Understanding Embedded Value EV in Financial Terms

Author

Reads 2.9K

Close-up of a calculator on financial documents with graphs and analysis papers.
Credit: pexels.com, Close-up of a calculator on financial documents with graphs and analysis papers.

Embedded value, or EV, is a financial concept that helps investors and analysts understand a company's underlying value. It's calculated by adding the present value of future profits to the company's assets minus its liabilities.

Embedded value is a key metric in the insurance industry, where it's used to determine the value of a life insurance company's assets and liabilities. This is because life insurance companies have a unique business model that involves managing a large pool of assets to pay out future claims.

The embedded value calculation takes into account the present value of future profits, which are the profits that a company expects to make in the future. This is an important consideration because it helps investors understand the company's potential for future growth and profitability.

In the insurance industry, embedded value is often used to determine the value of a company's business operations, rather than its assets alone. This is because the business operations are what drive the company's profits and growth.

Definition

Credit: youtube.com, What is the difference between Embedded Value and Enterprise Value?

Embedded value is a financial metric used in the insurance industry to estimate a company's value.

It provides insight into a company's profitability by considering its net asset value. This is especially useful for insurance firms.

The embedded value considers the present value of future profits, giving a more complete picture of a company's worth.

Key Concepts

Embedded value is a recognized method for measuring the shareholder value of life insurance companies. It's commonly used in Europe but less common in the US.

Embedded value combines three main components: Net Asset Value (NAV), Present Value of Future Profits (PVFP), and Cost of Capital. These components are calculated using a specific formula: Embedded Value = NAV + PVFP - Cost of Capital.

The formula is often expressed as: Embedded Value = Net Asset Value + Present Value of Future Profits - Cost of Capital.

To calculate embedded value, you need to know the company's net asset value, present value of future profits, and cost of capital. For example, if a company has a net asset value of $400 million, future profits amounting to $100 million, and a capital cost of $30 million, the embedded value is calculated as follows: Embedded Value = 400 + 100 - 30 = 470 million.

Credit: youtube.com, What is the difference between Embedded Value and Enterprise Value?

Different firms may use varying discount rates and assumptions, impacting the calculated embedded value.

Here are the key components of embedded value:

  • Net Asset Value (NAV): Represents the value of the company's equity after accounting for all liabilities.
  • Present Value of Future Profits (PVFP): An estimation of profits expected from existing insurance policies, discounted to their present worth.
  • Cost of Capital: Refers to the expense associated with financing new projects, ensuring returns exceed associated risks.

Embedded value is used primarily for calculating tax liabilities and regulatory compliance, and offers insights into long-term profitability and helps forecast financial health.

The embedded value formula can be expressed as: Embedded Value = Equity + Debt - Cash Reserves.

Embedded value serves as an essential tool in evaluating the performance of insurance companies, providing long-term insights into value creation that traditional accounting figures might not capture.

Insurance Company Perspective

From an insurance company's perspective, embedded value (EV) is a crucial metric used to estimate the consolidated value of shareholders' interest in an insurance company outside of North America.

Analysts use EV to make comparisons across the life insurance sector, serving as a performance metric, a basis for M&A deals, and the basis for executive compensation plans.

The EV is calculated by adding the present value of future profits of a firm to the net asset value (NAV) of the firm's capital and surplus.

You might like: Basis Point Value

Credit: youtube.com, What is Embedded Value? | Simplifying Saturday | Aastha Khurana

Some industry consultants track EV internally, while very few North American firms currently use it, but Manulife is one of them, releasing a 2021 Embedded Value Report for their insurance business.

Here's a brief overview of how EV is used by insurance companies:

Manulife's 2021 Embedded Value Report provides a detailed breakdown of their EV, giving insight into how they calculate and use this metric. Actuary.org also provides information on Embedded Value Reporting, highlighting the importance of EV in the insurance industry.

Components and Calculation

Embedded value involves analyzing various components to get a comprehensive picture of a company's potential long-term profitability. Understanding these components is crucial for accurate calculations.

Net Asset Value (NAV) represents a company's equity minus liabilities, accounting for assets and their depreciated value over time. It's essential to account for liabilities when calculating NAV.

The Present Value of Future Profits (PVFP) is an estimation of the profits expected to be realized from current insurance policies, discounted to their present value. This component is vital in evaluating a company's potential future earnings.

Credit: youtube.com, How to value life insurance company? | Embedded value and distance to market cap

Cost of Capital refers to the required return necessary to make a capital project, such as new insurance policies, worthwhile. It's essential in balancing potential gains against investment risks.

