1.1 Background of the Study
1.2 Statement of the Problem
1.3 Objectives of the Study
1.4 Research Question
1.6 Significant of the Study
1.7 Scope/Limitation of the Study
1.8 Operational Definition of Terms
2.1. Conceptual Reviews
2.2 Theoretical Reviews
2.3 Empirical Reviews
3.2 Research Design
3.5 Sampling Technique
3.6 Types and Source of Data
3.7 Variable Operationalization
3.8 Model Specification
3.9 Method of Analysis
3.10 Econometrics Issues
4.1 Data Presentation
4.2 Descriptive Data Analysis
4.3 Test of Hypotheses
4.4 Discussion of Findings
SUMMARY, CONCLUSION AND RECOMMENDATIONS
This study explored the effects of reinsurance arrangements on financial performance of insurance companies in Nigeria. It is worthy of note that insurance companies are exposed to a harsh environment once engaged in high-level risk taking that have the potentials to weaken their financial ability to settle claims and mostly threaten their survival. Hence, it is a known fact that reinsurance arrangement can provide some level of financial protections for insurers against the risk of their own default. In particular, the study assessed the effect of reinsurance utilization on underwriting profit, gross premium incomes and gross claim payments of insurance companies in Nigeria. Secondary data was collected from 32 licensed insurance firms who have reinsurance coverage out of the 42 registered insurance companies in Nigeria. The study used expo facto research design and data were gathered from published annual reports of NAICOM, insurers' annual financial reports and NIA digests from 2009-2018.Both descriptive and inferential statistics of OLS were employed in analysing the data. Results showed that reinsurance utilization relate positivity to underwriting profits, gross premium incomes, and gross claim payments of insurance firms in Nigeria from 2009-2018.The study conclude that insurers who utilizes reinsurance as a risk management strategy tends to underwrite more risks thus increases their underwriting profits, gross premium incomes and their financial ability in terms of payment of genius claims to insureds which most significantly increase policyholders' confidence and insurers' financial performance. Based on these findings, the study recommended among other things that NAICOM and other concerned agencies should ensure that all licensed insurance companies has reinsurance programme so as to be able to meet their financial obligations such as payment of genuine claims to insureds as this will deepens insurance penetrations and density in Nigeria.
LIST OF TABLES
Table 1: Data Presentation
Table 2: Summary of Descriptive Statistics
Table 3: Model Summary on Ordinary Least Squares Results for Hypothesis on
Table 4: Coefficients
Table 5: Model Summary on Ordinary Least Squares Results for Hypothesis Two
Table 6: Coefficients
Table 7: Model Summary on Ordinary Least Squares Results for Hypothesis Three
Table 8: Coefficients
LIST OF FIGURES
Figure. 1: Graphical Illustration on Gross Premium income
and Ratio of Ceded Reinsurance
Figure. 2: Graphical Illustration on Underwritting
Profit and Ratio of Ceded Reinsurance
Figure. 3: Graphical Illustration on Gross Claim Payments
and Ratio of Ceded Reinsurance
1.1 Background of the Study
Insurance is defined as a contract whereby one person, called the insurer, undertakes to make good for the loss of another, called the insured, on payment of a specific sum of money, called premium, to him on the happening of a specified event. Thus, insurance is a cooperative device to spread the loss caused by a particular risk over a number of persons who are exposed to it and who agree to insure themselves against the risk (Vaughan, 2008). Reinsurance on the other hand is a strategy through which one insurance firm (the “reinsurer” or “the ceding company”) enters into a contractual agreement with another insurance firm (the “reinsured”) to indemnify it against part or the entire loss that the latter may sustain under the policies which it has issued to its clients (Pitselis, 2008). As a consideration, the ceding company pays reinsurance premiums to the reinsurer.
Like insurance, the aim of reinsurance is to spread risk. Hence, insurance companies spread their risks and are able to protect themselves against extraordinary or unforeseen losses through reinsurance. For instance, in case of a catastrophic fire at an industrial enterprise the industrial enterprise’s claims may financially devastate an insurance company that covered the risk. According to Munich (2010: 34), “reinsurance enables all insurers to manage their financial burdens to the extent that none is faced with a financial burden that it is not able to pay”.
