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Abstract
Introduction
Michael K. McShane is at the College of Business and Public Administration, Old Dominion
University. Larry A. Cox is at the School of Business Administration, University of Mississippi.
Yanling Ge is at FNC, Inc. The authors can be connected via e-mail: mmcshane@odu.edu,
lcox@bus.olemiss.edu, and ymayer@fncinc.com, respectively.
1115
empirical researchers have explored whether early movers gain competitive advan
tages in new product markets. Further, the evidence that does exist is mixed at best.
Some researchers find that early movers into new financial products gain greater
market share, at least in the short run, and suggest that they may benefit from lower
costs because of economies of scale or proprietary information. Lower costs for new
financial products have been implied, rather than directly observed, in these stud
ies, however. Some researchers also find evidence that financial innovators are able
to charge relatively high prices, but others claim that imitators are able to leverage
favorable reputations to mitigate any early mover advantages. Researchers have not
been able to verify higher market or book returns to financial firms that innovate with
new products, however.
Our study fits within this vein of empirical research into financial product innova
tion as we empirically examine whether insurers have benefited by moving relatively
rapidly into the market for long-term care insurance (LTCI) that emerged in recent
decades. Product-specific data unique to LTCI allow rigorous examination of mar
ket share, profits, and pricing that is not possible for other financial products. We
first analyze innovations introduced in LTCI products. Then we empirically exam
ine potential early-mover advantages using our unique set of financial performance
measures and price estimates.
We find that early movers in the LTCI market gained relatively greater market share
than later entrants, which is consistent with prior research. This evidence is not
enough to demonstrate early mover advantage because insurers potentially could
"buy" market share merely by operating unprofitably. We therefore explore LTCI
profitability and pricing. We find that early movers into the LTCI line generally are
more profitable but are not charging higher premiums for LTCI policies. Although
like previous researchers we cannot observe product-specific costs, we argue that
early movers into LTCI have cost advantages because of their larger market shares
and profits in the face of apparently competitive pricing. Other explanations are
possible, such as a superior product mix and quality that increases revenues but are
not directly observed. In an effort to account for these other possibilities, we control
for the number of products offered, year in which specific policies were first offered,
and policy comprehensiveness.
Because our tests reveal no evidence of economies of scale or consumer lock-in,
we surmise that proprietary learning by early movers into LTCI products is the
likely source of reduced costs. An alternative explanation is that early movers have
established a reputation that allows them to charger higher premiums, and thus
increase profits. We argue that the reputation alternative is accounted for to some
extent by other variables that we include in the regressions, such as firm size, firm
age, and capital adequacy. Additionally our pricing model results provide no evidence
that early movers charge higher prices.
Additional empirical findings include a strong positive relation between product dif
ferentiation, firm size, and strength in traditional health insurance lines with both
LTCI market share and profitability. Our results also suggest that insurers issuing
relatively more individual, rather than group, policies are able to charge higher
prices and extract greater profits. This is consistent with the idea that group buy
ers have lower switching costs and therefore are less prone to consumer lock-in. Our
profitability results also imply strong initial underwriting effects for LTCI policies,
which disappears after 2 years.
Literature Review
Researchers have long recognized the importance of technical innovation for eco
nomic growth (Schumpeter, 1911; Solow, 1956; Romer, 1986) and theorized about the
importance of first- or early-mover advantages that provide an incentive to innovate.
In industrial markets, the costly entry barriers imposed by research and development
costs and patent protection have allowed first movers to realize advantages such as
lower production costs, larger market shares, higher survival rates, and greater profits
(see, e.g., Mueller, 1986,1997).
Carow (1999a) explores 64 bonds and preferred stocks that he classifies as innova
tive and were introduced during the 1974 though 1988 period. He extends Tufano's
study by controlling for the impact of specific attributes of the products and the
reputations of the underwriting firms on prices. He also creates variables that dis
tinguish between first movers, or "pioneers," and early movers. Carow's results
indicate that while product pioneers do not realize any pricing advantages, prices
decline as imitators enter new product markets. These results generally imply early
mover advantages. Additional results indicate lower prices for larger, more reputable
underwriters, which he attributes to economies of scale.
Carow (1999b) next conducts a more intensive study of reputation effects based upon
a subset of the 43 new bond and preferred stock innovations examined in his previous
study. He finds that investment banks entering a new product market generally offer
lower spreads, but this effect is mitigated for banks with stronger reputations. He
concludes that reputational capital therefore poses a barrier to entry in the markets
for financial innovations.
Charupat and Prisman (2004) investigate pricing in the market for installment receipts,
which securitize the installment purchase of underlying securities. Their test sample
contains data for 29 initial public offerings during the period 1991-2000. They find that
the premium on underwriting spreads exceeds implicit costs, in particular the costs of
buyer default. They claim that this finding supports Van Horn's (1985) hypothesis that
financial innovation must significantly reduce market friction costs to be successful.
Schroth (2006) examines demand for new offerings of 50 types of equity-linked and
derivative securities issued during the period 1985-2001. His proxy for demand is
the ratio of market share for the innovative security underwritten to market share for
all equity securities underwritten during the same period. He finds that early movers
benefit from greater demand than imitators initially although this advantage declines
over time. Schroth attributes these differences to informational advantages gained by
innovators. He argues that imitators must surmount barriers posed by the private
information obtained by early movers and this takes time.
