Financial Risks, Stability, and Globalization

6 Insurance in the Development of Financial Services Policy Implications and Issues for a Research Program

Omotunde Johnson
Published Date:
April 2002
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A Field of Opportunities and Contradictions

Insurance is a field offering extraordinary commercial, cultural, and intellectual opportunities, but the terrain is also mined with contradictions and frustrations. Consider, for example, the following:

  • Peter Bernstein aptly charts the history of risk in his important book, Against the Gods (1996), with insurance activity dominating the initial chapters. He explains how, in ancient times, insurance was already treated as a part of the developing art of risk management. Later, when he discusses the modern era, insurance has almost entirely disappeared—having been replaced by banking and related financial activities.
  • More often than not in Europe, university courses on banking and insurance begin with equal attention to both fields, but end up devoting almost exclusive attention to banking.
  • Traditional economic thinking, such as that which is based on the theories of Ernst Engels, has assumed that insurance is purchased only after other needs have been satisfied, suggesting that insurance is an economic good of lesser order. But the role played by insurance in modern societies is a key one in resolving almost every kind of contemporary problem—environmental risk, industrial and natural catastrophes, social security, health, and so forth. And in the industrial sector, insurance—as a protection against inherent vulnerabilities—is essential if large investments (such as constructing dams or developing oil rigs at sea) are to be considered.
  • Some years ago, when I mentioned to Claude Bébéar (who subsequently founded French insurance giant AXA, becoming one of the most successful entrepreneurs in Europe) how important I thought insurance was, he responded by saying, “That’s something you should tell my family; they’ve never understood why I should have settled for staying in insurance, since I had attended a relatively prestigious institute of higher education in France.” When I originally spoke to him, Claude Bébéar was the managing director of a small mutual company in northern France.
  • For years, insurance has been considered the poor relation of finance. But in Europe today, companies like Allianz in Germany, AXA in France, and Generali in Italy—far from being satellites and accessories to the financial world—are now at the center of the new financial solar system.
  • Nowhere in the economics literature, however, is there any recognition of the fact that for the last half century world insurance growth has been on the order of 5 percent annually in real terms. Some time ago, a managing director of an important European life insurance company told me I was an idealist for believing in the future of insurance. As far as he was concerned, advances in science and technology, by making the future increasingly predictable, would ultimately eliminate the need for insurance altogether. I tried to convince him without success that—even in the hard sciences—for several decades now, the notion of uncertainty has become a key and almost universally accepted concept.

Insurance, in fact, for some time has related our modern world to basic perceptions and philosophies about uncertainty through risk and risk management, and in a more fundamental way by transcending pure economic thinking. Through the Geneva Association and within the organization, I have contributed to urging neo-classical economists to delve deeper into the question of uncertainty. Today, a substantial literature exists, among other things, on the notions of imperfect and asymmetric information. Indeed, in that literature, these definitions should be more carefully examined for they seem to imply that there exists somewhere an economic world with perfect information. For insurance, however, perfect information will remain an illusion—not because of the imperfections of science, technology, or research methods—but quite simply because insurance has to do with facts and events that generate future costs that will always remain essentially uncertain and unpredictable, in spite of our efforts to estimate in advance.

Hence, it can be concluded that uncertainty, far from being a symptom of imperfection is, in fact, a natural property of economic—indeed, probably of all life—systems. Uncertainty relates to the development dynamics and behavior of such systems, and is destined perhaps to become the foundation of a new social philosophy and culture. Viewed in this light, uncertainty offers enormous scope for research in the future.

The Value of Performance

Moving to another set of considerations concerning the role of insurance institutions within the wider global economic environment, several observations can be made. First, I would like to underline some key macroeconomic phenomena that I have observed in my 14 years of experience in research and development, closely linked to the chemical and mechanical industry. An important point is recognizing that we now live in an economy predominantly based on services. This new context is the first relevant element in defining the real economic importance of insurance today.

