Post on 24-Feb-2023
Contents
Introduction...................................................
Risk and Insurance.............................................
Types of Risks.................................................
Methods of Handling Risk.......................................
Benefits of Insurance..........................................
Market Imperfections...........................................
Imperfections in Insurance Market..............................
Market Power...................................................
Demand for Insurance..........................................
Supply for Insurance..........................................
Pricing of Insurance..........................................
Benefits and Costs of Insurance...............................
Factors Affecting Insurance Consumption.......................
Conclusion....................................................
Bibliography..................................................
IntroductionInsurance is an arrangement by which a company or the state
undertakes to provide a guarantee of compensation for
specified loss, damage, illness, or death in return for
payment of a specified premium. It is the equitable transfer
of the risk of a loss, from one entity to another in exchange
for payment. It is a form of risk management primarily used
to hedge against the risk of a contingent, uncertain loss.
Risk arises out of uncertainty. If a person is able to
identify his/her loss then there cannot be any risk and
insurance without any risk is null and void. Insurance is the
tool for risk management. Economics underpins all business
activities, with insurance business being no exception.
Economics plays a pivotal role in operating and regulating the
insurance business. Therefore it is very important to
understand the economic environment that shapes the insurance
sector.
Any risk that can be quantified can potentially be insured.
Specific kinds of risk that may give rise to claims are known
as perils. An insurance policy will set out in detail which
perils are covered by the policy and which are not. Below are
non-exhaustive lists of the many different types of insurance
that exist. A single policy may cover risks in one or more of
the categories set out below. For example, vehicle
insurance would typically cover both the property risk (theft
or damage to the vehicle) and the liability risk (legal claims
arising from an accident). A home insurance policy in the
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United States typically includes coverage for damage to the
home and the owner's belongings, certain legal claims against
the owner, and even a small amount of coverage for medical
expenses of guests who are injured on the owner's property.
Business insurance can take a number of different forms, such
as the various kinds of professional liability insurance, also
called professional indemnity (PI), which are discussed below
under that name; and the business owner's policy (BOP), which
packages into one policy many of the kinds of coverage that a
business owner needs, in a way analogous to how homeowners'
insurance packages the coverage that a homeowner needs.
Risk and InsuranceInsurance is basically a form of risk management primarily
undergone for hedging the risk of a contingent loss in the
near future. The probability of risk can be hedged by
undergoing into some insurance. It is defined as the equitable
transfer of risk of loss from one entity to another in
exchange for a premium. Premium is an amount paid periodically
to the insurer by the insured for covering his risk. For
taking this risk, the insurer charges an amount called the
premium. The premium is a function of a number of variables
like age, type of employment, medical conditions, etc. The
actuaries are entrusted with the responsibility of2 | P a g e
ascertaining the correct premium of an insured. The premium
paying frequency can be different. It can be paid in monthly,
quarterly, semiannually, annually or in a single premium. The
company that sells the insurance policy is termed as the
insurer.
The primary function of insurance is risk spreading. It is a
co-operative device to spread the loss caused by a particular
risk over a number of persons who are exposed to it and who
agree to ensure themselves against that risk.
Risk arises out of uncertainty. There may be possibilities of
an outcome being different from that of the expected. A risk
and uncertainty are two different concepts. Risk is
essentially the level of possibility that an action or
activity will lead to lead to a loss or to an undesired
outcome. The risk may even pay off and not lead to a loss, it
may lead to a gain. Uncertainty, on the other hand, is
unpredictable. It has too many unknown variables which do not
even allow one to estimate as to what is going to happen. Risk
is insurable, while uncertainty is not. Risks become insurable
when past data makes it possible to predict or draw inference
of what will happen in the future, which is important to
future. These techniques are based around the probability
theory and the law of large numbers.
Types of RisksWith regards insurability, there are basically two categories
of risks;
Dynamic Risk
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Speculative (dynamic) risk is a situation in which either
profit or loss is possible. Examples of speculative risks
are betting on a horse race, investing in stocks/bonds and
real estate. In the business level, in the daily conduct
of its affairs, every business establishment
faces decisions that entail an element of risk. The
decision to venture into a new market, purchase new
equipment, diversify on the existing product line, expand
or contract areas of operations, commit more to
advertising, borrow additional capital, etc., carry risks
inherent to the business. Speculative risk is not
insurable.
