Valuation methods for life insurers: Conversion or chaos?

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1 Valuation methods for life insurers: Conversion or chaos? Henny Verheugen, AAG William Hines, FSA, MAAA Insurers set up financial and risk reporting to inform stakeholders about their financial position and performance. These stakeholders include financial analysts, regulators, rating agencies, policyholders, shareholders, and the industry and general investing public at large. A number of different reports are used for this diverse range of stakeholders. It can be very time consuming for insurers to maintain consistency among all these reports, as well as across reporting years. There is a real possibility that information can be misinterpreted because of different valuation and reporting bases. This paper aims to give background and insight into a number of valuation methods currently in advanced development. A lot of research has been undertaken in recent years to find the best valuation method. A good deal of interaction between banks and insurers has also occurred, through which new valuation methods have been developed. Both take on significant financial risk through the products they sell and in some cases because of common ownership. Important developments include: 1. IFRS 4 Phase II: Valuation of insurance liabilities/insurance project. When completed, this standard will apply to the valuation of insurance liabilities for companies that report under the international financial reporting standards (IFRS) framework. The International Accounting Standards Board (IASB) published a discussion paper in May 2007 resulting in feedback from 158 parties. The IASB aims to publish the final IFRS 4 Phase II standard in May It is expected that this final standard will then be effective from accounting year European Insurance CFO Forum market-consistent embedded-value principles 1 (MCEV principles). The European Insurance CFO Forum 2008 (CFO Forum) presented the MCEV principles that will be adopted by the members of the CFO Forum from 31 December Solvency II draft directive. The European Commission published this in 2007 and aims to have a final directive by After completion of implementation, transition to the new framework should be complete by There are concerns that the 2012 implementation date for Solvency II may be pushed back a few months to early 2013, particularly in light of the current disagreement between the European Parliament and the French presidency on the issue of group support and the current turmoil of the insurance industry. A lot of research has been undertaken in recent years to find the best valuation method. A good deal of interaction between banks and insurers has also occurred, through which new valuation methods have been developed. Other papers that support the development of practical aspects of IFRS 4 and Solvency II are also worth noting: 4. Market value of liabilities for insurance firms. To support the discussions and envisaged framework of the Solvency II project, the Chief Risk Officer Forum (CRO Forum) published this paper in July 2008 with a proposal for how insurance liabilities could be valued. 5. Measurement of liabilities for insurance contracts. A current estimate and risk margins prepared by the IAA ad hoc Risk Margin Working Group. 6. Several papers produced by the IAIS and IAA on risk management and capital measurement. The graph in Figure 1 gives a high-level overview of the evolution of the different valuation methods applicable to products issued by life insurers. 1. Copyright Stichting CFO Forum Foundation 2008.

2 Figure 1 Pricing and valuation Earningsbased Many insurers disclose EV results Accounting at market rates) Historic cost accounting European and traditional Phase 1 Background and status of the different developments European CFO Forum decided to disclose MCEV as of 2010 Marketconsistent EV IFRS4 - Phase 2 PBA (US) New environment Economic capital model Internal model approach Factor-based model IFSR 4 Phase II The IASB published the IFRS 4 Phase I standard in Prior to the publication of IFRS 4 Phase I, no IASB accounting statements governing insurance liabilities existed. However, IFRS 4 only met some of the initial goals of the IASB there were still many outstanding issues needing attention that were not addressed in Phase I. Overall, one could argue that the valuation bases and methods that apply under local generally accepted accounting principles (GAAP) could also be included in IFRS 4 Phase I. Solutions such as shadow accounting or valuing liabilities at market rates on interest were offered to solve the problems that arose because of accounting mismatch between assets (market value) and liabilities (local GAAP). However, a full set of principles for the fair valuation of insurance liabilities was outside the scope of IFRS 4 Phase I. Risk management approach models Deterministic actuarial Solvency regulation Stochastic model Simple margins Market-consistent embedded value Since the early 1990s, life insurers have reported embedded-value (EV) information in addition to the financial information that they make publicly available. EV has developed very fast since then. A large proportion of listed insurers in Europe and Asia, as well as mutual companies, report their EV. The large degree of diversity in the methods and assumptions used in EV reporting, the fact that analysts have been requesting better EV reports, and the increasing interest in EV reporting generally all prompted the CFO Forum to publish European Embedded Value (EEV) principles in May These EEV principles can be considered an alternative for the IFRS 