The Economics of Property-Casualty Insurance

Article excerpt

The Economics of Property-Casualty Insurance, edited by David F. Bradford, 1998, University of Chicago Press

This book is a collection of six papers published as a project report by the National Bureau of Economic Research. Its editor, David F. Bradford, states in the introduction that there has been "little attention paid" to the study of insurance by the economics profession. The National Bureau of Economic Research undertook this study "in the hope of expanding the network of economists who work on insurance and the stock of empirical knowledge useful to those who develop policies related to the industry." These statements immediately raised concerns for this reviewer. The insurance industry has many unique and peculiar features that must be clearly understood by "outsiders" before useful analysis can be performed, even by "outsiders" with strong economic, financial, or statistical backgrounds. In many cases, traditional analysis performed in other economic arenas must be modified to properly fit the propertycasualty industry before meaningful results can be developed. For the majority of the six papers included in this collection, my fears were not realized. Unfortunately, the first two papers were fraught with significant problems.

The final paper in the collection, by Born, Gentry, Viscusi, and Zeckhauser, is an interesting analysis of organizational form (stock versus mutual) and company performance. The existence of both mutual and stock insurance companies in the property-casualty insurance industry creates many interesting questions. This paper is especially useful in providing background material on the development of both forms of ownership and the strengths and weaknesses of each. Analysis of firm performance based on form of ownership is always difficult because many different factors (other than stock versus mutual) must be considered in the analysis. This article presents an enlightening argument that stock insurance companies appear to react more swiftly to changes in the level of profitability in their environment. Overall, however, the authors tend to conclude what many observers of the industry feel is true, that there is relatively little difference between the performance of stock and mutual companies.

The fifth paper, by Bohn and Hall, is the most interesting one included in this collection. It takes a unique look at insurance company insolvencies. Instead of attempting to predict insolvencies, or the factors leading to insolvencies, this paper looks at the costs associated with liquidating an insolvent insurance company and the timing of the payments made to claimants once liquidation begins. These issues have not been analyzed in this way, and the large costs identified by the authors should lead to additional research.

The fourth article, by Suponcic and Tennyson, analyzes rate regulation and its effect on the automobile insurance market. This is another in a series of important articles on this subject, and this paper adds to the literature by analyzing the effect of what is termed "stringent" regulation. "Stringent" regulation is defined to have occurred in the five states where at least twenty percent of drivers were insured in residual auto insurance markets throughout the eighties. Although the paper has other interesting results, the effect of "stringent" regulation is the most enlightening.

The third article, by Jaffee and Russell, presents an interesting look at auto insurance regulation and deals with traditional economic concepts such as distributional equity, welfare enhancement, and regulatory intervention and fairness. The most interesting part of this paper is its analysis of Proposition 103 and why, in general, insurance companies face consumer-based regulatory movements. Although this analysis is interesting, the final conclusions of the paper are fairly simplistic, such as "we have found evidence of a positive relationship between insurance premiums and the number of uninsured drivers."

The second paper, by Bradford and Logue, presents a thorough analysis of the consequences of tax-law changes on the property-casualty industry. It presents an excellent description of tax-law changes that have affected the industry during the last fifteen years, and it can be accessed as a reference tool for anyone desiring a summary of these changes. The analysis performed on the anticipated effects these changes should have on prices is also fascinating. It is particularly interesting that the predicted impact has not always been close to the actual impact. It makes intuitive sense, however, that the largest discrepancies have occurred in "long-tail" claims areas such as medical malpractice. Any predictions made in "long-tail" claims areas involve the greatest amount of risk, especially when discount rates over this significant time period are also brought into the equation, as is true in this analysis.

The problem inherent in this paper is the terminology. The authors insist on using terminology created solely for this paper. I can see no reason for that terminology other than to look on the industry and to others who analyze the industry with condescension, as though these are the first authors to "really" dissect the industry correctly. By using terms such as "spot policy" and "unit single-payment policy," the authors seem to infer that they are somehow breaking new ground when in fact they are not. In particular, the authors lose a great deal of credibility when making statements such as "the balance sheet entry corresponding to this new liability is the unpaid losses account, sometimes referred to as the insurer's loss reserve." Did they really say sometimes referred to as the loss reserve? When has it ever been called anything else, except in this paper?

Finally, the first paper in the collection, by Gron and Lucas, fails miserably. These authors needed to have a more complete understanding of the financial management of property-casualty insurance companies before beginning their analysis. The paper hypothesizes that the cycles observed in the property-casualty industry, with high prices and constrained supply, are the result of "temporary capital shortages." They hypothesize that during these times of "temporary capital shortages" corrections should occur through an infusion of new capital from external sources, especially when profit margins are high. To test this hypothesis, they use data from SECregistered debt and equity issues from 1970 to 1993, and then they attempt to predict when external funding should occur based on industry cycles. Unfortunately for the researchers, the results show little if any support for their hypothesis, which puzzles them. In their conclusions, they state, "these findings make the seeming reluctance of property-casualty insurers to rely more heavily on external capital markets somewhat surprising . . ."

The researchers show no understanding of how capital is created by property-casualty insurance companies. According to Best's Aggregates and Averages, during the period studied (1970-1993) the property-casualty industry had an increase in equity, as measured by surplus, of $166 billion. More important, "debt" capital in the form of unearned premium reserves and loss reserves increased by $394 billion! The "external" debt and equity issues studied by the authors amounted to only $25 billion combined, or less than five percent of the capital generated internally This industry simply has little need for external financing. Attempting to draw conclusions on the timing of this five percent of total capital raised during the time period studied is simply trivial. The authors do make one correct conclusion. In their last paragraph, they comment that over time the industry has increased its use of external financing, which is true. Had they become acquainted with CFOs in the industry, they would have been told that the relatively minute amount of external financing that does occur is almost always for the purpose of mergers and acquisitions, and everyone knows that activity has increased in this area in recent years, thus the increase in external debt and equity issues.

Overall, this book has merit, especially the final three articles. One more shortcoming of the book, however, is its lack of current data. Most of these papers appear to have been written in the early nineties, and there is hardly any data in this book more current than data from 1993. Although in some cases this is not a problem, it is a glaring weakness in other instances.

[Author Affiliation]

Reviewer: Barry D. Smith, New Mexico State University and editor, CPCU Journal

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