Other Lists

Question 1

Challenges in valuations for group life and health business

Answer 1

1. Group insurance encompasses different lines of business with different features
2. There is a wide variety of benefits and financial arrangements
3. For groups beyond a certain size, contracts are usually customized and contain side agreements
4. Record keeping and administration practices for third party administrators do not always meet the actuary’s needs
5. Statutory experience refund reserves may not equal the group’s surplus due to a difference in valuation bases
6. There is a wide variety of benefit types, contract provisions, and rating practices
7. Group contracts are traditionally short term, but some liabilities may be long term
8. There are often data issues

CIA Note

Question 2

Considerations in assessing trends in disability termination rates

Answer 2

1. Changes in the mix of disabilities by cause, by severity, or by geographical region
2. Changes in the level of benefits provided
3. Changes in claim administration practices
4. Economic cycles
5. Material change in inflation or benefit indexation
6. Changes in government plan definition of disability

CIA Note

Question 3

Common types of reinsurance for group life and health business

Answer 3

1. Coinsurance: the insurer cedes a portion of the business to one or more reinsurers. Each reinsurer holds the policy liabilities on its portion of the business
2. Modified coinsurance: the insurer cedes a portion of the liabilities to other insurers, but retains the assets backing the policy liabilities (as an amount owing to reinsurers)
3. Excess of risk reinsurance: the coverage of amounts above the insurer’s retention limit is ceded to a reinsurer who hold policy liabilities related to the coverage

CIA Note

Question 4

Principles for determining premium deficiency reserves

Answer 4

According to the American Academy of Actuaries PDR work group

1. Simulations that result in a PDR being established include:
   - A block of business expected to have near-term losses
   - A block of business expected to be profitable in the near term, but long-term guarantees will cause it to be unprofitable over the projection period
2. Should minimize false positives: no PDR should be required unless there is a meaningful potential for loss
3. Should minimize false negatives: a PDR should be required whenever there is an expectation for loss

Premium Deficiency Reserves Discussion`

Question 5

Contract groupings for PDR calculations

Answer 5

1. The process of grouping contracts consists of two levels:
   - The testing level is the minimum level at which financial projections are performed. The focus is on how to group contracts so that projections will provide meaningful and credible results
   - The reporting level is based on how management combines the testing level results for external reporting purposes. Contracts should be grouped in a manner consistent with how policies are marketed, serviced, and measured
2. Deficiencies on a product can be offset by profits on other products within its group, but not by profits in other contract groupings
3. The recommended groupings from the Health Reserves Guidance Manual are:
   - Comprehensive major medical
   - LTC
   - Income protection (disability income)
   - Limited benefit plans

Premium Deficiency Reserves Discussion

Question 6

Factors that affect how contracts are grouped at the testing level for determining a PDR

Answer 6

1. Materiality of a group relative to the size of the whole reporting entity
2. Similarity of product types
3. Differences in marketing methods
4. Potential rate restrictions
5. Geographical rating areas
6. Length of rate guarantee periods
7. Regulatory requirements
8. Line of business (individual vs group)
9. Case size within group business
10. Expected future growth or decline of a possible grouping

Premium Deficiency Reserves Discussion

Question 7

Statements the actuary must make in the Statement of Actuarial Opinion for the health annual statement

Answer 7

1. The liabilities are in accordance with accepted actuarial standards
2. The liabilities are based on appropriate actuarial assumptions
3. The liabilities meet the requirements of the laws of the state of domicile
4. The liabilities make good and sufficient provision for all unpaid claims and other actuarial liabilities
5. Liabilities are computed based on assumptions that are consistent with the prior year’s assumptions
6. Liabilities include appropriate provision for all actuarial items that out to be established

Statement of Actuarial Opinion for Health Annual Statement

Question 8

Approaches for signing the Statement of Actuarial Opinion when reserves are too high or too low

