It’s a good piece of legislation, even if at times some aspects of it may result in greater costs than benefits.

TimesLive has a story about the alleged noncompliance of medical schemes with the CPA.

Some of the issues may have merit, but this struck me as particularly troubling:

According to the act, it is unfair when a consumer is discriminated against on the grounds of age.

Our constitution explicitly allows discrimination on actuarially sound rating factors that have both a statistical and causal link. This is how insurance is South Africa still uses underwriting to select homogenous groups of risks and to limit anti-selection by policyholders. If widespread anti-selection were to occur, then life insurance would not be viable.

Medical Schemes in South Africa have only very limited underwriting options in order to provide as many citizens as possible with fair health coverage. “Late joiners” are charged a premium since they haven’t contributed to the societal risk pool since they were most healthy and therefore haven’t paid “their fair share”. This has to do with a specifically identified risk rather than general discrimination based on age. These restrictions are important to maintain the solvency and viability of medical schemes.

Some schemes prevent women who fall pregnant within nine months of joining the scheme from claiming for the pregnancy even though they pay full premiums

This point is more tricky, but it does again reflect a misunderstanding. “Full premiums” on an actuarial sound basis have probably not been paid, since the fair premium for a member who joins just to get pregnancy benefits and hasn’t contributed at other times would be much higher than the premium that is charged. This one is a little more grey and while I feel the rules are entirely fair, they may not be viewed that way by a particular judge on a particular day.

Some schemes require that members give three months’ notice when terminating their membership, whereas the act deems 20 business days to be reasonable

This might reflect the desire to not have members leave a scheme immediately after having utilized the maximum benefit available to them before joining another scheme. I don’t know how much of this behavior would ever happen, so this might also ultimately be changed.

Many schemes don’t enforce the allowed waiting periods for members joining. If some of these other changes were to be made, I would expect these provisions would be more regularly used. Of course, that is another of the problems cited with medical schemes arising from the CPA.

All in all, we may see some changes, but by and large these comments reflect a lack of appreciation for the actuarial realities of managing a health scheme with community rating.

New Business Margin, which is the Value of New Business (VNB) as a percentage of the Present Value of New Business Premiums (PVNBP) is a common measure of profitability of that news business.

But it’s a flawed measure, especially when it comes to comparing product lines and insurers or even to understand the change in profitability from one period to the next. It uses and unequal yardstick to measure business.

New Business Margin on Revenue (NBMR) provides a significantly improved measure of profitability that can be used to compare margins across products, across insurers and across time. Further, it leads easily to a component analysis of the margin, adding additional insights to shareholders, brokers and regulators.

If you haven’t read my introductory post on New Business Margin on Revenue, it would be worthwhile doing so now – this post is going to illustrate the sort of results it provides in a practical, numerical example.

Example 1 considers how NBMR clarifies distortions from a change in mix of business.

Example 2 shows how more complex dynamics can be understood through a component analysis of NBMR. The spreadsheet showing the underlying calcs is attached at the end of this post.

Example 1 – A change in mix of business

AGGREGATE PICTURE

Let’s look at the sort of aggregate information you’ll typically see in an EV report.

What one might take from this analysis is that VNB is constant, but margins are declining to below 2.0%. If this is the only information on which to base our analysis, this company might be a clear “sell” and products and pricing need to be updated by management.

Let’s see how this would look using NBMR

From this table we see again that VNB has been constant, but that the profitability of the business has actually been slightly increasing.  So, although we should consider attending to the zero-growth VNB, the actual margin we’re achieving on our business on this measure has improved slightly from 25.5% to 26.1%.

This is a more accurate picture, because as you can see from the following tables, all that has changed is our mix of business – and the investment business that we’re writing more of now actually has a higher NBMR than the risk business we’re selling less of.  The traditional New Business Margin measure is distorted because it treats the entire premium paid by the policyholder as “revenue” when in fact only a small share of it is fees and charges and the rest is more like a deposit.  Again, banks measure profitability and performance through RoE, Cost to Income Ratios and Net Interest Rate Margin and only very much behind those the return on total assets.

Analysis of NBMR and components via product line

So the New Business Margin is constant on a product view, but when compared it appears as if there is a declining trend.  Also, at 26.7% of revenue taken as profit for investment business, this is profitable business, a fact not obvious from the superficially low New Business Margin of 1.3% (which is actually a perfectly good profit margin on that measure, just difficult to understand and compare).

