Insurance in the Economic Universe Historical role; the Business Equation Today

 

Till the middle of the 20th century the world’s economies were largely ‘cash dependant’ and not ‘credit driven.’ Economic historians can quarrel about the specific date or event which marks a turning point from when ‘Credit,’ and not ‘Cash’ became the more dominant driver of economic growth, but for our general purpose it is not very material on what specific date or event they final agree upon. For a long duration of human history it was ‘Cash’ which was considered ‘King,’ the important fuel that drove the economy and commerce. Remember the old exhortation “Neither a Borrower nor a Lender be.” It used to be popular with the generation of our Grandparents, or their parents, people who grew up with the mindset of the 19th century. 

In simple terms, people of good social standing, who belonged to the ‘middle classes’ or better, considered it undignified, almost less than ‘moral’ to borrow money. A ‘debtor’ fell from grace, and grew small in stature, somehow. It is not as if ‘Credit’ as a source of finance did not exist, but rather, its role was comparatively minor in driving economic activity. In this scenario the ‘rich’ who held a major portion of the ‘wealth’ did not need ‘credit, and did not like the idea of ‘

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borrowing’ anyway. The rest, the ‘poor’ who could have utilized ‘credit’ had no access to it for the Banks would not lend them money. The Banks themselves were viewed as ‘repositories’ of cash rather than as ‘sources’ of finance. The world’s economy, and commerce, continued to grow at a slow, steady, conservative pace.

 Then, from the 18th century onwards, the Industrial Revolution which started in Great Britain and Europe, and spread through the world, set in motion two centuries of continuous economic expansion, which has culminated in our present state of a globalized, connected, interdependent economy. Greater exploitation of natural resources, increased supply of raw 

materials, an explosion of inventions and technology, all led to a massive growth in industrial output. The need to implement the new ideas and inventions created an expanding demand for finance. Entrepreneurs and Industrialists needed ‘money,’ but the Banks who possessed the resources would provide access to them only if they were assured that they would be able to recover their money even if the assets financed by them were destroyed by natural calamities or accidents. The Insurance industry provided this vital assurance of protection through its policies of insurance, and therefore, as the economy expanded, the Banking system grew, and so did ‘insurance.’ Remember we are only saying that from this time the Insurance Industry ‘grew,’ and not that this is when it was started or invented. Historians have found evidence of the existence of practices of distribution of risk akin to insurance among Chinese and Babylonian traders as long ago as the 2nd and 3rd millennium BCE. The Code of Hammurabi, c.1750 BCE, records the practice of marine insurance among merchants sailing the Mediterranean Sea. In the 1680s Edward Lloyd’s famous Coffee House in London became the location for a thriving marine insurance business transacted between merchants and underwriters who were its regular patrons. A few years earlier London’s first ‘Fire Insurance’ company had started business operations. The first Life Insurance policies were perhaps taken out in America in 1706. So, there is enough evidence to establish the existence of insurance as a risk management activity long before the events of the Industrial Revolution turbocharged its growth.

The Business Equation Today

What is the equation between Insurance, Banking and the Economy? What is the relationship between Insurance and Banking, and what is the strategic role ‘Insurance’ plays in economic activity?

                  Figure 2: Insurance and Other Support Systems for Credit Expansion  

Entrepreneurs, Industrialists and Traders, all need easy access to large amounts of capital to be able to grow at the rate that is now considered necessary. Without this access to capital they would have to rely solely on their own resources which would severely limit the scale and scope of their operations. Economic activity would not come to a halt, but it would slow down to a snail’s pace.

A Bank’s decision to provide finance for a venture, whether a new project, an industrial expansion or a commercial transaction generally depends upon four factors: 

Business Risks – Feasibility – as assessment of the technical and commercial feasibility of the proposed venture. Domain Specialists in the field of Project Management & Implementation provide this input. 

Default Risks – Credit Worthiness – an assessment of the borrower’s capacity and willingness, and past record, to repay loans. In addition to their in-house expertise Banks get this input from various types of Credit Rating Agencies. 

Legal Risks – Legal Protection – a strong legal system, comprising comprehensive laws and structure of enforcement, to be able to enforce contracts and recover their dues. The continuous evolution of the Legal System under democratic political systems has been able to fulfill this need. 

Material Damage Risks – Asset Loss Protection – a comprehensive system to obtain compensation for business assets and interests damaged by accidental occurrences. The development of the Insurance Industry and its products provides the needed support. We are now in a position to summarize the strategic role played by the Insurance Industry in Economic Activity. 

1. Safety Net for Banking Industry

 The Insurance Industry provides a vital ‘Safety Net’ for the Banking Industry. In the absence of an insurance policy, it would be very difficult, even impossible, for a Bank to recover loans advanced to finance assets and interests which may be damaged by accidental events. Without ‘Insurance’ Banking would become a much more risky venture. 

2. Growth Facilitator – Expansion of Industrial and Commercial Activity 

Without the safety net provided by Insurance, Financial Institutions would be extremely reluctant to advance large loans, and the pace of industrial activity would be limited by the ability of the venture to raise its own funds internally. The Insurance Industry acts as a facilitator of economic growth. 

3. Financial Liquidity Facilitator – Capital Productivity Enhancer 

Large amounts of capital would have to be kept aside in ‘Sinking Funds’ to provide for future losses. This would further reduce ‘liquidity’ in the financial system and create large pools of unproductive capital. Insurance enhances the productivity of capital by facilitating liquidity in the financial system.

4. Risk Management Tool – Enterprise Stabilizer 

Insurance acts as a useful risk management tool for enterprises and individuals. It helps them maintain the financial stability of organizations and individuals when they are faced with losses caused by accidental damages. 

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Quality of Life Booster 

The quality of life for individuals would also be adversely impacted. Today, an increasing number of individuals are able to fulfill their aspirations for a ‘dwelling house’ or a car of their dreams by taking loans from financial institutions. These loans are underpinned by insurance policies which protect the interest of the financial institution as a mortgagee in the event the asset itself is destroyed or damaged by an accident before the loan has been paid off. None of this would be possible without the protection provided by insurance policies. We shall now proceed to examine the activity of Insurance and the associated basic concepts and principles in greater detail.