Answer 8

1. Issue a qualified opinion: be straightforward in laying out the concerns and then state the actuarial opinion with those exceptions noted
2. Convince management to change the reserves to an appropriate level
3. If other options fail, notify management that you must sign an opinion stating that reserves are inadequate (you may lose your job as a result)

Statement of Actuarial Opinion for Health Annual Statement

Question 9

Uses of health insurance financial models

Answer 9

1. Pricing: financial and sales models are used to determine premiums
2. Reserve calculations and reserve basis evaluations: some reserves (such as gross premium reserves) are calculated by forecasting models
3. Monitoring of results: to validate assumptions, to warn of deviations from expected values, and for resource planning
4. Solvency testing: may indicate a need for gross premium reserves
5. Financial forecasting: corporations forecast results for various reasons
6. Actuarial appraisals: these are studies of the value of a block of business, typically used when transferring ownership

Leida Ch 8

Question 10

Essential characteristics of a good model

Answer 10

1. Reliable accuracy: a model must be good at predicting the future. It must also be robust
2. Suitability for use: the model should produce the results it is designed for, without adding unnecessary complications
3. Appropriate precision: this relates to how many decimal places should be kept in the values
4. Sensibility: the model should reflect a logical construction of what is being modeled. It should also be theoretically sound
5. Effectively communicated: this includes communicating everything necessary to understand and use the model’s results

Leida Ch 8

Question 11

Steps in building a forecasting model

Answer 11

1. Choosing the basic structure of the model
   - Tools used include spreadsheets, database models, and sequential programs
   - Model types include asset share models, reserve development models, and agent-based models
2. Choosing the information to be carried: the information needed will depend on the purpose of the model
3. Choosing assumptions and building a prototype projection
   - Starting values and assumptions must be built into the model
   - A prototype cell is defined, and then projected to the end of the forecast period
4. Extending the prototype: after the prototype cell is built, the model must be extended to other cells which represent the different subsets of the business being modeled
5. Validating the model
6. Documenting the model: this allows the model to be evaluated by other professionals, and makes it easier to make modifications
7. Designing output and communicating results: the model output can be useless unless it is put into the context of the question being asked

Leida Ch 8

Question 12

Methods for validating forecast models

Answer 12

1. Starting values are compared directly to the actual values for that year
2. Year to year changes in the model are compared to actual past historical results
3. Model results are checked for reasonableness by people familiar with the business
4. Stress testing: analyze how the modeled results behave when some of the underlying assumptions are changed (incl. sensitivity testing)

Leida Ch 8

Question 13

Assumptions needed for forecasting

Answer 13

1. Lapse assumptions: lapse rates vary widely by product, duration, company, and member or policy characteristics. They are generally highest in the first year, and then decrease thereafter
2. Mortality: some models treat mortality as a separate decrement, but most models combine mortality and lapses (because mortality is a minor assumption for health insurance)
3. Claim costs: it is best to use actual experience when possible. Trend assumptions are needed for determining future claim costs
4. Expense assumptions: expenses are usually expressed on a per unit basis (such as per policy or a percentage of premium or claims)
5. Profit assumptions: profits can be measured as an ROI, an ROE, or a percentage of premium
6. Model office assumptions: these assumptions define the proportion of the block of business that is represented by each model cell

Leida Ch 8

Question 14

ASOP considerations for estimating incurred claims

Answer 14

1. Health benefit plan provisions and business practices: reflect provisions and practices that materially affect the cost, frequency, or severity of claims
2. Economic and other external influences: such as unemployment levels, cost shifting, and catastrophic events
3. Behavior of claimants: consider pent-up demand for new benefits
4. Organizational claims administration: considerations include staffing levels, computer system changes, or seasonal backlogs
5. Claim seasonality: adjustments should be made for the impact of seasonality on claims
6. Credibility: consider how the credibility of the data affects the incurred claim estimates
7. Risk characteristics and organizational practices by block of business: consider the effects of marketing and underwriting on the types of risks accepted
8. Legislative requirements: consider how regulations can affect incurred claims, such as by mandating benefits or influencing rating, reserving, and underwriting practices
9. Carve outs: consider the effect of carved-out benefits on incurred claim levels
10. Special considerations for long-term products: such as cost of living adjustments, inflation protection, and integration with social insurance

