Authors: Christine van Heerden & Caesar Balona
Insurance companies are finding the current times increasingly more challenging and it is becoming ever more difficult to meet shareholder’s expectations of profits and return on capital.
The difficulty insurers face is that they have limited resources available to manage a few changes which are expected to have a significant impact. Management resources and oversight is a resource that is not easily scalable, hence the need to prioritise carefully.
QED has developed a capital and profit toolbox, which includes a framework for identifying areas which are likely to yield the greatest improvement to value, as well as levers which can be used to improve each area.
The framework follows a three step process:
1. Diagnostic phase
Identify key areas which require improvement, and levers which can be used to better results. This includes analysis of historical and projected profit and loss statements and balance sheets, as well as workshops with Senior Management and the Board, strategy review and forming the core hypothesis for what is required to improve results. The outcome of this phase is to select the most suitable products from the toolbox. These products can then be recommended to management and the Board for implementation with an initial estimate of the impact.
2. Implementation Phase
This stage involves implementing the actual projects chosen by management in the diagnostic phase including implementing the process changes and delivering the expected value.
3. Monitoring phase
This includes tracking of the expected benefits versus the actual benefits to establish the effectiveness of the various measures and to ensure that the result is achieved and is maintained over time.
The profitability section considers the key drivers of an insurer’s income statement, namely revenue, expenses, claims, reinsurance, and investments. The performance of each of these areas is assessed as part of the diagnostic phase to identify which are weak areas for the insurer. Once these areas have been identified, tools are selected from the toolbox based on what is expected to yield the greatest value given the insurer’s circumstances.
The diagram below sets out each of these areas, as well as the tools available in each area to assist with improving the result.
From the toolbox above we can see that there are various options offered by QED to assist in improving the performance of each area.
For example, if it is identified that claims are an area of concern we would consider the pricing methodology currently employed by the company, as well as the data available to determine whether a pricing review is required, and what type of review (Burning cost, GLM or gradient boosting) would be most applicable. It may also be identified that fraud is the driver of the problem, which would then indicate that a fraud analysis should be conducted.
As in the profitability toolbox we consider key drivers of the overall performance, and then consider levers available to improve these results.
If for example we were to identify that a large portion of the overall capital requirement is market risk driven by interest rate risk, we would consider an investment strategy which seeks to minimise the interest rate risk of the insurer.
QED has a broad offering, which is centred around combining the fields of core actuarial work with enterprise risk and capital management and data science, to assist insurers where the greatest value can be added.
To determine which projects will provide the greatest increase in value we require a holistic approach to manage and select projects to improve profitability. We require a method of comparing the benefits of different project options to ensure that the measures selected for implementation are expected to generate the greatest value. For example, we may want to compare an expense cutting initiative against implementing a new reinsurance structure which is expected to cut the capital required by 30%. The key question to answer is: which of these two options is better?
We need to develop a framework that will help us decide between the options by determining which option is expected to generate the greater value. We define value as the return generated in excess of the cost of capital (CoC).
Thus, we need to accurately quantify each element of the value equation: profit and cost of capital.
When considering the profit, we need to determine which profit figure to use. In South Africa, this could be IFRS profits, or SAM profits. In other countries, the only choice may be IFRS profits, as the regulatory basis used to calculate profit may not differ significantly to IFRS. Of course, there is also the ever-present consideration of tax implications.
Having decided the basis, the profit figure may need to be further adjusted for large losses and expenses for significant once off investments. For example, in the year of assessment, we may have invested heavily into expanding our office space. These costs are not expected to occur frequently and would result in the value of future projects appearing lower than they actually are. This could then lead to projects being rejected, as their true value is supressed.
Investment returns could also be normalised or adjusted. Again, infrequent events could impact profit greatly in a single year, such as a financial crisis, artificially lowering the possible value from a project.
There are also second order effects to consider. Our profit figure may be altered by the projects proposed. One key consideration is the contribution of projects to our fixed and overhead expenses. It is important then to consider underwriting profitability as well as profitability after allowing for overheads and operational expenses. Other second order effects must also be considered such as cross-sell opportunities generated by new products. These all tie in to complexities of value based management that cannot be discussed adequately in an introductory article.
Cost of Capital
To measure the cost of capital we need to consider shareholders’ expected returns on the capital of the company. This will be based on the IFRS equity value.
To truly understand the cost of capital we need to understand capital requirements on regulatory capital, any risk buffer which the company chooses to hold, as well as excess capital. The return generated on each component will differ, impacting management’s ability to generate the shareholder’s expected return on capital.
Shareholder’s expected return on capital will be based on their perception of risk within the company. Investors would require a return from investing in the insurer that is higher than less risky investments such as bonds or cash. Otherwise, they would just invest in those assets, and not bother with the insurer. When an investor chooses to invest in an insurer, it is an equity investment, and hence should attract higher returns for the higher risk. Furthermore, insurance companies are often viewed as riskier, as understanding the performance and drivers of an insurance company tends to be more difficult for the average investor than understanding the performance of other companies.
We will consider as an example a company which holds only the regulatory capital required and returns any additional capital to investors in the form of dividends. In practice this is unlikely to occur, as companies will want to hold some buffer to ensure that capital requirements can be met in changing conditions, however this simplifies the example for this article. We further assume that their regulatory capital requirement is 500m, and shareholders have a return expectation of 20%.
For this company their cost of capital is 100m.
Assuming in this example that the company generates a profit of 150m in a given year, it follows that the value generated in the year is 50m:
There are many complexities regarding determining the value of a company based on the above method, including the allocation of capital to subsegments, normalising profits, better measurement of long-term results etc. This article does not seek to detail these but provides a high-level overview of the methodology. When assessing the value of projects, QED is able to consider these complexities and apply appropriate solutions.
We now have a method of measuring and comparing the value created by different projects, to enable us to implement those with the greatest value generation.
Let’s use the method to determine whether we should embark on an expense cutting initiative or implement a new reinsurance structure that will reduce regulatory capital by 30%.
An insurance company is considering two options:
A. Reduce expenses by 35m. The expected impact on total profit is an expected increase of 25.2m after tax.
B. Change in the reinsurance structure. The expected impact is a decrease in the regulatory capital requirement by 30%.
There are only sufficient human resources to implement one project in the current year. Using the methodology described above we can determine which is expected to provide the greatest impact.
The value expected to be generated by the insurer after implementing B is 80m, a 30m improvement from the base case.
Given the comparison of the above two options, it is clear that the change to the reinsurance structure (option B) is expected to generate the greatest value for the insurer and should be implemented first.
QED provides a framework that not only helps to measure the value of projects but provides insurers with numerous projects to choose from. These projects range from simple changes to key areas such as basic pricing and reserving, to cutting edge machine learning and risk management tools. QED can assist with the selection of projects that maximise value while providing a robust framework to measure value.