Berger and Dick (2007) investigate early mover advantage in the banking industry
and find that banks entering a market earlier gain and maintain a larger market share
relative to later entrants. One key to holding onto the market share advantage appears
to be the strategic use of branch networks. Like previous early mover research, their
data set did not allow them to investigate early mover advantage in terms of profit
and price.
Two recent studies explore a variety of factors that can affect the propensity of financial
firm managers to introduce product innovations. Akhavein, Frame, and White (2005)
investigate 99 large retail banks that introduced credit scoring for small business
loans. They specifically examine effects of market, firm, and CEO characteristics on the
number of years that the banks applied credit scoring and the rates of adoption. They
find that centralized organizational structure and geographic location, specifically
headquarters in New York City, are positively related to early adoption. They provide
weak evidence that size is also positively related. Prior profitability is negatively
related to quicker adoption. In other words, less profitable firms are more likely to
adopt innovations.
Lerner (2006) explores 651 financial innovations reported in the Wall Street Journal
during the period 1990-2002 to assess characteristics of firms introducing financial
product innovations. He finds size, geographic location, firm age, and financial lever
age to be positively related to the number of innovations. On the other hand, prior
profitability is negatively related.
We note that the cost of a LTCI policy necessarily rises with the purchaser's age, which
coupled with the informational barriers discussed previously is likely to produce
relatively high switching costs and consumer lock-in. Cox and Ge (2004) provide
empirical evidence to this effect for long-term care insurers. The logical conclusion is
that early movers should benefit in a market with these characteristics.
Life-health insurers began developing LTCI, as we know it today, in the early 1980s
(Coronel, 2000) and approximately 130 insurers now offer the product. LTCI con
tractually obligates an insurer to pay benefits to an insured who is either unable
to perform certain activities of daily living without assistance or whose health and
safety is threatened because of cognitive impairment. LTCI quickly became the fastest
growing life-health insurance product during the period 1987-2002, with the num
ber of policies increasing by an average of 18 percent annually (Coronel, 2004). LTCI
premiums earned similarly grew at double-digit rates throughout the late 1990s and
early 2000s, but annual growth has fallen within the 6.5-7.5 percent range for the
period 2004-2007 (American Association for Long-Term Care Insurance, 2008).
Benefits Triggers. The primary contractual trigger for qualifying the insured to receive
benefits now generally specifies that the beneficiary cannot perform at least two of six
normal activities of daily living. These include bathing, continence, dressing, eating,
toileting, and transferring. The specific activities and the number required to trigger
1The extent to which many of these options are used is surveyed in a study by LifePlans Inc.
(2007).
benefits have evolved gradually. Benefits also generally are triggered if the beneficiary
becomes cognitively impaired. This part of the trigger was virtually nonexistent in
the earlier LTCI contracts.
Services Provided. From simple nursing home indemnity policies, LTCI contracts
evolved to cover the costs of assisted living, nursing home care, adult day care, home
health care, caregiver training, homemaker services, hospice care, and, even, respite
care. The latter is for purposes of rejuvenating caregivers.
Benefit Limits. The basic benefit amount generally provides reimbursement for ex
penses up to a limit for assisted living or nursing home facilities. Lower limits on
adult day care, home health care, homemaker services, and hospice care often apply.
Alternatively, some contracts offer a flat indemnity payment without regard to actual
expenses incurred. For a substantial additional premium, cost-of-living adjustments
(COLAs) can be added. The most common COLA is 5 percent annually, but some
plans index the adjustment.
Exposure to the future expenses of long-term care can differentially affect insurers
depending upon their primary lines of business. McShane and Cox (2009) generate
empirical evidence that insurers primarily engaged in health care lines are likely to
benefit from strategic focus by adding the LTCI line. We further surmise that adding
the LTCI line should partially hedge the short-term loss profile inherent in medical
expense insurance issued by health insurers. To the extent that they participate in the
LTCI market, health insurers effectively diversify the durations of their portfolio of
contingent claims outstanding and lengthen the average duration.
For traditional life insurers, LTCI can be viewed as a potential hedge against actuarial
mortality risk. After all, policyholders dying relatively early are quite costly to life
insurers, but few, if any, claims will have been paid on LTCI held by these same
policyholders. The problem for life insurers is that, in contrast to the well-defined
actuarial experience for life insurance, LTCI claims experience is not very extensive
and traditional life insurers have little internal data on or experience with the costs of
health-care-related expenses for the more advanced age population. Indeed, McShane
and Cox (2009) find no evidence of incremental benefits for traditional life insurers
issuing LTCI.
Research Design
In this study, we explore data for virtually the universe of U.S. insurers underwriting
LTCI to empirically assess the impact of early entry on insurer shares of this mar
ket, product profitability, and product pricing. We also test other factors that financial
researchers have found to affect financial performance and product pricing. We specif
ically apply regression analysis to an unbalanced panel for the years 1994-2002. A
LaGrange multiplier (LM) test is used to determine whether pooled OLS is more
suitable than random or fixed effects methods. A Hausman test (1978) is applied,
as needed to determine whether random effects or fixed effects estimation is more
appropriate for our data.
