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International dynamics in the service industries - the example of the Belgian insurance market.

Introduction

Service industries like the insurance business, cannot escape from the challenges posed by the ongoing opening up of European and international markets and its accompanying restructuring processes. Dynamic movements as reflected in entry and especially exit, are important phenomena in the Belgian insurance market and within these entry and exit movements, affiliates of multinational firms play an important role.

This paper examines whether MNE affiliates, enjoying advantages from operating on a large international scope, and evaluating the profit contributions from alternative location sites, enter and exit more or less easily than local companies. However, before turning to the examination of the different dynamical patterns in the insurance industry, the attractiveness of the Belgian market as location site is detailed first.

Some Basic Structural Characteristics of the Insurance Market

The section first evaluates elements from the structure, conduct and performance of the Belgian insurance market, after which the international orientation of the Belgian market is analyzed.

The Belgian Insurance market

Definition of the market

A great number of firms are licensed to operate in the Belgian insurance market(2). Compared to other European countries, Belgium, together with the Netherlands and Sweden, is one of the highest insurance intensive countries in terms of number of companies relative to its population. However, in terms of premium income per inhabitant, Belgium scores relatively low, especially in life insurance, indicating that there are still growth areas left untapped.

Most of the insurance companies operating in Belgium offer a broad spectrum of the majority of conventional risks, in view of the economies of scope on the cost and demand side that can be realized out of brand proliferation when offering more than one risk insurance. In terms of premium income, life and automobiles are the most important categories in Belgium(3).

The performance of insurance companies

The income of the Belgian insurance companies can be divided in technical income (premium income) and financial income, with the former accounting for 61% and the latter for 22.6% of total income (with another 5.5% from surplus value on assets). For a number of insurance activities, such as motor vehicles, fire and other damages the technical results are negative. In these activities a tougher competition prevails, driving down premium income. But due to cross-subsidization of good and bad risks, and to financial surplusses, the insurance in total is a profitable business. Especially life insurance seems to be the most (technically) profitable sector, although profit sharing implies that technical results are not net to the company. However, in comparison to other European countries, profitability of Belgian insurance companies is among the lowest.

TABULAR DATA OMITTED

In order to explain this performance pattern, we have to turn to an analysis of the structure as well as conduct of the Belgian market.

Conduct in the insurance market

Price setting behavior is heavily regulated by the government, where the insurance companies agree on the maximum and minimum policy price, which is confirmed and checked by the CDV, easing the sustainability of prices above competitive levels. Contrary to the U.S. and the U.K., most European countries including Belgium, further preclude an extensive price differentiation according to the type of risk. This higher European level of regulated standardisation does however not imply that it will be easier for consumers to compare prices across companies. Again the U.S. and the U.K., despite their high level of differentiation, are the most competitive markets where price shopping by consumers is an established practice.

Besides price, non-price elements such as service characteristics related to e.g. individual insurance counselling, as well as quality related to confidence and financial security, are important as competitive weapons. The fact that the expensive agency network is still the most common practice in Belgium might be an indication of the importance of these non-price elements. One could generally conclude that service and price competition exists but is rather imperfect.

Concentration in the Belgian insurance market

The importance of the price-setting characteristics of the Belgian market becomes clear when confronted with the tight oligopolistic structure of the Belgian insurance sector, with a small number of large insurance companies, next to a majority of small companies. Focusing on the life insurance market only, the results would show an even larger level of concentration.

The presence of small companies operating next to large enterprises may indicate that the large companies succeed in keeping prices above the competitive level, thus "protecting" inefficient producers or, that there are no real cost advantages of large scale operations, suggesting low entry barriers.

Barriers to entry

Being essentially an information-service industry, where the main part of its value-added activities consists of acquisition and management of information, insurance is a labour-intensive activity, demanding as basic operational requirements a well educated labour force. The majority of the capital requirements for relatively liquid funds to insure against uncertain states of repayment. Given the importance of a reputation of financial soundness, "confidence" is indeed a crucial asset to perform well in the insurance market. Also the minima required by regulation raise capital requirements(4).

