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Fall 2008 Version Professor Dan C. Jones FINA 4355 Risk Management and Insurance: Perspectives in a Global Economy 20. The Nature and Importance of Insurance Professor Dan C. Jones FINA 4355 Study Points The insurance production process Overview of insurance worldwide

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Fall 2008 version l.jpg

Fall 2008 Version

Professor Dan C. Jones

FINA 4355


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Risk Management and Insurance: Perspectives in a Global Economy20. The Nature and Importance of Insurance

Professor Dan C. Jones

FINA 4355


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Study Points Economy

  • 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 Production Process Economy(Figure 20.1)


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The Role of Capital and Surplus Economy

  • 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 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 Economy

  • 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 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 Economy

  • Two key functions

    • Selection (or rejection) of application

    • Classification of accepted risks

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


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Claims Settlement Economy

  • 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.

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


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Claims Settlement Economy

  • Claims personnel, sometimes with the assistance of an actuary, estimate amounts to be established as balance sheet liabilities (reserves) for unpaid nonlife claims.

    • Also known as policy reserves, mathematical reserves or 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 Economy

  • Direct response system

  • Distribution through agents

    • Captive (exclusive, tied) agents

    • Independent agents

  • Distribution through brokers

  • Distribution through other financial institutions  Chapter 25

  • Countrywide variations exist.


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Investment Management Economy

  • 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 Economy

  • Foreign investments can 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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Top 10 Global Reinsurers in 2006 Economy(by net premiums)



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Nature of Insurance Companies Economy

  • 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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2007 World Insurance Economy

Swiss Re Sigma (2008)






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Premium Growth vs. GDP Growth Economy(Emerging Markets)


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Insurance Density and Penetration Economy

  • Insurance density

    • The average annual per capita premium within a country

  • Insurance penetration

    • The ratio of yearly direct premiums written to GDP


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Insurance Density (2005) Economy(Figure 20.5)


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Insurance Penetration (2005) Economy(Figure 20.5)



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Premium per Capita and Penetration Economy(Emerging Markets)








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Cross-border Insurance Trade Economy

  • 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


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Establishment of Insurance Trade Economy

  • Agency

  • Branch

  • Subsidiary

  • Representative office




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Property Rights and Economic Development Economy

  • 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 Economy

  • Any action that diminishes the value of one’s ownership interest in private property hinders private financial services development.

    • Failure to control inflation

  • 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 Economy

  • Insurance firms 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.

    • Nonlife insurance, life insurance and banking are all shown to be important predictors of economic productivity.

    • Evidence exists of synergies among financial intermediaries.

    • Thus, 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 Economy

  • Promote financial stability

  • Substitutes for and complements government security programs

  • Facilitates trade and commerce


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Benefits of Insurance in Economic Growth Economy

  • 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 Economy

  • 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 Economy

  • 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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Price and Income Elasticity Economy(Table 20.3)


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Economic Factors Economy

  • Income

  • Inflation



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Demographic Factors Economy

  • Aging populations

  • Education

  • Household structure

  • Industrialization and urbanization


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Social Factors Economy

  • Cultural perceptions of the role of insurance products can vary substantially.

    • Asia – life insurance as a savings instrument

    • Muslim society and insurance

See also Chapter 11.


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Political and Legal Factors Economy

  • 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 Economy

  • 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 Question 1 Economy

  • 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 Economy

  • 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 Economy

  • 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 Economy

  • 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?


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