Risk based capital, asset allocation, firm size and investment returns of insurance companies in Kenya

Abstract

The recent wave of corporate failures across the globe and more importantly local insurance companies, that have been declared insolvent despite holding the minimum capital requirement as per the insurance act, has been a concern to both the industry players and regulators. This has triggered increased government regulation and the adoption of Risk Based Capital (RBC), where risks are identified in a timely manner and capital is injected early enough to prevent a company from collapsing. The link between RBC and investment returns remains imprecise due to divergence in findings. The differences in research outcomes is attributable to how the study variables were operationalized, selection of variables and control variables, the econometric models used and differences at contextualization, which give rise to conceptual, methodological and contextual gaps. The study’s main goal was to establish the relationship among risk based capital, asset allocation, firm size and investment returns of insurance companies in Kenya. The study first looked at the relationship between RBC and investment returns, then explored the effect of asset allocation as an intervening variable and firm size as a moderating variable. The joint effect of all variables on investment returns was also tested. Risk based capital was calculated by incorporating capital required for market risk, insurance, credit and operational risk which is computed by applying a set of defined risk factors. Asset allocation was measured using a composite score of investment vehicle and time horizon. Gross written premium and total assets were used as a measure of the size of the firm and investment income ratio as an indicator of investment returns. The population under study encompassed 63 insurance companies licenced by Insurance Regulatory Authority. A longitudinal (panel) design was used to describe the association amongst variables on the study duration. Moreover, secondary data was collected from the insurance companies’ annual returns submitted to IRA for a period of 5 years (2014-2018) which yielded suitable data points for analysis. Test of normality, linearity, homogeneity of variance, multicollinearity, independence and cointegration were undertaken with the findings meeting the requirements to undertake linear regression analysis. Multiple linear regression was applied in determining the nature of the relationship among variables based on 5% significance level and the stated study hypothesis. Coefficient of determination ( 𝑅2) was derived to show how the model fits the data. The findings of the study revealed that the relationship between RBC and investment returns was found to be significant. After introduction of asset allocation as an intervening variable, there was an effect on the relationship between RBC and investment returns thus an indication of mediation. Gross written premiums and total assets had a moderating effect on the relationship between risk based capital and investment returns. The results showed that RBC, asset allocation and firm size had a joint effect on investment returns of insurance companies in Kenya. This study has generally contributed to the field of finance and risk management and, particularly risk based capital and the effect of asset allocation and firm size on insurance companies’ investment returns. The study has also contributed to policy especially in the implementation of the risk based supervision model in the insurance industry. The results would help portfolio managers to diversify their investment to maximize their returns without being concerned on the amount of capital to hold. This is attributed to by the study findings which indicate a positive relationship between RBC and investment returns, thus allowing the managers to justify high risk investments that attract a high risk factors.