That’s the ballpark figure I usually work with as the minimum number of micro insurance policies required for scale. The expenses of running even a micro insurer are not that trivial.

For underwritten products within a full life licence? Larger premiums per policy but definitely more complexity. Competition is tougher too. Hyper local brands don’t translate into trust at this level. Viable niches may exist, but at what volumes?

You might wonder if there is scope to sell greater value products at higher premiums that can bring that number down in some contexts?

The rise of embedded insurance

Turns out this has been given plenty of thought already – “micro” insurance is the less popular name these days from a product and provider perspective. Inclusive Insurance certainly sounds better and more inclusive (!)

I think part of that push though was recognising the challenges and limits of truly “micro” insurance, at least at an individual level in providing commercially viable options that meet needs at the scale necessary.

Inclusive Insurance has been eclipsed in some words for “embedded insurance”, a term that talks less to the needs and objectives for society, and more to one that is practical and viable commercially. Embedding insurance in other products are services can drive down some of the costs, but then by virtue of being embedded, the absolute amount of premium is even further limited. Volumes may go up – and there have been some success stories here – but margins typically remain fine so I’m going to guess that my 40,000 may be too low in these instances. The success stories are in the 6- and 7-digit volume space.

Microinsurance licence restrictions

Back to “microinsurance” and the regulatory restrictions that apply in South Africa:

• Savings elements might seem attractive to increase premium size and provide “value” rather than a set price point. But savings elements are not permitted in microinsurance policies in South Africa.
• Loyalty schemes or cash back may be a way to attach greater value to a product, but again are not permitted in the microinsurance framework.
• Fairly large sums assured are possible within microinsurance – often attracting increased adverse selection or outright fraud.

Can product tailoring increase average premium?

Product tailoring can be expensive and can counter plans for
economies of scale while simultaneously targeting a smaller market. I’d still like to see more of this rather than pure commodity products. I’d be happy to be wrong if this approach meant a viable micro insurer could provide genuine value, see strong demand, and require fewer than 40,000 policyholders or comfortably sell more than that.

Microinsurance pros and cons – an important choice

A key point here is whether a standalone microinsurer is the right vehicle for a truly niche insurer? The increased governance and compliance policies effected by the major cell providers have frustrated cell owners and entrepreneurs, slowed down innovation and led them to look elsewhere. A microinsurance licence is a great option for some, but not a panacea for everyone.

I’ve helped insurers apply for licences, buy licences, consider alternative arrangements, and I’m sure at some point I’ll be working with micro insurers to transfers portfolios to other insurers and close down licences.

There is also opportunity to apply to the Prudential Authority for scope to do more with the licence, with careful consideration of the risks and capital.

Does digital fix everything?

Digital sales is a complex area. Some insurers have had some success with purely digital sales. But when these distribution channels are owned by someone else, the costs are not as low as “digital† might make you think. If NTUs are high, and premium collections are low, it can quickly become expensive. There’s a fine line between removing friction from a sales and underwriting process (which definitely improves sales) and making it so easy to “sell† that the customers haven’t really decided that they want what they’ve bought.

Parametric insurance – watch this space!

We should be doing far more with parametric insurance in South Africa. Thinking around climate risk and the positive role insurers can provide in this space (rather than only worrying about the risks it poses to them) may present some new opportunities. Insurers can apply their expertise in understanding and pricing risk, while providing a socially and economically beneficial product at a price that shows value and profit.

A distribution channel that has never quite got off the ground is even more challenging. With confidence shaken, it’s easy to wonder whether success and scale will ever be possible.

Over the last couple of years, I haven’t engaged with a life insurer that hasn’t experienced some of this. You might be surprised by how ubiquitous this is:

• Yesteryear’s giants of funeral products struggling against the compelling advantage of bank branch, app and call centre distribution. This shakeout has probably benefitted customers with more attractive pricing at the cost of margin for providers.
• Organisations with strong brand and huge existing customer base struggling to generate meaningful volumes of commodity products, becoming reliant on expensive aggregators to achieve some amount of scale.
• Insurers seeing their market attacked by banking competitors investing significant sums into their banking operations – looking for a share of banking revenues and profit, but very much also looking to defend their insurance customers from extremely competitive banks. Some of the success of banks relates to their better digitalisation of distribution systems and related processes. Digitalisation is necessary but not sufficient – as evidenced by the banks slow progress in distributing complex underwritten products.
• Established insurers with success in non-underwritten products, and others with success in complex fully underwritten products, both struggling for scale, persistency and profitability in simplified issue / lightly underwritten products. Maybe it’s only a matter of time before someone cracks this, but for now I’m pretty wary of impressive sales volume projections.
• Insurers with impeccable track records of successful distribution feeling unfamiliar pressure on margins and volumes. (Increasing prices to improve margins can be self-defeating if volumes drop and fixed expenses burn margins further.)
• Life insurers urgently looking for new markets to expand to, including non-life, in order to keep growth going as their core market stagnates. (There are opportunities, but it’s not a simple transition. A key message is that what works for one market segment quite likely won’t work for another.)

I’ll be posting more on this theme in the coming weeks. If you have questions, post below and I’ll try to work them into future posts.

If you are a master of the dark arts of distribution, what do you see as the common or recent failings? What is the key to focus on? Is there just one?

I’ve had reasons to think about Nigeria recently, in general but also from an insurance market and acquisition environment. I’ve helped several investors looking at Nigerian insurers over the years. Familiarity with the market and the expectations of these investors has bred complexity rather than contempt. This isn’t an easy diagnosis of land of plenty or dystopian money pit.

Nigeria still presents a compelling opportunity with its expansive land, sizable population, youthful demographics, positive growth trajectory, and abundant natural resources. Beyond its renowned oil and agriculture sectors, Nigeria boasts a vibrant movie industry (Nollywood) and a robust financial services sector, albeit with banks making more headway than insurers. Wholesale and retail trade are the biggest contributors to economic growth. This dynamic mix showcases Nigeria’s diverse economic landscape and entrepreneurial spirit and an increased focus on the service sector over energy extraction and farming.

While Nigeria’s potential has long been evident, ongoing challenges test that optimism. 

Inflation (29.9% annual for January 2024) and currency depreciation (74% down against USD since January 2022) have impacted individuals and businesses, amplifying economic strains. The local impact of foreign currency denominated debt has ballooned due to Naira depreciation. Ghana’s recent default weighs on everyone’s mind.

Food security for many is now a significant risk. Infrastructure limitations persist, impeding the full realization of economic growth. High unemployment rates, coupled with security challenges and governance issues, have eroded public and investor trust. In the insurance sector, while some have some growth and success with new product lines, overall insurance penetration remains modest. Insurance adoption has not accelerated as rapidly as envisioned over the past decade or two

While Nigeria stands to gain from ongoing disruptions in the Middle East and related waterways, the nation’s oil and gas sector remains a double-edged sword—both a source of revenue and trouble. Given the historical challenges of theft and attacks on infrastructure, Nigeria may not be able to maintain let alone increase production to meet an increased demand.

The recent decision by Shell to exit Nigeria’s onshore oil sector highlights the substantial risks involved, not only to infrastructure but also to human life. As a significant portion of Nigeria’s economy is still reliant on the oil and gas sector, these developments raise concerns about potential prolonged challenges, affecting the economy and therefore adding headwinds to insurers growth aspirations.

Insurers can’t fix these challenges directly. They need to focus on perception and reputation, on paying claims and improving operational efficiencies. Some insurers are excited about mandatory health and pensions, to go along with mandatory cover for motorists, but these compliance push factors do little to promote trust in insurance unless servicing and claim payment are slick and reliable too.

Most of the growth that insurers have managed over recent years has related to growth in GDP rather than an increase in penetration. The sorts of sustained 20%+ real growth that attracts investors and revolutionises a market will not come from economic and population growth alone.

There are opportunities for growth. When someone cracks microinsurance distribution and costs, and reaps the rewards of brand awareness, that can unlock massive growth and profits over time. There are many uninsured vehicles that could be bought into the insurance net. Smaller group policies covering household help could meet a needs of employers and employees. Annuities are a growing product for some insurers, and may present a further way to accumulate assets and also demonstrate trust worthiness to the market. (On the flip side, a single failure of a provider of annuities will crush this market for decades.)

