D.2 Embedded Value practice and theory

Question 1

Embedded Value Definition

Answer 1

EV = measure of shareholders value in an insurer = Current value of freely distributable surplus + PV of existing business future DE

EV = measurement of value that SH own in an insurance enterprise

uses of EV:

• justify stock prices and acquisition purchase price
• performance measurements for executive comp
• profit analysis for LOB
• assessment of returns for capital allocation

Question 2

EV vs AAV

Answer 2

• AAV includes contribution of future NB, EV does not
• AAV discount rate is higher than EV
• Expense assumptions in EV are more company specific, AAV reflects general market sentiment

Question 3

EV components and formulas

Answer 3

-EV = Adjusted Net Worth + inforce business value

Adjusted Net Worth (ANW)
ANW = RC + Free Surplus (FS)
-excludes intangible assets
-the entire ANW is not distributable since it includes RC
Valuing ANW:
1. Literal approach: only FS is marked to market and tax effected
2. Practical approach: entire ANW is marked to market

Inforce business value (IBV)

• IBV = PVBP - PV(CoC)
• BP = Surplus(t) - Surplus(t-1) * (1+i)
• BP = growth in surplus other than from IR earned
• CoC = RC (t-1) * (hurdle - i(t))

CAPM cost of equity = rfr+ B * (RM - rfr)
-rm = expected return rate (ex SP 500)
-RM - RF = market risk premium
B = Measure of relative rise of a company’s stock to that market
-B = Cov(company stock, market return) / var(market return)

Recognizing debt in the CoC;
RDRwacc = e* (E / (E+D)) + d * (D / (E + D))

DE = Stat AT income - increase in RC

Question 4

EV assumptions: economic vs non economic

Answer 4

Non economic assumptions - relate to existing and future operating environment of the company.

• ex: PH behaviors, mortality rates, interest crediting strategies
• combination of company and industry data
• expenses rely on company data

Economic assumptions - relate to existing and future economic environment

• ex: IR, asset default rate, credit spreads, inflation
• based on management best estimates
• investment returns = actual asset portfolio performance - investment expenses and expected defaults

RDR = Hurdle = rfr + risk margin
2 approaches for RDR to reflect the cost of debt:
1. top down approach: group WACC
2. Bottom up approach: product specific WACC
-reflect risks in each product group
-product specific betas

Question 5

MCEV

Answer 5

total value of financial options/gts= Intrinsic value + TVOG

• intrinsic value = O/G value assuming the current ITM level does not change in the future
• TVOG = Deterministic PVDE - Mean Stochastic PVDE

EV w/ TVOG = Deterministic EV - TVOG
-products with a TVOG component: GMxBs, UL & fixed def annuities w/ gtd min crediting rates, options and floors in EIA contracts, ULSG, CMO

Question 6

Analysis of movement

Answer 6

• reconciliation between opening and closing EV that allocates the total change into various categories:
  1. contribution from new business
  2. Contribution from inforce business
  3. contribution from free surplus
• portion of ANW that is not required to support in force business
• Contribution = FS(t-1) * i(t)
  4. capital movements
  5. other (ex forex)

Question 7

EV disclosure and guidance issues

Answer 7

criticism of EV:

• susceptible to manipulation
• not useful for comparing across different companies
• Challenging to compare EV within a company over time if the observer doesnt understand all the changes

disclose:

• key assumptions
• how key assumptions were determined
• methodologies
• reconciliation of opening to closing EV
• analysis of change in FS
• sensitivity to key assumptions