Determinants of insurance companies

Insurance companies provide unique financial services to the growth and development of every economy. in Ethiopia, the business of insurance plays significant intermediary roles in terms of risk transferring, enhancing private investment, creation of job opportunities and ensuring various development related projects.

For insurance companies to be sustainable in the competitive globalized environment, earning profit is a pre requisite. in the absence of profit, insurers can’t attract outside capital so as to meet their objectives.

The profitability of insurance companies can be affected by a number of factors such as age, size, leverage ratio, premium growth, capital growth, tangibility ratio, liquidity ratio, loss ratio, market share, GDP growth and inflation rate.

Some of these factors might have a positive impact on the insurers’ profitability while others could have a negative effect. Furthermore, some of these factors that affect insurers’ profitability could be under the control of the insurers’ management ȋinternal factorsȌ whereas others might be out of its control ȋexternal factorsȌ.

Understanding the internal and external factors that can have an impact on the profitability of insurers is essential not only for the insurance managers and supervisors but also for policy makers and regulators. Therefore, the purpose of this paper is to clearly identify the key determinants of profitability of insurance companies in the country.

Operational definitions of independent variables

In this study, the return on assets ȋROAȌ is used as a measure of insurance companies’ profitability against which various internal and external variables were regressed. )nternal variables are those that managers of insurance company have control over them.

In another words, these are factors that are often influenced by policies and decisions of the insurers’ management. External variables are those that are beyond the control of management of insurance companies. The operational definitions of those variables are provided below;

Insurer’s size [isz]

Size of an insurance company is one of the most important variables considered by the study. Because it is too difficult to precisely measure the size of insurance companies, then the logarithm of total assets is used as a proxy for insurers’ size.

The main reason for considering insurers’ size as a major determinant of profitability is that firstly, large insurers usually have greater capacity for dealing with adverse market fluctuations than smaller ones and the second is that insurers with large size can take advantages of economies of scale in terms of labour cost.

Regardless of the above facts, however, there is no consensus among the different researchers as long as the relationship between size of insurers and profitability is concerned in the literature. As a result, the sign of insurers’ size and profitability is subject to further empirical study.

Leverage ratio [Lvr]

the leverage ratio of an insurance company is defined as the ratio of debt to equity. )t indicates the amount of debt used to finance the assets of a given firm. An insurance company with significantly more debt than equity is considered to be highly leveraged.

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 it is further increased beyond that optimum level.

For instance, Renbao and Wong ȋʹͲͲͶȌ stated that leverage beyond the optimum level could result in higher risk and low value of the firm. (arrington ȋʹͲͲͷȌ also stated that the relationship between leverage and profitability has been studied extensively to support the theories of capital structure and argued that insurance companies with lower leverage will generally report higher return on assets ȋROAȌ. Therefore, the leverage ratio is expected to have a negative relationship with profitability.

Capital adequacy ratio [cpa]

this refers to the excess of the value of assets over that of libilites of insurance companies. In the context of finance literature, equity to asset ratio is used as a proxy for capital adequacy. It is an important indicator of the financial strength of an insurer and also shows its ability to survive in the long run.

Insurance companies with greater equity to asset ratio are considered to be financially more sound and thereby capable of attracting various policyholders. )n another words, insurance companies with higher capital adequacy ratio are relatively assumed to be safe in times of loss and bankruptcy.

On the other hand, the higher the ratio of equity to asset of insurers, the lower is the risk and this could pave a way to increase their credit worthiness. Consequently, insurers will have lower cost of funding.

Furthermore, insurance companies with higher equity to asset ratio will have less demand to raise funds from external sources. (owever, it is very difficult to confirm what relationship exists between equity to asset ratio and profitability and as a result, it is subject to empirical study.

Liquidity ratio

this refers to the ability of an insurer to meet its short term obligations when it is due. )t is commonly measured by the ratio of current assets to current liabilities. It also shows the ability of an insurer to convert its assets in to cash as quickly as possible.

An insurer can use liquid assets in order to finance its activities and investments in times when there is less availability of external sources of funds. Low liquidity ratio indicates that an insurer is facing difficulties in meeting its short term obligations.

On the other hand, an extremely high ratio of liquidity could also mean that the insurer is keeping idle cash that could have generated income by investing in profitable areas. Therefore, this makes the sign of liquidity ratio and profitability to be unpredictable and consequently, subject to further investigation.

Loss ratio

is the ratio of total losses incurred ȋpaid and reservedȌ in claims plus adjustment expenses divided by the total premiums earned. This ratio is one of the most important profitability indicators for insurance companies.

Loss ratio, which is also expressed as the underwriting risk in the relevant literature, shows the effectiveness of the underwriting activities of insurance companies. In this study, loss ratio is calculated by dividing the incurred claims with the earned premiums.

Insurance companies that consistently experience high loss ratios may be in bad financial health. It is an indication that they are not collecting enough premiums to pay claims, expenses, and still make a reasonable profit.

Accordingly, it is expected that loss ratio will have a negative impact on the profitability of insurance companies.

Market share

market share is measured by the ratio of an insurer’s total assets to the total assets of the insurance sector as a whole. It constitutes how much is the percentage of the asset of a given insurance company in comparison to the total asset of the insurance industry.

The higher the percentage of an insurer’s asset to the total asset of the insurance sector, the greater is the market share and thereby better profitability. (owever, not all studies have found an evidence that support market share and profitability are always positively related. As a result, the anticipated sign is subject to empirical examination.

Real GDP growth rate

this reflects the economic activities and level of development of a particular country over a specified time period, usually a year. It is one of the most primary macroeconomic indicators which is used to measure the economic health of a country.

Poor economic conditions can worsen the quality of the finance portfolio, thereby reducing profitability. )f GDP grows, the likelihood of selling insurance policies also grows and insurers are likely to benefit from that in form of higher profits.

Maja ȋʹͲͳʹȌ also studied that GDP growth positively affects insurers profitability i.e. growth of overall economic activity encourage demand for insurers services and indirectly result in harvesting higher profit. Therefore, it is expected that growth rate of GDP will have a positive impact on insurers’ profitability.

Inflation rate

Based on Peter ȋͳͻͻʹȌ, the association between inflation rate and insurance companies’ profitability relies up on the nature of inflation. i.e. whether the inflation is anticipated or unanticipated. Therefore, the expected impact of inflation up on insurers’ profitability is subject to further empirical study.

Location: Indonesia