COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

The Determinants of Profitability on Insurance Sector: Evidence from

Insurance Companies in Ethiopia

A thesis Submitted to the Department of Accounting and Finance,

College of Business and Economics, Addis Ababa University, in Partial
Fulfillment of the Requirements for Degree of Master of Accounting and
Finance

Addis Ababa University

Addis Ababa, Ethiopia
May, 2015

By Mistre sisay GSR/1561/06

i
 The Determinants of Profitability on Insurance Sector: Evidence
from Insurance Companies in Ethiopia

Mistre sisay

A Thesis Submitted to
The Department of Accounting and Finance

Presented in Partial Fulfillment of the Requirements for the Degree

of
Master of accounting and finance

Addis Ababa University

Addis Ababa, Ethiopia
May 2015

ii
Declaration

I, Mistre Sisay declare that, this thesis entitled: The Determinants of Profitability on Insurance

Sector: Evidence from Insurance Companies in Ethiopia is my original work produced under the

guidance of my advisor Dr. P. Laxmikantham, and has never been published and/or submitted

for any award of Degree in any other University. Any source used is duly acknowledged in this

study.

Signed: --------------------------------------------------- Date: --------------------------------

Mistre Sisay: ID No.GSR/1561

ii
 Addis Ababa University
School of Graduate Studies
This is to certify that the thesis prepared by Mistre Sisay, entitled: The Determinants of
Profitability on Insurance Sector: Evidence from Insurance Companies in Ethiopia and submitted
in partial fulfillment of the requirements for the Degree of Master of Accounting and finance
complies with the regulations of the University and meets the accepted standards with respect to
originality and quality.

Approved by the examining committee

Examiner _________________________ Signature ___________Date______________
Examiner__________________________ Signature ___________ Date______________
Advisor Signature ____________ Date_____________
________________________________
Chair of department or Graduate program coordinator

iii
 ABSTRACT
Organizational performance has attracted scholarly attention in corporate finance literature
over several decades. However, in the context of insurance sector, it has received a little
attention in developing economies. The objective of this study is to determine the relationship
between factors affecting insurance profitability (Age of companies, Size of companies,
Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio, Reinsurance
dependence, Solvency margin and GDP growth rate and financial performance of insurance
companies in Ethiopia. In order to carry out the study, secondary data of 9 insurance companies
over the period of 2003-2014 was obtained on the financial performance from the annual reports
and audited financial statements and secondary data supported by primary data obtained
through open-ended questionnaires held with insurance companies chief finance officers .Data
collected was analyzed using Eviews 7 econometrics software . Regression analysis was used to
analyze the data from secondary source and data from primary source were streamlined
presented to support regression result. The study findings indicate that the variables are
statistically significance to influencing financial performance of insurance companies in
Ethiopia. This implies that loss ratio, size of insurance companies, leverage ratio, and solvency
margin has significant impact at one percent significance level on profitability of insurance
companies operating in Ethiopia and the primary source data also supports that the above
variable has an impact on profitability of insurance companies. Based on the findings, the study
recommends that insurers must work towards improving their solvency margin, underwriting
risk, and increase their size of asset, financing decision and improving management and
employee’s competency. Further studies should be undertaken to analyze the different sectors in
the economy to determine any significant differences in the relationship between firm
characteristics and financial performance in the insurance sectors by incorporating other
independent variable.

Key Terms: Financial Performance, Profitability, Insurance Companies in Ethiopia, Return On

Asset (ROA)

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 ACKNOWLEDGMENTS
I wish to thank the Almighty God for His grace throughout this journey and wish to acknowledge
the support of my parents for giving me the emotional support that I needed throughout this
course. I also acknowledge the support and the guidance received from Dr. P. Laxmikantham,
my supervisor on this research. It is his patience that has enabled me to finally complete this
research paper. My appreciation also is to all my friends and classmates who assisted or
contributed in one way or the other to the completion of this research, especially Tsiyon Admasu
and Yinebeb Efrem.

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 Table of contents

Contents page
List of Tables ............................................................................................................................................... ix
List of Figure................................................................................................................................................. x
List of Acronyms and Abbreviations........................................................................................................... xi
CHAPTER ONE ........................................................................................................................................... 1
INTRODUCTION ........................................................................................................................................ 1
1.1. Background of the study ............................................................................................................... 1
1.2. Statement of the problem ..............................................................................................................4
1.4. Research hypothesis...................................................................................................................... 6
1.5. Objectives of the study.................................................................................................................. 6
1.5.1. General objective .................................................................................................................. 6
1.5.2. Specific objectives. ............................................................................................................... 6
1.6. Significance of the study............................................................................................................... 7
1.7. Scope and limitation of the study..................................................................................................8
1.8. Organization of the paper..............................................................................................................8
CHAPTER TWO .......................................................................................................................................... 9
RELATED LITERATURE........................................................................................................................... 9
2.1 Introduction......................................................................................................................................... 9
2.2. Global insurance industry .................................................................................................................. 9
2.3. Historical Development of Insurance in Ethiopia............................................................................11
2.3.1. In pre 1974 Ethiopia.................................................................................................................. 12
2.3.2. During this period/post 1974..................................................................................................... 12
2.3.3. In 1990s..................................................................................................................................... 12
2.4. Financial Soundness of Ethiopian insurance companies .................................................................14
2.4.1. Capital Adequacy......................................................................................................................14
2.4.2. Assets quality ............................................................................................................................ 15
2.4.3. Reinsurance Business................................................................................................................ 15
2.4.4. Adequacy of technical provisions .............................................................................................16
2.4.5. Management Soundness............................................................................................................16

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 2.4.6. Premiums ..................................................................................................................................16
2.4.7. Profitability ...............................................................................................................................17
2.4.8. Liquidity management ..............................................................................................................17
2.5. Theoretical Review .......................................................................................................................... 17
2.5.1. Traditional Theory ....................................................................................................................17
2.5.2. Resource Based Theory ............................................................................................................18
2.5.3. Pecking Order Theory............................................................................................................... 19
2.5.4. Agency Theory.......................................................................................................................... 20
2.5.5. Efficiency Hypothesis............................................................................................................... 21
2.5.6. Capital Asset Pricing Model (CAPM) ......................................................................................22
2.6. The Concept of Profitability ............................................................................................................22
2.7. Determinates of Profitability in Insurance Companies: An Empirical Review ...............................24
2.7.1. Firm size and age ......................................................................................................................27
2.7.2. Liquidity....................................................................................................................................28
2.7.3. Leverage....................................................................................................................................29
2.7.4. Loss ratio (LOSS): ....................................................................................................................30
2.7.5. Tangibility of assets .................................................................................................................. 31
2.7.6. Growth Rate ..............................................................................................................................31
2.7.7. The reinsurance dependence ..................................................................................................... 32
2.7.8. The solvency margin................................................................................................................. 32
2.7.9. Growth in gross domestic product ............................................................................................ 33
2.8. Conceptual frame work. .................................................................................................................. 33
CHAPTER THREE ....................................................................................................................................34
RESEARCH METHODOLOGY................................................................................................................ 34
3.1. Research design ...............................................................................................................................34
3.2. Source of data and collection methods ............................................................................................ 34
3.3. Sampling design...............................................................................................................................35
3.4. Choice of Dependent Variable and its Measurement.......................................................................35
3.5. Choice of Explanatory Variables and their Measurement ...............................................................36
3.6. Model specification.......................................................................................................................... 38
3.7. Methods of data analysis.................................................................................................................. 39
CHAPTER FOUR....................................................................................................................................... 41

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RESULTS AND DISCUSSION ................................................................................................................. 41
4.1. Introduction...................................................................................................................................... 41
4.2. Descriptive statistics of the study variables .....................................................................................41
4.3. Correlation Test ...............................................................................................................................43
4.4. Regression Analysis.........................................................................................................................45
4.4.1. The average value of the errors is zero .....................................................................................45
4.4.2. Normality Test .......................................................................................................................... 45
4.4.3. Autocorrelation Test ................................................................................................................. 46
4.4.4 Heteroscedasticity Test ..............................................................................................................47
4.4.5. Multicollinearity Test................................................................................................................ 48
4.5. Fixed effect Versus Random effect..................................................................................................49
4.6. Finding and Regression Result ........................................................................................................49
CHAPTER FIVE ........................................................................................................................................ 61
SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS .......................................61
5.1. Summary ..........................................................................................................................................61
5.2. Conclusions ...................................................................................................................................... 62
5.3. Recommendations ........................................................................................................................... 63
5.4. Recommendations for future research............................................................................................64
References.....................................................................................................................................................A
APPENDICES .............................................................................................................................................. F

viii
 List of Tables
Table No. Title of tables Page
Table 4.1 Descriptive statistics of the study variables...................................................................42

Table 4.2 Pearson’s correlation coefficient matrix…………………………................................44

Table 4.3 Durbin Watson, Autocorrelation Test……………………………................................47

Table 4.4 Heteroskedasticity Test: White......................................................................................47

Table 4.5 Multicollinearity Test: correlation analysis of independent variables…………...........48

Table 4.6 Summary of Regression Result ……….........................................................................50

ix
 List of Figure
Figure. No. Title of Figure Page
Figure 2.1. Conceptual frame work of the study ……………………………………………..33

Figure 4.1 Jarqu-Bera Normality Test.......................................................................................46

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 List of Acronyms and Abbreviations
AGE- Age of Insurance Companies

GDP- Gross Domestic Product

GRP- Gross Written Premium

ISD- Insurance Supervision Directorate

LAV- Leverage Ratio of Insurance Companies

LIQ- Liquidity Ratio of Insurance Companies

LOR- Loss Ratio of Insurance Companies

NBE – National Bank of Ethiopia

OLS – Ordinary Least Square

RED- Reinsurance Dependency

ROA- Return on Asset

ROE- Return on Equity

SIZE- Size of Insurance Companies

SOM – Solvency Margin of Insurance Companies

TAN- tangibility of asset

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 CHAPTER ONE

INTRODUCTION

1.1. Background of the study

The importance of insurance in modern economies is unquestioned and has been recognized for
centuries. Insurance is practically a necessity to business activity and enterprise. But insurance
also serves a broad public interest far beyond its role in business affairs and its protection of a
large part of the country’s wealth. It is the essential means by which the disaster to an individual
is shared by many, the disaster to a community shared by other communities; great catastrophes
are thereby lessened, and, it may be, repaired.

Without insurance coverage, the private commercial sector would be unable to function.
Insurance enables businesses to operate in a cost-effective manner by providing risk transfer
mechanisms whereby risks associated with business activities are assumed by third parties. It
allows businesses to take on credit that otherwise would be unavailable from banks and other
credit-providers fearful of losing their capital without such protection, and it provides protection
against the business risks of expanding into unfamiliar territory new locations, products or
service which is critical for encouraging risk taking and creating and ensuring economic growth.
Beyond the commercial world, insurance is vital to individuals. Lack of insurance coverage
would leave individuals and families without protection from the uncertainties of everyday life.
Life, health, property and other insurance coverage’s are essential to the financial stability, well-
being and peace of mind of the average person.

Insurance is a financial product that legally binds the insurance company to pay losses of the
policyholder when a specific event occurs. The insurer accepts the risk that the event will occur
in exchange for a fee, the premium. The insurer, in turn, may pass on some of that risk to other
insurers or reinsurers. Insurance makes possible ventures that would otherwise be prohibitively
expensive if one party had to absorb all the risk.

1
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 and Sümegi, 2008). The insurance sector of any
country can take major part in the economic growth and development (Brainard, 2008; Ward &
Zurbruegg, 2000). But this sector in developing countries has an inactive role in the economic
growth and development.

The history of insurance service is as far back as modern form of banking service in Ethiopia
which was introduced in 1905. At the time, an agreement was reached between Emperor Menelik
II and a representative of the British owned National Bank of Egypt to open a new bank in
Ethiopia. Similarly, modern insurance service, which were introduced in Ethiopia by foreigners,
mark out their origin as far back as 1905 when the bank of Abyssinia began to transact fire and
marine insurance as an agent of a foreign insurance company. According to a survey made in
1954, there were nine insurance companies that were providing insurance service in the country.
With the exception of Imperial Insurance Company that was established in 1951, all the
remaining of the insurance companies were either branches or agents of foreign companies. In
1960, the number of insurance companies increased considerably and reached 33. At that time
insurance business like any business undertaking was classified as trade and was administered by
the provisions of the commercial code, Hailu Zeleke (2007).

According to Hailu Zeleke (2007), the first significant event that the Ethiopian insurance market
observation was the issuance of proclamation No. 281/1970 and this proclamation was issued to
provide for the control & regulation of insurance business in Ethiopia. Consequently, it created
an insurance council and an insurance controller's office, its strange impact in the sector. The
proclamation defined '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 nationals or national companies. After four years that is after the enactment of
the proclamation, the military government that came to power in 1974 put an end to all private
enterprises. Then all insurance companies operating were nationalized and from January 1, 1975

2
onwards the government took over the ownership and control of these companies & merged
them into a single unit called Ethiopian Insurance Corporation. In the years following
nationalization, Ethiopian Insurance Corporation became the sole operator. After the change in
the political environment in 1991, the proclamation for the licensing and supervision of
insurance business heralded the beginning of a new era. Immediately after the enactment of the
proclamation in the 1994, private insurance companies began to increase.

The performance of any business firm not only plays the role to increase the market value of that
specific firm but also leads towards the growth of the whole sector which ultimately leads
towards the overall prosperity of the economy. Assessing the determinants of performance of
insurers has gained the importance in the corporate finance literature because as intermediaries ,
these companies are not only providing the mechanism of risk transfer, but also helps to
channelize the funds in an appropriate way to support the business activities in the economy.
However, it has received little attention particularly in developing economies (Ahmed et al,
2011).

Ethiopia’s Insurance sector has shown strong resilience to a challenging macroeconomic

environment and global development. Despite slow growth in premiums (3%) in 2014, the total
capital of the industry, in which non-life business represents 95% of the total size of capital in
2014, reached Birr 8.1billion as at June showed a 32% growth rate over the preceding year
owing to considerable improvements in capital injections and investment returns.

General insurance continued to dominate the insurance business. It took around 94% of the total
premium and 95% of the total insurance capital. Private insurers constituted 60% and 79 % of
the total market share and capital size respectively. The slow growth of premiums in the current
year makes insurance penetration went down to 0.83% from 0.87% in June 2014 .This is still a
sign of the low level of progress of insurance in Ethiopia.

The market is dominated by state insurer which comprised about 54% of the total size the
market. However the index also indicates the size of market for top 3 and top 4 insurers declined

3
to 53% and 61% from 61% and 69% in 2010 respectively which in turn signaled the increasing
trends of competiveness of the private sector over the years, (NBE,ANNUAL REPORT 2014).
Despite the current insurance companies’ development with respect to both total assets and in
number, there are some studies conducted to investigate the determinants of performance of
insurance sector in Ethiopia. Therefore, the objective of this study is to identify the factors that
influence insurance companies’ performance in Ethiopia. The significance of this study stems
from the fact that various studies in Ethiopia have investigated the determinants of performance
only for non-financial and banking sectors. Therefore, the researcher believes that the study fills
an important gap in understanding the determinants of performance for insurance companies in
the developing economy. Such an understanding is important, because it equips financial
managers with applied knowledge for determining factors that affect firms’ performance. From a
theoretical point of view, it provides an important data for comparing determinants of
performance of insurance companies between developed and developing economies.

