IMPACT OF CORPORATE GOVERNANCE ON RISK: EMPERICAL EVIDENCE FROM INSURANCE AND TAKAFUL OPERATORS IN

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IMPACT OF CORPORATE GOVERNANCE ON RISK: EMPERICAL EVIDENCE FROM INSURANCE AND TAKAFUL OPERATORS IN

MALAYSIA

BY

SARFARAZ DAWAR KHAN

A Research Paper submitted as partial fulfilment of the requirements for the degree of Masters of Science in

Islamic Banking and Finance

INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA

2013

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ABSTRACT

Over the past couple of decades, the failure of big corporations especially the financial institutions have brought the issue of ineffective and weak corporate governance in the corporate world. Especially, during the last decade the collapse of big corporations across the globe like Merlyn Lynch, American Insurance Group (AIG), Enron, Lehman Brothers and so on, have made the issue more acute. As a matter of fact, most of these corporate failures took place in banking and finance industry (insurance industry is one its components). With a growing complexity of the banking and financial institutions’ operations, these corporations are exposed to enormous amount of risk; especially the insurance industry, the very nature of which is taking risk by providing protection to individuals and businesses against various risks they are exposed to. Due to this reason it has become essential to conduct study on these institutions’ leadership (that is, board of directors) to find out the effectiveness and ability of the board in managing enterprise resources efficiently and protecting these corporations from any catastrophe. Therefore, this research paper intends to study the corporate governance (more particularly related to board of directors) role in managing risk of insurance and takaful companies in Malaysia. More precisely, it is to find out the extent to which corporate governance impacts risk of these financial institutions. In order to study this relationship mainly four components of corporate governance have taken. These components are: separate role of board Chairman and Chief Executive Officer (CEO), frequency of board meetings, percentage of independent non-executive directors and board size. On the other had three areas of risk are analysed, that is, liquidity, underwriting and operational risk. For the purpose of quantifying these risks, financial ratios have been taken. In regards to the sample data, total 25 companies were shortlisted (including both conventional insurance and takaful) out of which 21 companies have been analysed. The sample data was collected from 2007 to 2011. As the sample data was parametric (panel data) in nature, therefore the empirical model selected for this study was regression analysis.

The empirical findings showed that selected components of corporate governance have significant impact on risk of insurance and takaful companies. It means any change in these components of corporate governance, whether positive or negative will either increase or decrease the risk of insurance and takaful company significantly.

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iii

ثحبلا ةصلاخ

نييضاملا نيدقعلا رادم ىلع

،

ىربكلا تاكرشلا لشف ناك

،

ةيضق ناهذلأا ىلإ رضحتسا دق اهنم ةيلاملا ةصاخبو

رايهنا ناك اصوصخ ىضاملا دقعلا للاخو .ةيراجتلا تاسسؤملا ملاع ىف ةيسسؤملا ةرادلإا فعضو ةيلاعف مدع شيل نيلرام لثم ةرومعملا ربع ىربك تاكرش

،

ومجمو ( ةيكيرملأا نيمأتلا ةع )AIG

،

إو نورني

،

ماهيل ناوخإو

لعج دق اهريغو ةعانصلا تاسسؤم ىف تعقو دق كلت لشفلا تلااح مظعم نأ ةدكؤملا ةقيقحلاو . ةدح رثكأ ةيضقلا

يلاملاو ةيفرصملا تاسسؤملا تايلمعل ديازتملا ديقعتلا عمف . ) نيمأتلا ةعانص اهنمض نمو ( ةيليومتلاو ةيفرصملا

،

ة

رطاخملا نم لئاه مكل ةضرعم تاسسؤملا هذه تدب

،

ةصاخبو كلت

ريفوت ىف اهلمع ةعيبط ددحتت ىتلا تاسسؤملا

.اهل نوضرعتي ىتلا رطاخملا فلتخم دض تاكرشلاو دارفلأل ةيامحلا ءارجإ ىرورضلا نم ناك دقف ببسلا اذهل اعبت و

