Classroom 2: Embedded Value (EV)

Embedded Value (EV)

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.

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

It is a common valuation measure used outside North America, particularly in the insurance industry.

The present value of future profits considers the potential profits that shareholders will receive in the future, while adjusted net asset value considers the funds belonging to shareholders that have been accumulated in the past.

Drawbacks of EV:

As per Investopedia, Embedded value is a conservative valuation method, as it excludes certain aspects of goodwill from its calculation of a company's worth. Goodwill includes intangible assets that increase the value of a company beyond its assets minus liabilities, such as strong management, good location and a happy workforce. Furthermore, to add to its conservatism, the EV calculation of a firm does not allow for any increase in future business.

EV in insurance:

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.

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.

European Embedded Value (EEV) and Embedded Value (EV):

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