Practice II

Read the following text and be ready to speak on the functions of insurance in the modern economy.

Insurance, capital and economic stability

Insurance is not just about the financial compensation of victims; insurance is also the central part of the capitalization process of a modern economy. It creates huge capital assets. The Amsterdam Circle of Chief Economists (ACCE), which is coordinated by The Geneva Association, estimated the total share of insurance assets in 2007 to be around 11 per cent of all assets worldwide. The funds handled by insurance, due to the nature of the contracts and the sometimes very long time horizons involved, usually stay in the financial market of a given economy for quite some time. Most often it is not fickle investment capital that rushes around looking for quick gains, as it is oriented towards the medium to long term. It thus plays a special role underpinning the steady growth of an economy.

The insurance mechanism furthermore allocates assets according to market forces where needed, and this in a largely stable environment. It allows a process of maximizing returns according to market forces that are directly related to the existing risk structures. At the same time, insurers have to produce a return on their assets and as market participants looking for profitable investments, they are submitted to the same basic constraints that other investors face. It would be naive to assume that asset managers in insurance would stop investing in a certain sector solely because of that sector’s negative climate impact. As long as external effects on climate change are not fully internalized by those actors responsible for them, asset managers will respond to the distorted incentive to invest.

Another key point is the buffer function of insurance in the modern economy. This buffer function is of great importance for a modern economy because it allows filtering out sudden surges in financial needs linked to a disaster for all insured players that might otherwise be pushed into bankruptcy. The existence of insurance allows forward planning with more certainly, avoiding or mitigating specific risks that are deemed to be threatening to the general business process.

Even when subjected to great stress, the insurance sector has a tendency to be more stable than other parts of the financial services sector, as the current financial crisis has demonstrated. Insurance crises play out in fundamentally different ways compared to e.g. banking crises. In a banking crisis the most feared phenomenon is a run on a bank. The effect is immediate and it has to be stopped otherwise it will destroy the economy as ever more funds are withdrawn and the capacity of the banking system to cope with the reduction in assets deteriorates very rapidly. A major crisis in insurance sector develops differently as there is less liquidity risk and usually more time to react. Most insurance risks cannot be triggered by the policy-holder. Or, such as in the case of risk life, accident or health policies, they will usually not be triggered as they involve grave personal harm. Even in the case of saving products, insurance companies often build in withdrawal costs that stabilize the system in adverse times as it makes the cancellation of policies more costly to be insured.

In the event of an insurance firm becoming technically insolvent it can continue to operate for a certain time (sometimes years) without having to cease its activities. After a major crisis insurers could start paying out claims while recapitalizing at the same time and using parts of the premium income for future risks to finance current liabilities. While this s not a desirable situation, both insurers and regulators, would want to avoid it whenever possible, in a moment of utmost stress on the financial system, the resilience is much higher for insurers than for banks due to this flexibility.