Robert J Sharkey - Canadian Institute of Actuaries LInstitut by Levone


									       Canadian             L’Institut
        Institute           canadien
               of           des
       Actuaries            actuaires
    2007 Annual Meeting ● Assemblée annuelle 2007
Assemblée annuelle 2007
  2007 Annual Meeting

                          Embedded Value and Value of New
                           CIA Presentation, June 29, 2007

                                            Bob Sharkey
                                   Sun Life Financial Inc.
                          Embedded Value and Value of New
Assemblée annuelle 2007   Business
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                            –   Problems with Book Equity, Income and Return on Equity (ROE)

                            –   Embedded Value (EV) and Value of New Business (VNB)

                            –   Significance of EV to Management, Analysts and Shareholders

                            –   EV Methodology Considerations

                            –   VNB Methodology Considerations

                            –   Measures of Product Profitability

                            –   VNB and Earnings

                          GAAP Book Equity Not Always A Good
                          Value Measure
                            –   “BE” is not always a good measure of value. There is no
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                                necessary link between historical accumulation of retained
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                                capital & a company’s value.
                            –   BE of regulated financial intermediaries is driven by regulatory
                                and rating agency solvency capital requirements. Thus BE
                                relates to in-force risk rather than to value or the working capital
                                required to carry on business.
                            –   At acquisition Insurance company P/B ratios often exceed 2,
                                which means that BE captures less than 50% of the perceived
                            –   Liabilities include prudential margins: not “best estimate” or “fair
                                value”. Not all assets are at market.
                            –   BE does not adequately measure:
                                 • Value created in prior years that will emerge as future income.
                                 • Value created by new sales over their product lifetime.
                                 • Value creation capacity of the company.
                                 • Value of Intangible assets.
                                 • Value of future sales.
                                 • Value impact of mergers, acquisitions and structural, operational and
                                   environmental changes.

                          GAAP Income Not Always a Good Measure
                          of Value Creation (The Black Box)
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                            Stock prices life insurers discounted because GAAP Income is:
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                               •   A black box obscured by arcane actuarial and accounting practices.
                               •   Historical rather than forward looking. Dominated by income generated
                                   from sales in prior years.
                               •   Accounted for differently from other sectors and in each jurisdiction.
                               •   Not a good basis for assessing acquisitions and divestitures.
                               •   Challenged by economic, operational and environmental changes.
                               •   Challenged by products with uneven patterns revenue & expense over
                                   life time. Can be reduced by New bus. Losses on high, value added
                               •   Challenged by cash flows subject to statistical fluctuations and future
                                   contingencies over long periods. Increased by high, value destroying
                                   policy surrenders.
                               •   Not adjusted for risk and capital costs.
                               •   Not a measure of value added by current management and new
                          ROE Not Always a Good Performance Measure

                           – ROE is supposed to measure “how effectively a company
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                             uses its investors’ money”.
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                           – ROE inherits all the problems with GAAP income and
                             Book Equity (BE) as measures of value created and value
                             deployed. Major components BE not deployable capital.
                           – ROE for new sales not connected to ROE on in-force,
                             which will dominate ROE. Poor in-force ROE can obscure
                             good ROE on sales & vice versa.
                           – Income and RC for a product can be miss-matched from
                             year to year, since RC is a point in time risk measure.
                           – Capital required & income generated by products can
                             change dramatically over long product life times.
                              • Ind. Life sales have doubly negative ROE impact. They
                                generate income losses at sale & need substantial capital.
                              • Past Individual Life sales generate quite high ROE levels.
                              • Capital requirements and the resulting ROE on products
                                with embedded options are tied to market experience and
                                can vary dramatically with markets over time.

                          Embedded Value and Value of New Business
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                             – Embedded Value (EV) and Value of New Business (VNB)
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                               address these limitations of GAAP BE, Income and ROE.
                                • EV measures the underlying value of a company.
                                •   EV and VNB capture a company’s capacity for value creation,
                                    including a means to estimate the value of future business.
                                •   The change in EV measures the value created and the
                                    analysis of this change throws light on the performance of
                                    current management.
                                •   VNB isolates & measures value created by current sales.
                                •   EV & VNB reflect capital costs over product life times.
                                •   EV reflects the “tangible” value of intangibles.
                                •   EV measures the value impact of mergers, acquisitions and
                                    structural, operational and environmental changes.

