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Market Power, Risk-Taking and Solvency in the U.S. Property-Liability Insurance Industry
Introduction
The effect of competition on the risk-taking, and solvency issues of financial institutions has been long discussed in the literature. In the analysis of banking industry, Keeley (1990), Hellmann, Murdoch and Stiglitz (2000) and Carletti and Hartmann (2003) argue that bank competition causes firm franchise value to decline, which in turn results in increases in default risk and reductions in capital. However, Boyd and De Nicolo (2005) states that greater bank competition reduces loan rates through adverse selection and encourages firm stability. In terms of insurance industry, Harrington and Danzon (1994) suggest that when insurers face competition, they may price below cost because of the existence of guarantee funds. In response to underpricing by some firms, they suggest that other firms may cut prices to preserve market share and induce higher firm risk-taking. Apparently, the debate between the relationship of competition and solvency issues do not lead to a firm conclusion for the financial industries.
Another related strand of research is regarding the measure of market competition. A number of researches use measures of concentration, such as the Herfindahl index or n-firm concentration ratio, but these measures are controversial when used to proxy market competition. For example, Beck, Demirguc-Kunt and Levine (2006) show that, the measures such as entry and activity restrictions, which are usually used to measure firm competitiveness, perform the same way as concentration measures in improving firm’s financial stability. The fact that both concentration and competitiveness of the banking system is positively related to stability suggests that concentration may not be an sufficient measure of firm competitiveness. In addition, in the literatures of examining market competition and
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price adjustments, most studies estimate price adjustments as a positive function of market competition, but Jackson (1997) suggests a potential non-monotonic relationship between market concentration and price rigidity, implying that the concentration measures may not be a good proxy for market competition. Some studies therefore suggest other measures to assess the degree of competitiveness.
For example, Maudos and Fernandez de Guevara (2007) apply the Lerner index to estimate the market power in the European Union banking sectors and show the existence of a positive relationship between market power and cost X-efficiency.
This paper examines the issue of competition and solvency in the U.S. property liability insurance industry in the period of 1996 to 2011. We follow Boyd and De Nicolo (2005) and propose that insurers facing lower competition, i.e., insurer with higher market power and charge high premiums, tend to take high risks due to adverse selection. Boyd and De Nicolo (2005) state that more market power may result in higher bank risk as the higher interest rate charged to loan customers make the borrows harder to repay loans and exacerbate moral hazard incentives of borrowers.
The higher rates may also result in a riskier set of borrowers due to adverse selection.
Similarly, we argue that insurers with more market power may charge higher premium to customers or may even collude with each other. Under this circumstances, policyholders who purchase insurance with facing high premium are usually with high risks, a result of adverse selection. Higher market power of the insurers thus may result in higher risks.
On the other hand, Harrington and Danzon (1994) suggest that insurers may decrease prices to preserve market share due to moral hazard from guarantee fund.
These insurers are likely to take high risks and may result in insolvency. We thus have two competing hypotheses for the relationship between market power and risk-taking.
Browne and Hoyt (1995) examine a set of factors which are exogenous to
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property liability insurers’ characteristics related to insurer insolvencies. Specifically, they use macroeconomic and insurance market variables in a time-series model in assessing insolvency risks and find that the number of insurers in the market seriously results in higher insolvency rate. In their analysis, they use the number of insurers mainly to proxy for low capital and surplus requirements (see Munch and Smallwood, 1980) and also proxy for the degree of competition in the insurance market.
In our analysis, we examine the competition issue on insolvency but through a pooled time-series cross-sectional model at individual firm level. We apply the Lerner index applied by Maudos and Fernandez de Guevara (2007) to estimate the market power of U.S. property liability insurers. We believe Lerner index is a better proxy for competitiveness because Lerner index is a function of price and marginal costs. It can reflect whether an insurer would cut its prices too low relative to its marginal costs.
Thus, it is a more relevant measure to predict insolvency comparing to number of insurers in the industry. We examine whether high market power insurer would leads to high or low propensity of firm insolvency. Finally, we consider how underwriting cycle may affect the relationship between market power and risk-taking.
Assume that insurers tend to take higher risks when facing higher competition.
Excessive competition in the soft market may increase completion and induce insurers to further cut prices. These behaviors in the soft market will result in more risk-taking behaviors than in the hard market when price competition is not severe.
On the other hand, if insurers collude with other insurers in the hard market then the insurance premiums would be higher than in the soft market because the premiums are high in the first place. Under this circumstance, insurers would have high risk because of more severe adverse selection problems. Based on the two competing argument, whether cycle affects the relationship between market power and risk-taking and in what direction is an empirical question.
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