Insurers need to have a strategic plan to manage their business within the turbulent environment. Some of what’s needed:

• A focus on consolidation around key products, unsentimental views of product profitability and underwriting performance.
• Allocation of capital to products to demonstrate return on capital, or at least incorporating an appropriate cost of capital into performance measures.
• Clear separation of investment returns generated on shareholder assets when understanding operating performance. (Warren Buffet’s words can be on “the float” misconstrued to destroy shareholder value.)
• (While you’re at it, it’s way past time to carefully segregate portfolios and match or at least hypothecate assets to specific purposes.)
• Clear-eyed evaluation of participating products. Customer expectations, levels of fees and charges. Fair investment returns and bonuses. The aim is to grow trust over time and wealth for your policyholders. Performance for shareholders will come.
• In general, a greater proportion of premiums must be used for benefit payments to policyholders, distribution costs must be contained, and expenses must be decreased. This is necessary to drive customer value and build trust, while leaving space for returns to shareholders.
• A better understanding of the role and benefit of reinsurance in life insurance. Different structures and different retentions may provide better results than rolling over similar structures indefinitely.
• A Digital Distribution and Servicing Strategy than recognises the trust deficit insurers have to work with and constantly pushes that flywheel to build trust rather than just drive the next sale. Customers want ready access to policy information and up-to-date account balances and policy status. On the back end, a single view of customer is required, giving customers and servicing agents the ability to update details once – and then use those details for effective, useful communication to policyholders. The more self-service possible the more empowered customers will feel.
• Recognition that driving down unit expenses (per policy expenses) is necessary for profitability and customer value. And decreasing unit expenses requires economies of scale. And that economies of scale requires BOTH scale and low variable costs – which is a function of automation, Straight Through Processing, Standard Operating Procedures and streamlined products.

Nigeria presents an opportunity, but it’s not without risks. The time necessary to realise investment objectives may be longer than is palatable to many, and disinvesting in difficult times often leaves a bitter taste and a lightened pocket.

Focus areas will differ by entity, but based on my experience, the points above are a sensible starting point for most. Add the controversial elements of tax rule application consistency and greater market conduct regulation and Nigeria’s market could really begin to take off.

Many researchers are comfortable with a range for Equity Risk Premiums of between 3% and 5%. Many corporate finance practitioners use a range from 5% to 8% or even higher. My nearly eight-year-old blog post on mis-estimating the ERP covered these differences in detail.

This post is a little different. Forget about what theory says, what are the implications of using a high risk discount rate (RDR) when calculating embedded values and then trying to maximise value.

Solvency II and SAM suggest a 6% (excess over risk-free) cost of non hedgeable capital. Most South African insurers calculating real-world embedded values use risk-free + 3.5% as their RDR.

Some insurers want to use an RDR closer to 15% or even 20%. The problem here is one of conviction. If the cost of capital was truly felt to be 20%, then capital optimisation, value optimisation and therefore reinsurance decisions should be made with this in mind.

It will almost always be the case that reinsurance will have an implied cost of less than 20%. Thus, the consistent action would be to grab as much reinsurance as possible, at least up the point where the reinsurer was concerned about skin in the game.

I don’t see this happening in practice.

Some insurer will argue that they don’t want to give away all their profits to a reinsurer. This fundamentally misunderstands how reinsurance is priced and the impact of return and profit commissions to facilitate reasonable commercial terms.

Similarly, the pursuit of greater investment returns usually results in more risk and more capital required. At a 20% return on capital requirement, pretty much no avoidable market risk should be retained. Yet I still see insurers opting to take on more credit risk (even at current depressed credit spreads) in pursuit of a little extra yield.

We can have a debate about the range of reasonable RDRs to use. But there is a credibility problem if this rate isn’t also used to decide on reinsurance and investment strategies.

The larger insurance players seem reluctant to enter the market. Why do you think this market has been slow on the uptake? The regulatory barriers to entry certainly don’t appear to be that restrictive so either existing insurance companies are not flexible enough to offer the products required or it’s a poor business decision/larger risk that they’re unwilling to take on. Do you have an opinion on what is causing the low number of microinsurance players in the market?

So here goes. Certainly a far from complete or perfect answer, but a starting point based on my discussions with many people and entities actively interested in pursuing the market over the last few years.

What do we mean by micro insurance in the South African context?

