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CHAPTER 3: LITERATURE REVIEW
Insurance business involves a lot of risk because it provides cover against future uncertainty that clients will face either in their ordinary life or in the course of doing business. Insurance services vary with the types of risk against which a client wishes or intends to insure. This chapter is a review of literature focusing on the types of insurance and performance measurement of insurance companies. The rest of this chapter is organized as follows. Section one is about classification of insurance. Section two discusses the performance of insurance companies based on evidence on extant literature. Section three briefly discusses the impact of corporate governance on insurance companies’ performance. Section four reports the research gap.
3.1 Insurance Classification
Insurance can be grouped into three principal categories viz: (1) Life Assurance, (2) General Insurance and (3) Re-Insurance (Financial Stability Forum, 2000).
Life assurance aims to compensate the insured beneficiaries’ in the event of his/her death. Unlike general insurance, life assurance is different (Brockett et al., 1994). The fund to compensate life assurance client is generated from the premium contributed by the insured. Because mortality rate is relatively low in many countries (both developed and emerging) unforeseen contingency as loss of life is also relatively low. In this vein Carson (2000) contends that life assurance companies are financially stable and that could be seen from their financial reports.
The growth of industry at all levels (ranging from primary, secondary to tertiary) has entailed the needs for new insurance services under the umbrella of life assurance. For instance Gracia (2001) suggests that industrialization has called for the needs for employee pension fund, cash-back life assurance policy and life assurance with home loans facilities. In developed economies there are newer products in terms of investments which potential life insured can invest.
General insurance covers all insurances other than life assurance (Meador et al, 2000). Because of the various products that general insurance offers and the probability of the risk is uncertain, risk-taking is higher (Mansor and Radam, 2000). Recent business development in emerging economies like India, China, Brazil and Russia has significantly driven the general insurance market. Yao et al (2007) contends that China has recorded an annual increase of nearly 25 percent in general insurance over the last decade.
Existing literature provides different definitions of re-insurance and re-insurers. This is because of its complex features (Cole and McCullough, 2008). In a nutshell, reinsurance is the insurance for insurers. It provides an insurance cover to the insurance companies which have undertaken a legal contract to insure clients for life or general purpose insurance.
Reinsurance may be regarded as the intensive care unit of the insurance companies. By purchasing reinsurance, the insurance companies have taken protection against huge losses that could entice to bankruptcy. It is mandatory for all insurance business across the globe to purchase re-insurance policy.
3.2 Performance Measurement
Extant literature in accounting and finance has mainly used the financial reports to assess performance of any business organization in any sector including the insurance sector. Some have used the conventional ratio analysis approach whereas others have tended to sophisticate their approach by using a set of selective indicators which they argue pertain to a specific sector. For instance the CARAMELS model which is also used by the World Bank to determine performance of firms in the non-banking financial services sector. CARAMELS comprise of a series of ratios computed from the financial reports to assess performance. Both academics and practitioners argue that financial reports are the most appropriate and relevant source of data to assess performance of a firm (Nguyen, 2004) because they are prepared according to proper accounting standards as well as audited in compliance with relevant auditing standards (Boolaky, 2012; Boolaky, et al, 2013).
Conventional financial ratios are used to measure the underwriting performance of insurers. According to Angoff (2005) the loss ratio represents the pure cost of insurance coverage as opposed to the expense ratio which is the non-claims-related activities of the insurer. The sum of these two ratios - the combined ratio - thus reports the effectiveness and efficiency of underwriting operations (Berger et al., 1992, Cummins and Danzon, 1997, and Hoyt and Powel, 2005).
Ratio analysis is a financial analysis tool to dissect a financial report in case one needs to know how well or bad a company is doing. They provide useful indicators for decision making (Watson et al., 2002). Management uses ratios to assess performance in each function of the company whereas analysts use them to decide on their choice of investment. Regulators use ratio analysis as one of their supervisory tools. Ratios provide signals about risk level in the company. Using ratios it is possible to determine performance during both good and bad years. Often analysts use a set of ratios when conducting time series performance analysis of companies (Worrell, 2004). Hirao and Inoue (2004) uses cost ratio to assess efficiency and effectiveness of insurance sector in the Japanese context whereas Bikker and Bos (2008) use the conventional ratio of profitability to assess efficiency of banks.
