international journal of creative research and studies

International Journal of Creative Research and Studies

Volume-2 Issue-11, November-2018

INTERNATIONAL JOURNAL OF CREATIVE RESEARCH AND STUDIES www.ijcrs.org

ISSN-0249-4655

Risk Management Practices and Marine Premium Growth of Insurance Firms in Kenya Dr Caren B. Angima* Lecturer, Department of Business Administration School of Business, University of Nairobi Nairobi, Kenya Wakwoba Musungu Alfred Student, Masters in Business Administration School of Business, University of Nairobi, Kenya *Corresponding Author

Abstract An effective risk management program continually identifies, assesses, intervenes and involves fallback planning. The study used a multivariate regression model to investigate the relationship between risk management practices and premium growth of thirty four (34) firms that transact the marine class of insurance in Kenya. Both primary and secondary data were used. The study established that the degree to which various risk management practices affect premium growth of t h e firms varies from one firm to another and that and that risk management practices and premium growth are positively and significantly related. The conclusions were that the main categories of risk management practices used were risk transfer through risk financing and loss retention, using reinsurance, as well as risk control through loss prevention and loss control, all of which were significant determinants of premium growth. The implication is that risk management is a key competitive strategy in a robust market environment if a firm desires to grow its premiums. It is recommended that further research be carried out focusing on all classes of insurance business to confirm these findings and for overall conclusions on the relationship between premium growth and risk management.

Keywords: Risk, Risk management Practices, Premium Growth, Marine insurance, Marine Insurance Firms www.ijcrs.org

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Introduction Risk is the dispersion of actual from expected results or chance of a loss and is an inherent component in any business undertaking. Risk and returns are normally related and any successful organization w ou l d therefore be associated with good management of its p or t f o l i o of risks and their associated rewards (Acharya & Richardson, 2009). Insurers are always guided by the traditional belief of risk meeting opportunity hence carefully venture into underwriting new classes of business, more so for marine insurers. Risk management is a formal process, and fundamental to business conduct hence should be part and parcel of a firm’s processes to help in achieving its overall objectives. (William & Glennings, 1989). Crises emanate from various sources including clients, government, competitors, and natural calamities among others and organizations need to prepare themselves to cope with these. If risk management is inbuilt into insurance firms’ daily operations as well as in their corporate strategy, they should be able to respond to these new challenges. (Lehmann, 2009). For most insurance firms, the primary source of revenue is premium income, with the leading component of this income being gross written premiums, which is also an indicator of net earned premiums. Gross written premiums is total premiums income written before deducting outgoing reinsurance premium (IRA, 2016). Growing premium income could be a dilemma for insurance companies as ideally, they desire that the growth rate exceeds the industry average, but this growth should not be substituted with higher risk clients. On the contrary, an insurer who is too picky and accepts only high quality clients may experience a slower premium growth (D’Arcy and Gorvett, 2004). According to Shimell (2009) although premium revenue is often considered a risk factor it should nevertheless help predict future revenue and earnings growth. According to Cummins (1991), the coverage given under a marine policy include loss or damage of the hull (sailing ship or vessel) on inland waterways or at sea as well as cargo in transit irrespective of the mode of transport. The marine line of insurance carries extreme property and liability dangers especially for those who deal with remote areas and a dearth of historical data (Akerlof, 2009). Risks covered include fire, shipwreck, piracy and related expenses and, any fortuitous physical damage, but excludes particular losses or those occurring under certain circumstances. Such policies will include a "time element" to cover costs associated with delays occasioned by such covered loss.Different kinds of cover with specific exclusions against each are provided under various marine insurance policies (Cummins, 1991).

Literature Review Risk Management Process Risk is a broad term that encompasses everything from reputation, product innovation, market risk and supply chain risk while risk management can be defined as a systematic process that identifies, defines objectives, identifies risk sources, analyzes and evaluates these uncertainties as well as formulates managerial responses that balances between risk and opportunities (Vaughan & Vaughan, 2008). According to Johnson (2001), risk management practices influence organizational success and lead to a proper understanding of the firm’s sensitivity to various risks. Lam (2001) further observes that engaging in risk management in the organization leads to benefits such as reduction in earnings volatility, promotion of job security, maximization of shareholder value and i m p r o v e d financial security in the organization. It can t h u s be s a i d that it would be beneficial for insurance firms to engage in risk management practices to mitigate various risks facing them (McGrew & Bilotta, 2009). The major components of the risk management program include: identification of risk, risk analysis, techniques of managing the risks and, risk monitoring and review (Bandyopadhyay et al.,1999). Since business involves risk, it is necessary for the organization and its stakeholders to understand the risks accepted by the firm in pursuit of www.ijcrs.org

