RISK MANAGEMENT TECHNIQUES AND
FINANCIAL PERFORMANCE OF INSURANCE COMPANIES
Kokobe Seyoum
Alemu*1 Gemechu Dugasa 2
1 Ambo
University, Ethiopia
2 Commercial Bank of Ethiopia, Ethiopia.
|
|
ABSTRACT |
Keywords: Insurance Company; financial performance;
risk management; Ethiopia |
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Risk if not well managed could lead to
collapse for most organizations especially those whose core business deals
with day to day handling of risk. This
involves identifying and
analyzing risks, developing and
implementing risk handling techniques and monitoring the progress of these in
order to avoid and/or
reduce the impact
of risk on
the financial performance
of the firm.
The study used both primary and secondary data. Primary data was
collected through questionnaires and Secondary data was collected from
yearend financial report of the selected company. The result from regression
analysis shows that risk management practice and financial performance are
not correlated. This opens a door for other problem on the application of the
management techniques. Publisher All rights reserved. |
INTRODUCTION
Due to globalization and intense competition, risks are increasing and
risk management is becoming an integralpart for the success of almost every
organization, especially for the insurancesector because of theirhigh-risk
businesses, as the risks are associated with every client in the business and
their own risk. Insurance companies are in the core business of managing risk.
The companies manage the risks of both their clients and their own risks. This
requires an integration of risk management into the companies’ systems,
processes and culture. The riskmanagement process consists of a series of
steps, which are establishing the context, identifying, analyzing,assessing,
treating, monitoring and communicating risks, which allow continuous
improvement of decisionmaking(Standards Australia, 1999). By implementing risk
management organization can reduce unexpected & costly surprises and
effectiveallocation of resources could be more effective. It improves
communication and provides senior management aconcise summary of threats, which
can be faced by the organization, thus ultimately helping them in
betterdecision making.
LITERATURE REVIEW
In the last decade in
Ethiopia insurance market has gone through an important stage of its
development and consolidation. And now, it can be said that it has reached at a
very pleasing level of development and as such can provide highly qualitative
services for the citizen of the country. This is indicated by increased
performance from year to year, which has been reflected by the increasing
number of contracts and the increased volume of premiums. However it should be
mentioned that this sector still has challenges ahead to achieve higher quality
services, further increasing security offer and
contemporary products and , especially,
in perfecting methods and risk management, in order to achieve the
highest possible performance in business and also the application of
international standard in this field. Many companies often establish risk
management procedures in their plans for improving the performance and increase
the profits. Insurance companies' risk relates to the types of insurance
products thecompany writes. Some products have a much lower insurance risk than
others while some products have much higher insurance risk. Different documents
and guidelines suggested that established risk management practices should be
on ongoing basis to bring about improved performance and increase profits.
Several studies draw
the link between good risk management with improved financial performances. In
particular, Mohsen,
et al (2011), Tony et al. (2012) and Mua, et al. (2009) argued that there is a
positive and significant relationship between total risk management and
company’s performance. Moreover, Smith (1995) and Schroeck (2002) revealed
that prudent risk management practices reduce the volatility in institutions’
financial performance, namely operating income, earnings, firm’s market value,
share return and return on equity. Schroeck (2002) also indicated that ensuring
best practices through prudent risk management result in increased earnings. However, Gordon,
et al. (2009) and Gupta (2011) examined the relation of enterprise risk
management and performance. They argued that the relation of enterprise risk
management and performance is contingent upon some factorssuch as environmental
uncertainty, industry competition, firm complexity, firm size, and board of
directors’ monitoring. Those studies have made immense contributions to
the risk management and financial
performance; they were inclined towards the developed countries. However,
developing countries received little attention in various literatures on this
issue, at the same time majority ofthese studies were in banking industry.
Consequently, a designfeature that works well in one country/industry may not
be in another.
RISK
MANAGEMENT AND FINANCIAL PERFORMANCE
The
main focus of
risk management has
mainly been on
controlling and for
regulatory compliance, as opposed to enhancing financial performance (Banks, 2004). However,
this riskmanagement often leads to enhanced financial performance as regulatory
compliance and controlof risks enables the organization to save on costs. Banks
(2004) further suggests
that bymanaging risks,
the managers are
able to increase
the value of
the firm through
ensuring continued profitability of the firm.
Standard and
Poor’s (2013) identifies
poor liquidity management,
under-pricing and under reserving, a high tolerance for investment risk,
management and governance issues, difficulties related to
rapid growth and/or
expansion into non-core
activities as main
causes of financial distress and
failure in insurance
companies. It is important that
these factors be managed efficiently by insurance companies, to avoid financial
failure and bankruptcy to the firm.
