Study Notes and Published Refences - Note SN 8I-304-00

Study Notes and Published Refences - Note SN 8I-304-00 - VALUE BASED FINANCIAL MEASUREMENT

Background

rapidly changing business environment
external forces
- megers/consolidation in fin services sector
- continues product revolution/evolution
- shrinking profit margins b/c incr competition and unbundling of services
- turbulence in inv mktplace
- significant internal/external replacements
- increased consumer sophistication
- shorter product life cycles
- frequent/major tax code changes
- restructuring of product delivery systems
internal forces
- inadequate co performance (vs goals/expections)
- replacement of obsolete admin systems
- desire to measure g/l by source
- analysis of appropriate surplus levels
- pressure to lower acq and maint expense
- incr demand for incentive comp
- limited capital resources
purpose/limitations - use of a value-based fin measurement system for internal/mgmt reporting purposes only

Concepts Underlying Value-Based Financial Measurement

Key Elements of a Financial Measurement System
- Mgmt needs relevant and timely fin info
  - assist making economic decisions
  - evaluate fin condition and performance of co
  - compare fin results w/ pre-determined goals
    - allows appraisal of mgmt performance
- Desirable characteristics of fin system
  - should reflect economic fundamentals w/ underly co's business
  - results s/b available by profit center
  - results s/b readily communicable to and understandable by senior mgmt
Shortfalls of Stat and GAAP for Internal Reporting
- designed for external uses
- contrained by rules and guidelines
  - hampers timely measurement of emerging experience and/or underlying profitabilty of a product
- Stat Reporting
  - measured on a liquidation (vs ongoing) basis
    - solvency is main concern
  - calced using prescribed conservative methods and assumptions
  - NB production expenses charged 1st yr w/ limited relief
  - non-admitted assets may have real utility/value to co
  - causes anomalous situations relatvie to positive actions taken by ins co mgmt
    - increase in NB can cause decrease in current year stat earnings b/c
      - 1st yr expenses > 1st yr revenue
      - modified reserve system only provides partial relief
    - decrease in NB production may result in increase in CY stat income
    - policy termations via lapse/surrender result in incr in stat earnings in year of termination b/c Vx > CV
      - not usually best LT interest of CO since future stat profits won't be realized
    - substantial capital expenditures charged in year incurred despite LT benefits of these expenditures
      - enhanced IT capabilities or field force expansion
- GAAP Reporting
  - F60 codified life ins GAAP acctg
  - shortcomings have appeared
    - best suited for periods of economic stability
      - does not adapt on time basis to flucuations in int rates or lapse rates
    - UL type products don't fit into F60 well - F97 developed
      - 2 very different acctg methods depending on product types
    - GAAP is transactional based - reflects earnings based on transactions central to co's operations
      - inconsistent w/ way most cos price products
    - several mechanical features of GAAP create distortions in measuring fin performance of co
      - non-deferral of certain acq costs
      - lock-in assumption @ issue
      - PADs
      - treatment of deferred taxes
  - GAAP acctg often doesn't provide adequate "early warning" signs to mgmt until too late to react properly

Description of Value-Based Measurement

utilized concepts and techniques consistent w/ Anderson pricing method
reports earnings as change in economic value of life ins co over a specified period of time
economic value - PV expected future cash flows discounted @ hurdle rate
cash flows - defined as stat earnings for this purpose (aka book profits)
- includes delta stat Vx - a non CF item
- stat earnings best represent "free cash flows"
  - can be dividended, reinvested, or RE
economic value at YR = adj stat capital and surplus + value fo business inforce
- adj stat capital and surplus = stat capital and surplus + items which are allocations of surplus (MSVR) or reclassification of certin stat itmes (restoring non-admitted assets)
- value business inforce = PV future stat book profits @ hurdle rate
delta economic value + shareholder divs = value based earnings for year
consistent actuarial assumptions at both end points - so change is not due to change in assumptions
consistent hurdle rate between endpoints
- then new calc showing difference due to change in hurdle rate
3 elements to value based earnings
- earnings on adjusted capital and surplus
- earnings on business inforce at BOY
- earnings on NB written during year
if actual = expected
- earnings on adj cap and surplus = after tax investment earnings of assets supporting it
- earnings of BOY inforce = hurdle rate * value of inforce BOY
- earnings on NB depends on relationship to pricing ROI and hurdle rate
  - pricing ROI = hurdle rate - no economic value b/c PV future renewal renewal book profits = 1st yr surplus strain
  - pricing ROI < hurdle rate - economic value reduced
  - pricing ROI > hurdle rate - economic value increased
- critical that new products priced and measured using realistic assumptions
- since actual rarely expected, variations would be reflected in value based system
Determination of the Hurdle Rate
- viewed as desired, risk adjusted, rate-of-return on invested capital
  - closely linked to co's cost of capital
- can use CAPM
- CAPM breaks expected returns into 3 components
  - risk free rate of return
  - rate of return on avg equity investments
  - business risk factor - identifies variance in risks between different cos and industries
- ROR = (I + R(r)) + B(R(m)-I-R(r))
  - I - inflation rate
  - R(r) - real rate of return
  - B (aka Beta) - business risk adj factor
  - R(m) - rate of return on avg equity inv
  - I + I(r) - risk free rate of return available to investors
- cost of debt capital - typically after-tax int expense paid on debt
- equty capital tend to be more expensive than debt capital
- may be appropriate to ahve different hurdle rates for different LOBs to reflect underlying risk of each LOB

