Embedded Value and Insurance Valuation

Ordinary accounting statements value an insurance company poorly, because a life insurance policy sold this year might not pay out its full profit for decades, and standard accrual accounting doesn't cleanly capture the value of that long-tail future profit stream sitting on the books today. Embedded value was developed specifically to fix this for life insurers.

Embedded value has two pieces. The first is net asset value: the company's assets minus liabilities, valued at market prices, roughly the same idea as ordinary book value. The second is the value of in-force business: the present value of all future profits expected from policies already sold, discounted back to today at a rate that accounts for the risk that actual experience (mortality, lapses, investment returns) differs from assumptions. Adding the two together gives a single number meant to represent what the insurer is actually worth, capturing value that a plain balance sheet leaves out entirely.

Worked example. A life insurer's balance sheet shows net assets of $4 billion. Actuaries separately estimate that its existing book of in-force life insurance policies will generate $3 billion of profit over the coming decades, in present-value terms after discounting for risk. The insurer's embedded value is $4bn + $3bn = $7 billion — a figure analysts compare to the company's market capitalization to judge whether the stock trades above or below the value locked into business already written.