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									What to make of Market Consistent
Valuation for Insurance Products?
PRMIA Session

Doug Caldwell
Chief insurance Risk Officer
ING Asia Pacific Ltd

24 June 2010
  Traditional Actuarial Valuation

 Traditional Approach                            Common Concerns
 I.    Reflect expected investment results       I.    Expected returns differ by business; higher
                                                       asset risk leads to lower liability
 II.   Deterministic in nature                   II.   Ignores options and guarantees
 III. Best estimate economic assumptions         III. Economic "bets" not explicit
 IV. If stochastic, real world scenarios         IV. RW scenarios do not properly value options
 V. IRR is common pricing hurdle                 V. How to set target IRR commensurate with risk

 Actual Application
  Financial Statement Liability                  Reserve Adequacy Testing
  Embedded Value/VNB                             M&A
  Rating Agency                                  Profit Test for new products

                                      Key question:
                          Are investment risks adequately valued?

ING Asia Pacific                             2
  Market Consistent Valuation

 Market Consistent Approach                                   Common Concerns

 I.   Liabilities valued separately from assets               I.   Profit sharing products difficult to separate
 II. Discount at risk free rate                               II. Too conservative since ignores asset spreads
 III. If stochastic risk neutral scenario are reflected       III. Scenarios are not realistic
 IV. Valuation of CF consistent with capital markets          IV. What if market is at all time high or low
 V. Current market assumptions                                V. Could be excessively volatile for a LT business

 Actual Application
 • Financial Statement (MV accounting)                        • MCEV (CFO Forum)
 • Solvency II                                                • IFRS Phase II
 • Profit Test for New Products                               • Valuation of Derivatives

                              Key question:
 How to manage a “long term” life insurance business with volatile metrics?

ING Asia Pacific                                          3
     Example 1: One Pay Five Year Endowment

                                                                 IRR: 3.8%                                                             IRR: 21.5%
                                                                                                                              Local    Distributable
                                                                   Total           Discount        Change in   Investment                              Discount
 T   Premium       Lapse    Death   Maturity    Comm.    Exp.                                                                Capital    Earnings
                                                                    CF             At swap          Reserve      Income                                   DE
                                                                                                                            Required       (DE)
 0   1,000,000                                  30,000              970,000             970,000

 1                  7,500   1,000          0             4,956      (13,456)            (13,370)    991,145        42,770     39,646        (31,476)     (29,144)

 2                  7,912   1,038          0             5,073      (14,023)            (13,694)     23,365        43,447     40,580           5,124       4,393

 3                  8,314   1,125          0             5,192      (14,630)            (13,885)     23,812        44,466     41,533           5,071       4,026

 4                  8,705   1,257          0             5,313      (15,275)            (13,968)     24,212        45,512     42,501           5,057       3,717

 5                     0    1,434   1,098,073            5,490   (1,104,998)           (967,665)     35,539        45,812     43,923         45,849       31,204

                                                                 MCVNB             (52,581)                                               VNB           14,196

 •    10 year Government (G) bond rate of 3.5%                                     •      Taxes are ignored
 •    Corporate bond spread of 1.0%                                                •      Payout at the end of year 5 is 115% of premium
     (net of 10bp investment expense and 10bp of default)                          •      Zero swap curve
 •    Equity spread of 4.5%                                                                1yr: 0.64%
 •    Asset mix: 60%(G bond)/30%(C bond)/10% (Equity)                                      2yr: 1.20%
 •    Real world earned rate is 4.3%                                                       3yr: 1.76%
 •    Local capital at 4.0% of reserve                                                     4yr: 2.26%
 •    Risk discount rate of 8.0% (3.5% + 4.5%)                                             5yr: 2.69%

                           Why do the two value measures give a different view?

