RESEARCH REPORT - THE IMPACT OF REINSURANCE PURCHASE ON INSURANCE COMPANIES' PERFORMANCE. CASE : GENERAL INSURANCE COMPANIES IN MALAYSIA

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1 RESEARCH REPORT - THE IMPACT OF REINSURANCE PURCHASE ON INSURANCE COMPANIES' PERFORMANCE. CASE : GENERAL INSURANCE COMPANIES IN MALAYSIA BIRO PENYELIDIKAN DAN PERUNDINGAN INSTITUT TEKNOLOGI MARA SHAH ALAM, SELANGOR, MALAYSIA

2 Members : Zahiyah Itam Othman V Mohd Badri bin Abd. Shukor Radzuan bin Abdul Ghani

3 Our sincere thanks to all the Librarians and officers whom we consulted through a countless visits particularly to the staffs of PTAR 2 ITM, Malaysian Institute of Insurance, Bank Negara Malaysia, Malaysian National Reinsurance Berhad (MNRB) and The Malaysian National Insurance Sdn. Bhd. Thanks also to friends and colleagues. Last but not least to our family for their encouragement, understanding, love and care pampered all these years.

4 Abstract ABSTRACT Doherty and Korkie (1980) in one of their researches had concluded that "the enormous volume of dollars changing hands in reinsurance brings only small and uncertain benefits to those involved". The findings of Von Eiji (1989) includes "there is minimal impact of reinsurance in reducing total risk". If these are true, then why do insurers still willing to spend millions of dollars on reinsurance? This research try to relate whether those findings are acceptable in the Malaysian general insurance market. Based on the 10-years performance of the Malaysian general insurers, the study aims to find out the impact of reinsurance purchase on their profit performance as well as risk reduction. Upon regressing the premiums paid for reinsurance against other relevant variables chosen using TSP, the empirical study shows mixed results. The profit performance proved to be not affected and the risk is not reduced. Therefore, it is concluded that there is no significant impact of reinsurance purchase on the profit performance and the risk reduction of the Malaysian general insurers.

5 Terminologies iii GLOSSARY OF TECHNICAL TERMS For readers who are not familiar with insurance and reinsurance, the following glossary briefly defines various technical terms as used in this research. Accumulation: Concentration of risks which may be affected by the same loss event or concentration of shares in the same risk through reinsurance treaties. Capacity: (re insurance. The maximum amount of a risk that can be accepted in Cash deposits: A sum left by the reinsurer in the hands of his client to guarantee contractual liabilities. Ceding company: The reinsurer's client, i.e. the insurer, who passes on (cedes) risks to the reinsurer against payments of a premium. Cession: Insurance that is reinsured; passing on of the insurer's risks to the reinsurer against payment of a premium. Claim: contract. Payment for the loss incurred under the terms of a (re)insurance Claims handling: The work in connection with the investigation, settlement and payment of claims from the time of their occurrence until settlement. Claims incurred: All claims payments plus the adjustment in the outstanding claims reserve of a business year. Co-insurance: part of a risk. Where a number of insurers and/or reinsurers each share Cover: agreement. Insurance and reinsurance protection based on contractual

6 Terminologies iv Earned premium: Part of the premium (including unearned premium of the previous year) applicable to the expired part of a reinsurance period continuing after the balance-sheet date. Facultative reinsurance: individual basis. Reinsurance of the insurer's risks on an Gross premium: Insurance premium before deduction of the ceded premium (cession) or reinsurance premium before deduction of the retroceded premium (retrocession). Insurer (also direct/primary insurer): Insurance company in a direct contractual relationship with the policyholder. Net premium: Insurance premium after deduction of the ceded premium (cession) or reinsurance premium after deduction of the retroceded premium (retrocession). Non-proportional reinsurance (also excess of loss reinsurance): Form of reinsurance in which the reinsurer assumes that part of the insurer's losses that exceed a certain amount against payment of a specially calculated premium. Outstanding claims reserve: incurred but not yet finally settled. Reserve for claims which have been Policyholder: The insurer's contractual partner who receives cover in return payment of a premium. Portfolio: The totality of risks assumed by an insurer or reinsurer; also the totality of investments of a company. Premium: Amount paid by the policyholder to the insurer in the business year in return for insurance cover.

