Chapter 3 Embedded Value and Appraisal Value – Valuation of Indian Life Insurance Companies

CHAPTER 3

Embedded Value and Appraisal Value

Introduction

3.1.In this chapter, I will define two terms—embedded value and ­appraisal value— discuss how they are calculated, and specify their relation to the share price of the company.

What is embedded value?

3.2.Simply put, embedded value is the total value to the shareholders of the business currently on the company’s books. This value is the sum of all the profits the shareholders will earn in the future from the in-force policies discounted to the present date and the value of the extra assets that belong to the shareholders. This calculation makes no allowance for the future business that the company will write and looks at only the policies in the company’s books.

What are the basic differences between the share price of an ordinary company and the embedded value of an insurance company?

3.3.Let us consider a company in the manufacturing industry. The share price of this company is based on the profits the company will earn from the goods that the company will sell in the future. A part of the share price will be the brand value of the company. There are no profits from the goods sold in the past.

3.4.In insurance companies, profits arise in the future from policies sold in the past. The value of these profits, plus the extra assets in the fund, is the embedded value. In these calculations, the policies that will be sold in the future and the profits arising from those policies are not considered at all.

How is embedded value calculated?

3.5.Embedded value is found by projecting the cash flows of all the policies currently in the company’s books into the future and discounting the shareholders’ share of the profits to the present date. To this value of in-force policies, the extra assets in the fund that belong to the shareholders are added, to arrive at the embedded value.

3.6.A lot of assumptions go into this calculation. In simple terms, we have to project each and every item in the Revenue Account and Shareholders’ Non-technical Account into the future, find the profits in each year, and then discount the profits back to the present date. For this exercise, we have to split the profits arising in the future into two groups, the first being the profits from the policies that are on the books already and the second the profits on the new business that the company will write in each future year. For the time being, we will ignore the future new business because the embedded value is the value of the profits of the existing business only.

3.7.We will, therefore, have to estimate, among other things, how many policies will be in force, what is the mortality expected, when and what other decrements (like lapses/surrenders) are expected, what is the interest that the company will earn, and what are the reserves the company will have to hold for these policies. Reserves are the sums companies hold to meet future liabilities. The expenses assumption also forms an important aspect of this projection, and we will assume that the company is open to new business, although the profits from the new business will not be accounted for in this calculation.

3.8.There are basically two methods.

Method 1

3.8.1.One of the methods of calculating embedded value is to use a policy-by-policy approach. This means that we chalk out the cash flows of each and every policy, allowing for mortality, expenses, expected interest to be earned, valuation reserves, surrenders, lapses, taxation, and so on, and then discount the profit of each policy back to the present date. An investor will be unable to do this for many reasons, chief among them being the following:

  1. She does not have the data.
  2. The calculations are very complicated.
  3. She does not know the surrender experience, mortality experience, and so on.
  4. Valuation reserves also have to be calculated.
  5. Volumes are huge.

Method 2

3.8.2.A second method is to use model points. This method first groups the policies into homogenous groups. Each group is represented by sample points, and these sample points are used to roughly estimate the embedded value. This will reduce the volume of the calculations as only representative policies will be used in the calculations. This is again a fairly complicated process and has many of the problems outlined above.

3.9.This only shows that the embedded value calculation is beyond the capabilities of an ordinary investor and that she has to rely on the embedded value quoted in the company’s accounts.

What are the components of the embedded value?

3.10.The embedded value is expressed as the sum of value of in force (VIF) and the adjusted net worth (ANW). In India, it is called as the Indian embedded value or IEV.

IEV = VIF +ANW

3.10.1.VIF is the present value at the valuation date of future profits expected from all the in-force business. The company will first project the future profits and then discount them to the valuation date.

3.10.2. ANW is the balance assets left in the funds that belong to the shareholders.

Where is the embedded value available?

3.11.The embedded value is available in the annual report and accounts along with the VIF and ANW. The change in the embedded value from one year to the next is analyzed and split into various components and presented along with the breakup of the embedded value into ANW and VIF at the beginning and the end of the year.

3.12.Some companies also publish the Embedded Value report, ­although this is not mandatory. Companies have to vet this ­embedded value calculation with an independent actuary but this report is not published. A copy of this report is available in the red herring prospectus. This information, again, is available only for the years after the IPO and not before.

How is the embedded value used?

3.13.The companies simply quote the embedded value, analyze how it has grown over the year, split the growth into its various components, talk about the growth rate, and then leave it at that.

3.14.Although companies quote the total embedded value, they almost never quote the embedded value per share. If they do so, the difference between the share price and the embedded value per share will be immediately obvious and it will also prompt an analyst to ask the next question as to why there is such a huge difference between the two figures. Having said this, you may be wondering if there is some relationship between the embedded value and the share price.

Is there a relationship between the embedded value and share price?

3.15.Because the embedded value is the shareholders’ share of future profits, there is a relationship between the embedded value and the share price. What then is missing in the above equation?