ING Asia Pacific                                                               4
  Example 2: Credited Rate for Dividend on Deposit in
  Hong Kong participating insurance products

  • Policyholder can elect to keep dividend with the company to earn interest
  • Policyholder can withdraw the fund from Dividend on Deposit (DoD) at any given time

  Current Market Environment
  • Current 3-month risk free rate: 0.1%
  • Current 10-year risk free rate: 3.1%
  • Current interest rate for a short-term bank deposit: 0.015% to 0.015%
  • Current interest rate for an one-year bank deposit: 0.15% to 0.20%
  • Current interest rate for a 5-year bank deposit: about 0.5%

  • Nevertheless, current credited rate for DoD in the HK market: 4.0% to 5.0%

                                How does this happen?

ING Asia Pacific                              5
  Example 3: Value Linked to Share Price

  See example provided by Tom Wilson, CRO, Allianz in Life & Pensions article:

     Comparison of market valuations - Allianz                      Comparison of market valuations - Industry
       Division               Q2 2008      Q2 2009     %              Division            Percentage       Comments

      Traditional                                                  Traditional EEV
                              €19.7bln     €20.3bln   +3%                                   -13.3%              -
         EEV                                                     (Aegon, Generali, ING)

                                                                    MCEV value              -32.0%          As stated
                              €21.9bln     €12.5bln   -43%        (Allianz, Aviva, AXA,     -39.8%       Without liquidity
         value                                                   Ergo, Swiss Life, ZFS)                premium, AXA, Aviva
      Eurostoxx                                                       Eurostoxx
      Insurance                     -         -       -62%            Insurance             -62%                -
        Index                                                           Index
   Source: Life & Pensions, January 2010

                      Which metric most closely tracked values of the firm?
               Is it important for value metrics to closely track market value of
                                           the firm?

ING Asia Pacific                                             6
  Example 4: Solvency II Capital Framework

   Definition: Solvency II capital is defined as the maximum loss to an insurer Market Value Surplus
   (MVS) within a 99.5% confidence interval based on shocks which could occur over a one-year horizon.

                                                                          One year MVS
      Market              Market
      Value               Value
      Assets              Liabilities
      (MVA)               (MVL)                       Expected value

                                                                                    Solvency II Capital
                                                                                 99.5% worst case

   Based on total Market Value Surplus                Solvency II Capital definition
   • Current balance sheet value only – no future     • Max loss within a confidence interval over one year
     business or future return expectations           • 99.5% confidence interval consistent with BBB rating
   • MVL (including financial options), rather than   • Company has the choice to use internal model (subject
     best-estimate liabilities                          to regulatory approval) instead of standard model

                   Is this progress or the end of insurance in Europe?

ING Asia Pacific                                      7
    Market Consistent Valuation - FCL

•    The Financial Component of Liabilities at issue, FCL is equal to the present value of expected future
     payouts (deaths, surrenders, and expenses) plus initial acquisition costs less present value of future
        - Similar to current (traditional) calculation
        - But cash flows are discounted back using the swap curve
        - Stochastic risk neutral scenarios if cash flows vary due to change of interest rate or equity market

            FCL = PV (future payouts) + acquisition expense – PV (premiums)
                                 Premium inflow


           Acquisition costs             Payouts (death, surrenders, and expenses)

                               PV cash flows by discounting with swap rate

ING Asia Pacific                                         8
  Market Consistent Valuation - MVM

   •    Market Value Margin MVM represents the risk premium required over and above the BEL for non-
        hedgeable risks
   •    MVM is calculated using the “cost of capital” approach and is calculated as the present value of the
        “future cost of capital charges” for the lifetime of the product

                                    Economic           Cost of         Capital         Discount
                   Period           Capital            Capital         charges         factor
                         0                EC0      *     COC %       = Cap charge0 *        D0
                         1                EC1      *     COC %       = Cap charge1 *        D1
                                         EC      *     COC %       = Cap charge *        D     Swap discount

              Economic Capital (EC) for            CoC rate                 MVM is equal to the
              non-hedgeable risks                  usually 2-6%           sum of the discounted
              ECs need to be estimated at                                  “capital charges” for
              issue and projected for all future                          each projection period

