1. An Introduction to Embedded Value
Peter Erlandsen, CFO, Manulife
Rio Winardi, Chief Actuary, Astra CMG
Simon, Chief Accountant, Panin life
Date: 8 December, 2005

2. AGENDA Why Calculate Embedded Value? What is Embedded Value? Net Worth
Value of In-Force
Value of new business
Other Issues
Question & Answer

3. I. Why Calculate Embedded Value An Introduction
Embedded Value Estimates Value.
Quiz 1 - What Does Profit Measure?
Income less Outgo
Quiz 2 – Why is Profit not a measure of Value?
Profit is a measure of this year’s results
Value is a measure of long-term worth
Quiz 3 – Why doesn’t value = profit * P/E ratio?
New Business Strain

4. “Typical” Profit Signature

5. “Typical” Projection
The loss in the first year is often called New business Strain.
Over the life of the policy we expect PV profit to be positive.

6. What’s wrong with Statutory Profit?
Profit drivers for Statutory Reporting incorrect!
Shows a loss when writing lots of profitable new business when in value is actually added
Shows a gain when policies cancels when value is actually lost
A growing company writing profitable business can have a negative statutory profit for many years, but is generating a lot of value for it’s shareholders.

7. I. Why Calculate Embedded Value Reasons to Calculate Value
A measure of performance
To calculate Return On Equity (ROE)
Increase in value / starting value
Carrying value in accounts of owner
Sale or Purchase
Management bonus

8. II. What is Embedded Value?
Embedded Value comes from three segments:
Net Worth (Assets – Liabilities)
PV of profit from in-force business
PV of profit from future sales
Sometimes:
1 + 2 is referred to as Embedded Value
is referred to as Appraisal Value

9. III. Net Worth Net Worth = Assets – Liabilities Assets
Market Value of Assets
Costs of sale of investments / assets (tax, fees)
Value of some assets depends on purpose of calculation.
In a sale situation computer software may have no value.
Difficult to value some assets
Intangible assets (e.g. Goodwill) often set to zero
Property, direct holdings, … have no ready market value
Do deferred tax assets have value?

10. III. Net Worth Net Worth = Assets – Liabilities Liabilities
Local Indonesian policy reserves
Should include RBC requirements
Cannot be distributed
Market Value of other liabilities

11. IV. Value of In force (VIF) Definition
VIF = Present Value of future Distributable Profits from in force policies
Distributable Profits
= Statutory Profits less increase in required RBC
Statutory Profits
= Premium + II – claims – expenses – change Resv - tax

12. IV. Value of In force (VIF) Assumptions
VIF = Present Value of future Distributable Profits from in-force policies
Assumptions
Best estimate assumptions needed
Mortality/Morbidity
Interest earnings
Inflation
Lapses
Expenses
Tax
etc.

13. IV. Value of In force (VIF) Risk Discount rate
Profits are discounted at the Risk Discount Rate (RDR)
RDR represents
The company’s minimum desired rate of return on capital
Sometimes referred to as the “hurdle rate”
RDR should reflect:
the Expected Shareholder’s return
the risk that future profits will not match expectations (risk profile of the business)
the current local market conditions

14. IV. Value of In force (VIF) Risk Discount Rate
Profits are discounted at the Risk Discount Rate (RDR)
The RDR is key to the final Embedded Value figure
Often a range of figures is used to show sensitivity
CAPM says
RDR =Risk free + Beta * (Market Rate – Risk Free)
Currently perhaps
RDR = * (20.0 – 14.0) = 21.2%

15. V. Value of New business (VNB)
VNB = Present Value of future Distributable Profits from future sales.
Assumptions
Same issues as VIF
How many years New business?
Judgment but often around 5 years.
Additional Assumptions
Future sales growth, agency size, productivity, product mix, …

16. VI. Other Issues Expense Over-run Minimum or target RBC ratio
Expense budget versus Expense allowables
Minimum or target RBC ratio
120% or 150% of estimated RBC
Later year losses
How should we treat later year losses (25 years from now!)
Investment Return
Should be consistent with asset valuation.
Should a change in asset mix affect value?
Can we forecast changes to current rates?

17. VI. Other Issues
It is extremely important that future bonus rates on with-profit policies should be consistent with:
Future assumptions.
Likely future management action
Policy holders reasonable expectations
Future Sales (Value of New Business)
Can we assume a re-price of loss making products
Are future margins going to be the same as today?
Should we use a higher RDR because of greater uncertainty?

18. VI. Other Issues Product Guarantees Valuation Software
Investment /mortality – no value in deterministic approach
Valuation Software
Many available (e.g. Prophet, VIP, AXIS, MOSES, etc)
Possible but cumbersome to do in spreadsheets
Model points Vs seriatim data.
Changing Assumptions
How often depends on purpose
Assumptions are long term to try to not have big swings
Future improvements in mortality

19. VII. Question & Answer