EMBEDDED VALUE

Question 1

What is the difference between TEV and MCEV?

Answer 1

Everything is listed in APN 107 additional note

Question 2

What is EVM required capital?

Answer 2

• This is meant to cover residual risk i.e. the risk that is not already priced into liabilities
• This capital cannot be distributed to SHs
• In total we want to hold a certain “target capital” amount (usually 2 x SCR)
• We don’t have to hold this full amount and some risk accounted for in liabilities
  > restricted assets = target capital less supervisory liabilities
  > required capital = restricted assets - EVM liabilities
• we project EVM and supervisory liabilities separately because underlying drivers are different
• The capital comes from SHs who return > risk-free rate of return available on the market
• could use supervisory basis as they use risk margin but:

Question 3

What is VIF?

Answer 3

• VIF is the PV of future CSM release + Risk Adjustment release
• PV of the future shareholder cash flows projected to emerge from that block of business
• If dealing with WP business:
  > project future bonuses
  > determine future mix of bonuses (reversionary, terminal etc. )
  > project profits from lapses + surrenders, non-profit business
  > determine SH entitlement, usually some of bonus allocated to SH e.g. 10%
  > almost a “call option” that should be deducted from MV of business

Question 4

What are the shortfalls of the TEV?

Answer 4

1. Cost of option and guaranteed not allowed for appropriately
   > calculated on valuation date using market consistent basis, deterministically
   > if assumptions allow, could be valued at zero (option/guarantee does not bite)
2. Cost of capital
   > only concerns minimum capital held
   > doesn’t reflect target capital/actual capital held
   > may understate too cost of capital
3. Risk discount Rate is inaccurate
   > reflects industry norms rather than based on company risk profile
   > same rate used for all risks, may not be appropriate
4. EV inconsistency
   > calculation differences and disclosures EV make comparisons across companies difficult.
   > might have subsidiary company inccurring losses which isn’t reflected in EV of company

Question 5

How is MCEV used to address the shortfall of EV?

Answer 5

1. Options and guarantees
   ✔valued using standard option-pricing techniques, and with stochastic simulation in more complex cases.
   ✔consistent with financial markets (e.g. guaranteed annuity rates valued as a series of swaptions)
2. Cost of capital
   ✔adjusts for the cost of required capital, not just minimum levels.
   ✔ reflects the opportunity cost of trapped capital.
   ✔introduces a “cost of double taxation” — adjusting for the fact that returns on capital held in an insurer are taxed more than if held directly.
   ✔ adds an agency cost to reflect shareholder concerns about capital inefficiency and lack of transparency.
3. Risk Discount Rate
   ✔ Moves away from subjective RDR.
   ✔ Discounts each cash flow using a rate reflecting its specific risk, or uses risk-neutral valuation.
   ✔ Better alignment with market pricing of risk.
   ✔ Reduces incentives to game the system by using unrealistic RDRs.
   ✔ Increases transparency and comparability.

Question 6

What is the difference between calculating EV/VNB on opening or closing assumptions?

Answer 6

Opening basis
- means that assumptions based on basis at beginning of reporting period
- any changes to assumptions during the year, counted as experience variance/operating assumption changes
- separates impact of assumption changes on underlying business performance

Closing basis
- EV/VNB calculated on final basis at the end of the financial year
- this gives a more accurate view of the value
- makes it difficult to compare

Hybrid approach
- usually companies use opening basis for demographic assumptions
- closing basis used for economic assumptions, to keep in line with market-consistent principles