- Email: [email protected]
The limits of competition: Housing insurance in Switzerland
EUROPEAN ECONOMIC REVIEW ELSEVIER
EuropeanEconomicReview
40(1996)
1111-1121
The limits of competition
The limits of competition: Housing insurance in Switzerland Thomas von Ungern-Sternberg University of Lausanne, Batiment du Rectorat et de I’Administration
Centrale busanne,
Switzerland
Abstract
In Switzerland there are seven cantons where the housing insurance market is competitive, while in the 19 others there are local state monopolies. This paper compares the price/performance relationship of these different market forms. It is shown that for a very similar product the state monopolies charge 70% lower prices, that they spend substantially more on fire prevention, and that they have much lower damage rates. One of the main reasons for the higher prices of the private insurance companies is the fact that they spend considerably more on sales and administrative costs. The housing insurance market is thus a classic example of a situation where state monopoly outperforms private sector competition. JEL classification: Keywords:
Ll; L32; L33; L52; L89
Housing
insurance;
Competition;
Public enterprise
1. Introduction Economic directions:
theory and policy are currently
developing
in somewhat
incoherent
- On the one hand there have been important new developments in theoretical industrial organisation. We now have models that give us a much better understanding of why real world competition might not lead to socially desirable results: Oligopolistic firms may spend excessive amounts on advertising; ’ monopolistic
’ The Rasmussen equation tells us that advertising expenditures go up with price-cost margins. practical examples about the importance of advertising expenditures in oligopolistic industries, Scherer and Ross (1990). 0014.2921/96/$15.00 0 1996 Elsevier Science B.V. All rights reserved SSDI 0014-2921(95)00119-O
For c.f.
1112
T. uon Ungern-Sternberg/
European
Economic
Review 40 (1996) 111 I-1121
competition may lead to unnecessary duplications of fixed costs; * market intmnsparencies may lead to high price-cost margins, 3 etc. When reading a standard manual of industrial organisations theory, one does not come away with the impression that real world competition necessarily leads to first-best results. 4 - On the other hand privatisation is at the moment particularly fashionable. ’ Government is being reinvented, 6 and (if possible) eliminated. The results obtained by some of the more important privatisations are ambiguous. When the deregulators are asked why this is so, the answer often is: ‘deregulation was not sufficiently thorough’ or ‘even more competition is necessary’. These may of course be the correct explanations. They may also be mere declarations of faith. The models typically used to promote deregulation are excessively simplistic, and do not take into account many of the real world complications. A particularly good example is the deregulation of the US airline market. Even though the results were (arguably?) favourable, the economists pr:dictions about the future development of the market were woefully inadequate. The fashion at the moment is to deregulate just about everything with the possible exception of hard-core natural monopolies. I agreed to organise this session, because I believe that economists should think more carefully about this attitude. In most markets there is a certain amount of market failure, and in most government activities there is a certain amount of government failure. The extent to which privatisation and/or an introduction of competition leads to socially desirable results is thus necessarily a question of second best. Such questions typically cannot be solved by armchair (and often back-of-the-envelope) theorising. The ‘deregulators’ should take a more careful look at how the real world actually works. To drive home this point all the papers in this session analyse one very simple market. The market for housing insurance against fire and natural damages. This market is interesting for a number of reasons. _ First, it is quite definitely not a natural monopoly. For many economists (and indeed the EEC commission) it is a classical candidate for the introduction of competition.
* In the standard Salop model of monopolistic competition, for example, the equilibrium number of firms is twice as high as the social optimum. (C.f. Tirole, 1988, pp. 282-284). s C.f. Klein and Leffler (1981) or van Ungem-Stemberg and von Weizslcker (1981). ’ C.f. Tirole (1988). 5 Cf. Vickers and Yarrow (1990). ’ C.f. Osborne and Gaebler (1993). ’ C.f. Borenstein (1992) for an excellent discussion of the issues and an interesting list of references.
T. uon Ungem-Sternberg/
European Economic Review 40 (1996~1111-1121
1113
- Second, even within the same country the market is organised differently in different regions. In Switzerland, which is the topic of this paper, there are 19 cantons with regional state monopolies, and seven cantons with only private insurance companies and no government supplier. This permits some interesting cross-section comparisons. It turns out that the state monopolies are considerably more efficient than the private insurance companies. - Third, in Germany the state monopolies were abolished in 1994, * when the federal government accepted the 3rd EEC guidelines on insurance. The transition from state monopoly to competition allows some time-series analysis. The next paper will show that so far the introduction of competition has led to a substantial increase in prices (without any significant increase in quality). We thus have a market where both cross-section and time-series observations allow us to deduce that state monopoly is considerably more efficient than real world competition. Hard-core amateurs of privatisation programs may respond to this by saying, that a privately run regulated monopoly might be even more efficient than the state monopolies. Since 1 have no empirical information on this question, it lies outside the scope of this paper. The only point I wish to drive home is, that state monopoly may vastly outperform real world competition. This is a particularly worrisome observation, since the introduction of competition is usually an irreversible decision. Economic theory tells us that irreversible decisions should be taken only if there is a very high probability that the result is a net increase in social welfare. ’ The papers in this session are about one particular market. The message we wish to convey is, however, a general one. The way privatisation is currently being handled even by academic economists is frequently a matter of ideology. In order to really analyse the merits of deregulation and privatisation it is not sufficient to tell anecdotes about the inefficiencies of government bureaucracies and then vaunt the advantages of ‘perfect competition’. The true choice is quite frequently a choice between the limits of government and the limits of competition. There is no a priori reason, why the former should always be greater than the latter. Quite to the contrary, there is strong empirical evidence, that government bureaucracies can clearly outperform real world competition.
