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.
Embedded value, also known as market consistent embedded value (MCEV), 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 is generally considered a conservative estimate of value because it does not factor in the value of potential new policies the life insurance company may sell.
The current value of future profits captures projected future profits from in-force policies. Net asset value of capital and surplus are the funds belonging to shareholders that have accumulated in the past.
- Embedded value is a recognized method for the measurement of the shareholder value of life insurance companies.
- 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.
- EV is a commonly used metric in Europe, but is less common in the U.S.
How Embedded Value Works
Embedded value is a standard valuation metric for European life insurers. Regulatory authorities don't require insurance companies to report this metric, but it has become an industry norm for an insurer to track EV components and to try to increase the value of the company.
The formula for embedded value is:
Embedded Value (EV) = Present Value of Future Profits (PVFP) + Adjusted Net Asset Value (ANAV)
With this standard, analysts can make comparisons across the life insurance 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 use EV, but some companies track and report it internally.
The embedded value methodology adopted by insurance companies is based on a bottom-up market consistent approach to allow 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 market prices.
Where markets have limited data availability, the valuation is based on historical averages. Embedded value excludes any value from future new business. Instead, it is split between shareholders’ net assets and value of business in-force, or the total amount of paid-up policies an insurer carries.
Example of Embedded Value
Manulife Financial is one example of a life insurance company that tracks and reports its embedded value. As of Dec. 31, 2021, Manulife's EV was $64.8 billion, or $33.35 per share, up $3.7 billion from a year prior.
Manulife reported that it generated New Business Value (NBV) of $2,243 million in 2021, up $441 million or 31% from 2020. It's NBV margin increased to 39.2% in 2021, up from 33.8% in 2020. The company states that it's management uses the change in EV as a measure of the value created by its operations during that reporting period.
What's embedded value of an insurance company?
EV is used by life insurance companies outside of North America to estimate the consolidated value of shareholders' interest in an insurance company. It's 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.
Why do insurance companies measure embedded value?
Analysts use EV to make comparisons across the life insurance sector. EV can serve as a performance metric, a basis for M&A deals, and the basis for executive compensation plans. Very few North American firms currently use EV, but some industry consultants track it internally.
What is the difference between embedded value and enterprise value?
Embedded value is a metric used by life insurance companies, primarily in Europe. It is used to estimate the shareholders' interest in the company. Enterprise value, on the other hand, can be used across sectors, not just by life insurance companies.
The Bottom Line
Embedded value, while not commonly used in the U.S., is a useful indicator of the shareholder's interest in life insurance companies. This metric, calculated by adding the value of future profits to the net asset value of the company's capital and surplus, can be used to compare one company's shareholder interest to another, among other uses, including internal analysis.