APN 107-Embedded Value Reporting

Question 1

outline considerations regarding renewals, reinsurance and tax when determining the PVIF? (2)

Answer 1

• PVIF includes the expected value of renewals of inforce business (example group risk business) therefore the actuary needs to determine whether the contract boundaries used for determining liabilities are appropriate for EV
• PVIF should be net of reinsurance and net of tax

Question 2

Outline the general APN 107 methodology for calculating EV?(3)

Answer 2

• The assets relating to existing covered business, policyholder liabilities and required capital should be projected until the expected covered business is no longer expected to be in-force
• The EV should reflect the aggregate risk in covered business when projecting cashflows therefore interactions between embedded investment guarantees, level and cost of required capital and the risk discount rate
• The guidance in these notes relate to a real world approach where investment returns and the risk-discount rate are set equal to the risk-free rate plus a risk margin

Question 3

Outline the specific allowance for tax in APN 107 EV methodology? (3)

Answer 3

• The valuation must allow for taxes which would affect cashflows before distribution to shareholders
• The projections should allow for tax on a tax liability basis which may be different to the liability valuation chosen for EV purposes
• Where appropriate the actuary should discount deferred tax assets or liabilities on the balance sheet depending on materiality

Question 4

outline the valuation of free surplus according to APN 107? (5)

Answer 4

• The value placed on assets should exclude intangibles to the extent there value is supported by profit recognised in PVIF (e.g. deferred acquisition costs and negative policyholder reserves)
• Or to the extent that that they represent the book value of acquisitions (such as transactions relating to goodwill)
• Any value placed on intangibles may only be included in assets backing required capital and liabilities
• The value of assets should include total assets attributable to covered business even if not included as part of prudential reporting
• Assets should be valued at fair value i.e. market value or valued according to generally recognised valuation techniques using market observable values e.g. private equity, over the counter options

Question 5

outline the valuation of required capital according to APN 107? (5)

Answer 5

• Where EVM is aligned to SAM methodology and assumptions required capital can be aligned with SCR given that the EVM liabilities are aligned with SAMs liability metric
• The required capital should include capital required to meet internal objectives
• The amount of required should be presented from a shareholder perspective and so should net of sources of funding other than shareholder resources example subordinated debt
• The minimum is subject to SCR required by prudential regulation

Question 6

outline the difference regarding new business and renewals in APN 107? (10)

Answer 6

• New business is defined as the sale of new contracts and once of premium increases in respect of inforce business during the reporting period (excluding cancelations at inception)
• Typical examples of once of premiums include:
o Continuations beyond the original term of an individual policy fixed maturity date (unless continuation assumption was made in PVIF)
o Non-contractual premium increases
o Renewable single premiums
o Premium increases from new benefits

• The projected cashflows used to calculated PVIF should anticipate renewals of in-force business and reasonable predictable increases in renewable premiums
• Reasonable predictable variations in premiums of in-force premiums should be included in PVIF
• Typical example of renewals and reasonably predictable variations in premiums are:
o Continuations beyond the minimum term of an open ended contract
o Renewable recurring premiums under group assurance such as PHI and group life assurance
o Automatic regular increases
o Increases in premiums due to increases in member’s salaries in group contracts

Question 7

outline the allowance for debt and reinsurance in the calculation of EV? (3)

Answer 7

• Financing types of reinsurance and debt including subordinated debt and contingent loans can create a leveraging effect which should be included in the risk to shareholders
• Such debt should be calculated at fair value and deducted from EV
• Projections of all future cashflows should be net of outward reinsurance

Question 8

outline the methodology regarding sensitivity checks in the reporting of EV? (9)

Answer 8

• Sensitivity of the results due to change in key assumptions should provide the users with a better understanding of valued placed on covered business
• Sensitivities should be provided for the PVIF, CoRC and VNB
• Accounting standards require the disclosure of sensitivity of profit and loss to changes in key assumptions (consistent with these test are encouraged)
• In general all other assumptions should remain the same unless where directly affected by revised economic conditions (e.g. bonus rates)
• Where companies dynamically vary reserving basis it would be acceptable to include a day one impact on reserving basis changes

• The impact of investment market
changes should be allowed in valuation of embedded investment derivatives as this affects the shareholder cashflows

