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The Application Of Fundamental Valuation Principles To Property/Casualty Insurance Companies Derek A. Jones, FCAS Joy A. Schwartzman, FCAS. Valuation Principles. The value of any business has two determining factors: The future earnings stream generated by a company’s assets and liabilities.
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The Application Of Fundamental Valuation Principles To Property/Casualty Insurance CompaniesDerek A. Jones, FCASJoy A. Schwartzman, FCAS
This risk is reflected in the cost to the entity of acquiring capital, measured by the investors’ required rate of return (“hurdle rate”).
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In this case, the logical action would be to liquidate assets.
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Financial Professionals
Value = PV of Future Cash Flows
Where cash flows represent
dividendable earnings or earnings
that can be released to investors
Actuaries
Value = ANW + PV of Future Earnings – COC
Where ANW = adjusted net worth
PV = Present Value
COC = Cost of Capital
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A DCF model discounts free cash flows at the hurdle rate to determine value
An EVA model defines
Value = Initial capital invested
+
PV of “Excess returns”
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Methodology
common, the two methodologies yield
identical results.
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a) it is released
or
b)it generates operating earnings
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In summary inputs to compute DCF value are…
DCF Value = Free Capital +
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+ PV “Excess Returns”:
Where excess returns
= after-tax operating earnings
– (hurdle rate x capital invested)
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“ANW” represents Initial Capital
“PVFE – COC” represents excess returns
PVFE = PV [after tax operating earnings]
COC = PV [each period starting capital x hurdle rate]
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For Valuing an Insurance Company…
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Scenario 1A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings = Hurdle Rate
Table 1
Valuation Results
Earnings Growth Rate = 0%
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Scenario 1B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings = Hurdle Rate
Table 2
Valuation Results
Earnings Growth Rate = 3%
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Scenario 2A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings > Hurdle Rate
Table 3
Valuation Results
Earnings Growth Rate = 0%
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Scenario 2B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings > Hurdle Rate
Table 4
Valuation Results
Earnings Growth Rate = 3%
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Scenario 3A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings < Hurdle Rate
Table 5
Valuation Results
Earnings Growth Rate = 0%
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Scenario 3B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings < Hurdle Rate
Table 6
Valuation Results
Earnings Growth Rate = 3%
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