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The nature and history of insurance ...........................................................1

Role of government in insurance ................................................................3

Profile of the modern insurance sector ......................................................4

Developm

ent paths for the insurance sector .............................................5

Insurance and development .......................................................................10

Policy issues in insurance market developm

ent ......................................11Industrial structure and m

inimum

capital ..........................................11Financial insurance ................................................................................12Liberalization .........................................................................................13Financial supervisor cooperation or integration .................................14Catastrophe risk .....................................................................................14Accounting and inform

ation systems ...................................................14

Insurance taxation .................................................................................15D

istribution and intermediaries ...........................................................16

References .....................................................................................................17

Annex I: Bank deposits versus insurance and pension assets,

OECD

survey 2001 ...................................................................................19

Annex II: N

on-life insurance and private sector credit growth ............20

Box 1. The global m

etrics of insurance markets .................................4

Table 1. Geographical em

phasis of transnational insurers ................5Table 2. Sequencing of classes of insurance .........................................6

Figure 1. Non-life insurance elasticity ..................................................7

Figure 2. Life insurance elasticity versus GD

P growth ......................8

Figure 3. Minim

um capital requirem

ents for non-life insurers w

orldwide ............................................................................................12

Insurance in its pure form is a social good and in a num

ber of cases can be classified as a public good (that is, it generates desirable externali-ties). Insurance com

panies, mutuals and cooperatives enable individ-

uals and firms to protect them

selves against infrequent but extreme

losses at a cost which is sm

all compared to the feared loss. Th

ey do this through the w

orkings of the law of large num

bers and the central limit

theorem w

hich ensure that a sufficiently large num

ber of reasonably hom

ogenous risks will produce w

ell behaved and highly predictable aggregate results follow

ing a roughly Gaussian loss distribution.

Life insurance contracts can be for short periods (for example,

accidental death) or very long periods (for example, w

hole of life). In consequence life insurance can intrinsically include a savings elem

ent, and in m

any late transition and industrial countries this component

dominates funds flow

s in the sector. This flow

of funds effect can be exaggerated by the fact that in recent decades the life insurance sector has begun to com

pete directly with m

utual funds and unit trusts through unit linked contracts offering a life insurance ‘tax w

rapper’. N

on-life insurance contracts, which insure m

aterial and finan-cial risks, typically run for one year and are renew

ed on the basis of updated risk inform

ation. G

iven its fundamental role in spreading risk it is not surprising

that references to insurance can be found in antiquity. A form

of risk sharing for m

arine ventures known as bottom

ry (not unlike modern

catastrophe bonds in concept) was in existence m

ore than two

millennia ago. N

on-life insurance in its modern form

(also known

as Property and Casualty or P&

C, and general insurance) became

established in Italian cities such as Genoa in the fourteenth century

to support their active marine based trading activities, w

ith the first regulation appearing in 1336. Th

e concept spread rapidly to other parts of Europe and eventually to the N

ew W

orld. Life insurance goes back to at least Rom

an times w

hen funeral societies became popular.

Various forms of insurance have been banned from

time to tim

e for religious reasons (for exam

ple fire insurance was shunned in Southern

Germ

any for a period because it was seen as prevented G

od from

exercising his displeasure) and because of fraudulent or morally ques-

tionable schemes such as tontines and pyram

id arrangements. Th

e grow

th of the sector was m

ost rapid in the United Kingdom

, largely because of a long-standing liberal approach to m

arkets, and the U.K.

