DCAT and Embedded Value, Superior Tools For Management

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DCAT and Embedded Value, Superior Tools For
Management
The Grand Hyatt, Mumbai, September 4, 2006
Sylvain Goulet, FSA, FCIA, MAAA
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Dynamic Capital Adequacy Testing (DCAT) -
Discussion Points

• 1 Background and Objective
• 2 Process
• 2a Development of Base Scenario
• 2b Examination of Risk
• 2c Development of Plausible Adverse Scenarios
• 2d Projections and Analysis of Capital Adequacy
• 2e Financial Conditions Reporting

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Dynamic Capital Adequacy Testing (DCAT) -
Discussion Points

• 1 Background and Objective
• 2 Process
• 2a Development of Base Scenario
• 2b Examination of Risk
• 2c Development of Plausible Adverse Scenarios
• 2d Projections and Analysis of Capital Adequacy
• 2e Financial Conditions Reporting

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1. Background and Objective

• Canadian Institute of Actuaries (CIA) issued
  Standard of Practice, Dynamic Capital Adequacy
  Testing in 1998.
• Adopted by the Office of the Superintendent of
  Financial Institutions (OSFI) in 1999.
• Objective
• Project the trends of a companys capital
  position given its current circumstances, its
  recent past, and its intended business plan under
  a variety of future scenarios.

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1. Background and Objective

• The Appointed Actuary is mandated to help Senior
  Management and the Board with planning and risk
  management through identification of
• plausible threats to solvency
• actions which would reduce the likelihood of
  threat and
• actions which mitigate a threat should it occur.
• DCAT isolates key information that can be
  produced regularly and on a timely basis to guide
  Senior Management and the Board of Directors on
  the need for modifying the business plan and
  preparing for contingencies.

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Dynamic Capital Adequacy Testing (DCAT) -
Discussion Points

• 1 Background and Objective
• 2 Process
• 2a Development of Base Scenario
• 2b Examination of Risk
• 2c Development of Plausible Adverse Scenarios
• 2d Projections and Analysis of Capital Adequacy
• 2e Financial Conditions Reporting

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2. Process

• 2a - Development of a Base Scenario
• 2b - Examination of Risk
• 2c - Development of Plausible Adverse Scenarios
• 2d - Projections and Analysis of Capital Adequacy
• 2e - Financial Conditions Reporting

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Dynamic Capital Adequacy Testing (DCAT) -
Discussion Points

• 1 Background and Objective
• 2 Process
• 2a Development of Base Scenario
• 2b Examination of Risk
• 2c Development of Plausible Adverse Scenarios
• 2d Projections and Analysis of Capital Adequacy
• 2e Financial Conditions Reporting

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2a. Development of Base Scenario

• Consistent with the business plan.
• Based on best estimate assumptions that are used
  for valuation purposes as reported in the
  Appointed Actuarys (AA) Report.
• The previous years financial position from the
  AA Report is used as the starting point.

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Dynamic Capital Adequacy Testing (DCAT) -
Discussion Points

• 1 Background and Objective
• 2 Process
• 2a Development of Base Scenario
• 2b Examination of Risk
• 2c Development of Plausible Adverse Scenarios
• 2d Projections and Analysis of Capital Adequacy
• 2e Financial Conditions Reporting

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2b. Examination of Risk

• Mortality Risk
• Morbidity Risk
• Persistency Risk
• Cash Flow Mismatch Risk (C-3 Risk)
• Deterioration of Asset Value (C-1 Risk)

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2b. Examination of Risk

• New Business Risk
• Expense Risk
• Reinsurance Risk
• Government and Political Action
• Off-Balance Sheet Risks

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Dynamic Capital Adequacy Testing (DCAT) -
Discussion Points

• 1 Background and Objective
• 2 Process
• 2a Development of Base Scenario
• 2b Examination of Risk
• 2c Development of Plausible Adverse Scenarios
• 2d Projections and Analysis of Capital Adequacy
• 2e Financial Conditions Reporting

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2c. Development of Plausible Adverse Scenarios

• Relevant risk categories is firstly
  stress-tested that is, a determination of just
  how far the risk factor has to be changed in
  order to drive the companys surplus into a
  negative position.
• The level of change is checked for plausibility.
• When stress-testing a risk, a limited degree
  (that is, a couple) of ripple effect is
  permitted.

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2c. Development of Plausible Adverse Scenarios

• Ripple Effect refers to the adjustment of
  related factors as a result of the change in risk
• for example, say the tax benefits of a new
  product are likely to be eliminated in the next
  two years then this would decrease new business
  acquisition which would put a strain on
  recovering expenses.
• The three risk categories that result in the
  greatest surplus sensitivity are then expanded to
  take into account a full ripple effect.

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Dynamic Capital Adequacy Testing (DCAT) -
Discussion Points

• 1 Background and Objective
• 2 Process
• 2a Development of Base Scenario
• 2b Examination of Risk
• 2c Development of Plausible Adverse Scenarios
• 2d Projections and Analysis of Capital Adequacy
• 2e Financial Conditions Reporting

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2d. Projections and Analysis of Capital Adequacy

• The projections are evaluated using the
  (Canadian) regulatory formula for the capital
  adequacy standard, Minimum Continuing Capital and
  Surplus Requirement (MCCSR) which is currently
  120 of the base calculations.
• (Canadian) Regulators also have a target ratio
  specific to a company that is greater than 120.

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Dynamic Capital Adequacy Testing (DCAT) -
Discussion Points

• 1 Background and Objective
• 2 Process
• 2a Development of Base Scenario
• 2b Examination of Risk
• 2c Development of Plausible Adverse Scenarios
• 2d Projections and Analysis of Capital Adequacy
• 2e Financial Conditions Reporting

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2e. Financial Conditions Reporting

• Sample Report Outline
• Executive Summary
• Introduction to DCAT
• Capital Adequacy Measurement
• Base Scenarios
• Adverse Scenarios
• Analysis of Risks by Line of Business
• Conclusions and Recommendations
• Appendices

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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

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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

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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

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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 of emerging profits

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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

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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)

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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

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3. Value of In Force Business

• If No PfADs (based on Canadian method)
• 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 (Present Value f PfADs)
• Except should be discounted at risk discount rate
  of say at 10 (will be discussed later) instead
  of the valuation interest rate, say 5

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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

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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,
  UK, Australia
• MCCSR Measure of Locked-In Capital
• Target MCCSR Ratio may be 185-215

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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, SP, Fitch)
• At 175, this means 35 million

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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

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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)

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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

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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

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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
  benchmarks
• 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

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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

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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

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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 only few company publishes
  results

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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

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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)

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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

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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

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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 automatically
  include intangibles like value of sales force or
  brand value, but those can be substantial
• AV EV New Business (using a different
  discount rate)

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6. What is Embedded Value

• Embedded Value Appraisal Value

PV _at_ long-term bond 5-7
PV _at_ long-term bond 3-4
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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

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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)

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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

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7. Calculation of Embedded Values
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7. Calculation of Embedded Values
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7. Calculation of Embedded Values
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7. Calculation of Embedded Values
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7. Calculation of Embedded Values
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7. Calculation of Embedded Values
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7. Calculation of Embedded Values
EV CS PV(IF Business) Cost of LIC
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7. Calculation of Embedded Values
EV CS PV(IF Business) Cost of LIC
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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

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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

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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)
• Change in EV of in force
• Figure at end of year
• Arises from change in EV assumptions compared to
  previous year

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8. Change of Embedded Values
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8. Change of Embedded Values
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8. Change of Embedded Values
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8. Change of Embedded Values
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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

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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

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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

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Thank You

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