Reinsurance has been identified as an important component of the insurance industry (International Association of Insurance Supervisors ‘IAIS’, 2012). Furthermore, IAIS has stated that reinsurers reduce volatility of earnings of the insurance companies by absorbing losses that the insurance Companies do not retain on their book or have transferred. The reinsurance business is similar to that of insurance companies, because they enter into contracts with insurance companies to indemnify them against future claims that the insurance companies may have against the policies to which they pay premiums today.
Also, like other business enterprises, insurance companies offer a wide range of finances. But they are unique in their operations because it often leads to the creation of explicit liabilities each time they sell their products. Actually, most of the liabilities of typical insurers are held by their policy holders who are the buyers of the firms’ products. Again, for an insurer’s businesses to succeed, they should not only charge appropriate premiums to cover the risks, but should also provide assurances that claims made by policyholders will be paid expeditiously according to the insurance policies (Lin, Yu & Peterson, 2015; Yang, 2015). That is, an insurers’ success depends on proper rating of policies and prompt payment of claims. This is due to the nature of insurance business, whereby a policy is expected to pay off when the event or peril insured occurs.
There are a number of mechanisms, which can credibly provide assurances that insurance companies will pay claims once a loss occurs such as purchase of reinsurance which is a practice whereby insurers transfer portions of their risk portfolios to other parties known as reinsurers by some form of agreement to reduce the likelihood of paying a large obligation resulting from an insurance claims, and commitment of sufficient capital which can be seen as the projected capital expenditure an insurance company commits to spend on long-term liability such as claim payments, or surplus fund which refers to an alternative source of funds to insurance companies in addition to its reserves and reinsurance, if it needs to pay a higher than expected amount of claims. (Borch, 2010).
According to Blazenko (2006:21), “reinsurance is a form of insurance in which an insurer, known as the reinsurer, accepts part of or all the risks of losses covered by another insurer, known as the ceding company.” This is a transaction whereby an insurer cedes insurance risks and premiums to a reinsurer, enabling the ceding firm to simultaneously reduce the variability of its financial leverage and cash flows (IAIS, 2012). On the basis of this, it could be argued that an insurer’s decision to reinsure is both a capital structure and a risk management decision. Insurers offer policies and collect premiums from policyholders with a promise to pay claims in future when the insured events occur. The settlement of losses for a number of types of insurance may take long periods of time which can stretch to several months or even years after the insured incident or accident has occurred.
In case this risk was reinsured, and during this period of waiting for settlement of the claim the insurance company defaults paying premiums to the reinsurer, or in case the insurer defaults, policy holders may lose all or part of their claims. Therefore, policyholders should be greatly interested in the continued financial performance of insurance companies. A major challenge to policyholders is their inability to diversify their insurance risk through use of many insurers to perfectly monitor the actions of insurance company managers due to the costs involved and their lack of specialized expertise.
Harrington & Niehaus (2010) argue that the cyclical nature of the insurance business and the potential of large catastrophic losses make the reinsurance incentives attractive to stakeholders. Reinsurance therefore enables insurance companies to manage the underwriting residual risks and hence limit huge losses, lower agency costs and alleviate the insurance cycle, and through this, reinsurance reduces the risk of insolvency and enforces insurance firms’ financial viability. Therefore, in the light of this claim, this study is conducted to know whether or not reinsurance significantly influences financial performance of insurance companies in Nigeria.
1.2 Statement of the Problem
A number of works have made reference to the importance of reinsurance in a nation’s insurance market as well as in the larger economy (Obonyo, 2016; Kamua, 2013; Soye & Adeyemo, 2017; Aduloju & Ajemunigbohun, 2017) Although insurance companies manage the risks of other businesses, they also have to mull over the optimal handling of risks, which can be done through reinsurance (Iqbal & Rehman, 2014). Studies reveal that insurers go through some levels of financial risk in the area of underwriting, claim settlements and reinsurance portfolio (Soye & Adeyemo, 2017; Obonyo, 2016; Lee, 2012).