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achievement of its strategic objectives. Risk assessment and strategy development should be coordinated to ensure that there is consistent, efficient and effective risk management by all stakeholders, both internal and external. This process should have mandate and support of top management in order to achieve organizational goals (King, 2001). However, with growth in business operations, it becomes harder to implement effective strategic risk management tools. This is especially so when business operates in multiple locations, becomes more complex and ventures into different lines of business. Managing risk therefore needs better knowledge and appreciation of the risks involved (Faisal et al., 2006). Risk Management Practices The mechanisms that the insurance sector uses in management of risks involve risk control and risk financing. Risk Control Under risk control, losses can be reduced to manageable proportions through loss prevention or control and reduction, or through risk avoidance. Avoiding risk means that a certain loss exposure is never undertaken especially if it has a very high likelihood of resulting into a loss, if improvement is not tenable; or a loss exposure that exists is abandoned (Rejda, 2003). Otherwise if such risks are not avoided, they can lead to bankruptcy of the insurers (Kiochos, 1997). A system of strategies, policies and resources is thus applied by insurance companies so as to avoid such risks (Owen, 1995). Rejda (2003) contends that insurers should avoid some insurance policies, despite their popularity and profitability due to the accumulation of resultant enormous losses / claims by clients. Such policies include; various kinds of disability, children's life policies, and some policies that cover diseases such as cancer. He however further affirms that, avoidance is not possible and practical in all situations but can be useful in a myriad of circumstances. Risk reduction is used where certain risks cannot be avoided completely and must be borne. The insurer tries to reduce their frequency and severity by employing various reduction and preventive mechanisms (Williams & Glenenning, 1989). These measures are particularly related to the nature of the devices utilized in businesses and also involve the human factor. They include safety programmes and loss prevention measures such as in medical care, employee and client training, reduction or minimization of occurrence of fire, installation of sprinklers systems, use of security guards and burglar alarms, reduction of vessel or motor vehicle accidents and strict enforcement of safety rules (Vaughan & Vaughan, 2008). For example, to prevent or reduce the possibility of fire occurring, insurance companies generally recommend some preventive measures that should be taken and would only reimburse financial losses caused by fire. Incidental losses that are intangible such as loss of or destruction of files or valuable information would not be covered as they can be taken care of through other means (Rejda, 2003). Insurers advise and encourage clients to practice good housekeeping habits, like ordering goods from reputable overseas suppliers with good track record or using reputable shipping lines. (Kiochos, 1997). Such advisory services add value in the risk management program, form part of the insurance package and are normally free. Risk Financing Risk financing involves devices that focus on arranging and making funds available to cater for losses arising from residual risks after application of risk control mechanisms. This is done through risk transfer and retention or diversification (Johnson, 2001). To ensure funds are available in the event of a loss, insurers engage in aggressive marketing and prudent underwriting, premised on sound risk assessment and premium rating techniques. The insurance premiums charged should reflect both the expected claims and expenses for www.ijcrs.org

