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Embedded Value Miroslav Petkov Director Standard&Poor’s. Embedded Value Setting the Scene. Origins of Embedded Value. Developed as a concept in the UK in 1980’s Origins in valuing life companies (appraisal values) Introduced widely in the equity markets in 1990’s
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Origins of Embedded Value • Developed as a concept in the UK in 1980’s • Origins in valuing life companies (appraisal values) • Introduced widely in the equity markets in 1990’s • Embedded Value is gaining global acceptance e.g. Europe, Australia, Canada, South Africa • US companies stand out as the exception • Embedded Value initially drove a re-rating in the UK sector • Flaws in methodology have seen price/EV’s collapse
Development in the UK • In the UK, achieved profit (EV) guidance notes first issued in July 1995 • Appraisal values rose as embedded value methodology gained wide acceptance Appraisal Value = Embedded Value + Goodwill • Association of British Insurers issued guidance notes on EV reporting in 2001 to improve consistency in reporting • From 2002, all companies use active economic assumptions (investment returns and discount rates)
UK Life Sector Emergence of E.V. Reporting
Development in Continental Europe • Myriad of local statutory solvency accounting bases around Europe • Continental Europe were slower to embrace EV, but implemented following pressure from investment community • Companies were already using EV internally for many years as a product-pricing tool. • Unlike UK, European companies often saw share price fall as disclosure coincided with de-rating of the insurance sector. • EEV Principles were introduced in 2004 by the CFO Forum
Development in the US ? • US companies have stuck with US GAAP • Signs this may be changing • Many large US life companies have European parents eg. AEGON, AXA, ING & Prudential • These US subsidiaries report embedded values • US life businesses viewed as under-valued in some quarters • Perceived valuation arbitrage may encourage US life companies down EV route
Value of a Life Company • In most sectors, a companies value is equal to net assets Net Asset Value (NAV) = Assets minus Liabilities • Life insurance is different By design contracts are written for the long-term Additional value is taken for “guaranteed” future income Many (traditional) life insurance contracts have exit penalties Consequently, they tend to be maintained for long periods of time • Expected profits from life insurance contracts are referred to as value in force (VIF) • VIF = NPV of future profits from contracts already written (sold) • The actual value and intangible value are jointly referred to as Embedded Value (EV) • EV = NAV + VIF
Traditional Accounting Methods • Traditional accounting regimes provide a lagging indicator of current performance • Balance sheets give limited view on value ‘locked-in’ within life business • P&L reflect historic management performance/actions • Current actions will only emerge through earnings over time • Consequently, the traditional accounting methods provide little perspective on management efficacy
Traditional Accounting Methods Statutory Level of Conservatism Cash Profit GAAP EV Economic Value
“In the end we’re all dead…….” All the reporting basis give the same total profits, timing being the only difference
Embedded Value – The Weaknesses • Four areas analysts should be aware of : • Cash • Risk • Consistency • Subjectivity
Not all about Embedded Value !! Traditional EV failed to flag impact from falling markets to asset liability mismatch and costly options and guarantees Therefore, for full perspective of a company need to consider : Embedded value – for value creation Statutory earnings – for cash potential Capital model – for assessment of capital generation and needs
Background to EEV • European Embedded Value (EEV) is the first set of financial reporting principles to be developed by the insurance industry. • A potential driver of EEV was to influence/provide solution for the IASB • It aims to provide supplementary disclosure, particularly in relation to long-term insurance business • It seeks to eradicate the different methodologies that have made EV comparison difficult • And address some of the inherent weaknesses of traditional EV • Goal is to build on strengths of existing EV methodologies
European Embedded Value (EEV) • EEV designed to be more risk sensitive :- • Stochastic projections to evaluate cost of options and guarantees • New business margins reported on PV of NB premiums • Service companies valued on look-through basis • Allowance made for holding company operating expenses • Value cost of capital used to support any ALM mismatch • Definition of cost of solvency capital widened • Risk discount rates may vary between product groups and territories – not prescriptive • Standardized set of sensitivities
Market Consistent Embedded Value • Actuarial consultancies marketing MCEV that seeks to more fully allow for cost of risk and cost of capital • Cost of options and guarantees, priced on a basis consistent with that of the financial markets • Applies principle of no arbitrage re. asset risk premia • Expected cashflows valued using risk discount rate to reflect inherent product and ALM risks • Products that do best under MCEV are those that take no investment risk eg protection business. Market value of assets – market-consistent value of liabilities – cost of capital
Advantages of EV for analysing operating performance • Captures profits over the life of the portfolio rather over one year • Contribution from new and existing business clearly defined • Deviations in experience more transparent • Options and guarantees quantified
S&P Approach • Establishing the credibility of EV Results • Applying adjustments to EV Results • Analysis of EV Results
Analysis of EV Results • What S&P is seeking to analyse: • Value added as a result of management actions • Risk exposure of VIF • Overall EV Performance
EV Profit • It considers EV Profit gross of tax • EV Profit breakdown: • Expected income (unwinding + expected income on NA) • VNB • Economic variances • Changes in economic assumptions • Operating variances • Changes in operating assumptions • Development costs • Currency movements • Modelling changes • Unexplained
Value Added by Management • Areas where management can influence results: • VNB • Some items among operational variances and change in assumptions, e.g.: • Expenses • Persistency • Investment performance
VNB • Areas of new business to be analysed • Aggregate VNB • Individual Product New Business Profitability • VNB Exposed to Risk
Aggregate VNB • To assess the scale of the new business • Key Ratios: • VNB / VIF (SOY) • NB Margin • IRR
Individual Product New Business Profitability • In order to understand Product Profitability, NB profit margins (and IRR) by product category, country and preferably by distribution channel are required. • The aims of the analysis are: • To establish NB margins (and IRR) on consistent basis • To link NB margins (and IRR) with competitiveness and strategy of the company, e.g.: • Higher margins consistent with competitive advantages? • Lower margins as a result of aggressive strategy?
Linking NB profitability and Competitive Position • It is important to understand how company’s competitive position factors contribute to the new business profitability, i.e. how company competitive position translate into financial results.
VNB to Exposed to Risk • Ratios: • PVNBER = NB Risk Exposure / VNB (overall and per product) • NB Risk Exposure / NB Margin (overall and per product)
Performance Related Value Added • The analyst needs to decide whether credit should be given to the management in respect of value created (or destroyed) as a result of their particular actions, e.g: • expense reduction • persistency improvement • outperforming investment benchmark (without assuming more risk)
Total Value Added by the Management • (VNB + Credit in respect of management actions) / • VIF (SOY)
VIF Exposed to Risk • To analyse the robustness of VIF under adverse scenarios using sensitivities results. • An indication of likely volatility of VIF. • Ratio: • PVIFER = VIF Risk Exposure / VIF
Overall EV Performance Assessment • “EV Return on capital” ratio – standardised industry measure: • Adjusted EV Profit / BBB Risk Capital • Return on Embedded Value (ROEV) • EV Profit / ((EV (SOY) + EV (EOY))/2)
