Cost stickiness and the firm’s organizational form: evidence from the property-liability insurance sector

The current market environment emphasizes the importance of cost management in the insurance sector. In particular, the low interest environment erodes investment income and the digital transformation requires enormous resources, putting pressure on insurance firms’ profitability. Hence, to ensure sufficient funds for current challenges, cost management is an essential determinant of success in the insurance sector. This also holds for cost cutting measures in volatile times, that is, if activity levels decrease, costs should decrease accordingly in order to maintain profitability. However, previous research from other industries shows that the decrease in costs is smaller for decreasing than the increase in costs for increasing activity levels for a given amount of change (Anderson et al. 2003; Guenther et al. 2014). This asymmetric effect is called ‘cost stickiness’. The behavior of costs for differing levels of activity has to be closely analyzed, as non-consideration of cost stickiness deteriorates planning and may lead to suboptimal decisions (Anderson et al. 2003).

In this research, we examine the existence of cost stickiness in the German property-liability insurance sector. We analyze if the magnitude of an increase in administrative costs associated with an increase in levels of activity is greater than the magnitude of a decrease in administrative costs associated with an equivalent decrease in levels of activity (Anderson et al. 2003). In particular, we follow related papers (e.g. Anderson et al. 2003, Balakrishnan et al. 2004) and test for sticky cost behavior by estimating an empirical model that relates changes in the insurance firms’ administrative costs to contemporaneous changes in their premium income, thereby analyzing if the percentage increase in administrative costs for a rise in premiums is larger than the percentage decrease in administrative costs for an equivalent drop in premiums.

In addition, previous papers indicate that the degree to which cost stickiness occurs depends on the firms’ corporate governance structure and agency-related reasons (Chen et al. 2012, Calleja et al. 2006). While some costs are sticky by nature and cannot be affected by managers (such as long-term purchase contracts), there are agency-related reasons why costs are not reduced in times of decreasing activity levels (Guenther et al. 2014; Chen et al. 2012). Based on the agency theory, managers are self-interested and therefore make decisions to maximize their own utility. For example, managers might try to avoid a loss of status when their division is downsized or refrain from dismissing familiar employees (Guenther et al. 2014). Such agency-related cost stickiness might be mitigated by adequate corporate governance mechanisms, if managers are properly monitored. The insurance industry offers a unique setting for an analysis on the role of corporate governance on cost stickiness, as the industry comprises, apart from stock insurance firms, mutual insurance companies.¹ In these organizations, policyholders are the owners of the firms. In contrast to stock insurance firms, where stockholders want to maximize their own profits, mutual insurance firms aim to provide insurance coverage for their members, hence mitigating customer-owner conflicts. This benefit, however is offset by less effective control of the owner–manager conflict (Mayers and Smith 2013). While the stock ownership form provides more effective mechanisms due to their alienable ownership claims (providing, e.g. the possibility of proxy fights or hostile takeovers), the control mechanisms for mutual firms are much weaker (Cummins et al. 1999). This makes it more difficult to mitigate agency-related reasons for cost stickiness. Moreover, as stock insurance firms are strictly profit-oriented, manager’s compensation in stock companies is closely linked to corporate performance, hence incentivizing them to reduce costs in order to meet profitability targets (Dierynck et al. 2012). Therefore, we expect that the degree of cost stickiness will be more pronounced in mutual insurance firms relative to stock insurance firms.

Our research builds on various studies that analyze the stickiness of costs and the determinants of this cost behavior for firms from the industrial or non-financial service sector (e.g. Anderson et al. 2003; Balakrishnan et al. 2004). However, sticky cost behavior varies between industries due to differences in production, operational, and economic environments (Subramaniam and Watson 2016). For example, compared to industrial firms, insurance firms’ show higher proportions of labor costs, but much lower proportions of costs of material and supplies with respect to their overall costs. As labor costs are relatively inflexible in the short run, insurance firm’s cost behavior might strongly differ from industrial firms. Moreover, Germany has very strict labor market rules, making it more difficult to adjust a firm’s staff in times of decreasing levels of activity. Hence, the results from previous studies from other industries and countries are not directly applicable for the German insurance industry. Moreover, we build on related studies which examine the differences between stock and mutual insurance companies, e.g. regarding their efficiency (Cummins et al. 1999) and product focus (Lamm-Tennant and Starks 1993), but have not analyzed the impact of insurance firms’ organizational form on their cost behavior. We fill this gap by providing evidence on the role of insurance firm’s organizational form with respect to the degree to which their administrative costs are sticky.

