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University of Technology, Taiwan, ROC No. 168, Jifong E. Rd., Wufong Township,

Taichung County 41349, Taiwan, ROC. Mei-Ching Chen Associate Professor

Department of Business Administration Chaoyang University of Technology, Taiwan,

ROC No. 168, Jifong E. Rd., Wufong Township, Taichung County 41349, Taiwan, ROC.

Tel: 886-4-23323000 ext. 4202 Fax: 886-4-23742331 E-mail:

mcchen@mail.cyut.edu.tw. Wen-Ju Liao Graduate Student for Ph.D Program

International Business Studies, National Chi Nan University No. 1, University Road,

Puli Nantou 545, Taiwan, R.O.C. Tsung-Hsien Chen Instructor Department of

Insurance Chaoyang University of Technology, Taiwan, ROC No. 168, Jifong E. Rd.,

Wufong Township, Taichung County 41349, Taiwan, ROC. Influence of Capital

Structure and Operational Risk on Profitability of Life Insurance Industry in Taiwan

Abstract Purpose- The solvency of insurance companies is closely related to the

policyholders, and consequently regulators in Taiwan pay considerable attention to

this area. Several studies have demonstrated a close correlation among capital

structure, operational risk and profitability. This study provides evidence regarding

the influence of capital structure and operational risk on profitability of life

insurance industry in Taiwan. Design/methodology/approach- Structural equation

modeling, which involves factor-analysis and path-analysis, is used to justify the

relationship among capital structure, operational risk and profitability. Additionally,

adding the macroeconomic latent variable to the model as a control variable

demonstrates that the macroeconomic latent variable positively influences capital

structure, operational risk and profitability. Findings- This study leads to four key

findings. First, according to the empirical result, the research model has excellent

goodness-of-fit. That is to say, using multiple financial indexes suitably measures

the specific financial factors. Second, the capital structure exerts a negative and

significant effect on operational risk. Third, there is no reciprocal relationship but a

one-way effect between capital structure and operational risk. Fourth, the

operational risk exerts a negative and significant effect on profitability. Practical

implications- The empirical result shows the profitability decreased with the higher

equity ratio. Hence, the regulatory organizations must urge insurance companies to

effectively diversify their investments and employ risk avoidance strategies.

Effective use of hedging and diversifying will help to divide risk and create financial

revenue. Original / value- This study proposes that the government loosen

investment restrictions and develop other instruments to assist RBC in checking the

financial condition of insurance companies. Keywords: capital structure, operational

risk, profitability, structure equation model. 1. Introduction The depressed economic

situation and declining market interest rates significantly affect the operations of

financial services, particularly the insurance industry. Insurance companies face

financial crises when the underwriting capacity is reduced and the interest risk

increases. The solvency of insurance companies is closely related to policyholders,

and consequently policyholders have become the focus of considerable attention by

regulators in Taiwan. Modigliani and Miller (1958, 1963) indicated that firm value is

Several studies found a close correlation among capital structure, operational risk

and profitability. In Taiwan, Changchieh (2000) and Lin (2003) considered that

operational risk influences capital structure. Several experts noted that the

interrelationships between capital structure and operational risk exist in the

operations of the insurance industry (see Cummins and Sommer, 1996; Chen and

Tsai, 2002; Chen, Chen and Lin., 2004). Furthermore, the recent research found that

there were both positive and negative effects of capital structure on the profitability

of the insurance companies. Chen, Chen and Lin (2004) provided evidence that the

impact of capital structure and risk on profitability for property-liability industry

using by structural equation model. In general, the operational risk of propertyliability industry focuses on the underwriting risk and the level of hedge. There is a

significant difference between property-liability industry and life insurance industry.

