Market-Consistent Embedded Value (MCEV)

Transcription

1 Market-Consistent Embedded Value (MCEV) SOA Spring Meeting / Session 3 Phoenix, Arizona Hubert Mueller, Principal (860) May 9, Towers Perrin Agenda Recent Trends with European Embedded Value (EEV) Why move to MCEV? Technical Issues 1

2 Recent Trends with European Embedded Value (EEV) RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) In May 2004, the European CFO Forum published the European Embedded Value (EEV) Principles 12 key Principles, 65 areas of Guidance Commentary on Principles & Guidance Describes basis for conclusions Both real-world and market-consistent approaches are acceptable The EEV Principles introduce several major improvements: Codification of several areas of current best practice, including disclosure on methodology and assumptions used Requirement for stochastic evaluation of options and guarantees Suggestion to use company-specific economic capital requirements Disclosure of sensitivities and analysis of movement 2

3 RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) European Embedded Value (EEV) is now published by almost all major insurance groups in Europe Aegon Allianz Aviva AXA CNP Eureko Friends Provident Fortis Generali Hannover Re ING Irish Life Legal and General Mapfre Mediolanum Munich Re Old Mutual Prudential (UK) Scottish Widows Standard Life Swiss Re Zurich RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) Recent developments Life insurance companies have started to publish results under the EEV Principles (since 2004) Equity analysts have criticized the variety of approaches taken CFO Forum has responded to analyst comments by publishing Additional Guidance on EEV Disclosures and updates to the EEV principles (October 2005) 3

4 RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) Updated EEV Principles The main areas of change are around allowing for risk ILLUSTRATIVE 1. What is EEV 2. Business coverage 3. Allowance for risk 4. Free surplus 5. Required capital and cost of capital 6. Value of in-force covered business 7. Financial options and guarantees 8. New business and renewals 9. Assumptions 10. Economic assumptions 11. Participating business 12. Disclosures Key No change Small change, to previous methodology Significant changes to previous methodology RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) Some European-based companies are looking for greater sophistication than the EEV principles offer Issues with EEV principles Difficulty in selecting the appropriate RDR Single, company-wide RDR may give misleading product profitability information Need different RDRs for different products RDRs should vary with investment policy Cost of capital adjustment is too broad Preference to allow for product risk explicitly Need allowance for non-financial risk Calculating the cost of options and guarantees on a real world basis is not usually capital market-consistent In particular, not appropriate when evaluating cost/benefits of hedging 4

5 RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) What is MCEV? Market-Consistent Embedded Value ( MCEV ) is a development of traditional EV techniques which attempts to give a more robust answer to the questions: How should we set the risk discount rate? How should we allow for the cost of financial options and guarantees? How should we allow for the cost of holding capital? Further details on MCEV can be accessed at: RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) Bottom-up MCEV methodology was developed to help answer key questions Risk Discount Rates Options & Guarantees Cost of Capital Reflect risk inherent in individual cash flows and any asset/liability mismatches Valued explicitly, consistent with capital-market prices Reflects frictional costs (e.g., tax), based on overall capital requirements Market Consistent EV = market value of assets market-consistent value of liabilities frictional cost of capital 5

6 RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) Most major insurance groups are adopting MCEV as their main internal performance measure Insurance cash flows are valued by reference to equivalent traded capital market instruments Options are valued using option pricing techniques High-risk assets are discounted at higher RDRs Complex options depending on policyholder behavior are valued using stochastic modeling with risk-neutral scenarios, discounted at the risk-free rate Risk-neutral scenarios are validated by replicating to current market prices of options and futures Stochastic valuation of O&G using risk-neutral scenarios RDR varies based on the riskiness of the underlying products Using risk-free rate for some products (e.g. term) RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) In an MCEV framework, selecting assets does not create value Assume that the investor has capital of 20, borrows 80 (at 5% pa) and then invests 100 in equities (with an expected return of 7% pa) Day 1 One year on Assets Liabilities (80) (84) Capital The discount rate is an output of the valuation, not an input The actions of borrowing and investing do not create value on Day 1 Using traditional EV techniques the 23 might be discounted at, say, 8%. This would give a value of 21.3 on Day 1 Under MCEV the asset cash flows are discounted at 7% and the liability cash flows at 5%. This would give a value of 20 on Day 1. The effective risk discount rate is 15% 6

