Ed Morgan and Jeremy Kent describe a valuation methodology for insurance merger and acquisition transactions, the Solvency II Appraisal Value, or SII-AV
The introduction of Solvency II is driving significant changes for the European insurance sector, including insurance mergers and acquisitions (M&A).
In our experience, investors are often interested in projected shareholder cashflows, that is, the expected real-world distributable profits, and wish to discount them at their required rate of return. A number of factors may influence distributable profits, but the most important medium- to long-term drivers are likely to be the required Solvency II capital and the own funds available and eligible to cover it.
Thus buyers and sellers of insurers are usually highly focused on the current and future capital position. Solvency II makes this position harder to determine than under Solvency I, but there is also much more scope for capital synergies and to improve the capital position through management actions.
While, in theory, the net present value of distributable profits could be obtained from a full, long-term projection of the Solvency II balance sheet and SCR, in practice it may be very challenging to get such a projection in a transaction situation. Approximations likely to be available, such as business plan or own risk and solvency assessment (ORSA) projections, may introduce material distortions into any valuation approach.
Our methodology, therefore, decomposes the valuation into given components, which can be determined with a reasonable level of precision, based on information likely to be available. Furthermore, this decomposition can be very useful in understanding the value attributed to activities such as new sales and asset management. This can be a base from which to assess the value that may be added by changing elements of the company's strategy.
This methodology can be applied equally to life, non-life, and health business.
Starting point - assumption of no hedgeable risks
Under the simplifying assumptions that all hedgeable risks are hedged, that assets earn the risk-free rate, that the solvency ratio (Solvency II own funds/SCR) is exactly 100%, that the shareholders' required rate of return is 6% above the risk-free rate, and, in the absence of any tax and any future business, it can be shown that the present value of projected distributable profits, SII-AV, equals the initial own funds.
The above conditions would not be realistic in any real-life situation, thus we need to make adjustments to this value to allow for the tax rate, and a different shareholders' required rate of return and solvency ratio. This is the approach we will follow here.
Our research paper, noted below has more details of the development of formulae to allow for these generalisations.
Impact of taking market risks
Generally, companies are not obliged to take unhedged market risks and, therefore, do take them because they are expected to be more than compensated by increased investment returns (when the uplift in expected returns exceed capital charge related to risky assets).
We can determine the impact on SII-AV of investing in 'risky' assets by considering:
- The uplift in returns from investing in risk-free, less
- The cost of additional capital arising from risky assets, which will be a function of the additional capital, and the shareholders' required rate of return, applied to the volumes of risky assets, allowing for tax as appropriate.
This calculation can be simplified if we assume that the uplift in returns, and the proportional additional capital required for risky assets, are constant over time. In practice, these may be expected to vary (for example, to allow for declining residual duration of corporate bonds, or diversification with non-hedgeable risks).
By allowing for value to be created (or destroyed) through holding risky assets, we have made an important departure from market-consistent methodology. Our approach reflects the investor's own view of expected additional returns, and the risk is captured through the cost of the additional capital, which needs to be held. In our experience, this reflects more closely the decision-making framework used to run and buy insurance companies.
All other things being equal, we would expect there to be a theoretical optimum proportion of risky assets, in particular because, as more risky assets are added, the proportional diversification benefit with other risks will diminish. This is illustrated in Figure 1 below. Of course, in practice, a diversified portfolio of risky assets would be sought.
For participating business we would need additionally to make allowance, in the calculation of the impact of investing in risky assets, for:
- Part of additional returns potentially being passed to policyholders
- The impact of loss-absorbing capacity of technical provisions (LACTP) on the additional capital.
This calculation can again be simplified if the above elements are constant proportions over time. In practice, they may vary over time - for example, as older business with higher guarantees runs off.
Depending on the circumstances, consideration may need to be given to the impact of a real-world approach on the projected value of financial options and guarantees.
To complete the valuation, it is necessary to put a value on all future premiums not within the contract boundary definitions of the initial Solvency II balance sheet. A common approach in appraisal value methodology is to consider the value of one year's new business (NBV), and apply a multiplier, rather than projecting all future years' new business.
NBV is calculated using a method analogous to that for in-force described above, beginning with the own funds generated at point of sale, and making various adjustments.
It is also necessary to consider how new business may interact with the in-force (diversification benefits in respect of capital, ALM interactions, etc) in order to produce NBV on a marginal basis.
Determining a suitable multiplier to apply is a problem also in embedded value (EV) methodologies, in particular when there is a need to reflect an expectation of changing profitability over time.
There may be other constraints on profits being distributable other than those prescribed by Solvency II.
However, we believe, to estimate distributable profits, it will usually be better to base the valuation on Solvency II metrics and possibly adjust the target solvency ratio, than to use a definition of distributable profits based on accounting earnings.
Other factors related to Solvency II that may need to be considered include the eligibility/tiering of capital, use of transitional measures and subordinated debt.
Our methodology has similarities to a traditional EV (TEV) methodology, with statutory accounting and capital replaced with Solvency II values.
However, while a TEV approach based on accounting profits is difficult to apply in a Solvency II framework (in particular, determining cost of capital is problematic), the SII-AV approach is a workable one.
While some buyers may prefer to stay with an approach based on market consistent EV (MCEV) methodology, we note that:
- Investors are typically not interested in the theoretical 'market value' of the liabilities (which is the basis for MCEV and, indeed, the Solvency II balance sheet), but rather the expected dividend stream
- MCEV makes no allowance for the shareholders' view of expected real-world investment returns and the cost of holding capital for hedgeable risks.
Our methodology has similarities to the forward-looking perspective of the overall solvency needs assessment under ORSA, but we note that ORSA is not a valuation standard in itself and does not deal with issues like cost of capital.
We believe SII-AV provides a workable methodology for use in M&A transactions, which is aligned with the way that investors generally view potential target companies. It can be applied to all types of insurance business, and provides a basis for investors to consider synergies with existing businesses, and other value-adding actions.
For more details, please refer to Milliman's paper: SII-AV - a valuation methodology for insurance companies under Solvency II
Ed Morgan is a principal with Milliman and specialises in international insurance consulting
Jeremy Kent is a principal with Milliman and specialises in international insurance consulting