The Organizational Structure of Insurance Companies: The Role of Heterogeneous Risks and Guaranty Funds
Ligon, James A., Thistle, Paul D., Journal of Risk and Insurance
We examine a market with observably heterogeneous risks and a government sponsored guaranty fund and consider whether it is optimal to form a single insurer or separate insurers for each consumer type. Given the economic environment, pooling never dominates the formation of separate insurance companies. This result provides an incentive for the phenomenon of insurance fleets.
One of the peculiarities of organizational form within the insurance industry is the presence of a large number of separate insurance companies within a single overarching parent organization. These groups or fleets, as they are known within the industry, would appear to offer less protection against insolvency risk than a single multiline insurance company, since, of necessity, they would have a smaller pool of equity capital in each company than a combined enterprise. The grouping phenomenon is quite strong in the property-liability industry. Cummins and Weiss (1991, p. 122) note that although there were approximately 3,000 property-liability insurance companies in the United States as of 1989, "only 1900 firms play a significant role in the market and 1300 of these are clustered together in approximately 340 insurance groups under common ownership."
Vaughan (1997, p. 226) notes that insurance company groups originally developed in response to legal constraints. For example, fire companies were forbidden to write casualty coverage and vice versa. A natural response to this legal constraint was to form separate companies for each type of coverage and operate them in tandem. However, he also notes that this reason for the fleet form of organization no longer exists as the legal constraints to multiline operation have, in general, been removed. This is the only explanation for the existence of the fleet phenomena that we have found in insurance texts or the academic or industry literatures. By itself, it would suggest that fleets continue to exist because of inertia. Given that the group structure would be expected to involve higher legal and administrative costs, it seems unlikely that inertia can explain the continued existence of the fleet form of organization. It must be the case that the group form of organization provides some advantage over a larger multiline firm, at least for some members of the industry.
We provide a model explaining the advantage of the fleet organizational structure based upon the heterogeneity of consumer risk types and the presence of guaranty funds. We assume that there are two distinguishable groups of policyholders with different risk characteristics. These can be interpreted as high and low risks in a given line of insurance (e.g., normal vs. assigned risks in automobile insurance). These can also be interpreted as homogeneous risks in two different lines of insurance. We also assume there is a government sponsored guaranty fund that pays all claims in the event of insurer insolvency and charges a non-risk-adjusted assessment based on premium volume. Using a contingent claims framework, we address the question of whether it is optimal to serve the two groups of policyholders with a single, pooled stock insurance company or with two separate stock insurance companies. (1)
In the absence of a guaranty fund, the potential benefit of pooling the two groups is that it improves the subdivision of risks thereby decreasing the probability of ruin. The potential cost is that the different risks imply different default probabilities, so that there is potential cross-subsidization between risk types. In the presence of a guaranty fund charging non-risk-based premiums, the probability of ruin and cross-subsidization are not an issue since benefits are guaranteed and the cost of the insurance is not sensitive to risk. This causes organizational form to affect shareholder wealth. Specifically, when insurance guaranty fund premiums are not risk based, a fleet form of organization benefits shareholders at the expense of the fund because it increases the combined value of the insolvency puts of the fleet, compared to an equivalent multiline company, without a corresponding increase in the guaranty fund premium. …