Measuring True Profits using Embedded Value

Transcription

1 Measuring True Profits using Embedded Value by Peter Luk Plan-B Consulting Ltd. May

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3 Measuring True Profits using Embedded Value A. Introduction The reported profit of a company seldom gives the true indication of its value. The widely used US GAAP has been severely criticized over the decades, particularly for the artificiality of its DAC (deferred acquisition cost). The IASB (International Accounting Standards Board) has been trying hard to come up with a better, universally accepted (i.e., by all countries) accounting standard. Due to all the kinds of honest difference of opinion as well as political bickering, it appears that this is at least anywhere between three to five years away. Meanwhile, the use of embedded value has gained increasing acceptance. Even in the US, as recent as five years ago, not many people have heard of the term embedded value. Today, almost all major companies calculate their EV, although not all of them publish such information. While EV (embedded value) and AV (appraisal value) have become such important a subject, there is little actuarial literature on it. It is hoped that what is described here can fill this gap to some extent. B. The anatomy of the value of a company If somebody asks the question How to value a life insurance company, the simple answer given here is: It equals three companies plus a painting. What is that? It means that an insurance company can be considered as a holding company with three subsidiaries: a service company, a sales company and an investment company, plus a painting. The method described below is for the valuation of a life insurance company, but the principles are actually mostly applicable to any kind of company, not just an insurance company. 1) Service company This company makes money by providing services for the existing clients. The company needs certain capital to keep it working, but it will not keep more than enough. Any excess will be paid back to the holding company as dividends. Obviously, the value of this company equals the present value of those dividends minus the initial required capital. The present value is arrived at by discounting the dividends at the rate of i, commonly called the hurdle rate. Alternatively, i is described as shareholder s rate of return or cost of capital. As mentioned before, this company needs capital. There are two kinds of capital. Any company will need operating capital, for equipment, machinery, space, logistic support, etc. For banks and insurance companies, due to their fiduciary - 3 -

4 duty to the general public, there is another kind of capital, risk capital, mandated by regulations (often called solvency margin or risk-based capital in the case of insurance companies). It is like a cushion there to ensure that such financial institutions will not fail under unfavorable economic conditions. In most cases (though not always), the risk capital exceeds the operating capital. If there is no regulatory restriction how such risk capital can be invested, the operating capital can make up part of the risk capital. Under such circumstances, de facto, the company only needs to have the risk capital. If part of the operation is outsourced to an outside company, this outside company will have to have its own operating capital, which will not be covered by the banks or insurance companies risk capital. For an insurance company, particularly a life insurance company, the maintenance of inforce policies is akin to the function of a service company and the value of the inforce policies is akin to the value of a service company. The value of an inforce policy is calculated as follows. Make a year-to-year projection of the company s accounts using realistic (best-estimate) assumptions about the future including investment return (j), mortality and morbidity, lapse and surrender, acquisition and maintenance expenses, both variable and fixed, taxes, etc. Reserve for policy liabilities is calculated using statutory basis (often more conservative ones). Solvency margin is also calculated in accordance with regulatory requirements. This projection will produce for each year a distributable earning, the amount that is not required to be kept by the service company for its operation. It is assumed that these distributable earnings are transferred to the investment company (see (3) below) for investment. Prudential actuarial practice requires that the distributable earnings be positive for every year in the projection. A negative number for a particular year would imply the need for capital injection for that year. If the company has no money to inject, the policyholders will not get paid. The fiduciary nature of the business does not allow this to happen. The only time a loss is allowed to be incurred is at the policy inception, i.e., at the time new business is generated. Such losses are termed new business strain. The new business strain, an accounting loss, may be considered as investments of the company to acquire new business. If a company cannot afford the new business strain, it should stop writing new business. It should be noted that j and i are quite different. j refers to the return of the portfolio of assets (consisting of bonds, equities, etc.) of the company, currently at around 5% p.a. for many companies. On the other hand, i refers to the shareholders expected rate of return. Since a business operation involves significantly higher risk than portfolio investments, i is usually much higher. A rate of i between 10% and 15% is not uncommon. 2) Sales company The sales company does nothing but generating new business. As soon as the new business is generated, it is sold to the service company for a fee, which is the equivalent of the present value of all the future profits the service company - 4 -

