An Analysis Of Conventional Insurance And Takaful Insurance

Published Date: 02 Nov 2017

BY

NAME: EFFI SAIFULLAH BIN YAHYA

STUDENT NUMBER: SCM 016539

LECTURER: MS. UNG SZE NIE

DATE OF SUBMISSION: 14TH DECEMBER 2012

Signed Declaration

I declared that the thesis for the BA (Hons) degree in accounting and finance at the SEGi University and Teesside University, hereby submitted by me, is my original work and has not previously been submitted for a degree at this or any other University. All the references materials contained therein have been duly acknowledged.

Name : Effi Saifullah Bin Yahya Advisor’s Name: Ms. Ung Sze Nie

Signature: Signature:

Content

ABSTRACT

CHAPTER 1:

INTRODUCTION

1.1

Background of Study

1.2

Motivation of Study

1.3

Research Aim

1.4

Research Objectives

1.5

Research Questions

1.6

1.7

1.8

Hypotheses

Significance of Study

Summary

CHAPTER 2:

LITERATURE REVIEW

2.0

Introduction

2.1

Age and Size of an insurance company

2.2

Leverage of an insurance company

2.3

Volume of Capital of an insurance company

2.4

Conceptual Framework

2.5

Summary

CHAPTER 3:

RESEARCH METHODOLOGY

3.1

Introduction

3.2

Samples

3.3

Sampling Frame

3.4

Data Collection

3.5

Summary

CHAPTER 4:

TIMELINE

REFERENCES

ABSTRACT

Profitability is one of the most important objectives of financial management because one goal of financial management is to maximize the owner` s wealth and profitability is very important determinants of performance. This research investigated the determinants of profitability in conventional and Takaful insurance companies of Malaysia. Specifically, this examines the effects of firm specific factors (age of company, size of company, volume of capital, leverage ratio on profitability proxied by Return on assets. Profitability is dependant variable while age of company, size of company, volume of capital, leverage ratio are independent variables. The samples in this study include 14 companies divided to two (2) groups, conventional and Takaful insurance companies which cover the period of three (5) years of 2008-2012. For this purpose, the firm specific characteristics such as size, age, leverage and working capital are regressed against Return on Assets. Secondary data obtained from the annual reports (Balance sheet and Profit/Loss account) of insurance companies and financial publications of State Bank of Malaysia. This research had led to the conclusion profitability on insurance companies is positively and significantly influenced by the size and age and working capital. The leverage can be concluded that it does not have a significant relationship to profitability, therefore, not influenced by it.

CHAPTER 1: INTRODUCTION

Background of study

The insurance sector plays an important role in the service-based economy and its services are now being integrated into wider financial industry. In Malaysia, insurance companies act as financial intermediaries. Insurance companies (private and public, conventional and Takaful) consisting the organizations which provides life, fire, accident, causality and many other forms of insurance. Malaysia’s Financial Sector has shown strong resilience to a challenging macroeconomic environment and global developments. Insurance sector continues on its sluggish pace of growth and gradually increasing penetration of insurance services. According to Malik (2012), the insurance industry has enjoyed robust growth in the last few years, driven by favorable economic conditions, expansion of the financial sector as a whole, privatization of large state-owned entities and foreign investments. Generally, the firm’s performance can be estimated by measuring the firm’s profitability, and Insurer’s financial performance is related to such potential determinants identified as the variables in this research such as company’s size, loss ratio, investment ratio, capital structure, and the growth of written insurance premiums past performance. Institutional and political environments also play vital role besides firm specific factors of firm behavior.

According to Billah (2003), there was no specific legislation in Malaysia regulating the insurance practices. The insurance industry in Malaysia was mainly based on the British system because of the advent of colonialism and at that time, the existing law on insurance was drawn from the legislation in the United Kingdom in 1909. After Malaysia received its independence in 1957, the Government introduced the Insurance Act 1963 (now replaced by Insurance Act 1996) to monitor and supervise the insurance industry.

According to Wan A (2012), Takaful industry in Malaysia however, is relatively a new industry as compared to its conventional counterparts. The first Takaful company was established in 1984, shortly after the setting up of the first Islamic Bank in 1983. The idea to set up an Islamic Financial system was mooted by the former Prime Minister of Malaysia, Tun Mahathir.

