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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 297The COC is used to measure excess returns in each period for theEVA valuation methodology. Excess returns are computed as thedifference between operating earnings in each period (inclusiveof gains and losses in capital that do not flow through earnings)and the COC. This concept is more thoroughly discussed in Sections2 and 3.Economists and other financial professionals equate the termcost of capital with the hurdle rate. Care should be taken inusing and understanding the meaning of the term in a particularcontext.5. RECENT CHANGES AND OTHER CONSIDERATIONSA variety of changes have occurred over the past 15 years thatmay affect the valuation of a property/casualty insurer. Whilemany of these changes may not affect valuation methodology,they are relatively new developments that require considerationin the determination of value.5.1. Accounting 24Codification of Statutory Accounting PrinciplesThe starting point for valuation based on EVA and DCFmethodologies is the statutory balance sheet. One significantchange with respect to the determination of statutory surplus isthe 2001 codification of statutory accounting principles (SAP).With the introduction of codified SAP, there are at least twokey changes that affect statutory surplus for many companies:(i) the treatment of deferred taxes, and (ii) the requirement toestablish a premium deficiency reserve. Both of these changesmitigate the differences between statutory and GAAP accounting.24 One might question why accounting changes should affect value. As statutory earningsand statutory capital influence free cash flows (when either capital can be released from acompany or additional capital contributions are required), accounting changes that affectstatutory income or statutory surplus influence value.