This is in the context of embedded values being increasingly important within life insurance industry reporting and thus with analysts.

The development of European Embedded Values (EEV) principles by the CFO Forum attempted to address some of the weaknesses and inconsistencies in the approaches being used by companies across Europe.

While EEV principles have been a success in many ways there are still different approaches being adopted, the major one being market consistent (MCEV) versus “real world” approaches to setting economic assumptions.

Within the MCEV approach, the individual cashflows are discounted separately by reference to traded assets with the same cashflows.

- for example if you expect a series of cashflows to increase with returns of 7 per cent per annum in the future (e.g. the annual fund management charges on an equity unit-linked fund) then they are discounted at 7 per cent pa so no “value” is created immediately on day one.

- In practice the MCEV approach means investment profits and credit spreads are not anticipated before they arise. These profits are accounted for if and when they arise in the future. Arguably this provides a more meaningful analysis of investment profits.

Under the alternative “real world” approach, cashflows are projected using the full expected future returns and then discounted at a rate which is appropriate to the risks associated with the cashflows.

This allowance for risk can be rather subjective as it is generally set at a single level across all the cashflows rather than individually.

Another criticism of the real world approach is it capitalises elements of potential future investment profits.

There has been a general movement towards companies using MCEVs, especially by companies moving to EEV reporting more recently. However, there are still inconsistent approaches between companies using MCEVs.

These mainly relate to the following:
- definition of the risk free rate
- the allowance for non-diversifiable non-market risk, e.g. operational risk
- different approaches for agency costs and double taxation

This demonstrates the need for more detailed definitions of appropriate methodologies that should be followed to ensure more commonality is achieved.

This will make MCEV a more credible and accepted approach. The EEV principles may need to be updated to reflect the more general use of MCEVs and thereby gain greater consistency in the approaches being used.

In addition, there is a need to enhance the wider understanding of the market consistent approach so the results are fully understood. Companies who use MCEVs often back solve the results to provide a real world basis of presentation when making disclosures to the market.

The main challenge for companies who move from a real world to a MCEV approach is not the change in the modelling or processes but rather the effective communication and understanding (both internally and externally) of the changes in the figures. This is not something to be underestimated especially when looking at individual product lines.

John Jenkins is a financial services partner at KPMG