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    Introduction to the

    Insurance Industry

    primer series on insurance

    issue 1, march 2009

    www.worldbank.org/nb

    Rodney Lester

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    Introduction to the Insurance Industryii

    2008 The International Bank for Reconstruction and Development/The World Bank1818 H Street, NWWashington, DC 20433Internet: www.worldbank.org/nbE-mail: [email protected]

    All rights reserved.First printing March 2009

    This volume is a product of the staff of the International Bank for Reconstruction and Development/The WorldBank. The ndings, interpretations, and conclusions expressed in this paper do not necessarily reect the viewsof the Executive Directors of The World Bank or the governments they represent.

    The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors,denominations, and other information shown on any map in this work do not imply any judgement on thepart of The World Bank concerning the legal status of any territory or the endorsement or acceptance of suchboundaries.

    Cover and publication design: James E. QuigleyCover illustration: Imagezoo/Corbis

    Author Rodney Lesteris is a senior advisor at the World Bank with global experience ininsurance development and supervision, and 30 years of experience in the private sectorinsurance and fund management industries. Before joining the World Bank he was a ManagingDirector in AMP, Australias largest non-bank nancial institution with responsibility forinsurance businesses in Australia, New Zealand and the UK. During this time he servedas President of the Insurance Council of Australia. He has also been CEO of a number ofmedium-sized diversied nancial services groups operating in all areas of the insurance andfunds management industries and in leasing. At the World Bank, his activities have includedpensions and insurance industry reform and resolution work, development of private pensionmechanisms, natural disasters funding, corporate governance and microinsurance.

    THIS ISSUE

    Series editorRodolfo Wehrhahn is a senior insurance specialist at the World Bank. He joinedthe Bank in 2008 after 15 years in the private reinsurance and insurance sector and 10 years inacademic research. Before joining the World Bank, he served as President of the Federation ofthe Interamerican Insurance Associations representing the American Council of Life Insurers.He was board member of the AEGON Insurance and Pension Companies in Mexico, and wasCEO of reinsurance operations for Latin America for Munich Reinsurance and for AEGON.

    For questions about this primer, or to request additional copies, please contact:[email protected]

    The Primer Series on Insurance provides a summary overview of how the insurance industryworks, the main challenges of supervision, and key product areas. The series is intended for

    policymakers, governmental ofcials, and nancial sector generalists who are involved with theinsurance sector. The monthly primer series, launched in February 2009 by the World BanksInsurance Program, is written in a straightforward, non-technical style to share concepts andlessons about insurance with a broad community of non-specialists.

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    Introduction to the Insurance Industry iii

    iii

    Contents

    Te nature and history o insurance ........................................................... 1

    Role o government in insurance ................................................................ 3

    Prole o the modern insurance sector ...................................................... 4

    Development paths or the insurance sector ............................................. 5

    Insurance and development ....................................................................... 10

    Policy issues in insurance market development ......................................11Industrial structure and minimum capital..........................................11

    Financial insurance................................................................................ 12Liberalization ......................................................................................... 13Financial supervisor cooperation or integration .................................14Catastrophe risk .....................................................................................14Accounting and information systems ................................................... 14Insurance taxation .................................................................................15Distribution and intermediaries ........................................................... 16

    Reerences .....................................................................................................17

    Annex I: Bank deposits versus insurance and pension assets,OECD survey 2001 ...................................................................................19

    Annex II: Non-lie insurance and private sector credit growth ............ 20

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    Introduction to the Insurance Industryiv

    BoxesBox 1. Te global metrics o insurance markets ................................. 4

    Tablesable 1. Geographical emphasis o transnational insurers ................ 5able 2. Sequencing o classes o insurance ......................................... 6

    FiguresFigure 1. Non-lie insurance elasticity .................................................. 7Figure 2. Lie insurance elasticity versus GDP growth ...................... 8Figure 3. Minimum capital requirements or non-lie insurers

    worldwide ............................................................................................12

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    1

    Introduction to theInsurance Industry

    Rodney Lester

    The nature and history of insurance

    Insurance in its pure orm is a social good and in a number o cases can

    be classied as a public good (that is, it generates desirable externali-ties). Insurance companies, mutuals and cooperatives enable individ-uals and rms to protect themselves against inrequent but extremelosses at a cost which is small compared to the eared loss. Tey do thisthrough the workings o the law o large numbers and the central limittheorem which ensure that a suciently large number o reasonablyhomogenous risks will produce well behaved and highly predictableaggregate results ollowing a roughly Gaussian loss distribution.

