Cairo University Faculty of commerce Mathematics and insurance Department

Cairo University Faculty of commerce Mathematics and insurance Department The Effect of Inflation and Exchange Rates on Reinsurance, Solvency and Capital of Non-Life Insurance Companies Research Paper Cairo University International Conference for Business Sciences

Contents Abstract... 3 Introduction:... 3 The inflation rate and exchange rate... 4 Inflation effects on insurance demand... 6 Inflation risk and claims... 7 The inflation rate effect on Solvency and Capitalization... 8 The inflation rate and Insurer s Profitability... 11 Conclusion... 16 Appendix 1... 20-2-

The Effect of Inflation and Exchange Rates on Reinsurance, Solvency and Capital of Non-Life Insurance Companies Abstract Inflation and exchange rates in Egypt increased significantly over the recent period, essentially from October to December 2016, where inflation rate increased by approximately 10% from 15.71% to 25.86%, and exchange rate raised as a result of the decision to the float the pound's exchange rate against the dollar, which increased from 8.88 EGP to 18.38 EGP. These increases affect almost all economic sectors specially the insurance industry. For property and casualty insurance companies, the effect of increasing inflation and exchange rates is not limited to decrease in insurance consumption, as it will lead to rising claims costs, thereby eroding profitability. Also the issues resulted from increases of inflation and exchange rates will affect reinsurance, capacity and solvency of insurance companies due to deterioration of capital value. This research aims to discuss the effect of increasing inflation and exchange rates on property and casualty insurance market and possible solutions to limit that effect. Key words: Inflation, Exchange rate, Non-life insurance, Reinsurance, Solvency, Capital value. Introduction: The variation in economic environment affects insurance industry, especially in existence of increasing competition between insurance companies. The inflation rate and exchange rate increase have significant negative effect on financial performance insurance companies, where inflation risk considered one of top risk list for insurers. (1) Also the fluctuations of exchange rates a resource of additional risk for insurance companies due to significance of reinsurance business and the absence of an Egyptian reinsurance company. The inflation rate directly affects both claims cost and investment performance and so affects both assets and liabilities of insurance company. Regarding to the liabilities, the property & liability insurance industry is more sensitive to the inflation of goods and services related to claim process rather than the general inflation rate. The magnitude of the effect of the inflation rate depends on term of both inflation rate increase and development of insurance claims. The long period of inflation rate increase significantly affect line of businesses with long tail claims. Also, The Inflation impact on the future claims cost of current policies will increase the technical reserves. (2) 1 Swiss Re, 2010: The Impact of Inflation on Insurers. Sigma 4/2010 2 Ahlgrim and D Arcy, 2012, The Effect of Deflation or High Inflation on the Insurance Industry, Causality Actuarial Society, Feb 2012. -3-

Regarding to the Assets, the effect of inflation on values of assets depends on assets type (3). The equity value first decrease due to the drop in company profitability then increase with decrease of inflation rate due to the return opportunity at lower price. The value of assets with fixed rate of return will decrease as the newly issued assets have higher return (due to inflation). Although properties and other real assets are more effective in facing inflation effect, they have low liquidity level which increases the regulatory constrains for percentage of real assets to total assets for insurers. On the other hand, non-life insurance premiums, underwriting and investment returns are negatively affected during the inflationary periods (4). Also, the policyholder surplus would drop as a result to increased liabilities and devaluation of assets. So, the inflation rate affects liabilities value, profitability, investment performance and solvency of property and liability insurers The reinsurance is effective risk mitigation for increase in insurance liabilities due to inflation especially excess of loss treaties. But most of the reinsurance treaties in Egypt are defined in USD terms (especially in property and liability insurers) due to lack of reinsurance companies. The increase in inflation rate leads to decrease in the purchasing power of the local currency (EGP) which decreases EGP-USD exchange rate which increases both risk retained by insurance company and decreases the ceded premium to reinsurance. Also, the increase in the inflation and exchange rates leads to a decrease in the capital value in USD which affects the reinsurance business of insurance companies in Egypt and affects their solvency. This is paper consists of three parts; the first part provides background on inflation and exchange rates and the relationship between them. The second part analyze the inflation rate affects liabilities value, investment performance and solvency of insurance property and liability insurers. The third part contains estimation for the effect of inflation and exchange rates on profitability of non-life insurance industry. The inflation rate and exchange rate: The inflation rate can be defined as Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling (5). The inflation rate is mainly measured from both consumer and producer points of view which creates two main measures of inflation which are CPI and PPI. The exchange rate is an economic variable which represent the value of the domestic currency in terms of another currency. The exchange rate risk is the unexpected changes in exchange rate 3 Lowe and Watson, 2010, Post-Recession Inflation: An Emerging Risk for P&C Insurers, Causality Actuarial Society, Emphasis 3, 24-29. 4 Ahlgrim and D Arcy, 2012, Op. cit. 5 Investopedia: Inflation Definition, http://www.investopedia.com -4-

