Objective 3 - Actuarial Appraisals Flashcards Preview

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Flashcards in Objective 3 - Actuarial Appraisals Deck (23):
1

Circumstances that lead to a proper fit between a seller and a buyer of a block of insurance

1. Non-core business - the business is profitable, but is non-core to the seller and likely to be a core block for the buyer
2. High admin costs - the business is good intrinsically, but the seller is unable to meet profit targets due to high admin and marketing costs
3. Poor management - the block has poor operating results due to poor management by the seller
4. Seller's reputation - the reputation of the seller prevents effective corrective actions (such as high rate increases)
5. Conservative reserves - the seller may have extra conservative reserves, but be unwilling to release some reserves
6. Regulatory fire sales - buying this type of business can be risky, but the buyer may be able to get a very good deal

2

The role of the actuary in the M&A process

1. Being an active member of the due diligence review team
2. Interviewing management
3. Interfacing with regulators, reinsurers, and investors
4. Acting as a general advisor to management regarding the merger and acquisition process
5. Creating an actuarial appraisal

3

Code of Professional Conduct criteria for an actuary to perform appraisal services

1. The actuary's ability to act fairly is unimpaired
2. There has been disclosure of any conflict to all principals whose interest would be affected
3. All such principals have expressly agreed to the performance of the actuarial services by the actuary

4

Steps for calculating the value of inforce business

1. Develop a projection model - the type of model will vary based on the time allowed for the analysis and the quality of data available:
a. Windshield appraisal model - appropriate where time is very limited and data is scarce (this will produce only a rough estimate)
b. Intermediate detail model - these often result from a lack of detailed data
c. Full-blown appraisal model - the preferred approach when there is appropriate time and data
2. Determine starting in force values - should reflect the impact of actions already taken
3. Create a specific set of assumptions that reflects reasonable expectations for the business
4. Perform the projection by applying the starting values and assumptions to the model

5

Items included in the actuarial appraisal report (in accordance with ASOP #19)

1. Descriptions of the scope of the assignment and its intended use
2. Reliances and limitations the actuary has placed on his/her work product
3. A description of the business being valued
4. The actuarial appraisal value
5. The methodology and assumptions used
6. The validation techniques and results
7. Adjustments made when valuing net worth
8. How federal income taxes were considered
9. The annual projection results
10. Disclosure of any deviations from ASOPs

6

Challenges in determining the value of an insurance company

1. Long duration of liabilities
2. Sensitivity to interest rate fluctuations and the performance of capital markets
3. Subjective art of loss reserving
4. Cyclical nature of insurance
5. Impact of reinsurance recoverables
6. Challenges associated with non-market competitors, such as state funds
7. Varying state and sometimes federal regulations
8. Impact of statutory accounting on operational decisions
9. Influence on rating agencies

7

Techniques used by investment bankers to determine the value of a company

1. Comparable company analysis - the value of the company is estimated based on the values of a peer group of comparable companies
2. Comparable transaction analysis - the value is estimated based on results of recent insurance mergers that are similar
3. Discounted cash flow analysis - the projected cash flows and terminal values are discounted to a net present value using the WACC

8

Formulas for using a discounted cash flow analysis in an actuarial appraisal

1. An actuarial appraisal is a discounted cash flow analysis
2. Actuarial appraisal value = PV(distributable cash flows)
3. Distributable cash flow = after-tax earnings - increase in required capital
4. The discount rate is the weighted average cost of capital (WACC) from the Capital Asset Pricing Model
5. WACC = r = rD * %debt + rE * %equity, where
rD = required after-tax return on debt
rE = expected return on equity = rF + beta * (rM = rF)
rF = risk-free rate of return
beta = the risk level of a company's stock
rM = expected rate of return for the market as a whole
%debt = D / (D + E)
%equity = E / (D + E)
D = market value of a company's debt
E = market value of a company's equity

9

Components of the actuarial appraisal value

1. Adjusted book value - the net worth of the insurance company on a statutory basis, adjusted for the value of misc. items not captured elsewhere (see separate list)
2. Value of inforce business - the present value of future profits arising from business that is on the books as of the valuation date. An adjustment is included to reflect the cost of capital
3. The value of future business capacity - the present value of future profits arising from business that is expected to be written following the valuation date. An adjustment is included to reflect the cost of capital.

10

Uses of an actuarial appraisal

1. Help value the company - potential buyers will make the following adjustments to the actuarial appraisal:
a. Discount rate - buyer will reflect its internal view of the appropriate discount rate
b. Experience and product management assumptions - a buyer may adjust certain assumptions based on its internal views.
c. New business values - a buyer may adjust new business values based on its view of future business capacity
d. Synergies - buyer may reflect the benefits from anticipated synergies or cost savings
e. Structure - buyer may reflect the impact on the business of the buyer's tax and capital structure
2. Form the basis for alternate accounting methods for cross-border transactions
3. Can be adjusted to calculate pro forma earnings and to establish the opening purchase GAAP balance sheet
4. Measure ongoing performance after the acquisition

11

Assumptions needed for actuarial appraisals

1. Mortality - typically based on company experience compared to an industry standard
2. Morbidity - also based on company experience
3. Persistency - lapse assumptions and any shock lapses should be considered
4. Investment returns and spreads - consider expected investment returns, reinvestment rates, and interest rates credited on insurance policies
5. Operating expenses - this assumption could be based on various approaches (most commonly based on target unit expenses plus an unallocated expense)
6. Discount rate - seller typically gives a range of reasonable rates instead of a specific rate (the CAPM may be used to determine this rate)
7. Cost of required capital - the company will have an opportunity cost associated with setting aside capital to comply with required capital regulations
8. Taxes - the actuarial appraisal should reflect a deduction for federal income taxes