Here's a breakdown of the components involved in embedded value calculation:

Components

Embedded value calculation is a fundamental technique in evaluating the worth of an insurance firm. This calculation integrates several financial components to provide a picture of the potential long-term profitability and strategic outlook.

The embedded value formula is a valuable tool in assessing the economic worth of an insurance company. It combines several financial elements to provide a comprehensive picture of a company's potential profitability in the long term.

Embedded value comprises three main components: Net Asset Value (NAV), Present Value of Future Profits (PVFP), and Cost of Capital.

Here are the three components in detail:

  • Net Asset Value (NAV): Indicates the company's equity after accounting for liabilities, represented by assets and their depreciation.
  • Present Value of Future Profits (PVFP): Projected profits from existing policies, discounted to present value.
  • Cost of Capital: Required return rate necessary for covering capital investments, blending potential earnings with risks.

To calculate the embedded value, you simply add the NAV and PVFP, then subtract the Cost of Capital. For example, an insurance firm with a NAV of $300 million, expected future profits of $80 million, and capital costs amounting to $20 million would have an embedded value of $360 million.

Accurate predictions of future profits and interest rates are crucial for precise calculations. Companies may use stochastic modeling to assess diverse scenarios, enhancing accuracy.

Example

Credit: youtube.com, Determine the number of components - Definition, formula with five examples

Manulife Financial is an example of a company that tracks and reports its embedded value, which was $64.8 billion as of December 31, 2021.

The company's embedded value per share was $33.35, up from a year prior. This increase in embedded value is a significant indicator of the company's financial health.

Manulife reported a New Business Value (NBV) of $2,243 million in 2021, which is a substantial amount of value created by the company's operations. This is a 31% increase from 2020.

The NBV margin also increased to 39.2% in 2021, up from 33.8% in 2020. This improvement in margin suggests that Manulife's operations are becoming more efficient.

Take a look at this: How to Increase Home Value

Financial Information

Financial information is crucial for understanding the performance and health of a company, especially when it comes to embedded value.

The overview of business results and forecast provides a snapshot of the company's current state and future prospects.

Financial and non-financial highlights offer a concise summary of key metrics, such as revenue growth and customer satisfaction.

Credit: youtube.com, What is Embedded Value (EV)?

Financial statements data, including balance sheets and income statements, offer a detailed look at a company's financial health.

Consolidated solvency margin ratios provide a measure of a company's ability to meet its financial obligations.

Here's a breakdown of the key financial information you might find in a company's report:

  • Overview of Business Results and Forecast
  • Financial and Non-Financial Highlights
  • Financial Statements Data
  • Consolidated Solvency Margin Ratios

Enterprise Value

Enterprise Value is a key concept in the world of Embedded Value. It's essentially the total value of a company, including its debt and cash.

The Enterprise Value can be calculated by adding the company's market capitalization to its total debt and subtracting its cash reserves. This gives a more comprehensive picture of a company's worth than just looking at its market capitalization alone.

In the context of Embedded Value, Enterprise Value is used to determine the present value of future profits. This is because Embedded Value is the value of a company's assets and liabilities, which in turn affects its Enterprise Value.

For example, if a company has a market capitalization of $100 million, $50 million in debt, and $20 million in cash, its Enterprise Value would be $130 million. This is calculated by adding the market capitalization to the debt and subtracting the cash.

If this caught your attention, see: What Is Market Value in Stocks

Frequently Asked Questions

What is the difference between embedded value and enterprise value?

Embedded value is a metric used by life insurance companies in Europe to estimate shareholder interest, whereas enterprise value is a broader metric applicable across sectors to evaluate a company's overall value. Enterprise value provides a more comprehensive picture of a company's worth compared to embedded value.

What is the difference between EEV and traditional EV?

EEV goes beyond traditional EV by considering additional business elements and explicit costs, providing more comprehensive disclosures. This makes EEV a more detailed and accurate way to evaluate an insurance company's performance.

Anne Wiegand

Writer

Anne Wiegand is a seasoned writer with a passion for sharing insightful commentary on the world of finance. With a keen eye for detail and a knack for breaking down complex topics, Anne has established herself as a trusted voice in the industry. Her articles on "Gold Chart" and "Mining Stocks" have been well-received by readers and industry professionals alike, offering a unique perspective on market trends and investment opportunities.

Love What You Read? Stay Updated!

Join our community for insights, tips, and more.