CONSOLIDATION AND EFFICIENCY OF THE NON-LIFE INSURANCE SECTOR IN POLAND

Sylwester Kozak
Faculty of Economic Sciences, Warsaw University of Life Sciences - SGGW, Poland

ABSTRACT

The paper examines the level of the cost efficiency of the Polish non-life insurance industry in the period 2003-2007. The analyzed period characterizes intensive restructuring due to the preparation and first years of operations on the common pan-European financial market. Relatively low density and penetration of insurance services in Poland were important motivations for foreign insurance companies to enter the Polish market. The 80% share of foreign capital in the Polish insurance sector resulted in reduction of dominance of the main state-owned insurer and the increase of competition on the Polish non-life insurance market. The examination was conducted on the group of 34 Polish insurers based on their annual data provided by the Polish Insurance Chamber. The stochastic frontier analysis showed that during this period the average level of cost efficiency was decreasing from 49% to 43%. The regression analysis indicates that operational costs have negative impact on the level of efficiency. Additionally firms lowered their efficiency in a result of reduction of the market concentration and increase of competition, which is in accordance with the Structure- Conduct-Performance (SCP) paradigm. Higher acquisition costs are expected to be responsible for the lower level of cost efficiency. Economic downturn is expected to have a positive impact on the efficiency. No correlation between efficiency and insurer’s size could indicate an absence of scale effects in the non-life insurance sector in Poland.

Key words: efficiency, consolidation, non-life insurance sector, financial stability, Poland.

INTRODUCTION

The beginning of the 2000s was the period of significant transformation for the Polish insurance industry. Improvements of the economic conditions and the EU accession encouraged European insurance companies to enter the Polish market. Additionally, harmonization of the Polish accounting and supervisory regulations with European standards created a favorable environment for reliable assessment of the company's financial performance and market value. For the insurance sector the accession into the uniform pan-European financial market changed the conditions of operations and influenced competition and some group of costs, mostly acquisition costs.

On the common financial market, the competition on the insurance market comes not only from domestic, but foreign companies as well. As a result, after the decade of the 1990s, characterized by limited privatization and restructuring, the insurance sector experienced accelerated internationalization and consolidation. The overall structure of the industry has been gradually changed, moving from monopolistic and state-owned to more diversified, with bigger presence of foreign and privately-owned firms. The total evaluation of the Polish insurance sector restructuring process in the early 2000s indicates positive effects, expressed in the growing values of gross written premiums, as well as profitability and financial stability of the sector.

The concept of assessing the company's performance with the efficiency scores was developed in the 1950s by Farrell [20], and also applied to the financial services. The efficiency scores are determined with various definitions, but the most frequently used are: technical efficiency and cost efficiency. Technical efficiency is related to the ability of a firm to produce outputs with given inputs. The production plan is technically efficient if there is no way to produce the same output(s) with less input(s) or to produce more output(s) with the same input(s). Cost efficiency is determined by calculating how a firm's costs lie close to the cost efficiency frontier for a given technology. The efficiency frontier is determined by two conditions: technical efficiency (minimum use of inputs) and allocative efficiency (optimal mix of inputs given relative price factors) [21]. Cost efficiency is measured with two estimation techniques: non-parametric (Data Envelopment Analysis, DEA) and parametric (Stochastic Frontier Approaches, SFA). In empirical studies, the cost function, which substitutes the production function, represents the relationship among inputs and outputs.

Efficiency analysis of insurance companies has become an important item of the sector's financial stability assessment. It measures the company's ability to minimize operating costs or maximize revenues and profits [4,20,22]. Such type of company's evaluation is especially important in the context of the current financial crisis, when worsening economic conditions force enterprises to minimize operating costs in their efforts to survive on the market and sustain appropriate level of profitability. Therefore it could be said that the cost efficiency is crucial for the enterprise to withstand its financial stability.