Also, it has been shown that insurers are subjected to a harsh environment once engaged in high-level risk taking that have the potentials to weaken their financial ability to settle claims and thus threaten their survival; and, without returns on their investment, insurance companies find it difficult to profit from the business of insurance (Lin, Yu & Peterson, 2015; Yang, 2015). It is believed that reinsurance contracts can provide some levels of protections for insurance companies against the risk of their own default, especially during financial turbulence, partly because reinsurance providers are said to be knowledgeable in risk management skills, which could assist cedants recover from adverse experience (Cummins, Feng & Weiss, 2012). Those authors are of the opinion that when there exists an unhealthy hedge in the expected value between asset and liability, buying a reinsurance policy can boost “insurers” solvency and make them better able to assume greater risk taking on the side of asset investment. But to date, empirical evidence on this assertion are scarce.
Put it differently, due to the technical nature of reinsurance, empirical studies on its link to performance of ceding companies seems to be scare. However, few studies are either in different countries or on different variables. For example, Chen and Lee (2012) conducted a study on the reinsurance and performance of Taiwan property liability insurance companies and found the relationship between reinsurance and firm’s financial performance to be negative. Chen and Lee (2012) noted that insurers which purchased less reinsurance have higher returns on assets while low firm performance was witnessed among insurance ompanies which have high dependence on reinsurance. In a study on effect of reinsurance on the financial performance of general insurance companies in Kenya, Obonyo (2016) found out that the net cede commission, net claim ratio and net premiums cede had a positive significant effect on the performance of insurance companies in Kenya. Another study by Aduloju & Ajemunigbohun (2017) on reinsurance and performance of ceding companies in Nigeria shown that profitability of the firm is sensitive to change in reinsurance utilisation and that it has a positive relationship with reinsurance utilization. Aduloju & Ajemunigbohun (2017) considered only two financial years, hence, this study will be carried out using the data of nine financial years from 2009 - 2018.
Most of the studies (Obonyo, 2016; Soye& Adeyemo, 2017; Aduloju & Ajemunigbohun, 2017) conducted on reinsurance have attempted to research the influence of reinsurance on individual indicators of financial performance such as capital management, returns on assets, net claim ratios, net premium incomes, underwriting profits and profitability separately, and majority of these studies was not conducted in Nigeria from 2009 - 2018 as considered by this study. This shows that there is a clear gap since empirical studies on reinsurance and it's link on performance of ceding companies seem scare and no study have combines underwriting profit, gross premium incomes and gross claim payments as performance measures from 2009-2018 on this regard.
Therefore, this study seeks to contribute to filling this gap by investigating the impact of reinsurance on the financial performance of ceding companies in Nigeria with emphasis on financial performance indicators such as underwriting profit, gross premium income and gross claim payments from 2009-2018.
1.3 Objectives of the Study
The main aim of this study is to find out the impact of reinsurance on financial performance of insurance companies in Nigeria from 2009-2018. Specifically, the focus of the study is based on the following objectives:
i. to investigate the relationship between reinsurance and underwriting profit of insurance companies in Nigeria from 2009-2018.
ii. to find out the effect of reinsurance on gross premium income of insurance companies in Nigeria from 2009-2018.
iii. to investigate the effect of reinsurance on gross claim payments of insurance companies in Nigeria from 2009-2018.
1.4 Research Question
The following research questions were drawn from the statement of the problem presented above:
i. What is relationship between reinsurance and underwriting profit of insurance companies in Nigeria from 2009-2018?
ii. What is effect of reinsurance on gross premium income of insurance companies in Nigeria from 2009-2018?
iii. What is the effect of reinsurance on gross claim payments of insurance companies in Nigeria from 2009-2018?
The following Null hypotheses are formulated for test;
Ho1: There is no significant relationship between reinsurance and underwriting profit of insurance companies in Nigeria from 2009- 2018;
Ho2: There is no significant effect of reinsurance on gross premium income of insurance companies in Nigeria from 2009-2018;
Ho3: There is no significant effect of reinsurance on gross claim payments of insurance companies in Nigeria from 2009-2018.
