By Sithembile Bopela.
What is insurance?
Insurance is a financial arrangement between two parties: 1) the insurer who takes on risk to redistribute the cost of unexpected losses and 2) the insured party (or insurance policyholder) who makes regular payments (called premiums) to the insurer for a promise to receive compensation in the event of one or more covered losses such as accidents, theft, or natural disasters.
An insurance company, therefore, collects these premiums from many policyholders to create pools of funds - these are referred to as claims reserves or insurance reserves. When a claim is made, the insurer uses these funds to compensate the policyholder(s) for their loss, according to the terms of the policy.
Different types of insurance?
Short-term Insurance
This type of insurance is designed to provide coverage over a relatively short period (typically 12 months), with the option to renew at the end of that period. Short-term insurance includes:
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Property insurance: Offers protection against damage or loss of property due to events like fire, theft, or natural disasters. This encompasses both personal property insurance (e.g., home and contents insurance) and commercial property insurance.
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Vehicle insurance: Covers damage to or loss of vehicles, and includes comprehensive coverage against loss, fire, theft, hijacking etc, as well as liability cover.
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Liability insurance: Offers protection against legal claims arising from damage and injuries to property or people.
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Travel insurance: Coverage for various risks associated with travelling, such as medical emergencies, trip cancellations, and luggage loss.
Long-term Insurance:
Long-term insurance provides protection over an extended period, often several years or even a lifetime, and includes:
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Life insurance: Guaranteed payment of a specified amount to a designated beneficiary upon the death of the insured party, thus offering financial protection to the beneficiary as opposed to the insured party.
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Health insurance: Also known as medical insurance, covers the cost of an insured person's medical and surgical expenses per the policy outlines. In South Africa, this is often referred to as medical aid, which is slightly different in structure from health insurance found in other countries. Medical aid, or medical schemes, offer a comprehensive healthcare solution that can provide coverage for various medical expenses and hospitalisation, depending on the plan type.
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Disability insurance/income protection: Provides financial support to the insured in the event of a disability or other events that prevent them from working.
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Annuities and retirement annuities: Pay out a fixed stream of income to an insured individual after retirement.
Reinsurance
Simply put, reinsurance is insurance for insurance companies. The insurance company cedes or transfers some of the risk it has taken on from primary policyholders to the reinsurer who assumes all or part of those insurance policies. This allows insurers to expand their underwriting capabilities through risk transfer. Risk transfer reduces the likelihood of the primary insurer (also called ceding company) facing large claim payouts, for example during a natural disaster that affects an entire city. This helps insurers remain solvent as they can pay out claims while being able to recover all or part of those payouts.
Key financial performance metrics
Some of the main financial metrics and ratios to look at when analysing the financial performance of an insurance company include:
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Premiums written: Also termed gross written premiums is the total amount of insurance premiums written by the company during a specific period, indicating the volume of business generated. Net written premiums factors in deductions such as agent commissions, legal expenses, and reinsurance costs. The growth and sustainability in premiums written over time are an essential gauge of the company's ability to adapt, manage risks and meet customers' needs while maintaining financial stability.
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Premiums earned: This represents the amount due to the insurance company for the portion of an expiring policy, i.e., what an insured person paid (excluding prepayments) while the policy was in place. This is crucial for understanding the revenue actually recognised from underwritten policies.
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Mortality: The rate at which death occurs within a specific population is referred to as mortality. For a life insurer, this measure, and specifically accurate predictions of mortality, are crucial as they impact the pricing of life insurance policies and the level of reserves set aside for claims. This is because higher-than-expected mortality rates can reduce profitability due to increased claims payouts, and vice versa.
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Persistency: This is a measure of the proportion of policyholders who continue their insurance policies without lapsing or cancelling them. High persistency generally ensures continued premium inflows and reduces administrative costs associated with acquiring new policyholders. On the other hand, low persistency may indicate customer strain or dissatisfaction and can strip away profitability due to a subsequent loss of premiums and high acquisition costs for new clients.
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Loss ratio: This measures the percentage of premiums paid out as claims, highlighting the company's effectiveness in underwriting policies. A lower ratio indicates better profitability, but very low ratios might also suggest overly conservative underwriting, which in turn could limit business growth in the long term.
