SLIDE 1
Good afternoon.
My name is xxxxxx, and as the Chairman has mentioned, I'm an actuary. It's been said that a person becomes an actuary because they find the prospect of being an accountant too exciting, but I shall do my best not to send you to sleep. It will help, I trust, that I will be talking about something which I'm sure is as dear to your hearts as it is to mine: money.
Over the next half hour or so, I hope you will be patient with me, since at least a part of what I have to say is unavoidably very technical. Much of what I do in my day to day working life is very technical. But it's important, I think, for you to understand it - at least in broad terms - for one basic reason. And that reason is this: if there is one message I'd like to leave you with today, it is this one:
SLIDE: UNDERSTAND BETTER WORK TOGETHER
The world is getting more complex; our industry is getting ever more challenging; but every challenge is also an opportunity. (NB - deep breath!) Only when all of us develop a better understanding of what all of us do - what makes our business tick, and what makes us money, and where each and every one of us fits into that process - will we be able to seize those opportunities, and work together to build a more successful, more profitable future.
When I first came into this industry, back in the 1970s, it was all pretty laid back. Business was fairly slow, but steady. Everything was more or less predictable. You knew where you stood from year to year, and you didn't really have to work - or to think - too hard. It was pretty boring, sure. And as an actuary, of course, I mean that as a compliment. But you knew that if you did your job fairly well, you could take it fairly easy, and look forward to a fairly safe career and a fairly well-provided retirement.
SLIDE: THAT WAS THEN NOW IS NOW
Well - that was then, and now is now.
Now, it's a case of 'all change'. Take a look at the industry today, and we see:
SLIDE:
RAPID CHANGE
MASSIVE UNCERTAINTY
SAVAGE COMPETITION
Rapid change in the marketplace, reflecting rapid change in society at large
Massive uncertainty, with no-one knowing they'll have a job next year, let alone in twenty years
and, last but certainly not least:
Savage competition - from a new emerging breed of companies like Virgin and Marks & Spencer. Companies with no background in the industry, but with excellent, well-trusted brands, and a simple but devastating strategy of low-cost products, sold hard.
In such an environment, it's up to all of us to work not just harder but - if anything, more importantly - smarter.
What does that actually mean to a marketer?
Well, I think it means two things:
First, marketers have to do what they've always done - sell product - better
Second, they have to work more closely with others in the organisation to help create better-selling, and more profitable, product.
Traditionally, marketers have worked in more or less glorious isolation. Their job was to learn about the products as they came out; learn about their customers - what they were looking for, what buttons to push; and put the two together, to make the right sale of the right product to the right person. And that's as important now as it's ever been.
Take a quick look at all the activities involved in successful marketing:
SLIDE 2
Now, given that you have a limited amount of money for marketing, how do you decide where to spend it? Do you increase the advertising budget? Or invest in better point-of-sale materials? Is it worth spending on sponsorship, on attending trade-shows, on public relations? And how does the return from £100,000 spent on sales-force incentives compare with the return from spending that same sum on research?
SLIDE 3
The point I'm working around to is that whereas in the old days, we used to do these kinds of things in a fairly free & easy way - and largely on the grounds, simply, that 'you have to do that sort of thing' - nowadays we are having to be much more organised. In brief, we have to try to find ways to measure results. To get a much clearer picture of what the real answer to those questions really is. As opposed to, say, thinking 'well, we spent x on advertising last year, so this year I guess we should spend x-plus-5%'.
What, after all, are we really trying to achieve? Most of the answers are pretty obvious and banal: but just because an answer's banal, doesn't mean it isn't right, and important. So, what are we trying to achieve? Well, for starters:
SLIDE: MORE SALES
More sales. But is that enough? Clearly, it isn't. You'd be surprised how many products have sold in vast numbers and still lost money. It's said - and I don't know whether this is true or not, so don't quote me, that during the glory days of British Leyland, they sold several million Minis. Still one of the most successful cars ever built. Sadly, through bad accounting, they apparently lost £50 on every single one. So - sales are good, but even good sales are not enough. So - what else?