ASOP #5

Question 15

ASOP procedures for analyzing incurred claims

Answer 15

1. Unpaid claims liability: use incurral and processing dates to estimate the liability for claims incurred as of the valuation date. In doing this, consider:
   - The intended purpose or use of the estimate
   - Plan provisions
   - The claim dating methods used
   - Provision for adverse deviation
   - Time value of money
   - The assumption and methodology used: these should typically be consistent with those used for estimating related liabilities
2. Categories of incurred claims: consider separate estimation of claims for each category exhibiting different lag patterns, costs, or trends
3. Reinsurance arrangements: consider their effect on estimated claims
4. Large claims: consider the effect or large claims, which includes distortions in payment patterns
5. Coordination of benefits, subrogation, and government programs: understand these items and how they are reflected in the data
6. Provider contractual arrangements: consider how these affect trends, claim cost levels, and claims processing, and consider any changes in these arrangements

ASOP #5

Question 16

Items to include in an actuarial communication subject to ASOP #5

Answer 16

1. Important dates used in the analysis, such as the incurral, processing, and valuation dates
2. Significant limitations that constrained the actuary’s analysis
3. Specific significant risks and uncertainties that could cause actual results to vary from the incurred claim estimate
4. Any explicit provisions for adverse deviation
5. The risk that provider insolvency may have a material effect on the liability
6. Any follow-up studies the actuary may have utilized in developing the incurred claim estimate
7. When updating a previous estimate, changes in assumptions, procedures, methods, or models that the actuary believes to have a material impact on the incurred claim estimate, as well as the reasons for such changes

ASOP #5

Question 17

Purposes of cash flow analysis

Answer 17

1. Determination of reserve adequacy
2. Determination of capital adequacy
3. Product development or ratemaking studies
4. Evaluation of investment strategy
5. Financial projections or forecasts
6. Actuarial appraisals
7. Testing of future benefits that may vary at the discretion of the insurer (such as dividend scales)

ASOP #7

Question 18

When to do cash flow testing

Answer 18

1. Situations where cash flow testing is needed:
   - Where there are material asset risks
   - Where there are liabilities that have cash flows far out into the future
   - Where a company has a new or rapidly growing line of business
   - Where policyholder options are likely to result in antiselection
2. Situations where cash flow testing is not needed
   - Products with short-term liabilities supported by short-term assets
   - Business that is not sensitive to changes in economic conditions or interest rates
   - If the risk being evaluated is unanticipated sources of significant claims (e.g., AIDS and asbestos)

ASOP #7

Question 19

Cash flow analysis documentation required by actuarial standards

Answer 19

1. Whether any prior analyses were relied on
2. The purpose of the analysis and the risks analyzed
3. The type of analysis performed (such as cash flow testing)
4. The results of the analysis
5. The actuary’s conclusions or recommendations
6. Any conclusions or recommendations related to sensitivity testing
7. The data, assumptions, and methods used

ASOP #7

Question 20

Methods used for asset adequacy analysis

Answer 20

1. Cash flow testing: is appropriate where cash flows of existing assets and liabilities may vary under different economic or interest-rate scenarios
2. Gross premium reserve test: may be appropriate where the policy and other liability cash flows are sensitive to moderately adverse deviations in the actuarial assumptions
3. Demonstration of extreme conservatism: when the degree of conservatism in the liabilities is so great that moderately adverse deviations are covered, then a demonstration of this conservatism is sufficient
4. Demonstration that risks are not subject to material variation: for products that have risks that are not subject to material variation, it is sufficient to demonstrate this fact and show that moderately adverse deviations are covered
5. Risk theory techniques: for products with short-term liabilities supported by short-term assets, it may be more appropriate to measure moderately adverse deviations using risk theory techniques
6. Loss ratio methods: these may be appropriate when the cash flows are of short duratiion

