Objective 2 (A): Actuarial Appraisals

Question 1

Challenges in determining the value of an insurance company (9)

Answer 1

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

Question 2

Techniques used by investment bankers to determine the value of a company (3)

Answer 2

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)

Question 3

Formulas for using a discounted cash flow analysis in an actuarial appraisal (4)

Answer 3

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

Question 4

Components of the actuarial appraisal value (3)

Answer 4

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
2) The value of inforce business - this equals the present value of future profits arising from business that is on the 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.

Question 5

Uses of an actuarial appraisal (4)

Answer 5

1) Help value the company - potential buyers will make adjustments based on their internal views
2) Form the basis 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

Question 6

Adjustments to the actuarial appraisal made by potential buyers (5)

Answer 6

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 values - 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

Question 7

Assumptions needed for actuarial appraisals (8)

Answer 7

1) Mortality - typically based on the 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

Question 8

Components of the adjusted book value (or net worth) of an insurance company (7)

Answer 8

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 realizable 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

Question 9

Approaches for using reinsurance to sell a block of business (3)

Answer 9

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, expect that the assets backing the liabilities remain with the selling company

Question 10

The major objectives of mergers and acquisitions (M+A) due diligence (5)

Answer 10

1) Confirm strategic value: Successful M+A bids create more value after acquisition than existed prior.
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 operation findings into financial values
4) Construct appropriate bid
5) Prepare for successful integration

Question 11

Examples of value-added strategies used during M+A (5)

Answer 11

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

Question 12

The seller’s functional areas examined during the due diligence of M+A operations (12)

Answer 12

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 of hidden liabilities
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
8) Product management: affirm what the target’s practices are and plan how they will be integrated
9) Claims: operational review includes claim intake, validation, and settlement
10) Reinsurance: Identify the overall exposure to certain risks to make sure that the combined entity does not end up with more risk than desired
11) Risk management: if the targets 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

Question 13

Sources of information to be used by an actuary to quantify assumptions used in an actuarial appraisal (4)

Answer 13

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

Question 14

Areas for actuarial due diligence in life and health (5)

Answer 14

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

Question 15

Reason for review of experience reports during actuarial due diligence (4)

Answer 15

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

Question 16

Due diligence issues to explore when validating the model that underlies the seller’s appraisal (10)

Answer 16

Used as the first step in developing the buyer’s 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 statements
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”

8) 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

9) A comparison across the different sets of assumptions above may highlight key issues that are worth further review
10) The last step in determining appropriate buyer’s appraisal assumptions is to compare against external industry benchmarks, which is particularly important for group products.

Question 17

Description and formula for embedded value

Answer 17

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

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 non-admitted assets that have realizable value.
b) In-force business value (IBV)

Question 18

Uses of embedded value (4)

Answer 18

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

Question 19

Ways in which embedded value differs from actuarial appraisals (4)

Answer 19

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

Question 20

Formulas for in-force business (IBV) and value of new business (VNB) (5)

Answer 20

1) IBV = PVBP - PVCoC
a) Both present values are computed with best-estimate assumptions and are discounted to the valuation date at a risk discount rate (RDR)
b) 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 formula 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 value 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+i(t)), 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) CoC(t) = RC(t-1) * (RDR - i(t)) when there is no debt financing or debt is reflected implicitly in the RDR
c) CoC(t) = [(RC(t-1) - D(t-1)) * (RDR - i(t))] + [D(t-1) * (d(t) - i(t))] 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

Question 21

Categories of assumptions used in calculating EV (2)

Answer 21

The assumptions used should be best estimate assumptions

1) Non-economic 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 and 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 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 - 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 non-economic components

Question 22

Ways in which financial options and guarantees are reflected in EV (2)

Answer 22

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)

Question 23

Description and categories for an analysis of movement in EV (2)

Answer 23

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 form in-force business
c) Contribution from free surplus
d) Capital movements
e) Other (e.g., foreign currency changes

Question 24

Formulas for expected contribution (EC) to EV from new and in-force business and free surplus (3)

Answer 24

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)

Question 25

Formulas for expected IBV and net income (NI) (3)

Answer 25

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 ENI(t) = (NB)ENI(t) + (IFB)ENI(t)

Question 26

Approaches for analyzing the impact of individual assumptions on IBV and NI (2)

Answer 26

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

Question 27

Formulas for analyzing the aggregate contribution (AC) to value (3)

Answer 27

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

Question 28

Calculation of effective EV rate (4)

Answer 28

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) represents the adjusted increase in EV during year t
b) EV(t-1) = IBV(t-1) + 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).

Question 29

Recommendations by the CFO Forum of items to disclose in EV reporting (6, 7)

Answer 29

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

Question 30

Formulas for calculating embedded value for a block of business (2)

Answer 30

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

Question 31

ASOP #19 - Appraisals of Casualty, Health, and Life Insurance Businesses

Recommended practices for performing actuarial appraisals (6)

Answer 31

1) 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
2) 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
3) Consider displaying appraisal values using several discount rates
4) Perform validation tests to determine whether the model reasonably reproduces results
5) Address the sensitivities of the appraisal value to changes in key assumptions
6) Provide documentation in sufficient detail that another actuary qualified in the same practice area can evaluate the reasonableness of the work

Question 32

ASOP #19 - Appraisals of Casualty, Health, and Life Insurance Businesses

Items included in an actuarial appraisal report (17)

Answer 32

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 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 in the same practice area could 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