Nature and Importance Insurance

5/21/2018 Nature and Importance Insurance

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20. The Nature and Importance of

Insurance

Dr. Jan-Juy Lin

Dept. of Risk Management and Insurance

ETP course, CNCCU


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Introduction

The insurance production process

Overview of insurance worldwide

The international dimensions of insurance

supply

The role of insurance in economic growth

Determinants of insurance market structure

Question Discussion


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The Insurance Production Process


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The Production Process (Figure 20.1)


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The Role of Capital and Surplus

Insurance policies are contingent claim contracts

that rely on pricing Inversion.

The product is priced before actual production

costs are known.

Insurers must provide a margin for unfavorablepricing deviations.

The greater an insurers capital compared with its

premium writings and liabilitiesthat is, the less its

financial leveragethe greater the perceived

security and the more favorable its reception among

informed buyers.


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Pricing and Product Development

Pricing(premium rates and reserves) using theirbest estimates as to future losses and expenses

with an eye toward competitiveness.

The greater the average period between premium

receipt and loss payout, the greater the influence

of investment returns in setting premium rates.

(life vs. non-life) (experience rating v. exposure

rating & model)Product innovationand price competitiveness are

often understandably crucial determinants of

success, especially for new entrants.


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Underwriting

Two key functions:Selection (or rejection) of application

Classification of accepted risks

Q: adverse selection

The underwriter must assemble informationaboutthe applicant and the subject of insurance in order

to assess the loss potential. (complex case)

It requires knowledge of local conditions and thelocal environment.


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Claims Settlement

Claims under life insurance policies typically can besettled easily. A local presence of the insurance

company is not required.

Health insurance claims can range from simple tocomplex. (e.g., insurance fraud, veteran hospital)

In lines of insurance where losses require on-siteexamination (e.g., property insurance), some type of

local presence is typically necessary.


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Claims Settlement

Claims personnel, sometimes with the assistance ofan actuary, estimate amounts to be established as

balance sheet liabilities (reserves) for unpaid nonlife

claims.

Contract situs

The jurisdiction whose law applies to contract

creation, interpretation and enforcement.One of principal consumer protection issues

within the insurance pricing, underwriting and

claim settlement process.


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Distribution

Direct response systemCompanies distribute products without the use of

intermediary.

Distribution through agents (authority granted)

Captive (exclusive, tied) agents

Independent agents

Distribution through brokers

A broker is a legal representative of an insurancepurchaser, represents the interests of the insured.

Distribution through other financial institutions

e.g. bank, convenient store, post office


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Investment Management

Insurers are key institutional investors in capitalmarkets worldwide.

Regulators and supervisors pay close attention tothe composition and management of invested

assets of insurance companiesChapter 21

Nothing inherent in the investment managementfunction requires a local presence.


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Foreign investments can exacerbate thebuyers (and the regulators) problem of

information asymmetry.National regulation typically placessevere limits on foreign investmentsby domestic insurers.


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A related but different concern arises withcross-border insurance trade.

If a foreign insurer in cross-border business

fails to meet its obligations, the host-country

insureds could be at a legal, not to mention

a practical, disadvantage.

The resolution of this issue is essential if

cross-border insurance is to grow.Asset management, ALM, RM, DFA

2nd significant function of insurers


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Overview of Insurance Worldwide


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Worlds Largest Life Insurers (2005) (Table 20.1)


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Worlds Largest Nonlife Insurers (2005) (Table 20.1)


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Worlds Largest Reinsurers (2005) (Table 20.1)


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Nature of Insurance Companies

Ownership structureStock insurers

Mutual insurers

Assessment mutuals (e.g., Protection and Indemnity

clubs)Non-assessment mutuals

Licensing statusAdmitted vs. non-admitted insurers

Composite insurersPlace of domicile

Domestic vs. foreign insurer (alien insurer in the U.S.)