7 RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) MCEV in practice For cash flows without any embedded options, in practice MCV means using the certainty equivalent approach All gross earned rates equal the risk discount rate, which equals the gross risk free rate For cash flows with certain easily identifiable embedded options, in practice MCEV means using the certainty equivalent approach plus closed form, Black-Scholes type, option valuation formulae For everything else it typically means Monte Carlo simulation, using a risk neutral or equivalent Economic Scenario Generator (ESG) RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV) In North America, EEV adoption has been slower Traditional EV (TEV) not yet widely accepted in the US Dominance of US GAAP reporting Hartford Life is the only US-based company that has published EV results A growing number of US-based companies use TEV for performance measurement and incentive compensation US subsidiaries of European multinationals calculate and publish EEV results TEV reporting is more widely accepted in Canada Sun Life, Manulife and Industrial Alliance annually publish TEV Quarterly source of earnings analysis has replaced EV in importance Market consistent techniques are increasingly used in the US to model impact of hedging or to price embedded guarantees on a market-consistent basis Provides consistency between pricing and valuation AXA (US), Allianz Life, Munich Re and Old Mutual have published on MCEV basis for year-end

8 Why Move to MCEV? WHY MOVE TO MCEV? Why more multinationals are moving to MCEV this year Credibility with financial analysts (mostly Europe) Consistency with their peers Internal financial management Theoretical strength Increased use in pricing/risk management Link to Economic Capital a a a a a a 8

9 WHY MOVE TO MCEV? What does the market want from EEV? Hopes for EEV Disclosure Cash flows discounted at a rate commensurate with the risk profile Investment profits on contracts not booked until earned Options and guarantees would capture the actual cost of hedging potential risks to the balance sheet Consistent application of the rules to allow effective comparisons between companies Hopes for Cash Disclosure What is the cash (and free capital) emerging on the in-force How much is needed to finance new business for what return How much is residually available for dividends Source: Andrew Crean, Infoline EEV Conference, 9 November 2005 WHY MOVE TO MCEV? To date, EEV has not yet fully met these hopes EEV allowance for risk Top-down approach Bottom-up approach Unadjusted WACC Adjusted WACC Product-specific beta Stochastic real world Indirect MCEV Direct MCEV 9

10 WHY MOVE TO MCEV? Recent EEV disclosures have favored the marketconsistent approach CFO Forum Companies Non-CFO Forum Companies Total Other Top-down Other Other Top-down 3 9 Top-down Bottom-up market-consistent Bottom-up market-consistent Bottom-up market-consistent Source: Tillinghast Research WHY MOVE TO MCEV? By adopting MCEV for year-end 2006, Allianz became the first company to change EEV methodology after first-time adoption 10

11 Technical Issues TECHNICAL ISSUES There are a wide range of approaches to diversifiable risk Increased granularity Top-down WACC Addition to RDR Addition to CoC Granular risk allowance AEGON Prudential Allianz Friends Provident AVIVA Standard Life Fortis Scottish Widows ING Swiss Re Munich Re Zurich Market-consistent techniques increase the granularity of the allowance for market risk. We are seeing the same trend in non-market risk. The trend towards granularity is broader than EEV reporting Pricing Risk & capital management ICA (UK) / PBA (US) / Solvency II (Europe) 11

12 TECHNICAL ISSUES The rationale regarding the MCEV allowance for non-market risk has varied by company Number of Companies Allowance via best estimates and frictional costs (i.e. no addition) 4 Additional allowance and rationale provided 10 Additional allowance but no rationale provided 8 Source: Tillinghast Research (March 2007) TECHNICAL ISSUES The debate over the choice of risk-free rate continues UK-based Companies Non-UK Companies Total Based on government bonds Based on swaps Not disclosed Source: Tillinghast Research (March 2007) 12

13 TECHNICAL ISSUES In the US, credit risk modeling can get tricky Investment returns over time and their split between the stakeholders Credit spread shareholder Level of risk-free returns policyholder Is there symmetry in shareholder gains and losses with respect to credit risk? YES NO default We can use the take out credit spread approach Stochastic risk premiums and defaults TECHNICAL ISSUES Other technical issues Generating risk-neutral scenarios Economic scenario generator (ESG) Historical versus implied volatilities No Arbitrage test Impact of management actions Policyholder actions Reflecting dynamic policyholder behavior 13

14 TECHNICAL ISSUES So where have we got to with EEV/MCEV? Improvements Clearly linking allowance for risk and business valued Understanding impact of risk on value Improved disclosures Focus on managing the business EEV / MCEV Challenges Different methodologies Different applications of the methodology Different views of impact of risk on value Different levels of disclosure Has the industry achieved what companies and analysts need? TECHNICAL ISSUES What does this mean for North America? Multinationals are setting the bar for EEV/MCEV reporting Domestic players are gradually coming around, driven by advances in risk and capital management Canadian companies have introduced some changes since they first published EV in 2000 Quarterly reporting of VNB Quarterly Source of Earnings disclosure Move to IFRS should further accelerate development of MCEV in North America Provides fair value of liabilities IFRS #8 requires disclosure of a business segment s profit/loss and balance sheet on the basis that is used to manage the business more EV disclosures 14

