LIFE INSURANCE CONTRACTS WITH EMBEDDED OPTIONS: VALUATION, RISK MANAGEMENT, AND REGULATION

CHAPTER ONE

INTRODUCTION

1.1   Background

Profitability can be defined as the capability of a firm to generate or earn profits. It indicates the earning power and business success of a corporation (Kimmel, Weygandt, & Kieso, 2012). The main role of insurance firms is pooling the resources of many individuals with similar risks and ensures that the few that experience loss are shielded. Owners of the insurance firms wish to get sound returns on their investment. Creditors also are curious about the profit as they will wish to understand whether or not the corporate will meet its financial obligations. Regulators like Insurance Regulatory Authority (IRA), Central Bank of Nigeria (CBK) and Association of Nigeria Insurers (AKI) could also be concerned about levels of adherence to rules and regulations while seeking to notice any signs of financial distress and malpractices and prescribing timely remedial action. Tax authorities like KRA could also be interested in knowing whether insurance firms fulfill their fiscal obligations by promptly paying taxes. Due to the large number of stakeholders interested in the overall fiscal performance and in particular the profitability of insurance firms, it is vital that insurance firms earn satisfactory profits. Mwangi & Iraya (2014) advance that good performance of insurance firms is essential owing to the vital role that these entities play in the economy.

There is absolutely no business that can be profitable minus measured risk taking and effective risk management. Consequently, risk management should be a core function of businesses although approaches could also be totally different. Within the insurance

business, there are two schools of thought of risk management; alternative approach and silo approach. Silo approach manages risk in isolation and while alternative approach controls risks in a singular and holistic framework. Owing to high levels of risk within the general insurance in several countries, insurance firms have resorted to the employment of the silo approach. This led to the separation of general insurance from life insurance in order to tackle risk in general insurance in isolation (Nocco & Stulz, 2006).

Even as managers of insurance companies try to boost profits, they ought to think of the risks faced in pursuit of these profits. If an insurance underwriter is in a position to manage its risks well it will increase its profit. Williams, Bertsch, Dale, Iwaarden, Smith & Visser (2006) outlined that: “Risk management aims to provide decision-makers with a systematic approach to coping with risk and uncertainty.” LAs and GIs are exposed to totally different risks as they do not underwrite similar risks. This distinction in risk exposure affects the profit of the two insurance models in different ways. In essence, the two models are not expected to make similar profits and these profits will depend on how well they manage the risks they face. This study aimed to evaluate the profitability of insurance firms doing business in Nigeria based on their line of business for nine quarters 2014-16.

1.1.1   The Concept of Profitability

 Profitability refers to the capability to create profits in each and every business activity of a firm. It shows how well the management will generate profit as a result of utilizing all resources obtainable in the marketplace. Harward & Upton, (1961) say that profitability is an investment’s ability to earn revenue from its usage. Typically, ‘Profit’ and ‘Profitability’ have been sometimes used interchangeably. Nonetheless, in reality, there's a big distinction between these two. Profit is absolute but profitability is relative. In spite of this, they’re closely linked, and in addition, are mutually interdependent. They also have separate roles in the world of business. Profit is the total financial gain attained by the enterprise throughout a specified time period, whilst profitability is the operative efficiency of a business. It’s ability of an entity to earn sufficient return on capital and staff employed in business operations. Companies that have the same profits might vary in profitability. Profit in the two separate entities could be identical, but their profitability varies based on the size of investment.