Data
Our source of financial data for each insurer and for the LTCI line of business is the
InfoPro database, including data collected from LTCI Reporting Forms, compiled by
the National Association of Insurance Commissioners (NAIC). This data set encom
passes LTCI policies in force with virtually all U.S. insurers underwriting LTCI during
the period 1994-2002. Our study period begins in 1994 because it is the first year for
which the NAIC separately collected and reported LTCI data. It ends in 2002 because
the period of double-digit growth in this product market was complete by then (see,
e.g., Coronel, 2004; American Association for Long-Term Care Insurance, 2008).
We note that the LTCI database does not allow us to identify insurers that entered and
exited the LTCI market prior to 1994. If pre-1994 exits occurred and were the result
of poor performance in the LTCI business, survivorship bias could be introduced.
We consequently conduct a comprehensive search of ABI/Inform, LexisNexis, and
National Underwriter sources and find that three insurers exited the LTCI market
prior to 1994. Two seemingly were facing financial distress.2 The low number of early
exits from the LTCI business indicates to us that survivorship bias, if any exists at all,
is extremely limited.
We are able to examine the data reported for each policy form issued by each insurer
and omit those with missing or apparently outlying observations, such as negative
claims, negative premiums, or unrealistically high or low premiums per insured life,
based upon comprehensive surveys of LTCI pricing (Coronel, 2000,2004). The NAIC
states that a particular policy form is "issued to substantially similar risk classes and
... issued under similar underwriting standards" (NAIC, 2001, p. 374). Different LTCI
policy forms issued by the same insurer therefore should impound different levels of
underwriting risk depending upon the contractual options offered. Our consultations
with two LTCI actuaries and one insurance commissioner indicate that new policy
forms generally (1) limit or expand coverage, (2) offer alternative contractual triggers,
or (3) address new regulations, such as changes in tax law.
2United Equitable, one of the LTCI market pioneers, sold its entire block of 60,000 in-force
policies to Standard Life and Accident in 1986, before eventual liquidation of the firm. Re
liable Life and Casualty was liquidated in 1990, reportedly after LTCI underwriting losses.
Massachusetts Indemnity canceled all in-force LTCI policies in 1989, reportedly because of
large underwriting losses.
We use a multivariate approach to test the impact of early movement and other factors
on LTC insurers' market share, which we define as the ratio of LTCI premiums earned
by an insurer to total LTCI premiums earned by all insurers in our sample. We next
discuss the independent variables and applicable proxies that we test.
Early Mover. Our primary variable of interest measures the extent to which the
insurer is an early mover into the LTCI market. We use the number of years that
the insurer has been participating in the LTCI line as our proxy for early movement.
If early mover advantages exist and outweigh the advantages of later imitation, we
expect a positive relation with market share.
Cox and Ge (2004) find evidence of consumer lock-in in LTCI markets but no consistent
effect of group versus individual buying on LTC insurer profitability. They do find
that individuals are less susceptible to price increases than group buyers, which runs
counter to existing theory. They conjecture that group buyers extracted substantially
discounted premiums in the early years of LTCI and, as unfavorable claims experience
developed in subsequent years, relative price increases consequently were larger for
3 We note that in industrial studies spanning many decades, market tenure has been interpreted
as a survival measure and, therefore, as a measure of firm performance across a product life
cycle (see, e.g., Klepper and Simons, 2000; Klepper, 2002). Such an interpretation is not valid
for our data because only a few insurers exited the LTCI market prior to or during our period
of study, as discussed previously. We conclude that market tenure is not effectively a firm
performance measure at this early stage in the LTCI product life cycle.
these buyers. To control for individual versus group buying, we apply the ratio of
premiums earned from individual LTCI policies to total LTCI premiums earned.
Firm Size. Schumpeter (1942) first suggested that larger firms are better able to inno
vate and a lengthy stream of literature was spawned.4 Akhavein, Frame, and White
(2005) report evidence of larger banks being more prone to innovate via credit scoring
in their lending processes. In a comprehensive examination of financial innovations
by investment banks, Lerner (2006) finds a positive relation between size and the
number of innovations. Most pertinent to our study, Doerpinghaus and Gustavson
(1999) argue that larger firm size produces greater name recognition and positive
reputation, which should be very important in attracting customers in the compara
tively new, long-tailed LTCI line of business. For these reasons, we expect firm size to
positively affect market share. The natural log of total assets serves as our measure of
insurer size.
Stock Form. Equity capital increases the incentives of stock firm managers to engage
in risky projects because of the greater potential for wealth transfers to equity holders
(Jensen and Meckling, 1976). The managerial discretion hypothesis first proposed by
Mayers and Smith (1981) specifically suggests that mutual managers will focus on
lines of insurance for which actuarial experience is well defined. Because stock man
agers generally should be more proactive in exploiting markets for which actuarial
experience is not well defined, such as that for LTCI, we anticipate a positive relation
between stock ownership and market share. Our proxy for a stock organizational
form is a binary variable with a value of one for stock insurers and zero otherwise.
Firm Age. Holmstrom (1989) suggests that older firms primarily focus on produc
tion and marketing, which compromises incentives to innovate. Klepper and Simons
(2000) suggest that older and larger firms are more likely than their younger and
smaller competitors to emerge as dominant firms, however. McShane and Cox (2009)
maintain that older firms have more actuarial experience in general, which can give
them a comparative advantage when entering a new market. We define our age vari
able as the attained age of the insurer when it first underwrites a long-term care
policy.
