How to calculate embedded value?

When it comes to assessing the financial worth of an insurance company, one of the key metrics used is the embedded value. Embedded value helps determine the intrinsic value of an insurance company’s in-force business and its future profitability. In this article, we will delve into the concept of embedded value, its significance, and the steps involved in calculating it accurately.

Understanding Embedded Value

Embedded value is a financial metric extensively used in the insurance industry to assess the value of a company’s in-force business, which includes both existing policies and the expected future profits from those policies. It provides insights into the long-term worth of an insurer and its ability to generate sustainable profits.

How to calculate embedded value?

Calculating embedded value entails a multi-step process that involves several key components. Here is a step-by-step guide on calculating embedded value:

1. Start with the available financial data: Gather all relevant data, including the company’s annual reports, financial statements, and actuarial reports. These documents provide information on policies, premiums, claims, expenses, investments, and other factors that influence an insurance company’s financial performance.

2. Identify the value components: Break down the company’s embedded value into several components. The most common components include net asset value, adjusted net worth, present value of future profits, and value of future new business.

3. Calculate the net asset value (NAV): Begin by determining the net asset value, which represents the value of the company’s assets minus liabilities. This step involves assessing the market value of all tangible and intangible assets, deducting liabilities, and accounting for any adjustments necessary.

4. Assess the adjusted net worth: Adjusted net worth is the net asset value adjusted for items that are not captured under accounting standards, such as deferred tax assets and contingent liabilities.

5. Determine the present value of future profits (PVFP): Calculate the present value of projected future profit streams based on actuarial assumptions, including expected mortality rates, policy persistency, investment returns, and expense ratios. These assumptions are crucial in determining the profitability and sustainability of the insurer’s business.

6. Evaluate the value of future new business (VNB): Evaluate the expected profitability of new policies written in the current year, based on assumptions similar to those used in determining PVFP. This step helps assess the incremental value generated by new business activities.

7. Consider other components: Depending on the specific circumstances and industry practices, additional components such as risk and solvency capital, adjustments for non-economic assumptions, or time value of options and guarantees may be included.

8. Calculate the embedded value: Once all the components are evaluated, sum them up to determine the embedded value. This value represents the estimated worth of the insurance company’s in-force business.

Frequently Asked Questions (FAQs)

1. What is the importance of embedded value?

Embedded value helps assess an insurance company’s long-term profitability, financial stability, and ability to generate sustainable returns for shareholders.

2. Why is net asset value (NAV) significant?

Net asset value quantifies the company’s tangible and intangible assets and provides a basis for calculating embedded value accurately.

3. How are future profits calculated?

Future profits are estimated by considering actuarial assumptions, such as mortality rates, policy persistency, investment returns, and expense levels.

4. What does the value of future new business indicate?

The value of future new business reflects the incremental value generated by new policies written in the current year.

5. Can embedded value calculations be adjusted based on risk?

Yes, additional components such as risk and solvency capital can be included in the calculation to account for potential risks.

6. How do non-economic assumptions impact embedded value?

Non-economic assumptions, such as changes in regulations or customer behavior, may require adjustments to the embedded value calculations.

7. What is the role of contingencies in adjusted net worth?

Contingencies, such as future legal claims or uncertain liabilities, are considered when calculating adjusted net worth.

8. Are there different methods to calculate embedded value?

Various methodologies exist to calculate embedded value, with some focusing on more specific elements or adapting to industry-specific requirements.

9. Does embedded value consider investment returns?

Yes, embedded value calculations often incorporate the impact of investment returns, taking into account the company’s investment portfolio and expected returns.

10. How frequently is embedded value calculated?

The frequency of embedded value calculations can vary, but it is typically performed annually to provide an updated assessment of an insurance company’s worth.

11. Can embedded value be negative?

Yes, it is possible for embedded value to be negative, indicating that the company’s liabilities outweigh its assets and future expected profits.

12. What other factors influence embedded value?

Factors such as regulatory changes, market trends, technological advancements, and competitive dynamics can impact embedded value calculations over time. Regular reassessments are essential to capture these trends accurately.

In conclusion, calculating embedded value involves a meticulous analysis of various components and assumptions, allowing for a comprehensive evaluation of an insurance company’s worth. This metric aids investors, insurers, and other stakeholders in understanding the business’s financial health and future prospects.

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