Hence, this study examines the influence of capital structure and operational risk on

profitability of life insurance industry in Taiwan using a structural equation model

(SEM) that involves factor-analysis and path-analysis statistical techniques. The

model includes the macroeconomic latent variable in the model as a control

variable, and then justifies the relationship among capital structure, operational risk

and profitability. Based on the empirical results, this study provides some

suggestions for the regulation of insurance industry in Taiwan. The remainder of this

paper is organized as follows. Section 2 develops a framework for testing and

verifying the relationship among capital structure, operational risk and profitability

for life insurance industry in Taiwan. Section 3 then describes the data and empirical

methodology. Next, section 4 presents the empirical results. Finally, section 5 details

the conclusions. 2. Framework Capital structure describes the ratio of debt to equity

in a company. This study examines the influence of capital structure and operational

risk on the profitability of life insurance industry in Taiwan. This study attempts to

build a research model by examining the problems arising from previous studies.

2.1 Hypotheses and Variables Modigliani and Miller (1958) argued that the capital

structure of a firm is irrelevant to the firms value, assuming perfect markets and

zero transaction costs. Modigliani and Miller (1963) showed the impact of corporate

income taxes on the capital structure of a firm and found that firms will increase

their use of debt to exploit the tax deductibility of interest. However, higher debt

financing increases the probability of bankruptcy. Market equilibrium must exist in

which the benefit of using debt-financing equals increased risk of bankruptcy owing

to the high leverage of firms. Additionally, Staking and Babbel (1995) supported the

hypothesis found by Modigliani and Miller. Jou (1999) found the value of a firm

initially increasing with financial leverage and then falling with financial leverage.

Chen, Chen and Lin (2004) have used SEM to test and verify the relationship among

capital structure, risk and profitability of property-liability insurance industry in

Taiwan. They found that there were both positive and negative influences of capital

structure on profitability. Furthermore, finance theory maintains that firm value is

determined by the discounted present value of cash flow. Therefore, the following

hypothesis is developed: H1: Capital structure positively influences the profitability

company solvency are capital structure and operational risk. Chen and Tsai (2002)

collected information from all of the life insurance companies operating in the

United States in 1997, and then used the two stage least squares method to

estimate the relationship between capital structure and risk. Their analytical results

are the same as the study of Cummins and Sommer (1996). In Taiwan, Changchien

(2000) found a positive relationship between the insurance disclosure and the

liability ratio. Lin (2003) found that there was a simultaneous and causal influence

of risk and premium on firm capital strategies in the property-liability insurance

industry in Taiwan. In addition, Lin used the vector autoregression method to

demonstrate the negative relationship between liability ratio and risk. Therefore,

this study develops the second hypothesis: H2: A negative relationship exists

between capital structure and operational risk in the life insurance industry in

Taiwan. Cummins and Harrington (1988) used the CAPM model to examine the

property-liability insurance industry, and subsequently found a significant

relationship between the expected return and systematic risk and unsystematic risk.

When insurance companies encounter increasing operational risk, it becomes

necessary for policyholders to pay increased risk premiums due to the increased

probability of financial crisis. Jensen and Meckling (1976) also indicated that the

agency cost would reduce a firms value. Lai, Lu and Wu (1999) demonstrated the

financial index of the property-liability insurance industry from 1992 to 1996 in

Taiwan and found that the company had long-term strong solvency with higher

operational performance. Lin and Huang (2002) used the option-based valuation

model to develop a surplus valuation model for property-liability insurance industry

in Taiwan and further demonstrated that a much lower surplus is achieved if the

associated catastrophe risk comprises systematic components. Additionally, Liu

(2003) used the SEM to test and verify the relationships among industry structure,

business strategy and profitability. The evidence suggests that larger life insurance

companies may adopt a conservative strategy of pursuing gradual growth in Taiwan.

