organisational structure and internal control in the uk insurance industry
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Organisational Structureand Internal Control in theUK Insurance IndustryHilary Ingham aa Manchester School of Management , UMIST,Manchester, M60 lQD, UKPublished online: 28 Jul 2006.
To cite this article: Hilary Ingham (1991) Organisational Structure and InternalControl in the UK Insurance Industry, The Service Industries Journal, 11:4,425-438, DOI: 10.1080/02642069100000067
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Organisational Structure and Internal Control in the UK Insurance Industry
HILARY INGHAM
A significant body of literature supports the superiority of the multidivisional organisational structure for the management of a diversified enterprise. However recent research b cast doubt on the widespread existence of optimally organised multidivisional firms and h suggested that, in practice, what is observed is a hybrid type of administrative structure. This paper focuses on the extent and nature of divisionalisation within UK insurance companies. Such companies are of par- ticular interest for two reasons. First, changes in organisational structure have been recent and, second, the companies tend to operate in related areas of business. The results herein support the notion that a hybrid structure is more prevalent since the evidence presented suggests that where divisionalisation exists it is sub-optimal.
Regulatory changes have radically altered the nature of financial service provision in the UK. In the wake of liberalisation many financial service companies have diversified into new areas which have tended, for the most part, to be related to their primary line of business. Recourse to the work of Channon [I9731 suggests that a policy of diversification may well render companies' administrative structures obselete thus necessitating organisational change. Although much research has been conducted on the strategy structure linkage within manufacturing there is a dearth of evidence for the service industries. This paper considers the strategy structure link for one segment of the financial service industries - the insurance market. The following section considers the theoretical linkage between diversification and organisational structure. The existing empirical evidence on the hypothesised performance superiority of the multidivisionai structure is also discussed.
Hilary Ingham: Manchester School of Management, UMIST, Manchester M60 lQD, UK.
The Service Industries Journal, Vol. 11, No.4 (October 1991). pp.425-438 PUBLISHED BY FRANK CASS, LONDON
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Later the focus turns to the insurance industry. Thus, whf,lst many firms in the economy can be viewed as divisionalised, only a sub-set of these operate within an op tha l multi-divisional structure. This section highlights the stringent conditions for optimal divisionalisation and questions whether or not these are likely to be fulfilled within the insurance industry. Since the information required to ascertain this is not available in published sources, the fourth section presents the results of a questionnaire survey. The survey not only covers the basic issues of diversification and organisational structure but also sheds some light on the internal management and control systems operational within the sample companies. Thus the results provide a much more accurate picture of the management d divisionalised enterprises than has hitherto been available. It is therefore possible to ascertain whether or not the conditions for optimal divisionalisation are met.
STRATEGY AND ORGANISA'RONAL STRUCTURE
The seminal work on the linkage between a company's diversification strategy and the subseqent need for organisational change k that of Chandler [1962]. Subsequent work for UK manufacturing companies is contained in Channon [1973].* Using case histories of major US corporations, for example, Du Pont and General Motors, Chandler noted how technology driven diversification had caused radical changes in the nature and scope of the companies' operations.2 Within a single product enterprise the unitary form of organisational structure (U-form) was the prevalent administrative system in operation. Thus companies were structured according to key functional areas: marketing, personnel, finance etc. The advantages of such a structure are derived from the gains from specialisation [Smith, 19371.
However, as companies diversified, the weaknesses of the U-form structure for the managemeat of multi-product firms became apparent. Primarily, if a company is operating in more than one market, the diversity of information that the head office must absorb increases significantly. Within a U-form structure all decision making is vested in top level management but bounded rationality will severely limit their effectiveness within a. diversified company.3 Thus the inability of top management to handle the information flows tends to result in a situation where operational decision making is given priority thus crowding out matters of c o p r a t e strategy.
A proposed solution to the problem was the organisational iaraovation of the multi-divisional structure (M-form). This involves the decom- position of the company into a number of quasi-firms which are divisions of the organisation. Each division is organised into functional areas; thus
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ORGANISATION STRUCTURE IN THE INSURANCE INDUSTRY 427
a M-form firm comprises a number of divisions each of which resembles a U-form firm. The efficiency advantages of such a structure are as follows. First, it facilitates the decentralisation of decision making; this mitigates the effects of bounded rationality. Routine operational decisions can then be decentralised to the divisional managers leaving top management free to concentrate on global, or company wide, matters. Furthermore the decomposition of the company improves the information available to top management. With the establishment of divisions it is possible to observe the performance of all constituent parts of the enterprise.
