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

260 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES2. Current net worth 4 plus the discounted value of futureearnings less cost of capital.The first method corresponds to DCF methodology. The secondmethod is also discussed by Miccolis [17] and in other actuarialliterature asANW + PVFE ¡ COC,whereANW = adjusted net worth (statutory capital and surpluswith a series of modifications);PVFE = present value (PV) of future earnings attributableto in-force business and new business; andCOC = cost of capital.= PV of [(hurdle rate £ required starting capitalfor each period) — (investment earnings on capitalexcluded from future earnings)]. 5This second method is a form of the EVA model, in whichPVFE ¡ COC equals the present value of expected excess returns.2.1. Discounted Cash FlowA company’s value may be determined by discounting freecash flows to the equity owners of the company 6 at the costof equity, or the hurdle rate. Free cash flow is often definedas the after-tax operating earnings of the company, decreasedby earnings that will be retained in the company, or increased4 Throughout this paper, we use the terms capital, equity, net worth, and surplusinterchangeably.5 If future earnings include investment income on capital, the cost of capital calculationwill be modified to be equal to the present value of (hurdle rate £ starting capital eachperiod).6 Free cash flows are released in the form of dividends or other capital releases to theequity owners.