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Determinants of Corporate Diversification: Evidence from the Property-Liability Insurance Industry

The US property-liability (P/L) insurance industry consists of over two thousand active firms that differ substantially across several characteristics, including size, group affiliation, ownership structure, distribution system, geographic scope, and product diversification. The extant literature provides explanations for the coexistence of firms differing across the majority of these characteristics.

A striking exclusion from prior empirical analysis is the observed heterogeneity in line-of-business (product) diversification. While measures of product diversification are used in several agency theoretic analyses as proxies for managerial discretion, little evidence exists regarding the determinants of line-of-business diversification by P/L insurers.

This paper develops and tests hypotheses explaining the coexistence of insurers specializing in one or a few lines of business and insurers that diversify their operations across many business lines. The predictions of three dominant explanations; the agency theory hypothesis, the efficiency hypothesis, and the coinsurance hypothesis; are used to develop a model explaining variation in P/L insurer diversification.

A key contribution of this paper is the development of a measure of unrelated diversification to better test the prediction of the managerial discretion hypothesis that mutual insurers should be less diversified than stock insurance companies. Of many predictions stemming from the managerial discretion hypothesis, lesser degrees of diversification among mutuals has not received empirical support. Mayers and Smith (1988), Lamm-Tennant and Starks (1993), and Pottier and Sommer (1997) find no significant difference in line of business concentration between stocks and mutuals. Contrary to the diversification prediction of the managerial discretion hypothesis, Regan and Tzeng (1999) find that stocks are significantly more concentrated (in the 10 lines of business that they analyze) than mutuals.

Determinants of Corporate Diversification: Evidence from the Property-Liability Insurance Industry