With the recent initial public offers of life and non-life insurers and a reinsurer in India, investors and analysts are faced with the task of understanding an industry that they probably are not quite acquainted with. Insurance can be compared to a backroom support system for the economy or a play in the backyard, never attracting the limelight but chugging along in the background with monotonous regularity, not quite associated with the glamour of financial services, so to say in a very direct way. This is despite the central role it plays in the effective functioning of the economy and shouldering the risks of physical damage, mishaps, calamities, frauds, going so far as accident and product liability awards. This piece focuses on non-life insurance business and the term insurer includes reinsurer, unless specified otherwise.
The gamut of risks borne by non-life insurers is a veritable kaleidoscope barring the life, annuity, morbidity and mortality risks. From the run-of-the-mill fire and property to marine (hull and cargo) to motor, crop, aviation, space and director’s liability to mega risks to cyber and body parts of sports persons, the universe of a non-life underwriter is interesting, challenging and evolving. Throw in emerging risks such as cyber and climate change, and it would appear that the challenge is mammoth. Insurers, given their usual limited geographical presence for business operations and a particular level of capital resources, cannot bear these risks on their own in all cases. Insurers buy insurance from another set of insurers who are usually called reinsurers.
The risk and uncertainty arising from the potential event with downside has to be absorbed by an insurer and she will shed the risks beyond her comfort zone to reinsurers. The risk will travel further in the market till it is fully absorbed, subject to the willingness and capacity of the other players to absorb the risks, given the constraints imposed on them by regulators, investors and rating agencies. The role of reinsurers to absorb risks becomes quite important. For all practical purposes, they can be considered the wholesalers or manufacturers of the “capacity” to absorb the risk backed by their capital resources. This is particularly important when the insurer is faced with potential for a number of risks or an entire portfolio getting affected at the same time, such as flood or earthquake or a mega risk threatening the profitability or even the survival of the entity, unless supported by a reinsurer.
The transfer of risk from a given entity or geography to the global risk pool is quite interesting. It can happen in a series of transactions, and the risk can be sliced and diced. Insurer is usually supported by a number of reinsurers since every player seeks to benefit from diversification. Each player accepts risks commensurate with the risk appetite defined by their management within the regulatory framework imposing capital requirements.
At the core of the reinsurer business is sound risk-assessment—in comparison to an insurer—backed by bigger scale, greater geographical diversification, enhanced business diversification (across insurance classes) together with sound exposure management. They rely on analytics and advances in fields such as meteorology, seismology and interdisciplinary approaches to assess the risk and mitigate them through “financial engineering”. Reinsurers deal with the risks at portfolio-level, relying on the law of large numbers in spatial dimension and bank on trend assessment in temporal dimension.
It is noteworthy that insurance industry presents an interesting dynamic in that the premium is collected upfront and claims are settled after a lag—the event may happen some time after the assumption of risk, and once the event happens, there would be a process for ascertaining the loss quantum, further delaying the actual settlement. Cases involving litigation or complexity lead to stretching of this period in a very significant way. This leaves funds with the insurers, which they can invest, and this is known as “float” in the industry. In a way, it is free money with the risk carriers to invest and earn investment income from.
The Oracle of Omaha, Warren Buffett, who is reckoned to be one of the greatest investors of all time, has a particular affinity for the industry, largely because of the float which could come at a very low or no cost. The size of the float, which is a function of the lag in settlement and the investment yield, thus presents important variables underpinning the business of insurers. Certain insurance classes provide opportunities for higher float and certain economies present more attractive investment returns on account of the growth potential and investment climate.
Given this dynamic, there is a case for evaluating insurance business in a different way. Indian insurance market and the economy is quite different from those in the developed world and, therefore, presents a unique proposition in terms of business growth and profitability. Given the under-penetration, the growth for a couple of decades can be expected to be higher than in mature economies or even the global average. In fact, growth in the emerging markets is pulling up the global average just like in the case of global GDP. Industry during the last decade and a half has seen top line driven business strategies being pursued by market players to achieve scale, which is crucial, given the nature of the industry, and is now entering the consolidation phase.
Indian insurance sector is set to grow in the context of economic growth, demographic profile, urbanisation and transition to middle income country, apart from certain macro drivers such as climate change and governmental focus on resilience and protection.
It is moot how long the stock markets—which tend to be more sentiment-driven than fundamental-driven in the short term—will take to fully factor in the ‘idiosyncrasies’ of the industry which facilitates the smooth running of economy. Indian insurance industry makes for an attractive business opportunity owing to under-penetration on the business side. The icing on the cake is the opportunity to invest in the economy which is again attractive given the overall growth potential. It will be no exaggeration to say that managing risk and rewards, in all their dimensions, is at the core of the insurer business model.
By Alice Vaidyan
Chairman & Managing Director, GIC Re