Affiliation. Grace and Klein (2000) state that insurers with a larger group affiliation
are likely to reap cost advantages because of economies of scope, but their empirical
results are contraindicative. Cummins and Sommer (1996) alternatively argue that
policyholders may demand a risk premium from a group-affiliated insurer because
group managers can have incentives to let the affiliated insurer fail while protecting
other assets. In their study of LTCI markets, McShane and Cox (2009) find virtually no
relation between participation in LTCI lines and group affiliation, however. To control
for affiliation, we incorporate a binary variable with one indicating affiliation.
Health Insurer. McShane and Cox (2009) argue that insurers with prior experience
in health insurance lines should have informational advantages over other insurers
emanating from more extensive actuarial loss data pertaining to policyholder health
across the age spectrum. They find a very significant, positive relation between health
insurance experience and activity in LTCI markets. We consequently include the ratio
of health insurance premiums written, excluding LTCI premiums, to total insurance
premiums written by each insurer to control for possible differences in core compe
tence.
Our basic model for estimating the effects of product innovation and other variables
on LTCI market share follows:
where it means the value for the zth insurer in period t, Tt is the time-specific effect
for years 1994-2002, a is the individual effect, and en is the time-varying error.
Market share (MS) is the individual insurer's relative market share in the LTCI line
and the independent variables are as defined earlier. Specifically, Early is our proxy
for early movement into LTCI, ProdDiff is our proxy for product differentiation, Indi
measures relative activity in individual lines, Size is firm size, Stock indicates stock
organization form, Age is insurer age at the time of LTCI market entry, CapAdeq
signifies the capital adequacy of the insurer, Ajfil indicates whether the insurer has
a group affiliation, and Health is the relative activity in health insurance lines other
than LTCI.
Profit Model
rarely available. The unique data for LTCI do allow direct observation of product
specific profits, however.
An argument for greater profits for early movers in a new product line is that earlier
movers can achieve lower costs (Tufano, 1989). LTCI is a long-tailed line and the
largest costs consist of largely distant, future claims, for which projections are highly
uncertain because of limited actuarial experience. Early movers conceivably can ben
efit from proprietary learning advantages by gaining actuarial experience that leads
to superior underwriting decisions, hence ultimately lower claims relative to later
entrants.
Expected Loss Ratio. The NAIC requires LTC insurers to estimate expected loss ratios.
Cox and Ge (2004) use both current-year loss ratios and reserve-adjusted loss ratios as
their LTCI profitability dependent variable and find that expected loss ratios have a
positive and significant relation with both these profitability ratios. For our dependent
variable profit measure, a higher value means greater profitability, so we expect a
negative relation to expected loss ratio. LTC insurers report a premium-weighted
anticipated loss ratio, which we use as our proxy for expected loss ratio.
Policy Age. Most LTCI claims are expected during policyholders' more advanced
years, so the LTCI loss distribution is necessarily long tailed. Furthermore, the positive
impact of the initial underwriting and selection process should dissipate rapidly over
the term of the policy. Insurers with relatively older policies outstanding are likely to
incur greater claims, which necessarily reduce profitability. We consequently expect
insurer profitability to be positively related to the more newly issued policies in force
and negatively related to older policies in force.
Insurers report their LTCI premiums earned on policies that have been in force for
seven duration categories, that is, 1, 2, 3, 4, 5, 6 through 9, and 10 or more years.
We therefore apply the ratio of premiums earned in each time-in-force category, with
the exception of the 10+ category,6 to total premiums earned. Our policy age factor
therefore is a vector of the ratio of premiums for the policy age category to total
premiums for LTCI policies in the six categories discussed previously.
Pricing Model
As we discussed previously, researchers of investment banking have examined fi
nancial innovators to determine whether they realize pricing advantages because
of such barriers as proprietary learning and economies of scale. Carow (1999b) and
Charupat and Prisman (2004) report evidence of higher spreads charged by early
movers into certain investment banking products, but most researchers find no such
pricing premium. We earlier analyze how the characteristics of the LTCI market can
lead to potential informational advantages related to proprietary claims experience
and relatively high switching costs that allow insurers to extract price premiums, al
though potential pricing advantages for product innovators in the insurance industry
are heretofore unexplored.
Part of the empirical research problem is that pricing data for a broad group of
insurance policies simply are not available. In contrast to most insurance pricing
studies that are only able to examine average prices for broadly defined insurance
lines (see, e.g., Weiss and Chung, 2004), LTCI data allow development of average
price proxies for each specific policy form within this single line. We consequently
exploit these unique data to assess potential pricing advantages of early movers into
LTCI markets.
6The Policy Age variables are not binary (dummy) variables. Each is defined as the ratio of
LTCI premiums earned for the policy age category to total LTCI premiums earned by the
insurer. However, the sum of the all the Policy Age ratios for each insurer is 1, so if we include
all Policy Age variables in the regression, perfect multicollinearity blows up our results, so
we omit one of the ratios (10+ years). The results are not interpreted like dummy variables
would be but are directly interpreted as the relation to profitability, not relative to the omitted
variable. We confirmed this by alternately omitting other Policy Age variables and including
the 10+ Policy Age variable. This did not significantly change the results for the other Policy
Age variables and the 10+ variable is negatively and significantly related to profitability when
included.
