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Group and Health FV-A > Actuarial Appraisals > Flashcards

Actuarial Appraisals Flashcards

1
Q

Challenges in determining the value of an insurance company

A
  1. Long duration of liabilities
  2. Sensitivity to interest rate fluctuations and the performance of capital markets
  3. Subjective art of loss reserving
  4. Cyclical nature of insurance
  5. Impact of reinsurance recoverables
  6. Challenges associated with non-market competitors, such as state funds
  7. Varying state and sometimes federal regulations
  8. Impact of statutory accounting on operational decisions
  9. Influence of rating agencies
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2
Q

Techniques used by investment bankers to determine the value of a company

A
  1. Comparable company analysis - the value of the company is estimated based on the values of a peer group of comparable companies
  2. Comparable transaction analysis - the value is estimated based on results of recent insurance mergers that are similar
  3. Discounted cash flow analysis - the projected cash flows and terminal values are discounted to a net present value using the weighted average cost of capital (WACC)
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3
Q

Formulas for using a discounted cash flow analysis in an actuarial appraisal

A
  1. An actuarial appraisal is a discounted cash flow analysis
  2. Actuarial appraisal value = PV(distributable cash flows)
  3. Distributable cash flow = after-tax earnings - increase in required capital
  4. The discount rate is the weighted average cost of capital (WACC) from the Capital Asset Pricing Model
  5. WACC = r = r^D * %debt = r^E * %equity
    r^D = required after-tax return on debt
    r^E = expected return on equity = rf + B^E * (rm - rf)
    rf = risk-free rate of return
    B^E = the B (risk level) of a company’s stock
    rm = expected rate of return for the market as a whole
    %debt = D / (D+E)
    %equity = E / (D+E)
    D = market value of company’s debt
    E = market value of a company’s equity
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4
Q

Components of the actuarial appraisal value

A
  1. Adjusted book value - this is the net worth of the insurance company on a statutory basis, adjusted for the value of miscellaneous items not captured elsewhere (see separate list from page 129 of this study note)
  2. The value of inforce business - this equals the present value of future profits arising from business that is on he books as of the valuation date. An adjustment is included to reflect the cost of capital.
  3. The value of future business capacity - this equals the present value of future profits arising from business that is expected to be written following the valuation date. An adjustment is included to reflect the cost of capital.
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5
Q

Uses of an actuarial appraisal

A
  1. Help value the company - potential buyers will make adjustments based on their internal views (see separate list of adjustments that are made)
  2. Form the bases for alternate accounting methods for cross-border transactions
  3. Can be adjusted to calculate pro forma earnings and to establish the opening purchase GAAP balance sheet
  4. Measure ongoing performance after the acquisition
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6
Q

Adjustments to the actuarial appraisal made by potential buyers

A
  1. Discount rate - a buyer will reflect its internal view of the appropriate discount rate
  2. Experience and product management assumptions - a buyer may adjust certain assumptions based on its internal views
  3. New business value - a buyer may adjust new business values based on its view of future business capacity
  4. Synergies - a buyer may reflect the benefits from anticipated synergies or cost savings
  5. Structure - a buyer may reflect the impact on the business of the buyer’s tax and RBC situations
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7
Q

Assumptions needed for actuarial appraisals

A
  1. Mortality - typically based on company experience compared to an industry standard
  2. Morbidity - also based on company experience
  3. Persistency - lapse assumptions and any shock lapses should be considered
  4. Investment returns and spreads - consider expected investment returns, reinvestment rates, and interest rates credited on insurance policies
  5. Operating expenses - could be based on various approaches (most commonly based on target unit expenses plus an unallocated expense)
  6. Discount rate - seller typically gives a range of reasonable rates instead of a specific rate (the Capital Asset Pricing Model may be used to determine this rate)
  7. Cost of required capital - the company will have an opportunity cost associated with setting aside capital to comply with required capital regulations
  8. Taxes - the actuarial appraisal should reflect a deduction for federal income taxes
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8
Q