ه تاسسؤملا هذه ةدايق ىلع ةساردلا هذ

،

لاجم اديدحتو ىف سلاجملا هذه ةردقو ةيلعاف ىدم فاشكتسلا اهترادإ س

ةسارد ىلإ فدهت ةيثحبلا ةقرولا هذه نإف مث نمو . ثراوكلا نم تاسسؤملا هذه ةيامحل ةيلاعفب ةسسؤملا دراوم ةرادإ رطاخملا ةرادإ ىف ) ةرادلإا سلجمب قلعتي ام اديدحت رثكأ لكشبو ( ةسسؤملا ةرادإ رود

،

تلا تاكرش ىف كلذو نيما

ضو رثكأ وحن ىلعو .ايزيلام ىف لفاكتلاو أ ىلإ ةفرعم ىلإ ىعست ةساردلا نإف احو

ةسسؤملا ةرادإ بولسأ رثؤي دح ى

اههجاوت ىتلا رطاخملا ىلع ةيلاملا .

د لجأ نمو أ رايتخا مت دقف ةقلاعلا هذه ةسار

ةرادلإا تانوكم نم تانوكم عبر

رل لصفنملا رودلا ىهو ةيسسؤملا ةرادلإا سلجم سيئ

،

ىذيفنتلا ريدملاو

،

سلاجملا تاعامتجا ةيرودو

،

ةبسنلاو

نييذيفنتلا ريغ نيلقتسملا نيريدملا نيب

،

رخآ بناج نمو . ةرادلإا سلجم مجحو

،

رطاخملل تلااجم ةثلاث ليلحت مت

ةلويسلا ىهو

،

ةيتحتلا تانيودتلاو

،

ليغتشتلا رطاخمو إ رطاخملا هذه ليوحت ضرغبو .

ل ةبسن ذاختا مت ةيمك ميق ى

نم ةمئاق تدمتعا ةساردلا ةنيعب قلعتي اميفو . رابتعلاا ىف ةيلام 25

مت دقو ) ىلفاكتلاو ىراجتلا نيمأتلا مضت ( ةكرش

ليلحت 21 ةنس نم اءدب ةساردلا ةنيع ةدام عيمجت مت دقو اذه . اهنم ةكرش 2007

ىتح 2011 ةنيعلا ةدام نإ ثيحو .

ةيدودح ( اهتعيبطب ةيحول تانايب

،

) دقو .ىعجرلا ليلحتلا وه ناك ةساردلا هذهل راتخملا ىبيرجتلا جذومنلا نإف

تاكرش اههجاوت ىتلا رطاخملا ىلع ربتعم ريثأت اهل ةيسسؤملا ةرادلإل ةراتخملا تانوكملا نأ ةيبيرجتلا جئاتنلا ترهظأ لس تانوكملا هذه ىف رييغت ىا نأ ىنعي ام وهو .لفاكتلاو نيمأتلا ههجاوت ىذلا رطخلا صقني وأ ديزيس ايباجيإ وأ ايب

.لئاه لكشب ةكرشلا

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APPROVAL PAGE

I certify that I have supervised and read this study and that in my opinion; it conforms to acceptable standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for the degree of Master of Science in Islamic banking and finance.

……….

Dr. Sheila Nu Nu Htay

This research paper was submitted to the Institute of Islamic Banking and Finance and is accepted as a partial fulfilment of the requirements for the degree of Master of Science in Islamic banking and finance.

………

Rusni Bt Hassan

Deputy Dean, Institute of Islamic Banking and Finance

This dissertation was submitted to the Kulliyyah of Institute of Islamic Banking and Finance and is accepted as a partial fulfilment of the requirements for the degree of Master of Science in Islamic banking and finance.

………..

