CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The insurance industry plays a crucial role in achieving sustainable growth of an economy by facilitating financial security, capital formation, and funding development initiatives, as well as promoting trade and commerce (Authority, 2017). Despite the vital role it plays, the insurance sector has been recording poor performance globally. In the US, insurers have been registering underwriting losses, decreasing premiums, and an overall decline in net income. In Europe, there has been a negative effect of the continued low-interest-rate environment on the insurance industry, which has led to poor investment returns. In Africa, return volatility and underwriting losses have been experienced across all countries. Insurance penetration is also low averaging 3% compared to a world average of 6%. Africa’s life insurance premiums have also stagnated over the years (Re, 2016).

In an ever dynamic and uncertain world, insurance firms continuously face risks that emerge in all fields conceivable. It is thus extremely hard, if not impossible, for an insurance firm to triumph unless proper risk mitigation measures are put in place. The emergence of pandemics such as the recent COVID-19 has impacted and continues to adversely affect the performance of insurance firms globally. COVID-19 has increased challenges to the sector, which include limitations inoperations, financial distress and regulatory issues (Baumann, 2020). Stock returns in various countries, especially in developing countries, have been negatively affected by COVID-19 thus negatively affecting the performance of insurance firms (Farooq et al., 2021). In China, the impact of COVID-19 has led to decrease in insurance premium income, lowered the growth rate ofpremium, decreased the insurance depth and insurance density (Wang et al., 2020). In Kenya, COVID-19 has adversely impacted the insurance firms through decreased returns from funds invested in capital markets, decrease in premiums and increase in claims in some insurance classes like medical (Authority, 2020). Risky decisions are thus necessary for every institution, and a firm may not realize its objectives without taking risks (Fama & MacBeth, 1973; Mushafiq

et al., 2021). Risk is the possibility that an event will occur and adversely affect the achievement of objectives, creates financial loss, and arises from uncertainties of given situations plus certainties of exposing oneself to such situations (Shafiq & Nasr, 2010). The risk from the financial service sectors like the Insurance firms has contributed to large-scale bankruptcies, institution failures, government intervention, and rapid consolidation (Quon et al., 2012). The major risks facing the insurance firms are credit, liquidity, market risks, and operational risks (OECD, 2014)

The persistence of risks and their effects in the insurance industry prompted the creation of regulatory bodies to oversee the performance of insurance companies and come up with policies and guidelines that assist in mitigating the risks. The U.S. National Association of Insurance Commissioners (NAIC) was established to offer standard-setting and regulatory support to all states. In Europe, the European Insurance and Occupational Pension Authority (EIOPA) is mandated to promote a sound regulatory framework and supervision of the insurance industry. In South Africa, the insurance sector is supervised and regulated jointly by Prudential Authority (PA) and Financial Sector Conduct Authority (FA). In Kenya, the Insurance Regulatory Authority (IRA) was established to develop, supervise and regulate the insurance sector. The efforts made by the various regulatory bodies to ensure insurance firms put in place proper risk management practices have, however, not fully mitigated cases of financial distress or failures in insurance firms. Some of the firms that have had financial distress in the recent past include AIG, Conseco, Executive Life Insurance Company, and Penn Treaty Network America Insurance, among others in the USA. In Europe, some of the firms that have collapsed include Horizon Insurance, Enterprise Insurance, Alpha Insurance, Qudos Insurance and Gable Insurance. In Kenya, there have been cases of customer complaints due to the inability of insurance firms to honor customer claims. Some insurance firms were also put under statutory management for instance, United Insurance, Blue Shield Insurance, Concord Insurance, and Standard Assurance (Authority, 2017).

The continued failures of insurance firms have motivated studies to examine the effectiveness of the various risk management guidelines and risk management practices adopted by insurance firms. The results of the studies are, however, inconclusive and give mixed results. Most of the studies have also focused on enterprise risk management practices, which include risk identification,risk analysis, risk monitoring, and risk management committee (Santomero & Babbel, 1997; Wang & Faber, 2006; McShane et al., 2011; Akotey et al., 2011; Hoyt & Liebenberg, 2011; Eckles et al., 2014; Jabbour & Abdel-Kader, 2016; Kokobe & Gemechu, 2016;

Nguyen & Vo, 2020), while minimal efforts have been made to analyze the effect of the various risks on the financial performance of insurance firms. The studies also did not adequately reveal the strategy adopted in managing the specific risks and the effect of those risks on the performance of insurance firms.The major reason of all established business is profit as they meet human demonstrable needs and want, and continue to dominate the market, but every economic activity is faced withboth internal and external risks.

At times, these risks involve noticeable losses that could deprive a profit-making company from surviving in the market if effective management is not established. Considering the increasing in risks in organizations, managing risk is a matter of necessity. Risk management is the total process of identifying, controlling and minimizing the influence of uncertain events. This days, businesses put great emphasis on hazard administration 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) stated 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 behavior of managers.

