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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 261by capital releases to maintain an appropriate level of capital tosupport the ongoing business of the company.After-tax operating earnings usually constitute changes incapital during a period other than capital infusions or distributions.For property/casualty insurance companies, however,there are gains and losses in surplus due to “below the line”adjustments 7 that do not flow through statutory earnings. Capitalchanges associated with the change in unrealized capital gainsor losses, the change in nonadmitted assets, the change in statutoryreinsurance penalties, the change in foreign exchange adjustment,and the change in deferred income tax must be consideredalong with after-tax operating earnings when evaluatingfree cash flows. For the valuation formulas discussed throughoutthis paper, after-tax operating earnings include these directcharges and credits to statutory surplus.A company creates value for its shareholders only when itearns a rate of return on invested capital (ROIC) that exceedsits cost of capital or hurdle rate. ROIC and the proportion ofafter-tax operating earnings that the company invests for growthdrive free cash flow, which in turn drives value. For some industries,regulatory or statutory restrictions create an additionalconsideration that limits dividendable free cash flow.The DCF value of the business is often projected as two separatecomponents: (i) the value of an explicit forecast period, and(ii) the value of all years subsequent to the explicit forecast period(the “terminal value”). Projections for the forecast period, whichis usually five to 10 years, 8 typically include detailed annualearnings projections that reflect revenue projections, loss and7 “Below the line” refers to the Underwriting and Investment Exhibit in the statutoryAnnual Statement prescribed by the NAIC. Direct charges and credits to surplus areshown below the line for Net Income, which is the starting point for regular taxableincome.8 Five to 10 years is typical because beyond that period it is usually too speculative toproject detailed financials. A long-term earnings growth rate and a corresponding capitalgrowth rate are selected to derive value beyond the forecast period.