Home vs. host country


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Share of Insurance Premiums (2005) (Figure 20.2)

0% 20% 40% 60% 80% 100%

Asia

Africa

Europe

World

Oceania

North America

Latin America

Life NonlifeSource: Swiss Re (2006)


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Distribution of Insurance Premiums (2005) (Figure 20.3)

Source: Swiss Re (2006)


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Worlds 10 Largest Markets (2005) (Figure 20.4)



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Insurance Density and Penetration

Insurance densityThe average annual per capita premium within a country.

Values are usually converted from national currency to

US dollarscurrency fluctuations affect comparisons.

Insurance penetration

The ratio of yearly direct premiums written to GDP.

It shows roughly the relative importance of insurance

within national economiesunaffected by currency

fluctuations.


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Insurance Density (2005) (Figure 20.5)



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Insurance Penetration (2005) (Figure 20.6)



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Insurance Supply


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Cross-border Insurance Trade

Pure cross-border insurance tradeWhen the resultant insurance contract is entered

into because of solicitations.

Own-initiative cross-border insurance tradeMany corporations often seek insurance abroad

trying to secure coverage either more favorable

terms.

Consumption-abroad cross-border insurance trade

Ex. Travelers may purchase a short-term

automobile insurance for rental car.


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Cross-border Insurance Trade

Difference-in-conditions (DIC) and difference-in-limits (DIL) insurance trade

A global firm purchases DIC or DIL coverage as

part of its global management.

Excess and surplus (E&S) insurance

An insurer places the risk with a non-admitted

insurer.

E&S brokerssuch trades are prohibit exceptthrough specialty domestic E&S brokers.


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Establishment of Insurance Trade

AgencyA domestic agent represents a foreign insurer for thepurpose of making sales.

BranchNot separate corporation but a part of the home-country

insurers.Subsidiary

The local subsidiary of a foreign insurer is a domesticcorporation.

Representative office (532 in China)market research, interest promotion

No risk bearing, no insurance selling


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Market-share of Foreign-owned Insurers (Table 20.2)



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The Role of Insurance in

Economic Growth


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Property Rights and Economic Development

Property rightsThe right to own and alienate real and personal property

The right to contract

The right to be compensated for damage resulting from

the tortuous conduct of others

Private financial services will not flourish unless

individuals ownership interests in property are well

defined and protected. (legal environment and

infrastructure) Ex. Shin Kongs joint venture in

Beijing.


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Property Rights and Economic Development

Any action that diminishes the value of onesownership interest in private property hinders

private financial services development.

Failure to control inflation

Substantial trade restrictions

High income tax rate

Private property rights, however, are restrictive by

their nature.

Without some restraints, their complete exercise could

actually interfere with the efficient functioning of markets.


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Financial Development and Economic Growth

As financial intermediaries, insurance

companies perform the same types of

functions and provide similar generic

benefits to a national economy as otherfinancial intermediaries.

Financial services generally and

insurance in particular are of primordial

importance to economic development.


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Financial Development and Economic Growth

Financial services offer the possibility ofproviding such externalities, thereby

enhancing economic growth.

Non-life insurance, life insurance and

banking are all shown to be important

predictorsof economic productivity.

Thus, the more developed and efficient a

countrys financial market, the greater willbe its contribution to economic prosperity.


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Benefits of Insurance in Economic Growth

Promote financial stabilityBy indemnifying those who suffer or

harm, insurance helps stabilize the

financial situation of individuals,families and organizations.

It encourages individuals and firms to

invest and create wealth.Peach of mind and financial

carelessness.


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Substitutes for and complementsgovernment security programs

Private insurance can relieve pressure

on social insurance system,preserving government resources for

essential social security.

Pension fund and life insuranceNatural disaster indemnity plan

Q&A: surname of insurance?


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Facilitates trade and commerceMany products and services are

produced and sold only if

adequate liability insurance isavailable to cover any claims for

negligence.

Ex. PL and MalpracticeInnovation

Credit enhancement


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Helps mobilize savings

Insurance and financial intermediation

Insurance enhance financial systemefficiency in three ways

Reduce transaction costs associated with

bringing together savers and borrowers

Create liquidityFacilitate economies of scale ininvestment


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Financial intermediaries vs. financialmarkets

The more developed a countrys financialsystem, the greater the reliance on

markets and the less the reliance onintermediaries.

