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Uncovering value: by using embedded value reporting, insurers can get a clearer picture of where they are making--and losing--profits.

More and more companies worldwide are evaluating performance using value-based techniques such as embedded value. In the United States, however, embedded value reporting has been experiencing limited acceptance to date. Although a recent Tillinghast survey of North American insurance chief financial officers reveals they believe that value-added methods such as embedded value are superior lot tracking the change in company value over time, U.S. generally accepted accounting principles remain the predominant internal and external financial reporting methodology.

This is about to change. Recent demands for greater transparency, coupled with a growing awareness of shortcomings in U.S. GAAP reporting, are expected to lead to greater use and reporting of embedded values.

What Is Embedded Value?

Embedded value is equal to the sum of the value of the in-force business and the shareholders' net worth, adjusted for the cost of holding capital. As a method of measuring financial results, it clearly articulates where companies are and are not adding value relative to the company's own cost of capital. Embedded value can be used to help management make important decisions about bow a company should deploy its capital, directing the company away from products or lines of business that are destroying value and moving it toward those that are adding value. Embedded value reporting also can aid in communication with stakeholders by improving the transparency of financial performance information.

Embedded value can be a useful management tool that promotes long-term thinking and aligns management and stakeholder interests with value creation. When used as part of an overall financial management system, it provides a consistent basis for pricing and risk management.

Companies adopt an embedded value reporting system for many reasons. It is, foremost, an excellent internal performance measurement tool that fills key information gaps in the following areas:

Link to pricing--Embedded value forces companies to evaluate the reasonableness of their pricing assumptions, reflecting recent experience.

Link to risk analysis--When used with stochastic modeling and scenario testing, embedded value can greatly enhance an enterprise risk management analysis that links risk and value together to better frame risk/reward decisions for senior management.

Performance reporting--Embedded value enables management to assess actual current year experience vs. expected experience and measures the value added from new sales; it also facilitates comparison of performance across regions.

Strategic and operational planning--Embedded value completes the modeling cycle of pricing, corporate planning and forecasting: helps determine how alternative strategies impact value: and enables management to develop a framework for connecting and prioritizing specific activities and team goals for value creation.

Second, embedded value provides a sound basis for helping employees understand which of their actions and behaviors help create value for the company and can be used to establish incentive programs that reward employees for those behaviors. For example, the value of new business is an excellent metric to track the value contribution from sales in short-term incentive plans. For long-term incentive plans, the change in embedded value over time is a more appropriate measure.

Finally, many financial analysts have endorsed embedded value as providing a clearer and more transparent way of reporting financial performance to the investment community. Analysts believe that this method allows better disclosure and clarifies profitability and return on capital. It allows investors to gauge the extent to which profitable new business is written, how actual gains/losses on in-force business measure up against pricing assumptions, and how much of the company's value is based on in-force vs. growth in new business.

In general, analysts feel that embedded value reporting promotes long-term thinking and provides a strong internal economic performance measure. It also is viewed as a better measure for start-ups and new business profitability, and it is a good basis for acquirers to substantiate takeover prices. In particular, analysts like that new business value is broken out, experience variances are reflected immediately and a full balance sheet view of the in-force business is given.

A Comparison

Embedded value demonstrates the value of an insurance company emerging over time, while U.S. GAAP provides a more static picture of profits, based on a prescribed pattern. Managing an insurance business purely on the basis of U.S. GAAP earnings may lead to incorrect decisions, particularly in volatile markets.

Embedded value offers distinct advantages over U.S. GAAP accounting by answering two very important questions:

* Is my company writing profitable new business?

* How well is my company managing its in-force business?

Let's take a quick look at the key differences between the two systems. Although both are based on future assumptions (such as investment return, expenses, mortality and persistency), embedded value calculates the value of future cash flows based on realistic assumptions and discounts them at a risk discount rate to arrive at present values. The risk discount rate reflects the shareholders' views as to an appropriate return on their capital. Typically, this rate is set at 3% to 4% above the current 10-year treasury rate. U.S. GAAP calculates the value of future cash flows based on realistic assumptions and calculates reserves and deferred-acquisition-cost assets so that profits are reported in a stable pattern.