remains the m

ost ‘insured’ country in the world H

owever the m

odern approach to the prudential regulation of the insurance sector w

as largely pioneered in the U

nited States in the nineteenth century, and in M

assachusetts in particular.Insurance by its nature is an intangible good, involving paym

ent in advance for an unknow

able quality of delivery in the future. Thus trust

is a critical element, and public good classes such as health, disability

and work place injury or illness have to date often been delivered

through state entities. How

ever most classes of insurance are usually

delivered through private markets and insurance regulation tends

to reflect solvency concerns and information asym

metry betw

een suppliers and policyholders: m

any countries have explicit reference to insurance contracts in their civil codes and specialized law

s including specific provisions for retail (B to C) m

arkets. As fiscal pressures

mount there is an increasing trend to entrust m

ore social good classes, such as w

orkman’s com

pensation and annuities, to the private sector and this adds to the pressure for effective m

arket conduct and pruden-tial regim

es.G

overnment intervention to enforce m

andatory insurance (most

comm

only motor third party, w

orkman’s com

pensation and construc-tors all risk) aside, private insurance m

arkets form naturally w

hen risk aversion ensures that individuals w

ill pay more than the expected loss

in order to hedge against the possibility of a loss that is large relative to available resources. Th

e reason that the market prem

ium is greater than

the expected loss is that the expenses of running the business need to be factored in, together w

ith the cost of the capital set aside to under-w

rite the risks involved. Typically the market prem

ium is not greatly

in excess of the expected loss for most com

mon classes such as m

otor collision insurance, w

here claims are relatively frequent (around 11 to

15 percent annually) and the average claim size is sm

all, thus gener-ating statistically credible databases. H

owever the cost of capital can

dominate w

here large elements of uncertainty exist and system

ic events can affect m

any risks at once, such as credit insurance and natural disasters coverage.

A m

ajor industry subset, the global reinsurance sector, has largely arisen from

its ability to modify the frequency and claim

s profile of a direct insurer at a price that is effi

cient for both parties (that is, rein-surers are insurers of insurers). For a typical m

ature non-life insurer in an industrial country the net cost of reinsurance in a norm

al year accounts for approxim

ately 8 percent of gross premium

revenues. H

owever reinsurers also effectively ‘lend’ capital to rapidly grow

ing insurers (both life and non-life and som

etimes know

n as surplus relief reinsurance) and the proportion reinsured can be m

uch larger in em

erging markets. Th

e reinsurance sector has also been the core source of technology transfer betw

een developed and developing markets and

is the subject of Module 2 of this series.

Given the balance sheet risks involved, the capital m

anage-m

ent of insurers bears some resem

blance to that of banks. In both cases it ideally reflects a desire to set som

e upper limit on the prob-

ability of failure within a defined period of tim

e. Hence elem

ents such as m

arket, credit and operational risk are increasingly reflected in solvency regim

es as various countries introduce risk based supervi-sory regim

es. How

ever insurance capital determination is consider-

ably more com

plex as both sides of the balance sheet are stochastic in nature (liabilities are the present values of uncertain future obligations) and the correlations betw

een liability and asset risks can be much less

obvious than for banks.

Governm

ent has three roles in insurance. The first is to ensure that

those who are granted licenses are com

petent to enter the business and w

ill have sufficient scale. Th

e second is to ensure that there are suffi-

cient competitors to prevent cartels from

developing, while lim

iting num

bers to a level that prevents pyramid structures (know

n as cash flow

underwriting) from

emerging. Insurers are prone to pyram

id structures because prem

iums are paid w

ell in advance of claims and

the ultimate cost of claim

s is uncertain. The m

ain tools to achieve these potentially conflicting objectives are m

inimum

capital require-m

ents (see figure 3), licensing rules and centralized claims data collec-

tion so that indicative pure premium

s (that is, expected losses per unit

of coverage) can be published. Market prem

iums are pure prem

iums

loaded for expenses and cost of supporting capital.Th

e third role is to protect the public. This is not the sam

e as preventing insurer insolvency (Stew

art Economics, Inc. 2003). In fact

allowing an insurer in trouble to delay insolvency (know

n as regulatory forbearance) can be inim

ical to the public interest and involve substan-tial unexpected and unnecessary public expenditures. Th

is recogni-tion has contributed to the developm

ent of risk based supervisory approaches, including corrective actions and enforcem

ent based on the ratio of actual capital to statutory m

easures of risk based capital.

