ECONOMIES OF SCALE IN THE

AUSTRALIAN GENERAL INSURANCE INDUSTRY

1.)y
Peter Praetz
Murray Beattie*

Abstract:
This paper finds very strong evidence of economies of
scale for a sample of 143 private sector companies
from the 1979-80 Insurance Commissioner's Report.

Keywords:
ECONOMIES OF SCALE; GENERAL INSURERS

*Monash University, Clayton, Victoria, Australia.

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1. INTRODUCTION
This paper seeks evidence of economies of scale for a sample of 143 private
sector companies from the 1979-80 Insurance Commissioner's Report. Very strong
evidence of economies is found for these companies.
The industry is regulated by the 1973 Insurance Act which monitors the industry
and does not control output, investment, or prices but minimum solvency margins.
Tickle (1979) contains an excellent discussion of the operations of the Act. The
industry has increased from 2.2 percent at 30/6/1952 to 5.4 percent at 30/6/1980
of the total assets of financial institutions, Reserve Bank of Australia (1981).
The industry is not highly concentrated with the five (ten) firm concentration
ratio at 1/1/1980 for this study of 25 (45) percent using premiums. We exclude
government insurance offices (G. 1. 0.) and reinsurance and other atypical firms.
The number of firms was 202 at 30/6/1981. The above features give some insight
on industry regulation and structure.
Table 1 has premium incomes and percentages of public and private sectors, the
proportion of private business and its expense rate for eight main classes of
business.
The main private components are Motor Vehicles (32%) and Employers' Liability
(22%) while for public insurers, they are Compulsory Third Party (56%) and
Employers' Liability (23%). The latter is much more heavily concentrated than
private even though it only has 35% of the total business. The individual
business class proportions of private to total average 65% and range from 100% to
6% (Compulsory Third Party).
The expense rates average 32% and range from 13.9% to 45.9%. They may not be
reliable because of the difficulties of joint cost allocation.
Section 2 surveys current research in this area, while 3 discusses the theory and
implications of estimating cost curves for general insurance data. Section 4
discusses the data used and the estimation results while 5 has conclusions and
some policy recommendations.

2. RECENT RESEARCH ON ECONOMIES OF SCALE IN GENERAL INSURANCE

Benston (1972) contains a good survey of the issues involved in economies of
scale for financial institutions. Johnston (1960) discusses the theory of cost
curves, their estimation and empirical studies on financial institutions.
For Australian financial institutions, Praetz (1931) and Elstone (1980) have
given strong evidence of economies of scale for life insurance companies and
building societies.
Halpern and Mathewson (1975) analysed 88 Canadian general insurers and found
public companies had economies from more lines but not from line expansion but
mutual companies achieved economies from both sources.
For Australia, Purcell (1968 and 1974) has a good institutional description of
the general in<;urance industry and its financial characteristics. The former
paper has expense rates for Victorian insurers in 1957-58 for separate classes of
insurance which fluctuate a great deal with premiums. Even on aggregation, only
a few large companies are a little better off. Trowbridge (1981) has a very goon
discussion on pricing in a competitive environment although he doubts economies
exist.
In the U.S., the property-liability insurance industry has been studied
intensively. Hammond et al (1971) studied 173 insurers in 1968 and found
evidence for economies of scale. Allen (1974) analysed three year averages over
1967-9 for 49 Nebraska insurers and gave only very weak support. Cummins (1977)
used premiums as his output measure and found that economies did not exist for

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independent insurance agencies from a questionnaire sample of agents. Johnson et

al (1981) studied 262 of the largest insurers in 1976. They found economies of
scale for big companies but that small and medium insurers had decreasing
returns. Doherty (1981) uses claims instead of premiums and finds strong
evidence for economies with this alternative specification.

3. ECONOMIES OF SCALE
Economies of scale should come froln office staff and the technology of non-labour
(data processing), all of which should generate lower average cost as the size of
the business increases if economies of scale exist.
The multiple outputs consist of many classes (e.g., fire, motor vehicle,
employers' liability) of insurance business and cost functions for the main
classes are not estimated separately as even though they have quite different
cost behaviour. As data are not available for the types separately all the
classes are aggregated. The index of aggregate output is $ premium income which
should be deflated by an index of prices for the policies but as cross-section
data are used where prices across firms for each policy type are fairly uniform
this $ index is hoped to be a good proxy for the true quantity index. Data
limitations make adjustments for these kinds of factors very difficult.
A Cobb-Douglas total cost and production (dual) function is used below in 4 on
total costs and total premiums, which log transforms both variables which is
appropriate given the substantial non-linearity in the data.
Even though prices and output were not controlled and even though the industry
has become more competitive since the Trade Practices Act (1974) output is hoped
to be exogenous.
Cost data are not available for separate classes of business and only aggregate
costs given are for management expenses, commissions and other underwriting
eKpenses and insurance business expenses. These are added for a total cost
variable. This may be a problem if other activities such as life insurance are
also carried on jointly by the company, although they should be separate.
For firm i, the variables are denoted by Qi (index of output for firm i), Ci
(total cost for firm i) and ACi (average cost for firm i Ci/Qi)'
Average cost is written as ACi = f(Qi) which omits prices as they are assumed
constant over the firms. Economies of scale imply a decreasing relationship
between AC and Q, i.e., dAC/dQ < 0, similarly, diseconomies would have a
derivative being> 0 beyond some level of Q.