Components of the adjusted book value (or net worth) of an insurance company

A
  1. Capital and surplus - includes statutory capital stock, contributed surplus, and retained earnings
  2. Asset valuation reserve (AVR) - this liability is part of surplus and is allocated to the lines of business
  3. Interest maintenance reserve (IMR) - this liability represents past interest-related capital gains not yet amortized into income
  4. Deferred tax asset - the admitted portion of the statutory deferred tax asset is deducted from adjusted book value
  5. Non-admitted assets - the realized value of assets that were non-admitted for statutory purposes, if they will contribute to earnings over time
  6. Surplus notes and other debt - a reduction is appropriate for any debts owed to another party
  7. Mark-to-market on assets allocated to adjusted book value - this component reflects some riskier assets that are allocated to adjusted book value
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9
Q

Approaches for using reinsurance to sell a block of business

A
  1. Assumption reinsurance - contracts are transferred from the seller’s books to the buyer’s books. The policyholder must be notified, and some states require policyholder consent to transfer the policy.
  2. Indemnity coinsurance - the financial interest is transferred to the buyer, but the policy stays with the seller. The policyholders do not need to be notified, but the seller remains in the middle of future transactions.
  3. Modified coinsurance - similar to indemnity coinsurance, except that the assets backing the liabilities remain with the selling company
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10
Q

The major objectives of mergers and acquisitions (M&A) due diligence

A
  1. Confirm strategic value: Successful M&A bids create more value after acquisition than existed prior. See separate list for examples of value-added strategies
  2. Confirm financial value: Establish there are no “holes” in the seller’s financials and develop the assumptions needed to support the buyer’s appraisal
  3. Confirm operational value: compare the operational areas of both parties to determine any potential system integration issues and quantify operational findings into financial values
  4. Construct appropriate bid
  5. Prepare for successful integration
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11
Q

Examples of value-added strategies used during M&A

A
  1. Increase in market share
  2. Derivation of synergies through complementary markets, products, or distribution
  3. Exploitation or leveraging of superior technology
  4. Increase in scale and ability to leverage existing resources better
  5. Preventing a new entrant from gaining a foothold in the market
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12
Q

The seller’s functional areas examined during the due diligence process of M&A operations

A
  1. Financial: requiring teamwork from the buyer’s accountants, actuaries, investment bankers, and other financial specialists
  2. Investments: Review of asset types, investment strategies, and assess any changes needed
  3. Tax: validate the tax strategies and quantify various options to the buyer
  4. Legal and compliance: The legal due diligence team determines if there are any legal impediments or hidden liabilities (See separate list for the variety of matters reviewed by the legal due diligence team)
  5. Marketing and distribution: marketing, specifically the distribution channels, holds the key to the value of new business, and significantly impacts the value of existing business
  6. Systems: ensure systems are operating efficiently, have proper licensing, and ongoing costs are ascertained
  7. Human resources: People-related costs can have a material effect on the value of a deal (See separate list for the required due diligence steps to review from the targets personnel, compensation, and benefits)
  8. Product management: affirm what the target’s practices are and plan how they will be integrated (See separate list for the key considerations in the due diligence process for life and annuity coverages)
  9. Claims: operational review includes claim intake, validation, and settlement
  10. Reinsurance: (See separate list for strategic and operational issues considered during due diligence)
  11. Risk management: if target risk management function is robust then their documentation should be very helpful to the due diligence team
  12. Actuarial: An actuary has the specific responsibility to translate the data and information developed by the due diligence team into quantified expressions of value
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13
Q

Matters reviewed by the legal and compliance due diligence team during a M&A process

A
  1. Proper formation and authorization of the target
  2. Corporate structure and ownership of subsidiaries
  3. Existence of prior acquisitions
  4. Compliance with applicable laws, including but not limited to: securities, tax, and insurance laws
  5. The results from the most recent market conduct exam and financial examinations
  6. In the case of life insurance companies, compliance of products with statutory and tax requirements
  7. In the case of reinsurance companies, compliance with state laws and regulations with respect to giving or receiving credit for reinsurance
  8. In the case of property casualty companies, the types of risks covered by contract forms (i.e. asbestos)
  9. Exposure to regulatory problems or lawsuits
  10. Material financing arrangements and any defulats thereunder
  11. Ownership of assets, including but not limited to intellectual property and real property
  12. Employee liabilities
  13. Other material contracts or agreements of any type
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14
Q

The required due diligence steps to review from the targets personnel, compensation, and benefits