Insurers vs. other financial intermediaries

Commercial banksshort-term deposits

Contractual saving institutionslong-termview


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Enables risk to be managed moreefficiently

Risk pricinggreater the expected loss,higher the price (u/w and investment)

Risk transformationrisk exposures can betransferred to an insurer for a price

Risk pooling and reduction

(1) insurers make reasonably accurateestimates as to the pools overall losses.

(2) insurers diversify their portfolios.


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Encourages loss mitigationIf pricing is tied to loss experience, insureds

have economic incentives to control losses.

Ex. experience rating, no claim bonus

Fosters a more efficient capital allocation

Insurers will monitor the companies to reducerisk-increasing behavior and act in the best

interests of their various stakeholders.

A watch-dog role.


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The Costs of Insurance to Society

Insurers incur sales, servicing, administration andinvestment management expenses.

The higher are such expenses, the less efficient are.

The existence of insurance encourages moralhazard.

All such moral hazard caused behavior causes

premiums to be higher than they would be otherwise,

represents a deadweight loss to society, can lead todisruptions in otherwise well-functioning markets, and

truly is a societal cost of insurance.


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Determinants of Insurance

Market Structure


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Economic Factors

IncomeThe higher an economys income, the more it

spends on all types of insurance.

The income elasticity of insurance premium

The relative change in insurance premiums

written for a given change in national income.

Inflation

Considered as detrimental to life insurancesupply and demand.


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Insurance and Economic Development (Figure 20.7)


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Demographic Factors

Aging populationsA greater demand for savings-based life insuranceproducts, long-term care insurance. e.g. longevity risk

Education

The more educated population, the greater the likelihoodof understanding the need for insurance.

Household structureLife insurance demand increase as the number of youngchildren in the house hold increases.

Industrialization and urbanizationThe positive between Industrialization and urbanizationand insurance consumption. e.g. new urban risks


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Social Factors

Cultural perceptions of the role ofinsurance products can vary substantially.

Asialife insurance as a savings

instrument

Muslim society -- insurance as

inappropriate because of religious belief.

Koreaimpolite to say no in some

circumstances.


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Political and Legal Factors

Improvements in a countrys political environmentenhance insurance demand.

Governments make decisions that directly affect

insurance demand and supply.

Insurance product within the regulatory jurisdiction

through a policy review and approval process.

Tax laws and the premium approval process greatly

influence product design, availability and value.

An improvement in legal systems had a significant and

positive affect on life insurance demand.


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Globalization

The continuing globalization of financial servicesadds a new dimension to insurance consumptionEspecially for markets that have been highly restrictiveregarding new entrants

With increasing internationalization can come

increased capital from abroad, product andmarketing innovations, and different ways ofmanaging companies.

More competition

More consumption

Product and marketing innovation

New management style

Greater consumer choice and value


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Discussion Questions


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Discussion Question 1

For what reasons might two countrieswith roughly equivalent levels of per

capita incomes exhibit vastly different

insurance density and penetrationfigures?


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With a few important exceptions, U.S.insurers seem to have less interest in

international expansion than do many

European insurers. Suggest somehistorical, cultural and other reasons that

might explain this situation.


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With a life cycle hypothesis, during pre-adult years, we arenet dissavers. During our early working years, we save some

but usually to acquire durables. During our later working

years, we tend to focus much more intensely on saving for

retirement. During retirement, we tend to draw down savings.

Of what benefit might this hypothesis be to a life insurer

contemplating expansion into other markets?

Of what benefit might this hypothesis be to a government

thinking about how to encourage personal saving forretirement?


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What specific economic, social,demographic and political factors do you

find have affected consumption of (a) life

insurance and (b) nonlife insurance inyour country?

Do you also find globalization of financial

systems in general and insurance in

particular has affected insurance

consumption in the country?

Nature and Importance Insurance

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