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Effects of Corporate Diversification On Firm Performance Evidence From The Serbian Insurance Industry
Effects of Corporate Diversification On Firm Performance Evidence From The Serbian Insurance Industry
To cite this article: Ranka Krivokapic, Vladimir Njegomir & Dragan Stojic (2017)
Effects of corporate diversification on firm performance: evidence from the Serbian
insurance industry, Economic Research-Ekonomska Istraživanja, 30:1, 1224-1236, DOI:
10.1080/1331677X.2017.1340175
OPEN ACCESS
The aim of this paper is to provide empirical evidence on the relation Received 14 February 2016
between line-of-business diversification and performance for the Accepted 16 August 2016
insurance companies that operated in the republic of Serbia in KEYWORDS
the period 2004–2014. The research results show that the relation Insurance; diversification;
between risk-adjusted returns measured both by return on assets and conglomeration;
return on equity and line-of-business diversification and performance performance
measured by entropy is significant and positive, which means that
diversified insurers outperform undiversified insurers. These results JEL CLASSIFICATIONS
could be useful in decision making for insurance companies as they G22; L25; O50
suggest the need for diversification (specialisation), growth in size,
capitalization and affiliation (grouping).
1. Introduction
The development of insurance as a key form of risk financing in Serbia is influenced by
the general economic development. Before the Second World War the insurance industry
was underdeveloped and dominated by foreign insurers. After the Second World War it
developed in a socialist economic environment where ‘private insurance was neither much
needed nor purchased’ (Dorfman, 2008, p. 76). During the transition period, which started
in the 1990s, privatisation incentivised the development of risk management and the growth
of demand for insurance. ‘The pace of growth and subsequent possibility for profit genera-
tion, the need for servicing their multinational customers and geographical risk spreading
have attracted foreign insurers to Serbian life and non-life insurance markets’ (Njegomir
& Stojic, 2010b).
According to 2014 data, the non-life insurance premium amounted to U.S.$87 per capita
while the life insurance premium per capita amounted to merely U.S.$24 (Sigma 4, 2015). As
the share of life insurance in total insurance premiums is only around 20% in Serbia, we have
decided to analyse the total insurance premium as an adequate representative of insurance
companies’ activities, though we control for an insurer’s participation in both industries.
Theory suggests that diversification is associated with both costs and benefits. If there
is sharing in the production process, which is associated with concentration, costs for
joint production will be lower than the sum of the costs for producing each product sep-
arately (Teece, 1980). The diversification benefit can stem from efficient internal govern-
ment mechanisms (Williamson, 1985). Product diversification is analysed in a context of
performance of insurers that focus on either the life–health or property–liability industry,
and insurers that diversify across both industries (e.g., Cummins, Weiss, Xie, & Zi, 2010;
Foong & Idris, 2012; Hardwick & Adams, 2012; Meador, Ryan, & Schellhorn, 2000). There
is still little evidence for the performance effect of diversification or focus within the life or
non-life insurance industry. Line-of-business diversification and the performance relation
of property and liability or non-life insurers is analysed in several studies (see, e.g., Berry-
Stolzle, Liebenberg, Ruhland, & Sommer, 2012; Elango, Ma, & Pope, 2008; Liebenberg &
Sommer, 2008; Pavic & Pervan, 2010). To our knowledge, there is no previous research
and empirical evidence on the performance effect of diversification in the Serbian non-life
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insurance industry.
In response to market deregulation many insurance companies wanted to take advantage
of diversification across, not only life or non-life, but also within the non-life insurance
industry. This is why we are interested in doing empirical research on the effects of business
line diversification within the non-life insurance industry; these effects are still unclear.
Therefore, the aim of this paper is to provide empirical evidence of the impact of line-
of-business diversification of non-life insurance companies on their performance. Following
theory and previous empirical research we test two hypotheses: the conglomeration hypoth-
esis, which emphasises the benefits associated with diversification with a positive impact on
performance, and the strategic focus hypothesis, which emphasises the costs of diversification
with a negative impact on performance.
The findings of this study will be of particular importance for the management of insur-
ance companies as they define business strategies and diversification plans in the hope of
better positioning themselves in the market. The study results will provide governments with
information necessary to determine policies regarding incentive and disincentive measures
for product diversification, life and non-life diversification, grouping, capitalization, firm
size and competitive policies that will facilitate the performance of insurance companies.
