An Approach to Measure Financial Risk Relative Indices: A Case Study of Indonesian Insurance Companies

Abstract

The number of insurance companies in Indonesia has been increasing over the years. This is a good indicator of the society’s awareness ofthe importance of insurance. In order to ensure the sustainability of acompany as well as its customers’ safety, the insurance companies have to maintain the quality of their performance. To deal with this, the Financial Service Authority (OJK) of Indonesia needs to monitor the risk level of each insurance company. For the company, financial risk analysis is required to formulate strategies for reducing its risk. Financial risk analysis is also important for prospective investors or creditors as one of the considerations to formulate a business plan with the company. This chapter introduces an approach to measure financial risk through financial performance data as reported in the company’s annual report. In this case, the risk variables in the balance sheet are available only on a yearly basis, and hence, a time series based approach for measuring risk, such as Value at Risk (VaR), cannot be applied. The limited number of series will explode the variance estimate of the parameter distribution used to calculate VaR. As an alternative, the risk can be measured by an index showing the financial risk of a company relative to the others. The fact that financial risk is a latent variable, which can be measured only through its indicators, leads to the idea of calculating the index by using the concept of the Confirmatory Factor Analysis (CFA). This chapter applies that idea to calculate the financial risk relative indices of life insurance companies in Indonesia. This approach offers another benefit, the ability to investigate variables which significantly contributes to increase the risk. The analysis shows that a company is said to have a high financial risk relative to the others if the index is below 0.29.