For our analysis, we use company level data from German property-liability insurance firms for the years 2001–2017. Our sample contains 1426 firm year observations for 109 insurance firms. Using regression analyses, our results indicate that administrative costs are sticky in the German insurance industry: We show that administrative costs increase on average 0.82% per 1% increase in premiums but decrease only 0.6% per 1% decrease in premium income. This is consistent with the findings of related studies for other industries (Anderson et al. 2003). Moreover, our results indicate that cost stickiness is more pronounced in mutual insurance firms, consistent with theory that predicts that mutual insurance firms have weaker control mechanisms than stock insurers and therefore lower means to reduce agency problems within their organizations. Our results are robust to the inclusion of different company-level factors which might explain insurance firms’ cost behavior.

We contribute to the literature by providing an analysis of cost stickiness in the insurance sector, hence extending the existing literature which is mostly focused on firms from the industrial or non-financial service sector (e.g. Anderson et al. 2003; Chen et al. 2013). Moreover, we provide evidence that a firm’s organizational form is an important determinant of the degree of cost stickiness. We show that costs are more sticky in mutual insurance companies, hence extending the existing literature on the effect of corporate governance on cost behavior (e.g. Calleja et al. 2006) and on the differences between stock and mutual insurance companies (e.g. Cummins et al. 1999). Our results are particularly relevant for managers of insurance firms, as the current market environment strongly emphasizes the importance of cost management. As investment income erodes in the current low interest environment and the digital transformation puts pressure on firms to become more cost efficient, knowledge on the cost behavior for different levels of activity is highly valuable. Moreover, imprecise information on cost behavior leads to wrong planning and suboptimal decisions (Anderson et al. 2003), hence knowledge on the degree of cost stickiness can help to improve the performance of insurance firms.

The remainder of this paper is organized as follows: The next section provides the Literature Review and Hypotheses Development. This is followed by the Data and Methodology sections, respectively. The Results appear in the succeeding section, and the Conclusion follows.

We start our analysis by providing an examination on the development of insurers’ average premium income (measured by GWP) and administrative costs for property-liability insurers during our sample period (2001–2017) in Fig. 1. Table 1 provides detailed information for both measures in each year. Fig. 1 indicates that both average administrative costs and premium income increased during our observation period. In general, both measures show similar developments. For example, in 2010, cost changed by −2.5% while premiums changed by −2.4%. In other years, however, both measures developed differently from each other. For example, in 2016, premiums increased by 0.5% while costs decreased by 2.2%. Such heterogeneous development indicates that costs do not necessarily change proportionally, hence indicating the need for a more pronounced analysis of the cost behavior of German property-liability insurers.

Cost management, and in particular the behavior of costs, is an important issue for virtually every firm.² Traditionally, cost functions have been considered as linear functions, including fixed and variable costs (Guenther et al. 2014). While fixed costs are mostly inflexible on the short run, variable costs are considered as flexible and change proportionately with respect to changes in the level of activity (Noreen 1991; Anderson et al. 2003). This implies that the magnitude of cost changes should be independent from the direction of activity changes (decrease or increase). However, previous research (e.g. Anderson et al. 2003; Balakrishnan et al. 2004; Subramaniam and Watson 2016) shows that the decrease in costs is smaller for decreasing than the increase in costs for increasing activity levels for a given amount of change (Guenther et al. 2014). This asymmetric effect is called ‘cost stickiness’.

