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JEAS
30,2

96

Modelling foreign exchange

rate exposure
An industry level study using panel
econometric methods from Egyptian
insurance data
Islam Amer
Bradford University School of Management, Bradford University,
Bradford, UK and Cairo University Business School,
Cairo University, Cairo, Egypt
Abstract

Journal of Economic and

Administrative Sciences
Vol. 30 No. 2, 2014
pp. 96-120
r Emerald Group Publishing Limited
1026-4116
DOI 10.1108/JEAS-03-2013-0009

Purpose The purpose of this paper is to fill a gap in the foreign exchange rate exposure
management literature as the existing literature has focused only on developed economics, and also
the current literature on foreign exchange rate exposure of cedant insurance companies is very limited.
As Egyptian insurance companies deal directly with foreign exchange rates, they face exposure to
exchange rates through their international reinsurance operations.
Design/methodology/approach Martin and Mauer (2003, 2005) three-stage model is used to
estimate foreign exchange rate transaction exposure for the sample of 23 Egyptian insurance
companies over the period 2002-2009. However, the author has two innovations to this method. The
authors first innovation is that instead of looking at the unanticipated operating income for each
cedant company (as in both previous papers), this paper looks at the unanticipated operating income
on an aggregate level. The authors second innovation is that instead of the model used in previous
papers the author uses a model from the actuarial field that was proposed by Blum et al. (2001) for
modelling foreign exchange rates with their relevant constituents (inflation and interest rate).
Findings The central finding of the study is that the foreign exchange rate exposure across the
Egyptian insurance industry is not significant (at the 10 per cent level) and investigates this result.
Research limitations/implications This study has made considerable contributions to the
existing academic literature, but the findings also illustrate the limitations of the research undertaken.
These limitations, however, provide important directions for future research. This thesis focused
exclusively on the transaction exposure that Egyptian insurance companies experience to fluctuations
in the US dollar exchange rate in relation to their international reinsurance operations. As a result,
investigating both translation and economic exposure was beyond the scope and purpose of this study.
Practical implications The findings of this research provide meaningful implications for industry
practitioners. As Egyptian insurance companies are not immune from exchange rate risks, efforts
must be made by each insurer to approximate and quantify their individual foreign exchange rate
transaction exposure. Additionally, as Egyptian insurance companies increasingly operate worldwide
(through the international reinsurance industry), this research and its results are significant for
practitioners not only in Egypt, but also further afield. Finally, it is believed that this research will
highlight greater implications for international financial players active in Egyptian financial and
non-financial sectors, including banks not exposed singularly to US dollars, but to multiple currencies.
One recent Egyptian example is Egypt Air, which lost an estimated US$600 million in 2013 due to
foreign exchange rate fluctuations.
Originality/value Since Egyptian insurance operates worldwide, the results of this paper are
of significant not only for Egyptian insurance managers but also to practitioners beyond Egypt.
Keywords Egyptian insurance companies, Emerging insurance markets,
Foreign exchange rate exposure, Panel econometric estimation methods, Reinsurance,
Exchange rate fluctuations
Paper type Research paper

1. Introduction
The leitmotiv of this paper is modelling foreign exchange rate exposure, which is a
vast and sophisticated field for any company that operates internationally in general
and for insurance and reinsurance companies in particular.
In the initial stages, many emerging countries resorted to the imposition of restrictions
on insurance operations in general and on reinsurance operations in particular. In many
emerging countries, national reinsurance companies were established by the government.
This action targeted increasing the national retention and stemming the outflow of
foreign currency and retaining invested funds within countries for their own
development plans. These national companies were expected to play a pivotal role in
the preservation of foreign currency by providing local insurance capacity and
underwriting some risks that were shunned by private reinsurers, particularly foreign
companies. However, many of these national companies, which were new to the field of
reinsurance, initially lacked managerial experience and therefore many of these
companies with their limited capital could not properly assess the overall risks attached.
Meanwhile, economic reform programmes were implemented by many emerging
countries, resulting in a reduction in the involvement of governments in the insurance
industry. Terms such as liberalization, privatization and deregulation became
household names during this phase. All these factors resulted in local risks finding
their way into international insurance markets. In brief, most insurance companies in
emerging countries now reinsure their business in the international insurance market
in order to obtain the widest coverage for risk.
As a result most of the insurance companies in emerging markets, such as the
Egyptian insurance market, reinsure most of their business in the international
reinsurance market. Owing to the international nature of reinsurance operations,
insurers are affected by any instability in the international monetary system. Hence any
instability in the exchange rates of various currencies arising from domestic economic
problems in individual countries is a serious potential problem. Indeed, the great number
of reinsurance contracts exposes these companies to foreign exchange risk, involving
issues of insolvency and profitability. However, these markets often have few financial
instruments to create a common hedge for such financial exposure. Many of the standard
tools used to hedge currency risk, such as futures, swaps and options contracts, are not
available in emerging markets. Moreover, cedant insurance companies have been slow to
adopt or even formulate a strategy to deal with potential exposure.
The main purpose of this paper is to fill a gap in the foreign exchange risk exposure
management literature, as the previous literature has only focused on developed
economies; and also, the existing literature on the foreign exchange exposure of
insurance companies (from the perspective of cedant companies) is very limited
(Louberge, 1979, 1983; Agmon and Kahane, Wong; Mange, 2000; Blum et al., 2001).
The key research question that drives this work is:
RQ1. In the light of the lack of both adequate foreign exchange risk management
and hedging tools in the Egyptian insurance market, is foreign exchange rate
exposure of the Egyptian insurance companies significant?
The study investigates the wide industry effect of the net premiums variable on the
operating income variable. As there is no reason to expect that the effect should be the
same or even similar in different insurance groups, the study examines the heterogeneity
between insurance companies.