4 Phase I standard that was published in the same period. The EEV principles can be regarded as a form of self-regulation by insurers at a financial reporting level. After their publication, analysts commented on a number of issues. Several improvements were required by the industry and have been implemented in the MCEV principles. Improvements include: Risk-neutral economic assumptions: The risk premium assumed for equity returns, property returns, and discount rates commonly employed within EEV approaches is not applicable under MCEV. Implied volatilities used in place of historical volatilities for valuation of options and guarantees: This is likely to increase the volatility of MCEV earnings. Phase II of the IFRS 4, the Insurance Project, commenced after publication of Phase I. In 2007, the IASB published a discussion paper. On the basis of feedback from stakeholders, the IASB is now developing an exposure draft that it aims to publish in October 2009, with a goal of publishing the final standard in May This plan has not been revised, even though: The Financial Accounting Standards Board (FASB) has decided to take part in the Insurance Project. This increases the geographic scope of the project, as well as the number of parties that need to reach consensus. The current economic situation is likely to affect the priority given to some of the other projects of the IASB, thus potentially reducing the priority of the Insurance Project. There are still a number of significant issues to be resolved, including field testing of the proposed valuation method. Cost of capital effectively replaced by frictional cost component. Allowance for non-hedgeable risks more transparent. Risk accounted for and allocated using a bottom-up instead of a top-down approach. The MCEV principles facilitate better comparison between companies, which should assist investors. Solvency II The Solvency I framework for determining insurance liabilities, the calculation of required solvency, and the determination of eligible capital is regarded as insufficiently risk-based and thus modernization was called for. The Solvency II project started in the 1990s with exploratory studies by many agencies. In addition, the European Commission would like to use it to improve consumer Valuation methods for life insurers: Conversion or chaos? 2

3 protection, modernise supervision, deepen market integration, and increase the international competitiveness of European insurers. To assist the development of guidance on the valuation of insurance liabilities, the CRO Forum published a paper in 2008 highlighting the principles and approaches for determining the market value of insurance liabilities. Concurrent with the work of the CFO Forum, an ad hoc working group of the IAA developed a paper about determining best estimates and risk margins in practice. Overview The table in Figure 2 gives an overview of the scope and stakeholders that the different valuation bases apply to, as well as their applicability and when they should come into force. Market-consistent as a solution One important area that the different methods have in common is the use of market valuations using techniques from the financial markets. The accounting mismatch between the valuation of assets and liabilities is reduced using this approach. A market-value approach is essential for the construction of an economic balance of the liability cash flows should be reflected in the replicating instrument s cash flows. If these requirements are met, the market value of the insurance liability can be set equal to the market value of the financial instrument that produced the replicating cash flows. Often swap instruments are used to replicate insurance liabilities. However, for many currencies there isn t a swap market that can be used to replicate liabilities with an outstanding term of more than 30 years. In such cases, techniques are used to lengthen the curve for calculation purposes, in order to be able to replicate longer-term cash flows. A similar situation applies for insurance liabilities whereby guaranties are given on equity indices. There is no option market with maturities of more than 10 years. In both these examples, some market risk remains with the insurance products whose term is expected to exceed 10 years. There is no deep, liquid, and transparent market for insurance risks. Although longevity and mortality risks are increasingly being hedged, there is no perfect market with daily quotes that are available to all parties. Therefore, it is important to find a solution Figure 2 ifrs 4 Phase ii mcev Principles solvency II First applied by industry Opening Balance Sheet 2013 Opening Balance Sheet 2010 Opening Balance Sheet 2013 (publication May 2011) (publication in 2010) Scope value of value and performance Financial report insurance liabilities of the company and solvency position Stakeholders disclosure to analysts Disclosure to analysts Disclosure to and public domain and public domain local supervisor Companies mandatory for mandatory for members Every EU insurance company. european-listed companies of the CFO Forum small companies under a threshold are exempted sheet, which is used as the starting point for solvency or riskmanagement calculations. The best reflection of the market value of an insurance liability is where the cash flows of the liability can be replicated by cash flows from a financial instrument that is traded in a deep, liquid, and transparent market. Hedgeable insurance liability Solvency II declares that, where it is possible, the value of an insurance liability can be replaced by the market value of a basket of financial