    Lie insurance contracts can be or short periods (or example,

    accidental death) or very long periods (or example, whole o lie). Inconsequence lie insurance can intrinsically include a savings element,and in many late transition and industrial countries this componentdominates unds ows in the sector. Tis ow o unds eect can beexaggerated by the act that in recent decades the lie insurance sectorhas begun to compete directly with mutual unds and unit truststhrough unit linked contracts oering a lie insurance tax wrapper.Non-lie insurance contracts, which insure material and nan-cial risks, typically run or one year and are renewed on the basis o

    updated risk inormation.Given its undamental role in spreading risk it is not surprisingthat reerences to insurance can be ound in antiquity. A orm o risksharing or marine ventures known as bottomry (not unlike moderncatastrophe bonds in concept) was in existence more than two

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    Introduction to the Insurance Industry2

    millennia ago. Non-lie insurance in its modern orm (also knownas Property and Casualty or P&C, and general insurance) became

    established in Italian cities such as Genoa in the ourteenth centuryto support their active marine based trading activities, with the rstregulation appearing in 1336. Te concept spread rapidly to otherparts o Europe and eventually to the New World. Lie insurance goesback to at least Roman times when uneral societies became popular.Various orms o insurance have been banned rom time to time orreligious reasons (or example re insurance was shunned in SouthernGermany or a period because it was seen as prevented God romexercising his displeasure) and because o raudulent or morally ques-

    tionable schemes such as tontines and pyramid arrangements. Tegrowth o the sector was most rapid in the United Kingdom, largelybecause o a long-standing liberal approach to markets, and the U.K.remains the most insured country in the world However the modernapproach to the prudential regulation o the insurance sector waslargely pioneered in the United States in the nineteenth century, andin Massachusetts in particular.

    Insurance by its nature is an intangible good, involving payment inadvance or an unknowable quality o delivery in the uture. Tus trust

    is a critical element, and public good classes such as health, disabilityand work place injury or illness have to date ofen been deliveredthrough state entities. However most classes o insurance are usuallydelivered through private markets and insurance regulation tendsto reect solvency concerns and inormation asymmetry betweensuppliers and policyholders: many countries have explicit reerence toinsurance contracts in their civil codes and specialized laws includingspecic provisions or retail (B to C) markets. As scal pressuresmount there is an increasing trend to entrust more social good classes,

    such as workmans compensation and annuities, to the private sectorand this adds to the pressure or eective market conduct and pruden-tial regimes.

    Government intervention to enorce mandatory insurance (mostcommonly motor third party, workmans compensation and construc-tors all risk) aside, private insurance markets orm naturally when riskaversion ensures that individuals will pay more than the expected lossin order to hedge against the possibility o a loss that is large relative toavailable resources. Te reason that the market premium is greater than

    the expected loss is that the expenses o running the business need tobe actored in, together with the cost o the capital set aside to under-write the risks involved. ypically the market premium is not greatlyin excess o the expected loss or most common classes such as motorcollision insurance, where claims are relatively requent (around 11 to

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    Introduction to the Insurance Industry 3

    15 percent annually) and the average claim size is small, thus gener-ating statistically credible databases. However the cost o capital can

    dominate where large elements o uncertainty exist and systemic eventscan aect many risks at once, such as credit insurance and naturaldisasters coverage.

    A major industry subset, the global reinsurance sector, has largelyarisen rom its ability to modiy the requency and claims prole o adirect insurer at a price that is ecient or both parties (that is, rein-surers are insurers o insurers). For a typical mature non-lie insurerin an industrial country the net cost o reinsurance in a normal yearaccounts or approximately 8 percent o gross premium revenues.

    However reinsurers also eectively lend capital to rapidly growinginsurers (both lie and non-lie and sometimes known as surplus reliereinsurance) and the proportion reinsured can be much larger inemerging markets. Te reinsurance sector has also been the core sourceo technology transer between developed and developing markets andis the subject o Module 2 o this series.

    Given the balance sheet risks involved, the capital manage-ment o insurers bears some resemblance to that o banks. In bothcases it ideally reects a desire to set some upper limit on the prob-

    ability o ailure within a dened period o time. Hence elements suchas market, credit and operational risk are increasingly reected insolvency regimes as various countries introduce risk based supervi-sory regimes. However insurance capital determination is consider-ably more complex as both sides o the balance sheet are stochastic innature (liabilities are the present values o uncertain uture obligations)and the correlations between liability and asset risks can be much lessobvious than or banks.

