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
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.
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
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 theprocess of data
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.
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