Pure or Static Risk:
The second category of risk is known as pure or static
risk. Pure (static) risk is a situation in which there are
only the possibilities of loss or no loss, as oppose to
loss or profit with speculative risk. The only outcome of
pure risks are adverse (in a loss) or neutral (with no
loss), never beneficial. Examples of pure risks include
premature death, occupational disability, catastrophic
medical expenses, and damage to property due to fire,
lightning, flood etc.
Methods of Handling Risk1. Risk Avoidance:
A risk management technique whereby risk of loss is
prevented in its entirety by not engaging in activities
that present the risk. For example, a construction firm
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may decide not to take on environmental remediation
projects to avoid the risks associated with this type of
work. Of course, all stocks cannot be avoided. By
avoiding risk, one may be avoiding many opportunities of
life.
2. Risk Distribution:
It implies the spreading of risk over a number of
individuals so that the resultant gain or loss can be
shared among them.
3. Risk Combination:
It is linked to the law of large numbers. Two persons
agreeing to share each other’s’ risk bring no substantial
advantage. Combining individual exposure units in large
numbers reduces uncertainty as predictions to the outcome
of pure risks can be made with acceptable accuracy.
4. Risk Transfer:
The most effective way to handle risk is to transfer it
so that the loss is borne by another party. Insurance is
the most common method of transferring risk from an
individual or group to an insurance company. There is no
reduction in risk, but it will transfer the risk from the
insured to the insurer.
5. Hedging:
Hedging implies making an investment to reduce the risk
of adverse price movements in an asset. Normally, a hedge
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consists of taking an offsetting position in a related
security, such as a futures contract.
6. Self- Insurance:
It is the handling of the unavoidable risk internally by
creating funds, out of which the losses will eventually
be met.
Benefits of InsuranceInsurance is another major method that most people,
businesses, and other organizations can use to transfer pure
risks by paying a premium to an insurance company in exchange
for a payment of a possible large loss. By using the law of
large numbers, an insurance company can estimate quiet
reliably the amount of loss for a given number of customers
within a specific time. An insurance company can pay for
losses because it pools and invests the premiums of many
subscribers to pay the few who will suffer significant losses.
Speculative risks are not insurable. Major benefits of
insurance as stated by Life Insurance Council are-
Risk Cover:
Life today is full of uncertainties; in this scenario
Life Insurance ensures that your loved ones continue to
enjoy a good quality of life against any unforeseen
event.
Planning for life stage needs:
Life Insurance not only provides for financial support
in the event of untimely death but also acts as a long
term investment. You can meet your goals, be it your
children's education, their marriage, building your dream
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home or planning a relaxed retired life, according to
your life stage and risk appetite. Traditional life
insurance policies i.e. traditional endowment plans,
offer in-built guarantees and defined maturity benefits
through variety of product options such as Money Back,
Guaranteed Cash Values, Guaranteed Maturity Values.
Protection against rising health expenses:
Life Insurers through riders or standalone health
insurance plans offer the benefits of protection against
critical diseases and hospitalization expenses. This
benefit has assumed critical importance given the
increasing incidence of lifestyle diseases and escalating
medical costs.
Builds the habit of thrift:
Life Insurance is a long-term contract whereas
policyholder, you have to pay a fixed amount at a defined
periodicity. This builds the habit of long-term savings.
Regular savings over a long period ensures that a decent
corpus is built to meet financial needs at various life
stages.
Safe and profitable long-term investment:
Life Insurance is a highly regulated sector. IRDA, the
regulatory body, through various rules and regulations
ensures that the safety of the policyholder's money is
the primary responsibility of all stakeholders. Life
Insurance being a long-term savings instrument, also
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ensures that the life insurers focus on returns over a
long-term and do not take risky investment decisions for
short term gains.
Assured income through annuities:
Life Insurance is one of the best instruments for
retirement planning. The money saved during the earning
life span is utilized to provide a steady source of
income during the retired phase of life.
Protection plus savings over a long term:
Since traditional policies are viewed both by the
distributors as well as the customers as a long term
commitment; these policies help the policyholders meet
the dual need of protection and long term wealth creation
efficiently.
Growth through dividends:
Traditional policies offer an opportunity to participate
in the economic growth without taking the investment
risk. The investment income is distributed among the
policyholders through annual announcement of
dividends/bonus.
Facility of loans without affecting the policy benefits:
Policyholders have the option of taking loan against the
policy. This helps you meet your unplanned life stage
needs without adversely affecting the benefits of the
policy they have bought.