SLIDE: MORE PROFITABLE SALES
More sales that generate profit. Now we're getting closer. Now, it's my turn to talk - and you get yours at the end, when you get to tell me how boring and unimaginative actuaries are - so I will say that marketers have a reputation for coming up with great ideas for new products. Great ideas that, unfortunately, never happen. Why don't they happen? Well, one possibility is that it's because people like me have no imagination. The other possibility, which I'd beg you to at least consider, is that we've run the numbers, and come up with clear evidence of one of two things:
The price is too high - so it won't sell in sufficient volumes to cover the heavy up-front costs of production and promotion, or
The price is too low - so even tho' we'd sell loads, it would be the Mini of the life industry: we'd lose money on every policy
So - we want more sales. And we want more sales that actually make profit. But beyond all this, what's the absolute bottom line? The ultimate reason? The basic justification for pursuing any kind of marketing activities? The answer is:
SLIDE: PURSUING CORPORATE OBJECTIVES
because they help us in the pursuit of our corporate objectives.
If they don't do that, they ain't worth diddly. In fact, they're worse than that: they're negative worth. Or, to use a technical term we actuaries sometimes use, 'money down the drain'.
So, what are our corporate objectives? Well, we want to be respected by our peers, and valued by our customers. We want to be a good company to work for, and one that everyone recognises as an organisation you can trust. And all those things are very important, and I hope you won't feel I'm degrading them when I say that when it comes right down to it, these are all - however valid and even noble - essentially means to two specific ends:
SLIDE 4
What it all comes down to at the end of the day is making money, improving the capital base, in brief - enhancing shareholder values. That, ultimately, is what all business is about.
Now I'd like to take a slightly closer look at that, and particularly at one specific part of it, called 'embedded value'.
SLIDE: 'EMBEDDED VALUE'?
This may be a new concept to you, but it's a very important one, and - crucially - is becoming ever more important as time passes. Why? Because:
The more fast-changing the environment becomes, the more crucial the concept of embedded value is to getting an accurate picture of what's really going on and where we really stand.
Ok, so what is 'embedded value'? We actuaries would call it a 'discounted cashflow technique'. Another way to look at it is as 'present value of future shareholder margins'. There are people around who would tell you that it's just a fancy way of pulling a fast one, counting money you haven't got, to try to make it appear that you're better off and hence more successful than you really are. But they're wrong. And I'll tell you why.
Life and pensions is not like any other business. It's not like being a widget manufacturer, and it's not like being a corner shop. In those businesses, you don't need the concept of 'embedded value': you don't have any. Value is what you have in the till at the end of the day. Value is what you have in the bank at the end of the year. More or less. Give or take. The point is, at the end of any given year, compare your current assets - money and inventory - with your current liabilities - bills you haven't paid yet - and you have a pretty accurate picture of your financial position.
Life and pensions isn't like that.
Imagine if you tried to decide whether writing life business was a good business to be in by looking only at the costs and revenues associated with brand new products launched and sold this year. Yikes! You'd probably find yourself thinking 'I'd better find myself a safer business to invest in, like, say, beef farming'. You'd be looking at all the high, front-end start-up costs, and only one out of perhaps 30 years' worth of revenues. The picture would probably not look too good, to say the least of it.
SLIDE 9
'Embedded value' then, is a way to try to get an accurate picture of the total value of a policy to you over its full term. It's not 'money in the bank'. But, over time, it will be. Time, as they say, is of the essence.
SLIDE 6
This is why it's become pretty standard accounting practice, among many financial institutions in the UK - including life companies, and banks with life assurance operations - to include the 'embedded value' of their existing policies in-force, on the balance sheet, along with shareholder funds.
Now that we've got embedded funds where they belong - on the balance sheet, along with other assets - the question arises, how are we to manage our capital assets? What is it we're trying to achieve?