Traditional economic theory still distinguishes among three sectors: the primary or agricultural one, the secondary or industrial one, and the tertiary one including all services. Such a classification is a “vertical” one and is essentially centered around the industrialization process, where the predominantly agricultural societies are those that are not yet industrial and the tertiary sector is very often a “residual sector” simply used to classify all those economic activities that cannot be called industrial, of which they are simply an appendix.

In reality, for all these sectors of the economy—agriculture, industry, and services—the relevant point is the reference to the priority given to better stimulate the overall production of wealth and welfare. In an industrial society, agriculture does not disappear but becomes increasingly efficient because of its industrialization. Industrialization does not develop as a completely separate productive activity from agriculture; it also modifies the traditional way by which agricultural products are produced and distributed. In the same way, the service economy is not the product of something completely detached from the industrial productive structure, but penetrates the very industrial production systems that become predominantly dependent on the performance of service functions within (as well as outside) the production process. The real phenomenon, therefore, is not the decline and growth of three vertically separated processes of sectors, but their progressive horizontal interpenetration and integration. In other words, the new service economy does not correspond to the economy of the tertiary sector in the traditional sense, but is built on the fact that service functions today are predominant in all types of economic activities.

The real changes toward the service economy stem precisely from the fact that services are becoming indispensable in making basic products and services fulfill basic needs. Services are no longer simply a secondary sector, but they have become indispensable production tools to satisfy the basic needs and to develop the fundamental tools in increasing the wealth of nations.

The insurance industry is a typical example: until a decade ago, everybody, including people in the insurance industry, accepted that insurance policies covering, for example, life risks or material damages, were a typical secondary product in the traditional economic sense that they could only expand once the basic needs were satisfied by material production. During the decade following 1973, however, when the growth of global GNP dropped from an average of 6 percent to less than 3 percent per year, the overall sales of policies continued to grow about 5 percent per year. If insurance consumption were of secondary importance, the slowing down in other activities and, in particular, in manufacturing would have produced—according to Engel’s law—more a than proportional reduction in the sales of insurance.

The explanation of the continuous growth of insurance activities, even in periods of decline, lies precisely in the nature of the modern production system that depends on insurance and other services as key tools for guaranteeing that it functions properly. At a very advanced technological level of production, where risks and vulnerabilities are highly concentrated and represent an essential managerial challenge, insurance has become a fundamental precondition for investment—increasingly so in these last decades. Similarly, at a more general level, social security, and health and life insurance have by now achieved the status of a primary need in most industrialized and industrializing countries.

Pricing Under Conditions of Uncertainty: The Insurance Paradigm

Selling a personal computer, for instance, means that 90 percent of the business done is based on an estimate of costs and prices concerning the period of utilization related to a future period of time. The classical economic equilibrium between supply and demand has become a kind of uncertain system in which the probabilistic nature of future costs destroys the Utopia of a possible perfect price certainty. Uncertainty is the phenomenon that defines the service economy.

In classical industrial economics, prices are normally fixed by reference to production costs in meeting demand. By contrast, the insurance experience has always been that of a “reversed cycle” in which a price has to be fixed on the basis of an uncertain event happening in the future. Increasingly, today, pricing systems in all economic sectors have begun to resemble insurance policies and are moving away from the traditional simplified “industrial,” equilibrium-based, price-setting model. Indeed, some of the costs occasioned by product or system utilization (including waste disposal) require a judgment at the moment of selling that comes closer to the way an insurance underwriter thinks and acts: future events, which are only probable, will affect the cost of any economic performance. This is particularly clear in the case of leasing. Expansion of liability costs for products and services has thus become a way of incorporating the future “quality” of performance of products and systems as a factor in the calculation of the “costs of production.”1

Although classical industrial economics could aim at a “perfect equilibrium” for prices given adequate information, in the service economy, the notion of uncertainty is an integral part of both practice and theory. Prices increasingly reflect a probabilistic judgment on the future costs of utilization. In such circumstances, no “scientific” information could ever generate what is thought of as “perfect” information. Economics needs to look closer at how insurance price systems work.

Risk Management, Vulnerability, and Insurability

The notion of systems becomes essential in the service economy. Systems produce positive results or economic value when they function properly. The idea of systems operation (or functioning) requires the consideration of real time and the dynamics of real life. Whenever real time is taken into consideration, the degree of uncertainty and of probability which conditions any human action becomes a central issue.

The economics of the Industrial Revolution could, in contrast, rely on the more limited model of a perfect equilibrium theory (outside real time and duration), based on the assumption of certainty. During most of the economic history of the Industrial Revolution, risk and uncertainty have been a major subject for historians and sociologists, but not for economists. The first systematic attempt to take risks and uncertainty into consideration was made by Frank Knight (1921) by establishing a link between the level of risk and the level of profit expected during the 1920s.

Any system aiming at obtaining some future results is by definition in a situation of uncertainty, even if different situations are characterized by different degrees of risk, uncertainty, or even indeterminacy. But risk and uncertainty are not a matter of choice: they are simply part of the human condition. Rationality is therefore not so much a problem of avoiding risk and eliminating uncertainty, but of controlling risks and of reducing uncertainty and indeterminacy to acceptable levels in given situations. Furthermore, the very systemic nature of modern economic systems and the growing complexity of technological developments require a deeper economic understanding and control of the increasing vulnerability of these systems.

The growth of vulnerability is the second important element in understanding the economic relevance of insurance today. Unfortunately, the notion of vulnerability is generally misunderstood. To say that vulnerability increases through the augmentation of the quality and performance of modern technology might seem paradoxical. In fact, the higher level of performance of most technological advances relies upon a reduction of the margins of error that a system can tolerate without breakdown.

Accidents and management mistakes happen on occasion, but their effects now have more costly systemic consequences. Opening the door of a car in motion does not necessarily lead to a catastrophe, but in the case of a modern jet airplane, it will. This shows that the concepts of system functioning and vulnerability control become a key economic function where the contributions of people like economists and engineers must be integrated. In a similar way, problems of social security and savings for the individual have to take into account the management of vulnerability. Thus, the idea of risk and the management of vulnerability and uncertainty become key considerations of the service economy. One recent example of vulnerability has been provided by the viruses introduced on the Internet.

I now turn to the idea of insurability (i.e., the ability to manage risk and uncertainty), which, although unknown in most courses on economics, is a fundamental concept in the contemporary economy. Although pure risks (depending on the initial implicit vulnerability of any system) and entrepreneurial risks (depending on the taking or not taking of a specific action) are in many cases interrelated and interdependent, it is important to make a clear distinction as to their very different nature. It is important to remember that only entrepreneurial risks, as such, have been considered (although belatedly) by economic theory and analysis (see Figure 6.1).

Figure 6.1.Pure Versus Entrepreneurial Risks

In fact, entrepreneurial risk itself is increasingly conditioned, in all sectors, by the adequate understanding and control of pure risk, starting from the management of financial risk through to the question of systemic risk. Everything seems to be pointing to one key issue: that when it comes to the identification of the level of the threshold of insurability, whatever the political ideology of a government, the public authorities at large have to step in. But as attempts are made to minimize the vulnerability (financial, economic, and social) of governments and society, it is clear that the notion of insurability is moving, little by little, to the center stage of economic policymaking in the future.

Governments increasingly recognize that they have a vested interest in stimulating an efficient private insurance system in all fields in order to develop an adequate economic policy. In fact, most governments in today’s world are forced into privatizing many activities, not only to make them more efficient, but also to reduce their deficits. Once again, this process concerns key policies like social security, the effects of natural catastrophes, industrial and environmental risks (with all the consequences for liability that they involve), health insurance, and crime and terrorism prevention (including fraud and moral hazard-related issues).2 All these activities can be transferred to private institutions, to the extent that they fall within the limits of insurability.

There are, of course, essentially two levels of insurability:

  • An upper level at which, in theory, all risks can be insured, provided they are sufficiently defined as a class and adequately quantified as far as their frequency and gravity are concerned.
  • A second level, which is determined by the capacity of the insurance industry or of any risk management institution to properly cover these risks. The word “capacity” embraces both financial and management potential.