    Role of government in insurance

    Government has three roles in insurance. Te rst is to ensure thatthose who are granted licenses are competent to enter the business andwill have sucient scale. Te second is to ensure that there are su-cient competitors to prevent cartels rom developing, while limitingnumbers to a level that prevents pyramid structures (known as cashow underwriting) rom emerging. Insurers are prone to pyramid

    structures because premiums are paid well in advance o claims andthe ultimate cost o claims is uncertain. Te main tools to achievethese potentially conicting objectives are minimum capital require-ments (see gure 3), licensing rules and centralized claims data collec-tion so that indicative pure premiums (that is, expected losses per unit

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    Introduction to the Insurance Industry4

    o coverage) can be published. Market premiums are pure premiumsloaded or expenses and cost o supporting capital.

    Te third role is to protect the public. Tis is not the same aspreventing insurer insolvency (Stewart Economics, Inc. 2003). In actallowing an insurer in trouble to delay insolvency (known as regulatoryorbearance) can be inimical to the public interest and involve substan-tial unexpected and unnecessary public expenditures. Tis recogni-tion has contributed to the development o risk based supervisoryapproaches, including corrective actions and enorcement based on theratio o actual capital to statutory measures o risk based capital.

    Prole of the modern insurance sector

    oday the insurance sector is a major global industry covering ahuge range o risks ranging rom natural disasters and environmentalhazard, through lie and disability and standard property risks (re,explosion, burglary, and so orth) to various types o liability undertort and civil codes to protecting the balance sheets o credit grantinginstitutions. In the latter case the sector has developed overlaps with,

    and become the backstop or signicant sections o the banking andshadow banking sectors. It is also a signicant source o investmentunds (box 1).

    In 2003 seven insurers were in the top fy corporations in theworld in terms o revenues and insurers accounted or two o the topour global nancial institutions by market capitalization. Te industryis global by nature as it is in the risk spreading business, but in prac-tice less than feen insurers can be called genuine global players

    Box 1. The global metrics of insurance markets

    Total premium revenues (2006 data):

    LifeUS$2.2 trillion o.w. developing markets US$176 million Non-lifeUS$1.7 trillion o.w. developing markets S$160 million

    Assets under management (2005 data):

    InsurersUS$17 trillion plus Standalone pension fundsUS$20 trillion plus Mutual fundsUS$18 trillion plus

    Source: Swiss Re and OECD.

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    Introduction to the Insurance Industry 5

    (and these are mostly European), with the balance having more o aregional approach or being conned to their home countries. In termso geographical involvement it is clear that colonial pasts and cultural

    aliations have played a large part in oreign investment, in addition toproximity (table 1). However other actors are also important.

    O particular note is the act that, the global success o the sectornotwithstanding, there is a massive dichotomy between developedand developing markets (see box 1). Te density o insurance (that is,premium per capita) in an industrial country like France at US$4,075is many multiples o the US$38.4 reported by a poor country like India(Swiss Re 2007). In parts o Arica the sector is eectively non existent,despite its undamental social and economic role. Te insurance devel-

    opment path is discussed in detail below but can in part be explainedby the sequencing o the introduction o the various classes o insur-ance (table 2), which in turn ollow developments in the real sector andthe establishment o property rights.

    Te major challenge or development institutions is to work tochange the traditional development patterns to support real sectordevelopment and hence generate more rapid sectorial development ina virtuous cycle.

    Development paths for the insurance sector

    Te growth o insurance markets has been dierent to that o bankingsectors, with the insurance sector being more sensitive to undamental

    Table 1. Geographical emphasis of transnational insurers (percent revenues)

    Home country

    Host region

    Europe CEE Africa LAC AsiaPacic

    WestAfrica

    United States 24.8 10.3 4.1 25.6 28.3 6.9

    United Kingdom 37.7 6.5 1.3 7.8 40.2 6.5

    France 43.4 1.5 5.9 17.1 28.4 3.7

    Germany 34.1 20.6 12.1 9.5 21.1 2.6

    Netherlands 38.1 15.5 10.4 7.8 24.9 3.2

    Switzerland 36.8 12.3 8.7 5.5 31.8 4.8

    Spain 25.0 5.5 2.8 55.6 8.3 2.8

    Italy 35.9 17.9 2.6 23.1 12.8 7.7

    Source: UNCTAD 2005.

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    Introduction to the Insurance Industry6

    real sector development, and in particular to average income levels(Annex I). Tis partly reects the act that insurers are usually notallowed to borrow or take on net oreign exchange exposures.1 Teirbalance sheet leverage (typically around 10 to 1 or lie and 5 to 1 or

    less or non-lie) is naturally generated by the need to hold reservesagainst claims incurred but not yet settled and uture obligations. Tusinsurers are more dependent on local nancial resource mobilizationand in turn on growth in domestic economic activity.