                          Appraisal Value Exceeds Embedded Value
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                           Present Value of
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                           adjusted earnings*             Value of
                           from future new               future new
                           business                       business

                          Present Value of
                          adjusted earnings*            Value of in-
                          from in-force                force business                             Appraisal
                          business                                                                 Value

                          Realizable value                Value of
                          of surplus                    shareholder
                                                         net worth

                          * Adjusted earnings equal after tax earnings less the cost
                            of solvency capital.
                          Glossary of Terms
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                              EV    =    (IBV) + (ANW).
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                              RDR =     Risk Discount Rate. After-tax, risk-adjusted rate used to discount
                                         future values. Equals a risk free rate plus a risk margin. Is the cost
                                         of equity capital.
                              RC    =   Required Capital. Surplus deemed to be required to maintain
                                         statutory solvency and capital strength.
                              NCRC (t) =     The outstanding RC in year “t” times the difference between
                                              the RDR and the after-tax return assumed to be earned on RC.
                              IBV   =   Insurance Business Value. Present Value (PV) of after-tax (book)
                                         profits expected to emerge from in-force business (PVFP), minus
                                         the PV of the NCRC for all future years. PVFP does not include
                                         income earned on surplus or required capital.
                              ANW =     Adjusted Net Worth. The realizable, tax effected market value of
                                         total capital and surplus.
                              AV    =   Appraisal Value. EV + Value of Future Business.
                              VNB   =   Value of New Business. Value includes acquisition costs.
                              Value of Future Business is often expressed as a multiple of VNB. Multiple
                               reflects growth, synergies, intangibles.

                          Significance to Management
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                             –   Value measures can profoundly impact all aspects of
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                             –   Management can link business activities and analysis and
                                 shareholder communication and disclosure to value creation.
                             –   Focus more on long term value creation rather than short term
                                 bottom line.
                             –   Value drivers inform strategic thinking, business plans and
                             –   Value measures must be integrated into key management
                                 financial reports and incentive compensation.
                             –   Value based targets and incentives align management and
                                 shareholder interests.
                             –   Used to manage product development and pricing process.
                             –   Sensitivity of EV to financial risks measures value at risk.
                             –   Allocate capital on value creation, rather than “bottom line”.
                             –   Assess mergers and acquisitions and structural changes in
                                 value terms.
                          Significance to Shareholders & Analysts

                            –   GAAP statements, E/S, P/B, ROE remain critical.
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                            –   However, EV adds a forward-looking, longer term, value
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                                creation perspective.
                            –   Change in EV provides public measure of total value creation
                                and VNB provides public measure value created by new sales.
                            –   Price to EV and new business multiples by product are
                            –   Supports value comparisons between companies within and
                                across jurisdictions. Supports value based assessments of
                                merger and acquisition activities, and cross pillar activities such
                                as bancassurance.
                            –   Canadian analysts are lukewarm to EV, unlike in Europe, where
                                EV is a key determinant of stock price. Canadian GAAP is more
                                useful to analysts than European. Canadian EV disclosure is
                                minimal, whereas European is extensive. There are few
                                Canadian insurers reporting EV and EV measurement and
                                reporting standards are minimal. The considerable effort to
                                understand EV has little payback for analysts.
                            –   Until trend lines established, disclosure enhanced and
                                methodology, assumptions and reporting standardized, EV will
                                remain secondary.
                          Significance to Shareholders & Analysts
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                            –   EV is the value of the existing business. Let (M x VNB) =
                                “franchise value”, i.e. the value of future business. Then the
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                                market capitalization MC = EV + (M x VNB). “M” is the new
                                business multiple.
                            –   Given EV and VNB can determine an “implied” “M” from MC.
                            –   Specify “M” and you can get a target stock price. If M = 15, (EV
                                + 15 x VNB) / # o/s shares = target stock price.
                            –   Judgement required to determine M. A multiple of 20 or higher
                                reflects an excellent assessment of current and future value
                                creation opportunities through sales growth. A multiple of 10 or
                                lower reflects a poor assessment.
                            –   A crude estimate of the new business multiple can be
                                determined by dividing 1 by the RDR less the expected sales
                                growth rate. Using RDR of 9% and sales growth rate of 4%
                                provides a multiple of 20 (1 divided by .05 = .09 - .04). The
                                sales growth rate can vary by product to get product specific
                                VNB multiples. Also, the sales growth rate (and the VNB per
                                dollar of sale) can vary over future periods.
                          Change in Embedded Value
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                            Start           End
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                                                          Change in EV
                                          Business       Expected return on
                                                          opening value
                                                         Value of New
                                                         Variances from
                                                          expected experience
                                         In Force
                           In Force                      Change valuation
                                                         Change prospective
                                            Net           assumptions