5 expects to make on this block of business, minus the required risk and/or operating capital. In other words, the service company makes no profit out of it. The sales company builds a model that estimates sales volume it can make in the coming year (the base year) by reference to the past data. This is a static calculation. It simply extrapolates the past into the future. It does not take into account the dynamics of the general economic and sociopolitical environment, an area that is reserved for the visionary. Thus, the sales company can expect certain profit for the base year. The sales company then projects the expected profit for each year thereafter by assuming certain growth rates (that can vary from year to year). The period of projection typically varies from 5 years to 30 years, depending on personal preference. Such profits are then discounted back to the present at a rate of k, which is usually larger than i to compensate for the extra risk of uncertainty that the projected sales growth may or may not materialize. It is quite often to see k = i + 5% though nobody knows the rationale behind that. There are limited attempts to incorporate increasing competitiveness of the business into the model. Two commonly seen methods are (a) the use of a declining scale of growth rates over a period of, say, 10 years, which then remain flat thereafter and (b) the use of a so-called margin squeeze whereby profit margin is assumed to decline by say, 0.5% p.a. over a period of time. The value of this sales company is the present value so arrived at in the preceding paragraph less the operating capital required. When the sales company is part of the insurance company, the service company can lend it part of their surplus capital (i.e., the excess of its risk capital over its operating capital) effectively make the sales company a zero-capital company. This would not be true if the sales function is outsourced to an outsider broker or general agency company, both of whom will have to put up their own operating capital, which will be a charge to the value of the company. 3) Investment company When one hears about Microsoft sitting on billions of dollars of cash, possibly investing in risk-free Treasury bonds earning minimum return, one cannot help wondering what would happen if the money is distributed to their shareholders. Would the stock price be affected? The rational answer is a simple no, since the pile of cash is not affecting Microsoft s earnings. By the same token, the excess capital (i.e., the net worth less the solvency margin), which is sometimes referred to as free surplus, will be kept by the investment company investing in marketable securities. The value of the investment company is the total market value of those securities, there being no discounting of future income cash flow. The analogy described above does not take into account the possible impact on a company s rating if such surplus cash is distributed

6 4) Painting? Why painting? It is used here to represent the psychological part of the investing public. Imagine a Picasso painting costing millions of dollars (his Boy with a Pipe was auctioned on 5 th May 2004 in New York for US$104 million). It generates no cash flow whatsoever, but people are nevertheless willing to pay a hefty price for it. It does not reflect its economic value. Rather, it reflects its emotional or psychological value at a particular moment. Each painting is unique and its value changes from time to time. The stock market ebb and flow reflects the mass psychology of the investing public. The market value of a company can easily go up or down two or three percent in a day s time without the company s fundamentals changing a bit. It defeats any attempt at rational analysis. We call this part of the company s value its painting-value. The interesting thing here, though, is that a company s painting value can be negative. For instance, where a company is in a forced sale situation, either because the company needs cash or because the management makes a strategic decision to quit a market, the painting value can be negative. An often confusing item is goodwill. See the section on Debate for more detail. C. Insurance terminology The combined value of the service company and the investment company is called embedded value (EV) in insurance jargon. Sometimes the value of the inforce policies refers to the value before the solvency margin and sometimes it refers to the value after the solvency margin. This can be confusing. One must determine its true meaning in context. In the above anatomy, the required capital is assumed to be kept by the service company and the investment company keeps the surplus capital. In any event, the following expression should not cause any confusion:- EV = value of inforce + net worth solvency margin = value of inforce + free surplus The combined value of the embedded value and the value of the sales company is called appraisal value (AV). The combined value of the appraisal value and the painting-value is the company s market price. D. An illustrated example of projection It is often helpful to illustrate complex theories by a numerical example. It is hoped that the following example helps one understand what is discussed here

