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Demystification of the MCEV

Klaus Miller
Member of the Executive Board

14th International Investors' Day


Hannover, 23 June 2011
Market Consistent Embedded Value is. . .

. . .today's valuation of the

future distributable earnings

of the business written in the past.

1
Market Consistent Embedded Value is...

MCEV
(Market Consistent Embedded Value)

SNW VIF
(Shareholder Net Worth) + (Value in Force)

- CoRNHR1)
Required
Free Surplus Present Value
+ Capital
(FS) of Future
(RC) - FCoRC2)
Profits (PVFP)

- FOGs3)
1) Cost of Residual Non Hedgeable Risks
2) Frictional Costs of Required Capital
3) Financial Options and Garantees

2
Analysis of Change (AoC)
Using the example of Hannover Life Re

1. Movement items that are not part of total MCEV earnings


in m. EUR 2010
Opening MCEV 2,066.2 2. Explained in detail on the next slide

Opening Adjustments 204.4 1. 3. Hereunder, we show the deviations from expected economic
result of the reporting year as well as the impact of changes
Change in currency exchange rates 197.3
in economic assumptions for the future
Other implications 7.1 - Experience variances on investment return due to
unrealised gains/losses only (mainly market value of
Adjusted Opening MCEV 2,270.6
assets)
Total MCEV Earnings 448.8 2. - Experience variances on investment return
(expected vs. actual investment returns)
Operating MCEV Earnings 289.6 3.
- Economic assumption changes (e.g. impact of
Economic variances 159.2 changes in interest rates on VIF)
- Experience variances on tax and inflation
MCEV before Closing Adjustments 2,719.5
4. Movement items that are not part of total MCEV earnings
Closing Adjustments (151.2) 4.

Capital injection / reduction (109.9) 5. According to the MCEV Principles the return has to refer to
the Adjusted Opening MCEV. As in the past Closing
Dividend payments (41.3) Adjustments are eliminated.
Closing MCEV 2,568.3

Return on MCEV* 19.8% 5.

due to - Operating MCEV Earnings 12.8%

- Economic variances 7.0%


* (MCEV before Closing Adjustments Adjusted Opening MCEV ) / Adjusted Opening MCEV

3
Operating MCEV Earnings
Using the example of Hannover Life Re

1. VIF NB + profit/loss during the year (see next page)


2010
in m. EUR 2. Expected contribution on Adjusted Opening MCEV
- Roll forward of the last year's figures (shareholder net worth
New business value 149.3 1.
with risk free rate)
- VIF: unwind of discount (discounting only for n-1 years and
Expected existing business contribution
90.2 2. not for n years), release from costs for CoRNHR, FCoRC,
(reference rate)1) FOGs related to the current year
- Shift of the expected cash flow for the current year (part of
Expected existing business contribution PVFP) from VIF to SNW
18.7 3.
(in excess of reference rate)2)
3. It is assumed that the shareholder net worth earns more than
Experience variances 1.4 4. the risk free rate, i.e. a rate in line with the expectation of the
management
Assumption changes (34.5) 5.
4. Actual vs. expected deviations
- This refers to the development of business in respect to
Other operating variance 64.7 6.
mortality, morbidity, lapse, expenses rates, etc. in the
reporting year
Operating MCEV Earnings 289.6
- The expectation of the experience variances is zero

5. Impact of the change/revision of the best estimate actuarial


assumptions (mortality, lapse, expenses) for the future
- The expectation of impact is zero
- If over some years deviations actual vs. expected are
observed for certain treaties, the best estimate assumptions
have to be revised
1) Swap yield rates
2) Additional return consistent with the expectation of the management 6. Model changes and residual

4
New Business Value
Using the example of Hannover Life Re

2009 2010
in m. EUR
Profit/Loss on new business during year (295.1) (127.4)

Present Value of New Business Profits 706.4 331.0

- Cost of Residual Non Hedgeable Risks (303.6) (42.9)

- Frictional Costs of Required Capital (28.8) (11.4)

- Financial Options and Guarantees 0.0 0.0

New Business Value 78.9 149.3

5
Sensitivities of the MCEV (economic assumptions)*
Using the example of Hannover Life Re

in m. EUR Total

MCEV (base) 2,568.3

Interest rate environment +100 bps -13.5

Interest rate environment -100 bps +7.9

Swaption implied volatilities +25% -4.8

* Base run without liquidity premium. The impact of the sensitivity 'liquidity premium +10 bps'
is immaterial (< 1% of MCEV) and therefore not shown

