Organizational Form in the Property-Liability Insurance Industry

Abstract

INTRODUCTION Recent research has argued that alternative organizational forms will coexist in an industry because of differential relative advantages. (See, for example, Jensen and Meckling, 1976; Klein, Crawford, and Alchian, 1978; Fama and Jensen, 1983; Williamson, 1985.) The two important elements of organizational form are the ownership structure of the firm, and the degree to which the firm internalizes or outsources production, that is, the level of vertical integration. The property-liability insurance industry is characterized by firms that differ on both of these dimensions of organizational form. The range of ownership structures includes stock corporations, mutuals, and reciprocal organizations. Stockholder-owned insurers dominate the market, with 67.7 percent share of premiums written in 1994. Stock insurers controlled 55 percent of the personal lines market, which includes auto and homeowners insurance, but held a commanding lead in commercial lines, with a 79 percent share. Property-liability insurance firms also vary widely in the degree of vertical integration of the distribution system, with some firms using exclusive dealing arrangements and others contracting the sales function to independent agents who have ownership rights in the client list and who can represent a number of competing insurers. Independent agency insurers controlled 52 percent of the total market in 1994, and 71.8 percent of the commercial lines market.(1) The organizational form literature in property-liability insurance has largely treated ownership and distribution system choice separately. However, some overlap exists between the theory and empirical predictions across the ownership form and distribution system literature. For example, Mayers and Smith (1988) argue that stock insurers should be associated with a more complex mix of business than mutual insurers while Cummins and Weiss (1992), Regan and Tennyson (1996), and Regan (1997) argue that independent agency insurers should be preferred to exclusive dealers when complexity is higher. It is difficult to separate these effects empirically. An exception to treating these elements of organizational form as independent is Kim, Mayers, and Smith (1996), who argue that stock ownership and independent agency distribution are strategic complements, because independent agency is an effective device for minimizing agency costs that arise between owners and policyholders in a stock firm. Therefore, stockholder-owned insurers should choose independent agency distribution rather than exclusive dealing arrangements to minimize agency costs. While the authors of this article agree that independent agency distribution and stock ownership forms are likely to be strategic complements, the reasoning differs from that of Kim, Mayers, and Smith. An alternate explanation for the observed correlation between stock ownership form and independent agency distribution is that each of these elements offers advantages in certain lines of business and underwriting environments. In particular, the authors test the hypothesis that both stock ownership and independent agency distribution are more suited to complex lines of business and underwriting environments characterized by more risk than other combinations of ownership form and distribution system. Thus, rather than stockholder-owned firms choosing independent agency distribution, firms might first choose a business strategy, and then jointly choose ownership form and distribution system. The theory that supports this hypothesis is reviewed below. Several tests of the hypothesis are then presented. The direct correlation between ownership form and distribution system across lines of business is first measured using independence tests. Then, the authors compare the allocation of aggregate underwriting capacity to risky and complex lines of business between stock and non-stock insurers, and between independent agency and exclusive dealing insurers. …