which depends on general economy, domestic production and balance between imports and exports. It also influenced by performance of financial sectors such as banking and insurance. So, the exchange rate is affected by number of economic variables on macroeconomic scale which includes inflation rate and interest rate. The following graph shows the USD/EGP exchange rate over period 1986 to 2015 (6) : USD - EGP Exchange Rate 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00-6.3+1.28E-11 X 1-2.26 X 2-20.47 X 3 +22.32 X 4 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Actual Exchange Rate Estimated Exchange Rate The actuarial exchange rate is based on year average. The estimated exchange rate is based on Ramasamy variables (7) where X 1, X 2, X 3, X 4 are GDP, CPI, deposit interest rate and External balance on goods & services over same period of 30 years (8). Due to the use of GDP and CPI as measures and indicators for inflation and the effect of inflation on value of deposit interest rate, the inflation rate significantly affect exchange rate. In 2016, both inflation and exchange rates have significant increase as headline CPI increases from 11.06% to 23.27%, core CPI increases from 7.24% to 25.86% and USD/EGP increases from 7.8 to 18.38. These significant changes has affected major financial sectors especially insurance industry due to effect of exchange rate on reinsurance processes 6 Central Bank of Egypt, USD/EGP Statistics 7 Ramasamy, R, 2015, Influence of Macroeconomic Variables on Exchange Rates, Journal of Economics, Business and Management, February 2015, Vol. 3, No. 2 8 Central Agency for Public Mobilization and Statistics-Egypt (CAPMAS) 1986-2015. -5-

Inflation effects on insurance demand: Inflation rate represent the increase in the prices of goods and commodities which meet needs for current and potential insurance policy holder. These needs could be essential or luxury needs. The increase in inflation rate combined with lower increase in income push the policy holder to increase percentage of consumption on his essential needs especially if inflation rate for these essential needs are higher than the other needs. Also, due to limitation of insurance culture for Egyptian population, the insurance policies are not considered as part of these essential needs. Also, the increase in inflation rate will increase the value of property to be insured, claims cost and administration expenses of the insurance company which will lead to increase in insurance premium. This will help in further decrease the demand for insurance. Due to lack of published information about economic measures for salary increase in Egypt (like weekly average earning WAE), the change of GDP per capita is used as indicator for the increase annual income. Regarding to relationship between GDP growth and insurance premium, the increase in GDP per capita (as indicator for income increase) will increase insurance demand and so the direct premium. The following graphs shows changes at GDP per capita (EGP) and direct premiums over period 1990 to 2015 (9) : 4000 3500 3000 2500 2000 1500 1000 500 0 GDP per capita 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 GDP per capita 9000000 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0 Direct Premiums 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Direct Premiums The above graphs illustrate there is a strong positive relation between GDP per capita and the direct premiums, where the correlation coefficient is 99.16%, which means that GDP per capita has a significant effect on non-life insurance premiums. The exception of this correlation occur at 2004 GDP per capita decreased as shown in the graph but direct premiums increased that in the view of high inflation rate at this year. 9 World Bank Data: GDP per Capita Statistics; Egyptian Financial Supervisory Authority (EFSA), Annual Reports of Insurance Market, 1990-2015. -6-