However, the conservative strategy generally has problems dealing with dynamic

markets. Consequently, if a major change occurs in the investment environment,

the larger scale insurers will suffer major losses. Therefore, this study develops the

third hypothesis: H3: Operational risk negatively influences the profitability of the

life insurance industry in Taiwan. Many experts have discussed the influence of

macroeconomic factors on the operations of insurance industry in Taiwan using

economic models. Chan (1997) and Wang (1999) demonstrated that

macroeconomic factors lead the policy lapse rate to rise in the life insurance

industry. Chen (1999) employed the vector autoregression model to examine the

interrelationship among the effective premium, national income, consumer price

index, the economic growth rate and expenditure on medical treatment and health

protection. Chen (2002), Chu (2002) and Chen (2001) confirmed that a relationship

exists among macroeconomic factors and premium receipts in the life insurance

industry. The above results show that the macroeconomic variables truly influence

the operations of insurance industry in Taiwan. Bykerk and Thompson (1979)

analyzed the effect of policy loans on policyholders and companies and found a

positive relationship between the rates of commercial paper and policy loans.

Additionally, Mark, James and Robert (1999) applied Poisson regression to identify

the influence of exogenous factors, including interest, real estate and stock return,

rate of unemployment and the number of insurance companies facing probable

bankruptcy in the industry. This study chooses the observed variables for each

latent variable based on the studies mentioned above. Table 1 lists the formulas of

each variable. However, market conditions clearly are continually changing (see

Figure 1). To avoid obtaining incorrect results in this research model, this study adds

the macroeconomics latent variable into the model as a control variable. -4% -2%

0% 2% 4% 6% 8% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

year % GR IR UR Figure 1: Macroeconomic variables observed during the period

1993 to 2003. Note: ER indicates the economic growth rate; IR indicates the

inflation rate; UR indicates the unemployment rate. Table 1: Variables Definitions

Latent Variables Observed Variables Formula Economic growth rate ( 1 x ) ( ) GDPt

GDPt1 GDPt1 , where GDP respects Real Gross Domestic Product Inflation rate

( 2 x ) ( ) CPIt CPIt 1 CPIt 1 , where CPI respects Consumer Price Index.

Macroeconomics( 1 ) Unemployment rate ( 3 x ) The number of unemployed

population is divided by the number of employed population. Liability ratio 1 y

Total liabilities is divided by total assets Equity ratio 2 Capital Structure y

Shareholders equity is divided by total assets 1 Reserve-to-liability ratio 3 y

The reserve is divided by total liabilities Portfolio concentration ( 4 y (The

investment of i k / total investments)2 i k =bond, common stock, preferred stock,

mortgage loan, real estate. Operational Risk2 Insurance leverage 5 y The

reserve is divided by shareholders equity. Profit margin ( 6 y ) The profit before tax

is divided by total Profitability revenue. 3 Return on assets ( 7 y ) The net

income is divided by total assets. 2.2 Theoretical Model The theoretical model

(original model) includes an exogenous latent variable and three endogenous latent

variables. The exogenous latent variable is a macroeconomic variable reflected by

three observed variables. The macroeconomic latent variable includes the economic

growth rate ( 1 x ), the inflation rate ( 2 x ) and the unemployment rate ( 3 x ). The

model employs three endogenous latent variables, including capital structure (1 ),

operational risk ( 2 ) and profitability (3 ). Capital structure is reflected by liability

ratio ( 1 y ), equity ratio ( 2 y ) and reserve-to-debt ratio ( 3 y ); meanwhile,

operational risk is reflected by portfolio concentration ( 4 y ) and insurance leverage

( 5 y ); finally, profitability is reflected by profit margin ( 6 y ) and return on assets

( 7 y ). Therefore, the theoretical model is shown in Fig.2. Figure 2: Theoretical