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By employing a mean group correlated common effects (MGCCE) estimator

(Pesaran, 2006), the study finds that there is no problem with Cross-Sectional
Dependence and serial correlation, as the majority of parameters are insignificant.
Furthermore, by using the MGCCE method, the precision of the exposure estimates
is improved. Moreover, the MGCCE estimator reveals that there is a considerable
heterogeneity in the patterns on average (across the industry).
Generally, the results show that, on average, the lagged operating income variable
has negative effects on operating income and is statistically significant on the first lag
at the 10 per cent level. Further, on average, the lagged net premiums variable has
a positive effect on operating income and is statistically significant on the third lag at
the 10 per cent level.
The central finding of the study is that the foreign exchange rate exposure across
the Egyptian insurance industry is not significant (at the 10 per cent level) and
investigates this result.
1.1 Research objective
This work overlaps with a number of areas that address the problem of foreign exchange
rate transaction exposure; including finance, econometrics and actuarial mathematics.
This study takes both an aggregated and individual firm-level perspective when
studying the impact of the fluctuation of exchange rate on the cash flow of Egyptian
insurers. The majority of previous studies consulted have addressed the problem of
foreign exchange rate exposure from finance, insurance and actuarial perspectives. The
contribution of this work also involves combining all these streams of literature.
Therefore, the main objective of this thesis is to study the impact of fluctuations in the
exchange rate on cedant insurance companies, operating in the Egyptian insurance
sector, following a broader approach than that taken in previous studies.
Moreover, in light of the globalization of markets and the recent currency war crises,
foreign currency exposure has gained more attention in finance and considerable
advances have been made in our understanding of this issue, by both academics and
practitioners. However, there are several potential reasons why there is a still need for
more research on this topic, especially related to insurance companies in emerging
markets. First, prior research has focused mainly on developed countries, such as the
USA, the UK, the Eurozone and Japan. Moreover, the empirical evidence of previous
studies has produced conflicting results. That is why it is usually referred to as the
foreign exchange risk exposure puzzle. This leaves room for further discussion about
different alternatives to deal with this phenomenon. The novelty of this paper derives
from the reality that this work has never been done before, for any insurance company
in an emerging market, and therefore it constitutes an extra source of motivation for
this work.
1.2 Contribution of the study
This study adopted a three-stage design similar to examples in recent literature (the
cash-flow-based approach) that focused on the sensitivity of an insurers cash flow to
variations in the foreign exchange rate (Martin and Mauer, 2003a, 2004, 2005). The aim
of this method is to estimate foreign exchange rate transaction exposure for insurance
companies in relation to the association between operating income and lagged and
contemporaneous foreign exchange rates.
The association between unanticipated operating income and short-term and
long-term exchange rate movements was measured using a distributed lag model.

Uniquely, this study developed a crucial, threefold methodological innovation to the

existing approach, precisely in the first, second and third stages.
First, the study estimates, in the first stage, the operating income for all Egyptian
insurance companies and not for each individual company as cited in the methodology
(Martin and Mauer, 2003a, 2005; Li et al., 2009). Second, the study contributes to the
existing research by adding inflation as a macroeconomic variable that explain
changes in the foreign exchange rate in the second stage. Ferson and Harvey (1997)
indicate that the foreign exchange rate is related to inflation in some countries
and markets. Finally, while Martin and Mauer (2003a, 2004, 2005) determined that
optimal lag based on the Akaike Information Criterion (AIC; Akaike, 1973), this study
determines optimal lag based on the lowest absolute t-statistic (coefficient/standard
error).
Moreover, this study contributes to the existing literature by empirically
documenting foreign exchange rate exposure in an emerging insurance market (the
Egyptian insurance market) for the first time with a specific focus on small and large
life and non-life insurers. Furthermore, this study pioneers a methodology for
modelling foreign exchange rate transaction exposure that can lead to the development
of sound risk management strategies to manage foreign exchange transaction
exposure in emerging insurance markets like Egypt.
The paper is organized as follows: Section 2 introduces the background of the study.
Section 3 explains the data used in the study. Section 4 includes the empirical analysis.
Section 5 incorporates the estimation of different models. Section 6 shows the results of
the study. Section 7 depicts the practical implication of the study. Section 8 determines
the limitation of the study. Section 9 concludes.
2. Background and methods
The main advantages of the cash flow approach are: first, the market participants do
not need to know and use all the available information about how a company may be
affected by fluctuations in the exchange rate. Second, this method allows corporate
financial managers to understand the nature of the exposure by separating the
short-term and long-term effects of exchange rate risk. Finally, companies in general
and insurance companies in particular are concerned about the stability of their cash
flows and how they might be affected by variations in the exchange rate.
First stage: unanticipated operating income is estimated for each insurance
company.
Second stage: the foreign exchange rate is estimated and the residual (which
captures the unexplained change in foreign exchange rates) is obtained.
Third stage: this includes estimating the sensitivity of unanticipated operating
income (from the first stage), to contemporaneous and lagged foreign exchange
variables (from the second stage).
The main estimation model follows Almons (1965) distributed lag technique to
estimate the foreign exchange exposure coefficient biq which represents the sensitivity
of cash flow to short-term and long-term exchange rate changes (to be estimated for
each insurer).
Each insurance company is determined to have significant foreign exchange
exposure, or not, by using the F-static generated from the estimation in the third stage.
Following Martin and Mauer (2003a) and Li et al. (2009), short-term exposure is
identified if the insurance company has an optimal lag of four quarters or fewer and
long-term exposure if it has optimal lag of eight or more quarters.