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ISSN-0249-4655

commissions, claim settlement, administrative costs, as well as profit margin and risk taken by the underwriter (Alijoyo, 2004). Under risk retention and/or diversification, special contingency funds are set aside for the purpose of meeting loses. Both Naik (2003) and Ayali (2000), concur that the use of re-insurance, (the transfer of whole or part of a risk to a reinsurer) is the most appropriate mechanism for risk financing as it can lower losses of the original insurer hence leading to its improved financial performance. Premium Growth Premium growth can be achieved in two ways, namely, through increasing the number of policyholders (exposure growth) or by raising the average price o f t h e p r o d u c t s (rate-level growth), both of which have different outcomes and risk implications (Barth & Eckles, 2009). The authors further assert that exposure growth is valuable if the products are appropriately priced. However, considering competition in the market, substantive exposure growth may be a sign of under-pricing. A number of mixed outcomes, both desirable and undesirable may therefore emanate from premium growth, hence the reason for using premium growth as a probable early warning sign of financial impairment (Horvath, 2011). On the other hand, premium growth due to increases in rates may lead to risk reduction if the same risk exposure is being paid for by the same customers. (Harrington & Danzon, 1990). However, if the increased rates alter the mix of customers, the resulting new business can generate unanticipated losses if it is wrongly priced (Selma, 2013). Premium growth through exposure growth, or by rate increase per exposure, or by changing the risk exposure mix are not independent and may affect each other. Price increases may lead to a decrease the number of policies sold unless the product in question is perfectly inelastic. (Cummins & Lewis, 2003). Actually, a company could be increasing the number of policies sold considerably through under pricing with insignificant premium growth, depending on the type of insurance written as well as market conditions. Assuming that there no new customers substituted for veteran ones this would lead to risk reduction since the insurer collects more premiums from exactly the same exposures. (Horvath, 2011). (Harrington & Danzon, 1990). assert that premium growth as a result of changes in the average premium level has to take into account several factors, including historical changes in rating as well as rate plan changes. Also to be considered is whether rate plans that modify average premium levels and change in the range of products and customers mix over time are in existence. Some of these factors may lead to sudden one off changes in average premiums with others causing more regular continual shifts. The one-off shifts effect, if measurable can be accounted for by a direct adjustment to the figures for historical premiums. This direct approach ensures that these changes will not obscure the more gradual continual shifts in overall average premium rates (Tseng, 2007). Related studies in the area among others include Epermanis and Harrington (2006) on abnormal premium growth in relation to financial strength ratings for property/casualty insurers; Omasete (2014) on the risk management and and financial performance of insurance companies in Kenya; Tillinghast-Towers Perrin (2004) on risk management by insurers as essential to creation and improvement of shareholders’ value through better risk-based decision making and capital allocation; and Barth & Eckles (2009) on growth effects on short term changes in loss ratios.

Research Problem Although it is the oldest class of insurance, the marine insurance sector in Kenya contributes only 3.3% of the total gross written premiums hence is still at its infancy (IRA, 2016). Despite the fact that Kenyan imports surpassing exports, this is not reflected in the gross underwritten marine premiums. With the increase in infrastructural projects, importation and exportation of capital assets to and from Kenya it is necessary that www.ijcrs.org

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marine underwriting firms step up their operations in anticipation of increased business. This requires evaluation of all factors that affect premium growth, among which is their risk management practices which encompass underwriting and rating of risks in a competitive manner (Angima, 2017). Additionally, although previous research points to a growing numbers of insurance companies embracing and applying risk management systems, there has been little research work investigating the adoption, drivers and determinants of risk management practices implementation within insurance sector. In addition, limited empirical research has been carried out to gauge the effect of risk management practices on premium growth in the context of insurable risks within the marine class of insurance, hence the focus of this study.

Data and Methodology The study adopted a descriptive research design and targeted all the 34 general insurance firms that underwrite marine insurance class of business in Kenya as at December, 2016. Primary data on risk management practices was obtained by use of questionnaires from the marine Underwriting departments of these companies while secondary data on premium growth rates, was obtained from the annual financial reports of the firms for the period 2011-2015. The risk management practices were measured on a 1 to 5-point Likert scale, with the most favourable response for the practices scored at 5 and the least favourable scored at 1. The dependent variable in this study was average premium growth rate over the five year period while the independent variable was risk management practices represented by risk financing (transfer and retention); and risk control ( risk avoidance and risk prevention / control), measured by the mean scores for the likert scale type questions administered to the respondent firms The following null hypothesis was tested: The relationship between the risk management practices, and premium growth is not significant The linear regression models used to test the hypotheses was: Y = β0 + β1X1 + β2X2 + β3X3 + e Where, Variable Premium Growth Rate (PGR)=Y Risk Financing (Transfer & Retention) (X1) Risk Control- ( Avoidance) = (X2) Risk control ( Loss Prevention / Control) = (X3) α β₁, β2, β3 e

Description / represented by Average Marine PGR of the 5year period that (20112015). Mean Score Risk Financing Mean score for Risk Avoidance Mean score for Risk Prevention and Control Regression Constant or Intercept coefficient for the respective determinants Error term

The responses for risk management practices are reflected in descriptive statistics by use of mean (average score) and standard deviation while regression analysis was used to determine the relationship between the risk management practices and premium growth rate of the firms.

