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THE

Robert W. Beal*

AND

IRR

ABSTRACT

Internal rate of return (IRR) measures the level annual return over the life of an investment, whereas return on equity (ROE) measures the return over each accounting period. This paper develops the relationships between IRR and ROE by presenting and proving four algebraic theorems involving IRR and ROE. These theorems are developed using generic investment terminology that does not rely on any specic accounting basis. The relationships are then expressed using U.S. statutory and GAAP terminology. The paper demonstrates that IRR is not just a statutory concept and ROE is not just a GAAP concept. Financial projections for a hypothetical insurance product illustrate these relationships.

1. INTRODUCTION

IRR is a prot objective used to determine the level annual return over the life of an investment of capital. ROE measures the annual return of the investment over each accounting period. The term ROE, as used in this paper, has also been referred to as return on capital (ROC), return on total capital (ROTC) and return on investment (ROI) in other papers mentioned in this paper. IRR has been viewed as a statutory concept; that is, it is the expected level annual return over the life of an investment of statutory capital. On the other hand, ROE has been viewed as a generally accepted accounting principles (GAAP) concept, (that is, the return on GAAP equity over a specic accounting period). The concept of IRR is sometimes dismissed as irrelevant when prot objectives are framed in GAAP terms. In this situation, certain key relationships between IRR and ROE are ignored. This paper develops these relationships. Sondergeld (1975, 1982) discusses certain fundamental characteristics of IRR and ROE. Lombardi (1986) and Smith (1988) further develop these concepts. All four of these papers discuss these concepts using statutory and GAAP terminology. Section 2, Algebraic Relationships Between ROE and IRR, presents four algebraic relation-

ships (in the form of theorems) between IRR and ROE using generic investment terminology that do not reference either statutory or GAAP accounting. Section 3, Application Using Statutory and GAAP Accounting, applies U.S. statutory and GAAP accounting terminology to the four theorems from Section 2 and denes statutory and GAAP ROE, relating both of these concepts to IRR. Section 4 provides the concluding comments. Appendix A presents proofs of the four theorems from Section 2. Appendix B illustrates the relationships from Section 3 using asset share projections for a hypothetical individual disability income product.

This section presents four algebraic relationships between ROE and IRR in the form of theorems, using generalized terminology to represent annual capital ow, annual equity, and annual returns. Appendix A provides proofs of these theorems. In Section 3, these relationships are expressed using U.S. statutory and GAAP terminology. 2.1 Denitions

*Robert W. Beal, F.S.A. is a Consulting Actuary with Milliman & Robertson, Inc., 121 Middle St., Suite 401, Portland, ME 04101, e-mail: bob.beal@milliman.com

Capital Flow

Let CFt, for t 1, . . . , N, represent the annual capital ow over N years for a specic investment.

1

CF0, the initial capital investment, is assumed to be negative. CFt for t 0 may be either positive or negative, where a positive value represents a return of interest and principal to the investor and a negative value represents additional capital investment.

Equity

2.2 Theorems The rst theorem states that equation (1) holds when the IRR is replaced by the vector ROEt, for t 1, . . . , N. Both Sondergeld (1982) and Lombardi (1986) discuss this relationship.

Theorem 1

Let Et, for t 0, . . . , N, be a vector representing the value of the equity at time t. The term equity, as used in this paper, is typically the book value as dened by some accounting standard. This discussion does not limit the calculation of equity to any specic accounting standard but assumes the following two requirements are satised: (1) E0 CF0, and (2) Et 0 for t 1, . . . , N 1. Section 3 develops two denitions of equity that satisfy both requirements using statutory and GAAP concepts. EN is often set equal to zero. However, a non-zero EN may represent the book value or residual value of the investment at the end of the investment period.

Internal Rate of Return

CF 0

t 1

CF t

t N

EN 1

s 1

1

s 1

ROE s

ROE s (2)

The next theorem states that the equity at the end of any year is the present value of the future capital ow, discounted using the vector of ROEs, for the remaining years of the investment. Although equity can be dened using specic accounting terminology, as it is in Section 3, equity (provided it satises the two criteria described in the previous denition of equity) must satisfy equation (3).

