Chapter 10: Profitability of existing and new business

Question 1

1. WHAT IS PROFITABILITY

Question 2

What is profitability:

The profits in any given period _____:

Answer 2

The profit in any given period will be the change in excess assets on the published reporting basis, adjusted for any dividends and capital raised or repaid.

Question 3

What is profitability:

A true and fair view is one that takes into account: (4)

Answer 3

1. The “going-concern” concept, i.e the insurer will continue in operational existence for the foreseeable future.
2. The “accruals” concept, i.e. revenue and costs are recognised as they are incurred, not as money is received and paid (unless this is inconsistent with prudence).
3. The “consistency” concept, i.e. consistency of like items within a period and from one period to the next.
4. The concept of “prudence”, i.e. revenue and profits are not anticipated and provision is made for all known liabilities.

Question 4

What is profitability:

Alternative measure of profitability (alt. to change in excess assets on the published reporting basis):

Answer 4

• An alternative measure of profitability is the change in the embedded value (EV) of the life company.
• In addition to current surplus, EV also takes into account of surpluses arising in the future at market rates, net of the cost of capital.

Question 5

What is profitability:

For the EV, Future surpluses are expected to arise on existing business mainly due to the following factors: (3)

Answer 5

1. Compulsory and discretionary margins included in the published reporting reserves (where these are calculated on the FSV basis)
2. Expected future shareholder cash flows that were not taken into account when calculating the liabilities. (example?)
3. The shareholder’s entitlement to a portion of the future declared bonuses on with-profits business, where these have not already been included in the embedded value as part of the shareholders’ funds.

Question 6

2 EMBEDDED VALUE (EV)

Question 7

Embedded Value:

The EV of a proprietary life insurance company consists of __________:

Answer 7

The EV of a proprietary life insurance company consists of the adjusted net worth (ANW), which is equal to the free surplus attributed to the shareholders and the required capital to support the business, the present value of the future after tax profits from the policyholders’ fund (PVIF), and an adjustment in respect of the cost of required capital (CoRC)

Question 8

The EV of a proprietary life insurance company consists of the: (3)

Answer 8

1. Adjusted Net Worth (ANW) - the free surplus attributed to shareholders and the required capital (RC) to support the business,
2. The present value of the future after tax profits from the policyholder’s fund (PVIF), and
3. and an adjustment in respect of the cost of required capital (CoRC).

Question 9

Embedded value:

Define the Adjusted net worth and outline its two components:

Answer 9

The adjusted net worth of a company is defined as the excess value of assets over liabilities

This is split into the following two components:

1. The free surplus attributed to the shareholders.
2. The required capital

Question 10

Adjusted net worth (ANW):

Answer 10

The free surplus attributed to shareholders in respect of covered business, and the required capital (RC) to support the covered business.

Question 11

The level of required capital should be based on the level of assets required to meet internal objectives, such as those based on: (3)

Answer 11

1. internal risk assessment,
2. specified multiple of solvency capital, or
3. those required to obtain a targeted credit rating.

Question 12

The value of new business (VNB) should be calculated as ____:

Answer 12

The VNB should be calculated as the present value at point of sale, of after-tax shareholder cash flows arising from new business, less the corresponding cost of required capital.

Question 13

The calculation of VNB should allow for: (3)

Answer 13

1. actual acquisition costs,
2. cash flow strains under the statutory valuation basis; and
3. the expected cost of embedded investment guarantees (as per the APN 110 requirements)

Question 14

Define “New business”:

Answer 14

New business is defined as the business arising from the sale of new business contracts and one-off premium increase in respect of in-force business during the reporting period.

Question 15

The present value of new business premiums (“PVNBP”) should be calculated: (3)

Answer 15

1. By projecting the premiums expected in each future year, using assumptions and projection periods that are consistent with those used to calculate the VNB.
2. Using premiums before reinsurance, unless there are specific situations where this approach would be misleading.
3. Using the same definition of new business as is used in the calculation of VNB and, where appropriate, other sales figures reported externally.

Question 16

Define new business profit margin:

Answer 16

The new business profit margin is defined as the ratio of VNB to the PVNBP.

Question 17

Define appraisal value:

Answer 17

An appraisal value is a method used to put a value on an insurance company.

The appraisal value of a company is made up as follow:

• EV
• Present value of future new business (PVFNB)

Question 18

Before basing the EV CoRC on the (prudential supervision) risk margin, the actuary needs to consider whether: (5)

Answer 18

1. The risk margin is a suitable measure of the Cost of Required Capital from a shareholder perspective and adjust appropriately.
2. The risk margin cost of capital rate of 6% is appropriate and if not, determine an appropriate rate;
3. They are comfortable that the frictional cost of capital on the total level of capital has been adequately allowed for in the risk margin and adjust appropriately;
4. The Cost of Required Capital must allow appropriately for any differences between contract boundaries
5. The Cost of Required Capital must allow appropriately for any differences between contracts included in the risk margin calculation and those included as covered business in the EVM.

