EMPIRICAL ANALYSIS OF THE IMPACT OF INDIVIDUAL AND

ECONOMIC RISKS ON THE PROFITABILITY OF THE MACEDONIAN

NON-LIFE INSURANCE COMPANIES

Mihail Petkovski, PhD

Faculty of Economics Skopje
mihail.petkovski@eccf.ukim.edu.mk
Jordan Kjosevski, PhD
Silk Road Bank
koseskijordan@gmail.com

Abstract

The aim of this paper is to examine the impact of individual and economic risks on the
profitability of the Macedonian non-life insurance sector. In our empirical model, the
profitability of the insurance sector ( measured through ROA) is a function of liquidated
damages in gross written premiums, market concentration, interest rate on deposits, inflation
rate and GDP growth. The analysis covers eleven non-life insurance companies in the period
2009: Q1 to 2018: Q3, using five different panel methods to achieve the purpose of the work.
The results indicate that liquidated damages in gross written premiums (reflecting the individual
insurance risk), market concentration and GDP growth strongly affect the profitability of the
Macedonian insurance sector.

Key words: individual and economic risks, profitability, non-life insurance companies,
insurance industry

JEL classification: G22, C23, O52

1. Introduction

The last economic and financial crisis has left behind the consequences that we still feel
today. The global economy faces slow rates of economic growth, low interest rates, as well as
more pronounced volatility in financial markets. These trends did not circumvent the insurance
sector, as an integral part of the financial markets. Thus, around the world, the largest non-life
insurance markets are below average profitability, according to Sigma report of the Swiss Re
Institute (Sigma No 4, 2018). The global non-life insurance sector is in a weak phase of the
profitability cycle, which reflects soft risks, weak investment and a high level of capital assets.
The analysis shows that insurers in the main Western markets and Japan need to improve their
margins of insurance (profit margin as a percentage of premium) by around 5 to 9 percentage
points, if they want to deliver the desired return on equity (ROE) of 10% in the future (Sigma No
4, 2018).
Bearing this in mind, in this paper, we analyse how individual and economic risks affect
the profitability of the Macedonian insurance companies. The Macedonian insurance sector is
the third largest sector of the financial system. Its share in total assets of the financial system in
2017 was 3.7% (NBRM Annual Financial Stability Report, 2017). The Macedonian insurance
sector consists of 11 insurance companies for non-life insurance and five for life insurance. The
share of non-life insurance in the total gross written premiums is dominant, amounting to around
85% in 2017. Due to this high participation, only non-life insurance companies are analysed. The
analysed period is from the first quarter of 2008 to the third quarter of 2018.
According to the best knowledge of the authors, this is the first empirical study which is
entirely focused on the impact of individual and economic risks on the profitability of insurance
companies and it offers several novelties. We use unbalanced panel for the period from Q12009
to Q32018 for 11 Macedonian insurance companies. The selected period is determined by the
need to encompass a period of relative boom, (i.e., upswing of economy, downfall, economic
crisis), as well as its recovery. Also, within this study, we include a greater number of individual
and economic risks than other papers, in order to determine how they affect the profitability of
the Macedonian insurance companies. The other novelty is that, in order to provide consistent
and unbiased results, we have implemented five alternative estimation techniques: the average
ordinary squares-OLS, the fixed effects model, the random effect model, the GMM model and
the System GMM.
The structure of the paper is as follows. After the Introduction, Section 2 gives an
overview of the literature on empirical findings relevant to the determinants for profitability of
insurance companies. The sources of the employed data, as well as the methodology are
presented in Section 3. Section 4 shows empirical results for the determinants of the insurance
companies’ profitability. Section 5 concludes the paper and provides policy recommendations.

