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Using EV and VNB to close the GAAP in reporting metrics

Insurance Consulting and Technology
Insurer Solutions

By Dan Kim , Dominique Lebel and Mark Mennemeyer | July 31, 2020

The wider business value that embedded value and value of new business reporting metrics can provide is encouraging more U.S. life insurers to supplement their standard regulatory and financial returns.

Reporting plus

Having recently adapted to remote working, new sales processes, very low interest rates and other changes brought about by COVID-19, the prospect of adding additional reporting requirements beyond statutory and generally accepted accounting principles (GAAP) may not immediately seem appealing; however, a growing cohort of companies are seeing the value from embedded value (EV) and value of new business (VNB) metrics and choosing to calculate them within business-as-usual processes. In the case of mutual companies, some are considering replacing GAAP with EV due to upcoming changes to GAAP standards (i.e., Long Duration Targeted Improvements [LDTI]).

Why are they doing it

Companies are using EV and VNB metrics for the simple reason that they, and obviously we, believe these metrics can provide valuable additional information for the wider running of the business.

In broad terms, EV measures the return that a company’s existing book of business has generated based on best estimate assumptions. VNB does the same but on new business written in the financial period in question. These measures are expressed in dollar amounts that enable calculation of management metrics such as return on capital or return on premium.

By contrast, statutory earnings can become distorted by conservatism embedded in the assumptions or by an inadequate reflection of the cost associated with taking on risk. Traditional techniques for setting sales targets based on volume rather than value produce further challenges in that they also take no account of the extent to which those policies are likely to generate profit or contribute to risk exposures. Meanwhile, GAAP earnings and return on equity metrics are smoothed and significantly influenced by decisions made in prior years (see “Profit recognition” box). Another limitation of GAAP is that earnings figures will become increasingly volatile under LDTI that will take effect in 2023.


Profit recognition

The same profits arise under statutory, GAAP and economic; the difference is the timing of profit recognition.

Profit recognition
  • Under statutory reporting, a loss emerges in the year of issue.
  • Under GAAP reporting, the value of improved sales is spread over all future periods, resulting in little improvement in the current year’s results.
  • Under economic reporting, the value of improved sales shows up in the current period.
The consequence of deferring profit is that results today are dominated by decisions made in earlier periods.

The upsides of doing EV and VNB metrics are therefore fairly obvious. Anything that paints a clearer picture of company performance and prospects is typically well received by senior management and other stakeholders, such as regulators and rating agencies. Indeed, EV and VNB can be used for strategic and operational decision making and include wider business applications (see below). Areas where EV and VNB can be particularly useful include making performance comparisons between diverse lines of business using a consistent framework and, from that, capital allocation based on the likely future returns.

VNB provides an instant summary of the categories of new business that are likely to deliver the most value.

The quickest wins are available from VNB, because senior management can take much more effective capital management decisions on new business much more quickly than on existing business. VNB provides an instant summary of the categories of new business that are likely to deliver the most value, thus enabling them to set priorities accordingly. EV, because it considers business that is entrenched in the books, is more of a long-term play, but it potentially opens the way to a broader array of management actions. This explains why some companies have opted to implement VNB metrics but not EV.

Getting the work done

A common reason given by companies that are not currently providing EV and VNB metrics is that they rely too heavily on actuaries’ assumptions of cash flows and discount rates. Yet this argument overlooks the fact that GAAP and statutory returns are also based on similar assumptions.

Nonetheless, for all the inherent advantages we see in undertaking these economic reporting metrics, it would be wrong to portray doing them as a trivial exercise from an actuarial standpoint. A key decision, for example, for individual companies is whether to opt for a market-consistent (more risk neutral) or real-world (incorporating factors such as credit spread) approach. Discount rates, the cost of capital and the cost of non-hedgeable risks are among the components of calculating EV and VNB that will vary depending on which approach is taken. Incidentally, of the 10 U.S. insurers that we’re aware made public EV and VNB disclosures at 2019 year-end, four went the market-consistent route, five chose real world and one used something of a hybrid methodology in specific business lines.