Insurance performance is not only in the interest of insurance companies themselves but
also in the interest of governments, as increased performance can facilitate the achievement
of greater social welfare.
The reminder of this article is organised as follows. The second section reviews the litera-
ture. The third section presents a theoretical framework that encompass the hypotheses and
the explanation of variables used in the research. The fourth section presents the data and
the empirical methodology employed in the analysis. The empirical results are presented
in the fifth section, which is followed by the conclusions.
industries, including insurance and other industries (e.g., Grant, Jammine, & Thomas, 1988;
Santalo & Becerra, 2008; Selcuk, 2015; Servaes, 1996; Volkov & Smith, 2015), while most
of the empirical research studies have focused on specific industries, such as the finance
industry (for a review of studies see Martin and Sayrak (2003)). Research studies that pro-
vide empirical evidence of diversification and conglomeration in the insurance industry
are by Hoyt and Trieschmann (1991), Meador et al. (2000), Berger, Cummins, Weiss, and
Zi (2000), Cummins and Nini (2002), Li and Greenwood (2004), Elango et al. (2008),
Liebenberg and Sommer (2008), McShane and Cox (2009), Cummins et al. (2010), Pavic
and Pervan (2010), and Berry-Stolzle et al. (2012). As our study is primarily focused on the
determination of diversification and strategic focus, and their relationship with insurance
companies’ performance, we will provide a more detailed review of these studies.
Some of the first researchers in the insurance industry who studied strategic focus and
conglomeration hypotheses were Hoyt and Trieschmann (1991). Their study focuses on
a risk–return comparison for life–health, property–liability, and diversified insurers for
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the period 1973–1987. They analyse risk–return relationships using mean-variance and
CAPM (Capital Asset Pricing Model) approaches. The results of the study give evidence
that specialised insurers performed better over the sample period.
Berger et al. (2000) provide evidence on the validity of the conglomeration hypothesis
versus strategic focus hypothesis for financial institutions using data on U.S. insurance
companies. They use profit scope economies, which measure the relative efficiency of joint
versus specialised production, to distinguish between the conglomeration and strategic
focus hypotheses. Their results suggest that the conglomeration hypothesis dominates for
some types of financial services providers and the strategic focus hypothesis dominates for
other types.
Meador et al. (2000) focus on the relationship between a firm’s output choice and meas-
ures of X-efficiency. Using data for the life insurance industry for the period 1990–1995 they
find that diversification across multiple insurance and investment product lines resulted in
greater X-efficiency than a more focused production strategy.
Cummins and Nini (2002) investigate the use of capital by insurers to provide evidence on
whether the capital increase represents a legitimate response to changing market conditions
or a true inefficiency that leads to performance penalties for insurers. Their empirical anal-
ysis includes a regression of performance on capitalization and several controls, including
line-of-business diversification. They find an inverse relation between diversification and
Return on equity.
Li and Greenwood (2004) examine the effect of diversification upon intra-industry per-
formance in the Canadian general insurance industry. Their test of a theoretical model indi-
cates that mutual forbearance provides advantage under specified conditions, that market
structuration also provides advantages, but that diversification per se does not.
Liebenberg and Sommer (2008) examine performance as a function of line-of-business
diversification and other correlates for a sample of property–liability insurers for the period
1995–2004. Their results indicate that undiversified insurers consistently outperform diver-
sified insurers. They find a diversification penalty of at least 1% of return on assets or 2% of
return on equity. They find some additional interesting results. They find that capitalisation
and size are positively related to performance, that insurance groups underperform com-
pared to unaffiliated insurers, and that stock insurers outperform mutual insurers.
ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA 1227
Elango et al. (2008) examine the relationship between product diversification and firms’
performance in the U.S. property–liability insurance industry for the period 1994–2002.
They find that the extent of product diversification shares a complex and nonlinear rela-
tionship with firms’ performance and that performance benefits associated with product
diversification are contingent upon an insurer’s degree of geographic diversification.
McShane and Cox (2009) examine what makes these long-term care insurers different
and whether managers are following a diversification or strategic focus strategy. They find
that strategic focus is a consistently important factor and that managers’ participation and
volume decisions are made independently.