ING Asia Pacific                                                 9
  Examples of Products with Options & Guarantees

   • Variable annuity (Unit linked with guarantees)

   • Variable products with no lapse guarantees or with fund switch options

   • Profit-sharing products (or participating products)

   • Non-participating products with long duration and regular premiums- due to interest rate
     guarantees & cash surrender value with no MV adjustment

   • Universal life / savings products with minimum interest rate guarantees

   • Premium reinstatement option by policyholders

   • Products with premium holiday features or top up features

   • Deferred annuity with guaranteed annuitization option

            Bottom line: Basically all life insurance products have options
                                  and/or guarantees

ING Asia Pacific                                 10
  ING use of Market Consistent Measurement

                      ING Risk and Capital Management includes
                     significant focus on Market Consistent principles

                    MC pricing has become mandatory as of 2009 for
                   approval of all new products globally (began in 2006)

                    Management of MV Balance Sheet is increasingly
                       important for managing shareholder value

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  Benefits of Market Consistent Management

  • Separate valuation of assets and liabilities
        − Consistency with capital markets including option/guarantee costs
        − Reduces reliance on actuarial or management investment assumptions
        − Clearer picture of the impact from asset/liability management choices: allows
          separate analysis of investment decision versus whether or not to hedge market risk
  • Risk-based pricing
        − Clear identification of market price of individual risks enables product pricing to
          reflect specific risks
        − Improved comparison across different products versus approaches which set top-
          down discount rates
  • Convergence of reporting measures creates efficiencies
        − Fewer metrics to manage for reporting, risk, and strategy
        − Resource synergies

ING Asia Pacific                                   12
  Managing Value

                               Creating shareholder value

     Improve profitability        Grow profitably            Reduce cost of capital
     • Expense management         • Improve value of new     • Increase transparency
                                    business                   towards the market
     • Claims handling
                                  • Retain customer base     • Reduce volatility through
     • Improved (re-)pricing
                                                               improved risk management
                                  • Investment performance

      MCEV enables these drivers to be measured consistently at both the
       product and individual risk level – same drivers as traditional EV

ING Asia Pacific                              13
  Growing MCEV - Liability Side

                   Managing MCEV through improving liability margins

    Increase client balances       Managing Persistency         Efficiency Gains
    • Growing client balances      • Managing persistency       • Improving expense ratios
      at lowest possible cost        adds value through           and claims management
                                     reducing the market          adds value through
    • Improving new business
                                     value of liabilities via     reducing the market
      values grows MCEV
                                     increased future margins     value of liabilities
    • Pricing of new business
      is critical to balancing
      growth and margin

ING Asia Pacific                               14
  Growing MCEV – Assets side

                   Asset management contributes to MCEV growth
                    by generating superior risk-adjusted returns

     •     Total market value asset return is an important focus of MCEV

     •     Asset managers should achieve excess return versus benchmarks as
           established in investment mandates

     •     Focus should be on achieving this excess return within risk business unit
           defined risk tolerance

     •     MCEV growth via generating “alpha”, or market outperformance

ING Asia Pacific                             15
MC pricing: viewing liabilities in terms of funding cost

   • MC VNB by itself is difficult to                    Swap curve valuation of liabilities
     understand and communicate                      • MC VNB value can be associated with the
                                                       expected yield curve used to estimate the
   • MC VNB can also be expressed as a                 cost of raising liabilities in the capital
     percentage of PV Premium which is                 markets
     more helpful.
   • MC VNB can also be expressed as a                Curve                    1. Cost of liability >swap
     funding cost of issuing liabilities                                          MC VNB < 0

                                                                               2. Cost of liability = swap
   • This funding cost can be coupled with                                        MC VNB = 0
     the duration of the liability. Thus, the
     funding of the liability can be compared                  Opportunity     3. Cost of liability < swap
     to other ING debt costs and also the                                         MC VNB > 0
     potential illiquidity spreads of
   • Funding cost analysis most appropriate
     for single premium products

