
exercise of their functions (assemblies, elections, notices, refresher courses etc.) in
abidance by current regulations.
414 19 Competences and Organisational Functions

19.7.3 Organisation

The objective of the Organisation unit is managing, upgrading and developing

organisation structures and processes consistently with the strategy pursued by the
insurance undertaking. In this activity come analysis and definition of new
organisational structures and new roles, revisiting and updating of corporate pro-
cesses, periodic review and publishing of the corporate organisational chart and
managing plans for change. Often, within Organisation a unit can be found dealing
with managing and organising the projecting activity of the firm. Management of
special projects provides support of a specialist and coordination kind for all
corporate projects. Specifically, it looks into defining objectives, costs and timings
of a project in connection with all its components (IT, resources, organisation),
prepares the project plan, identifies and analyses critical variables for achieving the
project itself and supplies support in the realisation phases. Additionally, in its role
of coordination, it looks into analyses of impacts and relations with any other
corporate projects there may be, checking any pre-existing areas and giving overall
visibility to the project and priorities. Lastly, it is responsible for preparing
documents relative to periodic milestones. Demand Management, which is often
linked to the management of projects in the firm, deals with gathering the needs of
units, defining priorities and estimating the resources necessary, determining plans
of work, and producing an overall corporate plan of all activities and demands for
carrying on the ordinary business of the undertaking. These phases are preparatory to
the activities performed by management of special projects.

19.7.4 Administration, Financial Statements and Fiscal

The Administration, Financial Statements and Fiscal unit is responsible for

proper management of administrative compliances connected with the economic
and capital management of the undertaking. As indicated by the name itself, within
this unit, a distinction can usually be made between three macro environments:
administration, financial statements and fiscal matters, each one featuring activities
that are peculiar to it.
Specifically, Administration ensures proper representation of corporate events
once the necessary civil and fiscal verifications in respect of relations with
administration-accounting significance with assureds (in terms of recording
premiums, loss events and settlements), with distributors (commissions, discretion-
ary incentives, rebates, etc.) and with the suppliers of the undertaking have been
carried out. Additionally, it monitors and ensures abidance by criteria of bookkeep-
ing and produces accounting documentation/situations (entries, balancing, reports,
briefings, etc.) relative to the activities assigned to it.
Financial statements is responsible for defining accounting standards and the
valuation and formation criteria for financial statements of an accounting period (and
possible consolidated financial statements). This unit:
19.7 Service Units 415

• Deals with defining the structure of the plan of accounts, relative procedure for
updating and laying down accounting standards of administration events.
• Processes the balancing of periodic accounting situations and aligning them with
management ones.
• Controls and aggregates accounting data from the various corporate structures;
processes, in abidance by rules applying and proper accounting standards, finan-
cial statements for an accounting period as well as semi-annual accounting
situations, and takes care of mandatory accounting bookkeeping.
• Takes care of the proper and itemised compliances of briefings owed to control
Authorities and provides the necessary support to external auditing firms.

The Fiscal area is responsible for activities of advice and assistance in fiscal and
contributory matters. Specifically, it deals with meeting duties of declaration for the
purposes of the various annual and periodic taxes and payments; It defines criteria
for applying fiscal regulations and analyses how this impacts profitability and
capital; it takes care of relations with the financial and tax administration.

19.7.5 Management Control

Management Control is responsible for monitoring trends in the undertaking

through a watch kept over the costs and profitability of the various structures. The
purpose of this unit is to draw up the budget, monitor trends in economic and
management activities through a system of summary and detail indicators, and
with variances as compared to historic trends and the current budget. The unit
works on the following activities: it supports Top Management in making forecasts
over the short/medium and long term (budget, forecasts and plans); it evaluates
future scenarios starting from historical trends; it assists the other corporate
organisational units in analysing the main indicators; it prepares summary reports
periodically on the economic situations for Top Management.

19.7.6 Finance

Finance deals with ensuring optimum management of financial means and

guaranteeing hedging, through adequate investments, for the commitments given
by an insurance undertaking towards assureds. Among its tasks come: optimising the
capital structure, management of reserves and liquidity, proper management of
monetary flows; monitoring and optimising of hedging for risks (market, credit
and liquidity). It deals with the management of relations with banks, bodies and
financial intermediaries in respect of what is of its concern.5

5
For a detailed explanation of the investments process see Chap. 22
416 19 Competences and Organisational Functions

Coordinating with the Risk Management function, Investments provides proper

allocation of economic capital on the basis of a level of risk/return set by the
organisational unit. This is defined on the basis of overall exposures to risk.
Additionally, where there are extraordinary financial transactions, it takes care of
the relative compliances for this activity. Other important activities of this unit are
the administering of securities and trading in stock, bond and derivative markets. In
life business, this unit is also assigned to the choice and maintenance of assets
hedging life products.

19.7.7 Treasury

Treasury essentially performs two macro-activities: managing cash flow and

recording transactions of investment/disinvestment (i.e. activities of securities
back-office). The former allows rationalising to be achieved in financial flows and
managing of liquidity risk so as to optimise the financial position of the undertaking.
Consistently with this outlook, the unit is also involved in preparing reports
providing forecasts for cash management and allowing an evaluation to be made
of corporate liquid funds. In respect of the latter activity of securities back-office,
the unit:

• Deals with the administrative management of a securities portfolio.

• Verifies and records investment/disinvestment transactions.
• Proceeds periodically to valuing the securities portfolio.
• Deals with monthly accounting closure for sectional securities.
• Performs periodic compliances required by external supervisory bodies and for
internal control and audit, in addition to those tied to drawing up Financial
Statements.

19.7.8 Information and Communication Technology (ICT)

The Information and Communication Technology (ICT) unit aims to direct the
technological choices made by an insurance undertaking while privileging effective-
ness and efficiency in the choice of systems for management and sales channels. IT
systems of insurance undertakings feature functional modules directed mainly
towards managing to take on business, issuing of releases and the management
and settlement of loss events. This unit defines the guidelines for the IT architecture
of reference, watches over and coordinates planning, management and development
of corporate IT systems, both hardware and software. It supervises the management
of purchases of goods and services coordinating with general services, so as to
optimise levels of costs and to satisfy operational and business needs. The unit
carries on an activity of ordinary and developing maintenance of the IT system,
developing the technological innovations that serve to achieve strategic and
operating objectives of the insurance undertaking. Its activity consists of running
19.7 Service Units 417

the corporate fleet of applications and in managing connectivity (internal network

and IT connections with the outside world). Concerning maintenance and overhaul
of IT systems, ICT coordinates all technological interventions, and management of
relations with technological suppliers in order to arrange working partnerships, or
assigning activities in outsourcing. For management of connectivity, the ICT unit
deals with optimising the performance of the network (internal and external) and is
responsible for the maintenance of electronic and messaging communications
systems, checking the security and accessibility to the network (after having defined
protocols for communication and levels of access protection). It defines
specifications for managing archiving of data (space in the cloud and relative backup
processes). In relations with external parties, it ensures maximum performance in the
level of communication and transfer of data: it is to be borne in mind that the network
of distributors (agencies, bank branches, etc.) is constantly linked by the IT systems
of the undertaking during activities of the ordinary management of insurance
contracts (both at the quotation stage and after-sales. Recently, activities relative to
management and transforming of traditional hardcopy documents into digital format
have been taking on ever greater importance for the ICT unit: the process of
dematerialising insurance contracts indeed foresees transforming hardcopy physical
documents into a new digital magnitude, which contains all the features of the
original document while ensuring abidance by requirements suited to legitimising
it and required from time to time if used. The process foresees a generation of
documents that are significant from the legal standpoint solely via IT and/or
telematic support for acquiring the elements actually making up the contract. This
activity takes place while ensuring either digital or hardcopy consultation to the same
extent. The process of IT management concerns all stages of document management:
generation, sending, preserving and archiving the document itself.
Within the ICT, a unit is often found dealing with IT security. The task of this
unit is to safeguard the security of systems and data of the undertaking so as to avoid
their being hit by IT attacks from outside (for example viruses, malware, hackers,
etc.) Its activities consist of:

• Defining a strategy of protection of the IT environment (systems, data, networks

and programs) from potential attacks;
• Avoiding and preventing breaches, transforming and/or destruction of sensitive
corporate data and information (or interruption of corporate operations);
• Designing, developing and setting up digital security systems;
• Assessing the vulnerability of the corporate IT system (and, where necessary,
remedying this);
• Responding to attacks and threats to IT security.

19.7.9 Property Management

Property management deals with administering and managing the real estate of an
insurance undertaking. Effective managing of assets essentially foresees the
418 19 Competences and Organisational Functions

following activities being carried on: planning allocation of capital (i.e. choice of the
area in which to invest: residential, commercial, theme parks, metropolitan areas,
etc.); ordinary and extraordinary administration of real property units (both in terms
of maintenance and building works, and in terms of management of leases and
incomes) and finally activities of sales/purchase in order to obtain a maximum
return, and planning of actions to be taken in the market place (for their disposal
or transactions of other types).

19.7.10 General Services

The General Services unit ensures the proper functioning of real property manage-
ment processes, installations and capital assets of the undertaking. In carrying on its
activity, it deals with coordinating infrastructure and logistics intervention, selecting
suppliers and watching over all issues relative to corporate security. In respect of the
purchase procedure, it takes care of the entire process of provisioning goods and
services consistently with the general aims and the corporate budget.

19.7.11 Purchases Unit

The Purchases unit, on the basis of requests made by the units concerned, purchases
goods and services with the aim of achieving efficiency and value-for-money in
provisioning, while abiding by internal procedures and operating demands of other
corporate units. This unit carries out analyses of the market for supply of goods and
services, defines strategies for purchases and ensures that alternatives and best
solutions for purchases are identified, consistently with the needs expressed by the
organisational units. On the other hand, it defines criteria for selecting and
accrediting suppliers for the insurance undertaking and takes care of management
of the supplier registry and relative relations with these, while monitoring the level of
service received. Lastly, it manages the process of negotiating with suppliers with
the objective of maximising the ratio of aggregate cost, quality of the good/service
and times of provisions; it performs the drawing up of framework agreements and
supply contracts, and deals with managing tender procedures and sees to it that they
are properly run.6

6
For a detailed explanation of the purchasing process see Chap. 33—Management Control.
19.8 Control Function Units 419

19.8 Control Function Units

" Definition The control function units typical of an insurance undertaking are
the following four key functions: the Risk Management function, the function of
Internal Audit, the function of Compliance, the Actuary7.

For these four functions to be able to carry on their activities of control, they must
have two fundamental features: operate permanently along the entire production
cycle of the undertaking and maintain their independence from the action of corpo-
rate structures. Conversely, they preserve characteristics that are common from the
standpoint of formal reporting: the hierarchical relationship to the Administrative
Body must be direct, whereas functional reporting is directed towards individual
corporate areas.
Alongside the key functions of this type, other three specific functions of control
also figure: anti-money-laundering, which has the task of identifying the application
of rules in the matter of the financing of terrorism and money-laundering, the
function of complaints management, within the customer area and which deals
with clearing up complaints, the privacy function which is responsible for managing
and processing data gathered.

19.8.1 Risk Management Function

The Risk Management function ensures that the risks for an insurance undertaking
are identified, assessed and controlled so as to keep these risks at a level consistent
with the availability of capital of the undertaking and according to guidelines and
methods set out8. In a general sense, it is possible to bring into Risk Management
four fundamental roles in managing risks: (1) identifying risks (2) quantification of
risks identified as “critical”, by estimating their possible effective impact;
(3) planning of activities aimed at reducing risk so as to avoid, mitigate or transfer
the potential impact of a possible risk; (4) control of risks though executing a
contingency plan foreseen and constant monitoring of risk indicators.
In particular, the function carries on the following activities:

• It concurs in defining the risk management model for the undertaking consistent
with any regulatory and supervision provisions; it supports the Managing Direc-
tor in defining limits of risk consistent with the risk appetite of the undertaking

7
In this paragraph, these units are called control functions (not organisational units), in accordance
with the requirements of the directive Solvency II. See Commission Delegated Regulation 2015/35/
EC of 10 October 2014 supplementing Directive 2009/138/EC of the European Parliament and of
the Council on the taking-up and pursuit of the business of Insurance and Reinsurance
(Solvency II).
8
For the task of Risk Management, see Article 269—Commission Delegated Regulation 2015/35/
EC of 10 October.
420 19 Competences and Organisational Functions

(such as taking part in defining the type of product to place in the marketplace,
concurring in defining reinsurance policies on the basis of strategic choices
defined by the Board of Directors).
• It measures and performs monitoring of risks with specific methods and tools.
• It deals with validating the information flows needed to ensure timely control of
exposures to risk and designs the structure of reports to be addressed to the Board
of Directors, the Managing Director and all persons responsible for the areas
involved in the process of risk management, in addition to supervising
achievement.
• It is responsible for ensuring consistency of risk management models with the
provision applying under regulation and supervision. In life business, Risk
Manager defines, develops and achieves models of integrated management of
assets and liabilities (Asset Liability Management—ALM).

19.8.2 Internal Audit Function

The Internal Audit function ensures that there is constant action taken in checking
progress and operations and from the standpoint of risk of an insurance undertaking,
guaranteeing the functioning and adequacy of the system of internal controls overall,
and evidencing compliance with provisions of regulation and supervision, or
through periodic and/or extraordinary Inquiries and monitoring the removal of
anomalies detected in operations9. In this view, therefore, it evaluates periodically
the effectiveness of processes and tools for risk management and applying sector
regulation. The function does not go into what operational activities are performed,
but it informs management bodies concerning the status of achievement and effec-
tiveness of the risk-management system; it verifies actual implementation of action
plans agreed with the persons responsible for processes given any during the course
of previous inquiries made by the function itself, and to meet evidence detected
during the course of risk assessment and shared with the persons actually responsible
for these processes (follow-up).
In particular, the function is responsible for preparing the annual Audit plan to
submit for approval to the Board of Directors of the undertaking; Concerning the
operational accuracy and compliance with the law and regulations with the
organisational units and outsourced structures, checking abidance in the various
operating environments by limits foreseen in mechanisms of delegation and reliabil-
ity of IT systems, effectiveness/efficiency and adequacy of control over operating
processes and removing anomalies detected during the course of checks. Lastly, it
prepares and forwards summary reports periodically to the Board of Directors, the
Managing Director, to Top Management and the Board of Auditors concerning the
checks made during the period in accordance with what is laid down under the
regulations of reference.

9
For the Internal Audit’s task, see Article 271—Commission Delegated Regulation 2015/35/EC of
10 October.
19.8 Control Function Units 421

19.8.3 Compliance Function

The Compliance function arises as a response to the need to manage the compliance
risk, meaning by this the risk of failing to comply with rules, when legal or
administrative sanctions, financial or reputational losses may ensue as a consequence
of failure to abide by laws, regulations, codes of conduct and standards of propriety
applicable to the activities performed10. The Compliance function has the task of
verifying the fact that in all operational sectors of the insurance undertaking there are
mechanisms that ensure abidance by rules applicable to insurance business (such as,
those referring to relations with customers or consumer protection). The function
identifies, assesses and monitors situations of compliance risk, assists and reports to
Top Management, promotes and disseminates a culture of legality and constant
attention being given to abidance by rules.
In particular, this function performs the following activities:

• Identifying the rules applicable on a continuous basis and carrying out assessment
of the impact on processes and procedures;
• Proposing organisational and procedural modifications for the oversight of risks
identified; proposing a reporting system for top management and the functions/
structures concerned (for example internal audit);
• Controlling the effectiveness of organisational interventions suggested and ensur-
ing monitoring of these by verifying the timely completion of plans for
surmounting criticalities detected on the system of controls;
• Coordinating and planning activities necessary to up-date and maintain the
documentary set-up required for regulatory purposes;
• Readying the final accounting on results of activities of verification and assess-
ment carried out for the purposes of the certification that top management must
issue on the systems of internal audit.

19.8.4 Actuary Function

The figure of the Actuary is foreseen in a distinct manner for control purposes and
operative activities. In this section we will describe the first aspect11. This function is
responsible for assessing the assumptions underlying calculation of premiums and
adequacy of reserves12.

10
For the task of Compliance, see Article 270—Commission Delegated Regulation 2015/35/EC of
10 October.
11
In the following paragraph, within technical insurance organisational units, we will explain the
operative roles and activities for actuary.
12
For the task of Actuary, see Article 272—Commission Delegated Regulation 2015/35/EC of
10 October.
422 19 Competences and Organisational Functions

In particular, the Actuary is responsible for four activities: coordinating the

calculation of the technical provisions; managing of underwriting policy; supporting
overall reinsurance arrangements; preparing a written report to be submitted to the
administrative, management or supervisory body,
Concerning the calculation of the technical provisions, they deal with checking
the way a tariff has been built up. They assess also whether technical reserves are of
sufficient capacity. In detail, in respect of the checks on tariffs:

• They verify in advance the technical bases utilised, the statistical methods applied
and the technical and financial assumptions employed in determining tariff
requirements;
• They assess the consistency of tariff premiums against the technical bases
adopted by the insurance undertaking (i.e. whether they are based on corporate
data or statistical detections from the marketplace). The activities performed are
drawn up in a technical report in which they describe the method, criteria and
technical and financial assumptions used by the insurance undertaking to deter-
mine tariff needs and the average tariff premium; indeed the relation indicates the
technical bases utilised and related methods applied in selecting and using the
variables for customising; they indicate, based on the tariff model adopted, items
such as the frequency of loss events used, the average cost of claims and all the
other assumptions estimated (for example, financial yield from investments,
loadings, etc.).

With regard to underwriting policy, the actuarial function has to provide

indications regarding the sufficiency of the premiums to be collected and the
coverage of claims and future expenses.
As far as reinsurance is concerned, the actuarial function must express an opinion
regarding the insurer underwriting policy and the rating of reinsurers. In this logic,
they also prepare simulations with “what if hypotheses” and stressed scenarios.
Regarding the annual written report, this has to be submitted to the administrative,
management or supervisory body. In this report, the activities carried on and their
results are described. The Actuarial function also clearly identifies any deficiencies
and provides recommendations as to how such deficiencies should be remedied.

19.8.5 Anti-money-Laundering Function

The Anti-money-laundering function is responsible for identifying the rules apply-

ing in matters of money-laundering and financing of terrorism and assesses their
impact on the processes and internal procedures of the undertaking. It deals therefore
with continuous checking on the level of effectiveness of the system of internal
controls and procedures aimed at preventing and combating these risks. It evaluates
the adequacy of the systems and internal procedures directed towards meeting the
duty of making sufficient checks upon customers and recording, along with systems
of detection, assessment and reporting of suspect transactions. It prepares proper
19.9 Technical Insurance Units 423

flows of information towards corporate bodies, Top Management and in connection

with the issues of its concern. Among its activities, checks are foreseen concerning
the reliability of the IT system feeding the IT archive and forwarding the data
required to external bodies concerned. It is also responsible for preparing an ade-
quate training plan aimed at achieving continuous updating of staff and collaborators
in addition to disseminating a culture in the matter of anti-money-laundering.

19.8.6 Complaints Management Function

The Complaints Management function is usually placed within the area of cus-
tomer relations. In general, it deals with clearing up complaints in accordance with
the rules laid down by the Supervisory Body. This means ensuring that customer
complaints and requests are monitored. The activities are: receipt, analysis, protocol
and classifying of the documentation so as to achieve the filling out of a case file that
will be included in the complaints register. During the following stage, it processes
solutions for customers. Among the areas of responsibility of the function, close
collaboration is additionally foreseen with the internal audit function, both in
verifying that proper procedure is followed, and in the matter of any issues in
managing complaints, to be forwarded subsequently to the organisational units of
administration and of control. Finally, the function is responsible for proposing
fitting actions for improvement deriving from analysing the complaints made by
customers.

19.8.7 Privacy Function

The Privacy function deals with issues relating to applying legal regulations on
privacy from an operational standpoint. It is thus responsible for applying rules in
respect of managing data gathered. It indicates the purposes of the processing and
ensures a proper manner of use of this information is followed.

19.9 Technical Insurance Units

" Definition Technical insurance organisational units deal with managing the
characteristic activities that are typical of an insurance undertaking, i.e. all the
activities of key processes for developing and creating insurance products and
services. In particular, the following units belong here: Pricing/Reserving, Product
development, Underwriting risks, Reinsurance, Claims management, Technical
portfolio management and Intermediary accounting.
424 19 Competences and Organisational Functions

19.9.1 Pricing/Reserving Unit

Among the technical organisational units, the Pricing/Reserving unit is the one that
has the task of ensuring development and proper management of products that is
adequate from the standpoint of technical fitness and market sustainability and
dealing with proper determining of technical reserves, both at the time of budget
and at the final reckoning. In the case of a life undertaking, the Pricing/Reserving
also deals with calculating Embedded Value and takes part in processes for building
up and managing Asset Liability Management—ALM13.
In its pricing activity, therefore, fall studying and developing insurance products
and evaluating their respective profitability, preparing related technical notes for
sending on to the sector Authority, and technical support for preparing contract
packages. Concerning watch over and analysis of actuarial risks, the unit provides
support to Risk Management and often analyses the technical features of reinsurance
treaties.
The activity of calculation and evaluation of life and non-life reserves is
performed by the Pricing/Reserving unit in compliance with provisions of contract,
criteria of prudence and standards of financial statements (local and IFRS). These
tasks are carried out by preparing and checking forecasting models for estimating
future claims and settlements.

19.9.2 Product Development

The Product development unit is responsible for developing new products,

collaborating with other corporate units, by identifying the components of the
offering and determining technical structure and yield profile while adhering to a
mix of products taken as a strategic objective. It deals with coordinating the entire
cycle of design, achievement and launch of the new product. In detail, it is therefore
responsible for defining the product concept, analysing its profitability and economic
margins, defining the various stages of insurance product release, up until when they
are marketed. This unit also takes care of determining the preliminary sales budget,
management of communications and, finally, support and assistance to the network
in managing before and after sales issues. The concept defining phase of a new
product or revisiting the components of an existing product (new version) usually
takes place taking customer demands and distributors requests into account. These
are gathered through qualitative inquiries (field interviews) and quantitative analyses
on potential in demand that is unexpressed or is to be redirected.14
Together with Legal and Marketing, it deals with preparing technical datasheets,
briefing packages and policy documentation to meet current regulations.

13
For a treatment of system and models of ALM see Chap. 31.
14
For an explanation of the product development and launch process, see Chap. 20.
19.9 Technical Insurance Units 425

19.9.3 Risk Underwriting

Risk underwriting ensures the aggregate exposure of an insurance undertaking over

various categories of risk in line with corporate strategy and underwriting policies.
The tasks performed are distinguished according to the type of risk handled,
i.e. underwriting industrial risk as compared to underwriting mass risks.15
In the case of industrial risks, risk Underwriting has the responsibility of
gathering and analysing all the information there is concerning a risk and proceeding
to draw up an insurance contract. In practice, it analyses and assesses the level of
risk, calculates the price and, on the basis of this, offers the cover that the insurance
undertaking can provide the assured with. Often, in determining prices, it
coordinates with the Reinsurance unit so as to comply with constraints deriving
from treaties in force or proposes new reinsurance agreements if the existing ones are
not sufficient for the risk section policy put in place by the undertaking.
In the case of mass risks, the risk underwriting activity tied to standard insurance
products is usually carried on directly by the network of distributors (agencies, bank
branches, online etc.) that actually carry out underwriting activity for all products
that require pre-set contract conditions, indemnification clauses and sums of pre-
mium. If specific conditions or departures from standard insurance products are
required, the Risk Underwriting Unit deals with finding the technical-operational
information as to the feasibility of affording the insurance covers sought.
In order to perform the foregoing tasks, it controls underwriting activity so as to
verify the aggregate exposure of the insurance undertaking to various categories of
risk and authorises, subject to prior evaluation of the specific circumstances (impor-
tance of the customer, aggregate portfolio of the agent, rating of the agency ...), the
underwing of risks that exceed the autonomy of sales channels. Additionally, it deals
with preparing itemised data to meet requirements and rules defined by the insurance
undertaking and ensures there is technical assistance for sales channels on the
distinctive features of individual products, all the while aiding the networks in
quotations, preparing estimates and drafting special policy conditions. This unit
may be either unique or repeated by specialisation in units headed by the various
lines of business that the insurance undertaking finds itself operating in.

19.9.4 Reinsurance

The Reinsurance unit is responsible for identifying reinsurance that is the best
possible from the economic/contract standpoint for an insurance undertaking con-
sistently with framework resolutions approved by the Administrative Body16. It
deals with negotiating and drawing up reinsurance treaties in addition to concurring
in optimising the administrative and accounting management of these treaties.

15
For a detailed description of the underwriting process, see Chap. 21
16
For an explanation of techniques and the process of Reinsurance, see Chap. 17.
426 19 Competences and Organisational Functions

Materially, in respect of treaties, it takes care of operational issues from defining

reinsurance commissions to drafting the reporting on the progress of treaties in terms
of evaluating their performance. This unit also has concern for drafting facultative
treaties for the reinsurance of risks that exceed standard treaties.

19.9.5 Claims Management

Among technical organisational units Claims management is the unit set up to

ensure there is the proper handling of claims, ensuring both effectiveness of the
process and technical balance. In order to deal with the activities performed it is
necessary to make a distinction between non-life business and life business. The
former actually manages case files for indemnification of the losses incurred by an
assured, whereas the latter looks at the settlement and payment of surrenders,
annuities, maturities and loss events (only in the case of products with cover for
cases of decease).17
In the area of non-life claims handling, the activities performed by this unit
concern both administrative-accounting issues and those of a technical-assessment
kind and cover all the phases of the settlement cycle. The first phase consists of
opening the claims file, i.e. the act through which the claim is recorded by the
insurance undertaking and which foresees the performing of the following
operations: assigning a case file number, input of the claim to the system and setting
up of the relative hardcopy folder (administrative opening) and check upon the
regularity/existence of the cover requested and evaluation of a first reserve (technical
opening). The second phase concerns dealing with the claim which foresees all the
actions subsequent to technical opening consisting of managing the claim with third
parties (adjusters, injured parties, their representatives, etc.) policyholders,
distributors (agents, bank-windows) in order to assess the sum of the loss. Within
this phase there is adjuster management which foresees the appointment of an
adjuster (i.e. an expert, coachbuilder, physician etc. from among those of references
and already included in the registry of the insurance undertaking), related assigning
of an appointment, performing of a survey on the part of an adjuster. Once the
outcome of the adjustment is received, the undertaking has then available all the
items of information needed for the final stage of settlement of the loss. Settlement
and indemnification of the claim foresee the following operations being performed:
defining of the quantum to be settled to the injured party and subsequently to be paid,
handling of the deed of settlement and issue of a release that will be signed by the
injured party. Once acceptance has been signed by the injured party, payment and
subsequent recording in accounts of the closing of the entry may be proceeded
to. The Claims management unit is responsible also for other activities such as
eliminating losses filed without claim, i.e. all those claims that, while initially
opened, must be closed without any payment being made later than the time of
origin. This activity foresees performing the following operations: a deed of

17
For a detailed description of the claims management process, see Chap. 23.
19.9 Technical Insurance Units 427

rejection of the claim to the policyholders by registered letter and input to the system
of the transaction, with resulting automatic zeroing of the reserve.
An activity of valuation of the reserve18 requires the following operations:
continuous evaluation of the loss reserve (i.e. taking events subsequent to the technical
opening into account), assessment of the reserve at year-end (so-called inventory
reserve), entering into financial statements. Any variation made to reserves requires
a consequent drawing up of a journal of dealing and related input to the system.
In a number of insurance undertakings, the entire management of losses (or part
of it) is outsourced to a provider. In this case, in addition to all the activities indicated
above (which will be performed by an outside provider), outsourced claims man-
agement requires determining guidelines for direction and control in respect of
dealing with losses entrusted to outsourcing and defining of standards for handling
and levels of authorisation to make payment in respect of claims.
Among the last different activities, the Claims management unit is responsible for
management claims litigation and return of recoveries and of the franchises19,
forwarding reports of losses to relative reinsurers (on the basis of the treaties in
force) and providing the control Authority with the information requested via the
forms that are foreseen (for example, the templates required by Solvency II
concerning claims).
Within Claims management, the Claims technical secretariat deals with the
gathering of data in respect of trends in claims and analysing them through specific
indicators so as to show up any variances between planned objectives and results
achieved or anomalous trends, and then informing the bodies responsible. Claims
accounting is the unit watching over the process of statements of account and
monitoring the administrative situation of claims dealt with (closed and open) by
the structures of the undertaking during a period of reference, so ensuring adherence
by these to regulations in force and internal ones. Via this activity, proper alignment
and administrative-accounting regularity of data of a technical kind of the claims
settlement procedure is periodically checked against the economic situation of the
respective accounts in general Accounts.
Concerning non-life business, a distinction is additionally made between the
activities performed by the central head-office structure from those operating locally.
The tasks of the head-office structure consist both in coordinating and monitoring the
performance of the settlement network locally and outside adjusters, both in
handling any claims that cannot be managed peripherally due to their particular
complexity (for example, claims that necessitate specialist adjustment by official
technical consultants or that require checking in the terms of special covers, etc.) or
because they concern sums that are greater than the autonomy of the settlement
network. Among the other activities performed by the head-office structure, the anti-

18
For an explanation of methods of valuing claims non-life reserves, see Chap. 12.
19
Recovery is the sum requested in action taken by the insurer against its assured to recover sums
paid out to injured third parties, not having been able to hold certain contract exceptions
against them.
428 19 Competences and Organisational Functions

fraud procedure is of special importance as it allows trickery that might be tried against
an insurance undertaking to be avoided. The actions that form this procedure consist of
monitoring at the time the claim is opened (to detect any anomalies there might be such
as recurring names of witnesses, licence plates involved in multiple accidents, etc.)
reporting, internally and to authorities concerned, the subsequent activity of investiga-
tion locally. In cases of claims managed locally, settlement takes place via Settlement
Centres or claims inspectors present in the area of reference and that perform the
activities of handling the claims, management of adjusters and settlement of the loss in
accordance with procedures received from the central head office structure.
In the case of life business, the activities carried out differ in respect of settlement
and payment of surrenders, annuities and maturities. The sum found to be payable to
the assured or beneficiaries is tied to the sum determined under contract conditions of
the policy.

19.9.6 Technical Portfolio Management and Technical Accounting

Technical Portfolio management manages transactions pertaining to the portfolio

of the insurance contract in force, carrying out all the compliances connected with
the life cycle of insurance products and related contracts. It also watches over the
process of preparing, feeding into and verifying the management system for products
in a portfolio and for those issued during the period.
The unit, therefore, deals with all the activities that allow issue and management
of policies (including the issue and any endorsements). The activities concern any
variation occurring in the status of the policy from the administrative standpoint:
managing policy duplicates, population register variations, managing withdrawals
and failure to conclude, management and control of processes of sending notices to
customers, keeping of records, various regulatory compliances, monitoring of the
substance of the portfolio, management of releases and collection of premiums.
Furthermore, it checks on the alignment between physical archives (documentary
supports and hard copies) and IT ones and monitors the accuracy of commission
calculations.
Technical accounting is the unit responsible for activities of statements of
account and monitoring of the administrative and accounting situation of the portfo-
lio of insurance contracts. Via this activity, proper alignment and regularity of data
of a technical kind of the portfolio of securities as compared to the economic
situation of the accounts in general Accounting is checked periodically.

19.9.7 Intermediary Accounting

Intermediary accounting is the unit that watches over the monitoring of adminis-
trative and accounting processes for sales channels (agencies, brokers, bank
windows and branches, etc.). In fulfilling its tasks, intermediary accounting checks
alignment and regularity (in merit and in form) of cash sheets for distributors; it
19.10 Sales-Distribution Units 429

controls that anomalies between what has been issued and what has been collected
are resolved; it prepares data for accounting in general accounts and checks that there
is proper alignment and regularity between the data from distributors’ accounting
and the economic situation of accounts in general Accounting; it carries out a
periodic audit of sales channels; manages legal compliances in respect of records
of issues, collections, etc. Finally, it deals with assistance to sales channels in solving
issues of an administrative kind.

19.10 Sales-Distribution Units

" Definition The activities of the sales-distribution units revolve around the
commercial process (objectives, strategies and policies) and the world of promotion,
distribution and sales of insurance products. In particular, it is usual to make a
distinction between: Commercial, Commercial Planning, Channel management and
development and Marketing.

19.10.1 Commercial Unit

The Commercial or Sales unit performs several tasks:

• It defines commercial policies and objectives and manages sales channels based
on the different features and the diverse roles assigned to them in delivering
services to customers.
• It deals with ensuring that strategies for portfolio management of concern to each
sales structure are defined, ensuring continues monitoring so as to maintain in
respect of each product a proper balancing of risks and profitability of policies in
the portfolio while abiding by guidelines defined and business goals.
• It is responsible for developing and managing the sales network so as to ensure
achievement of the pre-set commercial objectives of the undertaking.
• It deals with watching over product and distribution policies, it selects new
inclusions to the network (collaborating with the Channel management and
development unit).
• It manages the tools and commercial initiatives supporting sales.

19.10.2 Commercial Planning

Commercial planning unit provides commercial planning, formalising of sales

targets and connected systems of incentives, consistently with the policies and
objectives of the insurance undertaking. In detail it is responsible for defining and
managing the revenue and costs and the budget process of network management,
interfacing with strategic Planning and Management Control. The detailed
activities are:
430 19 Competences and Organisational Functions

• It manages the process of assigning sales targets to all levels of the commercial
structure, consistently with the related revenue and costs budget.
• It takes care of setting up the commission system and incentives structure in
agreement with units of control (and product development/pricing).
• It carries out monitoring of sales network productivity by identifying suitable
performance evaluation parameters; it concurs in defining and setting up a system
of indicators so as to evaluate the results and profitability of the individual
components of the sales network.
• It prepares periodic reporting tools to Top Management necessary for giving a
proper representation of achievement of the pre-set objectives.

19.10.3 Channel Management and Development

Channel management and development watches over the process of recruiting

and training the sales network consistently with the guidelines of the insurance
undertaking. For this purpose, it is responsible for coordinating activities of search
and selection of sales structures, it coordinates the administrative activities tied to the
process of economic offerings and drawing up of letters of appointment/mandate by
the insurance undertaking. It deals with proposing training plans for the sales
structures, taking care of their actual execution; it coordinates activities of design
and delivery of training and manages any regulatory compliances vis-à-vis the sector
Authority, if necessary.

19.10.4 Sales Force Inspection

Sales force inspection in practice consists of a structure made up of various figures

locally who deal, on the one hand, with checking the administrative regularity of the
contracts taken out (administrative inspection), and on the other, monitoring
achievement by sales structures of the budget targets set centrally as well as
incentivising the sale of new products (commercial inspection). In respect of
administrative inspection at sales structures, the activities that are mainly
performed are: formal ascertainment in respect of all the contracts in the agency
(expiry, overdue, subject the recovery procedure, annulled, etc.), verification that the
sales process has taken place properly (for example proper filling in of the forms
foreseen at the sales phase, display in premises of pre-contractual documentation for
customers, etc.).The outcome of these checks may lead to reports of any criticalities
there are in the ordinary management of sales and after-sales activities20 with the

20
Inspection in respect of the propriety of the manner of sale were introduced mainly to meet rules
foreseen from local Authorities. These inspections, called Audits, must be carried out by insurance
undertakings on their networks at least annually, and consist of checks on the operating methods
vis-à-vis customers and the undertaking as well as internally, in line with what is laid down under
internal circulars of insurance undertakings.
19.11 Coordination Committees 431

risk, in the most serious cases, of suspension or revocation of the mandate. In respect
of development and incentivising of sales, commercial inspection is responsible for
providing adequate and continuous assistance to the network and managing com-
mercial relations with the central structure while managing, if necessary, delivery of
training activities for the sale of new products, defining commercial actions and
analysing the positioning of the agency and even in a number of cases to support the
intermediary in partnering during the process of sales. The two structures (adminis-
trative inspection and commercial inspection) traditionally have hierarchical
objectives and hierarchical dependence. The former reports to control functions
(for example Internal Audit, Compliance, etc.) whereas the latter reports to the
Commercial or Sales unit.

19.10.5 Marketing

Marketing performs an activity of commercial promotion and deals with constant

monitoring of the positioning of the undertaking vis-à-vis competition. It identifies
and proposes actions to facilitate the positioning of the insurance products of the
insurance undertaking, defining the best mix of sales by product/channel and taking
care of the product package. It carries out customer satisfaction analyses and for
customer segmentation and analyses the findings; it coordinates the build-up of the
corporate marketing plan following guidelines from Top Management: it proposes
guidelines pertaining to product communication, advertising campaigns,
sponsorships and free gifts to the sales structures and customers in line with
corporate directives. Within the Marketing unit, Operational Marketing is often
to be found and which deals with the design, management and provision of support
and sales tools for the distribution network: in this case, it can be stated that
techniques of marketing are intended for the channel rather than the final customer.
Operational Marketing is then responsible for providing all the support needed for
sale and marketing actions specifically carried by the channel21, such as promotional
flyers, in-store promotion, fidelity programmes, sales kits, set-up of points of sale,
comarketing, etc.

19.11 Coordination Committees

" Definition Coordination committees are meccanismi decisionali that, in view
of profiles and professional skills that are different, allow an insurance undertaking
to reach a series of collegial decisions, mainly of a technical or institutional kind. On

21
For further details see Chap. 24. These activities (of direct management of operational Marketing
at the point of sale) are defined “below the line” and are distinguished from those that are “above the
line”, i.e. actions of direct marketing to the consumer, such as on-air advertising, institutional
advertising campaigns in specialist press and others, hoardings, etc.
432 19 Competences and Organisational Functions

the basis of the strategic function of the various committees, each group has a
frequency of meeting that is variable, in general pre-defined (i.e. monthly, quarterly,
etc.) and above all may be permanent or temporary, being activated by request to
meet certain issues.
The committees dealt with specifically are the following: Executive committees,
Investment committees, ALM committee, Product committee, expenses committee,
Risks committee, Risk Management committee, operational and other risks commit-
tee, Audit committee and Crisis committee.

19.11.1 Executive Committee

The Executive committee has the responsibility of establishing the overall

objectives and strategy of an insurance undertaking, in addition to controlling their
actual achieving. Among its tasks, there are validation of the Business Plan, defining
the annual plan, approval of the budget and validation of the draft financial
statements for the accounting period. The Committee may additionally play a role
of support to Top Managers in decisions in matters with economic-financial
implications that are of a significant sum.
Among the fixed membership of the executive committee are the Managing
Director, Top Management, including the upper management concerned (for exam-
ple the persons responsible for the areas Finance, Technical-Insurance, life business,
non-life business, etc.)
The frequency at which the committee is convened varies between weekly and
monthly.

19.11.2 Investment Committee

The Investment Committee has the task of analysing the macroeconomic and
financial situation and the overall riskiness of the investment portfolios of the
undertaking in connection with the indicators matching assets and liabilities (Asset
Liability Management) and allocating investments. It deals with giving opinions on
proposals for a strategic allocation of assets and for hedging the main risks of
investments and their possible variation during the year. Additionally, it checks
the consistency of corporate management policies in respect of assets and examines
any situations that are critical and come to light when managing investments.
The committee meets at set intervals (i.e. quarterly) and taking part are the
Managing Director and top management responsible for the Finance and
Investments areas and Risk Management. It is possible for outside interlocutors to
be invited and who take part in the financial management of the undertaking (for
example consultants from merchant banks, representatives from delegated
representatives, etc.)
19.11 Coordination Committees 433

19.11.3 ALM (Asset and Liability Management) Committee

The ALM (Asset and Liability Management) Committee has the task of
evaluating the adequacy of integrated management policies of assets and liabilities
and their impact on corporate variables. More especially, the committee sees to it that
methodological approaches and models of analysis for identifying, measuring,
evaluating and managing and control of financial risks and mismatches over the
duration of assets and liabilities are examined.
Necessarily taking part in the committee are the Managing Director and top
management responsible for the Finance and Investments areas, the area of planning
and strategic control and Risk Management.

19.11.4 Product Committee

The role of the Product Committee is to identify new products or propose a review
of existing ones. It is responsible for analysing customer needs and distribution
channels, also in view of what its competitors are doing and developing specific
commercial offerings (plan, products and pricing). This activity is made possible
thanks to in-depth knowledge of the market and identification of the opportunities
there are for growth. The product committee also deals with examining any
criticalities there may be in the area of distribution and evaluating proposals for
the launch of strategic projects in addition to monitoring trends in insurance
products.
The committee meets bi-monthly or quarterly and involves all corporate areas
engaged in designing, developing and creating new products beginning with the
Managing Director, top management responsible for life business, non-life business,
the pricing area, Marketing, Sales, Risk Management and Finance.

19.11.5 Expense Committee

The expense Committee deals with authorisation of expenses and requests for
purchases of the undertaking for significant sums or in respect of goods and services
from outside via bidding procedures. It also deals with monitoring trends in expense
budgets and may propose corrective action for avoiding exceeding this budget. It
additionally defines guidelines for preparing expense budgets for the next account-
ing period and validates guidelines for peopling the corporate suppliers Registry and
managing bidding procedures (jointly proposed with Legal). Lastly, it may also do
monitoring of the level of use made of main suppliers.
The Committee usually meets monthly so as to facilitate the process of
authorising expenses. Among those taking part are the Managing Director, top
management, Purchases, Information and Communication Technology (ICT), and
General Services.
434 19 Competences and Organisational Functions

19.11.6 Risk Committee and Related Sub-committees

The Risk Committee has responsibility for defining policies for underwriting and
managing risks for submission for approval to the Board of Directors, and ensuring
they are implemented. This committee is often split into two further sub-groups: the
Risk Management Committee and the Operational Risks Committee. While this
committee focuses on a high strategic level (by examining indicators of return on
capital, approaches to Capital Allocation and policies of fund gathering), the other
two deal mainly with areas tied to the characteristic operation of the undertaking.
The risk Committee is responsible for proposing levels and limits to the risk
structure, evaluating policies for hedging risk and the risk appetite of the undertaking
(also in accordance with a number of scenarios). It also deals with defining and
monitoring mapping the risks of the undertaking and examining relative findings
based on the various types of risk present.
The Committee meets at quarterly intervals and involves the Managing Director,
top management responsible for Administration, Financial statements and Fiscal
matters, Finance and business areas and Risk Management.
The Risk Management Committee has a more operational task than the risk
committee and deals with analysing insurance risks, assessing the underwriting,
reserving and reinsurance policies set in place by an insurance undertaking. It meets
every 3 months and requires the participation of the top management responsible for
the business areas (including Claims management), the pricing area for products, the
Actuary and Risk Management.
The role of the Operational risk and other risks Committees is to check on the
level of exposure of the undertaking to all other risks. With this goal, it deals with
defining and implementing mapping of operational risks and other risks (compli-
ance, reputational, belonging to a group, etc.), monitoring the progress of action
plans for mitigating and checking the actual achievement of initiatives approved. In
this case too, the committee meets every 3 months and requires the attendance of top
management responsible for the areas of business (including Claims management),
the Compliance function and Risk Management.

19.11.7 Audit Committee

The Audit committee has the task of looking at activities and audit systems so as to
identify and manage the main risks that the undertaking may be exposed to. It deals
with reporting any weak points in the functioning of the undertaking to the Admin-
istrative Body and taking on the appropriate remedial actions. It additionally assesses
the activities performed by Internal Audit and whether the necessary levels of
independence and Functioning are achieved.
The Committee meets quarterly and involves the Managing Director, top man-
agement responsible for Administration, Financial statements and Fiscal matters,
References 435

Finance, Legal, Corporate Secretary, the Internal Audit function, Compliance and
Risk Management.

19.11.8 Crisis Committee

The Crisis Committee has the responsibility for deciding whether or not to declare a
crisis after having assessed the impacts, threats and opportunities in the medium and
long term that are a consequence of a current situation. It thus defines strategies to be
adopted and formulates guidelines to meet the crisis. It determines the strategies of
communication towards outside and internal structures. Finally, when an emergency
has concluded it may revoke the state of crisis.
The committee is convened by the crisis leader or any other permanent member
and involves the Managing Director and top management responsible for the main
areas involved in the crisis. Also invited to take part are the external contacts
involved or concerned in crisis situations.

19.12 Questions

1. What is an organisation chart?

2. Explain the support tools
3. How many are the levels in an organisational hierarchy?
4. Describe the role of the governing body
5. What are the units within the coordination and policy units?
6. Illustrate the activities performed by the staff units
7. What are the service units?
8. Describe the four control units and their tasks
9. What are the activities carried out by the risk underwriting?
10. Explain the activities of the commercial – sales unit
11. Describe the role of a coordination committee

References

Directives and Regulations: Chronological Order

Commission Delegated Regulation 2015/35/EC of 10 October 2014 supplementing Directive 2009/

138/EC of the European Parliament and of the Council on the taking-up and pursuit of the
business of Insurance and Reinsurance (Solvency II)
436 19 Competences and Organisational Functions

Suggestions for Further Study

Dorfman MS (2008) Introduction to risk management and insurance, 9th edn. Pearson, London
Marano P, Siri M (2017) Insurance Regulation in the European Union. Palgrave Macmillan,
Cham
Marano P, Noussia K (2022) The governance of insurance undertakings. Springer, Cham
Vaughan EJ, Vaughan TM (2013) Fundamentals of risk and insurance, 11th edn. Wiley,
Hoboken NJ
Williams RL, Anzsar J, Bulmer R et al (2016) Application of the Solvency II Actuarial Function to
general insurance firms. British Actuarial Journal 21(3):476–530. https://doi.org/10.1017/
S1357321716000052
Product Development Process
20

Abstract

This chapter aims to illustrate the process of product development and launch.
This process can be split into six stages: identifying the product concept, defining
the macro-structure and model of the product, product realisation, internal vali-
dation of the product, presenting the product and sharing it with channels, final
release of the product in the industry. In the following paragraphs, we provide the
details of the activities. At the end of the chapter, we describe the recent regula-
tion Product Oversight Governance—POG. Nowadays the process of developing
and launch of a product must abide by what is laid down under the new
regulations. For the first time, lawmakers have defined rules for a new system
of governance and monitoring of the process of product development in the
insurance industry.

Keywords
Analysis of competition · Product benchmark · Channel involvement · Definition
of product concept · Bill of materials (BoM) of the product · IT operating model ·
Product launch scheduling · Pricing (technical bases) · Sales and after-sales
processes · Contractual documents · Functional analysis and IT parametrisation ·
Third Party Administrators (TPA) · Reinsurance agreements · Internal validation ·
Product presentation · IT development · Sales kit · Commercial agreement ·
Product Oversight Governance (POG)

# Springer Nature Switzerland AG 2024 437

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_20
438 20 Product Development Process

20.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Explain the process of new product development and launch

2. Describe the phases and activities requested for developing and
implementing a new product in an insurance undertaking
3. Know the process owners involved and coordination and control
mechanisms
4. Illustrate the Product Oversight Governance (POG) regulation and the
related impacts on product development and the launch process

20.2 Stages of Product Development Process

The process of developing and launching a product can be split into six stages:
identifying the product concept, defining the macro-structure and model of the
product, product realisation, internal validation of the product, presenting the prod-
uct and sharing it with channels; final release of the product in the industry.
The activities usually have a duration over a medium-long time frame. Develop-
ment and launch of a new product may last 9–12 months within an insurance
undertaking (considering all activities, beginning with the initial study up until the
issue of the first policy by a sales channel).
In this process, various players from various corporate areas are involved.
Generally involved are: Marketing, Actuarial (pricing and reserving department)
Sales, Information and Communication Technology (ICT) unit, Organisation, con-
trol functions, Reinsurance, Purchase function (where there are external providers),
Legal area. In the treatment in this chapter, which activities involve each of these
players will be seen.
In Figure 20.1, an outline is given of the stages of the process of development and
launch of a new product.
Lastly, the process of development and launch of a product must take into
account, in a transverse manner, the latest requirements set by lawmakers1. It is
therefore necessary to keep the following five areas under control:

1. Procedure for developing and approving products leading to formalising and

control of the activities for design, monitoring, review and distribution of insur-
ance products and corrective actions in respect of insurance products that might
not be aligned with customer needs.

1
See delegated Regulations 2017/2358 dated 21 September 2017—POG (Product Oversight
Governance).
20.3 Product Concept 439

4
2 5 Sharing
Internal
Framework 3 with the 6
1 corporate
and Product channels Product
Product concept validation
operating Realisation and product release
of the
model presentation
product

Fig. 20.1 Stages in the process of developing a product

2. Possession and certification of skills in respect of personnel involved in designing

and creating insurance products
3. Identification for each insurance product of the market of reference and the group
of customers compatible with this (so-called Target market)
4. Activities of scenario verification and analysis (prior to putting products on the
market). The product test must verify whether or not the insurance product meets
the demands and needs of the Target market over its life cycle.
5. Monitoring, continuously, to check whether products continue to be consistent
with the demands and needs of the Target market.

20.3 Product Concept

The Product concept phase aims to define the characteristics of a product and its
positioning at a high level in the insurance market in comparison with competitors’
offerings. In this phase, the sales area can be involved to assess the actual commer-
cial potential of the new insurance solution being studied by the insurance undertak-
ing. This phase consists of the four activities described below.

20.3.1 Preliminary Analysis of Competition

In order to launch a product, an insurance undertaking must set in motion a prelimi-

nary analysis of the competition.
The analysis of competition is performed in the reference market so as to
understand how best to proceed. Usually, Marketing staff of the insurance undertak-
ing deals with:

• Analysing the market context where it intends to launch the new products.
• Assessing who the main competitors are who have introduced a similar type of
product and have developed the relative insurance solution.
• Exploring what the demands and needs of customers are.
440 20 Product Development Process

20.3.2 Benchmarking the Product

On the basis of a first analysis made of competition, the Marketing staff carry out a
more detailed analysis on the product to be developed.
For developing a suitable product, Marketing staff performs a product bench-
mark based on five critical activities:

• Performs a product analysis by comparing the types that already exist in the
market.
• Analyses the products that exist in the market, comparing them on the basis of the
covers offered, policy limits of indemnity and technical features such as waiting
periods, excesses and any self-insurance.
• Awards a qualitative-quantitative score to the products selected for benchmarking.
• Analyses any positioning of the product and the most effective distribution
model.
• Understands what the main potentialities from business are and relative impact.

20.3.3 Involving the Channel

Once the market has been analysed, demands and needs explored and the product
has been benchmarked, an insurance undertaking involves the sales channel.
Channel involvement is performed in order to share the findings of the analyses
set in motion by the Marketing structure. In this phase, the potential of the product,
the reference market and the idea for the development of the product are shared and
put under pressure.
Usually, in case of restyling of an existing product, the management of the most
important improvement requests from channels is carried out to collect the
requirements, need for change, priorities, and the relative estimates.

20.3.4 Product Concept Finalisation

Following setting the preliminary process in motion, the Marketing staff of the
insurance undertaking performs activities defining the concept of the product on
the basis of what is discussed also with the channel with potential customers.
The definition of the product concept consists of:

• Identifying a Value Proposition.

• Laying out its structure and main features.
• Identifying a Selling Proposition in terms of sales arguments (e.g. commercial
messages, differences from competitors, targeted communications, branding,
etc).
20.4 Framework and Operating Model 441

In detail, the objective is to define the outline (i.e. a concept) of the insurance
solution. This should meet the client needs identified in the previous phase.
The product is described with the purpose of making clear the new value
proposition.
The Marketing staff must explain the product idea the insurer is going to launch.
In this phase, it is enough to express the value of the product, the basket of
characteristics and attributes that could be perceived by the customer.
The proposal must be formulated highlighting all the potentially interesting areas
of the product:

• Structure of guarantees/deductibles and pricing.

• List and description of services.
• Pre- and post-sales processes.

For the structure of the guarantee, in this phase, the definition of the following
features is usually required: risk definition, type of benefit, benefit limit, coverage
maximum duration, waiting period, exclusion period, eligibility, deductible, age
limits, specific exclusions.
Framing how the product works and a coverage explanation is the objective.
Sometimes at the end of these activities, it is already possible to provide a rough
indicative price. After collecting these elements, Marketing staff organises a focus
group2 with customers to verify the confirmation of the concept identified.

20.4 Framework and Operating Model

At this product launch stage, after a careful analysis has been made of the reference
market, an insurance undertaking deals with defining the distinctive features of the
product that it intends to offer clients.

20.4.1 Bill of Material of the Product

The bill of materials of the product lays out various detail sections of the product:

• Identifying a target of reference clients to aim the product at.

• Indicate the pertinent line of business.
• Defining the underwriting method, duration and any extensions of cover.
• Describing the technical details on the manner of paying the premium (possible
instalments through the year).

2
The focus group conducts a preliminary investigation of the customer’s needs. The focus group
usually includes the following activities: presentation of a preliminary product solution, verification
of satisfaction of customer needs, understanding what possible changes.
442 20 Product Development Process

• Describing the type of risk covered, covers and distinctive features such as the age
of entry and exit from cover, limits of indemnity, waiting periods, excesses, self-
insurance and any exclusions.
• Defining the technical features of reinsurance (type of reinsurance, percentage of
premium ceded, etc.).

All the items delineated above go into defining the qualitative-quantitative

features of the product.

20.4.2 IT Operating Model

Once the structure of the product to offer has been defined, the insurance undertaking
identifies an IT operating model.
The definition of the IT operating model provides for the preparation of a
technical sheet necessary to correctly set the product parameters in the information
system of the insurance undertaking.
The IT datasheet contains a series of items of information of a general kind useful
for entering it into the system:

• Product code for tariff setting.

• Product code to be passed to the product portfolio.
• Summary and extended description of the product.
• Image/logo for the product to present it on the sales platform.
• Sales channel for the product.
• Type of policyholder, beneficiary and assured.
• Minimum and maximum contract duration.
• Underwriting criteria.

Accompanying the datasheet all the contract forms relative to the product
(i.e. product information, general conditions insurance, proposal form, policy sched-
ule, etc.) are identified.
When setting parameters in the IT system of the product, all the parameters that
have a bearing on the tariff or products are also detailed:

• Commissions to be paid to the distributor.

• Taxes and fiscal charges on the premium (if any).
• Promotions and percentages of bonus/discount to be applied.
• Parameters for the tariff form (personal data, duration, risks, etc.).
• Any indexing.

In the final part of the datasheet, the mechanics for the functioning of the product.
Post-sales operations are highlighted, such as the manner of suspension, withdrawal
and revocation, re-activation of premium payment, contract cancellation, changing
personal data, etc.
20.5 Product Realisation 443

20.4.3 Product Launch Scheduling

The timing definition stage is accompanied by the drawing up of a project manage-

ment datasheet where all the characteristics/timings of execution tied to the project
are set out:

• Identification of project characteristics.

• An indication of the team devoted to IT developing of the product with relative
roles and responsibilities.
• Defining project timings.

A product launch scheduling is set out over five phases:

1. Definition of the model (purpose, target analysis, preliminary analysis of risks,

cost/benefit assessment and IT architecture).
2. Setting in motion of works (plan of work, risk assessment).
3. Design/organisation (design requirements, benefits of the plan).
4. Implementing of the product.
5. Trial stage of the product (updating of costs/benefits, assessment test of the
product).

Each design stage requires a certain period of time which is needed for the proper
process leading to the final development of the product and subsequent launch in the
marketplace. See Figure 20.2 for a Gantt representing a product launch scheduling.

20.5 Product Realisation

In this phase, the product is implemented in accordance with all the specifications.
The pricing and technical bases of the product are finalised. Contractual and
precontractual documents are written and validated. The functional analysis is

Year 1
Month 1 Month 2 Month 3 Month 4 Month 5

1 Product’s concept

2 Framework and model of the product

3 Product Realisation

4 Internal corporate validation

5 Sharing with the channels

6 Product release

Fig. 20.2 Example of product launch scheduling Gantt

444 20 Product Development Process

performed, and the ICT function goes on with the parametrisation of the IT system.
Finally, any third-party administrators are selected to guarantee the services
provided by the product. In the end, in the case of reinsurance, treaties are prepared.

20.5.1 Pricing (Technical Bases)

Once the structure of the product and the IT operating model have been defined, the
Actuarial function of the insurance undertaking deals with defining the pricing
(technical bases) of the product that lead to building up the insurance premium.
Actuarial (pricing department) draws up the Business Plan for the Product on the
basis of underwriting decisions. Such parameters are:

• Costs tied to implementing the product (fixed costs, administration costs, etc.).
• Acquisition costs.
• Commissions paid upon collection.
• Product loadings.

On the basis of the findings of the Business Plan, Actuarial (pricing department)
evaluates the sustainability of the product over time.3
Additionally, the Actuarial (pricing department) department assess a scheme of
reinsurance in the event of the insurance undertaking intending to reinsure the risk
underwritten by selling the product.
At the conclusion of the pricing activity for the product, the findings obtained are
formalised in a technical datasheet evidencing details of the pricing simulations run.

20.5.2 Sales and After-Sales Processes

The activities of this phase are aimed at defining the operating model and explaining
how the product works. The sales and after-sales processes are described according
to four areas: Sales, Underwriting, Claims Settlement and Customer Services.
For Sales area, the channels, the commercial process, the sales methodologies
(i.e. customer engagement and tools) and marketing positioning (communication)
are explained.
For the underwriting area, the process, the constraints, the controls and the
operating procedures (e.g. questionnaires, data collection forms, etc.) are defined.
For the claims settlement area, the process and activities are illustrated.
For the services area, the use of the services is defined, as well as the management
of the suppliers.

3
For an explanation of the non-life pricing, see Chap. 11.
20.5 Product Realisation 445

20.5.3 Contractual and Precontractual Documentation

In this part of the process, a product development and launch team draw up all the
contractual and precontractual documentation related to the product, general
conditions of insurance, explaining of covers, guarantees and economic conditions
and proposal forms are prepared.
Such sections are:

• General conditions of insurance, wherein how the product functions and its
economic conditions are described.
• Proposal forms.
• Product training for salesforces.
• Any other documents which there may be.

20.5.4 Functional Analysis and IT Parametrization

The functional analysis stage leads to drawing up a report/operating manual in

which details of how the product works are set out.
These activities consist of:

• Process structure (the data input stage, processing, drawing up the report).
• Technical analyses (tied to technical L/P trends of the product4).
• Method for loading data (software and extractions, flows of input, transcoding
tables).
• Business requirements (specific requests, attribute mapping, etc.).
• Methods of process updating.

IT development consists of the activities that a team of expert developers carries

out to create the routines and operating instructions for the IT system. Development
activities involve writing the instructions according to a specific programming
language. The duration of this phase can be as long as a few weeks/months
depending on the complexity of the new product.
Development activities are carried out after completing the analysis and design of
the IT system.

20.5.5 Requirements and Selection of TPA

Many insurance products include services offered to clients. To provide these

services, insurers make use of third-party suppliers, so-called Third Party

4
L/P means Loss/Premiums. The ratio is known as Loss Ratio. A loss ratio, in general terms, is the
ratio of losses to gains. See Chap. 34 for insurance ratios.
446 20 Product Development Process

Administrators (TPAs). An insurance undertaking, when choosing a TPA in the

provision of services, evaluates a series of qualitative and quantitative variables that
may have a bearing on a final decision.
These selection criteria can be the following:

• Positioning in the marketplace.

• Relations with competition.
• Quality in contract management.
• Reliability and quality of services offered.
• Technical and economic conditions.

Additionally, the suppliers/TPAs are selected with a profile of professionalism,

integrity and financial capacity.
By concluding and agreeing to outsource services/activities, a supplier must
ensure:

• High-quality performance in the activities outsourced in abidance by regulations

and provisions set by the undertaking.
• Proper communications with the insurance undertaking on any matter that might
impact significantly on its capacity to perform the activities outsourced.
• Confidentiality of data relating to the undertaking and assureds.

Usually, the insurance undertaking also defines the procedures for control of the
service level.

20.5.6 Reinsurance Agreements

Once the product overall has been defined, the insurance undertaking may decide to
take on the entirety of risks tied to the product or sign reinsurance agreements in
accordance with corporate risk appetite.
The contract is concluded through the following stages:

• Concluding/drawing up of a reinsurance treaty.

• Negotiating contract conditions with a professional reinsurer.
• Closing the final contract once the treaty has been shared.5

20.6 Internal Corporate Validation of the Product

The process of developing and launching new products concludes with the setting in
motion of the internal authorisation process of the insurance undertaking.

5
For a detailed explanation of the reinsurance, see Chap. 17.
20.8 Product Release 447

The corporate validation process of the product consists of having information

of product launch circulated and indicating any corporate filing (or directory) for
consultation of all the pre-contractual documentation on the product and ensuring
complete training for involved staff.
Usually, the new product is authorised and validated by two internal committees:
a product committee and a control committee6. The Product Committee examines
any criticalities there may be in the distribution and underwriting areas. Members of
this committee are top management, responsible for line of business, Actuarial
(pricing department) Marketing, Sales, Risk Management and Finance.
The control committee is responsible for checking on the level of exposure of the
undertaking to all risks. It defines operational risks concerning the launch of the new
product (i.e. underwriting, compliance, reputational, etc.). Generally, members of
this committee are the control functions (Risk Management, Internal Audit, Compli-
ance, Actuary) and a member of the Legal organisational unit.

20.7 Product Presentation to the Sales Channels

After having obtained the validation of the product, Sales area deals with an official
presentation to the channels identified for distribution.
Product presentation on the market means attracting the attention of customers.
Through the presentation, it is possible to explain the functions and peculiarities of
the product and demonstrate the related advantages.
The presentation of the product has to be tailored depending on the recipients:
sales force, influencer or final customers. Usually, the presentation of the product
includes several activities:

• Describe the new solution and vision.

• Present the unique selling proposition (USP).
• Illustrate the sales tools (marketing and commercial process).
• Provide information on the budget (costs, activities and resources).
• Product vademecum with indication of underwriting limits, possible warranty
extensions allowed with the relevant clauses to be inserted, replacement rules for
upgrading products in the portfolio and further operational details.

20.8 Product Release

The product release phase can be split into three activities: IT tests, issue of the sales
kit and product training material, signing of a commercial agreement with the
channel.

6
For roles and activities of the committees, see Chap. 19.
448 20 Product Development Process

20.8.1 IT Tests

At the launch stage of the product, the Information and Communication Technology
(ICT) unit deals with setting in motion/developing the procedure requiring final tests
according to the guidelines drawn up during the course of the process.
In this phase, after the analysis and design of the IT system, the new information
procedure to support the commercial process is released. Usually, in this phase, all
the checks and final testing activities of the prototype (or pilot) of the product are
also conducted.

20.8.2 Issue of the Formal Sales Kit and Training

Once the product is released, the sales force is supplied with the final version of a
sales kit.
Sales kit is a set of specific marketing tools to support the commercial process
and to promote the product.
Usually, the sales kit consists of a brochure, catalogue, presentation and forms for
offers and quotation. In addition, gadgets, promotional items and multimedia tools
are developed for promoting the activities on the field.
Formalisation of the product requires the issue of a series of contract and
pre-contractual documentation by way of accompaniment.
A briefing package made up of:

• Briefing note and glossary.

• General conditions of policy.
• Proposal form.
• Policy schedule.
• Health History Questionnaire (HHQ) (if any).

Detailed material is drawn for the training of the salesforce. The training relates to
the new product, legislation, sales techniques, and commercial processes.

20.8.3 Commercial Agreement with the Sales Channels

At this stage, sale of the product is proceeded through concluding a commercial

agreement with the channel.
The commercial agreement consists of a contract signed between the parties
(insurer and distributor) to define a series of reciprocal rights and obligations relating
to the trading of the new product.
Usually, this contract requires:
20.9 POG: Product Oversight Governance 449

• Defining the SLAs (Service Level Agreement between distributor and insurance
undertaking).
• References to Local Regulations.
• Defining a sales mandate from the insurance undertaking.
• Defining of economic remuneration for the distributor.

20.9 POG: Product Oversight Governance

As mentioned at the beginning of the chapter, the process of developing and launch
of a product must abide by what is laid down under recent regulation, Product
Oversight Governance (POG).
For the first time, lawmakers have defined rules for a new system of governance
and monitoring of the process of product development in the insurance industry7.
This control system is called Product Oversight Governance (POG). The regula-
tion foresees a sort of quality and traceability certification for insurance products
(as occurs for other sectors of consumer goods).
The activities impacted upon are the following five, shown in Figure 20.3.
In the following paragraphs, we describe the areas impacted by POG regulation:

1. Procedure of developing and approval of products. An insurance undertaking

must set up a detailed corporate procedure wherein points of control applying

Procedure of developing
Shills and competences
and approval of product

Segment of customers
and Target Market

Product Test Monitoring

Fig. 20.3 The main impacts deriving from POG

7
Reference is made to delegated Regulations 2017/2358 dated 21 September 2017 - POG (Product
Oversight Governance) For a complete treatment of the distribution see Chap. 25.
450 20 Product Development Process

during activities of development and approval of a product are indicated. The

procedure applies both in respect of new products and any significant change
made to an existing product. The aim of this requirement from lawmakers is to
avoid any development of insurance products that might not be aligned with
customer needs.
2. Skills and competences on the part of personnel involved in designing and
creating insurance products. An insurance undertaking must demonstrate that
personnel involved in designing and creating insurance products have the skills,
knowledge and experience necessary for the activities they are involved in.
3. Segment of customers and group of compatible customers (so-called Target
market). Each product must be developed by an insurance undertaking taking
the market of reference into account (so-called Target market). This must be
identified in detail (characteristics, risk profile, requirements and demands, etc.).
4. Product test. An insurer must perform an activity of scenario verification and
analysis (prior to putting products on the market). Through these tests, it is
necessary to verify whether the insurance product meets the demands and needs
of the target market over its life cycle.
5. Monitoring. An insurance undertaking must carry out a continuous process of
verification and monitoring of products. The aim is to check that products
continue to be consistent with the demand and needs of the target market.

20.10 Questions

1. What are the activities performed during the product analysis and
benchmarking activity?
2. What is meant by “Bill of Material” of the product?
3. What are the functions usually involved in the product development and
launch process?
4. Indicate the sales and after-sales processes (defined in phase: technical struc-
ture of the product)
5. Illustrate the activities planned for the product release
6. What are the areas involved by the new rules POG?

Regulations: Chronological Order

Commission Delegated Regulation (Eu) 2017/2358 of 21 September 2017 supplementing Directive
(EU) 2016/97 of the European Parliament and of the Council with regard to product oversight
and governance requirements for insurance undertakings and insurance distributors
Regulations: Chronological Order 451

Suggestions for Further Study

Crainer S, Dearlove D (2003) The ultimate business guru book. The greatest thinkers who made
management. Capstone Publishing, Oxford
Lynch RL, Cross KF (1991) Measure up – the essential guide to measuring business performance.
Mandarin, London
Marano P, Rokas I (2019) Distribution of insurance-based investment products. Springer, Cham
Marano P, Noussia K (2021) Insurance distribution directive. Springer, Cham
Porter M (1985) Competitive advantage: creating and sustaining superior performance. Free Press
MacMillan, New York
Selikoff, S. (2020) The complete book of product design, development, manufacturing, and sales,
Product Development Academy
Underwriting Process
21

Abstract

The aim of this chapter is to illustrate the process of underwriting risks and
issuing policies. The standard process is made up of the following five stages:
Acquisition information and consideration of Demand & Need quotation,
processing a proposal, verification/waiver of underwriting limits, policy issuing
and premium receipt.
The activities that relate to three different types are illustrated: the process for
non-life retail and life insurance products, the process for industrial risks and, the
process for standard contracts sold via the bankinsurance channel or distance
marketing. Each of these three processes has a number of differences as compared
to each other.
After the introduction of the IDD regulations, the traditional commercial
approach has changed so as to place far greater emphasis on preliminary assess-
ment of requests from customers and their level of knowledge and awareness.
In the case of industrial risks, the process of underwriting and quotation of
related risks are not standardised. Each risk has to be assessed specifically.
In the process of underwriting standardized contracts, no tariff waiver is
foreseen.
Lastly, the two main post-sale operations tied to the underwriting cycle are
explained: the renewals and the technical and administrative endorsements.

Keywords
Quotation · Proposal · Offer and acceptance · Consideration · Issuing the contract ·
Conclusion of a contract · Release for premium · Premium collection · Insurance
Distribution Directive (IDD) · Insurance Product Information Document (IPID) ·
Key Information Document (KID) · Packaged Retail Investment and Insurance

# Springer Nature Switzerland AG 2024 453

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_21
454 21 Underwriting Process

Products (PRIIPs) · Insurance-Based Investment Product (IBIPs) · Falling due

policy · Technical endorsement · Administrative endorsement

21.1 Learning Objectives

At the end of this chapter the reader should be able to:

1. Explain the process of underwriting a risk and issuing an insurance

contract.
2. Describe the differences between a retail product an industrial risk and a
standardized policy.
3. Identify the corporate players involved in these activities and the role of the
distributor.
4. Know the supporting documentation required (from quotation to final
issue).
5. Explain the differences main post-sale operations tied to the underwriting
cycle.

21.2 Stages of Underwriting Process

The sales process, which in the insurance world is the same as actually underwriting
a risk. Usually it starts life in the distribution channel of the insurance undertaking.
The process displays features that are typical of the insurance industry, life or
non-life, and the channel through which the process operates. Notwithstanding this
fact differences can be found. Here, below the two general principles of a standard
underwriting process are laid out acquiring informations from the potential cus-
tomer, risk selection and evaluation.

Consideration of the Demands and Needs of the Customer The information

acquired by the distributor should include age, state of health, work activity, family,
financial and insurance situation, and relative future expectations. If possible, any
insurance coverage already in place are also to take into account.
Only if the product is deemed to be consistent with the customer’s Demands and
Needs the distributor can propose the contract. In any case, before signing the
contract, the assured must be informed through specific pre-contractual documenta-
tion (i.e. Key Information Document (KID) for life products or Insurance Product
Information Document (IPID) for non-life products).
21.3 Underwriting Process for Insurance Products 455

The distributor must refrain from placing the product in any case in which the
consistency of the offer with the customer’s Demands and Needs is not ascertained.

Principles of Risk Selection and Evaluation i.e. the ones that impact upon the risk
and so upon the premium. In the case of a life policy for example, the general state of
health of a potential assured and their lifestyle are the data that concern an insurance
undertaking. Where, on the other hand, a client comes to take out an Automobile
civil liability policy, the information that is useful are the age, residence and state of
risk certification, or claims record. For theft and fire policies on a dwelling, for
example the insurance undertaking usually wants to know the value of the house,
whether there are intrusion alarms and if there have been previous losses of this kind.
Only after having gathered this information is it possible to judge the riskiness of a
potential assured.

21.3 Underwriting Process for Insurance Products

For non-life insurance and traditional life insurance products, the process can be
broken down into various specific activities, such as quotation, proposal, verifica-
tion/waiver of underwriting limits, contract issue and release for premium paid. The
five stages in the underwriting process for standard products are represented in
Figure 21.1.

21.3.1 Consideration of the Demands and Needs of the Customer

In this phase, first of all, distributors must acquire all useful and relevant information
from the customer to assess their Demands and Needs. The information requested
from the customer, according to the provisions of the Demands and Needs test,
relates to their personal characteristics and insurance/social security needs.
Once the information has been received, an assessment of the appropriateness/
adequacy of the insurance product in comparison with the needs must be carried out.
Note that distributors can only propose contracts that are consistent with the gathered
evidence.
The information on the insurance contract offered must be objective and in an
understandable form to allow the customers to make an informed decision. All the
pre-contractual and contractual information, that must be provided to the customer

1 5
Acquisition 4
3 Issuing the
information 2 Verification/waiver
and Processing contract and
Quotation of underwriting
consideration of a proposal release for
Demand&Need limits
premium

Fig. 21.1 Stages in the underwriting process for insurance products

456 21 Underwriting Process

on the product, consists of the summary sheet (standards for all EU countries).
Template for non-life products is called Insurance product information document
(IPID), whereas for life investment products it is called Key Information Document
(KID).1

21.3.2 The Quotation

" Definition The activity of quotation allows for collection of the data needed for
defining a quote for an individual client and can lead to drawing up a budget for the
policy. It is important to underline the fact that at this stage, a preliminary and
generic quotation is produced on the basis of the indications of needs and demands
indicated by a potential customer.
The quotation is tied to a generic party with characteristics similar to those of the
potential customer.
This stage can be broken down into the following six activities:
Acquiring the information needed for the quotation relates to all the activities
tied to gathering data needed from the client for defining a first quote. In the case of
Automobile liability, for data of a technical kind (i.e. license plate and personal data)
checks are made at the same time online on the data provided by a client via access to
outside databases. Another example is the case of a life insurance policy where a
medical history questionnaire can be filled in.
Input of data for client profiling relates to activities of input of data collected
from a client for comparison with insurance profiles the undertaking has prepared.
This activity calls up features of the IT system2 (policy portfolio) in order to
associate the quotation for the risk with the profile of the client.
Check of underwriting limits takes place via automatic grids foreseen in the
systems IT and leads to carrying out activities of check on underwriting limits tied to
the risk and the parameters associated with the profile of the client. For instance, for a
theft insurance policy, the insurer evaluates different elements such as: location
(comparing the local percentage of thefts versus national average), the type of
dwelling (i.e., multiple entrances, level and floor), the installation of a security
systems, etc. Whereas, for example, for a life insurance policy, it is necessary to
check the parameter weight—height.
At the budgeting stage, pricing allows a definition to be made of the premium and
performance of the policy via the tariff engine.
The manner of issue and prior notice generated vis-à-vis the client takes into
account the hard copy and digital means used by the insurance undertaking. The
quotation and budgeting stage has therefore the aim of providing: 1) a preliminary

1
For a detailed discussion of these two templates (IPID and KID), see below in the following
paragraphs.
2
For the components of an IT System in an insurance undertaking, see Chap. 18.
21.3 Underwriting Process for Insurance Products 457

and general quotation based on the Demands and Needs indicated by a potential
customer. 2) the pre-contractual documentation one, which illustrate the product and
its adequacy.

21.3.3 The Proposal

" Definition After the stage of budgeting, proposal stage transforms the quotation
into a formal insurance proposal document. The personal data of the assured and
policyholder are gathered and entered (in the case of life products, data of the
beneficiary are also collected).

Later, drawing up of the policy proposal is proceeded to. Through this, subsequent
acceptance/refusal of the proposal is arrived at. This phase is made up of the
activities shown below.
Transactions begin when a party proposes to exchange something of value with
another party.

" Definition The offer is the proposal to make an exchange. If the other party
agrees to the exchange, this is an acceptance.

When purchasing an insurance product, a party ordinarily completes an applica-

tion form and in doing so makes an offer to purchase insurance. If the insurance
undertaking accepts the offer, it agrees to insure the applicant. Note that insurance
agents though soliciting new business, legally are not offering to sell insurance.
Technically, we can say they are inviting the insured to make an offer. If the insurer
issues a policy, that indicates acceptance.
Delivery to the client of the pre-contractual documentation and filling in of
the adequacy evaluation. This is a series of activities that aim to provide the client
with all the pre-contractual documentation necessary and foreseen under regulations
and proceed to assessing adequacy. The proposal needs to be compliant with the
demands and needs of the client.3
Uploading of data to the application or incorporation of those from the
quotation. There will also be activities of uploading data and adding in of
information collected in the earlier quotation phase.
For risk assessment and check of underwriting limits activities, the same
actions and the same checks as already presented during quotation activity are
performed.
Drawing up and notifying the proposal leads up to actual issue of the policy
proposal. This takes place on various supports, either hard copy or digital. In cases
of Internet and telephone channels, the proposal, together with further
pre-contractual documentation, may be sent by email to the address indicated by

3
For the rules about distribution (directive IDD—Insurance Distribution Directive), see Chap. 25.
458 21 Underwriting Process

the client. Regarding acceptance of the proposal, a client may decide whether to
accept or refuse the conditions foreseen in the proposal via an acceptance of the
terms of the proposal form. In cases of refusal, the completion of additional forms
is not usually required.

" Definition Consideration corresponds to the value exchanged between the

parties to a contract that is, what each party gives to the other. Consideration may
take a tangible form, such as money, or it may take the form of a promise to do
something or not to do. There must be an exchange of consideration to have a valid
contract.

In case of positive acceptance from the customer, the insurance contract is issued.

21.3.4 Verification/Waiver of Underwriting Limits

When underwriting a risk, technical assistance support and queries from the insurer
may be needed to help the sales structure in applying the authorisations it has, or
requesting waivers where this is not the case. At this stage, once the documents have
been defined, a revised underwriting limit may even be needed. Materially, at this
stage, following definition of documents, it may be necessary to authorise new
underwriting limits.
In this case, activities are managed differently as compared to what is indicated in
the previous chapter for a standard risk and normally foresees what follows:

• Acceptance of a type of risk or a level of risk not foreseen in the guidelines of the
insurance undertaking.
• Departure from the premium applied by the insurer. This means that a commercial
discount is granted against a risk that would have a higher price.

Once data have been received from the sales structure, for supporting the decision
regarding these exceptions, head office structures carry out verification of the
insurability of the risk and verification of any documentation received from the
client. On occasions for some specific non-life lines of business (i.e., theft insurance,
fire insurance, etc.), a survey is performed by a delegate of the insurance undertaking
to check the actual status of the subject matter of the insurance. For instance, for life
policy, medical records are requested and previous illnesses could be excluded.

21.3.5 Issuing the Contract and the Release for Premium Paid

Issuing the contract and the release for premium is the phase wherein the activities
connected with effective acquisition of a contract occur and are made up of the
following three
21.4 Underwriting Process for Industrial Risks 459

Upon issue of the insurance, an insurer issues a policy contract, verification of

the documentation forwarded or delivered by the client is done by the structures of
the undertaking. The contract is signed by both parties: by the customer or policy-
holder and by the distributor or insurance undertaking. Indeed, an insurance under-
taking takes time to verify the match-up between the data given in the document
provided by the client and those notified/entered at the time of quotation. In the event
of non-matching, the client is contacted, and action is taken as a consequence. For
life policy, the policy contract is issued after verification of the documentation
forwarded by the client (sometimes a medical examination is required).
Collection of the premium by the distributor or in the manner agreed by the
insurance undertaking (cheque, bank transfer, direct debit cash).
Release for premium is the document that the undertaking issues to certify
payment has been made of premium instalments subsequent to the first premium.
It must bear the signature of the person authorised to collect and the date (and, at
times, the hour) collection takes place. Premium receipt consists of written evi-
dence given to a policyholder by an insurance undertaking or an insurance distribu-
tor that it has received a premium.
Archiving corresponds to the series of actions to be performed for the purpose of
properly preserving all the documentation referring to the process of contract.

21.4 Underwriting Process for Industrial Risks

In cases of specific risks, the request for a quotation often takes place upon an
indication from a specialist network of distributors, such as brokers, who submit
particular risks for assessment to the undertaking specifically case by case. For
this reason, activities cannot be standardised but rather follow a special course at
head office. The activities are the following six: acquisition of the request, related
preliminary opening/assessment, management of the quotation and verification of
underwriting limits, sending of the quotation to the distributor, confirmation of
cover, issue of the contract and release note for payment. The stages in the
underwriting process for an industrial risk are represented in Figure 21.2. Note
that the insurance products offered are tailor-made and customized. For this
reason, this kind of customer the issuance of precontractual documentation is
not applicable.

