Introduction to international risk and insurance Tapen Sinha, ITAM

1
Introduction to international risk and
insuranceTapen Sinha, ITAM

• Why international?
• Definition of international risk
• Management of international risk
• Multinational enterprises
• Insurance classification
• Country classification
• Economic development and insurance

2
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

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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

4
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)

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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

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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

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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

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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)

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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)
• workers compensation payments

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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)

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Types of insurance

• Direct versus reinsurance
• Insurance 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

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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

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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

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Intergovernmental organizations

• Members of OECD
• Austria, 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

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Intergovernmental organizations

• 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

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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

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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

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International Environment

• Economic/financial environment
• Political/legal environment
• Regulatory/tax environment
• Demographic and social environment
• Physical and technological environment

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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

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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

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Why does insurance help in economic development?

• 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

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Why does insurance help in economic development?

• 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.

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Why does insurance help in economic development?

• 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)

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Why does insurance help in economic development?

• 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

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Why does insurance help in economic development?

• 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

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Why does insurance help in economic development?

• 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

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Why does insurance help in economic development?

• 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)

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Why does insurance help in economic development?

• 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

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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)

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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.

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Common objections policy makers raise in against
foreign insurance companies

• 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.

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Common objections policy makers raise in against
foreign insurance companies

• 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

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Common objections policy makers raise in against
foreign insurance companies

• 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.

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Common objections policy makers raise in against
foreign insurance companies

• 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.

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Common objections policy makers raise in against
foreign insurance companies

• 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

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Common objections policy makers raise in against
foreign insurance companies

• 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.

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Common objections policy makers raise in against
foreign insurance companies

• 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!

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Common objections policy makers raise in against
foreign insurance companies

• 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?

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Common objections policy makers raise in against
foreign insurance companies

• 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