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Embedded Value A Teaching Session

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Companies usually only publish life business EV (including unit-linked) ... Immediately reflects expected long-term impact of management action ... – PowerPoint PPT presentation

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Title: Embedded Value A Teaching Session


1
Embedded ValueA Teaching Session
Caribbean Actuarial Association- 2004 -
Accepting New Realities
Presentation by Sylvain Goulet, FCIA, FSA, MAAA
2
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

3
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

4
1. Valuation Methods
  • Implicit Methods
  • Net Level Premium
  • US GAAP
  • Does not necessarily recognize current emerging
    experience
  • Explicit Methods
  • Canadian Policy Premium Method (PPM)
  • Canadian Asset Liability Method (CALM)
  • Does recognize current emerging experience

5
1. Valuation Methods
  • Embedded Value
  • Works regardless of the valuation method
  • but
  • must recognize the true emergence of income
  • Valuation methods should not materially affect
    the ultimate total emergence of profits
  • but
  • affect the value of the business because of
    discounting

6
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

7
2. Concept of PfAD
  • Best-Estimate Assumption
  • e.g. Unit Expense per policy 50 per policy
  • MfAD (Valuation Assumption)
  • Margin for Adverse Deviation
  • MfAD of 7.5, i.e. add 7.5 on expenses
  • PfAD (Valuation Assumption)
  • Provision for Adverse Deviations
  • PfAD 7.5 x 50 x 60,000 x 7 1,575,000
  • (discounted at, say, 5.5)

8
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

9
3. Value of In Force Business
  • If No PfADs
  • Value Present Value of future profits 0
  • All expected profits have been capitalized at the
    time of issue (PPM/CALM)
  • If PfADs as in PPM/CALM
  • Value Present Value of future profits
    20,000,000 .
  • Except should be discounted at risk discount rate
    of say at 10 (will be discussed later)

10
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

11
4. Concept of MCCSR
  • Minimum Continuing Capital Surplus Requirements
    (MCCSR)
  • Measure of solvency used in Canada
  • Also used by many Caribbean insurers
  • Similar concepts in other countries, e.g. USA
  • MCCSR Measure of Locked-In Capital
  • Target MCCSR Ratio may be 185-215

12
4. Concept of MCCSR
  • However, not all is Required, or locked-in
  • Recommendation (draft) from the Canadian
    Institute of Actuaries for EV Calculation
  • Use 150 Target MCCSR ratio
  • For example, 20 million for 100, 30 million
    for 150
  • Market demands more (175 - 200)
  • Rating agency influence (A.M. Best)
  • At 175, this means 35 million

13
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

14
5. Release of MCCSR
  • A Locked-In Capital LIC
  • B Over time, as in force business goes off the
    books, the 35 million can be released into Free
    Capital or paid out in Shareholders Dividends
    (wholly or partly)
  • C While the Capital is Locked-In
  • Earn investment income
  • So Cost of Locked-In Capital -(A-B-C)

15
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

16
6. What is Embedded Value
  • Definition of Embedded Value (EV)
  • EV is the sum of
  • capital surplus, and
  • the present value of profits attributable to S/Hs
    from in force business, less
  • the cost of carrying of locked-in capital
  • CS PV(IF Business) Cost of LIC

17
6. What is Embedded Value
  • Reasons for EV
  • Effective way to analyze and manage financial
    results
  • In line with long-term nature of life insurance
    business
  • Allows better capital allocation and entry/exit
    decisions
  • Improves internal communication among business
    units and with corporate management by providing
    a common framework, set of standards and language

18
6. What is Embedded Value
  • Reasons for EV
  • Effective way of measuring financial performance
    (for reward system) by reporting the whole impact
    of a change in management action
  • Statutory reporting does not properly reflect
    actual performance

19
6. What is Embedded Value
  • Reasons against EV
  • Requires considerable effort and commitment
  • Long learning and implementation curve
  • Not yet well understood by North American
    (especially US)/ Caribbean markets (but analysts
    starting to take notice)
  • Volatility of results, sensitivity to
    non-controllable factors
  • Lack of comparability, lack of benchmarks

20
6. What is Embedded Value
  • UK is where concept originated
  • Some have been doing for nearly 20 years
  • Companies usually only publish life business EV
    (including unit-linked)
  • Publish economic but not experience assumptions
  • Europe
  • Large multinationals have also adopted and
    started to publish
  • Generally follow UK methods

21
6. What is Embedded Value
  • CANADA
  • The ex-Mutuals have taken the lead
  • Public figures and some detail, total corporate
    EV, including non-life and non-insurance
    businesses
  • Key financial analysis measure
  • USA
  • Just starting to take an interest
  • A few pioneers, but no company publishes yet