Prof. Dr. Ahamed Kameel B. Mydin Meera Dean, Institute of Islamic

Banking and finance

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DECLARATION

I hereby declare that this dissertation is the result of my own investigations, except where otherwise stated. I also declare that it has not been previously or concurrently submitted as a whole for any degrees at IIUM or other institutions.

Sarfaraz Dawar Khan

Signature ……… Date ………

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INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA

DECLARATION OF COPYRIGHT AND

AFFIRMATION OF FAIR USE OF UNPUBLISHED RESEARCH

IMPACT OF CORPORATE GOVERNANCE ON RISK: EMPIRICAL EVIDENCE FROM INSURANCE AND TAKAFUL OPERATORS IN

MALAYSIA

No part of this unpublished research may be reproduced, stored in a retrieval system, or transmitted, in any from or by any means, electronic, mechanical, photocopying, recording or otherwise without prior written permission of the copyright holder except as provided below.

1. Any material contained in or derived from this unpublished research may ony be used by others in their writing with due acknowledgement.

2. IIUM or its library will have the right to make and transmit copies (print or electronic) for institutional and academic purpose.

3. The IIUM library will have the right to make, store in a retrieval system and supply copies of this unpublished research if requested by other universities and research libraries

Affirmed by Sarfaraz Dawar Khan

……….. ………

Signature Date

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LIST OF TABLES

Table No. Page No.

3.1 Breakdown of Data Collection 38

4.1 Descriptive Statistics 54

4.2 Normality Test Results 58

4.3 Correlation Test Analysis 60

4.4 GLS Regression Result for Quick Ratio 66

4.5 GLS Regression Result for Contribution Receivables to Gross

Contributions Ratio 68

4.6 GLS Regression Result for Cash to Claims Ratio 69

4.7 GLS Regression Result for Claims Ratio 71

4.8 GLS Regression Result for Expense Ratio 72

4.9 GLS Regression Result for Combined Ratio 74

4.10 OLS Regression Result for Retakaful (Reinsurance) expense to

Takaful (Insurance) Gross Contribution (Premium) Ratio 76 4.11 Summary of Risk Measuring Variables in Relation to Corporate

Governance Variables 80

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CHAPTER TWO

... 15

LITERATURE REVIEW

... 15

2.0. INTRODUCTION ... 15

2.1. AGENCY THEORY ... 17

2.1.1. Separate Roles Of Chairman And CEO ... 18

2.1.2. Board Composition ... 19

2.1.3. Board Size ... 20

2.1.4. Board Meetings ... 20

2.2. RISK FROM ISLAMIC PERSPECTIVE ... 22

2.3. RISK PERTAINING TO INSURANCE AND TAKAFUL INDUSTRY 24 2.4. EMPIRICAL STUDIES OF RELATIONSHIP BETWEEN CORPORATE GOVERNANCE AND RISK ... 25

2.4.1. Separate Roles Of Chairman And CEO And Risk ... 26

2.4.2. Board Composition and Risk ... 26

2.4.3. Board Size And Risk ... 27

2.4.4. Board Meeting and Risk ... 28

CHAPTER THREE

... 31

DEVELOPMENT OF HYPOTHESIS AND RESEARCH DESIGN

31 3.1. INTRODUCTION ... 31

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3.2.1. Separate Role Of Chairman ... 31

