Market-Consistent Embedded Values

Transcription

1 Market-Consistent Embedded Values Emerging trends in financial reporting Joint Regional Seminar Current Topics in Financial Reporting Kuala Lumpur: June Taipei: June Hong Kong: 28 June Beijing: June James Creedon, FIA Tillinghast, a business of Towers Perrin

2 James Creedon, FIA James Creedon is a consultant at Tillinghast-Towers Perrin. Since joining Tillinghast in 1999, James s experience includes: Embedded value reporting The application of market-consistent techniques within life insurance companies Stochastic financial modelling James has worked with a number of European insurers on the implementation of market-consistent embedded values and realistic balance sheet reporting He has also assisted companies with the development of their individual capital adequacy requirements and the development of their stochastic modelling capabilities James has a first class degree in Actuarial and Financial Studies from University College, Dublin (Ireland) and is a Fellow of the Institute of Actuaries. 2

3 Agenda What is MCEV? Shortcomings of EEV MCEV reporting Issues in MCEV Conclusion 3

4 Background Historical development of embedded value Anderson SoA paper Internal management Defence document Supplementary information ABI guidance Fair Value / MCEV CFO Forum EEV 4

5 Investment market shocks highlighted the disadvantages of traditional EV reporting Bond yields (%) Index levels Gilt yields Equity price i d Year Sources: long gilt yields, IMF (2004,2005); Equity price index, FTSE all-share index 5

6 Bottom-up MCEVs were developed to help answer the three key questions 1. How should we set the Risk Discount Rate? 2. How should we allow for options and guarantees? 3. How should we allow for the cost of capital? The aim is to value projected cash flows in line with the prices of similar cash flows that are traded on the open market. 6

7 MCEV Methodology 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 tax and agency costs, based on all capital held Market-Consistent EV Value = market value of assets marketconsistent value of liabilities frictional cost of capital 7

8 Bottom up individual cash flow approach Finance theory tells us that every cash flow should be discounted at a rate that reflects the risk in the cash flow 0 Discount at risk free rate t Completely certain cash flow Equity return 0 Discount at equity earned rate t Market linked cash flow 8

9 A single aggregate RDR can be derived from the weighted average of the individual RDRs Invest 100 in equities Day 1 One year on Aggregate RDR = Assets Liabilities (80) (84) Value % % = 15% = 15% RDR The method appears difficult, 9

10 Risk neutral valuation makes it practical Invest 100 in equities Assume investment earns risk free Day 1 One year on Day 1 One year on Assets Liabilities (80) (84) Value Assets Liabilities (80) (84) Value % RDR 5% RDR The correct value is derived if all projections are assumed to be risk free risk neutral valuation using the certainty equivalent method 10

11 MCEV - summary An objective framework for the allowance for risk Consistent with the financial markets Allowance for risk automatically reflects changes in economic conditions Risk neutral valuation means can be relatively easy to implement for some product lines 11

12 Agenda What is MCEV? Shortcomings of EEV MCEV reporting Issues in MCEV Conclusion 12

13 CFO Forum Terms of Reference set out the objectives of EEV Address the current reservations/criticisms of existing EV reporting by ensuring that the guidance: Is sufficiently credible and robust to address key concerns relating to consistent application between peer group companies; Explicitly includes the valuation of guarantees and options, addressing the criticism that within the current methodology, the time value of options and guarantees is not adequately dealt with; and Prescribes a minimum level of disclosure, including sensitivity analysis, to address analysts concerns about comparability of the results of companies adopting different assumptions. 3.3 Ensure that the methodology reflects the economic value of long-term insurance business. 13

14 In summary Objective Objective met? Reflects the economic value Explicit valuation of guarantees Credible, robust, consistent, comparable Sufficient disclosure 14

15 It is clear that each company has put a lot of thinking into their analysis RDR Capital / COC Allowance for risk Cost of FOG Taken individually each publication is a significant step forward 15

