Insurance in Developing Economies Role and Relevance for Development

Transcription

1 Draft Michael Klein December 12, 2011 Insurance in Develping Ecnmies Rle and Relevance fr Develpment Insurance markets tday Insurance markets are a majr part f develped financial markets. In 2009 assets managed by insurance cmpanies and pensin funds amunted t 15.5 per cent f all financial assets cmprising bank assets, stcks and bnds. Revenues f insurance cmpanies glbally amunted t 4.3 trillin dllars in By way f cmparisn, the largest crpratin by revenue was Wal Mart with revenues f 422 billin dllars in Revenues split int 2.5 trillin dllars fr life insurance prducts and 1.8 trillin dllars fr nnlife prducts. Glbal agricultural insurance premia amunt t 19.4 billin dllars 0.4 per cent f the ttal. Micr insurance prducts are estimated at abut 1 billin in premia r 0.02 per cent f the ttal. Over 83 per cent f revenues are cllected in OECD ecnmies, 5.5 per cent in Asia excl. Japan and the high incme ecnmies f the regin, and 0.3 per cent in Africa excl. Suth Africa. Insurance penetratin is highest in rich cuntries. Fr example, premia fr nn life prducts amunt t ver 3 per cent f GDP, whereas in lw incme cuntries they barely reach 0.7 percent f GDP. The Prmise f Insurance The relative size f the insurance industry expands as cuntries grw. The demand fr insurance increases as purchasing pwer grws. The csts f insurance als fall as fixed administrative csts decline in relative terms and sme risks are better managed. Fr example, deaths frm large disasters have declined substantially with ecnmic grwth. Individuals benefit frm insurance as it can reduce calamitus incme fluctuatins, fr example, due t sickness, inclement weather r the death f the main incme earner. Insurance prducts thus make a cntributin t the achievement f all Millennium Develpment Gals, fr example thrugh health, life r weather insurance and thrugh the impact f insurance n incme grwth and thus pverty reductin. Insurance supprts grwth by allwing peple t reduce diversificatin and benefit frm greater specializatin. It als allws peple t engage in riskier, but prmising activities. As peple cmmit sizable sums f mney t fund insurance and pensin systems they create a surce f lng term funding that can help manage maturity mismatches that therwise plague financial markets. The effect f insurance r pensin system develpment n grwth des nt perate by raising aggregate saving levels. If anything, mre insurance allws saving t be reduced. Pensin

2 New Risks system develpment als des nt, in general, lead t mre saving. Cnsider tw extreme cases t see the main arguments. Saving matters fr investment and thus greater cnsumptin pssibilities, even in a hypthetical sciety where peple die as sn as they stp wrking. Pensins are abut an intergeneratinal cmpact, under which wrking peple agree t supprt lder nn wrking peple, even thugh the ld nes cannt ever reciprcate. This cmpact is relevant even in ecnmies withut investment, such as hunter gatherer scieties. The ntin f a cmpact des nt imply that it has t take the frm f a pay as yu g system. It may als take the frm f a funded defined cntributin system. Each system defines in different ways hw ex ante and ex pst risks and bligatins are defined and adjusted. Demgraphic change A majr demgraphic transitin is underway. In mst cuntries, first mrtality rates fr children fell, while fertility rates remained high. Ppulatin grwth explded. Since abut 1970 fertility rates in mst cuntries fell rapidly and mrtality f ld peple declined. The result is slwer, albeit still significant ppulatin grwth, cmbined with very rapid ageing. Neither life insurance nr pensins can insure against an verall risk like massive ageing. The key cntributin f life insurance r the insurance elements f pensins is t cver the variability arund the expected duratin f life. One basic way f making pensin systems wrk in rapidly ageing scieties is t make the retirement age a functin f life expectancy. The cre issue f funding pensin systems fr ageing peple is neither a matter f insurance nr f saving. It is a matter f hw many peple are wrking t supprt ld peple and hw prductive they are. That means fertility rates clse t replacement level and educating children well is key. Financial prducts that supprt prductivity grwth, such as student lans, are pssibly mre imprtant fr managing ageing scieties than mre cmplex pensin systems. The latter cannt by themselves raise prductivity and just cnstitute different means t supprt the intergeneratinal cmpact that helps supprt ld peple. Climate Change and Fd Security The earth appears t be warming in part t man made emissins f greenhuse gases. The degree f likely warming remains uncertain with main estimates varying rughly between 1 and 6 degrees centigrade by the end f the current century. The effect n weather patterns acrss the glbe remains uncertain. It may be that weather patterns becme mre vlatile, fr example, with less frequent but mre intense strms in parts f the wrld. It appears likely that peple in develping cuntries are mst at risk frm the ill effects f glbal warming. Farmers are particularly weather dependent and hence expsed t risks frm glbal warming. This may affect fd security. As a result the demand fr insurance may rise. Hwever, insurance cannt cver the general risk f glbal warming. It can help manage variability f the climate. As extreme weather becmes mre likely and patterns becme mre unpredictable, the cst f insurance wuld rise. First, damages may rise and thus increase expected