Theorem 2

N

Let IRR be a level annual interest rate that solves Equation (1):

N

Et

s t 1

CF s

s N

EN ROE k

k t 1

1

k t 1

ROE k (3)

0

t 0

CF t 1 IRR

EN 1 IRR

(1)

Although the theorems provided below hold true whether or not there are multiple solutions to Equation (1), for discussion purposes we will assume that there is only one meaningful solution. Promislow (1980) provides a much deeper treatment of yield rates and investigates multiplevalued and nonexistent yields.

Annual Return

Unlike Theorem 1, which states that the level annual IRR can be replaced by the annual ROEs in Equation (1), Theorem 3 below states that the annual ROEs cannot be replaced by the IRR in equation (3) unless the ROEs are level and equal to the IRR.

Theorem 3

N

Let ARt, for t 1, . . . , N represent the annual return in year t, that is, the investors annual prots in year t, less any decrease in equity. By denition, ARt CFt (Et 1 Et).

Annual Return on Equity

Et

s t 1

CF s 1 IRR

s t

1 for t

EN IRR

N t

0, . . . , N

(4)

ROE t for t

1, . . . , N.

1, . . . ,

Unless the equity values are equal to the present value of future capital ow, where the level annual discount rate is equal to the IRR, then the annual ROEs will be nonlevel. Sondergeld (1975) explores this idea by developing the internal rate of return method of accounting (IRRMA) by

BRIDGING

THE

AND

IRR

which the expected annual earnings related to a closed block of business emerge as a uniform percentage of IRRMA surplus, where the uniform percentage is the IRR. Theorem 4 shows that the IRR is equal to the ratio of the present value of the annual returns to the present value of the equity, where the discount rate is the IRR.

Theorem 4

At the end of each year, the statutory after-tax book prot, less the increase in required capital, represents a ow of capital between the corporate surplus and the lines surplus. If this amount is negative, then the amount represents additional capital infusion into the line. If this amount is positive, then capital equal to this amount ows from the lines surplus to corporate surplus.

N

PV AR

t 1

AR t IRR

and PV E

t 1

Et 1 . 1 IRR t

Using Equation (5), the IRR may be solved reiteratively given that the annual returns and equity values are known for each year of the investment. In addition, based on Equation (5), the IRR can be viewed as the weighted average annual return divided by the weighted average equity at the beginning of each year, where the weights are dened as 1/(1 IRR)t for t 1, . . . , N.

AND

The relationships between IRR and ROE discussed in Section 2 are presented below using both statutory and GAAP accounting terminology. In other words, statutory and GAAP equity, annual returns, and ROE are dened and applied to the theorems. Although the GAAP expressions are more widely utilized, illustrating both sets of terms demonstrates that the relationships in Section 2 are not limited to GAAP accounting only. The formulas assume the following scenario:

A line of business of an insurance company issues a cohort of policies. At issue (t 0), the company transfers statutory capital from the corporate surplus to the lines surplus equal to the required capital necessary to cover the risk in the rst year.

The following terminology will be used: N number of years that the cohort of policies as a whole persists; Pt premium income in year t; NIIt net investment income in year t; Bt benets paid in year t; Expt expenses incurred in year t; ResS statutory reserves and liabilities at the t end of year t; G Rest GAAP reserves and liabilities at the end of year t; DACt unamortized deferred acquisition costs at the end of year t; S FIT t statutory federal income taxes incurred in year t; G FIT t GAAP federal income taxes incurred in year t; S BPt statutory after-tax book prot in year t 0; S Pt NIIt Bt Expt (Rest S S Rest 1) FITt G BPt GAAP after-tax book prot in year t 0; G Pt NIIt Bt Expt (Rest G Rest 1) (DACt DACt 1) FITG t RCt required capital at the end of year t; CFt capital ow at time t; RC0 at t 0; S BP t (RCt RCt 1) for t 0; DTRt GAAP deferred tax reserves at the end of year t; G S FIT t FIT t DTRt DTRt 1

