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Coase (1937) in his paper on ‘the nature of the firm’ explained that the boundaries of organizations depend not only on the production technology but also on the cost of transacting business. He saw the decision to organize transactions within the firm as opposed to on the open market as an attempt to reduce the cost of the exchange. The open market mechanism entails certain transaction costs: costs of negotiating contracts, monitoring performance, discovering prices and getting to know trading partners (Obinska-Wajda, (2015) citing Parada, 2002 and OECD, 1993). Within the firm, the entrepreneur can reduce these ‘transaction costs’ by internal coordination of these activities. However, even when internally coordinated, every mode of economic organization incurs costs. For instance, internal coordination of transactions comes with other forms of costs, such as the problem of information flow, incentives, monitoring, and performance evaluation.

Coase observed that the internal coordination of transactions is not governed by price mechanism but rather, by entrepreneurial coordination, which is different from profit maximization through the price mechanism. In line with the internal coordination of transaction, which ensures conditions of a competitive market for factors of production, Coase asked why there are any market transactions if the

organization can reduce the cost (Coase, 1937). He maintained that since entrepreneurs can reduce transaction costs by coordinating activities related to contractual commitment internally, it is worth applying the same measure on a larger scale. Transaction cost theory then is concerned with the study of the transactions costs involved in the concentration and dilution of property rights, and the optimal design of organizational interfaces between market and hierarchy. It includes the costs of running the economic system.

According to Coase, as the firm’s internal transaction costs increases, the entrepreneur fails to make the best use of the factors of production and incurs additional transaction costs. He argued that the introduction of institutions to coordinate this transaction on a larger scale is the logical answer to the problem of transaction costs (Obinska-Wajda, 2015 citing Coase, 1937). Williamson added to Coase three ideas that indicate when business functions should be organized within the firm either by buying out the partner or by in-sourcing the function and not working with a market-partner: they include. (i) When transaction costs, using the market, are high because of information asymmetry and where internal management of information is cheaper; (ii) where opportunistic behaviour can become strong due to asymmetric information and can be prevented by internal coordination; (iii) and where investments (into assets) are specific to another market participant (Williamson, 2000). The nature of the firm, then, is determined by the relative costs of organizing transactions under alternative institutional arrangements through outsourcing and insourcing of business functions.

In application to the insurance sector in a less-developed economy characterized by uncertainties, information asymmetries, and trust issues, it will prove to be pivotal to introduce an institutional arrangement that will decrease the transaction costs of insurance. It is amongst the central hypothesis of this thesis, a hypothesis that will be tested in the analytical section of the thesis, that a conducive institutional arrangement will also be able to ensure the enlargement of the risk pool through the inclusion of the poor at a cheaper policy premium. This, in turn, increases the welfare of the poor and leads to overall economic growth.

78 3.6.3 Agency theory

The agency theory is concerned with the delegation problem that arises between the principal and the agent in economic exchange. It explains the relationship between principals and agents or buyers and supplier as it has to do with delegation and performance of tasks. (Obinska-Wajda, 2015 citing Eisenhardt, 1989). The theory begins with Berle and Mean’s (1932) identification of the ‘separation of ownership and control’ in the large firm. According to Geraldi (2007), the salary managers are the controllers of the firm because:

The principal (owners) has less information than the salary workers (agents) concerning how to accomplish the task, which leads to the hidden information problem. The principal cannot observe the negotiations, intentions, and activities of the agent – leading to an action problem.

Agents and principal tend to have a conflict of interest, as both strive for this individual maximum gain. (Geraldi, 2007 citing Berle and Mean 1932).

The manager may use his discretion to maximize his profit from this hidden information and action at the expense of the principal’s value. This shirking of responsibility by the agent is a form of behaviour that, if incentivised by the institutional arrangement, results in moral hazard. It includes all behaviours of the agent that are not in conformity with the contract or agreement entered with the principal. For example, when an insurance firm fails to promptly indemnify a client who experienced losses. Hence, to control the actions of the agent, the principal incurs agent cost by employing all the needed mechanisms to reduce the moral hazard on the part of the agent. These mechanisms usually include outcome-oriented contracts, incentive programmes, and information reporting and controlling systems.

(Geraldi, 2007).

With the use of outcome-oriented outcome and incentive programmes, the agent would not want to act against the principal’s interest even when there is an opportunity to do so because it will not match the principal’s expected outcome. The agent is also disincentivised from aberrant activities with the application of monitoring mechanism by the principal. The application of information system mechanism helps to curb the adverse selection that can happen as a result of the

principal’s inability to verify the agent’s claim. It helps the principal to make an informed decision and not depend on the words of the agent who is inclined to maximize personal benefit even at the expense of the principal.

Jensen and Meckling (1976) classified the agency costs that ensure that the principal and agent relationship is mutual into three types. They include the principal’s costs, the agent’s costs, and the alternative costs. The principal’s costs involve the costs of the mechanisms employed to monitor the agent’s actions. The costs incurred by the agent to win the trust of the principal or ensure that the principal is compensated in the case of failure to deliver on the target objective is called the agent’s costs. The third type of costs covers the costs incurred by the principal because of the agent’s failure to meet the expected interest or objective (Jensen and Meckling, 1976).

3.7 New institutional economics and insurance

The below paragraph from North (2000) provides a good introduction to this section, which is aimed at looking at the relationship between new institutional economics and the performance of micro-insurance in less-developed nations:

“The cost of transacting, to put it in its bluntest form, is the key to economic performance. When I go to third world countries and look at how they perform badly and examine how factor and product markets are really working, in every case, be it capital, labour or product markets, one observes that the cost of transacting is high. The cost of transacting results in the economy performing badly because it is so costly for human beings to interact and engage in various kinds of economic activities that the result is poor performance and poverty and so on. Where this takes us, of course, is to try to understand why the cost of transacting is so high…” (p 37).’

Earlier in this chapter, I established the impossibility or difficulty in using neo-classical economics to explain situations where market failure and incomplete markets exist as a general rule (because of higher transaction costs and information asymmetries) in less-developed countries. Such occurrences could be attributed partly to the absence of many of the institutional or formal rules of behaviour that

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are taken for granted in developed countries which render market exchange less risky and less costly. Having explored new institutional economics and how it tries to tackle the above mentioned economic problems, one is inclined to apply for the framework in analyzing the market failures and incomplete market in the insurance industry of less-developed nations, in this thesis, obviously especially Nigeria.

Therefore, the focus of this session is to emphasize the suitability of new institutional economic theory, using Oliver Williamson’s framework, in the analysis of the development of micro-insurance industry in less-developed countries such as Nigeria. This is because of its suitability in describing the full range of relevant institutions, and the relationship between them, and then to identify the subset of institutions upon which research in the new institutional economics has focused.

Under the framework of new institutional economics and based on transaction costs, Williamson (2000), stated that an appropriate legal and political environment leads increases the confidence level of investors towards insurance activities and thereby increase the demand and supply for insurance products. In other words, the performance of an economy (in this case, micro-insurance) is the result of underlying institutional arrangement (North 1990). He identified four interrelated levels of social or institutional analysis. The below figure provides an example of how Williamson’s framework can be applied to micro-insurance development, with emphasis on selected cases of policy initiatives relating to each of the four levels.

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