3.2.2. Board Composition ... 33

3.2.3. Board Size ... 35

3.2.4. Frequency of Board Meetings ... 36

3.3. RESEARCH DESIGN ... 37

3.3.1. Data ... 37

3.4. VARIABLES ... 38

3.4.1. Independent Variables ... 39

3.4.2. Dependent Variables ... 41

3.5. REGRESSION MODEL ... 48

3.6. CONCLUSION ... 50

CHAPTER FOUR

... 51

EMPIRICAL RESULTS AND DATA ANALYSIS

... 51

4.0. INTRODUCTION ... 51

4.1. CORPORATE GOVERNANCE AND RISK ANALYSIS ... 52

4.1.1. Descriptive Analysis ... 52

4.1.3. Multi-collinearity ... 59

4.1.4. Auto Correlation ... 61

4.1.5. Heteroscedasticity ... 62

4.1.6. Selection of Fixed Effect and Random Effect Models (Hausman Test Analysis) ... 63

4.2. EMPIRICAL FINDINGS ... 65

4.2.1. Regression Analysis For Liquidity Risk Estimators And Corporate Governance Variables ... 66

4.2.2. Empirical Findings for Underwriting Risk Variables ... 71

4.2.3. Empirical Findings for Operational Risk Variables ... 75

4.3. CONCLUSION ... 77

CHAPTER FIVE

... 81

CONCLUSION

... 81

5.0. SUMMARY ... 81

5.1. CONTRIBUTION OF THE RESEARCH ... 84

5.2. RESEARCH LIMITATIONS ... 85

5.3. FUTURE RESEARCH PROSPECTS ... 86

BIBLIOGRAPHY

... 87

APPENDIX I

... 104

APPENDIX II

... 108

APPENDIX III

... 112

APPENDIX IV

... 117

APPENDIX V

... 121

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CHAPTER ONE

1.0. INTRODUCTION

Today Insurance industry plays an important role in the financial system of any country in facilitating domestic and international commerce. (Lael, 2008: 1) has stated that, “insurance fulfills somewhat different economic functions than do other financial services, and in turn requires particular conditions to flourish and to make a full economic contribution.” According to the Lakshmi Puri (2007), insurance companies carry out financial activities that facilitate the financial stability, support trade and commerce, and improve the standard of living for the individuals. Whereas, Mojekwu, Agwuegbo and Olowokudejo (2011), have stated that it is important to have efficient and well governed insurance industry in order to have a sound financial markets as well governed insurance industry helps the individuals and businesses to mitigate their risk. Surely, “insurance has existed for many centuries. In other words, there is a need for human to prepare for the loss,” (Jacky, Muhammad and Yura, 2010). For this very reason various governments had developed insurance system for facilitating their societies in order to reduce the risk. Therefore, the basic philosophy behind practicing the insurance mechanism is to mitigate the risk of any individual, entity or an organization. The insurers carry out this process by identifying the risk based on various factors as per the policy offered to the customer. For instance, in life insurance, the insurer considers the age and health of an individual. Based on these various examinations the insurers predict the possible occurrence of that particular uncertain event (risk).

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In practical scenario, there are numerous policy holders that put their funds in an insurance company in the form of premiums against the risk they had sought the protection for. Basically, the concept of insurance is that the insurer accumulates funds from the public in the form of a premium (that is, by selling the insurance policies to the customers) and put those funds in the common pool of insurance premium. In a case, if any policy holder incurs a loss it will be spread among various policy holders. Mark, (1991: 4) defined insurance as, “A contractual arrangement whereby one party agrees to compensate another party for losses. The party agreeing to pay for the losses is called the insurer. The party receiving the payment for a loss is called the insured. The payment insurer receives is called a premium.” In pure financial terms, insurance can be defined as the mechanism for arranging and redistributing the losses that would arise due to unpredicted events especially in commercial transactions. Therefore, “The indemnification and risk pooling properties of insurance facilitate commercial transaction and the provision of credit by mitigating losses as well as the measurement and management of non-diversifiable risk more generally, (Lael, 2008).” While (David, 1983: 67) has stated that, “The function of insurance is to assume the burden of the risks which individuals are unwilling to carry.” In the context of Malaysian market the discussion of insurance industry seems to be incomplete if that does not includes Islamic insurance or in Islamic term called

‘Takaful’. In terms of functions the takaful companies play similar role as conventional insurance. However, when it comes to the structure and the underlying principles both have distinct features. Unlike conventional insurance companies, the basic underlying principle on which any takaful company operates is “tabarru”.

Besides, it should be free from interest (riba) and uncertainty (gharar). This research paper will not be discussing the technical structure and the models adopted by takaful

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operators. It would rather be confined to the corporate governance and risk management discussed in succeeding chapters.

