Market Consistent Embedded Value At a turning pointoportunidades.deloitte.cl/marketing/Web/market_consistent.pdf · Market Consistent Embedded Value ... IFRS 4 Phase II. This year’s

Welcome to this special edition of the Insurance Market UpdateMarket Consistent Embedded Value (MCEV) reporting has not enjoyed a smooth ridesince its birth in 2008. It was unfortunate timing that MCEV came into force duringone of the most severe financial crises in more than 60 years. The volatile MCEVnumbers reported by insurers over the last few years, coupled with the very slowprogress towards applying a consistent methodology and the seemingly complexnature of this reporting metric, resulted in analysts and investors questioning themerits of MCEV. The 2010 MCEV reporting season showed some signs ofconvergence in methodology forced by regulatory regimes (mainly Solvency II). It wasalso characterised by the steady decline in the prominence of MCEV in insurers’financial reports with more focus being given to IFRS earnings, cash flow and capitalgeneration. Even with the uncertain future of MCEV, it is still one of the key metricswithin the insurance sector and the knowledge developed in producing thesenumbers forms the cornerstone of the quantitative skills required for Solvency II andIFRS 4 Phase II.

This year’s special edition of the Insurance Market Update analyses the resultspublished by 19 major European insurers, although our focus is principally on thosecompanies with UK operations.

In this article we draw out some of the key themes that have emerged over the lastcouple of years, by comparing embedded values across the industry. We also analysethe disclosures and their merits, and the relationship between embedded value andshare price. Finally, we discuss what the future of embedded value might look like.

We are always interested to get your feedback and hear your views on the topics wecover. If you would like to contribute to the debate, or ask questions of our experts,please speak to your usual Deloitte contact, or one of the team listed at the end ofthis article.

Roger SimlerPartner – Actuarial & Insurance Solutions

Market Consistent Embedded ValueAt a turning point

July 2011

MCEV: At a turning point 2

Methodology and assumptions2010 could be the point at which convergence inapproach to determining MCEV started in earnest.Most insurers in our sample are now adjusting theiryield curve for illiquidity premium and are calculatingtheir Cost of Residual Non-Hedgeable Risk (CRNHR)using the cost of capital methodology in a very similarway to the Solvency II framework.

In 2010 we have seen a mix of market consistent andnon-market consistent embedded values. As the MCEVPrinciples are not currently compulsory, and with theCFO Forum’s move away from making MCEV the solereporting methodology, we do not expect to see anincrease in convergence in this area.

Economic varianceSome insurers in our sample showed significant(negative) economic variance. As ‘economic variance’includes both market movements and economicassumption changes it is difficult to analyse thegenuine impact of market movements as opposed tomanagement decisions.

DisclosureThere has been a clear sign in disclosures of theincreased prominence of cash flow, capital generationand IFRS earnings. Market reaction to the complexity of MCEV is likely to have played a large part in thistrend. In our view, cash flow reporting is a usefuladdition to insurers’ disclosure but it should not berelied upon exclusively as an indicator of performance.The cash flows rely on the same embedded valueassumptions and do not help in understanding theeconomic risk affecting shareholder value.

Embedded value versus share priceSince the start of the financial crisis and the resultingsell-off of insurance stocks, the life sector performancehas dropped and has been consistently lower than themarket. If embedded values are believed to be a goodreflection of an insurer’s value then market capitalisationshould be higher than embedded value; this has notbeen the case for the majority of our sampledcompanies. There are a number of reasons why marketcapitalisation and embedded value will always diverge,however in our view the combination of the complexityand volatility of MCEV with the frequent changes inmethodologies, does not help investors’ or analysts’acceptance of this metric.

Embedded value post Solvency II and IFRS 4Phase IICould we be seeing the end of the embedded valueera? With Solvency II and IFRS 4 Phase II coming intoforce in the near future, will embedded value survive? Both these regimes use calculation techniques similar to those applied in embedded value and will, withpotentially minor changes, convey similar information.This may reduce the impetus for embedded valuereporting. It is our view that insurers should considerhow Solvency II and IFRS 4 Phase II can be used toconvey management’s view of value. This may be usedas an opportunity to simplify their reporting.

Deloitte view


Methodology

Aviva considers that its experience in managing creditand insurance risk means it is confident of realising thespread margins in the real-world. Figure 1 belowrepresents the main difference in the yield assumptionsbetween the ‘Equivalent Embedded Value’ and theMCEV approaches, and looks at the impact that this hason Aviva’s shareholders’ equity.

Aviva’s aim of this additional reporting is to make thecomparison to its UK peers publishing under the EEVmethodology easier for analysts and investors, as wellas showing investors that there is more value in thebusiness than currently reflected in the share price. We acknowledge Aviva’s concerns regarding its MCEVfigures and recongnise the importance of reflecting anaccurate view of value. However, adding yet anothervariant to embedded value may only serve to increaseanalysts’ perception of the complexity of life insurance,while moving further away from the CFO Forum’s aimof harmonising embedded value reporting.

Figure 1. Aviva ‘Equivalent Embedded Value’ vs. MCEV

MCEV assumptions

Expected default

Liquidity premium

Spread earnings

Yield

Portfolio

Swap rate

Duration

‘EquivalentEmbedded

Value’ assumptions

Source: Aviva disclosure & Deloitte analysis

‘Equivalent Embedded Value’(YE 2010) = £18.3bn or 657p per share

‘MCEV’ (YE 2010) = £16.1bn or 579p per share

As compliance with the MCEV Principles was notmandatory as at year-end 2010, insurers continued topublish embedded value using a variety of approaches.Based on our sample of 19 companies, 11 reportedunder the MCEV Principles published by the CFO Forumin October 2009, four companies reported under theEEV Principles using a market consistent approach andthe remaining four reported under the EEV Principleswithout being market consistent.