16 Two different approaches to allow for risk Top down Bottom up Cascades an assessment of risk from market data Builds up a risk assessment cash flow by cash flow Top-down and bottom-up approaches aggregate should yield similar results 16

17 Setting a top-down RDR Group WACC = (r f + β (ERP)) (E/V) + (r d (1-t c )) (D/V) Risk free = 4.5% - 5% ERP = 3% - 3.5% Beta = Cost of debt = 3.6% Debt ratio = 20% RDR = 7.4% - 9.2% 1.8% range in RDR 10% - 15% impact on value 17

18 Risk Discount Rate: Top Down approach AEGON Allianz Aviva ING L&G Currency Euro Euro Sterling Euro Sterling Risk free 3.60% 3.60% 4.60% 4.60% 4.50% Equity Risk Premium 3.20% 3.50% 3.00% 3.60% 3.00% Beta N/A Cost of Equity N/A 6.75% 8.80% 8.92% 8.55% Cost of Debt N/A % 4.50% 3.90% Debt/equity ratio N/A 0/100 30/70 30/70 20/80 Group WACC N/A 6.75% 7.40% 7.59% 7.60% Adjustments to Group WACC N/A - (0.10)% - (0.10)% RDR 6.80% 6.75% 7.30% 7.59% 7.50% Risk margin 3.20% 3.15% 2.70% 2.90% 3.00% 18

19 Financial options & guarantees There are two choices Market-consistent Option valuation calibrated to reproduce market traded option prices Real world Option valuation calibrated to reflect management views of the expected level of future asset values and returns 19

20 Impact of alternative models Key components of model Real World Market consistent Choice of model Choice of calibration approach Choice of discounting approach Choice of model output Material impact Material impact Material impact Material impact Immaterial No choice No choice No choice 20

21 Comparison of values 5yr put-option Model / Calibration Real world model A Calibration 1 Real world model A Calibration 2 Constant RDR 6.9% 10.7% Discounting approach Earned Rate 12.4% 18.2% Cash Rate 8.6% 12.0% Real world model B 3.3% 5.2% 4.0% Market-consistent not allowed not allowed 14.2% Market price 14.2% 21

22 There are two choices Real world Market-consistent x x x but a range of possible answers Market price Real world price Marketconsistent price 22

23 Has the industry met the objectives set by the CFO Forum? Objective Reflects the economic value Explicit valuation of guarantees Credible, robust, consistent, comparable Sufficient disclosure Individual company? - Industry??? 23

24 The analysts view A missed opportunity Does not address the issue of consistent and comparable results Overall progress is being made, if not at the pace that some would have hoped HSBC Citigroup MCEV rather than EEV is the answer Bear Stearns 24

25 Agenda What is MCEV? Shortcomings of EEV MCEV reporting Issues in MCEV Conclusion 25

26 Non-CFO Forum Non-CFO Forum Non-CFO Forum Non-CFO Forum Non-CFO Forum Non-CFO Forum Key: Top-down Bottom-up Recent announcements have favoured the bottom-up approach Company Aviva ING RAS Allianz AEGON Legal & General Prudential Old Mutual Irish Life Friends Provident St. James s Place Capital AXA Storebrand Date 13 January February March March May May June June July October December December February 2006 Comment Interim 2004 restatement 2004 reporting 2004 reporting 2004 reporting 2004 reporting 2004 restatement 2004 restatement 2004 restatement 2004 restatement 2004 restatement 2004 restatement 2004 restatement 2005 reporting Resolution Fortis CNP Swiss Re Winterthur 7 March March April April May 2006 Interim 2005 restatement 2005 reporting 2005 reporting 2005 reporting 2005 reporting Munich Re 9 May reporting Generali 10 May reporting Skandia and Standard Life published EEV but did not disclose the approaches used to allow for risk. 26

27 AXA used MCEV to calculate its EEV results 27

28 The implied RDR is derived so that the deterministic EV equals the MCEV 28

29 AXA disclosed the implied risk margin by country (2005 values) US France In-force New business UK Japan Benelux Australia Hong-Kong Germany Southern Europe Total