Although the efficiency evaluation of the insurance industry gains a growing popularity, the literature of this subject is still rather limited. Most of papers analyze US insurance companies, which is a result of a better data accessibility and unprecedented consolidation conducted on this market [5,9,10,11,12,15,24,25,33]. In the EU majority of efficiency analyses of the insurance industry cover total European market [16,17,18]. Some papers examine efficiency for the individual country market, inter alia, in Austria [19,29], Ireland [27], Spain [7,8], the Netherlands [6], the UK [26,28] and Italy [14]. According to the author's knowledge, there is no comprehensive assessment of efficiency of the Polish insurance institutions. The first attempt to estimate efficiency scores was performed by Pawlowska and Kozak [30] as a part of the analysis of Polish insurance sector's ability to withstand competition from the foreign insurance companies in case of Poland's accession to the euro zone.

This article, for the first time, presents full analysis of the state and recent developments of efficiency the Polish non-life insurance sector and main determinants of its development. For the purpose of the research a two-stage regression model was applied. Firstly, the model shows that the level of cost efficiency of the Polish non-life insurance industry is decreasing. Secondly, the cost efficiency is positively affected by the restructuring of the industry and the increase of competition, and negatively by the level of acquisition costs. The results are in the accordance with the SCP theory which states that a high concentration reduces competition and increases profitability and efficiency of the company. The data for the research are acquired from annual financial reports of individual companies for the period of 2003-2007 published by the Polish Insurance Chamber (PIU). The examined period covers the process of the industry preparation for the EU accession and first years of operation on the uniform pan-European financial market.

The rest of this paper is organized as follows. The next section gives the literature review on the consolidation and efficiency of the insurance sector in Poland and in other EU and non-EU countries. Subsequently, the paper evaluates the state of the Polish non-life insurance sector. Next, the general concept of efficiency and methods of its measurement are presented, and also sources of data and methodology of the research. Last sections discuss results and summarize the paper with conclusions.

LITERATURE REVIEW

The literature concerning efficiency of insurance industry is rather limited, and majority of it refers to the US market. In the EU insurance sector, a growing interest in efficiency evaluation has been observed during recent years however it does not refer to Poland and other CEE countries. Efficiency assessments of the US and European insurance companies indicate their high sensitivity on macroeconomic and market conditions. Cummins, Tennyson and Weiss [13] noticed an impact of the sector consolidation on the efficiency of the US life insurance firm. They found out that M&A transactions lead to the efficiency improvements of the acquired company. In turn, Cummins and Rubio-Misas [7] surveying performance of Spanish insurance companies for the period 1989-1998 found out that consolidation leads to minimum improvements of efficiency in both merging companies. Additionally, they noticed that higher efficiency and reduction of operating costs make prices lower, both on life and non-life insurance market.

Cummins and Weiss [15] examined effects of insurance sector consolidation in the EU for the second half of the 1990s. It was a time after introduction of the third life assurance Directive which came in force since 1994 [34]. The directive established the uniform pan-European financial market, which means that any insurance company registered in any EU members state could operate without limits on the entire EU market. Analyzing 2595 transactions of domestic and cross-border mergers and acquisitions of insurance companies for the period 1990-2002 they noticed, that both domestic and cross-border consolidation cause an increase of efficiency of the acquired company. They claimed that such rule could be important for the market development of a country which absorbs foreign investments in financial sector. Moreover they noticed that implementation of regulations aimed on reduction of market entry barriers results in an increase of competition and efficiency.

Fenn et al. [23] examining life and non-life insurance companies in Europe noticed that the value of assets and company's market share affect efficiency, and volatility of profits and costs of the company. Also Cummins and Zi [12] analyzing life insurance sector in the USA for the period of the 1990s found out positive correlation between the levels of efficiency and values of firm's assets. In turn, Bikker and Leuvensteijn [6] analyzing performance of around 100 Dutch life insurance companies for the period of 1995-2003, noticed in their operation the existence of the effect of scale and a positive correlation between efficiency scores and values of firm's assets. The average level of the effect of scale amounted to 20%, however for small companies the score equaled 42%, and for large companies 10%. Such relationship may result from the higher competition, which was recognized between big numbers of small insurance companies.

Pawlowska and Kozak [30] examined the life and non-life insurance market companies in Poland and neighboring countries for the period of 2003-2006. They found that the level of the cost efficiency of Polish insurance companies is comparable with results in other EU countries. Such developments mean that Polish accession to the euro zone and expected increase of completion should not diminish their profitability and financial stability.