2. Housing insurance
in Switzerland
As mentioned in the introduction, the Swiss housing-insurance market has a dual system. In 19 of the 26 cantons there are local state monopolies, from which 8
The decision was taken in 1992, but competitors was two-year transition period. 9 C.f. Henry (1977) and the references therein.
could enter the market only in 1994, i.e. there
1114
T. uon Ungern-Sternberg/European
Economic Rwiew 40 (1996) 111 l-1121
State monopolies Fig.
Private insurances
1.Comparison of premium rates
the house-owners have to buy insurance against fire and natural damages. In the remaining seven cantons (essentially Geneva, the Valais, Tessin plus four small ones) there is no government supplier. lo The customer can (and often must) buy insurance from a private insurance company. Fig. 1 compares the average premium rates of the two systems. and tries to explain the differences by looking at the different components. ” One notes that the state monopolies are considerably cheaper than the priuate insurance companies, The price difSerentia1 is about 70%. A first reaction by economists confronted with these numbers is usually to suggest that the difference is probably due to the state companies being subsidised. This is not the case, if anything the opposite is true. These substantially lower prices have allowed the state monopolies to accumulate huge reserves. One can safely predict that the price differential will continue to widen. Fig. 2 gives a more disaggregated picture of the premium-rates paid in the different cantons. Given the fact that damage rates strongly depend on geographic location it is not surprising that the same is true for the premium rates. What is
7
The analysis in this section draws on two much more detailed papers by myself (van UngemStemberg. 1994; von Ungem-Stemberg, 1995), which the interested reader can obtain free of charge. Upfortunately the original texts exist only in French and German. The premium rates are measured in centimes per 1000 francs insurance oalue, abbreviated ct./ IWO Fr. The time period 1984-1993 was chosen, because the private insurance companies consider it to give a representative picture.
7: uon Ungern-Siernberg/European
Economic Review 40 (1996) 1111-1121
OS 02 HS
alz 10 XV
HZ -.
1116
T. uponUnngern-Stemberg/ European Economic Review 40 (1996) 1111-1121
striking, however, is that all the cantons with private insurance have higher rates than (practically) all the cantons with a state monopoly. Let us now return to Fig. 1, and look at the decomposition of the premium rates. One first notes that the government monopolies spend a much larger absolute (and relative) amount on fire prevention. This is probably partly due to the fact, that the state monopolies are (as a good first approximation) vertically integrated into fire fighting. This is an interesting application of the Coase theorem, which states that externalities [the reduction in damage costs] should be intemalised [into the insurance (plus fire fighting) organisation]. Second one notes that the government insurance companies have a much lower damage rate. The private insurance companies try to explain this difference by arguing that they happen to have only the cantons that are ‘bad risks’, i.e. they claim that the difference in damage rates is essentially exogenous. It is hard to accept this explanation at face value. When one compares the data at a more disaggregate level, one notes that the canton of Geneva has damage rates (both for fire and for natural damages) that are twice as high as those of the structurally very similar town of Lausanne (the two towns lie practically next to each other on the lake of Geneva and have a similar housing structure). In view of these numbers, there seem to be two possible explanations for the differences in damage rates: Either the larger expenditures for prevention by the state monopolies lead to much lower damage rates, or the private insurances are much more liable to moral hazard (i.e. the physical damage rates are quite similar, they just pay more). All of the numbers mentioned so far are undisputed, i.e. they are accepted as being correct both by the private insurance companies and by their state countercomponents from the total parts. ” When one subtracts the two above-mentioned premium rate one is left with a differential of 17.7 ct/lOOO frs for the state monopolies and 46.9 ct/lOOO frs for the private insurance companies. These are the amounts left to cover various administrative costs and yield a profit. The data on the state companies administrative costs are reasonably precise. They are single product firms. Their administrative costs are very low, 6 ct/lOOO frs so they are left with Il.7 ct/lOOO frs for their reserves. ” The use the private insurance companies make of their remaining 47.9 ct/lOOO frs is less clear. They are multi-product firms and it is not easy to allocate their administrative costs to their various branches of activity. The insurance companies themselves usually affect their costs in proportion to the premium revenue generated. The official statistics proceed in the same way. On the basis of this
” C.f. however Schips (1995) for an interesting attempt to interpret these numbers as showing. that it is in fact the private insurance companies that are more efficient. ” In Table 1 the reserves are simply the difference between the premium and all the identified cost components.