 A robust hazard administration framework can help organizations to reduce their exposure to risks, andenhance their financial performance (Iqbal and Mirakhor, 2007). Further; Mikes and Kaplan(2014) argued that “the selection of particular risk tools tends to be associated with the firm‟s calculative culture and the measurable attitudes that senior decision makers display towards theuse 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. «Lately, insurance companies have

increased their focus on hazard administration. Meredith (2014) advised that there should be careful judgment, by management of insurance companies, of insurable risks in order to avoid excessive losses in settling claims. It follows that administration of hazard is an important factor in improving financial performance (Okotha, 2003). Sanusi (2010) pointed out that “in recent yearsexcessive credits and financial asset growth went unchecked. Risk, in insurance terms, is the possibility of a loss or other adverse event that has the potential to interfere with an organization‟s ability to fulfill its mandate, and for which an insurance claim may be submitted”.

According to Christopher, and Peck (2004) “as risk-bearing institutions can, and do, fail if risks are not managed adequately”. The central function of an insurance company as observed by Merton (1995) is its‟ ability to distribute risk across different participants. Saunders and Cornett (2008), also state that “modern insurance companies are in the administration of hazards‟ business. They discuss that insurance companies undertake risk bearing and managementfunctions 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 be focused on in the running of insurance companies. Management of various financial risks is the center stage of the insurance industry. Risk management, can be defined as risk pooling, transfer and indemnification in order to reduce the costly financial loss evolving from probabilistic occurrence and volatility. Skipper (1997) opined that “this fundamental aspect of insurance through the structured administration of hazard process involves identifying the exposures toaccidental loss, evaluating alternative techniques for treating each loss exposure, choosing the best alternative and monitoring the results to refine the choices”. According to Curak and Loncar (2008), “in the process of making decision on underwriting risk, insurance companies gather relevant information on risk factors and assess risk which reflects in the price of risk (premium) and the policy conditions”.

According to Levine (2004), “few studies have shown that insurance activities, as ameans of risk transfer and indemnification, contribute to economic growth by promoting financial stability, allowing different risks to be managed more efficiently, encouraging theaccumulation of new capital and helping to mitigate losses as well as the negative consequences that random shocks may have on capital investment in the economy”.Rejda (2003) stated that “risk management means to a process of identifying loss exposures faced by an organization and selecting the most appropriate techniques for treating these particular exposures effectively.

There are many techniques available for insurance companies to manage risks including; loss financing, risk avoidance and loss prevention and control”. Ingram (2006) observed that insurance refers to a form of risk transfer where one party (the insurer) undertakes to indemnify the other (insured) in the event of an insured risk taking place in consideration of a premium.

1.2 Statement of the Problem

The insurance industry is a vital component of modern economies, providing financial protection to individuals and businesses against various risks. However, the industry’s performance is heavily influenced by the effectiveness of risk management practices employed by insurance companies. Effective risk management is crucial for insurance companies to minimize potential losses, maintain solvency, and enhance their competitiveness in the market. Despite the significance of risk management, many insurance companies continue to experience poor financial performance, which can be attributed to inadequate risk management practices.

The problem of inadequate risk management in the insurance industry is multifaceted. Firstly, insurance companies often struggle to accurately assess and price risks, leading to potential losses and decreased profitability. Secondly, the increasing complexity of risks, such as climate change and cyber threats, requires insurance companies to adopt more sophisticated risk management strategies. Lastly, the regulatory environment is becoming increasingly stringent, with regulatory bodies demanding greater transparency and accountability from insurance companies.

The consequences of poor risk management can be severe, including financial losses, damage to reputation, and even insolvency. For instance, a study by the International Association of Insurance Supervisors (IAIS) found that inadequate risk management was a major contributor to the collapse of several insurance companies in the past decade (IAIS, 2020). Therefore, there is a pressing need to investigate the effects of risk management practices on the performance of insurance companies and identify effective strategies for improving risk management in the industry.

The insurance industry’s performance is heavily influenced by the effectiveness of risk management practices employed by insurance companies. Effective risk management is crucial for insurance companies to minimize potential losses, maintain solvency, and enhance their competitiveness in the market. However, many insurance companies continue to experience poor financial performance, which can be attributed to inadequate risk management practices.

1.2.1 Research Questions 

1.2.1.1 Main Research question

How do the risk management practices affect the financial performance of insurance companies Bamenda?

1.2.1.2 Specific research questions  

1) how does the reinsurance affect the financial performance of insurance companies in Bamenda?

2) How does the risk evaluation affect the financial performance of insurance companies Bamenda?

3) How does the risk evaluation affect the financial performance of insurance companies in Bamenda

1.3 Objectives of the Study

1.3.1 Main research objective

To examine the relationship between risk management practices and the performance of insurance companies.

1.3.2 Specific research objectives

1) TO investigate the impact of diversification on the financial performance of insurance companies in Bamenda

2) To assess the effect of reinsurance on the financial performance of insurance companies in Bamenda

3) To examine the effect of risk evaluation on the financial performance of insurance companies in Bamenda