1.6 Significant of the Study
The findings of this study will be useful to executive managers of insurance companies by providing the connection between reinsurance and financial performance which will enable them to make better informed decisions on their reinsurance utilization. Again the results of this study will also provide feedback to the reinsured as regards to whether they are benefiting from their reinsurance arrangements in terms of aiding their financial performance. The outcome of the study will inform the National Insurance Commission (NAICOM) and other agencies on how to better regulate the industry in terms of policy as pertains to reinsurance and performance of insurance companies.
This study opens the scope for other researchers in reinsurance field to identify areas for further research. Scholars therefore in the future can research on how reinsurance can be used to ensure better financial and underwriting results of insurance companies in Nigeria. This will enable them to enhance their literature on the financial benefits of reinsurance.
1.7 Scope/Limitation of the Study
This study focuses on the impact of reinsurance utilization on the financial performance of insurance companies in Nigeria with more emphasis on financial performance indicators such as gross premium incomes, underwriting profits and gross claim payments based on reinsurance utilization.
Also, this study is limited on data from thirty-two selected registered insurance companies in Nigeria as published by National Insurance Commission from 2009 to 2018. This is because not all registered insurance companies in Nigeria have reinsurance covers.
1.8 Operational Definition of Terms
i. Cedant: This is a party in an insurance contract who passes financial obligation for certain potential losses to the insurer in return for bearing a particular risk of loss, the cedent pays an insurance premium (Woldegebriel, 2010).
ii. Reinsured: This is the insurance company or an insurer that contracts with a reinsurer (Reinsurance Company) to share all or a portion of its liabilities under insurance contracts it has issued in return for a stated premium. Also called the "ceding company or cedant" (IAIS, 2006).
iii. Reinsurer: A reinsurer is an insurance company that insures the risks of other insurance companies. (Blazenko, 2006).
iv. Financial performance: Financial Performance refers to the degree to which financial objectives of a firm has been accomplished over a given period of time (Choi, 2005).
v. Solvency: This is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. It can also be described as the ability of a firm to meet its long-term fixed expenses and to accomplish long-term expansion and growth (Adams, 2006).
vi. Insurance Claim: An insurance claim is a formal request by a policyholder to an insurance company for coverage or compensation for a covered loss or policy event (Vaughan, 2008).
vii. Leverage: leverage also referred to as gearing is any technique involving the use of debt (borrowed funds) rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost (Adams, 2006).
viii. Underwriting profit: This consists of the earned premium remaining after losses have been paid and administrative expenses have been deducted (Kamua, 2013).
ix. Gross Premium Income: This is a statement of the money that an insurer has earned from premiums and eliminates any money that is or will be paid out elsewhere from those premiums (IAIS, 2006).
x. Retrocession: A retrocession is a transaction in which a reinsurer cedes to another reinsurer (the retrocessionaire) part of the reinsurance the former has assumed (Woldegebriel, 2010).
xi. Retrocessionnaire: A reinsurance company that take retrocession or assumes the risk portfolios of other reinsurance companies (Woldegebriel, 2010).
This chapter presents substantive review of writings in this area of study. The chapter deals specifically with the conceptual reviews, theoretical reviews and empirical reviews of the study.
2.1. Conceptual Reviews
Conceptual framework deals with the presentation of intermediate ideas that attempt to show the possible path to solving a problem based on generally accepted methods, practices and procedures (Uyanga & Etudor-Eyo, 2015).
