Study For Market-Consistent Embedded Value Of Life Insurance Company

The study object of this thesis is Market-Consistent Embedded Value (MCEV), which is the further development of Embedded Value (EV). As a financial reporting and value measuring tool, EV has been in widespread use in the international insurance industry. However, in recent years some weaknesses in the EV methodology have begun to appear. These have become particularly apparent in the light of the significant downturn in global equity markets and accompanying reductions in interest rates. This valuation technique suffers from a number of shortcomings, principally: no, or inappropriate, allowance for the cost of options and guarantees; failure to recognize the cost of market risk; an average allowance for the impact of risk on value. These shortcomings all stem from the use of a single risk-adjusted discount rate to discount all projected cash flows. So, the transparency of financial reporting from life insurance companies is now being questioned by more and more shareholders and investment analysts. Furthermore, the rationality of internal wealth management decisions is also decreasing. MCEV is based on a combination of financial economics and corporate finance principles. It values the assets, the liabilities, the impact of company structure separately and takes the cost of options and guarantees into account objectively. What is most important and fundamental for this new valuation technique is to value all projected cash flows in line with the prices of similar cash flows that are traded on the open market. Although only a few life insurance companies currently calculate and publish MCEV, MCEV is being recognized by more and more international life insurance companies and investment analysts. As a result, some companies start to use MCEV as part of their internal financial management and internal performance measurement, which is followed by a more concern and more intensive study about MCEV in the international life insurance industry. The current application of EV in China which is limited to measure the value of life insurance companies when increasing capital or listing is still at the exploratory stage. China Insurance Regulatory Commission (CIRC) pushed ahead with the research project on EV in 2004 and published"Life Insurance Embedded Value Reporting Preparation Guidance"in the next year to further push forward the research and application of EV in China. When life insurance companies in China are not familiar with EV, the research on MCEV may appear to be born before this time. However, with the complete opening of the insurance industry in China, our insurance industry will develop in parallel with international insurance industry, which will undoubtedly improve the management and actuarial technologies. Consequently, MCEV will undoubtedly be applied widely in domestic life insurance companies for its outstanding merits. The study on MCEV is almost absent in China. In order to clearly impress the MCEV methodology on the people and enable domestic life insurance companies to be fully aware of the weaknesses of EV methodology when applying it and promote the introduce of MCEV in future, this thesis focuses on MCEV.MCEV covers many contents and many aspects which are worth investigating and researching. By reviewing the research results associated documents, this thesis focuses on basic research of MCEV, including comparison between MCEV and EV or Fair Value (FV) and preliminary investigation into its application to the wealth management in life insurance companies.This thesis consists of a preface and four chapters.Preface is mainly about the theoretical and practical significance. In theory, the research on MCEV is a significant research project in international life insurance industry; in reality, with the further application of EV in domestic life insurance companies, there is no doubt that MCEV will arouse the attention and response of the life insurance industry in China.The opening chapter gives a general overview of EV, consisting of four sections. Section one introduces EV in the sequence of the arising and development history, fundamental definitions, status in company valuation. Section two is about EV calculation, consisting of EV variance and EV calculation steps. Section three introduces EV management system and the European Embedded Value (EEV) Principles introduced by Chief Financial Officer (CFO) Forum.Chapter Two analyses the solutions provided by MCEV to the shortcomings of EV. There are five sections in this chapter. Section one analyses the weaknesses in the EV methodology. The next section introduces the market-consistent valuation. The key principles underlying market-consistent valuation is as follows: No arbitrage, Replication, Equilibrium, Diversification, Agency costs. It includes valuation of assets, valuation of liabilities and the impact of company structure. The following three sections focus on the three key problems: risk discount rates, options and guarantees and the cost of capital. For the risk discount rates, there are two approaches to setting them: the'top-down'WACC-based approach and the'bottom-up'approach used in MCEV. The former sets the only risk discount rate by taking the risk of whole company into account, and values aggregate cash flows of the company. The latter looks to the market to provide an appropriate risk discount rate for each individual cash flow in a company, and then aggregates upwards. For products without options or guarantees, there are two common approaches to calculating the market-consistent value of liabilities: Cash Flows Discount Method and Certainty-Equivalent Techniques. In the former method, each individual cash flow is discounted at a rate which reflects the risk it carries. In the latter method, the cash flows are risk adjusted and can be discounted at the risk-free rate. For the products with options and guarantees, there are two ways to determine the market-consistent value of the liabilities: Option Pricing Formulae and Stochastic Modeling. The cost of capital in MCEV is different from the cost of capital in EV, consisting of tax shields, double taxation, agency costs, franchise value, financial distress and limited liability put option (LLPO). Which items should be included in a market-consistent valuation depends upon the purpose of the valuation. External financial reporting, internal performance measurement and mergers and acquisitions (M&A) are the three chief purposes.Chapter Three is about MCEV and Fair Value (FV). Section one introduce the development background of FV, FV valuation principle of insurance policies and FV valuation methodology of insurance liabilities. Section two is about the comparison between MCEV and FV. The main differences between them lie in following items: certain intangibles such as LLPO, tax shields, double taxation, agency costs, franchise value, financial distress; policyholder liabilities; market value margins(MVM) on non-investment assumptions; allowance for future renewals; deferred tax assets. It can be demonstrated that each difference is the weakness of FV through an example of valuing the new business in a company. Lastly, the author takes a long view of the development of FV and MCEV.Chapter four is the discussion on the application of MCEV. This new methodology may be used in the following areas: product pricing and design; mergers, acquisitions and other business investment decisions; asset allocation and investment policy; assessment of reinsurance arrangements and management performance valuation. Currently, there are many limits to introducing MCEV into China. However, with the development of the insurance industry and financial market in China, it is undoubted that MCEV will go far in China.