The embedded value concept and its application in South Africa

Abstract

The purpose of this research report is to review the embedded value concept and to examine its practical use in South Africa. Important recent developments relating to the embedded value concept are discussed and compared with the existing embedded value concept. These developments include fair value accounting, market-consistent embedded value and the European Embedded Value Principle. In the second part of the report, the disclosure of the embedded value information of four major South African life assurance companies is examined. It was found that the market capitalisations of these companies were smaller than their embedded values for most of the period under the investigation. Reasons for this phenomenon are considered and tested against the data available. It was found that the risk discount rates used by some life assurance companies in calculating their embedded values may be too low. It appears that a ‘herding’ tendency exists among South African life assurance companies when selecting risk discount rates for the embedded value calculation. It is suggested that a more market consistent approach for the embedded value calculation and a better disclosure for the embedded value reporting should be considered by life assurance companies in South Africa. This should improve investors’ understanding and confidence in the embedded value disclosed, which in turn should help narrow or eliminate the discount of the market capitalisation to the embedded value observed in the market.