The Revenue Per Premium (RPP) is 100% for risk business and 5% for investment business.  Depending on policy size, a 5% deduction from every premium might be a little on the high side and from a Treating Customers Fairly and sustainability perspective, this area may require some attention.  It’s also fair to ask “why are we losing market share in risk products and what can be done about it”, but at least we see this as a mix of business and market share issue and not a business margin issue.

Example 2 – Complex changes in volume, profitability and other components

Aggregate picture

Example 2 is more complex.  Let’s look at the aggregate information on a traditional presentation first.

In this case it looks like we have a severe margin squeeze problem in spite of increased business volumes and increased VNB. By now it should be clear that it’s dangerous drawing conclusions from this information.

A more coherent aggregate view can be obtained using NBMR:

Here we see a strong 2011 increase in all of VNB, Business Volumes and New Business Margin on Revenue after a poor year in 2010.  On the whole, we are hanging to customers longer than before (Discounted Premium Term or DPT up form 5.4 in 2010 to 5.6 in 2011, but still not at the levels of 2009. This is worth investigating.

The share of each premium we get as revenue has dropped sharply – clearly suggesting a change in mix of business as this sort of change wouldn’t typically be seen otherwise. Clearly we need to dig further, but the previously bleak picture is already looking better – and as we’ll see this is a more accurate reflection of business reality.

ANALYSIS OF NBMR AND COMPONENTS VIA PRODUCT LINE

Immediately we see a huge amount of new information.  Risk business has been declining in profitability significantly and has also had a dramatic increase in lapse rates (since the Discounted Premium Term has dropped to 3.2, suggesting major problems with persistency).

At the same time, although 2010 was a step backwards in terms of DPT for Investment business, the increase in volumes of business (API), allied with a restoration of the DPT to close to 2009 levels, a reduction in RPP (suggesting better value for policyholders, which should give rise to better future sales, lower persistency and less regulatory intervention) and a strong growth in NBMR, driven off efficiencies, expense reductions and economies of scale through greater sales.

Our risk business is in trouble and requires attention, but we are building a solid, profitable and sustainable investment business that should provide good returns to shareholders.

Conclusion

These are stylised examples filled with hidden good news. The reality is that many insurers are struggling in several business units.  The analysis and tools outlined here can help make better informed decisions around product strategy and pricing, and for analysts wanting to better understand the current and potential future financial performance of these stocks.

For short-term business (group risk, health insurance, health administration, general insurance etc.) it is something different since these lines don’t have long-term prudent provisions. In these cases it reflects the present value of future profits expected to be earned out of the existing business.

The inclusion of these short term types of business within EV is widespread. It seemingly increases consistency between different types of contracts since we are considering the long-term expected profitability in all cases. More on this apparent consistency in a moment.

What do we include in the EV and VIF?

EV is not a complete economic measure of the value of an insurer, since it ignores future profits arising from future new business. This is by design. An Appraisal Value incorporates the Value of Future New Business (VFNB) as well, although there is always subjectivity over how many years of future new business should be included. (More on this in a separate post.)

Existing Business vs Future Business

The idea of “existing business” and “future new business” is clear in the individual life context. It’s existing business if you have a contract, and future new business if not. Premium increases and slight benefit modifications can usually be accommodated within the existing contract and so should ideally be included in the Value of In Force (VIF) based on the expected probabilities of these changes.

As such, the expected future premium increases should also be factored into the Value of New Business (VNB) when the business is originally sold. (Don’t confuse VNB with VFNB.  VNB is the value of business written over some past historical period, typically the last month, 6 months or year. VFNB is the expected value to owners of the business from business that will be sold at some point in the future.)

What counts as In Force for short term contracts?

The position is less clear for Group Risk or Motor policies. These are typically annual contracts, but with high expectations of renewal. In this case the renewals are typically included in the VIF at some assumed level of premium inflation reflecting wage growth rather than new business. Premium inflation is an important consideration in countries with non-negligible inflation. New employees on an existing Group Risk policy are also usually not considered new business since no new sales activity was performed or purchasing decision was made.

The rules applied then are quite well understood. However, we are valuing two different things between short term and long term contracts, and also a little bit of something we shouldn’t.

The source of value for long-term and short-term contracts in the EV

For long term contracts, we are valuing expected future surpluses arising out of a long-term contractual right and prudent regulatory provisions.

For short term contracts we are valuing the existing contract (a small portion of the total value) and the customer relationship that will give rise to future renewals.

There is also a component of customer relationship in the long-term contractual rights since poicyholders can lapse the contract, incur some penalties possibly, but ultimately not be required by law to continue paying premiums. It’s difficult to separate these components though.