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ISSN-0249-4655

Results and Discussion Descriptive Statistics The response rate was 82.4% and shown in table 1 below is a summary of the descriptive statistics. Results showed that generally, the most adopted risk management tool was risk transfer through reinsurance (mean of 4.50) while the least adopted is risk control through avoidance- where the firms avoid risks in which the level of risk exposure is high and adopt the ones with low exposure (mean 2.36). Table 1: Risk Management Practices Mean Risk Financing (Transfer and Retention) Wholly retains risk without transferring to other insurers/reinsurers for covers of up to KShs1 million without affecting cash flows The company re-insures treaties for amounts that are beyond its retention limits Premiums payable are based on expected claims for the portfolio, certain loadings to cover the risk undertaken by going on cover The company rejects some risks on the basis of higher likelihood of the risk being severe on occurrence The firm conducts risk assessment prior to going on cover and recommends risk improvement measures to the insured The company spreads its risk exposure by insuring different business lines and not concentrating only on one or a few markets

Mean Score Risk (Control)- Avoidance The firm selects the type of risks that it can take and avoids the high exposure ones The firm has benchmarks for identifying and selecting risks that cannot be covered and those that can be insured. The firm has a process to incorporate the impacts of major risk types (operational, strategic, hazard, financial, and legal) into the overall organizational operations The analysis of the clients financial health is multifaceted and includes areas like claims experience, stature in society, profitability, repayment capacity, liquidity solvency and financial efficiency measures which will establish their capacity.

Std deviation

4.11

.737

4.50

.793

3.39

.786

2.39

.916

3.18

.723

3.21 3.46

1.166 .854

Mean

Std Deviation

2.36

1.162

3.00

1.155

3.39

.875

2.93

1.215

2.92

1.102

2.86

.970

3.39

1.227

2.89

1.397

3.75

1.110

4.14

1.297

Mean Score

Risk Control (Loss Prevention and Control) The firm trains its clients through in-house seminars on preventive operational measures that can be taken to minimize the level of risks The company makes suitable recommendation to clients on risk improvement e.g. the routes that should be taken to avoid piracy prone areas The Insured’s supply chain network is considered and reputable service providers like clearing agents and shipping lines are encouraged to increase and secure subrogated insurers’ third party recovery chances The insurance company has measures in place that reduce the gravity/seriousness of a loss after it occurrence The insurance firm communicates the evaluation results openly to all the clients concerned www.ijcrs.org

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3.41

1.200

3.30

1.305

Mean score Overall Mean Score (All Risk Management Practices)

The firm’s establishment of a process to integrate the effects of major risk types (strategic, operational, financial, hazard and legal) into the overall organizational operations is the key risk management practice associated with risk avoidance (mean of 3.39) reflecting adoption to a moderate extent among the insurance firms. The insurance firms’ ability to communicate the evaluation results openly to all the clients concerned is the most used risk management practice with respect to loss prevention and control and adopted to a large extent (mean of 4.14) . the overall mean of 3.30 for all risk management practices implies that the firms have adopted them to a moderate extent while the overall standard deviation (1.305) points to a wide variation in the responses given, implying that the degree to which various risk management practices affect premium growth of t h e firms varies from one firm to another,

Regression Analysis The regression analysis results are shown in Table 2 Table 2- Regression Results: Dependent Variable-Premium Growth Rate; Predictors – Risk Transfer, Risk Avoidance and Loss Prevention /Control a) Model Summary Model

1

R

.954a

R2

.910

Adjusted R2

Standard Error of the Estimate

.074

2330.008

a. Predictors: (Constant), Risk Transfer, Risk Avoidance and Loss Prevention / Control.

b) ANOVA (Goodness of Fit) Model Sum of squares 1 Regression 6249288.137 Residual 1.303E8 Total 1.365E8

df 3 24 27

Mean square 2083096.046 5428940.543

F 2.384

sig .001b

a. Dependent Variable: Premium Growth Rate b. Predictors: (Constant), Risk Transfer, Risk Avoidance and Loss Prevention /Control

c) Regression Coefficientsa Model Constant Risk Financing Risk Avoidance Risk Prevention/Control