T. uon Ungern-Sternberg/
European Economic Review 40 (1996) I1 1 l-1121
1117
approximation one obtains the result that the private insurance companies spend 16.9 ct/ 1000 frs for commissions and 14.9 ct/ 1000 frs for administrative costs. i4 Even if these numbers are not quite correct, they reflect one obvious fact: The state monopolies do not have to run after their customers, and thus pay no commissions to representatives. In most branches of the insurance business the costs of acquisition, i.e. the amounts paid out to representatives make up between 15% and 20% of the annual premium payment. In the year the contract is signed it is substantially more. The data available for Germany corroborate these magnitudes. I5 The state monopoly leads to a substantial cost-saving and this allows an important reduction in the premium rate. Similarly a large part of the administrative costs of an insurance is swallowed up, by managing an important sales staff and keeping track of customer fluctuations. It is thus totally unsurprising that the state monopolies also have substantially lower administrative costs. Taking these numbers together one finds that the costs of administration and representation of the state monopolies are lower by 25 ct/lOOO frs. The total insurance capital in the 19 cantons with state monopolies is 1,300 billion Frs. The state monopolies thus save their customers 325 mio. Frs each year, just in costs of administration and representation. This is a substantial cost saving. To the best of my knowledge the cost structure in the liability damage car insurance is quite similar. As a first approximation one can probably say that every year more than 20% of the premium payments are used up for the costs of acquisition and administration. It seems obvious that the consumers could obtain substantial savings if this highly standardised product were offered by state monopolies. Maybe the economists so preoccupied with the eficiency gains of privatisation should attempt to seriously examine the question, whether this part of the insurance business should not be nationalised?
3. A more detailed analysis A comparison between state monopoly and private insurance cannot, of course, limit itself to simply comparing average premium rates. Other dimensions of the problem may be just as important. 3.1. Premium structure It is well known that state monopolies tend to misuse the price mechanism to achieve redistributional aims. Prices do not reflect costs and this leads to ineffiI?
It is interesting to note that the insurance companies have not so far claimed that these cost estimates are too high. This is probably due to the fact that they are on the low side. In particular there are reasons to believe that the commissions are even higher. I5 Cf. Felder (1996).
1118
T. uon Ungem-Stemberg/
European Economic Review 40 (1996) 1111-1121
Table 1 Premium rates
Premium rate Damage rate Premium-damages Premium/damages
Small customers
Industry customers
1.OZ%O 0.44%0 0.58%0 232%
1.44%0 1.14%0 0.30%0 126%
cient resource allocations. The state insurance monopolies are no exception in this respect: Their premium rates do not reflect risk differentials adequately. In the extreme case (e.g. Zbrich) all customers pay identically the same rate. While it is difficult to generalise across 19 cantons each of which has its own policy, as a first approximation one can probably say that at least agriculture gets subsidised in all cantons. The first reaction to this observation might be to say that privatisation would surely improve this state of affairs. I see no reason for such a claim. It is well known that in situations of real world competition prices reflect elasticities of demand just as much as costs. The officially available data give a striking illustration of this. Table 1 gives the premium rates the private insurance companies charge small customers and business customers. One notes that the margins the private insurances charge the small low risk customers (essentially the owners of houses and apartments) are very much higher than the margins charged to industry customers. In view of these observations, it is a moot point which of the two market forms charges prices that are closer to marginal cost. Competition tends to favour customers with bargaining power, state monopolies favour low income groups. I see no reason why the first alternative should preferable to the second.
3.2. Innovation
It is often claimed that private industry is more innovative than state monopoly. This is probably correct. One of the interesting points about the housing insurance market is that innovations have played a very secondary role in the last century, i.e. it is essentially a static market. In Switzerland the main innovations have been: . the stepwise introduction of natural damage insurance (in the 20s and 30s) . inflation indexation (in the 20s) . insurance at the new construction value (in the 50s and 60s) . the creation of an earthquake pools (in the 70s). In all but one of these examples the innovators were the state monopolies, and they were then copied by the private insurance companies. The exception is the insurance at the new construction value.
