Life Insurance Company M & A: accounting standards and requirements

An Actuarial Approach to the unique to life insurance operations.

Determination of Value
An indication of the growing importance
of the independent actuarial appraisal is
By Camilio Salazar and Jim Toole
the fact that over the last several years, the
SEC (Securities and Exchange
Because the article and commentary prepared by
Commission) in the U.S. has required that
the professionals of our firm are often general in
appraisal reports be referenced in the
nature, we recommend that our readers seek the
mailings to shareholders and filed with the
advice of an actuary or an attorney before taking
SEC. Also, more and more, independent
action.
actuarial appraisals are being referenced in
the offering memorandum prepared by
It is not uncommon these days to open
investment bankers as they present a
the business section of the newspaper and
company to interested parties.
read about the latest merger or acquisition
in our increasingly global insurance
Components of Value. The value of any
market. Aegon-Transamerica, in the U.S.;
enterprise is ultimately determined by its
AXA-GRE in Europe; Generali-La Caja
capacity to generate future profits. In
in Argentina; ING-Bital in Mexico; and
measuring that capacity, the actuarial
Royal Sun Alliance-La Construcción in
appraisal value for a life insurance
Chile are only a few recent examples of
company is defined as the sum of the
this trend, and the list can go on.
following three components determined
as of a chosen valuation date:
In this article, we will present an overview
of how the value of a company is
1. Adjusted Statutory Book
determined from an actuarial perspective,
Value: This component
and how a price is ultimately established.
represents the capital and
We will discuss the elements that need to
surplus of the company. In
be considered and why an independent
addition, adjustments are
actuarial appraisal is typically one of the
made to reflect certain items
first items a seller will need to develop,
such as reserve redundancies,
and that a prospective buyer will want to
the realizable value of certain
examine.
non-admitted assets, and the
book vs. market value of
The actuarial appraisal process is the
assets, where appropriate.
application of discounted cash flow
(DCF) methodologies to a life insurance
2. Value of Inforce Business:
company operation. DCF is an approach
This component is defined in
that is used universally in the valuation of
terms of the actuarial present
all types of industries and business. The
value of future profits from
actuarial appraisal process combines
the current business inforce
typical DCF techniques with the specific

MILLIMAN USA
 as of the valuation date. The
actuarial calculations to The items above are typically adjusted for
determine projected profits the cost of required capital. This cost
take into account revenues reflects the fact that the capital and
generated from the business, surplus of the company, and the expected
benefits presumed to be paid profits are not necessarily immediately
and expenses actually expected available for distribution to the
to be incurred, adjusted for shareholders. Rather, some capital and
applicable taxes. profits need to be retained within the
company to maintain favorable ratings
3. Value of Future Business: and regulatory relations.
This component can be
thought of as the “franchise” Developing Assumptions. The most
or “going concern” value of critical part of the actuarial appraisal
the company. It reflects the process is the development of
present value of future assumptions to be utilized in the
statutory profits of future projections. These assumptions reflect
business to be sold after the actuarial analysis and judgement related to
valuation date for a specified the historical experience of the business
period of time, typically ten to activities being valued, current market
twenty years. The actuarial conditions, and management expectations
calculations to determine for future performance in areas such as
projected profits for future new business activities, operating
business are done in a manner expenses, investment returns and strategic
consistent with the current direction.
business inforce.
These assumptions can be grouped into
Key assumptions in the three broad categories:
determination of the value of
future business are 1. Macro Economic
· the level of future annual Assumptions: Baseline
production expected over hypotheses for the economic
the period of time chosen environment where the
and, company operates.
· the profile of the products
to be sold. 2. Projection Assumptions:
Utilized to project the
The actuarial appraisal report behavior of the business into
may illustrate different the future.
production scenarios with
current distribution systems, 3. Discount Rate
as well as expected future Assumptions: Utilized to
distribution methods, where compute the economic value
appropriate. These scenarios of the projected profits.
help illustrate the impact on
value of various new business Macro Economic Assumptions: In
production levels. conjunction with economists or other
financial advisors, macroeconomic

MILLIMAN USA
assumptions are established, such as value of each and let the reader choose
returns on different asset classes, inflation, the most appropriate rate.
growth in GDP and the growth of the
insurance market in general. These The determination of the discount rate by
assumptions will have a direct and the user of an actuarial appraisal typically
significant impact on other assumptions involves consideration of the following
such as expected company returns and items:
future business production scenarios.
Future investment yield assumptions will 1. Long Term Return
also need to be established based on Expectations: This typically
macro economic assumptions described reflects a corporate
above and the company’s investment benchmark used to measure
strategy. various investment
alternatives.
Projection Assumptions: Projection
assumptions are intended to be “best 2. Cost of Funds: This typically
estimate” assumptions for future reflects the cost of financing
experience of the business being valued. the purchase or acquisition,
In establishing some assumptions, historic which might involve a mix of
experience, if such data exists and is debt and equity instruments.
reliable, is used as the basis for future
expectations. For other assumptions, past 3. Internal Hurdle Rates:
experience is of little relevance and must Some companies use internal
be developed from general knowledge of benchmark rates for the
the market and the future expectations of pricing of internally generated
management. In any event, sound business. This rate is used to
judgement must always be applied in compare the value of acquiring
setting these assumptions. business externally.

Projection assumptions typically include 4. Return on Unused Funds:

mortality, persistency, new business If the transaction produces a
production, operating expenses, higher return than the current
distribution expenses, and management’s yield on the funds that would
profit expectations. These will vary by line be used for the purchase, it is
of business, distribution channel, likely to be considered as an
underwriting and operating policy, and attractive investment.
management policy regarding retention of
earnings and distribution of dividends. 5. Country Risk: The required
discount rate might be
Discount Assumptions: Discount rate increased to reflect the
assumptions will vary according to the additional risks of operating in
user of the actuarial appraisal. Each user, a different country which
whether the owner or a potential buyer, exposes the potential buyer to
must determine this value according to currency, political and
their own internal corporate requirements. economic fluctuations.
For this reason, most actuarial appraisal
reports will present a range of discount Discount rates have trended down in
rates in order to illustrate the impact on recent years, partly due to lower interest

MILLIMAN USA
rates, but also due to the level of activity
in developing markets in which there are
typically more buyers than sellers. The
discount rate might also be lowered due to
strategic considerations, such as the
opportunity value of entering a new
market, which is deemed strategically
important to the buyer.

Price: Ultimately, the price that a buyer is

prepared to pay will depend on issues that
go far beyond the actuarial appraisal. The
price will vary from buyer to buyer for
various reasons. For instance, a potential
buyer already operating in a market with a
competitor company might see value in
merging the two companies and extracting
administrative and operating savings. A
buyer looking to enter the market will not
be able to achieve such synergies, but
might be willing to pay a premium for
gaining access to the market.

In both cases, however, the independent

actuarial appraisal will be a critical tool
used as the fundamental basis for
determining value in the analysis of the
transaction and the negotiation process.
Additionally, the actuarial appraisal
process provides an excellent means for
managing the financial aspects of the
business going forward.

MILLIMAN USA