G Since DTRt DTRt 1 FIT t DTRt can be dened as follows:

t

FIT S, then t

DTR t

s 1

G FIT s

S FIT s

Statutory and GAAP equity are dened as follows: S Et Statutory equity at time t RCt S E0 RC0 CFt

GAAP equity at the end of year t S G RCt Rest DACt Rest DTRt G E0 RC0. In this example, EN is equal to zero for both statutory and GAAP terms, since no policies are assumed to persist beyond N years. The following demonstrates that the statutory and GAAP annual returns are equal to the statutory and GAAP book prots: S S S ARt CFt (Et 1 Et ) S BPt (RCt RCt 1) (RCt 1 RCt) S BPt . G G G CFt (Et 1 Et ) ARt S S BPt (RCt RCt 1) (RCt 1 Rest 1 G DACt 1 Rest 1 DTRt 1) (RCt Re S G st DACt Rest DTRt) G G Pt NIIt Bt Expt (Rest Rest 1) G (DACt DACt 1) FITt G BPt . As a result of the above denitions, both statutory and GAAP ROEs can be calculated as follows: ROE

S t S BP t for t RC t 1

G Et

RC t

s t 1

S BP s s

RC s 1

RC s

S ROE k

(11)

k t 1 N G Et s t 1 k t 1 S BP s s

RC s 1

RC s

G ROE k

(12)

Theorem 3 is not true when statutory and GAAP values are used, since both statutory and GAAP equity are not equal to the present value of capital ow where the discount rate is equal to the IRR. This is illustrated in the hypothetical example in Appendix B. Finally, Equation (5) in Theorem 4 can be expressed in statutory and GAAP terms as follows:

N S BP t 1 IRR

IRR

t 1 N

(13) RC t 1 1 IRR

G BP t 1 IRR G Et 1 1 IRR t

t 1

0;

N t

G ROE t

BP for t G Et 1

G t

0.

IRR

t 1 N

(14)

t

Equation (1) from Section 2, which denes IRR, can now be written as follows:

N

t 1

0

t 0 S where BP 0

BP

S t

RC t RC t 1 IRR t

1

0 and RC

(8)

Equation (2) from Theorem 1 can be expressed in terms of statutory or GAAP ROE:

N S BP t t t 0 s 1 N

RC t 1

RC t

S ROE s

Equation (13) provides an alternative to equation (1) for deriving the IRR using statutory book prots and required capital. Equation (14) shows that IRR can be determined using GAAP book prots and equity values. These two equations demonstrate that IRR is both a statutory and GAAP concept. Appendix B illustrates the results in Section 3 using a hypothetical individual disability income product.

(9)

4. CONCLUSION

1

0

t 0

BP

S t t

RC t 1

RC t

G ROE s

(10)

s 1

Similarly Equation (3) in Theorem 2 can be expressed in statutory and GAAP terms as follows:

For an insurance company, new business involves the investment of statutory capital. GAAP equity is the book value determined by GAAP accounting standards and represents a value placed on the outstanding investment. The IRR measures the level annual return over the life of the investment. ROE measures the return over each accounting period, and its denition is subject to

BRIDGING

THE

AND

IRR

specic accounting rules. ROE is typically nonlevel and might be only a rough approximation of the IRR. Only in very specic denitions of equity will the expected annual ROE equal the expected IRR. Although GAAP parameters might be used that will generate expected ROEs that are relatively level each year, management should appreciate the differences between GAAP ROE and IRR when trying to understand the nancial results. Although IRR and ROE are not normally expected to be equal, this paper claries their close interrelationship, and in doing so, claries the close interrelationship between statutory and GAAP accounting. The IRR can be derived using statutory values or GAAP values. The present value of the capital ow is zero whether discounted using the IRR or the vector of annual ROEs. As a result, it is incorrect to state that IRR is only a statutory concept or ROE is only a GAAP concept. REFERENCES

