2. 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 2 3. The Insurance Production Process 4. The Production Process (Figure 20.1) 4 5. The Role of Capital and Surplus Insurance policies are contingent claim contracts that rely on pricing Inversion.The product is priced before actual productioncosts are known.Insurers must provide a margin for unfavorablepricing deviations. The greater an insurers 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.5 6. 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 premiumreceipt and loss payout, the greater the influenceof investment returns in setting premium rates.(life vs. non-life) (experience rating v. exposurerating & model) Product innovation and price competitiveness are often understandably crucial determinants of success, especially for new entrants.6 7. Underwriting Two key functions: Selection (or rejection) of application Classification of accepted risksQ: adverse selection The underwriter must assemble information about the applicant and the subject of insurance in order to assess the loss potential. (complex case) It requires knowledge of local conditions and the local environment. 7 8. 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. (e.g., insurance fraud, veteran hospital) In lines of insurance where losses require on-site examination (e.g., property insurance), some type of local presence is typically necessary. 8 9. 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. 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.9 10. DistributionDirect response systemCompanies distribute products without the use ofintermediary.Distribution through agents (authority granted)Captive (exclusive, tied) agentsIndependent agentsDistribution through brokersA 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 10 11. 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.11 12. Investment Management Foreign investments can exacerbate the buyers (and the regulators) problem of information asymmetry.National regulation typically placessevere limits on foreign investmentsby domestic insurers.12 13. Investment Management A related but different concern arises with cross-border insurance trade.If a foreign insurer in cross-border businessfails to meet its obligations, the host-countryinsureds could be at a legal, not to mentiona practical, disadvantage.The resolution of this issue is essential ifcross-border insurance is to grow.Asset management, ALM, RM, DFA2nd significant function of insurers13 14. Overview of Insurance Worldwide 15. Worlds Largest Life Insurers (2005) (Table 20.1) 15 16. Worlds Largest Nonlife Insurers (2005) (Table 20.1) 16 17. Worlds Largest Reinsurers (2005) (Table 20.1)17 18. Nature of Insurance Companies Ownership structureStock insurersMutual insurers Assessment mutuals (e.g., Protection and Indemnity clubs) Non-assessment mutuals Licensing statusAdmitted vs. non-admitted insurersComposite insurers Place of domicileDomestic vs. foreign insurer (alien insurer in the U.S.)Home vs. host country18 19. Share of Insurance Premiums (2005) (Figure 20.2) Latin America North AmericaOceania WorldEuropeAfrica Asia 0%20% 40% 60%80% 100% Source: Swiss Re (2006) Life Nonlife19 20. Distribution of Insurance Premiums (2005) (Figure 20.3)Source: Swiss Re (2006)20 21. Worlds 10 Largest Markets (2005) (Figure 20.4) Source: Swiss Re (2006) 21 22. Insurance Density and Penetration Insurance densityThe average annual per capita premium within a country.Values are usually converted from national currency to USdollars currency fluctuations affect comparisons. Insurance penetrationThe ratio of yearly direct premiums written to GDP.It shows roughly the relative importance of insurancewithin national economies unaffected by currencyfluctuations.22 23. Insurance Density (2005) (Figure 20.5)Source: Swiss Re (2006)23 24. Insurance Penetration (2005) (Figure 20.6) Source: Swiss Re (2006) 24 25. Insurance Supply 26. Cross-border Insurance Trade Pure cross-border insurance trade When the resultant insurance contract is entered into because of solicitations. Own-initiative cross-border insurance trade Many 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. 26 27. Cross-border Insurance TradeDifference-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 brokers such trades are prohibit except through specialty domestic E&S brokers. 27 28. 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-countryinsurers. SubsidiaryThe local subsidiary of a foreign insurer is a domesticcorporation. Representative office (532 in China)market research, interest promotionNo risk bearing, no insurance selling 28 29. Market-share of Foreign-owned Insurers (Table 20.2)Source: Swiss Re (2004) 29 30. The Role of Insurance inEconomic Growth 31. 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. (legal environment and infrastructure) Ex. Shin Kongs joint venture in Beijing. 31 32. Property Rights and Economic Development Any action that diminishes the value of ones ownership 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.32 33. 