The effects of risk management on financial

performance of Ethiopian insurance companies

By: Zinaye W/Michael

Addis Ababa, Ethiopia

January, 2017
 The effects of risk management on financial
performance of Ethiopian insurance companies

By: Zinaye W/Michael

A thesis submitted to the Department of Accounting and

Finance in partial fulfillment for the requirement of the
Degree of Master of Science in Accounting & Finance

Addis Ababa University

Faculty of Business and Economics
Department of Accounting and Finance

Addis Ababa, Ethiopia

February, 2017
 Declaration

I, undersigned declare that this thesis is my original work. Furthermore, all sources of

materials used for the thesis had been duly acknowledged.

Name: Zinaye W/Michael

Signature: ________________

Date: ____________________

Place: Addis Ababa University

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 Addis Ababa University
Faculty of Business and Economics
Department of Accounting and Finance
This is to certify that the thesis prepared by Zinaye W/Michael, entitled: Effects of Risk
Management on the Financial Performances of Ethiopian Insurance Companies: submitted in
partial fulfillment of the requirements for the Degree of Master of Science in Accounting and
Finance complies with the regulations of the university and meets the accepted standards with
respect to originality and quality.
Signed by the examining committee:

Advisor: Dr. Sewale Abate Signature _________________ Date___________

Examiner: Dr. P. Laxmikantham Signature_________________ Date____________

Examiner: Dr. Mehari Mekonnen Signature_________________ Date____________

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 Table of Contents

List of Tables………………………………….....v
List of Figures……………………………….….vi
Acknowledgement……………………………...vii
Acronyms and Abbreviations………………...viii
Abstract………………………………………….ix

CHAPTER ONE: BACKGROUND OF THE STUDY ……………………………1

1.1. The Insurance Industry in Ethiopia ……………………………………………….2
1.2. Statement of the Problem.....………………………………………………..……..3
1.3. Objective of the Study.............................................................................................4
1.4. Hypothesis of the Study………….………………………………………………..5
1.5. Scope of the Study………………………………………………………………...6
1.6. Significance of the Study.........................................................................................6
1.7. Organization of the Paper……………………………………………………….…6

CHAPTER TWO: REVIEW OF LITERATURE …………………………..….…7

2.1. Theories of Risk Management and Financial performance………………….…....7
2.1.1. Contingency Planning Theory…………………………………….……….8
2.1.2. Enterprise Risk Management Theory………………………………….…..9
2.1.3. Managerial Self-interest Theory…………………………………….……..9
2.1.4. DuPont Theory …………………………………………………….……..10
2.2. Insurance and Risk Management ……………………………………………....…11
2.3. Financial Performance Measurements……………………………………….…....15
2.4. Risk Management & Financial Performance: An Empirical Review…………......17
2.5. Risk Selection and Research Hypothesis……………………………….……...….20
2.6. Related Empirical Studies in Ethiopia……………………….……………….…...22
2.7. Summary and Knowledge Gap ………………………………………………...…30
2.8. Conceptual Framework……………………………………………….…….……...31

CHAPTER THREE: RESEARCH DESIGN AND METHODOLOGY…..….….33

3.1. Research Design………………………………………………………..….…....…33
3.2. Research Approaches……………………………………………………..….…....33
3.3. Population and Sampling Techniques…………………………………….…..……34
3.4. Source of Data and Data Collection Instruments…………………………...…......36
3.5. Variable Measurement……………………………………………………...….…..37
3.6. Model Specification……………………………………………………......……....39
3.7. Data Presentation and Analysis Techniques………………………...………..…….41
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CHAPTER FOUR: RESULT AND DISCUSSION ………………….…….……....42
4.1. Descriptive Statistics…………………………………………………..….….…… 42
4.2. Correlation Analysis………………………………………………….….…..……..45
4.3. Model Specification Test …......................................................................................46
4.4. Model Diagnosis…………………………………………………………...….……48
4.5. Regression Results and Analysis……………………………………………….…..52
4.5.1. Technical Reserve Risk and Return on Asset……………….…….…….…...55
4.5.2. Company Size and Return on Asset……….. ………………….……...…….56
4.5.3. Reinsurance Risk and Return on Asset……………….………………….…..57
4.5.4. Liquidity Risk and Return on Asset ………………….……………….….….58
4.5.5. Claim Settlement Risk and Return on Asset……….……………………..….60
4.5.6. Underwriting Risk and Return on Asset………….………………….….…...60

CHAPTER FIVE: SUMMARY CONCLUSION & RECOMMENDATION……63

5.1. Summary…………………………………………………………….…….………..63
5.2. Conclusion………………………………………………………….…….…..…….64
5.2. Recommendations………………………………………………….……..….…….65

References

Appendixes

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 List of Tables

Table 3.1 Sampled Insurers‟ Market Share…………………………….….……….36

Table 3.2: Description of the Variables…………………………………….....……39
Table 4.1: Descriptive Statistics of the Variables…………………………….…….42
Table 4.2: Correlation Matrix……………………………………………………….45
Table 4.3: Random Effect Test………………………………………………..……46
Table 4.4: Redundant Fixed Effect Test…................................................................47
Table 4.5: Heteroskedasticity Test: White………………………………………….49
Table 4.6: Correlation Matrix between Independent Variables………………….…51
Table 4.7: Regression Result…..................................................................................54

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 List of Figures

Figure 2.1: conceptual Framework………………………………………………........32

Figure 4.1: Rejection and Non-Rejection Regions for Durbin-Watson Test………….50
Figure 4.2: Normality Test Result……………………………………………….…….52

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 ACKNOWLEDGEMENT

First and foremost, I would like to thank and praise the Almighty God for being my strength,
His endlessness and all-embracing not only for helping me to finalize this paper, rather for
showing me the light and for being there for me in all the difficult and annoying times
throughout my life. My dearest mother W/ro. Ayelech Awoke and my beloved father Ato
W/Michael Tajebe, who gave me a moral and spiritual support to start this program; you are
my counselors and supporters in life, I will always love and thank you. Also my sincere and
deepest gratitude goes to Ato Alemu Tereda for his expert guidance, helpful criticism,
valuable suggestions and encouragement during the completion of this work. And my special
appreciation also goes to Ato Muhidin Shifa and Ato Yinebeb Ephrem, for their comments
and suggestions which contributed significantly to my study. I would also like to thank my
sincere colleagues and friends for their kind support and encouragement to finalize this study.

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 Acronyms and Abbreviations

BLUE Best Linear Unbiased Estimator

CLRM Classical Linear Regression Model
CNWP Change in Net Written Premium
COSO Committee of Sponsoring Organizations of the Tread way Commission
CP Contingency Planning
CS Claim Settlement
DW Durbin Watson
EIC Ethiopian Insurance Corporation
EML Estimated Minimum Loss
ERM Enterprise Risk Management
FEM Fixed Effect Model
ISD Insurance Supervision Directorate
LQ Liquidity Risk
NBE National Bank of Ethiopia
OLS Ordinary List Square
REM Random Effect Model
ROA Return on Asset
ROE Return on Equity
RR Reinsurance Risk
SIB Supervision of Insurance Business
SZ Size
T Current year
T-1 Previous Year
TA Total Asset
TR Technical Reserve Risk
TRM Traditional Risk Management
UNCTAD United Nation Conference on Trade and Development
UR Underwriting Risk

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 Abstract

The study focuses on the investigation of the risk management factors that affect the financial
performance of the Ethiopian insurance industry. Managing risks is an important factor
which insurers must attend to achieve their financial performance. From this perspective, risk
management becomes one of the most important practices to be used in insurers in order to get
higher returns. Therefore, this study is attempted to ascertain the relationship between risk
management and financial performance of insurers in Ethiopia. In order to achieve this
objective, the study used explanatory research design, mixed research approach. Panel data
covering eleven-years (2005–2015) are analyzed for nine insurers in Ethiopia. Also in-depth
interview is conducted with the NBE officers. The results of the fixed effect regression model
revealed that technical reserve and liquidity risks have negative & significant impact on ROA
(proxy measure for financial performance) of non-life insurers in Ethiopia, whereas company
size and reinsurance risk have positive & significant effect on ROA. The study led to the
conclusion that technical reserve, size of a company, reinsurance risks and liquidity risk are
the pull factors for the financial performance of insurers. On the basis of these findings, the
study recommends that there is greater need for Ethiopia insurers to manage the risks
particularly technical reserve risk, reinsurance risk and liquidity risk more integrally. The
study also recommends Ethiopian insurers to increase their size by enhancing their assets
base.

Keywords: risk management, financial performance, insurance companies

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 Chapter One:
Background of the study
In modern society, financial industry is growing rapidly and gaining importance in the global
financial development. According to Mishkin & Eakins (2013), financial markets and institutions
not only affect our everyday life but also involve huge flows of funds, which in turn affect
business profits, the production of goods and services, and even the economic well-being of
countries. The role of financial institutions in the economy of a country in general and insurance
companies in particular are facilitate the efficient and effective financial system through saving
mobilization, risk transfer and intermediation (Das et al., 2003). Therefore, financial institutions,
channel funds and transfers risks from one economic unit to another economic units so as to
facilitate trade and resources arrangement. More specifically the insurance sector plays important
role in the financial services industry in almost developed and developing countries, contributing
to economic growth, efficient resource allocation, reduction of transaction costs, creation of
liquidity, facilitation of economics of scale in investment, and spread of financial losses (Haiss &
Sumegi, 2008). Research surveyed by Naveed et al. (2011), cited in (Yuvaraj, 2013), shows that
the efficiency of financial intermediation and transfer of risk can affect economic growth while
at the same time institutional insolvencies can result in systemic crises which have unfavorable
consequences for the economy as a whole. Uncertainty and volatility are the main attributes of
today‟s nations‟ economies. While, insurers represent the major players in these economies, its
risk management are crucial issues that need more investigation.

Risk management is an important discipline in business especially the insurance business.

Recently, businesses put great emphasis on risk management as this determines their survival
and business performance. Geczy et al. (1997) note that companies use financial risk
management to reduce cash flow variations which could otherwise prevent companies to invest
in different growth prospects. Boyabatli & Toktay (2004) state that increasing shareholder value
by enhancing firm value through the management of risk exposures is the main objective of risk
management programs. Insurance companies are in the risk business and as such cover various
types of risks for individuals, businesses and companies. It is therefore, necessary that insurance
companies manage their risk exposure and conduct proper analysis to avoid losses due to the
compensation claims made by the insured. A robust risk management framework can help
organizations to reduce their exposure to risks, and enhance their financial performance (Iqbal &
Mirakhor, 2007). Further, it is argued that the selection of particular risk tools tends to be
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associated with the firm‟s calculative culture the measurable attitudes that senior decision makers
display towards the use of risk management models. While some risk functions focus on
extensive risk measurement and risk based performance management, others focus instead on
qualitative discourse and the mobilization of expert opinions about emerging risk issues (Mikes
& Kaplan, 2014). Moreover, Bandara & Weerakoon (2012) asserted that risk management is
important in insurance firms as it is the backbone of success

Finally, this study is examined the effects of risk management on insurer‟s financial performance
in Ethiopia. This will not only add to existing literature but also it will serve as identifying the
effects of risk management on insurance companies‟ performance is useful for insurance
practitioners, researchers, financial analysts and supervisory authorities.

1.1. The Insurance Industry in Ethiopia

The history of insurance service is as far back as modern form of banking service in Ethiopia
which was introduced in 1905 when the bank of Abyssinia began to transact fire and marine
insurance as an agent of a foreign insurance company. Subsequently the number of insurance
companies increased significantly and reached 33 in 1960. According to Hailu (2007), the first
significant event that the Ethiopian insurance market observation was the issuance of
proclamation No. 281/1970 and it was issued to provide for the control & regulation of insurance
business in Ethiopia. The law required an insurer to be a domestic company whose share capital
to be not less than Birr 0.4 million for a general insurance business and Birr 0.6 million in the
case of long-term insurance business and Birr 1 million for both insurance business. Non-
Ethiopian nationals were not barred from involving in insurance business however domestic
company as a share company having its head office in Ethiopia and in the case of a company
transacting a general insurance business at least 51% and in the case of a company transacting
life insurance business, at least 30% of the paid-up capital must be held by Ethiopian national
companies. Four years later the enactment of the proclamation, the military government that
came to power in 1974 put an end to all private enterprise. Then all insurance companies
operating were nationalized and from January 1, 1975 onwards the government took over the
ownership and control of these companies & merged them into a single unit called Ethiopian
Insurance Corporation.

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The nationalization of private insurance companies, the restrictions imposed on private business
ventures, and management of the insurance sector had significant adverse impact on the
development and growth of Ethiopian insurance industry (Hailu, 2007). However, following the
change in the political environment in 1991, the proclamation for the licensing and supervision
of insurance business No. 86/1994 heralded the beginning of a new era. Immediately after the
enactment of the proclamation private insurance companies began to flourish. According to the
Directive of ISB/34/2014, any insurance company required to be a domestic company whose
share capital to be not less than Ethiopian Birr 60 million for a general insurance business and
Ethiopian Birr 15 million in the case of long term (life) insurance business and Ethiopian Birr 75
million to do both long-term & general insurance business.

Today the total number of insurance companies, their asset and capital increased significantly. At
2015, there are 17 insurance companies in operation. Ethiopian Insurance Corporation (EIC) is
state owned while the rest all are private. The total asset and total capital of the sector reached
8.36 billion and 2.55 billion respectively. In addition the gross premium of sector is 5.56 billion
in 2015.

1.2. Statement of the Problem

Insurance companies are in the core business of managing risk. They 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. Agyei & Yeboah (2011) indicated that, some
financial institutions have had difficulties in growth of their profitability and some end up
closing their doors; probably inadequate risk management policies and practices are the major
causes of failures and poor performance of these firms. Further, Kadi (2003) stated that most
insurance companies are accepting to cover all the insurable risks without first carrying out
proper analysis of the expected claims from the clients and they have not put in place a
mechanism of identifying various methods of reducing risks. They have accumulated claims
from clients and this has led to consistent increase in losses which resulted in hindering of their
financial performance (Magezi, 2003). So according to these authors, insurers‟ financial loss
may be happened due to inadequate liquidity management, underpricing (imprudent
underwriting practice), management issues and high tolerance to investment risks.

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Nonetheless, in the context of Ethiopian insurance industry, the subject has received a limited
research attention. In which case, in order to either prove the above premises or reach into some
other assertion regarding the relationship between risk management and financial performance of
Ethiopian insurance companies, empirical investigation is lacking. As far as the knowledge of
the researcher is concerned, there are only two studies regarding risk management and insurance
financial performance in Ethiopian insurance industry until this date. In the case of Ethiopian
insurance industry as the best knowledge of the researcher there are only two studies regarding
risk management and insurance financial performance. Rebuma (2013), and kokebe & Gemechu
(2016), both studies focused on risk management techniques (loss prevention & control, loss
financing, and risk avoidance) and analyzed by using correlation matrix. According to Brooks
(2008), though regression as a tool is more flexible and more powerful than correlation, the two
studies‟ data were analyzed by correlation which simply stated that there is evidence for a linear
relationship between the variables, and that movements in the variables are on average related to
an extent given by the correlation coefficient. Nevertheless the researcher motivation is kinds of
risk management in insurance companies the targeted factors are liquidity, technical reserve,
company size, claim settlement, reinsurance and underwriting risk and their effect on financial
performance in Ethiopia and data analyzed by multiple linear regressions in addition to
correlation.

Therefore, this paper is intended to fill this gap and provide helpful empirical evidence in the
study area on the issue of interest.

1.3. Objectives of the Study

The general objective of this study is to empirically test the effects of risk management on the
financial performance of non-life insurance companies in Ethiopia. The specific objectives of
this study are;
 To examine the effects of liquidity risk on the financial performance of Ethiopian
insurers.
 To test the effects of technical reserve risk on the financial performance of Ethiopian
insurers.
 To experiment the effects of company size on the financial performance of Ethiopian
insurers.

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  To investigate the effects of claim settlement risk on the financial performance of
Ethiopian insurers.
 To examine the effects of reinsurance risk on the financial performance of Ethiopian
insurers.
 To examine the effects of underwriting risk on the financial performance of Ethiopian
insurers.
 To rank the impacts of factors according to their degrees of influence on Ethiopian non-
life insurers‟ financial performance.
 To draw conclusions and forward recommendations to insurers and regulator.

1.4. Hypothesis of the Study

Hypotheses of the study stands on the theories related to insurers‟ risk management and financial
performance that have been developed over the years by insurance industry and researchers‟ past
empirical studies related to insurers‟ risk management and financial performance. The results
from the literature review were used to establish expectations for the relationship of the different
variables. Hence, based on the objective, the present study seeks to test the following six
hypotheses:

H1: Liquidity risk has a significant and negative effect on Ethiopian non-life insurers’
financial performance;
H2: Technical reserve risk has a significant and negative effect on Ethiopian non-life
insurers’ financial performance;
H3: Company size has a significant and positive effect on Ethiopian non-life
insurers’ financial performance;
H4: Claim settlement risk has negative and significant effect on Ethiopian non-life
insures’ financial performance;
H5: Reinsurance risk has positive and significant effect on Ethiopian non-life
insurers’ financial performance;
H6: Underwriting risk has negative and significant effect on Ethiopian non-life
insurers’ financial performance;

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 1.5. Scope of the Study

The researcher focused on the effects of risk management on the financial performance of
insurance industry by taking evidence from insurance companies for the period of eleven years,
from 2005 to 2015. The dependent variables are delimited to financial performance level (ROA).
The explanatory variables are delimited to liquidity risk, technical reserve risk, company size,
claim settlement risk, reinsurance risk and underwriting risk. And the study area of this research
is delimited to non-life insurance companies in Ethiopia, and under operation after the fiscal year
2005.

1.6. Significance of the Study

This study is of immense value to insurance companies, academics and other concerned
stakeholders. As there is scarcity of empirical studies in insurance industries, some existed
studies are mainly focused on examining the determinants of profitability of insurance industry
and its contribution to economic growth. Hence this study might fill the gap by examining the
effects of risk management on the financial performances of insurance companies in Ethiopia.
The result of this study will also serve as a data base for further researchers in this field of
research. Further, the observed findings are pertinent for policy-makers, corporate boards,
executives and other stakeholders.