ANDERSON, J.C.H. 1959. Gross Premium Calculation and Prot Measurement for Nonparticipating Insurance, TSA 11: 357 420. LOMBARDI, L.J. 1988. Relationships Between Statutory and Generally Accepted Accounting Principles (GAAP), TSA 40: 485508. PROMISLOW, S.D. 1980. A New Approach to the Theory of Interest, TSA 32: 53118. SMITH, B. 1987. Pricing in a Return-on-Equity Environment, TSA 39:25793. SONDERGELD, D.R. 1975. Earnings and the Internal Rate of Return Measurement of Prot, TSA 26: 61736. SONDERGELD, D.R. 1982. Protability as a Return on Total Capital, TSA 34: 41533.

value of the equity at the end of year t, satisfying three conditions: (1) E0 CF0, (2) Et 0 for t 1, . . . , N 1, and (3) EN 0.

N

0

t 0

CF t 1 IRR

EN 1 IRR

(A.1)

Theorem 1

N

CF 0

t 1

CF t

t N

EN 1

s 1

1

s 1

ROE s

ROE s (A.2)

PROOF

Solving for E0, we arrive at the following equation E0 CF 1 1 ROE 1 E1 ROE 1 (A.3)

Since E0 CFO0, we can derive Equation (A.4), which is Equation (A.2) for N 1. 0 CF 0 CF 1 1 ROE 1 E1 ROE 1 (A.4)

APPENDIX A

Appendix A provides proofs of the four theorems presented in Section 2. All theorems assume the following denitions and conditions:

CFt, for t 1, . . . , N, is a vector representing the annual capital ow over N years for a specic investment. CF0, the initial capital investment, is assumed to be negative. CFt for t 0 may be either positive or negative, where a positive value represents a return of interest and principal to the investor and a negative value represents further capital infusion. Et, for t 0, . . . , N, is a vector representing the

Assume that equation (A.3) is true for all years through N 1, that is,

k 1

CF 0

t 1

CF t

t k 1

Ek 1

s 1

1

s 1

ROE s 1, . . . , N

ROE s 1 (A.5)

for k By denition, CF N

1,

EN 1 EN 1

EN

(A.6)

EN

CF N 1 ROE N

EN , ROE N

Theorem 3

(A.7)

N

Et and substituting Equation (A.7) into Equation (A.5) for k N 1, we arrive at equation (A.2).

Theorem 2 Proof

N s t 1

CF s IRR

1 for t

EN IRR

, (A.9)

0, . . . , N

ROE t for t

1, . . . , N.

Et

s t 1 k

CF s

s t 1

EN ROE k

k N t 1

ROE k (A.8)

If IRR ROEt for t 1, . . . , N, then by Theorem 2, Equation (A.9) is true. Assume the converse; that is, Equation (A.9) is true. By denition, ROE t CF t Et 1 Et 1 Et . (A.10)

PROOF

CFt ROEt

s t

CFs IRR

s t 1

EN IRR

N N t 1 s t 1

CFs 1 IRR

s t

EN IRR

N t

Et

(A.11)

Then,

CFt ROEt

1 1 IRR

N s t

CFs 1 IRR s

EN IRR N Et 1

N t s t 1

CFs 1 IRR s

EN IRR N

. (A.12)

CFt ROEt

IRR 1 IRR

N s t

CFs 1 IRR

s t

1 Et

EN IRR

1

N N t s t 1

CFs IRR

s t

EN IRR

N t

. (A.13)

BRIDGING

THE

AND

IRR

CF t ROE t

CF t

IRR 1 IRR

N s t

CF s 1 IRR

1

s t

EN IRR

N t

Et

(A.14)

N

R

t 1

Et 1

N 1

IRR

t t 1

N

IRR

s t

CF s IRR

s t 1

EN IRR

N t 1

Et Because

N s t

. (A.15)

t 1

Et 1 1 IRR

t 1

it

t 1

is

CFs 1 IRR s

t 1

Et . 1 IRR t

(A.18)

IRR.