The issue with micro insurance is scale, particularly of distribution and distribution costs. Okay, followed closely by premium collections (and that is about maintaining scale so that you don’t lose insurance policies as quickly as you sell them). These are the two issues that need to be solved for real success for any new micro insurer or a new platform for micro insurance.

Micro insurance and funeral insurance

Whether micro insurance is big in South Africa or not comes down to how one defines “micro insurance†.  There are major life insurance players that have funeral products with modest premiums, below R100 or even R50 per month. So those large insurers (major traditional insurers plus the bancassurers) are operating in this space already, but as “assistance business† as the current licence category is termed.

Under some definitions, South Africa is already one of the largest micro insurance markets in the world. On other measures, there are still plenty of excluded people who could benefit from appropriately priced, appropriate value insurance on a micro scale. I still hope to see viable products with premiums below R10 per month (and not on some misleading bundled basis) or even less on a micro-transaction basis.

These players are less interested in the particulars of a micro insurance licence because they have yet to see a material benefit. Product restrictions and the complexity of an additional licence don’t warrant lower capital since they aren’t actually constrained by regulatory capital but rather by their own view of economic capital.

Distribution innovation

Some of these players have tried innovative products (pre-paid funeral plans, allowing skipping premiums) with low, no or at best moderate success. The bancassurers push heavily into ATM, USSD and call centre sales rather than branch sales because they are lower cost, and sometimes lower risk of anti-selection. Getting life insurance via the banking apps is an easy step (and some have taken it) so probably the view is that a dedicated app just for insurance is unnecessary.  The banking brands (target of popular complaints as they sometimes are) are still generally well trusted.

The traditional insurers have invested in their own distribution channels, more typically broker- or agent-driven, for decades and this has carved them a good, profitable niche. Changing that for revolutionary distribution has risks.

Fraud and anti-selection are key concerns when you have the ability to turn coverage on and off.  I think many insurers are quite nervous about this. I’d love to see someone dedicating a small pot (R25m or something, so significant enough to do something with, but small enough for major players not to declare a national emergency if I doesn’t work) and experiment with something and see how it goes.

Micro insurance for assets

On the non-life side it’s more a definite gap. Acquisition costs, risk selection, differentiated pricing, claims underwriting and fraud risk (very serious fraud risk!) are non-trivial things to overcome.

Underwriting / risk assessment at policy inception is an expensive exercise. Claims stage underwriting can be problematic from a customer experience perspective if the policyholder genuinely expected to be covered and wasn’t (in which case even refund of premiums paid doesn’t help them, and with that the insurer has likely already incurred a loss based on the claims assessment and administration costs).

Credit insurance and micro insurance – but are we doing it right?

Credit insurance is the one area that sidesteps many of these issues. Clearly established need, assessment of ability to pay, distribution and lower fraud. It’s a pit this is also one of the areas that has achieved such a bad reputation (much of it deserved) for charging high premiums and making super profits based on the lack of a good market. It feels like we should be doing better here.

It would be amazing if someone could also consider what sort of loss they’d be prepared to take on a pilot programme to see if our worst fears are realized for asset insurance outside of the credit insurance space.

All the other hot trends

I’m staying close to developments on what I term “hyper selection† and also peer-to-peer insurance.  Some of this may present opportunities to unleash micro insurance from its current constraints.  I haven’t yet seen developments that seem ready for prime time and which solve what I view as the fundamental problems. Hopefully someone is already quietly working on something incredible in this space.

Micro insurance – opportunity for society, opportunity for business or both?

But the real answer to your question is that the supposed huge potential of micro insurance is a little difficult to pin down in pure commercial terms. Most of the success stories of micro insurance in emerging markets and public-private partnerships, NGO programmes etc.  Many of these also fail even with an explicit return on capital requirement.  Solving these issues on acceptable commercial terms for insurers who already have a successful business is a big question mark.

So even with my belief that micro insurance and inclusive financial services is a good thing for society, it’s less clear to me that it’s an easy buck to make for insurers.

In particular, he mentioned a specific assumption set he had seen including:

• ERP of 6.8%
• company specific risk premium of 4%

He also commented on how haphazard the use of risk premiums can be and referenced a few sources I’ve used myself.