T. uon Ungem-Stemberg/
European Economic Review 40 (1996) 1111-1121
1119
The lesson this observation suggests is that it might be useful to have certain geographic areas in which there are state monopolies, while in others one lets the private insurance companies operate. In this way each institution can learn from the other, and copy any improvements which might appear. This suggestion is radically different from what currently seems to be the accepted approach (at least in the EEC): Organise the markets in all the countries in the same way, i.e. standardise the economies to a large extent. My way of looking at the problem is much closer to that of competition between institutions (or yardstick competition) 16. For society to be able to compare the eficiency of different institutions, they must both be allowed to exist. 3.3. Freedom of choice One of the solutions frequently suggested, when talking about the huge premium differentials, is that the private insurances should be allowed to compete with the state monopolies. Rather than having the rather indirect ‘competition between institutions’ approach, both forms of suppliers should be able to compete on the same market. This should give the consumers a maximum of choice and thus maximise consumer satisfaction. The problem with this ‘revealed preference’ type of argument is that such an argument works only in situations of complete information. One of the essential characteristics of an insurance contract is that it is anything but transparent. Insurance contracts are frequently cited as a classic example of a ‘credence good’. ” One can often judge the quality of an insurance contract, only when the damage has occurred. As a result, a convincing sales representative is a much better sales argument than a 20% lower price. This is particularly true in the case of housing insurance, where one buys insurance against low-probability-high-cost events. The danger of not getting one’s money in case of an accident looms large, and consumers presumably have a tendency to judge quality by price. In Switzerland there is one private insurance company (Secura), whose pricing policy on this market is and has always been: ‘market minus 10%‘. It cannot, of course, afford expensive representatives. Its market share is less than 2%. The next paper goes into some detail why the a priori interesting solution of having a low cost state monopoly compete with more expensive private insurance companies has not worked in practice. In my view, the advantages of having no direct competition is really one of the most interesting aspects of the market. It is well known to industrial organisation economists that in very many consumer markets producers spend huge amounts in advertising (of various types) to differentiate essentially similar products or to
I6 C.f. Shleifer (1985). ” Cf. Finsinger (1983).
1120
T. eon (Ingem-Sternberg/
European Economic Rerjiew 40 (1996) 1111-1121
establish their brand. There is very little empirical or theoretical evidence these unavoidable side effects of competition are always of much social use. creation of a monopoly permits the producer to avoid these huge selling costs. best way to improve performance in this market is not to increase competition, to eliminate it completely.
that The The but
4. Conclusion The purpose of this paper was to try to motivate economists to think more carefully about the relative advantages of public monopoly versus competition between private companies. Public opinion at the moment seems to be that an economist is somebody who favours competition. I had always thought that economics was in large part concerned with the quest for economic efficiency. The two are not necessarily identical. The example used to drive home this point was the market for housing insurance against fire and natural damages. In spite of a gross premium d&@-ential of 70% in j&our of the state monopolies, there is at the moment an active debate in Switzerland about the introduction of competition. For those who do not think this evidence sufficiently conclusive, the next two papers analyse the huge increase in costs the introduction of competition has so far caused in several states in Germany. It has always been clear that the results of competition are not particularly equitable. There are apparently also situations, where real world competition leads to outcomes that are not even particularly efficient. If economists are willing to think objectively about the comparative advantages of public enterprise, they cannot avoid analysing in greater detail the limits of competition.
Acknowledgements I would like to thank Martin Kamber for his invaluable help in obtaining and understanding the empirical data, as well as thoughtful discussion of the issues involved.
References Borenstein, S.. 1992, The evolution of U.S. airline competition, Journal of Economic Perspectives 6, 45-73. Felder, S., 1996, Fire insurance in Germany: A comparison of price-performance between state monopolies and competitive regions, European Economic Review 40. Finsinger, .I., 1983, VersicherungsmZrkte (Campus Verlag, Frankfurt/Main). Henry. C., 1977, Option values in the economics of irreplacable assets, Review of Economic Studies, 89- 104.
T. ~lonUngem-Stemberg/European
Economic Retliew 40 (1996) 1111-1121
1121
Klein, B. and K. Leffler, 1981, Non-governmental enforcement of contracts: The role of market forces in assuring quality, Journal of Political Economy 88, 615-641. Osborne. D. and T. Gaebler, 1993, Reinventing government (Plume, London). Scherer, F.M. and D., Ross, 1990, Industrial market structure and economic performance, 3rd ed. (Houghton Mifflin, Boston, MA). Schips. B., 1995. Gkonomische Argumente fur den wirksamen Wettbewerb such im Versicherungszweig ‘Gebhdefeuer und Gebaudeelementarsch’riden’. Unpublished manuscript (ETH. Zurich). Shleifer, A., 1985. A theory of yardstick competition. Rand Journal of Economics 16. 319-327. Tirole, J., 1988, The theory of industrial organisation (MIT Press, Cambridge, MA). Vickers, J. and G. Yarrow, 1990, Privatisation: An economic analysis (MIT Press, Cambridge, MA). von Ungem-Stemberg, T., 1994, Die kantonalen Gebaudeversicherungen: Eine ijkonomische Analyse. Research paper 9405 (DEEP, University of Lausanne, Lausanne). von Ungem-Stemberg, T., 1995, Kritische Uberlegungen zu dem Gutachten von Professor Schips bber die kantonalen Gebaudeversicherungsmonopole. Research paper 9502 (DEEP, University of Lausanne, Lamanne). von Ungem-Stemberg, T. and C.C. von Weizslcker. 1981. Marktstruktur und Marktverhalten bei Qualitltsunsicherheit. Zeitschrift fur Wirtschafts- und Sozialwissenschaften 101, 609-626.
