Significance of Business Case in Insurance

Business Case (BC) Development is one of the most important aspects in the transaction of?insurance. A BC provides a rationale or justification as to why a course of action needs to be taken. It examines how the benefits of the action outweigh its costs and why it should be executed rather than doing something else or nothing at all.?

A BC is often thought to be useful when establishing a startup company or for executing some project which requires investment of time, money and effort. This need not necessarily be the case. Even routine, day to day transactions also involve a BC.?

How important is BC in insurance??

In insurance business, the decision to underwrite a certain risk boils down to a BC. The acceptance of risk has to have sound justification, in terms of alignment with the company’s underwriting philosophy and its management objectives. This may not be such a big BC, but a BC nevertheless.?

A boss of mine used to tell me that the worst thing that can happen to an underwriter is accepting a risk and at the time of a major loss, looking at the mirror and thinking that had he done the BC properly he might not have written that risk and thereby avoided the claim. If the BC had been done satisfactorily before acceptance and still the loss came, then that’s something you’re in insurance business for - to pay out an unforeseen claim.?

In the Indian context, one can cite the example of some Public Sector General Insurers running high loss ratios on the group health business and government schemes. These didn’t have any valid BC and thereby ran up accumulated losses that have eroded their net worth. Consequently, these insurers are now facing negative solvency and have to depend on capital infusion by the government to improve their financial situation.?

Major and minor BC’s

While routine acceptance decisions are minor BC’s which don't involve any monetary investment, there can be major BC’s like getting into some new line of business or to introduce some new product in the market. There is considerable investment involved in creating underwriting capacity which has to be justified by business volumes written. This must also happen with a certain profitability to justify the return on investment made.?

BC is collective for all participants, not selective:

There is a quote from Arthashastra, the treatise on statecraft, politics and economics written in the 2 BC, which sums this up.?

“The fundamental principle of economic activity is that no man you transact with will lose; then you shall not”

Incidentally, this is the guiding philosophy of Murugappa Group, a well respected 124 year old business conglomerate based in Chennai, India.?

BC that suits one party to the expense of another in a transaction can’t sustain for long.

Analysis of a typical BC:

Let’s take an example of a BC to understand the concept and how it plays out in real life.?

An insurance company wanted to start aviation insurance. In aviation, you normally don’t get proportional reinsurance capacity. So the company entered into an excess of loss (XOL) arrangement.?

The problem with XOL is that it is costly. It has a minimum deposit premium (MDP) which needs to be paid to the reinsurer. There is an upfront cost. Any company going for XOL should have some assurance that it will be able to write the premiums needed to meet the MDP as well as generate some net earned premiums (NEP) for itself. The NEP should be sufficient to pay for net claims and underwriting expenses.?

What were the assumptions??

The company was confident that given its market standing and existing corporate relationships, it will be able to generate sufficient business. So there was unmet market demand that could be tapped into.?

The company was already participating in some airline fleets with coinsurance shares that were being backed by facultative reinsurance. Some of this share could flow into its own new capacity without relying on external reinsurance capacity. This was a low hanging fruit ready for picking.?

The company could also offer capacity to other insurers and get inward reinsurance business, in addition to the direct business that it would be writing.?

Despite all the above tailwinds, the BC eventually failed.?

What went wrong??

The bulk of aviation premiums in most markets come from airline fleet business. The company was not a lead quoting market for aviation fleet business, but a follow one. It was getting “verticalized”, whereby the follow markets get a lower rate on line than the lead markets. It was not getting enough premiums for the exposure it was retaining to its own book.?

To offset the above premium deficiency from the fleet business, it had to write a significant chunk of general aviation premium. But again it had to avoid loss making segments like single engine rotor wing aircraft with poorer safety record. But with the limited number of fixed wing aircraft available for underwriting and combined with highly competitive pricing in the market, the expected volume of written premiums were not achieved.?

Aviation insurance business by its nature is highly volatile. Even when the market is benign and you don’t encounter any major disasters with total loss claims, there are always losses like bird hit damage to engines, runway excursions leading to nose wheel damage etc., which are partial losses, but still can run into hundreds of thousands of dollars.?

These losses are not high enough individually to reach the attachment point of XOL, whereby recovery can be done from reinsurers. But collectively they are not small. These losses ate into the NEP of the company. This left it with little or negative margins to justify the solvency capital being allocated to the business.?

Ultimately, the insurance company decided to wind up the aviation business and run off the portfolio.?

Could it have been avoided??

Was it irrational exuberance that the success the company had in other lines of business could be easily replicated in the aviation business? Were the assumptions behind the BC sufficient cross checked or validated? Was the financial model stress tested for different scenarios?

Of course, one can become wiser in hindsight and ask such questions.?

The success of a BC is essentially dependent on avoiding certain biases or traps. First is the anchoring bias. Too much weightage was given to the business opportunity availability in aviation. Sure, business was there to underwrite, but at what cost? This anchoring bias then leads to confirmation bias. Once the opportunity of aviation business was made, the subsequent analyses were all done to support the decision of entering the aviation insurance market, rather than to question it. By the time realisation dawned, it was too late.?

Critiquing of a BC is absolutely essential to avoiding the potential anchoring and confirmation traps and making objective decisions.

There was also no collective benefit in the above BC. While the customers who got insurance coverage, the intermediaries who brought the business,? the reinsurers who offered the XOL capacity and the brokers who placed the reinsurance arrangements, all benefitted, but the insurer did not.?

To conclude:

Ability to develop, present and secure acceptance of a BC is such an important and useful skill, but often overlooked. This is something which is required of future leaders of the insurance industry. But I wonder if any of the insurance certification courses or institutions that offer insurance qualifications train their students in BC.