instruments. Only if the insurance cash flows are replicated by the cash flows of that specific basket of traded financial instruments in a deep, liquid, and transparent market. This replication should apply not only for the best-estimate scenario, but also for stress scenarios. Depending on the variability of the cash flows of the insurance liability under different economic scenarios, the cash flows of the liability should be replicable under a material number of different scenarios with a large degree of statistical significance (depending on the chi-square test). Extreme scenarios should be included in the scenario set. Thus, if there is a change in the cash flow profile under a different scenario, for instance because of profit sharing, the characteristics for the quantification of insurance technical risks that can be used for non hedgeable insurance liabilities. Although it is not explicitly stated in the MCEV principles or IFRS 4 documentation, the replicating portfolio methods may possibly be used for the calculation of the insurance liabilities with the same conditions. Non hedgeable insurance liabilities Methods for the valuation of non hedgeable insurance liabilities are being set up for many purposes (for example IFRS, MCEV, and Solvency II). These definitions are currently not the same and it is unlikely that they will be. The biggest reason for the difference is that the stakeholders receiving the information have different needs. Although analysts and insurers continue to pursue one standard, it isn t achievable over the short term. Components of the non hedgeable insurance liability are presented in the table in Figure 3. IFRS 4 Phase II The IASB is currently considering five options for the valuation of insurance liabilities. Valuation methods for life insurers: Conversion or chaos? 3

4 Figure 3 ifrs 4 Phase II, ifrs 4 Phase II, option 1 options 2-4 mcev Principles solvency II Principle Current exit current fulfilment Current fulfilment Current exit value value value value Components Certainty-equivalent Certainty-equivalent Certainty-equivalent Certainty-equivalent value value value value time value of options Time value of options Time value of options Time value of options and guarantees and guarantees and guarantees and guarantees risk margin risk margin cost for non hedgeable Cost for non hedgeable market and non market non market risk risk service margin service margin frictional costs additional margin (dependent on decision of IASB) 1. Current exit value as proposed by the discussion paper Preliminary Views on Insurance Contracts. 2. Current fulfilment value, including a risk margin based on the cost of bearing risk. 3. Current fulfilment value, including a risk margin based on the cost of bearing risk and, separate from the risk margin, an additional margin as the difference between the premium and the expected value of the cash flows plus the margin for bearing risk. 4. Current fulfilment value, including a single margin calibrated at inception to the premium. 5. Unearned premium for the pre-claims liability of shortduration contracts. Life insurance is characterised by long-term liabilities, and thus the last option is less relevant and will not be considered further in this paper. A more detailed description of the differences of the presented current fulfilment values is presented hereinafter in this paper. Current exit value or current fulfilment value The current exit value is based on the principle of transferring the insurance liabilities to a well informed third party and valued as an arm s-length transaction. Methods and principles that reflect the market situation are used, not entity-specific bases. The current fulfilment value represents the burden for the insurer of running off the policyholder liabilities over time. Important elements of the current fulfilment value include the following: 1. In the absence of good market information, estimates of the insurer are used. 2. Cash flows should be based on the entity s own cash flows and, consequently, could include some cash flows that would not occur for other market participants. Certainty-equivalent value This is the deterministic projection of the cash flows on a bestestimate basis. The assumptions used for the valuation should be observable in the market as much as possible. In the following section we will elaborate on the economic assumptions. For the non economic assumptions, entity-specific assumptions are used, given that there is a limited availability of statistically sound non economic assumptions. With the exception of the current exit value approach under IFRS 4 Phase II, entity-specific assumptions are used as estimates by the undertaking. Future premiums There is a difference in approach of application of the premiums between MCEV principles and Solvency II on the one side and IFRS 4 Phase II on the other. MCEV principles and Solvency II consider only the future premiums that are payable on insurance contracts in force on the valuation date. Future single premiums can also be included under MCEV principles on certain contracts. Determining the parameter for future premiums is entity-specific. Positive margins that emerge from future premiums are thus taken into account on the valuation date. IFRS 4 Phase II is stricter with regard to including future premiums. Future premiums can be included only if they are contractually enforceable by the insurer or if they are required to maintain the right to guaranteed insurability. Guaranteed insurability is a right that permits continued insurance coverage without reconfirmation of the policyholder s risk profile and at a price that is contractually constrained. In general, this is an issue only for products whose future is completely variable. Flexiblepremium products can be largely affected by the IFRS 4 phase II principle for future premiums. Look-through principle The aim of MCEV principles is to give shareholders insight into the value of the company. Here the company is not just the insurer, but includes all other business units within the group of the insurer. The value of any service companies that conduct services for the insurer and that are part of the group is also included for Valuation methods for life insurers: Conversion or chaos? 4

