Sophisticated Pricing Builds Competitive Products — ②: Shareholder-Perspective Pricing

Authored by Jihyun Kim, Global Sales Executive RNA Analytics

Shareholder-Perspective Pricing

In 2023, IFRS 17 was fully introduced. Changes to the accounting regime inevitably affect corporate decision-making. Following the adoption of IFRS 17, insurers came to emphasize the CSM metric, and this influenced pricing as well, with insurers adopting the new-business CSM margin as a metric for pricing decisions. This represents a shift in the basis for product decisions from a sales-volume orientation to a profit perspective — broadly a desirable direction. Even so, it is regrettable that product-profitability analysis has tended to fixate solely on CSM-margin testing at the individual-product level, because the CSM margin has limitations in supporting decisions from a shareholder-profit perspective.

The CSM under IFRS 17 aggregates, at the insurance-contract level and in accordance with accounting standards, the present value of the profit expected as consideration for providing future insurance services. In a strict sense, it is not a concept that fully reflects the actual economic value attributable to shareholders.

Pricing decisions, however, must consider the profit that flows back to shareholders through product sales. Viewed in this light, using the CSM margin alone as the pricing-decision metric is problematic: there is a risk of overlooking costs that should be considered from a shareholder-profit perspective, and conversely, an unfortunate risk of missing opportunities by overlooking the potential to create shareholder profit through product sales.

For the following reasons, the CSM is an insufficient metric for fully reflecting the shareholder perspective.

First, because the CSM captures only the direct profit from providing insurance services under the contract, it excludes the returns expected in the real world from investing the premiums collected. In reality, however, investment income is an important source of profit for savings-type insurance and long-term life-insurance products. Only by looking beyond the CSM metric alone — examining together the investment-income opportunity the product will bring — can one avoid missing opportunities and make optimal decisions consistent with the shareholder-profit perspective.

Second, because the CSM considers only costs directly attributable at the contract level, it excludes overhead and taxes that must be considered at the company-wide level, and in particular omits the cost of regulatory capital, which is important from a shareholder’s standpoint. Even if the CSM margin is healthy, a product with high required capital may actually lower the company’s capital ratio or, in severe cases, trigger additional capital injections from shareholders. Conversely, even if the CSM margin is somewhat low, a product with low capital requirements may be the better choice from a capital-efficiency perspective. In short, from a shareholder-profit perspective, evaluation through the lens of capital efficiency matters — but the CSM says nothing about it.

To summarize from an overall perspective: for the shareholders who have invested in the company, what matters is growing the “Distributable Earnings” that remain after bearing all the costs and capital costs entailed in actually operating the company and after accounting for corporate tax. Judgments about products and pricing, too, must be grounded in this perspective for shareholder-optimal decision-making to be possible.

Third, the CSM is a metric computed according to strict assumptions and methodologies specified by accounting and supervisory standards, so the application of the company’s own discretionary judgment to those assumptions and computation methods is limited. Moreover, the valuation methodology adopts a Risk-Neutral (RN) basis, relying on market-price information as of the valuation date and excluding forward-looking views such as excess asset-management returns. This is because the CSM, as a financial-reporting accounting metric, is one for which comparability and reliability are emphasized given its public-disclosure purpose. Owing to these purpose-driven constraints, however, financial metrics prepared in accordance with accounting standards have limitations in reflecting economic substance. By contrast, for management metrics that support the company’s business decisions, it is reasonable to reflect and use management’s forward-looking views and the expected effects of business strategy.

In other words, the CSM reflects only insurance-service profit and does not reflect investment-income opportunity; it differs from the Distributable-Earnings perspective that also considers the effect of capital costs; and as an accounting-purpose metric it does not actively reflect management’s future expectations and strategic effects. In these respects, it has limitations as a metric for supporting shareholder-perspective pricing decisions.

In fact, the shareholder-profit perspective is better reflected in the Value of New Business (VNB) based on the Traditional Embedded Value (TEV) methodology, which was used to value insurers even before IFRS 17. Traditional VNB evaluates the present value of shareholder-perspective distributable earnings, and here forward-looking views can be applied to the rate of return, the discount rate, and other assumptions. Because it involves considerable subjectivity in its computation, it may be unsuitable as an accounting-disclosure metric; but for analytical purposes supporting business decisions within the company, it can in fact be used to good effect.

That said, under the IFRS 17 and K-ICS environment, traditional VNB based on the TEV methodology cannot be used as is; it must be adjusted to fit the requirements of the current regimes. Consistent with the current regimes, one must compute and reflect reserves and required capital at every future point of the projection, as well as the cost of options and guarantees embedded in insurance contracts — and this can be implemented through an approach called “Nested Scenario” modeling. The Nested Scenario modeling methodology will be introduced in the next installment of this series.

It goes without saying that the CSM metric disclosed externally under the IFRS 17 regime is important. However, it is more appropriate to regard it as a constraint to be managed than as the principal driver of shareholder-perspective decisions. Let me emphasize once more that, for shareholder-optimal decisions, review must be conducted on a distributable-earnings basis. Pricing analysis and decisions, too, should be examined with a metric that reflects distributable-earnings valuation and the management perspective at the center.