ABSTRACT
Risk if not well managed could lead to collapse for most organisations 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. The objective of the study was to establish the effect of risk management practices adopted by Nigerian insurance companies on the financial performance of these companies. An exploratory research design was used for the study, with the target population being the 49 registered insurance companies in Nigeria. The study used both primary and secondary data. Primary data was collected through questionnaires with 44 insurance companies giving a response. Secondary data was collected by use of desk search techniques from published reports as well as data from financial statements maintained by IRA for a period of five years from 2008 to 2012. Content analysis was used to analyse qualitative data while the quantitative data was analysed using SPSS. Regression analysis was also used in the study. The results were presented using tables and charts. The study established that a majority of insurance companies in Nigeria had adopted risk management practices in their operations and that this had a strong effect on their financial performance. Risk identification was found to be the most significant in influencing financial performance, followed by risk mitigation, risk management program implementation & monitoring and risk assessment & measurement respectively. This study concludes that there is a positive relationship between the adoption of risk management practices and the financial performance of insurance companies in Nigeria. The study recommends that insurance companies in Nigeria should adopt a multifaceted approach to risk management in order to derive greater benefits from their risk management efforts. Further, Nigerian insurance companies should follow current international leading practice by adopting Enterprise Risk Management (ERM) which incorporates other insurance risk quantification models. This will ensure that the companies remain afloat during such times of strict regulatory regimes such as solvency 11 and Basel.
1.1 Background to the Study
Risk management is an important discipline in business especially the insurance business. Recently, businesses put great emphasis on risk management as this determines their survival and business performance. Insurance companies are in the risk business and as such cover various types of risks for individuals, businesses and companies. It is therefore, necessary that insurance companies manage their risk exposure and conduct proper analysis to avoid losses due to the compensation claims made by the insured. However, Kadi (2003) observes that most insurance companies cover insurable risks without carrying out proper analysis of the expected claims from clients and without putting in place a mechanism of identifying appropriate risk reduction methods.
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).
In recent years, insurance companies have increased their focus on risk management. Meredith (2014) suggests that there should be careful judgement, by management of insurance companies, of insurable risks in order to avoid excessive losses in settling claims. It follows that risk management is an important factor in improving financial performance (Okotha, 2003). According to Standard and Poor’s (2013), insurers, as risk-bearing institutions can, and do, fail if risks are not managed adequately.
The central function of an insurance company is its ability to distribute risk across different participants (Merton, 1995). Saunders and Cornett (2008), also state that modern insurance companies are in the risk management business. They discuss that insurance companies undertake risk bearing and management functions on behalf of their customers through the pooling of risks and the sale of their services as risk specialists. This indicates that management of risks should take the centre stage in the operations of insurance companies.
1.1.1 Risk Management
Risk is defined as the uncertainty associated with a future outcome or event (Banks, 2004). Further, risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or future event (Douglas and Wildavsky, 1982). Rejda (2008) defines risk management as the process through which an organization identifies loss exposures facing it and selects the most appropriate techniques for treating such exposures.
In risk management, a prioritization process must be followed whereby the risk with the greatest loss and greatest probability of occurrence is handled first and risks with lower loss are handled
later (Kiochos, 1997, and Stulz, 2003). There is however, no specific model to determine the
balance between risks with greatest probability and loss and those with lower loss, making risk management difficult. Banks (2004) notes that the key focus of risk management is controlling, as opposed to eliminating, risk exposures so that all stakeholders are fully aware of how the firm might be impacted.
Insurance companies borrow heavily from the risk management process suggested by Kiochos (1997). According to Kiochos (1997), the risk management process involves four steps: identifying potential losses, evaluating potential losses, selecting appropriate risk management techniques for treating loss exposures and implementing and administering the risk management program. Kimball (2000) concurs that risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it and mitigation of risk using managerial resources. Generally, a proper risk management process enables a firm to reduce its risk exposure and prepare for survival after any unexpected crisis.
1.1.2 Financial Performance
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.
Solvency measures give an indication of a firm’s ability to repay all its indebtedness by selling all of its assets. It also provides information about a firm’s ability to continue operating after undergoing a major financial crisis. Quach (2005) states that solvency measures the amount of borrowed capital used by the business relative to the amount of owners’ equity capital invested in the business as an indication of the safety of the creditors interests in the company.
Liquidity indicates a firm’s ability to meet its financial obligations as and when they mature without disrupting the normal operations of the business. According to Quach (2005), liquidity can be analysed structurally and operationally. Further, operational liquidity refers to the cash flow measures while structural liquidity refers to the composition of the balance sheet.
The incidence and relative magnitude of internal or external disruptions to business activities from risk events also vary considerably across firms depending on the nature of activities and the sophistication of internal risk measurement standards and control mechanisms. While companies should generate enough expected revenues to support a net margin that absorbs expected risk losses from predictable internal failures, they also need to hold sufficient capital reserves to cover the unexpected losses or resort to insurance (Zsidison, 2003). This ensures that losses do not impact negatively on the firm’s financial performance.
1.1.3 Risk Management and Financial Performance
The main focus of risk management has mainly been on controlling and for regulatory compliance, as opposed to enhancing financial performance (Banks, 2004). However, this risk management often leads to enhanced financial performance as regulatory compliance and control of risks enables the organization to save on costs. Banks (2004) further suggests that by
managing risks, the managers are able to increase the value of the firm through ensuring continued profitability of the firm.