1.7. Organization of the Paper

The research paper was organized in to five chapters. Chapter one is background of the study
where overview of the insurance industry in Ethiopia, statement of the problem, objectives of the
study, hypothesis of the study, scope, and significance of the study presented. Chapter two is
review of literature in which theories, empirical evidence and conceptual frame work are
identified. Chapter three deals with research methodology, chapter four presented the research
results and discussions. Finally, chapter five contained the summary, conclusion and
recommendations for the finding.

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 Chapter Two:
Review of Literature
The word risk is quite modern; it entered the English language in the mid-17th century, coming from
the French word risque and in the second quarter of the 18th century the Anglicized spelling began to
appear in insurance transactions (Flanagan, 1993). Though the term risk has no a single definition,
Rejda (2008) defined as, it is uncertainty concerning the occurrence of a loss. According to this
definition a risk exist only if an uncertain action or event happens that leads to occurrence of that
risk. Although risk and uncertainty are often used interchangeably, there is a distinction between
them. Uncertainty is referred to not being sure of what is going to happen in the future and risk is
the degree of this uncertainty. In finance, one measure of risk is the probability that the actual
return on an investment will diverge from its expected value. How risky an investment is
depends on how much the actual return is likely to diverge from its expected value (Clark &
Mairos, 1996). Moreover, risk is a phenomenon that by definition and by nature cannot be
eliminated.

Risk management is the process of implementing and maintaining appropriate management

controls including policies, procedures and practices to reduce the effects of risk to an acceptable
level. The principles of risk management can be directed both to limiting adverse outcomes and
achieving desirable ones. The process involves identifying, analyzing, assessing, treating and
monitoring risk in all areas of agency operations and business (Moeller, 2007). Further more risk
management is the process of identification, assessment, and prioritization of risks followed by
coordinated and economical application of resources to minimize, monitor, and control the
probability and/or impact of unfortunate events or to maximize the realization of opportunities
(Wenk, 2005).

2.1. Theories of Risk Management and Financial performance

The concept of risk management theory involves studying the various ways by which businesses
and individuals raise money, as well as how money is allocated to projects while considering the
risk factors associated with them Sarkis (1998). There are a number of theoretical perspectives
which are used in explaining the effects of risk management on firm‟s financial performance.
The theories reviewed in this section are contingency planning theory, enterprise risk
management theory, managerial self-interest theory and Dupont Theory.

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 2.1.1. Contingency Planning Theory
According to Hisnson & Kowalski (2008), contingency planning (CP) also known as business
continuity planning is a crucial element of risk management. The fundamental basis of
Contingency Planning is that, since all risks cannot be totally eliminated in practice, residual
risks always remain. Despite the organization‟s very best efforts to avoid, prevent or mitigate
them, incidents will still occur. Particular situations, combinations of adverse events or
unanticipated threats and vulnerabilities may conspire to bypass or overwhelm even the best
information security controls designed to ensure confidentiality, integrity and availability of
information assets (Hisnson & Kowalski, 2008).

Riley (2012), defines contingency planning as a forward planning process, in a state of

uncertainty, in which scenarios and objectives are agreed, managerial and technical actions
defined, and potential response systems put in place in order to prevent, or better respond to, an
emergency or critical situation. A contingency plan is meant to help network and coordinate
individuals, agencies and organizations to affect a rapid and effective response. Contingency
planning ensures the availability of stand-by resources and provides mechanism for rapid
decision-making that can shorten disaster response and ultimately save lives.

It is the act of preparing for major incidents and disasters, formulating flexible plans and
marshaling suitable resources that will come into play in the event, whatever actually eventuates.
The very word „contingency‟ implies that the activities and resources that will be required
following major incidents or disasters are contingent (depend) on the exact nature of the
incidents and disasters that actually unfold. In this sense, CP involves preparing for the
unexpected and planning for the unknown. The basic purpose of CP is to minimize the adverse
consequences or impacts of incidents and disasters.

Therefore, as insurance companies‟ operations are full of probability, their business transactions
and policy contracts are also on contingent basis. If in the policy period no damage/loss is
happen, the insurer earns the whole premium which is a rare case, yet if the claim is reported
within the policy contract period the compensation should be paid. Both the magnitude of the
compensation and the time are not known certainly.

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 2.1.2. Enterprise Risk Management Theory
The underlying premise of Enterprise Risk Management (ERM) is that every entity exists to
provide value for its stakeholders. All entities face uncertainty and the challenge for management
is to determine how much uncertainty to accept as it strives to grow stakeholder value. Enterprise
risk management theory is one of the most common frameworks was introduced by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2004, which
defines ERM as (COSO, 2004) it is a process, effected by an entity‟s board of directors,
management and other personnel, applied in strategy setting and across the enterprise, designed
to identify potential events that may affect the entity, and manage risk to be within its risk
appetite, to provide reasonable assurance regarding the achievement of entity objectives. It also
emphasizes that the organizational benefits of risk management can create value for firms
(Nocco & Stulz, 2006).

According to Tseng (2007), Enterprise Risk Management (ERM) is a framework that focuses on
adopting a systematic and consistent approach to managing all of the risks confronting an
organization. ERM is an organizational concept that applies to all levels of the organization.
Furthermore, a firm‟s total risk can be reduced, financial distress is less likely (Meulbroek, 2002;
Gordon et al., 2009). Traditionally the approach of risk management has been a silo approach in
which one risk is managed at a time. In this approach, risk management is purchased without
acknowledging the interrelationship of risks. The silo (traditional) risk management causes
inefficiencies due to the lack of coordination between the various risk management departments
(Hoyt & Liebenberg, 2011). Whereas enterprise risk management is not strictly a serial process,
where one component affects only the next. It is a multidirectional, iterative process in which
almost any component can and does influence another (COSO, 2004).

Most empirical studies conclude that ERM generally has a significant positive impact on firm
value and performance. As opposed to Traditional Risk Management (TRM), where individual
risk categories are managed separately in risk silos, ERM allows firms to manage a wide array of
risks in an integrated, enterprise-wide fashion (Hoyt & Liebenberg, 2006).

2.1.3. Managerial Self-interest Theory

This theory was first put forward by Stulz (1984), who argued that firm managers have limited
ability to diversify the significant portion of their personal wealth held in the form of stock in the
firm and the capitalization of their earnings from the firm. Such managers would prefer stability
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of the firm's earnings to volatility because, other things equal, such stability improves their own
utility, at little or no expense to other stakeholders. This argument can be traced back to the
literature on agency. In this area, the relationship between firm performance and managerial
remuneration is clearly developed in such work as Ross (1977).

Demarzo & Duffie (1992), point out that observed outcomes may influence owner perception of
managerial talent. This would, in turn, favor reduced volatility, or at least the protection of firm
specific market value from large negative outcomes that may be found within the distribution of
possible returns. For this, if for no other reason, there appears to be ample justification for the
assumption that managers will behave in a manner consistent with a concave objective function.
Thus, this theory links risk management and firm performances.

2.1.4. DuPont Theory

DuPont analysis, a common form of financial statement analysis, decomposes return on net
operating assets into two multiplicative components: profit margin and asset turnover. These two
accounting ratios measure different constructs and, accordingly, have different properties.
According to Mitchell et al. (2013), the traditional role of DuPont formula is to help rational
investors decide on the optimal investments to undertake but has since evolved into a modern
tool used to find out the strength, weakness and likely improvement on the capital structure of an
organization that will help maximize stock holders‟ wealth. The first Du Pont model was
developed before 1970s when firms‟ main goal was that of maximizing return on assets (ROA),
(Liesz & Maranville, 2013). According to (Liesz & Maranville, 2008), Brown F. D. who was an
electrical engineer had been contracted by General Motors company to analyze their finances
after which he discovered a relationship that existed between total asset turnover, net profit
margin and return on assets. He found out that return on assets is equals to net profit margin
multiplied by total asset turnover, which is actually profitability multiplied by efficiency.

Gitman (1998) contend that, in the 1970s the generally accepted goal of financial management
became maximizing the wealth of the firm‟s owners, and focus shifted from return on assets to
return on equity (Liesz & Maranville, 2008) which then led to the modified DuPont model now
commonly known as, DuPont identity, where return on equity is equals to return on assets
multiplied by total assets and divided by equity. This was to cater for the ways institutions
leverage their operations and the modern goal of organizations which is maximization of owners‟
equity. Raza et al. (2013), contend that insurance firms when measured according to their net
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income levels do not rank the same as when measured using return on equity and usually the best
performers in terms of net income do not manage to perform in terms of return on owners‟
equity. Policyholders therefore do not like the highly performing insurance firms but the insurers
which give them high returns on their investments and hence support DuPont method of
measuring an insurance firm‟s performance (Raza et al., 2013).

2.2. Insurance and Risk Management

The term insurance defined by referring two important schools of thoughts: i) transfer school and
ii) pooling school. According to transfer school, “insurance is a device for the reduction of
uncertainty of one party, called the insured, through the transfer of particular risks to another
party; called the insured, who offers a restoration, at least in part of economic losses suffered by
the insured” (Irving, 1956). On the other hand, according to pooling school “the essence of
insurance lies in the elimination of uncertainty or risk of loss for the individual through the
combination of large number of similarly exposed individuals” (Alfred, 1935), cited in (Tanveer,
2010). Insurance operates on the principle of pooling risks where the people contribute to a
common fund in form of premiums and where the lucky ones who do not suffer loss help the
unlucky ones who suffer loss during a defined insurance period (Irukwu, 1994). Insurance is a
contract in which the insured transfers risk of potential loss to the insurer who promises to
compensate the former upon suffering loss. The insured then pays an agreed fee called a
premium in consideration for this promise. The promisor is called the insurer and the promise is
called the insured (Lowe, 1999). Insurance premium is the monetary consideration paid by the
insured to the insurer for the cover granted by the insurance policy. The Insurer takes on a
number of clients (Insured) who pay small premiums that form an aggregate fund called the
premium fund (Norman, 2000). The likelihood of an event or loss may be mathematically
calculated or it may be based on the statistical results of past experience in order to determine the
amount of premiums that would be required to accumulate a common fund or pool, to meet the
losses upon their arising (Grose, 1992).

UNCTAD (2007) underlines the insurance industry as one of the pillars of the finance sector that
plays a key and dual role (of infrastructural service and commercial service) which are both
crucial to the economic development of a country:

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  From infrastructural perspective, a well-functioning insurance enables efficient allocation
of capital, mobilize and channel savings; support trade, commerce and entrepreneurship
and improve the quality of lives of individuals in a given country.
 From a commercial service perspective, insurance companies promote the domestic
financial sector, become significant players in the international capital market, and give
financial confidence for investments.

It seems Insurance not only facilitates economic transactions through risk transfer and
indemnification but it also promotes financial intermediation (Ward & Ralf, 2000). More
specifically, insurance can have effects such as promote financial stability, mobilize savings,
facilitate trade and commerce, enable risk to be managed more efficiently, encourage loss
mitigation, foster efficient capital allocation and also can be a substitute for and complement
government security programs (Skipper, 2001). Insurance provides economic protection from
identified risks occurring or discovered within a specified period. Insurance is a unique product
in that the ultimate cost is often unknown until long after the coverage period, while the revenue
premium payments by policyholders are received before or during the coverage period.
Insurance is an important growing part of the financial sector in virtually all the developed and
developing countries (Das et al., 2003). A resilient and well regulated insurance industry can
significantly contribute to economic growth and efficient resource allocation through transfer of
risk and mobilization of savings. In addition, it can enhance financial system efficiency by
reducing transaction costs, creating liquidity and facilitating economies of scale in investment
(Bodla & Garg, 2003).

Some of the contributions of the insurance industry to economic development as (Davies &
Podpiera, 2003) state are:
 Insurance promotes financial stability through transfer and pool of risks, thereby
encouraging individuals and firms to specialize, create wealth, and undertake beneficial
projects they would not otherwise consider.
 Insurance mobilizes savings and channels them to the capital markets, and developing
countries with higher savings rates tend to show faster growth and investment.
 Strong insurance can relieve pressure on government budget. It can play an important
role in personal retirement planning and health insurance programs, and to that extent
can reduce demands on government social security and health programs.

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  Insurance supports trade, commerce and entrepreneurial activity to have heavy influence
on all economic and commercial activities.
 Insurance may lower the total risk faced by the economy through risk diversification
across border as well as to promote risk mitigation activities.
 Insurance improves individuals‟ quality of life and increase social stability through, for
example, individual health, life insurance, pension funds and worker‟s compensation.

Insurance business is usually divided into two main classes namely: a) General insurance
business. This is a contract between an insurer and the insured where by the insurer undertakes to
indemnify the insured against losses, which may result from the occurrence of specified events
within specified periods. General insurance business can be subdivided into: motor, fire,
accident, oil and gas, contractors‟ all risks and engineering risks; marine and credit insurance,
bond and surety ship etc. This is a contract between the insurer and the insured whereby the
insurer undertakes to pay benefits to the policy holder on the attainment of a specified event. b)
Life assurance business: comprises individual life business, group life insurance and pension
business, health insurance business and annuities.

Risk management and insurance are closely related as it is indicated in most literatures.
Insurance alone is not risk management rather Insurance Companies are a corporation primarily
engaged in the business of providing insurance protection to the public and sale contracts of
insurance. Risk management is far broader and includes the concepts of preventing, minimizing,
and avoiding losses. In addition, risk management addresses methods other than insurance for
transferring the financial consequences of losses that do occur (Stulz, 2004 and Dorfman, 1997).
Risk measurement is a fundamental to the insurance industry, from the pricing of individual
contracts to the management of insurance and reinsurance companies to the overall regulation of
the industry. Insurance services offered by non- life insurance firms do cushion against risks
faced by people and non-insurance firm industries (Amaya & Memba, 2015). Transfer of
uncertainties to insurance firms by people and non-insurance firm industries is important because
risk management is a difficult thing to do by any person as it involves identification of source of
risk and then coming up with methodology of quantifying the risk using mathematical models
which helps understand risk profile of the person which assists in handling the risk (Kealhofer,
2003). According to Ndwiga, et al. (2012), identifying risk is the first step in the process of risk
management and methods used in identifying risks involve tools used to optimize opportunities
of knowing hazards inherent in certain systems, facilities or products and the tools are
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categorized in broad headings of inductive, deductive or intuitive methods. Organizations are
faced with many risks which can emanate from financial variables‟ uncertainties, accidental
occurrences or even failing of businesses; this can be reduced through risk monitoring and
controlling (Saunders, 1996).

In insurance companies, risk management produces as well as the overall quality of management
are considered as important factors and together with sufficient financial resources are key
factors in protecting against insurance company insolvency. In addition, the process of effective
risk management should cover all key elements of the business cycle and more importantly to
adequately manage the risks to which the company is exposed.

Effective risk management can bring far reaching benefits to all organizations, whether large or
small, public or private sector (Ranong & Phuenngam, 2009) and risk management may reduce
or eliminate costly lower-tail outcomes (Stulz, 2003), which may also result in lower expected
costs of regulatory scrutiny and external capital (Meulbroek, 2002). These benefits include,
superior financial performance, better basis for strategy setting, improved service delivery,
greater competitive advantage, less time spent firefighting and fewer unwelcome surprises,
increased likelihood of change initiative being achieved, closer internal focus on doing the right
things properly, more efficient use of resources, reduced waste and fraud, and better value for
money, improved innovation and better management of contingent and maintenance activities
(Wenk, 2005). Only the amount of quantifiable risks which are beyond the level of risk appetite
of the insurance organization needs to be managed by the company at its own. This is the point
where an insurance company needs to conceive a better risk management approach, employing
sound and fruitful techniques, tools and procedures, which will promise the remarkable returns,
thus, satisfying the organizational goals. Laconically, insurance companies resort to the three
main ways of managing risks, i.e., Risk Avoidance through business practices, Risk Transference
through the construction of portfolios or Diversification and Managing the risk at the firm level
by holding the persons accountable. Further, there exist markets for many of these risks borne by
the insurance companies. These include catastrophic risk which can be offset by undertaking
positions in the catastrophic futures or bonds. Indeed a number of alternatives to minimize the
adverse impacts of such risks are under consideration Jaffee & Russell (1997). Generally an
insurance organization relies on a number of techniques in their risk management framework.
But most prominently, four types of practices evolve as instrumental in managing the risk and
thereby improving the financial performance of the organization. These important techniques
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include standards and reports, underwriting authority and limits, investment guidelines or
strategies, and incentive Schemes. These tools are employed to quantify the risk exposure, spell
out the procedures to manage and limit such exposures to the acceptable levels, and manage or
motivate the risk managers to manage risk in a way which is consistent with the organizations
goals and promises the better performance of the organization.

Danijela & Zeljko (2009) suggested the risk managers to devote their efforts and resources in
eliminating or mitigating the risks for sound profitability. Literature further witnesses that the
Insurers use hedging instruments to maximize value. Moreover, these instruments are employed
to absorb the negative consequences of asset volatility, liquidity, exchange rate and interest rate
risks (Cummins et al., 2001). Addressing risks in a more sophisticated manner, Stulz (1996)
argued that the theory of risk management, if applied in a well-defined manner will protect the
financial companies from the market shocks, bankruptcy and financial distress. Following the
basics of risk management, managers in their best capacity can enhance the value of their
business undertakings through their productive efforts. Thus, with the help of provisions of risk
management, financial institutions can make themselves withstand against the downside
movements of risk.

2.3. Financial Performance Measurements

Insurance companies are engaged in the business of taking risks. Throughout the globe, these
companies deal with a host category of risks which have a direct impact on the performance of
these companies. These risks prove to be a greater setback in the process of achieving growth in
terms of size, assets and performance of the company which is measured in the form of returns.
It is understood that the primary goal of performance (both financial and non-financial)
measurement is to assess the progress of achieving corporate objectives. In addition, the output is
utilized to allocate resources appropriately throughout the organization (Christopher, 2003). The
analyst or investor may wish to look deeper into financial statements and seek out margin growth
rates or any declining debt. If underlying profitability continues to deteriorate, more stock
buybacks or debt leverage will be necessary to maintain return on equity, more increasing
company exposure to unanticipated downturns in consumer demand or financial market crises.
But letting return on equity decline is often too painful to contemplate since the impact on stock
performance hence financial performance can be immediate. The risks on the other side are less

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immediate and less quantifiable, so there is an understandable temptation to avoid immediate
pain (Hagel et al., 2010).

