Economics of Insurance

  7 min 52 sec to read
Economics of Insurance

Efficient insurance markets are essential for countries that are going through transitional phases like Nepal to integrate into the global economy.


Insurance is familiar to the general people of insurance of car, buildings and contents and life insurance.  Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Thus, insurance is an equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be taken as a guaranteed compensation of a probable small loss and minimising a large, possibly devastating loss. 

Similarly, insurance is a co-operative device of distributing losses, falling on an individual or his/her family, over a large number of persons, each bearing a nominal expenditure and feeling secure against heavy loss. According to this school of thought, insurance is a social device to accumulate funds to meet the uncertain losses arising through a certain risk to an individual who is insured against the risk.

How Insurance Functions 
In insurance business, each person/household (policy owner) pays a premium to transfer 'catastrophic risks' to an insurer. The insurer (insurance company) calculates the premiums according to actuarial techniques using statistical data in such a way that on average the insurer makes a profit, even though it will have to pay out possible claims.  The principle is based upon the insurer spreading its risk over many different clients, some of them will sustain losses and make claims, but most of them will not. In this regard, insurance has been introduced to safeguard the interest of people from uncertainty by providing certainty of payment at a given contingency. 

Economic Value of Insurance 
For the economic growth of the country, insurance provides a strong platform to protect against loss of property and system to accumulate adequate capital for investment. A strong and healthy insurance sector is of utmost importance for all groups and sectors 
of an economy. 

Health, life and motor third party liability insurance enable private households to obtain a higher quality of life by satisfying their desire for security and for a guaranteed income level. Similarly, transport, product liability and property insurance promote entrepreneurial activities and commerce. Insurances against premature death or disability in part substitute governmental social spending and save government resources for other essential social purposes. 

Life insurance promotes the development of capital markets and the financial sector as a whole by creating a demand for long-term financial assets. Consequently, insurance should not be seen as a luxury good, but as a necessary condition for sustainable economic growth in any country. 

Insurance has become a significant economic force in most industrialised countries. Insurance market activities contribute to economic growth, both as a financial intermediary and provider of risk transfer and indemnification by allowing different risks to be managed more efficiently, and by mobilising domestic savings. 

Employees buy insurance packages to cover their work related injuries and health problems. Businesses also insure their property, including technology used in production, against damage and theft. Because, it makes business operations safer, insurance encourages business to make economic transactions, which benefits the economy. 

Insurance companies also have a role in the redistribution of money. They collect premiums and eventually redistribute the money as payment of the claims. Depending on the type of insurance redistribution can take anywhere from a few months to decades. Because of this delay between collecting and paying out funds, insurance companies invest their funds to bring extra revenues. Such investments help business and government to finance their operations and generate profits from those investments.

Social Value of Insurance
Insurance has a long and distinguished history. The UK has played its part in the insurance story, from as far back as the reaction to the Great Fire of London in 1666 and the development of insurance trading in Edward Lloyd's coffee shop in 1688. Since then it has been an essential part of everyday life, playing a crucial role in both economic development as well as having a role in supporting wider societal ends.

Though insurance products are provided in a commercial context, both for individuals and for corporate customers, they clearly serve a wider social purpose. Insurance helps to oil the engine of economy, for example, in underwriting trade through trade credit. It also provides peace of mind to the public through collective insurance for a host of perils including flood, fire, and health. In short, the economy and society as a whole benefits from the certainty insurance brings through the following ways: 
•    Efficiently protecting the public through innovative risk management techniques.
•    Freeing up businesses and professionals from everyday risks and encouraging innovation and competition.
•    Relieving the burden from the state and providing comfort to individuals by providing safe, effective and affordable pension savings, protection and diversified products that convert pension savings into retirement income.

Importance of Insurance in Nepal
Insurance benefits society by allowing individuals to share the risks faced by many people. It also serves many other important economic and societal functions. Insurance also provides the capital that the developing countries need to make large volumes of investment to accelerate the overall economic development. 

Efficient insurance markets are essential for countries that are going through transitional phases like Nepal to integrate into the global economy and achieve sustainable as well as strong economic growth. In this connection, insurance can play an active role for the economic development of Nepal in the following ways: 

• Risk Transfer Role
One of insurance's key roles is safeguarding the financial health of small and medium-sized enterprises. In addition to the protection provided by social security systems, private insurance cover is crucial for people to insure themselves against inability to work, set aside money for retirement or protect themselves against the loss of their assets. This is where insurance comes in as a key component in ensuring the healthy development of small and medium-sized enterprises - a fact which is of paramount importance to a country's economic stability. 

A vibrant insurance sector is also important in encouraging domestic production, innovation and trade. Insurance reduces the investment risk faced by companies and the state. This is especially important in emerging markets, as a shortage of capital is one of the major disincentives to investment. By reducing investment risk, insurance can also encourage companies to think more long-term and increase their risk tolerance. 

• Information Role
Insurance plays an additional role in the economy: that of providing information. The level of insurance premiums provides an indication of existing risks and of how probable it is that a loss will occur. This helps companies make a comparison of the risk/return profiles of projects, thereby ensuring that the available resources are put to the best possible use. 

This is highly important in a country (Nepal) with an infrastructure gap and striving to graduate from LDC status to the status of a developing country. To infrastructure investments: if it weren't for insurance, a lot of infrastructure projects - such as power plants, railways or airports would not have been financially feasible. Insurance companies also offer consultancy services, advising on how to improve safety standards and a product's quality.

• Capital Market Role
As institutional investors, insurance companies contribute to the development as well as functioning of a capital market. Insurance companies receive premiums and set them aside as provisions for the payment of future claims. They proceed to invest them in the capital market, which gives them the status of major investors. 

The End Note
From a macro-economic point of view, the insurance market could help to mobilise national savings and narrow the investment gap of developing economies. In emerging markets, domestic savings have not been fully mobilised despite huge funding needs arising from infrastructure projects. Insurance companies as important long-term institutional investors, therefore functioning as financial intermediaries, contribute to bringing together savers and borrowers. Life insurance, in particular, can make savings available – although life insurers are themselves dependent on a functioning capital market if they are to measure up to their role in the area of risk transfer. 

The writer is the Director of the Confederation of Nepalese Industries.

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