Theorem 4

N

N

PV AR

t 1

AR t 1 IRR

t 1 t

Et 1 1 IRR

N t t 1

CF t 1 IRR

N

and PV E

t 1

Et 1 . 1 IRR t

1

N

t 1

Et 1 1 IRR

t 1

Then, IRR

PROOF

PV AR . PV E

N

(A.19)

t 1

N t 1

Let R

PV AR , then R PV E

t 1

t 1

CF t 1 IRR

CF 0

EN 1 IRR

N

N

R

t 1

Et 1

IRR

CF0

EN 1 IRR

R

t 1

Et 1 1 IRR

N

N t t 1

CF t 1 IRR

N t t 1

E0

N

EN 1 IRR Et 1

1

t 1

Et 1 1 IRR

Et . 1 IRR t

(A.17)

IRR

t 1

IRR

(A.20)

Because CF0 E0, we can determine from Equation (A.20) that R IRR.

APPENDIX B

For the purpose of illustrating the theorems and results in Sections 2 and 3, a hypothetical individual disability product is shown here. It is based on an insured age 45 with a 90-day elimination period and a to-65 benet period (with a 24month minimum benet period). Because these projections are just illustrative, it is not necessary to describe all but a few actuarial assumptions: 1. The pre-tax interest rate on assets, net of investment expenses and defaults, is a level 7% per year. 2. The ratio of the present value of paid benets to present value of premiums over the life of the policy (that is, 22 years), discounted at 7%, is 51.4%. 3. The federal income tax rate is 35%, and the DAC tax is incurred in every year; except for illustration purposes, the DAC tax is fully amortized at the end of year 20. 4. The IRR is 12.53%. 5. All noncommission acquisition expenses are deferred for GAAP purposes. 6. The GAAP benet reserves are based on the expected claim costs with a 10% margin for adverse deviation and 100 basis points for margin in the valuation interest rate. 7. The GAAP expense reserves take into account the ongoing claim management expenses and ination on the per policy maintenance expenses. 8. The GAAP expenses in the GAAP income statement are equal to commissions and other expenses plus the increase in the GAAP expense reserves. Table 1 shows the projected statutory asset share. As in Section 3, the statutory ROE for each year is dened as the after-tax statutory book

prot divided by required capital at the beginning of the year. Table 2 shows the projected GAAP asset share. As in Section 3, the GAAP ROE for each year is dened as the after-tax GAAP book prot divided by GAAP equity at the beginning of the year. Table 3 demonstrates that the sum of the discounted capital ow is zero whether the discount rates are based on the IRR, the GAAP ROEs, or the statutory ROEs. The reader can use Table 3 to calculate the GAAP equity and statutory equity (i.e., required capital) at the end of any given year for each of the three sets of discount rates by summing the future discounted capital ows and dividing the sum by the discount factor for that year. For example, GAAP equity at the end of year 15 is 5.6161 divided by 0.16881, which is 33.27. This agrees with GAAP equity at the end of year 15 from Table 2. Similarly, required capital (i.e., statutory equity) at the end of year 15 is 4.1554 divided by 0.16126, which is 25.77. This agrees with required capital at the end of year 15 from Table 1. Table 4 demonstrates that the ratio of the present value of after-tax GAAP book prots divided by the present value of GAAP equity (as of the beginning of each year but discounted from the end of each year) is equal to the IRR when the present values are based on a discount rate equal to the IRR. Similarly, the present value of aftertax statutory book prots divided by the present value of required capital (as of the beginning of each year but discounted from the end of each year) is equal to the IRR when the present values are based on a discount rate equal to the IRR.

Discussions on this paper can be submitted until April 1, 2001. The author reserves the right to reply to any discussion. Please see the Submission Guidelines for Authors on the inside back cover for instructions on the submission of discussions.

