Embedded Value of a Life Insurer
Statutory profit hides what a life insurer's policies are worth. Embedded value is how the industry shows it.
A life policy earns its profit over many years, but statutory reserving is prudent and defers that profit, and statutory earnings can be distorted by new business strain. So one year's statutory profit is a poor guide to what a life insurer's book of policies is worth.
Embedded value (EV) is the answer the industry built. It measures the value of the shareholders' interest in a life insurer's business. EV reporting began in the UK in the 1980s, because the accounting standards of the time were poorly equipped for life insurance. IC-26 covers it under "Innovative Concepts in Financial Reporting".
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The Building Blocks
Every EV method shares two components: adjusted net worth and the value of in-force business.
- Adjusted net worth (ANW)
- The shareholders' net assets, including free surplus and required capital. Roughly what shareholders would get back if all assets were sold and all liabilities settled today.
- Free surplus
- The market value of capital allocated to, but not required to support, the in-force covered business (EEV Principle 4).
- Required capital
- Assets over and above liabilities whose distribution to shareholders is restricted. EV must allow for the cost of holding it (EEV Principle 5).
- Value of in-force business (VIF)
- The discounted future distributable earnings from policies in force at the valuation date. The Watson Wyatt paper also calls it PVFP, the present value of future profits.
- Covered business
- The business EV reporting applies to: typically long-term life, accident and health, and group risk. There is no standard for applying EV to general insurance.
EV, Appraisal Value and What Each Includes
Embedded value
Made of
ANW (free surplus + required capital) + VIF
Future new business?
Excluded
Appraisal value
Made of
EV + value of future new business (goodwill) + any control premium
Future new business?
Included
| Measure | Made of | Future new business? |
|---|---|---|
| Embedded value | ANW (free surplus + required capital) + VIF | Excluded |
| Appraisal value | EV + value of future new business (goodwill) + any control premium | Included |
Statutory Profit vs EV Profit
The difference between statutory profit and EV profit is mainly one of timing, not of the final amount. Total profit on a contract is the same either way; what changes is when it is recognised and so its present value. Statutory reserving defers profit, while EV is more realistic and shows it sooner.
The movement in EV from one year to the next is the EV profit, which the source likens to economic value added. Goodwill in an appraisal value is usually worked out as a multiple of one year's new business value.
What EV and Appraisal Value Are Used For
| Embedded value | Appraisal value |
|---|---|
| Profit reporting in published accounts | Merger or sale of an insurer |
| Internal management accounts and business unit management | Demutualisation |
| Incentive schemes | Stock market flotation |
| Financial planning | Fair share price of a listed insurer |
| Comparing companies | Shadow share price of an unlisted insurer |
Cost of Capital, Options and Guarantees
- check_circleTime value of options and guarantees (TVOG): in Traditional EV it is only implicit, inside a risk-adjusted discount rate. In MCEV it is a mandatory market-consistent calculation using stochastic models.
- check_circleDoing TVOG properly needs stochastic models and economic scenario generator software, which lengthens reporting timelines.
- check_circleCost of capital in EEV is mandatory: required capital held at the valuation date less the present value of its projected releases.
- check_circleIn MCEV the cost of capital is split into frictional cost of capital (FCoC) and the cost of residual non-hedgeable risks (CRNHR). Swapping these two is a likely trap.
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Discount Rates Under Each Method
| Method | Discount rate |
|---|---|
| Traditional EV (TEV) | Subjective; usually one rate: a risk-free rate plus a margin, or the portfolio return plus a margin |
| European EV (EEV) | Top-down (one curve for all cash flows) or bottom-up (risk-free plus a risk margin per cash flow) |
| Market Consistent EV (MCEV) | Bottom-up only, typically on swap rates; government bond rates stand in where swaps are illiquid |
| Indian EV (IEV) | Risk-free rate with an explicit CRNHR allowance |
How EV Rules Developed
- 1
1980s, UK: Traditional EV
Deterministic methods that loaded the cost of options, guarantees, mismatch, credit risk and capital into one risk discount rate.
- 2
2004: EEV principles
The European Insurance CFO Forum's principles standardised definitions, calculations and disclosures, making insurers more comparable.
- 3
2008: MCEV principles
Market-consistent valuation of assets, liabilities and financial risks became mandatory, with more specific disclosures. The plan to make MCEV mandatory for members from 2012 was withdrawn in 2011, pending Solvency II and IFRS developments.
- 4
2013, India: APS10 and IEV
The Institute of Actuaries of India published APS10, "Determination of the Embedded Value". It draws on MCEV and sets minimum disclosures for life insurers seeking an IPO.
Indian Embedded Value (IEV)
IEV is described as "MCEV+": MCEV with extra requirements.
- check_circleProductivity gains and expense efficiencies after the valuation date must not be counted.
- check_circleThere is a materiality limit, set by the Board, which MCEV lacks.
- check_circleThere are data audit requirements.
- check_circleMany sensitivity disclosures and a detailed analysis of movement are required.
- check_circleCost of guarantees needs stochastic methods and explicit disclosure.
- check_circleAPS10 applies to actuaries reviewing or reporting EV for a life insurer's IPO, and the EV forms part of the prospectus. For voluntary disclosure unrelated to an IPO, an insurer may use any EV method.
Analysis of Movement and Sensitivities
EEV guidance requires an analysis of the movement in EV over the period, and the CFO Forum set minimum sensitivities in 2005.
- check_circleMovement drivers: unwind of the risk discount rate, new sales, experience variances, assumption changes, capital injections and dividends.
- check_circleEconomic sensitivities: risk discount rate down 100 bp, interest rates down 100 bp, equity and property values down 10%.
- check_circleNon-economic sensitivities: maintenance expenses down 10%, lapse rates down 10%, mortality and morbidity down 5%.
- check_circleEV operating profit (EVOP) margin is EV operating profit divided by opening EV. Analysts ask what EVOP margin is sustainable, and the same question of value of new business (VNB) margin, which has its own page.
The Other Concept in This Chapter
The source pack covers Ind AS 117 alongside EV under "innovative concepts", and says the syllabus does not specify which one it means. Ind AS 117's contractual service margin and measurement models are on the accounting standards page linked below.
Exam Traps
EV excludes future new business; appraisal value adds it as goodwill. Free surplus and required capital sit inside ANW, not VIF. EEV is 2004, MCEV is 2008, APS10 is 2013. MCEV uses bottom-up discounting only; TEV uses one subjective rate. Frictional cost of capital and CRNHR are different things. IEV bars post-valuation productivity gains and adds a Board-set materiality limit. Statutory and EV profit differ in timing, not in total.
FAQs
What is embedded value in life insurance?expand_more
A measure of the value of shareholders' interest in a life insurer: adjusted net worth (free surplus plus required capital) plus the value of in-force business, the discounted future profits from policies already written.
Why do life insurers report embedded value?expand_more
Statutory reserving is prudent and defers profit, and new business strain can depress reported profit. EV shows the value locked into existing policies sooner.
What is the difference between embedded value and appraisal value?expand_more
Appraisal value is EV plus the value of future new business (goodwill) and any control premium. EV ignores future new business.
What is Indian Embedded Value?expand_more
The method set by the Institute of Actuaries of India's APS10 (2013). It draws on MCEV, adds requirements such as a Board-set materiality limit and data audit, and sets minimum disclosures for insurers seeking an IPO.
What drives the change in EV from one year to the next?expand_more
Unwind of the discount rate, new sales, experience variances, assumption changes, capital injections and dividends. The change is the EV profit.
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