EuropeanEconomicReview
40(1996)
1111-1121
The limits of competition
The limits of competition: Housing insurance in Switzerland Thomas von Ungern-Sternberg University of Lausanne, Batiment du Rectorat et de I’Administration
Centrale busanne,
Switzerland
Abstract
In Switzerland there are seven cantons where the housing insurance market is competitive, while in the 19 others there are local state monopolies. This paper compares the price/performance relationship of these different market forms. It is shown that for a very similar product the state monopolies charge 70% lower prices, that they spend substantially more on fire prevention, and that they have much lower damage rates. One of the main reasons for the higher prices of the private insurance companies is the fact that they spend considerably more on sales and administrative costs. The housing insurance market is thus a classic example of a situation where state monopoly outperforms private sector competition. JEL classification: Keywords:
Ll; L32; L33; L52; L89
Housing
insurance;
Competition;
Public enterprise
1. Introduction Economic directions:
theory and policy are currently
developing
in somewhat
incoherent
- On the one hand there have been important new developments in theoretical industrial organisation. We now have models that give us a much better understanding of why real world competition might not lead to socially desirable results: Oligopolistic firms may spend excessive amounts on advertising; ’ monopolistic
’ The Rasmussen equation tells us that advertising expenditures go up with price-cost margins. practical examples about the importance of advertising expenditures in oligopolistic industries, Scherer and Ross (1990). 0014.2921/96/$15.00 0 1996 Elsevier Science B.V. All rights reserved SSDI 0014-2921(95)00119-O
For c.f.
1112
T. uon Ungern-Sternberg/
European
Economic
Review 40 (1996) 111 I-1121
competition may lead to unnecessary duplications of fixed costs; * market intmnsparencies may lead to high price-cost margins, 3 etc. When reading a standard manual of industrial organisations theory, one does not come away with the impression that real world competition necessarily leads to first-best results. 4 - On the other hand privatisation is at the moment particularly fashionable. ’ Government is being reinvented, 6 and (if possible) eliminated. The results obtained by some of the more important privatisations are ambiguous. When the deregulators are asked why this is so, the answer often is: ‘deregulation was not sufficiently thorough’ or ‘even more competition is necessary’. These may of course be the correct explanations. They may also be mere declarations of faith. The models typically used to promote deregulation are excessively simplistic, and do not take into account many of the real world complications. A particularly good example is the deregulation of the US airline market. Even though the results were (arguably?) favourable, the economists pr:dictions about the future development of the market were woefully inadequate. The fashion at the moment is to deregulate just about everything with the possible exception of hard-core natural monopolies. I agreed to organise this session, because I believe that economists should think more carefully about this attitude. In most markets there is a certain amount of market failure, and in most government activities there is a certain amount of government failure. The extent to which privatisation and/or an introduction of competition leads to socially desirable results is thus necessarily a question of second best. Such questions typically cannot be solved by armchair (and often back-of-the-envelope) theorising. The ‘deregulators’ should take a more careful look at how the real world actually works. To drive home this point all the papers in this session analyse one very simple market. The market for housing insurance against fire and natural damages. This market is interesting for a number of reasons. _ First, it is quite definitely not a natural monopoly. For many economists (and indeed the EEC commission) it is a classical candidate for the introduction of competition.
* In the standard Salop model of monopolistic competition, for example, the equilibrium number of firms is twice as high as the social optimum. (C.f. Tirole, 1988, pp. 282-284). s C.f. Klein and Leffler (1981) or van Ungem-Stemberg and von Weizslcker (1981). ’ C.f. Tirole (1988). 5 Cf. Vickers and Yarrow (1990). ’ C.f. Osborne and Gaebler (1993). ’ C.f. Borenstein (1992) for an excellent discussion of the issues and an interesting list of references.
T. uon Ungem-Sternberg/
European Economic Review 40 (1996~1111-1121
1113
- Second, even within the same country the market is organised differently in different regions. In Switzerland, which is the topic of this paper, there are 19 cantons with regional state monopolies, and seven cantons with only private insurance companies and no government supplier. This permits some interesting cross-section comparisons. It turns out that the state monopolies are considerably more efficient than the private insurance companies. - Third, in Germany the state monopolies were abolished in 1994, * when the federal government accepted the 3rd EEC guidelines on insurance. The transition from state monopoly to competition allows some time-series analysis. The next paper will show that so far the introduction of competition has led to a substantial increase in prices (without any significant increase in quality). We thus have a market where both cross-section and time-series observations allow us to deduce that state monopoly is considerably more efficient than real world competition. Hard-core amateurs of privatisation programs may respond to this by saying, that a privately run regulated monopoly might be even more efficient than the state monopolies. Since 1 have no empirical information on this question, it lies outside the scope of this paper. The only point I wish to drive home is, that state monopoly may vastly outperform real world competition. This is a particularly worrisome observation, since the introduction of competition is usually an irreversible decision. Economic theory tells us that irreversible decisions should be taken only if there is a very high probability that the result is a net increase in social welfare. ’ The papers in this session are about one particular market. The message we wish to convey is, however, a general one. The way privatisation is currently being handled even by academic economists is frequently a matter of ideology. In order to really analyse the merits of deregulation and privatisation it is not sufficient to tell anecdotes about the inefficiencies of government bureaucracies and then vaunt the advantages of ‘perfect competition’. The true choice is quite frequently a choice between the limits of government and the limits of competition. There is no a priori reason, why the former should always be greater than the latter. Quite to the contrary, there is strong empirical evidence, that government bureaucracies can clearly outperform real world competition.