1.2. Statement of the problem

It has been noted that without the insurance sector, the economy and the wealth creation
associated with it can be adversely affected (International Accounting Standards Board, 2007).
The insurance industry forms an integral part of the country‘s financial sector and its benefits
cannot be over-emphasized. If this crucial sector was missing, the consequence on the economy
would be devastating.

The subject of financial performance has received significant attention from scholars in the
various areas of business and strategic management. It has also been the primary concern of
business practitioners in all types of organizations since financial performance has implications
to organization’s health and ultimately its survival. High performance reflects management
effectiveness and efficiency in making use of company’s resources and this in turn contributes to
the country’s economy at large. (Naser, and Mokhtar, 2004)

Performance represents a difficult concept, both in terms of definition and quantification. It was
defined as output of activity, and the appropriate measure selected to assess corporate
performance is considered according to the organization type and objectives of evaluation.
Researchers in strategic management have offered a variety of models that can be used to

4
analyze financial performance. Nevertheless, there is no consensus on what constitutes a valid
set of performance criteria (Ostroff and Schmidt, 1993).

Profitability, defined as proxy of financial performance, is one of the main objectives of

insurance companies’ management. Profit is an essential prerequisite for an increasing
competitiveness of a company. In addition, profit attracts investors and improves the level of
solvency, and thus, strengthens consumers’ confidence. The financial analysis of a company is
an important tool used by actuaries in the process of decision-making on underwriting and
investment activities of the insurance company. The financial performance of insurance
companies is also relevant within the macroeconomic context since the insurance industry is one
of the financial system’ components, fostering economic growth and stability. Therefore, the
determinants of insurance company’s performance have attracted the interest of academicians,
practitioners and institutional supervisors. Hence, these are important issues to be investigated
for the insurance managers, professionals, regulators and policy makers to support the sector in
achieving the excellence so that required economic outcomes could be obtained from the help of
the sector in Ethiopia by understanding the success and failure factors of profitability. In
Ethiopia factors affecting financial performance of insurance companies has not been adequately
investigated. While taking in to consideration the absence of empirical inquiry into the factors
affecting insurance companies’ financial performance, the researcher attempts to supplement
empirical evidence in the country by incorporating insurance specific determinates (variables)
which are untouched by previous researchers. The study's main objective was to identify and to
what extent that the factors affecting profitability of insurance companies' operating in Ethiopia.

1.3. Research questions

Therefore, this study seeks to answer the following questions:
 What are the basic factors affecting profitability of Insurance Companies in Ethiopia?
 To what level that determinant’ of profitability impact the performance of insurance
companies in Ethiopia?

5
1.4. Research hypothesis
The study tasted the following research hypotheses formulated based on prior empirical
literature.
H1. Age of a company has a positive impact on performance of insurance companies in Ethiopia.
H2. The size of a company has a positive impact on performance of insurance companies in
Ethiopia.
H3. Leverage has a negative impact on performance of insurance companies in Ethiopia
H4. There is a positive relationship between tangibility of assets and performance of insurance
companies in Ethiopia.
H5. Liquidity has a positive impact on performance of insurance companies in Ethiopia.
H6.The insurance premium growth has a negative impact on performance of insurance
companies in Ethiopia.
H7. Loss ratio has a negative impact on performance of insurance companies in Ethiopia.
H8.Reinsurance dependence has a negative impact on performance of insurance companies in
Ethiopia.
H9. Solvency margin has a positive impact on performance of insurance companies in Ethiopia.
H10. Growth of GDP growth has a positive impact on performance of insurance companies in
Ethiopia

1.5. Objectives of the study

1.5.1. General objective

The main aim of this study was to investigate the factors that determine the profitability
(financial performance) of insurance companies in Ethiopia .

1.5.2. Specific objectives.

Based on the above general objective, the researcher examined the following specific objectives:

1. To identify the main determinants of insurance companies
profitability.

6
 2. To identify the effect of Age of companies, Size of companies, Leverage, Tangibility of
assets, Liquidity, Premium Growth, Loss ratio, Reinsurance dependence and Solvency
margin on the financial performance of Ethiopian insurance companies.
3. To determine the relationship between firm characteristics and profitability in insurance
companies in Ethiopia.

1.6. Significance of the study

The study importance emerges from the fact that insurance sector plays a significant role in
enhancing the country economy, and providing critical services for people in Ethiopia, the
current study also empirically supplement a comprehensive analytical framework of financial
performance in the case of Ethiopian insurance sector. Other importance of this study could be
summarized as the following:

 In Ethiopia, a few researches have been investigated factors affecting Ethiopian insurance
companies' financial performance, so the current study will be a base for other studies in
the same field, and it will help in adding value to this subject.
 The current study will also provide a comprehensive framework and literature about of
firm financial performance, and the factors influencing it in the case of Ethiopian
insurance companies.
 To provide some conclusions and recommendations for top management and decision
makers at insurance companies to deal with variables that affect financial performance In
order to enhance their company financial performance.
 To provide the local libraries with scientific material dealing with variables that affect
financial performance on Ethiopian insurance companies.
 Finally the current study will identify the effect of Age of companies, Size of companies,
Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio, Reinsurance
dependence, Solvency margin, and GDP growth on Ethiopian insurance companies.

7
1.7. Scope and limitation of the study
The scope of research was limited on the relationship of selected variables that determine the
profitability of insurance companies and profitability (financial performance) of insurance
companies in Ethiopia. The limitations of the study mean the constraints that the researcher faces
during the study which are time, finance, attitude of respondents and source of information.

1.8. Organization of the paper

The research paper organized in main five chapters. The first chapter comprise; background of
the study, statement of the problem, research hypothesis, the research objective (general and the
specific research objective), significance of the study, and scope and limitation of the study. The
second chapter contains the related literature review. The third chapter comprised, research
methodology which includes; research design, data used in the research, sampling technique,
choice of dependent variable and independent variables their measurement, and model
specification. Chapter four incorporated; the research finding, the research analysis and
interpretation of the result. Lastly chapter five deals with conclusion drawn and recommendation.
The paper also incorporated acknowledgement, abstract, definition of terms, appendix, list of
acronyms and reference.

8
 CHAPTER TWO

RELATED LITERATURE

2.1 Introduction
This chapter is structured based on the research objectives. It reviews relevant literature available
that focuses on factors that influence the financial performance of insurance companies in
Ethiopia. This chapter widely explores Age of companies, Size of companies, Leverage,
Tangibility of assets, Liquidity, Premium Growth, Loss ratio, Reinsurance dependence, Solvency
margin, and GDP growth and how these factors affect the financial performance of insurance
companies. The chapter also presents a theoretical review on firm characteristics.

2.2. Global insurance industry

The insurance industry forms an integral part of the global financial market, with insurance
companies being significant institutional investors. In recent decades, the insurance sector, like
other financial services, has grown in economic importance. This growth can be attributed to a
number of factors including, but not exclusively: Rising income and demand for insurance,
Rising insurance sector employment, and increasing financial intermediary services for
policyholders, particularly in the pension business (Ward and Zurbruegg, 2002). Expanding on
the link between GDP and insurance market development, it must be remembered that the
insurance industry‘s primary function is to supply individuals and businesses with coverage
against specified contingencies, by redistributing losses among the pool of policyholders.
Insurance companies, therefore, engage in underwriting, managing, and financing risks.

The importance of insurance in modern economies is unquestioned and has been recognized for
centuries. But insurance also serves a broad public interest far beyond its role in business affairs
and its protection of a large part of the country’s wealth. It is the essential means by which the
disaster to an individual is shared by many, the disaster to a community shared by other
communities; great catastrophes are thereby lessened, and, it may be, repaired. Insurance is an
essential element in the operation of sophisticated national economies throughout the world

9
today. Without insurance coverage, the private commercial sector would be unable to function
(Peter R. Haiss and Kjell Sumegi (2008).

Insurance enables businesses to operate in a cost-effective manner by providing risk transfer

mechanisms whereby risks associated with business activities are assumed by third parties. It
allows businesses to take on credit that otherwise would be unavailable from banks and other
credit-providers fearful of losing their capital without such protection, and it provides protection
against the business risks of expanding into unfamiliar territory – new locations, products or
services – which is critical for encouraging risk taking and creating and ensuring economic
growth(Ward and Zurbruegg, 2002).

Beyond the commercial world, insurance is vital to individuals. Lack of insurance coverage
would leave individuals and families without protection from the uncertainties of everyday life.
Life, health, property and other insurance coverage’s are essential to the financial stability, well-
being and peace of mind of the average person. Insurance is a financial product that legally binds
the insurance company to pay losses of the policyholder when a specific event occurs. The
insurer accepts the risk that the event will occur in exchange for a fee, the premium. The insurer,
in turn, may pass on some of that risk to other insurers or reinsurers. Insurance makes possible
ventures that would otherwise be prohibitively expensive if one party had to absorb all the risk.
Advancements in medicine, product development, space exploration and technology all have
become a reality because of insurance. Distribution of insurance is handled in a number of ways.
The most common is through the use of insurance intermediaries. Insurance intermediaries serve
as the critical link between insurance companies seeking to place insurance policies and
consumers seeking to procure insurance coverage (Ward and Zurbruegg, 2002).

According to Hifza Malik (2011) insurance plays a crucial role in fostering commercial and
infrastructural businesses. From the latter perspective, it promotes financial and social stability;
mobilizes and channels savings; supports trade, commerce and entrepreneurial activity and
improves the quality of the lives of individuals and the overall wellbeing in a country. Michael
Koller (2011) in his investigation identified that insurance companies are playing the role of
transferring risk channeling funds from one unit to the other (financial intermediation) such as

10
general insurance companies and life insurance companies respectively. This implies that
insurance companies are helping the economy of a country one way by transferring and sharing
of risk which can create confidence over the occurrences of uncertain event and in another way
insurance companies like other financial institutions plays the role of financial intermediation so
as to channel financial resources from one to the other.

Therefore, we can divide insurance companies in to two broad categories based on their role to
the economy; the general insurance companies and life insurance companies. For instance,
Renbao Chen et.al (2004) summarized firm specific factors affecting property/liability which is
general insurers and life/health insurance profitability separately that again provide valuable
guidelines for insurers financial health. This is because life/health insurance companies are
different from property/liability insurers in terms of operation, investment activities,
vulnerability and duration of liabilities. Life insurers are said to function as financial
intermediaries while general insurers function as risk takers, Renbao Chen et..al (2004)

2.3. Historical Development of Insurance in Ethiopia

It is believed that Ethiopians practiced banking for several hundred years. During the Axumite
Ethiopian Kingdom (from 1st century to the 7th century), it seems unimaginable that such an
advanced society existed at that time without the concept of some kinds of banking facilities.
And no one knows when and how the insurance business begun in Ethiopia. According to
"Markets of the World", published by the Swiss Reinsurance Company, it is stated: "Although a
systematic study of Adulis has not been completed, it has already proved that the Greek
merchants reached this thriving port south of Massawa in the 1st Century. During that time it is
believed that some form of Marine Insurance was used probably "General Average" along
Rhodian Lines.

Financial markets and institutions interact and combine in various ways to form a county’s
financial systems. At the centre of the system there are financial instruments in which financial
institutions deal in the market. Financial systems evolve over time. They reflect a county’s
political and economic history. Financial systems in many African countries, for example,
evolved from colonial times. Evolution of modern institutionalized financial system in Ethiopia

11
started in 1905 following the establishment of the first bank by historically reminiscent name of
Bank of Abyssinia (Belay P.69). This Bank introduced for the first time in Ethiopian financial
systems history banking services and instruments such as deposit accounts and export financing.

2.3.1. In pre 1974 Ethiopia

The financial system operated in a free market economic environment. However, in 1980s, the
financial system was restructured and reorganized to serve centrally planned economic system
which was created following the change of government in 1974.

2.3.2. During this period/post 1974

The Government nationalized all financial institutions in the country and created three
specialized banks (excluding the central bank) and one insurance company. Private ownership of
financial institutions was prohibited. Following the principles of mono-banking, the three state
owned banks and the insurance company were administered by the central bank –the National
Bank of Ethiopia (NBE). Indeed, the NBE used to run those governments owned financial
institutions like its own cost centered functional units. Among the specialized banks, the then
Agricultural and Industrial Development Bank (the current Development Bank) was responsible
for financing agricultural and industrial projects with medium and long gestation period, while
the then Housing and Savings Bank (the current Construction and Business Bank) used to lend
for construction of residential and commercial buildings. The third bank, Commercial Bank of
Ethiopia, was the only bank engaged in trade and other short term financing activities. The only
insurance firm, the Ethiopia Insurance Corporation, was responsible for provision of all types of
insurance services. Although there were efforts, to reach the poor through rural and urban
cooperatives, particularly, by extending farm input loans, access to finance during the socialist
oriented regime was virtually not possible for the rural poor. By the end of the socialist oriented
regime, because of the failure of most cooperatives to repay their loans, banks totally pulled out
of lending to rural farmers.

2.3.3. In 1990s
As a result of the shift from socialist to market economic system, Ethiopia reformed its financial
services industry. The reform measures included comprehensive restructuring of government

12
owned financial institutions and opening the sector for local private equity participation. The
three governments owned banks and one insurance company inherited from socialist regime
were made autonomies in terms of managing their business and recapitalized. While there was
no change in the role of Commercial Bank of Ethiopia (as short term financer), Development
Bank of Ethiopia (as provider of medium and long term development finance) and Ethiopian
Insurance Corporation (as provider of both general and life insurance services), Construction and
Business Bank has been allowed to engage in short-term financing activities.
Opening of the financial services industry for local private equity participation resulted in
establishment of nine banks, ten insurance companies and 28 microfinance institutions until June
2008. The newly established banks and insurance companies are all owned 100% by local
private shareholders.

The history of insurance describes the development of the modern business of insurance against
risks, especially regarding cargo, property, death, automobile accidents, and medical treatment.
The industry helps to eliminate risks (as when fire insurance companies demand the
implementation of safe practices and the installation of hydrants), spreads risks from the
individual to the larger community, and provides an important source of long-term finance for
both the public and private sectors. The insurance industry is generally profitable and provides
attractive employment opportunities.

Following the liberalization process, unlike the pre-reform practice, the pattern of financial
intermediation has been largely geared towards the private sector as opposed to the public and
cooperative sector. The people are getting more confident of private financial enterprises through
time. Private sector participation in the financial sector has facilitated the smooth implementation
of the monetary and financial intermediation through the creation of competition there by
contributing to the development of the sector.