    Formal lie insurance markets normally develop well afer non-lieinsurance markets. Tis reects the ormers dependence on the emer-gence o a middle class and, ideally, the development o reasonablydeep and liquid capital markets. However culture can play a part, withlie markets appearing sooner where strong savings ethics apply, such

    as in North Asia and ormer British colonies.I non-lie premiums/capita (premium density) is graphed against

    GDP/capita it can be seen that economic growth is the main driver(gure 1), with a global elasticity between premium/capita and GDPcapita o approximately 1.3.2 However densities vary considerablybetween countries at similar stages o development.

    Te mechanisms o non-lie insurance growth have varied both overtime and according to country context. Originally most non marineinsurers started as mutual organizations set up to meet a common need

    1. Some major markets (or example, the European Union and the United States) do in actallow insurers to borrow to support solvency, but only on terms that strictly limit theinvestors capacity to redeem the relevant notes.

    2. Tat is, a 1 percent increase in GDP per capita corresponds to a 1.3 percent increase inpremium per capita.

    Table 2. Sequencing of classes of insurance (percent of written premiums by major class,2006 data)*

    Canada Croatia Senegal

    Transport 0.5 4.6 17.1

    Motor vehicle 26.0 45.8 35.6

    Liability 5.7 3.0 5.1

    Property 13.6 15.5 16.3

    Other non-life 1.4 2.0 4.9

    Life 52.8 29.1 20.9

    Source: UNCTAD 2005.* Medical and workmans compensation have been omitted as the treatment of theseclasses tends to be subject to local political economy considerations.

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    Introduction to the Insurance Industry 7

    Figure 1. Non-life insurance elasticity

    or out o natural linkages. State Farm, now one o the largest insurers in

    the world, began lie as a mutual to insure armers vehicles. Fire insur-ance was ounded in France by the water company, which organizedthe rst re brigade service. Te lie insurance industry grew out owidows unds and arrangements set up by various religious groups,and subsequently by the raternal movements (supported by industrial-ization and increasing population concentration). Many large and longestablished lie insurers in industrial countries had mutual structuresuntil relatively recently, when competition and the obvious existenceo lazy capital (and the chance or current management to utilize the

    prots created over many decades o operations) orced a move toshareholder structures.

    Te current pattern in developing markets tends to be dierent.ransport (MA), industrial and commercial non-lie lines rst appear,driven by the requirements o trading partners and oreign investors/partners and the arrival o international insurance brokers. Even themost extreme centrally planned economies require marine and trans-port insurance. In addition certain economic sectors, such as agri-culture, ofen see the early emergence o insurance mechanisms or

    consumption smoothing purposes: such classes are ofen subsidizedby the state. However the general public usually remains unexposedto insurance until motor car eets begin to build, ofen with a suddenincrease in trac related deaths and injuries, at which point compul-sory third party liability insurance is almost inevitably introduced by

    Figure 1. Non-life insurance elasticity

    8

    7

    6

    5

    4

    Lnpremiump

    ercapita

    Ln GDP per capita

    Source: Swiss Re Sigma 2000; World Bank analysis.

    3

    2

    1

    00 2 4 6 8 10 12

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    Introduction to the Insurance Industry8

    Figure 2. Life insurance elasticity versus GDP growth

    law. Because o the strong cash ows generated by this class it ofenattracts questionable entrepreneurs and the insurance sector can

    rapidly lose the publics condence. Tereafer the main driver tendsto be the development o ormal credit markets with attendant needsto cover loss o a wage earners lie or loss o collateral. Tis helps toexplain the strong link to GDP growth and an observed nexus with thedevelopment o credit markets (see Annex II).

    Lie insurance based savings develop along a somewhat dierentpath. Sales people oering hard currency contracts arrive on thescene as soon as a middle class with surplus income begins to appear.Te insurers are ofen rom other countries and the transactions

    are carried out in hotel rooms. Local lie insurers usually cannot besustained until a reasonable level o income is attained by a signi-cant number o amilies (typically corresponding to a GDP/ capita obetween US$5,000 and US$8,000 in 2007 dollars), the local regulatorysystem has been strengthened and there is at least some local currencycapital market development. Tereafer it tends to grow rapidly, witha premium density elasticity to GDP/capita growth o approximately2 times. Ofen the rst stage will involve some variant o multi levelselling (that is, using social contacts) and proessional sales channels

    ollow some time later. However banc-assurance, in one o its variousorms, is increasingly being tried at the early stages in emergingmarkets, with varying degrees o success (see discussion below). Tus,while lie insurance development is also primarily driven by GDP/

    Figure 2. Life insurance elasticity versus GDP growth

    9

    8

    7

    6

    5

    4

    Lnpremiump

    ercapita

    Ln GDP per capita

    Source: Swiss Re Sigma 2002.

