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The Actuary The magazine of the Institute & Faculty of Actuaries

The actuarial fashionista

Next year’s fashion shows are rumoured to include two new collections of little numbers, with each design house producing its own version of both. Enigmatically named MCEV and EEV, they are largely based on this season’s design, the (EV).
As LV is important to almost all top fashion productions, EV is a feature in almost all actuarial ones. Unlike Louis Vuitton though, the full name of EV is not glamorously French. In fact, it’s plain English: embedded value.

Each design house, or ‘corporate actuarial team’ produces its own EV number. Although the details of their designs may differ, the EV is, broadly speaking, each team’s best estimate of the present value of future profits arising from the life insurance business currently on its company’s books. It is each team’s answer to these questions from shareholders: ‘How much profit do we think we’ll make from all of the policies that we’ve sold in the past and that are still if force? And what do you think that profit is worth today?’
In answering the second part, we calculate the present value of the profit to shareholders by using a discount rate called the risk discount rate, or RDR. (RDR is one of the actuarial world’s ever-growing collection of TLAs*.)

More technically, the EV includes all sources of profits (or losses) to shareholders from the operations of the life company. Common examples are:
– Shareholders’ portion of future bonus declarations (this happens in 90:10 and other shared profits funds).
– Expected mortality, investment, expense, and other margins emerging on non-profit, unit-linked, and any other business, where these are allocated to shareholders.
Some of the more detailed forms of EV include an allowance for other sources of profit (or loss):
– The interest earned on current liabilities, which works as follows. Although a company’s net assets are published after deducting the current liabilities, its interest-earning assets include the amount of the current liabilities. This is because, by definition, the liabilities have not yet been settled. In other words, the company still has the money in its bank account, even though it’s not showing it in its balance sheet, and the interest it earns on the money is a profit to shareholders. Where a company has a fairly steady level of current liabilities, as will usually happen if old ones are paid and replaced by new ones, there will be a long-term stream of interest profits that can be allowed for.
– The profits from captive asset management operations (ie owned by the life company). These may be included in their entirety, or only the profits from the management of the life company assets might be included.
– An increasing number of companies, spurred on by Equitable Life’s collapse, are allowing for a statistically calculated reduction to their EV. These reductions are the expected values of any future payments made to policyholders from shareholders’ funds. These payments will typically only be made at claim stage when market returns to the date of claim have been worse than the (usually low) returns promised to policyholders.

New fashion lines
One of the most eagerly awaited items in each EV collection is the EV from business written in the preceding financial period. This is called the value of new business, or the new business contribution, or a further two TLAs: VNB and NBC.
VNB tends to be a volatile figure, varying each year with many factors such as the life insurance cycle, the pricing policies of each insurer, the subjective allocation of the costs of initially obtaining a policy (often mainly commission), and the chosen RDR.
As it represents the present value of all of the profits that a life insurer expects to make over the lifetime of its new policies sold, it can be interesting and instructive to compare it to the costs of writing that new business. I have seen cases where broker commission (paid upfront) exceeded the life company’s expected future profit from new business. This gives rise to the question: would you prefer to be a broker, and have £100 paid to you now with a high level of certainty for each policy you sell, or an insurer, and receive £100 over many years from that same policy, with a low level of certainty?
I needn’t add that as a fairly successful broker you’ll also get overseas trips and probably additional commission in each month that a premium is received from a policyholder.

EV has been the ‘in thing’ for some years now, and it is still evolving to give a better reflection of the shape of each insurer’s profit figures. Its popularity looks set to continue with the imminent release of at least one of its two new editions, these being the market-consistent EV and the European EV.