Of course the establishment of a two-tiered management structure creates an agency problem within the firm akin to that caused by the divorce of ownership from control [Jensen and Meckling, 19761. Control mechanisms are therefore necessary to minirnise opportunistic behaviour on the part of divisional managers. Two such measures exist both of which link a divisional manager's performance to a remuneration system. First, an internal capital market can be created. Head office assumes the role of capital allocator and divisional managers who do not act in a manner consistent with company policy can be starved of funds. This internal capital market supercedes the external market as a provider of funds. Such an internal market is arguably more efficient as information asymmetries between those internal to the firm and those outside it mean that capital allocation within the firm will be based on superior information to capital allocation via the market. In addition, divisional managers' opportunism can be curbed by linking their salary directly to their division's performance; specific examples of such schemes are cited by Baiman and Demski [1980].
Although Chandler's work was written over two decades ago its resurgence in the economics literature can be attributed to Williamson [1975,1979, and 19851. Although his writings explore the many facets of market failure, one of his most researched contributions is his M-form hypothesis. This states that:
The organization and operation of the large enterprise along the lines of the M-form favors goal pursuit and least cost behavior more nearly associated with the neoclassical profit maximisation than does the U-form alternative.
Williamson, 1975, p. 150
Early empirical studies (see, for example, Amour and Teece, 1978 and Steer and Cable, 1978) were supportive of the superior performance achieved by M-form firms. More latterly however, certain studies [Cable and Dirrheimer, 1983 and Cable and Yasuki, 19851 have failed to find positive performance effects.4 Furthermore Hill [I9851 and Hill and
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Pickering [I9861 provide evidence which suggests that the existence of optimally organised M-form firms is rare. In particular &key note the unwillingness of top management to decentrdise decisioc asking and their failure to implement the necessary control systern~.~ Thus it would appear that the optimal M-form company is rare. Hf a sub- optimal hybrid is, in actuality, the dominant organisational form then it can no longer be assumed that this divisionalised form of enterprise enjoys the efficiency advantages attributed to the pure M-fom. The following section therefore considers the requisite conditions for optimal divisionalisation and investigates to what degree these are likely to be met in the insurance industry.
OPTIMAL DIVISIONALISATION AND THE INSURANCE INDUSTRY
Insurance business in the WK is conducted within a wide spectrum of business organisations. For the UK registered companies whose major line of business is the provision of insurance two legal f o m s exist. Proprietary companies distribute profits to their shareholders whilst in the mutual companies profits are distributed amongst the 'with profits' policy holders. However insurance business is also conducted within a variety of other business oaganisations. Many other financia; service companies own insurance companies; Abbey Life is, for example, owned by Lloyds Bank. Grtain non-UK insurance companies have UK subsidiaries - Equity and Law is owned by Compagnie du Midi.6 Finally certain conglomerates include an insurance company amongst their portfolio of holdings; Eagle Star is a wholly owned subsidiary of BAT.
Although the strategy structure link has been subject to much examination in the case of manufacturing, far less research has been conducted on the service industries despite their increasing prevalence in the UK economy.7 For the insurance companies the only major existing work is that of Channon [I9781 which was conducted over a decade ago. For the twenty-three insurance companies which he studied, Channon noted the slow development of product and geographic diversification. He identified the large proprietary firms as the earliest diversifiers even though some retained a dominant position in a particulair market ~ e g m e n t . ~ In the light of this diversification certain of the insurance companies recognised that their organisational structures had become inappropriate. Historically composite insurance companies had divided their operations into life and non-life divisions which were administered within a semi-divisional organisational structure.9 Reorganisation in- volved establishing autonomous product and geographic divisions although autonomy was somewhat superficial since group profitability
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ORGANISATION STRUCTURE IN THE INSURANCE INDUSTRY 429
was in part dependent on investment performance; investment management was, therefore, a critical function.