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Expense ratio: The ratio of operating expenses to net earned premiums. A lower ratio indicates that a larger portion of premiums is available for paying claims and generating profits, thereby enhancing the company's financial health. A high expense ratio may suggest operational inefficiencies or macroeconomic headwinds (e.g., higher cost inflation) as a smaller portion of premiums is available for paying claims and generating profits, thereby weakening the company's financial health.
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Combined ratio: This is a measure of profitability calculated as the sum of the loss ratio and the expense ratio. A combined ratio <100% indicates that the company is making an underwriting profit, while a ratio >100% implies an underwriting loss, i.e., the company is paying out more money in claims than it is receiving from premiums.
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Solvency ratio: This ratio indicates an insurance company's ability to meet its debt and other obligations. A higher solvency ratio suggests a more financially stable company capable of covering claims, paying out benefits, and withstanding financial stress.
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Investment income: Because premiums are received upfront, but claims are paid out over time, insurance companies invest these funds. The return on these investments can significantly impact an insurer's profitability, making investment income an important metric.
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Operating ratio: Similar to the combined ratio but focuses on operational efficiency by subtracting investment income from the combined ratio. A lower operating ratio indicates better operational efficiency and profitability.
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Embedded Value: Embedded Value (EV) is the sum of the present value of future profits from existing business (also termed in-force policies) and the adjusted net asset value (NAV). This measure provides a comprehensive look at a company's intrinsic worth - denoting the profitability of its current operations and financial health, without considering its capacity to generate new business.
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Return on Embedded Value: Return on Embedded Value (ROEV) calculates the rate of return on the embedded value over a specified period. This indicator shows how effectively an insurance company is generating profits from its in-force business relative to its embedded value. On a relative basis, a higher return on EV is positive as it indicates strong value creation for shareholders through efficient management and improved profitability, and a solid foundation for future growth.
While this is not an exhaustive list, these metrics provide a good health check of an insurance company's underwriting performance, operational efficiency, financial health, and future growth prospects. However, it's also crucial to understand the factors that impact the company specifically, including its market position, product mix, geographic footprint or exposure, regulatory environment, and other macroeconomic factors that could affect its performance.
Regulation
Insurers are subject to regulatory oversight to ensure the balance between consumer protection, affordability, and operational resilience, such as ensuring insurers maintain sufficient reserves to cover claims and protect policyholders. In South Africa, the insurance sector is regulated by the Financial Sector Conduct Authority (FSCA), ensuring that companies operate fairly, transparently, and in the best interest of consumers.
Macroeconomic impacts
The industry faces numerous macrolevel economic factors such as inflation and changes in interest rates that impact insurance companies' performance and prospects. For instance, as inflation increases, insurers face upward pressures on their operational costs, such as salaries, utilities, and technology expenses as well as the costs associated with settling claims. These can costs of medical treatments, auto repairs, replacement parts, and legal expenses, among others.
These higher costs usually necessitate an increase in premiums to maintain profitability. This can lead to challenges in customer retention, or lower persistency, as policyholders facing pressure on their disposable income instead look for more affordable options or cancel their insurance products altogether.
Insurers also rely on investment income to manage their funds. During periods of high inflation, returns on investments like bonds might underperform, prompting insurers to adjust premiums to ensure overall financial stability. In the same breath, periods of low interest rates translate to lower returns on these investments, thereby weighing on investment income.
Since insurers are required to maintain adequate reserves to cover future claims, inflation can erode the value of these reserves, essentially making them insufficient over time. Meaning that companies must set aside higher reserves to avoid possible bankruptcy, which in turn raises the overall cost of insurance policies.
Similarly, since interest rates are vital in discounting future liabilities, a low interest rate environment increases the present value of future claims - requiring insurers to hold more capital. Conversely, high interest rates make borrowing more expensive, affecting an insurer's capital structure and operational flexibility.
The combined effect of inflation and interest rates can create a volatile macroeconomic environment which can strain a company's ability to meet its debt obligations.
Lastly, a tougher economic landscape typically forces insurers to be more stringent in their underwriting practices, potentially tightening policy requirements or excluding certain risks. This limited insurance capacity can, in the absence of strategic management action, lead to heightened competition, lost premiums due to lapsed or surrendered policies, and ultimately dampened profitability.
Positive support and risk factors in the local insurance industry
The South African insurance sector boasts strong fundamentals and opportunities for growth, amid changing demographics and consumer needs and preferences, as well as rapid development and adoption of new technologies. Still, the sector faces challenges related to economic instability, regulatory changes, and technological disruptions.