BRIDGING

THE

AND

IRR

Policy Year Paid Benets Commission & Expenses Statutory Reserves 15.81 31.51 53.35 72.69 88.99 102.88 114.08 122.67 128.67 132.10 132.82 134.29 134.14 130.89 123.85 111.67 94.34 70.86 42.85 11.07 3.13 0.00 13.95 27.86 48.39 66.72 82.35 95.87 106.97 115.67 122.01 125.93 127.23 126.47 125.34 123.06 117.20 106.38 90.49 68.46 41.66 10.74 3.05 0.00 Tax Reserves 46.98 10.26 9.40 8.87 8.46 8.16 7.92 7.71 7.51 7.37 6.57 6.42 6.29 6.16 6.01 5.82 5.65 5.47 5.37 5.33 0.19 0.07 (12.23) 18.75 7.56 6.99 7.63 7.82 8.27 8.59 8.73 8.82 9.48 5.55 3.96 3.68 3.73 4.88 5.77 7.19 6.34 4.44 0.26 0.07 (2.46) 8.05 3.73 3.25 3.21 3.04 3.00 2.92 2.80 2.69 2.87 2.52 1.57 0.81 0.80 1.18 1.50 2.05 1.86 1.35 (2.54) 0.02 (9.77) 10.70 3.83 3.74 4.43 4.78 5.28 5.67 5.93 6.13 6.61 3.03 2.39 2.86 2.93 3.71 4.27 5.15 4.48 3.09 2.80 0.05 1.71 3.91 5.75 7.59 9.35 11.10 12.97 14.83 16.71 18.63 20.61 22.68 24.90 27.24 29.68 32.18 34.64 37.18 39.83 42.42 8.07 3.13 15.81 15.70 21.84 19.35 16.30 13.88 11.21 8.58 6.00 3.44 0.72 1.46 (0.15) (3.26) (7.04) (12.18) (17.33) (23.47) (28.02) (31.77) (7.94) (3.13)

Premium Income

Change in Statutory Reserves Pre-tax Statutory Book Prot Statutory Federal Income Tax After-tax Statutory Book Prot 29.89 27.63 26.49 26.50 26.92 27.44 28.04 28.54 28.90 29.22 29.29 29.04 28.67 28.07 27.11 25.77 23.91 21.48 18.36 14.82 1.25 0.35 0.00

Required Capital

Capital Flow (29.89) (7.51) 11.83 3.83 3.32 3.90 4.18 4.79 5.30 5.62 6.06 6.85 3.39 3.00 3.82 4.28 5.57 6.70 8.26 8.02 16.66 3.70 0.40

After-tax Statutory Book Prot 9.77 10.70 3.83 3.74 4.43 4.78 5.28 5.67 5.93 6.13 6.61 3.03 2.39 2.86 2.93 3.71 4.27 5.15 4.48 3.09 2.80 0.05

Statutory ROE 32.68% 38.72 14.47 14.11 16.44 17.43 18.83 19.85 20.52 20.98 22.56 10.42 8.33 10.20 10.82 14.38 17.85 23.97 24.37 20.84 224.92 14.27

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

49.81 43.19 38.46 35.42 33.18 31.38 29.94 28.59 27.35 26.35 25.31 24.16 23.11 22.12 21.12 20.17 19.33 18.48 17.63 16.89 0.00 0.00

2.47 5.43 6.10 7.38 8.57 9.58 10.44 11.11 11.60 11.91 12.07 11.96 11.89 11.70 11.26 10.53 9.41 7.89 5.88 3.53 0.58 0.13

