CHAPTER ONE

INTRODUCTION

1.1       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 andthose 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 cashflow 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 macro-variables 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 auto-regression 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.

1.3       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 the process 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.