April 2001April 2001

An Introduction to Life Insurance An Introduction to Life Insurance Appraisal ValuesAppraisal Values

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The material that follows is a presentation of The material that follows is a presentation of general background information about the Bank’s general background information about the Bank’s activities current at the date of the presentation, 3 activities current at the date of the presentation, 3 April 2001. It is information given in summary form April 2001. It is information given in summary form and does not purport to be complete. It is not and does not purport to be complete. It is not intended to be relied upon as advice to investors or intended to be relied upon as advice to investors or potential investors and does not take into account potential investors and does not take into account the investment objectives, financial situation or the investment objectives, financial situation or needs of any particular investor. These should be needs of any particular investor. These should be considered, with or without professional advice considered, with or without professional advice when deciding if an investment is appropriate.when deciding if an investment is appropriate.

DisclaimerDisclaimer

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Speaker’s NotesSpeaker’s Notes

• Speaker’s notes for this presentation Speaker’s notes for this presentation are attached below each slide.are attached below each slide.

• To access them, you may need to To access them, you may need to save the slides in PowerPoint and save the slides in PowerPoint and view/print in “notes view.”view/print in “notes view.”

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AgendaAgenda

• TheoryTheory– What is an Embedded Value?What is an Embedded Value?– Moving from Embedded to Appraisal ValueMoving from Embedded to Appraisal Value– Understanding movements in Appraisal ValueUnderstanding movements in Appraisal Value– Appraisal Value ‘Uplift’Appraisal Value ‘Uplift’

• PracticePractice– Commonwealth Bank Group Appraisal ValuesCommonwealth Bank Group Appraisal Values– Appraisal Value forecastsAppraisal Value forecasts

Embedded ValueEmbedded Value

The present value of future profits from inforce business and the shareholders

interest in the net worth of the life insurance funds

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Embedded ValueEmbedded Value

No value toShareholder

Net WorthFull Value

Embedded ValueBalance Sheet

SupportingCapital

Net Worth

NTA

BestEstimate

PolicyLiability

ProfitMargins

MoS

Lia

bilit

y

PV CapitalDiscountedValue

PV MarginsDiscountedValue

Net Worth

Value ofInforceBusiness

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EV - Alternative PresentationEV - Alternative Presentation

NetTangibleAssets

VIF

Net Worth

PV Capital

PV Margins

Net Worth

PV Capital

PV Margins Value of Inforce= PV Margins - Cost of Capital

NTAas per MoSBalance Sheet

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ClaimsExpenses

InvestmentIncome

Premium

Valuation ModelValuation Model

Inforce

NewBusiness

Net Worth

Shareholder

Capital

Capital Dividends + Imputation Credits

CapitalRelease

Profits

DCF Valuation

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Valuation AssumptionsValuation Assumptions

• Best estimate assumptionsBest estimate assumptions of future experience: of future experience:– ExpensesExpenses– ClaimsClaims– PersistencyPersistency

• Economic assumptions:Economic assumptions:– Investment IncomeInvestment Income– InflationInflation– Risk Discount RateRisk Discount Rate

• Imputation CreditsImputation Credits– 30% wastage30% wastage

Based on own andindustry experience.Independent review (Trowbridge)

Standard economic basisagreed with Trowbridge(RDR on CAPM methodology)

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Key Drivers of Inforce ValueKey Drivers of Inforce Value

• ‘‘Gap’ between net earnings rate and risk discount rateGap’ between net earnings rate and risk discount rate• Investment marketsInvestment markets

– affects value of shareholder fundsaffects value of shareholder funds– affects value of future asset fees on investment businessaffects value of future asset fees on investment business– policy guarantees ‘gear up’ effect of investment returnspolicy guarantees ‘gear up’ effect of investment returns

• PersistencyPersistency– affects recovery of acquisition expenses or achievement affects recovery of acquisition expenses or achievement

of expected future marginsof expected future margins• ExpensesExpenses• Mortality / MorbidityMortality / Morbidity

Note changes in future assumptionsNote changes in future assumptionshave an immediate (capitalised) impact on valuehave an immediate (capitalised) impact on value

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Movements in Embedded ValueMovements in Embedded Value

Net Worth Inforce

Earns net i ‘Unwinds’ at RDR

Profit &Capital Release

Embedded Value

New Business

Capital Injection

If experience is as planned ...If experience is as planned ... CAN WE VALUEFUTURE NEWBUSINESS?