Unintended inclusion of brand value

Now the interesting part: I maintain that by using a best estimate future renewal rate for short term contracts, we are actually valuing a portion of the brand over and above the customer relationship. This is best demonstrated by an example.

Example of confounding of customer relationships and brand value

Take a company with a 20pc market share in the group risk market in which it operates. Let’s also say that best estimate future renewal rate is 80pc. If we assume a constant market share percentage (arising because of the value of the brand, but may be also broker networks etc.) then 1 in 5 employer groups looking for group risk cover will choose our hypothetical company – ignoring customer relationships.

Some of our customers will be very pleased with our service and will renew for that reason. The good customer relationship is a significant source of value. However, some of our customer won’t particularly value our service or relationship. Some of these will leave, but others will stay anyway – because of the value of our brand.

In fact, we should expect 20pc of our existing customers to renew even if there is no customer relationship at all. Why should existing customers be less likely to choose us again even if there is no customer relationship than a brand new customer?

Some of our customers may be so put out by an unfortunate incident, poor service or a repudiated claim that they may deliberately not renew. A customer relationship doesn’t have to have positive value.

So of our 80pc renewals, 20pc renew for reasons independent of our customer relationship. So the correct renewal rate to apply when measuring customer relationships is actually 60pc.

The impact can be significant

This makes a significant difference to the VIF. For a 20 year projection and 20pc market share, the difference is a reduction in VIF of 46pc. For a 10 year projection with a 5pc market share, the difference is still 14pc.

You can test the impact using this Renewal Test model under Example Models.

What does this mean practically?

Now we haven’t changed the true value of the business; we’ve changed how much of it we recognise as a customer relationship. With a lower VIF, we would expect to see positive renewal experience variances (if we compare actual renewal rates to modelled) or higher volumes of new business (if we treat the portion of renewals related to overall market share as new business) athough the new business margin on revenue will be lower since we are modelling a lower Discounted Premium Term (DPT).

Neither of these results is very satisfactory. Perhaps the answer lies in separating renewal into a change in market share impact and the remaining renewal variance so that the VNB is still objectively measured as new sales, but the persistency profits are separately allocated between the known adjustment for brand and the actual deviations from renewals being further different than expected.

Merger and Acquisition pricing and accounting

Specifically though, this has important implications for accounting for insurance mergers and acquisitions and the types of intangibles created. It also feeds into the purchase price decision and valuation adopted for an acquisition. Ultimately, views of the Appraisal Value of annually renewable business must incorporate these important differences when compared to individual life businesses.

It wasn’t that long ago that financial institutions needed marble-clad offices and multi-decade histories to show that they were serious and were financially stable and could be trusted. Now the organisations that generate trust are barely a decade old and interact with customers in a purely virtual form.

“If Google got up and said we are going to offer a savings account, for me, that would be very difficult and confronting,”

I already use and love Google Checkout, which allows me to purchase items quickly from a variety of sites without having to enter (or share!) my credit card information with the new merchant. I honestly wish all merchants supported it.

PayPal has had a difficult history in South Africa, given that only very recently have we been able to withdraw funds from PayPal (and only via FNB even now). Still, I trust them more than most merchants.

One reason I might be concerned about Google as a bank is that since it would be so internationally successful, it would be an insanely attractive target for hackers. The number of attack vectors that would be pointed its way would be particularly concerning. (Yes, I’m writing this from a virtually virus-immune Mac for similar reasons.)

All companies must focus on trust and genuine relationships with clients, but no more so than financial services companies.

It’s done none of these because the logic underlying it was flawed. Analysts focused on interconnect as an expense, happily ignoring the revenue side (since it was a fee paid to another company within the industry). Never has a telecoms issue been so badly hijacked by lack of understanding.

Now, in a press release that is a little vague, BMI TechKnowledge reflect concerns that telecoms growth rates may be lower as a result of falling mobile termination rates.

The economics of a fund manager depends entirely on growing funds under management so that revenues (based on assets under management) grow to be larger than costs (significantly fixed and at most semi-variable). Details of performance fees and the second order impact of investment performance aside, a successful fund manager must attract positive net client cashflow, and lots of it.

Half the 960 available unit trusts have less than R100m in AUM. Some of these may be rapidly growing new funds, but many have been stagnant with slow growth for several years.

The FSB’s attention presents opportunities for consolidation between funds and should place larger funds in a stronger position competitively. Total Expense Ratios (TER) for these funds with significant scale should already be lower than smaller funds. Maybe it’s time the larger funds made more if their size and cost efficiencies. If they are going to take the heat for being too large to be nimble, they might as well reap the benefits too.

