Category Archives: Embedded Value

The Perfect Storm – Part 0

The world of financial reporting for insurers has never been this close to the edge.

There is more change brewing now even than when Europe adopted “European Embedded Values” and later “Market Consistent Embedded Values”. The irony is that Embedded Values may well fall away as a result of the latest change.

So what is changing?

  1. Solvency Assessment and Management (SAM) is still planned for 2015 in South Africa. SAM will change the calculation of actuarial reserves, or Technical Provisions as they are now known, for regulatory reporting purposes. Solvency II in Europe is now likely to follow rather than precede SAM by a few year, but with nearly identical implications.
  2. IFRS4, the accounting standard covering insurance contracts, is due for a radical change effective in 2016/2017, although this is years later than originally planned. IFRS4 “Phase 2” as it is referred to throws out most of what we’re used to in terms of profit recognition, financial impact of assumption changes, impacts of asset and liability mismatches and may very well push insurers to value their assets on a different basis.
  3. IFRS9, a new standard replacing IAS39 and covering financial instruments, whether these are assets or liabilities, will poke and prod insurers into different decisions now and possibly before knowing exactly how IFRS4 will pan out.
  4. Finally, although this part is still speculative, Embedded Value reporting may fall away as SAM and Solvency II achieve much of the objections of Embedded Value.

This post is the first in a series covering important aspects if the change in financial reporting standards, covering news of the developments as it emerges as well as the likely implications for financial reporting, product design, ALM, financial reinsurance and others. I’d encourage you to post comments or questions on this or later posts and I’ll try to answer those through the series.

  • Part 1 – IFRS reporting under SAM
  • Part 2 – EV in a SAM/Solvency II world
  • Part 3 – Apocalypse! – SAM as the tax basis
  • Part 4 – Acquisition accounting under IFRS4 Phase II – a little speculation

New thoughts on renewal rates for Embedded Values

Embedded Values (EVs) are widely used to measure value for life insurers. In the context of long-term contracts such as individual life, it reflects the value embedded in prudent regulatory provisions (or “actuarial reserves”).

For short-term business (group risk, health insurance, health administration, general insurance etc.) it is something different since these lines don’t have long-term prudent provisions. In these cases it reflects the present value of future profits expected to be earned out of the existing business.

The inclusion of these short term types of business within EV is widespread. It seemingly increases consistency between different types of contracts since we are considering the long-term expected profitability in all cases. More on this apparent consistency in a moment.

What do we include in the EV and VIF?

EV is not a complete economic measure of the value of an insurer, since it ignores future profits arising from future new business. This is by design. An Appraisal Value incorporates the Value of Future New Business (VFNB) as well, although there is always subjectivity over how many years of future new business should be included. (More on this in a separate post.)

Existing Business vs Future Business

The idea of “existing business” and “future new business” is clear in the individual life context. It’s existing business if you have a contract, and future new business if not. Premium increases and slight benefit modifications can usually be accommodated within the existing contract and so should ideally be included in the Value of In Force (VIF) based on the expected probabilities of these changes. Continue reading New thoughts on renewal rates for Embedded Values

New Business Margin on Revenue

A new measure of life insurance new business profitability is required.

What is New Business Margin?

Many life insurers currently calculate a measure of the profitability of new business sold over a period called “new business margin”. As defined by the CFO Forum’s MCEV Principles and confirmed in South Africa’s PGN107 covering embedded values, this is the Value of New Business (VNB) divided by the Present Value of New Business Premiums (PFNBP) calculated on a consistent basis.

This is a useful measure since it shows, on average, how much of each premium goes to shareholders as profit, after deducting operating costs, benefits paid to policyholders and a cost of the capital required to support the business.

It’s far more useful than a common previous metric of VNB / API where API is Annual Premium Income or APE Annual Premium Equivalent, since the numerator reflects a multi-year stream of profits and the denominator just a single year. It’s a more difficult number to interpret intuitively.

Of course, New Business Margin is also fatally flawed. Continue reading New Business Margin on Revenue

Your ERP estimate is still too high

I recently had a conversation with a colleague who had been told that “Credit Suisse recommended an Equity Risk Premium of 7%”.  I’m curious to know whether they truly view that as an appropriate ERP.  If your ERP is 7%, it’s still too high.

The authors of Triumph of the Optimists have joined forces with Credit Suisse to publish the Credit Suisse Global Investment Returns Yearbook 2010 (pdf) which is a brief update of their brilliant research.  You should definitely read the original book.

The updated research shows a very familiar picture to that of the book.  Here are a few important outcomes:

  • Realised excess returns of equities over bonds have been negative for most countries for the last decade.

Clearly, using realised excess returns (or historical ERPs) over a short period as a measure of future ERP is a bad idea.  I’m fairly sure the future ERP is positive.

  • For the World, the US, the UK, Australia, Belgium, Canada, Denmark, France, Germany, Ireland and South Africa (a few countries I chose to look at before I realised the trend is near-universal) have had declining historical ERPs over the last 110 years. Some have had a few bumps in between, but the overwhelming trend has been downward.  The last decade’s poor performance has obviously helped establish this trend, but it was pretty well established for most of these countries even without the last decade.

Using unadjusted historical ERPs over long periods is a dangerous idea because trends in the data make it a poor estimate of future experience.

You can’t eat that

I was in a meeting today with a great company and with great people. We were discussing financial measures for a life insurer, including Embedded Value, when one of the well respected actuaries asks what the Return on Equity is (rather than Return on Embedded Value).

Now there are many people who don’t like Embedded Values, and they certainly have some good reasons for being wary of it. Embedded Values are a measure of shareholder value in a life insurer that adds the shareholder valued embedded in prudent regulatory reserves to the net worth of the company with an adjustment for the cost of holding capital. It is needed because current accounting measurement of insurance liabilities is also typically overly prudent and thus book value on an accounting basis is a really bad measure of shareholder value in a life insurer.

Embedded Values are flawed due to imperfect allowances for risk, lack of comparability across countries and even sometimes companies and a methodology that can make value magically appear out of taking on mismatch risk.  Worst of all, in a practical sense, is that life insurers typically trade at a discount to Embedded Value in the market (Embedded Value is greater than Market Value) even though theory suggests Embedded Value should be less than Market Value since we haven’t included any allowance for future new business/goodwill/franchise value.

None of this was the basis for the preference for Return on Equity over Embedded Value.

You can’t eat Embedded Value.

That was the criticism. You can’t eat Embedded Value. This is true.  Of course, you can’t eat Equity either.  You can’t eat Book Value.  You can’t eat earnings.  While we’re at it, you can’t actually even eat cash, although you are reasonably likely to be able to potatoes directly with the cash (as in a dividend) than with most other measures.

So while you can’t eat Embedded Value, you just as well can’t eat Book Value.  In the life insurance space, it’s really hard to get a handle on “tangible” asset value.  Our liabilities will always be based on an estimate of future cashflows. Embedded Value is in its most basic form just a different value of different future cashflows discounted at a different rate.  It is no less (or more) tangible than Book Value.  Return on Embedded Value is no less tangible than Return on Equity since they both depend on uncertain estimates of future cashflows and experience.

The difference is, we know that Book Value is categorically, definitely undervalued.  The degree of undervaluation is different from one company to another depending on the level of prudence included in the liabilities. In South Africa, it’s also fundamentally undervalued because the liabilities ignore the economic value arising out of optional (but reasonably predictable) future premium increases.

This means that Return on Equity is an overstated measure of return since the measure of Equity is understated because the liabilities are overstated.  Worse, we can’t compare it from one insurer to another since their liability valuations will be different.

So while you can’t eat Embedded Value, you will make more value for your shareholders basing decisions on Embedded Value than on Book Value.

Interestingly, new accounting developments (IFRS4 Phase 2) and regulatory developments (Solvency Assessment and Management, based on Solvency II from Europe) will completely change the way we measure financial performance of insurers. And no, I still won’t be using Return on Equity.