The ERP of 6.8% does seem high. However, it really isn’t possible to comment on the specifics of the company specific risk premium without knowing the company.

Although I haven’t updated my research on this in a few years, in my own work I still generally stick with a range of 3% to 5% for an ERP, before considering company specific factors, liquidity, and so on. Historically / empirically estimated ERPs shouldn’t change frequently since the time series used is long. Another few years on a 20 year estimation period shouldn’t have much impact.

Why some practitioners persist in using too-high ERP estimates

This delves into the area of philosophy, but here are my top reasons (a post from 2011 also covers this):

• Naive analysis of the historical returns in the US over very successful periods for the US economy and stock market easily give high ERP estimates
• comparison of equity returns against short dated T bills rather than longer term T bonds.  (This is less terrible if you apply the premium to short dated rates, but still problematic for several reasons.  It is totally wrong if you apply the rate to bond yields.)
• Confusing of ERP with the total risk premium for a specific share (and more on that later in this post)
• Declining ERPs over time has boosted historical realised ERPs compared to forward looking estimates.

Quick updated estimate of market implied ERP

The use a market implied ERP is still useful as a forward looking measure, especially where a valuation relative to current listed market instruments is important (and it usually is). However, it’s not like this isn’t a subjective process either.

Using this old spreadsheet ERP estimation tool, I used the following quick assumptions:

• Dividend yield of 2.8% (from the All Share)
• Real risk-free yield (R210 yield, which matures in about ten years time) of 2.5%
• Break Even Inflation of 6.1% (based on nominal ten year bond yields of 8.6% and the 2.5% real risk free yield)
• Assumed real GDP growth of 1.8% per annum (based on a combination of sources including our reserve bank, world bank and others) showing 1% growth in the immediate future possibly getting up to 2% over time.  (None of this is pretty, and none of this will really materially increase GDP per capita).

This gives a market implied ERP of just 2.2%. Although this feels quite low, it shouldn’t be surprising given that we all recognise the economic fundamentals feel weak but our stock market is priced at record nominal levels.

Other estimates of market implied ERP

The reader sent me to this website, which shows market implied ERPs. It’s a useful resource. Here is the current view up to 30 September.

They end up with a higher ERP of 2.6%, which actually gives me comfort in my quick estimate of 2.2%, especially when I see that in August their estimate was only 2.4%, which is even closer.

The problem with the JSE as the market for South African companies

Tencent. In a word, that is.And other multinationals and entities with significant exposures outside of South Africa. I believe one of the reasons these ERPs are looking so low is that growth prospects outside of South Africa are better than inside South Africa, so the stock market prices look “too high” compared to South African country prospects, resulting in a too-low ERP.

The problem with “risk free” in emerging markets

Risk free is a term that makes less and less sense the more one thinks about it.  Is Greece government debt risk-free? Is South African government debt risk-free? What about the credit and liquidity characteristics?

Differences between these even within a country, say between the chosen nominal and real bonds used to estimate certain parameters can influence the estimates.

Although the credit spreads should in theory be removed in the estimation of ERP, it is hard to shake the concern that there might be second order implications that are not quite so simple.

So what about other countries then?

From that same site (I’m not going to do a whole range of other countries myself):

• UK 5.8%
• US 3.6%
• Australia  4.4%
• Canada 4.8%
• Switzerland 5.8%
• Germany 6.4%
• France 6.1%
• China 3.8%
• Brazil 2.0%
• India 2.3%

I don’t know enough about Brazil or India to know where there are specific issues for those markets, whether the methodology here falls down, or whether this is part of an emerging market trend.

But overall, these ERPs fall mostly within a comfortable range of 3% to 5% , with some stretching a little outside that on either side.

Company specific parameters

Standard CAPM models assume company specific factors are irrelevant because that risk can be diversified away and therefore should earn no reward. This is broadly true for a diversified investor investing in listed, liquid stocks. Empirically it is absolutely not true for privately held shares, illiquid shares, investments where control may be gained or given up and a host of other possible scenarios.

Estimating a reliable Beta to apply in the CAPM model is about as difficult as anything else covered here, so even then the ERP is not the end of the story.

When valuing a private company, one needs to look at how private companies are valued.