In the preindustrialized economy, insurance and risk management organizations could remain on the sidelines of economic activity; they now must operate as a fundamental part of it. Today, it is important that insurance succeeds in emphasizing to governments (and to economic experts, scientists, and institutions) that an adequate understanding of, and efficient policy for, the development of the private insurance sector is the key to success for their policies.

Of course, any analysis of insurability involves specific issues like the market and regulatory conditions for adequate capacity-building, the development of professionalism in risk selection (the improvement of rating management), creating regulations on solvency and fiscal conditions, as well as the control of liabilities contracted in the past and their effect on the future solvency of insurance companies and institutions, along with establishing reserve constitution in cases of extreme uncertainty. But such analysis also involves, as a matter of general economic policy, the setting up of economic incentives that facilitate economic development through the control of vulnerabilities. In economic terms, this means that any optimization process has to consider on the one hand the cost of services from research to waste management and, on the other, the risk management procedures relating to all possible hazards.

Finally, insurability is also the line along which a new division of labor is being developed between private insurance and private industry, on the one hand, and the public sector, on the other.3

Insurance Within the Financial System4

Nature of Insurance in the Present World

Insurance has a decided advantage over most other financial activities in the present economic world: its core functions are very specific and constitute a fundamental key point of reference. This has to do with the idea that insurance has to provide funds, largely in the long term, to repair or compensate for the real value and costs of damages, accidents, and various losses in all fields of material activities, as well as life and health. In other words, this means that the money made available at a given point in time, as promised by any sort of policy (including life), has to provide funds with real purchasing capacities. This is obvious in the case of an automobile accident, but it is also true for somebody saving money to be used at some future date, which must then provide the expected purchasing capacities of goods and services. In other words, insurance is a financial system where, to varying degrees, the task for which the insurance has been set up has to correspond to real performance. This is not the key preoccupation of other financial activities like banking, although of course there are often intermediate situations.

The second specificity of the insurance activity is to provide funds for those in need under given conditions that rely on a system of mutuality and that is organized by a number of separate risk classes. When only one risk class exists, a communist economy exists, and when there is absolutely no insurance, the other extreme exists where there can be no solidarity and where society is totally disaggregated.

In other words, insurance is, in political-economic terms, the key for a free society based on solidarity—a solidarity that can only be efficient in a situation where a multiplicity of interest groups coexist, based on a communal nature of risks or vulnerabilities in specific areas. See Box 6.1

This latter point does not penetrate much into the world of academia concerned with financial institutions. In fact, most finance professors are content with Kenneth Arrow’s definition of insurance as being a “conditional claim.”5 By that, he meant that buying insurance is like depositing money at the bank, where you get your capital out under the condition of a specific event. This view has very largely obscured the true and fundamental connotations of insurance, which I have described previously. But this view has satisfied financial economists, letting them believe that insurance was simply a subsector of banking. The question remains, however, whether it is worth making a special effort to study insurance from a new, more specific angle?

Box 6.1.The Insurer: Guardian of Adequate Reserves

It Is often said that when an entrepreneur in industry says “yes,” he means “maybe,” that when he says “maybe,” he means “no,” and when he says “no,” he is not really an entrepreneur. In other words, the entrepreneur in an industrial system must always be ready to evaluate any project as a possibility and, in the search for new market endeavors, he only retreats after verifying the opportunities in detail.

The situation of the insurer is quite the reverse: he must say “no” at the beginning, in the sense that he must select the risks he accepts according to stringent criteria. Therefore, “no” often means “maybe.” If he says “no” too quickly, he might forgo any control over what he is underwriting. Therefore, when an insurer says “maybe,” in all practicality he means “yes”; but if he says “yes” right away, he is not a good insurer.

The problem is apparent in the following situation. Facing a lake, an entrepreneur looks at the water as something to be used and consumed. An insurer looks at the lake and the water in it and wonders just how long he will be able to maintain the water at its current level and whether he will ever be able to raise that level. And if he is looking for a reserve, he will want to be sure that the water will be there for a long time, even for decades. In other words, the only way to be a progressive manager in insurance is to be very “conservative.”