Moving fromMoving fromEmbedded ValueEmbedded Value

totoAppraisal ValueAppraisal Value

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Introducing the Appraisal ValueIntroducing the Appraisal Value

• Embedded ValueEmbedded Value– measures the value of the inforce businessmeasures the value of the inforce business

• Appraisal ValueAppraisal Value– is a measure of the economic value of the businessis a measure of the economic value of the business

as a going concernas a going concern

• The difference is a measure of the capacity of the The difference is a measure of the capacity of the company, in its existing form, to generate value by company, in its existing form, to generate value by writing profitable future businesswriting profitable future business… … the the Value of Future New BusinessValue of Future New Business

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Value of Future New Business - ModelValue of Future New Business - Model

Value of future NB may be presented as a multiplier of the previous year’s NB value

Multiplier reflects expected sales volumes, growth, mix and future profitability

plus

equals

PV Expense(Overrun)/ Underrun

StructuralValue

Projected Growth

Projected Margins

on long termexpense

assumptions

SalesVolumes

ProfitMargins

Value ofFutureNew

Business

X =Multiplier

Value of1 year’sNew Bus

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Value of New Business - IssuesValue of New Business - Issues

• Sales volumesSales volumes– Base volumes - is latest year ‘representative’?Base volumes - is latest year ‘representative’?– Market growth & own market shareMarket growth & own market share

• Profit marginsProfit margins - are they sustainable? - are they sustainable?

• Business mixBusiness mix may change, involving a move to may change, involving a move toproducts with higher or lower marginsproducts with higher or lower margins

• Ability to eliminate any Ability to eliminate any expense overrunsexpense overruns ? ?

Movements in Movements in Appraisal ValueAppraisal Value

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Movement in Appraisal ValueMovement in Appraisal Value

If experience is as expected:If experience is as expected:• Net Worth earns net investment income, increases by Net Worth earns net investment income, increases by

profit earned on inforce business and decreases by profit earned on inforce business and decreases by dividend paiddividend paid

• Inforce unwinds at the risk discount rate and reduces by Inforce unwinds at the risk discount rate and reduces by profit earned (which becomes net worth)profit earned (which becomes net worth)

• Inforce is supplemented by each year’s New BusinessInforce is supplemented by each year’s New Business• Value of future New Business moves forward in line with Value of future New Business moves forward in line with

sales growthsales growth

We can only add further value by managing experience We can only add further value by managing experience favourably versus assumptions, or via new initiativesfavourably versus assumptions, or via new initiatives

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Information AvailableInformation Available

Financial statements disclose:Financial statements disclose:• Shareholders net tangible assetsShareholders net tangible assets• Value of inforce businessValue of inforce business• Value of future new businessValue of future new business• Risk Discount RatesRisk Discount Rates• MoS profitsMoS profits

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Recognition of Expense SynergiesRecognition of Expense Synergies

• Assume net savings of $10m per annum over 3 years:Assume net savings of $10m per annum over 3 years:

MoS Profits Change in Appraisal ValueEffect is spread overthe life of the business

Value is booked immediately

Yr 1 savings

Unwinding ofdiscount rate

Yr 2 savings

10 20 30 30 30 30

Yr 3 savings

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Expense Synergies Expense Synergies ExampleExample

Assume we take $20m off the expense base:Assume we take $20m off the expense base:

Effect on MoSEffect on MoS• First full year: $20m less tax @ 30% = +$14mFirst full year: $20m less tax @ 30% = +$14m• Subsequent years: $14m increases at inflation rateSubsequent years: $14m increases at inflation rate

Effect on Appraisal ValueEffect on Appraisal Value• Net profit $14m inflating @ f%, valued at RDR%Net profit $14m inflating @ f%, valued at RDR%

Value ~ 14 / (RDR - f) say $140mValue ~ 14 / (RDR - f) say $140m• Value of increase in imputation credits from the increase in Value of increase in imputation credits from the increase in

future SH tax (ie. higher profit)future SH tax (ie. higher profit)Value ~ 70% x ( 6 / 14 ) x $140m = $42mValue ~ 70% x ( 6 / 14 ) x $140m = $42m

Appraisal Value “Uplift”Appraisal Value “Uplift”

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Appraisal Value UpliftAppraisal Value Uplift

• Businesses owned by life companies are held at Businesses owned by life companies are held at market value (= Appraisal Value)market value (= Appraisal Value)

• The “profit” earned on these businesses is the The “profit” earned on these businesses is the dividend received and the increase in Appraisal Value dividend received and the increase in Appraisal Value (less capital added)(less capital added)

• For clarity, the Group reports separatelyFor clarity, the Group reports separately

- the accruals profit (MoS earnings)- the accruals profit (MoS earnings)

- and the balance of “profit” (- and the balance of “profit” (AV UpliftAV Uplift))

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Appraisal Value UpliftAppraisal Value Uplift

• The AV Uplift represents the increase in Appraisal The AV Uplift represents the increase in Appraisal Value in excess of the change in NTAValue in excess of the change in NTA

Net Profit+ Capital Transfers less Dividends+ Foreign Exchange Movement= Change in Shareholder NTA

+ Change in Value of Inforce Business= Change in Embedded Value

+ Change in Value of future New Business= Change in Appraisal Value

AVUplift

MoSProfit

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Effect of Paying a DividendEffect of Paying a Dividend

• The Appraisal Value calculation discounts distributable The Appraisal Value calculation discounts distributable profits at a gross of tax discount rateprofits at a gross of tax discount rate

• The AV also includes a value for any franking credits The AV also includes a value for any franking credits attaching to distributable profitsattaching to distributable profits– valued at 70%, ie. 30% wastage assumedvalued at 70%, ie. 30% wastage assumed

• When dividend is paid from Life Co, the AV reduces byWhen dividend is paid from Life Co, the AV reduces by– the amount of the dividendthe amount of the dividend– the value of attaching franking creditsthe value of attaching franking credits

• However, the NTA only reduces by the amount of the However, the NTA only reduces by the amount of the dividend (the franking credit being transferred directly dividend (the franking credit being transferred directly to the parent’s f.c. account)to the parent’s f.c. account)

franking credits are ‘lost’ from the AV Upliftfranking credits are ‘lost’ from the AV Uplift

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Volatility of AV UpliftVolatility of AV Uplift

• Appraisal Value is more volatile than MoS profitAppraisal Value is more volatile than MoS profitFor example:For example:Change of assumptions / Movement in interest ratesChange of assumptions / Movement in interest rates– MoS ‘spreads’ the effect by adjusting future marginsMoS ‘spreads’ the effect by adjusting future margins– Appraisal Value ‘capitalises’ the future effectAppraisal Value ‘capitalises’ the future effect

=> Difference (AV Uplift) will be volatile=> Difference (AV Uplift) will be volatile

• AV Uplift may also be negative, eg.AV Uplift may also be negative, eg.– adverse valuation assumptions hits AV harderadverse valuation assumptions hits AV harder

than MoS profit (presuming positive future margins)than MoS profit (presuming positive future margins)– loss of franking credits on dividends hits AVloss of franking credits on dividends hits AV

but has no effect on NTAbut has no effect on NTA

April 2001April 2001

An Introduction to Life Insurance An Introduction to Life Insurance Appraisal ValuesAppraisal Values