It will be interesting to see what this means for white labelled funds and whether the economics of these convince the regulator that they should survive.

Posted with WordPress for BlackBerry.

It’s based on US research, so the parallel to South Africa isn’t perfect. On the other hand, it may prove predictive for our population.

A few snippets (it’s a long article, but well worth reading the whole thing):

1. The median age at first marriage in the early 1970s was 21 for women and 23 for men; by 2009 it had climbed to 26 for women and 28 for men
2. Definitions of adulthood vary widely – people can vote at 18, but in some states they don’t age out of foster care until 21. They can join the military at 18, but they can’t drink until 21. They can drive at 16, but they can’t rent a car until 25 without some hefty surcharges. If they are full-time students, the Internal Revenue Service considers them dependents until 24; those without health insurance will soon be able to stay on their parents’ plans even if they’re not in school until age 26, or up to 30 in some states.
3. Definitions of adulthood are clearly not just a function of age. (and so our marketing to them should consider more subtle measures than simply age ~ David Kirk)
4. As “emerging adults”, young men and women are more self-focused than at any other time of life, less certain about the future and yet also more optimistic, no matter what their economic background. This is where the “sense of possibilities” comes in, he says; they have not yet tempered their ideal­istic visions of what awaits. “The dreary, dead-end jobs, the bitter divorces, the disappointing and disrespectful children . . . none of them imagine that this is what the future holds for them”. Ask them if they agree with the statement “I am very sure that someday I will get to where I want to be in life,” and 96 percent of them will say yes.
5. But despite elements that are exciting, even exhilarating, about being this age, there is a downside, too: dread, frustration, uncertainty, a sense of not quite understanding the rules of the game. More than positive or negative feelings, what Arnett heard most often was ambivalence — beginning with his finding that 60 percent of his subjects told him they felt like both grown-ups and not-quite-grown-ups.
6. The 20s are when most people accumulate almost all of their formal education; when most people meet their future spouses and the friends they will keep; when most people start on the careers that they will stay with for many years. This is when adventures, experiments, travels, relationships are embarked on with an abandon that probably will not happen again.

This is thought-provoking stuff.

Marketing to this demographic must factor in South Africa’s demographic, social, economic and political changes over the last 40 years (and continuing development).

Further, marketers and communicators must consider how this changing pattern of early adulthood will affect these adults later in life. How it will affect their views and preferences, the goods they demand, who they listen to and what marketing works.

The DA has released a confidential report outlining how Eskom has been selling heavily discounted electricity, sometimes at increased discounts at the same time as increasing charges to ordinary users. This effectively makes the point I made around inappropriately lower tariffs being more of a problem than possible tariff hikes. Moneyweb reported on this too.

The hype and hoopla around this topic is fueled by our feelings as consumers of being charged too much big big monopoly companies. So I should start by saying that I’m not saying that we are paying too much. I’m not saying that because I don’t know enough about the costs of providing cellular services in South Africa. Maybe we are, maybe we’re not. Also, I’m not saying there aren’t monopolistic practices in the market – again I simply don’t know. Given the other stories torn from inside companies by the sharp teeth and salivating jaws of the Competition Commission, it’s understandable that many suspect consumer-unfriendly play by most large South African companies, particularly those in industries with a small number of players.

What I am saying is that most of what you read in the news about interconnect is horribly misguided.

The biggest misconception is that interconnect fees are an expense for cellular providers, and that the removal of this expense would allow them to reduce tariffs to consumers. Well, it is an expense, but it is also a source of revenue. Every time one company pays an interconnect fee, another company is receiving it.

Interconnect does not change the total amount of profit within the cellular industry. It may redistribute it a little, and there may be negative medium term competitive implications arising from interconnect, but lower interconnect won’t automatically increase profits that could allow competitive price lowering for the benefit of consumers.

TechCentral has an interesting article: Bain warns consumers not to expect cellular price cuts.  Of course, it also include some done-to-death flawed statements (whether from Bain or inserted by the zealous staff writer) such as:

Because new players have few customers at first, most calls on their networks will be to networks of other operators. High interconnection fees make it difficult for them to enter the market.

It’s not that this statement is incorrect (it is in fact correct) it’s just that it is horribly misleading because it only presents one side of the story. I’ve reworded it to provide the stunning insight:

Because new players have few customers at first, most calls to their networks will be from networks of other operators. High interconnection fees make it profitable for them to enter the market.

