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

266 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESTo evaluate the ROIC an estimate of after-tax income earnedby the firm in each period is needed. Again, the accounting measureof operating income has to be considered. For an insurancecompany valuation, this component represents the projection offuture statutory earnings of the insurance entity, modified in considerationof initial valuation adjustments made to statutory capital,and inclusive of all direct charges and credits to statutorysurplus. These earnings will include the runoff of the existingbalance sheet assets and liabilities along with the earnings contributionsfrom new and renewal business written. This componentmay also include investment income on the capital base. 12The earnings will reflect a specific growth rate (which couldbe positive, flat, or negative) that must also be reflected in growthin capital needed to support the business. The ROIC representsthe after-tax operating earnings in each period (including any“below the line” changes to capital during the period) as a ratioto the starting capital for the period.The third and final component needed to estimate the EVA isthe hurdle rate. Considerations in the determination of the hurdlerate are discussed in Section 4.For the EVA model, “excess returns” are represented by theexcess of (i) the operating earnings in each period over (ii) theproduct of the starting capital for each period and the hurdlerate. 13 Recall that a company has value in excess of its investedcapital only when ROIC exceeds the hurdle rate for the company.Therefore, a company has positive “excess returns” in a periodonly when the after-tax operating earnings for that period exceedthe product of the hurdle rate and the required capital at thebeginning of the period.12 If investment income on the capital base is excluded from earnings, the cost of capitalcalculation will be modified accordingly. This is discussed further in Section 3.13 If operating earnings exclude investment income on capital, then the investment incomeon capital will be subtracted from term (ii).