Although economies of scale and scope in the insurance sector confer the advantages of spreading risks and reducing transaction costs, previous studies have found no support for important scale advantage (for the U.S., Joskow 1973, for the U.K., Carter and Dickinson l979, for Germany, Finsinger 1989). These studies show that the economies of operating on a large scale are quickly exhausted and are already for medium sized firms no longer important.

Although scale effects need not impede entry, there can be other important barriers to entry related to the distribution of insurance services. Setting up an own network of insurance agents, who will market the company's policy exclusively, is expensive. But new companies can plug into existing networks of independent agents or brokers, without too many costs. Entry strategies through independent agents imply commission fees, but might ease the company's recognition problem. The alternative of entry through direct insurance avoids commission fees, but in this case product recognition is more difficult, demanding large advertising sums. And if customers have a strong preference for a closer individual insurance counselling, direct insurance companies may have a further disadvantage. Table 2 details the various distribution channels per country and per category, with reference to the corresponding cost structure.

Table 2 reveals the large variance in total cost levels between countries and categories. Commission fees and total costs are strongly correlated: entries with low shares of commission fees have in general a low total cost structure and vica versa. The economies on commission fees which direct writers enjoy, seem not to be fully absorbed by higher marketing expenses, a finding confirmed by previous studies (Joskow l973). Belgium, for instance, where the direct-writing system is least established, is also the country with the highest cost structure.

TABULAR DATA OMITTED

In summary, there might be barriers to entry especially for small companies, related to capital requirements and building up of expertise and confidence, but these investments may not be over estimated. Furthermore, potential competition may be coming from diversifying companies, such as banks, which are less restrained by the above mentioned barriers.

Foreign Presence in the Belgian Market

Based on the previous section, one can state that Belgium, as a host country to foreign companies, offers only a very small market, but it is relatively less insurance intensive, such that especially in life insurance, a large growth potential is still left untapped. Belgium's favourable location, with (international) customers as well as competition clustered, offers agglomerative economies while internalizing possible spillovers. Being close to customers is important, as indicated supra, but also being close to competitors could be important to maintain competitive positions.

Exports versus foreign affiliates: the regulatory framework(5)

The (relative) importance of foreign establishments (FDI) vis-a-vis exports, as modes of serving foreign insurance markets, is heavily influenced by government intervention. Trade in insurance markets (i.e. the direct insurance of risks abroad) is marginal, with the exception of the re-insurance market and large, unusual risks. This low trade-intensity can be related to the service character of the good, but also importantly to the restrictive legislation of the majority of countries. In Belgium for instance, insurance activities may only be performed by companies established in Belgium, except for large risks like reinsurance, transport, industrial, commercial and special risks.

Regarding establishments of foreign affiliates, the obstacles that exist are in most cases less drastic, but the impact of these obstacles is more important, since foreign establishments are the dominating mode of serving the strongly segmented foreign insurance markets. The obstacles for FDI that exist relate mainly to limitations of licensing(6) or differential operational terms under which foreign companies are required to function. Belgium reports no differential operational terms, except on the level of financial requirements for non-EC foreign insurers(7).

Efforts to liberalize international insurance markets have been underway for some years through institutions such as the GATT, OECD Insurance Committee and the EC, where the latter is particularly inclined at harmonizing the national insurance controls. The horizon 1992 implies for the liberalisation in the insurance market a new elan. But even within the EC, full integration still has a long way to go.

Multinational presence in the Belgian insurance market

Whereas the direct foreign establishments of Belgian insurance companies are very limited, the importance of subsidiaries of foreign based multinational insurance companies in Belgium cannot be ignored and is growing, but is in 1985 (the last year available) relatively small according to Belgian standards(8). As MNEs are counted not only companies with registered office outside Belgium, as the CDV uses as criterion, but also whose assets are for more than 10% in the hands of foreign companies, the official criterion used by the OECD.
Table 3. Multinational presence the Belgian insurance market,
1985
 Insurance Total economy
Share of MNEs in turnover 29.2% 39.8%
Share of MNEs in establishments 54.7% 17.3%
Average size of MNEs (in mio Bfr.) 480.0 2,687.0
Average size of local companies 1,433.8 850.7
Source: Vanden Houte and Veugelers, CDV, own calculations.


