Session 61, Overview of Embedded Value. Moderator: Zeeshan Ramzan Ali Rehmani, FSA, MAAA. Presenter: David Lawrence White, Jr.

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1 Session 61, Overview of Embedded Value Moderator: Zeeshan Ramzan Ali Rehmani, FSA, MAAA Presenter: David Lawrence White, Jr., FSA, MAAA

2 Overview of Embedded Value David White, FSA, MAAA KPMG LLP Zeeshan Rehmani, FSA, MAAA KPMG LLP August 30, 2016

3 Contents Agenda: Why use EV? What is EV? EV assumptions EV metrics EV in decision making Questions 2

4 Why use Embedded Value?

5 Value creation matrix Value creation matrix Organic Inorganic In-force New business In-force New business Short-term Costs/Expenses N Sell business/blocks N Capital management strategy N Reinsure business/blocks Securitize Share buybacks Hedging N/A N N/A Long-term Investment strategy Product portfolio N Purchase business/blocks Product design N Customer retention Distribution channels Questions to consider: How to measure performance? How to look at the results of the analysis? What levers to use to improve company performance? 4

6 The benefits of using an EV basis Embedded Value provides benefits in managing an insurance company Provide a consistent enterprise-wide value metric that can be paired with risk metrics (e.g., economic capital) for a more holistic view of running a business. Assess the key levers in managing the in-force and new business, analyzing the profitability of business and optimizing the capital allocation for the enterprise. Produce a consistent realistic valuation measure of the business for assessments of shareholder value and financial strength. Develop the ability to quantify, analyze and communicate activities that have increased shareholder value over a given time. Assess mergers, acquisitions and reinsurance deals. 5

7 What is Embedded Value?

8 Types of EV reporting disclosed What is Embedded Value? Embedded Value (EV) = Value In Force (VIF) + Required Capital (RC) + Free surplus (FS) Four types of EV reporting: Traditional Embedded Value (TEV) European Embedded Value (EEV) Market Consistent EEV Market Consistent Embedded Value (MCEV) TEV EEV Market consistent EEV MCEV Future of EV reporting unclear given SII Less guidance Best estimate More guidance Risk neutral, Market consistent Additional types of shareholder value reporting Swiss Re publicly reports Economic Value Management (EVM) which is their integrated economic valuation and accounting framework for business planning, pricing, reserving, steering which: - Shows stakeholders a direct connection between risk-taking and value creation - Provides a market consistent valuation of all assets and liabilities For E13 they have provided a high level reconciliation from EVM to MCEV. 7

9 Value of an insurance business MCEV, MC EEV and EEV comparison Assets MCEV Liabilities MC EEV EEV Net worth = Required Capital + Free Surplus Net worth = + Required Capital + Free Surplus Net worth = + Required Capital + Free Surplus Market value of assets VIF Frictional Cost Time Value of Options Guarantees Cost of Non Hedgeable Risks PVFP discounted at RF (risk free discount rate usually plus a liquidity premium, market consistent assumption) VIF Cost of Capital Time Value of Options Guarantees Could be based on RDR or RF Could be based on market consistent/ real world scenarios VIF Cost of Capital Time Value of Options Guarantees PVFP discounted at RDR (risk adjusted discount rate, best estimate assumps) Market Consistent Value of Liabilities Statutory Value of Liabilities Statutory Value of Liabilities 8

10 Value of an insurance business An insurance company has assets today and profits in its products which will emerge over time The embedded value is the sum of the company s net assets and the value of the in-force policies to the extent they have not already been included in the value of net assets. Therefore, EV capture all the profits in the insurer, both now and in the future. Components of overall value of a life business Value of future new business The EV does not take credit for the value of future business not yet written. The EV does include the value of new business written in the current year. Value of in-force business Embedded value Shareholder net worth 9

11 Future profits Value of in-force (VIF) measures the profits which are expected to emerge in the future VIF includes a projection of the future statutory profits expected to emerge on the current contracts. It also makes an allowance for the cost of holding capital and the cost of some options and guarantees. VIF components Definitions VIF The present value of future profits = PVFP - Cost of Capital There will be an opportunity cost involved where the firm cannot use this to invest in other projects. - Time Value of Options Guarantees The cost of providing options and guarantees to a policyholder that is not captured in the PVFP. 10

