Insurance is often an unseen yet ubiquitous part of the world economy. It is vital for the sustainable economic growth of a country like any other financial institution such as the banking sector and stock market. Naturally, humans are inherent to risk in every activity ranging from economic to social life. This calls for an advanced and collective form of a risk management system that forms the essence of Insurance.
Insurance is thus a mechanism to mitigate the risk and uncertainty in the future, while also being the motor for the development of the modern economy. Yet for many years Insurance has been a stodgy domain and its macroeconomics role was not a major topic of interest. But in the last two decades, it has become a subject of intense concern and debate among many people. To throw light on insurance we must start from the concept of Risk.
The basic of Insurance – Risk
A risk can be explained as a variation that can happen out of a situation in a given time. We cannot eliminate risk from our life, but we can mitigate risk in two possible ways with an effective response. In one way, efforts and expenditure can be done to lessen the risk and the other way is to buy insurance against whatever risks exist.
Humans usually tend to avoid activities that have risk aversion, which leads to taking excessive precautions. Prudent individuals either avoid taking risks or maintain a surplus fund to meet the contingency. These options, turning back from taking a risk or maintaining a fund are of no use. Since it will resultant in the unproductive use of the resources for the well-being of the community. Society will still suffer from the existence of the risk and fails to achieve their desired outcome.
The conception of Insurance
Insurance works on the fundamental principle of pooling, which is aggregating risks, and mutualizing them financially. This gives economic materiality to the concept of solidarity against any risks. In short, insurance connects the mishaps of a few to the fortunes of many in the community.
The underlying concept of risk-sharing in insurance has existed since the 14th century BC. Stonemasons in Egypt established and followed the risk-sharing method in large projects like Pyramids to aid funds in case of accidents. The mechanism of strategically mobilizing savings and distributing the risk among others has been a catalyst for many historic achievements.
By transferring risk to third parties, the insurance system increases confidence and reduces the fear of uncertainty, frustration, anxiety, and demoralization that prevent them from engaging in potentially riskier tasks. Besides removing the fear of mishaps it encourages the development of creativity, innovation, trade, infrastructure, and entrepreneurship activities in society. Read the Complete Insurance Bible to know how you can make use of an Insurance policy to save your money and time.
Our blog tries to explain how insurance contributes to the functioning of the modern economy and society on the whole. The contribution of insurance to macroeconomic development can be grouped under three broad categories – Economic growth, Stabilization, and Distribution.
The insurance and economy – Growth
Economic growth is deeply rooted in the decision-making that involves financial, human, and even reputation risks. These risks stretch beyond the capacity of an individual to bear them. Since the industrial revolution the insurance has grown exponentially and its role in the modern economy is multi-faced.
Economic growth and risk-taking
In the theory of economic growth, the development of insurance is an interesting as well as an important component. The growth of the economy is generally a combined effect of quality, the efficiency of labour, and capital intensity. So it is hardly possible to predict the outcome since it is the sum of individual decision which all involves an amount of risk.
Insurance manages this general uncertainty both at the individual level and corporate level. By providing health and life insurance, the individuals who are exposed to typically riskier activities and the environment are protected. At the corporate level, insurance is decisive for companies to trade and agreement by taking risks to productively invest minds and assets in the economy.
Insurance and lower interest rates
The role of reducing risk aversion by the insurance is a key factor for the positive impact in the economic development, thus decreasing the market risk premium and the equity premium. Insurance lowers the term premia that allow to ease the credit condition. Thereby facilitating investment and increases financial returns.
By providing a wide range of insurance targeted at loan repaying ability for property loss, damages for firms and households can lower credit risks. As a consequence, it can improve the overall ability of the financial sector. Also by the purchase of the long-term assets, the insurers can reduce the premium rates. It can lead to insurers favouring infrastructure and investment with low-interest rates in the bond market.
Insurance and collective savings
The pooling mechanism of insurance eases the decision-making at the face of risk to engage in an uncertain activity. At the individual level insurance reduces the precautionary savings and optimize capital at the collective level. The attempt to self-insure to meet the future needs can be minimized and the collective savings is enhanced for investment.
So the insurance company invests the collected premium as a long-term investment in the economy. This provision of liquidity at the macro level of the economy gives optimized, enhanced, and stabilized investments that are large and less volatile.
Also, the community with poor households and low income do not need to do ineffective precautionary savings as a coping mechanism. Most microinsurance is tailored to meet the needs of low-income people. It can considerably increase the productivity of the individuals by providing healthier life and habitat. The individuals whose needs are covered with the formal insurance can invest the remaining income in some other.