The economies of scope that MNEs in the insurance market enjoy originates from common inputs present with in the parent company, which can be deployed elsewhere at no or little incremental costs, such as reputation, the general marketing or managerial expertise, specialized technical expertise, economies of portfolio risk-spreading, access to transnational clients etc. ... All these elements are most likely to be capitalized through internalisation (FDI) rather than through market transactions (licenses). The significance of these scope advantages are reported by Daly et al. (1985), who found that the larger was the proportion of foreign business of Canadian life insurance companies, the higher the cost advantages which these firms could realize.

Foreign companies, to the extent that they opt more frequently for direct insurance (cf. Duron 1989), might further enjoy a higher cost efficiency in that commission fees are avoided. In view of the multinational's established brand name, marketing expenses accompanying this direct writing system, will not be prohibitively high for affiliate direct writers.

Despite their advantages of operating on a larger scope, subsidiaries of insurance multinationals are on the average smaller than local companies, which is contrary to the situation for the Belgian economy as a whole, as well as for the Belgian service sector. This smaller MNE size can be related to the home advantage of the domestic firms with their broader net of local branches vis-a-vis MNEs, but also to governmental obstacles affecting the (operational) terms under which foreign companies are required to function.

In line with the small character of MNE establishments, multinational involvement is much more important in terms of number of firms. Compared to other European countries, Belgium has the most multinationalized insurance market, at least in terms of number of foreign establishments, as figure 3 shows (Source: Sigma).

As figure 4 details, the origin of the insurance subsidiaries is highly concentrated in the EC (79.5%) in contrast with the total Belgian economy where the USA is the main home country (3l% of MNEs are U.S. based). The USA, although it is the largest insurance market (43% of total world market) and the most dense market (8.8% of GDP comes from premium income), is nevertheless little internationally oriented and in addition is the least profitable in terms of underwriting results (Source: Sigma). Within the EC, the striking dominance of UK insurance companies, as with Swiss firms among non-EC companies, can be related to the country's strong insurance and international orientation. Germany, which is the largest insurance market in Europe, and has good underwriting results, is relatively less internationally oriented.

Figure 5 shows that a marked difference in DOM and MNE specialization pattern, reflecting the fact that MNEs have a comparative advantage especially in transborder risks (airways, marine, railways and transported goods), where this is less pronounced in personal insurance (cf. also Carter and Dickinson (1979) for evidence on U.K. MNEs).

Differences in Dynamical Patterns Between MNE and DOM

Having detailed the typical features of the Belgian insurance market, this section focuses on the role of MNE affiliates in the dynamical processes characterizing this market. In order to understand the impact of the growing internationalization of insurance markets on Belgium, it is important to understand the differences in dynamics between MNEs and local companies. More particularly, it needs to be investigated whether MNE affiliates enter and exit more or less easily and how all this relates to the competitive position of MNEs relative to local firms. Before turning to the empirical findings, the theoretical hypotheses are detailed first.

Theoretical hypotheses

Classical barriers to entry are less effective to impede entry from MNEs, given that affiliates can build on the stock of capital and knowledge (expertise), which is already present within the company (Shapiro l986, Gorecki 1976). In addition, serving a larger variety of international markets may further enhance this knowledge base, such that all existing affiliates of the parent company may benefit from the expansion of the international network of affiliates (Veugelers 1990). Furthermore, because of their size and access to financial markets, MNE insurance companies are less likely to be restrained by capital requirements in setting up foreign establishments. Similarly, economies of scale prevailing on all levels of functional activities are less binding for the MNE since it can set up subsidiaries which operate with only a limited set of functional activities, keeping central those activities where economies of scale cannot be fully captured on a decentralized scale.