The new economic policy has contributed to the rise of private sector market share in the
banking and insurance business. During the defunct regime, the state - owned Ethiopian
Insurance Corporation has been in a position to control the insurance business by monopoly. The
new comers privately owned insurance companies have penetrated the financial market and

13
reduced the market share of Ethiopian Insurance Corporation from 100 percent to 57 percent.
(Source NBE)

2.4. Financial Soundness of Ethiopian insurance companies

2.4.1. Capital Adequacy

The total capital of the industry, in which non-life business represents 95% of the total size of
capital in 2014, reached Birr 8.1billion as at June 30, 2014. Despite slow growth in premiums
(3%), shareholder’s fund registered a 32% growth rate over the preceding year of Birr 1.56billion
owing to considerable improvements in capital injections and investment returns.

Insurer’s capital to total liabilities, which was characterized by volatile trend from 2007 to 2013,
registered a year on year result of 33% over the last two years. This ratio, which is expected not
to fall below 20%, still could provide a sufficient buffer to absorb losses that occur in the normal
course of business.

The gross premium to capital (gross risk ratio) stood at around 2.4 times, which according to
early warning test (EWT) ratio standard can run up to 7 times. The net premium to total capital
also worked out to 1.8 times which stood at below the standard of 3 times. This gives an
indication that the capital employed by the sector was adequate enough to carry the level of risk
accepted and also has extra space to accommodate more volume of premium production.

On the other hand as per ISD’s solvency rule, the industry’s admitted capital should exceed at
least 15% of the preceding year net written premium .With less rigorous solvency test (without
considering admissibility rules) the capital of the industry are turned out to 66% of last year’s net
premium which is well above 15% of the industry’s net premiums which could provide a 41%
(66-15) buffer for consideration of potential disallowed assets. In general As at June 30, 2014,
the insurance sector was operating at a relatively safe capital adequacy position, (NBE ISD
ANNUAL REPOERT 2014).

14
2.4.2. Assets quality
As at June 30, 2014, the insurance sector was operating at a sound asset quality position.
Dominated by investments of fixed income securities and short term deposits, the assets of the
insurance business grew by 19% to reach Birr 8.18billion in 2014 from Birr 6.86billion in 2013
driven by significant improvements in these invested assets.

Short term investments comprised 55% the total assets during the last two years. In the same
period investment in equity shares accounted for only 9% of the total investments and 23% of the
total net worth where insurers are allowed to invest up to 100% of their net worth. The industry
complied with the investment directives in which case investment in short term securities and
deposits must be greater than 65% of admitted assets. However as the investment opportunities
available to insurers are so limited in variety and with low interest rate, tiding more than 85% of
the total investments to bank deposits and fixed income securities (treasury bills) in effect
generate less return to its capital structure, (NBE ISD ANNUAL REPOERT 2014)

2.4.3. Reinsurance Business

The industry retained Birr 3.63billion in its account registering retention ratio of 73% in the year
2014 which can be considered fairly outside ISD’s threshold, which is expected not to exceed
70%. The state insurer, influenced by the emergence and acceptance of billion size exposures in
recent years, retained 65% of its business and complied with the requirement of 70% maximum
threshold.

On the other hand during the period under review private insurers retained 78% of their business
with 13 of which surpasses the 70% maximum threshold. While it can be argued that with 1.8 of
net risk ratio, the industry can retain more to the point that net risk ratio should not exceed 2.5
times its capital base. This might hold true under normal circumstances. However under
abnormal cases where return on premiums fall by 50%-100%, retention in excess of 70% result
return on equity to fall significantly only to affect its capital base, ((NBE ISD ANNUAL
REPOERT 2014)).

15
2.4.4. Adequacy of technical provisions
Insurance regulators often ensure the adequacy of technical provisions by measuring the level of
capital adequacy ratios and safety ratios. Safety ratio, reserve for outstanding claims to equity
that need to be at most 2.5 times, stood at 0.87 times. This indicates the adequacy of reserves for
outstanding claims. All insurers reported below the threshold. On the other hand the average
equity to liability ratio of the industry stood at 33% which is higher than the minimum standard
of 20%. This is an indication that the industry has been setting aside adequate reserves to meet
claims obligations and other liabilities without affecting the capital base, (NBE, ISD ANNUAL
REPOERT 2014).

2.4.5. Management Soundness

The latest assessment of management and governance practices of most of Ethiopian insurers
was found to be moderate. As part of good practice, audit, risk management and Human resource
sub committees have been established in most of the insurance companies. The board has been
conducting regular meetings with special focus on claims approval, sales of Company share,
budget approval and staff and management benefit matters. Although the aforementioned issues
could also be the domain of the board, the strategic roles that should be played by the board did
not get the required attention and initiation. Strategic plan was not approved and risk
management program which is the main responsibility of the board has not get the required
attention by the board, policies and procedure manuals were not revised and not established for
some tasks such as with respect to disposals and recovery yard management, (NBE ISD
ANNUAL REPOERT 2014).

2.4.6. Premiums
While Table 5 showed that gross written premiums rose by 3 % to reach 4.98billion in June 2014
from the previous year of 4.82billion, the growth in net premiums stood at 17% to 3.63billion.
Please not in the appendix that general insurance business continues to dominate by constituting
94 % the total market size. The change in underwriting results stood at 10% which in turn lower
than the year before (23%) due to low underwriting performances in engineering classes and

16
property classes of businesses.

2.4.7. Profitability
Insurers registered claims ratio of around 72% during the current year higher by 12% from last
year. About six companies reported claims ratio of more than 70% three of which reported more
than 80%.This may be attributed by low growth rate of premiums, higher claims ratio of some
classes (motor) and may be higher retention ratio as insurers are required retain more obligations.

Whilst insurance companies reported total profit of Birr 777million for the year ended June 30,
2014 and grew by 10% from 2013, ROE showed 38% in 2014 that is by far exceeded the
acceptable standard of 10%.The current year result of ROE was lower than the year before (45%)
mainly due to lower growth in premiums higher claims ratio, and lower underwriting result.
However this was somehow compensated by yield on average invested assets as it went to 9% in
2014 higher than a year before (7%). This was attributed by substantial returns from real estate
investment by few insurers, (NBE ISD ANNUAL REPOERT 2014)

2.4.8. Liquidity management

As at June 30, 2014, the insurance industry was operating at a marginally acceptable current ratio
position of 100% which is higher than last year of 98%

2.5. Theoretical Review

2.5.1. Traditional Theory

This theory holds that there exists an optimal level of leverage. The implication is that
minimizing the cost of capital when the optimal level of debt capital is employed maximizes the
value of the firm (Brealey and Myer 1998). It’s based on the argument that at low levels of debt,
increased leverage doesn’t increase the cost of debt hence the replacement of an expensive
source of capital (equity) with a cheaper source (debt) translates to an increase in the value of the
firm. It’s this that creates borrowing incentives to firms. Brealey and Myers (1998) observe that
this argument holds because investors who hold debt are informed of the increased risk at

17
‘moderate’ debt levels and will continue demanding the same return on debt. They argue that it’s
only at ‘excessive’ debt levels that they demand a higher return. Alexander (1963) better
explains the fact that debt funds are cheaper than equity funds carries the clear implication that
the cost of debt plus the cost of equity together on weighted basis will be less than the cost of
equity, which existed on equity before debt financing; that’s the weighted average costs of
capital will decrease with the use of debt.

The validity of the traditional view is questioned on the ground that the market value of the firm
depends upon its net operating income and risk attached to it. The form of financing doesn’t
change net operating income nor the risk attached to it but simply the way in which the income is
distributed between equity holders and debt holders (Brealey & Myers 1998).Modigliani& Miller
(1958), criticize the traditional view on the ground that the assumption that the cost of equity
remains unaffected leverage up to some reasonable limit does not provide sufficient justification
for such an assumption. They do not really add very much to the riskiness of the share.

2.5.2. Resource Based Theory

This theory addresses performance differences between firms using asymmetries in knowledge
(Chen, 1996). At the corporate strategy level, theoretical interest in economies of scope and
transaction costs focus on the role of corporate resources in determining the industrial and
geographical boundaries of the firms’ activities. At the business strategy level, explorations of
the relationships between resources, competition and profitability include the analysis of
competitive imitation, the appropriate of returns to innovations, and the role of imperfect
information in creating profitability differences between competing firms.

A firm’s ability to earn a rate of profit in excess of its cost of capital depends upon the
attractiveness of the industry in which it is located and its establishment of competitive
advantage over rivals. Industrial organization economics emphasizes industry attractiveness as
the primary basis for superior profitability, the implication being that strategic management is
concerned primarily with seeking favorable industry environments, locating attractive segments
and strategic groups within industries and moderating competitive pressures by influencing

18
industry structure and competitors behavior. Thus, a resource based theory of the firm entails a
knowledge based perspective.

2.5.3. Pecking Order Theory

This theory explains why internal finance is much more popular than external finance and why
debt is classified as the most attractive external finance option. Pecking order refers to a
hierarchy of financing beginning with retained earnings followed by debt financing and finally
external equity financing. The theory basically suggests that companies with high profitability
may use less debt than other companies because they have less need to raise funds externally and
because debt is the ‘cheapest’ and most ‘attractive’ external option when compared to other
methods of capital raising. Donaldson followed by Myers suggests that management follows a
preference ordering when it comes to financing.

First, internal financing of investment opportunities is preferred because it avoids the outside
scrutiny of suppliers of capital and also there no floatation costs associated with the use of
retained earnings. Secondly, straight debt is preferred. Not only does debt result in less intrusion
in management by suppliers of capital, but floatation costs are less than with other types of
external financing. Also asymmetric information and financial signaling considerations come
into play. The third in order of preference is preferred stock, which carries some features of debt.
This is followed by various hybrid securities such as convertible bonds. Finally the least
desirable security to issue is straight equity. The investors are the most intrusive, floatation costs
are highest and there’s likelihood to be an adverse signaling effect.

However, Pecking order hypothesis suggests that corporations don’t have a well throughout
capital structure. Rather a company finances overtime with the method providing the least
resistance to management and there’s little capital market discipline on management’s behavior.
The capital structure that results is a by- product and changes whenever there’s an imbalance
between cash flows and capital investments.

19
2.5.4. Agency Theory
According to the Agency theory developed by Jensen and Meckling, agency costs arise from
conflicts of interest between shareholders and managers of the company. Agency costs are
defined as the sum of monitoring costs incurred by the principal, bonding costs incurred by the
agent, and residual loss. Lower agency costs are associated with better performances and thus
higher firm values, all other things being equal. Agency theory states that management and
owners have different interests (Jensen and Meckling, 1976).Companies that separate the
functions of management and ownership will be susceptible to agency conflicts (Lambert,
2001).They show that regardless of who makes the monitoring expenditures, the cost is borne by
stake holders. Debt holders, anticipating monitoring costs, charge higher interest. The higher the
probable monitoring costs, the higher the interest rate and the lower the value of the firm to its
shareholders all other things being the same. There are three types of agency costs which can
help explain the relevance of capital structure.

Asset substitute effect: as debt to equity increases, management has an increased incentive to
undertake risky projects. This is because if the project is successful, shareholders get all the
upside, where as if it is unsuccessful, debt holders get all the downside. If the projects are
undertaken, there’s a chance of firm value decreasing and a wealth transfer from debt holders to
shareholders. Underinvestment problem: if debt is risky, the gain from the project will accrue to
debt holders rather than shareholders. Thus, management has an incentive to reject positive net
present value projects, even though they have the potential to increase firm value. Free cash
flow: unless free cash flow is given back to investors, management has an incentive to destroy
firm value through empire building and perks etc. Increasing leverage imposes financial
discipline on management.

Complete protection would require the specification of extremely detailed protective covenants
and extra ordinary enforcement costs. As residual owners of the firm, the stock holders have an
incentive to see that monitoring costs are minimized up to a point. Monitoring costs may limit
the amount of debt that’s optimal for a firm to issue. It’s likely that beyond a point the amount of
monitoring required by debt holders increases with the amount of debt outstanding. When there’s

20
little or no debt, lenders may engage in only limited monitoring. Costs associated with protective
covenants are substantial and rise with the amount of debt financing. Shareholders incur
monitoring costs to ensure manager’s actions are based on maximizing the firm’s value. Jensen
and Meckling (1976) noted that with increasing costs associated with higher levels of debt and
equity an optimal combination of debt and equity might exist that minimizes total agency costs.

2.5.5. Efficiency Hypothesis

A theoretical attempt to offer an alternative explanation on the market Structure Conduct
Performance (SCP) relationship was first made by Demsetz (1973) who also proposed the
Efficiency Hypothesis. He stated that higher profits of banks are not due to their collusive
behavior but because of high efficiency level, which in turn, leads to larger market shares that
banks possess. In other words, profitability of bank is determined not by the market
concentration but by bank efficiency Grygorenko (2009).
This hypothesis stipulates that a bank which operates more efficiently than its competitors gains
higher profits resulting from low operational costs. The same bank holds an important share of
the market. Consequently, differences at the level of efficiency create an unequal distribution of
positions within the market and an intense concentration Mensi S and Zouari A (2010).
Smirlock (1985) performed empirical examination of the Efficiency Hypothesis where he
considered market share as a proxy to efficiency. In his empirical study of 2700 banks, Smirlock
(1985) was able to demonstrate that there was no association between market concentration and
bank profitability while significant relationship between bank profitability and market share was
present. Thus by his work, the Structure-Conduct-Performance (SCP) model was invalidated.
However, Rhoades (1985) doubted the conclusion that the positive relation between market share
and profitability was due to efficiency. He stated that this pattern might occur because of product
diversification and correspondingly, ability of some banks to set higher prices on their services.
According to Grygorenko (2009), further empirical investigations did not bring clarification to
the issue as to which of the theories mentioned above is best in explaining bank profitability:
Ahmad N.H and Haron S (1998) and Yu P and Neus W (2005) confirmed Structure-Conduct-
Performance (SCP) theory, while Mamatzakis C and Remoundos C (2003) and Naceur (2003)
found evidence for Efficient-Structure Hypothesis.

21
2.5.6. Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected
(required) return. In this model, the expected return on a firm’s stock is defined as a function of
risk-free rate and a premium based on the systematic risk. The greater the systematic risk, the
greater the return the investors will expect from the security. The underlying logic behind this
model and its relevance in this study is based on the fact CAPM views the total portfolio risk as a
function of systematic risk and unsystematic risk. The systematic risk is attributable to factors
that affect the market as a whole such as government policies, changes in the economy and the
political climate. The unsystematic risk is specific to a particular company such as industrial
relations, quality of firm’s management or a new competitor in the industry. Systematic risks
cannot be avoided through diversification. However unsystematic risk can be avoided through
diversification. Although the Capital Asset Pricing Model (CAPM) describes stock and portfolio
risks it can be applied to firms. It asserts that in market equilibrium, a security is expected to
provide return commensurate with its systematic risk. Investors should not be compensated for
unsystematic risks as it assumes investors are rational and risk-averse enough to diversify
unsystematic risks.

