An Examination of Cost Economies in the United States Life Insurance Industry (1992)

Using an industry sample of 423 U.S. life insurers, this study reports estimates of overall and product specific scale economies, as well as, pair-wise cost complementarities for a wide variety of products. Estimates of these cost characteristics are provided for numerous output vectors since theory suggest that the magnitude of scale economies and cost complementarities may vary with the scale and mix of outputs. In contrast, previous studies only provide a single point estimate of industry cost characteristics using the sample mean output vector. This study, therefore, provides a more complete representation of the industry's cost characteristic and, in turn, new insights into decisions related to the optimal scale and mix of outputs. Potential cost savings arising from economies of scale and scope in the life insurance industry are important to both firm managers and regulators. The potential for economies of scale and scope affects managerial decisions regarding the scale and mix of outputs. Substantial cost economies may result in a highly concentrated industry that would facilitate collusive pricing behavior. In a multiproduct industry, however, a concentrated market structure may only be one of many possible equilibria. Another equilibrium may entail a large number of firms producing only a small range and scale of outputs. In either case, regulators would be interested in the existence of cost economies and their effects on market structure.(1) Early studies of the life insurance industry limit their analysis to the estimation of single-product scale economies (e.g., see Geehan, 1986, for a review of studies using a single output measure). These studies' methodologies do not explicitly incorporate the multiproduct nature of most life insurance firms, and estimates of scale economies are provided for only the sample mean level of output. More recent studies (e.g., Fields, 1988, Fields and Murphy, 1989, and Kellner and Mathewson, 1983) use a multiproduct methodology to derive estimates of economies of scaled and scope for the industry sample mean vector of outputs. Economic theory, however, suggests that the magnitude of cost economies varies with the scale and mix of outputs. Hence, previous studies' estimates of cost economies which are derived solely from the sample mean vector of outputs provide only limited insights into the cost characteristics of firms away from the sample mean firm. A thorough analysis of the cost structure of the life insurance industry, therefore, requires estimates of cost economies for firms varying in both the scale and mix of outputs. Such an analysis is essential to the study of the life insurance industry since the industry is comprised of many firms exhibiting substantial variation in the scale of outputs and the range of product offerings. Using a multiproduct cost function and an industry sample of 423 U.S. life insurers this study reports e estimates of overall and product-specific scale economies as well as pair-wise cost complementarities for a wide variety of products. Estimate of these cost characteristics are provided for a number of output vectors varying in the scale and mix of outputs, organizational form (stock versus mutual), and production/distribution structure (agency versus non-agency). This study, therefore, provides a more complete representation of the industry's cost structure than previous studies. The results show increasing overall scale economies for all but the largest agency firms which display approximately constant returns to scale. Significant increasing product specific scale economies are found for accident and health and investments products for all companies, and ordinary life for agency companies. The results do not support the hypothesis of cost complementarities being the raison d'etre for multi-product production among life insurers. Regarding the effects of organizational form, mutuals are not shown to incur higher costs than stock companies for a given scale and mix of outputs. …