Insurance and the complex position of the insurer

In order to better understand the contribution of insurance to the modern economy, we have to understand the complex position that insurers find themselves in when they conduct their business.

One of the classical definitions understands insurance as a social or commercial device providing financial compensation for the effect of misfortune, and the payments being made from the accumulated contributions of all parties participating in the scheme.

At the core of the insurance mechanism lies this idea about accumulating financial assets for times of potential misfortune. There is a sort of fund in which all insureds will pay an assessed contribution (premium), which is not the same for everybody, depending on the specific risk profile.

In return, all those who contribute have the right to ask for an appropriate payment, should an insured event occur. The fund is usually created in such a way that it is highly unlikely that all risks in the scheme are affected at the same time.

The insurer determines premium and payout mechanisms for everybody contributing to the scheme. He is at the same time a fund manager, an owner, and a risk expert.

In order to understand what can be organised in insurance markets, it is necessary to understand this very complex position: on the one hand, an insurer is a custodian or a treasurer of the established fund; on the other hand, he is the owner of the fund.4 Through this setup he has a direct interest in its performance.

The two interests cannot easily be aligned and under normal circumstances they would possibly lead to unsolvable problems. However, with the mechanism of insurance, this can be managed.

When constituting a fund for future claims, it is usually so well capitalised that in the event of payout there will be some money left over.

This money, which is in excess of what has to be paid, can be drawn on because it is the right as owner of the established fund that permits the insurer to profit in such a way from his activity.

At the same time, the obligation as a custodian of the fund means that he will have to pay out for any claims that meet the pre-established criteria.

When dealing with questions of insurability and of insurance market mechanisms, this has to be kept in mind because the insurer always has a basic interest in paying out properly established claims, honouring his function as custodian.

This obligation, however, also forces him to act in the proper interest of the other parties that form part of the scheme and that might have future claims. Their participation in the insurance scheme constitutes a potential right to drawon the available funds – and more if need be.

A potential shortfall has to be made up by the insurer. The rights of the participants in the scheme need to be protected too, hence the insurer becomes a champion of those rights.

It is thus not sufficient to assume that if an insurer refuses to pay out for a disputed claim, he is doing so merely with his own personal interest in mind. He might actively be protecting the other participants in the scheme as custodian.

An insurer also works as a risk expert and risk manager because he has to understand and assess the risks he will accept or decline for the scheme. If somebody buys into that scheme, a newrelationship is established and has to be judged on its merits, not least vis-a`-vis the existing participants and their risks.

Whenever an insurer accepts a newrisk into the scheme, this affects everybody who is already in the scheme. It is not just a decision that the insurer takes and where he has a direct obligation concerning the risk per se, he also has an obligation to his other business relations.

For the insurer as risk manager and custodian of a pool of risks, unexpected legal changes present a fundamental problem when they affect the payout scheme.

This is especially true if the legal environment changes suddenly in a major way during the period in which risks were accepted and before payments for claims are made.

The insurer’s liabilities will have already been calculated and the necessary premia to finance those collected before the change in the legal system renders these initial calculations inappropriate. In effect, the insurer will then have placed (voluntarily or not) a bet on the legal development.

Often, when policymakers discuss legal changes, these particular effects on the insurance system are not fully reflected upon by the norms setters. As stated earlier, the insurer defines the conditions for future payout and he establishes some guidelines for behaviour.

There is a positive impact too in the contribution that insurance can have on the development of an economy that goes beyond just the risk-sharing mechanism. An insurer is of course an entrepreneur.

He is looking for newmarkets, for business models and strategies; he wants to grow, to establish client relationships, to create an operational infrastructure. He needs welleducated human capital and a sophisticated business infrastructure.

All this leads to positive knock-on effects in other parts of the economy. The insurer is also a key transmitter of preferences in a society. Very often, particular insurance schemes are encouraged to compensate for specific behavioural structures that a society believes it should influence.

Tax breaks for taking out life insurance, mandatory third-party liability insurance or long-term care insurance are examples. In some cases the insurance coverage is a precondition for other businesses to operate.

And sometimes that pre-condition is not cheap: if one considers operating aircraft, for example, insurance rates are very costly, especially if they are large commercial aircrafts flying over crowded cities.

The insurance sector is subject to very tight regulations; fewother industries are as tightly regulated and supervised.

This supervision ranges from the initial right of establishment to the types of risks that can be underwritten; it spans the direct protection of consumers to specific contractual arrangements such as reinsurance schemes and other risk transfer mechanisms and howand under which conditions they are permitted; it comprises the language used in contracts as well as general and special requirements for capital held, etc.

All the aforementioned specificities have to be borne in mind when considering the contribution that insurance makes to the modern economy. Insurance is unlike any other business and even the similarities with other financial services providers are limited.

Location: Indonesia