Regarding to relationship between inflation rate and salary increase, the following graph illustrates the CPI and change in GDP per capita over period (1980-2015) (10) : CPI and Change in change in GDP Per capta 30% 25% 20% 15% 10% 5% 0% -5% 1980 1985 1990 1995 2000 2005 2010 2015-10% -15% -20% inflation CPI Change in GDP per capita The above figure shows that the change rate of GDP per capita is lower than the changes in the inflation rate in most periods of 35 years especially before 1995. At 2004, inflation rate rose by 150% comprising with 2004 to reach 11.3%, while GDP per capita fall by 6.66%. Also at 2013 inflation rate increased by 32.36% to reach 9.4%, while GDP per capita increased by 1.19%. This mismatch leads to the devaluation of the real income which decreases the demand for insurance. Inflation risk and claims: The inflation rate has direct effect insurance claim process by increasing the severity of insurance claim. Also, the inflation rate means an increase in the price of an average group of goods and services increases over certain period of time. These goods and services include processes related to handling and settlement of insurance claims. The change in prices of performing claim processes affects level of the claims costs which called social inflation (or superimposed inflation). (11) So, the total effect of inflation rate on claim amount (which is called Claim Inflation rate) divided into two components which are general (measured by CPI) and social inflation The claim inflation rate is estimated by the excess of claim amount and claim costs in the current year over corresponding value and costs of similar claim settlement in the previous year. 10 Central Bank of Egypt, Inflation rate (CPI) Statistics; World Bank, GDP per Capita Statistics 11 Gesmann, M. &Moore,T. 2014, Claims Inflation: Discussion Document, Lloyd s, Nov 2014, PP 4. -7-

Due to change in nature of insurance risk of each insurance branch, each branch have different claim inflation rate. Ex: increase in cost of process of car repair and increase price of replaced parts for motor insurance. Another example is the massive increase in medical costs due to increasing trend of medical development. This makes the medical inflation rate become higher than general inflation rate. So both claims amount and its relevant costs increase with higher rate than increase in claim costs in other insurance branches From Insurance company point of view, it receives the premiums in advance and is responsible for payment of uncertain claim amount in the future where the claim amount and claim costs increase by inflation. So, the insurance branches with long tail nature are exposed more to the inflation rate risk than insurance branches with short tail nature. (12) So, due to the effect of expected value of insurance claim and its cost of settlement, the claim inflation of each insurance branch should be involved in reserving, pricing and capital modeling of this branch. Regarding to pricing process, estimated insurance premium should be sufficient to cover claim amount, expected claim costs, commissions and administrative expenses (which are affected by inflation rate).the severe unexpected inflation increases are to be taken into consideration when estimating the economic capital (which can be used by insurance company to cover losses results from unexpected events). The cost of financing this capital should be allocated to each insurance product and included in the premium rate. Also, an accepted profit margin is included in premium rate to achieve the profitability target of the insurance company (which is an important factor in maintaining solvency and financial strength of the insurance company). The mispricing will lead to an excess of claims and its costs over the value of the premium which will decrease the profitability and so the capital value. The decrease in capital value will significantly affect the solvency of the non-life insurance company The inflation rate effect on Solvency and Capitalization: The effect of significant increase in inflation rate on capital and solvency on insurance company can be divided into the following categories: a) Investment: The inflation increase generally has negative effect investment performance of insurance company (13). The intensity and term of this negative effect depends on assets category (14). For the equity, the significant increase in inflation has short term negative effect on equity value due to the decrease in company profitability caused by inflation. But over longer period of time, the decrease in inflation rate back to normal long term trend will increase the value of 12 De Ravin, J. &Fowlds, M, 2010, Inflation Risk In General Insurance, General Insurance Seminar, the Institute of Actuaries of Australia, Nov 2010, PP 17. 13 D'Arcy, S. P., 1982, A Strategy for Property-Liability Insurers in Inflationary Times, Proceedings of the Casualty Actuarial Society 69, 163-186. 14 Lowe and Watson, 2010, Op. cit., 24-29. -8-