10

Policy Year Paid Benets GAAP Expense 47.85 11.01 10.08 9.47 8.97 8.60 8.29 8.00 7.72 7.49 6.61 6.38 6.16 5.92 5.65 5.32 5.02 4.67 4.44 4.29 0.04 0.02 (32.88) 2.13 1.81 1.63 1.52 1.44 1.38 1.34 1.30 1.29 1.93 1.91 1.90 1.89 1.88 1.88 1.89 1.90 1.91 1.94 0.00 0.00 6.40 7.61 6.88 6.93 6.97 7.02 7.05 7.02 6.94 6.83 6.64 6.39 6.35 6.33 6.24 5.98 5.57 4.94 4.27 3.65 0.22 0.06 2.24 2.66 2.41 2.42 2.44 2.46 2.47 2.46 2.43 2.39 2.33 2.24 2.22 2.22 2.18 2.09 1.95 1.73 1.50 1.28 0.08 0.02 4.16 4.94 4.47 4.50 4.53 4.56 4.58 4.57 4.51 4.44 4.32 4.16 4.12 4.11 4.06 3.88 3.62 3.21 2.78 2.37 0.14 0.04 29.19 53.15 73.18 90.36 105.30 118.10 128.78 137.30 143.58 147.60 149.18 147.93 143.63 136.07 125.00 110.34 91.95 69.63 42.69 10.82 3.07 0.00 0.87 1.62 2.29 2.89 3.40 3.85 4.21 4.50 4.71 4.84 4.88 4.84 4.70 4.46 4.11 3.61 2.97 2.18 1.25 0.20 0.06 0.00 Change in DAC 1.71 3.91 5.75 7.59 9.35 11.10 12.97 14.83 16.71 18.63 20.61 22.68 24.90 27.24 29.68 32.18 34.64 37.18 39.83 42.42 8.07 3.13 29.19 23.95 20.04 17.18 14.94 12.81 10.68 8.52 6.28 4.02 1.59 (1.25) (4.30) (7.56) (11.08) (14.66) (18.39) (22.32) (26.94) (31.87) (7.75) (3.07)

Premium Income

Change in GAAP Benet Reserves Pre-tax GAAP Book Prot GAAP Federal Income Tax After-tax GAAP Book Prot

Deferred Tax Reserves 4.70 (0.69) (2.01) (2.83) (3.60) (4.18) (4.71) (5.17) (5.54) (5.84) (6.39) (6.68) (6.02) (4.62) (3.23) (2.31) (1.86) (2.18) (2.55) (2.62) (0.01) 0.00

Deferred Acquisition Costs (32.88) (30.75) (28.93) (27.30) (25.79) (24.35) (22.97) (21.63) (20.33) (19.04) (17.11) (15.20) (13.30) (11.41) (9.52) (7.64) (5.75) (3.85) (1.94) 0.00 0.00 0.00

GAAP Equity 29.89 41.55 34.67 35.31 36.49 37.12 37.50 37.30 36.57 35.46 33.84 31.30 32.06 33.19 33.49 33.27 31.59 28.51 23.46 18.21 3.92 0.36 0.00

GAAP ROE 13.92% 11.90 12.89 12.75 12.41 12.29 12.22 12.24 12.33 12.52 12.76 13.28 12.86 12.40 12.11 11.68 11.46 11.25 11.84 13.01 3.57 11.31

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

49.81 43.19 38.46 35.42 33.18 31.38 29.94 28.59 27.35 26.35 25.31 24.16 23.11 22.12 21.12 20.17 19.33 18.48 17.63 16.89 0.00 0.00

2.47 5.43 6.10 7.38 8.57 9.58 10.44 11.11 11.60 11.91 12.07 11.96 11.89 11.70 11.26 10.53 9.41 7.89 5.88 3.53 0.58 0.13

