Embedded Value: Definition, Calculation, and Application in the Insurance Sector
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Summary:
Embedded value (EV), also known as market-consistent embedded value (MCEV), is a crucial metric utilized predominantly by life insurance companies outside of North America to assess the consolidated value of shareholders’ interest. This article explores the intricacies of EV, its calculation methodology, significance, and applications within the insurance sector.
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What is embedded value?
Embedded value (EV) is a fundamental valuation measure primarily employed by life insurance companies worldwide, excluding North America. It represents the combined value of shareholders’ interest in an insurance company.
Understanding the components of embedded value
EV is determined by summing the present value of future profits (PVFP) and the adjusted net asset value (ANAV) of the company’s capital and surplus. PVFP encompasses projected future profits from existing policies, while ANAV reflects the accumulated funds belonging to shareholders.
How embedded value operates
Although regulatory bodies do not mandate the reporting of EV, it has become an industry standard for insurers to monitor and enhance their EV components. The formula for calculating EV is straightforward: EV = PVFP + ANAV. It serves as a performance metric, facilitates M&A transactions, and influences executive compensation plans.
Market-consistent approach
Insurance companies adopt a bottom-up market-consistent approach to determine EV. This entails valuing asset and liability cash flows using risk discount rates consistent with those applied in capital markets. Options and guarantees are valued using market-consistent models calibrated to market prices.
Example of embedded value
Manulife Financial serves as an example of a company actively tracking and reporting its embedded value. As of Dec. 31, 2021, Manulife’s EV amounted to $64.8 billion, reflecting its shareholder value. The company attributes changes in EV as a measure of the value created by its operations during the reporting period.
Frequently asked questions
How does embedded value differ from enterprise value?
Embedded value is specific to life insurance companies, primarily in Europe, and estimates shareholders’ interest. Conversely, enterprise value is a broader metric applicable across various sectors, not limited to life insurance companies.
Is embedded value commonly used in North America?
No, embedded value is predominantly utilized by life insurance companies outside of North America. While some North American firms may track EV internally, it is not widely adopted as a standard metric in the region.
Key takeaways
- Embedded value (EV) is a critical metric used by life insurance companies to estimate shareholders’ interest.
- It is calculated by adding the present value of future profits to the net asset value of the company’s capital and surplus.
- EV serves as a performance metric, aids in M&A transactions, and influences executive compensation plans.
- Despite its prevalence in Europe, EV is less commonly used in North America.
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