equity. This is due to equity s return opportunity with low market price which will increase demand for this equity and the increase its price. So, the equity value is significantly decreased with increase in inflation rate in USA over period 1933 to 1981 but not during 1977 to 2006. This is due to whether the increase in inflation rate is expected or not (15). For fixed income assets, the regulatory requirements for investment of insurance companies have high limit for fixed income assets. This is due to high level of liquidity and the income stability. Due to the increase in inflation rate, the newly issued financial assets have higher fixed returns if compared with fixed return of insurer financial assets (new money rates) (16). So, the market value of the insurer's financial assets will decrease. Although there is no regulatory requirement for reporting of fixed return assets in their market value, the real value of these assets will decrease. To benefit from these investments and create real rate of return the company need to liquidate part of its financial assets to invest in current financial assets which will lead to investment capital loss for current financial year. This capital loss will negatively affect financial position of insurance company for the current year especially when combined with decrease in its underwriting surplus. For properties and other real assets, this category of assets is effective investment due to the general trend of increase in its value in period of high inflation. But the regulatory requirements for investment in this category have very low upper limit percentage. This is due to the low level of liquidity and mismatch between its investment term and short term nature of non-life insurance liabilities. So, the significant increase in inflation rate has negative effect on investment performance of which affects the financial strength non-life insurance company. Due to rare application of enterprise risk management process in insurance industry and lack of hedging strategy for the inflation risk, the effect of the inflation increase will significantly affect solvency of insurance companies. b) Reserving: The traditional reserving methods are not efficient in reflecting inflation risk in claim reserves. The chain ladder method is most common reserving method in Egyptian non-life insurance market. The inflation adjusted chain ladder assumes that the claims severity development will follow constant trend in future. This means that the claim inflation rate (measured by CPI and social inflation) will have same growth rate in following number of years till full claim development. So, a significant increase in inflation rate (like 2016 increase) will lead to insufficient reserves to meet the future liabilities which will affect the solvency of the non-life insurance company. As a result of this issue, the insurance companies should adjust its loss reserves to match with changes in claim amount and its expected costs due to inflation risk. 15 Krivo, R. 2009, An Update to D Arcy s - A Strategy for Property-Liability Insurers in Inflationary Times, Casualty Actuarial Society E-Forum. 16 Fisher, Irving, 1930, The Theory of Interest, Macmillan, New York. -9-

c) Economic Capital and Reinsurance: The regulatory solvency and capital requirements for insurance companies in the Egyptian insurance supervision law require that the insurer s total assets should exceed liabilities with 20% of earned premium or 25% of incurred claims (17). This method of estimation of capital considers only the insurer current business & claim volume and do not reflect insurance company risk portfolio especially economic risks other than insurance risk which increases the effect of significant increase in inflation on solvency of insurance company. Also, this method will create cycle fluctuation in capital requirement due to the underwriting cycle in premium and claim amount. So, the current capital requirement needed to be adjusted to reflect various risk categories of insurance company and its emerging nature specially the inflation rate. The effect of significant increase in inflation rate on solvency of insurance company is due to its contribution in decreasing the real value of capital and increasing in claim value and costs. This effect will decrease insurance capacity of the company and increase its insolvency probability. The reinsurance is effective risk mitigation for increase in insurance liabilities due to inflation especially excess of loss treaties But, the increase in inflation rate increases the USD-EGP exchange rate which will decrease the value of available capital in USD terms and so the financial strength of insurer from reinsurer point of view. Also, the exchange rate increase will lead to the decrease of the volume in reinsurance premium in USD which will decrease the significance of reinsurance business from reinsurer point of view. The intensity of effect of both inflation and exchange rate on reinsurance depends on type and currency of reinsurance treaty. For Reinsurance treaties with EGP terms and conditions, the increase in sum assured of insurance policies (due to inflation increase) will lead to increase the probability of reaching the treaty limit and more need for facultative treaties which requires increase ceded insurance business with same reinsurance company or contract with other reinsurance companies. For Reinsurance treaties with USD terms and conditions, the effect of inflation and exchange rate have two scenarios based on increase in sum assured. This is due to the effect of inflation increase on need to adjust sum assured to reflect increase in value of asset/property to be insured. These two scenarios are summarized as follows: If the sum assured didn't increase: the increase in inflation rate and USD exchange rate will decrease ceded premium and insurance portfolio for reinsurer which could lead to termination of reinsurance treaty If the sum assured increases: the reinsurance company business and ceded premium for current in-force business will be the same. But increasing SA will decrease the new business and renewal rates which will decrease reinsurance business portfolio. Also, The current capacity and capital of the insurance company will not be enough to support the increase in business volume 17 Law no. 10 of 1981:Supervision of insurance sector in Egypt, Sector 9 - Chapter 1- title 3-10-

