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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

20. The Nature and Importance of Insurance

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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

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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 as contingent claim contracts that rely on pricing Inversion• The product priced before actual production costs are known• Thus, insurers factor in 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.

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Pricing and Product Development

Pricing (premium rates and reserves)• Use of 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.

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Underwriting

Two key functions• Selection (or rejection) of application• Classification of “accepted” risks

It also requires knowledge of local conditions and the local environment.

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Claims Settlement

Life insurance• Typically can be settled easily• A local presence of the insurance company is not required.

Health insurance• Claims ranging from simple to complex• Health insurance market structure of the country affect claim

complexity.

In lines where losses require on-site examination (e.g., property insurance), some type of local presence is typically necessary.

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Claims Settlement

Claims personnel, with the assistance of an actuary, estimate amounts to be established as balance sheet liabilities (reserves) for unpaid nonlife claims. The reserves are also known as:• Policy reserves• Mathematical reserves• 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

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Distribution – Marketing Channels

Direct response system

Distribution through agents• Captive (exclusive, tied) agents• Independent agents

Distribution through brokers

Distribution through other financial institutions

Countrywide variations exist. Chapter 25 discusses distribution channels via other financial institutions

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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.

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Investment Management

Foreign investments 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.

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Overview of Insurance Worldwide

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Top 10 Global Insurers in 2007 (by revenue)

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Top 10 Global Insurers in 2008 (by revenue)

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World’s Largest Life Insurers (2005) (Table 20.1)

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Top 10 Global Life Insurers in 2007 (by revenue)

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World’s Largest Life Insurers (2008)

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World’s Largest Nonlife Insurers (2005) (Table 20.2)

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World’s Largest Nonlife Insurers (2007)

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World’s Largest Nonlife Insurers (2008)

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World’s Largest Reinsurers (2005) (Table 20.3)

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Top 10 Global Reinsurers in 2006 (by net premiums)

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Top 10 Global Reinsurers in 2008 (by net premiums)

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World’s Largest Intermediaries (2008) (new)

Rank Company Brokerage revenues (1)    Country

1 Marsh & McLennan Cos. Inc. $11,516.0    U.S.

2 Aon Corp. 7,310.0    U.S.

3 Willis Group Holdings Ltd. (2) 3,362.0    U.K.

4 Wells Fargo Insurance Services Inc. (3) 1,743.1    U.S.

5 Arthur J. Gallagher & Co. 1,611.3    U.S.

6 Jardine Lloyd Thompson Group P.L.C. 992.8    U.K.

7 Brown & Brown Inc. 966.0    U.S.

8 BB&T Insurance Services Inc. 962.1    U.S.

9 Gras Savoye & Cie 786.4    France

10 Lockton Cos. L.L.C. 778.3 (4)    U.S.

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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)

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2008 World Insurance Swiss Re Sigma (2009)

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Total Real Premium Growth (2008)

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Total Real Premium Growth (1980 - 2008)

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Life Insurance Growth (1980 – 2008)

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Life Insurance Growth (2008)

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Solvency of Life Insurance (2002 – 2008)

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Nonlife Insurance Growth (1980 – 2008)

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Nonlife Insurance Growth (2008)

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Nonlife Insurance Solvency (1999 – 2008)

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Insurance Premiums - GDP (2008; All)

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Insurance Premiums - GDP (2008; Emerging)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Density and Penetration (2008)

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Insurance Supply

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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 The E&S system is unique to the U.S.

which maintains state regulation.

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Establishment of Insurance Trade

Agency

Branch

Subsidiary

Representative office

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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 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.

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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 as an example

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

Insurers 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.• Insurance and banking are important predictors of economic

productivity.• Evidence exists of synergies among financial intermediaries.• The more developed and efficient a country’s financial market, the

greater will be its contribution to economic prosperity.

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Benefits of Insurance in Economic Growth

Promote financial stability

Substitutes for and complements government security programs

Facilitates trade and commerce

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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!

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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

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The Costs of Insurance to Society

Insurers incur sales, servicing, administration and investment management expenses.• The higher are such expenses, the less efficient are.

The existence of insurance encourages moral hazard.• All such moral hazard caused behavior causes premiums to be

higher than they would be otherwise, represents a deadweight loss to society, can lead to disruptions 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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Price and Income Elasticity (Table 20.3)

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Economic Factors

Income

Inflation

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Insurance and Economic Development (Figure 20.7)

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Demographic Factors

Aging populations

Education

Household structure

Industrialization and urbanization

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Social Factors

Cultural perceptions of the role of insurance products can vary substantially.• Asia – life insurance as a savings instrument• Muslim society and insurance

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Political and Legal Factors

Improvements in a country’s political environment enhance insurance demand.

Governments make decisions that directly affect insurance demand and supply.• Insurance regulators worldwide typically determine whether a given

insurance product can be sold within their 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 services adds a new dimension to insurance consumption• Especially for markets that have been highly restrictive regarding

new entrants

With increasing internationalization can come increased capital from abroad, product and marketing innovations, and different ways of managing 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 countries with roughly equivalent levels of per capita incomes exhibit vastly different insurance density and penetration figures?

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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 some historical, cultural and other reasons that might explain this situation.

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Discussion Question 3

The life cycle hypothesis discussed in Chapter 2 suggests that individuals’ savings decisions are influenced by their location within their life cycle. Thus, during pre-adult years, we are net 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 for retirement?

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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 in your country? Do you also find globalization of financial systems in general and insurance in particular has affected insurance consumption in the country?