Category Archives: life insurance

What is best practice for matching annuities in Greece in 2012?

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Best practice for matching non-profit annuities in most countries, certainly from a risk perspective, is still to cash flow match (or at the very least, match key durations) using government bonds.

The theory is that the insurer isn’t then exposed to changes in the term structure on interest rates, only exposed to illiqudity/reinvestment risk to the extent of mortality fluctuations, isn’t exposed to currency risk and certainly isn’t exposed to credit risk. Without complex margining requirements like some swaps and without the need to roll cash investments over, government bonds should allow ALM teams to sleep well.

Now, Solvency II is likely to adopt a swap yield curve rather than bond yield curve. There are some good reasons here, including arguably fewer distortions from temporary supply and demand imbalances, improved liquidity and so on. The same yield curve is used for liquid liabilities so the allowance for an illiquidity premium over and above the swap curve at some times, in some ways and for some products is still under debate.

But what should Greek insurers do in the meantime?

Frankly, Greek government bonds don’t remove credit risk and the huge credit spreads on these instruments will create huge funding gaps and variability in earnings unless a Greek govi yield curve is used to value liabilities as well. It’s not clear at all that Greece will stay part of the Euro, so German government bonds don’t remove currency risk. German government bonds in any case are show signs of nervousness as yields creep up.

The swap market is exposed to the same Euro break-up risks as bonds. Which banks will survive, what happens to currencies in the meantime and what does that do to long-term Euro swaps? What about Euro-Sterling swaps issued by Greek banks (I’m not sure if these even exist though).

All in all, it’s good to be involved in ALM in South Africa, and even the Middle East just at the moment.

Gaining new insight into insurer profitability through New Business Margin on Revenue

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The Value of New Business written by an insurers is a good measure of the value created through sales activity over a certain period. It’s not the easiest number to interpret in terms of profitability though.

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. Continue reading →

New thoughts on renewal rates for Embedded Values

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Embedded Values (EVs) are widely used to measure value for life insurers. In the context of long-term contracts such as individual life, it reflects the value embedded in prudent regulatory provisions (or “actuarial reserves”).

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. Continue reading →

In Bahrain for a few days

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I’m in Bahrain for a few days kicking off an ERM implementation project. 35 degrees at 7am in Doha on the way there…

Bahrain has a population of around 1.2 million but has a well developed insurance sector. Economies of scale limit domestic growth and regional expansion faces tough competition and increased complexity. Will be interesting to see more.

The cost of regulation

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Basel II (and the collection of changes called “Basel II” by some), King III, Solvency II / SAM, IFRS changes, Treating Customers Fairly, FICA, Protection of Personal Information, RE exams and of course RICA all cost a small fortune.  Only the last doesn’t affect financial services companies.  No wonder the major industry concern is over-regulation.

A good explanation of the perceived problems of annuities

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There is much to recommend in purchasing an annuity at retirement to manage the risks and uncertainty of longevity. It’s well known though that surprisingly few people who have the option to purchase an annuity do so.

Richard Thaler presents some of the common perception problems with annuities in this article in the NY Times. The basic message is still as it has been for decades. Individuals are reluctant to pay a large portion (often the majority) of their life savings to an insurer with the risk that they will die in a few years and “not have got their money back”. The peace of mind that should come to the policyholder turns into a matter of stress.

The bequeath motive is strong – and amplified by a lack of understanding of exactly how long we’re likely to live in retirement these days and how much money will be required. Those to whom many plan to bequeath may ultimately become the source of support when the income draw-down products are depleted with no longevity guarantee to boost the funds available.

It’s a good explanation although he doesn’t break much new ground. He also doesn’t talk about the concerns some potential policyholders have, in some countries at least, of whether the insurance company who sells the annuity will definitely be around over the next 40 years come what may.  This is more common in developing markets with weaker regulation (probably a good reason to have concerns) and less history of annuities (a cultural bias that will probably disappear over time).

