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The Actuary The magazine of the Institute & Faculty of Actuaries
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Is insurance a luxury?

The natural disasters that have hit central America, south Asia, and Africa in recent years underscore the failure of formal insurance markets in developing countries. Without properly functioning insurance markets or access to the global reinsurance system, these nations bore devastating fiscal losses and became even more dependent on donor support. Why are insurance markets in developing countries failing?

Shortage of data
There is in fact very little research on insurance consumption. What exists is typically based on time series data and often aggregates classes of insurance, meeting different needs and driven by diverse regulatory and taxation environments. Even recent works incorporating modern statistical tests of bias, cointegration, and causality appear to be dependent on data sets which, to an industry practitioner, appear to be subject to a host of unsuspected and often idiosyncratic variables. In this article we point to an alternative way of attacking the issue and some initial conclusions for general insurance.

The luxury assumption
A frequent reason given for the lack of depth in non-life insurance markets in developing countries is that consumers perceive insurance as a luxury item. Insurance penetration is clearly related to a country’s income level. The link between a country’s aggregate demand for insurance and level of gross domestic product (GDP) is clear, but the forces driving the demand for insurance at the micro level are not. The insurance-as-luxury assumption implies that income distribution in developing countries is such that insurance can only be consumed in small quantities. This is common sense after all, spending money to protect against losses is not feasible unless income is reasonably high and consumers have possessions to which they have title, and an interest in protecting them. The key is to determine when income levels pass the ‘reasonably high’ mark, and when consumers believe that they have amassed enough property to merit protection. Traditional thinking holds that, especially in developing countries, personal insurance services are of interest largely to the top economic groups and, because this demographic is minuscule, the insurance market should be minuscule as well.

Consumption smoothing
However, a vast literature documents the presence of consumption-smoothing behaviour and protection against future losses in all income strata in developing countries. People in developing countries at all income levels engage in consumption-smoothing activities, even in the absence of formal risk management institutions, and these informal coping mechanisms are usually inefficient. Informal insurance (including savings mechanisms) is severely limited and can be detrimental to economic growth and mobility. In addition, many households, especially the poorest, lack access even to informal mechanisms.
Why has the formal insurance system failed to emerge in many developing countries? We attempt to provide a preliminary answer and to offer a direction for policy.

The micro approach to insurance demand
The role of the insurance industry in financial system development and economic growth has been examined extensively. In addition, a sizeable policy-orientated literature proposes measures for strengthening the supply side of the market, including privatisation, deregulation, training, better supervision, and allowance of foreign competition. Yet practitioners are sceptical about whether these methods will bring significant improvement because the demand side is so inadequate. Are insurance markets in developing countries doomed to long-term under-development because consumers are not interested in their product?
In our study we use micro-level (survey) data and measures of insurance consumption by expenditure decile from the Eurostat NewCronos household budget survey for 13 European Union countries and the World Bank Living Standards Measurement Survey (LSMS) for seven developing countries. The analysis involves a cross section of data from the mid-1990s. All data points represent households that purchased insurance in the formal insurance market. We consider general non-life insurance as a single service and exclude life insurance. The data are based on expenditure, not income, deciles. In surveys, especially in developing countries, there is consistent under-reporting of household income levels. Household expenditure data are believed to be more accurate than income levels, and most studies using LSMS data use expenditure aggregates to create deciles. Household expenditure better reflects permanent income and is less subject to short-term fluctuations than current income.

