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

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.