The two systems also have a significant difference in the timing of cash flow recognition. Embedded values are seen as a leading indicator of changes in U.S. GAAP earnings. Embedded value reporting recognizes the value of new business or any unexpected change in in-force business (such as experience differing from assumptions) in the year it occurs. U.S. GAAP reporting defers most of this impact on profits, spreading it over all future periods. For a business that has long-term contracts with embedded options, guarantees and risks, stakeholders need to have a clear picture of the value emerging from current new business activities. Embedded value reporting provides this insight, while U.S. GAAP does not.

Getting a Foothold

Embedded value is well established in Europe and the United Kingdom, and it is accepted and widely used in Australia and South Africa. Multinational insurers and insurers in the United Kingdom were the first companies to adopt embedded value reporting. Currently, most of the larger life insurance companies domiciled in Europe (and many others) use embedded value reporting. In addition, sign-off by consulting actuaries is starting to bring greater consistency to both embedded value assumption sets and methodologies.

Embedded value reporting is a somewhat more recent development in Canada. It was adopted by most companies in 2001, following the demutualization of several large Canadian life insurers in 1999 and 2000. In 2000, investment analysts used public data to estimate the embedded values of newly listed Canadian insurers and then demonstrated that the Canadian insurers were "undervalued" compared with their European counterparts. This research piqued investor interest in the insurance sector and prompted Canadian life companies to publish their own calculations of embedded value and the value of new business written--which provided more accurate information than the external estimates.

The United States is one of the last major developed insurance markets to adopt embedded value reporting. The good news is that there is increasing interest within the investment community, and growing acceptance among U.S. insurers. Currently, nearly all of the life insurance subsidiaries of multinationals are calculating embedded values, and these figures are being reported as part of the global release of embedded values from their parent companies to financial analysts and investors. In addition, a growing number of U.S. insurers (mostly life insurance companies) have started implementing embedded values as their preferred tool for internal performance measurement. Some are even starting to report this information externally. For example, Hartford Financial Services Group is reporting the embedded value of its variable annuity in-force business in the supplementary financial data it discloses with its earnings every quarter.

The use of embedded value (for both internal and external purposes) will likely become much more widespread over the next few years. Some recent developments support this contention. A number of the multinationals already disclose separate embedded value results for their U.S. subsidiaries to investment analysts, and those that don't are planning to do so over the next several years. In addition, investment analysts may begin to exert pressure on U.S. companies. In Canada, investment analysts were in favor of the publication of embedded values and played a key role in encouraging companies to publish these results. So far, we have not witnessed such an activist stance in the United States. At least one analyst, however, has published estimated embedded values for listed companies, and more may do so in the future.

Quoted U.S. life companies may want to get a head start on preparing embedded values because it is likely that competitive forces will require them to report values in the not-too-distant future. It typically takes two to three reporting cycles for management to truly understand the impact of strategic and operating decisions on embedded value. It would be better to go through this learning process internally rather than doing it under full public scrutiny, which is what happened to the Canadian life insurers when they introduced embedded value reporting a few years ago.

Moving Slowly

Given the potential benefits of using embedded values, why aren't more U.S. insurers adopting these reporting methodologies? The reasons seem to be divided between the philosophical and the practical.

Critics have pointed to shortcomings in the embedded value methodology and question whether it is really the true best measure of value. Some say that it is overly complex, involves too many assumptions and has the potential for misinterpretation. Others criticize traditional methods as too simplistic and say that a more rigorous framework is needed to measure the cost of options and guarantees. In response to these criticisms and changes in the business environment, traditional embedded value methodologies are being enhanced. These new methodologies accurately allow lot the cost of credit risk or market risk for mismatched products. They also provide for the cost of policyholder options and guarantees that are in or out of the money.

On the practical side, many companies feel that implementing an embedded value measurement system would require too much extra work at a time when resources are strained and the emphasis within their companies is on cutting costs. They don't have existing resources to implement an embedded value system or the budget to hire additional resources. Embedded value builds off of many of the things that companies are already doing, however. So, while the effort required to implement an embedded value system is not negligible, it can be less work than anticipated.

How to Get Started

Successfully implementing an embedded value system requires careful planning and the commitment of senior management. The typical steps in the reporting cycle include the following:

* Setting the methodology;

* Establishing the assumptions:

* Calculating embedded value results;

* Analyzing and communicating the results;

* Factoring the implications into business planning and new business pricing; and

* Reassessing the process based on management's analysis of prior period embedded value results.

