Actuarial Services Group Insurance and Actuarial Advisory Services Embedded Value for Insurance Company Jonathan Zhao, FSA, FCIA, FCA, MAAA October 17, 2005 1
Agenda General overview of embedded value Components of embedded value Deterministic vs. Stochastic EV Practical Application EV at Risk Development of EV framework 2 2
General overview of embedded value EV reporting\disclosure is widespread in U.K., Europe, Australia EV reporting is now required by China Insurance Regulatory Commission (CIRC) for all Chinese Insurance Companies May be included in published financial statements, in presentations to analysts and rating agencies Increasingly common in the U.S and China for Incentive Compensation Use for pricing and plan validation (Global) Stochastic EV is used for Enterprise Risk Management European Embedded Value and Market Consistent EV 3 3
Insurance and Actuarial Advisory Services Components of Embedded Value 4
Basic Components of Embedded Value Actuarial Appraisal Value Value of Future Business Value of Inforce Business Adjusted Net Worth Embedded Value 5 5
Value of Inforce Present Value (PV) of Distributable Earnings = PV after-tax book profits PV Cost of Capital Distributable Earnings (year t) = After-tax Book Profit (year t) + TS Released (year t) + After-tax earnings on TS (year t) Allocate assets to business lines, project cash flows using best estimate assumptions, include statutory reserves, discount distributable earnings to present value at a hurdle rate reflecting risk 6 6
PV Cost of Capital Timing difference between TS now and future TS releases net of after-tax investment earnings on assets backing TS = Target Surplus PV Future Target Surplus Released PV Future after-tax earnings on assets backing TS 7 7
Adjusted Net Worth = Statutory capital and surplus (i.e., target surplus) + Allocations of surplus, such as AVR + Non-admitted assets with realizable value + Reduced for the value of any obligations not considered in the value of inforce + Adjustment for difference between market value and book value of assets backing adjusted net worth Target surplus is usually included in adjusted net worth for presentation purposes 8 8
Embedded Value Change = Value Added or Achieved Profits Achieved Profit Amount Adjusted Net Worth Starting Embedded Value Value of Inforce S/H Dividend Adjusted Net Worth Value from New Sales Value of Surviving Inforce Ending Embedded Value Achieved Profits = Unwinding of discount (at hurdle rate) +/- Variances from expected distributable earnings + Value of new business added during the year + Stockholder dividends paid, if any 9 9
Sample Deterministic EV Results Year Adjusted Statutory Book Value Target Surplus Free Surplus Adjustments to Statutory Capital and Surplus Total Adjusted Statutory Capital and Surplus 2004 3,780,991 - - 3,780,991 2005 4,344,061 - - 4,344,061 Value of Existing Business Present Value of Future Profit Cost of Capital Total Value of Existing Business 11,543,586 (1,127,290) 10,416,296 14,003,938 (1,254,137) 12,749,801 Total Embedded Value 14,197,287 17,093,861 10 10
Sample EV Movement Analysis Embedded Value Added or Achieved Profits ($MM) 1% $0.11 2% $0.3 10% $1.36 8% $1.14 121% $17.11 100% $14.2 2004 EV 8% Return on Existing Business EV New Business EV 8% Return on New Business EV Capital Transfer 2005 EV 11 11
EV Reporting Advantage Provides an economic measure of performance and current value (excluding new business) Reflects cost of capital Closely linked to commonly accepted actuarial appraisal methodology Provides valuable insight regarding profitability of new business and returns on economic capital 12 12
Insurance and Actuarial Advisory Services Deterministic vs. Stochastic EV 13
Deterministic EV Traditional Embedded Value uses a set of best estimate assumptions Single, deterministic scenario Reflects overall risk in the discount rate Higher discount rate for riskier products Easy to implement and understand However, Focused primarily on interest-rate risk Does not reflect tail exposure Unable to measure the interaction of risks 14 14
Stochastic EV Enables companies to capture the interaction of risks Quantifies risks (total enterprise basis & by line of business) Helps management to determine a comfortable level of risk and to optimize the risk/reward relationships An approach that distinguishes a company from its competitors in terms of enterprise risk measurement and management 15 15
What is Stochastic EV? Examples of simple application Various interest rate scenarios used in cash flow testing Sensitivity testing (e.g., increasing lapse rate, lower mortality rate) Formal stochastic approach Identify risk elements (e.g., interest, mortality, and default) Use a stochastic process to define a range of selected risk elements (e.g., Monte Carlo, Economic Scenario Generator) Run EV model over a range for selected risk elements Start with a deterministic model Stochastic Assumption = deterministic assumption x stochastically generated factor 16 16
Insurance and Actuarial Advisory Services Practical Application EV at Risk 17