12 Value of New Business (VNB) The profit recognized at the point of sale, i.e., the value of new business, can be characterized as the return on distribution and policy-set up activities. VNB is equal to the statutory profit or loss at point of sale plus the VIF created. Total value of charges at point of sale Profit on new business Acquisition costs Cost of required capital Total value of charges at point of sale 287 Less: cost of future expenses (102) Less: cost of required capital (3) Available to meet distribution and set up costs 183 Less: distribution costs (100) Less: set-up costs (70) EV profit at point of sale 13 Present value of future maintenance costs NOT TO SCALE 11

13 Embedded Value assumptions

14 Factors affecting embedded value EV is responsive to all the internal and external business impacts, which make it a useful management tool The embedded value profit reflects all the factors that ultimately determine the economic performance of the business New business volumes Product charges Profit on new business Initial costs Capital required ields Cost of required capital Discount rate Value of in-force Servicing costs Mortality Persistency Investment performance (a) Assumption changes Variances Net assets Note: (a) As well as the direct impact on the value of the company s investments, the investment performance of policyholder assets also affects the company s result since the annual management fees are based on a percentage of the value of the funds 13

15 Embedded Value metrics

16 Key metrics Key definitions NB management metrics Metric Description Metric Description VNB VNB % EV The value of new business written over the period The proportionate contribute of VNB to total EV In-force management metrics VIF Required capital The value of inforce business (i.e., PVFP TVOG CoC) Assets, over and above liabilities whose distribution to shareholders is restricted. NB margin VNB as a percentage of ANP EV/RC Total EV over Required Capital ANP Investment in new business (INB) Investment in new business % ANP IRR Payback period Annual new premium (i.e., = RP + 0.1*SP). The loss at point of sale plus Required Capital to support the new business The percentage of ANP eliminated by the Investment in New Business The discount rate that makes the net present value of all cashflows equal to 0. The period of time required to reach the break-even point on Investment in New Business % Dist. cashflows IRR Payback period The proportion of total cash flows of the policy that can be distributed in a given time horizon The discount rate that makes the net present value of all cash flows equal initial Required Capital The period of time required to reach the break-even point on Required Capital at the valuation date 15

17 Cash flow profile analysis Product 1 Metric Value (USD million) Acquisition Cost (% of ANP) Capital (% of ANP) 110% 55% Payback NB margin 12 years 18% DE ear Acumm DE IRR 10.3% Product 2 (USD million) ear DE Acumm DE Acquisition Cost (% of ANP) Capital (% of ANP) IRR 110% 10% 11.1% Payback NB margin 9 years 16% Product 3 (USD million) Acquisition Cost (% of ANP) Capital (% of ANP) 50% 10% Payback NB margin 3 years 20% ear DE Acumm DE IRR 67.8% 16

18 Cash flow profile analysis Questions to consider Which product has the most attractive: - Acquisition costs - Capital - IRR - Payback period - NB margin Therefore which product is the most attractive? Which product would you prefer out of 1 and 2 if your business had: - Capital constraints Out of the three metrics (IRR, payback and NB margin), is there one metric that is always better than the others in choosing one product over the other in optimizing company capital return? 17

19 Cash flow profile characteristics 01 The profile is characterized as modest amongst the group and shows signs of weakness with a relatively high initial strain, low NB margin and long payback period. Alternatively, this profile shows strength in areas such as a high IRR and low cost of capital. Product 02 The profile is characterized as modest amongst the group and shows signs of weakness with a relatively high initial strain, low NB margin and long payback period. Alternatively, this profile shows strength in areas such as a high IRR and low cost of capital. 03 This profile is characterized as the most attractive of the three having a low initial strain, low cost of capital, a quick payback period, a high NB margin and a high IRR. 18

20 Product 1 Overall returns Performance across key metrics, 2015 Key performance drivers NB Margin 0% 10% 18% 18% Low High Payback (years) High Low IRR 0% 8% 12% 10.3% Low High Capital (% of ANP) 20% 12% 0% 55% High Low 19

21 Product 2 Overall returns Performance across key metrics, 2015 Key performance drivers NB Margin 0% 10% 18% 16% Low High Payback (years) High Low IRR 0% 8% 12% 11.1% Low High Capital (% of ANP) 20% 12% 0% 10% High Low 20

22 Product 3 Overall returns Performance across key metrics, 2015 Key performance drivers NB Margin 0% 10% 18% 20% Low High Payback (years) High Low IRR 0% 8% 12% 67.8% Low High Capital (% of ANP) 10% 20% 12% 0% High Low 21

