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

296 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESFor the DCF methodology, capital requirements dictate theamount of capital to be retained in the company to support ongoingoperations, thereby determining distributable earnings andassociated value. For the EVA methodology, capital requirementsdictate the capital that underlies the cost of capital calculation.The higher the capital requirement, the higher the cost of thecapital element of the valuation formula.Property/casualty insurance companies are subject to statutorycapital requirements. Statutory capital requirements are determinablethrough the property/casualty insurance industry’s riskbasedcapital (RBC) requirements. The results can be viewed asminimum capital requirements. Often, larger capital investmentsare required to satisfy the financial rating agencies such as A. M.Best, Standard and Poor’s, and Moody’s in order to maintain desirablefinancial ratings. All of these factors are considerationsin determining capital requirements for valuation.Premium-to-surplus ratios, loss reserves-to-surplus ratios, andmultiples of RBC have been used in valuation to determine capitalneeds. These are typically based on comparable ratios for“peer companies,” which are companies with premium volumeand lines of business comparable to the subject company. In theseinstances, it is essential that the selected capital match or exceedRBC requirements.In actuarial and finance literature, there are many articles andpapers related to capital requirements and capital allocation forinsurers. Theories about capital requirements range from simplisticrules of thumb (e.g., maintenance of a premium-to-surplusratio of 2.0) to intricate risk models. In practice, it is commonfor insurance companies to maintain a level of capital that issufficient for a desired financial rating.4.9. Cost of CapitalWe defined the cost of capital (COC) as the product of thepresent value of each period’s starting capital and the hurdle rate.