Model 3. Empirical Methodology 3.1 Data Data for the empirical analysis is obtained

from the Annual report on the life insurance industry, Republic of China published

by the Life Insurance Association of the Republic of China, Insurance leverage

Portfolio concentration Return on assets Profit margin 4 Unemployment rate

Inflation rate Economic growth rate Liability ratio Reserve-toliability ratio Equity

ratio Profitability 2 1 3 1 2 3 5 6 7 Macroeconomics Capital structure

Department of Statistics, Ministry of Economic Affairs. This study observes the local

life insurance industry in Taiwan from 1993 to 2003. To minimize the possibility of

biased results, only firms for which data is available throughout the sample period

are included. After deleting missing values and incomplete data, the sample

includes a total of 13 insurance companies. 3.2 Structural equation modeling The

structural equation model minimizes the difference between the sample covariance

and the predicted covariance, which is capable of defining the relationship between

the observed and latent variables, and also the interaction among the latent

variables. Therefore, this study uses SEM with the SPSS AMOS 4.0 statistics

software. Additionally, SEM comprises measurement and structural equations, with

the former being used to describe the relationship between the observed and latent

variables, and the latter being used to analyze the causality among the latent

variables. The measurement equation comprises two parts, and the corresponding

mathematical model can be specified as follows (Huang, 2003): = + y y (1) x

= x + (2) where, ( ) p1 y : vector of endogenous observed variables, ( ) q1 x :

vector of exogenous observed variables, ( ) m1 : vector of endogenous latent

variables, ( ) n1 : vector of exogenous latent variables, y( ) pm : coefficient

matrix relating ( ) p1 y to ( ) m1 , x( ) qn : coefficient matrix relating ( ) q1

x to ( ) n1 , ( ) p1 : measurement error vector for ( ) p1 y , ( ) q1 :

measurement error vector for ( ) q1 x . As for the structure equation, the

corresponding: = B + + (3) where, B : coefficient matrix for ( ) mm ( )

m1 , ( ) mn : coefficient matrix for ( ) n1 , ( ) mn : latent error vector in

equations. 1 2 3 4 5 6 7 1 2 3 1 1 2 2 3 3 4 4 1 5 5 2 6 6 3 7 7 1 1 1 2 2 3 3 000 000

000 0 00 0 00 00 0 00 0 000 000 000 y y y y y y y x x x y y y y y y y x x x

= +

With the following assumptions: (1) E() () ( ) = E = E = 0 . (2) is uncorrelated

with . (3) is uncorrelated with . (4) is uncorrelated with . (5) , and are

mutually uncorrelated. (6) ( ) I B is nonsingular. The two methods most often used

for estimating SEM are generalized least square (GLS) and maximum likelihood

(ML). Both of these methods should satisfy the normality assumption. If data size is

small, GLS outperforms ML. This study uses the GLS method because the data size

is 143. Seven criteria exist for measuring the goodness of fit of the specified model:

(1) 2 value: Goodness of fit increases with decreasing score, but is affected by

sample size. (2) GFI (Goodness of Fit Index) value: a value between 0 and 1, with

the nearness of the value to one indicating increased goodness of fit. GFI resembles

the 2 R value used in multi-regression. (3) AGFI (Adjusted Goodness of Fit Index)

value: Similar to the 2 R value used in multi-regression, AGFI can be used to

compare with each different degree of freedom model. (4) RMSEA (Root-MeanSquare Error of approximation) value: This variable has a value between 0 and 1,

and a numerical value below 0.5 reflects a better goodness of fit. (5) CFI

(Comparative of Fit Index) value: This variable has a value between 0 and 1, with a

value closer to 1 reflecting a better goodness of fit. (6) AIC (Akaike Information

Criterion) value: This variable can be used to compare models, and an AIC value

closer to 0 reflects a better goodness of fit. (7) Stability value: This variable is used

to judge the stability of a non-recursive model. A stability value closer to 0 indicates

a stable model. Accordingly, there are seven exogenous observed variables. The

measurement and structure equations are shown below: 4. Empirical Results 4.1

Goodness-of-fit measures This study uses seven criteria to assess the goodness of

fit of the specified model (see Table 3). The model estimates are listed in Tables 4

and 5. As mentioned earlier, the goodness of fit increases with the closeness of GFI,

AGFI and CFI relative to 1. Each research method used must satisfy several

assumptions, and thus the results are believable. The basic assumptions of SEM

include: (1) sufficient sample size, (2) multivariate normality, (3) correct model

specification, (4) simple random sampling and (5) non-systematic missing value.