Cummins et al. (2010) examine economies of scope in the U.S. insurance industry over
the period 1993–2006. They analyse whether it is advantageous for insurers to offer both
life–health and property–liability insurance or to specialise in one major industry segment.
They find that property–liability insurers realise cost scope economies, but they are more
than offset by revenue scope diseconomies. On the other hand, they find that life–health
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insurers realise both cost and revenue scope diseconomies and conclude that strategic focus
is superior to conglomeration in the insurance industry.
Pavic and Pervan (2010) examine the performance effect of diversification in the Croatian
non-life insurance industry for the period 2004–2007. Their results indicate that both meas-
ures of diversification have a negative and statistically significant influence on profitability.
Berry-Stolzle et al. (2012) examine variations in line-of-business diversification status and
extent among property–liability insurers for the period 1996–2006. Their results show that
the extent of diversification is not driven by risk pooling considerations; insurers operating
in more volatile business lines do not diversify more. Using a measure of unrelated line-of-
business diversification they find support for the diversification prediction of the managerial
discretion hypothesis, that mutual insurers should be less diversified than stock insurers.
While mutual insurers tend to exhibit higher levels of total diversification, they engage in
significantly less unrelated diversification than do stock insurers.
Although the results of most studies of the strategic focus hypothesis versus the con-
glomeration focus hypotheses in the insurance industry shows results that are in favour of
the strategic focus hypothesis, there is still a lack of consistency at the international level.
This, together with the lack of similar studies for the Serbian non-life insurance industry,
served us as a motivator for an analysis of the topic.
diversification also provide risk reduction economies of scope, larger internal capital markets,
and greater market power (see, e.g., Besanko, Dranove, Shanley, & Schaefer, 2007; Cummins
& Danzon, 1997; Cummins, Phillips, & Smith, 2001; Cummins & Trainar, 2009; Montgomery,
1994; Stein, 1997). Scope economies can stem from the situation where firms may possess
specific resources that can be utilised in diversified product markets (Penrose, 1995).
The product specialisation strategy suggests that specialised insurers may perform better
than diversified ones. Product-specialised insurers can benefit from managers who can
develop expertise for a few lines of insurance rather than many lines of insurance, and can
achieve cost savings through fewer costs of hiring and training of actuaries, underwrit-
ers, and claim adjusters (Chen et al., 2007). As demonstrated in many empirical studies,
diversified insurers are outperformed by diversified insurers (see, e.g., Cummins & Nini,
2002; Hoyt & Trieschmann, 1991; Liebenberg & Sommer, 2008; Pavic & Pervan, 2010).
Diversification may increase agency costs (Aron, 1988; Harris, Kriebel, & Raviv, 1982;
Rotemberg & Saloner, 1994) and lead to inefficient allocation of capital among divisions of
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Dependent variable
As measures of financial performance we use return on assets (ROA) and return on equity
(ROE). The use of ROA and/or ROE as proxies for measurements of an insurer’s financial
performance are most common in the literature (e.g., Amit & Livant, 1988; Hill, Hitt, &
Hoskisson, 1992; Lai & Limpaphayom, 2003; Mayer & Whittington, 2003; Pottier & Sommer,
1999; Wang, Jeng, & Peng, 2007). In line with Liebenberg and Sommer (2008) we perform
an empirical analysis on both performance measures. In order to incorporate the effects of
risk on returns, we observe risk-adjusted returns (RAROA, RAROE) by dividing the ROA
(ROE) by the standard deviation of observed returns on assets (equity), respectively, over
the previous five years.
Explanatory variables
Following the literature (see, e.g., Elango et al., 2008; Liebenberg & Sommer, 2008; Pavic
& Pervan, 2010), for explanatory variables we use: product diversification within non-life
ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA 1229
(i.e., exclusively focused company), the coefficient of entropy will take the value zero
(E = 0). The maximum value that the entropy measure can take in a situation where a com-
pany has the same shares in all lines, is calculated as the natural logarithm of the number
of insurance lines in the industry, ln(IL).
