Chapter 1: Introduction

1.1. Background of the Study

The role of finance in business is crucial to its existence and success, as it supports a company's fixed
assets and working capital needs. Companies can raise capital through earnings, borrowing, or selling
ownership interests. The mix of debt and equity used to raise capital is known as leverage, and it's an
important finance decision that firms face. The relationship between leverage and a firm's value and
performance has been a topic of debate for many years, with various theories developed to explain it.
It's important to have empirical evidence on the impact of leverage on financial performance for the
benefit of firms and investors. Despite being a significant topic, studies on the effects of leverage on
financial performance in the Ethiopian private insurance industry are limited. This study aims to fill that
gap by examining the effect of leverage on the financial performance of private insurance companies in
Ethiopia, providing financial managers with applied knowledge to optimize leverage for optimal financial
performance and shareholders' wealth.

The researcher is studying the discipline of finance which examines the effect of leverage on the
financial performance of insurance companies. The study focuses on the impact of the financing mix of
debt and equity on the financial performance, measured by profitability, of private insurance companies
in Ethiopia. This discipline explores the trade-off between risk and return of the firm and how the
financing decisions affect the firm's value. It is a critical area of research as it provides insights into how
firms can optimize their financing mix to maximize their financial performance and ultimately their
shareholders' wealth.

1.2. Problem Statement

The financial performance of private insurance companies plays a crucial role in the stability and growth
of the financial sector in Addis Ababa, Ethiopia. Despite its importance, the effect of leverage on
financial performance of these companies in the city has not been extensively researched. This study
aims to fill this research gap by investigating the effect of leverage on the financial performance of
private insurance companies operating both general and long-term insurance businesses in Addis Ababa.

Previous studies on the profitability determinants of the insurance sector in Ethiopia have either only
focused on the general insurance business or neglected to consider variables such as operating leverage
in their analysis. Let’s see some of the previous works on this area.
The leverage decision related to a given business entity is at the center of many other decisions in the
area of corporate finance. One of the many objectives of a corporate financial manager is to ensure low
cost of capital and thus maximize the wealth of shareholders in which it has direct relationship with the
leverage of a given firm.

In fact, the study of relationship between Leverage and firm performance have been tried to be
addressed in different jurisdiction (developed and developing countries). The irrelevance theorem of
Leverage of Modigliani and Miller (1958) has now become irrelevant itself since the effect of Leverage
on financial performance of a given firm is empirically supported. Different studies conducted in
different countries show that leverage, measured by different ratios, has either positive or negative
effect on a given firm’s financial performance. For instance, studies of Mauwa et al (2016), Omukaga
(2017), and Tharmila and Arulvel (2013) conducted on stock exchange of different developing countries
and other firms revealed that leverage is negatively associated with return on asset and return on
equity.

In Ethiopian context too, the findings of effect of Leverage on financial performance are mixed, both
positive and negative, though the number of studies conducted related to Leverage is limited. From
these limited studies, almost half of them studied determinant factors of a given firm’s leverage. For
instance, Amanuel (2011) investigated determinants of leverage for manufacturing share companies in
Addis Ababa city; Bayeh (2011), Mohammed (2014), Saddam (2014), Tesfa(2016), and Guruswamy &
Adugnaw (2016) studied determinants of leverage of insurance companies in Ethiopia; Weldemikael
(2012) examined determinants of leverage on commercial banks in Ethiopian banking industry.

However, there are also studies that have been conducted on effect of leverage on non-financial and
financial institutions. On non-financial companies, Abnet (2013) studied the effect of leverage on
financial Performance of Ethiopia’s Metal and Engineering Industry; Frezewed (2016) investigated
corporate leverage and its impact on profitability of manufacturing firms in Ethiopia; Asrat (2016)
studied the relationship between leverage and financial performance of Ethiopian cement Companies.
On the other hand, Mathewos (2016) studied the effect of leverage on financial performance of
commercial banks in Ethiopia; Muhammed, Ashenafi and Netsanet (2015) conducted study on the effect
of leverage on financial performance of commercial banks
in Ethiopia. Except the study of Aragaw (2015) that found the existence of negative effect of leverage on
financial performance of commercial banks in Ethiopia, all of the above studies found that leverage
measured by different ratios have positive effect on financial performance.

Except the fact that some studies have been conducted on the factors that affect the performance
(profitability) of insurance industry in Ethiopia, there has not been any comprehensive study that has
been conducted on the effect of leverage on financial performance of insurance companies in Ethiopia
in general and private insurance companies in particular as far as the researcher’s knowledge
concerned. Regarding factors that affect the performance (profitability) of insurance industry in
Ethiopia, Meaza(2014), Hannamariam (2015), Hadush (2015), Mistre (2015), Suheyli (2015), Gemechis
(2017), and Adenew (2017) have conducted researches by including different firm specific factors
(company size, liquidity, age of the firm, asset tangibility, leverage, loss ratio, reinsurance dependency),
industry level factors (Industry Concentration ratio), and macro factors (growth domestic products and
inflation). The selection of variables and findings on some variables, including leverage ratio, of these
studies, however, were inconsistent and look contradictory. These previous studies could not tell us the
effects that leverage has on financial performance of insurance companies that engages in general and
life insurance business than showing us determinant factors of leverage and determinants of financial
performance of insurance companies.