Coverage. LTCI policies with more comprehensive coverage attributes should com
mand higher prices. Because we cannot observe the contractual features of each LTCI
policy form to directly assess coverage, we use the total policy reserve for the cohort
of new policyholders under each policy form divided by the number of lives insured
under each form. The total policy reserve is the insurer's approximation of the present
value of all claims anticipated on a particular policy form. To our knowledge, LTCI
is the only insurance product for which such comprehensive information is available
for each policy form offered.
Results
We first examine statistics that provide an overview of market structure and the over
all market tenure and profitability of the LTCI insurers in our sample. After this, we
discuss the results produced by our market share, profit, and pricing models. For
all three models, LM test results show that fixed and random effects regressions are
Table 1
Top Underwriters in the LTCI Market
more suitable than the pooled ordinary least squares (OLS) method, while subse
quent Hausman tests indicate that fixed effects regressions are more appropriate than
random effects estimations. Consequently, only the fixed effects results are shown in
the subsequent tables. Standard errors are corrected using White heteroskedasticity
consistent covariance estimators (Greene, 2003, p. 314).
Table 2
Descriptive Statistics for the Sample of Long-Term Care Insurers
Correlation With
Insurer Characteristics Mean (S.D.) Median Early Mover
(41.77)
Adjusted Profit Margin (%) 13.89 14.01 0.362
(4.19)
Product Differentiation 5.66 3.00 0.436
(6.80)
Firm Size 20.85 20.64 0.088
(2.31)
Firm Age 52.63 43.00 0.023
(37.27)
Stock Form 0.86 1.00 0.032
(0.35)
Capital Adequacy 7.78 5.630 -0.023
(8.76)
Notes: The sample consists of 1,139 annual observations for the period 1994-2002. Early Mover
is the number of years since the insurer issued its first LTCI policy. Market Share is the ratio of
LTCI premiums earned by each insurer to total LTCI premiums earned by all insurers in the
sample. Unadjusted Profit is defined as the gross LTCI premiums earned less underwriting losses,
divided by gross LTCI premiums earned. Adjusted Profit is defined as the gross LTCI premiums
earned less underwriting losses and policy reserves, divided by gross LTCI premiums earned.
Product Differentiation is the count of different policy forms issued by the insurer in the current
year. Firm Size is the natural log of total admitted assets. Firm Age is the age of an insurer at the
time it entered the LTCI market. Stock Form equals one if the insurer is a stock firm and zero
otherwise. Capital Adequacy is the risk-based capital ratio, which equals total adjusted capital
divided by minimum risk-based capital as defined by the National Association of Insurance
Commissioners. Values in parentheses are standard deviations.
As shown in Table 2, the mean and median for tenure in the LTCI market, our early
mover variable, fall between 9 and 10 years, with a standard deviation of 5.47 years.
Despite the substantial market shares of the larger LTC insurers apparent in Table 1,
the typical LTC insurer controls less than 1 percent of the market. The data also reveal
that the average LTC insurer issues between five and six policy forms, although the
median is only 3. In results not contained in the tables, we observe some correlation
between our early mover variable and market share, profit margin, and product
differentiation, but the correlation coefficients never exceed 0.45. We compute the
variance inflation factors (VIFs) developed by Belsley, Kuh, and Welsch (1980) and
find that all are below 3.5, so collinearity is unlikely to be a problem.
Table 3
Market Share Results
Notes: Fixed-effects regression is applied to unbalanced panel data for individual insurers
issuing long-term care insurance (LTCI) from 1994 through 2002. The unbalanced panel contains
1,139 observations. Market Share is the ratio of LTCI premiums earned by the insurer to total
LTCI premiums earned by all sample insurers in the current year. Early Mover is the number of
years since the insurer first issued an LTCI policy. Product Differentiation is the count of different
LTCI policy forms issued by the insurer and outstanding in the current year. Individual Business
is the percentage of total LTCI premiums earned on individual, as opposed to group, policies.
Firm Size is the natural log of total assets. Stock Form equals one if the insurer is a stock firm and
zero otherwise. Firm Age is the attained age of the insurer at the time of market entry. Capital
Adequacy is the risk-based capital ratio, which equals total adjusted capital divided by minimum
risk-based capital as defined by the National Association of Insurance Commissioners. Group
Affiliation equals one if the insurer is a member of a group and zero if the insurer is unaffiliated.
Standard errors are corrected for heteroskedasticity using White's estimators. Health Insurer is
the ratio of health insurance premiums written, excluding LTCI premiums, to total insurance
premiums written by each insurer. ***, **, and * indicate significance at the 1%, 5%, and 10%
levels, respectively.
Our much more conservative adjusted profit estimate, with a mean and median of
approximately 14 percent, better reflects profit expectations in a relatively new, long
tailed insurance line. We note that our measures of LTCI underwriting profits do not
impound investment profits earned by insurers because we cannot directly link the
portion of the each insurer's general investment portfolio attributable to premiums
generated by the sale of LTCI products.
Table 3 reveals that the early mover variable is positively related to market share,
with a p-value of 0.058. Our results support the hypothesis that early movers gain
market share advantages, which is consistent with evidence from previous studies.