In a majority of research papers that are similar to this study, profitability is measured using ratios. Rasiah (2010) suggests that using profitability ratios is the most suitable approach to measure profitability. This is for the simple reason that they are not influenced by price fluctuations. Then again, Kabajeh, Nu’aimat & Dahmash (2012) vouch for three alternative ways to measure profitability: ROA, ROI and ROE. This particular study has used ROE and ROA to examine profits. ROA is the ratio of net profit to total assets. It shows managerial efficiency as they strive to convert assets into earnings. A high ROA shows superior performance and the reverse is true. ROE is the ratio of net profit to total equity. Thus, it evaluates the rate of return on the shareholders' equity, (Bourke, 1989; Molyneux & Thornton, 1992). It appraises the management’s ability at generating profits per unit of equity. A higher ROE indicates higher prospects and vice versa. Agbamuche (2012) in his study on investment of insurance funds within the Abuja market finds that with the exception of funds obtained through collecting premiums, insurance firms do have other sources  of profit. Insurance companies invested their surplus monies in government securities, shares along with property in order to earn more income and consequently increase profitability.

1.1.2      Life Assurance

Life assurance is defined as an agreement between an assurer and a policy holder of an insurance policy that pays a given amount of money once somebody dies or on an agreed date if they are still alive. Depending on the agreement, alternative events like terminal diseases, critical sickness, permanent incapacity and partial incapacity may also initiate payment. The holder of the policy usually pays premiums regularly or in a lump sum payment. Additional expenses, for example, funeral ceremony expenses may also be included within the benefits. Life insurance contracts are long-term in nature. According to Thornber (2001), life insurance contracts are generally for considerably longer periods, usually five years and beyond. They insure the peril of death; death is definite though the time of incidence is uncertain.

Governments are persuading people to buy life assurance products for two major reasons: first and foremost, to offer protection to their heirs and dependents against the monetary consequences of the breadwinners’ premature death; and second, to encourage future saving and the provision for retirement. The acquisition of insurance, therefore, provides the individual with a technique of securing the long run well-being for self and dependents with no undue reliance on the different state welfare schemes. The Nigerian government offers a tax relief of 15 percent of premiums contributed to a registered life insurance scheme. It is meant to be an incentive to encourage the Nigerian citizens to secure their future and that of their dependents through saving in life insurance firms.

The profitability of LAs is influenced by a range of factors. Borome (2015) in his study of determinants of financial performance (FP) for LAs in Nigeria finds a strong positive relationship between FP of LAs and solvency margin in addition to diversification, a moderate positive relationship between FP and insurance financial leverage and weak positive association for investment ratio. Company size and retention ratio had a strong negative association to FP whereas growth of premiums showed a weak negative association to FP (Borome, 2015).

There are four significant issues that ought to be addressed in the provision of life insurance policies. Firstly, the parties within the contract ought to be clearly specified; the insured, applicant, insurer and beneficiary. Secondly, the benefits ought to be clearly indicated, thus survival and death benefits. Third, exclusions in the life policy, this is often what could bar the insured from enjoying stated benefits. And lastly, provisions and conditions that every party within the contract ought to fulfill.

1.1.3   General Insurance

General insurance is commonly outlined as whatever insurance that’s not determined to be life assurance. It helps persons and establishments shield themselves and also the things they consider important, like their homes, their cars, and their valuables, from the economic impact of risks – from floods, storms, fires and earthquakes, to theft, automobile accidents, travel mishaps – and even from the cost of legal suits against them. It is typically property, liability and casualty insurance. It's insurance that offers protection against the incidence of future events (Choi, 2010; Calandro & Lane, 2002; Doff, Bilderbeek, Bruggink & Emmen, 2009; and Elango, Ma & Pope, 2008). General insurance is short-term. In contrast to life assurance policies, the tenure of general insurance policies is often not that of an entire lifetime. The typical term lasts for the period of a specific economic activity or for a given amount of time. Most general insurance policies are yearly contracts. However, there are few policies that have an extended term.

General insurance works by distributing the cost of unforeseen risks among a large number of individuals within the same area who share the same risks. Once a person takes up a general insurance policy, they pay a monthly or annual premium. This individual payment joins the premiums of the many thousands of different policyholders and goes into an enormous pool of funds. An individual might never get to draw from the pool. However, if he is affected by an unforeseen calamity, the pool of funds may be used to aid the affected person up to the limit that they had chosen in their policy. Hussain (2011) says that usually, in general insurance, the event that is insured might or might not happen.