2.1.1 Meaning and Concept of Reinsurance Programme
International Association of Insurance Supervisors (IAIS) (2006) sees reinsurance contract as “an arrangement between a party known as (re-insurer) and another party (insurer or cedant) to indemnify against losses on one or more contracts issued by the cedant in exchange for consideration (premium). Reinsurance arrangement covers the liability which an insurer had undertaken under its own contract of insurance with its policyholder (Irukwu, 2001). Also, Park (1799) in his study, discussed that: “re-insurance, as understood by the law of England, may be said to be a contract, which the first insurer enters into, in order to relieve himself from those risks which he has incautiously undertaken, by throwing them upon other underwriters, who are called re-assurers”. Munich (2010) sees reinsurance as transaction whereby one insurance company (the“reinsurer”) agrees to indemnify another insurance company (the “reinsured, “cedant” or “primary company) against all or part of the loss that the latter sustains under a policy or policies that it has issued. For this service, the ceding company pays the reinsurer a premium.
Croatian Insurance Act (2013) sees reinsurance as a major financial activity as it allows direct insurance companies to have higher underwriting capacities to engage in insurance business, provide insurance cover and also to reduce their capital costs by facilitating a wider distribution of risks at worldwide level; furthermore, reinsurance plays a fundamental role in financial performance, since it is an essential element in ensuring the financial soundness and the viability of direct insurance markets as well as the financial system as a whole, because it involves major financial intermediaries and institutional investors.
Outreville (2002) defined reinsurance as “the transfer of liability from the primary insurer, the company that issued the insurance contract, to another insurer, the reinsurance company. The business placed with a reinsurer is called a cession of an insurance company. An insurance company’s policyholders have no right of action against the reinsurer, even though the policyholder is probably the main beneficiary of reinsurance arrangements. According to the author, a reinsurance contract therefore deals only with the original insured event or loss exposure, and the reinsurer is liable only to the ceding insurance company”. Similarly, Wehrhahn (2009) sees reinsurance as “a financial transaction by which risk is transferred (ceded) from an insurance company (cedant) to a reinsurance company (reinsurer) in exchange of a payment (reinsurance premium)”. The author affirmed that reinsurers are professional entities that exclusively deal with the activity of reinsurance.
Furthermore, Patrik (2001) posits that the reinsurer reciprocally agrees to indemnify the reinsured for a specified share of specified types of insurance claims paid by the cedant for a single insurance policy or for a specified set of policies. “Reinsurance can be considered as one of the most important capital and risk management tools which are available to the primary insurance companies. The term insurance simply refers to the acceptance of the risk by a company which is engaged in insurance business. The company accepts this risk for consideration called premium” (Swiss, 2002).
Woldegebriel (2010) opines that a professional reinsurance company can be a multi-national organization operating through a subsidiary or branch offices in different countries, or licensing reinsurance brokers or on a direct basis with its ceding companies. The author also established that reinsurance in turn reduces its underwriting risk by purchasing reinsurance coverage from other reinsurers both domestic and international referred as a retrocession and the assuming reinsurer called retrocessinnaire. Reinsurance is one of a number of options or tools to reduce the financial cost to insurance companies arising from the potential occurrence of specified insurance claims; thus, further enhancing innovation, competition, and efficiency in the market place (Patrik, 2001).
2.1.2 Cost and Benefits of Reinsurance Utilization to Insurance Companies
Reinsurance purchase is essentially a capital structure decision. Insurers seek to keep an optimal level of underwriting risk relative to their capitalization level (Kamua, 2013). In the case of large losses, equity holders are only liable to pay losses until the assets of the company have been depleted. If there are remaining losses to be paid, equity holders have the option to declare bankruptcy and default in the remaining losses. Phillips, Cummins, & Allen (1998) noted that policyholders consider the value of the insolvency option when deciding how much they are willing to pay for the insurance contract. To achieve their solvency target, insurers could increase their capitalization by raising new capital or reduce the risk by transferring a part of it to reinsurers. Thus, reinsurance plays the role of a substitute for capital (Hoerger, Sloan, & Hassan, 1990; and Garven & Lamm Tennant, 2003).
With reinsurance contracts, an insurer transfers premiums collected from customers to a reinsurer. In turn, the reinsurer accepts to bear a part of the risk assumed by the insurer. With proportional reinsurance, premiums and claims are shared between the insurer and the reinsurer in the proportion stipulated in the contractual agreement. In addition, the reinsurer pays a “ceding commission” to the insurer to compensate it for the costs of underwriting the ceded business (Kamua, 2013). However, the commission is also determined by the nature and composition of the insured business and by the underwriting results. In non-proportional reinsurance, the reinsurer assumes only the losses that exceed a certain amount, called the retention or priority. In calculating the price of the risk transferred, the reinsurer takes into account the loss experience during the previous years and the expected future losses according to the type of risks involved.