The Capital Asset Pricing Model (CAPM) has not gone unchallenged. It takes a very simplistic
view of the relationship between risk and return neglecting the effects of market imperfections.
As a result of these challenges it does not reflect the reality in the market. The Asset Pricing
Theory (APT) extends the idea of the Capital Asset Pricing Model. This theory asserts that in a
competitive market arbitrage will assure equilibrium pricing according to risk and return. The
security expected return is the risk-free rate plus risk premiums for risk factors which are
uncertain Horne (2008). The notion is the same as that of the Capital Asset Pricing Model
(CAPM) with the exception that we now have multiple risk factors.

2.6. The Concept of Profitability

Profitability is one of the most important objectives of financial management because one goal of
financial management is to maximize the owner` s wealth and profitability which in turn
indicates better financial performance. Renbao Chen et.al (2004) stated in their investigation that

22
“higher profits provide both the means (greater availability of finance from retained profits or
from the capital market) and the incentive (a high rate of return) for new investment”. Therefore,
we can understand from the above explanation that insurance companies have double
responsibility: in one way they are required to be profitable so as to have high rate of return for
new investment. On the other hand, insurance companies need to be profitable in order to be
solvent enough so as to make other industries in the economy as they were before even after risk
occurred. Profitability is one of the most important objectives of financial management because
one goal of financial management is to maximize the owner` s wealth and profitability which in
turn indicates better financial performance. According to Hafiz Malik (2011) insurance plays a
crucial role in fostering commercial and infrastructural businesses. From the latter perspective, it
promotes financial and social stability; mobilizes and channels savings; supports trade,
commerce and entrepreneurial activity and improves the quality of the lives of individuals and
the overall wellbeing in a country.

William H. Greene and Dam Segal (2004) argued that the performance of insurance companies
in financial terms is normally expressed in net premium earned, profitability from underwriting
activities, annual turnover, return on investment, return on equity. These measures could be
classified as profit performance measures and investment performance measures. However, most
researchers in the field of insurance and their profitability stated that the key indicator of a firm’s
profitability is ROA defined as the before tax profits divided by total assets. Philip Hardwick and
Mike Adams (1999), Hafiz Malik (2011) are among others, who have suggested that although
there are different ways to measure profitability it is better to use ROA. Therefore, being
profitable means that insurance companies are earning more revenues than being disbursed as
expenses. As explained above just to analyze the drivers of profitability, it is useful to
decompose either the return on asset ROA or ROE into their main components. According to
Swiss Re (2008) Profits are determined first by underwriting performance (losses and expenses,
which are affected by product pricing, risk selection, claims management, and marketing and
administrative expenses); and second, by investment performance, which is a function of asset
allocation and asset management as well as asset leverage. The first division of the
decomposition shows that an insurer’s ROE is determined by earnings after taxes realized for
each unit of net premiums (or profit margin) and by the 14 amount of capital funds used to

23
finance and secure the risk exposure of each premium unit (solvency). That is why most
researchers use ROA as a measure of profitability in financial institutions.

The term profit can take either its economic meaning or accounting concept which shows the
excess of income over expenditure viewed during a specified period of time. On one hand, profit
is one of the main reasons for the continued existence of every business organization. On the
other hand, profit is expected so as to meet the required return by owners and other outsiders.
John J. Hampton (2009) clarified profitability ratio as a class of financial metrics that are used to
assess a business’s ability to generate earnings as compared to its expenses and other relevant
costs incurred during a specific period of time. Accordingly, the term 'profitability' is a relative
measure where profit is expressed as a ratio, generally as a percentage. Profitability depicts the
relationship of the absolute amount of profit with various other factors. Similarly, Michael Koller
(2011) argued that profitability is the most important and reliable indicator as it gives a broad
indicator of the ability of an insurance company to raise its income level. In practice, executives
define profits as the difference between total earnings from all earning assets and total
expenditure on managing entire asset-liabilities portfolio Kaur and Kapoor, (2007).

The variation of profit among insurance companies over the years in a given country would
result to suggest that internal factors or firm specific factors play a crucial role in influencing
their profitability. It is therefore imperative to identify what are these factors as it can help
insurance companies to take action on what will increase their profitability and investors to
forecasts the profitability of insurance companies in Ethiopia.

2.7. Determinates of Profitability in Insurance Companies: An Empirical Review

While there have been many studies aimed at isolating the characteristics, behavior and
performance determinants of insurance companies in developed countries, there are few that
focus on developing countries of Africa, and indeed none in Ethiopia. For instance, Chen et al.
(2009) examined the determinants of profitability and the results showed that profitability of
insurance companies decreased with the increase in equity ratio. Sloan and Conover (1998)
deduced that the functional status of insurers does not affect the profitability of being insured but
public coverage has significant impact on profitability of insurance companies. Chen and Wong

24
(2004) found that size, investment, liquidity are the important determinants of financial health of
insurance companies.

Profitability in insurance companies could be affected by a number of determining factors. These

factors, as explained above could be further classified as internal, industry, and macroeconomic
factors. However, as will be discussed in the coming consecutive sections of the review, in most
literatures, profitability with regard to insurance companies usually expressed in as a function of
internal determinants. Rather, most researches concerning determinants of profitability in
insurance companies are divided in to two, such as determinants of profitability in
property/liability or general insurance companies and in life/health insurance companies.

According to Yuqi Li (2007) financial institutions’ non-financial statements variables are

classified as management quality, efficiency and productivity, age and number of branches.
Most researches concerning insurance companies are conducted with respect to only financial
statement variables. Hence, newly established banks are not particularly profitable in their first
years of operation, as they place greater emphasis on increasing their market share, rather than
on improving profitability Athanasoglou et al., (2005). Similarly, Yuqi li (2007) indicate that
older banks expected to be more profitable due to their longer tradition and the fact that they
could build up a good reputation. Obviously, the above empirical studies those include age as
one of their explanatory determinant indicates a positive relationship between age and
profitability.

According to Athanasoglou et al., (2005) the effect of a growing size of a bank on profitability
has been proved to be positive to a certain extent. Consequently, a positive relationship is
expected between size and profitability by many insurance area researchers. However, for firms
that become extremely large, the effect of size could be negative due to bureaucratic and other
reasons Yuqi Li (2007). Hence, the size-profitability relationship may be expected to be non-
linear. Therefore most studies use the real assets in logarithm and their square in order to capture
the possible non-linear relationship.

25
Renbao Chen and Rie Ann Wong (2004) stated that leverage beyond the optimum level could
result in higher risk and low value of the firm. Empirical evidences with regard to leverage found
to be statistically significant relationship but negative. The relationship between leverage and
profitability has been studied extensively to support the theories of capital structure and argued
also that insurance companies with lower leverage will generally report higher ROA, but lower
ROE. Since an analysis for Return on Equity (ROE) pays no attention to the risk associated with
high leverage.

Studies conducted in different countries found that for non-life insurance companies, size of
capital is one of the important factors that affect ROA; Hafiz Malik (2011) examined the
relationship between volume capital and return on asset for Pakistan insurance industry and
found positive and statistically significant relationship between insurance capital and
profitability. Tangibility of assets in insurance companies in most studies is measured by the
ratio of fixed assets to total assets.

A study by Naveed Ahmed et.al... (2011) investigates the impact of firm level characteristics on
performance of the life insurance sector of Pakistan over the period of seven years. For this
purpose, size, profitability, age, risk, growth and tangibility are selected as explanatory variables
while ROA is taken as dependent variable. The results of Ordinary Least Square (OLS)
regression analysis revealed that leverage, size and risk are most important determinant of
performance of life insurance sector whereas ROA has statistically more of insignificant
relationship with, tangibility of assets. However, Hafiz Malik (2011) found that there exists a
positive and significant relationship between tangibility of assets and profitability of insurance
companies and argued that the highest the level of fixed assets formation, the older and larger the
insurance company is. In contrast to this, Yuqi Li (2007) in UK found no significant relationship
between tangibility of assets and profitability of insurance companies.

In developing countries, the importance of the insurance industry as an essential component of

the financial system it is not fairly appreciated. In this context, Mehari and Aemiro (2013) assess
the impact of the Ethiopian insurance companies’ characteristics on their performance. The study
includes 9 insurance companies which are analyzed through panel data technique, during 2005–

26
2010. According to the results, company size, loss ratio, tangibility and leverage represent
important determinants of insurers’ performance, while growth of gross written premiums, age
and liquidity have an insignificant statistical power.

The following are the variables used in researches concerning profitability of insurance
companies and related financial institutions and the details of internal financial statement and
one non financial statement variable are discussed in detail in this section.

2.7.1. Firm size and age

Firm size is one of the most influential characteristics in organizational studies. Chen and
Hambrick (1995), and Mintzberg (1979) provide a summary and overview of the importance of
firm size. Firm size has also been shown to be related to industry- sunk costs, concentration,
vertical integration and overall industry profitability (Dean et al., 1998).

Newly established banks are not particularly profitable in their first years of operation, as they
place greater emphasis on increasing their market share, rather than on improving profitability
Athanasoglou et al., (2005). Similarly, Yuqi li (2007) indicate that older banks expected to be
more profitable due to their longer tradition and the fact that they could build up a good
reputation. Obviously, the above empirical studies those include age as one of their explanatory
determinant indicates a positive relationship between age and profitability.

Several studies have been conducted to examine the effect of size and age on firm profitability.
However, the empirical evidences of the linkage between profitability and firm size are
somewhat inconsistent. For example, evidence collected by Philip Hardwick and Mike Adams
(1999) from UK companies suggests that there is an inverse relation between profitability and
firm size. Jay Angoff Roger Brown (2007) found that there is a positive and significant
relationship between the age of a company and its profitability as measured by ROA. Similarly,
the research conducted on the relationship among firm characteristics including size, age,
location, industry group, profitability and growth by Swiss Re (2008) indicated that larger firms
are found to grow faster than smaller and younger firms found to grow faster than older firms. In
contrast, Hamadan Ahamed Ali Al-Shami (2008) found no significant statistical relation between

27
age and profitability of insurance companies in UAE but there exist a positive and statistical
significant relation between firm size and profitability. Similarly, Hafiz Malik (2011) in his
Pakistan study found that there is significantly positive association between age & size of the
company and profitability. The older the firm the more may be the profitability of the firm. This
could be justified as experience and efficiency in the operation process may decrease cost of
production and he found even that age is the strongest determinant of profitability.

In most literatures the effect of size on banks profitability are represented by total asset. Flamini
et.al (2009) indicated that size is used to capture the fact that larger firms are better placed than
smaller firms in harnessing economies of scale in transactions and enjoy a higher level of profits.
One of the most important questions underlying bank policy is which size optimizes bank
profitability. According to Athanasoglou et al., (2005) the effect of a growing size of a bank on
profitability has been proved to be positive to a certain extent. Consequently, a positive
relationship is expected between size and profitability by many insurance area researchers.
However, for firms that become extremely large, the effect of size could be negative due to
bureaucratic and other reasons Yuqi Li (2007). Hence, the size-profitability relationship may be
expected to be non-linear. Therefore most studies use the real assets in logarithm and their square
in order to capture the possible non-linear relationship. Athanasoglou et al. (2005 and Yuqi Li
found positive relationship between size and profitability.

2.7.2. Liquidity
Liquidity from the context of insurance companies is the probability of an insurer to pay
liabilities which include operating expenses and payments for losses/benefits under insurance
policies, when due then shows us that more current assets are held and idle if the ratio becomes
more which could be invested in profitable investments. For an insurer, cash flow (mainly
premium and investment income) and liquidation of assets are the main sources of liquidity
Renbao Chen and Kie Ann Wong (2004). Empirical evidences with regard to liquidity revealed
almost inconsistent results. For instance, Naveed Ahmed et.al. (2011) in his investigation in
Pakistan found that ROA has statistically insignificant relationship with liquidity. Similarly,
several other studies also have been conducted to measure the performance of the insurance
companies. In contrast, Chen and Wong (2004) examined that, liquidity is the important

28
determinants of financial health of insurance companies with a negative relationship. Similarly,
Hakim and Neaime (2005) observed that liquidity, current capital and investment are the
important determinants of banks profitability. Valentina Flamini, Calvin McDonald, and Liliana
Schumacher (2009) in their investigation regarding Sub-Saharan countries found significant and
negative relationship between bank profitability and liquidity.

2.7.3. Leverage
Firm leverage is the degree to which a company uses fixed-income securities, such as debt and
preferred equity. With a high degree of financial leverage come high interest payments. The
trade-off between agency costs of debt and equity (Jensen and Meckling, 1976); the limited
liability effect of debt (Brander and Lewis, 1986); and the disciplining effect of debt (Grossman
and Hart, 1983; Jensen, 1986) all suggest a positive effect of leverage on performance. Bolton
and Scharfstein, 1990; Chevalier and Scharfstein, 1996; Dasgupta and Titman, 1998; suggest that
leverage opens up opportunities for rivalry predation in concentrated product markets, thus
conditioning the performance effect of leverage on the degree of competition in the insurance
industry.

The trade of theory suggests a positive relationship between profitability and leverage ratio and
justified by taxes, agency costs and bankruptcy costs push more profitable firms towards higher
leverage. Hence more profitable firms should prefer debt financing to get benefit from tax shield.
In contrast to this pecking order theory of capital structure is designed to minimize the
inefficiencies in the firms’ investment decisions. Due to asymmetric information cost, firms
prefer internal finance to external finance and, when outside financing is necessary, firms prefer
debt to equity because of the lower information costs. The pecking order theory states that there
is no optimal capital structure since debt ratio occurs as a result of cumulative external financing
requirements. Insurance leverage could be defined as reserves to surplus or debt to equity. The
risk of an insurer may increase when it increases its leverage. Literatures in capital structure
confirm that a firm’s value will increase up to optimum point as leverage increases and then
declines if leverage is further increased beyond that optimum level.

29
For instance Renbao Chen and Rie Ann Wong (2004) stated that leverage beyond the optimum
level could result in higher risk and low value of the firm. Empirical evidences with regard to
leverage found to be statistically significant relationship but negative. For instance Renbao Chen
and Kie Ann Wong (2004), in Canada, Hamadan Ahamed Ali Al-Shami (2008) in UAE, Hifza
Malik (2011) in Pakistan, Sylwester Kozak (2011) in UK Swiss Re (2008) in Egypt and Flamini
et..al (2009) in Sub-Saharan countries found that negative but statistically significant relationship
between leverage and profitability of firms. Harrington (2005) stated that the relationship
between leverage and profitability has been studied extensively to support the theories of capital
structure and argued also that insurance companies with lower leverage will generally report
higher ROA, but lower ROE. Since an analysis for ROE pays no attention to the risk associated
with high leverage.

2.7.4. Loss ratio (LOSS):

Insurance companies could prosper by taking reasonable leverage risk or could become insolvent
if the risk is out of control. Adams and Buckle (2000) provide evidence that insurance companies
with high leverage have better operational performance than insurance companies with low
leverage. Nevertheless, more empirical evidence supports the view that leverage risk reduces
company performance. Carson and Hoyt (1995) find that leverage is significantly positively
related to the probability of insolvency. Moreover, a negative relationship between leverage and
performance has also been found in Browne et al. (2001).