B

.439 .583 .434 .762

Std error 1.496 .155 .312 .880

t .002 .703 .132

Sig. .001 .001 .002

.588

.001

a. Dependent Variable: Premium Growth Rate

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Table 2 (a-c) shows the regression results with premium growth rate being predicted by the risk management practices of risk transfer, risk avoidance and risk control through prevention/control. The model reveals a significant statistical relationship between these practices and premium growth rate (P>.05) with 𝑅̅2 = .074, F (3, 24) = 2.384, with a standard error of 2330.008. The risk management practices of transfer and control account for 7.4% of the variation in premium growth rate. Model coefficients as reflected in Table 2(c) show risk control through prevention is the most influential predictor (β = .762), p>0.05), followed by risk financing through transfer (β = .583), p>0.05), and risk control through avoidance (β = .434), p>0.05). The null hypothesis was rejected and the resultant model is therefore specified as: Y = 0.439 + 0.583X1 + 0.434X2 + 0.762X3 Where; Y = Premium growth: (Average percentage growth rate of Marine premium sales volume over the last five years) X1= Risk Financing (transfer and retention) X2 = Risk Control (avoidance) X3= Risk Control (prevention & control) The above means that if all the independent variables at he l d c o ns t a n t ( zero), the marine premium growth for the firms will be 0.439 and holding all other independent variables constant, a unit increase in risk financing will lead to a 0.583 increase in the marine premium growth of the insurance firms. On the other hand, keeping all other variables constant, a unit increase in the company’s risk avoidance will lead to an increase of 0.434 in the marine premium growth of the insurance firms, while a unit increases in risk control through prevention and control will lead to a 0.762 increase in marine premium growth of the insurance firms in Kenya.

Discussion of Results Descriptive statistics show that the marine insurance sector relies mostly on the risk transfer financing methods (transfer and retention) of risk management, which is expected in their line of business due to the cyclical nature of the insurance business and the potential of large catastrophic losses which makes risks in this area enormous. Risk control through prevention and avoidance are used to a lesser extent, possibly due to the limited marine insurance market and low marine insurance penetration levels which imply a limited clientele making avoidance of risk untenable. The findings support both Naik (2003) and Ayali (2000), who posited that through the use of re-insurance practice, insurers can apportion risks to those parties who can most suitably to bear them thus reducing the losses of the ceding insurer hence improve premium retention rate and thus performance. Reinsurance also improves capacity for accessing and underwriting more risks which can indirectly lead to higher premium growth rates. On risk management practices and premiums growth rate, the findings depict a near perfect positive and significant the relationship, among the insurance firms in the marine class of insurance in Kenya, as evidenced by the high coefficient of multiple determination (R2= .910; p= .001). This implies that those firms that adopt appropriate risk management practices would perform better in terms of growth in premiums than those that do not. The insurance companies thus avoid or reduce the possibility of being overwhelmed by the cash required to settle their claims, partially met from premium income, thus enhancing its premium volumes. www.ijcrs.org

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These findings support those of Alijoyo (2004) who established that risk retention, risk transfer and diversification could be used as measures of loss financing in insurance companies.

Conclusions and Recommendations It is noted from the findings that the experiences of premium growth of a particular firm would depend on the companies’ degree of risk management practices adopted. It is therefore in the interest of insurers, more especially the marine insurance ones, to mitigate against risks of premium growth by making correct application of their risk management practices through engaging in changes in business mix (through diversification), changes in target markets or distribution, (using loss prevention or control); abandoning specific markets and / or and products (through avoidance) or reducing coverage; and / or making changes in governance or process controls (through loss reduction and control) Although the study covered the marine insurance class only, this finding is useful to the insurance sector in Kenya with respect to risk management adoption in their business operations. In addition, some of the risk management practices cut across all class of insurance and it is sometimes impossible to attribute the growth of marine premiums to these practices so it is imperative that a study of this magnitude should include all classes of insurance in future. The need for further research into this aspect of risk management is further compounded by the fact that the risk management discipline is a relatively new phenomenon in Kenya. Additionally, the linear regression model presumed that only risk management practices influence the premium growth of the marine class for insurers in Kenya. However, several other factors that may have an influence on premium growth such as underwriting, marketing, claims management and managerial competence among others were not considered in this study.

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