A
  1. Schedules of personnel by function, salary, job grade; also, turnover and hiring plans
  2. Employment contracts, severance policies, special severance agreements, stock options, bonus plans, loans to staff, etc.
  3. Health, disability, retirement, and other benefit programs; retirement pension and health liabilities; benefits budgets and projections
  4. Benefits administration systems, use of vendors or consultants
  5. Comparison of seller’s benefits to buyer’s benefits, integration plans, and potential costs
  6. Potential liabilities that may be triggered by the transaction
  7. Whether any pension or health liabilities are underfunded
  8. Any cultural differences that need to be addressed
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15
Q

Product management key considerations in the due diligence process for life and annuity coverages

A
  1. Review underwriting philosophy and practice to determine if the formal guidelines are liberal or conservative
  2. The target’s handling of changes made to inforce policies must be ascertained
  3. Allocation of costs for corporate functions and external company-wide capital
  4. The target’s profit goals (may vary by product or market)
  5. The quality of the target’s relationships with their reinsurers, if applicable
  6. Confirm claims adjudication processes are appropriate for the product line
  7. The target’s policyholder management mechanisms should be identified
  8. Distribution channels: agents’ and policyholders’ reaction to the change of ownership should be estimated
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16
Q

Strategic and operational issues considered during the due diligence check of target’s reinsurance

A
  1. Functions that the reinsurer is responsible for managing, but in which the target company is at risk:
    a) Asset management
    b) Policy administration
    c) Claims management
    d) Underwriting
  2. Ascertain the retention levels, rights, and options of the target company
  3. Identify the effect of reinsurance on the combined entity
  4. Identify the overall exposure to certain risks to make sure that the combined entity does not end up with more risk than desired
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17
Q

Sources of information to be used by an actuary to quantify assumptions used in an actuarial appraisal

A
  1. Information and opinions developed by the buyer’s team during due diligence efforts
  2. Information provided by the seller
  3. External industry benchmarks
  4. General industry knowledge and experience
18
Q

Areas for actuarial due diligence in life and health

A
  1. Review of financial statements: balance sheet, income statement, and experience reports
  2. Review of operations: Actuarial operations, risk management functions, support other subteams
  3. Development of buyer’s appraisal and PGAAP pro forma
  4. Support of bid development and negotiations
  5. Preparation for closing and integration
19
Q

Actuarial components of the balance sheet to be reviewed during due diligence

A
  1. Reserve adequacy or margins
  2. Statutory reserve methodology
  3. Tax reserve methodology
  4. Adjusted net worth
20
Q

Patterns in income statements to be reviewed during due diligence

A
  1. Fluctuations in earnings can indicate unusual volatility or exposures
  2. Recent earnings used to initiate projections may not represent long-term trends
  3. Nonrecurring adjustments to earnings can be cause for concern of integrity or internal accounting/actuarial practices or controls
21
Q

Earning analyses and management metrics a seller will use to manage its business

A
  1. Breakdowns of earnings to product or line of business
  2. Explanations of earnings (pricing) variances in terms of operations (claim frequency and severity)
  3. Patterns of key indicators over time (actual to expected mortality or lapse)
  4. Embedded value (EV) statements, especially change in EV and associated explanations
  5. Deferred acquisition cost (DAC) recoverability testing
22
Q

Reason for review of experience reports during actuarial due diligence

A
  1. Reports are used as the primary basis for assumptions underlying the seller’s actuarial appraisal
  2. Reports generally drive the key management metrics and explanations of earnings
  3. The seller’s experience should be compared to the buyer’s and the differences analyzed
  4. The quality of the seller’s reports reflect on the quality and competency of the seller’s staff
23
Q

Operation areas from which the actuary will identify the quality of methodologies, assumptions, and practices

A
  1. Pricing and profitability management
  2. Product development, including coordination with underwriting and sales
  3. Valuation
  4. Business plans
  5. Setting non-guaranteed elements
  6. Experience monitoring
24
Q

Due diligence issues to explore when validating the model that underlies the seller’s appraisal

A

Used as the first step in developing the buyers actuarial appraisal

  1. Develop an understanding of the model’s robustness, level of cell refinement, and steps taken to develop the model
  2. Static model fit: Can the model reproduce initial balance sheet items and inventory amounts
  3. Dynamic model fit: Can the model reproduce recent experience matching statutory or GAAP income statemetns
  4. Policy illustration compared against model projections for a selection of specific cells
  5. Experience assumptions should be reviewed for consistency with historical studies and compared to industry benchmarks
  6. Review of management plan assumptions (production and expenses)
  7. Review of new business profitability