The economic problems with which the insurer is involved, directly or indirectly (health systems, social security, and environment), are mostly of a long-term nature. In the future, our ability to recognize and accept that the appropriate management of any economic problem has to be adjusted to the optimum life span or duration of any economic phenomenon or activity will be of very great economic significance. This optimum duration, to be considered a reference time unit, might be anything from a few years to a decade or more. Economic measures should not make this optimization impossible. Economists must accept that the reference unit of time (one year or one decade or more, according to the problem) is a fundamental parameter upon which the economic optimization of a system will depend. The definition of the time span of economic problems will be essential to a more rational fiscal policy.

The key here is to correctly understand the principle of mutuality, which is a supply system where economic principles, solidarity, and market freedom complement each other.

The Question of Inflation and Lower Interest Rates

The long-term issue implicit in insurance activities, in particular, requires a lowest possible level of inflation and, in my very conservative view, no inflation at all. Of course, financial returns or yields can compensate for inflation but this adds a second level of uncertainty: price instability is added to the volatility of the financial markets. Normally, insurers know that adding two types of risk, one on top of the other, is like following a negative Newton law.

In practice, some insurers admit that 2 or 3 percent inflation makes the analysis easier. The problem with inflation is that once a certain level has been reached, one discovers that in order to maintain the same advantages, one has to scale up that level again.

In addition, it seems very dangerous not to be conservative on the question of inflation if one is really serious about increasingly proposing the privatization of different aspects of social security, including pension, health, accidents, and the like. If inflation is not under strict control, customers will, in the end, prefer government guarantees.

It would also be easier to explain to the general public issues such as the increasing costs deriving from living a longer life, or those deriving from new health treatments, which necessarily increase the cost of insurance by categorizing them as real developments and not integrating them with the general discussion on monetary inflation.

This type of debate still reflects the almost total dominance in financial economic thinking, including insurance, of a culture based on banking and related activities. If some of the points that have been raised are only partly acceptable, any discussion on interest rates should also be organized at the level of real interest rates and not nominal interest rates, as has often been done.

In the banking sector, where the horizon is normally much shorter, one can provisionally accept discussion of nominal interest rates; but in the end, it does not make much sense for any long-term activity. Again, insurance is linked to the true cost of life, and not recognizing this fact and the implicit acceptance of the banking views on this issue (for historically understandable reasons) is destined to change sooner or later. Leaders of the insurance industry increasingly need to understand and make clients aware of the cost of its performance in various sectors. Presenting these facts, based purely on monetary inflated indicators, just confuses the issue (Holsboer, 2000).

Relationship Between Banks and Insurance

It is clear that there are many gray zones between banking and insurance. When Bill Gates (Chairman of Microsoft, Inc.) said, “We need banking, but we do not need banks,” he was probably referring to the fact that banking activities currently are moving into many different directions and special activities, each of which can be placed within other institutions. Thus banks have to develop an exceptional management capability and exploit their historical functions in order to transform themselves and perform consistently as well. When banks sell insurance, they are just insurance companies disguised as banking savings schemes. In contrast to the dispersion of banking activities, the core functions of insurance are much more specific. This situation may lead to one where, when a bank offers real insurance, it simply adds another name to the insurance market, whereas banking activities might become integrated into other sectors (post offices, department stores and chains, financial advisers, brokers, and the like). In this sense, banks then tend to lose their identity.

The gray zone in which bank and insurers collide is, of course, the very important one of the options and futures markets in various areas.6 Although there clearly are important issues here, once again, a better consideration of the characteristics of insurance is clearly needed.

Insurance and Liquidity in the Economy

In order to envisage the correct role of insurance within the financial institutions, it is also clear that the role played by insurance in the question of creating liquidity in the economy is a fundamental one. Thus, some initial comments on this issue should be noted by Philippe Trainard, economist of the French Federation of Insurance Companies, who is currently preparing a more extensive study on this issue to be published in The Geneva Papers.