Mr Thaler doesn’t propose any solutions for the insurers in boosting sales – a common “fix” is to combine a traditional pay-until-death annuity with a guaranteed minimum period or a death benefit (either for a limited term or at any point).  These adjustments reduce the “risk” of “making the wrong decision but purchasing an annuity but only living for a short period”.

There’s no free lunch.  In the same way that cash-back bonuses on short-term insurance products actually increase the average cost of insurance and reduce the risk-transfer from insured to insurer, these guarantee periods increase the cost of annuities.

New Business Margin on Revenue

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A new measure of life insurance new business profitability is required.

What is New Business Margin?

Many life insurers currently calculate a measure of the profitability of new business sold over a period called “new business margin”. As defined by the CFO Forum’s MCEV Principles and confirmed in South Africa’s PGN107 covering embedded values, this is the Value of New Business (VNB) divided by the Present Value of New Business Premiums (PFNBP) calculated on a consistent basis.

This is a useful measure since it shows, on average, how much of each premium goes to shareholders as profit, after deducting operating costs, benefits paid to policyholders and a cost of the capital required to support the business.

It’s far more useful than a common previous metric of VNB / API where API is Annual Premium Income or APE Annual Premium Equivalent, since the numerator reflects a multi-year stream of profits and the denominator just a single year. It’s a more difficult number to interpret intuitively.

Of course, New Business Margin is also fatally flawed. Continue reading →

You can’t eat that

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I was in a meeting today with a great company and with great people. We were discussing financial measures for a life insurer, including Embedded Value, when one of the well respected actuaries asks what the Return on Equity is (rather than Return on Embedded Value).

Now there are many people who don’t like Embedded Values, and they certainly have some good reasons for being wary of it. Embedded Values are a measure of shareholder value in a life insurer that adds the shareholder valued embedded in prudent regulatory reserves to the net worth of the company with an adjustment for the cost of holding capital. It is needed because current accounting measurement of insurance liabilities is also typically overly prudent and thus book value on an accounting basis is a really bad measure of shareholder value in a life insurer.

Embedded Values are flawed due to imperfect allowances for risk, lack of comparability across countries and even sometimes companies and a methodology that can make value magically appear out of taking on mismatch risk.  Worst of all, in a practical sense, is that life insurers typically trade at a discount to Embedded Value in the market (Embedded Value is greater than Market Value) even though theory suggests Embedded Value should be less than Market Value since we haven’t included any allowance for future new business/goodwill/franchise value.

None of this was the basis for the preference for Return on Equity over Embedded Value.

You can’t eat Embedded Value.

That was the criticism. You can’t eat Embedded Value. This is true.  Of course, you can’t eat Equity either.  You can’t eat Book Value.  You can’t eat earnings.  While we’re at it, you can’t actually even eat cash, although you are reasonably likely to be able to potatoes directly with the cash (as in a dividend) than with most other measures.

So while you can’t eat Embedded Value, you just as well can’t eat Book Value.  In the life insurance space, it’s really hard to get a handle on “tangible” asset value.  Our liabilities will always be based on an estimate of future cashflows. Embedded Value is in its most basic form just a different value of different future cashflows discounted at a different rate.  It is no less (or more) tangible than Book Value.  Return on Embedded Value is no less tangible than Return on Equity since they both depend on uncertain estimates of future cashflows and experience.

The difference is, we know that Book Value is categorically, definitely undervalued.  The degree of undervaluation is different from one company to another depending on the level of prudence included in the liabilities. In South Africa, it’s also fundamentally undervalued because the liabilities ignore the economic value arising out of optional (but reasonably predictable) future premium increases.

This means that Return on Equity is an overstated measure of return since the measure of Equity is understated because the liabilities are overstated.  Worse, we can’t compare it from one insurer to another since their liability valuations will be different.

So while you can’t eat Embedded Value, you will make more value for your shareholders basing decisions on Embedded Value than on Book Value.

Interestingly, new accounting developments (IFRS4 Phase 2) and regulatory developments (Solvency Assessment and Management, based on Solvency II from Europe) will completely change the way we measure financial performance of insurers. And no, I still won’t be using Return on Equity.