2. Literature

Most of the papers that carry out empirical research on the impact of the risk
management on the profitability of insurance companies, usually focus on joint consideration of
determinants (non-life insurance and life insurance).
Hoyt (2008) used Sample Pearson Correlation Coefficients, concluding that the profits of
insurance companies depend on the carrying amount of the assets, the carrying amount of the
liabilities, the paid dividend, the market value of the shares and the industrial diversification. The
time period for which he conducted his research was from 2000 to 2005.
Harrington and Niehaus (2003) analysed the impact on profitability based on two
determinants: the first determinant encompasses variables that stimulate profitability as a result
of improving the company's reinsurance plan. For example, it confirms that proportionally to the
increase of transferred premiums in reinsurance, there is an increase of profits realized by
insurance companies annually. The second determinant encompasses variables that influence the
decisions of the insurance companies for the level of application of the ERM (Enterprize Risk
Management).
Babbel (1994) gives an explanation of the impact of the risk management process on the
profitability of insurance companies (non-life insurance and life insurance). The author uses a
model with two variables (independent and dependent) to determine the impact of the risk
management process on the profitability of insurance companies, represented by the amount of
gross premiums as an independent variable, and the annual net profit, as a dependent variable.
Pervan, Ćurak and Popovski (2013) analysed the determinants of the profitability of
insurance companies in Macedonia from 2002 to 2011. They used a return on assets as the
dependent variable. The model employed two groups of independent variables, i.e. variables
specific to insurance companies, and external variables, or variables specific to the insurance
industry and macroeconomic variables. The first group included: share of costs, share of
damages and the size of the insurance company, while in the second group were GDP growth and
inflation. The results of the survey showed that the share of costs and the share of damage has a
negative and statistically significant impact on the profitability of insurance companies. The
variable size of the insurance company has a positive, but statistically insignificant impact on
profitability. The external variable GDP growth has a statistically significant and positive impact,
and, in contrast, variable inflation has a statistically significant, but negative impact on the
profitability of insurance companies in Macedonia.

3. Methodology

According to the discussion in the introductory part, the economic model that we use in
the empirical analysis should cover the risks in the insurance sector and their potential impact on
profitability. As a measure of profitability of the insurance companies, we employ ROA, because
it is implemented in most of the studies (Santomero and Babbel, 1997; Dorofti and Jakubik,
2013).
In order to identify the variables that will potentially influence profitability, we divided
the insurance sector’s risks into individual and economic risks. Individual risks are difficult to
cover individually, because data that indicate the likelihood of a fire, theft, the incidence of road
accidents, the likelihood of an earthquake, and the like are needed. Therefore, it is common in
the literature to include them by implementing liquidated damages in gross policy premiums,
since all these events are reflected on the claims paid. Economic risks are included in the
analysis through the following of four indicators: market concentration, measured by the
Herfindahl-Hirschmann index; the interest rate on the deposits of the Macedonian banking
system, inflation rate; and GDP growth rate. The model does not include variables for covering
the liquidity risk, given its low significance in non-life insurance, due to the small investments of
Macedonian insurance companies in government bonds and shares. Insurance Supervision
Agency (2015). . The empirical model is as follows:

ROAi , t  a0  1 GROCP i ,t +  2 CONC i ,t   3 IRD t +  4 INFt   5 GDPGt + u t   i ,t

(1)

