How to look at valuation of life insurance cos

Written by Prakash Praharaj | Updated: Apr 21 2012, 09:29am hrs
The valuation of a company is determined by discounting the future cash flows or by multiplying current earnings with the price/earning multiple. The P/E multiple factors in the growth potential of the industry as well as the company. The valuation of a life insurance company is also estimated on similar lines but the process is complicated due to the long-term contractual nature of the life insurance business and the wide variety and complexity of products. But one tool has the ability to synthesise the information on long-term profitability in one simple value this tool is called the embedded value.

Embedded value versus appraisal value

The valuation of life insurance companies will usually require the use of a valuation method that involves the projection of future cash flows. The embedded value (EV) is a measure of the consolidated value of shareholders interest in the life insurance business. It covers the value of in-force business including the future renewals on them but excludes the future new business, where as appraisal value additionally includes the new business. The appraisal value of a company is the best proxy of the true value of a company. But embedded value is preferred over appraisal value because the growth rate of a company fluctuates year on year and it is extremely difficult to determine the long-term future growth rate of a company with any reasonable degree of confidence. The most popular method of valuation in recent years is to first calculate the embedded value of a company and then apply a multiplier reflecting its growth potential.

Indian embedded value

The Institute of Actuaries of India issued a guidance note on December 17, 2011 on the methodology of arriving at the Indian embedded value (IEV). According to the guidance note, the IEV consists of the value of in-force covered business, the required capital identified to support the business and the free surplus allocated to the covered business.

Value of in-force business

The value of in-force business or covered business is the present value of the amount generated by the in-force policies that will be distributable to the shareholders in the future. Distributable amounts are discounted using the return expected by shareholders on their investment. The present value should be calculated by projecting the premiums expected in each future year, using assumptions and projections. The after-tax profit on in-force business is arrived at by deducting expenses, benefits, change in required capital and tax on income from the total of premium and investment income.

Required capital

Required capital is the amount of assets attributed to the covered business over and above that required to back liabilities for covered business, whose distribution to shareholders is restricted. The level of required capital should meet at least the shareholders portion of the level of solvency capital at which the regulator is empowered to take any action and which cannot be distributed to the shareholders. This is also known as locked-in capital. The required capital should also include amounts needed to meet internal objectives based on an internal risk assessment.

Free surplus

It is determined as the market value of any excess of assets attributed to the business but not backing liabilities over the required capital to support the covered business. The free capital is the capital of the company in excess of the required/locked-in capital at the valuation date. This amount can be distributed to the shareholders.

Adjusted net worth

The sum of the free surplus and required capital is the adjusted net worth. This is the value of all assets allocated to the covered business that are not required to back the liabilities of the covered business.

Assumptions: Economic

Economic assumptions must be internally consistent and should be determined such that projected cash flows are valued in line with the prices of similar cash flows that are traded on the capital market. The factors include inflation, investment rate, discount rate, reference rate for liabilities, etc.

Assumptions: Non-economic

For participating business the method must make assumptions about future bonus rates and the determination of profit allocation between policyholders and shareholders. These assumptions should be made on a basis consistent with the projection assumptions, established company practice and regulatory requirement.

Future expenses

Future expenses such as commissions, renewal expenses and other maintenance expenses should reflect all the expected ongoing expense levels required to manage the in-force business.

The expense assumptions should consider required investment to maintain productivity levels and service levels to meet customer expectations and inflation.


Appropriate allowances should be made in the value of in-force business for premium persistency, lapse and surrender rates, partial withdrawals, policy revivals and renewals based on past evidence and expected future experience.

Mortality & morbidity rates

Appropriate allowance should be made in the value of in-force business for mortality and morbidity rates based on past evidence and expected future experience.

Sensitivity analysis

As required under the guidelines, the actuary should also illustrate the impact different assumptions have on the value of new business and embedded value. This is particularly important if there is limited information based on which the actuary has developed the projection assumptions.

In the recent past, Reliance Life Insurance entered into transaction with Nippon Life Insurance of Japan for selling 26% stake in which the valuation was reportedly arrived at 3.9 times the EV.

Similarly, Max New York Life also entered into a stake sale to Mitsui Sumitomo with valuation reportedly at 3.3 times the EV. The high multiples indicate the growth potential of life insurance business in the days ahead.