SLIDE 7
Well clearly, what we're trying to do is manage them in such a way that they grow. That, to put it bluntly, they're bigger next year, and the year after that, than they are today. To achieve that, it will help to take another look at what distinguishes the life business from most other businesses.
Our business is like any other in one regard: the name of the game is to combine resources - which cost - into a form we can sell, thus gaining revenues. With the difference between costs and revenues producing profit. The difference is, as I mentioned earlier, that time - and lots of it - plays such a crucial role in the ultimate outcome. It's not about trading off costs and revenues today, but over periods of thirty years or more. Let's compare a few financial sectors....
SLIDE 10
The top graph, for general insurance, indicates a fair measure of stability and predictability. The insurance business, of course, involves careful calculation of what you might call 'embedded cost': ie, the money you have to set aside this year, to cover the claims that you know will come in over time. And, broadly and generally speaking, you can calculate these 'embedded costs' with a fair degree of accuracy. There are the occasional wild-cards, of course: insurance is, by definition, a risky game. And occasionally, a big wind or a catastrophic disaster can put a major glitch in the best laid plans. But, broadly speaking, general insurance is fairly predictable over time.
Bank deposit and mortgage business is also relatively predictable. Again, costs are loaded up-front; again, revenues come in steadily over a period of many years. And, again, events in the world outside, such as a massive recession, can throw the numbers off course. But generally speaking, you pretty much know where you stand. Much the same is true of typical French capitalisation products: an initial loss, followed a regular revenue streams over a long period of time.
Now we come to the UK life assurance market. This graph indicates what happens when an entire product sector has been thoroughly stirred and shaken for a few years. Major variations; major fluctuations; uncertainty and unpredictability as a way of life. Plotting these same industries on a chart indicating the importance of the concept of 'embedded value' shows starkly the relationship I touched on earlier:
SLIDE 11 - (but, I'd suggest, simplified as follows):
IMPORTANCE OF 'EMBEDDED VALUE' TECHNIQUE
MOST BUSINESSES: NONE
SOME RETAIL BANKING: MORE
UK LIFE PRODUCTS: VITAL
Simply, the more varied the pattern of cashflow, and the longer the period over which revenues emerge (costs, remember, having been heavily loaded at the front-end), the more useful - indeed, indispensable - the concept of embedded value becomes, when assessing capital employed and profit achieved.
To sum up this section: in our industry, the use of embedded value techniques enables us to get a much clearer and more accurate picture of our real financial position, at any given point in time, and over any given period.
Now - how do we use these embedded value techniques in real life, day to day practice?
What we have to do is build a detailed cashflow model, incorporating accurate assessments of the complex interactions between a large number of variables. Key ones including: premiums, investment returns, claims, expenses, tax and reserves. We then have to set assumptions for each of these variables, and build these into an incredibly complicated model, for the monster number-crunching computer to get its teeth into. Then, at regular periods, results are monitored, compared with earlier projections, and the model refined in the light of the variations revealed between what we expected to happen, and what did, in fact, happen.
Fine-tuning the model, and thus the extent to which your projections turn out to be accurate, is absolutely crucial for two reasons:
SLIDE: WHERE ARE WE? WHERE DO WE WANT TO BE?
The better your model, the more accurately you'll be able to judge where you actually are at any given time.
The better your model, the more powerful and useful it is in helping you get where you want to be.
Let's take a look at the critical issues affecting profitability: specifically for the life business in the UK.
SLIDE 16 - (but for this and slides 17 & 18, I'd suggest substitute 'CRITICAL ISSUES' for 'KEY ASSUMPTIONS')
Sales, of course, is key. If you don't generate enough sales, you won't reach the critical mass of revenues necessary to cover your expenses. But it's not just about the sheer volume of sales; you also have to consider the mix of sales. You need to consider factors such as price-sensitivity and margins. You have to take into account age distribution - particularly with certain types of protection business. And you have to consider average size of policy. Analysis of these and similar factors enables you to check whether your pricing assumptions were valid, and to assess the accuracy of your embedded value estimates. Ultimately, whether or not you're profitable.
