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

270 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESture in whichExcess returns = after-tax operating income¡ (hurdle rate £ capital invested):The second form, EVA(b), will use the following definition:Excess returns = after-tax earnings on insurance operationsexcluding investment income on capital¡ [(hurdle rate ¡ average investment ratefor capital) £ capital invested]:Excess returns for EVA(a) and EVA(b) are equivalent in theory.However, while EVA(b) is discussed in actuarial literatureon company valuation [20], there are a number of advantages tousing the EVA(a) model in practice. The advantages, previouslydisclosed, are these:1. The earnings projections will be more in line with historicalearnings so one can review the reasonableness ofthe projections relative to past experience.2. It is not necessary to allocate assets between capital andliabilities.3. It is not necessary to allocate taxes, tax carryforwards,and other factors between investment earnings on capitaland all other earnings.3.2. Basic Model AssumptionsWe will use the following assumptions to demonstrate thebasic calculations for the DCF and EVA models applied to aproperty/casualty insurer.² The capital at time 0, just prior to projected year 1, is $100.For a property/casualty insurance company, this amount is thesurplus.² Expected growth rate values of g =0%andg =3%wereused.