5 example, margins earned on investment funds within the group and distribution organizations. Conversely, within Solvency II and IFRS 4 phase II, it is the insurer that is of primary consideration. Financial parameters required for the calculation of the certainty-equivalent value MCEV principles and Solvency II are quite clear about the financial parameters that are to be used for example, the use of swap rates as a proxy for risk-free interest rates, or the implied volatility for equity, property, and swaptions. The IASB is still discussing what to require regarding the choice of economic parameters. Within Europe there is a strong preference for the use of swap rates. The argument is that the swap rate is commonly used by financial market participants to value financial instruments and therefore any market risk that may exist in the insurer s assets is excluded from the value of the insurance liabilities. The IASB is still discussing what to require regarding the choice of economic parameters. Within Europe there is a strong preference for the use of swap rates. The argument is that the swap rate is commonly used by financial market participants to value financial instruments and therefore any market risk that may exist in the insurer s assets is excluded from the value of the insurance liabilities. Theoretically, the cash flows are invested in swaps. The swap market is not totally risk-free, however, and the CFO Forum and Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) use the swap yield curve to facilitate consistency among companies. There is less of a preference for using the swap rate curve outside Europe. A curve set by the regulator that is inferred from the bond market is an alternative this creates a better connection to how the Figure 4 insurance liabilities are set and how the assets backing them are invested. A consequence 90 of this is that some 80 financial-market risk is included in the valuation 70 of the insurance liabilities. Another problem (particular to Asia) is the negative spread that exists between the crediting rate (rate of the insurance contract) and the actual market interest rate. The application of the swap rate for the valuation of the insurance liabilities as per the valuation date, VIX Level and consequently the capitalization of the negative credit spread for the remaining duration, will lead to significant losses. If a company utilizes cash-flow matching, the risk and impact are limited. However, in many Asian countries there is no market for sufficiently long-term government and corporate bonds, and there is a significant mismatch for cash flows with a long duration. Furthermore, the future premiums must accumulate at the contractual crediting rate and not all the initial investment instruments are still available to invest in. The current swap market is very volatile. At longer durations the interest rate swap rates are lower than the return on government bonds. It is likely that the CFO Forum will issue guidance on what approach to take in such circumstances. The time value of options and guarantees This may be calculated using stochastic models, or alternatively via closed formulas or the market value of assets replicating the options and guarantees (where applicable). In all of these approaches the market-implied volatility is used to value the insurance liability. The volatility has spiked enormously during the current financial crisis (see the graph in Figure 4 showing the CBOE Volatility Index); therefore the time value is also currently unusually high. Risk margin/cost of residual non hedgeable risks A risk margin is included for the uncertainty of the projected cash flows. The shareholders need to earn extra return for taking on risk and this extra return can be seen as part of the insurance liability. In Europe, there is a preference for the cost-of-capital method to be used for determining the risk margin for life insurers. The method determines the capital required for the non hedgeable risks. Thereafter, the extra return due to the shareholders is calculated over the entire run-off of the liabilities. The IFRS 4 Phase II discussion paper also describes the risk margin as an extra return for bearing risk, but doesn t give any more detail. Volatilty Index (VIX) Jan 2004 Nov 2008 Valuation methods for life insurers: Conversion or chaos? 5