Since deregulation diversification has increased though most com- panies have tended to enter other financial service markets; either via related products or via geographical expansion. Such a diversification strategy is consistent with the work of Luffman and Reed [I9841 who note that firms tended to move through the single-dominant-related- unrelated product spectrum rather than making a quantum change. Given that at the time of Channon's study the majority of companies had only diversified to the dominant product stage such moves into related areas conform to expectations. This however poses certain problems for the installation of a divisionalised structure. Citing Williamson [1975, p. 1491 the requirements for optimal divisionalisation are severe since it entails:
1. the identification of separable economic activities within the firm; 2. according quasi autonomous standing (usually of a profit centre
nature) to each; 3. monitoring the efficiency performance of each division; 4. awarding incentives; 5. allocating cash flows to high yield uses; 6. performing strategic planning (diversification, acquisition, and re-
lated activities) in other respects.
Thus the observable pattern of diversification which has occurred within the insurance industry suggests that these organisations may differ markedly from the textbook conglomerate to which Williamson's work refers. In this respect insurance is not unique, the degree of diversification of many of the UK manufacturing companies is limited. It is, therefore, apposite to question how applicable a M-form organi- sational structure is for such companies since, if such divisionalisation is only feasible for pure conglomerates, many companies may be operating with administrative structures which they believe to be optimal for their organisations but which are, in fact, not so.
One problematic area is the relatedness of the companies' activities which will tend to cause the volume of inter-divisional transfers to be high [Umapathy, 19791. The linkage between endowment mortgages and estate agency provides one such example. However, once inter- divisional transfers take place, the related issue of transfer pricing moves to the fore since the final price decided will be a revenue to the supplying division and a cost to the receiving division. Referring to the first two conditions cited for optimal divisionalisation the requirement is that the company can be decomposed into a number of autonomous profit centres. But any inter-divisional transfers affect the profit of more
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than one division. The transfer price must therefore be consistent with divisional profit maximisation if it is viewed as equitable by divisional managers.
Of course such a problem extends beyond inter-divisional transfers since internal charging systems are also necessary when certain services are subject to central provision [Radner, 19861. The cost allocated to the divisions for these services also affects the divisional managers' ability to maximise their individual local profit. Divisional autonomy is also reduced if the purchase of a good or service is mandated to be internal. If a divisional manager can obtain a better price by purchasing externally, but is forbidden by head office from so doing since corporate profit is maximised when the transaction is an internal one, his autonomy is likewise reduced.
Thus the crucial question that must be addressed is whether internally determined prices are likely to be consistent with profit maximisation for the individual divisions concerned. Note that in order for the system to be viewed as equitable by all the divisional managers pady to any transaction the achievement of joint profit maximisation wiH not suffice since the normal expectation is that these managers will be evaluated on the basis of individual pefomance.
There are differing possible solutions to this problem [Eccles, 19851. Rrst, if an external market exists for the good or service, the problem is lessened since shadow prices can be imputed to the divisions. However, for many internal transactions, no external market exists and such information is, thus, unavailable. If this is the case one possiblity is that the final price can be determined via bargaining between the divisions concerned. Clearly the final outcome depends on the bargaining strengths of the divisions and, given that internal markets are likely to be thin in terms of the numbers of buyers and sellers, the eventual outcome is unlikely to be one which would pertain under competitive conditions.10
Alternatively head office could mandate that all internal transactions be priced at full cost. In this instance the selling division must be designated as a cost centre hence violating another condition for optimal divisionalisation. Finally a dual pricing system could be adopted such that the selling division receives a market price whilst the receiving division pays full cost; the revenue discrepancy is then borne at head office level. Of course this mechanism still requires that a shadow price which mirrors an external, market, price can be imputed.
Thus the choice of any internal charging system radically affects whether or not a company can be broken down into a number of autonomous profit centres. If the decomposibility requirement cannot be met because of inter-divisional transfers the resulting cprganimtional
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structure is not pure M-form. Even if this requirement is satisfied, further problems can be present which also prevent a firm from achieving true M-form status. These concern the internal control systems. Thus if divisional managers are not monitored and remunerated - both in personal terms via their salaries and in divisional terms via capital allocation - accordingly it is still incorrect to view the firm as M-form. This is, however, a different problem to the one discussed above. Interdependencies between the divisions mean that an M-form structure cannot be established whereas the lack of effective control systems means that the company has failed to efficiently operate a M-form structure.
