Chapter 17 Embedded Value questions

Hi Rachael
'Business units' in this context might more typically refer to different subsidiaries within the overall umbrella group. Yes, these might be in different countries - but could also be within the same country: eg where a life insurer has taken over other life insurance companies, and these remain as separate legal entities within the group rather than being absorbed into the main company. Basically, the point is referring to any unit where it would make sense to determine a separate embedded value to provide information on that unit (typically a subsidiary), before then consolidating across all units to form the overall (group) EV.

The primary statements are the main accounting statements, particularly the balance sheet and P&L account (or income statement). If embedded value is reported, this is normally done within supplementary information rather than as part of the main accounts. It makes sense for any presentation and consolidation of EV information to be consistent with how the main accounting information has been presented and consolidated.

 

Hi Rachael: see whether the following thread is enough to help you understand this (the Chapter number has changed from 18 to 17 since that post was made):

https://www.acted.co.uk/forums/index.php?threads/cmp-chapter-18-question-18-2ii.17901/

 

Yes, you are correct - it would be extremely unlikely that a prudent basis would be used. The experience / projection basis would normally be either fully realistic or market-consistent.

 

Yes, that's correct

 

In an EEV calculation, we deduct the 'cost of holding required capital' from the locked-in equivalent of 'net assets' - and this allows for the fact that it is not possible to distribute these immediately.

In a traditional EV calculation, it's up to the company as to whether they simply value net assets at face value (for practical reasons: ease of calculation) or whether they allow for some discounting to reflect that it would not be possible for the shareholders to take these net assets out of the company immediately. See Subject SP2 (which only covers traditional EV) Chapter 15 Section 2.1, Core Reading paragraph: 'These (net) assets may be valued at market value or may be discounted to reflect 'lock-in', for example if they are required to be retained within the fund to cover solvency capital requirements.' Effectively, under a traditional EV approach there can also be an adjustment made to reflect the cost of holding capital (lock-in) - there are no prescribed rules, it's up to the company.

For the WP example, assuming that the estate is all distributed at the end of the projection period is just a practical way of performing the calculation, much simpler than estimating the possible pattern of estate distribution over that period and then allowing for that pattern of release in the projections. Unless it is huge, estate would not normally be distributed to the WP policyholders (with the related shareholder transfers) in an open WP fund until the fund is closed - and it might be difficult to make an estimate of when that point might fall within the projections.

 

Required capital under the EEV and MCEV Principles was defined as any capital that has restrictions on its distribution to shareholders. Therefore it would need to be at least as high as whatever the minimum regulatory solvency capital requirements are, since by definition that capital cannot be returned to shareholders immediately. As noted in the course (near the top of page 7, Chapter 17) it is possible that in a Solvency II balance sheet the risk margin might also be treated as part of (locked-in) required capital, along with the SCR.

There might be other reasons, beyond meeting the regulatory requirements, why capital cannot be removed from the business. Indeed, required capital might be determined on a more stringent internal (economic) capital basis, perhaps targeted at a level to meet a desirable credit rating.

 

The calculation of the cost of holding the required capital is explained towards the bottom of page 8 of Chapter 17, including under a market-consistent approach (ie an explicit estimate of the frictional costs of having the capital locked in)

 

Be careful: there is no choice about the 'valuation method' - that's just whatever the regulator requires. So it might or might not be market-consistent for either EEV or MCEV, it will depend on the jurisdiction.

If an insurer adopts an MCEV basis, it has to use a market-consistent projection basis. If it adopts EEV, it could use either a traditional or market-consistent projection basis.

This is the main difference. Also, the cost of holding required capital has to be done using an explicit frictional cost approach for MCEV, as the formula for 'cost of required capital' (as given in the course notes) would give a zero result if used under MCEV (since discount rate = expected return).

 

I'm not sure quite what you mean by the points under 'allowance for risk'. An EEV can be determined on a traditional basis, which involves (normally) best estimate projection assumptions and a risk loading within the discount rate. Alternatively it can be done on a market-consistent basis.

The main differences between EEV and the more traditional EVs that were being calculated before are:

• the split of net assets into required capital + free surplus (and allowing for cost of holding the former)
• a requirement to make allowance for the time value of guarantees and options.

(There were also other differences in terms of a little more prescription on how assumptions were set and in relation to reporting / disclosures.)

 

If we roll the required capital up at investment return = risk-free rate, then discount (the releases of) that capital back at discount rate = risk-free rate, we just get back to the original required capital that we started with. Hence the calculation falls to zero.

 

The context is a company that is subject to Solvency II, calculating its EV on a market-consistent basis.

If the risk-free yield curve (used to value the liabilities) moves in a different way than the yields on assets, then the change in the value of liabilities will differ from the change in the value of assets. Hence there will be a change in the value of 'net assets' (which here = RC + FS, as it is an EEV-style calculation).

Of course, asset yields changing can also impact the present value of future profits (VIF); eg if asset values have changed, then the amount of charges projected on UL business will change. And the VIF would also be impacted by the risk-free yield curve moving (the experience basis will use future risk-free rates, since market-consistent) - whether this is categorised as an economic variance or economic assumption change depends on the company.