Insurance as a necessary item
Demand for necessary items increases by a proportion equal to or less than an increase in income. In contrast, demand for luxury items increases by a proportion greater than the increase in income that is, demand increases sharply when incomes are sufficiently high and decreases equally sharply as incomes fall.
Insurance consumption is closely related to total expenditure that is, consumption of insurance grows in concert with the increase in total expenditure for all deciles. (In the Netherlands, France, and Belgium, however, the strong positive relationship between expenditure levels and insurance consumption is reversed. All three countries show a negative correlation between insurance consumption and total expenditure. This surprising outcome may well provide the basis for a separate study, if the data are correct.)
Although wealthier individuals allocate more to insurance than poorer individuals, our interest is in whether the insurance share in total expenditure changes as total expenditure increases.
Government intervention plays an important role in insurance markets throughout the world. In many countries, a number of public good type insurance products are the monopoly of the public sector (motor bodily injury, workers’ compensation). Even in the European Union, which has made regulatory and legislative alignment a priority, important differences remain. In France and Belgium, demand for insurance is highly regulated, with a multitude of mandatory insurances in all major non-life categories (in the rest of Europe, between five and eight types of insurance are required by law). Such an excessive level of regulation means that everybody in these two countries, regardless of circumstances, is compelled to purchase. These factors need to be considered when generalising about the nature of insurance demand.
Our findings support the notion of insurance as a necessary item. If demand for insurance increases in lockstep with total income or expenditure, it is a necessary item. The ratio of the change in average insurance consumption to the change in average total expenditure should be more or less constant as we move up in deciles. However, if demand for insurance increases more than the growth in income, it is a luxury item. This ratio should increase as we move up in deciles.
Increases in overall expenditure bring comparable increases in demand for insurance products among all income groups in both developed and developing countries. The ratio of growth in insurance consumption to growth in general expenditure is relatively stable. Insurance does not resemble a luxury item in any of the countries studied, which vary significantly by level of GDP and income distribution.
This result is supported by figure 1 (above right), which plots the share of insurance expenditure in total expenditure for each decile. In most cases, the share of insurance decreases slightly as total expenditure rises, which is consistent with the characteristics of a necessary item. (Because of the outlier characteristics of insurance demand in the Netherlands and Belgium, these two countries are not included in the figure. However, the behaviour of insurance share in these two countries does not contradict the thesis of insurance as a necessary item.) This does not imply that actual expenditure on insurance declines as total expenditure increases. On the contrary, the correlation between insurance spending and total spending is close to 1 for the vast majority of our sample. Instead, the negative curve means that incomes (or total expenditure) grow faster than individual demand for insurance.
Policy implications
Previous surveys of the determinants of insurance penetration have shown a positive relationship between volume of non-life premiums and GDP per capita. Countries with GDP below a given level and countries with GDP above a given level (about $10,000 for non-life insurance) exhibit unitary income elasticity of demand, while countries in between exhibit income elasticity of demand of up to 2 or even more. Our study includes some countries in the top and bottom income groups as well as several in the middle. Our results are largely consistent across countries, implying that, even when insurance penetration is poised for outsize growth on the macro level, this need not be a result only of demand in the wealthiest strata.
In general, policies aimed at macro reform will have a bigger effect on demand for insurance than on supply, while measures aimed at restructuring the industry will affect supply in greater degree. Both types of policies may have wider, unexpected results. For example, the removal of protectionist restrictions on foreign vendors in the market probably will increase the amount and variety of services available, but it also may affect demand for services as consumers’ confidence in the industry improves and the need to purchase additional insurance abroad diminishes. Also, deregulation in one big market may lead a multinational to increase its insurance spending there and reduce it elsewhere, without reflecting changes in policy and environment in the smaller markets. Business insurance introduces ambiguities to the analysis.
Our micro-based, demand-side approach shows that consumer demand for insurance products resembles that for a necessary item, both in developed and in developing markets. Demand-side insufficiencies cannot explain why formal markets in developing countries are so small. Our assertion is that households in all economic strata understand the need to protect against risk and understand the limitations of informal coping mechanisms. Demand for insurance products exists in developing countries, and policy initiatives should seek to bring these products to more consumers through measures involving financial innovation, structural reform, adaptation to cultural and religious mores, or a greater role for the government as a broker.

Past experience
An interesting comparison may be made between the current conditions in the insurance industry in developing countries and conditions in the credit market in many of these same countries a few decades ago. It was thought that credit could not be extended to large parts of the world’s population because people in the lowest economic strata did not understand or need credit and did not own collateral. The experience and financial innovation of Grameen Bank in Bangladesh and other institutions (mostly in South and North America) have shown that lending to the poor is a viable proposition, although an initial period of subsidies may be required.
Similar developments in the insurance market may be imminent. Recent efforts by the World Bank and local non-governmental organisations (NGOs) to introduce micro-insurance schemes in rural areas in several developing countries have shown promising results. In India, 12 micro-insurance projects are under way. In addition, micro-insurance schemes are under way in Bangladesh (life insurance), Sri Lanka (loan, group, housing, insurance), and the Philippines (loan, life, pension, insurance). Though still preliminary, these efforts are pointing in the right direction.

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