An Introduction to Embedded Value

1. An Introduction to Embedded Value Peter Erlandsen, CFO, Manulife Rio Winardi, Chief Actuary, Astra CMG Simon, Chief Accountant, Panin life Date: 8 December, 2005

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

3. 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 year’s results • Value is a measure of long-term worth • Quiz 3 – Why doesn’t value = profit * P/E ratio? • New Business Strain

4. “Typical” Profit Signature

5. “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.

6. What’s 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 it’s shareholders.

7. 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

8. 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

9. 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?

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

11. 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

12. 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.

13. IV. Value of In force (VIF)Risk Discount rate Profits are discounted at the Risk Discount Rate (RDR) RDR represents • The company’s minimum desired rate of return on capital • Sometimes referred to as the “hurdle rate” RDR should reflect: • the Expected Shareholder’s return • the risk that future profits will not match expectations (risk profile of the business) • the current local market conditions

14. 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%

15. 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, …

16. 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?

17. 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?

18. 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

19. VII. Question & Answer