15 Market Consistent Embedded Value Society of Actuaries Life 2007 Spring Meeting Chris Murphy Senior Actuary Phoenix 9 May Agenda 1. ING's approach to MCEV 2. What impact has it had on the company's strategy? 3. Practical issues around resources/modeling systems etc. 1

16 MCEV - Basic principles Management expectations of future financial market developments do not influence market consistent embedded value calculations. This means that investment decisions do not immediately lead to value changes, although the impact will come through in later periods in line with actual experience. Market consistent approaches uniquely determine the right discount rate to be used for financial risks, implying that equities, bonds, options and guarantees are priced in a manner consistent with their pricing in the financial markets; Insurance risks are priced using a proxy for how an external market would price them (expected losses and the cost of economic capital) Separates the valuation of assets and liabilities, which allows management to manage the business in a more informed manner The Market Value balance sheet is a key component of the market consistent framework Market Value Balance Sheet MVA MVL EC Free Assets MV Surplus = MCEV Market Value Surplus (MVS) is the difference between the Market Value of Assets (MVA) and Market Value of Liabilities (MVL). Market Value of Liabilities is the value at which the liabilities could be transferred to a willing, rational, diversified counterparty in an arms length transaction under normal business conditions. ING internally defines Market Consistent Embedded Value (MCEV) as being equal to the Market Value Surplus 2

17 Market Value Balance Sheet - stylized example Assets Year T Liabilities Year T Investments Market Value Insurance liabilities Real property and office buildings - Financial Component Liabilities (FCL) Participating interest 8 - Non-linked life insurance 2,982 Shares Unit-linked life insurance 3,525 Cash 390 Total Financial Component Liabilities 6,507 Fixed interest securities 3,819 MVM 291 Total investments 4,528 Total Market Value Insurance liabilities 6,798 MVL Investments for risk of policyholders 4,036 Deferred tax liabilities 280 Other assets 139 Other liabilities 405 7,483 MVA Market Value Surplus Tied surplus (EC) 667 Free surplus 553 Total market value surplus 1,220 MCEV Total market value assets 8,703 Total market value liabilities 8,703 Market Value Liabilities can be calculated by decomposing into parts Decomposition of liabilities MVL Financial Component of Liability MV Hedgeable Financial Risks MV Non-hedgeable Financial Risks Non-financial Component = MV Hedgeable Insurance Risks* MV Non-hedgeable Insurance Risks Examples 10 year USD, EUR, Yen cash flow or interest rate option 10 year equity option Rational lapse behaviour 60 year USD, EUR, Yen cash flow or interest rate option 15 yr emerging markets cash flow Irrational lapse behaviour Screen or Most insurance exchange traded risks, e.g. mortality, CAT risks property, casualty, Actively traded etc. securitized risks Valuation approach Mark-to-market based on market valuation rates (e.g. discount rates, volatilities, etc.) Mark-to-model based on extended market valuation rates (e.g. discount rates, volatilities, etc.) Mark to market approaches consistent with capital markets valuation Mark to model approach based on cost of capital, not confidence intervals * Defined by two-way, liquidly traded volume. Few markets for insurance risks exist today but may be developed in the future. 3

18 Risk neutral valuation Risk neutral valuation is stochastic valuation approach that allows us to value cost of embedded options of liability portfolios Risk neutral valuation is generally used in pricing of derivative securities, and therefore can be used to calculate the market value of liabilities assuming a full portfolio hedge The calibration of the risk-neutral valuation model is done to ensure that such a model would re-produce observed market prices for traded instruments; by extension it should fairly value the more complex options and guarantees embedded within the products Risk neutral valuation is only one of various forms of capital markets valuation tools e.g. state price deflators, analytical formulas Economic Capital is calculated to protect the market value surplus (MCEV) over a 1 year time horizon Probability Worst Case Value Economic Capital 99.95% Value Expected Value Economic Capital is calculated as the difference between expected Market Value Surplus in 1 year s time and the 1 in 2000 worst case outcome In practice, economic capital is calculated separately for each risk type separately Calculations take into account all financial options in assets and liabilities as well as company and policyholder behaviour 4

19 Under a market consistent framework, increases in value are measured as increases in market value of surplus Market Value Balance Sheet at Beginning of Period Market Value Balance Sheet at End of Period MVA = 1000 MVL = 900 EC = 50 Free Assets = 50 MCEV = 100 MVA = 1100 MVL = 950 EC = 50 Free Assets = 100 MCEV = 150 In this example, the MCEV has increased by 50, so value created over the period = 50. MCEVPROFIT = Change in MCEV less Cost of Capital Value creation comes from the usual sources (eg profitable new business, expense management, favorable investment markets), but is entirely measured using market value principles. MCEV source of earnings analysis is a powerful tool for understanding the performance of the business MCEVNB If the market consistent value of new business is positive, then this directly leads to an increase in MCEV. Underwriting profit As with traditional Embedded value, better than expected mortality and lapse experience leads to increases in value. Investment profit Equity and credit risk premiums are only reflected once they have been earned. In the calculation of MVL, a risk free earning rate is assumed. Risk Margins Profits from taking on non-market risks (eg policyholder behaviour) are released over time as the risk is reduced. Total Return on Assets backing MCEV The market value of surplus will change directly with the total return of the assets backing EC and Free Assets Cost of Capital Economic profit is generated if the total increase in MCEV exceeds cost of capital 5