    3

    2

    1

    0

    0 2 4 6 8 10 12

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    Introduction to the Insurance Industry 9

    capita, there are strong threshold eects, and other actors such asincome distribution, the role o social transers and religious mores

    can have a signicant impact3 (gure 2). Recent history also plays arole with a well known international brand being seen as a positive insome countries, particularly those o the ormer Soviet Union whichsaw savings destroyed by hyperination and other countries wherepyramid schemes have collapsed.

    Aside rom these actors the major determinant o lie insurancedevelopment is the level o involvement the sector has in managingunded pension arrangements. Tere is evidence or a substitutioneect when mandatory second pillar pensions are introduced in more

    developed countries, although orced savings in poorer countries doesappear to lead to a net increase in overall savings.

    Little work has been done on the tradeos between establishinglocal insurers and introducing oreign players, although UNCADhas encouraged the development o locally owned sectors. Te mainocial drivers o this policy stance usually involve retention o oreignexchange, creation o a competitive domestic market and local controlo long term unds. Te economic justications behind the secondand third drivers can be questioned. FDI has no apparent relation-

    ship to market size but it does appear to be related to non-lie under-writing capacity and product/distribution innovation, and oreigninsurers tend to be less driven by local bank unding needs and issueso government paper.

    Te retention o oreign exchange argument may be more sustain-able provided the mechanism adopted eciently uses local capacity.For example a more ecient use o local nancial and human resourcecapacity is sometimes achieved through mandatory reinsurancethrough a local or regional reinsurer. Such entities enable a more

    attractive and larger portolio to be oered to international risk transermarkets and, through a critical mass o technical sta, can oer adviceto small insurers.

    Most insurance markets are now opening up as the GAS negotia-tions proceed although these liberalization eorts are being imple-mented with highly varying level o skill and sometimes in the absenceo necessary institutional settings (see policy issues below). Likebanks, state controlled insurers created to provide mandatory insur-ances and to insure state owned enterprises have been misused under

    directed lending and investment programs. Even in some late transi-tion countries insurers have been required to direct unds to sociallypreerred sectors such as housing (or example, New Zealand in the

    3. akaul insurance is now showing signs o growing rapidly in Muslim communities.

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    Introduction to the Insurance Industry10

    1970s). Tis and the strong linkages that typically exist between theinsurance sector and the inuential classes in developing markets has

    been a major source o resistance to eective market liberalization insome jurisdictions.

    A new role outside the normal development path is now emergingor the insurance sector. Tis involves protecting the working poor romalling into poverty due to catastrophic idiosyncratic events such asdeath or illness o the wage earner or systemic events such as droughtand is somewhat similar to the social role played by riendly societiesand industrial insurers in the U.K. and Europe in the late nineteenth andearly twentieth centuries. It comes under the general heading o micro-

    insurance and emerged out o the micro nance industry in the latetwentieth century as a means to raise collateral against micro-lendingand to develop alternative sources o contribution to overheads. Teocial unds ow and GDP numbers likely to be generated by this sub-sector are small but the social and poverty impacts can be considerable,with more than 100 million poor people already covered and the numberincreasing rapidly. Tis series discusses micro-insurance in Module 3.

    Insurance and development

    Tere has been virtually no academic research on the economicrole o insurance: risk considerations appear to be absent rom mosteconomics courses. However a body o research, largely supportedby the World Bank and UNCAD, is now emerging that demon-strates growth related causalities rom insurance sector development toeconomic development. Tese appear to apply or non-lie insuranceat all stages o development (no country can trade without insurance)

    and or lie insurance at the later stages o development (Arena 2006).Anecdotal evidence would point to the process as being iterative.

    Research has shown the central role o insurance in supportingcredit creation (Annex II) and trade nance, and the development oequity and long term debt markets (Impavido 2003). Recent nancialcrises have also pointed to the unreliability o bank lending (particu-larly cross border lending) under stress and the importance o devel-oping more reliable long term sources o unding. Finally it is nowbecoming clear that risk markets can play a key role in protecting

    developing countries rom scal and liquidity stresses ollowing majornatural catastrophes.Tere are very ew examples o insurance sector ailure adversely

    systemically aecting the economy. In most cases where this hasoccurred it has arisen rom links with the banking sector: the Jamaican

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    Introduction to the Insurance Industry 11

    meltdown in the late 1990s is perhaps the best known example. Onlyone recent case o a direct impact on the economy is known. Tis was

    the HIH collapse in Australia, which threatened to bring the construc-tion industry to a halt because o lack o required insurance coverage.However this was rectied quickly. Similarly only one recent case o asignicant liquidity sourced insurer ailure is known. Tis was Coned-eration Lie in Canada, which was siphoning its liquid assets to leasingand property subsidiaries. Most insurers ail because o insolvency,although reduced cash signicant ows are ofen a sign that problemsare brewing or non-lie insurers.