According to Angell & Brewer (2003), financial performance is determined by asset utilization,
relative profitability and company‟s financial leverage. Zenios et al. (1999) stated that
profitability analysis focuses on the relationship between revenues and expenses and on the level
of profits relative to the size of investment in the business through the use of profitability ratios.
Return on equity (ROE) and return on assets (ROA) are two of the most important measures for
evaluating how effectively a company‟s management team is managing the capital that
shareholders entrust to it. Return on equity indicates if a company‟s value is growing at an
acceptable rate. It‟s calculated as annual net income divided by average shareholders‟ equity,
while return on assets reveals how much profit a company earns for every money of assets. It‟s
calculated as annual net income divided by total assets. The return on total assets ratio is one of
the most used methods of quantifying financial performance. It was developed in (1919) by
DuPont and it emphasizes the company‟s ability to efficiently use its assets.

Financial institutions such as banks, insurance companies, securities and credit unions have very
different ways of reporting financial information (Flemings, 2004). Insurance companies
financial performance can be measured using underwriting and profitability ratios (Flemings,
2004). On the other way, William et al. (2004) argued that the performance of insurance companies
in financial terms is normally expressed in net earned premium, profitability from underwriting
activities, annual turnover, return on investment, and return on equity. These measures could be
classified as profit performance measures and investment performance measures. On the other
hand the return on total assets ratio represents one of the most used methods of quantifying
financial performance; it emphasizes the company‟s ability to efficiently use its assets (Maria,
2014). It reflects the ability of insurance‟s management to generate profits from the insurers‟
assets, although it may be biased due to off-balance-sheet activities. Most researchers in the field
of insurance and their financial performance stated that the key indicator of a firm‟s financial
performance is ROA. Arif & Showket (2015), Njeru (2013), Catherine (2014), Mike (1999), and
Hafiz (2011) are among others, who have suggested that although there are different ways to
measure profitability it is better to use ROA as it helps to measure the overall resource (asset)
performance.

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 2.4. Risk Management & Financial Performance: An Empirical Review

Now day‟s entity stakeholders are demanding greater attention to major risks facing by the entity
to ensure that stakeholder value is preserved and boosted. One response to these growing
expectations is the development of a new model “Enterprise Risk Management” as an internal
control system. At the same time, organizations have been implementing “Performance
Measurement System” as one of management control systems vital for corporate success.
Subsequently studies have been conducted regarding on risk management, the studies which are
conducted in different business sector in general, financial sector and more specifically in
insurance industry provided herein under.

The study conducted by 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. In
addition Gupta (2011) examined the risk management in Indian companies and explore the
reasons for the adoption or lack of adoption of integrated approach to risk management using the
survey research methodology that includes structured questionnaires and interviews of 130
companies. The study shows that effective risk management can improve organizational
performance. Moreover Mohsen et al. (2011) assessed effective risk management and company‟s
performance by emphasizing investment in innovations and intellectual capital. The data had
been collected from the companies‟ financial statements and notes are available in the years of
2003 - 2008. 52 companies from 13 different industries were selected purposefully. Their result
indicated that positive and significant relationship between total risk management and
company‟s performance. Other study conducted by Giorgio et al. (2013), the effect of enterprise
risk management implementation on the firm value, on a sample of 200 European companies,
belonging to both financial and non-financial industries, they did this performing a fixed effects
panel regression analysis. They found a positive statistically significant relation between the
ERM adoptions and firm value. On the other hand, a study of Tony et al. (2012) investigated
enterprise risk management and business performance during the financial and economic crises.
It examined 156 non-financial companies listed on the Standard & Poor‟s (S&P) Toronto Stock
Exchange (TSX) Composite Index for 2007 - 2008 and 2008 - 2009 through a content analysis of
their annual reports. The study rated risk exposure, risk consequences and risk management

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information among types of risks. No conclusive results on the relationship between ERM and
firm performance.

Mwangi (2014) studied on the effect of risk management on financial performance of

commercial banks in Kenya. Descriptive research design was used in the study. Secondary Data
was collected from Central Bank and banks financial reports and multiple regression analysis
used in the data analysis. The study found that there was a strong positive relationship between
risk management and financial performance of commercial banks in Kenya. The study also
found that there was a negative relationship between credit risk, insolvency risk, interest rate
sensitivity and financial performance of commercial banks. The study additionally revealed that
there was a positive relationship between capital adequacy, size of the banks, operational
efficiency and financial performance of commercial banks.

Ahmed et al. (2011) conducted a study on risk management practices and Islamic Banks in
Pakistan. The study used credit, operational and liquidity risks as dependent variables while size,
leverage, NPLs ratio, capital adequacy and asset management are utilize as explanatory variable
for the period of four years from 2006 to 2009. The study concluded that size of Islamic banks
have a positive and statistically significant relationship with financial risks, whereas its relation
with operational risk is found to be negative and insignificant. The asset management establishes
a positive and significant relationship with liquidity and operational risk. The debt equity ratio
and non-performing loans ratio have a negative and significant relationship with liquidity and
operational risk. In addition, capital adequacy has negative and significant relationship with
credit and operational risk, whereas it is found to be positive and with liquidity risk.

Kenny et al. (2014), studied on risk management practices and financial performance: evidence
from the Nigerian deposit money banks, the study used secondary data gathered through content
analysis of the selected banks‟ annual reports and accounts. The cross sectional data were
analyzed using descriptive statistics to show pattern and robust standard errors OLS regression to
estimate significant influence between banks‟ risk management practices (credit, liquidity,
operating and capital risk practices) and their financial performance. Risk management practices
have a significant influence on banks‟ performance. While the credit and capital risk display
significant positive influence on ROA.

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Catherine (2014), the effects of risk management on financial performance of insurance
companies in Kenya, data collected from 44 insurance companies and published reports for a
period of 2008 - 2012. The study established that a majority of insurance companies in Kenya
had adopted risk management practices in their operations and that this had a strong effect on
their financial performance. Risk identification was found the most significant in influencing
financial performance, followed by risk mitigation, risk management program implementation &
monitoring and risk assessment & measurement respectively. The study concluded that there was
a positive relationship between the adoption of risk management practices and the financial
performance of insurance companies in Kenya.

Patrick & Florence (2015) influence of risk management practices on financial performance of
life assurance firms in Kenya: a survey study of Kisii, the target population was one hundred and
eighteen respondents. Census sampling method was used. Questionnaires were used for data
collection. Risk management practice is the independent variable which contained; underwriting
practice, premium valuation methods, and adjustment provisions of claim liabilities. The
findings, Premium valuation methods had positive influence on financial performance of life
assurance firms in Kenya. The study established that underwriting guidelines had a positive
effect on financial performance of life assurance firms in Kenya. Further the study revealed that
adjusting claims and benefits paid to policy holders of insurance firms‟ increase value of
investment and this gave a reason for claims adjustment to get the best estimate of acceptable
costs for every person which is usually determined by observed costs based on risk factors.

The study conducted by Arif & Showket (2015) relationship between financial risk and financial
performance of Indian insurances revealed that capital management risk, solvency risk, liquidity
risk, volume of capital and size of company were most important determinants of financial
performance of life insurance companies in India, whereas had statistically insignificant
relationship with underwriting risk. The study led to the conclusion that underwriting risk was
found to have statistically insignificant relationship with financial performance of life insurance
companies. And capital management risk, solvency risk and underwriting risk exhibit a negative
relationship with financial performance while liquidity risk, size and volume of capital exhibit a
positive relationship with financial performance of life insurance companies in India.

Joyce & Willy (2016), studied on effects of risk management practices on financial performance
of non-life insurance firms operating in Kisii County in Kenya descriptive survey research

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design was used to collect data. Target population was 237 respondents, comprising of 116
directors and 121 senior managers. Stratified random sampling method was used to get the
sample. Primary data was collected using a structured questionnaire while secondary data was
collected from published reports and financial statements. The study shows that there was a
positive relationship between financial performance of non-life insurance companies, risk
identification practices, risk mitigation practices and risk monitoring practices. The study
concludes that there is a strong relationship between risk management practices and financial
performance of insurance companies in Kisii County, Kenya

Musa et al. (2014) examined the relationship between enterprise risk management and
organizational performance: evidence from Nigerian insurance industry, using purposive
sampling technique, 10 general insurance companies were selected from 49 companies operating
in Nigeria. Contingency reserve, shareholders‟ fund, gross premium and net premium were used
as dummies for ERM indicators. Panel data was adopted for a ten year period of 2001-2010. The
study reveals that there is joint cause relationship among ERM variables and organizational
performance though, individual relationship of the indicators differ. Both contingency reserve
and net claims respectively have significant positive impacts on organizational performance.
Liquidity ratio has no significant impact on organizational performance. Shareholders‟ funds
have a negative significant impact on organizational performance.

Eric (2005) investigated risk management techniques and financial performance in the insurance
sector in Uganda. The findings on the financial performance of the insurance companies for this
study show fluctuating ratios as measured by ROE. Likewise a study by Mwangi & Iraya (2014)
found that financial performance was positively related to earning assets and investment yield for
Kenyan General Insurers and that growth of premiums and size of underwriter were not
significantly related to financial performance. Adams & Buckle (2003) argued that highly geared
and low liquid Bermuda insurers perform better and that their underwriting risk is directly related
to a resilient financial performance.

2.5. Related Empirical Studies in Ethiopia

To the best knowledge of the researcher there is no study on the Ethiopian insurance industry
exclusively focused on risk management and financial performance of insurers. In Ethiopian
banking industry there are a few studies like Eneyew (2013), Endaweke (2015) and Tsion

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(2015). In the case of Ethiopian insurance industry, there are two studies undertaken in relation
to risk management techniques and insurers‟ financial performance. More details are presented
subsequent paragraphs.

Eneyew (2013) conducted his study on the impact of financial risks on the profitability of
commercial banks for a total of eight commercial banks in Ethiopia, covering the period of 2000-
2011. The study adopted a mixed methods research approach by combining documentary
analysis and in-depth interviews. The findings of the study show that Credit risk and liquidity
risk have a negative and statistically significant relationship with banks‟ profitability.

The study conducted by Endaweke (2015) was Risk management and its impact on performance
in Ethiopian Commercial Banks, balanced fixed effect panel regression was used for the data of
8 commercial banks in the sample covered the period from 2002 - 2013. The results of panel data
regression analysis showed that credit risk management indicator, Liquidity risk management
indicator and operational risk indicator had negative and statistically significant impact on banks
performance. Capital adequacy ratio had positive statistically insignificant impact on banks
performance. In addition to this, analysis of primary data by descriptive statistical tools and on
hypothesis testing using regression model, leads the researcher to conclude that banks with good
risk management policies have a lower risk and relatively higher return on asset. Finally none
performing loan ratio, liquidity ratio and cost to income ratio are significant key drivers of
performance of commercials banks in Ethiopia.

Tsion (2015) examined the effectiveness of risk management practice of commercial banks
operating in Ethiopia. Information was obtained from 15 purposely sampled commercial banks
& adopted concurrent mixed research design. Open and closed-ended questionnaires were
administered to 86 respondents from selected commercial banks. The main conclusions of the
paper were: risk managers perceive risk management as critical to their banks performance; the
types of risks causing the greatest exposures are credit risk, operational risk, liquidity risk,
interest rate risk and foreign exchange risk; there was a reasonable level of success with current
risk management practices and, banks are utilizing some of the approaches/techniques
traditionally used to manage risks. She finally concluded that banks operating in Ethiopia are
indeed risk-focused.

Rebuma (2013), studied on risk management techniques and financial performance of Ethiopian
insurance companies the purpose of the study was to examine the relationship between applied

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risk management techniques and financial performance of the insurance companies in Ethiopia,
covering the period of 2002-2011. Correlation analysis was used identify the relationship
between risk management techniques and financial performance. The findings of the study
indicated that risk management techniques (loss prevention and control, loss financing and risk
avoidance) were applied in the Ethiopian insurance companies. However, risk management
techniques were not commonly applied among insurance companies. The findings also revealed
low increase ROE ratios and a general increase in loss ratios of the insurance companies; i.e. a
poor financial performance especially as indicated by the loss ratios. Finally, the study indicated
the existence of weak relationship between risk management techniques and financial
performance that show ineffective on how risk management techniques are applied to improve
performance of the insurance companies.

Likewise, Kokobe & Gemechu (2016), worked on risk management techniques and financial
performance of insurance companies in Ethiopia, primary data was collected through
questionnaires and secondary data was collected from year-end financial report of the selected
company. Primary data was collected from employees and secondary data was collected from
financial statements of selected insurance companies and analyzed using Pearson correlation to
check the relation between insurance performance and risk management techniques. The result
shows that risk management practice and financial performance are not correlated.

2.6. Risk Selection and Research Hypothesis

Rather than taking all the many possible risks insurers facing, the researcher established some
relevant and critical risks. Based on the previous empirical studies, insurers‟ financial
performance is influenced by both financial and operational risks. There are so many risks under
these two broad categories however the researcher wants to focus on main risks. Under financial
risks; liquidity, credit and technical reserve risks. Solvency and market risks are very common
financial risks yet solvency risk more the same with liquidity risk in Ethiopian insurance market
because the industry contains almost all insurers except two or three have no long term liability,
in addition to this their main liability is technical reserve which also considered in this study.
Regarding market risk it mainly arises from stock price fluctuation and interest rate volatility but
in Ethiopia this is not the case as there are no structured primary and secondary market and the
floor interest rate is fixed so the minimum return is known. On the other hand operational risk
contains; company size, claim settlement, reinsurance and underwriting risks. Information
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Technology risk is a key type of risk now days in developed, emerging, and some developing
countries as well, however in Ethiopian insurance industry that is not the case, because only two
or three insurers are partially operating with this technology. Therefore taking into consideration
the above realities, the selected crucial risks are more emphasized herein under with their
corresponding hypothesis.

In light of the challenging capital and insurance market environment, strong enterprise risk
management (ERM) is a crucial element in maintaining financial strength and ensuring a safe
insurance industry. Barges (1963) defines financial risk to be the added variability of the net cash
flows of the owners of equity that results from the fixed financial obligation associated with debt
financing and cash leasing. Also, financial risk encompasses the risk of cash insolvency.
However, this notion will be expanded to include the risk of being unable to meet prior claims
with the cash generated by the firm, which is determined by the dispersion of net cash flows and
the level of fixed obligations, as well as the firm's pool of liquid resources (Jacques & Nigro,
1997). In a similar manner, Allen & Santomero (1997) have explained the increased importance
of financial or corporate risks because of a variety of reasons stemming from price fluctuations,
interest rate fluctuations, increased competition and greater deregulation. Moreover, with the
advent of derivatives which acts as hedging instruments has let the organizations to resort to an
additional avenue to protect their organizations against the shocks of financial risks (Bartram et.
al., 2011).

According to Kithinji, (2010) financial risk management practices fall into three major
categories; credit risk practices, liquidity risk management practice and market risks. When we
look at the insurance industry not only these three risks but also technical reserve risk is the other
most crucial risk the reason that the insurance operation is full of contingency due to this much
reserves are needed.

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people
and systems or from external events. It is the risk associated with everyday activities of an
organization, which involves the management of the performance of its processes, its people, and
its systems, to reach the expected business performance. Operational risks breakdowns in
internal controls, which can lead to financial losses through frauds, or failure to carry out
operations in timely manner. However, in the case of insurance industry the main operational
risks are underwriting, claim settlement, and reinsurance risks. Other aspects of operational risks

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include major failure of IT systems but this IT system has not that much using by Ethiopian
insurance industry.

Liquidity, technical reserve, company size, claim settlement, reinsurance and underwriting risks
are the selected variables based on the above analysis.

a. Liquidity Risk

Liquidity shows the ability to convert an asset to cash quickly and reflects the ability of the firm
to manage working capital when kept at normal levels. It measures the ability of managers in
insurance and re-insurance companies to fulfill their immediate commitments to policyholders
and other creditors without having to increase profits on underwriting and investment activities
and/or liquidate financial assets (Adams & Buckle, 2003). A firm can use liquid assets to finance
its activities and investments when external finance is not available or it is too costly. On the
other hand, higher liquidity would allow a firm to deal with unexpected contingencies and to
cope with its obligations during periods of low earnings (Liargovas & Skandalis, 2008).
According to Barney (1997) the test of an insurer's ability to meet financial obligations is the
acid test. It tests whether a firm has enough short-term assets to cover its immediate liabilities.
Poor liquidity causes investment losses and hence poor financial performance when the insurer
must sell assets prematurely to cover claims. Having sufficient cash on hand will ensure that
creditors, employees and others can be paid on time. Liquidity risk could include two different
types of risk: the risk that an insurance company will become unable to assure itself of adequate
funding due to a decline in new premium income caused by a deterioration, etc. of its financial
position, or an outflow of funds caused by a big disaster, or it will incur losses because it is
forced to sell assets at markedly lower prices than normal and therefore unable to maintain cash
flow (capital liquidity risk), and the risk that upheavals, etc. in the market will render it
impossible to trade and therefore force the company to engage in transactions at prices that are
markedly more disadvantageous than normal (Black et al., 1998).

More empirical findings have confirmed that there is a positive relationship between liquidity
ratio and financial performance of insurers (Ambrose & Carroll 1994; Carson & Hoyt, 1995;
Chen & Wong, 2004 and Amal et al., 2012). Companies with more liquid assets are less likely to
fail because they can realize cash even in very difficult situations. Furthermore Browne et al.
(2001) found evidence supporting that performance is positively related to the proportion of

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liquid assets in the asset mix of an insurance company. When looking at any company's financial
statements and attempting to understand where it stands as regards to its viability, liquidity ratios
are quite important. The higher a company's liquidity ratio, the healthier it is. Entities with high
debt and low liquidity are more likely to fail and riskier investments. It is therefore expected that
insurance companies with more liquid assets will outperform those with less liquid assets.

Therefore liquidity risk is the shortage of liquid asset and the most popular ratio other than
current ratio is current liability to current asset which is the exact opposite of current ratio. The
ratio current liability to current asset can show easily the liquid asset bases of the current
liability. Thus, based on the above theories and empirical studies the researcher formulate the
following hypothesis.

