EV evolution... to MCEV?

[scarlets]

Hi
Chapter 22 seems to describe an evolution from traditional EV all the way to MCEV.

I thought the point of EV was to get a more reliable estimate of shareholder value compared to the information in company accounts etc. which understate shareholder value.

The developments make sense until we reach MCEV, the example p21.

For a company with £100m liabs and £100m assets in equities expected to earn 8%. Under MCEV the result is £0m as per the company accounts. But I thought EV was supposed to give a truer picture than the company accounts. Clearly this company is worth more to shareholders than another company where the £100m is put into assets with expected return 7%? And so I don't see how the MCEV is an improvement.

 

[veeko]

Hi
Chapter 22 seems to describe an evolution from traditional EV all the way to MCEV.

I thought the point of EV was to get a more reliable estimate of shareholder value compared to the information in company accounts etc. which understate shareholder value.

The developments make sense until we reach MCEV, the example p21.

For a company with £100m liabs and £100m assets in equities expected to earn 8%. Under MCEV the result is £0m as per the company accounts. But I thought EV was supposed to give a truer picture than the company accounts. Clearly this company is worth more to shareholders than another company where the £100m is put into assets with expected return 7%? And so I don't see how the MCEV is an improvement.

True, EV is supposed to give a truer picture of profit than other measures used in company accounts:
- EV takes into account the time value of options and guarantees but the Achieved Profit Method (APM)doesn't
- EV takes into account Cost of Capital, which isn't included in the APM.

The move from EV to MCEV is so that all insurers in the industry are "aligned" when they report on profit.
With EV, you arrive at the PVFP by discounting the stream of future profits at the risk discount rate. This will be different from company to company.
With MCEV you arrive at the PVFP by discounting the stream of future profits at the risk free rate. I think all companies are adopting the swap rate (ie curve of swap rates) as the risk free. Whether there is an allowance for illiquidity of liabilities is still under consultation and hasn't yet been finalised.
So with all companies adopting the risk free, it effectively aligns the standard for all companies in the industry.

I think I've covered the major points here - if I haven't (anyone) please add to this.

 

[scarlets]

With MCEV you arrive at the PVFP by discounting the stream of future profits at the risk free rate. I think all companies are adopting the swap rate (ie curve of swap rates) as the risk free. Whether there is an allowance for illiquidity of liabilities is still under consultation and hasn't yet been finalised.
So with all companies adopting the risk free, it effectively aligns the standard for all companies in the industry.

I think I've covered the major points here - if I haven't (anyone) please add to this.

Aren't you getting confused with S2 here? As I thought MCEV differed from EEV because for MCEV you discount at a rate that reflects the riskiness of the constituent cashflows not the risk free rate. So any positive cashflows from investment returns from equities would be discounted at higher rate than cashflows from expected return on government bonds.

 

[echo20]

I think there's another important point:

It's not clear that investing £100m in equities of company A with an expected return of 8% is better than investing the same amount in equities of company B with an expected return of 7%. From a financial economics point of view, both investments have the same value - the extra return on company A is to compensate for greater risk.

For example, perhaps they pay the same dividends but company A's share price is lower because the market thinks it's more likely to go belly up. If we wanted to value the investment, we should discount the dividend stream for company A at 8% and that for company B at 7% - but we don't need to, we'd just end up with the share price again. The market has assessed the risk and done the discounting for us!

MCEV, and market consistent techniques in general, aim to approach valuation from this financial economics point of view.

 

[scarlets]

I think there's another important point:

It's not clear that investing £100m in equities of company A with an expected return of 8% is better than investing the same amount in equities of company B with an expected return of 7%. From a financial economics point of view, both investments have the same value - the extra return on company A is to compensate for greater risk.
.

Seems very clear to me. You expect more profits from company A so it's worth more. If assumptions are borne out in reality you will get more profits.

I thought the point of EV was to help distinguish between such companies where the company accounts could not.

 

[scarlets]

Ok, two neighbours have just paid off their mortgage on their £150k houses. Both then borrow £100k for 25 until their retirement. Neighbour A puts £100k on equities, neighbour B puts it in government bonds. Who will have the most money when they retire in 25 years?

 

[echo20]

Seems very clear to me. You expect more profits from company A so it's worth more. If assumptions are borne out in reality you will get more profits.

As you say, you "expect" more profits. The "expected" return is greater in company A, but the standard deviation of returns will also be higher. So there's more chance you'll lose out. So you discount the profits at a higher risk discount rate, and end up with an investment the same value as that in company B.

