Technical Note
MCEV
Market Consistent Embedded Value (MCEV) is a popular method used in the insurance industry that is designed to provide a market-consistent valuation of an insurance company, considering the present value of future cash flows and associated risks.
The definition states MCEV as a way to evaluate the total worth of shareholder’s stake in the covered business. The “covered business” is the core business or segment of the company and it has to be clearly identified and disclosed. It should also include, at the very least, any contracts that are considered long-term insurance business by the local insurance supervisors.
MCEV assesses all insurance products including annuities. Several key factors considered for valuing an annuity portfolio under MCEV include:
- Expected cash flows of the annuity contract over its lifetime which includes both premiums and future benefits and expected pay-outs from the insurance company.
- Discount rate to reflect the time value of money. It is calculated using both risk-free rates and risk premium to account for specific risks associated with annuities.
- Investment returns earned on the assets backing the annuity portfolio.
- Expenses and costs associated with administering and managing the annuity portfolio.
- Risk and uncertainties associated with annuities such as mortality risk, interest rate risk, and lapsation risk. They are modelled using stochastic techniques to capture the range of possible outcomes and their associated probabilities.
MCEV – methodology
MCEV represents the current value of shareholder’s interest or ownership in the profits that can be distributed from the assets allocated to the covered business, considering an appropriate provision for the risks associated. MCEV is the sum of Free surplus allocated to the covered business, required capital and Value in-force. The value of future new business is excluded in the calculation
MCEV = Free surplus+ Required Capital + Value in-force (VIF)
Free Surplus
It refers to the market value of all excess capital or financial resources available to a company after accounting for its liabilities and obligations related to the covered business. Free surplus is calculated by subtracting the required capital to support the covered business from the market value of assets associated with the covered business that are not allocated to cover liabilities.
Required capital
It refers to the market value of assets associated with the covered business and is required by the regulatory bodies over the liabilities already accounted for covered business. The capital allocated must be greater than or equal to the shareholder’s portion of the required solvency capital determined by the supervisory body and its distribution is restricted.
Value of In-Force covered business (VIF)
The value of in-force covered business (VIF) consists of the following components:
- Present value of future profits (PVFP)
- Time value of financial options and guarantees (TVFOG)
- Frictional costs of required capital (FC)
- Cost of residual non-hedgeable risks (CNHR)
Present value of future profits (PVFP) – PVFP is the present value of distributable future profits arising from the in force covered business and is calculated as the cash flows from the in-force business, post-taxation, projected based on the insurance company’s best estimate of persistency, mortality/morbidity rates and expenses. It also includes the value of renewals of in-force business.
Time value of financial options and guarantees (TVFOG) – In MCEV, it is necessary to make allowance for the potential impact of financial options and guarantees within the in-force covered business on future shareholder cash flows. This includes making an allowance for the time value of these options and guarantees. Stochastic techniques backed by methods and assumptions consistent with the capital market valuation of assets are employed to estimate this allowance.
Frictional costs of required capital (FC) – It is the additional cost of taxation and investment management incurred by shareholders for holding assets within the company to back the required capital, as opposed to holding them directly in the market. Frictional costs are independent of non-hedgeable risks.
Cost of residual non-hedgeable risks (CNHR) –cost of non-hedgeable risk represents an allowance or an approximate provision for the uncertainty associated with the best estimate of shareholder cash flows due to non-hedgeable risks. This includes an allowance for risks that may not have been explicitly accounted for in the assessment of PVFP, such as operational risks.
Irrespective of the method employed, it is necessary to present it as a single average charge encompassing all residual non-hedgeable risks. Its determination should involve an internal economic capital model with methods that project profit and loss distributions or employ suitable approximations. The resulting capital should align with a 99.5% confidence level over a one-year period, with consideration for management actions if necessary.
As insurance companies strive for more accurate and comprehensive assessments of their financial position and shareholder value, MCEV provides a valuable framework that aligns with market conditions and incorporates various risk factors. It is this realistic view of presenting the underlying profitability of the company that has made MCEV distinct and popular among other valuation frameworks.
Comparison - MCEV, US GAAP, Statutory Accounting and IFRS 17
| Framework | Objective | Approach | Focus |
|---|---|---|---|
| MCEV | To assess the economic value of insurance contracts and analyse profitability of insurance company’s business | Market-consistent valuation methodology – includes market variables and stochastic modelling. | Focus on value drivers of insurance contracts – cash flows, discount rates, expenses, investment returns and risks. |
| US GAAP | To provide a standardized framework for financial reporting to ensure transparency, comparability and consistency in presenting the financial statements. | Historical cost or amortized cost principles, with fair value measurement applied in specific situations. | Emphasizes adherence to specific accounting rules, including revenue recognition, measurement, and disclosure of insurance contract |
| Statutory Accounting | Accounting framework prescribed by insurance regulators to report financial statements for regulatory compliance purposes. | Prioritizes solvency and prudential concerns over economic or fair value considerations. Rules may vary by jurisdiction | To ensure financial stability and solvency by establishing specific requirements for capital adequacy, reserve calculations and other regulatory ratios. |
| IFRS 17 | To provide a consistent and comprehensive framework for valuing insurance contracts under international accounting standards. | Principles-based approach emphasizing the use of current and unbiased market variables, future cash flows, and measuring insurance liabilities at a present value. | Focus on providing transparent and comparable financial information about insurance contracts. |
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Copyright © 2023 Annuity Risk India Pvt. Ltd.