Future Capital Kenya

These are interesting times to be a Kenyan, although the times are unrelated to this post, it is still a very interesting time to be a Kenyan. With the ICC, wikileaks and KACC boss PLO Lumumba all with harmonic unison attacking the establishment. It is going to be an interesting two years up till the general election in 2012. For me, one key thing that could be a game changer is the ICC summons. If summons to the six people mentioned in the list are issued, then the ICC has the right to freeze the accounts of the six suspects, this could have interesting effects on Kenya's stock market and real estate industry in large. It will be an interesting event to follow and I will be waiting with both cautious optimism and a tinge of reservation over the next year.

My post today is about insurance. Insurance in essence is the business of hedging risk i.e.transferring risk from the 1st and 2nd parties of a transaction the third party. What this means with an example is in the case of motor insurance, if an accident occurs, the risk of covering the costs of that accident is transferred from e.g the drivers of both cars involved in the accident to an insurance company. However, this transfer of risk is not free as the person who takes out the policy has to pay premiums regularly as stipulated in the insurance contract, the premium can be paid weekly, monthly or even yearly. Furthermore, the insurer has to cede some of those earned premiums to a re-insurer who is the insurance companies insurer.

When the premiums are paid up front to the insurer, the insurer has the advantage of having a lump sum of money without any immediate expenses in the form of claims from the policyholders. Insurers are usually required by regulators to keep some funds to cover claims, the amount is calculated by actuaries who determine the probability of incurring claims and their costs. With the rest of the cash, usually called a float, the insurers invest it in bonds, stocks, real estate, treasury bills and any other fathomable investment given the country they are in. They then reap investment income. In a nutshell insurance companies earn premiums, cede some of those premiums to re-insurers, pay out claims and earn investment income from their float.

However, for someone keen to invest in an insurance company and for the country's welfare in general, it is important to understand the economics of the insurance industry, more so the insurance industry in Kenya. For this some micro-economic concepts would be fitting. To this we turn to "The Sage of Omaha" Warren Buffett in his 1982 letter to his shareholders. Where he characterises the insurance industry in two terms "excess capacity" and a commodity product".

Excess Capacity means that the industry has over-supply, i.e. the industry can produce much more than the demand requires. If a manufacturer of batteries for example has a factory that produces 200,000 lithium iron batteries per year, whereas demand stands at 150,000 batteries. Then there is excess capacity of 50,000 lithium iron batteries. How does this happen with insurers, one may ask?. Well with insurers, excess capacity lies in the underwriters pen. His willingness to underwrite policies. Excess capacity also lies with the insurers ability to raise more capital. However, the former occurs much more frequently than the latter. Underwriters are usually very eager to underwrite policies and earn premiums

The second issue is a "commodity product" or like most economists would say a "homogenous" product. Think of Sugar, when you're sitted at Dormans or Java and would like a bowl of sugar to sweeten your latte, you seldom will ask for a bowl of mumias sugar, you just ask for sugar. There are no defining characteristics that single out a particular kind of sugar from another. Sugar is a commodity product, all sugar producers are producing the same thing and therefore all of them have to by way of marketing, emphasise the uniqueness of their products. All "commodity product" producers have to keep advertising to remind us of the novelty of their product, take Kenyan examples such as crown paints, Safaricom, Zain and most banks who are constantly buying up media space to advertise their goods. The key thing though, is that with commodity products competition is done with price and this is scary for insurers.

The two factors lead to the insurance industry shaping up to be a monopolistic competitive industry. Where a commodity product and excess capacity bring up both price competition and thin margins. What happens now in the insurance industry is that insurers will scamper to lower premiums and incur heavy marketing costs so as to remain competitive. The danger of low premiums is that they often do not cover both the firms expenses and the claims incurred. The combined ratio is a ratio used in the insurance to gauge operational efficiency. It can be calculated as the sum of operational expenses and claims incurred divided by the net earned premiums. A ratio below 100% is healthy whereas one above 100% is very unhealthy. A ratio of 98% shows that the insurer is covering both operational expenses and claims incurred and getting a 2% profit. A ratio of 105% shows that the claims and expenses incurred exceed the premiums earned by 5% and therefore the insurer has to earn an investment income of above 5% to earn a profit.