The creation of a national reinsurance company will decrease the effect of current inflation and exchange rates but this reinsurance company will need to increase its capital (with increase in exchange rates) to conduct reinsurance business internationally which is essential for reinsurance company for pooling risks. Also, it will need to increase the capital to conduct same reinsurance business nationally (due to increase in inflation rate and sum assurance). If this company is unwilling to increase its capital, it will need to cede more business to other reinsurance companies which will create same issues above. For national insurance companies that perform reinsurance process, the increase in inflation rate and USD exchange rate will lead to decrease the company capital and so will decrease its credit rating and reinsurance business internationally. A possible solution for the effect of inflation on reinsurance process by use of a stability clause which link the treaty limit by change in suitable inflation index (Ex: CPI or average weekly earnings (AWE)). Also, the effect of inflation of specific industry on the reinsurance of long term insurance contracts(like constriction sector) can be mitigated by adding inflation explicit cap to reinsurance treaties to take into account constriction index for insurance claim inflation and general inflation (18). The inflation rate and Insurer s Profitability: In Egypt, the volume of the insurance premiums is commonly used as indicator for management performance and so it is considered as top priority for the company management and may affect expenses margin for high premium contracts due to competition. But this indicator does not take in to consideration the value of claims and its related costs. The significance of surplus of the insurance company is one of key indicators for financial strength of insurance company as it considers premiums, claims, reserves change and expenses of the insurance company. The analysis of profitability of insurance company considers both operating surplus and underwriting surplus. The operating surplus is the increase of revenues over expenses of insurance company. The underwriting surplus is similar to operating surplus but with neglecting the investment revenue from the revenue of the insurance company. The following graph shows both operating and underwriting surplus for whole market of non-life insurance companies in thousands over period from 2003 to 2015 : (19) 18 Swiss Re (2010): Op. cit. 19 Egyptian Financial Supervisory Authority, EFSA Annual Reports of Insurance Market, 2002/2003-2014/2015-11-

Underwriting and Operating Surplus 2000000 1500000 Surplus in 1000 EGP 1000000 500000 0-500000 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015-1000000 -1500000 Underwritting Surplus Operating Surplus investments return From the past graph, there is a dependency on the investment return to cover the underwriting deficit of the non-life insurance market where the insurance policies have short term. The investment return can be used as a second not a first layer of security to cover claims and expenses if they exceed the premium. So, the underwriting surplus is a clearer indicator for financial performance of the non-life insurance companies. The factors that affect the profitability of insurance company can be divided into three main categories which are company specific factors, industry specific factors and general economic factors. The company specific factors include volume of capital and liabilities. This category also includes risk profile, risk management, employees average age and productivity (20). The industry specific factors include competition intensity and the development of existing and new insurance products. This category also includes changes in needs of policy holders, market segmentation and insurance regulation (21). The general economic factors include inflation, GDP, exchange rates and interest rates (22). 20 Molyneux, P., Thornton, J., 1992, Determinants of European bank profitability, Journal of Banking and Finance. Vol 16, PP 1173-1178. 21 Andersen, T. and Schroeder, P., 2010, Strategic Risk Management Practice: How to Deal Effectively with Major Corporate Exposures, Cambridge University Press, Ch. 7. 22 Brinson, G. P., Singer, B. D. &Beebower, G. L., 1991, Determinants of Portfolio Performance II: An Update Financial Analysts Journal. -12-

