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The Actuary The magazine of the Institute & Faculty of Actuaries

Life assurance value measurement

The actuarial profession has developed a range of methods for valuing businesses and specifically liabilities in the insurance and pensions industries. Traditionally the profession has been considered to be far ahead of its counterparts in the banking industry, where the main focus has been measuring single-period profitability.
Over the past two decades, however, the banking and securities industries have been revolutionised by the use of state-of-the-art finance theory to support their trading activities and the adoption of shareholder value-orientated frameworks for measuring business-level value generation. This has increasingly prompted actuaries to question whether the profession can learn from the methodologies and approaches adopted by their banking cousins.
A number of actuarial working parties have looked at the different approaches and applications of value measurement. Recently the Life Assurance Value Measurement Working Party was established under the aegis of the Value Measurement Steering Group to look at the application of value measurement in the life industry. Specific goals included:
– summarising the value measurement models being used by life offices;
– studying the ways in which value measurement models might be used in practice.
The purpose of this article is to give a flavour of the discussions rather than any definitive conclusions of the working party.

Shareholder value
To quote from a 1999 ICA discussion paper entitled ‘Inside out: reporting on shareholder value’:
‘“Shareholder value” has become a widely used cliché but it is, perhaps, not widely understood. This may be because the different measures of shareholder value capture different aspects of performance.
‘From the investors’ perspective, value created is commonly measured as the growth in a company’s share price over a period together with dividends received from it, the total shareholder return (TSR). This is an essentially forward-looking measure since share prices reflect the market’s expectations of future cashflows. If a stockmarket prices shares efficiently, this will reflect the value created by management in a period.
‘From management’s perspective, the insight offered by a “value” focus is that the use of equity capital is not “free”, it is invested in the expectation of earning a return and this required return defines the company’s cost of equity capital. Management can only create value for shareholders if the company consistently, over the long term, generates a return on capital which is greater than its cost of capital.’
‘Economic value added’ is a measure of financial performance designed to reflect this insight that capital has a cost. EVA“ is technically a registered trademark of Stern Stewart & Co, who use the definition:
EVA=net operating profit after taxes (NOPAT)
[capital¥the cost of capital”
More generally it can be defined as profit from the accounting period (adjusted for accounting conventions, eg depreciation) less a cost of capital. This definition leaves open the choice of measures of profit, capital, and cost of capital. More advanced models tend to make several modifications:
– especially in a long-term business, the profit measure needs to be the change in some value, where the value measure looks forward over future cashflows (and allows for future growth prospects) see below;
– capital can be allocated based on explicit modelling of contributory risk;
– cost of capital may vary between different parts of the business, based on the degree of systematic risk. However, it is probably fair to add that there is some divergence of opinion on whether it is appropriate to assign a zero cost to diversifiable risk estimates of mean cashflow may not capture well effects on the tails of the cashflow distributions.

Methods of value measurement
Actuarial values have traditionally been prepared on the basis of discounted cashflow (DCF). This method is simple to understand. However, it also contains subjective estimates in the selection of discount rates and the period over which to project, not to mention the parameter assumptions for projecting future experience (such as lapse rates, expenses, etc).
In the use of such DCF approaches the actuarial profession is still somewhat ahead of many banks, eg many commercial banks still do not carry out rigorous net present value (NPV)-based profit testing of their commercial loan portfolios taking into account realistic projections of expected credit losses.
However, there has been considerable discussion over the years concerning:
– the choice of discount rate and how it might be affected by the characteristics of the business in question;
– more generally, how the actuarial values resulting from DCF valuation relate to the observable value of the (frequently tradable) assets that typically comprise the bulk of a life office’s balance sheet.
Alternative methods of value measurement have therefore been developed, often based upon deriving a ‘market price’ as a measure of value and using asset pricing techniques, or option pricing approaches, or replicating portfolios. The bulk of these approaches do not attempt to find an objective valuation, but instead seek a relative valuation, consistent with the observed market values for those same assets.
In addition to the adverse impact of risk on value, there has also been more recent discussion concerning how traditional DCF approaches can be reconciled with the high valuations attached to business ventures that seem to have highly uncertain profits in the future, ie the impact of upside risk. Much recent valuation literature has therefore focused on the modelling of ‘real options’ to make sense of the values of businesses ranging from oil exploration projects to new economy ventures. Such approaches again use stochastic techniques, only this time to analyse the impact that management’s ability to take decisions dynamically has on the value of a project.
Increasing use of such techniques does not obviate the need for actuarial judgement in terms of assumptions and parameters assumptions concerning mortality, expenses, lapses, and the relationship between these and financial variables will still need to be made, typically with very little relevant data to support such estimates. However, by reducing the need for subjective judgement in how risk is valued, the approaches outlined above can allow the actuary to focus efforts on improving the robustness of the other parameter estimates where the need for judgement is unavoidable.

Use of value measures
Actuarial valuation techniques were originally designed to ensure that a life office had sufficient assets to meet its obligations to its policyholders. With the advent of a more explicit shareholder value orientation in financial services, such applications have since expanded to include mergers and acquisitions valuation, business planning and performance measurement, and profit-testing of individual products.
The use to which the valuation is being put has clear implications for the approach that is used in practice to carry out valuations. For analysing the impact on value of different investment strategies, sophisticated market-price-consistent approaches are becoming significantly more widespread, in order to ensure consistency in the treatment of assets and liabilities. This is similarly true when developing profit-testing models for products with complex guarantees and profit-sharing formulae. However, when one is comparing two valuations with similar asset/liability characteristics, a simpler approach is typically adequate, eg assessing the impact on appraisal value of potential synergies in an acquisition.
For performance measurement, the use of valuations that are as objective as possible is particularly critical, given the need to ensure that the measures cannot be gamed and do not inadvertently encourage perverse behaviour on the part of business management (for example, encouraging management to take extra economic risk that is not adequately rewarded in terms of extra economic return).
In a life company that is part of a wider financial group, there may of course be additional constraints on how performance is measured in order to ensure reasonable consistency with the accounting conventions of other parts of the group, especially long-term businesses such as asset management and mortgages. Some institutions have found that adopting an ‘embedded value’ approach for all their businesses is the only way to square this circle; others have adopted dual accounting for their life businesses a value-based approach and an accrual-based approach, often based on US GAAP (generally accepted accounting practices). This is particularly true of those companies with large international operations.
Beyond the applications discussed above, there are still many other areas where actuaries, and actuarial values, have yet to become widely deployed. Customer value and the integration of traditional profit testing with elasticity analysis to generate value-based product design are two areas where there is considerable further scope for actuaries to apply their expertise.

Learning curve
The working party has yet to reach any firm conclusions, although the findings look like being positive overall for actuaries. There is much that other industries, and particularly banking, can learn from actuaries specifically in the valuation of long-term businesses and indeed many banks are now actively using value-based models for the ‘profit testing’ of new product designs, for the evaluation of business strategies, and even for measuring business unit performance.
However, it is also clear that there is much that actuaries can learn from the developments in financial economics over the past 30 years both in the use of market price-driven valuation methods, and in the application of valuation techniques to broader business decisions.