3 insurance pay uts and hence premia. Secnd, when risks are hard t predict and hard t diversify, insurance cmpanies need t charge premia that cver situatins f significant, nn diversifiable damages. This requires charging mre than the expected value f lsses. At the same time, recent experience, fr example, after Hurricane Katrina suggests that capital markets may able t cpe with increasing damages. This wuld mean markets wuld nt shut dwn in the face f mre severe risks and the cst f capital may nt rise. Hwever, due t the first tw effects verall charges are likely t rise. Challenges in develping insurance markets Infrmatin Infrmatin is key t insurance in tw ways: Perfect infrmatin leads t the cllapse f insurance markets, because fr each persn it is knwn what will happen and the demand fr insurance evaprates. What remains is an incentive fr each persn t take precautins including saving. When infrmatin is highly uncertain, risk assessment becmes hard and insurance supply disappears. Fr insurance t functin an assessable level f infrmatin is required risk, neither certainty nr uncertainty. Risk aversin The demand fr insurance is driven by risk aversin. Peple are said t be risk neutral when they are willing t pay, fr example, 10 dllars fr a cncert ticket r 5 dllars fr the chance t btain the ticket with a chance. The price fr the gamble at which peple are indifferent between the tw ptins is a measure f their willingness t pay fr insurance and the highest pssible risk premium. Fr example, if peple were indifferent between dishing ut 12 dllars fr a certain ticket and 5 dllars fr the chance f getting it, they are in fact willing t pay 2 dllars as an insurance premium. Fr arguments sake, assume yu are faced with the chice f paying 25 dllar fr eye cataract surgery at Aravind Eye Care Systems, which has an excellent recrd f success r 12.5 dllars at a less reputable utfit with a chance f restring yur eye sight, which wuld yu chse? Hw much culd Aravind raise the price until yu switch t the ther utfit? Pling Insurance requires a ppulatin f clients that are all affected by the insured risk, but in ways that are independent f each ther r nt psitively crrelated with each ther. Each risk averse individual wuld be willing t pay a premium. The insurer, hwever, wuld n average just pay ut the expected value f the risk. Cmpetitin amng insurance cmpanies wuld prvide an incentive fr insurers t charge just the actuarially fair price. Pling becmes smewhat prblematic, if risks amng the insured clients are psitively crrelated. Fr example, hurricanes regularly hit Caribbean islands. Nt all get hit each time, but the likelihd f being hit is crrelated. Hence pricing will exceed the expected value f lsses cmpared t a scheme with uncrrelated risks. Hwever, recurse t reinsurance markets can prvide ptins fr further diversificatin.

4 Trust and cunterparties Insurers pay first, insurance cmpanies later and they d nt like paying ut; insurers may g bankrupt r disappear altgether by the time the insured event ccurs; when insurance premia have been cllected, but befre payuts, there are funds available fr investment there can als be a temptatin t abuse these funds ranging frm substandard investment that erdes the value f the funds t utright stealing. Fr example, the Argentine gvernment recently seized the assets f private pensin funds and MF Glbal, while nt an insurance cmpany, gambled with earmarked client funds and lst them. Trust that an insurer is respnsible and will be arund when the insured event might ccur is critical fr effective demand. The tw detailed impact evaluatins that exist n small scale insurance fr rainfall in India and Malawi suggest that peple shy away frm insurance and prefer credit as a means t manage financial prblems. In fact, mre risk averse clients may demand less insurance. Their willingness t pay fr insurance may be ffset by their distrust in the insurer (India rainfall). Life and pensin prducts are particularly tricky. Life expectancy f peple may well exceed that f insurers. Insurance and behavir Insurance can affect behavir. Insured peple may indulge in mre risky activity. Disaster insurance may explain why s many peple maintain beachfrnt huses in risky areas f the US cast. This is the phenmenn f mral hazard. A particular frm f mral hazard and exciting mtif fr mvies is the attempt t kill smene and cash in n life insurance. In respnse t mral hazard cncerns, insurers may cntractually require certain undertakings frm the insured r exclude insurance in case f reckless behavir. Setting prices right helps instill prudence in the insured. Thus mre risky classes f drivers, fr example, shuld pay higher prices. When insurance cmpanies cannt distinguish between gd and bad risks, premia cver the average cst f risk. Gd risks then pt ut and premia g up. Markets shrink r cllapse. That is the phenmenn f adverse selectin. Pssible respnses t adverse selectin are gvernment mandated insurance e.g. health r subsidy. Subsidies are mre dubius because they may instill greater mral hazard. But in sme cases, it is nt pssible t mandate insurance, fr example, disaster insurance fr Caribbean svereign states. In that case, sme frm f subsidy might just be justified cmbined with cntractual strictures that require the insured states t take preventive measures. Efficient pricing means discriminatin. Effective cntracts mean binding incentives t imprve risk management and behavir. This may sit uneasily with nble gals such as insurance fr all r equal treatment f peple. Crrelated Risks Glbal risks such as glbal warming r ageing cannt be insured against unless we find ther planets with independent warming r ageing patterns. A key class f crrelated risks that affects insurance arises due t the state f the ecnmy. A depressed ecnmy reduces incme frm investments. It may als g tgether with greater risk, fr example, bad weather tends t be crrelated with