In the 21stcentury has
seen great efforts to risk management. Babbel and Santomero (1996) note
that insurers should
assess the various
types of risks
they are exposed
to and devise
ways of effectively managing
them. They further suggest that insurers should accept and manage at firm
level, only those
risks that are
uniquely a part
of their services.
This will reduce the risk exposure.
Stulz (1984) suggested
that risk management is a viable
economic reason why
firm managers, might concern
themselves with both the expected profit and the distribution of firm returns
around their expected
value, hence providing
a rationale for
aligning firm objective functions in order to avoid risk.
Proper risk management is important in the
daily operations of any insurance company to avoid financial losses and
bankruptcy. This is in line with Jolly
(1997) contribution that preventinglosses through precautionary measures is a
key element in reducing risks and consequently, a keydriver of profitability.
The efficiency of risk management by insurance companies will
generallyinfluence their financial performance. Gold (1999), asserts that
insurance companies could notsurvive with increased loss and expense ratios.
Meanwhile, risk
management has been linked with shareholder value maximization proposition. Ali and Luft (2002), suggested that a firm
will only engage inrisk management if it enhances shareholder
value; Banks (2004),
contributed that it
is important for
each firm to
retain and actively manage
some level of
risk if it
is to increase
its market value
or if the
probability of financial distress
is to be lowered; Pagano (2001), confirms that risk management is an important
function of insurance institutions in creating value for shareholders and
customers.
Generally, company
operations are prone
to risks and
if the risks
are not managed
the firm’s financial performance
will be at
stake. Firms with efficient risk
management structures outperform their peers as they are well prepared for
periods after the occurrence of the related risks. This
study hopes to
come up with
an expected positive
relationship between risk management and performance of insurance
companies.
In the aftermath of global financial crisis
and corporate failures, entity stakeholders aredemanding greater oversight of
key risks facing the enterprise to ensure that stakeholder value ispreserved
and enhanced. One response to these growing expectations is the emergence of a
newparadigm known as "Enterprise Risk Management" as an internal
control system. At thesame time, organizations have been implementing
"Performance Measurement System" as oneof management control systems
vital for corporate success. Considering the importance of these twocontrol
systems, the possibility of incorporating ERM into the existing performance
measurement system needs to be explored. It isexpected that risk management
will complement performance measurement system by identifying and mitigating
risks in achievingstrategic objectives. Empirical evidence regarding this link
in insurance sector is still lacking particularly in Ethiopia, therefore, this
paperinvestigated the linkage between risk management and performance. The
following paragraphs present few related empirical studies on risk management
and organizational performance.
A study by Eric (2005) revealed that risk
management techniques are applied in the insurance companies of the country,
Uganda. The findings on the financial performance of the insurance companies
for this study also show fluctuating ratios as measured by ROE. A study by
Mohsen, et al. (2011) titled: "Effective risk management and company’s
performance: Investment in innovations and intellectual capital using
behavioral and practical approach". This research focused on ability of
risk management response to out of control market factors to facilitate
consistent profitability that leads to improvement in company’s performance.
That is an empirical research that investigates the association of total risk
management and company’s performance. The 6-year average level of performance
for ROA and ROI ratios as dependent variables and total risk management,
innovation and market-book ratios as independent variables and firm size and
financial leverage are considered as control variables.Their results indicated
that positive and significant relationship between total risk management and
company’s performance in companies that have invested in research, development
and innovations along with companies that have greater level of intellectual
capital and industries that have rapid knowledge growth. In addition, their
results confirm that the findings of previous researches in terms of functional
and practical behaviors approach.
A study by Tony, et al. (2012) titled: "Enterprise risk
management and business performance during the financial and economic crises". Their
research was based on a broader set of performance measures that places it in
the middle ground with previous research which had demonstrated non-conclusive
results on the relationship between ERM and firm performance. Furthermore, they
indicated that more research is needed to investigate the relationship between
ERM and firm performance on a much larger sample and for a much longer period
of time.
Other studies like Mua, et al. (2009); using a
sample of Chinese firms, examine the effect of risk management strategy over
performance of new product development. Their finding shows that risk management
strategies that focus on technological, organizational, and marketing factors,
individually and interactively improve the performance of new product
development. However, Gordon, et al. (2009) examined the relationship of
enterprise risk management and performance. They indicated that the relation is
contingent upon five firm-specific factorsnamely, environmental uncertainty,
industry competition, firm complexity, firm size, and board of directors’
monitoring. Finally, they stated that for implementing ERM firms should pay
attention to the contextual variables that are surrounding the firm. Likewise,
Gupta (2011) examines the risk management in Indian companies and explore the
reasons for the adoption or lack of adoption of integrated approach to risk
management. He shows that even though effective risk management can improve
organizational performance, companies do not have adequate infrastructure to
implement enterprise wide risk management. He concludes that a deep change in
risk perception is required to build up risk culture across business segments
and incentivize risk management adoption.
