Fall 2008 Version Professor Dan C. Jones FINA 4355
Risk Management and Insurance: Perspectives in a Global Economy20. The Nature and Importance of Insurance Professor Dan C. Jones FINA 4355
Study Points • 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
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 unfavorable pricing deviations. • The greater an insurer’s capital compared with its premium writings and liabilities – that is, the less its financial leverage – the greater the perceived security and the more favorable its reception among informed buyers. • Harmonization of the standards and valuation methods in insurance is one of the important objectives that the IASB hopes to achieve.
Pricing and Product Development • Pricing (premium rates and reserves) using their best 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. • Product innovation and price competitiveness are often understandably crucial determinants of success, especially for new entrants.
Underwriting • Two key functions • Selection (or rejection) of application • Classification of accepted risks • It requires knowledge of local conditions and the local environment.
Claims Settlement • Claims under life insurance policies typically can be settled easily. • A local presence of the insurance company is not required. • Health insurance claims can range from simple to complex. • In lines of insurance where losses require on-site examination (e.g., property insurance), some type of local presence is typically necessary.
Claims Settlement • Claims personnel, sometimes with the assistance of an actuary, estimate amounts to be established as balance sheet liabilities (reserves) for unpaid nonlife claims. • Also known as policy reserves, mathematical reserves or technical provisions • 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
Distribution • Direct response system • Distribution through agents • Captive (exclusive, tied) agents • Independent agents • Distribution through brokers • Distribution through other financial institutions Chapter 25 • Countrywide variations exist.
Investment Management • Insurers are key institutional investors in capital markets worldwide. • Regulators and supervisors pay close attention to the composition and management of invested assets of insurance companies Chapter 21 • Nothing inherent in the investment management function requires a local presence.
Investment Management • Foreign investments can exacerbate the buyer’s (and the regulator’s) problem of information asymmetry. • National regulation typically places severe limits on foreign investments by domestic insurers. • A related but different concern arises with cross-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.
Nature of Insurance Companies • Ownership structure • Stock insurers • Mutual insurers • Assessment mutuals (e.g., Protection and Indemnity clubs) • Non-assessment mutuals • Licensing status • Admitted vs. nonadmitted insurers • Composite insurers • Place of domicile • Domestic vs. foreign insurer (alien insurer in the U.S.) • Home vs. foreign country See also Chapter 24 (Insurance Regulation)
2007 World Insurance Swiss Re Sigma (2008)
Insurance Density and Penetration • Insurance density • The average annual per capita premium within a country • Insurance penetration • The ratio of yearly direct premiums written to GDP
Cross-border Insurance Trade • Pure cross-border insurance trade • Own-initiative cross-border insurance trade • Consumption-abroad cross-border insurance trade • Difference-in-conditions (DIC) and difference-in-limits (DIL) insurance trade • Excess and surplus (E&S) insurance • E&S brokers
Establishment of Insurance Trade • Agency • Branch • Subsidiary • Representative office
Property Rights and Economic Development • Property rights • The 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.
Property Rights and Economic Development • Any action that diminishes the value of one’s ownership interest in private property hinders private financial services development. • Failure to control inflation • Private property rights, however, are restrictive by their nature. • Without some restraints, their complete exercise could actually interfere with the efficient functioning of markets.
Financial Development and Economic Growth • Insurance firms perform the same types of functions and provide similar generic benefits as other financial intermediaries. • Financial services generally and insurance in particular are of primordial importance to economic development. • Financial services offer the possibility of providing such externalities, thereby enhancing economic growth. • Nonlife insurance, life insurance and banking are all shown to be important predictors of economic productivity. • Evidence exists of synergies among financial intermediaries. • Thus, the more developed and efficient a country’s financial market, the greater will be its contribution to economic prosperity.
Benefits of Insurance in Economic Growth • Promote financial stability • Substitutes for and complements government security programs • Facilitates trade and commerce
Benefits of Insurance in Economic Growth • Helps mobilize savings • Insurance and financial intermediation • Insurance enhance financial system efficiency in three ways • Reduce transaction costs associated with bringing together savers and borrowers • Create liquidity • Facilitate economies of scale in investment • Financial intermediaries vs. financial markets • Insurers vs. other financial intermediaries Discussion in pages 518-519
Benefits of Insurance in Economic Growth • Enables risk to be managed more efficiently • Risk pricing • Risk transformation • Risk pooling and reduction • Encourages loss mitigation • Fosters a more efficient capital allocation