The variable risk is found to have a negative and statistically significant (at the 1 % level of
significance) relationship with ROA according to study by Daniel Mehari and Tilahun Aemiro
on Ethiopian insurance . According to the nature of the insurance industry, the ratio of net claims
paid in net premiums earned (loss ratio) is used as a proxy to measure the risk of the insurance
companies in Ethiopia. This shows that insurers that underwrite risky business (e.g., catastrophe
coverage) will need to ensure that good standards of management are applied to mitigate their
exposure to underwriting losses ex-ante and maximize returns on invested assets ex-post.
Otherwise, they will turn out to be poor performers. Excessive risk-taking could adversely affect
the performance of insurance companies. Malik (2011) and Ahmed et al. (2011) also found the

30
same result. The results of this study also indicate that having a large proportion of fixed assets
to total assets (tangible) entails significant and positive impact on performance.

2.7.5. Tangibility of assets

Tangibility of assets in insurance companies in most studies is measured by the ratio of fixed
assets to total assets. A recent study by Naveed Ahmed et.al... (2011) investigates the impact of
firm level characteristics on performance of the life insurance sector of Pakistan over the period
of seven years. For this purpose, size, profitability, age, risk, growth and tangibility are selected
as explanatory variables while ROA is taken as dependent variable. The results of OLS
regression analysis revealed that leverage, size and risk are most important 22 determinant of
performance of life insurance sector whereas ROA has statistically more of insignificant
relationship with, tangibility of assets. However, Hafiz Malik (2011) found that there exists a
positive and significant relationship between tangibility of assets and profitability of insurance
companies and argued that the highest the level of fixed assets formation, the older and larger the
insurance company is. In contrast to this, Yuqi Li (2007) in UK found no significant relationship
between tangibility of assets and profitability of insurance companies.

2.7.6. Growth Rate

Growth as measured by the percentage change in total assets or sometimes percentage change in
premiums of insurance companies is expected to positively related with profitability of insurance
companies in Ethiopia. Insurance companies having more and more assets over the years have
also better chance of being profitable for the reason that they do have internal capacity though it
depends on their ability to exploit external opportunities. Emperical evidence by Naveed Ahmed
et al (2011) in Pakistan, Yuqi Li (2007) in UK and Hamadin Ahmed Ali Al-Shami (2008) in
UAE of their investigation found a positive and statistically significant relationship between
growth and profitability of insurance companies.

Premium growth measures the rate of market penetration. Empirical results showed that the rapid
growth of premium volume is one of the causal factors of insurers’ insolvency (Kim et al. 1995).

31
Being too obsessed with growth can lead to self-destruction as other important objectives may be
neglected.

Ahmed et al., 2011 also investigated the impact of firm level characteristics on the performance
of the life insurance sector of Pakistan over the period of seven years from 2001 to 2007. The
results of the OLS regression analysis revealed that leverage is negatively and significantly
related to the performance of life insurance companies. Growth of written premium and age of a
firm has also negative relation to performance of life insurance companies but they are
statistically insignificant.

2.7.7. The reinsurance dependence

The reinsurance dependence is calculated as ratio of gross written premiums ceded in
reinsurance to total assets. 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. Therefore, a negative connection between the reinsurance dependence
and the insurer’s financial performance is expected. According to research from Romania the
reinsurance dependency has positive influence on the insurer’s financial performance, as
reinsurance involves a certain cost.

2.7.8. The solvency margin

The solvency margin is calculated as ratio of net assets to net written premiums, and represents a
key indicator of the insurer’s financial stability. A positive linkage between this variable and the
insurer’s financial performance is expected, since the insurer’s financial stability is an important
benchmark to potential customers. According to research from Romania the solvency margin,
has s a positive linkage between this variable and the insurer’s financial performance, because
the insurer’s financial stability is an important benchmark to potential customers.

32
2.7.9. Growth in gross domestic product
The use of GDP growth as a variable does not feature extensively in the literature. However,
Hoggarth et.al. (1998) conclude that the behaviour of real GDP fails to explain the greater
variability of banking sector profits in the UK than in Germany. But they do not say that GDP
variability did not affect profits, only that they could not use it to explain different UK/German
banks performance. This is because the default risk is lower in upturn than in downturn
economy. In addition, higher economic growth may lead to a greater demand for both interest
bearing and non-interest bearing financial services sector Athanasoglou (2005) and Kosmidou
(2008).

2.8. Conceptual frame work. The conceptual frame work of this stud sows the linkage between
independent variables to the dependant variable. The conceptual frame work is shown bellow as
Figure 2.1.

Figure 2.1. Conceptual frame work of the study

Age of company (AGE)

Size of company (SIZE)

Leverage (LAV)

The tangibility of Assets (TAN)

Liquidity (LIQ)

Premium Growth (PRG) ROA

Underwriting Risk

The Reinsurance Dependence

The Solvency Margin

33
GDP
 CHAPTER THREE

RESEARCH METHODOLOGY

3.1. Research design

The primary objective of this study is to examine the impact of Age of companies, Size of
companies, Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio, Reinsurance
dependence ,Solvency margin and GDP growth on insurance companies financial
performance(profitability). To achieve the research objective explanatory type of research design
with a mixed approach, more of quantitative, was employed. The explanatory type of research
design helps to identify and evaluate the causal relationships between the different variables
under consideration (Marczyk et al., 2005). So that, in this study the explanatory research design
was employed to examine the relationship of the stated variables. Mixed methods research
provides better (stronger) inferences. Therefore, by using a mixed approach it is able to capitalize
the strength of quantitative and qualitative approach and remove any biases that exist in any
single research method (Creswell, 2003). A panel data study design which combines the
attributes of cross sectional (inter-firm) and time series data (inter-period) was used. The
advantage of panel data analysis is that more reliable estimates of the parameters in the model
can be obtained (Gujarati, 2004), Diction of cause and effect (Cassell & Symon, 1994).Panel
data comprise data sets consisting of multiple observations for each sampling unit. By using
panel data, we can get better estimations and we can test more sophisticated behavioral models,
with less restrictive assumptions (Baltagi, 2008).

Working with panel data allows using various techniques to estimate models with specific
effects. The cross-sectional or cross-temporal specific effects can be identified and analyzed by
using techniques for fixed effects or random effects.

3.2. Source of data and collection methods

The researcher mainly used secondary data sources and supplements the result by using primary
data source to accomplish his objective. The secondary data was collected from the consolidated
financial statements of the selected insurance companies; this data was comprised 12 years data

34
from insurance company’s financial statement and annual GDP growth rate from annual report
of national bank. The secondary data are available from national banks which is convenient for
the researcher. Primary data was obtained by questioner to support the result from secondary
data. The questioners were unstructured and open-ended & they are addressed by selected
insurance company’s chief finance officers.

3.3. Sampling design

The population size of insurance companies in Ethiopia is all 17 insurance companies, which one
is public insurance companies and the other 16 are private insurance companies. From the above
population to select sample insurance companies, purposive sampling technique was employed.
In the sample insurance companies that have complete financial statement for the study period
were included purposively i.e. based on the age and availability data for the study period.
According to the information obtained from National Bank of Ethiopia there are only 9 insurance
companies that have complete financial statements for the study period out of the total insurance
companies operating in Ethiopia i.e. 17 insurance companies as of December 2014. Thus, these
nine insurance companies were selected as a sample (See appendix III)

3.4. Choice of Dependent Variable and its Measurement

In line with earlier studies that investigated the determinants of Insurances’ and Banks’
profitability, this study relies on one commonly used measure of performance, which is return on
total assets (ROA). Return on total assets (ROA) is calculated as net profit before tax by total
assets. This is probably the most important single ratio in comparing the efficiency and financial
performance of insurance companies as it indicates the returns generated from the assets that
Insurers owns. William H. Greene and Dam Segal (2004) argued that the performance of
insurance companies in financial terms is normally expressed in net premium earned,
profitability from underwriting activities, annual turnover, return on investment, return on equity.
These measures could be classified as profit performance measures and investment performance
measures. However, most researchers in the field of insurance and their profitability stated that
the key indicator of a firm’s profitability is ROA defined as the before tax profits divided by total
assets. Philip Hardwick and Mike Adams (1999), Hafiz Malik (2011) are among others, who

35
have suggested that although there are different ways to measure profitability it is better to use
ROA. The formula for the performance measure is given as follows:
ROA = Net profit before tax (t) / Total Assets (t)

3.5. Choice of Explanatory Variables and their Measurement

The choice of explanatory variables is based on their theoretical relationship with the dependent
variable. Generally speaking, the chosen explanatory variables are expected to partly explain the
variation of the dependent variable. In this paper, firm specific variables affecting the
performance of Ethiopian insurance companies were accounted. These explanatory variables and
their measurement are as follows.
1) Age of company (AGE): Firm age (measured as the number of years a company is
operating in the market since it was founded) is an important determinant of financial
performance. Past research shows that the probability of firm growth, firm failure, and
the variability of firm growth decreases as firm’s age (Evans, 1987; Yasuda,
2005).According to the life cycle effect, younger companies are more dynamic and more
volatile in their growth experience than older companies (Evans, 1987).Maturity brings
stability in growth as firms learn more precisely their market positioning, cost structures
and efficiency levels. This variable is measured as the number of years from date of
establishment

2) Size of company (SIZE): Firm size is one of the most acknowledged determinants of a
financial performance (Beard & Dess, 1981). The causal relationships between size and
financial performance have been widely tested with ambiguous results. Several studies
suggest that a positive relationship exists between company size and financial
performance. Bigger firms are presumed to be more efficient than smaller ones. The
market power and access to capital markets of large firms may give them access to
investment opportunities that are not available to smaller ones (Amato and Wilder, 1985).
Firm size helps in achieving economies of scale. Performance is likely to increase in size,
because larger firms will have better risk diversification, more economic scale advantage,
and overall better cost efficiency. In this study, total asset will be used as a proxy for
Company Size. Company Size = Natural log of total assets

36
3) Leverage (LAV): It is a financial ratio that indicates the percentage of a firm's assets that
are financed with debt. The Leverage Ratio is measured as: Leverage Ratio= Total
Liabilities/Total Asset

4) The tangibility of Assets (TAN): It is a ratio that measures the share of Fixed Assets from
Total Assets. TAN = Fixed Assets / Total Assets.

5) Liquidity (LIQ): The Liquidity Ratio measures the firm's ability to use its near cash or
“quick” assets to retire its liabilities. Maintaining high liquidity can reduce management’s
discipline as regards both underwriting and investment operations. Moreover, according
to the theory of agency costs, high liquidity of assets could increase agency costs for
owners because managers might take advantage of the benefits of liquid assets (Adams
and Buckle, 2000). Liquidity Ratio = Current Assets / Current Liabilities.

6) Premium Growth (PRG): Proxy for Premium Growth is the percentage increase in Gross
Written Premiums (GWP). The equation is expressed as follows: PRG = (GWP (t) –
GWP (t-1)) / GWP (t-1).

7) The Underwriting Risk Emphasizes/Loss ratio/ (LOR): The efficiency of the insurer’s
underwriting activity and it is measured through the loss rate, which is computed as a
ratio of gross claims to gross written premiums. Loss ratio = Net claims incurred / Net
earned premiums.
8) The Reinsurance Dependence: Is calculated as ratio of gross written premiums ceded in
reinsurance to total assets. 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. Therefore, a negative connection
between the reinsurance dependence and the insurer’s financial performance is expected.

9) The Solvency Margin (SOM): Solvency margin is one of the indicators of financial
soundness. Insurance companies with higher solvency margin are considered to be
sounder financially. Financially sound insurance companies are better able to attract
prospective policyholders and are better. It’s calculated as ratio of net assets to net
written premiums, and represents a key indicator of the insurer’s financial stability. A

37
 positive linkage between this variable and the insurer’s financial performance is
expected, since the insurer’s financial stability is an important benchmark to potential
customers.

10) Growth in gross domestic product (GDP):- This is measured by the real GDP growth rate
and it is hypothesized to affect insurance company’s profitability positively. This is
because the default risk is lower in upturn than in downturn economy. In addition, higher
economic growth may lead to a greater demand for both interest bearing and non-
interest bearing financial services sector Athanasoglou (2005) and Kosmidou (2008). In
line with the previous literatures can expect a positive relation between the economic
growth (GDP) and the profitability of insurance companies in Ethiopia.

3.6. Model specification

The researcher used the multiple regression econometric model through which the financial
performance of the insurance companies in the Ethiopian market is analyzed. Based on the
hypotheses and previous study, the following general empirical research model is developed. To
capture the tendency of profits to be persistent over time (due to market structure imperfections
or high sensitivity to auto-correlated financial factors), the researcher tried to adopt a dynamic
specification of the model, with a lagged dependent variable among the repressors. Cheris
Brooks (2008) in his book for introductory econometrics for finance argued that lagged values of
variables may capture important dynamic structure in the dependent variable that might be
caused by a number of factors such as inertia of the dependent variable and overreactions. This
yields the following model specification:
Yit= β0 + ΣβKXit + εit
Where:
 Yit represents the dependent variables (ROA) of insurance i for time period t.
 β0 is the intercept
 βK represents the coefficients of the Xit variables
 Xit, represents the explanatory variables (Age of companies, Size of companies,
Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio, Reinsurance
dependence ,Solvency margin and GDP/capita) of insurance i for time period t.

38
  εit is the error term

The above general empirical research model is changed into the study variables to find out the
impact of Age of companies, Size of companies, Leverage, Tangibility of assets, Liquidity,
Premium Growth, Loss ratio, Reinsurance dependence ,Solvency margin and GDP on insurance
companies financial performance(profitability) as follows:

ROA = β o+ β1AGEi,t + β2SIZEi,t + β3LAVi,t +β4TANi,t +β5LIQi,t + β6PRGi,t +

β7LORi,t + β8REDi,t + β9SOMi,t + β10GDPi,t +Є it
Where:
 ROA = Return+ on total assets;
 AGE = Age of companies;
 SIZE = Size of companies;
 LAV = Leverage;
 TAN = Tangibility of assets;
 LIQ = Liquidity;
 PRG = Premium Growth;
 LOR = Loss ratio;
 RED = Reinsurance dependence
 SOM = Solvency margin
 GDP= GDP/capita
 Є = is the error component for company i at time t assumed to have mean zero E [Є it] =
0
 β o= Constant
 β 1, 2, 3, …..9 are parameters to be estimated;
 i = Insurance company i = 1, . . . , 9; and t = the index of time periods and t = 1, . . . , 12

3.7. Methods of data analysis

The multiple regression model was used to identify the relationship between the profitability of
insurance companies and Age of companies, Size of companies, Leverage, Tangibility of assets,
Liquidity, Premium Growth, Loss ratio, Reinsurance dependence ,Solvency margin and GDP

39
growth. In this study to analyze the collected data; descriptive, correlation and multiple panel
linear regression data analysis method were employed. The descriptive statistics was used to
quantitatively describe the important features of the variables using mean, maximum minimum
and standard deviations. The correlation analysis was used to identify the relationship between
the independent, dependent and using Pearson correlation analysis. The correlation analysis
shows only the degree of association between variables and does not permit the researcher to
make causal inferences regarding the relationship between variables (Marczyk et al., 2005).
Therefore, multiple panel linear regression analysis was also used to test the hypothesis and to
explain the relationship between profitability of insurance companies and Age of companies,
Size of companies, Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio,
Reinsurance dependence ,Solvency margin and GDP growth. Qualitative analysis also used for
qualitative data collected through open ended questionnaire. Eviews 7 econometric software was
used for analysis of secondary data and the results were presented through table’s graphs and
also the primary data collected through questioner were streamlined and presented to support
result from regression analysis.

