Agenda

Traditional Embedded Value (TEV)

Embedded Value Calculation for Life Insurers
European Embedded Value (EEV)
ICTI 2006
Market Consistent Embedded Value (MCEV)
Marcin Piskorski

Actuarial Software - Prophet

Questions

1 2003 Deloitte & Touche LLP 2 2005 Deloitte Advisory Sp. z o.o.

A QUICK SUMMARY OF THE EMBEDDED VALUE CONCEPT

2 3

COMPONENTS OF THE
EMBEDDED VALUE
1
Traditional Embedded Value Adjusted Net Asset
Value

NPV of Future Profits

from the existing
business
Adjusted NPV of Cost of Embedded
Net Future Capital Value Cost of Capital
Asset Profits (CoC) (EmbV) (PV of capital
Value (NPVFP)
charges)
(ANAV)

3 2005 Deloitte Advisory Sp. z o.o. 4 2005 Deloitte Advisory Sp. z o.o.

ADJUSTED NET ASSET VALUE NET PRESENT VALUE OF FUTURE PROFITS

1 2

BALANCE SHEET P&L inforce business (local statutory)

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 ...
+ Premium
+ Interest income
Actuarial Benefits
Book reserves Increase act.reserves
value Alloc. to participation
(local Tax
statutory)
Net profit xxxx xxxx xxxx xxxx xxxx xxxx xxxx
Statutory Statutory
equity equity

Hidden
Expected
Undis-
actuarial closed future net
Hidden Hidden
reserves* reserves*
reserves surplus profits
Discounting at
Assets Liabilities Adjusted Share of Tax Adjusted risk discount
Asset hidden Net rate
Value reserves Asset NPVFP
NPVFP
* In bonds, stocks and real estate Value
allocated
(ANAV)
5 to NPVFP 2005 Deloitte Advisory Sp. z o.o. 6 2005 Deloitte Advisory Sp. z o.o.

1
 COST OF CAPITAL 3
Policyholders
Required part
capital for Shareholders
part
inforce
business ...
(EU solvency
margin) Year Year Year Year ... Year
1 2 3 4 n
((Earned
Earned rate
rate risk
Shareholders
Shareholders part
risk discount
part of
discount rate)
of required
rate) xx
required capital
capital
Capital charge
European Embedded Value
Capital
...
charges

Discounting at
risk discount rate
Cost
Cost of
of ...
Capital
Capital

7 2005 Deloitte Advisory Sp. z o.o. 8 2005 Deloitte Advisory Sp. z o.o.

CFO Forum

Membership made up 19 of the large AEGON

European multi-national insurance Allianz
groups Aviva
AXA
Chaired by Chris Sewell of Aviva Fortis
Generali
Hannover Re
Moderated by PwC
ING
Legal & General
No consultants allowed in the group Munich Re
Condition of membership was adherence Old Mutual
to a confidentiality code prior to
Prudential
publication date
Scottish Widows
Skandia
Standard Life
Swiss Life
Swiss Re
Winterthur
ZFS

9
WWW.CFOFORUM.NL 2005 Deloitte Advisory Sp. z o.o. 10 2005 Deloitte Advisory Sp. z o.o.

CFO Forum
THE EUROPEAN EMBEDDED VALUE CONCEPT

Goals of the group

COMPONENTS OF THE
2 3 EUROPEAN
To develop guidance on the presentation of an embedded value as EMBEDDED VALUE
supplementary financial information for European insurers 4
Adjusted Net Asset
Value
To address the existing criticisms of Embedded Value
Methodology is credible, robust and capable of being consistent across NPV of Future Profits
geographies / companies 1 from the existing
The cost of financial options and guarantees are catered for explicitly business
There is sufficient disclosure with sensitivity analysis
Cost of Capital
Adjusted NPV of Cost of Explicit European (PV of capital
To ensure that the methodology reflects the economic value of long charges)
Net Future Capital Value of Embedded
term insurance business
Asset Profits (CoC) Gtees Value
Value (NPVFP) and Explicit Time value of
(EEV)
(ANAV) Options Gtees and Options
(VoG)
11 2005 Deloitte Advisory Sp. z o.o. 12 2005 Deloitte Advisory Sp. z o.o.

2
What are the key challenges Time value of options and guarantees

How do we calculate the fourth component the time value of options The benefits written in participating life insurance business have an option-like
and guarantees? pay off profile
They have a floor (the guarantees provided)
They have an upside (future bonus decisions)
How do we set an economic basis that is consistent throughout the
calculations? So it is appropriate to use option based techniques to value these contracts

How do set the risk discount rate now that we have explicitly allowed If they were simple pay off structures we could use a technique like Black
for a large portion of the risk? Scholes to achieve this

Unfortunately they are not and we are pushed in the direction of more
How do we present the result?
sophisticated techniques like stochastic valuation

Using a stochastic valuation technique we can calculate a value for the options
and guarantees (time and intrinsic value) of the business written

13 2005 Deloitte Advisory Sp. z o.o. 14 2005 Deloitte Advisory Sp. z o.o.

This doesnt look like an Embedded Value

The Operational Steps for Implementing the EEVP

We havent cut it into its four component parts

3 2 4 5
1 6 Have we taken care of all of the risks, in particular the non financial
risks?

Step 1: Step 3: Step 2: Step 4: Step 5: Step 6:

EV based on = (2) (1) EV based on = (2) = (5) (4) Traditionally = (3) = (5) (3)
market con- Time value of pure risk free Traditionally Reduction calculated Time value of EEVP
sistent valua- financial op- roll up. calculated due to use of EV, financial op- conform EV.
tion of finan- tions and EV, in-creased but with an tions and
cial options gua- but with an risk discount risk discount gua-
and guaran- rantees. risk discount rate. rantees.
tees. rate greater
than risk free
that reprodu-
ces the value
of Step 2.