7 Revenue projection and embedded value of one policy *acquisition *maintenance Increase in operating Increase distributable *value of *net solvency free Embedded *increase growth Year *premium*commision expense expense claims* surrender* interest* reserve* profit* in SM* earnings* inforce worth margin* surplus* Value* in EV of EV* 1 1, % % % % % , % , % , % , , , ,285 1, % ====== ======= ======= ======= ====== ======= ====== ======= ====== ====== ======= 0 1,285 ====== ===== ====================== Note 1: In the above table, year-start cash flow is indicated by * preceding the title whereas year-end cash flow is represented by * following the title. Note 2: Investment return = 5% and the accumulation rate = Note 3: Hurdle rate = 15% and the discount rate = Note 4: The increase in reserve and increase in solvency margin are both positive. Because they are outgo items, they are shown as negative in the above table. Note 5: The rollover of inforce value works as follows: starting value of inforce 1.15 profits for the year + increase in solvency margin = year-end value of inforce For example: = 390 (ignoring some rounding error) The same applies to the new busine ss. One just adds an item on the left side of the equation: year-end value of the new business. Note 6: The beginning value of inforce, 323, actually represents the value of a new policy. It is the value at the inception of the policy, before any cash flow happens. At that time, the company has a net worth of 120, which accumulates to = 126. However, it suffers a first-year loss (new business strain) of 82 during the year leaving a net worth of 44, barely enough to cover the required solvency margin of 43. At that time, the new policy actually generates a future value of 496 at the end of the first year (i.e., the same as the beginning of the second year). A similar rollover equation is as follows ( 82) + 43 = 496 Note 7: Interest = (starting reserve + starting SM + cash flow) interest rate. Thus, for year 2: ( ) 5% = 62 Note 8: Year-end net worth = year-start net worth + profit + year-start free surplus interest rate. Thus, for year 6: % =

8 E. Rollover of the inforce value Embedded value calculations can be used to show the realistic operating profits as shown below. Let W = Net Worth (W 0 and W 1 ) i = discount rate used to calculate F = shareholders' expected rate of return = hurdle rate = cost of capital F = value of Inforce (F 0 and F 1 ) (calculated using reserve = statutory; discount rate = i; other assumptions such as mortality, interest rate, lapse, expense, etc. are all based on the realistic ones) SM = solvency margin or required capital (SM 0 and SM 1 ) R = free surplus (R 0 and R 1 ) = W SM EV = embedded value (EV 0 and EV 1 ) = F + W SM = F + R (1) B = year-end value of new business generated during the year j = realistic rate of investment income for the year W 0 + statutory profits = W 1 where statutory profits can be decomposed into 4 elements: P u = unwinding profits (profits from unwinding of F, if actual experiences equal assumed. This includes, as mentioned previously, the interest on solvency margin.) P i = investment income from the free surplus = Rj P e = experience profits (deviation of actual from assumed) S = new business strain (i.e., statutory loss suffered due to the generation of new business). This can be estimated as new business premiums new business commissions and overriding allocated new business administration expenses year-end reserve for the new business claims, etc. (sometimes, an interest element is also built into it). T = True profit of the operation There is no value creation in P u and P i. The former represents the unwinding of the profit embedded in the inforce policies and the latter represents simply the interest income of the net worth. The company incurs losses S for the generation of new business. However, it also creates value B. The value creation of the new business is represented by B S. On the other hand, if P e is positive it represents value creation. If P e is negative, it represents value destruction. Therefore, the true profit T = P e + B S is the best indicator of the strength of the company: - 8 -