In April 2011, the CFO Forum withdrew its intentionthat MCEV should be the only recognised format ofembedded value reporting from 31 December 2011.This decision was driven by the ongoing developmentof insurance reporting under Solvency II and IFRS. TheCFO Forum, however, remains committed tosupplementary reporting, including embedded value.Given this situation, we do not expect to see furtherconvergence in approaches any time soon.

In addition to the above mentioned embedded valuemethodologies, Aviva introduced a new variant ofembedded value called ‘Equivalent Embedded Value’.Aviva’s aim is to “provide enhanced embedded valueinformation to allow a direct comparison to EEV”.1

Contrary to some of its UK peers publishing a non-market consistent EEV, Aviva uses a market consistentapproach which does not give credit to any return dueto spreads earned on corporate bonds.

1 Aviva analyst presentation as at January 2011.


Assumptions

For year-end 2010 there is evidence of assumptionsconverging towards the expected Solvency IIspecifications. For example, in Allianz’s MCEVpresentation the three main assumption changes wereclearly made to achieve greater consistency with itspeers and the Solvency II Directive. These changes aresummarised in Table 1.

A table summarising each sampled company’sassumptions is provided in the appendix. Below wecomment on the key features and emerging trends inthese assumptions.

Liquidity premiumMost insurers (13 out of the 19 companies in oursample) are now adjusting their yield curve to allow foran illiquidity premium. This includes some of the majorEuropean players who were initially sceptical about thecase for illiquidity premium, such as Allianz and ZurichFinancial Services (the latter who plans to include anilliquidity premium by year-end 2011). Furthermore, ofthe 12 out of 13 companies that disclosed themethodology used to calculate the illiquidity premium,half used the CFO/CRO Forum and QIS 5 recommendedformula [Max(0, 50% × (Spread – 40bp))]. Allcompanies using this approach bucketed their liabilitiesin-line with the recommendations so that the differentlevels of illiquidity premium (i.e. 100%, 75% and 50%)are applied in-line with the nature of the liabilities.

Cost of residual non-hedgeable risk (CRNHR)The CRNHR used to be an area where insurers divergedsignificantly; this year we have seen the first signs ofconvergence beginning. Of our sample, 11 calculatedthe CRNHR as a cost of capital charge applied to thecapital required to cover the non-hedgeable risks. The capital charge applied by 5 of those 11 companieswas 4.0% (including Zurich Financial Services which willapply the 4.0% at year-end 2011). This is consistentwith the CRO Forum recommendation2 which indicatedthat a suitable charge is in the range 2.5% – 4.5%. The capital charge for the CRNHR is lower than thecharge applied in calculating the risk margin under theSolvency II framework. Insurers may be using thepublication of MCEV as a means to lobby the regulatorto lower the Solvency II capital charge.

There remain differences in the treatment ofdiversification between covered and non-coveredbusinesses in the CRNHR. MCEV Principle 9.7 prohibitsthe use of this diversification. Some companies believethat this does not reflect the risk management processand have made some allowance for diversification. If the CFO Forum introduces future amendments to the MCEV Principles, this might be an area for review.

Volatility and reference ratesVolatility and reference rates are the two assumptionswith greater consistency. During the financial crisiswhen markets were dislocated, insurers applieddifferent adjustments to volatilities and reference rates.Now that markets are generally accepted to havereturned to more normal levels, all insurers reportingunder a market consistent approach are using the swaprates (where there is a deep and liquid market) andimplied volatilities at the calculation date.

Table 1. Allianz’s key assumptions changes

Allianz assumption change

Impact on (EUR)

New businessvalue

MCEV

Inclusion of illiquidity premium:In-line with the CFO/CRO Forum recommendation +113m +1.7bn

Yield curve extrapolation:In-line with EIOPA guidance

+45m +0.6bn

Cost of capital charge for non-hedgeable risk:In-line with major European peers (equivalent to 4% charge on risk capitalcalculated at 99.5% confidence level)

+47m +0.5bn

Source: Allianz analyst presentation as at 25 February 2011

2 Paper titled: Market Value of Liabilities for Insurance Firms, Implementing elements for Solvency II, June 2008.


Figure 2. Global Life embedded value by region for years 2008 – 2010 (£m)

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BaloiseGroupamaKBCStorebrandSwiss LifeAgeasStandard LifeResolutionOld MutualLegal & GeneralLBGZFSMunich ReAvivaPrudentialGeneraliAllianzAxa

Source: Companies’ disclosure & Deloitte analysis

Notes:– Baloise did not publish an MCEV in 2008.– Groupama: the embedded value for Europe is only that of French business. The rest of the world figure contains all other businesses. – Resolution: Continental Europe represents the embedded value of Lombard.– Standard Life: the rest of the world figure contains the embedded value of the German and Irish branches as well as the rest of the international business.– Swiss Life: the embedded value includes the private placement life insurance through Singapore.

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We have expanded the number of insurers in oursample from 16 in last year’s special edition to 19 in this year’s. The comparisons below with last year’snumbers are done on a like-for-like basis.

2010 was a year where most insurers in our samplesaw an increase in embedded value. 15 out of the19 companies produced a positive return on embeddedvalue (in local currency) bringing the aggregateembedded value for long term covered business to£201bn, an increase of 7.6% (including the effect ofexchange rate changes) compared to 2009.

Of the £201bn, £43bn is written in the UK, £99bn inContinental Europe and £59bn in the rest of the world.Figure 2 below shows the total embedded value foreach company over the last three years (in descendingorder) split by region.

Results


AXA remains the largest insurer (measured by theembedded value of the covered business) in our samplewith a considerable margin over Allianz and Generali.In 2010, AXA sold most of its UK business to Resolution(with the combined portfolio of Friends Provident, AXAand BUPA now renamed Friend’s Life) which significantlyreduced its UK embedded value. AXA has subsequentlytaken over full control of its Asia-Pacific business afteralmost 18 months of negotiation. This consolidation,which happened in April 2011, does not show in theembedded value numbers in this article.