Today the insurance sector is a major global industry covering a

huge range of risks ranging from natural disasters and environm

ental hazard, through life and disability and standard property risks (fire, explosion, burglary, and so forth) to various types of liability under tort and civil codes to protecting the balance sheets of credit granting institutions. In the latter case the sector has developed overlaps w

ith, and becom

e the backstop for significant sections of the banking and shadow

banking sectors. It is also a significant source of investment

funds (box 1).In 2003 seven insurers w

ere in the top fifty corporations in the w

orld in terms of revenues and insurers accounted for tw

o of the top four global financial institutions by m

arket capitalization. The industry

is global by nature as it is in the risk spreading business, but in prac-tice less than fifteen insurers can be called genuine global players

(and these are mostly European), w

ith the balance having more of a

regional approach or being confined to their home countries. In term

s of geographical involvem

ent it is clear that colonial pasts and cultural affi

liations have played a large part in foreign investment, in addition to

proximity (table 1). H

owever other factors are also im

portant.O

f particular note is the fact that, the global success of the sector notw

ithstanding, there is a massive dichotom

y between developed

and developing markets (see box 1). Th

e density of insurance (that is, prem

ium per capita) in an industrial country like France at U

S$4,075 is m

any multiples of the U

S$38.4 reported by a poor country like India (Sw

iss Re 2007). In parts of Africa the sector is effectively non existent,

despite its fundamental social and econom

ic role. The insurance devel-

opment path is discussed in detail below

but can in part be explained by the sequencing of the introduction of the various classes of insur-ance (table 2), w

hich in turn follow developm

ents in the real sector and the establishm

ent of property rights.Th

e major challenge for developm

ent institutions is to work to

change the traditional development patterns to support real sector

development and hence generate m

ore rapid sectorial development in

a virtuous cycle.

The grow

th of insurance markets has been different to that of banking

sectors, with the insurance sector being m

ore sensitive to fundamental

real sector development, and in particular to average incom

e levels (A

nnex I). This partly reflects the fact that insurers are usually not

allowed to borrow

or take on net foreign exchange exposures. 1 Their

balance sheet leverage (typically around 10 to 1 for life and 5 to 1 or less for non-life) is naturally generated by the need to hold reserves against claim

s incurred but not yet settled and future obligations. Thus

insurers are more dependent on local financial resource m

obilization and in turn on grow

th in domestic econom

ic activity. Form

al life insurance markets norm

ally develop well after non-life

insurance markets. Th

is reflects the former’s dependence on the em

er-gence of a m

iddle class and, ideally, the development of reasonably

deep and liquid capital markets. H

owever culture can play a part, w

ith life m

arkets appearing sooner where strong savings ethics apply, such

as in North A

sia and former British colonies.

If non-life premium

s/capita (premium

density) is graphed against G

DP/capita it can be seen that econom

ic growth is the m

ain driver (figure 1), w

ith a global elasticity between prem

ium/capita and G

DP

capita of approximately 1.3. 2 H

owever densities vary considerably

between countries at sim

ilar stages of development.

The m

echanisms of non-life insurance grow

th have varied both over tim

e and according to country context. Originally m

ost non marine

insurers started as mutual organizations set up to m

eet a comm

on need

1. Som

e major m

arkets (for example, the European U

nion and the United States) do in fact

allow insurers to borrow

to support solvency, but only on terms that strictly lim

it the investors’ capacity to redeem

the relevant notes.2.

That is, a 1 percent increase in G

DP per capita corresponds to a 1.3 percent increase in

premium

per capita.

or out of natural linkages. State Farm, now

one of the largest insurers in the w

orld, began life as a mutual to insure farm

ers’ vehicles. Fire insur-ance w

as founded in France by the water com

pany, which organized

the first fire brigade service. The life insurance industry grew

out of w

idows’ funds and arrangem

ents set up by various religious groups, and subsequently by the fraternal m

ovements (supported by industrial-

ization and increasing population concentration). Many large and long

established life insurers in industrial countries had mutual structures

until relatively recently, when com

petition and the obvious existence of lazy capital (and the chance for current m

anagement to utilize the

profits created over many decades of operations) forced a m

ove to shareholder structures.