Companies implementing embedded value for the first time must first agree on the methodology. It is important to decide who will determine the methodology used, what factors will be included in the methodology, what assumptions will be used and how the results will be used. Determining the risk discount rate and the level of target surplus are particularly sensitive issues. First time users must also validate the initial results to ensure that they are appropriate and that the methodology and assumptions are correct. Finally, some first-time users will need to deal with company-specific challenges such as incomplete accounting information or vocal critics within the company.

These challenges are not insurmountable. They can be overcome by using the most up-to-date methodologies, paying close attention to the details and attaining the buy-in and support of senior management.

As more U.S. insurers realize the competitive edge available to them. the momentum for embedded value is growing. Embedded value reporting enables management to get a better handle on their company's business and make course corrections more quickly and more accurately. They are able to confidently identify where they are making money and where they are losing money, allowing them to redirect their capital to products and businesses that will maximize shareholder value. In today's volatile and increasingly complex marketplace, reliance on U.S. GAAP financial results is no longer enough.

Embedded Value: Key Terms

The embedded value of the life insurance operations of an insurance company is equal to the sum of the value of the in-force business and the shareholders' net worth, adjusted for the cost of holding capital.

Value of in-force business: the present value of the projected stream of future after-tax profits expected to generate from the policies in force at the valuation date.

Present value: calculated using a risk discount rate that is typically set at 3% to 4% above the current risk-free rate.

Shareholders' net worth: comprises the market value of the net assets of the life insurance company.

Required capital: the capital needed to satisfy the company's financial strength requirements. The annual charge for the cost of maintaining capital is the difference between the after-tax rate earned on assets supporting required capital and the risk discount rate.

Embedded value earnings: the change in the embedded value over the reporting period, after adjustment for any capital movements. Embedded value earnings comprise:

* The value added by new business written during the year, after allowance for the cost of holding capital:

* The profit from existing business equal to the expected return on the value of in-force business, including allowance for the cost of holding capital;

* The impact of changes in economic assumptions during the year;

* The experience variances caused by the differences between actual and expected experience and the impact of changes in assumptions for future operating experience; and

* The expected investment return on the shareholders' net worth.

Analysis of embedded value earnings reveals the underlying drivers of value. Management can isolate the changes in embedded value via model changes, assumption changes, expected return and new business. Management can then focus its attention on operating variances and the underlying causes of those variances.

RELATED ARTICLE: Embedded value added vs. U.S. GAAP net income.

Embedded value offers significant advantages over U.S. generally accepted accounting principles as a method for evaluating new business opportunities. In this example, a life company is considering a new business opportunity that offers above-target returns for only a limited upfront investment cost. Over time, the ability to achieve above-target returns will decrease but there is a window of opportunity to enter this new market and build critical mass before competition heats up. In "Taking Another Look" we show how this opportunity looks from the different perspectives of projected GAAP net income and increases ha embedded value.

Only the first tour years are illustrated in the chart. In later years, the GAAP net income becomes quite high and exceeds the increase in embedded value after year 10. From many perspectives, it is clear that the new business opportunity is favorable with profitability significantly above target levels. However, GAAP net income is negative in 2004 due to the impact of start-up costs and is low for several years due to the impact of fixed costs until sufficient scale is achieved. If a company is managed based solely on short-term GAAP net income targets, then this initial pattern may cause management some concern and, potentially, allow the opportunity to pass. In contrast, the change in embedded value is positive in each year and provides an immediate indication of the value added due to the above-target returns achieved on each year of new issues. Using the increase in embedded value as an added metric, the company's management will be in a better position to appreciate the potential value of pursuing the opportunity immediately before competitors can step in and eliminate potential above-market returns.

Taking Another Look

Based on GAAP reporting, a life insurer measuring the effectiveness of its new product would cite negative net income in 2004 and would let the opportunity pass. On the other hand, embedded value reporting shows a positive response over four years, allowing the company to appreciate the potential value of pursuing a new idea.

COPYRIGHT 2003 A.M. Best Company, Inc.
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Copyright 2003, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Title Annotation:Accounting
Author:Mueller, Hubert
Publication:Best's Review
Geographic Code:1USA
Date:Oct 1, 2003
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