2010 EEV/MCEV. Focus on value and cash flow. Table 01. Summary of approach to allowing for risk companies reporting EEV/MCEV 1

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1 May 2011 Insights 2010 EEV/MCEV Focus on value and cash flow The 2010 life insurer reporting season showed a continuing focus on supplementary information, with an emphasis by several companies on projected cash flows and other additional metrics. In this publication, we review the year-end 2010 embedded value (EV) and related supplementary metrics published by life insurers who reported under either the European Embedded Value Principles (EEV Principles) or the European Insurance CFO Forum Market Consistent Embedded Value Principles (MCEV Principles, copyright Stichting CFO Forum Foundation 2008). Almost all companies publishing under either the EEV or the MCEV Principles at year-end 2010 followed the same basis of preparation (whether EEV or MCEV Principles) and a similar methodology as at year-end Table 01 sets out the number of companies reporting under the EEV Principles and the MCEV Principles as at year-end 2010 and prior year-ends. A proportionate breakdown of the approach to allow for risk is provided for companies reporting under the EEV Principles. Further details of the 2010 EEV and MCEV publications by company are provided in the Appendix. In April 2011, the CFO Forum announced the continued coexistence of the EEV and MCEV Principles going forwards, by withdrawing the requirement for the mandatory adoption of MCEV Principles by CFO Forum companies by the end of In that announcement the CFO Forum noted its ongoing commitment to supplementary reporting, including embedded values. In the remainder of this edition of Insights, we: Describe the supplementary disclosures provided by life insurance companies. Describe recent financial and regulatory reporting developments affecting insurance companies and how they may affect future supplementary reporting. Briefly describe the methodology followed by market-consistent reporters for year-end 2010 publications. Speculate as to the potential role for supplementary reporting going forwards. Table 01. Summary of approach to allowing for risk companies reporting EEV/MCEV 1 MCEV Principles Reporting under the EEV Principles 2 Total Total Top-down Market-consistent Other Indirect Direct End 2010 reporting % 11% 64% 4% End 2009 reporting % 12% 64% 4% End 2008 reporting % 17% 60% 3% End 2007 reporting N/A 34 20% 18% 56% 6% End 2006 reporting N/A 35 26% 17% 46% 11% End 2005 reporting N/A 21 33% 24% 24% 19% End 2004 reporting N/A 5 80% 20% 0% 0% 1 Includes both CFO Forum and non-cfo Forum companies publishing by the end of May For a description of these approaches, see our May 2008 Update 2007 EEV: Stable accounting in volatile markets.

2 Supplementary disclosures In recent years, a number of life insurers have expanded the supplementary information to reflect a range of metrics used in strategic decision making and/or to provide additional insights. This section describes year-end 2010 practice, covering both compulsory disclosures required by the EEV/MCEV Principles and additional voluntary disclosures. Compulsory EEV/MCEV disclosures Required disclosures include the balance sheet (accompanied by a reconciliation to IFRS or other consolidated GAAP equity), the analysis of earnings (or movement), the value of new business (VNB), and the sensitivities. This set of information can help provide the basis for indicating the components of value, understanding a company s risk exposures, determining capital requirements, understanding capital flows and assessing risk-adjusted targets and performance. The MCEV Principles prescribe the format for presenting the analysis of earnings in Appendices A and B of that document. Appendix A requires that the MCEV movement is split between free surplus, required capital and the value of in-force business, highlighting the capital generation of in-force business and the capital strain of new business. Appendix B, the Group MCEV analysis of earnings, requires a combined analysis of covered business MCEV and non-covered business IFRS results to be shown. At year-end 2010, 12 of 13 MCEV Principles publications included an Appendix A analysis of MCEV earnings (13 of 14 in 2009). At year-end 2010, eight of the 13 publications also included an Appendix B analysis of Group MCEV earnings (8 of 14 in 2009). There were 11 EEV Principles publications at year-end 2010 which included information similar to the Appendix A analysis of earnings (nine in 2009). Voluntary disclosures In recent years, a number of life insurers reporting EEV/MCEV results have expanded the supplementary information provided to users, to include additional information such as: The timing of the emergence of future statutory (regulatory) distributable profits, with the projected profits typically presented net of shareholder required capital and on a real-world economic basis (that is, including expected investment risk premia). The internal rate of return, which is typically defined as the discount rate applied to the projected real-world distributable profits on new business (including the new business strain, and typically net of shareholder required capital) to produce a nil present value at the point of sale. This metric provides the user with an indication of the expected reward given the capital invested. The payback period, which is typically defined as the length of time required before the sum of the projected real-world distributable profits (including the new business strain, and typically net of shareholder required capital) on a block of new business is greater than nil. It helps stakeholders understand how long it takes before capital employed is expected to be returned. The payback period is generally calculated using undiscounted profits. Figure 01 summarises the numbers of companies (of those included in the Appendix) publishing these supplementary metrics at year-end 2010, 2009 and Companies also publish sensitivities of their EEV/ MCEV results. Both the EEV Principles and the MCEV Principles require the publication of a minimum set of sensitivities to the EV and the VNB. Some companies published additional voluntary sensitivities related to either credit risk or the illiquidity premium. At year-end 2010, eight companies published a credit spread sensitivity (seven at 2009). The section Market-consistent methodology below provides details of the illiquidity premium sensitivities. Figure 01. Voluntary supplementary EV-related metrics reported by life insurers Metric Timing of emergence of projected distributable profits on in-force business Timing of emergence of projected distributable profits on new business New business internal rate of return New business payback period Numbers publishing towerswatson.com

3 Financial and regulatory reporting developments This section describes recent Solvency II, IFRS and US GAAP developments related to insurance companies and how they may affect future supplementary reporting. Solvency II During 2010 many European life and non-life insurance companies participated in the Solvency II 5th Quantitative Impact Study (QIS 5). The QIS 5 Specification was published on 5 July 2010, following an earlier draft published on 15 April A detailed summary and analysis of QIS 5 is provided in our August 2010 Insights Solvency II: Getting to grips with QIS 5. An analysis of the QIS 5 results was published by EIOPA on 14 March The European Commission published a provisional version of the draft text of the Omnibus II Directive on 19 January This directive will, if adopted, amend the Solvency II Directive. It is proposed that Article 311 of the Solvency II Directive is replaced by: Articles and Annexes shall apply from 1 January As widely anticipated, this introduces a two-month delay to the implementation of Solvency II. This publication also sets out a transfer of powers from CEIOPS to EIOPA, and is described in more depth in our January 2011 e-alert Publication of Omnibus II Directive and EIOPA work plan for On 29 March 2011, the Pan European Insurance Forum, the CEA, the CFO Forum and the CRO Forum co-signed a letter to the European Commission voicing concerns with the current direction of the Level 2 implementing measures, setting out key outstanding issues and requesting EIOPA and the Commission deliver effective solutions that address these concerns, and do so before summer Companies have to date not disclosed the impact of Solvency II on the performance metrics described in the previous section, with Solvency II-related disclosure limited to the ongoing cost of Solvency II implementation programmes. This is not surprising, given the uncertainty to date regarding the details of the final Solvency II Pillar 1 basis and that both the EEV Principles and the MCEV Principles refer to allowing for current legislation and known future changes in the projection. Given the uncertainty regarding the date of finalisation of the Level 2 implementing measures, it is not clear whether the year-end 2011 EEV/MCEV reporting season will provide any additional insight on the impact of Solvency II on supplementary metrics. Primary accounting developments Primary accounting developments have been observed both within current accounting practice and the development of new accounting standards. In recent years, several insurance companies have published supplementary IFRS disclosures, providing an alternative margin analysis form of the income statement, where earnings are typically split between investment margin, insurance margin and expense margin. On 