Over the past decades the growth of insurance industry globally has been remarkable. The globalization of the world economy has boosted international trade among various nations. With the growth and expansion of businesses in various regions the demand for insurance products by the business sector as well as household increased tremendously. According to PRWeb, it is estimated that the global Insurance industry would reach US$ 1.6 trillion of Insurance premiums by 2015. The Malaysian insurance market at the national level has shown significant growth.

According to the Economy Watch, in 2004 the growth rate of Malaysian insurance industry recorded 17.2% both in life and general insurance, that is, RM 22, 038.9 million. Due to the global economic downturn, Business times reported that the growth rate of Malaysian insurance industry had moderated in 2011 and recorded between 14 to 15 percent. However, Islamic insurance (takaful) has shown an outstanding growth in the Malaysian insurance industry which was outstanding.

According to the World Takaful report (2011), Malaysian takaful industry recorded 30% growth rate in 2009. According to International Insurance News, over the period of last 5 to 6 years, the Malaysian insurance industry had grown on an average rate of 27 percent per annum in terms of net premium contributions, whereas the family takaful grew at 28 percent. Family takaful contributes more than 80 percent of the takaful market in Malaysia. Notwithstanding the growth of Insurance industry, the dynamically changing business environment has exposed the insurance companies both at global as well as at the domestic (Malaysian market) level to a great amount of risk due to which insurance industry is facing many challenges in managing day to day operations and minimizing risk involved in the transactions. Everis (2009) stated

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that the uncertainty in insurance industry has been growing and consequently led the insurance companies to provide high level safety through various approaches and one of them is regulating and reviving risk techniques. Due to this reason risk mitigation and control has become one of the aspects of strategic goals for insurance companies.

In regards to takaful companies, they too are exposed to risk as the basic operations of takaful companies are similar to conventional insurance companies. Nooraslinda and Toszana and Kamil (2011) stated that risk for financial institutions would that be a conventional or an Islamic requires equal attention in terms of managing and mitigating risk. Indeed, the responsibility of carrying this task of managing and mitigating risk falls on top management of an organization. As generally known, it is the top management (board of directors) who formulates and endorses risk mitigating policies. However, it has been found that the interest of board of directors in implementing effective risk management mechanism varies based on the ownership structure of the organization. Basel Committee on Banking Supervision (BCBS, 2010: 1) termed this mechanism as corporate governance. It refers to “a set of relationships between a company’s management, its board, its shareholders and other stakeholders.” Hontz and Shkolnikov (2009: 12) have asserted that “corporate governance encompasses a wide variety of tools that also address the environment within which companies operate, that is, issues associated with the institutional development of countries.” According to the Organization for Economic Co- operation and Development (OECD, 2004), corporate governance in any company tends to be affected by the behaviour and relationships of various participants in the governance system of the organization. Besides, Ali and Nazrul (2006) have highlighted that an ownership structure based on Agency Theory impacts the company’s risk. This was focusing on debt as well as the factors that determine the

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interdependence of ownership structure and corporate debt policy. In this research paper the discussion would be confined to the Malaysian insurance industry (conventional and takaful) and the role of corporate governance pertaining to risk.

1.1. PROBLEM STATEMENT:

According to Donald (2011) the corporate failures have driven the focus of policy makers towards corporate governance agenda and to form effective mechanisms that would reduce the possibility of corporations’ failure by mitigating the risk factors both inside and outside a company. Therefore it is very important to have effective corporate governance in an organization. Bob (2009) mentioned that the board of directors is responsible for identifying the potential risk that could be effective to the value drivers of the corporation and endangered the firm’s survival.

Ira, Michel, Sir Adrian, Robert, Dieter, and Nobuo (1998) have asserted that the corporations must strive to create a competitive edge by maximizing their profits.