    Microinsurance or the poor and inormal sectors is still at an early

    stage o development but has considerable potential, both in the creditrelated sense through MFIs and or social saety net purposes throughmutuals and community based organizations.

    Policy issues in insurance market development

    Industrial structure and minimum capital

    A rough rule o thumb is that the minimum sample size (in terms onumber o claims) to develop a pure premium or a given rating cell(that is, a collective satisying a given set o risk characteristics such amotor vehicle power, age o driver, and so orth) is 1,000. Assuminga claims requency o 10 percent this means one rating cell needs10,000 policyholders. Tus many insurers in developing, transitionand industrial countries are too small to be statistically ecient. Teyare able to operate because reinsurance is able to remove the poten-tial extreme results o their risk portolios. Essentially these small

    insurers are ronts or international reinsurers and the Europeanreinsurers in particular have a long history o providing technicalsupport to set up such entities. Operating scale and scope can alsobe important but studies carried out to date indicate that there is anoptimum level beyond which complexity and loss o local knowledgebegin to reduce eciency.

    From a supervisory point o view a large number o insurers isundesirable given the limited resources typically allocated by govern-ments to the non bank sectors and the possibility o excess competition

    arising rom a breakdown in signaling mechanisms. Tis is relevant tothe insurance sector because o the opacity o pricing and a consequentinherent tendency towards pyramidal structures.

    Several signicant jurisdictions (Nigeria and Russia are two recentexamples) have increased minimum required capital to orce consoli-

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    Introduction to the Insurance Industry12

    Figure 3. Minimum capital requirements for non-life insurers worldwide

    dation o overly ragmented insurance sectors and to help develop localchampions. Some major countries opening up to oreign players (or

    example, China and India) have set very high initial capital require-ments to lter out all but the major global insurers and to supportheavy initial capital needs (gure 3). It is now almost universallyrequired that lie and non-lie insurance be written through separatelylicensed companies and as a rule the minimum capital requirementsare greater or lie insurers (and or reinsurers).

    Financial insurance

    Financial insurance includes such lines as mortgage lenders insur-ance, which typically covers deault risk on higher levels o LV ratios(particularly i secondary mortgage markets have ormed), debentureguarantee insurance (which supports debenture credit ratings), projectnance insurance (covering large long term projects dependent onsupplier or end user nancing), retail consumer credit insurance andduciary insurance (which covers the dishonest behavior o companyocers handling nancial transactions and is known as bankers

    blanket bonds or banks). It can be argued that, like reinsurers, creditinsurers are centers o specialized underwriting and risk managementexpertise, able to support a wider range o originators. However italso needs to be recognized that credit related risks have parallels withcatastrophe reinsurance as the law o large numbers tends to be irrel-

    Figure 3. Minimum capital requirements for non-life insurers worldwide

    25

    20

    15

    US$millions

    Source: AXCO, 2005 data.

    10

    5

    0

    ArgentinaBrazil Chile

    Mexico

    Austria

    Panama

    DenmarkFrance

    BelgiumSpainUnited Kingdom

    NigeriaKenya

    GhanaCameroon

    Cambodia Thailand

    Indonesia

    India

    United States

    Sri Lanka Bangladesh

    Pakistan

    RussiaUkraine

    Georgia

    Belarus Poland

    AustraliaCanada

    Czech Republic

    Hungary

    The Philippines

    Vietnam

    Japan

    Korea

    South AfricaColombia

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    Introduction to the Insurance Industry 13

    evant within a given jurisdiction when such insurance is really needed(that is, arising rom some combination o systemic events such as high

    interest rates and high unemployment). In industrial and some transi-tion countries credit risks typically have to be written through special-ized insurers called monolines with heavy capitalizations reectingthe 400 to 600 percent loss ratios that they can experience every decadeor so. Where countries already have nancial insurers or are contem-plating them the normal advice is to have a separate specialized sectiono the law, to require that they are segregated rom other lines o busi-ness (preerably in a separate licensed entity) and are appropriatelycapitalized with adequate reinsurance. Aside rom the highly dieren-

    tiated capital needs the argument or segregating monolines revolvesaround their unique natureeectively a limitless downside and anupside constrained by competition and regulation and, possibly, a tightlinkage to the rating o capital market instruments. In these situations aclean structure able to raise capital quickly and be assessed by the creditrating agencies in a way that is meaningul or investors is essential.