Tax Benefits:
Insurance plans provide attractive tax-benefits for both
at the time of entry and exit under most of the plans.
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Mortgage Redemption:
Insurance acts as an effective tool to cover mortgages
and loans taken by the policyholders so that, in case of
any unforeseen event, the burden of repayment does not
fall on the bereaved family.
Market ImperfectionsMarket imperfections generally mean any deviations from the
assumptions of perfect competition. Many of the assumptions in
a perfectly competitive model are implicit rather than
explicit. Below is a description of the different types of
imperfections and distortions. Different types of distortions
are- Monopoly, Duopoly and Oligopoly.
Monopoly, Duopoly and Oligopoly:
Perhaps the most straightforward deviation from perfect
competition occurs when there are a relatively small number of
firms operating in an industry. At the extreme, one firm
produces for the entire market, in which case the firm is
referred to as a monopoly. A monopoly has the ability to
affect both its output and the price that prevails in the
market. A. duopoly consists of two firms operating in a
market. An oligopoly represents more than two firms in a
market but less than the many, many firms assumed in a
perfectly competitive market. The key distinction between an
oligopoly and perfect competition is that oligopoly firms have
some degree of influence over the price that prevails in the
market. In other words, each oligopoly firm is large enough,
relative to the size of the market, and changes in its output
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cause a change in the equilibrium price prevalent in the
market.
Another key feature of these imperfectly competitive markets
is that the firms within them make positive economic profits.
The profits, however, are not sufficient to encourage entry of
new firms into the market. In other words, free entry in
response to profit is not allowed. The typical method of
justifying this is by assuming that there are relatively high
fixed costs. High fixed costs in turn imply increasing returns
to scale. Thus, most monopoly and oligopoly models assume some
form of imperfect competition.
Imperfections in Insurance MarketCompetition not only leads to economic efficiency, it provides
an automatic mechanism for fulfilling consumer needs and. for
creating a greater variety of choices. Additionally,
competition compels the insurers to improve their products and
services, thus further benefiting the b conditions are buyers.
The following necessary for a perfectly competitive insurance
market:
1. A sufficiently large number of buyers and sellers
such that no one buyer or seller or group of them
can influence the market.
2. Sellers have freedom of entry into and exit from the
market.
3. Sellers produce identical products.
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4. Buyers and sellers are well informed about the
products.
A market that is workably competitive functions well and
provides most of the benefits of perfect competition. Markets
characterized by workable competition generally have low entry
and exit barriers, numerous buyers and sellers, good
information, governmental transparency, and the absence of
artificial restrictions on competition. The markets for
numerous products satisfy these conditions sufficiently such
that little government intervention is required for the market
to function well. For an insurance market to be workably
competitive, however, rather substantial government
intervention is ordinarily necessary because of the important
imperfections that exist in such markets. Because of these
market imperfections, government intervention into key areas
is required to ensure healthy competition and good
performance.
The existence of imperfections in insurance markets explains
and justifies innumerable insurer practices and operations, as
well as most insurance regulations. Nonetheless, the four
broad categories shown in the following diagram-
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Market PowerThe insurers can also acquire market power under some
circumstances, which per-mits them to limit competition.
Market power is the ability of one or a few sellers (or
buyers) to influence the price of a product or service. Under
the competitive model, sellers and buyers are price takers,
meaning that they are so small compared to their market that
they cannot exercise any meaningful influence over the price
and quantity of a good or service, either individually or
collectively. If some in the market can affect price and
quantity significantly to serve their interests, the
allocation of resources be inefficient. Following are the four
ways in which market power in insurance markets can arise:
1. Barriers to entry or exit
2. Economies of scale or scope
3. Price discrimination
4. Product differentiation
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Market Imperfecti
ons
Market Power
Barriers to
Entry/ExitEconomies
of Scale/Scop
ePrice
Discrimination
Product Differntia
tion
Externalities
Positive
Negative
Information Problems
Asymetric Informatio
nNonexisten
t Informatio
n
Free Rider Problems
Barriers to Entry or Exit:
The suppliers have market power if a market has barriers to
entry or to exit. The governments often put restrictions on
entry or exit for various reasons. There are entry barriers in
all countries in the form of licensing requirements and
minimum capital requirements. But exit barriers are
comparatively exceptional worldwide.