23 Embedded Value in decision making

24 Key value levers in New Business Using the key value levers in new business to improve EV performance Key value levers Required actions Business implications 1 Product portfolio Change the performance profile of the future business by closing unprofitable LoBs and using capital to expand sales in more profitable areas Removal of business lines may reduce effectiveness of market offering, and diversification of risks Management of closed book 2 Customer retention Change sales, marketing, underwriting and customer services approaches Costly to implement and results are not guaranteed 3 Product design Change the design of the products on offer to reduce capital strain and payback period Upfront costs of product re-design, pricing and marketing Misunderstanding of attractiveness of features could reduce future sales 4 Investment strategy Consider approaches to increase the returns available from backing assets without adjusting the risk profile e.g., use of derivatives to apply return floors Expertise may be costly and erode the benefits Continuing eligibility or admissibility of assets for matching purposes 5 Costs Reduce costs of writing new business by reducing sales costs or increasing charges to reflect actual cost levels Competitive constraints 6 Capital management strategy Look for ways to reduce the Required Capital needed through product features and risk diversification across LoBs with the aim of increasing VNB and EEV Effectiveness can be limited by statutory requirements, and reinsurance can be expensive 23

25 Examples of usage in business decision making Company European Based Global Life Insurance Company Asian Life Insurance Company Actions taken 2012 MCEV Report: In the USA there was a favorable increase of life protection products. The repricing and redesign of products also contributed to the positive impact of the change of business mix MCEV Report: The VNB increased by 21%, driven mainly by the positive development of business mix and management action motivated by difficult market conditions. The NBM increased from 1.8% to 2.1%, driven by management action that led to a positive development of the business mix and change in assumptions. The USA, Italy, France, Switzerland and Belgium stand out with respect to re-pricing and management of new business mix Change in business mix [in the U.S.] reflects early management response to the challenging market in the first half of the year. Re-pricing of the fixed index and variable annuity lines had a positive impact on business mix. Sales of fixed annuity products with relatively high margins were promoted, which resulted in especially increased new business volumes in the second half of the year. The change in business mix impacted VNB by EUR 84mn and NBM by 110bps. COMPAN Group Ltd Annual Results Investor Briefing: (When speaking of a new scorecard of KPIs) This new scorecard is already generating a significant shift in focus and behavior wide across the company. Fully half of incentive compensation from this year will be driven by absolute VONB; an additional 20% will be driven by embedded value to keep the team focused on protecting and nurturing the in-force book, even as they pursue profitable new business growth. COMPAN Group Ltd Annual Results Investor Briefing: We are taking actions to enhance our margins further in These include: redesigning products to raise unit VONB margins; ensuring that our Product Team works closely with Distribution to manage product mix more proactively than in the past; and expanding our product proposition into higher-margin segments 24

26 Examples of usage in business decision making (continued) Company European Based Global Life Insurance Company European Life Insurance Company Global Life Insurance Company European Based Global Life Insurance Company Global Life Insurance Company Actions taken Announced the sale of the U.S. business in 2012 at a large loss, due to the drag on earnings and capital. It considerably strengthens COMPAN s financial position, increases group liquidity and improves our economic capital surplus whilst also reducing its volatility. On COMPAN s financial reports, this represented a MCEV uplift of $300 million and an IFRS net asset write-down of $5 billion. Analyzed commercial benefits from using a risk-based approach that resulted in the following actions: used EV to provide proper allowance for risk in annuity rates; reduced writing new with-profits business; assessed attractiveness of an acquisition. In 2010, announced the sale of the U.S. life business and reported an MCEV uplift of 718 million (over $1 billion). Reasons given included risk exposure outside the Group s risk appetite, and unlikely to meet Group targeted returns. From Strategy report: COMPAN s strategic focus considers key metrics related to profit, cash and capital. They monitor six key metrics, of which three are EEV operating profit, EEV new business profit, and free surplus generation. EV is used as an input into acquisition decisions and in selective participation in bulk annuities. Annual Report and Accounts 2013: Both IFRS and MCEV results are referenced throughout and are featured prominently in the KPIs. With reference to the transformation initiatives: When we started the restructuring and transformation journey, the group was generating less than 100 million of sustainable free surplus. In 2013, this has risen to 331 million. The value of U.K. new business was negative three years ago whereas in 2013 our businesses generated 184 million of VNB. This turnaround in profitability has been delivered by applying rigorous financial discipline, and we have now reduced our U.K. and Heritage operating cost base by one-third since

27 Questions

28 Overview of Embedded Value Presenters David White, FSA, MAAA KPMG LLP Principal Actuarial and Insurance Risk Cell: Zeeshan Rehmani, FSA, MAAA KPMG LLP Director Actuarial and Insurance Risk Cell:

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