Embedded value

You cannot value a life insurer the way you value a factory.

When an insurer sells a 25-year policy, it takes in premiums for years and pays a claim at some uncertain point far in the future. This year's profit tells you almost nothing about the business it has written.

So analysts value the book instead. They take every policy already in force, estimate the future cash flows it will produce, weight those cash flows by how likely they are, and discount the result back to today.

That figure is the embedded value. It is what the existing policies are worth, before a single new policy is sold.

The definition. Section 10.8.4, among the workbook's other valuation ratios: "Price/Embedded value: This metric is specifically used in the case of life insurance business. Embedded value refers to the present value of the expected net future cash flow (adjusted for probability) of a life insurer from the policies that are currently in force. Embedded value is a critical metric for life insurers. Hence analysts prefer to use this ratio."

Unpack the 3 conditions inside that sentence:

1. Present value — future cash flows discounted back to today.
2. Adjusted for probability — not the most likely cash flow, but the cash flow weighted by the chance of it arising. A death benefit is a probability, not a certainty.
3. Policies currently in force — the existing book only. Business the insurer has not yet written is excluded.

Why probability-weighting, not a risk premium. Section 10.3 explains where this sits in the workbook's map of valuation approaches. Cash flow based, or intrinsic, valuation splits into 2 branches. Risk neutral valuation "involves adjusting the cash flows by the probability of realising the cash flow. It is then discounted at risk free rate," and the workbook says directly: "Insurance companies are typically valued using this approach (embedded value and appraisal value)." The other branch, real world valuation, estimates the most likely cash flow and discounts at the risk-free rate plus a risk premium.

So embedded value is a risk neutral valuation, and that is where the "adjusted for probability" phrase comes from. The risk is handled in the numerator, not in the discount rate.

How it is used as a multiple. Price ÷ embedded value, the way price to book value is used for a bank or adjusted book value for an NBFC. Section 10.8.4 groups all 3 as industry-specific answers to the same problem: an earnings multiple that does not describe the business.

On figures. The workbook gives no numbers for embedded value — no worked calculation, no discount rate, no typical multiple range. It names the metric, defines it and places it. Any figure you meet in a question will be supplied by the question.

Illustrative — the workbook provides no worked calculation. A life insurer's existing book is valued policy cohort by policy cohort.

The insurer's market capitalisation is Rs 37,500 crore.

Price / Embedded value = 37,500 ÷ 14,995 = 2.5 times

That 2.5 times is the number an analyst compares across life insurers. And it carries a specific meaning: the market is paying Rs 22,505 crore more than the existing book is worth, which is its price for all the policies the company has not yet sold.

Note what happens if the insurer writes no new business at all next year. Embedded value still runs down as policies mature — but the Rs 22,505 crore of value above it, which rests entirely on future sales, is the part that disappears first.

Section 10.8.4 (Other metrics) defines embedded value as part of the Price/Embedded value ratio, alongside Price/Adjusted book value for NBFCs and EV/Capacity for special situations. Section 10.3 separately classifies insurance valuation as risk neutral valuation, naming embedded value and appraisal value as the 2 approaches used.

The standard question matches the metric to the industry: embedded value for life insurance, adjusted book value for NBFCs, EV/Capacity for a steel plant out of operation or a start-up. A harder question asks which valuation approach insurers are valued under, where the answer is risk neutral valuation — probability-adjusted cash flows discounted at the risk-free rate.

• Embedded value covers policies currently in force only. Value from future new business is not in it — which is exactly why an insurer usually trades above its embedded value.
• Probability adjustment happens in the cash flows, not in the discount rate. That is what makes it a risk neutral valuation. Adding a risk premium to the discount rate as well would double-count the risk.
• It is a life insurance metric. The workbook says "specifically used in the case of life insurance business." Do not reach for it to value a general insurer or a bank.
• Do not confuse embedded value with enterprise value. Both get abbreviated to EV in practice, and the workbook uses EV for enterprise value throughout chapter 10.
• Appraisal value is the workbook's companion term, named in the same breath in 10.3. Embedded value and appraisal value are both listed as insurance valuation approaches, so do not treat them as synonyms for one another.