Ask yourself - why is the expected return on A higher? It's purely because the share price is lower. The market generally puts a lower value on shares in A, so that the expected income stream is a greater proportion of the original investment. But the reason the share price is lower is because the market generally agrees that there's a greater chance the income stream won't emerge.

Ok, two neighbours have just paid off their mortgage on their £150k houses. Both then borrow £100k for 25 until their retirement. Neighbour A puts £100k on equities, neighbour B puts it in government bonds. Who will have the most money when they retire in 25 years?

Good question! This illustrates the point. You "expect" the equities to yield more, but there's a greater chance the stockmarket will take a nosedive in 25 years time and the value will fall below the bond payout.

 

[scarlets]

Good question! This illustrates the point. You "expect" the equities to yield more, but there's a greater chance the stockmarket will take a nosedive in 25 years time and the value will fall below the bond payout.

Doubt it. Over 25+ years equities beats bonds far more often. That's why insurance companies are heavily weighted in equities not bonds. As their shareholders wouldn't be happy otherwise. Again I don't see the improvement over company accounts if MCEV = £0 for both.

 

[echo20]

Doubt it. Over 25+ years equities beats bonds far more often. That's why insurance companies are heavily weighted in equities not bonds. As their shareholders wouldn't be happy otherwise. Again I don't see the improvement over company accounts if MCEV = £0 for both.

Guess we could go round in circles like this until after the exam!

Yep, equities beat bonds more often - that's why we "expect" to get a higher return. But sometimes it'll be a lot worse.

The reason that MCEV = £0 is an advantage is an arbitrage argument. You shouldn't be able to borrow some money, invest it and make an instant profit, so MCEV shouldn't go up just by entering into that financial transaction.

Now I'm starting to worry that we shouldn't be able to ever increase MCEV, even by writing policies! But the arbitrage argument doesn't apply there - there's a limited supply of insurance, it's an inefficient market, imperfect information, etc.

 

[mugono]

If I may enter the (very interesting ) discussion (my thoughts)

I think it's important to be clear what EV,...MCEV is trying to achieve. It is an attempt to create a realistic/objective view of an insurer's financial health.

One way to think of it is that although you might EXPECT equities to outperform bonds (or whatever else) is besides the point. I'm sure we all agree that equities are risky and the point of MCEV is to allow for the inherent risk. (It was felt that previous approaches to EV did not allow sufficiently for risk).

The fact Scalets that you would expect "Over 25+ years equities beats bonds far more often" implicitly accepts equities have risk and it is not guaranteed (if it were then it would be risk free!)

To appreciate the benefit of using embedded value versus IFRS (or whatever else) is to note that IFRS (say) is based on accounting principles, particularly that only income/expenditure etc incurred during the reporting year are recognised.

However, insurance is a long-term business and so it doesn't sufficiently allow for the future cashflows to emerge (premiums, claims etc) creating distortions.

A particular distortion is that business that is written that is profitable would appear as though it was unprofitable (due to the new business strain) - which is clearly perverse!

Embedded Value is an attempt to 'correct' for this.

One of the big issues with previous measures of EV was precisely the point (Scarlets) that you're making. It could make a company invested (say) in equities appear to be more profitable when in reality they may be taking an unacceptably high level of risk!

Whilst you might 'expect' equities to out perform in the long-run, you won't be getting any of it if you are insolvent by that time (e.g. after a financial crisis!)

This is point is actually of fundamental importance.

Any comments/queries welcome

 

[scarlets]

The point I'm making is that the narrative in Chapter 22 seems to end up going round in a circle.

It starts off saying companies provide supplementary reporting to give a truer view of the profitability of the business. Hence alongside company account showing £100m liab + £100m asset = £0m profit you produce an EV showing =£2m profit. Hence telling the world - "Look! We are not showing a profit right now in our accounts - but it's coming folks!". Thus helping to defend the company from a takover at a price that's too low etc.

Whereas company account and MCEV would show £0m on both. Thus it seems defeating the object of EV in the first place.

So it seems to me that MCEV takes us back to where we started in this respect.

But the company investing in equities would in the long run be more profitable than one just in bonds so MCEV is far too prudent and doesn't show credit for that, hence why I'm confused why it's seen as an improvement to the gap that EV was supposed to fill in the first place!

There's no use saying oh but you may not get the return on equities. Surely in all our studies and the behaviour of insurance companies investing mostly in equities then we surely assume that equities will provide best return in the long run, as the long run will iron out the risks of the short term MV blips. Otherwise we'd all just invest in bonds. And no one does that. And selling your equities to buy bonds would not change your company balance sheet or MCEV but I'd take a bet with you that your shareholders would quickly disappear!