The Insurance and finance – Stabilization
To protect the financial system from any external shock insurance have a stronghold on it by stabilizing and providing stable funds to the financial system. By the method of derivatives, insurance companies not only protect themselves from any external financial shock but the whole financial system from collapsing.
Stabilizing the cycle of the economy
Individuals who are facing idiosyncratic or aggregated shock-like tsunami or food can have a smooth consumption because of the stabilizing role of the economy. It is evident in the countries with low income as they may not have the fund to recover from the disaster. So the risk is transferred to the insurance industry to reduce the drastic effects in the economy due to natural catastrophes.
Another function of insurance is to save retirement income and other savings. Contracts like variable annuities stabilize the income of the policyholder by diversifying savings towards potential and larger investments. It enables them to benefit from the future minimum guaranteed income.
Stabilizing the cycle of finance
As a fact to be stated, insurance is a substantially stable sector than the banks, which is the key source of stable funding for the global financial market. The business model of the insurance is future-oriented, where the insurance company collects the liquidity from the community to fund their future lifestyles.
But in contrast banking sector works with a present-oriented business model. Banks provide credits to fund the present lifestyle from the future liquidity. The relationship with differing times is visible and how important is liquidity for both insurance and banking sectors.
The banking sector starves for liquidity while the insurers are rich in liquidity funds. Also, insurers have stable and long-term liabilities that are matched with their assets. In turn, insurers become the net providers of capital to the country’s economy. One fine example is that in 2012 insurance sector alone invested over € 8.4 trillion in the European Union, making 60 percent of the GDP growth.
Stabilizing and role of derivatives
Derivatives are potentially a backup system to withstand any shock by transferring the financial risk to other investors. Insurers invest the collected premia from the policyholder in the financial market. These investments are exposed to catastrophes, but insurers are credible to honour the commitments to policyholders.
By diversifying the financial risk to the willing investor the exposure to the large capital market variation is limited. Apart from limiting the exposure to financial shocks, corporate insolvency is also limited and allows the insurer to get an income from the investment.
The Insurance and society – Distribution
The insurance system is devised as a network of shared risks and income irrespective of income but considering only the common uncertainty. By proving trust among the individuals in the community the insurance can catalyst many historic achievements by distributing mechanisms.
The nature of risk is unequal
Insurance is a web of solidarity provided by connecting people, places, times, preferences, and priorities. As we already know, insurance aggregates risk and distributes it financially. Unlike public distribution system, which distributes by comparing the prior and subsequent level of the income, usually from rich to poor.
In insurance, the risks are neither shared among other individuals nor overtime. So this inequality has nothing to do with income and also social, technological dimensions contribute to the risk & cycle.
Distribution between intergeneration
The mechanism of the insurance system facilitates insurers to provide income between different generations. Sharing financial risk in between generations has intergenerational welfare. An early generations build up funds that mature at the expiry of the contract and benefits the next generation.
Distribution among individuals
Insurance is a distributive method that spread among individuals at a point in time irrespective of their income. Insurers actively distribute liquidity in the form of claims and settlements. As part of the participating mechanism, the risk arises from the investment of the savings, and premium is also distributed among the individuals.
Relationship between insurance and innovation
Insurance has a close relationship with innovation by giving confidence to the innovators in the face of risk and protecting them from external shock. So these funds invested in the innovative projects help to develop industries, eventually more employment opportunities and capital for the economy.
Impact of microinsurance on society
By issuing microinsurance at the basic level of the society large liquidity can be optimized which acts as the driving force for investment. People with low income don’t need to opt for any other saving mechanism for the future. Microinsurance can greatly increase the productivity of individuals by providing healthier habitats and life. It is estimated that nearly four billion people comes under new insurance product in microinsurance.
Microinsurance, without a doubt, is a point that emphasizes the need for insurance, saving, and investment for the development of the economy both at the micro and macro level.
The blog presented here gave a framework of how a variety of the contributions from the insurance helps to grow the macroeconomics. Truly insurance is the endeavour of human and technological resources. Besides giving confidence and financial protection insurance gives a feeling of relief.
Statistics show that the insurance sector in the developed countries is used by many people. While people in developing countries approach the insurance sector with doubt and fear. This happens because of the misinformation about the insurance. Thus, insurance is not much growing in developing countries than the developed countries.