Numerical Illustrations of Fin Measurement Systems

Level Return on Equity
- special case of value-based-methodology
- hurdle rate = pricing ROI
Policy Premium Method
- Gross Premium Reserve - based on best estimate assumptions
  - less "limited adn reasonable" PAD
- all future benefits adn expenses accounted for
- can result in profit at issue
- similar to value-based - can have profts/loss at issue
- different - renewal years earnings from release of PADs
regardless of method used - total earnings equal
- different reserving methods affect the incidence of profits, not amounts in total
Comparison of Earning Emergence
- Stat - large first year loss followed by increasing profits
- US GAAP - smaller 1st yr loss followed by fairly level stream of profits
- PPM - fairly level streams of profits in all years
- Value-Based - level early, trailing off near end
  - spread over life of product in proportion to equity employed
  - not front-ended at issue
- Level ROE method - 1st year earnings = 0 by def
  - earnings spread over lifetime of product in proportion to equity employed at Pricing ROI
Comparative Observations
- Stat produces substantially different pattern of earnings that other methods compared
- methods which do not permit full deferral of acq costs generally report loss in year of issue
  - even if product is profitable
- neither value-based nor PPM report all earnings at issue
  - both methods accelerate reporting of earnings for profitably priced business
- value-based & PPM more responsive in reflecting underlying profitability of product
- reported earnings (except Stat) similar during middle years
  - early and later years diverge => rapidly growing/contracting co would report signficantly different earnings depending on method used

Practical Considerations of Implementing a Value-Based System

Model Office Projectinos
- basic tool req'd for value-based system
- 20-30 yrs of future stat projections needed
  - PV s/b determined over period of time sufficient to allow runoff of significant portion of business inforce
- "HowTo Model" is discussed
- actuarial assumptions used s/b best estimates consistent w/ recent experience and pricing assumptions
- appropriate to use pricing over current experience for items when realistic improvement toward pricing assumptions can be made
- static validation - compares total beg reserve and prem inforce for each model plan to actual amounts
  - shows how well plans and ages have been modeled
- dynamic validation - performed by projecting backward one year and comparing model to actual prev year results
Other Lines of Business
- for smaller blocks, less refined modeling techniques can be used
  - annuities - if major, cell-based model
    - if relatively minor - project using aggregate int rate spread approach
      - if most of stat profit in annuity line is from spread, shoudl be sucessfully modeled using aggregate appraisals
  - group life and health - if considered 1 year YRT, value of business inforce is zero
    - most appraisals develp value by assuming business renews each year adn expected stat profits discounted to appraisal date to determine value
    - unless large block, appropriate to assign no value to any expected future profits
      - value-based earning = stat earnings
    - if projections are made - aggregate expense and loss ratio approach w/ all items expressed as function of premium yields reasonable results
  - indiv A&H - if significant, cell-based approach appropriate
    - if line is immaterial or primarily coverage w/o active life reserves, aggregate approach similar to group is appropriate
  - group pension - aggregate int rate spread, similar to annuities often adequate
    - if major line - cell-based approach more appropriate
  - misc line - two approaches
    - assume no further stat profits => no value exists for business inforce
    - project stat profits in aggregate adn spread between earn inv rate and stat int rate
Pricing Assumptions vs Current Expereince
- if current exp <> pricing, may be appropriate to use pricing if a plan established to restore current experience to pricing over a reasonable timeframe
- typical approach in value-based syste for this situation
  - calculate value of business inforce using pricing
  - calculate difference between pricing assumptions and current expereince
  - determine plan of action to make disappear ove a relatively short timeframe (3-5) years
    - if you can't do this, s/b using current and not pricing
  - calc PV of difference @ hurdle rate and deduct from prev calced value of business inforce (optional)
Target or Required Surplus
- used to reflect need to maintain minimal level of surplus (in pricing and profit testing)
  - for regulatory reasons and rating agencies
- if co does price incorporating target surplus formula, it should be recognized in value-based fin measurement system
  - stat profits increased by inv income earned on target surplus adn decreased by increase target surplus
- further adjustments
  - req'd surplus -> transferred from adj net worth component of value to value of business inforce component
  - adj net worth becomes "free" surplus
  - value of business inforce and value of business written during year calculated using "available profits" instead of stat book profits
- net reserves - state reserves + req'd surplus - PV future avail profits
- introduction of req'd surplus changes pattern of earnings reported in value-based fin measurement system
- comparison reveals lower earnings in first-year followed by higher earnings in renewal years

Copyright © 2004 Steve Welander.
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