Determinants of Insurance Demand The Case of Life Insurance

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Determinants of Insurance Demand The Case of Life Insurance

    stRevised 31 May 2007

    Preliminary draft: Comments and suggestions are welcome

    Are Life Insurance Demand Determinants valid for

     Selected Asian Economies and India?

     thPaper for Presentation at the 11 Annual Meeting of APRIA, NCCU Taipei,

    July 22-25 2007

    Subir Sen Dr. S. Madheswaran PhD Student Professor

    Centre for Economic Studies & Policy Centre for Economic Studies & Policy Institute for Social and Economic Change Institute for Social and Economic Change Nagarabhavi, Bangalore 72, Nagarabhavi, Bangalore 72, Karnataka: INDIA Karnataka: INDIA

    Ph. No.: +919845640923 Ph. No.: +918023215468 (Office: Extn. 210)

JEL Classification: G22, C33, C32,

    Keywords: Life Insurance, Insurance Demand, Panel Estimation, Time Series Analysis.

     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?


During the post 1990 period, services sector in most of the Asian economies witnessed

    growth fueled by substantial changes in the financial sector of these economies. The

    insurance industry, in most of the Asian economies were publicly owned and remained

    isolated from domestic private or foreign participation. But, regulatory reforms and

    policy changes in the ASEAN economies in the post financial crisis period, liberalization

    process in some of the SAARC countries, China‟s accession to WTO and creation of

    Hong Kong SAR had led to phenomenal changes in the growth pattern of insurance

    industry in these economies. This study is focused on 4 SAARC countries, 2 countries

    from Greater China Region and 6 ASEAN countries and is an attempt to search for

    crucial economic and other socio-political variables which can play a significant role in

    explaining the life insurance consumption pattern in these economies for the 11 year

    period (1994-2004) studied. An independent exercise is undertaken for re-assessing

    variables best explaining consumption pattern in India for the period 1965 to 2004. We

    find some of the variables capable of strongly determining life insurance demand but

    contradictions to earlier studies arise as some of the determinants are observed to be

    either weak or due to the methodology employed, turn out to be incompetent in

    explaining demand.


     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?


    The growth of the services sector in the Asian economies led to substantial changes in the financial sector. The Asian Financial Crisis, affecting the ASEAN economies in particular resorted to more regulatory measures to enhance delivery of products with minimal risks and failures. The countries surrounding the ASEAN economies also went through a phase of economic-restructuring, the most notable event being the impact of China‟s accession to WTO. The insurance industry in most of the Asian economies were

    publicly owned and operated. Government monopoly kept this segment of the financial market isolated from domestic private or foreign participation. Barring few exceptions, the insurance market on an average remained underdeveloped in terms of insurance density and penetration. Regulatory changes since mid eighties and opening of these markets to private and foreign entry have been luring global heavyweight insurers to enter these economies. As more suppliers enter these markets, the issue is to re-examine the factors that can probably elevate demand for insurance products. This study on 4 SAARC countries, 2 countries from Greater China Region and 6 ASEAN countries, deals with this particular issue. After reviewing existing theoretical as well as empirical literature, we identify variables determining demand and categorize them as economic, demographic, legal and socio-political variables. Using a time series framework we then take into account a single economy, India, and reassess the issues and hypothesis dealt in the panel analysis.

    The paper is organized as follows. The paper begins with the theoretical as well as empirical review of literature. Based on the theoretical review as well as the results obtained from earlier research studies, we frame our set of researchable questions and issues. We present our identified preferred set of determinants and a priori expected relationship with the demand proxy. The methodology portion is divided into explaining briefly the 12 selected Asian economies and India followed by data sources. Next, we specify the two separate models to be estimated via use of two different econometric techniques viz. panel data analysis and time series analysis. Proceeding to the results and interpretation, we present the estimation results relating to the panel and the time series data. Lastly, we summarise the findings and draw conclusions.


     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?

