Economies of Scale in Independent Insurance Agencies

Abstract

Among the recent developments in the property-liability insurance markets which constitute a potential threat to competition are the erosion of the independent agents' market share and the merger movement among independent agencies. The goal of this study is to provide information to guide regulators in formulating positions with respect to these developments. Specifically, the article reports results of tests for scale economies in the operation of independent agencies. Estimation of short and long-run cost functions provides no evidence of economies of scale. Hence, agency mergers generally cannot be justified on the basis of cost economies. The independent agency system traditionally has been the dominant form of marketing channel in property-liability insurance. Independent agents maintain contacts with several different insurers and are not obligated to place business with any particular one of them. During the past two decades, independent agents have lost a substantial share of the insurance market (particularly in auto and homeowners insurance) to exclusive agents, who deal with a single insurer (such as State Farm or Allstate) and place business only with that insurer. Independent agents are still dominant in the commercial insurance markets, but their preeminence in these markets is being challenged. These developments may have significant implications for the maintenance of competition in the property-liability insurance markets. For many years, a substantial share of the property-liability insurance market has been operated under a cartel-type arrangement whereby most insurers set rates in concert through organizations known as rating bureaus. Regulators have permitted this system to exist because of the argument that pooling J. David Cummins is Associate Professor of Insurance, Wharton School, University of Pennsylvania. He is Research Director of the S. S. Huebner Foundation for Insurance Education. Some of his publications include An Econometric Model of the Life Insurance Sector of the U.S. Economy; Impact of Consumer Services on Independent Insurance Agency Performance (coauthor); and Investment Activities of Life Insurance Companies (editor). He has been a frequent contributor to the Journal of Risk and Insurance and serves as secretary of its editorial board. The research on which this article is based was supported in part by a grant from the IMA Education & Research Foundation. The author is grateful to Steven N. Weisbart, Associate Professor of Insurance at Georgia State University, for his valuable comments and suggestions during the preparation of this article. Of course, the author is solely responsible for any errors or omissions.