Similarly, affiliates are more likely to exit relative to domestic firms: when the Belgian market becomes less attractive compared to other national markets, MNEs, having sunk the search costs of alternative markets, are more inclined to leave the current market than local companies (Hilke and Nelson l988). In addition, since the managers who have to make the divestment decision are mostly not located where the decision is made, they are less restricted to implement exit decisions (Boddewyn 1983).

However the economies of scope argument which was argued to stimulate MNE entry, is likely to impede MNE exit. Given the jointness of inputs of knowledge and expertise, the cost of terminating a particular business should be analysed in relation to the rest of the enterprise. Hence, in view of the loss of complementarities, exit can be more costly for a multimarket than for a unimarket company (Caves and Porter 1977).

The importance of MNEs in dynamical processes

That affiliates from multinational networks are important and distinct actors in the entry and exit movements observed in the Belgian market, is documented in the following table.

Them major part of dynamic movements in the insurance market, originates in subsidiaries of multinational firms, and this not only because of their slightly higher share in total establishments but also through larger change rates, particularly in exit processes. MNEs contribute substantially more to total industry exit, which can to a large extent be explained by a toughening in legislation after 1976, which made Belgium less attractive compared to other possible home countries. The small differences in importance between foreign and local entrants might indicate that the scope advantages of MNE affiliates do not largely exceed the home advantage of local insurance companies in general or that Belgium in particular is not that attractive as location site.

Most of the new companies, local as well as foreign affiliates, start from scratch ("de novo") which reflects low sunk entry costs in the insurance market. TABULAR DATA OMITTED Take-overs are relatively less favoured entry models by MNEs, which might be related to the scope advantages of MNE insurance companies, emerging inter alia out of brand name confidence, reducing the incentives for take-overs of the brand name of existing companies, Similarly, exit by MNEs occurs relatively more through scrapping than through take-overs.

Size of entry and exit

A general characteristic of entrants and exitors, which is not only typical in the insurance market, is there small size in terms of premia, but also in terms of number of activities.

When foreign companies enter the Belgian market, they operate on a larger scale than new local companies, especially in comparison with the average scale of incumbents. Local firms start on a smaller scale, especially in terms of TABULAR DATA OMITTED number of risks to secure, and follow a slow growth path. During the two years after entry, they show no important expansion of their market share. The larger market share of foreign entrants is however due to the take-over entrants. Although small in number, take-overs entrants start at a larger scale (in terms of market share and activities) than de novo entrants. Foreign affiliates starting from scratch are smaller than their local counterpart in terms of premia but not in terms of product proliferation.

All this might suggest that foreign affiliates enjoying the scope advantages of belonging to an international company, face lower entry barriers in setting up a broad diversified product line, but this does not automatically imply a large market share which they can effectively assure. In the early stages, foreign affiliates have to overcome the disadvantage of not operating at home. They have to get familiar with the specificities of the Belgian market, something which the local entrants have less problems with, which might explain their larger market share. The average entry strategy of local firms consists of starting with a limited number of activities (mostly 1) but in which they have successfully scanned the market and delineated their customers. Foreign entrants set up a broad service line, optimally benefitting from their scope advantages, but where they have to overcome their "non-home-marketness". The fact that these new MNE affiliates show soon a larger growth rate than domestic entrants, might however indicate a quick learning process. Taking over an existing (mostly local) plant combines the scope advantages of the MNE with the home advantages, expertise and clients of the local plant resulting in higher market shares.

Domestic companies exit on a larger scale than foreign firms, but this is only attributable to take-over exits. If exit is limited to exit by scrapping, foreign companies leaving the Belgian market, are on average twice as large as local companies exiting. This larger size may reflect the larger set of alternatives open to multimarket firms.