Previous literature discussed a variety of reasons for the existence of cost stickiness (Guenther et al. 2014; Anderson et al. 2003):

Previous research provides evidence for the existence of cost stickiness in various industries. For example, Anderson et al. (2003) show that the percentage increase in costs for an increase in sales revenue is larger than the percentage decrease in costs for an equivalent decrease in sales revenue for a large set of industrial firms. Balakrishnan et al. (2004) confirm these findings for physical therapy clinics in the US. However, sticky cost behavior might be strongly pronounced in some industries, but less pronounced in others due to differences in production, operational, and economic environments (Subramaniam and Watson 2016). Hence, the results from other industries might not hold for firms from other sectors, such as the insurance sector.

Insurance business strongly differs from the business of industrial firms.³ Instead of tangible goods, insurance firms produce risk protection for individuals and companies and compensating them in the case of insured losses. Hence, insurers do not require machines and inventories, but strongly rely on the capabilities of their employees, while the asset side of the balance sheet mostly consists of financial assets. This affects the cost behavior of insurers, leading to significant differences when compared to industrial firms.

Insurers mostly generate their revenue from premium and interest payments, while expenses mostly consist of claim payments, distribution and administrative expenses. Though insurance firm’s expense structure is usually dominated by claim payments, administrative expenses are still a relevant success factor in the insurance industry. This holds particularly in the current market environment that is dominated by the ongoing process of digitalization and the persistent low interest rates. Both trends increase the pressure on insurance firms to reduce their administrative costs in order to have the financial capacity to finance the digital transformation and to counteract lower investment income.

Against this background, we add to the literature an analysis on cost stickiness in the insurance sector and formulate the following hypothesis:

Moreover, recent research emphasized the role of corporate governance and agency-related reasons for the existence of sticky cost behavior. While some costs are sticky by nature and cannot be affected by managers (such as long-term purchase contracts), most variable costs can be reduced in times of decreasing activity levels, depending on the managers’ preferences. However, agency theory posits that managers are self interested and aim to maximize their own utility. Hence, they might refrain from downsizing their departments or dismissing familiar employees (Guenther et al. 2014). Chen et al. (2013) show that cost stickiness increases in the degree of managerial overconfidence. Such managerial-related cost-stickiness might be mitigated by adequate corporate governance mechanisms, if managers are properly monitored. Calleja et al. (2006) state that differences in firms’ cost stickiness are attributable to differences in systems of corporate governance and managerial oversight.

While information on the characteristics of internal governance systems are usually not publicly available, the insurance sector offers a unique setting for an analysis, as it mainly comprises two organizational forms with different governance mechanisms, which strongly affects the degree to which principal-agent problems arise and how they are mitigated: Stock insurance firms and mutual insurance firms.⁴ In stock insurance firms, a complete separation of the manager, owner, and customer functions exists. In mutual insurance firms, the policyholders are both customers and owners of the firm. This mitigates customer-owner conflicts, as mutual insurers rather focus on providing coverage for the policyholders than to maximize profits.

This benefit, however, is offset by less effective control of the owner–manager conflict. Agency theory states that, due to the separation of the manager and owner functions, managers do not bear the full wealth effects of their actions. This leads to an incentive problem, as their interests are usually not aligned with the interests of their owners (Mayers and Smith 2013), and thus to the occurrence of agency-related costs. As the manager and owner functions are strictly separated in stock companies, their managers are closely monitored, for example by institutional investors and other large stockholders. Because they have alienable ownership claims, opportunistic behavior by managers can be reduced by, e.g., the possibility of proxy fights or hostile takeovers (Cummins et al. 1999). The control mechanisms available to mutual owners are much weaker, as ownership claims are not alienable, and therefore managers in mutual insurance are usually not monitored by third parties. Moreover, as stock insurance firms are more profit-oriented, manager’s compensation in stock companies is closely linked to corporate performance, hence incentivizing them to reduce costs in order to meet profitability targets (Dierynck et al. 2012).

