CHAPTER ONE
Background of the Study
INTRODUCTION
Risk management is a crucial issue, not only for the survival and profitability of the insurance industry, but also for the socio-economic growth and development of the whole economy. As major risks underwriters, insurance companies need to adopt good practices or quality measures in the management of financial risk (Akotey and Abor, 2011).
Risk if not well managed could lead to collapse for most organizations especially those whose core business deals with day to day handling of risk. Risk management should, therefore, be at the core of an organization’s operations by integrating risk management practices into processes, systems and culture of the entire organization. This involves identifying and analysing risks, developing and implementing risk handling techniques and monitoring the progress of these in order to avoid and/or reduce the impact of risk on the financial performance of the firm (Omasete, 2014).
Insurance companies are in the business of taking risks and Worldwide these companies write policies that deal with specific risks, and in many cases, even underwrite exotic risks. In carrying its core activities, i.e., pricing, underwriting, claims handling and reinsurance management, an insurer will face a wide range of risks which are often interlinked and if not properly managed, could threaten the ability of the institution to achieve and sustain its viability. Therefore, obtaining coverage for every insurable risk is being replaced by the risk management concept. Risk management, which includes insurance coverage, is intended to minimize the costs associated with assuming certain types of risk and providing prudent protection. It deals with
pure risks that are characterized by chance occurrence and that may only result in a financial loss (Arif et al., 2015).
Poor management of risk, by insurance companies, leads to accumulation of claims from the clients hence leading to increased losses and hence poor financial performance (Magezi, 2003). Risk management activities are affected by the risk behaviour of managers. A robust risk management framework can help organizations to reduce their exposure to risks, and enhance their financial performance (Iqbal and Mirakhor, 2007). Further; it is argued that the selection of particular risk tools tends to be associated with the firm’s calculative culture – the measurable attitudes that senior decision makers display towards the use of risk management models. While some risk functions focus on extensive risk measurement and risk based performance management, others focus instead on qualitative discourse and the mobilization of expert opinions about emerging risk issues (Mikes and Kaplan, 2014).
Risk management is a process of identifying loss exposures faced by an organization and selecting the most appropriate techniques for treating such exposures (Rejda, 2003). There are many techniques available for insurance companies to manage risks. These include: loss financing, risk avoidance and loss prevention and control (Arif et al., 2015). Management of insurance companies is argued to carefully judge the insurable risks so as not to incur excessive losses in settling claims. Managing risks is an important factor which insurance companies must attend to if they are to achieve financial performance. Insurance companies apply various techniques to manage risks. Some of their risks are re-insured by some companies abroad (Meredith, 2004).
The companies have been characterized by low risk transfers, low levels of loss prevention and control and are not avoiding highly insurable risks (Rejda, 2003). Kadi (2003) also stated that
most insurance companies are accepting to cover all the insurable risks without first carrying out proper analysis of the expected claims from the clients and they have not put in place a mechanism of identifying various methods of reducing risks. They have accumulated claims from clients and this has led to increased losses (Magezi, 2003). He further stated that loss ratios have consistently increased and therefore hindering financial performance.
Risk is inherent in every business, but organizations that embed the right risk management strategies into business planning and performance management are more likely to achieve their strategic and operational objectives. Risk taking is core to the Insurance Company’s business, and the risks mentioned earlier are an inevitable consequence of being in business. The insurance’s aim is therefore to achieve an appropriate balance between risk and return and minimize potential adverse effects on its performance. This requires more dynamic and sound Risk Management methods to perform well in an ever dynamic and highly competitive insurance industry, which will translate into having a competitive advantage and thus generate growth in profits (Adrian, 2014).
Financial performance can be measured through evaluating a firm’s profitability, solvency and liquidity. A firm’s profitability indicates the extent to which a firm generates profit from its factors of production. Financial performance can be measured by monitoring the firm’s profitability levels. Zenios et al. (1999) states that profitability analysis focuses on the relationship between revenues and expenses and on the level of profits relative to the size of investment in the business through the use of profitability ratios. The return on equity (ROE) and the return on assets (ROA) are the common measures of profitability. By monitoring a firm’s profitability levels, one can measure its financial performance.