2. Housing insurance
in Switzerland
As mentioned in the introduction, the Swiss housing-insurance market has a dual system. In 19 of the 26 cantons there are local state monopolies, from which 8
The decision was taken in 1992, but competitors was two-year transition period. 9 C.f. Henry (1977) and the references therein.
could enter the market only in 1994, i.e. there
1114
T. uon Ungern-Sternberg/European
Economic Rwiew 40 (1996) 111 l-1121
State monopolies Fig.
Private insurances
1.Comparison of premium rates
the house-owners have to buy insurance against fire and natural damages. In the remaining seven cantons (essentially Geneva, the Valais, Tessin plus four small ones) there is no government supplier. lo The customer can (and often must) buy insurance from a private insurance company. Fig. 1 compares the average premium rates of the two systems. and tries to explain the differences by looking at the different components. ” One notes that the state monopolies are considerably cheaper than the priuate insurance companies, The price difSerentia1 is about 70%. A first reaction by economists confronted with these numbers is usually to suggest that the difference is probably due to the state companies being subsidised. This is not the case, if anything the opposite is true. These substantially lower prices have allowed the state monopolies to accumulate huge reserves. One can safely predict that the price differential will continue to widen. Fig. 2 gives a more disaggregated picture of the premium-rates paid in the different cantons. Given the fact that damage rates strongly depend on geographic location it is not surprising that the same is true for the premium rates. What is
7
The analysis in this section draws on two much more detailed papers by myself (van UngemStemberg. 1994; von Ungem-Stemberg, 1995), which the interested reader can obtain free of charge. Upfortunately the original texts exist only in French and German. The premium rates are measured in centimes per 1000 francs insurance oalue, abbreviated ct./ IWO Fr. The time period 1984-1993 was chosen, because the private insurance companies consider it to give a representative picture.
7: uon Ungern-Siernberg/European
Economic Review 40 (1996) 1111-1121
OS 02 HS
alz 10 XV
HZ -.
1116
T. uponUnngern-Stemberg/ European Economic Review 40 (1996) 1111-1121
striking, however, is that all the cantons with private insurance have higher rates than (practically) all the cantons with a state monopoly. Let us now return to Fig. 1, and look at the decomposition of the premium rates. One first notes that the government monopolies spend a much larger absolute (and relative) amount on fire prevention. This is probably partly due to the fact, that the state monopolies are (as a good first approximation) vertically integrated into fire fighting. This is an interesting application of the Coase theorem, which states that externalities [the reduction in damage costs] should be intemalised [into the insurance (plus fire fighting) organisation]. Second one notes that the government insurance companies have a much lower damage rate. The private insurance companies try to explain this difference by arguing that they happen to have only the cantons that are ‘bad risks’, i.e. they claim that the difference in damage rates is essentially exogenous. It is hard to accept this explanation at face value. When one compares the data at a more disaggregate level, one notes that the canton of Geneva has damage rates (both for fire and for natural damages) that are twice as high as those of the structurally very similar town of Lausanne (the two towns lie practically next to each other on the lake of Geneva and have a similar housing structure). In view of these numbers, there seem to be two possible explanations for the differences in damage rates: Either the larger expenditures for prevention by the state monopolies lead to much lower damage rates, or the private insurances are much more liable to moral hazard (i.e. the physical damage rates are quite similar, they just pay more). All of the numbers mentioned so far are undisputed, i.e. they are accepted as being correct both by the private insurance companies and by their state countercomponents from the total parts. ” When one subtracts the two above-mentioned premium rate one is left with a differential of 17.7 ct/lOOO frs for the state monopolies and 46.9 ct/lOOO frs for the private insurance companies. These are the amounts left to cover various administrative costs and yield a profit. The data on the state companies administrative costs are reasonably precise. They are single product firms. Their administrative costs are very low, 6 ct/lOOO frs so they are left with Il.7 ct/lOOO frs for their reserves. ” The use the private insurance companies make of their remaining 47.9 ct/lOOO frs is less clear. They are multi-product firms and it is not easy to allocate their administrative costs to their various branches of activity. The insurance companies themselves usually affect their costs in proportion to the premium revenue generated. The official statistics proceed in the same way. On the basis of this
” C.f. however Schips (1995) for an interesting attempt to interpret these numbers as showing. that it is in fact the private insurance companies that are more efficient. ” In Table 1 the reserves are simply the difference between the premium and all the identified cost components.