7 Terminologies v Profit commission: Contractually agreed commission paid by the insurer or the reinsurer in proportion to his profit in a particular piece of insurance or reinsurance business. Proportional reinsurance: Form of reinsurance in which the premium and losses of the insurer are shared proportionally by the insurer and reinsurer. Quota-share reinsurance: Form of proportional reinsurance, providing that the reinsurer accepts a specified share of each risk of an insurer in a specified class of business. Reinsurer: Company which accepts a share of the insurer's risks in return for payment of a premium. Reinsurance premium: the risk accepted. Premium paid to the reinsurer by the insurer for Reinsurance treaty: Contractual agreement between insurer and reinsurer. Retention: The amount of a risk which the insurer does not reinsure but keeps for own account. Retrocession: Passing on by the reinsurer of the risk accepted in reinsurance to the other companies (retrocessionaire). Retrocessionaire: Company which accepts risk by way of retrocession. Retrocession premium: of the risk accepted. Premium paid to the retrocessionaire for the part Risk: Insured object, hazard or interest. Risk category: characteristics. Grouping together of risks with similar hazard Risk of change: Fluctuation of actual from statistically anticipated claims experience as a result of technical, social, commercial or political changes.

8 Terminologies vi Risk management: Management tool for the comprehensive identification and assessment of risks based on knowledge and experience in the fields of natural sciences, technology, economics and statistics. Risk spread: Stabilisation of the claims experience by a large number of similar risks as possible. Surplus reinsurance: Form of proportional reinsurance, in which risks are reinsured over a specified amount. Treaty reinsurance: Participation of the reinsurer in certain sections of the insurer's business as agreed by treaty. Underwriting result: Total of earned premium, less commissions, profit commissions and claims incurred. Unearned premium: Premium applicable to the part of the period of reinsurance continuing after the business year of a balance-sheet (earned premium).

9 List of Tables LIST OF TABLES TABLES PAGE 1. Development of Reinsurance and National 13 Retention in Malaysia 2. R-squared Ratings Regression Output (REPREM Vs. OPL 56 - Yearly Average) 4. Regression Output (REPREM Vs. OPL 58 - By Company) 5. Regression Output (REPREM Vs. NCLAIM 60 - Yearly Average). 6. Regression Output (REPREM Vs. NCLAIM 62 - By Company). 7. Regression Output (AVEREP Vs. SD of NCLAIM) Regression Output (AVEREP Vs. SD of GCLAIM 66 -NCLAIM).

10 List of Appendices viii LIST OF APPENDICES A. Selected General Insurance Companies (Samples for the Research). B. Research's Programme. C. Student's T-Distribution Table. D. General Insurers: Increase or Decrease in Reinsurance Premiums Paid (Average Percentage). E. General Insurers: Increase or Decrease in Operating profit/loss (Average Percentage). F. General Insurers: Increase or Decrease in Net Claims Paid (Average Percentage). G. General Insurers: Average Reinsurance Premiums Paid. H. General Insurers: Standard Deveiation of Net Claims Paid. I. General Insurers: Standard Deviation of Gross Claims. J. Average REPREM Paid, STD of NCLAIM, & the Differences of STD NCLAIM & GCLAIM. K. Regression Output on OPL against REPREM (Yearly Average). L. Regression Output on OPL against REPREM (By Company). M. Regression Output on NCLAIM against REPREM (Yearly Average).

11 List of Appendices ix N. Regression Output on NCLAIM against REPREM (By Company). O. Regression Output on STDDEV against AVEREP. P. Regression Output on STDG-N against AVEREP. Q. Average (%) INC/DEC in OPL, NCLAIM and REPREM. R. Graph 1: Performance of Variables (REPREM, OPL and NCLAIM). S. Average (%) INC/DEC in REPREM, OPL and NCLAIM (By Company). T. Graph 2: Performance of Variables (REPREM, OPL and NCLAIM - by company). U. Graph 3: Performance of Variables (AVE REP against SD of NCLAIM). V. Graph 4: Performance of Variables (AVE REP against SD of GCLAIM - NCLAIM).

12 Table of Contents x TABLE OF CONTENTS CONTENTS TITLE PAGE ACKNOWLEDGEMENT ABSTRACT TERMINOLOGIES LIST OF TABLES LIST OF APPENDICES TABLE OF CONTENTS PAGES i ii iii vii viii x CHAPTER ONE: INTRODUCTION 1.1 Preamble Background of the Research Importance of the Research Objectives of the Research Hypotheses Scope, Limitation and Assumption Organisation of the Paper 9 CHAPTER TWO: REINSURANCE AND RISK 2.1 Current Development of 12 Reinsurance in Malaysia 2.2 Reasons for Reinsurance 16 Purchase

13 Table of Contents mmmmdlv 2.3 Risk and Types of Risk Methods of Handling Risk Measuring the Risk 27 CHAPTER THREE: LITERATURE REVIEW 3.1 Vagueness of Reinsurance 30 Concept 3.2 Reinsurance Decision and 31 Total Risk 3.3 Reinsurance Decision and 32 Systematic Risk 3.4 Reinsurance Decision and 34 Tax Shield 3.5 Reinsurance Decision and 35 Value Maximisation CHAPTER FOUR: RESEARCH METHODOLOGY 4.1 Methodology Sample for the Research 37 # 4.3 Source of Data Test of Hypotheses Using 40 Regression Analysis 4.5 Determination of the Variables Descriptive Analysis 54