3
4 6
2 Management
Sending Issuing the
1 Preliminary of the 5 Sending
the contract
Acquisition of assessment quotation and confirmation
quotation and release
the request of the verification of of cover
to the for
request underwriting
distributor premium
limits

Fig. 21.2 Stages in the underwriting process for an industrial risk

460 21 Underwriting Process

21.4.1 Acquisition of the Request

Acquisition of the request for quotation of a risk may occur in different ways:
sending by mail or hard copy post (for example, for taking in part in tender processes
or competitions), rather than by sending an email directly to the undertaking with a
point-by-point description of the risk to insure. Usually, right from the giving of the
first items of information, the underwriting office of the undertaking is able to check
whether this request falls within a class of risk in which the insurer operates and is
sufficiently detailed for it to make an assessment, express and then formulate an
initial judgement and interest. Otherwise, it is rejected, or further information is
requested. The underwriting office’s activities consist of the following: defining the
underwriting conditions, carrying out underwriting checks and providing pricing
information.4

21.4.2 Preliminary Assessment of the Request

The stage of setting in motion a preliminary opening/assessment of the request for

cover leads often to prior verifying of the standing of the distributor to formulate this
request (for instance, for a broker, a copy of a mandate may be asked for). Later, the
underwriting office checks whether all the items are there for proceeding to assessing
the risk (if necessary, contacting the distributor for additions and clarification).
Preliminary opening of a request in practice requires preparing various items of
information such as, for example personal data for the distributor, type of risk and
product, line of business, commencement state of the contract, limits of indemnity
covered, any reinsurance or coinsurance needed. Once this information has been
recovered and the checks for verification of the completeness performed, the
underwriting office enters the quotation request into the IT system, filling all
compulsory fields necessary from opening. After this, it creates the electronic
order for the cases with all the documentation relating to the quotation (for example,
in the case of property risks: scanned ground-plan files, technical data of the
buildings, location, safety and prevention systems, etc.).

21.4.3 Management of the Quotation and Verification

of Underwriting Limits

Once a request for quotation has been opened, following preliminary verification for
opening, it may be refused or quoted. In cases of refusal, the underwriting office will
point out, following research and further assessment, that the request for quotation is
not acceptable for the insurer (for example, if it exceeds underwriting capacity) and

4
Note that within the underwriting office, the pricing unit may be an internal one. If this is external,
the underwriting office send the information relating to the quotation to an external unit.
21.4 Underwriting Process for Industrial Risks 461

sends notice of this to the distributor specifying the reasons for refusal. On the other
hand, if a quotation is issued, the underwriting office sets in motion the process for
negotiation and dealings with the distributor. Then it draws up the quotation using
the tariff engine of the IT system. At this stage, various surveys of the facilities that
are the subject matter of the insurance are often performed in order to assess the
material exposure to risk. At this stage, risk management advice activity is some-
times provided (and which is useful for corporate risk prevention). At the conclu-
sion, underwriting office prepares the quotation and attaches general conditions of
insurance referring to the product that is the subject matter of the quotation. Finally,
the underwriting office sends the quotation to the distributor via the channels and in
the manner agreed. The case is made subject to protocol and all the documentation
that has supported the quotation is filed in the electronic folder.

21.4.4 Sending the Quotation to the Distributor

and the Confirmation of Cover

If upon reception of the quotation on the part of the distributor it is deemed

interesting, it will give notice to the undertaking by sending a firm order to the
underwriting office, indicating acceptance of the proposal.
Otherwise, the distributor may decide not to accept the proposal from the insurer,
notifying this or by not providing any response by the commencement date of the
cover. Normally, in this case, the underwriting office proceeds to closing the case
opened and changing status in the IT system.
Following acceptance of the quotation by the distributor, the underwriting office
deals with performing the following activities: archiving the firm order sent by the
distributor after checking that it is compliant with the quotation. Then, it generates
the policy number through the related feature in the IT system used. Finally, it sends
the distributor confirmation of cover, with the policy number as reference. Lastly, it
prepares instructions for issue of the contract to the back-office. Rules for accounting
for the premium to the administration office are provided. See Figure 21.3 which
represents the activities, the process and the players for a quotation and confirmation.
In property insurance, a temporary contract called a binder often is used before
the formal insurance policy is issued. The binder must meet all the requirements for a
legal contract. The purpose of the binder is to provide cover during the time it takes

Instructions to
Management Rules for
Activity Confirmation the back-office issuing of the
of the accounting for
of cover and Admin contract
quotation the premium
dept

Player Underwriting Back-office Administration

office office

Fig. 21.3 Process and players for quotation and confirmation activities
462 21 Underwriting Process

to process an application. Normally, a binder will specify the amount of insurance,

the validity period and the parties to the binder.

21.4.5 Issuing the Contract and the Release for Premium

Management of activities for issuing, accounting recording and collection of the

contract is performed by the various players and in a precise sequence. In practice,
the back-office issues a new policy following the instructions for issue received from
the underwriting office. The underwriting office checks and signs the insurance
contract prior to sending it to the distributor. If the document requires changes, the
underwriting office requests reworking while providing relative instructions to the
back-office. Final sending to the distributor is made up of a number of documents:
policy contract, general conditions of insurance, and relative accompanying letter
wherein commissions are formally set out.
Release for payment and collection of the premium takes place at the same time as
delivery of the contracts to the assured by the distributor, who deals with subsequent
remittance to the undertaking.
Release for premium is the document issued by the insurer to certify payment
has been made. It must be signed and dated.
After collection of the premium, the distributor can collect his/her sales commis-
sion and advisory fees.

21.5 Underwriting Process for Standardized Contracts

Differently from the two processes described previously, in cases of standardized

products (which do not foresee departures from tariffs), the underwriting and issue
stages are performed directly by front-end for issuing in a fully autonomous manner.
For this reason, this type of product is defined as an over-the-counter (OTC) product.
This case is usual for the bank insurance channels and distance marketing (i.e.,
online or phone). The stages in the underwriting process for the standard contracts
are represented in Figure 21.4.

1
4
Consideration of the 3
2 Issuing the contract
Demands and Needs Processing a
Quotation and release for
of the Customer proposal
premium

Fig. 21.4 Stages in the underwriting process for standard contracts

21.5 Underwriting Process for Standardized Contracts 463

21.5.1 Consideration of the Demands and Needs of the Customer

For standardized contracts, before processing a quotation, distributors must acquire

all useful and pertinent information from the customer in order to assess the
Demands and Needs. The information collected from the customer relates to their
personal characteristics and insurance/social security needs.
After the collection of all this information, the distributor must carry out an
assessment of the appropriateness and adequacy of the insurance contract offered
with respect to customer’s actual needs. Only insurance policies consistent with the
evidence collected can be offered by the distributor.
The information provided on the product offered must be objective. The goal is to
allow the customer to make an informed decision about the insurance contract.
The pre-contractual information of these standard contracts must always be
provided to the customer. This consists of summary templates (standard for all EU
countries). For non-life products, this is called Insurance product information docu-
ment (IPID), whereas for life investment products, this is called Key Information
Document (KID).5

21.5.2 Quotation

At this stage, the distributor (acting as an enabled user) accesses front-end directly
and prepares the policy budget by entering the data requested. Then, front-end
generates a quotation and the subsequent budget, automatically with the aid of a
tariff engine and ready for printing out by the distributor, who then delivers this to
the prospective client. It is underlined that at this stage, a preliminary and generic
quotation is produced on the basis of the indications of demands and needs set out by
a potential customer. The quotation is not customised. It is linked to a generic party
with features similar to those of a potential customer.
This means that an assessment of adequacy also needs to be papered by filling in
form for this purpose. The distributor needs to understand the demands and needs of
the prospective customer. and must offer an insurance solution that meets the
requests made by the client and based on their own knowledge of insurance
products.
The distributor presents the budget prepared via front-end to the client. Should the
client fail to accept the related budget, it will, in any event, remain saved for
statistical purposes,6 and if on the other hand they accept, the conditions of the
budget, front-end can be accessed again for confirmation and subsequent activities.

5
For a detailed discussion of these two templates (IPID and KID), see below in the following
paragraphs.
6
After having received authorisation for processing of data in compliance with what is laid down
under Privacy regulations.
464 21 Underwriting Process

21.5.3 Processing Proposal

After having gathered and entered all personal data for the assured and policyholder
(in the case of life products, data of the beneficiary are also collected) drawing up of
a proposal is proceeded to. Front-end automatically generates a definitive policy
wording showing all the information present in the budget accepted by the client.
Further pre-contractual documentation is delivered to the client. Once all the com-
pulsory information has been entered, the distributor proceeds to printing out and
delivering the policy generated from the platform directly.

21.5.4 Issuing the Contract and Release for Premium

Once the policy has been issued, front-end proceeds automatically to updating the
portfolio system of the undertaking and providing instructions for accounting for the
contract, splitting the sum of premiums into the relative lines of business. Releases
and collection of premium take place at the same time as delivery of the contract to
the assured by the distributor, who deals with the subsequent remittance to the
insurance undertaking.
In this case, usually release for premium is automatically issued by the front-end
to certify payment has been made.
Archiving of the documentation issued by front-end takes place in accordance
with the agreements concluded between the distributor and the insurer.

21.6 Pre-contractual Documentation for Life and Non-Life

Products

The legislation of the Insurance Distribution Directive (IDD) provides new

information obligations and rules of conduct for insurance undertakings and
distributors. A general principle has been introduced: distributors should act in the
interests of their customers. Gathering of information on the demands and needs of
consumers or the assured is compulsory, including information on the personal
characteristics and insurance or life provision demands of the customer.7 In addition
to this, there are two sets of regulations that have been issued and that apply directly
within Member States laying down an obligation to draw up pre-contract documen-
tation for life and non-life products. The aim of lawmakers is to offer the consumer
information on the product that is easy to read and understand and is comparable at a
community level.

7
For the detailed discussion of directive IDD, see Chap. 25.
21.6 Pre-contractual Documentation for Life and Non-Life Products 465

The first regulation8 lays down an obligation to draw up a new pre-contractual

documentation for non-life products: the Insurance Product Information Docu-
ment (IPID). This delivery is compulsory for all non-life insurance products, in
addition to the documentation foreseen locally prior to signing a new contract. The
IPID for non-life business is drawn up in accordance with what is laid down in detail
in the regulations of the European Commission. The document was developed by
preparing a structure and a format that is common to all Member States. Icons and
common symbols are included. The IPID is split into sections that answer the nine
key questions for an insurance non-life product.
The second regulation concerns the pre-contractual documentation foreseen for
Packaged Retail Investment and Insurance Products (PRIIPs).
KID applies to all insurance investment products IBIPs and PRIIPs.
The outline must be drawn up in a concise manner and in non-technical language
to allow retail investors to acquire clear information prior to investing in a financial
product. Icons and common symbols are included. The KID is split into sections that
answer the eight key questions for a PRIIPs product.
The PRIIPS classification includes all products, regardless of their shape or
structure, created by financial institutions for which the final amount due to the retail
investor is subject to fluctuation. The reason for this is tied to their exposure to the
reference values or subject to the yield of one or more financial assets.9 This applies
only to retail investors. In relation to insurance market, the PRIIP classification
includes insurance products that offer a maturity or surrender value and where that
maturity or surrender value is wholly or partially exposed, directly or indirectly, to
market fluctuations (for instance, unit linked, index linked etc.).10
See the following concept formula:

PRIIPs ¼ PRIPs þ IBIPs ð21:1Þ

Insurance-Based Investment Products (IBIPs) are insurance investment

products. The IDD Directive defines them as insurance products that have a maturity
or a surrender value and in which such expiry or surrender value is exposed in whole
or in part directly or indirectly to market fluctuations. Basically, IBIPs are a subset of
PRIIPs (of insurance products). Packaged Retail Investment Products (PRIPs),
by way of exclusion, include the remaining five categories: unit investment trusts,
structured products and deposits, convertible bonds, derivatives and products issued
by SPVs intended for the retail market. Compared to PRIIPs, PRIPs do not consider

8
See Commission Implementing Regulation (EU) 2017/1469 of 11 August 2017 laying down a
standardised presentation format for the insurance product information document—(I)PID.
9
For the PRIIPs definition see Article 4 of Regulation (EU) No 1286/2014 of the European
Parliament and of the Council of 26 November 2014 on key information documents for packaged
retail and insurance-based investment products (PRIIPs).
10
PRIIPs include financial products such as bonds, derivatives, structured products (as well as
insurance products linked to these underlying assets).
466 21 Underwriting Process

pre-assembled insurance products. For this, the two types of products have different
pre-contractual documents and rules since the underlying financial products are
different.11
This regulation introduces the Key Information Document (KID). This is a
standardised document drawn up according to a common template for all member
States. The KID provides retail investors with the information they need to make an
informed investment decision.
KID applies to all insurance investment products.

21.7 Management of Renewals

After describing activities that concern analysing due dates, four distinct types of
process are explained for dealing with managing renewals. These are:

• Policies not to be renewed.

• Policies to be renewed with different conditions at the due date.
• Policies with no request for modification.
• Policies to be cancelled.

21.7.1 Analysis and Management of Due Dates

To manage renewals in practice, on a periodic basis, every last ten days of the month,
the system automatically processes a list with an indication of all the policies
falling due. This activity can be carried out by the distributor’s staff or by the
insurance undertaking.

" Definition A falling due policy means a contract that reached its due date for
payment, or repayment, or renewal.

This list is sent to the persons responsible for the various lines of business of the
underwriting office for their respective analyses and activities of their concern (such
as, for example the technical trend of the policy, abidance by corporate guidelines,
there being requests for modifications by the distributor etc.); following the analysis,
the underwriting office determines whether policy is to be kept unaltered (it will go
to renewal or expiry) or to be reworked.
All variations, cancellations and manual renewals, once agreed with the distribu-
tor, are forwarded to back-office in good time and consistently with timing for

11
A detailed description of the PRIIPs and IBIPs is available in the chapter 8.
21.8 Technical and Administrative Endorsement 467

release (so as to avoid accounting registration of policies that should not be

renewed).

21.7.2 Management of Policies Falling Due

Policies falling due are managed differently depending on the following

circumstances:
Policies not to be renewed. In this case, the policy ceases to exist at the due date
and as a result the underwriting office provides instructions to back-office to deal
with cancelling the policy from the system.
Policies to be renewed with different conditions at the due date. The
underwriting office deals with assessing all technical and financial parameters in
accordance with corporate guidelines. In favourable cases, it sets in motion
negotiations with the distributor (agreeing on any changes to be made) and checks
on any necessity there may be for performing an activity of specific quotation and
related steps12 (negotiation and contract). Following the foregoing, back-office deals
with issuing an endorsement (keeping the same numbering as for the contract) or
replacing the policy at renewal conditions. In this case, the back-office, on the basis
of instructions received, proceeds to printing out the document and updating the
system. Release for payment by the administration office and collection of the
premium takes place at the same time as delivery of the contracts to the assured by
the distributor, who deals with subsequent remittance to the undertaking.
Policies with no request for modification. In this case, once individual policies
have been analysed by the the underwriting office, no further activities are called for.
Renewal takes place automatically with issue of a release. The policy is accounted
for by the administration office.
Policies to be cancelled. A request for cancellation is to be dealt with within the
terms for cancellation indicated in the policy and achieved, where this is possible, in
a fitting timeframe prior to generating the premium receipt.

21.8 Technical and Administrative Endorsement

" Definition The term technical endorsement is used to indicate any modification
made to the policy determining a single variation or multiple ones in respect to the
insured risk. In detail, technical endorsements concern the amount of the premium
and/or exposure to risk and/or contract terms.

12
Only for industrial risks, the procedure may be different. In this case, once a firm order has been
received from the distributor, the underwriting office sends the relative confirmation of cover.
468 21 Underwriting Process

For example, typical requests that usually modify these items are: variation in the
limit of indemnity, extension/change in duration, extensions of cover in terms of
subject matter, change of policyholder/assured etc.
This type of endorsement may be requested by the distributor who deals with
sending the request for variation to the undertaking. Sometimes, the variation
proposal comes directly by the insurance undertaking during the year so as to modify
a number of contract conditions (usually following a loss event occurring).

" Definition By (non-technical) or administrative endorsement is meant, on the

other hand, any modification made bringing about a single or multiple variations in
respect of items that are not the amount of the premium and/or exposure of the risk
and/or contract terms.

For example, typical requests that might change these items are a variation in
non-binding personal data fields of the assured and the policyholder, fuller
specifications etc.

21.8.1 Acquisition and Assessment of a Request for Technical

Endorsement

A request for contract variation from the distributor subsequent to the issue of the
policy may be made in various ways provided this is foreseen in the policy
conditions.
To assess the request, the underwriting office, having ascertained the fact that this
requires a technical endorsement, must examine the request and check the extent of
the variation and any need there might be for an activity of specific quotation and
steps related to this (negotiation or contract). Then, modifications must be agreed
upon with the distributor. After that, once an agreement with the distributor has been
defined, the underwriting office must send confirmation of the variation having been
made and deal with providing back-office with the relative instructions for issuing
the document.

21.8.2 Managing a Technical Endorsement

Once a request for a technical endorsement has been received, for the activity of
managing the variation, the back-office must update the policy portfolio system so as
to include the new conditions.
At this final stage, back-office, upon an indication given by the underwriting
office, proceeds to printing out two originals of the document (paying attention to
making copies for any pledgees creditor who are potentially concerned in variations
made to the contract).
Later, it is necessary to send the signed document to the distributor. In the event of
the document foreseeing collection of a premium and/or a change to commissions,
References 469

an accompanying letter must be attached. Lastly, back-office deals with updating the
system. Release for payment and collection of the premium take place at the same
time as delivery of contracts to the assured by the distributor, who deals with
subsequent remittance to the undertaking.

21.9 Questions

1. Describe the stages of the underwriting and issue process.

2. What are the controls for quotation of an industrial risk?
3. Define the activites related to underwriting process for standard contract.
4. What are the pre-contractual documentation for life and non-life products?
5. What is a technical endorsement?

References

Directives and Regulations – Chronological Order

Directive (EU) 2016/97 of the European Parliament and of the Council of 20 January 2016 on
insurance distribution – IDD
Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November
2014 on key information documents for packaged retail and insurance-based investment
products (PRIIPs)
Commission delegated regulation (EU) 2017/2359 of 21 September 2017 supplementing Directive
(EU) 2016/97 of the European Parliament and of the Council with regard to information
requirements and conduct of business rules applicable to the distribution of insurance-based
investment products
Commission Implementing Regulation (EU) 2017/1469 of 11 August 2017 laying down a
standardised presentation format for the insurance product information document – (I)PID
Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on
insurance mediation – IMD
Directive 2002/65/EC of the European Parliament and of the Council of 23 September 2002
concerning the distance marketing of consumer financial services and amending Council
Directive 90/619/EEC and Directives 97/7/EC and 98/27/EC

Suggestions for Further Study

Borda M, Grima S, Kwiecień I (2020) Life insurance in Europe. Springer, Cham
Dorfman MS (2008) Introduction to risk management and insurance, 9th edn. Pearson, New Jersey
Marano P, Noussia K (2021a) Insurance distribution directive. Springer, Cham
Marano P, Noussia K (2021b) Transparency in insurance regulation and supervisory law. Springer,
Cham
470 21 Underwriting Process

Marano P, Rokas I (2019) Distribution of insurance-based investment products. Springer, Cham

Marano P, Siri M (2017) Insurance regulation in the European Union. Palgrave Macmillan, Cham
Marano P, Siri M (2018) Cross-Border insurance groups: towards a comprehensive supervision
under solvency II*. Geneva Pap Risk Insur Issues Pract 43:594–614. https://doi.org/10.1057/
s41288-018-0090-7
Vaughan EJ, Vaughan TM (2013) Fundamentals of risk and insurance, 11th edn. Wiley, New
Jersey
Investment Process
22

Abstract

The chapter aims to illustrate the complementary nature of technical insurance

management and asset-financial management. The overall profitability of an
insurance undertaking depends on a synergy being found between technical
insurance management and the financial wealth management.
Transactions relating to asset management may conceptually be split into two
logical moments: one is the asset management and the other is release disinvest-
ment to meet claims or surrenders.
By investments we mean special kinds of transaction through which a long-
term deployment of substantial volumes of financial assets are made in order to
achieve a flow of economic returns over periods of varying length.
The investments of an insurance undertaking meet three fundamental
requirements: profitability, security and liquidity. Diversification is a way in
which the right combination of these requirements can be found.
Typical investment and disinvestment processes can be split into six stages:
Strategic planning—strategic asset allocation (SAA), Investment Portfolio build-
up, Tactical Asset Allocation (TAA), Negotiation, Monitoring and benchmarking
and Administration management.
Within the process of investment and disinvestment, treasury has a responsi-
bility for managing corporate liquidity. It deals with all issues tied to money
flows, incoming and outgoing, as well as cash needs and relative applications.

Keywords
Financial wealth management · Investment · Profitability · Security · Liquidity ·
Diversification · Strategic asset allocation (SAA) · Investments · Tactical Asset
Allocation (TAA) · Credit default swap (CDS) · Liquidity risk · Market risk ·
Interest rate risk · Exchange rate risk · Share or equity risk · Real investment ·
Credit investment

# Springer Nature Switzerland AG 2024 471

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_22
472 22 Investment Process

22.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the importance of asset management in an insurance undertaking.

2. Describe the stages of the investment process.
3. Explain the principles of investments.
4. Explain treasury activities.
5. Distinguish the types of investments.

22.2 Overall Approach: Premiums, Investments and Reserves

As you may recall, In order to fully understand the functioning of an insurance

undertaking, it is worthwhile holding on to a unitary view of the two corporate
managements of the undertaking, each one contributing to the other.
As can be seen in Figure 22.1 the overall profitability of an insurance undertaking
depends on a synergy being found between the two managements, technical insur-
ance and financial wealth. Indeed, although thanks to technical insurance manage-
ment the undertaking obtains its first financial manifestation, i.e. a flow of revenue
due to the placing of risks in the market, the extent of this depends on the
expectations that are inherent to financial wealth management. Although technical
insurance management comes earlier, i. e. when determining the cost of the insur-
ance itself, taking into account the profitability of financial asset management is of
fundamental importance, too.
Additionally, it should be noted that the resulting core management of an
insurance undertaking is determined by both the margin achieved by underwriting
contracts, and the financial margin, achieved from the yield on technical and
mathematical reserves.1

22.2.1 Cycle of Activities in Financial Wealth Management

As mentioned on more than one occasion herein, an insurance undertaking enjoys a

special feature, one that is unique as compared to any other form of entrepreneurship
and consisting of an inversion in the production cycle. This mechanism puts an
insurance undertaking into a position of being able to self-provision through
displacing revenues—costs in time. So as a result of inversion of the production
cycle, the first financial manifestation coming to light is a flow of revenues enriching

1
For a detailed explanation of the two managements (technical insurance and financial wealth), see
Chap. 3.
22.2 Overall Approach: Premiums, Investments and Reserves 473

T0 T1 T2
Timeline

Technical- Asset Technical-

Management
Insurance Financial Insurance

Claims
Premiums’
Activities Investment Yield settlement
collection
Life
performances
settling

Outflow -
Inflow

Overall
Profitability

Fig. 22.1 Complementary nature of technical insurance and financial wealth management

balance sheet assets. This flow, which underpins revenues, is tied to collection of
premiums following the conclusion of insurance policies in the marketplace.
Subsequent activities foresee management of assets. Only finally, are there negative
financial manifestations, i.e. the outgoes tied to indemnities, annuities or sums
covering losses insured and actually occurring.

" Definition Transactions relating to financial wealth management can be

thought of as been carried out in two specific areas: the first being management of
assets, and the second being their release to meet demands for indemnities or
surrenders. Looked at in this way, the typical series of activities of financial wealth
management begun with transactions of actual premium collection are, on the asset
side: management of income flows and activities of investing in assets to act as
technical reserves. On the liabilities side we find activities of disinvestment in equity
and later payment of claims. See figure 22.2 which sets out the cycle of financial
equity management.

The determination of the amount of the tariff is closely tied to the profitability of
investments. It can be drawn from this that it will be the actual profitability of
investments that will determine the competitive capacity of an insurance undertaking
and its positioning in the industry. The more efficiently the resources gathered from
assured are invested, the better will be the insurance services offered and the stronger
will be the capacity to meet the risk connected with the typical business of the
undertaking in question.
474 22 Investment Process

Premiums’
collection

In / Out flows Technical reserves Overall Activities

management Investment Administration

Input cycle

Assets Treasury
Disinvestments management

Outgo cycle Claims settlement

Life performances
settling

Asset Financial Management

Technical-Insurance Management

Fig. 22.2 Typical management of an insurance undertaking

Typically therefore, the business of an insurance enterprise is made up of two

items: insurance processes and investment processes. Integrating these two items
into a single management is indeed a factor that is critical to its success over time.

22.3 Definition of Investments

" Definition By investments we mean special kinds of transaction through which
a long-term deployment of substantial volumes of financial assets. This activity is
made in order to achieve a flow of economic returns over periods of varying length.

Insurance undertakings add to the accumulation of cash funds mainly through

insurance transactions. Depending on the line of business they adopt efficient
deployment of these. Indeed, choices made and investment strategies are different
in the life and the non-life areas.
In managing the resources obtained via the technical cycle of the life area, the
financial component is firmly prevalent over all other insurance components. In the
non-life area, the two managements are complementary in the same way, but
differently from life lines of business, they are less interdependent.
The reasons for differentiating investment policies between the two areas lie in
three items: the length of contract duration, the stability, and the sums involved in
income and outgo.
The specially extended duration of life contracts indeed allows a great accumula-
tion of resources, the mathematical reserves, over a long arc of time. Investment of
22.3 Definition of Investments 475

these latter must ensure the meeting of the commitments made by the undertaking.
Outgoes on the other hand, deriving from performances, surrenders and claims are
predictable. Indeed, conditions and performances are determined within certain
bounds at the time the contract is concluded. Claims depend on demographic
variables that are found to be quite stable over time and fluctuate only slowly. A
typical choice made in financial wealth management in the life area is often therefore
to cover performances that are deferred so much over time that they are just about
certain, with assets carried out to achieve long-term.
In non-life business, the duration of contracts is usually brief. The technical cycle,
and the related management of flows, is often dealt with over periods of less than one
year. In claims there often appears a high-speed dynamic of settlements (which is a
situation typical of mass loss events with short tail features) These conditions do not
allow long-term investment in financial assets and so instruments that can be
liquidated readily are preferred.

22.3.1 Principles for Investments

Through financial wealth management, an insurance undertaking thus seeks out

deployments that are adequate to meet three fundamental requirements: profitability,
security and liquidity. These requirements are not only imposed by regulations but
the nature of the production process itself and dynamics of income and outgo flows
of insurance undertakings demand that investments have these characteristics.
Diversification is a way in which the right combination of these requirements can
be found. In Figure 22.3 we outline the three principles for investments.
The three goals cannot always be pursued together: there is often a trade-off of
one against the other. The undertaking must also carry out an investment policy
featuring general criteria of diversification and dispersion so as to achieve a fitting

Fig. 22.3 Principles for

Profitability
investments
Financial-Asset
management Security
requirements

Liquidity

Diversification
476 22 Investment Process

split of the above requirements over an aggregated portfolio of assets. Here, below,
the characteristics of each of the three requirements are defined.

" Definition Profitability is the capacity of an investment to produce a fitting

return over time, or a one-off return at the time of liquidation (so-called capital gain).
It is well-known that the level of yield is proportional to risk.

This requirement takes on special relevance in the life area where achieving
sufficient yield is essential as the performance may be pre-set at the time of taking
out and be guaranteed by the undertaking. In this case, it is foreseen under
regulations that an insurance undertaking must have available assets that can objec-
tively guarantee the yield promised over time.

" Definition The concept of security of investments is tied to the constancy of

flows on return over time, and like their scale, this depends on the level of risk.
Security is measured as the capacity of a specific investment to keep its economic
value unchanged over time.

It can easily be imagined that this concept is of fundamental importance since

asset investments are a guarantee for investors and assureds. Here security can be
achieved through careful selection of forms of deployment of funds and especially in
diversifying them. In the past, investments in real estate were considered able to hold
their value unchanged over time. Concerning credit investments on the other hand,
another type of investment judged to be secure and lasting over time is in issues of
State securities.

" Definition The liquidity requirement consists in the capacity of an investment to

be transformed into money in the shortest time possible.

This aspect is of fundamental importance for an insurance undertaking since in

the light of the inverse cycle, a need could arise at any time for a cash commitment
due to claims made by assureds. An insurance undertaking must be able to foresee
variations in expected events from actual ones, such as an increase in losses, a
reduction in premium income or an increase in surrenders, so as to implement
management policies for unforeseen releases.
As mentioned, a number of times during the course of the chapter, the machinery
by which a fitting split over the three requirements is achieved is diversification.

" Definition By diversification is meant the process via which the riskiness of
return from a portfolio of securities reduces since within it there is a number of
financial securities whose yields are not perfectly correlated.
22.4 Stages of Investment Process 477

22.4 Stages of Investment Process

Here below in this treatment, the activities that are typical of investment and
disinvestment processes and financial wealth management are illustrated. These
activities are performed by resources and means of production of the insurance
undertaking that is distinct from the administrative and management standpoint.
The processes that underlie the financial area are common to all insurance
undertakings.2 The aim of this area is to maximise revenues generated by its activity
while utilising the least possible capital and keeping its portfolio of financial
instruments within certain limits of risk and setting out over time the yield and
capital gains from principal.
The activities of the process can be outlined as indicated in Figure 22.4.
The strategic planning process, which can be called strategic asset allocation
(SAA), consists of planning of asset investment. This activity defines the objectives
in respect of target return and threshold of acceptable risk, i.e. risk appetite, in line
with the strategy of the undertaking. In addition to these two parameters, strategic
planning must also take duly into account cash management policies, i.e. the rates of
incoming and outgoing cash flow by analysing expected future cash flows so as to
assess financial needs arising in the short-medium term. Here, careful analysis is
done of the industry so as to note trends in the main indicators of the sector and
macroeconomic ones. The yield of financial instruments through the use of internal
studies and external ones is benchmarked.

Fig. 22.4 Characteristic

activities of the investment Process of investment
process
1. Strategic planning - Strategic Asset Allocation (SAA)

2. Investments Portfolio build-up

3 Tactical Asset Allocation (TAA)

4. Negotiation

5. Monitoring and benchmarking

6. Administration management

2
In various actual corporate situations, the activities performed and the corporate area itself are
often defined as Asset Management.
478 22 Investment Process

Once the planning stage has concluded, we move on to investment portfolio

build-up. This activity seeks to achieve the right combination of profitability,
security and liquidity in line with financial needs through diversification. In this
phase, the target return and the risk appetite that are specific to the undertaking are
considered. At this stage policies of tactical asset allocation (TAA) are defined and
applied.
The negotiation stage pertains to sales–purchase transactions on securities,
i.e. the series of activities connected with contracting in financial instruments in
regulated markets.3 In general, negotiation is done by transaction by specialist
intermediaries who are able to operate directly in the industry.
The monitoring stage lasts over the life of investments through constant analysis
and benchmarking4 of these so as to identify and possible criticalities and set in
motion any corrective actions for implementing, such as disinvestment, further
charging and hedging processes.5 The activity is at all times performed consistently
with the guidelines for tactical and strategic asset allocation as regards objectives of
risk and return. Updating may be continuous over the course of the day concerning
verification of single position or carried out at discrete intervals in respect of the
breakdown of the entire portfolio.
At the end of the process, there is the bookkeeping activity. Activities linked to
administrative management relate to keeping the accounting of securities, produc-
ing records and updating the historical value of the various positions held. Also,
available are procedures for making a calculation of the quotas of a fund (Net Asset
Value; NAV) or draw value from the financial assets of the undertaking.

22.4.1 Characteristics of Investment Process

Investment processes can be defined by two factors:

• The prospective duration of the monetary sums gathered.

• The complex detailing and combination of variables such as rates, extent and
riskiness of incoming and outgoing flows.

The combination of variables can be outlined as indicated in Figure 22.5.

3
The story goes that the origin of the term lies in the habit of Wall Street brokers of hanging around
the Stock Exchange to do business on the premises (over the counter) even outside business hours.
Securities were negotiated there that were not included in official exchange listings. Over the
counter (OTC) markets do not have standard sales–purchase contracts and methods and are not tied
to a series of rules (admissions, controls, disclosure obligations etc.) that regulate official markets.
4
A benchmark is an objective parameter of reference made up by referring to financial indicators
prepared by third parties and commonly used by sector operators.
5
A hedging transaction is achieved by acquiring or selling one or a number of derivative contracts
(hedges, futures swaps or options) whose value depends on the same source of risk influencing the
value of the underlying asset.
22.4 Stages of Investment Process 479

cash flow dynamics life-cycle of the undertaking

subject of ordinary and extraordinary

investment processes management

Fig. 22.5 Combination of variables—investment process

Directing the processes and policies of investment are therefore not only the
characteristics of cash flow dynamics, but a series of factors. A combination of assets
within the undertaking at a specific time and their level of liquidity indeed needs to
be considered in addition to limitations dictated by regulations. All this together has
to be tied in with the features of liabilities (duration, uncertainty and exposure to
macroeconomic variables). Very often, as we will see later, it is the structures of
liabilities that have a great bearing on asset management policies.
Attention needs to be paid to how investment policies may vary depending on the
life cycle of the insurance undertaking. Indeed, often, small-scale undertakings, or
ones with small market shares, at the beginning of the business, pursue investment
policies that ensure constant return and liquidity. These policies are based on
management that takes very much into account the dynamics of asset release,
above all in periods of high claims. On the other hand, however, insurance
undertakings that have now consolidated, and due to their having been present in
the market place for quite some time, do have available large sums of financial
reserves which by their very mass contribute to the liquidity of the undertaking, and
this makes for a need to seek to meet this requirement in planning investments less
pressing.
In respect of the subject of investment processes, a distinction can be drawn
between processes of movable investments (shares, securities, derivatives) and
immovable (real estate of different types). The former make up a fairly high
proportion of wealth assets for insurance undertakings. Their yield makes up a
significant part of the profitability of financial wealth management. Thanks to their
features, they display a good ability for transformation into liquid cash in a relatively
short time. The latter, investments in real property are typical of insurance
undertakings as compared to other financial intermediaries. Indeed, for their very
nature, they are able to pursue the requirement of security as they usually keep their
lasting value over time and often generate capital gains, i.e. yield. Profitability is
480 22 Investment Process

given by rents and lettings that are typical returns on real property investments. They
are considered to be more or less liquid, depending on the period and the industry.
Lastly, in the area of financial wealth management, a distinction can be drawn
between ordinary and extraordinary management.
Ordinary management allows insurance undertakings to increase the value of
available resources over time due to collection in advance of premiums and
investments of assets via the series of characteristic transactions that identify the
technical-economic functions of the undertaking.
Extraordinary management has as its subject matter on the other hand investment
and disinvestment transactions whose significance is tied to the extent and excep-
tional nature of the results achieved. The management of events of an extraordinary
kind that fall outside current management cannot be easily planned and replicated
over time. A typical example of strategic management consists of: acquisitions of
strategic quotas in other enterprises, spin-off transactions,6 equity investments,
disinvestments etc.

22.4.2 Activities of Treasury Process

Within the process of investment and disinvestment, treasury has a responsibility for
managing corporate liquidity. It deals with all issues tied to money flows, incoming
and outgoing, as well as cash needs and relative applications. The main tasks of
treasury consist in:

• Optimising corporate liquidity.

• Planning income and outgo.
• Controlling monetary flows and reconciling bank current accounts.

In summary, treasury is responsible for managing incoming and outgoing mone-

tary flows for an insurance undertaking. The activity is performed in coordination
with the finance area and other corporate areas:

• To plan liquidity needs and not run into emergencies in finding funds (in cases of
loss settlements or surrenders by customers).
• To manage recurring payments tied to operating expenses for running the under-
taking (i.e. utilities, salaries for staff, purchases, commissions to the sales network
etc.).
• To plan the application of any excess cash.

6
In the past, the insurance industry went through ferment relating to spin-off operations of real
property assets. Through these transactions a part of property of the insurance undertaking is
conferred upon a new legal entity. Evaluations of assets often generate large capital gains. The
securities of the new entity are assigned as share quotas of the original company.
22.5 Types of Investments 481

Fig. 22.6 Characteristic

treasury process Treasury’s activities

1 Management of cash flow

2 Foreseeing investments

3 Short term investments

4 Payments

5 Reporting

In Figure 22.6, the typical activities of treasury are outlined.

Management of cash flow includes activities for determining sources and
applications of financial flows deriving from technical insurance management. In
this view, treasury deals with preparing a periodic budget (weekly or monthly) of
expected flows (income and outgo) and adds in all non-technical flows to cash flow
(for example, management fees). Finally, it carries out balancing of inflows and
outflows.
Activities of foreseeing investments consist of determining the sum of
investments available to invest and lines of financial management of the undertak-
ing. In this view, it determines all cash-in and withdrawals by assureds and calculates
the liquidity that cannot be invested but rather comes under direct short-term
financial assets (for example, funds in the current account to reimburse to claimants).
Short-term investments concern short-term management of cash-on-hand.
In respect of payments, both technical payments (for example, surrenders and
settlements) and non-technical payments, i.e. invoices from suppliers, salaries of
employees, taxes and contributions, commissions for the sales network, etc. are all
considered.
Lastly, reporting may be divided into:

• Operational, i.e. verification of daily operations.

• Managerial, i.e. preparing the summary situation for management.
• Institutional, i.e. reporting to the Authority and reports for anti-money laundering
disclosures.

22.5 Types of Investments

In the financial wealth management of insurance undertakings, a distinction is drawn

between two types of investment: real and credit. The former are investments in real
estate and securities, at times, even corporate investments. The latter include
mortgages and loans. In Figure 22.7, the main types of investments are outlined.
482 22 Investment Process

Shareholding

Shares
Trading

Public Rating
Issuer
Private
Rating
Securities Bonds company

Variable

Yield
Derivatives
Fixed
Real Duration
Grounds
Currency
Investments Stock
Real Estate Buildings Exchange
Negotiability
Building After market
areas

Corporate
Investments Convertible
Options
Mortgages and No
Credit
Loans convertible

Fig. 22.7 Types of investments

Concerning the real investments, in insurance undertakings, the most substantial

investments are more than anything else in government securities. They allow flows
of income to be achieved that is to a large extent known in advance, especially if held
to maturity, If needed, they are assets that can be readily and cheaply realised and are
almost completely free from credit risk i.e. non-reimbursement at maturity. They are,
however, subject, just like other investments, to price risk and risk of loss of the
purchasing power of the currency (exchange rate) and for which a careful assessment
must be made looking forward.
Investments in securities are the mainstay for their good mix of risk profitability,
security and liquidity.
To hedge against the risks that may derive from fluctuations in prices, insurance
undertakings tend to diversify bonds by varying the duration, negotiability, issuer
and currency. For instance, if the issuer of the bond is a private company, the
insurance undertakings pay special attention to yield on the security and hold them
in extremely limited numbers.
A special type of bond is the convertible bond that allows the holder to convert it
into shares in the issuer company or one other than the issuer. Their flows are thus
closely tied to the prices of the shares into which they can be converted. For this
reason and due to the limits imposed by the Authority, they are hardly used in
insurance.
Insurance undertakings that invest in shares run the risk tied to trends in the
market and enterprise both concerning income achievability and variations in capital
value (see equity risk). For this reason, insurance undertakings turn to them more for
22.6 Regulation of Investments 483

the purpose of creating majority or controlling equity investments in other insurance

undertakings.
Real estate investments lead to a more lasting deployment of funds for the
purpose of:

• Safeguarding the real value of the deployment.

• Drawing a worthwhile periodic income (through letting and rental charges).
• Maintaining a differential plus valuation (a capital gain), when they are
liquidated.

There are, however, disadvantages: firstly, they reduce the level of liquidity, and
after that there are fiscal imposition and maintenance costs. For this reason, the real
estate assets of insurance undertakings are not easily renewed. They apply mainly in
insurance undertakings set up earlier in the past.
Concerning the credit investment, solely in the life business, assureds may
obtain loans on a policy granting these insurance undertakings subject to achieving
a certain value of the mathematical reserves relating to the policy. Granting loans to
assureds under policies are investments that are among the safest that can be made by
insurance undertakings since they have a special kind of collateral supporting them.
In general, they are modest in size because administering them requires supporting
disproportionate costs as compared to the benefits that can be achieved.

22.6 Regulation of Investments

The Authority has placed a number of limitations on investments with the aim of
limiting excessive risk-taking. These limitations are of two fundamental types. The
first category is of a general kind whereas the second is of a special kind.
The first category meets a standard of exclusivity of the subject matter of the
insurance undertaking. Under this rule, eligible categories of investment are
governed.
The second one apply solely to percentage and mix of assets covering technical
reserves. In this case, regulations place a requirement of investment in a number of
asset classes. These limits take technical reserves as a parameter of reference. For
both insurance areas, there applies an obligation to cover technical reserves with
specific investments that display the characteristics set out above (profitability,
security, liquidity) consistent with the peculiarities of liabilities.
484 22 Investment Process

22.7 The Case of the American Insurance Group

In this paragraph, the importance of sound and careful financial wealth

management is given. We report the striking case of the crisis of AIG, one
of the most important insurance undertakings in the world. The low prudence
in financial wealth management was the cause of the crisis.
AIG, American International Group Inc., had been, up until mid-2008 the
largest insurance undertaking in the world by market capitalisation and a
fundamental link in the American financial system. AIG was number one in
insurance policies in the USA and the leading provider of fixed-rate annuities.
The European Headquarters of AIG in London, with credit default swaps
of around 441 billion dollars in securities was originally considered triple A
(the best rating and thus security in the industry). In reality, at least 57.8 billion
dollars of this sum were insurances on sub-prime mortgages packaged and
sold on to various companies. In other words, at that time AIG was
guaranteeing hundreds of billions of financial products that seemed safe. A
credit default swap is indeed a kind of insurance on a financial product against
events like the bankruptcy of the company that the product is tied to.
AIG in London was able to “INSURE” the risk of failure to reimburse
credits and in this way created a default swap in return for a premium. In this
way, and given that AIG was itself rated AAA, if it sold a “default swap” on
the debt of any issuer, the effect was to turn the underlying debt into one that
was rated AAA too.
A large number of American and European finance companies indeed
bought credit default swaps from AIG to keep the trust of supervisory
authorities and rating agencies without giving up high yields.
In this way, European banks were able to lend billions without having to
add capital and reserves against possible losses. By law indeed, banks must
cover risk assets that they acquire with qualifying equity. AIG however
offered a way out. By insuring “risk securities” through credit default swaps,
high margins of security can be maintained and downgrading by Supervisory
authorities and rating agencies can be averted.
If an asset were to turn out not to meet the requirements of honoured debt,
AIG would, however, have been constrained to reimburse what was needed. If
AIG had failed, all the banks insured throughout the world would have had to
reimburse the money needed to guarantee their investments from their own
resources in order to return to the criteria imposed by Basel 2.
For this reason, since a downgrade from rating agencies had caused a
liquidity crisis for AIG, risking forcing it into bankruptcy, on 17 September
2008 the Federal Reserve (FED) sought above all to put together a consortium
of guarantors formed in the private sector. Subsequently, finding this attempt

(continued)
Reference 485

impossible to achieve, it opened a line of credit of 89 billion dollars for the

benefit of AIG in exchange for a share of 79.9% of the capital of the
undertaking. This was in practice the biggest bailout of a private undertaking
in the history of the USA. On 9 October 2008, the FED activated a further loan
of 37.8 billion dollars for the benefit of the insurance undertaking.

22.8 Questions

1. What are the three principles for financial-asset management?

2. What is meant by investments?
3. Indicate the six stages of the investment process.
4. What are the treasury activities?
5. Illustrate the main types of investments.

Reference
Babbel DF (1997) Economic evaluation models for insurers, Wharton Financial Institutions Centre,
working paper

Directives and Regulations – Chronological Order

DIRECTIVE 2009/138/EC Of The European Parliament And Of The Council of 25 November
2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II)

Suggestions for Further Study

Fabozzi FJ, Coggin TD, Englewood C (1995) Investment management. Prentice Hall, New Jersey
Loss Event Management Process
23

Abstract

This chapter has the purpose of explaining the process of managing loss events. In
detail, the process of managing loss events is the process through which an
insurance undertaking fulfils the obligations taken on vis-à-vis an assured. In
life business, it delivers a reimbursement of the performances foreseen, while in
performances foreseen, while in non-life business, indemnification for the loss
event is the same as the claim.
In what is dealt with in this chapter, the management of a loss event for various
types of insurance products is illustrated. The management of a property protec-
tion product is explained (for example, a claim under a homeowner insurance).
Focus is placed upon the opening and management of Automobile Liability loss
events.
Special focus is placed on the procedure for opening and dealing with an
Automobile Liability claim, as certain further items of information must be
provided.
Lastly, the chapter explains the manner of reimbursement under a life policy. .
Concerning this reimbursement, two procedures are in place: settlement of the
lump sum in the event of decease, or reimbursement following a request for
surrender (partial or total) of a life insurance product.

Keywords
Process of managing loss events · Report of loss event · Settler · Loss adjuster or
forensic physician · Special treatment loss event · Ex gratia loss event ·
Reimbursement for decease · Partial surrender · Total surrender

# Springer Nature Switzerland AG 2024 487

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_23
488 23 Loss Event Management Process

23.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Explain the process of loss event management

2. Describe the phases and the activities
3. Know the differences between claims management for non-life business
and for life business
4. Illustrate the features of the process of settlement specific to Automobile
Liability

23.2 Stages of Loss Event Management Process

" Definition The process of managing loss events is the process through which an
insurance undertaking meets the obligations taken on vis-à-vis an assured.

The five stages in the loss event management process are the following: reporting a
loss event, opening of a loss event, assessment of a loss event, settling losses and
authorising payment (See Figure 23.1).

3
2 4 5
1 Assessment
Opening of Settling Authorizing
Reporting a loss event of a loss
a loss event losses payment
event

Fig. 23.1 Stages in the loss event management process

23.3 Loss Reporting

There are different ways a loss event can be reported. Moving on in dealing with this,
the various channels used by insurance undertakings to collect reports are described
(physical, agencies, telephone, online etc.). Focus is placed upon the opening and
managing of Automobile Liability loss events. Finally, the peculiarities in managing
a loss event for a life policy in the event of decease or cases of early surrender are
explained.
23.3 Loss Reporting 489

23.3.1 Taking a Loss Report

If a loss event occurs, a client may deal with reporting it in three different ways:

• By visiting a point of sale of the distributor channel/network. In this case, the

client directly delivers all the documents and receives the first useful information
needed for opening the claim.
• By calling the telephone assistance area of the insurance undertaking or sending
an e-mail.
• By reporting online on the website of the insurance undertaking.

" Definition Irrespective of the channel used, the report of loss event foresees that
the subject reporting provides all the information necessary so as to register a report.
A report of loss event has to be filled in with some required data that are used to
uniquely identify the event.

The procedure of data gathering requires especially:

• Date of the event (date, hour, place, detailed description of the events).
• Data of the assured (personal data).
• Data or person report (if different from the assured).
• Contract number.
• Data of other parties (often this is same as one of the injured parties).
• Data of witnesses (if available).
• Data of the policy.
• Photos and other documents needed (for example, a formal report by the
authorities concerned intervening at the place, i.e. fire department, estimates of
expense etc.).

At this stage, the report can therefore be made either by the subject who caused
the damage or by the subjcet who suffered the event. In detail, in the stage of loss
reporting, a distinction is made between:

1. Direct damage (i.e., personal accident, healthcare, homeowner insurance, etc.)

where the insured and the injured party coincide
2. Indirect damage (i.e., Condominium buildings insurance, etc.) where the insured
causes damage (for instance, spilling of water) to a third party or the injured party
(tenant of an apartment). Compensation deriving from liability insurance falls also
within this category. In this case, the insured is sued by a third party for damage
caused by their action. As the reader can understand, in this kind of damages,
insured and injuring party coincide. It is here pointed out that in policies where the
Contracting Party is not the same as the Assured, the report of loss is submitted by
the Contracting Party. Taking up the example of the Comprehensive Buildings
policy, the report of loss is indeed submitted by the condominium administrator in
the name and on behalf of self as Contracting Party of the policy. A further example
490 23 Loss Event Management Process

is Personal Accident policies on the employees of a Company when the accident is

reported by the Contracting Party via the Human Resources office.

23.4 Screening of Loss Events

Once the loss event has been collected, an initial screening as to the loss event being
indemnifiable in the terms of the policy is carried out and whether there are any
waiting periods/excesses is checked. In cases of:

• There being no waiting periods/excesses: the operator provides indications useful

for the client as to the further documentation to be produced on the basis of the
type of loss event, cover activated etc.
• There being waiting periods/excesses: the operator advises the client that cover of
the loss event may lead to rejection as indicated in the policy conditions.

After entering into the System IT, the case file is sent to the Claims back-office of
the insurance undertaking for verification of the relative cover.
Where insurance cover applies, and if the case file is found to be proper from the
administrative standpoint (it means that the premium has been regularly paid), the
Claims back-office prepares a communication (e-mail or letter) by which:

• The claim file opening protocol number is indicated.

• If necessary, with a listing of further documents to be sent for assessing the loss
event and then deals with sending it.

To avoid double reports, each report is recorded and for each written report
received the Claims back-office checks whether a matching report has previously
been recorded.
In the event of the loss event being reported not foreseeing insurance cover, the
report is closed without claim and a letter of no-cover is sent to the client. At the
same time, all the documentation, that has reached the insurance undertaking relating
to the subject who has suffered the loss event, is returned to the person reporting and
is eliminated from all hard copy and/or electronic archives.

23.5 Opening and Quantifyng of the Loss Event

Should the loss event reported foresee insurance cover, the Claim back-office
assigns the case file to a settler who will deal with checking all the documentation
received along with the written report: Where all the administrative data necessary
for opening are present to the settler can start to manage the case file; otherwise,
reminders for the sending the data needed are proceeded to.
23.6 Assessment of Loss Events 491

" Definition The settler deals with ascertaining, defining and assessing the loss
event. They are responsible also for providing indications for paying claims. They
are normally employees of the insurance undertaking.

The process of assigning claims to settlers usually takes place based on two
criteria. The first is based on geographic area and the second is tied to the type of loss
event. In respect of the first criterion, most insurance undertakings share out reports
by pertinent geographic area so as to ease management and interactions in loco with
an injured party. Because of this, there are often local loss settlement centres, each of
which manages reports that are geographically pertinent. The second criterion is
based on the type of loss event. In this case, the coordinator of the claims area assigns
loss events to individual settlers on the basis of skills and past experience. In this
way, a complex loss event deriving from a fire in an industrial installation, for
example maybe handled by a settler expert in this area, whereas a loss event that
has involved two vehicles with only slight property damage may be handled by a less
expert settler.
Once it has been ascertained that all the documents needed are there, the report is
opened and the assessment stage begins.

23.6 Assessment of Loss Events

During the assessment of loss events, each settler proceeds to evaluating and
quantifying losses assigned to them.
The activities foreseen and possible in the area of assessment are:

• Quantifying the value of the indemnity for the loss on the basis of all the
documentation that has been handed over by the injured party.
• Checking whether it is possible to proceed with reinstatement in a specific form or
proceed with repair of the damage reimbursed directly by the insurance undertak-
ing (so avoiding the dual step of payment by the injured party and subsequent
reimbursement by the insurer).
• If the settler does not have all information available, they usually request inquiries
by a loss adjuster to quantify property damage, or by a forensic physician to
quantify injures to persons.

" Definition A loss adjuster or a forensic physician have the task of

investigating and adjusting losses. The offered services are focused on the activities
of administration, management, treatment and settlement of claims according to the
requests of the insurance undertaking.
492 23 Loss Event Management Process

23.6.1 Requesting an Opinion of an Adjuster or a Medical Board

If during the assessment phase of the case file the settler feels an adjuster or medical
opinion is necessary, they forward the request for support. They explain the reasons
for requesting the opinion. The request is accompanied by a “Form for assessment”
compiled in the parts of concern by the settler and completed by the adjuster or the
physician with the opinion requested. An insurance undertaking at this stage assigns
an appointment to an adjuster or forensic physician formally.
After receiving the appointment, the activities performed by an adjuster
consist of:

• Making a site visit to ascertain the loss directly (taking photos, seeing the extent
of damage etc.).
• Preparing a technical report in which they provide support items to ease
quantification&spi2;of the loss (e.g. they provide an opinion on the cost-
effectiveness of repair rather than replacement of damaged equipment, they
collect alterbative estimates).

If a medical opinion is requested, the examination usually has the aim of

ascertaining physical injury and determining a percentage of disablement, as the
assessment of the settler will be based on this item so as to be able to determine a sum
of indemnification.1
After receiving reports from the loss adjuster or forensic physician, the settler is
able to take a decision on the loss event (settle or reject).
If the settler does not have all the documentation needed for a decision available,
they can request additional documentation.

23.6.2 Escalation Process: Opinion from a Loss Coordinator

During the assessment phase of the case file, the settler may see fit to request an
opinion from a higher level. This request is justified by a search for a further view
and the need to have authorisation from a more expert level, which the Loss
coordinator is. In this case, the settler forwards the request for support with the
reasons for this.
When the request is received, the loss coordinator assesses the case file by
analysing the proposal for a decision and the documentation received and gives an
opinion to the settler.

1
For the explanation of personal accident and sickness insurance, see Chap. 9.
23.7 Settling Losses 493

23.6.3 Managing Special Treatment and Closing the Claim File

If there are cases where the loss is not indemnifiable according to what is laid down
in contract conditions, the settler may be called upon to assess whether or not the loss
can be settled as special treatment. In this case the claim is settled, and the technical
term used is special treatment.

" Definition Despite the contractual conditions excluding the risk that caused the
damage, the settlement of the claim is granted. Losses settled as special treatment
concern losses that depart from contract conditions in the policy and/or settling rules.

" Definition On the other hand, the “ex gratia” loss event is the sum of money
paid when there was no obligation or liability to pay it by the insurer (“ex gratia
payment”2).

23.7 Settling Losses

At this stage, if the settler has all the items requested, they deal with settling the loss
and, depending on the type of cover reported under, may make a full or partial
payment.
A settler is autonomous in decision-making in accordance with a grid of
authorisations based on thresholds defined on the basis of the type of decision
(acceptance/refusal), performance delivered and sum. If an individual settler cannot
autonomously decide on settlement, the loss is handed over to a player with a wider
power to decide.
Prior to proceeding to settlement of the performance, in the cases foreseen in anti-
money laundering regulations in the manner indicated in the general conditions of
insurance, identification data of beneficiaries need to be gathered and checked.
Payment may take place in different ways. It is possible via bank cheque or
transfer and in this case the beneficiary needs to provide all the banking coordinates
(i.e. current account number, banking institution and branches).

23.7.1 Authorising Payment or Rejecting the Loss

On the basis of the authorisations grid for payment of the loss, the settler gathers the
signatures foreseen for settling it.

2
Ex gratia payment: A sum of money paid when there was no obligation or liability to pay it. For
example, a lump sum payment over and above the pension benefits of a retiring employee. In
insurance claims, it may take the form of payment for which the insurer did not appear to be liable.
Ex gratia is Latin for “out of goodwill”. Also called ex gratia settlement.
494 23 Loss Event Management Process

Depending on whether it is full or partial payment, the settler deals with drawing
up a letter of acceptance to be sent to the person reporting. After the settlement of the
claim, the beneficiary issues a receipt which certifies the compensation paid. The
receipt must contain: the amount paid, the information relating to the claim and the
signature of the person collecting the payment. On the basis of the items they have,
the injured subject may decide to reject payment of the loss. Even in this case, the
settler must, in any event, update the letter of acceptance, indicating that the payment
has been rejected.

23.8 Procedure for an Automobile Civil Liability Claim

To open a report for an Automobile civil liability loss event, it is necessary to follow
a procedure that is partly different from the process shown in foregoing paragraphs.
In detail, a number of items of information that are specific to the type of loss event
must be provided:

• Date of the report (date, hour, place, detailed description of the events).
• Data of the assured (personal data).
• Contract number.
• Data in respect of vehicles involved (licence plates, driving licence of the driver,
insurance undertaking of vehicles etc.).
• Copy of the report signed by the parties at the time of the incident. It should be
noted that in a number of European States there is a specific pre-printed form for
incidents between vehicles and this template eases the gathering of data and the
dynamic of the event. If there is a disagreement between the two drivers as to who
is liable, the insurer may resolve the dispute with the insurance undertaking of the
other driver reconstructing the dynamics of the accident.

For determining the cost of the repair, the settler request for an estimation for
repair of the vehicle. Often in this stage, the injured subject negotiates and sometime
does not accept the initial amount foreseen for repairing the car.
If, following a loss event, the person reporting also suffers physical injuries, the
insurance undertaking must proceed to estimating the reimbursement due for physi-
cal injury. In this case, the person reporting can be requested to send the following
documents:

• Medical documentation in respect of any physical injuries (i.e. formal record of

Accident and Emergency unit, specialist examinations, prescriptions and medica-
tion expense, any forensic examination there may be and any invoices etc.).
23.9 Reimbursement Under a Life Policy 495

23.9 Reimbursement Under a Life Policy

Concerning the reimbursement under life policies, the specifics can be three in
number; settlement of the lump sum in the event of decease, or reimbursement
following a request for surrender (partial or total) of an insurance product.
Concerning the reimbursement under life policies, the specifics can be three in
number: settlement of the lump sum in the event of decease, performance settling
at the end of the period or reimbursement following a request for surrender (partial or
total) of an insurance product. See Figure 23.2 that represents different types of
settlement under a life claim.

Payment out of the • In case of

Death
lump sum assured decease

Types of settlement
under a life claim • At the end of
deferred annuity or
lump sum the period

Life performances
settling
Partial
• While the
Surrender policy is in
Total force

Fig. 23.2 Types of settlement under a life claim

" Definition In cases of reimbursement for decease, the documentation to submit

is usually the following:

• Policy number.
• Death certificate of the assured.
• A statement from which it can be expressly discerned whether or not the deceased
has left a will.
• A list of legitimate and/or testamentary heirs of the deceased (specifying all
population registry data; for example, place and date of birth, degree of
relationship, etc.).

If the deceased has left a will, it is necessary to give details of the will (date of
will, date of publication, notary, repertory number etc.).
Beneficiaries must fill in claims settlement forms in all their parts and provide
valid identity document and fiscal details. They must provide data in respect of
current accounts to which they wish the lump sum to be credited.
496 23 Loss Event Management Process

Finally, depending on the causes of decease, it may be necessary to produce a

report from the personal doctor of the assured. The doctor will have to draw up this
report in the most detailed and exhaustive form possible. The insurance undertaking
may also request clinical case files (including that of first admission containing
personal patient history).
As appears obvious from what is set out above, the insurance undertaking, in this
case, needs to receive all the information needed to assess whether the decease falls
within the general conditions of insurance and settle sums only to entitled persons.
In the case of life performance settling at the end of the period, the insured can
receive a lump sum or an annuity depending on the contractual conditions.
Often some policies are not collected by the beneficiary after the due date. These
can be term-policies (for the case of the death of the insured) of which the
beneficiaries were not aware, or policies which, having reached maturity, were not
collected for various reasons. In many European countries, the rights deriving from
these types of life policies lapse after 10 years from the date of the event (death of the
insured or contract expiration).
In cases of reimbursement following a request for partial or total surrender of an
insurance product, the procedure usually foresees the request for surrender being
expressed in an unequivocal manner by the policyholder.

" Definition Partial or total surrender represents the amount the policyholder
will get from the insurer in case of exit from the policy before maturity.

It is necessary to provide specific items of information:

• Population registry data of the policyholder and contract number.

• The sum to claim (or in the case of a product linked to a fund, Unit linked, e.g. it is
possible to indicate the number of units to disinvest or the percentage of the fund
to disinvest.3).
• Data in respect of the current account to which the policyholder wishes the lump
sum to be credited.
• Valid identity document and taxation details.

It should be noted that if the assured is different from the policyholder, it is

usually necessary to produce a proof of life certificate for the assured or an original
signed statement from the policyholder that the assured is still alive.

3
In the case of a product linked to a number of funds, it is necessary to indicate from which fund/s it
is wished to disinvest and the number of units or percentage of fund/s to claim.
References 497

23.10 Questions

1. What are the items of information necessary for opening a report?

2. List the stages that make up the process of handling loss events
3. What is meant by a loss event settled by “special treatment”?
4. Describe the documentation that is a feature of a report of an Automobile
Liability loss event
5. What are the types of settlement of a life claim?

References

Directives and Regulations—Chronological Order

DIRECTIVE 2009/138/EC Of The European Parliament And Of The Council of 25 November
2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II)
Claims Reserving Manual, published by the Institute of Actuaries – 1997 update

Suggestions for Further Study

Dorfman MS (2008) Introduction to risk management and insurance, 9th edn. Pearson, New Jersey
Vaughan EJ, Vaughan TM (2013) Fundamentals of risk and insurance, 11th edn. Wiley, New
Jersey
Insurance Marketing
24

Abstract

This chapter aims to illustrate the meaning of marketing and the marketing of
services. Insurance marketing takes into account the fact that the main insurance
performance is the taking on of a risk insured in return for an insurance premium
and settling a loss or paying annuities/lump sum upon the occurring of a chance
event. A definition of marketing is illustrated, i.e. forming competitive strategies
for an insurance undertaking oriented towards acquiring, developing and keeping
a competitive advantage over competing insurance undertakings over time.
In later paragraphs, the difference between external and internal marketing is
explained.
Then, a definition of communications is provided, and its tools are illustrated,
such as, advertising, promotion, the sales channels and public relations.
In the final part of the chapter, the new frontier of marketing is presented, tied
to the social world and new techniques of non-conventional marketing. The
concept of Customer Relationship Management (CRM) is explained. Lastly,
recent experiments in integrating insurance covers and digital services are
illustrated. The chapter closes with a definition of Customer Experience and
Customer Journey in the insurance services.

Keywords

Marketing management · Marketing of services · Experience or credence

services · Servuction model · Service recovery system · External marketing ·
Strategic marketing · Macro-environment · Competitive environment · Strategic
Business Unit (SBU) · Segmentation · Positioning · Internal marketing ·
Communications · Advertising · Corporate image · Prosumer societing · Non-
conventional marketing · Customer Relationship Management (CRM) ·
Interaction · Insight · Offering · Digital marketing · Customer Experience ·
Customer Journey

# Springer Nature Switzerland AG 2024 499

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_24
500 24 Insurance Marketing

24.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the meaning of the discipline of marketing

2. Explain the differences between traditional marketing and the marketing of
services
3. Distinguish between strategic marketing and operational marketing
4. Indicate the manner of defining a marketing strategy
5. Explain the concepts of external insurance marketing and internal insurance
marketing
6. Define communications and advertising in the insurance industry
7. Indicate the three fundamental areas of Customer Relationship Manage-
ment (CRM)
8. Be aware of the recent developments in digital insurance solutions
9. Learn the meaning of Customer Experience in insurance services

24.2 Marketing of Services

" Definition Marketing is defined as “the process of planning and executing the
conception, pricing, promotion, and distribution of ideas, goods, and services to
create exchanges that satisfy individual and organisational goals”.1

The definition just proposed contains and summarises the main concepts that make
up marketing. It is a process that is managerial and, transverse and involves an
insurance undertaking in its relations and transactions with various stakeholders and
implies an exchange taking place of goods, services and value intended to satisfy the
needs of individuals.

" Definition The way in which insurance undertakings may take advantage of
marketing activities is dealt with by marketing management as a process of planning
and executing activities of conceiving, pricing and distributing goods, services and
ideas so as to create exchanges aimed at meeting the objectives of individuals and
organisations.2

The development of marketing studies has undergone over time the dominating
influence of the development of industrialisation of economies. Production models

1
Kotler P., Marketing Management, Prentice Hall, 1994.
2
Definition approved in 1985 by the American Marketing Association.
24.2 Marketing of Services 501

and consumption of goods and services. Different orientations of marketing have

been pursued over time by insurance undertakings.

• Production orientation: The aim is to produce as much as possible so as to benefit

from economies of scale in contexts where market demand exceeds supply; an
insurance undertaking focuses or production volumes and a grass roots presence
of points of sale.
• Product orientation: In this context an insurance undertaking sets itself an objec-
tive of continuous improvement in supply, making the process of sales in the
market place a secondary concern.
• Sales orientation: At a stage when demand begins to absorb all the products
supplied by insurance undertakings in the industry, their attention shifts to
maximising sales by seeking to outdo the competition.
• Market orientation: The attention of insurance undertakings shifts to consumers,
to the study of their needs and ways of meeting them; understanding what the
market wants becomes imperative to be obeyed; additionally, the study of
products, supplying them at competitive prices and activities of promotion and
communication to customers become important.
• Customer orientation: The main aim of insurance undertakings becomes knowing
the wishes of customers so as to make them faithful and enter into long-term
relationships with them.

Studies of marketing in the services sector became widespread after 1970.

" Definition In general terms, services can be defined as actions or performances

that one party supplies to another in return for a price consideration; they are
distinguished from tangible goods by characteristics of intangibility, inseparability
between production and, consumption and perishability and, finally, heterogeneity.

• Immateriality or intangibility. This is the fundamental distinguishing charac-

teristic of a service as distinct from a tangible good; the essence of a service is the
performance, which cannot be seen nor touched nor smelled nor heard. At the
time when a consumer receives the performance of a service, they have an
experience of consumption but encounter great difficulties in expressing a judge-
ment on the quality of the service itself; to surmount this difficulty, the choice
made by a consumer will be grounded on the basis of prior experience of friends
and relatives and the reputation of the provider of the service
• Inseparability of production and consumption Goods are usually produced
first and later distributed, purchased by consumers and finally consumed. How-
ever, in the services sector, the process of production implies both the sale and the
consumption at the same time and necessitates the simultaneous presence and
interaction between the producer/provider of the service and its consumer. In this
case, the consumer will tend to see the service that is delivered to them at that time
and contact personnel as one and the same
502 24 Insurance Marketing

• Perishability. Unlike goods, on the one hand, services cannot be either preserved
or stored: this leads to the conclusion that a on one hand, service undertaking has
no special problems of a logistical kind to deal with on the other, not being able to
have a “service warehouse”, they have greater difficulty in synchronizing supply
and demand
• Heterogeneity or variability. The qualitative characteristics of performance
might vary greatly from one to another based on the person who at that time
provides the service and even in connection with activities of customer/provider
interaction.

These peculiarities distinguish and characterise the approach of marketing of

services as compared to traditional marketing in the goods sector.

" Definition In general terms, the main issues that the marketing of services is
called upon to deal with concern: managing the interaction with the customer,
emphasising the tangible components of the supply, developing internal marketing
and creating long-term customer relations.

24.3 Peculiarities of Insurance Marketing

The insurance service is one that is highly intangible, abstract, often complex and
whose benefits are future and uncertain, given the chance nature of the event that is
to be insured against.
This characteristic of immateriality is the one that bears most as compared to
others seen previously on the way the quality of the services provided is perceived
and it renders a comparison difficult in itself.
Additionally, insurance services belong to the category of experience or even
credence services.

" Definition The term experience or credence services, means the sentiment of
the consumer. The customer is normally able to formulate an evaluation of the
service that they have purchased only after having enjoyed it.

This is true, for example a holiday in a hotel but in other cases, it might be found
difficult even after consuming (as, e.g. in cases of a need for financial protection).
In managing an insurance service, an insurance undertaking needs to know how
to deal with the consequences that come from immateriality: indeed, it is from this
that the importance arises of the delivery model of insurance services, the importance
of reputation in the market place and the trust that not only the insurance undertaking
enjoys but also the insurance intermediary through which its insurance products are
distributed.
These characteristics are even more relevant if we consider that there is little to
distinguish one insurance service from the offerings of competitor insurance
undertakings and many product innovations in the sector can easily be imitated.
24.3 Peculiarities of Insurance Marketing 503

The main insurance performance consisting of taking on a risk insured in return

for payment of an insurance premium, and settlement of a loss or payment of an
annuity/lump sum upon the occurring of a chance event, is accompanied by addi-
tional services of a kind accessory to the main one.
The complexity that is a feature of the insurance service in its legal-contract and
technical-actuary aspects, augments the difficulty of a consumer in fully
comprehending and evaluating it; indeed, the latter will have difficulty in assessing
the propriety and high-quality of risk-selection techniques and premium tariffs
applied by an insurance undertaking; their evaluation will instead be directed
towards the series of pre-purchase advisory services, assistance at the later loss
event occurrence stage, and a settlement of the insurance performance, which in
the final analysis, make up the insurance product considered overall.
Due to the features of intangibility, heterogeneity and simultaneous timing of
production and consumption of services, any judgement that a consumer might make
as to the quality of the insurance service will be strongly conditioned by the way in
which the entire process of delivering the service is carried out and especially, by
contact personnel dealing with the assured/insurance intermediary relationship.

" Definition A servuction model shows that all the components of an insurance
undertaking are involved in the process: the visible and invisible parts of the
undertaking, personnel in contact with the customer, the physical environment
where performance of the service takes place, all have a bearing on the consumer
and other customers of the undertaking and, finally, the series of benefits of the
service received by the consumer.

A graphic representation of the servuction model that is offered here is useful for
an understanding of the bonds and interaction between the various items. Figure 24.1
shows an outline of the servuction model.
Satisfying the needs of a customer contained in the definition of marketing just
proposed is one of the main aims of marketing itself. In general terms, satisfaction is
linked to a comparison made between the expectations that a consumer harbours
regarding the performance expected during the pre-purchase phase and the perfor-
mance actually received at the time of production/distribution of the service; a
favourable or unfavourable outcome of this process of a psychological kind
determines the degree of satisfaction or vice-versa dissatisfaction with the perfor-
mance received.
However, satisfaction is not of itself sufficient to lead a consumer to repeat
purchases and conquering their fidelity as this latter, on the basis of information in
their possession, compares the degree of satisfaction with the possible alternatives
offered by competitor insurance undertakings and costs associated with a change in
one’s company (switching costs: the time for seeking out new alternatives, costs of
closing relations, loss of discounts granted to faithful customers, changes in pur-
chasing habits, emotional stress tied to changes in insurer).
504 24 Insurance Marketing

Inanimate
Customer
Environment
A
Invisible Organisation
and System
Contact personnel
or Service Provider

Invisible Visible Customer

B

Bundle of Service
Benefits Received
by Customer A

Fig. 24.1 Outline of the servuction model. Source: Hoffman K. D., Bateson J. E. G. (2010)

The psychological process leading to forming expectations is influenced by

previous experiences had, word-of-mouth, the knowledge and skills possessed
and the socio-economic characteristics of a consumer.
Even at the time of making a complaint to the undertaking on the part of a
dissatisfied customer, this needs to deal with it as an important occasion for contact
with the latter; the better the response of the undertaking is in terms of efficiency in
handling the complaint, the greater will be likelihood that a customer remains
faithful to their insurer. However, not all dissatisfied consumers actually make a
complaint to their intermediary or directly to the company; indeed, alongside these
there are many others who simply do not take action or who turn to third parties like,
for example consumer associations, the oversight Authority or an ordinary judge; in
the worst of cases, a consumer dissatisfied with the service received will simply
leave the insurer and complain of the adverse experience they have been through
with relatives and friends (adverse word-of-mouth). In choosing whether or not to
submit a complaint, not only economic reasons concerning the performance in itself
come into play, but there are other psychological motives: if contact personnel has
behaved disagreeably by displaying discourteousness or aggressiveness, this will
increase the sense of dissatisfaction and frustration in a consumer; additionally, if the
intermediary is a person known to them, the emotional cost of forwarding a
complaint will be greater, especially if there will necessary future contacts between
the two, and in the latter scenario if switching costs are low or non-existent, a
consumer might leave the insurer for competitor insurance undertakings.

" Definition The term Service Recovery system refers to the resolution of a
problem by a firm in case of complaints from a dissatisfied customer. Turning a
disappointed customer into a loyal customer by solving the problem and satisfying
24.3 Peculiarities of Insurance Marketing 505

Increased
Do the job right the Effective Complaint
+ = Satisfaction and
first time Handling
Loyalty

· Conduct research
Identify Service · Monitor complaints
Complaints · Develop “ Complaints as
opportunity” culture

Develop effective system

Resolve Complaints
and training in
Effectively
complaints handling

Learn from the

Conduct root cause analysis
Recovery Experience

Close the loop via feedback

Fig. 24.2 The components of an effective Service Recovery system. Source: Lovelock (2001,
p. 171)

their expectations is the goal. Figure 24.2 shows the components of an effective
Service Recovery system.

In marketing terms, relationship management between an insurance undertaking

and its customers implies managing a plurality of relationships: the first is the one
that is created between a company and an assured of an insurance undertaking/
customer kind; the second type of relationship is one binding the insurance under-
taking and its distribution channels and which mostly concerns parties that are
external to the company and bound to the latter by distribution agreements of various
kinds; lastly, there is the relationship that is formed between the insurance interme-
diary and the consumer.
In the direct relationship between insurance undertaking/assured—consumer; at
the time the policy is taken out, an insurance undertaking undertakes to make the
assured whole in respect of a loss suffered when a loss event occurs, in exchange for
payment of an insurance premium calculated on the basis of the likelihood of the
adverse event occurring and the value of the good insured; in life business, in return
for payment of the premium, the insurance undertaking undertakes to pay an annuity
or a lump sum to the beneficiary of the insurance policy upon the occurring of an
event tied to the human life of the assured. In this relationship, the role of marketing
communication is central.
The moment of distribution of the insurance product/service is managed by
parties external to the insurance undertaking: insurance intermediaries perform a
506 24 Insurance Marketing

function of facilitating a meeting between demand for, and supply of, insurance
cover in the market, take part in insurance services and marketing production/
distribution processes and, lastly, they provide information and insurance advice to
the assured.
The function of insurance distribution takes on significant importance for the
insurance undertaking: the features of intangibility, heterogeneity and simultaneous
production and consumption of an insurance service indeed make it difficult for a
consumer to evaluate what they are being offered and they tend to see the service that
is proposed to them at the time and contact personnel as one and the same.
In interactions with final customers, the main functions that an insurance inter-
mediary carries out are:

• Communicator: Concerning an awareness and defining of the need for security of

the customer and proposing an insurance policy as the right response to the need
to protect coming to light: creating accurate expectations in customers concerning
the insurance performance, and finally, communicating a sensation of compe-
tence, professional skill in the intermediary, along with one of reliability and
solvency of the insurance undertaking.
• Salesperson: An accurate, transparent and professional illustration of the clauses
contained in the insurance policy and proper selection of the risks to be insured
• Deliverer of services: At the pre-sales stage, they carry out an activity of insur-
ance advice concerning the needs to be met and customising the policy according
to the necessities of an individual proposed for insurance; at the after sales stage,
presence, efficiency and availability based on new insurance needs of the cus-
tomer and assistance in the loss event settlement phase and executing of the
insurance performance.

As selector of risks to be insured, finally, they represent a crucial resource for the
immediate and future profitability and solvency of an insurance undertaking.

24.4 Strategic Insurance Marketing

" Definition Strategic marketing is called upon to support the forming of com-
petitive strategies by an insurance undertaking directed towards acquiring, develop-
ing and maintaining competitive advantages over competitor insurance undertakings
over time. Planning and implementing corporate strategy are the crucial time
qualifying marketing activitities: once the objectives of marketing strategy have
been set, market targets are identified to which types of potential purchasers of the
offering is aimed at and the components of the marketing mix are set out.

In external marketing, the strategy for communicating the values of an insurance

undertaking, reinforcing its image in the industry and its brand.
24.4 Strategic Insurance Marketing 507

24.4.1 Macro-environment and Strategies

" Definition By macro-environment is meant the general environment where an

insurance undertaking finds itself operating at an economic production, political,
sociocultural, demographic and technological level conditioning its actions.

Identifying critical environmental factors is needed in order to evaluate impacts both

favourable and unfavourable on the objectives and results of an insurance undertak-
ing. Whether the economic situation is favourable or not does have the capacity to
influence, even heavily, the general trend in financial markets and market demand
for life insurance covers and the purchasing power and savings of individuals;
information technology is even now a thrust in the process of innovation that is
important for the insurance industry overall: it means, indeed, mainly product,
process and channel innovation; socio-economic transformations that have taken
place in recent decades have contributed to changing the needs of consumers who
today find themselves having to deal first hand with their needs for security;
demographic changes recorded in recent decades too, and the progressive ageing
of the population of the most industrialized countries, have significant reflections in
policies of development in the insurance industry and in managing risks of longevity
and non-self-sufficiency.

" Definition The competitive environment is a part of the macro-environment; of

this subset there form a part: direct competitors of an insurance undertaking,
customers, intermediaries, suppliers of substitute products/services and potential
new entrants into the industry.

The environment in which an insurance undertaking intends to compete can be

defined through a strategy definition process that identifies Strategic Business Units
(SBUs) for the insurance undertaking.

" Definition The term Strategic Business Units (SBUs) means, in other words,
going on to define which customer segments to consider, in which geographical
areas, with what products to make the offering and which distribution channels to
use for placing policies.

Not all Strategic Business Units identified will have the same weight: it is indeed
necessary for proper positioning in the industry of an insurance undertaking to
identify for each area of business the degree of attractiveness and the competitive
capacity a company has. Marketing then provides an assessment of strong/weak
points and threats/opportunities for Strategic Business Units of reference identified
and possible approaches for entering them.
508 24 Insurance Marketing

24.4.2 Segmentation, Positioning and Targeting

The information that an insurance undertaking has concerning its customers is

fundamental for operating demand segmentation.

" Definition By segmentation, we identify a sub-group of consumers, homoge-

neous with each other, to which a good or service can be offered as efficiently as
possible and, rather than attacking the entire market, become the leading undertaking
in the offering within the segment identified. The most common variables used to
segment the customers are geographic, demographic, socioeconomic, lifestyle, life
cycle stages, etc.

Irrespective of the criteria used for segmenting demand, they must allow groups
of customers that are as internally homogeneous as is possible inside them in terms
of behaviour and motivation to be identified and, at the same time, be different from
each other so as to be able to apply a different strategy of marketing to mix each
segment identified. Once an effective segmenting of the market has been done, the
insurance undertaking has to evaluate the attractiveness, for each market segment it
must be possible to find data for those who have been included in the segment; the
scale needs to be significantly large to be cost effective for the insurance undertaking
to set in motion operations of positioning within it and, finally, it must be accessible
in terms of know-how and availability of required resources. Following this evalua-
tion, the insurer chooses the segment(s) within which to operate (the so-called target
segments).

" Definition The next step concerns the definition of strategies of positioning in
their turn identify the way in which an insurance undertaking wishes to be perceived
in proposing the service offered, highlighting logical, functional or symbolic features
of the service that render it different from the offering of competitors.

In the marketing process, formulating the marketing mix follows segmentation,

targeting and positioning.
To be effective, a strategy of marketing mix must be able to be consistent both
internally—congruent with the pricing, product, distribution and promotion policies
adopted—and vis-à-vis the strategies of positioning, targeting and segmentation on
which it should be based.
In terms of marketing, managing relations between an insurance undertaking and
its customers requires managing a plurality of relations.

24.5 Internal Insurance Marketing

" Definition Internal marketing consists in the promotion of a firm’s vision,
goals, communication, culture and mission statement within the organisation itself.
24.6 Communications 509

In studies of marketing in the service sector, Internal Insurance marketing influences

the relationship between an insurance undertaking and its customers. This relation-
ship is greatly influenced by the quality of relations, motivation and performance of
contact personnel in general,”
Communication in marketing within and insurance undertaking is a useful tool
for creating and keeping a sense of unity and belonging to the undertaking both on
the part of employees and above all insurance intermediaries.
In the process of delivering an insurance service, internal communications have a
noteworthy influence on the level of performance expected by an insurance con-
sumer, on what they expect to receive; contact personnel should be considered as
true (internal) customers of the undertaking, alongside consumers. Communication
includes in the message a promise in respect of the insurance service making up the
offering; for it to be credible outside, it first needs to involve contact personnel
effectively and persuade them.
It is necessary to adopt a policy of internal communications aimed at building up
a corporate culture of transparency and propriety of conduct, even through adopting
and sharing the values contained in codes of conduct and self-discipline at every
level of the undertaking.

