Market-Consistent Embedded Value (MCEV)

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Hubert Mueller, Principal (860) 843-7079

May 9, 2007

Market-Consistent Embedded Value

(MCEV)

SOA Spring Meeting / Session 3 Phoenix, Arizona

Agenda

Recent Trends with European Embedded Value (EEV)

Why move to MCEV?

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Recent Trends with European Embedded

Value (EEV)

In May 2004, the European CFO Forum published the “European Embedded Value (EEV) Principles”

12 key Principles, 65 areas of Guidance

Commentary on Principles & Guidance

Describes basis for conclusions

Both real-world and market-consistent approaches are acceptable

The EEV Principles introduce several major improvements:

Codification of several areas of current best practice, including disclosure on methodology and assumptions used

Requirement for stochastic evaluation of options and guarantees

Suggestion to use company-specific economic capital requirements

Disclosure of sensitivities and analysis of movement

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European Embedded Value (EEV) is now published by almost all major insurance groups in Europe

Irish Life

Legal and General

Mapfre Mediolanum Munich Re Old Mutual Prudential (UK) Scottish Widows Standard Life Swiss Re Zurich Aegon Allianz Aviva AXA CNP Eureko Friends Provident Fortis Generali Hannover Re ING

RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV)

Recent developments

Life insurance companies have

started to publish results under the EEV Principles (since 2004)

CFO Forum has responded to

analyst comments by publishing Additional Guidance on EEV Disclosures and updates to the EEV principles (October 2005)

Equity analysts have criticized the

variety of approaches taken

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Updated EEV Principles – The main areas of change are around allowing for risk

1. What is EEV

4. Free surplus 2. Business coverage 3. Allowance for risk

5. Required capital and cost of capital

6. Value of in-force covered

business 12. Disclosures

11. Participating business 10. Economic assumptions 9. Assumptions

8. New business and renewals 7. Financial options and

guarantees

Key

No change Small change, to previous methodology

Significant changes to previous methodology

ILLUSTRATIVE RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV)

Some European-based companies are looking for greater sophistication than the EEV principles offer Issues with EEV principles

Difficulty in selecting the appropriate RDR

Single, company-wide RDR may give misleading product profitability information

— Need different RDRs for different products — RDRs should vary with investment policy

Cost of capital adjustment is too broad

— Preference to allow for product risk explicitly — Need allowance for non-financial risk

Calculating the cost of options and guarantees on a real world basis is not usually capital market-consistent — In particular, not appropriate when evaluating

cost/benefits of hedging RECENT TRENDS WITH EUROPEAN EMBEDDED VALUE (EEV)

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What is MCEV?

How should we set the risk discount rate?

How should we allow for the cost of financial options and guarantees?

How should we allow for the cost of holding capital?

Further details on MCEV can be accessed at:

http://www.towersperrin.com/tp/jsp/tillinghast_home.jsp?selected=home

Market-Consistent Embedded Value (“MCEV”) is a development of traditional EV techniques…

… which attempts to give a more robust answer to the questions:

Bottom-up MCEV methodology was developed to help answer key questions

Reflect risk inherent in individual cash flows and any asset/liability

mismatches

Valued explicitly, consistent with capital-market prices

Reflects frictional costs (e.g., tax), based on overall capital

requirements Risk Discount Rates

Options & Guarantees

Cost of Capital

Market Consistent EV = market value of assets – market-consistent value of liabilities – frictional cost of capital

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Most major insurance groups are adopting MCEV as their main internal performance measure

Insurance cash flows are valued by reference to equivalent traded

capital market instruments

Options are valued using option pricing techniques

High-risk assets are discounted at higher RDRs

Complex options depending on policyholder behavior are valued

using stochastic modeling with risk-neutral scenarios, discounted at the risk-free rate

Risk-neutral scenarios are validated by replicating to current

market prices of options and futures

Stochastic valuation of O&G using risk-neutral scenarios

RDR varies based on the riskiness of the underlying products

Using risk-free rate for some products (e.g. term)