Banks, which are the main source of liquidity in the economy (to the extent that their credits make their deposits), are frequently viewed differently from insurance companies, which, like other finance institutions, appear not to possess this ability to create their own money, since they can, after all, only lend as much liquidity as they have previously received.

This approach seems, however, to be a little simplistic. Without getting into a substantial debate on whether the “credits equal deposits” principle sets banks apart from other finance institutions, one should remember the teachings of John Maynard Keynes (see, for example, Keynes, 1936), namely that money creation is designed to secure adequate liquidity in the economy and to fund investment when savings are hoarded. In this way, money creation transforms a liquid investment (amassed savings) into a nonliquid or unrealizable investment (i.e., the financing of an activity that will reach maturity in the longer term). In withdrawing “outside” money from circulation and replacing it with their own money, banks indirectly transform amassed savings into economic investments that have risks that are mutualized within each banking establishment.

But, as Gurley and Shaw (1960) demonstrated back in the 1960s, financial intermediaries like insurance companies do exactly the same thing. The aim of insurance companies is to transform amassed savings—in this instance, for microeconomic purposes—into economic investments that have risks that are mutualized within each insurance company. Unlike banks, however, because of the pooling both of the risk of financial outcomes and of the liquidity requirements resulting from risks covered by insurance, their action limits the volume of amassed savings at the same time.

On the one hand, insurance and banking services are identical. Asset transformation services enable insurers and bankers alike to optimally dispose of available liquidities in financing the economy, by

  • size (divisibility)—transforming small liabilities into substantial investments;
  • quality (risk)—transforming risk-free, low-yield receivables into high-risk receivables (which the market can only do directly at a high cost) and market nonnegotiable receivables (which, for banks, means credits and, for insurance companies, insurance contracts) into negotiable deposits (for banks and investments for insurance companies); and
  • redemption (maturity)—transforming short-term into long-term receivables and assuming the resulting liquidity risk; insurance companies, like banks, perform, such transformation functions.

On the other hand, insurance is different because of the way it performs these services. Banks basically offer their depositaries a payment system that has given rise to the “credits equal deposits” principle and that makes it possible to reduce the reserves earmarked for transaction costs; insurance companies offer a rather different service that makes it possible to reduce the contingency reserve.

As a specific service, the insurance contract does a number of things. First, it offers, in exchange for slightly reduced deposit liquidity, a return that is normally guaranteed (in some instances, actually improved by favorable fiscal terms)—for example, life insurance, which accounts for the vast bulk of the liquidity brought to the economy by insurance.

Second, the insurance contract provides coverage of the material and moral risks insurees run in everyday life, enabling the latter to reduce the contingency reserve earmarked for covering such risks. That is, by mutualizing individual risks, insurance enables insurees to diversify their assets almost as perfectly as would be possible in a complete market, thereby helping to optimize allocation of resources. The insurer must nevertheless protect himself against moral hazard and adverse selection in order to consolidate the economic welfare achieved through coverage of the risks itself:

  • prior to signing a contract, by devising a tariff structure that adequately reflects the extent of the risks already underwritten; this can be achieved through risk research, the establishment of an optimal tariff structure, and subsequent management of contracts on a tacit renewal basis; and
  • after signing a contract, by tariff differentiation, risk prevention incentives, and rigorous assessment of damage and of the circumstances under which it occurred. That is, in insurance, the supply of liquidity to the economy is brought about through a complex combination of financial and real services, which in banking is done through a complex combination of financial and monetary services.

Insurance controls a substantial share of financial intermediation. The figures are most revealing:

In France: In 1996, insurance companies held 4.5 percent of total equity shares (24 percent were held by households) and 36 percent of total bonds.

In the United States: In 1998, life and non-life insurance held 4 percent of total equity shares (59 percent were held by households) and 13 percent of total bonds. In the same year, private pension funds held 10 percent of total equity shares and 5.5 percent of total bonds.

In Europe: In 1998, insurers controlled 21 percent of stock market valuation in Europe, and their financial investment was equivalent to 49 percent of GDP (or 36 percent of that of the euro area) and has been rising steadily since the beginning of the 1990s.


