Efficiency, competition and risk-taking behaviour in the short-term insurance market in South Africa

Alhassan, Abdul Latif

Efficiency, competition and risk-taking behaviour in the short-term insurance market in South Africa

Doctoral Thesis

2016

Publisher

University of Cape Town

Department

Research of GSB

Faculty

Faculty of Commerce

Abstract

In the regulation of financial services markets, policy makers have generally pursued the twin-goal of improving efficiency and competition to promote stability. This has stimulated academic inquiries into measurement and assessment of efficiency; competition and its effects on market stability in the achievement of these regulatory objectives. Despite the recognition of the role of insurance markets in complementing other financial services to promote economic growth in emerging markets; studies examining the industrial organization and microeconomics of insurance markets appear to be more focused on developed markets. Against this background, this thesis presents a collection of empirical papers on the efficiency, competition and stability of the largest short-term insurance market in Africa. Specifically, annual firm level data on 80 firms in the short-term insurance market in South Africa from 2007 to 2012 is employed to examine several industrial economics theories using a series of panel data econometric techniques. The findings from the empirical analysis are summarized as follows: First, the results from the data envelopment analysis technique indicate that short-term insurers operate at about 50% of their productive capacity, with only 20% of insurers operating at an optimal scale. Productivity growth, which reflects efficiency changes over time, is attributable to technological changes. Firm size, product line diversification, reinsurance and leverage are identified as the significant determinants of efficiency and probability of operating at constant returns to scale. The effect of size was, however, found to be non-linear. Over the study period, the results of convergence analysis suggest a slower rate of 'catch-up' by inefficient firms. Second, the estimates of the Panzar-Rosse H-statistic suggest that short-term insurers in South Africa earn their revenues under conditions of monopolistic competition. Further analysis also reveals that competitive pressures in the market are driven by the activities of small, foreign-owned and single-line insurers. Using the stochastic frontier analysis, average cost and profit efficiency scores of 80.08% and 45.71% respectively suggest that short-term insurers have high levels of efficiency in cost and low efficiency in profit. Competition is found to be positively related to cost and profit efficiency to validate the "Quiet-Life" hypothesis that competition improves efficiency. In examining a broader set of firm level characteristics that drive the exercise of high pricing power, proxied by the Lerner index, the thesis identifies firm size, cost efficiency, product line diversification, concentration, leverage and reinsurance contracts as significant predictors of pricing power in the market. However, the effect of cost efficiency, business line diversification and reinsurance are found to be heterogeneous across different quantiles of pricing power. Third, the thesis also documents evidence in support of the 'competition-fragility' hypothesis to indicate that competition is detrimental to the stability of the short-term insurance market. The 'competition-fragility' effect is, however, found to be stronger for weaker insurers compared with stronger insurers. Firm size, capitalization, reinsurance, business line diversification and foreign-ownership were also identified as other significant predictors of market stability. Three main policy recommendations for the regulation of the market are derived from the findings. First, in order to improve on the high levels of inefficiency in the market, the insurance regulator is encouraged to direct efforts at improving competitive conditions since competition is found to be efficiency-enhancing. Second, the regulator is also encouraged to place restrictions on mergers that result in increased market concentration. This will reduce market power and the tendency for the exercise of high pricing power. Another way of improving competitive conditions in the market is through the increased presence of foreign-owned insurers. This could be achieved through the formulation of policies that are friendly to encourage and attract foreign-owned insurers to participate in the local market. This will help reduce the monopolistic tendencies enjoyed by domestic-owned insurers. Finally, in order to ensure a positive effect of competition on market stability, the regulator should seek to reduce information imbalances through institutionalization of a reference bureau on claims. This will be useful in collecting data to achieve actuarial fair pricing of insurance policies and reduce the incidence of adverse selection and moral hazards which are characteristic of competitive insurance markets and induces instability.

Keywords

Insurance Industry

Competion

Reference:

Collections

PhD / Doctoral

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