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2.1 Innovations to this method

The author has two innovations to add to this method. The first innovation is that the
researcher has estimated the foreign exchange exposure to the USD for all Egyptian
insurers. Instead of looking at the unanticipated operating income for each cedant
company (as in both previous papers), this paper looks at the unanticipated operating
income on an aggregate level.
The study uses industry-level analysis to determine the insurance industry wide
effect of foreign exchange exposure. This industry-specific analysis is consistent with the
argument by Khoo (1994), who contends that industry-level analysis is more efficient
compared to single-equation estimation for individual companies, since industry returns
have less noise than individual returns. Moreover, he sees that this procedure as being
more appropriate, especially if the grouped firms is working in the same industry.
By looking at all companies working in the Egyptian insurance industry, foreign
exchange exposure risk can be better understood and properly mitigated.
The author has estimated unanticipated operating income by using a dynamic
panel data method for several reasons: first, to be consistent with the current trend of
shifting the estimation of long-run relationships from a single time series (as in both
previous papers) to panel data methods. Moreover, this is considered to be the first time
of using these methods (more precisely the MGCCE estimator) in the literature on
foreign exchange exposure. Furthermore, it is believed within the actuarial profession
that a major challenge can be found in the management of various cash flows.
Hence, one of the primary attributes of an actuary should be the successful application
of up-to-date statistical techniques in the analysis of insurance data. In addition,
using panel data can enrich the empirical analysis. Compared with the time series
used in both previous papers, a panel approach has important advantages. The first
benefit is that it controls for the presence of unobserved industry-specific effects.
Its second advantage is that it addresses the problem of the potential endogenity of all
the regressors. In sum, if you construct a regression equation for each insurance
company you do not know how misspecified is your equation, but if you do it with
a panel you will know the properties (such as cross-section dependence (CSD)).
By employing the MGCCE estimator (Pesaran, 2006) the study finds that there is
no problem with CSD or serial correlation as the majority of the parameters are
insignificant. Furthermore, by using the MGCCE method the precision of the exposure
estimates is improved. Moreover, the MGCCE estimator reveals that there is
considerable heterogeneity in the patterns of both average (wide-industry) and
individual insurance companies.
The second innovation is that instead of the model used in previous papers I use
a model from the actuarial field that was proposed by Blum et al. (2001) for modelling
foreign exchange rates with their relevant constituents (inflation and interest rate).
2.2 Crucial issues needing to be specified when using panel econometric methods
Panel data include observations on cross-section units (firms, countries, industries,
etc.), i 1, 2, y, N over repeated time periods, t 1, 2, y, T.
The bottom line is measuring the effect on a dependent variable Y it of a set of
regressors, a K  1 vector Xit, which may include lagged Y it.
As mentioned earlier, panel data have certain benefits over a single time series,
N 1. In this paper both N and T are large (N 23, T 32). This type of panel:
provides a larger sample which may improve efficiency; mitigates collinearity; allows
more heterogeneity; and allows identifying the effect of unobserved variables that are

company specific but relatively constant over time. Nevertheless, when dealing with
this type of panel (large N and large T datasets), one should be aware of three main
issues: CSD, heterogeneity and dynamics.
2.3 CSD
One could gain a little improvement in efficiency from panel estimators relative to a
single time-series if the CSD is large and not dealt with. Indeed, CSD has attracted
considerable attention in the past few years and many econometricians recognize the
importance of accounting for it. For example: Phillips and Sul (2003) argue that
the consequences of ignoring CSD can be serious; pooling may provide little gain in
efficiency over single equation estimation, estimates may be badly biased and tests for
unit roots and cointegration may be misleading.
A large number of estimators have been suggested to deal with the CSD. However,
the market leader, according to Monte Carlo Studies, appears to be correlated common
effect (CCE) type estimators.
2.4 Heterogeneity and dynamics
It is natural to consider heterogeneous panel models where the parameters can differ
between insurance companies. As a specification test one should compare the
estimates via a Hauseman test.
The majority of time series are non-stationary, one important aspect of which is
their order of integration (how many times should it be differenced to become
stationary?). However, most time series appear to be integrated and of order one I (1).
Tests for unit root and cointegration in a panel include the fact that the spurious
regression problem usually associated with I (1) variables does not appear to be a big
problem. Indeed, non-stationary variables will lead to problems with estimates and
inferences.
3. Data
A sample of quarterly data between the years 2002 and 2009 is used in this study.
Following Martin and Mauer (2003a) and Li et al. (2009), insurance companies are
required to have at least 30 continuous observations over the 2002-2009 examination
periods. The insurance companies are filtered according to the availability of data;
in this case, companies with more than 30 quarterly observations are used, leaving 23
companies in the final sample. All data used in the study are denominated in Egyptian
pounds (data are not adjusted for inflation as most studies have used nominal such as
Bodnar and Wong, 2003; Choi and Prasad, 1995; Amihud and Levich, 1994).
Note that the data are nominal, i.e. not adjusted for inflation. Most studies have used
nominal for several reasons. First, it has to be stressed that if exchange rate
movements are measured in real terms, all variables in the regression equation have to
be measured in real terms for consistency. Moreover, as financial markets do not
observe inflation rates instantaneously, it is highly probable that investors are
primarily incorporating the impact of nominal exchange rates in stock price (Bodnar
and Gentry, 1993) . Furthermore, the low variability of inflation differentials relative to
exchange rate movements on monthly basis implies that nominal movements actually
dominate real exchange rate movements. As a consequence, the use of real vs nominal
exchange rates has negligible effect on exposure estimates (e.g. Bodnar and Gentry,
1993; Choi and Prasad, 1995; Amihud and Levich, 1994; Chamberlain et al., 1997;
Griffin and Stulz, 2001).

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4. Empirical analyses
The data comprise quarterly observations for the period 2002-2009 and cover
23 insurance companies in the Egyptian insurance industry. Different estimators are
applied to a panel dataset of N  T 23  32 736 observations. Stata version 11.1 for
estimating different types of panels is used.
The summary statistics for the main variables used in this paper are given in Table I.
Table II is a pairwise correlation matrix for the variables of interest and it shows
that operating income correlates positively with net premiums.
4.1 Panel unit root and cointegration tests
In order to avoid problems of spurious regression, I first verify the existence of longrun relationships between the variables. In this study, an IPS test and a Hadri
Lagrange Multiplier (LM) test (Hadri, 2000) are employed to test for panel unit roots.
The results of the IPS test indicate that the null of non-stationarity is rejected for all
variables. However, Karlsson and Lothgren (2000) demonstrate that for a panel dataset
with large T, the IPS test has high power and there is a potential risk of concluding that
the whole panel is stationary even when there is only a small proportion of stationary
series in the panel. Therefore, the rejection of non-stationarity by an IPS test might be a
result of over-rejection associated with the test.
In order to overcome the inconclusiveness of the IPS test, I also conduct another
panel unit root test proposed by Hadri (2000). The null hypothesis of Hadris (2000) LM
test is that all series in the panel are stationary. The result of the Hadri LM test rejects
the null for stationarity in all series of the panel. Although there is some ambiguity in
the test results for the stationarity of all the variables in level terms, both the IPS and
Hadri LM tests prove that the first differences of all variables are stationary, i.e. all
variables in the sample follow an I (1) process.
If a linear combination of a set of I (1) variables is I (0), then there exists a long-run
equilibrium relationship between the variables. The study conducts panel
cointegration tests as proposed by Pedroni (1999).
The results suggest that the null of no cointegration is rejected. Therefore, there is
strong evidence in support of the existence of long-run relationships among the
variables used in our analysis.
4.2 CSD
After investigating CSD, the study reports both average and average absolute
correlation coefficients in Table III. The average correlation coefficient is 0.11, whereas
the average absolute coefficient is 0.24 as before. Therefore, CSD is small.

