Embedded Value of Life Insurance Companies in India. Presented by Philip Jackson FIA, FIAI Consulting Actuary

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1 Embedded Value of Life Insurance Companies in India Presented by Philip Jackson FIA, FIAI Consulting Actuary 1

2 Disclaimer The views expressed here are my personal views and not that of my employer This presentation is intended solely for educational purposes and presents information of a general nature. It is not intended to guide or determine any specific individual situation and persons should consult qualified professionals before taking specific actions. Neither the presenters, nor the presenters employer, shall have any responsibility or liability to any person or entity with respect to damages alleged to have been caused directly or indirectly by the content of this presentation. 2

3 Agenda What is embedded value? Components of embedded value Methodologies Public disclosures Metrics for calculating market values 3

4 Embedded Value Why should I care? 4

5 The Problem with Embedded Value Embedded value reporting generates a mixed response from equity analysts. This might have something to do with the terminology Alphabet Soup: The world of embedded value reporting VIF

6 How is life insurance priced? Mortality Mortality Expenses Expenses High acquisition costs Premiums Commissions Maturities Surrenders Commissions High first year commissions Profits Other outgo Premium Components Statutory reserves Loss in first year

7 Issues with statutory accounts (1) 7 7

8 Issues with statutory accounts (2) But despite the initial losses, profits are expected in future years. 8

9 Present Value of Future Profits We project our future transfers to shareholders and discount back to the present day

10 Components of Embedded Value How do I read an EV? 10

11 Embedded value and appraisal value Embedded Value Adjusted Net Asset Value Value of in-force business Value of future new business (Goodwill) Appraisal Value

12 Embedded value and appraisal value Embedded Value Adjusted Net Asset Value Value of in-force business Value of future new business (Goodwill) Appraisal Value

13 Embedded value and appraisal value Embedded Value Adjusted Net Asset Value Value of in-force business Value of future new business (Goodwill) Appraisal Value

14 Present Value of Future Profits We project our future transfers to shareholders and discount back to the present day

15 Value of in-force business Value of In-force Business: The real meat in the embedded value. The discounted value of the future profit cash flows to the company Based on assumptions about future performance of the company Deductions in order to arrive at the value of inforce business Frictional Costs / Cost of Capital the lost value caused by holding assets in excess of those required to meet the liabilities of the company Time Value of Options and Guarantees Cost of non-hedgeable risks the cost of variability in those assumptions that cannot be hedged away 05 June 2015

16 Embedded value Traditional EV Market Consistent EV Net Worth Present Value of Future Profits Frictional Costs Time Value of Options and Guarantees Cost of Non- Hedgeable Risks Embedded Value 05 June 2015

17 Embedded value and appraisal value Embedded Value Adjusted Net Asset Value Value of in-force business Value of future new business (Goodwill) Appraisal Value

18 Value of future new business Value of oneyear s new business An assumed capitalisation factor Value of future new business Can we a very subjective calculation... Key assumptions A typical year of new business (is the previous year typical?) Profitability of the new business written during the typical year An assumed capitalisation factor (how many times in future, will the profitability as contained in the business from the typical year, be repeated) May vary by product line and / or distribution channel Capitalisation factor may depend on: number of years of new business growth in new business risks attaching to the business not yet sold level of maturity of the distributi on channel turnover of sales force / loyalty of sales force etc.

19 Expense overrun: Example of an efficient company Expense overrun for 5 years Actual Expenses Expense Loadings Expense Overrun (6) (18) (30) (40) (55) (70)

20 Expense overrun: Example of an inefficient company Expense overrun continues Actual Expense Expense Loadings Expense Overrun

21 Adjusting for expense overruns Some companies report the value of new business both before, and after, expense overruns Before overruns means using expenses which are at the expected long term level rather than at the today s level After overruns means using actual expenses incurred Essential to take into account expense overruns, but should we assume some future economies of scale? 05 June 2015

22 Valuation of insurance companies Value of in-force business Value of future new business Other dictators of value Adjusted Net Asset Value Embedded Value (EV) Appraisal Value (AV) Market Value

23 Methodologies Traditional versus Market Consistent 23

24 TEV vs MCEV Traditional Embedded Value techniques use real world assumptions, and discount future profits at the Risk Discount Rate (RDR) The RDR represents shareholder s required return on their investments and is expected to allow for the inherent risks in the business (which is otherwise not explicitly reflected in the projection of cash-flows) Market Consistent Embedded Values use market information to tell us the price of each risk where possible. Especially for economic risks. 05 June 2015

25 TEV vs MCEV What are the impacts TEV The assumptions are usually long term best estimates The risk discount rate is a catch-all item it represents the price of the combined portfolio of risks the company takes MCEV Assumptions are derived from markets where possible can make them more consistent across companies Assumptions more volatile as market linked? In India we do not have as deep or liquid markets for long term instruments or more exotic instruments such as long term government bonds, index-linked bonds, swaptions etc. this hampers our ability to value exotic product features Separates out each risk and values it, which may be more informative But will one give a larger result than the other? 05 June 2015