                                           Worth         Capital movements
                             Net                         Change in currency
                                           Dividend       and discount rates
                          Analysis of Change in EV

                           –   EV is effectively an accounting system. Thus, AOC in EV is
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                               quite similar to SOE and has similar components.
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                           –   SOE analysis is part of the AOC in EV, since the income
                               transferred to surplus is a major component of the change in the
                               value of surplus.
                           –   Usually currency (experience) and RDR (assumptions) are
                               shown separately.
                           –   AOC in EV has a capital transaction component.
                           –   The Value impact of an experience variation or basis change
                               includes the income impact, but adds the PV of the future
                               income and cost of capital impact.
                           –   Value impact of experience and assumptions can be quite
                               •   Group income impact ends at next contract renewal. Value impact
                                   ends only when the client terminates, so is many times larger.
                               •   Income impact of mutual and segregated fund performance is
                                   linked to average assets under management. However, the value
                                   impact of fund performance adds to the income impact the impact
                                   on future income of the change in AUM in the period.

                          EV and VNB Rest on Many Assumptions
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                           –   While each assumption may be reasonable, a change in
                               assumption can materially impact EV and VNB.
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                                •   Trends are perhaps more important than absolute numbers.
                                •   Important to use same method and assumptions over time.
                                •   Impact of material changes should be analyzed and reported
                                •   Method and assumptions should be grounded in financial
                                    reporting and capital markets and validated by a thorough
                                    review process.
                                •   Quality processes & controls & internal reviews are critical.
                                    External peer review ensures compliance, consistency and
                                •   Disclosure of key assumptions and their sensitivities mitigate
                                    concerns with assumptions as with GAAP income.
                                     – Sensitivity of EV and VNB to equity risk premium and capital
                                     – Redemption rates, M&E charges and unit expenses for asset
                                       management companies and segregated funds.

                          EV Considerations
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                           1. Accounting Basis
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                                 •  Regulatory after-tax income and regulatory or rating
                                    agency capital are used not GAAP after-tax income and
                                    economic capital.
                                 •  CAS / MCCSR, unless local more conservative.

                           2. Required Capital Level (150% MCCSR)
                                 •   Higher capital, such as 200% MCCSR, should be used in
                                     pricing and IRR, if required by rating agencies for rating.
                                 •   Capital level materially impacts IBV and VNB of capital
                                     intensive products. Typically, retail has high and Group
                                     Benefits, Retirement Savings are low.
                                 •   Local minimum capital requirements, such as those
                                     applicable in Asia, must be recognized.

                          EV Considerations              (cont’d)
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                          3. Adjusted Net Worth (ANW)
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                                 •  Derived from Book Equity. FIAC reduces, but does not
                                    eliminate, differences between ANW and Book Equity.
                                 •  Alternative, but equivalent, EV approach sets ANW equal
                                    to value of surplus in excess of RC and includes PV
                                    projected income on RC in IBV.
                                 •  Alternative is more complex & value of RC is based on
                                    investment income projections, rather than market values.
                                 •  Alternative is less revealing since mixes value embedded
                                    in reserves with value of earnings on RC. IBV may be
                                    more or less due to earnings on RC. Two businesses may
                                    have similar IBV, but very different values embedded in
                          4. Closed Par Accounts
                                 •  Have negative IBV equal to the net cost of RC.
                                 •  IBV of reserve margins less than the MV of assets
                                    supporting the margins.

                          EV Considerations             (cont’d)
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                            5. Risk-Adjusted Discount Rate
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                               •   Capital Asset Pricing Model used to set RDR, the equity
                                   cost of capital.
                               •   RDR = Risk Free (gov. bond) Rate (RFR) at report date plus
                                   an Equity Risk Margin (ERM).
                               •   Assume a AA rated insurer has BETA of 1 & market has
                                   Equity Risk Margin (ERM) of 3.5%, then RDR = RFR+3.5%.
                               •   Currency and country risk margin (Asia) reflected in RDR.
                               •   Varies by country. Same RDR used for all products in a
                                   country, unless higher risk product requires a higher ERM.
                               •   Higher risk products include asset management companies,
                                   variable annuities and segregated funds.
                               •   Business with a “stand-alone” BETA of 1.3 should have an
                                   ERM of 4.5% = 1.3 x 3.5%.
                               •   ERM changes have relatively less impact on short-dated
                                   products with low capital requirements such as mutual
                                   funds. Changes have a material impact on long term, capital
                                   intensive products.
                          EV Considerations                (cont’d)