where ROA is the profitability of the insurance company i at time t; LDOCP is liquidated
damages in gross written premiums; CONC is the Hirfindahl-Hirschman Index; IRD is the
average interest rate on deposits in domestic currency in the banking sector of Macedonia at time
t;INF is the rate of inflation; GDPG is the rate of GDP growth; u t is the error member specific
for each insurance company (individual heterogeneity);  t ,i an idiosyncratic error member.
Given that the economic model (1) has a time and cross-sectional component, a panel
method is needed for its evaluation (i.e. the evaluation of the odds from up to). The starting point
in each panel model is the assessment of fixed and random effects. They are well documented in
literature, for example (Wooldridge, 2007). In short, the analysis of fixed effects assumes that the
units of interest (in our case, the insurance companies) are fixed, and that the differences between
them are not of interest. What is of interest is the variance within each unit, assuming that the
units (and their variations) are identical. By contrast, the analysis of random effects assumes that
the units are a random sample extracted from a larger population, and that therefore the variance
between them is interesting and a conclusion can be drawn for a larger population. The more
fundamental difference between them is the way of locking. The model of fixed effects supports
only a conclusion for the group of measurements (countries, companies, etc.). The random
effects model, on the other hand, provides a lock to the population from which the sample was
extracted. Judson and Owen (1996) argue that the model of fixed effects is desirable in the
analysis of economic and financial systems for two reasons: i) the unobserved individual effects
that represent the characteristics of units (i.e. companies) are very likely to be in correlation with
other regressors; and ii) it is quite likely that such a panel is not a random sample of many
countries/companies, but most of the countries/companies of interest. Accordingly, for our
analysis of the insurance companies, the model of fixed effects is adequate, since the data set
covers all Macedonian insurance companies and the conclusions drawn from this analysis will
only apply to them. However, in addition thereto, we also conduct the famous statistical test of
(Hausman, 1978) for distinguishing between the models of fixed and random effects.
The models of fixed and random effects imply that all the variables on the right side of
the model (1) are exogenous. However, for some of them, it can be argued that there is a
reciprocal causation, as part of them arise from the balance sheets of the insurance companies
themselves. Such feedback may cause inconsistency in the assessment of the model of fixed or
incidental effects. In order to overcome it, the model can be evaluated by means of the so-called
instrumental variables technique, in which potentially endogenous variables are instrumented
with variables that are highly correlated with the particular regressor, but are not correlated with
the error member (Wooldridge, 2007). The most common method for evaluating with instrument
variables is the generalized method of moments (GMM). In a GMM assessment, the information
contained in the population momentum constraints is used as instruments (Hall, 2005), that is,
the instruments are most often generated from the past values of the potentially endogenous
variables. A second critique that can be given to models with fixed and random effects is the
potential inertia of the dependent variable. Namely, the profitability in our model (1) can involve
inertness in its movement, that is, its present value to a certain extent depends on its past value.
However, one drawback of the GMM approach, is that in samples with a limited time
dimension (small T) and high persistence, the estimation has low precision (Blundell and Bond
1998). Therefore, we also estimate a "system GMM "developed by (Arellano and Bover, 1995)
and Blundell and Bond (1998), which addresses this concern. Under this approach, the lagged
bank level variables were modelled as pre-determined (thus instrumented GMM-style in the
same way as the lagged dependent variable) while the country-level variables and the global
variables were treated strictly exogenous (instrumented by itself as an "IV style" instrument,
(Roodman, 2009).
According to all of the above, the further analysis evaluates the economic model (1)
through 5 panel methods: the basic OLS method, the method of fixed effects, the method of
random effects, the GMM method and the system-GMM method. The primary OLS method is
presented only indicatively, since it ignores the individual heterogeneity in the panel. The choice
between the fixed and the random effects is made on the basis of the Hausman test (1978). The
validity of selected instruments for parametric evaluation can be tested using the Sargan test. The
second group of tests refers to tests of serial correlations in different residuals (first-order (m1)
and second-order (m2) serial correlation). The first-order autocorrelation in the differed residuals
does not imply that the estimates are inconsistent (Arellano and Bond, 1991). However, the
second-order autocorrelation would imply that the estimates are inconsistent.
 4. Data

The model (1) is rated quarterly for all 11 non-life insurance companies, from the first
quarter of 2009, including the third quarter of 2018. The time period of the model is mainly
determined by the availability of data. However, 39 time periods and 11 insurance companies
give 429 observations, which is enough for a credible assessment of the model. The data on the
ROA, the capital, the liquidated damages in gross policy premiums, the Hirfindahl-Hirschman
Index are taken from the Insurance Supervision Agency. The interest rate on deposits was taken
from the monetary statistics of the National Bank. The inflation and GDP data were taken from
the State Statistical Office.

