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CONSOLIDATION AND EFFICIENCY IN THE MAJOR EUROPEAN INSURANCE MARKETS: A NON DISCRETIONARY INPUTS APPROACH
Nurhan Davutyan & Paul J. M. Klumpes
Abstract: This paper examines the relationship between mergers and acquisitions, efficiency and scale economies in the major European insurance markets. Technical and scale efficiencies are estimated over a period of significant consolidation and harmonisation of currency and insurance regulation rules. Unlike previous studies, we include non-discretionary inputs like institutional quality and insurance penetration of each country in measuring efficiency. We predict that this behaviour is consistent with a diversification hypothesis. We assess efficiency determining factors using panel data methods. We find that: a) post consolidation technical efficiency generally improves whereas scale efficiency deteriorates; b) as asset size increases scale efficiency goes up but technical efficiency moves down; c) results for the non-life sector tend to be stronger than for the life sector.We also use multinomial logit analysis to explain the drivers of M&A activity. Our findings indicate: a) in the life insurance sector, after mergers, business inputs replace labour for both targets and acquirers but these effects do not apply to non-life targets; b) mergers do not significantly impact acquirer behaviour. These results imply that consolidation in European markets has had disparate effects on various segments of the insurance industry.
JEL Classification: G2, G22, G34; L11
Keywords: Efficiency, Insurance, Mergers and Acquisitions, Scale Economies, Data Envelopment Analysis.
- Introduction
Understanding the link between consolidation trends and the efficiency of financial services firms is particularly important in environments where a combination of market integration, information technology, stability of economic conditions and market deregulation occur simultaneously. Most of the existing literature analyses various life and non-life United States insurance markets, which has common legal structures, culture and monetary policy. Prior research by Cummins et al. (1999) finds that US life insurers engaging in M&A activity had higher efficiency gains than non M&A firms. Cummins and Xie (2008) find that M&As in US property-liability insurance were primarily associated with financial vulnerability and the desire for earnings diversification. However these linkages are also becoming more pertinent to the more mature and dense European insurance markets, which until recently have been heavily regulated and rather fragmented.
Over the last decade, the European Union has sought to promote the freedom of services, goods and labour by developing a number of Directives in an effort to harmonise and integrate various financial services markets. The deregulation of European insurance markets occurred primarily through the EU’s Third Generation Insurance Directives, implemented in July 1994. The Third Directives effectively deregulated the EU insurance markets, with the exception of solvency regulation, which is still carried out by the insurer’s home country (but is currently being revised).
Although the primary stated objective of the Third Directives was to promote the efficiency and competitiveness of the entire European insurance market, there is relatively little empirical research evidence that evaluates their economic impact. Cummins and Weiss (2005) examine the stock price impact of M&A transactions on target and acquiring firms operating across the entire European insurance market. They find European M&As created small negative cumulative average returns for acquirers, but were value creating for targets.
However there are a number of reasons for further clarifying these findings. First, Cummins and Weiss (2000) do not attempt to discriminate among life versus non life acquirers and/or targets, and whether the value generated systematically differed for the active UK market where most M&A transactions occurred. Second, they examined a small fraction (52 out of 256) the total M&A transactions that actually occurred over this period, since their event study methodology precluded examination of M&A deals involving non publicly traded firms or mutuals. Third, although Cummins, Weiss study all M&A transactions across 17 European countries, many smaller markets have market concentration, product segmentation and price regulation. Their analysis also extended over periods prior to when the 3rd Directive was actually fully implemented by various member states. In fact, most M&A transactions occurred during a fairly narrow 1999 to 2000 window, when the combination of Euro’s introduction, rapidly rising equity markets and monetary and interest rate stability facilitated intense M&A activity, both in value and volume. Further, most of this activity took place in the equity capital oriented UK market, where the total number and value of deals exceeded that of all other European countries, combined.
This paper complements prior events-study research in this area (Cummins et al., 1999; Cummins et al, 2003; Campbell et al., 2003) by directly examining the alleged benefits in M&A activity in the major European insurance markets, by reference to enhancement in operating efficiencies. The objective of this paper is to provide further analysis on the effects of deregulation and consolidation on financial services market efficiency by analyzing the motives for the consolidation and the sources of M&A value creation in the major European insurance markets. The analysis focuses specifically on the to the post 3rd Directive implementation M&A period 1999 2000, discriminates between life and nonlife acquirers and/or targets.The analysis is restricted to those seven European countries having the largest world share of the global insurance market outside the United States and Japan (ranked first and second in each market, respectively). France, Germany, and the United Kingdom are the three largest European insurance markets for both the life and non-life insurance markets; Switzerland has the highest insurance density of all European markets. The United Kingdom and Switzerland have the highest insurance penetration for the life market and non-life markets, respectively (Klumpes et al., 2006).