The current pattern in developing m

arkets tends to be different. Transport (M

AT), industrial and comm

ercial non-life lines first appear, driven by the requirem

ents of trading partners and foreign investors/ partners and the arrival of international insurance brokers. Even the m

ost extreme centrally planned econom

ies require marine and trans-

port insurance. In addition certain economic sectors, such as agri-

culture, often see the early emergence of insurance m

echanisms for

consumption sm

oothing purposes: such classes are often subsidized by the state. H

owever the general public usually rem

ains unexposed to insurance until m

otor car fleets begin to build, often with a sudden

increase in traffic related deaths and injuries, at w

hich point compul-

sory third party liability insurance is almost inevitably introduced by

law. Because of the strong cash flows generated by this class it often

attracts questionable entrepreneurs and the insurance sector can rapidly lose the public’s confidence. Th

ereafter the main driver tends

to be the development of form

al credit markets w

ith attendant needs to cover loss of a w

age earner’s life or loss of collateral. This helps to

explain the strong link to GD

P growth and an observed nexus w

ith the developm

ent of credit markets (see A

nnex II). Life insurance based savings develop along a som

ewhat different

path. Sales people offering hard currency contracts arrive on the scene as soon as a m

iddle class with surplus incom

e begins to appear. Th

e insurers are often from other countries and the transactions

are carried out in hotel rooms. Local life insurers usually cannot be

sustained until a reasonable level of income is attained by a signifi-

cant number of fam

ilies (typically corresponding to a GD

P/ capita of betw

een US$5,000 and U

S$8,000 in 2007 dollars), the local regulatory system

has been strengthened and there is at least some local currency

capital market developm

ent. Thereafter it tends to grow

rapidly, with

a premium

density elasticity to GD

P/capita growth of approxim

ately 2 tim

es. Often the first stage w

ill involve some variant of m

ulti level selling (that is, using social contacts) and professional sales channels follow

some tim

e later. How

ever banc-assurance, in one of its various form

s, is increasingly being tried at the early stages in emerging

markets, w

ith varying degrees of success (see discussion below). Th

us, w

hile life insurance development is also prim

arily driven by GD

P/

capita, there are strong threshold effects, and other factors such as incom

e distribution, the role of social transfers and religious mores

can have a significant impact 3 (figure 2). Recent history also plays a

role with a w

ell known international brand being seen as a positive in

some countries, particularly those of the form

er Soviet Union w

hich saw

savings destroyed by hyperinflation and other countries where

pyramid schem

es have collapsed.A

side from these factors the m

ajor determinant of life insurance

development is the level of involvem

ent the sector has in managing

funded pension arrangements. Th

ere is evidence for a substitution effect w

hen mandatory second pillar pensions are introduced in m

ore developed countries, although forced savings in poorer countries does appear to lead to a net increase in overall savings.

Little work has been done on the tradeoffs betw

een establishing local insurers and introducing foreign players, although U

NCTA

D

has encouraged the development of locally ow

ned sectors. The m

ain offi

cial drivers of this policy stance usually involve retention of foreign exchange, creation of a com

petitive domestic m

arket and local control of long term

funds. The econom

ic justifications behind the second and third drivers can be questioned. FD

I has no apparent relation-ship to m

arket size but it does appear to be related to non-life under-w

riting capacity and product/distribution innovation, and foreign insurers tend to be less driven by local bank funding needs and issues of governm

ent paper. Th

e retention of foreign exchange argument m

ay be more sustain-

able provided the mechanism

adopted efficiently uses local capacity.

For example a m

ore efficient use of local financial and hum

an resource capacity is som

etimes achieved through m

andatory reinsurance through a local or regional reinsurer. Such entities enable a m

ore attractive and larger portfolio to be offered to international risk transfer m

arkets and, through a critical mass of technical staff, can offer advice

to small insurers.

