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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 281describes the economic value of a property/casualty insurancecompany as composed of three parts: (i) current net worth, plus(ii) the discounted value of future earnings, less (iii) the cost ofcapital, where future earnings and cost of capital are defined perour EVA(b) model.Miccolis [17] describes a computation similar to the one bySturgis to determine an insurer’s economic value: (i) adjustedsurplus, plus (ii) discounted value of future earnings, less (iii)cost of capital. Miccolis, however, is unclear regarding the computationfor the cost of capital.We consider the EVA(a) model to be the preferred structurefor applying the economic value added model. EVA(a) is morestraightforward to apply and avoids potential complications. Itrelies on financial estimates of earnings that are comparable toactual financial projections for a property/casualty insurer. Touse the EVA(b) model, one must attempt to isolate the sourceof earnings between amounts earned from premium written andinvestment income on the capital. This approach further necessitatesan allocation of invested assets between those supportingthe liabilities and assets underlying the capital and surplus.In addition, splitting earnings into its “component” parts raisespotential tax application questions that complicate the valuationprocess.4.1. Accounting4. PARAMETERIZING THE VALUATION MODELInsurance companies in the United States use multiple formsof accounting. Statutory Accounting Principles (SAP) are usedfor reporting to state regulatory authorities and Generally AcceptedAccounting Principles (GAAP) are used for reporting tothe Securities and Exchange Commission and the public. Taxaccounting underlies the computation of taxable income. SAPfocuses on the current solvency of an insurance company and itsability to meet its obligations. Due to this focus on protection