24.6 Communications
" Definition Communications means exchanging information, knowledge, needs
and behaviours between people involved in a specific context on common issues.

The aim of communications is usually to meet a need to:

• Provide information addressed to potential customers regarding the insurance

undertaking, its organisation, the promise of the brand, the main features that
characterise the offering as compared to competing insurance undertakings.
• Persuade customers of the high quality of the offering proposed overall as the best
response to insurance needs, also when compared to that of other insurance
operators.
• Maintain and develop direct contacts and relations with consumers and potential
new customers.

Inside the tools of communication, there are advertising, promotion, the sales
channels and public relations.

" Definition Advertising has been found to be a valid tool for disseminating
information concerning an insurance undertaking or the main characteristics of an
insurance solution but is not able in itself to convince a consumer to purchase
insurance.
510 24 Insurance Marketing

In fact, to reach taking out a policy, an encounter and direct communication

between a consumer and the sales channels is necessary.
One of the greatest difficulties in planning communication strategies is the
immateriality of the insurance service. For this reason, marketing communications
in the insurance industry have aims that are mainly institutional, reinforcing corpo-
rate image and value of the brand.

" Definition Differently from being well-known, which merely holds that an
insurance undertaking is recognised, corporate image incorporates within itself
the idea of a medium-long term belief based on a number of components.

The components are as follows:

• Communications, meaning the series of initiatives adopted and procedures used

to disseminate information.
• The visible component of the undertaking: its structures, agencies, equipment,
codes of ethics, social statements, report on financial statements etc.
• The conduct of all the figures who for various causes come into contact with
consumers such as sales personnel, call centre operators, adjusters and settlers.
• Insurance services delivered.
• The image of the insurance intermediaries that the undertaking avails itself to
distribute its products, especially agents and brokers.

24.7 Price in Insurance Industry

" Definition The insurance premium is the price paid by an assured to an
insurance undertaking to purchase an insurance service. It summarises the overall
value of the offering of an insurance performance: cover for the risk insured,
intermediation, information, advice and all the accessory services that make it up.

In the overall process of determining the premium numerous factors come into play:

• The technical/actuarial component, which attributes the chance part that cannot
be eliminated to the premium (the chance event, calculating the likelihood of
occurrence, the law of large numbers and the extent of the loss to be indemnified).
• Remuneration for management costs that, by virtue of the inversion of the
production cycle, a goodly part of are future ones, costs of intermediation,
figurative charges, accessory costs, discounts granted by the insurance intermedi-
ary and taxes.

Concerning the first factor, it can be stated that in general, insurance undertakings
apply a differentiation to the premium on the basis:
24.8 New Trends in Marketing and Online Marketing 511

• Of a higher or lower loss experience of the class/home category of the assured—

an example being the bonus-malus mechanism in Automobile Liability.
• Of the geographic area where the risk insured is located; for example areas
considered to be areas of natural calamity.

A goodly part of the second component forming the insurance premium is

influenced by the choices and management capacities of the management of an
insurance undertaking: policies of cost containment, proper practices of risk selec-
tion, efficiency in managing loss settlement processes.
In determining the price, an insurance undertaking must additionally take into
account the elasticity of demand in respect of the premium, referring to each of the
lines of business dealt with and the dynamics of competition.
From the standpoint of the assured, it is the sacrifice that the party is willing to
bear in exchange for the performance; comparing the overall benefits in respect of
the offering, it becomes an indicator of the quality of the service purchased.

24.8 New Trends in Marketing and Online Marketing

In a society that is in transition towards post-modernity, sociologists observe an

orientation towards individualism, meaning a trend towards personal development,
self-determination and a refusal of a certain sense of conformism and social condi-
tioning. Individuals express a need to rediscover values that were up until now felt to
be “archaic”, as a sense of community, a search for authenticity, integrity simplicity
and localism opposed to globalism. New social aggregations can be seen, held
together by passion, emotion and sentiment whose common denominator is con-
sumption. In summary, post-modern consumers appear to sociologists as parties who
are individualists seeking experiences of socialising, aggregation and a sense of
belonging to a group; these forms of social aggregation are quite different from
traditional ones such as political parties, trade unions, volunteer work and
association.
Technological innovation is the means through which a post-modern individual is
able to marry the clear conflict between the two trends observed; in particular, the
rapid development of web that has highlighted the role of relations and participation
of the digital channels the spread of blogs and social networks has allowed a sharing
with others not only of ideas, passions and common interests, but of life
moments too.
The keywords to describe the change in the post-modern individual/
consumer are:

• Diffidence and scepticism towards traditional marketing strategies, especially in

corporate communications.
• Empowerment: autonomy, in-depth awareness of the product, capacity to select
and use of technology.
512 24 Insurance Marketing

• Prosumer: no longer passive parties to consumption, but increasingly often “co-

producers” of goods and services.
• Awareness of having earned a new role in the industry.

A number of scholars make use of a new word societing,

" Definition Societing summarises the importance that sociology has assumed
within studies of marketing: the environment of reference extends from the under-
taking to a comprehension of society in the aggregate, where producer and con-
sumer, rather than playing opposing roles, work together in a co-creation of value.

Marketing is therefore called upon to manage change in consumption in passing

to post-modernity and which of necessity requires enormous efforts of innovation
and creativity given that traditional marketing strategies are being revealed to be no
longer sufficient in the new context.
Post-modern marketing needs to be aware of social dynamics and cultural
phenomena that belong to the context of the post-modern individual and seek in
some way to be a part of it.

" Definition The term non-conventional marketing indicates this new approach
to marketing: it intentionally calls to mind military techniques that are shifted away
from those commonly adopted in strategies of war.

It has the concept of change and continuous innovation implicit within it: what at
a given time is held to be non-conventional may become traditional very quickly.
In the post-modern era, sociologists observe new social aggregations held
together by passions, emotions and sentiments. These communities are more fre-
quently known as neo-tribes.
Traditional marketing finds itself in a difficult situation linked to there being
markets that are hyper-fragmented, and consumers who are ever more indifferent to
marketing communications.
We find ourselves midway between mass marketing and one-to-one marketing:
working on small material groups, on social groups. The point of observation
becomes the reality of social micro-groups and social contacts become important;
daily experiences and manner of interaction between the various parties belonging to
groups/communities/tribes.
24.9 Customer Relationship Management 513

24.9 Customer Relationship Management

" Definition By the term Customer Relationship Management (CRM) is meant
an approach used by an insurance undertaking to manage all its contacts and its
relationships with potential and existing customers.3 Managing contacts and
relations can be illustrated as three key moments; interaction, insight and customised
offering.

Figure 24.3 shows the three components of the Customer Relationship Management
system.

" Definition By the moment of Interaction is meant a series of all the points of
contact between the customer (or potential customer) and the firm during each phase
of their purchasing experience.

Omni-channel models4 of contact with customers foresee the interaction and

operation being able to take place in a transverse fashion at every point and over
any material or digital support.

" Definition The moment of Insight is analysis or knowledge of the customer.

Through Insight, a firm is able to interpret trends (evident or latent) in human
behaviour.

The analysis is carried out for the purpose of increasing the effectiveness of a
product or service for consumers Insight aims to understand the reason why a
customer is interested in the brand, their motivations for purchase and the
expectations of a customer.
Via the moment of Insight, a firm gathers and seeks to interpret the information
that will allow it to acquire, develop and hold on to customers. A new possible
development is research into motivation in order to press for change in customer
behaviour for mutual benefit.

3
According to Philip Kotler and Gary Armstrong (2018), “CRM is concerned with managing
detailed information about individual customers and all customer ‘touch points’ to maximise
customer loyalty. It can also be defined as an alignment of strategy, processes and technology to
manage customers, and all customer-facing departments and partners”. In short, CRM is about
effectively and profitably managing customer relationships through the entire life cycle.
4
An omni-channel contact model indicates a customer—firm interaction through all possible points
of contact. Often a customer is at all times connected 24/7 and the purchasing experience varies
depending on the point of contact.
514 24 Insurance Marketing

Interaction

Offering Insight

Fig. 24.3 The components of CRM

" Definition The moment of the Offering consists of developing a customised

offering based on customer needs.

The offer is studied and designed on the basis of the clues gathered at the time of
interactions and analysed in an iterative fashion during the insight moment.

24.10 Digital Marketing in Insurance Industry

In recent times, insurance product marketing has seen the development of new
offerings with the integration of insurance covers and services and the digital
context. An offering of this kind is called digital insurance.

" Definition Digital insurance foresees three components being integrated: the
insurance products, the service and an electronic product.

In this model, each of the three components works to create a new insurance
solution featuring a high standard for the customer. Indeed, an insurance solution
needs to foresee covers that are innovative and modular so as to meet customer
needs. An electronic product is a subject matter that is touchable. It is a tool that is
felt to be of value both upfront for quotation (tools for telemedicine) and later,
following a loss event (e.g. a black box to report the position of an automobile
accident). The service is the soft component creating a perception in the assured of a
performance that is useful and continuously available.
In Figure 24.4, the wave of new offerings of digital insurance solutions can be
seen.
24.10 Digital Marketing in Insurance Industry 515

Risk Management
4. Corporate

3. Health Wearable

White Box
2. House Video surveillance

1. Motor Black Box

Fig. 24.4 Development of digital insurance solutions

This trend originated in Automobile Liability products. Later it developed in

products for protecting wealth (e.g. homeowner insurance). Insurance undertakings
are experimenting with this approach also with insurance solutions for the care of the
person (illness policies, for example). It is even possible to imagine offerings for the
corporate segment (e.g. policies protecting against cyber risk).
All above describes a new digital marketing model. An integrated approach
between technology and insurance solutions is the new key factor. This paradigm
is based on the application of new technologies in the insurance industry. Increasing
the efficiency and effectiveness of insurance products to meet customer needs is the
real goal.
The smart devices integrated into the insurance solution are based on technology
Internet of Things (IoT). Internet of Things (IoT) are devices, equipment,
installations and systems that are recognisable, thanks to Internet. The typical
features consist of identifying, connecting, positioning, the capacity of to process
data and capacity to interact with the outside environment.5
In detail, with regard to the automobile business, digital insurance solutions aim
to support the mobility ecosystem. New services offered could consist of transporta-
tion management, offering of services and new creative solutions for the different
forms of travel.
Current Automobile Liability insurance products combine the policy with a
technological device (called black box). The device is a satellite GPS installed on

5
For the explanation of new technology-based insurance products, see chapter 9. (see the
paragraphs smart illness policy and telematics, Automobile insurance and telematics, homeowner
insurance and telematics, etc)
516 24 Insurance Marketing

the vehicle. Through the black box, the position of the vehicle is recorded. The
database of information gathered will allow insurance undertakings to develop new
predictive statistical models that can assess the quality of a risk based on the driving
style of the driver. Usually, alongside the blackbox, the insurance undertakings offer
a number of useful services via a dedicated app. These services are indications on
driving style, information on travel statistics and traffic alert, diagnosis and state of
maintenance of the vehicle; accurate reconstruction of the dynamic of a road
accident, theft prevention, etc.
Regarding home/domotics, insurance solutions offering is integrated with
technologies suitable for improving the quality of life and safety in the house.
Alongside the homeowner insurance, new services of assistance can be added
based on home automation devices and sensors that are installed in the dwelling
and managed by a dedicated app. Intelligent sensors are preventing the befalling of
adverse events. They are connected to appliances and notify the occurring of
electrical phenomena, flooding, and spreading of smoke, loss of power, etc. The
device managing all the sensors is called home box. When an event occurs, the
assured receives a notification on their smartphone thank to the home box.
About health, offer of insurance solutions is integrated with new services (for
example, online reservations, check up, prevention, etc.) and a number of devices
devoted to health and wellbeing. The new services are managed through a dedicated
app and via wearable device. The acronym WYOD means “wear your own device”.
Wearables are clinically approved and usually provided by the insurance undertak-
ing. The following devices are the most useful: a wristband monitoring activities
performed (distance walked and calories burnt), an instrument for measuring blood
pressure, a wireless wrist pulsometer etc. All the devices are connected to the
dedicated app, which keeps and files all the data communicated relating to the
activities performed and the condition of health of an assured. The data are processed
and allow for updating programmes in the software to increase the wellbeing of the
customer.
The last trend concerns the pet insurance. An increasing number of products
offer services for the care of a domestic animal and the possibility of combing a
dedicated app and a telematic device. Usually, the telematic device is a
geo-positioning collar useful for seeking out the animal and monitoring its daily
movements. Alongside a service of telephone assistance, a dedicated app foresees
managing the technological device and allows consultation of the digital clinical
charts of the pet. The technological device allows for various features, such
as. information relating to the movements of the domestic animal, activation of a
virtual enclosure (with notifications if the barrier is surmounted by the pet),
geo-positioning for situations of emergency/rescue etc.
Another important innovation consists in spot or instant insurance. Spot insur-
ance means an insurance service that allows the assured to enjoy temporary policies
for a relative period of time based on their needs (geolocation and in real time).
Thanks to this solution, insurers are able to respond to customers' insurance needs
exactly when the need arises and only for the strictly necessary time. The process is
24.12 Questions 517

all digital. The range of application can be wide (i.e. on the occasion of a trip, when
playing a sport occasionally, in case of use of a sharing service etc).

24.11 Customer Experience in Insurance Services

" Definition By Customer Experience is meant the sum of total experiences that a
customer has gone through while interacting with the firm at all stages of the
pathway that a customer follows when entering into a relationship with an insurance
undertaking over time.6 It is the result of how the customer subjectively perceives
their interaction overall with a firm. For this reason, Customer Experience has in
recent years become one of the most important objectives in designing marketing
activities. Customer Experience occurs at times of direct and indirect contact.

" Definition By Customer Journey is meant the pathway followed by a customer

when entering into a customer–firm relationship. It occurs over time and is the
“history of the bond” between a customer and a firm. A customer Journey depends
on the whole pathway and considering all points of contact.

In the sector of insurance services, the new frontier is developing of a customer–firm

bond at moments of truth like, for example dealing with a loss event, taking out a
new contract and renewing an expiring policy, etc.

24.12 Questions

1. What is the definition of marketing?

2. What are the components of a Service Recovery system?
3. Explain the characteristics of strategic marketing
4. Describe the components of internal marketing
5. What is non-conventional marketing?
6. What are the key moments in CRM?
7. What is the definition of Customer Experience?

6
Meyer and Schwager (2007), Understanding customer experience, Harvard Business Review.
518 24 Insurance Marketing

References
Eiglier P, Langeard E (1987) Servuction, le Marketing des Services. McGraw-Hill, Paris
Kotler P, Armstrong G (2018) Principles of marketing. Pearson
Lovelock C (2001) Service marketing. People, technology, strategy. Prentice Hall Press
Meyer C, Schwager A (2007) Understanding customer experience. Harvard Business Review

Suggestions for Further Study

Hennig-Thurau T, Hansen U (2000) Relationship marketing. Gaining competitive advantage

through customer satisfaction and customer retention. Springer, Cham
Hoffman KD, Bateson JEG (2010) Services marketing: concepts, strategies, & cases, 5th edn.
South-Western College
Kotler P (1994) Marketing management. Prentice Hall
Kotler P, e Keller KL (1994) Marketing management. Upper Saddle River (NJ), Pearson
Kotler P, Trias de Bes F (2003) Lateral marketing: new techniques for finding breakthrough ideas,
1st edn. Wiley
Schmitt BH (2003) Customer experience management: a revolutionary approach to connecting with
your customers, 1st edn. Wiley
Turchetti G (2000) Innovazione e reti distributive nel settore assicurativo. Analisi teorica
e comportamenti strategici. Franco Angeli, 2000: 79–81
Insurance Distribution
25

Abstract

The chapter aims to lead to an understanding of the role played by an insurance

intermediary. Indeed, intermediation consists of facilitating the meeting of
demand for and supply of insurance covers in the industry.
It is explained that in this directive the guarantee of transparency on the part of
distributors, both in terms of costs and disclosures on risk/effective cover of
products distributed, is of great importance Lawmakers require, additionally, that
a distributor bears in mind the demands and needs of consumers and that
monitoring takes place in the period after sales in order to check that the product
sold is actually adequate to meet these.
Then, four sets of delegated regulations implementing IDD regulations are
explained: PRIIPs—Packaged Retail Investment and Insurance Products;
(I)PID—Insurance Product Information Document; POG—Product Oversight
Governance, i.e. governance of the insurance offering; IBIPs—Insurance Based
Investment Products.
After this, distribution channels through which insurance undertakings make
their products available on the market directly via dedicated owned sales
structures or making use of insurance intermediaries are illustrated.

Keywords

Intermediation · Insurance Distribution Directive 2002/92/EC (IMD) ·

Distribution · Insurance Directive 2016/97/EC (IDD) · Ecosystem of operators ·
Product centred vs. Customer centred · Demands and needs · Product Oversight
Governance (POG) · Manufacturer · Target market · Product testing · Product
monitoring and review · Insurance Based Investment Products (IBIPs) · Packaged
Retail Investment and Insurance Products (PRIIPs) · Insurance Product
Information Document ((I)PID) · Key Information Document (KID) · Demands
and Needs · Pre-contractual documentation · Distance marketing · Multi-channel
and omnichannel · Financial Modernization Act · Gramm-Leach-Bliley Act

# Springer Nature Switzerland AG 2024 519

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_25
520 25 Insurance Distribution

25.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the definition of insurance intermediation.

2. Explain the development of regulations of reference (from intermediation
to distribution).
3. Illustrate the characteristics of the European In Distribution Directive—
IDD.
4. Explain the regulations in respect of recent changes on the subject of
distribution (POG, IBIPs, (I)PID.
5. Define the various intermediary and distribution figures.
6. Illustrate possible channel strategies in insurance distribution.

25.2 The Function of Insurance Distribution

" Definition The function of distribution that insurance distributors perform
consists of facilitating the meeting of demand for, and supply of, insurance covers
in the industry.

Dsitributors take part in the production/distribution process of the insurance service,

the marketing process and carry out an important function of information and
insurance advice to the assured, so contributing to the spread of an insurance culture.
Consistent with the provisions of the legislation, a distributor performs the
activities of advising on, proposing, or carrying out other work preparatory to the
conclusion of contracts of insurance, of concluding such contracts, or of assisting in
the administration and performance of such contracts, in particular in the event of a
claim.1
The function of insurance distribution takes on significant importance for an
insurance undertaking. The characteristics of intangibility, heterogeneity and simul-
taneous production and consumption of the insurance service on the one hand make
it difficult for a consumer to evaluate what is being offered, and on the other, they
have a tendency to see the service that is being proposed and contact personnel as
one and the same.
In interacting with the final customer, the main functions performed by an
insurance distributor are the following five:

1
For this definition, see article 2—Directive (EU) 2016/97 of the European Parliament and of the
Council of 20 January 2016 on insurance distribution—IDD.
25.3 From Intermediation to Distribution 521

• Communication and promotion in making aware and defining the need for
security on the part of the customer and proposing the insurance policy as the
right response to the need for protection coming to light, creating the right
expectations in the customer concerning the insurance performance and, finally,
transmitting sensations of competence and professionalism of the intermediary
and the reliability and solvency of the insurance undertaking.
• Correct identification of customer demands and needs: Activity carried out in the
pre-sale phase to define the adequacy and consistency of the possible insurance
solutions.
• Advice: Provision of personalised recommendations to a customer, either upon
their request or at the initiative of the distributor with respect to customer needs.
• Sale: Proper, transparent and professional illustration of clauses contained in the
policy of insurance and proper selection of the risks to insure.
• Post-sales monitoring: Continuous verification of the actual adequacy of the
product sold with respect to the real needs of the consumer at a time following
the purchase (even after several years).

As the reader can understand, delivering services means:

• At the pre-sales stage, an activity of insurance advice concerning the needs to be

met and customising the policy in accordance with the needs of an individual
proposer of insurance.
• At the post-sales, providing presence, efficiency and availability based on new
insurance needs of the customer and assistance at the time of a loss event being
settled and execution of the insurance performance.

An insurance distributor, in their capacity as selector of risks to be insured

represents a critical resource for immediate and future profitability and solvency of
an insurance undertaking.

25.3 From Intermediation to Distribution

In July of 2012, the European Commission set in motion a process of change in

regulation on insurance intermediation. The proposal for modification is grounded in
a need coming to light following the crisis and turbulence in financial markets for
greater consumer protection in general and assureds specifically and to improve
activities of sale of insurance products.
Going back to the beginning, the approach taken by lawmakers followed a
thread that developed in three successive waves. The first started in the 1970s with
the discipline on intermediaries, and later the business of intermediation was
regulated and, finally, the new rules on the activity of insurance distribution
were introduced.
522 25 Insurance Distribution

Fig. 25.1 Development in

regulations: from
intermediation to distribution Phase III: Legislation on insurance
distribution – Dir. 2016/97/EC

Phase II: Legislation on insurance

intermediation – Dir. 2002/92/EC

Phase I: Legislation on insurance

intermediaries – Dir. 77/92/EEC

1970 2018

A graphic representation of the three waves of change in regulation can be

seen in Figure 25.1 The waves are set on the time axis, beginning in the 1970s up
until the coming into force of the IDD directive in respect of insurance
distribution.
Looking at the historical span, Phase 1 (the 1970s) concerned the discipline of
the insurance intermediary. The objective of the regulations issued in those years
concerned the intermediary and not the business carried on. A principle of differ-
ence between an employee and independent intermediaries was introduced. Lastly,
registration and verification of the professional quality of intermediaries were
foreseen. In this sense see directive no. 77/92/EC and the recommendation of the
Commission no. 92/48/EC, dated 18 December 1991 in respect of insurance
intermediaries.
Phase II (the 2000s) relates to the discipline on insurance intermediation.
Regulations were developed placing the emphasis on the activity performed by an
intermediary. Rules of conduct and transparency in carrying on the business were
laid down. The regulations of reference are directive 2002/92/EC Insurance Media-
tion Directive (also known as IMD).
Phase III (after 2015) disciplines a new concept: insurance distribution. The
regulations of reference are directive 2016/97/EC. Through this reform, lawmakers
consider an activity that is wider than intermediation. The focus is on a concept of
distribution under which, in addition to intermediaries (in the broad sense) insurance
undertakings that make direct sales also fall. New rules are also defined in respect of
professional quality and transparency and rules of conduct along with new rules on
disclosure for consumer protection. Additionally, the subject of the adequacy of the
product and a census of the demands and needs of the customer is more deeply
studied.2

2
The subject was drawn from the directive of the European Union no. 2004/39/EC (also known as
the MiFID directive; MiFID is an acronym for Markets in Financial Instruments Directive).
25.3 From Intermediation to Distribution 523

25.3.1 Regulations on Insurance Intermediation

To understand more fully the concepts of insurance distribution (Phase III) it is

necessary to deal with the rules that characterised the previous phase, Phase II (the
2000s). Insurance Directive 2002/92/EC of December 9, 2002 Insurance Mediation
Directive (IMD) is based on certain pillars:

• Definition of intermediation,
• Equality of treatment,
• Creation of the single market,
• Single registration system,
• Possession of the professional requirements,
• Information requirements.

The definition of insurance intermediation concerns the series of activities

pertaining to the time of the sale of the insurance service and the phases leading
up to and down from this.
The intermediary is an active participant in presenting contracts, providing
assistance and supplying advice, performing activities preparatory to the insurance
policy and carrying out activities to actually conclude them, as well as collaborating
with the parties involved for various causes in the process of settlement and handling
loss events and executing the insurance service.3
Concerning equality of treatment, rather than identifying each category of
parties, Community lawmakers have chosen equality of treatment among all the
different types of insurance operators/intermediaries acting in the European insur-
ance context, both as concerned the current insurance panorama and the prospects
for future development of possible new parties entering the industry.
The broad definition that Directive 2002/92/EC gives of the business of insurance
intermediation allows all the forms in which this activity can be carried on to be
included, either via traditional channels or through distribution channels that are
more recent, by considering all parties carrying on the activity as intermediaries.4
The achievement of a single market in financial services aims to ensure greater
protection of consumers who find themselves before an insurance offering that is
broader and more varied as a consequence of the opening of the market to other
European operatives and greater competition in premiums. For this purpose, a
number of harmonised rules common to all member states were introduced
concerning access to and carrying on of insurance intermediation business. Once

3
A definition of insurance intermediation is introduced by Art. 2 of Directive 2002/92/EC of the
European Parliament and the Council dated 9 December 2002 on insurance intermediation.
4
In this view see one of the inspiring principles of the regulations: “insurance products can be
distributed by distinct categories of parties or bodies, such as agents, mediators and bank assurance
operators. Equality of treatment between operators and consumer protection demand that this
directive be applied to each of these categories”.
524 25 Insurance Distribution

authorisation has been obtained on the basis of meeting severe professional

requirements from the authority of own country of origin, an insurance intermediary
will also be allowed to operate in other member states in addition to home country,
according to principles of mutual recognition and home country control.
The single registration system allows an intermediary to operate, once registra-
tion has been achieved. They are licensed to act in other member States beyond their
own under a freedom of establishment (FoE) and freedom of services (FoS).5
Additionally, the authorities of host member states may not submit intermediaries
to further controls or registrations other than those tied to abidance by conditions of
general interest.
The Directive left member countries free to adopt even more than one registry
while setting out the criteria for enrolment and foresaw the creation in each member
state of a single information point from where relevant information could be
obtained on enrolees and identifying the various Authorities concerned in each
State and, finally, the countries where individual intermediaries operate under a
freedom of establishment (FoE) or under freedom of services (FoS). Within this
provision, the figure of foreign intermediary carrying on business non-exclusively
nor prevalently is included.6
Professional requirements at all times concern:

• Adequate knowledge and ability which is left to being identified by member states
on the basis of products offered for sale and whether the activity of intermediation
is or otherwise the main business carried on.
• Good repute, i.e. enjoying civil rights (e.g. not being convicted of crimes).
• Holding an insurance for professional liability valid in all member countries.
• Organisational requirements such as to ensure a capacity to transfer premiums
collected to an insurance undertaking or the insurance performance or return of
the insurance premium to the assured.

In respect of duties to inform that an intermediary must meet vis-à-vis consumers;

in particular are foreseen:

5
Concerning freedom of estabilishment and freedom of services, see chapter 4.
6
Art. 2 of the Directive defines the figure of the tied insurance intermediary introduced for the
purposes of registration so as to a take into account the features of a number of European
marketplaces. This intermediary is: “any person who carries on the activity of insurance intermedi-
ation for and on behalf of one or more insurance undertakings in the case of insurance products
which are not in competition but does not collect premiums or amounts intended for the customer
and who acts under the full responsibility of those insurance undertakings for the products which
concern them respectively”. Equally held to be a tied insurance intermediary is “any person who
acts under the responsibility of one or more insurance undertakings for products that respective
concern them, while carrying on an activity of insurance intermediation by way of a complement to
his main professional activity, if the insurance is complementary to the goods and services in the
framework of this principal professional activity and the person does not collect premiums or
amounts intended for the customer”.
25.4 Insurance Distribution Directive 525

• Abidance by a principle of adequacy requiring specification of the reasons upon

which are set the assessments of requests and needs of consumers upon which the
advice provided is based, depending on the complexity of the insurance contract
proposed.
• Abidance by a informative transparency, requiring highlighting of any conflicts
of interests that an insurance intermediary might self in with insurance
undertakings.

25.4 Insurance Distribution Directive

In respect of Phase III (after 2015), the European Insurance Distribution Directive
2016/97/EC (hereafter just Insurance Distribution Directive (IDD)) dated 20 January
2016 on insurance distribution replaced the previous directive 2002/EC dated
9 December 2002 on insurance intermediation.

" Definition Insurance Distribution Directive 2016/97/EC (IDD Directive)

provides a legal framework that has been harmonised and updated at a European
level and contains rules applicable to the distribution of insurance and reinsurance
products, including life and investment products. In order to allow implementation
by member states, IDD regulations came into force on 1 October 2018.7

In particular, the objectives pursued by lawmakers with these regulations are:

• Improvement in the protection of consumers and retail investors who acquire

insurance products or insurance investment products.
• A guarantee of greater transparency on the part of distributors concerning the
price and costs of products distributed.
• Fuller disclosure and greater transparency on the product and rules of conduct
optimised, in particular, in the matter of advice given.
• A gathering of information concerning the demands and needs of the consumer,
paying special attention to their aims and characteristics.

Additionally, for the first time in the industry, lawmakers recognise the existence
of an Ecosystem of operators in the distribution of insurance products.

" Definition Through this Ecosystem of operators the new rules apply to all
parties involved in distribution activities. Pre- and post-sales operations are allowed
through all distribution channels with the aim of creating conditions of equality for
all distributors and ensure high, uniform standards of consumer protection.

7
It should be remembered that the regulations effect a recasting of directive 2002/92/EC (IMD
Insurance Mediation Directive) on insurance intermediation. As this was a recasting, the new
directive replaces the previous directive completely, which was definitively abrogated.
526 25 Insurance Distribution

According to this approach, any consumer can enjoy a full buying experience
over different channels, starting an activity (i.e. quotation) in one channel and
concluding the stipulation in another one (i.e. physical point of sale).8
Two sets of delegated regulations of the European Commission and directly
applicable in member states with effect from the date of application of the IDD of
1 October 2018 complete the new regulatory framework. The first set of delegated
regulations no. 2017/2358 deals with POG (Product Oversight Governance),
i.e. governance of the insurance offering from insurance undertaking. The second
set of delegated regulations no. 2017/2359 deals with IBIPs (insurance-Based
Investment Products), i.e. financial insurance products, including in this category
all products that give an opportunity to invest to retail investors and for which the
sum due to an investor is subject to oscillations due to exposure of the reference
values or return on underlying assets not acquired directly by the investor. In
summary, all life products excluding those of pure risk (such as, e.g. term life,
TCM and LTC and immediate income).
Concerning the precontractual documentation, the European Commission
additionally issued delegated regulations no. 2017/1469 on 11 August 2017
and these are directly applicable in member states and that lay down the format
of the new pre-contractual documentation for non-life contracts. The new docu-
ment is called (I)PID: the acronym stands for (Insurance) Product Information
Document.9
Finally, within this regulatory phase are to be included delegated regulations
no. 1286/2014 in respect of a pre-contractual documentation containing key infor-
mation for retail investment products, among which there are Packaged Retail
Investment and Insurance Products, PRIIPs. The regulations were approved on
26 November 2014 by the European Parliament and the Council of the European
Union. The regulations foresee the introduction of a KID—Key Information
Document.
See Table 25.1 for a summary itemising of the regulations characterising
Phase III.

8
Note that the Directive IDD (article 2) includes the parties providing information concerning one
or more insurance contracts in accordance with criteria selected by customers through a website or
other media, and compilation of an insurance product ranking list, including price and product
comparison, or a discount on the price of an insurance contract, when the customer is able to directly
or indirectly conclude an insurance contract using a website or other media.
9
The document is foreseen under Art. 20 of the IDD directive This is the standardised
pre-contractual documentation foreseen for non-life insurance products carrying the main informa-
tion concerning the product. The template of reference is to be found attached to delegated
regulations of the Commission no. 1469/2017.
25.5 New Paradigm of Insurance Distribution 527

Table 25.1 Outline itemising of Phase III regulations

Date References Topic
26 November Delegated Regulations Key Information for PRIIPs (Packaged Retail
2014 1286/2014 Investment and Insurance Products)
20 January European IDD Directive Insurance Distribution Directive
2016 no. 2016/97/EC
11 August Delegated Regulations Format of the new pre-contractual documentation
2017 2017/1469 for non-life contracts (I)PID
21 September Delegated Regulations POG (Product Oversight Governance),
2017 2017/2358 i.e. governance of the insurance offering
21 September Delegated Regulations IBIPs (Insurance Based Investment Products)
2017 2017/2359 i.e. financial insurance products

25.5 New Paradigm of Insurance Distribution

The IDD regulations changed the approach taken by lawmakers up until that time
substantially. In particular, special emphasis was placed on consumer protection at
the time of purchasing insurance and investment products. A guarantee of transpar-
ency on the part of distributors (both in terms of cost and disclosure on the risk/
effective cover of the products distributed) was felt especially critical along with
taking into consideration the demands and needs of consumers so as to optimise the
offering of customised products and a check made in the period subsequent to the
sale on actual adequacy are required. Finally, a series of limits to the payment of
commissions and compensation for the activity of intermediation provided by the
insurance distributors was introduced.
In sum, the overriding aim of the regulations is thus to ensure that distributors act
in abidance by a principle of what is in the best interests of consumers by advising
insurance products that meet the demands and insurance needs of customers.
All these items lead to a history-making change in perspective occurring. This
change might be summarised in a slogan: from a product centred industry to a
customer centred industry. See Figure 25.2 for a schematic representation.
On the x-axis the number of customers reached is shown. While on the y-axis the
percentage of needs met is indicated.

" Definition A product centred business model tends to offer a limited number of
insurance solutions to a high number of consumers. This serves to increase turnover
irrespective of the real effectiveness of the insurance solution offered. On the
contrary, a customer centred business model tends to offer the best and most
complete insurance solution to each individual customer.

The aim of this is to increase customer penetration and the percentage of needs
met with products that are adequate for this.
528 25 Insurance Distribution

Fig. 25.2 New paradigm Customer’

from Product Centred to share
Customer Centred
% needs of

oriented
satisfied
customers

Product oriented

Customer
Revenues

Number of
customers reached

Analysing IDD regulations, the main differences as compared to previous

regulations concern:

1. An extension of the rules on intermediation also to insurance and in direct sales;

an extension to all cases of sale, even via comparison websites for insurance
products; an extension to participants in the industry who sell insurance policies
as ancillary business (travel agencies, car-hire firms etc.).
2. The proposal also considers business done online, evidencing the fact that it is
important that all persons who provide information on one or a number of
insurance contracts in response to criteria selected by a customer via a website
or other means or when providing a classification of insurance or reinsurance
products or a reduction in the price of a contract when the purchaser is able to
conclude an insurance contract at the end of the process, do not remain without
clear rules too.
3. An essential distinction is to be made between distribution rules applying to
insurance products in non-life lines of business and those dedicated to financial
insurance products, so-called IBIPs (Insurance Based Investment Products).10
4. A definition of advice as the providing of a customised recommendation to a
customer, requested or otherwise.
5. Introduction of a single European electronic registry of intermediaries in the form
of a portal linked directly to national Databases.

10
For pre-contractual documentation required for IBIPs financial insurance products and non-life (I)
PID products, see the related paragraph of this chapter.
25.6 Product Oversight Governance 529

6. Introduction of the role of intermediary of insurance products as an ancillary

business, i.e. parties who may perform activities of intermediation (but who are
not however insurance intermediaries). These are, for example travel agencies
and car hire firms.
7. In respect of obligations to inform and rules of conduct, there have been added:
(a) A general principle that distributors should act in the interests of their
customers, etc.
(b) Requirements for disclosure similar to those of insurance undertakings.
(c) An obligation to notify the basis and sum of compensation by insurance
distributors.
(d) Gathering of information on the demands and needs of consumers or the
assured including information on the personal characteristics and insurance
or life provision demands of the customer.

25.6 Product Oversight Governance

Delegated regulations no. 2017/2358 deal with Product Oversight Governance

(POG) and define the rules for a new general system of governance and audit of
the process of product development This control is a kind of quality and traceability
certification for insurance products (as occurs for other sectors of consumer goods).

" Definition Product Oversight Governance (POG) has the purpose of ensuring
that all insurance products on sale to customers meet the demands of the segment of
reference, so avoiding or reducing in advance any risk there may be of non-abidance
by rules of consumer protection. POG foresees continuous monitoring as to the
actual adequacy of the product sold to meet the real demands of consumers at a time
subsequent to purchase (even after several years).

POG applies to various parties; producers of insurance products such as insurance

undertakings and insurance intermediaries who create insurance products and
distributors of insurance products who offer advice or propose insurance products
not created by them.
In particular, the regulations indicate the insurance undertaking by the term
manufacturer.11

11
It should be noted that an insurance undertaking is defined a manufacturer within the IDD
directive. A manufacture must set in place oversight and procedures of accurate and complete
disclosure to customers concerning them main features of the insurance products it sells in the
marketplace. From this standpoint, a manufacturer must also implement oversight in the matter of
governance and audit of the products (POG).
By the term manufacture is de facto meant an insurance intermediary who autonomously
determines the significant items of a product (e.g. cover, costs, risks, performances and guarantees).
This both at the creation stage of a new product and changes made to an existing product.
530 25 Insurance Distribution

" Definition A manufacturer is required to prepare a specific corporate procedure

for the process of product development. In this procedure, the undertaking must
indicate the controls applying during the activities of development and approval of a
product (whether a new one or changes made to an existing product).

Through this process, an insurance undertaking must demonstrate that it has

available measures and procedures that are able to avoid developing insurance
products not aligned with demand & needs of customers. The insurance undertaking
must additionally be able to demonstrate that personnel involved in designing and
creating insurance products have the skills, knowledge and experience necessary for
comprehending the insurance products sold.
An important item of innovation is the requirement to identify the target market.

" Definition A Target market is market of reference for the product prior to
setting the process of product development in motion.
Regulations require an insurance undertaking to identify its market of reference
for each insurance product. Identifying a market of reference must take place at a
sufficiently detailed level and take into account the characteristics, risk profile,
complexity and nature of the insurance product.12
Additionally, prior to the release of the product, the insurance undertaking must
perform a series of qualitative and quantitative tests on the product.

" Definition These tests are called Product Testing. Product Testing must be able
to evaluate whether or not the insurance product is able to meet the requirements,
needs, objectives and characteristics identified for the target market.

Lastly, it is foreseen in the regulations that the undertaking set in motion an

activity of post—sales monitoring.

" Definition Product monitoring and review aims to verify that the target market
and the actual needs of consumers are consistent with each other.

Monitoring must be carried out continuously and must be performed in a regular

manner on all insurance products put on the market.

12
Article 25 of the IDD directive lays down that a manufacturer (and de facto manufacturer)
involved in the process of producing contract conditions must set in place procedures aimed at
seeing to it that: (1) the parties involved in thinking up an insurance product meet the necessary
requirements of skill and professional experience; (2) in respect of each product put on the market a
procedure of verification is followed showing that the product has been conceived for a specific
target of customer; (3) the product is distributed with strategies and via channels that are adequate
vis-à-vis the chosen target customers and (4) undertakings take all steps aimed at ensuring that
distribution of the product is materially directed at chosen target customers.
25.7 Rules of Conduct for Distributors and Pre-contract Disclosure 531

For an illustration of the main impacts resulting from the POG on the business of
an insurance undertaking. the reader can see what has already been covered in this
work.13

25.7 Rules of Conduct for Distributors and Pre-contract

Disclosure

Obligations of protection of the assured,14 pertain to the rules of conduct for

distributors and pre-contract disclosure.
In general terms, in carrying on their activity of distribution and especially in
offering insurance policies and managing a contract relationship with an assured
intermediaries are called upon among other duties to behave with diligence, propri-
ety, transparency and professionalism. They must acquire the information necessary
in order to evaluate the insurance and life provision needs of potential assureds, act
without causing harm to the interests of assureds, identify and avoid conflicts of
interest and, where this is not possible, ensure the transparency necessary as to any
possible adverse effects while proposing insurance products aligned with the
interests of assureds. In connection with the activity performed and the type of
contract proposed, distributors must propose policies at the best possible conditions
taking into account the time, the scale and the nature of the contract. They must
operate so as to contain the costs borne by policyholders and obtain the best result
possible for the objectives insured. Finally, the distributors must abstain from
proposing contract variations at unnecessary frequency for the needs insured, and
refrain from behaviour that might give advantage to some customers to the detriment
of others.
Concerning detecting the insurance demands of the customer, the IDD directive
draws inspiration from the principle of giving pride of place to the interests and
demands of the consumer. The role as advisor of the distributor is enhanced through
precise indications given on how to propose a product that is suited and consistent
with the insurance and life provision demands of a consumer.

13
The main impacts deriving from POG are described in chapter 20

1) Procedure of developing and approval of products

2) Skills and competences on the part of personnel involved in designing and creating insurance
products
3) Target market
4) Product test
5) Monitoring

14
The duties to inform that will be mentioned do not apply either to reinsurance intermediaries nor
anyone operating in large risks.
532 25 Insurance Distribution

" Definition A Demands and Needs approach means collecting all useful infor-
mation relevant from the customer to assess their needs and insurance requests. After
carrying out an assessment of appropriateness and adequacy, a distributor can
propose only contracts consistent with the aforementioned requests and a customer’s
insurance needs.

During the pre-contract phase, a distributor is called upon to check on the needs
and requirements of a consumer so as to identify the product most consistent with the
needs of the customer. The distributor must also provide all the information that is
useful for making an informed decision.
On the other hand, the information to request includes socio-demographic
references of the customer, their profession, financial insurance situation and their
expectations in connection with taking out the contract in terms of cover and
duration, also taking into account any other insurance covers already in force.
On the basis of the information gathered, distributors (bearing in mind the type of
consumer and the nature and complexity of the product offered), provide the
consumer with objective information on the product by illustrating its features,
duration, costs, limits of cover and all other information useful for an informed
decision. Any refusal by a consumer to provide certain information must be shown in
a specific statement to be attached to the proposal or the policy taken out. It is indeed
necessary to preserve documentary evidence of the activities performed to detect the
demands of consumers.
Fundamental importance is given to the pre-contractual documentation.

" Definition Pre-contractual documentation has to be provided by insurance

distributor to the proposer of insurance specifying whether they provide advice on
the basis of an impartial analysis. Distributor assessments must be founded on a
number that is sufficiently broad of contracts in order to council a product fit to meet
the requirements of the customer.

Distributors must advise the name of the insurance undertaking (or undertakings)
for which they are proposing certain contracts and the names of the insurance
undertakings with which they may have business relationships; prior to concluding
the contract, the distributor, also on the basis of information provided by the
consumer, must propose or counsel a policy that fits the needs of the proposer of
insurance, illustrating the duties deriving from the policy for both parties: proposer
and insurance undertaking.

25.8 Non-life Products Pre-contractual Information: (I)PID

Implementing regulations no. 2017/1469 dated 11 August 2017 and directly appli-
cable in member states lay down an obligation to draw up the IPID.
25.9 Life Products Pre-contractual Information KID 533

" Definition (I)PID (Insurance) Product Information Document is a new

pre-contractual documentation for non-life products. As a consequence, with effect
from 1 October 2018 delivery of these documents is necessary for all non-life
insurance products in addition to the documentation foreseen locally prior to signing
a new contract. The (I)PID for non-life business is drawn up in accordance with what
is laid down in detail in the regulations of the European Commission. The aim of
lawmakers is to offer the consumer information on the product that is easy to read
and understand and is comparable at a community level.

The document was developed by preparing a structure and a format that is

common to all European States. Icons and common symbols are included. The
(I)PID is split into sections that answer the following nine questions:

1. What kind of insurance is it?

2. What is insured?
3. What is not insured?
4. Are there limits of cover?
5. Where does cover apply?
6. What obligations do I have?
7. When and how must I pay?
8. When does cover commence and finish?
9. How can I cancel the policy?

25.9 Life Products Pre-contractual Information KID

" Definition The Key Information Document (KID) is a pre-contractual docu-
mentation introduced by PRIIPs regulations. This is a standardised document drawn
up according to a template. The standard basic document KID (Key Information
Document) applies to all insurance investment products (IBIPs, Insurance Based
Investment Product) and PRIIPs. The KID provides retail investors with the infor-
mation needed to come to an informed decision on investments and compare the
various financial insurance products so as to increase transparency for the benefit of
consumers.15

The general purpose of the KID is thus to allow retail investors to understand and
compare the characteristics and main risks of financial insurance products.
The outline must be drawn up in a concise manner and in non-technical language
to allow retail investors to acquire clear information prior to investing in a financial

15
Attention is here given to the KIID; which is not to be confused with the KID The acronym stands
for Key Investor Information Document. The KIID is a pre-contractual documentation containing
key information for understanding the features and the workings of unit trusts employed as
underliers to the insurance investment product.
534 25 Insurance Distribution

product. Regulations require the KID to be drawn up and printed on a maximum of

3 sides of A4 paper. The document was developed by preparing a structure and a
format that is common to all European States. Icons and common symbols are
included. The KID is split into sections that answer the following eight questions:

1. Basic information: an overview of the PRIIP.

2. What is this product? Information pertaining to the PRIIP.
3. What are the risks and what is the potential return? Risk-return profile of the
product calculated on the basis of the requirements of regulations.
4. What happens if the PRIIP issuer is unable to pay out what is owed? Details of
guarantee schemes and another hedging.
5. What are the costs? costs associated with the PRIIP (direct and indirect)
6. For how long I must hold it, and can I withdraw principal early? Details on the
period of holding recommended and the consequences in the event of early
withdrawal.
7. How are complaints made? Contacts in cases of complaints (issuer and
distributor).
8. Other relevant information: other detailed information concerning the document
and useful for an investor.

25.10 Pre-contractual Information for IBIPs

Implementing regulations no. 2017/2359 dated 21 September 2017 lay down the
obligations to inform and rules of conduct applicable to the distribution of IBIPs
(Insurance-Based Investment Products).

" Definition Insurance-Based Investment Products (IBIPs) are insurance

investment products. The Directive IDD defines them as insurance products that
have a maturity or a surrender value and in which such expiry or surrender value is
exposed in whole or in part, directly or indirectly to market fluctuations. For
instance, segregated funds, unit linked and index linked or multiline products
which mix segregated fund with a unit-linked product. Basically, IBIPs are a subset
of PRIIPs (of insurance products16).

The main aim of the regulations is to ensure that distributors act abiding by a
principle of the best interests of the customer, recommending insurance products that
meet the requirements and insurance demands of consumers.
The regulations provide indications as to the manner of delivery of incentives to
insurance intermediaries. The rules provide a list of criteria for assessing whether or
not the incentives paid to an insurance intermediary or an insurance undertaking

16
For the PRIIPs’ definition see below in this chapter.
25.10 Pre-contractual Information for IBIPs 535

increase the risk of adverse repercussions on the quality of the service/product

provided to a consumer.17
Insurance undertakings must prepare, set in motion and maintain efficient over
time, a procedure to identify and manage conflicts of interest. The procedure must be
drawn up in writing and fit the scale, organisation, nature and complexity of each
undertaking.18
A wider category as compared to IBIPs products are the PRIIPs—Packaged
Retail Investment and Insurance Products.

" Definition PRIIPs are Packaged Retail Investment and Insurance Products.
This classification includes all products, regardless of their form or structure, created
by the financial sector in which the final amount due to the retail investor is subject to
fluctuations. This may be to their exposure to reference values or subject to the yield
of one or more financial assets.19 It applies only to retail investors. In relation to
insurance market, the PRIIPs’ classification includes insurance products that offer a
maturity or surrender value, and where that maturity or surrender value is wholly or
partially exposed, directly or indirectly, to market fluctuations (for instance, unit
linked, index linked contracts etc.).20

The following simplification helps the reader understand the relationship between
PRIIP and IBIPs products. See the conceptual formula that follows:

PRIIPs ¼ PRIPs þ IBIPs

PRIIPs products include two categories: both insurance products and financial
products. PRIPs (Packaged Retail Investment Products) pick up the remaining five
categories (not insurance): unit investment trusts, structured products and deposits,
convertible bonds, derivatives and products issued by SPVs intended for the retail
market. Differently from PRIIPs, PRIPs do not take in consideration pre-assembled
insurance products. Because of this, the two types of products have different
pre-contractual documents and rules, since the underlying financial products are
different.21

17
It should be noted that in respect of conflicts of interest, that the rules contained in these delegated
regulations follow what is already laid down in the MiFID II directive very closely.
18
The IDD directive for IBIPs products, by way of an analogy with what is laid down in the MiFiD
II directive for investment services refers to the concept of inducement. The IDD directive
introduces a series of limits to payment of fees and compensations paid to distributors.
19
For the PRIIPs definition see Article 4 of Regulation (EU) No 1286/2014 of the European
Parliament and of the Council of 26 November 2014 on key information documents for packaged
retail and insurance-based investment products (PRIIPs).
20
PRIIPs include financial products such as bonds, derivatives, structured products (as well as
insurance products linked to these underlying assets).
21
A detailed description of the PRIIPs and IBIPs is available in the chapter 8.
536 25 Insurance Distribution

25.11 Figures of Insurance Distributors

Insurance undertakings place their products in the marketplace either directly, via
owned dedicated sales structures or making use of traditional insurance
intermediaries such as agents, brokers, bank insurance, post offices, independent
advisors (i.e. family office) and financial advisors.
Following the rapid spread of new communication technologies, insurance
undertakings have since the second half of the nineties of the last century, begun
to make use of direct sales not only via the telephone channel but also online.
In addition to traditional intermediaries already regulated under the IMD directive
(such as agents, brokers, banks, online, etc) IDD regulations allow access to insur-
ance distribution by new (or reformed) types of distributor:

• Insurance undertakings when they perform direct sales and so without the aid of
autonomous intermediaries.
• Insurance product comparison websites when a customer may actually take out a
contract from the website.
• Insurance intermediaries by way of ancillary business, those enrolled with the
registry of intermediaries and those acting under exemption from the duty to
enrol.

The following paragraphs summarise the essential features of the main types of
insurance distributors present on the industry. The seven types of insurance distrib-
utor are the following:

• Insurance agent.
• Insurance broker.
• Bank insurance.
• Post-office network.
• Insurance multi-level marketing (MLM).
• Financial advisor.
• Comparison websites.

Concerning direct sales in an insurance undertaking, there operate agencies

owned by the undertaking and run by parties acting in the direct employ of the
insurance undertaking.
An insurance agent is a party who is autonomous from the insurance undertak-
ing or undertakings for which they place insurance products. They receive a mandate
from an insurance undertaking to manage and develop a customer portfolio referring
to an agency in a specific target market. The agent takes on the enterprise risk and
their remuneration is made up wholly or in part of commission paid to them by the
insurance undertaking or undertakings on whose behalf they work.
In their activity of insurance distribution, an insurance broker brings the insur-
ance undertaking into direct contract with the proposer for insurance from whom
they have received an appointment of mediation. Often, brokers perform services of
assistance and advice in defining the risks and content of an insurance policy in
25.11 Figures of Insurance Distributors 537

addition to possibly collaborating in managing and executing a insurance contract.

They are directed towards industrial undertakings and bodies where they offer
services of advice on the management and control of corporate risks; Once solutions
of transfer of risks, most fitting for an individual customer, have been determined,
brokers research the insurance policy or rather, the insurance policies/solutions, to
meet the insurance needs to be brought to light. In the post-sales phase, a broker
deals with managing the contracts and assists the undertaking at the loss settlement
stage.
From the standpoint of an insurer, the bank insurance, is a tool for containing
distribution costs and is an effective method for reaching customer segments not
otherwise reached.
Over the years, models of bank insurance have featured a variety of forms of
governance adopted by individual undertakings:

• A simple distribution/marketing agreement between insurance and banking

partners.
• A reciprocal exchange of minority equity investments for the purpose of giving
strategic valency to the distribution contract.
• Joint ventures, the acquisition of majority investments by a bank or vice versa by
and insurer.
• Setting up a company of banking provenance or insurance provenance going as
far in a number of cases as creating corporate groups with a conglomerate
structure.

In many European countries, the post-office network offers insurance products.

Often this channel is one of the major player in the domestic insurance industry.
Usually, their points of sale are very numerous and the number of potential
customers high. Originally, the offer was focused on life insurance policies, invest-
ment and savings insurance products. Later, they developed a wide range of non-life
insurance policies. In detail, in non-life business, they offer numerous standardised
products, such as a wide range of personal risk coverage (i.e. accident and sickness),
property coverage (i.e. homeowner insurance).
Insurance multi-level marketing (MLM) is a form of direct selling where
sellers sell insurance products directly to clients and encourage them to hunt for
new sellers so that they are rewarded not only for sales made, but also for those made
by other sellers they recruited. In some European countries, this form of disguised
pyramid sales is sanctioned as illegal.
A financial advisor is a professional person who is highly skilled in financial
products. They are able to provide advice, especially in respect of investment and
capital management for their customers (usually retail ones). This distributor may
promote and place insurance policies, life and non-life. The insurance offering is
must however related to standard insurance products. As described for the figure of
insurance agent, both independent and captive advisors can offer their insurance
services in the industry.
538 25 Insurance Distribution

One of the newer distribution channels are the comparison websites. This
distributor offers a free comparison service for potential insurance customers.
Comparison websites show the client the quotation of the insurers they have
commercial agreements with (usually, a wide range). In fact, this distributor does
not have only a business partnership with a single insurance undertaking. It is a sort
of broker or independent agency provided by numerous distribution mandates and a
structured commercial process that compare policies in terms of prices and
guarantees. Before this distribution model, prospective policyholders had to request
a quotation for their insurance through high-street agents/brokers or directly through
the insurers’ websites. A comparison website is a kind of advisor to customers,
helping them save time and money. In Europe, this model started in 2000 with the
first online car insurance comparison websites. Currently, comparison sites provide
insurance solutions for many types of insurance (automobile, homeowner, life, etc.),
financial services (i.e., mortgage, loan, etc.) or utilities.

25.12 Distance Marketing

In distance marketing, consumer and insurance undertaking or insurance intermedi-

ary find themselves at a distance from each other, both at the preliminary stage and in
the subsequent phases up to concluding the insurance policy. Insurance undertakings
choose to place their insurance policies directly with the customer without making
use of insurance intermediaries, exclusively via the most widespread means of
distance communication like the telephone and the Internet.

" Definition Distance marketing is defined as any marketing activity with finan-
cial services as subject matter concluded between a provider and a consumer in the
area of a system of sale or performance of services at a distance and organised by the
provider who, for this contract, employs exclusively one or a number of distance
communication techniques up to concluding the contract, including conclusion of
the contract itself.22

The notion of distance communication techniques has a broad meaning as it is the

same one as any means that, without a physical and simultaneous presence of a
provider and a consumer, can be employed for distance marketing of a service
between the parties.23

22
See Directive 2002/65/EC of the European Parliament and of the Council dated 23 September
2002, concerning distance marketing of financial services to consumers. These regulations modify
the previous directive 90/619/EEC of the Council and directives 97/7/EC and 98/27/EC.
23
For this definition, see Directive no. 2002/65/EC.
25.14 Bank Insurance in Europe and in the United States 539

25.13 Channel Strategies in Insurance Distribution

In the insurance industry, distribution takes on significant importance. This comes

directly from the key valency of the distribution function within the delivery model
of an insurance service. The choices made by insurance undertakings concerning
distribution and its structure are, therefore, strategic in nature.
In the current panorama of insurance, it can generally be stated that a dichotomy
is its most evident feature. There are two opposing types of distribution strategies for
insurance services. On the one hand, there are the specialist insurance undertakings
in the marketplace and on the other there is the multi-channel or omnichannel
distribution strategy.

" Definition A multi-channel strategy foresees a broad spread of distribution

channels and leaves the customer the choice of which channel to activate case by
case on the basis of their own insurance culture, needs of the moment and the level of
service they require. On the other hand, an Ominichannel strategy involves the
overall management of all contact points (or touchpoints) and channels of interaction
between insurance undertaking and customer. Throughout the commercial process
(advertising, pre-sales, payment and after sales) contact points are to be identified.
They can be both physical and online (social media, mobile apps, e-commerce sites).

This strategy allows greater grassroots penetration to be ensured in local domestic

offerings, leading to reaching portions of the demand for insurance services never
before met and at limited cost. Having available various distribution channels allows
insurance undertakings to adopt strategies of market segmentation and direct the
distribution of different insurance products to the channel best suited for each type of
these.

25.14 Bank Insurance in Europe and in the United States

After its birth in France, the expression bank insurance indicates a manner of
distributing insurance products via bank windows. Defining bank insurance as a
mere distribution channel is reductive: it is actually an example of success of
integration between the insurance and banking industries falling within a wider
process of restructuring of the European financial system and convergence in
financial, banking and insurance industries toward a single large industry, the
Financial Services Industry.
Starting in France in the Eighties, it spread quickly to other countries. Histori-
cally, the development of bank insurance at a European level can be outlined in three
distinct periods:

• Up until the Eighties, banks proposed strictly insurance products to their

customers such as, for example covers tied to house ownership.
540 25 Insurance Distribution

• In the period 1980–1990, the offering was extended to policies with a more
financial and deployment of savings content.
• In the Nineties, Europe recorded a widespread expansion of banks within the
insurance business following the issue of the Second Banking Directive.24

Operations of banking intermediaries as universal banks and the introduction of

the single European licence contributed decisively to improving the level of compe-
tition in the context of European finance.
In the United States, the legislation current prior to 1999 foresaw expressly a
prohibition against American banks performing transactions of expansion into other
financial sectors close to banking, including insurance.

" Definition In 1999 the Financial Modernization Act, also called the Gramm-
Leach-Bliley Act),25 was introduced. The Gramm-Leach-Bliley measure has been
held to be of great importance for the subsequent development of the sector of
offering financial, insurance and savings investment services.

The bank insurance model has been an important driver in the development of
business in the European insurance market, generating significant flows of merger
and acquisition transactions. Insurance undertakings have exploited the tool of
shareholding investments by acquiring significant quotas (often 50% of capital) of
banking-like bank insurance companies with a number of strategic aims; diversify
the distribution structure, conquer significant market shares and, finally, as a form of
entry into foreign markets.

25.15 Questions

1. Can the reader indicate the difference between three waves in the develop-
ment of regulations on distribution?
2. What are the pillars of the Insurance Mediation Directive (IMD)?
3. What is meant by Demands and Needs?
4. What are the differences between the new paradigm Product Centred versus
Customer Centred?
5. Can the reader explain POG regulations?
6. What is meant by PRIIPs
7. What are the characteristics of the KID and the (I) PID?
8. Explain the different business models for bank insurance

24
Reference here is made to Second directive 89/646/EC of the Council dated 15 December 1989,
relating to coordination of legislative provisions, regulation and administration concerning access to
activities of credit bodies and carrying on this activity and bearing changes to directive 77/780/EC.
25
Il Gramm-Leach-Bliley Act is also known by the acronym GLBA. This is the Financial Services
Modernization Act of 999.
Directives and Regulations—Chronological Order 541

9. What is the difference between multichannel and omnichannel?

10. What is the innovation introduced by the Financial Modernization Act?

Directives and Regulations—Chronological Order

Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November
2014 on key information documents for packaged retail and insurance-based investment
products (PRIIPs)
Directive (EU) 2016/97 of the European Parliament and of the Council of 20 January 2016 on
insurance distribution—IDD
Commission Implementing Regulation (EU) 2017/1469 of 11 August 2017 laying down a
standardised presentation format for the insurance product information document—(I)PID
Commission delegated regulation (EU) 2017/2358 of 21 September 2017 supplementing Directive
(EU) 2016/97 of the European Parliament and of the Council with regard to product oversight
and governance requirements for insurance undertakings and insurance distributors
Commission delegated regulation (EU) 2017/2359 of 21 September 2017 supplementing Directive
(EU) 2016/97 of the European Parliament and of the Council with regard to information
requirements and conduct of business rules applicable to the distribution of insurance-based
investment products
Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on
insurance mediation—IMD
Directive 2002/65/EC of the European Parliament and of the Council of 23 September 2002
concerning the distance marketing of consumer financial services and amending Council
Directive 90/619/EEC and Directives 97/7/EC and 98/27/EC
Second Council Directive of 15 December 1989 on the coordination of laws, regulations and
administrative provisions relating to the taking up and pursuit of the business of credit
institutions and amending Directive 77/780/EEC (89/646/EEC)
Gramm-Leach-Bliley Act of 12 November 1999

Suggestions for Further Study

Eckardt M (2007) Insurance intermediation—an economic analysis of the information services

market. Springer, Heidelberg
EIOPA (2020) EIOPA’s approach to the supervision of product oversight and governance.
Publications Office of the European Union, Luxembourg
Marano P (2019) Navigating InsurTech: The digital intermediaries of insurance products and
customer protection in the EU. Maastricht Journal of European and Comparative Law 26
(2):294–315. https://doi.org/10.1177/1023263X19830345
Marano P, Noussia K (2019) InsurTech: a legal and regulatory view. Springer, Cham
Marano P, Noussia K (2021a) Transparency in insurance regulation and supervisory law. Springer,
Cham
Marano P, Noussia K (eds) (2021b) Insurance distribution directive. Springer, Cham
Marano P, Rokas I (2019) Distribution of insurance-based investment products. Springer, Cham
Marano P, Siri M (2017c) Insurance regulation in the European Union. Palgrave Macmillan, Cham
542 25 Insurance Distribution

Marano P, Rokas I, Kochenburger P (2016) The ‘dematerialized’ insurance: distance selling and
cyber risks from an international perspective. Springer, Switzerland
Nicoletti B (2021) Insurance 4.0. Palgrave Macmillan, Cham
Siri M (2021) Insurance-Based investment products: regulatory responses and policy issues. In:
Marano P, Noussia K (eds) Insurance distribution directive. AIDA Europe Research Series on
Insurance Law and Regulation, vol 3. Springer, Cham. https://doi.org/10.1007/978-3-030-
52738-9_5
Turchetti G (2000) Innovazione e reti distributive nel settore assicurativo. Analisi teorica
e comportamenti strategici. Franco Angeli, Milano
 Part IV
Performance and Key Indicators
Financial Statements of an Insurance
Undertaking 26

Abstract

The aim of this chapter is to explain the implementation of European directives

concerning the representation of accounting records in the insurance industry.
The legislator, taking into account the normative experiences of the single
countries, has tried to reconcile opposing demands of the parties concerned
with insurance financial statements.
In the following paragraphs, the reader can learn the accounting principles.
The Local Generally Accepted Accounting Principles (Local GAAPs) are
defined. Then, the IAS/IFRS principles are illustrated. For easing in the compre-
hension, a comparison of the main Local GAAPs versus IAS/IFRS principles has
been performed.
The principles for drawing up financial statements are explained: principle of
formal clarity and transparency, principle of continuity (or going concern),
principle of prudence, principle of accrual, prevalence of substance over form,
principle of materially, consistency principle.
At the end, the components of the financial statements, in accordance with IAS
1, are described: statement of Financial Position, single Statement of Profit or
Loss, statement of Other Comprehensive Income, statement of changes in equity
for the period, statement of Cash Flows, explanatory notes containing a summary
of accounting policies.

Keywords
Accounting principles · Local Generally Accepted Accounting Principles (Local
GAAPs) · Principle of formal clarity and transparency · Principle of continuity
(or going concern) · Principle of prudence · Principle of accrual · Prevalence of
substance over form · Principle of materially · Consistency principle · IAS/IFRS
principles · Components of financial statements · Balance Sheet · Profit and Loss

# Springer Nature Switzerland AG 2024 545

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_26
546 26 Financial Statements of an Insurance Undertaking

account · Statement of comprehensive income · Statement of changes in equity ·

Statement of cash flows · Explanatory notes

26.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Explain the evolution of the European regulations on the subject of finan-

cial statements.
2. Know the definition of the financial statements.
3. Illustrate the principles underlying the preparation of the financial
statements.
4. Describe the structure of the Profit and Loss Account and Balance Sheet.

26.2 Harmonising of European Regulations on Financial

Statements

Over the course of the last 30 years, we have seen a progressive upgrading of rules for
drawing up financial statements and consolidated financial statements so as to achieve
community harmonising and allow fuller comparability of financial statements.
Implementing of European directives concerning the representation of accounting
records in the insurance industry, also taking into account previous regulatory
experiences, has sought to reconcile opposing demands of the stakeholders
concerned with insurance financial statements, i.e. the demands for synthesis made
known by third-party readers against requests for analytical and detailed information
coming from the oversight Authority.
In order to pursue the aim of economic integration between Members, European
lawmakers have also dealt with harmonising financial data and information to be
disclosed to the public given their non-negligible impact on the workings of market
machinery. The philosophy followed by the community has been in any event
informed by a principle of harmonising up to a minimum of national legislations,
i.e. seeking out the minimum common European level from among the various
countries, leaving then a maximum of discretion to individual member States when
requiring a greater degree of depth in disclosure from undertakings.
The first interventions by community lawmakers date back to 25 July 1978 with
the issuing of directive no. 78/660/EEC, also better known as the fourth directive
on annual accounts of undertakings, which was later followed by the seventh
directive on the consolidated accounts of undertakings in June 1983 (directive
no. 83/349/EEC dated 13 June). This process of harmonising rules for drawing up
26.3 Purposes of Financial Statements 547

financial statements has been of concern to all undertakings over various phases,
firstly industrial enterprises and subsequently banks and financial intermediaries and
finally the insurance industry.1 The reasons that led to a different route being taken
depending on the business sector can be found fundamentally in a recognition on the
part of lawmakers that the production process for banks and insurances is atypical.
National provisions dealt with under community interventions as above, mainly
concern three issues relating to the structure and content of accounts (both annual
and consolidated) and relative management reports, valuation methods and, lastly,
the actual publication of the documents.
The two directives and the new rules deriving from them, also apply to the
insurance industry in the parts where there was no conflict between the general
law and special law.
At a European level, in order to recognise the peculiarities and go further into the
specific subject of the insurance industry, working parties were set up at a
Community level and made up of accounting experts with the aim of formulating
a specific proposal for insurance undertakings to deal with the peculiarities of the
insurance industry under community directives. The work done led to the issue of
community directive no. 91/674/EEC dated 19 December 1991 in respect of annual
and consolidated accounts for insurance undertakings.

26.3 Purposes of Financial Statements

Drawing up financial statements meets an important minimum disclosure function to

all stakeholders in the economic, wealth and financial position of an insurance
undertaking and additionally provides useful information for evaluating the work
of the directors of the insurance undertaking. The purpose of financial statements is
to set out the make-up of the equity and economic result while applying criteria that
are able to protect the interests of partners and creditors through a prudential
assessment of the capital invested. As set out above, this disclosure function takes
on greater meaning as compared to other industries due to the social function
performed by insurance undertakings and the sheer number of parties concerned:
shareholders, assureds, employees, injured third-parties, insurance intermediaries,
suppliers, reinsurers, creditors, consumer organisations, oversight Authorities, cate-
gory associations etc.
Financial statements are the lowest common denominator of knowledge for
meeting the expectations and requirements of all stakeholders: a complex of
accounting information useful for all possible users for having a representation of
the components of revenue and equity and evaluating the current and future perfor-
mance of a company for the purposes of decision making.

1
Under the IV Directive, Member States are granted leave to exclude from community provisions
any undertakings, such as banks, other financial institutions or insurance undertakings subjected to
special regulations This leave will be kept under the VII Directive.
548 26 Financial Statements of an Insurance Undertaking

Each category has its own aims to achieve by reading financial statements and
these aims may be different from each other and opposing. In general, the series of
items of accounting information summarised in financial statements must allow all
possible stakeholders to evaluate current and future performance tied to the company
for decision-making purposes.
As seen previously, the production cycle of an insurance undertaking has unique
features such as, for example income precedes disbursements in time and revenues
(premiums) are earned in advance as compared to the performance provided to
assureds; the duration of the commitments taken on vis-à-vis assureds, especially
in the life business, is multi-year in nature; the interval between the occurring of a
loss event in the non-life business and settlement and payment of the indemnity is
often extended over time and concerns a number of accounting periods. This model
leads to the forming of mathematical reserves and other technical reserves, cash-flow
management.
In addition to illustrating the purposes of the financial statements, to understand
its functioning it is useful to follow a didactic approach in which the accounting
principles and the reporting templates formats are presented. See Figure 26.1, which
explains the topics that will be described in the next paragraphs.
The topics relating to the matter of drawing up financial statements will be
addressed starting from the accounting principles. The definition of the accounting
principles will be provided in the next paragraph. The different types of accounting
principles will also be explained. At the end of the chapter, the reporting template for
publishing quantitative information and insurance undertaking’s economic and
financial information will be described.

Purposes of the
What is the main purpose of Disclosure and information on the financial position
financial
statements a financial statements? Transparency towards stakeholders

Fundamental Accounting Principles

Accounting What are the accounting
General Accepted Accounting Principles (GAAP)
principles principles?
IAS/IFRS accounting standards

Balance Sheet
Profit and Loss account
Reporting What are the components of
Templates Financial Statements? Statement of comprehensive income
Statement of changes in equity
Statement of cash flows
Notes (summary and explanatory notes)

Fig. 26.1 The basics questions for exploring financial statements topics
26.4 Account Principles 549

26.4 Account Principles

Accounting principles are the common rules and guidelines that companies must
follow when preparing their financial statements. Accounting principles ensure that
companies follow registration standards, correct methods of recognition and presen-
tation of economic events. Accounting principles differ from country to country.
Therefore, accounting for a cost or revenue can be quite different even between two
neighbouring countries.
Although there are currently no universally standardized accounting principles,
there are various accounting frameworks that define the standard body. The most
common accounting principles used are IFRS, vs. Local GAAP. There are
similarities and differences between these frameworks, where GAAP is mainly
rules-based while IFRS is mainly principle based.
In detail, the local accounting principles are collectively known as Local Gener-
ally Accepted Accounting Principles (Local GAAPs). Local GAAP provides the
framework for each country and the accounting rules. They represent a guideline on
how to prepare and communicate the financial statements. Local GAAP aims to
regulate and standardize accounting practices for ensuring a transparent. accurate
and relevant information in financial statements.
The most common Local GAAP principles in the world are UK GAAP and US
GAAP. The others are usually applied by the companies at their domestic level and
by their subsidiaries to meet the needs of the parent company (e.g. French GAAP is
used by French insurance companies outside France).
In respect of regulations foreseen under the international framework applying to
insurance undertakings for drawing up financial statements, financial statements
must be drawn up with clarity and must represent the equity and financial position
of the insurance undertaking and the economic result of the accounting period
truthfully and accurately. Some of the accounting principles concerning the drawing
up of financial statements.
The principle of formal clarity and transparency of financial statements
requires comprehensibility through the drawing up of templates and the Additional
Notes wherein descriptive content must facilitate overall understanding of the
documents of the financial statements. Substantial clarity on the other hand imposes
forming and representing values as transparently as possible so as to ensure neutral-
ity and impartiality by way of protection of all stakeholders in an insurance
undertaking.
A principle of continuity (or going concern) should inform the approach taken
by those concerned in preparing the financial statements for an accounting period. In
their activity, these latter must at all times bear in mind the fact that an undertaking is
functioning, and the image of the corporate position shown in financial statements
must be given from the perspective of a going concern and of continuity in corporate
operations.
A principle of prudence requires the party drawing up financial statements to
inform their assessments so as to ensure there is safeguarding of the integrity of
equity and solidity of the undertaking, so avoiding evaluations being made that are
550 26 Financial Statements of an Insurance Undertaking

excessively optimistic in respect of plus items of income and equity assets and any
failure to consider events becoming known even subsequently to the accounting
period being closed off. One of the clearest applications of this principle is to be
found, for example, in the duty to include probable losses, even if not finally realised,
and it being possible to detect only profits achieved as at the closing of the
accounting period in financial statements. This principle has a further connotation
and relevance in referring to insurance undertakings when looking at the special
protection of covers offered to assureds and the solvency of individual undertakings
and stability of the entire system.
The principle of accrual lays down a criterion according to which the various
events of economic management concur in forming the result only in respect of
economic relevance, irrespective of when they show up financially. As already
mentioned previously, the need to have an image of the position of the firm
periodically, usually on an annual basis, runs up against the fact that an undertaking
has a potentially infinite lifespan and many cycles of corporate consumption and
production take place over a number of accounting periods. The criterion chosen by
lawmakers imposes the drafter to consider management events of the accounting
period only at the time when the relative rights and/or corresponding duties arise,
rather than the principle of collection according to which a management event is
attributed to the accounting period when payment of a right shows up or disburse-
ment to meet an obligation is made. For an insurance undertaking, given the special
economic-financial cycle in which revenues precede costs, premiums are considered
accruing to the accounting period in which maturity takes place.
The principle of prevalence of substance over form requires detection and
presentation of headings being made taking into account the substance of the
transaction or contract, i.e., taking into account the economic function of the item
of assets or liabilities considered and the aggregate of correlated transactions, even if
they are formally distinct.
Completeness is ensured by the principle of materiality, as all material
transactions should be accounted for in the financial statements.
Finally, the consistency principle in applying criteria of evaluation meets the
need for financial statements that are chronologically successive to each other and
the development of the position of the firm from one accounting period to the next,
based on homogeneous criteria of evaluation, is understandable. Otherwise, any
comparison would be found to be difficult, if not impossible, for an outside observer
of the firm.
IAS/IFRS principles are international accounting standards, issued by a group of
professionals with the aim of standardizing accounting rules worldwide. The goal is
to make the comparison between financial statements and financial reporting of
companies operating in different countries simpler and more transparent. In order
to overcome the main differences between countries, one of the key concepts
introduced by the IAS/IFRS principles is the definition of the concept fair value.
Fair value represents the value for which an asset can be exchanged, or a liability
extinguished, between knowledgeable and willing parties, in a transaction between
26.5 Components of Financial Statements 551

independent third parties. In accordance with this concept, all evaluations must be
made at fair value.
For ease of understanding, Table 26.1 shows a comparison between Local GAAP
and IAS/IFRS standards. For the comparison, one of the most commonly used
international GAAP principles is used: US GAAP. This table contains the main
differences. it is not meant to be an exhaustive list. The aim is to make the
understanding for the reader easier.

Table 26.1 Comparison US GAAP vs. IFRS

Main differences US GAAP IFRS
1. Local principles Used in the United States and Used in most countries around
vs. global at U.S. subsidiaries abroad the world (including the EU
and many Asian and South
American countries)
2. Rules vs. principles More rules-based More principles-based
(i.e. industry-specific rules and (i.e. principles that require
guidelines to follow) judgment and interpretation)
3. Fair value revaluations Revaluation is prohibited Revaluation (either an increase
except for marketable or a decrease) of the following
securities assets is allowed: inventories,
property, plant and equipment,
intangible assets and
investments in marketable
securities
4. Impairment losses Allowed. On the other hand, Allowed. Losses can be
(on long-lived assets when reversals of impairment losses reversed for all types of assets
the market value of an asset for all types of assets is except goodwill
decline) prohibited
5. Fixed assets (long-lived Are valued at historic cost and Are initially valued at cost, but
assets such as buildings, depreciated appropriately can later be revalued up or
furniture and equipment) down to market value
etc etc etc

26.5 Components of Financial Statements

In accordance with IAS 1, a complete set of financial statements should include the
following reporting templates:

1. Statement of Financial Position

2. Single Statement of Profit or Loss
3. Statement of Other Comprehensive Income
4. Statement of changes in equity for the period
5. Statement of Cash Flows
6. Explanatory notes containing a summary of accounting policies
552 26 Financial Statements of an Insurance Undertaking

Statement of Financial Position is also known as the Balance Sheet. It contains a

classified representation of financial position, separating current and noncurrent
assets and liabilities of a company at a given date. It is comprised of three main
elements: assets, liabilities and equity. IAS 1 does not prescribe the format of this
statement. Usually, the first template contains assets that are presented as current
then non-current. Assets are mainly represented by financial investments, made with
funds deriving from premiums collected (in respect of which performances have not
yet been paid). The second template contains liabilities, which are presented as
current then non-current. Liabilities include the technical reserves (for non-life
business) or mathematical reserves (for life business). As already explained, the
reserves are estimated commitments towards assureds for delivering the
performances covered and provisions for claims management costs. The second
template also contains the equity, In general terms, the sum of equity (Eq) and
liabilities (Ls) has to be equal with the value of assets (As). The general calculation
of the statement is as follows: As = Eq + Ls.
Statement of Profit or Loss and statement of Other Comprehensive Income
contain all revenues and all costs incurred during the reporting period. The templates
are represented with the scalar form. As in the case generally for enterprises,
adopting a scalar form allows immediate identification to be achieved of intermedi-
ate results and the part played by individual operations in the economic result for the
reporting period, and thus ease of viewing of the results from the various areas of the
insurance undertaking.
Statement of changes in equity contains the reconciliation of the beginning and
ending balances in a company’s equity during the reporting period. This template
starts with the opening equity balance, and then adds or subtracts such items as
profits and dividend payments in order to define the closure value at the ending
balance.2 The general calculation of the statement can be represented as follows:
opening equity + Net income - Dividends ± Other changes = closure equity.
Statement of Cash Flows is a template that contains the amount of cash and cash
equivalents inflow and outflow during the reporting period. The cash flow statement
represents sources and uses of funds. It explains where a company has generated its
cash from and how it was spent or put to use. The main components of the cash
inflow statement are cash received from operating activities and cash from financing
activities. The main elements of the cash outflow statement are cash spent for
operating activities and cash invested in activities. In accordance with the IAS
policies, two methods of calculating cash flow are available: the direct method and
the indirect method.
Explanatory notes containing a summary of accounting policies include the
explanation of the measurement basis used in preparing the financial statements and

2
Note that the statement of changes in equity represents the changes in owner’s equity. It also
includes the non-controlling interest attributable to other individuals and organisations
(i.e. including minorities interests).
References 553

the other accounting policies used. It provides supporting information for items
presented in the previous templates.

26.6 Questions

1. What is the financial statement’s definition?

2. What is the representation template of the balance sheet?
3. What does the continuity principle provide?
4. What is the purpose of Community Directive 91/674/EEC?

References

Directives and Regulations—Chronological Order

Council Directive 91/674/EEC of 19 December 1991 on the annual accounts and consolidated
accounts of insurance undertakings
Council Directive 83/349/EEC of 13 June 1983 based on the Article 54(3)(g) of the Treaty on
consolidated accounts
Fourth Council Directive 78/660/EEC of 25 July 1978 based on Article 54(3)(g) of the Treaty on the
annual accounts of certain types of companies

IFRS Principles—Chronological Order

IAS 1 (2003) Presentation of financial statements. International Accounting Standards Board,

London
IFRS 1 (2003) First-time adoption of international financial reporting standards. International
Accounting Standards Board, London

Suggestions for Further Study

Bellandi F (2012) The handbook to IFRS transition and to IFRS U.S. GAAP dual reporting:
interpretation, implementation and application to grey areas. Wiley regulatory reporting.
Wiley, Chichester
Christian D, Lüdenbach N (2013) IFRS essentials. Wiley regulatory reporting. Wiley, Hoboken, NJ
Marano P, Noussia K (2021) Transparency in insurance regulation and supervisory law. Springer,
Cham
Introduction to IFRS and Consolidated
Financial Statements 27

Abstract

This chapter aims to illustrate the IAS/IFRS historical development and the
requirements for consolidated financial statements. The historical development
of this evolution is described in the paragraphs (i.e. the transformation from IAS
to IFRS principles).
The Regulations of the European Community no. 1606/2002 have been
illustrated. These regulations lay down the new rules introducing IAS/IFSR in
the insurance industry with effect from 2005.
In accordance with IFRS 10, which defines the consolidation area, in the
chapter, the area of consolidation is illustrated.
IAS 1 provides the components for drafting up consolidated financial
statements. They are consolidated balance sheet, consolidated statement of profit
or loss, consolidated statement of comprehensive income, consolidated statement
of changes in equity, consolidated statement of cash flows.
Obligatory templates for drafting are consolidated Balance Sheet, consolidated
statement of profit or loss, consolidated statement of comprehensive income,
consolidated statement of changes in equity and consolidated statement of cash
flows.

