COMPARING APPLES TO ORANGES: Choosing the right project to increase company value

Authors: Christine van Heerden & Caesar Balona

SEPTEMBER 2020

QED Actuaries & Consultants

QED INSIGHT

QED INSIGHT | 02 SEPTEMBER 2020

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:

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. This stage involves implementing the actual projects chosen by management in the diagnostic phase including implementing the process changes and delivering the expected value. 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.

1. Diagnostic phase

2. Implementation phase

3. Monitoring phase

QED INSIGHT | 03 SEPTEMBER 2020

PROFIT TOOLBOX

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.

Next best productGeospatial analysis Branch location & pricing support

Gradient boosting

Burning cost analysis

Fraud analysis

GLM

Deep learning on claims reserves to improve accuracy

Gradient boosting

Liquidity analysis Asset liability modelling Investment strategy optimisation

Reinsurance analysis Reinsurance optimisation

Functional cost typeExpense allocation

to LoBFixed vs variable

cost analysis

* An expense peer comparison can be performed if QED has sufficient data around expenses of market peers.

Revenue

Expenses

Investments

Reinsurance

Claims

QED INSIGHT | 04 SEPTEMBER 2020

CAPITAL TOOLBOX

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.

Risk Appetite Framework and Target Capital

Financing and alternative Risk Transfer

Fungibility Analysis

Capital Tier Analysis and Optimisation

Premium & Reserve Risk Calculation

Catastrophe Risk Review

Solvency Reinsurance

Geo-Spatial Analysis of Exposure

Product Mix and LoB Mapping

SAA/Investment Strategy

Rebalancing for Concentration Risk

Derivatives to optimise Investment Risk

*Regulatory Risk Model Validation

Asset Liability Management

Receivable Management

Internal Model for Operational Risk

Insurance for Default Risk of Receivables

*Loss Absorbing Capacity of Deferred Taxes review

and optimisation

Credit Risk Modelling

*These items are applicable in the South African environment under SAM.

Capital

Insurance Risk

Credit Risk

Other (LACoDT, OpRisk)

Market Risk

QED INSIGHT | 05 SEPTEMBER 2020

PROJECT SELECTION

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).

Simply put:

Thus, we need to accurately quantify each element of the value equation: profit and cost of capital.

ProjectWhen 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.

Value = Profit - Cost of Capital

QED INSIGHT | 06 SEPTEMBER 2020

Cost of CapitalTo 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.

CoC = Capital x ReturnCoC = 500m × 20% = 100m

QED INSIGHT | 07 SEPTEMBER 2020

Value1

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:

Value = Profit - CoCValue = 150m - 100m = 50m

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.

Option A

The value expected to be generated by the insurer after implementing A is 75.2m, which is a 25.2m improvement from the base case;

Value = (150m + 25.2m) - 100m = 75.2m

Option B

Regulatory capital reduces by 30% from 500m to 350m. The remaining 150m is returned to shareholders as dividends, meaning that capital held

in the company reduces to 350m.

Value = 150m - 70m (350 x 20%) = 80m

The value expected to be generated by the insurer after implementing B is 80m, a 30m improvement from the base case.

Conclusion:

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.

1 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.

QED INSIGHT | 08 SEPTEMBER 2020

Anton Reinke FIA FASSAAssociate Director

D +27 11 038 3742M +27 82 552 0524anton.reinke@qedact.com

Speciality: General Insurance

Anton is a Fellow of the Actuarial Society of South Africa and a Fellow of the Institute & Faculty of Actuaries UK. He has more than 18 years’ experience working for several insurance groups.

Christine van Heerden FASSA FNASSenior Actuarial Manager

D +27 11 038 3732M +27 72 738 3725 christine.van.heerden@qedact.com

Speciality: General Insurance

Christine is a Fellow of the Actuarial Society of South Africa and a Fellow of the Nigerian Actuarial Society. She has been consulting to insurance companies across Africa for the past 7 years. Christine is the holder of a practising certificate in short term insurance issued by the Actuarial Society of South Africa.

Caesar Balona FASSAAssistant Actuarial Manager

D +27 11 038 3745M +27 72 439 4512caesar.balona@qedact.com

Speciality: Short-term Insurance

Caesar is a Fellow of the Actuarial Society of South Africa. He has 5 years’ experience in short-term insurance and data analytics. Caesar is responsible for a range of traditional short-term insurance work including reserving and pricing, as well as developing several of QED’s cutting-edge Data Science products.

CONCLUSION

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. If you would like to discuss any of the above in greater detail please reach out to your QED contact, or contact Anton Reinke and the authors Christine van Heerden and Caesar Balona on the details below:

QED INSIGHT | 09 SEPTEMBER 2020

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