An Introduction to Embedded Value

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An Introduction to Embedded Value

• Peter Erlandsen, CFO, Manulife
• Rio Winardi, Chief Actuary, Astra CMG
• Simon, Chief Accountant, Panin life
• Date 8 December, 2005

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AGENDA

• Why Calculate Embedded Value?
• What is Embedded Value?
• Net Worth
• Value of In-Force
• Value of new business
• Other Issues
• Question Answer

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I. Why Calculate Embedded ValueAn Introduction

• Embedded Value Estimates Value.
• Quiz 1 - What Does Profit Measure?
• Income less Outgo
• Quiz 2 Why is Profit not a measure of Value?
• Profit is a measure of this years results
• Value is a measure of long-term worth
• Quiz 3 Why doesnt value profit P/E ratio?
• New Business Strain

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Typical Profit Signature
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Typical Projection

• The loss in the first year is often called New
  business Strain.
• Over the life of the policy we expect PV profit
  to be positive.

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Whats wrong with Statutory Profit?

• Profit drivers for Statutory Reporting incorrect!
• Shows a loss when writing lots of profitable new
  business when in value is actually added
• Shows a gain when policies cancels when value is
  actually lost
• A growing company writing profitable business
  can have a negative statutory profit for many
  years, but is generating a lot of value for its
  shareholders.

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I. Why Calculate Embedded ValueReasons to
Calculate Value

• A measure of performance
• To calculate Return On Equity (ROE)
• Increase in value / starting value
• Carrying value in accounts of owner
• Sale or Purchase
• Management bonus

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II. What is Embedded Value?

• Embedded Value comes from three segments
• Net Worth (Assets Liabilities)
• PV of profit from in-force business
• PV of profit from future sales
• Sometimes
• 1 2 is referred to as Embedded Value
• 1 2 3 is referred to as Appraisal Value

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III. Net Worth

• Net Worth Assets Liabilities
• Assets
• Market Value of Assets
• Costs of sale of investments / assets (tax, fees)
• Value of some assets depends on purpose of
  calculation.
• In a sale situation computer software may have no
  value.
• Difficult to value some assets
• Intangible assets (e.g. Goodwill) often set to
  zero
• Property, direct holdings, have no ready market
  value
• Do deferred tax assets have value?

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III. Net Worth

• Net Worth Assets Liabilities
• Liabilities
• Local Indonesian policy reserves
• Should include RBC requirements
• Cannot be distributed
• Market Value of other liabilities

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IV. Value of In force (VIF)Definition

• VIF Present Value of future Distributable
  Profits from in force policies
• Distributable Profits
• Statutory Profits less increase in required RBC
• Statutory Profits
• Premium II claims expenses change Resv
  - tax

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IV. Value of In force (VIF)Assumptions

• VIF Present Value of future Distributable
  Profits from in-force policies
• Assumptions
• Best estimate assumptions needed
• Mortality/Morbidity
• Interest earnings
• Inflation
• Lapses
• Expenses
• Tax
• etc.

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IV. Value of In force (VIF)Risk Discount rate

• Profits are discounted at the Risk Discount Rate
  (RDR)
• RDR represents
• The companys minimum desired rate of return on
  capital
• Sometimes referred to as the hurdle rate
• RDR should reflect
• the Expected Shareholders return
• the risk that future profits will not match
  expectations (risk profile of the business)
• the current local market conditions

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IV. Value of In force (VIF)Risk Discount Rate

• Profits are discounted at the Risk Discount Rate
  (RDR)
• The RDR is key to the final Embedded Value figure
• Often a range of figures is used to show
  sensitivity
• CAPM says
• RDR Risk free Beta (Market Rate Risk Free)
• Currently perhaps
• RDR 14.0 1.2 (20.0 14.0) 21.2

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V. Value of New business (VNB)

• VNB Present Value of future Distributable
  Profits from future sales.
• Assumptions
• Same issues as VIF
• How many years New business?
• Judgment but often around 5 years.
• Additional Assumptions
• Future sales growth, agency size, productivity,
  product mix,

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VI. Other Issues

• Expense Over-run
• Expense budget versus Expense allowables
• Minimum or target RBC ratio
• 120 or 150 of estimated RBC
• Later year losses
• How should we treat later year losses (25 years
  from now!)
• Investment Return
• Should be consistent with asset valuation.
• Should a change in asset mix affect value?
• Can we forecast changes to current rates?

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VI. Other Issues

• It is extremely important that future bonus rates
  on with-profit policies should be consistent
  with
• Future assumptions.
• Likely future management action
• Policy holders reasonable expectations
• Future Sales (Value of New Business)
• Can we assume a re-price of loss making products
• Are future margins going to be the same as today?
• Should we use a higher RDR because of greater
  uncertainty?

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VI. Other Issues

• Product Guarantees
• Investment /mortality no value in deterministic
  approach
• Valuation Software
• Many available (e.g. Prophet, VIP, AXIS, MOSES,
  etc)
• Possible but cumbersome to do in spreadsheets
• Model points Vs seriatim data.
• Changing Assumptions
• How often depends on purpose
• Assumptions are long term to try to not have big
  swings
• Future improvements in mortality

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VII. Question Answer