Economic Value Management
EVM is an integrated economic accounting and steering framework based on market consistent valuations and defines the method for measuring value creation for all business activities of Swiss Re.
Economic Value Management (EVM) is Swiss Re’s integrated economic valuation framework for planning, pricing, reserving and steering the business. Since 2003, Swiss Re has used the EVM framework as a tool to support business and strategic financial decisions, including compensation decisions. EVM also provides the basis for determining available capital under the Swiss Solvency Test (SST) and, in the future, Solvency II.
The key EVM valuation principles are summarised below.
Market consistent valuations
All traded assets and liabilities are marked to market, based on quoted prices in active markets or observable inputs. Untraded assets and liabilities are valued consistently with market prices. The Group’s insurance liabilities are valued on a market consistent basis by replicating future expected cash flows with liquid financial market instruments. As the majority of the Group’s insurance liabilities do not contain embedded financial market risk exposure other than to interest rates, the market consistent value can be determined by discounting future cash flows using prevailing risk-free interest rates. If insurance liabilities include embedded options or guarantees (eg, variable annuities or interest sensitive life business), they are valued on a market consistent basis using stochastic models and other appropriate valuation techniques.
Performance split of insurance underwriting and investment activities
EVM values underwriting and investment activities separately. Underwriting activities create value by raising funds on insurance markets at a lower cost than through other sources. The investment functions are assessed on a risk-adjusted basis. This makes possible a like-for-like comparison of underwriting and investment activities.
EVM recognises all cash flows associated with a new contract at inception, and any changes in estimates as they occur. In comparison, the deferral and matching principle under US GAAP postpones recognition of revenues until they are earned and matches expenses to those revenues. EVM excludes the recognition of all potential future new business activities, as well as potential renewals.
Swiss Re values assets and liabilities based on best estimates of underlying cash flows – premiums, claims, expenses, taxes, capital costs, etc. – taking into consideration all the information available when a contract incepts. As with other valuation methods that depend on projections of future cash flows, EVM involves a significant degree of judgement in establishing what assumptions should be used. Swiss Re actively and carefully reviews its assumptions, seeking both to achieve consistency across business activities and to reflect all available information.
Performance measurement after capital costs
EVM explicitly recognises opportunity costs for shareholder capital. Cost-of-capital charges include the base cost of capital and frictional capital costs. The base cost of capital is reflected through a charge for risk-free returns on available capital and market risk premiums. Market risk premiums compensate for systematic, non-diversifiable risk exposure, mainly assumed through investing activities. Frictional capital costs compensate for agency costs, costs of potential financial distress and regulatory (illiquidity) costs; they are reflected through a 4% charge on available capital and an average 2% charge on leverage.