Measuring cost efficiency in the property-liability insurance industry

Abstract

Escalating prices and periodic availability problems in property-liability insurance markets are often attributed to insurance company inefficiency and lax claims settlement practices. This paper investigates these issues by estimating stochastic cost frontiers for three size-stratified samples of property-liability insurers over the period 1980–1988. A translog cost function and input share equations are estimated using maximum likelihood techniques. The results show that large insurers operate in a narrow range around an average efficiency level of about 90 percent relative to their cost frontier. Efficiency levels for medium and small insurers are about 80 and 88 percent in relation to their respective frontiers. Wider variations in efficiency are present for these two groups in comparison with large insurers. Large insurers slightly over-produce loss settlement services, while small and medium-size insurers under-produce this output. The small and intermediate size groups are characterized by economies of scale, suggesting the potential for cost reductions from consolidations in the industry.