Most insurance m

arkets are now opening up as the G

ATS negotia-tions proceed although these liberalization efforts are being im

ple-m

ented with highly varying level of skill and som

etimes in the absence

of necessary institutional settings (see policy issues below). Like

banks, state controlled insurers created to provide mandatory insur-

ances and to insure state owned enterprises have been m

isused under directed lending and investm

ent programs. Even in som

e late transi-tion countries insurers have been required to direct funds to socially preferred sectors such as housing (for exam

ple, New

Zealand in the

3. Takaful insurance is now

showing signs of grow

ing rapidly in Muslim

comm

unities.

1970s). This and the strong linkages that typically exist betw

een the insurance sector and the influential classes in developing m

arkets has been a m

ajor source of resistance to effective market liberalization in

some jurisdictions.

A new

role outside the normal developm

ent path is now em

erging for the insurance sector. Th

is involves protecting the working poor from

falling into poverty due to catastrophic idiosyncratic events such as death or illness of the w

age earner or systemic events such as drought

and is somew

hat similar to the social role played by friendly societies

and industrial insurers in the U.K. and Europe in the late nineteenth and early twentieth centuries. It com

es under the general heading of micro-

insurance and emerged out of the m

icro finance industry in the late twentieth century as a m

eans to raise collateral against micro-lending

and to develop alternative sources of contribution to overheads. The

official funds flow

and GD

P numbers likely to be generated by this sub-

sector are small but the social and poverty im

pacts can be considerable, w

ith more than 100 m

illion poor people already covered and the number

increasing rapidly. This series discusses m

icro-insurance in Module 3.

There has been virtually no academ

ic research on the economic

role of insurance: risk considerations appear to be absent from m

ost econom

ics courses. How

ever a body of research, largely supported by the W

orld Bank and UN

CTAD

, is now em

erging that demon-

strates growth related causalities from

insurance sector development to

economic developm

ent. These appear to apply for non-life insurance

at all stages of development (no country can trade w

ithout insurance) and for life insurance at the later stages of developm

ent (Arena 2006).

Anecdotal evidence w

ould point to the process as being iterative. Research has show

n the central role of insurance in supporting credit creation (A

nnex II) and trade finance, and the development of

equity and long term debt m

arkets (Impavido 2003). Recent financial

crises have also pointed to the unreliability of bank lending (particu-larly cross border lending) under stress and the im

portance of devel-oping m

ore reliable long term sources of funding. Finally it is now

becom

ing clear that risk markets can play a key role in protecting

developing countries from fiscal and liquidity stresses follow

ing major

natural catastrophes.Th

ere are very few exam

ples of insurance sector failure adversely system

ically affecting the economy. In m

ost cases where this has

occurred it has arisen from links w

ith the banking sector: the Jamaican

meltdow

n in the late 1990s is perhaps the best known exam

ple. Only

one recent case of a direct impact on the econom

y is known. Th

is was

the HIH

collapse in Australia, which threatened to bring the construc-

tion industry to a halt because of lack of required insurance coverage. H

owever this w

as rectified quickly. Similarly only one recent case of a

significant liquidity sourced insurer failure is known. Th

is was C

onfed-eration Life in Canada, w

hich was siphoning its liquid assets to leasing

and property subsidiaries. Most insurers fail because of insolvency,

although reduced cash significant flows are often a sign that problem

s are brew

ing for non-life insurers.M

icroinsurance for the poor and informal sectors is still at an early

stage of development but has considerable potential, both in the credit

related sense through MFIs and for social safety net purposes through

mutuals and com

munity based organizations.