In an MCEV framework, selecting assets does not create value

The actions of borrowing and

investing do not create value on Day 1

Using traditional EV techniques

the 23 might be discounted at, say, 8%. This would give a value of 21.3 on Day 1

Under MCEV the asset cash

flows are discounted at 7% and the liability cash flows at 5%. This would give a value of 20 on Day 1. The effective risk discount rate is 15%

Day 1 One year on

Assets 100 107

Liabilities (80) (84)

Capital 20 23

Assume that the investor has capital of 20, borrows 80 (at 5% pa) and then invests 100 in equities (with an expected return of 7% pa)

The discount rate is an output of the valuation, not an input

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MCEV in practice

For cash flows without any embedded options, in practice MCV means using the certainty equivalent approach

All gross earned rates equal the risk discount rate, which equals the gross risk free rate

For cash flows with certain easily identifiable embedded options, in practice MCEV means using the certainty equivalent approach plus closed form, Black-Scholes type, option valuation formulae

For everything else it typically means Monte Carlo simulation, using a risk neutral or equivalent Economic Scenario Generator (ESG)

In North America, EEV adoption has been slower Traditional EV (TEV) not yet widely accepted in the US

Dominance of US GAAP reporting

Hartford Life is the only US-based company that has published EV results A growing number of US-based companies use TEV for performance

measurement and incentive compensation

US subsidiaries of European multinationals calculate and publish EEV results

TEV reporting is more widely accepted in Canada

Sun Life, Manulife and Industrial Alliance annually publish TEV Quarterly source of earnings analysis has replaced EV in importance Market consistent techniques are increasingly used in the US to model

impact of hedging or to price embedded guarantees on a market-consistent basis

Provides consistency between pricing and valuation

AXA (US), Allianz Life, Munich Re and Old Mutual have published on MCEV basis for year-end 2006

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Why Move to MCEV?

Why more multinationals are moving to MCEV this year

a

Link to Economic Capital

a

Increased use in pricing/risk management

a

Theoretical strength

a

Consistency with their peers

a

Internal financial management

a

Credibility with financial analysts (mostly Europe)

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What does the market want from EEV?

Source: Andrew Crean, Infoline EEV Conference, 9 November 2005

WHY MOVE TO MCEV?

Hopes for EEV Disclosure

Cash flows discounted at a rate commensurate with the risk

profile

Investment profits on contracts not booked until earned

Options and guarantees would capture the actual cost of

hedging potential risks to the balance sheet

Consistent application of the rules to allow effective

comparisons between companies

Hopes for Cash Disclosure

What is the cash (and free capital) emerging on the in-force

How much is needed to finance new business for what return

How much is residually available for dividends

To date, EEV has not yet fully met these hopes

EEV allowance for risk Top-down approach Bottom-up approach Unadjusted WACC Adjusted WACC Product-specific beta Stochastic ‘real world’ Indirect MCEV Direct MCEV

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Recent EEV disclosures have favored the market-consistent approach 1 4 11 3 9 22 CFO Forum Companies Non-CFO Forum Companies Total 11 5 2 Top-down Top-down Top-down Bottom-up market-consistent Bottom-up market-consistent

Other Other Other

Bottom-up market-consistent

WHY MOVE TO MCEV?

Source: Tillinghast Research

By adopting MCEV for year-end 2006, Allianz became the first company to change EEV methodology after first-time adoption WHY MOVE TO MCEV?

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Technical Issues

There are a wide range of approaches to

diversifiable risk

Market-consistent techniques increase the granularity of the allowance for market risk. We are seeing the same trend in non-market risk.