14 Table of Contents mmmmdl CHAPTER FIVE: FINDINGS AND ANALYSIS OF THE FINDINGS 5.1 Regression Model Regression Model Regression Model Regression Model Regression Model Regression Model Descriptive Analysis of 67 the Variables CHAPTER SIX: SUMMARY, CONCLUSION AND RECOMMENDATIONS 6.1 Summary Conclusion Recommendations 76 BIBLIOGRAPHY APPENDICES

15 Introduction 1 CHAPTER ONE INTRODUCTION 1.1 PREAMBLE Reinsurance, by virtue of its nature and functions is very important to insurance company. In fact, insurers cannot deny that reinsurance plays a vital roles in ensuring the survival of any modern economy. Just as no modern economy can survive without an organised insurance industry, no insurance company can function efficiently without an organised reinsurance system. Thus, we can always see that insurers often treat reinsurance as a very special tool needed in pursuing their business. Reinsurance is an arrangement by which an insurance company transfers all or a portion of its risk under a contract (or contracts) of insurance to another insurance company. 1 It is a device whereby an insurance company may avoid the catastrophe hazards in the operation of the insurance mechanism. As the term indicates, reinsurance is insurance for insurers that is also based on 1 James L. Atheam, S. Travis Pritchett, Joan T. Shmit, Risk and Insurance, 6th ed. (St. Paul: West Publishing Company, 1989): 61.

16 Introduction 2 the principles of sharing and transfer as insurance itself. In order to protect themselves against the catastrophe of a comparatively large single loss or a large number of small losses caused by a single occurrence, reinsurance seem to be the most perfect answer. 2 Malaysian insurers is just like insurers abroad, gambling much on the reinsurance in order to survive competing in their business. As stated in the Director General of Insurance Annual Report 1993: "By an optimum harnessing of reinsurance capacity, the insurance industry in Malaysia can achieve sound and rapid development This means that an adequate support of reinsurance network is essential for an insurance system in Malaysia to function and develop effectively. Reinsurance support is operationally critical, irrespective of the size of the insurer, to cover the risks in excess of its prudent retention capacity. Furthermore, reinsurance support is also needed by insurers to uplift their gross underwriting capacity. 2 Emmet J. Vaughan, Fundamentals of Risk and Insurance, 5th ed. (New York: John Wiley & Sons, 1989): , "Reinsurance and National Retention" DGI Annual Report (1993): 72.

17 Introduction BACKGROUND OF THE RESEARCH Over the 10-year period of , reinsurance premiums on general insurance business grew at an average annual rate of 9.9%, with total premiums ceded increasing from RM0.7 billion in 1983 to RM1.6 billion in During the same period, written premiums recorded an average annual growth of 11.5% to reach RM2.9 billion in 1992 (1983: RM 1.1 billion). 4 The statistic simply reflects that our general insurers are getting more and more generous in spending on reinsurance. It is not obvious to say that most insurers tend to spend millions of dollars on reinsurance. But, what do they get in return? Does it bring any extra profit to them? One thing for sure, whatever amount they spent on reinsurance premiums is regarded as cash outflows or expenses to the company's account. Therefore, their profit performance will definitely be affected as more expenses mean reduction in the profit margin. This then lead to another question of how significant is.the impact of reinsurance purchase (reinsurance premiums paid) on the profit performance of those insurers. In fact, Doherty and Korkie (1980) in one of their researches had concluded that "the enormous volume of dollars changing hands in reinsurance brings only small and uncertain Ibid.

18 Introduction 4 benefits to those involved". Does this conclusion applies to our general insurers? If it is true that reinsurance brings only small and uncertain benefits to those involved, then why does insurers still willing to spend millions of dollars on reinsurance? Could it be because of its function as a tool that can reduce the risks faced by the insurers? To what extent does reinsurance really reduce the risks? These questions are not easy to answer. There is no doubt about what reinsurance can do to help spread the risks faced by insurers. But, to what extent that the risk can be reduced, is something difficult to measure and need further study. Based on the arguments stated above, this paper endeavours to explore the major issue pertaining to the purchase of reinsurance and attempts to analyse the impact of reinsurance on the performance and returns of general insurers in Malaysia. With regard to risk reduction, this paper will also attempt to analyse on how significant is the impact of reinsurance on the insurers' effort to reduce their risks. IMPORTANCE OF THE RESEARCH Insurance companies are also regarded as one of the financial

19 Introduction 5 institutions with respect to their nature of business. As deposit taking institution, they play important roles towards the credit creation in the economy. Whenever an insurance company is performing good in business, people will admire its financial controller. Similarly, the poor performance of an insurance company is a reflection of its poor and unreliable financial controller. Thus, it is hoped that this paper would be able to provide our general insurers (particularly the financial controller involved) on certain areas to be considered in assessing their returns from millions of dollars that they spent on purchasing reinsurance. Another importance of this research would be, because due to the lack of research that had been carried out in this area (reinsurance in Malaysia), it is hoped that this paper will be of some help in contributing to the research's need. OBJECTIVES OF THE RESEARCH objectives This study aims at achieving various objectives. include: These To study the development of reinsurance market and their importance in the Malaysian insurance industry.

