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

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 as of the valuation date. The
actuarial calculations to
determine projected profits
take into account revenues
generated from the business,
benefits presumed to be paid
and expenses actually expected
to be incurred, adjusted for
applicable taxes.
3. Value of Future Business:
This component can be
thought of as the “franchise”
or “going concern” value of
the company. It reflects the
present value of future
statutory profits of future
business to be sold after the
valuation date for a specified
period of time, typically ten to
twenty years. The actuarial
calculations to determine
projected profits for future
business are done in a manner
consistent with the current
business inforce.
Key assumptions in the
determination of the value of
future business are
· the level of future annual
production expected over
the period of time chosen
and,
· the profile of the products
to be sold.
The actuarial appraisal report
may illustrate different
production scenarios with
current distribution systems,
as well as expected future
distribution methods, where
appropriate. These scenarios
help illustrate the impact on
value of various new business
production levels.
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The items above are typically adjusted for
the cost of required capital. This cost
reflects the fact that the capital and
surplus of the company, and the expected
profits are not necessarily immediately
available for distribution to the
shareholders. Rather, some capital and
profits need to be retained within the
company to maintain favorable ratings
and regulatory relations.
Developing Assumptions. The most
critical part of the actuarial appraisal
process is the development of
assumptions to be utilized in the
projections. These assumptions reflect
actuarial analysis and judgement related to
the historical experience of the business
activities being valued, current market
conditions, and management expectations
for future performance in areas such as
new business activities, operating
expenses, investment returns and strategic
direction.
These assumptions can be grouped into
three broad categories:
1. Macro Economic
Assumptions: Baseline
hypotheses for the economic
environment where the
company operates.
2. Projection Assumptions:
Utilized to project the
behavior of the business into
the future.
3. Discount Rate
Assumptions: Utilized to
compute the economic value
of the projected profits.
Macro Economic Assumptions: In
conjunction with economists or other
financial advisors, macroeconomic
assumptions are established, such as
returns on different asset classes, inflation,
growth in GDP and the growth of the
insurance market in general. These
assumptions will have a direct and
significant impact on other assumptions
such as expected company returns and
future business production scenarios.
Future investment yield assumptions will
also need to be established based on
macro economic assumptions described
above and the company’s investment
strategy.
Projection Assumptions: Projection
assumptions are intended to be “best
estimate” assumptions for future
experience of the business being valued.
In establishing some assumptions, historic
experience, if such data exists and is
reliable, is used as the basis for future
expectations. For other assumptions, past
experience is of little relevance and must
be developed from general knowledge of
the market and the future expectations of
management. In any event, sound
judgement must always be applied in
setting these assumptions.
Projection assumptions typically include
mortality, persistency, new business
production, operating expenses,
distribution expenses, and management’s
profit expectations. These will vary by line
of business, distribution channel,
underwriting and operating policy, and
management policy regarding retention of
earnings and distribution of dividends.
Discount Assumptions: Discount rate
assumptions will vary according to the
user of the actuarial appraisal. Each user,
whether the owner or a potential buyer,
must determine this value according to
their own internal corporate requirements.
For this reason, most actuarial appraisal
reports will present a range of discount
rates in order to illustrate the impact on
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value of each and let the reader choose
the most appropriate rate.
The determination of the discount rate by
the user of an actuarial appraisal typically
involves consideration of the following
items:
1. Long Term Return
Expectations: This typically
reflects a corporate
benchmark used to measure
various investment
alternatives.
2. Cost of Funds: This typically
reflects the cost of financing
the purchase or acquisition,
which might involve a mix of
debt and equity instruments.
3. Internal Hurdle Rates:
Some companies use internal
benchmark rates for the
pricing of internally generated
business. This rate is used to
compare the value of acquiring
business externally.
4. Return on Unused Funds:
If the transaction produces a
higher return than the current
yield on the funds that would
be used for the purchase, it is
likely to be considered as an
attractive investment.
5. Country Risk: The required
discount rate might be
increased to reflect the
additional risks of operating in
a different country which
exposes the potential buyer to
currency, political and
economic fluctuations.
Discount rates have trended down in
recent years, partly due to lower interest
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.

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