That’s not as vapid as it may sound. Valuation should be concerned with market consistency. This is why we speak about “market implied ERP” in the first place. So, if most other private company valuations (and transactions) factor in company specific factors such as:

• liquidity
• control
• small stock effects
• key person risks
• concentrated customer risks
• leverage (especially if not factored into the Beta).

then a valuation that aims to be consistent with other valuations should factor these in too.

That list isn’t complete and many of the items overlap.  Each one also needs to be carefully weighed against:

• is this not already factored into the ERP?
• is this not already factored into the Beta if one is used
• is this not already factored into the estimation of cash flows

That last one is key.  In fact, it is often the reverse that is true.  Known risks are not reflected in a true probability weighted best estimate manner in the future cash flows. Thus, without some risk adjustment in the discount rate, the value will be overstated.

Scenarios and cash flows as alternative ways to allow for risk

If multiple scenarios are used in the valuation, with attached probabilities, it may be that these risks are adequately considered in the cash flows and do not need an additional adjustment in the discount rate.  Key person risk or customer concentration risk can be reflected in a scenario with a 10% or 20% probability of seriously negative consequences of losing that rainmaker or specialist knowledge, or of losing a single customer along with 50% of revenues.

For larger businesses, with more diversified revenue streams, larger numbers of customers and fewer key person risks (or better ways of mitigating them), these risks tend can be reflected naturally in the cash flows since past experience will likely include some instances of the risk. (This links to another post on ENID.)

Consistent with the market

A useful resource here is PwC’s valuation methodology survey.

Final thought – is a company specific risk premium of 4% too high?

While it is hard to say without knowing the specifics of the company, it doesn’t strike me as obviously too high for a moderate sized, unlisted company.

There have been plenty of debate around the regulations, in part because of the dramatic financial and operational impact they will have, and partly because of how imperfectly worded they are and the scope for interpretation.

I’ll be posting about this more in the coming days.

Basing the premium on initial or outstanding balance

First, a real anomaly is the ability for insurers  to charge the capped premium rate either on initial loan balance or on the declining outstanding balance.

There are good practical reasons to want to charge a single, known amount to policyholders. It is easier to administer and policyholders have greater clarity on what they are paying.

The actual premium charged over the lifetime of a loan can be substantially higher where it is based on the initial balance rather than the declining balance, particularly for longer term loans. How a cap designed to moderate profits and improve value for money can allow such disparity is bizarre.

There is an interesting quirk here, which I hope is exploited to drive value for money and increased competition in the market. The credit life regulations require lenders to permit substitute policies where the policy meets the minimum regulatory required benefits. Where an insurer (or in practical terms, usually the lender) is charging a premium based on the initial loan balance, it becomes easier for a third party insurance company to offer a substitute policy at a cheaper rate, based on the lower actual sum assured partway through the loan or policy term.

I am not a fan of outright caps, although I recognise there are times when it might be the least bad regulatory intervention. The holy grail is a competitive market where consumers have access to information and providers compete for the business.  This will drive profit margins down to reasonable returns for the risk and capital required, and drive business into the arms of the operational cost (and distribution cost) competitive providers.

Those entities still charging on initial balance will actually help to drive this competitive market.

As much as I believe in the right of businesses to make money and make good money, value for money will be driven by competition and more of it is still needed.

Take deductibles for example. A deductible in an insurance claim decreases the number of claims an insurer has to deal with. More than that though, it reduces the claims where the administration costs of checking out the claim and paying it are large relative to the benefit to the policyholder. Sometimes these costs would have been larger than the claim itself.

In that case it does not make sense for the insurer to be processing and paying the claims – the increase in premiums required would be more than reasonable to policyholders.

Lemonade’s new “zero everything” removes the deductible and guarantees no premium increases for up to two claims per year. The reporting on this innovation has generally been silent on the practical reasons why this is hard for traditional insurers and easier for Lemonade.

Lemonade on the other hand explicitly recognise (or at least claim) that due to their AI-based claims underwriting process they can drive down costs and therefore manage small claims cost effectively.

This is important. Many complain about the lack of innovation in insurance. Removing deductibles isn’t innovation. Reducing costs to the extent it becomes viable is the step that enables differentiation and better value for customers.

You don’t even need to look at this proposal being counterproductive, populist silliness.