Cash-flow is relevant for entrepreneurs, and it is also true for managers of financial institutions. The insurance industry controls cash flows by integrating its relationships with risk and investment management after determining and documenting the dynamic connections between them. One strategy for reducing agency costs resulting from over investments in free cash flow is to effectively deploy a risk management system.
The unpredictability of market cycles is taken into account when assessing the cash-flow risks associated with insurers' cash-flow management and the capacity to use the highly regulated insurance industry as a study sample and include elements particular to the insurance company.
This chapter will address the background information that motivated this study, the challenges that prompted it, its aim, and its objectives as a preface to subsequent sections of the study. Additional factors include the study's significance, scope, limitations, research questions and hypotheses, and the definition of technical terms.
1.2 Background of Study
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 risk, not observed in other industries. 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:
- The earnings that result from core activities and cannot be modified and
- 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. In addition, a well-established investment portfolio can efficiently utilize free cash flows for better asset allocation. Furthermore, we extend the research to explicitly consider the dynamic effects of economy-wide macro-variables and industry-wide common factors. The research sample, based on the insurance industry, provides an opportunity to incorporate the factors uniquely specific to this industry, namely, insurance underwriting cycles and regulatory requirements, into the model. Therefore, this study conducts a comprehensive analysis of cash-flow modeling and cash-flow risk management in the insurance industry. The existing literature provides evidence that suggests the relationships between cash flows, investment, and risk management. As demonstrated in Alti (2003), cash flows contain valuable information about a firm’s investment opportunities.
Rochet and Villeneuve (2011) examine how risk management mechanisms interact with the uncertainty of cash-flow levels and conclude that the decisions are simultaneously endogenous. In addition, the literature has shown that insurers have more actively participated in the derivative markets by employing financial derivatives not only to smooth cash-flow uncertainty from their invested assets and underwriting liabilities but also to generate more cash flows. Therefore, cash-flow management is important in the field of risk management, particularly for the insurer firms who intend to reach effective asset/liability duration management. To the best of our knowledge, very few of the existing studies have addressed the issues of cash-flow risk management of insurers under the framework of considering the dynamic risk management in investing, financing, and underwriting. In this project we apply dynamic factor modeling (Stock and Watson 2006, 2009) 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 major source 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. Therefore, in Nigeria where the research was carried out, the activities that was conducted is to know the Impact of Cash Flow Management on the Insurance Industry.
1.3 Statement of Problems
Investigation revealed that most insurance businesses encounter cash flow risk management problem at one time or another. Furthermore, cash flow problems can be serious and threaten your ability to stay in business if not well analyzed. Insurance companies are more at cash flow risk due to the nature of their business.
1.4 Aim and Objectives of Study
The aim of the study is to examine the Impact of Cash Flow Management on the Insurance Industry. In achieving this aim, the following specific objectives were laid out as follows:
- To investigate the management of cash flows by the insurance industry; and
- To identify and capture the dynamic relationship between cash flow management and risk management in insurance industries.
1.5 Research Questions
The study came up with research questions so as to be able to ascertain the above stated objectives. The specific research questions for the study are stated below as follows:
- Does cash flow risk management positively impact the insurance industry?
- What dynamic relationship exists between cash flow management and risk management in insurance industries?
1.6 Research Hypothesis
In order to pursue the objective of this study, the following generalized statements have been designed to guide and aids in obtaining the result for the experiment to be conducted. For this work, the null hypothesis will be represented with H0 while the alternative hypothesis will be represented with hypothesis H1.
- H0: There is no significant relationship between cash flow management and risk management in insurance industries.
- H1: There is significant relationship between cash flow management and risk management in insurance industries
1.7 Significance of Study
This research is significant due to the fact it uses a dynamic factor modelling framework, which can capture the dynamic interactions between an insurance firm's activities in financing, investing, underwriting, and risk transferring, to model cash-flow risks and empirically analyse the cash-flow risk management of insurance firms. Moreover, the empirical study may simultaneously take into account the effects of macro-factors common to the entire economy and those industry-specific to the insurance sector by employing a factor-augmented auto regressive (FAAR) approach.
Furthermore, researchers will greatly benefit from this study, and non-researchers might utilize it to further their own research endeavours. This work advances knowledge and may function as a model for future research.
1.8 Scope of Study
The scope of the research is focused on the Impact of Cash Flow Management on the Insurance Industry will cover various approaches to the study and its impact on insurance industries in Nigeria.
1.9 Limitations of the Study
During the course of this study, there were some problems encountered which stood as limitations to the research work. Some of the limitations include:
- Time Constraint:The time frame given to accomplish this project was very short due to school academic calendar and it was carried out under pressure which made the researcher not to implement some necessary features.
- Establishment Policies:Establishment policies posed a serious limitation as most staffs are not ready to release information needed for this research work. There were lots of information needed from the staffs of this establishment to enhance the study which took them time to release or they did not release at all for security purposes, hence the scope was reduced.
- Research Material: availability of research material is a major setback to the scope of the study.
- Financial Constraint: Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview).
- Initial Cooperation Delay from Respondents: A particular limitation of this work came as a result of the respondent refusal to offer their cooperation at the initial time they were contacted. This contributed in making the success of this research study difficult.