PART II: THE ENIGMA OF ENTERPRISE GROUP LTD
THE CONCEPT OF EMBEDDED VALUE
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. 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. Recognizing 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 10 Cedis will suffice to honour promises made to a policyholder, an additional margin of prudence of 20% might be added so that the reserve recognized as a life fund liability on that balance sheet is 12 Cedis, instead of 10 Cedis. Accrual accounting rules compels the life company to incur 12 cedis as its “change in insurance contract liabilities-life fund” expense in its income statement.
The embedded value calculation removes that last 2 Cedis additional margin of prudence so that the “embedded value” “change in insurance contract liabilities-life fund” is 10 Cedis, not 12 Cedis. It is permissible to remove that last margin because the reserve of 10 Cedis 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. In the case of Enterprise Life, the real discount rate (after adjusting for inflation) is 10%. That discount rate is 5.5% above the forecast annual real investment return of 4.5%.
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% which, in turn, was 3.6% above the forecast annual real investment return of 2.9%. Sanlam Kenya’s 2016 embedded value report, prepared by the actuary used by Enterprise, assumed a real discount rate of 8% that was 4.3% above a forecast annual real investment return of 3.7%.
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. After all, $1 invested today at 10% is worth $10.8 in 25 years, $6.85 when invested at 8%, and $4.8 when invested at 6.5%. Ghana’s fiscal profligacy, inducing high and variable inflation, is the cause of these differences because it forces actuaries to be more conservative than necessary in more fiscally responsible countries. But, an insurance company buying another insurance company is willing to pay for those hidden profits in the policyholders life fund of that target company.
The unrecognized profits (from an accounting perspective) sitting in the life fund of Enterprise-referred to as “value of in-force business” at the end of 2016 was $50.33 million. Simultaneously, Enterprise’s life fund was treated as a liability owed to policyholders of $79.8 million. In fact, 63% of that liability-$50.33 million-was not a liability at all in discounted cash flow terms. Rather, it was deferred profits expected to accrue to Enterprise shareholders over time.
The accounting net worth of the three Enterprise divisions in which Sanlam had an interest-property and casualty insurance, life assurance, and pensions administration, was reported as $42 million at the end of 2016. In fact, at $94 million (the sum of embedded value of Enterprise Life and the accounting net worth of the other two Enterprise divisions) , the economic net worth was more than twice that accounting net worth. As it turns out, Enterprise has been conservative in calculating its embedded value.
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.
Among the listed sub-Saharan African insurance companies that publish embedded value reports, the profitability of Enterprise’s new business is second to that of a South African company called Clientele Ltd and far ahead of the average. Enterprise’s new business margin is 19% versus 27% for Clientele and an average of 8% (excluding Enterprise’s margin). Enterprise’s return on embedded value is simply the best: 30% versus an average return of 14% (excluding Enterprise).
Despite the disappearing act of the Cedi against the Dollar since 2011-the Cedi depreciating by 66% against the Dollar-Enterprise’s embedded value rose by 63% from $49 million in 2011 to $80 million in 2016. As comparison for that period, Botswana Insurance Holding’s embedded value rose 26% from $322 million to $406 million, Sanlam Kenya’s embedded value fell 6% from $49 million to $46 million, and Sanlam’s embedded value declined 13% from $4.3 billion to $3.7 billion. Simply put, Enterprise has been one of the best creators of embedded value in the Sanlam group of companies.
Interested readers can visit the websites of Sanlam Kenya, Botswana Insurance Holdings Limited, and Sanlam itself to study the respective embedded value reports. Yes, Ghana’s macro-economic migraines of the last five years have been severe.
Yes, the Cedi has depreciated more sharply against the Dollar than the Kenyan shilling, Botswana Pula, or the Rand. Yet, in Dollars, Enterprise’s embedded value has been the fastest growing among the listed Sanlam entities. Undoubtedly, Enterprise Life bears the scars of Ghana’s tough setting. The value of its new business has halved between 2013 and 2016 to $6.8 million. As disposable income begins a gradual recovery, the value of new business should climb more rapidly.
It is time to report briefly on some of the other divisions of Enterprise. Enterprise Trustees’ 2016 return on equity and return on assets were, respectively, 45% and 34%. These were significant jumps from 2015 return on equity and return on assets of 21% and 15% and outright losses in preceding years. Its pension assets under management have risen from $64 million in 2013 to $258 million in 2016. Enterprise Insurance had similarly impressive returns. Its 2016 returns on equity and assets were 36% and 17%, up from 22% and 12% in 2015, and 30% and 15% in 2014.
Offsetting these returns have been the investments in property and funeral services. Like the pension administration business, those last two divisions seem to have exited their cash consuming phases. The salient trait of the non-life divisions of Enterprise is high profitability. Added to the embedded value picture of Enterprise Life, one sees a group dominant in rapidly expanding segments of Ghana’s service economy with a track record of high profitability.
FRANCIS DANIELS, AUGUST 18, 2017