Variable
Table I.
Summary statistics of
Y
main regression variables X

Table II.
Pairwise correlation
matrix of the regression
variables

Y
X

Description

Obs.

Mean

SD

Min.

Max.

Operating income
Net premiums

736
736

1.65e 07
4.20e 07

2.71e 08
1.73e 08

4.18e 09
9.27e 08

3.66e 09
2.58e 09

1
0.4034

5. Different estimation techniques

According to the literature, when numerous individual firms are observed over time,
the problem of specifying the stochastic nature of disturbances becomes conceptually
difficult. For example, some of the omitted variables may reflect factors which are
peculiar to both the firms and time periods for which observations are obtained; others
may reflect firm-specific differences which tend to affect the observations for a given
firm; still other variables may represent factors which are peculiar to specific time
periods. As such, if these unobservable other effects are not taken account of in the
estimation process, an ordinary least square (OLS) method is instead applied,
the estimates of the bs in the equation may be both biased and inefficient . Moreover,
the OLS approach cannot be used because the estimator is biased in the presence of
lagged dependent variables or firm-specific effects on the right hand side of the
equation.
Indeed, the impact of the net premiums variable on operating income dynamics may
take effect both in the short run as well as in the long run, particularly as firms in
insurance industry groups adjust to underwrite new policies and face new risks.
Accordingly, the underlying notion of equilibrium in this approach is inter-temporal, as
the path of the equilibrium process is influenced not only by the current value of
fundamental determinants but also by expectations about the future evolution of these
variables. This study, by focusing on the effects over different time horizons, sets the
basis for an explanation of the apparent contradictory effects of the net premiums
variable on the operating income variable. Moreover, by distinguishing the effects
based on time horizons, the approach should provide an additional dimension for
examining the heterogeneity between insurance industry groups. It should be noticed
that there is no reason to expect that the effect of net premiums on operating income
will be the same or even similar for different insurance companies. This point is
consistent with the findings from the large N, large T literature that argues that the
assumption of homogeneity of the slope parameters is often inappropriate (see Pesaran
and Smith, 1995; Pesaran et al., 1999; Phillips and Moon, 2001). Accordingly, it is
considered important to employ an estimation methodology that incorporates slow
adjustment and allows for different short-run and long-run effects.
Recapitulating the main methods to estimate non-stationary dynamic panels in
which the parameters are heterogeneous across groups, Pesaran et al. (1999) state that
there are two traditional methods for estimating panel models: averaging (mean group
(MG)) and pooling (dynamic fixed effect (DFE)). The former involves running N
separate regressions and calculating coefficient means (Pesaran and Smith, 1995).
Notably, the main hypothesis of the MG estimator is to allow the slope coefficients to
vary across their cross-section (e.g. insurance companies in the case of this study), both in
the short run as well as in the long run. Alternatively, pooling (DFE) data typically
assumes that the slope coefficients and error variance are identical, expect for the
intercept, which is allowed to vary across industries. This is unlikely to be valid for
short-run dynamics and error variances, although it could be appropriate in the long run.
Variable

CD-test

p-value

Corr.

abs(corr)

Residual

9.39

0.000

0.112

0.240

Note: Under the null hypothesis of cross-section independence CDBN (0, 1)

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Table III.
Average correlation
coefficients and Pesaran
(2004) CD test

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Pesaran et al. (1999) proposed the pooled mean group (PMG) estimator as an alternative
approach, which is an intermediate case between the averaging and pooling methods of
estimation, and involves aspects of both. The PMG can be thought of as weighted
average of individual group estimators, with are proportional to the inverse of their
variance. Unlike the MG estimator, the PMG estimator only allows heterogeneous
short-run coefficients; it constrains long-run parameters to be the same across units. In
another way, the PMG restricts long-run coefficients to be equal over the cross-section,
but allows short-run coefficients and error variances to differ across groups in the
cross-section. Thus, the PMG estimator averages short-run parameters and pools
long-run parameters, thereby combining the efficiency of the pooled estimation while
avoiding the inconsistency problem of pooling heterogeneous dynamic relationships.
Blackburne and Frank (2009) note that the hypothesis of homogeneity of long-run
policy parameters in the PMG estimation cannot be assumed a priori. This, according
to Blackburne and Frank, is due to the fact that often the hypothesis of slope
homogeneity is rejected empirically. Accordingly, with PMG, the pooling across
industries yields efficient and consistent estimates only when the restrictions are true.
Otherwise, if the true model is heterogeneous, the PMG estimates are inconsistent; the
MG estimates are consistent in either case. Thus, the effect of the heterogeneity of
coefficients is determined by a Hausman-type test (Hausman, 1978).
The empirical framework to evaluate the insurance industry-wide effect of the net
premiums variable on the operating income is based on Autoregressive Distributed
Lag (ARDL) or dynamic linear regression. In the case of this study (having one
exogenous variable), ARDL ( p, q) takes a dynamic panel specification of the form:
p
q
X
X
0
lij Yi;tj
dij Xi;tj mi eit
i 1; 2 . . . N ; t 1; 2; . . . T;
Yit
1
j1

j0

where Y it is a scalar dependent variable; x it(k  1) is the vector of explanatory variables

for group i; mi represents the fixed effects, the coefficients of the lagged dependent
variables (lij) are scalars; and gij are (k  1) coefficient vectors.
T must be large enough, as is arguably the case in this study, in order for the model
to be estimated for each cross-section. As the variables in (Equation (1)) are I (1) and
cointegrated, then, the error term is an I (0) process for all i.
One important feature of cointegrated variables is their responsiveness to any
deviation from the long-run equilibrium. This suggests an error correction model in
which the short-run dynamics of the variables in the system are influenced by
deviation from the equilibrium. Therefore, (Equation (1)) can be reparametrized into
the error correction equation as follows:
p1
q1