Prior research by Cummins,Rubio-Misas (2003) analyses the Spanish insurance industry over the ten-year period 1989-1998. They measure efficiency by estimating ‘best practice’ production and cost frontiers for each year in the period using data envelopment analysis. They also use Malmquist analysis to measure total factor productivity change. They find that small, inefficient and financially under-performing firms were eliminated from the market due to insolvency and liquidation. They observe that the market experienced significant growth in total factor productivity over the sample period, and reduced the number of firms operating with increasing returns to scale and increased the number operating with decreasing returns to scale. They conclude many large firms should focus on improving efficiency by adopting best practices rather than on further growth.
However a major impediment to competition is press claims of poor investment management and risk management practices, and a severe lack of transparency by the European insurance industry (e.g. The Economist, January 31, 2005). In order to address this issue we consider the implications of takeover activity for the input usage and outputs of each firm by using multinomial logit analysis. Consequently our study focuses on the importance of takeover activity in enhancing service provision to customers, through the enhancement of asset-liability management and risk management practices.
To provide additional information on the effects of consolidation, this study separately analyses the characteristics of life and non-life insurance targets and acquiring firms operating in the seven major European insurance markets. Several types of efficiency are calculated over the period 1997-2001, by using data envelopment analysis. Unlike previous studies, we include non-discretionary inputs like institutional quality and insurance penetration of each country in measuring efficiency. Our statistical tests show these variables to be significant in the expected direction. We assess efficiency determining factors using panel data methods. Our findings can be broadly interpreted as follows: a) post consolidation technical efficiency generally improves whereas scale efficiency deteriorates; b) as asset size increases scale efficiency definitely goes up but technical efficiency suffers to some extent; c) results for the non-life sector tend to be stronger than for the life sector. Our findings also favour a fixed effect –rather than random effects-interpretation, which means their validity, is restricted to our sample of 188 life and 284 non-life insurers.
We also use multinomial logit analysis to explain the drivers of M&A activity. Our findings indicate: a) in the life insurance sector after mergers business inputs replace labour for both targets and acquirers whereas in the non-life sector –especially for targets- just the opposite holds; b) on the output front, mergers do not seem to significantly impact acquirer behaviour. Post merger investment output seems, for non-life targets investment services to increase, but decrease for life insurers. These results imply that consolidation has had a disparate effect on various sectors of the European insurance industry.
The paper proceeds as follows. Section 2 discusses the institutional background and the efficiency concepts used in this study. Section 3 presents the hypotheses. Section 4 describes sample selection, and section 5 outlines the method used to calculate insurance inputs and outputs. Section 6 presents our estimates of efficiency and scale economies, and Section 7 concludes the paper.
2. Institutional Background
This section briefly overviews the major features of the seven major European insurance markets and explains the institutional background underlying the motives for M&A activity. The insurance industry in Europe traditionally was subject to stringent regulation affecting pricing, contractual provisions, the establishment of branches, solvency standards, etc. A separate market existed in every European country, and cross-border transactions were rare, except for reinsurance and some commercial coverage. Competitive intensity was generally low, with minimal price and product competition and stable profit margins (Swiss Re, 2000).
The implementation of the EU’s Third Generation Directives, beginning on 1 July 1994, represented a major step in creating conditions in the EU resembling those in a single deregulated national market. The Third Generation Directives have three key components: (1) the establishment of a single EU license, whereby an insurer is required to obtain only one license to operate in the EU rather than being licensed in each member nation (2) the principle of home country supervision, whereby an insurer is regulated only by the nation which issued its license and not by each host country where it operates. And (3) the abolition of ‘substantive insurance supervision’, meaning that regulation is limited to solvency control and pricing, contracting and other insurer operations are effectively deregulated. Thus, insurers are allowed to engage in true price competition in personal lines and also to compete more freely in products and services. The Directives also encouraged the entry of foreign firms and banks into the domestic European markets, making it more difficult for small, inefficient firms to survive.
The European insurance market was undergoing significant regulatory changes that offered opportunities for aggressive insurers to gain market share, potentially both reducing costs and enhancing revenues. During the past decade the major European insurance markets have experienced an unprecedented wave of mergers and acquisitions. The traditional industry specialist firm has been faced with competition from non-traditional sources such as banks, mutual funds and investment trusts. The increased competition has narrowed profit margins and motivated insurers to seek ways to reduce costs. Firms can grow either internally via the acquisition of productive assets, or externally through the acquisition of other ‘ongoing’ firms.
There is evidence of considerable rationalisation of the European insurance market in recent years.Diacon et al. (2002, p454) find that the number of competing firms nearly halved from 1996 to 1999 in Spain, Netherlands and Switzerland, and reduced by 30% in France, Germany and the UK. However prior empirical evidence on takeovers in the US and UK generally is mixed on the costs and benefits of takeovers to owners of both target and acquiring firms (Klumpes, 2004).
