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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 285ital infusions or distributions, but also from (iii) “below the line”adjustments to capital. These adjustments represent items that donot flow through the statutory income statement for changes inunrealized capital gains or losses, changes in nonadmitted assets,changes in provisions for reinsurance, change in foreignexchange adjustment, or changes in deferred income taxes. Tothe extent that these adjustments increase (decrease) the equityof the firm, they also increase (decrease) free cash flows for theDCF valuation methodology and increase (decrease) excess returnsfor the EVA valuation methodology.For a property/casualty insurer, estimating after-tax operatingearnings (including “below the line” statutory adjustments tocapital) typically requires rigorous analysis. For the purpose ofanalysis, the sources of future earnings can be subdivided intotwo broad categories: the runoff of the existing balance sheet andfuture written business.4.3. Runoff of the Existing Balance SheetThe runoff of the existing balance sheet produces earnings associatedwith (i) underwriting profit embedded in the UEPR 20 ;(ii) investment income on the assets supporting (a) the loss reserves(inclusive of all loss, allocated loss adjustment expense,and unallocated loss adjustment expense reserves) and (b) UEPRliabilities until all the associated claims are paid; and (iii) investmentincome on the capital base supporting the runoff of thebusiness. 21The earnings associated with new (or renewal) business derivesfrom (i) the underwriting profit generated by the business;(ii) the investment income on the assets generated by the pre-20 Profit embedded in the UEPR represents underwriting profit and profit associated withthe prepaid expenses (corresponding to the deferred acquisition cost asset established forGAAP accounting).21 For an EVA valuation, if one projects earnings with a capital base of zero (an EVA(b)scenario), this component will be zero.