Firm size is found in previous studies (e.g., Cummins & Nini, 2002; Elango et al., 2008;
Liebenberg & Sommer, 2008) to have a positive impact on the performance of insurance
companies. Following the literature, we measure firm size as the natural logarithm of total
assets. We expect that firm size is positively related to insurers’ performance. We measure
the firm size (SIZE) by the natural logarithm of a firm’s total assets.
Well-capitalised insurers are considered to be safer by solvency regulators and rating
agencies. Those insured are willing to pay a higher premium to insurers who are less likely
to become insolvent (Sommer, 1996). Firm capitalisation is measured as the capital-to-asset
ratio of the company (CAPITALISATION). We expect that firm capitalisation is positively
related to insurers’ performance.
The structure–conduct–performance paradigm implies that market performance is deter-
mined by market conduct, which in turn directly and indirectly depends on market struc-
ture. ‘According to S-C-P hypothesis, higher profitability in any market is associated with
anticompetitive behaviour induced by higher market concentration’ (Njegomir & Stojic,
2010a). The support for the S–C–P hypothesis is abundant (e.g., Bajtelsmit & Bouzouita,
1998; Chidambaran, Pugel, & Saunders, 1997; Njegomir & Stojic, 2011; Pope & Ma, 2008).
To capture the impact of the competitiveness of firms’ markets on performance, we first
calculate a Herfindahl-Hirschman concentration index for each line of business (j = 1 to
IL) across all firms (i = 1 to n) in each year t
n
( )2
∑ DPWijt
HHIjt =
i=1
DPWjt
The larger the value of HHIjt, the more concentrated is that line of business and ‘the greater
is the potential for super-normal profits’ (Liebenberg & Sommer, 2008). We then calculate
each firm’s (i = 1 to n) participation in each line of business (j = 1 to IL) for each year t
DPWijt
wijt =
DPWit
1230 R. KRIVOKAPIC ET AL.
Using wijt as weights we then calculate the weighted sum of a firm’s exposure to industry
concentration across all of the lines in which it operates
23
∑
WCONCit = wijt HHIjt
j=1
Firms with small values for WCONC are exposed to competitive business lines. We expect
WCONC to be positively related to performance.
Our study is primarily focused on the investigation of product diversification within the
non-life insurance industry and insurers’ performance. However, many insurance compa-
nies write life insurance in addition to non-life insurance. Therefore, following Liebenberg
and Sommer (2008), we control for an insurer’s participation in both industries by includ-
ing a variable equal to the percentage of total premiums (non-life plus life) attributable
to operations in the life insurance industry (PCTL). As this variable may indicate greater
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the ROA (ROE), company size, capitalisation, share of life premiums, specific line market
concentration, and three dummy variables: GROUP, PUBLIC, and FOREIGN.
The ROA (ROE) show no trend, hence both the F-test and the Welch test are acceptable
for measuring individual and time effects. Both tests suggest we accept the alternative
hypothesis that claims the existence of individual effects, as shown in Table 2(a) and (b).
We use the same test for testing time effects, that is, heterogeneity of the observed variable
in time. The general equation to be estimated using pooled least squares is
yit = 𝛼i + 𝛾t 𝐱𝐢𝐭 𝛽 + uit
where yit is a scalar dependent variable, i.e., the company’s ROA (ROE), xit is a K × 1 vec-
tor of independent variables, uit is a scalar disturbance term, i indexes the company in a
cross-section, and t indexes time, measured in years.
We further analyse whether the observed individual and time effects in the model should
be specified as fixed or stochastic. We first estimate the model with stochastic effects, in
order to apply the Hausman test for correlated random effects in Table 3.
There is strong evidence in support of hypothesis H1 that the individual random effect
model is not appropriate, therefore we adopt a model with country-specific and time-fixed
effects.
All variables were tested for unit root using the Breitung (1999) test since both the LL
test and the IPS test (Im, Pesaran & Shin, 2003) require n → ∞ and T → ∞ in the way that
1232 R. KRIVOKAPIC ET AL.
N/T → 0. The variable SIZE is found to have a unit root in levels, but not in first differences,
hence it is introduced in the model in the first differences, and is observed as the change
in total assets for each company.
nal results and interpretations concerning the model observed. The results consist of both
dependent variables, RAROE and RAROA, and the estimated coefficients are presented in
Table 4.