A rough rule of thum

b is that the minim

um sam

ple size (in terms of

number of claim

s) to develop a pure premium

for a given rating cell (that is, a collective satisfying a given set of risk characteristics such a m

otor vehicle power, age of driver, and so forth) is 1,000. A

ssuming

a claims frequency of 10 percent this m

eans one rating cell needs 10,000 policyholders. Th

us many insurers in developing, transition

and industrial countries are too small to be statistically effi

cient. They

are able to operate because reinsurance is able to remove the poten-

tial extreme results of their risk portfolios. Essentially these sm

all insurers are ‘fronts’ for international reinsurers and the European reinsurers in particular have a long history of providing technical support to set up such entities. O

perating scale and scope can also be im

portant but studies carried out to date indicate that there is an optim

um level beyond w

hich complexity and loss of local know

ledge begin to reduce effi

ciency. From

a supervisory point of view a large num

ber of insurers is undesirable given the lim

ited resources typically allocated by govern-m

ents to the non bank sectors and the possibility of excess competition

arising from a breakdow

n in signaling mechanism

s. This is relevant to

the insurance sector because of the opacity of pricing and a consequent inherent tendency tow

ards pyramidal structures.

Several significant jurisdictions (Nigeria and Russia are tw

o recent exam

ples) have increased minim

um required capital to force consoli-

dation of overly fragmented insurance sectors and to help develop local

champions. Som

e major countries opening up to foreign players (for

example, China and India) have set very high initial capital require-

ments to filter out all but the m

ajor global insurers and to support heavy initial capital needs (figure 3). It is now

almost universally

required that life and non-life insurance be written through separately

licensed companies and as a rule the m

inimum

capital requirements

are greater for life insurers (and for reinsurers).

Financial insurance includes such lines as mortgage lenders’ insur-

ance, which typically covers default risk on higher levels of LTV

ratios (particularly if secondary m

ortgage markets have form

ed), debenture guarantee insurance (w

hich supports debenture credit ratings), project finance insurance (covering large long term

projects dependent on supplier or end user financing), retail consum

er credit insurance and fiduciary insurance (w

hich covers the dishonest behavior of company

officers handling financial transactions and is know

n as bankers blanket bonds for banks). It can be argued that, like reinsurers, credit insurers are centers of specialized underw

riting and risk managem

ent expertise, able to support a w

ider range of originators. How

ever it also needs to be recognized that credit related risks have parallels w

ith catastrophe reinsurance as the law

of large numbers tends to be irrel-

evant within a given jurisdiction w

hen such insurance is really needed (that is, arising from

some com

bination of systemic events such as high

interest rates and high unemploym

ent). In industrial and some transi-

tion countries credit risks typically have to be written through special-

ized ‘insurers’ called monolines w

ith heavy capitalizations reflecting the 400 to 600 percent loss ratios that they can experience every decade or so. W

here countries already have financial insurers or are contem-

plating them the norm

al advice is to have a separate specialized section of the law, to require that they are segregated from

other lines of busi-ness (preferably in a separate licensed entity) and are appropriately capitalized w

ith adequate reinsurance. Aside from

the highly differen-tiated capital needs the argum

ent for segregating monolines revolves

around their unique nature—effectively a lim

itless downside and an

upside constrained by competition and regulation and, possibly, a tight

linkage to the rating of capital market instrum

ents. In these situations a clean structure able to raise capital quickly and be assessed by the credit rating agencies in a w

ay that is meaningful for investors is essential.

There is strong pressure on transition countries to open up their local

insurance sectors to international competition, even if this only m

eans the ability to establish a local subsidiary or joint venture. Th

is pressure com

es from various sources, although the W

TO (G

ATS) negotiations tend to be the m

ost comm

on factor mentioned. A

number of countries

have agreed to open up their insurance sectors, sometim

es as a trade off for enhanced physical goods access to developed m

arkets or to deflect attention from

the banking sector. Unfortunately because the insurance

sector is small the liberalization is often hurried and poorly thought

through, with foreign insurers cherry picking the m

iddle class (if there is one) and little or no technology transfer occurring. Critical steps required before an insurance m

arket is opened up include strength-ening the regulatory regim

e and raising the capacity of the supervi-sory entity, developing necessary local skills and standards (accounting, auditing actuarial) and privatizing, or at least corporatizing any govern-m

ent owned or controlled insurers. It m

ay also be necessary to first put m

andatory insurance classes such as motor third party liability onto a

sound financial and operational basis.