6 Further definitions and interpretations of the risk margin by the IASB, CEIOPS (Solvency II), and the CFO Forum are different. The basic philosophy of MCEV is that all expected cash flows can be matched using the interest-rate swaps. However, insurance risks and operational risks embedded in the insurance portfolio lead to uncertainty of cash flows unrelated to financial risk and hence to a situation of non hedgeability. The basic philosophy of MCEV is that all expected cash flows can be matched using the interest-rate swaps. However, insurance risks and operational risks embedded in the insurance portfolio lead to uncertainty of cash flows unrelated to financial risk and hence to a situation of non hedgeability. This can be compared with the risk margin in the Solvency II framework. A difference with the Solvency II framework is that the residual market risk should be valued too. As mentioned before, residual market risk can occur where liabilities have a duration exceeding that of the swap yield curve, or where the duration of embedded equity options exceeds the duration of observable equity options. The level of the return required by the shareholder for bearing the risk of the uncertain cash flows is not prescribed by MCEV principles. While some companies may use the rate of 600 basis points (bps) per annum, as is defined in the Solvency II framework, the aforementioned CRO Forum paper advocates a lower charge for the cost of capital. The level of the cost will be different by region, type of products and risks, and, last but not least, the requirement of the shareholder. An alternative approach is to use the risk premium (added to the risk-free rate) present in the risk-discount rate used for the EEV calculations. Many companies have used CAPM 2 -based methods to derive this EEV risk premium and, depending on its appropriateness (i.e., actual reflection of the risk), the aforementioned risk premium could be used too. The IASB has studied a range of approaches for the measurement of insurance liabilities and more specifically the determination of the risk margin. Three of the options explored are explained below in the context of fulfilment value. The following numbering follows the numbers of the candidates as proposed by staff of the IASB. 2. Current fulfilment value including a risk margin based on the cost of bearing risk. The risk margin is not dependent on the financial result of the contract as determined at inception. The financial result in this case is defined as the present value (PV) of future premiums minus the PV of benefits (including the time value of options and guarantees), where PV is derived using current bestestimate assumptions. Thus, profit or loss is created at inception of the contract. 3. Current fulfilment value, including a risk margin based on the cost of bearing risk, and, separate from the risk margin, an additional margin as the difference between the premium and the expected value of the cash flows plus the margin for bearing risk. The level of the risk margin is dependent on the financial result of the contract at inception. Furthermore, an additional margin is determined whereby the financial result at inception is zero (in other words, at inception the certainty-equivalent plus time value of options and guarantees plus risk margin plus additional margin equals zero). In the case of profitable products, the additional margin will be positive, but there is no financial result at inception. The additional margin is released over the lifetime of the insurance contract. For unprofitable insurance contracts, the loss will be recognized in income because the additional margin cannot be negative. Thus, a loss can be made at the inception of a contract, but not a profit. The calibration of the additional margin for in-force insurance portfolios with a considerable history will be a difficult task. 4. Current fulfilment value, including a single margin calibrated at inception to the premium. Basically, this candidate is equal to candidate 3 above. The difference is that the additional margin is not recognized separately, but as an aggregated component. The risk margin is determined as the balancing item to ensure that the financial result of the contract is zero at inception (in other words, at inception the certainty-equivalent plus time value of options and guarantees plus risk margin equals zero). The risk margin is independent of the realistic risk related to the insurance contract and cannot be negative. Thus, a loss can be made at the inception of a contract, but not a profit. The calibration of the risk margin for in-force insurance portfolios with a considerable history will be a difficult task. The IASB s final choice of which option to use will be revealed in the exposure draft scheduled for release in the first quarter of The frictional costs of required capital (MCEV principles) The required capital should be derived using the company s own capital requirements or the minimum regulatory requirement if that measure is higher. The cost of the non hedgeable residual risk does not reflect the real risk position of the company, but the cost of the theoretical mismatch or uncertainty. The true risk is reflected via the required capital. The cost to the shareholder is presented as the frictional costs. The frictional costs are the investment costs of managing the assets backing the required capital and the tax on the returns of the assets backing the required capital. 2. Capital asset pricing model Valuation methods for life insurers: Conversion or chaos? 6

