Embedded value

The Embedded Value (EV) of a life insurance company is the present value of future profits plus adjusted net asset value. It is a construct from the field of actuarial science which allows insurance companies to be valued.

Background

Life insurance policies are long-term contracts, where the policyholder pays a premium to be covered against a possible future event (such as the death of the policyholder).

Future income for the insurer consists of premiums paid by policyholders whilst future outgo comprises claims paid to policyholders as well as various expenses. The difference represents future profit.

For companies, the net asset value is usually calculated at book value. This needs to be adjusted to market values for EV purposes.

Value of the insurer

EV measures the value of the insurer by adding today's value of the existing business (i.e. future profits) to the market value of net assets (i.e. accumulated past profits).

It is a conservative measure of the insurer's value in the sense that it only considers future profits from existing policies and so ignores the possibility that the insurer may sell new policies in future. It also excludes goodwill. As a result the insurer is worth more than its EV.

Formula

Embedded Value is calculated as follows:

EV = PVFP + ANAV

where

EV = Embedded Value

PVFP = present value of future profits

ANAV = adjusted net asset value

Improvements

European Embedded Value (EEV) is a variation of EV which was set up by the CFO Forum which allows for a more formalised method of choosing the parameters and doing the calculations, to enable greater transparency and comparability.

Market Consistent Embedded Value is a more generalised methodology, of which EEV is one example.

In its second Life Insurance CFO Survey in 2008, Towers Perrin’s Tillinghast insurance consulting business explored different measures of embedded value (EV).The survey found that use of EV methodologies like traditional embedded value(TEV), European embedded value (EEV)and market-consistent embedded value(MCEV) is becoming more widespread among North American life insurance companies. Companies recognize that these are leading measures of value creation, and they are using them to better manage their business. However, some limitations to extending the use of these measures still need to be overcome. Finally, developments around EEV and MCEV in Europe are expected to have an impact on North American companies, and the preponderance of CFOs believe MCEV will be a useful metric.

References

• Embedded value definition from Investopedia
• European Embedded Value Principles and Market Consistent Embedded Value (MCEV) Principles
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