This can only be achieved when the board is sound enough to manage risk proactively taking necessary actions within the specific time in alignment with the frequently changing environment. They had further stated that this is possible only when there is a proper co-ordination and positive relationship established among the shareholders, board members and the managers, that is, through efficient corporate governance.

Referring to the 1997-98 South Asian financial crises, it has been said that one of the causes for that financial crisis during which Malaysia was affected badly was due to poor corporate governance. Thomas (n.d.) stated that the directors of various companies had borrowed huge amount of funds from the market, however those funds were not used in the venture for which the funds had been accumulated. Besides,

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there were also cases wherein the corporations hardly use disclosed the company’s information to the investors and other shareholders. He also highlighted that scenario prior and during the 1997-98 crises, the management controls had gradually moved in the hands of single family control. Therefore, in order to counter this, during the post crisis the government of Malaysia drafted and regulated the laws pertaining to corporate governance. It has also been noticed that the role of Chairman and CEO was played by the same person. It was presumed that this had provided the Chairman absolute power and to maintain secrecy. Besides, there were very few independent directors (non-executive) represented on the board. The roles and authority of these non-executive directors were not clearly defined. There were also cases where executive directors had influenced the audit committee by becoming a member of the audit committee. Therefore, it is necessary to have effective corporate governance for the growth, sustainability, efficiency and performance of any organization.

With the expansion and growth of insurance industry in Malaysia it has become necessary for the insurance companies (both conventional and Islamic) to regulate appropriate policies within the organization in order to manage and minimize the amount of risk that insurance companies are exposed to.“For insurance companies, risk management is of the utmost importance because insurance is the business of risk assumption (IBM Global Business Services; n.d: 3).” Everis (2009: 11) asserted that

“their growingly frequent uncertainty necessarily leads supervisors and companies to look for higher levels of safety through new approaches to solvency, supervision and risk management procedures.” Boudkeev and Harris (2007) stated that one of the most important and critical factors for rating insurance and takaful companies is “the overall risk culture that management has built” and also the “company’s appetite for

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management of risk and leverage.” Therefore, it is necessary to carry out research on managing risk in insurance and takaful companies. Zulkornain, Alias, Noriszura and Rubayah (2011) have similar opinion that the insurers and takaful operators can sustain for a longer duration, by managing their risk effectively and also be able to increase the rate of return on the equities and the profitability of the firm. This would help them in meeting the regulatory requirements pertaining to the solvency and compensating the policy holders accordingly. This can be possible only through managing risk efficiently by the top management. According to the data collected so far and as per my knowledge, no research or studies are found in the context of corporate governance and its impact on risk of insurance and takaful companies in Malaysia. As Malaysia is on the verge of becoming a financial hub therefore it is feasible to conduct this research on Malaysian insurance and takaful companies. Thus, the objective of this study is presented in next session.

1.2. RESEARCH OBJECTIVE:

As mentioned above that corporate governance do have impact on every aspect of the financial institution’s operations especially on the risk. Therefore, based on this study, the main objective of this research is:

 To find the impact of effective corporate governance on the risk of Malaysian insurance and takaful operators.

1.3. RESEARCH QUESTIONS:

a) Do corporate governance variables have impact on risk of takaful and insurance companies?

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b) To what extent, could Insurance and Takaful companies with better corporate governance mechanisms contribute towards lower risk?

1.4. LIMITATIONS OF THE RESEARCH:

As this research is mainly based on the panel data (secondary data) it does not involve any sort of survey or any personal interview. In short, all our analysis is based on the information available in the annual reports of insurance and takaful companies in Malaysia. Therefore, this research is subjected to certain limitations which are as follows:

1. In regards to the Corporate Governance variables, this research is based on mainly board and ownership structure. For this research paper the four corporate governance variables are the main independent variable (for the detail discussion on these variables, refer section 2.1). We are going to find the impact of these corporate governance variables on the risk of insurance and takaful companies.

2. Coming to the dependent variables, related to risk measuring ratios this research is confined to these risks measuring ratios that are discussed in third chapter. However, qualitative risk assessment and those ratios pertaining to credit and market risks have been excluded in this research.

