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

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  1. Introduction.
  2. Principles and characteristics.
    1. European embedded value.
    2. Market consistent embedded value.
  3. Strenghts, weaknesses and contribution to valuation.
    1. European embedded value.
    2. Market consistent embedded values.
  4. Transposition in other industries.
    1. Favourable context.
    2. Possibility.
    3. Limitations.
  5. Conclusion.
  6. Bibliography.

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. [...]

[...] 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? How? - Allowance for optionality in hedging assets in FOG? - Choice of discount rate for each scenario? Different choices could lead to significantly different answers. [...]

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