An insurer will accept to pay loading fees over the actuarial price of the risk transferred. The loading fees should correspond to the cost of the marginal capital needed to support the risk. Since the cost and the quantity of the capital needed to support the risk could be different for the insurer and the reinsurer, the transaction could take place without arbitrage. The reinsurance contract is generally negotiated and signed before the beginning of its effectiveness. At that time, the agreement is accepted by both sides and considered as a fair contract. Moreover, loading fees could include the price of insurer’s benefits from reinsurer product development skills and risk management expertise. The reinsurer plays an important role in assessing and underwriting risks, and in assisting insurer’s efforts to handle claims efficiently (Swiss Re, 2004).
An insurer is able to diversify underwriting risk when losses of individual policyholders are statistically independent. In insurance markets where risks are statistically independent, such as automobile collision insurance, the expected losses from a large pool of risks are highly predictable and the loss per claim is moderate. Hence, an insurer will provide coverage for large number of policyholders without having to hold large amounts of costly equity capital relative to the quantity of insurance being underwritten (Doherty & Dionne, 1993).
According to Phillips, Cummins, & Allen (1998), statistical independence is violated when a mega-catastrophe occurs. A single event can cause losses to many policyholders simultaneously. However, the risk of a catastrophe in the U.S. for instance is independent from the risk of a catastrophe in other countries. This provides an economic motivation for a global reinsurance market. The U.S. insurance industry diversifies losses across the world to provide coverage and pay losses in areas such as Florida and California, which have high exposure to catastrophic risks and large concentrations of property values (Phillips, Cummins, & Allen, 1998). Thus, with global diversification, the amount of capital needed by international reinsurers to support catastrophic risks is lower than the amount of capital needed by local insurers.
Insurance markets are subject to cycles, experiencing alternating phases of hard and soft markets (Cummins & Outreville, 1987; Cummins, Harrington, and Klein, 1991; Harrington & Niehaus, 2000; Weiss, 2007). In a hard market, the supply of coverage is restricted and prices rise, whereas in a soft market, coverage supply is plentiful and prices decline. Hard markets are usually triggered by capital depletions resulting from large event losses that cause insurers to re-evaluate their pricing practices and reassess their exposure management. Following a large loss, it is difficult for insurers to raise capital at a relatively low cost. Thus, insurers have the choice between reducing coverage supply, increasing insolvency risk, and purchasing more reinsurance. Reinsurance allows insurers to maintain client relationships without increasing insolvency risk (Kamua, 2013).
However, underwriting cycles characterize both insurers and reinsurers because both of them share the large unexpected losses (Weiss and Chung, 2004; Meier and Outreville, 2006). In soft markets, insurers take advantage of low reinsurance prices and high coverage supply by reinsurers to increase their underwriting capacity. In hard markets, when insurers have the largest need for reinsurance, reinsurers’ capacity is also reduced and reinsurance prices rise, and this could aggravate insurers’ crisis in hard market (Berger, Cummins, and Tennyson, 1992).
In spite of its susceptibility to cycles and crises, the reinsurance market is a global market, and capital markets respond quickly to new capital needs of reinsurers. Following catastrophic losses in 2004-2005, the reinsurance industry raised about $30 billion in new capital in a multitude way: new equity capital for start-up companies ($9.5 billion), seasoned equity issues ($12.5 billion), sidecars ($5 billion), and CAT bonds ($5 billion) (Cummins, 2007). Because of this superior capacity to raise quickly new capital, the reinsurance market responded efficiently to large unexpected losses and reinsurance prices began to soften in late 2006 and early 2007 (Benfield, 2007). Hence, reinsurance alleviates the underwriting cycle and increases the speed of primary insurers to get out of hard market periods.