40
 CHAPTER FOUR

RESULTS AND DISCUSSION

4.1. Introduction
This chapter presents the descriptive statistics, correlation analysis, multiple panel linear
regression analysis of the study variables and qualitative result of study. It has four sections. The
first section is the descriptive statistics which summarizes the main features of the study variable
such as mean, maximum, minimum and standard deviation. The second section is the correlation
analysis which shows the degree of association between the study variables. The third sections of
the chapter, regression results report the OLS estimation output of the regression models. The
last section present result for qualitative result from unstructured questionnaires were
streamlined and presented.

4.2. Descriptive statistics of the study variables

This section discussed the summery statistics of each variables of the study. The variables
include the dependent and independent variables. The dependent variables used in this study in
order to measure the sample insurance companies financial performance is return on asset
(ROA) whereas the explanatory variables (independent variables) are Age of companies, Size of
companies, Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio, Reinsurance
dependence ,Solvency margin and GDP growth.

The researcher conducted descriptive statistic using Eviews.7 software in order to give the
audience more understanding about the study variables that are being analyzed. According to
(Abdul Raheman and Mohamed Nasr, p.286, 2007) Descriptive statistics is the first step in our
analysis. Descriptive Statistics is the foundation stone for any type of analysis which enables the
researcher to describe the relevant aspects to all the study variables that will entail detailed
information about each relevant variable (Saswata Chatterjee, p. 24, 2012). Descriptive statistics
is derived from statistical analysis before another test performed using multiple regression
analysis (Djoko Suhardjanto, et al, p. 240, 2009).

41
Descriptive studies produced the mean, minimum, maximum and standard deviation for each
variable. Accordingly, the descriptive statistics for all variables are presented below in table 4.1.
Table.4.1. descriptive statistics of study variables
Std.
Variables Mean Median Maximum Minimum Dev. Observations
ROA 0.077834 0.079972 0.192055 -0.102274 0.052642 108
TAN 0.173053 0.149674 0.541653 0.022029 0.110432 108
LIQ 0.672148 0.775628 2.604086 0.022029 0.551622 108
SOM 0.859503 0.727071 2.772665 0.29924 0.473253 108
LOR 0.626205 0.650834 0.913137 0.158603 0.152891 108
PRG 0.149198 0.145955 0.863892 -1.096688 0.196964 108
SIZE 18.96337 18.92308 21.55226 16.52656 1.083744 108
AGE 14.83333 13 39 1 7.862724 108
LEV 0.665249 0.659541 0.840607 0.334611 0.098545 108
GDP 0.099491 0.108772 0.126442 -0.0210 0.027205 108
RED 0.158201 0.133581 0.47378 0.031715 1.708211 108
Source: Own estimation from Eviews summery Descriptive statistics result

Table 1 shows the descriptive statistics of each variable, computed based on the 108 observations
recorded. It can be noticed that the return on total assets ratio fluctuates between -0.102274 and
0.192055, with an average value of 0.077834, ROA deviates from the average value with about
0.052642, which implies the presence of moderate variations among the values of profitability
across the insurance companies included for this study. The mean value of tangibility of asset
ratio (TAN) is 0.173053 and the value of standard deviation is 0.052642 this implies that low
variation in tangibility of asset. The mean value of Liquidity quick ratio (LIQ) is 0.672148 with
the standard deviation of 0.551622 which implies moderate variation of liquidity ratio among
insurance companies. The mean value of Solvency margin ratio (SOM) is 0.859503 while the
value of standard deviation is 0.473253 this implies moderate variation of solvency margin ratio.
The mean value of Los (LOR) is 0.626205 and the value of standard deviation is 0.551622 which
implies moderate variation of underwriting risk among insurance companies. The mean value of
Growth written premium ratio is 0.149198 and the value of standard deviation is 0.196964 this

42
implies that low variation in growth written premium among insurance companies. The mean
value of Company size (SIZE) is 18.96337 and the value of standard deviation is 1.083744. The
mean value of Company age (AGE) is 14.83333 and the value of standard deviation is 7.862724,
there are big differences between values of company age because of standard deviation is high at
7.862724. The mean value of Leverage ratio (LEV) is 0.665249 and the value of standard
deviation is 0.098545 which implies low variation of leverage ratio among insurance companies
operating in Ethiopia. The mean value of GDP growth ratio (GDP) is 0.099491 and the value of
standard deviation is 0.027205 this implies there is low variation of GDP growth in the country.
The mean value of Reinsurance dependency ratio (RED) is 0.158201 and the value of standard
deviation is 1.708211 this implies high variation of reinsurance dependency ratio among
insurance companies .Table 4.1 shows that the values of standard deviation ranges from
0.027205 to 7.862724, revealing that there is not much of variation, and this also implies that the
model of multiple regression analysis will be lead into significant results indicating the strength
of data and also The positive values imply that the variables under the model are significant in
determining the financial performance of insurance companies in Ethiopia.

4.3. Correlation Test

This section of the study presents the results and discussions of the Pearson correlation analysis.
To identify the relationship between profitability of insurance companies and Age of companies,
Size of companies, Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio,
Reinsurance dependence, Solvency margin and GDP growth, Pearson correlation coefficients
were used. The correlation coefficients show the extent and direction of the linear relationship
between profitability of insurance companies and Age of companies, Size of companies,
Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio, Reinsurance dependence
,Solvency margin and GDP growth. According to (Wajahat Ali, p.35, 2010) before the start of
regression analysis it is important to check the correlation test between dependent variable and
independent variables. In this study the researcher used Pearson’s correlation coefficient matrix
generated through the Evies.7 software which shows the cross-relationship between all of the
variables. Pearson correlation coefficient is the most commonly used to measure the association
between two quantitative variables (Robert Hutchinson, p. 110, 2007). Pearson’s correlation
coefficients are test in order to determine the strength of the relationship between independent

43
 and dependent variables. The Pearson correlation scale ranges from -1 to +1, any value greater
than zero indicates a positive direct relationship between the two variables, which implies that
every increase in the independent variable will led to the increase in dependent variable, while
any value less than zero indicates a negative indirect relationship between the two variables, that
means that every increase in the independent variable will led to the decrease in dependent
variable (Abdul Hafiz, p.14, 2012). The correlation coefficients are also checked for the
presence of high collinearity among regressors. Since the correlation analysis shows only the
degree of association, it is followed by multiple regression analysis. The Pearson’s correlation
coefficient matrix for all variables is presented below in table 4.2.

Table.4.2. Pearson’s correlation coefficient matrix

Correlation ROA TAN LIQ SOM LOR GRP SIZE AGE LAV GDP RE
ROA 1.0000
TAN -0.0718 1.0000
LIQ -0.0683 0.0284 1.0000
SOM 0.1343 0.1186 0.3670 1.0000
LOR -0.3896 -0.0077 0.0135 -0.4453 1.0000
GRP 0.2192 0.0749 -0.0842 -0.2280 -0.1087 1.0000
SIZE 0.5312 -0.2488 -0.1893 -0.4422 0.0936 -0.0107 1.0000
AGE 0.4184 -0.1542 0.2423 -0.3446 0.1866 -0.0317 0.7746 1.0000
LAV 0.0997 -0.1662 -0.2523 -0.7862 0.3253 0.0605 0.6690 0.5629 1.0000
GDP 0.2545 0.0357 -0.0657 -0.2104 0.0531 0.0345 0.3045 0.2188 0.2610 1.0000
RED -0.3554 -0.3182 -0.1873 -0.1534 -0.3150 0.1979 0.5006 0.4514 0.3654 0.0299 1.0
Source: Own estimation from Eviews summery of Pearson’s correlation

Correlation test shows that return on assets (ROA) has strong and positive correlation between
size of insurance companies with the value of (0.5312) , age of insurance companies with the
value of (0.4184), Growth in GDP with the value of (0.2545), growth in gross written premium
with the value of (0.2192), and solvency margin with the value of (0.1343). Leverage ratio with
the value of (0.0997) has weak and positive correlation with ROA. Reinsurance dependency
with the value of (-0.3554) and loss ratio with the value of (-0.3896) has strong and negative

44
correlation between ROA, and also liquidity ratio with the value of (-0.0683) and tangibility of
asset with the value of (-0.0718) has weak and negative correlation.

4.4. Regression Analysis

In order to test multiple linear regression models, the researcher must assess the study data
collected through five assumption tests; these tests include the following taste;

4.4.1. The average value of the errors is zero.

If a constant term is included in the regression equation, this assumption will never be violated.
So that in the model of this study a constant term is included. As a result this assumption was not
violated.

4.4.2. Normality Test

The examination of the normal distribution of the data of the study is one of the fundamental
requirements for linear regression analysis between the study variables. Normality tests are used
to determine whether a data set is well-modeled by a normal distribution or not, or to compute
how likely an underlying random variable is to be normally distributed (Gujarati, 2009). This
assumption requires the disturbances to be normally distributed. Bera-Jarqu normality test which
is the most commonly used normality test was conducted for the model. Based on the results
shown below, the p-values is insignificant for the model and the researcher failed to reject the
null hypothesis, which says the residual value is normally distributed. Therefore, there is no
normality problem on the data used for this study.

45
Graph.4.1.Jarqu-Bera Normality Test
12
Series: Standardized Residuals
Sample 2003 2014
10 Observations 108

8 Mean 1.28e-19
Median 0.001157
Maximum 0.065772
6 Minimum -0.075146
Std. Dev. 0.025476
4
Skewness -0.130534
Kurtosis 3.037110

2 Jarque-Bera 0.312904
Probability 0.855173
0
-0.08 -0.06 -0.04 -0.02 0.00 0.02 0.04 0.06

Source: Own estimation from Eviews, Bera-Jarqu normality test

4.4.3. Autocorrelation Test

According to (Rafika and Muhamad, p. 149. 2012) autocorrelation test objective to test the linear
regression model there is a correlation between the errors in period t with bullies’ error in period
t-1 (previous period). Durbin-Watson (DW) is use to test the independent variables of errors
(autocorrelation), for a level of significance of 0.05 (Nagib, et al, p. 13). (Nagib, et al, p.
13.2012) quoted (Field, 2009). It is assumed that the errors are not correlated with one another. If
the errors are correlated with one another, it would be stated that they are ‘serially correlated’. A
test of this assumption is therefore conducted. The test for Durbin-Watson which is shown below
regression output of the models. As per this test the values of Durbin--Watson for the model is
1.843878 which is near to two. So there is no problem of autocorrelation.

46
Table.4.3. Durbin Watson, Autocorrelation Test

R-squared 0.765803 Mean dependent var 0.077834

Adjusted R-squared 0.718437 S.D. dependent var 0.052642
S.E. of regression 0.027933 Akaike info criterion -4.159647
Sum squared resid 0.069443 Schwarz criterion -3.687790
Log likelihood 243.6209 Hannan-Quinn criter. -3.968326
F-statistic 16.16788 Durbin-Watson stat 1.843878
Prob(F-statistic) 0.000000

Source: Own estimation from Eviews, Durbin Watson, Autocorrelation Test

4.4.4 Heteroscedasticity Test

According to (Gujarati, 2003, p. 387) Heteroscedasticity test an important assumption of linear
regression model, is that the disturbances appearing in the population regression function are
homoscedasticity; that is, they all have the same variance. Heteroscedasticity test aims to test
whether the regression has difference variance from the residue between observations (Djoko, et
al, p. 240, 2009). If this assumption is not satisfied, there is heteroscedasticity. This assumption
requires variance of the errors to be constant. To check this assumption White test was conducted
for the model as shown below. The model has no problem of heteroskedasticity or the error
variance is constant since the p-value is not significant. This means the null hypothesis was not
rejected which says that the error variance is constant.

Tabale 4.4. Heteroskedasticity Test: White

F-statistic 2.359166 Prob. F(65,42) 0.1019

Obs*R-squared 84.77964 Prob. Chi-Square(65) 0.1503
Scaled explained SS 85.21456 Prob. Chi-Square(65) 0.1471

Source: Own estimation from Eviews, Heteroskedasticity White Test

47
4.4.5. Multicollinearity Test
According to (Gujarati, 2003, p. 374) one of the assumptions of linear regression model is that
there is no multicollinearity among the explanatory variables. The multicollinearity test helps to
identify the correlation between explanatory variables and to avoid double effect of independent
variable from the model.

Table.4.5. Multicollinearity Test: correlation analysis of independent variables

variables TAN LIQ SOM LOR GRP SIZE AGE LAV GDP RED
TAN 1.0000
LIQ 0.0284 1.0000
SOM 0.1186 0.3670 1.0000
LOR -0.0077 0.0135 -0.4453 1.0000
GRP 0.0749 -0.0842 -0.2280 -0.1087 1.0000
SIZE -0.2488 -0.1893 -0.4422 0.0936 -0.0107 1.0000
AGE -0.1542 0.2423 -0.3446 0.1866 -0.0317 0.7746 1.0000
LAV -0.1662 -0.2523 -0.7862 0.3253 0.0605 0.6690 0.5629 1.0000
GDP 0.0357 -0.0657 -0.2104 0.0531 0.0345 0.3045 0.2188 0.2610 1.0000
RED -0.3182 -0.1873 -0.1534 -0.3150 0.1979 0.5006 0.4514 0.3654 0.0299 1.0000
Source: Own estimation from Eviews, Multicollinearity Test

A correlation is a single number that describes the degree of relationship between two variables.
In other words, multicollinearity describes the relationship among explanatory variables. As
indicated on the correlation matrix almost all correlations that have occurred among explanatory
variables are surprisingly weak correlations; this indicates there is no the existence of
multicollinearity problem on the study. Even if, relatively high positive correlation existed
between size and age with value of correlation (0.7746) and leverage and size with value of
positive correlation of (0.6690) the researcher ignored this near multicollinearity problem.
Because Cooper and Schindler (2009) and Hailer et al (2006) suggested that multicollinearity
problem should be corrected when the correlation extent to be above 0.8 and 0.9 respectively.

48
4.5. Fixed effect Versus Random effect
It is also necessary to determine whether the fixed effect or random effect approach is
appropriate. A common practice in corporate governance research is to make the choice between
both approaches by running a Hausman test. To conduct a Hausman test the number of cross
section should be greater than the number of coefficients to be estimated. But, in this study the
numbers of coefficients are greater than the number of cross sections so it is not possible to
conduct a Hausman test. Therefore, a redundant fixed effects test was conducted to determine
whether the fixed effect is appropriate for the models. As a result the time-fixed effect approach
was used. In this case the cross section fixed is appropriate, so cross section fixed approach was
applied. Simple pooled multiple regression techniques also used on which fixed or random effect
test is not allowed to test hetrocedakisty.