Table 1 Descriptive statistics

Variable Obs. Mean Std. Dev. Min Max

ROA 394 0.90 4.7345 -27.2 9.9
CONC 404 8.30 4.3089 0.2 25.2
LDOCP 429 0.41 0.10 0.27 0.65

IRD 429 4.59026 2.04187 1.99 8.36

INF 429 1.27949 1.77207 -2.1 4.9
GDPG 429 2.04 2.53 -3.7 8.5
Source: Authors’ calculation based on data

Based on the data we can say that there are significant differences among the Macedonian
companies for non-life insurance in all selected variables. Namely, for ROA there are companies
where this determinant has a negative value of -27.2, up to 9.9. It is similar with the other
variables. For example, there are companies that have market share of 25.2%, compared to a
company that only has 0.2% of the market. It is similar with the other variables. It is similar with
the macroeconomic variables, where we have large oscillations in the analysed period.
Table 2 Estimation Results

Ordinary Instrumental
Variables least squares Fixed Effects Random Variables - System
(OLS) (FE) Effects (FE) GMM GMM
ROA(-1) -0.970
(0.129)
[0.000]
Const 12.45 11.10 9.804 8.221 7.125
( 3.72 ) ( 4.07 ) ( 3.69 ) ( 4.08 ) (5.332)
[ 0.000] [ 0.007] [ 0.001] [ 0.044] [0.211]
CONC 0.584 0.575 0.468 0.438 0 .344
( 0.301) ( 0.335) ( 0.204) ( 0.336) (0. .272)
[ 0.006 ] [ 0.086 ] [ 0.122 ] [ 0.196 ] [0.074]
LDOCP -0.338 -0.327 -0.178 -0.159 -0.449
( 0.114 ) ( 0.119 ) ( 0.101 ) ( 0.114) (0.444)
[ 0.003] [ 0.002] [ 0.078] [ 0.145] [0.081]
IRD -0.254 -0.098 -0.280 -0.107 -0.264
( 0.122 ) ( 0.124 ) ( 0.101 ) ( 0.121 ) (0.399)
[ 0.212 ] [ 0.430 ] [ 0.011 ] [ 0.396 ] [0.522]
-0.321 -0.370 -0.308 -0.363 - 0.705
INF ( 0.142 ) ( 0.112 ) ( 0.112 ) ( 0.121 ) (0.388)
[ 0.004 ] [ 0.002 ] [ 0.062 ] [ 0.003 ] [0.911]
0.031 0.055 0.02 0.659 0.622
GDPG ( 0.071 ) ( 0.076 ) ( 0.065 ) ( 0.083 ) (0.047)
[ 0.883] [ 0.078] [ 0.692] [ 0.085] [0.053]
Number of
Insurance companies 11 11 11 11 11
Number of instruments 9
Hausman test 0.1586

Hansen test (p-value) 0.719 0.315

Ho: The instruments are valid
Arellano-Bond test AR (1) 0.040
Arellano-Bond test AR(2)
0.218

Source: Authors’ calculation

5. Results and discussion

Table 2 presents the results. Columns (1) - (5) represent the five assessment techniques
presented in section 4.2. Diagnosis is given in the lower part of the table. The Hausman test does
not reject the zero hypothesis that the fixed effect evaluator is efficient and consistent with that
of random effects. The GMM model uses the past values of potentially endogenous variables to
correct their endogeneity, as instruments. Potentially endogenous variables are treated for
liquidated damages in gross policy premiums and the market share, given that they are all
calculated with variables arising from the balance sheets of the insurance companies. The model
is well specified according to the tests for the identification and validity of the instruments. The
endogenous test of the instrument variables evaluator reject the zero hypothesis that these
variables should actually be treated for exogenous. This suggests that calculation with instrument
variables is required. Accepting the endogeneity is not surprising, given that insurance
companies in Macedonia are unlikely to change the solvent margin, in order to manage
individual and market risks. In other words, this important finding may indicate the
underdeveloped risk management process in the Macedonian insurance sector.
The system-GMM evaluator, on the other hand, assumes that in profitability there is
inertia and treats the endogeneity of the dependent variable with the past value. In order to do
that, we used past values in the levels and the first difference, in order to increase the efficiency
of the assessor. The model is well-specified according to the Hansen test for instrument validity
and the serial correlation tests. Also, we found that profitability was assessed as statistically
insignificant variable, which can indicate that profitability has inertia. Hence, the column (5) is
adequate assessment of our model. According to all this, in the further discussion, as the most
appropriate assessment of our model we will consider the model of system-GMM in the column
(5). However, the view of Table 3 points to the high robustness of our results, given that in all
specifications, regardless of their specifics, the variables generally retain their economic and
statistical significance.
In the assessment of the model (5), three variables are statistically significant: the claims
liquidated damages in gross policy premiums, the concentration and the GDP. The other
variables are not statistically significant, probably due to the following empirical facts: 1. the
method of calculation of ROA net income/total assets by the insurance companies. However,
since the subject of interest in this paper is to examine the impact of individual and economic
risks on ROA, in this paper we excluded determinants that do not represent a risk factor; and 2.
insignificant investments in real estate and other assets that depend on the change in the rate of
inflation and other interest rates in the system.
The results indicate that: the increase of CONC of one percent will cause an increase in
the ROA margin of 0.344%; while an increase in LDOCP of one percent would trigger a ROA
decline of about 0.449%. Furthermore, the increase in gross domestic product by 1 percentage
point will cause ROA growth of 0.622%. The signs of the significant variables coefficients are
expected. These results emphasize the need to pay attention to both individual and economic
risks, and above all GDPG, given that according to the results they have the greatest impact on
ROA.