This study is different from these previous studies in the objectives it aims to achieve, hypotheses it aims
to test, and variables it aims employe. I Most of the previous studies that dealt with profitability
determinants of insurance sector in Ethiopia focused only on general insurance business (non-life) and
did not include long-term insurance service (life insurances business) in their studies. These studies, in
fact, overlooked effect of leverage on financial performance of composite insurance business operation
(both general and non-life business) in Ethiopia.

This study is an attempt to address these limitations by examining the effect of leverage on the financial
performance of private insurance companies that offer a composite of general and long-term insurance
services.

The findings of this study will have important implications for the private insurance companies in Addis
Ababa, as well as for stakeholders and policy makers in the financial sector. By providing empirical
evidence on the relationship between leverage and financial performance in the private insurance
industry in the city, this study will contribute to the existing body of knowledge and inform future
research in this area.

1.3. Research Question

1. What is the effect of leverage on the financial performance of private insurance companies in
Ethiopia?
2. How does reinsurance dependence impact the financial performance of private insurance
companies in Ethiopia?
3. Does company size have a significant effect on the financial performance of private insurance
companies in Ethiopia?
4. How does the claim ratio affect the financial performance of private insurance companies in
Ethiopia?
5. What is the relationship between premium growth and the financial performance of private
insurance companies in Ethiopia?

1.4. Objectives of the Study

1.4.1. General Objective
To examine the effect of leverage on financial performance of private insurance companies in Ethiopia
and determine their optimal level of leverage to achieve optimum level of firm's financial performance
(profitability) and hence shareholders' wealth.

1.4.2. Specific Objectives

1. To determine the optimal level of leverage for private insurance companies to achieve
maximum financial performance and shareholders' wealth.
2. To analyze the impact of leverage on profitability of private insurance companies operating in
life and non-life insurance business.
3. To assess the effect of total debt on financial performance of private insurance companies in
Ethiopia.
4. To examine the effect of degree of operating leverage on financial performance of private
insurance companies in Ethiopia.
5. To examine the effect of reinsurance dependence on financial performance of private insurance
companies in Ethiopia.
6. To assess the effect of company size on financial performance of Private insurance companies in
Ethiopia.
 7. To examine the effect of Claim ratio on financial performance of Private insurance companies in
Ethiopia.
8. To assess the effect of premium growth on financial performance of Private insurance
companies in Ethiopia.

1.5. Significance of the Study

The significance of the study would be to provide insights into the impact of leverage on the financial
performance of insurance companies. This information could be useful for insurance companies,
investors, regulators and other stakeholders in the insurance industry.

First and foremost, the study is important for management bodies and shareholders of Ethiopian private
insurance companies by providing information on the effects of leverage on performance of their
company and the care needs to be made during financing decisions as well. For managers, it can
empower and guide them in achieving an optimal leverage decision which in turn help them to minimize
a cost of capital and maximizing their firms’ value.

Furthermore, this study is important for current shareholders and potential investors of Ethiopian
private insurance companies by giving an ample knowledge and direction about the relationship
between leverage and insurance companies’ performance.

The study could also contribute to the existing body of knowledge on the relationship between leverage
and financial performance in the insurance sector, and inform future research in this area.

1.6. Scope of the Study

This study deals with the effect of leverage on financial performance, which is considered an internal
(firm-specific) factor. Thus, external (industry-specific and macroeconomic) factors that may impact the
performance of insurance companies are not covered in this study.

Additionally, the study is limited to a ten-year period from 2008 to 2017 and only includes selected
private insurance companies with 18+ years of establishment. The government insurance company, the
Ethiopian Insurance Company, is excluded from the study due to the researcher's belief that company
size has an effect on financial performance, and the large size of this company could potentially affect
the data due to outlier effect.

As companies are the unit of analysis, company-level data from their head offices (located in Addis
Ababa), websites, and the National Bank of Ethiopia will be utilized for this study.
1.7. Definition of Terminologies
Leverage: refers to the use of borrowed funds to finance a company's assets, operations, or
investments. It is a way for a business to raise capital and increase its financial stability and growth
potential. In leverage, the company can either borrow funds or issue new ownership interests to raise
capital. The mix of debt and equity used by a company is referred to as its leverage decision, which is an
important financial decision made by companies. The study of leverage, its effects on a company's
financial performance and how it impacts firm value and costs of capital, is an area of research within
the field of corporate finance and accounting.

Financial Performance: refers to a company's overall financial health and success, typically measured by
key performance indicators such as profitability, revenue growth, and return on investment.

Insurance Companies: refers to businesses that offer insurance products and services to individuals and
organizations. Insurance companies are responsible for managing risk and protecting their customers
against financial loss.

Private Insurance Companies: refers to insurance companies that are owned by private individuals or
organizations, rather than by the government.

National Bank: refers to the central bank of a country, responsible for implementing monetary policy
and regulating the financial system.

Capital Adequacy: refers to the requirement for financial institutions, such as insurance companies, to
maintain a certain level of capital in proportion to their risk-weighted assets. This is done to ensure that
the financial institution has the necessary resources to absorb losses and maintain stability in the event
of financial difficulties.

1.8. Organization of the Paper

This study is organized in to five chapters. The first chapter states the general introduction and
background of the study. Chapter two presents’ theoretical and empirical literatures related to the
research area. The third chapter outlines the research methodology and research design. The research
results and discussions are presented in chapter four. The last chapter presents the drawn conclusions
and recommendation.