Technically, national licensing requirements are entry
barriers, although they are justified on consumer protection
grounds. Some entry restrictions are appropriate to ensure
that the insurers are financially sound and their owners and
managers are honest and competent. However, some governments
go beyond this legitimate objective and will not grant a new
license unless a market need to do so is established. Other
countries will not grant new licenses under any circumstances
or will require local equity participation. Transparency in
the licensing process is less than desired in many markets due
to the presence of numerous unwritten rules. Reasonable
freedom of entry does not exist in many of the world's
insurance markets. Several countries prohibit or severely
limit the creation of new national insurers, and many erect
substantial entry barriers to foreign insurers, although the
trend is towards more liberal markets.
Economies of Scale or Scope:
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Market power can originate from a firm enjoying economies of
scale or scope. The economies of scale characterize a
production process in which an increase in the scale of the
firm causes a decrease in the long run average cost of each
unit. The economies of scope are conceptually similar to
economies of scale. Whereas the economies of scale primarily
refer to efficiencies associated with supply-side changes,
such as increasing or decreasing the scale of production of a
single product type, the economies of scope refer to
efficiencies primarily associated with demand-side changes,
such as increasing or decreasing the scope of marketing and
distribution of different types of products.
Studies on insurance scale economies generally find increasing
returns to scale for small to moderate size firms, and either
constant, moderately increasing or decreasing returns for
larger firms. Thus, market power because of scale economies
might be minimal in insurance, with no compelling evidence of
a natural monopoly.
Whether an insurer possesses market power from scale or scope
economies depends upon its size relative to its market, rather
than its absolute size. A small firm in a small market may
have market power. A big insurer in an international may have
very little such power.
Price Discrimination:
It occurs when a firm charges different price to different
group of consumers for identical goods or services, for
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reasons not associated with cost. The insurers often attempt
price discrimination, although regulatory requirements may
prevent this strategy. The insurance regulators become
concerned about price discrimination when the insurer's
underlying loss experience or expenses do not justify price
differences on otherwise identical policies.
Product Differentiation:
Distinction/Differentiation in the looks of a product may be
done to make the product more attractive by contrasting its
unique qualities with other competing products. Successful
product differentiation creates a competitive advantage for
the seller, as customers view these products as unique or
superior. If an insurer can differentiate its products from
those of its competitors in the minds of its customers, it
gains market power and can secure higher profits. Product
differentiation exists when buyers prefer one firm's products
to those of its rivals. Product differentiation is good from
the customer point of view also, as it can lead to enhanced
consumer choice and to continuous product improvement. But the
regulators are often concerned if the effect of product
differentiation is to mislead purchasers.
Externalities:
Externalities represent economic actions, which have effects
external to the market in which the action is taken.
Externalities can arise either out of the production processes
(production externalities) or out of the consumption
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activities (consumption externalities). The external effects
can either be beneficial (positive externalities) or
detrimental (negative externalities) to others. Typically
because the external effects occur to someone other than the
producer or consumer. They do not take the effects into
account while making their production or consumption
decisions. Nature of Externalities The conditions described
earlier for a perfectly competitive market presume that all
costs of production are fully included in each firm's costs.
This is not always true. The producers can impose positive and
negative spread out effects on others.
Positive production externalities occur when:
1. Production has a beneficial effect in other markets
in the economy.
2. Consumption has a beneficial effect in other markets
in the economy.
Negative production externalities occur when:
1. Production has a detrimental effect in other markets
in the economy.
2. Consumption has a detrimental effect in other
markets in the economy.
The purely competitive economic model does not accommodate
externalities easily because the prices of goods and services
that carry externalities fail to reflect the true benefits and
costs of such goods and services. The problem lies with
allowing competitive markets to deal freely with goods and
services that carry externalities.
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1. With negative externalities, too many goods or
services will be produced or consumed, the price
will be too low, and too little effort and resources
will be devoted to correcting or reducing the
externality.
2. Conversely, with positive externalities, too few
goods or services will be produced, the price will
be too high, and too little will be devoted to
enhancing the externality.
Externalities and Insurance:
In life and health insurance, both negative and positive
externalities exist. Health insurance related fraud is the
most significant negative externality. Another extreme example
of a negative externality related to life insurance is when a
murder is committed in an effort to collect the death
proceeds.
Positive externalities also exist in insurance. For example,
the insurers h • e very rarely sought protection under
intellectual property law for their product and service
innovations. Consequently, tendency may exist for firms to
engage less in such development than they would otherwise. Free rider problems:
The collectively consumed goods and services that are desired
by the public are called public goods. Public goods have two
defining characteristics - non-rivalry and non-excludability.