15 2005 Deloitte Advisory Sp. z o.o. 16 2005 Deloitte Advisory Sp. z o.o.

Intrinsic and time value of options

Operational Steps for Implementing the EEVP

The intrinsic value of an option is based upon the risk free yield curve

3 2 4 5
In our first calculation we have time and intrinsic combined 1 6

Step 1: Step 3: Step 2: Step 4: Step 5: Step 6:

EV based on = (2) (1) EV based on = (2) = (5) (4) Traditionally = (3) = (5) (3)
market con- Time value of pure risk free Traditionally Reduction calculated Time value of EEVP
sistent valua- financial op- roll up and calculated due to use of EV, financial op- conform EV.
tion of finan- tions and discounting EV, in-creased tions and
cial options gua- but with an risk discount gua-
and guaran- rantees. risk discount rate. rantees.
tees. rate greater
than risk free
that reprodu-
ces the value
of Step 2.

17 2005 Deloitte Advisory Sp. z o.o. 18 2005 Deloitte Advisory Sp. z o.o.

3
One of the four pieces
Operational Steps for Implementing the EEVP

Now we have the time value of the options and guarantees, we just do
our traditional EV and we are finished?
3 2 4 5
1 6
Yes, but.

We must choose a basis that is consistent

Investment return roll up Step 1: Step 3: Step 2: Step 4: Step 5: Step 6:
EV based on = (2) (1) EV based on = (2) = (5) (4) Traditionally = (3) = (5) (3)
Risk discount rate market con- Time value of pure risk free Traditionally Reduction calculated Time value of EEVP
sistent valua- financial op- roll up and calculated due to use of EV, financial op- conform EV.
tion of finan- tions and discounting EV, in-creased tions and
cial options gua- but with an risk discount gua-
So lets set the investment return assumption as we have always done and guaran- rantees. risk discount rate. rantees.
tees. rate greater
Based on asset mix than risk free
Yields on different asset classes that reprodu-
ces the value
Risk premiums for some assets classes (eg equities) of Step 2.
Incorporate the run off of UNRCG from bonds

19 2005 Deloitte Advisory Sp. z o.o. 20 2005 Deloitte Advisory Sp. z o.o.

What about the Risk discount rate

Operational Steps for Implementing the EEVP

I have goal seeked to get a risk discount rate for my embedded value
basis
3 2 4 5
1 6
Does it capture all of the risks that I want?

No, what about non financial risks?

Step 1: Step 3: Step 2: Step 4: Step 5: Step 6:
EV based on = (2) (1) EV based on = (2) = (5) (4) Traditionally = (3) = (5) (3)
market con- Time value of pure risk free Traditionally Reduction calculated Time value of EEVP
sistent valua- financial op- roll up. calculated due to use of EV, financial op- conform EV.
tion of finan- tions and EV, increased risk but with an tions and
cial options gua- but with an discount rate. risk discount gua-
and guaran- rantees. risk discount rate greater rantees.
tees. rate greater the one used
than risk free in Step 4 in
that reprodu- order to incor-
ces the value porate a mar-
of Step 2. gin for other
risks than
those from
financial
options and
21 2005 Deloitte Advisory Sp. z o.o. 22 guarantees. 2005 Deloitte Advisory Sp. z o.o.

Operational Steps for Implementing the EEVP

3 2 4 5
1 6

Step 1: Step 3: Step 2: Step 4: Step 5: Step 6: Market Consistent Embedded Value
EV based on = (2) (1) EV based on = (2) = (5) (4) Traditionally = (3) = (5) (3)
market con- Time value of pure risk free Traditionally Reduction calculated Time value of EEVP
sistent valua- financial op- roll up. calculated due to use of EV, financial op- conform EV.
tion of finan- tions and EV, increased risk but with an tions and
cial options gua- but with an discount rate. risk discount gua-
and guaran- rantees. risk discount rate greater rantees.
tees. rate greater the one used
than risk free in Step 4 in
that reprodu- order to incor-
ces the value porate a mar-
of Step 2. gin for other
risks than
those from
financial
options and
23 guarantees. 2005 Deloitte Advisory Sp. z o.o. 24 2005 Deloitte Advisory Sp. z o.o.

4
Market consistent valuation

All assets are valued at their market value

Discounting cash flows rather than profits

Usually risk-neutral scenarios used

Dynamic calculations (management actions, policyholder behaviour)

Actuarial Software - Prophet

Stochastic calculations (options and guarantees)

25 2005 Deloitte Advisory Sp. z o.o. 26 2005 Deloitte Advisory Sp. z o.o.

iWORKS Prophet iWORKS Prophet

Prophet - Life provides a fast, friendly and flexible solution for At the October 2005 SunGard purchased Prophet system and the life
actuaries involved in life assurance, permanent health insurance and libraries from Deloitte
insured pension products. It manages the calculations and financial The main rationale for the sale was regulatory
models used for:
SunGard can offer clients a significant improvement in the IT field of
Prophet.
Embedded and appraisal valuations
Deloitte will be continuing to use Prophet in all its consultancy work
Cash flow and financial projections
and will be continuing to provide implementation and other services
Net premium, gross premium and discounted cash flow valuations around Prophet to clients.
Realistic earnings valuations and reporting (including achieved profits, US
GAAP and Margin on Services) More information - http://www.prophet-web.com
Asset/liability modelling
Dynamic solvency testing
Stochastic projections
Surplus and bonus strategy analyses
Product pricing and design
Analysis of surplus and movement in embedded values

27 2005 Deloitte Advisory Sp. z o.o. 28 2005 Deloitte Advisory Sp. z o.o.

Questions?

29 2005 Deloitte Advisory Sp. z o.o.