H1: Liquidity risk has negative and significant effect on Ethiopian insurers’
financial performance;

b. Technical Reserve Risk

Insurance companies collect premiums in advance and keep them in reserve accounts for future
claim settlements. For instance, most premiums collected by insurance companies are kept in
outstanding claims and unearned premiums reserves which are two main accounts in the liability
side of the balance sheet. Outstanding claims reserve is considered riskier than ordinary long-
term corporate debt since neither the magnitude nor the timing of the cash outflows is known
(Shiu, 2014). Its risk is both holding insufficient technical provisions and holding unjustifiably
excessive provisions. Where reserves are set at a lower level than actually required then this
could present the company‟s financial position in a better light than it actually is. This could
result in inappropriate underwriting decisions being made. For example, more risky policies may
be underwritten on the basis that more capital is available to support this than is actually the case,
or higher levels of business may be written. The insurance technical reserve is calculated as the
ratio of net technical reserves to equity, and reflects the potential impact of technical reserves‟
deficit on equity in the event of unexpected losses. This ratio demonstrates the potential impact
of deficiencies in technical reserves due to the occurrence of unexpected losses on the equity
(Adams & Buckle, 2003). Moreover, a negative relationship between technical reserve and
performance has also been found in Browne et al. (2001). Consequently, a negative linkage
between the insurance financial reserve and the insurers‟ financial performance is expected.

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H2: Technical reserve has negative and significant effect on Ethiopian insurers’
financial performance;

c. Company Size

Insurance size is associated with diversification which may impact favorably on risk and product
portfolio. On the other hand, increased diversification can reduce risk in the business portfolio
thereby reducing returns. Insurers that have become extremely large may exhibit negative
relationship between size and profitability as a result of bureaucracy and agency cost. (Hardwick,
1997) suggested that large insurers are likely to perform better than small insurers because they
can achieve operating cost efficiencies through increasing output and economizing on the unit
cost of innovations in products and process development. The research conducted on the
relationship among firm characteristics size and growth by Swiss Re (2008) indicated that large
firms are found to grow faster than smaller and younger firms found to grow faster than older
firms.

Several studies have been conducted to examine the effect of size on the financial performance
of insurance companies. Most of the researchers in insurance have found a positive relationship
between size and profitability. For example, Demirguc & Maksimovic (1998) and Sommer
(1996) have established a positive correlation between size and profitability. Also,
Asimakopoulos et al. (2009) found that the profitability of companies is positively impacted by
company size. Browne et al. (2001) has shown empirically that company size is positively
related to the financial performance of US life insurance companies. Moreover Almajali et al.
(2012) surveyed 25 insurance companies of Jordan during the period 2002-2007 by using a
number of basic statistical techniques such as T-test and Multiple-regression. The results showed
that Size has a positive statistical effect on the financial performance of Jordanian Insurance
Companies.

In this study company size is computed as logarithm of total assets of the insurance company. A
positive linkage between company size and its profitability is expected, since larger firms have
more resources, a better risk diversification, complex information systems and a better expenses
management. Thus, the researcher formulates the following hypothesis:

H3: company size has positive and significant effect on Ethiopian insurers’ financial
performance;
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 d. Claim settlement Risk

Singh (2007) noted that claims are the defining moment in the customer relationship for
insurance firms, with a firm‟s success often defined by one factor: the customer‟s experience
around claims. If a company does not effectively handle its claims service, it can tarnish its
image and hence affect the sales and marketing of its insurance products. Insurance company‟s
attitude to claims settlement has in the past provoked a lot of public criticism and even attracted
the attention of governments (Harry, 2012). In fact, it is the only reason the consumer (insured)
buys an insurance product. Parsons (2005) one of the principal functions of insurance is the
settlement of claims. Claims, being the heartbeat of insurance, are the most critical contact the
insuring public has with the industry and thus, critical moment of truth that shapes a customer‟s
overall perception of their insurer (Crawford, 2007). Moreover, Christian & Versicherun, (2015)
stated that insurance contracts have, in their function and structure, particular characteristics
which must be considered in order to ensure an effective claims settlement.

Roff (2004) has point out the claim settlement practices that to all intents and purposes, the claim
department can be seen as the “shop window” of the insurance company. It does not matter how
cheap an insurance company‟s premiums are, or how efficiently they conduct their underwriting
administration if a claim is not properly and fairly dealt with, this is where an insurer will be
judged. Furthermore, Lijadu (2002) stated that the insurance industry in African is bogged down
by unwholesome public perception. He stated that the insurance industry is aware of the public‟s
misconstrued image of the insurance sector. Moreover he emphasized this by saying that the
insurance industry is perceived as quick to collect premium, slow to pay claims, using small
prints to confuse you, providing poor services and engaging in sharp practices. Harrington &
Niehaus (2006) who asserted that insurers need to take their claim handling function more
seriously because if a claim is handled well, it results to higher customer retention but if handled
poorly, policyholders will lose confidence in the insurer and this may damage its most cherished
reputation.

Pervan et al. (2012) investigated the claim ratio of Bosnia and Herzegovina insurance industry‟s
profitability. Their findings indicated a strong negative influence of claims ratio on profitability.
This also supported by Mirie & Cyrus (2014) financial performance was negatively related to
loss ratio. Moreover according to Yusuf (2014) effects of claim cost on insurers‟ profitability on
Nigerian Insurers an inverse relationship exist between loss ratio (claim ratio) and profit before
tax. Insurance firms with higher claim ratios should be at greater risk of insolvency. Conversely,
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one might expect that firms with lower loss ratios should be better performers, all else equal
(Kevin, 2009). Claims erode earnings, and hence the lower the loss ratio, the higher the financial
performance. For these reasons, the claim settlement risk and insurances financial performance
has a negative relationship and affects significantly.

H4: Claim settlement risk has negative and significant effect on Ethiopian insurers’
financial performance;

e. Reinsurance Risk

Reinsurance is a contract of indemnity against liability by which an insurance company procures

another insurance company to insure it against loss or liability by reason of the original
insurance. It has a global feature as manifested by economic interdependency, mobility of capital
and transactions across borders, sharing regulations, international competition and management;
and like any product, it is subject to cycles and fluctuations driven by internal and external
factors (Plantin, 2006). It is a secondary market and is the main feature of the non-life insurance
in the insurance business industry and is one of a number of options or tools to reduce the
financial cost to insurance companies arising from the potential occurrence of specified
insurance claims, thus, further enhancing innovation, competition, and efficiency in the
marketplace (Patrik, 2001). According to the Chartered Insurance Institute (2004), insurance
companies use reinsurance for capacity, business, asset management, catastrophe protection,
spread of risk, and market environment reasons, which are all needed at different times in a
company‟s development.

Garven & Lamm (2003) describe reinsurance as both risk management and financial structure
decision. In terms of risk management, reinsurance enables the reinsured leverage with skills of
analysis and proper and modern way of management of risk portfolios including assessing of
underwriting risks, and handling of claims properly and efficiently. Insurance companies
reinsure a certain amount of the risk underwritten in order to reduce bankruptcy risk in the case
of high losses. Although reinsurance improves the stability of the insurance company through
risk dispersion, achievement of solvency requirements, risk profile equilibration and growth of
the underwriting capacity, it involves a certain cost. Purchasing reinsurance reduces insurers‟
insolvency risk by stabilizing loss experience, increasing capacity, limiting liability on specific
risks, and/or protecting against catastrophes. However, transferring risk to reinsurers is

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expensive. The cost of reinsurance for an insurer can be much larger than the actuarial price of
the risk transferred.

Cummins et al. (2008) analyzed empirically the costs and the benefits of reinsurance for a
sample of US property-liability insurers. The results show that reinsurance purchase increases
significantly the insurer‟s costs but reduces significantly the volatility of the loss ratio. With
purchasing reinsurance, insurers accept to pay higher costs of insurance production to reduce
their underwriting risk. Insurers with higher reinsurance dependence tend to have a lower level
of firm profitability. It is possible that an insurer that cedes more business to reinsurer and keeps
lower retention more or less operates like a reinsurance broker who only transfers risk without
underwriting risk and is likely to report less profit for a relatively high percentage of the
premium received is ceded to reinsurers (Lee, 2012).

Retention ratio (net written premium to gross written premium) is the most common ratio in
assessing reinsurance risk. Therefore, a positive connection between the retention ratio and the
insurers‟ financial performance is expected, because if insurers retain more premiums, they can
increase their income and then intensify their ROA.

H5: Reinsurance risk has positive and significant effect on Ethiopian insurers’
financial performance;

f. Underwriting Risk

Underwriting is the process of selecting certain types of risks that have historically produced a
profit and rejecting those risks that do not fit the underwriting criteria of the insurer. Sound
underwriting guidelines are pivotal to an insurers‟ financial performance. Insurance prices are
established based on estimates of expected claim costs and the costs to issue and administer the
policy. The estimates and assumptions used to develop policy pricing may prove to ultimately be
inaccurate. This may be due to poor assumptions, changing legal environments, increased
longevity, higher than expected weather catastrophes (Ernst & Young, 2010).

Underwriting risk is the risk that the premiums collected will not be sufficient to cover the cost
of coverage. It comprises a high proportion of an insurer‟s overall risk. Huge fluctuations in net
premiums written indicate a lack of stability in underwriting operation of an insurance company.
An unusual increase in net premiums written might indicate that the company is engaging in the

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so called cash-flow underwriting to attempt to survive its financial difficulty. However, this is
not necessarily the case. An unusual increase in net premiums written could indicate favourable
business expansion if it is accompanied by adequate reserving, profitable operations, and stable
products mix (National Association of Insurance Commissioner, 2001). Good underwriting risk
selection normally produces a favorable loss ratio. This means the premium collected, less loss
and expenses, produces a profit for the insurer. Insurers must carefully underwrite all risks to
avoid being the victim of adverse selection. The underwriting risk reflects the adequacy or
otherwise of insurers‟ underwriting performance (Adams & Buckle, 2003).

Barth & Eckles (2009) found a negative relationship between premium growth and changes in
loss ratios, suggesting that premium growth alone does not necessarily result in higher
underwriting risk. Organizations that engage in risky activities are likely to have more volatile
cash flows than entities whose management is more averse to risk-taking (Fama & Jensen, 1983).
Therefore, a negative connection between the underwriting risk and the insurers‟ financial
performance is expected, since taking an excessive underwriting risk can affect the company‟s
stability through higher expenses. Furthermore, insurance companies with high annual insurance
losses will tend to increase their level of corporate management expenses example, claims
investigation and loss adjustment costs that could further worsen a decline in their financial
performance. Excessive risk-taking could adversely affect the performance of insurance
companies. Thus taking the above facts into consideration the researcher expects the following:

H6: Underwriting risk has negative and significant effect on Ethiopian insurers’
financial performance;

2.7. Summary and Knowledge Gap

This section summarized the existing literature on risk management and insurance performance.
Financial performance is influenced by a combination of factors facing the firm; a review of the
literature provides evidence as to why firms should concern themselves with risk management.
The studies revealed that, the awareness and willingness of companies in managing their risks
has definitely increased in the emerging economies due to impact of events such as the European
financial crisis. That is, the demand for risk management is increasing, especially in the past few
years.

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The review of the literatures correspondingly revealed the existence of gap, and shown that a risk
management and firm performance is issue that requires further investigation. Different scholars
using empirical investigation on the risk management and firm performance are resulting in
dissimilar conclusions. For instance, an empirical study by Mohsen et al. (2011) indicated that
positive and significant relationship between total risk management and company‟s performance.
On the other hand, Ahmed et al. (2011) conducted a study on risk management practices and
Islamic Banks his result was negative and insignificant. Besides a study conducted by Eric
(2005) examined the relationship between risk management techniques and financial
performance of insurance companies in Uganda. The study was restricted to a single year
financial performance data and concluded fluctuating financial performance.

Generally, the lack of study on the risk management and financial performance of insurance
companies in Ethiopia and the existence of knowledge gap highly absorbed. Research gaps exist
since none of the studies address the effects of risk management on the financial performance of
organizations. There are studies on risk management and its effect on the performance of
Ethiopian commercial banks like Eneyew (2013), Endaweke (2015) and Tsion (2015) however
insurance industry is much more differ from banking as there are many exclusive risks facing by
banks (technical reserve, underwriting, claim settlement, reinsurance) in addition the similar risk
like liquidity still is not the same by its nature with the banks. Of course there are two studies
were conducted as the best knowledge of the researcher in Ethiopian insurance; Rebuma (2013)
and Kokebe & Gemechu (2016) both studies focused on risk management techniques and
insurers‟ financial performance. However the researcher not wants to study the techniques but
risk managements effect on financial performance of Ethiopian insurers by taking the factors
liquidity, technical reserve, company size, claim settlement, reinsurance and underwriting risks.
Therefore, this study will investigate the relationship between risk management and financial
performance of insurance companies in Ethiopia.

2.8. Conceptual Framework

Smyth (2004) defines a conceptual framework as a framework that is structured from a set of
broad ideas and theories that help a researcher to properly identify the problem they are looking
at frame their questions and find suitable literature. The conceptual framework of the study will
consist of independent variables; liquidity, technical reserve, company size, claim settlement,

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reinsurance, & underwriting risk and a dependent variable; the financial performance of
insurance firms (ROA).

Figure 2.1: Conceptual Framework

Risk Management
variables

Insurers’ Financial performance

Liquidity risk
management
Technical reserve
risk management
Company size RETURN
Claim settlement ON
risk management ASSET
Reinsurance risk
management
Underwriting risk
management

Source: Researcher design based on theories and empirical literature review

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 Chapter Three:
Research Design and Methodology
The preceding chapter presented reviews of literature on risk management and insurers financial
performance with respect to the theoretical perspectives and prior empirical studies. The results
from a review of the literature are used to establish expectations for the relationship of the
different factors and it confirms that there was no study conducted on effects of risk management
on financial performance of Ethiopian insurers. This chapter outlines and explains the
methodology employed to achieve the research objective and test the research hypotheses
formulated in the study. First section provides a brief overview of the research design followed
section two with the research approach and section three discussed about population and
sampling techniques adopted in the study, section four includes actual data sources & collection
instruments and then section five present variable measurements. Section six and seven
discussed about the model specifications and data presentation and analysis techniques used in
the study respectively.

3.1. Research design

The primary aim of this study is to examine the effects of risk management on the financial
performance of insurance industry. To achieve this objective explanatory research design is
employed in the study. The explanatory type of research design helps to identify and evaluate the
causal relationships between the different variables under consideration (Marczyk et al., 2005). If
the objective is to determine which variable might be causing a certain behavior, i.e. whether
there is a cause and effect relationship between variables, explanatory research must be
undertaken (Shields, 2013).

3.2. Research Approach

When conducting a research, there are different ways of approaching the problem. According to
Creswell (2009), there are three approaches of research; quantitative, qualitative and mixed. The
functional or positivist paradigm that guides the qualitative mode of inquiry is based on the
assumption that social reality has an objective onto logical structure and that individuals are
responding agents to this objective environment (Morgan & Smircich, 1980). Quantitative
research is a means for testing objective theories by examining the relationship among variables
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(Creswell, 2009). Finally, mixed methods approach is an approach in which the researchers
emphasize the research problem and use all approaches available to understand the problem
(Creswell, 2003).

Therefore, based on the above discussions of the three research approaches and by considering
the research problem and objective, in this study, the quantitative method is primarily used.
However, to have a better insight and gain a richer understanding about the research problem, the
quantitative method is supplemented by the qualitative method of inquiry. That is, to get the
benefits of a mixed methods approach and to mitigate the bias in adopting only either
quantitative or qualitative approach. Thus, employing mixed approach is used to counterbalance
the biases (limitations) of applying any of a single approach and a means to offset the
weaknesses inherent within method with the strengths of the other method (Creswell, 2003). In
addition, adopting mixed approach in this study is justified as it provides the best understanding
of a research problem because it opens the door to multiple methods of data collection and to
both generalize the findings to a population and develop a detailed view of the meaning of a
phenomenon or concept for individuals (Creswell, 2003).

3.3. Population and Sampling Techniques

The target populations of the study are all insurance companies registered by NBE and under
operation in Ethiopia from 2005 to 2015 to allow the researcher to obtain sufficient data for
calculating the representative data from each insurer. The eleven years is assumed to be relevant
because five years and above is the recommended length of data to use in most finance
literatures. Thereafter, to make the balanced panel data structured, i.e. every cross-section
follows the same regular frequency with the same start and end dates.

As noted in Jonker & Pennink (2010) it is obvious that researchers are typically unable to study
the entire population. Therefore, researchers typically study a subset of the population which
known as a sample. The procedure used for drawing the sample from the available lists is the
insurance service year profile, for the reason that the study intend to use document sources.
Therefore, sample size is decided based on the availability of operating data in the insurance
operating in Ethiopia. The sampling techniques can broadly be divided as probability sampling
and non-probability sampling (Leedy & Ormrod, 2005). Singh (2006) when the subjects used in

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the sample is homogeneous; using purposive sampling technique is appropriate, that is part of
non-probability sampling.

A sample of 9 insurance companies are taken from the total population of 17 insurers over 11
years period covering calendar years from 2005 to 2015 to provide for 99 observations (9
insurers * 11 years) which is well enough to operate regression techniques in customarily
minimum of 95 observations is recommended by many researchers. According to Green (1991)
for regression models (Eviews, ANOVA, GLM, etc.), where you have k predictors, the
recommended minimum sample size should be 50 + 8k to adequately test the overall model.
Therefore the number of observations, 99, provided in this study is above the minimum required
of 98 (50+8*6 independent variables = 98) observations to the model 50+8K. Furthermore the
researcher believes that the sample size is sufficient to make sound conclusion about the
population as far as it covers more than 50% of the total population. In addition to this, the
selected insurance companies have significant shares from the total population in terms of total
asset, capital and profit before tax. Eleven years average total asset, capital and profit before tax
of non-life insurance industry were 3.74billion, 1.04billion and 0.43billion respectively out of
these 3.38billion, 0.93billion and 0.39billion were owned by the selected 9 insurers so this also
can take us in a conclusion that, the sampled insurers can represent the total population
(Ethiopian insurers). The sample size includes Ethiopia Insurance Corporation (EIC), National
Insurance Company of Ethiopia (NICE), Awash Insurance Company (Awash), Africa Insurance
Company (Africa), Nyala Insurance Company (Nyala), Nile Insurance Company (Nile), Global
Insurance Company (Global), United Insurance Company (Unic), and Nib Insurance Company
(Nib).