The scope of MNEs

The scope at which MNEs operate, driving the relative cost efficiencies of these companies, is an import determinant of the dynamic reaction patterns of these firms. Table 6 details the scope of the network to which most of the foreign affiliated located in Belgium, belong. The average MNE operates with 8.4 foreign establishments. The most frequently observed scope at which insurance affiliates in Belgium operate is 1 foreign establishment, while giant MNEs (i.e. with more than 30 establishments) are rare. The smaller is the number of foreign establishments, the more likely that these foreign establishments are located in the EC.

TABULAR DATA OMITTED

When distinguishing MNEs according to their home country, the large scope of U.K. firms, the small scope of German firms, and the bi-modal distribution of Dutch and Italian firms (relatively more small, but also giant companies) is striking. Swiss firms, are highly international and of a relatively larger, but not massive, scope.

If the size of affiliates in Belgium in terms of premium income is regressed on the scope the MNE network to which these affiliates belong, the following results emerge (estimation is through OLS, between brackets are standard errors). The number of activities of the company are also included to capture possible scope effects from offering a broad product spectrum:

LOG(PREMIUM87) = 9.123 + 0.728 LOG(FOREST) + 0.778 LOG(ACT) (0.656) (0.186) (0.306)|Mathematical Expression Omitted~ = 0.246

PREMIUM87 = Affiliate premium income in 1987. FOREST = Number of foreign affiliates of the parent company. ACT = Number of activities of the affiliate.

The sign and magnitude of the coefficient of log (FOREST), being positive and smaller than 1, indicates that a larger scope results in larger market shares for the affiliates, but at a diminishing rate (cf. also ACT). Since the coefficient is more close to one than to zero, the results seem to indicate that in the sample range of foreign establishments |1, 55~, the scope advantages were important in terms of market share that could be gained and that these advantages are only slightly diminishing with the MNE's scope. The results should however be handled with care since only one quarter of the variance is explained, calling for other firm characteristics which determine market share(9).

Scope of entrants and exitors

Entering MNEs operate on average with 6 foreign establishments, 26.7% of them have only 1 foreign branch, 20% only 2 foreign branches and only one company had more than 30 subsidiaries. But although entering MNEs operate at a lower scope compared with the incumbent MNE subsidiaries, the scope and the resulting efficiency gains of the former firms are nevertheless considerable.

Because of the mostly small character of exiting firms, in only one third of the cases could their number of establishments be detected. In this restricted sample, half of the companies operated at the smallest scope possible: 1 foreign establishment. Hence, if through leaving the Belgian market increasing scope advantages associated with serving this market will be lost for the rest of the company, these negative effects of exit are less important for MNEs which have a small international network.

Conclusions

Scope advantages of MNE affiliates in the insurance market, related to i.a. confidence, reputation for financial soundness, brand name recognition, are important. The increase in these scope advantages tend to diminish only slightly when the international network of the parent company expands. Only for firms with over 50 foreign establishments, scope advantages seem to be exhausted. As a consequence, one could expect a lot of MNEs operating on the Belgian market. These indeed large number of affiliates, taking advantage of their competitive advantage, offering a wide, but more specialized, differentiated product range, have however on average a smaller market share, reflecting the importance of the home advantage of local firms. Local firms, especially in the large segments of cars, fire and life, build their strength on this home advantages. But how long this home advantage will stand the test of time against scope advantages, is hard to predict.

Footnotes

1 Where this article represents only the views of the author, the comments of Prof. R. De Bondt and the collaboration of Prof. L. L'Ooghe and the C.D.V. are gratefully acknowledged. Financial support was provided by the National Fund for Scientific Research (N.F.W.O. Grant) and the Research Fund of the K.U. Leuven (0T/89/5).

2 Any insurance company operating in Belgium must be licensed for each of the activities in which it operates. The "Controledienst voor de Verzekeringen" (CDV) has to approve on any new establishment as well as any expansion of an existing company. However, no authorisation is required for the insurance of "large risks" as transport, industrial and commercial risks, as well as special risks which are not insured by existing companies. Companies restricting operations to reinsurance are also not controlled by the CDV.