ASOP #22

Question 21

Considerations when forming an opinion with respect to asset adequacy

Answer 21

1. Reasonableness of results
2. Adequacy of reserves and other liabilities under moderately adverse conditions. Reserves do not need to be so great as to withstand any conceivable adverse circumstance
3. Analysis of scenario results: inadequacy in only a small percentage of scenarios does not indicate the need for additional reserves
4. Aggregation during testing: separate blocks of business should not be combined for reserve testing if their assets cannot be shared for satisfying the liabilities
5. Aggregation of results: results from separate blocks can generally be combined so that deficiencies in one business segment can be offset by sufficiencies in another segment
6. Trends: the actuary should reconcile results from prior years
7. Management action: consider anticipated actions by management to address adequacy concerns
8. Subsequent events: consider all material subsequent events that are likely to affect the analysis

ASOP #22

Question 22

Considerations for determining contract reserves

Answer 22

1. Interest rates: rates should be reasonable and consistent with the purpose of the reserve
2. Morbidity: this assumption should reflect the underlying risk, including factors such as age, gender, durational effects, and adverse selection
3. Persistency: this assumption should include both involuntary and voluntary terminations
4. Expenses: consider whether maintenance, acquisition, or claim expenses should be included
5. Trend: inflation, utilization, morbidity, and expense rates should reflect the appropriate trend
6. Premium rate changes: assumptions for future rate changes should reflect market conditions, regulatory restrictions, and rate guarantees
7. Valuation method: when the valuation method is not prescribed, the actuary should choose an appropriate method

ASOP #42

Question 23

Considerations for determining provider-related liabilities

Answer 23

1. Risk-sharing and capitation arrangements: the nature of the arrangement should be considered when determining whether to establish a liability
2. Provider financial condition: consider whether the provider will be able to meet its obligations
3. Provider incentive payments: if an agreement with a provider calls for incentive payments, consider whether a liability should be held for those payments

ASOP #42

Question 24

Challenges in determining the value of an insurance company

Answer 24

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

GHFV-130-19

Question 25

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

Answer 25

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)

GHFV-130-19

Question 26

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

Answer 26

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

GHFV-130-19

Question 27

Components of the actuarial appraisal value

Answer 27

1. Adjusted book value: this is the net worth of the insurance company on a statutory basis, adjusted for the vaue 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
3. The value of future business capacity: this equals the PV 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

GHFV-130-19

Question 28

Uses of an actuarial appraisal

Answer 28

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

GHFV-130-19

Question 29

Adjustments to the actuarial appraisal made by potential buyers

Answer 29

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

GHFV-130-19

Question 30

Assumptions needed for actuarial appraisals

Answer 30

1. Mortality: typically based on 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

GHFV-130-19

Question 31

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

Answer 31

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

GHFV-130-19

Question 32

Approaches for using reinsurance to sell a block of business

Answer 32

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

GHFV-130-19

Question 33

The major objectives of mergers and acquisitions due diligence

Answer 33

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 operational findings into financial values
4. Construct appropriate bid
5. Prepare for successful integration

GHFV-131-19

Question 34

Examples of value-added strategies used during M&A

Answer 34

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

GHFV-131-19

Question 35

The seller’s functional areas examined during the due diligence process of M&A operations

Answer 35

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 or hidden liabilitties
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
11. Risk management: if the target’s 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

GHFV-131-19

Question 36

Matters reviewed by the legal and compliance due diligence team during a M&A process