The preliminary results are in favour of the conglomeration hypothesis. Namely, the
companies’ returns measured both by RAROE and RAROA are positively correlated with the
entropy, hence diversification is positively related to performance change in gross written
premium per capita. This result is consistent with previous studies focused on developed
insurance markets (e.g., Meador et al., 2000).
The size of the insurer significantly affects both returns on assets and returns on equity.
Growth in total assets has a positive impact on returns at a 1% level. This result is in line
with most of the insurance literature (e.g., Liebenberg and Sommer (2008).
The weighted sum of a firm’s exposure to industry concentration across all of the lines
in which it operates has a positive and significant effect at a 5% level on companies’ perfor-
mance. (Liebenberg & Sommer, 2008).
The time effects are captured through individual year dummies, and all of the signifi-
cant variables are negatively correlated to returns. The table of company-specific effects is
available upon request.
Regarding other explanatory variables, we find that the share of life insurance premiums
within the total premiums does not affect the returns. The possible explanation lies in the fact
that we are observing all insurance companies, hence life insurance is just one of the lines
offered and as such does not have a significant influence on the total return. Also, dummy
variables, which are used to test whether affiliates, publicly traded companies, and domestic
companies generate different returns when compared to companies that are not groups, are
not publicly traded, or are in foreign ownership, are found to be insignificant at all levels.
It is also interesting to see how the results correspond to individual companies, namely
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whether the size measured by the total premium collected affects the entropy and the
profitability. We ran correlation tests for all companies as well as for the top five for each
year observed.
The correlation coefficient between the size and the diversification ranges between 0.5
and 0.7 for all years and all companies. However, when we split the sample into two cate-
gories and observe only the top five insurers (which cover up to 75% of total premiums)2
the correlation turns negative (at around −0.2 for all years). The seemingly odd results may
be explained by either a small number of observation, or due to the internal management
of specific companies.
6. Conclusions
The main objective of this article is to examine whether product diversification promotes
the economic performance of insurance companies in Serbia. Additionally, we examined
how firm size, industry concentration, capitalization, diversification across business lines,
ownership structure, group membership, and public trading affects insurance companies’
performance. Our sample covers the period 2004–2014. The model observed focuses on
the effects of diversification measured by a company’s entropy on risk-adjusted returns.
Our results are consistent with previous studies focused on developed countries. The
insignificant impact of dummy variables signal urgent action towards the implementation
of government measures in order to further develop the insurance industry as well as other
industries dealing with financial services. The findings are important for Serbian policy mak-
ers as its economy is in desperate need of financial resources that would propel economic
growth, which has been burdened by the limited available capital stocks and foreign debt.
The findings of this study will be of particular importance for the management of insur-
ance companies, as they formulate business strategies and diversification plans in the hope
of better positioning themselves in the marketplace. The study results provide governments
with the information necessary to determine policies regarding incentive and disincentive
measures for product diversification, life and non-life diversification, grouping, capital-
ization, firm size, and competitive policies that will facilitate the performance of insur-
ance companies. Insurance performance is not only in the interest of insurance companies
1234 R. KRIVOKAPIC ET AL.
themselves but also in the interest of governments, as increased performance can facilitate
the achievement of greater social welfare.
A possible limitation of the research results could be the insignificance of most of the
control variables appearing in models. Additionally, research related to the costs associ-
ated with both geographic and product diversification would aid management in devising
cost-effective strategies that will facilitate higher firm performance. Further research should
involve the testing of alternative hypothesis, namely geographic diversification, in pursue of
higher significance levels for the explanatory variables. In addition, further research should
include a greater number of countries to help the gaining of more consistent cross-country
estimators.
Notes
1.
The following companies are included in the research: AMS, AS, AXA nonlife, AXA life,
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Basler nonlife, Basler life, DDOR, Delta, Dunav, Energoprojekt, Globos, Grawe, Metlife,
Merkur, Milenijum, Sava nonlife, Sava life, Societe Generale, Takovo, Triglav, Uniqa nonlife,
Uniqa life, and Wiener
2.
The top five companies are unchanged: Dunav, Delta, DDOR, Wiener, and Uniqa nonlife.
Disclosure statement
No potential conflict of interest was reported by the authors.
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