POLISH NON-LIFE INSURANCE SECTOR

For many decades the Polish insurance sector was almost entirely monopolized by the state-owned firm, Powszechny Zaklad Ubezpieczen (PZU). The first stage of the sector transformation was associated with its division into the life and non-life segments [35]. As a consequence, PZU was broken down into: PZU and PZU Life, still dominating their segments of operations. First attempts to foster competition, made in the second half of the 1990s, were focused on introduction of new private, mostly foreign-owned insurers. Unfortunately state-owned giants preserved their dominant market positions. The only significant privatization decision was related to WARTA, the public insurer, specializing in protection of international business transactions, which shares were sold through the Warsaw Stock Exchange in 1995.

Due to direct investments in insurance sector the number of companies has increased, the most in the period 2000–2003, it means from 68 to 77 for the total insurance sector, and from 33 to 41 in non-life sector. At the same time the share of foreign capital in the sector's own capital increased from 59% to 72%. However the market concentration remained still very high, reaching in 2003 for non-life insurance the levels of 53% (CR1) and 81% (CR5) (CR1 and CR5 state for the market share of, respectively, one and five largest firms).

The next stages of the sector restructuring took place in the period 2003–2007 and were associated with Poland's accession into the EU. Consolidation at this period was aimed on the reduction of the market concentration and enhancement of competition. These goals were party gained with the further increase of foreign investments and establishment of new, mostly, foreign-owned companies. As a result in 2007 the concentration of the non-life insurance market significantly dropped to the level of 44% (CR1) and 74% (CR5). The consolidation of small firms has reduced the overall number of firms to 35 (see Table 1).

The analyzed period is composed of two sub periods. The first one covers the process of harmonization of the Polish financial regulations with European requirements, and the second, the early years of Polish companies' presence on the common pan-European financial market after the EU accession. A huge space for the growth of the insurance market penetration and density of the insurance services on the Polish market, accounted for an investment attractiveness of the Polish market (see Tables 2 and 3).

Another feature of the Polish insurance sector is the scope and form of distribution channels. In the 1990s, the range of non-life policies was concentrated mainly on automobile protection, distributed directly through the insurers' branch network. Developments of non-life insurance coverage led to reduction of the motor-insurance to 60% in 2007, and new technologies changed the structure of distribution channels focusing on individual agents, brokers & banks, and also on declining channel of insurers` network. In the meantime, due to the efforts of cost minimization, a new direct distribution channel was developed which utilizes Internet and telecommunication network. The share of direct sales has increased to 2% in 2007 (More information on the insurance sector transformation in the CEE countries see: [1,2,3,31,32]) (see Fig. 1).

DATA AND METHODOLOGY

For assessment of the cost efficiency of the non-life insurance in Poland and determinants affecting its level, the two-stage regression model is applied. The efficiency scores of individual insurers are calculated during the first stage, and next applied to the regression as a dependent variable. The independent variables consist of characteristics of insurance companies, insurance market and domestic economy.

In the first stage for efficiency assessment the Stochastic Frontier Approach method is applied with the translog cost function:

ln c_i = C(y_i, w_i; β) + v_i + u_i i = 1, 2,..., N

where c_i is the observed cost of production for the i-th firm
y_i is the logarithm of the output quantity
w_i is a vector of logarithms of input prices
b is a vector of unknown parameters to be estimated
n_i is the random error
u_i is the non-negative cost inefficiency effect

The insurer's output is estimated with the value of gross written premiums (GWP), and inputs are represented by labor and acquisition expenses. Prices of inputs are defined as follows: w₁ – price of labor is estimated as the ratio of administration expenses to the GWP, and w₂ – price of acquisition services is estimated as the ratio of acquisition expenses to the GWP (for variables definitions see Table 4).

In the SFA estimation the error term is assumed to have two components. The error term v_i captures effects of statistical noise, and is independently and identically normal distributed with zero mean and variance σ_v². The second term µ_i is responsible for the inefficiency, and is strictly non-negative distribution. The frontier estimation techniques measure the efficiency score for a given firm as the relative distance between that firm's efficiency and the best-practice or most efficient firms' frontier. Cost efficiency can take values between zero and one, where one indicates the most efficient firm. For example, an insurer with cost efficiency of 0.75 is 75% efficient. It means it can improve its efficiency by 25%, for example by reducing its costs.  In other words it can be said that the insurer is 25% inefficient.

