Valuation of A Life Insurance Business

Valuation of A Life Insurance Business
March 12, 2018 ARM Life

Life Insurance is a unique business.

Unlike many other businesses and even Non-life insurance where value is measured using one or several of the familiar metrics in investment analysis such as net asset value, price-to-earnings ratio and profitability, an indispensable tool for ascertaining the true value of a life insurance business is Embedded Value.

Generally, insurance business is about the underwriting of short to long tailed liabilities in return for a fractional charge (Premium) today. In other words, the business model accepts to carry risks, few of which will crystalise in the future with resultant multiples in the liability relative to the premiums received much early on.

The challenge posed therefore to many investment analysts in the valuation of the insurance business is that while the company under reference could be seemingly doing well today according to universally accepted valuation tools, how do you advise a potential investor in the insurance business of the soundness of the investment desire when it is almost certain that some of the risks for which premium has been received could result into losses and in some cases, near catastrophic losses to the business after the investment decision has been made?

Embedded Value is the inherent and innate value in the business of Life Insurance. It is a measure of the distributable profits to shareholders and/or the cost of capital in the insurance business.

This tool has gained prominence across the World in the measure of the ‘real’ performance of a Life Insurance business. To appreciate this concept, we will look at how profits emerge in every insurance business.

Profit in the insurance business is the aggregation of both the Underwriting Performance of the business and the Investment Income. The Underwriting Performance is the measure of the performance of the core business and the Investment Income is the outcome of its investment activities which is driven by the Shareholders’ Funds (Equity + Insurance Funds + Premium). Embedded Value is a tool which has the ability to determine the long term profitability of a Life Insurance company. It is the summation of the valuation of the current in-force value of the existing and active policies of the company and the value of its free capital.

Earlier, we mentioned about the measure of profits in the insurance business. This is arrived at using the following formula: (Premiums (P) + Investment Income (I)) – (Claims (C) + Expenses (E) + Change in Statutory Actuarial Reserve (+ Tax (T)) 2 ARM Life Plc is licensed and regulated by the National Insurance Commission of Nigeria (NAICOM) to underwrite Life, Annuity and Health insurance.

Embedded Value could be calculated using either the Profits to Shareholders Method or Cost of Capital Method Whereas the former calculates the distributable profits to the shareholders within a calendar period and then takes the present value of those profits, the latter quantifies the cost of capital at the end of a period.

Embedded Value is also a useful tool in setting the compensation of the senior management of a company. Being the decision makers, it could be useful to align their management decisions and career horizon to the long-term goals and objectives of the company. This can be achieved by tying the impact of those decisions to the impact on the embedded value of the Life insurance company.

There should also be a correlation between the stock market valuation of a Life Insurance company and its embedded value. This tool is highly useful in identifying potential bargains in the stock market valuation/pricing of insurance company stocks. Furthermore, the embedded value tool is also applicable and highly effective in actuarial appraisal. This is the inclusion of potential future new sales in the valuation of a life insurance company for the purpose of determining a fair and accurate acquisition value of a life insurance business.

The embedded value is another tool that can be used by investment managers and financial advisors in the valuation of a life insurance asset in addition to other tools such as price-to-earnings ratio, return on equity and net asset value. Before you make that decision to acquire a life insurance company or indeed advise a client to invest in one, you must amongst other factors take cognisance of this tool and its outcome by leveraging the services of actuaries and skilled investment managers/financial advisors.

“Kindly note that the above article is not intended for advisory or consultancy purposes and therefore it cannot be represented as legal or professional opinion of ARM Life or its employees. We advise that you seek professional counsel in this regard.

For professional advice on Life Insurance please contact:

ARM Life Plc. Head office: No. 8 Kasumu Ekemode, Off Saka Tinubu, Victoria Island Lagos

019035888-9

[email protected]

www.armlife.com.ng