PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

258 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESmerger, acquisition, and divestiture activity, although the needfor valuation arises from other sources. An insurance companyvaluation might be prepared for lending institutions or ratingagencies. It might be performed as part of a taxable liquidationof an insurance company, reflecting the value of existing insurancepolicies in force. A valuation might also be prepared forthe corporate management of insurance companies in order toprovide the clearest picture of value and changes in value of thecompany over a given time period.The assumptions underlying the valuation, and therefore thecomputed value, may differ for different uses. 1 As such, the purposeof the valuation and the source of the assumptions shouldbe clearly identified.Before discussing valuation methodologies, we introducesome basic principles.1. The value of any business has two determining factors:(a) The future earnings stream generated by a company’sassets and liabilities, and(b) The risk of the stream of earnings. This risk is reflectedin the cost to the entity of acquiring capital,measured by the investors’ required rate of return(i.e., the “hurdle rate”).2. For a given level of future risk, the greater the expectedprofits, 2 the greater the value of the business.3. For a given level of future profitability, the greater thevolatility (and therefore the higher the hurdle rate), thelower the value of the business.1 For example, in an acquisition, the purchaser may be able to lower expenses, grow abusiness faster because of the purchaser’s current business, reduce the effective tax rate,or reduce the cost of capital for the acquired or target entity. These assumptions wouldserve to increase the value of the target entity. These same assumptions may not be validfor valuing the target entity as a stand-alone business unit.2 Expected profits refer to the present value of the expected earnings stream.