The second step is to compare the internal consistency of assumptions across various sets of “best estimates”

  1. It can be informative to compare the seller’s appraisal assumptions to the following:
    a) Business plan assumptions
    b) Pricing assumptions
    c) Cash flow testing assumptions
    d) US GAAP FAS 97 assumptions
    e) Embedded value assumptions
  2. A comparison across the different sets of assumptions above may highlight key issues that are worth further review
  3. The last step in determining appropriate buyer’s appraisal assumptions is to compare against external industry benchmarks, which is particularly important for group products
25
Q

Issues to be reviewed because of requirements imposed by Sarbanes-Oxley

A
  1. Assessing internal audit functions
  2. Reviewing risk management policies and practices
  3. Reviewing any relevant audit committee comments or concerns
  4. Reviewing the use of estimates for reserves or actuarial liabilities
  5. Reviewing potential contingent liabilities
  6. Assessing data quality and internal controls
26
Q

Description and formula for embedded value

A
  1. Embedded value (EV) is:
    a) A financial measurement basis applied primarily to long-duration insurance business that provides an alternative means of measuring value at any point in time and assessing financial performance over time
    b) A measurement of the value that shareholders own in an insurance enterprise, comprised of capital, surplus, and the present value of earnings to be generated from the existing business
  2. EV = ANW + IBV
    a) Adjusted net worth (ANW) is the realizable value of capital and surplus. Statutory capital and surplus are adjusted to include certain liabilities that are allocations of surplus and nonadmitted assets that have realizable value.
    b) See separate list for formulas of in-force business value (IBV)
27
Q

Use of embedded value

A
  1. Justification for stock prices and acquisition purchase prices
  2. Performance measurement for executive compensation
  3. Profitability analysis for lines of business
  4. Assessment of returns for capital allocation purposes
28
Q

Ways in which embedded value differs from actuarial appraisals

A
  1. Actuarial appraisals typically assign a value to the contribution of future new business, but EV does not
  2. Actuarial appraisals are typically calculated using higher discount rates than EV
  3. Expense assumptions used in calculating EV are typically more company specific than those used in actuarial appraisals
  4. In general, EV cannot be used directly to produce an actuarial appraisal. But an analyst could modify VNB, apply a multiple to it, and add that to modified EV to produce a somewhat independent valuation of the company’s market value.
29
Q

Formulas for in-force business value (IBV)

A
  1. IBV = PVBP - PVCoC. Both present values are computed with best-estimate assumptions are are discounted to the valuation date at a risk discount rate (RDR)
    a) RDR is often based on just the cost of equity capital. But it does sometimes implicitly reflect the cost of debt as well, in which case it is referred to as a weighted average cost of capital (WACC).
  2. VNB is calculated with the same formulas as IBV, but reflecting only the value of business sold in the reporting period. It does not reflect all future years of new business like an actuarial appraisal would.
  3. PVBP is the present alue of after-tax statutory book profits
    a) For a particular reporting period, statutory book profit (BP) is the after-tax net income achieved after resetting invested assets at the beginning of that period exactly equal to the statutory reserves
    b) BP(t) = Surplus(t) - Surplus(t-1) * (1+it), where i represents the after-tax rate of return on invested assets supporting surplus. This formula assumes there have been no shareholder dividends or paid-in capital during the period.
  4. PVCoC is the present value of the cost of capital
    a) The cost of capital for a reporting period represents the cost of the required capital (RC) earning a rate of return lower than the RDR. Assets supporting RC will only earn i.
    b) Cost of Capital(t) = RC(t-1) * (RDR - it) when there is no debt financing or debt is reflected implicitly in the RDR
    c) Cost of Capital(t) = [(RC(t-1) - D(t-1)) * (RDR - it)\ + [D(t-1) * (d(t) - it)]
    when a portion of RC is funded with debt (D) and the cost of debt (d) is not implicitly included in the RDR, but is explicitly reflected in this formula instead
  5. IBV is different than the present value of distributable earnings (PVDE) used in acquisitions
    a) PVDE = IBV + RC when there is no debt financing or debt is reflected implicitly in the RDR
    b) PVDE = IBV + (RC - D) when there is explicit recognition of debt
30
Q