 X
X
0
0
lij DYi;t1
dij Xi;tj mi eit
DYit fi Yi;t1  yi xit
j1

where:
fi 1 1 

p
X
j1

lij 

p
X
mj1

!
lij ; yi

j0

q
X
j0

dij = 1 

!
lik ;

lim j 1; 2; . . . ; p  1; and dij 

q
X
mj1

dim

j 1, 2, y, q1. The parameter fi is the error correction coefficient measuring the

speed of adjustment towards the long-run equilibrium. The vector y0 i contains
the long-run relationships between the variables (Blackburne and Frank, 2009). It is
assumed that the disturbances e0 it are independently distributed across i and with zero
means and variance s2i40.

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5.1 MG estimator assumption

This was proposed by Pesaran and Smith (1995). The main hypothesis of the MG
estimator is to allow the slope coefficients; intercept and error variances to vary across
the cross-section (e.g. insurance companies in the case of this study) both in the short
run as well as in the long run. So the model is fitted to each group, and a simple
arithmetic average of the coefficients can be calculated.

105

5.2 DFE estimator assumption

It is assumed that slope coefficients and error variance are identical, expect for the
intercept, which is allowed to vary across industries. This is unlikely to be valid for
short-run dynamics and error variance, although it could be appropriate in the long
run. If the coefficients are not identical, then the DFE produces inconsistent and
potentially misleading results.
5.3 The MGCCE estimator assumption
This was proposed by Pesaran (2006) and involves adding the means of the dependent
Y it and independent variables Xit as additional regressors to remove the effect of the
factors (that are treated as nuisance parameters). As mentioned earlier, nowadays, the
CCE estimator is considered the market leader, according to Monte Carlo studies, to
deal with the CSD issue. This estimator is simple to apply and can handle serial
correlation in errors.
5.4 Diagnostic test
In time series, it is standard to carry out diagnostic tests. However, in panel time series
this is not common. For example, in this study one cannot compare the previous three
estimators on the ground of the residual since the residual will always be stationary I (0).
5.5 Empirical results
Tables IV, V and VII show the respective results on the insurance industry wide effect of
net premiums variable on operating income using the MG, DFE and MGCCE estimators
respectively for the operating income model as depicted in (Equation (2)). Further, as
explained earlier, first, considering the importance of heterogeneity, the study tests the
difference between the MG and DFE estimators by a Hausman-type test (Hausman,
1978), particularly where both N and T are sufficiently large, such as is the case in this
study, in order to determine which of the two is consistent and efficient. The Hausman
statistic, which is distributed w2(9), and the p-value, for all the coefficients of the
explanatory variables jointly, is 71.90 (0.0000) for the operating income model (see
Table VI). Hence, the null hypothesis of the homogeneity of slopes is rejected. Thus, the
MG estimator a consistent estimator under the null hypothesis is preferred.
Accordingly, the analysis focuses on those parameters obtained with the MG estimator.
However, to deal with the issue of CSD, and to handle serial correlation in
errors, currently, the market leader estimator is the CCE estimators. Hence, the
study applies the MGCCE. Table VII shows that, on average, there is no problem with

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L1y
L2y
L3y
L4y
X
L1x
L2x
L3x
L4x
_cons

Table IV.
Pesaran and Smith
(1995) Mean
Group Estimator

Table VI.
Hausman test between
mean group and
fixed-effects estimation

SE

0.1556669
0.1186682
0.1009991
0.0979325
0.4693176
0.0289937
0.0309379
0.0427069
0.0320624
8610336
Root

0.0523395
0.0487415
0.0443924
0.1311889
0.1572553
0.1227236
0.1074366
0.0783498
0.1299209
1.61e 07
mean

2.97
2.43
2.28
0.75
2.98
0.24
0.29
0.55
0.25
0.53
square

p4|Z|
0.003
0.015
0.023
0.455
0.003
0.813
0.773
0.586
0.805
0.594
error

95 % conf. interval
0.2582505 to 0.0530833
0.2141997 to 0.0231366
0.1880066 to 0.0139916
0.159193 to 0.355058
0.1611028 to 0.7775232
0.2115402 to 0.2695276
0.179634 to 0.2415098
0.1108558 to 0.1962696
0.2225779 to 0.2867026
2.30e 07 to 4.02e 07
(sign): 20.0E 7

Notes: L1y refers to lag 1 for dependent variable y; L1x refers to lag 1 for independent variable x,
and so on

Table V.
Fixed effects
(within) regression

Coef.

L1y
L2y
L3y
L4y
x
L1x
L2x
L3x
L4x
_cons

L1y
L2y
L3y
L4y
x
L1x
L2x
L3x
L4x

Coef.