The trend towards granularity is broader than EEV reporting

Pricing

Risk & capital management

ICA (UK) / PBA (US) / Solvency II (Europe) Prudential Standard Life Swiss Re … Addition to RDR AEGON AVIVA ING … Top-down WACC Friends Provident Scottish Widows Zurich … Granular risk allowance Increased granularity Allianz Fortis Munich Re … Addition to CoC TECHNICAL ISSUES

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The rationale regarding the MCEV allowance for non-market risk has varied by company

Allowance via best estimates and frictional costs (i.e. no addition)

Additional allowance and rationale provided

Additional allowance but no rationale provided

4

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TECHNICAL ISSUES

Source: Tillinghast Research (March 2007)

Number of Companies

The debate over the choice of risk-free rate continues 4 6 4 Non-UK Companies 6 2 Not disclosed 8 2 Based on swaps 8 4

Based on government bonds

Total UK-based

Companies

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In the US, credit risk modeling can get tricky

policyholder

shareholder

Level of risk-free returns

Is there symmetry in shareholder gains and losses with respect to credit risk?

Investment returns over time and their split between the stakeholders default Credit spread YES NO

We can use the “take out credit spread” approach Stochastic risk premiums and defaults

Other technical issues

Generating risk-neutral scenarios

Economic scenario generator (ESG)

Historical versus implied volatilities

“No Arbitrage” test

Impact of management actions

Policyholder actions

Reflecting dynamic policyholder behavior TECHNICAL ISSUES

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So where have we got to with EEV/MCEV?

Clearly linking allowance for risk and business valued

Understanding impact of risk on value Improved disclosures Focus on managing the business Improvements Different methodologies Different applications of the methodology Different views of impact of risk on value Different levels of disclosure Challenges EEV / MCEV

Has the industry achieved what companies and analysts need?

What does this mean for North America?

Multinationals are setting the bar for EEV/MCEV reporting

Domestic players are gradually coming around, driven by advances in risk and capital management

Canadian companies have introduced some changes since they first published EV in 2000

Quarterly reporting of VNB

Quarterly “Source of Earnings” disclosure

Move to IFRS should further accelerate development of MCEV in North America

Provides fair value of liabilities

IFRS #8 requires disclosure of a business segment’s profit/loss and balance sheet on the basis that is used to manage the business more EV disclosures

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Phoenix – 9 May 2007 www.ing.com Chris Murphy Senior Actuary

Market Consistent Embedded Value

Society of Actuaries Life 2007 Spring Meeting

Agenda

1. ING's approach to MCEV

2. What impact has it had on the company's strategy?

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MCEV - Basic principles

• Management expectations of future financial market developments do

not influence market consistent embedded value calculations.

• This means that investment decisions do not immediately lead to

value changes, although the impact will come through in later periods in line with actual experience.

• Market consistent approaches uniquely determine the ‘right’ discount

rate to be used for financial risks, implying that equities, bonds, options and guarantees are priced in a manner consistent with their pricing in the financial markets;

• Insurance risks are priced using a proxy for how an external market

would price them (expected losses and the cost of economic capital)

• Separates the valuation of assets and liabilities, which allows

management to manage the business in a more informed manner

The Market Value balance sheet is a key component of the market consistent framework

• Market Value Surplus (MVS) is the difference between the Market Value of Assets (MVA) and Market Value of Liabilities (MVL).

• Market Value of Liabilities is the value at which the liabilities could be transferred to a willing, rational, diversified counterparty in an arms’ length transaction under normal business conditions.

• ING internally defines Market Consistent Embedded Value (MCEV) as being equal to the Market Value Surplus

MVA

MVL

EC

Market Value Balance Sheet

MV Surplus = MCEV Free Assets

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Assets Year T Liabilities Year T

Investments Market Value Insurance liabilities

Real property and office buildings - Financial Component Liabilities (FCL)

Participating interest 8 - Non-linked life insurance 2,982

Shares 312 - Unit-linked life insurance 3,525

Cash 390 Total Financial Component Liabilities 6,507

Fixed interest securities 3,819 MVM 291

Total investments 4,528 Total Market Value Insurance liabilities 6,798

Investments for risk of policyholders 4,036 Deferred tax liabilities 280

Other assets 139 Other liabilities 405

7,483

Market Value Surplus

Tied surplus (EC) 667

Free surplus 553

Total market value surplus 1,220

Total market value assets 8,703 Total market value liabilities 8,703

Market Value Balance Sheet - stylized example

MVA

MVL

MCEV

Market Value Liabilities can be calculated by decomposing into parts

MV Non-hedgeable Insurance Risks MV Hedgeable Financial Risks

MVL

HedgeableMV Insurance Risks* MV Non-hedgeable Financial Risks Non-financial Component Financial Component of Liability

=

+

• 10 year USD, EUR, Yen cash flow or interest rate option • 10 year equity option • Rational lapse behaviour • Mark-to-market based on market valuation rates (e.g. discount rates, volatilities, etc.)