The UK life insurers have reported a strong set of resultsfor 2010 with upbeat messages from their CEOs and anincrease in dividend payments. Both Aviva andPrudential reported significant increase in new businesscontribution in the UK market (see page 9).

The top three performers in terms of return onembedded value (ignoring the effect of Resolution‘sacquisition of AXA’s UK business) were Old Mutual,Swiss Life (based on return in CHF) and Prudential. Old Mutual attributed this to positive marketmovements, lower yield curves and tax deductions onincome and gains as a result of the current tax positionof the UK tax group. In addition, the strengthening ofthe Rand, Dollar and Krona relative to Sterling had asignificantly positive effect on the MCEV (which isreported in Sterling). Swiss Life’s increase in MCEV waslargely driven by assumption changes such as futuremortality, morbidity and longevity rates. The effect ofthe ongoing cost reduction programme and a revisedpolicyholder bonus approach, driven by the low interestrate environment, gave the MCEV a significant upswing.The effect of these changes represented 20% of theopening MCEV. It is not clear what level ofmanagement discretion has been applied in arriving atthese changes. Prudential’s embedded value increasedby 19%, largely driven by the 31% increase in its Asianbusiness embedded value.

The worst performer was Groupama with a drop inembedded value of 21%, attributed largely to economicconditions, the new tax regime in France and anincrease in future bonus rates assumption.

One of the striking features of embedded value results in2010 was that nearly two thirds of insurers in our samplereported negative economic variance. Most companieswith negative economic variance attributed this to lowerinterest rates, widening sovereign bond spreads, higherinterest rate volatilities and higher credit spreads. As shown in Table 2 below, the economic environmentmainly had an adverse effect on Continental Europeaninsurers, whereas the UK based insurers seem to haveweathered the market situation much better. Under thecurrent MCEV guidelines, companies are not obliged tosplit the impact on embedded value of the marketmovement and the economic assumption changes,hence the economic variance is the total of those twoelements. This approach lacks the transparency neededto understand the genuine impact of market movementas opposed to management decisions. For example, overoptimism on illiquidity premium does not show up as aseparately disclosed item, but is buried within theeconomic variance.

Table 2. Economic variance as % of opening embedded value


Economic variance as % of opening embedded value

Old Mutual 13% ZFS -5%

Std Life 10% Munich Re -7%

Storebrand 3% Allianz -10%

Resolution 3% KBC -11%

LBG 3% Generali -14%

Legal & General 2% Groupama -18%

Aviva 1% Fortis-Ageas -19%

Prudential -1% Swiss Life -24%

Axa -4% Baloise -26%

CNP -5%


Sensitivities

We have analysed the available economic sensitivities to better gauge the potential impact of market movement on the insurers’ embedded value.Table 3 below summarises those sensitivities.

Illiquidity premium Risk free rateEquity/property

valuesVolatilities

Company10bp increase

to referencerates

Removepremium

+100bps -100bps -10 % Equity +25%Interest rate

+25%

Axa 2% -4% 2% -6% -5% -2% -3%

Allianz – -6% 8% -15% -4% -3% -2%

Aviva 2% – -1% -1% -5% -2% -2%

Baloise – -9% 24% -32% -13% -3% -3%

CNP 0% – 0% -1% -4% -4% -2%

Ageas 2% -8% 5% -15% -7% -5% -1%

Generali 1% -6% 4% -8% -6% -2% -1%

Groupama – – -7% 6% -16% -7% -2%

KBC – – 0% -1% -2% – –

Legal & General – – -2% 2% -2% – –

LBG 1% – – 2% -3% – –

Munich Re 3% – 6% -11% -1% -2% -1%

Old Mutual 1% – -3% 3% -5% -2% -1%

Prudential 1% – -3% 3% -3% – –

Resolution – -7% -2% 2% -4% 0% 0%

Standard Life – – 0% -2% -5% – –

Storebrand – – 6% -19% -11% -3% -6%

Swiss Life – – 10% -17% -16% -6% -5%

ZFS 1% – -1% -4% -3% -1% -1%


Notes: – ZFS did not include an illiquidity premium in the year-end 2010 embedded value but will include one at year-end 2011. The ZFS illiquidity premium sensitivity listed

above was shown to illustrate the potential impact.– Allianz did not disclose the impact of the illiquidity premium in the embedded value report but showed its impact in the analyst presentation.

Table 3. Economic sensitivities


Embedded value reporting is currently the main reporting metric showing a wide range of sensitivities, allowinginvestors and analysts to understand the economic risk affecting shareholder value. Analysing sensitivities gives aview of the companies’ potential asset and liability mismatch, and the opportunity for reducing volatility throughhedging. The first MCEV reporting coincided with the beginning of the financial crisis which dislocated the marketand resulted in unpredictable and volatile embedded value results. This made it difficult for investors, analysts andeven insurers themselves, to accept that the embedded value numbers fully represented the true outlook for theunderlying business. As the insurance industry moves closer to the implementation of market consistent techniquesthrough Solvency II and IFRS 4 Phase II, stakeholders will develop a better understanding of the embedded valueresults (assuming embedded value reporting survives – see page 12).

Given the decrease in the yield curves between 2009 and 2010 in most countries (except Sweden which mainlyaffects the results of Storebrand) the economic variance shown in Table 2 is largely consistent with the sensitivitiesof the embedded value to interest rate movements. These sensitivities are shown in Figure 3 below. Aviva showsone of the smallest sensitivities to interest rate movement (as well as the smallest economic variance); this is likely to be due to its hedging strategy. Baloise is showing the biggest sensitivity to a decrease in interest rate movement (-33%) probably explained by an asset and liability mismatch. Compared to Swiss Life, one of its peers in the Swissmarket, the contrast is marked. Swiss Life’s interest rate sensitivity dropped from -37% in 2009 to -17% in 2010.This implies that Swiss Life took action to protect its financial position from interest drops whereas Baloise, which isstill showing a similar level of sensitivity as in 2009, seems to be betting on an increase in interest rates.

