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W. Jean Kwon, Ph.D., CPCUSchool of Risk Management, St. John’s University

101 Murray StreetNew York, NY 10007, USAPhone: +1 (212) 277-5196

E-mail: Kwonw@stjohns.edu

Risk Management and Insurance: Perspectives in a Global Economy

3. The Economics of International Trade

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Study Points

Economic theory of trade

Fair trade concepts

International trade in insurance: economics and policy

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The Economic Theory of Trade

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Theoretical Development

Mercantilism• By restricting imports and promoting exports through government

subsidies or other preferential treatments, a nation could become richer because increased exports required increased payments from other nations.

Classical economic theory (Adam Smith)• The goal of economic activity should be to satisfy consumers’

demand for goods and services. • By producing goods and trading them with others, a country could

increase its wealth.

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Absolute and Comparative Advantage

David Ricardo• A firm (or country) has an absolute advantage over another firm

(country) if it can produce the same output as the other firm (country) at less absolute cost.

• A firm (country) has a comparative advantage over another firm (country) if it can produce the same output as the other firm (country) at less relative or opportunity cost.

• An illustration (Table 3.1)• Only two countries – East and West• Only two products – wine and cheese

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Production Costs for East and West (Table 3.1)

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Common Misconceptions about Trade (Insight 3.1)

Free trade is beneficial only for efficient producers. Some countries are inefficient at producing everything and therefore would always lose.

Low-wage foreign competitors always will take jobs away from higher-wage markets.

Trade exploits a country and makes it worse off. This is especially true if the country uses more labor to produce the goods it exports than other countries use to produce the goods it receives in return.

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Static Welfare Analysis (Figure 3.1)

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Effect of an Increase in Supply (Figure 3.2)

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Welfare Effects of Trade Restrictions (Figure 3.3)

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Dynamic Welfare Analysis

A case of Japan-made automobile imports to the U.S.

Economic rent• Benefits that are greater than the opportunity costs of production that

are captured by private entities (or individuals) as a result of government action

Rent seeking is a directly unproductive, profit-seeking activity.

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Trade Restricting Techniques – Tariffs (Figure 3.4)

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Trade Restricting Techniques – Quota (Figure 3.5)

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Trade Restricting Techniques – Subsidy (Figure 3.6)

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Trade Restriction – Government Procurement

Governments typically are required by their own laws to buy from local producers.• Government procurement allows domestic producers to charge the

government (thus taxpayers) more than they charge other buyers.

The Agreement on Government Procurement (1996)• Places certain limits on government procurement practices that

favored national producers• Covers mainly general rules and obligations concerning tendering

procedures based on the principle of non-discrimination

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Fair Trade Concepts Market access

• The right of a foreign entity to enter a country’s market

Non-discrimination (most favored nation treatment)• No country’s entities obtain better market access than any other country’s firms do.

Transparency• Regulatory/legal requirements regarding market access and domestic operation should be clearly

set out and easily available.

National treatment• Foreign firms are accorded treatment no less favorable than domestic producers in similar

circumstances.

Reciprocity• The response in kind by one or more governments to trading actions taken by another government.• “You lower your trade barriers, and I will lower mine.”

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International Trade in Insurance

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Fair Trade in Insurance?

Market access difficulties• Localization of ownership requirement• Domestication requirement• Localization of insurance requirement• (Economic) needs test• Mandatory cessions of reinsurance

Non-discrimination problems• Less prevalent than market access, transparency and national

treatment problems

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Fair Trade in Insurance?

Transparency issues• Common in insurance as insurance laws and regulations in several

countries are not clearly set out and readily available.

National treatment inconsistencies• Many governments failing to observe this in insurance• Denial of equality of competitive opportunity can take on more subtle

forms.

Reciprocity issues• Conceptually, reciprocity can result in treatment more favorable than

national treatment. Its application, however, has most often resulted in less favorable treatment.

• Mirror-image reciprocity

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Arguments for Restricting Trade in Insurance

1. Foreign insurers will dominate the domestic market.

2. The insurance industry should remain locally owned for strategic reasons.

3. Foreign insurers will provoke a greater foreign exchange outflow.

4. Trade restrictions are necessary for market development and consumer protection.

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1. Foreign Insurer Dominance

Argument Economies of scale and scope

Price and market distortion• Political dimensions• Economic dimensions

• Local control• Adverse effects• Dumping and under-pricing• Competition regulation

Infant industry protection

Remarks Insurance may not enjoy a

comparative advantage

Protection has already been extended for decades

Protection causes higher price or inferior quality

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2. Strategic Reasons

National security• The London market and Arab insurance companies (1970s)• Falkland Islands’ conflict between the U.K. and Argentina (1982)

National economic diversification• The government’s desire for national economic diversification

• Can government truly identify the “right” industries that warrant favored treatment?

• Nothing in the diversification argument suggests that the local capacity need be exclusively or even primarily locally owned.

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3. Preservation of Foreign Exchange Reserves

Insurance substitution issue

The nature of insurance-related trade flows• In a given year, outflows (of premiums) could exceed inflows (of

claims payment) or vice versa.

• Over the long run, outflows could be expected to exceed inflows.

• The more competitive the economies’ goods and services, the greater the foreign exchange inflow will be.

A case:• Cambodia’s 2000 enactment of its insurance law, which bars outflow

of insurance premiums from the country

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4. Market Development & Consumer Protection

Macroeconomic effects on the national economy• Cross-border insurance trade has negative macroeconomic effects

for the national economy.

• But, an inadequate local capacity or limiting spread of risk can endanger the insurance market.

• Forcing consumers to purchase higher priced or more limited coverage locally means they have inferior coverage or pay more for the coverage than consumers elsewhere in the world.

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4. Market Development & Consumer Protection

Protection of ill-informed buyers• Government has an obligation• Insurance laws commonly prescribe the protection.

• The logic for restricting pure cross-border insurance trade with respect to individuals and other poorly informed buyers is sound.

• An exception occurs when a reciprocal agreement exists between two jurisdictions.

• The logic in favor of restriction is less compelling with insureds’ own-initiative cross-border insurance trade.

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Deregulation and Liberalization in Insurance

Privatization

Deregulation• The process of reducing regulation to that which is minimally

necessary to achieve its goal and, in the process, placing greater reliance on market forces to ensure consumer protection

Liberalization• The process of breaking down government and artificial barriers for

international trade and investment

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Discussion Questions

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Discussion Question 1

What are the pros and cons of allowing foreign insurer entry into developing markets? Is your answer different if you are considering a developed economy?

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Discussion Question 2

“Infant industry protection is the only way to ensure that insurance firms in emerging markets can survive, and a national insurance industry is essential to economic growth and vitality.” Analyze this quote.

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Discussion Question 3

Explain carefully the differences between tariffs, quotas, and voluntary restraints. Who benefits from each of these methods to restrict trade?

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Discussion Question 4

What is the most common rationale for restricting international trade in insurance for your country? Evaluate that position based on the mercantilist philosophy, the free-trade philosophy and the managed trade philosophy.