ING Asia Pacific                                16
  Illiquidity Spreads are arguably applicable for
  some insurance liabilities

                                                             Includes bank deposits
   • There is value in long term         Products that can   and comparable savings      Category 1:
                                                             products that can be
     insurance liabilities which are      be surrendered     withdrawn with little or
                                                                                         Highly liquid liabilities
                                                                                         with zero spread
     not easily surrendered               with no penalty    no prior notice or
         − “Sticky” retail funding has
           become increasingly
           important                                                                     Category 2:
                                                             Includes savings            Liquidity comparable to
                                         Products that can   products that may include   covered bonds.
         − Allows investment in           be surrendered     a redemption penalty and    Spread adjustment is
                                                             protection business
           assets that have additional     with penalty      where there is a
                                                                                         based on the spread
                                                                                         over swap rate for
           returns for illiquidity                           discretionary surrender
                                                             value                       covered bonds.

         − The valuation of insurance
                                                                                         Category 3:
           liabilities could match not                                                   Lowest liquidity.
                                                              Products such as
           only the risk profile but       Products that      annuities in payment       Spread adjustment is
                                            cannot be         that cannot be             equal to the spread of
           also the liquidity profile                         transferred to another     covered bonds over
                                           surrendered        provider or surrendered    swaps, plus an
   • ING has added an illiquidity                             for a lump sum.            additional amount to
                                                                                         be confirmed.
     premium to the swap for some

ING Asia Pacific                            17
      The level of illiquidity premium proposed for
      Solvency II
 • The proposed formula for SII to obtain the level of illiquidity premium is 50%*(spread_model_portfolio – 40)
 • Illiquidity premium is flat until a cut off date linked to the availability of the illiquid assets in the market.
 • Model portfolio depends on the availability of illiquid assets for each currency.
 • The model portfolio is independent from the actual assets held by insurer. For USD & EUR, model portfolio
 is Markit overall corporate spread. Spread level is relative to swap rates with a correction for credit risk.
 • It is still difficult to determine what products should use the illiquidity premium, but standards are being
 developed for Solvency II

                   Historical Illiquidity Premium (bps)
250                                                                                 Question: What part of the risky asset spread
                                                      USD Illiquidity premium       should be passed to customers?
                                                      Eur Illiquidity premium
                                                                                    Compensation       Compensation        Illiquidity premium reflecting
150                                                                                  required by         required by       compensation that investors
                                                                                     investor for     investor for their   require for bearing risk they
                                                                                   expected default      exposure to           might not be able to sell
100                                                                                     losses           unexpected                  immediately
                                                                                                        default losses
                                                                                            A                 B                       C
                                                                                                                                              Full expected











                                                                                Swap rate       Represented using an arbitrary scale















                                                                                                                                              return on asset


ING Asia Pacific                                                                  18
  What is market consistent when there is no

   Yield curve limitation – many developing markets do not have liquid assets for
    the same duration as liability cash flows
   Implied volatility – where do we get the implied volatilities to value long dated
    options in insurance contracts
   Market stresses as in 2008 can cause formerly liquid markets to become
    illiquid- what do we do then?
   What do we do when swap curves become lower than government curves?
   Insurance, business, and operational risks cannot be priced in a liquid market
      Techniques needed to estimate market price of non-hedgable risks
      Key issue is how to handle diversification of these risks with the market
         and each other
      Cost of Capital method is most popular, but CoC must be estimated
   Similarly, the cost of non-hedgable risk for long term market risk must be
    valued in some manner

ING Asia Pacific                          19

      MC valuation is volatile and so is insurance company value
      Allows improved risk management based on underlying economics
      Increases transparency of risk taking and value creation
      Makes economic bets clear as reduction in economic assumptions
      More consist with economic theory and capital markets pricing
      However,
               Difficult to manage volatility
               Not primary market practice in Asia
               Difficult where markets are not complete

ING Asia Pacific                           20

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