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Non-rivalry means that the consumption or use of a good by one
consumer does not diminish the usefulness of the good for
another. Non-excludability means that once the good is
provided, it is exceedingly costly to exclude non-paying
customers from using it. The main problem posed by public
goods is the difficulty of a free market to get people to pay
for them.
Public goods provide a very important example of market
failure, in which market-like behavior of individual gain-
seeking does not produce efficient results. The production of
public goods results in positive externalities, which are not
remunerated. Because no private organization can reap all the
benefits of a public good that they have produced, there will
be insufficient incentives to produce it voluntarily. The
consumers can take advantage of public goods without
contributing sufficiently to their creation. This is called
the free rider problem (because consumer's contributions will
be small but not zero).
Free Rider and Insurance Free rider problems also exist in
insurance. Insurance-related free rider problems arise when
individuals know that if they suffer any losses then there are
others who will make good of such losses. Thus, if an
individual knows that he/she will receive free emergency
medical care, he will have less incentive to purchase any
personal health insurance. The characteristics of a public
good are incorporated in the insurance regulation, thereby
benefiting the individuals and firms even if they pay little
or nothing for it.
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Information problems:
A critically important assumption of the competitive model is
that both buyers and sellers are well informed. Information
problems abound in insurance, and are arguably the industry's
most important market imperfection.
Insurance is a complex business with buyers having superior .r
information to sellers in certain instances (e.g., the buyers
have better be relative risk when they apply for insurance)
and vice versa in others (e.g., the insurer knows more about
its financial condition than does the buyer). Asymmetric
information problems exist when one party to a transaction has
the relevant information that the other does not have.
The nature of the insurance transaction involves a contract
that makes a present promise of the future performance upon
the occurrence of the stipulated events. Individuals and
businesses purchase policies in good faith, relying on the
integrity of the insurance company and its representatives.
Assuming that the insured could be induced to take an interest
in the financial condition of their insurers, few are
sufficiently knowledgeable to do so without any assistance.
Insurance is necessarily a technical and complicated subject,
and the true financial condition of an insurance company can
be determined only by expert examination. Also, some
individuals may have difficulty in understanding the complex19 | P a g e
nature of insurance contracts. These statements are less
applicable for sophisticated buyers, such as large businesses,
than for individuals.
Information problems for insurance customers provide the
rationale for the great majority of insurance regulations. The
insurers and their representatives have little incentive to
disclose adverse information to potential customers. Doing so
hurts sales. The government seeks to rectify the unequal
positions between insurance buyer and seller by mandating
certain disclosures for the insurers, by monitoring the
insurer's financial condition, by regulating the insurer's
marketing practices, and through other means.
Because insurance is a financial future-delivery product tied
closely to public interest, the governments judge this
information imbalance between buyers and sellers to warrant
substantial oversight of the financial condition of the
insurers. The widely accepted view is that the public,
especially poorly informed consumers must be protected. In
many aspects of insurance processes, neither the buyer nor the
seller has complete information because the desired
information simply does not exist. The insurers cannot know
the future. Environmental factors, such as the economy,
inflation, new laws and regulations, and changing consumer
attitudes and preferences, present great uncertainty to both
the insurance buyers and sellers. Asymmetric information and
other factors can lead to principal-agent problems in the
insurance markets. Such problems arise, for instance, when the
policyholders have difficulty in monitoring and controlling
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the behavior of their insurer. The insurer might incur
additional financial risk that is hazardous to its
policyholders' interests or fail to meet its obligations to
the policyholders. If the insurer becomes insolvent or refuses
to pay claims, the policyholders may find it very costly or
impossible to recover funds or force the insurer to fulfill
its obligations. Unequal resources and bargaining power
between the insurer and an individual policyholder can
exacerbate the problem. Because of these problems and other
market imperfections, private insurers will not supply every
type of insurance that the consumers demand. The insurers may
perceive excessive adverse selection or moral hazard problems
or they may be unable to diversify their loss exposures.
Nonexistent Information:
The desired information does not exist in many aspects of the
insurance processes. As a result neither the buyer nor the
seller has complete information. In insurance contracts, both
the insurers and the individuals face uncertainty as it
promises future delivery and the price is set before the cost
of production (claims and expenses). The insurers cannot know
the future. Similarly, individuals cannot have complete
knowledge about the consequences of their present and future
choices. Nonexistent and asymmetric information problems are
also responsible for individuals who are so completely ill-
informed unable to know their own best interests.
