Chapter 10- Profitability and Existing New Business

Question 1

Outline the calculation of profitability of a insurance contract and the recognition of profit over a reporting period? (5)

Answer 1

• The actual profitability from a policy is not known until it terminates and the final payment could be made

• The actual profit at that stage is the earned assets in excess of the final payment

• Companies, however, don’t wait until termination to report on the profitability of existing and new business written

• The aim of companies financial statements is to show a true and fair value of profit

• The main challenge is that even though a valuation basis does not change the total surplus that arises on a policy it changes the incidence of the emergence of the surplus

Question 2

outline the criteria and accounting principles that define true and fair profitability? (4)

Answer 2

• The going-concern concept i.e. the insurer will continue in operation existence for the foreseeable future

• The accruals concept i.e. revenue and costs are recorded as they are received or incurred not when cashflows are received or paid

• The consistency concept i.e. consistency from one period to the next

• The concept of prudence i.e. revenue and profit is not anticipated and provisions are made for known liabilities

Question 3

Outline reason why future surplus is expected to emerge on new business? (3)

Answer 3

• Compulsory and discretionary margins included in published reporting reserving (where these are calculated on the FSV basis)

• Expected future shareholder cashflows not included in the liability e.g. cashflows for group business before the renewal date

• Shareholders entitlement to the portion of future declared bonuses on with-profit business (if not included in shareholder funds)

Question 4

Outline the definition of covered business? (3)

Answer 4

• Contract regarded to regulators as long-term insurance business

• But it may be permissible to include non-life, health care administration and asset management business

• It may also be possible to exclude certain long-term insurance contracts if reported on separately

Question 5

List the components of EV?(3)

Answer 5

• Adjusted net worth (ANW) (free surplus available to shareholders and required capital (RC) to support business plus

• Present value of future profit after tax from policyholder fund (PVIF)

• Adjustment for the cost of required capital (CoRC)

Question 6

Outline the components of adjusted net worth (ANW)? (2)

Answer 6

• The free surplus attributable to shareholders (the excess assets over liabilities and RC)

• Required capital (the assets attributed to business over and above assets backing liabilities)

Question 7

Outline the required capital? (3)

Answer 7

• The cost of capital include assets attributable to covered business over and above required to back liabilities whose distribution is restricted to shareholders

• The level of capital should be based on internal objectives e.g. certain multiple of SCR held, obtaining a certain credit rating

• Regardless of the method to obtain required capital the EMV liabilities and EVM capital target should always exceed the value of liabilities and SCR on a prudential supervisory basis

Question 8

Explain why there is a cost in holding required capital? (4)

Answer 8

• Capital comes from shareholders and they expect a higher return on their money than the risk-free rate available in the market (because investing in a company is more risky)

• The required rate of return of shareholders is called the risk discount rate (RDR) i.e. risk-free rate plus a risk premium

• The RDR is expected to be higher than the investment return net of tax earned on required capital

• The difference creates an opportunity cost of required capital

Question 9

Outline the considerations that needs to be taken into account when considering using the risk margin in prudential valuations as the CoRC for EV purposes? (5)

Answer 9

• Is the risk margin is a suitable measure of CoCR from a shareholders perspective
o Determine if an adjustment is required for non-hedgeable risk or capital buffers (Need to include cost of total Required capital)

• The risk margins cost of capital rate of 6% is appropriate

• Comfortable that the friction cost of capital (e.g. double taxation and asset management) on targeted level of capital has been adequately allowed for in the risk margin

• Differences in contract boundaries

• Difference in the contracts included in risk margin calculation and contracts included in covered business

Question 10

Outline the calculation of cost of required capital for embedded value purposes? (4)

Answer 10

• The cost of required capital (at time t)=RDR*Capital at time t less after tax investment income on the capital

• The total cost of required capital is then set equal to the sum over all future years of the present value of the cost of capital discounted using the RDR

• This is equivalent to taking the difference between the required capital and present value of the release of required capital allowing for the investment expected net of tax

• When calculating projected required capital restricted assets and EVM liabilities may need to be projected separately as they may have different underlying drivers