5 depressed ecnmic activity in agricultural ecnmies. Thus claims may g up. All this may frce insurance cmpanies t raise prices, which may reduce demand. The insurance industry is thus typically subject t insurance cycles f cntractin and expansin. It is nt n a nice smth grwth path. The state f the ecnmy ver lnger perids may als be a majr factr. A particular interest rate and stck return envirnment may last fr decades affecting what pensin funds r insurance cmpanies can ffer. During recent decades pensin schemes culd d with cmfrtable cntributins because investment returns were high. This may nt be the case fr sme decades with majr cnsequences fr pensin levels. As in any ther areas there may be a temptatin t prmte new instruments such as insurance withut a full assessment n whether the value fr custmers (demand) is actually exceeding the cst f supply. The fllwing key pieces f analysis need t cme tgether: What is the willingness t pay f (ptential) custmers based n their risk preferences What reasn d custmers have t trust cunterparties and hw can trust issues be managed? What alternative means f managing insurable risks are available, fr example, saving r credit prducts, reliance n traditinal slidarity mechanisms and what is their cmparative cst? Can lessns frm behaviral finance prvide clues t better ways f revealing latent demand? Fr example, prviding peple with the chice t pt ut f pensin systems tends t lead t greater participatin than giving the chice t pt in all else being equal. At the same time the message frm behaviral finance is nt that peple are systematically irratinal. The rules f thumb peple may use may be efficient in sme brader perspective and what may appear irratinal t sme is a valid cncern, fr example, abut trust in the cunterparty. Cnsidering all the issues t be addressed when develping sustainable insurance schemes the standard view n the rle f insurance yields the fllwing rules f thumb abut where supply meets demand : Just try t avid activities that generate frequent lw lsses insurance cannt help Cver infrequent lw lsses ut f pcket; pssibly use financial tl such as credit t manage such lsses When high frequency high lsses lm take adaptive measures. Mve yur huse frm the beach, build a dike. Insurance cannt help and true csts f insurance wuld be prhibitive. Fr medium frequency lw t medium lsses cnsider insurance. Fr very high, rare lsses there may be rle fr gvernment as insurer r rather prvider f last resrt. New appraches and business mdels Sme new appraches t supplying insurance prmise further pssibilities t expand the reach f insurance New mdeling and assessment techniques may make risks insurable New distributin channels may help cut administrative csts. This may invlve new develpments in infrmatin and cmmunicatin technlgy. It may mean using existing

6 distributin channels t sell prducts, fr example, banks r nn banks like supermarkets r just the mbile phne. Parametric insurance may thrive n the basis f better data, fr example, fr weather risks, and help reduce csts assciated with claims assessment and payment while expanding ptins fr prducts. Rles fr Gvernment Gvernments are the key t prviding public gds. This includes the framewrk f laws, cntracts and prperty rights that insurance needs. It can als mean develpment f data systems that supprt, fr example, parametric insurance. Prudential regulatins and cnsumer prtectin remain a gvernment task Gvernments may als have a rle in mandating r subsidizing pling t cpe with adverse selectin. In several fields gvernments may de fact be the required lng lived cunterparty and insurer f last resrt. This will vary depending n the type f gvernment and its stability. Prviding subsidies raises several issues Subsidies are liable t prevent desirable adaptatin and risk mitigatin In transparent subsidies via insurance f sme type may be prtectinist measures in disguise and distrt cmpetitin. Subsidies can raise csts as mral hazard is diminished and lead t wasteful expenditure. Fr example, US natinal fld insurance spent 0ver 40 per cent f premia n administrative cst, mst n private agents. It is questinable whether there is any case fr subsidizing set up csts fr private insurance firms. Luckily there is evidence, fr example, frm agricultural insurance that private insurance markets withut subsidy may reach as many clients as subsidized markets and perate prfitably at the same time, whereas gvernment subsidized schemes have tended t make lsses. As a result it wuld be imprtant fr gvernments t intrduce mre transparent, nbalance sheet accunting fr the insurance and subsidies it prvides. Gvernment spnsred insurance prgrams shuld als be subject t cst benefit analysis. The same applies t public develpment finance rganizatins. Aid and Insurance Insurance is a frm f cntractual slidarity in mdern scieties Mre and mre markets at the bttm f the pyramid are becming rich enugh t start expanding insurance, while increased scial mbility means that traditinal frms f slidarity are under stress. Develpment rganizatins have thus a clear rle in helping develp insurance systems in client cuntries. In the case f disaster insurance an increased reliance n frmal insurance mechanisms rather than pst disaster relief effrts may help imprve the rapidity and predictability f pst disaster assistance