The inflation rate negatively affect premium and increases the claims and its associated costs. It also increases administration cost. Also, pricing process is mainly based on past history which makes most of significant inflation rate increases are not included in insurance rate. Also, most of insurance companies have neither enterprise risk management process nor a hedging strategy for the inflation risk. So, the inflation rate increases liabilities of insurance companies. Also, the inflation rate decreases the investment return of insurance company. For multinational insurance companies, the profit reporting is in terms of USD to parent company which will significantly decrease the company portfolio and profit from parent company point of view. So, significant increase in inflation and exchange rate in 2016will significantly decreases the profitability of the insurance companies due to increase in value of liabilities and decrease in value of assets of insurance company. Due to the expression of value of CPI in form of percentage, the profitability is expressed as percentage using return on assets (ROA) measure. The following graph shows the consumer price index in Egypt and ROA for whole non-life insurance market over period from 2003 to 2015 (23) 20.00% CPI and ROA 15.00% 10.00% 5.00% 0.00% -5.00% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015-10.00% CPI % ROA From the previous graph, there is a significant increase in inflation rate in years 2004, 2008 and 2016 which are related to significant decrease in underwriting surplus in years 2006 and 2010. The lag between inflation rate increase and underwriting surplus decrease is due to lag between general economic cycle and underwriting cycle, lag between premium and claim timing, lags in claim process and claim development and absent of actuarial report for non-life insurance companies (which cause less accuracy in estimation of IBNR due to use of % of outstanding claim reserve). 23 Central Bank of Egypt, Inflation rate (CPI) Statistics, 2003-2015 ; EFSA Annual Reports of Insurance Market, 2002/2003-2014/2015-13-

So, the inflation rate and the related economic factors are used in analysis of profitability of insurance company. The related economic factors include: CPI (24) USD exchange rate GPD growth rate (25) Interest rate (26) Change in employment population (27). All the economic variables mentioned above are highly correlated with inflation. The CPI is a measure for inflation. The increase in inflation rate affects purchasing power of local currency which affects the exchange rate. The GDP growth means higher production level which increase costs of production and the inflation rate. Also, a decrease in interest rate leads to increase in the borrowing and spending of population which leads to economic growth and inflation rate increases (28) The increase in population leads to increase demand on various services more than supply which leads to change in competition intensity in various financial and non-financial sector and prices increase and inflation rate increase. Also, the employment population change leads to change in availability of working force. The following analytical model is used to assess the relationship between return on assets and inflation rates (and other related economic factors): Y = α + β 1 X 1 + β 2 X 2 + β 3 X 3 + β 4 X 4 + β 5 X 5 + ε Where: Y : Return on Assets which is calculated by dividing underwriting surplus to total assets of nonlife insurance market over period 2004 to 2013 (29) X 1 =GDP growth rate over period from 2006-2015 (30) X 2 = Consumer Price Index (CPI) over period from 2006-2015 (31) 24 Chen, T.J. & Huang M.H., 2001, An Empirical Analysis Of Determinants Of Cash Holdings By Insurance Companies In Taiwan. Insurance Monograph, 66: 1-26. 25 Doumpos, M. &Gaganis C., 2012, Estimating And Explaining The Financial Performance Of Property And Casualty Insurers: A Two-Stage Analysis, The Business and Economics Research Journal, 5(2): 155-170 26 Felix, J., 1998, Dynamics Of Growth And Profitability In Banking, Journal of Money, Credit & Banking, 36(1); 1069-1091. 27 Berlemann, M.&Thum, M., 2010, Demographic Change and Bank Profitability. Empirical Evidence from German Savings Banks, Cesifo Working Paper No. 2911 28 Semuel, H &Nurina, S (2015), Analysis of the Effect of Inflation, Interest Rates, and Exchange Rate on gross domestic product (GDP) in Indonesia, International Conference on Global Business Economics Finance and Social Sciences-Thailand, Feb 2015 29 Egyptian Financial Supervisory Authority, EFSA Annual Reports of Insurance Market, 2002/2003-2014/2015 30 Central Agency for Public Mobilization and Statistics-Egypt (CAPMAS) 2006-2015 31 Central Bank of Egypt, Inflation rate (CPI) Statistics, 2003-2015 -14-