Review of Literature

(a) Theoretical Studies

Studies on life insurance consumption dates back to Heubner (1942) who postulated that

    human life value has certain qualitative aspects that gives rise to its economic value. But

    his idea was normative in nature as it suggested „how much‟ of life insurance to be

    purchased and not „what‟ will be purchased. There were no guidelines regarding the kind

    of life policies to be selected depending upon the consumers capacity and the amount of

    risk to be carried in the product.

Economic value judgments are made on both the normative as well as positive issues.

    1Later studies on insurance gradually incorporated these issues via assimilating

    developments in the field of risk and uncertainty following works by von Neumann and

    Morgenstern (1947), Arrow (1953), Debreu (1953) and others. The economics on

    insurance demand became more focused on evaluating the amount of risk to be shared

    between the insured and the insurer rather than evaluation of life or property values. This

    emerged because it was risk associated with individual life or property that called for an

    economic valuation of the cost of providing insurance.

Life insurance is essentially a form of saving, competing with other forms of saving in

    the market. The theory of life insurance demand thus developed through the life-cycle

    model(s) of saving. Let a person‟s income rate and his consumption plan are represented by a continuous function of time and respectively. Thus, net saving (positive ytct????

    2or negative) at time t is given by

    ttt??? --- (1) steeyscsds???????????0

    where, δ is the rate of interest.

     1 Yaari (1963), Mossin (1968), Hakansson (1969), Fisher (1973), Borch (1977), Pissarides (1980),

    Campbell (1980), Karni and Zilcha (1985, 1986), Lewis (1989), Bernheim (1991) to mention few. 2 This section is based on Chapter 4 of Borch(1990)


     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?

Even though all individuals want to consume as much possible, this does not happen in

    reality and the above expression of saving is constrained by number of possibilities. For

    example, the person has no debt [], solvent at time of his death at time T st?0??[] and leaves a bequest of amount B []. sT?0sTB?????

Uncertainty associated with time of death is represented by a random variable with

    ?density , where is the probability that a person at age x shall still be ??ftt??t??????

    alive after a time t. Taking expectation of (1) and discontinuing, we get

    ??t??????ts??esttdtyscsedstdt?? --- (2) ?????????????????????000??

    ???s --- (3) ???seyscsds?????????0

    If the individual takes pure endowment insurance, single premium being

    t??t??EteEds???, ????????txxs????0??

    ?t??Edsytctdt??Thus, net saving equals. ????????????xs??????00??This shows that saving through life insurance takes place at a higher rate of interest than

    conventional saving. In the determination of optimal insurance consumption, the

    conventional utilitarian theory is adopted which reflects individuals preferences over

    different consumption patterns. Let us consider the utility function of the form T

    t??--- (4) vceuctdt??????????0

    where, β is the „impatience‟ to consume.

    Assuming the person had no debt at time T i.e., , the problem is to maximize its sT?0??

    ???t???utility (4). The solution gives us, . Within this framework, various vctke???????forms of life insurance are introduced; the probability associated with death or number of

    maximum life years is considered; and then the expected utility of consumption is


     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?

maximized subject to any one of the three restrictions on the net savings as described


The role of insurance in the above model has been predominantly to smoothen out

    consumption over time, make bequests, and repay debts or to insure a constant income

    stream after retirement. The ongoing discussion also reveals that individuals‟ current

    income and future anticipated consumption expenditure plays a crucial role in

    determining the amount of insurance purchased (we are, for a while ignoring the form in

    which insurance is purchased). The importance of rate of interest (δ) or the impatience

    factor (β) is also worth considering. Preferences over different consumption pattern vary

    from person to person and there are „qualitative‟ factors which affects such preferences.