Figure 3. Embedded value sensitivity to interest rate movement

Risk free rate +100bp

Risk free rate -100bp

Source: Companies’ disclosure and Deloitte Analysis

Note: Lloyds Banking Group and Old Mutual do not report sensitivity to interest rate movement.

EEVCompanies reporting under MCEV or market consistent EEV

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New business

The total volume of new business of our 19-company sample (as measured by present value of new business premium – PVNBP) increased by 4%to £329bn. Over the same period the value of new business (net of tax) increased to £7.8bn, an increase of 15%, reflecting an improvement inthe underlying margins.

Figure 4. New business volumes (measured by PVNBP) by region for years 2008 – 2010 (£m)


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Figure 5. Value of New Business (net of tax) by region for years 2008 – 2010 (£m)


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The UK value of new business showed a significantincrease in 2010, helping drive embedded value andoperating profits higher. Lloyds Banking Group has thelargest value of new business in the UK, but Legal &General has narrowed the gap. Based on our sampleinsurers, the UK value of new business increased by17%, although volume (as measure by PVNBP) onlyincreased by 6% indicating a shift towards highermargin business such as protection and annuities inaddition to improving capital efficiency and bettermarket conditions. Bulk annuity business contribution to new business volumes showed significant increase,particularly at Aviva and Prudential (four fold increase to £871m and 13% increase to £820m respectively). The area where Aviva and Prudential differ significantlyis in their US new business. Despite improvements in2010, Aviva’s US business continues to underperform,with a reported negative value of £(194)m (with an IRRof 14% and a payback period of four years)3 andcontinued speculation around future sale of thisbusiness. Prudential’s US business is seen as animportant contributor to growth with value of newbusiness of £495m (with an IRR in excess of 20% and apayback period of one year). It should be noted that asAviva uses an MCEV approach compared to Prudential’sEEV approach a direct comparison of these numberscannot be made.

A key development that will affect new businessvolumes in the UK is the implementation of the RetailDistribution Review (RDR) which will take effect on 1 January 2013. As intermediaries will no longer be ableto accept commissions for recommending insuranceproducts to UK retail customers, it is expected that RDRwill reduce churning of business and hence affect newbusiness volumes. It remains to be seen what the fullimpact of the RDR will be, but different companies areclearly pursuing different strategies.

3 Value on new business calculated on an MCEV basis. IRR and payback period calculated on a “real world” basis.


Disclosure

Disclosure of insurers’ results is continuously evolvingand each year provides new additions. The annualreports of Aviva and Prudential have become soexhaustive that they are now nearly as big as companiessuch as Barclays. There is a fine line between increasingvolumes of useful information and informationoverload, and companies should guard against thelatter.

Insurers, in particular UK based ones, are shifting thefocus of their disclosure from embedded value to IFRSearnings and cash flows. This is partly driven by themarket reaction to the complexity of MCEVs. By disclosing cash flow and capital generation, theinsurance industry hopes to show investors that the lifeindustry can generate cash in the short term. This is alsoapparent in insurers’ push to shorten the paybackperiod for new business.

A clear example of this trend in disclosure is illustratedby Prudential’s cash flow reporting which has beendeveloped from the now typical five year grouping ofcash flows, into an annual cash flow disclosure (seeFigure 6 below). We expect other companies to followPrudential’s approach in 2011 and Legal & General, at their analyst meeting, committed to providingenhanced disclosures.

Cash and capital generation has become a metric thatinvestors are using to judge life insurers’ performanceand drive their share price. Investors and analysts weredisappointed when Legal & General lowered its cashflow target for 2011 (to £700m from £728 generatedin 2010). While the additional disclosure of cash andcapital generation met with approval from investors andhelped to improve the transparency of the results, itshould not be relied on exclusively to judge acompany’s performance. One should not forget thatthose cash flows are generated using the sameassumptions as the embedded value and are not certain.Reality might prove the assumptions used to be wrong.In addition, cash flows do not tell us about the riskunderlying the insurers’ liability. In our view cash flowreporting is a useful addition to the insurers’ disclosure,but it should not be relied on exclusively as an indicatorof performance.

Figure 6. Prudential and Aviva cash flow disclosure

Source: Aviva and Prudential disclosure

Note: Aviva’s free surplus reporting is based on the ‘Equivalent Embedded Value’ cash flows.

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The future of embedded value

Embedded value versus share price (includingnon-covered business)The life insurance industry historically performed broadlyin line with the market. Since the start of the financialcrisis and the resulting sell-off, the sector has notreturned to its previous highs and has consistentlyunderperformed the market (see Figure 7).

One would expect that embedded value (including non-covered business) should give a reasonable indication ofwhat the market capitalisation of an insurance companyshould be. There are many reasons why embeddedvalues and market capitalisation will diverge, includingthe absence of new business in an embedded value,timing issues and the complexity of some of thecalculations.

Assuming an insurer is writing profitable new businessits market capitalisation should, all other things beingequal, exceed the embedded value. Based on insurers inour sample, only Zurich Financial Services (which has asubstantial non-life business not reflected in theembedded value) and Baloise (which is well positionedto benefit from a potential increase in interest rate – seepage 8) were trading at a higher multiple to theembedded value as at year-end 2010 (see Figure 8).