Regarding unstructured interview with NBE‟s insurance supervision directorate officers, the
sample design was non-probability (purposive) sampling method was adopted, to explore the
view of regulator officers about the effects of risk management on the financial performance of
insurers, some officers are selected according to their position. National Bank of Ethiopia (NBE)
is the regulatory body for Ethiopian insurers. Insurance Supervision Directorate (ISD), which is
the direct concerned directorate in NBE. From this directorate the researcher interviewed three
highest officers, in order to get adequate explanations by using unstructured face-to-face
interviews. Their specific positions are one Director, one Principal Insurance Examiner and one
Senior Insurance Examiner.

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Table 3.1 Sampled Insurers’ Market Share
The Sampled Insurers
Insurance Industry(In The Sampled (9) Share
Years 000,000) Insurers(In 000,000) in Per Cent
TA Capital Profit TA Capital Profit TA Capital Profit

2005 1,298 353 91 1,297 352 91 100% 100% 100%

2006 1,564 544 106 1,565 544 106 100% 100% 100%

2007 1,694 545 122 1,696 546 122 100% 100% 100%

2008 1,960 548 137 1,937 537 134 99% 98% 98%

2009 2,230 610 158 2,197 601 159 99% 99% 101%

2010 2,760 772 306 2,654 739 309 96% 96% 101%

2011 3,450 879 312 3,248 823 300 94% 94% 96%

2012 4,857 1,143 534 4,502 1,067 499 93% 93% 93%

2013 5,932 1,503 852 5,255 1,336 746 89% 89% 88%

2014 7,059 1,960 969 6,016 1,631 865 85% 83% 89%

2015 8,365 2,555 1,131 6,830 2,001 1,011 82% 78% 89%

Total 41,169 11,412 4,718 37,197 10,177 4,342 90% 89% 92%

Average 3,743 1,037 429 3,382 925 395 90% 89% 92%

3.4. Source of Data and Data Collection Instruments

The sources of data for this study are mainly from secondary sources, but for the purpose of
supporting the finding of the study, primary data were also used to some extent. Secondary data
were collected from the audited balance sheet, income statement and revenue account of 9
purposively selected insurers. From these insurers, 11 consecutive years‟ balance sheet, income
statement and revenue account (filed with NBE for the period 2005 to 2015) have been used for
the study to examine the effect of risk management on insurers‟ financial performance.

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While primary data on effects of risk management on insurers‟ financial performance, were
collected from the regulatory officers through unstructured face to face interview. Smith et al.
(1991) commented that the interview method is the most fundamental of all qualitative methods
and is claimed to be the best method for gathering information. The unstructured face to face
interview has been used because of its flexibility and also allowing new questions to be bring up
during the interview. As a result, the response of the interviewees‟ for the interview questions is
used for supporting the result obtained from analysis of structure record reviews or as arguments.

3.5. Variable Measurement

This section explains the variables used as dependent (explained) and independent (explanatory)
variables in this study. The definitions or measurements used for these variables are described as
follow:

a. Dependent variable

The most commonly used financial performance ratios are net profit margin, return on assets
(ROA) and return on equity. ROA also resolves a major shortcoming of return on equity (ROE).
ROE is arguably the most widely used profitability metric, but many scholars quickly recognize
that it doesn't tell you if a company has excessive debt or is using debt to drive returns
[www.investopedia.com]. In most of the previous studies on insurance sector, return on assets
(ROA) is being used as a proxy of profitability (Ahmed, 2011); (Al-Shami, 2008); (Malik,
2011); (Lee, 2014) and it also can help to measure the whole company‟s resources. Moreover,
the return on assets compares the net earnings of a business to its total assets. It provides an
estimate of the efficiency of management in using assets to create a profit, and so is considered a
key tool for evaluating management performance. The return on assets ratio can be used to
compare the efficiency of asset usage within an industry, since each of these businesses should
require roughly the same proportions of assets to sales in order to provide services to customers.

Therefore, this study has intended to measure financial performance by using ROA similar to
most of the above mentioned researchers. ROA= Net profit before tax /Total assets

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 b. Independent variables

This subsection describes the independent variables that are used in the econometric model to
estimate the dependent variable. To measure the predictor variables of insurance companies‟
performance in Ethiopia, six factors are used as independent variables which are extracted from
different studies. The variables namely; liquidity, technical reserve, company size, claim
settlement, reinsurance and underwriting risk.

Liquidity risk: Black et al. (1998) define liquidity ratios as the amount of money that companies
and other private entities have on hand at any time available to pay their debt. The liquidity ratio
measures retire its liabilities to the firm's ability to use its near cash or quick assets. It measured
by Liquidity Ratio = Current liabilities / Current assets.

Technical reserve risk: Most common reserves in insurance are outstanding claims reserve.
Outstanding claims reserve is reserve for reported claims/losses but not yet paid because after
reporting time different processes are undertaking like claim investigation, loss assessment and
different documentation matters. The reserve held according to the best estimations of the
officers. Risk of holding insufficient technical reserve or of holding unjustifiably excessive
reserve. Where provisions are set at a lower level than actually required then this could present
the company‟s financial position in a better light than it actually is. A technical reserve is
measured by a Safety ratio = Outstanding claim reserve/Equity.

Company size: is computed as natural logarithm of total assets of the insurance company.
CZ = Log (Total asset).

Claim settlement risk: The claims ratio also termed as loss ratio in insurance business is
defined as the claims incurred to net premiums earned. Claims settlement or compensation for a
loss is the only reason the consumer (insured) buys an insurance product. Form insurers point of
view low ratio is preferable, since low ratio means low damage/loss/ in any subject matter of
non-life insurance product and low claim turnover. It is measured through the losses incurred
divided by annual premium earned. This ratio indicates how much percentage of net claims is
incurred from the firm‟s or sectors net earned premium.
Claim ratio = Net claims incurred/Net earned premium.

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Reinsurance risk: Insurance companies reinsure a certain amount of the risk underwritten in
order to reduce bankruptcy risk in the case of high losses. However it may also be sources of risk
like estimation error, cost of reinsurance and credit risk from reinsurers. The reinsurance risk is
measured by retention ratio.
Retention ratio = Net written premium/Gross written premium

Underwriting risk: The underwriting risk emphasizes the efficiency of the insurers‟
underwriting activity and it was measured by the change rate of net premium it is measured by
percentage change in gross written premium that shows the growth of current net written
premium from previous year net written premium in any single insurance firm as well as
insurance sector. Proxy for Premium Growth is the percentage increase in Net Written Premiums
(NWP). The equation is expressed as follows: CNWP = (GNWP (t) – GNWP (t-1)) / GNWP
(t-1). For the purpose of this calculation the researcher lagged one year that means year 2004 is
included.

The following table 3.1 presents the summary of the explanatory variables (independent
variables) and insurance performance (dependent variable).

Table 3.2 Description of the Variables

Variables Definition/Measure Expected

Result
Dependent Financial Net profit before tax/total assets N/A
Performance (ROA)
Independent Liquidity risk Current liabilities / current assets _
Technical reserve risk Outstanding claim reserve/equity _
Company size The natural logarithm of total asset +
Claim settlement risk Claim incurred / premium earned _
Reinsurance risk Net premium / gross premium +
Underwriting risk (CNWPt - CNWPt - 1)/CNWPt - 1 _
Source: Compiled by the researcher based on earlier studies

3.6. Model Specification

According to William et al. (2010), model building involves specifying relationships between
two or more variables; perhaps extending to the development of descriptive or predictive
equations. In order to achieve the objectives of this study, the panel data regression model is used

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to identify the relationship between the financial performance of non-life insurance companies
and explanatory variables liquidity risk, technical reserves, company size, clam settlement risk,
reinsurance risk and underwriting risk. This is because prior studies; the collected panel data is
analyzed using descriptive statistics, correlations and multiple linear regression analysis. Mean
values and standard deviations are used to analyze the general trends of the data from 2005 to
2015 based on the sector sample of 9 insurance companies and a correlation matrix is also used
to examine the relationship between the dependent variable and explanatory variables. In
addition, ordinary least square (OLS) is conducted using statistical package “EVIEWS” to
determine the most significant and influential explanatory variables affecting the financial
performance of the insurance industry in Ethiopia.

Modeling is based on panel data techniques. Panel data or longitudinal data, comprises of both
cross-sectional elements and time-series elements; the cross-sectional element is reflected by the
9 different Ethiopian insurance company and the time-series element is reflected the period of
study (2005-2015). Panel data is favored over pure time-series or cross-sectional data because it
can control for individual heterogeneity and there is a less degree of multi-linearity between
variables (Altai, 2005).

In light of the above, to investigate the effect of risk management on insurers‟ financial
performance, the following general multiple regression model is adopted from different studies
conducted on the same area.

The equation that account for individual explanatory variables which are specified for this
particular study is given as follows.

ROAit =β0 + β1LQi, t + β2TRi, t + β3SZi, t + β4CSi, t + β5RRi, t + β6URi, t + ε

Source: developed by researcher by reviewing previous research works.

Where;
ROA = Return on asset;
LQ = Liquidity risk;
TR = Technical reserve risk;
SZ = Company size;
CS = Claim settlement risk;
RR = Reinsurance risk;

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UR = Underwriting risk;

ε =is the error component for company i at time t assumed to have mean zero E [Є it] = 0
β0= Intercept
β= 1, 2, 3…6 are parameters to be estimate;
i = Insurance company i = 1. . . 9; and t = the index of time periods and t = 1. . . 11

3.7. Data Presentation and Analysis Techniques

After the data were collected from National Bank of Ethiopian (NBE) the researcher rearranged
and coded the data. The collected panel data are analyzed and interpreted by using descriptive
statistic, correlation analysis and multiple regression estimation method. To enhance the
robustness of the models and to control the cross section effects of the intercepts the study
employed fixed effect regression technics. The simplest types of fixed effects models allow the
intercept in the regression model to differ cross-sectionally (Brooks, 2008). The fixed-effects
model controls for all time-invariant differences between the individuals, so the estimated
coefficients of the fixed-effects models cannot be biased because of omitted time-invariant
characteristics.

The study checked whether the proposed empirical model is free from autocorrelation,
multicollinearity, heteroskedasticity and normality. As mentioned in Brooks (2008), there are
basic assumptions required to show that the estimation technique, OLS had a number of
desirable properties, and also so that hypothesis tests regarding the coefficient estimates could
validly be conducted. If these Classical Linear Regression Model (CLRM) assumptions hold,
then the estimators determined by OLS will have a number of desirable properties, and are
known as Best Linear Unbiased Estimators (BLUE). Therefore, for the purpose of this study,
diagnostic tests are performed to ensure whether the assumptions of the CLRM are BLUE or not
in the model. If any one of those phenomenon turns out to be present, this would be a violation
of a key assumption of OLS regression. To conduct this, the researcher used Eviews 8 software
as recommended by Brooks (2008) due to its ability to help researchers to analyze research
easily and efficiently. Redundant fixed effect (likelihood ratio) test is also made to ensure that a
fixed effect regression technique is appropriate.

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 Chapter Four:
Result and Discussion
This chapter presents the results and analysis of data of selected Insurance Companies in
Ethiopia using the annual balanced panel data, where all the variables are observed for each
cross-section and each time period. The study has a time series segment covering from the period
2005 up to 2015 and a cross section segment which considered nine Ethiopian insurance
companies. The chapter organized into five sections. Section one presents descriptive statistics,
section two correlation analysis, section three model specification, section four tests for the
classical linear regression model assumptions and section five analysis of results.

4.1. Descriptive Statistics

The descriptive statistics of the dependent and explanatory variables for the sample Insurance
Companies were summarized in table 4.1. The total observation of the study was 99. Also, the
table shows the mean, standard deviation, minimum and maximum values for the dependent and
independent variables.

Table 4.1: Descriptive Statistics of the Variables

ROA LQ TR Ln(TA) CS RE CNWP

Mean 0.09 1.03 0.79 12.32 0.71 0.73 0.25
Median 0.09 1.00 0.76 12.26 0.67 0.74 0.18
Maximum 0.19 2.74 2.57 14.72 5.64 0.87 1.56
Minimum -0.05 0.43 0.11 10.05 0.29 0.37 -0.41
Std. Dev. 0.05 0.27 0.37 1.04 0.52 0.11 0.31

Observations 99 99 99 99 99 99 99
Source: Own computation from the financial statements using Eviews 8
Note: Return on Asset (ROA), Liquidity (LQ), Logarithm of Total Asset (Ln (TA)), Claim
Settlement (CS), Reinsurance (RE) and Change in Net Written Premium (CNWP)

Financial performance: As indicated in the above table 4.1, the financial performance
measured by (ROA) shows that Ethiopian insurance company achieved on average a positive
(9%) before tax profit over the last eleven years. The mean ROA (9%) indicated that the sampled
no-life insurers were out-performed as it was more than the most common international practices

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(5%). For the total sample, the range of ROA was a maximum of (19%) and a minimum of (-
5%). That means the most successful insurers among the sampled earned 19%. The standard
deviation was (5%) of the selected non-life insurers; it means the value of ROA deviate from its
mean to both sides by (5%) which indicate there was low variation from the mean. The lower
standard deviation is a good indication that most of the observations are concentrated around the
mean.

Liquidity risk: This test measures the proportion of liabilities covered by cash and quickly
convertible investments. It indicates a company's ability to meet its maturing obligations without
requiring the sale of long term investments or the borrowing of money. The average value of the
liquidity measured by liquidity ratio was (1.03) that was less than the required standard of (1.05).
The mean value (1.03) indicates that for each 1.03 birr current liability there was 1 birr current
asset to meet obligation. The maximum value and the minimum value were (2.74) and (0.43)
respectively for the study period. Wherein, variations between non-life insurers in terms of the
given indicator are relatively high, given that its value, individually viewed, ranges from only
(43%) to as much as (274%). The value of standard deviation (0.27) indicates a little bit high
dispersion from the mean value of liquidity in the case of Ethiopia non-life insurance companies.

Technical reserve: The average value of technical reserve as measured by the ratio of safety for
net outstanding reserve to equity was (0.79). This implies that on average, reserve for
outstanding claims was (0.79) times of equity. The highest technical reserve to equity for a non-
life insurance company was (2.57) which are above the maximum standard of (2.5) times and the
minimum was (0.11). The dispersion/standard deviation was (0.37) which indicated that there
was a high dispersion from the mean value of technical reserve on non-life Ethiopian insurers.

Company size: Insurance size measured by logarithm of total asset is used as a proxy. The mean
of the logarithm of total assets during the period was (12.32). Size of insurance companies was
highly dispersed from its mean value (i.e. 12.32) with the standard deviation of (1.04.) which
means it is the most deviated variable from its mean. The maximum and minimum values were
(14.72) and (10.05) respectively.

Claim settlement: This risk measure by claim ratio indicates how much percentage of net claims
is incurred from the insurers‟ of sectors net earned premium. From insurers point of view low
ratio is preferable, since low ratio means low damage/loss/ in any subject matter of non-life
insurance product and low claim turnover. Therefore, it is expected that the more having low

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ratio is the more generating a good profit. By looking towards table 4.1, the value of claim ratio
of the selected non-life insurance companies at maximum, minimum, and average is (5.64),
(0.29) and (0.71) respectively. The average (0.71) of claim ratio fits the expected standard of not
more than (0.7%). This implies that Ethiopian non-life insurers on average (71%) paid for claims
the remaining premium (29%) goes to expenses and net income. Whereas, variations between
non-life insurers in terms of the given indicator are very high, given that its value, individually
viewed, ranges from only (29%) to as much as (564%). Similarly, the difference in value of
claim ratio across the selected samples of non-life insurance companies is (0.52), which shows
the values of claim ratio of each sample selected insurance companies are highly far from the
samples mean value of claim ratio. Therefore, there is high deviation in value of claim ratio
among the study sampled size of nine non-life insurance companies in Ethiopia from their mean
value.

Reinsurance risk: Although it represents the most important instrument of risk management for
insurance companies, reinsurance by itself generates certain risks in terms of the inadequately
estimated self-retention limit and arranged reinsurance coverage, but also credit risk, i.e. inability
and/or unwillingness of reinsurer to meet its obligations to the insurer. The outputs of the
descriptive statistics table 4.1 indicate that the mean of reinsurance risk as proxies by net written
premium to gross written premium was (73%) which is slightly higher than the maximum
acceptable standard of (70%). This means that on average (73%) of gross written premium in
retained by the selected Ethiopian non-life insurers and the remaining (27%) was ceded to the
reinsurers. it may be an indicator of the insurers are utilizing their capital properly that means
there is no idle capital. The maximum value of premium retention ratio was (87%) and a
minimum value of (37%), it is slightly out of the acceptable international practice ranged from
(30%) to (70%). The sampled Ethiopian non-life insurers‟ standard deviation was (11%) low
dispersion from the mean value of retention ratio.

Underwriting risk: Concerning the underwriting risk variable, as a proxy the percentage
increase/decrease in Net Written Premiums (NWP) was (25%), while the accepted value of
premium growth range is between (–33% and +33%) in this respect the selected non-life
insurers‟ mean value fall within the acceptable range. On the subject of, the maximum &
minimum values of net premium growth rate were (156%) & (-41%) respectively. In which,
variations between non-life insurers in terms of the given indicator are very high, given that its
value, individually viewed, ranges from only (-41%) to as much as (156%) this indicates that

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unstable premium collection. The standard deviation of the selected non-life insurers was (31%),
which also indicated that there was high variation.

4.2. Correlation Analysis

As noted in Brooks (2008), Correlation between two variables measures the degree of linear
association between them. Values of the correlation coefficient are always ranged between
positive one and negative one. A correlation coefficient of positive one indicates that a perfect
positive association between the two variables; while a correlation coefficient of negative one
indicates that a perfect negative association between the two variables. A correlation coefficient
of zero, on the other hand, indicates that there is no linear relationship between the two variables.

The most widely used bi-variant correlation statistics is the Pearson product movement
coefficient, commonly called the Pearson correlation. The result of the correlation analysis is
shown in Table 4.2. It indicates a relationship between financial performance and company size
had positive relationship; liquidity ratio, technical reserve (safety ratio), claim ratio, retention
ratio, and underwriting risk have negative relationship with insurers‟ financial performance. No
case of multi-collinearity among the independent variables existed. Table 4.2 below provides the
Pearson‟s correlation matrix for the variables used in the analysis.