From what I have learned, In Takaful business, the customer (Policyholder) is agreed to fund and share the liability of each customer in the pool. So, if one customer has faced some misfortunes or calamity then the pool would support him from the contribution of all policyholders. It would strictly remove the element of Gharar which is not permissible in Islam. In Takaful, the policyholders share in the profit and loss of the Takaful business, it means they do not transfer the risk to Takaful Company. Where, in conventional insurance, all the risk is transferred to the insurance company. If the Takaful business makes a surplus then it is shared between the policyholders. Where, in conventional insurance, the surplus is shared in the policyholders and become the part of income of insurance company. This is how both Takaful and Conventional insurances are developed and sustained to serve their participants and shareholders.

There are a number of significant differences between Takaful and conventional insurance companies. According to Guidelines on Takaful Operational Framework, Takaful companies not only follow the principles of Shariah, but also have distinctive features compared to conventional companies. In an overwhelming majority of Islamic Shariah, the objection is against the existence of the weaknesses in the insurance contract namely Gharar (Uncertainty), Mansir (Gambling) and Riba (Usury) which differs from conventional insurance. Takaful insurance companies are based on mutual-corporation while conventional insurance companies are based solely on commercial factors. On takaful companies, any surplus in the Takaful Fund is shared among participants only, and the investment profits are distributed among Participants and shareholders on the basis of Mudaraba or Wakala models. This is a distinctive difference compared to conventional insurance company whereby all surpluses and profits belong to the shareholders only.

However, both conventional and Takaful insurance have their respective importance to their own participants. As in general, insurance provide security and safety against any loss on a particular event and with this, the insured have a peace of mind of their own. According to guidelines on Takaful Operational Framework, Takaful insurance provides religious activities in exchange of their investment in Takaful fund. In other words, a part of the money paid by the insured will be donated to the needy as part of Islamic law called ‘Zakat’. With this, not only the insured take part in investing, but doing what is right from the religious point of view.

The impact of having an insurance whether conventional insurance or Takaful insurance is very broad. Insurance encourages saving to people and as mentioned before, provide a peace of mind in case of anything unwanted event occur.

According to De Cuyper (2012), (From website interview, the statistics gained from Etiqa) Takaful definitely has a higher growth perspective. If the compound growth over the last five years was measured, Takaful industry is growing between 15% and 20%, while the conventional industry has grown just above GDP growth at about 5% to 7%. With the strong position and market leadership in Takaful of more than 40% market share, Takaful industry is very well positioned to tap into the growth of the Malaysian market. This has shown the significance growth of both conventional and takaful insurance businesses in Malaysia over the years.

1.2 Statement of problem

Literature shows that most of the studies conducted on the banking sectors both commercial and Islamic and these focused on determinants of profitability. However, few studies are conducted on the insurance sectors. One study found is to determine the profitability of life insurance corporations in United Kingdom and another study is to measure the profitability of auto insurance in United States. (Citation needed)

For developing countries such as Malaysia, there are no studies found on examine the profitability of insurance companies, hence there is a need for such studies in insurance sector in developing countries. In addition these studies that assists in identification of the factors of profitability determinants also help to avoid losses.

1.3Motivation of study

Insurance companies including Takaful insurance in Malaysia have grown significantly faster every year. However, researches on profitability of insurance companies particularly in Malaysia have not been yet studied or initiated extensively. To examine the profitability of an insurance company, variables collected are the age and size of a firm plus the leverage and volume of capital of the firm. To determine whether every variable selected have significant relationship to profitability for insurance companies is essential in order to determine the effectiveness of the variables. Previous studies on profitability found are only on the Islamic banking sector in Malaysia, hence to study on the insurance sector in Malaysia is encouraging. All of the variables play vital roles and responsibilities towards profitability in insurance companies. Nevertheless, to examine and understand about conventional insurance is vital to complete my comparison between the two insurance operators.

1.4 Research Aim

This study aims to identify and examine the determinants of profitability for the insurance sector in Malaysia.

