Understanding value in the life industry

Gareth Stokes, FAnews Online Editor

How do you define value in the life insurance sector? The answer to this question varies from one stakeholder to the next. If you ask a policyholder what their cover is “worth” they will probably refer to the sum insured. In stark contrast the insurance b

An accurate measure is imperative because the life insurance industry boasts global premium income of some $2,500 billion and $18,000 billion assets under management. Dr Lukas Steinmann, co-author of the sigma study, says that a life insurance “profitability indicator” is indispensable to all stakeholders. An accurate measure of performance can be used by insurance company management to steer their businesses and make operational decisions, by investors to guide their investment decisions, and by policyholders who want assurances about the long-term viability of their chosen risk cover provider.

Unpacking life insurance profit

Before we measure life insurer profits we need to know how these profits are generated. Swiss Re notes that profit accrues to these companies by way of insurance and investment operations. If we drill down a bit further we find that the principle sources of profit are underwriting margin (premiums received versus claims paid), the investment result (returns generated on accumulated funds) and fee income. Profit profiles vary from company to company in accordance with their product mix – because pure risk products (such as term or disability insurance) have a different profit footprint to savings products (such as annuities). “For example, insurers’ results for protection products rely heavily on underwriting experience, while earnings from savings products depend mostly on fee income and the allocation of investment results,” observes Swiss Re.

The biggest difficulty in reporting on life insurer profits is the long-term nature of the business. “Life policies run over periods of 10 to 40 years which makes profitability measurement complicated,” observes Steinmann, in a podcast discussion on the study. Life insurers set the price for a policy (by way of premiums) at the point of sale whilst costs run over the life of the contract. “There are many factors that may cause underwriting results to deviate from assumptions and reduce earnings,” he continues. The bottom line is that an insurer only knows whether a sale is profitable or not when all of the policy obligations are met, typically decades after the implementation date.

Existing accounting methodologies cannot reflect this long-term value. “The statutory and GAAP/IFRS accounting-based indicators do provide a high-level picture of life insurers’ historical performance, but they fail to fully capture the long term nature of life and health insurance operations,” says Dr Milka Kirova, the other co-author of the study. He notes that you cannot learn much about a product’s risk profile and its likely impact on profitability under different conditions. “A life insurance balance sheet is a conglomeration of many different contracts written over a number of years. And each type of contract from the past may contributed in a different way to the current year profit,” agrees Steinmann. There are also a number of factors – including regulatory oversight – that hamper “like for like” comparisons of life insurance companies from one jurisdiction to the next.

Annual report ignores product risk

“Profitability as reported in accounting is difficult to interpret and one can hardly draw meaningful conclusions on how a company creates value and earns profits from these reports,” adds Steinmann. “A profitability indicator has to be forward looking and consistent in the way assets and liabilities are valued.” The industry has addressed these difficulties by developing embedded value reporting frameworks in use at most large life insurers today. European insurance companies use market consistent embedded value methodologies (similar to Swiss Re’s MCVE) to take into account the cost of capital, cost of writing business and cost of various embedded guarantees.

Over time different insurance companies have developed their own performance metrics to supplement traditional accounting-based financial reporting. There are pros and cons to these decisions. On the plus side stakeholders might find the information more accurate, and therefore more valuable. On the negative side there is a fine line between valuable information and confusing stakeholders – with the added twist of not being able to compare a particular life company against its peers. In conclusion: “The market consistent embedded value concept (MCEV) or Swiss Re’s very similar Economic Value Management framework will only prove useful for external reporting once they gain wide acceptance.” It is hoped that insurance specific accounting rules and new regulatory frameworks will lead to standardised financial reporting and make insurance profitability more accessible to all stakeholders in the future.

Editor’s thoughts: Each financial services stakeholder has a different set of needs. While insurers, stock market analysts and regulators no doubt obsess over profits of life insurers, there is a sense brokers are less worried over insurer profit and loss statements than with their operational ability. Do you consider life insurer annual reports before selling its policies? Add your comment below, or send it to gareth@fanews.co.za