While it is tem

pting to apply a one size fits all approach to supervi-sory coordination, experience to date show

s that every country is different and a degree of caution is needed before m

aking any substan-tive recom

mendations. In sm

aller countries there has often been a bias tow

ards moving all financial sector supervision under the central

bank—and w

here this has happened results have generally been encouraging. H

owever central banks often decline the opportunity and

at this point it is better not to be specific about options. While the need

for greater coordination should naturally emerge from

any reasonably thorough assessm

ent using some or all of the IA

IS ICPs the safest route is to form

a joint working group to look at needs and options and to

then develop a detailed plan—possibly w

ith technical support.

Many developing and transition countries are subject to severe natural

catastrophe risk. How

ever the poor development of local insurance

markets can lim

it opportunities to transfer risk because of limited or

even negligible penetration into the household and SME sectors. In

addition there is a certain size of direct insurer below w

hich interna-tional insurers cannot justify any support for transaction cost reasons. A

number of structures and products have been developed by the

World Bank and other developm

ent organizations to fill this lacuna.

Insurance accounting needs to be on an accrual basis of meaningful

information is to be generated. Th

is means that the unearned portion

of premium

s as at the accounting date need to be reserved together w

ith the present value of future claims obligations. Th

is latter amount

can be simply an addition of claim

s outstanding in claims files, w

ith a m

echanistic adjustment for claim

s incurred but not reported, or very com

plex calculations based on models in the case of long term

life insurance and classes of non-life insurance w

here claims take a

long time to stabilize and settle (such as for exam

ple a quadriplegia w

orkman’s com

pensation claim). Revenues need to reflect changes in

unearned premium

s, and claims costs changes in claim

s reserves and provisions. A

module on insurance accrual accounting appears later in

this series.

Historically the reserving process has been controlled by actuaries,

who tend to build in substantial safety m

argins. In addition assets were

held at the lower of book or m

arket, building in further safety margins.

How

ever accounting doctrine now requires that reported profits are a

good representation of reality and that surplus distribution to policy-holders and ow

ners is equitable over time. Th

is has led to a require-m

ent that assets are held at ‘fair’ value (that is, market for listed assets)

under international accounting standards. The valuation of liabilities

is also conceptually to be at ‘fair value’ but as no effective market in

insurance liabilities exists the meaning of this concept rem

ains unclear. Th

e core insurance accounting standard (IFRS4 – Insurance contracts) is currently in an half w

ay house and its final version will probably

remain unresolved until 2012 at earliest. In the interim

Solvency II, the EU

approach to prudential controls of the insurance sector, will require

that reserves and provisions have some resilience but that m

ost of the balance sheet risk is carried by capital.

Insurance information system

s are critical for both general accounting and statutory reporting purposes, and for effective m

anagement of insurers (and pricing in particular). In recent decades

there has been a move tow

ards relational databases so that analysis of em

erging experience can be carried out along a number of vectors.

The use of increasingly sophisticated analytical techniques such as

generalized linear models has also put increasing pressure on data

granularity and accessibility. Countering this has been a dependence

on legacy systems, particularly by life (long-term

) insurers that have sold a w

ide range of product types over the years. The role of legacy

systems has been a constraint on rationalization of life insurance

sectors, although some acquirers sim

ply put the relevant business into run off. Run off has in fact becom

e a profitable business in some juris-

dictions with supporting legislation.

Many IS firm

s now offer insurance system

s and this has become less

of a competitive factor over tim

e.

Insurance companies can conceptually be taxed on the sam

e basis as any other com

mercial enterprise. Th

at is on declared profits and at the corporate tax rate. For non-life insurance this is in fact the norm

al approach, although a num

ber of countries will only allow

for case esti-m

ates in setting claims provisions, rather than also allow

ing for incurred but not reported claim

s. This reflects a desire to be able to audit the tax

accounts and to minim

ize scope for creative tax accounting.

