Non-life insurance businesses have faced a volatile and tumultuous period, from the impact that COVID-19 had on the industry to climate change and the knock-on effect this has had on the claims – the list goes on.

This period of uncertainty has left insurance businesses feeling the crunch, not only in their operations but also in the value of their business. While the core elements of the insurance business models has not changed, the risk profile in the industry and that of global equity markets has shifted, making for an interesting impact on value.

Although the fundamentals of these businesses have not shifted significantly, the re-evaluation of cost structures, the adaptation of risk assessment processes and the scale at which technology has been implemented across the value chain have all led to a position where they are better equipped to adapt, improvise and tackle the unknown.

The question therein lies, how do we prescribe value to these businesses, particularly in times like these? How do we account for the tumultuous past and rapidly evolving future? In this piece, we will unpack five key considerations when determining the intrinsic value of non-life insurance businesses in the current environment in South Africa.

Non-Life Insurance

1. Gross Written Premium Considerations

A non-life insurer’s primary income source is insurance premiums. What drives that? Simple, consumers (either individuals or corporates for the most part) taking out insurance policies. Ideally, the entity would want more consumers taking out insurance policies than existing policyholders cancelling or moving their policies, but we will save that for later. It’s a simple equation, but in the current macro environment with rising interest rates, electricity price increases and an unsteady source of power (to say the very least), the South African economy is facing recessionary pressures and ultimately, the consumers, which these insurance businesses are relying on, are being squeezed.

While it is imperative to understand the overall trend, when trying to interpret what this means for an insurance business and their future outlook, one needs to understand the Living Standard Measure (“LSM”) of the consumers and the products offered to them. For those consumers with lower disposable income, the propensity to spend on specific insurance products becomes less desirable and more unattainable. Those who may have previously held insurance may no longer see this as a necessity and may choose to forgo this in an attempt to release and redistribute their income to other areas. This will not only impact the new business, but it may also impact insurers existing books; therefore, it is imperative to understand the segmentation of the insurers existing and target clients when looking at developing top line forecasts and how that will play out in line with general macro factors impacting the end consumer.

Typically if the macro factors are not playing in the consumer’s favour, significant top line growth is going to be challenging, and this should be carefully evaluated when building out forecasts as these businesses will seek to improve the bottom line through other levers.

Other key considerations when assessing top line forecasts are as follows:

  1. Brand equity in the market;
  2. Historic and forecast price points;
  3. Product innovation; and
  4. Historic lapse curves and churn rates.

2. Claims considerations

Now that we’ve discussed some key considerations from a top line perspective, the next big-ticket item is assessing the claims cost for the insurer.

Of late, the South African industry has faced the perfect storm. Top-line performance has been heavily impacted whilst claims costs have also been exacerbated through factors such as the pandemic (of which there were both pros and cons), continuous (and seamlessly never-ending) load-shedding and changes in weather patterns due to climate change, to name a few. To put it into perspective, reinsurers such as Willis Re launched a new Hail Catastrophe Risk model, quantifying the risk from damaging hail events across South Africa. Insurers experienced weather-related claims over the 2022 financial period which were in excess of the average experienced over the preceding years demonstrating the severity of the change in weather patterns.

Whilst the pandemic provided some respite to the motor-insurance segment of the market, travel patterns have reverted to levels similar to that experienced pre-COVID as people across the country start returning to the office1. This becomes an important consideration when analysing historic claims costs, particularly over 2020 and 2021, when the large majority were at home or where travel was less frequent than previously seen. A starting point to this would be to push the historical analysis out slightly further to get a view on what ‘normal’ (used in inverted commas because who knows what normal is anymore) levels would be and how the forecasts stack up against these.

A critical factor when carrying out an analysis of historical performance as well as when predicting the outlook for claims cost over the forecast period, is considering the product mix in the underlying insurance books. Most non-life insurance businesses will have a mix of personal lines and commercial businesses. Understanding the underlying composition and lines of business is a fundamental step when carrying out this analysis. Linking this to the forecast progression in the product mix is essential when forecasting the performance of the claims costs in the business given the varying risk profiles attached to each.

A major grey area, however, comes in when trying to understand how to account for abnormal or catastrophic (“CAT”) events. Do you adjust the cash flows? Do you adjust the discount rate? Do you exclude these entirely as they are somewhat impossible to predict? While there is no correct answer, the same principle in valuation remains, and as past events are not an indicator of what may happen in the future, the cash flow impact may be near impossible to predict. Therefore, adjusting for future CAT events or once-off anomalies is best excluded from the cash flows and accounted for in the discount rate. Being extremely subjective and up to interpretation which will no doubt differ from individual to individual, displaying the consideration in the discount rate is a sure way to demonstrate to investors, stakeholders or any interested party, for that matter, that the risk has been considered and accounted for appropriately.

3. Reinsurance

Premiums and claims are relatively (used rather loosely) similar across non-life insurance businesses and where the significant differential will come in, in most instances, is in how each insurer mitigates its risk through reinsurance.

