MCEV
Background information
The Embedded Value (EV) of a life insurance company is the present value of future profits plus adjusted net asset value:See Wikipedia definition
The European Embedded Value (EEV) is an effort by the CFO Forum to standardize the calculation of the EV. For this purpose the CFO Forum has released guidelines how EV should be calculated. The EEV allows greater consistency for such calculations, making them more useful: See Wikipedia definition
European Embedded Value Paper
On the 4th June 2008, the European Insurance CFO Forum published the Market Consistent Embedded Value (MCEV) Principles and associated Basis for Conclusions. This will represent the only CFO Forum endorsed method of embedded value reporting from 31st December 2009.
CFO Basis for conclusions(PDF)
Towers Perrin (PDF) Towers Perrin (PDF)
Definitions
For MCEV the reporting system is designed to focus on shareholder interests. MCEV is the present value of the contribution of the covered business to shareholder distributable earnings. This is defined as the sum of the following three components:
a) Free surplus:
The free surplus is the market value of any assets allocated to, but not required to support, the in-force covered business at the valuation date (principle 4).
b) Required capital:
Required capital is the market value of assets, attributed to the covered business over and above that required to back liabilities for covered business, whose distribution to shareholders is restricted (principle 5).
c) Value of in-force covered business (VIF)
VIF consists, according to principle 6, of following components:
i. The present value of future profits(PVFP), less
ii. The time value of financial options and guarantees(TVFOG)(def. in principle 7), less
iii. The frictional costs of required capital(def. in principle 8), less
iv. The cost of residual non hedgeable risks(CRNHR)(def. in principle 9)
MCEV calculation starts from a net asset position (free surplus and required capital), based on a valuation of assets and liabilities. The PVFP is then calculated, ensuring that the liabilities projected are consistent with those used in the valuation of the net assets. From this, the time value of financial options and guarantees (TVFOG), the CRNHR and Frictional Costs of Required Capital are deducted to arrive at the MCEV result.
PWC: CFO Forum MCEV Principles PDF
Discounting of future cash flows:
Traditional embedded value calculations use a single "risk discount rate", a rate obtained by adding a risk premium to the risk free rate, to discount projected profits. The risk premium is meant to reflect the risks inherent in a life company, and is the reward to investors for taking on the risks.
However, the choice of the risk discount rate can be subjective and the allowance for risk through the risk discount rate is relatively primitive as it may not accurately reflect the appropriate weighting of the risks in the company's projected profits and the risk within asset returns.
Another criticism is that the risk discount rate does not vary over time as the risk profile of the overall business changes, or as investment markets change.
The use of a single discount rate applied to the net cash flows also ignores the risk characteristic of the individual cash flows being valued.
MCEV techniques, in theory, discount each projected cash flow at a rate that reflects the risk associated with that cash flow. This means that different discount rates are used for each cash flow, as shown below:
| Type of Cash Flow | Example | Discount Rate |
|---|---|---|
| Cash flow known with certainty. | Term-certain, non-participating, non-indexed immediate annuity. | Risk Free Rate |
| Cash flow is uncertain, but that uncertainty is not systematic (i.e. the risk is not associated with the market, e.g. mortality risk). | Single premium, non-participating endowment policy. |
Risk free rate. The rationale for using a risk free rate is of the theory that in an efficient market, risks uncorrelated to market risks (e.g. mortality risks) are diversifiable (e.g. by selling a large number of such policies, through reinsurance, or by investing in other types of business not exposed to mortality risks) and hence there is no reward for assuming such risks (i.e. no risk premium is needed). |
| Cash flow is uncertain, but that uncertainty is systematic. | Management charge linked to unit-linked fund values. | Expected earning rate of equivalent asset. |
The above approach can be simplified by using certainty equivalent techniques. This works by projecting returns using the risk-free rate (i.e. risk-adjusting the cash flows) and discounting them using the same rate. Both approaches will give the same values, regardless of the discount rate, as long as the projection and discounting are carried out consistently.
Allianz Reinsurance: Life Matters Feb 2005
Value of in-force covered business (VIF):
The MCEV Principles set out the requirements for economic assumptions, when performing a market consistent valuation, in Principles 12 to 15.
In calculating the value of in-force covered business (VIF) the discount rates should be consistent with those that would be used to value such cash flows in the capital markets (principle 13). In order to perform this calculation the Principles define the reference rate which is a proxy for the risk free rate, as the swap yield curve without adjustment for liquidity or credit premiums (principle 14).
Time value of financial options and guarantees (TVFOG):
In calculating the time value of financial options and guarantees (TVFOG) the stochastic models used should be calibrated to the most recent market data available. Volatility assumptions should be, where possible, implied volatilities derived from the market rather than based on historic information. The TVFOG along with the intrinsic cost of the options and guarantees included in the future profits should therefore represent the current market price of hedging the financial options and guarantees.
PWC: CFO Forum MCEV Principles
Cost of capital:
Traditional embedded value techniques value the cost of holding capital as a function of the difference between the risk discount rate and the assumed earning rate on the capital. This means that the traditional cost of capital reflects both the market related risks and the true economic costs of holding capital.
The weaknesses of this approach are that firstly, it results in a lower cost of capital invested in riskier assets (which commands a higher earning rate), and secondly, it does not explicitly allow for the specific risks associated with the holding of capital in a life company.
MCEV, on the other hand, allows for asset and liability risks separately from the cost of holding capital. The valuation of assets and liabilities already reflect the market risks. The cost of holding capital is then determined explicitly by quantifying the following components of cost:
| Cost | How the costs arise |
|---|---|
| Agency Costs |
This is the term used to describe the cost arising from shareholders ceding control of capital to the company's management, and therefore becoming exposed to the risk that management will not always act in the shareholder's best interest, which is to maximize shareholder value. The value shareholders place on agency costs will depend on factors such as their assessment of the quality of management and transparency of how the company is run. Hence, this value is difficult to quantify but empirical studies suggest that it is a function of the amount of capital or cash flow. |
| Double Taxation | Investing assets in an insurance company is generally less tax-efficient than holding them directly because investment returns are first taxed at the company tax rate and then dividends are taxed a second time at the shareholder's marginal rate. |
Allianz Reinsurance: Life Matters Feb 2005 (PDF)
Allowance for risk:
The MCEV Principles set out a framework, rather than a prescribed method of allowing for risk. Risks can be subdivided into two types: hedgeable and non hedgeable. Hedgeable risks are those where it is possible to reduce an exposure by purchasing a hedging instrument or transferring the exposure to a counterparty in an arm's length transaction under normal business conditions. Non-hedgeable risks are risks that cannot be hedged or easily transferred to a third party, due to the lack of a deep and liquid market. This is the risk subdivision the proposed Solvency II framework uses. Risks can also be subdivided into those that are financial and those that are non financial in nature.
