Drivers of growth -Insurance and Development

All insurers have a strong incentive to keep losses at a minimum, which can bring significant social benefits.

RAMA DAHAL
The role of insurance sector and its links into other financial sectors is assuming greater importance by the day. While there is a plethora of research on the causal relationship between bank lending and economic growth, and capital markets and economic growth, the insurance sector has not received ample attention in this respect.

Financial development promotes economic growth by increasing marginal productivity of capital, by helping channel saving into investment and technological innovation.

Empirical studies suggest financial intermediation plays a supporting role. Among financial intermediaries, insurance companies in particular play a vital role in economic growth. They are main risk management tools for individuals and companies. By issuing insurance policies they collect premium and transfer them to economic units for financing real investment. Therefore, the insurance sector could make a significant contribution to economic growth.

In almost every economy, the insurance-growth nexus is deepening due to the growing share of this sector in the aggregate business environment. Closer link between insurance and other players in the financial sector also emphasize the important role of insurance companies in economic growth. While insurance, banking and securities markets are closely related, insurance fulfills somewhat different economic functions as compared to other financial services. This in turn calls for a particular set of conditions.

Evidence suggests that insurance contributes materially to economic growth by improving investment climate and promoting a more efficient mix of activities. This contribution is magnified by the complementary development of banking and other financial systems.

Nonlife insurance contributes to growth at many levels of development. With insurance companies further reinsuring with the international market, it helps protect domestic companies as well. One particular loss will not damage the insurance company; but the insured will also be compensated adequately.

Life insurance makes a substantial contribution to growth mostly in wealthier countries, since life insurance is typically a smaller part of the total insurance market in low income countries. The relationship between per capita income levels and insurance penetration is also strong in the other direction—with rising income a strong driver of life insurance coverage. However, it is difficult to establish whether lower insurance consumption at lower income levels reflects reduced demand for life insurance products or constraints on the supply side associated with weak regulatory and supervisory environments and high costs of insurance provision.

Contribution to growth
Fundamentally, the availability of insurance enables risk adverse individuals and entrepreneurs to take more risks on higher return activities, promoting productivity and growth.

Risk management is fundamental to entrepreneurial activity. Entrepreneurs manage the risk of accidental loss by weighing the costs and benefits of each alternative. In a structured risk management process, this involves: identifying exposures to accidental loss; evaluating alternative techniques for treating each loss exposure; choosing the best alternative; and, monitoring the results to refine the choices.

Those who do not apply a structured process still make decisions about risk, although by default rather than design. The scope of an economy’s insurance market affects both the range of available alternatives and the quality of information to support decisions.

Insurers also contribute specialized expertise in the identification and measurement of risk. This expertise enables them to accept carefully specified risks at lower prices than non-specialists. They also have an incentive to collect and analyze information about loss exposures, since the more precisely they measure the cost of risk, the more they can expand. As a result, the insurance market generates price signals for the entire economy, helping allocate resources to more productive uses.

Insurers also have an incentive to control losses, which is a significant social benefit. By offering discounts for smoke detectors, or other measures that reduce the frequency or severity of losses, they lower their eventual claims costs, in the process saving lives and reducing injuries.

On the investment side, due to the long term nature of their liabilities, sizeable reserves, and predictable premiums, life insurance providers can serve an important function as institutional investors providing capital to infrastructure and other long term investments as well as professional oversight to these investments.

Of course, these benefits are fully realized only in markets where insurance providers invest a substantial portion of their portfolios domestically. The net result of well functioning insurance markets should be better pricing of risk, greater efficiency in the overall allocation of capital and mix of economic activities, and higher productivity. Importantly, these unique functions of insurance should be complementary to the penetration of banking and financial sectors. For instance, insurance facilitates create transactions such as the purchase of homes and cars and business operations, while depending in turn on well functioning payment systems and robust investment opportunities.

source:Dahal, Rama (2013),"Drivers of growth", republica,12 may 2013
The author is assistant General Manager, Everest Insurance Company Limited
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