Introduction to international risk and insurance Tapen Sinha, ITAM Why international? Definition of international risk Management of international risk

Introduction to international risk and insurance

Tapen Sinha, ITAM

• Why international?

• Definition of international risk

• Management of international risk

• Multinational enterprises

• Insurance classification

• Country classification

• Economic development and insurance

Importance of internationality

• Coca-Cola is the most recognized brand name in the world

• AIG operates in 173 countries (started in China! Operates in Bulgaria!)

• growth in international trade has been double that of the growth in world GDP

• foreign direct investment has grown twice the rate of international trade

Why does foreign ownership matter at all?

• only domestic: less competition/monopoly

• pricing is less competitive

• global: more competition hence pricing is of strategic importance

• future: internet sales of insurance products

• Does it matter where you are located?

• international competition forces domestic companies to price products better

Major factors• insurance companies are local (they have

local distribution channels)

• insurance companies are global (they may have foreign owners): reinsurance

• government (sets tax rates, approve policy forms also perhaps rates)

• local investment climate (most investment require domestic laws)

• other local institutions (banks)

What is international risk and insurance?

Two characteristics of international risk and international insurance– unintended outcome– insurance transactions that transcend national

boundaries

Examples– Tokio MFI sells a policy to AG (Germany)– typhoon causing property damage in several

countries

Defining and managing risk

• insurance: to cause loss/chance of loss

• economics: relative variation of actual from expected outcome

• risk management:– identifying and evaluating possible outcomes– exploring techniques for dealing with them– implementing a plan– dynamically evaluating plans

MNE MNC TNC

• multinational enterprise/multinational corporation/transnational corporation same

• 38,000 MNE

• 250,000 affiliates

• 90% based in market based developed countries

• 50% affiliates in developing countries

Types of insurance

• social versus private– government provides some types of insurance

retirement benefits (IMSSS in Mexico)– unemployment benefits (UI in US/UK)– government sometimes provides straight

insurance as well (France)

Types of insurance

• life – death benefits (usually called life insurance)– living a certain period (endowment/annuity)– disability (disability insurance)– injury or incurring diseases (health insurance)

• property casualty/general (UK)– property (damage to home/business etc.)– liability (negligence: product/professional)– worker’s compensation payments

Types of insurance

• Commercial versus personal lines– personal lines are purchased by individuals

such as homeowners insurance, automobile insurance, etc. (in Europe, they are called mass risks)

– non-life insurance purchase by businesses such as product liability, business interruption, automobile fleets, etc. (also called large risks in Europe)

Types of insurance

• Direct versus reinsuranceInsurance sold to the public and non-insurance

commercial organizations are called direct insurance and they are called direct writing insurers (premiums are called direct written premiums)

Insurance bought by direct writing insurers are classed as reinsurance and is sold by reinsurers

Reinsurers purchase reinsurance-retrocede

Country Classification

Two major categories of classifications• United Nations (UN)• International Monetary Fund (IMF)

These approaches are not consistent with one another

• Alternative– by membership of intergovernmental organizations– by stage of economic development

Intergovernmental organizations

• European Union (EU-was called EC)Austria, Belgium, Denmark, Finland, France,

Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, UK

• European Free Trade Association (EFTA)Iceland, Liechtenstein, Norway, Switzerland

• NAFTA

• OECD: 26 members


• Members of OECDAustria, Belgium, Denmark, Finland, France,

Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, UK,

Iceland, Norway, Switzerland

Canada, Mexico, US

Australia, Czech Republic, Korea, Japan, New Zealand, Turkey

Latest: Mexico, Czech Rep., Korea


• G7: US, Japan, Germany, France, Italy, UK and Canada

• G10

• ASEAN: Brunei, Indonesia, Malaysia, The Philippines, Singapore, Thailand, Vietnam

• MERCOSUR: Argentina, Brazil, Paraguay, Uruguay

• Arab League/CARICOM

Stage of Economic Development

• Developed market-economy countries (also called north/advanced/first-world/industrialized countries)

• Economies in transition (Eastern Europe)

• Developing countries (include least developed to Newly Industrialized Economies (NIEs)) also called LDC/south/third world/developing countries

Worldwide insurance market

• Largest markets are US (31%), Japan (30%), EU (23%) and others

• Another measure: insurance density– average per capita premium within a country– two measures: absolute (dollar) value or

measured relative to GDP (which is better?)– high penetration is correlated with high saving

countries

International Environment

• Economic/financial environment

• Political/legal environment

• Regulatory/tax environment

• Demographic and social environment

• Physical and technological environment

Financial development and economic growth

Importance of capital accumulation in economic growth– capital accumulation needs domestic saving and/or

foreign investment

– efficient use of capital is possible by financial development-it also reduces the risk for foreign investor

– Levine shows positive association between various measures of financial developments and economic growth for many countries

Why does insurance help in economic development?