Financial Reporting for insurance business has some additional disclosure requirements over and above the normal disclosure framework. In this context any insurance company has to comply with the International Financial Reporting Standards (IFRS) 4: Accounting for Insurance Contracts. However, ratios remain the basis for analysing the performance of these companies (Liu, 2009). Below is a description of some key ratios used in the literature to assess insurance company performance.
Long Term Stability
Any company has to have sufficient capital to continue business. In the case of insurance business, it is required by law that each insurance company meets the capital adequacy threshold. Any company in the industry will be considered insolvent if it does not have the minimum capital requirement (Sterling, 2000). Klumpes (2004) uses a set of performance benchmarking in financial services sector with special reference to the life insurance industry in the UK and draws attention on the importance of solvency, reinsurance as well as investments made by the insurance companies when assessing the financial health of an insurance company.
Solvency is measured by comparing the assets and the liabilities of a company. Brockett et al (1998) suggests that it is the safety valve of the insurance company which it can use to protect itself against any unforeseen vagaries. In the context of Mauritius any company including insurance has to pass the solvency test set by the companies Act 2001 in addition to the capital adequacy test of the Insurance Act. The purpose of regulating solvency both for the long and short term is to mitigate the risk associated with market failures (Fenn et al, 2008). In general insurer‘s capital must be capable of providing covers to any future risk event (Das et al., 2003).
The strength of a company rests in its assets. This implies both non-current and current assets of the companies. In the context of insurance sector because insurance is itself investment business, the more diversified is its investment portfolio the more stable and less risky is the business. Generally insurance companies would tend to adopt a low gearing policy in order to ensure that is assets may be used in the event of a catastrophic situation. In this context all insurance companies are led to adopt a conservative financial gearing policy. Moreover variable such as investment in real property and its potential to generate cash are important. If the ability to generate cash from real property is low then the risk associated with those assets are considered high. However if they can be easily converted into cash to settle debts then they will be considered as less risky (Jeng et al, 2007).
Profitability is defined as the ability of a business entity to generate profit. It is measured by a number of ratios such as net profit margin, return on assets, return on equity, assets turn over. Extant literature has used these ratios to demonstrate performance of business entities including insurance business. In the insurance sector Berger and Mester (1997) focus more on standard profit efficiency rather than normal profit. They argue that the efficiency of profit is a more comprehensive measure of insurance performance than cost efficiency. According to them profit efficiency measures the firm’s ability to realize maximum profit under a given condition.
Yuan and Phillips (2008) argue that alternative profit efficiency assesses change in a firm’s profits adjusted for random error. Efficiency changes depend on management efforts and environmental variables. When comparing standard profit efficiency with alternative profit efficiency, the latter uses the variable output quantities than variable output prices. Many other researchers have worked on profit efficiency of insurance companies (see Berger et al, 2000; Ward, 2002, Klumpes, 2004; Jarraya and Bouri, 2013).
3.3 Corporate Governance and Performance
There are several studies which have investigated the effect of corporate governance on insurance companies’ performance. Cummins and Weiss (2000) suggest that stock companies and mutual funds performance differs because of different corporate governance approach. They argue that mutual companies are characterized by lower managerial discretion as opposed to stock companies. Greene and Segal (2004) reveal that mutual companies and stock companies are both cost efficient. But others argue that mutual companies are least efficient than stock companies (Diboky and Ubl, 2007). Hardwick et al (2004) investigate the relationship between size of the board of directors and insurance firms efficiency and infer that there is a direct relationship between the two variables.
Das et al., (2003) suggest that effective management is an important driver of the financial strength of an insurer. Moreover, unsound efficiency indicators could indicate potential problems in the management of technical and investment risks. Boolaky (2007) investigates how compliance with corporate governance code by the financial services sector in Mauritius contributes towards effective performance. His study was based on the whole population of the financial services firms and he drew data from their annual reports. His findings suggest that firms with higher compliance level are more effective and efficient.
3.4 Research Gap
Research on the insurance sector is very rich around the world. Some researchers have investigated the agency risk in the insurance business whilst others have delved into determinants of performance. But majority of these studies were confined to large economies including developed, emerging and developing economies. As yet there is no published study on the insurance sector of Mauritius and in particular on the performance evolution of this sector. My project aims to fill the gap by conducting a time series analysis on the performance of three key insurance companies in Mauritius over a period of fifty years. Ratio analysis is used to compute the performance indicators and unit root test to investigate for stationarity. More details are given in chapter 4- Research Methodology.