SURVEY RESULTS
This section presents the results of a questionnaire which was designed to investigatk the existence and nature of divisionalisation amongst companies operating in the insurance industry. All companies registered for conducting insurance business were included in the survey. At the time of mailing, June 1989, one hundred and seventy companies were so registered. The choice of this broad sample base was twofold. First, it
TABLE 1
DIVERSIFICATION IN THE INSURANCE INDUSTRY
Number of Areas Mutual Companies Proprietary Companies of Operation Independent Subsidiary
1 3 8 1 2-4 6 25 2 5-7 13 11 5 8+ 4 4 3
N 26 48 11
Areas of Operation:
Life Pensions General Reinsurance Insurance Brokerage Risk Management Investment Management Property Investment Undemiting Mortgage Finance Maritime Estate Agency
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432 THE SERVICE INDUSTRIES JOUIPiAL
pnff concerns allows comparison of those companies which are independ, with those which are wholly owned subsidiaries and semndly, on a practical note, it ensured that the returns would yield a meaningful sample size." Eighty-seven returns were received thus giving a, response rate of 51 per cent.
Table 1 indicates the range of activities undertaken by the sample companies.12 Channon [1978] noted that many of the mutual companies were specialised firms operating only in the life insurance market. The evidence provided here shows that this is no longer the case. In fact casual inspection of Table 1 does not indicate a marked difference in the range of products offered by the mutual and proprietary wmpanies.
On turning to the organisational structures within which these enter- prises were administered, Table 2 indicates that only 30 per cent of the sample companies were governed via a divisionalised system. Where they were the prevalent basis for the decomposition was by the establishment of product divisions.13 There was a noticeable difference between the mutual and proprietary companies with the figure for the fomer being as low as 2 per cent whilst that for the latter was 40 per cent. Of course it is possible that organisational structures are laggiqg behind diversification; to investigate this companies were questioned about the timing and nature of organisational change within their enterprise.
TABLE 2
ORGANISATIONAL STRUCTURE AND ORGANISATIONAL CHANGE
Mutual Proprietary - -
Divisional Functional
Organisational Change within the Last Five Years: Functional to Divisional 17 Divisional to Divisional 9 Divisional to Functional 27
The responses which this generated do not conform to expectations. Somewhat surprisingly, although the majority of companies have under- gone organisational change in the last five years, the traditional strategy structure link is refuted since the dominant trend is towards recentrali- sation. The responses given in Table 2 indicate that the most frequently cited reason for organisational change was poor performance; this was cited by 38 per cent of the respondents. This finding mirrors results produced for manufacturing by Thompson [1981]. Twenty-nine per cent of respondents cited a new acquisition as being the cause of
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ORGANISATION STRUCTURE IN THE INSURANCE INDUSTRY 433
reorganisation whilst only 14 per cent cited diversification. Thus the evidence available suggests that the dissatisfaction with divisionalised structures is due to the fact that the expected performance benefits were not realised.
The move towards recentralisation deserves further attention. It was noted in the preceding section that optimally organised M-form companies are indeed rare and that, given the related nature of the activities undertaken by insurance companies, it is likely that any divisionalised company will more closely resemble a corrupted M- form structure. To ascertain this it is necessary to investigate whether divisional autonomy is upheld and whether control mechanisms are operational.
Table 3 addresses the degree of autonomy afforded to the divisions within divisionalised firms. With cost centre status divisional managers have control only over the human and physical resources needed to accomplish assigned tasks. A manager of such a centre is judged on his ability to accomplish set tasks within a given budget. Within a pure M-form firm decentralisation of decision making affords divisional managers greater autonomy than that provided by cost centre status. As noted earlier, divisions are normally designated as profit centres. With profit centre status a division is given an imputed profit in each accounting period and the divisional manager is given incentives to maximise his division's profit. On matters of investment even profit centre managers much defer to head office; only those divisions granted investment centre status have autonomy in this area.
