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The Actuary The magazine of the Institute & Faculty of Actuaries
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Making sense of life office management

Over recent years we have seen extraordinary
changes in the way in which life insurance
companies manage and report their business. This has been a process of evolution rather than revolution, where the approach has developed in a reactive way. In the 1980s embedded value accounting attempted to turn the combination of cashflow losses combined with an increase in balance sheet value into P&L profit. In the 1990s, the reaction to the cost of guarantees led to the use of economic capital techniques and to the introduction of internal capital assessment.
We now have European embedded values (EEV) which have attempted to bring a common approach to profit reporting. But this has led to some heated debate about how to set discount rates, how to allow for capital, and what capital to allow for. Considering the best ways to update pricing and profit testing has been pushed aside by unavoidable redevelopment of regulatory and accounting models.
Although we now appear to have more information than ever on how insurance companies are performing this does not mean that we have a good understanding of shareholder returns and the true risk/reward of investing in insurance. What is needed by both the industry and shareholders is a coherent view to bring all of this together. In this article, we set out five fundamental principles that should form the foundations of such a framework.

1 Valuations should use market prices to allow for market risk
In many industries there is a lack of information available to determine the impact that market movements have on the performance of a company. The crude measure of return on equity, adjusted to reflect a company-wide cost of capital based on historic betas, may be the best available measure.
Insurers are fortunate in that they know exactly what their exposure is to equity markets, interest rates, or credit risks. Companies can look through their business to allow for these risks at a high level of granularity. This should give life insurers a significant advantage over companies that are operating in other industries.
In our view, life insurance companies should use this insight to improve the way in which risks and rewards are monitored. Life insurance companies would be well advised to capitalise on this advantage in their financial reporting and product pricing by making a bottom-up allowance for market risk.
In practice this means developing market-consistent value measures which are incorporated into pricing, performance measurement, and determining capital needs.
2 Performance measurement should be based on an objective approach which fully allows for market risk
Conventional performance measures used by life insurance companies make it difficult to disaggregate the impact of stockmarket performance from the value added by the management team. By using market-consistent techniques it is not only possible to get significantly better performance measures, but also to remove much of the subjectivity associated with estimating long-term parameters.
First, we consider the conventional approach. By observing the performance of your stock you may think that your business has a historic beta of 80%. That means that when the stockmarket rises overnight by 10% your business is expected to rise by 8%, plus or minus firm-specific effects which are not driven by markets.
Traditional return on equity models work out the long-term return that shareholders require. If the risk-free rate is 4.5% and the equity risk premium is 6% then this implies that a share with a beta of 80% should return 9.3%. Companies can then compare this to the actual accounting return on equity.
This is a blunt tool which works well in a year where there is no adverse stockmarket performance. However, life insurance companies are at an immediate disadvantage in years when the stockmarket performs poorly.
In addition, historic betas do not tell the whole story. If two portfolios have the same beta then they appear to have the same exposure to stockmarket levels. But they might still have different exposures to movements in yield curves, real estate markets, credit spreads, currencies, or implied volatilities. By using a market consistent approach we can get greater clarity. The company can build a replicating portfolio model which quantifies the fair value exposures to all of these factors, based on a bottom-up model of how the business actually works rather than on historic correlations alone. Performance measurement then involves comparison of actual shareholder returns by business unit relative to the corresponding replicating portfolios.
The replicating portfolio method is more informative than the traditional beta approach because:
– It eliminates any effect of market movements, whether beneficial or detrimental, by capturing market movements in the replicating portfolio.
– It is objective rather than subjective.
– It removes the need to estimate long term parameters such as the equity risk premium which address a fundamental weakness in current techniques.
– Replicating portfolios can price correctly for interest rates, credit, and other sensitivities as well as stockmarket movements.
3 Shareholder returns should be measured relative to total shareholder value putting the right E into ROE.
Suppose that you acquire a business for £120. It has £80 of net assets, but requires £60 of economic capital. Of course you should measure the return on the £120 you spent and not on the £60 of economic capital, even though the return on £60 is probably a higher number.
The £120 represents a market consistent valuation of the business structures, distribution capability and customer relations. The economic capital of £60 captures the risk bearing capacity which is only one of several scarce resources required to deliver the product. Economic capital is about risk, not value creation. Shareholders require a return on their total investment not just on the shareholders’ net assets as implied by the currently popular ‘return on equity’ measures.
As part of a consistent framework this approach needs to be incorporated in product pricing, target setting, and financial performance measures.

4 Hold capital to optimise shareholder value not just the ‘what’s needed to meet your risks’
Companies have found internal capital assessment (ICA) and economic capital invaluable as a means of understanding their true capital structure. Economic capital is about how much you need to protect against extreme events - usually to achieve a given ruin probability over a given time horizon. An abrupt boundary divides ‘inadequate’ and ‘enough’.
However, this approach does not attempt to measure the impact of ruin or to put it another way how much the shareholders stand to lose. Nor is there a measure of the cost of holding the capital. Economic capital simply provides a minimum amount of capital to hold but does not help answer the question ‘how much capital should be held to optimise shareholder value?’
Away from the theoretical world of economic capital models, capital structure is a business decision subject to regulatory constraints. Weakly capitalised firms may miss business from credit-sensitive customers, and ultimately the whole firm is at risk from adverse movements. On the other hand, shareholders see an opportunity cost to capital especially if there’s a lack of clarity around what it is needed for. Therefore, the amount of capital that you decide to hold, and the associated dividend policy, comes from an assessment of the cost and benefit of different capital structures over a firm’s lifetime. Economic capital on its own does not provide the tools to make these assessments but techniques are now available to perform this analysis.

5 Move beyond the impact of market risk to understand embedded credit risk
As we have discussed above, models of market risks are well developed and widely used. However, companies are still considering the way in which they will allow for ‘other risks’. A particular example of this is locking-in adjustments which are often used in European embedded value reporting. Generally this leads to significant adjustments when ‘top-down’ discounting is used, but much smaller adjustments result from ‘bottom-up’ techniques.
If we consider the existing economic capital framework it is fundamentally linked to credit risk. A percentile based capital requirement is usually expressed in terms of a desired credit rating. Economic capital may mean that we have better measures to help us provide for the risk, but we need more than that to shed light on what the risks mean for required shareholder returns.
At first sight it might appear that credit risk is beneficial to the shareholders of a life assurance company because of the value of the limited liability put options that allow them to walk away if the business fails. However, in the real world, shareholders in a failed company also forgo many years of potential future earnings. This financial loss typically exceeds many times over any relief that the shareholders may enjoy from defaulting on current obligations.
Credit risk reflects the possibility that a company fails entirely. Share prices make an allowance for this risk of failure when pricing the dividend stream. Much like a corporate bond, the growth in a company’s share price is boosted as ‘default risk’ unwinds. Ideally, any model for shareholder value should allow for the effect of this contingent loss of franchise value in the event of corporate failure. Techniques for valuing this effect, linking to economic capital requirements, are now beginning to emerge and should prove important in making the elusive allowance for ‘other risk’ in market consistent reporting measures.

Coherent views
The application of market-consistent valuation to life insurance has provided a major breakthrough. Market-consistent embedded value could yet improve the consistency of financial reporting across the industry, but making allowance for ‘other risk’ continues to prove elusive. Without this, question marks will remain. Techniques for allowing for a company’s own credit risk are now emerging and will provide one of the missing links. This will be critical if financial reporting in life insurance is to move on to provide a coherent view of shareholder valuation, performance measurement, capital management, and pricing.

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