Question 11

outline the present value of future cashflows from inforce covered business? (4)

Answer 11

• PVIF is the present value of future cashflow attributable to shareholders that will emerge from the inforce block of business

• The shareholders cashflows should be discounted at the risk discount rate

• The expected future cashflows emerging should be calculated using best estimate assumptions

• If the EVM liabilities where set equal to the prudential standards liabilities then a portion of PVIF may be included in ANW as prudential standards liabilities are valued on a best estimate basis with very few margins

Question 12

outline the modern financial economics approach to the calculation of EV? (3)

Answer 12

• Modern financial economics is based on the principle of no arbitrage and that investors cannot be rewarded for assuming non-systematic risk

• Under this approach EV should be calculated by discounting using the risk-free rate

• This approach does not take into account the investors pain of risk or individual utility

Question 13

outline the traditional actuarial approach to the calculation of EV? (3)

Answer 13

• This approach assumes that shareholders require additional returns for taking on risks, not only systematic risks

• The traditional approach produces best estimates for future cashflows and is the approach described in APN 107

• However this does not preclude the use of market consistent methods or the prudential supervision basis adjusted appropriately

Question 14

outline the additional complexity for participating business in the calculation for PVIF? (5)

Answer 14

in the South African context, this relates to participating business where the profit emerging is divided between shareholders and policyholders

• Therefore to calculate the future stream of shareholder profits future, therefore, bonuses would first need to be projected

• This is likely to mean bonuses will be declared such that asset share will be paid out at maturity

• The value does not take into account that the policyholder may have to inject additional funds

• This represents a call option that needs to be deducted from the market value of the business (requires stochastic modelling to calculate)

Question 15

Outline the how a basis will be set for the calculation of PVIF of EV?(5)

Answer 15

• The process of determining the present value of future profits is similar to carrying out a profit test

• The basis elements will be similar to those used for that purposes excluding elements related to new business such as initial expenses

• In addition the risk discount rate should be set to reflect existing business rather than new business

• In general assumptions should be realistic and represent a best estimate of the future

• The assumptions will be different if the book if still open to new business or closed book
o This specifically refers to expense assumption (reducing economies of scale) and withdrawal assumptions

Question 16

List the possible different basis required for with-profit contracts? (3)

Answer 16

• A basis to assess future bonus rates

• A projection basis to project liabilities to determine bonus given

• A valuation basis used to determine the cost of each future years bonuses

Question 17

Describe the traditional embedded value (TEV)?(5)

Answer 17

• Until recently most life insurers reported their EV results on traditional appraisal value techniques of discounting future profits on a deterministic basis

• The main advantage of TEV is that it recognises profit at the point of sale and allows management to get an insight of key drivers of profit through an analysis of change in EV

• Profit from new business is not necessarily recognised at the outset when on a IFRS and prudent statutory reporting

• Despite the advantages the limitations were exposed following extreme market conditions in recent years e.g. fall in interest rates and equity markets causing guarantees to become uncovered

• The led to a review to TEV especially consideration to allow for market risk

Question 18

Describe the critisms of traditional embedded value? (4)

Answer 18

• Allowance for the cost of financial options and guarantees
o TEV projected cashflows on a deterministic basis and this resulted in financial options and guarantees being valued at intrinsic value
o The time value of the option was only included implicitly through discount rates

• Allowance for the cost of capital
o TEV allowed for the cost of holding minimum regulatory capital which does not allow for appropriate level of capital to be different from the minimum level of capital

• Risk discount rate
o It was not clear whether the risk to which the shareholder are exposed were allowed for in the risk discount rate

• Lack of consistency in methodology, assumptions and disclosure
o This made comparison between companies difficult

Question 19

Outline the 12 European embedded value principles (12)?