9 T = P e + B S (2) = P e + ( B S ) = Experience profits from inforce business + profits from new business In arriving at the inforce value, we go backwards by discounting the future profits at i. It is therefore only natural that in calculating future profits we should roll forward by multiplying the inforce value by (1 + i ). This is, in the actuarial jargon, called unwinding (or rollover) of the inforce value. As shown in the above illustrated example, the unwinding of the profit embedded in the inforce policies is, ignoring new business, simply, F 0 (1 + i) P u + SM = F 1 With the addition of new business it becomes, F 0 (1 + i) + B P u + SM = F 1 (3) Further, we have W 0 + P u + P i + P e S = W 1 (4) SM 0 + SM = SM 1 (5) Combining (3), (4) and (5) together and taking note that EV = F + W SM, P i = Rj and T = P e + B S, EV 0 + F 0 i + B + R 0 j + P e S = EV 1 (6) And the most important item of profit measurement, the true profit T, equals T = EV - F 0 i - R 0 j (7) To paraphrase equation (7) into simple language: the gross value creation is EV. However, since F 0 i is merely the unwinding of the interest discount originally embedded there, it should be excluded. Moreover, the interest earned on the free surplus cannot be considered as value creation either and therefore should be excluded too. If there is any capital injection during the period, that should be excluded too since it is obvious that capital injection is no value creation. If we equate true profits with value creation, then it becomes apparent that formula (7) is universally true purely based on the first principle regardless of the type of business and the structure of the company. Thus, a company many have many different kinds of assets (F 0, R 0, etc.). Some of them (like R 0 here) are to earn market-based interest rates (j), some of them (like F 0 here) are to earn the company s cost of capital (i). The interest so earned cannot be considered as true value creation. If we deduct them from the gross value creation ( EV), what is left is the true value creation, or the true profit (T), which is the only indication of the profitability of the company s operation. Sometimes, the assumptions used to calculate F 0 and those for F 1 are not the same due to change of environment, etc. In such cases, it would be desirable to calculate F 1 first using the same assumptions as F 0 and then calculate separately the effect of assumption changes on F

10 To evaluate a company s true profits, one must go to its statutory statements, not the GAAP statements. Fortunately, in most countries, such information is publicly available. Statutory profits and net worth are always reported. Solvency margin is often (though not always) reported. Embedded value is sometimes reported. Value of inforce is seldom reported. Equation (1) is therefore helpful in helping us arrive at the value of the inforce policies: F = EV + SM W = EV R (1a) i, the discount rate, is sometimes reported along with the embedded value. However, j is not often reported. Even when reported, it is often different from what we want. For instance, investment performance from unit-linked portfolio should be excluded as it does only affects the performance of the policyholders value, not the performance of the company (which is often meant to represent the shareholders value). Very often, there is some information in the published statement wherefrom j can be estimated. One would have expected that T is, at least in most cases, positive, since one would have expected profits to be generated from new business. B and S from equation (2) are often not available in the form of public information, but in-house actuaries should have no problem arriving at some kind of reasonable estimates about them. If T is negative, particularly if it is negative for several years in succession, this should give cause to concern. Either the experience profit is negative or the new business profit is negative. And it can be both. In the former case, it is suggestive of unrealistic assumptions being used in the calculation of F. While it is technically easy to recalculate the numbers using more realistic (in this case more conservative) assumptions, it is however politically quite difficult as the management does not like to see their EV shrink simply because of the say-so of some actuaries. Estimating profits from the new business is quite straightforward too. S is usually positive, meaning losses being incurred in generating new business. Should S be negative in some rare circumstances, it would be indicative of lack of competition. In a free market, this rarely happens as competition would quickly drive the new business profit into the negative region. It is not unusual to find S in the vicinity of 10% to 50% of the new business premiums for regular premium business or zero to 2% in the case of single premium business. On the other hand, B is almost always positive, but it is important that B S be also positive, meaning that it is desirable and profitable to generate new business. In a very mature market, one could find B S close to zero, a strong indication that the market is overdue for consolidation. As actuaries could always use, in theory, aggressive assumptions to make B S positive, it is desirable to look for assumptions used behind B, or at least to check if B and F are calculated using consistent assumptions. Any significant departure is a sign for serious concern

