Fall 2008 Version

1. Fall 2008 Version Professor Dan C. Jones FINA 4355

2. Risk Management and Insurance: Perspectives in a Global Economy20. The Nature and Importance of Insurance Professor Dan C. Jones FINA 4355

3. 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

4. The Insurance Production Process

5. The Production Process (Figure 20.1)

6. 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 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.

7. 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 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.

8. Underwriting • Two key functions • Selection (or rejection) of application • Classification of accepted risks • It requires knowledge of local conditions and the local environment.

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

10. 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. • 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

11. Distribution • 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.

12. 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.

13. Investment Management • 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.

14. Overview of Insurance Worldwide

15. Top 10 Global Insurers in 2007 (by revenue)

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

17. Top 10 Global Life Insurers in 2007 (by revenue)

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

19. Top 10 Global Nonlife Insurers in 2007 (by revenue)

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

21. Top 10 Global Reinsurers in 2006 (by net premiums)

22. World’s Largest Intermediaries (2007) (new)

23. 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)

24. 2007 World Insurance Swiss Re Sigma (2008)

25. Real Premium Growth (Total)

26. Real Premium Growth (Life)

27. Real Premium Growth (Nonlife)

28. Premium Growth vs. GDP Growth (Total)

29. Premium Growth vs. GDP Growth (Emerging Markets)

30. Insurance Density and Penetration • Insurance density • The average annual per capita premium within a country • Insurance penetration • The ratio of yearly direct premiums written to GDP

31. Insurance Density (2005) (Figure 20.5)

32. Insurance Penetration (2005) (Figure 20.5)

33. Premium per Capita and Penetration (US$) (2007)

34. Premium per Capita and Penetration (Emerging Markets)

35. Premium by Region/Organization (Total)

36. Premium by Region/Organization (Life)

37. Premium by Region/Organization (Nonlife)

38. World’s 10 Largest Markets (2005) (Figure 20.2)

39. World’s 10 Largest Markets (2007) (new)

40. Insurance Supply

41. 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

42. Establishment of Insurance Trade • Agency • Branch • Subsidiary • Representative office

43. Market-share of Foreign-owned Insurers (Table 20.2)

44. The Role of Insurance in Economic Growth

45. 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.

46. 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 • Private property rights, however, are restrictive by their nature. • Without some restraints, their complete exercise could actually interfere with the efficient functioning of markets.

47. Financial Development and Economic Growth • 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.

48. Benefits of Insurance in Economic Growth • Promote financial stability • Substitutes for and complements government security programs • Facilitates trade and commerce

49. 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

50. 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