TABLE 3
STATUS OF DMSIONS
Percentage of Divisionalised Companies Cost Profit Investment
Life Pensions General Reinsurance Insurance Brokerage Risk Management Investment Management Property Investment Underwriting Mortgage Finance Maritime Estate Agency
Recalling the conditions for optimal divisionalisation the normal
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asumption is that the divisions will be granted profit centre status. Table 3 shows that, for most areas of operation, in excess of 50 per cent of the operations of the divkionalised companies in the sample were designated as profit centres. What is surprising is the relative frequency of investment centres; however, autonomy in this respect is not usually complete since most investment decisions are made in consultation with head office.
It was also noted above that internal transactions may well render any incentive schemes based on profit centres inequitable. Forty-one per cent of the divisionalised companies in the sample reported the existence of inter-divisiond business in their organisation whikt 74 per cent reported the existence of centrally provided services. A further facet of this problem is the frequency with which such transactions recur. As Wiamson [I9751 notes, the more frequently any transaction occurs the more worthwhile it is for the firm to establish a formal pricing system. In this particular sample 70 per cent of the divisionalised companies stated that such transactions recurred on a monthly basis.
Table 4 shows that the mst-based pricing system was the most commonly employed internal charging system. Sixty three per cent of the divisionalised companies im this particular sample used this form of transfer pricing somewhere within their organisation. As was noted above the deisignation of divisions in this manner makes it inequitable to judge the supplying divisions on a profit measure. The evidence uncovered is, therefore, contradictory since whilst the majority of divisions within the sample are formally designated as profit centres the transfer pricing systems present in their organisations prevent them from maximising their divisions' profit.
TABLE 4
INTERNAL PRICING SYSTEMS IN DMSIONALISED COMPANIES
Percentage of Divisiondised Companies Operating Priciw
System
Cost-Based Market (Shadow Price) Based Negotiated Dual
Of the other possible internal charging systems the negotiated price, where the price is determined via bargaining between the parties concerned, was employed in approximately one quarter of the sample enterprises. It was stated above that this system is likely to favour the stronger divisions at the expense of their weaker counterparts.
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ORGANISATION STRUCT'URE IN THE INSURANCE INDUSTRY 435
Furthermore, in the case of negotiations between divisions and head office, a favoured division is likely to be able to negotiate a lower price. Neither imputed market prices nor dual pricing systems were found to be extensively employed by the companies in the sample.
The final requirement for an optimally divisionalised company is the existence of an effective monitoring and reward system. Two thirds of the sample's divisionalised companies stated that their firm did operate some form of managerial incentive scheme. Table 5 shows that remuneration linked to company-wide performance, i.e., share options and firm profitability, were more prevalent than those based upon divisional performance. This reveals inequities since managers will then be remunerated according to the outcome of decisions which were outside their control.
TABLE 5
MANAGERIAL INCENTIVE SCHEMES IN DMSIONALISED COMPANIES
Percentage of Divisionaiised Companies
Share Option Scheme 30 Divisional Profit-sharing Scheme 11 Company Profit-sharing Scheme 37
Divisional Managers Evaluated On:
Absolute Individual Performance Relative Individual Performance Absolute Divisional Performance Relative Divisional Performance Absolute Firm Performance Relative Firm Performance
On the assessment procedures themselves the most popular form of evaluation was on individual performance - divisional measures were rarely used. Furthermore, absolute performance was used in preference to relative performance; Hart [I9831 advocates the use of the latter measure since it encourages the weak to emulate the strong.
SUMMARY AND CONCLUSIONS
It is a widely accepted view that a firm's diversification may bring about a subsequent need for it to change its organisational structure. For manufacturing companies the early research supports the superior performance capabilities of a divisionalised organisational structure.
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Later work has been less supportive and doubts must be voiced 2s to the widespread existence of pure M-form organisations. In part the hybrid organisational forms which we observe may occur as the result of failure on behalf of the firms concerned to implement the necessary monitoring and control systems. However it must also be questioned whether the M-form organisational innovation can be adopted by companies whose range of activities is much more restricted than that of the traditional conglomerate.