7 Service margin The service margin is intended for services that the insurer provides as a byproduct of the insurance liability. This is an area that needs to be investigated further by the IASB. Deriving the surplus The main pillar of Solvency II and MCEV principles is market consistency. This means that all components of the balance sheet should be valued using methods and assumptions that are in line with the valuations implied by financial and other markets and their participants. In this regard, there is a strong parallel with the Solvency II framework. Assets should be valued at their market value, or should be valued via a market-consistent method or mark-to-model method. Markto-model methods are only used where a deep, liquid, transparent, and undisturbed market is nonexistent. There are many situations in which the market value of an asset is not available. Examples are direct loans, subordinated loans, shares in unlisted companies, or property for a company s own use, such as the office building. For these investments, an appropriate method and basis need to be found to arrive at their market values. We note, however, that current turmoil in the financial markets caused by decreased mutual confidence among market participants has changed the perspective on liquidity risk. Up to mid-2008, the liquidity risk associated with bonds and loans was less of an issue and financial markets were generally considered to be deep, liquid, transparent, and undisturbed. Only subordinated loans and tailor-made financial instruments were considered to involve significant liquidity risk. The expectation is that liquidity risks will now become much more important within future valuation frameworks for all markets. Two approaches Two main approaches are used to derive the surplus and present results: the distributable earnings approach and the balance sheet approach. There is no preference for either one of these approaches, but the balance-sheet method is generally considered to be rather more complex to analyse in its development. 1. The balance-sheet approach is based on the following definition: the market-consistent embedded value is equal to the market-consistent value of assets in excess of the market-consistent value of liabilities. This method is in line with economic balance-sheet approaches and can contribute valuable information for both IFRS 4 Phase II and Solvency II purposes. 2. The distributable-earnings approach instead uses the following definition: the market-consistent embedded value is equal to the current net-asset value plus the present value of expected future distributable earnings. For deriving the distributable earnings, the financial result is adjusted to reflect the cost for non hedgeable risks, the time value of options and guarantees, the frictional costs, and taxes. Disclosures In general, stakeholders, like analysts, require a more detailed presentation of the results, methods, assumptions, and sensitivities. With sufficiently detailed information, analysts will be able to make an assessment of the financial figures presented and to give advice to investors. Whereas performance measures (for example, the income statement) are not within the scope of the Solvency II framework, the IASB continues to work on this aspect and the CFO Forum has made clear its vision of the presentation of performance. By doing so, the CFO Forum has smoothed the path towards future use of MCEV within primary financial statements. The disclosures laid down by the CFO Forum have been expanded in comparison to those of the prior EEV principles. Some important changes include the following: The presentation of the analysis of earnings has been expanded and includes more components: The new presentation aims to increase insights into the origin of risks, returns, and cash flows. The last component is imported to satisfy the needs of financial analysts; they want to have insight into the available surplus for paying shareholder dividends. Inclusion of non covered business: The IFRS results for all business excluding the long-term life insurance business should be included in the MCEV results. Outside Europe, many companies have not yet adopted IFRS reporting and may struggle with this requirement. For illustrative purposes, disclosure of a considerable number of sensitivities is required: These require new economic scenarios to be generated and fresh calculation of all components. Several companies will calculate and present the implied discount rate: The implied discount rate provides a bridge between the prior EEV results and the new MCEV results. It is not mandatory to disclose the implied discount rate, but this is likely to be common practice during the first few years of disclosure. The disclosures will contain a declaration that the information disclosed has been prepared in accordance with the CFO Forum MCEV principles. MCEV principles are a major step forward in the valuation of insurance portfolios and the interests of shareholders. Users of the information will gain increased insight into the characteristics and performance of portfolios. It is likely that the level of comparability between companies, and between time periods, will increase. One further consequence of the introduction of MCEV principles is that a policy of risk mitigation will become more important, as the reporting principles essentially imply little reward for risktaking. The next step for the industry will likely be to focus on the development and adoption of risk-adjusted performance measures. While the industry will be more risk-conscious, management needs to have a clear understanding of how much risk has been taken and how many have been rewarded. For new business where, in the pricing process, risk premiums have been added to set the guaranteed credit rate for instance, a credit spread on top of the swap rate to derive the guaranteed credit rate for fixed annuities the new business value will decrease. Valuation methods for life insurers: Conversion or chaos? 7