30 Friends Provident went one stage further: RDR by product 12 October 2005 Derived Risk Discount Rates by Product Type - EEV % EEV WP Annuities Other UK International Total Risk-free rate Impact of: Bottom-up RDR Cost of options: market risks non-market risks Non-market risk Risk discount rate Results at 31 December 2004 excluding Lombard 11 30

31 The cost of options and guarantees varies between companies and over time Market-consistent cost of options and guarantees as a percentage of PVFP Axa Fortis Friends Provident IL&P Munich Re Swiss Re Vienna Winterthur

32 MCEV reporting so far Trend towards using a bottom-up approach for financial reporting Provides more granular information on business that highlight the differences in risks Link back to traditional approach by solving for RDR Allows comparability across companies and over time 32

33 Agenda What is MCEV? Shortcomings of EEV MCEV reporting Issues in MCEV Conclusion 33

34 Issues in MCEV typical challenges Setting the economic assumptions There is no market to set the assumptions. This means there is no point doing MCEV Volatility of earnings Using MCEV for financial reporting will lead to unnecessarily volatile earnings. Management, analysts and investors typically like smooth predictable results 34

35 Setting the economic assumptions This is a real issue! Lack of reliable market data means there is subjectivity in setting some assumptions Applying MCEV techniques still valid and provides information that helps understand the risks in your business Comparing traditional and MCEV results gives better management information than a single measure 35

36 EV analysis of earnings: the key to effective performance monitoring Analysis of Movement in MCEV MCEV BoY Expected investment profit Unexplained MCEV EoY Opening adjustments Assumption changes Experience variances Unexpected investment profit Investment results Insurance results Dividends to shareholders New Business 36

37 For MCEV, there are differences in the analysis of movement approach Traditional approach Net worth 0 Expected return Net worth 1 VIF 0 Unwind at single RDR VIF 1 Market-consistent approaches MVA 0 MVL 0 Expected return Expected change given best estimate returns over time 0 to 1 MVA 1 MVL 1 MCEV 0 MCEV 1 Note: under the market-consistent approach above, the overall expected return on MCEV can still be split into expected return on net worth and VIF. 37

38 To measure performance, insurers need to understand insurance and investment results Economic balance sheet Market value of assets Market value of liabilities Investment balance sheet Strategic Asset Allocation Insurance balance sheet Market value of assets Strategic asset allocation Strategic asset allocation Replicating portfolio Replicating portfolio Market value of liabilities Investment results Strategic asset result Insurance results Stock picking variances Cost savings Identification of niche opportunities Actual mis-match variances relative to expectations Experience variances Changes in assumptions 38

39 What sort of company do you want to be? Return on MCEV Expected return 0 Volatility -100% Matched Mismatched Different investment strategies will create different risk / return profiles but they may not add value on day 1 39

40 Agenda What is MCEV? Shortcomings of EEV MCEV reporting Issues in MCEV Conclusion 40

41 The MCEV approach is becoming widely accepted Reporting Management Reserving Solvency MCEV M&A RBS ICA EEV Hedging SST IFRS Pricing Solvency II Economic Capital CRO Forum 41

42 MCEV is not just for financial reporting Provides a consistent link between risk,capital and value Value Can be used for all aspects of financial management Pricing Product design Performance measurement Capital allocation Risk Capital Value 42

43 In conclusion.. MCEV is coming Asian markets bring their own issues It will take time to implement and to understand the results, but the rewards are real More credible reporting Better understanding of risks Key management tool MCEV is a journey. Starting now will keep you ahead of the game 43

44 Useful publications Market-Consistent Embedded Value Allowing for risk within an embedded value framework, 2003 European Embedded Values A significant step forward, 2004 Market-Consistent Embedded Value Dispelling the myths, 2005 Making Sense of it all Building a consistent framework for measuring and managing risk, capital and value, 2005 European Embedded Values The story so far, 2005 Available at end of June: European Embedded Values A trend emerges All available on: 44

45 Contact details James Creedon Phone: Fax: