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.
The underlying problem with New Business Margin
The premium for a risk-type product (term assurance, credit life, funeral insurance etc.) can be thought of as the cost of obtaining the service, which in this case is insurance against death or disability. The profit margin is the share of this premium that the insurer takes as profit for providing the service. So far so good. VNB / PVNBP is present value of profit over present value of revenue to the insurer.
The premium for investment or savings business – well frankly it’s a pity it’s also called a “premium”. It’s money handed over by a policyholder to an insurer for the insurer to manage on the policyholder’s behalf, generate an investment return, and return to the policyholder at a later point. The “premium” is not the cost of the service.
You don’t pay a “premium” to your bank when you deposit your salary. You don’t pay a “premium” when you invest in unit trusts.
Policyholders also expect to get the vast major if their premium straight back, and hopefully with some investment return. The cost of service is actually the charges or fees deducted from the investment account balance by the insurer to pay for operating expenses, cost of capital, risk benefits (if the policy also has death or disability cover, for example) and shareholder profit.
The correct stream of revenue for the insurer is not “premium” but rather the fees and income deducted from the policyholder’s account. New Business Margin as it is currently defined shows a miniscule margin because it’s not comparing profit to revenue, but rather profit to the money entrusted to the insurer to look after.
Banks focus on interest rate spreads and cost to income ratios, rather than profit compared to total liability base. Because, well, that’s just not that useful.
Why New Business Margin is not useful
Setting aside for the moment the problem that New Business Margin for investment / savings products is not a coherently defined metric, why should we care on a practical level about finding a better measure for new business margin?
- You can’t compare New Business Margins across companies, products or business units.
The comparisons will reflect both differences in actual underlying profitability as well as, and in far greater magnitude, differences in product types and the mix of risk vs savings products. A 4% new business margin is either low for risk business or very high for savings business. Or totally indeterminate for a mix of both types.
- It confuses the required strategic and product decisions to improve shareholder value.
If New Business Margin is the measure, then most insurers should stop writing investment business altogether, even though this can be a shareholder value-creating business line.
- It can create distorted sales incentives.
It is much easier to sell a R2,000 per month savings policy than a R2,000 per month risk policy. Disproportionately skewing incentives towards high margin risk products could end up reducing total VNB generated through smaller average policy sizes.
A better alternative – New Business Margin on Revenue
A more useful and comparable measure of profitability would be the VNB / PVFR, where PVFR is Present Value of Future Revenue, and where Revenue is recognised as income flowing to shareholders, which would exclude the deposit-like components of savings business “premiums”.
- It is a consistent measure across risk and savings business
- It is easy to calculate using existing systems
- It uses familiar terminology, while adding more information
- It supports relevant component analysis to better understand drivers of margins (see below)
- It drives the correct strategic, business mix and sales-target decisions
Simple component analysis of New Business Margin on Revenue
This new definition of new business margin naturally gives rise to an interesting component analysis:
VNB = (VNB / PVFR) * (PVFR / PVNBP) * (PVNBP)
Which shows that Value of New Business is my proposed New Business Margin * Revenue Per Premium * Present Value of New Business Premiums
Revenue Per Premium is a measure of how much total revenue is deducted from each premium on average for the insurer. Higher numbers reflect more value extraction for shareholders, but a higher Reduction in Yield for policyholders. For risk-only policies, (PVFR / PVNBP) is 100%.
Present Value of New Business Premiums is then the overall volume measure for new business sold over the period.
The preferred approach to New Business Margin on Revenue component analysis
VNB = (VNB / PVFR) * (PVFR / PVNBP) * (PVNBP / API) * (API)
Which expands Present Value of New Business Premiums into the product of API (Annual Premium Income, or the annualised value of premiums on new business sold during the year, which is an important volume measure) and the average discounted term of future premiums reflecting the durability of the book. Short-duration product or product line with high lapse rates will have a low (PVFP / API) ratio, reflecting value creation for shorter periods. Long-duration policies with low lapses will generate value over a much longer period.
Increasing VNB can be accomplished by increased any of the four components, but increasing the revenue per premium component is at the direct expense of policyholder value for money.
|VNB||Value of New Business|
|VNB / PVFR||New Business Margin on Revenue (NBMR)|
|PVFR / PVNBP||Revenue Per Premium (RPP)|
|PVNBP / API||Discounted Premium Term (DPT)|
|API||Annual Premium Income|
So VNB = NBMR * RPP * DPT * API
This analysis is of course most useful if it is performed separately for business/product lines to show the drivers of profit for each. I hope some insurers will take the step to disclose this level of detail.
Extensions of this analysis
Several extensions to this analysis are possible. One the most interesting is where we add a component for cost of capital, showing the percentage reduction in VNB as a result of deducting the cost of capital required to support the new business. Another, more complex analysis would be to separate fixed and marginal expenses in order to determine the effective operational gearing of the business to new business.
It is possible to get too carried away so I suggest these measures as additional, optional measures possibly better suited to internal analysis than widely distributed external reporting.
The burden of unbundling
New Business Margin on Revenue is another call for unbundling of insurance contracts into investment and insurance components. This isn’t a popular idea for many insurers because of the expensive system and reporting changes this would require with limited immediate benefit to offset the costs. (Unbundling isn’t actually required to implement New Business Margin on Revenue.)
My view is that unbundling is inevitable. IFRS4 Phase 2 is pushing for it, reviews of life insurance taxation could well end up requiring unbundling and from an internal value- and risk-reporting perspective there are clear advantages. There are known challenges, for example the unbundling of some older whole of life endowments where there isn’t necessarily an explicit risk premium to unbundle. Also, as many contracts are priced and designed without unbundling in mind, the separation of fees and charges is not objective and will involve decisions around allocating cross-subsidies.
While recognising these challenges, I would counter that the improved discipline of understanding more clearly activity based costs for general administration, investment management and risk administration is actually a positive outcome which will come with unbundling.
New Business Margin on Revenue (NBMR)
NBMR = VNB / PVFR
and the component analysis:VNB = NBMR * RPP * DPT * API
The advantages of New Business Margin on Revenue outweigh the initial work to set up systems to calculate the new, more useful, more comparable and ultimately, more enlightening metric.
Contact me to pre-order the comprehensive New Business Margin on Revenue methodology and understand more complex component analysis for financial reporting, treating customers fairly, due diligence, how NBMR links into IFRS4, Solvency II and SAM and the systems implications of introducing NBMR.