                               Gross Equity Growth Rate for Policyholder Accounts
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                                •   Assumed policyholder fund gross equity growth rate cannot
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                                    exceed RDR. Fixed costs may mean RDR should exceed the
                                    policyholder fund growth rate. Necessary to avoid implication
                                    that businesses whose income is driven by equity returns are
                                    less risky than equities.
                          7.   Anticipated Productivity and Profitability Improvements
                                •   Reflected in EV only if reflected in CAS best estimate
                                    reserves or reasonably assured.
                                •   Benefits of tax effective investments and structures reflected
                                    in EV only if reflected in CAS reserves or reasonably assured.
                                •   Group and reinsurance profit margins & renewal rates for
                                    future renewals consistent with current margins and rates.
                          8.   Expenses
                                •   Method of allocating expenses and splitting between
                                    acquisition and maintenance to be reserve method.
                                •   Actual acquisition and maintenance expenses to be used.
                                •   Recurring non-policy related expenses to be capitalized.
                          EV Considerations            (cont’d)

                          9. Cost of Guarantees and Embedded Options
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                               •   IBV and VNB must reflect the expected cost of
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                                   guarantees and embedded options determined
                                   stochastically or using market prices, if the cost is
                               •   Often stochastic models are used to price guarantees
                                   or embedded options in new sales or the in-force as
                                   part of product pricing, valuation, risk management, or
                                   economic capital work. These prices equate to an
                                   annual basis point charge that can often be used to
                                   reflect appropriately their costs in VNB and IBV
                                   without doing VNB and IBV stochastically.
                               •   Examples of such guarantees and options include
                                   U.S. variable annuities and segregated funds with
                                   GMIB, GMDB, GMMB, GMWB options and Universal
                                   Life with minimum rate and/or no lapse guarantees.
                               •   IBV and VNB must reflect the full cost of in-force and
                                   new business hedging programs.

                           EV Considerations                      (cont’d)

                          10.   EV and Acquisitions
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                                  •    Dilution impact of acquisitions on EV/per share and P/B are quite different.
                                  •    They throw light on the proportionate amounts paid for the three components of
                                       value, ANW, IBV and franchise value/synergies. Comparatively greater dilution
                                       does not mean too much was paid for an acquisition.
                                  •    ANW = Net Assets which are marked to market at acquisition.
                                  •    IBV = EV – Net assets (ANW).
                                  •    Price – EV = value paid for synergies and profits on future sales.
                                  •    EV per share dilution increases as ((Price – EV) / Price) increases.
                                  •    Greater EV per share dilution means no more nor less than that a greater
                                       proportion of the price was paid for synergies and profits on future sales.
                                  •    Greater Price to Book (Net Assets) ratio means no more nor less than that a
                                       lower proportion of the price was paid for net assets.
                                  •    Acquisitions with similar P/B can have different EV / share dilution. The similar
                                       P/B means the same proportion of the price was paid for net assets. Differing
                                       EV / share dilution because a greater or lesser proportion of the price was paid
                                       for synergies and profits on future sales.
                                  •    Acquisitions with similar EV per share dilution can have different P/B ratios.
                                       Similar EV per share dilution means that a similar proportion of the price was
                                       paid for EV. Differing P/B ratios result from paying relatively a greater or less
                                       proportion of the price for net assets.

                          VNB Considerations
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                          1. Definition of New Business: Consistent with sales disclosure.
                             Issues: premium increases, recurring single premiums, renewals,
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                             annuitizations, new members to Group plans, longevity reinsurance.
                          2. Recognition of New Sales: Sales recognized when liability first
                          3. Standard VNB: Measured using RDR, 150% MCCSR, valuation and
                             other assumptions at report date, actual acquisition expenses
                             including distribution subsidiaries.
                          4. Useful VNB Variants: Sensitivity testing, pricing or projected plan
                             assumptions (for rapidly changing businesses).
                          5. Estimating VNB:
                               •   Must be done separately for each product.
                               •   A simple VNB per dollar of sale factor estimate may be poor, if
                                   acquisition and fixed expenses per dollar vary materially with sales
                               •   An adjusted VNB per dollar of sale should be determined using
                                   acquisition and fixed expenses set to 0. Estimate VNB by applying
                                   adjusted factor to new sales and then deducting actual and fixed
                                   expenses for the new sales.

