Objective 3 Flashcards
Circumstances that lead to a proper fit between a seller and a buyer of a block of insurance
- Non-core busines
- High admin costs
- Poor management
- Seller’s reputation
- Conservative reserves
- Regulatory fire sales
The role of the actuary in the merger and acquisition process
- Active member of due diligence review team
- Interviewing management
- Interfacing with regulators, reinsurers, investors
- Acting as a general advisor to management regarding m and a process
- Creating an actuarial appraisal
Code of Professional Conduct criteria for an actuary to perform appraisal services
- Actuary’s ability to act fairly is unimpaired
- Disclosure of any conflict to all principals whose interest would be affected
- All such principals have expressly agreed to performance of the actuarial services by the actuary
Steps for calculating the value of in force business
- Develop a projection model (windshield, intermediate detail, or full-blown)
- Determine starting in force values (reflect impact of actions already taken)
- Create set of assumptions reflecting reasonable expectations
- Project
Items included in the actuarial appraisal report, in accordance with ASOP 19
- Scope and intended use
- Reliances and limitations
- Description of business being valued
- Actuarial appraisal value
- Methodology and assumptions
- Validation techniques and results
- Adjustments made when valuing net worth
- How federal income taxes were considered
- Annual projection results
- Any deviations from ASOPs
Challenges in determining the value of an insurance company
- Long duration of liabilities
- Sensitivity to interest rate fluctuations and performance of capital markets
- Subjective art of loss reserving
- Cyclical nature of insurance
- Impact of reinsurance recoverables
- Challenges associated with non-market competitors (i.e. state funds)
- Varying state and sometimes federal regulations
- Impact of statutory accounting on operational decisions
- Influence of rating agencies
Techniques used by investment bankers to determine the value of a company
- Comparable company analysis
- Comparable transaction analysis
- Discounted cash flow analysis
Formulas for using a discounted cash flow analysis in an actuarial appraisal
- Act. appraisal is a discountet cash flow analysis
- Actuarial appraisal value = PV (distributable cash flows)
- Distributable cash flow = after-tax earnings - increase in required capital
- Discount rate is WACC from CAPM
Normal formulas for r_E and WACC
Components of the actuarial appraisal value
- Adjusted book value
- Value of in force business (adjusted for cost of capital)
- Value of future business capacity (adjusted for cost of capital)
Uses of an actuarial appraisal
- Help value the company
- Form basis for alt. accounting methods for cross-border transactions
- Adjusted to calculate pro forma earnings and establish opening purchase GAAP bal sht
- Measure ongoing performance after acquisition
Assumptions needed for actuarial appraisals
- Mortality
- Morbidity
- Persistency
- Investment returns and spreads
- Operating expenses
- Discount rate
- Cost of required capital
- Taxes
Components of the adjusted book value of an insurance company
- Capital and surplus
- Asset valuation reserve
- Interest maintenance reserve
- Deferred tax asset
- Non-admitted assets
- Surplus notes and other debt
- Mark-to-market on assets allocated to adjusted book value
- Adjustments to assets the user values differently
- Adjustments to liabilities the user values differently
Approaches for using reinsurance to sell a block of business
- Assumption reinsurance
- Indemnity coinsurance
- Modified coinsurance
Techniques for estimating property and casualty loss reserves
- Loss development
- Expected loss
a) Expected loss = forecasted exposure * expected ultimate loss rate
b) Expected loss = earned premium * expected loss ratio - Bornhuetter-Ferguson method: for each accident year,
Reserve = [1 - (1 / PLDF) ] * expected loss
where PLDF is from loss development (1) and expected loss is from (2)
Diagnostic tools for evaluating claim reserve estimates
- Assessing the convergence of various loss reserving techniques
- Analyzing various reserving statistics (i.e. dev triangles of settlement rates, dev patterns of avg size claim)
- Testing runoff of prior reserve estimates
Formulas for market value of equity
- MV(E) = MV(A) - MV(L)
2. MV(E) = FV + MV(TA) - PV(L) + PO
Formulas for calculating embedded value (for a block of business, or the company as a whole)
For a block of business:
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
For the company as a whole:
1. Embedded value = PV after-tax profits + cost of capital + tied capital + free capital
Uses of embedded value for a block of business
- To set a value on the block for sale or purchase
- As part of the calculation of the value of the company. Would also include value of future new business
- To ensure that new business sold is generating an increase in value
- To determine compensation for sales staff
- To measure the impact of specific management actions on long-term value of company
Definition of embedded value
- Calculation of the value of a block of business, based on the present value of surplus distributable to shareholders
- Based on current in-force business only
- Equals the value of in force business plus the value of free capital (in excess of regulatory capital requirements)
Formulas for calculating embedded value for a company
Two methods are equivalent. PV discounted using hurdle rate.
- Profits to shareholders method
a) Embedded value = free capital + PV (profits to shareholders)
b) Profits to shareholders = after-tax profits + after-tax investment income on capital - increase in locked-in capital
c) After-tax profit = premiums + investment income - benefits - expenses - increase in statutory reserve - tax on income
d) Tax on income = Tax rate * (premiums + investment income - benefits - expenses - increase in tax reserve) - Cost of capital method
a) Embedded value = free capital + locked-in capital + PV (after-tax profits) - PV (cost of capital)
b) Cost of capital = h * locked-in capital - after-tax investment income on capital
Formulas illustrating the change in embedded value over time
- Embedded value (t+1) = embedded value (t) + normal increase in embedded value + value added by new sales - dividends paid + unexpected change in embedded value
- Normal increase in embedded value = (embedded value (t) - free capital) * (1+h) + free capital (1 + i), where i is the after-tax investment income rate
- Value added by new sales = PV (future after-tax profits on new sales) - PV (future cost of capital to support those sales)
- An unexpected change in embedded value could occur for various reasons, such as actual experience differing from expected, change in an embedded value assumption, or capital injection