The circumstances under which insurance supplies liquidity to the market ensure optimum allocation of resources within the economy:

  • hoarding is minimized and saving is channeled toward the most efficient investments; and
  • reduced insuree risk, risk-prevention incentives, and optimal investment choices all help to lower the necessary reserve rates, which, in turn, reduce the need for financial intermediation to a strict minimum.

It should be noted that, in contrast to the situation in banks, in insurance companies households are over-represented under liabilities, because life insurance enables them to mobilize their financial capacity.

Some Other Key Issues

Although the issues summarized in this paper are already extensive, it is necessary to mention some other key problems and areas, particularly with respect to the issue of managing financial stability7 and the issue of spreading systemic risk, or even its originating, in the insurance sector. For a long time, there has been speculation as to the extent to which an unexpectedly huge loss might result—for instance, from an earthquake in Tokyo or a hurricane in the southern United States that could provoke damages and disruptions at a cost of $50 billion to $100 billion or more.

Naturally, the damage would be even more severe if such events occurred at the same time. Linked to this latter issue is the question of identifying the insurance equivalent of the lender of last resort in the banking system. In practice, the lender of last resort is first of all represented by governments and local and international institutions and, secondly, simply by those suffering from damages with no possibility of being rescued. Here again, the issue of the definition of insurability arises, along with the key issue of the repartition of tasks between private and public institutions.

A further step is the one represented by current discussions and initiatives being taken by many international and national organizations on the question of regulations and solvency. One especially delicate issue concerns financial conglomerates that have resulted from the many mergers of banks and financial institutions and how to develop ways to more closely complement all the varieties of institutions.8

The regulations issue also appears to be of great relevance for the negotiations on financial services promoted by the World Trade Organization (WTO) in Geneva.9

As a last consideration and hypothesis in this framework concerning the WTO negotiations, one could also imagine that if indeed we do live in the new global economy based on services in all sectors, the present discussion in Geneva on services, which considers services as one specific sector, might in fact well open the door for an innovative way of enhancing global negotiations. What is now still considered a sector is in fact the main road leading to the whole global economy.

Another important point to evaluate in order to better understand and develop the function of insurance is the question of defining the characteristics of the insurance industry’s supply system. An insurer, by nature, tries to diversify its risks in many ways. An important way is to do this within the whole insurance system horizontally and vertically by transferring risk, for instance, to one or more reinsurance companies and/or even by transferring risks horizontally to what normally would be considered their competitors.

In a sense, the insurance business can be considered by traditional economic standards as a natural and necessary oligopoly. This structure optimizes and ameliorates the possibility of covering risks just because the quality of supply is finally improved by the commitments of all companies who are, on the one side, competitors and, on the other side, sharing at least part of the same risks. A large number of companies increases the possibilities of splitting the risks in a variety of ways, achieving a higher degree of efficiency. One should therefore consider that although insurance, like many other economic activities, is in a process of concentration, even the largest possible insurance companies will never cover the same amount of the market that one can, for instance, find in sectors such as automobiles and telecommunications. There are, in Europe and in the United States, a couple of dozen automobile producers but still thousands of insurance companies. There will never be an insurance company of the size of IBM or Microsoft.

Some Additional Issues in the Service Economy

Another key difference between the former industrial economy and the service economy is that an industrial economy essentially values products that exist materially and are exchanged, whereas the service economy more closely values performance and real utilization (in a given period of time) of products (material or not) integrated in a system. Whereas during the classical economic revolution the value of products could be identified essentially with the production costs, the notion of value in the service economy is shifting toward the evaluation of costs incurred with reference to results obtained in utilization.

Some call this process the emergence of immaterial goods. But the idea of services or of a modern economy based on “immaterial goods” stems in fact from a misconception. Hard products and services are not separate; they are in fact complementary. When a piece of hardware is used, it produces a service. For example, an automobile is a piece of hardware that provides transportation from one place to another—that is, a service. Therefore, the difference between material and immaterial is in the observer’s mind and not actual reality. If one considers telecommunications, not a single telephone call could be made or information system operate without hardware; similarly, no hardware could be used without adequate services.