Answer 36

1. Proper formation and authorization of the target
2. Corporate structure and ownership of subsidiaries
3. Existence of prior acquisitions
4. Compliance with applicable laws, including but not limited to: securities, tax, and insurance laws
5. The results from the most recent market conduct exam and financial examinations
6. In the case of life insurance companies, compliance of products with statutory and tax requirements
7. In the case of reinsurance companies, compliance with state laws and regulations with respect to giving to receiving credit for reinsurance
8. In the case of property casualty companies, the types of risks covered by contract forms
9. Exposure to regulatory problems or lawsuits
10. Material financing arrangements and any defaults there under
11. Ownership of assets, including but not limited to intellectual property and real property
12. Employee liabilities
13. Other material contracts or agreements of any type

GHFV-131-19

Question 37

The required due diligence steps to review from the target’s personnel, compensation, and benefits

Answer 37

1. Schedules of personnel by function, salary, job grade; also, turnover and hiring plans
2. Employment contracts, severance policies, special severance agreements, stock options, bonus plans, loans to staff, etc.
3. Health, disability, retirement, and other benefit programs; retirement pension and health liabilities; benefits budgets and projections
4. Benefits administration systems, use of vendors or consultants
5. Comparison of seller’s benefits to buyer’s benefits, integration plans, and potential costs
6. Potential liabilities that may be triggered by the transaction
7. Whether any pension or health liabilities are underfunded
8. Any cultural differences that need to be addressed

GHFV-131-19

Question 38

Product management key considerations in the due diligence process for life and annuity coverages

Answer 38

1. Review underwriting philosophy and practice to determine if the formal guidelines are liberal or conservative
2. The target’s handling of changes made to inforce policies must be ascertained
3. Allocation of costs for corporate functions and external company-wide capital
4. The target’s profit goals (may vary by product or market)
5. The quality of the target’s relationship with their reinsurers, if applicable
6. Confirm claims adjudication processes are appropriate for the product line
7. The target’s policyholder management mechanisms should be identified
8. Distribution channels: agents’ and policyholders’ reaction to the change of ownership should be estimated

GHFV-131-19

Question 39

Strategic and operational issues considered during the due diligence check of target’s reinsurance

Answer 39

1. Functions that the reinsurer is responsible for managing, but in which the target company is at risk:
   - Asset management
   - Policy administration
   - Claims management
   - Underwriting
2. Ascertain the retention levels, rights, and options of the target compnay
3. Identify the effect of reinsurance on the combined entity
4. Identify the overall exposure to certain risks to make sure that the combined entity does not end up with more risk than desired

GHFV-131-19

Question 40

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

Answer 40

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

GHFV-131-19

Question 41

Areas for actuarial due diligence in life and health

Answer 41

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

GHFV-131-19

Question 42

Actuarial components of balance sheet to be reviewed during due diligence

Answer 42

1. Reserve adequacy or margins
2. Statutory reserve methodology
3. Tax reserve methodology
4. Adjusted net worth

GHFV-131-19

Question 43

Patterns in income statements to be reviewed during due diligence

Answer 43

1. Fluctuations in earnings can indicate unusual volatility or exposures
2. Recent earnings used to initiate projections may not represent long-term trends
3. Nonrecurring adjustments to earnings can be cause for concern of integrity of internal accounting/ actuarial practices or controls

GHFV-131-19

Question 44

Earnings analyses and management metrics a seller will use to manage its business

Answer 44

1. Breakdowns of earnings to product or line of business
2. Explanations of earnings (pricing) variances in terms of operations (claims frequency and severity)
3. Patterns of key indicators over time (actual to expected mortality or lapse)
4. Embedded value (EV) statements, especially change in EV and associated explanations
5. Deferred acquisition cost (DAC) recoverability testing

GHFV-131-19

Question 45

Reason for review of experience reports during actuarial due diligence

Answer 45

1. Reports are used as the primary basis for assumptions underlying the sellers’ 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

GHFV-131-19

Question 46

Operations areas from which the actuary will identify the quality of methodologies, assumptions, and practices

Answer 46

1. Pricing and profitability management
2. Product development, including coordination with underwriting and sales
3. Valuation
4. Business plans
5. Setting non-guaranteed elements
6. Experience monitoring