SE

0.4179772
0.2102876
0.114311
0.120998
0.7941134
0.0295312
0.1475197
0.1615142
0.0561264
1.76e 07
Root

0.0392944
0.0432552
0.0436562
0.0407774
0.0867221
0.066191
0.0647208
0.064083
0.0728713
1.24e 07
mean

10.64
4.86
2.62
2.97
9.16
0.45
2.28
2.52
0.77
1.42
square

p4|t|
0.000
0.000
0.009
0.003
0.000
0.656
0.023
0.012
0.441
0.157
error

95% conf. interval

0.4951453 to 0.3408091
0.2952342 to 0.125341
0.2000452 to 0.0285768
0.2010786 to 0.0409175
0.6238043 to 0.9644225
0.1595203 to 0.1004578
0.2746216 to 0.0204179
0.2873615 to 0.0356669
0.1992345 to 0.869816
6764815 to 4.19e 07
(signs): 23.0E 7

Coefficients
(b)
mg

Difference

sqrt (diag(v_b_v_B))

(B)
fe

(b-B)

SE

0.1556669
0.1186682
0.1009991
0.0979325
0.4693176
0.0289937
0.0309379
0.0427069
0.0320624

0.4179772
0.2102876
0.114311
0.120998
0.7941134
0.0295312
0.1475197
0.1615142
0.0561264

0.2623103
0.0916194
0.0133119
0.2189305
0.3247959
0.0585249
0.1784577
0.2042211
0.0991888

0.0345743
0.022466
0.0080511
0.1246905
0.1311812
0.1033433
0.0857545
0.0450797
0.1075603

Notes: b, consistent under H0 and Ha; obtained from xtmg, B, inconsistent under Ha, efficient
under H0; obtained from xtreg, Test: H0: difference in coefficient not systematic, w2(9) (b-B)0
[(v_b_v_B) * (1)] (b-B), 71.90, Prob.4w2 0.0000

Y
L1y
L2y
L3y
L4y
x
L1x
L2x
L3x
L4x
my
mL1y
mL2y
mL3y
mL4y
x
mL1x
mL2x
mL3x
mL4x
_cons

Coef.

SE

0.0734298
0.0894998
0.1328058
0.1217399
0.2235942
0.1654952
0.1220405
0.2000381
0.3311438
1.204289
0.1001881
0.0748143
0.2900406
0.161143
0.5303705
0.1150693
0.1627237
0.0662392
0.2920822
2.15e 07
Root

0.033403
0.0598316
0.0959273
0.1541473
0.2446025
0.1636511
0.1684825
0.1200674
0.347798
0.8857905
0.1491343
0.998914
0.191862
0.5250152
0.6127995
0.2420237
0.092012
0.1672038
0.2395607
3.03e 07
mean

2.20
1.50
1.38
0.79
0.91
1.01
0.72
1.67
0.95
1.36
0.67
0.75
1.51
0.31
0.87
0.48
1.77
0.40
1.22
0.71
squared

p4|z|
0.028
0.135
0.166
0.430
0.361
0.312
0.469
0.096
0.341
0.174
0.502
0.454
0.131
0.759
0.387
0.634
0.077
0.692
0.223
0.478
error

95% conf. interval

0.1388985 to 0.0079611
0.2067676 to 0.0277679
0.0552082 to 0.3208198
0.423863 to 0.1803832
0.255818 to 0.7030064
0.1552551 to 0.4862455
0.2081792 to 0.4522602
0.0352896 to 0.4353659
1.012815 to 0.3505277
0.5318285 to 2.940406
0.1921098 to 0.392486
0.1209692 to 0.2705979
0.6660833 to 0.0860021
0.8678678 to 1.190154
1.731435 to 0.6706944
0.5894271 to 0.3592886
0.343064 to 0.0176166
0.3939527 to 0.2614742
0.1774483 to 0.7616126
3.78e 07 to 8.08e 07
(sigma): 7.5E 7

Notes: m y refers to additional mean of dependent variable y, mL1x refers to additional mean of
independent variable L1x and so on

Modelling
foreign exchange
rate exposure
107

Table VII.
Pesaran (2006) common
correlated effects mean
group estimator

the CSD and serial correlations since the majority of the parameters are insignificant.
Moreover, considering the issue of which estimator provides a better representation
of data, the study test applies a Hausman-type (1978) test for the difference between
the MGCCE and MG estimators. Table VIII shows that the joint Hausman test
statistic is 32.80 (0.0001) and is distributed w2(9), therefore the MGCCE estimator
is preferred.

L1y
L2y
L3y
L4y
x
L1x
L2x
L3x
L4x

Coefficient
(b)
cce

(B)
mg

Difference
(b-B)

sqrt (diag(v_b_v_B))
SE

0.0734298
0.0894998
0.1328058
0.1217399
0.2235942
0.1654952
0.1220405
0.2000381
0.3311438

0.1556669
0.1186682
0.1009991
0.0979325
0.4693176
0.0289937
0.0309379
0.0427069
0.0320624

0.0822371
0.0291683
0.2338049
0.2196724
0.2457234
0.1365015
0.0911026
0.1573312
0.3632061

0.0346999
0.0850374
0.0809374
0.1873531
0.1082617
0.1297834
0.0909807
0.3226205

Notes: b, consistent under H0 and Ha; obtained from xtmg; B, inconsistent under Ha, efficient under
H0; obtained from xtmg, Test: H0: difference in coefficients not systematic, w2 (9) (b-B)0
[(v_b_v_B)*(1)] (b-B), 32.80, prob 4 w2 0.0001

Table VIII.
Hausman test between
mean group CCE and
mean group estimation

JEAS
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108

Overall, MGCCE estimation (Table VII) reveals that there is considerable heterogeneity
in the patterns in the average (wide industry). This may be observed by considering
the difference across insurance groups, in the signs of the coefficients, as well as
in their statistical significance. Generally, the results show that, on average, the
lagged operating variables have a negative effect on the operating income and
are statistically significant on the first lag at the 10 per cent level. Further, on average,
the lagged net premiums variable has a positive effect on operating income and is
statistically significant on the third lag at the 10 per cent level.
5.6 Methodology for assessing the foreign exchange variable
According to Blum et al. (2001, p. 6): There are two basic ways to analyse and model
the interplay of foreign exchange rates with other economic variables involved:
fundamental (economic) and technical (statistical) analysis.
In this paper, instead of the methodology used by both Martin and Mauer (2003a);
Li et al., 2009 the study uses an alternative (statistical) approach proposed by Blum
et al. (2001) to analyse and model foreign exchange rates with their constituent relevant
variables. I relate the foreign exchange rate to the real rates of return in the USA
and Egypt.
5.7 Data
Quarterly data from 2002 to 2009 are being used. The US dollar is the main currency
chosen for this study since all Egyptian insurance companies reinsure their business
in US dollars. Exchange rate data are taken from the OANDA-FOREX trading and
exchange rates service. Short-term interest rates (interbank money rates) for each
country are taken from Datastream. Inflation for the USA is taken from Research
Datastream. Inflation for Egypt is taken from the web site of the Ministry of Economic
Development: www.mop.gov.eg.
5.8 Definition of terms
The study uses the spot exchange rate with respect to the US dollar.
USD=EG

St

Denotes the USD price for one unit of the EG at time t.

