An Introduction to Embedded Value Peter Erlandsen, CFO, Manulife Rio Winardi, Chief Actuary, Astra CMG Simon, Chief Accountant, Panin life Date: 8 December, 2005

AGENDA Why Calculate Embedded Value? What is Embedded Value? Net Worth Value of In-Force Value of new business Other Issues Question & Answer

I. Why Calculate Embedded Value An Introduction Embedded Value Estimates Value. Quiz 1 - What Does Profit Measure? Income less Outgo Quiz 2 – Why is Profit not a measure of Value? Profit is a measure of this year’s results Value is a measure of long-term worth Quiz 3 – Why doesn’t value = profit * P/E ratio? New Business Strain

“Typical” Profit Signature

“Typical” Projection The loss in the first year is often called New business Strain. Over the life of the policy we expect PV profit to be positive.

What’s wrong with Statutory Profit? Profit drivers for Statutory Reporting incorrect! Shows a loss when writing lots of profitable new business when in value is actually added Shows a gain when policies cancels when value is actually lost A growing company writing profitable business can have a negative statutory profit for many years, but is generating a lot of value for it’s shareholders.

I. Why Calculate Embedded Value Reasons to Calculate Value A measure of performance To calculate Return On Equity (ROE) Increase in value / starting value Carrying value in accounts of owner Sale or Purchase Management bonus

II. What is Embedded Value? Embedded Value comes from three segments: Net Worth (Assets – Liabilities) PV of profit from in-force business PV of profit from future sales Sometimes: 1 + 2 is referred to as Embedded Value 1 + 2 + 3 is referred to as Appraisal Value

III. Net Worth Net Worth = Assets – Liabilities Assets Market Value of Assets Costs of sale of investments / assets (tax, fees) Value of some assets depends on purpose of calculation. In a sale situation computer software may have no value. Difficult to value some assets Intangible assets (e.g. Goodwill) often set to zero Property, direct holdings, … have no ready market value Do deferred tax assets have value?

III. Net Worth Net Worth = Assets – Liabilities Liabilities Local Indonesian policy reserves Should include RBC requirements Cannot be distributed Market Value of other liabilities

IV. Value of In force (VIF) Definition VIF = Present Value of future Distributable Profits from in force policies Distributable Profits = Statutory Profits less increase in required RBC Statutory Profits = Premium + II – claims – expenses – change Resv - tax

IV. Value of In force (VIF) Assumptions VIF = Present Value of future Distributable Profits from in-force policies Assumptions Best estimate assumptions needed Mortality/Morbidity Interest earnings Inflation Lapses Expenses Tax etc.

IV. Value of In force (VIF) Risk Discount rate Profits are discounted at the Risk Discount Rate (RDR) RDR represents The company’s minimum desired rate of return on capital Sometimes referred to as the “hurdle rate” RDR should reflect: the Expected Shareholder’s return the risk that future profits will not match expectations (risk profile of the business) the current local market conditions

IV. Value of In force (VIF) Risk Discount Rate Profits are discounted at the Risk Discount Rate (RDR) The RDR is key to the final Embedded Value figure Often a range of figures is used to show sensitivity CAPM says RDR =Risk free + Beta * (Market Rate – Risk Free) Currently perhaps RDR = 14.0 + 1.2 * (20.0 – 14.0) = 21.2%

V. Value of New business (VNB) VNB = Present Value of future Distributable Profits from future sales. Assumptions Same issues as VIF How many years New business? Judgment but often around 5 years. Additional Assumptions Future sales growth, agency size, productivity, product mix, …

VI. Other Issues Expense Over-run Minimum or target RBC ratio Expense budget versus Expense allowables Minimum or target RBC ratio 120% or 150% of estimated RBC Later year losses How should we treat later year losses (25 years from now!) Investment Return Should be consistent with asset valuation. Should a change in asset mix affect value? Can we forecast changes to current rates?

VI. Other Issues It is extremely important that future bonus rates on with-profit policies should be consistent with: Future assumptions. Likely future management action Policy holders reasonable expectations Future Sales (Value of New Business) Can we assume a re-price of loss making products Are future margins going to be the same as today? Should we use a higher RDR because of greater uncertainty?

VI. Other Issues Product Guarantees Valuation Software Investment /mortality – no value in deterministic approach Valuation Software Many available (e.g. Prophet, VIP, AXIS, MOSES, etc) Possible but cumbersome to do in spreadsheets Model points Vs seriatim data. Changing Assumptions How often depends on purpose Assumptions are long term to try to not have big swings Future improvements in mortality

VII. Question & Answer