• 60 year USD, EUR, Yen cash flow or interest rate option • 15 yr emerging

markets cash flow • Irrational lapse

behaviour • Mark-to-model

based on extended market valuation rates (e.g. discount rates, volatilities, etc.) • Screen or exchange traded CAT risks • Actively traded securitized risks • Mark to market approaches consistent with capital markets valuation • Most insurance risks, e.g. mortality, property, casualty, etc. • Mark to model approach based on cost of capital, not confidence intervals

* Defined by two-way, liquidly traded volume. Few markets for insurance risks exist today but may be developed in the future.

Decomposition of liabilities

Examples

Valuation approach

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Risk neutral valuation

• Risk neutral valuation is stochastic valuation approach that allows us

to value cost of embedded options of liability portfolios

• Risk neutral valuation is generally used in pricing of derivative

securities, and therefore can be used to calculate the market value of liabilities assuming a full portfolio hedge

• The calibration of the risk-neutral valuation model is done to ensure

that such a model would re-produce observed market prices for traded instruments; by extension it should fairly value the more complex options and guarantees embedded within the products

• Risk neutral valuation is only one of various forms of capital markets

valuation tools e.g. state price deflators, analytical formulas

Economic Capital is calculated to protect the market value surplus (MCEV) over a 1 year time horizon

Economic Capital is calculated as the difference between expected Market Value Surplus in 1 year’s time and the 1 in 2000 worst case outcome

In practice, economic capital is calculated separately for each risk type separately

Calculations take into account all financial options in assets and liabilities as well as company and policyholder behaviour

Economic Capital Probability Value Expected Value 99.95% Worst Case Value

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Under a market consistent framework, increases in value are measured as increases in market value of surplus

• In this example, the MCEV has increased by 50, so value created over the period = 50.

• MCEVPROFIT= Change in MCEV less Cost of Capital

• Value creation comes from the usual sources (eg profitable new business, expense management, favorable investment markets), but is entirely measured using market value principles.

MVA = 1100

MVL = 950

EC = 50 Free Assets = 100

MCEV = 150

Market Value Balance Sheet at End of Period MVA = 1000 MVL = 900 EC = 50 Free Assets = 50 MCEV = 100

Market Value Balance Sheet at Beginning of Period

MCEV source of earnings analysis is a powerful tool for understanding the performance of the business

•MCEVNB– If the market consistent value of new business is positive, then this directly leads to an increase in MCEV.

•Underwriting profit – As with traditional Embedded value, better than expected mortality and lapse experience leads to increases in value.

•Investment profit – Equity and credit risk premiums are only reflected once they have been earned. In the calculation of MVL, a risk free earning rate is assumed.

•Risk Margins – Profits from taking on non-market risks (eg policyholder behaviour) are released over time as the risk is reduced.

•Total Return on Assets backing MCEV – The market value of surplus will change directly with the total return of the assets backing EC and Free Assets

•Cost of Capital – Economic profit is generated if the total increase in MCEV exceeds cost of capital

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Understanding the market value balance sheet is good preparation for the implementation of IFRS Phase II

• IFRS Phase II is widely expected to be market value based reporting.

• CRO and CFO forums in Europe are advocating IFRS II calculation of

the market value of liabilities similar to the approach taken in this presentation.

• Full market value reporting would mean that changes in the market

value balance sheet will go through the Profit & Loss statement. This is the approach that ING has taken with its implementation of MCEV.