20 Understanding the market value balance sheet is good preparation for the implementation of IFRS Phase II IFRS Phase II is widely expected to be market value based reporting. CRO and CFO forums in Europe are advocating IFRS II calculation of the market value of liabilities similar to the approach taken in this presentation. Full market value reporting would mean that changes in the market value balance sheet will go through the Profit & Loss statement. This is the approach that ING has taken with its implementation of MCEV. Market Consistent Embedded Value at issue - MCEV(0) MCEV (0) represents new business value assuming complete hedging of ALM risk and without accounting for future expected asset spread arbitrage including cost of non-market risk capital Market value of assets and liabilities includes capital markets valuation of options and guarantees Credit spreads and equity risk premiums are only recognized when earned Cost of EC for non-hedgeable risks included 6

21 MCEV (0) can be interpreted as the cost of raising funds that can then be invested MCEV (0) can be viewed as the value of this alternative relative to other sources of raising funds, eg debt MCEV (0) is positive MCEV (0) is negative Company has generated funds at less than the cost of funding Created shareholder value Company has generated funds at more than the cost of funding Destroyed shareholder value MVL methodology applied to new business provides pricing discipline and key source of change in MVS Traditional Value of New Business/IRR Gives an indication of future potential GAAP/STAT earnings. Based on best estimate future investment yields, equity premia, credit spreads. Does not value financial assets and liability cash flows, options and guarantees consistently with financial markets. Market Consistent Value of New Business Gives an indication of theoretical mark-to-market value. Based on current market rates, volatilities, etc., using capital markets pricing techniques. Values assets and liability cash flows, options & guarantees consistently with financial markets. MVL is independent of the asset or hedging strategy and reflects current market price to fully hedge risks If the MVL is less than the initial premium, implies that the product relies on assumed investment risk premia (equity risk premium, credit spreads) for profitability 7

22 Market consistent pricing is providing more insight into the profitability of products globally Market consistent pricing implemented globally for new products beginning 2006 Integrated into strategic planning targets for Nearly all products contribute value on a market consistent basis Products with negative market consistent price tend to be: Found in highly competitive markets Strongly reliant on investment returns for earnings, e.g. credit spreads/equity premia Products with negative value on an MC basis can be improved by: Product repricing Adjusting product features There is no single right answer - Often there is a tradeoff between value creation and earnings potential Key planning questions Resource availability How many risk professionals are there currently in the organisation? What other responsibilities do they have? How time consuming are the other responsibilities? What on-going projects are there? When do you expect the crunch times to be? Possibility of getting external resources? Possible relocation of internal resources for MC pricing? MC pricing capabilities Are there currently resources with MC pricing capabilities? How many resources do you expect to require to train? What is the best approach to training e.g. specific groups, all at one time, temporary relocation of personnel etc? Product prioritisation How many products do you aim to model? What new products are you expecting to sell that will require MC pricing? What are your main products e.g. in terms of volume, profitability? Can they be applicable to a large portfolio? Are there differing MC pricing capabilities in resources for different products? Infrastructure considerations What is the current feasibility of infrastructure adjustments e.g. adjust models internally, develop new models, construct an external MC pricing add-on? What is the man power requirement for each? Cost of implementation of each? How easy/difficult would it be to implement practically? Are you considering any updates to your current infrastructure? If so, is it applicable to MC pricing? 8

23 Analyst Opinion of MCEV Part 1 There is no clear consensus at any level, with a wide diversity of views ranging from very positive to very negative. There is general consensus that MCEV is a good management tool and should be used by companies, but a high proportion have doubts whether it is useful to analysts and fund managers. Many believe that MCEV is actually too complicated for the market and is therefore not going to be used by increasingly sceptical analysts who will revert to IFRS earnings. Many consider that MCEV is not understood and is confusing the market Analyst Opinion of MCEV Part 2 There are also many who see MCEV as less useful than traditional EV and would prefer to stay with EEV MCEV is more of a black box, analysts are suspicious that companies are fixing their assumptions with traditional EV they can make their own adjustments Most understand that MCEV disadvantages certain products especially spread products - they are suspicious that this has driven companies without spread business to be early adopters Some are concerned about reconciling EEV with MCEV and have asked for full disclosure of both sets of data. There is a general feeling of inevitability in that most analysts expect all companies to move to MCEV reporting. 9