30 July 2010, the International Accounting Standards Board (IASB) published the long-awaited exposure draft (ED) of a new Insurance Contracts standard. A detailed summary of the ED and the wider IASB developments affecting insurance companies (the financial instruments, fair value measurement and revenue recognition projects) is provided in our October 2010 Insights IASB s Insurance Contracts Exposure Draft. On 17 September 2010, the Financial Accounting Standards Board (FASB) published its discussion paper (DP) entitled Preliminary Views on Insurance Contracts. The insurance contracts project is a joint project between the IASB and the FASB. The FASB DP is very similar to the IASB ED, with a small number of clear differences in policy. These are also summarised in our October 2010 Insights publication. The latest IASB information suggests that a final IASB Insurance Contracts standard may be published in the fourth quarter of 2011, with a possible effective date of 1 January A FASB exposure draft is expected to be published at a similar time as the publication of the IASB final standard. Given this, it is possible that IASB/FASB Phase II will have little impact on supplementary EV reporting and related metrics for several years. Focus may instead turn to how the key performance messages arising from the EV analysis of movement relate to the messages arising from the supplementary IFRS margin analysis, for those companies that publish such an analysis. Given the uncertainty regarding the date of finalisation of the Level 2 implementing measures, it is not clear whether the year-end 2011 EEV/MCEV reporting season will provide insight on the impact of Solvency II on supplementary metrics. towerswatson.com 3

4 Market-consistent methodology A brief summary of the methodology for the 13 companies reporting under the MCEV Principles and the 21 companies reporting under the EEV Principles using a market-consistent approach is provided in this section. In many areas there has been little change from year-end 2009; further details of year-end 2009 practice are provided in our May 2010 Insights 2009 EEV/MCEV: Greater consistency, challenges remain. Reference rate (including illiquidity premium) Table 02 summarises the reference rate approach used by these 34 companies at year-end Almost all of these companies were classified in the same category as at year-end 2009, but the influence of Solvency II could be seen this year-end in, inter alia, the derivation of the illiquidity premium. Three specific aspects in calibrating the illiquidity premium are as follows: 1. Assessing the illiquidity risk premium within yields on illiquid assets. The QIS 5 approach uses the following formula to measure the level of illiquidity risk premium in illiquid assets (described further in our May 2010 Insights): Illiquidity premium = max [0, 50% * (Spread 40 bps)] 2. Determining for which products an illiquidity premium can be included within the valuation, and what proportion of the illiquidity risk premium to apply. The QIS 5 approach applies a bucket approach (described in our August 2010 Insights) to allocate 50%, 75% or 100% of the illiquidity premium to products, depending on their features. 3. Determining over what period the illiquidity premium applies. The QIS 5 approach applies the illiquidity premium additively to the basic swap curve up to cut-off points (defined by currency) at which point the addition applied to the forward rate is reduced linearly to nil over the next five years. Table 03 opposite describes in more detail the reference rate approach taken by CFO Forum companies. It shows that of the ten companies allowing for an illiquidity premium, six adopted the QIS 5 formula to measure the asset illiquidity risk premium at year-end 2010, in a change from year-end 2009 practice. Only one of these six stated it applied exactly the bucket approach prescribed in QIS 5 to allocate the illiquidity premium to products. It remains to be seen whether the QIS 5 illiquidity premium approach will form part of the Solvency II Level 2 implementing measures, or whether that aspect of the measurement of technical provisions will be changed by the time Level 2 is finalised. Table 02. Reference rate approach for market-consistent publications, year-end 2010 EV MCEV Principles EEV Principles Swaps 7 4 Swaps/swaps plus illiquidity premium 1,2 5 4 Swaps plus illiquidity premium 0 3 Government bonds 0 4 Government bonds/government bonds 1 3 plus illiquidity premium 2,3 Other A small number of companies following this approach applied swaps less 10bps, not swaps. 2 An illiquidity premium is applied for some, but not all, lines of business. 3 One company defines its reference rate, pre-illiquidity premium, as government bonds + 10bps. Although neither the EEV Principles nor the MCEV Principles require the publication of illiquidity premium sensitivities, 15 of the 34 market-consistent companies published a sensitivity at year-end 2010 (12 of 33 at 2009). These 15 companies included some which did not include an illiquidity premium within their main EEV/MCEV results. The published sensitivity varies, with five companies illustrating the impact of removing the illiquidity premium entirely (six at 2009) and nine companies showing the effect of a 10 bps increase in the illiquidity premium (eight at 2009). Another area which has seen some change from year-end 2009 is the extrapolation approach used to determine the reference rate for longer durations. At year-end 2009, many EEV/MCEV publications did not disclose the extrapolation approach used, but those that did tended to extrapolate a level forward or spot rate from the longest credible duration. The QIS 5 specification sets out a macroeconomic extrapolation technique which assumes a long-term equilibrium rate (the ultimate forward rate), for certain currencies, which interpolates between the entry point to extrapolation (which is specified) and the ultimate forward rate. The stated aim of this technique is to reflect economic views on how unobservable long-term rates are expected to behave and to improve financial stability. At year-end 2010 four companies adopted the QIS 5 approach to extrapolation, with most other companies not disclosing the approach used. For those companies with businesses in certain Eurozone countries, the sovereign debt crisis impacted results. While certain sovereign debt assets held fell in value during 2010, the reference rate calibration method used by most companies 4 towerswatson.com

5 Table 03. Summary of reference rate calibration approaches CFO Forum market-consistent publications only, year-end 2010 EV Company EEV or MCEV Reference rates Principles Ageas EEV P Swaps less 10bp, increased by illiquidity premium calibrated in line with the CFO/CRO Forum recommendations to EIOPA and applied to products in 100%/75%/50% buckets. Ageas uses a weighted average illiquidity premium for each insurance company based on their liability mix, of bps in Eurozone, bps in the US and bps in Hong Kong. Allianz MCEV P Swaps less 10bp, plus illiquidity premium where the illiquidity premium is calibrated using the QIS 5 formula. The 100% illiquidity premium adjustments are 59 bps in Eurozone, 64 bps in the US, 7 bps in Switzerland and 14 bps in the Czech Republic. No illiquidity premium is applied to unit-linked and variable annuity business, and 75% illiquidity premium is applied to all other business. For Korea government bond yields with no illiquidity premium are used. Aviva MCEV P Swaps, increased by an illiquidity premium for certain contracts. The illiquidity premium calibration is based on the QIS 5 formula. For immediate annuity type contracts an increase of 109 bps in the UK, 36 bps in France and Spain. For Delta Lloyd, a QIS 5 buckets approach is applied to allocate the 36bp illiquidity premium to products. For US business the illiquidity premium is 66 bps for immediate annuities and 56 bps for all other contracts. AXA EEV P Swaps, increased by an illiquidity premium calibrated using the QIS 5 formula. The 100% illiquidity premium adjustments are 79 bps in the UK, 36 bps in Eurozone, 56 bps in the US, 65 bps in Australia and 8bps in Switzerland. No illiquidity premium is applied to unit-linked and variable annuity business; other products are allocated to 100%/75%/50% buckets. CNP MCEV P Swaps, plus illiquidity premium for certain products. Illiquidity premium calibrated using QIS 5 formula, and applied to products using buckets 75%/50%/0%. The weighted average Illiquidity premium applied to Euros savings and retirement business and annuities is 41 bps and 27 bps is applied to some other products. Generali EEV P Swaps, increased by an illiquidity premium calibrated and applied to products in line with the QIS 5 approach. The 100% illiquidity premium adjustment is 79 bps in the UK, 36 bps in Eurozone, 56 bps in the US and 8 bps in Switzerland. For the Czech Republic and Israel government bonds are used. Hannover Re MCEV P Swaps, unadjusted. Lloyds Banking Group 1 EEV P Reference rate for UK annuities set to government bonds plus illiquidity premium of 75 bps; government bonds for all other business. Munich Re MCEV P Swaps, unadjusted. Old Mutual MCEV P Swaps, increased by 75 bps for US Life business and 45 bps for Old Mutual South Africa Retail Affluent immediate annuity business; unadjusted for other business. Prudential EEV P MCEV approach used for UK annuities only: reference rate set to swaps plus 92 bps for in-force business and swaps plus 79 bps for new business. Standard Life EEV P Reference rate for UK business set to 3.49% based on government bonds. For UK annuities that are level or subject to fixed escalations investment return is set to 4.91%. Zurich MCEV P Swaps, unadjusted. 1 Includes HBOS and Scottish Widows. Scottish Widows is a member of the CFO Forum. meant that the valuation of the liabilities was not directly impacted. One company that had used a local Eurozone government bond yield at year-end 2009 changed its approach at year-end 2010 to avoid taking credit for widening government spreads in the calibration of the reference rate. End-period implied volatilities Of the 34 companies, all those who disclosed their approach at year-end 2010 used end-period implied equity option and swaption volatilities (as was generally the case at year-end 2009), with the exception of one company that used a 27 December calibration. Non-hedgeable risks The EEV Principles require that sufficient allowance is made for the aggregate risks in the business but do not provide further explicit guidance on the allowance for non-hedgeable risks (NHR). In contrast, the allowance for NHR is covered in a number of areas of the MCEV Principles, described further in our May 2010 Insights. The MCEV Principles requires that sufficient disclosures are provided to enable a comparison to a cost of capital methodology. Table 04 provides summary statistics for the equivalent cost of capital charge disclosed in the 13 MCEV Principles publications at year-end 2010 and the 14 publications at year-end 2009, showing little change from 2009 to Table 04. Equivalent annual cost of capital charge for NHR for MCEV Principles publications Year Minimum Lower quartile Median Upper quartile Maximum % 2.5% 2.9% 4.0% 7.0% % 2.5% 2.8% 4.4% 7.0% towerswatson.com 5

6 Towers Watson perspectives In recent years, many companies have incorporated improvements into their supplementary reporting, whether as a result of the adoption of the EEV or the MCEV Principles, or by providing additional voluntary disclosures. In the next few years, both primary and regulatory reporting frameworks are expected to change significantly. In the early years of transition, consistency of supplementary reporting over time, rather than between companies, may be desirable to provide a basis of continuity for investors during a period of change. This view has much merit, but would mean that consistency of supplementary reporting across the life insurance industry remains a distant goal. With the onset of Solvency II and IASB/FASB Phase II, the longer-term role of supplementary reporting is uncertain. It is clear supplementary reporting will have to adapt, but is there a chance it will be superceded altogether? On the one hand, life insurers are somewhat unique among industries in producing three sets of financial reports, regulatory, primary accounting and supplementary. Given the moves within both primary and regulatory reporting towards a market-consistent approach, and the practical implementation challenges, companies may be tempted to scale back supplementary reporting. On the other hand, existing supplementary reporting facilitates good engagement with investors by focusing on shareholder value and cash flow, strengthening the case for a longer-term role for supplementary reporting. One development that we welcome is the expansion of the supplementary reporting pack in recent years. We believe that the additional cash flow/new business metrics and IFRS margin analyses provide additional insight into business performance, helping senior management and investors make better decisions. However, this expansion in the number of key metrics provides its own challenges, as each metric can provide different performance messages in a single reporting period. A clear understanding and explanation of such differences helps reinforce confidence in a company s results and strategy. One development that we welcome is the expansion of the supplementary reporting pack in recent years. We believe that the additional cash flow/new business metrics and IFRS margin analyses provide additional insight into business performance, helping senior management and investors make better decisions. 6 towerswatson.com