Using the expected utility framework in a continuous time model, Yaari (1965) studied

    the problem of uncertain lifetime and life insurance. Including the risk of dying in the life

    cycle model, he showed conceptually that an individual increases expected lifetime utility

    3by purchasing fair life insurance and fair annuities. Simple models of insurance demand

    were proposed by Pratt (1964), Mossin (1969), Smith (1968) and others; considering a

    risk averse decision maker with an initial wealth W. The results indicate that demand for life insurance varies inversely with the wealth of the individuals. Hakansson (1969) used

    a discrete-time model of demand for financial assets and life insurance purchase in

    4particular to examine bequest motive in considerable detail. Pissarides (1980) further

    extending Yaari‟s work proved that life insurance was theoretically capable of absorbing

    all fluctuations in lifetime income. Lewis (1989) found out that the number of dependents

    as an influence on the demand for life insurance.

To sum up, the theoretical review yields macroeconomic variables like income, rate of

    interest, and accumulated savings in wealth form; along with a set of demographic or

    social variables having potential impact on an individuals‟ decision to opt for or not to

    demand life insurance. Life insurance consumption increases with the breadwinner‟s

     3 „Fair‟ actuarially means the premium or price of insurance that exactly equals expected value of payments

    in case of claims or loss by the insurer, without charges for expenses or profits. 4 Refer Skipper (2003) page 20.


     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?

    probability of death, the present level of family‟s consumption and the degree of risk aversion.

(b) Empirical Studies

    In this section, we explore some of the pioneering empirical exercises on determinants of life insurance. Most of these studies had focused on both the demand side factors and the supply side factors.

    Headen and Lee (1974) studied the effects of shortrun financial market behaviour and consumer expectations on purchase of ordinary life insurance and developed structural determinants of life insurance demand. They considered three different sets of variables: first, variables stimulating demand as a result of insurer efforts (e.g. industry advertising expenditure, size of the sales force, new products and policies, etc.); second, variables affecting household saving decision (e.g. disposable, permanent and transitory income, expenditure expectation, number of births, marriages, etc.) and lastly, variables determining ability to pay and size of potential markets (e.g. net savings by households, financial assets, and consumer expectation regarding future economic condition). They concluded that life insurance demand is inelastic and positively affected by change in consumer sentiments; interest rates playing a role in the shortrun as well as in the longrun.

    Using an international dataset (12 countries over a period of 12 years) to examine the relationship between property liability insurance premiums and income, Beenstock et al. (1988) found out that marginal propensity to insure i.e., increase in insurance spending when income rises by 1$, differs from country to country and premiums vary directly with real rates of interest. Assuming a two period simple model; they considered the case when wealth W is reduced by G following a loss and no insurance purchased in the first

    period. If there had been some insurance purchased than wealth in the first period equals (W- premium paid) and assuming loss, end period wealth is (G sum insured). Thus,

    again the decision of consumer and his/her initial wealth status too are significant factors when shortrun or longrun consumption of insurance is considered.


     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?

The study by Truett et al. (1990) discussed the growth pattern of life insurance

    consumption in Mexico and United States in a comparative framework, during the period

    1964 to 1984. They assumed that at an abstract level demand depends upon the price of

    insurance, income level of individual, availability of substitute and other individual and

    environment specific characteristics. Further, they experimented with demographic

    variables like age of individual insured(s) and population within the age group 25 to 64

    and also considered education level to have some bearing on insurance consumption

    decision. They concluded the existence of higher income inelasticity of demand for life

    insurance in Mexico with low income levels. Age, education and income were significant

    factors affecting demand for life insurance in both countries.

Starting with a brief review of Lewis‟s theoretical study and an assumption that

    inhabitants of a country are homogeneous relative to those of other countries, the study

    by Browne et al. (1993) expanded the discussion on life insurance demand by adding

    newer variables namely, average life expectancy and enrollment ratio of third level

    education. The study based on 45 countries for two separate time periods (1980 and 1987)

    concluded that income and social security expenditures are significant determinants of

    insurance demand, however, inflation has a negative correlation. Dependency ratio,

    5education and life expectancy were not significant but incorporation of religion, a

    dummy variable, indicates that Muslim countries have negative affinity towards life


Based on a cross-sectional analysis of 45 developing countries, Outreville (1994)

    analysed the demand for life insurance for the period 1986. In his study he considered

    variables such as agricultural status of the country represented by the percentage of

    agricultural labour force; health status of the country in terms of amenities like

    percentage of population with access to safe drinking water; percentage of labour force

     5 “Religion can provide weights into individuals … and life insurance consumption is less in predominantly

    Islamic countries” studies by Douglas et al. (1982), Henderson et al. (1987), Zelizer (1979) and Warsaw

    (1986): cited in Browne et al (1993) page 621.