• Sensitivities should be disclosed annually
• Usually a single direction change in assumptions are adequate unless the opposite direction would result in a asymmetrical change
• Where appropriate the actuary should take into account likely management actions which should be disclosed

Question 9

outline checks that will be conducted on EV results? (4)

Answer 9

• The comparison of items such as opening reserves, premiums and claims in the first year of profit projection with number in the financial statements
• The reconciliation of expense assumed for EV purposes with expenses to actual expense incurred
• The level of profit projected to be earned in the first year of the projection period relative to actual profit earned in the previous year
• External disclosures of the above checks are not required

Question 10

outline general considerations when setting EV assumptions? (8)

Answer 10

• The assessment of appropriate assumptions should have regard to both past, current and expected future experience and to any other relevant data
• Changes for expected future experience should be allowed when sufficient evidence exists indicating that changes are relatively certain
• If EV assumptions are set to be over-optimistic then these will emerge in future years as negative operating experience and/or investment variances
• The projection assumptions should be determined using best estimate assumptions of future cashflows for each policy group
• The best estimate assumptions should be consistent with other form of reporting e.g. SAM, IFRS
• The most important assumptions to be disclosed should be discussed and approved by the board and relevant committees
• The VNB assumptions can be based on assumptions (demographic and economic) at the point of sale or revised assumptions at the reporting date
• However where premiums are based on investment yields e.g. annuities the VNB must be based on investment yields at the point of sale

Question 11

outline operating assumption considerations for EV calculations? (3)

Answer 11

• Premium increases should be modelled under EVM using a best estimate take up rate
• Business where reserves are set retrospectively e.g. group business management would have to make a view on future experience e.g. growth in business
• However growth assumptions based on current experience would need to be adjusted in later years

Question 12

outline considerations in setting expense assumptions for Ev calculations? (8)

Answer 12

• Future renewal and claim expenses should reflect expected on-going expenses to support covered business including investment in systems to manage the inforce portfolio
• The future expenses should be set based on actual experience and split by acquisition expenses, renewal expenses and non-recurring/ development expenses consistent with the liability basis where relevant
• For group business expenses are typically not included in the valuation of liabilities but should be set based on current experience allowing for inflation and the growth/decline of the business
• Once of costs not included in unit expenses should be separately disclosed
• Overhead expenses should be allocated to new business, existing business and developmental projects in a way that is consistent with past allocations, current business plans and future expectations
• Favourable changes in unit costs such as productivity gains should not include more than what is achieved at the end of the reporting period
• All expected expense overruns should be appropriately allowed for
• Where an external service company is used in the management of covered business the actual and future expected fee or charges should be allowed in calculation PVIF, CoRC and VNB

Question 13

outline the setting of economic assumptions? (2)

Answer 13

• Economic assumptions should be internally consist and consistent with observable, reliable market data (no smoothing is permitted)
• Economic assumptions should be regularly reviewed i.e. updated for each reported calculation of EV

Question 14

outline the setting of investment assumptions? (6)

Answer 14

• Assumed investment return should reflect the expected return of assets attributed to covered business
• Returns should reflect expected default on the investment
• Regular review of risk-free rate and risk premiums for different asset classes are encouraged
• Current gross redemption yields implied by zero-coupon yield curve and swap yield curve should be considered with current portfolio when setting fixed interest assumptions
• Reinvestment of future positive cashflows would require consideration of the expected future investment strategy
• Assumptions may allow switching between investment classes which needs to be allowed for in capital requirements

Question 15

outline the setting of inflation assumptions? (2)

Answer 15

• Assumptions should be consistent with observed inflation and investment markets e.g. inflation-linked securities
• The expense inflation needs to be consistent with the type of expenditure (e.g. office space, staff, IT systems) expected which could be different from price inflation

Question 16

outline the setting of risk discount rate assumptions? (6)

Answer 16

• Risk discount rate should be reviewed for each reporting period
• The discount rate should be set equal to the risk-free rate plus a risk margin

• Typically the risk discount rate can be set using one or a combination of the following approaches:
o A top down approach where a single discount rate is used across all products based on the risk profile of the individual company WACC
o A bottom up approach where risks are considered at a more granular level and hence discount rates may vary by product

• The risk-discount rate could be term-dependent using a reference curve
• The risk-discount rate should reflect any risk associated with the emergence of future cashflows not allowed for anywhere in the valuation
• The risk-discount rate will not allow for a particular tax position as this is different across investors