GHFV-131-19

Question 47

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

Answer 47

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 assumptiosn to the following:
   - Business plan assumptions
   - Pricing assumptions
   - Cash flow testing assumptions
   - US GAAP FAS 97 assumptions
   - 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

GHFV-131-19

Question 48

Issues to be reviewed because of requirements imposed by Sarbanes-Oxley

Answer 48

1. Assessing internal audit functions
2. Reviewing risk management policies and practices
3. Reviewing any relevant audit committee comments or concerns
4. Reviewing the use of estimates for reserves or actuarial liabilities
5. Reviewing potential contingent liabilities
6. Assessing data quality and internal controls

GHFV-131-19

Question 49

Description and formula for embedded value

Answer 49

1. Embedded value (EV) is:
   - 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
   - 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
2. EV = ANW + IBV
   - 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 nonadmitted assets that have realizable value

Embedded Value: Practice and Theory

Question 50

Uses of embedded value

Answer 50

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

Embedded Value: Practice and Theory

Question 51

Ways in which embedded value differs from actuarial appraisals

Answer 51

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.

Embedded Value: Practice and Theory

Question 52

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

Answer 52

1. IBV = PVBP - PVCoC. Both present values are computed with best-estimate assumptions and are discounted to the valuation date at a risk discount rate (RDR)
   - 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
   - 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
   - BPt = Surplust - Surplust-1 * (1 + it) where i represents the after-tax reate 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
   - 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
   - CostofCapitalt = RCt-1 * (RDR - it) when there is no debt financing or debt is reflected implicitly in the RDR
   - CostofCapitalt = [(RCt-1 - Dt-1) * (RDR - it)] + Dt-1 * (dt - it)] when a portion of RC is funded with debt (D) and the cost of debt (d) is not implicitly included in RDR, but is explicitly reflected in this formula instead
5. IBV is different than the present value of distributable earnings (PVDE) used in acquisitions
   - PVDE = IBV + RC when there is no debt financing or debt is reflecting implicitly in the RDR
   k- PVDE = IBV + (RC - D) when there is explicit recognition of debt

Embedded Value: Practice and Theory

Question 53

Categories of assumptions used in calculating EV

Answer 53

The assumptions used should be best estimate assumptions

1. Noneconomic assumptions: these should be based on the specific circumstances of the company or the business for which EV is being calculated
   - Policyholder behavior
   - Interest-crediting strategies
   - Mortality and morbidity: companies typically credibility weight their own experience with industry data. Mortality improvements should also be reflected
   - Persistency: rates typically rely more on company-specific data than on industry data. Rates are generally set by both product type and duration
   - Expenses: these also rely more on company-specific data than on industry data. All types of expenses should be reflected in EV calculation. It is common to reflect expense inflation
   - 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
   - Interest rates
   - Asset default rates
   - Inflation rates
   - Investment returnd
   - 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

Embedded Value: Practice and Theory

Question 54

Ways in which financial options and guarantees are reflected in EV

Answer 54

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 option and guarantees given the potential changes in financial markets to increase or decrease their value before they expire
   - Products that typically require valuations of TVFOG include variable annuities, variable universal life insurance policies, and policies that guarantee minimum crediting rates
   - 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)

Embedded Value: Practice and Theory

Question 55

Description and categories for an analysis of movement in EV

Answer 55

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

Embedded Value: Practice and Theory

Question 56

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

Answer 56

NB = new business, IFB = in-force business, and FS = free surplus

• nbECt = VNBt * (1 + RDR)^.5. VNB is calculated using beginning of period assumptions and assuming all new business is written in the middle of the year
  2. ifbECt = (IBVt-1 + RCt-1) * RDR
  3. fsECt = FSt-1 * it

Embedded Value: Practice and Theory

Question 57

Formulas for expected IBV and net income (NI)

