THE FINANCIAL R - PDF document

1 THE FINANCIAL R PAGE 20AGE 20advocates f
THE FINANCIAL R PAGE 20AGE 20advocates for determining thevalue of business acquired (VOBA) forinsurance purchase GAAP. VOBA (alsoknown as PVP, PVFP, CIP, VIF) is thethe familiar DPAC intangible asset. Longduration life contracts, in particular,Milholland’s approach is attractive,s approach is attractive,)may unfairly depress earnings. They dothat because they keep implicit, and mayignore, certain necessary costs insurersface when they assume risks. This trans-lates into an excessively high VOBA andhigh VOBA amortization costs. The rootcause of the problem is lack of clarityabout the mechanism which links riskmargins, cash flows, and the riskresulting VOBA. “How can this stat stuffinsurer’s liabilities, which is what GAAPline is, MdM can work. However,business, it is wrong to apply MdM. Weeillustrate the formulas and concepts. Thesecond installment will focus on the linkbetween PGAAP earnings, cash flows,and the risk discount rate. It will illustratepricing and reporting in several practicalsituations.MdM AlgebraMdM uses two equations to solve for twounknowns, VOBA and the relateddeferred tax liability. Recall that it startswith a fair and complete buyer’s actuarialVOBAValue of business acq

2 uiredTax reserveTax basis proxy DAC asse
uiredTax reserveTax basis proxy DAC asset BVAMVATVATax value of invested assets NotePP article GW, ES and non-modeleda)VOBA (MVA BVA) b)DTL DTL (MVA TVA) deferred tax liability. VOBA is a pretaxtemporary difference while appraisalappraisal value, increased to offset anyin the stat appraisal, decreased to offsetdeferred tax liability. Since the GAAPwe have high confidence in data quality.assumption that BVA (a1)VOBA MVA On the Fair Value of Business Acquired (part I of II) PAGE 21c)VOBA VOBA
35%*(TVA (MVA tion in Luke Girard’s work on the fairFair Value Algebraalue Algebraalways possible to rearrange the elementsof an ordinary indirect actuarial appraisalinto the formd)DDE (MVA’ 35%*(TA’ supporting target surplusMVA’Tax basis assets supporting Tax basis liabilities supporting capital charge which is proved recursively. We canis a charge, at the cost of capital rate, forand tax timing differences. Each of theseflows only. In either case we can performappraisal value. We can do this for anyTo skip ahead for a moment, which settently but separately. Pure insuranceliabilities separately, we can determine afree cash flow. In practice, this approachdifferent value from the market-basedferent val

3 ue from the market-basedsubscripts. MVLt
ue from the market-basedsubscripts. MVLtand RPt+1appear circu-lar. Next period required profit depends ontoday’s liability but to value the liabilityremove the circularity, to start at thement” item TBA’, equal to the last termgovernment. To see that, suppose we soldequal to TA’ and tax liabilities equal toTA’ pay TBA’ to the government. Since statu-statutory reserves, TBA’ is residual, bestwe need to distinguish TBA’ from the’ from thefrom the market value of other productassets, and from the consideration of taxassets in TBA’. This is for ease of exposi-tion. Without changing the resulting RPPVDE =DDEMVAMVA’ + RSATA’ 35%* (TA TBA’ (d1)PVDE 35%)*(MVA i) * (MVA A (
35%)]*TBAtwhere k is the cost of capital hurdle rateand i is the return on invested assets,MVANote if TA MVA and TL MVA Fronting tax payments is in effect a tax(e)VOBA VOBA
TBA] / (1
35%)
(MVA We need the two-step process in (e) offor taxes precisely because FAS 109requires an undiscounted tax liability. THE FINANCIAL R PAGE 22temporary and permanent tax differences(f1)VOBA (MVA (MVA (f2)VOBA VOBA CF and RP, at portfolio yield ] - (MVA (f3)VOBA VOBA PGAAP profit margins, at a risk The profit margins in (f3) consist ofsional sc

4 rutiny. To apply (f2), we could also pro
rutiny. To apply (f2), we could also projectfits and expenses together, then discountthe excess assets. We are left with (f2.1)VOBA VOBA liability CF and RP, at portfolio portfolio yield and RP. Now, what is the risk rate in (f3)?, what is the risk rate in (f3)?)establishing the risk rate are: the yieldsgenerated on similar currently issuedbusiness; the cost of capital to the acquir-ing entity; the discount rate implicit inthe seller’s offering price; the generalenvironment. Critically, accountingprofit marginslet’s face it, even if we could get aroundexplicit margins and pads to projectedNow, required profit (RP) as calcu-resulting in a small RP. There would alsowhat can happen under FAS 60. “True”flow, and then discount this at 5.3%ple of $909. Having argued this far, it isprofit margin, which is the interest on theClearly, the risk rate must adjust forprofit margins on a GAAP basis toFinally, and most intuitively, further(g)VOBA VOBA should be the margin in theties. Conversely, if PGAAP reserves arebe no VOBA. Now, I don’t think it ist think it isan example in which UL PGAAP liabil-ity is calculated directly, and it is greaterconsistent with GAAP. Clearly (f3) saysis, in place of premium

5 for FAS60, grossprofits for FAS 97 and
for FAS60, grossprofits for FAS 97 and gross margins forFAS 120 products. On the Fair Value of Business Acquiredcontinued from page 21 PAGE 23should be calculated from the buyer’scompany’s stock as if it were the directfor example, the sale of assets can affectthe buyer’s perspective, it stands tocosts, timing differences between whenmargins are earned and cash flows arepaid, and leverage. To decide if the riskall those functions explicitly.off-market though, the result may bemargin for interest rate risk by projectingrate. How high? Well, ask three expertswhere they come from is emerging fromIn equilibrium marginal costs adjust toequal marginal price. But why is it thatperiod to period. It must be that marginalginalwith a cost of capital, we can derive RPand the liability spread that produces thesame value for the company. What if wedon’t know the hurdle rate or the price of [Fair value of liabilities , less value of tax costs] * (1  d) in the liability cash flows. Tax costs playvalue of a block of business directly,block’s value, we can compute a leveland target surplus. The next half of themargins for conservatism perform inconsistency, transparency, direct exten-auditability. Better

6 information providesfrom the author, wh
information providesfrom the author, which applies the formu-To apply MdM, for example as in (e), THE FINANCIAL R PAGE 24Be sure that all the transactions and are included in the appraisal’s present include tax and statutory effects trig-In general, valuation spreads carry too an explicit load to cash flows. Ideally, Where possible, when applying a dis-for an insurer’s liabilities includes a charge for tax costs.MdM does not support the use of dis-years, the net effect of using DE rather than product margins as the amortiza-amortization expense for FAS 97 York, NY. He can be reached at1)Luke Girard, “Fair Value of Liabilities Different?” Risks & Rewards2)Luke Girard, “Market Value of 3)Luke Girard, “Market Value of Valuation,” The Fair Value of Academic Publishers: 7-113, 4)James Milholland, “Determining the Value of Business Acquired, with Some Fair Value of Liabilities U.S. GAAP for Life Insurers,T. Herget et al., Society of Actuaries, On the Fair Value of Business Acquiredcontinued from page 23 Society of Actuaries475 N. Martingale RoadSuite 800Schaumburg, Illinois60173Phone: (847) 706-3500 Article from: The Financial Reporter September 2001 – Issue