RISK MANAGEMENT TECHNIQUES
Meredith (2004) and Rejda (2003) indicated
that insurance companies use various techniques for managing risks. Johnson
(2001) alsostated that a company with any degree of risk exposure would develop
a philosophy thatexplicitly indicates its approach to riskmanagement
techniques. Techniques used to manage risks according to them include:loss
prevention and control, loss financing, andriskavoidance.
LOSS PREVENTION AND CONTROL
Kiochos (1997) states that to prevent or to
minimize the chance of loss, insurance companies generally advise that some
preventive measures be taken. He also commented that insurance companies can
only reimburse financial loss but not intangible things such as valuable
information and files. Loss prevention refers to the measures that reduce the
frequency of a particular loss for example: measures that reduce truck
accidents and strict enforcement of safety rules (Rejda, 2003). Insurers
generally advise their clients to instill good housekeeping habits in their
employees, such as not smoking on the premises or smoking only in designated
areas.
Insurers also give
advice to clients, for example to prevent fire - on fire prevention measures.
These advisory services are either for free or are considered as value added
service with the insurance package. An experienced insurer also advises on the
preventive measures that could be installed in the building (Kiochos, 1997).
Rejda (2003), also states that insurance companies can put in place measures
that reduce the severity of a loss after it has occurred. Examples include:
Installation of an automatic sprinkler systems that promptly extinguishes fire
and segregation of exposure units so that a single loss cannot simultaneously
damage all exposure units such as having warehouse with inventories at
different locations. He further argued that insurance companies should be
careful because where a policyholder successfully shows that an insurer
breached the covenants of good faith and fair dealing, the insured can receive,
all damages caused by the breach (Alexander, et al., 2004). Any ambiguity or
uncertainty in a policy or in a choice of wording or in meaning is resolved in
favor of the policyholder and against the insurer.
Meyer (2000), states that where a policyholder's lack of knowledge could result into
loss of benefits under a policy, an insurer is required to bring facts to the
insurer's attention and to provide relevant information to enable the insured
to take action to secure rights provided by the policy. Therefore, good loss
prevention and control practices are thought to enhance insurers' performance.
LOSS FINANCING
In insurance companies, Alijoyo
(2004)indicated that this is a broad category that involves riskretention, risk
transfer and diversificationas measures of loss financing.It is primarily
concerned with ensuring the availability of funds in the event of losses.
(a)Risk Retention
Johnson (2001) asserted that retention is the
act of keeping thepossibility of loss with no attempt to transfer that loss to
another party. The method isappropriate when the risks of loss or the loss
exposure is either too small with littleimpact or too great to be able to do
anything with it. Risk retention is regarded as self-insurance.In insurance
companies, retention is used with other risk management techniques. For
example, most insurance policies include a deductible so that the
insuredretains a portion of the loss. Rejda (2003) also asserts that all risks
that are not avoided ortransferred are retained.
(b)Risk Transfer
Insurance companies
use this technique to transfer the exposure of a loss to another person
orentity that can be able to bear the loss (Johnson, 2001). Naik (2003) also
indicated that insurance companies, transfer risks through insurance and
reinsurance diversification and hedging. He agrees with Alijoyo (2004) who
asserts that a risk transfer involves causing another party to accept the risk.
Reinsurance technique is used by an insurer to retain a bearable part and
transfers the remaining part of the risk to the reinsurer who indemnifies him.
Both Naik (2003) and Ayali (2000) agreed that using a reinsurance technique,
insurance companies can allocate risks to those parties who are most appropriate
to bear them. This can reduce losses of the originalinsurer and therefore
improve financial performance.
(c)Diversification
Meredith (2004) indicated that this technique
is used in spreading or diffusing risk exposures. It is a common technique of
risk management that seeks to lower risk by combining exposures that are not
related (not correlated) to one another. Diversification has got its foundation
in Markowitz 1952 work related to capital marketsportfolio theory which
demonstrates how diversification permits the investors who averse to taking
risk create portfolios that optimize various levels of risk and return.
RISK
AVOIDANCE
Avoidance means that a certain loss exposure
is never acquired or an existing lossexposure is abandoned (Rejda, 2003). It is
a technique, which implies that the chance of loss is reduced to zero because
the loss exposure is never acquired. If insurance companies fail to avoid some
of the risks, they can run bankrupt (Kiochos, 1997). Insurance companies
therefore apply a system of policies and strategies in order to avoid the risk
of bankruptcy provided their resources are applied effectively (Owen, 1995).
They can also avoid risks by selling small policies instead of comprehensive
one (Pippidis, 2002). Many insurance policies, although surprisingly popular
should be avoided because they tend to be very profitable to the insurance
companies but they lead to losses especially when claims by clients accumulate.