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11 1.5. SIGNIFICANCE OF THIS RESEARCH:

1.5.1. For Regulators

According to Yunus (2010) Insurance regulators in Malaysia have shown concerns over the impact of global financial crisis (which was caused mainly by the inefficient management of risk) on Malaysian Insurance industry. For this reason they had a conference in 2010 on Risks and Risk Management Conference for Insurance Sector.

This research will provide a scope for Malaysian Insurance and takaful regulators to formulate guidelines pertaining to the insurance and takaful industry for strengthening the boards, monitoring this industry closely and make ensure that proper risk mitigating mechanism is implemented.

1.5.2. For Industry

As far as the insurance industry (that includes conventional insurance and takaful companies) is concerned, this research will give a new dimension to companies. This will help them in restructuring their board committees by increasing the number of independent qualified directors who can effectively take decisions without any influence and implement control mechanisms across organization. It will help them in reviving company’s strategic goals, that is, inclusion of improvising corporate governance in the risk management agenda. This will even provide the industry a shock absorbing shield that can minimize or prevent any losses in the event of any financial crisis.

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12 1.5.3. For Consumers

When an industry successfully and efficiently manages the risk, it will help in building the trust among the consumers that their funds are effectively managed, and protected.

Financial markets and institutions are volatile in nature therefore consumers are usually quite hesitant and do not easily trust these financial institutions. A small deviation or mismanagement of these institutions creates chaos in the market and consumers will lose their trust in financial institutions as we have noticed during the 2007 financial crisis. The failure of big financial institutions had tremendous negative impact on consumers’ trust, thus for over two years they became reluctant to put their savings in financial intermediaries. When the consumers see the seriousness of the industry’s regulators as well as boards to ensure the safety of their funds it will have a positive impact on their investment appetite.

1.5.4. For Researchers

So far researchers have focused their research either on risk management or corporate governance of takaful and insurance companies. There have also been studies found on the relationship of risk management with the performance and efficiency of insurance and takaful companies. In regards to corporate governance of insurance and takaful companies most of the researches are based on board structure, that is, the separation of Chairman and CEO roles, number of non-executive/independent directors and the board size of the companies (mostly independent in nature).

Besides, there have also been researches carried out on directors’ remuneration and its impact on the performance and efficiency of the insurance and takaful companies.

However, so far there is no known research related to the corporate governance and its impact on the risk of takaful and insurance companies. This research would help the

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researchers and students in providing them a new dimension for carrying out further researches on this aspect.

1.5.5. For Retakaful / Reinsurance Operators

As a part of risk management strategy, generally insurance and takaful companies purchase insurance from retakaful/reinsurance operators. Usually retakaful/reinsurance operators too are exposed to same sort of risk as insurance and takaful companies. Therefore, this research paper would also be useful for retakaful and reinsurance operators and help them in strategizing their risk managing policy.

1.6. ORGANIZATION OF THE RESEARCH:

This research paper is organized mainly in five chapters. The first chapter discusses about the back ground, problem statement, research objectives, research questions, significant of this research and the limitations. The second chapter discusses the literature review, that is, the theories and previous articles and journals written related to this area. The third chapter discusses the research methodology, wherein it discusses the variables (both dependent and independent variables) that are used for this research paper. Besides, it also discusses the generating hypothesis along with the statistical tool that will be used for analyzing the data. This includes the discussion on the data type (whether it is time series, cross section or panel data) and the source from which the data was collected. The fourth chapter is about empirical results and data analysis. This chapter discusses and analyzes the results of various statistical tests that are used to contemplate the relation between corporate governance variables and

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their effect on risk of insurance and takaful companies. Finally, the last chapter is about conclusion.