Answer 57

1. EIBV = expected ending IBV
   - nbEIBVt = VNBt * (1 + RDR)^.5 - nbBPt
   - ifbEIBVt = [IBVt-1 * (1 + RDR)] - ifbBP + [(RDR - it)*RCt-1]
2. ENI = expected net income
   - nbENIt = nbBPt
   - ifbENIt = ifbBPt + (it * RCt-1)
   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
   - Targ IBVt = nbEIBVt + ifbEIBVt
   - Targ NIt = nbENIt + ifbENIt = nbBPt + ifbBPt + (it * RCt-1)

Embedded Value: Practice and Theory

Question 58

Approaches for analyzing the impact of individual assumptions IBV and NI

Answer 58

This is difficult because not all assumptions are independent. THe basic approaches for dealing with the interaction of assumptions are:

1. Independent assumptions changes with model resets
   - A modeled assumption is replaced with corresponding actual experience. The resulting change in IBV and NI is then attributed to the assumption
   - This is then done for each assumption individually, resetting the model before each assumption
   - 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
   - Assumptions are again modeled one at a time. But the revised model is not reset after an assumption is analyzed
   - The impact assigned to subsequent assumptions is only the additional impact caused by adding that assumption

Embedded Value: Practice and Theory

Question 59

Formulas for analyzing the aggregate contribution (AC) to value

Answer 59

1. ACt =- (AdjANWt - ANWt-1) + (IBVt - IBVt-1), where AdjANW removes the impact of any investor cash flows during the period
2. ACt is compared to aggregate expected contributions (EC) for a high-level analysis of change. The aggregate EC is the sum of the EC from new business, in-force business, and free surplus
3. ECt = [VNBt * (1 +RDR)^.5] + [(IBVt-1 + RCt-1) * RDR] + [FSt-1 * it]

Embedded Value: Practice and Theory

Question 60

Calculation of effective EV rate

Answer 60

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. EffEVRatet = (ACt - VNBt)/(EVt-1 + .5*VNBt)
   - ACt represents the adjusted increase in EV during year t
   - EVt-1 = IBVt-1 + ANWt-1
4. The effective EV rate should be compared to expected RDR. If combined experience variations and prospective assumption changes produce a net decrease in value, the effective EV rate would be less than the RDR (and vice versa)

Embedded Value: Practice and Theory

Question 61

Recommendations by the CFO Forum of items to disclose in EV reporting

Answer 61

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:
   - 100 basis point increase in the RDR
   - 100 basis point reduction in the interest rate environment
   - 10% decrease in equity or property values
   - 100 basis point increase in yield on equities or property
   - 10% decrease in maintenance expenses
   - 10% decrease in lapse rates
   - 5% decrease in mortality and morbidity rates

Embedded Value: Practice and Theory

Question 62

Formulas for calculating embedded value

Answer 62

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

GHFV-133-19

Question 63

Recommended practices for performing actuarial appraisals

Answer 63

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

1. When setting assumptions:
   - Consider historical experience, adjusted for trend and known environmental changes
   - Ensure that each set of assumptions used is internally consistent
   - Consider the circumstances, needs, and strategies of the intended audience
2. Consider displaying appraisal values using several discount rates
3. Perform validation tests to determine whether the model reasonably reproduces results
4. Address the sensitivities of the appraisal value to change in key assumptions
5. Provide documentation in sufficient detail that another actuary qualified in the same practice area can evaluate the reasonableness of the work

ASOP #19

Question 64

Items included in an actuarial appraisal report

Answer 64

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 results of the model validation
10. A discussion of the level of capital reflected in the appraisal and how this level was determined
11. The assumptions, described in sufficient detail that another actuary qualified in the same practice area could evaluate their reasonableness
12. The source of any assumption selected by someone other than the actuary
13. The extent to which taxes have been considered and on what basis
14. Any sensitivity testing results deemed material by the actuary
15. The source and extent of reliance on information supplied by others
16. Disclosures in accordance with ASOP #41, if applicable

ASOP #19