3. Hypotheses formulation
Mergers and acquisitions may be motivated by a number of reasons. The most stated reason is to increase shareholder value by exploiting opportunities to improve firm operating performance. Mergers may enhance a firm’s efficiency by adopting the best practice technology (technical efficiency). In addition, costs can be reduced by attaining the optimal scale –through increasing firm size if the firm is below optimal scale or reducing firm size if the firm is larger than the optimal size. Weinvestigate the systematic relationship between variations in (pure) technical and scale efficiencies, the incidence of merger and acquisition activity, and various characteristics of the acquirer and/or target firm. We consider the risk diversification, operating and financial synergy and financial vulnerability hypotheses.
An alternative rationale for mergers and acquisitions – risk (and/or earnings) diversification – may provide a particularly strong motivation for mergers and acquisition activity in the European general insurance industry and in the reinsurance industry due to multiple sources of risk. Sources for risk facing insurance firms include investment risk, operational risk, underwriting risk and credit receivables default risk. By increasing the breadth of the policyholder pool, losses become more predictable and earnings volatility due to underwriting income is reduced. This gives the insurer an opportunity to take on more risky, higher yielding investments, thus increasing revenues for a given level of overall risk. This provides another rationale for the hypothesis that acquired firms should show greater efficiency gains than non-M&A firms.Such ‘economies of scope’ considerations would predict a greater incidence of firms which are “composites” i.e. offer both life and non-life services. This diversification motive is consistent with a desire for entry into other EU countries, especially those where insurance penetration is relatively low. We test this hypothesis by including insurance penetration as a nondiscretionary input.
Cummins et al. (1999) argue there are a number of operating and financial synergy reasons to believe that mergers and acquisitions can permit insurance firms to operate more efficiently. Operating synergies allow firms to increase their operating income, increase growth or both. Consequently, opportunities for post-merger performance improvements may be greater in firms that are currently relatively inefficient, and thus M&A may involve relatively efficient insurers taking over and reforming inefficient firms.
As Cummins et al. (1999) argue, this reasoning implies insurance targets should exhibit lower efficiency prior to their acquisition, and/or that less efficient firms should be more likely to be acquired. Acquiring poorly managed firms and removing incumbent management practices should increase the value of control. If the managers of acquiring firms are more capable than those of targets, one would expect to observe efficiency gains, resulting from a change in management following a merger or acquisition.
In addition, Cummins et al. (1999, 327) argue there are financial synergy benefits attributable for relatively efficient firms in terms of cost and revenue-related efficiency gains from affiliating with others. The predominant organisational model in the insurance industry is the insurance group, consisting of several insurers under common ownership. Merger and acquisition activity involving the formation of an insurance group develops a business model consistent with Williamson’s (1985) M-form organisation. A number of the largest insurance enterprises in Europe, such as Allianz, Axa and Aviva, involve the creation of a holding company that undertakes low-frequency activities, such as planning, budgeting and treasury, while high-frequency activities concerning operational decision –making are delegated to the subsidiary level. Although members of groups operate relatively independently in terms of marketing, a number of important operations such as information systems, investments, and policyholder services usually are conducted centrally. Spreading the fixed costs of financing these operations over a broader base has the potential to improve financial capital allocation and thus enhance cost efficiency. This implies that the creation or development of an M-form organisation will result in relatively greater revenue efficiency, since consolidation facilitates cross-selling, improves customer satisfaction, and otherwise enhances the firm’s ability to produce revenues (Klumpes, 2005). Accordingly, following Cummins et al. (1999), it is hypothesized that the revenue efficiency of target firms will tend to increase following an acquisition by an insurance group. For our “nondiscretionary” inputs approach, cost and revenue efficiencies are not measurable. This is due to the “non-existence” of all the relevant prices. However, the cost savings and revenue enhancements in question should also be reflected as higher scale efficiencies for larger insurers implementing such innovations.
The changes in marketing system and technology have also been dramatic. Consequently, in this environment, firms that possess leading-edge competencies in the areas most subject to change may be viewed as attractive acquisition targets. This may be captured by technical efficiency. However, following Cummins et al. (1999, 326), we do not have a strong prediction with regard to whether acquisition targets are likely to be relatively inefficient or relatively efficient.
The quest for scale economies is often given as another operating synergy rationale for mergers and acquisitions. Under this motive, firms operating with non-decreasing (constant or increasing) returns to scale (NDRS) will be attractive acquisition targets because they are currently operating in the optimal size range or have the opportunity to become more efficient through growth. Firms operating with decreasing returns to scale are likely to be viewed as unattractive acquisition targets because they are already ‘too large’ in terms of scale economies.
Another objective frequently mentioned for mergers and acquisitions is to enhance market power by increasing market share in a firm’s core lines of business. However this particular rationale for takeover may be subject to regulatory and political visibility and possibly interference by insurance regulators, national governments and the European Union. Thus we expect an inverse relationship between “regulatory strictness” and such chasing of market power.