An Economic Analysis of Life Insurance Company Expenses

An Economic Analysis of Life Insurance Company Expenses

By

Dan Segal

Leonard N. Stern School of Business

New York University

40W. 4th St.

NYC, NY 10012

(212) 998 0036

E-mail: dsegal@mgmt.utoronto.ca

This report has been submitted to the North American Actuarial Journal

for publication consideration

August 2000

An Economic Analysis of Life Insurance Company Expenses

Summary of Results

This paper estimates the acquisitionand maintenance costs associated with life policies as

a function of the amount of insurance and number of policies of an insurer by estimating a cost

function for our sample of insurers. Our sample consists of firms that responded to a survey

requesting information regarding the number of employees and agents employed by the firm

from 1995 to 1998. We excluded very small firms from the analysis. The final sample consists of

448 firm-year observations. The overall costs associated with life policies, that is, acquisition and

maintenance costs, are computed as the marginal cost of the cost function, which represent the

present value of total costs.

We examine several statistical characteristics of these costs - at the mean and at the

median of the sample, and for different company sizes. The data indicate that there is a large

variation among life insurance companies and that the costs associated with life policies of the

largest insurers are much higher than the corresonding costs of other firms. Comparing the costs

between firms that use branches as their main distribution system (henceforth referred to as

"branch firms") and firms that use other marketing systems ("non-branch firms") reveal that the

costs of branch firms are generally higher.

Given the estimated marginal costs, we illustrate an "Expense Table" using the

following assumptions: (1) the ratio of acquisition (maintenance) expenses to total costs is

69.37% (30.63%), (2) the average duration of whole (term) life policy is 14 (11) years, and (3)

the discount rate is 10%. The Expense Table is constructed separately for branch firms and non-

branch firms.

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An Economic Analysis of Life Insurance Company Expenses

Expense Table- Illustration

First Year Charges ($) per Policy and Amount of Insurance for Branch and Non-Branch

Firms

Branch Firms Non-Branch Firms

Whole Term Whole Term

Policy 149.00 149.00 158.00 158.00

Amount (000) 9.40 2.60 6.70 1.00

Maintenance Charges ($) per Policy and Amount of Insurance for Branch and Non-Branch

Firms

Branch Firms Non-Branch Firms

Whole Term Whole Term

Policy 9.30 10.70 9.80 11.40

Amount (000) 0.58 0.19 0.41 0.07

I - Methodology

The purpose of this study is to develop a methodology that can be used to construct life

insurance industry benchmark expense factors. To do so, an illustrative Expense Table ("the

Expense Table") is constructed based on reported expense experience for U.S. insurers during

1995-98. The costs reflected are all operating expenses of the life insurance line of business

except commissions and taxes.

When estimating the costs associated with life insurance policies, one needs to take into

account the multi-product nature of the life insurance industry. Broadly, the products of life

insurance companies can be classified into three lines of business: life insurance, annuities and

other accumulation products, and Accident & Health (A&H). As these product types are

different in nature, so too are the costs associated with each of them. The National Association of

Insurance Commissioners (NAIC) Annual Statement shows both the total costs associated with

the entire operation of the insurer and the costs associated with each line of business. However,

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An Economic Analysis of Life Insurance Company Expenses

the allocation of the total costs across lines of business crucially depends upon the allocation

method used by each insurer. Since insurers may employ different cost allocation methods, each

of which may provide different allocations of the same costs, relying on the allocations made by

the companies may provide distorted results as