6. Conclusion

Our results provide evidence of statistically significant relationships between the

individual and economic risks and the profitability of the insurance sector. In particular, we
provide strong evidence that the overall Macedonian insurance sector’s profitability positively
depends on the GDP growth and market concentration, and negatively on the liquidated damages
in gross written premiums. These results are consistent with those obtained in the insurance
literature. According to the best knowledge of the authors, this is the first empirical study which
is entirely focused on the impact of individual and economic risks on the profitability of
insurance companies.
 The results of the study offer useful recommendations both for managers of insurance
companies and for regulator of the insurance sector (Insurance supervisory agency). For
example, expenditures in respect of damages incurred may be reduced by structural reforms and
improvements in risk management, the design of products, damage management and premiums
written. As it was mentioned before, the profit of companies is determined by their investment
activity and gross written premium. However, in the absence of significant revenue from
investment activity, due to the global decline of interest rates, insurance companies need to pay
more attention to the ratio of liquidated damages and gross premium. Furthermore, the Insurance
supervisory agency should enhance its training on the management risk to insurance companies,
offering them a more advanced methodology, that includes exposure to individual and economic
risks.
The results of this study, suggest the need for changing the business model of
Macedonian insurance companies. The purpose of changes would be strengthening of their
internal capacities for recognizing the significance of operational risks, in this context of
operating costs and the amount of liquidated damages, as key variables for their success.
Specifically, the existing strategy of the Macedonian insurance companies, characterized by
“the race for policies” resulting with high costs, should be replaced by a sustainable business
model that will generate and sustain profitability, as a result of efficient management of
individual and market risks and the process of payment of damages.

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ЕМПИРИСКА АНАЛИЗА ЗА ВЛИЈАНИЕТО НА ИНДИВИДУАЛНИТЕ

И ЕКОНОМСКИТЕ РИЗИЦИ ВРЗ ПРОФИТАБИЛНОСТА НА
МАКЕДОНСКИТЕ КОМПАНИИ ЗА НЕЖИВОТНО ОСИГУРУВАЊЕ

Апстракт

Целта на овој труд е да испита како индивидуалните и економските ризици влијаат врз
профитабилноста на компаниите за неживотно осигурување во македонскиот
осигурителен сектор. Профитабилноста на компаниите е изразена преку индикаторот РОА,
додека како детерминанти се користат односот на ликвидираните штети врз бруто-
премијата, концентрацијата на пазарот, каматната стапка на депозитите, стапката на
инфлација и растот на БДП. Анализата опфаќа единаесет компании за неживотно
осигурување во периодот од првиот квартал на 2009 година до третиот квартал на 2018
година и применува пет различни панел методи. Резултатите укажуваат дека односот на
ликвидираните штети врз бруто-премијата, концентрацијата на пазарот и растот на БДП,
влијаат врз профитабилноста на македонскиот осигурителен сектор.

Клучни зборови: индивидуални и економски ризици, профитабилност, компании за

неживотно осигурување, oсигурителна индустрија.

JEL classification: G22, C23, O52.