Market Structure and Performance in Private Passenger Automobile Insurance

INTRODUCTION Despite the proliferation of research on the relationship between concentration and profitability in many industries,(1) the existence of such a relationship in the property and liability insurance sector has not received much attention in the literature. Carroll (1993) examines this issue for the workers compensation market and is unable to find the positive relationship that is predicted by industrial organization theory. Since automobile insurance is the largest source of income for property-liability insurers(2) and competition in consumer markets tends to be local, concentration may be a more significant factor in pricing for this line than it is for workers' compensation. Although many companies sell automobile insurance, most are affiliated with larger groups of insurers and a fairly small number of companies control a large share of the business in the United States, with more concentration in certain states. (3) Under these circumstances, market structure may play a greater role in the pricing of private passenger auto insurance. The auto insurance industry has been under fire in the last two decades and has been accused of making excessive profits by colluding to restrict supply and keep prices artificially high. The passage of Proposition 103 in the state of California demonstrates that such beliefs may be widely held and can have dramatic consequences. Legislative proposals at the federal level, intended to repeal the antitrust exemption for insurers under the McCarran Ferguson Act, can also be attributed to this type of consumer attitude. Although the last decade has been a period of rising auto insurance premiums, particularly in certain geographical areas, the industry has consistently argued that higher prices are the result of rising costs, and that profit margins are slim. (4) This argument apparently won judicial support in California where the voter-approved twenty percent rollback of premiums was halted based on evidence that such a reduction would imply negative profits for many insurers. The purpose of this study is to investigate the relationship between profitability and concentration in the United States private-passenger automobile insurance industry. Since antitrust regulation is based on the assumption that concentration promotes collusive behavior, the results of this study should prove valuable to policy-makers, industry professionals and, ultimately, to consumers as well. The next section of the paper details the theoretical background and reviews previous empirical studies. The third section presents the data and methodology followed by a summary of the empirical results. Conclusions and policy implications are provided in the final section of the paper. BACKGROUND The industrial organization literature provides two competing hypotheses for the relationship that exists between performance and concentration. The structure-conduct-performance paradigm (SCP) suggests that market share concentration creates conditions for collusive anti-competitive behavior that can lead to monopoly profits. The SCP paradigm therefore predicts a positive relationship between profitability and market concentration level. The efficient structure (ES) hypothesis offers an alternative explanation for the positive relationship between profit and concentration. First proposed by Demsetz (1973), the ES hypothesis suggests that firms with superior efficiency (lower costs) will gain a larger market share. Thus, if larger firms have a comparative advantage in production or services provided, they may achieve higher profits without resorting to collusive measures such as raising prices or restricting supply. From a public policy standpoint, the SCP paradigm and the ES hypothesis have conflicting implications for industrial regulation. The first provides justification for strict antitrust regulation and the latter would imply that an unrestricted marketplace would result in the lowest prices to consumers. …