ItUSD
ItEG
RtUSD
RtEG

Denotes the rate of inflation for the USA at time t.

Denotes the rate of inflation for Egypt at time t.
Denotes the risk-free short term interest rate at time t.
Denotes the risk-free short term interest rate at time t.

5.9 Data analysis

The study estimates FX from the following equation:
USD=EG

st

s;EG
EG USD
USD
EG
EG EG
aEG
aEG
aEG
0 a1 rt
2 it
3 rt a4 it et

where s, r, i refer to logarithmic FX, interest and inflation rate, as introduced earlier.
EG
aEG
0 . . . a4 Refer to constant regression parameters (Table IX).
In order to reduce the number of parameters to be estimated, the FX rate is modelled
by the real rates of return in the USA and Egypt. Hence, for simplicity, a1 a2 and
a3 a4 (following Blum et al., 2001). The residual FOREX (to be used in the main
estimation model).

5.10 Residual diagnostics

When you have multiple regressions, it is important to ensure that the model meets
the normality homoscedasticity assumption and is free of the serial correlation
problem.
1-Check residual for normality. A common assumption of time series models is a
Gaussian innovation distribution. After the model has been fitted the residuals should
be checked for normality.
Table X indicates a one-sample Kolmogorov-Smirnov test and which fails to reject
the null hypothesis of normality ( p-value 0.219).
2-Check residuals for heteroscedasticity. A white noise innovation process has
constant variance. The homoscedasticity assumption is disrupted if the regression
model has a heteroscedasticity problem, which refers to a condition where the
variance of the residuals is not constant. A White test is used to prove the
existence of a heteroscedasticity problem. A White test fails to reject the null
hypothesis of constant variance, hence the homoscedasticity assumption is met
( p-value 0.2503).
3-Check residuals for autocorrelation. In time series models, the innovation
process is assumed to be uncorrelated. No serial correlation implies that the size of
the residual for one case has no relationship with the size of the residual for the
next case. I conduct a Ljung Box Q test on the residual series. It tests whether the
first k(lag) autocorrelations are zero against an alternative in which at least
one is non-zero. The LB Q statistic shows that the null hypothesis of no serial
correlation can be rejected, hence the no serial correlation assumption is not met
( p-value 0.00004119).
Remediation of this problem requires knowledge about the nature of
interdependence among the disturbance. Therefore, the coefficient of the first-order
autocorrelation (r) should be estimated.

Modelling
foreign exchange
rate exposure
109

5.11 The Cochrane-Orcutt iterative procedure is being used

The ultimate target of this method is to provide an estimate of r that may be used to
^ instead of true r , this method
obtain a GLS estimate of the parameters. Since we use r
is known as Feasible GLS.

EG
1.7153
0.3284
0.3284
0.1796
0.1796

a0
a1
a2
a3
a4

Null hypothesis

Test

Sig

Decision

H0: The distribution is Normal

One-Sample Kolmogorov-Smirnov test

0.219

Retain H0

Table IX.
Parameters estimation
(OLS) (Equation (3))

Table X.
Testing the normality of
the residual: one-sample
Kolmogorov-Simrnov test

JEAS
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5.12 The main estimation model

The unanticipated operating income (the residual from (Equation (2)) divided by its
standard deviation (e.g. Walsh, 1994; Martin and Mauer (2003a); Li et al., 2009) and the
contemporaneous and lagged foreign exchange variables FOREX (the residual from
(Equation (3))) are then used to estimate the exposure to exchange rate risk for each
insurer as follows:

110
UOIit ci

Li
X

biq FOREXtq eit

q0

where UOIit is the standardized unanticipated operating income before adjustment for
depreciation and foreign exchange gains or losses, as a proxy for cash flow for insurer i
in time period t.
FOREXtq is the percentage change in the unexplained change rate factor in
the time period tq; ci is the intercept for insurer i. biq are foreign exchange
exposure coefficients, which represent the sensitivity of cash flows to short-term
and long-term exchange rate changes (to be estimated) for insurer i with q quarters,
0 through L. biq follows the Almon (1965) technique, where Li is the lag length, up to
12 quarters, as determined by the AIC (Akaike, 1973) for insurer i; * the stochastic
error term.
The study estimates (Equation (4)) using the polynomial distributed lag technique
developed by Shirley Almon (1965); as the degree of the polynomial is largely a subjective
decision, the study follows Martin and Mauer (2003a) and Li et al. (2009) in using a third
degree polynomial. Hence, obtaining biq from the following equation (Table XI):
^ a^0i a^1i q a^2i q2 ^
b
a3i q3
iq

Substituting (Equation (5)) into (Equation (4)), I obtain:

UOIit ci

L 
X
 
 
a^0i a^1i q a^2i q2 a^3i q3 FOREXtq eit
q0

ci a0i

L
X

FOREXitq a1i

q0

a2i

L
X
q0

q2 FOREXitq a3i

L
X

qFOREXitq

q0
L
X

q3 FOREXitq eit

q0

EG

Table XI.
Parameters
estimation (FGLS)

a0
a1
a2
a3
a4

1.76342
0.0040868
0.0040868
0.00733770
0.00733770

Modelling
foreign exchange
rate exposure

Defining:
Z0it

L
X

FOREXitq FOREXit FOREXit1 . . . FOREXitL

q0

Z1it

L
X

111

qFOREXitq 1FOREXit 2FOREXitq . . . LFOREXitL

q0

Z2it

L
X

q2 FOREXitq 12 FOREXit 22 FOREXit2 . . . L2 FOREXitL

q0

Z3it

L
X

q3 FOREXitq 13 FOREXit 23 FOREXit2 . . . L3 FOREXitL

q0

Hence, writing (Equation (6)) as:

UOIit ai a0i z0it a1i z1it a2i z2it a3i z3it eit

Once a0-a3 are estimated from (Equation (7)) by the usual OLS procedure, the original
biq coefficients can be estimated from (Equation (5)).
The insurance industry is deemed to have significant foreign exchange exposure
or not by using the F-statistic generated from estimating (Equation (4)). Table XII
illustrates the results.
6. Results and discussion
The first finding is that foreign exchange rate exposure for the Egyptian insurance
industry is not significant (at a 10 per cent level of significance), and on investigating
this result I find that there are various possible reasons why Egyptian insurance
companies have insignificant currency risk exposure in their operating cash flows.
First, Egyptian insurance companies do not think they need to know the currency risk
exposure of their operating cash flows. No formal calculation of currency risk exposure
is involved. All they may try to achieve is to balance foreign currency in inflows and
outflows. Moreover, they may operate with a strategic setup until the currency rate
changes (besides changes in other market conditions), and then impose a modification.
Thus, Egyptian insurance companies do not measure the currency risk exposure
of their operating cash flows. They simply wait and see, and if the consequences of
currency fluctuations are serious enough they make the appropriate changes.
This argument is consistent with the finding of Brown (2001, p. 27). Moreover,
Egyptian insurance companies currency exposure may be minimal. One could argue
that Egyptian insurance companies exposure to US dollar currency risk is so small
that it might be a waste of time to assess it formally. Supporting evidence for this claim
F-statistic
Prob. (F-static)
Adjusted R2
Note: At a 10 per cent level of significance

0.464310
0.76194
0.004690

Table XII.
Significance exchange
rate exposure

JEAS
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112

appears to come from studies that examine the sensitivity of stock prices to changes
in currency rates; such sensitivity is small not only in the USA ( Jorion, 1990) but also
elsewhere (Bodnar and Gentry, 1993). Furthermore, Egyptian insurance companies
might not want to protect their currency risk. If they speculate rather than protect
against currency risk, there is no reason why they should know the currency risk
exposure of their operating cash flows. One could argue that Egyptian insurance
companies are guided in their protection decision by views about the evolution of
exchange rates. This practice comes closer to speculating on the future course of
currency rates. Given this seemingly myopic perspective, it is unlikely that they will be
interested in designing effective protective currency risk management. Finally,
Egyptian insurance companies may believe that unexpected currency rate movements
are offsetting. One could argue that they believe that changes in foreign exchange rates
are offsetting in the short term. Consequently, risk management has little justification.
Egyptian insurance companies do not protect long-term cash flows since they believe
that positive and negative currency movements cancel each other out.
7. Practical implication
The findings of this research provide meaningful implications for industry
practitioners. As Egyptian insurance companies are not immune from exchange rate
risks, efforts must be made by each insurer to approximate and quantify their
individual foreign exchange rate transaction exposure.
Additionally, as Egyptian insurance companies increasingly operate worldwide
(through the international reinsurance industry), this research and its results are
significant for practitioners not only in Egypt, but also further afield.
Finally, it is believed that this research will highlight greater implications for
international financial players active in Egyptian financial and non-financial sectors,
including banks not exposed singularly to US dollars, but to multiple currencies. One
recent Egyptian example is Egypt Air, which lost an estimated US$600 million in 2013
due to foreign exchange rate fluctuations.
8. Limitation and further research
This study has made considerable contributions to the existing academic literature,
but the findings also illustrate the limitations of the research undertaken. These
limitations, however, provide important directions for future research.
This thesis focused exclusively on the transaction exposure that Egyptian
insurance companies experience to fluctuations in the US dollar exchange rate in
relation to their international reinsurance operations. As a result, investigating both
translation and economic exposure was beyond the scope and purpose of this study.
It is hoped that future work will further examine transaction foreign exchange
exposure to improve the model through the adjustments for specific needs. The
features and current levels of transaction foreign exchange rate exposure rely on the
respective insurance companies operating income. Therefore, modifying the lag
structure for the exchange rate exposure, controlling for other macroeconomic effects
or firm-specific effects, can be implemented to improve model performance and
produce more significant results.
9. Conclusion
Fluctuations in foreign exchange rates are an everyday fact of life in the insurance
industry all over the world. Due to the gap between insurance and econometrics and

the nature of currency risk, researching this topic has to date been largely anecdotal.
In this paper, the study adopts an industry level analysis to determine the insurance
industrys approach to foreign exchange exposure. By looking at all companies
working in the Egyptian insurance industry, their foreign exchange exposure risk
can be better understood and properly mitigated.
First, the study investigates the broad industry effect of the net premiums variable on the
operating income variable. As there is no reason to expect that the effect should be the same
or even similar in different insurance groups, the study examines the heterogeneity between
insurance companies. In light of the problems associated with purely time series regressions
the study employs panel dynamic methods. Considering the importance of heterogeneity, the
study tests the difference between the MG and DFE estimators. The MG estimator, a
consistent estimator under Hausman (1978), is preferred. However, to deal with the CDS and
serial correlation in errors, currently the market leader is the CCE estimator. Hence, the
study employs the MGCCE estimator (Pesaran, 2006) and finds that there is no problem with
CSD or serial correlation as the majority of the parameters are insignificant. Furthermore,
using the MGCCE estimator results in lower RMSE than the one of the MG estimator.
Overall, the MGCCE estimator reveals that there is a considerable heterogeneity in
the patterns on average (industry wide). Generally, the results show that, on average,
the lagged operating income variable has negative effects on operating income and
is statistically significant on the first lag at a 10 per cent level. Further, on average,
the lagged net premiums variable has a positive effect on operating income and is
statistically significant on the third lag at a 10 per cent level.
Finally, the study uses a cash flow based framework to decompose exchange rate
exposure into short-term and long-term elements for the 23 Egyptian insurance
companies between 2002 and 2009. The central finding of the study is that the foreign
exchange rate exposure for the Egyptian insurance industry is not significant, and
investigates this result.
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Corresponding author
Islam Amer can be contacted at: esso1712@hotmail.com

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