Performance of the Life Insurance Industry Under Pressure: Efficiency, Competition, and Consolidation

• Date: 01 March 2016
• Published date: 01 March 2016
• DOI: http://doi.org/10.1111/rmir.12059
• Author: Jacob A. Bikker

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2016, Vol.19, No. 1, 73-104

DOI: 10.1111/rmir.12059

PERFORMANCE OF THE LIFE INSURANCE INDUSTRY

UNDER PRESSURE:EFFICIENCY,COMPETITION,

AND CONSOLIDATION

Jacob A. Bikker

ABSTRACT

This article investigates efficiency and competition in the Dutch life insurance

market by estimating unused scale economies and measuring efficiency-market

sharedynamics during 1995–2010. Large unused scale economies exist for small-

and medium-sized life insurers, indicating that further consolidation would

reduce costs. Over time average scale economies decrease but substantial dif-

ferences between small and large insurers remain. A direct measure of com-

petition confirms that competitive pressure is lower than in other markets. We

do not observe any impact of increased competition from banks, the so-called

investment policy crisis or the credit crisis, apart from lower returns in 2008.

INTRODUCTION

Using a unique, not publicly available, insurer-specific supervisory data set, this article

investigates efficiency and competitive behavior on the Dutch life insurance market.1

In the Netherlands, the life insurance sector is important with a business volume of

€22 billion in terms of annual premiums paid, invested assets of €337 billion, and in-

sured capital of €990 billion at end-2010.2This market provides important financial

products, such as endowment insurance, annuities, term insurance, and burial funds, of

frequently sizable value to consumers. Financial planning of many households depends

on the proper functioning of this market. The complexity of the products and depen-

dency on future investment returns make many life insurance products rather opaque.

Therefore, competition and efficiency in this sector are important for consumers (Bikker

and Spierdijk, 2010). Most life insurance policies have long life spans, which makes

Jacob A. Bikker is affiliated with De Nederlandsche Bank (DNB), Supervisory Policy Division,

Strategy Department; phone: 31-20-524-2352; e-mail: j.a.bikker@dnb.nl; and is professor at the

Utrecht School of Economics, Utrecht University. The author is grateful to unknown referees,

Paul Cavelaars, and Janko Gorter for useful comments and Jack Bekooij for excellent research

assistance.

1Differentfrom most other countries, in the Netherlands, health, disability, and accident insurance

is not included in the life sector, but in “nonlife.”

2Insured capital is the sum over all policies of (1) the benefit in case of a death or expiration

(€639 billion) and (2) 10 times the future annual benefit in case of survival (€351 billion), a

standard measure used by life insurance companies.

73

74 RISK MANAGEMENT AND INSURANCE REVIEW

consumers sensitive to the continuity of the respective firms. Life insurance firms need

to remain in a financially sound condition over decades in order to be able to pay out

the promised benefits.

In recent years, the life insurance sector has been confronted with several major chal-

lenges. First, the ongoing, long-lasting decline in interest rates, world-wide but partic-

ularly in the euro area, has reduced insurers’ income that is—among other things—

needed to cover future benefits to policyholders. Second, the credit and government

debt crises have lowered the value of stocks and PIIGS countries bonds, which have

impaired insurance firms’ buffers. In the Netherlands, two additional problems for life

insurers have emerged. In order to increase competition between banks and insurers,

tax privileges for insurance products, such as old-age savings and redemption plans for

mortgage loans, have since 2008 also been available for comparable banking products.

The impact of this tax reform has been huge: more than half of the new production on

the respective life insurance markets has been generated by banks. We expect that this

change has contributed further to the need for insurance companies to increase effi-

ciency in order to improve their competitive position. Finally, insurers are faced with the

aftermath of the scandal about mis-selling and hidden costs of insurance policies in the

Netherlands. Around 2006, public awareness increased that various types of unit-linked

saving policies (such as annuities and mortgage redemption saving plans), which were

based on capital market investment at the risk of policyholders, carried high operational

costs and relatively high premiums on included life risk policies, eating 50–60 percent

of the premiums paid. Under public pressure, insurers agreed to pay compensation

to policy holders for incurred and future costs on the respective policies, estimated at

€2.5 to 4.5 billion,3while potential claims may come to a multiple of that amount. One of

the consequences of this crisis is that consumer trust in insurance firms and the volume

of new production have decreased.