Question 17

outline the setting participating business assumptions? (2)

Answer 17

• Allowance should be made for future bonus rates and allocations between policyholders and shareholders
• This should be consistent projection assumptions, policy conditions and business practice

Question 18

outline disclosure requirements for definitions of coverage as well as bases used in results? (5)

Answer 18

• Clear description of covered business should be provided as well as any changes made to types of covered business since previous valuation
• If business other than long-term insurance business is included in covered business if material needs to be shown separately
• Disclosure of the basis to allow for the amount of, and cost of, required capital and any other encumbered capital in respect of both new business and inforce business separately
• Clear description of the chosen liability basis should be included where this is not already covered in the primary financial statements
• Furthermore additional adjustments to boundary conditions needs to be disclosed

Question 19

outline disclosure requirements for the calculation of VNB? (5)

Answer 19

• Disclosure of the method to determine the value of new business including:
o Definition of new business

o Any material change in the definition of value of new business since previous valuation date

o A reconciliation of volumes of new business should be provided to the extent that definition is different to that provided in the financial statements

o Whether investment yields/demographic assumptions at year end or point of sale are used to determine VNB

o To what extent has the allowance for diversification been assumed for the purpose of determining the cost of capital

• For consistency VNB should use consistent basis between two reporting periods

Question 20

outline disclousre regarding methodology and assumptions? (9)

Answer 20

• Methods to calculated cashflows underlying EV should be disclosed
• It should be made clear that cashflows are based on releases of margins from liability basis (which may be different from published reporting)
• Specific focus should be given to areas of material change in methodology
• Return on embedded value (RoEV) is earnings over the period expressed as a percentage of EV at the beginning of the period
• Reasons for changes in the risk margin in the risk discount rate should be disclosed
• The approach to determine future bonus and bonus smoothing should be disclosed for participating business
• The extent to which any non-recurring expenses and development costs are excluded should be disclosed
• Future productivity gains should be quantified and disclosed
• The approach used to allow for company tax in projections should be disclosed

Question 21

outline the principle economic assumptions that should be disclosed? (4)

Answer 21

• The principle economic assumptions should be disclosed
o Before tax investment returns assumption
o Future changes in asset mix backing capital
o Inflation rate
o Risk discount rate

• The process used to derive assumptions should be disclosed

Question 22

outline disclosure regarding the reconciliation of opening and closing balance of EV? (7)

Answer 22

• The opening and closing EVs together with a change in EV over the period should be disclosed

• The break down for a change in EV should be split between those items that relates to:
o ANW
o PVIF
o CoRC

• EV earnings are defined as the change in EV over the period after adjusting for any capital movements such as:
o Dividends paid
o Capital injections
o Cost of treasury shares

•	EV earnings would typically include
o	Value added by new business
o	Expected return on existing business
o	Operating experience variances
o	Changes in assumptions
o	Change in minority shareholding interest
o	Minus cost of capital and 
o	Investment variances

• Explanations of material variation between actual experience assumptions and previous projection assumptions should be provided
• The effect of any model changes or approach changes should be disclosed
• Finally any assumption changes should also be disclosed

Question 23

Outline interest rate and asset sensitivities? (3)

Answer 23

• 100 basis point increase in the risk discount rates

• 100 basis point per annum reduction in the interest rate environment
o Allowing for movements in future expected return, bonus rates, inflation rates and discount rates

• 10% decrease in equity and property values at the valuation date without corresponding fall in dividends

Question 24

outline the expese and persistency and insurance risk sensitivities? (4)

Answer 24

Expense and persistency
• 10% decrease in maintenance expenses (on-going cost of administering contracts)

• For VNB a decrease of 10% in acquisition costs other than commission and commission related expenses
• 10% proportionate decrease in lapses, paid-ups and surrenders

Question 25

outline the external review and audit disclosure? (3,7)

Answer 25

``` • Where an external review has been performed on the EV calculations it is desirable to disclose which formed part of the following: o Methodology underlying the calculation o Assumptions o Model changes over the period o New products o Major adjustment to existing models o Analysis of change in EV o Analysis of actual vs. expected earnings ``` * Where EV was subject to an external audit in accordance with international standards on auditing the EV should refer to audit report rather than above disclosure requirements * Where no review or audit was performed this should be disclosed