First, SEM has no sample size criteria with the sample size depending on the

characteristics of the sample data. Second, this study uses GLS, which must satisfy

the assumption of multivariate normality. If the absolute value of skew were greater

than 3 and the absolute value of kurtosis were greater than 10, the model would be

against multivariate normality. Table 2: Summary Statistics variable mean Standard

deviation skew kurtosis 1 x 0.0489 0.0257 -1.7943 2.5729 2 x 0.0142 0.0178

-0.0451 -1.1309 3 x 0.0304 0.0126 0.5190 -1.0248 1 y 0.7981 0.2646 -1.8922

2.3926 2 y 0.2014 0.2651 1.8828 2.3758 3 y 0.8577 0.2059 -2.5425 6.2069 4 y

0.0597 0.0437 1.0463 1.5909 5 y 17.9655 92.3823 11.4402 134.6596 6 y -0.0606

0.1919 -2.2766 7.5266 7 y -0.0365 0.0961 -2.5527 7.2983 Owing to the insurance

leverage ( y5 ) exceeding the normal range, the variable is eliminated and a new

estimate is made. The model is continuously modified until it is considered

acceptable. Deleting liability ratio ( y1 ) and insurance leverage ( y5 ) resulted in a

modified model. For the modified model, 2 (16) =20.059, p-value (0.218) is

greater than 0.05, GFI=0.965, AGFI=0.921, CFI=0.975, RMSEA=0.042 and

AIC=60.059, all index values indicate that the modified model is 1 12 1 11 1 2 21 2

21 1 2 3 31 32 3 31 3 0 0 0 0 0

= ++ acceptable. Therefore, the model

used in this study has excellent goodness of fit (see Table 3). Table 3: Goodness of

Fit Measure original model modified model ( ) 2 df 2 (29) =45.087 2 (16)

=20.059 p-value 0.029 0.218 GFI 0.936 0.965 AGFI 0.88 0.921 RMSEA 0.063 0.042

CFI 0.913 0.975 AIC 97.087 60.059 stability 0.098 0.01 Macroeconomic

Unemployment rate Inflation rate Economic growth 1 x 2 x 3 x 21 11 31

32 12 21 31 Equity ratio Reserve-toliability ratio 2 y 3 y Capital structure

Portfolio concentration 4 y Return on assets Profit margin 6 y 7 y Operational

risk Profitability 2 1 3 2 3 4 6 7 1 2 3 Figure 3: Modified Model

4.2 Relationship between latent variables and observed variables The identification

problem in the model which the latent variable is measured by few observed

variables is easy to have an under-identified result, i.e. the model has more

parameters than data, and it cannot be uniquely estimated. It can solve this

problem by setting the relationship between latent variables and one of observed

variables to 1. Therefore, this study sets 1 x , y2 , y4 and y6 equal to 1. The

analytical results demonstrate that all of the observed variables significantly reflect

the latent variable. The economic growth rate and inflation rate positively affect

macroeconomics. However, the unemployment rate negatively affects

macroeconomics. Additionally, the equity ratio positively affects capital structure.

