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.
[...] According to Towers Perrin “companies using MCEV tools have gained new insights into value creation and the impact of asset/liability mismatches within their businesses because they are increasingly aware that they are effectively running two operations: an insurance business and an investment business”. MCEV uses a ‘bottom up' approach in order to estimate present values of a life insurer's future policy and expense cash flows. This gives us a valuable discipline, indeed the difference in value found by “adding constituent at market price and by the “overall value” needs explanation. [...]
[...] Then, the objectives of the CFO forum in setting the European insurance groups are: - To develop guidance to be applied by European insurance groups - To address current criticism of existing embedded value reporting by ensuring that the guidance: Is sufficiently credible and robust to address concerns over consistency Explicitly includes the valuation of options and guarantees Prescribes a minimum level of disclosure, including sensitivity analysis - To reflect the economic value of long term business - To consider implementation and systems and data issues 1.1 .2Principles: Principle EV as a measure. [...]
[...] As a result, the transposition of the Embedded Value methodology, favoured by the environment, has begun and is not only geographical but also sector-based Possibility The transposition of the Embedded Value methodology is possible from a theoretical but also practical point of view Theoretical: The Embedded Value has a firstly a contribution in valuation because, combining today the past value of assets (Adjusted Net Asset Value) and the future value of earnings on existing business (In force) and the potential development (New Business), it evaluates the economic value of the balance sheet and plays a significant role in merge and acquisitions transactions. [...]
[...] So, the Embedded Value techniques can be improved and are not applicable to all businesses. Thus, the other industries can use the Embedded Value methodology if and only if they have the same characteristics as the insurance company. The transposition in the financial businesses has begun and will be generalized because of financial skills and similar issues. Then, the transposition in the industries which have similar issues will be slower because of the lack of skills. Eventually, the transposition in the industries which have different characteristics is not possible. [...]
[...] However, whether or not the CFO Forum will succeed in its objectives will depend on how, in practice, companies deal with the three key areas in which they have significant discretion: - How to determine the risk discount rate The risk discount rate “should be set equal to risk free rates plus a risk margin” and risk margin should reflect any risk associated with the emergence of distributable earnings that is not allowed for elsewhere in the valuation.” - How to calculate the cost of financial options and guarantees - The appropriate allowance to be made for the cost of capital MCEV: Market consistent embedded value MCEV is not a formalised set of principles like for the EEV, but rather a concept. [...]
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