11 F. A Case Example A Company reported the following results: Year 2002: Statutory net worth: 460,000,000 Embedded value: 2,130,000,000 Solvency margin: 226,000,000 Discount rate: 15% p.a. Year 2003: Statutory net worth: 530,000,000 Investment yield: 8.4% p.a. Embedded value: 2,189,000,000 Solvency margin: 260,000,000 Discount rate: 15% p.a. The company made a respectable statutory profit of 70,000,000 for the year, representing an increase of 15.2% of its net worth. Using equation (1a): R 0 = W 0 SM 0 = 460,000, ,000,000 = 234,000,000 F 0 = 2,130,000, ,000,000 = 1,896,000,000 i = 15% j = 8.4% EV = 2,189,000,000 2,130,000,000 = 59,000,000 Therefore, true profit T is, T = 59,000,000 1,896,000, ,000, = (245,000,000) This shows that the company made a staggering loss of 245 million during year

12 G. The Debate There are quite a number of issues where there is no consensus as yet. Discussions of a few of the most important ones are listed below for reference. G1. Determination of the hurdle rate i This will be a relatively easy task if one is acting for the buyer in an M & A transaction. The buyer would specify their expected rate of return. On the other hand, the seller could also specify their own version of the hurdle rate. However, such hurdle rate normally would not exceed what the prevailing market condition would imply, unless there are special circumstances such as (a) when the sale would give the potential buyer the critical mass in a highly competitive market, (b) when the sale would give the potential buyer entry into a market that is not normally easy to obtain, (c) when the sale would give the potential buyer substantial scale of economy, (d) when the sale would give the potential buyer control of the company, etc. The most difficult situation is where the actuary who is performing the EV calculation is acting in an independent capacity such as in the case of an IPO (initial public offering). The hurdle rate in such cases would be equivalent to what the prevailing market would imply. A great deal of judgment could be involved. It is not unusual to see i exceeds the prevailing risk-free rate by 3% to 6% to reflect the appropriate risk premium. Sometimes, the CAPM (capital asset pricing model) would be used to determine the risk premium as: i = risk free rate + β (average rate of return of the market risk free rate) where β can be determined from market data using the regression method. In Asia, β is quite often between 0.7 and 1.0. What is not seen in the usual actuarial literature is that in Asia i is often higher than what one would normally expect. This could be due to one of the following reasons: (a) Asian stock markets are more volatile and a higher premium is expected, (b) a risk premium for currency risk is incorporated where the potential buyer thinks in terms of US dollar, (c) the perception that Asian markets are less mature, less transparent and therefore more risky. By the same token, a Chinese company listed in the U.S. should command a lower valuation (i.e., due to a higher risk premium) than a similar company listed in its domestic stock market. G2. Determination of the rate of return j The rate obtained from the data disclosed by the company is often not appropriate for the purpose here. Different companies have different risk appetite that is often reflected in the investment performance of the company for the period under review. It is much better to estimate j from the market average and leave the variance as part of P e. While moderate deviation could be ascribed to the performance of the investment managers, substantial deviation, whether positive or negative, is often indicative of high risk appetite of the

13 company. Consequently, one should be wary of superior investment results in a company s financial statement. Contrary to what one would think, it is often not a good thing. Another plausible method is to consider j as the current risk free rate for the period and take any excess as the return for the risk taking and therefore represents value creation, whether positive or negative. G3. Dividend discount model or P/E method? The P/E ratio method is probably the most widely used method to value a listed company. This method assumes a certain constant growth of the annual earnings and then discounts the stream of the earnings at the rate of the cost of capital (the hurdle rate) to arrive at the capitalization rate. The target price then simply becomes the product of the capitalization rate and the annual earnings. The dividend discount model (DDM) is essentially the same as the P/E ratio method if one assumes a constant dividend payout ratio. The following illustrates the theoretical method to arrive at the target P/E ratio. Let P = target price of the stock E = annual earnings r = dividend payout ratio D = r x E = annual dividend g = compound annual growth rate i = discount rate (or cost of capital) Then, the following detailed formula can be obtained: r E (1 + g) (1+ i ) r E (1 + g) 2 (1 + i ) r E (1 + g) (1 + i ) 2 3 P = (8) Further, the previous formula can be reduced to a simple one as follows: P E r (1 + g ) = (9) i - g For instance, if we assume a constant dividend payout ratio of 0.65, a compound earnings growth rate of 8% p.a. and a discount rate of 12% p.a., the above formula will produce a target P/E ratio of The above DDM model is well documented in the security analysts' bible Graham and Dodd's Security Analysis. It is actually an application of the well-known discount cash-flow (DCF) method to an assumed stream of future earnings, a method that is the basic stock-in-trade of all actuaries and financial analysts. It is now apparent that while the P/E ratio method is an effective and simple method it fails to work in circumstances where the current earnings are negative. While the future earnings can still be positive and the DCF method is still applicable, the P/E ratio method fails because it

