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

280 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESTABLE 6Valuation Results WhenEarnings on Operations = 0:0%and Total Earnings = 4:0% (Investment Only) andEarnings and Capital Are Growing @ 3% Per Annum10-Year Forecast Terminal In PerpetuityModel Period Value (Total)DCF 5.57 2.77 8.33EVA(a) 38.78 (30.45) 8.33EVA(b) 38.78 (30.45) 8.333.9. Comparison of EVA(a) and EVA(b)We present two versions of the EVA model: EVA(a) andEVA(b). The EVA(a) version defines excess earnings as the differencein after-tax operating income and the cost of investedcapital. After-tax operating income is recognized for the companyas a whole; the amount is not segregated into investmentversus operational earnings. Likewise, the cost of capital relieson the product of the “full” hurdle rate and the amount of capital.The EVA(b) model formula defines earnings and cost of capitaldifferently. The EVA(b) model formula does not include investmentearnings related to the capital as earnings. In the contextof a property/casualty insurer, earnings are only underwritingearnings from premium written and investment income onassets supporting the liabilities ensuing from writing insurancepolicies. Under EVA(b), earnings are lower, but so is the cost ofcapital. The cost of capital is the hurdle rate less the investmentincome rate the company will earn on its capital–in a sense, theshortfall in investment earnings relative to the hurdle rate.From the basic valuation examples presented in this section,the two forms of the EVA produce identical results. EVA(a) followsfrom financial valuation fundamentals [15]. EVA(b) is oftenregarded as the “actuarial valuation method.” Sturgis [20]