There is an intrinsic problem in respect to statutory accounting in the sense that companies writing profitable new business tend to show bad statutory returns as a consequence of the new business strain, the effect that the commissions paid are higher than the premium received. Obviously, statutory accounting misses some part in the value, namely the future gains. The aim of the embedded value accounting is to include future gains in the balance sheet. This is done by recognizing the present value of future profits (PVFP).[1]

The present value of profits in the embedded value calculation is not simply the present value of margins calculated with the reserve methodology, because it would assume that the present value is done using the valuation interest rate. In fact, shareholders require a higher rate of return than the valuation rate, so the present value of profits should be lower than the present value of margins calculated using the valuation rate.

The Appraisal Value of a business is made up of Embedded Value and value of Future business.

The Embedded Value is further divided into two categories; free capital and the value of in-force business. Free capital is the market value of the capital held by the company. Whereas value of in-force business is the assessment of the present value of distributions that will accrue to the shareholders over the future lifetime from all existing policies.

The Value of future business is the assessment of the life business’s ability to generate profits from its organization assets by writing future business.

Due to the long-term nature of the life insurance business, profits are generally expected to emerge gradually over the years. An Appraisal Value takes into account the expected future cash flows and discounts future profits at a suitable rate. It is equal to the sum of the Embedded Value of Business and the Value of Future Business, as at the valuation date.

The Appraisal Value at any date comprises of:

  • the Net Assets of the company as at Valuation Date;
  • the Present Value of Future Profits (after tax) that is expected to emerge from the In-force business net of renewal expenses; and
  • the Present Value of Future Profits emerging from the Future business

Key Assumptions

The Appraisal Value is calculated based on a wide number of assumptions regarding future business volumes, lapse/persistency rates, claim payments, management expenses, taxation etc. It is difficult at this stage to ensure for a newly established life insurance company that the assumptions made would reflect past trends as the portfolio will take some time to mature. The values indicated therefore need to be seen in the light of the assumptions made, as well as sensitivity of the results to the assumptions of business volumes, persistency and expenses.

Volume & Expenses:

The projected expenses are derived from the expenses provided by the company in its business plan and budgets, which can then be broken down for each Line of business. For individual life, we can assume factor approach where the expenses are derived on per policy basis using projected premiums and policy count and then using the per policy factors the total expenses are derived.

Discount Rate:

Discount rate consists of risk free rate required by shareholders in addition to a risk return, depending on the riskiness of the business, is also required. We can use Capital Asset Pricing Methodology CAPM model to derive the base discount rate used for appraisal value analysis i.e. X+Y% p.a., this consist of current risk free rate i.e. X% with a risk premium of Y%.

Key Performance Indicators

The company can have a direct sales force with branch managers as well as relations with banks based on bancassurance. This can help in forecasting policies that will be likely to be sold over the coming years. Seeing trend of new business volumes over the historical past can also provide a guide to future levels of sales.


The Appraisal Value of the company can be categorized into following categories:

  • Value of Inforce Business
  • Free Capital
  • Value of Future Business
  • Embedded Value
  • Appraisal Value                                                                  
  • Embedded Value
  • Free Capital


 The capital of the company is the market value of the company’s net capital and surplus (free capital).

Present Value of Inforce Business

The value of existing business is the present value of profits derived from business in force as of the valuation date projected till the maturity date for each policy. The value is usually calculated and presented using a range of risk discount rates in order to demonstrate sensitivity to the discount rate.

An analysis of the portfolio of in-force business is usually carried out as at the valuation date and determining the “model points” which can be taken to represent the whole portfolio.

The projections of future premiums of the in-force business, claims, reserves, expense provisions etc. are done using realistic assumption about the future experience.

The likely expense over run over the next few years should also be reflected in these future projections.

Value of Future Business

Future Business should be projected separately for the company’s existing lines of business of Individual Life (Direct Sales Force and Bancassurance separately), Group Family and Group Health.                                                                                                                 

We can project future premiums of the business, claims, reserves, expense provisions etc. using realistic assumptions about the future experience for a decade or so. After a decade or so, a goodwill factor should be applied on future profits.

The Appraisal value is based on the assumption that the projected mix of future business in today’s business plan is representative of the future mix of the new business. Any change in the mix of future business would naturally affect the valuation.

The estimated taxation charge after taking into account the tax losses brought forward from the past should also be reflected.

The individual business can be broken into two segments of Individual Business Acquisition Costs and Individual Business Administration Costs.

In the determination of costs, we can assume that the expenses of the company would be in accordance with different costs for different years of business. This can be carried out to take into account the expense over runs of the company in the initial historic years.

Underwriting expenses would be incurred to judge the medical status of the Participant. The first year expenses would be greater than subsequent year expense and has to be borne by Share Holder fund in case of takaful.


Mortality rates using any reasonably valid and representative mortality table can be used. For Group Life and Group Health the loss ratio can be calculated to gauge loss ratios for the future.

Discount Rate

Interest rates are used to discount future profits in the Appraisal Value. The rate is calculated in a way that it should reflect the long-term, risk free rate plus an estimate of the risk premium expected by investors, for investing into this business.

