EEV consists 3 parts: free surplus, required capital less cost of capital and PVIF. Changes to EV are normally analysed (that I have seen) for 2 parts out of 3: free surplus and PVIF, why is required capital less cost of capital not analysed? Or is it normally analysed? Thank you.
Free surplus and required capital should together form the excess assets or net asset value of the company. As part of the analysis of change in embedded value (AoEV), the change in excess assets will also be analysed. Ideally, you can imagine an AoEV table in which the various components of AoEV (e.g. actual vs. expected experience, assumption/modelling changes, return on excess assets, unwinding of RDR, etc..) listed as rows, and three columns for each of NAV, VIF, and Cost of Capital. Cost of capital can be analysed as well. For example, if RDR is changed as part of assumption/modelling changes, then cost of capital can change if these figures are discounted at the RDR. Also, if the modelling/assumption changes result in change in reserves and if reserves are used as a driver to calculate the pattern of solvency capital, then cost of capital can change as well. So, all in all, each element of EV will need to be analysed for any changes in an AoEV exercise.
Possible reasons / considerations: Free Capital + Required Capital is Net Assets. So could it be that the analysis were done as; Analysis of Net Assets & Analysis of VIF rather? Required Capital will probably be Pillar I capital requirements ( or Pillar II if more onerous). There may already be a feel for causes of movement through various other analyses e.g. Analysis of Surplus, Analysis or Working Capital, Analysis of Movement in ICA etc. So it is possible that a simplification of the analysis of EV is adopted as you've described in your query - rather than do a more granular breakdown of all parts. The Cost of Capital component will be something close to a linear function of the require capital. It's calculated by projecting future capital releases and multiplying by some factor (e.g. 4%) so analysis of this is really not important and moreover it will usually not be material anyway. These are my initial thoughts, hopefully its a useful starting point for further thought.
For cost of capital, a better approach is to have separate run-down factors for each element of the components of required capital. For example, mortality and morbidity risk components can be run down using projected future sum assureds. If a large proportion of expenses are percentage of premiums then expense risk component could be run down using projected future premiums. The core reading does not go into such detail though. Hence cost of capital will change if any of the run down factors change. The magnitude of change may not be as significant as on NAV and VIF but it cannot be left out from an AoEV exercise.
Thanks for the comments Iori. I went back to notes and as you said under EEV the analysis of free surplus and required capital can be combined (into net assets that you mentioned). Under MCEV the three columns you mentioned is required disclosure.
Thanks for the comments dok87. I think its really good thinking that the analysis of required/working capital has been done in pillar 1/2 and also that the cost of capital is not significant anyway.