Persistency is, of course, another key variable. How long do policies stay in force? Are the periods the same for all distribution channels, and within a distribution channel for all segments? If you discover a particular segment with a particularly bad lapse rate in the early months, are you looking just at a blip - a one-off, about which you can do nothing but shrug your shoulders? Or is there some serious, underlying problem, which will continue to cause you grief over time unless you take some kind of action?
SLIDE 17
Then, of course, you have to look at the numbers on mortality/morbidity. You have to compare them against national statistics, and ask yourself various questions. If trends are improving, should you reduce rates, given that some existing policyholders are also new policyholders? For example, we recently decided to upgrade the definitions for critical illness - on existing policies, and without charge - to encourage those policyholders to stick with their existing policies rather than cancel them in favour of a new policy offering better terms.
And underlying all these sorts of considerations, there's also one basic factor: all existing policyholders have a vested interest in the continuing financial health of the organisation. Existing traditional policies - particularly ones with a large cash value - have a large stake in protecting the value of that investment, and should therefore be willing to contribute to maintaining the underlying corporate financial position which underpins that investment.
SLIDE 7 - with top and bottom highlighted
This brings us onto another crucial area - that of costs.
SLIDE 18
It is vital that we understand more fully what actually drives our cost base. It's a tricky business, in our industry. Again, for the widget manufacturer or the corner shop, keeping tabs on costs is fairly straightforward. But in our business, it can be quite hard to work out exactly where your money's actually going.
We're beginning to get to grips with - for example - gaining a better understanding of the unit costs on various types of existing business. We're discovering quite wide variations in the ongoing maintenance costs for different types of long-term policies. Old-style, inflexible, policies are relatively cheap to maintain; newer, more adaptable policies tend to mean a higher cost-base. And, again, underlying it all, there's an ongoing benefit in ensuring persistency. If that means loyalty bonuses, so be it. Policies that lapse can do horrible things to your embedded value assumptions.
SLIDE 19
Until recently, we used the same sort of horizontal/vertical analysis for expenses as any other business. But the problem with this approach is that it's not a very powerful tool for getting to the real understanding you need about what drives your costs.
What are the inputs? From whom?
What are the outputs? And to whom?
The limitations of this vertical/horizontal model are driving us towards a fundamentally new analytical tool: the horizontal cost relationship. This takes us away from a fragmented, departmentalised, 'who does what? Where do they do it?' perspective, towards a more 'holistic' approach, as you might call it, which attempts to look at 'what we do to deliver x' across the organisation.
SLIDE 20
Ie, we're trying to analyse the total costs of a given business process, rather than the individual costs of particular activities. We're at the relatively early stages in carrying out this kind of analysis, and certainly we're not yet at the point where we can calculate with total accuracy. But as in most of life, it's better to be approximately right than precisely wrong.
Ok. So far so good, I hope.
I'd like now to try to cover arguably the single most important area of all: profitability.
Are we achieving the returns we need for our shareholders?
If not, what remedial action can we take?
This is where things get really complicated, so I'll try to simplify it as much as I can, without actually distorting it into a parody of what really happens; you hold onto your hats.
SLIDE 22
'Gross margin' is the present value of premiums less the value of benefits.
'Costs' takes into account the present value of both initial and ongoing renewal expenses.
SLIDE 23
So, 'profit' can be restated as contribution less overheads, where 'contribution' means the excess of the marginal net revenue times volume. The name of the game, of course, is to try to maximise contributions, given that there's relatively little you can do, at least in the short term, about overheads.
This 'Contribution approach' makes decision making easier, since it's volume-related, and incorporates a recognition that profit depends on both volume and price achieved. All three factors - price, profit and volume - are combined in one, simple measure. The approach also clearly separates fixed and variable costs - a great help when it comes to monitoring subsequent performance.