Profitability of GIs is similarly affected by varried factors. Murigu (2014) studied the determinants of FP of general insurance firms in Nigeria and discovered that profitability of GIs in Nigeria is absolutely and considerably influenced by leverage and equity capital; firm size and ownership structure holds a negative and substantial influence on performance of GIs in Nigeria; liquidity bears negative and marginally important impact on FP of GIs in Nigeria. Retention ratios of the establishment and underwriting risk have a positive and insignificant impact on the FP of GIs in Nigeria. There is no evidence of an influence of management competency index and age of the firm on the performance of GIs in Nigeria (Murigu, 2014).

As is the case in provision of life insurance, general insurance policies ought to address some issues on the provision of policies, including; parties, benefits, exclusions, provisions and conditions. Firstly, the parties within the contract ought to be clearly specified; the insured and insurer. Secondly, the benefits ought to be clearly indicated, thus what the policy holder is entitled to incase insured risk occurs. Third, exclusions in the general insurance policy, this is often what could bar the insured from enjoying stated benefits. And lastly, provisions and conditions that every party within the contract ought to fulfill.

1.1.4      Insurance Industry in Nigeria

Insurance business in the Republic of Nigeria is controlled by IRA, a State Corporation whose mandate is to manage, supervise and develop the business. Until 2012, insurance firms in Nigeria were run as General, Life or Composite firms. In compliance with Insurance Act, Cap 487, revised 2010, composite firms were forced to separate life and general business and operate those two as separate entities. Kimbowa (2012) anticipated that Nigeria would have no composite insurance firms by 2015. This meant that insurance firms in Nigeria were under the legal obligation to separate their life insurance from general insurance as compared to having them run as composite insurance firms. This move was envisaged to assist the insurance companies to mitigate the risk that had resulted in the collapse of some insurance firms that were running as composite firms and additionally facilitate the realization of profit and survival (AKI, 2010).

According to AKI (2015), by December 2015 there were thirty-six registered general insurance firms and twenty-six firms that wrote life insurance business, 139 authorized insurance brokers, twenty-two medical insurers and 6,424 insurance agents. The Nigerian insurance business has been lively the past ten years with Nigerian insurance firms spreading their foothold within the region covering EAC, COMESA, and SADC. This was necessitated by the desire of insureds in Nigeria with interests in production, tourism, transport, communication, building and construction across the region to be insured by a similar underwriter. Insurers found it necessary to start offices across Eastern and Central African and to some extent Southern African. Several Nigerian insurance firms have additionally taken advantage of growth opportunities and simplicity of doing business in Rwanda, and lack of native insurance firms in Southern Sudan. Mergers and Acquisitions have as well played a major role in the growth.

The industry realized gross written premium of KES 173.79 billion in 2015 compared to KES 157.21 billion in 2014, representing growth of 10.55%. Gross earned premiums were KES 146.16 billion in 2015 and KES 133.12 billion in 2014 representing growth of 9.8%. The business recorded a profit of KES 11.57 billion before tax in 2015 as opposed to KES 15.74 billion in 2014. The asset base of the industry in 2015 grew by 11.5%, thus the asset base stood at KES 465.98 billion compared to KES 417.76 billion in 2014. The insurance penetration in 2015 was 2.79% against 2.93% in 2014. In 2014, penetration was influenced by rebasing of the gross domestic product (GDP) upwards. The low penetration is a sign of untapped opportunities for insurance business in areas like oil and gas, property, infrastructure, bancassurance, micro-insurance, and agriculture. The insurance industry is working towards boosting this penetration to make sure that firms across all sectors are insured and many more Nigerians are likewise insured.