                          Measures of Product Profitability
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                          –   New Business Impact (NBI) is not a measure of profit margins.
                              Trends in NBI do not indicate profit margin trends. NBI says
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                              something about when profit is recognized, not about profit margins.
                          –   Ratio VNB to sales is simple, easily understood profit margin
                              measure. Ratio VNB to PV expected premiums better, because
                              adjusts for product life time.
                          –   IRR is readily calculated using the same after-tax income and
                              capital cost projections as are used to calculate VNB.
                          –   IRR is familiar measure linked directly to other performance targets.
                               •   When IRR = RDR, the equity cost of capital, then VNB = 0.
                               •   If IRR > RDR of 10% say, but less than hurdle rate of 15% say, then
                                   VNB > 0 and sales add value, even though they do not add sufficient
                                   value to meet hurdle rate.
                               •   If IRR < RDR, sales are destroying value.
                               •   Annual ROCE is a problematic measure for businesses, where profits
                                   emerge over many years and profits and Capital Employed (CE)
                                   fluctuate & are miss-matched.
                               •   Define “Lifetime ROCE” (LTROCE) = LTE/LTCE on NB, where
                                      –    Lifetime earnings, LTE = PV earnings on NB + earnings on CE.
                                      –    Lifetime capital employed, LTCE = PV of capital employed.
                          –   If LTROCE is discounted using the IRR, then LTROCE = IRR.
                          Measures of Product Profitability (Profit
Assemblée annuelle 2007   Margin Trends)
                           –   Profit margin trends should be analyzed at the product
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                               level. Even so, implications must be considered carefully,
                               since trends may be temporary or permanent.
                           –   Trends in profit margin can be misleading, if aggregated
                               across products with different profit margins.
                                •   Multi-product profit margin trends are usually dominated by
                                    product sales mix trends, rather than specific product margin
                                •   A downward profit margin trend can result from sales
                                    increases across all products, as a result of sales mix trends,
                                    even if all products have good margins and no specific
                                    product profit margins have decreased.
                                •   An upward profit margin trend can result from sales declines
                                    across all products, as a result of sales mix trends, even if
                                    profit margins are poor and no specific product profit margins
                                    have increased.

                          Measures of Product Profitability (Profit
Assemblée annuelle 2007   Margin Comparison)
                             –   Product characteristics often underlie systematic
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                                 differences in the ratio of VNB to sales or PV of future
                                 expected premiums.
                                  •   Relatively, long-term, high capital/risk products (par) require material
                                      reserves and tend to have high VNB to premium ratios.
                                  •   Relatively short-term, minimal capital/risk products (fee-based)
                                      require minimal or no reserves and have low VNB to premium ratios.
                             –   Differences in VNB to premium ratios do not make one product
                                 fundamentally more attractive than another.
                                  •   Low profit margin products may absorb fixed costs and have huge
                                      sales without competing with high margin products for scarce capital,
                                      resources and distribution capacity.
                                  •   Low and high margin products complement each other. The goal is a
                                      balanced portfolio where all products add value and optimize capital,
                                      resources and distribution capacity.
                             –   In product design, increasing profit margins (IRR, VNB to prem.
                                 Ratio) is not necessarily a good thing. Goal is to maximize VNB
                                 not to maximize profit margin. Thus, VNB a better performance
                                 measure than profit margin measures including IRR or LTROCE.

                          Relation of VNB Growth to Earnings
                          Growth is Complex
                           –   Not surprisingly, it is difficult to relate VNB and earnings growth.
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                               Why bother with VNB if this was not the case.
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                           –   VNB is a lifetime measure not impacted by profits on in-force
                               business. It reflects capital costs. In contrast, earnings is an
                               annual measure dominated by profits on in-force. It does not
                               reflect capital costs.
                           –   Some products have low or negative income impact in the first
                               years after sale, eventually increasing to higher levels.
                           –   VNB of some products is earned over a few years, while some is
                               earned over many. % of VNB that flows into earnings in initial
                               years varies greatly by product. (as low as 5% per year annuities).
                           –   Strong and growing sales can lead to strong and growing VNB
                               and material and increasing NB loss. Beneficial earnings impact of
                               VNB growth can be deferred for many years , as NB losses from
                               growing sales offset emerging profits on sales in recent years.
                           –   Experience variations, assumption changes & rate of in-force run-
                               off can dominate modest initial earnings impact of VNB growth.

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