X 3 =Annual change in USD exchange Rate (period average) over period from 2006-2015 (32) X 4 =Deposit interest rate over period from 2006-2015 (33) X 5 =Rate of change in employment (aged 15-64) to population ratio over period 2006-2015 (34) α = Regression constant β 1, β 2, β 3, β 4, β 5 are regression coefficients ε= estimation Error which assumed to be normally distributed with mean of zero. This model is same as Kemuma analytical model but with adjustment of two years lag for ROA and the use of underwriting surplus instead of the operating profit in calculation of ROA (35). The following graph shows the actual and estimated ROA based on economic variables mentioned above: Actual and Estimated ROA 0.00% -1.00% -2.00% -3.00% -4.00% -5.00% -6.00% -7.00% -8.00% -9.00% -10.00% 0.35-0.61 X 1 0.35 X 2 + 0.13 X 3 4.83 X 4 2.17 X 5 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Actual ROA Estimated ROA The estimation of the coefficients of inflation, exchange rate and other related economic factors is performed using multiple regressions where results are summarized in appendix 1. The Pearson correlation between estimated and actual ROA is 95.3%. Regarding to the correlation between the inflation rate and ROA with two years lag is -69.6% using Pearson correlation. 32 World Bank, USD-EGP Statistics, 2003-2015 33 Central Bank of Egypt, Interest rate Statistics, 2003-2015 34 World Bank, Statistics of Employment to population ratio: 15-64, Egypt, 2003-2015 35 Kemuma, N. (2015), the effect of foreign exchange rate volatility on profitability of insurance industry in Kenya, School of business, University of Nairobi -15-

So, based on the above results, the profitability of the non-life insurance market is negatively affected by inflation and it also affected by other related economic factors. Conclusion: The Inflation risk affects many aspects of non-life insurance operations, as the above analysis shows the following: The increase inflation rate is combined with less increase in income and increase in the value of property to be insured, claims costs and administration expenses. All these changes will lead to decrease the demand for insurance especially with significant increase in inflation (like inflation rate at end of 2016 reached 25.86%). Non- life insurance companies can mitigate the effect of inflation on insurance demand through following different Marketing strategies, and managing expenses more efficiently or putting more limits for insurance coverage. Increase inflation rate leads to raise claims costs which affect reserves, premiums and profitability of insurance company. Without efficient risk management for inflation risk, inflation rate increase will lead to increase of claims value and costs. So, premium will not cover the claim amount and its costs. Also, reserves will be insufficient to meet the future liabilities. As a result of this, profitability and the capital value will decrease which will significantly affect the solvency of the non-life insurance company. So, reserves and premiums must be adjusted to reflect inflation risk which can be achieved by efficient risk management for inflation risk. Overall investment performance of insurance companies is adversely affected due to increasing inflation rate, which affects assets value and so the financial strength of non-life insurance company. This is due to rare application of enterprise risk management process in insurance industry and lack of hedging strategy for the inflation risk which increases its effect on solvency of insurance companies. The current method of capital estimation doesn t reflect insurance company risk portfolio especially economic risks other than insurance risk which increases the effect of significant increase in inflation on solvency of insurance company. Increase in inflation rate will contribute in decreasing the real value of capital and increasing in claim value and costs which will decrease insurance capacity of the company and increases its insolvency probability. So, the current capital requirement needed to be adjusted to reflect various risk categories of insurance company and its emerging nature specially the inflation rate which can be achieved by using Economic capital for regulatory capital requirement. -16-

The reinsurance is effective risk mitigation for increase in insurance liabilities due to inflation especially excess of loss treaties. But increase in inflation rate combined with increase in the USD-EGP exchange rate will leads to following results: The value of insurer capital and ceded premium will drop in USD terms that will lead to decrease the insurer financial strength and significance of its reinsurance business from reinsurer point of view. For EGP treaties, the probability of reaching the treaty limit will increase which create more need for facultative treaties which requires increase ceded insurance business with same reinsurance company or contract with other reinsurance companies. For USD treaties, if sum assured didn t increase or increasing SA will drop the new business and renewal rates, reinsurance business portfolio in USD will decrease which may terminate reinsurance treaty. Insurance company can decrease the effect of current inflation and exchange rates on reinsurance treaties through: Creation of a national reinsurance, which will solve the problem partially as this company will need to increase its capital to conduct reinsurance business internationally (due to increase in exchange rates) and nationally (due to increase in inflation rate and sum assurance). Add a stability clause to reinsurance treaty which links the treaty limit by change in suitable inflation index. Adding inflation explicit cap to reinsurance treaties to take into account specific industry index which reflect both general and social inflation. The analytical study of non-life insurance profitability shows that: The inflation rate negatively affect premium and increases the claims and its associated costs. It also increases administration cost. Also, pricing process is mainly based on past history which makes most of significant inflation rate increases are not included in insurance rate. Also, most of insurance companies have neither enterprise risk management process nor a hedging strategy for the inflation risk. So, the inflation rate increases liabilities of insurance companies. Also, the inflation rate decreases the investment return of insurance company. So, based on study results, the profitability of the non-life insurance market is negatively affected by inflation and other related economic factors. So significant increase in inflation and exchange rate in 2016 will significantly decreases the profitability of the insurance companies due to increase in value of liabilities and decrease in value of assets of insurance company. -17-