For life insurance the position is much m

ore complex as reserving

offers substantial scope for creativity and there is the additional compli-

cation of how the policyholders’ equity in em

erging surplus (profits) should be allocated and taxed. As a rule of thum

b policyholders are enti-tled to participate in surplus receive 90 percent of the profits em

erging from

the business lines they are supporting. It is not uncomm

on for taxation regim

es in developing markets to tax investm

ent income less

the expenses incurred in generating that income (called the I-E m

ethod) rather than the declared surplus. Th

e investment incom

e arising from

pension related business may be exem

pted from tax. Th

is approach has the advantage of being relatively objective but can result in an unprofit-able insurer being taxed and further weakened.

Insurance intermediation com

es under a range of headings:

Tied agents, w

ho normally represent only one insurer for each

class of insurance.

General agents, w

hich may have agency arrangem

ents with a

number of insurers for a given class, and w

hich employ sub

agents. This category is banned in m

any countries because of the confusion it can cause for consum

ers.

Brokers, who represent the insured and w

ho can deal with any

insurer. Brokers can accept comm

ission from the insurer in m

ost countries and ideally they should be required to disclose this to their client.

Insurers ow

n staff selling from the insurers ow

n premises.

Bancassurance, w

here a bank either acts directly for an insurer or provides space for an insurer’s representative in its retail outlets. Th

is channel has become very successful in such countries as

France and Italy and is being implem

ented in many countries

around the world as high initial costs can be offset by low

er distribution costs in the long run.

Call centers have had m

ixed success but can be very effective for highly specialized m

arkets and when linked w

ith radio and internet advertising. Like bancassurance initial costs can be very high.

O

ther businesses where insurance is ancillary to a m

ain business, such as travel agents.

For non-life insurers distribution and marketing costs typically

range between 10 and 40 percent, depending on the pow

er of the inter-m

ediary networks and the class of business. M

andatory lines typically have a cap placed on com

mission levels, although this has proved to be

difficult to enforce in som

e countries.For life insurance, m

arketing and distribution is typically 70 percent of the total annual costs. For agency based system

s the costs of putting a new

policy on the books is typically more than the prem

iums

received in the first year (the so called new business strain) and is

recovered from subsequent years’ prem

ia.In m

ost transition and industrial countries insurance agents need to be at least registered and there is an increasing trend to require a level of training com

mensurate w

ith the complexity of the product being

sold. The European U

nion now has a directive covering insurance

intermediaries. Th

is topic is covered in greater detail in a later module.

Arena, M

arco. 2006. “Does Insurance M

arket Activity Promote

Economic G

rowth?” W

orld Bank Policy Research Working

Paper, No. 4098, W

orld Bank, Washington. D

.C.

Brainard, Lael. 2008. “What is the role of insurance in econom

ic devel-opm

ent?” Zurich: Zurich Insurance Group.

Impavido, G

regorio, Alberto R. M

usalem, and Th

ierry Tressel. 2003. “Th

e Impact of C

ontractual Savings Institutions.” World Bank

Policy Research Working Paper, N

o. 2948, World Bank, W

ash-ington. D

.C.

Liedtke, Patrick M. 2007. “W

hat’s Insurance to a Modern Econom

y?” Th

e Geneva Papers on Risk and Insurance Issues and Practice 32 (2): 211-221.

OECD

(Organisation for Econom

ic Co-operation and D

evelopment).

2003. Institutional Investors—Statistical Yearbook, 1992–2001.

Paris: OECD

.

Stewart Econom

ics, Inc. 2003. Managing Insurery Insolvency

2003—Updating the 1988 Report. W

ashington, D.C.: N

ational A

ssociation of Insurance Brokers.

Swiss Re. 2007. Sigm

a No 4/2007.

UN

CTAD

(United N

ations Conference on Trade and D

evelopment).

2005. Trade and Developm

ent Aspects of Insurance Services and Regulatory Fram

eworks: UN

CTAD/D

ITC/TNCD

/2005/7. G

eneva: UN

CTAD

.

Webb, Ian. 2006. Assessm

ent on how strengthening the insurance industry in developing countries contributes to econom

ic growth.

Washington, D

.C.: USA

ID.