Categories of assumptions used in calculating EV

A

The assumptions used should be best estimate assumptions

  1. Noneconomic assumptions - these should be based on the specific circumstances of the company or the business for which EV is being calculated
    a) Policyholder behavior
    b) Interest-crediting strategies
    c) Mortality and morbidity - companies typically credibility weight their own experience with industry data. Mortality improvement should also be reflected.
    d) Persistency - rates typically rely more on company-specific data than on industry data. Rates are generally set by both product type and duration.
    e) Expenses - these also rely more on company-specific data than on industry data. All types of expenses should be reflected in EV calculations. It is common to reflect expense inflation.
    f) Taxes - should reflect the paid amount and timing of federal and local taxes paid
  2. Economic assumptions - these apply broadly across the economy and are not specific to the company
    a) Interest rates
    b) Asset default rates
    c) Inflation rates
    d) Investment returns
    e) RDR (described in prior list) - may be determined using a “top-down” approach where the RDR’s risk margin is based upon a group WACC, or a “bottom-up” approach where product-specific betas are calculated (rather than a single market beta) to reflect the volatility of product cash flows

Some assumptions have both economic and noneconomic components.

31
Q

Ways in which financial options and guarantees are reflected in EV

A
  1. Intrinsic value - this is the value of the financial options and guarantees at the valuation date assuming the current in-force business is projected with best-estimate assumptions (typically a deterministic scenario)
  2. the time value of financial options and guarantees (TVFOG) - this is the value of the options and guarantees given the potential changes in financial markets to increase or decrease their value before they expire
    a) Products that typically require valuations of TVFOG include variable annuities, variable universal life insurance policies, and policies that guarantee minimum crediting rates
    b) TVFOG can be calculated as the mean of the PVDE for a set of stochastic scenarios minus the PVDE for a single deterministic scenario (the best-estimate scenario that includes the intrinsic value)
32
Q

Description and categories for an analysis of movement in EV

A
  1. Description of the analysis of movement - this is a reconciliation between the opening and closing EV, with the difference between the two allocated to various explanatory categories
  2. The analysis of movement decomposes the change in EV into the following broad categories:
    a) Contribution from new business
    b) Contribution from in-force business
    c) Contribution from free surplus
    d) Capital movements
    e) Other (e.g., foreign currency changes)
33
Q

Formulas for expected contribution (EC) to EV from new and in-force business and free surplus

A 
NB = new business
IFB = in-force business
FS = free surplus
  1. NB_EC(t) = VNB(t) * (1 + RDR)^0.5. VNB is calculated using beginning-of-period assumptions and assuming all new business is written in the middle of the year.
  2. IFB_EC(t) = (IBV(t-1) + RC(t-1)) * RDR
  3. FS_EC(t) = FS(t-1) * i(t)
34
Q

Formulas for expected IBV and net income (NI)

A
  1. EIBV = expected ending IBV
    a) NB_EIBV(t) = VNB(t) * (1 + RDR)^0.5 - NB_BP(t)
    b) IFB_EIBV(t) = [IBV(t-1) * (1 + RDR)] - IFB_BP(t) + [(RDR - i(t)) * RC(t-1)]
  2. ENI = expected net income
    a) NB_ENI(t) = NB_BP(t)
    b) IFB_ENI(t) = IFB_BP(t) + (i(t) * RC(t-1))
  3. The expected (or target) amounts at the end of the period are the sum of the new business and in-force business amounts from the above formulas
    a) Targ IBV(t) = NB_EIBV(t) + IFB_EIBV(t)
    b) Targ NI(t) = NB_ENI(t) + IFB_ENI(t) = NB_BP(t) + IFB_BP(t) + (i(t) * RC(t-1))
35
Q

Approaches for analyzing the impact of individual assumptions on IBV and NI

A

This is difficult because not all assumptions are independent. The basic approaches for dealing with the interaction of assumptions are:

  1. Independent assumption changes with model resets
    a) A modeled assumption is replaced with corresponding actual experience. The resulting change in IBV and NI is then attributed to that assumption.
    b) This is then done for each assumption individually, resetting the model before analyzing each assumption
    c) The sum of the above attributed changes will not equal the actual change in IBV and NI, so a residual change must be included in this analysis.
  2. Stepwise assumption changes with no model resets.
    a) Assumptions are again modeled one at a time. But the revised model is not reset after an assumption is analyzed.
    b) The impact assigned to subsequent assumptions is only the additional impact caused by adding that assumption.
36
Q

Formulas for analyzing the aggregate contribution (AC) to value

A
  1. AC(t) = (AdjANW(t) - ANW(t-1)) + (IBV(t) - IBV(t-1)), where adjANW removes the impact of any investor cash flows during the period
  2. AC(t) is compared to aggregate expected contribution (EC) for a high-level analysis of change. The aggregate EC is the sum of the EC from new business, in-force business, and free surplus (see formulas in previous list).
  3. EC(t) = [VNB(t) * (1 + RDR)^0.5] + [IBV(t-1) + RC(t-1) * RDR] +[FS(t-1) * i(t)]
37
Q

Calculation of effective EV rate

A
  1. An effective EV rate can be calculated as a measure of value added expressed as a percentage
  2. Adjustments must be made for the value added by new business, so that the result is a return on in-force business only.
  3. EffEVRate(t) = (AC(t) - VNB(t)) / (EV(t-1) + 0.5 * VNB(t))
    a) AC(t) (see formula in prior list) represents the adjusted increase in EV during year t
    b) EV(t-1) = IBV(t) + ANW(t-1)
  4. The effective EV rate should be compared to expected RDR. If combined experience variations and prospective assumption changes produced a net decrease in value, the effective EV rate would be less than the RDR (and vice versa).
38
Q

Recommendations by the CFO Forum of items to disclose in EV reporting

A
  1. Key assumptions
  2. How key assumptions were determined
  3. Methodologies
  4. Reconciliation of opening to closing EV by source
  5. An analysis of the change in free surplus
  6. Sensitivities to key assumptions, including the impacts of the following:
    a) 100 basis point increase in the RDR
    b) 100 basis point reduction in the interest rate environment
    c) 10% decrease in equity or property values
    d) 100 basis point increase in yield on equities or property
    e) 10% decrease in maintenance expenses
    f) 10% decrease in lapse rates
    g) 5% decrease in mortality and morbidity rates
39
Q

Formulas for calculating embedded value

A

For a block of business:

  1. Embedded value = PV after-tax profits + cost of capital
  2. Cost of capital = PV future tied capital releases minus increases + PV after-tax investment income earned on tied capital - tied capital
40
Q

Recommended practices for performing actuarial appraisals

A

An actuarial appraisal is an appraisal of an insurance business presenting a set of actuarial appraisal values based on a range of discount rates and assumptions

  1. When setting assumptions:
    a) Consider historical experience, adjusted for trend and known environmental changes
    b) Ensure that each set of assumptions used is internally consistent
    c) Consider the circumstances, needs, and strategies of the intended audience
  2. Consider displaying appraisal values using several discount rates
  3. Perform validation tests to determine whether the model reasonably reproduces results
  4. Address the sensitivities of the appraisal value to the changes in key assumptions
  5. Provide documentation in sufficient detail that another actuary qualified in the same practice area can evaluate the reasonableness of the work
41
Q

Items included in an actuarial appraisal report

A
  1. The scope of the assignment and any limitations as to the availability of data
  2. The actuary’s principal (client or employer)
  3. The duty, if any, that the actuary is assuming with respect to any user of the report other than the actuary’s principal
  4. A description of the intended use of the report
  5. A description of the business being valued
  6. The appraisal date
  7. An appraisal value or range of appraisal values
  8. The methodology used to develop the appraisal and reasons for the choice of methodology
  9. The projection model, the accounting basis used, and the other key items included in the analysis
  10. The results of the model validation
  11. A discussion of the level of capital reflected in the appraisal and how this level was determined
  12. The assumptions, described in sufficient detail that another actuary qualified int he same practice area would evaluate their reasonableness
  13. The source of any assumption selected by someone other than the actuary
  14. The extent to which taxes have been considered and on what basis
  15. Any sensitivity testing results deemed material by the actuary
  16. The source and extent of reliance on information supplied by others
  17. Disclosures in accordance with ASOP #41 if applicable

Group and Health FV-A (2 decks)

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