Market Consistent Embedded Value at issue - MCEV(0)

• MCEV (0) represents new business value assuming complete

hedging of ALM risk and without accounting for future expected asset spread “arbitrage” including cost of non-market risk capital

• Market value of assets and liabilities includes capital markets

valuation of options and guarantees

• Credit spreads and equity risk premiums are only recognized when

earned

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MCEV (0) can be interpreted as the cost of raising

funds that can then be invested

• MCEV (0) can be viewed as the value of this alternative relative to

other sources of raising funds, eg debt

Company has generated funds at

less than the cost

of funding

Created

shareholder value

MCEV (0) is positive MCEV (0) is negative

Company has generated funds at

more than the cost

of funding

Destroyed

shareholder value

MVL methodology applied to new business provides pricing discipline and key source of change in MVS

• Gives an indication of future potential GAAP/STAT earnings.

• Based on ‘best estimate’ future investment yields, equity premia, credit spreads.

• Does not value financial assets and liability cash flows, options and guarantees consistently with financial markets.

Traditional Value of New Business/IRR Market Consistent Value of New Business • Gives an indication of theoretical

mark-to-market value.

• Based on current market rates, volatilities, etc., using capital markets pricing techniques.

• Values assets and liability cash flows, options & guarantees consistently with financial markets.

MVL is independent of the asset or hedging strategy and reflects current market price to fully hedge risks

If the MVL is less than the initial premium, implies that the product relies on assumed investment risk premia (equity risk premium, credit spreads) for profitability

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Market consistent pricing is providing more insight into the profitability of products globally

• Market consistent pricing implemented globally for new products beginning 2006

• Integrated into strategic planning targets for 2007- 2009

• Nearly all products contribute value on a market consistent basis • Products with negative market consistent price tend to be:

•Found in highly competitive markets

•Strongly reliant on investment returns for earnings, e.g. credit spreads/equity premia

• Products with negative value on an MC basis can be improved by:

•Product repricing

•Adjusting product features

There is no single right answer - Often there is a tradeoff between value creation and earnings potential

Key planning questions

Resource availability

MC pricing capabilities

Product prioritisation

Infrastructure considerations

• How many risk professionals are there currently in the organisation? What other responsibilities do they have? How time consuming are the other responsibilities?

• What on-going projects are there? When do you expect the “crunch” times to be?

• Possibility of getting external resources? • Possible relocation of internal resources for MC

pricing?

• Are there currently resources with MC pricing capabilities?

• How many resources do you expect to require to train?

• What is the best approach to training e.g. specific groups, all at one time, temporary relocation of personnel etc?

• How many products do you aim to model? • What new products are you expecting to sell that will

require MC pricing?

• What are your main products e.g. in terms of volume, profitability? Can they be applicable to a large portfolio?

• Are there differing MC pricing capabilities in resources for different products?

• What is the current feasibility of infrastructure adjustments e.g. adjust models internally, develop new models, construct an external MC pricing add-on? • What is the man power requirement for each? Cost of

implementation of each?

• How easy/difficult would it be to implement practically? • Are you considering any updates to your current

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Analyst Opinion of MCEV – Part 1

• There is no clear consensus at any level, with a wide diversity of views ranging from very positive to very negative.

• There is general consensus that MCEV is a good management tool and should be used by companies, but a high proportion have doubts whether it is useful to analysts and fund managers.

• Many believe that MCEV is actually too complicated for the market and is therefore not going to be used by increasingly sceptical analysts who will revert to IFRS earnings.

• Many consider that MCEV is not understood and is confusing the market

Analyst Opinion of MCEV – Part 2

• There are also many who see MCEV as less useful than traditional EV and would prefer to stay with EEV

•MCEV is more of a black box, analysts are suspicious that companies are ‘fixing’ their assumptions

•with traditional EV they can make their own adjustments

• Most understand that MCEV disadvantages certain products – especially spread products - they are suspicious that this has driven companies without spread business to be early adopters

• Some are concerned about reconciling EEV with MCEV and have asked for full disclosure of both sets of data.

There is a general feeling of inevitability in that most analysts expect all companies to move to MCEV reporting.