Competition and efficiency in financial markets is difficultto measure, particularly due to

the unavailability of data with respect to costs and prices of individual financial products

(Bikker, 2010). The solution in the literature has been to assume a single insurance (or

banking) product and to use balance sheet and profit and loss data of entire financial

institutions. As a measure of inefficiency, this article estimates unused scale economies,

which at the same time is an indirect measure of competition: where competition is

high, insurers are forced to reduce their cost level wherever possible. Further, we apply

a rather new measure of competition that has to date been rarely used in the literature,

namely,a performance-conduct-structure (PCS) model, also known as the Boone indicator,

developed by Hay and Liu (1997) and Boone (2000, 2008). For an overview, see Bikker

and Van Leuvensteijn (2014). Where the well-known structure-conduct-performance

(SCP) paradigm of Mason (1939) and Bain (1951) explains performance via conduct

from market structure, this alternative model explains market structure via conduct or

competition from performance, as in the so-called efficiency hypotheses (Smirlock, 1985;

Goldberg and Rai, 1996). This approach is based on the notion that competition rewards

efficiency and punishes inefficiency. In competitive markets, efficient firms are expected

to perform better—in terms of market share and hence profit—than inefficient firms.

The PCS indicator measures the extent to which efficiency differences between firms

3http://www.verzekeraars.nl/sitewide/general/nieuws.aspx?action=view&nieuwsid=880.

PERFORMANCE OF THE LIFE INSURANCE INDUSTRY 75

are translated into performance differences. The more competitive the market is, the

stronger is the relationship between efficiency and performance. The PCS indicator is

usually measured over time, giving a picture of the development of competition.

Other measures of competition, such as the Lerner index and the Panzar and Rosse

model, are less suitable because the required data (output prices, cost price, profit

margin) are lacking, while the Concentration index and the SCP model have serious

shortcomings (see Bikker and Bos, 2008). Another advantage of the PCS indicator is that

it requires only a small number of data series. We combine the two measures of efficiency

and competition, unused scale economies and PCS indicator, to find out whether they

match or differ.

Earlier research on the life insurance market has revealed that the efficiency of life

insurers tends to be poor (Cummins and Weiss, 2012) and that competition between

insurers is not strong (Bikker and Van Leuvensteijn, 2008). Unused scale economies

point to weak competition: stronger pressure on cost efficiency would lead to further

consolidation. The four above-mentioned problems facing the Dutch life insurance sector

(declining interest rates, falling shareprices, crumbling tax privileges, and the mis-selling

and hidden cost policy scandal) all have in common that cost efficiency would help to (1)

maintain market shares in the competition struggle against banks and (2) either restore

profitability and impaired buffers, or reduce the hidden costs in unit-linked products

(or both).

Life insurance firms sell several different products through various distribution chan-

nels, thereby creating several submarkets. The degree of efficiency and competition

varies across these submarkets. For instance, the submarket where parties negotiate col-

lective contracts (mainly employer-provided pension schemes) is expected to be more

competitive than the submarkets for individual policy holders. Our data sets allow the

subdivision of insurance policies into collective and individual contracts and, for each

submarket, a split into unit-linked policies (where investment results are for the risk of

policyholders) and policies guaranteeing benefit payouts in euro. Collective unit-linked

policies consist mainly of annuities where individual policies with benefits expressed in

euro (or fixed-benefit policies) usually take the form of endowment policies. Therefore,

the two approaches measuring scale economies and competition will be estimates for

the four submarkets too. Data on submarkets enable us also to further investigate the

structure of the life market: do insurers, over time, go for specialization or do they, on the

other hand, tend to sell all types of life insurance products in order to take full advantage

of scope economies?4Furthermore, we pay attention to developments in efficiency and

competition over time, in order to assess how insurers have responded to the challenges

mentioned earlier. We relate this to the structure of the market and to entry and exit of

insurers.

This article is structured as follows. “The Production of Life Insurances” section presents

a short review of the production of life insurances, followed by a survey on the literature

on efficiency and competition in the insurance industry.The next section highlights styl-

ized facts of the Dutch insurance markets and its developments over time, while “The

4Scope economies reflect the lowering of the average cost for a firm by combining the production

of two or more products.