Valuing Life Insurance.
Why traditional P/E ratios fail when assessing life insurance companies
An eager investor looks at a life insurance company writing thousands of new policies daily. The premiums are rolling in, and the cash registers are ringing. Yet, when he opens the profit and loss statement to calculate the P/E ratio, he finds the numbers don't make sense. He is looking at a black box.
Traditional P/E ratios fail for life insurers. When you buy a car or soap, the company makes the sale, registers the cost, and books the profit immediately. But in life insurance, a customer pays a premium today, while the claim might occur decades later. A company that looks highly profitable today might be sitting on massive future losses, or vice versa.
To understand a life insurer's true worth, we use Embedded Value (EV). EV represents the current value of the insurer, combining its net assets with the present value of future profits expected from policies already sold. Think of it as the liquidation value of the company plus the value of the business already on the books.
When a company sells a new policy, it generates new business. We measure this using Value of New Business (VNB). This represents the present value of future profits expected from new policies sold in a year. The VNB Margin is calculated by dividing VNB by the Annualized Premium Equivalent (APE). It tells us the profitability rate of this new business. It shows how many rupees of future profit are created for every hundred rupees of standardized premium collected.
The Gold Jewellery Rule
When you buy gold jewellery, the price is not just the raw gold weight. You pay for the gold rate and the making charges. Similarly, the value of a life insurance company is its Embedded Value—the gold already in the vault. Added to this is the Value of New Business, representing the making charges or premium value of new designs it can sell. You cannot judge the shop's worth solely by the daily footfall without knowing the gold rate and what margins they make on each necklace.
Why this matters
When you buy shares of a life insurance company, you are buying a long-term contract of trust. If you rely only on simple premium growth or standard P/E ratios, you might buy a company that is rapidly selling unprofitable policies. By tracking Embedded Value and VNB Margins, you can see if the management is creating real value or just chasing empty volume.
Where people go wrong
- Equating premium growth with profitabilityA company can grow its premiums rapidly by selling low-margin savings products. However, this does not necessarily translate to a higher Value of New Business.
- Comparing Embedded Value directly to book valueEmbedded Value accounts for future policy profits using actuarial assumptions, whereas traditional book value only records historical accounting assets.
- Ignoring the VNB Margin during product shiftsDifferent insurance products have vastly different margins. Failing to track the VNB margin prevents you from seeing if the product mix is becoming less profitable.
P/E ratios fail because insurance premiums are collected today but policy claims are paid decades in the future.
Embedded Value represents the insurer's total current value, combining net assets and projected future policy profits.
VNB Margin indicates the profitability rate of new policies, calculated by dividing VNB by annualized premiums.
Investors default to familiar metrics like P/E ratios because analyzing complex actuarial assumptions feels too unintuitive.