In the second stage of the econometric model efficiency scores are implemented to the panel regression equation with fixed effects:

Y = F [TC, GWP, CR5, Δ GDP] + ε

where the independent variable represents efficiency scores, and independent variables represent the firms characteristics (total costs and GWP), and characteristics of the market and domestic economy. The structure of market is estimated by the CR5 concentration ratio, it means the market share of five largest insurers. The macroeconomic conditions of the insurers' operations are defined by the annual GDP growth.

The data on individual insurance companies comes from the annual financial reports of 34 non-life insurance companies, published by the Polish Insurance Chamber (PIU). The macroeconomic data are provided from the Polish Statistical Office (GUS). Descriptive statistics of the variables applied to both of equations are presented in the Table 5.

EMPIRICAL RESULTS

Assessment of the efficiency of non-life insurance companies shows a decreasing trend in the cost efficiency in the sector (see Tables 6 and 7). The values of the sector's average gradually decline from 49% in 2003 to 43% in 2007. The largest drop of the efficiency score (2.3%) is noticed in 2004, the year of the EU accession.

The results of the regression model which explains developments of cost efficiency indicate that its values are negatively correlated with the total costs of insurance company. It means that increasing the value of total costs an insurer reduces its efficiency. The next statistically significant coefficient is associated with the level of market concentration. Positive correlation between concentration and efficiency stays in according to SCP theory, which states that higher contraction is favorable for main players to become more profitable and more efficient. For the Polish non-life insurance sector such results indicate that at the beginning of the 2000s, when the market is fairly monopolized (the main insurer took more than 50% of the market), the sector, on average, is much more efficient than after a short operation within the common pan-European, characterized with a growing domestic and foreign competition. The higher competition may require increasing expenses on acquisition to sustain on the market. For the analyzed period the ratio of acquisition costs to the GWP has increased from 14.6% in 2003 to 16.3% in 2007, which could indicate the presence of the competition pressure.

The GDP growth is another factor affecting the non-life insurance cost efficiency. Such correlation may have two explanations. The first could increase the sector's efficiency and be associated with the growing demand for the property and liability protection from individuals and businesses during the worsening economic conditions. The risk protection refers to customers' willingness to cover personal and corporate durable assets and production facilities, and also to cover professional responsibility risk (for example the growing demand for D&O policies during the current financial crisis, and also medical staff and lawyers liability insurance). On the other hand a slower GDP growth may reduce efficiency of the non-life insurance segment due to the reduction of value of durable assets, which has impact on the values of the GWP and insurers' earnings.

The estimation results could not prove any relationship between the scale of the insurance company (represented by the GWP) and its efficiency. Although the sign of the coefficient is positive, it is statistically insignificant. It may suggest that during the examined period there are no affordable circumstances in the Polish non-life insurance sector to obtain effects of scale.

CONCLUSIONS

The results of evaluation of the non-life insurance sector efficiency in Poland for the 2003-2007 period enable to draw the following conclusions:

1. The Polish non-life insurance industry has undergone intensive restructuring during the period of 2003–2007. Perspective of joining the EU and common financial market and a huge space for the growth of insurance business encouraged foreign insurance companies to enter the Polish market, what has increased the share of the foreign capital in the sector's own capital to about 80%.

2. Entrance of the foreign insurers and integration with the common financial market has resulted in the reduction of the dominance on the market of the main state-owned insurer and the increase of the competition on the Polish non-life insurance market.

3. The period of 2003–2007 covering the process of preparation and joining the common financial market characterizes with the reduction of the cost efficiency of the Polish non-life insurance sector.

4. The efficiency reduction could be associated with a higher competition coming from foreign insurers and the intensive growth of the operating costs, especially acquisition costs.

5. Efficiency of companies is negatively correlated with total insurer's costs and the rate of economic growth. Worsening economic conditions could have a positive impact on the demand for non-life insurance services, and create additional premiums and improve efficiency of the insurer's operations.

6. There is no correlation between the level of efficiency and the scale of insurance company. It means it is difficult to claim that there is an effect of scale in the Polish non-life insurance sector.

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The opinions expressed in this paper are the authors' opinions and should not be attributed to the institutions of his employment.

Accepted for print: 28.01.2010

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