D.2 EVA/RAROC vs MCEV earnings

Question 1

definitions: EVA, MVA, RAROC, franchise value and how they relate

Answer 1

EVA = annual accounting profit in excess of required return on capital = (ROC - COC) * Capital

MVA = Market value added = positive when value for shareholders has been added
= Market Value - Capital

RAROC = return on risk using a risk adjusted capital
= NOPAT / Risk adj capital
NOPAT = net operating profit after tax
-difficult to calculate RAROC on a LOB because it is challenging to allocated capital to a single business

Franchise value = MV of the company in excess of the GAAP BV of equity
= MV of equity - BV of equity
MV of equity = PV of all future dividends to shareholders

Question 2

Definition of MCEV

Answer 2

MCEV = discounted CF measure 
MCEV = NAV + VIF

appraisal value = MCEV + Goodwill

MCEV = VIF + RC + FS
VIF = PVFP - TVOG - FCRC - CRNHR

Question 3

analysis of movement in MCEV

Answer 3

Closing MCEV = 
Opening MCEV
\+ Opening Adj
\+ NB Value
\+ Unwinding MCEV
\+ Operating Variances
\+ Economic Variances
\+ Closing adjustments

• unwinding of MCEV = expected contribution of existing business: earnings, II, release of profits and RC into FS
• operating variance = experience variances + impact of experience assumption changes
• Economic variance impact of changes in economic factors

Question 4

Net value created NVC

Answer 4

NVC = change in entity value in excess of change required by shareholders
NVC = total MCEV earnings - MCEV unwinding

• NVC measures the excess MCEV over the unwinding of existing business
• NVC is made up of EVA + excess return on unrecorded franchise value

Question 5

EVA vs MCEV differences

Answer 5

insurers create value when RAROC > COC
- or when EVA > 0

RAROC = NOPAT / RA capital = EVA / RA Capital + COC

differences:

1. discount rates:
   - MVA uses hurdle
   - VIF uses rfr
2. cost of capital
   - MVA = based on NAV
   - VIF = based on solvency capital requirements under solvency ii
3. Projection horizon
   - MVA: shorter projection horizon and needs a terminal value after time T
   - VIF projects all CFs until complete settlement
4. Future NB
   - MVA includes future NB CFs in NOPAT
   - VIF doesnt include NB
5. Frictional costs
   - VIF accounts for FCRC
   - MVA does not

-NVC captures change in franchise value from unwinding business, this is ignored by traditional accounting based measures

similarities:

1. both reduce accounting bias - bring accounting based performances in line with market based measures
2. both can be traced back to residual valuation theory