Historical data, vital to design

Households slip into “bad states of the world” due to several reasons, including accident or death of the earning member, medical emergency of a family member, poor or excess rainfall that ruin crop production, theft or fire. Insurance offers a mechanism for households to financially protect themselves against the impact of these, making it one of the most powerful financial products. But unfortunately, it is among the least used.

According to Insurance Regulatory and Development Authority's Annual Report (2009), the penetration of life insurance is 4.6 per cent and that of general insurance 0.6 per cent. Health shocks that commonly destabilise household finances are rarely insured against.

A World Bank survey (2002) estimated that 40 per cent of individuals hospitalised in India borrow money or sell assets to cover costs; and 85 per cent of healthcare spending is expended “out-of-pocket”.

Why is penetration of insurance products so low in India? The reasons lie with product design and channel factors.

Pricing

For an insurer, the key issue is appropriate pricing of products. Two principal components of pricing across all products are risk and distribution costs.

Risk pricing is determined by assessing the probability of making the payout if the event occurs. Availability of historical data on its occurrence is crucial.

Unfortunately, long-term data is seldom available for most parameters that impact episodic events — either data quality is poor (as in the case of livestock) or infrastructure is not available for the collection of reliable data on an ongoing basis (for instance, weather stations to record rainfall).

Assessing the price of life insurance products is easier because historical data on life expectancy exists. Adequate, systematic and long-term collection of high-quality data — such as primary health data from PHCs to assess health risk or rainfall data from weather stations to assess rainfall risk — requires infrastructure.

Distribution costs are determined by channels employed for selling insurance. A large fraction of first year premium typically goes towards defraying just the agent commission. There is need for innovation and competition to lower distribution costs in the long-run, particularly in remote rural areas.

The technology that integrates front-end delivery at all customer interaction points with back-end processing by the insurer can substantially reduce transaction and delivery cost, making products more affordable.

Reinsurance

A well-developed reinsurance market that allows primary insurers to transfer risk to entities with a global risk pool is important. Reinsurers, again, require access to historical data to determine the underlying risk.

The absence of it significantly increases risk assessment by reinsurers, resulting in poor market for such products.

This makes it difficult for primary insurers to cover their risks, leading them to charge high premiums that may make products untenable for end-customers. Development of reinsurance mechanisms is important to bring affordability and continuity in the insurance market.

Moral hazard arises when the insured party begins behaving in a manner that increases insurer costs. A common example is motor insurance, where the person who has insured his vehicle may not take good care to protect the vehicle since any damage is compensated by the insurance company. Such issues can be addressed through careful product design, wherein, the insurance company can make customers bear a fraction of the claim.

For products such as livestock insurance, key concerns revolve around establishing the veracity of claims.

Technology, such as radio-frequency-tagging of livestock that sends signal to the local veterinarian when the animal dies, can prevent fraudulent claims.

Adverse selection occurs when persons who purchase insurance are at higher risk than the average risk estimated by insurers. This means premiums set by insurers would eventually be insufficient to service all claims that can arise.

Adverse selection can be mitigated by increasing the size and diversity of the population insured.

Product and process features

Insurance products need to be designed with focus on specific features that make them relevant to customers. For instance, if the payout in agricultural insurance is a function of average yield, and the farmer with higher than average yield is not adequately compensated for the loss, insurance becomes inadequate for him.

Similarly, for insurance to serve its purpose, it is important that claims settlement be convenient and reliable. For instance, accident or health insurance, without a process in place for immediate claim settlement, may lead to households becoming worse-off when faced with an event, as they may be forced to tide over the situation either by selling assets, or borrowing at high interest rates.

The selling process

Who should buy insurance and how much? These are important, but technical questions and cannot be left to the judgment of the customer.

For example, life insurance must protect the net present value of an individual's lifetime earnings (human capital), which varies across age-groups and skill levels. Intuitively, human capital would be highest at the peak of earning capacity, and least, closer to retirement age. However, sale of life insurance products often does not take into account the value of human capital. This leads to under-insuring or over-insuring, and even mis-sale to people who don't need to buy life insurance. This is a challenge with almost all insurance products and can be tackled through accreditation requirements for agents, discouraging pure volume-based incentives and putting the onus of providing adequate insurance cover on the insurer rather than on the insured.

(The authors are with The Centre for Insurance and Risk Management, IFMR, Chennai. blfeedback@thehindu.co.in )

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