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Role of Insurance in Economic Development Term Paper

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Updated: Sep 8th, 2021

Introduction

Studies have proved that countries with well-developed financial systems have achieved faster and more stable long-term economic growth. Well-developed financial markets have a significant potential impact on the total productivity of the country which later gets transformed into economic growth. The importance of the insurance sector in the economic development of the country is being increasingly felt, due to the continued increase in the contribution of the insurance sector to the overall financial sector. The parallel and rapid growth of total insurance premiums and total bank assets about the GDP growth has improved the potential for economic development for both developed and developing nations. The insurance companies together with the other mutual and pension funds represent the largest institutional investors in the stock and real estate markets. The potential impact of the insurance sector on economic development is likely to grow further because of the issues like an aging population and widening disparity of income. Globalization also adds up the strength of the insurance sector in this respect. With this background, this paper analyses the role of insurance in the economic development of any country.

Importance of the Insurance Sector

Rule (2001) identifies that the growing relationship between the insurance sector and the other financial sector signifies the possible role of insurance in the overall economic growth of any country. This is evident from the fact that the insurance companies have increasingly been entering into the financial sector activities by involving themselves in credit default swaps and other risk pass-through vehicles. It may be noted that these activities were primarily remained as belonging to banks and capital markets. The insurance sector can be considered similar to the banks and capital markets, as they happen to serve the needs of the business units as well as the private individuals in the function of financial intermediation. The availability of insurance enhances the confidence of the business participants and as a result, they tend to accept aggravated business risks which lead to the development and stability of the economy.

The insurance companies must accept and pay claims and for this purpose, they have to create a reserve and other funds. This helps to create and improve internal cash flows. These cash generations when invested in the capital market results in the creation of more assets and hence contribute to the economic growth of the nation.

Insurance as the Channel of Growth

The primary role of the insurance sector in any economy is to convert the potential savings of the public into investment projects. In this respect, the role of insurance can be considered important in channelizing resources. According to Rousseau and Wachtel (2001), the important functions of the financial sector in an economy include:

  • Improving the allocation of resources by a continued screening of the fund seekers and monitoring the recipients of funds
  • Continued mobilization of potential savings of the public
  • Attempting to lower the cost of capital through economies of scale and sector specialization and
  • Improving risk management and liquidity of funds

The role of insurance companies in the above functions is quite significant and hence it can be considered that the insurance sector contributes most to the economic growth.

Risk Transfer

The major function of the insurance sector in respect of its clients is risk transfer. The insured is expected to pay a premium and against which a specific uncertainty concerning his business or person is secured. Thus by reducing uncertainty and volatility the insurance companies perform the function of smoothening the economic cycle and reduce the impact of economic crises on the micro levels of the economy which is very much important for the balanced growth of any economy.

The underlying principle of the working of the insurance sector is that there is always the demand for protection against losses of property caused by a natural disaster, crime, violence, and accidents, etc. The indemnification of losses business the insurance companies greatly facilitates the risk-free purchase, possession, and sale or alienation of the properties. Hence the assured safety and protection to the properties enlarges the scope for increased trade, transportation, and capital lending and this also makes many industrial and trade sectors heavily reliant on the insurance sector. While assuring the individuals to invest in movable and immovable properties, by relieving their fear and increases the national consumption, insurance also facilitates the companies to guard themselves against the risks accruing from the business activities like collection of receivables, equipment breakdown, risks of transportation, and all other risks against loss of property. This greatly enhances the possibilities of potential business growth and thereby leads to the development of the economy as a whole.

However, there exists one negative aspect of the risk transfer in which the policyholder tends to change his behavior due to insurance coverage. Since risk transfer not only enables the insured to cover his losses in the case of the happening of an insured event but also dispenses him from taking such precautionary steps as may be necessary to prevent the occurrence of the secured event. “A survey about the influence of workers compensation insurance by Butler, Gardner, and Gardner (1998) shows that due to the beneficial insurance coverage productivity is lower, the number of severe injuries is higher, and the periods of illness are longer than in companies not offering this benefit.” Butler, Gardner, and Gardner (1998)

Saving Substitution

Insurance offers an additional source of potential investments for the customer to diversify the portfolio or to substitute the investments. Since there is a possibility for indemnification of losses is assured by the insurance, the companies and individuals reduce their dependence on the savings with precautionary measures. However, the magnitude by which the investments are substituted depends on the mode of financing the premiums. Insurance premiums may represent an additional flow of money into the financial market which involves no substitution. It may also be a shift from one intermediary asset like withdrawal from the bank account to insurance income or assets. Thus the insurance services can lead to increased consumption of the household and as a result, there could be an increase in the market consumption which in turn results in improved market efficiency.

