Intermediation, Compensation and Tacit Collusion in Insurance Markets

1. Andreas Richter Ludwig-Maximilians-University Muinch Intermediation, Compensation and Tacit Collusion in Insurance Markets Uwe Focht University of Hamburg Jörg Schiller WHU – Otto Beisheim School of Management ARIA Annual Meeting Washington 2006

2. Agenda • Introduction • Model Framework • Market without Intermediation • Market with Intermediation • Fee-for-Advice • Commission • Collusion and Intermediation • Concluding Remarks

3. Collusive Behavior in German Commercial Insurance • In 2005, the German Federal Cartel Office imposed a 150 Million Euro fine against 17 leading commercial insurance companies. • From 1999 to 2002 insurance companies established a cartel in order to enforce higher premiums as a “reorganization measure”. • In particular, they agreed to • Increase premiums and deductibles • Waive premium reductions • Unify terms and conditions • Enforcement measures for the cartel • Insurers: Exclusion from pool solutions • Brokers: Termination of cooperation

4. Main focus • Why is collusive behavior in commercial insurance a common phenomenon? • What is the specific role of an insurance broker in this context? • To what extent does the broker’s compensation affect pricing and collusive behavior of insurance companies?

5. Model Framework (I) • Insurance market with heterogeneous risk profiles and differentiated products (Schultz, 2004). • Consumers’ risk profiles are uniformly distributed in [0,1]. • Two insurers (i = 0,1) offer policies at the two extremes of the risk profile space and compete in premiums pi. • Constant marginal costs c.

6. Model Framework (II) • Willingness to pay v for consumers is sufficiently large. • In equilibrium the market is completely covered. • Disutility of mismatch t·, increases linearly in the distance to the demanded product. • Two types of consumers: • Informed consumers with fraction (0,1] are perfectly informed about their risk profile and the premiums pi; • Uninformed consumers with fraction (1−)only form rational expectations regarding their risk profile and premiums pi.

7. Market without Intermediation Sequence of play: • Insurers simultaneously offer contracts at premiums pi. • Consumers decide whether and where to purchase an insurance policy. • In the symmetric subgame perfect Nash equilibrium prices and profits are and • Both premium level and profits decline in the fraction of informed consumers. • One half of the uninformed consumers match with the wrong product • Resulting welfare loss:

8. Market with Intermediation • The broker is endowed with an information technology which perfectly reveals the risk profile of an individual consumer. • Cost per risk analysis . • Two compensation systems are considered: • Broker is paid by the insured (fee-for-advice) • Broker is paid by the insurance company (commission) • The broker acts completely non-strategic!

9. Market with Intermediation (Fee-for-Advice) • Broker‘s fee at which uninformed consumers are indifferent • If k≤ (1/4)tholds, the broker offers risk analyses and all uninformed consumers purchase this service. • Thus, since = 1, equilibrium premiums and profits are and

10. Market with Intermediation (Commission) • The risk analysis service does not cause any costs for uninformed consumers, therefore = 1. • Broker’s commission at which insurers are indifferent • Insurance companies accept offer and charge the premiums and • The resulting insurer profit is:

11. Fee-for-Advice vs. Commisson System • From a social planner‘s point of view both remuneration systems are equivalent. • But: In a modified model there might be incentives for a broker to match uninformed consumers with the wrong insurance company (intentional mismatch). • In both cases, due to the increased transparency on the consumer side, the insurers’ profits decrease. • Greater incentives for collusion

12. Collusion (I) • Assumption: Insurance companies jointly decide upon premium offers and the broker’s remuneration. • The coalition maximizes its joint profit subject to the broker’s participation constraint . • In our model, rationing is not profitable for the cartel. • A commission system is superior to a fee-for-advice system. • Prices can not be differentiated in a fee-for-advice system. • A fee reduces the maximum possible premium, since

13. Collusion (II) • The broker is compensated by a break even commission. • The profit maximizing premium for the cartel is: • In our model, collusion does not affect social welfare (no rationing) • There is (just) a redistribution of income.

14. Concluding Remarks • In markets with uninformed consumers and heterogeneous risk profiles, intermediation has the potential to improve social welfare. • Intermediation reduces the market power as well as profits of insurance companies and increases collusion incentives. • In a competitive market both remuneration systems are equivalent. • Under collusion • a fee for advice limits the insurers‘ opportunities to extract rents from informed consumers. • less differentiated products are offered (→ in the paper). • In our analysis we do not examine the broker’s incentive problem.

15. Backup

16. Product Differentiation Without collusion: • Insurance companies maximize profits by offering differentiated products outside at: • Product differentiation increases consumers’ disutility of mismatching and negatively affects social welfare. In the case of collusion: • Profit maximizing product characteristics are: • In order to maximize the coalition’s joint profit, insurance companies equalize product characteristics.

17. Rationing • Rationing is only profitable, if and only if • Collusion is profitable, if and only if • The coalition’s joint profit under collusion is strictly higher without any rationing!