    Liberalization

    Tere is strong pressure on transition countries to open up their localinsurance sectors to international competition, even i this only meansthe ability to establish a local subsidiary or joint venture. Tis pressurecomes rom various sources, although the WO (GAS) negotiationstend to be the most common actor mentioned. A number o countrieshave agreed to open up their insurance sectors, sometimes as a trade oor enhanced physical goods access to developed markets or to deectattention rom the banking sector. Unortunately because the insurance

    sector is small the liberalization is ofen hurried and poorly thoughtthrough, with oreign insurers cherry picking the middle class (i thereis one) and little or no technology transer occurring. Critical stepsrequired beore an insurance market is opened up include strength-ening the regulatory regime and raising the capacity o the supervi-sory entity, developing necessary local skills and standards (accounting,auditing actuarial) and privatizing, or at least corporatizing any govern-ment owned or controlled insurers. It may also be necessary to rst putmandatory insurance classes such as motor third party liability onto a

    sound nancial and operational basis.

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    Introduction to the Insurance Industry14

    Financial supervisor cooperation or integration

    While it is tempting to apply a one size ts all approach to supervi-sory coordination, experience to date shows that every country isdierent and a degree o caution is needed beore making any substan-tive recommendations. In smaller countries there has ofen been abias towards moving all nancial sector supervision under the centralbankand where this has happened results have generally beenencouraging. However central banks ofen decline the opportunity andat this point it is better not to be specic about options. While the needor greater coordination should naturally emerge rom any reasonably

    thorough assessment using some or all o the IAIS ICPs the saest routeis to orm a joint working group to look at needs and options and tothen develop a detailed planpossibly with technical support.

    Catastrophe risk

    Many developing and transition countries are subject to severe naturalcatastrophe risk. However the poor development o local insurance

    markets can limit opportunities to transer risk because o limited oreven negligible penetration into the household and SME sectors. Inaddition there is a certain size o direct insurer below which interna-tional insurers cannot justiy any support or transaction cost reasons.A number o structures and products have been developed by theWorld Bank and other development organizations to ll this lacuna.

    Accounting and information systems

    Insurance accounting needs to be on an accrual basis o meaningulinormation is to be generated. Tis means that the unearned portiono premiums as at the accounting date need to be reserved togetherwith the present value o uture claims obligations. Tis latter amountcan be simply an addition o claims outstanding in claims les, witha mechanistic adjustment or claims incurred but not reported, orvery complex calculations based on models in the case o long termlie insurance and classes o non-lie insurance where claims take a

    long time to stabilize and settle (such as or example a quadriplegiaworkmans compensation claim). Revenues need to reect changes inunearned premiums, and claims costs changes in claims reserves andprovisions. A module on insurance accrual accounting appears later inthis series.

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    Introduction to the Insurance Industry 15

    Historically the reserving process has been controlled by actuaries,who tend to build in substantial saety margins. In addition assets were

    held at the lower o book or market, building in urther saety margins.However accounting doctrine now requires that reported prots are agood representation o reality and that surplus distribution to policy-holders and owners is equitable over time. Tis has led to a require-ment that assets are held at air value (that is, market or listed assets)under international accounting standards. Te valuation o liabilitiesis also conceptually to be at air value but as no eective market ininsurance liabilities exists the meaning o this concept remains unclear.Te core insurance accounting standard (IFRS4 Insurance contracts)

    is currently in an hal way house and its nal version will probablyremain unresolved until 2012 at earliest. In the interim Solvency II, theEU approach to prudential controls o the insurance sector, will requirethat reserves and provisions have some resilience but that most o thebalance sheet risk is carried by capital.

    Insurance inormation systems are critical or both generalaccounting and statutory reporting purposes, and or eectivemanagement o insurers (and pricing in particular). In recent decadesthere has been a move towards relational databases so that analysis o

    emerging experience can be carried out along a number o vectors.Te use o increasingly sophisticated analytical techniques such asgeneralized linear models has also put increasing pressure on datagranularity and accessibility. Countering this has been a dependenceon legacy systems, particularly by lie (long-term) insurers that havesold a wide range o product types over the years. Te role o legacysystems has been a constraint on rationalization o lie insurancesectors, although some acquirers simply put the relevant business intorun o. Run o has in act become a protable business in some juris-

    dictions with supporting legislation.Many IS rms now oer insurance systems and this has become less

    o a competitive actor over time.

    Insurance taxation

    Insurance companies can conceptually be taxed on the same basis asany other commercial enterprise. Tat is on declared prots and at

    the corporate tax rate. For non-lie insurance this is in act the normalapproach, although a number o countries will only allow or case esti-mates in setting claims provisions, rather than also allowing or incurredbut not reported claims. Tis reects a desire to be able to audit the taxaccounts and to minimize scope or creative tax accounting.