Such policies include; burial, children's life, disability and single disease
such as cancer (Rejda 2003). He further indicated that avoidance has two major
disadvantages: where the insurance company may not be able to avoid all the
risks and it may not being practical to avoid all the losses.Therefore,
avoidance may seem the answer to all risks, but avoiding risks also means
losing out on the potential gain that accepting (retaining) the risk may have
allowed. Not entering a business to avoid the risk of loss also avoids the
possibility of earning profits.
METHODOLOGY
Based on the above
discussions we hypothesize that
H1: There is a
significant relationship between risk management techniques and the insurers'
performance.
Primary data was collected from employees and
secondary data was collected from financial statements of selected insurance
companies and analyzed using person correlation to check the relation between
insurance performance and risk management techniques.
FINANCIAL PERFORMANCE OF ETHIOPIAN INSURANCE COMPANIES
In this study, the
financial performance is assessed based on ROE and loss ratios. On average, the
descriptive statistics show that mean of ROE for twelve years ranges from
0.03408 (2004) to 0.28213 (2010). It is higher for the year 2010 (with mean of
0.28213) followed by 2013(with mean of 0.23053) than other years. Also, for the
years under investigation, Ethiopian Insurance Corporation has the highest
ROE(with mean of 0.478104 and standard
deviation of 0.354784) among all the Insurance Companies being
considered and followed by Awash Insurance Company (with mean of 0.235035 and standard deviation of 0.182064).
The remaining companies in the sample have lower ROEthat ranges from 0.220983
(NIC) to 0.478104 (EIC) as
compared to the average
Table
4.8Correlations matrix of risk management techniques
and financial performance
|
ROE |
Loss prevention and control |
Loss financing |
Risk avoiding |
Loss ratio |
|
ROE |
Pearson Correlation |
1 |
|
|
|
|
Sig. (2-tailed) |
|
|
|
|
|
|
N |
12 |
|
|
|
|
|
Loss prevention and control |
Pearson Correlation |
.228 |
1 |
|
|
|
Sig. (2-tailed) |
.588 |
|
|
|
|
|
N |
8 |
8 |
|
|
|
|
Loss financing |
Pearson Correlation |
.120 |
-.190 |
1 |
|
|
Sig. (2-tailed) |
.758 |
.652 |
|
|
|
|
N |
9 |
8 |
9 |
|
|
|
Risk avoiding |
Pearson Correlation |
.792 |
.238 |
-.158 |
1 |
|
Sig. (2-tailed) |
.060 |
.649 |
.765 |
|
|
|
N |
6 |
6 |
6 |
6 |
||
Loss ratio |
Pearson Correlation |
.471 |
.357 |
-.603 |
.111 |
1 |
Sig. (2-tailed) |
.123 |
.385 |
.085 |
.834 |
|
|
N |
12 |
8 |
9 |
6 |
12 |
SUMMARY OF FINDINGS
This section presents the results and
discussions of the Pearson correlationcoefficients to identify the relationship
among the variables of risk management techniques (loss prevention and control,
loss financing and risk avoidance) andfinancial performance (ROE and Loss
Ratios).
The findings on the financial performance
of the insurance companies for periods under investigation (2002-2013) show low
general increase ROE ratios. The findings further indicated that ROE ratios
were concentrated between0 and 0.3. This indicated low rate of return on
shareholders' funds (poor financial performance) in the insurance companies.
The findings also indicated a general rise in loss ratios for the insurance
companies. This implied that outstanding paid claims were increasing more than the
premium earned. The findings are in accordance with Flemings (2000) who argued
that higher loss ratios might indicate thatan insurance company may need better
risk management techniques to guard against future possible insurance payouts. The
results are also consistent with findings of Rejda (2003), Pandey (1996) and
Flemings (2000) who asserted that loss ratios and ROE ratios are the best
measures of financial performance in insurance companies. They argued that
insurance companies should determine and monitor the above ratios so as not to
register poor financial performance.
Findings from the study indicated a low
positive relationship between loss prevention and control technique and ROE
(+22.8 percent). It also indicated a moderate positive relationship between
loss prevention and control technique and loss ratios (+35.7 percent). ROE and
loss ratios are both dimensions of financial performance in this study for the
insurance companies. Findings also indicated a low positive relationship
between loss financing and ROE (12 percent). Similarly, there is also a low
moderate negative relationship between loss financing and loss ratios (-60.3
percent). For the risk avoidance technique and financial performance, the study
shows that relationship is positive and strong. i.e.; risk avoidance is
strongly correlated with ROE (+79.2percent) and but the relation with loss
ratio is weak (+11.1percent).
So, insurance companies should adopt
enterprise risk management that is currently the best practice standard and
they should also apply risk management techniques effectively so as to improve
on their return on equity and reducing loss ratios.
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