Embedded Value and Listing
Origins of Embedded Value
The embedded value methodology was devised and developed in the nineteen eighties, mainly in Anglo-Saxon countries. The reason for such development was the increasing demand from shareholders and investors for more accurate and reliable information about the value generated by life insurance companies.
Traditional accounting is not forward looking and does not allow answering key questions such as:
- How much value is locked up in the company?
- How sensitive is the value to changes in key assumptions?
Embedded Value (EV) is not a metric that is in vogue in Indian stock markets, thanks to the non-existence of insurance companies in stock exchanges. The recent deals in the life insurance industry valued insurers at several times the embedded value. The valuation of Star Union Dai-ichi was close to four times the embedded value while Reliance Life was at three times. All eyes are now on the valuation of the HDFC Life and Max Life merger.
What is EV?
Embedded value is an estimate of insurance companies’ net assets and income expected from the policy in force. It is the present value of future profits and the net asset value — the difference between the total assets and liabilities of an insurer. It is measured by adding net assets. It is an actuarial term used to value insurance companies.
Embedded Value is calculated as follows:
EV = PVFP + ANAV
EV = Embedded Value
PVFP = present value of future profits
ANAV = adjusted net asset value
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.
Also Read:What is Solvency II?
Why embedded value?
It is used to measure life insurance business, as life insurance policies are long-term contracts, where policyholders pay premiums to be covered against any risk in the future. For insurers, future income is the premium paid by policyholders.
Companies have to pay claims to policyholders in the future at specified times. The value may change with the assumptions used in the calculations. There are various methods of reaching the embedded value, like the European Embedded Value method, the market consistent embedded value or cost of capital method by taking different parameters.
What is EV used for?
EV (or more specifically, analysis of EV) is used as a performance measurement metric. Internal uses of EV include justification for stock prices, incentive compensation of senior executives, analysis of product/line of business profitability and capital allocation.
External uses of EV include evaluation of mergers or acquisitions, estimates of available capital and comparison of companies across reporting jurisdictions. External parties such as investment analysts or rating agencies might estimate the EV of a company or a business sector in order to assist in their evaluations of company performance or financial strength.
What type of business is usually covered by EV?
EV is typically used by life insurance companies. In particular, it is used with long-term business such as life insurance and annuities. As a practical matter, certain short-term business may be excluded because the EV associated with such business may be immaterial.
Why is the value of an insurance company more than the embedded value?
As embedded value does not take into account the future sales and brand value while arriving at the valuation, there is a multiple paid on the EV. Multiple is paid on the brand, distribution strength and growth opportunities, among other factors.
What is the required EV for insurance companies to list in India?
Life insurance companies are required to have an EV of twice the share capital to be able to list on stock market. While removing the profitability requirement, the regulator mandated that companies must have EV twice the share capital to list its shares on the bourses.