Even though insurers cannot patent products, barriers to entry are low, and product
information is relatively transparent, early movers gain greater market shares. Fol
lowing Ziliak and McCloskey (2004), we also consider the economic significance of
early movement on LTC insurers' market share. We find that if the typical insurer in
our sample had moved into the LTCI market 5.5 years earlier, which is one standard
deviation from the norm, it would have gained over 2 percent in market share. This
would represent a quadrupling of the typical market share, which we regard as highly
significant in economic terms.
A positive and significant relation between prior health insurer experience and market
share is consistent with the McShane and Cox (2009) evidence that insurers with more
experience in traditional health insurance lines have informational advantages that
are beneficial in competing in the newer LTCI line. We find no relation between
the relative amount of individual business, capital adequacy, or group affiliation with
market share. The first result impresses us as particularly interesting because it implies
that insurers are not leveraging potential superior information to lock in individual
consumers and build market share.
A possible criticism of using the number of years since the insurer entered the LTCI
market as our early mover measure could be a mechanical relation with market share.
In other words, one could argue that an insurer participating in the LTCI market more
years logically should have a larger market share. We therefore perform an additional
regression to compare market shares after insurers have been in the LTCI market the
same number of years, which is similar to how Berger and Dick (2007) handled this
issue in their market share model. Our data set limits the extent to which we can do
this but does allow the following.
As described in the Data section, our data are from 1994 through 2002. We start with
1994 because it is the first year that the NAIC separately collected and reported the
LTCI data. The LTC insurers with the longest tenure in our data set entered the LTCI
market in 1978, and thus have tenure of 17 years by 1994.
The additional regression uses market share data for all insurers that had been in
the market for at least 17 years by 2002. For example, if an insurer entered the LTCI
market in 1978, we use the market share and other firm characteristic data for that
firm in 1994. If an insurer entered the LTCI market in 1986, we use the market share
and other firm characteristic data for that firm in 2002. The insurers in our data set
will be all insurers that entered the LTCI market between 1978 and 1986. The Early
variable will be the number years the insurer has been in the market as of 1986.
This regression allows us to investigate whether earlier entrants have larger market
shares relative to later entrants, after being in the LTCI market for the same number of
Table 4
Market Share Results Controlling for Years in LTCI Market
Notes: Early Mover is the number of years the insurer has been offering LTCI as of 1986. For other
variables, the values are for the firm in the 17th year since it first offered LTCI. The regression
uses data from a certain year for each insurer (the 17th year after the insurer entered the LTCI
market), so will be a simple regression not a panel data regression. See Table 3 for a general
description of the variables. ***, **, and * indicate significance at the 1%, 5%, and 10% levels,
respectively.
years (17 years). In this regression, the results for the Early variable can be interpreted
as evidence of whether being an early mover results in a market share advantage:
where Early$6 is the number of years the insurer has been offering LTCI as of 1986.
For example, for insurers that first offered LTCI from 1978, the value would be 9; from
1982, value would be 5; and from 1986, value would be 1. For other variables, the
values are for the firm in the 17th year after it first offered LTCI.
Note that the regression uses data from a certain year for each insurer (the 17th year
after the insurer entered the LTCI market), so will be a simple regression not a panel
data regression. Accordingly, the size of our data set is reduced because we can only
include insurers that entered the LTCI market between 1978 and 1986. In our data
set, 41 insurers were offering LTCI by 1986 and had been offering LTCI for at least 17
years by 2002. Table 4 shows the results of this regression. Early mover is still positive
and significantly related to market share, which offers additional support for Early
Mover advantage in gaining and maintaining market share.
An argument that favors later movers is that they may be able to co-opt information
on industry actuarial experience at low cost to gain market share advantage over
earlier movers. Our results do not support this view. We surmise that since early
movers have fewer competitors, they can gain market share more easily than later
imitators who face more competitors, including the entrenched early movers. The
early movers could, for example, maintain their market share lead over later movers
by aggressively pricing when competitors enter the market.
Profitability Results
The early mover variable is positive and significant for both profitability measures,
with a p-value of 0.018 for unadjusted profit and 0.052 for adjusted profit. In terms
of economic significance, an increase of one standard deviation in the early mover
variable would increase unadjusted profit for the typical insurer by 9.8 percent and
adjusted profit by 2.2 percent. In other words, if the typical insurer had entered the
LTCI market about 5.5 years earlier, relative increases in unadjusted and adjusted
profits above the means shown in Table 2 would have been 18.8 percent and 15.8
percent, respectively. Such increases again impress us as economically significant.
Considering these findings and our earlier results, we can see that early movers are
gaining market share, but not at the expense of profitability. The higher profitability
of early movers may be attributable to higher prices, lower costs, or a combination of
the two. Our exploration of pricing relations in the next section sheds further light on
these relations.
The product differentiation coefficient is positive and significant, once again show
ing that insurers offering greater LTCI policy choices gain a competitive advantage.
Expected loss ratio is negatively related to profitability, consistent with previous em
pirical evidence and our expectation. The individual business effect is highly positive
and significant at the 1 percent level, consistent with our expectation that individual
LTCI markets are less competitive than group markets and that relatively greater
switching costs can produce some consumer lock-in. Firm size also is positively re
lated to profitability, a result consistent with the suggestion by Doerpinghaus and
Gustavson (1999) that greater name recognition and positive reputation favor larger
firms entering the new and innovative LTCI market. The relative degree of prior
health insurance experience has a positive and significant relation to profitability,
which supports the McShane and Cox (2009) conclusion that insurers in traditional
health lines benefit from strategic focus when entering the relatively new LTCI line.
