EEV (European Embedded Value) and MCEV (Market Consistent Embedded Value)

Résumé du document

In May 2004 the CFO forum published European Embedded Value Principles. The “CFO Forum” is a high-level discussion group composed and attended by the Chief Financial Officers of 19 leading European insurers. These principles are intended to increase the quality, comparability and transparency of embedded value disclosures. Embedded Value is a measure of the economic value of a life insurance company, a component of the market (enterprise) value. It corresponds to the Sum of Adjusted Net Asset Value (ANAV) and Net Present Value of Future Profits (NPVFP) for in-force business, less cost of holding capital (CoC). It has been very successful in the last years but some limitations appeared (for instance the difficulty in reflecting the costs of financial options and guarantees (‘FOGs') in a deterministic approach). Moreover, there is no standard for the use of this method and that led to a variety of methodology and disclosure practices.

Extraits

[...] The stochastic simulation requires enormous calculation capacity and not all the industries have these resources and are not used to use this approach. However, it is not an appropriate use of fair value because it has still not been accepted by IASB to be included in the financial statements. It is probably due to the unrealistic allowance for risk, the dangers of double counting of elements, the misunderstanding of the synergistic nature of overall firm value and a naïve belief in market efficiency Assumptions: The present value of force in is based on many assumptions: economical, political, social, fiscal, demographical, financial, legal The assumptions are realistic for mature businesses with high barrier entries, long term relationship with customers and multi-years profits but become unrealistic for industries with no barrier entries, short term relationship with clients and single-year profit. [...]

[...] It is particularly obvious for the life insurance industry: the combination of falls in equity markets, decrease of interest rates and asset-liabilities mismatches has provoked unprecedented impact on financial positions, exposition of options and guarantees and has conducted to Solvency II. But, it is also true for the other financial businesses, and particularly for banking with Basel II. The valuation methods have changed due to the development of risk management and stochastic approach. Therefore, thanks to Market-Consistent Embedded Value, banks can understand the market cost of options and identify market risks. [...]

[...] Allowance must be made in the EV for the potential impact on future shareholder cash flows of all financial options and guarantees within the in-force covered business. This allowance must include the time value of financial options and guarantees based on stochastic techniques consistent with the methodology and assumptions used in the underlying embedded value. This Principle leaves many practical questions unanswered: - Use of option pricing techniques / market-consistent? - Use of historical or market-consistent volatilities? - Should policyholder behaviour be modelled? [...]

[...] Macve, G. Serafeim Market Consistent Embedded Values as ‘Fair Value' Measurements for Life Insurance Accounting: a Step Too Far with Finance Theory? G. Serafeim Evidence from embedded value accounting J. Hortana The Value Relevance of ‘Realistic Reporting': Evidence from UK Life Insurers B. Pollard Towards A Standard For Market-Consistent Embedded Value Reporting K. Foroughi & J. Creedon Life Insurance, Toward Better Embedded Value Reporting P. Whitlock Life insurance- A brave new world? [...]

[...] For example the market for life policy books is quite small. Thus the estimate of future cash flows will remain much a managerial decision. Moreover MCEV only valuates part of an insurer's life business (the ‘existing book'), but life insurance may not be an only business company. Indeed, there is a need for adjustments due to the interdependencies of value and risk. John Jenkins, a financial services partner at KPMG, says that within the MCEV approach, the individual cash flows are discounted separately by reference to traded assets with the same cash flows. [...]