Capital Market Development, Competition, Property Rights, and the Value of Insurer Product-Line Diversification: A Cross-Country Analysis

Article excerpt

ABSTRACT

In this article, we show that the effect of product diversification on performance is not homogeneous across countries. Diversified insurance companies perform significantly worse than their focused competitors in countries with well-developed capital markets, high levels of property rights protection, and high levels of competition. In addition, we find that the diversification-performance relationship for insurance companies depends on company size. For large insurers operating in countries with less developed capital markets, diversification significantly increases performance. Our results suggest that the optimal organizational structure may be different for insurers operating in emerging economies than for insurers operating in developed countries.

INTRODUCTION

Theory provides conflicting arguments about the impact of product diversification on firm performance. On the one hand, the creation of an internal capital market without information asymmetries (Williamson, 1975; Stein, 1997), economies of scope (Teece, 1980), and risk reduction (see, e.g., Cummins, Phillips, and Smith, 2001; Cummins and Trainar, 2009, p. 467 ff.) should be beneficial for corporations. On the other hand, diversification may increase agency costs (Harris, Kriebel, and Raviv, 1982; Aron, 1988; Rotemberg and Saloner, 1994) and lead to inefficient allocation of capital among divisions of a diversified firm (Stulz, 1990; Rajan, Servaes, and Zingales, 2000). Thus, the net effect of product diversification is an empirical question, and there is a large body of literature examining the relative performance of diversifiers versus specialized firms (see, e.g., Lang and Stulz, 1994; Comment and Jarrell, 1995; Berger and Ofek, 1995; Servaes, 1996; Cummins, Weiss, and Zi, 2003; Laeven and Levine, 2007; Liebenberg and Sommer, 2008; Schmid and Walter, 2009). While most researchers focus on measuring the average effect of diversification on the performance of all firms in their sample, few studies directly address the fundamental question of how the diversification-performance linkage varies across countries. The transaction cost theory proposed by Coase (1937) and Williamson (1985), however, suggests that the optimal structure of a firm depends on its institutional context. Hence, the main argument in our article is that diversification could systematically increase firm performance in some countries but damage it in others.

The goal of our research is twofold. First, we examine the diversification-performance relationship of insurance companies across a broad range of economies including those in the developing markets.1 Second, we explicitly examine country-specific factors and how these factors moderate the diversification-performance linkage.2

The factors we hypothesize to moderate the diversification-performance relationship are a country's degree of capital market development, the level of competition in the country's product markets, and the level of property rights protection in the country. We expect that internal capital markets and, hence, diversification are most valuable in countries where it is expensive to raise external capital. We also expect diversification to be value enhancing in concentrated markets with a small number of competitors because diversification establishes multimarket contact with competing firms and, hence, facilitates tacit collusion that allows firms to earn rents (Bernheim and Whinston, 1990).3 La Porta et al. (1997) document that countries with poorer investor protection have smaller capital markets; thus, internal capital markets should have a relatively high value in such countries. Furthermore, if business contracts cannot be predictably enforced, outsourcing may not be a viable alternative to diversification.

We examine these hypotheses by regressing firm performance on a diversification measure interacted with variables capturing different levels of capital market development, competition, and property rights protection across countries. …