In Kenya, the industry combined ratio as calculated from the Association of Kenyan Insurers data shows that the combined ratio from 2005 - 2009 are 126.72%, 131.28%, 124.71%, 118.37% and 121.66%. These figures are well above the 100% threshold and are a gauge of mismanagement of the firms. One may question these figures, they were arrived at by dividing (total operating expenses + net claims incurred)/ net premiums earned. The net in this case is adjusting for re-insurance earned and ceded. This further means that insurers have to earn high investment incomes and as the last two years showed, this is risky business given the uncertainty of Kenya's economic and political climate.

What this means is that the overall insurance picture is not at all pretty. Fraudulent claims, over eager underwriters and price competition are all conspiring to weaken our insurance industry. Regulators are constantly changing the rules so as to ensure a better insurance climate, but the cancer still remains.Some of the Kimunya laws such as increasing the capital requirements could help and will take time to produce results. In the mean time, I would urge regulators to take stronger measures to regulate premiums, even if it means reducing competition, as the insurance industry has the capacity to bring the entire financial system to its knees, case in point AIG and the global financial meltdown of 2008. From an investors perspective, invest in insurance companies that have sound underwriting principles and are well managed. At the end of the day, given the adverse nature of the insurance industry's market structure, management is the main competitive edge for Kenyan insurers. Key note, avoid investing in insurers that are heavily exposed to Motor Commercial insurance and WIBA (Workers Injury Benefits Act), both of these are usually very volatile from year to year and are subject to a great deal of fraud.

I have to apologise to the followers of this blog for the long absence. It has been a hectic month filled with traveling and completing my undergraduate studies. I am back in Kenya and enjoying it so far.

Just the other day I was attending an informal interview at a local investment bank, as I waited for the interviewers at the reception, I picked up a copy of "The African Investor". In it, I read an article about family businesses' and their great appeal to Private Equity. The article can be found here is a very interesting read especially the part where the Kenyatta's are given as an admirable example with Uhuru Kenyatta citing his net worth as being approximately 10 billion dollars. If this is the case, then Uhuru could have personally financed the 2009 budget by himself. However, I doubt the figures.

The article raises an important issue, more so about the state of family business ownership and succession issues especially amongst native Kenyans. This is an issue that needs immense research given that most businesses estimated at around  81% of the businesses in developing countries are family owned. With so much of national wealth and livelihoods dependent on the existence and success of these businesses. Kenyans need to be sensitised on this matter. Some of the key issues are;

1. Succession. It is important to have succession policies or plans in place. Replacing legendary managers such as Warren Buffett of Berskshire Hathaway or Walt Disney of Disney Inc is usually a very tough challenge, it is made worse when the incumbents are caught up in a cult of personality where as Prof Jeffrey Sonnenfeld of Yale University states "They develop such a heroic persona and there is so much legend and myth-making that their identity becomes one with the job: they feel threatened that somebody could come along to erode that persona". However, given prudent planning both by the current business leaders and preferably by a third party should lead to smooth succession. A number of Asian owned businesses in Kenya are having intergenerational problems due to conflicting aspirations with the latter generation often opting to pursue different interest other than the family business. Right now, this issue is offering ripe pickings for investors in Kenya. In true African style, myths exist that succession planning will lead to the death of the founders, such thinking really curtails any planning and often leads to the demise of the business. In S.Africa it has been found that only 25% of family businesses make it to the 2nd generation and only 10% make it to the third generation.
2.  Separating ownership from management. In the early phases of the business, it is often the case that the owner will control all key decisions and functions of the organisation. However, as the business grows, it will get more complex. At this stage, it is advisable for the owners to appoint capable managers who will be more qualified to handle the complex business functions. It is often the case in Kenya that owners will still want to retain control of the business functions such as the accounts, logistics, marketing and others more often than not leading to the demise of the business. There are plenty examples of this, with a prominent Stock Broking firm being the main example.
3. The other issue is remuneration, with owner managers, there is a tendency for many to use the company as a personal bank account. This is one of the biggest factors that ensure that most family owned businesses never reach the second generation. Remuneration structures are needed so that the business survives.  It is advisable and good business practice to pay the family member what the market value of that job is worth. However, in different countries tax considerations come into play that will also affect remuneration.

In a nutshell, it is worth mentioning that before the industrial revolution, there were family businesses, before Wall Steet, there were family businesses and if there is anything certain about our uncertain business environment is that there will be family businesses in the future. Their existence and success is crucial for the economy. Why would you care if you do not and will never have a family business, well, this exposes the great gap that needs to be filled in Kenya's financial circles. The need for dedicated business units in banks, investment firms and asset management firms that will focus solely on family business advice and research. Germany, England and South Africa are well ahead of the curve, it's about time that we got in on the act.