If you are a small cellular operator, most people calling your customers won’t also be your customers. You get to charge them an interconnect fee for most calls. You can model this in a spreadsheet (I’ve done it) and provided two basic assumptions hold, interconnect is irrelevant as a primary force. Fees in and expenses out equate .

1. “Cellphone users must make calls, on average, equally to all other subscribers independent of network.” If Cell C customers are more likely to call Cell C customers rather than a random cellphone user in South Africa, the numbers start to change. Although I don’t have info to back this assumption up, it feels reasonably robust.
2. “Customers on all networks must, on average, make the same number of calls.” This is actually where the problems arise and the true cost of interconnect exists.

Why is assumption #2 a problem? Think about the goal of competition for consumers: “Profit maximising companies see to increase volumes by lowering prices, gaining market share and thus making more profit. Provided Marginal Revenue is above Marginal Cost, companies should cut prices.”

So, what happens with interconnect fees above “true” cost of completing the call? When a company seeks to lower its prices, below that of the competition, its customers will make more calls than average. (This is intuitive and also expected from a downwards sloping demand curve.)

Company A reduces its call rates. Company A’s subscribers will make more calls (incurring interconnect expenses for Company A paying to Companies B, C and D) but customers of Company B (and C and D etc.) won’t be making more calls into Company A. Thus, Company A pays more interconnect and receives no more interconnect. Its costs have just gone up, pushing up Marginal Cost to a point where it doesn’t make sense to lower prices.

Voila – a perfect pricing system to force prices higher and higher. If Company B raises it’s prices, its subscribers will receive more calls than they make, resulting in more interconnect revenue than expenses for Company B. If the interconnect fee is sufficiently above the true cost, the reduction in profit form lower call volumes will be more than offset by the much  higher profit from interconnect fees being greater than interconnect expenses.

So interconnect fees need to come down to true cost plus a fair profit margin. It has little to do with interconnect being an expense factored into retail tariffs, but rather a function of the competitive pricing actions it encourages.

What Fin24 readers had to say

Nolulamo Matutu from Fin24 writes:

Acting CEO of the CMA Patrick Matshidze told MPs 18 schemes have fallen below the prescribed solvency ratio of 25%.

Clearly, these 18 schemes cannot pay all the claims we all would like in an ideal world.

However, more interesting to me than the article itself (fairly balanced and factual) were some of the comments written below. Clearly the misconceptions are still strong!

Fed Up had some strong views:

I’d like to see them look at medical aids the other way and see how many of them are making huge profits, some make billions are rands profit which in my opinion is really just ripping people off, medical aids should be non-profit as the less they pay out the more people suffer. Also medical aid is such a bad word, it should be called what it is medical insurance.

I wonder who be the one to break the news that medical aids are non-profit?

pdbphoto has a useful perspective, but still gets confused about “profit” versus surplus for the non-profit schemes:

I am sure that the high expenses that all medical aids incur are due to the huge amount of fraudulent claims being made by members and the large amount of unnecessary procedures prescribed by many in the medical profession. If all were honest Medical Aids could probably halve their fees to their members and still make a profit.

As I mentioned in my previous post, fraud is a serious problem for medical schemes.

Debbie lays the blame solidly at the feet of medical practioners:

It is time Specialists and Doctors who do not charge medical aid rates are investigate. Most of them live well above what most of us could hope for even in the best of situations. They are fleecing the average patient. One simply has to calculate their hourly rate to see that there is something wrong. I also dont buy into the argument that they have studied for so many years and work very hard, there are many other professions that also require years of study and equally hard word

But is countered by a rather unsuccessful sounding doctor (“doc“) highlighting the costs of running a practice that often aren’t appreciated. I’m not convinced his result of R35 per hour reflects average incomes though!

I sold my practice 7 years ago, no money in it for eithical doctors. I was busy but earned less than 15 k per month even though working more than 17 hours per day seven days per week. one must realise there are staff to pay, the vat man takes 14% off the top and then the equipment and room rentals, insurance, etc. when these are all added up then talled to an hourly take home rate it comes to about R 35 per hour a doctor earns after taxes and expenses if he practises ethically!!!!

I have a great deal of sympathy for doc, especially the point about ethics  amongst doctors. Inappropriate claims allowed by doctors turning a blind eye, or outright fraud by doctors are problems.

National debate on NHI?

With this level of misunderstanding commonplace, and personal interests at the forefront of most people’s minds, how can we hope to have useful, rigorous and informed debate around the proposed National Health Insurance?