All the above tests of basic classical linear regression model assumptions for OLS estimation
proved that, the results obtained from the regression model in this study are consistent, free from
bias and efficient since the assumption holds and the next step is analyzing and discussing the
outputs of the regressions.

4.6. Finding and Regression Result

The results of the regression model that have been estimated to examine the impact of Age, Size
of companies, Leverage, Tangibility of assets, Liquidity, Premium Growth, Loss ratio,
Reinsurance dependence ,Solvency margin and GDP growth on insurance companies financial
performance(profitability) shown below on table 4.6.

49
Table.4.6.Summary of Regression Result

Variable Coefficient Std. Error t-Statistic Prob.

C -0.448732 0.243319 -1.844213 0.0685
TAN -0.048533 0.037141 -1.306722 0.1947
LIQ 0.010280 0.014276 0.720078 0.4734
SOM 0.102367 0.020848 4.910099 0.0000*
LOR -0.218063 0.029846 -7.306241 0.0000*
GRP 0.007541 0.018489 0.407840 0.6844
SIZE 0.056062 0.016046 3.493836 0.0007*
AGE -0.000841 0.003050 -0.275852 0.7833
LAV -0.441878 0.096944 -4.558055 0.0000*
GDP 0.000973 0.008612 0.113043 0.9103
RED -0.034888 0.057623 -0.605445 0.5464

R-squared 0.765803 Mean dependent var 0.077834

Adjusted R-squared 0.718437 S.D. dependent var 0.052642
S.E. of regression 0.027933 Akaike info criterion -4.159647
Sum squared resid 0.069443 Schwarz criterion -3.687790
Log likelihood 243.6209 Hannan-Quinn criter. -3.968326
F-statistic 16.16788 Durbin-Watson stat 1.843878
Prob(F-statistic) 0.000000

Source: Eviews regression results based on the data obtained from sample insurance companies
Note: * significant at 1% level of significance.

As it is presented on the above table, the R2 for the models is 76.58 percent. Which means that
76.58 percent of the variation in return on asset was explained by the independent variables used
in this study, only 23.42 percent of variation in return on asset is due to other factor that are not
included in this study. The R2 results indicate the overall goodness-of-fit of the models used in
this study.

50
After modification the explanatory power of the model, adjusted R2 values, is 71.84 percent,.
This indicates that 71.84 percent, of the variation in the Ethiopian insurance companies return on
asset, was explained by the explanatory variables in the model. The adjusted R2 measures how
well the model fits the data by taking into account the loss of degrees of freedom associated with
adding extra variables.

In addition, the F-statistic shows the overall significance of variables in other words the
significance of model slope parameters. The F-statistics of the models is 16.16788 and the null
hypothesis of the model was rejected at 1 percent significance level. Therefore, model variables
are significant. The model adequately describes the data. Here one can infer from the results of
R-squared and F-statistics that the implemented model of this research are well fitted that
independent variables i.e. Age of companies, Size of companies, Leverage, Tangibility of assets,
Liquidity, Premium Growth, Loss ratio, Reinsurance dependence, Solvency margin and GDP
growth have a significant effect on insurance companies financial performance.

According to the regression result from table 4.6 solvency margin (SOM), loss ratio (LOR), size
of insurance companies (SIZE), and leverage ratio (LAV) have significant effects on
performance (profitability) of insurance companies in Ethiopia where as tangibility of asset
(TAN), liquidity (LIQ), growth written premium (GRP), reinsurance dependency (RED), age of
insurance companies (AGE) and growth in gross domestic (GDP) have no significant impact on
insurance companies profitability. The above profitability determinants of insurance companies
are individually discussed in the next paragraphs referring regression result of table 4.7 and
response from respondents of questioners distributed.

Tangibility of asset (TAN):-

The coefficient of the tangibility of asset (TAN) is negative with (-0.048533) and it is
statistically insignificant determinants of profitability for insurance companies in Ethiopia with
the probability of (0.1947). This finding is consistent with previous studies with Yuqi Li (2007).
According to Yuqi Li (2007) study found that there is no significant relationship between
tangibility of assets and profitability of insurance companies in UK. But in contrast Hafiz Malik

51
(2011) found that there exists a positive and significant relationship between tangibility of assets
and profitability of insurance companies and argued that the highest the level of fixed assets
formation, the older and larger the insurance company.

From result of questioner held with chief finance officers of nine insurance companies tangibility
of asset has little impact of their profitability with 4 of the respondents responded yes tangibility
of asset can determine insurance company’s profitability because a firm with large amount of
fixed asset tends to be more profitable because of increasing its future assets value. Firms with
large volume tangible assets are more likely to collateralize their assets to raise additional funds
with little risk due to the investments diversifications which at the end reduces the risk of
bankruptcy. From the finding from both regression and questioner response tangibility of asset
has insignificant impact on profitability of insurance companies.

Liquidity (LIQ):
The coefficient of liquidity ratio LIQ) is positive with (0.010280) and it is statistically
insignificant determinants of profitability for insurance companies in Ethiopia with the
probability of (0.4734). Empirical evidences with regard to liquidity revealed almost inconsistent
results. For instance, Naveed Ahmed et.al. (2011) in his investigation in Pakistan found that
ROA has statistically insignificant relationship with liquidity. Similarly, several other studies
also have been conducted to measure the performance of the insurance companies. In contrast,
Chen and Wong (2004) examined that, liquidity is the important determinants of financial health
of insurance companies with a negative relationship. Similarly, Hakim and Neaime (2005)
observed that liquidity, current capital and investment are the important determinants of banks
profitability. Valentina Flamini, Calvin McDonald, and Liliana Schumacher (2009) in their
investigation regarding Sub-Saharan countries found significant and negative relationship
between bank profitability and liquidity. As stated above this research is consistence with the
study of Naveed Ahmed et.al. (2011) study on Pakistan insurance industry.

Liquidity of insurance companies has an impact on the profitability of insurance as per majority
of the respondent, because a low liquidity level may lead to increasing financial costs and result
in the incapacity to pay its obligations. Also liquidity interpreted as an indicator of the degree of

52
independence of the company against creditors and its ability to face crises and unexpected
difficulties. Thus it is an important task for the financial manager to achieve the appropriate
balance between the adequate liquidity and a reasonable return for the company. Though the
response form respondents show that liquidity has significant impact on profitability of insurance
companies the regression result shows insignificant impact.

Solvency margin:
As shown on table 4.6 the coefficient of solvency margin (SOM) is positive with (0.102367) and
it is statistically highly significant determinants of profitability for insurance companies in
Ethiopia with the probability of (0.0000) at one percent significance level. A positive linkage
between this variable and the insurer’s financial performance is expected, since the insurer’s
financial stability is an important benchmark to potential customers. According to research from
Romania the solvency margin, has s a positive linkage between this variable and the insurer’s
financial performance, because the insurer’s financial stability is an important benchmark to
potential customers.

The respondent responded that solvency margin has significant impact on insurance company’s
profitability, because Solvency ratios look at the relationship between what the company owns
and what it owes. National bank of Ethiopia also use solvency margin of insurance companies as
controlling mechanism for the health of insurance companies. A solvent company has assets that
exceed its liabilities sufficiently to provide for reinvestment in the company’s growth. The
standard for profitability requires that income derived from the company’s business activities
exceeds the company’s expenses. While a company can be solvent and not profitable, it cannot
be profitable without solvency. Also Solvency impacts a company’s ability to obtain loans,
financing and investment capital. From the finding from both regression and questioner response
solvency ratio has insignificant impact on profitability of insurance companies.

Loss ratio:
As stated on table 4.6 the coefficient of los ration or underwriting risk (LOR) is negative with (-
0.218063) and it is statistically highly significant determinants of profitability for insurance
companies in Ethiopia with the probability of (0.0000) at one percent significance level.

53
According to the nature of the insurance industry, the ratio of net claims paid in net premiums
earned (loss ratio) is used as a proxy to measure the risk of the insurance companies in Ethiopia.
This shows that insurers that underwrite risky business (e.g., catastrophe coverage) will need to
ensure that good standards of management are applied to mitigate their exposure to underwriting
losses ex-ante and maximize returns on invested assets ex-post. Otherwise, they will turn out to
be poor performers. Excessive risk-taking could adversely affect the performance of insurance
companies. Malik (2011) and Ahmed et al. (2011) also found the same result.

Under writing risk also have significant impact as per respondents because Underwriting is a
critical risk mitigation mechanism adopted in the insurance industry. The process helps in
deciding the appropriate premium for an insured. The underwriter needs to match the premium
received with the claims paid with an eye on profitability. In the event of a dichotomy between
the two, with the premium received not sufficient enough to cover the claims, the insurer is
confronted with the probability of loss. The premium charged by the insurer must incorporate the
risk premium that covers not only the claims but also the capital requirements, also called the
solvency requirements. In the event that the matching is not done in a sensible manner, the
underwriting risk arises. The response from questioner also supports the regression result.

Growth written premium:

The coefficient of growth written premium (GRP) is positive with (0.007541) and it is
statistically insignificant determinants of profitability for insurance companies in Ethiopia with
the probability of (0.6844). However, this positive relationship is found to be statistically
insignificant with the p-value of 0.6844. The result of the study supports the findings of Chen
and Wong (2004). In contrast according to Yuqi Li (2007) in UK and Hamadin Ahmed Ali Al-
Shami (2008) in UAE of their investigation found a positive and statistically significant
relationship between growth and profitability of insurance companies.

Growth in written premium has significant impact on insurance company’s profitability as per
the respondents answer. Growth is defined as the annual percentage growth in the firms' total
assets between two successive years divided by the preceding year. A rise in growth rate is
regarded as an indication of a firm's financial strength and may cause higher demands for raising

54
equity funds from external sources. Insurance company collects premiums from policy holders,
invests the money (usually in low risk investments), and then reimburses this money once the
person passes away or the policy matures therefore increase in premium brings more investment
opportunity of insurance companies. Even though the questioner response shows significant
impact of growth in gross written premium the regression result shows insignificant impact on
profitability of insurance companies in Ethiopia.

Size of insurance companies:

The coefficient of Size of insurance companies (SIZE) is positive with (0.056062) and it is
statistically highly significant determinants of profitability for insurance companies in Ethiopia
with the probability of (0.0007) at one percent significance level. Empirical evidences of the
linkage between profitability and firm size are somewhat inconsistent. For example, evidence
collected by Philip Hardwick and Mike Adams (1999) from UK companies suggests that there is
an inverse relation between profitability and firm size. Jay Angoff Roger Brown (2007) found
that there is a positive and significant relationship between the size of a company and its
profitability as measured by ROA. This study is consistence with Jay Angoff Roger Brown
(2007). This reveals that performance of large size insurance companies is better than small size
companies. 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 (Hardwick, 1997). Large corporate size also
enables insurers to effectively diversify their assumed risks and respond more quickly to changes
in market conditions (Wyn, 1998). The finding of this study is congruent with, Gardner and
Grace (1993); Sommer (1996); Cummins and Nini (2002); Chen and Wong (2004); Liebenberg
and Sommer (2007); Malik (2011) and Ahmed et al. (2011). Hence, firm size is an important
determinant of the financial strength of insurers both in developing and developed economies.
This predicts that performance of large size life insurance companies is better than small size
companies. Flamini et.al (2009) indicated that size is used to capture the fact that larger firms are
better placed than smaller firms in harnessing economies of scale in transactions and enjoy a
higher level of profits.

55
The respondents responded that size of insurance companies has significant impact on financial
performance/profitability/of insurance companies. Company size is considered an important
issue in determining the nature of relationship for the company within its operating environment
and outside it, and the growing influences of the multinational corporations worldwide represents
a clear example of the importance of size and the role it can plays in the corporate environment.
Large companies are able to benefit from the economies of scale (the average unit cost declines
over a range of output), and from the economies of scope (an extra cost savings as a result of the
production process where separate products can share some production facilities). On the other
hand, large companies are able to benefit from the superior management and the superior
capabilities in product development, marketing, commercialization, financial scope,
specialization, stronger bargaining power, stronger competitive power, bigger market share, and
a more opportunity to work in the fields which require high capital rates since they have much
more resources and this situation provides them the opportunity to work in more profitable fields
with little competition. In the other hand, large companies have more ability for diversification in
their related and unrelated units and it have also more capital cost saving which generates more
sales in return. Large sized firms normally have more business diversification than small firms in
terms of credit ratings, constant cash flow, and lower risk of bankruptcy. Furthermore large firms
are capable of decreasing transaction costs of issuing long-term debt at a favorable low rate of
interest. Consequently, since it is easier for large sized firms to raise funds from creditors, a
positive sign is expected between firm size and leverage (Titman and Wessels, 1988). The
primary source of data also supports that size of insurance companies has significant impact on
profitability of insurance companies in Ethiopia.

Age of insurance companies:

As presented on table 4.6 the coefficient of age of insurance companies (AGE) is negative with
(-0.000841) and it is statistically insignificant determinant of profitability for insurance
companies in Ethiopia with the probability of (0.7833). This study is supported by studies like
Hamadan Ahamed Ali Al-Shami (2008) which found no significant statistical relation between
age and profitability of insurance companies in UAE and Naveed Ahmed (2007) stated that age
has statistically insignificant relationship with profitability. Also this finding is consistent with
what (Liargavas and Skandalis, 2008) who found that age has no significant statistical impact on

56
financial performance. Thus based on this research finding age of insurers’ is not considered as a
powerful explanatory variable to determine the performance of insurance companies in Ethiopia.

Age of insurance companies has little impact on profitability of insurance companies with the
majority respondents responded yes for the question that does age of company determine
profitability of insurance companies. Although age has importance for creating strong
relationship with customers and good governance experience so it has an impact on profitability.
The regression and also the questioner result show that age has little of no impact on profitability
of insurance companies in Ethiopia.

Leverage:
The coefficient of leverage ratio of insurance companies (LAV) is negative with (-0.441878) and
it is statistically highly significant determinants of profitability for insurance companies in
Ethiopia with the probability of (0.0000) at one percent significance level. Empirical evidences
with regard to leverage found to be statistically significant relationship but negative which
support this study. For instance Renbao Chen and Kie Ann Wong (2004), in Canada, Hamadan
Ahamed Ali Al-Shami (2008) in UAE, Hifza Malik (2011) in Pakistan, Sylwester Kozak (2011)
in UK Swiss Re (2008) in Egypt and Flamini et..Al (2009) in Sub-Saharan countries found that
negative but statistically significant relationship between leverage and profitability of firms.
Harrington (2005) stated that the relationship between leverage and profitability has been studied
extensively to support the theories of capital structure and argued also that insurance companies
with lower leverage will generally report higher ROA, but lower ROE. Since an analysis for
ROE pays no attention to the risk associated with high leverage.