Therefore, the real difference that emerged some thirty years ago is that while in the classical Industrial Revolution the cost of hardware was decisive and represented in economic terms the amount of resources used, in the service economy it is the cost and quality of the accompanying services, whether it be in utilization or other functions, that are quantitatively determinant.

If one accepts the idea that services are spread throughout all sectors and thus the traditional economic theory of the three separate sectors (agriculture, industry, and services) is somewhat obsolete, one should also acknowledge the fact that a manufacturing industry is “advanced” when it has developed the most and the best performing services, thereby dismissing the outdated concept that services are a kind of secondary or even rear-guard part of the economy.

One should also avoid confusing the preindustrial services (which justify the contempt against them by the economists of the Industrial Revolution) with those services that are the consequence of a mature industrial society, which have benefited from newer and the most efficient technologies.

Service functions that normally represent 70 to 80 percent of “production costs” in most “manufacturing” companies can be described as belonging to four categories:

  • before manufacturing (research, financing);
  • during manufacturing (financing, quality control, safety, and so forth);
  • selling (logistics, distribution networks, and the like);
  • during products and systems utilization (such as waste management and recycling).

In a graphic form, these services can be drawn in the following way:

R & D ← Production costs →Distribution → Utilization →Recycling ← →

Whereas, traditionally, costs could normally be essentially referred to as the “production” phase, costs related to all the other four phases have increased constantly relative to the pure manufacturing phase, up to the point of becoming dominant. In terms of economic value, it is not only related to the existence of a material product (traditionally limited to the phase of the material production), but it is extended over the performance of the system, whereas the utility is really dependent on the utilization of the product or system.

The notion of utilization requires a time reference (duration), which in itself can only be defined by a probability. Costs and benefits, therefore, cannot be analyzed adequately in a static system of reference, “The General Equilibrium Theory,” but must refer to an economic system that must optimize at different levels of uncertainty.


    ArkellJulian2000International Investment, Trade Liberalization and Competition: Some Issues for the Insurance Sector to Consider,Geneva Papers on Risk and Insurance—Issues and Practice Vol. 25 (January) pp. 10415.

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    ArrowKenneth1971Essays in the Theory of Risk-Bearing (Chicago: Markham Publishing Co.).

    ArrowKenneth1979Risk Allocation and Information,Geneva Papers on Risk and Insurance—Issues and Practice Vol. 4 (June) pp. 519.

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The question of moral hazard is a fundamental one and essentially defines the dividing line between pure and entrepreneurial risks. On the one hand, no manipulation or negative incentive of any kind should exist in managing pure risks, while on the other hand, entrepreneurial risks depend on constant possibilities of decision and modification of any economic activities by all economic agents. Pure risks are acts of God, whereas entrepreneurial risks are acts of mankind.


With reference to the notion of insurability, see Berliner (1982, p. 118); various articles on insurability published in the Geneva Papers on Risk and Insurance—Issues and Practice, No. 39 (April 1986); and No. 85 (October 1997) for articles on sustainability and insurability. Also, linked together with the concept of insura-bilty is the idea of moral hazard; see the special issue of the Geneva Papers, No. 26 (January 1983), introduced by Joseph E. Stiglitz with a study on “Risk, Incentives and Insurance: The Pure Theory on Moral Hazard”; see also No. 33 (October 1984), on “Uncertainty in Economics,” introduced by Walter Weisskopf.


See Arrow (1971 and 1979). Kenneth J. Arrow, Nobel prize winner in Economics, delivered the first Annual Lecture of the Geneva Association at the London School of Economics in 1977.


The literature on financial instability and how to manage it is, of course, large and significant. Note the Fall 1999 issue of the Journal of Economic Perspectives and, in particular, the articles with reference to a symposium on global financial instability; see also the article by Stanley Fischer on the need for an international lender of last resort.


The Geneva Association is closely following this area, particularly through the annual seminar in Geneva, where regulators and interested parties, including rating companies, are invited.


See, for instance, Woodrow (2000), as well as Arkell (2000).

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