Market Consistent Embedded Value and Implications for Pricing

Transcription

1 Market Consistent Embedded Value and Implications for Pricing 2007 SEAC Annual Meeting Douglas Doll November 15, Towers Perrin

2 RECENT MARKET TRENDS Recent EEV developments Life insurance companies have started to publish results under EEV Principles (since 2004), but reporting has been inconsistent Equity analysts have criticized the variety of approaches taken CFO Forum has responded to analyst comments by publishing Additional Guidance on EEV Disclosures and updates to the EEV principles (October 2005) CFO Forum will be publishing a principles and guidance document for MCEV in early 2008, recommending MCEV disclosure for year-end Towers Perrin 2

3 RECENT MARKET TRENDS MCEV methodology was developed to help answer key questions Risk Discount Rates Reflect risk inherent in individual cash flows and any asset/liability mismatches Options & Guarantees Valued explicitly, consistent with capital-market prices Cost of Capital Reflects frictional costs (e.g., tax), based on overall capital requirements Market Consistent EV = market value of assets market-consistent value of liabilities frictional cost of capital 2007 Towers Perrin 3

4 RECENT MARKET TRENDS In an MCEV framework, selecting assets does not create value Assume that the investor has capital of 20, borrows 80 (at 5% pa) and then invests 100 in equities (with an expected return of 7% pa) Day 1 One year on The actions of borrowing and investing do not create value on Day 1 Assets Liabilities (80) (84) Capital Using traditional EV techniques the 23 might be discounted at, say, 8%. This would give a value of 21.3 on Day 1, which implies a VNB of 1.3, or IRR of 15% Under MCEV the asset cash flows are discounted at 7% and the liability cash flows at 5%. This would give a value of 20 on Day 1, which implies a VNB of zero, consistent with the first bullet point above Alternatively, assume the assets earn 5%, which produces ending capital of 21, which gives 20 when discounted at 5% 2007 Towers Perrin 4

5 RECENT MARKET TRENDS Bottom-Up Top-Down Recent EEV disclosures have favored the market-consistent approach Aegon Allianz Aviva ING Legal & General First Half 2005 Old Mutual Prudential (UK) RAS Second Half 2005 AXA Friends Provident IL&P SJP Eureko Hannover Re Scor Vie SNS Reaal Storebrand 2006 Alleanza Chesnara CNP Fortis Generali Just Retirement Mapfre Mediolanum Munich Re Resolution Revios Scottish Widows Standard Life Swiss Re Vienna Insurance Winterthur Zurich Vital 2007 Allianz 2007 Towers Perrin 5

6 RECENT MARKET TRENDS In North America, EEV adoption has been slower Traditional EV ( TEV ) not yet widely accepted in the US Dominance of US GAAP reporting Hartford Life is the only US-based company that ever published EV results Growing number of US companies use TEV or VNB for performance measurement and incentive compensation US subsidiaries of European multinationals calculate and publish EEV results, increasingly on a market-consistent basis TEV reporting is more widely accepted in Canada Sun Life, Manulife and Industrial Alliance annually publish TEV Quarterly source of earnings analysis supplementing EV Market consistent techniques are increasingly used in the US to develop Economic Capital ( EC ), model impact of hedging or to price embedded guarantees on market-consistent basis Provides consistency between pricing and valuation AXA (US), Allianz Life and Zurich have converted from real-world EEV to MCEV basis in recent years 2007 Towers Perrin 6

7 RECENT MARKET TRENDS What does this mean for the U.S.? Multinationals are setting the bar for EEV/MCEV reporting Use of EC as required capital provides the link from EV to ERM EC has become the metric for assessing and quantifying risk Domestic players are gradually coming around, driven by advances in risk and capital management increased use in incentive compensation plans Move to IFRS should further accelerate development of MCEV and EC in the U.S. Provides fair value of liabilities (SFAS 159) IFRS #8 requires disclosure of a business segment s profit/loss and balance sheet on the basis that is used to manage the business more EV disclosures expected We would expect more domestic companies to be calculating (and publishing) EV to determine the fair value of liabilities 2007 Towers Perrin 7

8 MCEV GUIDELINES AND TECHNICAL ISSUES For MCEV reporting, the risk-free rate is generally the swap curve Common approach is to project profits, assuming that assets earn risk neutral returns based on the initial swap yield curve, and discount using forward rates implied by the initial swap yield curve Values at September 30, 2007 Maturity Treasury Swap Swap Spread over Treasury A Bond Spread over Treasury 1 1 year 4.05% 4.77% 0.72% 0.79% 5 year year year Note that swap spreads are significantly lower than typical assumed asset spreads. 1 Net of 10 bps expected default cost Towers Perrin 8

9 MCEV GUIDELINES AND TECHNICAL ISSUES MCEV implications for pricing results are numerous Assets earn risk-free rate (very bad!) Using risk-neutral scenarios (sometimes bad) No value for A/L mismatch Equity scenarios have lower expected return and higher volatility Profits discounted at risk-free rate (good) Cost of capital calculated using risk-free rate as discount rate (generally good) Allowance for non-market risk and agency costs Allowance for limited liability put option, i.e., company default risk (good if it exists) 2007 Towers Perrin 9

10 MCEV GUIDELINES AND TECHNICAL ISSUES Treatment of flexible policyholder crediting rates is a very important issue On a market-consistent basis, the average asset default cost is substantially larger than real world expectations The table below illustrates two potential MCEV situations 1) Company strategy is to set credited rate based on real world assumptions 2) Company has strategy (and ability!) to deduct all actual default costs Current EV MCEV No Asset Risk to Policyholder MCEV All Asset Risk to Policyholder Gross Earned Rate 6.00% 5.30% 5.30% Assumed Default (0.20) Net Earned Rate 5.80% 5.30% 5.30% Spread (2.00) (1.50) (2.00) Credited Rate 3.80% 3.80% 3.30% 2007 Towers Perrin 10

11 MCEV GUIDELINES AND TECHNICAL ISSUES MCEV profit margin effects we are seeing on typical U.S. products Term insurance: margins increase, as lower discount rate dominates SPIA: margins decrease a lot, when asset risk premiums removed UL: in-between term and SPIA regarding asset risk and, therefore, results Fixed annuities: between break-even and large decrease, depending on whether asset risk is transferred to policyholders Variable annuities: little change for basic product, but large decrease in cost of guarantees A few U.S. companies are currently struggling with these implications, particularly for SPIA and fixed annuities 2007 Towers Perrin 11

12 PRICING TARGETS & METRICS In our experience, MCEV has not found its way into pricing targets in the U.S. MCEV is still in its infancy in terms of influencing pricing in U.S. Theory suggests that if MCEV value-added for a product is positive, go ahead and sell it We believe that initially MCEV pricing targets will be linked to results under more traditional metrics Over time, targets for products may come together Depends upon whether insurers operating in U.S. embrace MCEV 2007 Towers Perrin 12

13 Questions? 2007 Towers Perrin 13