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    Introduction to the Insurance Industry16

    For lie insurance the position is much more complex as reservingoers substantial scope or creativity and there is the additional compli-

    cation o how the policyholders equity in emerging surplus (prots)should be allocated and taxed. As a rule o thumb policyholders are enti-tled to participate in surplus receive 90 percent o the prots emergingrom the business lines they are supporting. It is not uncommon ortaxation regimes in developing markets to tax investment income lessthe expenses incurred in generating that income (called the I-E method)rather than the declared surplus. Te investment income arising rompension related business may be exempted rom tax. Tis approach hasthe advantage o being relatively objective but can result in an unprot-

    able insurer being taxed and urther weakened.

    Distribution and intermediaries

    Insurance intermediation comes under a range o headings:

    ied agents, who normally represent only one insurer or eachclass o insurance.

    General agents, which may have agency arrangements with anumber o insurers or a given class, and which employ subagents. Tis category is banned in many countries because o theconusion it can cause or consumers.

    Brokers, who represent the insured and who can deal with anyinsurer. Brokers can accept commission rom the insurer in mostcountries and ideally they should be required to disclose this totheir client.

    Insurers own sta selling rom the insurers own premises.

    Bancassurance, where a bank either acts directly or an insurer orprovides space or an insurers representative in its retail outlets.Tis channel has become very successul in such countries asFrance and Italy and is being implemented in many countriesaround the world as high initial costs can be oset by lowerdistribution costs in the long run.

    Call centers have had mixed success but can be very eectiveor highly specialized markets and when linked with radio andinternet advertising. Like bancassurance initial costs can be very

    high. Other businesses where insurance is ancillary to a main business,

    such as travel agents.

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    Introduction to the Insurance Industry 17

    For non-lie insurers distribution and marketing costs typicallyrange between 10 and 40 percent, depending on the power o the inter-

    mediary networks and the class o business. Mandatory lines typicallyhave a cap placed on commission levels, although this has proved to bedicult to enorce in some countries.

    For lie insurance, marketing and distribution is typically 70percent o the total annual costs. For agency based systems the costs oputting a new policy on the books is typically more than the premiumsreceived in the rst year (the so called new business strain) and isrecovered rom subsequent years premia.

    In most transition and industrial countries insurance agents need to

    be at least registered and there is an increasing trend to require a levelo training commensurate with the complexity o the product beingsold. Te European Union now has a directive covering insuranceintermediaries. Tis topic is covered in greater detail in a later module.

    References

    Arena, Marco. 2006. Does Insurance Market Activity Promote

    Economic Growth? World Bank Policy Research WorkingPaper, No. 4098, World Bank, Washington. D.C.

    Brainard, Lael. 2008. What is the role o insurance in economic devel-opment? Zurich: Zurich Insurance Group.

    Impavido, Gregorio, Alberto R. Musalem, and Tierry ressel. 2003.Te Impact o Contractual Savings Institutions. World BankPolicy Research Working Paper, No. 2948, World Bank, Wash-

    ington. D.C.

    Liedtke, Patrick M. 2007. Whats Insurance to a Modern Economy?Te Geneva Papers on Risk and Insurance Issues and Practice 32(2): 211-221.

    OECD (Organisation or Economic Co-operation and Development).2003. Institutional InvestorsStatistical Yearbook, 19922001.Paris: OECD.

    Stewart Economics, Inc. 2003.Managing Insurery Insolvency2003Updating the 1988 Report. Washington, D.C.: NationalAssociation o Insurance Brokers.

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    Introduction to the Insurance Industry18

    Swiss Re. 2007. Sigma No 4/2007.

    UNCAD (United Nations Conerence on rade and Development).2005. rade and Development Aspects of Insurance Servicesand Regulatory Frameworks: UNCAD/DIC/NCD/2005/7.Geneva: UNCAD.

    Webb, Ian. 2006.Assessment on how strengthening the insuranceindustry in developing countries contributes to economic growth.Washington, D.C.: USAID.

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    Introduction to the Insurance Industry 19

    Annex I:

    Bank deposits versus insurance andpension assets, OECD survey 2001

    6

    5

    4

    3

    Lnquantuma

    spercentofGDP

    Ln GDP per capita

    2

    1

    0

    0 0.5 1.0 1.5 2.52.0 3.0 3.5 4.0

    Institutional investors

    Bank deposits

    Source: OECD 2003.

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    Introduction to the Insurance Industry20

    Annex II:

    Non-life insurance andprivate sector credit growth

    5

    4

    3

    Non-lifepremiuma

    sapercentage

    ofGDP

    Domestic credit to the private sector as percentage of GDP

    2

    1

    0

    0 50 100 150

    Source: Webb 2006 (data). Authors calculations.Note: Yearly date for 59 countries from 1960 to 2000.


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