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Demand for InsuranceBefore studying in detail about the demand for insurance, it
is better to know about the demand for goods. The quantity
demanded of a good is a function of:
1. Price of the goods
2. Price of the other good
3. Consumer incomes
4. Consumer tastes
These are the only factors that influence demand. The demand
for insurance comes from the need for the financial safety
achieved through risk transfer. An individual by taking an
insurance cover protects his own and his dependent's financial
interests against the losses caused by the occurrence of pure
risks. The determinants of demand are expressed in a short-
hand form below, followed by an initial interpretation.
Dn = f (Pn, Pog, Y, T)
where,
Dn = Demand for any normal product or
service
Pn = Price of the goods
Pog = Price of the other goods
Y = Consumer incomes
T = Consumer tastes
The determinants of demand are applied to insurance.
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There is an inverse relationship between price and demand. As
far as insurance is concerned, it is useful to focus attention
on the utility analysis of choice involving risk (developed by
Friedman and Savage). The consumers vary in their attitude to
risk–risk averters, risk neutrals, and risk preferrers. Risk
aversion is a common human characteristic well evidenced by
the existence of the insurance industry. A risk averter
prefers a certain premium that may exceed loss expectancy to
unknown losses. Persons unprepared to pay premium exceeding
loss expectancy are called risk neutrals. Risk preferrers seek
out risky situations and would gamble by not paying even as
much as for the loss expectancy of an equivalent amount. Also,
as an individual buys more insurance, his security increases,
and there is, thus, diminishing marginal utility from
additional purchases.
The demand varies directly with the price of a substitute. An
increase in return on the bank deposits may result in the
business abandoning the savings-based life assurance. An
increase in price of those substitutes can be expected to
increase the demand for insurance. The price of complements
for insurance is inversely related to the demand for
insurance. For instance, a fall in the price of cars increases
the demand for car insurance. When real income increases, the
demand for insurance will increase because:
1. To protect the increased standard of living there
will be a higher demand for insurance.
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2. Higher levels of income increase the ability to
save, leading to an increased demand for saving-
based life assurance.
3. Higher real incomes are associated with economic
growth, which increases investment in business with
corresponding increase in the demand for insurance.
Tastes and preferences are linked to attitudes ranging from
risk aversion to risk preference. Attitude, according to
Friedman and Savage, could change as wealth increases. A
wealthy person could at certain levels of income become a risk
preferer instead of being an averter.
Price Elasticity of Demand for Insurance:
The prices will affect the elasticity of demand for insurance
as it happens in the case of other products. In the cases of
compulsory classes of insurance, market demand would be
perfectly inelastic. On the other hand, in the cases of non-
com-pulsory classes of insurance, market demand would be more
and more elastic. In reality, as there are no close
substitutes available for insurance, the market demand for
insurance is relatively inelastic. But in case of life
insurance, where it takes a form of savings, there are close
substitutes available. The countries where social insurance is
not available, there may not be any close substitute for life
insurance, particularly for lower and middle-income groups.
Income Elasticity of Demand for Insurance:
In case of increase in incomes, the demand for life insurance
and property insurance will also increase. Demand for more
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consumption and leisure goods will increase the demand for
personal insurances. But in under-developed poor countries,
even increase in income may not increase such demand for
insurance, as they will absorb their additional income in
satisfying their consumption.
Cross-Elasticity of Demand for Insurance:
The changes in demand for insurance are due to changes in the
prices of other goods and services. This cross-elasticity of
demand for insurance will have a negative value, especially in
case of endowment policies where the saving element is more
because a person may invest his savings in highly productive
investments rather than in life insurance. This type of cross-
elasticity affects only the new business and not the existing
business because of the costs involved in transferring the
existing policies or surrendering them. This cross-elasticity
may not affect as far as the general insurance business is
concerned. The Government also influences the demand for
insurance. Taxation, inflation, compulsory insurance, and
regulatory changes are the various means through which the
Government practices its influence on the demand for
insurance.
Supply for InsuranceBefore studying in detail about the supply for insurance, it
is better to know about the supply for goods. The quantity
supplied of a good is a function of:
1. Price of the goods
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2. The (opportunity) cost of resources needed to
produce the goods
3. The technology available to produce the goods
These are the main factors that influence supply. But there
are some other determinants of supply, such as government laws
and prices of other goods. The determinants of supply are
expressed in a short-hand form below, followed by an initial
interpretation.
