European Embedded Value
Encyclopedia
The European Embedded Value (EEV) is an effort by the CFO Forum to standardize the calculation of the Embedded value
. For this purpose the CFO Forum has released guidelines how embedded value
should be calculated.
There is a lot of subjectivity involved in calculating the value of a life insurer. Insurance contracts are long-term contracts, so the value of the company now is dependent on how each of those contracts end up performing. Profit is made if the policyholder doesn't die, for example, and just contributes premiums over many years. Losses are possible for policies where the insured dies soon after signing the contract. And profitability is also affected by whether (and when) a policy might terminate early.
An actuary
calculates an embedded value
by making certain assumptions about life expectancy, persistency, investment conditions, and so on - thus making an estimate of what the company is worth now. But if each person has a different opinion on how things will turn out, you could expect a range of inconsistent estimates of the worth of the company. With this range of approaches, it is very difficult to compare EV calculations between companies.
The CFO Forum was formed to consider in general the issues around measuring the value of insurance companies. The EEV was the output of this forum, and allows greater consistency in the such calculations, making them more useful.
Real-world EEV usually uses a risk discount rate made up of the risk free rate plus a risk margin which reflects the weighted average cost of capital and Beta from the CAPM
model. Using company-level economic models clearly reflects a top-down approach to determining the risk discount rate.
Market-consistent EEV makes use of a bottom-up approach for determining the risk discount rate, which produces a number which equals the risk free rate plus an explicit allowance for operational risk
and market risk
.
Although initially there was an equal use of these two types of EEV, as time passes companies appear to be moving towards the market-consistent approach.
Embedded value
The Embedded Value of a life insurance company is the present value of future profits plus adjusted net asset value. It is a construct from the field of actuarial science which allows insurance companies to be valued.-Background:...
. For this purpose the CFO Forum has released guidelines how embedded value
Embedded value
The Embedded Value of a life insurance company is the present value of future profits plus adjusted net asset value. It is a construct from the field of actuarial science which allows insurance companies to be valued.-Background:...
should be calculated.
There is a lot of subjectivity involved in calculating the value of a life insurer. Insurance contracts are long-term contracts, so the value of the company now is dependent on how each of those contracts end up performing. Profit is made if the policyholder doesn't die, for example, and just contributes premiums over many years. Losses are possible for policies where the insured dies soon after signing the contract. And profitability is also affected by whether (and when) a policy might terminate early.
An actuary
Actuary
An actuary is a business professional who deals with the financial impact of risk and uncertainty. Actuaries provide expert assessments of financial security systems, with a focus on their complexity, their mathematics, and their mechanisms ....
calculates an embedded value
Embedded value
The Embedded Value of a life insurance company is the present value of future profits plus adjusted net asset value. It is a construct from the field of actuarial science which allows insurance companies to be valued.-Background:...
by making certain assumptions about life expectancy, persistency, investment conditions, and so on - thus making an estimate of what the company is worth now. But if each person has a different opinion on how things will turn out, you could expect a range of inconsistent estimates of the worth of the company. With this range of approaches, it is very difficult to compare EV calculations between companies.
The CFO Forum was formed to consider in general the issues around measuring the value of insurance companies. The EEV was the output of this forum, and allows greater consistency in the such calculations, making them more useful.
Types
EEV can be "real world" or "market consistent". The former takes the best estimate for parameters that is available, whereas the latter uses a slightly constrained set of parameters which are close to best estimate, but which produce results which match market-related hedge costs.Real-world EEV usually uses a risk discount rate made up of the risk free rate plus a risk margin which reflects the weighted average cost of capital and Beta from the CAPM
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
model. Using company-level economic models clearly reflects a top-down approach to determining the risk discount rate.
Market-consistent EEV makes use of a bottom-up approach for determining the risk discount rate, which produces a number which equals the risk free rate plus an explicit allowance for operational risk
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
and market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
.
Although initially there was an equal use of these two types of EEV, as time passes companies appear to be moving towards the market-consistent approach.