The importance of the insurance-growth nexus is growing due to the increasing share of the insurance sector in the aggregate financial sector in almost every emerging and mature market economy.
by Zulkifli Nazim
“The trade of insurance gives great security to the fortunes of private people, and by dividing among a great many that loss which would ruin an individual, makes it fall light and easy upon the whole society. In order to give this security, however, it is necessary that the insurers should have a very large capital.” (Wealth of Nations by Adam Smith, Scottish Economist - 1776).
The history of insurance traces the development of the modern business of insurance. Insurance is the oldest method of transferring risk, and is deemed to be one of the oldest in the field of economy. The first activities like insurance appeared nearly 4000 years ago and is as old as the historical society.
The so-called “bottomry” contracts were known to merchants of Babylon as early as 4000–3000BC. Bottomry was also practiced by the Hindus in 600 BC and was well understood in ancient Greece as early as the 4th century BCE.
[Bottomry, referring to the ship's bottom or keel, is a maritime transaction, where the owner of a vessel borrows money and uses the ship itself as collateral. If the money with interest is not paid at the time appointed at the ship's safe return or if the ship sinks the owner forfeits the ship itself to the creditor.]
While insurance can be traced back thousands of years, it is only in the last half century that we have come to a comprehensive and deep understanding of this most vital, yet complex, economic institution. To really understand insurance, it takes a deep knowledge of the subtleties of risk and probability, of how rational (and not so rational) people behave when faced with risk; of how insurance companies can be structured to cope with risk; of how governments can effectively intercede when insurance markets fail to deliver.
Whether in the past periods or in modern period the main goal of insurance is protecting health and assets of the people. Insurance is the main element in the operation of sophisticated national economies throughout the world today. Insurance stimulates business activities to operate in a cost-effective manner, by managing risks which associated with business activities are assumed by third parties. As we know risks and bad accidents can happen always in life. These risks effect people badly and negatively every time. But insurance protects people from these risks. We can say that insurance is a measure, which people take in advance to risks which can happen every time and any time.
The importance of insurance, like other financial institutions such as banking and the stock market, is vital for the sustainable economic growth of any country. The risk is inherent in every human activity ranging from social life to economic activities. The huge contribution of insurance to the economy as a whole, promotes a greater sense of security, peace of mind, reduction in anxiety and fear among individuals, businesses and governments.
The insurance industry is part of the services sector and is deemed to be a secondary branch of economic activity. Its effect is essentially indirect and intangible, because it deals with consequences of economic activity that would occur if insurance did not exist. Insurance serves production and consumption, international and interpersonal trade, payment and credit transactions, as well as the conservation of existing and creation of new wealth. However, the insurance industry has developed differently across industrialized countries due to differences in regulatory legislations by various regimes.
To individuals, insurance purchase enables an individual to sustain his continuous consumption of his property in the case of theft or damage or due to other endangerments and perils.
With regard to corporate institutions, Insurance enables businesses to operate in a cost-effective manner by providing risk transfer mechanisms.
To the Government, on the other hand, expenditure on damages caused by natural disasters such as fire, flood and other natural disasters is reduced if not eliminated with the help of insurance.
In developed countries insurance has become a vital part of the economy and they make it a point to insure all assets with reputed insurance companies. Insurance lets people as well as businesses to protect themselves against certain potential losses and financial hardship at a reasonable acceptable rate. In modern times there are certain specialized insurances which play great roles in the economy of countries.
The importance of the insurance-growth nexus is growing due to the increasing share of the insurance sector in the aggregate financial sector in almost every emerging and mature market economy.
The main intention of this article is to add to the understanding of the role of the insurance sector in the finance-growth nexus - whether and how insurance influences economic growth. The rationale behind this notion is twofold: on the one hand, the importance of the insurance sector within total financial intermediation has risen over time, including the magnitude and intensity of links between insurance, banking and capital markets. Thus the likely impact of insurance on the economy, consequently, increases.
The literature on finance and growth does not, however, pay sufficient attention to the important and rising role played by non-banking financial intermediaries such as insurance companies. While the actuarial processes for insurance have been in continuous development, it really took till the second half of the twentieth century for a modern theory of insurance economics to emerge. This laid out a model of an optimal insurance contract between risk-averse consumers and an insurance company capable of diversification.
In this ever growing field of enquiry in which rational consumers and rational insurers come to together in a mutually beneficial trade of risk. It deepened the understanding of how people come to share risk in an insurance market, and the natural frictions that occur (particularly the conflicting incentives of the policyholders and insurers), there was growing dissatisfaction with a theory that ignored the quirkiness of actual behavior; in real life people might not be quite so rational and raised questions like: “How would insurance market work in a world of limited rationality”?
Modern financial theory has another set of fascinating implications for those interested in insurance. Uncertainty is at the heart of insurance. This is already manifested in our limited knowledge about observable past events. All our activities depend on uncertain and unknown circumstances beyond the control of a single individual. Unambiguous, deterministic cause-effect relationships are replaced by ambiguity in the perception of the economic environment. With respect to the future, uncertainty looms still larger. Insurance is, however, of particular importance for risks with negative consequences.
What does “risk” mean in insurance parlance?
Usually risk is understood to mean as the danger of incurring a loss. This danger can materialize in different ways in a disaster-stricken community, ranging from complete loss, impairment or reduction of value of an asset, to the disruption of business, to the loss of a limb or even loss of life.
What is meant by the colloquial use of the word - “insurance”?
The pertinent literature gives various definitions of insurance. Problems arise because the term originates from business practices.
Individuals seek to protect themselves against irregular but probabilistic shocks impinging on their assets “health”, “wealth”, and “wisdom” by employing one or several tools of risk management mainly by purchasing insurance. Therefore, the importance of insurance presumably increases with growth in the value of these assets. In step with the growth in general wealth, the concentration of assets has also increased, leading to so-called catastrophic risks.
It will expose us to modern financial theories such as asset pricing theory and option theory and, in doing so, will expose us to such exotic financial instruments as catastrophe bonds. It will take us deep into public policy and the welfare state and into the challenges of operating universal health insurance programs; and it will face us with the challenges of a world where new and unpredicted risks are appearing and for which normal insurance mechanisms may not function; where such catastrophes are either triggered by human failure as a result of man-made disasters; or by nature (natural disasters).
Disasters with the largest financial consequences fall into the category of natural disasters. We have also witnessed that the more recent disasters are also the more severe ones. This gives rise to the conjecture that increasingly, natural disasters are in fact man-made, caused notably by environmental pollution through Carbon-di-Oxide - Green House Gases, causing global warming and the latest Corona virus - Covid -19 pandemic, pushing mankind into a state of extreme, irremediable, ruin and misfortune.
These challenges will lead to the expectation that the demand for insurance will tend to increase in the future. To achieve this, the industry has to be prepared for the unexpected and to be able to timely respond to the challenges laid before them, insurers and reinsurers must know and follow the trends and dynamics that characterises the global insurance and reinsurance industry.
[The writer counts over 50 years in the insurance industry and is an Associate of the Chartered Insurance Institute [London] and also holds the title of Chartered Insurance Practitioner; as well as an Associate of the Insurance Institute of India.]
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