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Introduction

This appendix supplements the discussion in chapter 4 on calculating the profit effects of trade restrictions in P&C insurance markets, and provides information on the previous literature, conceptual framework, data, variables, and econometric specification.

The Commission estimated the effects of trade restrictions on adjusted pretax profit earned per dollar of net premiums written (or adjusted profit margins) for P&C insurance. Profit-per-dollar premium, rather than a price-cost margin, was chosen for several reasons. Premiums vary by customer and are based on a variety of risk factors, while the ultimate cost of coverage is not known at the time a policy is written, and may not be known for years after the fact. In addition, the integral role that investment plays in the insurance industry warrants its inclusion in the model, rather than a variable that reflects underwriting activities alone. The use of a variable that includes investment returns is also supported by industry experts contacted by Commission staff. The model used by the

Commission estimates profit effects in two stages.1 _{In the first stage, data on more than}

2,700 firms are used to calculate country-level average profit margins adjusted for firm- level factors, including underwriting expenses (loss ratio and expense ratio) and investment returns. In the second stage, data from over 60 countries are used to calculate the effects on these adjusted profit margins of institutional, market, and macroeconomic

variables, including an index (the ITRI) reflecting barriers to trade.2 _{Profit effects are}

estimated as the amount by which P&C insurers’ adjusted profit margins are inflated due to trade restrictions.

Previous Literature

The two-stage econometric model employed to analyze the effect of NTMs on financial service industries, in particular the banking industry, was developed by Saunders and

Schumacher.3 _{Adding a trade policy variable to the second stage to calculate the effects}

of NTMs was pioneered by Kalirajan, et al.4 _{This method was first applied to P&C}

insurance by the OECD, which developed aggregate and modal tax equivalents of

NTMs.5 _{Analysis performed by the Commission, however, differs in important respects.}

The OECD’s analysis was limited to 26 transition or developing economies, whereas the Commission’s sample comprises over 60 countries at different stages of development.

1 _{See footnote 3 for a discussion of the two-stage econometric model.}

2 _{From this point forward, adjusted profit margins refer to the dependent variable used in the second}

stage.

3 _{It is possible to utilize a single-stage econometric approach in calculating profit effects. Estimation}

using a unified single-stage approach produced results qualitatively similar to those presented here. However, the use of firm-level data may skew results in a single-stage estimation, assigning greater weight to countries with many reporting companies. Additionally, it is possible that the results of a one-stage model may be subject to downward bias in standard errors, resulting in erroneous results. For example, see Saunders and Schumacher, “The Determinants of Bank Interest Rate Margins,” 2000; and Moulton, “Random Group Effects,” 1986.

4 _{Kalirajan, et al., “The Price Impact of Restrictions,” 2000.}

5 _{Tariff equivalents and tax equivalents are estimates of the price effects of NTMs, with the former}

measuring rents collected by incumbents and the latter measuring rents collected by exporters. Profit effects are similar to tariff equivalents in that they measure excess payments collected by incumbents, but they are different in that they measure the excess by profit margins rather than price-cost margins. Dihel and

Shepherd, “Modal Estimates of Services Barriers,” October 25, 2005; Dihel and Shepherd, “Modal Estimates of Services Barriers: Annex,” October 27, 2005.

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The aggregate and modal trade restrictiveness indices (TRIs) compiled by the OECD are based on commitments recorded in the GATS and restrictions found in the OECD

Product Market Regulations Database.6 By contrast, the Commission’s ITRI was

developed from measures currently in place, using a framework based on a model schedule developed by the insurance industry. Finally, the econometric work performed by the Commission and the OECD used largely different independent variables in each stage; the Commission’s ITRI variable was found to be statistically significant while the

OECD’s was not.7 _{Similarities between the OECD and Commission approaches include}

similar dependent variables and similar fit in the first- and second-stage equations.

Conceptual Framework

Restrictions on the sales of insurance by foreign firms effectively shift the foreign supply curve to the left in the domestic insurance market. Domestic supply remains unchanged because restrictions are discriminatory toward foreign suppliers. The upward shift in the foreign supply curve effectively raises the price of insurance premiums. Higher premiums and the larger investment they fund result in a wedge between the observed adjusted profit margin and the adjusted profit margin which would occur in the absence of trade

restrictions under ceteris paribus conditions. In the context of this report, this wedge is

called a profit effect.8 _{The analysis below utilizes an econometric model to estimate the}

size of this profit effect.