T. uon Ungern-Sternberg/
European Economic Review 40 (1996) I1 1 l-1121
1117
approximation one obtains the result that the private insurance companies spend 16.9 ct/ 1000 frs for commissions and 14.9 ct/ 1000 frs for administrative costs. i4 Even if these numbers are not quite correct, they reflect one obvious fact: The state monopolies do not have to run after their customers, and thus pay no commissions to representatives. In most branches of the insurance business the costs of acquisition, i.e. the amounts paid out to representatives make up between 15% and 20% of the annual premium payment. In the year the contract is signed it is substantially more. The data available for Germany corroborate these magnitudes. I5 The state monopoly leads to a substantial cost-saving and this allows an important reduction in the premium rate. Similarly a large part of the administrative costs of an insurance is swallowed up, by managing an important sales staff and keeping track of customer fluctuations. It is thus totally unsurprising that the state monopolies also have substantially lower administrative costs. Taking these numbers together one finds that the costs of administration and representation of the state monopolies are lower by 25 ct/lOOO frs. The total insurance capital in the 19 cantons with state monopolies is 1,300 billion Frs. The state monopolies thus save their customers 325 mio. Frs each year, just in costs of administration and representation. This is a substantial cost saving. To the best of my knowledge the cost structure in the liability damage car insurance is quite similar. As a first approximation one can probably say that every year more than 20% of the premium payments are used up for the costs of acquisition and administration. It seems obvious that the consumers could obtain substantial savings if this highly standardised product were offered by state monopolies. Maybe the economists so preoccupied with the eficiency gains of privatisation should attempt to seriously examine the question, whether this part of the insurance business should not be nationalised?
3. A more detailed analysis A comparison between state monopoly and private insurance cannot, of course, limit itself to simply comparing average premium rates. Other dimensions of the problem may be just as important. 3.1. Premium structure It is well known that state monopolies tend to misuse the price mechanism to achieve redistributional aims. Prices do not reflect costs and this leads to ineffiI?
It is interesting to note that the insurance companies have not so far claimed that these cost estimates are too high. This is probably due to the fact that they are on the low side. In particular there are reasons to believe that the commissions are even higher. I5 Cf. Felder (1996).
1118
T. uon Ungem-Stemberg/
European Economic Review 40 (1996) 1111-1121
Table 1 Premium rates
Premium rate Damage rate Premium-damages Premium/damages
Small customers
Industry customers
1.OZ%O 0.44%0 0.58%0 232%
1.44%0 1.14%0 0.30%0 126%
cient resource allocations. The state insurance monopolies are no exception in this respect: Their premium rates do not reflect risk differentials adequately. In the extreme case (e.g. Zbrich) all customers pay identically the same rate. While it is difficult to generalise across 19 cantons each of which has its own policy, as a first approximation one can probably say that at least agriculture gets subsidised in all cantons. The first reaction to this observation might be to say that privatisation would surely improve this state of affairs. I see no reason for such a claim. It is well known that in situations of real world competition prices reflect elasticities of demand just as much as costs. The officially available data give a striking illustration of this. Table 1 gives the premium rates the private insurance companies charge small customers and business customers. One notes that the margins the private insurances charge the small low risk customers (essentially the owners of houses and apartments) are very much higher than the margins charged to industry customers. In view of these observations, it is a moot point which of the two market forms charges prices that are closer to marginal cost. Competition tends to favour customers with bargaining power, state monopolies favour low income groups. I see no reason why the first alternative should preferable to the second.
3.2. Innovation
It is often claimed that private industry is more innovative than state monopoly. This is probably correct. One of the interesting points about the housing insurance market is that innovations have played a very secondary role in the last century, i.e. it is essentially a static market. In Switzerland the main innovations have been: . the stepwise introduction of natural damage insurance (in the 20s and 30s) . inflation indexation (in the 20s) . insurance at the new construction value (in the 50s and 60s) . the creation of an earthquake pools (in the 70s). In all but one of these examples the innovators were the state monopolies, and they were then copied by the private insurance companies. The exception is the insurance at the new construction value.
