Measuring up: new standards help insurance companies determine their true value in a changing world.
Management creates economic value if return on capital equals or exceeds the cost of capital.
However, it always has been difficult to quantify the financial health of insurance companies in an accurate and timely fashion. Increasingly, insurers who seek to raise capital of meet solvency requirements ate trying to add clarity and certainty in order to reassure investors and regulators. These efforts are resulting in a significant transformation of insurance company performance measurement, especially for risk, capital and liabilities.
Many insurers are beginning to value their business and make strategic decisions based on what is often called an economic valuation framework. This method focuses on tracing the timing and volume of values that are created in various activities, such as sales, servicing, investment and risk management. Companies' internal needs to facilitate and justify their decision-making, as well as pressures from regulatory and ratings agencies, are driving the adoption and implementation of this economic valuation framework. Regulators are moving their solvency framework to "principle-based" approaches, and accounting standard-setters are proposing fair-value reporting, which should lead to increased comparability.
This change--with the industry moving toward a next-generation view of their business and financial reporting--is revolutionary. However, it is never easy to move away from traditional thinking. Insurers need to resolve many critical issues as they move toward a more understandable and comparable valuation and reporting system.
Economic views and market consistency are the keys. Many promising economic and fair-value concepts and proposals are available, and now is the time to connect them.
The primary purpose of financial reporting is to provide investors with information they can use to make decisions. The new generation of valuation or financial reporting for insurance companies addresses two major issues that have affected industry valuations.
First is the economic view of value creation--how, when and how much value is created. Second is market consistency--the transparency, reliability and comparability of the financial figures used by investors.
Embedded value has long been used, especially in Europe, to measure the underlying risk and value of insurance liabilities. It is calculated by projecting relevant cash flows using both market and non-market assumptions, and then determining the present value of future profits using a discount rate that is typically based on equity returns plus a risk allowance.
However, conventional calculations of embedded value are often flawed, due to inconsistent valuation of options embedded in the underlying products and investment assumptions that aren't market-consistent. To correct these defects, many insurers employ market-consistent, embedded-value methodologies that value guarantees and options using methods consistent with those used for valuing other financial assets. These insurers also use a risk-neutral approach to set investment assumptions and discount rates.
Market-consistent embedded valuation has gained favor in Europe, and many investment analysts view it positively. As part of a shift to market-consistent reporting, MCEV offers increased transparency and comparability, reducing the information risks assumed by investors.
However, a market-consistent approach to quantifying economic levels of capital has not gained wide acceptance. That said, further development, including disclosure of insurers' methods of calculating economic capital, can enhance valuation and reporting.
In the past, the capital adequacy framework relied on regulatory of rating agency measures. Today, the framework is based on the determination of company-specific risks. Although there are different approaches to modeling economic capital, current practice focuses on fat-tailed events to set up capital hedging against low-probability, extreme-loss events.
Solvency II defines economic capital as the amount an insurer needs in order to absorb all losses within a year with a 99.5% probability. Still, it's unlikely to represent a true level of economic capital, given market realities that make recapitalization after insolvency unlikely.
Perhaps it's more appropriate to define market-based economic capital as the amount needed to absorb the first losses of an insurance portfolio and still allow an insurer to tap into the capital markets to fund further losses without paying an additional equity risk premium.
Economic capital often is defined as management's view of the risk of the business. However, economic capital should be based on the market's view of risk, not management's, similar to the move from embedded value to market-consistent embedded value.
Since economic capital and the cost of capital ate both market numbers, the risk margin required to accept insurance risks should be identical between insurers and other market participants wishing to be compensated for taking the same insurance risk. Both numbers can be used to determine the required return on liabilities, which indicates the appropriate risk margin demanded by the market.
Differences between companies would be due to the methods used to measure either economic capital or the cost of capital, including information risk, operational risk and frictions and "unknown unknowns." Each of these can affect the quality of economic capital modeling.
Information risk stems from limited transparency associated with business complexity and insurers' unwillingness to disclose certain information in order to protect their competitive advantages. This lack of transparency is so pervasive that insurers may require a higher risk margin for acquired business than for business they write themselves.
Frictional costs occur when insurers have to operate under higher financial costs and capital requirements. These costs also play a significant role in determining risk margins and valuing insurance liabilities, even though the risk in any purchase price theoretically should compensate the investor only for cash-flow uncertainty.
Additionally, operational risk--such as potential losses due to fraud, market conduct, rogue traders, failure of operating systems or physical disruptions--can contribute to the margins included by the market, even if such risks are difficult to quantify or model.
Finally, few models reflect rare, high-impact, hard-to-predict "black swan" events. While difficult to model, such "unknown unknowns" are major drivers behind many business failures. As Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Highly Improbable noted: "Almost all consequential events in history come from the unexpected."