Keywords

Generally Accepted Accounting Principles (GAAP) · International Accounting

Standards (IAS) · Accountants International Study Group (AISG) · International
Accounting Standards Committee (IASC) · International Accounting Standard
Board (IASB) · International Financial Reporting Standards (IFRS) · Parent
Company · Unitary management · Area of consolidation · Notion of control ·
Consolidated Balance Sheet · Aggregate Profit and Loss account · Consolidated
statement of comprehensive income · Consolidated statement of changes in
equity · Consolidated statement of cash flows

# Springer Nature Switzerland AG 2024 555

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_27
556 27 Introduction to IFRS and Consolidated Financial Statements

27.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the historical development of the IAS/IFRS issuing process.

2. Recognise the rules relating to the introduction of IAS/IFRS in the insur-
ance industry.
3. Define the conditions for the consolidation area.
4. Illustrate the obligatory templates for drafting a consolidated financial
statement.

27.2 IAS/IFRS Historical Development

The origin of a common set of accounting standards throughout the European Union
can be seen as a wish on the part of European lawmakers to harmonise the economic
context and integrate the single market for capital. This objective was a step further
beyond the introduction of community directives obliging all undertakings to set out
and structure financial statements in a homogeneous fashion and was intended to
lead to proper representation of economic events, including information that was
homogeneous, and thus comparable, and on assessment criteria. Underlying the
entire set-up there was the paradigm of financial statements being a faithful and
truthful representation of the economic condition of the undertaking.
The process of introducing a common set of accounting standards developed over
the course of a number of decades and required certain important choices to be made
by the body issuing them. Concerning the selection of accounting standards of
reference to lean, towards, the 4th Community Directive of 1978, on the one hand
supported the internationalising of undertakings through harmonising financial
statements and, on the other, laid out limits which make them unsuited for the
purpose they were intended to serve. The long delay in acceptance by individual
countries and the difference in interpreting them, such as it being possible to choose
between various accounting options, were an obstacle to achieving full harmonising
of criteria for presenting and measuring the financial statements of undertakings that
were competing with each other in the area of the competitive and efficient global
market that was developing. The choice of employing a single corpus of European
accounting standards was thus ruled out. Once it had been recognised that it would
have been impossible to adapt the accounting standards based on the (British and US
format), the so-called local Generally Accepted Accounting Principles (local
27.2 IAS/IFRS Historical Development 557

IFRS adoption in the

Insurance Sector
(European Community
IASC Constitution Issuing Regulation No
AISG (more Countries first 41 IASB 1606/2002)
Constitution involved) IAS Constitution IFRS 17 adoption

1968 1973 1975 1999 2001 2004 2005 2023 …

Development and adoption of

Issuing IAS Principles IFRS standards

Fig. 27.1 Historical development of the issue of IAS/IFRS accounting standards

GAAP),1 legislators have moved towards adopting standards of an international

kind ex novo.
The issuing of international accounting standards went through a number of
important stages, culminating in the issue in 1999 of the first forty-one International
Accounting Standards (IAS). See Figure 27.1 describing the historical develop-
ment of the IAS/IFRS accounting standards.
In 1968, the Accountants International Study Group (AISG), is set up and is
the first organisation to express the need to create common accounting standards in
Canada, the United Kingdom, the United States and it operates up until 1973. This is
the year other countries, namely Australia, Canada, France, Ireland, Germany,
Japan, Mexico and the Netherlands sign up, thus broadening the area of impact of
the new commission named the International Accounting Standards Committee
(IASC). Over the course of the subsequent 25 years, from 1975 to 1999, the IASC
works on preparing the first 41 International Accounting Standards (IAS).
These are issued by three committees in turn and, for related interpretations, there
is the Standing Interpretation Committee (SIC). In 2000, restructuring and
defining of the new articles of the IASC is set in motion and concluded in 2001,
with transformation of the IASC via founding and taking on of its functions by the
International Accounting Standard Board (IASB), a private, independent body
with offices in London and without regulatory powers.
The international accounting standards are known, up until the end of March
2001, by the initials IAS (International Accounting Standards). With effect from 1st
April 2001 with the setting up of the IASB, the international accounting standards
are referred to as International Financial Reporting Standards (IFRS).
This quick overview of the development of the standards and the body charged
with issuing them allows us to understand the current international state of affairs
and their impact on the insurance industry more fully.

1
Note that the description of local GAAP is referred to the country of reference. For example, for
GAAP within United States the name is “US GAAP”, for GAAP within France the name is “French
GAAP”, for GAAP within Germany, the name is “German GAAP” and so on.
558 27 Introduction to IFRS and Consolidated Financial Statements

27.3 Introduction of the New IAS/IFRS Accounting Standards

to the Insurance Industry

Concerning the accounting criteria valuing the entries in insurance financial

statements, Regulations of the European Community n. 1606/2002 lay down
new rules applying with effect from 2005. Companies whose securities are listed
on one of the regulated markets of the European Union must prepare their financial
statements in accordance with IAS/IFRS international accounting standards.
Through these regulations, the European Union, by adopting the internationally
recognised framework of the accounting standards drawn up by the IASB, indeed
set itself the purpose of rendering comparable the economic results of companies
residing in different member states of the Union and operating in different industries
and so protect investors by promoting transparency of financial information and
encourage the development of an integrated and competitive financial market.
For consolidated accounts of publicly traded companies, the regulator states that
for each financial year starting on or after 1 January 2005, the preparation by the EU
companies of their consolidated accounts in conformity with the international
accounting standards is mandatory.2 On the other hand, the regulator foresees an
option in respect of annual accounts of non-publicly-traded companies. Each
member states may require companies other than publicly traded companies to
prepare their consolidated accounts and/or their annual accounts in conformity
with the international accounting standards adopted.3
According to this option, many domestic regulators foresees adopting the new
IAS/IFRS standards in the following cases:

• Companies issuing financial instruments on regulated markets.

• Companies with financial instruments held by the public.
• Banks and financial intermediaries subject to supervision.
• Insurance undertakings, excluding financial statements for the accounting period
that must be drawn up following national standards.
• Companies included in consolidated financial statements of companies obliged to
draw them up in accordance with international accounting standards.
• Companies other than those indicated under foregoing points and that draw up
consolidated financial statements.
• Companies other than those indicated under foregoing points and those that draw
up financial statements in abbreviated form.

Especially, for insurance industry, a duty to apply the regulation has effect from
2005 in drawing up consolidated financial statements. Application is peremptorily

2
See Article 4—Regulation (EC) No 1606/2002 of the European Parliament and of the Council of
19 July 2002 on the application of international accounting standards.
3
See Article 5—Regulation (EC) No 1606/2002 of the European Parliament and of the Council of
19 July 2002 on the application of international accounting standards.
27.4 Consolidated Financial Statements 559

Insurance undertakings
(listed and unlisted firms)

Consolidated Standalone
Financial Financial
statements statements

Not Mandatory local

Mandatory IAS
IAS account

Listed insurance undertakings not

preparing consolidated financial
statements

Fig. 27.2 Area of adoption of IAS/IFRS standards in the insurance industry

excluded in respect of drawing up financial statements for an individual accounting

period with the exception publicly traded insurance undertakings that do not draw up
consolidated financial statements. The European Community allowed the use of
IAS/IFRS standards also by unlisted companies in the event that these, but excluding
insurance undertakings as has been stated, adopt the option to draw up their financial
statements according to these standards. For a graphic representation of the area of
adoption of IAS/IFRS standards in the insurance industry, see Figure 27.2.
As can be seen, in adopting IAS/IFRS standards, a so-called mandatory dual track
applies for insurance undertakings on the basis of which, although consolidated
financial statements are prepared to comply with the new international accounting
standards, those for the accounting period must be drawn up in accordance with
national standards.
Adopting international accounting standards requires insurance undertakings to
introduce new assessment and management criteria, so generating impacts not only
of a typical accounting kind, but also of business model and strategic approach that
concern a significant portion of the organisational structure as well as corporate
processes and systems.

27.4 Consolidated Financial Statements

The areas that have been most impacted by the IAS/IFRS standards are consolidation
of financial statements, adopting a specific plan of accounts and remeasuring relating
to financial instruments and the technical insurance area.
560 27 Introduction to IFRS and Consolidated Financial Statements

The treatment that follows will therefore concentrate on the matter of drawing up
these financial statements which requires, as an essential step, verification of the
assumptions foreseen in the regulatory framework for undertakings that are obliged
to draw them up.
Referring to the definition of the consolidation area of an insurance parent
company, the applicable regulatory framework is founded on the approach of
IFRS 10—Consolidated Financial Statements. In particular, this principle
foresees that:

• The parent company must have the characteristics of an insurance or reinsurance

undertaking or an undertaking with an insurance equity holding, that controls,
directly or indirectly, the companies making up the insurance group and which is
not, in its turn, controlled by another insurance or reinsurance undertaking or
another undertaking with an insurance equity holding, that can be deemed to be a
parent company.
• Insurance or reinsurance undertaking that control one or a number of companies,
must draw up consolidated financial statements in compliance with international
accounting standards.
• The obligation to draw up consolidated financial statements subsists also in cases
where two or more insurance or reinsurance undertaking, between which a
relationship of control does not exist, operate in accordance with unitary manage-
ment by virtue of a contract or a clause in their respective articles of association or
when their administrative bodies are made up of a majority of the same persons.
unitary management of undertakings may materialise also through significant
and lasting ties of reinsurance.

Undertakings obliged to draw up consolidated financial statements have to adopt

international accounting standards and introduce the templates, attachments and
rules for actually compiling the consolidated financial statements.
Defining the area of consolidation, undertakings that must draw up consolidated
financial statements supplement national provisions in the matter of control with
what is laid down under international accounting standards. So, the notion of control
and related national provisions in the matter of the duty to consolidate, configure
only the minimum perimeter of the area of consolidation, which must be
supplemented in accordance with the provisions4 of the IFRS 10.
IFRS 10 dictates, in particular, a notion of control on the basis of which an
investor holds control of an entity when they are exposed, or have the right, to results
that are variable deriving from their involvement in the entity and are able to
influence these results through their power in the entity itself.5 In particular, control
of an entity by an investor requires three essential conditions to be met:

4
See IFRS 10 art. 22, paragraph 1.
5
See IFRS 10 § 10.5–8.
27.5 Components of Consolidated Financial Statements 561

• Power over the relevant activities of the entity.6

• Exposure, or right, to results that are variable deriving from their involvement in
the entity.7
• Leave to use their power to influence the extent of these results.8

Finding the conditions underlying control therefore requires:

• Identifying material activities, i.e. those that have a meaningful bearing on the
results of the entity.
• Determining which party (if any) holds power over the entity, or holds any rights
that grant a current ability to direct relevant activities.
• Assessing whether or not the investor is exposed or can claim rights. over variable
results of the entity deriving from their involvement in it.

Appendix B to international accounting standard IFRS 10 provides a broad guide

to application with examples and guidelines for assessing the elements that are
essential for control.

27.5 Components of Consolidated Financial Statements

Consolidated financial statements are drawn up, in compliance with the template
foreseen in attachment of the IAS 1—Presentation of Financial Statements. In this
attachment the following components are enclosed: (1) consolidated Balance Sheet,
(2) Aggregate Profit and Loss account, (3) Consolidated statement of comprehensive
income, (4) Consolidated statement of changes in equity and (5) Consolidated
statement of cash flows.
See Table 27.1 for consolidated Balance Sheet, asset side and Table 27.2 for
consolidated balance sheet, liability and equity side.
For the representation of the aggregate Profit and Loss account, see Table 27.3.
It can be seen that the structure of the profit and loss account of insurance
financial statements drawn up in accordance with international accounting standards
foresees, in a scalar form, an offset between revenues and losing charges, different
from the profit and loss account of the financial statements drawn up in accordance
with Local General Accepted Accounting Principles (local GAAP). As in the case of
undertakings generally, adopting the scalar form allows intermediate technical
results and the participation of single insurance and financial divisions in the
economic result for the accounting period to be identified, as well as the distinctive
contribution made by the life business and the non-life business.

6
See IFRS 10 §10–14.
7
See IFRS 10 § 10.15–16.
8
See IFRS 10 § 10.17–18.
562 27 Introduction to IFRS and Consolidated Financial Statements

Table 27.1 Consolidated Balance Sheet—asset

Consolidated balance sheet—asset

Assets
Cash and cash equivalents
Investment assets
Insurance contract assets
Reinsurance contract assets
Other assets
Investments in associates and joint ventures accounted for using the equity method
Intangible assets
Investment properties
Right-of-use assets
Property and equipment owned
Total assets

Table 27.2 Consolidated Balance Sheet—liability and equity

Consolidated balance sheet—liability and equity

Liabilities
Current income tax liabilities
Other current liabilities
Investment contract liabilities
Insurance contract liabilities
Reinsurance contract liabilities
Provisions
Lease liabilities
Subordinated debt
Employee benefit obligation
Deferred income tax liabilities
Total liabilities
Equity
Share capital
Share premium
Retained earnings
Other reserves
Equity attributable to owners of insurance undertaking
Non-controlling interests in equity
Total equity
Total equity and liabilities

For the representation of the consolidated statement of comprehensive income

see Table 27.4.
The aggregate profit and loss account, in accordance with what is laid down under
IFRS 1 (First-time Adoption of International Financial Reporting Standards),
27.5 Components of Consolidated Financial Statements 563

Table 27.3 Aggregate Profit And Loss account

Insurance revenue
Insurance service expenses
Net expenses from reinsurance contracts held
Insurance service result
Interest revenue from financial assets not measured at FVTPL
Net gains on FVTPL investments
Net gains on investments in debt securities measured at FVOCI reclassified to profit or loss on
disposal
Net change in investment contract liabilities
Net gains from the derecognition of financial assets measured at AC
Net gains from fair value adjustments to investment properties
Net credit impairment losses
Net investment income
Finance expenses from insurance contracts issued
Finance income from reinsurance contracts held
Net insurance finance expenses
Net insurance and investment result
Asset management services revenue
Other finance costs
Other operating expenses
Share of profit of associates and joint ventures accounted for using the equity method
Profit before income tax
Income tax expense
Profit for the year
Profit attributable to
Owners of insurance undertaking
Non-controlling interests
Earnings per share for profit attributable to the ordinary shareholders (in CU per share)
Basic earnings per share
Diluted earnings per share

supplements the profit and loss account with the income components relating to
variations in assets and liabilities that on the basis of the rules of representation
foreseen by the respective international accounting standards, are not detected in the
profit and loss account, but rather directly from net equity (e.g. the heading “profits
or losses” on financial statements of the “available for sale” takes in the offsetting
item of the fair value assessment in financial statements of “Available for sale”
financial assets, the so-called AFS Provision. See Table 27.5 for the representation of
the consolidated statement of changes in equity.
564 27 Introduction to IFRS and Consolidated Financial Statements

Table 27.4 Consolidated statement of comprehensive income

Profit for the year

Items that may be reclassified to profit or loss
Net gains on investments in debt securities measured at FVOCI
Net gains on investments in debt securities measured at FVOCI reclassified to profit or loss on
disposal
Finance expenses from insurance contracts issued)
Finance income from reinsurance contracts held
Share of other comprehensive income of associates and joint ventures accounted for using the
equity method
Income tax relating to these items
Items that will not be reclassified to profit or loss
Revaluation of land and buildings
Share of other comprehensive income of associates and joint ventures accounted for using the
equity method
Remeasurements of post-employment benefit obligations, before tax
Income tax relating to these items
Other comprehensive income for the year, net of tax
Total comprehensive income for the year
Total comprehensive income attributable to
Owners of insurance undertaking
Non-controlling interests
27.5 Components of Consolidated Financial Statements 565

Table 27.5 Consolidated statement of changes in equity

Other reserves

Non-
Retained Fair Total
Share Insurance cont-
Share earnings value Other other Total
premium finance rolling
capital reserve reserves equity
reserve interests

Balance - 1 January 20X3 23,906 3,909 54,310 1,709 1,724 3,223 6,655 1,968 90,748

Profit for the year 9,350 255 9,605

Other comprehensive income 246 (279) 226 194 4 198

Total comprehensive income for the year 0 0 9,350 246 (279) 226 194 259 9,803

Dividends 0
- Employee share option scheme (1,206) (89) (1,295)
- Value of employee services 418 418 418
- Proceeds from shares issued 219 219

Total 219 0 (1,206) 0 0 418 418 (89) (659)

Balance - 31 December 20X3 24,125 3,909 62,454 1,955 1,445 3,866 7,266 2,138 99,891

Profit for the year 9,314 208 9,521

Other comprehensive income 376 (404) 161 134 3 136

Total comprehensive income for the year 0 0 9,314 376 (404) 161 134 210 9,658

Dividends (1,949) (105) (2,054)

Issue of share capital 3,125 1,688 4,813
Sales of treasury shares 0
- Employee share option scheme 313 163 475
- Value of employee services 534 534 534
- Proceeds from shares issued 269 269

Total 3,706 1,850 (1,949) 0 0 534 534 (105) 4,036

Balance - 31 December 20X4 27,831 5,759 69,819 2,331 1,041 4,561 7,934 2,243 113,585

Note: changes in net equity must be compiled with effect from the accounting period (n-2)

Table 27.6 describes a consolidated statement of cash flows (indirect method).

In connection with the cash flow statement, it can be seen that the indirect method
is the method that has been adopted almost universally by practice in the insurance
industry in drawing up the cash flow statement.
566 27 Introduction to IFRS and Consolidated Financial Statements

Table 27.6 Consolidated statement of cash flows

Cash flows from operating activities
Profit for the year
Adjustments for
Changes in insurance and reinsurance contract assets/liabilities
Changes in investment contract liabilities
Net gains on investment sides
Foreign exchange gains and losses, net
Interest expense
Interest income
Dividend income
Share of profit of associates and joint ventures accounted for using the equity method
Fair value adjustment to investment properties
Income tax expense
Other adjustments for non-cash items
Changes in investment assets
Proceeds from sales
Purchases
Changes in other working capital balances
Interest received
Dividend received
Income tax paid
Net cash outflow from operating activities
Cash flows from investing activities
Payment for acquisition of subsidiary, net of cash acquired
Payments for investment properties
Payments for intangible assets and property and equipment
Proceeds from sale of intangible assets and property and equipment
Dividends from joint ventures and associates
Net cash outflow from investing activities
Cash flows from financing activities
Proceeds from issuance of ordinary shares
Proceeds from sale of treasury shares
Proceeds from borrowings
Repayment of borrowings
Interest paid on borrowings
Net cash from interest rate swaps
Dividends paid to parent company’s shareholders
Dividends paid to non-controlling interests in subsidiaries
Net cash from financing activities
Net decrease in cash and cash equivalents during the year
Cash and cash equivalents—Beginning of year
Effects of exchange rate changes on cash and cash equivalents
Cash and cash equivalents—End of year
Directives and Regulations—Chronological Order 567

27.6 Questions

1. What is a Parent Company?

2. Explain the passage from IAS to IFRS
3. Describe the rules contained in the IFRS 10
4. Explain the meaning of a consolidated statement of changes in equity.
5. What are the obligatory templates for drafting the Consolidated Balance?

Directives and Regulations—Chronological Order

Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on
the application of international accounting standards

IFRS Principles—Chronological Order

IFRS 17 (2017) Insurance contracts. International Accounting Standards Board, London
IFRS 9 (2013) Financial instruments. International Accounting Standards Board, London
IFRS 10 (2008) Consolidated financial statements. International Accounting Standards Board,
London
IAS 1 (2003) Presentation of financial statements. International Accounting Standards Board,
London
IFRS 1 (2003) First-time adoption of International Financial Reporting Standards. International
Accounting Standards Board, London

Suggestions for Further Study

Alibhai A, et al (2020) WILEY 2020 Interpretation and Application of IFRS1 Standards, Print
ISBN: 9781119699361 Online ISBN: 9781119699415, https://doi.org/10.1002/
9781119699415, John Wiley & Sons, Ltd.
Cappiello A (2020) The European Insurance Industry: Regulation, Risk Management, and Internal
Control, London, Palgrave Macmillan.
Chaudhry A, et al. (2015) Wiley 2015 Interpretation and Application of International Financial
Reporting Standards, Print ISBN: 9781118889558 Online ISBN: 9781118889527, https://doi.
org/10.1002/9781118889527, John Wiley & Sons, Inc.
Christian D, Lüdenbach N (2013) IFRS essentials. Wiley regulatory reporting. Wiley, Hoboken, NJ
Mackenzie B, Coetsee D, Njikizana T, Selbst E, Chamboko R, Colyvas B, Hanekom B (2014) IFRS
2014: interpretation and application of international financial reporting standards. Wiley regu-
latory reporting. Wiley, Hoboken, NJ
Mackenzie B, et al. (2014) Interpretation and Application of International Financial Reporting
Standards, Print ISBN: 9781118734094 Online ISBN: 9781118870372, https://doi.org/10.
1002/9781118870372, John Wiley & Sons, Inc
Mechelli A (2009) Accounting Harmonization and Compliance in Applying IASB Standards: An
Empirical Survey about the First Time Adoption of IAS 7 by Italian Listed Groups. Accounting
in Europe, 6(2), 231–270. https://doi.org/10.1080/17449480903172077
International Accounting Standards (IAS)
and International Financial Reporting 28
Standards (IFRS)

Abstract

This chapter aims to illustrate the main impacts of IAS/IFRS standards on an

insurance undertaking. In the paragraphs that follow the impacts deriving from
IAS/IFRS are described in detail.
IAS 39 defines the main changes concern the introduction of new rules of
classification, and measurement of financial instruments.
IFRS 9, replacing the IAS 39, foresees new classifications and different
measurement criteria for assets.
IFRS 7 gives the requirements for disclosure in the matter of financial
instruments.
IFRS 4 governs the measurement criteria for insurance contracts and relative
technical components.
IFRS 17 introduces a new measurement model of an insurance contract,
replacing the IFRS 4.
IAS 38 applies to all intangible assets included within its area of application
(with some specific exclusions).
IAS 36 requires an analysis being made of possible losses of value for all
intangible assets.
IFRS 3 foresees business combination transactions, for instance, control
obtained of one or more corporate assets.
IAS 12 governs the criteria for accounting of income taxes.
IFRS 8 requires an entity to provide information allowing to assess the nature
and effects on the financial statements of the business activities.

Keywords
IAS 39 Financial Instruments: Recognition and Measurement · Fair Value
Through the Statement of Profit or Loss (FVTPL) · Held To Maturity (HTM) ·
Loans and Receivables (L&R) · Available For Sale (AFS) · Transaction date ·
Settlement date · Other comprehensive income (OCI) · Fair value-hedge

# Springer Nature Switzerland AG 2024 569

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_28
570 28 International Accounting Standards (IAS) and International. . .

accounting · IFRS 7 Financial Instruments: Disclosures · IFRS 9 Financial

Instruments · Solely Payment of Principal and Interest (SPPI) · Fair Value
Through the statement of Other Comprehensive Income (FVTOCI) · Hold to
collect · Hold to collect and sell · Held For Trading (HFT) · Fair Value Option ·
Forward-looking expected loss · Impairment · Staging allocation · Hedge
accounting · Expected credit loss impairment model · Deferral approach · Overlay
approach · IFRS 4 Insurance Contracts · Insurance contract · Significant insurance
risk · Discretionary participation · Unbundling · Liability Adequacy Test (LAT) ·
Shadow accounting · Deposit accounting · Deferred Origination Costs (DOC) ·
IFRS 17 Insurance Contracts · Building Block Model · Risk adjustment · Locked-
in · Contractual service margin · Shock absorber effect · Premium Allocation
Approach · Unearned premium · Variable fee approach · IAS 38 Intangible
Assets · IAS 36 Impairment of Assets · Cash Generating Unit (CGU) · IFRS
3 Business Combinations · Acquisition method · IAS 12 Income Taxes · IFRS
8 Operating Segments

28.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Define the main impacts of IAS/IFRS standards on insurance undertakings.

2. Know the classification of financial instruments according to IAS 39.
3. Explain the disclosure on financial instruments—IFRS 7.
4. Know the classification and measurement of financial assets according to
IFRS 9.
5. Understand the differences between IAS 39 and IFRS 9.
6. Define classification, measurement and disclosure for Insurance contracts
(IFRS 4).
7. Explain the principle of measurement of insurance contracts (IFRS 17).
8. Illustrate the remaining international accounting standards of significance
for the insurance industry.

28.2 The Main Impacts of IAS/IFRS Standards on Insurance

Industry

In the insurance industry, several areas have been affected by the IAS/IFRS
standards. For instance, some of them are consolidation of financial statements,
adopting a specific plan of accounts, remeasuring relating to financial instruments,
etc.
28.3 Financial Instruments: Recognition, Measurement and Disclosure 571

High
IFRS 4 IFRS 17
Impact high
Economic and financial impacts

IAS 39 Impact medium

IFRS 9
Impact low
Accounting impacts

IAS 36

IAS 12

IAS 38
IFRS 3

IFRS 7
IFRS 8

Low
Low Complexity in the organization High

Fig. 28.1 IAS/IFRS introduction impact framework

The following paragraphs will explain the most influencing principles for the
insurance industry. In Figure 28.1, a qualitative framework for analysing the impact
on an insurance undertaking has been illustrated. The axis of the ordinates considers
the economic impact, while the axis of the abscissas analyses the complexity in the
organization deriving from the introduction of the new principles.
In this chapter, the IAS/IFRS Principles will be described following this order:

• IAS 39 Financial Instruments: Recognition and Measurement.

• IFRS 7 Financial Instruments: Disclosures.
• IFRS 9 Financial Instruments.
• IFRS 4 Measuring an Insurance Contracts.
• IFRS 17 Insurance Contracts.
• IAS 38 Intangible Assets.
• IAS 36 Impairment of Assets.
• IFRS 3 Business Combinations.
• IAS 12 Income Taxes.
• IFRS 8 Operating Segments.

28.3 Financial Instruments: Recognition,

Measurement and Disclosure

In the area of financial instruments, the main changes as compared to local GAAP
(General Accepted Accounting Principles) essentially concern the introduction of
new rules in the matter of financial instruments. These rules concern classification,
and measurement of financial instruments. The path of change has included the
issuance of three standards. In the course of the discussion, accounting standards will
572 28 International Accounting Standards (IAS) and International. . .

be explained following the chronology of their issuance. First, IAS 39 is explained

and which is related to the classification and measurement of financial instruments.
Then IFRS 7 is described, which deals with disclosure of financial instruments.
Lastly, IFRS 9 is explained, which is a current classification of financial instruments
(An evolution from the previous IAS 39) into which financial assets and liabilities
fall, and typically assets to cover technical provisions and the subject matter of
investment, as well as subordinate financial assets among sources of financing and
derivative financial instruments.

28.3.1 IAS 39: Classification of Financial Instruments

IAS 39 aims to classify financial instruments no longer by nature, but rather by

purpose of use. IAS 39 defines the following five classification categories for
financial instruments:

• Derivative financial instruments.

• Financial assets and liabilities Held For Trade (HFT), i.e. “designated by the
undertaking at Fair Value Through the Profit and Loss account” exercising the
so-called. “fair value option”, Fair Value Through Profit and Loss (FVTPL).
• Financial assets Held To Maturity (HTM).
• Loans and Receivables (L&R).
• Financial assets Available For Sale (AFS).

Financial liabilities are also classified at amortized cost (see Table 28.1 for a
schematic representation of the five categories).
Lastly after initial classification, leave to reclassify financial instruments is
foreseen within the limits and at the conditions set by IAS 39 §50 and following
lines. In particular, in cases of transfer of bond securities from class AFS to L&R, the
financial instrument to be reclassified must meet the definition of “loans and
receivables” as at the reclassification date and the undertaking must intend, and be
able, to keep the instrument in its portfolio for the foreseeable future.

Table 28.1 Market Consistent Balance Sheet (MCBS) Valuation

Description Classification Initial
1. Derivative financial instruments Derivatives
2. Financial assets and liabilities held for trading Held For Trading HFT
3. Financial assets and liabilities held to maturity Held to Maturity HTM
4. Loans and credits Loss & Receivable L&R
5. Financial assets available for sale Available For Sale AFS
28.3 Financial Instruments: Recognition, Measurement and Disclosure 573

28.3.2 IAS 39: Measurement of Financial Instruments

Based on the operational choices adopted when classifying, IAS 39 foresees specific
methods of detection and assessment, for which retroactive application is laid down
when converting to IFRS. The method distinguishes between first entry and
subsequent measurement. See below for details of each.
At the time of first entry, every financial asset and liability is to be entered at its
fair value including (for all non FVTPL instruments) any cost differential at acquisi-
tion or issue. The charge in portfolio of the security acquired may be made either in
accordance with the criterion of accounting on the basis of so-called transaction
date (i.e. at the time when the contract or undertaking to acquire is concluded), or in
accordance with the criterion of accounting on the basis of so-called settlement date
(i.e. at the time the transaction is settled). Continuity in applying the criterion
adopted in each of the three categories set out above is required.
For later measurement, IAS 39 §46 foresee determining the amortised cost with the
real interest method for securities classified as HTM, AFS and L&R. This method
foresees capitalising compound interest periodically in respect of the differential (either
plus or minus) between the acquisition price and the reimbursement price at maturity of
the security. IAS 39 additionally foresees that the amortised cost is determined for each
security at the actual time of the acquisition and takes into account, as initial outgo, the
fair value paid, including directly attributable accessory charges.
For securities classified as AFS and FVTPL assessment at fair value determined
in compliance with IFRS 13 is foreseen, and whose variation has been registered as
offsetting item respectively as a net equity provision (hereafter referred also as AFS
provision) within the comprehensive profit and loss account (Other Comprehen-
sive Income-OCI).
At every closing of financial statements and in respect of all financial assets not
classified as FVTPL, whether there is objective evidence that an individual financial
asset or groups of financial assets has suffered impairment must be checked, and in this
case the value of the asset must be reduced by a value equal to the matching loss,
defined as the difference between entry value of the asset and the current value of its
future financial flows. Assessment of the impairment must not be based solely on an
automatic mechanism but must take into account evaluations of a qualitative kind based
on targeted analyses for the individual assets subject to examination (IAS 39, §59).1
In the case of AFS financial instruments, a capital loss of the value initially
applied to net equity is attributed to the profit and loss account (even if the financial
asset has not been sold), for a sum equal to the difference between the acquisition
cost (net of any reimbursement of capital account and amortising) and fair value. If
the fair value of the instrument increases in a later accounting period, and this
increase can be objectively correlated with an event occurring after entry of the
loss in the Profit and Loss account, this pick-up in value must be accounted for in the

1
In any case, a “significant or prolonged” diminishing of fair value of an investment in an
instrument representing capital below its cost represents objective evidence of a reduction in
value (IAS 39, §61).
574 28 International Accounting Standards (IAS) and International. . .

Profit and Loss account (§70) for debt instruments and in net equity for instruments
representing capital (§69).
Later measurement of financial liabilities is performed at amortised cost with the
effective interest method with the exception of the cases foreseen under IAS 39, §47.
Derivative financial instruments must be valued at fair value via the profit and
loss account. Where there is a relationship of hedging meeting specific requirements
in terms of effectiveness of the hedging required under IAS 39, a regime is foreseen
of accounting of coverage called hedge accounting which may be of a fair value type
or cash flow hedge.
Evaluating derivative instruments in accordance with the method called fair
value-hedge accounting, in respect of a relationship of hedging of the value of an
underlying financial instrument, foresees valuation at fair value of the derivative and
allows a correction of fair value of the financial asset or liability that the derivative
itself is hedged by to be rectified, irrespective of any rules of valuing foreseen for the
class this financial asset or liability belongs to (hedging the interest rate risk on
securities as classified HTM is not admitted).
Evaluating derivative instruments in accordance with the method called cash
flow-hedge accounting, for a relationship of hedging the cash flows of an underly-
ing financial instrument, foresees a valuing at fair value of the derivative while
suspending the net equity provision of the capital gain or loss not realised by entering
in the profit and loss account of any plus or minus excess in respect of fair value of
the derivative and the value of the future cash flows relating to interest on the
financial asset (or liability) hedged.

28.3.3 IFRS 7: Financial Instruments: Disclosures

IFRS 7 gives the requirements for disclosure in the matter of financial instruments
with the aim of providing information to users of the financial statements concerning
exposure to risks and the management implemented by an insurance undertaking,
and which allow an assessment to be made of the significance of financial
instruments on financial condition and corporate performance.
When preparing the disclosure required under IFRS 7, an insurance undertaking
is called upon to perform an analysis of corporate information sources in place
(including those within the perimeter of equity invested companies). In addition to
the sources of information deriving from the processes that are proper to the
administration units and financial statements, it is necessary to make reference to
the areas of concern and the wealth of information already available to Management
for appreciating and managing the risks the undertaking is exposed to and which, as
a rule, report to Risk Management, Actuaries and Investment Management.
Disclosure requirements are composed in particular of items on the following
matters:

• Accounting policies (classification criteria, assessment methods, impairment

etc.)—§21–B5.
28.4 IFRS 9: Developing the Standard of Classification and Measuring. . . 575

• Determination of fair value (methods and assumptions, hierarchy of fair

value)—§ 27–27A and B10A–B16.
• Qualitative information (nature of the risks and management processes of
these—§33) and qualitative information (analysis of exposure and accumulation,
variation in the period—§34) for the risks deriving from operations in financial
instruments.
• Liquidity risks (analysis by maturity of financial liabilities).
• Credit risk (exposure, collateral, loss of value, expired and renegotiated payables).
• Market risk (analysis of sensitivity of exposure to the risks applying as at the date
of financial statements in terms of the impacts on the profit and loss account and
equity).

28.4 IFRS 9: Developing the Standard of Classification

and Measuring of Financial Instruments

On 24 July 2014, the IASB issued the definitive version of the IFRS 9 to replace IAS
39. This new standard applies with effect from 1st January 2018, save for options for
deferring for the insurance industry foreseen in the amendments in 2016 to the IFRS
4 (see below § Deferment options).
The standard foresees new classifications and different measurement criteria for
assets and as compared to IAS 39 in respect of financial assets and new criteria for
representing the variation of creditworthiness for financial assets.
In particular, in connection with financial assets, it is made up of three fundamen-
tal pillars:

• Classification and measurement.

• Impairment.
• Hedge accounting.

In the next five paragraphs, each of these topics will be explained in detail.

28.4.1 IFRS 9: Classification and Measurement of Financial Assets

The international accounting standard IFRS 9 foresees new criteria for classifying
and measuring financial assets that are based on types of financial assets (debt or
capital instruments, on the basis of the criteria dictated by IAS 32), the characteristics
of the financial instruments and the business model underpinning management of the
portfolio of financial instruments. See Figure 28.2 for a representation of the new
criteria for classifying and measuring financial assets.
The flow chart in Figure 28.3 synthesizes the drivers used to classify and measure
financial instruments according to IFRS 9.
576 28 International Accounting Standards (IAS) and International. . .

Fig. 28.2 New criteria for IAS 39 IFRS 9

classifying and measuring
financial assets L&R / HTM Bonds
Amortized cost Amortized cost

Bonds
Fair Value
Through OCI
AFS
Fair Value Bonds
Through OCI Fair Value
FVTOCI Through PL

Shares
Fair Value
HFT / Derivatives Through OCI
Fair Value Shares/Derivatives
Through PL Fair Value
FVTPL Through PL

DEBT DERIVATIVES CAPITAL

INSTRUMENTS

NO YES Held for trading

Pass “SPPI” test?
HFT
YES

“Business Model” test (aggregate level) NO

1 Hold to 2 Hold to 3 Neither

collect (HTC) collect and 1 nor 2
sell (HTCS)

YES NO Fair Value Option

Adopting Fair Value Option?
through OCI?

NO NO YES

Amortized
FVTOCI FVTPL FVTOCI
Cost

Fig. 28.3 Drivers used to classify and measure financial instruments

28.4.2 IFRS 9: Classification and Measurement of Debt Instruments.

Test of the Characteristics of the Instrument and Business
Model

Among financial assets, debt instruments may, on the basis of the conditions
illustrated below, be classified under the following categories:
28.4 IFRS 9: Developing the Standard of Classification and Measuring. . . 577

• Amortised cost, with a valuation at cost and accounting in the profit and loss
account of interest earned, devaluations for impairment and profits and losses
from realisation.
• At fair value through Other comprehensive income (OCI), with detection of the
capital gains or losses in valuation with offsetting items in an equity provision,
and accounting in the profit and loss account of interest earned, devaluations for
impairment, profits and losses from realisation; this class differs from the IAS
39 category of financial assets that are “available for sale (AFS)” in that this is not
a residual category but a category that requires abidance by specific conditions.
• At fair value through the profit and loss account, with accounting in the profit and
loss account of all items of income.
• The fair value option can be exercised only if it aims to mitigate accounting
asymmetries.

For selecting the accounting category and related assessment criteria applicable to
a debt instrument, IFRS 9 § 4.1 requires a new check. This check has to be made both
of the characteristics of the instrument, called Solely Payment of Principal and
Interest (SPPI test), and the aims of the management of the portfolio of investments
of the insurance undertaking that the instrument is part of, (called a business model
test).2
For classifying at amortised cost or fair value through net equity, called fair value
through the statement of other comprehensive income (fvtoci), the contract
conditions of a debt instrument must foresee generating cash flows at a pre-set
date that are solely payment of principal and interest on residual principal, (called
Solely Payment of Principal and Interest SPPI). In this case, interest must represent
solely the consideration for the passing of time, the credit risk and other risks and
essential costs associated with credit business, (called basic lending risk and costs).
So, when first applying, each financial instrument must undergo a qualitative–
quantitative check, which aims to identify covenants that can influence typical
basic lending agreement characteristics by modifying the timing or sums of contract
cash flows, so altering their relationship with the mere financial value over time and
with a credit risk, such as, for example exposure to equity risk or a commodity price.
Analysis of the model and purposes of portfolio management aim to identify the
following business models (that match the classification categories mentioned
above):

• Hold to collect (HTC), which is aimed at collecting the cash flows from financial
assets and leads to classifying an amortised cost all instruments that pass the
SPPI test.
• Hold to collect and sell (HTCS), is aimed either to collect the cash flows of
financial assets or the sale of financial assets, and leads to classifying at fair value

2
See IFRS 9 § B4.1 for guidelines and examples given in the standard in the matter of SPPI (§
B4.1.7–26) and business model (§ B4.1.1–6) tests.
578 28 International Accounting Standards (IAS) and International. . .

through other comprehensive income (OCI) of all instruments that pass the
SPPI test.
• Other business models, for example financial instruments Held For Trading
(HFT), instruments managed on the basis fair value (and performance assessed
on this basis) and instruments that have failed the SPPI test.

In the Hold to collect (HTC) business model, sales transactions must be residual
and may be deemed consistent with the model if they fall into four phases:

• Frequent but not significant.

• Infrequent even if significant.
• Realised for an increase in the credit risk of the instrument.
• Performed close to maturity, or to meet extreme situations of liquidity stress.

In meeting the standard an undertaking is thus called upon to make operational

choices concerning a definition of the thresholds of increase in credit risk and
frequency and significance of sales, that is put into an explicit and formalised
accounting policy.
In the Hold to Collect and Sell (HTCS) model, sales are to be consistent with the
model and can be dealt with in ordinary liquidity management, maintenance of a
target return on the portfolio, and effective portfolio management with sales made to
seize favourable trends in the marketplace.

28.4.3 IFRS 9: Classification and Measurement of Derivatives

and Capital Instruments at Fair Value

On the basis of IFRS 9, derivative financial instruments and capital instruments are
usually assessed at a fair value via the profit and loss account. Concerning capital
instruments that are not held for trading, the standard allows exercise (in an irrevo-
cable fashion) of an option at the time of acquiring the instrument (i.e. first applica-
tion) to assess at fair value via Other comprehensive income (OCI), detecting capital
gains and losses by assessment in a net equity provision: however, in this case, no
subsequent result (profit or loss) realised following the disposal of the instrument
may pass through the profit and loss account.

28.4.4 IFRS 9: Classification and Measurement of Financial Liabilities

The rules for classifying and measuring financial liabilities dictated by IFRS 9 essen-
tially leave the provisions of IAS 39 unaltered, confining themselves to introducing
changes in applying the fair value option to take into account the credit risk of the
issuer. The measurement takes place at amortised cost save for cases where financial
liabilities are held for trading (derivatives included) and in cases of exercise of the
fair value option.
28.4 IFRS 9: Developing the Standard of Classification and Measuring. . . 579

YES
Hold For Trading / Derivatives

NO
Variation
OCI*
in the credit risk
Adopting Fair Value Option? YES
(in accordance with IAS39)
Other variations
P&L
NO in the fair value

Embedded derivatives YES

Split of embedded derivatives
are included?

NO

Amortized Debt instrument Derivatives

Cost “Host” embedded

Fair Value Through P&L

(FVTPL)

(*) No turn in the P& P&L mandatory disclosure except for specific exceptions

Fig. 28.4 Drivers used to classify and measure financial liabilities

The flow chart in Figure 28.4 synthesizes the drivers used to classify and measure
financial liabilities.
If the fair value option for financial liabilities is adopted (§5.7.7):

• Variation in fair value of financial liabilities attributable to a variation in the credit

risk of the issuer must be detected in other comprehensive income (Other
Comprehensive Income OCI) unless this treatment generates or increases
accounting asymmetries in the profit and loss account.3
• Recycling in the profit and loss account of variations recorded in comprehensive
profit is not allowed.
• The remaining part of the variation in fair value must be detected in the profit and
loss account.

28.4.5 IFRS 9: Impairment

The new impairment model of financial instruments sets out a new perimeter of
application including off-balance sheet items and applies to the following financial
assets:

3
Should, for example the liability subject of the fair value option be tied economically to another
financial instrument whose variation in fair value is in its turn detected in the P&L No contractual
link is required.
580 28 International Accounting Standards (IAS) and International. . .

• Debt instruments entered at amortised cost or at fair value via (FVTOCI).

• Receivables for leasing contracts (IAS 17).
• Irrevocable undertakings to pay out funds (i.e. margins on lines of credit).
• Guarantees issued (i.e. sureties).

The model is based on a principle of the concept called forward-looking

expected loss, which requires a provision prior to evidence of default arising, and
so is in contrast to incurred loss as per IAS 39.
The change in paradigm was called for especially by the financial crisis of 2007
which showed that impairment was not actually detected on the basis of IAS
39 prior to default. This limit led the IASB to introduce a criterion for detecting
the expected loss as soon as the financial instruments were initially detected and
updating the measurement at each assessment date based on variations underlying
credit risk. Measurement of the expected loss based on reasonable and supportable
information (which is available without undue charge or effort, taking into account
the characteristics of the undertaking and the context it operates in) and that includes
historical, present and future (called forward looking) information.
The model foresees categorising financial instruments in three stages (or buckets).
Each bucket matches with a different manner of measurement of corrections based
on the expected loss:

• Stage 1, includes instruments issued or acquired that have not recorded a signifi-
cant increase in credit risk as compared to the initial detection; expected loss is
measured on the basis of default events that may occur in the 12 months
subsequent to the valuation date.
• Stage 2, takes in instruments that display a significant increase in credit risk as
compared to the initial detection date; expected loss is measured based on the
expected loss deriving from default events that may occur over the entire life of
the instrument.4
• Stage 3, takes in instruments in respect of which increases in credit risk are such
that the credit is considered impaired: default events evidencing deterioration are
current and observable, with adverse impacts on future financial flows being
forecast for financial assets; the loss is measured on the basis of discounted
cash flows at the effective rate of interest of the loan.

An essential element of the so-called staging allocation for financial assets is an

appreciation of a “significant increase in credit risk” as compared to the date of initial
detection, which must be carried out by individual financial instrument so as to

4
IFRS 9 introduces a presumption of significant increase in credit risk after 30 days of overrun,
which may be overcome by specific analyses carried out on the portfolio of financial assets that
taking into account the de facto circumstances and the context in which the enterprise operates,
plausibly indicate a different threshold to be adopted.
28.4 IFRS 9: Developing the Standard of Classification and Measuring. . . 581

enhance disclosure in financial statements while focusing on the performance of the

financial instruments instead of their offsetting item.5

28.4.6 IFRS 9: Hedge Accounting

The introduction of IFRS 9 has not led to significant changes being made to the
fundamentals of accounting hedging through derivative financial instruments called
hedge accounting. The regime remains optional, and the mechanics of accounting
for fair value hedging and cash flow hedging foreseen under IAS 39 and already
illustrated above have not been modified. However a widening of the area of
application of the method to non-financial risks has taken place.
Among the main changes, we can mention broader disclosure requirements and
new rules for verifying the effectiveness of hedging where the quantitative range of
80–125% foreseen under IAS 39 has been replaced by a check to be made on the
objectives of the hedging focusing on the economic relationship applying between
the derivative financial instrument and the underlying asset and the effect that credit
risk has on this economic relationship. This latest development needs to be viewed
from the standpoint of greater alignment with risk management policies of the
undertaking and being possible to support the hedge accounting policy with infor-
mation produced internally in the risk management strategy area.

28.4.7 Deferment Option for Applying IFRS 9 to the Insurance

Industry

The first application made of IFRS 9 precedes that of the new standard to insurance
contacts, IFRS 17, which came into force in January 2023, and for an insurance
undertaking this leads to additional accounting asymmetries, for example in
connection with:

• Changes in the classification made to financial instruments and relative methods

(timings) of detection of pluses (minuses) from assessment and realisation in the
profit and loss account.
• Impacts in the profit and loss account deriving from applying the expected credit
loss impairment model.

In order to mitigate the foregoing temporary consequences of deferred application

of the two standards, the IASB has introduced changes to IFRS 4, the current
international accounting standard for measuring insurance contracts by proposing
two alternative approaches to allow undertakings issuing contracts falling within the

5
See IFRS 9 BC 5.167.
582 28 International Accounting Standards (IAS) and International. . .

scope of this standard to mitigate certain effects deriving from applying IFRS 9 prior
to applying the IFRS 17 standard to insurance contracts.

• Deferral approach means a temporary exemption of IFRS 9 up until the date of

coming into force of the IFRS 17 standard to insurance contracts, which is
available only to undertakings where issuing of contracts falling within the area
of application of IFRS 4 predominates.
• Overlay approach means adopting IFRS 9; however, for specific financial
assets, removal is permitted from the profit and loss account of part of the effects
of the accounting asymmetries that might come to light prior to the new standard
to insurance contracts being applied6—the possibility of using shadow account-
ing remains.

28.5 IFRS 4: Insurance Contracts: Classification, Measurement

and Disclosure

Recognising the extremely complex nature of the insurance business and the absence
of a framework of accounting standards that were sufficiently mature in the matter
the IASB decided to move forward in two stages in applying IAS/IFRS standards
concerning the definition of insurance contracts.
In the insurance industry, stage I, with starting date 1st January 2005, introduced
IFRS 4 as a transitional standard pending the development of a framework of
measurement for insurance contracts, which was put back to the next one entry
into force of IFRS 17 (starting from 1 January 2023).
IFRS 4 has governed the measurement criteria for insurance contracts and relative
technical components: This standard has required a process of classification of
contracts and then has dictated rules of measurement for contrasts falling within its
area of application.

28.5.1 IFRS 4: Classification of Products and Area of Application

On the basis of IFRS 4 §2, the standard must be applied to:

• All insurance and reinsurance contracts (save for the exceptions foreseen under
§4).
• Investment contracts containing an element of discretionary equity interest.

6
An undertaking that adopts the overlay approach must show a specific item in the profit and loss
account and the comprehensive profit and loss account with the value of the adjustment made to
apply this option and provide disclosure concerning the type of loading to financial assets in respect
of which the approach in question applies.
28.5 IFRS 4: Insurance Contracts: Classification, Measurement and Disclosure 583

A crucial step of the standard is a classification of the “contracts” issued by an

insurance undertaking in order to distinguish between contracts of insurance and
contracts of investment. It turns on the definition of an insurance contract.
... An insurance contract is defined as a contract under which one of the parties
(the insurer) accepts a significant insurance risk from another party (the policy-
holder) by agreeing to compensate the policyholder if a specified uncertain future
event (the insured event) adversely affects the policyholder (the insured claim).7 etc.
The insurance risk, defined as being other than financial risk (IFRS 4—Appendix
A), rests upon the following fundamental elements8:

• Adverse effect for the assured.

• Uncertainty as to whether and when this effect will arise in the future, or
uncertainty as to its quantification.9

An insurance contract must lead to the taking on of a significant insurance risk

that in the absence of quantitative indications from IFRS 4, is to be identified by an
approach of a qualitative kind supported by analyses of net cash flows deriving from
the contract interpreted on the basis of cash flows payable if the loss event does or
does not occur. In particular, the accounting principle states10:
“an insurance risk is significant if, and only if, an insured event might induce the
insurer to pay additional meaningful economic benefits in any circumstance, exclud-
ing circumstances without commercial substance (i.e., that have no identifiable effect
of the economic aspects of the transaction).”
IFRS 4 § 4 foresees specific exclusions in the area of application of the standard in
connection with the following types of contract (which may meet the definition of
insurance contract):

• Guarantees on products issued by the producer or commercial intermediary.

• Rights and obligations deriving from the future use of goods.
• Assets and liabilities originating in employee benefit plans.
• Contracts of credit guarantee.
• Receivables or payables deriving from extraordinary transactions.
• A direct insurance contract from the standpoint of the assured.

For the purposes of identifying investment contracts containing an element of

discretionary participation, IFRS 4 defines the notion of discretionary

7
See the definition IFRS 4.
8
See the definition IFRS 4—Appendix A.
9
For example, neither surrender risk nor persistence (early or postponed resolution of the contract)
nor the risk of cost (unexpected increase in contract management administration costs) are deemed
insurance risks.
10
See the definition IFRS 4—Appendix B.
584 28 International Accounting Standards (IAS) and International. . .

participation as a right of the assured to receive performances additional to

guaranteed benefits:

• Which will probably be a significant proportion of the aggregate performance of

the contract.
• Whose sum or timing is contractually subject to the discretion of the issuer.
• That are contractually based:
1. On the performance of specific contracts.
2. On the gains (losses) realised or not realised of a specific pool of assets held by
the issuer.
3. On the economic results of the issuer.

28.5.2 IFRS 4: Separation of Components (the Unbundling)

In most insurance contracts, components of deposit, either implicit or explicit, are

included as they are a part of the very structure of these contracts and are defined as
“non-derived contract components, which, if taken separately, would be included in
the area of IAS 39”. The need to separate these components (called unbundling),
aimed at applying accounting criteria that are consistent with respect to the treatment
foreseen for the stand-alone components, goes against the potentially close relation-
ship applying between the value of the various components making up a contract that
is managed in a unitary fashion, and any separating out of these various components
that are found together in an insurance contract and has consequences, both in terms
of measurement and of presenting in financial statements of the relative worth and
economic amounts (e.g. treatment of the financial component in an insurance
contract alongside a non-insurance financial contract, drawn into to the measurement
and presentation governance foreseen under IAS 39).

28.5.3 IFRS 4: Liability Adequacy Test and Shadow Accounting

The Liability Adequacy Test (LAT) foreseen under IFRS 4 consists of a check
made of the safeguarding of adequacy to meet insurance liabilities. The LAT
requires recording in the profit and loss account of any unfavourable difference
found between the value of the provisions entered (net of related intangible items)
and a forecast being made of future differential cash flows in respect of other contract
undertakings (IFRS 4 §15).
With the introduction of principle IFRS 17, the compliances tied to LAT have
been surpassed. Under principle IFRS 17, liabilities can be valued following the
Building Block Approach (BBA) or the Premium Allocation Approach (PAA).
Where the group of contracts is found to be loss-making as at the date of valuation,
a so-called Loss Component is recognised in the Revenue Account. In subsequent
paragraphs BBA and PAA will be explained.
28.6 IRFS 17: Development of the Principle of Measurement of Insurance Contracts 585

Shadow accounting foreseen under IFRS 4 is an optional accounting criterion

aimed at mitigating any accounting mismatch generated by recognising in net equity,
Other comprehensive income (OCI) or profit and loss account of capital gains and
losses in assessing financial instruments, respectively, classified as AFS or HFT that
do not have a bearing on measurement of related insurance liabilities (IFRS 4 §30).
With the introduction of principle IFRS 17, compliances tied to Shadow Account-
ing have been surpassed as the valuation of assets and liabilities must be market
consistent. Consistency is required, in so far as this is possible, with what can be seen
in the marketplace. If market variables are seen to occur current market values ought
to be considered.

28.6 IRFS 17: Development of the Principle of Measurement

of Insurance Contracts

After a long series of discussions with the anglo-saxon and european insurance
industry and other stakeholders, in May 2017, the IASB issued new accounting
standard IFRS 17 for measurement of insurance contracts bringing the process set in
motion at the beginning of the 2000s mentioned above to a conclusion.
This standard, while not innovating the classification of products set out above,
changed the pre-existing paradigm of measurement, taken from domestic accounting
standards, substantially, and this will require significant changes to be made by
insurance undertakings in organisation, procedures, accounting and disclosure. The
new standard came into force with effect from 1st January 2023 after allowing the
industry to have a period to make the upgrade it has foreseen a number of
simplifications concerning the duty of retroactivity in retroactive measuring during
the transitory period.
Concerning the definition of contract of insurance, since 1 January 2023 insur-
ance undertakings have applied principle IFRS 17 to all insurance and reinsurance
contracts in their portfolios The definition of a contract of insurance remains the
same as under the previous principle IFRS 4. IFRS 17 foresees in respect of a
contract of insurance that one of the parties accept a significant insurance risk from
another and agrees to restore the assured in the event that a specific future uncertain
event strikes in a damaging manner.11

28.6.1 The General Model: Building Block Approach

The so-called Building Block Approach (BBA) is the model introduced by the
principle as the main measurement model of an insurance contract. This approach
foresees that an obligation originating in an insurance contract is entered as a liability
in financial statements as being made up of the following three parameters:

11
See IFRS 17. Appendix A contract is deemed such only if it transfers a significant insurance risk.
586 28 International Accounting Standards (IAS) and International. . .

1) a forecast of future cash flows under the insurance contract, Present Value of
Fullfillment Cash-Flows (PVFCF):

– current, i.e. one that must reflect all information available, updated as at the date
of valuation
– based on expected values of flows (income and outflow) weighted by likelihood
of occurrence
– adjusted at current rates detected as at the valuation date, with an option to detect
in the comprehensive profit and loss account the difference between the rate at
issue of the contract, called locked-in, and the updated rate current as at the
valuation date

2) The application of an explicit Risk Adjustment (RA), this is an expression of

the remuneration that the undertaking requires in order to bear the uncertainty
attributable to the sums and timings of forecast cash flows. The algebraic sum of
these two items, current value of cash flows and Risk Adjustment makes up the
so-called fulfilment cash flow.
3) Detection of the comprehensive margin of the contract has to be determined
initially as at the issue date. This is called Contractual Service Margin (CSM) and is
calculated between liabilities at the time of underwriting, if positive (vice versa any
loss when underwriting the contract goes straight to the profit and loss account).12
Detection of this margin in the profit and loss account over the course of time is
performed with a systematic criterion that takes the release of risk into account.
Additionally, the above liabilities pick up variations in current forecasts of future
cash flows and a risk adjustment, updated as at every valuation date, so mitigating, as
long as it is positive and sufficient, any volatility in the profit and loss account
brought about by these variations (the so-called shock absorber effect of the contrac-
tual service margin).
See Figure 28.5 for a representation of the main items of insurance liabilities.
IFRS 17 foresees two distinct valuations for insurance liabilities based on when
the event insured occurs.

• Liability for remaining coverage (LRC) which quantifies an obligation of an

insurer to provide cover for insured events that have not yet occurred.
• Liability for incurred claims (LIC) i.e. which quantifies the obligation of an
insurer to indemnify events that have already happened (incurred losses). In
addition to the Building Block Approach (BBA) illustrated above, there are two
other approaches to valuing insurance liabilities.

12
The contractual service margin represents the expected profitability of the contract, measured as
the sum of the value of the same sum and opposite sign of the fulfilment cash flows and made up of
these cash flows discounted plus the risk adjustment.
28.6 IRFS 17: Development of the Principle of Measurement of Insurance Contracts 587

Fig. 28.5 Representation of IFRS 17 – Balance Sheet

insurance liabilities
Assets Liabilities

Firm’s funds
Equity

Contractual
Service
Margin
(CSM)

Assets

Technical provisions
Risk
Adjustment
(RA)

Present Value
Future Cash
Flows
(PVFCF)

• Variable fee approach (VFA): a variation of the BBA that applies in accounting
for direct sharing in Life business to take into account commissions for managing
the underlying assets paid to the insurance undertaking.
• Premium allocation approach (PAA): an alternative and simplified method as
compared to BBA and applicable to all contracts with a period of cover of the
premium of less than or equal to 12 months.

It is to be noted that the BBA approach is also defined as the general model (GM)
as it is the model taken as a starting point. As explained at the beginning of the
paragraph, this model is based on current value, actualised, weighted and corrected,
for a risk factor, risk adjustment (RA) of cash flows tied to a contract of insurance,
and foresees suspending the expected profit, the contract service margin (CSM), at
the time the contract is underwritten.
To allow for a better understanding, a comparison is shown here between the
building block structure of Solvency II and that for IFRS 17. These approaches are
similar, but display differences tied to measuring the Present Value of Fulfilment
Cash-Flows (PVFCF) as compared to Solvency II and determined by the Best
588 28 International Accounting Standards (IAS) and International. . .

Solvency II – Balance Sheet IFRS 17 – Balance Sheet

Assets Liabilities Assets Liabilities

Own Funds
Equity
Equity

Own Funds
Reserve for
reconciliation
(including
Present Value Contractual
Future Profit Service
(PVFP)
Margin
(CSM)

Risk Margin
Assets (RM) Assets

Technical provisions
Risk
Technical provisions

Adjustment
(RA)

Best Estimate
Liabilities Present Value
(BEL) Future Cash
Flows
(PVFCF)

Fig. 28.6 Comparison between liabilities under Solvency II and IFRS 17

Estimate of Liabilities (BEL) method.13 Additionally, the nature of the contractual

service margin (CSM) is different from PVFP. This is because the CSM is a liability
determined by applying defined rules for release and measurements are performed at
dates later than that of underwriting. See Figure 28.6 for a graphic representation of
the comparison between the structures of liabilities.

28.6.2 IFRS 17: The Revenue Account and Accounting Models for
Non-life Business

In this paragraph the two key aspects in applying IFRS 17 to non-life contracts are
illustrated:

1. the revenue account representation;

2. the building block approach (BBA) model and its simplified variant for valuing
contracts

13
It should be noted especially that the hypotheses for discount vary.
28.6 IRFS 17: Development of the Principle of Measurement of Insurance Contracts 589

Table 28.2 Comparison between a non-life profit and loss account under IFRS 4 and
IFRS 17

Non-life p/l account IFRS 4 Non-life p/l account IFRS 17

In the subsequent treatment, each of these two topics is explained with related
examples.
Concerning the instructions issued for preparing the insurance revenue account
for non-life business according to the IFRS 17 model, the new outline foresees a
representation in which premiums disappear and a concept of revenue deriving from
insurance services is introduced. See Table 28.2 for a comparison between the
traditional outline and the new outline introduced by IFRS 17.
To summarise, following the introduction of the principle IFRS 17, the main
impacts concern the following aspects:

• Disappearance from the e revenue account of insurance premiums which will be

replaced by a new definition of revenues.
• Amortising of the contractual service margin (CSM) for services provided during
the period.
• Amortising of the Risk Adjustment (RA) in the
• charging the sum of insurance expenses that it is foreseen will be borne in the
period (net of expenses for managing investments14). An Experience Adjustment
concerns both the costs for loss events and expenses for managing and amount to
the difference applying between actual flows and those expected in respect of the
insurance component.

Consistently with what is set out above, accounting models applied to determine
the value of contracts are the two following:

14
Net of the investment component means net of the so-called Investment Management Expenses
(IME) which are the costs of management that an insurance undertaking bears in investing technical
liabilities.
590 28 International Accounting Standards (IAS) and International. . .

Table 28.3 Comparison between accounting methods for loss reserves

Type of reserve General model (GM) Premium allocation approach (PPA)
Premium + Contractual service + Reserve by fraction of premium (net of
reserve margin (CSM) acquisition costs)
+ Risk adjustment (RA)
+ PVFCF
Loss reserves + Risk adjustment (RA) + Risk adjustment (RA)
+ PVFCF + PVFCF

• The general model (GM) which is used for multi-year contracts and allows the
insurance margin that is determined at the time of issue of a generation of
contracts to be measured.
• The premium allocation approach (PAA) which is used for annual contracts
with a period of cover less than or equal to 12 months. The premium allocation
approach (PAA) is a facultative and simplified accounting model as compared to
the general model (GM) and represents a good enough approximation to it.

In detail, the premium allocation approach (PAA) allows calculation of the

premium and loss technical reserves to be simplified. In Table 28.3 a comparison
is shown between the two accounting models for valuing the relative reserves.
In respect of the premium reserve, the PAA allows for a simplified approach.
However, in cases where circumstances arise for which a group of insurance
contracts is found to be burdensome, it is not possible to use the PAA accounting
method. In this case, an insurance undertaking must immediately recognise the
minus value in the revenue account, applying the general model (GM).
In respect of the loss reserve, the model of the general model (GM) and the PAA
model take the same approach. The value of reserves amounts to the Risk Adjust-
ment (RA) + Present Value of Fulfilment Cash Flows (PVFCF).

28.6.3 IFRS 17: The Revenue Account and Accounting Models for
Life Business

In this paragraph the three key aspects: of applying IFRS 17 to life contracts are
illustrated

1. calculations and dynamic of the contractual service margin (CSM)

2. the building block approach (BBA) and its variants for valuing contracts
3. the representation in the revenue account.

Continuing, each of these three topics is treated with relative examples.

In order to understand the dynamic of the contractual service margin (CSM) for
contacts in life business, two situations of initial measurement are illustrated. The
simulation shows two opposing situations. The first dynamic describes the valuing
28.6 IRFS 17: Development of the Principle of Measurement of Insurance Contracts 591

Profitable 70
insurance - - = CSM = 20
100 10
contracts 20

Expected present Expected present Risk Present

value of cash value of cash Adjustment value of
inflows outflows overall cash
flows

Unprofitable 110
insurance - - = CSM = 0
100
contracts
- 20
- 10

Expected present Expected present Risk Present

value of cash value of cash Adjustment value of
inflows outflows overall cash
flows

Fig. 28.7 Determination of the CSM for policies in life business

of a profitable insurance contract. The second illustrates valuation of loss making

insurance contract.
When initially measured, the CSM for a profitable contract foresees the profit
being deferred over the entire duration of cover. In cases of loss on the other hand,
this needs to be recognised immediately in the revenue account. It is to be noted that
in the latter case, aggregated net cash flows will be minus. In Figure 28.7 both cases
are shown: profitable contracts and unprofitable contracts.
Observing Figure 28.7, a number of indications concerning initial measurement
techniques for the value of the CSM can be provided. In the case of profitable
contracts, the plus value of aggregate cash flows is the same as the CSM. In this
sense, no earnings are foreseen at the time of underwriting. In the cases of loss
making contracts, the value of aggregate cash flows is minus and a loss component in
the revenue account is recorded. The value of the CSM amounts to zero (a negative
value cannot be indicated).
For the accounting models for valuing life business contracts, two methods are
foreseen, the general model (GM) and the variable fee approach (VFA). The latter
applies to accounting for contracts with re-valuable performances based on sharing
in profits. The VFA is a variant of the GM and is applied to take into account
commissions for managing assets (management fees) paid to the insurance under-
taking. In Table 28.4 a comparison between the two approaches is shown. In the
outline the two different types of insurance product (pure risk and products tied to
investments) are displayed.
As can be seen, at the time of initial measurement, the CSM is applied to both
products using the same hypotheses (both for financial and non-financial variables).
At the time subsequent measurement is made, non-financial variables (surrender
hypothesis, mortality, longevity, . . .) are updated to the day for both types of
592 28 International Accounting Standards (IAS) and International. . .

Table 28.4 Comparison between accounting methods for life products

General model (GM) Variable fee approach (VFA)
Type of product Pure risk product Traditional products(Separate
management and multi-branch)
and unit linked stand-alone
Initial CSM. The valuation takes in non-financial and financial variables defined at
measurement— the time of underwriting
at time of
underwriting
Subsequent Updates as at the date of valuation
measurement
(non-financial
variables)
Subsequent Interest on CSM calculated on the Interest on CSM calculated on the
measurement basis of market rates detected at initial basis of up-to-date market rates
(financial measurement (locked in rates) (current rates)
variables)

product. However, financial variables are valued differently depending on the type of
product. In cases of pure risk products, interest on the CSM is kept to a basis of
market rates detected at the time of initial measurement (locked-in rates), whereas, in
the case of traditional products tied to investments (separate management, multi-
branch, unit-linked stand-alone) interest on the CSM is updated on the basis market
rates detected at the time (current rates).
Concerning the new outline of revenue account for life contracts, it can be seen
that premiums are replaced by a new definition of insurance revenues. In Table 28.5
an example is shown of a life contract with profits (VFA model).
In detail, the differences as compared to the IFRS 4 revenue account can be
analysed. The first magnitude that stands out for the reader is the absence of
premiums. Premiums are no longer accounted for in the revenue account. In their
place, three new variables are valued:

1. the release of the contractual service margin (CSM.) for service provided in the
period. This magnitude represents the economic value of insurance contracts. The
relative value is released to the revenue account over the entire period of cover on
the basis of services rendered, whereas any economic losses are accounted for
immediately at the time of valuation
2. the sum of payments and expenses for expected claims in the period (excluding
IME i.e. costs of investment management):
3. release of the Risk Adjustment.

Special attention must be paid to variables that can have a bearing on the
economic result of the insurance undertaking. Among the most important variables
the following deserve mentioning:
28.7 Other International Accounting Standards of Significance for the. . . 593

Table 28.5 Example of IFRS 17 revenue account for a life product

Revenue account item Year 1 Note
Release of CSM 405.0 According to a plan of amortising on the basis of service
provided (coverage unit)
Claims and expected 65.0
costs in period (A)
Release of Risk 25.0 In line with hypotheses of release of risk
Adjustment
Revenue from 495.0
insurance contracts
Claims and expected -78.0 (B) + (A) = based on the experience of the product. The
costs in period (B) difference (-13) between actual cash flows (-78) and
those expected (65) relative to the insurance component of
the contract.
Result of insurance 417.0
business
Income from 2,000.0
investments
Interest of technical 2,000.0
reserves
Financial result 0.0 Result equal to 0. In life products with a VFA model,
financial revenues are allocated to the CSM
Profit or loss for the 417.0
period

• Any mismatch there may be between financial economic variables (rates, ...) are
reflected in a variation in the contractual service margin (CSM), in the case of a
variable fee approach (VFA) model, or in the aggregate revenue account in the
case of the general model (GM);
• Variations between forecast cash flows and those achieved (for example, the
actual value of claims and costs actually incurred in the period);
• The financial result does not determine any impact in the revenue account in cases
of life contracts valued according to a variable fee approach (VFA) as financial
revenue is allocated directly at the time the CSM is valued.

28.7 Other International Accounting Standards of Significance

for the Insurance Industry

Within the the international accounting standards, here below (without any pretence
of being exhaustive) some mention is made of elements felt to be essential of
standards IAS/IFRS that, in addition to the those illustrated above on financial
instruments and insurance contracts, are of special significance for the insurance
industry.
594 28 International Accounting Standards (IAS) and International. . .

28.7.1 IAS 38: Intangible Assets

IAS 38 applies to all intangible assets included within the area of application of the
insurance undertaking, subject to specific exclusion of the following specific intan-
gible assets deriving from:

• Deferred taxes (IAS 12).

• Employee benefits (IAS 19).
• Goodwill acquired in a business combination transaction (IFRS 3).
• Insurance contracts (IFRS 4 and IFRS 17).
• Assets intended to be disposed of (IFRS 5).

An intangible asset is an asset that, in general, to be such consists of a resource

(IAS 38 §8):

• Controlled by an undertaking resulting from past events.

• From which future economic benefits will flow to the undertaking itself.

An intangible asset sets itself apart from goodwill if it can be individually

identified since (a) it is potentially separable from the undertaking and is autono-
mously transferable or (b) it originates in contract or legal rights (IAS 38 §12). It may
be entered in financial statements if and only if (IAS 38 §22):

• It is probable that the undertaking will benefit from expected future benefits
attributable to the asset.
• Its cost can be reliably measured.

To assess the meeting of these requirements in connection with intangible assets

generated internally by the undertaking, the generation process is to be split into a
research phase and a development phase. Costs incurred for activities during the
research phase of an internal project are to be entered into the profit and loss account.
In cases of costs incurred in the development phase, these may be capitalised if the
undertaking is able to demonstrate that all the following circumstances apply:

• The technical feasibility of completing intangible assets for subsequent use or sale.
• The intention of pursuing completion and chance of subsequent use or sale.
• The future utility of the intangible asset.

28.7.2 IAS 36: Impairment of Assets

IAS 36 requires an analysis being made of possible losses of value (called an

“impairment test”) for all intangible assets included within its area of application,
subject to specifically excluding the following specific intangible assets
deriving from:
28.7 Other International Accounting Standards of Significance for the. . . 595

• Deferred taxes (IAS 12).

• Employee benefits (IAS 19).
• Financial instruments (IAS 39 and IFRS 9).
• Insurance contracts (IFRS 4 and IFRS 17).
• Assets intended to be disposed of (IFRS 5).

There is an impairment loss when the charging value of an asset or a Cash

Generating Unit (CGU) exceeds its recoverable value.
The recoverable value of an asset or a CGU is either the fair value net of sales
costs or the value in use (IAS 36 §6) whichever is the greater.
If there is an indication of a loss of value, the recoverable value must be estimated
for each individual asset or, if this is not practicable, the CGU to which the asset
belongs (IAS 36 §66).
A CGU is the smallest group of assets that is able to generate incoming cash flow
that is largely independent from that of other assets or groups of assets (IAS 36 §6) to
which an asset or goodwill can be allocated.
The perimeter of a unit:

a) Must represent The lowest level at which monitored by management in consis-

tency with the strategic vision of the business that directors have.
b) Must not be larger than the operating segment defined by IFRS 8.5 (IAS 36 §80).

The accounting value of the CGU must be identified consistently with financial
flows for the recoverable value estimate (IAS 36 §75).
In particular, goodwill entered following a transaction of business combination
(merger or acquisition) must be allocated to each CGU that it is expected will benefit
from the synergies achieved via the transaction (IAS 36.80); disclosure in financial
statements must specify the charging values allocated and illustrate how this is
proceeded to (IAS 36 §134 (a), (b)).
The recoverable value may be determined through:

• The fair value model net of sales costs, determined in accordance with a precise
hierarchy of sources:
– A binding agreement net of costs, if of any (IAS 36, §25).
– A price formed in an active marketplace, net of sales costs, or for the most
recent transaction available in the same sector (IAS 36, §26).
– The best information available for reflecting the amount that the entity might
obtain from disposing of the asset. Note that the generally accepted appraisal
techniques vary in line with the business and practice (in continuous develop-
ment). They may include the use of stock exchange ratios (i.e. price to earnings
basis, price to book, price to NAC and price to EV).
• An in-use value model, which foresees forecasting expected cash flows (IAS
36 §33) grounded in:
596 28 International Accounting Standards (IAS) and International. . .

– Best estimates of management throughout the useful life of the CGU.

– On the basis of financial plans approved by management and/or that are in any
case consistent with the industrial plan, including differential attributable costs
and excluding savings for expected improvement in performance; the
timeframe of the plan may go beyond 5 years if management is able to be
demonstrated this is reliable (IAS 36 §35).
– A forecast of the terminal value beyond the timeframe set out, on the basis of
one of the following four alternatives:
a) Stable or decreasing rate (unless shown to the contrary) and consistent
with rates observed over the long term for the market of reference.
b) The latest flow of the plan or a normalised flow.
c) The best estimate of economic conditions expected beyond the lifetime
of the good.
d) Of other valuation methods: perpetual rents, temporary, assignment
value, corroborated by sensitivity analyses.

28.7.3 IFRS 3: Business Combination

IFRS 3 foresees business combination transactions, i.e. transactions where an

acquirer obtains control of one or more corporate assets (IFRS 3 §B5–B12) being
accounted for according to the acquisition method (IFRS 3 §$) which in its turn
requires:

• The acquirer being identified (IFRS 3 §6).

• The acquisition date being determined (IFRS 3, §8).
• Detection and valuation of the assets that can be identified as acquired, liabilities
taken on and minority equity interests acquired (IFRS 3 §10).
• Detection and valuation of goodwill or alternatively profit for acquisition at
favourable pricing (IFRS 3, §32 and following lines).

In particular, detection and valuation of assets and liabilities that can be identified
as at the date of acquisition, distinct from goodwill, foresees, on the part of the
acquirer:

• Classification or designation of all assets and liabilities (IFRS 3, § 15).

• Measurement on the basis of fair value as at the date of acquisition (IFRS 3, § 18).

In connection with the acquisition of insurance contracts in the area of a transac-

tion of business combination or portfolio acquisition, IFRS 4 applies in particular.

• Of an insurance liability (technical provision) measured according to pre-existing

accounting standards.
28.7 Other International Accounting Standards of Significance for the. . . 597

• Of an intangible asset equal to the difference between the aforesaid insurance

liability and fair value of rights acquired and obligations taken on with the
acquisition.

Goodwill is detected as the plus difference between (IFRS 3 §32):

1. The aggregate consideration transferred (fair value as at the date of acquisition)

for the minority equity interests in the acquired entity and equity interests
previously held in the acquired entity (fair value as at the date of acquisition).
2. The net value as at the date of acquisition of assets acquired and liabilities
taken on.

Goodwill is an asset that cannot be amortised and is subject to an impairment test

in the terms of IAS 36 (see above § Impairment test of tangible and intangible
assets).
In cases of transactions of business combination achieved in stages (so-called step
acquisitions, e.g. in cases of subsequent acquisition of shares) the method of acquisi-
tion must be applied on the day when control is achieved, and the value of the interest
held previously in the acquired entity, recalculated at respective fair value as at the
date of acquisition, detecting any differences as profit or loss (IFRS 3§ 42).

28.7.4 IAS 12: Income Taxes

IAS 12 governs the criteria for accounting of income taxes, in reference to (IAS
12 §5):

• Current taxes relating to tax debits (credits) accruing on taxable results for the
accounting period.
• Deferred outgoing taxes, detected base on temporary differences relating to
taxable sums in subsequent accounting periods.
• Incoming deferred taxes, detected based on temporary differences relating to
sums that are deductible in subsequent accounting periods, fiscal losses carried
forward and tax credits for income taxes.

IAS 12 §5 defines taxable (deductible) temporary differences as the differences

between the fiscal value and the accounting value of assets or liabilities intended to
become taxable (deductible) sums in future accounting periods and where the value
of asset has been realised or that of the liability has been extinguished.
Deferred incoming taxes may be entered to the extent it is probable that sufficient
taxable results will be generated to cover temporary differences, i.e. that allow the
use of fiscal losses carried forward, tax credits for income tax (IAS 12 § 24 and 34).
Incoming and outgoing deferred taxes must be measured on the basis of rates of
tax that it is expected must be applied in the period when the assets and liabilities that
are respectively realised or extinguished using the fiscal rates (and rules) already
applying, or that it is foreseen will apply, by the end of the tax period (IAS 12, §47).
598 28 International Accounting Standards (IAS) and International. . .

28.7.5 IFRS 8: Operating Reporting

IFRS 8 concerning reporting requires an entity to provide information allowing the

stakeholders:

• A simple and clear reading of the financial statements.

• An assessment of the business activities and the effects on the financial statements.
• The understanding of the economic context in which it operates.

In particular, a segment reporting is defined as a component of an entity15:

• That engages in business activity from which it may earn revenues and incur
expenses (including revenues and expenses relating to transactions with other
components of the same entity).
• Whose operating results are reviewed regularly by the entity’s chief decision
maker to make decisions about resources to be allocated to the segment and assess
its performance.
• For which discrete financial information is available.

A number of segments may be aggregated into a single sector for disclosure if the
aggregation is consistent with the core principles of IFRS 8, the segments have
similar economic characteristics and they are similar in all the following respects:

• The nature of their products and services.

• The nature of their production processes.
• The type and class of client for which their products and services are intended.
• The method used for distributing their products or services.
• If applicable, the kind of regulatory context where they operate; for example
banking, insurance or public services.

28.8 Questions

1. What are the new criteria for classifying and measuring financial assets based on
IFRS 9?
2. Define the meaning of Operating Segments.
3. How does the building block model of IFRS 17 work?
4. Explain the PAA approach for the non-life business.
5. What is the meaning of LAT?

15
For the definition, see IFRS 8—Appendix A.
References 599

References

Directives and Regulations—Chronological Order

Commission Regulation (EU) 2023/1803 of 13 August 2023 adopting certain international account-
ing standards in accordance with Regulation (EC) No 1606/2002 of the European Parliament
and of the Council
Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on
the application of international accounting standards

IFRS Principles—Chronological Order

IFRS 17 (2017) Insurance contracts. International Accounting Standards Board, London

IFRS 9 (2013) Financial instruments. International Accounting Standards Board, London
IFRS 3 (2008) Business combinations. International Accounting Standards Board, London
IFRS 8 (2006) Operating segments. International Accounting Standards Board, London
IFRS 7 (2005) Financial instruments: disclosures. International Accounting Standards Board,
London
IAS 38 (2005) Intangible assets. International Accounting Standards Board, London
IAS 36 (2005) Impairment of assets. International Accounting Standards Board, London
IFRS 4 (2004) Insurance contracts. International Accounting Standards Board, London
IAS 39 (2003) Financial instruments: recognition and measurement. International Accounting
Standards Board, London
IAS 12 (1998) Income taxes. PricewaterhouseCoopers, London
IFRS 17, Insurance Contracts: An illustration Financial statements presentation and disclosures,
PWC 2021

Suggestions for Further Study

Bensadon D, Praquin N (eds) (2016) IFRS in a global world. International and critical perspectives
on accounting. Springer, Switzerland
Lavi, M.R. (2016). The Impact of IFRS Standards on Specific Industries. In The Impact of IFRS on
Industry, M.R. Lavi (Ed.). https://doi.org/10.1002/9781119170334.ch4
Marano P, Siri M, (2017), Insurance Regulation in the European Union, Palgrave Macmillan Cham
Meyer, L. Insurance and International Financial Reporting Standards. Geneva Pap Risk Insur Issues
Pract 30, 114–120 (2005). https://doi.org/10.1057/palgrave.gpp.2510012
Schwarzbichler M, Steiner C, Turnheim D, (2018), Financial Steering. Valuation, KPI Management
and the Interaction with IFRS, Springer Cham
Solvency of an Insurance Undertaking
29

Abstract

This chapter aims to describe the new approach introduced by European regulations
Solvency II. This Directive defines the new criteria for the calculation of solvency
margin for an insurance (and reinsurance) undertaking. The new system has three
pillars. The first pillar quantifies the capital cover for meeting risks.1 The second
pillar aims to arrange an internal organisation and the adoption of a series of
behaviours consistent with a holistic view of risk management. The third pillar
discloses the insurance undertaking’s operation transparently to the market.
Regarding the first pillar, the reader can learn the steps required by the
directive for: (1) calculation of solvency capital requirement (SCR) based on the
risks foreseen by the EIOPA’s framework; (2) determination of Own Funds
(OF) which are the capital available for covering the SCR; (3) calculation of
solvency ratio which is the fraction between OF and SCR (this ratio must be greater
than 1.0).
The second pillar illustrates a system of governance based on the concept of
risk management linked to governance and risk monitoring.
The third pillar explains the use of information required for monitoring the
actual state of solvency and financial stability overall of the insurance undertakings.