In layman’s terms, reinsurance is a form of insurance, on insurance. An insurer could incept several treaties across different components of its underlying book or risks and cedes a certain portion of that risk away, limiting its exposure and managing its balance sheet effectively given the stringent liquidity requirements the business has to comply with.

Should the insurer be able to manage risk levels to an acceptable extent, as determined by the reinsurer in the treaty, the insurer will earn a commission which has the potential to bolster earnings in addition to the aforementioned risk mitigation and balance sheet management. It’s a powerful tool in an insurer’s arsenal and is a vital cog when looking to value an insurance business.

When looking at the income statement of an insurance business, sound knowledge and understanding of not only the concept of reinsurance but also the ins and outs of the various treaties, including the retention limits, the excess of loss limits, the reinstatement requirements, the commissions’ sliders and the overall costs of the reinsurance is of utmost importance. This will allow one to overlay these elements with the forecasted premiums and claims costs to arrive at an accurate and representative view of how these will impact the overall cash flows and balance sheet requirements of the business.

4. Marketing engine

As the local non-life insurance market becomes more saturated in recent times, the effectiveness of an insurer’s marketing engine becomes more paramount, specifically for direct insurance companies. One metric stands above the rest when speaking of marketing efficiency in insurance, particularly for the direct non-life insurance business – the premium factor.

The premium factor (P-factor), indicates the success of the business in its marketing spend and the ultimate conversion of said spend into new business. A lower P-factor indicates the relative success of insurance businesses’ marketing efforts in gaining new clients.

With marketing spend being a core component of every non-life insurance business’s operating expense base, it becomes increasingly important to understand the overall strategy of the business in relation to marketing, the relevance of such to the business as well as the marketing engine and various routes to market for the business. Considering these elements and understanding where the business is positioned in the market and its existing foothold, will give a good sense of understanding the progression of a business’s P-factor over time and how it will likely trend moving forward.

For example, a business seeking to penetrate the market and gain market share (which in turn is looking to increase brand equity and awareness in the market) will most likely have a higher -factor than those more established players in the market. Understanding this when drawing comparisons in the market is critical to understand when interpreting and forecasting the P-factor as well as the related acquisition expense ratio (a ratio of acquisition expenses to total premiums).

In addition to the above, grasping the saturation point for the business in terms of policies sold and marketing spend will better help understand if, and when, an insurer will reach a steady state, and this will help determine what an appropriate run rate will be on the related ratios.

5.Understanding the businesses ability to innovate and adjust to changing market conditions

Whilst the preceding four points relate largely to the financial performance of the business and can be interpreted primarily through financial analysis, the final element is more strategic in nature. It speaks to the inherent culture of the business and the leadership team.

As mentioned, historically there have not been fundamental shifts in the core insurance model. Recently, however, tech, as in almost every industry, has disrupted the insurance model. As we all experienced through the pandemic, a seismic shift can take place overnight. Being forced to wear a mask and stay at home for months on end was a rude awakening for every single person on the planet.

The point is, that we are susceptible to events that can cause drastic changes in the blink of an eye. The ability, specifically for an insurance business, to adapt, improvise and overcome these has been thrown into the spotlight. Coupled with a market that is becoming increasingly more saturated, where consumers are being squeezed, and insurance products are becoming a nice-to-have as opposed to a necessity, innovation will need to be a primary focus for management teams moving forward.

Innovation however does not come solely through the integration of technology. Product innovation to account for the ever-changing landscape and risk profiles has become a key trend across non-life insurers. Customers will continue to seek bespoke, affordable products that cater directly to their needs and businesses that can meet those demands will be sure to continue to flourish in the market.

Although largely subjective and open to interpretation (which no doubt will differ based on who you speak to), understanding the ability of a non-life insurer to innovate, understanding the overall strategy of the business, as well as the quality of the leadership that sits behind the brand, become essential qualitative considerations when assessing the intrinsic value of a business

The beauty of valuing a business is that there are endless considerations that go into every element of the process. Every different type of business model will have its own nuances, with the non-life insurance industry being no different. Whilst the above is by no means an exhaustive list of potential considerations when looking at valuing a non-life insurance business in the current environment, these represent, key components of the process.

At Step, we provide a unique method of overlaying the technical fundamentals required to execute a valuation with the relevant commercial aspects and related market conditions underpinning business performance. This will assist in understanding the business’s overall value and the key drivers and risks in the business model upon which the value has been determined.

References:

  1. Based off Discovery data suggesting people are at the office 3 days per a week – Ntando Thukwana (2022). South Africans seem to be working from home two days a week, Discovery data suggests. News24, 15 July 2022. Available at: https://www.news24.com/news24/bi-archive/south-africans-seem-to-be-working-from-home-2-days-a-week-2022-7 (Accessed: 19 May 2023).
Jacques Tredoux

Author Jacques Tredoux

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