3 Since 1979 insurance companies intending to offer life insurances are required to open up a separate company.

4 Government regulation sets minimum amounts of solvency and requires a guarantee fund, which is a specific proportion of the solvency margin. Concerning technical reserves, requirements exists on the presence and composition of the assets representing these reserves.

5 As is the case for most services, it needs to be remarked that the distinction between trade and FDI is rather blurred.

6 E.g. in Belgium a license may be refused for those companies whose home-country imposes difficulties on Belgium firms to establish and operate.

7 Under the EC directive, an EC firm is required to calculate its solvency margin with respect to the whole of its business and to establish both its solvency margin and guarantee fund at its head office. But for a branch or agency of a non-EC company operating in the EC, the solvency margin must be calculated in respect of the business carried on in that country and be established there. The assets corresponding to the guarantee fund must be located in the country of activity. Moreover, a branch or agency of a non-EC company must make a deposit in each country where it operates. This policy of localisation of premium balances and reserve funds may result in distortions in comparison with an efficient insurer's localisation strategy, and may thus affect the operational terms of MNEs.

8 Given the (recent) waves of acquisitions in anticipation of 1992, it is to be expected that the more recent numbers are higher than those reported in Table 3.

9 An alternative explanation could be that firms which have an advantage, such as a superior product/production technology, are likely to enter more markets, and hence have a larger scope. The larger market share of these affiliates is directly related to this advantage, and not necessarily to the scope of their parent company. In this case, the scope is merely a proxy of the size of this specific advantage.

References

Boddewyn, J., 1983. Foreign Direct Divestment Theory: is it the reverse of FDI Theory?, Weltwirtschaftliches Archiv, 119, pp. 346-355.

Carter, R. and G. Dickinson, 1979, Barriers to Trade in Insurance, London, Trade Policy Research Center.

Caves, R. and M. Porter, 1977, From entry barriers to mobility barriers; conjectural decisions and contrived deterrence to new competition, Quarterly Journal of Economics, 37, pp. 247-261.

Daly, M., Rao, P. and R. Geeham, 1985, Productivity, Scale Economics and Technical Progress in the Canadian Life Insurance Industry, International Journal of Industrial Organisation, 3, 3, pp. 345-362.

Duron, W. 1989, De Verzekeringssector in Belgie post 1992, Tijdschrift voor Economie en Management, 34, 2, pp. 201-215.

Finsinger J. and K. Kraft, 1989, Kraftverkehrsversicherung, in Oberender (Ed.), Marktokonomie: Marktstruktur und Wettbewerb in ausgewahlten Branchen der Bundesrepublik Deutschland, Verlag Vahlen, Munchen.

Gorecki, P., 1976, The Determinants of Entry by Domestic and Foreign Enterprises in Canadian Manufacturing Industries: some Comments and Empirical Evidence, Review of Economics and Statistics, 58, pp. 593-605.

Hilke, J. and P. Nelson, 1988, Diversification and Predation, Journal of Industrial Economics, 37, 1, pp. 107-111.

Joskow, P., 1973, Cartels, Competition and Regulation in the Property-Liability Insurance, Bell Journal of Economics, pp. 345-427.

Shapiro, C., 1986, Entry, Exit and the Theory of the Multinational Corporation, in Kindleberger and Audretsch (Eds.) The Multinational Corporation in the 1980s, MIT press, Cambridge.

Vanden Houte, P. and R. Veugelers, 1989, Buitenlandse Ondernemingen in Belgie, Tijdschrift voor Economie en Management, 34, 1, pp. 9-34.

Veugelers, R., 1990, Scope Decisions of Multinational Enterprises, Doctoral Dissertation, K. U. Leuven, F.E.T.E.W., reeks nr 74.

Dr. Reinhilde Veugelers, Assistant Professor, Department of Applied Economics, K. U. Leuven, Leuven, Belgium.

Manuscript received March 1991, revised August 1991, revised August 1992.
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Author:Veugelers, Reinhilde
Publication:Management International Review
Date:Oct 1, 1992
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