Much less research has been conducted on the service industrias and this paper has sought to redress the balance by providing an up to date analysis of the insurance industry. Because diversification in this industry has lagged significantly behind that of the manufacturing companies the firms concerned have, to some extent, been able to learn from the experiences of the manufacturing companies. Survey evidence revealed that many of the sample companies had indeed diversified their activities across a wide range of insurance and related products. Furthermore, the majority of the companies in the sample had recently instigated changes in their organisational structures. The evidence did, however, reveal that the current dominant trend was away from a divisionalised structure back to a system with centralised decision making.
Further investigation revealed that poor performance had driven this organisational change, thus it is possible to surmise that the sample companies did not reap the anticipated performance benefits of a divisionalised structure. If these firms had only established corrupted M-form structures poor performance is not unexpected. To examine the exact nature of divisiondisation in the insurance companies she survey provided evidence on both intra-firm transactions and incentive schemes. The responses indicated a significant volume of imtra-firm business which renders the designation of divisions as profit centres problematic. Indeed the survey revealed that profit centre status was by no means universal amongst the divisions of the supposed ha-form companies. Evidence was also uncovered which suggested that internal charging systems were inappropriate; thus the extensive use of cost-based transfer pricing is inconsistent with profit centre status for the divisions. Furthermore, incentive schemes were not found to be operational in all of the sample companies and, where they did exist, schemes based on divisional performance were rare.
To conclude, the stringent requirements of an optimal M-form structure are only likely to be met by a conglomerate company. Thus the applicability of this organisational structure for companies whose portfolio of activities is of a related nature is doubtful. Within the insurance industry it wouild appear that diversification was rapidly followed by a move to a divisionalised structure. To what extentearly,
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ORGANISATION STRUCTURE IN THE INSURANCE INDUSTRY 437
supportive, evidence of the superiority of M-form structures caused this organisational change it is not possible to surmise. However the companies themselves appear to have rapidly become disillusioned with their divisionalised governance structures and within the industry there is now a marked trend towards recentralisation. That part of the cause of the failure of divisionalisation was outside the control of the companies themselves cannot be disputed since the related nature of their activities renders the establishment of pure M-form structures almost impossible. However, it must be recognised that the firms also appear to have contributed to the failure of organisational change via their choices of evaluation and remuneration systems for their divisional managers.
NOTES
1. Channon's [I9731 work was part of a larger study; Dyas and Tbanheiser [I9761 consider the spread of the M-form organisation across Europe.
2. The major technological innovations were the railroad and the telephone; both of these opened up new markets.
3. The term is Simon's (19571. It refers to the neurophysiological limits of the human brain.
4. These studies were conducted on German and Japanese data respectively. 5. Williamson and Bhargarva [I9721 call such an organisational structure a corrupted
M-form. - - - - - - . 6. Preceding the completion of the Single European Market in 1592 foreign insurance
com~anies are likely to make more acauisitions of their UK countemarts. The UK insurance market is-the most developedin Europe.
7. Insurance is the major foreign currency earner for the UK. 8. He cites General Accident for whom 60 per cent of premium income was derived
from motor insurance. 9. The semi-divisional organisational structure is not included in the classification
scheme proposed by Williamson and Bhargarva [1972]; it is attributable to Channon 119781.
10. bf Gurse internal bargaining is also beset with the small numbers problem discussed by Wiamson [1975).
11. What the chosen sample does preclude is the explicit testing of the M-form hypothesis since performance measures are not available. Thus using the share price methodology adopted by Thompson [I9811 is not possible because only a sub-set of companies have quoted share prices which relate to insurance business. Furthermore, for subsidiary companies, even if profitability were the chosen measure of performance published accounts are insufficiently disaggregated. If the sample had been restricted to those companies for which a share price was readily available the initial sample would have been restricted to less than forty. The returns would then have been likely to have been unacceptably small.
12. Only six companies operated in areas other than those mentioned here. 13. Companies were classified according to a simple functional/divisional dichotomy. It
therefore remained open to question whether the exact structure of a divisionalised company was M-form, H-form etc. This appeared appropriate as the purpose of the research was to exact information on internal control systems which would then allow a more accurate classification.
I am grateful to the Financial Services Research Centre, UMIST, and the TSB for funding the questionnaire on which this paper is based.
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