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Insurance and Actuarial Advisory Services

Actuarial Services Group

Embedded Value for Insurance CompanyJonathan Zhao, FSA, FCIA, FCA, MAAA

October 17, 2005

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AgendaAgenda

General overview of embedded value

Components of embedded value

Deterministic vs. Stochastic EV

Practical Application – EV at Risk

Development of EV framework

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General overview of embedded General overview of embedded valuevalue

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

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Components of Embedded ValueComponents of Embedded Value

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Basic Components of Embedded Basic Components of Embedded ValueValue

Actuarial

Appraisal

Value

Actuarial

Appraisal

Value

Value ofFuture

Business

Value ofFuture

Business

AdjustedNet WorthAdjusted

Net Worth

Value ofInforce

Business

Value ofInforce

Business Embedded

Value

Embedded

Value

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Value of InforceValue 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

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

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PV Cost of CapitalPV 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

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Adjusted Net WorthAdjusted 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 purposesTarget surplus is usually included in adjusted net worth for presentation purposes

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Embedded Value Change = Embedded Value Change = ““Value AddedValue Added”” or or ““Achieved ProfitsAchieved Profits””

Achieved Profit Amount

Achieved Profit Amount

StartingEmbedded

Value

StartingEmbedded

Value

EndingEmbedded

Value

EndingEmbedded

Value

AdjustedNet

Worth

AdjustedNet

Worth

Valueof Inforce

Valueof Inforce

S/H DividendS/H Dividend

AdjustedNet WorthAdjusted

Net Worth

Value fromNew SalesValue fromNew Sales

Value ofSurvivingInforce

Value ofSurvivingInforce

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

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Sample Deterministic EV ResultsSample Deterministic EV Results

17,093,861 14,197,287 Total Embedded Value

12,749,801 10,416,296 Total Value of Existing Business

(1,254,137)(1,127,290)Cost of Capital

14,003,938 11,543,586Present Value of Future Profit

Value of Existing Business

4,344,061 3,780,991 Total Adjusted Statutory Capital and Surplus

--Adjustments to Statutory Capital and Surplus

--Free Surplus

4,344,061 3,780,991 Target Surplus

Adjusted Statutory Book Value

20052004Year

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Sample EV Movement AnalysisSample EV Movement AnalysisEmbedded Value Added or Achieved Profits ($MM)

$1.14

100%

$17.11

2004 EV 8% Return on Existing Business

EV

New Business EV

8% Return on New

Business EV

$0.3

Capital Transfer

2005 EV

$0.11

$14.2

8%

10%

1%2%

121%

$1.36

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EV Reporting AdvantageEV 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

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Deterministic vs. Stochastic EVDeterministic vs. Stochastic EV

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Deterministic EVDeterministic EV

Traditional Embedded Value uses a set of best estimate assumptions

Single, deterministic scenarioReflects overall risk in the discount rateHigher discount rate for riskier products

Easy to implement and understand

However,Focused primarily on interest-rate riskDoes not reflect tail exposure Unable to measure the interaction of risks

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Stochastic EVStochastic 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

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What is Stochastic EV?What is Stochastic EV?

Examples of simple applicationVarious interest rate scenarios used in cash flow testingSensitivity testing (e.g., increasing lapse rate, lower mortality rate)

Formal stochastic approachIdentify 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 modelStochastic Assumption = deterministic assumption x

stochastically generated factor

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Practical Application Practical Application –– EV at RiskEV at Risk

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Embedded Value at Risk ConceptEmbedded 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 non-economic scenarios

Quantifies impact to EV for each individual risk elementsDemonstrates the correlation effect between different risk elements (i.e., sum of individual risk components is greaterthan 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

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Sample of Sample of EV@RiskEV@Risk

Comparison of Stochastic Runs

$796

$798

$800

$802

$804

$806

$808

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90

Embe

dded

Val

ue a

t 12/

31/0

1 (m

)

Stoch Lapse Only

Stoch Mortality Only

Stoch Lapse &MortalityBase Run

5th Percentile5th Percentile

MeanMean

2020

Stochastic Interest Results Stochastic Interest Results -- Universal LifeUniversal Life

Universal Life - Stochastic Interest

(200,000)

-

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

0.01 0.12 0.22 0.33 0.43 0.54 0.64 0.75 0.85 0.96

Valu

e of

Exi

stin

g Bu

sine

ss

Stochastic Interest Deterministic

Result % of MeanMean 561,599 100.00%Median 621,222 110.62%Minimum (142,731) -25.42%Maximum 879,532 156.61%Deterministic 561,872 100.05%

Statistics

Result % of Mean5th 163,304 29.08%25th 463,958 82.61%50th 621,222 110.62%75th 700,990 124.82%95th 775,944 138.17%

Percentile

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Stochastic Interest Results Stochastic Interest Results -- Universal LifeUniversal Life

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

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

Deterministic Mean EaRisk 5th 25th 50th 75th 95thGAAP 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$

Universal Life Results - Stochastic InterestPercentile

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Summary of Stochastic Results Summary of Stochastic Results –– All All

Percentile All Interest Mortality Defaults5th 173,862 178,958 174,652 176,58225th 177,220 178,996 177,198 177,57250th 179,126 179,018 178,679 178,64575th 180,976 179,034 180,672 180,02495th 184,316 179,077 182,711 182,448

Mean 179,116 179,014 178,764 178,931EaRisk 5,254 56 4,112 2,349

Correlation (1,264) Deterministic 179,232

2004 Operating Earnings - Universal Life

Percentile All Interest Mortality Defaults5th 954,438 926,190 1,264,557 1,107,44525th 1,137,281 1,226,844 1,298,890 1,234,91150th 1,337,677 1,384,108 1,319,582 1,314,28275th 1,514,501 1,463,875 1,344,527 1,443,07695th 1,692,022 1,538,830 1,377,207 1,554,656

Mean 1,323,899 1,324,485 1,321,195 1,320,977EVaRisk 369,460 398,295 56,637 213,532

Correlation (299,004) Deterministic 1,324,758

2004 Embedded Value - Universal Life

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Insurance and Actuarial Advisory Services

EV Reporting Framework DevelopmentEV Reporting Framework Development

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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.

Developed in the late 1980’s,

early 1990’s

CFO Forum published EEV

Principles in May 2004

Work in Progress

No defined approach

Move to Fair Value / Market consistent Financial Reporting

Traditional Embedded

Value Reporting

European Embedded

Value (CFO Forum)

Market Consistent

Embedded Values

Embedded Value Reporting Embedded Value Reporting DevelopmentsDevelopmentsTraditional 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

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European Embedded Value European Embedded Value PrinciplesPrinciples

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

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European Embedded Value European Embedded Value Principles Principles -- continuescontinues

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Market Consistent EVMarket Consistent EV

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

• Fair value approach

• Use risk neutral / arbitrage free scenarios

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Closing RemarksClosing 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 systemRisk management and optimizationReconcile with product pricingFacilitate capital allocationSegue to IAS/IFRS accounting

PitfallsRequire a robust actuarial modeling toolShort term business might present difficultiesDifficult choice of discount rate (deterministic EV)Determination of stochastic scenariosCommunication to senior managements