Insurers hit the jackpot as market recovers

The profits from investing their own capital, as well as the performance fees they make on investing other people's money, both depend on healthy equity markets to get things right.

And the latest set of results, including sector giants Old Mutual and Sanlam which was reported last week, show that they have hit paydirt.

A 29% increase in the All Share index during 2009 certainly helped.

Getting investment returns right is one important success metric for an insurance company. But it is the one management arguably has least control over. To really get a sense of how our insurance companies are doing, one has to dig into the work of their actuaries.

The critical measurement in any insurance company is "embedded value". The measure is an indication of what the business is really worth, but is based on a range of complicated assumptions that keep teams of actuaries busy. Essentially, embedded value represents the future profits that the insurer is going to make out of the policies it has signed up, added to the assets it currently has.

So each time you pay your monthly premiums, a certain percentage of that is profit for the insurers - add up the profits over the lifetime of your policy, discounted for the time value of money, and you get the embedded value for your policy.

The problem for insurers, however, is that their customers had become pretty shoddy at keeping up their payments during the recession of the past 18 months. And that leads to all kinds of head scratching by the actuaries. One of the assumptions they make is called "persistency", a measure of how long existing policies will remain in force.

During tough economic conditions, clients are more likely to quit paying their premiums and cancel their policies. That means lower persistency, which means lower embedded value. To try and address that risk, insurers are quick to warn of the dangers of cancelling your policies during recessionary conditions, and work hard to keep in touch with their customers and encourage them to keep paying.

Insurers also have some control over embedded value through their control of costs - the lower the administration and other costs, the more profits they earn from policies, and the higher embedded value.

That applies to the value of existing policies, but the other key issue to assess the life companies is how well they do at signing up new business. Good sales mean good things for embedded value, provided it's done at profitable levels - a positive margin. If there's no profit for the insurance company, its embedded value is not helped by new business.

So how did our insurers do in keeping persistency up, costs down, and signing up new clients? It is all captured in their embedded value.

Liberty Life saw a decline of 11%, Sanlam managed a 2% increase, Metropolitan a 6% increase and Old Mutual a 45% increase. Old Mutual certainly looks like the outlier, but that's because of an anomaly in its results.

In 2008 (and earlier), Old Mutual committed that sin of selling new business with a negative profit margin in the US - it sold guaranteed return polices, which promised to pay the holder a fixed percentage. It then bought high-yield corporate bonds that paid a high enough yield to be able to deliver the returns it had promised policyholders.

The problem is that when the financial crisis hit, Old Mutual was stuck with a commitment to policyholders on one side, and a decimated source of revenue on the other side. But, during 2009, the US corporate bond market recovered fast, and the embedded value on those policies turned positive, leaving Old Mutual in a safe position.

Sanlam's thin increase wasn't due to growth in new business; rather it was due to better cost performance and lower claims on its policies.

Liberty's decline was mainly driven by declines in the value of the asset base of the company and problems with persistency. Metropolitan saw a sharp decline in the new business it signed up, largely due to the termination of a range of products, but saw embedded value improve thanks to changes in assumptions behind its life policies.

But to really see what the market thinks of the insurer's prospects check the share prices relative to embedded value. Old Mutual's share is 30% below its theoretical value, Liberty's is 12%, Metropolitan's is 20%. Sanlam is the only one whose share price is currently around what the group's theoretical value is. That is the evidence that makes Sanlam stands out as the most respected insurer in the market. - banknotes@intellidex.co.za