Life insurance forms the basis for and is closely associated with the ‘saving substitution effect’ of insurance. Life insurance companies gained additional importance and reduced the market share of the banks by diverting more of the intermediate savings towards the insurance premium. (Van den Berghe, 1999 or Allen & Santomero, 1999) So the insurance companies focus their efforts on gaining more market share from other market competitors.

Investment and Insurance Assets

As a financial intermediary the insurance company collects premiums from many policyholders and through the premiums collected help the unfortunates who incur losses by indemnifying them against losses. The insurance companies have to manage the premiums collected professionally to ensure that the company does not suffer from liquidity bottlenecks. The liquidity of funds will be enhanced because the receipt of the premiums and the payment of the insurance claims are mutually independent and temporary phenomena. A sudden occurrence of a secured event can result in an increased demand for financial coverage. The insurance companies have to cover the depreciation in their reserves by carefully managed investments with yields that offset the depletion of the reserves through payment of claims. The reserve depletion can be neutralized by the capabilities of the insurance companies to invest their funds prudently so that the returns from the investments are maximized by their investment activities performed in the capital markets. Hence the insurance companies become the major investors within an economy and their enhanced activities in the capital markets stimulate economic growth. The kind and nature of investments undertaken by the insurance companies influence the overall performance of the insurance companies and the resultant changes in the pace of economic development.

The insurance companies can activate their investment activities in two different ways; one by acting as a fund manager promoting investments that prevent the devaluation of the insurance assets and thus maintaining a comfortable balance between the premiums they collect and the claims they settle. The profits for the insurance companies may be represented as a percentage of the premiums collected. The second way is that the insurance companies may become a venture selling titles of compensation on the happening of a certain incident which is covered.

Hence the vital contribution from the insurance companies to the growth of the GDP is derived from the insurance assets, their utilization in the financial markets through the kinds of investments the insurance companies do, the location and maturity of their investments, and finally by the efficiency of the company to widen the gap between the premiums they collect and the claims they pay off.

Institutional Aspects

Raikes (196) identifies that the growth of the insurance sector is dependent on the growth of the banking sector and such growth is more than facilitated by the economic reforms in the form of liberalizations, privatizations, and financial consolidations. The capital market activities undertaken resemble those of banks especially with the increased activities of the life insurance companies in the capital markets on the investment front. With the result that there has been an increased merger and acquisition activity in banking and insurance sector which reached Euro 950 billion for the period from 1990 to 2003. With the increase in the merger and acquisition activities, the economies of scale of the financial institutions within the country improves which ultimately results in the economic growth of the nation.

Credit Derivatives

The insurance companies of late are taking a more active part in the international capital markets. (IMF 2002) This increased interest is not only the result of their investment activities but also is largely influenced by the recent economic reforms in the form of liberalizations and privatization moves. The insurance companies are also showing great interest in credit insurance which has been recognized as a well-established means of transferring credit risks. It has been observed that in the recent past there has been a tremendous transfer of credit risks across the financial system through enhanced operations in the credit derivatives market. (Rule, 2001; Stulz, 2004)

Conclusion

As a result of globalization, there has been around increase in the activities of all the sectors of the economy, especially in the insurance sector that deals with individual and corporate business risks. This has necessitated the insurance companies to take an active role in the investment activities in the capital market which has a direct and positive impact on the development of the economy.

References

  1. Allen, Franklin / Santomero, Anthony, M., 1999, What do Financial Intermediaries do?, The Wharton School, University of Pennyslvania.
  2. Butler, R. J. / Gardner, B. D. / Gardner, H. H., 1998, More than cost shifting: Moral hazard lowers productivity, Journal of Risk and Insurance, 67(1): 73-90.
  3. IMF, June 2002, Global Financial Stability Report, World Economic and Financial Surveys.
  4. Raikes, David, 1996, Bancassurance: European Approaches to capital adequacy, Financial Stability Review No. 1, Bank of England.
  5. Rousseau, P., L., / Wachtel, P., 2001, Inflation, Financial Development and Growth, in Negishi, R. et al. (eds.), Economic Theory, Dynamics and Markets: Essays in the Honor of Ryuzo Sato, Deventer: Kluwer
  6. Rule, David, 2001, No. 11: 127-159. Web.
  7. Stulz, Rene, 2004, Should we fear derivatives?, Journal of Economic Perspectives 18, 173-192.
  8. Van den Berghe, L. A. A., 1999, Convergence In the Financial Services Industry, published in Insurance And Private Pensions Compendium For Emerging Economies, Book 1, Part 1:5a, Insurance and Private Pensions Unit, OECD, 2001, 173-285.
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