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2007 Annual Meeting ● Assemblée annuelle 2007 Vancouver. Canadian Institute of Actuaries. L’Institut canadien des actuaires. Bob Sharkey Sun Life Financial Inc. Embedded Value and Value of New Business CIA Presentation, June 29, 2007. 2007 Annual Meeting Assemblée annuelle 2007.

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2007 annual meeting assembl e annuelle 2007 vancouver
2007 Annual Meeting ●Assemblée annuelle 2007






L’Institut canadien




bob sharkey sun life financial inc
Bob Sharkey

Sun Life Financial Inc.

Embedded Value and Value of New Business

CIA Presentation, June 29, 2007

2007 Annual Meeting

Assemblée annuelle 2007


embedded value and value of new business
Problems with Book Equity, Income and Return on Equity (ROE)

Embedded Value (EV) and Value of New Business (VNB)

Significance of EV to Management, Analysts and Shareholders

EV Methodology Considerations

VNB Methodology Considerations

Measures of Product Profitability

VNB and Earnings

Embedded Value and Value of New Business
gaap book equity not always a good value measure
“BE” is not always a good measure of value. There is no necessary link between historical accumulation of retained capital & a company’s value.

BE of regulated financial intermediaries is driven by regulatory and rating agency solvency capital requirements. Thus BE relates to in-force risk rather than to value or the working capital required to carry on business.

At acquisition Insurance company P/B ratios often exceed 2, which means that BE captures less than 50% of the perceived value.

Liabilities include prudential margins: not “best estimate” or “fair value”. Not all assets are at market.

BE does not adequately measure:

Value created in prior years that will emerge as future income.

Value created by new sales over their product lifetime.

Value creation capacity of the company.

Value of Intangible assets.

Value of future sales.

Value impact of mergers, acquisitions and structural, operational and environmental changes.

GAAP Book Equity Not Always A Good Value Measure
gaap income not always a good measure of value creation the black box
Stock prices life insurers discounted because GAAP Income is:

A black box obscured by arcane actuarial and accounting practices.

Historical rather than forward looking. Dominated by income generated from sales in prior years.

Accounted for differently from other sectors and in each jurisdiction.

Not a good basis for assessing acquisitions and divestitures.

Challenged by economic, operational and environmental changes.

Challenged by products with uneven patterns revenue & expense over life time. Can be reduced by New bus. Losses on high, value added sales.

Challenged by cash flows subject to statistical fluctuations and future contingencies over long periods. Increased by high, value destroying policy surrenders.

Not adjusted for risk and capital costs.

Not a measure of value added by current management and new business.

GAAP Income Not Always a Good Measure of Value Creation (The Black Box)
roe not always a good performance measure
ROE is supposed to measure “how effectively a company uses its investors’ money”.

ROE inherits all the problems with GAAP income and Book Equity (BE) as measures of value created and value deployed. Major components BE not deployable capital.

ROE for new sales not connected to ROE on in-force, which will dominate ROE. Poor in-force ROE can obscure good ROE on sales & vice versa.

Income and RC for a product can be miss-matched from year to year, since RC is a point in time risk measure.

Capital required & income generated by products can change dramatically over long product life times.

Ind. Life sales have doubly negative ROE impact. They generate income losses at sale & need substantial capital.

Past Individual Life sales generate quite high ROE levels.

Capital requirements and the resulting ROE on products with embedded options are tied to market experience and can vary dramatically with markets over time.

ROE Not Always a Good Performance Measure
embedded value and value of new business7
Embedded Value (EV) and Value of New Business (VNB) address these limitations of GAAP BE, Income and ROE.

EV measures the underlying value of a company.

EV and VNB capture a company’s capacity for value creation, including a means to estimate the value of future business.

The change in EV measures the value created and the analysis of this change throws light on the performance of current management.

VNB isolates & measures value created by current sales.

EV & VNB reflect capital costs over product life times.

EV reflects the “tangible” value of intangibles.

EV measures the value impact of mergers, acquisitions and structural, operational and environmental changes.

Embedded Value and Value of New Business

Present Value of adjusted earnings* from future new business

Value of future new business

Present Value of adjusted earnings* from in-force business

Value of in-force business

Value of shareholder net worth

Realizable value of surplus

Appraisal Value Exceeds Embedded Value

Appraisal Value

Embedded Value

* Adjusted earnings equal after tax earnings less the cost of solvency capital.

glossary of terms
EV = (IBV) + (ANW).

RDR = Risk Discount Rate. After-tax, risk-adjusted rate used to discount future values. Equals a risk free rate plus a risk margin. Is the cost of equity capital.

RC = Required Capital. Surplus deemed to be required to maintain statutory solvency and capital strength.

NCRC (t) = The outstanding RC in year “t” times the difference between the RDR and the after-tax return assumed to be earned on RC.