For this chapter, a special acknowledgement goes to Marcello Ottaviani (consulting audit and
appointed actuary).
1
It should be noted that in order to be able to operate in the insurance sector and face its risks, an
insurance undertaking must have a certain amount of capital. In the insurance industry, the
minimum amount of regulatory capital is required by the oversight Authority and is called Solvency
Capital Requirement (SCR).

# Springer Nature Switzerland AG 2024 601

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_29
602 29 Solvency of an Insurance Undertaking

Keywords

Basel I · Basel II · Risk-oriented setting · Overall solvency system · Enterprise

Risk Management (ERM) · Solvency Capital Requirement (SCR) · Insurance
risks · Mortality risk · Longevity risk · Lapse risk · Expenses risk · Risk of
revision · Underwriting risk · Pricing risk · Reserving risk · Catastrophe risk ·
Market risks · Loss Absorbing Capacity (LAC) · Interest risks · Equity risks ·
Property risks · Spread risk · Currency risks · Concentration risk · Operational
risk · Risk relating to intangibles · Mark-to-model · Market Value Balance Sheet
(MVBS) · Market Consistent Balance Sheet (MCBS) · Book Value Assets
(BVA) · Best Estimate Liabilities (BEL) · Risk Margin (RM) · Standard formula ·
Minimum Capital Requirement (MCR) · Absolute Minimum Capital
Requirement (AMCR) · Basic Solvency Capital Requirement (BSCR) · Internal
model · Undertaking-Specific Parameters (USP) · Probability Distribution
Function (PDF) · Basic Own Funds (BoF) · Own Funds (OF) · Tier 1; Tier 2; Tier
3 · Solvency ratio (Cover ratio) · Own Risk and Solvency Assessment (ORSA) ·
Forward Looking Assessment of Own Risks (FLAOR) · Solvency and Financial
Condition Report (SFCR) · Regular Supervisory Reporting (RSR) · Quantitative
Reporting Templates (QRT)

29.1 Learning Objectives

At the end of this chapter the reader should be able to:

1. Illustrate the historical excursus concerning the directive Solvency II

2. Know the definition of the solvency capital requirement
3. Explain the risks of an insurance undertaking
4. Know the difference between the Market Value Balance Sheet and Book
Value Asset
5. Illustrate the main items of each of the three pillars
6. Understand how the standard formula and the internal model work
7. Describe the Own Funds (OF) and Solvency Ratio
8. Explain the Own Risk and Solvency Assessment (ORSA)
29.3 Historical Notes 603

29.2 Definition of the Solvency Requirement

An inverse production cycle, i.e. collection of premiums taking place before pay-
ment of losses is typical for the insurance market. Given the fact that the period of
time between collecting premiums and paying out insurance performances can be
longer or shorter, oversight Authority imposes upon insurance undertakings reserv-
ing funds needed to deal with the actual time of accrual of risks and to meet future
performances foreseen for assureds. This imposes setting up enormous funds on the
liability side of the balance sheet: technical reserves. There is the need to manage
related assets to cover them.2
In the industrial sector, the element of uncertainty is made up of failing to achieve
sufficient revenue to cover costs of production already incurred. On the other hand,
in the insurance industry, the risk is future unexpected costs arising that are greater
than the revenue already collected. In both cases, the consequences deriving from
this uncertainty generate a risk of insolvency for the enterprise.
To defend against possible unexpected sums, in respect of future commitments
given, an enterprise must have special capital—financial resources available as a
form of surety to protect the continuity of the business.
Concerning technical industrial risk, an insurance undertaking ought to ensure its
solvency through proper calculation of premiums and by identifying an adequate margin
of safety. Unfortunately, unexpected volatility in technical trends (i.e. the underlying
insurance risk), rates of interest, values of share indices and any insolvency of reinsurers
or credit institutions, as well as the economic losses generated by operational risk, could
lead to an insurance undertaking being placed in a situation of risking insolvency.
For the industry to remain stable and balanced, but also to increase competitive-
ness and protect stakeholders (i.e. assureds and surrounding economic activities)
European lawmakers3 have introduced measures and tools for auditing the capital
stability of insurance undertakings via a vision of an Enterprise Risk Management
(ERM) type, i.e. promoting a vision centring on risk. This aim has been achieved
through introducing a duty to set up a sort of “security fund” called Solvency
margin or Solvency Capital Requirement (SCR).

29.3 Historical Notes

The question of the solvency of insurance undertakings has been widely discussed
since the seventeenth century, when a number of well-known cases of local
governments began to worry about the new insurance undertakings starting life in
order to protect stakeholders, being the assureds.

2
In this chapter, reference will be made generally to an insurance undertaking (when indicating a
non-life or life or reinsurance undertaking) unless the one of these being referred to is specified.
3
In much of the world a similar approach has been adopted. In the USA RBC (Risk Based Capital)
has been adopted, SST (Swiss Solvency Test) in Switzerland, ICA (Individual Capital Assessment),
in the United Kingdom, in China the C-Ross (China Risk Oriented Solvency System), etc.
604 29 Solvency of an Insurance Undertaking

29.3.1 Solvency Prior to Solvency II

Leaving aside the lengthy discussions that went on up until the 1950s when the
european Commission requested several parties to perform analyses concerning
risks pertaining to insurance undertakings and criteria to define a solvency method,4
in the 1970s a shared approach was reached that was adopted Europewide.
This approach was reviewed a further 3 times over the next 30 years.5 The model
was defined as Solvency 0 (later Solvency I) based on parameters set in the studies of
the risk and failure of the insurance undertakings of the time.6
Over the course of the various editions of regulations concerning solvency, a
number of changes were made. Over the years, however, this approach has revealed
several limitations: 1) the criterion for determining the capital requirement is not related
to the actual risks of an insurance undertaking, but to the actual book and balance sheet
values; 2) the ratios are average market values for all insurance undertakings operating
in the sector; and 3) the methodology does not distinguish between generic companies
and insurance undertakings operating in specific lines of business or with particular risk
exposures. This evidence has led to the initiation of reflections on changing from the
Solvency 1 model to a new, more risk-weighted model.

29.3.2 A Cue from the Banking Industry: Basel II

The regulations applying to the solvency of insurance undertakings, the Solvency II

project, began life by referring to the model of Basel II for the banking industry.7,8”
Indeed, just like Basel II, Solvency II is structured around the same three supporting
pillars and the same reasons as underlie the development of the first Basel agreement
into Basel II follow those that brought in the transformation from the first regime into
the second very closely.

4
Directives 79/267/EC and 73/239/EC.
5
Second Directive 90/619/EC—Third Directive 92/96/EC, 92/49/EEC—Fourth Directive 2002/12/
EC, 2002/83/EC.
6
For the European area, in life business the parameters, for determining the capital requirements
were based on a percentage of the stock of mathematical reserves and capital at risk (which is
represented by the difference between the sums assured and the value of the Mathematical
Reserves), reduced by the share of reinsurance ceded but subject to a minimum bound below
which the value of the margin required cannot be reduced.
In the non-life business, the parameters for determining the capital requirements (called Sol-
vency margin) were either a percentage of gross written premiums or a percentage of losses. For the
evaluation, the greater of the two has to be selected. In this case too, the sum can be reduced through
there being outgoing reinsurance, subject to a minimum applying.
7
It is not by chance that the second conference held by the EU on 19 December 2001 on the theme
of Solvency I just then drafted, had the title: “Can the new Basel Accord serve as a model for the
Solvency II project?
8
See community directive MARKT/2056/01 “Banking Rules and the Pertinence of their Transpo-
sition to the Insurance industry”.
29.3 Historical Notes 605

It can, for example be seen the duty foreseen for banks by the first version of the
Basel agreement, the so-called Basel I system. Basel I foresaw the duty to set aside
resources amounting a percentage of capital lent so as to ensure the stability of their
business. The percentage was a pre-set figure, an absolute one, not weighted for risk.
The basic arrangement applying was a static vision of the enterprise, a snapshot of its
balance sheet, and undervalued its capacity to generate income over time. Basel II
introduced a new vision of the bank with a more sophisticated analysis structure for
understanding the reality of the insurance undertaking and placed the accent on the risk
implicit in capital lent, not merely the amount. With the adoption of the new criteria set
by Basel II, for example banks have classified clients via a rating system, which
identifies their creditworthiness. As a result, the selection of clients is done on the basis
of a rating awarded at each level corresponds a different cost for the credit assigned.
Financial institutions to set aside quotas of capital defined on the basis of risk of
credit granted to clients, in order to protect themselves from the risks taken on. A further
new area of Basel II and one which highlights its risk-oriented setting, is the identifi-
cation made of a new type of risk, which has always existed but was never formally
dealt with, i.e. operational risk, and to cover which, further capital needs to be allocated.
So, in the same way, a took place for Basel I, Solvency I, by foreseeing a sole
measure for the coefficient of risk based on the volume of business, ended up equating
insurance undertakings with quite different characteristics, so penalising, for example
larger enterprises, with stricter solvency constraints. However, enterprises with greater
volumes of business can count on a larger portfolio and through the greater maturity
and mutuality of these portfolios there is less variance between the assumptions made
and the actual out-turn. There are thus varying individual demands for capital cushions
which depend on the risk components the business carried on in the life or non-life
areas and the benefit deriving from diversification, etc. So, no longer set coefficients,
but rather a system for calculating requirements tied to a risk profile. Additionally,
Solvency II, just like its banking alter ego, includes operational risk.

29.3.3 Solvency II Introduction

The new regulations foresee a holistic vision of risk management. This new
approach is achieved in the organisational area (i.e. adopting a series of behaviours
consistent with effective management of risk) and a customised, specific, quantita-
tive model depending on the type of risk.
Establishing the SCR, i.e. the security fund, fell to the European Parliament
directive 2009/138/EC.9

9
See directive 2009/138/EC of the European parliament and the council dated 25 November 2009
in the matter of access to carrying on insurance and reinsurance business (Solvency II). This
directive was accompanied by an extremely broad series of documents issued by the body of the
European Union assigned to supervising insurances, the EIOPA, and others for local implementing
issued by local regulators, so as to integrate into every country in the EU the rule required under the
directive.
606 29 Solvency of an Insurance Undertaking

The regulations foresee that in determining capital requirements two methods

may be used:

• A standard model (or formula).

• An internal model.

or possibly a form mixing the two. The difference between the two models resides in
the fact that the first one is simplified, but still much more complex when compared
to Solvency I. The second one is instead a model defined by the insurance undertak-
ing and calibrated on its own specifications both as to type of business and its own
internal organisation, and needs to be approved by the Regulator, or by a board of
regulators, in the countries where the group operates.
The principle for calculating capital requirements foresees that insurance
undertakings analyse all the risks they face and evaluate for each of them the cost
that an adverse scenario would produce in the financial statements while taking care
to calibrate the scenario adequately and define the relative metric, which will be
based on specific rules of financial statements.
Later in this chapter, the three important issues will be analysed, and which are:

• Risk mapping of an insurance undertaking.

• Market Value Balance Sheet (MVBS) (evaluation of the balance sheet).
• Stress scenario.

In a way similar under Basel II, Solvency II is made up of three pillars. Indeed,
such a structure, acts as an ideal basis for evaluating the overall solvency of
insurance undertakings.
The first pillar quantifies the capital cover for meeting insurance, market, credit
and operational risk. The second pillar aims to spread a culture of risk within the
enterprise by setting up flags and units directed towards monitoring risk. Finally, the
third pillar must disclose its financial position and manner of operation transparently
to the market. For this illustration, see Figure 29.1.
For a comparison of the two systems, Solvency I versus Solvency II, see
Table 29.1.
Thereafter the activities for determining the solvency margin according to Sol-
vency II are shown. The procedure for calculation is based on the followingsix steps:

1. Carry out an assessment of the risks to which the insurance company may be
exposed
2. Determine the amount of capital required for each of the risks through stress
scenarios
29.3 Historical Notes 607

PILLAR I PILLAR II PILLAR III

Financial Requirements: Governance & Supervision: Reporting & Disclosure:
•Assets and liabilities - valuation at •Governance model •Public disclosure -Solvency and
market value Financial Condition Report (SFCR)
•Own Risk and Solvency Assessment
•Investments (ORSA) •Disclosure to the Supervisory Authority
•Solvency Capital Requirement (SCR) •Regulatory review process •Regular Supervisory Report (RSR)
•Minimun Capital Requirement (MCR) •Regulatory intervention, including •Quantitative Reporting Templates
•Basic Own Funds (BOF) capitalization requests (QRTs)

Fig. 29.1 Components of Solvency II regulation

Table 29.1 Comparison Solvency I vs Solvency II

Key elements Solvency I Solvency II
Solvency margin Based only on standard Base on Pillar I, i.e. Risks based.
determination parameters linked to the Assessment and calculation of all the
financial statements risks which can impact an insurer
Underlying No risk-oriented and based Overall approach and forward-looking
philosophy on past data
Governance and No Pillar II
control system
Disclosure and No Pillar III
Transparency
Available capital for Mainly Net Equity Own Funds classified in three tiers in
covering the accordance with their quality
required margin

a. choice of the model to be used or selection between the standard model and the
internal model
b. in the first case, the coefficients and formulas for the stress scenarios are
standard (formula) or specific and customized for each insurance company
c. calculation of capital for each of the risks
3. Add up the amounts of capital required for each of the risks considering the
correlation and diversification between the risks themselves. In this way the
required margin value is obtained, i.e. SCR
4. Define MCR which represents the minimum threshold
5. Determine the value of the capital elements that can be used to cover the required
margin The capital elements are referred to as BasicOwn Funds (BOF)
6. Calculate the ratio between OF and SCR

The next sections of the chapter provides details of each of the steps illustrated
above.
608 29 Solvency of an Insurance Undertaking

29.4 The Risks of an Insurance Undertaking

The risks an insurance undertaking faces, and foreseen in regulations, may be split
into five types: non-life risks, life risks, health risks, market risks, default risks.
Added to these is a sixth category represented by operational risks. See Figure 29.2
containing a graphic representation of the risks of an insurance undertaking in
accordance with the EIOPA’s requirements.

SCR

Adj BSCR OP

Market Health Default Life Non-life Intang

Interest SLT Non-SLT Premium

CAT Mortality
rate health health reserve

Premium Longevi-
Equity Mortality Lapse
reserve ty

Longevi- Disability
Property Lapse CAT
ty Morbidity

Disability
Spread Lapse
Morbidity

Currency Lapse Expenses

Concen-
Expenses Revision
tration

Revision CAT

Required intervention Included in the adjustment for the loss absorbing

of the actuarial function capacity of technical provisions under the modular
approach

Fig. 29.2 The risks of an insurance undertaking

Source: adaption from EIOPA, The underlying assumptions in the standard formula for the
Solvency Capital Requirement calculation (EIOPA-14-322)
29.4 The Risks of an Insurance Undertaking 609

29.4.1 Insurance Risks

Insurance risks are those that are tied to the core business of the insurance
undertaking, i.e. those that are the subject matter of business activities, and are
split into three macro lines of business, being: life, non-life and permanent health.
The prevailing risks in the life business are those of the covers that insurance
products offer, i.e. death, longevity and disablement.
By way of example, mortality risk arises from changes in the level, trend, or
volatility of mortality rates, where an increase in the mortality rate results in an
increase in the value of insurance liabilities.
Conversely, longevity risk is related to changes in the level, trend, or volatility of
survival rates, where this increase results in an increase in the value of insurance
liabilities.
Disability and morbidity risk relates to changes in the level, trend, or volatility
of community disability, disease, and pandemic (or morbidity) rates where the rate
increase results in an increase in the value of insurance liabilities.
Life-expenses risk (for insurance contracts) arises from changes in the level,
trend, or volatility of management and acquisition costs of insurance contracts,
where it results in a loss or unfavorable change in the value of insurance liabilities.
Revision risk of contract terms unfavorably for the insurer refers to the trend or
volatility of revision rates applied to life product annuities. Changes in the legal
environment or different health status of insured persons result in unfavorable
change in the value of insurance liabilities.
Lapse risk arises from changes in the level or volatility of maturity, early termina-
tion, renewal and surrender rates of policies. Changes in the expected surrender rate
can lead to the risk of loss or adverse change in the value of insurance liabilities.
Life-catastrophe risk for contracts connects with a strong change in pricing and
provisioning assumptions related to extreme or irregular events. These changes can
lead to a loss or adverse change in the value of insurance liabilities.10
In non-life insurance there is a lower number of risks applying, being
underwriting risk, which is split into two components, pricing and reserving,
non-renewal and catastrophic risk.
The pricing risk measures the capacity of an insurance undertaking to identify its
clients, design contracts and assess the risks insured, essentially an adequate tariff
charged for insurance products. The insurance undertaking must ensure consistency
of quality of assureds for which a contract has been concluded, and the tariff applied,
meaning technical bases must be used that are suited to representing the conduct of
clients.
Pricing risk measures whether or not the level of premiums collected is adequate
to cover expected losses, or if the behaviour of assureds is in line with what has been

10
For the risks see Directive 2009/138/EC of the European parliament and the council dated 25
November 2009 in the matter of access to carrying on insurance and reinsurance business (Solvency
II).
610 29 Solvency of an Insurance Undertaking

budgeted in technical bases. This may occur for various reasons, one of which being
so-called adverse selection of risks, meaning that if the premium is not well
calibrated, it may happen that this is advantageous for riskier clients or that
behaviour arises that is distorted as compared with what is expected and which
thus may occur in numbers in excess of expectations. If this had been known in
advance a higher level of premium would have been applied and which would have
led to the insurance undertaking collecting more or that would have allowed a
different distribution of clients, and thus risks being achieved, and this would have
led to a reduced expected cost of claims. In the life business there is a sub-risk called
expenses which is not foreseen, at least not specifically. Indeed, due to the way the
formula for calculating the requirement is structured, bases of calculation are used on
the basis of volume that includes expenses and so a premium will be right when it
meets the risk of an increase in the cost of claims and related costs too.
Reserving risk derives from uncertainty tied to estimating sums set aside to meet
future indemnities for losses that have occurred in the past in non-life insurance the
sums reserved are not always known in advance but are rather estimated on the basis
of a various processes, such as the loss survey, negotiations with the adversary party
and, in a number of cases, even after a court case.
The risk for an insurance undertaking derives from uncertainty relating to varia-
tion over time both in the probability of loss events occurring and their cost.
Even in non-life insurance there is a risk of lapse, although here it has a different
meaning, as the type of contract is different, but it is essentially the same; assessing
the risk that clients abandon or renew contracts with greater than expected probabil-
ity. The difference resides in the fact that non-life business contracts are much more
frequently for a recurring annual duration, whereas non-recurring multi-year
contracts are prevalent in the life business. For life contracts of savings, abandoning
a contract foresees reimbursement of a sum tied, mainly, to the value of the
mathematical reserve, whereas in the Non-life business, abandoning means failure
to pay a premium or, in certain cases, reimbursement of a quota of the premium
originally paid for the contract.
The catastrophe risk foreseen in regulations can be understood as being an
underwriting risk, but one that relates solely to contracts of a catastrophe kind being
one of the following modules; natural events (hail, flood, earthquake etc.) events on
non-proportional reinsurance tied to buildings, damaging events produced by man
and other catastrophe risks.
A third category of business is that tied to health. This line of business has been
split into two parts, i.e. one managed by life-type techniques and one by non-life-
type ones. For each of these two sub-modules, the same risks as have been seen
above for non-life and life risks respectively are foreseen. A separate sub-module
applies for catastrophe risks in the health line of business and which is based on the
risk of mass accident events, risks of accumulation of assureds who suffer the same
disastrous event, and pandemic events.
29.4 The Risks of an Insurance Undertaking 611

29.4.2 Market Risks

Another category of risk is market risks. These risks can be split into interest risks,
equity risks, property risks, spread risks, currency risks and risk of concentration.
Market risks refer to variation in economic-financial variables that can have an
unfavourable bearing on the value of assets and thus lead to a situation in which the
value of these is insufficient to cover the liabilities assumed towards assureds. In the
life business, the value of assets is tied, for contracts of a revaluing type, to the value
of liabilities and so a loss of value of the former also gives rise to a reduction in the
latter. This situation is referred to as the capacity to absorb losses Loss Absorbing
Capacity (LAC), and, depending on the conditions applying in the portfolio of
assets, types of guarantee offered to assureds, the features of management rules in
sales/purchase of securities, and other specific factors of the country (taxation, rules
defining profit sharing etc.) the impact may be more or less marked in the financial
statements of an insurance undertaking.
Interest rate risk relates to the sensitivity of the values of assets and liabilities
(also including all financial instruments) to possible changes in the term structure of
interest rates or the volatility of interest rates.
Equity risk is related to the impacts on the value of assets, liabilities, and
financial instruments resulting from changes in the level or volatility of market
prices of equities.
Property risk considers the sensitivity of asset and liability values to changes in
the level or volatility of real estate asset market prices.
Spread risk relates to the sensitivity of asset and liability values to changes in the
level or volatility of credit spreads relative to the term structure of risk-free interest
rates.
Currency risk relates to impacts on assets and liabilities as a result of changes in
the level or volatility of currencies and related exchange rates.
Concentration risk arises from a lack of diversification of the asset portfolio or a
large exposure to the risk of default of a single issuer of securities or a group of
related issuers.
Default risk expresses the risk of counterparty default. This reflects possible
losses due to unexpected default or deterioration in the creditworthiness of
counterparties and debtors.

29.4.3 Operational Risks

In the category of operational risk come risks connected with carrying on insurance
business. These may be split by type and by origin. Following the first classification,
a distinction is made between business and legal risks. Distinguishing by origin, the
taxonomy differentiates between external and internal risks. For the classification see
Fig. 29.3.
612 29 Solvency of an Insurance Undertaking

Fig. 29.3 Types of Operational

Operational Risk Risks

External Internal

Incapacity
Legal Risk
of the management

Risk of compliance Business interuption

Environmental
Intangible assets
changes

External operational risks are exogenous in the sense that their occurrence does
not depend on management choices made by the enterprise. Of this kind are legal
risks due to the effects of the introduction of new regulations in the sector and risks
of compliance that are a consequence of duties placed upon enterprises to adjust their
practices to meet legislative demands. Also forming a part of external risks are
business risks deriving from environmental change e.g., changes in the level of
competition, or fraud, or extreme situations such as the occurrence of terrorist acts or
the loss of intellectual property.
Internal operational risks are connected to an incapacity of management to
ensure there are effective or efficient processes in the enterprise.
These risks include the risk of business interruption and the risk relating to
intangibles. This last risk measures the risky nature of the financial statement values
of an intangible asset since this is subject to fluctuation in its value.

29.5 Pillar 1: Determination of the Amount of Required Capital:

Stress Scenarios

The first pillar of the Solvency II regulations describes the rules for determining the
SCR, eithers determined through the standard formula or through the internal model.
The first pillar provides guidance on quantitative issues. The first pillar provides
guidance on issues of a quantitative nature. In particular, it gives guidance on the
valuation of balance sheet items and on the valuation criteria for assets and liabilities,
and indicates the principles by which investments should be considered. With regard
to the calculation of regulatory requirements, the first pillar contains the rules and
formulas for determining the Solvency Capital Requirement (SCR). The Minimum
Capital Requirement (MCR) is given. Finally, guidance is given on the criteria and
classification of Own Funds (BOF).
29.5 Pillar 1: Determination of the Amount of Required Capital: Stress Scenarios 613

Description Calculation

Excess • It is the regulatory capital that • It corresponds to the VaR of

of capital

Own Funds
covers the unexpected losses own funds with a 99.5%
of the existing business (and confidence interval over a

SCR
the expected losses of the next one -year horizon.
SCR
12 months' business). • Scenario testing.

MCR • Factor based.

Assets
• This is the minimum limit
below which policyholders and
• Linear function calibrated to the

MCR
beneficiaries would be
exposed to an unacceptable VaR of core capital with a
Liabilities confidence interval of 85% over
level of risk.
a one -year horizon.
• It is between 25% and 45% of
the SCR .

Fig. 29.4 Solvency requirement MCR and SCR

29.5.1 Minimum Capital Requirement (MCR) and Solvency Capital

Requirement (SCR)

Insurance undertakings must hold a capital requirement making sure that this value
is never below a certain minimum amount called the Minimum Capital Require-
ment (MCR). MCR is formulated as a fixed threshold, called Absolute Minimum
Capital Requirement (AMCR) plus a percentage share of SCR.
The value of the MCR minimum capital requirement is thus the lower limit of the
capital a firm must set aside to be solvent. It is calculated with a linear formula and
ranges from a minimum of 25% to a maximum of 45% of the SCR.
MCR is calculated as a linear function, calibrated to the value-at-risk (VaR) of the
insurance undertaking basic own funds with a confidence level of 85% over a one-
year period, of a set or subset of the following variables: technical reserves;
premiums written; capital at risk; deferred taxes; and administrative costs of the
insurance undertaking.
Variables used are calculated net of reinsurance. See Figure 29.4 for a schematic
of the components of the MCR and SCR.
The SCR is calibrated to consider all quantifiable risks to which the insurance
undertaking be exposed, according to the risk map that has been described in the
preceding paragraphs.11

11
It matches the Value at Risk (Var) of own funds of the undertaking and reflects the economic
capital needed for operation subject to a confidence level of 99.5% over a timeframe of one year. In
other words, the SCR represents the expected value of a loss of own funds, with a timeframe of one
year in an unfavourable scenario that occurs once every 200 years.
614 29 Solvency of an Insurance Undertaking

Table 29.2 Market Consistent Balance Sheet (MCBS) valuing

Assets Liabilities
valued at the amount for which valued at the amount for which
they might be they might be
EXCHANGED TRASFERRED
Market Value Hedgeable Non hedgeable
(financial risks) (insurance risks)

Market to Market Market to Model Market Value Best estimate + Risk

Margin

29.5.2 The Market Consistent Balance Sheet (MCBS)

The approach by which all balance sheet items are valued takes into account the
value of risk and the market. According to this logic, the value of assets and
liabilities should reflect the expected risk as closely as possible. Assets are valued
using a market value, Market Value (MV) approach. While liabilities are valued
taking into account their level of hedging against risk (hedgeable or nonhedgeable).
Table 29.2 shows a schema synthesis illustrating this valuation model called Market
Consistent Balance Sheet (MCBS).
Analyzing the items in the table in detail, for all assets that have a market price the
market datum (market to market) must be used, in alternatively one must refer to
methodologies consistent with market valuations(market to model). The definition of
the valuation criterion is as follows: "the consideration at which an asset can be
exchanged, or a liability discharged or disposed of, in a free transaction between
knowledgeable and willing parties."
For liabilities, a distinction is made between valuation according to whether they
are financial or risks insurance risks. In the case of financial risks the principle is a
hedgeable approach. In this case the item is valued at Market Value. The value
hedgeable is highly responsive to changes in scenarios (e.g., to any minimal fluctua-
tion in a technical or economic parameter), and can generate changes in the balance
sheet that lead to high volatility in capital results.
For the valuation of technical provisions, on the other hand, the criterion follows a
nonhedgeable approach. The model is defined by regulation, giving rise to the so-
called Best Estimate Liabilities (BEL) plus a prudence value called Risk Margin
(RM). The RM can be seen as an unexpected cost of these outlays and can be viewed
as an additional cost burden. The purpose behind this approach is that both the BELs
and the RM must fulfill their obligations to policyholders, taking into account that
the RM is presented as a first-tier buffer, while the SCR represents an additional
prudence margin for risk(second-tier). In the current regulatory framework, the RM
is determined as the present value of a portion (set by the directive) of the SCRs
29.5 Pillar 1: Determination of the Amount of Required Capital: Stress Scenarios 615

Assets Liabilities

Available
Cover of
Capital SCR

Assets at MCR
Market Risk Margin
Value (MV) (RM)
Best
Estimate Fair Value (FV)
Liabilities of liabilities
(BEL) or
Technical
Provisions

Fig. 29.5 Market Consistent Balance Sheet (MCBS)

related to each year of future management, generated by contracts in force on the

valuation date. See as an example the following calculation:

• BEL = 100.
• SCR = 80.
• %RM = 6% (hypothetical value).
• Value of insurance risks = BEL + RM = 100.0 + 4.8 = 104.8.

Figure 29.5 shows the graphical representation of assets and liabilities according
to the Market Consistent Balance Sheet (MCBS) approach.
Another immediate consequence of the MCBS balance sheet is that the assets
effectively become the value at which to exchange the insurance undertaking in the
event of a sale and purchase, except of course for the value of goodwill (i.e., the
future ability to generate business), since it is excluded from the methodology
provided for calculating BEL.
Last of all, for completeness in information, it should be noted that civil financial
statements are at made at book value i.e. subject to Book Value Assets (BVA). This
approach has, on the one hand, the limitation of valuing items of assets and liabilities
at historical cost. On the other, it has the advantage of avoiding that temporary
fluctuations in the marketplace lead to short-lived differences in the valuation of the
insurance undertaking to the detriment of long-term stakeholders.

29.5.3 The Standard Formula

SCR is calculated though a modular type approach that quantifies the capital
requirements to meet various risks. In Fig. 29.6 the three logical steps are represented
616 29 Solvency of an Insurance Undertaking

MCR

SCR

Step 3 Adj BSCR OP

Step 2 Market Health Default Life Non-life Intang

Interest SLT Non-SLT Premium

Step 1 CAT Mortality reserve
rate health health

Premium Longevi-
Equity Mortality reserve Lapse
ty

Longevi- Disability
Property Lapse CAT
ty Morbidity

Disability
Spread Lapse
Morbidity

Currency Lapse Expenses

Concen-
Expenses Revision
tration

Revision CAT

Fig. 29.6 Approach for calculating SCR with standard formula

Source: Adapted from EIOPA, The underlying assumptions in the standard formula for the
Solvency Capital Requirement calculation (EIOPA-14-322)

and that allow the final value of the SCR to be determined starting from the first
determining of the value of the risk for each individual sub-module.
The first step is to determine the capital requirement for each sub-module of
risk.
This valuation it possible via two alternative approaches:

(a) the first approach (the one that is more widely used) is called the factor based
formula. The value is obtained via an “indirect” calculation. This foresees the
use of a closed formula including magnitudes suited to represent the exposure to
risk of the undertaking. In practice, each magnitude relative to the sub-module
of risk is multiplied by a parameter expressing the percentage of risk.
(b) he second approach is called scenario testing approach. The value is obtained
by means of a “direct” calculation of the Adjusted Net Asset Value (ANAV) that
29.5 Pillar 1: Determination of the Amount of Required Capital: Stress Scenarios 617

is a consequence of applying a scenario. The ANAS matches the net wealth of

the MCBS, In other words, the excess of assets over liabilities in the Solvency II
financial statements undergoes a stress scenario12

The second step is an aggregating of capital requirements by category of risk

and calculation of the SCR to meet intangible assets.
The third step requires the arithmetical sum of BSCR, SCR to meet the
operating risk and writing down effect of losses due to deferred taxes and technical
reserves.
The solvency capital requirement calculated on the basis of the standard for-
mula amounts to the sum of the following items:

• The Basic Solvency Capital Requirement (BSCR).

• The solvency capital requirement for operational risk (SCRop).
• An adjustment for the Loss Absorbing Capacity of technical provision (LACtp)
and deferred taxes (LACdt).

SCR = BSCR þ SCRop - LACtp - LACdt ð29:1Þ

The basic solvency capital requirement is calculated as the square root of the sum
of all possible combinations of SCR values for each line of business, multiplied by a
factor of correlation.

BSCR = i,j
scri  scrj  Corri,j ð29:2Þ

This means that all SCRs relating to each risk module are multiplied together, in
pairs, and multiplied by the factor of correlation identified for them. The square root
of the sum of these items represents the BSCR. SCRs are the families of risk
identified in Fig. 29.2, i.e. the following:

1. Non-life SCR
2. Life SCR
3. Health SCR
4. Market SCR
5. Default SCR

The reason for the risk modules being aggregated along these lines is because it is
supposed that not all risks may have an unfavourable outcome at the same time, i.e. it
cannot be assumed that all risks generate a 200-year worst-case scenario simulta-
neously as this would be like assuming that the correlation between all risks equalled
1, i.e. any change in certain variable shifts another variable of the same sign and

12
For a definition of ANAV and EV see Chap. 32.
618 29 Solvency of an Insurance Undertaking

same intensity. As the correlation between risks is likely to be less than 1, there will
be a smaller impact of unfavourable scenarios and so a lower capital requirement.
The amount of capital will therefore depend on the value of the correlation. The
closer to 1, the higher its value, the closer to -1, the greater will be the level of
diversification between risks (obviously the case of all values amounting to -1 is not
possible as the correlations can be negative only for pairs of risks).
In order to understand the application of the formula more fully, an example is
provided here below of possible SCR values for an insurance undertaking (expressed
in millions of Euros). See Table 29.3 containing the SCR Values split into line of
business.

Table 29.3 SCR Values split into line of business

Module SCR
Non-life 369
Life 77
Health 5.39
Market 264
Default 106

The factor Corr i,j may be read from the correlation matrix (example) described in
Table 29.4.

Table 29.4 An example of correlation matrix

j
i Non-life Life Health Market Default
Non-life 1 0 0 0.25 0.50
Life 0 1 0.25 0.25 0.25
Health 0 0.25 1 0.25 0.25
Market 0.25 0.25 0.25 1 0.25
Default 0.50 0.25 0.25 0.25 1

When they calculate solvency requirements, insurance and reinsurance

undertakings take into account the effect of risk reduction techniques, as long as
the solvency capital requirement adequately reflects default risk and other risks
deriving from the use of these techniques of risk mitigation.
In order to apply the formula determining the basic solvency capital requirement
applying the values shown in the example, all the values in the columns are
multiplied by all the values of the lines, by factors of correlation. See Table 29.5
which contains an example of formulas in the matrix.
29.5 Pillar 1: Determination of the Amount of Required Capital: Stress Scenarios 619

Table 29.5 An example of formulas in the matrix

j
i Non-life = 369 Life = 77 Health = 5.39 Market = 264 Default = 106
Non-life = 369 = 369*369*1 = 369*77*0 = 369*5.39*0 = 369*264*0.25 = 369*106*0.5
Life = 77 = 77*369*0 = 77*77*1 = 77*5.39*0.25 = 77*264*0.25 = 77*106*0.25
Health = 5.39 = 5.39*369*0 = 5,39*77*0.25 = 5.39*5.39*1 = 5.39*264*0.25 = 5.39*106*0.25
Market = 264 = 264*369*0.25 = 264*77*0.25 = 264*5.39*0.25 = 264*264*1 = 264*106*0.25
Default = 106 = 106*369*0.5 = 106*77*0.25 = 106*5.39*0.25 = 106*264*0.25 = 106*106*1

Thus, obtaining Table 29.6 with the values of the products.

Table 29.6 An example of a table with the values of the products

j
i Non-life Life Health Market Default
Non-life 136,161.00 – – 24,354.00 19,557.00
Life – 5,929.00 103.76 5,082.00 2,040.50
Health – 103.76 29.05 355.74 142.84
Market 24,354.00 5,082.00 355.74 69,696.00 69,996.00
Default 19,557,00 2,040.50 142.84 6,996.00 11,236.00

Once the table has been completed, the formula for aggregating the SCR is
applied via formula 29.2 and we have:

BSCR = 583.3 m€

If we were to assume a correlation of 1, i.e. if all the values for the capital
requirement were totalled together, we would have a much higher sum of capital:

BSCR = 821.4 m€

Generating a diversification effect of 29%, meaning almost one-third of risk can

be considered improbable, and then excluded from the assessment of the SCR.
The underwriting risk for non-life insurance is in its turn calculated as a combi-
nation of its components, i.e. the underwriting risk, lapse risk and catastrophe risk,
applying the same approach.

SCRnon - life = i,j

scri  scrj  Corri,j ð29:3Þ

The underwriting risk in life insurance derives too from the same aggregation of
sub-modules (mortality, longevity etc.).

SCRlife = i,j
scri  scrj  Corri,j ð29:4Þ
620 29 Solvency of an Insurance Undertaking

The underwriting risk for health insurance follows lines that are completely similar
except for the fact that it has two levels of aggregation (see Fig. 29.2), i.e. the three
lines of business are aggregated (health, SLT, CAT and health Non-SLT)13 and these
in their turn are aggregated, the first and the third, as if they were life and non-life
modules.
The same applies to the market module, whereas the default and revision modules
do not have risk sub-modules, so it will not be necessary to carry out any aggregation
of risks.
In order to determine the value of the SCR, regulations foresee determining the
value of two adjustments, i.e. the capacity to absorb losses of technical reserves and
deferred taxes, and these adjustments are to be added to the value of operational risk,
which by definition has no correlation with other risks (see formula 29.1). The first
adjustment applies only to the life business since, as was stated above, a life
insurance undertaking can decide how it shares losses with assureds. The fact that
it is here in this calculation phase aims to avert dual counting of the capacity to pass
on losses to assureds. In order to achieve this requires determining the nBSCR14 for
the purposes of verifying whether or not the difference between it and the BSCR,
i.e. the overall effect of losses offloaded on to assureds, is not greater than the Future
Discretionary Benefits (FDB).15
A second adjustment reflects the fiscal reduction of deferred taxes, calculated as a
snap loss in financial statements amounting to the value of the BSCR plus the
operational SCR and an adjustment on losses of technical reserves. In order to
lower the SCR of this sum, however, an insurance undertaking must be able to
demonstrate that it can recover this tax credit. In general, if in its financial statements
there are fiscal payables in excess of receivables, this excess can easily be used to
offset this credit, but if there are none, or they are insufficient, an insurance
undertaking should adopt other supports. A method that can be used is to utilise
fiscal estimates calculated on economic accounts implicit in the FLAOR16 to deter-
mine whether or not in years to come these generate taxable profits giving rise to
sufficient fiscal debts.17

13
Solvency II defines a 'Health SLT' contract as a contract written on a similar basis to life insurance
(i.e. long-term). The acronym SLT means "Similar to Life Techniques". A "Health non SLT"
contract is defined as a contract that is technically similar to non-life (i.e. short-term) insurance.
Subsequently, each category is further subdivided into defined Lines of Business or product types
14
That is, a BSCR calculated without the capacity of offloading losses on to assureds in all
scenarios.
15
Future Discretionary Benefits which are the sum of the technical reserves over and above the
value of the minimum guaranteed reserves, which in a number of countries really are discretionary;
in other countries they are so only indirectly, i.e. only the shares in securities management that
generate financial income matching variations in technical reserves are discretionary.
16
See later paragraph Own Risk and Solvency Assessment (ORSA).
17
There are in any case various methods that have been adopted by insurance undertakings, a
number of which are quite complex, and which are, however, outside what is dealt with in this text.
29.5 Pillar 1: Determination of the Amount of Required Capital: Stress Scenarios 621

29.5.4 The Internal Model and Undertaking Specific Parameters

(USP)

As an alternative to the standard formula, undertakings may obtain authorization to

use their own internal model in determining required capital. An internal model is a
set of processes, systems and calculations that quantify and classify the risks of a
business. An internal model for which an undertaking seeks authorisation may either
be partial. Undertaking-Specific Parameters (USP)18 can replace individual risk
modules in the standard formula. Authorisation can be total in order to replace the
entire standard formula. Using an internal model is subject to authorisation from
regulatory authorities. Authorisation is granted if the undertaking abides by a
number of conditions among which we can highlight:

1. The methodology adopted.

2. Calibration of variables—Probability Distribution Function (PDF).
3. Documents relating to the process.
4. Governance of the process.
5. Consistency with the level of protection of assureds the SCR wishes to cover.
6. Preparing a process of continuous validation of the model.

The possibility of choosing between a standard formula and using a specific

internal model for calculating the minimum capital required has been offered so as to
meet the need to create a system of regulation that does not distort the corporate
choices made by insurance undertakings and weighs less upon their economic
results. Indeed, using an internal model allows a result to be determined that is
more consistent with the true specific features of the insurance undertaking and an
amount that is for a lower sum than that resulting from using the standard model.
However, developing, using and maintaining a model of this kind is very costly.
Indeed, it requires appreciable internal skills, in addition to spending resources, in
order to adjust the model to the specifics of the insurance undertaking, and which
evolve over the passing of time, and for there to be a sophisticated technological
infrastructure for it to function. Therefore, adopting this is worthwhile for larger
insurance undertakings and above all those that have a number of lines of business,
both in non-life and in life business, for example so as to benefit from a risk
mitigation effect.
An important task foreseen by oversight Authorities consists of validating inter-
nal models that enterprises intend to use for calculating the solvency margin. This
task is a delicate one, as enterprises that propose measuring their own margin using
an internal model are those that believe they can achieve savings in the capital
required. Indeed, as the standard formula leads to setting up a margin that is
relatively high as compared to the actual risk situation of undertakings, a Regulatory
Authority must verify the models proposed extremely carefully so that undertakings

18
See EIOPA-BoS-14/178 EN Guidelines on Undertaking-Specific Parameters (USP).
622 29 Solvency of an Insurance Undertaking

with capital requirement that is inadequate to ensure solvency when adverse events
occur do not enter the marketplace.
Another feature that characterises the Solvency II directive is a principle of
proportionality according to which the weight of regulation must be proportional
to the size of the insurance undertaking. On the basis of this principle, insurance
undertakings of especially small size may use a simplified formula in calculating the
SCR, but this obviously represents a level of greater prudence as compared to the
standard formula. The simplified model is less costly to maintain and calculate, but is
more onerous in terms of the capital required.

29.5.5 Own Funds

Own Funds (OF), which are the subject matter of stress scenarios that serve to
determine the available capital, are made up of the sum of base own funds and
ancillary own funds.
Base Own Funds are made up of the following items: the excess of assets over
liabilities, reduced by the total of treasury shares held by the insurance or reinsurance
undertaking, and subordinate liabilities.
Ancillary Own Funds are made up of items other than base own funds that may be
utilised to absorb any economic losses and may include the following items to the
extent that these are not items of base own funds: insurance undertaking capital or
unpaid-up initial funding not called in; letters of credit or sureties; any other legally
binding pledge received from insurance or reinsurance undertakings.
The items of Own Funds are classified into three Tiers which represent their
quality. The classification of these items depends on the fact that these are items of
base own funds or ancillary own funds and the extent to which they display the
following characteristics: the item is available, or maybe called in on demand, to
absorb losses entirely from a perspective of corporate continuity as well as in the
event of liquidation; in cases of liquidation, the total sum of the items is available to
absorb losses and reimbursement of the item to the holder occurs only after all other
obligations have been honoured, including those of insurance and reinsurance to
policyholders and beneficiaries of contracts of insurance and reinsurance.
Items of base Own Funds are classified in Tier 1 when they have both these
features; they are classified as Tier 2 when they have only the second feature. Items
of ancillary own funds are classified in tier 2 when they have both features. All items
of base and ancillary own funds that do not fall into the area of application of the
features shown above are classified as Tier 3.
To determine whether or not items of own funds have these features, account
must be taken of the duration, especially whether there is a maturity date or not. Also
taken into consideration are the following features:

• Whether or not the item is free of obligations or incentives to reimburse its face
value.
29.5 Pillar 1: Determination of the Amount of Required Capital: Stress Scenarios 623

Surplus tier 1 Surplus tier 1

unrestr + restr unrestr + restr

SCR MCR

Tier 1 Tier 1
unrestricted unrestricted
Total T1 items ≥ 50% basic own funds Total T1 items ≥ 80% basic own funds
of SCR of MCR

Restr. T1 items < 20% Tier 1 restricted Restr. T1 items < 20% Tier 1 restricted
of total T 1 basic own funds of total T1 basic own funds

Tier 2 T2 ≤ 20% of MCR Tier 2

basic own funds basic own funds

Tier 2
T2 + T3 items ≤ 50% ancillary own funds
of SCR

Tier 3
T3 items < 15% basic own funds
of SCR
Tier 3
ancillary own funds

Fig. 29.7 Tiers

• Whether or not the item is without fixed mandatory expenses.

• Whether or not the item is free from encumbrances.

Figure 29.7 represents the components of each tier (tier 1, tier 2 and tier 3).

29.5.6 Solvency Ratio

Once the solvency requirement has been determined, an insurance undertaking must
determines the level of available capital so as to measure solvency, i.e. it must
measure the amount of capital available Basic Own Funds (BOF) against capital
required.
The ratio between is the size of its capital relative to all risks it has taken end the
Own Funds is called the Solvency ratio or Cover ratio. The solvency ratio is
given by:
624 29 Solvency of an Insurance Undertaking

BoF
Sr = ð29:5Þ
SCR
As this ratio increases an insurance undertaking is said to be more greatly
capitalised because it has a value of own funds greater than the capital required. If
values are lower than 1, an insurance undertaking is technically in a position of
insolvency, it should not operate, and intervention on the part of the regulator is
required and who order recapitalising and may impose a commissioner or other
mandatory measures, with an obligation to protect stakeholders.
In general, insurance undertakings prefer to hold levels of capital that fall within a
certain range. The reason for this is that it is wished not to exceed a certain level of
capitalisation so as to avoid excessive locking in of shareholder resources, but at the
same time it may not be below a certain prudential threshold which must avert
possible adverse scenarios and related shortfalls in economic availability.
A professional figure that is developed after the coming into force of the new
solvency regime, is that of Capital Allocation Manager, which is a professional
figure that aims to optimise the value of capital required and maximise the return on
capital invested, what is available, in order to optimise the performance of an
insurance undertaking in terms of risk/return.
In order to act, this figure has various tools available and the following can be
mentioned especially:
Business mix tools for risk mitigation diversification of risk.
Products put into production absorb differing levels of capital and so knowing
which ones and how many make up the business mix helps an insurance undertaking
to reduce the level of risk and thus the capital required. The same needs to apply to
insurance undertaking divisions, just think of Non-life business, life or health.
Focusing the mix consistently with the risk/return profile is the objective that must
be pursued.
Risk mitigation techniques are based both on forms of investment and on
reinsurance: the former, for example by using derivative instruments, or through
debt instruments, or to cover against exchange, interest, equity, property risks etc.
Through wise use of derivative instruments, for example or suitable financial
instruments, an insurance undertaking will be able to keep not only the level of
return under control, but also the value of capital, setting it at a level that the
insurance undertaking itself feels is consistent with its own strategic positioning.
The use of these instruments must at all times be looked at from the standpoint of
integrated management with liabilities (mainly in the life business) in the sense that
any change in return, duration or timing of cash flow, will have a bearing on the
value of liabilities. This relationship has a bearing on the value of capital.
Reinsurance is used to transform a business risk into counterparty risk which, is
typically much lower and so requires a reduced amount of capital (as said above).
There are also other forms of VIF19 Monetisation, which consists of assigning risk

19
VIF (Value of In Force) this is the economic value expected under a contract (or a portfolio) that
has been sold off by an insurance undertaking.
29.6 Pillar 2: Governance and Risk Monitoring 625

to a third party (typically a reinsurer) so as to have part of future profits advanced,

generally with profit-sharing clauses on extra-profits or losses.

29.6 Pillar 2: Governance and Risk Monitoring

Solvency regulations prescribe that insurance undertakings set up a system of

governance for the insurance undertaking based on the concept of risk management.
This means that if, on the one hand, an approach based on risk has to be adopted, in
respect of matters concerning capital prudence adopted to meet future adverse
scenarios, on the other one, it cannot be blind to risk when planning business
activities or when strategic choices are made regarding potential new business or
arranging processes for running the insurance undertaking. It is self-evident that the
audit system too must be based on this standard. It can be said that the second pillar
of Solvency II is a natural extension, by way of consistency, of risk management into
the business area.
The choice of giving a number of the internal issues of an insurance undertaking
the same importance derives from the awareness gained that most of the causes of
failure are a consequence of poor management of risk within the enterprise and
inefficiency of process, decision-making ones especially, and inadequacy of man-
agement rather than due to a below optimum capital position.
The activity of auditing an insurance undertaking is actually performed by a
number of functions in the second line of defence,20 i.e. risk management, the
actuarial function and compliance, and by functions of the third line of defence
such as internal audit. Later lines of control are the external auditor, the regulator and
possibly the controller of market transparency in respect of insurance undertakings
that are listed on financial markets. In respect of internal functions, these check that
corporate processes are consistent with the risk management system and the appetite
for risk the insurance undertaking has set for itself, i.e. they verify the fact that there
are in place suitable activities of monitoring and auditing of flows of information as
well as of corporate decisions that are taken by management in running the insurance
undertaking and the business and that have to be based on suitable risk-driven
criteria. Additionally, insurance undertakings must define a series of policies as:
their level of appetite for risk, their reinsurance policy, underwriting new business
and integrated.
The oversight Authority must check that the system of Governance is adequate to
deal with the risks the enterprise faces and if it fails to meet the requirements
demanded under regulations, it will make recommendations for improving the
situation. In more serious cases it may impose the holding of a solvency margin

20
The first line of defence is a function that own and manage risk. The second line of defence is a
function that oversee or specialise in risk management, compliance. The third line of defence is a
function that provide independent assurance, above all internal audit.
626 29 Solvency of an Insurance Undertaking

by the enterprise that is larger than that resulting from the standard formula or
internal model adopted, or rather it can order a greater Solvency ratio.

29.7 Own Risk and Solvency Assessment

Insurance undertakings need to do, at least annually, an assessment of overall risks.

This process is called Own Risk and Solvency Assessment (ORSA). This process
takes into account all the risks that the enterprise takes on or faces in running its
business, and at the same time determine the need for economic capital for the
purposes of maintaining conditions of solvency over time. The results of this risk
measurement activity for an insurance undertaking and assessment of solvency must
be forwarded to the Regulatory Authority so that it can both evaluate the capacity of
the enterprise to manage risks and have data available by means of which to judge
the actual stability of the insurance undertaking. As regards the first pillar, which
focuses on Own Funds (OF) and Solvency Capital Requirement (SCR), the ORSA
introduces a more holistic view of the risk profile of an enterprise and also foresees a
top-down assessment in respect of the qualitative features of risk that is not included
in the first pillar. These are, for example all the items of risk that characterise the
management of the insurance undertaking overall in order to track the aggregate
level of risk.
In a number of cases, in order to assess the capacity of an enterprise to remain
solvent should any of the risks taken on occur, Regulatory Authorities require
application of scenarios, called stress tests, that consist of economic-demographic
simulations. Through these simulations it is possible to see whether or not the
Solvency Ratio holds up in cases subjected to stress, i.e. verify that these do not
generate insufficiency of capital due to the effect of the adverse scenario (stress). In
cases where a situation of deficit is found, in a number of scenarios and following
certain risks, an insurance undertaking should duly apply precautions to cover these
shortcomings by adequate action. These stress tests, also called sensitivity analyses,
form an integral part of ORSA and are the main structural element in assessing the
overall risk of an enterprise.
In evaluating the ORSA, there is an essential item of governance of the enterprise
which is the so-called Forward Looking Assessment of Own Risks (FLAOR),21
which consists of demonstrating the capacity to identify, assess and control own
risks properly, from a prospective standpoint (relative to a number of future years) in
view of a level of risk that is defined as acceptable, and to adapt commercial
strategies accordingly. In general, the timeframe for assessing the FLAOR is the
same as the timeframe for the strategic planning of the insurance undertaking and
includes all the items of strategy defined within it such as, for example underwriting
policies and the product plan, Strategic Asset Allocation and choices made in respect
of investments, and even policies of dividend and remuneration for shareholders.

21
Forward Looking Assessment of Own Risks—FLAOR.
29.8 Pillar 3: Disclosure and Transparency (SFCR, RSR, QRT) 627

In order to be able to complete the analyses foreseen under ORSA, insurance

undertakings must have defined a number of parameters and have framed the series
of items needed:

• A definition of the level of appetite for risk.

• Risk mapping.
• A definition of the method of calculation of ORSA capital.
• A definition of methods for projecting ORSA capital and semi-year and multi-
year financial statements items.
• A definition of risk indicators suited to monitoring the activities of the insurance
undertaking.

The main structural item of FLAOR is the forward-looking vision of the capital
position of the insurance undertaking, its positioning in terms of Risk Appetite
Framework (RAF) and, as a result, the sustainability or otherwise of the business
actions foreseen. Sensitivity analyses are also utilised in assessing the stability of the
underlying assumptions made in strategic planning.

29.8 Pillar 3: Disclosure and Transparency (SFCR, RSR, QRT)

Insurance undertakings must make disclosure, i.e. to the Regulatory Authorities and
the market through a number of standard documents. The aim, on the one hand, is to
give the regulator the right tools for monitoring the actual state of solvency and
financial stability overall of the insurance undertakings operating in the insurance
industry and, on the other, to allow the public to make proper analyses for evaluating
the actual stability of insurance undertakings. In this area too, the European Directive
broadens and modifies items of disclosure already present in local regulations. It
introduces innovative items such as, for example public disclosure. This is indeed a
great innovation for all those Insurance undertakings that, not being listed, were
under no obligation to provide information publicly concerning their capital position
and financial stability.
The three documents foreseen are:

• Solvency and Financial Condition Report (SFCR).

• Regular Supervisory Reporting (RSR).
• Quantitative Reporting Templates (QRT).

The content, timing and objectives of the documents will now be analysed.
The Solvency and Financial Condition Report (SFCR) is the public document
that, an insurance undertaking must draw up in order to inform the market as to its
financial condition and other aspects of its business. It has to contain information of
both a quantitative and a qualitative kind. The covered issues are the following:
628 29 Solvency of an Insurance Undertaking

• Turnover and type of product in portfolio, with an indication also of sales

performance, return on assets and financial parameters of the insurance
undertaking.
• Governance of the insurance undertaking, with an indication of corporate struc-
ture and roles, and levels of auditing implemented (such as the actuarial function
and internal audit), the capacity to manage risk, any outsourcing of function and
how the interests of assureds are protected.
• Risk profile of the insurance undertaking, with an indication of the level of risk
for each category of risk and relative development over the latest year of
management and the techniques used to meet these risks.
• Assessment criteria for own funds with an indication of the assessment criteria
used for technical reserves and assets.
• Capital management, which is an indication in respect of the criteria for allocating
the items making up own funds, capital required and full details of assessment
criteria and shifts that have occurred in the latest year of management.

The breakdown of the information to be disclosed will be commensurate with the

nature size and complexity of the risks pertaining to the business of the enterprise
concerned. Insurance undertakings must publicly disclose an SFCR, annually, by
publishing it on their website or other information facilities. An insurance or
reinsurance with an insurance investment or a parent insurance company is
authorised to provide a single SFCR at a group level. The recipients of the SFCR
include other insurance and reinsurance undertakings, insurance intermediaries,
category associations, financial analysts, rating agencies, investors, shareholders,
assureds, regulatory authorities and in general all users of the financial market
concerned with these assessments.
The information contained in the Regular Supervisory Reporting (RSR) is
intended for oversight Authorities and includes the same items as are indicated for
the SFCR. These items must be submitted in greater detail, and so are useful to the
regulator in forming a precise idea of each item submitted and sufficient supporting
information must be provided in respect of the choices made and the criteria adopted.
Additionally, the RSR document also contains the forward-looking assessments of
the capital condition and the choices made by the business that was also assessed in
the ORSA. The RSR is a private document sent to the regulatory Authority. This
document too is required on an annual basis.
The Quantitative Reporting Templates (QRT) contain information that is
purely quantitative. All templates must be attached to the RSR and some of them
are also shown in the SFCR. In practice, there are two different sets of QRT; an
annual package containing all the QRT required under regulations and a quarterly
one that instead gives a subset of the annual ones. The quantitative templates for
annual reporting contain all financial and solvency information, plus information on
business such as, for example a list of the main reinsurance counterparties, a list of
investments, strategic equity interests held by the insurance undertaking and the sum
of reserves and premiums, split by line of business underwritten. The quarterly ones,
as mentioned, are a subset of the full ones and focus on magnitudes that determine
References 629

the solvency condition, such as the MCR, the SCR, liabilities, including technical
reserves, premiums and data on assets including equity interests and own funds.
In preparing the duties relating to transparency, both vis-à-vis the market and the
supervisory body, lawmakers have adopted an approach that aims to coordinate
between the Solvency II directive and new accounting standards IFRS, so that is it
not necessary for an insurance undertaking to prepare dual accounting, one for the
oversight Authority and the financial community, and the other for accounting
purposes.

29.9 Questions

1. Explain the solvency ratio

2. What is it the FLAOR?
3. How many Tiers have been classified?
4. Illustrate the annual evaluation ORSA
5. What is it a Quantitative Report Template?

References
Dreher M (2015) Treatises on Solvency II. Springer, Cham

Directives and Regulations—Chronological Order

Directive 2009/138/EC of the European parliament and the council dated 25 November 2009 in the
matter of access to carrying on insurance and reinsurance business (Solvency II)
Directive 2002/12/EC of the European Parliament and of the Council of 5 March 2002 amending
Council Directive 79/267/EEC as regards the solvency margin requirements for life assurance
undertakings
Directive 2002/83/EC of the European Parliament and of the Council of 5 November 2002
concerning life assurance
Council Directive 92/96/EEC of 10 November 1992 on the coordination of laws, regulations and
administrative provisions relating to direct life assurance and amending Directives 79/267/EEC
and 90/619/EEC (third life assurance Directive)
Council Directive 92/49/EEC of 18 June 1992 on the coordination of laws, regulations and
administrative provisions relating to direct insurance other than life assurance and amending
Directives 73/239/EEC and 88/357/EEC (third non-life insurance Directive)
Council Directive 90/619/EEC of 8 November 1990 on the coordination of laws, regulations and
administrative provisions relating to direct life assurance, laying down provisions to facilitate
the effective exercise of freedom to provide services and amending Directive 79/267/EEC
First Council Directive 79/267/EEC of 5 March 1979 on the coordination of laws, regulations and
administrative provisions relating to the taking up and pursuit of the business of direct life
assurance
630 29 Solvency of an Insurance Undertaking

First Council Directive 73/239/EEC of 24 July 1973 on the coordination of laws, regulations and
administrative provisions relating to the taking-up and pursuit of the business of direct insurance
other than life assurance
EIOPA-BoS-14/178 EN Guidelines on undertaking-specific parameters, Frankfurt,
2 February 2015
European Commission (2002a) MARKT/2027/01: Solvency II: Presentation of the Proposed Work
European Commission (2002b) Study into the methodologies to assess the overall financial position
of an insurance undertaking from the perspective of prudential supervision
Directive 2002/12/EC and Directive 2002/13/EC, 2002, modifying Directive 73/239/EC and
Directive 79/267/EC respectively for reinforcing the solvency margin of non-life and life
branches

Suggestions for Further Study

Allan B (2002) The Use of Internal Models for Determining Liabilities and Capital Requirements,
in North American Actuarial Journal 6(2):1–10
Artzner P, Delbaen F, Eber JM e Heath D (1999) Coherent Measures of Risk, in Mathematical
Finance 9:203–228
Basel Committee on Banking Supervision (2003) The New Basel Capital Accord – Consultative
Document, Basel, Bank for International Settlements.
Bonsdorff H, Pentikäinen T, Pesonnen M, Rantala J, Ruohonen M (1989) Insurance Solvency and
Financial Strength, Helsinki, Finnish Insurance Training and Publishing Company Ltd.
Canadian Institute of Actuaries (1999) Dynamic Capital Adequacy Testing – Life and Property and
Casualty, Committee on Solvency Standards for Financial Institutions, Canada, June.
Collings S, White G (2001) APRA Risk Margin Analysis, in Institute of Actuaries of Australia (a
cura di), XIIIth General Insurance Seminar, http://www.actuaries.asn.au.
Corlosquet-Habart M, Gehin W, Janssen J, Manca R, (2015) Asset and Liability Management for
Banks and Insurance Companies Print ISBN:9781848218833 Online ISBN:9781119184607
https://doi.org/10.1002/9781119184607, John Wiley & Sons, Inc.
Danielsson J, Embrechts P, Goodhart C, Keating C, Muennich F, Renault O, Shin HS (2001) An
Academic Response to Basel II, Working Paper, London, LSE Financial Markets Group.
Erdélyi OJ, (2016) Twin Peaks for Europe: State-of-the-Art Financial Supervisory Consolidation,
Springer Cham
European Commission (2002b) Study into the Methodologies to Assess the Overall Financial
Position of an Insurance Undertaking from the Perspective of Prudential Supervision.
Feldblum S (1996) NAIC Property/Casualty Insurance Company Risk-Based Capital
Requirements, CASACT; https://www.casact.org/pubs/proceed/proceed96/96297.pdf.
FSA (2003a) Enhanced Capital Requirements and Individual Capital Assessments for Non-Life
Insurers, Consultation Paper CP190, Financial Services Authority, UK, July.
FSA (2003b) Enhanced Capital Requirements and Individual Capital Assessments for Non-Life
Insurers, Consultation Paper CP195, Financial Services Authority, UK, August.
IAA (International Actuarial Association) (2004) A Global Framework for Insurer Solvency
Assessment. A Report by the Insurer Solvency Assessment Working Party, February 18–19,
New Delhi.
KPMG (2002) Study into the methodologies to assess the overall financial position of an insurance
undertaking from the perspective of prudential supervision, European Commission
Kriele M, Wolf J, (2014) Value-Oriented Risk Management of Insurance Companies, Springer
London
Loguinova K, (2019) A Critical Legal Study of the Ideology Behind Solvency II, Springer Cham
Michel A, Matt S (2002) Getting to Grips with Fair Value, presented to The Staple Inn Actuarial
Society on 5 March; www.macs.hw.ac.uk/~andrea/FASS/fairvalue.pdf.
References 631

Müller Group (1997) Report Solvency of insurance undertakings, conference of insurance supervi-
sory authorities of the member states of the European Union Belgium
RBC General Insurance Workgroup (2002) Risk Based Capital Framework for General Insurers in
Singapore, Monetary Authority of Singapore.
Rudolf, M. and Frenkel, M. (2014). From Basel II to Solvency II-Risk Management in the Insurance
Sector{. In Wiley StatsRef: Statistics Reference Online (eds N. Balakrishnan, T. Colton, B.
Everitt, W. Piegorsch, F. Ruggeri and J.L. Teugels). https://doi.org/10.1002/9781118445112.
stat03550
Sharma P (2002) Prudential Supervision of Insurance Undertakings, Conference of Insurance
Supervisory Authorities of the Member States of the European Union.
Starita MG, Malafronte I, (2014) Capital Requirements, Disclosure, and Supervision in the Euro-
pean Insurance Industry, Palgrave Macmillan London
Wilde T (1997) CreditRisk+: A Credit Risk Management Framework, October, Credit Suisse First
Boston; http://www.csfb.com.
Solvency II’s Capital Model
30

Abstract

The aim of this chapter is to provide a practical case for easing the reader to
understand, step by step, the SCR calculation.
The paragraphs begin with a numerical example. A complete financial
statements drawn up with IFRS data is the starting point. In order to allow the
comparison with Solvency II, these statements are adjusted and transformed into
Solvency II’s principles. The deltas are highlighted.
In paragraphs that follow, the value of the SCR is determined via a series of
stress tests applied to the value of financial statements. The reader can learn,
formula by formula, the detailed procedure for the SCR calculation. The approach
is based on the standard formula. A detailed explanation for each type of risk
(market risks, underwriting risk, life risk, non-life risk, health risk, counterparty
risk, aggregation) is provided.

Keywords
Capital Model · Market Value of Assets (MVA) · Market Value of Liabilities
(MVL) · Present Value of Future Profits (PVFP) · Best Estimates of Liabilities
(BEL) · Market Value Balance Sheet (MVBS) · Solvency Capital Requirement
(SCR) · Basic Solvency Capital Requirement (BSCR) · Own Funds (OF) · Basic
Own Funds (BOF) · Market risk · Underwriting risk · Health risk · Default risk

For this chapter, a special acknowledgement goes to Marcello Ottaviani (consulting audit and
appointed actuary).

# Springer Nature Switzerland AG 2024 633

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_30
634 30 Solvency II’s Capital Model

30.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Define the Capital Model’s concept

2. Describe the risk categories for SCR calculation
3. Explain the process for calculation and aggregation of risks
4. Understand a practical case of SCR calculation

30.2 Definition of Capital Model

The capital model represents the method or set of methods adopted in order to
determine the requirements that an undertaking must set aside so as to ensure to a
certain degree of confidence and solvency to meet adverse events. In order to achieve
this, the European regulator, in the same terms as other regulators in the rest of the
world, has defined a series of rules whose parameters have been determined after
having carried out a series of quantitative impact studies over a significant number of
years. The model, and its parameters thus defined, has been set as a Standard
Formula.1 The European authority, EIOPA, has conducted different quantitative
exercises over the years to assess whether the capital safeguards established with
Solvency II were sufficiently robust to survive in extreme situations.2

30.3 Case Study: SCR of an Insurance Group

By way of example financial statements drawn up with IFRS data are presented to
which the adjustments are made so as to transform them into Solvency II values, as
represented in Table 30.1.
The surplus of assets over liabilities3 in the IFRS evaluation is lower than that of
Solvency II. The main reasons for this can be found in a different accounting of
technical reserves, but also of assets, which in this case are at book value
(i.e. purchase value or in any case relating to historic value). These adjustments
may return greater or lesser values depending on market conditions for assets, and

1
In the course of this chapter, the term insurance undertaking will be used to identify both an
insurance and reinsurance undertaking as regulations of reference, Solvency II, refer to these
without distinction.
2
See Quantitative Impact Study 1, March 2006—Quantitative Impact Study 2, January 2007—
Quantitative Impact Study 3, November 2007—Quantitative Impact Study 4, November 2008—
Quantitative Impact Study 5, March 2011.
3
This is an intermediate step to the one needed to determine own funds for Solvency II and IFRS net
equity.
30.3 Case Study: SCR of an Insurance Group 635

Table 30.1 Financial Statements—IFRS vs Solvency II

IFRS value Solvency II value Adjustment

Total assets 10,161.0 10,154.1 -6.9
Total liabilities 9,921.3 9,424.4 -496.9
Excess of assets over liabilities 239.7 729.6 489.9

insurance risk in respect of liabilities. Where there are capital gains, or book values
lower than market ones, adjustments will be plus and so bring about an implied
greater value of assets. This greater implied value will, obviously, have as a
consequence an increase in the value of liabilities to the same extent, but this
increase will be attributable in part to assureds, in the Technical Provisions
(TP) and in part to shareholders in Own Funds (OF) via a calculation of their
respective amounts. It is here pointed out that in the world of Solvency II, the
three amounts cited are governed by an equation, i.e. the formula 30.1.

MVA = PVFP þ BEL = MVL ð30:1Þ

where:

MVA Market Value of Assets

MVL Market Value of Liabilities
PVFP Present Value of Future Profits
BEL Best Estimates of Liabilities
i.e. the market value of assets is equal to that of undertakings given to assureds
(and towards third parties) plus the current value of future profits of shareholders,
when the law governing the valuation of the three items is the same, i.e. that of being
risk neutral.
So, turning to our example, technical reserves of insurance products have been
accounted for in the aggregate in a prudent manner (a condition that depends on local
accounting criteria) and so the adjustment is minus and determines a greater value
for own funds. The value of assets is lower in the aggregate, leading to a reduction
(albeit a slight one) in assets, and so of own funds.4
In this example, it is assumed that there are no further differences between the
surplus of assets over liabilities and own funds and so the value of own funds is
found from the sum of the two foregoing adjustments.
In Tables 30.2 and 30.3, details are shown of the adjustments made to the balance
sheet of the insurance undertaking.
The data that are used here for demonstration purposes imagine an insurance
undertaking that has a business diversified across non-life, life and health. It can be
seen that the adjustments in respect of technical reserves of lines of business are not
always of the same sign and that for health business there is a plus adjustment, i.e. the
IFRS evaluation is not sufficient to represent liabilities in accordance with what is set

4
See Chap. 29 for definition of Market Value Balance Sheet MVBS and how it works.
636 30 Solvency II’s Capital Model

Table 30.2 Balance sheet asset—IFRS vs Solvency II

IFRS
accounts Solvency Valuation
Assets value II value movement
Intangibles 69.4 0.0 69.4
Goodwill 0.0 0.0
Deferred acquisition costs 64.0 -64.0
Intangible assets 0.9 0.0 -0.9
Deferred tax assets 4.5 0.0 -4.5
Pension benefit surplus 0.0 0.0 0.0
Property, plant and equipment held for own use 0.0 0.0 0.0
Investments (other than assets held for index- 5,402.4 5,512.4 110.0
linked and unit-linked funds)
Property (other than for own use) 55.0 55.0 0.0
Participations 350.0 460.0 110.0
Equities 119.0 119.0 0.0
Equities—listed 112.0 112.0 0.0
Equities—unlisted 7.0 7.0 0.0
Bonds 4,840.9 4,840.9 0.0
Government bonds 3,564.4 3,564.4 0.0
Corporate bonds 1,276.5 1,276.5 0.0
Structured notes 0.0 0.0 0.0
Collateralised securities 0.0 0.0 0.0
Investment funds 0.0 0.0 0.0
Derivatives 0.0 0.0 0.0
Deposits other than cash equivalents 0.0 0.0 0.0
Other investments 37.5 37.5 0.0
Assets held for index-linked and unit-linked funds 4,220.0 4,220.0 0.0
Loans and mortgages (except loans on policies) 0.9 0.9 0.0
Loans and mortgages to individuals 0.9 0.9 0.0
Other loans and mortgages 0.0 0.0 0.0
Loans on policies 5.6 5.6 0.0
Reinsurance recoverables from: 144.2 138.7 -5.5
Non-life and health similar to non-life 0.0 0.0 0.0
Non-life excluding health 0.0 0.0 0.0
Health similar to non-life 0.0 0.0 0.0
Life and health similar to life, excluding index- 132.8 127.7 -5.1
linked and unit-linked
Health similar to life 0.0 0.0 0.0
Life excluding health and index-linked and unit- 132.8 127.7 -5.1
linked
Life index-linked and unit-linked 11.4 11.0 -0.4
Deposits to cedants 6.5 6.5 0.0
Insurance and intermediaries receivables 44.3 44.3 0.0
Reinsurance receivables 3.2 3.2 0.0
Receivables (trade, not insurance) 158.0 4.0 -154.0
Own shares 0.0 0.0 0.0
(continued)
30.4 Market Risks 637

Table 30.2 (continued)

IFRS
accounts Solvency Valuation
Assets value II value movement
Amounts due in respect of own fund items or initial 0.0 0.0 0.0
fund called up but not yet paid in
Cash and cash equivalents 33.0 145.0 112.0
Any other assets, not elsewhere shown 80.0 80.0 0.0
Total assets 10,161.0 10,154.1 -6.9

out in the Solvency II balance sheet. The reason is that a sum for Risk Margin shows
up and which in fact increases the value of undertakings given, notwithstanding the
valuations of the technical reserve being lower than that of the IFRS.
The value of the SCR is determined via a series of stress tests applied to the value
of the Basic Own Funds (BOF), which for the sake of simplicity we can assume here
to be the same as the surplus of assets over liabilities. The variation in the BOF
determines the value of the individual SCRs. In coming paragraphs, the procedure
will be illustrated. Starting from the previous Figure 29.2 illustrated in the Chap. 29,
the reader can follow step by step each risk calculation and the final aggregation.
Figure 30.1 reports the cross-reference between each risk and the paragraph
(or table) which, in this chapter, calculates the risk based on the standard formula
foreseen by Solvency II model.

30.4 Market Risks

To determine the value of the SCR relating to market risks, and number of financial
variables are stress tested using parameters issued by EIOPA, the European supervi-
sory body. In particular, EIOPA issues a set of financial disclosure items that
insurance undertakings must use for the purpose of making the relative valuations.
The information needed is as follows, differentiated by country:

• Term structure of risk-free rates of interest.

• Volatility adjustment, i.e. an adjustment made to the structure of interest rates to
allow insurance undertakings to reduce volatility in prices of securities via a
pro-cyclical role.
• Ultimate Forward rate, i.e. the value of the rate of return over the awfully long
term, and towards which the structure of interest rates must converge in
valuations that are for a duration longer than the one for interest rates available
in a liquid manner in own market of reference.

From this information and using the parameters defined by regulations, capital
requirements of the sub-modules of market risk can be calculated: i.e. interest,
equity, property, spread, currency and concentration.
638 30 Solvency II’s Capital Model

Table 30.3 Balance sheet liabilities—IFRS vs Solvency II

IFRS
accounts Solvency Valuation
Liabilities value II value movement
Gross technical provisions—non-life (excluding 205.0 197.4 -7.6
health)
TP calculated as a whole 0.0
Best estimate 192.0
Risk margin 5.4
Gross technical provisions—health (similar to 56.0 59.5 3.5
non-life)
TP calculated as a whole 0.0
Best estimate 55.0
Risk margin 4.5
Gross technical provisions—health (similar to 0.0 0.0 0.0
life)
TP calculated as a whole 0.0
Best estimate 0.0
Risk margin 0.0
Gross technical provisions—life (excluding 5,154.6 4,709.5 -445.1
health and index-linked and unit-linked)
TP calculated as a whole 0.0
Best estimate 4,694.3
Risk margin 15.2
Gross technical provisions—index-linked and 4,383.1 4,212.6 -170.5
unit-linked
TP calculated as a whole 0.0
Best estimate 4,199.7
Risk margin 12.9
Other technical provisions 0.0 0.0 0.0
Contingent liabilities 0.0 0.0 0.0
Provisions other than technical provisions 6.0 6.0 0.0
Pension benefit obligations 3.0 3.0 0.0
Deposits from reinsurers 50.6 50.6 0.0
Deferred tax liabilities 0.0 125.1 125.1
Derivatives 0.0 0.0 0.0
Debts owed to credit institutions 0.0 0.0 0.0
Financial liabilities other than debts owed to credit 0.0 0.0 0.0
institutions
Insurance and intermediaries payables 10.4 10.4 0.0
Reinsurance payables 11.8 11.8 0.0
Payables (trade, not insurance) 0.0 0.0 0.0
Subordinated liabilities not in BOF 0.0 0.0 0.0
Subordinated liabilities in BOF 0.0 0.0 0.0
Any other liabilities, not elsewhere shown 40.8 38.5 -2.3
Total liabilities 9,921.3 9,424.4 -496.9
Excess of assets over liabilities 239.7 729.6 489.9
30.4 Market Risks 639

SCR

Adj BSCR OP

Market Health Default Life Non-life Intang

Interest SLT Non-SLT Premium

CAT Mortality
rate health health reserve

Premium Longevi-
Equity Mortality Lapse
reserve ty

Longevi- Disability
Property Lapse CAT
ty Morbidity

Disability
Spread Lapse
Morbidity

Currency Lapse Expenses

Concen-
Expenses Revision
tration

Revision CAT

Required intervention of = included in the adjustment for the loss absorbing capacity of
the actuarial function technical provisions under the modular approach

Fig. 30.1 Methodological references for the SCR calculation according to the standard Solvency II
formula
Source: adaption from EIOPA, The underlying assumptions in the standard formula for the
Solvency Capital Requirement calculation (EIOPA-14-322)

The interest risk (IR) is evaluated through recalculating financial statements

entirely, and thus the Basic Own Funds (BOF) before and after changes in financial
assumptions. The value of interest rates impacts upon a number of items in financial
statements, both assets and liabilities, and so any variation in the assumption leads to
the BOF value depending on the weight and sign of these variations. Additionally, in
life insurance undertakings, as technical reserves are calculated in a prospective
fashion, to any variation in the prices of assets there will follow a variation also in
their prospective return and so there will be a further element of variation given by
the impact that future returns have on cash flows that will be for payment to assureds.
Regulations foresee that two stress tests be carried out, with stress assumptions
interest rates increasing (IR UP), and of interest rates reducing (IR DOWN). The greatest
unfavourable impact on BOF is to be taken as the capital requirement for this risk.
In Table 30.4, data are shown for the two stress tests on the Basic Own Funds (BOF).
640 30 Solvency II’s Capital Model

Table 30.4 Two stress tests (IR Up and IR Down) on BOF

Base IR UP Delta IR DWN Delta

Total assets 10,154.1 9834.1 -319.9 10,496.5 342.5
Total liabilities 9,424.4 9,284.6 -139.9 9,568.4 143.9
Excess of assets over liabilities 729.6 549.6 -180.0 928.1 198.5

Table 30.5 Two stress tests (IR Up and IR Down) on TP

IR
Gross TP—Technical Provisions Base IR UP Delta DWN Delta
Non-life (excluding health) 197.4 192.4 -5.0 202.6 5.2
Health (similar to non-life) 59.5 58.4 -1.1 60.6 1.1
Health (similar to life) 0.0 0.0 0.0 0.0 0.0
Life (excluding health and index-linked and 4,709.5 4,577.2 -132.3 4,900.1 190.6
unit-linked)
Index-linked and unit-linked 4,212.6 4,212.6 0.0 4,212.6 0.0

It can be seen that the insurance undertaking is subject to a risk of rising interest
rates, i.e. as financial assumptions increase, the BOFs reduce a value by 180 approx.
In particular, both assets and liabilities show a reduction of the same sign. In
particular, both assets and liabilities have a reduction of the same sign. In the
event that, in life business, there is a greater reduction in the assets covered, the
insurance undertaking is able to reduce its commitments to assureds. This is possi-
ble, thanks to the contract clauses, which allow insurance undertaking to transfer part
of losses suffered to the assured, giving a lower return to the policy holder/assured.5
In Table 30.5, data are shown for the two stress tests on the Technical Provisions.
Analysing the values of technical reserves by line of business, the following
phenomena can be noted: non-life business shows a trend that is symmetrical in the
two scenarios since there are no guarantees given to assureds and so, as the financial
assumption varies symmetrically, the value of the technical reserve varies symmet-
rically. The value of the reserve of the life business, not of index-linked type, takes
on a value that is asymmetric as compared to stress test scenarios since the presence
of guarantees of a minimum towards assureds imposes that even in conditions of
lower return on assets, the insurance undertaking, in any case, gives a return. In cases
of a lowering in interest rate, therefore, future returns will be lower than the base case
but the insurance undertaking must guarantee the minimum level foreseen under its
contracts. Linked products do not contain securities tied to an interest rate and so no
variation in value takes place.
For the equity risk (in addition to other market risks, except that of concentra-
tion) the system is exactly the same, the sole difference being that the interest rate
also affects upon the valuation of liabilities directly (via actualising of cash flows)

5
For life insurance products that have guaranteed profit sharing clauses, see chapter 8.
30.4 Market Risks 641

Table 30.6 Results of stress tests on the equity area

Equity risk Base Equity Delta

Total assets 10,154.1 9,792.7 -361.4
Total liabilities 9,424.4 9,084.1 -340.3
Excess of assets over liabilities 729.6 708.5 -21.1
Life (excluding health and index-linked and unit-linked) 4,709.5 4,700.1 -9.4
Index-linked and unit-linked 4,212.6 3,881.7 -330.9

whereas this does not happen for other market risks. In Table 30.6, there are the
results of stress tests on the equity area.
The effect on equity area is much more limited than the interest rate risk one.
Indeed, although the interest rate risk has an offsetting effect between actualising assets
and that on liabilities, in our example, asset allocation is extremely unbalanced towards
the bond area while the equity risks are extremely limited. Therefore, a reduction of
more than 360 in assets matches a reduction of only 340, thus bringing about a loss/
negative delta of around 21. If linked business is analysed, and which is made up 100%
by share securities, it can be seen that the relative liabilities reduce almost proportion-
ally, or rather by a little less than the total variation of the related hedging assets. The
reason for this is to be found in the fact that although assets and liabilities express the
same value, the relative Best Estimate (BE) takes into account future profits (see
formula [30.1]). So, a reduction in assets also reduces the value of future profits,
which in formula [30.1] appears with a minus sign. Thus, the relative Best Estimate
(BE) reserve will reduce by less than assets so as to consider the lower profit that the
insurance undertaking expects to receive. The reduction in profits occurs as manage-
ment commissions are percentages and so proportional to the value of assets. The
component tied to securities not of linked type are in a minority but do in any case have
a reduction due to the lower value of assets, which leads to a lower prospective return.
Table 30.7 summarises the following risks: property, spread and currency.
The economic effect from stress testing on these risks is proportional to their
actual presence in the portfolio of the insurance undertaking. In the specific case,

Table 30.7 Results of stress tests on property, spread and currency area

Property risk Base Property Delta

Total assets 10,154.1 10,130.6 -16.5
Total liabilities 9,424.4 9,417.9 -6.6
Excess of assets over liabilities 729.6 719.7 -9.9
Spread risk Base Spread Delta
Total assets 10,154.1 9,898.8 -255.3
Total liabilities 9,424.4 9,236.7 -187.8
Excess of assets over liabilities 729.6 662.1 -67.5
Currency risk Base Currency Delta
Total assets 10,154.1 10,129.1 -25.0
Total liabilities 9,424.4 9,403.3 -21.1
Excess of assets over liabilities 729.6 725.8 -3.8
642 30 Solvency II’s Capital Model

there is a limited presence of real estate (property risk), an even more limited
presence of securities in foreign currency (currency risk). The only significant
effect is in the corporate bond sector (spread risk).6
The concentration sub-module expresses the concentration risk to exposure of
the portfolio of assets to the risk of default by issuers of debt securities, taking into
account therefore how much of an individual issuer is held, also through different
financial instruments. The securities counted here must of necessity be different from
those considered in counter-party risk7 so as to avoid double counting of the risk. In
summary, once all issuers, and the percentages of exposure of the portfolio have
been identified along with their relative rating via a fitting calculation, the sum of the
Solvency Capital Requirement.
SCR: Concentration risk value = 7.0.

