Microeconomics, Module 7: “Competition in the Short Run (Chapter 7)

(Application of microeconomic theory to the insurance industry. You may post the solution on the discussion forum for comparison with that of other candidates.)

(The attached PDF file has better formatting.)


Discussion Forum Exercise: The Insurance Industry and Competition

We compare the auto insurance industry with the auto manufacturing industry of 20 years ago (before foreign auto companies entered the U.S. market):

A.    Which industry had more firms providing the goods and services? (In 1980, how many firms produced cars in the U.S.? How many firms wrote auto insurance policies?)
B.    For which industry is entry easier? (How easy is it to start an auto manufacturing plant? How easy is it to start an auto insurance firm? Compare the number of new U.S. based auto manufacturers with new U.S. based auto insurers in the 1960’s and 1970’s.)
C.    Which industry has greater economies of scale? (An industry with large economies of scale has only large firms and no small firms. The most common reason for the mergers of auto firms around the world is that the firm can not compete unless it produces a high volume of cars. The minimum volume increases each year, as firms become more efficient.) Why do auto manufacturers have large economies of scale? Do auto insurers have significant economies of scale? (Economists differ on the last question; no answer is correct. Direct writers seem to have some economies of scale.)
D.    How similar are the goods and services produced by different firms? (Is a car from Ford just like a car from General Motors? Is an auto insurance policy from Allstate just like an auto insurance policy from State Farm? The firms do not sell exactly the same service, but how different are the services of Allstate vs State Farm compared to the differences in the vehicles produced by Ford vs General Motors?)

Question: Auto insurance has many firms entering and leaving each year; auto manufacturing has few firms entering or leaving. What causes this?

Answer: Entering the automobile manufacturing industry requires high volume and a long commitment. The industry has high economies of scale. Unless a firm can sell 50,000 cars a year for ten years, it doesn’t recover its costs.

Question: Do these economies of scale stem from buying items in bulk?

Answer: Large auto manufacturers can negotiate lower prices from suppliers, but these are not the primary economies of scale. Designing and manufacturing a new vehicle takes five years for experienced firms. Research and development, testing of prototypes, design work, fixing errors, and initial marketing are large costs. A new entrant into the market does not expect to earn a profit for ten or fifteen years.

Question: Do auto insurers have barriers to entry? Do they have economies of scale?

Answer: It is sometimes said that all one needs to sell insurance is a shingle and a copier. This is an exaggeration, but it is easier to sell auto insurance than to make autos.

Some economies of scale exist. Setting up an exclusive agency system is an expensive and long process. Independent agents are not a cost efficient distribution system.

Jacob: What do we have to know about auto manufacturing and auto insurance to answer this exercise?

Rachel: Three domestic firms (GM, Ford, Chrysler) were the auto industry 20 years ago in the U.S.; several hundred auto insurers competed in the insurance market. For many years, there were no entrants or exits from the auto industry, but a dozen entrants and exists from the auto insurance industry each year.

One learns microeconomics by studying industries, not just theory. As much as possible, we apply the theory in the textbook to the insurance industry. Overseas candidates may not know much about U.S. industries, life actuaries may not know much about workers’ compensation, and property-casualty actuaries may not know much about pensions or health insurance. We use examples from various actuarial subject areas, so most candidates can follow the illustrations.

I'll give this discussion a shot. There were many more auto insurance firms than auto manufacturing firms in 1980. Also, there were dozens of entries and exits from auto insurance industry each year, while there were hardly any (if any) entries and exits from auto manufacturing. This is clear evidence that it is easier to enter and exit auto insurance than it is to do so in auto manufacturing.

The economies of scale are significantly greater in auto manufacturing. A firm needs to produce a large number of automobiles in order to be able to sell them at a price that will be competitive in the marketplace. To manufacture an automobile, the firm needs to acquire many different materials and parts, and most of those items can be purchased at a lower price if the manufacturer buys them in bulk. Auto insurers, on the other hand, do not need to buy such a large number of bulk items in order to "manufacture" an auto insurance policy.

Do auto insurers have some economies of scale? Certainly, but it is unclear how significant those are. Theoretically, both smaller and larger auto insurance company should be able to write their policies at similar rate levels. The larger company may, however, have some additional efficiencies in its work force (through better ability to use specialized workers) which could reduce its expenses per policy written.

Auto insurance policies from different companies do not differ from each other nearly as much as automobiles themselves differ. Auto insurance is a commodity which many consumers perceive as interchangable from company to company. I believe, then, that according to the definitions and concepts discussed in our textbook, we can conclude that the auto insurance industry is more "perfectly competitive" than the auto manufacturing industry.

A.   There were many more insurance companies. The major American car companies were Ford, GM, and Chrysler.

B.   Entry is easier for insurance firms: their fixed capital costs are much lower. Factories are much more expensive and time consuming to make compared to the renting of office space and supplies. Also, factory workers may require a greater degree of specialized training than office workers in insurance firms.

C.   Auto manufacturers have economies of scale because it is less expensive to mass produce vehicles on an assembly line than to make them one by one. After an initial investment in factories, machines, and the training of labor, it is more efficient to produce more cars than fewer cars. For insurance on the other hand, the investment in capital is not as large, and a small office can work as efficiently as a large office.

D.   It appears that auto insurance is more uniform than cars. A person can compare policies from competing companies by examining the paperwork. For cars, it may takes years for a company to establish a reputation for quality.

The conclusion is that auto insurance is a more competitive industry than auto manufacturing. (At least that was the case 20 years ago.)

WALL STREET JOURNAL
Property Insurers Confront Rising Catastrophe Losses

By LAVONNE KUYKENDALL
June 30, 2008; Page C1

Bad weather has cost U.S. property insurers more than $5 billion so far in second-quarter catastrophe-related claims -- equal to about three-quarters of all catastrophe claims during 2007 -- and could push the industry to an underwriting loss.
The claims are occurring even as insurers continue to reduce prices, which gives them fewer resources for paying the claims.
"It has been busy," said Allstate Corp. spokesman Rich Halberg.
According to the property-claims services division of the Insurance Services Office, an insurance-service provider, there have been 15 weather-related catastrophes since April 1, resulting in more than one million claims for a total of around $5.5 billion. For the year, there have been total claims of $8.9 billion for 24 catastrophe events. Claims for all of 2007 amounted to $6.7 billion.
The Insurance Services Office defines a catastrophe as an event that causes more than $25 million in insured losses and causes a major disruption. So far this year, problems have included tornadoes, severe storms, hail, flooding and wildfires. It is usually the third quarter, not the second, that poses problems due to the potentially huge cost of hurricanes.
At the same time, a soft pricing cycle over the past two years has pushed some insurance policy premiums down by double-digit rates, putting a squeeze on insurers' profit margins. The rising losses could also help slow the rate of price-cutting.
The Property Casualty Insurers Association of America, which represents around 40% of insurers, reported an industrywide combined ratio of 99.9% for the first quarter, which means that losses and expenses ate up virtually all the premiums collected for the quarter.
Don Griffin, vice president of personal lines insurance for insurers association, said that preliminary loss estimates for recent catastrophes are likely to be revised upward, and that insurers may take reserves based on what they expect eventual claims to be. That could boost second-quarter loss reserves even more.

Write to Lavonne Kuykendall at lavonne.kuykendall@dowjones.com1

[NEAS: Read the words carefully: "and could push the industry to an underwriting loss" and "losses and expenses ate up virtually all the premiums collected for the quarter" (again, underwriting loss). The insurance industry expects underwriting losses in most years, and it earns its profits from investment income. The important item is the return on capital, which is more stable for auto insurers than for auto manufacturers.]