• promoting financial stability– uninsured losses cause business failure– uninsured persons become a burden on the

social system (government or family)– uninsured business/person suffering loss has a

negative impact on government tax revenue thereby reducing benefits to others

– provides “sleep insurance” reducing uncertainty


• insurance (especially life) can substitute government sponsored programs– OECD recognizes this and provides tax relief

for insurance premium (ITAM study)– Swiss Re study showed that there is a negative

relationship between social expenditure and life insurance premium in OECD countries


• Facilitates trade and commerce– modern trade depends on insurance– by law: flying commercial airplanes is illegal

without proper insurance– banks and other creditors insist that collateral be

insured or else they will not loan money or that insurer purchase life insurance

– without liability cover products will not be sold, freight will not be carried etc.


• mobilizes saving– fact: countries that save (invest) more tend to

grow faster in the long run (but causality is not clear)

– insurance (especially life) offers channeling of savings

– financial intermediaries help de-couple saving from investment (i.e., saving and investment need not take place in the same sector)


• Insurers enhance efficiency of financial system in three ways– reduced transactions costs: insurance premia

from many insureds can be invested where necessary

– liquidity creation: insurer “borrows” short term and “lends” long term

– economy of scale: small policies can fund large projects


• Is insurance company any better than any other financial intermediary?– compare them with banks: banks are more

likely to invest short term in a developing market than in the long term (why?)

– insurance companies (and pension funds) are in the business of investment in the longer run


• enables risk to be managed more efficiently

• how?

• risk pricing: insurer prices risk at two levels– insurers quantify the consequences of their risk

causing and risk reducing activities-hence create better pricing

– insurers only insure creditworthy insured, hence sends a signal to business owners, potential investors, customers, creditors, employees and other stakeholders


• risk transformation– insurance permits transformation of risk

exposure to suit their own needs better– property, liability, income loss risk exposures

can be transferred to insurer thus reducing the variability of cash flows (in that process, it can bring in adverse selection and moral hazard problems that may cause insurance company to lose money)


• risk pooling and reduction– law of large numbers permit insurance– both insurer and insured gain from it

• More efficient capital allocation– individual savers/investors cannot gather all the

information about riskiness– insurers monitor the firms for their own interest– signals potential investors about riskiness

A digression

• Fact: In many (developing) countries, foreign firms are allowed to operate in some sectors but not in others and especially in insurance sectors, they are prohibited (example: recent liberalization in India but not in insurance)Why?

• Many objections are raised for the following reasons (most of them make very little economic sense)

Common objections policy makers raise in against foreign insurance companies

– First, foreign insurers might dominate the domestic market and thereby precipitate adverse microeconomic (less consumer choice and value) or macroeconomic (failure to contribute adequately to economic development) effects.


– If a market offers great potential and if domestic insurers are inadequate and unsophisticated, market liberalization could lead to foreign domination.

– In such a case, however, no rational basis exists to support a parallel belief that the nation's consumers and businesses will suffer harm or that the national economy will be harmed.


– On the contrary, that the market offered great potential, was unsophisticated, and had an inadequate capacity suggests that the status quo was stifling microeconomic and macroeconomic improvements.

– Only if the foreign company is allowed to run a monopoly, there is a problem

– Such monopolies can be granted by government in exchange for monetary favor


– Second, foreign insurers might market insurance selectively, thereby leading to adverse microeconomic or macroeconomic effects.

– This selectivity may be because of concern that foreign insurers will market insurance only to the most profitable segments, only to multinational corporations or only to the commercial sector ignoring the retail market.


– Governmental efforts to discourage selective marketing can be harmful.

– Specialization and market segmentation lead to efficiency improvements.

– It is true that segmentation could cause some market segments to be under served.


– If it does and if these under served segments are judged critical, government policymakers would be wise first to examine whether repressive regulation (such as price suppression) was at fault.

– If not, insurers can be enticed into neglected segments through less distorting subsidies or other positive means.

– example: airline license is usually bundled


– Third, foreign insurers might fail to make lasting contributions to the local economy

– This is the common objection to any foreign involvement in industry or services

– The fact remains that whenever given a choice most foreign companies have decided to stay in the country

– Fourth, domestic market is already well-served by locally owned insurers or through reinsurance.


– Fifth, national industry should remain locally owned for strategic reasons, such as national security concerns or because of the desire for economic diversification

– Who typically raises such objections?– Special interest groups– Diversification just for the fun of it is no good!– Examples: Singapore imports ALL food

whereas Saudi Arabia exports wheat!


– foreign insurers may provoke a greater foreign exchange outflow

– But, loss of foreign exchange may not be substantial enough to justify the opportunity cost involved in running and upgrading national insurance corporations

– Why is foreign exchange such a valuable commodity in the first place?


– Seventh, full market liberalization should await insurance and possible macroeconomic regulatory reforms so as to minimize the chances of micro- or macroeconomic disruptions

– Wait for how long?– Reasonable insurance laws and regulation are

essential– This is true for both domestic and foreign insurers

Documents

Introduction to international risk and insurance Tapen Sinha, ITAM Why international? Definition of international risk Management of international risk