30.5 Underwriting Risk

Technical risks (i.e. those relating to the issuing of insurance products and the
management of technical reserves), are considered within the so-called underwriting
risk. These risks are different depending on the line of business, life, Non-life and
Health Non-SLT.

30.5.1 Life Risks

The risk of the life business is as follows: mortality, longevity, surrender, expenses,
revision of contracts and catastrophe. Differently from market risks, in respect of
underwriting risks, assets are not changed since stress tests are foreseen only on the
value of liabilities and so the variation in Basic Own Funds—BOF is measured by
variation in liabilities alone.
For each risk, regulations foresee a stress test of assumptions so as to measure
variation, always adverse, in the value of the BOFs. Indeed, the assumptions and
items that are the subject matter of stress tests are identified so that the effect of
scenarios will generate a loss for the insurance undertaking.
In respect of the surrender risk, for example regulations foresee that a valuation
must be made at the individual contract level if they are subject to a risk of increase
or reduction in surrender. Following the same reasoning as applied to Linked
products above, a contract producing an expected profit for the firm should be
considered. If this contract were to reduce its time spent in portfolio due to an
increase in surrender percentage, the expected profit, which is a part complementary

6
Note that the results of the stress test are consistent with what can be observed in the financial
statements reported in the paragraph with the basic data (the securities in foreign currency cannot be
identified).
7
For counterparty risk, please read the following section.
30.5 Underwriting Risk 643

to the value of assets in the Best Estimate Liabilities (BEL) valuation (according to
formula [30.1]), would reduce, producing an increase in the Best Estimate Liabilities
(BEL) and so a reduction in BOFs (i.e. an increase in the number of contracts for
which a reduction in expected-for profit is foreseen). So, in respect of this contract
the risk of surrender is an increase in this assumption. On the other side, if there is a
contract generating expected losses, the fact that the likelihood of surrender reduces
increases expected losses and so also the value of the BELs and a consequent
reduction in the BOFs. In this latter case, the risk is one of a reduction in surrender
assumptions. Matters become more complicated when there are penalties to be
applied to early redemption, which there are in certain saving products. In these
cases, as the relative assumption increases so does expected profit, due to an increase
in the value of the penalties, which offsets the lower profits earned due to the lower
mass managed. A univocal manner for determining the risk to which insurance
contracts are subject is to carry out simulations to effectively measure the cases in
which, and at what levels of stress, these contracts are found to be subject to the risk
of reduction or increase in surrender assumptions.
In case of surrender risk, the SCR is determined as the value either of three
stress tests: one of decreasing the surrender hypothesis, one of increasing the
surrender hypothesis, and the last of a mass surrender scenario. The difference
between the three scenarios is that in the first two, the surrender assumption is
modified in parallel according to a set of pre-defined stress parameters, whereas in
the third case, stress is verified massively in the first year of cash flow projection. In
Table 30.8, there are the numbers relative to the example.
The dominant risk is that of an increase in surrenders, a sign that the portfolio of
the insurance undertaking is profitable. Analysing the lines of business, it can be
noted that both linked products and traditional ones are subject to the risk of increase
in surrender risk. This phenomenon can be interpreted as a sign of good contract
duration. Indeed, in order to surmount the impact of mass surrenders there must be a
parallel movement in the base surrender curve that is long enough to be able to offset
the mass in exits that occur in a single year, but with a more significant effect.

Table 30.8 Results stress tests for surrender (three scenarios)

Lapse Lapse Lapse

Base Up Delta Down Delta Mass Delta
Total assets 10,154.1 10,154.1 0.0 10,154.1 0.0 10,154.1 0.0
Total liabilities 9,424.4 9,830.6 406.2 9,560.3 135.9 9,735.2 310.8
Excess of assets 729.6 323.5 -406.2 593.7 -135.9 418.8 -310.8
over liabilities
Life (excluding 4,709.5 4,897.2 187.8 4,803.4 93.9 4,869.1 159.6
health and index-
linked and unit-
linked)
Index-linked and 4,212.6 4,431.0 218.4 4,254.6 42.0 4,363.8 151.2
unit-linked
644 30 Solvency II’s Capital Model

Similar reasoning is followed to determine whether a contract is subject to the risk

of longevity or that of mortality. Products that are subject to the longevity risk are
those tied to survival of assureds: annuities, deferred capital products and life-
provision products are the main ones, whereas those tied to mortality risk are
term-life and investment products in general that contain a guarantee or a cover for
the event of death. In Table 30.9 SCRs calculated for the two risks of mortality and
longevity are shown.
Mortality risk affects both contracts of traditional life business and those of
linked-financial life business whereas longevity risk impacts solely, and marginally,
products of a traditional type, in the example shown.
Risk of expenses, revision of contracts follows the same approach as has been
seen for other life risks, i.e. through an increase in the expense assumptions foreseen
by the insurance undertaking in years of projection of cash flows. In Table 30.10 the
value determining the SCR are set out.
Catastrophe risk for life business is represented by mortality, i.e. by a mortality
event that can be considered a catastrophe, a pandemic or a nuclear explosion for
example. This scenario is determined by the same standard as the one for mass
surrender, i.e. via a raising of the assumption of significant mortality during the first
year of projection. Insurance undertakings exposed to mortality risk may attain
significant levels of loss associated with this risk. The insurance undertaking in the
example has a level of SCR that is fairly high, which is a sign that it is exposed to
mortality risk to a significant extent. This situation is usually generated by the

Table 30.9 SCR calculated for the two risks of mortality and longevity

Base Mortality Delta

Total assets 10,154.1 10,154.1 0.0
Total liabilities 9,424.4 9,510.2 85.7
Excess of assets over liabilities 729.6 643.9 -85.7
Life (excluding health and index-linked and unit-linked) 4,709.5 4,765.8 56.3
Index-linked and unit-linked 4,212.6 4,242.0 29.4
Base Longevity Delta
Total assets 10,154.1 10,154.1 0.0
Total liabilities 9,424.4 9,452.6 28.2
Excess of assets over liabilities 729.6 701.5 -28.2
Life (excluding health and index-linked and unit-linked) 4,709.5 4,730.6 28.2

Table 30.10 SCR calculated based on assumptions of expense increasing

Base Expenses Delta

Total assets 10,154.1 10,154.1 0.0
Total liabilities 9,424.4 9,518.6 94.1
Excess of assets over liabilities 729.6 635.5 -94.1
Life (excluding health and index-linked and unit-linked) 4,709.5 4,765.8 56.3
Index-linked and unit-linked 4,212.6 4,250.4 30.8
30.5 Underwriting Risk 645

Table 30.11 SCR calculated based on assumptions of catastrophe life risk

Base Cat Delta

Total assets 10,154.1 10,154.1 0.0
Total liabilities 9,424.4 9,573.9 149.5
Excess of assets over liabilities 729.6 580.2 -149.5
Life (excluding health and index-linked and unit-linked) 4,709.5 4,812.7 103.3
Index-linked and unit-linked 4,212.6 4,258.8 46.2

presence of contracts of insurance of a term type for decease or protection of the

capital of assureds generally. Table 30.11 represents the SCR of catastrophe life risk.

30.5.2 Non-Life Risks

Calculating the capital requirement in the non-life business is achieved through an

approach that is fundamentally different but is of the same conceptual kind as the
stress tests for the life business, i.e. determining the value of liabilities in a scenario
in which fundamental variables are subjected to stress. The risks are as follows:
underwriting, surrender and catastrophe.
The underwriting risk consists of two sub-risks that are the premium risk and
reserve risk, which are an incapacity on the part of an insurance undertaking to
succeed in repaying loss events that have been generated by contracts issued or to be
issued. For each line of business, volumes are found represented by premiums
acquired in the latest year, plus those to be acquired in future years on contracts
already acquired, plus loss reserves as at the valuation date. This sum is multiplied
by a factor depending on volatility (or variability in the lines of business and by
another coefficient of 3 (both set under regulations). This formula represents the
concept of variability in the business, i.e. the value of capital required to issue
premiums and value of capital required for the relative loss reserve. The volatility
around the value of exposure to risk is set out in Figure 30.2.
If an insurance undertaking has various lines of business, in calculating the
aggregate capital requirement the method of aggregation by matrices of correlation

Fig. 30.2 Volatility impact

+3s

-3s

Value of the measure of

volume
646 30 Solvency II’s Capital Model

Table 30.12 SCR based on volatility for each Line of Business/underwriting risk

Volume
Volume reserves σ
LoB Lines of business premiums (BE) (LoB) σ SCR
4 Motor, third-party liability 122.9 96.0 7.3% 39.9
5 Motor, other classes 17.6 13.4 6.9% 5.7
6 MAT (Marine, aviation and transport) 4.9 3.8 11.6% 1.6
7 Fire and other damage to property 32.4 25.0 6.9% 10.5
8 Third-party liability 24.2 19.2 9.6% 6.1% 7.9
9 Credit and surety 17.6 13.4 13.0% 5.7
10 Legal expenses 12.3 9.6 8.0% 4.0
11 Assistance 4.9 3.8 12.1% 1.6
12 Miscellaneous non-life insurance 9.7 7.7 14.0% 3.2
Total 80.0

is adopted and which were set out above. Aggregation is done on measures of
volatility; essentially, volatilities are aggregated on the basis of a specific formula
derived from the method described above, thus obtaining a value for volatility
which, when multiplied by the sum of measures of exposure, returns the capital
required for this risk. Table 30.12 reported a summary of the calculations above
described.
The surrender risk is found via increase/decrease in the basic assumptions used
for determining Best Estimate (BE) reserves. As for life risks, the variation in
technical reserves depends on the conditions of the contract/insurance product and
so for each contract or group of these, the risks they are exposed to must be identified
(by way of reduction or increase in the basic assumption). Once this analysis has
been made, calculating the two scenarios and determining the aggregate requirement
is done. See Table 30.13.
Catastrophe risks in the non-life business have been foreseen in current
regulations via a formula that is much more detailed than that adopted for other
risks. In particular, it foresees scenarios based on 4 classes of catastrophe risk to
which insurance undertakings are exposed. These are:

1. Risks of natural events.

2. A sub-module of natural event risks where there is non-proportional reinsurance.
3. Risks of events caused by Man.
4. Sub-module relative to other events caused by Man.

In respect of natural events, the following catastrophe events are foreseen:

• Windstorm.
• Earthquake.
• Flood.
• Hail.
• Subsidence.
30.5 Underwriting Risk 647

Table 30.13 SCR calculated on two scenarios of Best Estimate/lapse risk

Delta Delta
Reserves Lapse Lapse
LoB Lines of business (BE) up Down SCR
4 Motor, third-party liability 96.0 4.4
5 Motor, other classes 13.4 1.7
6 MAT (Marine, aviation and transport) 3.8 0.4
7 Fire and other damage to property 25.0 3.4
8 Third-party liability 19.2 3.8 18.5
9 Credit and surety 13.4 0.6
10 Legal expenses 9.6 2.3
11 Assistance 3.8 0.6
12 Miscellaneous non-life insurance 7.7 1.3
Please remember that Solvency II regulations require 12 LoB. The LoBs from numbers 1–3 are not
useful in the example presented. For description of LoBs, see Chap. 29

In respect of each of these, an insurance undertaking must determine a loss taking

into account the exposure of its risks on the basis of a specific natural event. The
event is imagined as taking place in any region of Europe, to which, however, a
correlation is associated so that the events do not take place simultaneously,
according to the same view as applies in aggregating risks represented above.
Once the requirements have been determined for each natural event risk, these are
in their turn aggregated according to a matrix of correlation, thus obtaining the
requirement for the first of four modules of Catastrophe risks. Table 30.14 reported a
summary of the 5 risks of the first module with detail for 4 European countries (IT—
Italy; AT—Austria; CH—Switzerland; DE—Germany).
The SCR of the first module is obtained as the square root of the sum of individual
values from the five scenarios just described and calculated. This method is the same
as assuming a correlation of zero, i.e. an absence of correlation between the risks.
The second module concerns insurance undertakings that have non-proportional
reinsurance exclusively. This module, or sub-module as it is defined in regulations,
foresees an instantaneous loss of a value that depends on the sum of premiums ceded
for the related non-proportional cover, and a sum that is based on pre-set parameters
in addition to the surrender risk in the non-life module. The insurance undertaking in
the example does not display this type of contract and so its SCR amounts to zero.
The third module concerns catastrophe scenarios caused by man, which follow
the same logic as seen for natural events. In particular, these are:

• Motor.
• Fire.
• Marine.
• Aviation.
• Civil liability.
• Credit and suretyship.
648 30 Solvency II’s Capital Model

Table 30.14 Impact from the 5 catastrophe events

Reserves
Windstorm BE IT AT CH DE
4. Motor, third-party liability 96
5. Motor, other classes 13.44 0.4704 0.8064 1.6128
6. MAT (Marine, aviation and 3.84 0.1344 0.2304 0.4608
transport)
7. Fire and other damage to property 24.96 0.8736 1.4976 2.9952
8. Third-party liability 19.2 0.672 1.152 2.304
9. Credit and surety 13.44 0.4704 0.8064 1.6128
10. Legal expenses 9.6 0 0 0
11. Assistance 3.84 0 0 0
12. Miscellaneous non-life insurance 7.68 0.2688 0.4608 0.9216
Coeff. 3.50% 6.00% 12.00%
Total 192 2.89 4.95 9.91
Windstorm area Coeff. LOSS SCR
Italy—IT 0 0
Austria—AT 0.008 0.02
Switzerland—CH 0.008 0.04 0.15
Germany—DE 0.009 0.09

Reserves
Earthquake BE IT AT CH DE
4. Motor, third-party liability 96 75.36 3.36 5.76 11.52
5. Motor, other classes 13.44 10.5504 0.4704 0.8064 1.6128
6. MAT (Marine, aviation and 3.84 3.0144 0.1344 0.2304 0.4608
transport)
7. Fire and other damage to property 24.96 19.5936 0.8736 1.4976 2.9952
8. Third-party liability 19.2 15.072 0.672 1.152 2.304
9. Credit and surety 13.44 10.5504 0.4704 0.8064 1.6128
10. Legal expenses 9.6 0 0 0 0
11. Assistance 3.84 0 0 0 0
12. Miscellaneous non-life insurance 7.68 6.0288 0.2688 0.4608 0.9216
Coeff. 78.50% 3.50% 6.00% 12.00%
Total 192 140.17 6.25 10.71 21.43
Earthquake area Coeff. LOSS SCR
Italy—IT 0.80 0.70
Austria—AT 0.10 0.00
Switzerland—CH 0.25 0.02 0.74
Germany—DE 0.10 0.01

Reserves
Flood BE IT AT CH DE
4. Motor, third-party liability 96 75.36 3.36 5.76 11.52
5. Motor, other classes 13.44 10.5504 0.4704 0.8064 1.6128
6. MAT (Marine, aviation and 3.84 3.0144 0.1344 0.2304 0.4608
transport)
7. Fire and other damage to property 24.96 19.5936 0.8736 1.4976 2.9952
(continued)
30.5 Underwriting Risk 649

Table 30.14 (continued)

Reserves
Flood BE IT AT CH DE
8. Third-party liability 19.2 15.072 0.672 1.152 2.304
9. Credit and surety 13.44 10.5504 0.4704 0.8064 1.6128
10. Legal expenses 9.6 0 0 0 0
11. Assistance 3.84 3.0144 0.1344 0.2304 0.4608
12. Miscellaneous non-life insurance 7.68 6.0288 0.2688 0.4608 0.9216
Coeff. 78.50% 3.50% 6.00% 12.00%
Total 192 143.18 6.38 10.94 21.89
Flood area Coeff. LOSS SCR
Italy—IT 0.10 0.14
Austria—AT 0.13 0.02
Switzerland—CH 0.15 0.04 0.25
Germany—DE 0.20 0.05

Reserves
HAIL BE IT AT CH DE
4. Motor, third-party liability 96 75.36 3.36 5.76 11.52
5. Motor, other classes 13.44 10.5504 0.4704 0.8064 1.6128
6. MAT (Marine, aviation and 3.84 3.0144 0.1344 0.2304 0.4608
transport)
7. Fire and other damage to property 24.96 19.5936 0.8736 1.4976 2.9952
8. Third-party liability 19.2 15.072 0.672 1.152 2.304
9. Credit and surety 13.44 10.5504 0.4704 0.8064 1.6128
10. Legal expenses 9.6 0 0 0 0
10. Assistance 3.84 3.0144 0.1344 0.2304 0.4608
11. Miscellaneous non-life insurance 7.68 6.0288 0.2688 0.4608 0.9216
Coeff. 78.50% 3.50% 6.00% 12.00%
Total 192 143.18 6.38 10.94 21.89
Hail area Coeff. LOSS SCR
Italy—IT 0.05 0.07
Austria—AT 0.08 0.01
Switzerland—CH 0.06 0.01 0.09
Germany—DE 0.02 0.00

Reserves
Subsidence BE IT AT CH DE
4. Motor, third-party liability 96 75.36 3.36 5.76 11.52
5. Motor, other classes 13.44 10.5504 0.4704 0.8064 1.6128
6. MAT (Marine, aviation and 3.84 3.0144 0.1344 0.2304 0.4608
transport)
7. Fire and other damage to property 24.96 19.5936 0.8736 1.4976 2.9952
8. Third-party liability 19.2 15.072 0.672 1.152 2.304
9. Credit and surety 13.44 10.5504 0.4704 0.8064 1.6128
10. Legal expenses 9.6 0 0 0 0
11. Assistance 3.84 3.0144 0.1344 0.2304 0.4608
(continued)
650 30 Solvency II’s Capital Model

Table 30.14 (continued)

Reserves
Subsidence BE IT AT CH DE
12. Miscellaneous non-life insurance 7.68 6.0288 0.2688 0.4608 0.9216
Coeff. 78.50% 3.50% 6.00% 12.00%
Total 192 143.18 6.38 10.94 21.89
Subsidence area Coeff. LOSS SCR
Italy—IT 0.05 0.07
Austria—AT 0.05 0.00
Switzerland—CH 0.05 0.01 0.09
Germany—DE 0.05 0.01

Please remember that Solvency II regulations require 12 LoB. The LoBs from numbers 1–3 are not
useful in the example presented. For description of LoBs, see Chap. 29

Insurance undertakings must calculate the SCR for each of the foregoing
scenarios according to the following outline. For motor risk, an instantaneous loss
is foreseen of the number of automobiles that display characteristics of limits of
indemnity in excess of (i.e. number above) and below (i.e. number below) a certain
sum. Based on these numbers and a formula that includes specific parameters, the
sum of this loss is found. See Table 30.15 for an example of SCR calculated for
motor risk.
The same approach is used for the fire risk, i.e. an instantaneous loss from fire in
the building where the maximum sum in terms of exposure lies. See Table 30.16 for
an example of the SCR calculated for fire risk.
For marine risks, the sum of exposure to risk for pollution by oil tankers and
breach of the hull and other risks such as recovery of the wreck, loss of earnings and
sinking is used. The second type of risk is simulated, i.e. an explosion on an oil rig
and the relative exposures are calculated consistently. The relative instantaneous
losses of the two risks are identified via specific parameters and then aggregated in
accordance with what is laid down for aggregation in the absence of correlation. See
Table 30.17 for an example of the SCR calculated for Marine risk.

Table 30.15 SCR calculated for motor risk

Motor Number of cars SCR
Number above 30,729.83
Number below 2,688.00 9.14

Table 30.16 SCR calculated for fire risk

Fire Amount of loss SCR
Building 8.9 8.9
30.5 Underwriting Risk 651

Table 30.17 SCR calculated for Marine risk

Marine Type of loss SCR
Loss of tanker 0.90
Loss of plant 1.25 1.54

Table 30.18 SCR calculated for Aviation risk

Aviation Amount of loss SCR
Aircraft 1.89 1.89

Aviation risk is determined as the loss of one aircraft, the one with the maximum
sum in terms of exposure. See Table 30.18 for an example of the SCR calculated for
aviation risk.
The catastrophe risk in the civil liability line of business is split by type of
insurance cover and areas of business, which are: professional liability, employers
liability, Directors and Officers liability, other forms of civil liability and
non-proportional reinsurance of the foregoing risks. Regulations foresee a level of
stress test (called Loss Factor coefficient) for each category to be applied to premiums
to be collected in the next 12 months. The results of losses generated from these risks
are aggregated via a matrix of correlation. In Table 30.19 there are the results.
The capital to be calculated for the risks in credit and surety line of business is
determined via two events, one of default and one of recession, relative to the credit
institutions for which the maximum exposure is held, and which generate an
instantaneous loss for the insurance undertaking. The scenarios are then aggregated
according to an assumption of non-correlation between the two events. See
Table 30.20 for an example of SCR calculated for credit and surety risk.

Table 30.19 SCR calculated for liability risk

Future Loss
Liability premiums factor Loss SCR
Professional malpractice liability insurance 17.68 25% 7.27
obligations
Employers liability insurance obligations 2.54 40% 11.63
13.53
Directors and officers insurance obligations 0.71 5% 1.45
Personal liability insurance obligations 4.66 30% 8.72
Non-proportional reinsurance 3.49 0% 0.00

Table 30.20 SCR calculated for credit and surety risk

Credit and surety Loss SCR
Probability of default (PD) 3.49
Probability of recession (PR) 0.75 3.57
652 30 Solvency II’s Capital Model

Table 30.21 SCR calculated for other non-life Catastrophe risks

Non- Risk
Other non-life Catastrophe risks proportional factor SCR
MATa 0.20 1.00
MAT Non-proportional reinsurance 0.00 2.50
Miscellaneous financial loss 0.12 0.40
Miscellaneous financial loss Non-proportional 0.00 2.50 0.21
reinsurance
Credit and surety Non-proportional reinsurance 0.00 2.50
a
The acronym MAT refers to the line of business made up by motor, aviation and transport.

The last of the four modules, the co-called sub-module of other catastrophe risks
for non-life is identified by a scenario linking 5 events, again referring to the same
lines of business as above already subjected to stress tests. In particular, this
sub-module stresses a number of risks not directly covered by the other scenarios
just described. The impact of the scenario is calculated via the volume of premiums
that are expected over the next 12 months for a pre-set level of stress. Table 30.21
reports the results of SCR calculated for other non-life Catastrophe risks.
The 4 catastrophe risk modules are then aggregated according to a formula for
aggregation taking a correlation of zero for events.

30.5.3 Health Non-SLT Underwriting Risks

The insurance undertaking in our example has underwritten a significant amount of

premiums in the health sector (classified in the non-life business).8 Regulations
foresee health business being dealt by the same standard as life and non-life
business. In particular, for health businesses underwritten with life techniques,
which is missing in our example, similar stress tests are performed as are foreseen
for life risks and will not be dealt with further here.
For risks tied to health business with non-life techniques, a calculation of
requirements tied to underwriting is foreseen, plus one of surrenders, by the same
standard as the approach in the non-life business indeed, whereas in reality the
catastrophe risk is dealt with separately and follows a viewpoint that is slightly
different from that of the non-life business.
The classes in the underwriting risk module are 4 in number, being the follow-
ing: medical expenses, income protection, accidents at work and non-proportional
reinsurance solely on the health line of business. The second class indicates risks tied
to illness and accidents due to which a worker is no longer able to work and so earn

8
Remember the distinction of health products between those classified in the life business and those
classified in the non-life business.
30.5 Underwriting Risk 653

Table 30.22 SCR calculated for underwriting risks

Volume Volume reserves σ

Line of business premiums (BE) (LoB) σ SCR
Medical expenses 20.3 14.6 5.0% 6.4
Income protection 50.3 40.4 8.5% 6.2% 16.8
Workers compensation 0.0 0.0 0.0% 0.0
Non-proportional 0.0 0.0 0.0% 0.0
reinsurance
Total 23.2

Table 30.23 SCR based on two scenarios (lapse down and lapse up)

Line of business Reserves BE Delta lapse up Delta lapse down SCR

Medical expenses 14.6 0.4
Income protection 40.4 3.7 4.1
Workers compensation 0.0 0.0
Non-proportional reinsurance 0.0 0.0

an income. The third covers only risks of accidents at work. See Table 30.22 which
represents SCR calculated for underwriting risks.
The risk of surrender follows the same set-up as non-life lines of business,
i.e. determining the risks that each Line of Business (LOB) is exposed to as shown in
Table 30.23.
The catastrophe risk in the health line of business is also of a certain complexity
and works over three macro scenarios: mass incident, a concentration scenario and a
pandemic.
The first covers the risk of having a certain mass of persons together in a single
place where a catastrophe event generates accidents to those present. The value of
the capital requirement is calculated as the product of the maximum exposure for
each State where there are risks of this kind and a pre-set stress test amount for each
source of risk (death, permanent total disablement etc.). the result of this scenario is
reported in Table 30.24.
The concentration risk is based on the fact that, for example many people work
in the same districts or managerial centres and a catastrophe event occurs in the
region bringing about accidents to persons. The approach taken is the same as for the
foregoing scenarios. It can be seen that the stress level is the same between the two

Table 30.24 SCR based on Mass Accident for health line of business

Mass accident Level of stress Exposure SCR by country SCR

Italy—IT 0.10 43,175 2.2
Austria—AT 0.02 1,925 0.0 3.36
Switzerland—CH 0.05 3,300 0.1
Germany—DE 0.13 6,600 2.6
654 30 Solvency II’s Capital Model

Table 30.25 SCR based on Concentration for health line of business

Concentration Level of stress Exposure SCR by country SCR

Italy—IT 0.10 50,765 2.8
Austria—AT 0.02 825 0.0 2.88
Switzerland—CH 0.05 2,310 0.4
Germany—DE 0.13 1,100 0.3

Table 30.26 SCR based on Pandemic for health line of business

Pandemic Impact scenario Exposure SCR by country SCR

Italy—IT 1.8 1.5
Austria—AT 0.8 0.3 1.56
Switzerland—CH 3.11 0.3 0.1
Germany—DE 0.2 0.1

scenarios, the amount of risk exposure changes and consequently the calculation of
the SCR. See Table 30.25.
The last of the items making up catastrophe risk is the risk of Pandemic. It is by
the same measure as catastrophe life risks, but in this case the risk is not of death but
of events due to which the pandemic disease lead to a lack of capacity to recover
after the event. This scenario will impact upon covers for injury (disablement from
work, both short and long term, and reimbursement of medical expenses products).
See Table 30.26 which reports an example of SCR based on Pandemic for health line
of business.

30.6 Default Risks

The counterparty risk is defined as a default risk (or insolvency) of an issuer

counterparty of a security or payable to the insurance undertaking. In cases of
default, the value of the underlying asset reduces and if the asset is in the financial
statements of an insurance undertaking hedging commitments to assureds, the value
of the related technical reserves, following the same set-up as seen in market risks,
will undergo a reduction in value too. The consequence is that the BoFs reduce. This
risk is not included in market risks and in its place, we find spread risk, i.e. a loss of
credibility in the marketplace, but European regulations have decided to keep this
risk separate and avoid dual counting with securities subject to spread risk, such as
corporate bonds for example. Counterparty risk actually measures an instantaneous
loss generated by a default in one of the following assets: reinsurance contracts,
securitising, derivatives or other contracts that have the aim of mitigating risks,
liquidity deposited with banks, deposits borne by reinsurers, receivables from other
insurance undertakings or reinsurers. Included are other types of receivables (from
assureds, intermediaries etc.) The former is defined as type I and the latter as type II
and they are dealt with differently in the method of calculation of capital
30.7 Aggregation 655

Table 30.27 SCR calculated for default risk

Credit quality step Loss given default PD (Probability of default) SCR

Type 1
Range 0 25.10 0.00%
Range 1 35.00 0.01%
Range 2 28.00 0.05%
Range 3 67.00 0.24% 38.25
Range 4 34.00 1.20%
Range 5 34.00 4.20%
Range 6 21.00 4.20%
Type 2
N/A N/A N/A N/A
Total SCR (diversification effect included) 36.57

requirement. Essentially, the issuers of these receivables are different from those of
debt securities which are subject to spread risk and additionally they are not strictly
tied to capital markets and so the risk is not included in market risk.
The formula for calculating the capital requirement for this risk foresees the use of
a probability of insolvency, called Probability of Default (PD) that is defined in
regulations and based on the credit standing Credit Quality Step (CQS) which is
instead defined by the marketplace. This is associated with the so-called Loss Given
Default (LGD), i.e. the value subject to risk of not being recovered from the
counterparty; the value will essentially be lost.
The formula replicates an adverse event for all issuers present in the aforesaid risk
category, and the adverse event occurs for each of them while taking into account its
own level of risk and own capacity to recover market value.
In cases of reinsurance undertakings operating in pools and so whose risk of
insolvency is diluted by risk-sharing contracts, these are considered by European
regulations through fitting calculations that allow capital requirements to be reduced,
and so reduce Loss Given Default (LGD). For an example of SCR calculated for
counterparty risk, see Table 30.27.

30.7 Aggregation

Once the complex calculations serving to determine the individual items of the main
risks have been done, i.e. those just calculated, they are aggregated via the correla-
tion matrix so obtaining the so-called Basic Solvency Capital Requirement
(BSCR).
The tables that follow show how the BSCR is reached via a number of steps of
calculation as just seen in the foregoing paragraphs.
656 30 Solvency II’s Capital Model

Table 30.28 SCR market risk

Cross reference
SCR market 242.9
Diversification effect -46.7
Interest risk 180.0 Table 30.4
Equity risk 21.1 Table 30.6
Property risk 9.9 Table 30.7
Spread risk 67.5 Table 30.7
Currency risk 3.8 Table 30.7
Concentration risk 7.0 Par. 30.4
The second column shows the numbers of the chapter tables in which the risk calculation was
determined

30.7.1 Aggregation of Market Risks

The sum of SCRs that have been calculated (See Table from 30.4 to 30.27), if added
up for a sum of 289, indicates the disbursement that the insurance undertaking may
have to bear if all the risks occur at the same time. Since it can rather be assumed that
they occur at different times, regulations foresee a formula that takes into account the
correlations that risks have with one another. For example, if two events have a perfect
correlation, when one occurs, so does the other. So, adding together the SCRs for these
risks would equate to assuming that all risks were correlated perfectly with each other,
which is something that does not happen in the specific case of market risk.
Regulations have therefore introduced a formula that takes into account the correlation
of risks and defines the values univocally via a matrix of correlation and calculates the
so-called diversification effect, i.e. the difference between the sums of risks (as if all
were perfectly correlated) and the value of the SCR. The value thus determined comes
to 242.9 with a diversification effect amounting to -46.7, as per Table 30.28.

30.7.2 Aggregation of Life Risks

For the same reasons as seen in the foregoing paragraph, we show here the aggrega-
tion of risks of life underwriting in Table 30.29.

Table 30.29 SCR life risk

Cross-reference
SCR Life underwriting 544.25
Diversification effect -219.40
Mortality risk 85.73 Table 30.9
Longevity risk 28.17 Table 30.9
Disability risk 0.00
Lapse risk 406.16 Table 30.8
Expenses risk 94.13 Table 30.10
Revision risk 0.00
Catastrophe risk 149.47 Table 30.11
30.7 Aggregation 657

Table 30.30 SCR Non-life risk

Cross-reference
SCR Non-life underwriting 88.76
Diversification effect -28.88
Underwriting 80.04 Table 30.12
4. Motor, third-party liability 39.9
5. Motor, other classes 5.7
6. MAT (Marine, aviation and transport) 1.6
7. Fire and other damage to property 10.5
8. Third-party liability 7.9
9. Credit and surety 5.7
10. Legal expenses 4.0
11. Assistance 1.6
12. Miscellaneous non-life insurance 3.2
Lapse 18.49 Table 30.13
Catastrophe 19.11
Nat Cat (diversification effect included) 0.80
Windstorm 0.15 Table 30.14
Earthquake 0.74 Table 30.14
Flood 0.25 Table 30.14
Hail 0.09 Table 30.14
Subsidence 0.09 Table 30.14
Man Made (diversification effect included) 19.09
Motor vehicle liability 9.14 Table 30.15
Marine 1.54 Table 30.17
Aviation 1.89 Table 30.18
Fire 8.90 Table 30.16
Liability 13.53 Table 30.19
Credit & Surety 3.57 Table 30.20
Other 0.21 Table 30.21
The second column shows the numbers of the chapter tables in which the risk calculation was
determined

30.7.3 Aggregation of Non-Life Risks

For the same reasons as seen in the foregoing paragraph, we show here the aggrega-
tion of risks of non-life underwriting in Table 30.30.
658 30 Solvency II’s Capital Model

Table 30.31 SCR health non-SLT risk

Cross-reference
SCR Health Not-SLT 23.56
Diversification effect -8.44
Premium and reserves 23.20 Table 30.22
Medical expenses 6.45 Table 30.22
Income protection 16.75 Table 30.22
Lapse risk 4.11 Table 30.23
Cat risk (diversification effect included)a 4.69 Tables 30.24, 30.25, 30.26
a
Note the reader. The amount is calculated considering diversification effect (Mass Accident
risk = 3.36; Concentration = 2.88; Pandemic = 1.56)

Table 30.32 BSCR calculation

Cross-reference
BSCR 685.66
Diversification effect -252.02
SCR market 242.86 Table 30.28
SCR Counterparty 38.25 Table 30.27
SCR Life 544.25 Table 30.29
SCR Health Not-SLT 23.56 Table 30.31
SCR Non-life 88.76 Table 30.30

30.7.4 Aggregation of Health Non-SLT Risks

For the same reasons as seen in the foregoing paragraph, we show here the aggrega-
tion of risks of health Non-SLT underwriting9 in Table 30.31.
The counterparty risk has been determined as a single sum and so does not need
further aggregation; the value of the BSCR is obtained as an aggregation with
previous sums.

30.8 Final Calculation of SCR of an Insurance Group

For the final SCR calculation, the process starts from determining the Basic Sol-
vency Capital Requirement. See Table 30.32 for this calculation.
As final steps in obtaining the aggregate sum of the SCR, two adjustments are
calculated to take in the capacity of technical reserves to cope with life technical
reserves and deferred taxes. The former is nothing more than a test as, indeed, in the
event of loss of value by assets due to market or counterparty risk, liabilities can also

9
Solvency II defines an “SLT health” contract as one that is deemed to be written on a similar
technical basis as life insurance (i.e. long-term business); SLT stands for “Similar to Life
Techniques”. A “Non-SLT health” contract is defined as one that is technically similar to non-life
insurance (i.e. short-term business). Each category is further split into defined lines of business or
product types.
Directives and Regulations—Chronological Order 659

Table 30.33 Final SCR calculation

BSCR 685.66
SCR OP (operational risk) 17.83
DT adjustment (Deferred Tax) -99.75
TP adjustment (Technical Provision) 0.00
SCR 603.73

be reduced, so generating a capacity to cope with the loss. The tests consist of
measuring the SCR without and with this capacity to cope so as to check whether this
difference is found to be greater than the current value of the Future Discretionary
Benefits (FDB), i.e. the part of technical reserves exceeding the value of the sums
guaranteed.10
Then the sum of operating risk is calculated by a formula based on the volume of
premiums written in the last 12 months and the level of reserves, and which also
considers the sum of the BSCR.
The sum drawn from this is added to the previous ones so as to calculate the final
item in the chain of calculations, minus in sign, i.e. the Deferred Taxes
(DT) adjustment. This simulates a reduction in own funds equal to a loss amounting
to the value of the BSCR plus operating risk capital and any adjustment made for
Technical Provision (TP). This reduction must, however, be justified in the sense that
it must be demonstrated that the insurance undertaking is actually able to recover this
sum fiscally if a loss of this value were to occur. What is obtained as aggregate sum is
reported in Table 30.33.

30.9 Questions

1. Explain capital model’s definition

2. What is the meaning of ultimate forward rate?
3. Which is the factor that indicates the volatility?
4. What are the five natural events for which the capital requirement is calculated?
5. Illustrate the meaning of LGD

Directives and Regulations—Chronological Order

Directive 2009/138/EC of the European parliament and the council dated 25 November 2009 in the
matter of access to carrying on insurance and reinsurance business (Solvency II)
EIOPA-BoS-14/178 EN Guidelines on undertaking-specific parameters, Frankfurt,
2 February 2015
EIOPA QIS5 Results: General findings, surplus and preparedness EIOPA hearing on QIS 5 Frank-
furt, 25 March 2011

10
For a definition and meaning of this reasoning, reference should be made to Chap. 30.
660 30 Solvency II’s Capital Model

CEIOPS-SEC-82/08 CEIOPS’ Report on its fourth Quantitative Impact Study (QIS4) for Solvency
II; November 2008
CEIOPS-DOC-19/07; CEIOPS’ Report on its third Quantitative Impact Study (QIS3) for Solvency
II Public Report; November 2007
CEIOPS-SEC-71/06S; QIS2 – Summary Report Public report, 11 January 2007
CEIOPS-FS-01/06; QIS1 – Summary report, 17 March 2006

Suggestions for Further Study

Balestreri, A., Kent, J. & Morgan, E. Dynamic Asset Liability Management A Method for
Optimising Investment Strategy. Eur Actuar J 1(Suppl 1):29–46 (2011). https://doi.org/10.
1007/s13385-011-0011-7
Buckham D, Wahl J, Rose S (2011) Executive’s guide to Solvency II: Wiley & SAS Business
Series. Wiley, Hoboken, NJ
Dreksler S, Allen C, Akoh-Arrey A, et al. (2015) Solvency II technical provisions for general
insurers: By the Institute and Faculty of Actuaries General Insurance Reserving Oversight
Committee’s working party on Solvency II technical provisions: British Actuarial Journal. 20
(1):7–129. https://doi.org/10.1017/S1357321714000099
Groupe Consultatif Actuariel Européen (GCAE) (2012) Market Consistency: MCEV.
Heep-Altiner M, Mullins M, Rohlfs T (2018) Solvency II in the Insurance Industry, Springer Cham
IAA (International Actuarial Association) (2004), A Global Framework for Insurer Solvency
Assessment, report of the IAA Insurer Solvency Assessment Working Party draft 23, www.
actuaries.org.
Insurer Solvency Assessment Working Party, A Global Framework for Insurer Solvency Assess-
ment, IAA, International Actuarial Association, 2004
O’Donovan G (2014) Solvency II: Stakeholder communications and change. Routledge, Farnham,
Surrey
Sandström A (2011) Handbook of solvency for actuaries and risk managers: theory and practice
series. Chapman & Hall/CRC Finance Series
Starita MG, Malafronte I (2014) Capital Requirements, Disclosure, and Supervision in the
European Insurance Industry, Palgrave Macmillan London
The European Insurance Industry (2020) Regulation, Risk Management, and Internal Control,
Palgrave, Macmillan.
Wilson TC (20215) Value and Capital Management: A Handbook for the Finance and Risk
Functions of Financial Institutions Print ISBN: 9781118774632 Online
ISBN:9781118774359 https://doi.org/10.1002/9781118774359, John Wiley & Sons Ltd
Asset Liability Management (ALM)
31

Abstract

In this chapter, the reader can learn the definition of Asset Liability Management
(ALM). Then the paragraphs that follow describe how the embedded options
work for an insurance undertaking. An explanation about the factors underlying
the ALM models is provided (1. Amount of present and future cash flows, in
terms of asset and liability; 2. Variance between asset and liabilities in terms of
size and duration and 3. Effect of the rate of interest).
ALM models are based on two possible alternative approaches: deterministic
approach or stochastic approach. The second one needs a generation of a large
number of economic scenarios. These scenarios can be of natural probability
(or Real World) or risk neutral. In the first case, the scenarios are calibrated on
historical economic data and reflect market volatility. In the second, the scenarios
exclude any risk premium and are determined based on the assumption that there
is no arbitrage.
Replicating portfolios approach is a technique that provides that two available
titles can be combined at any time together to constitute a portfolio that
reproduces the performances of other structured securities (derivatives). Based
on this concept, a passive contract can be modeled by building a portfolio
consisting of an opportune combination of two securities.

Keywords

Asset Liability Management (ALM) · Embedded options · Put option ·

Guaranteed Annuity Option (GAO) · Call option · Cash flows · Cash Flow
Matching (CFM) · Duration matching (DM) · Duration · Macaulay duration ·
Redington’s Immunisation Theory · Modified duration · Convexity ·
Deterministic approach · Stochastic approach · Economic Scenario Generator

For this chapter, a special acknowledge is for Marcello Ottaviani (consulting audit and appointed
actuary).

# Springer Nature Switzerland AG 2024 661

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_31
662 31 Asset Liability Management (ALM)

(ESG) · Real-world scenarios · Risk neutral scenarios · Market Consistent · Stress

scenarios · Historical scenarios · Model point · Models for a factor · Multi-factor
models · Proxy models · Equilibrium models · No-Arbitrage models · Replicating
portfolios or hedge portfolios · R2 (R-square)

31.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Know the definition of Asset Liability Management

2. Describe how the embedded options work in insurance products
3. Explain the factors for parameterizing a model of ALM
4. Describe the difference between a deterministic approach and a stochastic
approach
5. Provide the definition of Model Point
6. Illustrate the main techniques and models for the interest rate
7. Define Strategic ALM and Operational ALM
8. Show how Replicating Portfolio (RP) works

In the “Technical Appendix”, for the expert reader we provide the main
models for interest rate.

31.2 Definition of Asset Liability Management

There are several definitions of Asset Liability Management (ALM) in the litera-
ture. The cornerstone semantically, however, rests in the name itself. “integrated
management of assets and liabilities”.1
Although the concept of Asset Liability Management (ALM) can take on
different characteristics both from the standpoint of strategy and of operations
depending on its field of application. In this chapter, we will take as definitions of
ALM those that are best suited to the financial issues of an insurance undertaking:

• A series of methods and techniques developed for controlling the financial flows
of assets and liabilities in an integrated manner.

1
It should be noted that the techniques of ALM were developed initially in the banking sector to
meet the interest rate risk.
31.3 Embedded Options 663

• A management tool that allows choices of a financial and commercial kind to be

based on clear perceptions of risks and returns.
• A series of operational mechanisms aimed at maximising the profit function with
the risks taken on unaltered and meeting the strategic and operational constraints
of an insurance undertaking.

To summarise the foregoing points, the objective of ALM is thus to provide a

clear vision of the exposure of the insurance undertaking to volatility in rates of
interest and define the risk tolerance threshold below which the undertaking can
maintain a surplus of assets over liabilities and so achieving a return.
From what has been illustrated above, it is clear that ALM is in reality a tool that
is indispensable for undertakings in the life business as the liabilities in their
financial statements are especially sensitive to variations in interest rates.2
Indeed, in insurance undertakings operating in the non-life business, the rate of
interest is less important as contracts, and technical provisions too, are mainly for a
lesser duration than those of the life business. Additionally, in the non-life business,
there are no guarantees given for returns on assets to be paid out to assureds. ALM
has therefore mostly been adopted by these undertakings for the liquidity risk in
stress scenarios.
The ALM model was actually adopted initially to define, or test, asset allocation
strategies, i.e. the choices to be made in identifying the securities best suited to
representing the investment strategy with the aims of profitability and management
of financial risk as set out in the definitions above. Later, as these models represent
the behaviour of the insurance undertaking very well, they have been growing in
importance throughout the world since the start of the third millennium.

31.3 Embedded Options

It will be worthwhile describing the concept of embedded options that are generated
for an insurance undertaking in life insurance contracts. These contracts often
foresee options for the benefit of the assured and a number of these can generate
Embedded Options3 for an insurance undertaking.
Embedded options are brought in by the following:

2
On the one hand, the series of methods that aim to configure alignment between the assets and
liabilities of an undertaking are in some way relevant also for undertakings carrying on non-life
business.
3
An option in the financial sense is a contract on the basis of which the underwriter or seller assigns
to the purchaser or the proposer, in return for payment of a premium, the right to sell (put option) or
purchase (call option) a certain amount of financial or real assets, called underlying assets, at a
pre-set price, called the strike price.
664 31 Asset Liability Management (ALM)

1. A guaranteed financial return

2. Leave granted to the assured to surrender the policy prior to the natural expiry of
the contract
3. The possibility offered to the assured of converting the guaranteed lump sum into
an annuity at maturity at certain pre-set financial and demographic conditions

The distinction made between the assured’s options that can be exercised auto-
matically and those that are facultative is one that is fundamental for being able to
develop a proper strategy for managing the risks that are connected with them for the
insurance undertaking. In the first case, the risk is purely financial and can be
managed through an adequate investment policy. In the second case, proper design
of the product is needed and pricing that includes other factors in tariff variables such
as, for example mortality risk, longevity risk and lapse risk in order to meet the
overarching risk of having to pay a sum greater than that foreseen.
The most relevant embedded option is that given by the presence of minimum
guarantees in insurance contracts. This guarantee gives rise to a cost for an insurance
undertaking due to the fact that if returns on assets covering these contracts do not
produce a value greater than what is guaranteed, the insurance undertaking will have
to commit its own capital.
The characteristic that most fully represents the concept of embedded option
arises from the following situation. Let us take a look at the profit function of the
insurance undertaking as rates of return from the financial management of assets
covering the policy (or provision hedging a portfolio of policies) vary. If the return is
in excess of a certain threshold the insurance undertaking shares its earnings with the
assured (profit-sharing). If there are losses due to insufficient financial returns to
cover the guaranteed minimum, the insurance undertaking meets this cost in full.
This asymmetry generates an embedded option.
As can be seen from Figure 31.1, the profit for the insurance undertaking
decreases as returns from management diminish, but below a certain point, the
slope of the curve changes. This break depends on the policy conditions wherein
the profit-sharing mechanisms are described, and this point might coincide with the
guaranteed minimum. In this case, the insurance undertaking withholds a minimum
percentage of return provided it meets the guarantee given to assureds. Insurance
undertakings often withhold a minimum quota from management to meet a number
of costs.
On the basis of what we have just set out, the assured holds a contract that gives a
right to obtain a profit even in the event of returns being below a certain level. On the
other hand, the insurance undertaking has sold a right to the assured to ensure either a
pre-set rate of return or one based on the result of financial management, whichever
is the greater, i.e. a put option4 for the assured.

4
A put option is a right to sell a security (at a price St) when the price is higher than a certain strike
price (K ) according to the ratio (K - St; 0).
31.3 Embedded Options 665

Insurance
undertaking
profit

0
Management return
Profit sharing
Minimum
threshold
guaranteed

Fig. 31.1 Profit from financial management

Now we show a simple example for understanding the embedded options

generated by surrender and management of these from the standpoint of an insurance
undertaking. Let us imagine having a contract in portfolio wherein:

• It is the rate of return that the insurance undertaking grants the assured.
• Kt is the average rate of return on government securities in the country where the
policy is issued (which may be a wider, or different, basket of reference
depending on the characteristics of the clients concerned).

If we imagine that an investor has subscribed to the contract with ends exclusively
of financial investment, a rational hypothesis may be adopted, i.e. that the assured
will surrender the policy when Kt > It + α, where α is a value induced from the costs
of the sale and repurchase transaction.5
In this case, the risk of a financial type can be managed via an adequate strategy of
integrated management of assets and liabilities, i.e. by foreseeing inflows and
outflows that are consistent with the expectations of a return on assets and conse-
quent dynamic actions on the part of assureds.
In most cases, however, the behaviour of assureds is not rational. Insurance
undertakings have by now evidence of the fact that assureds mainly surrender
under conditions that are not tied to rational decisions of a financial type, but rather
tied to their own financial needs, which in a number of cases may be of a social kind,

5
This concept can be extended by including in α a value expressing the risk aversion of the assured.
666 31 Asset Liability Management (ALM)

for example under conditions of global crisis or of sovereign debt. These can
generate the psychological effects of a flight from savings or real effects of need.
In this situation the insurance undertakings may foresee mass surrenders and manage
them by taking suitable action.
In this case too, as for minimum guarantees, the insurance undertaking has sold a
put option, although one that is more complex as to the type of pay-off,6 and which
consists of making it possible for an assured to “re-sell” (surrender can be seen as a
form of re-sale) the contract when economic conditions are favourable to the
assured. Additionally, the insurance undertaking finds itself in an unfavourable
position as the portfolio of assets probably has capital losses, i.e. the purchase
price is higher than the current market, and surrender in these situations generates
possible economic losses for the insurance undertaking in selling securities with
capital losses to pay for re-purchase of the policy surrendered.
A further example is one of making it possible for the assured to convert the
guaranteed lump sum at expiry into an annuity. To cover the risk of insufficiency in
its financial resources, an undertaking must define the characteristics of the contract
in such a manner that, when the conversion takes place, it has set aside a cushion that
is consistent with expectations in respect of these disbursements while still taking a
certain volatility into account. Failure to do this will inevitably lead the undertaking
in taking on a risk due to the fortuitous nature of trends in rates of interest and
mortality between the time after the contract is concluded and when the lump sum is
converted into an annuity applying the Guaranteed Annuity Option (GAO). One
way for the undertaking to prevent this risk, even at the time of underwriting, is to
add an adequate loading (risk premium) when defining the price of the product.
This last example also represents a call option held by the assured.7 The assured
holds a purchase condition in a policy at conditions favourable as compared to what
they are in the marketplace. In the event that the conditions are not favourable for the
assured, they would have the right not to opt for the guaranteed annuity.
In order to capture the complexity and the asymmetry of these phenomena,
insurance undertakings use stochastic models of calculation that are able to highlight
all the issues that a deterministic model is unable to capture. These issues will be
dealt with later in the chapter.

6
The aggregate economic result of the security, represented by the payment from the counterparty
of the security.
7
A call option is the opposite of a put option, i.e. a right to purchaser a security (at a price St) when
the price is below a certain threshold value called the strike price (K ) according to the maximum
ratio (St - K; 0).
31.4 Traditional Model of ALM 667

31.4 Traditional Model of ALM

The ALM models used by insurance undertakings can vary from one to another from
various standpoints. However, they all concentrate on an analysis of the following
three factors:

1. The amount of present and future of asset and liability Cash Flows according to
when they appear
2. The variance between asset and liabilities in terms of size and duration
3. The effect of the rate of interest on asset and liability flows

Later on, each of the variables indicated above will be looked at by analysing the
characteristics and the requirements that need to be met when developing an ALM
model.
Cash flows are monetary movements within an undertaking during a certain
timeframe. They are split into cash inflows and outflows both from assets and
liabilities. The main issue in determining the amounts of flows in an insurance
undertaking is given by the chance nature present, both in terms of sums (think of
the amount of future indemnities), and in terms of when the flows actually appear
(think of the chance nature of policies surrendered).
Firstly, a classification of the assets of the insurance undertaking into macro-
categories in terms of the types of asset is proceeded to (bonds, shares, real estate,
loans, liquidity etc. and each of these macro-categories can be further split into
sub-categories). They can be classified into plain vanilla (standard trades) securities
or structured securities. For these latter, the aim is to break them down into a set of
elementary instruments to make it possible to determine the sums of individual
future cash flows. For example, in the case of securities with a variable rate with
coupons subject to a maximum8 the approach foresees breaking down the pay-off
profile of a structured security into elementary instruments such as a security with a
variable rate without limits and a Cap option. Once the asset has been broken down it
will need to be modelled so as to determine the price as the rate of interest, or another
economic variable, changes and time. In this case, fair value can be obtained for the
security by actualising the sum of future cash flows and pricing the Cap option.9
The undertaking must also analyse the make-up of its commitments towards
assureds, or other debtors and towards shareholders and the type of these
performances foreseen and expected incoming premiums, while seeking to model
them so as to obtain a fair value (with information relating to time too) and compare
them with asset cash flows. In this case too, the chance nature of future monetary
cash flows must be kept under control, and so it is necessary to make assumptions in
respect of trends in these. It will be necessary to model the propensity towards

8
The maximum constraint is called the “cap floor”.
9
For the expert reader, the future cash flow can be represented by the development of forward rates
that are implicit in the current spot curve, For a look at financial models see Sect. 31.10.
668 31 Asset Liability Management (ALM)

surrender by assureds, survival in the demographic risk, evolution of costs and

management expenses of the insurance undertaking, dividends foreseen for
shareholders etc.
There are various types of models used for this (each of them featuring differing
difficulties of implementation): there are static models (wherein the probabilities of
the events are pre-set and are independent of other factors), models based on rational
behaviour on the part of the assured (models tied, i.e. to rates of interest), models
based on the process of moral hazard (which include the information asymmetry in
the relationship between Insurer and assured) and theoretical models used for the
purposes of research.
Among the other factors that must be considered in representing the nature and
the features of liabilities, the following can be listed:

• Time step when cash flows (month, year, etc.) are projected.
• The behaviour assured in the terms of propensity towards surrender and a claim.
• Costs for the undertaking, management, fiscal issues etc.
• The dynamic behaviour of assured in situations of economic crisis or other factors
dependent on economic factors.
• Any embedded options contained in contracts.
• Extension of the projection of cash flows for maturities greater than those of
traditional analytical models.

So, in summary, in addition to assumptions tied to the marketplace and financial

risks, the undertaking also makes the actuarial assumptions and other non-technical
issues tied to the behaviour of liabilities.
Once the definition of flows stage has been completed, the next activity consists
of evaluating possible mismatches between assets and liabilities, either in terms of
absolute value Cash Flow Matching (CFM) or in the terms of duration matching
(DM).
For CFM, the aim is to determine an adequate strategy for managing assets that
minimises mismatches between expected flows from assets and liabilities and see to
it that every payment of a liability matches an inflow from the asset while taking into
account the level of liquidity of the insurance undertaking over the time period
normally adopted for paying performances to assureds. If an undertaking finds itself
with a value of assets below liabilities (deficit) it is then in a situation of shortfall. In
this case, it will need to bring new economic resources to bear in order to ensure
cover for liabilities anew; if on the other hand assets are found to exceed liabilities,
(surplus), the aim of the undertaking will be to optimise its investments so as to
remunerate both shareholders, by drawing down the extra cover of liabilities, and
assureds.
As can be seen, modelling asset and liability cash flow is done in a manner that is
independent and separate one from the other. The two “models” come into contact
with each other only when so-called “cash balances” are drawn, i.e. when all the
flows are compared so as to determine whether or not management, as at that
moment in time, requires a new investment of economic resources (cash surplus
31.4 Traditional Model of ALM 669

given by sums greater than premiums, coupons, reimbursements, dividends etc.) or

disinvestments in respect of securities (cash deficits given by greater sums at policy
maturity, surrenders, claims, expenses etc.).
In order to simulate a model that is as close to reality as possible, insurance
undertakings, in general, foresee the use of synthetic securities that represent newly
issued securities, either at fixed or at variable rates. These securities are priced on the
basis of conditions foreseen by the forward curve during the projection. This
approach has been adopted so as to simulate reinvestment in securities that have
not yet necessarily been purchased by the insurance undertaking.
One of the techniques adopted by insurance undertakings in managing financial
risks is that of minimising the time difference between assets and liabilities. The
most widely used index for this type of analysis is the duration (or average
financial duration), which measures the average life of an investment while taking
into account the distribution over time of cash flows generated by this investment.
From the mathematical standpoint, it is the weighted mean of maturities of cash
flows from the investments wherein the weightings are given by the ratio applying
between the current value of these flows and the current value of the entire invest-
ment (i.e. current percentage values of the individual items posted) and is measured
in units of time. Assuming a security foresees payments at timings t0, t1, . . ., tn the
duration is given by:

VAðt 0 Þt 0 þ VAðt 1 Þt 1 þ . . . þ VAðt n Þt n

D= , ð31:1Þ
VA
where

VA(ti) represents the current value of the payment made ti.

VA represents the current value of the entire security (i.e. the sum of current values
of individual payments).

To calculate this, the spot price structure applying in the marketplace needs to be
known so as to get current values. If the entire rate of return (yield) is used as a rate of
interest in actualising payments, the formula leads to the Macaulay duration.
Duration is a time intermediate between the time of the first payment and that of
the final payment and can be used as an indicator of the risk to indicate the sensitivity
of the value to variations in interest rates (volatility). In general, the volatility of the
value of a financial transaction in response to changes in market returns is propor-
tional to the duration of the transaction: the longer the duration the greater is the
percentage variation in value, given a certain variation in the rate of return. There-
fore, the greater the duration the greater the risk, since flows will be more exposed to
changes in rates of interest. The use of DM is based on a sound theoretical principle,
i.e. Redington’s Immunisation Theory.10 The theory of Redington’s Immunisation

10
Redington F. M. (1952), Review of the Principles of Life Office Valuations, Journal of the
Institute of Actuaries.
670 31 Asset Liability Management (ALM)

Theory can be translated by the following expression: a portfolio of assets can be

said to be immunised if the duration of the portfolio of assets is equal to that of the
liabilities, but its convexity (see later in the paragraph) is greater than that of
liabilities.
Through using the DM model, management must minimise the difference
between the two durations (assets less liabilities) since with a change in rates of
interest there would be the same impact on the current value of inflows and outflows
and the objectives of economic yield and performance stability would not be
influenced by changes in rates. Please note that To achieve matching, an insurance
undertaking must use investment and disinvestment strategies in respect of securities
in its portfolio that modify the duration of assets so as to render it as close to that of
its liabilities as possible.
If the difference between these durations is a plus, the undertaking becomes asset
sensitive, since a change in interest rates will bring about a greater variation in
assets, whereas if the gap is a minus, the undertaking is liability sensitive and a
change in interest rates has a greater impact on the value of liabilities. The sign of the
gap is clearly important in establishing the risk the insurance undertaking is exposed
to as interest rates change. If the gap is a plus (asset sensitive) the undertaking will
run into a loss if interest rates increase (assets will remain invested at lower rates and
future loans will cost more) and greater yield as rates fall. On the other hand, where
the gap is a minus, the undertaking will achieve benefits from an increase in interest
rates.
A model of this kind, although it is able to evaluate and signal the presence of a
risk deriving from various maturities in assets and liability flows by comparing
durations, is still exposed to non-linear variations in interest rate curves. For this
reason, in addition to comparing the durations of assets and liabilities, other
measures of the degree of sensitivity of the portfolio to interest rates are also used.
The most widely used indicators are: modified duration and convexity. Both of
these study the curve originating in the relationship there is between rates and the
current value of flows, the sole difference being that the former is a linear approxi-
mation while the latter is a spot check.
Modified duration is the relationship between the derivative prior to the current
value of the security as compared with the rate of interest changed in sign and the
value of the security itself. See formula 31.2.

dVA=d i
DM = - ð31:2Þ
VA
and so, measures the semi-elasticity of the price of a security as compared to its yield
or, in other words, it measures the speed of variation in price per unit of capital in the
event of a change in rates of interest. See Figure 31.2 representing the price–yield
curve and duration.
As can be seen from the graph in Figure 31.2, the price of a security does not
change in a linear manner as compared to the variation in yield offered and so a
linear approximation of this curve may not fully meet the case.
31.4 Traditional Model of ALM 671

Fig. 31.2 Price–yield curve and duration

Convexity is a better approximation of the price/yield curve as it includes a

second derivative term; it indicates the ratio between the second derivative of the
expected value of the security and the expected value of the security itself. See
formula 31.3.

d2 VA=d i2
C= : ð31:3Þ
VA
If security has positive convexity, then its price will increase as interest rates fall
more than it would reduce under an increase of the same size in rates of interest.
Now that measurements of the degree of sensitivity of portfolios to interest rates
have been introduced, the concept of immunisation can also be introduced:
immunisation is the procedure through which it is possible to achieve a portfolio
in which there is no exposure to the rate risk (or rather, this risk is considerably
reduced).
Let us assume having a series of debts with relative maturities t0, t1, . . .,tn. For the
undertaking, one way of covering against the interest rate risk is to invest in
securities without coupons with durations and values identical to those of the
individual debts (cashflow matching). Given the complexity of a portfolio, the
chance nature of relative cash flows in terms of surrender, and claims, the default
risk on securities, and for other reasons, it is not possible to achieve perfect
matching.
One method that insurance undertakings often adopt is forming a portfolio of
assets in such a way that the market value of liabilities is identical to that of assets.
See formula 31.4.

Market Value Asset ðMVAÞ = Market Value Liabilities ðMVLÞ ð31:4Þ

In cases where the interest rate curves undergo changes, a misalignment of the
two values will arise. For this reason, it is worthwhile having the respective durations
672 31 Asset Liability Management (ALM)

coincide. In this way, the value of the portfolio and the value of the debt will respond
in the same way (by linear movements in the curve) to variations in interest rates.
As changes in the interest curve often does not occur in a linear or flat way (shift),
but only certain parts of the curve change (short-term rates differently from long-
term, for example), a portfolio will need to be built up in which the convexity of
liabilities coincides with that of assets too.
The process of immunisation is an ongoing matter, i.e. the portfolio needs to be
recalibrated continuously so as to be immunised from the interest rate risk.

31.5 Risk Factors and Deterministic ALM/Stochastic ALM

In ALM, risk factors are all the magnitudes that might impact upon cash flow from
assets and liabilities. Among these there are, for example the structure of risk-free
rates, inflation and the credit risk, trends in share and real estate markets, and other
types of risk such as mortality, surrender etc. The value, or rather the cost, of these
risks is determined according to two possible alternative approaches: deterministic
approach and stochastic approach.
If, for example a risk factor (which might be represented by a chance variable) has
a certain probability distribution, the deterministic approach evaluates, for exam-
ple a single determination of this distribution, which might be the average (or most
likely, Best Estimate scenario). A stochastic approach, on the other hand, also takes
into account the rest of the distribution, and if there are non-symmetries in risk
factors, as set out in the foregoing paragraphs, the two evaluations give rise to results
that are quite different. It can be seen from Figure 31.3 that non-symmetrical effects
in a risk factor generate evaluations that are different between deterministic and
stochastic models.

Value of the fund

Best estimate
of yield

Behaviour B

Interest x+i
accruing in a Behaviour A Withholding
deterministic x
manner
Guaranteed
minimum

0 1 Time

Fig. 31.3 Effect of asymmetries in stochastic models

31.5 Risk Factors and Deterministic ALM/Stochastic ALM 673

Figure 31.3 represents a variation in the value of a fund as the yield varies over a
period (between 0 and 1) The black dotted line shows from x to x + i, where
i represents the increase given by the deterministic interest yield, i.e. the expected
yield, the most likely one. The bell curve represents the chance distribution of the
value of the fund as yield varies from management in this period.
So, a deterministic evaluation leads to considering solely the effect given by the
expected yield (which in the example is above the asymmetry threshold) whereas the
stochastic model considers, along with their probability, all the various cases other
than the Best Estimate occurring. So, the expected profit of the deterministic model
will be greater, albeit not by much, than the stochastic one (which will contain
adverse events that are non-symmetrical as compared to favourable ones).
The result of this reasoning is that in order to make estimates that consider
management risk consistently, stochastic models must be used and which consider
all possible cases and evaluate them consistently.
A model of a deterministic kind has the advantage that it is simple and easy to
check and manage the various stages of the calculation but is limited by not
considering the behaviour of the variables at the extremes (or tails) of the distribution
and by not taking into account the cost of embedded options. In order to make an
analysis of a stochastic type two approaches are necessary:

• A closed form calculation, but for complex evaluations these approaches do not
exist or do not come sufficiently close.
• The Monte Carlo methods, i.e. simulations.

To provide input data to these methodologies software is used that generates a

large number of economic scenarios through an Economic Scenario Generator
(ESG). An Economic Scenario Generator (ESG) consists of generating a large
number of scenarios that are sufficiently random so as not to have any correlation
between them and wide enough to be able to cover the entire range of possibilities
that the distribution domain of probabilities foresees (bell curve in Figure 31.3). As
they are equally probable, the result of the simulation is given by the arithmetical
mean of the individual results of the scenarios.
In a stochastic model, in order to define a sufficient number of scenarios, their
degree of mutual correlation needs to be taken into account. Through a probabilistic
structure, it is possible to obtain a large number of economic scenarios upon which to
perform the proper analyses.
There are two systems of measurement that are used to evaluate the economic
variables in an ALM model; one of natural probability (or real world) and one that is
risk neutral.11 In the real world, scenarios (or the scenario in a deterministic model)
are calibrated on historical economic data and reflect the volatility of the market,
which includes a risk premium.

11
There are also other measurements, but these are the most widespread and used.
674 31 Asset Liability Management (ALM)

In risk neutral, scenarios exclude any premium for risk and are determined on
the basis of the assumption that no arbitrage can be obtained.12 These scenarios serve
in determining the value of the embedded options. Where these scenarios match with
those of the market, scenarios are said to be Market Consistent. Risk-neutral
scenarios are used mainly from the standpoint of pricing, contrarily to real-world
scenarios, which are mostly used for managing capital. Real-world scenarios are
usually used for exploring distribution tails (extreme events).
The reasoning against using risk-neutral scenarios for ALM evaluations is the fact
that this system of measurement is not realistic and any asset allocation or manage-
ment choice made would be deviated by a representation of yields and evolutions in
prices of securities that do not represent the true trend of the market. So, ALM
evaluations are done with real-world measurement systems.
There are two types of approaches for generating scenarios and these are stress
scenarios, i.e. scenarios with high severity and low frequency and which reflect
improbable but plausible variations in risk factors, and historical scenarios,
i.e. stress scenarios based on assumed values of a number of risk factors in certain
periods featuring high volatility.
What is of fundamental importance is being aware of the timeframe of the risk
factors, their frequency (annual, half-yearly, monthly) and their duration. For exam-
ple, a model over 10 years with quarterly analysis, requires having 40-time nodes
available (4 quarters × 10 years = 40) for each of the variables analysed.
The number of scenarios to be simulated varies, however, and the greater the
number, the better the approximation will be, as a stochastic evaluation will con-
verge upon the expected value. From the practical standpoint, and considering the
limits imposed by calculation capacity of ALM software, for a single risk factor,
1000, scenarios are generally sufficient. In cases where an evaluation includes a
greater number of risks, the number of scenarios may rise to 5,000, or even more.
Cases of stochastic risks other than economic ones have not been looked at in this
paragraph. The reason for this is that their diffusion is limited solely to internal
models developed by insurance undertakings or groups with the aim of pricing the
aggregate risk for the insurance undertaking itself rather than evaluating manage-
ment strategies or asset allocation from an ALM perspective.

31.6 Definition of Model Point

The ALM models developed by insurance undertakings foresee using large IT

resources in order to be able to represent the commitments of assets and liabilities,
above all if these models are of a stochastic kind. In general, the number of securities
present in the portfolio of an insurance undertaking, even a large one, is not difficult
to manage for a calculation model. Something that is quite different is the number of
policies present in the portfolio of an insurance undertaking, even a small one. So, to

12
That is, obtaining certain gains without risk.
31.7 Techniques and Models for the Interest Rate 675

get around this technical issue, insurance undertakings prepare a method of aggre-
gation of policies called Model Point. Model Point is a method of aggregation into
homogeneous groups of policies, i.e. that have the same features, and with the aim of
reducing the data available and allowing the model to function in times that are
suited to the process of evaluation.
The variable used for aggregation must be chosen based on the objective of the
model itself, i.e. the aggregation criteria must avoid the risks relative to the policies
that are the subject of the evaluation offsetting each other. For example, in a portfolio
exposed to interest rate risk, what needs to be avoided is aggregating policies with
different guaranteed minima. If the average market rate of interest were around 2%
and if in the portfolio there are contracts with 1% and 3% guaranteed minima in
equal number, if these were to be aggregated, there would be offsetting of profits of
the latter against the losses of the former. Indeed, assuming an average of guaranteed
minimum of 2% there would be neither a loss nor a gain for the insurance undertak-
ing. If there is no aggregation there would be a loss of 1% on the former contracts
and a gain of 1% on the latter. At these conditions, there ought to be no difference,
but there are often limits to gains to yields of insurance products which, if present,
would generate a cap on the latter (e.g. it would make a 1% gain 0.9%) generating an
asymmetry.
For stochastic models, obtaining offsets between policy risks, which is less
verifiable a priori, is more frequently the case, because the set of economic scenarios
used to simulate the stochastic component foresees setting values for the financial
and economic variables that are, obviously, much broader than in the case of a
deterministic one. Essentially, in stochastic models, aggregation is necessary for
allowing the model to be able to work quickly and in timings that are more fitting,
but it is also a more delicate matter.

31.7 Techniques and Models for the Interest Rate

The models for the term structure of rates of interest allow the evolution dynamics of
interest rates used in processes of financial evaluation assets and liabilities to be
represented.
These models allow an evaluation to be carried out on instruments that are
sensitive to the interest rate risk factor using public information from capital markets.
In the literature there are various models, each based on different theoretical bases
and so as a result return different evolution dynamics, and so are calibrated starting
from specific information sets. In practice, it can be seen that “The Model” does not
exist, but rather there is a multiplicity of solutions, each with its own virtues and
flaws, and which have to be identified on the features they offer and are in line with a
portfolio of securities and the characteristics of liabilities. By way of example, a
number of models are based on symmetrical distributions and others that are not;
some are well calibrated for short-term interest rates and others are better suited to
the long term; the number of factors leads to greater precision but greater complex-
ity, both of calibration and of implementation etc.
676 31 Asset Liability Management (ALM)

In essence, selection of the model of reference is a compromise evaluation that an

insurance undertaking has to carry out in order to obtain results that are as suited as
possible to its specific needs.
A model must therefore be specified based on the financial characteristics of the
elements held in portfolio in order to determine the value properly and allow an
adequate representation of the risks that are inherent in it.
Here below a number of the most widely used models will be mentioned and they
will be classified on the basis of the number of parameters and the features of the
model itself. The models for a factor are based on the assumption that is sufficient
to capture the development dynamics of a single “node” of the curve so as to lead to a
representation of the entire structure of the curve. This assumption is based on a
direct functional relationship applying between this node (typically represented by
the spot rate of interest) and the other vertices of the curve while also foreseeing the
structure of today’s interest rates being maintained over the whole period of the
projection of term rates.
Most models included in this class allow the univocal analytical relationship
between spot rates of interest and each node of the curve to be defined (Hull-White
1 factor, Black Karasinski, Ho & Lee, CIR, Vasicek).
The class of models in question certainly has advantages tied to simple determi-
nation and calibration, which often allows analytical solutions in a closed form for
pricing of a broad class of pay-offs to be identified. This means that when using these
models, the evaluator does not need calculations that foresee stochastic simulations.
However, what could be a simplification, i.e. calibration of the short-term rate,
actually becomes complex, as in order to represent a phenomenon that is not found in
the short-term rate more fully, the evaluator needs to seek to include information
from the remaining part of the curve.13
The development dynamics that are implicit in the models additionally assume a
level of perfect correlation between the nodes of the curve, which is not a realistic
assumption, and is not applicable to pricing instruments that are sensitive to the
steepness of the curve.
Multi-factor models on the other hand, arise from the need to represent a
multiplicity of risk factors that are not perfectly correlated with each other. Among
these, there are models that are profoundly different based on the significance of the
factors represented (spot rate of interest, volatility, forward rates, real rate of interest
and rate of inflation etc.) and the number of factors represented within the model. In
multi-factor models, Brace Gatarek Musiela (BGM) models based on an estimate
of the future level of rate, also called the Libor Market Model (LMM) is one of the
approaches most used in practice to achieve a representation of the curve that is the
richest and most complete. This model represents each forward rate assuming a
functional dependence on the volatility and structure of the correlations of forward
rates as compared to all the other rates implicit in the curve.

13
For example, the models by Hull & White and Black Karasinski need an estimate of two volatility
parameters and mean reversion, obtained by calibrating the pricing model of Cap/Floor and
Swaptions in the marketplace.
31.7 Techniques and Models for the Interest Rate 677

Brennan-Schwarz
Vasicek (1977)
(1979)
C.Two-Factors models
A. Equilibrium model
of the short rate
Cox-Ingersoll-Ross
Hull-White (1994)
[CIR] (1985)

Ho-Lee

D.Heath-Jarrow-Morton
Framework (1992)

Ho-Lee (1986) Hull-White

B. No-Arbitrage model

Brace-Gatarek-
Hull-White (1990) E. Libor Market Model
Musiela (1997)

Fig. 31.4 Main models for a rate of interest

The model by Heath, Jarrow and Morton (HJM) assumes an approach that is
even more radical, by representing the curve as an infinite set of spot rates of interest.
In particular, the model considers the entire structure of rates by initial maturity, and
a specification of the volatility structure for forward rates. Starting from these
conditions, the model sets out an estimate of future forward rates by generating
scenarios achieved through binomial trees.
Over the last thirty years, the development of modelling techniques for interest
rates has breathed new life into a rich literature in the matter within which a split can
be made into two macro-families: the so-called “kindred models” and another
3 categories of models/frameworks (generically called “other models”). See
Figure 31.4 representing the main models for a rate of interest.
All proxy models model the process of development of the spot rate and display
the following characteristics:

• A resolution in a similar closed form.

• This closed form differs only in the complexity of the functional expressions in it.

Within proxy models it is possible to make a distinction between an Equilibrium

model and a No-Arbitrage model.
Equilibrium models do not allow “fitting” in an automatic fashion of the current
structure by maturity. Only by proper choice of parameters (calibration) does the
model succeed in approximating the structures by maturity that are found in practice
(the structure is an output of the model).
No-Arbitrage models are built up to be precisely consistent with the current
structure of interest rates (the structure is input to the model).
In respect of other models, two-factor models feature modelling of the develop-
ment process of the spot rate by implying two sources of uncertainty.
678 31 Asset Liability Management (ALM)

-A. Equilibrium model- -D. Heath-Jarrow-Morton Framework-

Cox-Ingersoll-
Vasicek Ho-Lee Hull-White
Ross
- Features -

1. Non-negativity of the rate

2. Means reversion factor

3. Non-divergence

4. Analytical treatability

5. Consistency with current

structure

6. Flexibility in describing
volatility structures

7. Need for calibration

Fig. 31.5 Comparison between interest rate models

The HJM model is in reality a method that, starting out from a modelling of the
forward spot rate (and not the spot rate itself) depending on the functional assump-
tion chosen for volatility of the underlying rate, leads to various known models. In
particular: constant volatility: Ho-Lee model and exponential volatility: Hull-White
model. The Libor Market Model comes under multi-factor models by modelling the
forward rate (not spot rate) and allows the future development of forward rates to be
described provided that volatility and spot correlations are available.
Here below four models are compared by examining seven variables of analysis
that are thought significant.
For dealing with this, it has been felt that at this stage it was worth concentrating
on the models of Vasicek, Cox-Ingersoll-Ross and, for the HJM framework, on the
models of Ho-Lee e Hull-White. The reasons for this choice are as follows: a
preference for greater ease of analytical treatment, a focusing of the analysis on
models that ensures a good ratio of complexity to performance while seeking, where
possible, to reduce computational impacts.
The following variables will be subjected to analysis: non-negativity of the rate,
means reversion factor, non-divergence, analytical treatability, consistency with
current structure, flexibility in describing volatility structures and need for calibra-
tion. In Figure 31.5 can be found a synoptic comparison table of the models.

31.8 Strategic ALM and Operational ALM

ALM techniques can be scheduled in a context supporting the strategic planning of

the insurance undertaking or become a tool that is more strictly operational for
supporting short/medium-term management.
31.9 Replicating Portfolio 679

Strategic Asset Liability Management (SALM) features an integrated set-up

and an approach that is global in type and brings in decisions for implementation and
audit of the results pursued by the undertaking in the aggregate. SALM sits in the
area of medium/long-term planning with a specification of objectives connected with
risks and yields (the approach used is of top-down type). In a certain sense, it can be
taken as the financial side of strategy since it is the tool through which the prospec-
tive equity structure for auditing financial risks can be evaluated along with an
analysis of profitability and financial equilibrium.
Operational Asset Liability Management (OALM) is an operational technique
supporting financial management for guiding daily decision making. The objective
of OALM is to manage assets and liabilities so as to achieve an equilibrium
economically and financially. The approach usually used is of bottom-up type and
its main purposes are planning and audit of processes, the development of “What if
. . .?” scenarios of analysis for evaluating the sensitivity to risk, and studying the
effects arising from launching a new product in portfolio.
To support the choices made under OALM there are a number of summary
quantitative indicators such as the gap between cash flow and duration, that ensure
important information is had concerning the make-up of assets and liabilities and
possible effects determined by variations in interest rates.

31.9 Replicating Portfolio

An alternative method that allows trends in cash flows from assets and those of
liabilities to be correlated is the replicating portfolios or hedge portfolios approach.
The conceptual foundation of replicating portfolios (or hedge portfolios)
approach, starts out from the reasoning on which the Black and Scholes equation
is based and which foresees that at any time two available securities can be combined
together in order to build up a portfolio that reproduces the behaviour of another
structured security (derivative). Based on this concept, a passive contract, which
foresees embedded options, can be modelled by constructing a portfolio made up of
an appropriate combination of two securities. It can thus be stated that a specific
portfolio of asset securities can replicate a passive contract.
The fundamental assumption for building up a replicating portfolio is that there is
a connection between the value of a passive insurance contract and a number of
factors that are typically financial, such as the rate of return, rate of inflation, and
share market trends, that will be simulated in various macroeconomic scenarios.
The objective is to construct a portfolio of securities and financial instruments so
that projected cash flows in various macroeconomic scenarios can be rendered equiv-
alent to the values of liabilities obtained through an actuarial approach; in this way,
liabilities are “replicated” in a method that is strictly financial, by a series of assets.
The great advantage of this technique lies in the fact that the market value of the
portfolio can be calculated very rapidly with any change in economic conditions, so
allowing insurance undertakings to monitor and manage financial risk more
680 31 Asset Liability Management (ALM)

frequently. From the standpoint of financial engineering, replication of a portfolio

allows conversion of a liability type item into an asset type item.
As compared to traditional ALM, this approach also considers, in addition to the
typical variables (like determination of cash flow, risk factors, maturities of flows),
the accuracy of the replication function.
Concerning the risk factors to be simulated in scenarios, these are generally the
same as those that bear upon the value of liability cash flows. For the purposes of
projecting cash flow from liabilities and replicating assets, the same set of macro-
economic scenarios needs to be used. Additionally, the scenarios must consider all
possible values of future risk factors, including extreme events. In practice, a good
replication of portfolio features a matching of the value of the cash flow of liabilities
and replicating assets, and the value of these in a number of sensitivity scenarios.14
For this, it will be worthwhile to have an accurate evaluation of the risk factors
present in financial markets.