Figure 7. Market vs. life assurance sector performance

FTSE 350 index

20092008200720062005 2010

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Old MutualCNPAvivaPrudentialGeneraliZFSAXAAllianz

Figure 8. Group embedded value vs. market capitalisation (£m)

Group embedded value(including non-coveredbusiness)

Market capitalisation

Analyst Target Market Cap

Source: Companies’ disclosure and Deloitte analysis

Note: – Market cap as at 31 December 2010.– Lloyds Banking Group, KBC (bankassurer), Munich Re (reinsurer) and Groupama (mutual) were excluded from this analysis as their market cap is not directly comparable to embedded value.– Aviva, Generali, Legal & General, Old Mutual, Prudential, Resolution, Standard Life, Storebrand analyst target based on Thomson Reuters.– The analyst target for Allianz is based on Commerzbank report, AXA and CNP is based on Societe Generale report, Ageas is based on KBC report, Swiss Life and Baloise is based on Deutsche Bank report and ZFS is based on Collins Stewart report.

MarketCAP/Group EV: 80% 85% 110% 92% 93% 72% 66% 68% 73% 67% 52% 57% 93% 59% 177%


Is this telling us that embedded value has becomedisconnected from the share price? Or has the insuranceindustry simply confused investors and analyst with amyriad of metrics? It should be noted that our sampleinsurers have their business primarily in the UK, Europeand US with the exception of Prudential with substantialAsian presence. Looking at insurers’ valuations in SouthEast Asia we observe that when AXA took full ownershipof AXA APH the deal valued AXA APH at more thantwice its 2010 embedded value. AIA is currently valuedat 1.5 × embedded value and Ping An (a Chinese insurer)is currently valued at 3 × embedded value. A possibleconclusion is that investors do not believe in the growthprospects of life insurance in Europe and are moreinterested in the potential of the emerging markets.This results in investors discounting more heavilyEuropean based insurers with no presence in thosemarkets. European based insurers are all striving toimprove their share prices, in part supported by theirextensive disclosures, though arguably this has not hadthe desired effect. Perhaps insurers should try to simplifytheir disclosure, report using a main metric which iskept consistent year-on-year to allow their key messagesto come through in their results. With Solvency II andIFRS 4 Phase II now on the horizon, the insurers’ taskwill be rendered even more challenging unless action istaken to cut through the range of competing measures.

A history of embedded value or… is embeddedvalue history?A recent article4 published by Deloitte consideredwhether embedded value will still have a futurealongside Solvency II and IFRS 4 Phase II. In the newworld, post Solvency II and IFRS 4 Phase II, investorslooking to back business models and managementteams over the long term may be reluctant to digestcomplex presentations of profits prepared using two orthree potentially contradictory methodologies. SolvencyII and IFRS 4 Phase II are based on market consistenttechniques similar to those of MCEV. The articlequestioned if it is now time to consign embedded valueto the history books, replacing its function with aversion of the balance sheets and analysis that willemerge from Solvency II. For this proposal to work theanalysis will need to reflect management’s view of thebusiness and not just the regulator’s.

The industry still feels there are a number of areaswhere the regulator is taking an overcautious view andthat the proposed regulations do not appropriatelyreflect the management view. Companies could use the‘Own Risk and Solvency Assessment’ (ORSA) as a tool toput forward their view of the business. The articlesuggests three key criteria to ensure this alternativeapproach would work. First, allow very limited scope forassumption changes to minimise inconsistencies.Secondly, management’s view should diverge fromSolvency II in only the most material areas where thereis a perception of excessive strength in the regulatoryview. Thirdly, open and direct dialogue with theinvestment community will be required to support a fullunderstanding of the underlying business dynamics.

The reality is that we are on a journey that will seesignificant changes in financial reporting over thecoming years. Companies should include in theirSolvency II programmes a view of how they would likeSolvency II and IFRS 4 Phase II to affect the way theycommunicate to the market, and start making thenecessary preparations now.

4 Insurance Market Update (April edition): http://www.deloitte.com/view/en_GB/uk/industries/financial-services/sector-focus/insurance/50baed4af469f210VgnVCM2000001b56f00aRCRD.htm.

In the new world, post Solvency II andIFRS 4 Phase II, investors looking toback business models and managementteams over the long term may bereluctant to digest complex presentationsof profits prepared using two or threepotentially contradictory methodologies.


Conclusion

Embedded values have been around since the 1980s andhave seen continuous developments and changes,receiving mixed reactions from the investmentcommunity. Embedded value is again at a turning point,with the new world of Solvency II and IFRS 4 Phase II onthe horizon. Only time will tell which direction it will take.Looking back at 2010, the embedded value reportingseason has provided some conflicting messages. On theone hand there have been some tentative signs ofconvergence in methodology and assumptions, driven by regulatory changes, which should improve investors’and analysts’ acceptance of this metric and fulfil the long term aim of the CFO Forum.

On the other hand, the information presented hasshown that embedded value has slipped down the listof key reporting metrics with IFRS earnings, cash flowand capital generation taking more prominent roles. Life insurance in general and embedded value inparticular is perceived as complex. The opacity of someof its elements such as economic variance and CRNHRdoes not help dispel this image. This lack of transparencymay explain why most insurers in our sample weretrading at year-end 2010 at a discount to embeddedvalue. In whatever shape embedded value emerges,post Solvency II and IFRS 4 Phase II, in our view insurersshould consider how they can convey management’sview of value in a consistent, stable and transparentway. These changes present an opportunity to reduceand simplify a company’s reports rather than beingviewed as increasing the reporting burden and complexity.


Appendix: Embedded Valueyear-end 2010 assumptionssummary


Co

mp

any

Met

ho

do

log

yIm

plie

d D

isco

unt

Rat

e (I

DR

)R

efer

ence

Rat

esIll

iquid

ity

Pre

miu

ms

(Met

ho

do

log

y)Ill

iquid

ity

Pre

miu

ms

(Val

ue

in b

ps)

Vo

lati

litie

sC

RN

HR

Age

asEE

V

(Mar

ket

Con

sist

ent)

No

t d

iscl

ose

dSw

ap r

ate

at 3

1 D

ecem

ber

2010

for

the

rele

vant

cur

renc

ies

wit

h 10

bps

dedu

ctio

n ac

ross

the

ent

ire

curv

e.