SLIDE 24
This slide shows a comparison between high volume/low price against the alternative. The high price may be the current approach; the chart shows the trade off between high price and lower volume, and the level of sales necessary to break- even if the price is lowered. In practice, it's important to take into account:
Are contributions across all products adequate to meet total overheads?
Have the knock-on effects of pricing changes been fully and accurately assessed? If a price change results in the replacement of existing high margin policies with emerging low-margin ones - what we call 'cannibalisation' - you can actually end up worse off. And this risk has to be taken into account explicitly and, as far as possible, measured.
These kinds of questions can lead us to various strategies such as 'do nothing' - which can often be absolutely the right thing to do - or 'launch a new, low-price/high-volume product line'. Then, with the aid of embedded value calculations, decide on the optimum strategy to adopt.
SLIDE 27
Embedded value techniques are also a powerful tool in other areas - whether or not to hire a new salesman, for example. As with a policy, hiring a salesman generally involves a high up-front investment, with ongoing revenue streams over a period of many years. Of course a salesman you recruit, train and manage who then leaves the company is a lot like a lapsed policy: you've incurred the up-front costs, but your ongoing revenue stream just walked out the door. But, again, a retained salesman can represent an excellent long-term profit-centre - a good one will still be generating excellent revenue streams after ten or fifteen years.
Or what about launching a whole new distribution channel?
Or what about undertaking a major advertising campaign?
Or investing in an upgrade of the corporate identity?
SLIDE 28
How about deciding what it's worth investing, whether in loyalty bonuses, better information provision, or relationship-building, to retain a client? All of these are areas where an up-front investment has to be weighed against as accurate an assessment as possible, of the likely returns over time. In each case, embedded value techniques can be enormously useful in helping you make the right decision. Ultimately, in achieving the vital objective: to give an appropriate return to shareholders.
That brings me almost to the conclusion of my section of this afternoon's events. I'm delighted to see that not one of you has fallen asleep! Let me just briefly re-cap a few of the areas I've tried to cover:
SLIDE:
RESOURCES FINITE
'EMBEDDED VALUE' ANALYSIS CRUCIAL
'CONTRIBUTION ANALYSIS' IMPORTANT
Companies have limited resources, and have to find ways to analyse the best way to invest those resources to achieve returns over time.
Embedded value techniques are crucial to any kind of meaningful analysis in a business like ours: volatile, unpredictable, and with heavily front-loaded costs to be set against long-term revenue streams.
Analysis of embedded value at any given time enables you to do two vital things: get an accurate picture of where you stand financially, now; and equip yourself to make the right decisions to get to where you want to be.
The 'Contribution' method of evaluation is also a vital tool, incorporating as it does the three key variables - price, profit and volume - in a single, measurable, variable, which can be tracked over time.
And finally, I'd like to conclude my presentation, on behalf of the actuarial side of our business, by making a few slightly more general comments.
SLIDE: PLUS ÇA CHANGE....
I've talked a lot about unpredictability; about the way the world is changing fast, and how we have to change with it if we want to carry on making money. But even within such a fast-changing environment, some things remain the same.
SLIDE:
DEVELOP PROFITABLE PRODUCTS
SELL PROFITABLE PRODUCTS
WORKING TOGETHER
It's still up to boring bean-counters like me to manipulate complex calculations like these, in order to develop effective new products: ones which will sell, ones which will make a profit.
And it's still up to guys like you to apply your charm and expertise in selling these products, and also trying to keep lapse rates to an absolute minimum.
But it's also up to all of us to see how by developing a better understanding of what each other do, by communicating more clearly and working together more effectively, we can all help each other to do both these things better.
And that will help us all to get what we want out of all this effort and endeavour: to have a good time, making a good living, in a dynamic and fast-moving industry.
Thank you for listening, and please feel free to ask questions.
