What Is Embedded Value?
Embedded value (EV) is a common valuation measure used mainly by life insurance companies outside of North America to estimate the consolidated value of shareholders' interest in an insurance company. It is calculated by adding the present value of future profits of a firm to the net asset value (NAV) of the firm's capital and surplus. It sometimes known as market consistent embedded value (MCEV).
The present value of future profits captures projected future profits from in-force policies, while net asset value of capital and surplus represents the funds belonging to shareholders that have been accumulated in the past.
- Embedded value is a recognized method for the measurement of the value life insurance companies outside of North America.
- Asset and liability cash flows are valued using risk discount rates consistent with those applied to similar cash flows in capital markets.
- Insurance policy options and guarantees are valued using market consistent models calibrated to observable market prices
Understanding Embedded Value
Embedded value is a standard valuation metric for European life insurers. It is not mandated by the regulatory authorities there, but it has become an industry norm for an insurer to track EV components and manage them to increase the value of the company. With this established standard analysts can study the numbers and make comparisons across the sector. EV serves as a performance metric, a basis for M&A deals, and the basis for executive compensation plans. Very few North American firms currently utilize EV, but some industry consultants believe they can benefit from tracking and reporting it, at least internally.
The embedded value methodology adopted by insurance companies is based on a bottom-up market consistent approach to allow explicitly for market risk. In particular, asset and liability cash flows are valued using risk discount rates consistent with those applied to similar cash flows in capital markets, and options and guarantees are valued using market consistent models calibrated to observable market prices. Where markets exhibit a limited data availability, the valuation is based on historical averages. Embedded value excludes any value from future new business. Embedded value is split between shareholders’ net assets and value of business in-force.
See details in next two sections.
Importance of Embedded Value
As an example of the importance of embedded value to European insurers, one can look at Zurich Insurance Group's annual reports on embedded value. For instance, the 40-page report for 2018[cite] contains an executive summary, an analysis of embedded value earnings and value of business in-force, sensitivities, reconciliation of shareholders' equity to embedded value, the regional analysis of embedded value, methodology, assumptions, a statement by directors and an auditor's report on embedded value.