CFO Forum backs liquidity premium for MCEV and Solvency II

The Chief Financial Officers’ (CFO) Forum has amended the principles for its market consistent embedded value (MCEV) metric to include a liquidity premium, and endorsed its use for Solvency II.

The group, representing the chief financial officers of Europe’s biggest insurers, also used the announcement to reaffirm industry support for a reference rate based on swaps, in contrast to the triple-A government bond rate favoured by the Committee of European Insurance and Occupational Pensions Super-visors (Ceiops) in its recent consultation papers on the implementation of the directive.

Under the changes, assets and liabilities will be discounted using a rate including a premium “where appropriate”, added to the swap yield curve corresponding to the currency of the cashflows. A spokesman for the group’s chairman, Philip Scott of UK insurer Aviva, would give no further details on the implementation other than that the CFO Forum would be working to develop more detailed guidance.

The forum wants the MCEV approach adopted as the methodology for balance sheet assessment under Solvency II and will continue to lobby for the inclusion of the measures in the directive.

“These changes align our approach to MCEV with our views on Solvency II,” said Scott.
The industry body said the existence of a liquidity premium was “clear”, and claimed this was “evidenced by a wide range of academic papers and institutions”, although it declined to provide references. The CFO Forum has been locked in talks to amend the accounting method since December last year, when it came under fire as a pro-cyclical and volatile underestimate of determining a firm’s value.

The announcement came shortly after Tom Wilson, chief risk officer of Munich-based insurer Allianz, mounted a robust defence of MCEV at Life & Pensions’ Solvency II and Risk Management conference on October 7 – while cautioning against using an excessively large liquidity premium.

Wilson said the size of the liquidity premium could increase the cost of funding to such an extent that the new business margins on many guaranteed products would shrink to untenable levels.

“When implementing the liquidity premium, we should think a lot about the impact on fundraising. Can you imagine your CEO going to the shareholders and saying: ‘this is my business model – employ 30,000 people to obtain retail funding at Libor plus 200 basis points, then use it to back portfolios with large amounts of downside guarantee risk and negative convexity’?

“The liquidity premium should be based consistently on the characteristics of the liability, in terms of other funding opportunities. We can fund short-term at Libor plus our credit default swap spread. But if I want funding for a five- or 10-year product I have to pay another spread on top, from the European medium-term note market. There is an identifiable cost of funding which has nothing to do with bond spreads, but with the particulars of the liability.”

Wilson said there was potential for an adverse effect on investor confidence from inappropriately applying the measure. “The market doesn’t think our earnings from these businesses are valuable, with the market-to book ratio averaging about 1.2 at the best of times. We need to be careful about how much of that liquidity premium we want to take on, as it might not be great for the shareholders.”

This was echoed by Duncan Russell, an analyst at JP Morgan. “The theoretical issue of the liquidity premium is of not much interest to investors, who are happy to accept zero, or 50bp. The problem comes when you are making assumptions of 150bp or 200bp – then we get concerned.”

There is a lack of consistency across the industry on this issue: Aviva used 150bp and Old Mutual 300bp in their 2008 figures. Allianz was one of only four of the 23 CFO Forum members who did not use a liquidity premium in its 2008 figures, along with Munich Re, Hannover Re and Zurich Financial Services.

Wilson acknowledged the increased volatility that MCEV brings to earnings figures, but argued that the metric more closely mimics the valuation of life insurance business made by investors and analysts than traditional approaches.

However, Russell disagreed. “It is one of the tools we use, along with International Financial Reporting Standards (IFRS) earnings, IFRS book value, cashflow and dividend yield, but it is not more important than the others. For instance, there’s no way I would recommend a stock based on MCEV alone. Theoretically, all these methods should give the same answer. When they don’t it is because there are inconsistent assumptions.”

Life & Pensions contacted six CFO Forum member companies and all declined to comment.