The economic assumptions refer to all the assumptions related to the economic market. Those are mainly future reinvestment rates on fixed income assets, future returns on variable income assets (such as stocks and real estate), currency exchange rates, default rates, inflation rates and investment expenses.4 Because those assumptions have a high level of correlation, it is very important to ensure consistency in their setting. Interest rates are used to project assets and liabilities as well as to discount future profits in the embedded value (the hurdle rate). The interest rates for assets and liabilities must be consistent for each future projection year. The hurdle rate is a fixed rate consistent with the actual environment at the embedded value calculation date. The hurdle rate must not vary for the projection period because it has to reflect the current rate curve, not the expected rate curve(s) in the future. This rate should reflect the long-term, risk free rate plus an estimate of the risk premium demanded by investors. The hurdle rate may vary according to the country in which the business operates to allow for differences in the risk free rate and the risk premium (as an example, the risk premium may be increased to reflect currency exchange rates). The future return on variable income assets should be consistent with the expected rates on fixed income assets and with the hurdle rate. Therefore, it may be appropriate to assume that the future return on stocks is not higher than the hurdle rate. Setting the future return on stocks equal to the hurdle rate has the advantage of avoiding to create unusual embedded value movement in the future. If the hurdle rate changes we automatically change our return expectation on stocks. For mortgages, a method to reflect the relationship with fixed income returns can be to set a risk premium over fixed income assets and to assume it is constant over time. Regarding the inflation rate, a method can also be developed to have it consistent with the fixed income rates.

Investment Return

A key aspect of the risk discount rate will be the return required by the shareholders on the capital they invest in an Insurance or Takaful company. Discount rates are used to project assets and liabilities as well as to discount future profits in the embedded value. It is the cost of capital employed and therefore reflects the risks inherent in the company.

The discount rate is a fixed rate consistent with the actual environment at the embedded value calculation date.

The idea of fixing the risk discount rate is based on the Capital Asset Pricing Model (CAPM). In practice, it is one of the most widely used models to calculate the discount rate. The CAPM breaks down the rate of return into two parts: the risk-free return plus a risk premium.

There are two concepts underlying the CAPM Model. Firstly, the shareholders are accepting a certain amount of risk by investing in the company instead of a ‘risk-free’ investment. Therefore, they require an additional return, on top of the risk free return, to compensate for the added risk. This added return is dependent on some measure of the risks inherent in the company and the price of that risk.

Secondly, a well-diversified portfolio of shares cancels out the risks of investing in individual shares and leaves only the unavoidable risks of investing in the stock exchange.

The question can then be asked as to how risky a particular company’s shares are compared with the diversified portfolio. The result of the CAPM is that the proper risk premium for any particular share is in proportion to its Beta.

This concept is shown by the equation below:

Where ‘r’ is the risk-free rate of return,  

Em is the expected return of the market as a whole and

 Bi is the measure of the systematic risk of the company.

The Beta factor can be thought of as a measure of the riskiness of the asset relative to the market as a whole. The beta identifies the systematic risk, or the market risk, of the asset. This factor is calculated by comparing the returns on the company over a period of time to the returns of the market as a whole over the same period of time.

This method is highly dependent on the period of time over which the returns have been observed. The share price data over the last three to five years should be considered.  One way of improving the estimate is to use an industry beta based on a group of similar companies. For this purpose four companies were selected to represent the industry should be insurance/takaful companies with similar structure as the company in question.

These companies should have the similar business risks as they are engaged in the similar activities.

Historical data from relevant stock exchanges and LIBOR rates (risk free rates) should be evaluated in a time series for 3 to 5 years. The problem in these long term time series will be discrete jumps such as market crash and market boom distorting the overall average of the interest rates to be used for the exercise. Time series decomposition should be applied as well as GARCH models which allows volatility to be non-constant and hence produce more accurate estimates.


Future expense inflation can be assumed to be in the vicinity of long term interest rates risk free Government bonds of term to maturity of 10 to 15 years. This is because there is a revolving and circular economic relationship between inflation and interest rates.

For products with reviewable administration charges, the charges should be assumed to increase with inflation in line with current practice.


The tax rate should be the one specified in the taxation regulations of the relevant country. In case of takaful, the tax of the company should be on shareholders’ fund only as the other funds belong to participants.

We understand that companies can defer its provision for tax for some years, but tax deferred cannot be used as a benefit as actuarial appraisal is a prudent exercise.

Equity Injection/ Dividend Payout

Equity injections, dividend payouts, repurchasing shares and many other capital management practices and historical experience should be considered in this exercise as well. For instance, if capital adequacy is following a decreasing trend, it is likely that in the future when the situation becomes uncomfortable that capital injection will be required.

The products for a life insurance company can be:

  • Individual-direct sales force
  • Marriage saving plan
  • Savings plan
  • Education plan
  • Supplementary benefits or riders such as: waiver of contribution, personal accident, permanent total disability, family income benefit
  • Individual plans-bancassurance
  • Group life
  • Group health
  • Critical illness
  • Others 

In conclusion, It is important to keep in mind that the embedded value must be used carefully, always having in mind the assumptions underlying the calculation. With its advantages and disadvantages, the embedded value is a portion of a whole and it must be taken this way. This is another tool for the investment community, which in addition to price to book value, rate of return on equity, earning by source and price to earnings ratio, adds value to a company.

[1] Embedded Value Calculation for a life insurance company- Frederic Tremblay