Product Ratings as a Market Reaction to Deregulation: Evidence From the German Insurance Market

• Author: Stephanie Meyr,Sharon Tennyson
• DOI: http://doi.org/10.1111/rmir.12030
• Published date: 01 March 2015
• Date: 01 March 2015

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2015, Vol.18, No. 1, 77-100

DOI: 10.1111/rmir.12030

PRODUCT RATINGS AS A MARKET REACTION TO

DEREGULATION:EVIDENCE FROM THE GERMAN

INSURANCE MARKET

Stephanie Meyr

Sharon Tennyson

ABSTRACT

This study provides the first investigation of information markets as a reac-

tion to deregulation of product forms in insurance markets. The article studies

the case of Germany,where insurance product ratings entered the market after

relaxation of product regulation in 1994. The ratings’ potential for enhancing

the performance of a deregulated insurance market is analyzed by considering

both market structure and governance characteristics of the rating market, since

the theoretical literature predicts that both areimportant determinants of rating

outcomes. Data from a unique panel data set containing disability insurance

ratings from the three major rating agencies are also examined in light of the-

oretical predictions. Results suggest that market governance and competition

characteristics are favorable for the production of unbiased and informative

ratings. Ratings for disability insurance support this interpretation, since the

characteristics of the ratings conform to theoretical predictions about ratings in

well-functioning rating markets.

INTRODUCTION

Due to concerns that information asymmetries and contract complexity may limit con-

sumers’ ability to evaluate insurance contracts, the content and form of personal insur-

ance contracts are subject to prior approval regulation in many countries. Statistics from

the International Association of Insurance Supervisors (IAIS) reveal that 80 percent of

reporting countries mandate specific policy content in at least some lines of property–

liability insurance, and 40 percent do so in life insurance lines. In both property-liability

and life insurance, about one–half of the countries require regulatory prior approval of

policy forms prior to market launch.1IAIS statistics also suggest that the pattern of cross-

country regulatory differences reflect philosophical differences and not just differences

in market development or consumer education. For example, regulatory prior approval

Stephanie Meyr is at the Munich Risk and Insurance Center (MRIC), Ludwig-Maximilians-

Universit¨

at Munich, Germany; e-mail: meyr@bwl.lmu.de. Sharon Tennysonis at the Department

of Policy Analysis and Management, Cornell University,Ithaca, NY 14853; phone: 607-255-2619;

e-mail: Sharon.tennyson@cornell.edu.

1Data are reported in Tennyson(2011b) and are derived from statistics compiled by the IAIS.

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78 RISK MANAGEMENT AND INSURANCE REVIEW

of products is widespread among the U.S. states, but countries of the European Union

(EU) eliminated regulation of most insurance product forms in 1994.2

Critics of insurance product form regulations argue that prior approval requirements

delay product innovations and reduce product variety, limiting competition and con-

sumer choice in insurance markets (Butler, 2002). On the other hand, survey research

suggests that many consumers do not understand insurance policy language and terms

(National Association of Insurance Commissioners [NAIC], 2010; Organisation for Eco-

nomic Co-operation and Development [OECD], 2008; Tennyson, 2011a), and that most

consumers do not read insurance policy disclosures (Cude, 2005). Some observers argue

that if consumers cannot or do not effectively compare products, regulatory protections

may lead to better market outcomes in practice, even if theory would suggest otherwise

(Trebilcock,2003; Schwarcz, 2010; Klemperer, 1999). Others note that productregulations

may support more effective consumer search and decision making, since consumers will

need less information to make informed choices (Grace and Scott, 2009).

The differing public policy perspectives and international variation in regulations raise

interesting questions about the need for product regulations, and about the functioning

of insurance markets where such regulations are not imposed. To provide insight into

these questions, this article studies the case of product information in German insurance

markets after the 1994 EU Insurance Directives. The research documents an interest-

ing private market response to product deregulation—the rise of independent product

ratings—and analyzes the potential for this market to provide insurance consumers with

reliable quality information. In doing so, the study contributes to the ongoing debate on

changes in regulatory design in other insurance markets by providing the first analysis

of rating markets as a possible reaction to product deregulation in the insurance context.

This outline of the product rating market’s structure and performance provides basic

insights on which to base further research in this field.

Our findings show that conditions in the German product rating market are conducive to

the provision of useful information for consumers. Wefurther document that the ratings

provided for one important product line in personal insurance (disability insurance) are

not characterized by the upward biases and opacity that can occur when rating markets

do not function well. These findings provide support for the idea that the private market

for product ratings may enhance the functioning of the deregulated insurance markets

in Germany.

The remainder of the article is structured as follows. The second section summarizes

product-related insurance regulation in Germany before and after the reforms in 1994.

The third section reviews the theoretical and empirical literatures on private rating mar-

kets in order to identify drivers of rating quality in such markets. The fourth section

describes the German market for insurance product ratings that developed after 1994.

The fifth section presents the first empirical evidence on German insurance product rat-

ings, using a hand-collected data set of product ratings for disability insurance. The sixth

section discusses the prospects for reliable and unbiased product ratings in Germany,

applying the academic literature on rating markets to the German insurance context.

2These changes occurred when the EU’s Third Generation Insurance Directives were adopted.