Embedded value too subjective, too complex for the average investor

By Martin Beaudry | October 20 2001 07:38PM

It’s become a widely accepted technique for assessing the market value of life insurance companies throughout Europe, and – spurred on by the recent spate of demutualizations – in Canada. But the concept of embedded value is still new to many advisors in Canada’s insurance and investment industries.

In the wake of the demutualization process, hundreds of thousands of insured became co-owners, through share ownership, of these new publicly traded companies.

Looking at their investments - which grew substantially since inception - they now ask their financial advisor the same question: how can I put a fair value on that stock? Is all the value of my company fully reflected in the stock's price?

Companies are using a tool to help investors determine just that: the embedded value (EV). For some, however, that measure is far from helping anybody.

The problem is that embedded value is difficult to calculate. It needs to be recalculated often. It is subject to potential bias according to the strategic goals of any given issuer. Despite it all, however, the Canadian Institute of Actuaries (CIA) suggested in August 2000 that all insurance companies disclose it and that it be calculated according to a given set of guidelines.

"The concept of embedded value is certainly valid, and you can make some exceedingly graceful calculations with it," says Mark Sylvia, Managing Partner with Canadian Insurance Marketing Inc., a company that specializes in business valuations, "but they may be meaningless in the real world."

The EV figures are intended to be used as the basis for more accurate indications of an insurer's fair market value than can be obtained through traditional measurements such as price/ earnings (P/E) ratios and net asset value (NAV) calculations.

Ideally, it allows analysts to get a better sense of the actual value of a company, as opposed to that shown by the book value. Embedded value accounts for additional future payments from current business, whereas book value, a more traditional measure, accounts only for the value of current contracts.

The EV of a company is calculated by adding the present value of future shareholders' after-tax income, the present value of any future changes and in locked-in capital, and any free capital at the evaluation date (see inset).

Tillinghast - Towers Perrin (TTP) principal Stephen Hardwick in Stockholm and TTP consultant Valerie Arabeyre in Milan explained in a study why EV can indeed be more reliable than these traditional formulae when it comes to life insurance company valuations. They acknowledge that, while traditional methods can be very appropriate for valuations of other types of companies, "P/E and NAV ratios ... can, at best, provide only a glimpse of a [life insurance] company's trading range. They are too volatile (both over time and between companies) to rely on, adding little to an understanding of the sector or to market efficiency."

"Unfortunately, the market doesn't always use as scientific a method as EV to set the price of a stock," Mr. Sylvia explains. "Perception, for example, can play a big role. We know of two major Canadian companies right now that are supposed to be taken over in the near future by bigger multinational companies, and that's certainly affected their share prices."

The calculation of EV is also itself not standardized. In assessing the present value of a future stream of receipts from their existing business, insurers use a discount rate to account for inflation and other factors.

This is to allow for the fact that $100 in ten years will not hold the same purchasing value as it does today. The calculation of the discount rate is thereby unique to each company.

"By using a higher discount rate, you get less value, all things equal. But the other problem is that all things are not equal," explains Mike Lombardi, Chair of the CIA's Committee on the Role of Appointed Actuary and consultant to TTP.

"Different companies write different kinds of business, with different risk characteristics. They write in different countries, different currencies... so to get an apples to apples comparison looking just at the discount rate may be a difficult exercise." The result, ultimately, is that insurer self-appraisals can vary not just in results, but also in method.

Brian Lynch, Vice President of Investor Relations at Canada Life, said that the CIA's proposal for insurers to publish their EV values was welcomed by the industry. "I think it's a positive number. If you look at our embedded value of five billion versus our book value of three and change, we're trying to make the point that there's a lot of hidden value on our balance sheet that Canadian GAAP (Generally Accepted Accounting Principles) would not let investors otherwise see."

Another benefit of doing so would be that it might feasibly convince investors to accept higher share prices. "We hope to increase the share price in doing that," said Mr. Lynch. "This company is worth more than its book value."

"As far as investors go, you need so much information and so much technical skill to use this technique that there's no way for the average guy to apply it with any accuracy," Mr. Sylvia says, and concludes with a note of caution when interpreting the results of any EV calculation. "People tend to throw these terms like EV around and they don't always mean the same thing," Mr. Sylvia notes. "You have to keep in mind that they're trying to sell something. So is this a valid concept? Yes. Is this something that most of the planet can use? Absolutely not."

"The economic value added calculation can be a wonderful tool," says Mr. Sylvia, "when you need to use it. If you were considering the acquisition of an insurance company, for example, then these calculations could be very useful, although if you are buying a company you would be taking down all this information anyway."

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