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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 265This formula represents the required capital at the valuationdate (time = 0) plus the present value of future economic profits.Economic profits for time period x are defined as after-taxoperating earnings (OE x ) reduced by the cost of capital, whichis the product of the hurdle rate and the required capital at thebeginning of each period (h £ C x ).To calculate EVA, we need three basic inputs:1. The level of capital needed for each period to support theinvestment, both initial capital invested and additionalcapital to support growth.2. The actual rate of return earned on the invested capitalfor each period, that is, ROIC.3. The selected hurdle rate.These are the same inputs required for the DCF model.To determine initial capital invested, we start with the bookvalue of a company. The book value of an insurance company isan amount that reflects the accounting decisions made over timeon how to depreciate assets, whether reserves are discounted, andconservatism in estimating unrecoverable reinsurance, amongother factors. As such, the book value of the company may bemodified in the valuation formula to adjust for some of the accountinginfluence on assets and liabilities.In valuing an insurance company, the initial capital invested isrepresented by the statutory capital and surplus 11 at the valuationdate, modified with a series of adjustments discussed later inthis paper. The surplus after modifications is often referred to asadjusted net worth (ANW). The capital needed to support growthis funded by retained earnings for the DCF model and reflectedthrough the cost of capital calculation for the EVA model.11 The reasons for using statutory accounting values instead of generally accepted accountingprinciples (GAAP) or other accounting values are discussed in Section 4.