References: 1. Ahlgrim and D Arcy, 2012, The Effect of Deflation or High Inflation on the Insurance Industry, Causality Actuarial Society, Feb 2012. 2. Andersen, T. and Schroeder, P. 2010, Strategic Risk Management Practice: How to Deal Effectively with Major Corporate Exposures, Cambridge University Press, Ch. 7 3. Berlemann, M., &Thum, M., 2010, Demographic Change and Bank Profitability. Empirical Evidence from German Savings Banks, Cesifo Working Paper No. 2911. 4. Brinson, G. P., Singer, B. D. &Beebower, G. L., 1991, Determinants of Portfolio Performance II: An Update. Financial Analysts Journal. 5. Central Agency for Public Mobilization and Statistics-Egypt (CAPMAS) 1986-2015 6. Central Bank of Egypt, USD/EGP Statistics. 7. Central Bank of Egypt, Interest rate Statistics, 2003-2015. 8. Central Bank of Egypt, Inflation rate (CPI) Statistics, 2003-2015. 9. Chen, T.J. & Huang M.H., 2001, An Empirical Analysis Of Determinants Of Cash Holdings By Insurance Companies In Taiwan. Insurance Monograph, 66: 1-26. 10. D'Arcy, S. P., 1982, A Strategy for Property-Liability Insurers in Inflationary Times, Proceedings of the Casualty Actuarial Society 69. 11. Doumpos, M. &Gaganis C., 2012, Estimating and Explaining The Financial Performance Of Property And Casualty Insurers: A Two-Stage Analysis. The Business and Economics Research Journal, 5(2): 155-170. 12. Egyptian Financial Supervisory Authority, EFSA Annual Reports of Insurance Market, 2002/2003-2014/2015. 13. Felix, J., 1998, Dynamics of growth and profitability in banking, Journal of Money, Credit & Banking, 36(1); 1069-1091. 14. Fisher, Irving, 1930, The Theory of Interest, Macmillan: New York. 15. Gesmann, M. &Moore,T. 2014, Claims Inflation: Discussion Document, Lloyd s, Nov 2014. 16. Investopedia: Inflation Definition, http://www.investopedia.com -18-

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Appendix 1: ROA & Economic Variables Regression Statistics Multiple R 0.95290 R Square 0.90801 Adjusted R Square 0.79303 Standard Error 0.01089 Observations 10 ANOVA Df SS MS F Significance F Regression 5 0.00468 0.00094 7.89693 0.03367 Residual 4 0.00047 0.00012 Total 9 0.00516 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.35042 0.08326 4.20864 0.01360 0.11925 0.58159 0.11925 0.58159 X1-0.60710 0.40314-1.50592 0.20655-1.72640 0.51220-1.72640 0.51220 X2-0.35343 0.13203-2.67679 0.05541-0.72001 0.01316-0.72001 0.01316 X3 0.13075 0.11378 1.14919 0.31452-0.18514 0.44664-0.18514 0.44664 X4-4.83326 1.22256-3.95338 0.01677-8.22764-1.43888-8.22764-1.43888 X5-2.16988 2.05199-1.05745 0.34994-7.86712 3.52736-7.86712 3.52736 X 1 : GDP growth rate X 2 : Consumer Price Index (CPI) X 3 =Annual change in USD exchange Rate (period average) X 4 =Deposit interest rate X 5 =Rate of change in employment (aged 15-64) to population ratio α = Regression constant β 1, β 2, β 3, β 4, β 5 are regression coefficients ε= estimation Error which assumed to be normally distributed with mean of zero. -20-