Results for the policy age variables provide explicit evidence of initial underwriting
effects on the profitability of LTCI. Our evidence reveals that first- and second-year
policies are relatively profitable. By the third year, the initially favorable underwriting
effect disappears. The policy age coefficients actually are significantly negative for the
fourth-year coefficients and beyond. These results imply an early underwriting effect
that disappears rapidly. Older policies in force generate significantly lower profits,
which probably reflect generally anticipated greater losses as policyholders' age.
Finally, our results suggest that general insurer characteristics such as organizational
structure, firm age, capital adequacy, and group affiliation do not significantly affect
LTCI profitability.
We also ran unreported regressions that interact the early mover variable with other
variables in the market share and profitability regressions, and describe significant
results here. We find that the early mover, product differentiation interaction term
is insignificant in the market share regression but positive and significant in the
Table 5
Profitability Results
Dependent Variable
Notes: Fixed-effects regression is applied to unbalanced panel data for individual insurers issu
ing long-term care insurance (LTCI) from 1994 through 2002. The unbalanced panel contains
1,139 observations. Unadjusted Profit is defined as the gross LTCI premiums earned less under
writing losses, divided by gross LTCI premiums earned. Adjusted Profit is defined as the gross
LTCI premiums earned less underwriting losses and changes in policy reserves, divided by
gross LTCI premiums earned. Early Mover is the number of years since the insurer first issued
an LTCI policy. Product Differentiation is the count of different LTCI policy forms issued by the
insurer and outstanding in the current year. Expected Loss Ratio is the aggregated anticipated
loss ratio for all LTCI policies the insurer has in force calculated using the data provided by
insurers for each LTC policy form for each year. Individual Business is the percentage of total
LTCI premiums earned on individual, as opposed to group, policies. Firm Size is the natural log
of total assets. Stock Form equals one if the insurer is a stock firm and zero otherwise. Firm Age
is the attained age of the insurer at the time of market entry. Capital Adequacy is the risk-based
capital ratio, which equals total adjusted capital divided by minimum risk-based capital as
defined by the National Association of Insurance Commissioners. Group Affiliation equals one
if the insurer is a member of a group and zero if the insurer is unaffiliated. Health Insurer is
the ratio of health insurance premiums written, excluding LTCI premiums, to total insurance
premiums written by each insurer. The Policy Age variables (first-year business, second-year
business, etc.) are the ratios of LTCI premiums earned for the policy age category to total LTCI
premiums earned by the insurer. ***, **, and * indicate significance at the 1%, 5%, and 10%
levels, respectively.
We find that the early mover, health insurance interaction term is significant and
positive in both the market share and profitability regressions. In both regressions,
early mover and health insurance remain significant even when the interaction term
is included. As described earlier, McShane and Cox (2009) argue that insurers with
more experience in health insurance lines should have informational advantages in
the LTCI market. These results suggest that an early mover advantage exists for the
LTCI market regardless of health insurance experience, but that the advantage is even
greater for early movers that have more health insurance experience.
Pricing Results
Table 6 displays our regression estimates for the pricing model. We observe no signif
icant relation between our early mover variable and the average prices for different
policy forms. Our pricing results support the argument made previously that early
movers maintain market share by pricing aggressively as new insurers enter the LTCI
market. Considering our previous observation of greater market share and profits for
early movers, the paucity of pricing advantages implies that early movers into LTCI
products most likely benefit from cost advantages. Economies of scale are unlikely
because of the insignificant results for our market share and firm size variables. We
suggest that a more likely explanation is that early movers generate proprietary learn
ing advantages. Because LTCI is a long-tailed line for which actuarial experience is
limited and full loss development takes years, earlier movers should be able to gain
actuarial experience that can give them informational advantages over later imitators.
Such an argument also is consistent with our earlier evidence that traditional health
insurers gain profit advantages, probably because of greater focus in a line for which
their prior experience with the health expenses of aging policyholders is useful.
We find a highly significant, negative relation between policy year and prices. This
suggests that standardization of LTCI over time and the emergence of imitators domi
nate the effects of limited benefits and allegedly stringent underwriting for early LTCI
policies. Our coverage variable is significant and positively related to average price,
as expected, indicating that policy forms with more comprehensive coverage have
higher premiums. As noted earlier, market share is not significant, which suggests
that monopolistic pricing practices are not possible in the relatively dispersed LTCI
market.
