Category Archives: life insurance

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.

Nasty or nice – playing the tail

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Insurance and gambling have much in common. They both involve uncertainty and money and the rational consumer will, on average, lose money through the interaction. Both business models involve leveraging the tail of probability distributions (one nasty and one nice).

The tail of a distribution includes the very bad and very good possible outcomes, that typically have a very low frequency of occurring. Having your house burn down is a very bad outcome, but fortunately happens very infrequently. Winning the lottery is very good, but unfortunately in this case is also very unlikely for any particular individual.

Managing the nasty tail

A rational person who wants to avoid the unlikely but catastrophic risk of  losing their house to fire will be prepared to pay more than just the average cost of the loss of the house in order to avoid the risk. Typically, we humans are risk averse (a wild generalisation given the research into utility and decision making that has led to behavioural finance and behavioural economics, but probably good enough for now). Insurance provides:

  • genuine decrease in risk and indemnification of losses against the loss event happening
  • peace of mind even if no loss is ever experienced, which has real value in terms of clearing the mind to think about other more important and more controllable personal and business matters
  • reduction in the amount of capital / liquid assets individuals and businesses need to keep against unforeseen events. This capital can be better used and invested elsewhere

Contrary to the popular view, insurance has value even if you never claim.

Gearing to the nice tail

Gambling can be dangerous and addictive. It can also be entirely rational to gamble within certain parameters. Continue reading →

New operational risk guidance from Solvency II

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CEIOPS issued additional guidance around the standard formula for calculating capital requirements in respect of operational risk late last year.

Why was a new OpRisk formula needed?

The original formula for OpRisk proposed in QIS4 was widely condemned. Complaints included being too simplistic, being insensitive to risk (and basely primarily on business size) and the impossibility of calibrating to 99.5% in a meaningful way. CEIOPS accepts most of this criticism, but counters by reminding stakeholders that the aim of the standard formula is partly about being simple.

A more serious problem is that in comparison against companies’ own internal models, the standard formula produced results lower than companies’ own assessment. Median internal model requirements for OpRisk were 133% of the standard formula and 13 out of 16 countries reported higher requirements under their insurers’ internal models.

One of the aims of the standard formula is to be slightly conservative to provide an incentive for insurers to develop their internal models. Clearly this objective is not being achieved. Continue reading →

Allocating capital to insurance products

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A friend “volunteered” me to answer an insurance question from Aardvark on allocating economic capital across different insurance products. After writing a short response, I received the frighteningly useful message: “Error”.

Having written a brief summary of the different techniques used in this really important area, I thought I should use it as a blog post. Maybe “Daan d.” from Cape Town will stumble across this answer eventually.

The question:

What is the standard practice to allow for diversification benefits when allocating capital required between different insurance products?

My brief answer (this is a huge topic!):

There is no standard practice. It’s one of the more irritating and subjective aspects of allocating capital between imperfectly correlated product

Economic Capital doesn’t have to be calculated as VaR, but I will use VaR below as a generalisation. Banks are typically slightly more mature in their capital allocation processes so what I’m describing below is often used in the banking world, but applies equally to insurance (life and non-life / P&C).

Splitting the capital in proportion to the sum of the components is frequently used, but is flawed and usually doesn’t give good results unless speed and simplicity are primary objectives. Continue reading →

Is South Africa sheltered or delayed?

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The South African Reserve Bank today lowered the REPO rate by a further 50 basis points, down to the level last seen in 2005 and the lowest the REPO and BA Rate have been in nearly 3 decades. Surveys leading up to the announcement and analysis of market interest rates suggests that the expectation was for rates to be held constant. Was this a purely populist decision, or does Tito Mboweni see more economic trouble ahead that other, more optimistic South Africans believe?

To date, the South African economy has been relatively less affected by the global financial crisis. Unemployment in Spain is up to 18% – within spitting distance of our own extravagant unemployment rates. Several large economies have been making eyes at 10% annual declines in GDP – often used as an informal definition of a depression (compared with a recession typically defined as two consecutive quarters of decline in real GDP). Property prices have been declining between 5% and 10% (depending on who you ask) and even after allowing for our higher inflation and thus greater real decreases, we compare very favourable to the drops of 20% to 50% in some parts of some countries. Continue reading →

Massive currency risk

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In my previous post I discussed some of the risks to various currencies.

Now what happens if your local currency is pegged to the US Dollar as it is in Lebanon? Speaking to Lebanese bankers and insurers there seems to be a devout belief  that the peg is rock solid.  This is surprising given the history of the Lebanese Pound (LBP) over the last 30 years. Decades of civil war and hyperinflation decimate a currency.

West Beirut strolling
Creative Commons License photo credit: austinevan

Now if you offer insurance policies denominated in USD or LBP, accepting premiums and paying benefit in currencies assumed always to be pegged at a fixed  rate you might want to consider what assets you have backing those policies. USD policies backed with assets in LBP (and LBP policies backed with USD assets) are a massive currency risk. The probability of a break in the peg may be small, but the result could be catastrophic.

Unfortunately, it is arguably worse. Even if the USD policies are backed with USD deposits and bonds at Lebanese banks, how will the banks fare if the currency is devalued? How about if the USD does plummet on the back of inflation concerns in the US economy and the LBP is forced to be revalued upwards? Unless the banks are managing this currency risk themselves and are appropriate matched the contagion of currency problems will flow through banks and straight to insurance companies.

Now is not the time to assume that artificial links will remain no matter what happens to the global economy. This is a massive currency risk.

Where’s the safe?

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Currencies aren’t what they used to be. The US Dollar can no longer be viewed as a safe bet as Obama and Bernanke spend their way out of a crisis partly fueled by too much spending. Inflation will come, it’s just a matter of time. Warren Buffet thinks so too. The current relative strength of the USD is a short-term reaction to the money flowing back into the US. It won’t last.

Fichet 1
Creative Commons License photo credit: plenty.r.

The Swiss are acting in the market to weaken the Swiss Franc to protect the economy. Given the problems Swiss banks have been having as a result of the credit crisis and pressure on banking secrecy rules out the franc.

The South African Rand? South Africa has a huge current account deficit, significant political risk, serious government spending and a decline in exports and production in our base metals economy.

The Pound Sterling is teetering on the back of a meltdown of the financial system – long the heart of the London and UK economy. I hear Ireland is in horrible shape too.

Some are suggesting the Norwegian Krone. It’s one of the world’s top ten traded currencies, which provides liquidity. Significant oil wealth has been accumulated and diversified in a “pension fund for the country”. However, currencies can be driven for extended multi-year period purely based on fashion. I don’t know that I want to risk being in a currency that simply goes out of favour.

The Japanese Yen has to deal with the worst economic declines in nearly 40 years. The Chinese Yuan is subject to state manipulation, usually pushing to keep it low to sustain an export-driven economy. Not sure I like my eggs  fried in that basket either.

The argument typically turns to Gold. The shiny metal that has been a store of value for several hundred years. Only problem is that gold arguably has less intrinsic value than steel or wheat or oil. The price is driven by demand – demand that is driven by assumed future demand. Flows into Gold ETFs have been strong, and significantly responsible for the current prices. Getting in now at around $900 per ounce might not be smart if everyone else is already in and looking for a time to sell.

So, where’s the safe?