1.5 Research objectives:

To identify the relationship between age of company with profitability of insurance companies in Malaysia

To identify the relationship between company size with profitability of insurance companies in Malaysia

To identify the relationship between leverage with profitability of insurance companies in Malaysia

To identify the relationship between volume of capital with profitability of insurance companies in Malaysia

1.6 Research question:

Does the age of company affect the profitability of insurance companies in Malaysia?

Does the size of company affect the profitability of insurance companies in Malaysia?

Does the leverage affect the profitability of insurance companies in Malaysia?

Does the volume of capital affect the profitability of insurance companies in Malaysia?

1.7 Hypothesis:

H1: There is a positive relationship between age and profitability of insurance companies in Malaysia.

H2: There is a positive relationship between company size and profitability of insurance companies in Malaysia.

H3: There is a negative relationship between leverage and profitability for Malaysian insurance companies.

H4: There is a positive relationship between volume of capital and profitability of insurance companies in Malaysia.

1.8 Significance of study:

The purpose of this study is to determine the relationship between age, size, leverage and volume of capital towards the profitability for insurance companies including Takaful in Malaysia. This study will also beneficial to finance students to identify the profitability of insurance companies and examine the sensitivity of the profitability in insurance companies towards the changing among the variables. As for practitioner, they can find this study significant to aid and enhance their understanding to the profitability sector. Therefore, this study is expected to provide experimental evidence on the profitability (financial performance) of insurance companies in Malaysia.

1.9 Summary

In conclusion, as above the background, motivation, objectives, questions, hypotheses and significance has been identified for the research.

CHAPTER 2 -LITERATURE REVIEW

2.0 Introduction

This chapter discusses literature review, summary and conceptual framework. That related to research. Preceding researches with regard to profitability mostly focused on financial institutions. This research analyze the determinants of insurance companies characteristics (age, size, leverage and volume of capital) on profitability of insurance companies in Malaysia from the year 2008, 2009, 2010, 2011, 2012. The results indicate that size, age and volume of capital are important determinants of performance of insurance companies in Malaysia while Return on Assets (ROA) has statistically insignificant relationship with leverage of a company.

2.1 The theory of insurance companies and their financial efficiency

According to Chen (2004), "higher profits provide both the means (greater availability of finance from retained profits or from the capital market) and the incentive (a high rate of return) for new investment". According to the quote, it is understandable that insurance companies are required to maximize profit to match the high rate of return for new investment.

2.2 The concept of profitability

Agreeing with Al-Shami (2008), there are several ways to measure profitability; Return on Asset (ROA), Return on Equity (ROE) and Return on invested capital (ROIC). The ROA is a measurement tool of how profitable a company is relative to its total assets. The ROA gives us an idea as to how efficient management is in using its assets to generate earning. In contrast, Greene and Segal (2004) argued that the performance of insurance companies in financial terms is normally expressed in net premium earned, profitability from underwriting activities, annual turnover, return on investment and return on equity. However, according to researches’ works from Hardwick and Adams (1999), Malik (2011), the key indicator of a firm’s profitability mainly in the insurance sector is the ROA.

The term profit itself can take either its economic meaning or accounting concept which shows the excess of revenue against expense measured for a specific time frame. Profit is one of the driving factors for company or organizations to continued existence in the ever competitive business industry. According to Hampton (2009), clarified profitability ratio as a class of financial metrics are used to assess a business’s ability to generate earnings as compared to its expenses and other relevant cost incurred during a specific period of time. Similarly, Koller (2011) argued that profitability is the most important and reliable indicator as it gives a broad indicator of the ability of an insurance company to raise its income level.

2.3 Age and Size of an insurance company

According to Born (2001), during 1980 the profitability of insurance companies varied across different a legal and regulatory measure that reveals that these environments were supposed to protect the insurance contract that may have had reverse effect if they created a significant constrained on the activities of the insurance companies. Several earlier studies (Batra, Lumpkin & Dess, 1999) argued that firm age has an influence on its performance. Newer and smaller firms, take away market share in spite of disadvantages like lack of capital, brand names and corporate reputation with older firms (Kakani, Saha, Reddy, 2001)

Bates, Murray, Jagger and Cowling (2008) found that both age and size of the firm had positive and significant effect for enterprise investment scheme recipients including the highest the level of fixed assets formation.