22
6. What is Embedded Value
  • Risk Discount Rate
  • The central assumption of the EV process
  • Is the after-tax target or hurdle rate desired to
    be achieved by the company
  • Present value is figured at the risk discount
    rate, set by Board/Management, in light of the
    market and of corporate objectives
  • Long-Term Risk-Free Bonds 3-4, say 9-10
  • (vs Appraisal LTRFB 5-7, say 11-13)
  • EV of long duration business is highly sensitive
    to the risk discount rate

23
6. What is Embedded Value
  • Locked-In Capital
  • Locked-in capital is the capital required to
    support the in force business from time to time
  • It is generally defined as a function of
    statutory capital requirements, what the market
    demands, and corporate views on target surplus
  • Is the amount of capital required to produce the
    target capital (MCCSR) ratio
  • Market demands 175 - 200 (A.M. Best)

24
6. What is Embedded Value
  • Participating Account Leverage
  • Positive if par account surplus produces higher
    than target ratio, and vice versa
  • Since target ratio is measured at total company
    level, excess par surplus is available to support
    non-par

25
6. What is Embedded Value
  • Important to ensure consistency among
  • EV assumptions,
  • DCAT assumptions,
  • Management plans, and
  • Valuation and best-estimate assumptions
  • DCAT / Financial Projections is a key companion
    tool to EV in that it measures the expected
    absorption and release of free capital

26
6. What is Embedded Value
  • Relationship to Appraisal Value (AV)
  • Appraised value is the sum of EV and existing
    structure value (also referred to as new business
    value or goodwill)
  • Neither Appraised Value nor EV include
    intangibles like value of sales force or brand
    value, but those can be substantial
  • AV EV New Business (using a different
    discount rate)

27
6. What is Embedded Value
  • Embedded Value Appraisal Value

28
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

29
7. Calculation of Embedded Values
  • Experience Assumptions
  • Mortality, morbidity, withdrawal, expense,
    default losses, asset composition, matching
  • Determined by territory, by line of business
  • Should be consistent with valuation best-estimate
    assumptions and with DCAT
  • Management has at least some control
    Pricing, Underwriting, Claim Management,
    Expense control / Efficiency, Investment
    selection and management (ALM)

30
7. Calculation of Embedded Values
  • Economic Assumptions
  • Future interest rates (risk-free and quality
    spreads), equity and real estate returns,
    inflation, exchange rates, taxation
  • Should be consistent with valuation best-estimate
    and DCAT
  • Normally determined by territory, but should be
    internally consistent
  • Management has no control

31
7. Calculation of Embedded Values
32
7. Calculation of Embedded Values
33
7. Calculation of Embedded Values
34
7. Calculation of Embedded Values
35
7. Calculation of Embedded Values
36
7. Calculation of Embedded Values
37
7. Calculation of Embedded Values
EV CS PV(IF Business) Cost of LIC
38
7. Calculation of Embedded Values
EV CS PV(IF Business) Cost of LIC
39
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

40
8. Change of Embedded Values
  • Components of change in EV (ignoring capital
    flows and S/H dividends)
  • Operating profit from in force business
  • P/L on new business
  • Change of EV of in force business, due to changes
    in assumptions (best-estimate or margin)
  • Sum also called Achieved Profits

41
8. Change of Embedded Values
  • Operating profit is sum of
  • Expected release of PfADs
  • Investment earnings on total capital
  • Difference actual vs expected
  • Profit / Loss on new business
  • Zero, positive or negative depending on
    relationship of pricing ROI and risk discount
    rate (if EV, pricing and valuation assumptions
    consistent)

42
8. Change of Embedded Values
  • Change in EV of in force
  • Figure at end of year
  • Arises from change in EV assumptions compared to
    previous year

43
8. Change of Embedded Values
44
8. Change of Embedded Values
45
8. Change of Embedded Values
46
8. Change of Embedded Values
47
Embedded Value ConceptDiscussion Points
  • 1 Valuation Methods
  • 2 Concept of PfAD
  • 3 Value of In Force Business
  • 4 Concept of MCCSR (Locked-In Capital)
  • 5 Release of MCCSR
  • 6 What is Embedded Value
  • 7 Calculation of Embedded Value
  • 8 Change in Embedded Value
  • 9 Conclusions

48
9. Conclusions
  • EV is a superior tool for management of a life
    insurance business, which is inherently long-term
  • Immediately reflects expected long-term impact of
    management action
  • Counterbalances short-term focus of current
    income measures
  • Sound capital allocation tool
  • Sound measurement of net long-term contribution
    from Management actions

49
9. Conclusions
  • Usefulness in practice will depend on
    understanding and buy-in
  • By the Board and Management
  • Ultimately by the investment community, if
    publication of results becomes widespread

50
Thank you very much ...
  • If you wish a copy of this presentation, please
    send an email to syg_at_eckler.ca / website
    www.eckler.ca
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