Table 4.2: Correlation Matrix

Covariance Analysis: Ordinary
Date: 12/14/16 Time: 21:26
Sample: 2005 2015
Included observations: 99

Correlation ROA LQ TR Ln(TA) CS RE CNWP

ROA 1.000000
LQ -0.224903 1.000000
TR -0.220022 0.406793 1.000000
Ln(TA) 0.633947 0.131657 0.346714 1.000000
CS -0.067093 0.150500 0.113295 0.075014 1.000000
RE -0.238459 0.149026 0.010175 -0.377763 0.120922 1.000000
CNWP -0.026981 -0.143193 -0.091269 -0.074913 -0.016347 0.103458 1.000000

Source: Own computation from the financial statements using Eviews 8

As can see from the above table 4.2, the correlation result between liquidity risks and technical
reserve (outstanding claim reserve to equity) had negative correlation with return on asset with
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the same coefficient of (-0.22). Likewise, claim settlement risk (loss ratio), reinsurance risk
(retention ratio) and underwriting risks had negative relationship with return on asset with a
coefficient of (-0.0671), (-0.2384) and (-0.0270) respectively. This indicates that as ratios of
liquidity, technical reserve, claim, retention and underwriting rate increases, financial
performance measured by (ROA) moves to the opposite direction. In contrary to the above
explained variables, the Pearson correlation coefficients of company size (0.6339) had positive
relationship with return on asset.

4.3. Model Specification Test

There are broadly two classes of panel estimator approaches that can be employed in financial
research: fixed effects models (FEM) and random effects models (REM) (Brooks, 2008). The
choice between these approaches is done by running a Hausman test and the result is presented
as follows.

Random Effect Model: The rationale behind random effects model is that, unlike the fixed
effects model, the variation across entities is assumed to be random and uncorrelated with the
predictor or independent variables included in the model. Random effect model assume that the
entity‟s error term is not correlated with the predictors which allows for time-invariant variables
to play a role as explanatory variables (Oscar, 2007). The result of the test displayed below the
table 4.3.

Table 4.3: Random Effect Test

Correlated Random Effects - Hausman Test

Equation: Untitled
Test cross-section random effects

Test Summary Chi-Sq. Statistic Chi-Sq. d.f. Prob.

Cross-section random 3.544235 6 0.7381

Source: Own computation from the financial statements using Eviews 8.

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The null hypothesis of the test was that the random effect method is the preferred regression
method. As shown above in table 4.4, random effect Hausman test provide statistical evidence of
P-value of 73 %, which means the random effect estimators are insignificant at significant level
of 1%. This implies the null hypothesis has been not rejected as according to Brooks (2008) the
p-value for the test is greater than 1%, indicating that the random effects model is appropriate.

Redundant Fixed Effects Tests: The fixed-effects model controls for all time-invariant
differences between the individuals, so the estimated coefficients of the fixed-effects models
cannot be biased because of omitted time-invariant characteristics. One side effect of the features
of fixed effects model is that they cannot be used to investigate time-invariant causes of the
dependent variables (Oscar, 2007). The pooled regression assumes that the intercepts are the
same for each firm. This may be an inappropriate assumption, and Brooks (2008) recommended
that we could instead estimate a model with firm fixed effects, which will allow for latent firm
specific heterogeneity. The simplest types of fixed effects models allow the intercept in the
regression model to differ cross-sectionally. To determine whether the fixed effects are necessary
or not, this study run a redundant fixed effects test as recommended by Brooks (2008). The
results of the test are summarized in the following Table 4.4.

Table 4.4: Redundant fixed effect test

Redundant Fixed Effects Tests

Equation: Untitled

Test cross-section fixed effects

Effects Test Statistic d.f. Prob.

Cross-section F 5.923222 (8,84) 0.0000

Cross-section Chi-square 44.284783 8 0.0000

Source: Own computation from the financial statements using Eviews 8.

From Table 4.4 we can conclude that, the p-values associated with the test statistics are zero to 4
decimal places, indicating that it is better to employ the fixed effect model.
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According to the above tests results both fixed effect and random effect models are allowable,
however as noted in Gujarati (2003) if T [the number of time series data] is large and N [the
number of cross-sectional units] is small, there is likely to be little difference in the values of the
parameters estimated by fixed effect model and random effect model. Hence, the choice here is
based on computational convenience. On this score, fixed effect model may be preferable than
random effect model (Gujarati, 2003). Since the number of time series (i.e. 11 year) is greater
than the number of cross-sectional units (i.e.9 insurance companies).

Brook (2008) stated that, in the econometric context, a regressor is said to be endogenous if it is
correlated with the error term of the data generating process in the population. Endogeneity
problems mainly arise due to omitted variables, measurement error of explanatory variables, or if
there is a reverse causality between the dependent and the explanatory variables, i.e. the
dependent variable causing some explanatory variable as well. A simple fixed effects panel
estimator would robust the findings of OLS regression, because the dummy variables included to
control for the individual effect automatically control for any time-invariant variable. However,
Jean & Michel (2006) suggested that the fixed effects model is preferred in cases where
conclusions have to be made on the sample and if the observation (panel data) is less, fixed
effects will be more efficient than random effects, while the interests of random effects model
are on the overall population.

Therefore, based on the above discussion the fixed effect model is preferable for this study.

4.4. Model Diagnosis

This section presents the test for the assumptions of classical linear regression model (CLRM)
namely the error have zero mean, hetroskedasity, autocorrelation, normality and
multicollinearity. To test multiple regression models, it is necessary to assess whether the
collected data violate the key assumptions of regression models because any assumption
violations can result in distorted and biased research results (Hair et al., 1998). Accordingly, the
data has to meet certain assumptions as indicated below.

The errors have zero mean: The first assumption required is that the average value of the errors is
zero. In fact, if a constant term is included in the regression equation, this assumption will never
be violated (Brook, 2008). In this study the model consisted a constant term called an intercept.
In addition by including the intercept we can avoid two main undesirable consequences; first, R-

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square, could never be negative and second, a regression with intercept parameter could not lead
to potentially severe biases in the slope coefficient estimates.

Heteroskedasticity: It has been assumed that the error terms are homoscedastic. That is, it
assumed that the error terms have a constant variance; otherwise they are said to be
heteroskedastic. The presence of heteroskedasticity makes the standard errors too big or too low
and hence any inferences made could be misleading. The most popular method, a white„s test has
to be made, to ensure that this assumption is no longer violated. If the probability of F-statistics,
Observed R-square, and Scaled explained SS of the heteroscedastic white test result is in excess
of 5% then there is no hetroscedastic problem. However, if one of these three is fail then there is
existence of hetroscedastic problem (Brook, 2008).

Table 4.5: Heteroskedasticity Test: White

F-statistic 1.072807 Prob. F(6,92) 0.3846

Obs*R-squared 6.473670 Prob. Chi-Square(6) 0.3723
Scaled explained SS 4.554022 Prob. Chi-Square(6) 0.6021

Source: Own computation from the financial statements using Eviews 8.

According to the hetroscedastic white test result which is presented on table 4.5 above shows that
the probability of F-statistics, Observed R-square, and Scaled explained SS are (38%), (37%),
and (60%) respectively. Hence, the probability of F-statistics, Observed R-square, and Scaled
explained SS are in excess of 5% and then there is no problem of hetroscedastic. This implies
that the assumption of homoscedasticity or errors have a constant variance full filled its
requirement. Therefore, the null hypothesis that the variance of the errors is constant
(hemoscedasticity) should not be rejected.

Autocorrelation: As noted in Brooks (2008) this is an assumption that the covariance between
the error terms over time is zero. In other words, it is assumed that the errors are uncorrelated
with one another. If the errors are not uncorrelated with one another, it would be stated that they
are “auto correlated” or that they are serially correlated. Figure 4.1 below presented the Durbin
Watson test for autocorrelation in panel data of this study; the null hypothesis being there is no
autocorrelation. Considering the fixed effect regression result and Durbin-Watson 5%
significance with 99 observations and 6 explanatory variables (excluding the constant term), the
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DW is (2.166). The relevant critical lower and upper values for the test are dL= 1.550 and
dU=1.803 respectively. The values of (4 - dU = 4- 1.803 = 2.197).

Figure 4.1: Rejection and Non-Rejection Regions for Durbin-Watson Test

0 1.550 1.803 2.166 2.197 2.45 4

Source: Own computation from the financial statements using Eviews 8.

Brook (2008) recommended that not to reject the null hypothesis of no autocorrelation, if the
DW test statistic would be in the non- rejection region of the upper limit (du) and (4-du). Thus
the DW test statistic of (2.166) is between the upper limit (dU) which is (1.803) and the critical
value of (4- dU) i.e. (2.197) indicating that there is no evidence for the presence of
autocorrelation and fail to reject the null hypothesis that states there are no serial correlations
between the error terms.

Multicollinearity Test: Multicollinearity in the regression model suggests that there are
substantial correlations among independent variables. This phenomenon presents a problem
because the estimates of the sample parameters become inefficient and entail large standard
errors, which makes the coefficient values and signs unreliable. It also hides the real impact of
each variable on the dependent variable (Anderson et al., 2008). High degrees of
multicollinearity can result in both regression coefficients being inaccurately estimated, and
difficulties in separating the influence of the individual variables on the dependent variables
(Hair et al., 1998). In addition, multiple independent variables with high correlation add no
additional information to the model. In order to examine the possible degree of multicollinearity
among the explanatory variables, correlation matrixes of the selected explanatory variables were
presented in table 4.6. Kennedy (2008) suggested that any correlation coefficient above 0.7 could

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cause a serious multicollinearity problem. Therefore, based on the correlation matrix table 4.6
there is no problem of multicollinearity.

Table 4.6: Correlation Matrix between Independent Variables

Covariance Analysis: Ordinary

Date: 12/14/16
Sample: 2005 2015
Included observations: 99

Correlation LQ TR Ln(TA) CS RE CNWP

LQ 1.000000
TR 0.406793 1.000000
Ln(TA) 0.131657 0.346714 1.000000
CS 0.150500 0.113295 0.075014 1.000000
RE 0.149026 0.010175 -0.377763 0.120922 1.000000
CNWP -0.143193 -0.091269 -0.074913 -0.016347 0.103458 1.000000

Source: Own computation from the financial statements using Eviews 8

Normality test: The normality assumption is about the mean of the residuals is zero. In this
study, the normality of the data was mainly checked with the popular Bera-Jarque test statistic
(Brooks 2008). The Jarque-Bera statistic has a P-value of 93% implies that the p-value for the
Jarque-Bera test for the model is very far greater than 5% which indicates that the errors are
normally distributed. Furthermore, according to Brooks (2008) the standardized measurements of
a distribution are known as its skewness and kurtosis. Skewness measures the extent to which a
distribution is not symmetric about its mean value and kurtosis measures how fat the tails of the
distribution area. A normal distribution is not skewed and is defined to have a coefficient of
kurtosis of 3. Skewness that is normal involves a perfectly symmetric distribution. Kurtosis
involves the peakedness of the distribution. Kurtosis that is normal involves a distribution that is
bell-shaped and not too peaked or flat. The eviews results for the tests of both Skewness and
Kurtosis are presented below figure 4.2 are fitted according to their expected conditions.

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Figure 4.2: Normality Test Result

12
Series: Standardized Residuals
Sample 2005 2015
10
Observations 99

8 Mean -9.97e-19
Median 0.000707
Maximum 0.062483
6
Minimum -0.060712
Std. Dev. 0.022497
4 Skewness -0.063461
Kurtosis 3.136067
2
Jarque-Bera 0.142821
Probability 0.931080
0
-0.06 -0.04 -0.02 0.00 0.02 0.04 0.06
Source: Eviews 8 output

Based on the statistical results, the study failed to reject the null hypothesis of normality at the
5% significance level.

In general, all tests illustrated above were testimonials as to the employed model was not
sensitive to the problems of violation of the CLRM assumption. The required Best Linear
Unbiased Estimators (BLUE) conditions are also fulfilled through these assumptions test and
discussed in the above section.

4.5. Regression Results and Analysis

The Fixed effect Model allows for heterogeneity or individuality among the Insurance companies
under this study by allowing its own intercept value. This section presents the empirical findings
from the econometric output and interview results on the effects of risk management on
insurance companies‟ financial performance in Ethiopia. Table 4.6 below reports regression
results between the dependent variable (ROA) and independent variables.

According to Brooks (2008) the standard error of the estimate is sometimes used as a broad
measure of the fit of the regression. It is a measure of how confident one is in the coefficient
estimate obtained in the first stage. If a standard error is small, the value of the test statistic will
be large relative to the case where the standard error is large. Large standard error is undesirable;
everything else being equal, the smaller this quantity is the closer is the fit of the line to the
actual data. In this study technical reserve, company size, claim settlement and change in net

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written premium had small standard error their corresponding standard error amount were
(0.0093), (0.0039), (0.0049) & (0.0087).

Moreover, from the findings in the below table 4.6, the value of R-Square, also known as the
Coefficient of determination is a commonly used statistic to evaluate model fit. R-squared
defined that the square of a correlation coefficient; it must lie between 0 and 1. If this correlation
is high, the model fits the data well, while if the correlation is low (close to zero), the model is
not providing a good fit to the data. The adjusted R-squared compares the explanatory power of
regression models that contain different numbers of predictors and it could control the extremes
and the biasedness of the model. The value measures how well the regression model explains the
actual variations in the dependent variable (Brooks, 2008). R-squared statistics and the adjusted
R-squared statistics of the model was (78%) and (74%) respectively. The result of this estimation
particularly the adjusted R-Squared indicates that the changes in the independent variables
explain 74.5% of the changes in the dependent variable. This means technical reserve ratio,
company size, reinsurance ratio, liquidity ratio, claim settlement ratio and underwriting rate
collectively explain 74.5% of the changes in financial performance. Thus these variables
collectively, are good explanatory variables to identify the effects of risk management on
insurance companies‟ financial performance in Ethiopia. However, the remaining 25.5% of
changes was explained by other factors which are not included in the model.

Overall reliability and validity of the model was further enhanced by the Probability (F-statistic)
value (0.000) which indicates strong statistical significance. Thus the null hypothesis of the
overall test of significance that all coefficients are equal to zero was rejected as the p-value was
sufficiently low (less than 0.05).

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Table 4.7: Regression Result

Dependent Variable: ROA

Method: Panel Least Squares
Sample: 2005 2015
Periods included: 11
Cross-sections included: 9
Total panel (balanced) observations: 99
Variable Coefficient Std. Error t-Statistic Prob.
C -0.500195 0.055164 -9.067358 0.0000
LQ -0.021960 0.010784 -2.036261 0.0449
TR -0.057336 0.009320 -6.151786 0.0000
Ln(TA) 0.048904 0.003911 12.50357 0.0000
CS -0.006348 0.004956 -1.280910 0.2038
RE 0.081406 0.034860 2.335216 0.0219
CNWP -0.008822 0.008752 -1.008011 0.3163
Effects Specification
Cross-section fixed (dummy variables)
R-squared 0.781781 Mean dependent var 0.087152
Adjusted R-squared 0.745411 S.D. dependent var 0.048160
S.E. of regression 0.024300 Akaike info criterion -4.457958
Sum squared resid 0.049601 Schwarz criterion -4.064758
Log likelihood 235.6689 Hannan-Quinn criter. -4.298869
F-statistic 21.49527 Durbin-Watson stat 2.166024
Prob(F-statistic) 0.000000
Source: Own computation from the financial statements using Eviews 8.

Table 4.7 above shows that four explanatory variables had significant impact on financial
performance of Ethiopian insurers. The significant variables are ranked based on their significant
levels; technical reserve risk (claims outstanding to equity), company size (natural logarithm of
total asset), reinsurance risk (net written premium to gross written premium) and liquidity risk
(current liability to current asset) were significant at 1% and 5% significance level since the p-
value for those variables were (0.0000), (0.0000), (0.0219) & (0.0449), respectively.

The negative coefficient of explanatory variables against financial performance are; claim ratio (-
0.0063), change in net written premium (-0.0088), liquidity risk ratio (-0.0219) and technical
reserve ratio (-0.0573). On the other hand, variables company size and retention ratio
(reinsurance risk) had a positive relationship with the financial performance of Ethiopian insurers
their respective coefficients were (0.0489), and (0.0814).
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Regarding the interview results, in depth interviews were conducted with three officers of
National Bank of Ethiopian, by using unstructured face to-face interviews. The three officers
interviewed were Insurance Supervision Directorate (ISD) officers. The interview questions were
fully unstructured and focused on the identification of effects of risk management on Ethiopian
insurance companies‟ financial performance in general. More specifically, the interview
questions tried to identify the major risk factors among the influential factors, how each risk can
influence insurers‟ financial performance, mitigation strategy taken by the ISD to reduce the
negative influence of controllable risks and their general opinion regarding the issue of insurers‟
risk management.

On the question that focuses on the effects of risk management on financial performance,
respondents offered some major risks. Almost all the three officers rose about the guideline for
risk management program, which drafted by the NBE insurance supervision directorate for
Ethiopian insurers, the guideline contained inherent risks of insurance industry. These risks are
credit, market, liquidity, technical reserve, underwriting, claim settlement risk, contagion and
reinsurance risk. Despite interviewees‟ responses were varied, the most common factors that
affect the financial performance of insurers includes such as; poor estimations for technical
reserve, imprudent underwriting practices, highly depend on reinsurers, insufficient liquidity
management, poor claim settlement process and in adequate volume of capital.

The financial performance influential risks are individually discussed in the next subsection by
referring regression result of table 4.7, interview results and previous empirical studies.

4.5.1. Technical Reserve Risk and Return on Asset

Technical reserve risk is that the insurance companies‟ liability to policyholders could be
understated or overstated. The liability level is determined by actuarial methods and it depends
on future liabilities and structure of insurance portfolio. The high level of technical reserve risk
indicator may signal a bad use of capital resources. On the other hand low level of technical
reserve risk indicates the insurer unable to pay its obligation in a proper manner this may
exposed it to liquidity problem and can lose its clients easily. The most common technical
reserve risk in insurance is outstanding claim reserve risk. Outstanding claims reserve is
considered riskier than ordinary long-term corporate debt since neither the magnitude nor the
timing of the cash flows is known.
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The regression result of this study shows that the coefficient of technical provision which is
measured by outstanding claim reserve to equity was negative coefficient (-0.0573), which
implies that if technical reserve risk increase by 1 unit, ROA will decrease by (0.0573) units
assuming that the remaining independent variables are unchanged. The result of (p-
value=0.0000) was statistically significant at a 1% significance level. It indicates that when
companies holding high reserves for outstanding claims, it will have a significant negative
impact on their financial performance.