20 Introduction To see the prospect of reinsurance demand in Malaysia as well as the reasons why it is greatly purchased by our general insurers To study the impact of reinsurance purchase on the general insurance companies' net claims paid in Malaysia as their effort to reduce risks To study the impact of reinsurance purchase on profit performance of general insurance companies in Malaysia. HYPOTHESES The following hypotheses were derived based on the objectives (Note that H 0 stands for null hypothesis and H t is the alternative hypothesis): * Hypothesis: (To study the impact of reinsurance purchase on general insurers' profit performance.) H 0 : H t : The profit performance of general insurers is not affected by the purchase of reinsurance. The profit performance of general insurers is affected by the purchase of reinsurance.

21 Introduction nd Hypothesis: (To study the impact of reinsurance purchase on risk reduction.) H 0 : Hj: The purchase of reinsurance will not reduce the risks faced by our general insurers. The purchase of reinsurance will not reduce the risks faced by our general insurers rd Hypothesis: The purpose of this hypothesis is to find out further pertaining to how strong will be the impact of reinsurance purchase on risk reduction. Therefore, the hypothesis derived is as follow: H 0 : Hj: The purchase of reinsurance has a weak impact on risk reduction. The purchase of reinsurance has a strong impact on risk reduction. SCOPE, ASSUMPTIONS AND LIMITATIONS The field work for this paper discuss on the impact of reinsurance purchase on the profit performance and risk reduction of general insurance company in Malaysia. The study will only

22 Introduction S concentrate on those general insurance companies in Malaysia that had survived in their business for the period of 10 years ( ). However, the data collected for the purpose of this paper is based on their performance from 1982 to List of those companies involved is as shown in Appendix A. The researcher assumed that the data based on the period of 10-years is sufficient for the purpose of this research. Since there are only 36 general insurance companies that have survived in their business for the period of 10-years, therefore, the researcher assumed that 30 companies selected by convenience for the sample size are sufficient to represent the general insurers in Malaysia. The premiums paid for reinsurance are categorised as expenses which will affect the net account of the company. Thus, it will reduce the profit of the company. However, it is worth to note that, when the insurers purchase reinsurance, their capacity of underwriting will increase and this might bring more profit to the company. Therefore, here, it is assumed that the purchase of reinsurance will affect the profit performance of the general insurers. It is also assumed that the main reason for the insurers to purchase reinsurance is for the purpose of spreading the risk or to share the risk with other insurers. After taking an excessive underwriting effort, the insurers fear that certain catastrophe

23 Introduction 9 hazard might turn their company into insolvency. Thus, reinsurance is assumed to reduce risk faced by the general insurers. In pursuing this research, the availability of data and time have became the major constraint. As required, this paper must be completed within the 'time frame of about 4 months, while collecting, processing and analysing of data need time frame longer than that. Data which are earlier than 1985 was not made available at our ITM library, thus the researchers had to seek the help from Malaysian Institute of Insurance (Mil). This had confronted the researchers again with problem of limited time (the Mil's library open only from 8.30 am to 5 pm) and other problems such as transportation and money. It is not obvious to say that the weather during the given period, especially the last two months, seemed to be very much against the completion of this research. With the rain and thunderstorms that occurred almost everyday, power failure has became very common that frequently interrupted most of the work as computers could not be used. ORGANISATION OF THE PAPER Chapter 1. An overview of the study beginning with the preamble and background of the research leading to the

24 Introduction 10 objectives, hypotheses, scope, assumption and limitations as well as the organisation of the paper Chapter 2. An extensive discussion on the development of reinsurance in Malaysia and the reasons why reinsurance is greatly purchased by our general insurers. Furthermore, the chapter attempts to define risks faced by general insurers and how they measure it Chapter 3. Compilation of some literature reviews, focused on vagueness of the reinsurance concept and the possible relationship of reinsurance decision with total risk, systematic risk, as well as with other factors such as tax and value maximisation. Certain relevant empirical findings from those studies are also included Chapter 4. A description of how the study is conducted based on test hypothesis, research methodology and data sources. The chapter also include the determination of the regression models, significance level and critical t-value as well as the determination of variables to be used Chapter 5. The empirical findings and the analysis of the findings as the results of the multiple regression analysis using the Time Series Programme (TSP) on the reinsurance