Practice Note on Market Consistent Embedded Values
investment income from assets supporting RC (on a best-estimate basis), including the projection of realized gains and losses from such supporting assets. Hence, the timing of taxes (on a best-estimate basis) is directly reflected in the resulting VIF. Likewise, taxable investment income from assets supporting FS is similarly projected on a bestestimate basis, and FS is adjusted to reflect the present value of such taxes. This second approach more accurately reflects timing of taxes. Although theoretically more accurate than the first approach, modeling and tax algorithms can become considerably more complex. A variant of this second approach treats assets supporting FS as in the first approach (i.e., such assets are marked to market and assumed to be immediately sold, allowing resulting assumed tax consequences to be immediately recognized). The logic for treating FS and RC differently is that FS is immediately distributable, but RC is not. Hence, the more complex treatment (a best-estimate projection of taxable income from supporting assets) is given only to assets supporting RC. A case can be made for any of the above approaches. Q12: How is the value of in-force business (VIF) defined? A: Principle 6 of the MCEV Principles states that VIF consists of: Present value of future profits (PVFP) Time value of financial options and guarantees (TVFOG) Frictional costs of required capital (FCRC), and Cost of residual nonhedgeable risks (CRNHR). In formula form: (3) VIF = PVFP-TVFOG-FCRC-CRNHR There are multiple ways of combining the components of VIF. In (3) above, PVFP would typically include the intrinsic value of financial options and guarantees, but not the time value, which is a separate component, TVFOG. Consequently, an alternative presentation might include TVFOG in PVFP. Likewise, frictional costs of RC and residual nonhedgeable costs are shown as separate components, even though both might be computed as the present value of cost of capital charges (subsequently discussed). Consequently, an alternative presentation might combine CRNHR with FCRC, resulting in a more inclusive cost of capital component. To more clearly introduce basic MCEV formulas in this section that are similar in form to their EEV counterparts, temporarily assume TVFOG and CRNFR are zero. Both TVFOG and CRNHR are thoroughly discussed in subsequent sections. With the above simplification, the basic VIF can be defined as the present value of future after-tax future profits (PVFP) less the frictional costs of required capital (FCRC). The projection of after-tax profits is based on best-estimate assumptions, with the exception
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