While economic capital modeling may effectively portray the carrier's risk, it is uniquely calibrated and not transparent to investors, policyholders of other stakeholders. Reasons include the complex nature of the modeling process, the intricate nature and longevity of the products and the difficulty (or impossibility) of reflecting every risk in the cash-flow models.
Even industry insiders question the quality of their economic capital analyses. A recent survey by PricewaterhouseCoopers found that 50% of insurers believe their economic capital data lack completeness and quality. In addition, 75%, believe their data should be furnished in a timelier manner.
Moreover, many analysts believe that insurers' internal models lack comparability, consistency and auditability; are too theoretical; and are subject to management manipulation. Consequently, any further modifications of value measurement should focus on increasing transparency and addressing analysts' concerns.
Ultimately, economic capital, and the cost of capital as contemplated and implemented today, is not sufficiently market-based to measure whether an insurer can expect to earn more than its cost of capital. Economic capital modeling is a valuable and powerful tool for understanding enterprisewide risks and rewards, but it has limits. Modeling cannot capture all risks or replace business judgment.
Rethinking Your Approach
Insurers can best reflect the condition of their businesses through the use of a performance measurement approach that incorporates the market's view of risk and the level of compensation the market demands to accept that risk. The first step is to determine the appropriate level of economic capital that will maximize transparency and the use of market information.
The most direct way is by posting the minimum capital required to satisfy a target debt rating. Other ways include the capital set-aside in securitization deals of in financial reinsurance transactions. Another would be the economic capital created from an internal projection of cash flows, which can be adjusted for risk premiums observed in more liquid markets. These techniques will allow the market to reach a consensus on insurers' values.
In addition, any changes in these values from one period to the next need to be transparent. Depending on the underlying products, companies will need to develop stable and understandable analytics in order to make these changes completely visible. For example, analytics could split market and nonmarket information of could address each relevant risk margin individually.
Measuring an insurer's performance or change in its capital adequacy depends on the type, amount and transparency of information that is provided to investors, regulators and the public. Just as in the shift from embedded value to market-consistent embedded value, economic capital based on a market view of risk can be more transparent and comparable across entities.
The insurance industry has many tools that can provide clearer, cleaner and more useful information to interested parties. Whether the approach is gain at issue or no gain at issue, more information and disclosure around capital needs and risk returns will allow the move to market-based performance measurement to begin in earnest,
* The Situation: Insurers need clear, accurate valuation of their companies in order to maintain access to capital markets.
* The News: To ensure consistent accounting, regulators and rating agencies are urging insurers to adopt a new economic valuation framework.
* The Upshot: Companies will begin measuring and reporting their capital and risk assumptions more transparently.
Much to Gain
Two major issues that have emerged regarding the valuation of insurance businesses ate the ways in which risk margins are calibrated, and the recognition of "gain at issue" or "no gain at issue." Both can be traced back to the original purpose of valuation reporting: to accurately reflect changes in shareholders' value.
In a world with perfect, readily available information and no transaction costs of liquidity concerns, the risk margin for insurance would compensate investors for bearing risk. This factor also would be reflected in the equilibrium price of the contracts themselves, as is the case with any investment transaction.
However, the risk margin can be distorted by regulatory restrictions, significant disparities in information, a variety of frictional costs and complications arising from economically inefficient decision-making by policyholders.
When accounting for market inefficiencies, analysts generally take one of two positions: Either there is a gain at issue--in which the company creates value simply through the sale of an insurance contract--or there is no gain at issue.
Proponents of gain at issue contend that insurers should be able to recognize an immediate gain for any premiums expected to be received during the life of a contract, over and above those implicitly required by the risk margin associated with the business being written.
Advocates assert that economic rent, or amounts that exceed compensation for bearing risk, can be generated through inefficiencies in insurance sales, such as insurers' market knowledge and experience in pricing, and policyholders' inability to fully value all the options and guarantees in their contracts. In their view, the sales process itself can result in policyholders paying a higher price, which generates economic rent and, therefore, a gain at issue for the insurer.
On the other hand, those who believe in no gain at issue view the premium received as the primary or even the only indication of the appropriate risk margin required by the market.
Many proponents of no gain at issue acknowledge the possibility of economic rent, but question whether it can be reliably measured. They have raised other concerns as well, including whether income from gain at issue could be recognized in the absence of a legal obligation on the part of a policyholder to pay future amounts that exceed the costs of providing benefits and services.
No gain at issue advocates also have a logical argument in their favor. The economic rent which would create gain at issue theoretically cannot exist in an efficient market--and fair-value accounting assumes that markets, in fact, are efficient.
Contributor Larry Rubin is a partner in PricewaterhouseCoopers' Actuarial and Insurance Management Solutions Practice. He may be reached at email@example.com.
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|Title Annotation:||Regulatory/Law: Company Valuation|
|Comment:||Measuring up: new standards help insurance companies determine their true value in a changing world.(Regulatory/Law: Company Valuation)|
|Date:||Jan 1, 2009|
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