6
Sensitivities of the MCEV (non-economic assumptions)
Using the example of Hannover Life Re

in m. EUR Total

MCEV (base) 2,568.3

Expenses -10% +48.1

Lapse +10% -206.2

Lapse -10% +114.3

Mort./Morb. +5%, life/disab. business only -617.4

Mort./Morb. -5%, life/disab. business only +802.3

Mort./Morb. +5%, annuity business only +59.7

Mort./Morb. -5%, annuity business only -63.0

7
Embedded Value Not Recognised
Using the example of Hannover Life Re

in m. EUR

2.400
625.2

289.9

1.600 721.0
822.3
2,568.3

2,066.2
800
1,222.1
953.9

0
2009 2010
Embedded Value IFRS Equity* Bridge financing EVNR
* After elimination of surplus notes

Reconciliation to IFRS equity reveals "off balance sheet"-values

8
Appendix
Glossary

CoRNHR Cost of Residual Non Hedgeable Risks


Explicit allowance for residual non hedgeable financial and non-financial risks
FCoRC Frictional Costs of Required Capital
Taxation and cost of asset management on the assets backing the required capital
FOGs Financial Options and Guarantees
Time value of financial options and guarantees; calculated by stochastic techniques consistent with the methodology and assumptions
used in the underlying Market Consistent Embedded Value (MCEV)
FS Free Surplus
The market value of any capital and surplus allocated to, but not required to support, the in-force business at the valuation date
MCEV Market Consistent Embedded Value
Shareholder Net Worth plus Value In-Force
P/L (NB) Profit or Loss on New Business during year
PVFP Present Value of Future Profits
The present value of future shareholder's cash flows projected to emerge from the assets backing liabilities of the in-force business
PV (NB) Present Value of New Business Profits
RC Required Capital
Assets attributed to the covered business over and above that required to back liabilities for covered business whose distribution to
shareholders is restricted
SNW Shareholder Net Worth
Free surplus plus required capital
VIF Value In-Force
The present value of future shareholder's cash flows projected to emerge from the in-force business and the assets backing the
associated liabilities after allowance for CoRNHR, FCoRC and FOGs
VNB Value of New Business

I
Formulae and abbreviations

MCEV MCEV = SNW + VIF

SNW SNW = FS + RC

VIF VIF = PVFP - CoRNHR - FCoRC - FOGs

CoRNHR CoRNHR = Cost of Capital Factor* x economic capital

FOGs FOGs = Base PVFP - mean stocastic PVFP

VNB VNB = P/L (NB) + PVNB - CoRNHR (NB) - FCoRC (NB) - FOGs (NB)

Return on
(MCEV before Closing Adjustments - Adjusted Opening MCEV)/Adjusted Opening MCEV
MCEV

* The capital charge for residual non hedgeable risk, so-called Cost of Capital Factor, was set to 4.5 % on a percentile of 99.95 % on internal risk capital. This
decision was made according to the CFO CoRNHR Working Group recommendation to use some value within the range of 2.5% - 4.5% for the Cost of Capital
Factor.

II
Present Value of Future Profit (PVFP)

PVFP CF1
The present value of future shareholder cash
(1 s1 )1 CF2 flows projected to emerge from the assets
(1 s2 ) 2 backing liabilities of the in-force covered
CFn
business
(1 sn )n

n
CFi
PVFP
i 1 (1 s i ) i
where
CFi = Cash Flow of year i:
Premiums
Claims
Change in Reserve
Loss during the year e.g. due to the Fees
Investment Results
acquisition costs (is included in the
Free Surplus) si = risk free spot rate
n = Projection horizon (e.g. 40 years)

1 2 3 4 5 6 7 8 9 10 11 12 13

Cashflow PVFP

III
Cost of Residual Non Hedgeable Risks (CoRNHR)

Non hedgeable risks are risks that cannot be hedged using instruments available in
financial markets. It includes non-financial risks typically included in the risk based capital
such as

mortality

longevity

morbidity

disability

pandemic

lapse

expense and

operational risks.