4. ESTIMATION AND DATA FOR THE AUSTRALIAN GENERAL INSURANCE INDUSTRY

This study excluded 46 of 189 firms with returns in the 1979-80 Insurance
Commissioner's Report, Appendix B as they were all different from a conventional
Australian insurance company. In particular, 22 were reinsurance companies and
so have a joint cost problem, 19 had negative premiums and 5 were very atypical
(e.g., winding down or dominated by other activities).
Ordinary Least Squares (OLS) is used to estimate the regression parameters. This
assumes that the output of each finn is determined outside the system. This
could be relaxed to avoid possible simultaneous equation bias by re-estimating
with instrumental variables.
Two important OLS assumptions are that the residuals have a constant variance and
are independent of each other. These can be validated from the estimated
residuals by counting peaks in the residuals (k) and seeking dependence in them
with the Durbin-Watson statistic (dw) and by counting the number of sign changes,
the standardised number of which is denoted by Zs • The sample has been ordered
by increasing values of premium income to detect possible OLS assumption

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violations in this cross-section. Violations usually lead to biased and

inconsistent estimators but, much more importantly, they diagnose mis-
specification of the economic specification which should be reconsidered and
probably re-estimated. Praetz (1979) has proved that dw detects mis-specified
models in cross-section or time series models.
Table 2 contains a two-way table of values of premiums (P), greater than 50, 10
to 50, 5 to 10, 1 to 5, and less than 1 (million $) with average cost (expense
rates) with the number of firms in each frequency class for the grouped data.
For these grouped data, there is a clear inverse association between the
decreasing premiums and increasing expense rates. Percentage expense rates
increase from 30.3 for firms with more than $50 million premiums to 43.3 for
those with incomes below $1 million - a difference of 13 percent. It is hard to
explain why many small companies survive in competition with much bigger ones
given economies of scale.
Table 3 has OLS estimates of cost functions containing log Q as an explanatory
variable for log C for the total sample as well as the first 40, middle 58 and
last 45 observations. The total sample is extremely successful with an R2 of
93 percent, a t statistic for log Q of 43.6 at the 5 percent single tail level
and of the correct sign and none of dw, Zs and k significant implying a very
well specified regression.
The first 40 sample comes from the first two classes in Table 2. It is very well
behaved and had an R2 of 79 percent, a t value of 12.0 which is correctly
signed and significant and acceptable values of k, dw and Zs' The middle
group comes from the third and fourth classes of Table 2. It has an R2 of 72
percent and a t statistic of 12.0 while the last group has an R2 of 63
percent and a t statistic of 8.6, which are also good and not invalidated by
the diagnostic measures.
The coefficients of Table 3 are elasticities so a 10 percent increase in premiums
is associated with increases of 9.2 percent for the total and 9.3 percent, 10.1
percent and 7.5 percent for the sub-groups. The .92 may seem a little low given
the wide variation in firm size but it is big enough to generate a 20 percent
increase in expense rates in Table 4. The 1.01 for the middle group implies
constant returns to scale - this may be caused by data differences for costs and
premiums or inability of the log-log model to fit all three groups. This minor
imperfection is the only one present in the study.
Table 4 has expense rates implied by the estimated cost function for 100, 10, 1
and .1 ($m). They range from 27.1 percent to 47.3 percent.
In Table 1, expense rates vary a lot with business class so any comparison
between companies using expense rates may be distorted by these differing costs
for companies with differing amounts of business in each class. A direct
incorporation of costs may be hard given the joint costs problem but if the
amounts of premiums for each class were available, total cost could be regressed
on them to produce a cost function adjusted for intercompany premium differences.
However, data limitations prevent this.
The simultaneity problem with instrumental variable esti.nation and previous
year's premiurns was not attempted as many companies could not be traced.
One other approach was tried but not included as it gave a perverse result.
Employer liability business, which is low expense and long tailed, may be
associated with outstanding claims.
The tentative conclusions that emerge from this section are:
(a) Table 2 has strong tabular evidence for downward sloping cost curves
as premiums decrease but there is no evidence of upward sloping

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curves;
( b) this effect is much stronger again in the regression with a very high
R2 and t statistics;
(c) an elasti.city of .92 implies cost savings through the less than
proportional increase in costs as premiums increase;
(d) the diagnostic statistics for heteroscedasticity and autocorrelation
give little evidence of model mis-specification.