The result was consistent with Shiu (2014) in UK found that negative relationship between
technical provision and profitability of firms. According to the interview results, the major
causes of technical reserve risk are management strained by shareholders, claims fluctuation,
moral hazard, inflation rate the reason that time difference between claim report and payment
settlement, no loss adjuster in the country, capacity limitations of the surveyors and a few
number of loss assessors in the country and this may lead to overstatement of current year‟s
financial performance but actually not.

Therefore, current study supports the hypothesis a significant negative impact of technical
reserve risk on Ethiopian insurance companies‟ financial performance. Thus, the null hypothesis
can‟t be rejected.

4.5.2. Company Size and Return on Asset

The size of the firm affects its financial performance in many ways. Large firms can exploit
economies of scale and scope and thus being more efficient compared to small firms. Larger
insurers can achieve operating cost efficiencies through increasing output i.e. they are able to
realize economies of scale especially in terms of labor costs, which is the most important factor
for delivering insurance services.

Company size is computed as logarithm of total assets of the insurance company. The regression
result of this study show that the variable size is positively coefficient (0.0489) related to
financial performance that means if the size of the company increase by 1 unit, ROA will also
increase by (0.0489) units considering that other independent variables remain constant. It also
statistically significant (p-value=0.0000) at a 1% level of significance. This indicates that large
volume of total asset has a significant effect on insurers‟ financial performance. Financial
performance is likely to increase in large size, because large insurance companies normally have
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greater capacity for dealing with adverse market fluctuations than small insurance companies and
have more economies of scale, complex information systems and a better expenses management.

The finding of this study is matching with, Malik (2011), Mehari et al. (2013) Chen & Wong
(2004) and Shiu (2014). They revealed that large corporate size enables to effectively diversify
their assumed risks and respond more quickly to changes in market conditions. An increase in
total asset such as the establishment of more branches and the adoption of new technologies
enables an insurer to underwrite more policies which may increase the underwriting profit and
the total net profit.

The regression result also supported by the NBE‟s officers, they responds that one of the main
reasons the directive issued minimum paid up capital requirement (Directive No. SIB/34/2013)
non-life insurers required to increase their capital from 3 million to 60 million was in order to
grow insurers‟ business and increase their retention capacity among the objectives of this
directive. If insurers have enough capacity, they can operate massively and this leads them to
increase their volume of premium and then their financial performance will increase.

Hence, this study supports the hypothesis that company size has a significant positive effect on
insurers‟ financial performance in Ethiopia and so there is no evidence to reject the null
hypothesis.

4.5.3. Reinsurance Risk and Return on Asset

Reinsurance is insurance for the insurance underwriter. Retention ratio is retained premiums to
gross written premiums this means the amount of liability for which an insurance company will
remain responsible after it has completed its reinsurance arrangements. The non-life insurance
underwriter makes the retention decision based on various factors, including the size and
concentration of the individual risk. Insurance companies usually take out reinsurance cover to
stabilize earnings, increase underwriting capacity and provide protection against catastrophic
losses; nevertheless it involves a certain costs.

The coefficient of reinsurance risk (retention ratio) which is measured as ratio of retained
premiums to gross written premium was positive (0.0814) it implies that when retention ratio
increase by 1 unit correspondingly insurers‟ financial performance will also increase by (0.0814).
Likewise, reinsurance risk was statistically significant at 5% significance level (p value=0.0219).
The significant parameter indicates that the reinsurance risk does affect considerably Ethiopian
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non-life insurers‟ financial performance indicating that its influence is high on insurers‟ financial
performance.

Referring to previous studies, the results concerning reinsurance risk are; Lee (2014) found a
significant negative relationship between reinsurance dependence and insurance profits. This
means if insurers more ceded their premium their profit will be decline because their retention
ratio decreased. Likewise, Shiu (2014) found a negative relationship between reinsurance
dependence and insurers profitability which is consistent with this study. Thus, both studies
result indicated that reinsurance dependency ratio has negative effect on insurers‟ profitability
and implying that retention ratio has positive impact on insurers‟ financial performance and this
has consistent result with this study result.

The interview result pointed out mixed ideas about the impact of reinsurance risk on Ethiopian
insurance companies‟ financial performance. According to the interviewees, reinsurance has
more important for insurance companies‟ financial performance due to protection against
exposure to large or accumulation of losses, additional capacity for insuring big risk, the higher
the premium ceded the higher is the reinsurance coverage, but determining an appropriate
retention level is important for insurance companies. The other idea was the negative side of
reinsurance on Ethiopian insurance companies financial performance is outflow of foreign
exchange to reinsurance business which have a negative influence over the insurance industry
(costs related to cross-border reinsurance transactions) and economy of the country. To reduce
the outflow of foreign exchange, National Bank of Ethiopia issued directives (SRB/1/2014)
about reinsurance company establishment in Ethiopia. The objective of this directive is to
promote a financial resource mobilization, and reduces cost related to cross-border reinsurance
transactions.

The fixed effect regression output also the same with the researcher expected hypothesis as
reinsurance risk (retention ratio) has positive and significant impact on Ethiopian insurers‟
financial performance. Consequently, the null hypothesis failed to reject.

4.5.4. Liquidity Risk and Return on Asset

The liquidity of insurer is evaluated based on their current liabilities (including unearned
premiums and provisions for claims) and the ratio of liquid assets, defined according to different
concepts, from cash and cash equivalents, up to short term securities. The study employed the
58 | P a g e
liquidity ratio which can easily express the liquidity risk that is current asset is a base for current
liability which computed as current liabilities to current asset.

The regression result in this study indicates that the relationship between liquidity risk and
financial performance is negative coefficient (-0.0219) this shows when liquidity ratio goes up
by 1 unit, on average return on asset will goes down by (0.0219) units provided that other
independent variables are constant. Beside, this ratio is significant (p-value = 0.0449) at 5%
significance level. This infers that more liquid insurance have higher financial performance, all
other things remain unchanged. On contrary, if the Ethiopian non-life insurers have more current
liability than current asset, their financial performance becomes deteriorate.

The current study is consistent with some previous empirical findings; (Amal, 2012; Browne et
al. 2001; Ambrose & Carroll 1994; Carson & Hoyt, 1995 and Chen & Wong, 2004). They
suggested that the insurance companies should increase the current assets and decrease current
liabilities because; companies with a lower level of liquidity will have more cash constraints and
will have more difficulties in repaying to policyholders when loss occurred. Since liquidity
measures the ability of insurance companies to fulfill their immediate commitments to
policyholders and other creditors without having to sale their fixed asset.

Regarding the impact of liquidity on financial performance, the interviewees revealed that
insurance companies by nature must be liquid to meet claims obligation, to avoid loss of business
and damage to public image. According to the interviewees major causes of liquidity risk are
premium may not collected as expected volume, when the company has no clear cash
management policies, lower rate of interest at bank for fixed time deposit & other deposits. The
study result also consistent with the National Bank of Ethiopia‟s issued directive No
SIB/25/2004 and the officers view. According to this directive, insurance companies should keep
amount of liquid cash and short term securities not less than 65% of total admitted asset to meet
their immediate commitments to policyholders. If the insurance companies meet this
commitment, they will become sound and increase customer satisfaction and helps to collect
more premiums from customers and results increase in financial performance.

Therefore, the regression result is matching with the researcher‟s hypothesis that is liquidity risk
has a significant and negative effect on Ethiopian insurers‟ financial performance. So the null
hypothesis cannot be rejected.

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 4.5.5. Claim Settlement Risk and Return on Asset

Yusuf & Dansu (2014) suggest a good claim management embraces: proactive in recognizing
and paying legitimate claims; assessing accurately the reserve associated with each claim;
reporting regularly; minimizing unnecessary costs; avoiding protracted legal disputation and
whatever possible, handling claims expeditiously.

The multiple regression result of this study explains that claim settlement risk measured by claim
ratio (net claims incurred to net earned premium) has a negative and insignificant relationship
with financial performance (ROA) of Ethiopian non-life insurance, since the beta coefficient and
p-value of claim ratio are (-0.0063) and (0.2038) respectively. The negative coefficient indicates
that when claim ratio increase by 1 unit ROA will decrease by (0.0063) unit. The result is
identical with (Pervan et al. (2012); Mirie & Cyrus (2014) and Yusuf (2014)). Regarding its
significances it is not significant even at a 10% significant level, this implies it is not a dominant
factor on Ethiopian insurers‟ ROA.

The interview result also shows that it has a negative effect on financial performance. However
one of the officers argued that policyholders main objective is to get compensation for their loss
if the insurers settled the claims properly and as much as possible with a short time they can
retain their customer and their premium volume will increase and then their financial
performance will score high amount.

The fixed effect regression output also the same with the expected hypothesis as claim settlement
risk (claim ratio) has negative impact on Ethiopian insurers‟ financial performance. The
hypothesis can‟t be rejecting because of the same negative impact as expected however it is
insignificant.

4.5.6. Underwriting Risk and Return on Asset

The underwriting risk emphasizes the efficiency of the insurer‟s underwriting activity and the
exposure to financial loss resulting from the selection and approval of risks to be insured. It is a
risk of losses from underpriced products, insufficient volume of premium, improper underwriting
controls, and the development of new products that are not properly priced.

The coefficient of underwriting which is measured by change in net written premium was
negative coefficient (-0.0088) that denotes if the net written premium growth rate goes up by 1
unit, ROA will goes down. Beside probability value of net written premium growth rate was (p-
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value=0.3163) statistically insignificant at 10% significance level. Thus the growth rate of net
premium was not influential factor of Ethiopian insurers‟ financial performance.

This finding is consistent with previous studies Lee (2014), Burca & Batrinca (2014). They
concluded that underwriting risk has a negative influence on the insurer‟s profitability, since
taking an excessive underwriting risk can affect the company‟s stability through higher expenses.

The finding is inconsistent with the interview results suggested that underwriting is a
fundamental objective to produce profitable book of business. The interviewees indicated that
the major causes of underwriting risk are lack of adequate pre risk assessment and risk selection,
difficulty of standard criteria for risk evaluation are not up to desirable practice level, most
operation managers are production oriented instead of profit oriented. The other basic reason is
moral hazard; the possibility that insured‟s may deliberately cause an insured event or pretend
that such an event occurred to obtain insurance payments.

Thus, this study supports the hypothesis that negative impact of underwriting risk on insurance
companies‟ financial performance however it was insignificant which is against the expected
result.

By and large this chapter offered the results of the structured recorded data reviews and in depth
interview and then discussed the analysis of these results together. From the above data analysis,
Ethiopian non-life insurers‟ financial performance is highly affected by all variables included in
this study except claim settlement risk and underwriting risk. The findings of the study showed
that liquidity risk and technical reserve risk have statistically significant and negative
relationship with Ethiopian non-life insurers‟ financial performance. However, claim settlement
risk has negative and insignificant relationship with financial performance. On the other hand,
variables company size and reinsurance risk have a positive and statistically significant
relationship with Ethiopian non-life insurers‟ financial performance.

ROAit =β0 + β1LQi, t + β2TRi, t + β3SZi, t + β4CSi, t + β5RRi, t + β6URi, t + ε

Where ROAit is return on asset of an insurer at time t,
LQit is liquidity ratio of an insurer at time t,
TRit is technical reserve ratio an insurer at time t,
SZit is natural logarithm total asset company size an insurer at time t,
CSit is claim settlement risk of an insurer at time t,

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RRit is reinsurance risk of an insurer at time t,
URit is the underwriting risk to an insurer at time t,
ε is the error term of an insurer at time t.

As generated by regression analysis, shown in table 4.7 above, the established regression
equation is:
ROAit = -0.5001 – 0.02196LQi, t – 0.0573TRi, t + 0.0489SZi, t – 0.0063CSi, t +
0.0814RRi, t – 0.0088URi, t + ε

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 Chapter Five:
Summary, Conclusion and Recommendation
This is the last chapter of the research paper and it comprehensively summarizes the whole
chapters of the research paper and followed by the conclusion of the study by concluding the
major findings of the study. The last part forwards some recommendations that are thought to be
practical and feasible.

5.1. Summary

This study examined empirically the effects of risk management on financial performance of
Ethiopian insurance companies. It analyzed by examining available empirical literature reviews
conducted in different countries and by selecting 6 variables considering the nature and data
availability of the Ethiopian non-life insurance sector. The study attempted to highlight the
critical risk management that managers should consider when setting their optimum financial
performance. To response the proposed main objective, descriptive statistics, diagnostic tests,
selection of appropriate model, multiple regression result and test of hypothesis have been run
using statistical package data of “EVIEWS 8”. The appropriate model that has selected for this
study was fixed effect model since the diagnostic test of all assumptions are valid and met, as a
result it is possible to conclude that the model is adequate, statistically good fit, and data‟s were
represented reliably.

During the study period Ethiopian non-life insurers maintained an average financial performance
(return on asset) ratio of (9%). The mean value of the liquidity measured by liquidity ratio was
(1.03) that was less than the required standard of (1.05). The average value of technical reserve
as measured by the ratio of safety for net outstanding reserve to equity was (0.79). The mean of
the logarithm of total assets during the period was (12.32). The average (0.71) of claim ratio fits
the expected standard of not more than (0.70%). The mean of reinsurance risk as a proxy by net
written premium to gross written premium was (73%) which is slightly higher than the maximum
acceptable standard of (70%).

The study also revealed that there was a joint significant relationship between the risk
management variables and Ethiopian insurers‟ financial performance. However, the individual
relationship differs a bit. Like, claim settlement risk and underwriting risk have no strong

63 | P a g e
relationship with return on asset. The results of the regression analysis showed negative
relationship between the ratio of technical reserve risk and ROA with strong statistical
significance. This shows that as minimizing technical reserves risk will certainly improve the
insurers‟ financial performance. A positive relationship between financial performance and
retention ratio implies a high retention ratio increases insurance companies‟ financial
performance. The ratio of net claims incurred to net premium earned has a negative impact on
ROA. This implies that higher level of claim ratio results in lower financial performance. The
logarithm of total assets has a positive impact on financial performance with strong significance
coefficient. This indicates that as larger non-life insurance companies of the country experience
significantly increases in financial performance through economies of scale. The liquidity ratio
has significant and negative influence on insurers‟ financial performance. On the other hand;
underwriting risk has negative impact on the financial performance of Ethiopian companies.

5.2. Conclusion

The study revealed that technical reserve risk, company size, reinsurance risk and liquidity risk
were the most influential factors of Ethiopian insurers‟ ROA, according to their respective order.
Giving to the result, the researcher concluded that the main risks affect the ROA of Ethiopian
insurers are technical reserve risk, company size, reinsurance risk and liquidity risk, since they
have statistically significant impact at confidence level of 99% and 95%. This conclusion implies
that non-life insurance companies with high liquid asset, low technical reserve, large total asset,
and retain more premium can make more profitable than non-life insurance companies with low
liquid asset, large technical reserve, low total asset and low retention. In general managing
insurers‟ risk by itself is difficult task as managing one risk solely may affect the other risks in
negative way, so managing risks in insurance companies should goes hand to hand with each
other and balancing accordingly is a mandatory. This means enterprise risk management (the
enterprise risk management (ERM) theory greatly looks to exert influence on the Ethiopian
insurers risk management. It is, therefore, important for this industry to be focused on the
integration of the whole company‟s risks. Similarly, the study concludes that there is a strong
relationship between risk management and financial performance of insurance companies in
Ethiopia as explained by the model variables explanatory power adjusted R-Square was 74.5%,
which means ROA of non-life insurance companies of Ethiopia is explained 25.5% by variables
other than the studied variables.

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 5.3. Recommendation
 Ethiopian non-life insurance companies should pay greater attention to the significant
variables of technical reserve, company size, reinsurance and liquidity risk, in order to
exceed their financial performance.

 The researcher recommendations concerning technical reserve risk is the insurers should
minimize their outstanding claim reserve through the following mechanisms;
 Insurers should make frequent adjustments on their outstanding claims reserves
by hiring post risk assessors and surveyors.
 The insurers have to minimize long outstanding claims by quickly pay for claims
as much as possible, this can helps insurers to avoid inflation cost and other
subsequent costs.
 Insurers should create more awareness on their customers regarding how to
protect and minimize from losses and encourage their customers by giving them
bonus and discounts.
 Finally, the insurers should formulate policies and procedures in order to mitigate
this technical reserve risk. By doing this they can predict the extents of losses and
also protect themselves against future possible losses and payout.

 Concerning the company size insurers should increase their asset volume with putting in
mind that as some times firms become larger they might suffer on inefficiencies and this
leading to inferior financial performance.

 Regarding reinsurance risk insurers should retain as far as their capacity which usually
measured by net risk (net written premium to equity). The researcher puts some tools
hereunder;
 First insurers should know their right capacity and to know this they should
examine all classes of business. For example in fire and lightning policy the
maximum probable loss/estimated maximum loss (EML) should be calculate.
 Insurers have to provide their stock to the public and existing shareholders up to
the extent their holding limit (5% of subscribed capital) that stated in
Proclamation No.746/2012, Article No. 12.

65 | P a g e
  Moreover, Ethiopian insurers have to formulate reinsurance policy and program.
This is a key tool when they are arranging reinsurance agreements, as their risk
appetite, risk tolerance and other matters are contained in this document.

 The other concerned issue in this study is liquidity risk. The researcher forwarded the
following recommendation.
 Insurers‟ have to underwrite more policies by using different marketing tools like
extensive promotion with taking in mind intelligent asset utilization system.
 The recovered assets from their customers in the case of total loss and/or when the
damaged couldn‟t be economical to repair, insurers should dispose promptly in
order to get more cash.
 Ethiopian insurer should also properly use NBE‟s Directive No. SIB/25/2004 that
commands the insurers to hold 65% of their admitted asset in the form of cash and
short term securities.
 Whenever insurers want to invest their funds accordingly the above directive, they
have to think twice before they put their funds in long term investment. Basically
they should do internal rate of return (IRR) which help them to know the potential
profitability of the targeted investment.
 Moreover, the insurers should formulate policy and procedure and have to
forecast their cash flows these can help them to utilize their working capital
efficiently.