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CHAPTER TWO LITERATURE REVIEW

2.0. INTRODUCTION:

The term corporate governance has been defined in different terms by various entities and individuals. In a simple way the term corporate governance can be defined as, ‘A mechanism that derives the rules specifically for structuring and defining the roles of organization’s board of directors, shareholders and stakeholders. It also structures various processes in order to increase the efficiency, transparency and also the sustainability of an organization.’ Bob (2003) has defined corporate governance as,

“the appropriate board structures, processes and values to cope with the rapidly changing demands of both shareholders and stakeholders in and around their enterprises.” Whereas, Zulkifli (2009) has stated that, “corporate governance includes the entire network of formal and informal relations involving the corporate sector and their consequences for society in general.” Clarke (2004: 1), has mentioned OECD’s definition of Corporate Governance as:

“Corporate Governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stake holders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.”

Over the past few decades the importance of corporate governance has emerged as the most effective mechanism in preventing the corporate failures. As

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stated by Nordberg (2011) the root cause for the failure of big corporations like Baring Bank, Enron, World.com etc., was the inefficiency of board of directors in managing risk mitigating factors due to which these big corporations were exposed to risk and resulted in the company’s closure. “With corporate failings driving the corporate governance agenda, it is perhaps not surprising that the focus of policy has been on finding mechanisms, inside the company and outside it (Donald, 2011: 52).” Robert and Donald (2010) have stated that it is the primary responsibility of the board of directors to manage and mitigate risk in an organization. Referring to the 2007 subprime crisis, he further stated that one of the main reasons for the crisis was the failure of corporate boards in mitigating the risk. Dallas (2004: 2) has mentioned that

“policymakers, market participants, and academics are studying comparative governance structures and practices, with a view to identifying areas of risk and to develop policy responses for reform and improvement.” This is mostly because corporate governance failure has often been resulted in fueling financial crisis.

Greene, Trieschmann and Gustavson (1992:14) asserted that “the objective of such activities is to efficiently minimize the adverse impact of losses on the achievement of a company’s goals.” Yatim (2009) has stated that there is a positive relation between the strong board structure and the risk. “Risk oversight is a responsibility of all board directors and is handled in some companies at the full board level (Fox, Bugalla and Narveez, 2011: 5).” Htay, Rashid, Adnan and Meera (2011), has also asserted that since the 1997-98 Asian crisis corporate governance has attracted lot of attention as it is vital for financial institutions to manage risk effectively and it is a responsibility of board of directors to ensure that the risk control tools are properly implemented in the organization. Therefore, “risk management initiative has been integrated as one of the important part of the CG code in many countries in the world (Manab, Kassim and

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Hussain, 2010: 240).” Similar incorporation of risk management in corporate governance code had taken place in Malaysia as well. Discussing about the corporate governance, there are many theories exist. Among them, the most popular one is an Agency Theory. Irrespective of some disadvantages found in the Agency Theory, it has been widely practiced. Therefore, all the corporate governance variables used in this research are based on Agency Theory.

2.1. AGENCY THEORY

There have been many theories developed under corporate governance. Each theory is subjected to the nature of organization’s business, jurisdiction’s law and the culture of the area where the company operates. Among these theories, the most familiar and used by various jurisdictions is Agency Theory. Abdullah and Valentine (2009: 89) have defined Agency Theory as “the relationship between the principals, such as shareholders and agents such as the company executives and managers.” Clarke (2004: 59) has defined Agency Theory as “a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent.”

It has been said that Agency Theory has always been subjected to the conflicts between the principals and the agent. In most of the cases the goals of agents and the principals do not align. Usually, most of the times principals focus on long-term profit-maximization, whereas the agent might focus on short term profit due to the involvement of self-interest factor. Clarke and Rama (2004: XXII) have mentioned that “the fundamental assumption of a universal separation of ownership and control upon which Agency Theory rests is open to challenge.” Clarke (2004) asserted that in

IMPACT OF CORPORATE GOVERNANCE ON RISK: EMPERICAL EVIDENCE FROM INSURANCE AND TAKAFUL OPERATORS IN