The Wealth Effects of Allowing Bank Entry into the Insurance Industry

By Carow, Kenneth A. | Journal of Risk and Insurance, March 2001 | Go to article overview

The Wealth Effects of Allowing Bank Entry into the Insurance Industry


Carow, Kenneth A., Journal of Risk and Insurance


ABSTRACT

The banking industry and the Comptroller of the Currency won three Supreme Court rulings allowing banks to sell annuities and other insurance products. Overall, bank stock prices have not changed significantly surrounding these rulings. However, these rulings significantly decreased insurance company stock prices. Life and health insurance companies and insurance agencies have the most negative reactions. Property-liability insurance companies have a less negative response. Insurance companies that sell via a brokerage system have the highest stock returns. The results are consistent with contestable market theory. Decreasing entry barriers reduces the economic rents of insurance companies and changes the competitive structure among insurance companies.

INTRODUCTION

Regulatory statutes traditionally segregated financial service companies. Before recent regulatory rulings, banks were unable to cross-sell banking, insurance, or security products. Based on current regulations, banks can take advantage of opportunities to sell insurance or to underwrite securities.

Kane (1984) and Dickens (1996) depict the fusion of financial services as an application of the theory of contestable markets. The theory of contestable markets (CMT), set forth in Baumol (1982) and Baumol, Pansar, and Willig (1982), explains why industry structures other than perfect competition may be optimal. The basis of the theory is that no industry earns economic profits for an extended period unless barriers prevent other potential sellers from entering the industry. In a contestable market, incumbent firms price their products and services at a level that discourages new competition. Regulatory restrictions to market entry prevent the free entry of competition.

Whether the removal of entry barriers reduces future cash flows in the insurance industry is an empirical question. When barriers to entry are removed, incumbent firms may experience increased competition. [1] After removing barriers to entry, the long-run economic rent to incumbent firms is reduced; however, the contestable market theory does not require positive economic rents for new entrants. The increased threat of competition may force the incumbent insurance firms to reduce their earning spreads. The increased competition and spread reduction imply that the long-run economic rents to banks entering the insurance industry may be insignificant.

Fama and MacBeth (1973) state that any change in the expected economic profit of the industry is immediately captured in firm stock prices. If the removal of barriers restricting banks from entering the insurance markets results in a reduction of future cash flows for incumbent insurance companies, the stock value will reflect this reduction on the date of the announcement.

This study focuses on how a reduction in the insurance industry's barriers to entry affects the value of company stocks within the insurance and banking industry. The author analyzes two important questions concerning the contestable market theory. First, did barriers to bank entry provide the insurance industry or a segment of the insurance industry with increased competition? Second, did the ability of banks to enter into the insurance market increase the value of the banking industry?

The results show that barriers to bank entry did provide the insurance industry with protection from increased competition and that the level of protection varied by industry segment. Overall, insurance companies experienced a significant reduction in wealth surrounding the Office of the Comptroller of Currency (OCC) and Supreme Court rulings. Changes in wealth are dependent on firm characteristics. Insurance companies with insurance agencies and life and health insurance companies have the most negative wealth effects, but insurance companies that market their products through a brokerage system have significantly higher returns than firms that do not market through a brokerage system. …

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