The insurance business has been experiencing a lot merger and acquisition activities through buyouts and consolidation. New firms are also entering the market. This trend is likely to continue buoyed by the attractiveness of the Nigerian insurance market. New regulatory changes like Risk Based Supervision, Takaful guidelines and Financial Services Authority are anticipated to have an effect on the insurance landscape once they become effective.

1.2   Research Problem

Profitability is one amongst the most vital objectives in financial management that results in maximization of owners’ wealth, Nguyen (2006). No business is profitable devoid of managing their risks effectively. If an underwriter is in a position to manage his risks well, then he will automatically increase his profitability. LAs and GIs face differing types of risks considering the kind of risks they insure. This distinction in risk exposure affects the profitability of the two insurance models in different ways. Their profits depend on how well they manage the risks they insure. Therefore, we do not expect the two models to exhibit identical profitability based on the risks they are exposed to and the way they manage them.

A number of comparative studies have been done to evaluate the profitability of varied organizations’ in the same industry. Thyigarajan & Kumar (2015) did a profitability analysis of chosen aluminum firms in India; the study observed that National Aluminum Company showed satisfactory performance with regard to profitability. Jain and Mehta (2013) in their study on FP of automobile firms find that Hero Honda Company performed well thanks to its usage of latest technology and Tata motors registered weak performance related to escalated production overheads and company’s inability to face competition. Bai and Buvaneshwaran (2015) compared the profitability of varied hotels in India and established that Royal Orchid was the most profitable. Jaksic, Mijik, Zekic and Poljasevic (2015) did a comparative profitability analysis of milk production firms to milk processing firms in Serbia and discovered that there was no significance distinction in profitability in the two types of firms engaged in the milk business.

Likewise, studies have been done to evaluate the profitability of LAs separately in varied parts of the globe. Dey & Adhikari (2014) carried out an analytic study on the profitability of LAs firms in India. Solanki (2016) did a study on a few private sector LAs in India. Similarly, the profitability of GIs has been analyzed independently by different studies. Varma (2012) did a comparative study on public and private sector GIs profitability. Kwong (1987) studied the profits of native general insurance firms in China.

Though comparative studies on profitability have been done to contrast the profitability of companies in various industries, there is no known comparative study that has been done within the insurance industry to compare the profitability of LAs and GIs in Nigeria and the international scene. Profitability analysis studies that have been done in the insurance business have only analyzed profits of either LAs or GIs separately. Hence, to our knowledge, there's no data on this subject. This has left a research gap that the study filled by conducting “a comparative analysis of profitability of life insurance and general insurance firms operational in Nigeria.” For that reason, this study thus filled the research gap by responding to the question “Do these two insurance models differ in profitability?”

1.3   Research Objective

This study’s objective is to compare the profitability of life assurance companies and general insurance companies operating in Nigeria

Hypothesis

Null hypothesis Ho: There exists no difference in the profitability of life assurance and general insurance companies in Nigeria (Ho: µ1=µ2)

Alternative hypothesis Ha: There are differences in the profitability of life assurance and general insurance companies in Nigeria (Ha: µ1≠µ2)

1.4   Value of Study

To be an eye-opener for each class of insurance companies to boost their returns for their stakeholders’ sake, in the event that these firms are found to be profit inefficient. It will be informative and attention-grabbing to observe which of these two models exhibits culpableness therein and so must adjust for the better. It will aid regulatory authorities to think about formulating just and relevant policies which will enable every class of insurance company to work effectively. The insurance corporations themselves will find this study quite helpful for it will give a scientific analysis of their profits. Investors will find this study helpful as they will be able to make informed decisions about where to invest their money given the two models. This study will benefit scholars who wish to undertake further studies aimed at improving and understanding profitability in Nigerian insurance companies. Thus it will be a significant addition to the pool of knowledge that already exists.

LIFE INSURANCE CONTRACTS WITH EMBEDDED OPTIONS: VALUATION, RISK MANAGEMENT, AND REGULATION