What Is Embedded Value in Insurance and How Is It Calculated?

Embedded value (EV) is a key financial metric that helps insurance companies assess long-term profitability beyond what is reflected in their financial statements. Investors, analysts, and executives use EV to estimate future income from existing policies, offering a clearer picture of an insurer’s financial health and strategic direction.

Purpose in Insurance Valuation

Embedded value provides a more comprehensive measure of an insurance company’s worth than traditional accounting methods, which focus on tangible assets and short-term earnings. Since insurers generate revenue from long-term policies, EV accounts for future expected earnings, making it a valuable tool for strategic planning.

Regulators and industry standards recognize EV as an important financial reporting metric. In many jurisdictions, insurers must disclose EV calculations to improve transparency. The European Insurance and Occupational Pensions Authority (EIOPA) and International Financial Reporting Standards (IFRS 17) have influenced reporting methods, promoting consistency. These standards help prevent companies from overstating profitability or understating liabilities, ensuring accuracy.

Beyond compliance, insurers use EV internally to evaluate product line profitability, assess underwriting decisions, and determine market expansion or exit strategies. If a life insurance policy consistently generates strong EV, a company may allocate more resources to similar products. Conversely, a declining EV in a product line may indicate the need for pricing adjustments or a shift in strategy.

Key Calculation Factors

Embedded value is calculated by determining the present value of future profits from existing policies while accounting for capital costs and risk adjustments. This ensures EV reflects both expected earnings and financial obligations.

Present Value of Future Profits

A major component of EV is the projected earnings from current policies, discounted to present value using a rate that accounts for time value and risk.

The calculation starts with estimating future cash flows, including premium income, investment returns, and policyholder benefits. Expenses such as claims payouts, administrative costs, and taxes are deducted to determine net cash flows. These amounts are then discounted using a rate that typically aligns with the insurer’s weighted average cost of capital (WACC) or a risk-adjusted rate. For example, if an insurer expects $100 million in net cash flows over the next decade and applies a 6% discount rate, the present value of those earnings will be lower due to discounting.

Regulatory frameworks like Solvency II in Europe require insurers to use market-consistent assumptions in their projections. This means estimates must be based on observable market data rather than internal forecasts, ensuring reliability.

Cost of Capital

Insurers must hold sufficient capital to meet regulatory requirements and cover future claims, and the cost of maintaining this capital reduces EV.

The cost of capital is determined by applying an expected return rate to the required capital level. For instance, if an insurer must hold $500 million in capital and investors expect a 7% return, the annual cost of capital is $35 million. This amount is deducted from the present value of future profits to arrive at the final EV.

Different jurisdictions impose varying capital requirements. Under Solvency II, European insurers must maintain a Solvency Capital Requirement (SCR) to withstand financial shocks, while the U.S. Risk-Based Capital (RBC) framework sets similar thresholds. These regulations impact how much capital insurers must hold and how much of their future earnings are offset by capital costs.

Adjustments for Risk

Since insurance involves uncertainty, EV calculations must account for risks that could affect future profitability, such as policyholder behavior, economic conditions, and regulatory changes.

One common adjustment is a risk margin, which reflects the additional return investors require to compensate for uncertainty. This margin is often calculated using a cost-of-capital approach, where higher risk leads to a greater reduction in EV. An insurer operating in a volatile market with fluctuating interest rates may apply a higher discount rate to future profits to reflect increased uncertainty.

Lapse rates, which measure the likelihood of policyholders canceling coverage before maturity, also impact EV. Higher-than-expected lapse rates reduce future profits, lowering EV. Insurers use historical data and actuarial models to estimate lapse rates, ensuring calculations reflect realistic policyholder behavior.

By incorporating these risk adjustments, EV provides a more accurate representation of an insurer’s financial position, helping stakeholders make informed decisions.

Use in Investor Communications

Embedded value is a key metric in how insurers present their financial position to investors, offering insights into long-term profitability that traditional accounting metrics may not capture. Since insurers generate revenue from policies that span decades, short-term earnings reports often fail to reflect the full economic value of the business.

Publicly traded insurers frequently include EV analyses in investor disclosures, breaking down how it has changed over time due to factors such as new business growth, changes in actuarial assumptions, or market conditions. If an insurer reports a year-over-year increase in EV due to higher policy retention rates, investors may interpret this as a sign of strong customer loyalty and stable future cash flows.

EV is also discussed in investor roadshows and earnings calls, where executives use it to justify strategic decisions. If a company is expanding into new markets or acquiring another insurer, management may highlight how the transaction is expected to enhance EV. Analysts scrutinize these projections, comparing them to industry benchmarks or historical trends to assess whether the company’s assumptions are reasonable.

EV helps investors differentiate between insurers focused on long-term policyholder value versus those prioritizing short-term profitability. Some insurers may report strong quarterly earnings but have declining EV, signaling weakening future earnings potential. Conversely, a company with modest current profits but steadily increasing EV may be reinvesting in high-value policies that will generate substantial returns over time. This distinction is particularly relevant for institutional investors, such as pension funds and asset managers, who prioritize long-term stability.

Influence on Capital Management

Embedded value influences how insurers allocate capital, guiding decisions on dividend policies, reinvestment strategies, and asset allocation.

Firms with strong EV growth often have greater flexibility in distributing surplus capital to shareholders through dividends or share buybacks, as they can demonstrate that future earnings will replenish reserves. Conversely, if EV stagnates or declines, insurers may need to retain more earnings to strengthen their financial position.

Capital efficiency is another area where EV plays a role, particularly in optimizing asset allocation. Insurers invest policyholder premiums in a mix of fixed-income securities, equities, and alternative assets, and EV analysis helps determine which investments contribute most effectively to long-term profitability. Life insurers with a significant portion of long-term policies may favor bonds with matching durations to minimize reinvestment risk and stabilize future earnings. If EV calculations reveal that certain asset classes are not generating expected returns, companies may adjust their portfolios accordingly.

Regulatory capital requirements also intersect with EV considerations, as insurers must ensure they meet solvency thresholds while maintaining profitability. In jurisdictions governed by risk-based capital frameworks, such as Solvency II in Europe or the NAIC’s RBC system in the U.S., insurers must hold sufficient capital to absorb potential losses. If EV models indicate that certain product lines are capital-intensive while delivering low returns, companies may restructure offerings or adjust pricing to improve efficiency. Some insurers even use EV as a benchmark when evaluating reinsurance strategies, ceding risk on high-capital products to free up resources for more profitable segments.

Interpretation in Mergers and Acquisitions

Embedded value plays a significant role in mergers and acquisitions (M&A) within the insurance industry, helping both buyers and sellers assess the financial attractiveness of a potential transaction. Since insurers derive much of their value from long-term policy obligations, traditional valuation methods such as price-to-earnings (P/E) ratios or book value may not fully capture an insurer’s profitability. EV provides a more comprehensive metric by incorporating expected future earnings from in-force policies.

During due diligence, prospective buyers analyze EV to assess whether the target’s policies generate sufficient returns relative to the capital required to support them. If an insurer has a high EV but a low market valuation, it may present an attractive acquisition opportunity. Conversely, if EV is declining due to unfavorable policyholder behavior or regulatory changes, buyers may demand a lower purchase price or reconsider the deal.

Insurers also use EV to evaluate potential synergies in a merger, such as cost savings from operational efficiencies or increased pricing power in key markets. If a life insurer acquires a competitor with a strong annuity business, EV calculations help determine how the combined entity’s profitability will evolve over time.