The respondents responded that leverage ratio of insurance companies has significant impact on
financial performance/profitability/of insurance companies. Leverage is viewed as a result of
events that determines companies' source of financing to run the business. Highly leveraged
insurance companies are riskier in terms of their return on equity and investment and also
financial leverage affects cost of capital, ultimately influencing firms’ profitability. Company’s
financial structure has a great importance in investment and financing decisions, due to its
impact on profitability, as well as risk degree faced by the company due to its dependence and

57
expanding on debt. Financial structure decisions Affect Company’s financial risk measured by
leverage which is a ratio of borrowed to owned money. The company with high profitability
from assets can detain greater part of its net annual profits to finance its needs and thus less
dependence on debt, but by deducting debt interest expense. This result also supports the
regression result.

Reinsurance dependency:
As presented on table 4.6 the coefficient of reinsurance dependency of insurance companies
(RED) is negative with (-0.034888) and it is statistically insignificant determinant of profitability
for insurance companies in Ethiopia with the probability of (0.5464). 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. Therefore, a negative connection between
the reinsurance dependence and the insurer’s financial performance is expected this supports the
outcome of the study result. In contrast According to research from Romania the reinsurance
dependency has positive influence on the insurer’s financial performance, as reinsurance
involves a certain cost.

From result of respondent Reinsurance dependency has little impact of their profitability with
majority of the respondents responded yes Reinsurance dependency can determine insurance
company’s profitability because reinsurance increases cost for insurance companies which
decrease the profitability of insurance companies.

Growth in gross domestic product (GDP):

The coefficient of growth domestic product (GDP) is positive with (0.000973) and it is
statistically insignificant determinants of profitability for insurance companies in Ethiopia with
the probability of (0.9103). It is expected to have a positive influence on the insurers’ financial
performance, since economic growth improves the living standards and the levels of income,

58
increasing the purchasing power of population. This result is in line with study form Romania
found that positive coefficient of GDP and it’s is not statistically significant.

The respondents responded that Growth in gross domestic product has an impact on financial
performance/profitability/of insurance companies because increase in GDP led the ability of
having insurance policy to the citizens. This result in contrast with regression output which
shows insignificant impact of GDP growth on profitability of insurance companies.

The following variables are variables that determine the profitability of insurance companies as
per respondents of questioner response. The respondents responded that the following are the
basic determinant other than variables discussed on the study:

 Management competency: - Management competence has a significant impact on

Financial Performance of insurance companies as per respondents answer. Which is
consistent with what (Liargavas and Skandalis, 2008) and (Merikas et al, 2006) have
found. Hence the level of education of professionals affects the assessment of the quality
of their competence and thus the company’s ability to achieve future success.
Management competency is a multidimensional concept and a number of well
documented attempts have been made in the literature to define it. More specifically, the
popularity of the term competence can be attributed to (Boyatzi, 1982). In “The
Competent Manager”(Boyatzi ,1982) defines competence as “an underlying characteristic
of a person”, stating it could be, “motive, trait, skill, aspect of one’s self-image or social
role, or a body of knowledge which he or sheuses”(Woodruffe, 1993) points out, that this
definition leaves the term open to a multitude of interpretations and argues that the term
‘competence’ can be used to refer to a ‘set of behaviors, skills, knowledge and
understanding which are crucial to the effective performance of a position’. (Nordhaug
and Gronhaug, 1994) interpret competence as “work-related knowledge, skills and
abilities” while (Rees, 2003) argues that there has been an enormous diversity of
interpretation of the term, ‘competence’, and no agreed definition. (Hamel and Prahalad
,1994) define competence as a bundle of skills and technologies that enable company to
provide benefits for customers rather than a single skill or technology.

59
 Employee competency and experience: - All companies realize the importance of
nurturing a talented workforce. With it, everything is possible, without it, you can count
on numerous unsuccessful strategic efforts. By clearly identifying the right competencies
and experience, organizations can make sure they are recruiting and managing talented
people in the most strategic way, putting the right people in the right jobs with the
abilities to perform at their maximum potential every day. In organizations utilizing best
practices, a small set of core leadership and values-based competencies are established
across the organization. These competencies are broadly applied to all employees and
send a powerful message, reflecting the company’s culture, business strategy,
expectations and unique market dynamics which led the companies to profitability.

 National bank supervision and regulation: - National bank of Ethiopia has significant
role for insurance companies profitability by creating fair market competition among
insurance companies, licensing and supervising, making directives suites for
development of insurance sector in the country. Also national bank of Ethiopia follows
each and every insurance company’s health continues which important for insurance
companies alert on their financial situation.

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 CHAPTER FIVE

SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS

It is fact; a strong and healthy financial system is a prerequisite for sustainable economic growth
of a given country. In order to survive negative shocks and maintain a good financial stability,
the financial managers and policy maker should identify the key performance determinants of
insurance industry. Because of this, the current study specified an empirical framework to
investigate the effect of insurance sector -specific determinants and one microeconomic
determinant on the profitability of Ethiopian insurance sector from 2003 to 2014. The study also
used an appropriate econometric methodology for the estimation of variables coefficient under
fixed effect regression models. The following sections discussed about the final conclusion
remarks of the study, applicable recommendations and future research recommendation.

5.1. Summary
In this study, the empirical analysis of investigating the determinants of the performance of
Ethiopian insurance companies was conducted using a panel data set consisting of financial data
of nine insurers over the period of 2003 to 2014 and supports the finding with primary source of
data. The results of pooled OLS regression analysis revealed that solvency margin; firm size,
leverage, and loss ratio/underwriting risk/, were statistically significant to explain performance
of insurance companies in Ethiopia. The result of the study also shows that insurers’ size and
solvency margin were positively related to insurance performance, while loss ratio, and leverage
ratio and were negatively related to performance (ROA). Whereas premium growth, growth in
gross domestic product, age of insurance companies and liquidity has positive relation with
insignificant impact on profitability of insurance in Ethiopia and determinates such as tangibility
of asset and reinsurance dependency has negative relation with insignificant impact on
profitability of insurance companies.

The data from primary source also support regression output, i.e. negative and significant
relation between loss ratio and leverage ratio on ROA (profitability of insurance companies), and
positive and significant impact of solvency margin and size of insurance companies on
profitability of insurance companies in Ethiopia . Also respondent generally suggested that
liquidity, GDP, and growth in written premium has positive and significant relation between

61
profitability and age of insurance companies, reinsurance dependency and tangibility of asset has
positive, negative, negative relation with little significant on profitability of insurance companies
respectively. All determinants selected on the study are concluded as follows:

5.2. Conclusions
 Size of insurance companies: As per the result from both regression and questioners
response size of insurance companies has positive and significant impact on profitability
of insurance companies in Ethiopia. The positive relationship between size and ROA
implies that size is used to capture the fact that larger insurance companies are better
placed than smaller once in harnessing economies of scale in transactions and enjoy a
higher level of profits.
 Solvency margin: The result from both regression and primary source reveled that there
is positive and significant impact of solvency margin on profit ability of insurance sector
in Ethiopia. Positive and significant powerful explanatory of solvency which implies
solvent insurance companies generate more profit than insolvent insurance companies.
 Underwriting risk /loss ratio/: Negative and significant impact of loss ratio
/underwriting risk/ on profitability of insurance companies which implies insurance
companies operating in Ethiopia with less underwriting risk will generate more profit
than higher underwriting risk.
 Tangibility of asset: - Tangibility of asset is not considered as powerful explanatory
variables to define the performance of insurance companies in Ethiopia over 12 years
with positive relation with ROA.
 Reinsurance Dependency: - Reinsurance Dependency is not considered as powerful
explanatory variables to define the performance of insurance companies in Ethiopia over
12 years with negative relation of ROA.
 Age of Insurance Companies: - Age of Insurance Companies is not considered as
powerful explanatory variables to define the performance of insurance companies in
Ethiopia over 12 years with positive relation of ROA.
 Leverage ratio: - Negative and significant impact of leverage on profitability of
insurance companies in Ethiopia. It is implied that highly profitable insurance companies

62
 are more likely relied on internally generated funds and equity capital than debt capital as
the source of financing.
 Growth in gross written premium: - The positive and statistical insignificant relation
between growth rate and profitability of insurance companies in Ethiopia implies that
insurance companies their positive relation of growth rate with no impact on profitability
of insurance companies in Ethiopia.
 GDP growth: - Positive and insignificant impact on GDP growth and insurance
company’s profitability.
 Management competency, employee competency and experience and national bank
supervision and regulation has significant impact on profitability of insurance as per data
gathered through open-ended questioners held with chiefs finance office of respective
sample insurance companies other than study variables.

5.3. Recommendations
Based on the research findings the following recommendations were presented for this study:
 It is positive to have high consideration of increasing the company assets. Because the
size of the company is an important factor as it influences its competitive power. Small
companies have less power than large ones; hence they may find it difficult to compete
with the large firms particularly in highly competitive markets.

 Great attention should be paid to leverage. Companies that are highly leveraged may be
at risk of bankruptcy if they are unable to make payments on their debt; they may also be
unable to find new lenders in the future. On the other hand, leverage can increase the
shareholders' return on their investment and make good use of the tax advantages
associated with borrowing.

 There is a significant need to have highly qualified employees in the top managerial staff
and experienced and motivated low and middle staff, as indicated on presentation of
primary data management and employee competency get high priority by respondents.

63
5.4. Recommendations for future research
This study focuses mainly on the internal factors affecting profitability of the insurance sector in
Ethiopia with only one macroeconomic variable. By taking this study as a standing point, it
could be possible to come up with a better insight and several extensions to this study are
possible. Considering the available time and resource the outcome of this study can be more
robust, if future researchers conduct a study on this area. First, by further increasing the study
population and the sample size to the whole financial sector. Secondly by taking evidence from
other industries, increasing the number of observations through the use of large sample size and
longer years of data, other issues that could be covered in future research include whether
insurance companies effectively and efficiently indemnify risks and intermediate savings for the
provision of risk to the other sectors in the economy, or whether they allocate resources and
manage risks efficiently hence factors affecting profitability of insurance companies and their
implications in risk management practices.

64
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 APPENDICES
Appendix I: Research Questionnaire

ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS
ACCOUNTING AND FINANCE MASTERS PROGRAM
RESEARCH QUESTIONNAIRE

This questionnaire contains open-ended question, you are requested replay the entire question.
There is no right or wrong answers, simply answer the question based of your working
experience and the current knowledge about the business environment of your insurance
company in particular and Ethiopia insurance industry in general. You are kindly request to give
your honest opinion on each of questions. The information from respondents will be keep
confidentially and no any effect on respondents. So, please answer the entire question frankly
and honestly, your frank and sincere responses will be highly appreciated.

Thank you in advance

Questionnaire prepared to ask the chief financial officers of the sampled commercial banks
of Ethiopia. Please put x for yes or no question and discuss the question.

1. Does tangibility of asset determines your profitability? YES ………., NO……..

If yes, how and to what extent it contribute profitability of insurance profitability?
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
…………………………………………

F
2. Does liquidity factor to insurance profitability? YES……………, NO…………..
If yes, how would Liquidity affect the insurance companies profit and to what extent it
determineprofitability?……………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………
3. Does solvency margin determine portability of insurance companies? YES………,
NO…………..
If yes, how it contribute for your insurance company profitability?

……………………………………………………………………………………................
………………………………………………………………………………………………
……………………………………………………………………………………………
4. Does loss ratio (underwriting risk) factor to insurance profitability? YES……………,
NO…………..
If yes, how would loss ratio affect the insurance companies profit and to what extent it
determine your profitability?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………
5. Does growth in written premium determine portability of insurance companies?
YES………, NO…………..
If yes, how it contribute for your profitability and to what extent impact Profitability of
insurance company?
…………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
6. Does size of insurance companies factor to insurance companies profitability?
YES……………, NO…………..
If yes how would loss ratio affect the insurance companies profit and to what extent it
determine your profitability?

G
 ………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………
7. Does age of insurance companies determine portability of insurance companies?
YES………, NO…………..
If yes how age of insurance companies contribute for your insurance company
profitability and to what extent impact Profitability?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
8. Is leverage factor for the insurance company’s profitability? YES -------,
NO……………
If yes how and to what extent your profitability is determine by Growth in leverage?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
9. Does reinsurance dependency factor to insurance profitability? YES……………,
NO…………..
If yes how would reinsurance dependency affect the insurance companies profit and to
what extent it determine your profitability?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
10. Is economic growth of the country contributed to the insurance company’s profitability?
YES -------, NO……………if yes how and to what extent your profitability is
determine by Growth in GDP?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

H
11. What are other determinates that affect your profitability of insurance company other
than stated factors above on this study? Specify and discuss them briefly.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……………………

Thank You Once Again!!!

May, 2015

I
Appendix II: Fixed Effect Regression Output

Sample: 2003 2014

Periods included: 12
Cross-sections included: 9
Total panel (balanced) observations: 108

Variable Coefficient Std. Error t-Statistic Prob.

C -0.448732 0.243319 -1.844213 0.0685

TAN -0.048533 0.037141 -1.306722 0.1947
LIQ 0.010280 0.014276 0.720078 0.4734
SOM 0.102367 0.020848 4.910099 0.0000
LOR -0.218063 0.029846 -7.306241 0.0000
GRP 0.007541 0.018489 0.407840 0.6844
SIZE 0.056062 0.016046 3.493836 0.0007
AGE -0.000841 0.003050 -0.275852 0.7833
LAV -0.441878 0.096944 -4.558055 0.0000
GDP 0.000973 0.008612 0.113043 0.9103
RED -0.034888 0.057623 -0.605445 0.5464

Effects Specification

Cross-section fixed (dummy variables)

R-squared 0.765803 Mean dependent var 0.077834

Adjusted R-squared 0.718437 S.D. dependent var 0.052642
S.E. of regression 0.027933 Akaike info criterion -4.159647
Sum squared resid 0.069443 Schwarz criterion -3.687790
Log likelihood 243.6209 Hannan-Quinn criter. -3.968326
F-statistic 16.16788 Durbin-Watson stat 1.843878
Prob(F-statistic) 0.000000

J
Appendix III: List of Insurance Companies Operating In Ethiopia

No. Insurance co. Establishment year

1 Ethiopian Insurance Corporation 1975
2 Africa Insurance Company S.C 1994
3 Awash Insurance Company S.C 1994
4 National Insurance Company of Ethiopia S.C. 1994
5 Nile Insurance Company S.C 1995
6 Nyala Insurance Company S.C 1995
7 Global Insurance Company S.C. 1997
8 The United Insurance S.C 1997
9 NIB Insurance Company 2002
10 Lion Insurance Company S.C 2007
11 Ethio-Life and General Insurance S.C. 2008
12 Oromia Insurance Company S.C. 2009
13 Abay Insurance Company 2010
14 Berhan Insurance S.C. 2011
15 Lucy Insurance S.C. 2012
16 Tsehay Insurance S.C. 2012
17 Bunna Insurance S.C. 2013