Answer 19

• Principle 1: EV is measures of the consolidated value of shareholder’s interest in covered business

• Principle 2: Business covered by the embedded value methodology (EVM) should be clearly disclosed

• Principle 3: EV is the present value of earnings distributable from assets allocated to covered business after sufficient allowance for aggregated risks in covered business. The EV consists of the following components:
o Surplus allocated to covered business
o Required capital less the cost of holding required capital
o Present value of future shareholder cashflows from inforce covered business (PVIF)

• Principle 4: The free surplus is the market value of any capital and surplus allocated to but not required to support in-force covered business at the valuation date

• Principle 5: Required capital should include any amount of assets attributed to the covered business over and above that required to back liabilities whose distribution is restricted. The EV should allow for the cost of holding the required capital

• Principle 6: The value of future cashflows from in-force covered business is the present value of future cashflows projected to emerge from assets backing the liabilities of the in-force covered business (PVIF). This value is reduced by the value of options and guarantees in point 7.

• Principle 7: Allowance must be made in the EV for the potential impact on future shareholder cashflows of all financial options and guarantees within inforce covered business. Allowance must be made for the time value of options and guarantees based on stochastic techniques used in methodology and assumptions underlying EV.

• Principle 8: New business is defined as that arising from the sale of new contracts in the reporting period. The value of new business includes renewal and contract alterations to those new contracts. The EV should only reflect existing business and exclude future new business.

• Principle 9: The assessment of appropriate assumptions for future experience should have a regard to current, pasts and expected future experience and other relevant data. The assumptions should be actively reviewed

• Principle 10 must be internally consistent and with market data. No smoothing is permitted

• Principle 11 For participating business, make assumptions about future bonus rates and profit allocation between PHs and SHs
a. Consistent with projection assumptions, PPFM etc.

• Principle 12 Disclose EV results at a consolidated group level using a business classification consistent with primary statements

Question 20

outline market consistent embedded value? (3)

Answer 20

• MCEV is the present value of shareholder’s interests in the earning distributable from assets allocated to covered business after sufficient allowance for aggregated risk

• The allowance for risk should be set to match the market price of risk where observable

• The MCEV consists of the following components:
o Free surplus allocated to covered business
o Economic capital (required or available)
o Value of in-force covered business
o NO Cost of Required Capital

Question 21

Outline the financial economic steps applied in market consistent EV? (5)

Answer 21

o Options and guarantees are valued using standardised option-pricing techniques and with stochastic simulations for more complex cases e.g. guaranteed annuity options can be valued using swaptions

o Cashflows that do not contain any options or guarantees are valued using a discount rate which reflects the inherent risk of cashflows

o A deduction is made to compensate of the effect of double taxation (assets are taxed in hand of company and then dividends distributed are taxed)

o Companies hold capital to protect themselves against market and non-market volatility in order to meet regulatory requirements, achieve certain credit ratings and attract clients (demonstration of financial strength)

o An additional cost of capital is identified helping shareholders quantify agency risk (subjective and depends on the degree of transparency)

Question 22

Describe the value of new business? (6)

Answer 22

• This is calculated as the present value at the point of sale the after tax shareholder cashflows arising from new business less

• Corresponding cost of required capital

• Treatment of tax should be consistent with VNB

• Allowance should be made for acquisition costs as well as valuation strain under statutory valuation basis

• Furthermore allowance should be made for expected cost of embedded investment guarantees

• New business is defined a selling of new contracts and one of premium increases from inforce business

Question 23

Outline the calculation of the present value of new business premiums? (3)

Answer 23

• Projecting premiums expected over future years using assumptions and projection periods consistent with the calculation of VNB (calculating will be done on a deterministic basis)

• Premiums should be calculated gross of reinsurance (unless misleading)

• The definition of new business should be consistent with that used to determine the VNB

Question 24

Outline appraisal value? (4)

Answer 24

• This is a method to put a value on a life insurance company which considers the value of existing and future new business

• Hence appraisal value consists on EV plus present value of future new business (PVFNB)

• The PVFNB is subjective as assumptions regarding future new business needs to be made

• Therefore it is common to produce various appraisal values indicating sensitivity to the PVFNB assumption

Question 25

Outline the calculation of the present value of future new business? (2)

Answer 25

• This can usually be set by looking at the VNB written over the previous 12 months

• The PVFNB can be estimated as a multiple of VNB