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.
In the 21st century has seen great efforts to risk management. Babbel and Santomero (1996) note that insurers should assess the various types of risks they are exposed to and devise ways of effectively managing them. They further suggest that insurers should accept and manage at firm level, only those risks that are uniquely a part of their services. This will reduce the risk exposure. Stulz (1984) suggested that risk management is a viable economic reason why firm managers, might concern themselves with both the expected profit and the distribution of firm returns around their expected value, hence providing a rationale for aligning firm objective functions in order to avoid risk.
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.
Meanwhile, risk management has been linked with shareholder value maximization proposition. Ali and Luft (2002), suggested that a firm will only engage in risk management if it enhances shareholder value; Banks (2004), contributed that it is important for each firm to retain and actively manage some level of risk if it is to increase its market value or if the probability of financial distress is to be lowered; Pagano (2001), confirms that risk management is an important function of insurance institutions in creating value for shareholders and customers.
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. This study hopes to come up with an expected positive relationship between risk management and performance of insurance companies.
1.1.4 Insurance Companies in Nigeria
According to Insurance Regulatory Authority, there are 49 insurance companies in Nigeria. Among the 49 insurance companies, 23 are life insurance companies and 26 are purely non-life insurance companies while the total number of general insurance companies is 37 (IRA, 2014). Out of the 23 life insurance companies, 16 companies also engage in general insurance business. This implies that there are 7 pure life insurance companies. The IRA is the industry regulatory body which is mandated to supervise and regulate the insurance industry players. The industry has also established self-regulation through the Association of Nigeria Insurers (AKI).
There are many challenges facing the insurance industry including structural weaknesses, fraud by both clients and employees, high claims, delays in claim settlement, delayed premium
collection, lack of liquidity leading to collapse of some firms, low economic growth, poor governance, low penetration of insurance services and industry saturation.
Over the past decade, at least 9 insurance companies have suffered and collapsed due to the above risks. The many risks and challenges facing the insurance industry in Nigeria have prompted the insurance regulatory body, IRA, to establish a comprehensive risk management guideline for the insurance sector, effective June 2013.
1.2 Research Problem
Insurance companies are in the core business of managing risk. The companies manage the risks of both their clients and their own risks. This requires an integration of risk management into the companies’ systems, processes and culture. Various stakeholders pressure their organizations to effectively manage their risks and to transparently report their performance across such risk management initiatives. Banks (2004) argues that some risks can and should be retained as part of the core business operations and actively managed to create value for stakeholders, while others should be transferred elsewhere, as long as it is cost effective to do so.
According to Stulz (1996), some risks present opportunities through which the firm can acquire comparative advantage, and hence enable it to improve on financial performance. Generally, review of the literature on risk management seems to suggest that better risk management practices result in improved financial performance of the firm. By linking risk management and performance, insurance firms can more effectively and efficiently understand the value of implementing a risk management framework.
A study by Aon 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 financal 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 number of studies have been conducted on risk management by companies in Nigeria but little has been studied on Insurance companies. A study on the effect of risk management practices on the financial performance of commercial banks in Nigeria by Mwangi (2010) showed evidence that risk management and the related practices are considered significantly important to the operations and financial performance of these commercial banking institutions. The study also found that some risk management practices have a greater significance on financial performance than others, that is, the existence of a risk management policy and the integration of risk management in setting of organizational objectives were considered to be the key risk management practices that had a direct effect on financial performance.
Kinyua (2010) assessed risk as a component of corporate strategy in selected life insurance companies in Nigeria and found out that insurance companies faced competitor, regulation and de-regulation risk and industry economics and recommended that insurance companies should deploy strategic planning tools to give the firms an all-inclusive perspective of strategic planning. Njoroge (2013) also conducted a research on the strategic risk management practices by AAR Insurance Nigeria Limited showed that reputational risk is significant in insurance
companies. The study emphasized the importance of risk management in insurance business.
This study on the relationship between the various risk management practices adopted by the companies in Nigeria and their financial performance was aimed at addressing the challenge of ever emerging risks within the sector. It was an attempt to critically examine the various practices through which insurance companies manage the various types of risks that they face, and determine if there was any relationship between the practices and the financial performance of these companies. The study, therefore, sought to fill the gap in knowledge about the possible existence of a relationship between risk management practices and financial performance by insurance companies in Nigeria and the nature of the relationship.
1.3 Research Objective
The research objective for this study is to determine the relationship between risk management and financial performance of insurance companies in Nigeria.
1.4 Value of the Study
This study will be significant to insurance companies, general public, students and the insurance regulators as it will offer valuable contributions from both a theoretical and practical perspective. Theoretically, it will contribute to the general understanding of risk management practices and their effect on financial performance.
The study will enable Insurance companies in Nigeria to improve their risk management process and to adopt efficient strategies to improve firm financial performance through the risk management processes. This will enable the insurance companies to perform better and to grow their businesses and maintain a competitive advantage.
Apart from benefiting the insurance companies, the general public will benefit from the study through improved insurance services and better management of risks. This will result to affordable rates of insurance premiums and reduction in levels of non-payment and fraud.
The study will be helpful to the government in setting regulations on insurance practices in Nigeria through the IRA and safeguarding the resources of the country. Lastly, the study will add to the existing body of knowledge on risk management to benefit academicians and aid further research on risk management in the insurance sector and the financial sector.