Several studies have been conducted to examine the effect of size and age on firm profitability. However, the empirical evidences of the linkage between profitability and firm size are somewhat inconsistent. For example, evidence collected by Hardwick and Adams (1999) from UK companies suggests that there is an inverse relation between profitability and firm size. Jay Angoff Roger Brown (2007), found that there is a positive and significant relationship between the age of a company and its profitability as measured by Return On Asset (ROA). Similarly, the research conducted on the relationship among firm characteristics including size, age, location, industry group, profitability and growth by Swiss Re (2008) indicated that larger firms are found to grow faster than smaller and younger firms found to grow faster than older firms.

In contrast, Hamadan Ahamed Ali Al-Shami (2008) found no significant statistical relation between age and profitability of insurance companies in UAE but a positive relationship between firm size and profitability. Similarly, Hafiz Malik (2011) in his Pakistan study found that there is significantly positive association between age & size of the company and profitability.

Flamini (2009) indicated that size is used to capture the fact that larger firms are better placed than smaller firms in harnessing economies of scale in transactions and enjoy a higher level of profits. In the case of insurance companies, size and age of a firm are direct profitability factors as the age and size have influential roles of conducting business and increase profits. In certain extent, age and size of hold the reputation of a firm affecting potential customers and investors. Consequently, a positive relationship is expected between size and profitability by many insurance area researches. However, Li (2007) discussed for firms that become extremely large, the effect of size could be negative due to bureaucratic and other relevant reasons.

The older the firm the more may be the profitability of the firm. This could be vindicated as experience and efficiency in the operation process may decrease cost and learning curve of production and he found even that age is the strongest determinant of profitability. Study of Vigaykumar and Kadirvelu (2004) suggests that age of firm is an important determinant of profitability. The older the firm the more will be the profitability due to experience and efficiency cost decreases. They found the positive relationship between firms’ profitability and age of the firm.

In this particular variable, the ratio might be used to determine how profitability will result the insurance company performance is:

Age

The number of years since establishment

Size

Log of Net Premium

(Total Premium earned – Reinsurance Ceded)

Size

Return on Asset

(Source: Charumathi, 2012)

2.4 Leverage of an insurance company

The trade of theory suggests a positive relationship between profitability and leverage ratio and justified by factors such as taxes, agency costs and bankruptcy costs push more profitable firms towards higher leverage. Insurance leverage could be defined as reserves to surplus or debt to equity. The risk of an insurer may increase when it increases its leverage. Therefore, insurance leverage could be defined as reserves to surplus or debt to equity. The risk of an insurer may increase when it increases its leverage.

For instance Renbao Chen and Rie Ann Wong (2004) stated that leverage beyond the optimum level could result in higher risk and low value of the firm. Empirical evidences with regard to leverage found to be statistically significant relationship but negative. Hutchison and Cox (2006) examined the relationship between financial leverage and return on equity for US banking industry. They found the negative relationship between bank capital and profitability except for the best performing banks.

For developing countries such as Malaysia there are no studies found specifically examined the profitability of insurance companies, hence there is a need for such studies in insurance sector in developing countries. In addition these studies that assists in identification of the factors of profitability determinants also help to avoid losses.

Harrington (2005) examined that the relationship between leverage and profitability has been studied extensively to support the theories of capital structure. Panayotis, Delis & Athanasoglou (2008) argued the bank with lower leverage will generally report higher ROA, but lower ROE. Since an analysis for ROE pay no attention to the risk associated with high leverage and financial leverage is often determined by regulation, ROA emerges as the key ratio for the evaluation of profitability. A study conducted in Thailand fount that for non-life insurance important factors that affect ROA are of capital fund, loss ratio and market power. Great market power does not increase profitability (Financial Service Liberalization, Final Report February 28, 2006).

Adams and Buckle, (2003) indicated the degree of financial leverage reflects insurance companies' ability to manage their economic exposure to unexpected losses. This ratio represents the potential impact on capital and surplus of deficiencies in reserves due to financial claims.

However, to calculate the financial leverage is important to determine a business’ financial solvency and its dependency upon its borrowings. The ratio used is:

Leverage

Total Debt / Shareholders’ Equity

(Source: Charumathi, 2012)

2.5 Volume of Capital of an insurance company

According to Ayele (2012), most of the studies concerning insurance companies’, volume of capital measures as the difference between total assets and total liabilities and in some cases it is measured by the ratio of equity capital to total asset. Insurance companies’ equity capital can be seen in two ways.