Age

as u

ses

a w

eigh

ted

aver

age

liqui

dity

prem

ium

for

eac

h in

sura

nce

com

pany

bas

edon

the

ir li

abili

ty m

ix.

• EU

R:

23 –

34

• H

ong

Kon

g: 2

8 –

35•

US:

46

– 50

Impl

ied

vola

tilit

y 31

Dec

embe

r 20

10,

exce

pt f

or p

rope

rty

vola

tilit

ies

whe

rehi

stor

ic m

arke

t da

ta is

use

d.

Cha

rge

of 0

.5%

on

proj

ecte

d to

tal r

equi

red

equi

ty.

Alli

anz

MC

EVN

ot

dis

clo

sed

Swap

rat

es 3

1 D

ecem

ber

2010

CFO

/CR

O F

orum

and

QIS

5 il

liqui

dity

for

mul

a *

• EU

R:

59

• C

HF:

7•

USD

: 64

Impl

ied

vola

tilit

y 31

Dec

embe

r 20

10,

exce

pt f

or p

rope

rty

vola

tilit

ies

whe

rebe

st e

stim

ate

leve

ls a

re u

sed.

Equi

vale

nt 4

% c

ost

ofca

pita

l on

the

risk

cap

ital

(99.

5% q

uant

ile,

1-ye

ar).

Avi

vaM

CEV

9.90

%Sw

ap r

ates

31

Dec

embe

r 20

10C

FO/C

RO

For

um a

nd Q

IS 5

illiq

uidi

ty f

orm

ula

* (f

or t

he U

S bu

sine

ss x

= 6

0%)

• U

K:

109

• EU

R:

36•

US

imm

edia

te a

nnui

ties

: 66

• U

S ot

her:

56

Impl

ied

vola

tilit

y 31

Dec

embe

r 20

10,

exce

pt f

or p

rope

rty

vola

tilit

ies

whe

rebe

st e

stim

ate

leve

ls a

re u

sed.

Cap

ital

cha

rge

of 3

.3%

appl

ied

to g

roup

-div

ersi

fied

capi

tal.

AX

AEE

V

(Mar

ket

Con

sist

ent)

6.90

%Sw

ap r

ates

31

Dec

embe

r 20

10C

FO/C

RO

For

um a

nd Q

IS 5

illiq

uidi

ty f

orm

ula

*•

EUR

: 36

• G

BP:

79

• U

SD:

56•

JPY:

0•

CH

F: 8

• A

UD

: 65

Impl

ied

vola

tilit

y 31

Dec

embe

r 20

10A

llow

ance

for

non

-fin

anci

alri

sk a

ssum

ing

a hi

gher

lock

ed-in

cap

ital

bas

e(c

orre

spon

ding

to

loca

l AA

capi

tal r

equi

rem

ent)

.

Bal

oise

Gro

upM

CEV

No

t d

iscl

ose

dSw

ap r

ates

31

Dec

embe

r 20

10C

FO/C

RO

For

um a

nd Q

IS 5

illiq

uidi

ty f

orm

ula

*•

CH

F: 1

0 •

EUR

: 35

Im

plie

d vo

lati

lity

31 D

ecem

ber

2010

,ex

cept

for

pro

pert

y vo

lati

litie

s w

here

hist

oric

mar

ket

data

is u

sed.

A c

apit

al c

harg

e of

4%

isap

plie

d to

the

pro

ject

edSS

T ca

pita

l.

CN

PM

CEV

7.70

%Sw

ap r

ates

31

Dec

embe

r 20

10C

FO/C

RO

For

um a

nd Q

IS 5

illiq

uidi

ty f

orm

ula

*•

EUR

: 55

Impl

ied

vola

tilit

y 31

Dec

embe

r 20

10A

llow

ance

for

non

-fin

anci

alri

sk a

ssum

ing

a hi

gher

lock

ed-in

cap

ital

bas

e.

Gen

eral

iEE

V

(Mar

ket

Con

sist

ent)

6.99

%Sw

ap r

ates

31

Dec

embe

r 20

10(e

xcep

t fo

r C

zech

Rep

ublic

and

Isr

ael)

CFO

/CR

O F

orum

and

QIS

5 il

liqui

dity

for

mul

a *

• EU

R:

36

• C

HF:

8

• U

SD:

56

• G

BP:

79

Impl

ied

vola

tilit

y 31

Dec

embe

r 20

10A

llow

ed f

or a

s a

char

ge o

f4%

app

lied

to r

elev

ant

risk

-cap

ital

(le

ss t

ax).

Gro

upam

aEE

V

(Mar

ket

Con

sist

ent)

No

t d

iscl

ose

dTh

e ri

sk-f

ree

rate

cur

ve w

asco

nstr

ucte

d by

wei

ghti

ng t

hego

vern

men

t yi

eld

curv

es b

y th

eco

rres

pond

ing

prop

orti

ons

ofso

vere

ign

bond

s in

the

por

tfol

io,

tota

ke a

ccou

nt o

f th

e di

scre

panc

y at

31

Dec

embe

r 20

10 b

etw

een

the

spre

ad o

f th

e m

ain

gove

rnm

ent

debt

san

d th

eir

unde

rlyi

ng c

redi

t ri

sk.

The

calc

ulat

ion

met

hodo

logy

is b

ased

on

the

diff

eren

ce b

etw

een

two

indi

cato

rs:

–A

n in

dica

tor

of t

he s

prea

d on

the

bon

dm

arke

t, w

hich

the

refo

re in

clud

es t

heill

iqui

dity

dis

coun

t–

An

indi

cato

r ba

sed

on C

DS

prem

ium

s w

hich

does

not

incl

ude

this

dis

coun

t.Th

e liq

uidi

ty p

rem

ium

is a

mor

tise

d af

ter

15 y

ears

com

ing

to a

n en

d af

ter

20 y

ears

.

