The market price to embedded value gap: an analysis of European life insurers

Abstract

Embedded value is commonly used by life insurers to measure the realistic valuation of their consolidated shareholders’ interest. Previous studies use market price as a yardstick for measuring the value relevance of embedded value. This study challenges that view by examining the market price to embedded value gap. We explain it by testing the intellectual capital hypothesis and the investor sentiment hypothesis. While the intellectual capital hypothesis asserts that the difference between market price and embedded value is due to the omission of intellectual capital in the calculation of embedded value, the investor sentiment hypothesis asserts that the market price to embedded value gap is driven by the bias of investor sentiment on market price. Drawing on a sample of European public life insurers, we find that insurers with market prices higher than their embedded values have lower future stock returns. Using the Heckman two-stage regression to control for life insurers’ endogenous decision to disclose embedded values, we also find that the market price to embedded value (PEV) ratio is not related to future financial performance, but is negatively associated with our crisis sentiment index in the short term. In addition, the PEV ratio is positively associated with analysts’ overestimation of long-term earnings. Such results support the investor sentiment hypothesis instead of the intellectual capital hypothesis. Our findings provide a better understanding of the gap between embedded value and market price.

Appendix 1 Definitions of variables

Variable	Definition (Codes of Thomson Reuters Datastream items in brackets)
Profitability measures
Net profit margin (%)	$\frac{{{\text{Net}}\;{\text{income}}\left( {{\text{WC01751}}} \right)}}{{{\text{Premium earned }}\left( {{\text{WC}}01002} \right)}} \times 100\%$
Return on assets (%)	$\frac{{\text{Net\;income}}_{\text{t}} \left({\text{WC01751}}\right)}{{\text{Total\;assets}}_{t} \left({\text{WC}}02999\right)+{\text{Total\;assets}}_{t-1} \left({\text{WC}}02999\right) }\times 2\times 100\%$
Return on equity (%)	$\frac{{\text{Net\;income}}_{\text{t}} \left({\text{WC01751}}\right)}{{\text{Book\;value\;of\;equity}}_{t} \left({\text{WC}}03995\right)+{\text{Book\;value\;of\;equity}}_{t-1} \left({\text{WC}}03995\right) }\times 2\times 100\%$
Firm characteristics
Capital asset ratio	The ratio of capital to assets (WC15121)
EV dummy (1/0)	A dummy variable equal to 1 if the insurer discloses embedded value on a group basis and 0 otherwise
Firm size	Logarithm of total assets (WC02999)
Income growth	$\frac{{\text{Net\;income}}_{\text{t}} \left({\text{WC01751}}\right)-{\text{Net\;income}}_{\text{t-1}} \left({\text{WC01751}}\right)}{\left|{Net\;income}_{t-1} \left(WC01751\right)\right|}$
Insurance penetration	The ratio of total premium written in the country to gross domestic product
Liquidity	$\frac{{{\text{Cash}}\;{\text{and}}{\mkern 1mu} {\text{equivalent}}\left( {{\text{WC02005}}} \right)}}{{{\text{Total}}\;{\text{assets}}\left( {{\text{WC02999}}} \right)}}$
Market share	$\frac{{{\text{Premium}}\;{\text{earned}}\left( {{\text{WC01002}}} \right)}}{{{\text{Total}}\;{\text{premium}}\;{\text{written}}\;{\text{in}}\;{\text{the}}\;{\text{country}}}}$
Non-insurance activities	$\frac{{{\text{Total}}\;{\text{liabilities}}\left( {{\text{WC03351}}} \right) - {\text{Insurance}}\;{\text{reserves}}\left( {{\text{WC03030}}} \right)}}{{{\text{Total}}\;{\text{liabilities}}\left( {{\text{WC}}03351} \right)}}$
PEV ratio	$\frac{{{\text{Market}}\;{\text{Value}}\;{\text{of}}\;{\text{Equity}}({\text{MV}})}}{{{\text{Embedded}}\;{\text{value}}}}$
Premium growth	$\frac{{{\text{Premium}}\;{\text{earned}}_{t} \left( {{\text{WC01002}}} \right)}}{{{\text{Premiume}}\;{\text{arned}}_{{t - 1}} \left( {{\text{WC01002}}} \right)}} - 1$
Use of reinsurance	$\frac{{{\text{Reinsurance}}\;{\text{premium}}\left( {{\text{WC01005}}} \right)}}{{{\text{Premium}}\;{\text{earned}}\left( {{\text{WC01002}}} \right)}}$
Determinants of embedded value disclosure
Firm size	Logarithm of total assets (WC02999)
Hostile takeover	Five-year average of $\frac{{{\text{Number}}\;{\text{of}}\;{\text{life}}\;{\text{insurer}}\;{\text{hostile}}\;{\text{take}}\;{\text{overs}}\;{\text{announced}}}}{{{\text{Number}}\;{\text{of}}\;{\text{life}}\;{\text{insurers}}\;{\text{in}}\;{\text{the}}\;{\text{country}}}}$
Product market regulation index	The Product Market Regulation Index developed by the Organisation for Economic Cooperation and Development
Inverse mills ratio	The selection bias correction term to control for the possibility that the insurer’s decision to disclose embedded value is endogenously determined
Crisis sentiment measure
Crisis sentiment index	The first principal component of the search volume for the terms “financial crisis,” “credit crisis,” “bank crisis,” and “subprime crisis” on Google
Analysts’ forecast errors
1-year forecast errors (%)	$\frac{{12{\text{month}}\;{\text{forward}}\;{\text{earnings}}\;{\text{per}}\;{\text{share}}_{t} \left( {{\text{EPS1FD12}}} \right) - 12{\text{month}}\;{\text{trailing}}\;{\text{earnings}}\;{\text{per}}\;{\text{share}}_{{t + 1}} ({\text{EPS}}1{\text{TR}}12)}}{{{\text{Stock}}\;{\text{price}}_{t} \left( P \right)}} \times 100\%$
t-year forecast errors (%) for t ≥ 2	Cumulative 1-year earnings forecast errors in the subsequent t years
Stock returns
Unadjusted return	Raw return of life insurers
Market-adjusted return	We regress the unadjusted returns of life insurers on the returns of the MSCI Europe Index and construct the market-adjusted returns as the residuals of the regression
PB-adjusted return	We regress the unadjusted returns of life insurers on the price to book value ratios and construct the PB-adjusted returns as the residuals of the regression
Size-adjusted return	We regress the unadjusted returns of life insurers on the logarithm of market prices and construct the size-adjusted returns as the residuals of the regression
Market-, PB-, and size-adjusted returns	We regress the unadjusted returns of life insurers on the returns of the MSCI Europe Index, price to book value ratios, and logarithm of market prices and construct the market-, PB-, and size-adjusted returns as the residuals of the regression