Download insurance - Dr Safdar Ali Butt

INSURANCE:
AN IMPORTANT INGREDIENT OF ECONOMIC DEVELOPMENT
Dr Safdar A. Butt
Professor of Finance, Mohammad Ali Jinnah University, Islamabad
There are essentially two angles of looking at insurance and the role it plays in the
development of an economy, or economic development of a country. The first from
the perspective of a person who seeks insurance (the insured), and the second is the
stance of the person who provides insurance (the insurer).
An insured – and I mean a businessman insured - looks at insurance as a means of
transferring his unavoidable risk. Running a business involves a number of risks.
Some of these risks are avoidable and for the purpose of this article will be assumed
that they are actually avoided by businessman. Other risks are unavoidable and
must be faced if any business is to be run at all. For example, if you buy a vehicle,
the risk of its theft or damage through an accident cannot be avoided. However, this
risk does not necessary have to be borne by the businessman. He can simply transfer
this risk to some one else (the insurer) by paying a small fee (the premium). While
many of these unavoidable risks do not have a great degree of probability of
occurrence and can possibly be assumed to avoid the premium cost, the same cannot
be said for all the unavoidable risks. For example, the likelihood of an airplane
falling over one’s factory and destroying it is rather small and one can easily assume
this risk. But the likelihood of a fire breaking out in a factory is too large and its
potential consequences are too grave to be assumed. Bearing such a risk can weigh
so heavily on the mind of a businessman that he may be unable to concentrate on
the actual conduct of business, thereby damaging its prospects. By transferring this
risk to someone else, the businessman can free himself from this worry and focus on
ways to improve, enhance or better his business.
From a small khokha-wala to large multinational corporations, all businessmen
resent uncertainty in the conduct of their affairs. Ask any business manager and he
will confirm that one thing that he values most is the ability to predict the future
course of events. If he can be reasonably assured of what is likely to happen to his
business over the next one month, one year or one decade, his task of planning and
implementing will become that much easier. While, it is impossible to remove the
element of uncertainty from all the aspects of business, there are a large number of
areas where a businessman or manager can safely transfer the “potential of
unfavorable consequences of an uncertainty” to an insurer by paying a predictable
fee. An insurance policy assures a businessman that even if an untoward event does
take place, he will not suffer any financial loss from such an event. He is not merely
saved from the potential loss, but from also the psychological effect of worrying
about the loss. This latter aspect can help him pay attention to the real issues of the
business and thereby improve its profits. Now, if each business unit in an economy
could be helped in this way, it will certainly have a big impact on the overall
economic situation of the country. A more profitable business will increase
employment (leading to increase in purchasing power of the economy as a whole),
improve tax revenue (enabling the government to carry out developmental projects,
leading to further increase in employment), and most importantly enhance return to
investors (thereby enabling them to launch more projects and thereby further
improve the economy).
I will like to cite a case study which I prepared a long time ago when teaching a
course on insurance to a undergraduate class. Ashraf Ali was 41 years old when he
was able to buy his first new car, a Suzuki Margalla. He had bought this car not for
his personal use but to run it as hire vehicle. He had paid only 40% of the car’s value
and borrowed the rest from a leasing company. Leasing company imposed the
condition of comprehensive insurance on him, which he complied with only very
unwillingly. Eight months later, his car was stolen, never to be found again. Had he
not insured the car, this would have put an end to his entrepreneurial dreams. Seven
years later, he had a fleet of 30 cars, fourteen of them his own, and was operating as
a car hire business from three different points in Rawalpindi Islamabad. When he
talks of his early days as a businessman, his eyes soften with tears. “I was so wrong
to assume that nothing will ever happen to me or my car. Thank God, I had insured
my car, otherwise I would have suffered complete disaster. I would have to pay the
leasing company without having means of earning the revenue. Now his fleet is
fully insured, and he has no fears of being driven out of business by any catastrophe.
He fully concentrates on his providing an excellent service to his clients, keeping his
vehicles in good shape and managing all his employees effectively. The premium he
pays to his insurers is a well deserved compensation for the sense of security
enjoyed by him.
Now let us look at the perspective of insurers. Insurance companies (and reinsurers) are businessmen who earn a profit on their investment by offering a
valuable service to other businessmen. Their profitability depends on their acumen
to correctly compute the premium rates based on historical and projected statistical
data. Insurance companies do not actually absorb any of the losses which befall their
clients. What they in effect do that the distribute the risk over a large number of
clients, thereby making each of them pay for only a small part of the total loss that is
experienced on account of a particular risk by the whole community of clients. Thus,
the premium collected from a large number of persons who get their cars insured is
used to pay the claims of those unfortunate few who actually suffer a loss through
theft or damage to their cars. This act of risk distribution ensures that the whole
economy contributes to save the unfortunate few from complete disaster. As a
result, all businesses retain the opportunity to survive unavoidable risks and
continue to prosper and participate in economic development of the country.
In addition to the “peace of mind to businessmen” aspect of their services which
greatly assist the economy, insurers contribute to the economic development of a
country in the following ways:
a. They provide employment to a large number of people directly and indirectly.
b. They contribute to the national exchequer in various ways like duties and taxes
on insurance policies and their profits.
c. Insurers are required, by the nature of their business, to maintain healthy liquid
reserves with banks. In this way, they assist the economy by providing deposits
to banks that use these deposits for lending to the businessmen, thereby lending
speed to the wheels of economic development.
d. Insurers collect and provide useful statistical data to the appropriate
governmental authorities. This data assists them to plan better for economic
growth of the country.
The above advantages related to general insurance companies. Life insurance
companies have a lesser role (then general insurance companies) in every day
conduct of business units in the country, but they are a very effective conduit for
channeling personal savings to the industry and commerce. Life insurance
companies collect premiums from individual insureds over a long period of time
and pay them the sum insured (plus profits, where applicable) at the end of
prescribed term. This places a tremendous amount of cash at their disposal, enabling
them to invest heavily in the economy. In brief, the involvement of life insurance
companies in the economic development of a country can be seen as follows:
a. They provide funds to the financial sector in various forms like deposits with
banks, purchase of long term bonds and securities, direct lending to certain
insureds against the policy, etc.
b. They are generally the biggest developers of real estate. The real estate sector
is in itself a very effective instrument of promoting economic growth,
particularly in developing countries like Pakistan.
c. In the developed countries where financial markets are more organized, life
insurance companies are greatest providers of funds to investment banks,
mutual funds, venture capital providers and other long term lending
institutions. In many cases, life insurance companies own these investment
vehicles themselves, thereby playing a more direct role in the development of
financial markets.
d. Since life insurance companies have long term funds, they often hold long
term equity interest in other companies. This enables them to get
representation on the boards of such company and play an active role in their
good governance. Even when they are not represented on the board, they
generally have the clout to seek and be provided explanation for the actions
taken by the investee companies. The boards of such companies value and
appreciate the input from life insurance companies. The improvement in the
quality of governance of companies directly benefits the economic
development of the country.
In brief, we can say that both general and life insurance companies play a vital role
in the economic development of the country through risk distribution and
channeling of individual savings to the financial, industrial and commercial sector of
the economy.