• EU

R:

16Im

plie

d vo

lati

lity

31 D

ecem

ber

2010

,ex

cept

for

pro

pert

y vo

lati

litie

s w

here

hist

oric

mar

ket

data

is u

sed.

Add

itio

nal r

isk

prem

ia o

f25

bps

and

50bp

s fo

rop

erat

iona

l ris

k an

dte

chni

cal r

isks

res

pect

ivel

yad

ded

to t

he C

oCca

lcul

atio

n.

KB

CM

CEV

No

t d

iscl

ose

dSw

ap r

ates

31

Dec

embe

r 20

10Li

quid

ity

prem

ium

s of

14b

ps a

re a

dded

to

the

risk

fre

e ra

tes

up t

o15

year

s an

d ar

e re

duce

dlin

earl

y to

zer

o ov

er t

he n

ext

five

yea

rs.

•14

up

to 1

5 ye

ars

•re

duce

d lin

earl

y to

zer

oov

er t

he n

ext

five

yea

rs

• B

elgi

um:

#N/A

• C

zech

Rep

ublic

& P

olan

d: I

mpl

ied

vola

tilit

y

Cap

ital

cha

rge

of 3

%ca

lcul

ated

bas

ed o

nin

tern

al e

cono

mic

cap

ital

.

Lega

l &G

ener

alEE

V#N

/A•

UK

RD

R =

7.3

%•

USA

RD

R =

6.6

%•

Euro

pe R

DR

= 6

.5%

#N/A

#N/A

Det

erm

ined

usi

ng m

arke

t da

ta a

ndsa

id t

o be

com

para

ble

to im

plie

dvo

lati

litie

s

#N/A

LBG

EEV

#N/A

•15

yea

r U

K g

ilt y

ield

for

non

-an

nuit

y bu

sine

ss•

An

equi

vale

nt s

ingl

e ri

sk f

ree

rate

for

annu

ity

busi

ness

bas

ed o

n U

Kgi

lt y

ield

cur

ve in

crea

sed

to a

llow

for

illiq

uidi

ty p

rem

ium

No

t d

iscl

ose

dN

ot

dis

clo

sed

Not

dis

clos

edN

ot d

iscl

osed


Co

mp

any

Met

ho

do

log

yIm

plie

d D

isco

unt

Rat

e (I

DR

)R

efer

ence

Rat

esIll

iquid

ity

Pre

miu

ms

(Met

ho

do

log

y)Ill

iquid

ity

Pre

miu

ms

(Val

ue

in b

ps)

Vo

lati

litie

sC

RN

HR

Mun

ich

Re

MC

EVN

ot

dis

clo

sed

Swap

rat

es 3

1 D

ecem

ber

2010

(exc

ept

for

coun

trie

s w

here

mar

kets

are

not

deep

and

liqu

id)

No

allo

wan

ce f

or li

quid

ity

prem

ium

#N/A

Impl

ied

vola

tilit

y 31

Dec

embe

r20

10C

apit

al c

harg

e of

7%

. N

o al

low

ance

for

dive

rsif

icat

ion

betw

een

cove

red

and

non-

cove

red

busi

ness

.

Old

Mut

ual

MC

EVN

ot d

iscl

osed

Swap

rat

es 3

1 D

ecem

ber

2010

Onl

y al

low

for

it o

n tw

o pr

oduc

ts.

Met

hodo

logy

und

iscl

osed

• U

S: 7

5•

OM

SA’s

Ret

ail A

fflu

ent

Imm

edia

te A

nnui

ty:

45

Impl

ied

vola

tilit

y 31

Dec

embe

r20

10 f

or d

eep

and

liqui

dm

arke

t. H

isto

ric

data

and

expe

rt ju

dgm

ent

else

whe

re

Allo

wed

for

as

a ch

arge

of

2.9%

appl

ied

to t

he g

roup

div

ersi

fied

cap

ital

requ

ired

in r

espe

ct o

f su

ch n

on-

hedg

eabl

e ri

sks

Prud

enti

alEE

V#N

/AW

eigh

ted

RD

R:

• 8.

1% (

Asi

a),

• 6.

9% (

Jack

son)

, •

9.9%

(U

K a

nnui

ty)

• 7.

0% (

UK

oth

ers)

Top

dow

n ap

proa

chU

K a

nnui

ty:

92

Com

bina

tion

of

actu

al m

arke

tda

ta,

hist

oric

mar

ket

data

and

an a

sses

smen

t of

long

er-t

erm

econ

omic

con

diti

ons.

Allo

wed

as

a m

argi

n in

the

dis

coun

tra

te.

Def

ined

as:

• 10

0 bp

s fo

r U

K a

nnui

ty b

usin

ess

• 50

bps

for

Gro

up’s

oth

er b

usin

ess

• ad

diti

onal

100

to

250

bps

for

Gro

up's

Asi

an o

pera

tion

s

Res

olut

ion

MC

EVN

ot

dis

clo

sed

Swap

rat

es 3

1 D

ecem

ber

2010

Two

appr

oach

es u

sed:

1) A

com

pone

nt o

f th

e di

ffer

ence

bet

wee

nth

e sp

read

on

a co

rpor

ate

bond

and

acr

edit

def

ault

sw

ap;

and

2) U

se o

f op

tion

pri

cing

tec

hniq

ues

tode

com

pose

the

spr

ead

into

its

com

pone

nts

incl

udin

g ill

iqui

dity

pre

miu

m

UK

ann

uity

: 75

Mar

ket

impl

ied

vola

tilit

ies

Cap

ital

cha

rge

of 2

% o

n pr

ojec

ted

Gro

up r

equi

red

capi

tal f

or a

ll no

n-he

dgea

ble

risk

.