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 other financial intermediaries. Financial services generally and insurance in particular are of primordial importance to economic development. 33 34. Financial Development and Economic Growth Financial services offer the possibility of providing such externalities, thereby enhancing economic growth.Non-life insurance, life insurance andbanking are all shown to be importantpredictors of economic productivity.Thus, the more developed and efficient acountrys financial market, the greater willbe its contribution to economic prosperity.34 35. Benefits of Insurance in Economic Growth Promote financial stability By 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.35 36. Benefits of Insurance in Economic Growth Substitutes for and complements government 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 planQ&A: surname of insurance?36 37. Benefits of Insurance in Economic Growth Facilitates trade and commerce Many products and services are produced and sold only if adequate liability insurance is available to cover any claims for negligence. Ex. PL and Malpractice Innovation Credit enhancement37 38. Benefits of Insurance in Economic Growth Helps mobilize savingsInsurance and financial intermediationInsurance enhance financial systemefficiency in three ways Reduce transaction costs associated with bringing together savers and borrowers Create liquidity Facilitate economies of scale in investment 38 39. Benefits of Insurance in Economic GrowthFinancial intermediaries vs. financialmarkets The more developed a countrys financial system, the greater the reliance on markets and the less the reliance on intermediaries.Insurers vs. other financial intermediaries Commercial banks short-term deposits Contractual saving institutions long-term view 39 40. Benefits of Insurance in Economic Growth Enables risk to be managed more efficientlyRisk pricing greater the expected loss,higher the price (u/w and investment)Risk transformation risk exposures can betransferred to an insurer for a priceRisk pooling and reduction (1) insurers make reasonably accurateestimates as to the pools overall losses. (2) insurers diversify their portfolios. 40 41. Benefits of Insurance in Economic Growth Encourages loss mitigationIf pricing is tied to loss experience, insuredshave economic incentives to control losses.Ex. experience rating, no claim bonus Fosters a more efficient capital allocationInsurers will monitor the companies to reducerisk-increasing behavior and act in the bestinterests of their various stakeholders.A watch-dog role. 41 42. 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 causespremiums to be higher than they would be otherwise,represents a deadweight loss to society, can lead todisruptions in otherwise well-functioning markets, andtruly is a societal cost of insurance. 42 43. Determinants of Insurance Market Structure 44. Economic Factors IncomeThe higher an economys income, the more itspends 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. InflationConsidered as detrimental to life insurancesupply and demand. 44 45. Insurance and Economic Development (Figure 20.7)45 46. Demographic Factors Aging populations A greater demand for savings-based life insurance products, long-term care insurance. e.g. longevity risk Education The more educated population, the greater the likelihood of understanding the need for insurance. Household structure Life insurance demand increase as the number of young children in the house hold increases. Industrialization and urbanization The positive between Industrialization and urbanization and insurance consumption. e.g. new urban risks46 47. Social FactorsCultural perceptions of the role ofinsurance products can vary substantially. Asia life insurance as a savings instrument Muslim society -- insurance as inappropriate because of religious belief. Korea impolite to say no in some circumstances. 47 48. Political and Legal FactorsImprovements in a countrys political environmentenhance insurance demand.Governments make decisions that directly affectinsurance demand and supply.Insurance product within the regulatory jurisdictionthrough a policy review and approval process.Tax laws and the premium approval process greatlyinfluence product design, availability and value.An improvement in legal systems had a significant andpositive affect on life insurance demand. 48 49. Globalization The continuing globalization of financial services adds 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 and marketing innovations, and different ways of managing companies.More competitionMore consumptionProduct and marketing innovationNew management styleGreater consumer choice and value 49 50. Discussion Questions 51. 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?51 52. 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. 52 53. Discussion Question 3 With a life cycle hypothesis, 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 insurercontemplating expansion into other markets?Of what benefit might this hypothesis be to a governmentthinking about how to encourage personal saving forretirement? 53 54. 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?54
