University Rostock, Germany The Effects of Liberalization and Deregulation on the Performance of Financial Institutions: The Case of the German Life Insurance Market Lucinda Trigo Gamarra University Rostock, Germany XXXIII SAE Zaragoza, Dec, 11-13, 2008

Liberalization of European Life Insurance Markets Three European Directives on Life Insurance (1979/1990/1992) Freedom of establishment and services Home country supervision (‚single license‘ principle) Abolition of material price and product regulation Aims: Fostering of inter- and cross-country competition Increase efficiency of insurance markets Increase customers‘ welfare by larger product variety and more competitive prices Motivation

The German Life Insurance Market Situation before liberalization in 1994 Ex-ante approval of contract conditions and new contract types Price regulation (cost-plus regulation) Limited competition (Exemption from competition law (GWB)) Few product innovations Stable, fairly high premium levels Competition mainly on service: Intense level of selling activities Aim of this study: Analysis of the Liberalization Effects Changes in cost and profit efficiency after liberalization Calculation of Total Factor Productivity (TFP) growth = technical change + cost efficiency change + scale efficiency change Motivation

Previous Evidence and Own Contribution Hypotheses Previous Evidence and Own Contribution Methodology and Modelling Approach Data Set and Variables Results Conclusions Outline

Changes in cost and profit efficiency  /  Cost efficiency (CE) Realization of cost-saving potentials due to increased competition Better risk diversification Adaptation and implementation costs to changes in distribution channels, internal communication, technologies Profit efficiency (PE) Increased competition  realization of unused profit potentials Relaxed investment rules Temporarily price-setting power caused by product and service innovations H1 Cost and profit efficiency in the German life insurance industry increased during the observation period. H2 Cost efficiency decreased, while profit efficiency increased. Hypotheses 

Scale efficiency and technical change Scale efficiency (SE) (H3) Market consolidation via M&A activities Realization of economies of scale Technical change (H4) Labour-saving potentials of progress in information technologies during the 90‘s  Hypotheses 

Previous Evidence and Own Contribution Hussels and Ward (2004) 30 randomly chosen German life insurers 1991-2002 Balanced panel Non-parametric Malmquist DEA Small increases in cost efficiency and positive technical change Mahlberg and Url (2007) Whole German insurance industry 1991-2002 No differentiation between insurance lines Large increases in scale efficiency Huge swings in technical change Previous Evidence and Own Contribution

Contribution of this study Sample covers whole life insurance industry Unbalanced panel accounts for possible effects by market entries/ exits Incorporation of profit efficiency change Firms‘ revenues are considered Liberalization effects on firms‘ profitability are taken into account Previous Evidence and Own Contribution

Technical cost efficiency x2 A  Methodology B  L(y) isoquant x1

TFP change Methodology y F(x) t+1 CRS F(x) t+1VRS MPSS t+1 F(x) t CRS  F(x) t CRS F(x) t VRS x MPSS t  A t+1  y t+1 C x t+1 SE  A t+1 SE Technical change x t+1*  A t+1* Methodology x t  y t A t B x t SE  A t SE  A t * x t *

Profit efficiency y * ' E y * y D D x x D x* Methodology PE = / *  Methodology y D  D PE = / * - ∞ ≤ PE ≤1 production frontier x x D x*

Parametric distance frontier Stochastic input distance translog frontier Panel estimator: inefficiency uit varies freely through time and across firms Firm-individual heterogeneity is accounted for by „true“ Fixed Effects estimator (Greene, 2005) Firm-individual technical cost efficiency (TCE) estimates: Estimation approach uit = E(uit| εit) => TCEit = [exp(-uit)]

TFP change – calculation and decomposition Estimation approach Technical cost efficiency change Scale efficiency change Technical change

Profit Efficiency Derivation of (alternative) profit efficiency according to Kumbakhar (2006): , where , and Profit efficiency change (PEC): PEC= ln (PEi2/PEi1) Estimation approach

Variables Main services provided by life insurers: Risk pooling/ risk bearing Financial intermediation Inputs Operating expenses Equity costs Outputs Incurred benefits (net of reinsurance) Additions to reserves (net of reinsurance) Bonuses and rebates Revenues Earned premiums (net of reinsurance) Investment income Variables and Data Set

Data Firm-individual information obtained by perodically published industry reports Observation period 1995-2002 Unbalanced panel Variables and Data Set

ML estimates – Input distance frontier Results

Mean Technical Cost and Profit Efficiency Results

TFP growth and decomposition Year Technical Change Technical Cost Efficiency Change Scale Efficiency Change TFP Growth Profit Efficiency Change 1995/96 4.031 5.429 12.715 22.175 0.017 1996/97 5.022 -2.304 12.066 14.784 1.088 1997/98 6.017 3.581 6.219 15.817 1.703 1998/99 7.081 -7.616 5.108 4.573 -2.402 1999/2000 7.835 2.100 6.264 16.200 1.664 2000/01 9.186 5.267 -1.604 12.849 2.063 2001/02 10.605 -9.408 -1.122 0.075 -1.535 Mean 7.111 -0.421 5.664 12.353 0.371 1995-2002 7.289 -0.214 24.265 31.339 1.518 Results

Conclusions Technical cost efficiency largely unchanged Profit efficiency largely unchanged No clear efficiency gains by liberalization Scale efficiency increases by 5.7 percent on average Effect of market consolidation under increasing returns to scale Positive technical change of 7.1 percent on average Largest contribution to positive TFP growth Consequence of innovations in IT Liberalization mainly causes size effects Reasons Foreign insurers prefer M & A‘s Cross-border services remain limited Results