14 uses the simplified formula (9) as shown above instead of the detailed formula (8). In so far as this valuation method actually incorporates the values of the service company and the sales company, it also fails to take into account the value of the investment company, as illustrated above in the case of Microsoft s huge cash surplus. An astute observer will notice that the above method is very sensitive to the earnings growth rate and where g is large relative to i, the P/E ratio can be so large (or even negative) that it can become meaningless. This is what happened to internet stocks a few years ago. In reality, the prevailing P/E ratio is often the result of a mixture of mathematics as shown above and investors' sentiment and preference at a particular moment. In other words, the paintingvalue plays a big role here. G4. Appraisal value or embedded value? As mentioned above, the combined value of the service company and the investment company is called embedded value (EV), and the combined value of the sales company and the embedded value is called appraisal value (AV). In theory, the appraisal value of a company is the best proxy of the true value of a company (barring the impossible task of evaluating its painting value). A good example is a 3-year comparison of the share prices of AXA China (listed in Hong Kong before it became privatized) versus its appraisal values. 1.6 AXA China - ratio of share price over appraisal value /96 8/96 9/96 11/96 12/96 1/97 3/97 4/97 5/97 7/97 8/97 10/97 11/97 12/97 2/98 3/98 5/98 6/98 7/98 9/98 10/98 11/98 1/99 2/99 4/99 5/99 6/99 8/99 9/99 11/99 In recent years, however, there has been a noticeable trend away from the use of appraisal value in favor of the use of embedded value. This is because the growth rate of a company is (a) not a constant as suggested in formulas (8) and (9) it fluctuates from year to year and

15 (b) it is extremely difficult, practically impossible, to determine the future growth rates of a company with any reasonable degree of confidence. The most popular method of valuation in recent years is to first calculate the embedded value of a company and then apply a multiplier reflecting its growth potential as well as its painting value. In a matured market, such a multiplier often varies between 0.8 to 3.0 (see chart on the next page). In a fast developing market, a much higher multiplier is not unusual. Another popular method, widely used in Asia, is to apply the multiplier only to the value of one-year s new business as mentioned in section B above. In such cases, the multiplier can easily be in the order of double digits. A good example is China Life s dual listing in New York and Hong Kong, the largest IPO in the world in The listing document gave the embedded value at a discount rate of 12.5% as HK$2.22 per share (the listing document actually published embedded values for three discount rates: 10%, 12.5% and 15%). It also gave the value of one year s new business, also at 12.5% p.a., as HK$0.158 per share. At the IPO price of HK$3.59, it meant a multiplier of 8.7. At its peak price of HK$7 a few weeks later, the multiplier worked out to around 30. G5. What assumptions? The mathematical analysis of the actuarial science is fairly straightforward. With the advent of the modern-day computers, the mathematical genius of actuaries is no longer needed. The most difficult part of an actuary s job is probably the determination of appropriate assumptions. Arguably, this is one of the areas where actuaries are susceptible to criticism. But strangely, this is also one of the areas where the profession has spent less than adequate effort in training new actuaries. Actuaries are supposed to think independently and professionally. Therefore, prescribed assumptions, apart from the regulatory context, are not considered desirable or appropriate. However, it is not infrequent to see pricing actuaries, under the pretext of independent thinking, use aggressive assumptions in order to make their products more saleable, only to find them unprofitable years later. This is acceptable if, and only if the management is fully aware of the circumstance and wants to use certain products as loss leaders to capture market share. This is not acceptable if the management is not aware of the implication of such actions on its capital adequacy. How can one then tell what the right assumptions are? In reality, there is no such thing as the right assumptions, as no one has the crystal ball to see the future. There are only varying degrees of acceptability. For instance, for a whole life insurance policy, an assumed long term interest rate of 4% to 6% may be considered acceptable with varying degrees of conservativeness, whereas an assumption of 2% p.a. might be considered too conservative and an assumption of 9% p.a. would be considered overly aggressive