12

Components of the adjusted book value (or net worth) of an insurance company

1. Capital and surplus - includes statutory capital stock, contributed surplus, and retained earnings
2. Asset valuation reserve (AVR) - this liability is part of surplus and is allocated to the lines of business
3. Interest maintenance reserve (IMR) - this liability represents past interest-related capital gains not yet amortized into income
4. Deferred tax asset - the admitted portion of the statutory deferred tax asset is deducted from adjusted book value
5. Non-admitted assets - the realizable value of assets that were non-admitted for statutory purposes, if they will contribute to earnings over time
6. Surplus notes and other debt - a reduction is appropriate for any debts owed to another party
7. Mark-to-market on assets allocated to adjusted book value - this component reflects some riskier assets that are allocated to adjusted book value
8. Adjustment in the value of certain admitted assets that the user values differently than the reported statutory value
9. Adjustment in the value of certain liabilities that the user values differently than the reported statutory value (for example, claim reserves)

13

Approaches for using reinsurance to sell a block of business

1. Assumption reinsurance - contracts are transferred from the seller's books to the buyer's books. The policyholder must be notified, and some states require policyholder consent to transfer the policy.
2. Indemnity coinsurance - the financial interest is transferred to the buyer, but the policy stays with the seller. The policyholders do not need to be notified, but the seller remains in the middle of future transactions.
3. Modified coinsurance - similar to indemnity coinsurance, except that the assets backing the liabilities remain with the selling company

14

Techniques for estimating property and casualty loss reserves

1. Loss development method (essentially the same as the development method for health insurance)
2. Expected loss method - the expected loss is determined in one of two ways:
a. Expected loss = forecasted exposure * expected ultimate loss rate
b. Expected loss = earned premium * expected loss ratio
(essentially the same as the projection and loss ratio methods for health insurance)
3. Bornheutter-Ferguson method - for each accident year: Reserve = [1 - (1 / paid loss development factor)] * expected loss from the expected loss method

15

Diagnostic tools for evaluating claim reserve estimates

1. Assessing the convergence of the various loss reserving techniques - when estimates from various techniques diverge, it may be a sign that there has been a change in claim development
2. Analyzing various reserving statistics - such as development triangles of settlement rates, and development patterns of average size claim
3. Testing the runoff of prior reserve estimates

16

Formulas for market value of equity

1. Market value of equity = market value of assets - market value of liabilities. MV(E) = MV(A) - MV(L)
2. Market value of equity = franchise value + market value of tangible assets - present value of liabilities + put option value. MV(E) = FV + MV(TA) - PV(L) + PO
3. Relationship between market value and firm risk exposure:
a. MV increases as insolvency risk increases (put option value increases)
b. MV increases as firm decreases in insolvency risk (franchise value increases)

17

Formulas for calculating embedded value

For a block of business:
1. Embedded value = PV(after-tax profits) + cost of capital
2. Cost of capital = PV(future tied capital releases minus increases) + PV(after-tax income earned on tied capital) - tied capital

For the company as a whole:
1. Embedded value = PV(after-tax profits) + cost of capital + tied capital + free capital = PV(after-tax profits) - PV(increase in locked-in capital) + PV(after-tax investment income on capital) + free capital

18

Uses of embedded value for a block of business

1. To set a value on a block of business for sale or purchase
2. As a part of the calculation of the value of a company. The company's value would also include the value of future new business.
3. To ensure that new business sold is generating an increase in value
4. To determine compensation for sales staff
5. To measure the impact of specific management actions on the long-term value of the company

19

Definition of embedded value

1. A calculation of the value of a block of business, based on the present value of surplus distributable to shareholders
2. Is based on current in-force business only (not new business)
3. Equals the value of in force business plus the value of free capital. Free capital is the capital in excess of regulatory capital requirements (locked-in or tied capital)

20

Formulas for calculating embedded value for a company

These two methods are equivalent. Present values are discounted using the hurdle rate (h).
1. Profits to shareholders method
a. Embedded value = free capital + PV(profits to shareholders)
b. Profits to shareholders = after-tax profits + after-tax investment income on capital - increase in locked-in capital
c. After-tax profit = premiums + investment income - benefits - expenses - increase in statutory reserve - tax on income
d. Tax on income = tax rate * (premiums + investment income - benefits - expenses - increase in tax reserve)
2. Cost of capital method
a. Embedded value = free capital + locked-in capital + PV(after-tax profits) - PV(cost of capital)
b. Cost of capital = h * locked-in capital - after-tax investment income on capital

21

Formulas illustrating the change in embedded value over time

1. Embedded value (t+1) = embedded value (t) + normal increase in embedded value + value added by new sales - dividends paid + unexpected change in embedded value
2. Normal increase in embedded value = (embedded value (t) - free capital) * (1 + h) + free capital * (1 + h), where i is the after-tax investment income rate
3. Value added by new sales = PV(future after-tax profits on new sales) - PV(future cost of capital to support those sales)
4. An unexpected change in embedded value could occur for various reasons, such as actual experience being different than expected, a change in an embedded value assumption, or a capital injection

22

Embedded value vs. stock price

1. Embedded value excludes the value of future business and may use a different discount rate
2. Because they are similar, embedded value calculations can be used to predict the impact of changes in the environment or decisions may have on stock price

23

Other uses of embedded value to insurer

1. Management compensation could be tied to changes in embedded value
2. Actuarial appraisal - is the value of in-force business (embedded value) + value of future business. Value of future sales is often expressed as a multiple of value added by 1 yr of sales
3. Goodwill - is the excess of a purchase price over fair value; embedded value can be used to determine the fair value