For companies that do produce EV and VNB metrics, or are contemplating doing so, an important consideration is to take advantage of the efficiencies available within financial and regulatory reporting cycles.

For companies that do produce EV and VNB metrics, or are contemplating doing so, an important consideration is to take advantage of the efficiencies available within financial and regulatory reporting cycles. Often, for example, companies can leverage existing pricing or in-force models to get started. In addition, other systems, such as robotic process automation systems, can be used to automate much of the process, while factor-based approximations can significantly reduce the effort involved in producing the EV and VNB figures frequently. We are aware of some companies that report VNB figures on a weekly basis!

Wider business applications

The clincher though for many companies to go ahead with EV and VNB metrics is their wider business applications, ranging from product development and pricing to the design of employee incentives (Figure 1).

Function: Business unit management

Application:

  • Develop product and pricing
  • Evaluate products, distribution channels and customer relationships
  • Manage and allocate capital

Function: Risk management

Application:

  • Validate pricing
  • Link risk, value and capital
  • Enhance rating agency discussions

Function: Financial reporting

Application:

  • Conduct internal financial reporting
  • Conduct external supplementary financial reporting

Function: Strategic planning

Application:

  • Set financial targets for business units and measure performance
  • Ensure that business plans do not destroy value

Function: Incentive compensation

Application:

  • Establish appropriate performance targets
  • Reward value created rather than sales
  • Involve external reviews

Figure 1. Potential applications of EV and VNB metrics

From a pricing perspective, integrating VNB with the pricing process can provide additional insight into profitability since, typically, it includes a full allocation of expenses that leads to a more thorough understanding of the price point at which profit is reached. Moreover, a VNB analysis of sales in the prior period will very often produce a different result from one using pricing, with the ability to drill down into those differences (Figure 2), such as variances between assumptions and volumes, and potentially to reflect those in future pricing.

It is critical for management to understand clearly the drivers of value at all times but especially in a very low interest rate environment like the one we are in now so that proper management actions can be taken.

This figure illustrates how a value of new business analysis of sales in the prior period will very often produce a different result from one using pricing, with the ability to drill down into those differences.
Figure 2. Illustrative example of reconciliation of VNB to pricing

Another area where several companies are also starting to use both EV and VNB information in different ways is their incentive frameworks, reflecting the heightened interest in risk-adjusted metrics since the financial crisis. This is especially true of VNB because many incentive plans reward growth without considering the impact on profitability — and VNB measures both. Measures often include annual business and incentive plan targets that are set in terms of VNB as well as longer-term bonus triggers based on EV growth. It’s worth noting, however, that these approaches to performance management typically entail up-front decisions and strong governance about what is considered within or outside management control, including the ability of executives to manage wider economic risks.

Value assessment

Amid the evaluation of all these potential applications of EV and VNB, the question we’re frequently asked is, “How do we judge the value of undertaking these additional economic reporting metrics?”

The answer is, we’ve worked with several companies that have changed capital allocation strategies and product priorities as a direct result of having EV and VNB metrics available.

We’ve worked with several companies that have changed capital allocation strategies and product priorities as a direct result of having EV and VNB metrics available.

These outcomes result from CFOs having a clearer forward-looking view of potential return on capital and the ability to project and compare the relative performance of different lines of business more reliably. Reliance on non-economic GAAP and statutory figures alone makes these objectives practically impossible, especially for new business.

In our view, any perceived short-term pain of implementing EV and VNB metrics really is worth the longer-term financial and operational gain to U.S. life insurers.

Authors

FSA, CERA, MAAA
Director
Insurance Consulting and Technology Life Insurance

FSA, MAAA, FCIA
Americas Life Practice Leader, Insurance Consulting and Technology

FSA, MAAA
Director
Insurance Consulting and Technology Life Insurance

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