How to calculate embedded value
Embedded value (EV) is a metric used to measure the true worth of an insurance company by considering both its present and future profits. It offers a clearer understanding of the insurer’s financial situation, helping investors make informed decisions. This article will guide you through the process of calculating embedded value and shed light on its significance in insurance valuation.
Step 1: Determine Net Asset Value (NAV)
Before you begin calculating embedded value, start with the net asset value (NAV) – the insurer’s net worth based on tangible assets. Calculate NAV by subtracting the company’s total liabilities from its total assets.
NAV = Total Assets – Total Liabilities
Step 2: Calculate Adjusted Net Worth (ANW)
Once you have determined the NAV, move on to the adjusted net worth (ANW). ANW includes both current shareholders’ equity and adjustments for any surplus capital which may be needed in the upcoming years.
ANW = Shareholders’ Equity + Surplus Capital Adjustments
Step 3: Estimate Present Value of Future Profits (PVFP)
Now that you have calculated ANW, proceed to estimate the present value of future profits (PVFP). This step requires actuarial expertise, as it involves estimating future cash flows and discounting them back to their present value under various assumptions.
PVFP = ∑ [Future Profits × Discount Factor]
Step 4: Calculate Cost of Capital at Risk (CoC)
Next, determine the cost of capital at risk (CoC). This cost signifies the funds mandated by regulators to back future liabilities. You can calculate CoC using the following formula:
CoC = Present Value of Capital Required × Cost of Capital Rate
Step 5: Compute Embedded Value
Now that you’ve calculated all necessary components, combine them in this manner to obtain the final Embedded Value:
Embedded Value = Adjusted Net Worth + Present Value of Future Profits – Cost of Capital at Risk
Calculating embedded value can be a complex task requiring actuarial expertise and deep knowledge of insurance valuation. However, understanding the core components and following a systematic approach can make the process easier. Measuring the embedded value is essential for insurers, investors, and regulators to gauge a company’s true worth and uncover potential avenues for growth. Keep in mind that assumptions and estimations play a significant role in the calculation, so it’s crucial to remain vigilant against possible inaccuracies.