The enigma of Enterprise Group (Part 2)

The embedded value of a life assurance company is an estimate of the economic value of that life company to shareholders, excluding the goodwill attributable to future new business and the value attributable to minorities.

The embedded value calculation enables a shareholder to ascertain the profit to be generated by that life assurance company from its existing book of life and investment policies, as opposed to the accounting profit. Why the differences between accounting profit, and embedded value earnings? A life assurance company issues to policyholders a stream of short-term to long-term promises, supported by a pool of shareholders equity and reserves.

There is no way, at the time of issuance of a promise, for a policyholder to know whether that promise will be honoured on the distant due date.
Thus, out of bitter experience from defaulted promises by life companies in several jurisdictions, the convention has emerged of extreme sobriety in the recognition of profits.

Promises

Insurance regulators place the understandable needs of policyholders to be able to trust those promises above the desire of shareholders to receive dividends and to witness the prompt recognition of profits.

The regulators require life companies to put money aside to pay for an expense called “change in insurance contracts-life fund”.

The money for that expense flows into the liability called “life fund-insurance contract liabilities” on the balance sheet of Enterprise.

Unlike the expense of “insurance benefits and claims” which are actual claims settled in an accounting year with cold cash, the “change in insurance contracts-life fund” expense is an estimate of anticipated future benefits and claims to be paid to existing policyholders.

Long-term promises, of necessity, rely on estimates about the future investment performance of funds entrusted to the life companies by policyholders; they rely also on future inflation estimates.

Recognising the fallibility of estimates, actuaries charged with making those estimates swaddle their best estimates with additional margins to absorb optimistic errors harmful to policyholders.

For example, if an actuary believes that a reserve of GH¢10 will suffice to honour promises made to a policyholder, an additional margin of prudence of 20 per cent might be added so that the reserve recognised as a life fund liability on that balance sheet is GH¢12, instead of 10 cedis.

Accrual accounting rules compels the life company to incur GH¢12 as its “change in insurance contract liabilities-life fund” expense in its income statement. The embedded value calculation removes that last GH¢2 additional margin of prudence so that the “embedded value” “change in insurance contract liabilities-life fund” is GH¢10, not GH¢12. It is permissible to remove that last margin because the reserve of GH¢10 itself sits on cushions of prudence.

“Embedded value earnings” in a specific year are the changes in embedded value that occurred in that year. Over time, one can find out the track record of a company’s embedded value report by studying the pattern of actual experience versus estimates. Thus, the simple way of understanding embedded value is that it is the net present value of future profits belonging to a life company’s shareholders lurking in the life fund’s liabilities to policyholders.

Like all other uses of “net present value” in other industries, embedded value uses discount rates to compute present profit, compelling analysts to assess the sobriety of those rates.

Re-discount rate

In the case of Enterprise Life, the real discount rate (after adjusting for inflation) is 10 per cent. That discount rate is 5.5 per cent above the forecast annual real investment return of 4.5 per cent.

These are stringent assumptions enforced by an independent actuary. The comparable assumption disclosed in the 2016 embedded value report of Botswana Insurance Holdings Limited, prepared by the very same actuary used by Enterprise Life was a real discount rate of 6.5 per cent which, in turn, was 3.6er cent above the forecast annual real investment return of 2.9 per cent.

Sanlam Kenya’s 2016 embedded value report, prepared by the actuary used by Enterprise, assumed a real discount rate of 8 per cent that was 4.3 per cent above a forecast annual real investment return of 3.7 per cent.

Higher discount rates seem to accompany higher gaps between the discount rates and forecast investment returns. These differences are anything but small and trivial over very long periods of time.

The proof of that assertion is that, over the last five years, its actual experiences have turned out better than assumed, thus, releasing profits to its shareholders. Sadly, Ghanaian analysts of Enterprise ignore completely the significance of embedded value. Following those analysts, investors trading on the Ghana Stock Exchange also ignore Enterprise’s embedded value. Hence, their utter shock at the enigmatically expensive proposal of Prudential/Leapfrog to pay 2.5 times the prevailing stock exchange share price of Enterprise.

Embedded values of different companies are not created equal. Some are more profitable than others. Also of crucial significance is the profitability of the new business being written in each year. The more profitable a company’s new business, the higher its value; the faster the growth rate of its embedded value, the higher its value.