7At the policy form level, the individual versus group data are available for only about one
third of the observations. We ran regressions that included and omitted the Individual Business
variable. The regression that omitted the variable had many more observations. The results
Table 6
Pricing Results
Notes: Fixed-effects regression is applied to unbalanced panel data for first-year, LTCI policy
forms issued by insurers from 1994 through 2002. Price is defined as the natural log of the ratio
of LTCI premiums earned by an insurer for a particular policy form in a certain year to the
number of lives insured under that form. Early Mover is the number of years since the insurer
first issued an LTCI policy. Policy Year is the calendar year in which a particular LTCI policy
form was first issued. Coverage is the total policy reserves for each policy form divided by the
number of lives insured under that form. Market Share is the ratio of LTCI premiums earned by
the insurer to total LTCI premiums earned by all sample insurers in the current year. Expected
Loss Ratio is the anticipated loss percentage provided by insurers for each LTC policy form for
each year. Individual Business is the percentage of total LTCI premiums earned on individual,
as opposed to group, policies. Firm Size is the natural log of total assets. Stock Form equals one
if the insurer is a stock firm and zero otherwise. Firm Age is the attained age of the insurer
at the time of market entry. Capital Adequacy is the risk-based capital ratio, which equals total
adjusted capital divided by minimum risk-based capital as defined by the National Association
of Insurance Commissioners. Group Affiliation equals one if the insurer is a member of a group
and zero if the insurer is unaffiliated. Health Insurer is the ratio of health insurance premiums
written, excluding LTCI premiums, to total insurance premiums written by each insurer. ***,
**, and * indicate significance at the 1%, 5%, and 10% levels, respectively.
supporting the argument that older firms are likely to have actuarial experience
in other lines that give them advantages in new markets. The significant inverse
relation between capital adequacy and pricing is consistent with the results of Doerp
inghaus and Gustavson (1999). Their explanation for these results was more selective
underwriting by less capitalized insurers.
were not significantly different between the two regressions and since the Individual Business
variable is significant, we provide only the regression results that include the Individual Business
variable.
Our results imply that insurers with traditional health insurance experience do not
have any pricing advantage in LTCI. As described previously, McShane and Cox
(2009) find evidence that insurers with prior experience in health insurance lines
when entering the LTCI market have informational advantages over insurers who do
not have this experience. The health variable is not significant in our price regression
but is significant in the profitability regression, providing evidence that the advantage
of prior health insurance experience is related to costs, not prices.
Firm size, stock form, and group affiliation also are not significantly related to policy
prices in our tests.
We use a unique and comprehensive data set to explore a relatively new and rapidly
growing financial market: the market for LTCI. We focus on the relation between early
movement into this new market and financial performance and pricing. Research on
financial innovation has been characterized by sparse data and correspondingly weak
empirical tests that have frequently produced conflicting results.
Our results support a positive relation between earlier movers and LTCI market share.
In this respect, our results are consistent with those generated via univariate tests by
other researchers. Product differentiation, firm size, stock organizational form, firm
age, and health insurance experience are also positively related to LTCI market share.
As described previously, studies using market share as the dependent variable are
prone to finding early mover advantages because early movers can cut prices to gain
market share at the expense of profitability. Our subsequent analysis suggests this is
not the case for LTCI, by revealing evidence of early mover effects on book measures
of LTCI underwriting profitability. These findings suggest that for a product such as
LTCI, with substantial informational asymmetries, proprietary learning can lead to a
comparative advantage in underwriting and sustained profitability by earlier movers.
We also find that underwriting individual LTCI business is more profitable for insurers
than group business, which is consistent with positive search costs in a competitive
market. Insurers appear to have informational advantages in the individual LTCI
market, which allow the development of better pricing schemes to lock-in existing
policyholders.
Our health insurance variable is also significant and positively related to profitability,
suggesting that more experience in health insurance lines provides informational
advantages to the insurer that are beneficial in competing in the newer LTCI line. This
result supports the strategic focus advantage when entering new lines of business
(McShane and Cox, 2009). Additionally, we also find positive, initial underwriting
effects in the first 2 years of LTCI policies, with negative effects appearing as early as
the fourth year that the policies are in force.
Our LTCI data also allow analysis specific to policy forms. We do not find evidence
that earlier movers can sustain higher prices as more entrants make their way into the
LTCI market, which is consistent with the inferences of other researchers. Combined
with the profitability results, this finding suggests that earlier movers are able to
sustain profits, not by charging higher prices, but by reducing costs. We argue the
reduced costs are likely to be the result of proprietary learning advantages generated
by longer actuarial experience for this new product. Coverage, individual policy
status, and firm age are positively related to LTCI policy prices while the initial policy
year and capital adequacy measures are negatively related.
This article covers LTCI during its emerging and growth phase until 2002. The growth
of the market slowed after 2002. Holm and Tergesen (2010) describe the recent exit
of some insurers, including Metlife in 2010, which had about 8 percent of the LTCI
market. Some of the exits are related to the overall economic climate after the financial
crisis of 2008. Another major reason is that some insurers were losing money in
the LTCI line because they overestimated the lapse rate; that is, policyholders were
holding policies longer than expected. Holm and Tergesen (2010) state that other
insurers have done a better job in estimating lapse rates and pricing coverage, so are
still doing well in the LTCI market.
The recent exit of some leading insurers from the LTCI market is a signal that the
market is undergoing important changes. Looking at the LTCI entry dates of the
insurers that recently exited from the LTCI market, such as Metlife, Fortis, Allianz,
and Lincoln Benefit, we find a number of firms that were relative latecomers to
LTCI, entering in the late 1980s or early 1990s. As the LTCI market matures, analysis
and testing of the characteristics of survivors versus those exiting the LTCI markets
may provide a promising area for future research. As new data become available,
investigations of the differences in insurer performance after the financial crisis and
of lapse rates across firms should be of particular interest in understanding the LTCI
market.
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