8 Risks are not rewarded at inception, but will be recognised during the lifetime of the product. This may alter an attitude to new product development. Performance/Income statement As suggested in the sections above, the analysis of change (AOC) of an embedded value is very important. The performance and risk position of the company can be determined from the AOC. In MCEV principles a format is presented that should at least be used for the disclosure of the AOC. Figure 5 Return on MCEV Analysis Opening MCEV Opening adjustments Adjusted opening MCEV New business value Expected existing business contribution (reference rate) Expected existing business contribution (in excess of reference rate) Transfers from VIF and required capital to free surplus Experience variances Assumption changes Other operating variance Operating MCEV earnings Economic variances Other nonoperating variance Total MCEV earnings Closing adjustments Closing MCEV Free Surplus Required Capital Insight is gained into cash flows to and from the shareholder by examining the transfer from the value in force (VIF) and required capital to free surplus. This insight is required by analysts to understand the level of free surplus in relation to the value in force, as well as to understand how shareholder capital is invested and what the return is. The operating MCEV earnings in relation to the size of the VIF and required capital give insight into the performance of the company. The development of the required capital and in particular the amount of capital required for new business, as well as that required for managing risks, is important for monitoring the development of the solvency position. The combination of MCEV earnings and development of the required capital is a risk-adjusted performance measure. Nevertheless, it is also important to understand the impact of real-world scenarios. In many companies, risks are managed and products are priced on the basis of real-world scenarios. The application of risk-neutral scenarios for pricing is justified theoretically, but in practice a different investment strategy is followed and a proportion of the returns are given back to the policyholder as a form of profit-sharing. VIF MCEV Goals of a financial statement include: Portraying a cohesive financial picture The AOC can be regarded as a type of income statement because it is a connection between the assets at the start of the year and at the end of the year. The cash flows from the insurance portfolio during the accounting year, such as premiums, outgo, and costs, cannot be determined from the AOC. However, it is useful to know the cash flows that make up the income statement and an alternative approach will therefore be developed. Link to IASB s financial statement project The IASB and FASB are busy with the financial statement project. Its aim is to publish a standard (in 2011) for setting up and presenting financial statements. This project includes the financial statements of all sorts of undertakings not only insurers. Disaggregating information so that it is useful in assessing future cash flows Presenting information about liquidity and financial flexibility Therefore, links are made between the financial position (balance sheet), statement of comprehensive income, and statement of Valuation methods for life insurers: Conversion or chaos? 8

9 Figure 6 Changes in assets and liabilities, excluding transactions with owners Not from remeasurements Cash component From remeasurements Accrual components A B C D E F G Caption in statement of cash flows Cash flows Accruals, allocations, and others Recurring fairvalue changes/ valuation adjustments All other changes Statement of comprehensive income (B + C + D + E) Caption in statement of comprehensive income cash flows. This is done by analysing the development of the value of the insurance liability over the year according to the requirements of the financial statement project. The table in Figure 6 gives insight into the building blocks used and how they interact with one another. It is clear that the insurance technical cash flows (for example, component B) need to be determined. Convergence, the future Convergence is coming. While there is still some time to wait before it will be realised, the needs of stakeholders for current and transparent understanding of insurer s business is leading to a common valuation framework. Subtle differences in methodologies are likely to remain that will affect how the business is managed, and they need to be understood by management and users of the information. MCEV and Solvency II are in more advanced stages of development. The details of what IFRS 4 Phase II will look like are not yet available, and profound discussions will be needed to solve at least the current issues of risk margins, discount rates, dayone profits, performance measurement, and product boundaries. However, there are clear benefits to convergence with the valuation methods being advanced for MCEV and Solvency II. The creation of the numbers and the preparation of the reports should become simpler. Coupled with an appropriate reconciliation of the different valuation bases, communication with investors and other stakeholders should be clearer and lead to a better understanding of insurers business. Contact your local Milliman consultant for more information. US: William Hines at Netherlands and Belgium: Henny Verheugen at +31 (0) UK: Oliver Gillespie at +44 (0) Southern Europe: Dominic Clark at The materials in this document represent the opinion of the authors and are not representative of the views of Milliman, Inc. Milliman does not certify the information, nor does it guarantee the accuracy and completeness of such information. Use of such information is voluntary and should not be relied upon unless an independent review of its accuracy and completeness has been performed. Materials may not be reproduced without the express consent of Milliman. Copyright 2008 Milliman, Inc. Valuation methods for life insurers: Conversion or chaos? Baarnsche Dijk 12c 3741 LS Baarn, Netherlands (+)