THEORY AND PRACTICE OF INSURANCE

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1 THEORY AND PRACTICE OF INSURANCE

2 THEORY AND PRACTICE OFINSURANCE By 1. Franc;ois Outreville ~. " SPRINGER SCIENCE+BUSINESS MEDIA, LLC

3 Library of Congress Cataloging-in-Publication Data Outreville, J. Francois (Jean Francois) Theory and practice of insurance / by J. Francois Outreville. p. cm. Includes bibliographical references and index. ISBN ISBN (ebook) DOI / Insurance. 2. Risk management. 3. Economic development. 1. Title. HG dc CIP Copyright 1998 by Springer Science+Business Media New York Origina1ly published by Kluwer Academic Publishers in 1998 Softcover reprint ofthe hardcover Ist edition 1998 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photocopying, recording, or otherwise, without the prior written permis sion of the publisher, Springer Science+Business Media, LLC. Printed an acid-free pa per.

4 "Les pieces empruntees d'autrui, illes transformera et confondra, pourenfaire un ouvrage tout sien, a savoir son jugement" ( Work borrowed from others, he will adapt and mingle to create his own text, namely his own thinking) Montaigne, Les Essais, Chap XXVI.

5 CONTENTS Page Preface IX 1. The Meaning of Risk 1 Part I Insurance in the Economy 2. Insurance and Economic Development Insurance in the World Economy Today 29 Part II The Principles of Risk Management 4. Risk Management Concepts Risk Analysis Fundamentals Risk Financing Decisions 91 Part III The Principles of Insurance 7. Risk Aversion and Insurance Insurance Concepts Pricing Insurance Contracts Retention, Self-Insurance and Captive Insurance Companies 179

6 viii Part IV The Characteristics of Insurance Operations 11. Organization of Insurance Markets Operations of Insurance Companies Reserves and Investments Reinsurance 263 Part V The Performance of Insurance Companies 15. Financial Reporting and Performance Supervision of Insurance Operations 315 Index 335 About the Author 340

7 PREFACE Often students do not read the preface of a textbook, however it frequently happens that the introduction clarifies the meaning of the text. A Look at the Past, the Present and the Future Risk! Uncertainty! Loss! these words are frequently in the minds of people involved in decision taking. The first scholarly treatment of the area of risk in relation to insurance was "The Economic Theory of Risk and Insurance" by Allan H. Willett originally published as one of the Columbia University Studies in History, Economics and Public Law) During most of the econorilic history, risk and uncertainty have been a subject for sociologists but it was rather taken for granted in a given cultural environment. In 1921, Frank Knight wrote a comprehensive book on the subject of "Risk, Uncertainty and Profit".2 The risks that he discussed were more or less limited to the "entrepreneurial" type. The field of the pure risk linked to the vulnerability of systems, was still considered too secondary to be treated as a priority among the managerial objectives of the firm. Classical economic theory was based on the assumption of certainty. This was a deterministic approach which ignored the economic behavior of individual agents. Thanks to the work by Allais, Arrow and Debreu in 1953,3 new developments in economic theory analyze how the traditional competitive analysis can be extended to treat lidcertainty. By assumption there are risks, 'contingent goods or "contingent claims", and there are contracts by which risks are implicitly or explicitly transferred from one economic agent to another economic agent, e.g. labor contracts, financial securities and insurance contracts.

8 x The Traditional Approach In the development of any academic discipline, several persons always stand out, and their work is regarded as a significant contribution to that discipline. Dr. Solomon Stephen Huebner introduced the first University-level insurance courses when he was a professor at the Wharton School, University of Pennsylvania. He also wrote the first University-level insurance textbooks.4 Most of the "classic" insurance textbooks published in the United States have been largely inspired by his work. However, in the traditional approach, like finance in the 1940s and 1950s, insurance is taught as a descriptive, institutional subject, viewed from the outside rather than from within the firm's managerial point of view. The Managerial Approach Methods of managing risks are increasingly important in modern economic systems and Risk Management has become a major concern in the curriculum of Business Schools.5 Recent growth in interest, understanding, and technical skill in the field of risk analysis and assessment have worked to promote this change. I t is not so much a problem of avoiding risks and eliminating uncertainty, but of understanding and controlling risks and of reducing the uncertainty to acceptable levels in given situation.6 The objectives of risk management and insurance have been formulated in the context of the objectives of the firm or the individual economic agent. In many formulations, the objective is stated in terms of utility, the satisfactions enjoyed by individuals that result in a set of preferences. Social responsibility is another complex issue which has to be taken into consideration by individual economic agents, firms and government. A Conceptual Approach Recent developments in North-American academic institutions have given rise to many questions about how collegiate insurance education is faring and what its future direction will be. In many other countries including developing countries, attempts are being made to popularize insurance subjects in colleges and universities. However, contrary to other fields like Finance or Marketing, there is a lack of material available on general concepts. The emphasis on decision making has progressed in recent years. However, most of the existing insurance textbooks have been written exclusively for the US market and still follow a descriptive sectorial a:.froach of insurance institutions and contracts rather than a conceptual approach.

9 xi Objective of this Text Regardless of the manner in which risk and insurance problems are approached, their existence affect the economic performance of all economic agents and therefore imposes constraints on the optimum allocation of resources and on the economic development of all nations. Insurance is a major tool of risk management and plays an important role in the economic, social and political life of all countries. Economic growth throughout the world has even expanded the role of insurance. At its first session in June 1964, The United Nations Conference on Trade and Development formally acknowledged the role of insurance in economic development. 8 Insurance is a concept, a technique and an economic institution. It is therefore important that the reader understand why insurance markets matters and how insurance institutions exist and function. This text does not claim to develop a new approach to the presentation of insurance. In fact, the author has been largely inspired by the major textbooks on insurance written in the United States. Because insurance is international by nature, a description of the fundamental principles should be emphasized. A detailed analysis of insurance in a particular country or a detailed description of specific insurance contracts has been avoided. The text is readily adaptable to the particular characteristics of each country and this approach in an introductory text is of greatest value to advanced undergraduate and graduate students. Acknowledgments Students who have read the draft chapters of this text when I was a visiting professor in Singapore at the National University and in The Netherlands at Nijenrode University. Disclaimer The content of this book does not relate to the purpose, activities or interests of the United Nations. J. Fran~ois Outreville

10 xii Notes 1 Allan H. Willett, The Economic Theory of Risk and Insurance, New York: Columbia University Press, 1901, reprinted by The University of Pennsylvania Press, Frank. H. Knight, Risk, Uncertainty and Profit, Boston: Houghton Mifflin, Maurice A1Iais, "L'extension des theories de l'equilibre economique general et du rendement social en cas de risque," Paris, CNRS: Econometrie, 1953, p Kenneth J. Arrow, "Le role des valeurs bousieres pour la repartition la meilleure du risque," Paris, CNRS: Econometrie, 1953, p ; translated as "The role of securities in the optimal allocation of risk-bearing," Review of Economic Studies, vol. 31, 1964, p Gerard Debreu, "Une economie de l'incertain," Paris, EDF: Mimeo, 1953; revised and published in Economie Appliquee, vol. 12, 1960, p Huebner S.S., Property and Liability Insurance, New York: Appleton and Co., 1911 and The Economics of Life Insurance, New York: Appleton and Co., The American Risk and Insurance Association published in November 1990 a position paper entitled: "Risk Management: an essentiel part of the common body of knowledge for Business." 6 It should be noted here that Allan Willett's book is probably the first modem textbook on risk management when comparison is made with the approach suggested today in Business Schools. The chapters of his book could easily be considered for any new risk management textbook: (I) The Nature of Risk, (II) Classes of Risk, (III) The Cost of Risk:, (IV) The Assumption of Risk:, (V) The Reward for Risk Taking, (VI) Ways of Meeting Risk, (VII) Insurance. 7 One notable exception is the book by Neil A. Doherty, Corporate Risk Management: A Financial Exposure, New York: McGraw-Hill Co., United Nations, Proceedings of the United Nations Conference on Trade and Development, First Session, vou, Final Act and Report, 1964.

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