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

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.

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.

 Total 2011 2010 2009 VNB 300 300 300 API 3 080 2 370 1 660 PVNBP 15 400 11 850 8 300 New Business Margin 1.9% 2.5% 3.6%

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

 Total 2011 2010 2009 VNB 300 300 300 API 3 080 2 370 1 660 PVR 1150 1162 1175 DPT 5.0 5.0 5.0 RPP 7.5% 9.8% 14.2% NBMR 26.1% 25.8% 25.5%

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

 Investment Risk 2011 2010 2009 2011 2010 2009 VNB 200 150 100 100 150 200 API 3 000 2 250 1 500 80 120 160 PVNBP 15 000 11 250 7 500 400 600 800 New Business Margin 1.3% 1.3% 1.3% 25.0% 25.0% 25.0% 2011 2010 2009 2011 2010 2009 VNB 200 150 100 100 150 200 API 3 000 2 250 1 500 80 120 160 PVR 750 562 375 400 600 800 DPT 5.0 5.0 5.0 5.0 5.0 5.0 RPP 5.0% 5.0% 5.0% 100.0% 100.0% 100.0% NBMR 26.7% 26.7% 26.7% 25.0% 25.0% 25.0%

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.

 Total 2011 2010 2009 VNB 113 97 89 API 1 225 765 505 PVNBP 6 900 4 100 2 900 New Business Margin 1.6% 2.4% 3.1%

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:

 Total 2011 2010 2009 VNB 113 97 89 API 1 225 765 505 PVR 650 750 620 DPT 5.6 5.4 5.7 RPP 9.4% 18.3% 21.4% NBMR 17.4% 12.9% 14.4%

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

 Investment Risk 2011 2010 2009 2011 2010 2009 VNB 70 28 17 43 69 72 API 1 100 650 400 125 115 105 PVNBP 6 500 3 500 2 400 400 600 500 New Business Margin 1.1% 0.8% 0.7% 10.8% 11.5% 14.4% PVR 250 150 120 400 600 500 DPT 5.9 5.4 6.0 3.2 5.2 4.8 RPP 3.8% 4.3% 5.0% 100.0% 100.0% 100.0% NBMR 28.0% 18.7% 14.2% 10.8% 11.5% 14.4%

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.