BRIDGING

THE

AND

IRR

11

Table 3 Present Value of Capital Flow Using IRR, GAAP ROEs, and Statutory ROEs

(1) Policy Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 Capital Flow (29.89) (7.51) 11.83 3.83 3.32 3.90 4.18 4.79 5.30 5.62 6.06 6.85 3.39 3.00 3.82 4.28 5.57 6.70 8.26 8.02 16.66 3.70 0.40 (2) IRR 12.534% 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 12.534 (3) Discount Factors 1.00000 0.88862 0.78964 0.70169 0.62353 0.55408 0.49236 0.43752 0.38879 0.34549 0.30700 0.27281 0.24242 0.21542 0.19143 0.17010 0.15116 0.13432 0.11936 0.10607 0.09425 0.08375 0.07442 Total (4) Discounted Capital Flow 29.8880 6.6692 9.3400 2.6860 2.0696 2.1637 2.0587 2.0941 2.0592 1.9414 1.8600 1.8698 0.8229 0.6456 0.7307 0.7277 0.8414 0.8999 0.9859 0.8509 1.5703 0.3096 0.0300 0.0000 (5) GAAP ROE 13.919% 11.900 12.893 12.748 12.411 12.295 12.224 12.240 12.331 12.519 12.761 13.278 12.864 12.397 12.112 11.676 11.461 11.254 11.838 13.015 3.570 11.315 (6) Discount Factors 1.00000 0.87782 0.78447 0.69487 0.61631 0.54826 0.48823 0.43505 0.38761 0.34506 0.30667 0.27197 0.24009 0.21272 0.18926 0.16881 0.15117 0.13562 0.12190 0.10900 0.09645 0.09312 0.08366 Total (7) Discounted Capital Flow 29.8880 6.5882 9.2788 2.6600 2.0457 2.1410 2.0414 2.0823 2.0529 1.9390 1.8580 1.8640 0.8149 0.6375 0.7224 0.7222 0.8414 0.9086 1.0069 0.8744 1.6069 0.3442 0.0337 0.0000 (8) Statutory ROE 32.681% 38.723 14.471 14.107 16.439 17.432 18.825 19.853 20.524 20.978 22.563 10.417 8.334 10.201 10.816 14.385 17.848 23.971 24.374 20.838 224.923 14.267 (9) Discount Factors 1.00000 1.48546 1.07081 0.93544 0.81979 0.70405 0.59954 0.50455 0.42098 0.34929 0.28872 0.23557 0.21335 0.19693 0.17870 0.16126 0.14098 0.11963 0.09650 0.07759 0.06421 0.01976 0.01729 Total (10) Discounted Capital Flow 29.8880 11.1487 12.6657 3.5808 2.7211 2.7493 2.5068 2.4150 2.2296 1.9628 1.7492 1.6145 0.7242 0.5902 0.6821 0.6899 0.7847 0.8014 0.7971 0.6224 1.0698 0.0730 0.0070 0.0000

(1) IRR Discount Factors 0.88862 0.78964 0.70169 0.62353 0.55408 0.49236 0.43752 0.38879 0.34549 0.30700 0.27281 0.24242 0.21542 0.19143 0.17010 0.15116 0.13432 0.11936 0.10607 0.09425 0.08375 0.07442 Total P.V. Ratio (2) Discounted A-tax GAAP Book Prot 3.697 3.905 3.137 2.807 2.510 2.247 2.006 1.775 1.558 1.363 1.178 1.008 0.889 0.788 0.690 0.587 0.486 0.383 0.294 0.223 0.012 0.003 31.543 (2)/(3) (3) Discounted GAAP Equity (BOY) 26.559 32.812 24.327 22.018 20.221 18.276 16.408 14.501 12.634 10.886 9.231 7.588 6.907 6.354 5.697 5.029 4.243 3.403 2.488 1.716 0.328 0.027 251.652 12.53% (4) Discounted Atax Statutory Book Prot 8.680 8.447 2.690 2.331 2.452 2.355 2.310 2.203 2.050 1.882 1.803 0.733 0.515 0.548 0.499 0.560 0.573 0.614 0.475 0.291 0.235 0.004 24.890 (4)/(5) (5) Discounted Required Capital (BOY) 26.559 21.814 18.591 16.524 14.916 13.511 12.270 11.095 9.986 8.970 7.990 7.041 6.177 5.373 4.612 3.895 3.211 2.563 1.948 1.397 0.104 0.026 198.574 12.53%

Policy Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

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