Economies of scale in financial institutions: A general model applied to insurance

Abstract

This study describes and applies an alternative methodology for measuring economies of scale in financial institutions. A complete model of a profit maximizing financial intermediary is constructed which yields a set of first-order conditions. These together with linear specifications of appropriate revenue and cost functions permit a two-stage estimation of cost and revenue parameters. Application of the model is illustrated by using data from the Canadian general insurance industry. Estimated cost functions suggest (1) that joint stock insurance firms realize no economies of scale from expansion of activity in any one line of insurance but realize diversification economies from writing the same aggregate dollar premiums over appreciably more lines; (2) that mutual companies enjoy direct economies of scale from a simultaneous expansion of insurance lines and, possibly, some diversification economies. Diversification economies may or may not yield special advantages to large firms depending on the competitive state of the reinsurance market.