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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 271² Investment income return on capital is 4% per annum.² The hurdle rate is 15% per annum.² Capital is determined based on a premium-to-capital ratio of2:1.² Total earnings are identified separately as investment incomeon capital and earnings from insurance operations. 15² The investment income on the capital component equals theproduct of the investment income rate and the capital at thebeginning of the year.² The insurance operation earnings component is a percentageof premiums earned for the year. Premium-related earningsencompass underwriting profits and investment earnings associatedwith all noncapital assets.For projection scenarios in which the hurdle rate is exactlyachieved, earnings are 5.5% of the earned premium. 16 For projectionscenarios in which the hurdle rate is not achieved, earningsare 5% of the premium. When earnings exceed the hurdlerate requirement, this percentage is 6%.We compiled projection scenarios using two time horizons.First, we estimated the company’s value using a 10-year forecastperiod. We also estimated the continuing value using thepresent value of earnings beyond 10 years using the same modelassumptions.This time horizon is important in valuing an actual company.The 10-year forecast period value will be based on detailed financialprojections by line of business as shown in Appendix A.The terminal value will be based on the simplified assumptions15 A number of judgments regarding asset allocation and tax allocation must be made todo this in practice.16 That is, 5.5%=15% hurdle rate less 4% investment income on capital, yielding 11%,which is divided by the premium-to-surplus ratio of 2.