Embedded Value at Risk Concept EV at risk is similar to the VAR concept - used for enterprise risk management EV@Risk TM : Difference between the mean EV value and the fifth percentile EV for each risk element (other confidence interval levels could also be used) Shows variance in EV over a range of economic and noneconomic scenarios Quantifies impact to EV for each individual risk elements Demonstrates the correlation effect between different risk elements (i.e., sum of individual risk components is greater than when all the risks are run together) Allows management to determine a comfortable level of risk Requires stochastic EV modeling in order to determine different levels of EV@Risk TM 18 18
Sample of EV@Risk Comparison of Stochastic Runs Embedded Value at 12/31/01 (m) $808 $806 $804 $802 $800 $798 Mean 5 th th Percentile $796 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 Stoch Lapse Only Stoch Mortality Only Stoch Lapse & Mortality Base Run 19 19
Stochastic Interest Results - Universal Life Value of Existing Business Universal Life - Stochastic Interest 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 200,000-0.01 0.12 0.22 0.33 0.43 0.54 0.64 0.75 0.85 0.96 (200,000) Stochastic Interest Deterministic Statistics Result % of Mean Mean 561,599 100.00% Median 621,222 110.62% Minimum (142,731) -25.42% Maximum 879,532 156.61% Deterministic 561,872 100.05% Percentile Result % of Mean 5th 163,304 29.08% 25th 463,958 82.61% 50th 621,222 110.62% 75th 700,990 124.82% 95th 775,944 138.17% 20 20
Stochastic Interest Results - Universal Life Universal Life Results - Stochastic Interest Percentile Deterministic Mean EaRisk 5th 25th 50th 75th 95th GAAP Eanings 2004 $ 179,232 $ 179,014 $ 56 $ 178,958 $ 178,996 $ 179,018 $ 179,034 $ 179,077 GAAP Earnings 2004-2007 $ 778,388 $ 777,616 $ 1,362 $ 776,254 $ 777,206 $ 777,605 $ 778,256 $ 779,014 Embedded Value $ 1,324,758 $ 1,324,485 $ 398,295 $ 926,190 $ 1,226,844 $ 1,384,108 $ 1,463,875 $ 1,538,830 Embedded Value w/o TS $ 561,872 $ 561,599 $ 398,295 $ 163,304 $ 463,958 $ 621,222 $ 700,990 $ 775,944 Observations: 2004 GAAP earnings at risk is about 0.0% versus the mean results while EV@Risk TM is about 30.1%. EV@Risk TM is 70.9% when calculated without target surplus 21 21
Summary of Stochastic Results All 2004 Operating Earnings - Universal Life 2004 Embedded Value - Universal Life Percentile All Interest Mortality Defaults 5th 173,862 178,958 174,652 176,582 25th 177,220 178,996 177,198 177,572 50th 179,126 179,018 178,679 178,645 75th 180,976 179,034 180,672 180,024 95th 184,316 179,077 182,711 182,448 Mean 179,116 179,014 178,764 178,931 EaRisk 5,254 56 4,112 2,349 Correlation (1,264) Deterministic 179,232 Percentile All Interest Mortality Defaults 5th 954,438 926,190 1,264,557 1,107,445 25th 1,137,281 1,226,844 1,298,890 1,234,911 50th 1,337,677 1,384,108 1,319,582 1,314,282 75th 1,514,501 1,463,875 1,344,527 1,443,076 95th 1,692,022 1,538,830 1,377,207 1,554,656 Mean 1,323,899 1,324,485 1,321,195 1,320,977 EVaRisk 369,460 398,295 56,637 213,532 Correlation (299,004) Deterministic 1,324,758 22 22
Insurance and Actuarial Advisory Services EV Reporting Framework Development 23
Embedded Value Reporting Developments Traditional EV Reporting - best estimated assumption, focus primarily on interest rate, easy to implement and understand, but not consistent across companies. Achieved profit (EV value added) are calculated based on the traditional EV reporting, it provides a considerable amount of useful information about a company s performance and where profits (or losses) are coming form. European Embedded Value (EEV) Reporting CFO Forum s 12 EEV principles are aimed to provide transparent and consistent financial information to the investors across major European insurance companies. Required the use of stochastic modeling for financial options and guarantees Traditional Embedded Value Reporting Developed in the late 1980 s, early 1990 s Market Consistent EV Reporting - there are discussions within the industry about the use of market-consistent EV techniques (MCEV). Several major European insurance companies have started piloting MCEV in some business units, to keep up with the ever changing demands regarding financial reporting. European Embedded Value (CFO Forum) CFO Forum published EEV Principles in May 2004 Market Consistent Embedded Values Work in Progress No defined approach Move to Fair Value / Market consistent Financial Reporting 24 24
European Embedded Value Principles The CFO Forum launched European Embedded Value (EEV) Principles in 2003 EEV principles are aimed to provide transparent and consistent financial information to the investors across major European insurance companies 25 25
European Embedded Value Principles - continues 26 26
Market Consistent EV Fair value approach Use risk neutral / arbitrage free scenarios Advantages Consistent with financial market pricing of risk Less subjectivity in setting discount rates Properly values items with observable market values Disadvantages Not aligned with how insurance business is priced or managed Lack of suitable long term options for calibration Subjective valuation of frictional costs 27 27
Closing Remarks EV is becoming a global financial reporting and measurement framework Can be used to create an effective decision support framework Act as an early warning system Risk management and optimization Reconcile with product pricing Facilitate capital allocation Segue to IAS/IFRS accounting Pitfalls Require a robust actuarial modeling tool Short term business might present difficulties Difficult choice of discount rate (deterministic EV) Determination of stochastic scenarios Communication to senior managements 28 28