Sn = f (Pn, Fc, Th)
where, Sn = Supply for any or service
Pn = Price of the goods
Fc = Cost
Th = Technology
The determinants of supply are applied to insurance.
Being a labour-intensive industry, an insurance company is in
a privileged position to enjoy the very low level of fixed
costs. The variable costs vary in proportion to the actual
business undertaken. Therefore, the insurer may be able to
reach at a break-even point at quiet a lower level so that
beyond this level the business tenders maximum profits. The
break-even point indicates that at a particular level of the
business, the total costs are equal to the total revenue. In
case of capital-intensive industry, this break-even point will
be at a substantially higher level, as compared to a labour-
intensive industry, due to the high level of fixed costs. In
the case of insurance business, uncertainty of the insurer's
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costs arises, as claims are the biggest single component of
total costs. The uncertainty faced by an insurer can minimize
by means of reinsurance, combining large numbers, selectivity
in underwriting, and effective claims handling. The insurance
market is such that it offers more incentives to the new
entrant. The insurance industry has to come up with different
plans of insurance to cater to different sections of the
people so as to meet their widely differing requirements.
Pricing of InsuranceIn industry, generally, price is determined through the
interaction of supply and demand. The insurance industry is
not perfectly competitive, therefore, price is not determined
by the interaction of supply and demand. Insurance premium is
the price for the insurance service. Premium is the monetary
consideration payable by the insured to the insurer for the
insurance granted under the policy.
Premium = Risk Premium + Expenses + Fluctuations Loading +
Profit
1. Risk Premium:
It is the product of probability of the event and average
loss expectancy.
2. Expenses:
Costs can be broken down into average fixed and average
variable costs. Claims, a significant cost, are included
in average variable costs and, therefore, in risk
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premium. Other variable costs include commission, which
is collected by the insurer as an integral part of the
premium and paid to the intermediary. Fixed costs are
allocated when direct, i.e., the result of the resources
used entirely in the supply of a particular class of
insurance.
3. Fluctuations Loading:
A reasonable provision must be made for fluctuations in
both experience and contingencies.
4. Profit:
A reasonable provision must be made for a margin for
profit. The amount depends on the business objectives,
extent of competition, and perhaps, effect on investment
income as well as demand. Non-price competition is one of
the features in insurance. It is the competition among
industries that choose to differentiate their products
through non-price means such as service quality, physical
evidence and celebrity endorsement. Product
differentiation, sales promotion and advertising, and
special schemes for selected groups are the examples.
Benefits and Costs of InsuranceEconomic and Social Benefits of Insurance:
Following are the major economic and social benefits of
insurance:
1. Indemnity for loss
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2. Less worries and fear
3. Source of investment funds
4. Loss prevention
5. Enhancement of credit
Indemnification for Loss:
As the principle of indemnity is applicable to insurance,
therefore, families and individuals are restored to their
earlier financial position after a loss occurs.
Indemnification provides financial security to families and
business firms, and hence is the most important benefit of
insurance.
Less Worries and Fear:
Insurance helps to reduce the worry and fear before and after
a loss. If insurance is there, the family feels secured and
enjoys greater peace of mind as they know that they are
covered in case any loss occurs and worry less after a loss
occurs as the insurer will pay for the loss.
Source of Investment Funds:
Insurance companies are collecting premium in advance and
funds, which are not immediately needed, are invested in
various sectors of a society such as hospitals and housing
development. These investments help to promote economic growth
and full employment.
Loss Prevention:
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Insurance companies that provide social and economic benefits
implement various loss prevention programmes.
Enhancement of Credit:
Insurance increases a person's credit risk as it provides a
guaranteed assurance that the loan will be repaid. The
financial institution as a col-lateral security accepts
insurance.
Costs of Insurance:
Following are the major social costs of insurance:
1. Cost of doing business
2. Fraudulent claims
3. Inflated claims
Cost of Doing Business:
An insurance company also requires economic resources, land,
labour, capital and business enterprise, for providing
insurance to the society. An expense loading is the amount
required to pay all types of expenses. These loadings are
added to the pure premium to cover the expenses incurred by
the company in their day to day operations. The cost of doing
business is one of the important costs.