IBV = Insurance Business Value. Present Value (PV) of after-tax (book) profits expected to emerge from in-force business (PVFP), minus the PV of the NCRC for all future years. PVFP does not include income earned on surplus or required capital.

ANW = Adjusted Net Worth. The realizable, tax effected market value of total capital and surplus.

AV = Appraisal Value. EV + Value of Future Business.

VNB = Value of New Business. Value includes acquisition costs.

Value of Future Business is often expressed as a multiple of VNB. Multiple reflects growth, synergies, intangibles.

Glossary of Terms
significance to management
Value measures can profoundly impact all aspects of Management.

Management can link business activities and analysis and shareholder communication and disclosure to value creation.

Focus more on long term value creation rather than short term bottom line.

Value drivers inform strategic thinking, business plans and decisions.

Value measures must be integrated into key management financial reports and incentive compensation.

Value based targets and incentives align management and shareholder interests.

Used to manage product development and pricing process.

Sensitivity of EV to financial risks measures value at risk.

Allocate capital on value creation, rather than “bottom line”.

Assess mergers and acquisitions and structural changes in value terms.

Significance to Management
significance to shareholders analysts
GAAP statements, E/S, P/B, ROE remain critical.

However, EV adds a forward-looking, longer term, value creation perspective.

Change in EV provides public measure of total value creation and VNB provides public measure value created by new sales.

Price to EV and new business multiples by product are revealing.

Supports value comparisons between companies within and across jurisdictions. Supports value based assessments of merger and acquisition activities, and cross pillar activities such as bancassurance.

Canadian analysts are lukewarm to EV, unlike in Europe, where EV is a key determinant of stock price. Canadian GAAP is more useful to analysts than European. Canadian EV disclosure is minimal, whereas European is extensive. There are few Canadian insurers reporting EV and EV measurement and reporting standards are minimal. The considerable effort to understand EV has little payback for analysts.

Until trend lines established, disclosure enhanced and methodology, assumptions and reporting standardized, EV will remain secondary.

Significance to Shareholders & Analysts
significance to shareholders analysts cont d
EV is the value of the existing business. Let (M x VNB) = “franchise value”, i.e. the value of future business. Then the market capitalization MC = EV + (M x VNB). “M” is the new business multiple.

Given EV and VNB can determine an “implied” “M” from MC.

Specify “M” and you can get a target stock price. If M = 15, (EV + 15 x VNB) / # o/s shares = target stock price.

Judgement required to determine M. A multiple of 20 or higher reflects an excellent assessment of current and future value creation opportunities through sales growth. A multiple of 10 or lower reflects a poor assessment.

A crude estimate of the new business multiple can be determined by dividing 1 by the RDR less the expected sales growth rate. Using RDR of 9% and sales growth rate of 4% provides a multiple of 20 (1 divided by .05 = .09 - .04). The sales growth rate can vary by product to get product specific VNB multiples. Also, the sales growth rate (and the VNB per dollar of sale) can vary over future periods.

Significance to Shareholders & Analysts (cont’d)


Change in EV

New Business

  • Expected return on opening value
  • Value of New Business
  • Variances from expected experience
  • Change valuation basis
  • Change prospective assumptions
  • Capital movements
  • Change in currency and discount rates

In Force

In Force



Net Worth


Change in Embedded Value


analysis of change in ev
EV is effectively an accounting system. Thus, AOC in EV is quite similar to SOE and has similar components.

SOE analysis is part of the AOC in EV, since the income transferred to surplus is a major component of the change in the value of surplus.

Usually currency (experience) and RDR (assumptions) are shown separately.

AOC in EV has a capital transaction component.

The Value impact of an experience variation or basis change includes the income impact, but adds the PV of the future income and cost of capital impact.

Value impact of experience and assumptions can be quite different.

Group income impact ends at next contract renewal. Value impact ends only when the client terminates, so is many times larger.

Income impact of mutual and segregated fund performance is linked to average assets under management. However, the value impact of fund performance adds to the income impact the impact on future income of the change in AUM in the period.

Analysis of Change in EV
ev and vnb rest on many assumptions
While each assumption may be reasonable, a change in assumption can materially impact EV and VNB.

Trends are perhaps more important than absolute numbers.

Important to use same method and assumptions over time.

Impact of material changes should be analyzed and reported separately.

Method and assumptions should be grounded in financial reporting and capital markets and validated by a thorough review process.

Quality processes & controls & internal reviews are critical. External peer review ensures compliance, consistency and reasonableness.

Disclosure of key assumptions and their sensitivities mitigate concerns with assumptions as with GAAP income.

Sensitivity of EV and VNB to equity risk premium and capital level.

Redemption rates, M&E charges and unit expenses for asset management companies and segregated funds.