31.9.1 Methodology for a Replicating Portfolio Model

The process required for building a replicating portfolio model can be summarised in the
following main activities. The first one is an activity wherein liabilities are split by
underlying assets and risk factors to be considered in the model are identified; the second
one is the stage wherein the objective function is defined along with the constraints
present in the model for resolving the problem in an optimal fashion; the third and final
activity foresees validating the model and when its robustness is checked.
In the first phase, an in-depth analysis of the passive contracts in portfolio needs
to be carried out, so as to understand their nature and characteristics. In particular, the
timeframe over which cash flows are projected (annually, monthly, variable due
dates etc.) need to be understood, as do the risk factors that can have a bearing on
their value, plus the finding of any embedded options and any other non-economic
sources of risk that can impact upon them. In general, in life insurance undertakings,
cash flows are projected over time horizons that are longer (even beyond 20 years)
than the duration of traditional financial instruments and the sources of risk mostly
analysed are the risk of mortality, longevity and the possibility of assureds exercising
options. Once liabilities have been analysed, it is necessary to identify the set of
financial instruments that can make up the so-called replicating portfolio.
The instruments are chosen in the knowledge that complex flows of passive
contracts may be broken down into simpler sub-flows. In order to obtain a better
“replication” of the portfolio, it may be additionally worthwhile to split the time
interval into a number of segments. In this way, it will be easier to identify a specific
asset that best replicates the initial liability. The choice of asset requires a high
degree of knowledge of liabilities as replicating requires not only having values and
maturities coincide, but it is also necessary for both assets and liabilities to be
impacted in the same fashion (or in a similar fashion) by the same risk factors.

14
The current market scenario, which coincides with the value of the postings valued in financial
statements, is included in this value.
31.9 Replicating Portfolio 681

Table 31.1 Comparison of insurance contracts and replications

Type of insurance contract Example of a “replica” financial instrument
Level term Zero-coupon bond
Constant annuity Fixed coupon bond
Variable annuity Variable coupon bond
Endowment Zero-coupon bond

In Table 31.1, a number of types of insurance contracts tied to their relative

replications are shown.
Observing the replication from the standpoint of financial instruments, each type of
asset succeeds in capturing various types of information; for example a Zero Coupon
Bond will be found useful for gathering information that is strictly actuarial, a Swap-
Floating Leg can be used to capture the variable part of interest rates, a European
equity (put) Option to gather the optionality of securities or share indices etc. Usually,
in order to have a good model, it is necessary to use a number of assets that is a sort of
compromise between combination and regularity. In particular, a number of assets that
is too high may lead to a problem of overfitting (the model will explain well only that
particular data sample) whereas too low a number may lead to great approximation.
The second phase of the process is the stage when the objective function needs to
be defined so as to minimise, by specifying the number of constraints, the distance
between cash flows from liabilities and the cash flows of the replicating portfolio
itself. Minimising the distance between cash flows of liabilities and those of the
replicating portfolio may be required for all the time steps of the simulations or solely
for the sum of their value actualised at time = 0. Usually, quadratic or linear functions
are used; resolving a quadratic equation, in the absence of constraints, is the same as
resolving an ordinary regression to ordinary quadratic minima, whereas resolving a
linear equation has the advantage of creating fewer problems from the computational
standpoint. From the practical standpoint, linear optimising is less sensitive to
outliers15 whereas quadratic optimising penalises small errors more greatly.
After optimising the replicating portfolio, we need to evaluate how well it fits
with a series of possible scenarios. In order to do this, a number of analyses can be
performed. Good replication of a portfolio features a match of the value of the initial
liability with replicating assets in the various scenarios simulated (among which
there is also a current market scenario). An approach that is quite simple maybe that
of comparing the current value of liabilities with the current value of the replicating
portfolio; an alternative is to evaluate the R2 (R-square)16 and the dispersion graph

15
We speak of outliers, or anomalous value, to indicate a datum that is distant from available
observations, within a sample of observations.
R , coefficient of determination, is the measure of the degree of fit of the model with the data. The
16 2

formula represents the ratio applying between the deviation explained by the model (covariance
square of variations of estimated data as compared to the mean) and total deviation (covariance
square of actual data as compared to the mean). The value of R2 falls between 0 and 1; the closer it
comes to value 1, the better the model explains the data: when it is 0 the model in no way explains
the data.
682 31 Asset Liability Management (ALM)

300,000

250,000

200,000
Quadratic match

150,000

100,000

50,000

0
0 50,000 100,000 150,000 200,000 250,000 300,000
Linear match

Fig. 31.6 Cash Flow Replication Error

of data points (see Figure 31.6). In particular the R2 (R-square) represents the quota
of variation deployed by the model in connection with the total variation of the
process and for this reason there will be a better fit when the index takes on a value
close to 1. However, in these cases we need to evaluate the problem set out
previously tied to overfitting.17

31.9.2 Limitations of Replicating Portfolios and Good Replication

Replicating portfolios can be extremely useful for quantifying and managing finan-
cial risk but add no value in respect of measuring or managing the insurance risk. A
number of types of liability in the area of insurance cannot be combined with any
financial instruments: this applies, for example to insurance risks that are especially
asymmetric.
The complexity of implementing a replicating portfolio model lies mainly in
calibrating scenarios; this process requires specific knowledge of financial

17
We speak of overfitting to indicate a statistical model that estimates the observed data on the basis
of an excessive number of parameters.
31.10 Technical Appendix 683

instruments and a very robust optimising model. The following are indices of good
optimising:

• The difference between current values (e.g. between that of liabilities and that of
the portfolio of replacing instruments);
• R2(R-square) and the dispersion graph providing a visual representation of cash
flows;
• Standard error of estimated weightings;
• Replication of the value perturbed by various stress scenarios;
• Replication of meanders of the portfolio and the average and maximum regret.

The coefficient of determination R2 provides an indication of the fraction of variance

explained: R2 is a measurement that is conceptually simple but tends to focus too
much on the centre of the distribution; indeed, overfitting results in an optimal R2..

31.10 Technical Appendix

31.10.1 Proxy Models—General Features

P(t, T ) = A(t, T )e-B(t, T) r(t) (31.5)

The expression represents a solution in a closed form for the price in t of a unitary
zero-coupon bond with maturity T which is common to all kindred models.
The differences between models reside in the factors A and B that may take on
functional expressions of differing complexities.

dr = m(r)dt + s(r)dz (31.6)

This class of term structure model is built up starting from the same variable of
state, spot rate r, which represents the rate applicable to an infinitesimal timeframe
and so is called instantaneous short rate.
The process of development of r depends on a single source of uncertainty and
m and s represent respectively the instantaneous drift and standard deviation and are
assumed to be functions of r.
Depending on the functional specifications of components m and s, multiple
models can be obtained.

31.10.2 Proxy Models—One-Factor Equilibrium Model: Vasicek

dr = a(b - r)dt + σdz (31.7)

The expression represents the development process of the spot rate in the Vasicek
model a, b and sigma are constants. The stochastic term sigmadz is normally
684 31 Asset Liability Management (ALM)

Fig. 31.7 Mean reversion

distributed. In the Vasicek model, the spot rate has the undesirable characteristic of
being able to take on negative values.
The model incorporates the concept of mean reversion. This characteristic is
especially important and captures the typical nature of the interest rate of converging
in the long term upon an average value. In the model, this characteristic is implicit in
the term a(b-r)dt. For a representation, see Figure 31.7.

31.10.3 Proxy Models—One-Factor Equilibrium Model:

Cox-Ingersoll-Ross

p
dr = aðb - r Þdt þ σ r dz ð31:8Þ

The model of Cox, Ingersoll and Ross ensures non-negative rates at all times
since the standard deviation of changes in the spot rate r in an infinitesimal period of
time is proportional to the square root of r.
This model too includes the concept of mean reversion present in the Vasicek
model. For a representation, see Figure 31.8.
The Cox, Ingersoll and Ross model allows us to model structures by maturity of
interest rates with a trend that is increasing, decreasing or “humped”.

31.10.4 Proxy Models—No-Arbitrage Models: Ho-Lee

dr = θ(t)dt + σdz (31.9)

31.10 Technical Appendix 685

Fig. 31.8 CIR Model

Fig. 31.9 Ho Lee Model

The Ho-Lee model assumes that the volatility of the spot rate σ is constant while
the term θ(t) is a function of the time chosen so as ensure that the model “fits” with
the initial structure by maturities.

θ(t) = Ft(0, t) + σ 2t (31.10)

The term θ(t) defines the average direction of shifts in r at time t and can be
calculated analytically. Ft represents the instantaneous forward rate with maturity
r at time zero. For a representation, see Figure 31.9.
686 31 Asset Liability Management (ALM)

Approximating θ(t) with Ft the average direction of the short rate in the future is
approximately equal to the slope of the instantaneous forward rate curve. In practice,
the slope of the forward curve determines the average direction of the short rate at
each time.

31.10.5 Proxy Models—No-Arbitrage Models: Hull-White

dr = [θ(t) - ar]dt + σdz (31.11)

The Hull-White model is a kind of extension of the Vasicek model with a and σ
constant. It is usually characterised as a Ho-Lee model with a mean reversion
factor a.

σ2
θðt Þ = F t ð0, t Þ þ aF ð0, t Þ þ 1 - e - 2at ð31:12Þ
2a
The analytical treatability of the model is similar to the previous model with a
different expression for the term θ(t).
Approximating θ(t) to the sum of the first two terms as the latter is usually
insignificant, on average the short rate r follows the slope of the initial instantaneous
forward rate curve. However, when the curve deviates the mean reversion factor
brings it back to rate a. For a representation, see Figure 31.10.

Fig. 31.10 Hull White Model

References 687

31.11 Questions

1. What is meant by an embedded option?

2. Which are the three requirements that need to be met when developing an ALM
model?
3. Explain the definition of convexity
4. Which are the characteristics of a stochastic approach?
5. Provide a definition of real-world scenarioand illustrate the differences with a
model risk neutral
6. Explain the meaning of model points.
7. Which are the main one-factor models and which more-factors?
8. Illustrate the differences between SALM and OALM
9. What are the main limitations of replicating portfolio?

References
Redington FM (1952) Review of the principles of life office valuations. J Inst Actuaries 78:286–340
Babbel DF (1997) Economic evaluation models for insurers, Wharton Financial Institutions Center,
working paper
Laster D (2000) Asset-Liability Management for insurance companies, Sigma report, No 6, Swiss
Re Corporate

For models forecasting the rate curve Basic bibliographic references:

Hull JC (2004) Options, futures and other derivatives. Prentice Hall

Suggestions for Further Study

Vasicek OA (1977) An equilibrium characterization of the term structure. J Financ, Wiley

Cox JC, Ingersoll JE, Ross SA (1985) A theory of the term structure of interest rate. Econometrica,
Bologna, Italy
Ho TSY, Lee SB (1986) Term structure movements and pricing interest rate contingent claims. J
Financ. Wiley
Hull J, White A (1990) Pricing interest rate derivative securities. Review of Financial Studies,
Oxford
Hull J, White A (1994) Numerical procedures for implementing term structure models II: two factor
models. J Derivat, London, UK
Heath D, Jarrow R, Morton A (1992) Bond pricing and the term structure of interest rates: a new
methodology. Econometrica, Bologna, Italy
Brace A, Gatarek D, Musiela M (1997) The market model of interest rate dynamics. Math Financ
Embedded Value
32

Abstract

The aim of this chapter is to explain the Embedded Value (EV) method. The
related components: Appraisal Value (AV) and Net Asset Value (NAV) are
described. The transition versus a new method, European Embedded Value
(EEV), is illustrated. The essential difference as compared to the traditional
calculation of Embedded Value lies in the calculation of the VIF, which is
adjusted through the value of the options and guarantees that are implicit in the
portfolio. Then, the more sophisticated method, Market Consistent Embedded
Value (MCEV) is represented. In the paragraphs following, to make easier the
comprehension, a numerical example is provided. Starting from three hypotheti-
cal insurance undertakings, A comparison between TEV, EV and MCEV is
performed. The example shows three different impacts on the capital requirement.
In the following paragraphs, the chapter introduces the concept of New
Business Value (NBV) and of Annual Premium Equivalents (APE). An indicator
for Embedded Value (ROEV) is illustrated. At the end of the chapter, the model
for determining Goodwill is explained.

Keywords
Embedded Value · Goodwill · Appraisal Value (AV) · Net Asset Value (NAV) ·
Adjusted Net Asset Value (ANAV) · Deferred Acquisition Cost (DAC) · Deferred
Income Reserve (DIR) · Value in Force (VIF) · Future industrial profits · Present
Value of Future Profits (PVFP) · Operating expenses · Expenses overrun · Risk
Appetite Framework (RAF) · EV Movement · Embedded Value Earnings (EVE) ·
Traditional Embedded Value (TEV) · Cost of Capital (CoC) · Risk Discount Rate
(RDR) · European Embedded Value (EEV) · Time Values of the Options and
Guarantees (TVOG) · Market Consistent · Real world · Best Estimate (BE) · Cost

For this chapter, a special acknowledgement goes to Marcello Ottaviani (consulting audit and
appointed actuary).

# Springer Nature Switzerland AG 2024 689

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_32
690 32 Embedded Value

of Residual Non-Hedgeable Risks (CRNHR) · Frictional Cost of required capital

(FCoC) · Last Liquid Point (LLP) · Implied Discount Rate (IDR) · Own Funds
(OF) · New Business Value (NBV or VNB) · Best Estimates Liabilities (BEL) ·
Return On Embedded Value (ROEV) · Annual Premium Equivalents (APE)

32.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Provide the definition of Embedded Value

2. Determine the amount of ANAV (Adjusted Net Asset Value)
3. Calculate the amount of Value in Force (VIF)
4. Know the measures of creation of value and profitability for an insurance
undertaking
5. Illustrate the history of Embedded Value
6. Know the definition of APE (Annual Premium Equivalent)
7. Explain the approach for determining Goodwill

32.2 Definition of Embedded Value

Embedded Value (EV) is the method that was most widely used during the nineties
and subsequent twenty years for assessing the business generated by an insurance
undertaking financially. It is a tool of fundamental importance in managing the
undertaking itself as it allows a measurement to be made of value from the stand-
point of shareholders and created through the activity carried on by the insurance
undertaking and, through a number of specific indicators, allows an in-depth aware-
ness of all the exogenous and endogenous factors that may place this value at risk.
Embedded Value can be defined as the “value already acquired by the interests of
shareholders in the business”. With the introduction of the European Solvency II
regime, this indicator has been replaced over time by Own Funds, which, however,
represents a concept that is similar.
Later in this chapter, the process of developing the techniques of Embedded
Value and its subsequent developments will be described.
Embedded Value is calculated as the sum of Adjusted Net Asset Value (ANAV)
and Value in Force (VIF) which represents the value that is intrinsic in policies
issued. It should be noted that the calculation is based on assuming a portfolio closed
to new contracts, i.e. without new future production, but using the assumption of a
going concern. Embedded Value can also be looked at as the sum of the value of
32.2 Definition of Embedded Value 691

Adjusted Net Asset Value of Embedded

Value Business Value
(ANAV) in Force (Closed Portfolio)
(VIF)

Fig. 32.1 Elements making up Embedded Value

tangible assets, i.e. Adjusted Net Asset Value, and intangible ones, i.e. the Value in
Force. See Figure 32.1 which represents the elements making up Embedded Value.
Concerning the first component, the Adjusted Net Asset Value (ANAV), this is
the net asset value adjusted to market values. The adjustments are needed in order to
break out all intangible assets (such as goodwill of acquired insurance undertakings,
non-physical assets and commissions to be amortised) and to set out realistic value
(such as adjustments to market value of securities valued at historical cost).
The Value in Force (VIF) is the current value of future technical-industrial profits
that can be distributed to shareholders solely from contracts already issued at the
time the assessment is made, net of maintenance cost of the risk capital used as a
guarantee of the solvency of the undertaking and net of any fiscal impact. In order to
calculate this value, it is necessary to project flows relating to these contracts up until
their natural expiry taking into consideration all the information (of a financial and
demographic type, for example) needed, so as to be able to make as realistic an
assessment as is possible.
Another indicator of value that is commonly calculated by insurance undertakings
is the value relating to new production made during the year. This indicator has the
dual objective of measuring the sales capability of the insurance undertaking from
year to year and reconciling the assessment made of Embedded Value at the start of
the year with that of year-end.
In order to calculate Embedded Value, Goodwill, i.e. the future value of newly
produced contracts issued in the future, is not taken into account. Appraisal Value
(AV) is the sum of Embedded Value and Goodwill and is generally calculated with
the aim of measuring the value of the insurance undertaking in terms of its strategic
positioning, i.e. the intangible value of an insurance undertaking reflecting the
position achieved in the market, its sales capability, reputation attained, strength of
the brand etc. In general, financial analysts prefer to utilise different models tied to
the free cash flow, such as the Dividend Discount Model (DDM) to make this kind of
assessment, because they are more consistent with the aims of strategic positioning
that they wish to measure, but if appropriate assumptions of calculation the two
692 32 Embedded Value

Appraisal
Goodwill Value

VIF Embedded Value

ANAV

Closed Portfolio Opened Portfolio

Fig. 32.2 From Embedded Value to Appraisal Value

valuations should be the same. See Figure 32.2 containing the transition from
Embedded Value to Appraisal Value.
The increasingly frequent use of Embedded Value to assess life insurance
undertakings and savings gathering insurance undertakings, has led to this method-
ology leaving the area of actuaries and taken on a growing relevance for many
analyses in the financial community. Most analysts and investors have indeed
considered Embedded Value as an essential piece of data, mainly in fully under-
standing the trend in profitability. In particular, this tool has been found useful for:

• Shareholders of the undertaking, who can compare the value that can be obtained
from the investment with market returns, or with returns from alternative projects,
or compare it with their expectations.
• Corporate management, who through the variation in value for the two periods,
can identify the critical factors that can put the profit issue at risk for the
undertaking and identify the “strengths” and “weaknesses” of the undertaking.
• Risk management, in verifying the stability of the value as economic and demo-
graphic conditions vary and carry out an allocation of economic capital.
• Extraordinary operations as an element underlying negotiation of sales value.

For all the issues indicated above, it is clear that, whereas in the past the
assessment was required purely for extraordinary transactions of insurance
undertakings or portfolios of policies (mergers and acquisitions) or when commenc-
ing or concluding a reinsurance treaty, this tool has been lately more and more
widely used even in “ordinary” conditions to provide more transparent information
to the financial community and to shareholders to assess the performance, or the risk,
of the insurance undertaking.
32.3 Definition of Adjusted Net Asset Value 693

Table 32.1 Items of net asset value

Items in financial statements Values in units

Insurance undertaking capital 5,000,000
Legal reserve 6,500,000
Other reserves 1000,000
Profits/losses carried forward -500,000
Equity 12,000,000
Net profit for the year 1,250,000
Dividends for distribution -1,100,000
Net Asset Value 12,150,000

32.3 Definition of Adjusted Net Asset Value

Generally, in determining the Adjusted Net Asset Value (ANAV), the value of net
equity is used, but this is not a required condition because another set of financial
statements can be used as a starting point, such as that of the IFRS, if consistent with
the timing and availability of this information and the aims of calculation, and fitting
adjustments are duly made.
Net Asset Value (NAV)1 is represented by the difference between assets and
liabilities in the balance sheet. It is made up of insurance undertaking capital,
increased by reserves (statutory, legal and others) and any profits achieved pending
application, net of possible pending losses being met. At a strictly accounting level,
all funds for charges intended to meet losses or debts of a specific kind, that certainly
or probably exist and with a sum or date of arising that is not determinable at the end
of the accounting period, are thus excluded from net assets, A further adjustment is
made to net assets by subtracting dividends paid or already resolved; this transaction
is needed because the value of dividends to be paid to shareholders, even if not yet
paid, cannot be included in the intrinsic value of the undertaking. See Table 32.1 for
a detail of the items of Net Asset Value.
Since the purpose of Embedded Value is to assess the insurance undertaking at
the time when it appears in the marketplace, all items of assets and investments need
to be appraised at market value, i.e. the value that an outside investor in the insurance
undertaking is willing to pay to acquire them. For this reason, the value of the
Adjusted Net Asset Value (ANAV) is calculated starting from the Net Equity or
another value of net assets taken from other financial statements and applying the
relative adjustments. The adjustments must be consistent with the methodology used
for calculating the Value in Force (VIF). Indeed, there are a number of items that for
their special nature can be classified either in the ANAV or in the VIF depending on
interpretation, and so it is necessary for the defining principles for these items to be
defined specifically or, more generally, to accompany the assessment with a note
aiming to explain how the results have been obtained.

1
The Net Equity Value of an insurance undertaking, adopting Anglo-Saxon terminology is also
called Net Asset Value (NAV).
694 32 Embedded Value

Table 32.2 Items of the ANAV

Items in financial statements Values in units

Net Asset Value 12,150,000
Equity investments (-)
Adjustments for intangible assets
(a) Goodwill
Goodwill (-) -1,500,000
(b) Other intangible assets
Other gross intangible assets -750,000
Figurative fiscal effect (i.e. 32.32%) 242,382
(c) DAC (Deferred Acquisition Cost)
Gross DAC -350,000
Figurative fiscal effect (i.e. 32.32%) 113,112
Adjustment for liabilities
(a) DIR (Deferred Income Reserve)
Gross DIR -259,000
Figurative fiscal effect (i.e. 32.32%) 83,703
(b) Latent capital gains/losses on portfolio of securities (+/-) 275,000
Gross capital gains/losses from assessment
Figurative fiscal effect (i.e. 32.32%) -88,873
(c) Capital gains/losses projected on to VIF net of taxes -400,000
Adjusted Net Asset Value 9,516,324

Table 32.2 illustrates the main adjustments applied in order to obtain the final
value of ANAV (starting from the IFRS balance sheet). See the following text for a
detailed description of each item.
In detail, from the Net Asset Value, adjusting all intangible assets is proceeded
to. Specifically, the value of goodwill for equity investments is deducted.2 It is
additionally necessary to deal with eliminating some intangible assets (including
amortising provisions) as the international regulator has laid down that for the sake
of simplicity these assets do not have market value, i.e. any other intangible postings
that do not have a value that is independent of the undertaking (i.e. investments in
software development, multi-year advertising expenses and costs of first installa-
tion). Lastly, among the main items that are reversed from the value of the Net Asset
Value there is Deferred Acquisition Cost (DAC). This item includes the acquisition
expenses for insurance contracts.
All postings will be calculated net of taxes (or, alternatively, the value of deferred
taxes will be increased).
From Adjusted Net Asset Value, all the reserves set up with the aim of meeting
any potential under-assessment of liabilities such as, for example any supplementary

2
It should be noted that since Embedded Value is an estimate of the value of existing business
(relating to sales that have taken place up to the assessment date), Goodwill relating to new business
from future life contracts has to be removed. In VIF only the value of production already achieved
can be considered.
32.4 Calculating Value in Force 695

reserve for guaranteed minimum and demographic risk reserves (such as excess
mortality or longevity risk) must additionally be excluded since these costs must
already be covered in the VIF assessment. The Deferred Income Reserve (DIR) is
the item that includes what is set aside for expenses and determined by capitalising
gross asset loadings. DIR has also to be reversed on the same basis as the DAC.
Subsequently, any capital gains, or latent (and unrealised) capital losses relating
to securities not hedging liabilities of assureds are considered in respect of any items
that have not been appraised at market value where accounting standards do not
impose, they be realised. Latent capital gains (+) are added together, whereas latent
capital losses (-) are entered as reductions, both calculated net of taxes (or by
increasing the value of Deferred Taxes—DT) and the effects of dividends. Mark-to-
market assessments, i.e. valuations of assets taking the market situation into account,
follow various methodologies connected with the type of asset. For example,
receivables will be valued at their presumable realisable value, lands and buildings
at market value, listed securities through official quotations on the day of assess-
ment, derivatives at their current value as confirmed by the counterparty and/or by
independent quotation.
Finally, capital gains/losses relating to assets hedging technical reserves that have
not been projected onto the Value in Force (VIF), net of the fiscal effect and
dividends, must be eliminated.3
The value obtained at the end of all these adjustments represents the final ANAV
of the insurance undertaking.
In cases of insurance groups, equity interests in other insurance undertakings
falling within the perimeter of consolidation must be reversed, so as to avoid dual
accounting for these.

32.4 Calculating Value in Force

By Value of In Force Business (VIF) is meant the value of the portfolio, commonly
defined as the current value of industrial profits net of taxes and cost of risk capital. A
forecast of flows generated by the business of an insurance undertaking requires, of
necessity, the construction of a model, i.e. a simplified, outline description of reality
based on specific assumptions that are typically long term in nature. This assessment
model must necessarily gather together the various aspects of insurance business; the
cash aspect, which evaluates purely monetary flows, the profitability issue, which
evaluates the forming of profits, and an equity one, which assesses issues of financial
statements.
Cash flows are projected for each contract or groups of these for each year of its
residual duration. In particular, income from premiums, payment of losses or

3
This item may, for example be booked both in ANAV and VIF. The most widespread practice is to
book it in the VIF when the differences in assessment are tied to assets hedging reserves, even if
there are different cases, and in the ANAV for assets covering equity.
696 32 Embedded Value

maturities, surrenders and expenses for managing the contracts, interest and other
financial income deriving from investments of assets, flows in respect of reinsurance
or to service insurance undertakings, are all considered. These cash flows are
supplemented by equity and treasury information (liquidity) so as to be certain of
the proper positioning of the insurance undertaking so it can take any corrective
action that might be needed. By way of example, whether or not the liquidity of the
insurance undertaking is adequate to meet cash outflows must be checked, other-
wise, management will have to sell off securities. Alternatively, a check needs to be
made as to whether or not the value of assets shown in financial statements is actually
greater than the mathematical provision; in not the insurances undertaking will need
to inject more capital.4
Future industrial profits are the profits that are either technical or financial
deriving solely from management of the portfolio and not those deriving from net
assets (ANAV). Expected industrial profit referring to a generic future year of
management t can be looked at as:

U t = V t - 1 þ Pt þ Rt - E t - C t - St - V t ð32:1Þ

• final reserve Vt - 1 for the previous year (or by analogy the initital reserve for the
current year)
• Pt tariff premiums collected in the year
• Rt, financial income generated from assets covering liabilities

From these positive flows, the following item are to be diminished:

• Et, expenses
• Ct capital sums in cases of decease and St in cases of surrender (or in cases of
survival if referring to the last year of the contract)
• Vt final mathematical reserve (representing a debt).

Once the sequence of future profits has been obtained in respect of all the years of
expected management, it is possible to obtain the Present Value of Future Profits
(PVFP), i.e. the sequence of industrial profits net of taxes, Ut. This formula is:

PVFP ¼ t→1
U t ð1 - TaxÞvt ð32:2Þ

where v represents the discount, factor based on the interest rate curve used in the
assessment made, and Tax, the average fiscal rate attributable to the projected year
and the insurance undertaking under examination.
To determine the PVFP, it is necessary for the model of calculation to make a
number of fundamental assumptions: the methodology to be used for determining

4
Accounting rules for financial statements vary, even greatly, from country to country and these
needs have to be foreseen in the calculation model.
32.4 Calculating Value in Force 697

the flows mentioned above is based on the assumption that each contract (or more
generically the model point5) for each instant in the assessment, has an event and so a
flow (from those cited above) that is consistent with its likelihood of occurring
(expected value). The so-called going concern assumption is adopted in which,
notwithstanding the need to foresee a closing to new business (portfolio run-off),
this assumption means that the insurance undertaking operates under a regimen of
normality, so avoiding, for example there is a gradual dismissal of employees, and so
a reduction in costs, or that investments/disinvestments are made that are not
consistent with normal activity but rather derive exclusively from the situation of
run-off of the portfolio.
Once the “standard” value of the undertaking has been obtained (and which
reflects a going concern regimen) it is possible to make corrections to assess the
effects caused by a specific situation of the undertaking (e.g. cases of starting up a
new insurance undertaking or a corporate restructuring) on value. In particular, the
main differences between mature insurance undertakings and those at the start-up
stage relate to installation costs and income taxes.
Other assumptions underlying the calculation are technical (or operational) or
financial in nature and concern other aspects relating to the situation in which the
insurance undertaking finds itself at the time the assessment is made: the rate of
actualisation and return on securities (financial assumptions), mortality rates (demo-
graphic assumptions), policy management expenses, surrenders and other contract
variations, the ratio of cover for the solvency margin, taxes and (investment) choices
made by management (insurance scenarios). The purpose of the PVFP is to deter-
mine the current value of the profit that is intrinsic to the policies issued through
actualising realistic cash flows; for this reason, it is necessary to use assumptions that
are realistic and that reflect probable forecasts of the matching parameters.6
In what follows, the three assumptions (financial, demographic and operational)
are discussed in detail, illustrating all the underlying parameters.
In respect of the financial assumption, this is used to determine future financial
income, which serves to determine the revaluation of mathematical provisions and
also to determine the current value of cash flows. This assumption is of fundamental
importance in determining the value of savings contracts, since these are generally
for longer durations and they have an investment component that prevails over that
of risk.
In respect of demographic assumptions, in estimating the expected frequency of
decease, insurance undertakings are able to use standard mortality tables built up
from experience in the reference marketplace (typically the country), fittingly
adapted through one or a number of multipliers, or to use specific tables built up
on the basis of the experience obtained with assureds of the insurance undertaking

5
By model point we mean a record obtained as an aggregation of one or a number of policies, or
positions is cases of group policies, in respect of insurance contacts.
6
The difference as compared to issues of pricing and reserving where prudential type assumptions
are required should be noted.
698 32 Embedded Value

itself. In general, a table based on recent data can be appropriate for the first years of
projection of the contract, whereas for years that are farther away, corrections can be
used so as to consider the possible (more favourable) rates of mortality in the long
term. It needs to be underlined that, in general, for insurance undertakings with a
significant presence of savings contracts, differences in the likelihood of mortality do
not lead to variations that are as significant in the value of the insurance undertaking.
On the other hand, in insurance undertakings with a prevalence of contracts tied to
the protection of capital (CPI), since these a more exposed to mortality risk than the
financial one, these generate greater sensitivity to the demographic variable.
Estimates about operating expenses must reflect the total of expenses necessary
for managing the portfolio efficiently and be estimates that are trustworthy even over
the long term, and also represent the global expense objectives of the insurance
undertaking, while also considering the expected inflation in costs. In general, three
classes of costs in insurance business are identified7: those of management, settle-
ment and acquisition (of new contracts). The first two types are used to assess the
PVFP, whereas the third, not relating to management of the portfolio, is excluded
and is used in calculating the value of new production.
The most widespread way of attributing the need for future expenses for the
insurance undertaking consists of attributing costs to products, or groups of these,
and later to individual policies, so as to distribute the actual costs over the duration of
each policy.
Often, in the case of a start-up undertaking, there is an excess of expenses, called
an expense overrun: this occurs when the expenses actually incurred exceed those
foreseen or those of the long term.8 If assumptions are made for a certain number of
future years leading systemically to total actual sums of expenses being in excess of
those foreseen under the business plan, the value of the current portfolio can be
corrected by subtracting the current incremental value of future overruns net of taxes.
In determining this value, management expenses only must be considered as any
assessment of future production is excluded from Embedded Value, as has already
been stated.
A further issue that has a bearing on the value of a portfolio is that of contract
options such as withdrawal, surrender or lapse and which therefore have to be
included in the assessment model as possible causes of interruption of, or change
made to, the contract. It is of fundamental importance that these assumptions are
evaluated via proper analyses of the behaviour of the portfolio with an adequate level
of granularity; indeed, in the case of savings contracts, this is extremely relevant and
impacts meaningfully on the value of the portfolio.
Other possible contract variations may be a reduction (i.e. the contract clause that
allows a reduction in sum assured in the event of a reduction taking place in the

7
Other types of specific costs may again come under this heading.
8
It should be noted that an excess of expenses (expense overrun) in financial statements does not
necessarily imply that the basic assumptions made were wrong, but rather that expense objectives of
the insurance undertaking have not been achieved.
32.5 Measuring the Creation of Value and Profitability 699

number or sums of agreed premiums), partial surrender or transforming at maturity

of an annuity into a lump sum or vice versa, a switch from one fund to another with
features that may be different etc. In the evaluation of a generic contract variation,
the methodology analyses likelihood of occurrence (obtained from past experience)
and related sums, separately.
In determining PVFP, both the sum of income taxes and any other indirect taxes
paid (on behalf of assureds, for example) or on financial income, are to be included.
Usually, taxes on income are determined by applying the marginal rate to gross profit
for the period considered. The main grounds for corrections being made to PVFP
tied to taxation is perhaps the achieving of negative profits in specific periods or
specific groups of policies (new production, e.g. often gives rise to negative profits in
the year of issue) and the possibility of partially recouping the loss over subsequent
accounting periods.
Finally, for the purposes of calculating the PVFP, the results deriving from
reinsurance treaties in force need to be borne in mind. In this case, we need to
distinguish between the ceding of new contracts (which normally generates periodic
commissions) and ceding portfolios, which leads to favourable cash flow at the time
the contracts are transferred.
To find the ViF, the cost of economic capital that the insurance undertaking
needs to hold in accordance with current regulations, i.e. the financial or fiscal cost
deriving from the fact that an insurance undertaking cannot have these sums, which
are the law of financial yield from assets it holds covering this, freely available needs
to be considered. Insurance undertakings hold the level of capital that is consistent
with its business model and appetite for risk (its Risk Appetite Framework).
According to the Risk Appetite Framework (RAF), these sums set aside lead to
costs that are financial, for management of the related assets covered. In ViF must
also be included costs deriving from risks the insurance undertaking must meet in
management, be they market, technical or operational.
A rule for checking whether a cash flow or an item in financial statements is to be
considered or not in calculating Embedded Value, is to verify whether they have an
economic impact from the standpoint of the shareholder, directly or indirectly. For
example, a tax paid by the assured on the lump sum received does not impact upon
shareholder value, whereas if the same tax is advanced by the insurance undertaking
during the life of the contract (the insurance undertaking acting as a collecting agent)
so generating a non-interest-bearing credit item since it gives rise to a loss of interest,
this would have an impact on the concerns of a shareholder and should be
considered.

32.5 Measuring the Creation of Value and Profitability

Usually, the shareholders in an undertaking are concerned with the overall yield
generated by their investment; this yield is made up of the sum of dividends received
(net of any further payments-in as capital made) and any increase in the value of the
investment.
700 32 Embedded Value

In the area of life insurance, it is necessary to use a model that succeeds in

measuring the level of value achieved over a specific lapse of time and “capture” the
typical nature of a business that normally features long-term contracts.
Embedded Value evolves over time due to the effects of a number of factors that
influence the development of the insurance portfolio, and analysing this shift is
called EV Movement (EVM).9
This analysis is based on the following elements: the opening EV, from the
previous year is, if necessary reviewed for any significant items of change to the
model (restatement). Then the rate of release of actualising (unwinding), due to the
fact that after one year we have one year less of actualising for old business. Lastly
the variation in expected profit for the accounting period of the year is measured
against that actually achieved10 and the effects on ViF due to any different number,
or type, of contracts in force at the end of the accounting period (indeed, if,
e.g. surrender assumptions made a year earlier have not been borne out, there will
be a different number of assureds at the end of the year). Lastly, the variances
between the assumptions made for the previous year are measured against those for
the subsequent year (operational and financial), then the NBV is inserted at the end
of the year and, finally, adjustments are made to account for movements in capital or
development costs. The sum of the items just described, before movements in
capital, and net any restatement, and variations in economic assumptions made, is
called Operating Profit since it mainly depends on choices made and actions taken by
management of the insurance undertaking, and in many insurance undertakings it is
an item of fundamental importance in assessing management performance. If eco-
nomic variations are also included, we have Embedded Value Earnings (EVE)
which measures the aggregate variation in EV net of movements concerning
shareholders and differences in calculation methodology.

32.6 History and Development of Embedded Value

Over the years, Embedded Value has undergone variations consistent with the
regulatory, economic and financial context created in Europe since the nineties
and up until the coming into force of the new solvency regime.

32.6.1 Traditional Embedded Value

The first approach that insurance undertakings and insurance practice followed was
called Traditional Embedded Value (TEV). It is calculated as the sum of ANAV
and VIF given by the PFVP net of taxes and net of the cost of risk capital Cost of

9
It is named Analysis of Movement or Analysis of Surplus.
10
Which will be shifted from ViF to ANAV, as achieved.
32.6 History and Development of Embedded Value 701

VIF

Cost of
- Capital

PVFP

EV
(VIF + ANAV)

ANAV

Fig. 32.3 Components making up Traditional Embedded Value

Capital (CoC). In Figure 32.3, the components of Traditional Embedded Value

(TEV) are set out.
Given the risk capital necessary to ensure an adequate level of solvency for an
insurance undertaking, valued today and in the same periods of projection for
calculation of Embedded Value, the Cost of Capital (CoC) is the current value of
the increases in this capital, by year of projection, net of financial yields generated by
hedging assets and reduced by related taxes on capital gains. It should be noted that if
the rate of actualising and yield were equal to zero, there would be no cost. Indeed,
the CoC represents the financial and fiscal cost of having to hold economic capital.
Usually there is no common criterion for defining the risk capital to be used for
the purposes of assessment. There are insurance undertakings that normally consider
the minimum solvency margin as risk capital, whereas others increase this value in
line with their solvency target or own Risk Appetite Framework (RAF).
The assumptions made in this context are the following: the model is of deter-
ministic type and does not use an Asset and Liability Management (ALM) approach,
i.e. it determines the rate of revaluation of assets via an exogenous real world-type
rate, often calibrated on the yield of its own assets. The rate of actualising is of a Risk
Discount Rate (RDR) type, i.e. it is given by the sum of a risk-free rate plus a risk
premium determined so as to reduce the value of the ViF and increasing the rate of
actualising so as to meet the risks the insurance undertaking runs, including financial
and technical ones. The most widespread approach for determining the RDR is the
Capital Asset Pricing Model (CAPM), which is a model that describes the relation-
ship between systematic risk and expected yield from an individual asset. The
CAPM is widely used everywhere in finance for determining the price of at-risk
securities and expected yields are calculated for certain assets with the risk of these
assets being determined on the basis of a certain relationship with the market.11

11
In the CAPM (Capital Asset Pricing Model) the risk premium to be added to the no-risk rate is
estimated according to the well-known formula s = rf + (E(Rm) - rf)b.
702 32 Embedded Value

The main advantage of the Traditional Embedded Value (TEV) methodology lies
in calculating expected profits in the most simple and immediate manner possible on
the basis of scenarios that can be easily identified since they do not depend on the
assets. Notwithstanding these advantages, extreme market conditions in recent years
have shown up its limitations. The volatility of interest rates and the stock market has
led to an appreciation of the guarantees implicit in insurance contracts, especially
financial ones, given the presence of minimum guaranteed returns. This limitation of
the TEV has led to the methodology being reviewed, above all in a greater recogni-
tion of market risks, interest and credit among them. Among the main limitations tied
to the choice of the rate of actualising Risk Discount Rate (RDR) the fact is
recognised that this may be subjective (e.g. in respect of defining the rate of
actualising of expected cash flow, the manner of calculating the cost of own capital
and defining own capital) and not reflect an appropriate weighting of expected profits
and yield risk of assets accurately. Another criticism relates to the fact that the Risk
Discount Rate (RDR) is a rate of actualising that does not vary over time by not
considering variation in risk profile and changes in global business, or changes in
financial markets. Finally, the use of a single discount rate applied to all cash flows
does not take into account the risk features of the individual flows that are the subject
of assessment. In order to surmount all these limitations, new standards for calculat-
ing the Embedded Value of an insurance undertaking were defined and new models
have been developed that will be illustrated in forthcoming paragraphs.

32.6.2 European Embedded Value

In May 2004, the CFO Forum held among heads of finance of the main European
groups defined the rules for calculating a new model of Embedded Value in a
homogeneous manner.12 The new method is defined as European Embedded
Value (EEV). The essential difference of European Embedded Value (EEV) as
compared to the traditional calculation of Embedded Value lies in the calculation of
the VIF, which has to be “adjusted” through the value of the options and guarantees
that are implicit in the portfolio, fittingly assessed via a type of model that is
alternative to the deterministic one, i.e. a stochastic model. The components of the
EEV are required capital and the free surplus, which are added to the ANAV. The
VIF, which is given by the PVFP net of the Time Values of the Options &
Guarantees (TVOG) (assessed via stochastic models) and the cost of required
capital (CoC). In required capital, a sum necessary to abide by a specific level of
rating may be included, or an objective value of capital rather than internal

12
The European Insurance CFO Forum is a high level discussion group in which the Chief Financial
Officers of the main listed, and some unlisted, European insurance undertakings participate. The
purpose of the Forum is to provide guidelines for setting out financial statements, reports based on
listings, and related regulatory leanings for insurance undertakings through its membership, who
represent a significant part of the European insurance industry. The CFO Forum was set up in 2002.
32.6 History and Development of Embedded Value 703

VIF VIF

- Cost of
Capital - Cost of
Capital

PVFP PVFP Value of

- Options &
Guarantees

EV Free
Surplus EEV
ANAV
Required
Capital

Traditional Embedded Value European Embedded Value

Fig. 32.4 From Traditional Embedded Value to European Embedded Value

assessments. See Figure 32.4 which represents the transition from Traditional
Embedded Value to European Embedded Value.
The methodology of the EEV foresees an assessment being made of the impact of
technical and financial risks on the future profits of an insurance undertaking. To
meet this requirement, insurance undertakings have adopted two alternative
methodologies: bottom-up and top-down. The former foresee risk (financial and
operational, or non-market risk) being defined at an insurance undertaking level,
than being included in the assessment through a modification made to the financial
parameter (risk premium). While foreseeing an ALM type model, this approach is
still tied to the traditional world and indeed foresees the use of financial assumptions
of a Real World type by adopting the RDR rate of actualising. The two most widely
used approaches for determining the RDR are the one adopted by the Traditional
Embedded Value model, i.e. the CAPM, or more widely, the WACC.13 The
standards foresee that different RDRs may be used within a single assessment, for
example by different lines of business.
The bottom-up method determines the cost of financial risk on the basis of actual
assessment through a stochastic model of the ratio between assets and liabilities
(Asset and Liability Management). In order to actualise cash flows the same struc-
ture is used as for rates of interest in determining the yield from risk-neutral/market
consistent securities,14 and the cost of the guarantees sold by insurance undertakings
determined via a calculation based on an analysis by product. The stochastic model
determines the cost of the financial guarantees by the following approach: the
difference between the PVFP calculated as an arithmetical mean of scholastic
scenarios and the central deterministic scenario (or Certainty Equivalent) is

13
By WACC (Weighted Average Cost of Capital) is meant the average return that an insurance
undertaking has achieved over a certain lapse of time as distributable profit split by investment
made, i.e. capital invested by shareholders.
14
To calculate the price of a security, and especially an option, it is necessary to adopt a system of
measurement called risk-neutral according to the Fundamental Theorem of Asset Pricing.
704 32 Embedded Value

calculated. The non-financial risk is calculated via an assessment external to that of

the PVFP.
Among bottom-up methodologies, the most widespread one includes a set of
economic scenarios of a Market Consistent type so as to replicate the prices of own
assets that are consistent with the market. This approach allows in particular the
value of financial guarantees sold by insurance undertakings, which are implicit
options, to be estimated correctly.15 Another possibility is to use Real-World
stochastic rates. This approach in reality do not properly estimate the cost of these
implicit guarantees because it is not an approach that is neutral with reference to risk,
and indeed the structure of a Real-World rates structure includes risk premiums and
so does not meet the Fundamental Theorem of Asset Pricing, which is a necessary
assumption for calculating an option.
Non-market risk mainly means insurance risks, or those tied to insurance busi-
ness, among which we find the risk of mortality, longevity risk, surrender risk,
operational risk and other minor ones depending on the type of business and
positioning of the insurance undertaking. Since assumptions are made, the risk that
these assumptions are not borne out ought to be assessed too, i.e. that the form of a
certain risk, deduced from historical data and expert judgement, does not appear as
per expectations. In general, insurance undertakings that take the top-down approach
have not made an explicit assessment of non-market risk, which has typically been
included in the risk premium (in addition to the rate calculated by the WACC or
CAPM method). Insurance undertakings using the bottom-up approach use various
methods for quantifying non-market risk, among which there are: explicit ones,
through assessment deduced from the internal model or assessment of capital,16 or
implicit ones, by introducing a premium for risk in the structure of interest rates or
unitary factor used for calculating the cost of capital.
In this context, the concept of Best Estimate assumptions was defined for the first
time. To obtain this estimate it is first necessary to define the probability distribution
of the chance variable of the risk that it is intended to calculate. The average of this
distribution is the Best Estimate (BE).
Additionally, European Embedded Value introduces a new regimen of transpar-
ency that allows the manner of calculation of Embedded Value to be made explicit.
Undertakings especially must disclose a number of items of information
supplementing the assessment: methodology, sensitivity analysis (variation of EV
as certain assumptions vary), analysis of movement (EVM), business segmentation
and the document on management assessments (including abidance by EEV
standards and reference to any external review).

15
Insurance undertakings especially, sell a put option on interest rates (short put).
16
For instance, ICA in the past for UK insurance undertakings or Solvency II more recently. ICA
(Individual Capital Assessment) is the assessment of economic capital for insurance undertakings
introduced in the United Kingdom at the end of 2004.
32.6 History and Development of Embedded Value 705

VIF

TVFOG

PVFP Frictional
Cost
ANAV CRNHR

Free
Surplus

MCEV
Required
Capital

Fig. 32.5 Market Consistent Embedded Value

32.6.3 Market Consistent

The main constraint of European Embedded Value is mainly due the wide margin of
discretion it allows to undertakings in respect of the choice of a top-down approach,
which is calibrated from the standpoint of the undertaking, and the simultaneous
presence of bottom-up approaches, calibrated consistently with the market and, as a
result, with the difficulty of comparing the results obtained. For this reason, in June
2008, the CFO Forum published new standards replacing the previous ones and
introduced Market Consistent Embedded Value (MCEV).
As can be seen in the figure, Market Consistent Embedded Value (MCEV) is at
calculated as the sum of required capital and free surplus, i.e. ANAV. VIF is the sum
of PVFP net of the Time Value of Financial Options & Guarantees (TVFOG),
Frictional Costs of Required Capital (FCoC) and the Cost of Residual
Non-Hedgeable Risks (CRNHR).
In essence, this set of standards acts in areas not covered by EEV by introducing
the concept of Risk Neutral/Market Consistent assessment, by eliminating de facto
top-down approaches and including, without, however, prescribing the ways, an
approach to risk for non-financial (non Hedgeable) and non-insurance risks. In order
to provide a synthetic definition, Market Consist Embedded Value for an insurance
undertaking is equal to the difference between the market value of assets and the
market value of liabilities, less the cost of non-market risks (CRNHR) and the cost of
capital (FCoC). Liabilities include performances owed to assureds but also all other
payments owed to third parties, excluding shareholders (e.g. portfolio management
expenses, taxes and sums insured to pay out to assureds) This calculation is said to
be indirect because it makes use of the following equation:
706 32 Embedded Value

MVA = MVL þ MCEV ð32:3Þ

where MVA = the market value of assets

MVL the market value of liabilities
MCEV* = MCEV net of FCoC and CRNHR which are items foreseen only in
MCEV standards, in addition to a risk-neutral assessment of future profits.
This equation can be read in the following way: the market value of assets may be
broken down through a risk-neutral assessment in the value to be paid to third
parties, (but also other third parties) and shareholders. The alternative is to assess
future shareholder cash flows directly, without therefore making a difference
between sums of another kind. As a matter of principle, the two methods must
give rise to the same value for MCEV and if this does not occur, we say that we have
an assessment model that generates leakage. By the term leakage we indicate the
situation where the assessment generates a greater or lower value of liabilities as
compared with what the insurance undertaking has available (MVA). This differ-
ence, which is not usually material if it does not apply, must be corrected either
through an analysis of the flows generated by the model, but which may be
extraordinarily complex and not lead to solutions that are certain or immediate, or
re-attributed through simplified methods, proportionally, for example between third
parties and shareholders.
PVFP, i.e. the actualised value of future industrial profits relating to the various
years of management net of taxes, is calculated so as to ensure that the projection of
liabilities is consistent with that used in the valuation of assets. The standards issued
initially in June 2008 foresaw the risk-free rate being identified, if possible, with the
swap yield curve for the currency of cash flows and no addition being made to this
curve to display the liquidity premium or the risk premium.17 Later, following
exceptional turbulence in financial markets recorded with effect from the end of
2008 crisis, the CFO modified these arrangements making a change to the approach
to allow inclusion of a liquidity premium. In the version issued later, in October
2009, an update to standard no. 14 foresaw that if liabilities are not liquid the rate of
reference is the swap yield curve considering a liquidity premium. This premium is
called Time Value of Financial Options & Guarantees (TVFOG).
The Frictional Cost of required capital (FCOC) (additional cost deriving from
the cost of maintaining required capital) must include taxes, which should be based
on actual rates for the undertaking, and the costs of investment in respect of financial
profits from the assets hedging mandatory capital. Commissions for intermediation
or costs due to severe distress in financial markets are not considered. The inclusion
of additional costs of capital must be independent of any other consideration of risk.
The Costs of Non-Hedgeable Risks (CRNHR) (cost of non-diversifiable resid-
ual risks) must take into consideration all non-diversifiable risks, both financial and
non-financial. The updating must be done for the cost of non-immunisable risks not
already taken into account in the time value of the options and guarantees, so on the

17
See standards nos. 3, 7 and 14 of the CFO Forum, Market Consistent Embedded Value Principles,
in the June 2008 version of the document.
32.6 History and Development of Embedded Value 707

PVFP. A suitable method for determining the indemnity for the cost of residual,
non-immunisable risk, must be applied and the information provided has to be
sufficient to allow a comparison to be made with the cost of capital method (COC).
The methodology used for determining the cost of residual, non-diversifiable risks
(CRNHR) is not set out in detail and indeed it is stated only that an appropriate
method must be used to determine the cost of CRHNR and that it needs to provide
sufficient transparency so as to ensure comparability of results with a cost of capital
method. The method that most insurance undertakings have used applies a rate to the
current value of required capital for each year of assessment of the EV. Capital is that
relating to risks not yet considered in the calculation of TVFOG. The rate used by
undertakings varies from 1% to 7% but most of them have settled on rates of 3–4%. It
should be noted that this methodology is practically identical to the one used for
calculating the Risk Margin foreseen under Solvency II.18
A further element to be taken into consideration for understanding the assessment
of MCEV is the choice of the curve of reference, and its extrapolation for considering
the longest durations where adequate liquidity of the market is assumed not to exist so
as to allow the use of reliable data. This methodology has been derived from the
context of Solvency II. For extrapolating the curve, the following elements are defined:

• Last Liquid Point (LLP) which corresponds to the last year of the curve for
which an adequate level of the liquidity of securities is assumed,19
• An extrapolation to find the Ultimate Forward Rate which is equal to a defined
perpetual value.20
• The number of years when this rate of interest is reached starting from the LLP.21

Another fundamental point of the Market-Consistent Embedded Value method is the

new transparency (disclosure) to markets regimen. The new requirements for informa-
tion foreseen in the MCEV standards foresee that insurance undertakings, in general,
give greater transparency as to their results and method for obtaining them, especially:

• The methods used for extrapolating the risk-free rates, the swap yield curve and
the criteria for selecting the illiquidity premium.
• Management actions adopted in the assessment model.
• The value of the Implied Discount Rate (IDR) broken down into its
components, i.e. risk-free rates, premium for market risks and non-diversifiable
risks and the cost of capital.

18
The main differences are those of duration and indeed Solvency II has its own contract
boundaries, and of the rate to be applied to capital which is set at 6% and so on average higher
than the one used for CRNHR.
19
Note that LLP is the point up to which it is possible to obtain Deep, Liquid and Transparent (DLT)
data about the expected returns on zero-coupon bonds, and then extract the discount rate curve.
20
For instance, during for this rate all undertakings have adopted a value calculated for the Euro
area by EIOPA.
21
The methodology of extrapolation that is most widespread is the one from Smith-Wilson, few
having used the Nelson-Siegel method.
708 32 Embedded Value

• The methods used for deriving the volatility and the correlations applying
between market risks and the methodologies by which economic scenarios are
generated.
• Results of the MCEV from the standpoint of the Group, i.e. the value of the
MCEV must be calculated in accordance with criteria of consolidation and
include analyses of reconciliation with IFRS financial statements.

These standards have the aim of having insurance undertakings converge on a

unique, shared approach that is consistent with the methodologies adopted by banks
and other operators in the industry. Already before the coming into force of Solvency
II, on 1 January 2016, a number of deviations by insurance undertakings from
principles of Solvency II occurred and, indeed, the value of Own Funds (OF) is
close to that of the MCEV except for certain elements of distinction. Actually, OF
are defined as the market value of assets net of commitments, again at market value
(as for the MCEV with the indirect method). Thus, in 2016 the CFO Forum issued a
number of modifications to the principles as follows:

• Contract boundaries may be used.

• If risk margins are used for reporting under Solvency II, it is not necessary to
calculate the FCoC.
• Methodologies for aligning determination the assumptions with those of
Solvency II.
• Economic financial assumptions can be aligned with those of Solvency II.
• Transparency and information towards the market can be aligned with to those of
Solvency II.

After this issue, the differences between MCEV and Solvency II, became
relegated in essence to the presence of the CRNHR (and not the FCoC as would
have been expected22). So, given the high degree of convergence of the standards,
mainly in simplification of the reporting stage, various groups and insurance
undertakings foresaw, at the end of 2016, abandoning in a number of cases, or
having principles of assessment converge fully, thus rendering the disclosure of both
values in the supplementary information, in actual fact, pointless.
In any event, although the two assessments are so similar, they remain essentially
different due to the fact that EV represents an evaluation of the interests of
shareholders, whereas OF represents an assessment of the funds available to the
insurance undertaking from the regulatory standpoint. So, there may be cases
(among which being an extraordinary transaction, for example) where the MCEV
assessment may be more informative, also because in this context, more suitable

22
Indeed, changes made to 2016 standards indicate that for insurance undertakings reporting in
accordance with Solvency II giving adequate consideration to frictional costs in assessing the Risk
Margin the FCoC may be omitted, but the value of the CRNHR would remain, which in reality is
close to the calculation of Risk Margin except for the unitary rate (6% set forth the Risk Margin).
32.6 History and Development of Embedded Value 709

assumptions can be used for the aim making an assessment. By way of example, the
contract boundaries foreseen under the Solvency II regimen in most cases shift the
classification of premiums that are more similar statistically to acquired business to
new business,23 and this different classification is a significant item in a change of
value since it likewise moves the value from acquired to that of new business. A
further possibility that there is favouring the choice of MCEV lies in making
economic assumptions including an illiquidity premium as foreseen under current
MCEV standards.
In conclusion, following the introduction of the Solvency II regime, the EV
model has lost importance, but it does continue, to be used in other contexts, such
as those of merger and acquisition transactions, and since practice always exceeds
the theory, we can only wait and see what new practice is in the light of what has
been said or the new developments there will be.

32.6.4 A Comparison Between TEV, EEV and MCEV

By way of example, shown here is a comparison made between three hypothetical

insurance undertakings with features of their liabilities that are fully identical, but
with a different portfolio of securities. It is assumed that the three insurance
undertakings report in accordance with the standards of Solvency II and so calculate
the SCR. See Table 32.3 reporting an example of three hypothetical insurance
undertakings.
As can be seen from the value of the SCR, evaluation Solvency II already prices
in the exposure of the insurance portfolio to the risk of holding shares (for insurance

Table 32.3 Example of three hypothetical insurance undertakings

Insurance undertakings Alpha Beta Gamma
Risk-free rate of interest 2.0% 2.0% 2.0%
Minimum guaranteed 1.5% 1.5% 1.5%
Rate withheld 0.5% 0.5% 0.5%
Amount of reserves €1,000 €1,000 €1,000
Residual duration of portfolio 10 10 10
Make-up of assets
– Bonds 70% 60% 50%
– Shares 20% 30% 40%
– Cash 10% 10% 10%
SCR €50 €55 €60
ANAV €60 €60 €60

23
Due to the fact that according to the Contract Boundaries of Solvency II (in the event of it being
possible for the insurance undertaking to reprice a recurring premium, this has to be considered as
new business, whereas in the assessment of NCEV, these premiums may come under acquired
business on the basis of the fact that they may be statistically forecast. The basis of future premiums
upon which the ViF is calculated thus reduces, but the basis for NBV increases.
710 32 Embedded Value

Table 32.4 Comparison between SCR of three insurance undertakings

Insurance undertakings Alpha Beta Gamma
TEV RDR 5.0% 5.0% 5.0%
PVFP € 39.2 € 40.2 € 41.2
CoC -€ 8.2 -€ 8.6 -€ 9.0
ViF € 31.0 € 31.6 € 32.2
EV € 91.0 € 91.6 € 92.2
EEV bottom up PVFP € 40.8 € 40.8 € 40.8
TVOG -€ 4.5 -€ 6.5 -€ 8.5
CoC -€ 8.2 -€ 8.6 -€ 9.0
ViF € 28.1 € 25.7 € 23.3
EV € 88.1 € 85.7 € 83.3
MCEV PVFP € 47.6 € 47.6 € 47.6
TVOG -€ 4.5 -€ 6.5 -€ 8.5
FCoC -€ 8.2 -€ 8.6 -€ 9.0
CRNHR -€ 7.5 -€ 7.9 -€ 8.4
ViF € 27.4 € 24.6 € 21.7
EV € 87.4 € 84.6 € 81.7
Solvency II Own Funds € 85.5 € 83.6 € 80.8

undertakings beta and gamma). See Table 32.4 for a comparison between SCR of
three insurance undertakings.
If the value of EV is analysed by TEV methodology, it can be noted that the three
insurance undertakings have the same EV value because even determining the risk
factor to be applied to the RDR, the methodology was not able, at the time when this
valuation was more widespread, to capture differences in the make-up of the
portfolio of securities of an insurance undertaking and so its exposure to risk. The
presence of riskier securities, as in the cases of insurance undertakings beta and
gamma, generates a greater expected yield, which should be adequately offset by a
risk factor included in the RDR. In practice, this was not strictly abided by, and RDR
rates were mainly drawn from the marketplace. Therefore, these rates were not
specific to the risk of the insurance undertakings except in a number of cases.
An EEV with risk-neutral Bottom-up approach displays a PVFP that is slightly
higher given by the fact that no RDR, but the risk-free curve, is applied, and the
lower rate of interest, does not impact upon profits of insurance undertakings, and an
adjustment is then calculated implicitly for non-financial risk. Financial risks are
calculated apart, in the TVOG, whose value depends notably on the type of assets
and related implicit volatility.
In the MCEV on the other hand, the financial risk and non-financial risk compo-
nent are broken out of the PVFP and the PVFP is thus found to be greater than the
EEV. It is to be noted that from insurance undertaking alpha to gamma, the ViF is
rising for the TEV value whereas, for the other valuations, the difference is due to
inadequate capacity to display the cost of financial risks in the TEV method.
32.7 New Business Value 711

The value of Own Funds, assumed here to be lower than the MCEV, is given by
the fact that it uses the contract boundaries of Solvency II, which give rise to a
reduction in value for the insurance undertaking according to what has already been
stated in the previous paragraph. In all cases, it has been assumed that the cost of
capital is that of Solvency II but at the time of widespread use of TEV methodology,
an evaluation of the SCR was not available, and so this is only a theoretical exercise.

32.7 New Business Value

New Business Value (NBV or VNB) measures the value that is intrinsic in newly
issued business relating to a pre-set period.24 Additionally, NBV is an indicator of
the capacity for making sales of an insurance undertaking and so this calculation
makes sense both for the purposes of external disclosures and as a tool for internal
assessment.
To make the calculation a number of approaches may be used depending on the
objective it is wished to achieve. Firstly, the system of calculation must be selected
and which, in order to be consistent with the valuations for Solvency II has to be of
Market Consistent type, but the same reasoning a seen above for other systems of
calculation, can be applied to NBV. Once the methodology and the principles of
reference have been defined, the time for performing the calculation has to be
identified and which may be at issue (point of sale), i.e. assuming performing the
assessment an instant prior to collecting premiums. It must be taken into account that
these premiums have been collected at different times over the course of the year and
so in order to be able to be added up they must be rendered financially consistent
through actualising (carrying them back to the start of the period) or capitalising (end
of period) Concerning the methods used for calculating NBV and related cash flows,
these are exactly the same as are found in assessing EV. Any difference may lie in
the presence of a further flow, when issuing the premium, relating to acquisition
expenses.
Assessment at issue, is an indicator that serves to value effectively the capacity of
the insurance undertaking to put profitable products on the market, either as man-
agement control or as analysis. Together with the NBV, other indicators are usually
added so as to understand more fully the logic of profit in new products. In particular,
these are tied to the flows occurring during the first year, or at issue, so as to assess
the impact, for example of acquisition costs or commissions, Other indicators of
profitability, such as an internal rate of yield, are important for comparison with the
rest of the market.
Another approach is to value NBV after having collected the premium, for
example at year-end, and in this case, they will be missing from the valuation

24
Indeed, in order to carry out an analysis of the changes in mathematical provisions for Solvency II
Best Estimates Liabilities (BEL) and Own Funds, it is necessary to calculate the value of new
production.
712 32 Embedded Value

relating to flows exchanged at the time of the sale of contracts because already
incurred and so not visible at the time of assessment. In the past, a number of
insurance undertakings based their assessments on the value of NBV at year-end and
not at issue, and so do not display the effect of the so-called initial strain, i.e. the
initial cost of sale of contracts. Indeed, new contracts, as they have acquisition costs
(as commissions or internal costs), and the cost given by making required regulatory
capital available, generally actually have a loss called strain.

32.8 Indicators for Embedded Value

There are various indicators used along with EV. These can be split between
performance and sensitivity indicators.
Return On Embedded Value (ROEV), is a performance indicator which
compares Embedded Value Earnings in the year to Embedded Value for the previous
year. See the formula:

EVEt
ROEVt = : ð32:4Þ
EVt - 1
In theory, if the assumptions used with a closed portfolio were perfectly abided by
and the yield from equity had returned interest amounting to that assumed (as a case
study) the ROEV would be equal to the rate interest for one year. Contrariwise, if the
ROEV were lower, this would mean that during the year destruction of value had
taken place. This has impacted adversely on the return from EV. In cases of Market
Consistent valuation, the comparison should in reality be made with the Real-World
rate of interest, since the assumption underlying this valuation is that there is no risk
premium in the rate of interest, but insurance undertakings invest in securities that
have risk.
The normalised ROEV is on the other hand net of economic effects and so it is as
if Operating Profit were used in the place of EVE.
It is easy to imagine that, in addition to an analysis of the ROEV of a single
accounting period it is of fundamental importance to analyse a historical series of
ROEVs achieved so as to verify that any creation of value is “sustainable” over time
and is not the fruit of particular events during the year. Additionally, since similar
effects occur also in other insurance undertakings, given the arising of phenomena
related to market events, it is necessary to compare own ROEV with insurance
undertakings, or group, that are similar in structure so as to verify whether the loss of
value is due to own effects or market ones.
Another type of indicator that is widely used is sensitivity analysis, which
consists of a series of EV values calculated as a number of pre-set parameters
vary. Typically, these are ones that are prescribed under MCEV standards (see the
paragraph above in this regard) with the intention of displaying how sensitive the
32.9 Annual Premium Equivalent 713

value for shareholders is to variations in a number of technical assumptions. In

general, these assumptions are of a financial and operational kind, where the latter is
represented by the technical risks of the insurance undertaking (i.e. mortality and
surrender above all) and the former are tied to the interest rate curve and market
prices for shares or their volatility.

32.9 Annual Premium Equivalent

As the value of new production obviously plays a particularly important role in the
valuation of an insurance undertaking, it is also necessary to analyse the profitability
of new production distinct from the rest of the portfolio separately. The most
widespread index for quantifying the profitability of New Business is the New
Business Margin (NBM) which is given by the ratio applying between the value
of new production and premiums issued. As there are usually both policies with
single premiums and policies with recurring premiums, we need to find an indicator
that takes into due consideration these differences in time and value. A solution is
given by the Annual Premium Equivalents (APE), which define in a flat term
single premium year by dividing it by 10, implicitly assuming a duration of 10 years
for each single premium contract.25 The calculation formula (32.5) is shown:

APEt = annual premiumst þ single premiumst =10 ð32:5Þ

This indicator, although it is a convention that is arbitrary and open to discussion,

has become a European standard that, once the value of new production is known,
allows the profitability of the new production to be obtained through a new produc-
tion margin.

NBVt
NBMt = ð32:6Þ
APEt
An alternative to this solution is to use as denominator, the current value of
premiums issued in place of the APE;

NBVt
NBMt = ð32:7Þ
PVNBPt
It is to be noted that the two indicators behave, in certain cases, very differently
based on the actual, duration of the contracts. In any case, the value of the first
indicator is always on average higher than the second by about 10 times; (this has
probably meant it has been preferred over the second, although it has a lower

25
Note that a discussion of the formula for calculating Annual Premium Equivalents (APE) in
comparison with Single Premium Equivalents (SPE) is given in Chapter 34
714 32 Embedded Value

information value). Following the introduction of Solvency II, the second indicator
is of better information value. Indeed, its assumptions are in line with what is
required by contract boundaries and so have the effect of expanding the scope of
new business premiums, and shortening the duration of portfolios.26 This approach
inevitably leads to the difference between the two indicators being wider still.
It is to be noticed that both NBM and ROEV are indices of multi-period
profitability, i.e. indices that implicitly take into account all future profits deriving
from the run-off the portfolio.
A number of possible indices of the profitability of new production are the ratio
applying between the value of new production and Embedded Value, which will
however be strongly influenced by the seniority of the portfolio (a portfolio that is
relatively young and growing will take on higher values) and the internal rate
return (IIR).27

32.10 Model for Determining Goodwill

The goodwill of an insurance undertaking consists of determining the value of future

new production that an insurance undertaking will achieve over a pre-set lapse of
time, beginning with the information held in the Business Plan, and so consistent
with the business model. To estimate the values in play, two approaches may be
followed: a Top-Down approach and Bottom-Up approach. In the first case, once the
aggregate value of premiums for new production with detail year-by-year of pro-
duction has been determined, this is split by number of contracts and by average
premiums at an individual product level. In the second case, on the other hand, the
estimate starts from a point-by-point assessment of the number of items/contracts
sold by individual channel and geographical area, and related average premium at a
single product level, the values progressively accumulating in the aggregate so as to
determine the amount of aggregate premiums of new production with detail by year
of production. See in Figure 32.6 the distinct logical steps required by the method-
ology according to the two approaches.
The number of future years taken into consideration usually varies in connection
with the features of the distribution networks and the characteristics of the insurance
undertaking. In particular, the Goodwill of an insurance undertaking which, at parity

26
The consequences of the rules, which limit the duration of a contract and change certain
conditions applying between the insurance undertaking and the insured, involve the following: in
a number of contracts that had recurring premiums and were deemed to be already acquired, this
may change to being acquired (and so new production). The effect is to broaden the number of
premiums that are to be acquired while the durations of contracts are shortened (on average over the
total of an insurance portfolio).
27
This latter, as a concept, is the same as the rate set out in the paragraph on profit testing, but this
time all new production (which may be made up of a number of products) and not by individual
product, is analysed; in this case too, for a mathematical solution to exist, it is necessary at least in
the first year for there to be a loss as compared to future profits.
32.10 Model for Determining Goodwill 715

Logical Steps

1 Estimate of the amount of New Production (detailed per

year of generation)

Aggregation

Division
Bottom-Up 2 Premiums calculation per lines of business Top-Down
approach approach
3 Splitment into type of insurance products

4 Splitment by sales channel - territorial area

5 Estimate of the number of pieces and average premium for

each product

Fig. 32.6 Logical steps for determining New Business Value

of levels of production and expected profits, has a distribution agreement that is

clearly more solid than another insurance undertaking with greater Goodwill. In
particular, Bank insurance agreements are more volatile as so less reliable than
corporate ones, and so will be of lower value, for example. The number of years that
ought to be adopted for calculating Goodwill cannot, therefore, be defined a priori
and are decided upon only during negotiations (in the event of an extraordinary
transaction of sales/purchase). Generally, Goodwill is calculated through a series of
pre-set years, a sort of vector based on a grid of reference, and within this the value
that is the subject matter of negotiation is actually selected.
The final result of this first step will be given by an economic estimate of
premiums collected for each individual generation considered (in the foregoing
example, 10 generations) On the other hand, for a Business Plan or internal Industrial
Plan of an undertaking, the time horizon of reference usually amounts to 3 or 5 years,
and so an extension to a greater number of years is carried out on the basis of an
estimate of the final year of projection or a function of this. Table 32.5 contains a
numerical example of Goodwill calculation.
In this example the, simplified, methodology for determining Goodwill foresees
that the value of the NBV as a percentage be calculated by a vector of 10 years of
production, through the use of the NBM by line of business, determined on the basis
of the latest year once the premium levels have been defined. In detail, NBV is given
by multiplying the NBM by expected premiums. This marginality is held constant,
therefore, and the variation in NBV depends only on any different mix of business
there may be. In this example, average marginality reduces as a the proportion of the
most remunerative product, which is the Term life insurance, reduces and the least
remunerative, which is financial products increases. To determine Goodwill, NBV is
actualised at a risk rate.
A development there has been in this simplified methodology has been the
determining of actual NBV for each year of production and relative projection
forward on the basis of more granular assumptions; for example, developments in
mortality and surrender and the slope in interest rates, and the risk rate that has been
assumed will display variations accordingly.
716 32 Embedded Value

Table 32.5 Numerical example of Goodwill calculation (10 years)

Product Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Products with-
956.6 983.3 983.9 984.3 984.9 985.5 986.0 986.5 987.0 987.6
profits
Financial
31.4 32.3 86.7 178.2 274.7 376.6 484.0 597.1 716.1 841.3
products
Term life 12.0 15.8 18.6 22.0 22.8 23.6 24.5 25.5 26.6 27.8
Total
1,000.0 1,031.4 1,089.2 1,184.5 1,282.4 1,385.7 1,494.5 1,609.1 1,729.7 1,856.6
Premium
NBM average 5.1% 5.1% 5.0% 4.8% 4.6% 4.4% 4.2% 4.1% 4.0% 3.8%

NBV 50.6 52.7 54.3 56.7 58.8 61.1 63.4 65.9 68.5 71.2

RDR 7.0%

Goodwill 414.8

32.11 Questions

1. Define Time Value of Financial Options & Guarantees (TVFOG)

2. How do you calculate VIF based on the Traditional Embedded Value method?
3. Define APE and how it works
4. Illustrate the indicator ROEV
5. Explain the difference between bottom-up approach and top-down approach for
Goodwill calculation

References
CFO Forum (May 2004a) European embedded value principles. http://www.cfoforum.eu/
CFO Forum (May 2004b) Basis for conclusions European embedded value principles. http://www.
cfoforum.eu/
CFO Forum (October 2005) Additional guidance on European embedded value disclosures. http://
www.cfoforum.eu/
CFO Forum (June 2008) Market Consistent Embedded Value Principles, http://www.cfoforum.eu/
CFO Forum (October 2009) Market consistent embedded value basis for conclusions. http://www.
cfoforum.eu/
Groupe Consultatif Acturiel Europeen (GCAE) (June 2012) Market consistency: MCEV. http://
www.gcactuaries.org/market_consistency/mcev.html/
References 717

Suggestions for Further Study

Ordine attuari (Edited) (2012) Principles and models for the embedded value calculation, Trieste,
February 2012. http://www.ordineattuari.it/media/3227/ONA_FVG_EV_752.pdf
EIOPA - Revised Guidelines on Contract Boundaries – publications – January 2023
Management Control in Insurance Industry
33

Abstract

This chapter has the purpose of explaining the importance of management control
within a modern insurance undertaking.
Starting from the generic definition of cost, costs by type are illustrated. Three
possible classifications are considered: fixed versus variable costs, direct versus
indirect costs and standard versus effective costs. In addition, the difference
between configurations of direct cost and full cost is explained.
The passage from costs by type to cost per intended use takes place thanks to
the concept of a centre of responsibility. This centre can be further classified into
centre of cost, centre of revenue and centre of profit. Continuing along this line of
thinking, cost centres in their turn are classified on the basis of their characteristic
activity: centre of organisational costs, centre of project costs and centre of pooled
costs.
Finally, the three procedures to determine a full cost (attribution, allocation
and imputation of costs) are explained.
At the end of the chapter, the methods of Activity-Based Costing (ABC) and
Activity-Based Management (ABM) are illustrated. They represent a different
way than the traditional one for attributing, allocating and charging costs.

Keywords

Management control · General accounting · Analytical accounting · Industrial

accounting · Variable vs fixed costs · Direct vs indirect costs · Specific vs
common costs · Standard vs effective costs · Direct vs full costs · Centre of
responsibility · Cost centre · Revenue centre · Profit centre · Centre of
organisational costs · Project cost centre · Pool cost centre · Corporate centre ·
Production centre · Service centre · Attribution stage · Allocation stage · Cycle of
allocation · Driver or basis of allocation · Imputation stage · Activity-based
costing (ABC) · Resource driver · Activity driver · Activity-based management
(ABM)

# Springer Nature Switzerland AG 2024 719

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_33
720 33 Management Control in Insurance Industry

33.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Define the concept of management control

2. Identify the four components of a management control model
3. Explain classifications of costs
4. Illustrate the model of centres of responsibility and of centres of cost
5. Describe the process or allocating, attributing and imputing costs
6. Know how the process of purchase management works
7. Explain the Activity-Based Costing (ABC) methodology and the Activity-
Based Management (ABM)

33.2 Definition and History of Management Control

In order to achieve strategic objectives, insurance undertakings, just like any other
enterprise organised on modern lines, need to achieve results in the short term that
are consistent with the long-term objectives set. The underlying strategies and
direction of an insurance undertaking are closely tied to the process of planning.
Planning, very briefly, defines what the objectives that it is sought to achieve are, and
what is to be done to achieve these objectives. Management control is operational
machinery that, especially in an area that is dynamic and discontinuous, has the
purpose of verifying that objectives set in advance are met and that the organisational
structure functions efficiently.
Management control is the discipline that allows us to define objectives and
measure the result that derives from totally or partially achieving these, monitoring
and analysing variances and proposing corrective actions. See Figure 33.1 which
represents a management control system.
In substance, through management control, every insurance undertaking should
be able to:

Results’
1 Targets 2 Actions 3
measurement

Corrective 4
5 actions Gap analysis

Fig. 33.1 Defining a management control system

33.2 Definition and History of Management Control 721

Period ’60-’70 Period ’80 Period ’90 - 2010 From 2020

Size factor Profitability Value Value/Risk

Guidelines
Strategic

/ Growth
Maximize Maximize value Risk-adjusted
Maximize volumes profitability for shareholders Capital
/ market shares

z Premiums z ROE z Value Based z Embedded Value

Management (risk based)
Performance

z Total Assets z Loss ratio

Indicators

z Points of sales z Expense ratio z Embedded Value z Risk Indicators

z Economic Capital (Rorac/Raroc)
z Number of z Combined ratio
z …
Customers z … z …
z …

Fig. 33.2 Development of management control

• Direct actions towards the objectives set in advance subject to punctual monitor-
ing point by point.
• Know when production costs are greater than the result.
• Know the cost of the activities with no economic return.

To fully understand the history and development of the role of management

control and grasp the importance of this machinery it is worthwhile briefly going
over the development from its origins up to the present.
Following the historical development of management control in the insurance
industry, it can be seen that in this sector too, it has been a tool for meeting new
demands from the market. Development went from the use of management systems
based on volume growth and rates of growth to methods founded on yield and value
creation. See Figure 33.2 which represents the development of management control.
In the sixties and seventies, management control supported the strategy that was
typical of that historical period: a vocation towards largeness and growth.1 Measur-
ing tools were used to assess the achievement of objectives such as rates of premium
growth, increases in the number of agencies, increases in resources and clients and
the value of total assets.
Since the eighties, on the other hand, the systems of management control have
focused on verifying the performance of the business. In this regard, insurance
undertakings have turned towards objectives of yield. As a consequence, special
attention has been paid to indicators such as yield on own means (e.g. ROE or Return
on Equity). The use spread of technical indicators such as Loss Ratio, Expense Ratio
and Combined Ratio,2 (which compare the characteristic headings of industrial
insurance management costs of insurance undertakings with premium volumes).

1
For a treatment of the history of insurances see Chap. 1
2
For an indication of corporate indicators see Chap. 34
722 33 Management Control in Insurance Industry

After the second half of the nineties, a further change was witnessed, brought
about by it becoming obvious that the indicators used were of an accounting kind.
These mainly concerned a decision-making reasoning aimed at maximising account-
ing profit, thus making them less useful for providing a clear and full representation
of performance. Additionally, they did not give a prospective view of trends in
enterprise activity as they highlighted the capacity of the enterprise to generate
income during a certain accounting period (usually in the past) but did not allow
an understanding to be had of what the probable future performance might
be. Finally, these indicators did not consider the risk of the business. The emergence
of these three issues forced the management of enterprises into creating value and
employing tools of performance measurement. For this reason, new indicators based
on the measurement of value created are introduced, such as, for example Value-
Based Management (VBM), Embedded Value (EV) and Economic Capital (EC).
In the following period, the focus is on the analysis of risk management and their
impact on profitability of insurance undertaking. This new setting requires the risk-
weighted performance of undertakings to be kept under control. In this area, metrics
such as RORAC and RAROC3 and stochastic Embedded Value were developed.
These parameters take into account the objectives of the undertaking adjusted for
risk. The complexity of calculating these indicators and the difficulty in managing
the underlying control systems lead, in most cases, to these metrics are shared within
the systems of management control reporting and the area of Risk Management of an
insurance undertaking.

33.3 Model of Management Control

The four characteristic elements of a management control model are the technical-
accounting system, the organisational structure of centres of responsibility, the
nature and type of costs and the process of attributing and allocating costs. See
Figure 33.3 representing the four elements of a management control system.
The technical-accounting system, is the one that gathers and coordinates the
information, generally expressed in monetary quantities, regarding the transactions
of the internal and external management of an undertaking.
Classification of costs allows the relationships between costs and the model of
functioning of the undertaking to be identified. Every cost can be classified
according to the level of activity (fixed costs vs variable costs), based on the cost
object (direct vs indirect costs) or based on the ends sought and need for control
(standard costs vs effective costs).
The organisational structure of centres of responsibility is both the series of
hierarchical relationships applying between the various organisational units and the
series of responsibilities (costs or incomes) assigned to the various corporate players.

3
Return-on-risk-adjusted-capital (RORAC) adjusts the ROE considering the risk of the profit
compared to the riskiness of the capital. Risk-adjusted return on capital (RAROC) is a risk-
adjusted measure for the return on capital.
33.3 Model of Management Control 723

Technical-
Classification of costs
accounting system

Management Control System

Organisational
Process of imputing
structure of centers
costs
of responsibility

Fig. 33.3 The four elements of a management control system

The process of imputing costs allows the value of the final cost that is subject to
calculation to be determined. This process is based on four specific stages: localising
costs, attribution, allocation and final imputation.
Here below each of these individual elements is presented.

