European embedded value

European Embedded Value (EEV) is a financial measure used in the insurance industry, particularly by companies in Europe, to estimate the value of an insurance company's future profit streams from its current book of life insurance policies. The EEV methodology aims to provide a more accurate and comprehensive assessment of an insurance company's financial situation by incorporating the value of future profits from existing policies in addition to the current net asset value.

Overview

The concept of Embedded Value (EV) is crucial in understanding the financial valuation of insurance companies, especially those involved in life insurance. Traditional accounting methods may not fully capture the future profits that these companies expect to generate from their existing policy portfolios. The EV approach, and more specifically the EEV standard, addresses this by including the present value of future profits in the company's valuation.

Calculation

The calculation of EEV involves several key components:

• Net Asset Value (NAV): This represents the current value of the company's assets minus its liabilities.
• Value of In-Force Business (VIF): This is the present value of expected future profits from existing policies, after accounting for the cost of capital and other risks.
• Cost of Capital: The EEV takes into account the cost of holding capital to support the underwriting of policies and the risks associated with the insurance business.

The formula for EEV can be simplified as: \[ \text{EEV} = \text{NAV} + \text{VIF} - \text{Cost of Capital} \]

Importance

The EEV provides several benefits over traditional accounting measures:

• It offers a more comprehensive view of an insurance company's financial health by including the value of future profits.
• It allows for better comparison between companies by standardizing the valuation of future profits.
• It helps investors and analysts understand the underlying value and risk profile of insurance companies.

Criticism

Despite its advantages, the EEV methodology has faced criticism:

• The calculation involves a number of assumptions and estimates, particularly regarding future interest rates, mortality rates, and other variables, which can introduce uncertainty.
• Different companies may apply the methodology in slightly different ways, potentially affecting comparability.

Conclusion

European Embedded Value is a significant measure for evaluating the financial strength and future profitability of life insurance companies. While it offers a more detailed view than traditional financial metrics, it is important to understand the assumptions and limitations involved in its calculation.