16 U.K. Companies Comparison Chart (Market Price / embedded value (%) ) St. James Place Capital CGU plc Prudential plc Legal & General 10/00' 08/00' 06/00' 04/00' 02/00' 12/99' 10/99' 08/99' 06/99' 04/99' 02/99' 12/98' 10/98' 08/98' 06/98' 04/98' 02/98' 12/97' 10/97' 08/97' 06/97' 04/97' 02/97' 12/96' 10/96' 08/96' 06/96' 04/96' 02/96' 12/95' Norwich Union plc Legal & General CGU plc Norwich Union plc Prudential plc St. James Place Capital

17 The best way to determine the appropriateness of the assumptions in the calculation of a company s EV is by full disclosure. By full disclosure it is meant that such disclosure would enable another actuary to arrive at, approximately, a new EV if this actuary wishes to change certain assumptions. A compromise, though less satisfying, is to publish the results of certain sensitivity tests or alternative scenarios. The disclosure of certain key assumptions such as discount rate, investment return, mortality tables used, unit expenses, etc. would enable the users to determine whether the assumptions are on the whole leaning towards the conservative side or the aggressive side. There may be outcry against this proposal on the ground of confidentiality. The fact is that history has taught us many lessons. In the face of inadequate disclosure, there is a tendency on the part of potential investors to assume the worst. One might recall that there was a huge outcry several decades ago when banks were asked to disclose their hidden reserve. The end results are such that no banks have been hurt by the fact that they were forced to disclose their hidden reserve. In fact, that led to a more transparent banking industry and more public confidence in it. G6. What is goodwill? An often confusing item is goodwill. This term is often loosely applied to anything that is intangible. But in most cases goodwill is not painting value. This is the case where the existence of goodwill is based on the expectation of future economic benefits. For example, when a company acquires another company for a substantial premium resulting in a huge amount of goodwill on its balance sheet. Such goodwill is assumed to reflect the present value of future benefits and is required by most accounting rules to be amortized against future earnings. In such cases, the goodwill should not be treated as painting-value. If it is regarded as part of the inforce value, then when we try to measure the true profit or value creation by using formula (7) of section E, F 0 in that formula should include the amount of this goodwill

18 References GAAP Stock Life Companies 1974, by Ernst and Ernst US GAAP for life insurers 2000, by Society of Actuaries Actuarial Appraisals Theory and Practice August 1995, by Henry Essert, Canadian Institute of Actuaries International Measure of Profit for Life Assurance Companies 1999, by P.J.L. O Keeffe and A.C. Sharp, Volume 5, Part II, No. 22 of British Actuarial Journal Developing an International Accounting Standard for Life Assurance Business 1999, by D.O. Forfar and N.B. Masters, Volume 5, Part IV, No. 24 of British Actuarial Journal Summary and Comparison of Approaches Used to Measure Life Office Values October 2001, by Life Assurance Value Measurement Working Party to The Staple Inn Actuarial Society Use of Embedded Values at United States and European Insurance Companies October 2001, by Milliman USA The Value of a Listed Life Insurance Company and How it May be Affected by Different Accounting Rules August 2002, by Peter Luk to Society of Actuaries of China at Lijiang An Overview of Embedded Value November 2003, by Hubert Mueller, Issue No. 55, The Financial Reporter, Society of Actuaries