Stan

dard

Life

EEV

#N/A

RD

R =

ris

k fr

ee g

over

nmen

t bo

ndyi

eld

+ a

risk

mar

gin:

•

7.09

% (

UK

Her

itag

e W

PF)

• 6.

19%

(U

K o

ther

) •

6.89

% (

Can

ada)

• 6.

56%

(Eu

rope

Her

itag

e W

PF)

• 5.

66%

(Eu

rope

oth

er)

• Fo

r A

sia,

ris

k ne

utra

l app

roac

h an

dan

allo

wan

ce f

or n

on•m

arke

t ri

skw

as u

sed

#N/A

#N/A

Impl

ied

vola

tilit

y 31

Dec

embe

r20

10

Allo

wed

as

a m

argi

n in

the

dis

coun

tra

te.

Def

ined

as:

• 1.

80%

(U

K H

erit

age

WPF

) •

1.60

% (

UK

oth

er)

• 2.

80%

(C

anad

a)•

1.80

% (

Euro

pe H

erit

age

WPF

)•

1.60

% (

Euro

pe o

ther

) •

Not

dis

clos

ed f

or A

sia

Stor

ebra

ndM

CEV

Nor

way

: 8.

9%Sw

eden

: 10

.0%

Tota

l: 9.

2%

• M

arke

t in

tere

st r

ates

are

app

lied

toth

e liq

uid

part

of

the

inte

rest

rat

ecu

rve

up t

o 10

yea

rs•

A lo

ng-t

erm

equ

ilibr

ium

leve

l is

appl

ied

from

20

year

s an

d on

war

ds•

Line

ar in

terp

olat

ion

is u

sed

betw

een

10 y

ears

and

20

year

s

• N

o al

low

ance

for

liqu

idit

y pr

emiu

m#N

/AIm

plie

d vo

lati

lity

31 D

ecem

ber

2010

, ex

cept

for

pro

pert

yvo

lati

litie

s w

here

his

tori

cm

arke

t da

ta is

use

d.

Cap

ital

cha

rge

of 2

.5%

on

the

dive

rsif

ied

risk

cap

ital

for

non

-he

dgea

ble

risk

.

Swis

s Li

feM

CEV

No

t d

iscl

ose

dSw

ap r

ates

31

Dec

embe

r 20

10•

No

allo

wan

ce f

or li

quid

ity

prem

ium

#N/A

Impl

ied

vola

tilit

y 31

Dec

embe

r20

10,

exce

pt f

or p

rope

rty

vola

tilit

ies

whe

re h

isto

ric

mar

ket

data

is u

sed.

Cap

ital

cha

rge

of 4

% p

er a

nnum

has

been

app

lied

to t

he r

esul

ting

proj

ecte

d ca

pita

l at

risk

.

ZFS

MC

EVN

ot

dis

clo

sed

Swap

rat

es 3

1 D

ecem

ber

2010

• N

o al

low

ance

for

liqu

idit

y pr

emiu

m•

Will

incl

ude

liqui

dity

pre

miu

m in

the

201

1M

CEV

bas

ed o

n th

e C

FO/C

RO

For

um a

ndQ

IS 5

illiq

uidi

ty f

orm

ula

*

#N/A

Impl

ied

vola

tilit

y 31

Dec

embe

r20

10,

exce

pt f

or p

rope

rty

vola

tilit

ies

whe

re h

isto

ric

mar

ket

data

is u

sed.

• C

apit

al c

harg

e of

2.5

% a

pplie

d to

the

dive

rsif

ied

risk

cap

ital

• W

ill in

crea

se t

he c

apit

al c

harg

e fr

om2.

5% t

o 4%

in t

he 2

011

MC

EV

Sour

ce:

Com

pani

es’

disc

losu

re a

nd D

eloi

tte

anal

ysis

* C

FO/C

RO

For

um a

nd Q

IS 5

illiq

uidi

ty f

orm

ula:

LP

= M

AX

(0,

x%

× (

Spre

ad –

y b

ps))

Whe

re:

x =

50%

and

y =

40b

psLi

abili

ties

are

cla

ssif

ied

in 4

buc

kets

in f

unct

ion

of t

heir

nat

ure.

Dif

fere

nt p

ropo

rtio

ns o

f th

e LP

are

app

lied

(100

%,

75%

, 50

% a

nd 0

%)


Deloitte contacts

UKRoger Simler+44 (0)20 7303 [email protected]

Richard Baddon+44 (0)20 7303 [email protected]

Andrew Smith+44 (0)20 7303 [email protected]

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AustraliaCaroline Bennet+61 (03) 9671 [email protected]

Central EuropeKrzysztof Stroinski+48 (22) [email protected]

DenmarkThomas Ringsted +45 [email protected]

FranceClaude Chassain+33 1 40 88 24 [email protected]

GermanyBharat Bhayani+49 221-97324 [email protected]

SpainJosé Gabriel Puche+34 915 145000 (ext. 2027)[email protected]

SwitzerlandJerome Crugnola-Humbert+41 44 421 68 [email protected]

USPatricia Matson+1 [email protected]

South AfricaAndy Rayner+2721 427 [email protected]

Hong KongSimon Walpole+ (852) 2238 [email protected]

Deloitte focuses on adding value for all our clients’ stakeholders through our combination of actuarial, consulting,tax, audit and corporate finance expertise. We are involved as strategic advisers to many companies in the industryand advise many of the largest companies in areas such as MCEV, Solvency II, replicating portfolios, risk and capitalmanagement, M&A and Finance Transformation.

If you would like to know more about these or any other areas addressed in this article please contact the followingpeople or your usual Deloitte consultant.

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