Inadequate Insurance Claims Reserving and Financial Distress in Non-Life Insurance Companies in Kenya: A Structural Equation Modeling Approach

Abstract

Financial distress (FD) is a common occurrence in Kenyan commercial sector and is not lacking in non-life insurance companies in Kenya. Several insurance companies have been placed under statutory management for failure to pay genuine claims and other creditors. Insurance companies provide unique financial services, not only to individuals but also to the growth and development of the economy; giving employment to workers and dividends to investors. Financial distress places insurable properties and businesses at risk thus reducing the general public confidence in the insurance sector. For this paper, the goal was to investigate whether inadequate reserving of claims (IRC) causes financial distress in non-life insurance companies in Kenya. In accounting for insurance claims reserves, increases in reserves mean a reduction of profitability of an insurer, whereas a decrease in reserves increases the profitability resulting in higher taxation and payment of dividends, which drains the insurer's cash flow, thus causing financial distress. Out of 37 non-life insurance companies, registered in 2018 in Kenya, four insurers were subjected to Pilot Testing and another four companies declined to participate in the survey. Secondary data from Insurance Regulatory Authority website was retrieved for calculations of Z-scores as per Altman (1993), amended formula. Primary data was also collected through a questionnaire. A partial least squares Structural Equation Modelling (PLS-SEM) was employed to assess the mediating effect of Insurance Regulatory Association (IRA) supervision on the association between inadequate reserving of claims and financial distress. Goodness-of-fit (GoF) indices were used to assess the model's goodness of fit. By using the discriminative Z-score formula, 52% of the institutions considered in 2018 were financially distressed, compared to 48% in 2017. However, when considering the average of ten years (2009 to 2018), financially distressed companies were 41%. The structural path from IRC to FD was found to be significant at 5% level of significance. Financial Distress (FD) increased with inadequate reserving of claims (IRC) (regression coefficient, This means that the relationship was significant in thisstudy. In other words, for every unit increase in IRC, FD significantly increased by 0.4972. The indirect effect of IRC on FD via IRA was not significant. Hence, IRA supervision was not a significant mediating factor. In a research in the USA by A. M. Best Company, Inc. (1999), inadequate reserving of claims was identified as a major contributor of failures, accounting for 34%. Managers manipulate claims reserves for several reasons; to please shareholders by paying a good dividend, and to trade-off between managers' personal and corporate goals (Fiordelisi et al., 2013). In Kenya, claims reserving in insurance companies is a top secret only handled by a few top employees. In this research, the findings were that Inadequate Reserving of Claims was significantly correlated to financial distress in non -l...