26 Embedded Value Disclosures What should we be looking for? 26

27 Public Disclosures Some companies are now starting to disclose EV IPOs will be a big driver of further EV disclosures IRDA and Institute of Actuaries have mandated the disclosure requirements Very prescriptive and detailed methods called the IEV or Indian Embedded Value IEV is essentially an MCEV so we can expect more market consistent disclosures Three important features of EV disclosures Value of New Business Sensitivities Analysis of Movement 05 June 2015

28 Sensitivities - Example Sensitivity Embedded Value Value of New Business Base Reduction in interest rates of 100 bps -1% -5% Increase in interest rates of 100 bps +1% +5% 10% reduction in persistency -4% -20% 20% fall in the value of equities 0% 0% Change in tax rate to 30% -10% -20% 05 June 2015

29 Analysis of Movement - Example June 2015

30 Analysis of Movement Investments? June 2015

31 Analysis of Movement New Business? June 2015

32 Analysis of Movement Persistency? June 2015

33 What are the key drivers of value? Persistency is a key driver of profitability What do the sensitivities and AOM tell us? How will this impact the embedded Value Assumed future new business What multiple of VNB should we take? How will big regulatory changes impact? Open architecture Direct tax code Expense Overruns 05 June 2015

34 The Multiple Myth? Significant discussion around new business volumes and the ratio of market value to embedded value does this make sense? Component Company A Company B Adjusted New Worth 8, VIF 2, Embedded Value 10,000 10,000 New business volumes VNB Expense Overrun New business capitalisation Appraisal Valuation 11,000 / 14,000 19,000 / 20,000 EV Multiple 1.1 / / June 2015

35 Contact information Philip Jackson FIA FIAI Consulting Actuary Tel +91 (22) Fax +91 (22) Mobile

36 Summary Market Consistent Embedded Value consists of: Net Worth (+) Present value of future profits (-) Frictional costs (-) Time value of Options and Guarantees (-) Cost of Non-hedgeable Risks We can try generate an appraisal value of a company by adding Present value of future new business (-) Present Value of expense overruns 05 June 2015

37 Time Value of Options and Guarantees - TVOG Consider two products as follows Both have a premium of 100 rupees. The premium plus investment income is returned to policyholder after one year and the contract ceases o In Product A, the company charges a 1% fee on the value at the end of the year o In Product B, the also company charges a 1% fee, but guarantees that the amount returned will be at least the invested premium of Rs June 2015

38 Time Value of Options and Guarantees - TVOG One year Investment Return Profit of Product A - Without Guarantee Profit of Product B - With Guarantee 20% 1.20% 1.20% 10% 1.10% 1.10% 5% 1.05% 1.05% 0% 1.00% 0.00% -5% 0.95% -5.00% 05 June 2015

39 Example - TEV If we were to value a traded company, say Microsoft under TEV. We might proceed as follows: Look at our expectations of future dividends given our experience and the current economic environment Discount that future stream of dividends back to the present day using an RDR i.e. how much return we would need in order to accept the risk that the Microsoft dividend stream may not meet our expectations? 05 June 2015

40 Example - MCEV If we were to value Microsoft under MCEV? We would go and look up the share price Under MCEV, we break up our Life Insurance contracts into pieces that look like traded instruments in the capital markets, and then value them in line with those instruments 05 June 2015

41 Back to Product A and B One year Investment Return Profit of Product A - Without Guarantee Profit of Product B - With Guarantee 20% 1.20% 1.20% 10% 1.10% 1.10% 5% 1.05% 1.05% 0% 1.00% 0.00% -5% 0.95% -5.00% 05 June 2015

42 Example - MCEV In our Product A example assume we invested the premiums into equities. We would value the MCEV of the product in line with the value of equities (there are theoretical approaches as to how to achieve this) In the Product B example. The pay-off to the Life Insurer is more like selling an equity put option, since we have a sharp fall profits once we cross the threshold (i.e. strike price). We would value the MCEV of the product using the market value of equity options (in fact, the TVOG would represent the cost of this feature) 05 June 2015

43 The TEV/EEV/MCEV journey How did we get here? Why MCEV? Increase in transparency for investors Traditional Embedded Value (TEV) ABI Guidance 2001 Achieved Profits Method European Embedded Value (EEV) Introduced in May 2004 by the CFO Forum Market consistent Embedded Value (MCEV) Introduced in June 2008 by the CFO Forum(*) Improve consistency of information reported A shareholder s perspective on value A market consistent approach to financial risk MCEV Principles copyright Stichting CFO Forum Foundation 2008

44 The TEV/EEV/MCEV journey A dominating TEV framework in Asia? Key multinational companies Key Reporting basis TEV EEV TEV India China Hong Kong TEV MCEV TEV / EEV Thailand Philippines MCEV/ IEV(*) US GAAP / TEV Indonesia Singapore EEV / MCEV (*) IEV: Indian Embedded Value

45 Definitions and practices Differences between MCEV and EEV MCEV versus EEV Expected return on assets is risk-free (+illiquidity premium?) Discount profits using reference rate (risk-free) Explicit cost of capital expressed in terms of a charge applied to 99.5% capital Expected return on assets is real-world Cost of capital may be expressed implicitly i.e. discount future profits and the release of capital using a risky discount rate (MC)EEV may look more like MCEV than EEV

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