T. uon Ungem-Stemberg/
European Economic Review 40 (1996) 1111-1121
1119
The lesson this observation suggests is that it might be useful to have certain geographic areas in which there are state monopolies, while in others one lets the private insurance companies operate. In this way each institution can learn from the other, and copy any improvements which might appear. This suggestion is radically different from what currently seems to be the accepted approach (at least in the EEC): Organise the markets in all the countries in the same way, i.e. standardise the economies to a large extent. My way of looking at the problem is much closer to that of competition between institutions (or yardstick competition) 16. For society to be able to compare the eficiency of different institutions, they must both be allowed to exist. 3.3. Freedom of choice One of the solutions frequently suggested, when talking about the huge premium differentials, is that the private insurances should be allowed to compete with the state monopolies. Rather than having the rather indirect ‘competition between institutions’ approach, both forms of suppliers should be able to compete on the same market. This should give the consumers a maximum of choice and thus maximise consumer satisfaction. The problem with this ‘revealed preference’ type of argument is that such an argument works only in situations of complete information. One of the essential characteristics of an insurance contract is that it is anything but transparent. Insurance contracts are frequently cited as a classic example of a ‘credence good’. ” One can often judge the quality of an insurance contract, only when the damage has occurred. As a result, a convincing sales representative is a much better sales argument than a 20% lower price. This is particularly true in the case of housing insurance, where one buys insurance against low-probability-high-cost events. The danger of not getting one’s money in case of an accident looms large, and consumers presumably have a tendency to judge quality by price. In Switzerland there is one private insurance company (Secura), whose pricing policy on this market is and has always been: ‘market minus 10%‘. It cannot, of course, afford expensive representatives. Its market share is less than 2%. The next paper goes into some detail why the a priori interesting solution of having a low cost state monopoly compete with more expensive private insurance companies has not worked in practice. In my view, the advantages of having no direct competition is really one of the most interesting aspects of the market. It is well known to industrial organisation economists that in very many consumer markets producers spend huge amounts in advertising (of various types) to differentiate essentially similar products or to
I6 C.f. Shleifer (1985). ” Cf. Finsinger (1983).
1120
T. eon (Ingem-Sternberg/
European Economic Rerjiew 40 (1996) 1111-1121
establish their brand. There is very little empirical or theoretical evidence these unavoidable side effects of competition are always of much social use. creation of a monopoly permits the producer to avoid these huge selling costs. best way to improve performance in this market is not to increase competition, to eliminate it completely.
that The The but
4. Conclusion The purpose of this paper was to try to motivate economists to think more carefully about the relative advantages of public monopoly versus competition between private companies. Public opinion at the moment seems to be that an economist is somebody who favours competition. I had always thought that economics was in large part concerned with the quest for economic efficiency. The two are not necessarily identical. The example used to drive home this point was the market for housing insurance against fire and natural damages. In spite of a gross premium d&@-ential of 70% in j&our of the state monopolies, there is at the moment an active debate in Switzerland about the introduction of competition. For those who do not think this evidence sufficiently conclusive, the next two papers analyse the huge increase in costs the introduction of competition has so far caused in several states in Germany. It has always been clear that the results of competition are not particularly equitable. There are apparently also situations, where real world competition leads to outcomes that are not even particularly efficient. If economists are willing to think objectively about the comparative advantages of public enterprise, they cannot avoid analysing in greater detail the limits of competition.
Acknowledgements I would like to thank Martin Kamber for his invaluable help in obtaining and understanding the empirical data, as well as thoughtful discussion of the issues involved.
References Borenstein, S.. 1992, The evolution of U.S. airline competition, Journal of Economic Perspectives 6, 45-73. Felder, S., 1996, Fire insurance in Germany: A comparison of price-performance between state monopolies and competitive regions, European Economic Review 40. Finsinger, .I., 1983, VersicherungsmZrkte (Campus Verlag, Frankfurt/Main). Henry. C., 1977, Option values in the economics of irreplacable assets, Review of Economic Studies, 89- 104.
T. ~lonUngem-Stemberg/European
Economic Retliew 40 (1996) 1111-1121
1121
Klein, B. and K. Leffler, 1981, Non-governmental enforcement of contracts: The role of market forces in assuring quality, Journal of Political Economy 88, 615-641. Osborne. D. and T. Gaebler, 1993, Reinventing government (Plume, London). Scherer, F.M. and D., Ross, 1990, Industrial market structure and economic performance, 3rd ed. (Houghton Mifflin, Boston, MA). Schips. B., 1995. Gkonomische Argumente fur den wirksamen Wettbewerb such im Versicherungszweig ‘Gebhdefeuer und Gebaudeelementarsch’riden’. Unpublished manuscript (ETH. Zurich). Shleifer, A., 1985. A theory of yardstick competition. Rand Journal of Economics 16. 319-327. Tirole, J., 1988, The theory of industrial organisation (MIT Press, Cambridge, MA). Vickers, J. and G. Yarrow, 1990, Privatisation: An economic analysis (MIT Press, Cambridge, MA). von Ungem-Stemberg, T., 1994, Die kantonalen Gebaudeversicherungen: Eine ijkonomische Analyse. Research paper 9405 (DEEP, University of Lausanne, Lausanne). von Ungem-Stemberg, T., 1995, Kritische Uberlegungen zu dem Gutachten von Professor Schips bber die kantonalen Gebaudeversicherungsmonopole. Research paper 9502 (DEEP, University of Lausanne, Lamanne). von Ungem-Stemberg, T. and C.C. von Weizslcker. 1981. Marktstruktur und Marktverhalten bei Qualitltsunsicherheit. Zeitschrift fur Wirtschafts- und Sozialwissenschaften 101, 609-626.