ECONOMIES OF SCALE IN LIFE AND HEALTH INSURANCE INDUSTRY.

• Author: Malhotra, D.K.
• Position: Report

INTRODUCTION

The life and health insurance industry is an important industry in the United States, generating nearly $900 billion. Like many industries in the financial sector, the economic crisis of 2008-2009 that originated in the financial services industry and impacted every type of financial intermediary, adversely affected the life and health insurance industry, which is an important component of the financial intermediation industry. Nearly ten years later, the industry continues to struggle with slow growth (and in some cases, a negative growth rate). Firms in this sector have adopted varied strategies to counter the slow growth (S&P Global Industry Surveys Insurance). Some companies, like MetLife, Inc., have expanded into high growth potential overseas markets especially in emerging markets, while others have diversified their product portfolios to include property-casualty insurance supplemental health coverage, and mutual funds and investment products.

Insurance companies have also turned to mergers and acquisitions to drive growth, and/or alter their business mixes. Aetna for example, merged with Humana in the state- and federally funded Medicaid program and Tricare coverage. Anthem WLP also--has announced an agreement to acquire CIGNA CI. The consolidation wave has raised concerns regarding the adverse impact on consumers of creating monopolistic conditions in some markets. Admittedly, with bigger insurance companies, bargaining power of consumers and physicians will be reduced considerably. On the other hand, insurance companies claim that an increase in size will lead to economies of scale and it will lead to lower health care costs, expanded access to health care and more health care provider partnerships.

In this study, cost efficiency is evaluated due to economies of scale in the life and health insurance industry for the years 2012 to 2015. Cost is measured in terms of total dollar cost of managing a life and health insurance company. Size of the firm is measured in two ways: total assets of a firm and total revenue of a firm.

An empirical evaluation of the health and life insurance industry is important for several reasons. First, insurance companies play an important role by absorbing risk that the household sector is unwilling or unable to cover. If the viability or health of insurance companies is at risk, it can have negative impact on household savings and overall societal welfare.

Second, insurance companies are interconnected to banks through their funding arrangements in reinsurance transactions. Any shock to the insurance sector could have a domino effect which results in increased demand for credit that can constrain the banking sector (Koijen & Yogo, 2015).

Third, insurance companies are the largest institutional holders of corporate bonds. If there is any threat to the financial health of insurance companies, it will result in a decline in demand in the bond market. Such declining demand will have a negative impact on availability of credit in the market for the business sector. Reduction in availability of credit will also have a negative impact on business, and consequently, slow economic growth and overall societal welfare (Koijen & Yogo, 2015).

This study helps the health and life insurance industry and regulatory agencies to gain a better understanding of the impact of the growth of health and life insurance firms on their expenses and benefits to shareholders in the form of higher returns and increased wealth to shareholders. This study expands the results of previous studies in two ways. First, no study has looked at economies of scale in the health and life insurance industry over a long period of time. Second, this study examines economies of scale over a period of four years (2012-2015) to investigate the consistency of economies of scale over a longer period of time. Finally, this study evaluates the cost efficiencies of the health and life insurance industry in the post-economic crisis period.

REVIEW OF LITERATURE

Previous studies in the context of performance of the insurance industry can be broadly classified into two categories: studies that examine cost efficiencies in the financial services industry in general, and studies that cover the performance of insurance companies. Other studies examined economies of scale in the banking industry. Edirisuriya and O'Brien (2001) studied economies of scale in Australian banks after financial deregulation. They found evidence of economies of scale and scope in four major Australian banks.

Toby (2006) reviewed previous studies on economies of scale in the banking industry and concluded that smaller banks are more efficient in comparison to larger banks in most countries. Stimpert and Laux (2011) reported that while costs decline and profitability increases as bank size increases, these relationships did not hold indefinitely and diseconomies of scale were experienced by larger banks. When size was measured by total assets, larger banks begin to encounter lower levels of net income, but the very largest banks were able to enjoy net income that increased as size increases. When size is measured by total deposits, net income increased at an increasing rate for a wide range of bank sizes and only began to decrease for the largest banks.

McNulty (2000) measured economies of scale for six large Canadian banks. He reported economies of scale in Canadian banking industry due to technological and regulatory changes. Margono and Sharma (2010) estimated cost efficiency, economies of scale, technological progress, and productivity growth among Indonesian banks from 1993 to 2000. They found that average cost efficiency of the banking sector over this period was 70%. They also reported a marked difference in cost efficiency before and after the Asian economic crisis. The banking sector cost efficiency was 80% prior to the crisis and 53% after the crisis.

Moreover, results indicated that private-owned banks and joint venture/foreign banks were more efficient than public-owned banks. They attributed cost reductions to technological progress and economies of scale. Kasman (2005) examined the cost efficiency and scale economies of banks operating in Poland and the Czech Republic during the period from 1995 to 2000. They found that Polish banks are, on average, more efficient than Czech banks. The study also suggested that foreign banks operating in the Czech banking sector had significantly higher efficiency levels than those of domestic banks. They also reported evidence of significant economies of scale for small and medium-sized banks, but diseconomies of scale for large-sized banks.

Das and Das (2007) used a multi-product Fourier flexible cost function specification to investigate scale economies, cost complementarities and technical progress of Indian banks during the post reform period 1992 to 2003. The empirical results revealed significant economies of scale for all size classes of banks and there is no evidence of diseconomies of scale, even for larger banks. Ray (2007) evaluated the size efficiency, as distinct from scale efficiency, of Indian banks. He found that often a bank is operating in the region of diminishing returns to scale but is not a candidate for break up.

Shahi and Singh (2015) analyzed the comparative performance of health insurance business of public and private general insurance companies in India on the basis of claims ratio and net retention ratio. Elango, Yu, and Pope (2008) investigated the relationship between product diversification and firm performance in the U.S. property-liability insurance industry. They reported that performance benefits associated with product diversification are contingent upon an insurer's degree of geographic diversification. Klumpes (2004) benchmarked the life insurance industry to measure the profit and cost efficiency of UK life insurance products that were required by "polarization" regulations to be distributed through either independent financial advisers or appointed and/or company representatives.

METHODOLOGY

Procedure

This study estimates the coefficients of a translog cost function to determine which factors contribute to economies of scale and their degree of contribution. The study then estimates cost elasticity with respect to the size of the firm using the first derivative of the translog cost function. The size of the firm is measured in two different ways:

1. Amount of assets

2. Total revenue

Cost elasticity is estimated for the total sample for each year and for subsets of the annual samples.

In order to investigate...