April 2001 An Introduction to Life Insurance Appraisal Values
Disclaimer The material that follows is a presentation of general background information about the Bank’s activities current at the date of the presentation, 3 April 2001. It is information given in summary form and does not purport to be complete. It is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any particular investor. These should be considered, with or without professional advice when deciding if an investment is appropriate.
Speaker’s Notes • Speaker’s notes for this presentation are attached below each slide. • To access them, you may need to save the slides in PowerPoint and view/print in “notes view.”
Agenda • Theory • What is an Embedded Value? • Moving from Embedded to Appraisal Value • Understanding movements in Appraisal Value • Appraisal Value ‘Uplift’ • Practice • Commonwealth Bank Group Appraisal Values • Appraisal Value forecasts
Embedded Value The present value of future profits from inforce business and the shareholders interest in the net worth of the life insurance funds
Net Worth Net Worth Full Value Net Worth SupportingCapital NTA DiscountedValue PV Capital Value ofInforceBusiness ProfitMargins DiscountedValue PV Margins BestEstimatePolicyLiability MoS Liability No value toShareholder Embedded Value Embedded Value Balance Sheet
Net Tangible Assets NTA as per MoS Balance Sheet Net Worth Net Worth PV Capital PV Capital Value of Inforce = PV Margins - Cost of Capital VIF PV Margins PV Margins EV - Alternative Presentation
NewBusiness InvestmentIncome Premium Inforce Claims Expenses Capital Profits CapitalRelease Net Worth Capital Dividends + Imputation Credits Shareholder Valuation Model DCF Valuation
Valuation Assumptions • Best estimate assumptions of future experience: • Expenses • Claims • Persistency • Economic assumptions: • Investment Income • Inflation • Risk Discount Rate • Imputation Credits • 30% wastage Based on own and industry experience. Independent review (Trowbridge) Standard economic basis agreed with Trowbridge (RDR on CAPM methodology)
Key Drivers of Inforce Value • ‘Gap’ between net earnings rate and risk discount rate • Investment markets • affects value of shareholder funds • affects value of future asset fees on investment business • policy guarantees ‘gear up’ effect of investment returns • Persistency • affects recovery of acquisition expenses or achievement of expected future margins • Expenses • Mortality / Morbidity Note changes in future assumptionshave an immediate (capitalised) impact on value
Embedded Value New Business Net Worth Inforce Earns net i ‘Unwinds’ at RDR Profit &Capital Release Capital Injection Movements in Embedded Value If experience is as planned ... CAN WE VALUEFUTURE NEWBUSINESS?
Introducing the Appraisal Value • Embedded Value • measures the value of the inforce business • Appraisal Value • is a measure of the economic value of the businessas a going concern • The difference is a measure of the capacity of the company, in its existing form, to generate value by writing profitable future business … the Value of Future New Business
SalesVolumes Projected Growth Value ofFutureNewBusiness Value of1 year’sNew Bus Multiplier X = ProfitMargins Projected Margins plus on long termexpenseassumptions PV Expense(Overrun)/ Underrun equals StructuralValue Value of Future New Business - Model • Value of future NB may be presented as a multiplier of the previous year’s NB value • Multiplier reflects expected sales volumes, growth, mix and future profitability
Value of New Business - Issues • Sales volumes • Base volumes - is latest year ‘representative’? • Market growth & own market share • Profit margins - are they sustainable? • Business mix may change, involving a move toproducts with higher or lower margins • Ability to eliminate any expense overruns ?
Movements in Appraisal Value
Movement in Appraisal Value If experience is as expected: • Net Worth earns net investment income, increases by profit earned on inforce business and decreases by dividend paid • Inforce unwinds at the risk discount rate and reduces by profit earned (which becomes net worth) • Inforce is supplemented by each year’s New Business • Value of future New Business moves forward in line with sales growth We can only add further value by managing experience favourably versus assumptions, or via new initiatives
Information Available Financial statements disclose: • Shareholders net tangible assets • Value of inforce business • Value of future new business • Risk Discount Rates • MoS profits
MoS Profits Change in Appraisal Value Effect is spread over the life of the business Value is booked immediately Unwinding ofdiscount rate Yr 3 savings Yr 2 savings Yr 1 savings 10 20 30 30 30 30 Recognition of Expense Synergies • Assume net savings of $10m per annum over 3 years:
Expense Synergies Example Assume we take $20m off the expense base: Effect on MoS • First full year: $20m less tax @ 30% = +$14m • Subsequent years: $14m increases at inflation rate Effect on Appraisal Value • Net profit $14m inflating @ f%, valued at RDR% Value ~ 14 / (RDR - f) say $140m • Value of increase in imputation credits from the increase in future SH tax (ie. higher profit) Value ~ 70% x ( 6 / 14 ) x $140m = $42m
Appraisal Value Uplift • Businesses owned by life companies are held at market value (= Appraisal Value) • The “profit” earned on these businesses is the dividend received and the increase in Appraisal Value (less capital added) • For clarity, the Group reports separately - the accruals profit (MoS earnings) - and the balance of “profit” (AV Uplift)
MoS Profit Net Profit + Capital Transfers less Dividends + Foreign Exchange Movement = Change in Shareholder NTA + Change in Value of Inforce Business = Change in Embedded Value AV Uplift + Change in Value of future New Business = Change in Appraisal Value Appraisal Value Uplift • The AV Uplift represents the increase in Appraisal Value in excess of the change in NTA
Effect of Paying a Dividend • The Appraisal Value calculation discounts distributable profits at a gross of tax discount rate • The AV also includes a value for any franking credits attaching to distributable profits • valued at 70%, ie. 30% wastage assumed • When dividend is paid from Life Co, the AV reduces by • the amount of the dividend • the value of attaching franking credits • However, the NTA only reduces by the amount of the dividend (the franking credit being transferred directly to the parent’s f.c. account) • franking credits are ‘lost’ from the AV Uplift
Volatility of AV Uplift • Appraisal Value is more volatile than MoS profit For example: Change of assumptions / Movement in interest rates • MoS ‘spreads’ the effect by adjusting future margins • Appraisal Value ‘capitalises’ the future effect => Difference (AV Uplift) will be volatile • AV Uplift may also be negative, eg. • adverse valuation assumptions hits AV harderthan MoS profit (presuming positive future margins) • loss of franking credits on dividends hits AVbut has no effect on NTA
April 2001 An Introduction to Life Insurance Appraisal Values