 The researcher encourages NBE‟s Directive No. SIB/25/2004 as it enforces the insurers
to have substantial amount (65%) of their admitted asset in the form of cash and short
term securities. However, as shown in the descriptive part in previous chapter, the sector
was not liquid (1.03) this indicates that NBE should follow continuously for the
application of this directive.

 The researcher also recommends the regulatory body (NBE) regarding technical reserve,
Directive No. SIB/38/2014, should be revise because it enforces the insurers to hold
100% reserves for claims under litigations, the researcher believe that this is not fair as
the chance for both win and defeat is 50% the reserve also should be 50% in order to
provide equitable reserve. Moreover, regarding this risk the regulator have to minimize
the licensing requirements for surveyors, loss assessors and adjustors as there is shortage
of loss assessor, surveyors and no loss adjustor in the country.
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Appendixes

Appendix A: List of Insurance Companies in Ethiopia

No Name Establishment date

.
1 Ethiopian Insurance Corporation 1975
2 National Insurance Company of Ethiopia 23/09/1994
3 Awash Insurance Company 1/10/1994
4 Africa Insurance Company 1/12/1994
5 Nyala Insurance Company 6/1/1995
6 Nile Insurance Company 11/4/1995
7 Global Insurance Company 11/1/1997
8 United Insurance Company 1/4/1997
9 Nib Insurance Company 1/5/2002
10 Lion Insurance Company 1/7/2007
11 Ethio-Life and General Insurance Company 23/10/2008
12 Oromia Insurance Company 26/01/2009
13 Abay Insurance Company 26/07/2010
14 Berhan Insurance Company 24/05/2011
15 Bunna Insurance Company 23/8/2011
16 Tsehay Insurance Company 28/03/2012
17 Lucy Insurance Company 15/11/2012

Appendix B: Instrument for Unstructured face- to-face interview of NBE

officers regarding on the effects of risk on insurance companies’ financial
performance in Ethiopia

1. What are major risks of Ethiopian insurance industry?

2. How do those variables influence the insurers‟ financial performance in general?
3. In what extent affect liquidity, technical reserve, company size, claim settlement,
underwriting and reinsurance risk to the financial performance of insurance
companies?
4. Among the problem that can influence industry‟s financial performance, which of
them is more affects the industry‟s financial performance?
5. What types of measures are taken as a regulator in order to reduce the influence
that affects financial performance negatively?
6. Any idea or comment?
 Appendix C: Sampled Insurers’ Total Asset, Capita & Profit (In 000, 000)

Company Account 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

TA 669 773 780 861 960 1,104 1,286 1,785 2,080 2,291 2,470

capital 109 262 246 225 245 266 261 313 361 425 428

EIC profit 66 91 102 78 83 147 144 243 344 440 467

TA 26 32 40 44 51 63 87 144 196 254 281

capital 7 10 13 15 16 19 18 36 61 67 90

NICE profit (1) 2 1 3 2 4 - 11 27 18 34

TA 86 106 134 153 182 217 331 469 559 580 648

capital 34 36 42 46 49 67 86 109 148 178 198

AWASH profit 7 6 9 11 9 24 26 37 83 65 75

TA 109 158 175 230 238 333 431 505 497 547 609

capital 35 47 44 46 50 64 76 95 109 126 200

AFRICA profit - 12 4 9 11 19 23 27 31 44 44

NYALA TA 109 124 127 143 151 188 215 308 426 543 747
 capital 52 52 53 52 65 76 91 125 163 215 280

profit 8 12 12 8 20 26 34 56 70 78 92

TA 152 181 192 189 195 225 268 364 423 485 574

capital 53 49 47 44 48 80 94 131 148 164 214

NILE profit 6 6 4 (5) 4 31 21 37 46 58 81

TA 23 30 37 44 54 61 65 94 124 154 186

capital 12 17 19 20 23 25 28 30 44 66 95

GLOBAL profit 1 1 2 1 3 5 2 2 13 17 25

TA 61 88 112 147 173 212 259 358 432 511 556

capital 25 41 45 56 54 79 90 126 164 194 244

UNIC profit (1) 8 11 15 8 30 23 44 75 72 73

TA 62 73 99 126 193 251 306 475 518 651 759

capital 25 30 37 33 51 63 79 102 138 196 252

NIB profit 6 3 7 14 19 23 27 42 57 73 120

Appendix D: Ratio Data Used for Analysis

Year company ROA LQ TR TA CS RE CNWP

2005 EIC 0.0986 0.8674 1.1595 668,876 0.5409 0.5941 0.1304

2006 EIC 0.1182 0.8125 0.4934 772,831 0.6662 0.5851 0.1246

2007 EIC 0.1309 0.8283 0.6528 780,053 0.6929 0.6030 0.2406

2008 EIC 0.0909 1.0077 0.7762 860,513 0.7177 0.5761 0.1410

2009 EIC 0.0868 0.9033 0.9033 960,291 0.7297 0.5680 0.1592

2010 EIC 0.1331 0.9198 0.7845 1,104,451 0.6174 0.5105 0.1939

2011 EIC 0.1122 1.0084 0.9646 1,285,641 0.7446 0.5503 0.3706

2012 EIC 0.1366 1.0632 1.1192 1,785,007 0.5591 0.6300 0.7248

2013 EIC 0.1652 1.0333 1.0717 2,080,395 0.6003 0.5174 0.1293

2014 EIC 0.1921 1.0154 0.8813 2,291,004 0.5959 0.6293 0.1214

2015 EIC 0.1891 1.0569 0.8672 2,470,166 0.6251 0.7080 0.1792

2005 NICE -0.0471 1.4177 1.1612 25,582 0.8415 0.7608 0.2715

2006 NICE 0.0620 1.3659 0.8475 31,517 0.6539 0.8549 0.1743

2007 NICE 0.0209 1.0537 0.9227 39,625 0.6459 0.8683 0.1946

2008 NICE 0.0572 1.0736 0.7264 43,869 0.6740 0.8112 0.0812

2009 NICE 0.0463 1.2327 0.8073 51,127 0.6813 0.7943 0.1164

2010 NICE 0.0588 1.0080 0.8421 63,029 0.6773 0.7582 0.2562

2011 NICE 0.0029 0.8924 2.5665 86,516 0.7276 0.8147 0.3379

2012 NICE 0.0756 0.9501 0.7891 144,488 0.5405 0.8076 0.6649

2013 NICE 0.1393 0.8317 0.6708 196,391 0.5903 0.7925 0.1077

2014 NICE 0.0695 0.8903 0.8385 254,255 0.7002 0.8153 0.0799

2015 NICE 0.1219 0.8278 0.8582 280,679 0.5620 0.8314 0.1282

2005 AWASH 0.0812 0.8658 0.5121 86,481 0.5548 0.8586 1.4654

2006 AWASH 0.0604 0.9053 0.4540 106,150 0.6602 0.7731 0.2214

2007 AWASH 0.0650 1.0109 0.6250 134,435 0.7769 0.8312 0.3739

2008 AWASH 0.0685 1.2238 0.8102 153,342 0.7014 0.8280 0.1537

2009 AWASH 0.0519 1.2729 1.0127 181,927 0.8145 0.7884 0.0898

2010 AWASH 0.1110 1.2017 0.9011 216,853 0.6249 0.8092 0.2311

2011 AWASH 0.0795 1.2745 0.9483 330,811 0.6165 0.8082 0.4719

2012 AWASH 0.0794 1.1755 1.3910 468,690 0.6612 0.7298 0.4303

2013 AWASH 0.1485 1.1248 1.2153 558,710 0.5905 0.8211 0.2074

2014 AWASH 0.1116 1.1615 1.0402 579,675 0.6295 0.7951 -0.0075

2015 AWASH 0.1161 1.2017 0.9616 647,717 5.6381 0.8252 0.1816

2005 AFRICA -0.0037 0.8954 0.8788 108,982 0.7345 0.7358 0.0983

2006 AFRICA 0.0732 0.8613 0.6882 158,141 0.6016 0.6832 0.1808

2007 AFRICA 0.0204 0.9231 0.8767 174,629 0.8072 0.6696 0.1938

2008 AFRICA 0.0373 1.0010 1.1165 229,943 0.8175 0.7190 0.3904

2009 AFRICA 0.0478 1.0682 1.2872 238,005 0.8283 0.7392 0.1661

2010 AFRICA 0.0579 1.1248 1.2174 333,438 0.8155 0.7255 0.4238

2011 AFRICA 0.0530 1.2090 1.3935 430,842 0.8200 0.7650 0.4623

2012 AFRICA 0.0532 1.4887 1.5086 505,285 0.8540 0.7414 0.3598

2013 AFRICA 0.0619 1.8413 1.5200 496,643 0.8535 0.7925 -0.0358

2014 AFRICA 0.0804 1.5830 1.5166 546,970 0.8952 0.7431 -0.0445

2015 AFRICA 0.0720 2.7428 0.9395 609,489 0.8098 0.7448 0.0381

2005 NYALA 0.0720 0.9227 0.4411 109,152 0.4903 0.7623 0.1080

2006 NYALA 0.0945 0.8364 0.6300 123,839 0.5932 0.8085 0.2940

2007 NYALA 0.0972 0.9284 0.6048 126,676 0.5240 0.7599 0.0784

2008 NYALA 0.0557 1.0287 0.8249 142,996 0.6822 0.8105 0.2506

2009 NYALA 0.1340 1.1034 0.6730 151,172 0.6171 0.7378 -0.1253

2010 NYALA 0.1377 1.0180 0.6311 187,778 0.5886 0.6219 0.1304

2011 NYALA 0.1591 0.9827 0.5407 215,232 0.5484 0.6698 0.1887

2012 NYALA 0.1820 0.9095 0.4191 308,079 0.4094 0.7243 0.4502

2013 NYALA 0.1647 0.8754 0.6298 426,363 0.4608 0.6493 0.1684

2014 NYALA 0.1434 0.8213 0.5978 542,608 0.4197 0.6657 0.0723

2015 NYALA 0.1227 0.8035 0.7452 746,621 0.5722 0.6725 0.1969

2005 NILE 0.0412 1.1921 0.6799 152,397 0.7245 0.8191 0.0724

2006 NILE 0.0357 0.9794 0.9930 181,091 0.7373 0.7803 0.1818

2007 NILE 0.0227 1.1350 1.3161 191,909 0.8550 0.8270 0.1650

2008 NILE -0.0265 1.4614 1.4956 188,611 0.8304 0.8159 -0.0201

2009 NILE 0.0217 1.3919 1.1953 194,973 0.6938 0.7338 -0.0013

2010 NILE 0.1379 1.0782 0.6235 225,030 0.5737 0.8162 0.3100

2011 NILE 0.0791 1.0371 0.5008 267,595 0.7145 0.8465 0.3688

2012 NILE 0.1020 0.9182 0.4954 364,175 0.7051 0.8530 0.4597

2013 NILE 0.1096 0.9002 0.7620 423,111 0.7303 0.8290 -0.0657

2014 NILE 0.1187 0.9175 0.7477 485,322 0.7006 0.8576 0.2095

2015 NILE 0.1409 0.8670 0.6488 574,291 0.6856 0.8749 0.1638

2005 GLOBAL 0.0404 0.4453 0.1052 23,072 0.4279 0.7042 0.3839

2006 GLOBAL 0.0432 0.4336 0.1121 30,376 0.5568 0.7431 0.4628

2007 GLOBAL 0.0546 0.6480 0.1292 36,658 0.5028 0.7105 0.0958

2008 GLOBAL 0.0140 1.1812 0.1757 44,267 0.5119 0.7395 0.2566

2009 GLOBAL 0.0541 1.0396 0.2175 53,996 0.5056 0.7110 0.0095

2010 GLOBAL 0.0805 1.1912 0.1829 60,772 0.4413 0.7697 0.3471

2011 GLOBAL 0.0364 1.0876 0.2570 65,360 0.8406 0.7441 0.4445

2012 GLOBAL 0.0203 1.0918 0.5911 93,596 0.9519 0.7624 0.9531

2013 GLOBAL 0.1041 0.8811 0.5254 124,206 0.5682 0.7721 -0.0425

2014 GLOBAL 0.1107 0.7397 0.3093 154,087 0.6328 0.7798 0.1566

2015 GLOBAL 0.1364 0.6128 0.2375 186,437 0.6990 0.7953 0.2026

2005 UNIC -0.0156 0.9843 0.6934 61,443 0.7379 0.7686 -0.1438

2006 UNIC 0.0922 0.8090 0.4735 87,612 0.6784 0.8098 0.5144

2007 UNIC 0.1002 0.8997 0.6558 111,541 0.7202 0.7336 0.5326

2008 UNIC 0.1017 0.9035 0.7362 147,443 0.5878 0.7076 0.3097

2009 UNIC 0.0472 0.9739 1.0010 172,717 0.7707 0.6628 -0.0269

2010 UNIC 0.1409 0.8551 0.7027 212,105 0.5826 0.7217 0.1928

2011 UNIC 0.0874 0.8408 0.7898 258,928 0.7130 0.7232 0.2916

2012 UNIC 0.1219 0.8030 0.6802 358,303 0.6413 0.7174 0.4643

2013 UNIC 0.1732 0.7884 0.6520 432,240 0.5436 0.7166 0.0403

2014 UNIC 0.1412 1.0975 0.5877 511,163 0.5329 0.7403 0.1385

2015 UNIC 0.1306 1.3724 0.4364 555,786 0.5326 0.7347 0.0726

2005 NIB 0.0919 1.0178 0.2002 61,735 0.7684 0.5581 0.0676

2006 NIB 0.0467 0.9951 0.2998 72,815 1.5440 0.4618 0.1669

2007 NIB 0.0757 0.9487 0.3665 98,717 0.6671 0.8299 1.5622

2008 NIB 0.1122 1.1665 0.6415 126,142 0.6611 0.8610 0.5646

2009 NIB 0.0975 1.0609 0.8378 193,192 0.6809 0.8580 0.3110

2010 NIB 0.0934 1.0207 0.8669 251,284 0.6633 0.8239 0.2573

2011 NIB 0.0899 1.0001 0.9368 305,682 0.2909 0.3854 -0.4118

2012 NIB 0.0885 1.0316 1.0765 475,192 0.2995 0.5258 1.1123

2013 NIB 0.1112 0.9508 1.0261 517,607 0.3029 0.3661 -0.3434

2014 NIB 0.1127 0.9026 0.9189 651,237 0.6975 0.4216 1.3462

2015 NIB 0.1591 0.9096 0.7479 759,032 0.6765 0.5924 0.0698

Appendix E: Regression Results For effects of risk management on insurance
companies financial performance

Dependent Variable: ROA

Method: Panel Least Squares
Date: 12/27/16 Time: 04:33
Sample: 2005 2015
Periods included: 11
Cross-sections included: 9
Total panel (balanced) observations: 99

Variable Coefficient Std. Error t-Statistic Prob.

C -0.500195 0.055164 -9.067358 0.0000

LQ -0.021960 0.010784 -2.036261 0.0449
TR -0.057336 0.009320 -6.151786 0.0000
Ln(TA) 0.048904 0.003911 12.50357 0.0000
CS -0.006348 0.004956 -1.280910 0.2038
RE 0.081406 0.034860 2.335216 0.0219
CNWP -0.008822 0.008752 -1.008011 0.3163

Effects Specification

Cross-section fixed (dummy variables)

R-squared 0.781781 Mean dependent var 0.087152

Adjusted R-squared 0.745411 S.D. dependent var 0.048160
S.E. of regression 0.024300 Akaike info criterion -4.457958
Sum squared resid 0.049601 Schwarz criterion -4.064758
Log likelihood 235.6689 Hannan-Quinn criter. -4.298869
F-statistic 21.49527 Durbin-Watson stat 2.166024
Prob(F-statistic) 0.000000

Appendix F: Redundant Fixed effect Tests

Redundant Fixed Effects Tests

Equation: Untitled
Test cross-section fixed effects

Effects Test Statistic d.f. Prob.

Cross-section F 5.923222 (8,84) 0.0000

Cross-section Chi-square 44.284783 8 0.0000
Appendix G: Heteroskedasticity Test: White

Heteroskedasticity Test: White

F-statistic 1.072807 Prob. F(6,92) 0.3846

Obs*R-squared 6.473670 Prob. Chi-Square(6) 0.3723
Scaled explained SS 4.554022 Prob. Chi-Square(6) 0.6021

Test Equation:
Dependent Variable: RESID^2
Method: Least Squares
Date: 12/30/16 Time: 00:52
Sample: 1 99
Included observations: 99

Variable Coefficient Std. Error t-Statistic Prob.

C 0.002140 0.000931 2.298849 0.0238

LQ^2 -8.13E-05 0.000133 -0.611414 0.5424
TR^2 0.000147 0.000132 1.110724 0.2696
Ln(TA)^2 -7.61E-06 4.50E-06 -1.691340 0.0942
CS^2 5.05E-06 3.26E-05 0.155015 0.8771
RE^2 -0.000279 0.000786 -0.354488 0.7238
CNWP^2 -0.000416 0.000259 -1.602721 0.1124

R-squared 0.065391 Mean dependent var 0.000784

Adjusted R-squared 0.004438 S.D. dependent var 0.001005
S.E. of regression 0.001003 Akaike info criterion -10.90335
Sum squared resid 9.26E-05 Schwarz criterion -10.71985
Log likelihood 546.7157 Hannan-Quinn criter. -10.82911
F-statistic 1.072807 Durbin-Watson stat 1.807764
Prob(F-statistic) 0.384601
Appendix H: Normality test
12
Series: Standardized Residuals
Sample 2005 2015
10
Observations 99

8 Mean -9.97e-19
Median 0.000707
Maximum 0.062483
6
Minimum -0.060712
Std. Dev. 0.022497
4 Skewness -0.063461
Kurtosis 3.136067
2
Jarque-Bera 0.142821
Probability 0.931080
0
-0.06 -0.04 -0.02 0.00 0.02 0.04 0.06

Appendix I: Autocorrelation test

0 1.550 1.803 2.166 2.197 2.45 4