Fraudulent Claims:
Submission and payment of fraudulent claims is the second cost
as it results in higher premiums to all the insured. These
costs directly fall on the society.
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Inflated Claims:
Inflated claims mean that amount of claims may exceed the
actual financial loss. Here the loss may not be intentionally
caused by the insured. Inflated claims are an important social
cost as they result in higher premium to all the insured. This
cost also directly falls on the society.
Factors Affecting Insurance ConsumptionPrice and many other economic, demographic, socio-cultural and
political factors determine the consumption of life and health
insurance of each economy.
Price:
It is an important determinant of insurance demand and supply.
The prices charged by the insurers are influenced by their
cost structures, competitiveness of the particular line of
insurance, and the government tax and other policies.
Economic Environment:
Among the many economic factors that influence life and health
insurance consumption, the most important is the level of a
country's economic development.
Income:
A country's income level is the most important factor in
determining the level of national life and health insurance
consumption. Other factors affecting insurance consumption
(event risk, statutory insurance mandate by government, etc.)
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being equal, the higher a country's income, the more it spends
on all types of insurances.
Inflation and Interest Rates:
Inflation and interest rates are important factors for
determining demand and supply. High inflation and the
resulting high and volatile interest rates may affect the
demand for life insurance policies. Policy owners may not
prefer longer-term policies. They may prefer shorter-term and
more liquid investment products.
Demographic Environment:
As we know, demography is the study of human population.
Therefore, changes in demographics affect insurance
consumption. High birth rate, low death rate, early marriage,
social and religious reasons, and illiteracy are some of the
reasons for increasing population. Population ageing is the
most significant result of the process known as demographic
transition. Reduction of fertility leads to a decline in the
proportion of the young in the population. Reduction in
mortality means a longer life span for individuals. Population
ageing involves a shift from high mortality/high fertility to
low mortality/low fertility, and consequently an increased
proportion of older people in the total population. India is
undergoing such a demographic transition. Increasing life
expectancy translates into a greater demand for savings-based
life insurance products, as well as for long-term care
insurance.
Education:
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Literacy plays a very important role. The educational level of
the population affects insurance consumption. It is expected
that more educated people can understand the need for
insurance.
Household Structure:
The nuclear family and the extended family are the core family
forms of most of the households. The demand for insurance may
change according to the needs of double income families and
single parent families also.
Industrialization and Urbanization:
Due to industrialization, family units have become smaller.
The outcome of industrialization is urbanization. Insurance
consumption has been affected due to industrialization and
urbanization.
Social Environment:
Today, due to higher education, consumers have become more
demanding. Higher education gives rise to insurance
consumption. Education and culture are the dimensions of the
social environment that influences insurance consumption. As a
result, cultural perceptions of the role of life and health
products can vary substantially.
Political Environment:
Insurance demand is influenced by country's political and
economic stability. An unstable political environment
depresses insurance demand and, at the same time, decisions
made by insurance regulators affect insurance consumption.
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ConclusionInsurance is the tool to manage risk, which arises out of
uncertainty. Due to the risk which is a common phenomenon,
insurance business is becoming so popular. As an individual or
a business person can transfer its pure risk to another
organization. As a part of the economic system, insurance
business is also affected by the regulation, operation and
practices relating to economics. Like other business
enterprises, insurance is also affected by the market
imperfections. It arises due to various reasons like market
power, externalities, information problems, free rider
problems etc. Demand, supply and pricing of the insurance are
very important aspects. Demand for the insurance products is
shaped by the factors like price of the goods, consumer
incomes, and consumer tastes etc. Thus, economic factors
affect the insurance business in a distinct manner.
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Bibliography
1. Mishra K.C and Bakshi M., “Insurance Business Environment
and Insurance Company Operations” Cengage Learning India
Pvt Ltd, 2009.
2. Cain M., “Risk and Insurance: Perspectives on Fertility
and Agrarian Change in India and Bangladesh”, Population
Council, 1981.
3. Retrieved from
http://www.lifeinscouncil.org/consumers/advantages-of-
insurance.
4. Eackhoudt L. and Kimball M. “Background Risk, Prudence
and the Demand for Insurance”, University of Michigam.
5. Michael H., “Categorizing Risks in The Insurance
Industry,” Quarterly Journal of Economics, 1982.
6. CROCKER, KEITH J. and SNOW, A., “The Efficiency Effects
of Categorical Discrimination in the Insurance Industry,”
Journal of Political Economy, 1986.
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