Question 19

Cost of Required Capital in a given year, formula:

Answer 19

{Cost of Required Capital}(t) = rdr * Capital(t) - {After Tax Inv Income on Capital}(t)

where:

Capital(t) is the required capital at the start of year t

Question 20

The APN definition of CoCR:

Answer 20

CoCR is the difference between the amount of required capital and the present value of future releases of this capital, allowing for future net of tax investment returns expected to be earned on this capital.

Question 21

Define the PVIF of a block of business:

Answer 21

The PVIF of a block of business is the present value of the future shareholder cash flows projected to emerge from that block of business.

Question 22

For With-profits contracts three bases will usually be involved: (3)

Answer 22

1. A basis to assess future bonus rates, unless it is assumed current rates will continue
2. A projection basis used to project the liabilities to determine the bonuses given each year
3. A valuation basis used to determine the cost of each year’s bonuses

Question 23

Criticism of TEVs: (4)

Answer 23

1. Allowance for the cost of financial options and guarantees (CFOG)
2. Allowance for cost of capital
3. Risk discount rate
4. Lack of consistency in methodology, assumptions and disclosure.

Question 24

The 12 EEV Principles: (12)

Answer 24

1. Embedded value (EV) is a measure of the consolidated value shareholders’ interests in the covered business.
2. The business covered by the EV methodology (EVM) should be clearly identified and disclosed.
3. EV is the present value of shareholders’ interests in the earnings distributable from assets allocated to the covered business after sufficient allowance for the aggregate risks in the covered business.
4. The free surplus is the market value of any capital and surplus allocated to but not required to support the in-force covered business at the valuation date.
5. Required capital should include any amount of assets attributed to the covered business over and above that required to back liabilities for covered business whose distribution to shareholders is restricted. The EV should allow for the cost of holding the required capital.
6. The value of future cash flows from in-force covered business is the present value of future shareholder cash flows projected to emerge from the assets backing liabilities of the in-force covered business (PVIF). This is reduced by the value of financial options and guarantees as defined in Principle 7.
7. Allowance must be made in the EV for the potential impact on future shareholder cash flows of all financial options and guarantees within the in-force covered business. This allowance must include the time value of financial options and guarantees based on stochastic techniques consistent with the methodology and assumptions used in the underlying EV.
8. New business is defined as that arising from the sale of new contracts during the reporting period. The value of new business includes the value of expected renewals on those new contracts and expected future contractual alterations to those new contracts. The EV should only reflect in-force business, which excludes future new business.
9. The assessment of appropriate assumptions for future experience should have regard to past, current and expected future experience and to any other relevant data. Changes in future experience should be allowed for in the value of in-force when sufficient evidence exists and the changes are reasonably certain. The assumptions should be actively reviewed.
10. Economic assumptions must be internally consistent and should be consistent with observable, reliable market data. No smoothing of market or account balance values, unrealised gains or investment return is permitted.
11. For participating business the method must make assumptions about future bonus rates and the determination of profit allocation between policyholders and shareholders. These assumptions should b made on a basis consistent with the projection assumptions, established company practice and local market practice.
12. Embedded value results should be disclosed at consolidated group level using a business classification consistent with the primary statements.

Question 25

Key changes that EEV introduced through its 12 principles include: (3)

Answer 25

1. an allowance for the cost of financial options and guarantees
2. the requirement to the use of required capital instead of minimum regulatory capital when calculating cost of capital.
3. improved consistency in methodology, assumptions and disclosure.

Question 26

Market consistent embedded value (MCEV)

Answer 26

MCEV is the present value of shareholders’ interests in the earnings distributable from assets allocated to the covered business after sufficient allowance for the aggregate risks in the covered business.

The allowance for risk should be calibrated to match the market price for risk where reliably observable.

Question 27

The MCEV consists of the following components:

Answer 27

1. Free surplus allocated to the covered business
2. Economic capital which could either be required capital or available capital
3. Value of in-force covered business (VIF)

Question 28

Key issues that companies still need to address when adopting the EEV framework: (3)

Answer 28

1. How to set the appropriate RDR?
2. How to calculate the cost of options and guarantees?
3. What adjustment to make for the cost of capital?

Question 29

New business profit margin:

Answer 29

The new business profit margin is defined as the ratio of VNB to the present value of new business premiums (PVNBP).

Question 30

MCEV is an EV methodology that uses financial economic principles as follows:

Answer 30

1. Options and guarantees are valued using option pricing techniques, including stochastic simulations where necessary.
2. Cashflows without options or guarantees are valued using a discount rate that reflects the risk inherent in each cashflow.
3. An adjustment is made for the negative impact of double taxation
4. An adjustment is made for the additional costs of capital for agency risk