7 Appendix: 2010 EEV and MCEV Principles publications Company Allowance for risk classification 1 Risk Discount Rate approach Year-end 2010 publications under the MCEV Principles Options and guarantees 1 Cost of capital 2 Allianz Direct market-consistent Bottom-up Market-consistent Frictional costs Aviva Direct market-consistent Bottom-up Market-consistent Frictional costs CNP Direct market-consistent Bottom-up Market-consistent Frictional costs Hannover Re Direct market-consistent Bottom-up Market-consistent Frictional costs Himawari Life 3 Direct market-consistent Bottom-up Market-consistent Frictional costs Mediolanum Direct market-consistent Bottom-up Market-consistent Frictional costs Munich Re Direct market-consistent Bottom-up Market-consistent Frictional costs Old Mutual Direct market-consistent Bottom-up Market-consistent Frictional costs Phoenix Group Direct market-consistent Bottom-up Market-consistent Frictional costs Resolution Direct market-consistent Bottom-up Market-consistent Frictional costs Sony Life 3 Direct market-consistent Bottom-up Market-consistent Frictional costs Swiss Life Direct market-consistent Bottom-up Market-consistent Frictional costs Zurich Direct market-consistent Bottom-up Market-consistent Frictional costs Year-end 2010 publications under the EEV Principles AEGON Top-down WACC Top-down Real-world Traditional Ageas Direct market-consistent Bottom-up Market-consistent Frictional costs AXA Direct market-consistent Bottom-up Market-consistent Frictional costs Chesnara Direct market-consistent Bottom-up Not material Frictional costs Dai-ichi 3 Direct market-consistent Bottom-up Market-consistent Frictional costs Delta Lloyd Group Top-down WACC Top-down Market-consistent Frictional costs Eureko Top-down WACC Top-down Both are used Traditional Generali Direct market-consistent Bottom-up Market-consistent Frictional costs Groupama Direct market-consistent Bottom-up Market-consistent Frictional costs Hansard Global 4 Direct market-consistent Bottom-up Not material Frictional costs IL&P Indirect market-consistent Bottom-up Market-consistent Traditional Just Retirement 4 Direct market-consistent Bottom-up Market-consistent Frictional costs KBC Direct market-consistent Bottom-up Market-consistent Frictional costs Legal & General Top-down WACC Top-down Real-world Traditional Lloyds Banking Group Direct market-consistent Bottom-up Market-consistent Not disclosed Mitsui Life 3 Direct market-consistent Bottom-up Market-consistent Frictional costs Prudential 5 Other Bottom-up Both are used Traditional PZU Direct market-consistent Bottom-up Market-consistent Frictional costs Royal London Direct market-consistent Bottom-up Market-consistent Frictional costs SJP Indirect market-consistent Bottom-up Not material Not disclosed SNS REAAL Top-down WACC Top-down Real-world Not disclosed Standard Life 6 Indirect market-consistent Bottom-up Market-consistent Traditional Storebrand Direct market-consistent Bottom-up Market-consistent Frictional costs Sumitomo Life 3 Direct market-consistent Bottom-up Market-consistent Frictional costs T&D Holdings 3 Direct market-consistent Bottom-up Market-consistent Frictional costs UNIQA Direct market-consistent Bottom-up Market-consistent Frictional costs Vienna Insurance Direct market-consistent Bottom-up Market-consistent Frictional costs Vital Top-down WACC Top-down Real-world Traditional 1 At year-end 2010 a number of different market-consistent approaches were used in EEV and MCEV to set the reference rate, to adjust for illiquidity, and to set the allowance for non-hedgeable risk. For more information see pages 4 and 5. 2 Traditional cost per unit capital is the difference between the top-down RDR and the net earned rate. Frictional costs were almost always defi ned as tax and investment expenses. 3 Financial year-end is 31 March Financial year-end is 30 June Prudential used a bottom-up product specifi c beta approach, except for UK annuities where it used a market-consistent approach with a risk-free rate of swaps plus an illiquidity premium adjustment. 6 Standard Life used an indirect market-consistent approach which separately calibrated the allowance for risk by in-force business/new business and by region. towerswatson.com 7

8 Contacts For further information, please contact your usual Towers Watson consultant or: Kamran Foroughi Stefan Bause Jean-François Cartier jean-francois.cartier@towerswatson.com James Creedon james.creedon@towerswatson.com Jan De Roeck jan.de.roeck@towerswatson.com Alexander Dollhopf alexander.dollhopf@towerswatson.com Ana Escudero ana.escudero@towerswatson.com Monica Florian monica.florian@towerswatson.com Masahiko Fujiki masahiko.fujiki@towerswatson.com Bernhard Gose bernhard.gose@towerswatson.com Colm Guiry colm.guiry@towerswatson.com Noel Harewood noel.harewood@towerswatson.com Dominique Lebel dominique.lebel@towerswatson.com Grace Marshall grace.marshall@towerswatson.com Gerard Pater gerard.pater@towerswatson.com Hannah Robbie hannah.robbie@towerswatson.com About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Towers Watson Limited, Towers Watson UK Limited and Towers Watson Capital Markets Limited are authorised and regulated by the Financial Services Authority. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. To unsubscribe, eu.unsubscribe@towerswatson.com with the publication name as the subject and include your name, title and company address. Copyright 2011 Towers Watson. All rights reserved. TW-EU May towerswatson.com