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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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Investment Management
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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Investment Management
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)
Source: Swiss Re (2006)
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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)
Source: Swiss Re (2006)
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Insurance Penetration (2005) (Figure 20.6)
Source: Swiss Re (2006)
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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)
Source: Swiss Re (2004)
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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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Benefits of Insurance in Economic Growth
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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Benefits of Insurance in Economic Growth
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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Benefits of Insurance in Economic Growth
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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Benefits of Insurance in Economic Growth
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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Benefits of Insurance in Economic Growth
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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Benefits of Insurance in Economic Growth
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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Discussion Question 2
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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Discussion Question 3
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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Discussion Question 4
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?