EV and VNB Rest on Many Assumptions
ev considerations
1. Accounting Basis

Regulatory after-tax income and regulatory or rating agency capital are used not GAAP after-tax income and economic capital.

CAS / MCCSR, unless local more conservative.

2. Required Capital Level (150% MCCSR)

Higher capital, such as 200% MCCSR, should be used in pricing and IRR, if required by rating agencies for rating.

Capital level materially impacts IBV and VNB of capital intensive products. Typically, retail has high and Group Benefits, Retirement Savings are low.

Local minimum capital requirements, such as those applicable in Asia, must be recognized.

EV Considerations
ev considerations cont d
3. Adjusted Net Worth (ANW)

Derived from Book Equity. FIAC reduces, but does not eliminate, differences between ANW and Book Equity.

Alternative, but equivalent, EV approach sets ANW equal to value of surplus in excess of RC and includes PV projected income on RC in IBV.

Alternative is more complex & value of RC is based on investment income projections, rather than market values.

Alternative is less revealing since mixes value embedded in reserves with value of earnings on RC. IBV may be more or less due to earnings on RC. Two businesses may have similar IBV, but very different values embedded in reserves.

4. Closed Par Accounts

Have negative IBV equal to the net cost of RC.

IBV of reserve margins less than the MV of assets supporting the margins.

EV Considerations (cont’d)
ev considerations cont d18
5. Risk-Adjusted Discount Rate

Capital Asset Pricing Model used to set RDR, the equity cost of capital.

RDR = Risk Free (gov. bond) Rate (RFR) at report date plus an Equity Risk Margin (ERM).

Assume a AA rated insurer has BETA of 1 & market has Equity Risk Margin (ERM) of 3.5%, then RDR = RFR+3.5%.

Currency and country risk margin (Asia) reflected in RDR.

Varies by country. Same RDR used for all products in a country, unless higher risk product requires a higher ERM.

Higher risk products include asset management companies, variable annuities and segregated funds.

Business with a “stand-alone” BETA of 1.3 should have an ERM of 4.5% = 1.3 x 3.5%.

ERM changes have relatively less impact on short-dated products with low capital requirements such as mutual funds. Changes have a material impact on long term, capital intensive products.

EV Considerations (cont’d)
ev considerations cont d19
Gross Equity Growth Rate for Policyholder Accounts

Assumed policyholder fund gross equity growth rate cannot exceed RDR. Fixed costs may mean RDR should exceed the policyholder fund growth rate. Necessary to avoid implication that businesses whose income is driven by equity returns are less risky than equities.

Anticipated Productivity and Profitability Improvements

Reflected in EV only if reflected in CAS best estimate reserves or reasonably assured.

Benefits of tax effective investments and structures reflected in EV only if reflected in CAS reserves or reasonably assured.

Group and reinsurance profit margins & renewal rates for future renewals consistent with current margins and rates.


Method of allocating expenses and splitting between acquisition and maintenance to be reserve method.

Actual acquisition and maintenance expenses to be used.

Recurring non-policy related expenses to be capitalized.

EV Considerations (cont’d)
ev considerations cont d20
9. Cost of Guarantees and Embedded Options

IBV and VNB must reflect the expected cost of guarantees and embedded options determined stochastically or using market prices, if the cost is material.

Often stochastic models are used to price guarantees or embedded options in new sales or the in-force as part of product pricing, valuation, risk management, or economic capital work. These prices equate to an annual basis point charge that can often be used to reflect appropriately their costs in VNB and IBV without doing VNB and IBV stochastically.

Examples of such guarantees and options include U.S. variable annuities and segregated funds with GMIB, GMDB, GMMB, GMWB options and Universal Life with minimum rate and/or no lapse guarantees.

IBV and VNB must reflect the full cost of in-force and new business hedging programs.

EV Considerations (cont’d)
ev considerations cont d21
EV and Acquisitions

Dilution impact of acquisitions on EV/per share and P/B are quite different.

They throw light on the proportionate amounts paid for the three components of value, ANW, IBV and franchise value/synergies. Comparatively greater dilution does not mean too much was paid for an acquisition.

ANW = Net Assets which are marked to market at acquisition.

IBV = EV – Net assets (ANW).

Price – EV = value paid for synergies and profits on future sales.

EV per share dilution increases as ((Price – EV) / Price) increases.

Greater EV per share dilution means no more nor less than that a greater proportion of the price was paid for synergies and profits on future sales.

Greater Price to Book (Net Assets) ratio means no more nor less than that a lower proportion of the price was paid for net assets.

Acquisitions with similar P/B can have different EV / share dilution. The similar P/B means the same proportion of the price was paid for net assets. Differing EV / share dilution because a greater or lesser proportion of the price was paid for synergies and profits on future sales.