Hence, the costs of managerial opportunism are higher in mutual insurance companies when compared to stock insurers. The “expense preference hypothesis” states that managers generate costs that are unnecessary due to the consumption of perquisites. Accordingly, mutual insurers are less successful in minimizing costs than stock insurers because of the different monitoring and incentive structures of their organizational form (Cummins et al. 1999). This in turn leads to a higher degree of cost stickiness of mutual insurers relative to stock insurers. We therefore formulate the following hypothesis:

We analyze the existence of cost stickiness in the German property-liability insurance sector, by analyzing if the magnitude of the increase in administrative costs associated with an increase in levels of activity is greater than the magnitude of the decrease in administrative costs associated with an equivalent decrease in levels of activity. Moreover, we examine if the insurers’ organizational form affects the degree to which cost stickiness occurs by analyzing differences in the cost behavior of stock and mutual insurance companies.

Using a dataset of 1426 firm year observations of German property-liability insurance firms for the years 2001–2017, we find that administrative costs increase on average 0.82% per 1% increase in premiums but decrease only 0.6% per 1% decrease in premium income. This provides empirical evidence for the existence of cost stickiness in the German insurance sector. Moreover, our results indicate that cost stickiness is more pronounced in mutual insurance firms, consistent with theory that predicts that mutual insurance firms have weaker control mechanisms than stock insurers and therefore lower means to reduce agency problems within their organizations.

We contribute to the existing literature by providing an analysis of cost stickiness for the insurance industry. Because the current market environment emphasizes the importance of cost management in the insurance sector, our research provides important finding for managers, investors and regulators of insurance firms. Furthermore, the suitability of standard cost accounting tools has to be questioned, and possibilities to adjust them given the existence of sticky cost behavior have to be discussed (Banker et al. 2011). In addition, we show that the degree of cost stickiness differs between stock and mutual insurance firms, as the cost behavior of the latter show higher levels of cost stickiness. This provides an important contribution to the literature that examines differences between mutual and stock insurance companies.

While our study is the first to analyze the existence and determinants of cost stickiness in the insurance sector and on the impact of the firm’s organizational form on the degree of cost stickiness, it leaves room for additional research. In particular, the use of more sophisticated econometric design might further corroborate the results of our analyses. For example, as cost stickiness might not be linear, depending on various conditions, more advanced research approaches such as the use of structural equation models might explain more complex structures for cost stickiness (Guenther et al. 2014). Moreover, our study focuses on the behavior of total administrative costs. Future research might provide information about the components of sticky costs and analyze a finer disaggregation of the administrative costs (Anderson et al. 2003; Guenther et al. 2014). In addition, while our research indicates the existence of cost stickiness in the German property-liability insurance sector, it is an open question if these results are also applicable in the life/health insurance sector or in the insurance markets in other countries. Finally, as cost management is particularly relevant in times of economic downturn, a closer examination of the period of the financial crisis of 2007–2009 or the most recent corona crisis in 2020 might complement our analyses.

Our study does suffer from data limitations. While we expect that the degree of cost stickiness will be heterogeneous across the insurance industry, as insurance firms with quickly scalable business models (such as direct/online insurers that focus on a single line of business) might show lower levels of cost stickiness when compared to insurance firms with more complex business models (such as industrial insurers that strongly depend on brokers, therefore needing to adapt their distribution support in case of changes in their level of activity), detailed information on the insurer’s business model is unfortunately not available in our dataset. Hence the impact of different business models on the degree of cost stickiness can only be analyzed rudimentarily. Moreover, our analyses include several firm level factors that explain the degree of cost stickiness. However, other factors that could affect insurance firms’ cost behavior, such as the quality of the firms’ internal accounting systems and governance, would provide useful information, but are not available for all firms in our dataset. As insurers’ costs are strongly determined by staff costs (in particular, salaries), a respective measure would be particularly relevant.⁸ Moreover, our study is not able to evaluate the role of managerial decision making and their motives due to the absence of the respective information. Developing a greater understanding of the managerial decision-making processes would greatly improve the understanding of cost stickiness (Anderson et al. 2003).