The reserve-to-liability ratio negatively affects capital structure. Operational risk

increases with portfolio concentration. Furthermore, profitability increases with

profit margin and return on assets. Table 4: Estimates for Parameters of

Measurement Equation parameter standardized estimator estimator standard error

p-value 1 x 0.829 1.000 0.000 0.000*** 2 x 0.953 0.804 0.055 0.000*** 3 x

-0.924 -0.550 0.041 0.000*** 2 y 0.965 1.000 0.000 0.000*** 3 y -0.898 -0.716

0.054 0.000*** 4 y 0.969 1.000 0.000 0.000*** 6 y 0.986 1.000 0.000 0.000*** 7

y 0.867 0.441 0.023 0.000*** Notes: The symbol *** indicates that the

correlation coefficient is statistically significant at a significance level of 0.01. **

indicates that the correlation coefficient is statistically significant at a significance

level of 0.05. * indicates that the correlation coefficient is statistically significant

at a significance level of 0.1. 4.3 Relationship among latent variables This study

takes the macroeconomic latent variable as the control variable. The relationship

between macroeconomics and operational risk is fixed in this study. The results

demonstrate that macroeconomics significantly and positively influence capital

structure and operational risk (see Table 5). Based on the results, the capital

structure exerts a negative and significant effect on operational risk and

profitability. Additionally, operational risk exerts a significant and negative effect on

profitability. Table 5: Estimated Parameters of the Structure Equation parameter

standardized estimator estimator standard error p-value 11 0.558 6.753 1.380

0.000*** 21 0.529 1.000 0.000 0.000*** 31 0.081 0.723 1.061 0.496 21 -0.379

-0.059 0.027 0.026** 31 -0.442 -0.324 0.085 0.000*** 12 -0.026 -0.167 1.131

0.882 32 -0.175 -0.825 0.466 0.076* Notes: The symbol *** indicates that the

correlation coefficient is statistically significant at a significance level of 0.01. **

indicates that the correlation coefficient is statistically significant at a significance

level of 0.05. * indicates that the correlation coefficient is statistically significant

at a significance level of 0.1. 5. Conclusion This study uses SEM to test and verify

the relationships among capital structure, operational risk and profitability of life

insurance industry in Taiwan. SEM not only reduces the problem of unsatisfactory

results, but uses multiple financial indexes to measure latent variables. SEM can

increase the explanatory power of the model and clarify the causal relationships

among latent variables. There are four important findings. First, there are excellent

empirical results in this study. The observed variables adequately measure the

latent variables and the modified model has goodness-of fit. That is to say, using

multiple financial indexes suitably measures the specific financial factors.

Furthermore, the modified model is close to the real financial state. Second, capital

structure exerts a significantly negative effect on profitability. It implies that a

company has higher profitability when the equity ratio increases or reserve-toliability ratio decreases. This result supports the first hypothesis and indicates that

the more conservative operational strategy does not lead to higher profitability. The

result is consistent with the results of Staking and Babbel (1995). Third, the capital

structure exerts a significantly negative effect on operational risk. There is no

reciprocal relationship but a one-way effect between capital structure and

operational risk. This finding indicates that the more conservative operational

strategy effectively reduces the operational risk. This result is consistent with the

results of some scholars (Changchien, 2000; Liu, 2003). But it does not support the

second hypothesis. Fourth, the operational risk exerts a significantly negative effect

on profitability. The higher portfolio concentration reflects the higher operational

risk, and causes the lower profitability. This finding supports the third hypothesis.

This result is consistent with the results of some scholars (Lai, Lu and Wu, 1999; Lin

and Huang, 2002; Liu, 2003).Additionally, the administrators must decrease or

diversify their investment to protect profits and prevent losses. In conclusion, the

purpose of the government establishing the risk-based capital (RBC) is to calculate

the base capital requirement for each company. Although the government regulates

each company reaching the base capital requirement, the government cannot

ensure that companies avoid insolvency. Insurance premiums are the main revenue

source for life insurance companies; financial revenue is the secondary source. A

higher premium represents the higher reserve and liability. The empirical result in

this study shows the profitability decreased with the higher equity ratio. Hence, the

regulatory organizations must urge insurance companies to effectively diversify

their investments and employ risk avoidance strategies. Effective use of hedging

and diversifying will help to divide risk and create financial revenue. This study

proposes that the government loosen investment restrictions and develop other

instruments to assist RBC in checking the financial condition of insurance

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