Embedded value

Question 1

How do different reserve valuation methods affect embedded value (EV) and profit emergence in life insurance?

Answer 1

• Embedded Value (EV):
  
  • EV = Net Assets + Present Value of Future Profits (PVFP)
  • Represents economic value of in-force life insurance business
  • Best Estimate (BE) Reserves:
  • Negative reserves possible → contract immediately profitable
  • PVFP = 0 at all times (all profit accounted for at inception)
  • Net Assets include full expected profit upfront
  • Profit front-loaded; little or no profit emerges later
  • BE + Margin (e.g., compulsory 5%):
  • Reserves increased → less negative or more conservative
  • PVFP > 0, reflecting profit deferred by margin
  • Profit emerges gradually as margin unwinds over policy term
  • Total EV unchanged; timing of profit shifted to later years
  • Zeroised Reserves:
  • Negative reserves capped at zero → no initial profit recognized
  • PVFP deferred to later periods
  • Profit emerges later (e.g., all deferred profit recognized towards end)
  • Smooths and delays profit recognition; reduces volatility at inception
  • General Principles:
  • Total E(Profit) is same across methods, only timing changes
  • Stronger reserves (margin/zeroisation) → lower initial EV, profit emerges later
  • BE reserves → higher initial EV, profit front-loaded

Actually economic profit isn’t the same because of cost of capital