It also includes some financial risks, if there are no instruments available with which to
hedge those risks (e.g. default and credit risk).

IV
Frictional Cost of Required Capital (FCoRC)
Examples

Frictional Cost of Required Capital


Double taxation on investment earnings
Additional investment management expenses

From the capital market's view From the reinsurance market's view
Company distributes 100 of required capital to Company cannot distribute 100 of required
shareholder capital to shareholder
Investor invests 100 directly Investor invests 100 indirectly through the
company
Risk free return 5% Risk free return 5%
Corporate tax 25%: 1.25
Investment management expenses incurred by
company 0.1%: 0.10
Company pays dividend of net return to
shareholder: 3.65
Income before personal tax and own investment Income before personal tax and own
management expenses: investment management expenses:

5 3.65

FCoRC of 1.35 for one year= risk free x (1-tax rate) + expenses

V
Most common Financial Options and Guarantees (FOGs)

Guarantees Options
Minimum crediting rates guarantee in the Lapse option
universal life policies and deferred annuities
Policyholder can exercise the lapse option at any
with fixed interest options time
Secondary guarantees in the variable Implementation of the dynamic policyholder
annuities and variable universal life policies behavior
such as Release of hidden reserves might be required
(e.g. in case of Guaranteed Minimum Withdrawal
Guaranteed Minimum Death Benefits
Benefit Contracts (GMWBs))
(GMDBs)
Lump-sum option
Guaranteed Minimum Income Benefits
(GMIBs) Lump-sum vs. annuity payments option at the
end of the premium period
Guaranteed Minimum Accumulation
Release of hidden reserves might be required
Benefits (GMABs)

Guaranteed Minimum Withdrawal Benefit


Contracts (GMWBs)

VI
Evolution from EV via EEV towards MCEV (cont'd)
Development of the Embedded Value

EV EEV MCEV
until May 2004 May 2004 - June 2008 June 2008 - October 2009
CFO Principles CFO Principles

Deterministic projections Partial stochastic simulations Stochastic simulatonen


Cash flows Static sensitivities (FOGs) (FOGs)
Partial dynamic sensitivities Dynamic sensitivities

Implicit allowance for FOGs Explicite FOGs calculation Market consistent FOGs
FOGs within discount rate (real-world capital market calculation (risk free capital
scenarios) market scenarios)

Risk RDRs depending on the "Top-down" WACC1) based Market-consistent


business structure, ALM approach and valuations
discount und enterprise risk appetite "Bottom-up"2) approach "Bottom-up"2) approach
rates used in EV are both No allowance for liquidity
(RDRs) acceptable premium

Local statutory minimum Maximum of


Statutory equity
Required solvency capital Local statutory minimum
solvency capital
capital
Capital to achieve the target
rating
Capital to achieve internal
management objective

1) Weighted average cost of capital


2) "Bottom-up" approach values individual cash flows rather than aggregate cash flows

VII
Evolution from EV via EEV towards MCEV (cont'd)
Development of the Embedded Value

MCEV MCEV
June 2008 - October 2009 October 2009 CFO Principles update,
CFO Principles compulsory from 2011

Stochastic simulations (FOGs) Stochastic simulations (FOGs)


Cash flows
Dynamic sensitivities Dynamic sensitivities
Implicit allowance for FOGs within Explicite FOGs calculation
FOGs discount rate (real-world capital market scenarios)

Interest/ Market consistent valuations Market consistent valuations


discount "Bottom-up" approach "Bottom-up" approach
rate No allowance for liquidity premium Allowance for liquidity premium

Maximum of Maximum of
Local statutory minimum solvency Local statutory minimum solvency
Required capital
capital
capital Capital to achieve the target rating Capital to achieve the target rating
Capital to achieve internal Capital to achieve internal
management objective management objective

MCEV: In October 2009, the CFO Forum published an amendment to the Market Consistent Embedded Value (MCEV) Principles to reflect
the inclusion of a liquidity premium. The CFO Forum recognises that the existence of a liquidity premium is clear, as evidenced by a wide
range of academic papers and institutions. It also recognises that its inclusion and quantification are equally important for Solvency II. The
changes affirm that the reference rate to be applied under MCEV should include both the swap yield curve appropriate to the currency of the
cash flows, and on top of it, a liquidity premium, where appropriate. (Source: CFO Forum)

VIII

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