     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?

with higher education and the level of financial development as factors explaining

    insurance demand other than the variables we have discussed above. Two dummy

    variables were used to reflect the extent of competition in the domestic market and

    foreign participation in the countries considered. The analysis shows that personal

    disposable income and level of financial development significantly relates to insurance development. Since the political philosophy regarding market openness varies from

    country to country, market structures dummy appeared to be significant.

Taking into account the expansion of the service sector during the early nineties and

    growth of insurance services in particular, Browne et al. (2000), tried to explain the differences in property liability insurance consumption across countries. They considered individual‟s income and wealth, degree of risk aversion, loss probability and price of

    insurance as variables affecting property-liability insurance demand, similar to those used for life insurance demand analysis. The analysis was focused on the OECD countries and concluded that in general, insurance purchase is influenced by various economic and

    demographic conditions. Another study based on nine OECD countries examined the

    short run and long run relationship exhibited between economic growth and growth in the insurance industry. This study by Ward et al. (2000) is a co-integration analysis using annual data for real GDP and total real premiums for the period 1961 to 1996. Results

    6give an indication that country specific factors influence the causal relationship between

    economic growth and insurance market development.

Allowing income elasticity to vary as GDP grows for an economy, Enz (2000) proposed

    the S-curve relation between per-capita income and insurance penetration. Using this one factor model one can generate longrun forecast for life insurance demand. Observing the outlier countries or countries distant from the S-curve plot, it is possible to identify structural factors like insurance environment, taxation structures, etc. resulting in such deviations.

     6 Country specific factors referred here to are attitudes towards risk and risk management, regulatory

    factors, legal environment, other modes or availability of financial intermediation, etc.


     Are Life Insurance Demand Determinants valid for Selected Asian Economies and India?

    There are two detailed studies on the determinants of life insurance demand, one taking into consideration only the Asian countries and the other based on 68 economies. The former study by Ward et al. (2003) and the later by Beck et al. (2003) evolves around the issue of finding the cause behind variations in life insurance consumption across countries. After almost three decades of empirical work in this direction, it is still hard to explain the anomalous behaviour of Asian countries with higher savings rate, large and growing population, relatively low provision for pensions or other security and a sound capital market but comparatively low per-capita consumption of insurance. Except Japan, most of the Asian countries have low density and penetration figures.

    The two main services provided by life insurance: income replacement for premature death and long-term savings instruments, are the starting point for Beck et al. (2003). They considered three demographic variables (young dependency ratio, old dependency ratio and life expectancy), higher levels of education and greater urbanization as independent factors in explaining insurance demand. Economic variables like Gini index and Human development index are new additions along with institutional variables reflecting political stability, access to legal benefits and an index of institutional development were used. The analysis considering the time period 1961 to 2000 shows that countries‟ with developed banking system, high income and lower inflation have higher life insurance consumption. The association of insurance demand with demographic is not statistically strong however older the population, higher tends to be insurance consumption. The luxury good nature of insurance did not reflect through its association with income distribution.

    In contrast to Beck et al. (2003) results, the study by Ward et al (2003) is indicative of the fact that improved civil rights and political stability leads to an increase in the consumption of life insurance in the Asian region as well in the OECD region. Following Laporta et al (1997, 1998, and 2000) works relating to supportive aspect of legal environment for finance, they too considered the same in determining insurance demand. Analyzing the data from 1987 through 1998 for OECD and Asian countries, they


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