Standard and Poor’s (2013) identifies poor liquidity management, under-pricing and under- reserving, a high tolerance for investment risk, management and governance issues, difficulties related to rapid growth and/or expansion into non-core activities as main causes of financial distress and failure in insurance companies. It is important that these factors be managed efficiently by insurance companies, to avoid financial failure and bankruptcy to the firm.
Proper risk management is important in the daily operations of any insurance company to avoid financial losses and bankruptcy. This is in line with Jolly (1997) contribution that preventing losses through precautionary measures is a key element in reducing risks and consequently, a key driver of profitability. The efficiency of risk management by insurance companies will generally influence their financial performance. Gold (1999), asserts that insurance companies could not survive with increased loss and expense ratios.
Generally, company operations are prone to risks and if the risks are not managed the firm’s financial performance will be at stake. Firms with efficient risk management structures outperform their peers as they are well prepared for periods after the occurrence of the related risks.
Statement of the Problem
Insurance firms continue to grow day in, day out and many people have changed their negative attitude towards insurance. This positive attitude has led to high growth in capital of insurance industry and hence increased its strength. Insurance firms are in the core business of managing risk. The firms manage the risks of both their clients and their own risk. This requires an integration of risk management into its core business activities, systems, processes and culture. Insurance firms have for a long time contributed to the development of economies, particularly in the developing countries. Unfortunately, these firms face numerous challenges associated with risk management practices. According to Agyei and Yeboah (2011), some financial institutions
have had difficulties in growth of their profitability and some end up closing their doors; probably inadequate risk management policies and practices are the major causes of failures and poor performance of these firms. Bandara and Weerakoon (2012) assert that risk management is important in insurance firms as it is the backbone of success but a few studies have been conducted concerning relationship between risk management practices and financial performance. It is unclear the extent to which performance of insurance firms can be linked to risk management practices.
A study by Aron Risk Solutions and Wharton School in 2011 revealed an existence of a positive relationship between the maturity of a firm’s risk management framework and its financial performance. The findings of the study reflect that higher risk maturity is associated with improved ROA and stock performance for most firms. Ernst & Young (2012) also reinforces this point of view by suggesting that companies with more mature risk management practices outperform their peers financially, and tend to generate the highest growth in revenue.
A study in the Netherlands by Laeven & Perotti (2010) has shown that the last financial crisis has had dramatic impact on the solvency level of insurance companies. The actual solvency capital was on a level above 300% of the required solvency level before the crisis and dropped dramatically in the years 2007 and 2008. Various individual insurance companies dropped to the level, or below, of the bare minimum requirements of solvency capital as stated by the Dutch Central Bank.
Evidence found in earlier studies show that insurance companies have suffered in different extends during the recent crisis. Some insurance companies had some setbacks and decreasing surplus, while other companies had to be bailed out by the government to prevent default (example: AIG (Eling & Schmeiser, 2010); Laeven & Perotti, 2010)).This shows the impact of
the crisis on insurance companies. The question now rises whether or not the effects of the crisis could have been diminished by having Risk Management system in place during the crisis.
Academics and industry experts argue that risk management is beneficial for insurance companies for several reasons. Risk management helps by decreasing earnings and stock price volatility, increasing capital efficiency, reducing external capital costs, and creating synergies between different risk management activities (Cumming & Hirtle, 2001; Lam, 2001; Meulbroek, 2002; Beasley, Pagach & Warr, 2008; Hoyt & Liebenberg, 2011).
Based on the review of Amaya and Memba (2015; Darzi, (2011); Ndwiga, et al., (2012); Saunders & Allen, (2002); Vaughan and Vaughan (2008); Ndwiga, et al., (2012) and Saleem & Abideen, (2011), it is apparent that the findings are controversial, in that risk management practices show a negative relationship to performance of firms in some studies while in other studies positive relationship is seen. According to Padachi and Howorth (2013), previous studies have shown that enterprises tend to avoid the study of financial and business risk management and hence the major reason for their poor financial performance.
This study therefore sought to assess the effect of risk management practices on financial performance of Insurance Companies in Ghana.
Research Objectives
The main objective of the study is to assess the effect of risk management practices on financial performance of Insurance Companies in Ghana.
The specific objectives of the study include;
- To determine the extent to which risk identification affects the financial performance of insurance companies in Ghana.
- To find out the extent to which risk assessment affects the financial performance of insurance companies in Ghana.