Acquisitions with similar EV per share dilution can have different P/B ratios. Similar EV per share dilution means that a similar proportion of the price was paid for EV. Differing P/B ratios result from paying relatively a greater or less proportion of the price for net assets.

EV Considerations (cont’d)
vnb considerations
1. Definition of New Business: Consistent with sales disclosure. Issues: premium increases, recurring single premiums, renewals, annuitizations, new members to Group plans, longevity reinsurance.

2. Recognition of New Sales: Sales recognized when liability first established.

3. Standard VNB: Measured using RDR, 150% MCCSR, valuation and other assumptions at report date, actual acquisition expenses including distribution subsidiaries.

4. Useful VNB Variants: Sensitivity testing, pricing or projected plan assumptions (for rapidly changing businesses).

5. Estimating VNB:

Must be done separately for each product.

A simple VNB per dollar of sale factor estimate may be poor, if acquisition and fixed expenses per dollar vary materially with sales volume.

An adjusted VNB per dollar of sale should be determined using acquisition and fixed expenses set to 0. Estimate VNB by applying adjusted factor to new sales and then deducting actual and fixed expenses for the new sales.

VNB Considerations
measures of product profitability
New Business Impact (NBI) is not a measure of profit margins. Trends in NBI do not indicate profit margin trends. NBI says something about when profit is recognized, not about profit margins.

Ratio VNB to sales is simple, easily understood profit margin measure. Ratio VNB to PV expected premiums better, because adjusts for product life time.

IRR is readily calculated using the same after-tax income and capital cost projections as are used to calculate VNB.

IRR is familiar measure linked directly to other performance targets.

When IRR = RDR, the equity cost of capital, then VNB = 0.

If IRR > RDR of 10% say, but less than hurdle rate of 15% say, then VNB > 0 and sales add value, even though they do not add sufficient value to meet hurdle rate.

If IRR < RDR, sales are destroying value.

Annual ROCE is a problematic measure for businesses, where profits emerge over many years and profits and Capital Employed (CE) fluctuate & are miss-matched.

Define “Lifetime ROCE” (LTROCE) = LTE/LTCE on NB, where

Lifetime earnings, LTE = PV earnings on NB + earnings on CE.

Lifetime capital employed, LTCE = PV of capital employed.

If LTROCE is discounted using the IRR, then LTROCE = IRR.

Measures of Product Profitability
measures of product profitability profit margin trends
Profit margin trends should be analyzed at the product level. Even so, implications must be considered carefully, since trends may be temporary or permanent.

Trends in profit margin can be misleading, if aggregated across products with different profit margins.

Multi-product profit margin trends are usually dominated by product sales mix trends, rather than specific product margin trends.

A downward profit margin trend can result from sales increases across all products, as a result of sales mix trends, even if all products have good margins and no specific product profit margins have decreased.

An upward profit margin trend can result from sales declines across all products, as a result of sales mix trends, even if profit margins are poor and no specific product profit margins have increased.

Measures of Product Profitability (Profit Margin Trends)
measures of product profitability profit margin comparison
Product characteristics often underlie systematic differences in the ratio of VNB to sales or PV of future expected premiums.

Relatively, long-term, high capital/risk products (par) require material reserves and tend to have high VNB to premium ratios.

Relatively short-term, minimal capital/risk products (fee-based) require minimal or no reserves and have low VNB to premium ratios.

Differences in VNB to premium ratios do not make one product fundamentally more attractive than another.

Low profit margin products may absorb fixed costs and have huge sales without competing with high margin products for scarce capital, resources and distribution capacity.

Low and high margin products complement each other. The goal is a balanced portfolio where all products add value and optimize capital, resources and distribution capacity.

In product design, increasing profit margins (IRR, VNB to prem. Ratio) is not necessarily a good thing. Goal is to maximize VNB not to maximize profit margin. Thus, VNB a better performance measure than profit margin measures including IRR or LTROCE.

Measures of Product Profitability (Profit Margin Comparison)
relation of vnb growth to earnings growth is complex
Not surprisingly, it is difficult to relate VNB and earnings growth. Why bother with VNB if this was not the case.

VNB is a lifetime measure not impacted by profits on in-force business. It reflects capital costs. In contrast, earnings is an annual measure dominated by profits on in-force. It does not reflect capital costs.

Some products have low or negative income impact in the first years after sale, eventually increasing to higher levels.

VNB of some products is earned over a few years, while some is earned over many. % of VNB that flows into earnings in initial years varies greatly by product. (as low as 5% per year annuities).

Strong and growing sales can lead to strong and growing VNB and material and increasing NB loss. Beneficial earnings impact of VNB growth can be deferred for many years , as NB losses from growing sales offset emerging profits on sales in recent years.

Experience variations, assumption changes & rate of in-force run-off can dominate modest initial earnings impact of VNB growth.

Relation of VNB Growth to Earnings Growth is Complex