5. CONCLUSIONS

For this sample of 143 firms, from the 1980 Insurance Commissioner's Report, the
evidence from the average cost curves for economies of size is remarkably strong.
The effect is also very clear in Table 2 on a tabular basis and is confirmed by
the elasticities.
Cost savings associated with larger size need to be considered with other recent
developments in the industry.
Overall industry expense rates have increased from 29.6 percent to 32.1 percent
of premium income over the last three years. This increase in expense rates
coupled with increasing underwriting losses with greater awareness of the large
range of costs may mean that mergers and/or takeovers may be the lot of many
small and medium sized companies in the future.

(Date of receipt of final typescript: May 1982)

REFERENCES

Allen, R., 1974, "Cross sectional estimators of cost economies in stock

property-liability companies," Review of Economics and Statistics, 56, 100-3.
Benston, G.J., 1972, "Economies of scale of financial institutions," Journal of
Money, Credit and Banking, 4, May, 312-41.
Commonwealth of Australia, 1980, 6th Annual Report of the Insurance Commissioner
for 1979-80.
Cummins, J.D., 1977, "Economies of scale in independent insurance agencies,
Journal of Risk and Insurance, 44, 539-53.
Doherty, N., 1981, "The measurement of output and economies of scale in
property-liability insurance," Journal of Risk and Insurance, 48, 392-402.
Elstone, R.G., 1980, "Returns to scale in the building society industry,"
Accounting and Finance, 20, 53-70.
Halpern, P.J. and Mathewson, G.F., 1975, "Economics of scale in financial
institutions: a general model applied to insurance, Journal of Monetary
Economics, 1, 203-20.
Hammond, J., E. Melander and N. Shilling, 1971, "Economies of scale in the
property and liability insurance industry," Journal of Risk and Insurance, 38,
181-91.
Johnston, J., 1960, Statistical Cost Analysis (McGraw-Hill, London).
Johnson, J.E., G.B. Flanigan and S.N. Weisbart, 1981, "Returns to scale in the
property and liability insurance industry," Journal of Risk and Insurance, 48,
19-35.
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Praetz, P.D., 1979, "The detection of omitted variables by llirbin-Watson

statistics in multiple regression models," Australian Journal of Statistics,
21, 129-38.
Praetz, P.D., 1981, "Economies of scale in the Australian life insurance
industry," Economic Record, 57, 269-276.
Purcell, G., 1968, "Australian non-life insurance since 1909," Economic Record,
44, 438-69.
Purcell, G., 1974, "Non-life insurance," in: R.R. Hirst and R.H. Wallace (eds.),
The Australian Capital Market (Cheshire, Melbourne), 207-45.
Reserve Bank of Australia, 1981, Statistical Bulletin, Financial Flow Accounts
Supplement.
Tickle, W.B., 1979, "Government regulation of the general insurance industry,"
Master of Administration Thesis, Monash University.
Trowbridge, J. R., 1981, "General insurance pricing in a competitive environment,"
Transactions of the Institute of Actuaries of Australia.

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Table 1

Premium income of public and private sectors, proportion of

private business and private eKpense rate by class of business
for 1980 from 1980-81 Insurance Commissioner's Report

Premium Income ($m) Proportion Private

of Private Expense
Class of Business Private Public Business Rate (%)

Fire 214 (10) 16 (1 ) 93 42.5

Householders and
Houseowners 228 (11) 47 (4 ) 83 45.9

Contractors 13 (1) (0) 100 39.6

Marine 102 (5) 4 (0) 96 29.4

Motor Vehicle 671 (32) 157 (14) 81 25.9

Compulsory Third
Party 37 (2) 636 (56) 6 13.9

Employers'
Liability 468 (22) 258 (23) 64 22.9

Public
Liability 80 (4) 5 (0) 94 43.2

Others 278 (13 ) 23 (2) 92 43.9

All Classes 2091 (100) 1147 (100) 65 32.06

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Table 2

Expense rates and number of firms by premium income classes

for 143 non-life insurers from the 1979-80 Commissioner's Report

Premium income range Expense Rate Number of Firms

($ million) (%)

greater than 50 30.3 9

50 to 10 33.8 31
10 to 5 36.2 26
5 to 1 37.0 32
less than 1 43.3 45
total 32.5 143

Table 3

Ordinary least squares estimates of regression statistics of cost

functions for 143 companies from the 1979-80 Insurance Commissioner's Report

All Company Size

Regression total sample big medium little
Statistics (n = 143) (n = 40) (n = 58) (n = 45)

log premiums .92 .93 1. 01 .75

( t) (43.6) (12.0) (12.0) (8.6)
R2 (%) 93 79 72 63
dw 1.90 2.07 2.09 1.89
Zs .3 .5 .7 .4
k 5 2 5 2

Table 4

Selected premiums' expense rate implied by the estimated regression

premiums ($m) expense rate (%)

100 27.1
10 32.6
1 39.3
0.1 47.3

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