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| FOCUS | GENERAL INSURANCE

Is insurance a luxury?
Theodora Galabova and Rodney Lester report on their study of the insurance industry in
developing countries.

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?
HE NATURAL DISASTERS

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 nonlife insurance markets in developing countries is that
consumers perceive insurance as a luxury item. Insurance penetration is clearly related to a countrys
income level. The link between a countrys 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.
Theodora Galabova is
completing a PhD in
economics at the University
of Maryland and is a
research associate at the
World Bank

Consumption smoothing
However, a vast literature documents the presence of
consumption-smoothing behaviour and protection
against future losses in all income strata in developing

32 | TheActuary | December 2001

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 policyorientated 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 shortterm 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

GENERAL INSURANCE | FOCUS |


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.
Figure 1 Percentage share of insurance in expenditure for each country and each decile

0
1

3
France

5
6
7
Expenditure deciles
Denmark

Bulgaria

10

Peru

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
continued over page

Rodney Lester leads the


insurance and private
pensions advisory team in
the World Bank Group; he
also works with the IMF on
industrial country insurance
sector assessments

December 2001 | TheActuary | 33

| FOCUS | GENERAL INSURANCE

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 worlds 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.

References
Enz, Rudolph (1999). The S-Curve relation between per-capita income and
insurance penetration, Sigma, Swiss Re.
Grimard, Franque (1997). Household consumption smoothing through ethnic ties:
evidence from Cte dIvoire, Journal of Development Economics, Vol 53,
pp391422.
Townsend, Robert M (1994). Risk and Insurance in Village India, Econometrica, Vol
62, No 3, pp53991.
Vittas, Dimitri (1995). Sequencing social security, pension, and insurance reform.
World Bank, p3.
Ward, D and Zurbruegg, R. Does insurance promote economic growth? Evidence
from OECD countries.
Wasow, Bernard (1986). Determinants of insurance penetration: a cross-country
analysis, Wasow et al, eds, The insurance industry in economic development,
New York University Press, pp16572.

34 | TheActuary | December 2001

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