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CHAPTER ONE
INTRODUCTION
1. Background of the study
To the insurance industry, cash flows can be generated through underwriting activities, financing and investing choices, and even managing risks; consequently modeling cash-flow risks will be on a dynamic basis process because it is essential to forecasting and managing financial and underwriting risks. To model the cash-flow
risks specific to the insurance industry, we have to capture the dynamics of the cash-flow–generating process of an insurer. The cash-flow–generating process can be characterized by two major components: (1) the earnings that result from core activities and cannot be modified and (2) other profits that can be modified through the dimensions of investment choices, risk management, and financial policies. In addition, the factors underlying the cash-flow–generating process may be intertwined and thus under the generating process can present the risks to the extent of cash-flow level. For instance, the downside risk of a company can be signaled by an abnormal
decrease in operating cash flows. Moreover, the discrepancy of the magnitude and timing of the cash flows generated from underwriting insurance policies and those generated from investment activities create cash-flow uncertainty and risks to insurance firms.
For insurance firms, cash flows generated from investment, underwriting, and risk management activities are important indicators in financial management and are the key variables in capital budgeting decisions. Hence, these generated cash flows will provide internally interacting feedback on determining the insurers’ strategies of
underwriting, risk management, and investment from time to time. Correspondingly, cash-flow processes and cash flow risks demonstrate their dynamic characteristics.
1.2 Statement of the problem
Cash is king. It is true for entrepreneurs, and it is also true for managers of financial institutions. Cash-flow risks have long been one of the most essential factors while managing a variety of risks, particularly for the insurance
industry, which faces unique underwriting risks not observed in other industries.
1.3 Significance of the study
In this project, dynamic factor modeling (Stock and Watson 2006, 2009) was applied to capture the dynamic interactions between risk management and investment management by incorporating economy-wide macrovariables and industry-wide business cycle variables. Moreover, to further empirically carry out the applications of dynamic factor modeling as suggested in Rochet and Villeneuve (2011), we utilize a factor-augmented autoregression model (FAARM) through which we model how cash flows respond to the dynamic interactions mentioned above to explicitly model the non-monotonic effects. The research by Born et al. (2009) and Lin et al.
(2011) explores the dynamic interactions between risk management and financial management in the U.S. property and liability insurance industry, but the explicit effects on cash-flow management are left for future research in their study. As financial intermediaries, the insurance industry is subject to various sources of risk,
including interest rate risk, market risk, credit risk, and liquidity risk. Engaging in investment activities is one majorsource that generates the risks mentioned above, and the variability of cash flows reflects a firm’s risks (Keown et al. 2007; Shin and Stulz 2000). All risks, particularly liquidity risk, are related to cash flows. Bakshi
and Chen (2007) concluded that investing in stocks leads to the cash flows embedded with higher risks. Ballotta and Haberman (2009) and Azcue and Muler (2009) specifically examine the investment strategies of insurance companies and emphasize minimizing the default risks of the insurers, but not the dynamic optimal investment
strategies of insurers over economic downturns. In other words, they estimate the credit risk or liquidity risk at the firm level but fail to consider the macroeconomic issues such as interest risk and market risk. The study by Wen and Born (2005) explores the dynamic interactions between investment strategies and underwriting cycles, and their study suggests that although one may investigate how insurers dynamically adjust their investment and hedging strategies, the dynamic interactions between asset and liability risks corresponding to the underwriting cycles should be taken into consideration.
1.4 Objectives of the study
This research is aimed at evaluating the impact of cash flow management in the insurance industry. To be concise, these objectives are: a. To identify whether cash flow management have any significant impact on insurance industry.
1.5 Research questions
In order to have a thorough grasp of the understanding of this research, certain questions need to be asked.
These are:
a. Does cash flow management have any significant impact on insurance industry?
1.6 Research hypotheses
Ho: Cash flow management has no significant impact on insurance industry.
Hi: Cash flow management has significant impact on insurance industry.
1.7 Limitations of the study
This study investigates management of cash flows by the insurance industry by incorporating its interactions with risk management and investment management after identifying and capturing the dynamic relationships between one another. The study was limited by two major factors; financial constraint and time. Insufficient fund and time tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in of data collection.
1.8 Scope of the study
This project models cash-flow risks and empirically analyzes cash-flow risk management of insurance firms under a dynamic factor modeling framework, which can capture the dynamic interactions between an insurance
firm’s activities in financing, investing, underwriting, and risk transferring. In addition, through the use of a factor-augmented autoregressive technique, the empirical analysis can simultaneously consider the effects of macro-factors that are common to the entire economy as well as those factors specific to the insurance industry.
1.9 Definition of terms
Cash Flow:The total amount of money being transferred into and out of a business, especially as affecting liquidity.
Management:The process of dealing with or controlling things or people.
Insurance: An arrangement by which a company or the state undertakes to provide a guarantee of compensation for specified loss, damage, illness, or death in return for payment of a specified premium.
REFERENCES
Almeida, H., M. Campello, and M. S. Weisbach. 2004. The Cash Flow Sensitivity of Cash. Journal of Finance 59: 1777–1804.
Alti, A. 2003. How Sensitive Is Investment to Cash Flow When Financing Is Frictionless? Journal of Finance 58: 707–722.
Azcue, P., and N. Muler. 2009. Optimal Investment Strategy to Minimize the Ruin Probability of an Insurance Company under Borrowing Constraints. Insurance: Mathematics and Economics 44: 26–34.
Bakshi, G., and Z. Chen. 2007. Cash Flow Risk, Discounting Risk, and the Equity Premium Puzzle. In Handbook of Investments: Equity Premium, edited by Rajnish Mehra, 377-402. Amsterdam: North Holland.
Ballotta, L., and S. Haberman. 2009. Investment Strategies and Risk Management for Participating Life Insurance Contracts.
Belviso, F., and F. Milani. 2006. Structural Factor-Augmented VARs (SFAVARs) and the Effects of Monetary Policy. B.E. Journal of Macroeconomics 6: 1-46.
Born, P., H.-J. Lin, M. Wen, and C. C. Yang. 2009. The Dynamic Interactions between Risk Management, Capital Management, and Financial Management in the U.S. Property/Liability Insurance Industry. Asia-Pacific Journal of Risk and Insurance 4: 2– 17.
Cummins, J. D., S. Tennyson, and M. A. Weiss. 1999. Consolidation and Efficiency in the U.S. Life Insurance Industry. Journal of Banking & Finance 23: 325–357.
Cummins, J. D., and M. A. Weiss. 2000. Analyzing Firm Performance in the Insurance Industry Using Frontier Efficiency and Productivity Methods. In Handbook of Insurance, ed. Georges Dionne,767-829. Norwell, MA: Kluwer Academic Publishers.
Cummins, J. D., and X. Xie. 2008. Mergers and Acquisitions in the US Property-Liability Insurance Industry: Productivity and Efficiency Effects. Journal of Banking & Finance 32: 30–55.
Fairley, W. 1979. Investment Income and Profit in Property-Liability Insurance: Theory and Empirical Results. Bell Journal of Economics 10: 192–210.
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