3.16.It is the value of the profits of future new business the company will write. If this is added to the embedded value, this will give the total profits expected from the current as well as future policies. This is called the appraisal value of the company.

Appraisal value = Embedded value + Value of future new business

3.17.We can then arrive at an estimate of the share price by dividing the appraisal value by the number of shares at the valuation date.

Share price = Appraisal value/number of shares

How is appraisal value calculated and where is it available?

3.18.Just by itself, the embedded value calculation is a very complicated one. To this complication, if you add the future new business, with additional sets of assumptions for the future, the results may be very subjective and the effort may not justify the results or the reliability of the calculation.

3.19.Companies also would have a lot of leeway in quoting a very high appraisal value by a very small tweak in the future assumptions. This would become an administrative nightmare for the regulator.

3.20.So, companies do not quote this value in their accounts although they may do these projections internally. The independent actuary’s report also states that it comments only on the embedded value and does not talk about the appraisal value.

3.21.The appraisal value is usually calculated by a rule of thumb used worldwide. It is expressed as a multiple of the embedded value. In Asia, this multiple is generally 2. Higher the multiple, higher is the reliance on the future business, and consequently, more optimistic is the share price.

3.22.One method of calculating the share price is to calculate the embedded value per share and then multiply this by 2. Using this method, the share prices for the three companies are

HDFC Life

Embedded value per share = Embedded value/number of shares in the company.

HDFC LIFE embedded value per share on March 31, 2018

=

15216 / 2,011,740,043 × 10,000,000

=

75.64 per share

Estimated share price

=

2× 75.64 = 151.28

(I have multiplied by 10,000,000 because the embedded value is in crores.)

(For ICICI Pru and SBI Life, I have multiplied by 1 billion because the embedded value is in billions.)

ICICI Pru

ICICI PRU embedded value per share on March 31, 2018

=

187.88 / 1,435,498,710 × 1,000,000,000

=

130.88 per share

Estimated share price

=

2× 130.88 = 261.76

SBI Life

SBI Life embedded value per share on March 31, 2018

=

190.7 /1,000,000,000 × 1,000,000,000

=

190.7 per share

Estimated share price

=

2× 190.7 = 381.4

3.23.It is interesting to see how these figures compare with those in the previous chapter. HDFC Life IPO share price is Rs 275, whereas our calculated appraisal value is Rs 151.28. ICICI Pru’s IPO price is Rs 300 and our calculated appraisal value is Rs 261.76. SBI Life’s IPO share price is Rs 700 and our calculated appraisal value is Rs 381.74. The calculated appraisal value of only ICICI Pru seems reasonably close to the IPO share price.

3.24.The share prices calculated here have inched upward from those calculated in Table 2.4 in the previous chapter but are again very different from the quoted share prices.

3.25.The difference between the appraisal value per share and the share price is then the brand value or goodwill of the company.

What is the current multiple used in the share price?

3.26.The appraisal value multiple implicit in the share price also depends on the buoyancy of the stock market. If the market is in a euphoric state, as it is currently (January 2019), investors usually are in an upbeat mood and will be willing to pay a price that is way above the norm. In the Table 3.1, I have calculated the ­appraisal value multiple as on December 31, 2018.

Table 3.1 Appraisal value multiple

Embedded value per share on March 31, 2018

Closing share price on December 31, 2018

Appraisal value multiple

HDFC Life

75.64

387.55

5.12

ICICI Pru

130.88

323.90

2.47

SBI Life

190.70

596.45

3.13

Share prices are from Bombay Stock Exchange (BSE).

What do the numbers in Table 3.1 mean?

3.27.The appraisal value multiple for HDFC Life is 5.12, which is way above the norm. This means that the brand HDFC Life holds a lot of value and the general public is willing to pay this high price for the brand. The other two are also above the mean value of 2, but the share prices are more reasonable compared with that of HDFC Life.

3.28.There is a timing mismatch between the embedded value per share date and the share price date. Embedded value is available only on financial year end dates in the annual report of the companies. On December 31, 2018, the embedded value will most likely (unless the company operates at a loss) be higher than the one used. This means that the embedded value multiple will be lesser than what is calculated. My guess is that it will not be drastically different from the ones calculated. This table aims to only give us a feel for the multiple, rather than place an exact value.

Conclusion

3.29.The important point to remember is that the investor is paying for business that is currently not in the company’s books, that is, she is paying for the future new business of the company. If the appraisal value is four times the embedded value, 75 percent of the share price reflects future new business and brand value and only 25 percent is for the profits expected from existing business. How each investor views this piece of information depends on how she believes the future will pan out.

3.30.Our next question is, what is the growth rate expected to be achieved in the future for the share price to be justified? In other words, we need some numbers to talk about instead of just future growth. If we assign some numbers to this growth rate, we may be able to judge for ourselves whether this is achievable. For this, we now move on to the next chapter, which puts a value to this growth rate.