Narrowly, as stated by Aburime (2008), it can be seen as the amount contributed by the owners of an insurance (paid-up share capital) that gives them the right to enjoy all the future earnings. More comprehensively, it can be seen as the amount of owners’ funds available to support a business. The later definition includes reserves, and is also termed as total shareholders’ funds. No matter the definition adopted, volume of capital is widely used as one of the determinants of insurance companies’ profitability since it indicates the financial strength of the firm.

The volume of capital is widely used as one of the determinants of insurance companies’ profitability since it indicates the financial strength of the firm. As it has been expected positive relationship between profitability and capital has been demonstrated by Athanasoglou (2005).

According to Worthingtion (2009), the law requires insurance companies and its subsidiaries to have its own capital. Volume of capital will help evaluate performance, it will allow better pricing of new business. Allocating capital can help avoid moral hazard and agency problems among managers and measure the profitability of an insurance company. However here in Malaysia, the volume of capital required to set up conventional and Takaful company is RM100,000,000. In certain extent, volume of capital plays a major role on determining the profitability of an insurance company. Thus, it can be concluded that the insurers with more capital adequacy will not have any comparative advantage to improve their return on assets (Charumathi, 2012).

Hifza Malik (2011) examined the relationship between volume capital and return on asset for Pakistan insurance industry and found positive and statistically significant relationship between insurance capital and profitability and size of capital is one of important factors affecting ROA. Similarly Hamadan Ahamed Ali Al-Shami (2008), found in his investigation that there exists a positive and significant relationship between volume of capital and profitability of the UAE insurance companies.

2.6 Summary on Literature Review

2.7 Conceptual Framework

Independent Variables Dependent Variable

Size

Profitability [Return on Asset] ROA

Age

Leverage

Volume of Capital

2.8 Summary on Conceptual Framework

This chapter comprises of age, size and the leverage of insurance companies in Malaysia affecting the profitability ultimately. It also contains conceptual framework to support. And literature reviews do support positively towards the research proposed.

CHAPTER 3: RESEARCH DESIGN AND METHODOLOGY

Introduction

This chapter converses the samples, sampling frame, data collection methods and statistical techniques. Therefore, the previous findings in literature review will be examined in this chapter. This chapter also includes the approach adopted to examine the effect of main determinants on profitability, the type of data used and techniques employed to collect the data, including sample size. Classical linear regression analysis based on the results of multiple regression analysis is adopted to measure the effect of determinants on insurance companies’ profitability by using SPSS.

Research Method

To comply with this thesis, quantitative method is adopted and multiple regression analysis is implemented to measure the effect of determinants on profitability. The method used reflects the simultaneous relationships amongst multiple numbers of independent and dependent variables found across the regression model, hence suited the nature of the study.

3.1 Sampling selection

For this research, the characteristics of the sampling frames are consists of Age and Size which will be derived from the Memorandum of Association from 14 Conventional and Takaful Insurances in Malaysia as stated below. The leverages of companies will be derived from the financial statements of companies selected.

List of Provision Companies selected in this research:

Conventional Insurance

Takaful Insurance

CIMB AVIVA ASSURANCE BERHAD

SYARIKAT TAKAFUL MALAYSIA BERHAD

GREAT EASTERN LIFE ASSURANCE (MALAYSIA) BERHAD

TAKAFUL IKHLAS SDN BERHAD

MANULIFE INSURANCE BERHAD

CIMB AVIVA TAKAFUL BERHAD

AMERICAN INTERNATIONAL ASSURANCE BERHAD

PRUDENTIAL BSN TAKAFUL BERHAD

ETIQA INSURANCE BERHAD

AIA AFG TAKAFUL BERHAD

PRUDENTIAL ASSURANCE MALAYSIA BERHAD

ETIQA TAKAFUL BERHAD

HONG LEONG ASSURANCE BERHAD

AMFAMILY TAKAFUL BERHAD

Source: Bank Negara Malaysia, 2012

3.2 Data collection methods

The secondary data method will be used in this particular research to gather the financial statements and reports of several conventional and Takaful companies in Malaysia in the duration of 2007-2011. The data and materials will be collected from the financial statements, financial reports, journals and articles from the selected companies. (e.g: Financial Reports of Conventional Insurance and Takaful companies, Annual Insurance Statistics from Bank Negara Malaysia Website). The data collected focused into the following variables:

. Return on Assets (ROA)

.Company Leverage (LV)

. Company Age (AG)

Differences between observation year and establishment year

. Company Size (SZ)

. Company Capital (EC)

(Sources Malik, 2011, Martani, 2011)

The companies’ performance and profitability selected are to be measured over the period of three (5) years from 2008 to 2012. For this study, financial data has been collected from financial statements (Balance Sheet and Profit & Loss Account) derived from the statement of accounts which is published Insurance Association of Malaysia and respective annual reports of the companies selected.

3.3 Research Method

This study is focusing on the Quantitative Analysis. So, Data analysis such Descriptive Statistic and Correlation Analysis is the best method to use. The quantitative analysis is used to gather much detailed information needed to complete this research. The database will be collected from the appropriate source such as journals, annual reports, and financial statements. The use of regression analysis is required as the firm specific characteristics such as Leverage, Equity capital, Age are regressed against return on assets (ROA). With linear regression analysis adapted to this thesis, the determinants on insurance companies’ profitability can be measured by using Statistical software package for social sciences (SPSS). With the use of multiple regressions, synchronized relationships amongst the independent and dependent variables can be initiated across the regression model.

3.4 Data Sources

In order to comply with the research objectives, the researcher concentrated on the secondary data method which the data is obtained from respective insurance companies’ annual reports and statement of accounts. Combining the data by introducing additional variation, mitigate problems of multi-collinearity that may arise if time series are modelled individually. Thus, by structuring the model in a proper way, the impact of certain forms of omitted variables bias in regression results can be removed.

3.5 Data Analysis

The data analysis section of this study is based on regression analysis. The correlation analysis between dependent and independent variables, deals the results of the liner regression and data analysis that constitute the main findings of this research.

3.6 Regression Analysis

The regression analysis is adapted to examine the relationship between the dependent variables (profitability) of Malaysian insurance companies selected and explanatory variables such as age, size, leverage and volume of capital.

Upon the result of regression analysis, an equation is determined represents the best prediction of dependent variable from independent variables. Correspondent regression model is selected from mixed and random effect regression.

The linear multiple regression model developed for this research is as follows:

ROA = β0 + β1 (AG) + β2 (SZ) + β3 (LV) + β4 (EC)

In this particular thesis, the dependent variable is Return on Assets (ROA), which is an alternative to profitability. ROA can be computed with Net income before tax divided by total assets. The independent variables considered for this thesis include AG, SZ, LV, EC. The assumptions of linear multiple regression model is also tested.

3.7 Variables Selection and Measurement

Profitability

In this research, net income before tax to total assets (ROA) is used to measure profitability.

Age of company

This particular variable is measured by the number of years from the date of establishment of the selected companies until 2009, 2010 and 2011 for three (3) consecutive years.

Size of company

The measurement for company size is taken from the calculated log of net premium. The log of net premium comprises of the reinsurance ceded deducted from the total premium earned from the companies selected.

Leverage

Leverage can be defined as the amount of debt used to finance a firm’s assets. Company has higher debt than equity is considered to be highly leveraged. Leverage is measure by total debt against total amount of equity in a company.

Value of Capital

Earlier researches used the book value of equity to measure the volume of capital. Likewise, the book value of equity will be taken as measure of volume of capital for this thesis. Total equity capital = book value of equity measured by the natural logarithm of book value of equity.

3.8 Summary on Research Design and Methodology

In nutshell, this chapter comprises of Introduction, samples, sampling frame, data collection and statistical analysis. This has to be done to perform the research adequately.

CHAPTER 4: ANALYSIS AND FINDINGS

4.0 Introduction

CHAPTER 5: TIMELINE

Month/Activity

Sept

Oct

Nov

Dec

Jan

Feb

March

April

May

Research Title, background of study, Research Objectives and aim

Research Hypothesis, Significance of study and Literature Review (articles)

Dependent and Independent variables, samples

Data Collection Methods and measurements