33.3.1 The Technical-Accounting System

In this paragraph, the relationship between management control and the three
technical-accounting components underlying it, and which are general accounting,
analytical accounting and industrial or technical accounting, are illustrated.
General accounting considers the values derived from exchanges between the
undertaking and third parties and represents an economic-financial summary of
running an insurance undertaking. It detects the costs and revenues by kind and
overall level in corporate management (not for specific items). General accounting
allows the gathering of information that is necessary for determining the economic
result for a certain administrative period (the outline of the Profit and Loss Account)
and connected capital-wealth of the insurance undertaking at the end of this (outline
of the Balance Sheet). It does not, therefore, permit detecting of events within the
insurance undertaking.
Analytical accounting identifies the more significant causes of trends in man-
agement through a series of statistical measurements that originate in values shown
in general accounting. Beginning with those values, it separates them out and
re-aggregates them in connection with different subject matters of calculation.
Analytical accounting actually records economic events (costs and revenues)
according to a principle of intended use for individual objects and not only by
their nature at an overall level.
Industrial accounting relates to statistical measurements concerning processes
of transformation of resources into products and processes of services delivery.
Industrial accounting thus records (as does analytical accounting) only events of
internal management. However, differently from the latter, its focus is specific to the
industrial process.
724 33 Management Control in Insurance Industry

33.4 An Approach for Cost Classification

An analysis of costs is something that is indispensable for managing the decision-

making process of an insurance undertaking to the best effect. Constant monitoring
of these actually allows them to be kept under control and ensure that resources are
utilised efficiently.
Costs may be classified considering three possible areas: the cost object and the
need for control by senior management. See Figure 33.4 for a representation of
possible classification of costs.
Concerning the level of activity, a distinction between variable and fixed costs
can be drawn. Variable costs are those that vary in aggregate amount to an extent
that is strictly proportional to the volume of activity. In the case of an insurance
undertaking, the main variable cost is the one tied to acquisition expenses
(e.g. commissions). Fixed costs on the other hand display the characteristic of not
varying as the volume of activity changes (e.g. in insurance undertakings, fixed costs
may be those of personnel, expenses relating to infrastructure and IT).
A further classification is the one applying between direct and indirect costs. This
applies when costs are classified on the basis of their relationship with the cost
object. The criterion used is the fact of it being possible to attribute it directly and
without the aid of any allocation of costs. In this regard, direct costs are strictly tied
to the subject matter of the calculation and do not present any difficulty of attribution
to this (e.g. if the cost object is the costs of settling losses, the costs of personnel
employed in this activity certainly comes under the heading of direct costs). Indirect
costs are common costs that can be allocated indirectly to the cost object only by
adopting methods of imputation (e.g. if the IT infrastructure supports all the
functions and processes of the undertaking and is not specifically dedicated to any
of these, it is necessary to allocate this generic cost indirectly to the individual
functions). This classification of costs can be defined also as specific costs, i.e. direct
costs and common costs, i.e. indirect costs.

Variables Costs

Fixed Costs
Level of activities
depending on the
volumes

Direct Costs Standard Costs

Indirect Costs Actual Value

Cost Object Senior management
control
Cost attribution (standard or actual
directly or indirectly values)

Fig. 33.4 A representation of possible classification of costs

33.5 Definition of Centre of Responsibility 725

A number of cost classifications are determined based on needs for senior

management control. Specifically, it is possible to distinguish between standard
costs and effective costs.
Standard costs are configurations of cost-objective expressing the consumption
of resources foreseen in achieving certain results, usually defined when drawing up
the budget. Effective costs are configurations of cost-result expressing the actual
value of the resources used. A number of insurance undertakings set standard costs
for the next accounting period based on effective costs for the previous year,
adjusted as necessary in respect of any factor of greater or lesser impact.

33.4.1 Main Cost Configurations

The main configurations by means of which costs are analysed are direct cost and
full cost. The direct cost method defines a configuration of cost in which only costs
classified as direct or variable are imputed directly to the cost object. In the simplest
version of this, direct cost foresees a clean separation of costs between fixed and
variable and leads to a direct imputing to the cost object only of costs that are direct
and variable. In its developed version, however, direct cost imputes direct or variable
e costs and also adds in specific fixed costs.
Full cost is the method of calculation at full cost that leads to a configuration of
cost in which all the items that consume factors of production employed for
achieving it are imputed to the cost object. The problem of this approach lies in
imputing indirect costs that have a mediated relationship with the final cost object.
This actually leads to using bases of sharing and parameters that are often not
objective.

33.5 Definition of Centre of Responsibility

In management control systems, a key concept is that of the centre of responsibility.

This is understood as being an organisation unit whose manager is held responsible
for achieving a specific series of results and/or resulting from a certain factors of
production.4
Centres of responsibility are organised according to a hierarchy that aligns both
with the organisational structure of the enterprise and the area of the cost object
(products, clients, channels, lines of business) of the insurance undertaking.
Three types of centre of responsibility have been identified:

1. Cost centre, i.e. an operational unit that brings together elementary operations or
production activities for which detecting costs is possible and worthwhile. Via

4
See Vancil RF, Anthony RN, Dearden J (1965) Management Control System: Cases and
Readings, Homewood, III.
726 33 Management Control in Insurance Industry

Focus Costs destination Performed Activity

Cost Centre Organizational Corporate Centre

Project / Production
Centers of Investment
responsibility
Services
Pool

Centre of revenue

Profit Centre

Fig. 33.5 Schematics of centres of responsibility

cost centres, various classes of cost, detected by kind, are aggregated around a
pre-set final cost object by intended use and which may an organisational unit
(e.g. the actuarial office and legal secretary) or a cost object (products, clients,
channels, lines of business).
2. Centre of revenue, i.e. an operational unit in which the direct focus and main
analysis are tied to revenues from sales (e.g. territorial areas, districts, channels
and individual agencies)
3. Profit centre, i.e. an operational unit that can be analysed along profit lines
(e.g. wealth management, financial management and property management).

This type of centre of responsibility allows the management control system to

impute to a cost object (products, clients, channels, lines of business) the costs
relating to them either directly or indirectly using bases of sharing set for the
purpose. Cost centres are thus tools by means of which the various classes of cost,
detected by kind from General accounting, are aggregated around a pre-set final cost
object (product, clients, channels, line of business) by intended use.
In forthcoming paragraphs, all the types of responsability centre are presented in
detail. The schematics of the various categories of intended use of costs and activities
performed are shown in Figure 33.5.

33.5.1 Guidelines for Defining a Cost Centre

Concerning the first type, cost centres are classified on the basis of four categories
that define the characteristic activity and the methodology for allocating costs.
The first category is the centre of organisational costs, which is the series of
operational units whose hierarchy reflects the structural and organisational
33.5 Definition of Centre of Responsibility 727

arrangements (the organigramme) of the insurance undertaking. To each organisational

unit of the undertaking there is usually a matching organisational cost centre.
In order to receive all the costs that are not attributable directly to the
organisational structure, two other technical entities are defined.

1. Project cost centre (or centre of investment) dedicated to gathering the costs of
specific initiatives or an organisational unit whose manager is held to be respon-
sible for managing the resources devoted to the project or investment made.
2. Pooling cost centre, which is a unit where costs that are not directly attributable
are gathered and which at the end of the period are allocated to organisational cost
centres by means of fitting bases for allocating them. These are fictional cost
centres, technical and non-organisational. They gather a series of common run-
ning costs that are not attributable directly to the centres that are the final
recipients of the expense.

33.5.2 Organisational Centres

The representation of an insurance undertaking by centres of responsibility aims to

define structural arrangements for an insurance undertaking set by objectives,
responsibilities and nature of relations between entities. It is indeed at a cost centre
level that quantitative, efficiency and effectiveness objectives are set. Again, thanks
to identifying centres of responsibility it is possible to locate where costs and
revenues are formed (reasoning by intended use), so allowing them to be attributed
to the related organisational unit once they accrue. Finally, through analysing links
between centres of responsibility, resources consumed and revenues generated.
Here below is represented the setting out of cost centres and the hierarchical
relationship there is between them.
In respect of organisational Cost centres, each cost centre of an insurer must
match an organisational unit. For each cost centre, there is to be defined:

• Its hierarchical relationship with other centres on the basis of the organisational
structure applying (when a cost centre is created its home node in the hierarchy
has to be defined).
• The type of Cost centre identifying the activity performed by the cost centre and
the method through which it offloads costs to other intended uses.

In detail, this further distinction between organisational cost centres foresees the
following 3 types which illustrate the various levels more fully:

1. A corporate centre is a type of organisational Cost centre that manages pro-

cesses that cannot be directly correlated with specific products or clients.
Activities are carried out to support the entire organisation (e.g. units correlated
with corporate governance, functions of auditing and units of coordination and
orientation).
728 33 Management Control in Insurance Industry

2. A production centre is a type of organisational Cost centre that is in direct

contact with the clients (market facing). Usually, it is a centre of attribution both
of costs and of revenues for the period (e.g. units performing primary activities of
the insurance cycle, such as underwriting and settlement).
3. A service centre is a type of Cost centre that manages processes that can be
correlated with specific organisational units (not causally linked to products or
clients). It usually performs activities that can be measured analytically. It is
configured as a pure cost centre and of support to other centres (e.g. units that
perform activities that are ancillary and of support to insurance business).

See Figure 33.6 which contains a hierarchical representation of organisational

centres.

33.6 Attribution, Allocation and Imputation of Costs

After having introduced the definition of costs and illustrated the types of centre of
responsibility, in this paragraph the process of cost reversal is dealt with. In order to
proceed to a final determining of the cost object, it is worthwhile distinguishing
between three specific stages (attribution, allocation and imputation) and go back
over the concepts introduced. See Figure 33.7 which represents an outline 326 for
the process of allocating, attributing and imputing costs.
The attribution stage defines the rules by means of which costs initially recorded
in the General accounting. System by kind are included in the cost centre structure
and so re-aggregated by intended use (direct costs vs indirect costs). Direct costs are
thus imputed to the final cost object, whereas indirect costs follow the allocation
stage and subsequent imputation. Indirect costs (i.e. non directly attributable to
organizational structures) are attributed to project cost centres and pool cost centres
[step 1].
The allocation stage allows cost to be determined by allocating indirect costs.
Typically, allocation may occur over cost centres of different levels: from an interme-
diate cost centre to a final cost centre. An intermediate cost centre is a cost centre that
allocates costs initially attributed to it to another cost centre. In this way, the interme-
diate cost centre is “emptied” of all costs. Whereas a final cost centre is a unit that
receives from one or a number of cost centres, the costs initially attributed to interme-
diate costs centres. The operation of emptying a cost centre into another is called
allocation cycle and is based on a number of drivers or bases of allocation.
The reasoning behind a cycle of allocation is, first of all, to respond to the
following question: to what extent and according to what factors of consumption
do cost centres perform their activity for the benefit of the final cost object for which
full cost is intended to be calculated? In allocating costs, arbitrary imputations of
costs, i.e. those not based on statistically significant relationships between consum-
ing resources and their delivery must be avoided. By way of example, a number of
cycles of allocation between one cost centre and another are the pooling cost centre
for utilities (intermediate) which allocates and “empties” its own common costs into
 33.6

Director

Personal
Assistant

Sales and Insurance Financial

Marketing Area Area

Network Technical Customer

Sales force Marketing Claim settlement
training Area Care
Attribution, Allocation and Imputation of Costs

Area 1 Actuarial
Point of sale 1 Deptt
District 1 Retail
Area n Risk
Point of sale 2
District n underwriting
Corporate
Point of sale n
Product Centre

Service Centre

Corporate Centre

Fig. 33.6 Hierarchical representation of organisational centres

729
730 33 Management Control in Insurance Industry

Attributing Imputing

4
1
Directly imputed to
the final object
Direct cycle of Direct Costs
imputing
i.e. commissions,
dedicated claims
settlement staff, …

di calcolo
di calcolo
(canale,
Final Cost
(canale,
prodotto)
Object (channel,
prodotto)
1 product, ..)
costo costo
costo Final cost
costo
Indirect cycle of intermedio
Intermediate finale
Indirect Costs intermedio centre
finale
attributing, cost centre
(Organizational
(pool, project)
allocating, and 2 3 ) 4
imputing i.e. IT infrastructure,
facility management, …
Allocation
cycle-emptying Drivers or Indirectly
allocation bases imputed

Attributing Allocating Imputing

Fig. 33.7 Outline allocating, attributing and imputing costs

organisational (final) cost centres; the corporate cost centre (to which costs of Senior
Management are generally attributed) which allocates its own common costs over all
organisational cost centres (Step 2).
A driver or basis of allocation is the elementary rule expressing the relationship
of causality applying between activity/operation and consumption of resources by
the various cost centres (Step 3). In the absence of drivers expressing a direct
causality between operations and costs, allocations of costs are based on conven-
tionally simplified criteria. In Table 33.1 a number of examples for pooling (inter-
mediate) cost centres are shown.
The imputation stage represents the final stage of the process of determining the
full cost of the subject matter of calculation. This stage has imputation of aggregated
indirect costs to final cost centres. The most problematic area of the imputation stage
is identifying the basis for sharing that best expresses the relationship there is
between the final cost centre and the cost object (products, clients, channels or line
of business).
Once the cycles of internal allocation between cost centres have ended, imputing
all costs towards the subject matter of the calculation to determine its full cost is
done. At this stage, all direct and indirect costs are added together (following all the
allocations made) so as to have a full cost for every centre of responsibility (Step 4).
A method that is alternative to the methods of traditional allocation and pass-
through is the ABC approach (Activity-Based Accounting) which we will deal with
in forthcoming paragraphs. By this approach, corporate resources are detected, the
activities they have been taken up by are identified and they are attributed by specific
methods to the object by which they have been consumed.
33.7 Stages of Purchasing Process 731

Table 33.1 Examples of driver for allocating pooling cost centres

Driver or basis of
Types of cost Manner of allocation
allocation
Utilities pool Contains expenses “water and “electrical power” for No. of resources for
headquarters the Headquarters. Cost centre
Allocation to organisational Cost centres on the basis headquarters.
of a conventional driver.
Pooling Contains expenses “hardware rental charges”, No. of PCs (fixed and
expenses IT “software rental charges”. portable) per office/
users Allocation item by item site.
Pooling costs Contains expenses for services of “shipping to the No. of goods
of shipping agency network”. dispatches per
Allocation on the basis of a conventional driver agency.
calculated on the basis of the flow of dispatches from
warehouse.

33.7 Stages of Purchasing Process

In order to identify the areas responsible and recipients of the costs of an insurance
undertaking enterprise, the management control system is usually linked to the
purchasing process of the insurance undertaking and the outgoing cycle.
Using this reasoning, in the area of the purchases management process, each
request for purchase sets in motion a series of authorisations that foresee control of
an economic type (budget system) and one of merit (authorising entity). Costs must
thus be identified right from their origin in related costs centres. In detail, manage-
ment control may generally be involved at the following four stages of the outgoing
cycle. See Figure 33.8 representing the stages in the purchases management process.
Stage 1: Creation of the request for the purchase of goods or services. Manage-
ment control provides indications concerning the capacity at a budget level and
whether or not the expense is consistent with the budget. The request for purchase
usually foresees a number of compulsory fields such as the cost centre, the type of
expense heading (indexed in the catalogue of goods and services of the enterprise
and linked to a general accounting ledger). The request for purchase, once
completed, authorized and signed by a manager, gives rise to issue of the related
purchase order.
Stage 2: Issue of the purchase order and related sending to the supplier. To each
purchase order corresponds an alphanumeric code. This number has to be shown in
the invoice and linked to the request for purchase. In this way management control
has a view of the budget committed and what still remains. The balance of the budget
committed represents what has an effectively been spent as at the date of reckoning.
Stage 3: Receipt of the good or service and related arrival of goods. Usually, the
purchases office or the requester checks compliance with what was received and
carries out the acceptance tests that are necessary. The goods inwards transaction
allows validation to be made of proper dispatch of the order by the supplier. The
732 33 Management Control in Insurance Industry

Stage 1 Stage 2 Stage 3 Stage 4

Creation of the request Issuing Goods inwards / Invoice

for purchase purchase order service registration and
certification payment

Fig. 33.8 Stages in the purchases management process

values on the goods inwards form must align with the invoice that the supplier will
issue. In this case, management control has a view of what remains of the order
(or actual closure of this) and may carry out an estimation of the invoices still to be
received concerning orders made.
Stage 4: Receipt of the invoice, control of goods inwards, registration of invoice
and relative payment. General accounting foresees carrying out all the activities
indicated above. At the end of these operations, invoice registration is carried out
and payment is made. After the cash disbursement, the residual budget is modified
automatically. Management control carries out monitoring of the sums actually spent
and keeps the remaining capacity of the budget under control.

33.8 Definition of Activity-Based Costing (ABC)

Activity-Based Costing (ABC) is a method that was introduced formally for the first
time at the end of the 1980s by the Harvard Business School and aimed at calculating
the yield from various cost objects5 (products, clients, channels or lines of business)
by determining the costs of activities and related corporate processes.6 The method is
founded on the fundamental precondition that activities performed at the various
stages of the production process take up resources. These generate costs as a result. It
should be noted that activities are meant a series of elementary actions and tasks
aimed at producing a tangible output or a service.
The ABC method meets a fundamental need for allocating indirect costs that arise
increasingly at the various stages in the value chain in the most appropriate manner
(following a causal reasoning and not generic volumetric bases).7

5
It should be noted that in this paragraph, by ABC method a subject of cost is dealt with specifically
and not a generic cost object.
6
See Kaplan RS, Bruns W (1987) Accounting and management: a field study perspective. Harvard
Business School Press.
7
See Porter M (1985) Competitive advantage: creating and sustaining superior performance.
Macmillan, New York.
33.8 Definition of Activity-Based Costing (ABC) 733

As compared to the traditional system of management control (based on volume/

costs relationships) the method has two specific steps:

• It requires that costs, before being imputed to the cost objects (products, clients,
channels and line of business) are attributed to the activities that have generated
them using bases of allocation for this purpose to link resources consumed with
the activities performed (resource drivers).
• It then correlates the consumption by the activity with the object of the cost
(activity drivers).

33.8.1 Stages of the ABC Method

As seen above, Activity-Based Costing is based on the consideration that:

• An insurance undertaking can be broken down into processes that are made up of
activities.
• The activities consume economic resources.
• The cost objects (products, clients, channels or line of business) absorb activities.

The stages of the ABC method can be numbered in 3; identification/mapping of

the make-up (resources/costs, activities, cost object) definition of drivers, allocation
of resources and activities. See Fig. 33.9 containing the stages of the ABC method.
Costs/resources represent the factors of production consumed by the various
activities in carrying out corporate processes: personnel, technologies, buildings,
purchasing expenses, consumables etc.
Activities are separated into 2 macro-categories, based on their direct or indirect
relationship with the object of cost:

• Primary activities, which are activities that take a direct part in the production,
management and sales of products/services defined.
• Support activities, which are processes or stages of the process not directly
connected to making the cost object and which in their turn are divided into:
• Directive activities that perform functions necessary for rendering the enter-
prise operational overall.
• Operational support activities that perform functions necessary for rendering
primary activities operational.

By object is meant products, clients, channel, line of business. Resource drivers

attribute costs to the activities that have generated them using bases of allocation for
this purpose to link the resource consumed to the activities performed (e.g. full-time
equivalent (FTE), number of transactions and IT). Activity drivers later correlate
the consumption of activities with the object of costs via measurement parameters
that are adequate for representing the volume of connected work.
734 33 Management Control in Insurance Industry

1. Identification/mapping Identify the Identify the Identify

fundamental elements resources activities cost objects

2. Drivers Define resources

Define activity drivers
drivers
definition

Allocate resources/
3. Resources and costs (direct and
Allocate resources Allocate activity
Cost calculation
drivers allocation drivers drivers
indirect)

Fig. 33.9 Stages of the ABC method

The allocations represent the rules governing the “machinery” of the ABC
method and allow costs to be imputed to the final object of the costs:

• Allocation among resources and activities is the causal relationship that

determines the absorption of resources/costs by activities and related parameters
(resource drivers).
• Allocation between primary activities and the object of costs is the causal nexus
tying the performance of an activity to the object of costs and relative parameters
(activity drivers).
• Allocation between support activities and primary activities/subject matter of
costs are the rules for assigning the costs of support activities based on the various
views of reporting.
• Direct attribution of costs consumed by specific activities/objects of cost does not
lead to defining parameters of allocation, but rather occurs directly.

See Figure 33.10 which explains how the ABC method works

33.8.2 Activity-Based Management (ABM)

Activity-Based Management (ABM) is a method for analysing corporate processes

and performance.8 It is used to identity and value activities that the insurance
undertaking performs and make analyses of the value chain. The ABM method is
generally used for projects that bring about strategic and organisational changes in
the enterprise.
Activity-Based Management is, additionally, a method of management support
that by adopting a vision of processes aims to:

8
Johnson HT, Kaplan RS (1987) Relevance lost: the rise and fall of management accounting.
Harvard Business School Press.
33.8 Definition of Activity-Based Costing (ABC) 735

Resources Acttivities
cost objects

Indirect Costs
Primary Activities
Products/Services,
Channels,
Customers/Segments,
…

Drivers

Drivers
Costs directly Drivers
related to activities …
/ cost objects Support Activities

Fig. 33.10 Mechanisms of the workings of the ABC method

Processes view

Processes Model

What does it consume resources?

Resources Activities Cost Objects

Primary Activity Based

Allocation costs

Activities Costing
Products/Services,
view

Costs Channels, Methodology for

Customers, calculating
Resource

Activity
Driver
Driver

…
Support product costs
Activities

Allocation
Costs Performance
of activity
Allocation measures
consumption

Why are resources consumed?

Activity Based Management

Process analysis and
business performance methodology

Fig. 33.11 View of product and process according to ABC and ABM

• Analyse corporate performance by process.

• Make a basis for decision making available for choices of rationalising and
improvement of process (in particular concerning a reduction of costs connected
with activities without added value).
• Highlight the contribution made by all activities performed in the enterprise for
client satisfaction.

As seen above, ABC sets out the relationships between costs and activities so that
costs can be more precisely assigned the object of cost. ABM on the other hand,
concentrates on managing activities to improve value for the client. See Figure 33.11
containing a view of product and process according to ABC and ABM.
736 33 Management Control in Insurance Industry

Analysis of costs and performance according to an Activity-Based Management

approach thus allows identification of overall process performance and the setting of
objectives for improvement in terms of:

• Reducing process times, for example intervening in activities that are bottlenecks.
• Eliminating activities that do not produce added value (overlapping, reworking
etc.) both from the standpoint of internal efficiency and of effectiveness in terms
of meeting client expectations.
• Redistributing resources among the various activities.
• Improving the quality of process inputs.

Through ABM, activities that add value to the product can thus be identified and
improved. While activities that do not add value may be related to their causes
(drivers) and be acted upon to reduce times and costs, and at the same time
increasing the value and competitiveness of the product or service.

33.9 Questions

1. What are the four components of a management control model?

2. What is the difference between standard costs and effective costs?
3. What is the definition of a pool cost centre?
4. What is meant by cost allocation process? What does final cost centre and
intermediate cost centre mean?
5. What is the definition of resource driver?
6. What is Activity-Based Management (ABM)?

References
Kaplan RS, Bruns W (1987) Accounting and management: a field study perspective. Harvard
Business School Press
Johnson HT, Kaplan RS (1987) Relevance lost: the rise and fall of management accounting.
Harvard Business School Press
Porter M (1985) Competitive advantage: creating and sustaining superior performance. Macmillan,
New York

Suggestions for Further Study

Vancil RF, Anthony RN, Dearden J (1965) Management control system: cases and readings.
Homewood, III
Schuster P, Mareike H, Pete C (2021) Management accounting. Springer
Performance Indicators in the Insurance
Business 34

Abstract

This chapter aims to explain the system of Key Performance Indicators (or KPI),
for the insurance undertaking and the industry. The reader can learn a detailed
explanation (with the related formulas) of the economic indicators. For non-life
business they are loss ratio, expense ratio, combined ratio, profitability of sales
etc. For life business, specific indicators are considered (annual premium
equivalent—APE, single premium equivalent—SPE, new business margin—
NBM, expense ratio, expense for asset under management—AUM). The
indicators for technical reserves are analysed (i.e. Reserve ageing ratio and
congruency of reserves index).
The profitability is analysed with the Return On Equity (or ROE). This
economic index of profitability is explained in detail. The related formulas are
explored in depth. It is divided into technical financial margin and profitability
from investments on free capital. Then, the indicators of capitalisation, the
solvency ratio and the indicators for the reinsurance area are illustrated. The
performance indicators for technical and claims area are explained with numerical
examples. For instance, a comparison between the ratio in the claim area is
provided.

Keywords

Key Performance Indicators(or KPI) · Loss Ratio (LR) · Expenses Ratio (ER) ·
Combined Ratio (CR) · Return on Sales (ROS) · New business margin (NBM) ·
Annual Premium Equivalent (APE) · Single Premium Equivalent (SPE) · Reserve
ageing ratio · Congruency of reserves index · Impact of loss event charges on total
mathematical and technical reserves · Return On Equity (ROE) · Capitalisation
index · Indebtedness (or debt) ratio · Solvency ratio · Level of retention ·
Efficiency of outwards reinsurance · Development in volumes · Speed of
settlement · Speed of elimination

# Springer Nature Switzerland AG 2024 737

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_34
738 34 Performance Indicators in the Insurance Business

34.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Understand the analysis of financial statements and by indices.

2. Know the indicators for technical-insurance management.
3. Illustrate the indicators relative to technical reserves.
4. Explain the indicators of profitability, equity stability and Solvency.
5. Know the management indicators in the technical and loss areas.
6. Perform a reclassification of the profit and loss and of the balance sheet.

34.2 Analysis of Financial Statements

Analysis of financial statements is a complex activity that is performed through the

use of data processing techniques by means of which reclassification and inquiries
into the financial statements are carried out. The final objective of an analysis of
financial statements consists of making a judgement on the health of an undertaking
as this analysis sets out to transform the data from financial statements into
information.
Analysis of financial statements is carried out by re-processing data in two ways:
the first consists of building up new classification schemas for the Profit and Loss
and balance sheet; the second one is a calculation made of many indices
(or indicators). It is worthwhile specifying that the significance of the information
does not rely so much on the number of schemas or indicators as on the ability of
these to show up the relationships there are between values that can allow financial
statements to be read in a systematic and integrated manner.
The best results achieved in terms of interpreting and evaluating come from
analysing a series of financial statements and studying trends over time so as to
understand the direction the undertaking is going and grasp the relationships
between variables and are the subject matter of the analysis.
Analysis of financial statements by indices (or indicators) is based on deter-
mining and interpreting certain financial statement ratios. Indices are actually arith-
metical ratios applying between values in financial statements and express the
morphological or attitudinal characteristics of the undertaking. Indicators can:

• Refer to different years, but relate to one undertaking (a so-called vertical

comparison).
• Refer to different undertakings, but over one period of time (a so-called horizontal
analysis or benchmark).
• Be compared against actual achievement of corporate objectives (variance or
achieving of the values set in a budget or plan).
34.3 Analysis by Indices or Ratios 739

Reclassification of the financial statements consists of highlighting a number of

aggregates from the balance sheet and some intermediate results from the Profit and
Loss that can facilitate making a judgement in the trends of the undertaking. This
analysis additionally allows a better understanding and interpretation to be drawn of
management fundamentals that are not often evident from a reading of the traditional
plans of financial statements foreseen under regulations.
In analysing financial statements, comparison over time is a significant dimension
as the analysis of an absolute metric is not normally significant of itself unless it is
compared against the trend in the same value in previous periods. An analysis must
indeed always be made against a multiperiod background of at least three or five
periods.
Comparison against the external market context is necessary since an analysis
must always be done so as not to be in isolation from the current situation in the
surrounding environment. From this standpoint, it is always a good idea to make a
comparison against a benchmark represented, for example by a market average,
direct competitors (peer comparison) or excellent undertakings that it is wished to
emulate (so-called best practice references).
Comparison with achievement of corporate objectives on the other hand allows
considerations to be made concerning the quality of what has occurred. Trends must
indeed be analysed while keeping in mind reference values set as objectives by an
insurance undertaking such as, for example a strategic plan and a budget. This so as
to understand direction and proximity as compared to what was set previously.

34.3 Analysis by Indices or Ratios

A system of Key Performance Indicators (KPI) is a tool for control based on

indicators that make available an overview that is integrated and constantly with
rends of an insurance undertaking. A KPI system additionally allows constant
monitoring and achievement of the objectives defined at the time of planning by
highlighting any variances in a timely manner and foreseeing corrective measures
that may be needed.
Further on, the main indices are presented that are used in analysing the state of
health of an insurance undertaking. The indicators dealt with are grouped in various
homogeneous series by kind (e.g. technical-insurance management, management of
reserves and wealth management) each of which covers one of the main business
areas of an insurance undertaking. Each series of indicators can be studied and
analysed independently, or in an integrated fashion along with indicators in other
areas in a sort of KPI system.
From the methodological standpoint, a formula is provided for each indicator
with a description of the individual addenda.
740 34 Performance Indicators in the Insurance Business

34.4 Non-Life Business: Indicators

The trend in technical-insurance management is kept under control by means of a

series of four indices that place together economic variables of the technical account.
These indices are Loss Ratio, Expense Ratio, Combined Ratio, profitability of sales.
The Loss Ratio (LR) is the ratio applying between loss events accruing and
premiums c accruing and indicates the loss statistic of an insurance undertaking. The
formula for loss ratio is calculated as follows:

LR = Charges relating to loss events=Premiums accruing ð34:1Þ

A ratio in excess of 100% indicates a technical deficit. Conversely, a ratio below

100% indicates that premiums are higher than losses. In this case there is a technical
surplus.
As seen above, losses accruing are made up of the sums of quotas and indemnities
settled during the accounting period and the balance of the loss reserve. So, the loss
ratio can be broken down into the part relating to the current generation and the
impact of run-off of previous generations, i.e. run-off of the loss reserve set aside in
prior accounting periods. According to this logic, the loss ratio from current man-
agement measure and so the ratio between losses and premiums, by analysing the
impact on premiums accruing of the sums paid and reserved for losses occurring
during the accounting period. Among these charges for loss events are direct
expenses for settlement are included (ALAE Allocated Loss Adjustment Expenses)
and outside expenses incurred in dealing with the claim, such as those of lawyers etc.
Not accounted for are indirect settlement expenses (ULAE Unallocated Loss Adjust-
ment Expenses) which refer to other costs, outside or in-house, incurred in dealing,
with claims but that are not directly attributable to an individual loss event.1
The Expense Ratio (ER) is the ratio applying between total management costs
and the total of premiums booked.2 Total costs include acquisition costs, production
and fixed costs of the structure. All these costs represents therefore a percentage of
costs of collecting premiums and administrative management.3

ER = Management expenses=Premiums booked ð34:2Þ

Premiums booked do not consider rectifications deriving from the balance of the
premium reserve. This indicator considers premiums booked for as they are the basis
for calculating payments for commissions on acquisition and collection.

1
For treatment of this see Chap. 12.
2
Note that in several EU Countries for this formula makes reference to the scale of premiums
booked and not the ones accruing.
3
Technical costs (included in the loading of the premiums) directly attributable to insurance
management are not considered. See Chap. 11 for an explanation of non-life insurance premium
loadings.
34.5 Life Business: Indicators 741

This indicator can be further broken down into two specific sub-indices: the first
relates to how onerous the distribution structure is and the second pertains to how
onerous the central structure is.
The percentage of onus of the distribution structure is given by the ratio applying
between commercial expenses that include commissions of acquisition and collec-
tion and other expenses of acquisitions on premiums booked. The second percentage
pertains to how onerous the central structure is and expresses the weight of the
operating structure (the so-called other administration expenses), made up of per-
sonnel costs and costs of facilities both fixed and variable on premiums booked.
The Combined Ratio (CR) is calculated as the sum of the two indicators
illustrated. This is indeed the sum of the Loss Ratio and Expense Ratio on premiums
booked.4 It is the main indicator of technical management of non-life business.

CR = LR þ ER = ðCharges relative to Losses=Premiums accruingÞ

þ ðManagement Expenses=Premiums bookedÞ ð34:3Þ

As can be easily understood, if the combined ratio remains below 100% the
insurance undertaking will be able to earn profits on technical management alone,
whereas otherwise, if the value is in excess of 100% this means that the insurance
undertaking evidences critical pits for improvement.
The sales profitability index, i.e. the Return on Sales (ROS) is calculated as the
ratio applying between the technical balance and premiums booked.

Prof :Sales = ROS = Technical Balance=Premiums booked ð34:4Þ

This index presents the percentage of yield on sales and the capacity of the
insurance undertaking to be able to adopt a proper pricing policy. For the purposes
of improving the depth of briefing, it can be calculated both for an insurance
undertaking overall and individually for specific product lines.

34.5 Life Business: Indicators

The trend in technical-insurance management in life business is kept under control

by means of two main indicators: new business margin and the Expense Ratio.
The new business margin (NBM) allows the value created by new business to be
measured and is obtained by setting an estimate of the current value of expected
future profits deriving from new production achieved during the year, net of the cost
of capital, against a standard measure of premiums newly produced. It is not,
therefore, an indicator that can be detected via an analysis of the values in the
technical account of insurance financial statements. It should be noted that an

4
The Combined Ratio takes on this name as it is found from the combination of the Loss Ratio and
the Expense Ratio.
742 34 Performance Indicators in the Insurance Business

estimate of current value of expected future profits drawn from new production
achieved in the year is determined by the profit test.
The value of the NBM can be expressed either as an absolute figure or as a
percentage For example:

• In percentage terms NBM of product 1 = 7.0%; NBM of product 2 = 6.1%, etc.

• As an absolute figure NBM of product 1 = 1,160; NBM of product 2 = 750. etc.5

The standardised measure of premiums of new production can be calculated

through two alternative methods; the Annual Premium Equivalent or the Single
Premium Equivalent. The Annual Premium Equivalent (APE) criterion consists in
converting all the premiums collected (single premiums and recurring premiums)
into annual premiums. This estimate is obtained by adding together annual
premiums and average annual sums of single premiums, calculated as a ratio
applying to single premiums and the average number of years’ duration of contracts,
by convention set at 10.
APE = ðsum of annual premiumsÞ þ ðtotal single premiums=10 yearsÞ ð34:5Þ

The Single Premium Equivalent (SPE) criterion consists in converting all

premiums collected into single premiums. In this case, the estimate is obtained by
adding together single premiums, and annual ones multiplied by the average number
of years’ duration of contracts, which in this case too, is set at 10 by convention.

SPE = ðtotal annual premiums x 10 yearsÞ þ ðsum of single premiumsÞ ð34:6Þ

The other indicators on the composition of the premium portfolio provide details
of the types of premium collected.

Composition of premium
= Premiums ðfirst years, subsequent years, singleÞ=Premiums booked ð34:7Þ

In detail the three ratios are as follows:

• Premiums booked in respect of first year/Premiums booked.

• Premiums booked in respect of subsequent years/Premiums booked.
• Premiums booked single premiums/Premiums booked.

The sum of the three items amounts to the total of premiums booked and allows
an analysis to be made of the impact of each of the three types on the total collected.
Usually, in the bank insurance distribution model, the percentage of single premiums
is usually greater.

5
For the method applied to the profit test see Chap. 16.
34.6 Indicators for Technical Reserves 743

The Expenses Ratio (ER) is the ratio applying between the total of management
costs and total of premiums booked.6 Total costs include acquisition costs, produc-
tion and organisation and fixed costs of the structure, represents, therefore, a
percentage of costs of collecting premiums and administrative management.

ER = Management expenses=Premiums booked ð34:8Þ

Premiums booked do not consider rectifications deriving from the balance of the
premium reserve. In life business, this indicator must be analysed in connection with
the method used by the insurance undertaking to amortise payed in advance
commissions deriving from multi-year contracts. Indeed, undertakings often select
a number of years of amortising commissions depending on corporate commercial
policy. For example, if commissions were all attributed to the accounting period
when the contract is concluded, profitability for the year would be found penalised.
A significant indicator for understanding the efficiency of an insurance undertak-
ing is the ratio between expenses and Asset Under Management (AUM). This ratio
shows how expenses impact and indicates the percentage points of loadings needed
for their coverage.

Management expenses=Asset Under Management ðAUMÞ ð34:9Þ

34.6 Indicators for Technical Reserves

In non-life business, the main indicators are as follows: the impact of individual
reserves on total e technical reserves and a congruence of reserves index. Concerning
life business, the indices used are two in number: the ratio between total technical
reserves and premiums booked (called Reserve ageing ratio) and the impact of loss
events charges on total reserves.
The first index expresses the impact of individual reserves (premiums and
loss) on total technical reserves. This index can be explained by two ratios based on
the type of reserve:

Loss reserve=Total technical reserves ð34:10Þ

Premium reserve=Total technical reserves ð34:11Þ

The indices set out above allow the composition of liabilities to be analysed by
comparing the values of the individual sub-classes of liability against the aggregate
value of liabilities of the class they belong to.

6
Note that in this formula, as for non-life business, reference is made to the magnitudes of premiums
booked and not those accruing.
744 34 Performance Indicators in the Insurance Business

The congruency of reserves index allows verification of the sufficiency of loss

reserves, i.e. the run-off of reserves set aside against premiums accruing. This index
expresses the degree of prudence of the insurance undertaking in determining
reserves to meet loss events from prior accounting periods.

Congruency of reserves set aside=Premiums accruing ð34:12Þ

Plus sufficiency or minus insufficiency of the sum set aside for loss events
occurring in previous accounting periods against loss events paid provides a measure
of the degree of congruency of loss reserves set aside by the undertaking previously
as compared to premiums accruing. This index is also called run-off of reserves and
allows an analysis to be made of the difference between the value of loss events
actually settled and the value of the reserves set aside previously.
Concerning life business, the Reserve ageing ratio is the ratio applying between
the total of mathematical and technical reserves at year-end and premiums booked.
In this case too, the index expresses the number of years whole or fraction of, over
which the life obligations of the insurance undertaking towards assureds extend. The
formula is as follows:

Mathematical and technical reserves at year‐end=Premiums booked ð34:13Þ

Premiums booked do not consider adjustments deriving the balance of the

premium reserve.
The index impact of loss event charges on total mathematical and technical
reserves expresses the percentage run-off of the reserve deriving from settlement of
losses (following deaths) payment of lump sums or annuities maturing, payment of
early surrenders requested by assureds and costs for settlement expenses.

Charges relative to losses=Total mathematical and technical res:start of year

ð34:14Þ

Note: That the total of mathematical and technical reserves at opening at the
beginning of the year matches the value of the reserves at the closure of the previous
accounting period.

34.7 Indicators of Profitability

For an insurance undertaking, as for industrial enterprises, corporate profitability can

be analysed through an index that expresses the remuneration own funds paid in by
partners. The Return On Equity (ROE) is an economic index of profitability of
own capital, obtained as a ratio between net profit in the accounting period and own
funds (or net equity). This indicator is used to verify the rate of remuneration on risk
34.7 Indicators of Profitability 745

Technical-
Insurance
Management
+
Ordinary
Management

+
ROE Financial
Management

Extraordinary
Management

Fig. 34.1 Breakdown of a ROE

capital, i.e. what the capital paid into an insurance undertaking by shareholders is
returning.

ROE = Net profit for the accounting period=Net Equity ð34:15Þ

The indicator can be considered to be a summary of the overall economic

performance of the undertaking, assessing how own funds have been managed
during the course of accounting periods to increase the profits from the enterprise.
If there is a loss, the ROE becomes negative. This means that economic imbalance is
serious enough to erode, de facto, net equity.
The ROE is not only determined by the choices made in the area of technical-
insurance operations, but also decisions concerning financial and extraordinary
management. See Figure 34.1 for a breakdown of a ROE.
In this approach, the ROE is the main indicator of the overall corporate economic
performance and holds within it the result of ordinary and extraordinary manage-
ment. In the area of ordinary management, the contribution comes from the
technical-insurance component and the financial one. In respect of the individual
items, reference is made to entries in the non-technical account in the financial
statements for the accounting period.

ROEðExtraordinary ManagementÞ
= Result of extraordinary activity=Net Equity ð34:16Þ

ROEðOrdinary ManagementÞ = Result of ordinary activity=Net Equity ð34:17Þ

Note that the items are net of figurative taxes.7

If on the one hand, the ROE, has the advantage of being a summary indicator and
can easily be calculated, on the other, as it is affected by the accounting rules
applicable, it has the limit of not considering the risk implicit in corporate activity

7
It is necessary to render the items net of figurative taxes (the average percentage of which amount
to the average tax weighting of the insurance undertaking) so as to allow reconciling with the items
of net profit.
746 34 Performance Indicators in the Insurance Business

and does not take into account the cost of capital. Given the formula for calculating
it, a further advantage of the ROE lies in the possibility of making easy comparisons
between firms that are similar as to scale and in the same industry, or even to set
benchmarks with other industries.
In order to judge the validity of an ROE for an undertaking, it is often compared
with a risk-free yield, i.e. the yield from assets without risk (usually treasury bonds
are referred to8). The difference between an ROE and risk-free yield determines the
risk premium, i.e. the premium that is granted to an investor in choosing to pay in
capital to an enterprise, or an investment that is riskier as compared to acquiring a
risk-free asset.
Relating to life business ordinary management can be broken down more
granularly. In this case profitability of technical-insurance management is calculated
as seen above via the New Business Margin (NBM). Concerning the profitability of
financial management on the other hand, this is calculated as a profit from
investments on premiums. The steps via which the quotient of financial profitability
are broken down are shown in the formula [34.18]:

Profit from investments Invest:return net techical reserves

= 
premiums booked net techical reserves premiums booked
Technical‐financial margin

other net financial income from free capital free capital

þ  ð34:18Þ
free capital premiums booked
Profitability index on investments on free capital

Profitability is obtained by breaking down the index into two sub-indicators:

• The technical-financial margin, i.e. the product of profits from investments on

technical reserves and the ratio of technical reserves to premiums booked.9
• Indicator of profitability from investments of Free Capital given by the
product from other financial income on Free Capital and the ratio between Free
Capital and premiums booked.

34.8 Indicators of Capitalisation

This type of indicator allows an analysis to be made of the equity solidity and
stability status of an insurance undertaking; equity indices analyse the structure of
investments and financing and express the capacity of the insurance undertaking to
maintain a position of structural balance over time. The main indicators used to
verify the equity stability consist of a capital index and an indebtedness index.

8
For a definition of risk-free yield, see Chap. 32 dealing with Embedded Value.
9
As dealt with above, for Life business, the formula for the Reserve ageing ratio is calculated as net
technical reserves/Premiums booked.
34.9 Indicators of Solvency 747

The capitalisation index of an insurance undertaking is calculated as the ratio

applying between net equity and total assets.

Capitalisation index = Net Equity=Total assets ð34:19Þ

The greater this ratio is the more internal sources for development are available
without having to turn to external indebtedness. This index expresses the ratio
between the net equity of the insurance undertaking and the total invested assets.
Given the peculiarity of the insurance sector, characterized by the Inverse production
cycle, this indicator is not used during ordinary management. It is used when
comparing insurers in the case of extraordinary operations (i.e. acquisitions or
mergers).
Indebtedness index (or debt ratio) expresses the relationship between total
financial debts and total assets.

Indebtedness index = consolidated liabilities=Total assets ð34:20Þ

Usually, this index takes on a value that is marginal in light of the well-known
inversion of the production cycle, which allows an insurance undertaking to have
available resources to invest in advance. However, if there are extraordinary
transactions and recourse is made to third-party funds, the dynamic of this ratio
becomes especially relevant.

34.9 Indicators of Solvency

The solvency ratio (or cover ratio) is of special importance for corporate continuity,
also in light of regulatory rules imposed by lawmakers. The indicator is measured by
the ratio between the solvency capital requirement held by the insurance undertaking
and the margin to be constituted on the basis of the rules imposed by the regulatory
system.10

Solvency ratio = Solvency capital required available=

Solvency capital to be constituted ð34:21Þ

Note that the amount must be net of reinsurance. The greater the excess of the
available margin is in absolute terms, the more the ratio exceeds 100%. The index is
especially important insurance undertakings as it allows for an appreciation of the
degree of capacity of the insurance undertaking to meet risks that could lead to
default.

10
For the Solvency II model, see Chaps. 29 and 30.
748 34 Performance Indicators in the Insurance Business

34.10 Indicators of Reinsurance Area

The main indicator that provide indications concerning reinsurance management

efficiency index of outwards reinsurance.
The efficiency of outwards reinsurance is Calculated as margin of contribution
brought by proportional ceding of risks in quota share.11
Here below the make-up of the margin is presented.

+ Premiums ceded during the accounting period

- claims paid and reserved for the accounting period
- Commissions
- Variations in loss events
Other items
= Margin of contribution of outwards reinsurance

The margin of contribution can be calculated for each individual branch or

individual reinsurance treaty. This sum arises from the difference between premiums
ceded and the items of cost relating to the contract of reinsurance that has been
concluded. This analysis allows an understanding to be achieved of how efficient or
otherwise the reinsurance policy is for each period.

34.11 Technical Area: Performance Indicators

Management indicators of scale are used to analyse the trend of an insurance

undertaking and develop an analysis of the relationship between the various rates
of growth in the main items of the Profit and Loss and balance sheet.
In respect of development in volumes, the first indicator is the rate of growth in
premiums written. This ratio is expressed as the difference in the value of premiums
written against premiums written in the previous period.

% var: premiums written = ½Premiums ðtime t Þ‐Premiums ðtime t - 1Þ=

Premiums ðtime t - 1Þ ð34:22Þ

Once this annual variation has been calculated it can be set against the develop-
ment in the Loss Ratio and growth in running costs. Concerning the growth in
running costs, the indicator used is one expressing the rate of variation in manage-
ment expenses. This is given by the ratio applying between the variation in total
management expenses and the total of management expenses for the previous
period.

11
In respect of reinsurance see Chap. 17 where proportion cession of risks is explained.
34.12 Claims Management Area: Performance Indicators 749

% var: man: exps: = ½manag:Exps:ðtime t Þ–Manag:exps ðtime t - 1Þ=

Manag:exps:ðtime t - 1Þ ð34:23Þ

The indicator used to monitor productivity and efficiency of the structure is the
value of average premiums per staff member. This quotient indicates the produc-
tivity per staff member and provides indications concerning the average volume of
premiums per individual employee. The formula considers premiums written set
against average staff numbers in the accounting period (expressed in units).

Productivity per staff member = Premiums written=

average number of employees during the accounting period ð34:24Þ

In addition to turnover per employee, productivity and commercial effectiveness

of the sales structure can be analysed. The index of average premiums per Agency
provides an indication in respect of the average volume of premiums per sales point.
The formula considers the total of premiums written as compared to the average
volumes of Agencies in the accounting period (expressed in units).

Commercial effectiveness = Premiums written=

average number of Agencies in the accounting period ð34:25Þ

34.12 Claims Management Area: Performance Indicators

Concerning the loss area, monitoring activity can be carried out on how management
is performed through a number of indicators of a technical kind, both in respect of:

• Trends/speed in settlement activities.

• Cost impact of expenses of the claims management process on the amount paid.
• Number of claims (average load) per settler.
• Concerning dynamics in the average cost of claims.

The first two indicators used to monitor seasonal variations in losses are the speed
of settlement and speed of elimination.
The speed of settlement is an index of efficiency in the settling network and
quality of the service provided to the client or the adversary party over a yearly
timeframe. This index is given by the ratio between the number of losses paid at the
end of the accounting period and the number of losses paid and reserved as at the
dates. See Table 34.1 which explains the formula for calculation with numerical
examples.
The Speed of elimination is the index that expresses the productivity of the
settlement network over the course of the year. This indicator indeed considers all
the losses managed by settlers (both paid and filed without claim). Thus, it is the ratio
750 34 Performance Indicators in the Insurance Business

Table 34.1 Calculation of speed of settlement/speed of elimination

Speed of Speed of settlement
Period # Type Sum settlement
Algorithm % Algorithm %
Year 0 1 Reported 1.000
2 Paid -100.0
3 No Claim -200.0
4 Residual Res. 700.0 2/(2 + 4) 12.50% (2 + 3)/1 30.00%
Year 1 4 Residual Res. 700.0
5 IBNR 400.0
6 Reopened 200.0
7 Paid -700.0
8 No Claim -100.0
9 Residual Res. 500.0 (2 + 7)/(2 + 7 + 9) 61.54% (2 + 3 + 7 + 8)/(1 + 5 + 6) 68.75%

applying between losses managed (paid and filed without claims) set against losses
occurring and reported (also including losses reopened) as at the date. Table 34.1
illustrates the formula for calculation with a numerical example.
The cost impact of expenses of the claims management process on the amount
paid provides a measure of the efficiency of the liquidation process. The efficiency
index is calculated as the ratio between:

• Total amount of process costs (direct and indirect), for example cost of facilities,
personnel costs, costs of an adjuster or a medical board.
• Amount settled.

The number of average claims (average load) per settler is calculated as the
ratio between the total number of opened claims and the total number of settlers of
the insurance undertaking. The ratio il explained in the following formula:

Total number of opened claims=Total number of settlers of the insurer ð34:26Þ

A further indicator used for analysing developments in losses, reported during the
accounting period, set against previous periods is the variation in the number of
losses. This formula is used for the purpose of checking any seasonal phenomena or
forecasting special structural trends set against the number of reports and is calcu-
lated as follows:

½Losses rep:ðtime t Þ–Losses rep:ðtime t - 1Þ–Losses rep:ðtime t - 1Þ ð34:27Þ

For analysis of the dynamics of the sums of indemnities, the indicator used is the
variation in the average cost of losses settled. This index distinguishes between the
current generation and prior generations. It needs to be seen that this indicator cannot
give a complete view of the development of loss event charges for the accounting
Suggestions for Further Study 751

period as the analysis confines itself to observing only losses closed and settled and
does not take in loss events that although having occurred still need to be settled. The
formula distinct between current generation and generations from previous years is
as follows:

½Average cost ðtime t Þ - Average cost ðtime t - 1Þ=Average cost ðtime t - 1Þ

ð34:28Þ

34.13 Questions

1. What is meant by speed of elimination?

2. Explain the ROE formula.
3. Calculate Reserve ageing ratio.
4. Indicate the meaning of SPE.
5. Calculate the Combined Ratio for a non-life insurance undertaking.

Suggestions for Further Study

Dr Holzheu T, Lechner R, Tamm K, Fan I (July 2018) Profitability in non-life insurance: mind the
gap, Sigma report, No 4, Swiss Re Corporate
Sigma report, World insurance series, Published annually, since 1968., www.swissre.com/institute/
research/sigma-research/World-insurance-series.html
The KPI Institute (2016) Insurance KPIs. The KPI Institute, Melbourne, Australia
Business Plan for an Insurance Undertaking
35

Abstract

This chapter has the purpose of explaining the preparation of the Business Plan
for an insurance undertaking.
Drawing up a Business Plan foresees an analysis being carried out in five
stages: 1. Opportunity assessment; 2. Strategy and vision definition; 3. Business
model; 4. Economic and financial analysis (also called Business case) and
5. Master plan. Each of these stages is illustrated in detail and practical examples
are provided.
A methodology for preparing the Business case is described: The approach for
the business case based on a logic tree is illustrated in detail, step by step.
The two different alternative approaches used for preparing the budget: Zero-
Based Budget (ZBB) and Continuity-Based Budget (CBB) are presented.
At the end, a number of main templates for the budget of an insurance
undertaking are presented: a sales Budget, an overhead costs Budget, a personnel
costs Budget, a Budget for the ICT area and a Budget for the Finance area, etc.
For each of them, the templates and the related tables are described in depth.

Keywords
Business plan · Opportunity assessment · Strategic vision · Business model ·
Economic-financial plan · Master plan · Zero-based budget · Continuity-based
budget · Business case tree approach · Sales budget · Budget of the operational
plan and overhead costs · Budget of costs of personnel · Budget of the ICT area ·
Budget of the finance area

# Springer Nature Switzerland AG 2024 753

M. Maggioni, G. Turchetti, Fundamentals of the Insurance Business, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-319-52851-9_35
754 35 Business Plan for an Insurance Undertaking

35.1 Learning Objectives

At the end of this chapter, the reader should be able to:

1. Illustrate why drawing up a Business Plan is needed and explain how it is

built up.
2. Know the five core stages for drawing up a Business Plan.
3. Explain the two approaches to the budget (Zero- and Continuity-Based
approach).
4. Set out the method for defining the economic-financial plan underlying the
Business case.
5. Prepare the main outlines for a budget present within and insurance
undertaking.

35.2 A Definition of Business Plan

A Business Plan, or economic-financial Plan is a document allowing the following

four items of an insurance undertaking to be defined and presented: the multi-year
Plan, lines of strategy, objectives and wealth, economic financial and patrimonial
planning.1 A Business Plan additionally allows a forward-looking feasibility evalu-
ation to be made of the Plan in respect of both of corporate structure and the
environmental context applying. The timeframe over which the Plan is executed
extends over the medium-long-term (not less than 3 years but not beyond 5 years).
In order to prepare a Business Plan properly, it is necessary to set out a number of
critical factors that underlie it. See Figure 35.1 where the following four key items
are identified:

• Explaining the reasons for it being drawn up.

• Identifying the recipients (both internal and external to the undertaking).
• Customising the content, depending on the corporate situation.
• Using standard formats typical and the form foreseen (tables, graphs etc.).

Th reasons underlying the preparation of a Business Plan may be tied to creating a

new firm (a start-up) or a line of business rather than future running of the business of
an existing undertaking.
A Business Plan applies within the insurance undertaking as it drives the assess-
ment of the potential of a project of investment. In this sense it stimulates the
contribution and sign-up to the corporate mission of the entire management. It

1
It should be noted that in certain contexts, the term Business Plan can also be applied in the area of
a single project (for instance, a product launch)and not the overall Plan of an insurance undertaking.
35.3 Stages for Setting Out a Business Plan 755

2. Recipients
1. Reasons
(internal – external)

BUSINESS
PLAN

3. Customization of the content 4. Formats

Fig. 35.1 Factors underlying a Business Plan

may focus externally by presenting the project to non-corporate interlocutors so as to

obtain the funds needed to set operations in motion.
The rules for preparing it foresee a customising of its content based on the type of
project and the specific realities of the undertaking it refers to. For example, projects
based on launching new products will have impacts on the marketing and production
strategies of the undertaking whereas projects that foresee opening up to new
markets will have impacts on commercial choices made etc. An estimate is also
required of the financial impacts of the plan, i.e. the cash flows generated/drawn
upon during the timeframe of the business plan. Accompanying these flows, a clear
and complete illustration is foreseen of the manner for determining them and the
assumptions used.
Concerning the form, a business plan must usually be written in a clear manner
and supported by effective illustration tables and briefing graphs. It must have a
general index of the points dealt with in the document and must open with an
Executive Summary, i.e. a synthesis of the content of the plan.

35.3 Stages for Setting Out a Business Plan

The template mainly used to prepare a business plan is based on a five-stage

structure: analysis of the external context, a strategic visioning, a business case, an
estimate of economic impacts and a master plan. In Figure 35.2 the five stages with
relative areas of analysis are set out.
Each of the five stages produces a well-defined result: diagnosis, definition of
strategy, model of functioning, economic and financial analysis and an action plan.
In the following paragraphs, each of these five phases is explained in detail.
Following Figure 35.2, the reader will be provided with a useful framework for
preparing the business plan of an insurance undertaking.
 756

F.1-Value creation opportunities

A - Opportunity Assessment
B - Strategic Visioning
1 Industry C - Business Model
D - Business Case
1 Corporate Governance
E - Master Plan
2 Market 1 Scenario planning
positioning 1 Profit & Loss 1 Projects planning and
Program Management
2 Organizational structure and
3 Organizational structure 2 Vision resources 2 Balance sheet

4 Processes 3 Production 2 Change journey

3 Cash flow analysis
3 Value proposition 4 Distribution
5 Information Technology 3 Contingency Planning
35

4 Profitability and impact

5 Technological and
6 Economic / financial on value
4 Strategic Positioning infrastructural model
Performances

7 Value diagnosis
F.2-Value creation strategy

Diagnosis Definition of Model of Economic and financial Action Plan

strategy functioning Analysis

Fig. 35.2 The five stages for building up Business Plan

Business Plan for an Insurance Undertaking
35.3 Stages for Setting Out a Business Plan 757

35.3.1 Analysis of the External Context

During the first stage of analysis of the external context, i.e. Opportunity Assess-
ment the external context where the insurance undertaking operates and its high-
level internal features in terms of positioning, organisational model, economic/
financial performance, in order to evidence opportunities for creating value are
analysed. This high-level analysis serves to frame to undertaking and the context
in which it operates with an overall top-down vision. For each of the above macro-
features, activities of analysis are carried out.
The positioning of the undertaking is analysed in three dimensions: products
(breadth, depth and innovation of the range), positioning on pricing and a distribu-
tion model (in the terms of the combination product/channel/segment).
Organisational arrangements are studied in four areas: corporate governance,
roles and quality of resources, analysis of processes and features of the technology
architecture (points of strength and weakness).
An analysis of the economic/financial performance of the undertaking
considers profitability, risk management and value created (understood both as
economic value and market value).
Value diagnosis macro-activity aims to identify the value of the insurance
undertaking in its current situation and provide preliminary indications of the
potential value of the insurance undertaking after internal and external
improvements.
At the completion of this stage, an initial diagnosis of the undertaking is available.

35.3.2 Strategic Visioning

The second stage, strategic visioning defines the basic objectives of the undertaking
and identifies the distinctive value that it intends to offer to its clients. During this
stage, four macro activities are performed: choosing the scenario of the expected
context, defining the visions and identifying the value proposition.
Scenario planning focuses on defining possible alternative scenarios and analy-
sis of possible strategic implications for the undertaking. For example, the
implications arising from the introduction of new regulations, a change in product
standards and trends in consumption and customer needs are analysed. On the basis
of these analyses, an undertaking defines the strategic actions that are to be taken.
During this stage, an undertaking also formulates a vision, i.e. what the undertak-
ing wishes to be in the future and the role it intends to take on in the market as
compared to competitors.
The definition of the value proposition consists of proposing value for a cus-
tomer and in orienting the organisation in its competitive strategy.
Upon completion of this stage, a definition of corporate strategy is available.
In strategic positioning macro-activity, the insurance undertaking develops and
identifies its positioning strategy in comparison with its competitors.
758 35 Business Plan for an Insurance Undertaking

35.3.3 Business Model

A Business Model defines the business architecture required to achieve pre-set

objectives by describing corporate operations overall in terms of corporate gover-
nance, internal organisational structure, production model, distribution model and
technological model. The overall definition of these 5 pillars allows an effective and
well-balanced architecture to be laid out.
Defining a model of corporate governance takes place through a structuring of
governing bodies and a definition of a system of direction in strategy, planning and
corporate control.
An organisational structure and resources are identified taking into account the
corporate organisation/functional chart and the scale of the structures.
A definition of a production model starts from a segmentation of customers,
setting it alongside this a suitable product range that can be developed by the
undertaking.
A distribution model includes the choices made in respect of three macro
variables: the operational model of channels, a model of integration between
channels and the organisational structure of the distribution network.
Lastly, the technological model is developed in terms of the technological
architecture that the undertaking wishes to have and the level of service that it
wishes to offer to customers and internal staff.
When this stage has been completed, the undertaking identifies a corporate
functional model.

35.3.4 Economic-Financial Plan

The economic-financial plan (or business case) develops economic/financial

projections focusing especially on profitability and measuring the impacts of the
various strategic options.
During this stage, three outlines are produced: the economic-financial situation,
trends in cash flows and value analysis.
In detail, in respect of preparation of the economic-financial situation: a pro-
spective Profit & Loss and a Balance sheet is processed, stock wealth magnitudes
making up the assets of the undertaking are estimated, and investments are assessed
(considering the time needed for the initial disbursement to be paid back2).
The cash flow analysis considers all the flows occurring over a certain period. All
movements increasing liquid funds available to the insurance undertaking (so called
sources) and the uses leading to a decrease in this liquidity (so-called applications)
are considered.

2
In financial terminology, the indicator calculated to assess the return on investment is defined
pay-back period.
35.4 Different Approaches to the Budget 759

Lastly, the profitabilty and impact on value provides an estimate the economic
value deriving from the actions set in motion by the plan. The aggregate value is
given by an inertial projection of the trends in the undertaking combined with the
impact of the strategic actions identified in the plan.

Future economic value of the undertaking = inertial projection

þ economic value drawn from the actions ð35:1Þ

When this stage has been completed, the undertaking has available a prospective
economic-financial analysis for the period of the plan.

35.3.5 Master Plan

The Master Plan orients implementation of the Plan by defining, setting in motion
and monitoring project actions.
During this stage preliminary planning is done of the scheduling of projects with
related project datasheets. In more structured situations, the master plan management
structure is also identified with related roles, responsibilities and reporting machin-
ery. A contingency plan is also prepared to manage project risks.
Alongside the master plan, a change journey is often also defined, i.e. a plan for
managing the schedule of changes in structures and persons operationally.
When this stage has been completed, an action plan is available along with a
scheduling of interventions to be implemented for achieving the strategy of the
undertaking.

35.4 Different Approaches to the Budget

Two alternative approaches are used for preparing a budget: the Zero-Based Budget
and the continuity-based budget.3
In the first method, Zero-Based Budget (ZBB) a budget is defined starting from
zero and considering the objectives and the prospective activities of the insurance
undertaking. This requires a defining of the impacts that new initiatives will have on
the revenue account of the insurance undertaking. A zero-based approach is a
method of budgeting through which the costs generated by each macro-activity are
analysed and quantified with each new drafting of the corporate budget. In particular,
each heading of the budget has a value of nil at the commencement of the process,
i.e. there is no correlation with historical data. Thus, it is a technique of planning that
is essentially devoted to discretionary costs, i.e. those costs for which it is not
possible to define a mathematical relationship between costs incurred and outputs
achieved. Each manager responsible for a function and a division takes an active part

3
Lynch TD, Sun J, Smith RW (2017) Public Budgeting in America, 6th edn. Prentice Hall.
760 35 Business Plan for an Insurance Undertaking

in drawing it up, with maximum involvement and sharing of underlying

assumptions. Some examples of costs that are usually estimated with the support
of this method may be: costs for consultants, representation expenses, discretionary
costs, IT expenses and investments for developing a new project, etc.
Among the main advantages of this approach are to be found: an identification
and reduction of superfluous costs (which may be generated by activities initiated in
the past and no longer justified in the present), specific and in-depth auditing of every
activity, and involvement of the person responsible for activities in drawing up a
budget of costs with a resulting increase in responsibility for achieving objectives.
To the contrary, among the points worthy of attention that can be identified are the
commitment required and the need to have available all members of the organisation
committing usefully to this activity, a need to coordinate and support activities of
analysis that every person responsible is called upon to carry out and, finally, a need
for continuous monitoring when running of the effectiveness of the actions
implemented and variances from objectives.
According to a Continuity-Based Budget (CBB) method a budget is defined
assuming that the relationship costs/revenues for the previous year will remain
constant. This leads to identifying the correlations that have constant impacts over
time on the revenue account of an insurance undertaking. A continuity-based budget
is, a method of budgeting via which costs and revenues are analysed and quantified
at each new drawing up of the corporate budget in accordance with a constant ratio
applying between costs and revenues from the preceding year. Each heading of the
budget at the commencement of the process is correlated with historical data and has
a value equal to that of the preceding year, proportionally modified depending on the
objectives of growth foreseen for the year. Thus, it is a technique for planning
devoted to budget headings for which it is possible to define a mathematical
relationship between costs incurred and output achieved.
Some examples of costs that are usually estimated with the support of this
method are: costs for utilities, costs for recurring hire charges, ordinary maintenance
expenses etc.
Among the advantages of this method, we can mention: a reduction in the time
taken to draw it up, the possibility of rapid auditing or forecast, less drain upon
managerial resources and a reduced involvement of persons responsible for other
areas. To the contrary, among the points we can detect: possible overestimating of
costs generated by activities commenced in the past and no longer justified in the
present and a need for constant monitoring when running of the effectiveness of the
actions implemented and variances from objectives. In Table 35.1 a comparison
between the two approaches is shown.
At times in practice, insurance undertakings adopt a further mixed approach,
defined as a Mix-Based Budget. Under this method, a budget is defined starting
from zero and considering the objectives and prospective activities of an insurance
undertaking, but considering historical trends too, especially for revenues and direct
costs, and the costs/revenues relationship taken from the preceding year. The
peculiarity of this method consists of combining the two techniques of budgeting
analysed above (Zero-Based and Continuity-Based), surmounting the limits of each
35.5 Components of Economic-Financial Plan 761

Table 35.1 Comparison between approaches to budgeting

Zero-based budget Continuity-based budget
Scope • New corporate initiatives • Variables constant from year to year
Advantages • Itemised auditing of each • Rapid auditing/short timings
activity • Reduced drain on resources
• A high degree of involvement
Disadvantages • A need for a high degree of • Possible overestimation of activities no
commitment longer justified

of them and creating the right balance between historical trends and new prospective
activities in a market that is developing quickly.

35.5 Components of Economic-Financial Plan

Building up the economic-financial outline of the Business case of an insurance

undertaking may take place through a tree structure representation. In this outline all
revenues and all costs possible of the insurance undertaking (or a specific project)
over a timeframe comprising a number of accounting periods (usually 3 years) are
considered. The difference between revenues (premiums) and costs leads to a sort of
first margin or technical balance. This value may be considered the point of arrival
(or roots of the tree). See Figure 35.3 which represents the roots of the Business case
tree.
The approach of business case tree is to visualise a tree with many branches and,
subsequently, many leaves. Each of these levels represents the variables underlying
the Business Plan. The critical item in the success of this approach is a capacity to

Premiums

Technical
margin

Costs

Fig. 35.3 Roots of the Business Case tree

762 35 Business Plan for an Insurance Undertaking

break down each level into the right variables. From each branch, branches stem that
in their turn branch through the next level. Only after having defined all the levels
and all the variables of the Business Plan, is it possible to set in motion the process of
making a quantitative estimation. Within the values for each individual level, it is
necessary to map the cause and effect of each variable. In this way, the economic-
financial outline can be split into manageable and definable chunks. In each block
the assumptions and key variables (revenues and costs) that determine the result at
the level are defined. Through this method, greater understanding is achieved of the
dynamics via which a performance is obtained and interconnections between differ-
ent variables come to light. In Figure 35.4 an example of a Business case tree is
shown.

% Annual Y1 Y2 Y..
[6]
Average
premium
[4]* %
Multiannual
[7]
Written
premiums
[2]
New Business (%
Gross written annual increase)
Premiums Number
[1] [5]
Renewal %
Premium
reserve
[3]
Technical Standard
margin Sales & Commissions
Distribution Incentive

Settlement Process
costs Legal expenses, ...
Costs Claims
Frequency
Payments Paid
Average
Cost Reserved

Investments
(depreciation)
Set up
...
Administra-
tion Staff, Personnel
Information Training
Running Technology
Other
… Communi-
cation

Fig. 35.4 Logic tree of the economic-financial outline of a Business case

35.5 Components of Economic-Financial Plan 763

By way of example, details of the first branch of the logic tree is analysed: the
item “gross premiums accruing”. The reader can follow the sequence of Arabic
numbers and focus on the grey coloured cells.
Starting from the left [cell 1], it correspond to gross premiums accruing. The two
variables making this up are “premiums issued” [cell 2] and “premium reserve” [cell
3]. Following this logic, an estimate of the premiums [cell 1] must assume calculat-
ing the two foregoing variables, i.e. [cell 2]–[cell 3]. Proceeding with the analysis,
quantification of the “premiums issued” [cell 2] item is found by multiplying an
“average premium” [cell 4] and “quantity” [cell 5], i.e. [cell 2] = [cell 4] × [cell 5].
The breakdown may proceed all the way to the last leaf of the branch. In this case,
“average premium” [cell 4] is made up of the percentage of as many premiums as are
annual and part-year [cell 6] and as many as are multi-year [cell 7] and so on.
It should be noted that using this method, it is first necessary to define the logic
tree and the relationship between variables and, later, the process of estimation and
assessment can be proceeded to. Estimation of the variables takes place from right to
left (i.e. from the last leaf to root). This approach allows a consolidation the
assumptions of the lower level up to the highest level, so obtaining the roots as a
synthesis of all the underlying estimates.4
In the following paragraphs, each of the main items of the tree is described in
detail and the relevant corporate budget is presented. More specifically, the follow-
ing five macro-items are described with their respective budget framework:

1) Sales budget;
2) Expenses budget and overhead costs;
3) Budget of Personnel Costs;
4) Budget for the ICT area;
5) Budget for the Finance area.

Note that with regard to the quantification of the cost of claims, it is necessary to
refer to the assumptions and actuarial methodologies presented in the previous
chapters.5

35.5.1 Sales Budget

Assessing the sales budget is based on two factors: calculation of the volume of
premiums by product (or line of business) and an estimate of the potential volume of
premiums by channel. The starting data used are, usually, of an accounting nature

4
Note that what has been described is typical of a bottom up approach. (i.e. from lower to higher).
This approach obtains its result via a process of continuing synthesis (one after the other).
Beginning with the basic items, aggregated case by case into an organised system.
5
See Chap. 12 for non-life insurance reserving methodologies.
764 35 Business Plan for an Insurance Undertaking

such as, for example the value of premiums booked6 in the last twelve months of the
year preceding the accounting period of the budget. To these are added in data of a
management and statistical kind such as: annulments, new head-office production
(not distributed through traditional channels), tariff variations etc. that contribute to
completing the total of premiums collected. The process is achieved in a fashion that
is different depending on whether this is non-life and life business.
In respect of non-life business, an estimate of premiums collected is based on the
following five steps:

1. Determining the volume of premiums for the budget accounting period (details by
line of business—if it is not possible, macro details foresee at least a distinction
between Automobile Liability, personal protection lines and property protection
lines).
2. Defining the average premium and number of distinct items new production and
renewals.
3. Estimating the premiums by products taking into account: an update of existing
products, launch of new products, replacement and/or cancellation of old
products.
4. Splitting the value over sales channels.
5. Drawing out details for each channel (e.g. for the traditional channel of agents—
distinguishing between new and existing for the bank insurance channel—
distinguishing between banking institutions).

Special attention is given to the Automobile Liability line of business. In this

case, determining premiums foresees further steps. In detail, the activities performed
are the following:

• Distribution of Automobile Liability premiums over geographic areas (consider-

ing urban areas compared with extra-urban areas and geographic peculiarities—
north, centre, south etc).
• Comparing the geographic concentration of premiums with the national mean.
• Analysis of the cover of vehicles compared of the national fleet.
• Analysis of the development of the average Automobile Liability premium as
compared to what has occurred in the national mean over the last 12 months.
• Assumptions of development in the average Automobile Liability premium of
new production compared with the national mean.

6
So as to have a certain item of data, reference is made to the value of releases for premiums
(i.e. premiums booked for which a release for collection has been issued).
35.5 Components of Economic-Financial Plan 765

Table 35.2 Items of the Head Office budget plan

Year 1 Year 2 Year 3

1. Expenses of communication and marketing
Advertising campaign
Institutional/mandatory disclosures
Product disclosures
Sponsorships
Printed matter
Gifts and gadgets
Total
2. Discretionary expenses
Expenses of representation
Travel and staff displacement
Other expenses of travel and stay
Total
3. Professional services
Administration advice
Financial advice
IT advice
Commercial advice
Audit financial statements
Expenses for fiduciary parties (adjusters, forensic physicians)
Total
4. Legal services/corporate costs/mandatory sector charges
Legal advice and fees for notaries
Association costs
Industry oversight levies
Statutory expenses
Total
5. Training
Courses, Congresses, Seminars
Total

35.5.2 Head-Office Expenses Budget and Overhead Costs

The Head-office expenses budget and overhead costs has the purpose of planning
the sum of recurring annual costs of running and insurance undertaking.
In the Head-office expenses budget, the following four items are usually
included: expenses for communication and marketing, discretionary expenses, pro-
fessional services, training. See Table 35.2 for details of expenses.
Within an insurance undertaking, costs pertaining to legal and corporate expenses
are especially important. Within this category are to be found various items tied to
legal services and mandatory sector charges. In particular, legal expenses include
legal advice and fees for notaries. Corporate costs include association costs, industry
766 35 Business Plan for an Insurance Undertaking

oversight levies, statutory expenses, expenses for stamp duty/rights, corporate and
general meeting professional services.
In respect of overhead costs, an estimate is made by type of expense concerning
general costs tied to management of places of business and facilities management.
These four categories of costs include: expenses for utilities, management expenses
for real estate and general and office materials expenses. In detail, expenses for
utilities usually include outgoing rental, water, electricity and telephone expenses.
Real estate management expenses contain Condominium expenses for properties
and heating, expenses for administration activities for buildings, maintenance and
repair, cleaning and security service and costs of waste disposal. Finally, general
expenses relate to postal/shipping expenses, hire and miscellaneous services, main-
tenance and repair of vehicles/leasing. Office material expenses include costs for
stationery and purchase of items not of high value.
At the end of the process of estimation, a summing of all the items is made as
indicated in Table 35.3.

Table 35.3 Items of the budget for overheads

Year 1 Year 2 Year 3

1. Expenses for utilities
Outgoing rental
Water
Electricity
Telephone expenses
Total
2. Real estate management expenses
Condominium expenses and heating
Administration expenses
Maintenance and repair
Cleaning
Security service
Disposal of waste
Total
3. General expenses
Postal/shipping expenses
Hire and miscellaneous services
Maintenance and repair of vehicles/leasing
Total
4. Office materials
Stationery
Books, subscriptions
Purchase of goods of marginal unit value
Total
35.5 Components of Economic-Financial Plan 767

Table 35.4 Outline for an estimation of a 3-year scale

Area Level Year 1 Year 2 Year 3
Claims Management Department Executive 1 1 1
Manager 2 3 3
Clerical staff 18 20 21
Underwriting Department Executive 1 1 1
Manager 1 2 2
Clerical staff 12 14 16
Finance Department Executive 1 0 0
Manager 1 1 1
Clerical staff 5 4 4
etc etc etc etc etc

35.5.3 Budget of Personnel Costs

The budget for personnel costs for an insurance undertaking starts out with an
estimate made of organisational needs and scale of resources. For this reason, the
first item of data estimated relates to the number of resources necessary for each
corporate area. Within each area, resources are split by paygrade. In Table 35.4 an
example of an outline for an estimation of the scale of resources over a number of
accounting periods (e.g. 3 years) is shown.
Subsequently, an average corporate cost of compensations for each of these
3 types of level is assumed. The estimation is refined by including any other costs
that are peculiar such as, for example fringe benefits or variable bonuses (tied to a
plan of incentives), paid in the form of goods or services.
Multiplying together the two values [number of resources] × [average compensa-
tion] gives the annual cost of personnel for an insurance undertaking. This sum is in
its turn increased to take into account corporate group policies or increases in costs of
compensations tied to renewal of the national work contract for the domestic sector,
which usually takes place periodically.

35.5.4 Budget for the ICT Area

The use of technology in managing and processing information has taken on

growing strategic importance for the insurance industry. Costs relating to the area
of Information and Communications Technology (ICT) are one of the most
important items of expense for an insurance undertaking. Within these costs are to
be found:

• All digital devices and software programmes.

• Activities of advisory useful for processing data and information.
• Costs for telecommunications (internal and external networks).
768 35 Business Plan for an Insurance Undertaking

Table 35.5 Items of the Budget for the ICT area

Year 1 Year 2 Year 3

Expenses for the ICT area
Costs for professional IT advice
Services tied to software (installation, assistance etc.)
Cost of licences
Costs for software development
Ordinary maintenance
Corrective maintenance
Development maintenance
Costs of purchase or hire of Hardware
Costs of monthly charges (purchase, iCloud space etc.)
Total

In Table 35.5 that main types of expense are shown. Classification of costs
follows the typical approach for a project of an IT kind in which costs for the
purchase of licences, daily rates for consultants who parametrise/create programmes
and software systems and hardware costs are foreseen.

35.5.5 Budget for the Finance Area

The economic result generated by the Finance area bears importantly on the perfor-
mance of an insurance undertaking. For this reason, the budget of annual income
generated by the Finance area and the budget for expected target returns get special
attention. In Table 35.6, the variables underlying profitability in this area are set out.
The initial item of data is given by the total sum of assets managed by the insurance
undertaking. This is broken down depending on the duration of the underlying
investment. By way of example, a situation is shown with different time intervals
to which a different target financial return is tied. Multiplication of the rate of
remuneration of each category of asset and the sum of the relative investment
provides the value of ordinary income generated by financial management. To this
income, extraordinary capital gains capital losses from realisation must be added or
subtracted. In addition, for life business, income deriving from separate management
in terms of management commissions (so-called management fees paid to the
undertaking) and the quota part of returns withheld by the insurance undertaking
may be added.
In respect of the budget for annual recurring costs of the Finance area, this is
determined on the basis of four items:

• An estimate of operational costs (i.e. charges and annual costs for licences).
• Costs of commissions paid out by an insurance undertaking for dealing with
managing assets with a depository bank (or another licensed party).
35.6 Questions 769

Table 35.6 Budget of income from the Finance area

Finance Area—Budget Income Year 1 Year 2 Year 3

Ordinary Income
Total Asset Under Management [1]
(A) Bonds area
1–3 months:
3–12 months:
> 12 months:
(B) Equity area
1–12 months:
> 12 months:
Rate of remuneration (%) [2]
Total Ordinary Income [1]*[2]
Extraordinary Income
+/- Extraordinary capital gains/losses from realisation [3]
Management fees and rebates [4]
Total Income [1]*[2] + [3] + [4]

Table 35.7 Budget of costs for the Finance area

Year 1 Year 2 Year 3

Costs for financial area
1. Charges and annual costs (licences, software etc.) [5]
2. Commissions paid out [6]
(a) % fees
(b) Assets Under Management
3. Costs of Trading [7]
(a) Transaction costs € per item
(b) Costs of transacted [basic point per sum]
4. Stamps and expenses [8]
Total Costs [5] + [6] + [7] + [8]

• Costs tied to activities of sales/purchase (trading) of securities.

• Costs of stamps (and other expenses foreseen under fiscal regulations).

See Table 35.7 which itemises an example of outline for costs tied to management
of the finance area.

35.6 Questions

1. Illustrate the logical steps in drawing up an economic-financial plan following the

structure of the logic tree
2. What are the 5 stages for drawing up a Business Plan?
770 35 Business Plan for an Insurance Undertaking

3. Indicate the features of the ZBB approach

4. What are the 4 factors underlying a Business Plan?
5. Indicate the list of costs foreseen in the budget for the ICT area

Reference
Lynch TD, Sun J, Smith RW (2017) Public Budgeting in America, 6th edn. Prentice Hall

Suggestions for Further Study

Entrepreneur Media (2015) Write Your Business Plan : Get Your Plan in Place and Your Business
off the Ground, Inc., Irvine, CA, Entrepreneur Press
Goodpasture JC, Tysons Corner V (2013) Maximizing project value: a project manager’s guide.
Management Concepts Press
McKinsey& Co (2010) How to write a Business Plan, paper, Boston. http://10k.inc.hse.ru/files/
McKINSEY_GUIDE_to_business_plan.pdf